Ideas

Behavioral Finance is Dead, Long Live Behavioral Finance

Ancient Grecians believed in geocentricity, the idea that the Earth is the center of the Universe around which all others objects orbit. In classical antiquity, it was widely supposed that the body contained four humors, blood, black bile, yellow bile and phlegm, and that optimal health resulted from an appropriate balance of the four. Maternal Impressionists explained birth defects in children as resulting from negative thoughts from the mother during pregnancy. And phrenology, the practice of making inferences about someone’s character and personality from the shape and contour of their head, was for some time thought to be a legitimate science.

Much as we laugh at these pseudo-scientific anachronisms, I am confident that the time is not far distant that we will puzzle that we ever developed financial models that did not somehow seek to account for the behavior of market participants. In making such a provocative statement, I do not wish to pick on traditional financial models or necessarily to elevate what currently constitutes the burgeoning field of behavioral finance. Rather, I hope to illuminate the ways in which arriving at any sort of truth is an imperfect endeavor and discuss the way in which ideas that begin on the lunatic fringe can sometimes be welcomed into the fold of legitimate scientific inquiry.

Almost since its inception and increasingly with its popularization, proponents of behavioral finance have delighted in dismantling the efficient market machine, gleefully poking holes in this dogma with quirky anecdotes about investor irrationality. For their part, efficient market theorists have given as good as they’ve gotten, criticizing behavioral finance for its lack of theoretical underpinning and inability to consistently improve investment returns. But all of this rhetorical jousting (while fun!), misses the point fundamentally.

Rather than hoping for the death or preeminence of one faction or the other, we ought to be working to combine the findings of both camps in applied ways that positively impacts actual investors, something Dr. Greg Davies calls “behavioralizing finance.” Behavioral finance has a great deal to learn from efficient market theorists about building a comprehensive, rigorous framework of assumptions. Traditional finance could learn a thing or two from the behaviorists about being tentative, respecting the limits of knowledge and safeguarding others’ assets accordingly.

Behavioral finance was born in the ivory tower of academia, legitimized with Daniel Kahneman’s Nobel Prize, popularized by Dan Ariely, Richard Thaler and others who taught us to laugh at and recognize our own financial misbehavior. Oddly enough, the next step in the progression of behavioral finance is an anonymity of sorts, the kind that comes with widespread acceptance and integration. After all, heliocentrism is not an idea anymore, it’s the “way things are.”

My children are six and two and it is my hope that when they attend college there will be no behavioral finance courses offered at their universities. If there are, we will still be mired in the same intellectual turf wars that can keep great ideas from exploring their points of fusion rather than their surface dissimilarities. My hope instead is that they will learn about finance, a complicated, tentative, somewhat messy discipline that their professors approach with some mathematical precision, but would never dream of disconnecting from the people that give it life.