Insight: Behavioral Economics
While Modern Portfolio Theory is a great starting point, Behavioral Economics contends that it fails to address many of the human idiosyncrasies so prevalent in today’s markets. Behavioral Economic models also address the psychology of the investor and the impact of public self-interest upon market decisions.
Though developed almost entirely from experimental observations or clinical surveys, the resultant Behavioral Economics model reveals insight into the psychology of investing. Key points include the ideas that people:
- often make decisions on rules of thumb, not strict logic.
- use stories and anecdotes to create emotional filters for the world.
- price markets inefficiently due to non-rational decision-making.
Simply speaking, Behavioral Economics models demonstrate that a successful economic model must address the statistically abnormal results revealed in the investors’ human tendencies.