A little while ago I published A Theory of Behavioral Finance, and subsequently I have been exploring each of my assumptions in greater detail. Of those foundations the first four deserved entire articles. Whereas assumptions 5 and 6 can be combined into a single piece. Next week I conclude the whole enterprise (just in time for the Holy Days) by exploring the predictions that may be made based on the Theory. Here are the two remaining assumptions as described in the Theory:

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

Impedances to Unbiased Behavior – Assumption 5

In each of the preceding assumptions the details of Assumption 5 have arisen as a natural consequence of the discussion. That said, assumption 5 needs slightly more detail. Before discussing this assumption deeper, let’s review the impedances covered so far that lead to biased behavior.

First up, in the discussion of Assumption 1 I said that in Vartanian and Mandel’s decision-making model there were three components: (P)erceptual; (C)entral; and (M)otor. Recall that we first perceive phenomena with either our senses or via self-reflection when we consider a thought itself. This is the P-stage.

Next, our brain does a check in with memory in the initial stages of the C-stage to see if the situation currently under consideration has a habit loop/program/bias associated with it. If it does, then we tend to quickly react to that initial stimulus in the M-stage. If, on the other hand, the situation is new to us then the situation is referred to the parts of our brain that do deeper thinking. Crucially, if this is the mental pathway taken then our thinking is slow relatively, and thus, the M-stage takes longer to execute.

Furthermore, both the P and M stages can happen in parallel/simultaneously. This is why athletes have lightning-fast reflexes. As phenomena are perceived, they react with muscle memory and rapidly. It is also why athletes who underperform frequently say they were too much in their head. Being in the head in the C-stage means we can only think serially/sequentially. This is much slower.

Why is this the case? Because as we explored in Assumption 2 – Biological Factors, during our ancient past we needed to conserve energy because food was hard to find. Furthermore, we also had to conserve time because delaying our response to a critical situation could mean the difference between life and death. This is an evolutionary response with physical consequences.

But there is another important thing at work here that we only discussed in passing previously. There seems to be a biological constraint on the number of independent thoughts that we can hold in working memory. Specifically, most of us can only accurately hold 3 independent thoughts in working memory.[1] While some outstanding people do better than this, even they seem tapped out at 5 items. Still others can only hold 2 separate thoughts front of mind. Note: meditators are able to expand their working memory, as well as to task switch much better than non-meditators; a subject discussed more in-depth in my next article.

Next, in Assumption 3 – Psychological Factors, we discussed that our motivations also play a key role in angling us toward habitual outcomes. Completing the P-C-M model, above, when a need/motivation is satisfied, hormones are released that make us feel good. When our needs/motivations are not satisfied the reverse is true. This hormonal response either amplifies or diminishes the course of action taken. If our choices satisfy our motivations consistently then they become habits.

Additionally, many of the habits that we carry around as adults were developed when we were young. While these habits may be successful at satisfying our needs, it is frequently the case that we have never updated our habit technologies. Consequently, our ways of habitual thinking and mental models frequently fail us as investors because our way of responding to the world is amateurish.

Assumption 4 – Sociological Factors put at its center the idea that being a part of a group increases the chance for our genes to propagate. Consequently, there are sociological factors – i.e. group pressures – that drive us to groupthink and to respond to the world in a biased way.

In summary, Assumption 5 states that there are impedances to correct thinking stemming from our evolutionary past, as well as an outright physical constraint. Additionally, our motivations and our desire to “fit in” with groups also affect the quality of our thinking; usually negatively.

Market Prices are Driven by Behavior

The final assumption of A Theory of Behavioral Finance, #6, is that financial market prices are the aggregate of the behaviors of individual market participants. I take this as self-evident, and you probably do, too. But researcher note the same thing. For example, Kurz (1998) advanced a theory of market prices called Rational Belief Equilibria in which he stated, “The conclusion of the paper is that the main cause of market volatility is the distribution of beliefs and expectations of agents.”[2]

However, Kurz’s work still assumes rationality on the part of investors. In other words, it is based on the failed paradigm of Modern Portfolio Theory that assumes that investors are rational. Whereas, the work of many researchers, even from the mid-1970s, shows that investors are not rational and that MPT does not describe reality. Criticism of MPT came early and often and from heavy hitters. Richard Roll stated of MPT in a take down that should have been the end of it:

“Testing the two parameter asset pricing theory [i.e. CAPM] is difficult (and currently infeasible). Due to a mathematical equivalence between the individual return/’beta’ linearity relation and the market portfolio’s mean-variance efficiency, any valid test presupposes complete knowledge of the true market portfolio’s composition. This implies inter alia, that every individual asset must be included in a correct test.”

In other words, MPT does not have falsifiable predictions, and so cannot constitute a theory.

Still other MPT naysayers, include Nobel Laureate, Robert J. Shiller, who demonstrated in 1980 that stock prices were much more volatile than they should be relative to the business fundamentals of those same companies.[3] In other words, investors are behaviorally biased and irrational. In fact, behavioral finance as a discipline demonstrates that people routinely make biased and irrational decisions even when mathematically correct answers are available.

Behavioral finance researchers also believe markets are the result of the aggregate interaction of market participants. Szyszka states, “The paper presents the Generalized Behavioral Model that describes how asset prices may be influenced by various behavioral heuristics and how the prices may deviate from fundamental values due to investors’ irrational behavior.”[4] In other words, markets are the net result of the interactions of its behaviorally biased actors.

In my next article, I conclude the Theory with a description of the predictions that may be made based on its assumptions. In turn, these are predictions are falsifiable. See you then.

[1] Fukuda, Keisuke, Geoffrey F. Woodman, and Edward K. Vogel. “Individual Differences in Visual Working Memory Capacity: Contributions of Attentional Control to Storage.” Mechanisms of Sensory Working Memory (2015): 105-119

[2] Kurz, Mordecai. “Endogenous Uncertainty: A Unified View of Market Volatility.” SSRN 97-027

[3] Shiller, Robert J. “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?” NBER Working Paper Series. (1980)

[4] Szyszka, Adam. “Generalized Behavioral Asset Pricing Model.” SSRN. (10 November 2008)