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Law, Finance, and the Investors Psychological Motive of Control

  • Klaus Heine (a1) and Erich Oltmanns (a2)


A recent survey by David Hirshleifer on investor psychology and asset pricing opens with a short story describing what might have happened to asset-pricing theory, had the founding fathers of modern finance not focused on rationality as the core of their thinking about financial markets, but, instead, followed Adam Smith, Irving Fisher, John Maynard Keynes and Harry Markowitz, who thought that psychology had a large impact on the outcome of financial markets. Had this path of theorizing been taken, today there might have been an influential school at the University of Chicago advocating the Deficient Markets Hypothesis and a Stanford psychologist would have become the inventor of a prominent asset-valuation model, the so-called DAPM (Deranged Anticipation and Perception Model).



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1 Hirshleifer, , “Investor Psychology and Asset Pricing”, 56 Journal of Finance (2001) 1533.

2 For a critical methodological analysis focusing on the role of Homo Economicus in Law and Economics see Medema, , “The Trial of Homo Economicus: What Law and Economics Tells us about the Development of Economic Imperialism”, in: Davis, (ed.), New Economics and Its History, Annual Supplement to Vol. 29, History of Political Economy (Durham: Duke University Press 1997) 122. A broad discussion of the connections between economics and sociology is presented by Foss, , “Understanding Business Systems: An Essay on the Economics and Sociology of Economic Organization”, Working paper 97-6, Department of Industrial Economics and Strategy, Copenhagen Business School (1997).

3 La, Porta, Lopez-de-Silanes, , Shleifer, and Vishny, , “Law and Finance”, 106 Journal of Political Economy (1998) 1113 (hereinafter “LLSV”).

4 The significance of path dependencies in the shaping of law is discussed in more detail by Heine, and Kerber, , “European Corporate Laws, Regulatory Competition and Path Dependence”, 13 European Journal of Law and Economics (2002) 47.

5 By the term micro-micro level we mean that we build our reasoning directly on the psyche or mental state of individuals. This is in line with Harvey Leibenstein's statement: “… the essence of micro-micro theory is the behavioral unit; e.g., shifting to the individual rather than to the firm or to the household.” See Leibenstein, , “A Branch of Economics is Missing: Micro-Micro Theory”, 17 Journal of Economic Literature (1979) 493.

6 Representatives of such neoclassical views are, e.g., Vishny, Shleifer, La Porta and Lopez-De-Silanes who have written a series of influential articles.

7 See, e.g., Berkowitz, , Pistor, and Richard, , “Economic Development, Legality, and the Transplant Effect”, European Economic Review (2002) (forthcoming).

8 The importance of economic predictability for running an economy was stressed early by the German economist Walter Eucken in the fifties of the last century. See Eucken, , Grundsädtze der Wirtschaftspolitik, 6th ed. (Tübingen: Mohr 1990).

9 See, e.g., Shleifer, and Vishny, , “A Survey of Corporate Governance”, 52 Journal of Finance (1997); La, Porta, Lopez-de-Silanes, , Shleifer, and Vishny, , “Legal Determinants of External Finance”. 52 Journal of Finance (1997) 737; La, Porta, Lopez-de-Silanes, , Shleifer, and Vishny, , “The Quality of Government”, 15 Journal of Law, Economics and Organization (1999) 222; Deutsche, Bundesbank, “Zur Unternehmensfinanzierung in Deutschland und Frankreich: Eine vergleichende Analyse”, 51 Monatsbericht (1999/1910) 29; Mayer, and Sussman, , “The Assesment: Finance, Law, and Growth”, 17 Oxford Review of Economic Policy (2001) 457; Pagano, and Volpin, , “The Political Economy of Finance”, 17 Oxford Review of Economic Policy 17 (2001) 502; Rajan, and Zingales, , “Financial Systems, Industrial Structure, and Growth, 17 Oxford Review of Economic Policy (2001) 467; Beck, , Demirgüç-Kunt, and Levine, , “Legal Theories of Financial Development”, 17 Oxford Review of Economic Policy (2001) 483; Mueller, and Yurtoglu, , “Country Legal Environments and Corporate Investment Performance”, 1 German Economic Review (2000) 187; and Berkowitz, Pistor and Richard, supra n. 7.

10 For a critical overview see Mayer and Sussman, supra n. 9.

11 Berle, and Means, , The Modern Corporation and Private Property (New York: MacMillan 1932).

12 Zweigert, and Koetz, , Introduction to Comparative Law, 3rd ed. (Oxford: Clarendon 1998).

13 Charkham, , Keeping Good Company (Oxford: Clarendon 1994); Schmidt, and Grohs, , “Angleichung der Unternehmensverfassung in Europa aus ökonomischer Perspektive”, in: Grundmann, (ed.), Systembildung und Systemlucken in Kerngebieten des Europäischen Privatrechts (Tübingen: Mohr 2000) p. 145.

14 LLSV, supra n. 3, 1115.

15 For an extended sorting see, e.g., LLSV, supra n. 3, or Berkowitz, Pistor and Richard, supra n. 7.

16 LLSV, supra n. 3, 1145.

17 LLSV, supra n. 3, 1152.

18 Such a research was undertaken by several authors, see, e.g., King, and Levine, , “Finance, Entrepreneurship, and Growth. Theory and Evidence”, 32 Journal of Monetary Economics (1993) 513; Levine, and Zervos, , “Stock Markets, Banks, and Economic Growth”, 88 American Economic Review (1998) 537; Levine, , “The Legal Environment, Banks, and long-run Economic Growth”, 30 Journal of Money, Credit and Banking (1998) 596. These authors were able to confirm the relation between economic growth and the legal rules governing a country's financial system.

19 LLSV, supra n. 3,1152.

20 Mayer and Sussman, supra n. 9,460.

21 For a review of the literature concerning the psychological theory of control, see Skinner, , “A Guide to Constructs of Control”, 71 Journal of Personality and Social Psychology (1996) 549; Osnabrügge, , Stahlberg, and Frey, , “Die Theorie der kognizierten Kontrolle”, in: Frey, and Irle, (eds.), Theorie der Sozialpsychologie, Vol. 3 (Bern: Huber 1985) 79; and Frey, and Jonas, , “Die Theorie der kognizierten Kontrolle”, Mimeo (2002). For an application of the psychological theory of control to the field of taxation, see Jonas, , Heine, and Frey, , “Ein Modell der Steuerzufriedenheit – psychologische Grundlagen (un)ökonomischen Handelns”, in: Fischer, , Kutsch, and Stephan, (eds.), Finanzpsychologie (München: Oldenbourg 1999) 160.

22 Brickman, , Rabinowitz, , Karuza, , Coates, , Cohn, and Kidder, , “Models of Helping and Coping”, 37 American Psychologist (1982) 368; Skinner, , Wellborn, and Connell, , “What it takes to do well in school and whether I've got it: The role of perceived control in children's engagement and school achievement”, 82 Journal of Educational Psychology (1990) 22.

23 Glass, and Carver, , “Helplessness and the Coronary-Prone Personality”, in: Garber, and Seligman, (eds.), Human Helplessness: Theory and Applications (New York: Academic Press 1980) 223.

24 Averill, , “Personal Control over Averse Stimuli and its Relationship to Stress”, 80 Psychological Bulletin (1973) p. 286; Burger, J.M., “Negative Reactions to Increases in Perceived Personal Control”, 56 Journal of Personality and Social Psychology (1989) 246.

25 For a more detailed taxonomy of different kinds of control, see, e.g., Skinner, supra n. 21; Grabitz, , “Kontrolle und Hilflosigkeit”, in: Frey, and Greif, (eds.), Sozialpsychologie. Ein Handbuch in Schlüsselbegriffen, 4th ed. (Weinheim: Beltz 1997) p. 227.

26 Frey and Jonas, supra n. 21.

27 Miller, , “Predictability and Human Stress: Toward a Clarification of Evidence and Theory”, in: Berkowitz, (ed.), Advances in Experimental Social Psychology, Vol. 14 (New York: Academic Press 1981) p. 203; Frey and Jonas, supra n. 21.

28 Frey and Jonas, supra n. 21.

29 Osnabrügge, Stahlberg and Frey, supra n. 21; Thompson, , “Will it Hurt Less if I can Control it? A Complex Answer to a Simple Question”, 90 Psychological Bulletin (1981) 89.

30 For an overview see Osnabriigge, Stahlberg and Frey, supra n. 21; Frey and Jonas, supra n. 21; Taylor, and Brown, , “Illusion and Weil-Being: A Social Psychological Perspective on Mental Health”, 103 Psychological Bulletin (1988) 193.

31 Hirshleifer, supra n. 1; Shiller, , “Human Behavior and the Efficiency of the Financial System”, Working paper, The International Center for Finance at the Yale School of Management (1997).

32 For such a population-ecology thinking see the seminal paper of Alchian, , “Uncertainty, Evolution and Economic Theory”, 58 Journal of Political Economy (1950) 211; see also Vanberg, , “Rational Choice vs. Program-Based Behavior”, 14 Rationality and Society (2002) 7.

33 See, e.g., LLSV, supra n. 3.

34 In the literature on Law and Finance we find some variables, like “rule of law” or “risk of expropriation”, but to measure the predictability of a legal system from a psychological point of view these variables seem too broad.

35 Berkowitz, Pistor and Richard, supra n. 7.

36 See LLSV, supra n. 3.

37 King, and Levine, , “Finance, Entrepreneurship, and Growth. Theory and Evidence”, 32 Journal of Monetary Economics (1993) 513.

38 For instance, Levine, , “Law, Finance and Economic Growth”, 8 Journal of Financial Intermediation (1999) 8. See also, especially for the method of constructing indicators, Clague, , Keefer, , Knack, and Olson, , “Property and Contract Rights in Autocracies and Democracies”, Journal of Economic Growth (1996) 243.

39 White, , “Heteroscedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroscedasticity”, 48 Econometrica (1980) 817. The classical linear regression model relies on homoscedasticity, what means that the variances of the regression disturbances are constant across observations. Economic data often violate this assumption. To avoid this problem (of heteroscedasticity), we use the White-estimator which presumes heteroscedasticity and includes homoscedasticity as a special case. For a critical discussion of this estimator and additional literature see Greene, , Econometric analysis, 4th ed. (London: Prentice Hall 2000).

40 King and Levine (1993), supra n. 37.

41 For instance, King, and Levine, , “Finance and Growth: Schumpeter might be Right109 Quarterly Journal of Economics (1993) 717737; Levine, supra n. 38.

42 Heine, , Oltmanns, and Stahl, , “The Impact of Cognition on Institutions: How does the Motive of Control Affect the Building of Financial Institutions”, 3 Marburg: Volks-wirtschaftliche Beiträge (2000), and Heine, , Oltmanns, and Stahl, , “The Impact of Cognition on Institutions: How does the Motive of Control Affect the Building of Financial Institutions”, in: Hölzl, (ed.), Proceedings of XXV Annual Colloquium of the International Association for Research in Economic Psychology (IAREP) and the Society for the Advancement of Behavioral Economics (SABE), July 12-16, 2000 in Baden, Vienna/Austria (2000) 190.

43 The database is provided by the World Bank. For a description see Beck, , Demirgüç-Kunt, and Levine, , “A New Database on Financial Development and Structure”, 2146 World Bank Working Paper (Washington D. C. 1999)

44 Heine, Oltmanns and Stahl, supra n. 42.

45 Brunetti, , Kisunko, and Weder, , Institutional Obstacles for Doing Business. Data Description and Methodology of a World Wide Private Sector Survey (Washington D.C.: World Bank 1997).

46 Beck, Demirgüç-Kunt and Levine, supra n. 43.

47 Heine, Oltmanns and Stahl, supra n. 42, would have had a maximum sample size of 22 countries. Therefore, the corresponding estimation results are not reported there.

48 This measure ranges theoretically from 0 (“no correlation”) to 1 (“perfect correlation”).

49 Small values (less than 0.1,0.05 or 0.1) mean that the estimated parameter has a significant influence. See, for instance, 0.059 in Table 2 for the (medium) significance of CONTROL on LTPDY.

50 Levine, supra n. 38.

51 Heine, Oltmanns and Stahl, supra n. 42.

52 For the assumptions underlying the method of constructing these proxies see Heine, Oltmanns and Stahl, supra n. 42.

53 Levine, supra n. 38.

54 Heine, Oltmanns and Stahl, supra n. 42.

55 Heine, Oltmanns and Stahl, supra n. 42.

56 Heine, Oltmanns and Stahl, supra n. 42.

57 See, e.g. Eucken, supra n. 8; Hay, , Shleifer, and Vishny, , “Toward A Theory of Legal Reform”, 40 European Economic Review (1996) 559.

58 Berkowitz, Pistor and Richard, supra n. 7.

59 For a broad discussion of “big bang” transformation vs. incremental transformation, see the contributions in the special issue of the Journal of Institutional and Theoretical Economics, Vol. 156(1)(2000).

60 Huberman, , “Familiarity Breeds Investment”, Working paper 97-04, Columbia University; Hirshleifer, supra n. 1.

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Law, Finance, and the Investors Psychological Motive of Control

  • Klaus Heine (a1) and Erich Oltmanns (a2)


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