Psychologists Tend to Overgeneralize

With the obvious failures of neo classical economics in the Global FInancial crisis, Behavioral Finance has been raised as the best explanation that we have for “how things work” and many people are trying to use BF as a basis for how to go forward.

BF is often held up as great work because its authors received a Nobel Prize.

But Behavioral Finance is psychology work that received a Nobel prize in Economics. I do not know, but I strongly suspect that few if any of the Nobel committee were experts on psychology.

But it does not take very much research to learn that there are quite a number of reasons to go slow in holding up BF as the next new thing to explain economic behavior.

Here are some things to think about when you look at Behavioral Finance:

  • Behavioral finance starts out with the premise that Neo Classical economics is “correct” and that anytime that their study reveals behavior that is not consistent with neo classical economics that people are “biased” towards “wrong” behavior
  • Many of the BF experiments were done with college students. Other researchers into the development of the brain find that the parts of the brain that support judgement are not fully mature until age 25 on the average
  • All of the BF experiments are done totally “out of context” by definition. Most research into general human decision making shows that humans rely heavily on context for decision making. Some of the “biases” that BF have “found” may simply be the result of people inserting a context that is common to their experience into their answers instead of the purely academic contextless point of view that is being imposed to judge the answers.
  • Psychologists strenuously try to avoid “the Practice Effect”. This is the effect of people learning from repeated tries on an experiment. However, “the Practice Effect” is the primary way that humans learn to get things correct. So it is possible that most of their conclusions only apply to the very first time that people make the sorts of decisions that are being tested. In fact, other psychologists have shown that the most consistently found bias, the overconfidence bias, can be completely overcome with experience.
  • Many of the findings of BF are much less strongly in evidence with fairly small changes in wording of the questions asked. For example, in one study they found that more people would say that Mary was likely to be a feminist and a bank teller than just a bank teller. However, if they simply instead asked out of 100 women, how many would be bank tellers and how many would be bank tellers and feminists the bias completely disappeared.
  • Some of the conclusions of BF that are questionable may be traced to flaws in neo classical economics. Neo classical economics assumes that there is exactly one correct view of both risk and expected reward. If you recognize that since both the risk and the reward are in the future and that it is impossible to in advance determine the exact correct answer for either risk or expected reward, the possibility of a variety of opinions is obvious. This line of reasoning permits may different “correct” answers.
  • Real economic actors will say that academic discussions are one thing, but people making real statements of opinion are only credible when they are expressed with the commitment of funds. None of the BF experiments involve commitments of amounts of money that is real and significant to the subjects. All of their answers are therefore suspect.

The human element is very real in economic affairs. However, the simple experiments of BF are by no means the last word. They open us up to alternate lines of thinking than the even more oversimplified ideas of human behavior embedded into neo classical economics.

The final and most compelling reason for distrusting BF is the extremely high degree to incompetence that seems to be implied for the human race from the scores of biases that have been identified.  That just does not square with the simple observation that we no longer live in caves and hunt with sticks.  Somehow, along the way, humans made many, many decisions correctly.  If there were such strong biases towards wrong decisions, then it would be hard to imagine any such progress at all.

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