Psychological Biases of Investors

Abstract We review the field of behavioral finance as it relates to investors. Specifically, we examine common investment mistakes caused by an investor's cognitive and emotional weaknesses and group these mistakes into two categories: how investors think and how investors feel. Although most recent research deals with these psychological influences in investor decision-making, we also discuss social factors that affect financial decisions. We suggest five steps that investors can take to help overcome common investor mistakes. Finally, we present some thoughts on further behavioral research involving investors. © 2002 Academy of Financial Services. All rights reserved. JEL Classification: D10; G10 Keywords: Behavioral finance; Investor psychology 1. Introduction Although cognitive and emotional weaknesses affect all people, traditional or standard finance ignores these biases because it assumes that people always behave rationally (Statman, 1995). One of the central propositions of financial theory for the past three decades is that markets are efficient. Efficiency means that the price of each security coincides with fundamental value, even if some investors commit errors due to biases or frame dependence (e.g., how they view a decision problem). Although a case can be made against efficient markets, existing evidence does not generally support the ability of investors to consistently produce excess returns. That is, although market inefficiencies may exist, they are generally not easy to exploit. If stock prices are efficient and transaction costs and taxes are ignored, investors should not do serious harm to their wealth if they trade frequently or follow specific investing strategies. Therefore, traditional finance has developed in a normative manner. That is, traditional finance concerns the rational solution to the decision problem by developing ideas and financial tools for how investors should behave. As a consequence, traditional finance typically does not focus on actual investor behavior and its consequences. Alternatively, behavioral finance examines how real people actually behave in a financial setting and is, therefore, descriptive. Behavioral finance is what Thaler (1993) calls "openminded finance" because it entertains the possibility that some agents in the economy behave less than fully rationally some of the time. At the most general level, behavioral finance is the application of psychology to financial behavior. Proponents of behavioral finance contend that people may not always be "rational," but they are always "human. " Thus, behavioral finance exposes the irrationality of investors in general and shows human fallibility in competitive markets. Not surprisingly, skeptics such as Fama (1998) and many others claim to be not persuaded by the mounting evidence about behavioral finance. For example, they point out that long-term anomalies, which challenge the efficient market hypothesis, are sensitive to methodology. Although departures from rationality are sometimes random, they are often systematic. As Shleifer (2000, p. 10) notes, "Investors' deviations from the maxims of economic rationality turn out to be highly pervasive and systematic. " For example, psychologists have known for a long time that people often act in a seemingly irrational manner and make predicable errors when forecasting. Behavioral finance relaxes the usual assumptions of traditional finance by incorporating observable, systematic, and very human departures from rationality into models of financial markets and behavior. By combining psychology and finance, researchers hope to better explain certain features of securities markets and investor behavior that appear irrational. Why does it matter if investors behave differently than traditional finance says they should? Shefrin (2000) notes that investors are prone to committing specific errors of which some are minor and others are fatal. …