Looking for a finance paper without complex models or rigorous math? This is it! Brav, Heaton, and Rosenberg discuss the debate over behavioral finance and conclude that neither side is totally correct.
Most of the existing debate centers on findings of apparent irrationality (example over trading, over confidence, price bounces, etc). The behavorialists find this anomaly and then the rationalist attempts to explain it in the context of rationality. Thus, when something that apparently does not jive with rationality, it must be that the model that the researcher is using must be incorrect.
In what is the paper's biggest contribution, Brav, Heaton, and Rosenberg correctly point out that in doing this, rationalists are making an implicit assumption, namely that people are rational. And this assumption, which may or may not be valid, flies in the face of what Milton Friedman position that the key part of any positive science is its predictive ability.
"The most controversial consequence of Friedman's approach is' the idea that theHowever, as the authors point out this lack of assumption importance is not the case. "Rather, rational finance seeks to 'explain' price behavior with coherent stories based on a constrained portion of the assumption space-- that portion that includes only assumptions consistent with complete rationality."
realism of "assumptions" is irrelevant to the assessment of a theory follows
from the primacy of predictive success. Put simply, those who worry about the
realism of assumptions unnecessarily constrain the 'proper' objective function
of a predictive science. Since that constraint may eliminate highly
'unrealistic' assumptions that nevertheless maximize predictive power, the
constraint hinders the 'ultimate goal of a positive science' and is therefore
(As an aside, the section by Mark Rubenstein is very good! Short version?: When I went to financial economist training school I was taught 'the Prime Directive': explain asset pricing by rational models. Only if all attempts fail, resort to irrational behavior. That is, as a trained financial economist, with the special knowledge about financial markets and statistics that I had gained and aided by the new high tech computers, databases and software, I must be careful how I used my power. Whatever else I did, I should follow the Prime Directive." Which while funny, is not that far from the truth. )
Following this opening, the authors shoot down most of the so-called successes of rational finance (no arbitrage, market efficiency, and NPV) as lacking predictive success or as being untestable (reversing the traditional attack on behavioral finance). The big success of rational finance? "the relative success of predictive models in derivative pricing is undeniable. Tellingly, derivative pricing theory may be the only theoretical endeavor in which assumptions regarding market structure are reasonably 'realistic'.
Moreover, many of these failures are derived (no pun intended) from institutional particularites that do limit the ability of participants (even those who are behaving rationally) from acting as so called rationalists would expect. Thus "the very flexibility of rational modeling that may help support the
existence of irrationality-induced anomalies in financial markets"
The authors conclude with a desire for a peace.
"Taunts traded by each side in the rational-behavioral debate are often both
inconsistent and unconstructive. Rational finance advocates have long criticized
behavioral finance for lacking novel and quantifiable predictions of financial
market behavior. But rational finance itself has few achievements of that sort.
At the same time, behavioral finance advocates criticize the effort to
'rationalize' behavior by factoring information sets, utility functions, and
transactions costs into the rational choice model [see De Bondt (2002)].
Behavioral finance advocates are perhaps right to criticize the flexibility of
the rational apparatus. But they go too far when they deny the role that
'rationalization' plays in supporting the limits of arbitrage."
"At the end of the day, however, the pretended debate over 'testability'
and 'prediction' often hides the real successes and failures of both sides,
and masks the interesting but unexplored links between the two approaches."
I told you it would get you thinking! :)
Brav, Alon, Heaton , James Breckinridge and Rosenberg, Alex, "The Rational-Behavioral Debate in Financial Economics". Journal of Economic Methodology, Forthcoming http://ssrn.com/abstract=473807