BBI of Chicago
Biases and their implications for investor decision making
By: Douglas Moreira da Silva.
With the sharp growth in the number of Brazilians who have started investing in the stock market, how these individuals make their investment decisions and the types of influence they suffer, become the subject of numerous studies. According to Kahneman and Tversky (1979), most people are immediatists, accept satisfactory solutions instead of optimal ones, cannot think long term, and are deeply influenced by emotional and psychological factors. These factors are also called behavioral biases, of which we list three among countless, that are closely related to the behavior of investors in the stock market. They are the loss aversion bias, the bias of excess and confidence, and the herd behavior bias.
We begin with the loss aversion bias, which, according to Kahneman and Tversky (1979), is explained by the tendency to not accept losing, being reluctant to get rid of losing stocks, and selling profitable stocks ahead of time. This behavior usually causes losses in the short term but has even more impact in the long term; because if the investor had maintained profitable positions for a longer period, they could have obtained better returns on their investments.
Usually, the overconfidence bias is noticed when we need to estimate situations that involve very complex variables. It has a direct impact on the decision-making process and also after this process. The individual who makes his decisions influenced by this bias, even if unconsciously, demonstrates a usually overestimated conviction of competence. Schrand & Zechman (2010) show that overly confident managers overestimate their abilities and underestimate bankruptcy risks.
Herd behavior is identified by many people trading the same asset, in the same direction as the market, without even minimal information from a fundamental analysis about the quality of this asset. It can lead to sharp highs or lows with no reason that supports such intense ups and downs in the asset's value. Tseng (2010) demonstrates that this phenomenon can lead the price of an asset to shift from its fundamental value.
We can conclude that the modern theory of finance, based on the hypothesis of market efficiency and the unlimited rationality of agents, finds a crucial complement in the theory of behavioral finance. Furthermore, biases are fundamental to explain, in the best way possible, the possible economic and financial decisions made by human beings: beings that are invariably permeated with emotions and triggers that activate the most different behavioral biases.
Kahneman, D.: Tversky, A. Prospect Theory: An Analysis of Decision Under Risk. Econometrica, V. 47, N. 2, P. 263 – 291, 1979.
Schrand, C.M. and S.L.C. Zechman 2010. Executive Overconfidence and the Slippery Slope to Fraud. Working Paper, University of Pensylvania.
Tseng, M.L. 2010. An assessment of cause and effect decision making model for firm, environmental knowledge management capacities in uncertainty. Environmental Monitoring and Assessment, 161, 549-564. DOI: 10.1007/ s 10661-009-0767-2.