Behavioral finance is the most interesting theoretical work on investing to come out of academia or from research of investment management firms in recent years.
Therein might be its problem, says Professor Merton H. Miller.
Behavioral proponents move away from standard finance theory of the markets, pioneered by Harry Markowitz and William F. Sharpe, as a description of market equilibrium. The new theory is trying to model the market based on the behavior of investors. Although a "behavioral capital asset pricing model" still is elusive, behavioral economists discern a potentially predictable pattern in investor reactions to fundamental corporate and market events.
Yet, Professor Miller has a different perspective of this new field's impact on traditional finance. The 1990 Nobel laureate in economics and professor emeritus of finance at the University of Chicago finds behavioral finance too interesting.
As he has written: "(S)tocks are usually more than just the abstract 'bundles of returns' of our economic models. Behind each holding may be a story of family business, family quarrels, legacies received, divorce settlements, and a host of other considerations almost totally irrelevant to our theories of portfolio selection. That we abstract from all these stories in building our models is not because the stories are uninteresting but because they may be too interesting and thereby distract us from the pervasive market forces that should be our principal concern."
Behavioral finance might be the more enduring of the recent theoretical descriptions of the market, replacing chaos theory and its fractals and the fanfare over neural networks.
Studying humans - from works in psychology to biography - is more fascinating than studying multipatterned blots of fractal images. But Professor Miller may be right about behavioral finance's beguiling nature.
Professional investors have long cited "psychology" as a convenient way to dismiss market crises, as manias and herd instincts. But it probably was bad psychology. The behavioral economists probably will better understand psychology, if it has any application to markets.
Werner F.M. De Bondt, professor at the School of Business, University of Wisconsin, Madison, and Richard H. Thaler, professor of behavioral science and economics, at the Graduate School of Business, University of Chicago, use a telling 79-year-old quote in a paper they co-authored on financial decision-making.
They cite John Maurice Clark in his "Economics and Modern Psychology," from a 1918 Journal of Political Economy, who wrote:
"The economist may attempt to ignore psychology, but it is sheer impossibility for him to ignore human nature . . . If the economist borrows his conception of man from the psychologist, his constructive work may have some chance of remaining purely economic in character. But if he does not, he will not thereby avoid psychology. Rather, he will force himself to make his own, and it will be bad psychology."
Interesting, but is it too interesting?