The Socionomics Foundation
Gainesville, Georgia

Taylor & Francis Group
Lawrence Erlbaum Associates
Philadelphia, Pennsylvania

JBF Paper Proposes a New Model of Finance 

Atlanta, GA, June 28, 2007 -- The Journal of Behavioral Finance has just published a research paper that for the first time places a solid line of demarcation between the fields of economics and finance. While the Law of Supply and Demand regulates prices in the economic realm, the Law of Patterned Herding rules prices in the financial realm, the authors claim.

In “The Financial/Economic Dichotomy in Social Behavioral Dynamics: The Socionomic Perspective,” Robert Prechter and Wayne Parker contend that stark differences in how people approach financial decisions and economic decisions begin at the individual neurological level and extend to the behavior of social aggregates.

In re-conceptualizing the relationship between economic theory and financial theory, their Socionomic Theory of Finance offers a new basis for understanding financial markets, providing an alternative to the long-established yet increasingly challenged Efficient Market Hypothesis.

For the past 30 years, Prechter has gathered data in support of an emergent paradigm called “socionomics,” the study of human social behavior in contexts of uncertainty. In this paper, Prechter and psychologist Wayne Parker show that humans behave one way when they are certain about economic value to themselves; they behave another way when they are uncertain about others’ future financial valuations. In the first case, they approach value rationally and consciously, while in the second case they unconsciously herd and then rationalize their decisions.

The authors’ Socionomic Theory of Finance challenges traditional claims of objective valuation, randomness and equilibrium-seeking in financial markets. According to this new theory, because financial values derive not from reasoning but from herding, the result is subjective valuation, predictable patterns of market behavior and unceasing dynamism.

Economists have assumed that people make financial decisions in the context of the Law of Supply and Demand, whereby sellers “supply” stock and buyers “demand” it. But these simplified terms, the authors say, are easily confused with what the Law of Supply and Demand actually means. The law refers to the market's producers and users, whose conflicting desires balance each other and thus create stable prices.

In the world of finance, all participants are of a single class: investors. They have a single, non-balancing desire: to profit from investing. Their shared desire creates unstable prices because the main thing that fluctuates in financial markets is the level of demand.

“The Law of Supply and Demand gets flipped on its head in the financial markets,” Prechter observes. “As a stock’s price rises, demand for it tends to increase. When prices are cheap, few want to buy. This is exactly the opposite of what happens in the butcher shop or the shoe store.” It is also contrary to what is supposed to happen according to economic theory. When behavior runs contrary to theory, say the authors, it is time for a new theory.

The authors explain how the Law of Patterned Herding accounts for the behavior of financial markets and argue that the two fields – economics and finance – are therefore completely different. Such a difference, if accepted, would change the basis for future work in both fields.

The Journal of Behavioral Finance is mailing its current issue to subscribers during the month of July. The paper is also available for purchase and immediate download from http://www.leaonline.com/doi/abs/10.1080/15427560701381028.