Over the summer I authored a series of articles that were deep dives into the major behavioral biases. I promised that these pieces would culminate in a theory of behavioral finance. Then business intervened. I was inordinately busy. My apologies. Without further adieu… A Theory of Behavioral Finance.

The Modern Paradigm

A criticism of behavioral finance is that it lacks an overarching theory.[i] Namely, that it is just a long list of quirks and oddities logged by scientists about human behavior, but without an explanation for why they exist. Furthermore, a lack of a theory limits behavioral finance from making specific predictions about future outcomes. In turn, this means that behavioral finance is just short of being a science. This work seeks to rectify this situation and to have behavioral finance replace the failed investment paradigm of Modern Portfolio Theory (MPT).

What constitutes a theory?

Theories are analytical tools for understanding, explaining, and making predictions about a given subject matter.[ii] In science a theory must have the following characteristics:[iii]

1. It makes falsifiable predictions with consistent accuracy across a broad area of scientific inquiry.
2. It is well-supported by many independent strands of evidence, rather than a single foundation.
3. It is consistent with preexisting experimental results and at least as accurate in its predictions as are any preexisting theories.

In the above list, note the importance of predictions to the necessary conditions for an analytical tool to be considered a theory. The dominant paradigm framing investing currently is Modern Portfolio Theory. But despite a deep search it is not clear what MPT is supposed to be predicting.

Based on my experience I can posit that MPT’s primary predictions are:

• That investors construct investment portfolios rationally to maximize expected returns relative to expected price fluctuations.
• Changes in the prices of securities within financial markets are rational responses to new information that affects expected returns and expected price fluctuations.

Does this summation seem reasonable? Assuming you agree that these are reasonable predictions for MPT then we can reject it as a theory because its assumptions are unsupported by data. However, we can also reject it because its prediction of rationality is also not supported empirically.

If we reject MPT then important questions include: What is the next paradigm? What are the new paradigm’s assumptions? What are the new paradigm’s predictions?

Assumptions and Predictions of a Theory of Behavioral Finance

Assumptions of a Theory of Behavioral Finance

1. Human behavior is a complex combination of multiple factors that must be considered in total to glean insight, these primary factors are:
   1. Biological, with energy and time conservation being the drivers of these factors
   2. Psychological, with the level of self-awareness being the driver of these factors
   3. Sociological, with the level of social pressures and the level of self-awareness being the drivers of these factors
   4. Immediacy of decision making, with time horizon being the driver of these factors
2. Biological secondary factors affecting human behavior include:
   1. Human biology evolved with a preference to conserve energy
   2. Instinctual and habitual behaviors are efficient relative to energy conservation
   3. Working memory resources are, for practical purposes, fixed
   4. Self-awareness is energy inefficient in the short-term
   5. Intellectual thought is energy inefficient in the short-term
3. Psychological secondary factors affecting human behavior include:
   1. Behaviors and habits formed based on:
      1. Goals/needs being attained, but relative to energy conservation; needs include:
         • Physiological needs
         • Safety needs
         • Belongingness and love
         • Esteem
         • Self-actualization
      2. Decisions driven by a desire that the benefits of outcomes exceed their costs, including energy and time conservation
      3. Positive feedback for courses of action from the environment, the self, and/or from others
   2. When behaviors and habits are automatic, they become energy efficient
   3. Behaviors and habits are typically learned and formed at a young age when self-awareness and self-determination are lower
   4. New behaviors and habits require an initial energy investment to develop strong neural pathways and are energy inefficient

4. Sociological factors affecting human behavior include:
   1. Safety
   2. Group feedback that is either positive or negative about attitudes, behaviors, and choices
5. Behavior is biased away from self-aware and intellectual responses due to energy and time conservation, as well as working memory constraints
6. Changes in the prices of securities within financial markets are the aggregate of individual investor behavior

Predictions of a Theory of Behavioral Finance

1. People, even when there is a rationally correct answer, overwhelmingly engage in instinctual, irrational behavior. Said another way, people are predominately behaviorally biased.
2. Changes in the prices of securities within financial markets are overwhelmingly instinctual, irrational, and larger than would be predicted by rational models (e.g. modern-portfolio theory, discounted cash flow valuation, and so on).

Importantly, each of the above behavioral finance assumptions are verified empirically, as are its predictions. It is for this reason that I posit behavioral finance as a theory is superior to modern portfolio theory.

What is Unique About this Theory?

First, many theories in science are siloed and limited in context to the scientific domain in question. My theory above recognizes behavioral finance as a combination of biological, psychological, and sociological factors that collide with time. I believe to fully understand human decision-making requires an appreciation of each of these factors. This systemic view of the problem is unique to my knowledge.

Second, the above theory constrains the concerns of behavioral finance. One of the complaints about behavioral economics is that because its emphasis is on the ex post facto effects of decisions, rather than on the ex ante causes, that it can explain everything. That is, when we witness bias in decisions we can always find a behavioral cause. But when we work in this bottom up fashion we avoid the gorilla-in-the-room (inside joke) question of: what caused these biases in the first place? In other words, behavioral finance is largely a diagnosis after the fact, without an apparent cause before the fact. Above, I have named what I believe are the causal factors. In turn, if as investors we are able to mitigate these causal factors then it changes behavioral finance from a mere diagnosis into a possible suite of prescriptions for how to overcome the biases.

Third, unlike Modern Portfolio Theory, the assumptions and predictions above meet the strict criteria for what constitutes a scientific theory.

What is Coming Next?

In the subsequent weeks I support each of the above assumptions with scientific evidence. Ultimately, I take the predictions above and demonstrate that the evidence does show behavioral bias effects the pricing and fluctuations in pricing that we see in financial markets.

[i] Vissing-Jorgensen, Annette. “Perspectives on Behavioral Finance: Does ‘Irrationality’ Disappear with Wealth? Evidence from Expectations and Actions.” National Bureau of Economic Research, SSRN (2 June 2003) Accessed on 23 February 2019

[ii] From Wikipedia’s article on “Theory;” https://en.wikipedia.org/wiki/Theory Accessed on 20 September 2018

[iii] From Wikipedia’s article on “Scientific Theory;” https://en.wikipedia.org/wiki/Scientific_theory#Characteristics_of_theories Accessed on 20 September 2018