My lec­tures on Behav­ioural Finance

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I’ve just com­pleted sec­ond year of my sub­ject Behav­ioural Finance at the Uni­ver­sity of West­ern Syd­ney. This is of course a non-tra­di­tional subject–meaning non–Effi­cient-Mar­kets-Hypoth­e­sis–but even here I take a non-stan­dard approach. While I have great respect for the work of Kah­ne­man and Tver­sky on behav­ioural eco­nom­ics, I argue that much of the sub­se­quent work is mis-directed, because of a cru­cial mis­in­ter­pre­ta­tion of the orig­i­nal work on expected util­ity by von Neu­mann and Mor­gen­stern.

Much of the stan­dard behav­ioural finance lit­er­a­ture shows that indi­vid­ual behav­iour vio­lates the pre­cepts of expected util­ity the­ory when faced with a choice between two hypo­thet­i­cal options, and then devel­ops some mod­i­fied util­ity func­tion that fits the actual behav­iour. The options are nor­mally pre­sented in this man­ner:

  • 1. Choose between 
    • A.$1000 with cer­tainty; OR
    • B. 90% odds of $2000 & 10% odds of -$1000
  • 2. Choose between 
    • A. $0 with cer­tainty; OR
    • B. 50% odds of $150 and 50% odds of -$100
  • 3. Choose between 
    • A. -$100 with cer­tainty; OR
    • B. 50% odds of $50; 50% odds of -$200

It is alleged that a ratio­nal per­son accord­ing to expected util­ity the­ory would choose B in all 3 cases, since the expected value of B exceeds A every time. The expected value is cal­cu­lated sim­ply by mul­ti­ply­ing the value of each out­come by the prob­a­bil­i­ties. Thus the val­ues above are

  • 1. Choose between 
    • A: $1000
    • B. .9 times $2000 + .1 times -$1000 = 1800 — 100 = 1700
  • 2. Choose between 
    • A. $0
    • B. .5 times $150 — .5 times $100 = $75 — 50 = 25
  • 3. Choose between 
    • A. -$100
    • B.  .5 times $50 — .5 times $200 = $25 — 100 = -$75

How­ever, when exper­i­ments are con­ducted, the major­ity of peo­ple choose option A in choices 1 and 2, but B in num­ber 3: they are “irra­tional” twice and ratio­nal once. This sets up all sorts of conun­drums, lead­ing to a range of inter­est­ing prob­lems, and a volu­mi­nous lit­er­a­ture on irra­tional­ity, bounded ratio­nal­ity, risk aver­sion, pref­er­ence rever­sal, and so on. The Wikipedia entry (as at Novem­ber 11 2010) encap­su­lates this per­spec­tive:

The expected util­ity hypoth­e­sis, as applied to eco­nom­ics, has lim­ited pre­dic­tive accu­racy, sim­ply because in prac­tice, humans do not always behave VNM-ratio­nally. This can be inter­preted as evi­dence that

  • humans are not always ratio­nal, or
  • VNM-ratio­nal­ity is not an appro­pri­ate char­ac­ter­i­za­tion of ratio­nal­ity, or
  • some com­bi­na­tion of both.

Had von Neu­mann lived to see the devel­op­ment of this the­ory, I expect he’d be ques­tion­ing, not human ratio­nal­ity in gen­eral, but the ratio­nal­ity of his interpreters–because his con­cept of expected util­ity was very dif­fer­ent to how it is now por­trayed in the lit­er­a­ture. The cru­cial dif­fer­ence is that the lit­er­a­ture uses a sub­jec­tive vision of prob­a­bil­ity, when this was explic­itly rejected by von Neu­mann and Mor­gen­stern:

Prob­a­bil­ity has often been visu­al­ized as a sub­jec­tive con­cept more or less inthe nature of esti­ma­tion. Since we pro­pose to use it in con­struct­ing anin­di­vid­ual, numer­i­cal esti­ma­tion of util­ity, the above view of prob­a­bil­ity would­not serve our pur­pose. The sim­plest pro­ce­dure is, there­fore, to insist upon­the alter­na­tive, per­fectly well founded inter­pre­ta­tion of prob­a­bil­ity as fre­quency in long runs.” (von Neu­mann & Mor­gen­stern 1944: 19)

What dif­fer­ence does that make? A lot! Try it with the above three exam­ples: con­sider exactly the same choices, but with the pro­viso that whichever option you choose you must repeat 100 times:

  • 1. Choose between 
    • A. Receiv­ing $1000 with cer­tainty 100 times; OR
    • B. 100 gam­bles with 90% odds of $2000 & 10% odds of -$1000
  • 2. Choose between 
    • A. Recev­ing $0 with cer­tainty 100 times; OR
    • B. 100 gam­bles with 50% odds of $150 and 50% odds of -$100
  • 3. Choose between 
    • A. Los­ing -$100 with cer­tainty 100 times; OR
    • B. 100 gam­bles with 50% odds of $50; 50% odds of -$200

Now there’s no doubt that option B is the ratio­nal one. The total val­ues of the options are now:

  • 1.
    • A. $100,000
    • B. 100 times (.9 times $2000 — .1 times -$1000) = 100 times ($1,800 — $100) = $180,000 — $10,000 = $170,000
  • 2.
    • A. $0
    • B. 100 times (.5 times $150 — .5 times $100) = 100 times ($75 — $50) = $2,500

3.

  • A. -$10,000
  • B. 100 times (.5 times $50 — .5 times -$200) = 100 times ($25 — $100) = -$7,500

Do the sums and you’d have to be irra­tional (or very bad at arith­metic) to choose A over B.

The dif­fer­ence between the way the lit­er­a­ture has inter­preted von Neu­mann and Mor­gen­stern and the way they intended their work to be used is that, in their model, the con­sumer actu­ally gets the Expected Value of the gam­ble, because if you take a gam­ble 100 times, the out­come is very likely to be close to the pre­dicted odds. If on the other hand you under­take a gam­ble only once, you don’t get the Expected Value: you get either one option or the other, and prob­a­bil­ity can tell you which is more likely, but it can’t tell you which one you’ll actu­ally get.

Con­se­quently I see much of the behav­ioural eco­nom­ics & finance lit­er­a­ture as inter­est­ing, but wrong-headed–and is so often the case in eco­nom­ics, using a def­i­n­i­tion of “ratio­nal” that is seri­ously irra­tional. My sub­ject there­fore devotes a mod­icum of time to the stan­dard lit­er­a­ture before mov­ing into what I see as a more real­is­tic approach, of con­sid­er­ing what the macro behav­iour of the finance sec­tor actu­ally is. This leads ulti­mately to Minsky’s Finan­cial Insta­bil­ity Hypoth­e­sis and the “Great Reces­sion”.

All my lec­tures (in pow­er­point for­mat) are linked below, as well as MP3 record­ings of the lec­tures and, in some cases, FLV record­ings of my pre­sen­ta­tion. I had some hard­ware and soft­ware has­sles while doing all this; hope­fully I’ll be able to post a more com­plete set of these next year.

Lecture 01: Economic Behaviour

Pow­er­point

Steve Keen’s Debt­watch Pod­cast

 

Lecture 02: Market Behaviour

Part 1 Demand: Pow­er­point

Steve Keen’s Debt­watch Pod­cast

 

Part 2 Sup­ply: Pow­er­point

Steve Keen’s Debt­watch Pod­cast

 

Lecture 03: Theoretical Financial Markets Behaviour

Part 1: Pow­er­point

Steve Keen’s Debt­watch Pod­cast

 

Part 2: Pow­er­point

Steve Keen’s Debt­watch Pod­cast

 

Steve Keen’s Debt­watch Pod­cast

 

Lecture 04: Actual Financial Markets Behaviour

Part 1: Pow­er­point

Steve Keen’s Debt­watch Pod­cast

 

Part 2: Pow­er­point

Steve Keen’s Debt­watch Pod­cast

 

Lecture 05: Fractal Markets Hypothesis

Part 1: Pow­er­point

Steve Keen’s Debt­watch Pod­cast

 

Steve Keen’s Debt­watch Pod­cast

 

Lecture 06: Inefficient Markets Hypothesis

Pow­er­point

Lecture 07: Statistics on money

Part 1: Pow­er­point

Part 2: Pow­er­point

Lecture 08: Endogenous money

Part 1: Pow­er­point

Part 2: Pow­er­point

Lecture 09: Modelling endogenous money

Part 1: Pow­er­point

Part 2: Pow­er­point

Lecture 10: Extending endogenous money

Part 1: Pow­er­point

Part 2: Pow­er­point

Lecture 11: The Financial Instability Hypothesis

Part 1: Pow­er­point

Steve Keen’s Debt­watch Pod­cast 

| Open Player in New Win­dow

Part 2: Pow­er­point

Steve Keen’s Debt­watch Pod­cast 

| Open Player in New Win­dow

Lecture 12: The “Global Financial Crisis”

Part 1: Pow­er­point

Part 2: Pow­er­point

Steve Keen’s Debt­watch Pod­cast 

| Open Player in New Win­dow

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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  • It’s more than that Tom. As we prove, MC=MR isn’t profit-max­i­miz­ing behav­iour. The threat of new non-profit-max­i­miz­ing agents isn’t part of the the­ory.

    Ulti­mately I want this stuff con­signed to the garbage can of intel­lec­tual his­tory, along with phlo­gis­ton, the aether and heav­enly orbs. But for now point­ing out that it is not inter­nally con­sis­tent is part of the process of get­ting rid of it.

    The other thing that has really annoyed me is that neo­clas­si­cals never con­cede that the Mar­shal­lian model is strictly false. If that were con­ceded, and it was no longer taught, then much of the neo­clas­si­cal edi­fice would crum­ble with it.

  • Hi Tom,

    I think part of the error of the EMH (as opposed to the IEH) is assum­ing Gauss­ian dis­tri­b­u­tions. So while I accept aspects of your model, I would not have a Gauss­ian dis­tri­b­u­tion of any­thing as part of it. Vari­ables and firms in a mar­ket econ­omy affect the out­come of other vari­ables and firms; the inde­pen­dence required for a truly ran­dom dis­tri­b­u­tion of any­thing is not met.

  • Tom Shaw

    Thanks for the feed­back. In fact white light itself doesn’t fol­low a Gauss­ian dis­tri­b­u­tion of fre­quen­cies — it fol­lows the black body radi­a­tion dis­tri­b­u­tion. So I see no prob­lem in allow­ing e.g. the power law dis­tri­b­u­tion for pric­ing errors. The require­ment is that the error of a stock at time A is inde­pen­dent of the error of that stock at long run time B.

  • Tom Shaw

    Why do you say the new agents are not profit-max­imis­ing? I’ve showed you the profit motive: go from $0 to greater than $0. It would be irra­tional NOT to take up this oppor­tu­nity!

    Are you defin­ing profit-max­imis­ing in terms of the mar­ket as a whole? The whole point of game the­ory is that ratio­nal, indi­vid­u­ally profit-max­imis­ing actors don’t nec­es­sar­ily reach the Pareto-opti­mum level (let alone their indi­vid­ual global max­i­mum level). That doesn’t mean they’re not profit-max­imis­ing.

    Regard­ing your goal of debunk­ing the Mar­shal­lian model, one thing I learnt from study­ing Nego­ti­a­tion is that a large num­ber of weak argu­ments does not per­suade some­one to change their mind. Every detail that they can rebut encour­ages them to entrench their posi­tion fur­ther. It’s bet­ter to repeat a few strong argu­ments that can’t be rebutted.

  • Tom Shaw

    PS Here’s the essence of your cir­cu­lar logic. You assume that there are no new entrants, so you derive that MC=MR isn’t profit-max­imis­ing behav­iour. You then use this result to prove that there are no new entrants.

  • Tom, the notion that MC=MR max­imises prof­its was first asserted by Mar­shall in the con­text of par­tial equi­lib­rium for a sin­gle mar­ket with­out the con­sid­er­a­tion of entry from other mar­kets. It is cat­e­gor­i­cally false. In par­tial equi­lib­rium, the actual profit-max­imis­ing rule is, as I have derived:

    MC-MR = (n-1)/n * (P-MC)

    I have not derived the rule for gen­eral equilibrium–nor am I inter­ested in doing so. I imag­ine it would fur­ther gen­er­alise my result for par­tial equi­lib­rium. Would you like to give it a try?

  • Tom Shaw

    Hi Steve, one of the explicit assump­tions of the model is that there are no bar­ri­ers to entry. How can you say with a straight face that the model doesn’t include con­sid­er­a­tion of entry from other mar­kets?

    It’s not a gen­eral equi­lib­rium model and it’s not try­ing to be. My point is that the per­fect com­pe­ti­tion model, with its flawed assump­tions and known lim­i­ta­tions, is at least inter­nally con­sis­tent. Your sim­u­la­tion is mis­lead­ing because it quickly leads to unre­al­is­tic “meta-Nash” strate­gies that can be dis­rupted by the slight­est change to the sim (includ­ing but not lim­ited to new entrants — again I’m happy to send you the code if you’re inter­ested).

  • Tom Shaw

    I should clar­ify that yes, when the Mar­shal­lian model con­sid­ers entry from other mar­kets, it’s clearly not con­sid­er­ing the impact on those other mar­kets and feed­backs between mar­kets — as you say, it’s a par­tial equi­lib­rium model.

    If your prob­lem with the Mar­shal­lian model is that it’s a par­tial equi­lib­rium model, then that’s a per­fectly valid crit­i­cism and I’d sup­port you on it. But that has noth­ing to do with its inter­nal con­sis­tency or the flaws in your sim.

  • Tom, par­don my bore­dom with this topic, but I spent 5 years engaged in this debate with neo­clas­si­cals from all over the planet, and I have heard all this before. I can say that the model doesn’t include con­sid­er­a­tion of entrant from other mar­kets because the “proof” that MC=MC is profit max­imis­ing in every instance I’ve ever seen it has been a sin­gle mar­ket proof. Find me some­where that entry is invoked to prove that MC=MR is profit max­imis­ing and I might be inter­ested in con­tin­u­ing the dis­cus­sion.

  • I have done count­less other sim­u­la­tions Tom–some of which have been pub­lished in other papers. All the effects you have gen­er­ated I have like­wise already seen, and then some. The bot­tom line is that it is a math­e­mat­i­cally flawed model (in its Mar­shal­lian guise) and a waste of time at an empir­i­cal level. The sooner eco­nom­ics aban­dons it, the bet­ter. Hav­ing spent 5 years of my life engaged in this debate, I am not inter­ested in con­tin­u­ing it any fur­ther. My apolo­gies for the blunt­ness here, but I’d rather con­tribute to the devel­op­ment of a worth­while alter­na­tive than con­tinue debat­ing this vac­u­ous model.

  • Tom Shaw

    Hi Steve, I’m not sure why you’re bored given I’m offer­ing a dif­fer­ent proof (the­o­ret­i­cal and sim­u­la­tion) of MR=MC, under neo­clas­si­cal per­fect com­pe­ti­tion assump­tions, than any you’ve seen before! I cer­tainly wouldn’t call myself a neo­clas­si­cal: Schum­peter + Min­sky + Porter as you’ve out­lined them make much more sense to me. But I am capa­ble of mak­ing my own argu­ments from neo­clas­si­cal assump­tions.

    Any­way, I appre­ci­ate that you’re under no oblig­a­tion to pub­lish your lec­tures let alone debate ran­dom strangers on the inter­net ad infini­tum, so thank you for your time and I hope I’m still wel­come to explore more inter­est­ing areas with you (such as my model of the inef­fi­cient mar­ket hypoth­e­sis).

  • Try five years of the same debate Tom! So yes, that’s filed under “been there, done that” for me. Min­sky and finan­cial insta­bil­ity are far more inter­est­ing and rel­e­vant to the real world. And by all means keep going on the IMH.

  • hoth­solo

    A friend of mine sent me a link to this and I had a com­ment. Great arti­cle. And it’s right, but I think it didn’t go deep enough. The “irra­tional” human the­ory also ignores Adam Smith: labor = value. When you look at it in that regard it is per­fectly ratio­nal.

    1. Choose between $1000 for no labor or the pos­si­bil­ity of $2000 with no labor or GIVING $1000 worth of your already expended labor (ie. wast­ing your time and effort).

    Labor that a per­son works is worth more to them than some­one else’s labor (ie. free money). Or to put it another way, you put more value on $1000 that you earned than $1000 that is given to you. And this is a ratio­nal posi­tion because our per­sonal time and labor is highly valu­able to us. So peo­ple will choose A because there’s no pos­si­bil­ity of them wast­ing their own labor.

    2. Choose between $0 for no labor or the pos­si­bil­ity of $150 with no labor or wast­ing $150 of already expended labor.

    Again, Option A is the only one with no chance of your own labor being wasted.

    3. Choose -$100 wasted labor or the pos­si­bil­ity of $50 with no labor or $200 wasted labor.

    Here the only option that has any chance of not wast­ing labor is option
    B. So peo­ple pick it.

    We always look at this stuff in regards to the money, but the money is only a marker for the value of labor. Peo­ple nat­u­rally abhor waste, and they should and it’s per­fectly log­i­cal. They espe­cially don’t want to see their own per­sonal effort wasted. Waste reduces wealth. Every­one knows this intrin­si­cally. It’s the Bro­ken Win­dow Fal­lacy.

  • Hi Hoth­solo,

    Thanks for the observation–that’s quite a sen­si­ble take. Ordi­nar­ily I bris­tle at “labor = value” argu­ments because of my own cri­tique of the labor the­ory of value (I have some papers on that on the Research tab). But this is a very sen­si­ble appli­ca­tion of the con­cept.