Professor Eugene Fama of the University of Chicago originated the efficient market hypothesis. In its simplest form, the hypothesis states that today’s current stock prices have factored into them all available information, and that past price performance has no relationship with the future. This means it is impossible to use technical analysis of past price performance to achieve exceptional returns. The assumptions behind this hypothesis are that investors are rational and that markets are perfectly competitive. However, we often see bubbles and busts in the stock market, a telling criticism of the efficient market hypothesis.
Behavioral economics, on the other hand, studies how people actually make financial decisions, as opposed to how they should make decisions. It finds that people are often irrational: they have biases that skew their decisions, they use heuristics to make choices, and they are impatient for instant rewards. These tendencies can cause people to make sub-optimal choices.
However, behavioral economics is still a rigorous science. People do not have to be rational in order to develop a model of their behavior; they only have to be predictable—that is, predictably irrational. The standard economic model of consumer choice has rigid assumptions that behavioral economists believe are either inaccurate or severely limited. Below, I have listed some of these assumptions as well as my thoughts on them.
Assumption: Economic agents are rational.
- While it’s true that people sometimes behave rationally, most of the time their actions are motivated unconsciously and emotionally.
Assumption: Economic agents are motivated by expected utility maximization.
- People are often motivated by material rewards, as this assumption states. However, it is important to remember people are motivated by a whole host of non-material rewards as well.
Assumption: An agent’s utility is governed by purely selfish concerns, without taking other’s utilities into consideration.
- The falsity of this assumption should be evident to you without much explanation. People care very much about others’ happiness.
Assumption: Agents are Bayesian probability operators.
- This is accurate. Bayesian logic is the opposite of scientific logic. Scientific logic looks at data with no preconceptions, while Bayesian logic holds that we have preconceived notions about most phenomena. Those preconceived notions are tested, and if we get an error message, we revise our preconceived notion.
Assumption: Agents have consistent time preferences according to the Discounted Utility Model (DUM).
- People have a very strong present bias, so future rewards are not anywhere near as salient as present rewards.
Assumption: All income and assets are completely fungible. Fungible means that they are completely substitutable.
- Assets are equivalent to income in that they generate an income dividend. That is, assets times an operator equals income (e.g., at a 10 % return an asset investment paying $1,000 per year would be worth $10,000: $10,000 × 0.10 = $1,000 annual return). However, people use mental accounting. We consider money we earn different from money we get as a gift and money in a savings account different from money in a checking account. We then treat this money differently (Wilkinson, 2008).