Most simply formulated, it is a paradox – the paradox of behavior which is at one and the same time self-perpetuating and self-defeating! …Common sense holds that a normal, sensible man, or even a beast to the limits of his intelligence, will weigh and balance the consequences of his acts: if the net effect is favorable, the action producing it will be perpetuated; and if the net effect is unfavorable, the action producing it will be inhibited, abandoned. In neurosis, however, one sees actions which have predominantly unfavorable consequences; yet they persist over a period of months, years, or a lifetime.
Perhaps it is purely a coincidence that Prospect Theory: An Analysis of Decision Under Risk and Cognitive Therapy of Depression were both published in 1979 and I am mistakenly attributing some significance to the temporal co-occurrence where none exists.
Afterall, the first offers a critique of expected utility theory and an alternative descriptive model of decision making under risk focusing on loss aversion, framing effects and the like while the second offers a theoretically and empirically derived treatment model for an affective disorder focusing on the centrality of the cognitive aspects of it.
However, upon closer inspection, the timing of the two works, and more importantly, the complementarity may not be so random.
Both possess meta-theoretical roots in the cognitive revolution which emerged during the third quarter of the twentieth century and extended cognitive psychological principles into specific domains of functioning. Both share common underlying assumptions about the way in which humans interact with the world. Both examine ways in which people act in ways which might not be in accordance with their own self interests. And finally, both prospect theory and cognitive therapy spawned new branches of social science with prospect theory playing a critical role in the birth and development of behavioral economics and cognitive therapy marking a milestone in the evolution of cognitive-behavioral and empirically validated theory and treatments of psychological disorders.
Currently, there is no unified comprehensive descriptive theory in behavioral finance that offers a framework within which the various investor behavior phenomena can be assimilated and organized. As well, there is currently no evidence based applied prescriptive model which outlines sets of adaptive change processes that may promote rational investor behavior.
Over the coming months on this blog, I will be outlining a broad descriptive theory of investor experience including an applied prescriptive model which promotes adaptive behavior change. It is an integration of Beck’s clinical cognitive theory and cognitive therapy model from the science of clinical psychology and the investor behavior phenomena described in the behavioral finance literature.
This applied theory which I call the cognitive theory of noise (CTN) offers a model of the structure and path of cognitive functioning that contextualizes the various investor behavior phenomena within a rich and axiomitized theory of human personality. It organizes the interrelationships between cognition, behavior and affect as well as describes how these processes interact with environmental factors.
The CTN also contains a critical prescriptive component which details a procedure for enacting adaptive behavioral change processes among market participants so that they may act in their own best interests more consistently. Finally, this model will be conducive to empirical exploration.
There are two main integrative aspects to the CTN. First, the theoretical model itself may be viewed as an assimilative integration as it seamlessly assimilates investor behavior models from behavioral finance into the framework of clinical cognitive theory. Second, by providing an organizational scheme it allows for a theoretical integration of investor behavior models which are currently somewhat fragmented and only loosely related by common theoretical antecedents including those offered by Daniel Kahneman and Amos Tversky.