Wednesday, 15 September 2010

What is the difference between cognitive economics and behavioural finance?

This question was posed in an interesting LinkedIn discussion group (Behavioural Finance: Theory and Practice) by Kerry Pechter.

I dashed off a quick answer which ended up being 500 words long. So I thought it might be useful to post on here.

Can anyone tell me the difference between cognitive economics and behavioral finance?

Cognitive economics is not yet a widely used phrase, though Marco Novarese and I have been using it as a name for a more microfounded version of what's typically called behavioural economics.

So I'll answer the question based on how I use the term.

The first difference is between "economics" and "finance". Economics is a broader field, including the trading of any kind of goods or services, whereas finance specifically focuses on investment and the value of financial instruments. Indeed I consider economics very broadly to be the study of how resources are allocated (by individuals, and across society).

The more fundamental distinction is between "cognitive" and "behavioural". In short, cognitive is about how we think, while behavioural is about what we do. Behavioural finance and economics focus on the phenomena of how people behave - for example what will they do (on average) when faced with a given choice between two ways of paying for something?

Cognitive economics (or finance), on the other hand, looks at what is actually going on within the individual's mind when they make that choice. What is the internal structure of their decision-making, what are the influences on it, how does information enter the mind and how is it processed, what form do preferences take internally, and then ultimately how are all those processes expressed in our behaviour?

I would also distinguish between the way that behavioural economics and finance are practised, and what cognitive economists do. Behavioural economics is quite an experiment-driven field. BE (and BF) people mostly start from the framework of classical economics and do experiments to find out where real behaviour differs from the classical assumptions of rationality. BE is quite practical in one sense - it gives us a way to imagine the ways that people might behave when confronted with a given situation. However it does not make good predictions about how they will behave - generally it will rely on experiments to distinguish among the different possible behaviour modes.

Cognitive economists start at a lower level, from a microfounded model of how people make decisions, and work upwards theoretically, to develop a self-consistent model of large-scale economic behaviour. Cognitive economics therefore should ultimately be able to explain or predict behaviour from a minimal set of base data. In some ways this is the same goal as classical economics, but with a richer and more accurate microfoundation leading to more powerful and better micro and macroeconomic predictions.

A simpler way to explain it is by analogy with the difference between engineering and physics. Behavioural finance is like engineering - engineers know some rules about how objects behave, and they can use those rules to design and test new implementations of existing inventions, and fix things that have already been built. Cognitive economics is like physics - physicists know the underlying theory of how things work, and they can use that to explain how existing inventions operate, and to work out how to create wholly new ones.

1 comment:

M. said...

I completely agree with your definition. It's nice that someone is interested in the difference between the two labels. Most of the researchers consider them as synonymous. Ester Miriam Sent, in a paper, define "old behavioural economics" something very similar to what we call "cognitive economics". She notes a difference between Simon and his group (old behavioural) and what later was called behavioural.
Yet in the last time, maybe, something is changing. Mental models and representations of the problems are called as important factors to understand reality, by authors like Akerlok, Stigliz and the same Thaler ...

Marco Novarese