Academic theory

Behave yourselves!

This article will skim the surface of a subject that is worthy of many a PhD thesis – the behavioral aspects of financial markets. I believe it is essential that investors consider the human aspects of investment markets when undertaking analysis and making decisions. Investment portfolio management could seem like a matter of data and applied mathematics but to limit one’s judgements to a purely quantitative approach would be a serious mistake.

The behavioural aspects of finance is a topic that has interested me sufficiently for me to have even started an Open University degree in Psychology some years ago (a mistake as it very quickly became apparent that it would take years of studying stuff of no interest at all to get to the ‘meaty’ bits’). Much of what I will now present comes from thinking presented in books or articles published in the last 20 or 30 years, plus video lectures and even one live talk by Professor Robert J Shiller, one of the founding fathers of the concepts of behavioral finance, but a man who clearly keeps up with new developments too.

This being a blog, I don’t want to get too formal, but I will mention one or two sources in case any reader is interested in acquiring a wider and more professionally presented understanding of the topics I will really only be able to introduce.

In case you think I am being lazy or careless, note that I will use the UK spelling of ‘behavioural’ but some quotations will be from the USA and will have the American spelling.

Definition and context

In the best tradition let’s start by narrowing down the subject under discussion.

Robert Shiller himself uses these words in his 2003 Yale University paper ‘From Efficient Markets Theory to Behavioral Finance’:

‘finance from a broader social science perspective, including psychology and sociology’

and further adds that:

‘it stands in sharp contradiction to the efficient markets theory’

The latter point is important because academic theory about how investment markets worked had matured after WW2 around the idea of what was still being called ‘modern’ portfolio theory when I studied it in the 1980s and 1990s even though the basic concept earned its creator a Nobel prize in the 1950s! It is also commonly generalised as ‘efficient markets theory’, as in Shiller’s words above..

By the 1970s a good deal of academic work had been done around the concept of the Capital Asset Pricing model (CAPM) which is the core (and surprisingly simple) calculation model of the efficient markets valuation model and although by the late 1970’s another famous business finance specialist, Eugene Fama, had noted some apparent anomalies that did not support the ‘efficient market’ idea, the general reaction of academics in the 1980s and 1990s was to develop bolt on additions (extra models and formulae) and it was not until the end of the millennium that the alternative idea of behavioral finance started to gain traction, with Richard Thaler and Robert Shiller being in the vanguard.

A general introductory discussion

Shiller argued from the start that the idea that markets worked on the basis of the participants being rational at all times and also being in possession of all necessary information to make trading decisions (as in what we might call an efficient developed Western market) was simplistic, and almost anyone could casually observe that at least some of the time, humans operating in investment markets behaved – well, like humans!

Most readers will be familiar with the granddaddy of all overblown non-sensical trading or ‘bubble’ markets, the tulip bulb boom of the late 1630s and the eventual bust of 1643. Plenty of other ‘bubbles’ are documented, but no-one was running Excel in 1643, so much of the evidence is not in a form that would satisfy modern academics.

I personally can find evidence of irrational human attitudes and behaviour relating to money and finance, including attitudes to equities and bonds and other credit instruments, throughout the great Victorian novels by the likes of Dickens, Thackery, Trollope (who was a well-qualified business commentator) and Eliot (whose research is impeccable). In fact, it was English Literature, not economics or finance studies that first triggered my interest in the real inputs of the average human being into financial decision making. Even the wealthy Mr Darcy of Jane Austin’s 1813 novel was ranked according to how much income (the enormous amount for the time of £10,000) he was getting from the money he had ‘in the 3 per cents’.

Perhaps the most obvious non-expert but manifestly true observation of irrational human behaviour that leads to catastrophic consequences is the evergreen success of Ponzi schemes, of which there have doubtless been many thousands, even though I can only immediately recall the really mega sized ones, like Bernie Madoff and Allen Stanford. There will be Ponzi schemes running somewhere in the world at this moment, probably based on crypto scams.

A review of the case files of the UK Financial Ombudsman Service would soon reveal a number of smaller UK cases. A wry aside is that (according to one source) in the 1990’s Ponzi schemes in Albania accumalated notional assets equal to around 50% of the country’s annual GDP! in UK terms that would be around £1 trillion!

In such cases, thousands of often well-educated people invest in organisations that are offering returns that are apparently better than everything else in a developed market, with a claimed ‘no-risk’ strategy. That is so patently irrational that there must be another explanation as to why people fall into the trap that does not assume the investors are logical people in possession of all the facts!

In essence the fact that Ponzi schemes have worked and keep working suggests that people investing money are not always interested in being in possession of all the facts and human behaviour is often far from rational when it comes to money.