On the Limitations of Behavioral Finance » Economic Sociology

There will always be an aggregation problem because individuals are not a uniform and consistent enough for aggregation to work.

The consequences for ignoring the other social sciences and mounting a very narrow critique of traditional finance and economics, include:

Limited predictive power

Behavioral finance tells us more about what people won’t do (e.g., behave according to notions of rationality outlined in economic theory) than what they will do.

Contradictory implications

Are investors risk-averse or overconfident? How should we reconcile seemingly contradictory findings like these? Behavioral finance doesn’t tell us, because of its…

Failure to offer a viable alternative to the theories it challenges

Pointing out all the ways that real life behavior doesn’t bear out the predictions of traditional economics and finance is interesting—even fascinating, at times—but it’s not an alternative theory. “People aren’t rational” isn’t a theory: it’s an empirical observation. An alternative theory would need to offer an explanation, including causal processes, underlying mechanisms and testable propositions.

All this keeps behavioral finance dependent on traditional economics and finance rather than allowing it to grow into a robust theoretical realm in its own right. Perhaps someday the field will develop into something more truly challenging to economic orthodoxy. Until then, behavioral finance will have to play Statler and Waldorf to the Muppet Show of mainstream finance—providing entertaining critique, but not replacing the marquee acts. (Now if economics would just substitute Milton Berle for Milton Friedman….)

via On the Limitations of Behavioral Finance » Economic Sociology.

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