Behavioral Economics and Finance

A burgeoning field within the economics discipline concerns itself with consumer psychology. As such, the field of behavioral economics and finance employs a broad array of tools and methods to create a substantial composite of the consumer. Such an illustration is critical as it aids economists, financial professionals and policymakers to implement effective approaches and responses to problems within a system. This paper takes an in-depth look at the growing field of behavioral economics and finance and its significance for the overall study of economics.

Keywords: Framing; Heuristics; Prospect Theory; Representativeness; Utility

Behavioral Economics & Finance

Overview

The esteemed political economist and writer Peter Drucker once said "A business exists because the consumer is willing to pay you his money. You run a business to satisfy the consumer. That isn't marketing. That goes way beyond marketing" ("Building brands," 2009).

The most significant "x-factor" in an economic system is the behavior of the consumer. How he or she acts or reacts in a given situation is arguably the key to determining a business's best course of action. It is for this reason that economics looks to understand consumer behavior as part of its pursuits.

For generations, the approach to understanding consumer behavior in economics has been somewhat limited, due scientific dependence upon modeling and "real time" assessments. Such a conservative approach has led to a lack of information regarding consumer mindsets and also on how consumer behavior impacts the economic system in question.

A burgeoning field within the economics discipline concerns itself with consumer psychology. As such, the field of behavioral economics and finance employs a broad array of tools and methods to create a substantial composite of the consumer. Such an illustration is critical as it aids economists, financial professionals and policymakers to implement effective approaches and responses to problems within a system. This paper takes an in-depth look at the growing field of behavioral economics and finance and its significance for the overall study of economics.

The Development of a New Sub-Discipline

Behavioral economics and behavioral finance are terms that apply to a field of study that involves the application of social and human cognitive and emotional patterns for the purposes of understanding economic decisions and how they impact market prices, returns and resource allocation ("What is behavioral economics?", 2005). Behavioral economics is combines the disciplines of psychology and sociology within an economic framework.

Because it entails the application of varying degrees of other scientific fields, a great deal of debate continues regarding the origins of behavioral economics. In the view of many observers, iconic economist Adam Smith was perhaps the first to see "psychology as part of decision-making," according to business professor Nava Ashraf, adding, "He saw a conflict between the passions and an impartial spectator" (Lambert, 2006). Regardless of the founder of this increasingly relevant field, the fact that many applications of behavioral economics in recent history have coincided with major changes in economic conditions is undeniable.

In the mid-19th century, for example, the introduction of the concept of social insurance (like Social Security) in Chancellor Otto von Bismarck's Germany represented a major change in economic systems. Such programs were implemented in large part to counter the growing socialist and communist movements in Europe. They also heralded a new order of government-managed financial assistance programs which transformed bureaucratic institutions and administrative budgets. At the same time that Bismarck introduced these programs, Germany saw an increase in the number of university departments and research institutions that were dedicated to studying the social aspects of economics. It was believed that the idea of social insurance programs originated not in economic policymaking circles but by non-academic social activists. Therefore, the study of the forces that created such programs would require methodologies and disciplinary applications from outside of the economic sphere, such as sociology, political science and psychology (Shiller, 2005).

Prospect Theory

The application of psychology and other non-economic disciplines to the study of economics has continued to develop for more than a century. One of the most prominent manifestations of this field of study came in 1979, when psychologists Daniel Kahneman and Amos Tversky introduced the "Prospect Theory." With this theory, Kahneman and Tversky offered a critique on the inability of mainstream economic analysis to accurately account for consumer decision-making behavior. Specifically, they noted that people tend to underweigh outcomes that are based on probability (as opposed to certain outcomes) in risk situations. In this capacity, value was assigned to gains and losses, rather than the conventional approach, which assigned value in terms of final assets ("Prospect theory," 2008). Their theory represented a milestone in the burgeoning field of behavioral economics and finance.

The evolution of behavioral economics and finance has indeed progressed alongside the ever-changing economic landscape; it is to the fundamental elements of this growing field of economics that this paper will next turns attention.

Heuristics

At the center of behavioral economics is the notion that neoclassical economics falls short of fully explaining consumer behavior. Neoclassical economics has long dominated microeconomics, focusing on supply and demand frameworks (such as pricing, output, profits and income distribution). However, it also relies heavily on assumptions that the actors involved in a given study are going to act in a rational manner in order to create the maximum utility (value derived from choice). Such themes are evident in utility theory, which is often used to explain decision-making in situations with risk and explicitly outlined probabilities ("Utility theory," 2009).

Behavioral economics does not necessarily dismiss utility theory — rather, it compliments it with an additional perspective. By adding the psychological concept of heuristics (a method used to rapidly come to a conclusion based on the probability of an optimal solution), behavioral economists believe a more comprehensive picture of the consumer's decision-making may be presented. In essence, heuristics involves so-called "rules of thumb" rather than in-depth, case-by-case analysis.

Heuristic decision-making processes entail biased judgments. In other words, past experiences or conditions that are either familiar or imaginable to the individual are seen as influences on the decision being made. In fact, people often overestimate the likelihood that past events and experiences will occur again (or have occurred prior to the decision), which will in turn create more biases in the decision-making process. In financial investments, such judgments may be critical to how the individual proceeds with his or her money.

Heuristic decision-making also often involves "representativeness." This term applies to judgments by individuals of conditional probabilities that are based on how the data or sample represents the existing hypothesis or classification (Camerer & Lowenstein, 2002). For example, an individual who is operating from the hypothesis that a student fits the profile to attend a certain class might glean a set of generalities about that class and affix them to the student's profile.

Like other forms of heuristics, representativeness does not necessarily provide wholly accurate information about a concept — however, what is important for the purposes of this paper is the fact that such a thought-process creates a short-cut methodology for individuals to make decisions on how they might proceed in a given economic situation. These "short-cuts" may in fact diverge from rational consumer behavior and create inconsistencies in terms of the outcome of a given transaction or series thereof.

Framing

In an ideal situation, an individual bases his or her decisions on the information that is manifest. In other words, the individual simply takes account of the data presented and acts based on that information. Of course, such ideal situations are rarely part of reality. Instead, data and information is both presented and perceived — this latter term suggests that the individual making the financial decision may experience bias due to the way in which the information is presented. This fact is demonstrative of another element of behavioral economics and finance, one that often proves integral in the manner by which individuals make their financial decisions: Framing.

In economic terms, framing can be defined as the manner by which a rational choice problem is presented. Framing looks beyond the rational and seeks to understand the perception of the individual, providing once again a more comprehensive illustration of the mindset of the consumer.

In retirement planning, for example, framing appears to play a role in individual savings. In a recent study, two approaches to an employee retirement plan were examined. On one hand, employees were told that they would have to make a "positive election" to join the company's 401(k) plan. On the other hand, employees were automatically signed up for the plan at a given participation rate with the ability to opt out of the program. The two ways by which this plan was presented showed a significant difference in terms of the amounts participants saved. Those who were told that they were required to opt into the program saved very little for the program. However, those who were simply enrolled at the company rate invested significantly more. One company saw plan participation rates skyrocket from 37 percent to 86 percent among new hires under the automatic enrollment. The clear divide in response between this framing suggests that workers are not particularly firm in their retirement planning behavior, and that the way in which options are presented may make a difference in how much an individual saves (Mitchell & Utkus, 2006).

By understanding the impact framing has on the consumer, the economist develops a better grasp of the individual's decision-making process. Indeed, framing is neither a fully rational nor logical type of behavior — in fact, it may be argued that it is largely based on sensitivity or emotion rather than rationality. However, taking framing into account helps an economist to better develop a profile of the consumer and aids businesses and leaders in the implementation of effective policies.

Market Anomalies

As stated earlier, behavioral economics and finance was borne of the view that the traditional notion of economics — a system that operates based on rational behavior — was too rigid to account for an assessment of certain anomalies. Thus far, this paper has focused on one side of the equation regarding such behavioral anomalies — the consumer. However, behavioral finance and economics concurrently reviews the economic system which is built, maintained and even undone as a result of consumer behavior: The market. It is to this area of the economy that this paper next turns attention in order to illustrate the field of behavioral economics.

Behavioral economics and finance has evolved as a response to irrational behavior among economic players. However, there are anomalies that occur in the marketplace that would suggest irrational behavior within the system itself. In the late 1970s and early 1980s, several scholarly works pointed to apparent inconsistencies between market prices and economic conditions. One suggested that an apparent illusion of inflation resulted in the undervaluation of the stock market. A similar claim was made regarding bond prices, suggesting that the realities of the economic landscape simply did not correspond with the resulting price.

The imbalance between the climate and market conditions has led to a reinvestigation of the traditional concepts of market efficiency. Some economists assert that this imbalance is caused by investors who take advantage of market inefficiencies so as to yield higher returns. These traditionalists suggest reviewing the returns as a method for pinpointing and correcting market inefficiencies. However, a 1993 study concluded that while this approach may remove some irrational behavior from the markets, it will not correct fundamental inconsistencies (Summers, 1993).

Prospect Theory

A useful analytical tool in this arena is the aforementioned Prospect Theory. Whereas traditional utility in economics has been measured by market returns, Prospect Theory focuses on the separation of gains and losses as definitive of utility. This practice provides a more comprehensive illustration of the consumer's trading behavior which permits investors to make decisions concerning risk on a case-by-case basis. In addition, Prospect Theory allows investors to combine high- and low-risk situations and assess the overall portfolio before proceeding.

In terms of market anomalies, Prospect Theory is of particular use in analyzing the behavior of market agents (those who make market transactions on behalf of the investors). According to a 1998 study on stock market trading and a 2001 study on housing transactions (both of which employed Prospect Theory in their evaluative approaches), investors treat each asset on a separate basis, weighing losses and gains and making decisions on risk aversion and acceptance appropriately. The resulting profile of investor behavior within the marketplace is therefore more complex than the traditional, return-based analysis of investor behavior (Pesendorfer, 2006).

Prospect Theory has come under some criticism, however, due to the sheer complexity of the profiles it creates. For example, the reference point by which utility is determined is somewhat nebulous, since it focuses on a set of gains and losses rather than a final, fixed figure. Still, in light of ongoing market inconsistencies in an era of economic flux, more careful analyses of how investor behavior affects markets (and vice versa) continue to generate interest in economics and finance.

Behavioral vs. Neoclassical Economics

Behavioral economics and finance developed from a perceived need to provide greater answers about consumer decision-making and how it affects the overall economy. However, there remains a debate as to the usefulness of applying psychological concepts to the field of economics.

The example of market anomalies described earlier in this paper provides one such area of controversy. The fact that much of this growing field focuses not on the outcomes of such decision-making but rather the risks and gains makes the process and its assessment somewhat difficult. Without conclusive evidence that such a focus provides insight on neoclassical utility analysis, traditionalists suggest that behavioral economics may not be of value in dealing with systemic inefficiencies.

This debate may not be concluded without mentioning the successful application of behavioral finance and economic tenets to fiscal policy. Behavioral concepts have been useful for the development of legal business contracts, as they allow consumer mindsets to be better understood and supported. As one study indicates, "the success or failure of the behavioral challenge will be judged by its ability to improve upon neoclassical economics — both descriptively and prescriptively — in specific legal applications" (Bar-Gill & Epstein, 2007-2008). Until greater clarity can be applied to the conclusions of behavioral economics as a compliment to neoclassical finance, the debate for or against its utility will likely continue.

Conclusion

The American author Dale Carnegie once advised, "When dealing with people, remember you are not dealing with creatures of logic, but creatures of emotion" ("Dale Carnegie quotes," 2009). Indeed, in virtually every facet of life, humans demonstrate the propensity to behave both logically and emotionally. Quite often, however, these two types of behavior are significantly divergent from one another.

Throughout its long history, the science of economics has proceeded from the standpoint that the system it studies adheres to a logical, rational mentality. Within this framework, economists conclude that markets and systems operate based on rational behavior that pursues maximum utility. This assumption in many ways discounts consumer behavior because it is not always manifested in this logical manner.

Since the late 19th century, as market economies have developed and flourished, it has become increasingly clear that the consumer is a more complex element than previously assumed. Although Adam Smith would make such assertions more than a century prior, interest in consumer decision-making and behavior became more relevant as social welfare programs became more commonplace. Kahneman and Tversky's Prospect Theory of the late 1970s was arguably one of the most significant contributors to the development of the subdiscipline known as behavioral economics and finance.

As this paper has demonstrated, behavioral economics and finance has evolved not as a replacement of neo-classical economics but as a complement thereto. By employing psychological techniques to the study of economic and financial systems, behavioral economics helps cast a light on irrational consumer decision-making and behavior.

Shown above, the study of heuristics, framing and market anomalies can help the economist create a more complete profile of consumer behavior. Adherents to the field of behavioral economics assert that understanding the basis of irrational consumer behavior not only aids business development but government policymaking as well; particularly during times of economic recession and/or market flux.

Debate continues as to the relevance of the application of behavioral economics in the study of economic systems. In particular, while the field does raise interesting questions about irrational consumer decision-making, it often falls short of contradicting the conclusions of neo-classical economic analysis. Nevertheless, behavioral economics and finance does provide important insight into the mechanics of economic systems; analyzing the relationship between the market and the rational and irrational human elements that play a major role therein.

Terms & Concepts

Framing: In behavioral economic terms, the manner by which a rational choice problem is presented.

Heuristics: Psychological method used to rapidly come to a conclusion based on the probability of an optimal solution.

Prospect Theory: 1979 theory serving as a critique of the inability of mainstream economic analysis to accurately account for consumer decision-making behavior.

Representativeness: Judgments of conditional probabilities that are based on how well the data or sample represents the existing hypothesis or classification.

Utility: Value derived from choice.

Bibliography

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Lambert, C. (2006, March/April). The marketplace of perceptions. Harvard Magazine. Retrieved April 4, 2009, from http://harvardmagazine.com/2006/03/the-marketplace-of-perce.html

Mitchell, O.S. & Utkus, S.P. (2006). How behavioral finance can inform retirement plan design. Journal of Applied Corporate Finance, 18, 82-94.

Pesendorfer, W. (2006). Behavioral economics comes of age. Journal of Economic Literature, 44, 712-721. Retrieved April 6, 2009, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=22285123&site=ehost-live

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Suggested Reading

Chuvakhin, N. (2002). Efficient market hypothesis and behavioral finance — is a compromise in sight? Graziadio Business Report, 22. Retrieved April 8, 2009, from http://ncbase.com/papers/EMH-BF.pdf

Driscoll, J. C., & Holden, S. (2014). Behavioral economics and macroeconomic models. Journal of Macroeconomics, 41, 133–47. Retrieved November 17, 2014, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=97335499

Hoje, J. & Kim, Dong Man. (2008). Recent development of behavioral finance. International Journal of Business Research, 8, 89-101. Retrieved April 8, 2009, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=35793508&site=ehost-live

Michaud, R.O. (2001, September). The behavioral finance hoax. Inquire UK. Retrieved April 8, 2009, from http://www.behaviouralfinance.net/introduction/Mich01.pdf

Ritter, J.R. (2003). Behavioral finance. Pacific-Basin Finance Journal, 11, 429-437. Retrieved April 8, 2009, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=10571083&site=ehost-live

Shefrin, H. (2002). Beyond greed and fear. Oxford: Oxford University Press. Retrieved April 8, 2009, from Google Books. http://books.google.com/books?id=hX18tBx3VPsC&printsec=frontcover

Shleifer, A. (2000). Inefficient markets. Oxford: Oxford University Press. Retrieved April 8, 2009, from Google Books. http://books.google.com/books?id=mGjStFEi2kQC&printsec=frontcover

Special report: The behavioral economy. (2008, October 23). Gallup Poll Briefing, 1. Retrieved April 8, 2009, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=35118452&site=ehost-live