METHODOLOGY
Although initially a lot of behavioural economics and finance theories were developed as the results of experimental observations and responses to surveys, today’s researchers are just as likely to use something like a Magnetic Resonance Imaging (MRI), as used by medical professionals, to determine which areas of a participant’s brain are more active when taking part in a certain experiment.
Researchers also rely heavily on market simulations such as trading games and auctions to determine what impact a particular bias such as stress or greed may have upon individual or group behaviour. Although behaviour can typically be explained in variety of ways, these experiments are carefully engineered to limit these various explanations – usually by involving real money and real transactions which are binding to ensure experiments are as close to real-world scenarios as possible.
Key Observations
Behavioural finance and behavioural economics are closely related fields which apply scientific research on human and social cognitive and emotional biases, to better understand economic decisions and how they affect market prices, returns and the allocation of resources. At the outset, behavioural economics and finance theories were developed almost exclusively from experimental observations and survey responses, though in more recent times real world data has taken a more prominent position.
There are three main components in behavioural finance and economics (Shefrin, 2002).
| HEURISTICS | People often make decisions based on approximate rules of thumb, not strictly rational analyses. |
| FRAMING | The way a problem or decision is presented to the decision maker will affect their action. |
| MARKET INEFFICIENCIES | Attempts to explain observed market outcomes which are contrary to rational expectations. These include mis-pricings, non-rational decision making, and return anomalies. |
As well as individual psychology, behavioural finance and economics also takes into consideration group or social psychology too to explain various market inefficiencies such as mispricing and the existence of arbitrage opportunities. These anomalies cannot be explained by individuals suffering from cognitive biases for two reasons:
- Biases displayed by individuals will have a negligible impact on the market as a whole;
- Biases displayed by individuals will typically cancel each other out, if not at a particular point in time then certainly over a particular period of time.
Therefore, these cognitive biases will only have real anomalous effects if they are society-wide with a strong emotional content (collective greed or fear), leading to more widespread phenomena such as Herding and Groupthink.
However, there are two exceptions to this general rule. Firstly, if enough individuals actual behaviour is significantly different from what is to be rationally expected, such behaviour could eventually become the norm and thus have wide-ranging effect on market behaviour. Secondly, even a small group of individuals may impact the market in a broader sense if they possess an unusually large degree of market power.