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Psychology & Behavioral Finance

Gary Karz, CFA (email)
Host of InvestorHome
Founder, Proficient Investment Management, LLC

     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 judgment have been documented in academic studies. The late Peter L. Bernstein wrote in Against The Gods 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. LSV Asset Management, Fuller & Thaler Asset Management, David Dreman and Ken Fisher are some money managers that invest based on behavioral finance theories.

     Among the many books with discussions about Behavioral Finance are What Investors Really Want from Meir Statman, Predictably Irrational (2009) by Dan Ariely, The Myth of the Rational Market (2009) by Justin Fox, Capital Ideas Evolving (2009) by Peter Bernstein, Your Money & Your Brain (2008) by Jason Zweig, Behavioral Finance and Wealth Management (2006) by Michael M. Pompian and Why Smart People Make Big Money Mistakes And How To Correct Them (2000) by Gary Belsky and Thomas Gilovich. Common examples of irrational behavior (some 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 judgment. 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? in the October 1998 issue of the Journal of Finance.

     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.

     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).

     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 Why Do Investors Trade Too Much? from Brad Barber and Terrance Odean.

     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.

     See also

"In summary, people trade for both cognitive and emotional reasons. They trade because they think they have information when they have nothing but noise, and they trade because trading can bring the joy of pride. Trading brings pride when decisions turn out well, but it brings regret when decisions do not turn out well. Investors try to avoid the pain of regret by avoiding the realization of losses, employing investment advisors as scapegoats, and avoiding stocks of companies with low reputations."

Meir Statman ("Investor Psychology and Market Inefficiencies," Equity Markets and Valuation Methods, The Institute of Chartered Financial Analysts, 1988)

I do not dismiss the behavioral aspects that Joe [Lakonishok] and others have argued which is to say that there are all kinds of reasons from cognitive psychology that suggest that a real dog is likely to get underpriced, and maybe people know it's underpriced and they still don't want to hold it.
     William Sharpe in Investment Gurus by Peter J. Tanous

"Markets invariably move to undervalued and overvalued extremes because human nature falls victim to greed and/or fear."
     William Gross in Everything You've Heard About Investing is Wrong!

The human mind craves clairvoyance, but anyone's ability to see the future is extremely limited.
     Frederick L. Muller, CFA

"Graham's conviction rested on certain assumptions. First, he believed that the market frequently mispriced stocks. This mispricing was most often caused by human emotions of fear and greed. At the height of optimism, greed moved stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moved prices below intrinsic value, creating an undervalued market."
     Robert G. Hagstrom, The Warren Buffett Way

"Recently we worked on a project that involved users rating their experience with a computer. When we had the computer the users had worked with ask for an evaluation of its performance, the responses tended to be positive. But when we had a second computer ask the same people to evaluate their encounters with the first machine, the people were significantly more critical. Their reluctance to criticize the first computer 'face to face' suggested they didn't want to hurt its feelings, even though they knew it was only a machine."
     Bill Gates in The Road Ahead

"Only two things are infinite, the universe and human stupidity, and I'm not sure about the former."
     Albert Einstein


1. Prospect theory
Kahneman and Tversky presented groups of subjects with a number of problems. One group of subjects was presented with this problem.
1. In addition to whatever you own, you have been given $1,000. You are now asked to choose between:
A. A sure gain of $500
B. A 50% change to gain $1,000 and a 50% chance to gain nothing.

Another group of subjects was presented with another problem.
2. In addition to whatever you own, you have been given $2,000. You are now asked to choose between:
A. A sure loss of $500
B. A 50% chance to lose $1,000 and a 50% chance to lose nothing.

In the first group 84% chose A. In the second group 69% chose B. The two problems are identical in terms of net cash to the subject, however the phrasing of the question causes the problems to be interpreted differently.

Source: Daniel Kahneman and Amos Tversky, Prospect Theory: An Analysis of Decision Making Under Risk, Econometrica, 1979.

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