Why investors often make bad decisions

Introduction:

In rational world investors make decisions to maximize their risk-return trade-off. They are assumed rational and able to overcome tendencies. However, the modern theory of investors’ decision-making suggests that investors do not always act rationally while making an investment decision (Bashir et al., 2013). When it comes to money and investing, they deal with several cognitive and psychological errors.  If different investors receive the same information, they will have their own interpretation of this information. These various interpretations will lead to different perception of the signals and therefore create differentiated behaviors. The established various behaviors will influence the financial markets through the decision making of these investors. Those behavioral factors, which often lead investors to make bad investing decisions & poor financial performances, are broadly categorized into two segment as shown in the figure 1 below.

Fig.1. Behavioral Biases (Author’s source) [Disclaimer: I have tried to figure out the framework that exclusively incorporate the established behavioural variables into relevant factors]

 A] Heuristic Decision Process

Heuristics are simple strategies or mental processes used to quickly form judgments, make decisions, and find solutions to complex problems (Gigerenzer & Brington, 2009). Investors’ decision-making is not rational so it is very difficult to separate the emotional and mental factors involved in the process of decision-making in which they go through by collecting relevant evaluation of the information. Following variables are included in Heuristic Decision process:

 a. Overconfidence: It is related to the self- attribution bias which is the tendency of an individual to attribute his success to his own talent and ability while blaming ‘bad luck’ for his failure, making himself overestimating his talent (Qadri & Shabbir, 2014). People have a natural tendency to be overconfident. People’s confidence systematically exceeds the accuracy of their choices. For example, the study conducted by Lichtenstein & Fischhoff, 1977 showed that when investors are given a market report of twenty stocks and asked to predict stock price changes, people rated their own accuracy in prediction at 68% while the actual accuracy was only 47%. Similarly, most people also think they are above average drivers, that they are more likely to live longer than others and are more likely to outperform than others. Investors who are overconfident, overrate signal precision and overreact to private signals.  Dittrich, Güth & Maciejovsky (2005) observed in their experiment that around two third of their participants prone to overconfidence. They further observed that those investors who lose their money in investment, gain more confidence. In certain cases, investors while overestimating their skills and knowledge indulge themselves into excessive trading. Further stated, only laypeople making decisions display significant overconfidence. Experts are usually more realistic in their expectations. In our context also, I have come across many cases where investors who are supposed to be more smart & confident were suffering higher losses on their investment.

b. Representativeness: Representativeness heuristic is used while making judgments regarding the probability of an event under uncertainty (Kahneman & Tversky, 1982). In such situation, investors make decisions established on previous experiences which is known as stereotype. For example, Consider Shruti Sharma. She is 33, single, outspoken and very bright. She majored in economics at university and, as a student, she was passionate about the issues of equality and discrimination. Is it more likely that Shruti works at a bank? Or, is it more likely that she works at a bank AND is active in the feminist movement?  Many people when asked this question go for option 2, that Shruti works in a bank but is also active in the feminist movement. But that is incorrect. In fact, in giving that answer, they’ve actually been influenced by representativeness heuristic bias. The inference from the story is that investors may always relate to the past performance of  particular stock and expect the same to go in future. But, this may not happen as expected and the decisions turn to be wrong.

c. Anchoring: Sometime investor’s decision options are affected by an original starting value or anchor known as anchoring effect. When they need to make a decision they often fail to do enough research because there is just too much data to collect and analyses. Hoguet (2005) shows that when investors need to define; a quantum investor will ‘anchor’ on the most recent information available. Therefore, they tend to underreact to new information. People start estimating final results by initiating from the beginning values about different situations. That starting point or initial value may be the partial computation or the formulation of a problem where adjustments are insufficient. Different initiating points lead to different estimates. For example, when asked to value the same property after being given different anchor values like initial cost of purchase, value of new infrastructure etc., real estate agents gave valuations that were significantly correlated with the arbitrary anchors provided; although 90% of them denied being influenced! (Northcraft, & Neale, 1987).

d. Gamblers Fallacy (GF): Investors often make non-optimal decisions involving random events. One such example is the gambler’s fallacy (GF), which is the belief that the occurrence of a certain random event is less likely after a series of the same event (Xue, et. al., 2012). For example, if the price of a particular stock (say, NLIC) is increasing continually for last 4 days, investors believe that it will not increase or go decrease for the next day.

e. Availability Bias and Salience: The availability bias happens when the individual acts upon recent information that is obtained easily. In other words, people overestimate the probabilities of the events affiliated with memorable, highly emotional or have happened recently. They have a strong tendency to focus their attention on a particular fact rather than the overall situation, only because this particular fact is more present or easily recalled in their minds (Nofsingera & Varmab 2013). For instance, the high level of insurance purchases made immediately after disasters such as floods and earthquakes, which gradually decline when memories fade. The availability effect is also observed when people make inferences about what is likely to happen based primarily on events of which they have direct experience. An example of this is when people resort to the saying “Well, grand-dad chain-smoked all his life but was never ill and lived to the age of 90” when deciding whether or not to quit smoking. This is a classic example of ignoring the overwhelming weight of evidence in the public domain in favour of a case, based on an unrepresentative sample of one person.

f) Trust: Recent literature in behavioural economics has highlighted the role of intangible, ‘soft’ influences such as trust, culture, social capital and other, regarding preferences on commercial interactions. investors rely on trust regarding the behaviour of their trading partners (Fukuyama, 1996). The more an individual trusts another individual or organisation, the less it is necessary to check information and impose controls. As a result, trust acts as a lubricant with the potential to reduce the cost of transacting significantly. Investors often make their decisions with trusting others without having to check for themselves (Kahneman, 2002).

B] Prospect theory:

Prospect theory explains how people value their gains and losses differently and make decisions based on the potential value of losses and gains rather than the final outcome. The simple concept is that investors make decisions based on perceived gains instead of perceived losses. It means, if two choices are put before an individual, both equal, with one presented in terms of potential gains and the other in terms of possible losses, the former option will be chosen. For example, assume that the end result is receiving Rs.5,000. One option is being given the straight Rs.5,000. The other option is gaining Rs.10,000 and losing Rs. 5,000. The utility of the Rs. 5,000 is exactly the same in both options. However, individuals are most likely to choose to receive straight cash because a single gain is generally observed as more favorable than initially having more cash and then suffering a loss. Key concepts of this theory can be explained with different dimensions below:

a. Loss aversion: Investors have been shown to be loss averse, generally appearing to dislike losing something roughly twice as much as they like gaining it.  Tversky & Kahneman (1991) illustrated that the investors usually try to avoid taking risk when they are gaining, however they might choose to take risk when they are with losing stocks. When an investor faces loss then he may become a risk-seeker, but becomes a risk-averse while enjoying gains. Loss aversion states that investors’ value function is concave for gains but convex for losses. In other words, they are more sensitive to losses compared to gains of similar magnitude (see Fig.2). The value function takes an asymmetric S-shape because marginal value (or sensitivity) declines as absolute gains and losses increase in size.

Fig.2. Pictorial view of loss aversion (Source: Tversky & Kahneman, 1991).

 b. Narrow framing: It is the propensity of an investor to select investments individually, instead of considering the broad impact on his/her portfolio. Barberis, Huang, & Santos (2001) state that narrow framing stand for the utility people receive direct from the outcome of a specific option and not-indirect through the contribution of options to his total wealth. In many cases when people evaluate risk, they often involve in narrow framing. Meaning they evaluate risks in isolation, separately from other risks they are already facing. When investors have to make two decisions they make a sub-optimal choice. They tend to concentrate on the outcome of each decision separately instead of the combined outcome of the two decisions. The decisions also depend on the way the choice is presented, or “framed”. People prefer positive rather than negative frames (McNeil, Sox & Tversky, 1982). For instance, in choosing cancer treatment, 82% of patients preferred surgery over radio therapy when surgery was described as having a 90% survival rate. However, only 56% preferred surgery over radio therapy when it was described as having a 10% mortality rate. These two pieces of information are factually equivalent; however, there exists a strong bias in favour of the positive frame.

c. Regret aversion: Regret is the negative feeling which occurs after a bad choice. In investment context it refers to the investor’s reaction at making a mistake. This kind of aversion arises when an investor desires to avoid the pain of regret occurring from a bad investment decision (Zeelenberg, et. al, 1996). Investors are not allowed to admit their mistakes and feel regret because if they do, they tend to avoid selling the stocks which decreased in value and sell the stocks they have increased in value promptly. Investors usually undergo sufferings from two types of mistakes. First one is the errors of commission and the second one is error of omission. The former happens when they choose wrong investing decision and the latter happens when they forgo or overlook the opportunities.

d. Mental Accounting: Mental accounting occurs when sums of money are treated and valued differently depending on where they came from and/or where they are kept (Thaler, 1999). It is the tendency of investors where they separate their accounts and classify them on the basis of variety of subjective criteria, showing the source of money and the intention of each account, and this determines the purchasing decision. Different styles of investing can be seen on the same investor while using different sources of funds (like; savings, loans, pension fund, tips, lottery etc.). Mental accounting violates the standard economic assumption that money is fungible, meaning that all money is treated equally regardless of its source or destination and doesn’t come with labels on. For example, most people coming to the Bhatbhateni Store to buy at lamp for Rs. 500 would travel to a newly opened different branch 5 minutes away if told that they could buy the same lamp at the other location for a special sale price of Rs. 250, thereby saving Rs. 250. However, most people coming to a store to buy a dinner table set for Rs.15,000 would not travel to a different branch 5 minutes away if told they could buy the same set for Rs. 14750. In both cases, the trade-off is a gain of Rs. 250 for 5 minutes of time. However, in the former case, the Rs. 250 is compared to Rs. 500, whereas in the latter case, it is compared to Rs. 15000. According to standard economic theory, Rs. 250 should be equally valued regardless of source and if it is worth 5 minutes of an individual’s, then it should be in all cases. This example illustrates why investors prefer trading decision to a particular stock over another.

Investors also have separate mental accounts for different categories of spending and are reluctant to transfer spending from one account to another. They also have set target of profit & losses for a fixed investment horizon. The most famous illustration of this is the behaviour of New York taxi drivers. A study by Camerer, Babcock, Loewenstein & Thaler (1997) revealed that these taxi drivers work shorter hours on good days (when there is much customers) and longer hours on bad days. This contradicts traditional economic theory, which says that they should work longer hours on good days so as to maximise their monthly income. The explanation is that these drivers have a separate mental account for each day and set daily earning targets. Each day, they stop working once their target is met, which happens quicker on good days and vice versa. Similarly, investors’ investing style may be changed when they meet their target earlier. 

e. Self-control: Investors always attempt to avoid the losses and shield their investments. According to the views of Thaler & Shefrin (1981) they always show some sort of tolerance and are looking for improving their self-control. Psychologically it is also known as self-regulation.

f) Disposition effect : The tendency of an investor to sell winners too early and hold losers too long  is known as disposition effect. According to Henderson and Vlcek (2012) investors are unwilling to sell assets at a loss comparing to the price at which they purchase this asset.  It is evidenced that on average 14.8% of the gains available are actually realized, while only 9.8% of the losses are realized. We can conclude that investors are 50% more likely to realize gains than losses. When an individual investor sells a stock in his portfolio, he has a greater propensity to sell a stock that has gone up in value since purchase than one that has gone down (Barberis and Xiong, 2009). It may become costly for investors to sell winner too soon and hold loser to long because of the higher marginal rates of gain in winner stock.

C] Cognitive Illusions:

Many behavioural theorists extended the Heuristic and Prospect theory with addition of other more behavioural biases possessed by investors:

a) Herding Behavior : It refers to “follow the leader” mentality. This is the tendency of an investor to follow the crowd because the decisions made by the majority are assumed to be always correct. The herding investors will base their investment decision on the crowd actions of buying and selling, creating speculative bubbles phenomenon hence making the stock market to be inefficient. Evidences show that the herd is almost always wrong, which contributes to excess volatility in the market. It is more prevalent with institutional investor than with individual investors (Hirt & Block, 2012).

b) Status Quo Bias: It is the tendency to stick with current choices/ patterns of behaviour, in other words to have an exaggerated preference for the status quo (Samuelson & Zeckhauser, 1988).  Sticking with the status quo involves less mental effort than considering more pro-active courses of action.

 c) Endowment Effect: It is the tendency of individuals to place a higher price or value on an object if they own it than if they do not. Put simply, according to standard economic theory, what we are willing to pay for a good should be equal to what we are willing to accept to be deprived of it. However, experimental studies have shown that we generally demand more money to part with something once we own it than we would be willing to pay for it in the first place (Knetsch,1989). This very nature determines the buying & selling behaviour of the investors in the market.

 d) Home Bias: Individual investors also tend to invest in stocks that are headquartered close to their home, a pattern called ‘home bias’. For example, investors disproportionately invest in local stocks-in their home countries and home states–which generates an undiversified portfolio and concentrates risk rather than spreading it out (Huberman, 2001). Worse yet, investors often invest in their own company stock, exposing them to a dangerous scenario of losing both labor income and stock market wealth if their company suffers financial distress.

e) Conservatism: The conservatism bias means investors are slow to react and to update their beliefs in response to recent evidence and development. According to Márcia et al. (2014) investors can initially underreact to the new information or rumours released on a company. As a result, prices will fully reflect the new information only gradually.

f) Cognitive Dissonance: It refers to the conflict caused by holding conflicting cognitions simultaneously. This concept was introduced by the psychologist Festinger (1956). Because the experience of dissonance is unpleasant, the person will strive to reduce it by changing their beliefs. When investors are confronted with new information, they want to keep their current understanding and reject or avoid the new information. Cognitive dissonance is considered as an explanation for attitude change, it is the mental conflict investors have to deal with when they realize they made a mistake. Investors do not want to change their decisions, so they persuade themselves that they made a rational decision which leads them to even worse situation.

Summary

Many investment decisions violate sound financial principles because of cognitive constraints and a low average level of financial literacy  (Frydman, & Camerer, 2016). Based on reviews and empirical evidences, I have highlighted the three key points related to the investors’ decision making in the stock market. First, investors act not always risk averse but often risk seeking while they make an investment decision, Second, investors interpret outcomes of various decisions differently, & Third, the expectations of investors are often biased in predictable direction, rather than rational. In many instances, Investors over-extrapolate from past returns and trade too often. Even smart institutional investors, make decisions that are affected by overconfidence and personal history. The ingrained human behaviors is one of the main reason why investors often make bad decisions. Here, I am not claiming that every investor would suffer from similar illusion, but just trying to shed light on different dynamics of behavioural biases. It is always better for investors to take necessary initiatives to avoid such illusions, which influence the process of decision- making, particularly while making investments in the stock market.

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