Institutional economics and behavioral finance

Abstract

Finance, while largely emerging out of economics, has tended to overlook its own intellectual history. Perhaps because of this lack of attention to its intellectual history, an important connection between two important schools of thought, one in finance (behavioral finance) and the other in economics (institutional economics), appears to have been largely overlooked. The parallels between the two schools of thought are striking.Institutionalism arose in opposition to the orthodoxy of mainstream microeconomic though being developed by such neoclassical economists as Jevons (1871) and Marshall (1890). Institutionalism rejected the idea of universal economic “laws” or theoretical systems. Rather, its adherents argued that economic behavior was hugely influenced by the participant’s historical, social and institutional context. According to these adherents, understanding such behavior required an interdisciplinary approach.Mainstream finance’s basic modern portfolio theory model began with Markowitz’s classic 1952 article. In the next twenty years the Capital Asset Pricing Model (CAPM) took shape. Behavioral finance is said to trace its roots back to a 1972 article by Slovic. Behavioral finance arose as an attempt to explain apparent inconsistencies between orthodox finance theory and real world financial market behavior.Clearly both institutionalists and behavioralists are operating outside of the main stream of their discipline. Both believe that their view of reality is more realistic than that of the mainstream models. Both can cite a host of theoretical and empirical evidence to support their viewpoint. Both argue for a multidimensional (especially psychological) approach. Both see the mainstream approach as too simplistic. Both are criticized by the mainstream for their ad hoc approach and lack of a central theoretical model.