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I was once a great fan of behavioural economics/experimental economics and, to a degree, I still am. But there are very big issues with integrating the discrete (and sometimes contradictory findings) from empirical evidence into workable economic models. Furthermore, I have become convinced that the explanatory power of the assumption of economic rationality is more robust than I once thought. Freakonomics contains many examples of what I mean by this.

I’m still convinced that behavioural economics/finance is excellent for sharpening our intuitions even if it is not particularised enough for us to make decisions or policy based on its findings.

But a thought recently occurred to me. Perhaps one way of integrating behavioural economics with standard economics is to analyse how people react at the margin.

Let me give you an example. Sure, most people are overconfident, but are the share market traders who actually move prices overconfident? The fact that traders act on intuition, rather than mathematical modelling, may seem to support the overconfidence hypothesis but that intuition is honed through a training and winnowing process. Traders learn from experience whether it is too risky to bet that a certain stock will go up. Those who do not are fired, or lose all their money. So it doesn’t matter if the mums and dads are irrational if traders are not overconfident. The same question should be asked of institutional investors and whether their expectations are irrational.

On the flip side, does rationality provide a more powerful explanation than the vague hand-waving of behavioural finance? Is it over-confidence in one’s bets that causes an asset bubble or is it due to rational factors? It would be rational for me to buy a stock, even if I knew it was overvalued, if I expected the bubble to continue a little while longer. Why do bulls outnumber bears? Is it because it is easier to punt on a share to go up than down? If I thought a share was going to drop in price, I would need to short-sell it. But there are many practical restrictions on how long I can short-sell for. That explanation is at least as powerful as the behavioural finance explanation.

I’m just throwing this idea out there, but it does provide a lot of help in determining whether a behavioural finance idea is ‘useful’ or not.

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