Classical economics begins with a central assumption that all people everywhere are rational. However, one of the chief problems with rationality is that it is relative. Rationality assumes that people consciously establish and verify all the facts of a given situation and use logical assumptions to arrive at a conclusion. Not only that, they revise their beliefs in the light of new evidence. If one were to look at the political discussions around the world today, it is very easy to understand that the world is anything but completely rational. Let us take an example. If we think that rational people always act in their own self-interest so much so that they optimize their behavior to the overall society, then we end up calling purely selfish people “rational.” On the other hand, if we consider people who give up their self-interest for the larger welfare of society, then people who optimize for their benefit as “irrational.” That is why classical economics cannot explain all economic behavior.
In his 1759 book The Theory of Moral Sentiments, Adam Smith introduced the concept of the invisible hand. This concept implies that if everyone were to act in their own self-interest, then the unintended consequence of these actions would be a social benefit in the form of an equilibrium where demand equals supply. This is the fundamental concept underpinning laissez-faire economic policy which postulates that the market, which is nothing but a crowd of people, will naturally reach equilibrium without government interference. It must be clarified that Smith used the term in the narrow sense of a businessman investing in a domestic economy to protect his own capital even though he may earn a higher return in a foreign market. Once again, the concept of the invisible hand illustrates the dilemma of defining an action as “rational.”
In 1960, Nobel Prize-winning economist Eugene Fama put forth a ground-breaking theory–the Efficient Market Hypothesis (EMH). The EMH states that markets are efficient and stock prices instantly reflect all available information. In other words, the wisdom of the crowd prevails and the crowd arrives at the correct valuation of a stock almost instantly. There are three flavors of this hypothesis: the strong version, the semi-strong version, and the weak version. Obviously, the strong version suggests that investors cannot earn a return higher than the market return irrespective of the information available to them or the tools they use. In its semi-strong flavor, the hypothesis states that markets price all available information rapidly and in an unbiased fashion such that no excess return can be earned by trading on that information. Finally, in its weakest form, EMH states that technical analysis or using historical share prices and/or historical data cannot yield excess returns. This theory has had tremendous appeal in all financial markets. Also, it is very tempting to think that the internet has exponentially increased the availability of information, especially about publicly traded companies.
It would be very easy if life followed predictable models and humans were ‘rational’ and all things remain the same. If such a world were to exist, markets would be free of bubbles or inflated prices. The tulip mania which came to an end in 1637, the dot com stock bubble which lasted from 1995 through 2000, and the most recent 2008 global financial crisis caused by the housing market in the United States would all be unexplainable.
This is where behavioral economics comes in. Behavioral economics is the study of psychological, cognitive, emotional and cultural factors on human decision making. Richard Thaler, after winning the 2017 Nobel Prize in economic sciences, famously said, “In order to do good economics, you have to keep in mind that people are human.” In fact, Richard Thaler winning the Nobel Prize was an important testament to the importance of behavioral economics. The author of a famous book Nudge, Thaler was awarded the coveted prize for persuading many economists to pay attention to human behavior.
However, Thaler is not alone. Many people, including the famous Israeli psychologist duo of Daniel Kahneman and Amos Tversky, have provided a variety of reasons why our behavior is not necessarily rational. They attribute our idiosyncratic behavior to many biases that prevent us from making rational choices. There are three prevalent themes as to why we behave this way.
The first theme, heuristics, implies that humans make 95 percent of their decisions using shortcuts such as rules of thumb. An example of a heuristic is availability heuristic. If a certain piece of information is readily available to us, or if we can recall a certain fact instantly, we will decide based on that single fact by ignoring the other facts. For example, if you recently heard a friend say that the Apple has a gross margin of 35 percent, you could end up buying that stock ignoring a host of other factors including fixed costs, dividend payout, growth prospects, competition, etc.
The second theme is framing, or the use of anecdotes and stereotypes to classify individuals and events. We are all familiar with our own versions of stereotypes. As an example, we often bracket people into convenient boxes to simplify our decision making.
Finally, there are market inefficiencies in the form of “mis-pricing.” A good example is how most of the bond market was led to believe by rating agencies that poor quality U.S. Mortgage Backed Securities (MBSs) are actually high quality. If we add the other human bias of thinking that the value of the homes underlying the mortgages bundled into such MBSs will continue to appreciate indefinitely, mis-pricing becomes almost inevitable. When foreign governments and financial institutions purchased such mis-priced MBSs, the housing crisis became a global contagion of staggering proportions.
The three themes above are just frameworks to begin to analyze our biases. The list of cognitive biases includes more than a hundred biases. Take the “status quo” bias, which is our unwillingness to reap significant benefits by making small, low-cost incremental changes. That is because we love to stick to the status quo.
In fact, the world of economics did not wake up to the benefits of behavioral economics until recently. Understanding our biases is the first step to overcoming them. This is a small price for us to pay to grow ourselves exponentially. One of the primary criticisms of behavioral economics today is that there is no cogent, unifying theory that behavioral economists have been able to espouse. This criticism does not take away from the importance of behavioral economics. It merely implies that the discipline is nascent.
In a nutshell, behavioral economics implies that there is much more to economics than cold, rigid, complex economic models. In other words, not everything that can be measured can explain our economic reality. There is a world that lies beyond numbers. We need to integrate inputs from psychology and neuroscience to help us move closer to a more complete understanding of our economic choices, the financial markets and the world we live in. We can also call the application of behavioral economics a complete use of the human brain, i.e., using both the left and the right versions of our intellect.