Behavioral Finance - History

History

During the classical period, microeconomics was closely linked to psychology. For example, Adam Smith wrote The Theory of Moral Sentiments, which proposed psychological explanations of individual behavior, including concerns about fairness and justice, and Jeremy Bentham wrote extensively on the psychological underpinnings of utility. However, during the development of neo-classical economics economists sought to reshape the discipline as a natural science, deducing economic behavior from assumptions about the nature of economic agents. They developed the concept of homo economicus, whose psychology was fundamentally rational. This led to unintended and unforeseen errors.

However, many important neo-classical economists employed more sophisticated psychological explanations, including Francis Edgeworth, Vilfredo Pareto and Irving Fisher. Economic psychology emerged in the 20th century in the works of Gabriel Tarde, George Katona and Laszlo Garai. Expected utility and discounted utility models began to gain acceptance, generating testable hypotheses about decision making given uncertainty and intertemporal consumption respectively. Observed and repeatable anomalies eventually challenged those hypotheses, and further steps were taken by the Nobel prizewinner Maurice Allais, for example in setting out the Allais paradox, a decision problem he first presented in 1953 which contradicts the expected utility hypothesis.

In the 1960s cognitive psychology began to shed more light on the brain as an information processing device (in contrast to behaviorist models). Psychologists in this field, such as Ward Edwards, Amos Tversky and Daniel Kahneman began to compare their cognitive models of decision-making under risk and uncertainty to economic models of rational behavior. In mathematical psychology, there is a longstanding interest in the transitivity of preference and what kind of measurement scale utility constitutes (Luce, 2000).