Eight Lessons from Neuroeconomics for Money Managers
Introduction (via Steven G. Sapra, CFA & Paul J. Zak @ CFA)
The 1970s ushered in the ascendance of the rational school of thought in economics. In particular, the development of the theory of rational expectations (Lucas 1972) led to substantially improved predictive models in economics and finance. By the 1980s, dynamic general equilibrium expectation models were being used to understand macroeconomic phenomena, such as business cycles and consumption patterns, as well as to characterize variations in financial markets and guide economic policies. The Nobel Prizes awarded to economists Robert Lucas, Jr., Edward Prescott, Finn Kydland, Harry Markowitz, Myron Scholes, Robert Merton, and William Sharpe reflect the importance of this research.
By the late 1980s, the dominance of rational expectations models had led many economists to categorically accept the assumption that human decisions are made with full foresight and rational deduction. In finance, the logical conclusion was that traded assets are always (or nearly always) fairly priced because investors consider all relevant outcomes and their related probabilities of occurrence. In other words, the theory of rational expectations led to the conclusion that markets are efficient because investors use all relevant information in forming their investment decisions. The development of index funds has been largely a result of the conclusions drawn from rational expectations models.
Recently, however, a revolutionary change has occurred in financial economics. The field of cognitive psychology—and, more recently, behavioral neuroscience—has allowed economists to observe the limits of human cognitive abilities and to appreciate the extent to which human biases often result in decisions starkly at odds with those predicted by models of rational choice.Even casual observation shows that human beings often behave, particularly in the financial markets, in ways vastly different from what is predicted by economic theory.