Partner, RSD Solutions Inc.
As I believe I have stated before, I am a product of a science background within the context of a liberal arts degree. That background is a bit of a rarity in the current world of specialization and hard core finance education. (Count all the different programs offered worldwide in quantitative finance and financial engineering.) However it is a background that I believe provides a unique advantage in many different situations.
One of the advantages is in the area of the social sciences. Very few finance practitioners these days have much more than a passing acquaintance with the social sciences – if that. That just might be the biggest weakness in finance and risk management at the moment – not regulation, not an over-reliance on mathematics, not greed, not any of the suggestions that the popular media is firing at finance and risk management these days – it simply could be the almost total lack of appreciation for the social sciences.
More than anything, risk management is about people management. Furthermore it is people management not only in the context of one on one (which is important), but also people management in the context of a crowd – which is a very different thing.
Some of you are probably saying at this point that Nason has obviously been in a cave for the last two decades as behavioural finance is now such a big topic – especially amongst academics. Leaving the topic of the relevance of finance academics alone for the moment, I would like to defend myself by stating that I am well aware of behavioural finance. (In fact I gave a day long pre-conference on the topic at the Canadian Derivatives Conference a few years ago.) Behavioural finance however is not what I call sociological finance, and behavioural finance is missing a lot of the point.
What’s the difference between behavioural finance and sociological finance? Good question – and to be honest one that I have a better intuitive feel for than a finely worded explanation for. Behavioural finance – as it has, and is being currently studied and researched - is focused on how the individual behaves. In other words it is how an individual makes financial decisions, and how those decisions are often more irrational than we as academics and modelers would like them to be. That is all fine and good, and it shows why our quantitative models may give inaccurate results. However it does not go nearly far enough.
Sociological finance is studying how a group of people makes decisions. That is very different from how an individual makes decisions, and is even different from how an individual makes a decision within the context of a crowd which is the bailiwick of behavioural finance.
A group of people, or a crowd if you will, is a very different entity from the summation of a group of individuals. In other words, understanding how five people will make decisions frequently tells you little to nothing about how they will collectively make decisions. Put yet another way, summing the decisions of the five tells you nothing about how the group as a whole makes a decision. Sociology differs from psychology in that decisions of individuals are not summable (I think I violated the English language on that one – thank goodness blogs are allowed to be informal.)
Crowds are not the sum of the people that make up the crowd. Crowds evolve differently from how individuals evolve. The study of complexity has shown us that crowds are an emergent system. Psychology does not necessarily apply.
Now the question to ask is are most risk and finance events the function of an individual or a crowd? For specific risk events the answer is that frequently it is the function of an individual. For finance and market related events, reflection will likely lead one to realize that it is the crowd that is the driving factor, not the sum of individual actions.
Thus the study of sociology is key to understanding systematic events, not psychology and behavioural finance.
