Psychological

biases and
decision making in
financePitfalls to
avoid
Dr Mirela Malin
Griffith Business School, Griffith University

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Recent developments in the world of financial markets have highlighted the contrasts
between the findings of new research and classical finance theory. Traditional finance
attempts to model the economic behaviour of individuals, markets and institutions under
extreme simplifications of human behaviourin particular, that investors always act
rationally. This approach creates a market where individuals and institutions interact
together to set prices and transfer financial instruments in a predictable setting and manner
that operates without great difficulties or conflicts for all participants. It assumes that
investors will make correct decisions in an environment that has complete information
transparency and no information asymmetry. This theory implies that the price of an asset
will be set by aggregate supply and demand and any unreasonable individual decisions
influencing the pricing of assets will cancel out and be absorbed by the efficient market
which in the end displays a market price that reflects the true value of assets.
As an increasing number of events in the world of financial markets cannot be explained
with reference to the efficient markets concept, the discipline of finance is taking a turn
towards understanding the markets with the aid of the behavioural insights of psychology.
The outcome is the field of behavioural finance, which has emerged in an attempt to better
understand and explain how emotions and cognitive errors influence investors in the
decision-making process. Hirshleifer (2001) classifies the more important psychological
biases that investors are subject to into: heuristic simplifications, self-deception, and
emotional loss of control. The next section discusses in more detail some of these biases,
and highlights the pitfalls investors and managers fall into when logic is replaced with
emotional decision-makingthe default option of our brain. They are also summarised in a
table at the end of the paper.
One of the best documented of all psychological errors is the tendency to be overoptimistic. Excessive optimism occurs when people overestimate the frequency of
favourable outcomes and underestimate the frequency of unfavourable outcomes (Shefrin,
2007). For example, individuals underrate the chance of getting divorced, being in a car
accident of suffering from a major illness, while they expect to live longer than others,
overestimate their success in the work force and believe that their children are especially
talented (Sharot, 2011). Optimism is important for financial intermediation; it can affect
corporate financial and accounting decisions; it can inflate security prices in the presence of
short-sale constraints; and it can lead to over- and under reaction in stock returns. Puri and
Robinson (2007) conclude that more optimistic people work harder, expect to retire later,
invest more in individual stocks, and save more, however, extreme optimists display
financial habits and behaviour that are generally not considered prudent. In a financial

decision-making situation, excessive optimism can lead to unsuccessful consequences. For

example a manager displaying unwarranted optimism might delay or avoid cutting costs
during a business recession, decision that will lead to lower future profits for the firm
(Shefrin, 2007).
Excessive optimism is similar to overconfidence however theyre not the same. One can be
pessimistic, yet confident about it. Thus, overconfidence happens when people are
convinced that they are better than they actually are. Psychologists have shown that
overconfidence causes people to overestimate their knowledge, underestimate risks, and
exaggerate their ability to control events. Overconfidence occurs greatly in investment
decision-making because security selection is a difficult task, thus making it the type of
activity at which people exhibit the greatest overconfidence. The literature shows that the
more ambiguous and difficult the question/task is, the greater the degree of
overconfidence (Griffin and Tversky, 1992) and professional investorsthe so-called
expertsare more prone to overconfidence than novices (Einhorn (1980), Yates (1990)).
Furthermore, Barber and Odean (2001) argue that overconfident investors overestimate
the precision of their information and thereby expect greater returns from trading. Their
study finds that men are more overconfident than women showing that men trade more
than women and achieve lower returns, this difference more evident between single men
and single women. In a similar vein, Malmendier and Tate (2005) find that overconfident
managers overvalue the returns to their investment projects and perceive external funds as
too costly. Consequently, they overinvest when the firm has ample cash, but restrain
investment when projects require external funds.
Another psychological predisposition toward error is the confirmation bias, which according
to Montier (2002) is the technical name for people's desire to find information that agrees
with their existing view. People attach too much importance to information that supports
their view while ignoring anything that contradicts those views (Shefrin, 2007). Turning a
blind eye to a certain fact just because it disagrees with a prior belief can cause some
investors to stick to unsuccessful trading strategies, causing mispricing to persist in the
market (Forsythe et al., 1992).
The illusion of control refers to people's belief that they have influence over the outcome
of uncontrollable events" (Montier, 2007, p. 22). For example, people value a lottery ticket
more that contains numbers theyve chosen rather than a ticket with randomly picked
numbers (Langer, 1975). The illusion of control is more likely to occur when many choices
are available, there has been early success at the task, there is a familiarity to the task at

hand, there is a lot of information available, and there is a personal involvement. Montier
(2007) relates these conditions to be akin to large portfolios, high turnover and short time
horizon, situations that encourage the illusion of control in the finance industry. Illusion of
control (thinking you can influence an outcome) together with the illusion of knowledge
(thinking you know more than everyone else) are psychological biases that lead to excessive
optimism and overconfidence, biases most commonly displayed by professional fund
managers.
Most managers tend to make decisions based on some rule of thumb or heuristic.
Representativeness is such heuristic that occurs when judgements are made based on
stereotypes and analogies. People tend to make judgments in uncertain situations by
looking for familiar patterns and assuming that future patterns will resemble past ones,
often without sufficient consideration of the reasons for the pattern or the probability of
the pattern repeating itself (Shiller, 2000, p. 144). Montier (2007) states that investors
tend to extrapolate recent past performance with what is more likely to happen in the
future by judging that companies with good recent record will always be good companies in
the future. Investigating the behaviour of investors in the Chinese market Chen et al.
(2007) show that Chinese investors display three behavioural biases: (i) disposition effect,
as they tend to sell good stocks but not poor performing stocks; (ii) overconfidence, as they
tend to trade too much; and (iii) representativeness as they believe that past returns are
indicative of future returns.
When making quantitative decisions people tend to become anchored on arbitrary numbers
mentioned in the statement of the problem, even when these numbers are not relevant
(Hirshleifer, 2001). Furthermore, when faced with new information or circumstances, there
is insufficient adjustment relative to the initial numbers, leading to anchoring and
adjustment bias (Shefrin, 2007). This causes investors to anchor to past data and to
underreact to new information as they are reluctant to give as much weight as they should
to the new information and fail to appropriately adjust their estimates (Fuller, 2000).
In psychology, the term affect means emotional feeling, while the affect heuristic is
described as the tendency of making decisions based on intuition, instinct and gut feeling
(Shefrin, 2007). While intuition is important and experience is valuable, they are not a
substitute of careful analysis of facts. Nevertheless, Slovic et al. (2002) state that reliance
on affect and emotion is a quicker, easier and more efficient way to operate in a complex
and uncertain world as people use images associated with positive and negative affective
feelings in judgements and decision making. La France and Hecht (1995) find that smiling

persons are considered more trustworthy, good, honest, sincere and genuine than
nonsmiling persons. Alhakami and Slovic (1994) also show that people judge an activity not
only on what they think about it, but also how they feel about it. Thus, if the activity is
pleasant, it is judged as low risk and high benefit, while an unpleasant activity will be
considered high risk and low benefit. This negative relationship between perceived risk and
benefit is evident in the finance area as well where it is well know that risk and return are
positively correlated. Thus stocks perceived as good based on a global attitude were judged
to have high return and low risk, while stocks perceived as bad, were considered to be low
in return and high in risk.
When faced with risky alternatives that have gain and loss possibilities, people tend to
experience a loss more acutely than a gain of the same magnitude. Shefrin and Statman
(1985) argue that because of loss aversion bias, investors tend to hold onto stocks that lost
value and sell those that have risen in value. This is known as the disposition effect. The
reason why investors hold on a loser stock is the belief that it will regain value eventually.
Even experienced, professional fund managers are affected by loss aversion. Using a sample
of approximately 30,000 US mutual funds, Frazzini (2004) finds that fund managers are
1.2 times more likely to sell winners than losers, and the best-performing funds are those
that are less loss averse. The consequence of loss aversion is that the loss associated with
giving up a good is greater than the gain of receiving the same good. Thaler (1980)
identifies this bias as the endowment effect because people value something they own
more than something theyve just gained.
The hot hand fallacy (term arising from basketball) or extrapolation bias occurs when
people make unwarranted extrapolations from past trends in forming forecasts. Thus when
markets are performing well, investors expect high returns from stocks and vice versa in
bear markets (Shefrin, 2007). Studies have shown that basketball players and fans believe
that a player has a greater chance of hitting a shot if the previous shot was a hit than if the
previous shot was a miss. This has sparked a lot of debate as most research has found
minimal scientific support for the hot hand. Closely related to this bias is the gamblers
fallacy the belief that reversals occur more frequently than actually happens (Shefrin,
2007). People fall into this trap because they fail to understand statistical independence
and randomness. A coin has no memory and after 7 flips of heads, the 8th flip can equally
turn out heads or tails. However if one is betting that it will turn out tails, one suffers from
gamblers fallacy (Montier, 2003).

In a study about driving competence Svenson (1981) shows that the majority of people
regard themselves as more skilful and less risky than the average driver. Self-attribution
bias is closely related to overconfidence and suggests that individuals believe to have above
average abilities (Shefrin, 2007). Thus, people take credit for positive outcomes and blame
others or bad luck for negative outcomes. Doukas and Petmezas (2007) find that managers
attribute successes to their own ability and therefore become overconfident and engage in
more merger and acquisition deals.
In closing, the following cartoon1 captures one of the most common biases that affect not
just investors and managers but also individuals in their everyday lifefollowing the crowds,
or the herding effect. To be a responsible business leader one must be aware of the fact
that markets are not 100% rational, as people make up the markets; and although the
technology has replaced or enhanced some features in the decision making process, still the
responsibility of taking a course of action ultimately rests with individuals.

The picture Buy! Sell! is an original by cartoonist Kevin (KAL) Kallaugher, Kaltoons.com.

Psychological
Phenomenon

Definition

Example of Faulty
Financial Decision

Excessive Optimism

Overestimation of frequency of
favourable outcomes and
underestimation of frequency of
unfavourable outcomes

Delay cost cutting during a

business recession

Overconfidence

Being convinced that you are

better than you actually are
regarding your ability or
knowledge

Making inferior acquisition when

firm has lots of cash

Confirmation Bias

Attach too much importance to

information that supports your
view relative to information that
runs counter to your view

Ignoring information that

revenue is declining which is
counter to your current
viewpoint that firm is doing great

Illusion of Control

Overestimate the extent to

which you can control events

Believing you can influence the

outcome of a project when in
fact the outcome is based on
chance

Representativeness

Making judgements based on

stereotyping and analogies

Believing that if the industry your

firm is in performs well, the
whole economy is doing well also

Anchoring and
Adjustment

The degree to which the initial

judgment about an event or
situation prevents you from
deviating from that position
regardless of new information to
the contrary

Become fixated on a certain

growth rate in earnings without
accordingly adjusting for changes
in the economy

Affect

Basing decisions primarily on

intuition, instinct and gut feeling

Rely on instinct when choosing an

investment or project rather than
formal valuation analysis like DCF
or NPV

Loss Aversion

Experiencing a loss more acutely

than a gain of the same
magnitude

Forgo tax shield advantages due

to loss aversion to debt

Hot-Hand Fallacy or
Extrapolation Bias

Making unwarranted
extrapolations of past trends in
forming forecasts

Expecting that during a bull

market, stock prices go up, while
in a bear market, prices go down

Self-Attribution Bias

Tendency to take credit for

positive outcomes and blaming
others or bad luck for negative
outcomes

Seek a high bonus for good

performance that stems from
external factors and resist a low
reward for poor performance

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