💰Psychology of Economic Decision-Making Unit 9 – Investor Psychology in Behavioral Finance

Key Concepts and Theories

• Behavioral finance combines psychological theory with conventional economics to provide explanations for why people make irrational financial decisions
• Prospect theory suggests people make decisions based on the potential value of losses and gains rather than the final outcome (Kahneman and Tversky)
• Mental accounting refers to the tendency for people to separate their money into separate accounts based on subjective criteria (such as the source or intended use of the funds)
  • Leads to irrational spending and investment behaviors
• Anchoring involves relying too heavily on an initial piece of information when making decisions
  • Investors may anchor to the price at which they purchased a stock and resist selling it even if new information suggests the stock is overvalued
• Overconfidence bias causes investors to overestimate their skills, knowledge, and ability to predict market movements
• Confirmation bias leads investors to seek out information that confirms their existing beliefs while ignoring contrary information
• Herding behavior occurs when investors follow the actions of a larger group, even if they disagree with the group's decisions

Cognitive Biases in Investing

• Representativeness bias involves making judgments based on stereotypes rather than objective analysis
  • Investors may assume a company with strong past performance will continue to do well, ignoring other relevant factors
• Availability bias causes investors to overweight recent events or information that is readily available to them
• Hindsight bias leads investors to believe past events were more predictable than they actually were
  • Can cause overconfidence in future investment decisions
• Illusion of control bias occurs when investors overestimate their ability to control or influence investment outcomes
• Self-attribution bias causes investors to attribute successful outcomes to their own skill while blaming failures on external factors
• Conservatism bias leads investors to insufficiently incorporate new information into their existing beliefs
  • Results in slow updating of opinions in the face of new evidence
• Disposition effect refers to the tendency for investors to sell winning investments too soon while holding onto losing investments for too long

Emotional Factors Influencing Investment Decisions

• Fear can cause investors to sell stocks at low prices during market downturns, locking in losses
• Greed leads investors to chase high returns, often by taking on excessive risk
• Regret aversion causes investors to hold onto losing investments to avoid admitting they made a mistake
  • Also leads to herding behavior as investors follow others to avoid the pain of making a wrong decision alone
• Overconfidence leads to excessive trading, under-diversification, and risk-taking
• Optimism bias causes investors to overestimate the likelihood of positive outcomes while underestimating risks
• Loss aversion refers to the tendency for people to prefer avoiding losses to acquiring equivalent gains (Prospect Theory)
  • Leads investors to hold onto losing investments in the hope of breaking even
• Endowment effect causes investors to value an asset more highly simply because they own it

Heuristics and Decision-Making Shortcuts

• Affect heuristic involves basing decisions on emotional responses rather than objective analysis
  • Investors may choose investments that "feel good" without thoroughly evaluating risks and potential returns
• Representativeness heuristic leads investors to make decisions based on an investment's similarity to a known class or category
  • Can cause investors to overlook important differences between investments
• Availability heuristic causes investors to overweight information that comes to mind easily, such as recent news or personal experiences
• Anchoring and adjustment heuristic involves fixating on an initial value and insufficiently adjusting away from it
  • Investors may anchor to a stock's 52-week high and use that as a basis for estimating its future potential
• Familiarity heuristic leads investors to prefer investments they are familiar with, such as domestic over international stocks
• Mental accounting causes investors to treat money differently based on its source or intended use
  • Leads to irrational spending and investment decisions
• Overconfidence leads investors to rely too heavily on their own knowledge and intuitions, resulting in under-diversification and excessive risk-taking

Market Anomalies and Investor Behavior

• January effect refers to the tendency for stock prices to rise in January, particularly among small-cap stocks
  • Possible explanations include year-end tax-loss selling and investors putting year-end bonuses to work in the market
• Disposition effect causes investors to sell winning investments too soon while holding onto losing investments for too long
• Momentum effect refers to the tendency for stocks that have performed well in the recent past to continue outperforming in the near future
  • Can lead to herd behavior as investors chase past returns
• Overreaction and underreaction to news events can cause stock prices to diverge from their fundamental values
  • Overreaction often occurs in response to highly salient, attention-grabbing news
• Small-cap effect refers to the tendency for small-capitalization stocks to outperform large-cap stocks over long time horizons
  • Behavioral explanations include neglect by institutional investors and higher risk perceptions among individual investors
• Value effect refers to the outperformance of stocks with low price-to-earnings or price-to-book ratios
  • May reflect investor overreaction to past poor performance or excessive pessimism about future prospects
• Calendar anomalies, such as the Monday effect or turn-of-the-month effect, demonstrate irrational patterns in stock returns

Risk Perception and Tolerance

• Risk perception is highly subjective and influenced by cognitive biases and emotions
• Availability bias leads investors to overestimate the probability of salient, easily recalled events (such as a recent market crash)
• Overconfidence causes investors to underestimate risks and overestimate their ability to control outcomes
• Illusion of control bias leads investors to believe they can manage risks through active trading or market timing
  • Often results in taking on excessive risk without commensurate returns
• Prospect theory suggests people are risk-averse when facing potential gains but risk-seeking when facing potential losses
  • Leads to irrational behaviors such as holding onto losing investments too long
• Framing effect occurs when people's risk preferences change based on how a situation is presented
  • Investors may reject a 20% chance of losing money but accept an 80% chance of making money, even though the two are mathematically equivalent
• Familiarity bias causes investors to perceive familiar investments as less risky than unfamiliar ones
  • Leads to under-diversification and a false sense of security
• Risk tolerance questionnaires used by financial advisors are often flawed and fail to capture true risk preferences

Social Influences on Investment Choices

• Herding behavior occurs when investors follow the crowd, even if they privately disagree with the consensus
  • Driven by factors such as fear of missing out, desire to conform, and belief that others have superior information
• Social proof bias leads investors to view an investment as attractive simply because many others are buying it
• Familiarity bias causes investors to prefer investments that are well-known or frequently discussed in their social circles
  • Leads to under-diversification and excessive risk concentration
• Home bias refers to the tendency for investors to overweight domestic stocks in their portfolios
  • Reflects familiarity bias and overconfidence in one's ability to assess local investments
• Mere exposure effect causes investors to develop a preference for investments simply because they are frequently encountered
  • Advertisers and media coverage can exploit this bias to attract investor attention
• Ingroup bias leads investors to favor investments associated with groups they identify with (such as their employer, alma mater, or local community)
• Social comparisons and relative wealth concerns can drive irrational investment behaviors
  • Investors may take on excessive risk in an attempt to "keep up with the Joneses"
• Advisor persuasion and sales tactics can exploit investors' behavioral biases and emotional vulnerabilities

Practical Applications and Investment Strategies

• Understand and acknowledge your own behavioral biases and emotional tendencies
  • Keep an investment journal to track your decisions and identify patterns of irrational behavior
• Develop a long-term investment plan and stick to it, regardless of short-term market fluctuations
  • Automate your investments through strategies like dollar-cost averaging to reduce the impact of emotions on your decisions
• Diversify your portfolio across multiple asset classes, geographical regions, and sectors
  • Avoid the temptation to concentrate your holdings in a small number of "favorite" stocks or sectors
• Rebalance your portfolio periodically to maintain your target asset allocation
  • Resist the urge to chase past performance or make drastic changes based on recent market events
• Focus on factors within your control, such as costs, tax efficiency, and savings rate
  • Minimize expenses by using low-cost index funds and tax-advantaged accounts
• Avoid checking your portfolio too frequently, as this can lead to overreaction and impulsive decision-making
  • Set a schedule for reviewing your investments (such as quarterly) and stick to it
• Seek out objective, data-driven analysis and ignore sensationalized media coverage and "hot tips"
  • Be especially wary of investments that seem too good to be true or that everyone else is buying
• Consider working with a fee-only financial advisor who can provide unbiased guidance and help you stay disciplined
  • Look for an advisor who takes a comprehensive, long-term approach rather than focusing on short-term performance or "beating the market"