Incorporating Human Behavior Into Wall Street Mathematical Models

After watching the stock market struggle for the past year, financial experts from Wall Street and academia are putting more effort into bringing behavioral modeling into their complex financial calculations. "The risk models proved myopic, they say, because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn't sufficiently take into account was human behavior, specifically the potential for widespread panic." Analysts are looking at research from other fields to supplement the hard mathematics of risk assessment. "Financial markets, like online communities, are social networks. Researchers are looking at whether the mechanisms and models being developed to explore collective behavior on the Web can be applied to financial markets." Another avenue they're exploring is how we react to the spread of disease. Jon M. Kleinberg, a computer scientist at Cornell, said, "The hope is to take this understanding of contagion and use it as a perspective on how rapid changes of behavior can spread through complex networks at work in financial markets."

Comments

Re:Such as?

[thefinite]

Actually, irrationality in finance is not only prominent, it's rampant. It was certainly at play in this latest bubble and burst. For example, most bankers peddling the toxic CDOs were using a model that relied on only about ten years of economic data. This is the byproduct of the Availability Heuristic. Additionally, their models often excluded the possibility of such a huge decline in housing prices because there had never been one like it before. The Representativeness Heuristic induces this kind of behavior, in spite of the warnings from others.

None of this is rational behavior. The idea you proposed that this is some sort of Prisoner's Dilemma situation ignores the fact that there are two sides to every transaction. Any of the people who rationally cashed out did it with the money of the irrational people buying their toxic instruments. The Prisoner's Dilemma falls short as an analogue because it doesn't require a buyer for the players to make their decisions. No one has to take the other side of their decisions, which is the case in a market.

For a great review of the hundreds of ways we behave irrationally in financial markets, I highly recommend BehaviouralFinance.net.