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Decision Making
Psychology &
Behavioural Finance
 Much
of economic and financial theory is based on the notion that individuals act
rationally and consider all available information in the decision-making
process. However, researchers have uncovered a surprisingly large amount of
evidence that this is frequently not the case. Dozens of examples of
irrational behavior and repeated errors in judgement have been documented in
academic studies. Peter L. Bernstein in Against The Gods states that the
evidence "reveals repeated patterns of irrationality, inconsistency, and
incompetence in the ways human beings arrive at decisions and choices when
faced with uncertainty."
A field known as "behavioral finance" has evolved that attempts to better
understand and explain how emotions and cognitive errors influence investors
and the decision-making process. Many researchers believe that the study of
psychology and other social sciences can shed considerable light on the
efficiency of financial markets as well as explain many stock market
anomalies, market bubbles, and crashes. As an example, some believe that the
outperformance of value investing results from investor's irrational
overconfidence in exciting growth companies and from the fact that investors
generate pleasure and pride from owning growth stocks. Many researchers (not
all) believe that these humans flaws are consistent, predictable, and can be
exploited for profit.
 Some
Professors recognized as experts in the field include Daniel Kahneman
(Princeton), Meir Statman (Santa Clara), Richard Thaler (University of
Chicago), Robert J. Shiller (Yale), and Amos Tversky. Tversky passed away in
1996 and is frequently cited as the forefather of the field (See Roger
Lowenstein's tributes to Tversky in the Wall Street Journal on 6/6/96 and
6/13/96). LSV Asset Management, Fuller & Thaler Asset Management, David
Dreman and Ken Fisher are some money managers that invest based on
behavioral finance theories. Common examples of irrational behavior (many
interrelated) that researchers have documented include the following.
Tversky and Kahneman originally described "Prospect Theory" in 1979. They
found that contrary to expected utility theory, people placed different
weights on gains and losses and on different ranges of probability. They
found that individuals are much more distressed by prospective losses than
they are happy by equivalent gains. Some economists have concluded that
investors typically consider the loss of $1 dollar twice as painful as the
pleasure received from a $1 gain. They also found that individuals will
respond differently to equivalent situations depending on whether it is
presented in the context of losses or gains. Here is an example from Tversky
and Kahneman's 1979 article. Researchers have also found that people are
willing to take more risks to avoid losses than to realize gains. Faced with
sure gain, most investors are risk-averse, but faced with sure loss,
investors become risk-takers.
Professor Statman is an expert in the behavior known as the "fear of
regret." People tend to feel sorrow and grief after having made an error in
judgement. Investors deciding whether to sell a security are typically
emotionally affected by whether the security was bought for more or less
than the current price. One theory is that investors avoid selling stocks
that have gone down in order to avoid the pain and regret of having made a
bad investment. The embarrassment of having to report the loss to the IRS,
accountants, and others may also contribute to the tendency not to sell
losing investments. Some researchers theorize that investors follow the
crowd and conventional wisdom to avoid the possibility of feeling regret in
the event that their decisions prove to be incorrect. Many investors find it
easier to buy a popular stock and rationalize it going down since everyone
else owned it and thought so highly of it. Buying a stock with a bad image
is harder to rationalize if it goes down. Additionally, many believe that
money managers and advisors favor well known and popular companies because
they are less likely to be fired if they underperform. See also Terrance
Odean's Are Investors Reluctant to Realize Their Losses?.
People typically give too much weight to recent experience and extrapolate
recent trends that are at odds with long-run averages and statistical odds.
They tend to become more optimistic when the market goes up and more
pessimistic when the market goes down. As an example, Professor Shiller
found that at the peak of the Japanese market, 14% of Japanese investors
expected a crash, but after it did crash, 32% expected a crash (Source: WSJ
6/13/97). Many believe that when high percentages of participants become
overly optimistic or pessimistic about the future, it is a signal that the
opposite scenario will occur. See Bull & Bears.
 People
often see order where it does not exist and interpret accidental success to
be the result of skill. Tversky is well known for having demonstrated
statistically that many occurrences are the result of luck and odds. One of
the most cited examples is Tversky and Thomas Gilovich's proof that a
basketball player with a "hot hand" was no more likely to make his next shot
than at any other time. Many people have a hard time accepting some facts
despite mathematical proof.
People are overconfident in their own abilities, and investors and
analysts are particularly overconfident in areas where they have some
knowledge. However, increasing levels of confidence frequently show no
correlation with greater success. For instance, studies show that men
consistently overestimate their own abilities in many areas including
athletic skills, abilities as a leader, and ability to get along with
others. Money managers, advisors, and investors are consistently
overconfident in their ability to outperform the market, however, most fail
to do so. Gur Huberman of Columbia University recently found that investors
strongly favor investing in local companies that they are familiar with.
Specifically investors are far more likely to own their local regional Bell
company than the other regional Bells. The study provides evidence that
investors prefer local or familiar stocks even though there may be no
rational reason to prefer the local stock over other comparable stocks that
the investor is unfamiliar with. See The Perils of Investing Too Close to
Home in BusinessWeek (9/29/97). See also Smart people, stupid money moves in
Money Magazine (4/18/97).
People often see other people's decisions as the result of disposition but
they see their own choices as rational. Investors frequently trade on
information they believe to be superior and relevant, when in fact it is not
and is fully discounted by the market. This results in frequent trading and
consistently high volumes in financial markets that many researchers find
puzzling. On one side of each speculative trade is a participant who
believes he or she has superior information and on the other side is another
participant who believes his/her information is superior. Yet they can't
both be right. See also Terrance Odean's Why Do Investors Trade Too Much?
Many researchers theorize that the tendency to gamble and assume unnecessary
risks is a basic human trait. Entertainment and ego appear to be some of the
motivations for people's tendency to speculate. People also tend to remember
successes, but not their failures, thereby unjustifiably increasing their
confidence. As John Allen Paulos states in his book Innumeracy, "There is a
strong general tendency to filter out the bad and the failed and to focus on
the good and the successful."
People's decisions are often affected by how problems are "framed" and by
irrelevant but comparable options. In one frequently cited example, an
individual is offered a set amount of cash or a cross pen, in which case
most choose the cash. However, if offered the pen, the cash, or an inferior
pen, more will choose the cross pen. Sales professionals typically attempt
to capitalize on this behavior by offering an inferior option simply to make
the primary option appear more attractive.
Arnold S. Wood of Martingale Asset Management describes the "touchy-feely
syndrome" as the tendency for people to overvalue things they've actually
"touched" or selected personally. In one experiment, participants where
either handed a card or asked to select one. Those that selected a card were
less interested in selling the card back and required more than four times
the price to sell the card as compared with the participants who were handed
a card. Similarly, many researchers believe that analysts who visit a
company develop more confidence in their stock picking skill, although there
is no evidence to support this confidence.
 The
dynamics of the investment process, culture, and the relationship between
investors and their advisors can also significantly impact the
decision-making process and resulting investment performance. Full service
brokers and advisors are often hired despite the likelihood that they will
underperform the market. Researchers theorize that an explanation for this
behavior is that they play the role of scapegoat. In Fortune and Folly: The
Wealth and Power of Institutional Investing, William M. O'Barr and John M.
Conley concluded that officers of large pension plans hired investment
managers for no other reason than to provide someone else to take the blame
and that the officers were motivated by culture, diffusion of
responsibility, and blame deflection in forming and implementing their
investment strategy. The theory is that they can protect their own jobs by
risking the managers account. If the account underperforms, it is the
managers fault and they can be fired, but if they overperform they can both
take credit.
"Psychographics" describe psychological characteristics of people and are
particularly relevant to each individual investor's strategy and risk
tolerance. An investors background and past experiences can play a
significant role in the decisions an individual makes during the investment
process. For instance, women tend to be more risk averse than men and
passive investors have typically became wealthy without much risk while
active investors have typically become wealthy by earning it themselves. The
Bailard, Biehl & Kaiser Five-Way Model divides investors into five
categories. "Adventurers" are risk takers and are particularly difficult to
advise. "Celebrities" like to be where the action is and make easy prey for
fast-talking brokers. "Individualists" tend to avoid extreme risk, do their
own research, and act rationally. "Guardians" are typically older, more
careful, and more risk averse."Straight Arrows" fall in between the other
four personalities and are typically very balanced
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