It's all a matter of how you behave

Many financial regulations and ways of doing businesses have been driven by specific historical incidents. For example, the Securities and Exchange Commission, the Investment Corporation Act, and the Federal Deposit Insurance Corporation in the United States were all created after the Great Depression that broke out in 1929.

People tend to pay too much attention to regulatory details, but ignore the rationale and principles behind the financial system. Therefore, one has to keep in mind that a market with a short history and no crisis is not a complete one.

China also has to look at things from a historical perspective. The country has a very long history and its financial markets have a long history as well. However, much about its financial markets was forgotten after the 1949 liberation so there is little memory of the past.

This can be quite a concern because the market is unfamiliar with the concept of fluctuations, risk and crisis. Without such memory, neither investors nor regulators can accurately estimate the risks in the financial system. This is worrisome given that risks lie at the center of the financial system. China has to watch out for such risks.

Behavioral finance not only looks into how individuals make investment decisions, it also concerns itself with how corporations function and how societies form values and expectations. History has witnessed many extremely exuberant and extremely desperate periods, and it is amazing to watch, in retrospect, how irrational the whole society and community of investors behaved and how soon people forgot about lessons learned the hard way not too long ago.

Such crazes are often accompanied by a few important elements - the relatively short history of the market in question, a relatively young and aspiring investor community, excessive liquidity and low interest rates, and some hard-to-value investment opportunities that have gained considerably in value.

All these factors seem to be present in the Chinese real estate market and some other sectors of the Chinese economy. It could behoove China to turn to behavioral finance for more suitable and sustainable growth policies in the long run.

The author is a faculty fellow at the International Center for Finance, Yale University; and deputy dean of the Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University. The article is based on his conversation with Professor Robert Shiller of Yale University, the 2013 Nobel Laureate in Economics. The views do not necessarily reflect those of China Daily.

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