Qualitative Research in Financial Markets

What can behavioural finance teach us about finance?

Werner DeBondt William Forbes Paul Hamalainen Yaz Gulnur Muradoglu
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Can behavioural
What can behavioural finance finance teach us
teach us about finance? about finance?
Werner DeBondt
De Paul University,Chicago, Illinois, USA 29
William Forbes
The Business School, Loughborough University, Loughborough, UK
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Paul Hamalainen
Essex Business School, University of Essex, Colchester, UK, and
Yaz Gulnur Muradoglu
Cass Business School, London, UK

Abstract
Purpose – The paper draws on the key themes raised at a Round Table discussion on behavioural
finance attended by academics and practitioners. The paper provides a background to the key aims of
behavioural finance research and the development of the discipline over time. The purpose of this
paper is to indicate some future research issues on behavioural finance that emanate from the financial
crisis and highlight areas of mutual benefit to both behavioural finance academics and the finance
industry so as to encourage a creative cross-fertilisation.
Design/methodology/approach – The paper draws on a Round Table discussion on behavioural
finance that was organized by the Behavioural Finance Working Group, the Centre for the Study of
Financial Innovation and Financial Services Knowledge Transfer Network.
Findings – The paper highlights numerous benefits that behavioural finance research can contribute
to the financial industry, but at the same time there is an evident discrepancy between the academic
and the professional world when it comes to utilising behavioural finance research.
Practical implications – The paper highlights several areas where behavioural finance can
contribute significant benefits to a wide array of aspects of the finance industry.
Social implications – The paper seeks to inform behavioural finance issues so as to encourage
collaboration between the academic world and finance practitioners. In so doing, the paper aims to
encourage a greater awareness of individual decision-making frames and heuristics and how industry
can apply these concepts to improve the allocation of finance products to society.
Originality/value – The paper brings together a wide array of finance professionals and academics
to encourage greater collaboration and mutual respect of each others interest in and uses for
behavioural finance.
Keywords Behavioural economics, Finance
Paper type Viewpoint

The authors would like to thank the Round Table Discussants at “What the behavioural sciences
can teach us about the wholesale and retail financial markets” held in London, 11 December 2009 at
Armourers’ Hall organised by the Centre for the Study of Financial Innovation and the BFWG and Qualitative Research in Financial
Markets
Financial Services Knowledge Transfer Network. Vol. 2 No. 1, 2010
The aim of the Round Table was to bring together the academic and business world and pp. 29-36
q Emerald Group Publishing Limited
introduce innovative and challenging research from behavioural finance to the financial 1755-4179
industry. This paper draws on the key themes from the Round Table discussion. DOI 10.1108/17554171011042371
 QRFM The immediate impact of the financial crisis was that the old certainty that “the market
2,1 knows best” seems to be cast in doubt. Both academics and practitioners need a new,
or at least a partial, explanation of recent history especially if such theorisations might
be harnessed in directing forthcoming financial market reforms or responding to their
implementation. Skidelsky (2009, pp. 38-9) in commenting on the policy stance that
oversaw the emergence of the crisis has three central insights:
30 [First] Markets are in general self-correcting, with market discipline a more effective tool than
regulation, [. . .] [second] the main responsibility for managing market risks lies with senior
management and the board of individual firms, [. . .] [and] [. . .] [finally] customer protection is
best ensured not by regulation or direct intervention in markets, but by ensuring that
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wholesale markets are as unfettered as possible and transparent as possible.

These beliefs, whatever validity they may have had before the crisis, look somewhat
naive after the crisis. In response to the crisis behavioural perspectives on finance
have gained popularity as a means of understanding some of the causes of the
crisis. As such, the behavioural approach is one stream of a broader questioning of
standard models of financial decision making. But behavioural finance has a much
longer gestation than its recent popularity suggests. We address some of this
history and shed some light on what behavioural finance can teach us about
finance.

1. What is behavioural finance and how do we make use of it?

Behavioural finance is a fully developed discipline that has its own theory base as well
as methods and methodology; and ranging from ethnographic research to experiments.
It was first developed in the early 1980s amongst a small group of academics from
various fields, such as economics, psychology and engineering, led by a small core
academic group organised out of the Russell Sage Foundation in New York. The
original members are now leading researchers in behavioural finance and the working
group is still going on with its second and third generation of academics. The
behavioural finance discipline was born out of the lack of evidence to support extant
finance theories on decision making and little theory that truly addressed many major
facts concerning financial decision making. Their primary focus, therefore, was to
uncover how decisions are made and how people really behave when they make
financial decisions. In other words, behavioural aspects from psychology could be
used to model financial decision making. We can understand the distinction between
extant finance theories and behavioural finance through a simple example: if someone
wishes to move to London, how does one approach making this decision? An economist
would say that this person would maximize his expected utility and choose an
apartment that is best for him. Behavioural finance would focus on the decision
process: he would choose something close to the work place, with a car park and a
necessary amount of bedrooms. Behavioural finance, therefore, contributes three major
insights:
(1) Human intuition is fragile – basic investment principles are not studied by
everyone who makes investments. That is why, they are biased and fall in
predictable patterns. This demands new theory a major spur to the Behavioural
Finance Working Group (BFWG) itself.
 (2) We have to consider decision processes if we want to know how decisions are Can behavioural
made in finance. How did this choice come about? In this, financial choices finance teach us
are analogous to medical, consumer and structured other choices.
(3) People’s personal beliefs are relevant in finance. Decision-making processes
about finance?
are already studied in medicine and the airline-industry in order to improve their
procedures and quality of services. Traditional financial economics puts
emphasis on the “homo-economicus” (fully rational reasoning) and it is important 31
that we study decision making in finance because this rationality is not always
the case in real life.
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Part of the contribution of the behavioural finance is to induce a Catholicism of

methodological approach which standard finance often denies. So the behavioural
perspective is often distinguished more by how it is done and not by what it studies.
This Catholicism of research method is ideal for research problems requiring an
interdisciplinary approach. Since much of the motivation for teaching finance in a
business school context is to harness the benefits of interdisciplinary work, we might
expect Finance academics working in business schools and their alumni to particularly
value the behavioural approach.

2. How psychology has enriched finance

Behavioural finance is informed by three strands of psychology. First is cognitive or
behavioural psychology, where the focus is upon how our minds undertake the
requisite calculations required to maximise wealth. Much of the Nobel Prize Winning
work of Daniel Kahneman (often in association with the late Amos Tversky) took this
form. The second is emotional responses to the intensity of trading, where the focus is
on decision-making being more than a strictly calculative process. The third is social
psychology, which recognises the need to find acceptance and even encouragement of
our acts. Certainly, rejection by our professional peers can be painful and potential
costly in career terms. We may prefer to “fail conventionally” rather than expose
ourselves to the social isolation non-conformity can bring.
This makes the adoption of a unified model hard and, perhaps, plain unhelpful.
It is true quantification has a central role in good social science. But a higher value is
the value of truth. The complexity of markets and social interaction more generally set
strict limits on the predictive power of asset pricing models including behavioural
alternatives. Behavioural finance studies how decisions are made by all kind of
investors, from private individuals to professional investors and covers all spectrums
of the financial arena (pensions, insurance, capital and money markets). It is an
incredibly fertile research area and in spite of the extensive research on behavioural
finance the discipline is not considered part of mainstream finance that one would find
in a standard finance textbook. Yet, both business school courses and textbooks to
service behavioural finance are now starting to appear.
Behavioural finance has a pragmatic aim – decision-making analysis. This means
that it has closer proximity with the real world than some more mainstream finance
approaches, such as the Chicago School of thought, where it is generally assumed that
the world is fully optimal and efficient. We cannot go on assuming that the markets are
fully rational and the people who think that the efficient market hypothesis is working
are now becoming a minority.
 QRFM 3. The professional response to the growth of academic interest in
2,1 behavioural finance
Finance theory, particularly at this time, is unusual in the degree to which it affects the
lives of ordinary people. Theories of financial decision making, such as the efficient
market hypothesis and the capital asset pricing model have had an impact on the way
practitioners perceived the world around them. Financial innovations have driven
32 the creation of whole markets, such as the development of portfolio insurance or
the Gaussian copula formula for the pricing and hence managing of default risk in
corporate credit instruments. Hence finance theory is “reflexive”, acting as both a
camera to represent current reality and an engine to create a new transformed reality
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facilitated by the insights of finance theory (MacKenzie, 2006). This symbiosis especially
marked in the area of “risk management” and the emergent belief that while risk could
never be eliminated it could be effectively managed. It was this faith that was so brutally
shattered during the financial crisis. For the emergent behavioural camp of finance
scholars the effective arbitrage of the most clearly documented stock market
“anomalies”, such as overreaction and post-earnings announcement drift has eroded
their ability to show practitioners the monetary gain that derives from their labours.
The professional world is unclear whether a unique model of behavioural finance
exists that is readily applicable to the financial industry. There is no straightforward
answer to this issue. While behavioural models do exist, no single one offers answers to
all of the questions. Models work in such a way that if you change slightly either the
input data or the model assumptions, the results will change each time. That is why
behavioural finance should not be looked into as a way of generating instant returns, but
rather as a way of approaching or using the knowledge to understand decision-making
processes. Just as in medicine, where there is not one drug for every disease so we should
not expect that there will be one model that will fit all of the behavioural finance aspects.
What is certain, however, is that all finance models that are used by practitioners need to
be modified to capture various behavioural aspects. One practical example of applied
behavioural finance comes from consumer debt-based financial instruments: the
services they offer have been enhanced because they use behavioural finance techniques
to understand more appropriately the psychology of the debtors.
Clear attractions with behavioural finance are its fertility in producing new
theoretical and practical insights. Behavioural finance is disciplined in triangulation
research methods. It is pragmatic and problem-based addressing practical problems
that investment managers and boards of directors face. Furthermore, it is inspiring
alternative ways of seeing financial decision making and, therefore, sharpening advice
to clients. Studying decision making is important, because when faced with a vast
number of choices people tend to avoid making one. The answer that behavioural
finance offers is that by studying human decision-making behaviour we can “nudge”
people into making their optimal choice. This discipline, therefore, creates a framework
in which we can help people; that is why academics wish that professionals would pose
issues that they want to be resolved.
One reason for embracing behavioural finance is that it articulates assumptions
about how investors choose what they choose. We make these assumptions in standard
models anyway by invoking the Von Neumann Morgenstern utility functions for
calculating the value of uncertain outcomes. So the question is not whether we
adopt of a psychology of human decision making, but rather whose psychology?
 Since psychology is now a well-developed part of medical science, or training aircraft Can behavioural
pilots, a traditional division of labour suggests that we might learn from that discipline’s finance teach us
lessons.
about finance?
4. The financial crisis as a spur to interest in behavioural finance
We cannot reflect on the crisis and say that there is nothing behavioural about it in the
sense that so many of its origins makes us despair about the frailty of human 33
judgement Alan Greenspan, stung by the criticism of his oversight of US monetary
policy prior to the crisis neatly encapsulates this (http://news.bbc.co.uk/1/hi/business/
8244600.stm):
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They [financial crises] are all different, but they have one fundamental source, That is the
unquenchable capability of human beings when confronted with long periods of prosperity to
presume that it will continue.
The presence of leading contributors to the behavioural finance tradition, like Larry
Summers and Cass Sunstein, both of whom are within President Obama’s new
administration, suggest that the behavioural finance tide will grow in policy circles.
Since practitioners spend considerable time responding to, and innovating around,
state intervention in financial markets and understanding of the behavioural tradition
is likely to become more germane to professional lives.
If we are conscious of some of the behavioural issues emanating from the crisis,
we can use behavioural aspects to help us reform regulation and partially anticipate
problems ahead of time. It became apparent that in the pursuit for profits the imbedded
regulations were not able to prevent CEOs from bending their financial reports in their
favour. Mark to market accounting methods allowed assets to be written up on the
back of the emerging speculative bubble in credit default swaps, and credit default
obligations. Many financial actors were responding to incentives and looking for
personal enrichment. So senior regulatory officials must see the bubbles in the making
and prevent them in their inception instead of allowing them to flourish in the hope
that the market will correct itself. This, of course, will be difficult in practice given
politicians’ focus on the electoral cycle and consequent lack of concern about even the
medium term.

5. Academics understanding of practitioners’ concerns

Practitioners being at the sharp end of understanding financial decisions may reasonably
ask “What has behavioural finance ever done for us?” in short can behavioural finance
specialists show us the money? The exact “value-added” of the behavioural approach
remains unclear for some practitioners. The predictive value of behavioural theory is a
primary concern to practitioners. Equally, the ability of the behavioural finance academic
community to “market itself” to the practitioner community, if they wish to do so, remains
a challenge. Of course, it is exactly this point where the reflexive nature of behavioural
finance theory most clearly bites. It is the very success of trading strategies motivated by
behavioural research, such as momentum and contrarian strategies, that has served to
some degree to undermine their profitability. Hence behavioural theorists must innovate
new strategies, and or refine old ones, to be of practical service to fund managers. Yet it is
not clear that it is the trading of financial instruments where the primary contribution of
behavioural insights lay.
 QRFM It may be that behavioural finance has its most immediate primary value as a lens on
2,1 financial regulation and as a way of debating its likely value. Hence those in compliance
functions may be the first wave of those encountering, challenging and re-engineering
financial regulation to address concerns about behavioural bias. As reformed poachers
make the best gamekeepers an understanding of, and felicity with the approach, which
informs regulatory reforms, may prove of value to practitioners. Less conspiratorially
34 practitioners and regulators have shared concerns about the ability of retail investors to
make decisions in their own best interest. Any financial provider with a clear customer
focus will be concerned by damage arising from a failure to fully anticipate a clients’
ability to effectively process the information that they are given when choosing
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between products.
Academic discussion concerning the problem of “self-control” suggests that there may
be limits to the caveat emptor principle when the consumer’s future self-resents the actions
of his earlier incarnation in predictable ways. For example, Laibson (1997) has shown that
future discount rates on consumption in the distant future are often far lower than those
currently applied. This may explain underinvestment in pensions by the young. As a
result, credit cards, which are often seen as an unambiguous blessing because they
effectively increase consumer choice regarding their consumption/investment plan, may
contain hidden downsides in a world of consumers lacking adequate self-control.
George Soros, the notorious Hedge-fund Manager, introduced the concept of
“reflexivity” reminding us that our behaviour as investors, reflects theory’s insights.
So diversification of fund portfolios reflects the insights of William Sharpe, John Litner
and others. Theory is an engine, not a camera, and chances the choice set investors
face. Behavioural finance applications in fund management will change what is now
profitable as observed trading flows respond to perceived arbitrage opportunities and
mined out “anomalies” disappear.
A useful insight as to the practical application of behavioural finance was provided
in the discussion from the consumer debt market. In buying consumer’s defaulted debt
at a discount the insights of behavioural finance can be beneficial in understanding
how consumer’s accumulate debt, why they default and how they may be motivated to
try to resume repayment. This market is valued at £229 billion in the UK with many
personal bankruptcies occurring each day. Cash-flow data are sparse and historic and
future cash flows are highly unpredictable. As one discussant at the roundtable said:
“understanding the history of defaulters convinces you that ‘bad things happen to
good people’”. This helps in developing practical aids to debt recovery which avoids
stigmatising defaulters, while offering them hope of renewed financial independence.
It is therefore possible within the defaulter community to isolate groups that are
most/least likely to repay their debts and assist accordingly.
A further example of human behaviour provided during the discussion was from the
pension industry. This highlighted how most of us actually prefer to avoid conscious
choices. Government policy in the pensions area is towards “stakeholder pensions” with
reasonably sensible defaults being sensibly set and avoids a natural tension to retain
excess earnings in cash-flow. “Nudging” consumers towards prudent decision making
in their financial planning may be a less coercive way to help the ignorant or weak-willed
from damaging their own lives and so seeking out social welfare payments. Part of
understanding choice is to understand how disturbing it is and part of professional
practice may be to avoid the tyranny of choice becoming too oppressive for clients.
 Clients are commonly asked their “attitude to risk” but on hearing their replies we may Can behavioural
despair at their ability to understand the concepts involved. This casts doubt of the value finance teach us
of the “buyer beware” safeguards against mis-selling financial products.
Additionally, in relation to the on-gong financial crisis one clear problem about finance?
practitioners encountered was better risk-management techniques (of VaR, Gaussian
copula default probability calculations, etc.) which allowed bigger risks to now be
assumed. The presence of “black-swans” and true uncertainty, or regime-shifts was 35
downplayed, if not outright denied. Banks like ABN/AMRO were pressured to take
bigger risks to match those of Goldman Sachs and other iconic market players.
It became apparent that presenting choices in different ways, or different orders, can
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influence choice. This had been observed in the selling of annuity products. Many clients
clearly display at least two cognitive biases; first inflation illusion and a failure to
understand how future inflation will erode the value of normal cash-flows and second,
loss-aversion. Finance professionals need to embrace their role as “choice Architects”
framing their clients decisions in a way that clearly represents the full consequences of
their choice, graphical representations of likely outcome scenarios can be very helpful in
this. Such insights have aided financial innovation to offer products that smooth out
returns in the best and worst years. Clients often love returns less than they hate downside
risk and are happy to enter risk-sharing contracts with financial product providers.
The impact on mental frames on investment choices has always been a primary
driver of behavioural finance research. A central insight here has been the “integration”
as opposed to “segregation” of elements of client’s losses. If a loss can be integrated
into a broader gain it seems more palatable and less painful to endure. Strategic
rearrangements of investors “mental accounts” can therefore be one way for sellers of
investment products to extract consumer surpluses.
Another delegate explained how in the retail investor market clear evidence of
information overload is present. While regulators have pressurised companies to make
many disclosures it is not clear how well the average consumer of say an insurance
product could use an undigested listing of such disclosures. So in signing up for
products on the internet, we often simply tab down to “I accept the stated conditions”
with little real understanding of what those conditions are. Retail investors, therefore,
seem to satisfice, not maximise wealth, in their financial decisions. So there is a limit to
disclosure as a remedy to poor decision making. This emphasises the need to be very
careful in making sure the default choice is the most reasonable one for a broad class of
clients. The general notion of “nudging” choice towards a sensible outcome is
increasingly popular in policy groups surrounding politicians (Sunstein and Thaler,
2008) Such interventions are a form of “liberal paternalism” that guides the consumer
without pre-empting his choice by taking “bad” ones off the menu he faces.
Financial products can be extremely complex today such that each professional
understands their part of it (the option swap or the interest-rate collar) but
understanding the whole impact on client wealth is not so easy. Confessing to ignorance
at risk-management meetings may not be a great career strategy. This concern has been
discussed in a growing literature on the “shrouded attributes” of retail investment
products. Strategic representation of financial products to myopic, ill-informed
consumers can undermine worthwhile investment planning. This opens up a possibility
for product innovation to better address clients’ true needs albeit that these are often
imperfectly articulated.
 QRFM 6. Conclusions
The Round Table discussion highlighted numerous benefits that behavioural finance
2,1 research can contribute to the financial industry, but at the same time there was an
evident discrepancy between the academic and the professional world when it comes to
utilising behavioural finance research. Academics wish to hear from industry about
specific problems that need solutions whilst the professionals feel that academics
36 should market themselves better and ask for research funding based on specific plans
linked to industry needs. It will be highly useful to both worlds if this gap is abridged
through stronger partnership and dialogue. The BFWG can act as this link and will
through future meetings and conferences encourage these relationships.
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References
Laibson, D. (1997), “Golden eggs and hyperpolic discounting”, Quarterly Journal of Economics,
Vol. 112, pp. 443-77.
MacKenzie, D. (2006), An Engine, not a Camera: How Financial Models Shape Markets,
MIT Press, Cambridge, MA.
Skidelsky, R. (2009), Keynes: The Return of the Master, Allen Lane, London.
Sunstein, C. and Thaler, R. (2008), Nudge: Improving Decisions about Health Wealth and
Happiness, Yale University Press, New Haven, CT.

Further reading
Gabaix, X. and Laibson, D. (2006), “Shrounded attributes, consumer myopia and information
suppression in competitive markets”, Quarterly Journal of Economics, Vol. 121 No. 2,
pp. 505-40.

Corresponding author
Paul Hamalainen can be contacted at: [email protected]

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