Psychology Problems Advice Info

Over the last two decades, investor behavior has been put under the microscope for identifying the factors that challenge the efficiency of capital markets. Although, investor behavior was originally assumed to be rational, in the process it has been discovered that investors are affected by a series of psychological biases in their buy-and-sell decisions. The evolution of Behavioral Finance led researchers to examine the psychological traits of investors and how they influence their investment decision-making strategies in stock selection. In this context, Behavioral Finance evolved to investigate the factors that contribute to capital market efficiency and explain portfolio allocations that are inconsistent with the paradigm of the expected utility of wealth.

Assisted of theories from the areas of Psychology and Sociology, Behavioral Finance focused on identifying portfolio anomalies that derive from various psychological traits of investors. Contrary to what Finance Theory asserts, investors make their investment decisions in a real-world setting that encompasses the cognitive elements of their character. To that end, Behavioral Finance asserts that profit maximization and finance models are useful tools for investment decision-making as long as they consider the financial market implications from psychological decision processes.

Scientific experimentation provides adequate evidence of irrational investor behavior as a result of psychological biases in buy-and-sell decisions.

Evidence for irrational investor behavior – Example 1

An investor has $1,000 and needs to choose between the following two options: (1) Gaining $1,000 and then losing $500 or (2) Gaining $500.

In Traditional Finance, the possibility of gaining $500 is equal to the possibility of gaining $1,000 and then losing $500 as, in both options, the net effect is a gain of $500.

In Behavioral Finance, investors prefer a single gain of $500 than gaining $1,000 and then losing $500. The implication is that investors are willing to resolve for a reasonable level of gains and abandon the chance of earning more and at the same time they are willing to engage in risk-seeking behaviors aiming to limit their losses. In other words, the weight of losses creates a greater feeling of distress compared to the enjoyment generated by equivalent amount of gains.

This is explained by the fact that investors are generally risk averse. This means that if they have to choose between two assets with the same value, they prefer the asset with the lower risk. Risk aversion causes investors to react nervously to market changes. For instance, if the markets decline for over a week, investors fear that these drops signify further, sharper declines and they do not identify these declines as an opportunity to buy good stocks at lower prices. Investors prefer to enter the options markets and buy defensive puts instead of increasing their stock positions in a declining market, while taking advantage of low stock prices. Therefore, risk aversion, and consequently, fear is the number one psychological factor that influences investment decision-making.

Evidence for irrational investor behavior – Example 2

A group of investors was asked the following question: “If you faced the prospect of gaining a 100% chance of winning $3,000 and an 80% chance of wining $4,000, what would you choose?”

In majority, investors replied that they would prefer option A, meaning a 100% chance to win $3,000, although, according to the probability theory, the second option would provide them with a higher value on a long-term horizon ($4,000 x 80% = $3,200). However, most investors are annoyed by the 20% probability of getting nothing if they choose option B, and therefore they choose the guaranteed option A, even if they get a lower return.

Stock market theorists and psychologists suggest that when investors face the risk of prospective losses, they prefer the safety of guaranteed returns. This becomes clearer when the above group of investors was asked ““If you faced the prospect of a 100% chance of losing $3,000 and an 80% chance of wining $4,000 and a 20% of winning nothing, what would you choose?” In majority, investors have chosen option B because they preferred to give themselves a chance of 80% to win something, even with a probability of 20% to win nothing, than going 100% on losing everything. Therefore, another psychological factor that influences investment decision-making is that investors are risk averse when they have alternative options, but they are willing to take a bad risk when their fear for losses exceeds their risk aversion.

Overall, in Traditional Finance, investment decisions are subject to the net effect of the gains and losses incurred in the portfolio. Investors calculate the net effect by considering utility in each possible option and by constructing a weighted average based on the probability of each option. Therefore, based on the Expected Utility Theory (EUT), expected utility depends on different ranges of probability.

On the other hand, Behavioral Finance suggests that investors tend to hold on to under-performing stocks and sell over-performing stocks. Typically being risk adverse, investors consider that selling quickly the shares that have over-performed they protect their portfolio for the losses incurred by the shares that have under-performed. This disposition effect is explained by Prospect Theory that holds that investors base their investment decisions more on perceived gains rather than perceived losses. Consequently, losses have a stronger emotional impact than an equivalent amount of gains.

Besides, investors are often over-confident considering that they have all the necessary information to buy or sell a stock. In the context of efficient markets, investors are provided with accurate information and buy securities at efficient prices. In other words, not only stocks are traded at their fair value protecting investors from buying undervalued stocks or selling overvalued stocks, but also investors receive a rate of return that implicitly includes the perceived risk of the stock. However, investors under the safety of information efficiency investors are able to consistently buy and sell quickly enough to benefit from the information. This is the only way they can beat the market and the only way to get over-confident. Otherwise, market is unbeatable for an extended period of time and investors should just index, or buy and hold all the stocks in the market.

Conclusively, investor behavior is irrational as a result of psychological biases. Risk aversion, fear, or over-confidence, are the major psychological factors that can make an investment strategy make or break. With the help of Behavioral Finance, stock market theorists, finance managers, equity analysts and anyone involved in stock market analysis can identify how investors evaluate certain events and react in stock market changes. Also, investors can understand and evaluate market changes gaining a broader understanding of the factors that drive their behavior.