Thursday, July 2, 2009

Behavioral economics / finance

Behavioral economics (and finance) has fully matured into its own sub-field. In essence, it examines how psychological factors influence the behavior of participants in various markets.

It is important to distinguish between the behavior of people reacting to incentives, which might seem irrational, and true behavioral factors. In the book "Freakonomics" there is a section on a day care center which tried to deal with tardy parents picking up their kids by imposing a fine on late pickups. The result - more late pickups, because the fine was less than the hourly cost of daycare, and parents rationally responded to the offer of this "after hours" care. This is not really an example behavioral economics.

An example of behavioral finance is the 1/n rule. If you give people "n" choices - say 4 mutual funds in their retirement plan, folks will tend to put 25% of their money in each fund, when optimally a different allocation is probably best.

Anyhow, Scientific American has a piece on how bubbles develop.

The article first talks about "money illusion" a topic close to my heart as this was the focus of my PhD dissertation and subsequent publication in the Journal of Financial and Quantitative Analysis. Money illusion occurs when individuals fail to appreciate the effects of inflation on asset values. To quote from the article:
Robert J. Shiller, a professor of economics at Yale University, contends that the faulty logic of money illusion contributed to the housing bubble: “Since people are likely to remember the price they paid for their house from many years ago but remember few other prices from then, they have the mistaken impression that home prices have gone up more than other prices, giving a mistakenly exaggerated impression of the investment potential of houses.”

The article goes on to cover several other well documented examples of behavioral irrationality. Overall an excellent read.