*
This paper was prepared for John B. Taylor and Michael Woodford, Editors, Handbook of
Macroeconomics. An earlier version was presented at a conference “Recent
Developments in Macro-
economics” at the Federal Reserve Bank of New York, February 27–8, 1997. The author is indebted
to Ricky Lam for research assistance, and to Michael Krause, Virginia Shiller, Andrei Shleifer, David
Wilcox, and the editors for helpful comments. This research was supported by the National Science
Foundation.
1
The Roberts (1967) paper has never been published; the fame of his paper apparently owes to
the discussion of it in Fama (1970).
1
Human Behavior and the Efficiency
of the Financial System
by
Robert J. Shiller
*
Abstract
Recent literature in empirical finance is surveyed in its relation to
underlying behavioral principles, principles which come primarily from
psychology, sociology and anthropology. The behavioral principles
discussed are: prospect theory, regret and cognitive dissonance, anchoring,
mental compartments, overconfidence, over- and underreaction, repre-
sentativeness heuristic, the disjunction effect, gambling behavior and
speculation, perceived irrelevance of history, magical thinking, quasi-
magical thinking, attention anomalies, the availability heuristic, culture and
social contagion, and global culture.
Theories of human behavior from psychology, sociology, and anthropology have helped
motivate much recent empirical research on the behavior of financial markets. In this paper
I will survey both some of the most significant theories (for empirical finance) in these other
social sciences and the empirical finance literature itself.
Particular attention will be paid to the implications of these theories for the efficient
markets hypothesis in finance. This is the hypothesis that financial prices efficiently
incorporate all public information and that prices can be regarded as optimal estimates of
true investment value at all times. The efficient markets hypothesis in turn is based on more
primitive notions that people behave rationally, or accurately maximize expected utility, and
are able to process all available information. The idea behind the term “efficient markets
hypothesis,” a term coined by Harry Roberts (1967),
1
has a long history in financial
research, a far longer history than the term itself has. The hypothesis (without the words
2
efficient markets) was given a clear statement in Gibson (1889), and has apparently been
widely known at least since then, if not long before. All this time there has also been
tension over the hypothesis, a feeling among many that there is something egregiously
wrong with it; for an early example, see MacKay (1841). In the past couple of decades the
finance literature, has amassed a substantial number of observations of apparent anomalies
(from the standpoint of the efficient markets hypothesis) in financial markets. These
anomalies suggest that the underlying principles of rational behavior underlying the efficient
markets hypothesis are not entirely correct and that we need to look as well at other models
of human behavior, as have been studied in the other social sciences.
The organization of this paper is different from that of other accounts of the literature
on behavioral finance (for example, De Bondt and Thaler, 1996 or Fama, 1997): this paper
is organized around a list of theories from the other social sciences that are used by
researchers in finance, rather than around a list of anomalies. I organized the paper this way
because, in reality, most of the fundamental principles that we want to stress here really do
seem to be imported from the other social sciences. No surprise here: researchers in these
other social sciences have done most of the work over the last century on understanding
less-than-perfectly-rational human behavior. Moreover, each anomaly in finance typically
has more than one possible explanation in terms of these theories from the other social
sciences. The anomalies are observed in complex real world settings, where many possible
factors are at work, not in the experimental psychologist’s laboratory. Each of their theories
contributes a little to our understanding of the anomalies, and there is typically no way to
quantify or prove the relevance of any one theory. It is better to set forth the theories from
the other social sciences themselves, describing when possible the controlled experiments
that demonstrate their validity, and give for each a few illustrations of applications in
finance.
Before beginning, it should be noted that theories of human behavior from these other
social sciences often have underlying motivation that is different from that of economic
theories. Their theories are often intended to be robust to application in a variety of
everyday, unstructured experiences, while the economic theories are often intended to be
robust in the different sense that, even if the problems the economic agents face become
very clearly defined, their behavior will not change after they learn how to solve the
problems. Many of the underlying behavioral principles from psychology and other social
sciences that are discussed below are unstable and the hypothesized behavioral phenomena
may disappear when the situation becomes better structured and people have had a lot of
opportunity to learn about it. Indeed, there are papers in the psychology literature claiming
that many of the cognitive biases in human judgment under uncertainty uncovered by
experimental psychologists will disappear when the experiment is changed so that the
probabilities and issues that the experiment raises are explained clearly enough to subjects
(see, for example, Gigerenzer, 1991). Experimental subjects can in many cases be con-
vinced, if given proper instruction, that their initial behavior in the experimental situation
was irrational, and they will then correct their ways.
To economists, such evidence is taken to be more damning to the theories than it would
be by the social scientists in these other disciplines. Apparently economists at large have
not fully appreciated the extent to which enduring patterns can be found in this ‘unstable’