Cognitivists……..the third gang of finance??

The world of finance is increasingly being gripped by gang wars….Their turf? Market efficiency…. Its probably the most brow-beaten research topic in the field of finance…My hunch is that more than 80% of the PhDs walking on the world today should say thanks to it…. But most of the work in this field is deductive in nature…In the sense that they process some empirical data and draw conclusions from it as to whether markets are efficient or not…But if we were to follow an inductive approach, some new ideas might crop up… So here, we’ll piece together small building blocks and construct the factors that explain how the market moves….

Yeah, lemme introduce the gangs to you…the first, well…. They don’t have a name, but we’ll call them the rationalists…. They are the people who love math…and equations… they attempt to find the logic and rationale in everything… they claim markets are efficient….so that they can keep themselves busy by doing a lot of research and finding many more models (of the mathematical variety, not the fashion one.. just to set the record straight)….

Anyways, the second gang has the behaviorists…. They claim the markets are not efficient…. Again, probably they are not good at math…hmm… I better fit into this…This school of thought has its roots in social psychology… and contends that well, external factors are responsible for the behavior of a person…and this behavior ultimately affects the market in a non-rational sort of sense… something like there is a bomb blast or a terrorist strike… this instills fear in people… this fear causes them to be skeptical of markets in general…they sell shares…and stock prices fall… in this case, the external environmental factor (bomb blast) determines the behavior of a person….

If we pause and study the evolution of behaviorism as a school of thought in psychology, it evolved because the psychologists of yore spent too much time brooding inwards, studying childhood experiences and attempting to rationalize the thought process…. This frustrated a lot of people because in this process, they never found the answers they were looking for….what motivates people to act the way they do? Championed by psychologists such as John B. Watson, Edward Thorndike, and B.F. Skinner, behaviorists argued that psychology should be a science of behavior, not the mind.

However, it became increasingly clear that although behaviorism had made some important discoveries, it was deficient as a guiding theory of human behavior. Noam Chomsky demonstrated that language could not purely be learned from conditioning, as people could produce sentences unique in structure and meaning that couldn't possibly be generated solely through experience of natural language, implying that there must be internal states of mind that behaviorism rejected as illusory. Similarly, work by Albert Bandura showed that children could learn by social observation, without any change in overt behavior, and so must be accounted for by internal representations.

This takes us to something that I’d like to name cognitive finance…. Put together the rationalists and the behaviorists…and throw in a new chota mota gang…and lo! We have a new school of thought!!! Lemme explain…. See, who make up the markets? It’s the people.. right? Now, when people determine the stock price in a free market, it makes sense for us to study their motivations…. Why they act in a certain way….for this we study their brains…

Human brain has 3 parts…first, the primal brain….which is present in all animals….this gives us our survival instincts…second, the emotional brain or the limbic brain… this explains why we act irrationally when we get emotional…and the last part is the neocortex, or the thinking brain…the behaviorist school of thought contends that man’s behavior is driven by external factors…yes, but this is a highly incomplete view…the way the human brain perceives and process these external stimuli is equally important…. The rationalists seem to think that the neocortex is the sole driver of human actions…but men are not robots… there are two more brains that drive human behavior which need to be taken into consideration…here comes in the cognitive school of thought…

Finance is an art…studying it will be a lot more fun if we were to adopt this integrated model, rather than just focus on one of the factors which drive the market….
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References:
1. Brealey Myers - The Principles of Corporate Finance (7th ed) Pg 347 for market efficiency
2. http://en.wikipedia.org/wiki/Psychology#Cognitive_psychology for the evolution of behaviorism
3. Daniel Goleman - Emotional Intelligence Pg 10-14 for the structure of the human brain