Aspects of Investor Psychology

Beliefs, preferences, and biases investment advisors should know about.

Decision theorist Howard Raiffa [1968] introduces useful distinctions among three approaches to the analysis of decisions. Normative analysis is concerned with the rational solution to the decision problem. It defines the ideal that actual decisions should strive to approximate. Descriptive analysis is concerned with the manner in which real people actually make decisions. Prescriptive analysis is concerned with practical advice and help that people could use to make more rational decisions.

Financial advising is a prescriptive activity whose main objective should be to guide investors to make decisions that best serve their interests. To advise effectively, advisors must be guided by an accurate picture of the cognitive and emotional weaknesses of investors that relate to making investment decisions: their occasionally faulty assessment of their own interests and true wishes, the relevant facts that they tend to ignore, and the limits of their ability to accept advice and to live with the decisions they make. Our article sketches some parts of that picture, as they have emerged from research on judgment, decisionmaking and regret over the last three decades. The biases of judgment and decision making have sometimes been called cognitive illusions. Like visual illusions, the mistakes of intuitive reasoning are not easily eliminated. Consider the example of Exhibit 1. Although you can use a ruler to convince yourself that the two horizontal lines are of equal length, you will continue to see the second line as much longer than the other. Merely learning about illusions does not eliminate them.


The goal of learning about cognitive illusions and decision-making is to develop the skill of recognizing situations in which a particular error is likely. In such situations, as in the case of Exhibit 1, intuition cannot be trusted and it must be supplemented or replaced by more critical or analytical thinking – the equivalent of using a ruler to avoid a visual illusion.

Providing timely warnings about the pitfalls of intuition should be one of the responsibilities of financial advisors. More generally, an ability to recognize situations in which one is likely to make large errors is a useful skill for any decision-maker.

We follow a long tradition in discussions of decision-making, which distinguishes two elements: beliefs and preferences. Decisions theorists argue that any significant decision can be described as a choice between gambles, because the outcomes of possible options are not fully known in advance. A gamble is characterized by the range of its possible outcomes and by the probabilities of these outcomes. People make judgments about the probabilities; they assign values (sometimes called utilities) to outcomes; and they combine these beliefs and values in forming preferences about risky options.

Judgments can be systematically wrong in various ways. Systematic errors of judgment are called biases. We start by dealing with a selection of judgment biases. Then we discuss errors of preference, which arise either from mistakes that people make in assigning values to future outcomes or from improper combinations of probabilities and values. In both cases, we introduce each bias with a question that illustrates the bias and conclude with recommendations for financial advisors to help mitigate the harmful effects of these biases.

We conclude the article with a checklist that advisors can use to measure their effectiveness at dealing with these biases.

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Psychology's ambassador to economics

The father of behavioural economics Daniel Kahneman talks to VIKRAM KHANNA about cognitive illusions, investor irrationality and measures of well-being.

A bat and a ball together cost $1.10. The bat costs $1 more than the ball. How much does the ball cost?
Did you say 10 cents?

More than half of a Princeton University economics class gave the same answer (as did most of my friends), and it is wrong.

'If I offer you a deal: I toss a coin and if it's heads, you will win $200, but if it's tails you will lose $100. Will you take the bet?

'The majority of people say no. They don't consider it attractive. They weigh pleasure against pain, and for most people, the pain of losing $100 outweighs the pleasure of winning $200. Losses are given a weight of more than 2:1 compared with gains. This is loss aversion.

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Kahneman: Master of the imperfect mind

Daniel Kahneman won a Nobel for explaining why people habitually make the wrong moves when investing or spending their money. Who better to tell you how to do it right?
It isn't often that a psychologist helps explain personal finance, but Daniel Kahneman isn't an ordinary psychologist. In 2002 he won a Nobel Prize in economics for his research into how people confront uncertainty.

Raised in France and Israel and formerly a professor at the Hebrew University of Jerusalem, UC-Berkeley and Princeton, Kahneman has spent half a century studying how the human mind works - or fails to.

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Disclosure: thanks to David for the original reference

A V Rajwade: When risk becomes uncertainty - III

Some instruments are so complex that it can take investment banks' computers entire weekends to value them!

Even as a measure of calm has returned to the financial markets, cautions are being sounded. The president of the Bundesbank described the events as “a classic bank run” — but on a different class of financial intermediaries like hedge funds, conduits, SIVs and SIV-lites. In the US, the number of foreclosures in the current year is expected to go up to 2 million, up from 1.2 million last year. This means that one of every sixty house-owners will be thrown out of his/her house, a rate not seen since the Great Depression of the 1930s. And, this is not the end: as many as 2.5 million adjustable rate mortgages (ARMs), where the initial rate was kept low to attract the borrower, are due for re-pricing next year. Quite often, a fall in home prices has been followed by recession. Could we see history repeating itself this year? There are some signs: US car sales in August showed a fall.

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Minding Your Money

Why do smart people make stupid financial choices—and how can they avoid repeating them? Having a head for investing, it turns out, isn't about doing arithmetic on napkins or studying spreadsheets. In fact, a key requirement is modesty and self-awareness, says Money magazine senior writer Jason Zweig, author of “Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich” (Simon & Schuster. $26). Zweig endured a series of MRIs to see for himself how the brain responds to financial challenges, and he culled insight from the growing field of neuroeconomics, which studies the biochemistry of our financial behavior. NEWSWEEK's Temma Ehrenfeld spoke to the author about the perils of our brain-triggered responses, how avid investors are like drug addicts and why women really are better investors. Excerpts:

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Our bouncy market reflects a very moody herd

ECONOMISTS don't like to think about it but, according to conventional theory, events such as the present wild gyrations in financial markets aren't supposed to happen.

That theory says share prices move only when investors quietly incorporate new information about the prospects of their investments, whereas it's clear the markets are swinging between blind panic and the thought that maybe it's just a great buying opportunity. The herd can't decide which way to run. How would you feel if you walked into a shoe shop and the manager rushed up and told you to buy extra shoes because prices had skyrocketed? Or if nervous customers warned you not to buy any socks because sock prices had fallen by half?

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Caravaggio`s anchor

Investors not only use psychological anchors to price assets but they also overestimate individual capabilities.

During normal decision making, individuals anchor, or overly rely, on specific information or a specific value and then adjust to that value to account for other elements of the circumstance. Usually once the anchor is set, there is a bias towards that value.

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