Behavioral Finance

“Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system.” (“How Did Economists Get It So Wrong?”, Krugman) Behavioral finance is a newer theory in which more economist are starting to use since the great recession. It is the study of how human psychology, such as our thoughts, attitudes, and feelings, influence financial decisions. Behavioral finance combines both classical economic theories with psychology to understand and create the changing thought patterns and modes of doing business that can bring a crisis. Economists who follow this model do not only consider the effects of market decisions but also focus strongly on public choices and how they react and feel. Before the recession, this way of thinking was rarely used. “Until the crisis, efficient-market advocates like Eugene Fama dismissed the evidence produced on behalf of behavioral finance as a collection of “curiosity items” of no real importance.” (“How Did Economists Get It So Wrong?”, Krugman)  Behavioral finance emphasizes on the inefficiencies and the different reactions to information as causes to different market trends such as crashes. It is very important when the market is unstable, which it often is. I feel if economist viewed things through a behavioral finance lens, the economy could have been a little more prepared and would have been more efficient in damage control.

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One Response to Behavioral Finance

  1. tesoman says:

    This is a very interesting development that in my mind was a direct response to how everyone, including those who denounced them, watched the big banks and hedge funds blatantly create models that were clearly unsustainable and ludicrously profitable. I think economists and financial analysts only believed in numbers as a clear indicator of what firms were doing and they did not want to take into account that there was a clear amount of social influence that caused the recession. Banks were giving out loans to everyone they could because there was this social idea among them that people would be able to pay the loans back and the mortgages on their homes because the economy was good. The practices had become so bad that there was no background check when people wanted to buy a home and banks were giving homes to people who were clearly incapable of affording them. This practice created a national phenomenon where people were spending well outside their means, borrowing more and buying more with the false pretence that they would be able to comfortably pay off the loan in the future or refinance it easy enough. However, as we all know, when the banks hit that ceiling and needed to start having their customers pay back their debt, the system came crashing down. (I can’t remember my source but it was an article I had to read in my corporate finance class last semester)
    Bernie Madoff got away with his ponzi scheme because the public was under the impression that he’s ability to guarantee astonishing returns made him one of the best people to invest it. Because he had so many big clients there was this social idea that whatever he is doing, it must be excellent to invest in and (most importantly) SAFE. “The psychological repercussions are enormous. People were already hurting from losing money the old-fashioned way. Now, there’s shock and anger. These are smart people but when it came to Mr Madoff they relied on trust. They are rattled to the core.” This is a quote from a Manhattan psychiatrist who counseled some of the victims of the scheme and it shows how misguided these “very smart” people were because of what everyone else was doing. –
    In both cases, there seems to be this mob mentality when everyone assumes that the investment must be safe because everyone else is doing it. And instead of asking the tough questions when something looks out of place, people rationale them as something they “just couldn’t understand” and moved on with things because after all…how could so many people be tricked at once?

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