Morning Must-Read: Noah Smith: Behavioral Economics vs. Behavioral Finance

Noah Smith: Noahpinion: Behavioral economics vs. behavioral finance: “Chris House has a new blog post that is pretty dismissive of behavioral economics….

I don’t think Chris gives a particularly enlightening explanation of where behavioral economics is falling short (what does ‘helps us much’ or ‘transcendent principle’ even mean??… It’s important to point out that ‘behavioral economics’ is a different thing from ‘behavioral finance’…. ‘Behavioral economics’ means something along the lines of ‘economics in which individual decision-making behavior is assumed to be subject to observable, predictable psychological biases’…. ‘Behavioral finance’… began… with Robert Shiller, who showed that stock prices fluctuate more than the standard theories would suggest….

A bunch of other ‘anomalies’ in standard theory were soon discovered… value… momentum…. These anomalies have proven so durable that they have become standard pieces of the risk models used by every large financial institution…. Most phenomena that don’t agree with classic, Gene Fama vintage efficient-markets theory have come to be labeled ‘behavioral finance’….

A second strand… finance based on informational frictions…. A third strand… that deals with individual investor behavior…. A fourth strand… noise-trader bubble models…. A fifth strand… tests the usefulness of psychological biases for investing strategies…. And of course a sixth strand… is experimental finance…. The behavioral finance rebels are merging with the old establishment instead of overthrowing it. So behavioral finance is not a speculative, marginal, or incipient field. It has already won at least two Nobel prizes (Smith and Shiller), or maybe four if you want to count Stiglitz and Kahneman.