Lec­ture in Behav­ioural Finance

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As noted ear­lier, I’m giv­ing a brand new set of lec­tures on Behav­ioural Finance at UWS. I am tak­ing a non-stan­dard approach (sur­prise sur­prise) because I am dis­sat­is­fied with the texts in this area–even though it is gen­er­ally a non-neo­clas­si­cal realm.

The rea­son is that most Behav­ioural Finance texts  give too much cre­dence to the neo­clas­si­cal def­i­n­i­tion of rationality–when that def­i­n­i­tion has as much to do with ratio­nal behav­iour as walk­ing on water has to do with mass trans­porta­tion. I also want to include mate­r­ial from chaos the­ory and econo­physics analy­ses of finance, which most texts haven’t incor­po­rated; and I’m con­sid­er­ing micro, macro and finance together since all three are inte­grated when one aban­dons the neo­clas­si­cal fan­tasies about “ratio­nal” agents who can accu­rately fore­see the future.

The first three lec­tures have been writ­ten and are now avail­able on the Lec­tures page of this blog. For those who’d rather click from here, these are the links:

I had hoped to base posts on each lec­ture, but given the time pres­sure I’m under right now, this will have to do!

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  • BH

    Thanks for post­ing these Steve. The slides on the one-off choice uncer­tainty vs long run prob­a­bil­ties are great (I was always dis­qui­eted by the focus on long run prob­a­bil­i­ties and one-offs not dis­cussed at all). And CAPM… I’m still annoyed at being hit around the head with util­ity the­ory and CAPM in my degree in the mid 80s. Strange that the the­ory I was taught didn’t seem to be used by peo­ple at the finan­cial firm I worked for after my degree — that is until they realised the mar­ket­ing value of design­ing port­fo­lios for dif­fer­ent investor “risks tol­er­ances”. CAPM was great for mar­ket­ing, dif­fer­ent beta assigned to dif­fer­ent com­pa­nies meant you could sup­pos­edly design port­fo­lios with dif­fer­ent risk pro­files, there­fore cre­at­ing a vari­ety of invest­ment port­fo­lio prod­ucts to sell to investors who were then con­vinced they fell on a con­tin­u­ous spec­trum of risk tol­er­ance.

    Some years ago my wife and I went to our first meet­ing with the firm that han­dles our super and WOW, I got asked my risk tol­er­ance (mul­ti­ple choice ques­tion — one of five answers “High Risk”, “Medium High”, etc.). Argh..

    Pity the firm stuffed up my super despite their “best prac­tise” and despite my “bal­anced” choice — who doesn’t want to be bal­anced? This par­tic­u­lar firms bal­anced option seems finely tuned to cap­ture all down­side and lit­tle upside and that was before the GFC.

    Choos­ing this firm over another, another one-off choice. How to prop­erly eval­u­ate their per­for­mance, best prac­tise would say wait five years and see if you have more money than at the start.

    Surely one-off choices dom­i­nate our lives.

  • pritcharded

    Your first three lec­tures con­tain some dev­as­tat­ing logic and have been easy to fol­low except for Slide #20 which con­tains logic sym­bols that have proved impen­e­tra­ble for non-econ­o­mists like me. An explana­tory extra slide would be most help­ful.

  • The ” ?” sym­bol sim­ply means “pre­ferred to” Pritcharded: “If shop­ping trol­ley A is pre­ferred to shop­ping trol­ley B then…”

  • bernard

    Hi Steve,

    Fol­low­ing the blog and your work with inter­est. Was won­der­ing if
    you had read any work by Morde­cai Kurz at Stan­ford and if so what
    your opin­ion was. This is in the con­text of some com­men­tary I
    read recently that behav­ioural eco­nom­ics wasn’t pro­vid­ing a
    con­vinc­ing and com­pre­hen­sive alter­na­tive to neo-clas­si­cal where
    as Kurz work was com­pli­cated but com­pre­hen­sive and very dif­fer­ent
    in approach.

    Regards

  • Hi Bernard,

    Kurz’s work is still in a largely equi­lib­rium “ratio­nal expec­ta­tions” frame­work. I am not a pro­po­nent of his approach.

  • Frank

    Can you offer dis­tance courses?

  • Jim

    Steve,
    It would be great if you could record these lec­tures and put the mp3’s up with the slides. It would cer­tainly help me and oth­ers under­stand the slides bet­ter!

  • No time for that I’m afraid Frank,

    And on Jim’s point I should have recorded MP3s but was just too busy to organ­ise to have it done!

  • djw65

    Steve
    Are you able to super­vise post-grad research in behav­ioural finance? It seems most Aust instos take only a pass­ing inter­est in the topic — per­haps because its unortho­dox, or unfa­mil­iar oustide its US strong­hold.

    I am inter­ested in pur­su­ing the topic fur­ther. I must say the dis­c­pline fits more with your eco­nomic views, and I was pleased to see you are now teach­ing the sub­ject.

    If not you, are there any peo­ple in Aus­tralia you would rec­om­mend?

    Dar­ren

  • I’m just too busy to even con­tem­plate it djw65, unless the prospec­tive stu­dent were about as self-super­vis­ing as I was in my own PhD! But apart from my lean­ings in that direc­tion, I’m not aware of any­one else work­ing in the field in Australia–at least to the level where they have research papers I’ve yet seen.

    Maybe dis­cuss this off-list via my debunking@gmail.com email.

  • gut­feel­ing

    Not sure if this is entirely rel­e­vant to this arti­cle, but thought this was a very inter­est­ing arti­cle: “Have the immoral actions of cen­tral bankers pre­cip­i­tated the decline of the West?”

    It’s not just the cul­ture of the West, or its pro­mo­tions, or even its social orga­ni­za­tion that is fin­ished. You CANNOT, as a soci­ety, wit­ness a cou­ple of guys pull a tril­lion out of their back pock­ets with­out feel­ing, well … snook­ered. And after feel­ing snook­ered, some­thing else begins to per­co­late. “Hey,” you say, “wait a minute. I sit here with my debts and my job and my house in fore­clo­sure and this guy — THIS GUY — throws around tril­lions? Wait a minute. WHEN DO I GET MINE!”

    And so it begins. You have seen the essen­tial immoral­ity of the sys­tem. You have felt it deep in the gut, just the way they did once they began to read Bibles (cour­tesy of the Guten­berg press) 500 years ago and began real­iz­ing that the Roman Catholic Church was pro­foundly immoral — that its entire ethic (you can buy your way into heaven) was built on a kind of lie. Just as soci­ety is today. Yes, he’s right. This finan­cial cri­sis and the “out­side the box think­ing” (Pres­i­dent Obama’s term) of Ben Bernanke and oth­ers has not just doomed the elite’s dom­i­nant social themes, it has prob­a­bly doomed the freakin’ CIVILIZATION.” 

    http://www.thedailybell.com/BellPage.asp?nid=500&fl=1

  • Jason Vella

    Steve, I will read these lec­tures with a lot of inter­est. It’s been a while since I focused my atten­tion on Behav­ioural Finance. I wish we had this sub­ject avail­able back when I was study­ing under grad.

  • Jason Vella

    Steve, I had a brief look through the slides (except for the sec­ond lec­ture — I am hav­ing prob­lems open­ing the slide pack) — they look great! Two areas I think that would be of inter­est to your course: 1) the rel­e­vance of mem­ory effects in asset price behav­iour — in par­tic­u­lar how this impacts stock prices (caus­ing fat tails) and chal­lenges the ratio­nal of Effi­cient Mar­kets Hypoth­e­sis; 2) how incen­tives in the finance indus­try encour­age assets price volatil­ity — i.e. this is how man­agers of funds make money. On both points, a nice link can be made to Keynes’ views of uncer­tainty (I never for­get the beauty con­test exam­ple).

    Apolo­gies if any of this is cov­ered in your sec­ond lec­ture. I hope I can access that some time soon.

    All the best

  • Hey Steve,

    good to see you debunk some more RE myths 🙂 Clearly ratio­nal expec­ta­tions are the realm of cen­tral bankers with super-com­put­ers and some hedge funds. The rest of us, not so much. I have blogged on a sim­i­lar theme here: http://bit.ly/sycOA

    I enjoyed your “non-com­putabil­ity” proof. Solid and well researched. Are you teach­ing com­puter sci­ence or eco­nom­ics?

    In any case, I have just read the first lec­ture. As men­tioned in email,
    1/ could you make the preso avail­able in PDF as opposed to PPT? I can read it OK in google docs but some signs get bun­gled.
    2/ MARKETING. Mar­ket­ing is designed to skew your choices by mak­ing a prod­uct sexy, pack­aged just right etc. Price isn’t every­thing in mak­ing a deci­sion. Mar­ket­ing KNOWS humans are irra­tional beings.

    Most humans, at least in amer­ica, bypass NP in-com­plete­ness with “gut feel­ing”, so what if you can’t com­pute, can “feel it”? Intu­itive investors should be mod­eled as ran­dom.

  • 1/ is done mar­cf999! And I’m teach­ing eco­nom­ics, but the field is so bad that I include as much wis­dom as I can from out­side it (god knows there’s pre­cious lit­tle inside).

  • Thanks steve, I wish I could attend those classes. 

    As for lack of wis­dom, I wouldn’t be too hard on the field but it is true that money as a the­ory is still in its infancy. I do believe in flow of funds work (first deriv­a­tive dynam­ics) like what you do are impor­tant.

    I think that biol­ogy, not least sys­tems biol­ogy, will yield pos­i­tive insights for econ­omy. I blab more about that there: http://www.thedelphicfuture.org/2009/07/economics-in-crisis.html

  • Steve,

    FYI the links are still ppt not PDF

    I am read­ing through the sec­ond class. To be fair, if an agent is assumed to have a lin­ear response, then the aggre­gate will be lin­ear, this is just the def­i­n­i­tion of “lin­ear”. As a result it speaks of a “sin­gle” agent and a sin­gle good, the aggre­gates. But it is akin to think­ing of the cen­ter of grav­ity in physics as a point. It is a valid approx­i­ma­tion.

    Arriv­ing at “I model lin­ear” is not a proof of absur­dity. It is just a restate­ment of the assump­tions. This is not a proof by the absurd, it is, how­ever a great intro­duc­tion to a more com­pos­ite model of demand that has the curved (non-lin­ear) priced-demand rela­tion­ships. The var­i­ous demands on a weighted aver­age basis can yield the shape you put up, depend­ing on weight of pop­u­la­tion. What I like about it is that if demand is close to lin­ear then lin­ear pre­dic­tion is easy and mapped in cur­rent macro. Cur­rent micro is a spe­cial case of your macro defined with weighted aver­age demand of non-lin­ear responses to price.

  • Read­ing through the mate­r­ial for gen­er­at­ing com­pos­ite demand. You can couch it in the quan­tum physics nar­ra­tive. It goes a lit­tle some­thing like this: the state of what we observe is a sum of dif­fer­ent states. The states are more or less heavy. For exam­ple: there are 4 types of buy­ers behav­ior (four pos­si­ble states) a buyer can adopt a/b/c or d like you define them in your text. Assign weights to it, 20/40/10/30 and sum them up. This is how you gen­er­ate your funky shape. micro has mod­elled lin­ear or 100% d. You are a gen­er­al­iza­tion because you assume more states avail­able to the indi­vid­ual. We had one 1 state avail­able before and now we have 4.

  • Just read­ing through slide 28–33 of the first pre­sen­ta­tion and it occurred to me. 

    If peo­ple were truly ratio­nal wouldn’t any mar­ket place even­tu­ally be squeezed down to the one provider as con­sumers ratio­nally choose one good/service over another con­stantly putting alter­na­tives pro­gres­sively out of busi­ness?

  • Dear Zippy,

    You have to recon­sider how you define the word “rational”–you’re still suc­cumb­ing to the def­i­n­i­tion econ­o­mists use. Apply­ing this to the real world, there has only ever been one ratio­nal person–Nostradamus (or your pre­ferred deity).

    Check the first few lec­tures in Behav­ioural Finance out on that front: not only is the neo­clas­si­cal def­i­n­i­tion oper­a­tionally dys­func­tional even to describe a shop­ping trip to a 7–11 (let alone a super­mar­ket), it also endows every agent with an accu­rate under­stand­ing of the work­ings of the entire econ­omy. Since there were 2 neo­clas­si­cally-ori­ented econ­o­mists who pre­dicted this cri­sis and about 20,000 who didn’t, I think we should also scotch that aspect of the neo­clas­si­cal vision of ratio­nal­ity.

    The mar­ket is also an evolv­ing creature–and per­fect adap­ta­tion never occurs in evolv­ing sys­tems. If it does, it occurs the day before extinc­tion.

  • habika

    Arriv­ing at “I model lin­ear” is not a proof of absur­dity. It is just a restate­ment of the assump­tions. This is not a proof by the absurd, it is, how­ever a great intro­duc­tion to a more com­pos­ite model of demand that has the curved (non-lin­ear) priced-demand rela­tion­ships. The var­i­ous demands on a weighted aver­age basis can yield the shape you put up, depend­ing on weight of pop­u­la­tion. What I like about it is that if demand is close to lin­ear then lin­ear pre­dic­tion is easy and mapped in cur­rent macro. Cur­rent micro is a spe­cial case of your macro defined with weighted aver­age demand of non-lin­ear responses to price.
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