Behavioral Finance: To Avoid Irrational Decisions

Northeastern University

Abstract
Behavioral finance is defined as the study of the influence of psychology on the behavior of
financial practitioners and its subsequent effect on markets. Behavioral finance is based on the
notion that a significant number of investors make financial decisions that are subject to irrational
behavioral biases. An individuals behavioral biases can lead to a significant loss of wealth for the
individual. Behavioral biases made by investors affect the market as well by causing inefficient
allocation of capital and diminishing the value of the entire market. This paper aims to describe
various irrational investment behaviors and propose methods that decrease the rate of irrational
investments by encouraging people to allocate more money into less risky assets. In order to reduce
the frequency of irrational investments decisions, financial institutions and governments should work
together to investigate and prevent irrational investments. Ultimately, the government should
regulate investors, but current investment product capabilities are limited and underutilized.

Behavioral finance
Behavioral finance studies the effect of human behavior on stock market abnormalities.
People cannot always be trusted to make rational decisions, especially when their own money is
involved. Those with previous investing experience tend to make more logical decisions with their
money when investing, while the average person may be tempted to make a fatal, spur of the
moment decision with their money.

In the late nineteenth century, scholars were intrigued to explore the connection between
psychology and the movement of the stock market, which lead to experiments on human behavior. In
1912, Selden wrote the Psychology of the Stock Market, which first indicated that the movement of
prices on the exchange are, to a large degree, dependent on the mental attitude of investors.
Following in Seldens footsteps were numbers of scholars who conducted research on how peoples
cognition affects their investing. In 1964, Pratt combined the utility functions with investors risk
preference, creating new methods to evaluate investment portfolios. Over the years, researchers
developed technical analysis to predict the return on the stock market and found the amount of
abnormal return was not addressed by elements used for prediction. In 1985, Werner F. M. De
Bondt and Richard Thaler published Does the Stock Market Overreact?, in which the concept of
behavioral finance was used to explain how investors reactions to unexpected news influences the
stock market.
Humans irrational behavior was studied by psychologists Daniel Kahneman and Amos
Tversky in a simple coin toss experiment. In considering tosses of a coin for heads or tails, people
picked the sequence of H-H-T-H-T-T-H as more likely to appear than H-H-H-T-T-T, which appears
less random. People expect that an example that looks more randomized is more likely, even though
the examples proposed are equally as likely to occur statistically.
Over the years, psychologists and financial experts have discovered behavioral biases that
affect peoples investment choices and tend to lead to poor investment decisions. When investors
only pay attention to selective information that supports their investment strategies, now coined
confirmation bias, they avoid critical reports that provide contradictory evidence and make

investment choices based off of their biased view of the market. The long-short bias refers to
investors who always bet on the long shot stock because it promises a very high return. Since these
stocks tend to fail more often than not, investors lose their money when betting on these long shot
stocks. Investors do not rely on rational facts, but tend to base their decisions on the price at which
the stock was purchased, called anchoring bias. Investors lose their money and then proceed to take
greater risks to make up for it. One of the most extreme examples is former derivatives broker,
Nicholas Leeson. Leeson spent years making fraudulent investments to make up for a former loss,
which eventually led to the collapse of Britains oldest merchant bank and his subsequent
imprisonment. Many investors also sell their stock too quickly when the prices starts to increase and
act surprised when they sustain a loss.
Loss aversion refers to a persons preference to avoid loss more than enjoying the pleasure of
winning. A perfect example is when the lottery jackpot gets so large, it starts making headlines. The
odds of a person winning do not increase with the size of the jackpot and the risk of losing money is
extremely high, but more people start buying lottery tickets because they feel that they are missing
out on a chance to win big. Even though the odds are extremely low, they are still above zero, and
peoples brains want to avoid any type of loss.
Investors mistakenly believe that their knowledge of the stock market and their previous
experience in finance gives them an advantage over others when investing. Although investors do
have an advantage over the average person dabbling in stocks, they still are just as likely to make the
same mistakes as an average person due to proven psychological phenomenon. An investor's belief

that they know better than anyone else is called overconfidence, and can lead to faulty investment
choices.
A persons culture affects how they invest. In the US, investors are more likely to take risks
and bet on extremely unlikely events believing it will lead to a positive outcome. In 2014, when the
Ebola epidemic was threatening to spread to the US, pharmaceutical companies raced to develop
vaccines to prevent the further spreading of the disease. The stock prices of those companies surged
incredibly as investors bet on the success of those medicines. One company called Lakeland
Industries had its stock price rise from $7 to $27 within two weeks, and dropped back down to $10
within a month. Investors tend to lose money when chasing after riskier assets, as shown in abnormal
situations like the Ebola epidemic. According to the study of Professor Thorsten Hens of the Swiss
Finance Institute, European investors are more patient and have a tendency towards lower risk assets.
European investors do not bet on extreme events in order to gain huge returns, but put their their
money into wealth management companies or invest in stable stocks.
The aggregate effects of irrational investment can boost or undermine the financial market,
causing positive or negative bubbles. In the world of finance and economics, the price of stocks or
goods should be equal to their intrinsic value. If investors purchase the shares whose price is already
in excess of its intrinsic value, the market moves towards a positive bubble, and vice versa. Both
actions cause inefficient allocation of capital. Since the entire market operates based on a smooth
flow of capital, misallocation will ultimately lead a small number of companies controlling an
excessive amount of money, while the remainder of companies lack the capital to grow their

business. In order to prevent this bubble effect, investors must be encouraged to make rational
investment decisions, which will lead to an increase in the efficiency of the market.

Solution
Before irrational investment choices can be eradicated, the belief that less risky assets deliver
less return must be eliminated. The government should encourage people to invest rationally. Even
though the government cannot conduct regulations to control peoples investing strategies, they
should take the majority of the responsibility in guiding investors and financial institutions towards a
more efficient market. The government should inspire people to put an increasing amount of money
in their retirement account. This could be made possible by initiating a program that requires
employers to contribute to employees retirement savings. To ensure that people do not dip into these
savings until retirement, regulations should be put in place that do not let the individual access the
money until their retirement.
People cannot be taught to stop being irrational, but the government can cooperate with
financial institutions and develop money management programs to educate and provide
professional advice to investors. Financial institutions including banks, mutual funds and asset
management companies should use their professional knowledge to convince individual investors to
put a larger amount of money in their companies in order to avoid individual exposure. Investment
education should be given a higher priority in schools. Public schools could start offering classes on
investing and money management that could prepare students for future endeavors. A generation that
is well educated on investing techniques and strategies could create a healthier future economy.

Information is critical to making investment decisions, but overwhelming amounts of

information cannot be processed, which leads to poor investment choices. The best way to release
relevant and important information to each individual is through media companies such as
Bloomberg, Yahoo Finance and Money Start. These media outlets can push news or earning reports
to investors in a timely manner and according to each investors portfolio, so each individual could
focus more on the information that really affects their investing portfolio. These companies can also
develop mobile applications that could allow investors to access information and their portfolio at
any time and place. That way, investors do not have to wait until the market has already moved
forward.
There is no definitive way to eliminate irrational behavior since all humans are irrational and
will, from time to time, make emotionally driven decisions. Fortunately, all people behave
irrationally in a similar way, and scientists have been able to distinguish a behavioral pattern. Firstly,
there is a pattern to the amount of overconfidence an individual feels that varies by gender and
marital status. Single men have the highest levels of overconfidence, followed by married men,
married women and lastly single women. Studies have shown that single women tend to avoid
changing their investment choices the most and consequently experience the highest returns and
lowest losses. Knowing this can help financial professionals to advise their clients and encourage
individuals to adhere to their original investment options.
People tend to invest in stocks that are familiar to them. This is best exemplified by people
overinvesting in their employers stocks, which can lead to dire consequences, as exemplified Enron.
When Enron went bankrupt, not only did people lose their jobs, but a large share of their 401Ks as

well. The collapse of such a large corporation affects the stock market, and preventative measures
should be taken to avoid this from occurring in the future. This financial disaster could have been
avoided had these employees been encouraged to diversify their portfolio and investigate some new
stock options. In an ideal world, regulations would be put in place by the government to limit the
amount an individual could invest in one company. Such regulations would also mean the end of a
free market; so instead, it is the responsibility of investment advisors to aid their clients in making
smart decisions with their money. Investors must be careful not to take this to extreme measures,
because naive diversification could have just as dire consequences.
Behavioral finance came about as a result of psychologists and economists alike growing
interested in the irrational behaviors of investors and humans in general. Even the most experienced
investors make fatal mistakes that lead to countless dollars lost due to simple irrational behavioral
patterns that have been uncovered by psychologists. Educating the public about these irrational
behaviors through government programs, classes in schools and news channels can help investors of
the present day and future alike avoid these mistakes and keep the market healthy. Additionally, the
media can help individuals understand the market by disclosing valid information. Financial
institutions should encourage investors to seek professional advices regularly.

Reflective Note:
This project offers a brief overview of behavioral finance and a description of various irrational
behaviors that lead to poor investment choices. As finance and psychology majors, we found a topic
that was the perfect marriage of both of our studies, since both psychologists and economists are
involved in the study of this topic. Behavioral finance is a relatively recent theory, and while there is

plenty of scientific research that has been conducted, it is still not a universally accepted concept.
Fortunately, there has been plenty of effort put forth by economists and psychologists to study and
understand the behavior of investors and finding answers as to why humans make irrational
decisions.
Working virtually always poses a challenge, but we were able to communicate through email
and Google docs alike. Using a Google doc made it easy to collaborate on the paper while
maintaining one style of writing. We were able to track the edits made and provide suggestions to
improve our paper. We made an effort to write in a simple style and not use too many colloquial
phrases or terms.

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