Financial Explorer

10th Edition (7-9) May 2022

The Students’ Association of Finance, FMSC, USJP

Behavioural Finance: Challenging “Homo economicus”

Dr.N.S.Nanayakkara
Department of Finance, FMSC, USJP
neelangie@sjp.ac.lk

“Homo economicus” or the economic man is a construct introduced in the work of Scottish
economist Adam Smith (1723–1790). The economic man makes decisions based on the rational
analysis of potential and desired outcomes and acts in his/her own rational self-interest. In other
words, they are rational in the sense that they try to maximise their overall utility as postulated by
Utility Theory of Morgenstern (1944) and they update their beliefs through Bayesian updating.
Homo economicus is the key assumption underlying theories in social sciences including
economics and finance.
Asset pricing in finance assume investors are always rational in their decision making.
Accordingly, they always try to maximise their utility, and consider probabilities of occurrence of
different outcomes to maximise their overall wealth. Therefore, at any given time the stock prices
in asset markets reflect the true value or the present value of all its future cashflows, and if there
are any mispricing the rational investors will quickly act to drive the prices to its intrinsic value.
This correction of mispricing associates with the assumption that there are unlimited arbitrage
opportunities in these markets, that is, these rational investors can immediately trade substitute
stocks to correct the mispricing.
Modern finance, which is built on the pillars of rational thinking, revolutionised the discipline in
1950’s with Markowitz portfolio theory (1952,1959) and the Capital Asset Pricing Model (CAPM)
(Sharpe, 1964; Lintner, 1965; Black, 1972) (SLB). It led the way to other asset pricing models
such as Arbitrage Pricing Theory (Ross, 1976), Three Factor Asset Pricing Model (Fama & French,
1993), Five Factor Asset Pricing Model (Fama & French, 2015) along with the Efficient Market
Hypothesis (EMH) (Fama, 1970). According to EMH if the asset markets are efficient the investors
cannot gain abnormal return other than by chance because stock prices reflect the true value.
However, to this date there are vast number of empirical research that try to capture the existing
anomalies to the asset pricing theories and models in finance.
Even though, modern finance says otherwise a careful analysis of financial markets, show that it
is possible for “noise traders” to gain abnormal returns than rational investors by inadvertently
bearing more risk. According to Black (1986) noise traders are investors who trade on noisy signals
that are unrelated to fundamentals and make security prices to deviate from its intrinsic value.
Behavioural finance term these traders as irrational traders and develops a counter paradigm on
the premise investors are not always rational (quasi- rational agents) which contradicts the notion
of “homo economicus”. Furthermore, these irrational investors can worsen the mispricing of asset
prices in a market because rational investors will become cautious in correcting the prices due to
risk associated with predicting the movement of noise traders.
Financial Explorer
10th Edition (7-9) May 2022
The Students’ Association of Finance, FMSC, USJP

The main difference between rational and an irrational investor is that, while former is considered
unemotional the latter is impacted by psychological biases and heuristics in their decision making.
Modern finance theories uniformly apply rationality of investor while behavioural finance finds it
difficult to build general models of asset pricing because they consider markets are made up with
both rational and irrational investors. Behavioural finance explains this irrationality through two
perspectives, namely, preferences and beliefs of investors (Nanayakkara et al., 2019). Comparative
to the utility theory of preferences in modern finance, behavioural finance describe those
preferences through the prospect theory of Kahneman and Tversky (1979). At the same time the
beliefs of quasi rational agents are considered erroneous comparative to rational beliefs. Therefore,
they argue that both preferences and beliefs of irrational investors can be explained through
psychological or emotional factors. These biases and heuristics are normally adopted from
psychology literature, and there are vast number of them such as overconfidence,
representativeness, conservativism, mental accounting, herding because of the complexity
associated with human mind (Arnott, 1998).
Baker and Wurgler (2006) state that most bubbles and crashes in asset markets cannot be explained
through rational thinking rather they are created through psychological aspects of investment.
Investor psychology played a major role in the Dot-com Bubble in late 90s, the Housing Bubble
in 2008 and similarly in the current Covid-19 Crisis. However, the existing rational theories, which
are normative theories, are built on how individuals should behave rather than how they actually
behave, and they find it difficult to give a viable explanation for the crises or how to avoid them
in the future. Therefore, it is evident that economic models should be descriptive, where they are
built on how individuals actually behave, which will enhance the ability and the applicability of
them in finance. This challenges the construct economic man, thus, Thaler (2000) state that finance
model should include more realistic conceptions of economic agent, and that it will be possible
when economists become more sophisticated, where they incorporate the findings of other
disciplines such as psychology into finance theories and models. Therefore, it can be concluded
that the future of economic theories and models will be where the “homo economicus” is evolved
into a “normal man” or as Thaler (2000) states “homo sapiens”.

List of References
Arnott, D. (1998). A taxnomy of decision biases. Victoria: School of Information Managemnt and
System, Monash University.
Baker, M., & Wurgler, J. R. (2006). Investor sentiment and cross section of stock returns. The
Journal of Finance.
Black, F. (1972). Capital market equilibrium with restricted borrowing. The Journal of Business.
Black, F. (1986). Noise. The Journal of Finance.
Fama, E. (1970). Efficient capital markets: Review of theory and emperical work. Journal of
Finance.
Fama, E. F., & French, K. R. (1993). Common risk factors in the stock returns and bonds. Journal
of Finance.
Fama, E. F., & French, K. R. (2015). A five factor asset pricing model. Journal of Financial
Economics.
Financial Explorer
10th Edition (7-9) May 2022
The Students’ Association of Finance, FMSC, USJP

Kahneman , D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk.
Econometrica.
Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock
portfolios and capital budgets. Review of Economics and Statistics, 1499-1529.
Markowitz, H. (1952). Portfolio selection. The Journal of Finance.
Morgestern, V. N. (1944). Theory of games and economic behavior. New Jersy: Princeton
University.
Nanayakkara, N. S., Nimal, P. D., & Weerakoon, Y. K. (2019). Behavioural asset pricing: A
review. International Journal of Economics and Financial Issues, 101-108.
Nanayakkara, N. S., Weerakoon, Y. K., & Nimal, P. D. (2019). Rational approach to noise trader
approach in asset pricing: A reveiw. International Journal of Innovation, Management and
Technology.
Ross, S. A. (1976). The arbitrage theory of capital asset pricing. Journal of Economics Theory.
Sharpe, W. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk.
Journal of Finance, 425-442.
Thaler, R. H. (2000). From homo economicus to homo sapiens. Journal of Economic Perspective,
133-141.