Finance theory is rooted in the conventional neoclassical economics assumptions of how rational people approach risk. It assumes that people can mostly be thought of as having consistent preferences over outcomes, evaluated according to the probability of their happening. Rationality, in the economics world, is pretty much defined by consistency. If you’re faced with two decisions that, whatever their surface differences, have the same essential risks and payoffs, you should treat them in the same way – consistently. This model underpins a vast literature on optimal portfolio selection, efficient markets and the rules for corporate investment decisions.
Behavioural economics and behavioural finance, based on experimental evidence from applied psychology, find that most people don’t act this way. Real people, even clever ones like doctors, make mistakes in the framing of risk-based problems, they mess up the calculations and they are often inconsistent in their choices.
Mainstream finance research now accepts, somewhat grudgingly and in a rather a la carte fashion, the findings of behavioural finance. So anomalies and inconsistencies in data are often explained as having “behavioural” causes. But the core of the paradigm remains the rational agent approach.
Now we have some good quality research on how people actually take decisions, based on a large number of people at the Alcoa corporation in the US. Researchers at MIT and Stanford got access to the decisions taken by Aloca employess on both health insurance and retirement, allowing them to see how far those risk-based decisions were consistent. The result: only about 30% of people made consistent choices. It tells you something about the state of economic “science” that the authors see this as providing some support for the mainstream theory. Author Amy Finkelstein, a brilliant rising star in US economics, says the result shows “the classical model has some bite.” Personally I would say it’s a bit al dente.
There will be more research from this excellent data source, opening up a rich new seam of knowledge on how people actually behave in real life situations. Lab-based experiments are suggestive but there is always a worry that the fact of it being an experiment may alter the results (though in some cases the subjects are not aware that it’s an experiment, so that is not a general criticism of this sort of research).
Anecdotally, I’ve frequently been struck by how otherwise intelligent, sensible people find it difficult to get to grips with personal finance problems, especially those concerning retirement. There seems to be something about the combination of risk, long term planning and the contemplation of retirement and even death that turns the mind to porridge. I don’t think this is caused by something as simple as the cognitive biases found in behavioural finance, though they have something to do with it. It’s partly the disutility (the pain) of thinking about things where the costs of error are quite high (a miserable retirement), combined with annoyance that the state hasn’t figured this out. Most people (in the UK at least) want a simple, predictable method of getting a decent retirement income, provided reliably by a trustworthy counterparty. The constant and bewildering changes in the rules, the tax treatment and the lack of trust in future governments not to meddle in the system make this quite difficult. Given all of that noise, stuffing money under a mattress or just blowing it all on current consumption don’t seem such irrational choices.