Posts Tagged ‘behavioral finance’

Regulating financial markets based on human nature

Tuesday, July 14th, 2009

Our new President Barack Obama is a man of action and reform.

After the blood bath taken by investors in nearly all market segments in recent history, one of Barack Obama’s efforts focusing on financial markets centers on his proposed “Consumer Financial Protection Agency”.

Interestingly the idea of this project is to apply the findings of behavioral finance to ensure transparency, simplicity and fairness to all market participants. The recent financial meltdown has demonstrated that some of our traditional human biases have exacerbated the risks taken by many individuals, leading to disastrous live-changing experiences for the most unfortunate.

Behavioral finance is a rather new field in finance. It was started as an independent methodology within finance about twenty years ago, even though some of its findings were known much earlier. But it took a long time for this “science of human behavior applied to finance” to become accepted amid academic circles. President Obama’s endorsement is a testimony of how much this modern approach has become mainstream.

This program falls under the nominee for heading the White House’s Office of Information and Regulatory Affairs, University of Chicago Professor Cass R. Sunstein. Professor Sunstein published “Nudge” last year with co-author Professor Richard H. Thaler, one of the leading scholars of behavioral finance. This very well received book describes how human behavior sometimes leads to suboptimal decisions in investing, health care, education and most venues of modern live.

This is a well known fact to all sales people who tend, consciously or not, to exploit these patterns in order to trigger a sale, sometimes using unfair or misleading tactics. For example risks that are hard to understand seem unlikely to occur (ask any mortgage-backed securities investor). Or it is believed that people providing more details tend to be honest (ask any Madoff investor).

Another hilarious example of how we human are dominated by such behavioral biases is that the same individuals who will omit investing in a 401k plan if they must opt in, will participate in it if they must opt out in order to cancel it. Even though the end result is the same, people behave differently if they need to act or not to act to achieve the identical final result.

It remains to be seen how effective this new regulatory approach will be. Wall Street is known to adjust to new rules faster than they get printed. But at least there is a general awareness of the issue of small biases leading to big losses in the Government, and maybe at some point in the public.