What drives good investors to make poor financial decisions? How come, despite everything that has happened over the last decades, we still engage in risky financial moves? Why don’t we learn from our past financial mistakes?

In this article, we’re going to explore some of the fundamental cognitive biases that lead to bad financial decisions and poor money management.

In 2008, the world’s biggest economic players were struck by a financial crisis which many experts compared with the Great Depression of the 30’s. It all began in 2007 with a collapse in the US mortgage market that triggered an entire chain of events. First, it was the Lehman Brothers who collapsed due to their excessive risk-taking. What followed the fall of this giant was a full-blown banking crisis that affected the entire world.

Though there were a lot of financial and economic factors that ‘choreographed’ this disaster, some experts gravitated towards alternative explanations.

The beginning of the 21st century was marked by the rise of the ‘positive thinking’ movement. Back then, the future looked bright, and people had absolutely no reason to suspect an imminent financial catastrophe. At least that’s what many of them thought.

The unfounded optimism prompted bankers and financial experts to get out of their comfort zone and ‘bet big’ in hopes of making huge profits. From top management to entry-level employees, everyone had an overall positive attitude towards the future. They mindlessly believed in a scenario that turned out to be completely different than what they imagined. What’s even more interesting is that they refused to listen to the few ‘rational thinkers’ who advised against risky financial investments and advocated caution.

Even if there were some ‘rational’ thinkers who had a balanced perspective and did not see the future as bright as the rest, their number was too small to ever have a presence in the competitive world of investment banking.

Long story short, the very few voices that where preaching financial moderation were eventually reduced to silence by the overwhelming majority of positive thinkers and optimists who saw the imminent financial crisis as yet another false alarm.

What happened afterward was a scenario that many of us are well familiar with. However, some questions still remain unanswered.

For instance, how come some were able to foresee an imminent financial crisis, while others weren’t? Why did the majority of investors and bankers ignore the warnings that came from the few who weren’t as optimistic about the future as the rest? Why did top financial experts with years of experience and tons of successful investments make such careless mistakes?

To answer these questions, we’re going to explore a new and revolutionary field that emerged at the frontier between human psychology and economics.

Behavioral Economics: Uncovering the Reasons Behind Our Poor Financial Decisions

Founded by economist and Nobel Prize winner Richard Thaler, behavioral economics is an emerging field of research that combines behavioral psychology and economy, in hopes of helping people make better financial decisions.

After 2008, research in this new field exploded, as more and more people began showing an interest in the inner workings of financial decision making and consumer behavior.

Many representatives of this field believe the 2008 financial crisis happened because our economic system was built on the wrong premise. ‘Classical’ economy starts from the assumption that individuals are in general capable to make the most informed and rational decisions when it comes to managing their finances.

The reality, however, tells a different story. People often make bad decisions, miscalculate risks, and repeat the same mistakes over and over again.

But how did we end up believing that humans, in general, make sound financial decisions?

It all began with Adam Smith, who used the term ‘Homo economicus’ to describe the economic man; the man who’s consistently rational in his financial decisions and pursues his financial goals responsibly and optimally.

What Adam Smith, The Father of Economics, failed to take into account — mainly because of the lack of advancements in behavioral sciences — were the cognitive biases that often interfere with the decision-making process.

This is where behavioral economics comes into play, giving us a better perspective on how our brain makes decisions. Being one of the ‘hottest’ emerging fields of study — with real-life implications — behavioral economics tries to integrate the latest advances in psychology into a more flexible and realistic explanation of human economic behavior. By taking into account all possible factors, from fluctuations in human rationality and emotions to marketing techniques, persuasion, and our inability to make sound financial predictions, this field offers a clear perspective on why we occasionally make bad investments.

As a result, behavioral economics has considerable implications in various domains, from public policy [1] and consumption [2] to nutrition [3], physician care [4], and even substance use disorders [5]

Let’s move on to how behavioral economics explains the decisions that lead to financial disasters.

Why Investors are Irrational, According to Behavioral Finance

#1 Herd Behaviour

Marketing and advertisement experts have long explored the human tendency to copy their kin. Think of the background laughter that you often hear during a sitcom. The minute one of the actors/presenters cracks a joke, you’re immediately hit by a wave of laughter from a supposed audience. So, what does our brain get from this? Well, it usually tells us that the joke must be funny. Otherwise, it would not amuse so many people.

The same principle applies to financial decisions. In other words, we invest in something not because we did thorough research which led us to believe the investment will pay off, but because others say it’s a good investment.

One of the mechanisms that underlie herd behavior is social influence. As the authors of one study state, “When someone purchases an asset, his peers may also want to purchase it, both because they learn from his choice (“social learning”) and because his possession of the asset directly affects others’ utility of owning the same asset (“social utility”).” [6]

This cognitive bias is most apparent during economic bubbles such as the ‘booming’ US mortgage market during 2007 (which triggered the 2008 financial crisis) or the dot-com bubble.

#2 Affect Heuristics

Although decision making is primarily a cognitive process, emotions seem to play a huge role in our financial decisions. In fact, any good marketer, advertising agent, or salesperson knows that to capture customers’ attention, one needs to: 1) appeal to their emotional side; 2) build positive emotions around the product/service. This is also the reason why storytelling is the best way to deliver a powerful message or convince people to make certain decisions.

For behavioral economics, making a decision based on emotion (rather than cognition) is a mental shortcut that can sometimes backfire. It’s a way in which your mind solves problems fast or prompts you to act based on current emotions.

Affect heuristics can sometimes result in biased decisions. One study on how affect heuristics can influence our decisions revealed that when presented with two scenarios that have the same negative outcome (in this case, number of birds killed by oil spills), people tend to evaluate more negatively the scenario in which humans caused oil spills compared to when nature caused them. [7]

In short, it wasn’t the outcome which leads to a decision, but the backstory. Same bias can occur in financial decisions. For example, we decide to invest in cryptocurrency, not because we did a thorough analysis and concluded that it’s a viable investment, but because a friend told us that he had made a profit by investing in certain coins.

#3 The Confirmation Bias

In general, people are in love with their ideas. We like to think that our thoughts and beliefs are the ‘right’ ones. In fact, we are so in love with what we believe is ‘right’ and ‘valid’ that we occasionally choose to ignore any piece of evidence that contradicts our beliefs.

This is what the confirmation bias is all about; a tendency to confirm our existing theories and beliefs about ourselves and life in general by choosing pieces of evidence that support our theories and explanations.

Instead of looking at ALL the evidence with a critical eye, we cherry-pick pieces of information that confirm what we already hold as accurate or valid.

By evaluating a group of UK value-glamor investors, researchers concluded that: “Pessimistic value investors typically under-react to good financial information, while they process bad information rationally or over-confidently. On the contrary, glamour investors are often too optimistic to timely update prices following bad financial information, while they are likely to fairly price or even over-react when receiving good information.” [8]

In short, each investor chose to interpret and integrate new information based on what they’ve already known. As a result, their decisions were influenced not by the new pieces of information, but by their personal beliefs and theories about market trends.

#4 Overconfidence

In broad lines, self-confidence is the sum of all self-perceived abilities. It is an inner sense of power that drives us to achieve various goals. As you will soon find out, too much confidence can often lead to poor financial decisions.

While ‘healthy’ self-confidence is based on proven skills and knowledge, ‘unhealthy’ self-confidence usually stems from disillusions. Contrary to what most people have thought for a long time, there are few advantages to thinking that you’re good when you’re not and plenty of advantages in knowing and accepting your weaknesses and limits.

For good investors, it’s ridiculously easy to fall victim to overconfidence, especially when others invest them with this quality. Whenever you’re on a winning streak the last thing that comes to mind is the possibility that you might be wrong.

As one 2014 study points out, overconfidence has a positive effect on risk-taking behavior, both in our personal and professional life. For investors or financial experts, overconfidence is what drives them to invest in risky markets. Furthermore, after interviewing 64 high-level professionals, the authors concluded that “Professionals are unable to make consistent predictions about future stock prices.” [7]

If we are to look at the 2008 financial crisis, it’s obvious that overconfidence was part of the recipe for disaster. Otherwise, investors would have paid more attention to the skeptics and who warned of a potential market collapse.

#5 Worry

Like any other system, our mind has limited capabilities. Just as bandwidth limits your Internet speed so is your mind’s processing power limited by the number of tasks performed at the same time. The more tasks your mind has to deal with, the bigger the cognitive load.

This means that specific factors such as work-related stress and financial worries can add to the cognitive load that impairs the decision-making process. As a result, any decision — be it financial or other nature — may end up being the wrong one simply because your mind didn’t have enough resources to do a thorough analysis.

In such cases, it’s possible that your mind might fall victim to affect heuristics which provides a fast way to make decisions, without having to spend too many resources.

The easiest way to prevent worrying from interfering with the decision-making process is to leave the big decisions for when you’re less stressed.

Works Cited

[1] S. Bhargava and G. Loewenstein, “Behavioral Economics and Public Policy 102: Beyond Nudging,” American Economic Review: Papers & Proceedings, vol. 105, no. 5, p. 396–401, 2015.

[2 ]S. R. Hursh, “Behavioral Economics and the Analysis of Consumption and Choice,” Managerial and Decision Economics, vol. 37, no. 4–5, p. 224–238, 2016.

[3] J. A. List and A. Savikhin Samek, “The behavioralist as nutritionist: Leveraging behavioral economics to improve child food choice and consumption,” Journal of Health Economics, vol. 39, pp. 135–146, 2015.

[4] E. J. Emanuel, P. A. Ubel, J. B. Kessler, G. Meyer, R. W. Muller, A. S. Navathe, P. Patel, R. Pearl, M. B. Rosenthal, L. Sacks, A. P. Sen, P. Sherman and K. G. Volpp, “Using Behavioral Economics to Design Physician Incentives That Deliver High-Value Care,” Annals of Internal Medicine, vol. 164, no. 2, pp. 114–119, 2016.

[5] W. K. Bickel, M. W. Johnson, M. N. Koffarnus, J. MacKillop and J. G. Murphy, “The Behavioral Economics of Substance Use Disorders: Reinforcement Pathologies and Their Repair,” Annual Review of Clinical Psychology, vol. 10, pp. 641–677, 2014.

[6] L. Bursztyn, F. Ederer, B. Ferman and N. Yuchtman, “Understanding Mechanisms Underlying Peer Effects: Evidence From a Field Experiment on Financial Decisions,” Econometrica, vol. 82, no. 4, p. 1273–1301, 2014.

[7] M. Siegrist and B. Sütterlin, “Human and Nature-Caused Hazards: The Affect Heuristic Causes Biased Decisions,” Risk Analysis, vol. 34, no. 8, p. 1482–1494, 2014.

[8]C. Duong, G. Pescetto and D. Santamaria, “How value–glamour investors use financial information: UK evidence of investors’ confirmation bias,” The European Journal of Finance, vol. 20, no. 6, pp. 524–549, 2014.

[9] M. Broihanne, M. Merli and P. Roger, “Overconfidence, risk perception and the risk-taking behavior of finance professionals,” Finance Research Letters, vol. 11, no. 2, pp. 64–73, 2014.

Conduct Mind

A publication looking at regulatory issues within financial services

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Compliance Tyler

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Tyler Woollard is the founder and MD of The Conduct Mind Limited, a compliance consultancy specialising in Conduct Risk. www.theconductmind.com

Conduct Mind

A publication looking at regulatory issues within financial services

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