The Hindu Business Line : The thin line of division between economic & financial behaviour

Humans behave one way when they are certain about economic value to themselves; they behave another way when they are uncertain about others future financial valuations.

G. Chandrashekhar

Washington DC, July 6 The fields of economics and finance are generally understood to be overlapping and interdependent. Indeed, the line of distinction between financial decision and economic decision is rather thin, and often invisible.

But, for the first time, a solid line of demarcation between the fields of economics and finance has been made in a research paper published by Journal of Behavioral Finance. While the Law of Supply and Demand regulates prices in th e economic realm, the Law of Patterned Herding rules prices in the financial realm, the authors claim.

In The Financial/Economic Dichotomy in Social Behavioral Dynamics: The Socionomic Perspective, authors Robert Prechter and Wayne Parker, a psychologist, contend that stark differences in how people approach financial decisions and economic decisions begin at the individual neurological level and extend to the behaviour of social aggregates.

In re-conceptualising the relationship between economic theory and financial theory, the authors of Socionomic Theory of Finance offer a new basis for understanding financial markets, providing an alternative to the increasingly challenged Efficient Market Hypothesis.

Based on data collected over 30 years, the authors show that humans behave one way when they are certain about economic value to themselves; they behave another way when they are uncertain about others future financial valuations. In the first case, they approach rationally and consciously, while in the second, they unconsciously herd and then rationalise their decisions.

Clearly, the traditional claims of objective valuation, randomness and equilibrium-seeking financial markets are challenged. Because financial values derive not from reasoning but from herding, the result is subjective valuation, predictable patterns of market behaviour and unceasing dynamism, according to the new theory.

In the economic market place, people make financial decisions based on supply and demand for goods and services. There are producers and consumers whose conflicting desires balance each other and thus create stable prices.

The world of finance is, however, different. All participants are of a single class: investors. They have a single, non-balancing desire to profit from investing. Their shared desire creates unstable prices because the main thing that fluctuates in financial markets is the level of demand.

The Law of Supply and Demand gets flipped on its head in the financial market, Mr Prechter, Executive Director of the Socionomic Institute in Gainesville, Georgia, observes, adding as a stocks price rises, demand for it tends to increase. When prices are cheap, few want to buy. This is exactly the opposite of what happens in the butcher shop or the shoe store.