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Did behavioral finance get it wrong?

Posted By Mukul PAL On July 7, 2010 @ 1:49 PM In Trashing Rationality | No Comments

Human beings may not be nice and dumb


Herbert A Simon got the Nobel Prize for economics in 1978 for his research on decision making process within economic organizations. Herbert is considered one of the most influential social scientist of 20th century. A study of history of behavioral finance also cites his 1955 paper “A behavioral model of rational choice” (1955) as the first thought which started it all.

Though the paper starts with the need for a revision of the economic model which assumes that the economic man is rational, has knowledge, computational skills, is well organized with stable system of preferences, can plan alternative courses of action, reach highest attainable point on preference scale but clearly states that the aim of the paper is not to discuss these doubts, or to determine whether they are justified but to think about a revision, a direction towards a better economic model. The author did not mention irrational or ‘not rational’ anywhere in the paper. The author mentions that entities may possess a hierarchy of rational mechanisms and comparing computation (computer) with humans is very difficult, as both may get labeled as a moron in a different situation. This should shock some of the behavioral finance believers who have accepted clichés like “Human beings are nice and dumb” by Terry Burnham (Harvard) and have started to believe that it is more about irrationality than rationality.

Herbert’s bounded rationality is a concept at the soul of behavioral economics. Daniel Kahneman (Nobel Prize winner 2002) proposes bounded rationality as a model to overcome some of the limitations of the rational-agent models in economics. Putting simply bounded rationality suggests that there is never enough knowledge to take decisions and hence the limitations in decision making. Unlike Daniel, Gerd Gigerenzer, a German psychologist argues that heuristics (thumb rules) should not lead us to conceive of human thinking as riddled with irrational cognitive biases, but rather to conceive rationality as an adaptive tool that is not identical to the rules of formal logic or the probability calculus. Gerd suggested that bounded rationality was misinterpreted by behavioral finance.

Did behavioral finance gurus got it all wrong? Did they just over emphasized the limitations of human decision making instead of working on a model as Herbert intended? Was it easier to deal with limitations than work on a rational thought model? Does this prove that fundamentalists are indeed correct in suggesting that behavioral finance is the great story of human errors?

It was not just the fundamentalists but even Gerd who mentioned about the behavioral finance over elaboration of human decision making limitations and the human inability to cope with optimized thinking. Gerd talks about simple alternatives to a full rationalizing analysis and how simple heuristics frequently lead to better decisions than the theoretically optimal procedure. After you read Gerd, heuristics suddenly start to sound better than what behavioral finance made it out to be - just an error.

This is not the first time great ideas have been ignored. Herbert’s initial thoughts on Artificial intelligence were ignored for 7 years. But the paper which I feel has not got its due attention in economics and psychology is the one he wrote in 1962 on the ‘Architecture of complexity’.

In that paper, he said that complexity frequently takes the form of hierarchy. Systems are hierarchic systems independent of specific content. Systems are interrelated at higher and lower levels. There are elementary subsystems. He detailed hierarchical social systems, biological, symbolic, self reproducing systems and even hierarchic structures in social interactions. Complexity had to evolve from simplicity. This was Herbert’s attempt to explain power law distributions (exponentiality in nature). Path of construction of a complex system is through the theory of hierarchy. If time is indeed a triad and hierarchical, we can easily comprehend Herbert’s architecture of complexity.

Can behavioral finance also suffer from bounded rationality? Claiming humans to be irrational when they were the ones who created such great things in the first place (including markets), the irrationality does not seem to add up somewhere. So the few questions for behavioral finance could be linked with the order. Can behavioral finance define and quantify long reversals in markets? Are these long reversals recurring? How different are these long reversals from the subject of time cycles (order) written over the last few hundred years? If investor autonomy is worthless (Benartzi, Thaler), finding Peter Lynch is tough (Hersh Shefrin) how can investors chose between passive index alternatives? Is there an order between passive index performances? Is this performance cyclical? If market success connected to addition and subtraction (Thaler, Lamont) what is the mathematics in long reversals and behavioral finance? We got the idea of irrationality but where is the model of rationality which Herbert proposed? How does behavioral finance change if time is the order Herbert was mentioning?

The Architecture of Complexity
A behavioral model of rational choice

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