Historical parallels

In: Uncategorized

9 Jul 2014

This box was part of my recent Fund Strategy cover story on behavioural finance.

Although behavioural finance owed much to modern psychology it also has other antecedents. Often they run parallel to discussions about irrational crowd behaviour.

In the 1970s, at about the same time as Daniel Kahneman and Amos Tversky were starting to develop their ideas, the first edition of Charles Kindleberger’s famous study of Manias, Panics, and Crashes was published. This is essentially a study of the history of financial crises including the Kipper- und Wipperzeit (tipper and see-saw) hyperinflation in central Europe from 1619-1622, the South Sea and Mississippi bubbles of the early eighteenth century and Tulipmania in the Netherlands in the 1630s. From an analysis of these events he develops a theory of crises and discusses the best way for the authorities to tackle them.

Kindleberger himself acknowledges the influence of other notable works in developing his framework. One is the famous study by Charles Mackay, a Scottish journalist and author, on Extraordinary Popular Delusions and the Madness of Crowds (first published in 1841). He also refers to a work by Gustave LeBon, a French author, on The Crowd (1895). LeBon was preoccupied with the dangers of political unrest but many have drawn parallels between unruly behaviour and market mania.

Perhaps the most surprising figure to find in the list of behavioural thinkers is Adam Smith. The eighteenth century author of The Wealth of Nations (1776) is often thought of as the originator of the idea of rational economic man. Indeed the rationalists of today often claim him as their own. This is perhaps not surprising since his seminal economic text contains one of the most famous statements on the importance of self-interest: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”

However, it is too often forgotten that Smith wrote two great books rather than just one. The focus of his Theory of Moral Sentiments (1759) is much more on the actual behaviour of individuals than his economic work. It is therefore not surprising that some authors have pointed to psychological insights in his work and one article has even dubbed him a “behavioural economist”. For example, an article in the Summer 2005 edition of the Journal of Economic Perspectives points to Smith as identifying the concept of loss aversion. Of course Smith used eighteenth century language rather than modern psychological terms: “Pain…is, in almost all cases, a more pungent sensation than the opposite and correspondent pleasure. The one almost always depresses us much more below the ordinary, or what may be called the natural state of our happiness, than the other ever raises us above it.”

Smith also wrote, among other things, of the tendency to overconfidence or in his words the: “over-weening conceit which the greater part of men have of their own abilities”.

It would be a mistake to read too much into the contemporary parallels with Smith’s thinking. The focus of the Theory of Moral Sentiments was on relationships between individuals rather than markets or the economy. But it is worth noting that contemporary behavioural insights are not always as path breaking as some of its proponents suggest.

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