PDF Ebook Finance, psychology, economics and the design of successful institutions
The theory of rational efficient markets dominated financial economics three decades ago. In recent years, however, psychology-inspired behavioral finance has overshadowed it. Both critics and proponents of the use of psychology in economics and finance base their positions on the premise that psychology primarily deals with human fallibility, systematic mistakes and biased judgment (Kahneman, Slovic and Tversky, 1982). The association of psychology with pathology seems to imply that normative behavioral economics and the design of successful institutions must focus on a benevolent paternalism aimed at saving individuals from themselves. This paper, in contrast, discusses how simple psychological processes frequently, but not always, function well in their respective environments. Using the concept of ecological rationality and the key findings of psychology in economics, three lessons for designing successful institutions are proposed.
Three decades ago, financial economics was dominated by efficient market theory. One leading finance researcher claimed that the efficiency of financial markets was the best established fact in economics (Jensen, 1978). Today, the most influential intellectual movement in financial economics is behavioral finance, the application of psychological theory and its empirical findings from laboratory experiments with human subjects to economic and financial decision making.
The ascendancy of behavioral economics can be seen in academic citation indexes, the fact that the 2003 Nobel Prize in economics was awarded to a psychologist, the 2001 and 2003 Bates Clark awards going to behavioral economists, and recent feature stories in on behavioral economics and behavioral finance in The Economist, The Wall Street Journal, The New York Times, and Fortune.
Efficient market theory makes two sharp predictions. First, market prices equal to intrinsic value. In other words, financial assets have an objective value based on economic fundamentals, expected cash flows and their level of risk (measured in various units). The second prediction is informational efficiency that prices adjust rapidly to the arrival of new information and therefore, because news arrives randomly, past price changes do not predict future price changes.
The prediction that market price equals intrinsic value was refuted by Lee, Shleifer, and Thaler (1991) (and later by many others) who showed that closed-end and open-end funds with identical portfolios do not closely track one another. Closed-end funds usually trade at a discount to their open-end counterparts, but sometimes trade at sizable premiums. Two baskets of claims on an identical set of future cash flows can, in the real world, have distinct market prices, violating the so-called Law of One Price.
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PDF Ebook Finance, psychology, economics and the design of successful institutions
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