Behavioural Finance: Putting the Market on the Couch

If you would have dropped by Goodes Hall last May hoping to hear the latest research on equity financing capacity or other insights on the rational and efficient marketplace, you would have been disappointed.

Instead, you would have been treated to presentations on, say, the role of social media in financial markets or the mystery of why the shrewdest investors seem to ignore the basic rules of arbitrage. Insights, in other words, on the less-than-rational and messy world of finance.

Chances are, you would have experienced a few aha moments. Queen's School of Business’s annual Behavioural Finance Conference — the only meeting of its kind in Canada — is riding a wave of interest in behavioural finance among academics and investors alike. During a time of chaos and confusion in financial markets, behavioural finance offers fresh perspectives by studying the influence of cognitive psychology on the behaviour of finance practitioners and the subsequent effect on markets.

“Especially after the financial crisis, people are now saying that the rational finance view has to be questioned,” says Fatma Sonmez, assistant professor of finance and founding force behind the Queen’s conference. “Market efficiency has to be questioned. We have to find different explanations, and behavioural finance offers different views.”

Research roots

Behavioural finance research started in earnest in the late 1980s, though some of the big themes were suggested in John Maynard Keynes’s 1936 classic, The General Theory of Employment, Interest and Money. “Keynes outlined all sorts of investor behaviour, investor biases, and how investors form their beliefs,” says Sonmez.

But during the 45 years that followed, finance and economic thought centered on rational finance and market efficiency, which seemed to preclude any need to study the behaviour of the actors within the system.

Behavioural finance researchers first questioned the traditional theory that fundamental value is accurately reflected in the market. Traditional theory could not offer convincing explanations for obvious mispricing, and behaviourists looked for alternate explanations. As their papers began to be published in academic journals, researchers branched out to explore investor trading behaviour — investors’ belief system or expectations and how those expectations are formed.

They also studied the role of behaviour in financing and investment decisions relating to corporate finance, such as mergers and acquisitions. “When you’re a manager, there are two important questions,” says Sonmez. “First, how to find money, and second, how to invest that money. Behavioural finance says there are behavioural biases that we have to understand in order to understand financing and investment questions.”

The most recent research focus is neuroscience — how biases arise from the workings of the brain.

The finance world takes notice

You can tell that behavioural finance has a following in the finance world; it’s now a buzz word in asset management circles. Behavioural finance offers possible explanations for questions that keep practitioners up at night: Why do investors overreact to glamour stocks or bad news? Why do some investors hold bonds over the long term despite the fact that equities offer much higher yield? Does an optimistic bias skew forecasting and expectations? What is the role of overconfidence in trading behaviour? Why do people delay saving and investing decisions? Some researchers are even studying the link between testosterone levels and risk taking behaviour.

Like other researchers in the field, Sonmez comes to behavioural finance with a hardcore mathematics and finance background. “We are really fascinated by this idea of understanding human behaviour,” she says. “We know that mathematics is just a tool, and it’s not a complete picture for what we see in the real life. What makes finance different from the other areas, like physics, is that there’s a human interaction to it. And once there’s a human aspect, you have to understand behaviour.”

While she and most of her behavioural finance colleagues do not have formal education in psychology, they turn to extensive experimental evidence in cognitive psychology and behavioural biases to try and better understand finance anomalies or puzzles.

Sonmez was first turned onto behavioural finance while doing doctoral studies at University of Toronto. She attended a workshop by Cornell scholar Ming Huang, who discussed new approaches to financial theories. “I never even heard of these experiments,” says Sonmez. “But then I started to look at the same questions from a different perspective. It’s like reading the same book from a different approach. But obviously, I was so into my thesis, and I couldn’t change it because I wanted to graduate on time.”

Behavioural finance at QSB

Another chance meeting, when she was Queen’s, would give Sonmez the opportunity to do something with this interest. She arrived at QSB in August 2009 and that fall attended a mathematics seminar, where she met Frank Milne, Professor of Finance in the economics department. They talked about the financial crisis and behavioural finance, and thought idly that it would be great to invite the big researchers in the field to Queen’s for a conference.

Though she was a junior faculty member with no published papers to her credit, Sonmez quickly drew up a list of possible speakers and started calling. The next day she had five speakers lined up. Soon after, she met with Dean David Saunders and was given the green light for the conference. Ten days after the chance meeting with Milne, the conference was on. “I have a very determined personality,” says Sonmez. “I did my Ph.D in just four years.”

The Queen’s conference has run for three years — Milne co-chaired the first conference and Fabio Moneta, Assistant Professor of Finance, co-chaired the subsequent two — and in that time has developed a reputation for attracting leading and up-and-coming researchers. This year’s conference saw papers delivered by scholars from Carlson School of Business, University of Minnesota; The Wharton School, University of Pennsylvania; Krannert School of Management, Purdue University; Marriott School of Management, Brigham Young University; Marshall School of Business, University of Southern California; Mendoza College of Business, University of Notre Dame; Carroll School of Management, Boston College; and Ivey School of Business, Western University.

QSB itself is home to research in behavioural finance, by professors such as Sonmez and Wei Wang.

“This is an important and emerging area of business research,” says Jay Handelman, Associate Dean of Research, “and Queen’s is well positioned to make important contributions and to create new knowledge for both scholars and anyone interested in investing and investor behaviour.”

— Alan Morantz