It's all a matter of how you behave

Modern way of looking at finance has a lot to teach us

After 30 years of rapid development, behavioral finance has become an important field. At the very beginning, it was a very informal discipline, with scholars who had similar questions and interests regularly meeting to discuss their ideas

Most of the early participants were not convinced by authoritative explanations for many things.

But they were fascinated by many scientific disciplines such as physics, psychology and sociology. Physics has always played an important role in the development of financial theory but psychology had not received as much attention until about 30 years ago.

While modern academics in many fields become interested in a few narrow research topics and may ignore ideas that are even more important, scholars in behavioral finance believe different disciplines offer different perspectives and toolkits to study economics and finance. Such new perspectives are valuable in expanding the scope of their research. Because economics and finance are concerned with many areas of human life, one has to rely on other fields to study the area.

Incorporating psychology, sociology and political science into the study of finance has been a big breakthrough.

While behavioral finance itself has fallen for the temptation to become too narrowly focused in some cases, new areas have emerged. Neural economics, for example, the intersection between neural science and economics and finance, seems very promising. It has already made some important headway by using magnetic resonance imaging technology to link human decision-making processes with physiological features of the human mind.

New York University research shows that more neurons fire up when a subject is asked to evaluate whether something is "vertical" or "horizontal". Far fewer neurons fire up when a subject is asked to evaluate whether something is tilted at a 45-degree angle.

This partly explains why investors favor familiar stocks. Because our brain is more active when processing more familiar information, investors tend to like those stocks that they have already heard of. But because one does not acquire additional information during such rapid thought processes, investors miss out on better investment performance, and indeed suffer worse performance due to their overconfidence.

Another study finds that a disproportionately large part of the human brain is dedicated to remembering human faces and names. Why? Because people live in societies in which they have to know the reputations of others in order to survive and thrive.

Why should we care? Behavioral finance and economics can be particularly important to Chinese financial markets, which have achieved unprecedented growth in the past couple of decades. Chinese leaders understand the importance of financial markets and smartly started designing, creating and regulating financial markets many years ago.

At the same time, China has to keep learning from the rest of the world, while not simply copying existing institutions or products. China has to learn about the principles and mechanisms of financial systems, not just short-term fluctuations in the market.

Behavioral finance emphasizes human psychology, social culture, social norms and history. One has to realize that many rules in finance have evolved and developed over a long time.

Many financial regulations and ways of doing businesses have been driven by specific historical incidents. For example, the Securities and Exchange Commission, the Investment Corporation Act, and the Federal Deposit Insurance Corporation in the United States were all created after the Great Depression that broke out in 1929.

People tend to pay too much attention to regulatory details, but ignore the rationale and principles behind the financial system. Therefore, one has to keep in mind that a market with a short history and no crisis is not a complete one.

China also has to look at things from a historical perspective. The country has a very long history and its financial markets have a long history as well. However, much about its financial markets was forgotten after the 1949 liberation so there is little memory of the past.

This can be quite a concern because the market is unfamiliar with the concept of fluctuations, risk and crisis. Without such memory, neither investors nor regulators can accurately estimate the risks in the financial system. This is worrisome given that risks lie at the center of the financial system. China has to watch out for such risks.

Behavioral finance not only looks into how individuals make investment decisions, it also concerns itself with how corporations function and how societies form values and expectations. History has witnessed many extremely exuberant and extremely desperate periods, and it is amazing to watch, in retrospect, how irrational the whole society and community of investors behaved and how soon people forgot about lessons learned the hard way not too long ago.

Such crazes are often accompanied by a few important elements - the relatively short history of the market in question, a relatively young and aspiring investor community, excessive liquidity and low interest rates, and some hard-to-value investment opportunities that have gained considerably in value.

All these factors seem to be present in the Chinese real estate market and some other sectors of the Chinese economy. It could behoove China to turn to behavioral finance for more suitable and sustainable growth policies in the long run.

The author is a faculty fellow at the International Center for Finance, Yale University; and deputy dean of the Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University. The article is based on his conversation with Professor Robert Shiller of Yale University, the 2013 Nobel Laureate in Economics. The views do not necessarily reflect those of China Daily.

(China Daily Africa Weekly 06/13/2014 page10)