If human beings were rational decision makers, as assumed in standard economics literature, the functioning of financial markets would have been a lot smoother than it actually is. If investors always behaved rationally, then they would have only bought assets that are undervalued and sold whenever prices went above the fair value. As a result, over time, all assets would have been priced to perfection and we would not have faced boom and bust cycles in the financial market. However, they are a regular feature and studies in behavioural economics show that people do not always act rationally. In an article on behavioural economics, Harvard Magazine has put this aptly. “Economic Man makes logical, rational, self-interested decisions that weigh costs against benefits and maximize value and profit to himself. Economic Man is an intelligent, analytic, selfish creature who has perfect self-regulation in pursuit of his future goals and is unswayed by bodily states and feelings… But Economic Man has one fatal flaw: he does not exist.” (See: The Marketplace of Perceptions, March-April 2006.)
What is behavioural economics?
It can be defined as a combination of psychology and economics which looks into the economic decision-making of individuals. It has been found that human behaviour is not always rational as previously perceived. Human beings have limited ability to process information and take mental shortcuts (also known as heuristics) to arrive at a decision. There are also cognitive biases that affect decisions.
Behavioural economics has gained popularity in the last few decades. Social scientist, Herbert A. Simon, was awarded the Noble Prize in economics in 1978 for “his pioneering research into the decision-making process within economic organizations”. In 1979, Daniel Kahneman, and Amos Tversky published an influential paper, Prospect Theory: An Analysis of Decision under Risk, which showed that people are risk averse. “…people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty. This tendency, called the certainty effect, contributes to risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses,” the authors noted. Kahneman was awarded the Nobel Prize in Economic Sciences in 2002.
Insight in the field of behavioural economics and economic decision-making can be used by investors, companies and policymakers to attain better outcomes. Investors can learn a great deal from the study of human behaviour in order to improve decision making and avoid mistakes. For example, research shows that people are generally overconfident about their abilities. When stock prices are rising, overconfidence can lead to wrong stock selection which can affect returns.