One of my hopes for 2016 is that awkward questions start to be asked about behavioural finance. Hardly an industry event went by this year without at least a passing positive reference to the approach. It has reached the stage where there should be no doubt that it has become an orthodoxy.

It is decidedly odd to come across industry experts referring to it as if they represent an intellectual vanguard. They seem unaware that two academics won the Nobel prize for economics for their contribution to the field way back in 2002. That, in turn, was a recognition of research started in the 1960s.

The philosophical antecedents to this approach go back even further. In the 1870s, one of the leading thinkers of the age, Friedrich Nietzsche, was already denigrating human reason. Admittedly, his subject was not finance and he did not use today’s jargon, but behavioural finance pundits have unwittingly adopted one of his key assumptions.

Indeed, the growing suspicion of human rationality helps explain why the behavioural approach has gained popularity. It chimes with the common tendency to disparage humanity – or at least those outside of a supposedly enlightened elite – as foolish and destructive. 

This points to one of the main weaknesses of behavioural thinking – it tends to rush too readily to assume human irrationality.

For instance, Daniel Kahneman, one of the 2002 Nobel laureates, uses the example of New York taxi drivers to illustrate his claim that people are not entirely rational. Evidently on busy days, such as when the weather is bad, they typically work until they have made their target level of income rather than complete their shift. Kahneman concludes that such behaviour is misguided because they could earn more by completing busy shifts while finishing quiet shifts early.

But there are other possible explanations for the taxi drivers’ behaviour. It could be that they have many short-term financial commitments so they do not have the luxury of taking it easy on quiet days. Kahneman’s approach demands some level of savings, in case busy days do not materialise for a while, and a reasonable degree of self-confidence. Or perhaps the taxi drivers have alternative calls on their time they can yield to once they have earned their required daily earnings.

The point is not that everyone always behaves rationally. It is rather that it is too easy to make sweeping claims about human irrationality.

In fact, a key weakness of conventional economics is not its assumption of rationality but, on the contrary, its underestimation of the power of human agency. Its probabilistic approach to its subject matter means that it struggles to appreciate people’s capacity to decisively shift events.

Next year would be a good time to start developing an alternative to both approaches.

What we loosely term ‘hedge funds’