The Potential Contributions of Behavioral Finance to Post Keynesian and Institutionalist Finance Theories

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MatthEw V. FuNg

The potential contributions of
behavioral finance to Post Keynesian
and institutionalist finance theories
Abstract: In their paper “Behavioral Finance and Post Keynesian–Institutionalist Theories of Financial Markets,” Raines and Leathers discuss how the theories of Keynes, Davidson, and Galbraith could explain financial bubbles and crises and show how those theories are both confirmed by actual events and supported by some findings in behavioral finance. The current paper comments on their discussion and explores the potential contributions of behavioral finance to future developments of Post Keynesian and Institutionalist theories in other fields in finance, especially portfolio theory and asset pricing theory. Key words: asset pricing theory, behavioral finance, financial bubbles, portfolio theory.

the focus of the Raines and Leathers paper, “Behavioral Finance and Post Keynesian–Institutionalist theories of Financial Markets,” in the current issue of this journal (pp. 539–553) is to show how the work of John Maynard Keynes, Paul Davidson, and John Kenneth galbraith have certain “behavioral tendencies” and how their theories are both confirmed by actual events and the findings of behavioral finance. another aim of their paper is to analyze how some economists have applied findings of behavioral finance to modify but not fundamentally change neoclassical theories, and to argue that the resulting models are incompatible with Post Keynesian and Institutionalist economics. this critical review of behavioral finance was the kind of response I was hoping for when I wrote the paper “Developments in Behavioral Finance and Experimental Economics and Post Keynesian Finance theory,” published in the fall 2006 issue of this journal.

Matthew V. Fung is an associate professor in the Department of Economics and Finance at Saint Peter’s College. Journal of Post Keynesian Economics / Summer 2011, Vol. 33, No. 4 555 © 2011 M.E. Sharpe, Inc.

0160–3477 / 2011 $9.50 + 0.00.
DOI 10.2753/PKE0160-3477330402

556

JOURNAL OF POST KEYNESIAN ECONOMICS

It is not surprising that Raines and Leathers chose to focus on theories on financial bubbles and crises, for these phenomena challenge the claim of the efficient market hypothesis (EMh) that market prices of financial assets fully reflect all relevant information about them. Raines and Leathers perform a service to economists who may not be well-versed in the behavioral finance literature by introducing some findings that are relevant to financial markets. In particular, their discussion of emotional finance suggests a new way of understanding financial behavior that may otherwise appear irrational and not amenable to study.

the survey presented by Raines and Leathers concentrates on Post Keynesian and Institutionalist writers whose work attacked EMh. although EMh is an important component of the neoclassical theory of finance, Post Keynesian critics of neoclassical theory have recognized other important elements of that theory. Findlay and williams described neoclassical finance theory as “an equilibrium pricing model cojoined with a notion about the efficiency of financial markets” (2008–9, p. 213), suggesting the importance of the neoclassical equilibrium pricing model. thompson et al. included in their list of the basic models of neoclassical computational finance “the portfolio selection algorithm of Markowitz, the capital market line of Sharpe, and the option pricing model of Black– Scholes–Merton” (2006, p. 3). It is interesting to explore how behavioral finance can help in the development of alternatives to some of these neoclassical finance models.

In this paper, I supplement the Raines and Leathers paper by suggesting what light behavioral finance sheds on portfolio theory and asset pricing and how in some cases it can provide an alternative to the neoclassical models. But first I evaluate some of the issues discussed by Raines and Leathers and try...
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