Behavioral finance and behavioral economics are closely related fields which apply scientific research on human and social cognitive and emotional biases to better understand economic decisions and how they affect market prices, returns and the allocation of resources. The fields are primarily concerned with the rationality, or lack thereof, of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory.
Behavioral analyses are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases.
History:
During the classical period, economics had a close link with psychology.
For example, Adam Smith wrote an important text describing psychological
principles of individual behavior, The Theory of Moral Sentiments
and Jeremy Bentham wrote extensively on the psychological underpinnings
of utility. Economists began to distance themselves from psychology
during the development of neo-classical economics as they sought
to reshape the discipline as a natural science, with explanations
of economic behavior deduced from assumptions about the nature of
economic agents. The concept of homo economicus was developed and
the psychology of this entity was fundamentally rational. Nevertheless,
psychological explanations continued to inform the analysis of many
important figures in the development of neo-classical economics
such as Francis Edgeworth, Vilfredo Pareto, Irving Fisher and John
Maynard Keynes.
Psychology had largely disappeared from economic discussions by the mid 20th century. A number of factors contributed to the resurgence of its use and the development of behavioral economics. Expected utility and discounted utility models began to gain wide acceptance which generated testable hypotheses about decision making under uncertainty and intertemporal consumption respectively, and a number of observed and repeatable anomalies challenged these hypotheses. Furthermore, during the 1960s cognitive psychology began to describe the brain as an information processing device (in contrast to behaviorist models). Psychologists in this field such as Ward Edwards, Amos Tversky and Daniel Kahneman began to benchmark their cognitive models of decision making under risk and uncertainty against economic models of rational behavior.
Perhaps the most important paper in the development of the behavioral finance and economics fields was written by Kahneman and Tversky in 1979. This paper, 'Prospect theory: Decision Making Under Risk', used cognitive psychological techniques to explain a number of documented anomalies in rational economic decision making. Further milestones in the development of the field include a well attended and diverse conference at the University of Chicago (see Hogarth & Reder, 1987) and a special 1997 edition of the respected Quarterly Journal of Economics ('In Memory of Amos Tversky') devoted to the topic of behavioral economics.
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