As with behavioural economics the conventional view of finance assumes that markets are efficient and that the price of shares, bonds and other financial instruments are a reflection of the fundamental economic values that they represent. Behavioural finance is all about understanding why and how financial markets are inefficient. If there is a difference between the market price of a share or bond and its fundamental value then in conventional economics no one can make money in financial markets by exploiting the difference.
Why are financial markets not efficient?
In an efficient financial market, share and bond prices move up and down according to the information about changes in the real economy. However this information must be accurate and unbiased and if there are errors people should be able to identify them. Additionally this information should be updated regularly so only the objective information affects people’s decision-making – Bayseian Updating.
This refers to people who are willing and able to modify their beliefs based on new, objective information. However in their decision-making, rationality of individuals is limited by the information they have and people don’t always know what good or objective information on the financial markets actually looks like.
Random Walk Hypothesis
This refers to the idea that financial asset price movements follow a random walk. This was made famous by Burton Malkiel who wrote “A Random Walk Down Wall Street”. He argued that past movements in asset prices don’t provide the information required to predict future prices. Basically you can’t get rich by beating the market although by selling advice to those who believe you can beat the market might earn you a high salary.
Some behavioural economists largely support this perspective that financial asset prices largely follow a random walk. Consequently using simple heuristics (enabling someone to work something out for themselves) as an investment strategy is an intelligent move. Other behavioural economists, such as Robert Shiller, state that there is easy money to be made on stock markets by smart investors which implies, along with bubbles, that financial markets are inefficient. This assumes that you can make money from market inefficiencies and the past can predict the future. Shiller argues that people can’t predict day-to-day changes in stock prices but it doesn’t mean that smart investors can predict nothing at all.
In 1996 Alan Greenspan, former chairman of the US Federal Reserve, used the term irrational exuberance to describe one of the greatest increases in the US stock market. The Dow Jones Industrial Average increased from 3,600 points in early 1994 to just under 12,000 by the start of 2000. This boom and bust during this time was dominated by tech stocks – shares in IT related companies. Shiller believes that irrational exuberance is the psychological basis of speculative bubbles in contrast to a price increase based on increases in fundamental values. Speculative bubbles encourages investment confidence and enhances animal spirits of investors who are being motivated by the excitement and the behaviour of others. Economists John Maynard Keynes and John Kenneth Galbraith emphasized psychological and sociological factors as well as the spread of misleading and overconfidence-breeding information, as a key to stock market booms and crashes.
In society today consumers do not have the ability or the perfect information to understand complex alphabet soup of financial investments from Collateral Debt Obligations (CDO’s) to Credit Default Swaps (CDS’s). Too often people’s decision making is influenced by the behaviour of others including experts and those at the higher end of the income ladder. However you don’t have to look much further than former head of the NASDAQ Bernard Madoff to see how someone who had immense respect amongst investors was in reality running a ponzi scheme.
Behavioural Economics for Dummies – Morris Altman. 2012