How is economic sociology different from behavioral finance?

April 19, 2010

In the past ten years, and especially in the wake of last year’s credit crisis, the field of behavioral finance has seen an extraordinary rise in influence. Academically, this is clear in the success of the work of Robert Shiller. On the policy front, the rise of Austan Goolsbee at the White House’s, and the administration’s proposal proposal to create a Consumer Financial Protection Agency

So the economists have accepted that “the social” matters. But now that they have rediscovered sociology, it is up to sociologists to explain how does their discipline differs. I experience this myself every week. Whenever I am introduced to finance colleagues at the LSE in the Senior Dining Room, they all respond to my statement that “I’m a sociologist of finance” with the well-intentioned remark, “ah, yes, behavioral finance — very topical.” And thus, on to a peaceful lunch.

But their reaction is not just a trip of the tongue. In drawing the lines around behavioral finance, Shiller claims sociology without bothering to read it. Shiller (2003: 83) writes,

Behavioral finance -that is, finance from a broader social science perspective including psychology and sociology-is now one of the most vital research pro- grams, and it stands in sharp contradiction to much of efficient markets theory.

But, surprise, when one turns to the article’s bibliography, there is not a single sociologist there. No Merton , not even Granovetter.

Thin sociality

Sociologists, it is clear, need to make clear where do they stand. My position is clear, and it comes from my ethnographic research. In my latest piece with David Stark, we examine an limited instance of financial crisis — an “arbitrage disaster” — and consider whether it matches what behavioralists argue. Our conclusion is that it does not. What behavioral finance offers is a thin view of sociality in which there are no material artifacts and no distributed cognition. A world, in other words, of fools with tools.

Behavioral accounts of systemic risk center on two versions. The social accounts blame systemic risk on herding and information cascades: if an investor makes the wrong decisions and others imitate her, the risk spreads out. The alternative account, Black Swans, centers on technical problems such as the use of financial models. If models are built on past occurrences, infrequent but disastrous events will not be sufficiently taken into account.

Fools with tools

Both behavioral approaches are unsatisfying. Straight imitation, as the concept of herding contends, is simply impossible in modern markets — they’re anonymous. And even if it weren’t, it is unlikely that the brainy eggheads that trade derivatives would do it. It goes back to the dilemma of cheating in school. The kid right next to you might have answered (a) where you wrote (b)… but if you decide to go with his answer, how do you know he’s right? The traders we know are professionals, not school kids. They pride themselves on arriving at their own conclusions. So one cannot blame systemic risk on social factors alone without understanding the technological context.

Take the Black Swan now. How irresponsible does a trader need to be to just follow the model blindly? Sure, we all make some critical decision simply on the basis of what the machine says. We use planes, gadgets, have medical treatments… without fully knowing what the consequences will be. There’s a measure of doubt in a high-tech society. But as users, we still know is that others have done so as well, are doing so now, and nobody seems to have problems. I would argue that professionals are even more careful. The bottom line is that one cannot blame technology without accounting for the social context in which it is used.

If you bother to check what actually goes on in a trading room…

Empirically, neither herding nor the Black Swan explains what we saw. I will not go into detail here. It’s in the paper. But this is how we summarize what we observe:

Our ethnographic observations in the derivatives trading room of a major investment bank demonstrate that systemic risk arises from the precautionary efforts of traders. Traders check for errors in their own calculations by using models in reverse that represent the positions of their anonymous and impersonal rivals. We thus find traders modeling social cues. Such reflexive use of models leverages the dissonance among rival traders, but in the absence of requisite diversity such dissonance turns to resonance. If enough traders overlook a key issue, their mistake will reverberate to others. The resulting cognitive lock-in leads to arbitrage disasters. The trading room we observed suffered one major such disaster. Our analysis challenges behavioral accounts of systemic risk by locating its roots in the socio-technical mechanisms of reflexivity rather than individual biases.

A sociological approach

How, then, is behavior social in markets? In my own sociological account, technology and the organization of work combine to create rich and durable sociality. Traders use co-located teams and equations because they make them smarter, not foolish. This needs to be recognized. By the same token, this does not mean that problems do not exist. Understanding “the social” in markets requires that we look at technology and social cues as a whole, not as forces that act independently to make us dumb.

22 Responses to “How is economic sociology different from behavioral finance?”

  1. marthapoon Says:

    This is a wonderful post Daniel. If anyone knows of a review article I would be interested in reading a more systematic account of what behavioral finance is all about.

    It seems to me there are a couple of points that can be disentangled from your comment. The first is that we should distinguish (a) a theory of coordinated action that involves the enmeshing of people and instruments from (b) a purely humanist version of social coordination based on a common psychology (or some other internalized individualized force).

    …But a separate issue is how to connect the idea of ‘coordinated action’ to the event of ‘financial crisis’. Here there are three possibilities that I think should be disentangled.

    1) People make different kinds of errors all over the place which leads to system malfunction (Stiglitz’ ‘Freefall’ might be an general example of this genre of argumentation).

    2) A more intriguing stance (which seems to be the at the heart of your paper) is that reflexively achieved mass coordination around a type of error can unintentionally lead to crisis outcomes.

    3) But another version of the achievement would be that coordination in and of itself can lead to systemic properties that, in disintegrating, give rise to disorder and distress. (In this last case coordination does not need to be placed in relationship to error to be linked to disaster.)

  2. danielbeunza Says:

    Hi Martha — here’s the key reference. Robert J. Shiller, 2003. “From Efficient Markets Theory to Behavioral Finance,” Journal of Economic Perspectives, American Economic Association, vol. 17(1), pages 83-104.

    Your two points are right on. On the first, most actor network theorists try to distinguish between people-centered and instrument-enmeshed theories of action. We argue they are missing a third option, instrument-centered such as Black Swans. We critique Black Swans.

    On the relationship between coordinated action and crises. How are your points (2) and (3) different? Unless you give more concrete examples, I cannot disagree *in principle*.

    • marthapoon Says:

      Daniel, Philip. Thanks for the references!

      Daniel, 2 and 3 are very different. In 2 you need a criteria by which to call the reflexively produced action an ‘error’. That is, you need to be able to identify an alternative position that was a) possible, b) would have lead to a different outcome and is therefor c) not an error.

      In 3 there is no need to differentiate errors or non-errors. The outcome situation defined as crisis is part of a continuous flow of action that can not, in and of itself be described as being right or wrong, but is simply what happened. (If I pour milk into a glass at a certain point the glass will overflow causing a mess. There is no error – the mess that is produced is a continuation of the pouring, the laws of gravity and of surpassing the limited volume of the glass…)

  3. […] Daniel Beunza addresses the difference between economic sociology and behavioral finance in a new blog post.  Daniel provides his own answer to the question of what makes them different, drawing of course […]

  4. Nice post. You might also enjoy Andy Clark

    Click to access Economic.pdf

    Note where the paper was published. Some in the NIE community have been pursuing these threads for decades.

  5. danielbeunza Says:

    MIchael — I could not agree more. My perspective is very related to Andy Clark’s notion of scaffolding. (See the citations in the paper on p. 11.)

    However, to my knowledge and from hearing Douglas North when I invited him to Columbia, my sense the importance of material tools in markets has never been the center of new institutional economics.

    • This is really nice work. I’m glad orgtheory pointed me over here.

      At this point, what I would really like to see is a model of reflexivity that puts upper and lower bounds on some observable group behavior. I think price is too complex a phenomenon. But some accounting measurements of firm value might work. The idea is that these theories won’t win over the most stubborn until their instrumental value can be demonstrated for policymakers. If that can’t be done, then how much better off are we than we are now with the identification problem of neoclassical economics?

      • danielbeunza Says:

        Michael — I disagree. boundary conditions are nice to have. but claiming that the study of reflexivity is not useful without them is not conducive to advancing the work.

        Having said that, here’s some indication that these ideas are useful to market actors. According to journalist Robert Clow of the Financial Times, one hedge fund (Atticus Global) made a generous return by understanding the mechanism of reflexivity that our paper explains.

        According to the journalist, “One of Atticus Global’s most successful recent trades was its contrarian position on General Electric’s proposed acquisition of Honeywell. Most risk arbitrage managers followed their usual strategy of going long the target, Honeywell, and short the buyer, GE, assuming that the spread between the two would close when the deal was finalised. However, Atticus Global shorted Honeywell and bought GE, making a 10 per cent return on its investment when the European Union blocked the deal due to antitrust concerns.”

        Source: “Atticus Global finds its strategy paying off” Clow, Robert, Financial Times, August 30th, 2001, p. 25.

  6. Philip Roscoe Says:

    Daniel, as ever, you are spot on. I too encounter that remark all the time. I think that you are being over-generous in allowing that behavioural finance has any sociological content at all (whatever Shiller claims). As far as I can see, behavioural finance shares the majority of its epistemological assumptions with the EMH – if pushed I suspect that most BF scholars would believe markets to be really long term efficient, with this silly irrational stuff happening in the short term. Their methodological assumptions are also similar, with the addition of cognitive underperformance at an individual level. I suspect that “very topical” means “just a fad”, rather than a serious challenge.

    Now, here’s the bit I have struggled with: assuming that we take the agencement as the uniot of calculation, within that agencement there are still human actors, and we have to allow that the empirical evidence (from psychology) for the kinds of cognitive failure that BF invokes is very strong. Moreover, I found clear indications of the effects predicted by BH, especially disposition, overconfidence and mental accounting, in my interviews with retail investors. So we have to find a way to wrap individual level irrationality inside the agencement, such that macro level effects are produced not only by our account of material sociology, but also by human irrationality. To put that another way, an agent could be performed as a certain kind of market player, but also be incompetent, stupid, dishonest, a gambler etc; how do we unravel a credit crunch (not mentioning any ex-Wall street investment bank titans by name!) style story that seems to contain all these elments working within the framework of a material sociology?

    This is a difficult balancing act, and I think you and David have really tackled this head on. Nice work!

    Martha: you could also try Daniel, K., Hirshleifer, D., Teoh, S. (2001). Investor psychology in capital markets: Evidence and policy implications. Journal of Monetary Economics, 49 139-209.

  7. danielbeunza Says:

    Hey Philip — I particularly like your second point: Mistakes happen. Does that prove behavioral finance right? Quite the opposite. It proves that, as Callon writes, I argue that calculation in the abstract is very difficult. People need tools: pocket calculators, formulae, excel spreadsheets, etc. What behavioral economists do is (1) argue that calculation is easy; (2) take the tools that make it possible away from people, and then (3) show they make mistakes.

    It gets worse. The behavioral policy recommendation is then to remove choice. Create the “default option”, etc. This, then, eliminates any incentive for anyone to create devices that facilitate choice. Which means that, for those deviating from the default option, mistakes will happen. A performative cycle for behavioral finance theorists.

    • Philip Roscoe Says:

      Daniel – your anger is well founded. But your mention of the default option at least reminds me of the behaviouralists’ most lasting (I imagine)social contribution: the aim-improving fly in airport urinals. They may be intellecually off point, but when it comes to pissing, they are right on.

      • joedeville Says:

        Thanks for posting the interesting & important paper Daniel – still taking some time to ruminate on it. But Philip’s mention of Thaler’s fly does I think bear further exploration, in relation to the role of materiality in at least some behavioral economics. Because it might be perhaps a little too easy to assume that the behavioralists’ recommendations necessarily focus on the default option, or indeed that they ignore socio-material devices/tools. In particular, although Thaler is a fan of (re)setting defaults in the interest of others, he does at other times also quite explicitly talk – in albeit different ways to Callon etc – about creating/formatting socio-material market devices, what he might call a market’s ‘choice architecture’, to nudge people away from their existing default options (e.g. in relation to ‘status quo bias’ in Medicaid plan choices), towards some kind of better (even if paternalistically informed) choice. I wonder whether this is something that your paper could engage with a bit more explicitly, as Thaler was it seemed absent. To me, one key difference between a Callonian approach to market devices and a ‘Thalerian’ (is that a term??) might/should perhaps be a different and more careful attention on the part of the former to the politics that not only inform these devices, but also that emerge from their use.

      • danielbeunza Says:

        Joe — your comment is characteristically right on. There are some similarities, if you dig deep enough, between Thaler and Callon. Both have proposals for reform. But — and here is they key — the STS-inspired study of the economy is built on a framework of “people as scientists”, that is, members of a knowledge-intensive society and able to engage in controversies. Thaler comes from “bounded rationality,” an approach that best characterizes misinformed, illiterate or simply very old consumers. In Callon’s case, the answer to the problem that consumers choose inadequately is more controversy, debate, problematization. In Thaler, it is less choice, or a choice made by a cadre of “expert” designers who claim to know what’s good for you. Thaler’s society is the 1950s… Blue collar plus elites. Callon’s is the society of bloggers, browsers and nonexperts who happen to have an opinion. Which you like best?

  8. Jacques-Olivier Charron Says:

    I recognized it’s annoying to see people confusing sociology of finance with behavioural finance, but two remarks came to my mind.

    First, the « Black Swan » hypothesis is not behavioural finance : it is part of a much older debate on probability and risk modeling, that can be traced back to Mandelbrot’s papers in the early sixties. Most of Eugene Fama’s doctoral thesis, published in 1965, was an attempt to demonstrate that price changes distributions were “fat-tailed”. In the seventies, Mandelbrot’s influence sharply diminished in academic finance, apparently because his ideas were too difficult to put into models; recently, the crisis has somewhat revived this “fat-tail vs. log-normal” issue, that Nassim Taleb has successfully introduced to a larger audience. That may be interesting and may not be sociological, but that’s not behavioural finance.
    Now the idea that investors blindly follow models may be behavioural, but not more than the idea they can follow anything salient, anything that just captures their attention. And then we are talking there about investors, that is, if we exclude the (very important, indeed) case of proprietary trading, about people who are not observable in a trading room because they just don’t work there. We are rather talking about asset managers or individual investors that rely on traders to get their orders “best executed” but that, nevertheless, make decisions to buy or sell. In the case of asset managers, for example, the practice of index funds or “benchmarked” funds means you one way or another “imitate” the market, or at least an index or a benchmark that is supposed to represent the market; and, arguably, to imitate the market is to imitate the others : I think the best definition of “the market” for an investor considered individually is just “the other investors”. When you “replicate” an index or a benchmark, you imitate people. The idea of herding may be justified this way, hence it does have some content.

    Second, Shiller, Thaler, Shleifer and the others certainly aren’t sociologists, but that does not imply that all they say is naïve or irrelevant. The idea that problems occur in capital markets because investors deviate from a “standard rationality” is indeed naïve from a sociological point of view; when you take in account social contexts and what you call “mechanisms of reflexivity”, it certainly misses the point. Nevertheless, this idea, that entails a (questionable) “therapeutic” approach of regulation (in order to “educate” investors) doesn’t say everything about behavioural finance. It recently struck me when, looking for efficiency tests that were not tests for abnormal returns, I found the best example of that was Shiller’s 1981 article “Do stock prices move too much to be justified by subsequent movements in dividends ?” (American Economic Review, 71 (3), 1981, p. 421-436), that made him famous. Precisely, the most interesting in this article is not the psychological assumptions but the methodology : because it studies the information – price relationship taking price as a starting point (and not information, as in the event study methodology), it allows to see cases where prices move when apparently nothing of consequence happens. This empirical evidence is interesting in itself : you can explain it using a psychological reasoning, as Shiller does, but nothing prevents you from explaining it with a sociological, historical or institutional reasoning (that has to be grounded with other data, of course). I found some other cases of efficiency tests taking price as a starting point, not all written by “behaviouralists”, and it is also true the greatest part of behavioural research uses the event study methodology (that is, taking information as a starting point and testing for abnormal returns). Nevertheless, Shiller can be credited for having created a methodology that really allows a debate on the construction of financial asset prices to take place.

    We talk of problems on capital markets when we see bubbles or crashes, that is, prices that seem to us, for various reasons, unjustified. Then what has to be explained is not investors’ behaviour but prices’ behaviour, and the jump between the two is nothing but obvious: you can have “rational” investors and “irrational” prices (there is a theory of “rational bubbles” that accounts for that) and you can also imagine “irrational” investors and “rational” prices (in a case where different kinds of “irrationalities” compensate each other). What is always consequential is price, whereas behaviour is only if it affects prices. The problem with behavioural finance is it seems to take this influence for granted, but I think at least some of the empirical material this research provides can make room for sociological accounts.

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  11. danielbeunza Says:

    Jacques-Olivier — I disagree with your two comments, but they’re interesting and worth discussing.

    Is Taleb a behavioral finance theorist? You argue that he is not, because he writes about extreme events and fat tails. But, critically, Black Swans are more than extreme events — they are extreme events that market actors underestimate. It is the presence of this bias that puts him firmly on the behavioral camp. By the way, Taleb also publishes on the Journal of Behavioral Finance, belongs to the Society of Judgment and Decision Making, and writes about confirmation bias and survivorship bias.

    On Shiller’s: whose methods should sociologists be looking at? I argue that sociology has its greatest impact when it does what only it can do, rather than emulating the methods of economics. That’s why I like so much the qualitative work of MacKenzie, Millo, Preda, Knorr-Cetina, Muniesa, Lepinay or Godechot. Economists don’t read economic sociology, much less find inspiration in its methods, so I don’t find compelled to look at theirs.

  12. yuvalmillo Says:

    I agree completely that sociology has a specific (and an important) contribution to make to understanding financial. The way I see it, the contribution in the case of this paper relies on very a basic, but very profound sociological concept, that of the generalised other. During socialisation, George Herbert Mead says, the child takes on the role of others. Those ‘others’ begin as concrete others (parents, siblings), but gradually, the child learns to take the role of more general others that represent groups or categories rather than specific individuals. I think that you present in your paper a lovely case where the traders construct, through the use of the spread plot, a portrait of a generalised other: the market. By using both social and technical tools and skills they maintain a dialogue within the trading room where they try to test the validity of the generalised other they gradually construct. That is, they ‘see’ the generalised other through the behaviour of the spread plot.

    I must say, though, that my reading of Taleb’s ideas does not place him in the behavioural ‘camp’, nor is he, I believe, ‘model-centric’. His argument, instead, refers to the futility of relying on forecasting beyond a very short horizon. Taleb complains (well, he rages…) that many professional perpetuate the lie that market behaviour can be predictable. However, that does not make him a behavioural finance scholar because BF scholars believe that by tracing and understanding the market anomalies (areas where markets diverge markedly from random walk) they would be able to make markets more predictable, while Taleb rejects this notion. In fact, he’s saying that no matter what people do, markets are and will be unpredictable. All this, of course, does not take away anything from your case, but I think that adding the Black Swan concept into the mix may distract some of the attention from the interesting findings you present.

  13. danielbeunza Says:

    Yuval — agreed on the generalized other. But I strongly disagree on your characterization of Taleb. As I write in our paper (p. 13) he is strongly model-centric in his attack on the Value-at-Risk formula. See the appearance he put up in Congress:

    And this is not just a sideshow for him… the New York Times has described him as a “crusader” against quantitative risk management. That’s model centric in my view.

    Second, is Taleb in behavioral finance? The issue here is what is behavioral finance at the core. And the belief of market predictability is not at its core. See, for example, the arguments of Shleifer in “The Limits of Arbitrage”. According to Shiller 2003, the core of behavioral finance is the notion that there are market-level “anomalies” that can be traced to biases in the decision making process of individual actors (or their models).

    I agree with you, however, in that my paper is the first to put Taleb and the herding crowd in the same bucket. But this makes the argument stronger because it really shows that the problem with behavioral finance does not lie in that they missed some factor in their analysis, whether technology or imitation. The key problem with behavioral finance is epistemic: its methodology (retrospectively explaining anomalies on the basis of hypothesized biases) cannot get at what actually goes on the trading floor. Confronted by a macro problem, they resort to micro flaws. What I show is that a macro bad can be the result of a micro good. And you would never know unless you leave the lab.

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