{"id":71,"date":"2013-08-10T20:47:00","date_gmt":"2013-08-10T20:47:00","guid":{"rendered":"http:\/\/www.guythomas.org.uk\/blog\/?p=71"},"modified":"2024-11-15T23:15:16","modified_gmt":"2024-11-15T23:15:16","slug":"on-the-limits-of-behavioural-finance","status":"publish","type":"post","link":"https:\/\/www.guythomas.org.uk\/blog\/on-the-limits-of-behavioural-finance\/","title":{"rendered":"On the limits of behavioural finance"},"content":{"rendered":"\n

Behavioural finance is a fas<\/a>hionab<\/a>le<\/a> genre of academic research, and a productive strategy for writing academic papers.  But it was not mentioned as a resource by any of the interviewees in Free Capital<\/em>, and I have never found it much help in my own investing.  There are several reasons for this. <\/p>\n\n\n\n

\u00a0Many explanations, few predictions\u00a0<\/strong>The comprehensive\u00a0m<\/a>enu<\/a>\u00a0of alleged behavioural biases offers an ex-post explanation for almost any decision which hindsight renders sub-optimal. Investors who borrowed money to invest in shares in September 1987 are said to suffer from \u201cover-confidence\u201d; those who failed to do so in March 2009 suffer from \u201cmyopic loss aversion.\u201d\u00a0\u00a0 Investors who respond too quickly to new information overweight \u201cavailability\u201d; those who respond too slowly are \u201canchored\u201d by prior beliefs. \u00a0And so on for every other\u00a0ex-post<\/em>\u00a0mistake. \u00a0<\/p>\n\n\n\n

This descriptive charm and versatility is palatable both to academic story-tellers and casual readers.  But to be scientifically or instrumentally useful, a paradigm needs to make some specific predictions.  Behavioural finance seems more like Freudian psychology: it can be contorted to explain anything ex-post<\/em>, and therefore predicts nothing ex-ante<\/em>. <\/p>\n\n\n\n

\u00a0Poorly defined allegations of \u201cirrationality\u201d<\/strong>\u00a0A common trope in behavioural finance is to document some observed behaviour of investors and assign to this the pejorative label \u201cirrational.\u201d\u00a0 This is an over-used and often unwise epithet, because \u201cirrationality\u201d is usually defined against a facile normative standard. \u00a0\u00a0On closer examination, it usually turns out that all we can say is this: large groups of people who follow the observed action indiscriminately over long periods of time will lose money compared with large groups of people who don\u2019t. It does not follow that all, or even most, instances of the action are individually irrational.<\/p>\n\n\n\n

Data mining and publication bias<\/strong> Any behaviour which can be labelled \u201cirrational\u201d (often dubiously \u2013 see above) against some normative standard is newsworthy and publishable. Null results where people behave \u201crationally\u201d are less exciting, and more likely to be filed in a drawer. <\/p>\n\n\n\n

Signal detection misconstrued as probabilistic inference\u00a0<\/strong>Many behavioural finance articles claim that investors make invalid probabilistic judgments. In the archetypal example, it is said to be a\u00a0\u201cconjunction fallacy\u201d<\/em>\u00a0that Linda, a 31 year-old with biographical data suggesting liberal social views, is \u201cmore likely\u201d to be (a) a bank teller\u00a0and<\/em>\u00a0a feminist rather than (b)\u00a0just<\/em>\u00a0a bank teller.<\/p>\n\n\n\n

But the answer (a) which most people give is not wrong if understood as a socially appropriate response to cues.  This type of response is learnt both in educational settings (did you ever see an exam question where you were not<\/em> expected to “use all the information provided”<\/em>?), and also in everyday life (the social costs of ignoring cues are usually larger than the social costs of over-responding to them). <\/p>\n\n\n\n

The so-called \u201cconjunction fallacy\u201d is generated only because the question is a sort of word-trick: a probability test masquerading as a cue-response test. \u00a0 With only a slight change in the question wording to focus attention on numerical frequencies rather than cue-response, most people give the \u201ccorrect\u201d probabilistic answer (see\u00a0Gigerenz<\/a>er<\/a>).<\/p>\n\n\n\n

Or to put this another way: the “wrong” answer may be probabilistically correct if I interpret the required probability as one conditional on Linda’s liberal social views\u00a0and\u00a0<\/em>the giving of the signal (i.e. the fact that you choose to draw my attention to those views).\u00a0<\/p>\n\n\n\n

Detecting dishonesty is more useful than simulating truth <\/strong>\u00a0Intuitions about truth and falsehood are often more usefully directed towards detecting liars, rather than simulating causal relations.\u00a0 For example, in the \u201cLinda\u201d example above: when considering\u00a0reports<\/strong> of past events, it may be a good heuristic to trust people who provide lots of details, becqause those who do this tend to be truthful witnesses. (This heuristic may invert when considering\u00a0predictions<\/strong> of future events, where people who provide lots of details tend to be charlatans.)\u00a0<\/p>\n\n\n\n

More generally, behavioural finance focuses mainly on failures of cognition and calculation, but largely neglects social phenomena such as trust and deception.\u00a0 An equity investor might reasonably expect the title “behavioural finance” to encompass the study of frauds, stock promotions, and pump & dump operations – all endemic behavioural phenomena in financial markets – but in fact the academic field almost never goes there.<\/p>\n\n\n\n

Few normative prescriptions\u00a0<\/strong>Behavioural finance invites us to gawp at all the foolish mistakes other investors make.\u00a0 This financial freak show is superficially entertaining, but it doesn\u2019t necessarily make us better investors: it doesn\u2019t tell us what to\u00a0do.\u00a0\u00a0<\/em>To catalogue all your biases and then do nothing about them is not humility, it is boasting of your modesty.<\/p>\n\n\n\n

\u00a0Update (16 March 2014): How\u00a0knowing a<\/a>bout biases can hurt you<\/a>.<\/p>\n\n\n\n

Update (11 April 2017): John Kay on the weaknesses o<\/a>f behavioural economics<\/a>.<\/p>\n\n\n\n

Update (12 June 2022): David Deutsch on how to obtain newsworthy results in experimental economics.<\/a><\/p>\n\n\n\n

Update (14 January 2024): A report in the The New Yorker: They studied dishonesty. Was their work a lie?<\/a> A sentence about Dan Ariely which speaks to the conceit of the whole field: “It never seems to have occurred to him that the vanity and disdain behind a certain kind of social engineering – keeping the buffet treats just out of reach – might exacerbate ambient resentments.”<\/em><\/p>\n","protected":false},"excerpt":{"rendered":"

Behavioural finance is a fashionable genre of academic research, and a productive strategy for writing academic papers.  But it was not mentioned as a resource by any of the interviewees in Free Capital, and I have never found it much help in my own investing.  There are several reasons for this.  \u00a0Many explanations, few predictions\u00a0The comprehensive\u00a0menu\u00a0of alleged behavioural … Read more<\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[5],"tags":[],"class_list":["post-71","post","type-post","status-publish","format-standard","hentry","category-investment"],"_links":{"self":[{"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/posts\/71","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/comments?post=71"}],"version-history":[{"count":9,"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/posts\/71\/revisions"}],"predecessor-version":[{"id":565,"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/posts\/71\/revisions\/565"}],"wp:attachment":[{"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/media?parent=71"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/categories?post=71"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/tags?post=71"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}