Why did behavioural finance end?
Richard Thaler's famous choice of words began the demise. Decay starts with decreasing relevance. Then science progresses, funeral by funeral (Max Planck). Behavioral finance is slowly disappearing from the CFA curriculum and has almost vanished from the asset management space. A behavioral finance fund with assets greater than $100 million with a track record longer than five years is hard to find.
Even though I’m somewhat relieved that science now has a better chance to evolve without the constraints of behavioral finance, deep down, I understand that inefficiency often has a role to play. While behavioral finance may not have been effective for generating alpha, it was critical in waking up modern finance—holding up a mirror to its flaws, especially the notion that markets are efficient. If all behavioral finance managed to do was shake modern finance from its slumber, then it achieved a lot.
Of course, for someone like me, who builds machines for investing, behavioral finance laid an important foundation for our business. It challenged the stubborn belief in stock selection and human skill. Behavioral finance conclusively proved that human beings are biased and that those biases cost them a lot of money. That’s why passive beats active, why augmentation works, and why automated investing is the future.
Now that I’ve paid my respects, let’s address the real question: why did behavioral finance die? To understand that, it helps to go back to where the subject began. Like most things, it’s hard to pinpoint the exact moment of origin, but for me, it started with John Rae's intertemporal choices in 1834. You could jump from Rae to Herbert Simon, who tackled the concept of a rational man alongside his work on AI and complexity. Simon’s take was nuanced and mathematical, yet it was all too easy to distort his view that man isn’t completely rational into the simpler idea that man is irrational—a huge ignore the mathematics leap.
As the mathematics of intertemporal choice and hyperbolic discounting were dropped, storytelling took over. You can fill more than a U-Haul truck with books on behavioral finance, which is likely why Eugene Fama was so upset. He couldn’t fathom how such work got published in the first place.
But after enough noise, a Nobel Prize became inevitable. Psychologists—or "behavioral finance experts"—staked their claim that there was no finance without psychology, as humans were flawed machines incapable of even basic arithmetic. The marketing of this narrative culminated in Kahneman’s Nobel in 2002, when for a moment, he was as big as Einstein. As a young researcher, I was dazzled, thinking this revolution would change everything. But markets are complex, ruthless entities—they allow for the illusion of victory before throwing you off.
Then I reached Robert Shiller. His 1981 work on market fluctuations puzzled me. Were those fluctuations really due to mass psychology, or could they be explained by the complexity of Rae’s theory of instant and delayed gratification, muddled by millions of investors with differing preferences? I wrote a critique, suggesting Shiller’s interpretation of non-normality was not just in psychology but could also be understood temporally. The paper came and went, and Shiller won the Nobel Prize.
Enter Richard Thaler. His “Nudge” sold well, governments started nudging, and his work on investor behavior (with Bondt) led him to declare the "End of Behavioral Finance." I disagreed, showing that his anomalies were simply failures of mean reversion. Again, my critique did not cause a dent, and Thaler also won a Nobel Prize, along with Fama, while I was speaking at a UChicago conference reexplaining his coefficients.
So, why doesn’t anyone use behavioral finance to manage money today? Because it’s a story of anomalies, and simply understanding anomalies doesn’t translate in alpha (more money than the markets). Behavioral finance failed because it neglected the mathematics, the statistics, and the rationality foundations it chose to ignore. Kahneman’s original work was brilliant, but without acknowledgment of its mathematical roots, it couldn’t have lasting impact. “Thinking, Fast and Slow” omits figures like John Rae and George Ainslie, who first discussed the mechanisms of psychology.
Behavioral finance was great story telling of anomalies, good for a laugh, and perhaps it will continue to claim Nobel Prizes, but as a money-making strategy, it’s long gone.
Behavioral Finance Jokes compiled by Evan Nesterak, Editor of Behavioral Scientist:
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Portfolio Manager at Implenia Services and Solutions Pvt Ltd
7moHi Mukul. Nice perspective it works very well in money making even in days of HFTs , algos and AI. I have been practising behaviour finance for more than a decade and it works very well in financial markets Will be happy to share my work and one of the presentation is posted on my profile ( very old) Can show with real life case studies. Im not from academic background so cannot be able to relate with the theories but can show market behaviour to returns
Co founder Jeevan Pravaas Life Mentoring Services, Submariner, Sociopreneur, Career & Wellbeing Mentor, Master Trainer & a Good Human Being
7moVery well written and researched article Mukul. Enjoyed reading it