A Behavioral Perspective of Decision Making Under Risk and Uncertainty

Here is the first part of a paper of mine that is available on the Social Science Research Network. Although the paper is several years old and I do not necessarily still agree with everything I had to say back then, I still stand by by the criticism of neo-classical economics and firmly believe that the manner in which economics is practiced at present makes it at best irrelevant and at worst dangerous and destructive. I do not still think that behavioral economics--that is, adding more "realistic" behavioral assumptions to the neo-classical model in order to allow for irrationality and to explain irrational outcomes-- is the way forward, or even a good program to adopt, adapt and work with. Some of these points can be found in my post on ecological rationality here. But, as I said, the criticism is still valid and therefore I am posting an excerpt from the paper here for anyone interested to peruse.

A Behavioral Perspective of Decision Making Under Risk and Uncertainty

by Doru Lung

Abstract

The global financial crisis that began in 2007 was not predicted by standard economic theory which assumes rational actors, efficient markets and equilibrium. Alternative explanations of economic behavior that are based on psychological regularities which are observed in human behavior were until recently relegated to the fringes of the discourse regarding economic phenomena. It will be argued that this has proven to have been a mistake. Psychology has a long history in economic thought, but its influence on economic theory has ebbed and flowed over the years. Keynes had important psychological insights, but they have not been focused upon sufficiently in the last decades. Since the late 1970´s, though, new theories have emerged that are behavioral in nature. That is, they attempt to explain economic phenomena by being based on empirically observed psychological regularities of human behavior. This paper will show that psychology needs to be taken into consideration when reasoning about economic phenomena. The assumption of rationality that is prevalent in much of economic theory is based on a series of axioms and assumptions that are unrealistic. It will be argued that when reasoning about economic phenomena, that theory should be adopted which has more empirical support. The findings are that adopting a behavioral perspective of decision making has more explanatory and predictive power.   

Keywords: economics, behavioral economics, behavioral finance, behavioral corporate finance, rationality, efficient markets, psychology

Word count: 6675

A slightly different version of this paper formed part of the literature review of my dissertation for the Master of Business Administration degree of the University of Wales, but it has never been published before.

A Behavioral Perspective of Decision Making Under Risk and Uncertainty

by Doru Lung

“However unwillingly a person who has a strong opinion may admit the possibility that his opinion may be false, he ought to be moved by the consideration that however true it may be, if it is not fully, frequently, and fearlessly discussed, it will be held as a dead dogma, not a living truth” John Stuart Mill (Mill 1859 / 2008, p45).

On July 26, 2009 the on-line edition of the Guardian newspaper reported on the response given to the Queen of England by economists after she had asked why no one had seen the credit crisis coming. As reported by the Guardian´s economics editor Heather Stewart, the answer cited “a failure of the collective imagination of many bright people...[a] psychology of denial...[and] wishful thinking combined with hubris.” Nevertheless, Professor Tim Besley of The London School of Economics, one of the signatories of the explanation addressed to the Queen, “denied that economics as a profession had been discredited by the scale of the crisis, but admitted that unconventional ideas - about how herd psychology and bouts of irrationality can grip financial markets, for example - had sometimes received "less play" during the boom years” (Stewart 2009, p1). Less august audiences than the Queen may ask themselves whether it would not perhaps be fruitful to have a look at some of these “unconventional ideas” in order to see whether they have more explanatory and predictive power than the conventional ones.

The global financial crisis that began in 2007 has drawn attention to the academic theories which underpinned most, if not all, regulation and risk management, as well as the assumptions of many financial market actors.  Many observers have asked themselves just how the economist community as a whole seemed to be taken utterly by surprise by the events that eventually unfolded. Some critics, such as Stiglitz (2010) or Akerlof (2010), place partial blame on the efficient markets hypothesis (EMH) and its postulate of  rational behavior on the part of investors. The EMH is accused of not being an accurate description of the behavior of financial markets and for having played a major part in the complacent behavior leading up to the ensuing economic meltdown. The efficient markets hypothesis states “that financial prices efficiently incorporate all public information and that prices can be regarded as optimal estimates of the true investment value at all times. The efficient market hypothesis in turn is based on more primitive notions that people behave rationally, or accurately maximize expected utility, and are able to process all available information” (Shiller 1998, p1). Assuming that people rationally pursue their perceived self-interest and that on average the prevailing market result (price) correctly represents the best estimate of fundamental value given all available information is a powerful theoretical statement which, if accepted unquestioningly, can be used to explain away any mis-allocation of resources, excessive valuation, boom or bust. Unfortunately, trusting "the market" has led to some rather suboptimal outcomes: a quick perusal of any major newspaper will show that the ongoing turmoil in financial markets, the demise of some storied institutions and the bailout of others, the deepest recession since the 1930´s, sovereign debt crises, and millions of jobs lost are just some of the consequences of the boom and bust sequence whose effects are still being felt. "The market" is at any time the sum of the decisions of individuals in the face of risk or uncertainty. Studying how individuals really make decisions, therefore, can provide a better understanding of the functioning of markets and the behavior of investors. In what follows a critical look will be taken at the postulate of rationality in standard economic theory and the efficient markets hypothesis, and evidence of deviations from rationality as posited by standard economic theory from the fields of Behavioral Economics and Behavioral Finance will be presented.   

Not only has the efficient markets hypothesis come under fire, but the standard neo-classical economic model (SEM) has also been accused of having failed for both descriptive as well as normative purposes. Smith (2010), for example, sees academic economics as having given intellectual respectability to the deregulatory movement that led to the subprime crisis, ensuing credit crunch, recession and overall economic turmoil. That standard economic theory is not a good description of reality has not stopped massive amounts of theorizing from being done on the basis of rather unrealistic assumptions. In his The Methodology of Positive Economics Friedman (1953) famously set forth the view that the realism of the assumptions does not matter as long as the predictions generated by the model are useful. This instrumentalist approach, however, is on precarious footing because when reality fails to conform to the model, it is not reality that is wrong. Rabin (2000) counters Friedman´s view by stating that "[c]eteris paribus, the more realistic our assumptions about economic actors, the better our economics. Hence, economists should aspire to making our assumptions about humans as psychologically realistic as possible" (Rabin 2000, p3). Rabin (2000) goes on to say that there is no reason that tackling economic questions should require an economic agent with 100% rationality, 100% self interest, 100% self-control, and many other assumptions that are used in economics but are not supported by the empirical behavioral evidence. Wilkinson (2008) sets forth the view that precision and psychological plausibility should be added as criteria for economic theory in addition to the criteria of congruence with reality, generality, tractability and parsimony. He goes on to show that adding realistic behavioral assumptions to economic theory does indeed fulfill all of the criteria mentioned above, and that the results are supported by empirical evidence. And Hausman reminds us that it is necessary to "look under the hood," that is, to evaluate the assumptions on which theory is based, especially “when extending the theory to new circumstances or revising it in the face of predictive failure” (Hausman 2008, p.185).

Are economic agents truly rational in the sense postulated by economic theory? This is a fundamental question whose answer has serious implications for academics, policy makers and, of course, market participants. The efficient markets hypothesis breaks down when market agents fuel bubbles that to everyone´s consternation eventually burst. Shiller (2002; 2006) shows us that markets are too volatile when compared to any discounted dividend model, and they can deviate from any measure of fundamental value, being prone to bubbles and busts. The huge swings in asset prices in both directions are just one indication that markets are not always efficient and that participants' behavior in the market does not conform to definitions of rationality.  Bromiley (2005) points out that if markets indeed tended toward equilibrium and were efficient and populated by rational agents, then there would be nothing to study since the optimal strategic decision would have already been made. A significant amount of empirical evidence has resuscitated the theory that (to use Keynes's [1936] felicitous phrase) animal spirits play a part in the determination of asset prices (see e.g. Akerlof and Shiller 2009) and has given birth to alternative theories that are behavioral in nature.

For the rest of the paper please go to the Social Science Research Network and download it.

Financial weapons of mass destruction strike again: naked

On October 23, 2008, in the middle of the biggest financial crisis since the Great Depression, Reuters ran an article entitled: “Greenspan says was ‘partially’ wrong on CDS regulation.”

“Former Federal Reserve Chairman Alan Greenspan acknowledged he was "partially" wrong in his belief that some trading instruments, specifically credit default swaps, did not need regulation.

Henry Waxman, the Democrat who chairs the U.S. House of Representatives Committee on Oversight and Government Reform, cited a series of public statements by Greenspan saying the market could handle regulation of derivatives without government intervention.

"My question is simple: Were you wrong?" Waxman said.

Greenspan said he was "partially" wrong in the case of credit default swaps, complex trading instruments meant to act as insurance for bond buyers against default.

"I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders and the equity," Greenspan said.

When asked by Waxman if his ideology pushed him to make bad decisions, Greenspan said he found a "flaw" in his governing ideology that has led him to reexamine his thinking” (Dixon 2008).

CDS is an acronym for Credit Default Swap, a credit derivative that resembles insurance in that the buyer pays a premium to the seller in order to protect against the default of another entity. The purchaser of a CDS may have an insurable interest in the entity on which CDS’s are being written, by being a creditor or a bondholder, for example, which consequently means that a legitimate interest in protection against default exists, and the purchase of CDS’s can be seen as constituting a hedge, or a way of managing risk. In case the purchaser does not have an insurable interest, however, the purchase of a CDS is termed “naked” and constitutes nothing more than speculation that the entity on which the CDS is written will default. In case of default or a credit event the seller of the CDS has to pay the CDS holder the previously agreed upon sum, as stipulated in the contract. So while this may seem to be a fairly straight-forward insurance-type product, the fact that these instruments are traded OTC, or “over the counter,” however, means that no one really knows who has written how many CDS’s, on whom, for how much, to whom they have been sold, or whether there is any money to pay out in case of a default. This last point came into focus quite clearly when American International Group (AIG) had to be bailed out by the US taxpayer to the tune of over $180 billion in large part because they did not have any money to pay out on the Credit Default Swaps they had written (Sjostrom Jr. 2008).  

As reported by the BBC, back in 2003, when the notional amount of the entire derivatives market was only $85 trillion, Warren Buffet famously likened them to time bombs and “financial weapons of mass destruction,” some of which seemed to have been devised by “madmen,” and the whole derivatives industry was similar to “hell... easy to enter and almost impossible to exit” (BBC 2003). While Buffet did not specify CDS’s at the time, by September 2011, when, as reported by The Bank of International Settlements (BIS 2011), the entire derivatives market had swollen to over $700 trillion and the notional amount of Credit Default Swaps outstanding was still $32 trillion, down from $62 trillion in 2007, the Financial Times had no problem running an article titled:”CDS: modern day weapons of mass destruction.” The article by Chapman (2011) cited a paper by Calice, Chen and Williams (2011) which found that “for several countries including Greece, Portugal and Ireland the liquidity of the sovereign CDS market has a substantial infuence on sovereign debt spreads,” meaning that CDS’s could contribute to rising bond yields and thus push up borrowing costs and increase the risk of default by sovereign countries. Faced with contagion in the Eurozone and a possible cascade of defaults, the German government, on whose shoulders much of the cost of bailing out the periphery falls, demanded a ban on “naked short selling” and, especially, “naked” CDS’s as well (Baker and Peel 2011).

In an article calling for a ban on “naked” CDS’s Wolfgang Münchau (2010) noted that a “naked CDS...is a purely speculative gamble [without even] one social or economic benefit [which is something that] even hardened speculators agree on. [Moreover a] universally accepted aspect of insurance regulation is that you can only insure what you actually own [and not] even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss,” especially if you proceeded to light a match to the house or push the boss of a cliff, which, after keeping in mind the findings from above, is what the whole thing amounts to. Greece, Portugal, Ireland, Spain, Italy are all facing ruinous borrowing costs in late 2011 and it is utterly uncertain whether the Eurozone will make it through 2012.

Credit Default Swaps are consequently living up to the moniker given derivatives by Warren Buffett: “financial weapons of mass destruction.” Alan Greenspan, Robert Rubin and Larry Summers refused to consider regulation of CDS’s back in 1997 when Brooksley Born testified before Congress that trading in unregulated derivatives would "threaten our regulated markets or, indeed, our economy without any federal agency knowing about it" (van den Heuvel 2008). They refused, due to the belief noted above that the self-interest of rational economic agents and organizations would be sufficient to prevent the taking on of too much risk and “was such that they were best capable of protecting their own shareholders and the equity.” After admitting that this belief was wrong and that he had found a flaw in his worldview, his ideology, the disciple of Ayn Rand also admitted that: “This modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year” (Andrews 2008). We are still dealing with the fallout and should prepare for worse, as reported by zerohedge, who address the meaning and significance of the derivatives market number reported by the BIS being

the biggest ever reported in the financial world: the number in question is $707,568,901,000,000 and represents the latest total amount of all notional Over The Counter (read unregulated) outstanding derivatives...Indicatively, global GDP is about $63 trillion if one can trust any numbers released by modern governments...

for the six month period ended June 30, 2011, the total number of outstanding derivatives surged past the previous all time high of $673 trillion from June 2008, and is now firmly in 7-handle territory: the synthetic credit bubble has now been blown to a new all time high. Another way of looking at the data is that one of the key contributors to global growth and prosperity in the past 10 years was an increase in total derivatives from just under $100 trillion to $708 trillion in exactly one decade. And soon we have to pay the mean reversion price. 

What is probably just as disturbing is that in the first 6 months of 2011, the total outstanding notional of all derivatives rose from $601 trillion at December 31, 2010 to $708 trillion at June 30, 2011. A $107 trillion increase in notional in half a year. 

There is much more than can be said on this topic, and has to be said, because an increase of that magnitude is simply impossible to perceive without alarm bells going off everywhere, especially when one considers the pervasive deleveraging occurring at every sector but the government. All else equal, this move may well explain the massive surge in bank profitability in the first half of the year. It also means that with banks suffering massive losses, and rumors of bank runs and collateral calls, not to mention the aftermath of the MF Global insolvency, the world financial syndicate will have no choice but to increase gross notional even more, even as the market value continues to get ever lower, thus sparking the risk of the mother of all margin calls: a veritable credit fission reaction.

But no matter what: the important thing to remember is that "they are all hedged" - or so they say, a claim we made a completely mockery of a few weeks back. So ex-sarcasm, the now parabolic increase in derivatives means that when the bilateral netting chain is once again broken, and it will be (because AIG was not a one off event), there will simply be trillions more in derivatives that no longer generate a booked cash flow stream for the remaining counterparty, until at the very end, the whole inverted credit0money pyramid collapses in on itself. 

Because once the whole bilateral netting chain is broken, net becomes gross. And gross market value becomes total notional outstanding. And, to quote Hudson, it's game over. 

Expect to see gross market value declines persisting even as the now parabolic increase in total notional persists. At this rate we would not be surprised to see one quadrillion in OTC derivatives by the middle of next year.

And, once again for those confused, the fact that notional had to increase so epically as market value tumbled most likely means that the global derivative pyramid scheme (no pun intended) is almost over.