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.

Towards Ecological Rationality

Economics as a discipline has detached itself from both psychology and political philosophy in an unfortunate turn of events that has led what used to be known as political economy to become an exercise in obfuscation through mathematics. By assuming what was supposed to be proven, and by blurring the lines between descriptive and normative theory, economics as it is currently practiced has become increasingly irrelevant to the description of the interaction of people going about their business. By forgetting that the economy is in the end comprised of people and instead hypothesizing a rational representative agent economics has assumed away that which it is supposed to describe and explain.

The problem is that economics divorced from political philosophy and psychology has been the cause of much mischief and suffering. It was thought that self-regulating efficient markets populated by rational economic agents pursuing their own interest would ensure the best possible outcome for everyone. But this Panglossian “invisible hand” was invisible precisely because it was not there. Ask Alan Greenspan, who, when asked by US congressmen why the crisis was not foreseen, admitted to finding a flaw in his worldview, his ideology (Andrews 2008). Four years on and the Global Financial Crisis is arguably still ongoing. Part of the blame can be laid squarely in the lap of neo-classical economics, which became obsessed with physics envy in its use of mathematics yet all the while almost obsessively ignoring psychology and real people. This unfortunate state of affairs needs to be rectified and getting rid of the rational representative agent with his well-ordered, transitive preferences is a first step. .

When the student of psychology is first confronted with the idea espoused in standard economic theory that people (or economic agents as they are called) are rational, have well defined preferences, take into account all relevant information in forming their preferences and making decisions, make decisions that maximize their utility (with utility being a catch-all phrase for anything someone perceives as good), and take into consideration only their own well-being when forming preferences or making decisions; well, then the student of psychology must first ask him- or herself whether this is a normative or a descriptive theory; second, whether this behavior being perceived as normative is something to be desired; and, third, if this behavior is also supposed to be descriptive, then beings of which planet, exactly, are being described.

That economics needs to do some soul-searching is not necessarily well accepted in the academic discussions about economic theory. Some accept as normative the rationality posited in economics and point out that human decision makers deviate from this posited rationality in a systematic and predictable manner; others claim that the deviations from rationality that are observed and discussed in much of the behavioral literature are either: a) artifacts of the population; b) artifacts of the (tricky) methodology used; c) not important because irrational actors are driven from the market by rational actors so that only rational outcomes prevail; or, d) not important because the rationality posited in economics is neither normative nor descriptive but rather a methodological stance. These disagreements are fundamental and irreconcilable but not necessarily the only two ways of looking at the issue at hand.

The heuristics and biases approach to decision making that has developed around the work pioneered by Daniel Kahnemann and Amos Tversky seems to accept as normative the rationality posited in economics while aiming to provide a better descriptive theory of decision making by pointing out that humans are loss averse, susceptible to anchoring or framing effects, affected by the representativeness bias, and in general do not make decisions in a manner that conforms to the rationality posited in economic theory because they are prone to deviate from this rationality due to an extended list of heuristics and cognitive and behavioral biases that lead to sub-optimal outcomes. This school of thought has blossomed into the relatively new field of behavioral economics, with the application of the insights gleaned therefrom leading to the even newer fields of behavioral finance and behavioral corporate finance. These disciplines aim at providing the theories of economics and finance with more realistic behavioral foundations by utilizing more realistic assumptions about the behavior of economic agents. That is, behavioral economics accepts as normative economic rationality but argues that because it is unrealistic descriptively better assumptions about how people behave are needed. While the finding that “people are sometimes irrational” may not strike one as being too profound, it is a mark of progress that has been achieved only after decades of argument.

The reason why behavioral economics was slow to catch on at first is because economic theory was under the spell of the representative rational agent. Standard neo-classical economic theory is based on a series of special assumptions. If the assumptions of the standard economic model were true, then there would be no need for any further psychological research since: “economic agents are rational, economic agents are motivated by expected utility maximization, an agent´s utility is governed by purely selfish concerns, in the narrow sense that it does not take into consideration the utility of others, agents are Bayesian probability operators, agents have consistent time preferences according to the discounted utility model, [and] all income and assets are completely fungible" (Wilkinson 2008, p5). These assumptions might strike one as being somewhat unrealistic but in his The Methodology of Positive Economics Milton 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 became known as the “as if” approach. That is, it does not matter whether people actually behave in the manner postulated or whether the assumptions made are realistic since if the results in the aggregate fit the hypothesis, then it can be assumed that people have to behave “as if” they were only rationally pursuing their enlightened self-interest (that is, by taking into account all available information in order to arrive at the decision that most maximizes their subjective expected utility), because if they did not, then they would be driven from the market by rational agents who did indeed behave in the manner dictated by standard economic theory.

Berg and Gigerenzer (2010) raise a fundamental question that not only undermines behavioral economics’ claim of greater psychological realism but neo-classical economics’ normative claim of rationality and selfish expected utility maximisation as well: Is there any evidence that people who behave rationally in the economic sense do better than those who do not behave in a manner that conforms to the rationality of neo-classical economics? In addressing this question they point out that “[t]he discussion of methodological realism with respect to the rational choice framework almost necessarily touches on different visions of what should count as normative.  It is a great irony that most voices in behavioral economics, purveyors of a self-described opening up of economic analysis to psychology, hang on to the idea of the singular and universal supremacy of rational choice axioms as the proper normative benchmarks against which virtually all forms of behavior are to be measured.  Thus, it is normal rather than exceptional to read behavioral economists championing the descriptive virtues of expanding the economic model to allow for systematic mistakes and biased beliefs and, at the same time, arguing that there is no question as to what a rational actor ought to do” (Berg and Gigerenzer 2010, p23). Furthermore, what they call the tension between “descriptive openness and normative dogmatism” is interesting precisely because “almost no empirical evidence exists documenting that individuals who deviate from economic axioms of internal consistency (e.g., transitive preferences, expected utility axioms, and Bayesian beliefs) actually suffer any economic losses” (Berg and Gigerenzer 2010, p24). Most importantly, then, neither do those who deviate from rational choice theory earn any less money, nor are they any less happy or live shorter lives. This most important finding has been overlooked or disputed for too long.

Berg and Gigerenzer thus point the way towards an ecological rationality that is not only more realistic than rational choice theory but also more human. According to Rieskamp and Reimer (2007, p1) “[h]uman reasoning and behavior are ecologically rational when they are adapted to the environment in which humans act. This definition is in stark contrast to classical definitions of rationality, according to which reasoning and behavior are rational when they conform to norms of logic, statistics, and probability theory.” Thus, according to this definition, behavior is rational if it suits the purpose at hand, with the normative aspect of neo-classical economics’ rational choice theory being dispensed with, and no further sleep being lost worrying whether preferences are ordered or transitive.    

Instead of accepting as normative rational choice theory and simply characterizing the manner in which people actually make decisions as anomalies or biases a movement towards ecological rationality would mean, then, that a new standard of rationality of correspondence or fit between the demands of the situation and the behavior of the person would be set, and this new standard of rationality is not only computationally and thus energetically parsimonious, but also evolutionarily plausible and probable. By taking into account philosophy -- what is rationality -- and psychology -- how do people actually behave -- economics as a discipline will no longer be an exercise in mathematical obfuscation but will once again concern itself with people going about their business, its original intent.

References

Andrews, Edmund L. (2008). ‘Greenspan Concedes Error on Regulation’. The New York Times October 23, 2008. Available at: http://www.nytimes.com/2008/10/24/business/economy/24panel.html [accessed May 28, 2010]

Berg, Nathan and Gigerenzer, Gerd (2010). ‘As-If Behavioral Economics: Neo-Classical Economics in Disguise’ History of Economic Ideas, Vol. 18, No. 1, pp. 133-166, 2010. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1677168 [accessed May 28, 2010]

Friedman, Milton (1953). ´A Methodology of Positive Economics´. Ch. 7 in Hausman, Daniel M. ed.  (2008). The Philosophy of Economics: An Anthology, 3rd edition. New York, NY: Cambridge University Press

Rieskamp, Jörg and Reimer, Thorsten (2007). Ecological Rationality. Max Plank Institute for Human Development, Berlin, Germany. Available at:
http://web.ics.purdue.edu/~treimer/Rieskamp_Reimer_2007.pdf [accessed May 28, 2010]

Wilkinson, Nick (2007). An Introduction to Behavioral Economics: A Guide for Students. New York: Palgrave Macmillan