Did the ‘homo economicus’ mutate to the concept of behavioural finance and economics?

Table of contents

1 Introduction and academic method

2 Classical theory in the context of new findings
2.1 The evolution of an idea
2.2 Basic observations and methods

3 A new succeeding concept
3.1 Behavioural finance and economics
3.2 Critics on behavioural finance and economics

4 Prospect theory: main findings in human behaviour
4.1 Heuristics
4.1.1 Loss aversion
4.1.2 Gambler's fallacy
4.1.3 Self-serving bias / Self-attribution Bias
4.2 Framing (economics)
4.2.1 Mental accounting
4.2.2 Anchoring
4.3 Anomalies
4.3.1 Endowment effect & status quo bias
4.3.2 Life cycle & inter-temporal consumption
4.3.3 Overoptimism & wishful thinking

5 Conclusion and assessment of the hypothesis

Abstract

List of references

1. Introduction and academic method

Former classic theories mainly strengthened the concept of a ‘homo economicus’^[1], who behaves economical and exceptionally rational in order to get the maximum advantage for himself. However, as some argue this picture supports not the reality since statistics proof^[2] mankind not always behaves rational and economical.^[3]

In the past decades, academic research progressed beyond this theory^[4], which saw the humans as robots, into the concept of behavioural finance and economics. This acknowledges indeed, people are breathing, sweating, pain-avoiding and pleasure-seeking mammals who have another definition of ‘rational’ than e.g. computers.^[5]

For this, laureate Kahneman worked on the question of how economical decisions could be described if there was no rationality expected at all.^[6] In this context, the prospect theory which is assumed to describe people’s economical behaviour better than the traditional theories, was developed. Further on, research was undertaken on heuristics, economical framing and anomalies. It was discovered, e.g., persons who feel not sure in their tasks, often disregard the laws of probability and follow their own rules, rather to weigh all potential risks in a rational sense.^[7]

So, the essay describes the concept of behavioural finance and economics as well as it is going to check, whether the homo economicus has mutated into it or not. However, although there is criticism^[8] on it, the hypothesis is humans are bounded rational and therefore only conditioned able to be described as homo economicus.

To gain more insight, firstly a brief description of the classic theory, observations and of the homo economicus is presented. Later the concept of behavioural finance and economics will be brought in. Secondly main findings in human behaviour will be explained en detail and examples from heuristics, economical framing and anomalies are shown. And finally, a conclusion finalizes the hypothesis up.

2. Classical theory in the context of new findings

As part of applied psychology, economic psychology gains access to all relevant aspects of economical life. Therefore, ongoing research is undertaken on the description, application and prediction of human behaviour in economic contexts.^[9]

Now scientists suggest, the homo economicus probably does not have only a ‘cold heart’, but discipline / self control are overlapped by feelings and hormones. However, individuals are seen as to be goal-oriented, planning and information-processing, but with limited capacity. Therefore, when they have alternatives to choose, they reduce their number and only remaining alternatives are reviewed.^[10]

How scientists came to these findings as well as which implications might follow out of them will be looked at more in depth in the next chapters. On the basis of historical developments and methods, the rise of a new concept can be observed.

2.1 The evolution of an idea

When economical research became more popular in the end of the 17th century, economics were closely linked with psychology. Adam Smith, for example, described the principles of individual behaviour on a psychological basis^[11]. The drift off from psychology started when neo-classical economics reshaped the discipline and gave it an ever more scientific touch. In this time also the concept of the homo economicus was developed and human behaviour was seen as only rational.

Therefore psychology had largely disappeared from economic discussions till the late 1950s. However, some factors led to the theory of behavioural finance and economics.^[12] Expected personal advantages and discounted-utility models began to come up. This in turn forced testable hypotheses to be made about the making of decisions under uncertainty and as well as of inter-temporal consumption.

And during the 1960s and 1970s, in opposition to behaviourist models, cognitive psychology began to describe the brain as an information processing unit. Leading psychologists of this field started to test their favoured models against the traditional economic models of rational behaviour. In 1979 the maybe most important and renowned paper for the development of behavioural finance and economics was written.^[13] This extensively used the techniques of cognitive psychology to explain some of the known anomalies in rational economic decision making.^[14]

2.2 Basic observations and methods

However, the theory of behavioural finance and economics itself was developed on experimental observations and surveys. In addition, the new ‘fMRI’^[15] has been successfully used to figure out which brain-areas are active during the process of economic decision making. New was, that especially the areas that are responsible for emotions then became active; overruling the concept of homo economicus.

Experiments^[16], which aimed to simulate specific market situations,^[17] were seen as being useful to isolate effects of one particular bias. This are systematic changes from the predictions that can be made from a function due to a given response modality (e.g. the assumptions of the phenomena of the homo economicus).

In this regard three mechanisms can be distinguished that bring out biases: (1) social influence, (2) frequency and (3) correspondence.^[18] And regardless where a certain time-constraint comes from, humans are facing always a conflict of two contrary aims: (1) to make a good decision and (2) to make it before a deadline.^[19]

However, observed behaviour over all could be explained in different ways and to test what’s the right one, specific experiments – involving real money! – were designed. Over all, three topics in the concept of behavioural finance and economics are to distinguish^[20]: (1) Heuristics, which assume people often decide on the basis of approximate rules of guess, but not on strictly rational analyses.^[21] (2) Framing: Here it is argued, the way how a question is presented to the decision maker will affect his specific action. And (3) market inefficiencies / anomalies: This tries to explain observed market behaviour, which is neither rational, nor market efficient.

3. The new succeeding concept

Behavioural finance and behavioural economics are two closely related fields. These apply scientific research on social and individual cognitive and emotional biases^[22] to the benefit of improved understanding of economic decision making and how it affects markets, prices and the allocation of scare resources.^[23] The concept is primarily concerned with the rationality of economic players - or its lack.

Some refer to this twin-area of interest still either as ‘behavioural finance’ (mainly for behaviour on financial markets) or as ‘behavioural economics’ (mainly for general economic behaviour). For the sake of ease, and since both combine the disciplines of psychology and economics^[24], nowadays many authors do not distinguish any more. Moreover, both explain why / how people make possibly irrational or illogical decisions and value risks when they spend, save, borrow or even invest money.^[25] In addition, fear and greed are generally speaking seen as the strongest parameters in the failure of human behaviour at certain markets.^[26]

Now the following two sub-chapters are going to (1) describe the concept itself more in depth and moreover (2) are looking at its critics. Both are the basic for the evaluation of the hypothesis in the conclusion chapter later.

3.1 Behavioural finance and economics

Generally speaking, the aim of the new discipline^[27] is seen as to get neo-classical economic theory more realistic and according to the actual behaviour of humans.^[28] However, the assumption of many economists is still that markets reach on the long run rational outcomes despite the irrational behaviour of some participants. Also standard economics assumes each person has certain stably and well-defined preferences, and that these are tried to be maximized rationally. Therefore these economists assume people behave extremely rational, which they do not. Furthermore, human deviations from rationality often are systematic. For this the new discipline relaxes traditional assumptions by incorporating such observable and systematic differences from rationality into the economic standard models.^[29]

How else could massive speculative bubbles such as the Dutch tulip mania in the 17th century, the temporary over-evaluation of stocks in 1929 and 1987, as well as the boost of junk bonds (especially in the Americas; but for different reasons) in the 1980s and, not to mention, the Tech-Bubble at the turn of the millennium be explained?^[30] These occasional scenarios of dramatic wins in value followed by incredible losses are hard to interpret on a rational basis. Therefore psychology and the concept of behavioural finance and economics are seen to help out well.

But how does it come, that humans who are seen as being rational still display limitations and complications? Maybe market-forces, individual learning and evolution leave these qualities irrelevant?^[31] Probably not, since people show such behaviour also in other economical contexts.^[32] Moreover, one can think of bounded rationality, which will be looked at more in depth later, instead. This reflects limited cognitive abilities that constrain the problem solving process of humans. Also bounded will-power might explain why people sometimes decide in a way that cannot be in their long-run interest at all. Further on, some argue these mistakes often are repeated because individuals are not always fully informed.^[33]

To gain broader insight in this, researchers have worked on certain behavioural principles^[34] such as the prospect theory (see later detailed along with some others), cognitive dissonances, anchoring, overconfidence, heuristics and gambling behaviour / speculation, magical thinking (in terms of stock market prognosis e.g. oracle of Delphi and astrology), attention anomalies and global culture.

Most of these boundaries seem be watched nowhere better than on financial markets.^[35] The flood of information leads everyone to try to get at least little understanding of what is going on.^[36] However, like Quixote’s fight against windmills there is hardly any chance to manage all information that’s available. And therefore individuals have to select which causes selective attention – and often leads to self-fulfilling prophecies. A phenomenon that is vital all the time, since it is mostly possible to frame certain decision problems in more than one way. Alternative frames may be compared to alternative perspectives on a visual scene.^[37]

On the basis of behavioural finance and economics the newly developed models are addressed now to particular observed anomalies and to modify standard neoclassical models. They describe humans as using heuristics and being affected by framing effects. Although it seems to be the nature of humans to view these conclusions as just another indication of how dumb everyone, rather one self is, behavioural finance and economics is now a significant part of the economical framework; though it doubts – or at least questions – rational human behaviour.

Nevertheless it was empirically proven people behave consistently irrational,^[38] there is still criticism. Therefore especially the concept of the effective market hypothesis is assumed to give an alternative answer. This however has not shown that the homo economicus has survived, but the new concept even strengthened.

[...]

^[1] Klose (1993), pp173 – Individuals act self-oriented and their action is determined by incentives.

^[2] Fischer (2005), pp69

^[3] Amann (2005), p34

^[4] It is also strongly linked with the efficient-markets theory.

^[5] The reasons therefore are maybe hormones like dopamine and adrenalin from the limbic system.

^[6] As an example, the willingness of consumers to drive long distances for a rebate on relatively cheap products – but not for more expensive ones (!) – was brought up.

^[7] Later this will be introduced as ’heuristics’.

^[8] The most popular alternative might be, amongst others, the effective market hypothesis.

^[9] Fischer (2005), pp69

^[10] Westhoff (1989), p191

^[11] This is ‘The theory of moral sentiments’. He described a fight between passion and observing.

^[12] Hogarth/Reder (1986), pp12

^[13] Kahneman/Tversky (1979), pp263 to 291

^[14] Hogarth/Reder (1986), pp14

^[15] Fischer (2005), pp69 – The functional Magnetic Resonance Imaging monitors brain activities.

^[16] Fischer (2005), pp69 – e.g. the ultimate or trust game; however, the question of trust and fairness came in when the game was repeated as well as the question of a social environment.

^[17] Auctions and the stock market for example.

^[18] Roth/Upmeyer (1989), p225

^[19] Schürmann (1995), pp36

^[20] Shefrin (2002), pp67

^[21] Also: cognitive biases and bounded rationality

^[22] Heuer (2004), p47

^[23] Camerer/Loewenstein (2002), pp37

^[24] Shefrin (2002), pp21 - Behavioural finance is seen as the study of how psychology affects financial decision making and financial markets and it is a growing area of psychological interest.

^[25] Heuer (2004), p47

^[26] Amann (2005), pp39

^[27] For this research, Daniel Kahneman won himself the Economics Nobel prize in 2002.

^[28] Many argue this is evolutionary: In earlier days there was hardly time for rational calculations.

^[29] Rabin (1998), pp11 to 46

^[30] In these entire scenarios one could find certain assets that gained up to 1,000 percent or even more, but later lost also more than 90 percent – both without any fundamental and rational reason.

^[31] Goldberg/Nitzsch (2000), pp259 and also pp273

^[32] Barber/Odean (1999) - E.g. two mistakes investors often make: excessive trading and the tendency to disproportionately hold losing investments while selling winners. These systematic biases seem to have their origins in human psychology. The tendency for human beings to be overconfident causes the first bias in investors, and the human desire to avoid regret prompts the second.

^[33] Goldberg/Nitzsch (2000), pp25

^[34] Shleifer (2000), pp19

^[35] This is the reason why most examples in the essay rely on / link with this financial topic.

^[36] Goldberg/Nitzsch (2000), pp10

^[37] Kahneman/Tversky (1985), pp25

^[38] Kahneman/Tversky (2000); pp2