DOCSLIB.ORG

The Behavioral Paradigm Shift

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
The Behavioral Paradigm Shift RAE-Revista de Administração de Empresas | FGV-EAESP 95 ESSAY Invited article DOI: http://dx.doi.org/10.1590/S0034-759020150109 THE BEHAVIORAL PARADIGM SHIFT In the last half decade, academic finance has experienced two revolutions, one neoclassical and one behavioral, which were jointly recognized in the awarding of the 2013 Nobel Prize in economics. Before 1960, academic finance was organized around a loose collection of anecdotes, puzzles, and investment philosophies. The neoclassical revolution changed all of this by importing the structure and rigor of rationality-based principles of microeconomics into finance. Three No- bel Prizes recognized its main contributors. The first, in 1990, was jointly awarded to Harry Mar- kowitz for mean-variance portfolio theory, to Merton Miller for corporate finance, and to William Sharpe for the capital asset pricing model (CAPM). The second prize, in 1997, was shared by My- ron-Scholes and Robert Merton for developing the Black-Scholes-Merton option pricing formu- la. Unfortunately, Fischer Black who co-developed the formula, died in 1995. The third prize, in 2013, was awarded to three economists, two of whom contributed to the neoclassical revolution - Eugene Fama, for his seminal work on market efficiency, and Lars Peter Hansen for his seminal work on asset pricing theory. The behavioral revolution imported ideas from behavioral psychology into finance, and replaced the rationality postulate with a more realistic alternative. Two of its main contributors were recognized with Nobel prizes. The first, in 2002, was awarded to Daniel Kahneman who shared the award with experimental economist Vernon Smith. The Nobel selection committee recognized Kahneman for his work with fellow psychologist Amos Tversky who died in 1996. The second prize, in 2013, was awarded to Robert Shiller for his work on asset pricing. Of course, this prize was shared by Shiller, Fama, and Hansen. Both of these revolutions created great intellectual value. The neoclassical revolution HERSH SHEFRIN provided a first pass at introducing structure and rigor into the way academics think about fi- [email protected] nancial issues. The behavioral revolution has provided a second pass at modifying this struc- Professor at Santa Clara University, ture to reflect the fact that human beings are not perfectly rational, but are instead imperfectly Leavey School of Business – Santa Clara – California, United States of rational. Behavioral finance focuses on the structure and implications of people’s imperfect at- America tempts to match means and ends when making financial decisions. ISSN 0034-7590 © RAE | São Paulo | V. 55 | n. 1 | jan-fev 2015 | 95-98 96 ESSAY | The behavioral paradigm shift In this second, behavioral, pass at they optimally balance expected return of extreme events are small, the aver- finance, behaviorists are modifying ev- against risk. Amazingly, in 1952 when age person is risk seeking in the domain ery nook and cranny of the discipline. Markowitz was developing mean-vari- of gains and risk averse in the domain of Mean-variance portfolio theory has its ance portfolio theory, he was also laying losses. counterpart in behavioral portfolio theo- the groundwork for behavioral portfolio The insights offered by prospect ry. Corporate finance has its counterpart in theory. In consecutive months he pub- theory motivated Meir Statman and me behavioral corporate finance. The CAPM, lished two seminal papers, one neoclas- to introduce “the disposition effect” into which neoclassical asset pricing theorists sical and the other behavioral. Kahneman finance literature. The disposition effect such as Hansen generalized to pricing ker- and Tversky built prospect theory with holds that investors are predisposed to nel theory, has its counterpart in behavior- Markowitz’s behavioral piece constitut- sell winners too quickly and hold losers al pricing kernel theory; a special case is ing one of its core elements. Psychologist too long, except in the month of December the behavioral Black-Scholes option pric- Lola Lopes also built SP/A theory with when the disposition will either weaken ing formula. Finally, the concept of effi- Markowitz’s behavioral insights as a core or reverse. Prospect theory was our start- cient markets based upon the idea of ar- element. ing point; however we pointed out that ex- bitrage has its counterpart in inefficient Prospect theory, applied to port- plaining the disposition effect required markets based upon the idea that there folio selection, tells us that investors other psychological elements such as re- are limits to arbitrage. will think about their portfolios as a col- gret and self-control. The behavioral revolution in finance lection of separate components (called Statman and I developed the psy- and economics came fast on the heels of a mental accounts), rather than as a single chological underpinnings for the dispo- similar behavioral revolution in psycholo- integrated entity. Kahneman and Tversky sition effect against the results of a ma- gy which gave us coherent frameworks to told us that this lack of integration will jor study of individual investors by Lease, study how people make choices among make people vulnerable to making choic- Lewellen, and Schlarbaurm who found ev- risky prospects, how they rely on heuris- es that violate first order stochastic dom- idence of disposition effect behavior, but tics to form judgments, and how their im- inance, meaning they will act as if they argued that it did not stem from psycho- perfections leave them vulnerable to par- throw away money. logical sources. Several years later, Ter- ticular biases. The set of psychological A key aspect of the explanation ry Odean built a rich database of U.S. in- frameworks and concepts from which be- for why investors behave in this fashion dividual investors and tested the main havioral economists draw includes pros- is that they evaluate these components hypotheses Meir and I had developed. pect theory, SP/A theory, regret theory, in terms of gains and losses, rather than Subsequently, the disposition effect has change of process theory, excessive opti- net asset position. Moreover, they exhib- become one of the most studied features mism, overconfidence, confirmation bias, it loss aversion in the sense of experienc- of investor behavior. Researchers have in- anchoring-and-adjustment bias, illusion ing losses more acutely than gains. Loss vestigated the disposition effect in differ- of control, representativeness, and the aversion will induce people to be risk ent countries, different time periods, and affect heuristic. Behavioral economists averse when facing situations in which different markets. They have also extend- have been applying these frameworks and they might experience gains if fortunate, ed the analysis to professional investors, concepts to investigate issues across the but might also experience losses if unfor- and studied its impact on asset prices. entire landscape of finance. tunate. However, at the same time, peo- The work of Lease, Lewellen, and In the remainder of these intro- ple will be averse to sure losses, and Schlarbaum told us that investors trade ductory remarks, I will offer a short per- prone to exhibiting risk-seeking behavior too much, and that the portfolios of those sonal perspective on how these develop- when dealing with the prospect of a re- who trade the most, the so-called “high ments from psychology impact aspects alized loss. Among Kahneman and Tver- rollers”, experience the worst perfor- of finance, effectively my impressions of sky’s key lessons is the fourfold pattern mance. Using transaction data that was how the behavioral approach adds in- in which people’s risk appetite is circum- more recent and more extensive, Brad sights and value to the major subfields stance dependent. When outcome prob- Barber and Terry Odean documented the of finance: portfolio theory, asset pricing, abilities are in the midrange, the aver- degree to which turnover hurts perfor- and corporate finance. age person is risk averse in the domain mance, and attributed excessive trading Mean-variance theory tells us how of gains and risk seeking in the domain to overconfidence. Lease, Lewellen, and investors can choose portfolios in which of losses. When outcome probabilities Schlarbaum also reported that high roll- © RAE | São Paulo | V. 55 | n. 1 | jan-fev 2015 |95-98 ISSN 0034-7590 AUTHOR | Hersh Shefrin 97 ers are overly prone to focus on short-term having data on investors’ expectations of acquisition activity, and corporate gov- capital gains and use technical analysis, returns, meaning ex ante judgments, as ernance. Although some of these issues and in recent work with Arvid Hoffmann, opposed to relying on ex post realized re- pertain to the impact of psychological im- which uses data from Dutch investors, we turns, can serve to distinguish whether or perfections on corporate managers, oth- find that this continues to be so. not prices are fully rational. This statement ers involve how corporate managers react In the last decade, research has applies both to the cross-section of secu- to market inefficiencies. shown that entertainment, gambling, and rity returns and to the time series. In re- I am going to close these remarks thrill seeking are important aspects in spect to the cross-section, Statman points by going back in time, first a few decades, portfolio decisions, not just risk and ex- out that investors’ need for value expres- and then a few centuries. My first work pected
Load more

Recommended publications
  • Risk, Return, and the Overthrow of the Capital Asset Pricing Model Andrew West, CFA Manager, Investment Research
    Special Topics: Fundamental Research March 2014 Risk, Return, and the Overthrow of the Capital Asset Pricing Model Andrew West, CFA Manager, Investment Research Harding Loevner invests based on common-sense principles drawn Competitive advantage within a favorable industry structure is a from our founders’ experience: we stick to high-quality, growing prerequisite for durable profitability in a company. A company in companies that we can identify through fundamental research. This an industry with unfavorable dynamics has a much steeper chal- general philosophy flows naturally from our nature as cautious, pa- lenge than one well-positioned with few rivals and strong bargain- tient people. It has been a constant throughout our firm’s existence ing power over buyers and suppliers. But, we also require that our since it was founded in 1989. In contrast to the boring continuity of companies possess competitive advantages that will allow them to thought in our little community, the prevailing wisdom in the larger sustain superior levels of return over time. Our analysts are primarily world of academic investment theory has turned about completely organized by industry rather than by geography as we believe that over this same quarter century. Theories regarding market behavior the understanding of industry structure and peer groups is key to and investment outcomes that were proclaimed as essential verities identifying such investment opportunities. and celebrated with Nobel Prizes at the beginning of this period were subsequently overturned at the end. That academic battle is an en- Sustainable growth allows cash flow and earnings to compound as grossing tale that we have followed with interest.
    [Show full text]
  • Hyperbolic Discounting and Pension Design the Case of Germany
    Stefan Zimmermann Hyperbolic Discounting and Pension Design The Case of Germany MSc Thesis 2010 Hyperbolic Discounting and Pension Design: The Case of Germany Master Thesis to achieve the degree Master of Science (M.Sc.) in Economics at the Faculty of Economics and Management at Tilburg University submitted by Stefan Zimmermann ANR: 661647 Words: 9509 Supervisor: Johannes Binswanger, PhD Second Reader: Nathanaël Vellekoop, Drs Berlin, August 17th, 2010 Abstract Both data and people’s self-reports reveal that there is a undersaving problem. Be- havioral economics seeks to explain this phenomenon with the concept of hyperbolic discounting. In essence, short-term actions are inconsistent with long-term goals. This is applied to the German pension system in this text. The results lean on a theoretical life-cycle model that is simulated in Matlab, whereby the parameters are calibrated to match the German economy. It is shown that myopic preferences lead to deviations from outcomes that would be desirable from a normative point of view. The savings rate is considerably lower for hyperbolic discounters, compared to standard discounters. Moreover, a fully funded pension scheme seems preferable to the current Pay-As-You-Go system. Contents List of Tables4 List of Figures4 1 Introduction5 2 Survey6 2.1 Facts about the German Pension System................7 2.2 Behavioral Aspects............................7 3 The Life-Cycle Model - LCM 10 3.1 The Life-Cycle Model without a Pension Scheme............ 11 3.1.1 Behavior of Private Agents.................... 11 3.2 The Life-Cycle Model with a Pension Scheme............. 16 3.2.1 Pay-As-You-Go Pension - PAYG...............
    [Show full text]
  • Myron S. Scholes [Ideological Profiles of the Economics Laureates] Daniel B
    Myron S. Scholes [Ideological Profiles of the Economics Laureates] Daniel B. Klein, Ryan Daza, and Hannah Mead Econ Journal Watch 10(3), September 2013: 590-593 Abstract Myron S. Scholes is among the 71 individuals who were awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel between 1969 and 2012. This ideological profile is part of the project called “The Ideological Migration of the Economics Laureates,” which fills the September 2013 issue of Econ Journal Watch. Keywords Classical liberalism, economists, Nobel Prize in economics, ideology, ideological migration, intellectual biography. JEL classification A11, A13, B2, B3 Link to this document http://econjwatch.org/file_download/766/ScholesIPEL.pdf ECON JOURNAL WATCH Schelling, Thomas C. 2007. Strategies of Commitment and Other Essays. Cambridge, Mass.: Harvard University Press. Schelling, Thomas C. 2013. Email correspondence with Daniel Klein, June 12. Schelling, Thomas C., and Morton H. Halperin. 1961. Strategy and Arms Control. New York: The Twentieth Century Fund. Myron S. Scholes by Daniel B. Klein, Ryan Daza, and Hannah Mead Myron Scholes (1941–) was born and raised in Ontario. His father, born in New York City, was a teacher in Rochester. He moved to Ontario to practice dentistry in 1930. Scholes’s mother moved as a young girl to Ontario from Russia and its pogroms (Scholes 2009a, 235). His mother and his uncle ran a successful chain of department stores. Scholes’s “first exposure to agency and contracting problems” was a family dispute that left his mother out of much of the business (Scholes 2009a, 235). In high school, he “enjoyed puzzles and financial issues,” succeeded in mathematics, physics, and biology, and subsequently was solicited to enter a engineering program by McMaster University (Scholes 2009a, 236-237).
    [Show full text]
  • Do Stock Prices Move Too Much to Be Justified by Subsequent Changes
    Do Stock Prices Move Too Much to be Justifiedby SubsequentChanges in Dividends? By ROBERTJ. SHILLER* A simple model that is commonlyused to and RichardPorter on the stock market,and interpret movements in corporate common by myself on the bond market. stock. price indexes asserts that real stock To illustrategraphically why it seems that prices equal the present value of rationally stock pricesare too volatile,I have plotted in expected or optimally forecastedfuture real Figure 1 a stock price index p, with its ex dividendsdiscounted by a constant real dis- post rational counterpart p* (data set 1).' count rate. This valuation model (or varia- The stock price index pt is the real Standard tions on it in which the real discount rate is and Poor's Composite Stock Price Index (de- not constant but fairly stable) is often used trended by dividing by a factor proportional by economistsand marketanalysts alike as a to the long-run exponential growth path) and plausible model to describe the behaviorof p* is the present discounted value of the aggregatemarket indexes and is viewed as actual subsequentreal dividends (also as a providing a reasonable story to tell when proportionof the same long-rungrowth fac- people ask what accounts for a sudden tor).2 The analogous series for a modified movement in stock price indexes. Such Dow Jones IndustrialAverage appear in Fig- movementsare then attributedto "new in- ure 2 (data set 2). One is struck by the formation" about future dividends. I will smoothness and stability of the ex post ra- refer to this model as the "efficientmarkets tional price series p* when compared with model"although it shouldbe recognizedthat the actualprice series.This behaviorof p* is this name has also been applied to other due to the fact that the presentvalue relation models.
    [Show full text]
  • Editor's Letter
    Why I Shall Miss Merton Miller Peter L. Bernstein erton Miller’s death received the proper somewhere,” he recalls. Miller was instrumental in tak- notices due a winner of the Nobel Prize, but ing Sharpe to the Quadrangle Club in Chicago, where Mthese reports emphasize the importance of he could present his ideas to faculty members like his intellectual contributions rather than his significance Miller, Lorie, and Fama. The invitation led to an as a human being. Nobody gives out Nobel Prizes for appointment to join the Chicago faculty, and Sharpe being a superior member of the human race, but Miller and his theories were on their way. would surely have been a laureate if someone had ever Miller’s role in launching the Black-Scholes- decided to create such a prize. Merton option pricing model was even more deter- Quite aside from the extraordinary insights gained mining. In October 1970, the three young scholars from Modigliani-Miller, we owe Merton Miller a deep had completed their work, and began the search for a debt of gratitude for his efforts to promote the careers journal that would publish it. “A Theoretical Valuation of young scholars whose little-noted innovations would Formula for Options, Warrants, and Other in time rock the world of finance. Works at the core of Securities”—subsequently given the more palatable modern investment theory might still be gathering dust title of “The Pricing of Options and Corporate somewhere—or might not even have been created— Liabilities”—was promptly rejected by Chicago’s by guest on October 1, 2021.
    [Show full text]
  • The International Monetary System: Quo Vadis
    Columbia University Department of Economics Discussion Paper Series The International Monetary System: Quo Vadis Robert A. Mundell Discussion Paper #:0102-34 Department of Economics Columbia University New York, NY 10027 March 2002 The International Monetary System: Quo Vadis Robert Mundell Columbia University February 8, 2001 Manuel Guitian Memorial Lecture, International Monetary Fund, February 8, 2001 I. Manuel Guitian Manuel Guitian was one of two brilliant students I met in 1965 at the Graduate Institute of International Studies in Geneva. Both went on to the University of Chicago for the Ph.D. program and to great distinction as economists. The other student was Rudiger Dornbusch. My students at Geneva were required to write a research paper on international monetary economics. Manuel and I agreed that he should look into the Poincare-Rist stabilization of the franc in 1926. That got him interested in exchange rate theory and it was an interest that persisted throughout his life. The quality of his analysis of that important episode from the inter-war years convinced me that Manuel had a good future as an economist and I encouraged him to go to Chicago for his Ph.D. University of Chicago Economics in the late 1960s was in one of its golden periods, maybe comparable to Vienna in the 1880s or Harvard, Chicago or Cambridge in the 1930s. There were Frank Knight (emeritus), Earl Hamilton (emeritus), Milton Friedman, Theodore Schultz, Harry Johnson, George Stigler, Hiro Uzawa, Arnold Harberger, Merton Miller, Bert Hoselitz, Robert Fogel, D. Gale Johnson, Gary Becker, Robert Aliber, Arthur Laffer, Stanley Fischer, Herbert Grubel, and myself.
    [Show full text]
  • Beyond Greed and Fear Financial Management Association Survey and Synthesis Series
    Beyond Greed and Fear Financial Management Association Survey and Synthesis Series The Search for Value: Measuring the Company's Cost of Capital Michael C. Ehrhardt Managing Pension Plans: A Comprehensive Guide to Improving Plan Performance Dennis E. Logue and Jack S. Rader Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation Richard O. Michaud Real Options: Managing Strategic Investment in an Uncertain World Martha Amram and Nalin Kulatilaka Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing Hersh Shefrin Dividend Policy: Its Impact on Form Value Ronald C. Lease, Kose John, Avner Kalay, Uri Loewenstein, and Oded H. Sarig Value Based Management: The Corporate Response to Shareholder Revolution John D. Martin and J. William Petty Debt Management: A Practitioner's Guide John D. Finnerty and Douglas R. Emery Real Estate Investment Trusts: Structure, Performance, and Investment Opportunities Su Han Chan, John Erickson, and Ko Wang Trading and Exchanges: Market Microstructure for Practitioners Larry Harris Beyond Greed and Fear Understanding Behavioral Finance and the Psychology of Investing Hersh Shefrin 2002 198 Madison Avenue, New York, New York 10016 Oxford University Press is a department of the University of Oxford It furthers the University's objective of excellence in research, scholarship, and education by publishing worldwide in Oxford New York Auckland Bangkok Buenos Aires Cape Town Chennai Dar es Salaam Delhi Hong Kong Istanbul Karachi Kolkata Kuala Lumpur Madrid Melbourne Mexico City Mumbai Nairobi São Paulo Shanghai Taipei Tokyo Toronto Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries Copyright © 2002 by Oxford University Press, Inc.
    [Show full text]
  • Eugene F. Fama Booth School, University of Chicago, Chicago, IL, USA
    Two Pillars of Asset Pricing Prize Lecture, December 8, 2013 by Eugene F. Fama Booth School, University of Chicago, Chicago, IL, USA. he Nobel Foundation asks that the Prize lecture cover the work for which T the Prize is awarded. Te announcement of this year’s Prize cites empirical work in asset pricing. I interpret this to include work on efcient capital markets and work on developing and testing asset pricing models—the two pillars, or perhaps more descriptive, the Siamese twins of asset pricing. I start with ef- cient markets and then move on to asset pricing models. EFFICIENT CAPITAL MARKEts A. Early Work Te year 1962 was a propitious time for Ph.D. research at the University of Chi- cago. Computers were coming into their own, liberating econometricians from their mechanical calculators. It became possible to process large amounts of data quickly, at least by previous standards. Stock prices are among the most acces- sible data, and there was burgeoning interest in studying the behavior of stock returns, centered at the University of Chicago (Merton Miller, Harry Roberts, Lester Telser, and Benoit Mandelbrot as a frequent visitor) and MIT (Sidney Alexander, Paul Cootner, Franco Modigliani, and Paul Samuelson). Modigli- ani ofen visited Chicago to work with his longtime coauthor Merton Miller, so there was frequent exchange of ideas between the two schools. It was clear from the beginning that the central question is whether asset prices refect all available information—what I labeled the efcient markets hy- pothesis (Fama 1965b). Te difculty is making the hypothesis testable. We can’t 365 6490_Book.indb 365 11/4/14 2:30 PM 366 The Nobel Prizes test whether the market does what it is supposed to do unless we specify what it is supposed to do.
    [Show full text]
  • Building on Kahneman's Insights in the Development of Behavioral
    7_SHEFRIN.DOCX 5/15/2013 12:46 PM Building On Kahneman’s Insights in the Development of Behavioral Finance Hersh Shefrin* INTRODUCTION First, I want to thank Michael Kaufman for inviting me to be part of this esteemed panel. And second, I would like to thank Danny Kahneman for his wisdom, insights, generosity, kindness, and much more. On a personal dimension, I first met Danny in 1978 when he and Amos Tversky were visiting Stanford University’s Center for Advanced Study in the Behavioral Sciences. At the time I was working with Dick Thaler, who was also visiting Stanford, on developing a System 1/System 2 model of economic choice.1 It should come as no surprise that what I learned from Danny and Amos in those first interactions, and subsequently over the years, dramatically influenced my own research and indeed the entire field of economics.2 * Mario L. Belotti Professor of Finance, Santa Clara University. This Article stems from remarks that I gave in response to Daniel Kahneman’s keynote address at Loyola University Chicago School of Law’s Second Annual Investor Protection Conference, “Behavioral Economics and Investor Protection.” 1. See generally DANIEL KAHNEMAN, THINKING, FAST AND SLOW 19–109 (2011) (describing System 1 and System 2 decision making processes). Professor Adam Zimmerman briefly summarizes the two Systems as follows: Cognitive psychologists and neurologists have identified two types of decisionmaking processes: intuitive and deliberative. Intuitive decisionmaking processes, which are sometimes called System I processes, are intuitive, automatic, and quick, encompassing the types of instantaneous judgments that permit a person to size up a situation.
    [Show full text]
  • Richard Thaler and the Rise of Behavioral Economics
    Richard Thaler and the Rise of Behavioral Economics Nicholas Barberis Yale University April 2018∗ Abstract Richard Thaler was awarded the 2017 Nobel Memorial Prize in Economic Sciences for his contributions to behavioral economics. In this article, I review and discuss these contributions. JEL classification: B2, D9, G1 Keywords: endowment effect, prospect theory, mental accounting, nudge ∗I am grateful to Hunt Allcott, Ingvild Almas, James Choi, Stefano DellaVigna, Keith Ericson, Owen Lamont, Ulrike Malmendier, Matthew Rabin, and Jesse Shapiro for helpful discussions about the content of this article. 1 I. Introduction From the 18th century to the first half of the 20th century, the leading economists of the day – figures such as Adam Smith, John Maynard Keynes, and Irving Fisher – were known to bring aspects of human psychology into their analysis of the economy. By the middle of the 20th century, however, this practice was less common, and with the advent of the rational expectations revolution in the 1960s, economists began to focus almost exclusively on models with the same, tightly-specified assumptions about individual psychology: that people have rational beliefs, and that they make decisions according to Expected Utility. In the early 1980s, a small group of economists began to argue that the rational ex- pectations revolution had gone too far, and that to understand many important economic phenomena, it was critical to develop new models that made assumptions about human be- havior that were psychologically more realistic, and that, in particular, allowed for less than fully rational thinking. This message was roundly dismissed at first, sometimes in scornful terms, but it gradually gained traction.
    [Show full text]
  • Matthew Rabin and Richard Ho Thaler
    Journal of Economic Perspectives- .Volume 15, Number 1. -Winter 2001. -Pages 219-232 Matthew Rabin and Richard Ho Thaler conomics can be distinguished from other social sciences by the belief that most (all?) behavior can be explained by assuming that rational agents with I stable, well-<lefined preferences interact in markets that (eventually) clear. An empirical result qualifies as an anomaly if it i~ difficult to "rationalize" or if implausible assumptions are necessary to explain it within the paradigm. Sugges- tions for future topics should be sent to Richard Thaler, c/oJournal of Economic Perspectives, Graduate School of Business, University of Chicago, Chicago, IL 60637, or ([email protected]). Introduction Most of the columns in this "Anomalies" series have discussed empirical results that, if taken at face value, immediately strike economists as violations of the standard economic model. Risk aversion, the topic of this entry in the series, is rather different. Here the behavior we will point to--the hesitation over risky monetary prospects even when they involve an expected gain-will not strike most economists as surprising. Indeed, economists have a simple and elegant explanation for risk aversion: It derives from expected utility maximization of a concave utility-Qf-wealth function. This model is used ubiquitously in theoretical and empirical economic research. Despite its central .Matthew Rabin is Professor of Economics, University of California, Berkeley, and visiting BP Professor of Economics, London School of Economics, London, United Kingdom. Richard H. Thaler is the Robert P. Gwinn Professor of Economics and Behavioral Science, Graduate School of Business, University of Chicago, Chicago, Illinois.
    [Show full text]
  • Behavioral Economics: Past, Present, and Future†
    American Economic Review 2016, 106(7): 1577–1600 http://dx.doi.org/10.1257/aer.106.7.1577 Behavioral Economics: Past, Present, and Future† By Richard H. Thaler* In recent years there has been growing interest in the mixture of psychology and economics that has come to be known as “behavioral economics.” As is true with many seemingly overnight success stories, this one has been brewing for quite a while. My frst paper on the subject was published in 1980, hot on the heels of Kahneman and Tversky’s 1979 blockbuster on prospect theory, and there were ( ) earlier forerunners, most notably Simon 1955, 1957 and Katona 1951, 1953 . ( ) ( ) The rise of behavioral economics is sometimes characterized as a kind of paradigm-shifting revolution within economics, but I think that is a misreading of the history of economic thought. It would be more accurate to say that the method- ology of behavioral economics returns economic thinking to the way it began, with Adam Smith, and continued through the time of Irving Fisher and John Maynard Keynes in the 1930s. In spite of this early tradition within the feld, the behavioral approach to eco- nomics met with considerable resistance within the profession until relatively recently. In this essay I begin by documenting some of the historical precedents for utilizing a psychologically realistic depiction of the representative agent. I then turn to a discussion of the many arguments that have been put forward in favor of retaining the idealized model of Homo economicus even in the face of apparently contradictory evidence. I argue that such arguments have been refuted, both theo- retically and empirically, including in the realm where we might expect rationality to abound: the fnancial markets.
    [Show full text]