Thursday, July 05, 2007

Economically-minded behaviors, Part 1

I’ve mentioned before that personal finance is more about a person’s behaviors than it is a function of their ability with crunching numbers. Taking this to its logical conclusion, a corollary would become that emotions and poor judgment lead a lot of people, exceptionally bright or not, to make, simply put, dumb financial moves. Historically, psychology has played an integral role in economics. For example, when Adam Smith wrote The Theory of Moral Sentiments it includedthe ethical, philosophical, psychological and methodological underpinnings to Smith's later works, including The Wealth of Nations (1776), A Treatise on Public Opulence (1764) (first published in 1937), Essays on Philosophical Subjects (1795), and Lectures on Justice, Police, Revenue, and Arms (1763) (first published in 1896).

Hersh Shefrin, in his 2002 work “Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing,” listed three main themes for behavioral economics:

· Heuristics: Using “rules of thumb” that are, at best, approximated, instead of strict rational analyses, people tend to make bad decisions.

· Framing: The context of the problem or the way it is presented to the decision maker will often affect his or her action; which can result in a bad decision.

· Market inefficiencies: Examples such as mis-pricings, return anomalies, and non-rational decision-making can explained observed market outcomes that are contrary to otherwise rational expectations of market dynamics.

College macroeconomics courses teach a concept of “utility,” a fundamental concept in neoclassical economics which depicts perceived value in a good or service. Prospect theory, as part of behavioral economics, describes decision processes as consisting of two stages: Editing and evaluation. Editing consists of possible outcomes of the decision are ordered following some heuristic. Specifically, people decide which outcomes they see as basically identical, setting a reference point and consider lower outcomes as losses and larger as gains. In the evaluation phase, people behave as if they would compute a value, or utility, based on the potential outcomes and their respective probabilities, and then choose the alternative having a higher utility.

Keep in mind, however, while all this theory is good for a foundation of understanding the basis for the mistakes—and successes—we will inevitably have when it comes to our finances, note that these models can fail to predict outcomes in real world contexts for one reason or another. As in the science of profiling, establishing patterns and trends are keys in determining if a particular model will accurately predict a desired outcome. On the other side of the token, it is argued that while behavioral insights can be used to update economic and financial theories that we’ve come to rely upon, they also offer greater depth into these two disciplines: Not only reaching the same (correct) predictions as traditional models, but also correctly predicting outcomes where traditional models have failed in the past.




No comments: