I caught a re-run of the PBS NOVA documentary "Mind over Money" last night. The documentary explores the role of behavioral finance in market bubbles and collapses. For those wondering: Behavioral finance is the study of how human psychology affects financial decision making. It is generally at odds with a lot of the predictions of the Efficient Market Hypothesis which states that prices reflect all available information and markets as a whole are rational. Whether markets are efficient or not is of great importance to investors and policy makers.
Back to the video - this is a MUST SEE for any student of finance. My current MBA students take note!
Here is the preview.
The video is well done and features interviews with those who are proponents of behavioral finance - notably Richard Thaler and Robert Shiller, and those that oppose it - Eugene Fama, John Cochrane and Gary Becker.
The experimental evidence for behavioral finance is very strong, but the link between what people do in a lab environment and what markets do as a whole is much weaker. Consider, for example, the housing bubble: Behavioral proponents will claim that a housing bubble occurred because of various irrational behaviors. For example people pay too much attention to recent events and see how prices rising and then extrapolate these increases. In addition, people observe how others are making money in housing, and they feel remorse if they don't buy also. Finally when prices do go up, people feel that their original decision to buy is being confirmed and that they were correct. This creates a self feeding cycle until finally the bubble bursts.
But an efficient market proponent would offer a different story - low interest rates, easy credit and limited downside for buying a house you can't afford creates an incentive to buy. In effect people who buy houses with close to 100% financing on teaser rates are really just buying a call option on the value of the house. If it goes up then they make money, but if it falls they just walk away. The rational thing to do for many people is to take the gamble.
Regardless of where you fall in the efficient markets vs behavioral finance debate, the insights of behavioral finance at the individual level are really important and can protect people from their own irrationality.