 Psychology of Investors

o Beliefs:

“I think one of the major results of the psychology of decision making is that people’s attitudes
and feelings about losses and gains are really not symmetric. So we really feel more pain when
we lose $10,000 than we feel pleasure when we get $10,000. -Daniel Kahneman

According to Traditional Finance, investors are, for the most part, rational “wealth maximizers.”
This theory says man acts only in a way that maximizes his returns and minimizes his risks. In
contrast, Behavioral Finance attempts to understand and explain actual investor behavior
versus theories of investor behavior.

Emotion and deeply ingrained biases influence our decisions, causing us to behave in
unpredictable or irrational ways. In fact, some may consider it to be predictably
irrational. Behavioral finance is a relatively new field that seeks to combine behavioral and
cognitive psychological theory with conventional economics and finance to provide
explanations for why people make irrational financial decisions.

 Daniel Kahneman and Amos Tversky

Cognitive psychologists Daniel Kahneman and Amos Tversky are considered the fathers of
behavioral economics/finance. Since their initial collaborations in the late 1960s, this duo has
published about 200 works, most of which relate to psychological concepts with implications
for behavioral finance. In 2002, Kahneman received the Nobel Memorial Prize in Economic
Sciences for his contributions to the study of rationality in economics.

“It’s frightening to think that you might not know something, but more frightening to think that,
by and large, the world is run by people who have faith that they know exactly what is going on.
-Amos Tversky

Investors are influenced by two primary behavioral biases: Cognitive Errors and Emotional
Biases:

1. Cognitive Errors

Cognitive Errors deal with how people think and result from memory and information-
processing errors and are, therefore, the result of faulty reasoning.
There are two sets of cognitive errors: belief perseverance biases and information-processing
biases.
Belief perseverance biases are those in which people have a hard time modifying their beliefs,
even when faced with information to the contrary. Belief perseverance biases include cognitive
dissonance, conservatism, confirmation, representativeness, illusion of control, and
hindsight.

Information-processing biases are those in which people make errors in their thinking when
processing information related to a financial decision. The information-processing biases
include anchoring and adjustment, mental accounting, framing, availability, self-
attribution, outcome, and recency.

2. Emotional Biases

Emotional biases are the result of reasoning influenced by feelings.

It is a very human reaction to feel mentally uncomfortable when new information contradicts
information you previously held to be true–a psychological phenomenon known as cognitive
dissonance. For example, two thousand years after the Greek philosopher Pythagoras proposed
the world is round, Columbus was still trying to refute the common belief that it was flat by
attempting to circumnavigate the globe.

Emotional biases are based on feelings rather than facts. Emotions often overpower our thinking
during times of stress. All of us have likely made irrational decisions at some time in our
lives. Emotional biases include loss aversion, overconfidence, self-control, status quo,
endowment, regret aversion, and affinity.