4. Bounded Rationality in Strategic Decision Making
4.9 Criticism and the Co-evolution of Normative and Behavioural Theories
There is a protracted debate between proponents of behavioural and neoclassical theories, particularly between proponents of the efficient market hypothesis or capital asset pricing model and the behavioural finance model. Anomalies in financial markets such as excessive volatility, overvaluation or undervaluation have been interpreted by both the efficient market and the behavioural finance arguments (Konte, 2010).
Behavioural theory has been criticised as lacking integrity due to the absence of a unified concept of the individual behaviour that applies across the various individual behaviours. Ross (2005) argued that behavioural finance was being defined by what neoclassical finance does not offer rather than by what behavioural finance does. Alm (2010) agreed with this critique, noting that models of behavioural economics typically identify a particular market anomaly and address it by describing decision makers as using heuristics and as subject to framing effects.
Perhaps the most notable critic of the behavioural finance concept is Fama (1998), who contended that behavioural finance is more a collection of anomalies than a true branch of finance, and that these abnormalities are either quickly priced out of the market or are explained by appealing to market microstructure arguments like the market efficiency theory.
Such an approach, the researchers believe, lacks the academic rigour often associated with theories and concepts. They claim that a concept can explain a phenomenon but fail to explain another related phenomenon, can arrive at different inferences from different angles and
explain a partial problem, but fail to expound the universal theoretical framework. Ross (2005) criticised the doom and death prophesies on standard finance models by proponents of the behavioural approach.
Another criticism of the behavioural approach is the focus on individual rather than group, aggregate or market behaviour. The argument put forward was that individual cognitive biases are distinct from social biases (Fama, 1998; Glaeser, 2003), where the former can be averaged out and its effects short-lived since they are short-term chance events. They also argued that the effect of individual choices is crowded out by aggregate behaviour, which is most relevant for finance and economics in particular. Alm (2010) countered this argument by proposing that the whole is made up of the sum of its parts, so it is prudent for researchers to understand the constituent parts (the individuals) before understanding the whole (the group, aggregate or market).
Another point of contention is around soft paternalism as a recommendation implied out of behavioural economic studies. Also referred to as asymmetrical paternalism or libertarian paternalism, soft paternalism as implied by behavioural concepts suggests that governments and other authorities should enact policies designed to assist irrational people (since they are not advancing their own interests in any case rather than allowing them to continue choosing), while not interfering with and/or infringing on the autonomy of those who make rational, deliberate decisions (Thaler & Sunstein, 2008). The economist, Klein (2004), criticised libertarian paternalism as oxymoronic, arguing against what he perceived as an oversimplification of the definition of libertarianism on the grounds that Thaler and Sunstein (2008) made no meaningful distinction between liberty and coercion. He also argues that aggregate behaviour cancels out individual irrationality over time.
Critics of behavioural economics typically stress the rationality of economic agents (Fama, 1998). They contend that experimentally observed behaviour has limited applications to market situations, as learning opportunities and competition ensure at least a close approximation of rational behaviour. Others note that cognitive theories, such as prospect theory, are models of decision making, not generalised economic behaviour, and are only applicable to the sort of
once-off decision problems presented to experiment participants or survey respondents (Thaler, 2005; Lovallo & Sibony, 2006)
Traditional economists are also sceptical of the experimental and survey-based techniques which behavioural economics have used extensively until recently. Economists typically stress revealed preferences over stated preferences from surveys in the determination of economic value. Experiments and surveys, they argue, are at risk of systemic biases and lack real-life incentive compatibility (Glaeser, 2003).
Some studies have offered explanations of the diversion, proposing that the two schools of thought came from different eras and from different theoretic backgrounds (psychology and philosophy vs. economics and mathematics), so the notion has largely been two mutually exclusive approaches (Alm, 2010; Shiller, 2006). Shiller (2006) suggested that the best way to differentiate between normative and behavioural finance is that, ―…behavioural finance is more eclectic, more willing to learn from other social sciences and less concerned about elegance of models and more with the evidence that they describe actual human behaviour‖.
Several researchers (Shiller, 2006; Konte, 2010; Alm, 2010) noted that by holding on tenaciously to one school of thought and model, researchers run the risk of making themselves irrelevant when they lose sight of the appropriate context and timing for the use of their models. Conlisk (1996) argued that while bounds of rationality are not always important, their frequency occurs often enough to render them important for inclusion in economic analysis.
These researchers instead proposed an interweaving of the two theories as a way to reconcile the arguments from both sides of the divide in the form of dynamic evolutionary or genetic algorithms. Lo (2005) proposed the adaptive market hypothesis to reconcile the two theories, by using evolutionary systems which argued that behavioural finance draws on a wide expanse of knowledge from all the social sciences that offer real and tangible alternatives which should not be lost. Other literature uses agent based models (adaptive or evolutionary systems) based on heterogeneity and bounded rationality.