Behavioral Biases in Investment Decision Making: A Literature Review

Wewelpanawa Gamage Thushari Sewwandi

Department of Commerce & Financial Management, Faculty of Commerce & Management Studies,
University of Kelaniya, Sri Lanka.
E-mail: sewwandi.dcfm.kln@gmail.com

Abstract

In traditional finance theory, the investors are expected to be rational decision makers going along with the expected
utility theory. Behavioral finance, in contrary to this, heavily criticize this rational perspective and they argue that the
investors tend to deviate from rationality whenever making investment decisions. Several behavioral biases that may
occur in investment decision making have been studied and empirically tested over the history. This paper attempts to
review the literature related to some behavioral biases based on the different studies done in different contexts.
Researchers, over the history, have been doing lots of studies on why investors behave far from rationality in making
their investment related decisions. Based on the studies done up to now, researchers have found that multiple factors
affect the behavior of individual investors. This paper attempts to present a conceptual model for selected behavioral
biases selected based on the author’s interest namely overconfidence, disposition effect and herding.

Keywords: Behavioral Biases, Overconfidence, Disposition Effect, Herding

1. INTRODUCTION
In the traditional/conventional finance theory, the investors are presumed to be rational wealth maximizers who always
make economic decisions based on the utility theory. Anyway, the assumption that investors are rational1 at both micro
and macro levels, is heavily challenged in the field of behavioral finance. The micro theory of behavioral finance
focuses on the behavior of the individual investors whereas the macro theory focuses on the behavior of the markets
questioning the idea of market efficiency. According to the micro theory, the investors’ decisions are subjected to
either emotional biases or cognitive errors. Emotional biases come from the feelings, intuition, or impulsive thinking
whereas cognitive errors occur due to the misunderstanding of data, faulty reasoning, statistical miscalculations, or
memory errors. Both types of biases can lead to poor investment decisions. At micro level, the biases affect the
individuals’ economic decisions whereas at macro level, markets are subjected to the effects of these collective
decisions. Even in a situation of perfect information, most investors are not able to make decisions without being
subjected to any bias or emotion. (Behavioral Finance vs. Traditional Finance Theory, 2015)

When looking at different empirical studies done in relation to the behavioral biases, most of the top researchers in
the field have focused on such behavioral biases as overconfidence, disposition effect, herd behavior and home bias
etc. Those empirical studies done in different contexts have proven that the investors, both individual and institutional,
and also the analysts tend to deviate from rationality in their investment decision making. They have also found out
number of factors affecting such kind of a deviation. For instance, Brad M. Barber and Terrance Odean have done
studies on investors’ overconfidence and disposition effect whereas Gokul Bhandari & Richard Deaves, Miller & Ross
have focused on overconfidence bias. Scharfstein and Stein, Abhijit V. Banerjee, Bikhchandani etc. have done several
studies related to investor herding. The attempt of this paper is to review the existing literature related to some selected
behavioral biases namely; overconfidence, disposition effect and herd behavior. Since the similar type of empirical
studies done concentrating on emerging markets are very few, the researchers in developing countries have a very
good opportunity to focus on such markets. This paper, on one hand, is expected to be useful for researchers, academics
and professionals who are interested in equity market to have an insight into so far published literature in the field.
possible behavioral biases and their impact on investment decision making.

1
Rational investors are the investors who “always prefer more wealth to less and are indifferent as to whether a
given increment to their wealth takes the form of cash payments or an increase in the market value of their holdings
of shares.” (Miller and Modigliani, 1961)

1
1.1. Investment Decision Making
As mentioned above, standard finance theory assumes that investors are rational whereas the behavioral finance
assumes that the investors all the time deviate from rational decision making. Several researchers have been studying
about why investors deviate from rationality whenever making decisions. The discussion from this point onwards
focuses on those behavioral biases.

1.2. Overconfidence
Overconfidence refers to the investors’ excessive confidence about their knowledge and future prospects and hence
ignoring the risk associated with an investment. Daniel et al (1998) defines an overconfident investor as one who
overestimates the precision of his private information signal, but not of information signals publicly received by all.
Odean (1998) shows that overconfident investors trade more than rational investors. Barber and Odean (2000) pointed
out that overconfidence will result in greater trading and thereby a lower expected utility. This is because that increased
trading will result in high transaction cost and the investors’ realized gains are not sufficient to cover such increased
costs. After accounting for trading costs, individual investors underperform the relevant benchmarks. Hence, it is said
that trading is hazardous for one’s wealth. As Odean points out, the overconfident investors expend too many resources
on investment information. Further they tend to hold riskier portfolios than those rational investors with the same
degree of risk aversion do. Since private information is rare, the active investment strategies will not outperform
passive investment strategies. They say that those who trade the most will realize the worst performance.

Several studies have been undertaken to examine the relationship between demographic variables and overconfidence.
Psychologists have found that in areas like finance, men tend to be more overconfident than women. Many researchers
such as Lundeberg, Fox and Punccohar (1994) and Barber and Odean (2001) have confirmed that gender and
overconfidence are associated. Barber and Odean (2001) through their study done using common stock investments
of 37,664 households from a large discount brokerage in USA from February 1991 through January 1997 show that
the relationship between gender and overconfidence results in two consequences; (i). Men will trade more than women
and (ii) the performance of men will be hurt more by excessive trading than the performance of women. According to
their findings, men trade 45% more than women. They found that women turn their portfolios over approximately
53% annually while men turn their portfolios over approximately 77% annually. They have also found that trading
reduces men's net returns by 2.65 percentage points a year as opposed to 1.72 percentage points for women. Also they
found that the stocks men choose to purchase underperform those they choose to sell by 20 basis points per month and
the stocks women choose to purchase underperform those they choose to sell by 17 basis points per month. They also
have found out that the average turnover rate of common stocks for men is nearly one and half times than that for
women. Both men and women reduce their net returns through trading, nearly 0.94 percentage points more a year than
women do. According to them, the difference in turnover and return performance are even more pronounced between
single men and single women. Single men trade 67% more than single women thereby reducing their returns by 1.44
percentage points per year more than do single women. This is because that married couples can influence each other's
investment decisions. Hence the observable differences in the investment activities of men and women will be greatest
among single men and single women. The historical findings show that overconfidence is greatest for difficult tasks.
Since selecting common stock that will outperform the market is a difficult task, it is said that people will become
overconfident. The model developed by Odean (1998) shows that overconfident investors believe more strongly in
their own valuations and they tend to overestimate the probability that their personal assessments of the security value
are more accurate than the assessments of others.
Bhandari and Deaves (2006) further found that highly educated males who are nearing retirement, who have received
investment advice, and who have experience investing for themselves, tend to have a higher certainty level. They also
conclude that highly-educated males are more subject to overconfidence. According to their findings, gender will be
a key determinant of overconfidence.

1.3. Disposition Effect

Shefrin and Statman (1985) defines the disposition effect as the tendency to hold losers too long and sell winners too
soon. According to Odean (1998), the disposition effect is one implication of extending Kahneman and Tversky’s
(1979) prospect theory to investments. Under Prospect theory, when faced with choices, people behave as if
maximizing an S-shaped value function. The function is concave in the domain of gains and convex in the domain of
losses. Also the curve is steeper for losses than for gains implying that people are generally risk averse. As Odean
(1998) explains, when an investor holds two stocks, one is up and one is down, the investor is more likely to sell the
stock that is up if the investor is faced with a liquidity demand and has no new information about either stock. He
also says that the investors choose to hold their losers and sell their winners not because they are reluctant to realize
losses but because they believe that today’s losers will soon outperform today’s winners.

Odean (1998) proved that the individual investors’ behavior is consistent with prospect theory and hence they exhibit
disposition effect by analyzing 10,000 individual accounts at a large discount brokerage house in USA. That is they
realize their profitable investments at a higher rate than their unprofitable ones but this is except in the month of
December each year. In the month of December, in contrary to this, investors are found to be selling loss making
stocks to get the tax advantage. Through the same study, they also identified some alternative reasons to hold losers
and sell winners such as; (i). anticipation of changes in tax law, (ii). desire to rebalance, (iii). belief that the losers will
bounce back, (iv). attempt to limit transaction costs, and (v). belief that all stocks revert to the mean. Shefrin and
Statman (1985) proposed that the investors sell their losing stocks in December as a self-control measure and specially
to get the tax benefit.

According to Odean (1998), investors may be behaviorally motivated to hold losers and sell winners because they
may have value functions as those explained in Prospect theory. He also points out that there are some rational reasons
for why investors choose to hold their losers and to sell their winners.

1. Investors who do not hold the market portfolio may respond to large price increases by selling some of the
appreciated stock to restore diversification to their portfolios (Lakonishok and Smidt,1986)
2. Investors who purchase stocks on favorable information may sell if the price goes up rationally believing that
the price now reflects this information and may continue to hold if the price goes down rationally believing
that their information is not yet incorporated into the price.
3. Trading costs tend to be higher for lower priced stocks and because losing investments are more likely to be
lower priced than winning investments, investors may refrain from selling losers simply to avoid the higher
trading costs of low priced stocks (Harris, 1988)

As Barber and Odean (2006) pointed out, in decision making, when there are options, those attracting more attention
are more likely to be considered whereas those options that do not attract attention are often ignored. Through their
study, they have proved that the individual investors are more likely to buy rather than sell those stocks that catch their
attention. This is because that attention affects buying more than selling.

Barber and Odean (2006) further explains that many theoretical models of financial markets treat buying and selling
as two sides of the same coin in contrast to what they found through their study. They say that informed investors2 are
equally likely to sell securities with negative signals as they are to buy those with positive signals. Uninformed noise
traders are equally likely to make random purchases or random sales. Shefrin and Statman (1985) points out that the
individual investors are concerned about the future returns of the stocks they buy as well as about the past returns of
the stocks they sell.

Barber and Odean again showed that “Attention” is a major factor determining the stocks individual investors buy but
not those they sell. They have found that the individual investors display attention driven buying behavior. At the
same time, they say that this cannot be equally applied to institutional investors due to two reasons. (i) Since
institutional investors own many more stocks than do individuals, they face a significant search problem when selling.
They routinely sell short and for them the search set for purchases and sales is identical. (ii) Institutional investors
devote more time to searching for stocks to buy or sell than the individual investors do and therefore attention is not
a scarce resource for institutional investors.

1.4. Herd Behavior

According to Kumar and Goyal (2014), Herding refers to the situation wherein rational people start behaving
irrationally by imitating the judgements of others while making decisions. Baddeley (2009) says that herding is the

2
Informed investors are those that are highly knowledgeable about financial securities and the fundamental evaluation
of their worth.
phenomenon of individuals deciding to follow others and imitating group behaviors rather than deciding independently
and atomistically on the basis of their own, private information. Keynes suggests that professional managers will
follow the herd if they are concerned about how others will assess their ability to make sound judgements. Scharfstein
and Stein (1990) studied and developed a theoretical model for some of the forces that can lead to herd behavior.
According to their findings, herd behavior can arise as a consequence of rational attempts by managers to enhance
their reputations as decision makers. In addition to reputational concerns, the extent to which there are commonly
unpredictable components to investment outcomes also leads people to follow the herd. Also, they have found out the
herding is more likely to be a problem when managers’ outside opportunities are relatively unattractive and when
compensation depends on absolute rather than relative ability assessment.

The models developed by both Banerjee (1992) and Bikchchandani et al (1992) show that people acquire information
in sequence by observing the actions of other individuals in their group who precede them. Banerjee (1992) proved
that people will be doing what others are doing rather than using their own information. They also showed that the
resulting equilibrium is inefficient. He defines herd behavior as everyone doing what everyone else is doing even
when their private information suggests doing something quite different. Herd behavior is affected by different
reasons.

Kumar and Goyal says that individual investors tend to show herd behavior because they follow the decisions of a
large group or noisy traders. When it comes to analysts’ decisions, they say that they exhibit herd behavior to protect
their reputational or compensation concern.

Lee et al (2004) points out that individual investors are more inclined to adopting herding behavior than are
institutional investors. According to the herd research economist, Vernon L. Smith, the experienced subjects
frequently produce a market bubble, but the likelihood is smaller than for inexperienced subjects. Olsen (1996)
concludes in his study that experts’ earnings predictions exhibit positive bias and disappointing accuracy due to some
combination of incomplete knowledge, incompetence, and/or misrepresentation. He also points out that the greater
the difficulty in forecasting earnings per share, the more will be the analysts’ herding behavior and thereby the greater
the bias in their earnings estimates. The greater the aggregate bias becomes the less accurate will the aggregate
forecasts be.

Prechter (2001) suggests that the human desire for consensus leads to herding behavior among earnings forecasters.
According to him, the forecasters’ inaccuracy worsens with herding. He also says that to forecast on the basis of
current sentiments of the herd is to forecast the present mood but not future events. He further points out that the
rational professionals are seduced by the opinions of their peers that they not only hold but also change opinions
collectively. He also mentions that revealing that one person is the same as the others will help them to maintain their
survival. This has been proven by the studies done by Gajdusek (1970). Prechter (2001) also says that in financial
markets, even when the best time to buy or sell a security is at hand, the person is refrained from doing so thinking
that he will be neglected from the crowd. This is the reason for why a market or other social trend can continue for a
long, long time. The researchers have proved that the analysts, for the first time, are reluctant to express their opinions
unless their peers do so or agree upon with his opinion. Kilka and Weber in their study on Home bias and international
stock return expectations say the despite the advantages of international portfolio diversification, actual equity
portfolio holdings show a strong bias towards domestic stocks due to the fact that they feel more competent about
domestic stocks. Their study revealed that the subjective probability distributions of stock returns are significantly
less dispersed and more optimistic for stocks associated with high competence levels than for stocks associated with
low competence level. In their study done using US stocks and German stocks, they have found that their findings
strongly supported the hypothesis that people are more competent in forecasting domestic stock prices than in
forecasting foreign stock prices.

The informational cascade model developed by Banerjee (1992) and Bidhchandani et al (1992) proves that people
acquire information in sequence by observing the actions of other individuals in their group who precede them in the
sequence.

Vieira and Pereira (2015) through their study done using the stocks listed during 2003-2011 on Portugese capital
market say that the market sentiment negatively influences herding behavior. They say that the evidence for herding
behavior is dependent on the approach used to measure the herding intensity. When they used the methodology used
by Patterson and Sharma (2006), herding intensity was negative and statistically significant. The methodology used
by Chang et al (2000) revealed no evidence of herd behavior.

According to the study done by Clement and Tse on financial analyst characteristics and herding behavior in
forecasting, bold forecasts are found to be associated with analyst’s experience. Bold forecasts are, on average, more
accurate than herding forecasts, even after controlling for analyst characteristics. Further, according to their finding,
bold forecasts appear to reflect analysts’ relevant private information to a greater extent than herding forecasts. They
also found that analyst forecast revisions are positively correlated with the analyst’s forecast error, and the relation
between forecast revisions and forecast errors is stronger for herding forecast revisions than for bold forecast revisions.

When talking about institutional herding, the literature suggests that institutional herding positively predicts short-
term returns but negatively predicts long-term returns. Scharfstein and Stein (1990) asserts that money managers may
herd because of reputational concerns. They have proved that in markets dominated by institutional traders, increasing
mispricing is associated with high trading volume and momentum in stock returns is associated with high trading
volume.

2. CONCEPTUAL FRAMEWORK

Demographic Factors
Behavioral Biases

Overconfidence
Irrational Decision
Disposition Effect Making Behavior

Herding

3. CONCLUSION AND IMPLICATIONS

The paper was done with the objective of reviewing the so far published literature on different behavioral biases related
to investment decision making. Four different biases were selected for the purpose of review based on the author’s
interest namely overconfidence, disposition effect and herd behavior. Most of the studies done concerning behavioral
biases in investment decision making focus on the developed markets. Hence this review will provide a platform for
the researchers in the emerging markets to do similar studies concerning their markets. Also this review will be helpful
for the researchers, academics and professionals to have an insight into the behavioral biases of the investors and
thereby to improve their decision making.
REFERENCES

1. Barber, BM & Odean, T 2000, ‘Investors, trading is hazardous to your wealth: the common stock investment
performance of individual’, The Journal of Finance, vol. 55, no. 2, pp. 773-806.
2. Barber, BM & Odean, T 2001, ‘Boys will be boys: gender, overconfidence, and common stock Investment’,
The Quarterly Journal of Economics, pp. 261-292.
3. Barber, BM & Odean, T 2008, ‘All that glitters: the effect of attention and news on the buying behavior of
individual and institutional investors’, Review of Financial Studies, vol. 21, no. 2, pp. 785-818.
4. Barberis, N & Xiong, W 2009, ‘What drives the disposition effect? An analysis of a long-standing preference-
based explanation’, The Journal of Finance, vol. 64, no. 2, pp. 751-784.
5. Bhandari, G & Deaves, R 2006, ‘The demographics of overconfidence’, The Journal of Behavioral Finance,
vol. 7, no. 1, pp. 5-11.
6. Caparrelli, FD, Arcangelis, AM & Cassuto, A 2004, ‘Herding in the Italian stock market: a case of behavioral
finance’, The Journal of Behavioral Finance, vol. 5, no. 4, pp. 222-230.
7. Christie, WG & Huang, RD 1995, ‘Do Individual Returns Herd around the Market?, Financial Analyst
Journal, vol. 51, no. 4, pp. 31-37.
8. Daniel, K, Hirshleifer, D & Subrahmanyam, A 1998, ‘Investor psychology and security market under-and
overreactions’, The Journal of Finance, vol. 53, no. 6, pp. 1839-1885.
9. Dasgupta, A., Prat, A. and Verardo, M. (2011b). The price impact of institutional herding. Review of
Financial Studies, vol. 24, no. 3, pp. 892-925.
10. De Bondt, WFM & Thaler, RH 1994, ‘Financial decision-making in markets and firms: a behavioral
perspective’ Working Paper No. w4777, Handbook in Operations Research and Management Science.
11. Dennis, PJ & Strickland, D 2002, ‘Who blinks in volatile markets, individuals or institutions?’, The Journal
of Finance, vol. 57, no. 5, pp. 1923-1949.
12. Hirshleifer, D & Hong TS 2003, ‘Herd behaviour and cascading in capital markets: a review and synthesis’,
European Financial Management, vol. 9, no. 1, pp. 25-66.
13. Hirshleifer, D, Subrahmanyam, A & Titman, S 1994, ‘Security analysis and trading patterns when some
investors receive information before others’, The Journal of Finance, vol. 49, no. 5, pp. 1665-1698.
14. Kumar S & Goyal N 2014, ‘Behavioral Biases in Investment Decision Making - A systematic Literature
Review’, Quantitative Research in Financial Markets, vol. 7, no. 1, pp. 88-108.
15. Odean, T 1998, ‘Are investors reluctant to realize their losses?’, The Journal of Finance, vol. 53, no. 5, pp.
1775-1798.