History, Application, And Outlook Of Behavioral Finance

Behavioral Finance is a subject closely related to Behavioral Economics. Scientific research on human, social, cognitive and emotional biases is used to better understand economic decisions and how they affect Finance, in particular market prices, returns and the allocation of resources. There is a very interesting and rich history of Behavioral Finace rooted in Behavior Economics and psychology, and today Behavioral Finance is a very important fundamental of finance and can be used to making financial decisions.

During the Classical Period there was a very close link between economics and psychology. Noted Author Adam Smith wrote meaningful words in his 1759 text The Theory of Moral Sentiments. This was an important text in describing an individual's behavior based on psychological principles. Smith's views closely followed those of his mentor Francis Hutcheson. The Theory of Moral Sentiments, Smith's first and in his own mind most important work, outlines his view of proper conduct and the institutions and sentiments that make men virtuous (Smith, 2000) Here he develops his doctrine of the impartial spectator, whose hypothetical disinterested judgment we must use to distinguish right from wrong in any given situation (Smith, 2000). Smith believed people by nature pursue their own self-interest. This makes independence or self-command an instinctive good. And neutral rules are as difficult to craft as they are necessary.

But society is not held together merely by neutral rules, instead society is held together by sympathy (Smith, 2000). Smith argues that we naturally share emotion and to a certain extent the physical sensations we witness in other people. Sharing the sensations of our fellow people, we seek to maximize their pleasures and minimize their pains so that we may share in their joys and enjoy their expressions of affection and approval (Smith, 2000). This was the first real writings on behavior where an educated person could put two and two together and link Smith's theories on how people behave and their impact on economics and finances. The ideas of these writings in relation to economics and finance did not last long and for many years the idea of linking Smith's ideas to economics and finances were lost in the new theories.

When Carl Menger, William Stanley Jevon and Leon Walra each wrote their books on economics and finance in the 1870's, they started a new revolutions of considered to be the neo-classical economics and finance based on the concept of marginalism. (Neo-Classical Economics, 2007 Para. 10) They were assuming that people act in their rational self-interest by pursuing opportunities that increase the satisfaction of their wants, such as pleasure or happiness, by weighing which alternative is most productive in the long run toward that end. Their idea of marginalism agreed with Adam Smith and the Classical Period in the fact people act in their own self interest, but differed greatly as there was no belief in sharing of sensations in fellow people and maximizing their plesaures, rather they meant that economic actors make decisions based on the margins. The neo-classicals were not interested in the behavioral aspects of economics and finance.

They were more interested in idea marginalism was about explaining relative differences in prices, using the forces of supply and demand. It wasn't until 1979 that behavior and psychology became a major player again in the world of economics and particularly finance, when Daniel Kahneman and Amos Tversky wrote their famous work "The Prospect Theory: Decision Making Under Risk." (Kahneman, 1982) After Kahneman and Tversky's famous writings, Behavior Finance became an accepted and practical application based on their theory.

Kahneman and Tversky used cognitive psychological techniques in a number of documented anomalies in economic decision making, including many in finance. Kahneman and Tversky's Prospect Theory is a real alternative to the expected utility hypothesis, where the utility of an agent facing uncertainty is calculated by considering a utility in each possible state and constructing a weighted average. (Kahneman, 1982) The expected utility hypothesis is an idea that agrees with marginalism. The Prospect Theory consists of two stages, stage one is editing and stage two is evaluation.

In stage one possible outcomes of the decision are ordered following a replicable method or approach for directing one's attention in learning, discovery, or problem-solving. This was known as Heuristics (Kahneman, 1982). In particular, The Prospect Theory said people make a decision on which outcomes they see as basically identical and they set a reference point. After setting a reference point they consider lower outcomes as losses and larger as gains.

In the second stage of evaluation, people behave as if they would compute a utility based on the potential outcomes and their respective probabilities, and then chose the alternative having a higher utility.

The behavior of computing a utility was based on a formula that Khaneman and Tversky devised, U= w(p1)v(x1)+w(p2)v(x2)+ Ð'.....(Prospect Theory 2007, para. 4) In this formula x1,x2 was the potential outcomes, p1,p2 were the probabilities, v was the so called value function assigning a value to an outcome, and U was the Utility. The w in the formula represented a probability weighting function expressing that people tend to overreact to small probability events, but underreact to medium and large probabilities (Prospect Theory 2007, para. 4). This formula by Khaneman and Tversky mathematically explained how people valued high utility leading to choosing their best alternative. Even though the prospect theory involves a somewhat complex formula the theory can be expressed in simple terms and helps us in the real world today understanding how we behave .

Many economists and financial analyists note using the Prospect Theory helps explain how loss aversion, and an inability to ignore sunk costs, leads people to take actions that are not in their best interest. The sting of losing money, for example, often leads investors to pull money out of the stock market unwisely when prices dip. When we use the Prospect Theory we concern ourselves with how decisions are actually made, rather than using an expected utility hopothesis, concerning ourselves with how decisions should be made under uncertainty.

It should be noted that in 1992 Khaneman and Tversky updated their famous theory, renaming it the Cumulative Prospect Theory (CPT) when they realized cumulative probabilites are transformed, rather than the probabilities itself. Khaneman concluded this leads to overweighting of extreme events which occur with small probability, rather than to an overweighting of all small probability events (CPT 2007, Para.