If it turns out that the financial predictions are not so significant, then how do we explain the anomalies in the financial phenomena that occur? 

Introduction

In the period of February to March 2020, the global stock market experienced an extraordinary level of volatility. Ten different countries with the highest levels of the COVID-19 pandemic at that time experienced an increased risk level of 26.6% which then caused systemic losses for investors and the market in a very short time (Zhang et al., 2020). A pandemic is indeed an extraordinary event and relatively no one – especially economists – predicts its impact, however, this raises fundamental questions about the inability to predict the situation to be a fundamental problem or not. A decade earlier, to be precise in the period 2007-2008, we know that financial crisis emerged which even according to Thaler (2015), almost no economist had predicted. The majority of economists, especially those with Keynesian views at that time, ignored basic advice to anticipate the crisis and instead held the view that the US government should be able to take advantage of the combination of high unemployment and low-interest rates for infrastructure investment. If it turns out that the financial predictions are not so significant, then how do we explain the anomalies in the financial phenomena that occur?

Those phenomena, if we only refer to the classic financial paradigm, it is likely that we will fail to explain the phenomenon that occurs. The classic financial paradigm generally assumes that the market and humans behave completely rationally. In addition, financial institutions and their instruments which are designed for humans, are assumed to be based on the assumption that markets and humans are equally rational, so that in practice it is very dependent on human behavior but seems to ignore the definition of humans as complex creatures, which are certainly capable of being rational, but it is possible on the other side of the coin that humans are also capable of being irrational. In short, we are faced with the classic assumption that people generally know what is in their best interest, and they behave based on that knowledge. While a more realistic assumption is that people sometimes still experience confusion or an inability to read financial situations – such as not knowing certain financial terms, for example – even when people know what is best, there is still an opportunity to behave otherwise – such as a tendency to behave in a massive consumptive manner compared to investment.

In classic financial theory, let us highlight the Efficient Market Hypothesis (EMH) theory which has been the reference since the mid-1950s. Baker (2014) stated that the Efficient Market Hypothesis (EMH) theory assumed that market prices are a representation of all available information, which means this theory must first assume that the market and its actors behave rationally for making financial decisions based on relevant information about market prices. The simple logic that arises from this theory is that it should be, the possibility of price fluctuations in a short time, stock crashes, and generally, the financial crisis must be very low – due to the market and its actors will always act rationally. However, we are faced with a fact that is often irrelevant to this theory which is characterized by the occurrence of extraordinary financial events within a certain period as exemplified earlier. This is what later became one of the points of disagreement between classic finance and behavioral finance in their quest for a better understanding of finance and its theoretical underpinnings (Kleinübing Godoi et al., 2005).

Researchers have attempted to identify alternative approaches that take into account the influence of psychology and other social sciences to better interpret human behavior when making certain financial decisions. Later on, behavioral finance emerged as an alternative to classic finance in the late 1970s, which is highlighted by the major work of Kahneman and Tversky (1979). Behavioral finance investigates the role of psychology and other social factors in the decision making process. Behavioral finance has received great attention from academics, professionals, and practitioners. However, even though this theory is gaining popularity, it is still considered new. Much effort is needed to develop a framework for the study of behavioral problems in finance mainly because of the discrepancy of the assumptions made compared to traditional financial theory and the lack of sufficient research to find a replacement theory.
Simply put, the fundamental difference that distinguishes behavioral finance and traditional finance is the way of looking at human nature in the context of the cognitive approach of determining financial decisions in any situation. This then creates a new thinking gap that needs to reveal whether humans, if based on a certain identity foundation – such as religious values, for example, will have a good significance to a domain in behavioral finance or not. In this case, Musse et al. (2015) explicitly criticize most of the existing literature regarding Islamic behavioral finance which still revolves around behavior patterns and preferences in the adaptation of certain Islamic-based financial products. They argue that there should be a comprehensive framework that applies a psychological theory that does not contradict the paradigm in Islamic teachings in a holistic manner. Meanwhile, in simpler terms, the application of the variables of religiosity, religious motivation, a religious obligation is often used as variables that influence financial decisions (Ibrahim et al., 2017; Kaakeh, 2018; Nik Abdullah & Abd Wahab, 2015). To answer this question, the way Islam defines humans and their nature is important to determine the right elements that are directly related to the fundamentals of behavioral finance.

The Dual-Process Theory in a Glance

Before discussing further how Islam defines humans and their nature, the embodiment of The Dual-process theory which is often used as the basis for the occurrence of phenomena in the concentration of behavioral finance is important to discuss first. In general, The Dual-Process Theory provides an overview of how the human mind works by focusing on the results of thoughts that are born from two different processes. The terms commonly used for both processes are implicit processes or thought processes automatically (unconsciously) and explicit processes or conscious controlled thought processes). This was then confirmed by Daniel Kahneman (2003) who divided the cognitive ability of the human brain to think and make decisions into two parts which are roughly differentiated by the concepts of reasoning and intuition. Among the researchers, there is substantial agreement about the characteristics that differentiate the two types of cognitive processes, for which Kahneman (2003) proposes a neutral label for naming the divisions as System 1 and System 2.

System 1 operates quickly, automatically, easily, associatively, regularly, unconsciously, and mostly emotionally; it is also closely related to habit, and therefore difficult to control or modify. When we think quickly, we react intuitively to stimuli. We tend to respond to things that happen in ways that don’t involve our conscious mind or our reasoning. While System 2 operation tends to be slower, serialized, painstaking, and requires deliberate thinking; the system is also relatively flexible and has the potential to follow applicable rules. It is this system that supports strategic thinking, structuring problem solving, long-term planning, and other conscious activities in our minds. This integration between system 1 and system 2 does not limit the components of the dual-process theory itself, for example, if we want to look at the concentration of the empathy gap, we will find a concept similar to system 1 – system 2, but with hot-state and cold-state in human cognition. Simply put, it is the integration between these two parts of human cognition that then forms perspectives, biases, and decisions in almost everything, including financial decisions.

Islamic Model of a Soul in a Glance

From an Islamic perspective, Islam introduces the concept of a comprehensive spiritual dimension which in its content we can categorize as the Islamic view of psychology (Haque, 2004). In general, Abdul Razak (2012), explains that the concept of human nature in Islam includes physical, social, psychological, and spiritual dimensions. In more detail, it is explained that human nature in Islam adheres to the concept that humans are Allah’s best creation, born with a fitrah (primordial nature), have dual nature (body and spirit), play a role as the khalifah of Allah on earth (Allah’s vicegerent). This writing will discuss a little deeper about dual nature in the concept of Islam. In order to be comparable fairly (although more references are needed to test this relevance), the concept of dual nature in Islam, especially in the spiritual realm, has several concepts that intersect with the dual-process theory.

In this context, Rothman & Coyle (2018) stated that there is general stigmatization that the word ‘self’ is an interpretation of the concept of the nafs in particular. This must then be understood with a concept based on modern psychology where the term ‘self’ is not limited to referring to non-material psychological concepts, but nafs in Islam refers to a spiritual entity that is part of the physical human being. In several references that discuss how Islam embodies human nature and certain psychological models, some researchers cited Ihya Ulumuddin by Imam Al Ghazali as a reference (Adam, 2016; Haque, 2004; Haque et al., 2016; Rothman & Coyle, 2018; Sabki et al., 2019; York Al-Karam, 2019). Imam Al Ghazali divides the human soul into four separate parts, namely the ruh, nafs, qalb and aql.

In a brief explanation, the concept of ruh is explained as the origin of life, as explained several times in the Qur’an (22:29; 32:9; 21:19). Ruh is considered as an unchanging and pure entity originating and will return to Allah (Rothman & Coyle, 2018). In the same source, the term nafs refers to the lower self, which is explained as that part of the soul that has an inclination to the world through desire – although in its classification there are quite significant differences between nafs muthmainnah, nafs lawwamah, and nafs ammarah. Nafs is also explained as an eternal and non-physical essence that gives life force to the human physical body. It is influenced by the mind, will, intellect, heart and other cognitive processes.

Then Rothman & Coyle (2018) explained that the qalb (heart) is the spiritual center of man and is the most important part of what determines the state of the soul. Qalb, represents the capacity of the human personality which enables people to know and understand the reality of things, make evaluative judgments, and filter out right from wrong. The qalb’s role as an evaluative decision-maker in the human psyche makes it the center of personality, along with other roles as a center of intellectual ability, understanding, affection, and emotion (Skinner, 2019). The qalb, when functioning properly, can enhance the positive tendencies of the human personality leading to a constant state of self-awareness and understanding. In Arabic, the word qalb comes from the root word qalaba (verb) which means turning. Its unstable and moving condition puts it in a situation where it will have a tendency or inclination to follow ruh or nafs (Abdul Razak, 2012). Then Aql, or often translated as intellect. The Arabic word for intellect is aql, and comes from the root word aqala, which means endowed with reason, intelligent, cultivated with reason, and comprehensive. Intellect in the highest sense is a great power that receives the revelation of pure light while in the lowest sense, it is the power of ordinary reasoning (Abdul Razak, 2012).

What is related to the previous discussion, is how the integration between the two parts of cognition (in this case the human spiritual dimension) is especially the integration involving the qalb and aql. Abdul Razak (2012) explains that the function of the qalb is the seat of knowledge that tends to achieve knowledge at the level of intuition, inspiration, and inspiration – with its abilities that do not take long and are natural. While the aql functions for reasoning and embodiment of perceptions that are motivated by certain senses to then be managed as information with its character that goes through several steps of reasoning, a relatively long time and others. This, if we examine more deeply, we do not find concepts that are in extreme contrast to dual process theory, especially in the role of cognition that underlies the formation of decision making and biases. Therefore, Al-Abbadi & Abdullah (2017) then explains that the use of instruments in behavioral finance – behavioral biases, for example – in general, can also be applied to the Islamic approach and related phenomena.

A Short Note

Behavioral finance in short is a study that involves elements of psychology and sociological influences in analyzing certain financial phenomena. The addition of the name Islam here is intended to specify the scope in which the related discussion includes Islamic finance. In general, Islamic behavioral finance can contribute in three distinguishing concentrations.

First, universal conditions in the formation of decision-making and biases based on Islamic financial and/or economic instruments related to them. The formation of decision-making, in this case, includes everything related to Islam which is still in the financial or economic context in general. The theory that is relatively general to be used in this case was born from the realm of psychology which was later adapted into economic and financial formats and instruments. In the context of forming intention – which will directly affect the decision – the theories used include the Theory of Planned Behavior, the Theory of Reasoned Action, the Agency Theory, Social Capital Theory, Regret theory, and other intention-forming theories. Several classical psychological theories mentioned earlier are generally closely related to social interactions, beliefs, expectations, and other factors that influence intentions so that in practice these theories can be used as a theoretical basis for placing variables in decisions that are directly related to Islamic finance. In this case, the use of this theory can be used to test or determine the level of intention – which leads directly to decision making – from decisions related to Islamic finance such as the intention to switch to Islamic banking, the intention to invest in one of the Islamic financial instruments, product selection certain Islamic financial institutions financial planning behavior is in accordance with Islamic and possibly other broad research topics. If the phenomenon being analyzed is related to investment, related theories such as Portfolio Theory, Social Practice Theory, Prospect Theory, and others can also be used (Kahneman, 2003). There are also other theories related to direct decisions such as Game Theory, Fuzzy Theory, and others (Vanderbei, 2020). For example, several studies related to this are the research conducted by Aziz et al. (2018) which
discusses behavioral intention to adopt Islamic banking in Pakistan; Kundisch & Dzoienziol (2008) which discusses decision support in financial planning; Ibrahim et al. (2017) which discusses Islamic home financing products in Malaysia, Khan et al. (2020) which discusses behavioral intention to invest in Pakistan.

A next approach is an approach that tries to uncover the cognitive bias that occurs during certain financial events. Common cognitive biases include cognitive dissonance, regret aversion, overconfidence, confirmation bias, anchoring bias, fundamental attribution error, and other cognitive biases (Kahneman, 2003). The analysis used based on the cognitive bias will reveal the irregularities of classical financial theory that often occur and explain the unanswered phenomena if we only pay attention – from problem reasoning to solutions – which use classical financial theory standards. What happens is within the scope of human behavior specifically. Because the context adopted is Islamic behavioral finance, the observed events are also related to Islamic finance. For example, topics that examine the cognitive bias that occurs when Muslim investors prefer issuers that are not listed in the Indonesian Sharia Stock Index (ISSI) than those that have been registered, or the cognitive bias that occurs when Muslim consumers tend to ignore the halal logo when choosing a product when the product is sold. is outside the classification of food and drink. Simply put, every anomaly that occurs – which of course is still within the scope of Islamic finance – is embodied and reviewed with a cognitive bias approach. For example, several studies related to this are the research conducted by Kourtidis et al. (2011) which discusses psychological bias for trading investors; Todd (2020) which discusses behavioral bias regarding message framing in financial planning; Fiksenbaum et al. (2017) which discusses financial threats and financial behavior; Rasool & Ullah (2020) which discusses the behavioral bias for individual investors; Mahapatra & Mishra (2020) which discusses mental accounting in financial decision.

Second, the general conditions in the term of behavioral finance that are examined based on the main sources of Islamic teachings – the Quran and Sunnah – as well as additional sources – the works of scholars. As stated by Muslim scholars, more than a third (1/3) of the content of the Qur’an is a story. Followed by the Sunnah of the Prophet which is also the whole – from the life story to the specific laws and wisdom that was born because of it – is a story. Becoming richer in scientific treasures when mixing and matching the works of classical scholars who also tell stories, or at least are motivated and even then produce stories. All of these stories will continue to be a source of knowledge and produce new findings that are useful for wisdom seekers. For example, the development of Islamic financial planning as a field of study and concentration in the financial sector is based on the interpretation of the Qur’an Surah Yusuf: 46-49. This is according to Abdullah & Muhammad (2013), in Al-Quran Surah Yusuf: 46-49, Allah emphasizes the importance of good financial planning where people must save abundant wealth in seven good harvest periods and prepare for seven terrible years. This then underwent a new definition, namely Islamic financial planning is a process to achieve one’s financial goals with existing resources and remain measurable with sharia parameters to achieve falah. (Ahmed & Salleh, 2016). Furthermore, financial planning behavior that is in line with Islam – if it has been applied at the individual and collective level – will become an additional reference that can describe the financial situation or even start a welfare project that was born from the integration of Islamic finance, which started with massive financial planning in line with Islamic values. For example, several studies related to this are the research conducted by Ahmed & Salleh (2016) which discusses inclusive financial planning; Billah & Saiti (2017) which discusses Islamic financial planning for sustainable eco-growth; Abdullah & Muhammad (2013) which discusses ethical values in Islamic financial planning.

Then the Sunnah of the Prophet, which is so rich, can become a benchmark for financial behavior. The story of The Prophet PBUH which is rich in meaning has been proven to have produced many books on the analysis of historical sources that make it easier for us to follow it. Prophet Muhammad SAW is the noblest human being who is proven to be rich in his background and achievements, so that if we specialize in the realm of entrepreneurship, for example, we can find out how The Prophet PBUH did business and developed his business. In the context of lifestyle, we can find how The Prophet PBUH carried out daily activities which then ignite us to analyze certain patterns of consumptive behavior. Such great wisdom also includes his attitude towards his companions, enemies, and certain events. As a result, we can take lessons that are directly or indirectly related to behavioral finance such as entrepreneurial behavior, investment behavior, consumer behavior, management behavior, halal financial behavior, certain behavior in dealing with crises, and others. These topics of discussion regarding how the Prophet Muhammad behaved can then be used as a reference as a basis for Muslim behavior and even the approach described in the previous classification – decision formation and bias – can also be applied. For example, several studies related to this are the research conducted by Arslan (2009) which discusses Islamic business ethics based on the Qur’an and Sunnah; Choudhury (2010) which discusses socio-economic development from an Islamic point of view; Hossain (2014) which discusses the rationalization of consumption from an Islamic point of view.

The next is the work of the scholars. History records Islam as a religion that gave birth to many world thinkers who became the originators of modern civilization. We know that the work of Muslim scholars includes a comprehensive discussion of anything in the world, from fiqh-oriented, such as Imam Abu Yusuf’s book Al Kharaj to law-oriented positivism such as algebra and algorithms which are the result of Al Khwarizmi’s thinking. In the context that specifically discusses economic phenomena, we can find Al Maqrizi’s thoughts in his work Ighatsah al-Ummah bi Kasyf al-Ghummah (helping people by knowing the causes of his illness). This work is motivated by the economic crisis in Egypt in 806-809. During that period, Egypt experienced a period of the ebb. The economy, in general, is experiencing a decline, production and food reserves are not sufficient to meet the needs of the population, which over time is increasing. This resulted in the scarcity of necessities, which led to mass famine in Egypt, something that had never happened before. Al Maqrizi in his work analyzes in-depth the main causes of this incident and proposes relevant solutions. In today’s terms, what is happening is inflation, and Al Maqrizi has so
comprehensively analyzed the causes that he even proposed relevant solutions long before John Maynard Keynes – the figure who is said to be the originator of the inflation theory – was born. This extraordinary event caused many lessons to be extracted, especially from the perspective of behavioral finance and/or behavioral economics. Starting from the pattern of community behavior depicted when facing a crisis to the formulation of policies for interested parties. For example, several studies related to this are the research conducted by Sunarso (2018) which discusses Al Maqrizi’s theory of money and inflation; Siregar et al. (2020) which discusses Al Maqrizi’s inflation theory and its application in the present; Fidiana et al. (2013) which discusses non-compliance behavior based on Ibn Khaldun’s framework.

Third, the general conditions in the term of behavioral finance that occur among Muslims, culture, habits, and things that underlie differences both in terms of different dimensions of place and different dimensions of time. This is because the Islamic world has become so vast that comparisons between certain criteria have become possible. The results of empirical research related to Islamic behavioral finance in a research object with certain characteristics, will not necessarily repeat the same results if the research is carried out on other research objects. For example, research conducted by Shah Alam & Mohamed Sayuti (2011) and Sherwani et al. (2018) discusses halal food consumption in Malaysia will not necessarily produce the same results in Indonesia, even though Indonesia and Malaysia are both labeled as countries with a Muslim majority. This example is only limited to geographical location as a differentiator, other distinguishing characteristics are still very possible to be studied further.

Author : 

Herdy Almadiptha Rahman - Alumni Institut Tazkia Angkatan 17