On distinguishing between behavioural finance and sociology of finance

April 24, 2010

Jacques-Olivier Charron posted this thoughtful set of distinctions in the comments section which I thought were worthy of being highlighted in the form of a post.  I found his observation that ‘Black Swans’ are natural inhabitants of the epistemology of probability an important reminder not to conflate the existence of ‘fat tails’ with errant behavior.  I also found his second point, that price changes can be due to any variety of factors that need not be exclusively behavioral, but this is precisely what behavioural finance takes for granted, a insightful step towards clarifying what is at stake in this debate.   – Martha

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.

By Jacques-Olivier Charron

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