Traditional vs. Behavioral Finance

Abstract

The traditional finance researcher sees financial settings populated not by the error-prone and emotional Homo sapiens, but by the awesome Homo economicus. The latter makes perfectly rational decisions, applies unlimited processing power to any available information, and holds preferences well-described by standard expected utility theory.

Anyone with a spouse, child, boss, or modicum of self-insight knows that the assumption of Homo economicus is false. Behavioralists in finance seek to replace Homo economicus with a more-realistic model of the financial actor. Richard Thaler, a founding father of behavioral finance, captured the conflict in a memorable National Bureau of Economic Research (NBER) conference remark to traditionalist Robert Barro: “The difference between us is that you assume people are as smart as you are, while I assume people are as dumb as I am.” Thaler’s tongue-in-cheek comparison aptly illustrates how the modest substantive differences in traditionalist and behavioralist viewpoints can be exaggerated by larger differences in framing and emphasis, bringing to mind the old quip about Britain and America being “two nations divided by a common tongue.” (For what it is worth, when confirming this account of the exchange, Thaler reports that Barro agreed with his statement.)

The purpose of this article is to guide readers through this debate over fundamental assumptions about human behavior and indicate some directions behavioralists might pursue. The article provides general map of research in finance and describes in greater detail the similarities and differences between behavioral and traditional finance. I then the disagreements between the two camps in the context of the philosophy of science: Behavioralists argue, à la Thomas Kuhn, that behavioral theories are necessary to explain anomalies that cannot be accommodated by traditional theory. In return, traditionalists use a philosophy of instrumental positivism to argue that the competitive institutions in finance make deviations from Homo economicus unimportant, as long as simplifying assumption is sufficient to predict how observable variables are related to one another.

A brief history of behavioral research in financial reporting then shows that while these two philosophical perspectives are powerful, they are incomplete. The success of behavioral financial reporting also depends heavily on sociological factors, particularly the commingling of behavioral and traditional researchers within similar departments. Because most finance departments lack this form of informal interaction, behavioralists must redouble their efforts to pursue a research agenda that will persuade traditionalists. The last section proposes a research agenda that behavioralists can use to address both their substantive and sociological challenges: developing and testing models explaining how the influence of behavioral factors is mediated by the ability of institutions (like competitive markets) to scrub aggregate results of human idiosyncrasies. Such research should establish common ground between traditionalists and behavioralists, while also identifying settings in which behavioral research is likely to have the most predictive power.

Keywords: behavioral finance, behaivoral economics, financial reporting, finance, experimental finance, philosophy of science

JEL Classification: C9, G00, M2, M41