Psychology of Individual Investors

Researchers have demonstrated that people are mostly not rational decision makers about financial issues. They are irrational in systematic ways that can be accounted for in investment decision making as well as aggregate market behavior. There now is a vast body of research validating those rather strong claims. This work was recently acknowledged by the award in 2002 of the Nobel prize in Economics to Prof. Daniel Kahneman of Princeton University, who developed the fundamental theory with his late colleague Amos Tversky in the late 1970s[ 1 ], [ 2 ].

Understanding these phenomena requires understanding both the psychology of investors and the nature of market risk. The biases and errors explained here focus on the psychological distortions most directly afflicting investors decisions. The current discussion is by no means comprehensive. It just points to some of the main biases we have and can manage with discipline. We draw information from papers and books about Behavior Finance (BF), with references listed at the bottom.

Compensating for these mental errors may well boost your investing performance. Compensation for these emotional and cognitive biases always involves striving for objectivity. In turn, this process entails self observation and interactions with others who will give you honest feedback. Further, the most perfect source of objective data about your trading is your own trading record. It’s useful to go over every trade and recall the reason you entered and/or exited the position. This is an illuminating process!

“I’d rather be right than rich”

“Regret” is the painful emotion associated with acknowledging you made a bad decision. “Pride” is the pleasure of acknowledging a decision turned out well. The disposition effect notes that most humans are disposed to avoid regret and to seek pride. This drive to be “right” powerfully affects investment decisions (not to mention most aspects of life).

Holding losses too long: “I rode it all the way down!”

The strong aversion to regret is typically manifested in the habit of many stock investors of holding their losing investments too long. Their fantasy is that they can eventually recover their losses. As long as these investors don’t sell their stock, they need not acknowledge a loss and experience regret. They can continue to take comfort in the fact that they have only a “paper loss.”

The investor’s inaction reinforces itself when action (selling to limit losses, in this case) may be in his best interests. That’s because people have a tendency to regret action more than non-action. They seem to believe the odds are high that action will lead to regret. This mechanism is why so many people rode stocks from say $120 to $6 during the late 1990s bubble. They took comfort during the plunge by avoiding the regret of selling.

Leaving money on the table: Selling winners too soon

Selling winners too soon is a form of pride-seeking. In any given time period, research shows individual investors are more likely to sell stocks that have gone up in value relative to their purchase price, as compared to stocks that have lost value. This urge to sell winners even ignores the tax incentive to hold (in an after-tax account) to avoid a taxable event.

The Reality Distortion Field: Dependence on Frame of Reference

All decision making occurs within a “frame of reference”, even if you don’t explicitly know it. Equivalent terms for frame of reference are “context”, “set of assumptions”, “worldview”, “mindset”, “orientation”, and “bias set”. The frame of reference may not be completely conscious to the decision maker. This lack of awareness is where it gets very interesting and significant.

Tversky and Kahneman revealed experimentally the importance of frame of reference in decision-making. Their research showed that people tend to become:

  • More risk-averse when they are facing the prospect of a gain; 
  • More risk-seeking when they are facing the prospect of a loss.

In other words, people act differently when they view their prospects from different frames of reference.

Experiments have also shown that when asked to choose among two alternatives, people will reach opposite decisions based solely upon which frame of reference they have adopted. Further, the research has shown that frame of reference can induce people to choose the alternative with the lower financial payoff. So becoming aware of your frame of reference can have a big boost to your performance.

Example of Frame of Reference effect

Following the insights in [ 1 ], consider these two frames of reference and associated decision:

Frame 1 (“Gains”)
Subjects are each given a virtual $1000 account. Then they are asked to decide between:

(a) 50 percent chance to gain $1,000 and a 50 percent chance to gain nothing and
(b) Sure gain of $500.

Frame 2 (“Losses”)
Subjects are each given a virtual $2000 account and must decide between:

(a) 50 percent chance to lose $1,000 and a 50 percent chance to lose nothing and (b) Sure loss of $500.

Before considering the results, what would you do?

Empirical results
In Frame 1 (“Gains”), 84 percent chose (b). In Frame 2 (“Losses”), 69 percent chose (a).


Interpretation

The rationally computed payoffs within each Frame are:

Frame 1 Payoff=$1000 + 0.5* $1000 + 0.5*$0 = $1500
Frame 2 Payoff=$2000 + 0.5* (-$1000) + 0.5*$0 = $1500

Thus, in each frame of reference, the payoffs are identical. The key insight here is that purely rational analysis implies if the majority chose the sure payoff of $1,500 by picking (b) in Frame 1, the majority therefore ought to take the same sure $1,500 payout in answer (b) in Frame 2. Instead, the majority is willing to take risk to try to avoid a sure loss when the problem is framed in terms of losses.

People will take more risk to avoid loss than to make an equivalent gain.

Memory and investment decisions

Boiling the frog.

Human perception of pain is constructed such that in a painful experience, the peak pain level and the pain at end of the experience determine the memory, which in turn depends on the average of the peak and ending pain levels. Thus, we can actually prefer to repeat a longer painful episode compared to a shorter one. This can occur when, for example, the average of the two pains is lower for the longer experience. Our memories clearly are subjective about painful experiences. This explains how investors make decisions based on faulty perceptions of price patterns.

In other words, the perception of pain or pleasure from a price change is amplified in intensity if the changes occur rapidly as opposed to gradually. Thus, people will “ride the stock down” when its price gradually drops, but sell quickly after a single, sharp price drop.

The frog will boil to death in water with temperature slowly rising to a boil, but will leap out if dropped into a vat of boiling water!

Group Think

Cognitive dissonance is the condition in which one is uncomfortable because the clear evidence directly contradicts one’s beliefs. Such pain can cause several kinds of odd behaviors. For example, many people discussing investments, and having varying degrees of cognitive dissonance, will all try to focus only on good data and ignore the bad. Thus, they will converge to a generally unrealistic positive picture. Then they will have further cognitive dissonance that will require them to believe their own investments are better than they really were. This process causes “Group Think”. This mechanism can lead to an investor buying a stock because it is rising fast, which is proof the “herd” likes it. This may well cause “momentum” plays.

In law, testimony of one witness is not permitted in presence of other witnesses to avoid the Group Think effect.


[ 1 ] Kahneman, Daniel, and Amos Tversky (1974), “Judgment Under Uncertainty: Heuristics and Biases”, Science 185, 1124-31
[ 2 ] Kahneman, Daniel, and Amos Tversky (1979), “Prospect Theory: An Analysis of Decision Under Risk”, Econometrica 47, 263-91.

 

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