Economics has traditionally confined itself to stylized facts and hypothetical decision-making mechanisms. Before the emergence of behavioral economics and finance, many economists committed themselves and their craft to the study of ideally rational behavior. As a result, the old paradigm of homo economicus paid little heed to the failure of economic theory, in many instances, to describe or predict what people actually do.

A romantic attachment to beautifully symmetrical, Platonically rational economic models is particularly treacherous in finance. Much of contemporary mathematical finance rests upon the Gaussian distribution, as if returns obeyed the normal rules of probability. In reality, markets behave quite badly. Catastrophic declines in asset prices happen with such frequency, and in connection with other negative economic events, that normal distributions cannot plausibly explain outcomes from actual markets.

Investor behavior likewise disobeys predictions of perfect rationality. Financial theory recommends that most investors hold the market portfolio. Very few investors actually do. Investors systematically sell winning stocks too soon and ride losers all the way down. Actual investors rarely achieve mutual fund returns based on the undisrupted holding of fund shares over a period of years. Instead, they redeem shares at market ebbs, only to reinvest when the market rides high again. A better recipe for wealth destruction can scarcely be imagined.

Abnormality, in the sense of statistically significant departures from Gaussian assumptions, is the modal condition of capital markets. Financial threats inspire irrational investor behavior. Confronted with volatility, spillover, and contagion, human actors take refuge in imperfect shortcuts: mental accounting, subjective weighting of probabilities, systematic disregard of correlation. In turn, the animal spirits of human investors may drive momentum in asset prices, pricing bubbles, and irrational exuberance in capital markets.

Behavioral phenomena may explain a wide range of abnormalities in financial markets. Downside correlation between certain asset classes and broader economic risk may account for excess returns on value stocks and small-cap companies. Risk aversion and life-cycle theories of consumption provide possible solutions to the equity premium puzzle, another iconic financial mystery. From actual lotteries to equity crowdfunding and initial public offerings, investors seem eager to pay a premium for highly skewed financial instruments, even where the expected return is nil or negative.

Prospect theory, perhaps the best known application of behavioral economics, describes the human decision-making as an internal conflict. The emotional basis of fast, instinctive System 1 thinking appears to have a built-in advantage over the cool, slow rationality of System 2.  Especially when threatened — or, conversely, when presented with very attractive opportunities — humans resort to innate tools for making decisions.

As Amos Tversky and Daniel Kahneman have said of prospect theory, the failure to make choices that are rational in the traditional sense does not render behaviorally motivated  decision-making “chaotic” or “intractable.” Humans make decisions that are ordered and justified on their own terms. Human choices make sense in the context of needs and aspirations that change over the course of a lifetime. Whether hedging against intertemporal changes in their ability to bear risk or climbing Abraham Maslow’s hierarchy of needs, investors arrange their portfolios and financial affairs according to their perception of physical and emotional needs.

Albert Einstein had it backwards: It is not God, but rather humanity, who plays dice with the universe. Behavioral finance reflects the quantum mechanics of human judgment. The human animal has its own elaborate mechanism for making decisions under uncertainty.

A final analogy to linguistics may be helpful. Natural language is not just a cultural artifact, but a species property arising from human biology. Risk-taking is likewise a species property, one whose underlying dispositions are susceptible to formal description, mathematical specification, and empirical verification or falsification. Behavioral finance may not be “rational” in a conventional economic sense, but it arises from the same material as universal grammar and the atoms of language.

James Ming Chen holds the Justin Smith Morrill Chair in Law at Michigan State University, USA. His books, Econophysics and Capital Asset Pricing, Disaster Law and Policy, Postmodern Portfolio Theory, and Finance and the Behavioral Prospect, cover a broad range of issues concerning extreme events and risk management, from natural to financial disasters. He is of counsel to the Technology Law Group of Washington, DC; a public member of the Administrative Conference of the United States; and an elected member of the American Law Institute. A magna cum laude graduate of Harvard Law School and a former editor of the Harvard Law Review, Chen also served as a clerk to Justice Clarence Thomas of the Supreme Court of the United States.