Financial History: Behavioural economics

The roots of behavioural economics can be traced back centuries; this fundamental discipline has helped economists explain why individuals sometimes make financial decisions that seem curiously irrational

Behavioural Economics is a branch of economic research that analyses and considers psychology as it relates to an individual's economic decision-making processes
Behavioural Economics is a branch of economic research that analyses and considers psychology as it relates to an individual's economic decision-making processes  
Adam Smith (1723-1790). The Scottish economist and author laid the foundations for behavioural economics

Adam Smith’s The Theory of Moral Sentiments represents an early example of behavioural economics. Some of the insights in the 1759 publication, particularly his theory of the balancing act between man’s “passions” and his more reasoned “impartial spectator”, correspond with later work done by psychologists and financial analysts. Smith’s discussion of human irrationality and myopia also prefigures some of the themes that would become fundamental to the field of behavioural economics.

In his 1844 essay On the Definition of Political Economy, John Stuart Mill laid the groundwork for the neoclassical economic notion that humans are rational and self-interested actors. He wrote that man is “a being who invariably does that by which he may obtain the greatest amount of necessaries, conveniences, and luxuries, with the smallest quantity of labour and physical self-denial with which they can be obtained”. From his work, the idea of the economic man, or ‘homo economicus’, emerged.

The 1929 Wall Street Crash triggered the Great Depression. Keynes published the bulk of his work in the depression years

John Maynard Keynes’ The General Theory of Employment,Interest and Money brought about a shift in macroeconomic thought by placing psychological factors at the heart of its theories. Published just after the Great Depression, Keynes’ work went against classical economics by claiming that aggregate demand, not the price of labour, determines employment levels. Demand, however, can be affected by factors that are not necessarily rational, such as notions of fairness and cognitive bias.

Milton Friedman reaffirmed homo economicus in his 1953 work The Methodology of Positive Economics. He insisted that, although humans may not literally work through mathematical equations when making a financial decision, they still “behave as if they were seeking rationally to maximise their returns”. He also believed that economic theories should be judged on the accuracy of their predictions, not by how closely they described real life, if economics was to be respected as a scientific discipline.

Although partly supportive of the concept, American economist Herbert Simon was not convinced that the ‘rational economic man’ was the full story. He instead asserted, notably in his 1955 article A Behavioural Model of Rational Choice, that limits to available information and man’s computational capacity often compromise decision-making. His belief that economic and business decisions occur, at best, as the result of ‘bounded rationality’ was later developed further by behavioural economists.

Eugene Fama supported the notion of the efficiency of markets owing to the ability of stocks to respond immediately to information

During the 1960s, Eugene Fama, through his work on the efficient market hypothesis, argued that stock prices respond to information almost immediately, meaning that markets are always efficient. If this is true, there are two notable outcomes: first, it is not possible to beat the market, and second, prices reflect an asset’s true value. While behavioural economists would not typically disagree with the former assumption, many would dispute the latter.

In 1979, Amos Tversky and Daniel Kahneman published a paper titled Prospect Theory: An Analysis of Decision under Risk, which had a huge impact on behavioural economics. They postulated that individuals make economic decisions by assessing potential losses and gains and, in doing so, place a greater importance on perceived gains – known as ‘loss aversion’. They have since highlighted a number of heuristics, or cognitive shortcuts, that cause people to make irrational choices.

After working with Kahneman and Tversky in his early career at Stanford University, Richard Thaler soon made a name for himself through his own theories. Notably, his ‘nudge theory’ explained how individuals could be subtly influenced to make decisions that were in their best interests. In 2017, he was awarded the Nobel Prize in Economic Sciences for his work in behavioural economics, providing further vindication for a field that recognises that markets are as much about psychology as they are statistics.