Classical economics has relied on the assumption that human beings are motivated by self-interest and capable of rational decision-making. From this assumption, economists have then been able to build elaborate mathematical theories about capital markets and economies. For example, under the Efficient—Market Theory, investors are expected to set prices rationally, and thus, even an unsophisticated investor can rely on market efficiency to ensure that he or she transacts a ‘fair’ price.
But history is replete with stock market anomalies, market bubbles and crashes across the world. A recent example is the tech bubble of 1999-2000. So, the obvious question to ask is—if man is a rational being and the markets are efficient, why did all this take place? The answer would probably lie in the vagaries of the human mind such as greed, fear and hubris. This is exactly what has been a focus area for a growing body of work over the past two decades. Labeled ‘Behavioral Economics or Finance,’ this field has attempted to better understand and explain how our emotions and cognitive errors influence our investment decision-making process.
The fundamental difference between classical finance and behavioral finance is that while the former is concerned with how people should behave, the latter has an empirical basis in that it is focused on how people have actually behaved in the real world, bringing together the fields of psychology and economics. In the world of classical finance, individuals are rational risk-averse profit maximisers. In reality, individuals do not behave like the rational being mentioned in textbooks. As we all know, individuals are subject to a raft of judgmental biases and emotions, that cause market prices to deviate markedly from fair value, resulting in the market cycles.
Let us look at some of the key findings of behavioral economics.
Money isn’t “fungible” due to mental accounting—that is, one rupee is not the same as another. Richard Thaler, considered a pioneer of behavioral economics, coined the term “mental accounting”, which refers to the inclination to categorize and treat money differently depending on where it comes from, where it is kept, and how it is spent. In the minds of most people, the value of money varies with circumstances. For instance, people will go out of their way to achieve a saving of Rs.5 on the purchase of goods worth Rs.25, but won’t go to the same trouble to save Rs.5 on the purchase of a CD worth Rs. 500. Most people sort their money into accounts like “current income”, “profits” and “savings” and justify different expenditures from each. One more finding related to this is that a rupee lost tends to be twice as painful compared to the pleasure of a rupee gained.
People are more concerned about the change in their wealth than about its ultimate level. In 1979, from the various experiments conducted for their “Prospect Theory”, Amos Tversky and Daniel Kahneman (Nobel prize winner for Economics) found that people place different weights on gains and losses, and on ranges of probability. They also believed that people respond differently to equivalent situations, depending upon whether it is presented in the context of losses or gains. Therefore, they concluded that people are willing to take more risks to avoid loss than to realize gains. One of the experiments they conducted was the following:
Group I: In addition to whatever you own, you are given Rs.1,000. You must choose between
• A sure gain of Rs.500 or
• A 50% chance to gain Rs.1,000 and a 50% chance to gain nothing.
Group II: In addition to whatever you own, you are given Rs.2,000. You must choose between
• A sure loss of Rs.500 or
• A 50% chance to lose Rs.1,000 and a 50% chance to lose nothing.
In the first group, 84% chose A. In the second group, 69% chose B. The two problems were identical in terms of net cash to the individual, but the phrasing causes different interpretations. Conventional theory predicts that the individual will be indifferent between the two but the responses varied due to a) increased initial amount and b) the phrasing.
People tend to ignore “sunk costs” and don’t like to accept losses. A familiar problem with investments is called the sunk cost effect, otherwise known as “throwing good money after bad.” It is also related to regret aversion and loss aversion.