"Kee Points" with Jim Kee, Ph.D.

I hope to discuss in Kee Point things that I think are of interest to our clients, and this week I thought I would take advantage of the long holiday weekend to talk briefly about the trendy fields of behavioral economics and finance.

The “behavioral” movement: There is no Nobel Prize for psychology or mathematics, so it is not uncommon for scientists from these fields to win the Nobel Prize in economics, presumably because it is the closest related field for which there is a Nobel Prize (the other five Nobel categories are literature, physics, chemistry, peace, and physiology & medicine). This combination of economics, psychology, and mathematics has led to both progress and confusion.

A key difference between economics and psychology is that economics abstracts or makes generalizations about human behavior, whereas psychology gets into the particulars. In fact, a common critique of economic theory is that its assumptions are unrealistic, i.e. that it generalizes too much, abstracting away important details until it doesn’t reflect reality. Economists respond that this burdens theory with the role of description, which is not what it is intended to do. In the words of George Stigler, who himself won the Nobel Prize in economics in 1982, “the role of description is to particularize, while the role of theory is to generalize - to disregard an infinite number of differences and capture the important common element in different phenomena.” But taken too far, complete abstraction results in pure mathematics, which means that the potential danger of excessive “mathematization” in economics is that it omits something(s) that is truly important. So economics requires some abstraction or generalization but not too much, like a roadmap that includes major cities but excludes every pothole. Unlike pure mathematics it needs people and assumptions about their behavior, but unlike psychology it is more interested in the average behavior of the group than of the behavior of the individual.

This is where “behavioral economics” and “behavioral finance” come in, two related fields that began gaining traction about 20 years ago, although the issues they confront go back much further. Again, traditional economics is predicated on avoiding the countless vagaries of psychology by relying instead upon only a few basic assumptions about human behavior. These assumptions or generalizations include the notion that people prefer more wealth to less, and that they act in their own (self) interest in commercial transactions (and often enough in non-commercial transactions, e.g. you might give a suit to the poor, but not your best suit). It is amazing how much of the behavior of large economic systems like the global economy and the countries and industries and firms within it can be explained with only a handful of such behavioral postulates. No uber-rational, optimization-calculating "economic man” is needed. In fact, the late Gary Becker argued that in a fully-integrated global economy characterized by a high degree of specialization, those who don’t make decisions rationally and intelligently aren’t likely to last long enough in a system of profit and loss to be impactful.

The behaviorists, on the other hand, argue that certain behavioral traits that are important have been omitted from economics and finance. Just about everyone today has heard the laundry-list of behavioral anomalies (e.g. anchoring, confirmation and hind-sight and bias, etc.) that seem to contradict even the most basic assumptions made by traditional economic theory. In finance, these are believed to lead to asset miss-pricings, bubbles, and other market inefficiencies and problems. When he was alive, Becker countered with, “one of the things some behavioralists have missed is that a specialized economy eliminates many mistakes because vulnerable people don’t get put into positions where they can make these mistakes.” The financial crisis and the Great Recession hardly resolved any of this, with the behavioralist saying, “see, we told you markets weren’t efficiently or rationally pricing assets!” and the traditionalists arguing, “see, we told you that interfering with markets would create perverse incentives and bad outcomes!”

Traditional economists (including Becker above) have argued that the rationality assumptions required to validate, say, the law of demand, which states that people in the aggregate buy less of a good at higher prices than at lower prices, are very low. “People do a lot of nutty things,” writes economist John Cochrane, “but when you raise the price of tomatoes they buy fewer tomatoes” (economists have worked out the effects of higher prices on perceived quality, “snob effects” of luxury goods, etc., over the past 70 years but it gets pretty technical). Perhaps most famously, in 2010 former UK Prime Minister David Cameron set up a Behavioral Insights Team, informally known as the “Nudge Unit” from Richard Thaler’s book by the same name. One of the group’s assertions was that the best way to get people to cut their electricity bills is to show them how much they are spending relative to how much their neighbors are spending and relative to what energy-conscious neighbors are spending (Cameron even did a TED talk on it). Traditionalists would respond (similar to Tim Hartford’s response in the Financial Times) that no, the best way to reduce energy consumption would be to simply raise energy prices, perhaps through a tax. I think these examples give you an idea of the ongoing back-and-forth between “behavioralists” and “traditionalists” in economics.

With respect to economics, my taste runs more closely with the traditionalists, and I see the contributions of the behaviorists more in the realm of psychology (e.g. using prices ending in odd numbers to denote value, and even numbers to denote quality, etc.). With respect to investing and finance, I am most in agreement with those like economist Victor Canto of La Jolla Economics who (for over a quarter of a century) have argued that the extreme doctrinaire version of the efficient markets (EM) school took market efficiency to a point where the core of economics, the simple behavioral response functions that dictate how markets adjust, was discarded. In that sense behavioral finance scholars, at least those at the top of the field rather than on the internet, seem to be bringing it back in what seems to be a meeting in the middle. In the words of Richard Thaler, past president of the American Economic Association and widely considered the “founding father” of behavioral finance, “I predict that in the not-too-distant future, the term “behavioral finance” will be correctly viewed as a redundant phrase. What other kind of finance is there?"