Electronic copy available at: http://ssrn.com/abstract=1596888 Johnson School Research Paper Series #22-2010 Traditional vs. Behavioral Finance Robert Bloomfield—Cornell University April 2010 This paper can be downloaded without charge at The Social Science Research Network Electronic Paper Collection.Electronic copy available at: http://ssrn.com/abstract=1596888Electronic copy available at: http://ssrn.com/abstract=15968881 | Page Traditional Versus Behavioral Finance ROBERT BLOOMFIELD NICHOLAS H. NOYES PROFESSOR OF MANAGEMENT AND PROFESSOR OF ACCOUNTING, CORNELL UNIVERSITY INTRODUCTION The traditional finance researcher sees financial settings populated not by the error-prone and emotional Homo sapiens, but by the awesome Homo economicus. The latter makes perfectly rational decisions, applies unlimited processing power to any available information, and holds preferences well-described by standard expected utility theory. Anyone with a spouse, child, boss, or modicum of self-insight knows that the assumption of Homo economicus is false. Behavioralists in finance seek to replace Homo economicus with a more-realistic model of the financial actor. Richard Thaler, a founding father of behavioral finance, captured the conflict in a memorable National Bureau of Economic Research (NBER) conference remark to traditionalist Robert Barro: “The difference between us is that you assume people are as smart as you are, while I assume people are as dumb as I am.” Thaler’s tongue-in-cheek comparison aptly illustrates how the modest substantive differences in traditionalist and behavioralist viewpoints can be exaggerated by larger differences in framing and emphasis, bringing to mind the old quip about Britain and America being “two nations divided by a common tongue.” (For what it is worth, when confirming this account of the exchange, Thaler reports that Barro agreed with his statement.) The purpose of this article is to guide readers through this debate over fundamental assumptions about human behavior and indicate some directions behavioralists might pursue. The next section provides a general map of research in finance and describes in greater detail the similarities and differences between behavioral and traditional finance. The ensuing section places the disagreements between the two camps in the context of the philosophy of science: BehavioralistsElectronic copy available at: http://ssrn.com/abstract=15968882 | Page argue, à la Thomas Kuhn, that behavioral theories are necessary to explain anomalies that cannot be accommodated by traditional theory. In return, traditionalists use a philosophy of instrumental positivism to argue that the competitive institutions in finance make deviations from Homo economicus unimportant, as long as simplifying assumption is sufficient to predict how observable variables are related to one another. A brief history of behavioral research in behavioral financial reporting then shows that while these two philosophical perspectives are powerful, they are incomplete. The success of behavioral financial reporting also depends heavily on sociological factors, particularly the comingling of behavioral and traditional researchers within similar departments. Because most finance departments lack this form of informal interaction, behavioralists must redouble their efforts to pursue a research agenda that will persuade traditionalists. The last section proposes a research agenda that behavioralists can use to address both their substantive and sociological challenges: developing and testing models explaining how the influence of behavioral factors is mediated by the ability of institutions (like competitive markets) to scrub aggregate results of human idiosyncrasies. Such research should establish common ground between traditionalists and behavioralists, while also identifying settings in which behavioral research is likely to have the most predictive power. A THREE-DIMENSIONAL MODEL OF RESEARCH IN FINANCE A helpful way to illuminate the similarities and differences between traditional and behavioral finance is to map finance research in a matrix with three dimensions: institution, method, and theory, as shown in Exhibit 2.1. The institution can be thought of as the topic of study of a finance researcher. As described in Bloomfield and Rennekamp (2009, p. 143), North (1990) emphasizes “the varying meanings and usage of the concept of institution. One of the oldest and most often-employed ideas in social thought, it has continued to take on new and diverse meanings over time, much like barnacles on a ship’s hull, without shedding the old.” We use the term institution to refer to laws, common practices and types of organizations that persist over long periods of time. Thus, institutions in accounting research would include the existence of capital markets and financial reporting,3 | Page managerial reporting techniques, tax laws, and auditing. Note that specific organizations are not institutions, but the types of organizations are. For example, Bear Sterns and Lehman Brothers were never institutions, but “banks” are. Sociologists emphasize that institutions include norms and beliefs that impact social behavior (Scott, 2007). Thus, we also include as institutions practices like management forecasting behavior or the nature of conference calls, and common forms of commercial arrangements and ‘best practices,’ such as long-term contracts, relative performance evaluation, and debt covenants. The most common research methods are economic modeling and econometric analysis of data archives, with experimentation a distant third, along with a smattering of field studies, surveys, and simulations. Almost every research study published in peer-reviewed finance journals is motivated or guided by a theory, even if not explicitly stated. By far the most predominant theories are drawn from economics. These include theories of efficient markets and no arbitrage (crucial for studies of asset pricing and market behavior), agency theory (central to corporate governance), monetary theory (in banking), and stochastic processes (for financial engineering). A growing number of studies draw their theory at least partly from psychology. Psychological research has made considerable progress over the last three decades developing robust theories of how people behave, which have been summarized into the categories of drive (fundamental