H R Khan: Understanding psychology for responsible financial
behaviour
Inaugural address by Shri H R Khan, Deputy Governor of the Reserve Bank of India, at the
Interdisciplinary Seminar on Psychonomics - Understanding the Psychology of Financial
Behavior organised by Maharshi Dayanand College of Arts, Science & Commerce, Mumbai,
6 February 2012.
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The speaker acknowledges the contribution of Shri. Anand Shankar, Shri Sittikantha Pattanaik and Shri. Surajit
Bose in preparation of the address.
1. I thank the organizers of the Golden Jubilee celebrations of the Maharshi Dayanand
College of Arts, Science & Commerce, Mumbai for inviting me to deliver the
inaugural address at this important seminar. The Interdisciplinary Seminar on
Psychonomics: Understanding the Psychology behind Financial Behaviour is indeed
a very topical subject and especially when the world is realizing the significance of
the import of human psychology in the economic behaviour of the markets. It is not
often that one gets an opportunity to share thoughts with an enthusiastic group of
students and faculty with diverse educational backgrounds and put forth views on
psychology in order to explain economics. Today, particularly in the context of
recent financial crisis, it is well-accepted that psychology does influence many
economic decisions which defy pure economic theories.
2. As we all know, during the classical period, economics had an established link with
psychology. For example, Adam Smith, who is considered as father of economics, in
his work on The Theory of Moral Sentiments, had described psychological principles
of individual behaviour. Jeremy Bentham, founding father of modern utilitarism
ideas, wrote extensively on the psychological aspects of utility. Overtime,
economists, however, began to distance themselves from psychology as they
sought to reshape the discipline as a natural science. By mid-20th century,
psychology lost its linkages with economics. In the 1950s, Herbert Simons
challenged some of the traits of standard economic model of human behaviour, i.e.,
unbounded rationality, unbounded will-power and unbounded selfishness. He
questioned the idea that people have unlimited information processing capabilities.
Rather he propounded the idea of "bounded rationality" to suggest a more realistic
conception of problem solving ability of human beings. It was also suggested that
human beings struggle to analyse problems objectively as they view them through a
"frame" of personal experience often shaped by social and cultural bias. In mid
1960s, Ward Edwards, Amos Tversky and Daniel Kahneman began to compare
their cognitive models of decision making under risk and uncertainty to economic
models of rational behaviour and this led to resurgence of psychology in economics.
3. The recent global financial crisis caused severe damages to many economies
across the globe. Governments and Central Banks had to step in to bailout many
financial institutions to protect the systemic stability. Greed and fear played a big
role in the way markets behaved much against the lines predicted by the
mathematical models. The behavioural economics do succeed in explaining the
recent market distortions driven by these two human traits. The greed for huge gains
drove financial engineers to innovate and sell complex financial products to
unsophisticated investors. As the crisis unfolded stock market reacted sharply and
stopped rallying. Fear then took over and accentuated the sell-off instead of
encouraging investments at lower prices. I do not intend to dwell on these areas in
detail but what I intend to highlight during my brief presentation is to focus on some
of the facets of interconnectedness of psychology with economics and how human
behaviour and emotions impact economic decisions. I would also attempt to put
forth some of the findings of behavioral finance talking along the contours of
mainstream and behavioural economics.
Sociology and psychology underpin economics
4. As we know, in the field of behavioural economics, insights are drawn from
psychology and sociology to arrive at explanations for economic phenomena. The
main departure of behavioral economics from its mainstream counterpart is that
behavioral economics questions the basic tenets of mainstream economics, i.e., the
assumption of fully rational agents with purely self-centered preferences. Once
these assumptions are relaxed, we are able to answer a lot many questions that do
not have clear cut answers in mainstream economics. Behavioral economics is a
truly fascinating field and it has been increasingly incorporated within the
mainstream framework.
Shifts in behaviour of economic agents
5. A large part of the thinking in finance during the 1970s was dominated by the
efficient market hypothesis which stated that markets are always right, decisions of
millions of rational investors make the markets the best judge of value of financial
products and that price of financial products contains the best possible information
about the fundamentals. In this connection, one can refer to Justin Fox, who, in his
book titled The Myth of the Rational Market: A History of Risk, Reward, and
Delusion on Wall Street has eloquently traced the origins of the irrationality of
efficient market hypothesis and has explained the events leading to the crumbling of
the myth of efficient markets. As we know, with passage of time, anomalies in
financial markets and in the behavior economic agents began to crop up. With this
there was a growing disquiet over models being used to capture real world events.
This gave rise to the search for newer paradigms of thinking so as to explain the
behavior of economic agents which differed from what was predicted by standard
economic or finance theory. This alternative paradigm explores the psychological
models of decision making in contrast to mathematical models and the irrationality of
the markets. The new ideas focus on how investors over-react or under-react and
end up making irrational decisions based on imperfect data. One such anomaly was
the increased and persistent volatility in the stock markets in the developed world.
Much of this volatility was unaccounted for. Some observers have, hence,
concluded that prices do not necessarily change due to changes in fundamentals
but due to "animal spirits" and mass psychology as well.
Understanding speculative build up
Price-price feedback loop
6. Another anomaly that caught the attention of academics was the bouts of
speculative increase in price of stocks. Speculative build-up of prices could lead to
expectation of further increase in prices and this in turn may cause further price
increase which is a departure from standard theory. Of course, high prices not
supported by fundamentals cannot stay high forever. Once the euphoria dies down,
prices fall. This phenomenon has come to be called the price-price feedback loop.
7. These feedback loops have long existed and were, for example, experienced during
the Tulip mania in Holland during the 1600s, the stock market boom in the early part
of 2000s and the housing bubble in the US which mainly contributed to the recent
global financial crisis. A negative feedback loop, i.e., one causing prices to fall could
also operate in a similar manner. Professor Robert Shiller points out that even with
the feedback loop working it is difficult to find discussions in standard text books. It
is possible that people may match increase in price of stocks with previous events
leading to a dynamic feedback loop even though fundamentals may not warrant any
significant change in prices.
Biased self-attribution
8. Feedback loops can be explained with yet another principle of psychology called
"biased self-attribution". Individuals may attribute, often misplaced, good happenings
to their own ability while bad happenings are passed off as outcomes of bad luck or
sabotage. In traditional finance theory, it is possible to argue that large number of
sophisticated investors offset the effects of behavior of the non-sophisticated
investors, thereby making markets efficient. For instance, when irrational optimist
investors buy stocks the sophisticated investor sells stocks and vice versa.
However, this behavior of sophisticated investors need not always lead to efficient
markets. It is possible that sophisticated investors increase the effects of the actions
of irrational investors, for instance, by buying stock ahead of irrational investors in
anticipation of price increases. This leads to prices of stock being away from their
fundamental value, i.e., mispricing.
Arbitrage of asymmetric information
9. It is seen that mispricing happens in securities for which information is sparse or
comes too slowly. Stocks may be mispriced for long periods of time due to a number
of reasons and investors trade on information which they believe is superior to
information available with anyone else. These could be forecasts or stock specific
news. However, it is possible that sometimes even the sophisticated investors
interpret the information incorrectly. It is also possible that overconfident investors
are able to take advantage of liquidity traders before rational investors, thereby
earning higher returns than rational investors. Mispricing can also persist for long
periods of time due to other happenings. For instance, if an investor identifies a
return pattern statistically, it is difficult for him to know whether other investors have
identified and acted upon that pattern or not. Therefore, uncertainty can lead the
prices to be away from the true value for long periods of time. In a related point, it is
also possible to see why there may be limits to arbitrage due to risks and costs
associated with exploiting the arbitrage opportunity.
10. Let us think of a situation in which irrational investors are bearish on a certain stock.
This will cause the price of that stock to fall. Standard theory will have us believe
that rational investors will sense an opportunity and buy the stock at the lower price
shorting a similar stock to hedge the position. Thus, buying of the stock will take the
price back to its fundamental value. This exposition of the dynamics of price change
is based on the assumption that every mispricing creates an immediate opportunity
to make riskless profits. This may, however, not be the case. There may be risks
and costs that dissuade taking advantage of arbitrage opportunities. Illustratively,
even when the stock price is down due to unwarranted pessimism, rational investors
may still face more downside risks to price due to adverse news about the company.
Risks to stock prices also arise due to the presence of noise traders who could
compel rational traders to liquidate their positions too quickly. In addition, there are
transaction costs involved in the process of taking advantage of arbitrage
opportunities. These costs could be prohibitively high sometimes and, hence, could
deter arbitrage.
Impact of level of knowledge on the decision making process
11. In the context of how level of knowledge influences the decision making process, let
us examine the question whether we always include all factors affecting the
happening of an event into account before making a decision. Standard economic
theory predicts that all factors are considered and that decision is optimal. In
practice, however, it appears that we do not. Evidence from psychology suggests
that due to the lack of time and cognitive resources, the brain develops rules of
thumb to analyze the problems, i.e., people depend on heuristics. This works well
when applied in appropriate settings; however, applying them in scenarios different
from what was initially intended creates biases. One assumption of mainstream
economics is that errors are independent across individuals in the sense that the
errors of one individual are not affected by or affect the errors of another individual.
In the modern world, humans are faced with many decisions at the same time and
with cognitive power being limited, heuristics are used to decide. There is obviously
no guarantee that these decisions will be optimal even though one could spend
more energy to make the optimal decision.
The halo effect
12. Very often in our lives we tend to appreciate one trait of another person so much
that we overlook the other, sometimes, undesirable traits. This is because of what
has come to be called the "halo effect". This effect can be used to analyze the
mispricing of stocks. Admittedly, in markets that are efficient, stocks could be good
in terms of growth prospects; however, this trait of the stock says nothing about the
future risk adjusted returns. Similarly, at times investors are unduly influenced by the
halo effect of "eminent" people or people with "star value" inducted into the boards of
companies. Thus, if this is the case, it is possible that stocks of certain companies
that are growing could be consistently mispriced.
The mental accounts
13. Let me now briefly turn to the concept of mental accounting. It is a process of
coding, categorizing and evaluating economic outcomes. For instance, people are
known to make notional mental accounts, i.e., accounts for education of children or
savings, etc. Even within investment accounts, there is a safe account designed to
provide for the "rainy days" and one account that is typically the risk taking account
designed to make money grow faster. However, theoretically, speaking money
should be fungible across accounts because money in one account is as good as
money in some other account. In practice, however, money is not found to be
fungible across accounts. For instance, fall in value of investment from the safe
account causes more pain than an equivalent fall in value in the other risk taking
accounts. Another interesting example popularly quoted is that due to risk aversion
trait, people tend to hold on to loss making stocks and sell profit making stocks. In
effect, people try to reduce loss and hence end up keeping loss making stocks for
longer.
Bracketing
14. Another issue of mental accounting is the concept of broad and narrow bracketing.
Many of us here may have noticed the getting a taxi on a rainy day is particularly
difficult. One would think that there would be more people willing to travel by taxis on
a rainy day than on a non-rainy day, thereby giving taxi drivers incentive to work
more and, hence, earn more. However, it is possible that taxi drivers focus on the
income from a day, i.e., the concept of narrow bracketing but not on the income over
a longer period of time, i.e., the concept of broad bracketing. On rainy days, the
income for the narrow bracketing is achieved more easily as the targeted earnings
are achieved for the day early. Hence, many taxi drives take rest earlier than usual,
thereby aggravating the problem of finding taxis on rainy days and also depriving
them of higher earnings on such days.
Emotions and expectations in economic decision making
15. Most theories in economics focus on debates without the involvement of any
emotions. I am sure you will agree with me that many of the decisions that we take
are based on or influenced by our emotions. Besides, there is also evidence to
prove that people are influenced by their current tastes and habits when predicting
futures tastes. Individuals in the framework of mainstream economics are said to
know the entire time path of the costs and benefits of their actions. In the event that
when they do something that may not be completely rational, say addiction to
alcohol, they are treated as taking rational decisions. We know one reason why
people below poverty line never move up the ladder is that often they spend large
portion of their meagre incomes on wasteful habits of consuming alcohol/tobacco or
spending on social events although they know such habits would only aggravate
their current economic problems. Behavioural economics explains why such
addictions happen. It is thus possible that people underestimate the effect of current
consumption on future consumption and may under appreciate the formation of a
habit.
16. Behavioral economics also throws useful insights for policy makers. Researchers at
the Federal Reserve Bank of Boston are engaged in studying the implications of
behavioral economics for economic policy. Papers presented at the 2007
conference on behavioral economics at the Boston Fed shed light on the role of
emotions and the idea of fairness on economic decisions. Evidence on how
emotions like anger and regret affect the price setting decision of firms and the
purchasing decisions of firms. The idea of fairness also has implications for labour
market outcomes. Evidence also suggested that it was difficult for US consumers to
formulate and executive saving plans. This obviously has immense implications for
policy makers and policy making. Many commentators were of the opinion that
complex sub-prime assets were sold to unsophisticated borrowers who did not
understand the contracts fully. Findings presented at the conference also suggested
that less than fully rational investors could affect housing prices. If prices are always
expected to continue their past trend among the irrational investors then house price
bubbles were more likely to form and macroeconomic stabilization could be more
difficult. This in fact actually happened in the US. Insights were given on how
behavioral economics could help central banks communicate economic policies.
Another important aspect from the point of view of central banks is that
expectations, not rational but adaptive, play an important role in influencing the
actual inflation path. For instance, if workers believe that inflation will be higher in
the future period then they may demand higher wages which could in turn feed into
the headline inflation through wage push effect. This has been evident in India in
recent years as not only inflation expectations have been high in double digits, even
the extent of increases in wages in both rural and urban areas has been higher than
the actual inflation levels. Generally, in a weak growth environment or a condition of
moderating demand, wage push spiral may not be sustained for long.
Antiinflationary monetary policy, that remains committed to containment of inflation till
the impact of moderating demand on inflation and wage demand becomes visible,
could work in containing inflation expectations. For anchoring inflation expectations,
therefore, balancing the growth-inflation mix, timing of policy actions, and clear
communication from central bank on its intent and commitment to inflation becomes
critical. Beyond this what further needs to be done to anchor the inflation
expectations could be an interesting subject for further exploration.
Concluding thoughts
17. In the mainstream framework, all of us would be individuals maximizing utility to
one's self irrespective of the utility of others around us. We do, however, care about
the welfare and consumption of people around us, i.e., our family and friends. Even
when we move away from the close circle of family and friends, we do not
necessarily always act in self centered ways.
18. In contrast, as was evident during the recent crisis in the financial markets, finance
and economics were being practised by set of people who had a totally different
mind-set, often conditioned for self-interest and greed. They were more mechanical
in nature, probably due to the fact they specialized in science and technology and
with less or no inputs from humanities during their course of education. They had
thus no compunction in mis-selling the products to unsophisticated
investors/borrowers, thereby sowing seeds of disaster for the households and the
economy. This, however, does not absolve them of the unethical behaviour leading
to selfish gains at the cost of deeper structural damages to the system and harmful
social consequences arising out of irresponsible financial behaviour as we have
seen in the recent financial crisis. Hence, there could be a case for conditioning of
all those who join finance professions by way of value based education and socially
relevant experiences during their college days.
19. To sum up, all of us could use the findings of behavioral economics in our daily lives
as well as in policy making. The important lesson of life is that we should not evolve
into insensitive individuals who care only for short term monetary gains by putting at
stake ethics and moral values, thereby disrupting the financial system and causing
huge social and economic damages. Hence, educational institutions like yours
should play an important role in creating human capabilities which are conditioned
by individual morality and social ethics aimed at responsible financial behaviour.
With this I intend to conclude and hope that this important seminar will highlight and
throw up interesting ideas for policy makers and practioners.