Behavioral economics vs. behavioral finance

Chris House has a new blog post that is pretty dismissive of behavioral economics:

In the early 2000’s, my colleagues and I were anticipating a flood of newly minted behavioral Ph.D’s from the top economics programs in the country. Later, when the financial crisis exploded in 2007-2008 we were again told that behavioral economics would finally come into full bloom. It didn’t happen though. The wave of behavioralists never came. After the financial crisis, young Ph.D’s turned their attention to studying financial macroeconomics – and when they did, they used mostly standard techniques based on rational decision making. They incorporate more institutional detail rather than behavioral elements... 

Today, it seems like behavioral economics has slowed down somewhat. For whatever reason, the flood of behavioral economists we were anticipating 10 years ago never really materialized and the financial crisis hasn’t led to a huge increase in activity or prestige of behavioral work. Certainly the evidence that people don’t typically behave rationally is quite compelling. It’s easy to find examples of behavior which conflicts with economic theory. The problem is that it’s not clear that these examples help us much. Behavioral economics won’t get very far if it ends up being just a pile of “quirks.”  Are these anomalies merely imperfections in a system which is largely characterized by rational self-interest or is there something deeper at play?  If the body of behavioral studies really just provides the exceptions to the rule then, going forward, economists will likely return to standard rational analysis (perhaps keeping in mind “common sense” violations of rationality like default options, salience effects, etc.). I would think that if behavioral is to somehow fulfill its earlier promise then there has to be some transcendent principle or insight which comes from behavioral economics that we can use to understand the world. In any case, if behavioral is to continue to develop, it will need some very smart, energetic young researchers to pick up where Laibson and the others left off. If not, behavioral economics gets a goodbye kiss from Heidi Klum and it’s “Auf Wiedersehen.”

I don't think Chris gives a particularly enlightening explanation of where behavioral economics is falling short (what does "helps us much" or "transcendent principle" even mean?? Update: see comment section.). But Chris certainly seems right that interest in behavioral econ has declined a bit in the last couple of decades, at least in America (Europe is a different story).

However, I think it's important to point out that "behavioral economics" is a different thing from "behavioral finance" (my own field).

As best I can tell, "behavioral economics" means something along the lines of "economics in which individual decision-making behavior is assumed to be subject to observable, predictable psychological biases". But the term "behavioral finance" has come to mean a much more expansive set of things.

"Behavioral finance" began not with Daniel Kahneman, but with Robert Shiller, who showed that stock prices fluctuate more than the standard theories would suggest. Shiller did not find that the excess fluctuations were caused by psychological biases. In fact, the search is still on for an explanation. But the "anomaly" Shiller found was real, and it has real-world implications - for example, Shiller's CAPE ratio can be used to predict the long-term movements of the stock market to a small but real degree.

A bunch of other "anomalies" in standard theory were soon discovered - most famously, the value anomaly demonstrated by Josef Lakonishok, Andrei Shleifer, and Robert Vishny (among others), and the momentum anomaly demonstrated by Narasimhan Jegadeesh and Sheridan Titman (among others). These anomalies have proven so durable that they have become standard pieces of the risk models used by every large financial institution, and have been used to make billions of dollars for firms like Clifford Asness' AQR Capital Management. As with Shiller's finding, we don't know why these anomalies happen, but the fact that they happen is pretty indisputable at this point, and they have obviously led to the creation of real-world technologies that have found widespread use in the private sector (unlike, say, DSGE macro models).

For some reason, most phenomena that don't agree with classic, Gene Fama vintage efficient-markets theory have come to be labeled "behavioral finance". This might have had to do with optimism that the ultimate explanation for these phenomena would be some sort of psychological bias on the part of investors. The jury on that is still out, but for some reason the name stuck.

There is a second strand of research that has come to be called "behavioral finance". This is finance based on informational frictions (i.e., problems with information processing). Early papers in this vein include Sanford Grossman and Joseph Stiglitz' landmark finding that information costs destroy strong-form market efficiency, and Paul Milgrom and Nancy Stokey's famous result that rational expectations leads to the absence of "information trading" in financial markets - a result that obviously shows that rational expectations are not a realistic description of financial markets, since information trading does in fact seem to be quite common. More recent papers in this vein include theories that try to mathematically model "bounded rationality", like the "sparsity" theories of Xavier Gabaix (which I saw presented at the Miami Behavioral Finance Conference in December 2012), "herd-behavior"models like this one by V.V. Chari and Patrick Kehoe, or subjective-expectations Bayesian models like Martin Weitzman's famous 2007 paper on asset return puzzles.

Informational-friction finance fits the name "behavioral finance" a bit better. I think most psychologists would agree that psychological heuristics and biases are ways that the human brain deals with information costs and bounded rationality. Behavioral finance people sometimes use psychological explanations for observed anomalies, but we are never quite comfortable doing so, because there is always the idea that underlying these psychological phenomena there must be some more fundamental (but difficult-to-model) process of limited information-processing capacity. For example, there are many behavioral finance models based on "overconfidence" (including, implicitly, the Harrison-Kreps model), but I heavily suspect that psychological overconfidence is just an occasionally useful stand-in for the cost of making inferences about others' information from hypothetical projections of their actions, or for the persistence of belief heterogeneity under rapid structural change.

Anyway, there is a third strand of "behavioral finance" research that deals with individual investor behavior, which is of course very useful to financial institutions that have to deal with customers, and also to regulators like the new Consumer Financial Protection Bureau. This is the kind of thing pioneered by the research of Brad Barber and Terry Odean, and picked up by researchers like Joshua Coval and Tyler Shumway. This literature is almost entirely empirical, and although it often tests hypotheses that are motivated by the psychology literature (e.g. "overconfidence"), it does not rely on an explicit, non-rational model of human behavior.

A fourth strand of "behavioral finance" has important implications for macroeconomics: noise-trader bubble models. These are theories that show how large, endogenous disturbances may spontaneously manifest in financial markets. Famous theories of this type include the 1990 models by Brad DeLong, Andrei Shleifer, Larry Summers, and Robert Waldmann, and the more recent model of Dilip Abreu and Markus Brunnermeier. These models are "behavioral" in the sense that they assume that some segment of the populace has incorrect beliefs, and focuses on showing how the more traditionally "rational" agents are unable to stabilize markets in the face of these "noise traders". There is some degree of empirical support for these models, but of course there are other, competing models of bubbles that rely on institutional frictions instead. Regardless, the Fed certainly believes that financial bubbles are important (an important sea change from previous decades), and the awareness of bubbles has an influence on Fed policy.

A fifth strand of "behavioral finance" research tests the usefulness of psychological biases for investing strategies. A great example of this is the attention-based M&A trading strategy in this paper by Stefano Giglio and Kelly Shue (both young recently hired profs at Chicago's Booth Business School). Another example is the recent series of papers by Ulrike Malmendier and Stefan Nagel cited in Chris House's post.This literature too is very empirical, and often does not include any explicit model of individual behavior - a big no-no in pure economics, but something that the finance literature has no problem with (because if you can trade on it and make money, then it's for real).

And of course a sixth strand of "behavioral finance" is experimental finance, which for most of its short history was limited to simple Vernon Smith-type "bubble experiments", but is now branching out. I just met a young macro-finance professor who makes DSGE asset-pricing models, but who also does experiments to test behavioral hypotheses. Very cool.

As you can see, "behavioral finance" is a somewhat poorly chosen catch-all term for a bunch of new and exciting research in finance. "Behavioral" doesn't mean the same thing in finance that it does in pure econ. And in fact, the term seems to be having less and less meaning, since so much "behavioral" stuff has gone so mainstream. More like the American revolution than the French, the behavioral finance rebels are merging with the old establishment instead of overthrowing it.

So behavioral finance is not a speculative, marginal, or incipient field. It has already won at least two Nobel prizes (Smith and Shiller), or maybe four if you want to count Stiglitz and Kahneman. Plenty of researchers in their prime at top business schools and economics departments are doing behavioral finance research.

But what about the younger generation? Interest seems to have increased, not declined. I am on two finance search committees at Stony Brook, and I can confidently say that a whole lot of job candidates - including many top ones - list "behavioral" as one of their interests. They are not using "behavioral" in the sense that Chris House uses the term; their "behavioral" research only occasionally invokes psychology. Instead, they are using the term in the more vague, expansive way that the academic finance community has come to use it.

Whatever the future of "behavioral economics", the future of "behavioral finance" is to merge completely with mainstream academic finance. And in fact, that future is already upon us.


Update: Chris House has a follow-up post. He believes that institutions, not psychology, will prove to be the key connection between financial markets and the macroeconomy. That's a whole new interesting topic, which I'll leave for a future post...