Behavioral finance IV. History of behavioral finance
The period up until the late 1950s
Theories of rational behavior, expected utility, and other significant theories from the era of classical economics concerning human action were long considered infallible, universally valid, and practically flawless. However, sets of statistical insights, which became easier to monitor with evolving technology and could be evaluated more objectively thanks to new methodologies developed by experts, gradually began to reveal areas where these time-tested theories were surprisingly not one hundred percent accurate. Upon thorough examination of deviations, local extremes, and atypical indicator trends, attention began shifting toward the domain of human thought and psychology.
In the modern context, errors cannot be attributed to advanced systems unless proven to result from serious technical issues. Similarly, in the past—over a century ago—there was no technology to blame. The key to resolving unanswered questions and verifying insufficiently substantiated observations appears to lie in understanding the human mind, which remains mysterious and unpredictable. This realization dawned on respected economists, financiers, psychologists, and sociologists as early as the late 19th century.
Alongside these technical findings, theories focusing on the human element as the core component of complex economic systems also developed, with practical applications often yielding unpredictable results. Over time, these approaches necessitated a new, interdisciplinary framework, combining knowledge across fields to create a more modern scientific understanding.
It has been over a century since Gustave Le Bon published The Crowd: A Study of the Popular Mind in 1895, a foundational work in social psychology. While Le Bon did not directly connect psychology with economics, his observations influenced future research by shedding light on group and individual behavior under various conditions. His conclusions indicate that rational human behavior cannot always be relied upon, especially in extreme situations impacting psychology or when group dynamics influence decision-making. These insights remain applicable today in fields like human resources, consumer preferences in marketing, or financial theories like collective investing.
The Psychology of the Stock Market by George Charles Selden, published in 1912, reflects his belief that market price movements are significantly influenced by the mental maturity and attitudes of the investing public. It is not just expected returns that matter, but also the intense emotions that surface during trading, as well as the knowledge level of market participants—where knowledge encompasses not only theoretical learning but also the emotional awareness and life experiences that shape an individual's character traits. Selden's work illustrates the strong influence of sociology and psychology on financial market phenomena.
Another crucial concept from this period is Game Theory, formalized in 1944 by John von Neumann and Oskar Morgenstern in Theory of Games and Economic Behavior. Game Theory, an applied mathematics discipline with psychological elements, studies strategic interactions using structured models of incentives, or "games."
Upon reviewing various literature, it is evident that this preparatory phase in the development of behavioral finance produced a relatively modest number of works. However, their importance was fundamental, laying the groundwork for understanding economic theories through insights from other disciplines or complementing economic theories with interdisciplinary knowledge.
The period from 1950 to 1979
After 1950, there was a "boom" in the development of various theories. A significant number of these were specifically focused on finance, while other works emerged that, over time, have come to be recognized as foundational concepts in behavioral finance.
Some authors refer to this period as the era of neoclassical finance, representing the mainstream financial theory in the business world. The foundational knowledge and models of neoclassical finance were developed between 1950 and 1980, driven by the practical needs of the post-war economic boom. The timeline of neoclassical financial theories almost perfectly aligns with the second stage of the development of behavioral finance, confirming their historical significance.
Herbert Simon introduced the "behavioral model of rational decision-making" in a 1955 article published in The Quarterly Journal of Economics. This work is categorized as psychological literature.
In the 1950s, specifically in 1956, American psychologist Leon Festinger, along with colleagues Henry Riecken and Stanley Schachter, introduced the significant concept of cognitive dissonance in social psychology. This theory explains human decision-making, suggesting that when two known beliefs or pieces of knowledge are inconsistent with each other, cognitive dissonance arises. Since this dissonance is uncomfortable, the individual will try to reduce or eliminate it by changing their beliefs. The inconsistencies in individual decision-making and problems arising from information asymmetry or psychological conflict are part of the daily work of managers at all levels. Festinger's theory did not directly aim to impact economics and finance, but its insights, through interdisciplinary work, reached these fields, significantly influencing managers—particularly financial managers, whose decisions often have substantial economic effects.
According to available sources, one of the earliest works under the banner of behavioral finance was created by economist John Muth, considered the "father of the rational expectations revolution in economics." His work, Rational Expectations and the Theory of Price Movements, was published in the prestigious Econometrica journal in July 1961.
Renowned economist and author of widely respected economics textbooks, Paul A. Samuelson, published Risk and Uncertainty: The Fallacy of Large Numbers in 1963. This work examines human psychology in risk acceptance and utility functions. Samuelson argued that people are willing to accept a larger number of identical risk situations, such as a set of identical gambling bets, even though they would typically reject a single isolated situation of the same risk.
In The Journal of Finance, a 1963 article titled In Defense of Speculative Prices and Random Walks by Robert E. Weintraub addressed speculation and hidden opportunities in financial markets. A year later, William F. Sharpe presented his work in the same journal with an article related to Weintraub's themes, titled Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.
In January 1966, The Journal of Business published Filter Rules and Stock Market Trading, a work by finance professor Marshall E. Blume and the well-known critic of financial theories, Eugene Francis Fama. In this article, the authors criticized random walks and other factors related to financial market behavior, which, according to behaviorists, are nearly unpredictable given human psychology. Based on research, Fama and Blume demonstrated that stock market relationships are interconnected and dependent, attempting to explain potential speculation and hidden opportunities rationally, using appropriate and sufficient data.
Later in 1966, The Journal of Business featured an article with a more psychological focus. A New Look at Stock Price Clustering by Victor Niederhoffer explored trader behavior in the stock market environment, analyzing trading patterns influenced by price shapes, such as the preference to buy or sell at certain figures or rounded numbers.
The March 1970 edition of The Journal of Finance posed a question in its article Commodity Futures: Trends or Random Walks? Richard A. Stevenson and Robert M. Bear combined forecasting methods with commodity price tracking, concluding that commodity price movements follow systematic rather than random patterns.
In 1971, The Journal of Business featured Victor Niederhoffer's World Events and Stock Prices: An Event Analysis. This work is classified as a key piece of behavioral finance research, examining the impact of global events—both positive and negative—on financial markets. Niederhoffer highlighted the strong connection between real-world events and financial outcomes, observing exaggerated or insufficient reactions similar to those seen at lower levels, like a manager's response to local news.
In 1974, Amos Tversky and Daniel Kahneman's groundbreaking work Judgment under Uncertainty: Heuristics and Biases appeared in Science. Like their subsequent 1979 paper, this work is fundamental in the field of psychology, with direct applications to economics and finance.
In 1976, Peter C. Fishburn's Unbounded Utility Functions in Expected Utility Theory was published in The Quarterly Journal of Economics. Fishburn explored different approaches to utility functions, attempting to prove that utility is unbounded, explaining that individuals strive to maximize their utility.
The latter half of 1977 saw the publication of two significant works in behavioral finance. The first, Patterns of Investment Strategy and Behavior among Individual Investors by Lewellen, Lease, and Schlarbaum, appeared in the July issue of The Journal of Business. The second, Risk, Uncertainty, and Divergence of Opinion by Edward M. Miller, published in the September issue of The Journal of Finance, primarily addressed the concept of uncertainty and derived new ideas from it.
When Daniel Kahneman and Amos Tversky wrote Prospect Theory: An Analysis of Decision under Risk, they likely had no idea that 1979 would become a landmark year in the history of behavioral finance. This revolutionary theory, respected by supporters and critics alike, was published in Econometrica. Experts agree that this work marked the beginning of a new era in behavioral finance, shaping the direction of future research and development in the field.
The period after 1979
Two years later, Kahneman and Tversky introduced more critical insights through the prestigious journal Science. Their work, Choices, Values, and Frames, focused on the concept of framing and its direct connection to rational choice.
Ongoing publications have contributed valuable ideas to behavioral finance, even if their impact is more local or regional, or their subjects are so specialized that they may not have global applicability. An exception is the compelling Regret Theory: An Alternative Theory of Rational Choice under Uncertainty by Graham Loomes and Robert Sugden, published in The Economic Journal at the end of 1982.
In 1983, Richard Thaler emerged among the elite in behavioral science with his article Interdisciplinary Relations. This piece emphasized the importance of collaboration among disciplines, particularly sociology, psychology, and other emerging scientific fields, in economic contexts. Just two years later, Thaler's name was again highlighted alongside his colleague Werner de Bondt in discussions about the article Does the Stock Market Overreact?. The Journal of Finance published this topic mid-1985 as two separate articles: one by Thaler and de Bondt and another by respected financial historian, economist, and market efficiency theory co-author Peter L. Bernstein.
In 1985, The American Economic Review and The Journal of Finance both featured works focusing on market behavior, the second central interest of behavioral finance. Thomas Russell collaborated with the renowned Richard Thaler on The Relevance of Quasi-Rationality in Competitive Markets, arguing that in a quasi-rational market—where systematic errors occur—there are not enough rational traders to keep prices at rational levels.
Perhaps the most cited work of 1986, alongside Rational Choice and the Framing of Decisions by Kahneman and Tversky, is Fischer Black's theory Noise. Black described noise as the opposite of information, asserting that noise pervades economics, making it difficult for people to distinguish whether they are dealing with noise or actual information.
The year 1986 was prolific for diverse behavioral theories, with numerous high-quality contributions published in academic journals. Notable examples include Decision Making under Ambiguity by Einhorn and Hogarth, Rationality and Utility from the Perspective of Evolutionary Biology by Donald T. Campbell, Anomalies in Financial Economics by Allan E. Kleidon, and Is the Rational Expectations Hypothesis Sufficient? by John P. Gould.
The following three years also brought fascinating insights, particularly in the realm of financial markets, stock exchange relations, and processes. A brief paper titled Non-Synchronous Trading and Market Index Autocorrelation garnered attention in the March 1987 edition of The Journal of Finance, co-authored by Atchison, Butler, and Simonds. That same year, a piece with a slightly sarcastic title, Rational Models of Irrational Behavior, drew interest as well. In this work, George A. Akerlof and Janet L. Yellen examined Keynesian theories and critiqued the functioning of the Keynesian economy, which, in their view, contains flaws leading to market issues. De Bondt and Thaler expanded on their research with Further Evidence on Investor Overreaction and Market Seasonality. Additionally, Thaler published an individual piece, Anomalies: The January Effect, where he explored the financial phenomenon known as the January Effect—observed stock price increases at the beginning of the year, giving investors an opportunity to buy stocks cheaply before January and profit from this trend.
The year 1988 continued the intense exploration of market behavior topics. Notable contributions included Nejat H. Seyhun's The January Effect and Aggregate Insider Trading and Brett Trueman's The Theory of Noise Trading in Stock Markets. In the April issue of The Journal of Political Economy, Eugene Fama and his colleague Kenneth R. French, well-known critics of behavioral finance theories, published Permanent and Temporary Components of Stock Prices. This work aimed to develop additional methods for predicting stock price movements based on historical analysis of the U.S. financial market, effectively countering the arguments of behavioral economists and reaffirming market efficiency hypotheses.
By 1989, we were gradually entering the contemporary stage of behavioral finance. One notable 1989 paper is Anomalies: A Mean-Reverting Walk Down Wall Street, for which Richard Thaler collaborated with Werner de Bondt. They discussed market efficiency, stock prices, and theories ranging from Keynes's General Theory to Williams's Theory of Investment Value, offering fresh insights into the ongoing debate surrounding financial market behavior.
Contemporary behavioral finance
From the 1990s onward, we can speak of contemporary behavioral finance, marking a modern stage of its development. At Princeton University, it has been noted that over the past 15 to 20 years, behavioral finance has grown tremendously, establishing solid empirical and theoretical foundations.
Collaborative studies by renowned experts have emerged, such as the work of Kahneman, Knetsch, and Thaler in 1990, where they described experiments demonstrating the persistence of phenomena like loss aversion and the endowment effect, even in markets that exhibit signs of perfect information and high efficiency.
Thomas Gilovich's book How We Know What Isn't So, published in 1991, discusses the everyday errors people make in decision-making. In the same year, Kahneman and Tversky introduced a model of choice under risk as a solution to their previous studies on loss aversion, emphasizing that people place significantly more weight on losses than on gains. Fernandez and Rodrik developed a model highlighting how uncertainty can lead to a "status quo" state, a concept examined by Samuelson and Zeckhauser in 1988.
In 1992, key behavioral science contributions appeared. Thaler published The Winner's Curse: Paradoxes and Anomalies of Economic Life, while Kahneman and Tversky refined their prospect theory into a more advanced version called "cumulative prospect theory." This model replaced the isolated view of decision weights with a cumulative perspective, allowing for different weights for gains and losses.
Scott Plous wrote The Psychology of Judgment and Decision Making in 1993, providing a clear and comprehensive explanation of decision-making processes, focusing on social aspects.
In 1994, Lakonishok, Shleifer, and Vishny focused on "value strategies" in financial markets. They explored the strategy of buying stocks with relatively low prices compared to earnings, dividends, and book value, arguing that such strategies yield higher returns because they exploit the suboptimal behavior of typical investors. The following year, Benartzi and Thaler offered an explanation for the "equity premium puzzle" (EPP), suggesting that the observed higher returns of stocks over bonds are influenced by loss aversion combined with a tendency to monitor wealth frequently, a concept they termed "myopic loss aversion."
In 1998, Bikhchandani, Hirshleifer, and Welch argued about the power of observational learning theory, particularly informational cascades, which they claimed could explain phenomena such as financial market collapses. At the same time, Barberis, Shleifer, and Vishny presented psychological concepts related to market behavior, proposing models of investor sentiment and describing overreactions and underreactions to market information. Fama responded with a sharp critique defending the efficient market hypothesis, arguing that such reactions are a normal part of trading and cannot be easily categorized. However, his criticism lacked sufficient evidence, as behavioral economists had compelling observational data showing that investor reactions are influenced by various psychological factors and occur over different time intervals.
In the September 1999 issue of Behavioral Decision Making, Richard Thaler summarized mental accounting in the article Mental Accounting Matters. A year later, Andrei Shleifer published Inefficient Markets: An Introduction to Behavioral Finance, challenging the efficient market hypothesis. In 2000, Hersh Shefrin released Beyond Greed and Fear, a book still popular today that aims to help readers better understand behavioral finance and the psychology of investing.
In 2002, Gilovich, Griffin, and Kahneman published Heuristics and Biases: The Psychology of Intuitive Judgment, compiling the most influential research on heuristics and cognitive errors since 1982. That same year, Daniel Kahneman was awarded the prestigious Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for his contributions to prospect theory, despite being a psychologist rather than an economist. Had Amos Tversky not passed away prematurely, he would have likely shared the prize with Kahneman as his collaborator and co-author of prospect theory.
An Overview of Behavioral Finance, a comprehensive summary of behavioral finance concepts, was published in 2003 by Nicholas Barberis and Richard Thaler at the University of Chicago. Like Yale University, Princeton University, and the California Institute of Technology, the University of Chicago is one of the leading academic institutions in the United States, where significant resources are dedicated to the continued development of behavioral finance. In Europe, the University of Zurich is among the institutions that pay considerable attention to this field.
Today, new theories often emerge from the combination of existing ones, the refinement of known theories, or the integration of empirical findings into other unexplored areas of economics and finance. Many contemporary theories are based on cumulative prospect theory, particularly for understanding decision-making under uncertainty. The goal is to advance and improve the field of behavioral finance, making theories more effective, efficient, and applicable.
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