Cognitive finance

What is understood by cognitive finance is a new, highly interdisciplinary approach to explaining complex processes in economics and capital markets. The etymological origins of the term ‘cognitive finance’ go back to the cognitive doctrines of ancient philosophy and the enlightenment; in its modern expression – which is relevant for our current purposes – it unites the latest findings in the fields of neuroscience, psychology and modern cognitive science into an integrated explanatory model.

Cognitive finance primarily addresses the problem of limited human cognitive ability and places this in a systemic context. Scientific studies from a range of different disciplines show that human beings are prone to systematic limitations, distortions and errors (cognitive deficits) when it comes to their ability to acquire and process information and to make decisions. These deficits are characteristic of human action in real life; the possible effects of these deficits therefore determine elementary processes in the economy, society and the capital markets. If we can understand these processes as elements within a networked system, we begin to obtain an extensively modified picture of reality. This new picture is similar to dynamic models of system theory and follows the fundamental assumptions of what is known as ‘complexity research’.

Cognitive finance thus opens up a new cognitively focused view of real systems and processes, especially – but not only – with regard to economics and the capital markets.

Objectives

The primary objective of cognitive finance is the integrated analysis, description and explanation of real-world scenarios in economics and in capital markets. It is based on a special analytical system which explicitly includes neuronal limitations, cognitive deficits and behaviours attributable to bounded rationality. The approach also combines the fundamentals of evolutionary biology, complexity research and system theory.

Cognitive finance represents a fundamental criticism of traditional models and paradigms of current economic and capital market theories. As recent history clearly shows, established models suffer from significant explanation deficits. This is mainly due to unrealistic or erroneous basic assumptions, including the ‘rational expectations’ and ‘efficient markets’ postulates.

The secondary objective of cognitive finance, therefore, is to overcome erroneous paradigms in the field of economics, which facilitates a new perspective of economics and financial markets.

Starting points for paradigm shifts

Cognitive finance seeks to spearhead the long overdue paradigm shift in economic theory. The basis for this is a more realistic, cognitively aware appreciation of what it is to be human and a thoroughly dynamic understanding of markets and market processes. The key starting points for cognitive finance, therefore, can be found on two levels closely linked with each other: human beings and market.

Market: In contrast to orthodox economic theory, markets – and entire national economies, for that matter – are not mechanisms with an inherent tendency towards stability or even equilibrium. Rather, they are highly complex and dynamic processes that are constantly changing and evolving. Modern complexity research provides some important basic insights into these processes. It offers easily comprehensible reasons why markets are subject to cyclical fluctuations, bubbles, crashes and other – previously difficult to recognise – phenomena. A crucial factor in this is the nature of human action which, given its heterogeneous characteristics and constant adaptation – reinforced by cognitive deficits – is incapable of being ‘rational’.

Human beings: This analysis level focuses on a new understanding of human action, informed by the findings of cognitive theory and what is known as ‘neuroscience’. Modern brain research has produced some astonishing findings regarding how the human brain, human consciousness and human behaviour function. Factors such as memory, shaping, the subconscious mind, emotion, instinct and intuition which, from the perspective of orthodox economics, are ‘irrelevant’, are shown to be powerful drivers of human action. They play a significant role in shaping the perception, processing and interpretation of information, not to mention the genesis and sequencing of the decision-making processes that follow.

Figure 1: Illustration of the evolution of previous paradigms of capital market theories

The basis for a long overdue paradigm shift in economics is therefore the readiness to accept the reality of human action as being the result of factors and limitations that are inherently cognitive and neurobiological in nature. The approaches adopted by what is generally referred to as behavioural economics have already highlighted some important paths leading in this direction in recent years.

Development and differentiation of behavioural finance

From an evolutionary perspective, cognitive finance is based on central assumptions of behavioural finance, although it has expanded and modernised these in crucial respects.

In recent years, the concept of behavioural finance has established itself as an alternative to the traditional paradigms of economics. Although behavioural finance has documented numerous anomalies, deficits and contradictions in how real market participants behave, it has, nonetheless, failed to represent either a complete or a sufficient explanation model.

Although the approaches adopted by behavioural finance allow us to have a more realistic view of economic processes, they frequently lack a clear foundation and a consistent methodological framework.

Relationships and interconnections to other disciplines, and thus the important aspect of interdisciplinary integration, remain largely ignored. The question how to explain real market cycles, in other words the ability to derive meaningful inter-temporal market models, remains unanswered to date.

Logical further development, which also takes into account the basic findings of neuroscience and cognitive theory, is therefore absolutely essential.

The novel approach adopted by cognitive finance overcomes existing behavioural finance deficits by changing perspectives, applying new methods and establishing a scientific basis that is purposely interdisciplinary in its nature. Questions of human perception, in other words the cognitive reception and perception of information, subjective decision-making and other neuronal and psycho-socially motivated actions are of significant importance in this regard.

Cognitive finance methodology

Modern cognitive science is central to the concept of cognitive finance. In its central findings, it refers back to elements of philosophy, psychology, neuroscience, (evolutionary) biology and anthropology; it also offers points of contact to modern computer science and concepts of artificial intelligence. This interdisciplinary approach creates a vital foundation for developing innovative analytical methods and gaining fundamentally new insights.

The practical application and implementation of the cognitive finance approach requires appropriate methodology. This should, fundamentally, be established on an interdisciplinary basis and should actively include para-sciences, in other words points of contact and points of overlap between different sub-disciplines (see Fig. 2: the arrows indicate important interdisciplinary interfaces and points of contact). The key starting point is not the quixotic image of homo oeconomicus, but rather the realities – and limitations – of human nature and human behaviour.

Figure 2: Cognitive finance as an interdisciplinary research method

Cognitive finance offers distinct advantages especially when it comes to the analysis and better understanding of real capital markets. The starting point is an epistemological concept which is used to analyse long-term trends and relevant developments and to condense them into a networked and dynamic scenario. In addition, cognitive finance methodology provides consistent hypotheses on human actions and interactions in complex situations, as can typically be observed in real capital markets.

Since cognitive finance methodology, with its basis in newer neurosciences, includes the influence of cognitive, psychological and socio-dynamic distortions and limitations, the emergence of ‘irrational’ phenomena can also be explained free of contradiction.

Application and future scenario

In addition to a thoroughly cognitive interdisciplinary theory and methodological framework (‘cognitive analysis’), cognitive finance also implies a direct practical orientation.

When it comes to economic research, cognitive finance methodology, by ‘networking’ relevant topics and by applying principles of complexity theory, permits significantly more extensive penetration of economic causalities and interdependencies (trends, cycles, structural breaks, disruptions, etc.) than has been possible heretofore using traditional economic or econometric methods.

With regard to capital market research, cognitive finance methodology permits a deeper understanding and a sharper and more comprehensive overall picture – the network and neural structure – of all relevant trends and factors that drive and determine the capital markets. Cognitive finance therefore provides a powerful approach when it comes to analysing, explaining, identifying and (to some extent) predicting complex market phenomena (such as ‘bubbles’, ‘crashes’, ‘sudden deaths’, ‘blind spots’, etc.).

The use of cognitive finance methodology delivers more sensitive, complete and much more dynamic findings than previous approaches. The methodology leads to significantly improved descriptions and explanatory models for the economy and for capital markets, giving decisive new impetus to informed economic and capital market research. This form of cognitive finance methodology lies at the heart of the work undertaken by the ‘FERI Cognitive Finance Institute’ where it serves as a contextual substrate and methodological basis for comprehensive micro and macro-economic analyses.

Cognitive finance therefore provides the most suitable framework for meaningful new research approaches, and ideally even provides a starting point for the long overdue paradigm shift in economic and capital market theory.

Bibliography

• Arthur, W. B.: Complexity and the Economy. Oxford University Press, New York 2015.
• Arthur, W. B.: Cognition: The Black Box of Economics. in: The Complexity Vision and the Teaching of Economics, Colander D., ed., Elgar, E. Publishing, Northampton 2000.
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• Kahneman, D.: Thinking fast and slow. Penguin, London 2011.
• Miller, G. A.: The Magical Number Seven, Plus or Minus Two – Some Limits on Our Capacity for Processing Information. in: Psychological Review, Vol. 101, No. 2, 1956, S. 343–352.
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• Oehler, A.: “Anomalien” im Anlageverhalten. in: Die Bank, Nr. 11, 1991, S. 600–607.
• Rapp, H.-W.: Absolut Report, Cognitive Finance ermöglicht neuartige Sicht auf Kapitalmärkte. Ausgabe 01/2017.
• Rapp, H.-W.: Wie effizient sind die Kapitalmärkte wirklich?. in: Finanz und Wirtschaft (Zürich), Nr. 7, 27.1.1993, S.21.
• Rapp, H.-W.: Der Markt für Aktien-Neuemissionen – Preisbildung, Preisentwicklung und Marktverhalten bei eingeschränkter Informationseffizienz. Diss. Mannheim 1995.
• Rapp, H.-W.: Behavioral Finance: Paradigmenwechsel in der Kapitalmarktforschung und Grundlage eines ganzheitlichen Anlagemanagements. GBR Ernst & Young, Bern 1997.
• Rapp, H.-W.: Der tägliche Wahnsinn hat Methode – Behavioral Finance: Paradigmenwechsel in der Kapitalmarktforschung. in: Jünemann B. /Schellenberger D. S. (Hrsg.), Psychologie für Börsenprofis – Die Macht der Gefühle bei der Geldanlage, Schäffer-Poeschel Verlag. Stuttgart 2000, S. 85–123.
• Rapp, H.-W.: “Black Swans”, “Long Waves” und “Sudden Deaths” – Die Bedeutung von Zeit und nicht - traditionellen Risikofaktoren im Asset Management. Vortrag beim Feri Institutional Forum, Königstein-Falkenstein, 3. März 2009.
• Rapp, H.-W.: Cognitive Finance – Paradigmenwechsel und neue Sicht auf Wirtschaft und Manuskript. Bad Homburg 2017.
• Rapp, H.-W., Cortés, A.: Cognitive Finance – Neue Sicht auf Wirtschaft und Finanzmärkte. Gabler/Springer 2017.
• Roth, G.: Aus Sicht des Gehirns. Suhrkamp Verlag, Frankfurt am Main 2003.
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• Unser, M.: Behavioral Finance am Aktienmarkt. Uhlenbruch Verlag, Bad Soden/Ts. 1999.

Weblinks

• FERI Cognitive Finance Institute
• FERI Cognitive Finance Institute bietet neue Sicht auf Kapitalmärkte. Institutional Money

References

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