Behavioral Finance

The only purpose of posting this piece is to save a link to an interview of Richard Thaler - Professor of Economics and Behavioral Science at Graduate School of Business , University of Chicago. He says "Well, we're humans, and we're busy. Life is complicated, and getting more complicated. We mentioned the term behavioral economics and people might wonder what that is. It's a field that only exists because regular economics is based on an idealized economic agent, sometimes called Homo Economicus. In the book we refer to such creatures as Econs. Econs are creatures that can calculate like a super computer, never get tempted by fatty or sweet foods, never get distracted, and probably aren't a whole lot of fun to be around. In contrast, real people, who in the book we call humans, don't make any appearance in standard economics. Behavioral economics is economics about humans. Humans are busy, can't solve every problem instantaneously, and get tempted by luscious desserts. Sometimes they need some help."

Quran describes the nature of human beings in Ayat 19-21 of Sura Al-Ma'arij

1. Truly man was created very impatient

2. Fretful when evil touches him;

3. And niggardly when good reaches him

So to speak in terms of behavioral finance, the human beings are irrational by nature and can't be expected to be rational in their decisions, if left to follow their natural instincts. These instincts or behaviors can be changed so as to behave rationally.

Again Quran provides the solution in Ayat 22-35 of Sura Al-Ma'arij

1. Not so those devoted to Prayer

2. Those who remain steadfast to their prayer;

3. And those in whose wealth is a recognized right

4. For the (needy) who asks and him who is prevented (for some reason from asking);

5. And those who hold to the truth of the Day of Judgment;

6. And those who fear the displeasure of their Lord

7. For their Lord's displeasure is the opposite of Peace and Tranquillity

8. And those who guard their chastity

9. Except with their wives and the (captives) whom their right hands possess for (then) they are not to be blamed

10.But those who trespass beyond this are transgressors

11.And those who respect their trusts and covenants;

12.And those who stand firm in their testimonies;

13.And those who guard (the sacredness) of their worship

14.Such will be the honored ones in the Gardens of (Bliss).

Measurement

In business measurement is an important concept. You tend to get an idea of the impact at the bottom line before you spend. There is a popular slogan " What you can't measure, can't get". But there are certain things that are just beyond measurement in terms of its impact on the bottom line like Corporate Social Responsibility expenditures. Guest blogger "Steve" at tompeters.com says "Many things that can't be directly measured are worth doing."

Small Things Matter

"Kaizen" - a Japanese technique for bringing improvement in work areas. It can also be successfully used in a variety of ways like personal improvement, societal improvement and so on. The beauty of this method is its incremental approach, a step at a time. Solar Aid is using this technique either consciously or unconsciously to alleviate poverty. These people are using micro projects rather than hugely funded programs to help poorest people. For the people who are not so lucky to have things that are a routine for others small things matters. These micro projects and micro products can make a huge difference between living below the line and life. We often ignore small helping hands that may save a life in the pursuit of mega projects. Sometimes small things matter most in life.

Economic Sense

The cause of indebtedness most of the time is the "Economic Sense" that is being inculcated through marketing tactics and promoting theories of finance. The "Economic Sense" is future projections show that it is feasible to finance the project through loan, our inflows are good enough to meet our interest plus installment obligations. It also makes "Economic Sense" to buy a car on lease finance for commuting to a higher paying job than presntly a less attractive. It is also an "Economic Sense" to buy a home on mortgage by calculating and equating interest plus installment to present rent.

Paul Krugman says best " the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess."

The economic sense is all mathematical equation devoid of reality. It assumes that nothing can go wrong. This false assumption leads us to disaster. It is synonymous to "Lead to destruction those whom thou canst among them with thy (seductive) voice; make assaults on them with thy cavalry and thy infantry; mutually share with them wealth and children; and make promises to them. But Satan promises them nothing but deceit." Aya 64 Sura Al-Isra

Beware of debt financing. It is just a mathematics, an illusion, a trap.

"the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place.

Now that the undiagnosed bubble has burst, the true riskiness of supposedly safe assets has been revealed and the financial system has demonstrated its fragility. U.S. households have seen $13 trillion in wealth evaporate. More than six million jobs have been lost, and the unemployment rate appears headed for its highest level since 1940."

The assumption was "nothing can go wrong", here is the projection, risk analysis, sensitivity analysis etc. etc.

Breaking the Shackles of Debt

The cause of indebtedness most of the time is the "Economic Sense" that is being inculcated through marketing tactics and promoting theories of finance. The "Economic Sense" is future projections show that it is feasible to finance the project through loan, our inflows are good enough to meet our interest plus installment obligations. It also makes "Economic Sense" to buy a car on lease finance for commuting to a higher paying job than presntly a less attractive. It is also an "Economic Sense" to buy a home on mortgage by calculating and equating interest plus installment to present rent. If it is good economic sense then why this financial turmoil? Why this burst of housing bubble? This false economic sense turns into a nightmare because of buying something that one could not be afford at the time of purchase, possibly bought more than needed and paid interest to acquire the same.

This debt trap affects the Muslim Society in three ways

1. Engage in Riba
2. Potentially consumes Zakat on unproductive activity
3. People don't pay Zakat because debt cancels assets and Zakat pool is smaller than the last year

One of the solution is providing indebted persons non-profit loans instead of charity like "give it and forget it" along with necessary financial planning guidance so that they may be able to shift from Zakat receiving to Zakat paying group. This article is an example of thinking differently than microfinance or microlending in a conventional or disguised way.

Here are few excerpts

Gharimeen are understood to be “those who are over burdened with debts”, “in debt” and “debtors” by some of the most notable translators of the Qur’an, such as, Muhammad Asad, Yusuf Ali and Marmaduke Pickthall, respectively. Throughout this article Gharimeen will be used for those who are either under debt already or are debt-prone until they successfully break out of this particular financial vulnerability and join the ranks of Muzakkis.

Gharimeen are a special segment of the population who may have jobs or businesses but due to debt their net asset value falls below the Nisab threshold and forces them to become potential Zakah recipients instead of Zakah givers or Muzakkis.

The challenge for Muslims is to make sure that the pool of Muzakkis is strong and expanding, instead of weak and contracting. Consumer financing is causing the Muzakki base among Muslims to contract through expanding debt in the community.

As envisioned in verse 30:39, the Zakah fund keeps growing as new money is donated every year, and as the money is repatriated from the interest-free loans given to Gharimeen in the previous years. Verse 9:60 designates part of the Zakah funds for Zakah collectors and distributors. So there are no operating costs which need to be passed on to the borrowers.

There is a need for a non-profit organization which helps Muslims and others eliminate interest as well as unnecessary acquisition of goods and services from their lives. This organization can also guide them in directing their savings towards safer investments than what is available through Wall Street.