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.