Friday, January 23, 2009

Behavioural models in finance

That market failure is not the only justification for government intervention in the marketplace is made abundantly clear by recent research in behavioural economics. Behavioural models have sought to replace the homo economicus model of utility maximizing rational agents with a more realistic concept of "bounded rationality", where agents, though on average rational, act based on their specific preferences.

Mark Thoma draws attention to a Vox article by Leigh Caldwell, which points to a few behavioural and psychological considerations that may have contributed to the present economic crisis, analyzes a few of these models and suggests more sophisticated policy responses that could break the crisis’s psychological hold on markets. Here is a list of these bounded rationality models that relaxes some of the standard theoretical assumptions

1. Utility is discounted in a time inconsistent manner - Experiments show that people apply a high discount on utility in the present, but a lower one in the future. This partially explains the recent huge variances between overnight and three-month interest rates. The "trust deficit" in the financial markets exacerbates this short-long time frames imbalance.
2. People do not have access to all relevant information - Financial markets are characterized by "information asymmetry" and therefore require "enforced transparency". This explains why many agents who in the absence of crucial information, were forced to make guesses in their investment and trading decisions, with catastrophic results.
3. All relevant information is not expressed through market prices - markets are efficient, reflecting the full value in prices, only when there is sufficient liquidity and when there are no moral hazard problems. In its absence, the price signals break down, and investment and resource allocation decisions are made based on non-price signals.
4. People cannot instantly weigh up the change in utility in any buying or selling decision - they rely on familiar choices to avoid the mental effort and risk of picking alternatives (anchoring or habit). Further, anchoring creates a tendency to fixate on one option too long when we might profitably switch to another –it limits the effects of all kinds of quantitative changes in policy.
5. People do not act to maximise their utility - alternative models of decision making include multi-dimensional ("vector") utility functions, value modelling, psychological attempts, and "local utility gradient" to understand subconscious mental drivers.

All these deviations from the standard financial market models, highlight the discepancies in our conventional policy responses, and needs to be taken into account when formulating regulatory policies.

Update 1
Chris Dillow lists out more cognitive biases - availability heuristic, self-serving bias/wishful thinking (people start risky projects), bandwagon effect (momentum investing), focussing effect (looking at one piece of data and under-rating others), status quo bias, gambler's fallacy (we’ve had a run of reds, so black must be due!), hot-hand fallacy, base-rate fallacy (ignoring prior probabilities) etc.

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