Given that we’ve gone through a recount of Game Theory as it has been used in finance in recent years, it is now time to look into what I view as game theory’s more successful peer: Behavioral Finance. Now, I know this commentary has touched on the pitfalls of Efficient Market Hypothesis before, that’s not what we’re doing today. We’re here to see how another relatively young field of study evolved throughout recent years, but this time we’re looking at quite the overachiever and how it helped progress the realm of auctions in Game Theory.
Piling up three Nobel prizes in economics since 2002 is quite impressive for a field of study that didn’t really take a formal shape until Thaler’s 1999 article “The End of Behavioral Finance” – spoiler alert: it wasn’t the end of behavioral finance, it was one of those ironic titles. I mean, its abstract basically speaks for itself: “The controversy surrounding behavioral finance is dying out as scholars accept it as simply a new way of doing financial economic research.” But that’s not important right now, I just really wanted to mention that more often that not abstracts aren’t as clear cut as that and is rarely prophetic like that abstract is, since just in just a couple of years Daniel Kahneman will go on to be the first Behavioral Finance related topic to win a Nobel Prize in 2002 for his work on Prospect Theory.
Daniel Kahneman’s Nobel Prize in 2002 marked a turning point for the field of Behavioral Finance. His groundbreaking work on Prospect Theory unveiled the complex nature of human decision-making under risk and uncertainty. It wasn’t merely a departure from traditional economic models but a profound shift in our understanding of how individuals approach financial decisions.
Prospect Theory does not assume irrationality; rather, it acknowledges that individuals may exhibit behaviors and biases that deviate from the strict rationality assumed by traditional utility theory. The core principle of Prospect Theory revolves around how people evaluate gains and losses relative to a reference point, usually the status quo or a particular starting point. This departure from rational bidding patterns was a game-changer in the world of finance, offering a more accurate portrayal of human behavior.
What Prospect Theory brought to asset auctions was a richer understanding of how participants assess and bid on assets. It revealed that individuals perceive gains and losses differently from the reference point, leading to the development of more realistic and descriptive models of decision-making. The concave shape of the value function for gains and the convex shape for losses captured the nuanced psychology of decision-making. It recognized that people are risk-averse when it comes to gains but risk-seeking when it comes to losses. This insight had profound implications for auctions and the strategies employed by bidders. Just as an aside, an interesting byproduct of Prospect Theory is the possibility of non-linear utility functions as implied by the concave-convex pattern mentioned above and has impacted asset pricing models as well.
Overbidding and the Role of Overoptimism
Much like the broader impact of behavioral finance on decision-making, the phenomenon of overbidding in financial auctions is a captivating aspect worth exploring within this context. It’s essential to clarify that overbidding doesn’t inherently signify irrationality but rather stems from the pervasive influence of overoptimism.
Overoptimism, a well-documented behavioral bias, plays a central role in the dynamics of auctions. Participants often find themselves overestimating the value of the assets being auctioned, which results in bids that surpass what traditional economic models would predict. Rather than showcasing irrationality, this behavior sheds light on the intricate interplay between human psychology and financial auctions.
The presence of overoptimism challenges the traditional notion that rational players should inevitably gravitate towards equilibrium. It highlights the complexities of decision-making in real-world scenarios and underscores the significant role that psychology plays in the realm of financial auctions.
The two other subfields of Game Theory impacted by Behavioral Finance worth noting are matching (the Efficient Market Hypothesis – which we touched on here and here) and its transition to non-cooperative games which we touched on last week.
At face value, the contributions of Behavioral Finance in the last 23 years are undeniably worth the awards and attention it has been getting. After all, behavioral finance has not only furthered the academic fields of psychology, finance, and game theory. It also made a lot of people a lot of money and it will continue to do so as developments in Neuroeconomics, Robo-advisors, and even ESG investing. Hopefully not just as non-cooperative games though.