- 1998: Volume 7, No. 6 Behavioral Finance: What Is It?

Editor's Note: This article is reprinted with permission from The Market Technicians Association Journal.

Behavioral Finance is something new in the halls of academia. For the better part of the past 30 years, the discipline of finance has been under the thrall of the random walk/cum efficient market hypothesis. Yet enough anomalies piled up in recent years to crack the dominance of the random walk. As a consequence, the popular press has been reporting the arrival of new thinking and different methods to explain market behavior. The headlines herald the arrival of something known generally as "behavioral finance."

Her are some of the headlines that have appeared in recent years:

• "Efficient? Chaotic? What is the New Finance?: Rational investors, beta, CAPM—everything they taught you in business school is now open to debate."
• "Frontiers of Finance: The idea that a financial market can be predicted is no longer confined to cranks..."
• Mind Over Matter: Psychology can help to explain the eccentric behavior of financial markets."
• "Financial Follies: Investors do the dumbest things. Now the budding science of behavioral finance seeks to figure out why—and how to benefit."
• Dismal Science Grabs a Couch: Psychonomics: If the old mathematical models don't work, you can always call a shrink."

Do those provocative headlines about behavioral finance signal threat or opportunity to technical market analysis? The answer depends upon where you stand, your perspective. Before coming to a conclusion as to the relative threat or opportunity to technical market analysis posed by the behavioral finance movement, a more fully documented description of the field of behavioral finance is needed.

Report: What Is It?

The purpose of this article is to provide a journalistic type of report on behavioral finance. Stanza one from Rudyard Kipling's poem, The Elephant Child, shall help organize this report:

I keep six honest serving men
(They taught me all I knew);
Their names are
What and Why and When
And How and Where and Who.

Behavioral Finance in Summary Form

What?—The use of psychology, sociology and other behavioral theories to explain and predict financial markets.
Who?—Academics.
How?—Computers and words.
Where?—Conferences.
When?—Increasing frequency.
Why?—Paradigm shift.

Behavioral Finance in Greater Detail

What?—D. Galant said in Institutional Investor, "a burgeoning field of study called behavioral finance, which derives from behavioral economics, is attempting to identify and learn from the particular human errors that are characteristic of financial market places. Behavioral finance strives to go beyond folk wisdom to detect distinct modes of market behavior. Behavioral finance theories range from self-evident to bizarre."

The following are samples of the theories found in the new behavioral finance: neurochemical gauges people's propensity to take risk; the "hubris hypothesis" says CEOs who initiate takeovers are acting out of overweening pride and arrogance; "barn-door closing" means chasing a past trend; "disposition theory" explains how trades become investments after they fall below costs; "anchoring" means that once an investor makes a decision about a stock's prospects, that decision rules despite fresh evidence to the contrary; and then there is the "cockroach theory" which says that, just as you never find just one cockroach, you never find just one earnings surprise. Then there are the familiar "next time will be different" and the "greater fool" theories.

As stated above, behavioral finance is derived from behavioral economics. In an April 10, 1995 Newsweek article entitled, "Dismal Science Grabs a Couch," Marc Levinson reports that economics is turning to psychology to help explain seemingly irrational behavior. Behavioral economics pays attention to such things as herd instincts, irrational fears and poor self-control. But he notes that when it comes to application, "No behavioral economist has more than a smattering of grad-school psych... the high flying math required to do even basic work in finance is beyond the grasp of most psychologists."

Who?—Daniel Kahnemann of Princeton and Amos Tversky of Stanford are credited with creating behavioral economics more than two decades ago. Richard Thaler at Cornell is a leading behavioral economist as is Joseph Lakonishok of the University of Illinois. Dr. Vernon Smith developed the University of Arizona's Economic Science Laboratory. Added to this list in behavioral finance are such academics as University of Texas professor Keith Brown and the editor of the Financial Analysts Journal, Van Harlow; Richard Roll of UCLA; Dean LeBaron and Werner DeBondt of University of Wisconsin, and Howard Rachlin, a professor of psychology at the State University of New York in Stony Brook.

The non-academics who are involved or at least dabble in behavioral finance include economist and investment manager Henry Kaufman, contrarian David Dreman and money managers Russell Fuller and Arnold S. Wood.

Although not pitched in the center of the behavioral finance movement, students of chaos theory are important influences. Important market chaoticians are Doyne Farmer, Norman Packard and Brian Arthur of Santa Fe, New Mexico, and author Edgar Peters.

How?—The chaoticians make extensive use of non-linear mathematics and the computer. Dr. Vernon Smith at Arizona conducts laboratory experiments. The duplications are often conjectures which seem to plausibly explain market behavior. But at least they are operating closer to the real world, for if you don't know psychology, they argue, successfully anticipating what people will do and hence how markets will behave is difficult.

Where and When?—You can find out what the behaviorists are up to by reading the articles listed above, by reading some books and articles written by those cited under "Who?," by consulting the Journal of Behavioral Decision Making, or by attending a conference devoted to the subject.

Why?—The fall of random walk and the rise of behavioral finance reflects a revolutionary change in the discipline of finance: what seems to be underway is a paradigm shift. What is taking place in finance is apparently an ideal case example of the paradigm shift model promulgated in the book The Structure of Scientific Revolutions, by Thomas S. Kuhn. For technical market as well as for behavioral financial analysis, the message of Kuhn's book is heady stuff. It essentially says that when the dominant theory of a discipline becomes beset by too many anomalies, a shift occurs in thinking which ultimately embraces a radically different model to explain the world. The revolutionaries who spawn and nurture the radically different model typically come from backgrounds outside the prevailing discipline. In contrast to the theory of the random walk, behavioral finance rests upon the more realistic assumption of behavioral man. Just as behavioral economics may become the inheritor and the beneficiary of a swing toward studying the markets according to how human beings really act and not upon how they are supposed to act, so too should technical market analysis as applied behavioral finance share in the inheritance and the benefits.

Behavioral Finance: Friend or Foe?

Technical market analysis has existed as a practice in the real world financial markets for a long time. It too has theoretical roots in psychology and sociology, but the emphasis has been on practical application by practical men and women of action. If we envision a theory-application spectrum, we can see behavioral finance occupying the theoretical pole while technical market analysis occupies the practical applications end.

Arguably technical market analysis championed the center stage of behavioral finance long before the arrival of what has now become known as behavioral finance. In 1969, Dr. Harvey Krow defined technical analysis as "behavioral finance." Dr. Krow wrote a notable summary of technical analysis concepts and procedures in a book entitled Stock Market Behavior: The Technical Approach to Understanding Wall Street. In the preface to that book, he identified three competing schools of thought: fundamental analysis, the random walk, and the behaviorist. Technical analysis fell within the behavioral or behaviorist school, concluded Dr. Krow.

Returning to the question of behavioral finance as a threat or opportunity for technical market analysis, the answer is that it is an opportunity if technicians act wisely, and a threat only if we are neglectful. Technical market analysis and behavioral finance are one and the same in their roots. Both are rooted in the assumption that man acts for behavioral reasons that, by the standards of classical economics, may seem irrational. Both approach the study of markets to uncover opportunities for profits.

A real block buster article appeared in the October 9, 1993 issue of the Economist that relates to the linkage between technical analysis and behavioral finance. The purpose was to discover whether a combination of computer horsepower and mathematical brain power has made it possible to find new sources of profit in the forecasting of financial markets. "What the new mathematicians are mining for is not inefficiencies in the flow of information but something entirely different. They have found new meat in the familiar fact that traders are a diverse bunch; by unearthing some of its previously unrecognized effects... the most popular idea for explaining it has to do with the heterogeneity of traders in particular, the fact that people reason differently about the information they receive, that they have different time horizons... and that they have different attitudes to risk... The efficient-market theory is... right that efficiency will delete time-arbitrage opportunities based on who does not have information, but wrong to conclude that therefore the market cannot be beaten.

"Prices do contain hints of what they will do next. Computers have resuscitated Chartism."

Through the attempt to predict using computers to study non-linear behavior, an appreciation of technical analysis has evolved. Moving average timing and break out signals produce profits more than by chance. Why? Because technicians are studying the behavior of people who make markets run. As the article in the Economist said, "Chartists—who prefer to be called technical analysts—justify their techniques with quite reasonable arguments about the behavior of investors. They do not claim to predict the behavior of investors. They do not claim to predict the behavior of the index so much as the behavior of the people who trade in the market... a rising price is a band wagon."

The behaviorist or behavioral finance school is in the resurgence. It behooves technicians to fully comprehend and to appreciate these new stirrings in the world of finance.

Henry O. Pruden, Ph.D., is a professor in the School of Business at Golden Gate University in San Francisco, where he has been teaching for the past 20 years. He is the executive director of the Institute of Technical Market Analysis (ITMA) and he sits on the board of directors of the Market Technicians Association (MTA). He is the editor of The Market Technicians Association Journal, the premier publication of technical analysts.