Behavioral Finance: When Investors Make Irrational Investment Decisions

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Can people become rational investors? Or is there something we do that prevents us from consistently making sophisticated financial decisions?

Human motives and fears are now recognized as inherent in investor behavior. How people invest, what stocks or funds they select, and their attraction to risky investments are among the factors examined to determine the path investors take between objectively evaluating financial advice and succumbing to psychological traps that cause economic losses.

Today, the area of study known as behavioral finance has identified some critical tendencies that can affect rational decision-making by otherwise thoughtful individuals and mar the process through bias, overconfidence, and unchecked emotions. When this happens, it reduces the chances of making profitable investing decisions.

Behavior Finance Gaining More Recognition

Behavioral finance moved to the international forefront of economic study when the 2002 Nobel Prize went to Daniel Kahneman, a psychologist, and Vernon Smith, an experiment economist, for their work in developing tools to study individual investor behavior. This recognition prompted additional study of people’s behavior patterns when making investment decisions.

Daniel Kahneman

Psychologists are now using behavioral finance to solve some financial puzzles, such as why markets become grossly overpriced or why sophisticated investors make bad decisions.

According to Hersh Shefrin, professor of finance at the Leavey School of Business at Santa Clara University, some basic human behaviors affect investment decision-making. At the individual level, the driving factors are framing, overconfidence, confirmation bias, and the illusion of control.

At the group level, committees and boards amplify individual errors through the “groupthink” process.

The Key Concepts

Here are the definitions of these key concepts:

Framing. When individuals make investment decisions, emotion and reason work together, but they produce very different emotional results depending on whether the investment is made or lost money.

For example, according to Shefrin, people tend to feel losses much more strongly than the pleasure they receive from making a comparable gain. This emotional strain is magnified when the person assumes responsibility for the loss, and the guilt produces an aversion to risk. However, the level of guilt can vary depending on how a financial decision is framed. For example, if an investor lost money buying a stock, the person could justify the loss by saying the stock also paid a dividend.

Hersh Shefrin
  • Confirmation bias describes the tendency of people to favor information that confirms their beliefs or hypotheses. People express this bias when they selectively gather or remember information. Alternatively, an investor can interpret data in a biased way. The confirmation is more pronounced in emotionally charged issues and deeply entrenched beliefs. People also tend to use confirmation bias to interpret ambiguous evidence to support their existing position.
  • The illusion of control. This bias develops when people overestimate their ability to control events.  For example, people can feel they control outcomes they could never influence.  This happens in gambling and investing when people experience a positive result, for example, in an event primarily determined by chance.

Individual and Group Dynamics

Individual investors commonly think they make sound investment decisions because they have good judgment and are objective. But there is more at work under the surface.

Individuals use the four biases named earlier to drive their decisions unconsciously. For instance, when a person chooses to buy a specific stock, they can review the data and past performance, but at a cocktail party, they can overhear another person talking about buying that stock.  That casual encounter can trigger a buying decision (confirmation bias) when it has nothing to do with the facts about the company.  Similarly, investors are notoriously slow to sell a poorly-performing stock since they would have to actualize the losses and, more importantly, admit they made a mistake by holding it too long.(framing).

Alternately, groups tend to amplify the prevailing emotion by sharing a “groupthink” mentality when making decisions that require a consensus. They often try to determine their members’ confidence levels when deciding. When this happens, the group overreacts, thinking other members strongly agree with the prevailing position. However, studies have found this is a mistake, especially when the board discovers they have made a terrible decision. Shefrin calls this the “illusion of effectiveness.”

To help avoid these situations, Shefrin recommends the following:

  • Look at the committee’s culture to see if it encourages people to express opposing viewpoints. The former chairman of General Motors, Alfred Sloan, used to advise his committees to reach a consensus but then think about that decision over the weekend to try and discover its flaws. Committees should try to re-examine any preconceptions they hold about complex issues. This type of critical self-examination can help individual investors, as well.
  • Heighten self-awareness. Investors should become more aware of their prejudices so these prejudices do not creep into a committee’s collective decision-making.
  • Don’t be overconfident. Shefrin says this overconfidence bias, called the “illusion of effectiveness,” is “absolutely rampant” at the individual and committee levels. Over-exuberance can be checked by increasing self-awareness about a person’s preconceived views.  Investors should recognize their confirmation bias, which supports existing views and overlooks evidence that may challenge prevailing ideas. Influential investors should take the time to evaluate and even solicit opposing ideas.

While behavioral finance can help explain instances of “irrational exuberance” at the individual and group levels, its primary benefit is to help identify how psychology affects financial decision-making. The challenge, Shefrin says, is to recognize the psychological traps people use when making investment decisions so they do not derail the actual investment process.

 

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