Cognitive Biases in the Investment

Decision Process

Patrick Silva, Jorge Mendonça , Luís M. P. Gomes , and Lurdes Babo

Abstract Behavioral finance aims to understand the reasoning patterns of investors,

constrained by emotional processes, and how they influence the decision-making
process. The main purpose of this work is to evaluate individuals’ decision-making
behavior under risk/uncertainty. The methodological procedure adopted exploratory
research with data collection through a questionnaire grounded by the prospect theory
with 329 valid responses from individuals in Portugal. The results are aligned with
those obtained in Kahneman and Tversky’s study on the effects of prospect theory.
Moreover, they support different behaviors between non-investors (more risk-averse)
and investors (more risk-prone), and consistency is observed between those familiar
or not with the concept of behavioral finance. Overall, individuals’ decision-making
behavior seems to be influenced by cognitive biases and the intuitive system. The
findings are important because they highlight the importance of strategic financial
literacy plans.

Keywords Behavioral finance · Decision making · Prospect theory · Risk

P. Silva
ISCAP, Polytechnic of Porto, Porto, Portugal
e-mail: patricksilva@granidense.com
J. Mendonça
SIIS, ISEP, Polytechnic of Porto, Porto, Portugal
e-mail: jpm@isep.ipp.pt
L. M. P. Gomes (B) · L. Babo
CEOS.PP, ISCAP, Polytechnic of Porto, Porto, Portugal
e-mail: pgomes@iscap.ipp.pt
L. Babo
e-mail: lbabo@iscap.ipp.pt

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 185
A. Mesquita et al. (eds.), Perspectives and Trends in Education and Technology,
Smart Innovation, Systems and Technologies 320,
https://doi.org/10.1007/978-981-19-6585-2_17
186 P. Silva et al.

1 Introduction

The way financial decision-making has been studied has evolved over the past few
years. This evolution was driven by behavioral finance, which proposes a more real-
istic view of investor decisions. This perspective studies “how” and “why” economic
agents behave effectively, unlike traditional finance, which adopts an ideal view of
reality [1].
Behavioral finance received an important contribution from prospect theory,
developed by Kahneman and Tversky [2], which explores the behavior of individuals
when making decisions in an environment of risk and uncertainty [3].
The field of behavioral finance has been expanding because recognizing the exis-
tence of gaps, it seeks to explain decisions not supported by traditional finance
by combining behavioral and cognitive psychology with traditional economics and
finance [4, 5]. Since it is a somewhat new area of knowledge, the challenges posed
to traditional finance are not yet fully explored. This fact constitutes a motivation
for this paper which the main objective is to figure out individuals’ decision-making
behavior under risk and uncertainty and determine the influence of cognitive biases,
contributing to scientific knowledge in the field of behavioral finance. The method-
ological procedure is based on exploratory research for data collection through a
survey led by the prospect theory to which a sample consisting of 329 individuals
in Portugal responded. The critical analysis of the data allows combining different
characteristics of the respondents to enrich the conclusions.
Besides this introductory chapter, the present paper is structured in three sections.
The second section presents behavioral finance, addressing the expected utility theory
and developing the prospect theory. The following section details the objectives
of the empirical study and the methodological procedures and then compares the
expected results with those obtained on the effects of the prospect theory. In addition
to the comparison with the original study, the results also allow distinguishing the
non/investor and non/knowledgeable behavioral finance profiles. The fourth section
emphasizes the main conclusions.

2 Behavioral Finance

Kahneman and Tversky [2] pioneer researchers in the field of behavioral finance
pointing out that this area’s main objective is to identify and understand the cognitive
illusions that lead investors to make continuous errors in the evaluation of values,
probabilities, and risks. The authors argue that most individuals do not act for a
reason because they are predisposed to the effect of these cognitive illusions.
We conclude that the man of behavioral finance is a normal being with weak-
nesses. This normality implies that humans often act irrationally making decisions
supported by emotions and cognitive errors and the same problem may be under-
stood in different ways, depending on the analysis perspective. Behavioral finance
Cognitive Biases in the Investment Decision Process 187

identifies how these emotions and cognitive errors can influence investors’ decision-
making process and how these behavioral patterns can lead to market anomalies [6,
7]. Researchers in the psychology field have complemented economic theories by
arguing that individuals systematically deviate from sound judgment in decision-
making [8]. Several studies recognize cognitive and emotional biases explaining the
deviation from rationality principles [7, 9, 10].

2.1 Prospect Theory

Prospect theory was developed by Kahneman and Tversky [2] as a critic of the
boundless rationality advocated by expected utility theory. This theory was first
proposed by Bernoulli [11] and later, von Neumann and Morgenstern [12] defined
the basis for its derivation. The theory was first developed as a normative model of
choice describing the idealized behavior of a rational individual [13]. The investor
is considered a rational being who knows and logically organizes his convictions,
striving to maximize the utility of his choices. To this purpose, he assigns probabilities
to future events that are conditioned by alternatives involving risk and uncertainty
[14].
The equations of prospect theory maintain the general bilinear form underlying
expected utility theory while assuming that values are associated with changes (rather
than final states) and that decision weights do not coincide with defined probabilities.
As pointed out by Bortoli [15] and Pan [16], individuals consider the changes in their
wealth or welfare at the time of decision making rather than the end state of the gains
and losses from the decisions. Therefore, Tversky and Kahneman [17] argued that
decisions should be analyzed independently, contrary to the expected utility theory.
According to Kahneman and Tversky [2, p. 277], deviations from expected utility
theory must lead to normatively unacceptable consequences, such as “inconsisten-
cies, intransitivities, and dominance violations.” Usually, the decision-maker corrects
such anomalies when he realizes the consequences of his preferences. Choices
between risky perspectives exhibit several effects inconsistent with the basic tenets of
expected utility theory. Thus, the authors presented the current as a theoretical basis
for analyzing the behavior of individuals when making decisions in an environ-
ment of risk and uncertainty. In this context, individuals are influenced by cognitive
biases in decision making, i.e., in complex situations, they tend to simplify prob-
lems through mental shortcuts [18]. Instead of weighing the probability, individuals
sum the possible future value function through the decision weighting function, thus
obtaining the final decision value [16].
Prospect theory distinguishes two phases in the process of choice under risk
[2]. The editing phase consists of a preliminary analysis of the perspectives offered,
based on a simpler representation of these options. The subsequent stage involves the
principles of judgment governing the valuation of gains and losses and the weighting
of uncertain outcomes.
188 P. Silva et al.

The frequencies of responses to the survey reported by [2] identified the following
phenomena (effects) that were not predicted by expected utility theory.
Certainty Effect
The individual prefers an event considered certain over an only probable event.
But when faced with two uncertain events, the individual tends to change behavior,
preferring the risk. Still, the degree of certainty has more importance in decision-
making. The above suggests that both loss aversion and the desire for gains increase
with the certainty of the event [2].
Reflection Effect
The individual prefers not to take risks when faced with a situation where he can win.
But when faced with a situation where he can lose, he tends to change his behavior,
preferring the risk. The above suggests the existence of risk aversion for gain and
risk propensity for loss [19]. According to the authors [2, 20], losing money causes
greater dissatisfaction than the satisfaction of gaining the same amount.
Probabilistic Insurance
Probabilistic insurance represents various forms of protection through a cost to reduce
the probability of an undesirable event occurring.
Isolation Effect
To simplify the choice between alternatives, the individual usually does not
consider the common components between the alternatives, focusing instead on the
components that distinguish them [2].
The author Michaelson [21] refers that Kahneman and Tversky [2] present the
isolation effect as a two-stage game. When a consequence is common and is encoun-
tered in the first stage it will be ignored, thereby isolating the probability of occurrence
in the second stage. If the choices are similar in terms of risk and distribution, to
move to the second stage, individuals will ignore the outcomes that do not depend
on the choice and focus on the outcomes that vary according to the choices (second
stage).
Value Function
The past and present context of an experience define a reference point for response to
an attribute. According to [22], after a favorable result (gain) the individual tends to
take more risk than usual, but after an unfavorable result (loss) the individual tends
to take less risk. Therefore, the value should be treated as a two-way function: the
asset position that serves as a reference point and the magnitude of the change from
that reference point [2].
Weighting Function
In prospect theory, the value of each choice is multiplied by a decision weight, which
is inferred from choices between perspectives. Decision weights measure the impact
Cognitive Biases in the Investment Decision Process 189

of events on the desirability of perspectives, not just the perceived probability of

those events [2].

3 Empirical Study

3.1 Aims of the Empirical Study and Methodological

Procedure

The central objective of this research is to understand the behavior of individuals when
facing decision-making, namely by identifying the influence of cognitive biases.
More specifically, the research intends to:
1. investigate whether the respondents’ answers are underpinned by the effects of
the prospect theory;
2. investigate whether investors’ answers diverge from non-investors’ answers
regarding the effects of the prospect theory;
3. investigate whether the responses of those familiar with the concept of behavioral
finance diverge from those not familiar with the effects of the prospect theory.
Data collection used exploratory research, based on a questionnaire survey
conducted between June 1 and August 31, 2019, through which 329 valid responses
were obtained from 618 respondents in Portugal. The exclusion criterion was age
under 18 years. The methodological procedure was based on the replication of
the prospect theory problems according to [2] survey. In addition, the survey was
supplemented with an initial group of questions to characterize the respondents.
The empirical study used both the LimeSurvey platform for questionnaire design
and online data collection and IBM SPSS 24 software for statistical treatment. The
Chi-square test was applied to assess any significant differences between the two
types of respondent choice.

3.2 Expectable Results on the Effects of the Prospect Theory

Next, we present the expected results for the questions associated with the effects
that we intend to study according to the theory of perspective.
Certainty Effect
The respondents’ choices are expected to follow the answers with 100% certainty,
even though they may present a lower expected utility function. Thus, for questions
1 and 3 the choice of option B is expected. In questions 2 and 4, the expected gain is
higher, and the difference in percentages is not significant, predicting the choice of
option A. Questions 5 and 6 analyze the effect for non-monetary data. In question 5
190 P. Silva et al.

the choice of option B is expected with 100% certainty, and in question 6 the choice of
option A is expected with a non-significant percentage difference and higher utility.
A subgroup called the “possibility effect” is represented in questions 7 and 8.
Although having the same expected utility, in question 7 it is expected that option
B will be chosen (with no certain gains but with a higher possibility of occurring).
When the possibilities are reduced (question 8) it is expected to choose option A
(higher gain).
Reflection Effect
The questions presented change the values from gains to losses, expecting symmet-
rical answers. In question 9, which involves the certainty of loss, risk-seeking is
expected through option A. In questions 10 and 11 it is expected to choose B and A,
respectively, which have a lower probability of loss. In question 12 the values should
be considered, and the probabilities ignored, which are reduced, being expected the
option for B.
Probabilistic Insurance
In question 13 the choice of option B is expected, rejecting probabilistic insurance,
which is an unusual option, and demonstrating aversion to change.
Isolation Effect
Questions 14 and 4 have the same expected utility value, but question 14 adds two
probability steps. It is expected that the first stage will be ignored by the respondents,
and they will focus on the second stage by choosing option B (yielding an opposite
choice to the one expected in question 4). In questions 15 and 16, respondents are
given additional resources to see if they change their choices. In the expectation
that they will ignore these additional resources and keep their choices, respondents
should choose B for question 15 and A for question 16.
Value Function
To verify if the value function is concave for gains and convex for losses, the questions
are only distinguished by the sign. In question 17 it is expected that option B (the
alternative with the highest probability of gain) is chosen and in question 18 it is
expected that option A (the alternative with the lowest probability of loss) is chosen.
Weighting Function
In questions 19 and 20 the expected utility value is the same but faced with low
probabilities for a high value it is expected that respondents will choose according
to the value. In question 19 they are expected to ignore the certain gain, because it
is low, and choose A, with low probability but high gain. In question 20 they are
expected to choose B, with a certain loss of low value.
Cognitive Biases in the Investment Decision Process 191

3.3 Results and Discussion

As mentioned before, the study received 329 valid questionnaires. In terms of overall
characterization, most respondents are female (64.1%), aged up to 29 years (90.6%),
and have a university degree (53.8%). Their professional activity is diversified, with
education (45.9%) and management (24.3%) prevailing. In addition, most respon-
dents are not investors (76.3%) and do not know the concept of behavioral finance
(67.2%).
Results Obtained on the Effects of the Prospect Theory
Table 1 compares the survey’s results from the original study of Kahneman and
Tversky [2] and this empirical study for the purposes of the prospect theory.
Regarding the certainty effect, what was expected is confirmed. The frequency
of responses converges with the original study, except for the lack of statistical
significance of response 4. The results suggest that respondents value the certainty
of gain (1B and 3B). Faced with alternatives with similar probability, respondents
value the higher gain (2A). These approaches also underlay the choices in questions
5 (B) and 6 (A). Faced with alternatives with different gains, respondents valued the
higher probability (7B) but faced with low probabilities they valued the higher gain
(8A).
In the reflection effect, responses 10 and 12 converge with the original study
and confirm what was expected, despite the lack of significance of response 10.
Faced with alternatives with low probability, respondents preferred the smaller loss
(12B). In addition to diverging from the original study, answers 9 and 11 have lost
significance due to the balance of respondents’ choices.
The option chosen in question 13 converges with the original study and confirms
what was expected, i.e., that respondents do not value the probabilistic insurance
option.
Regarding the isolation effect, what was expected is also confirmed. The frequency
of responses converges with the original study, except for the lack of significance
of response 16. The results suggest that respondents ignore the first phase of the
game and value the certainty of winning (14B). In addition, respondents ignore the
additional resources and value the certainty of the win (15B).
Concerning the value function, responses 17 and 18 converge with the orig-
inal study and confirm what was expected. The results suggest that faced with
gains, respondents value the higher probability (17B); and that, faced with losses,
respondents value the lower probability and ignore values (18A).
Concerning the weighting function, the expected is confirmed. The frequency of
responses converges with the original study, except for the lack of significance of
response 19. Despite the same expected utility in both questions (5000 × 0.1% = 5
× 100%), the results suggest that respondents prefer the certainty of a low loss (20B)
over the weak probability of a high loss (20A).
192 P. Silva et al.

Table 1 Effects of the prospect theory

Original study Empirical study
Effect Question Option N Result Sig N Result Sig
Certainty 1 A 13 18% 91 28%
B 59 82% * 238 72% *
2 A 60 83% * 211 64% *
B 12 17% 118 36%
3 A 19 20% 73 22%
B 76 80% * 256 78% *
4 A 62 65% * 174 53%
B 33 35% 155 47%
5 A 16 22% 74 22%
B 56 78% * 255 78% *
6 A 48 67% * 189 57% *
B 24 33% 140 43%
7 A 9 14% 63 19%
B 57 86% * 266 81% *
8 A 48 73% * 231 70% *
B 18 27% 98 30%
Reflection 9 A 87 92% * 162 49%
B 8 8% 167 51%
10 A 40 42% 152 46%
B 55 58% 177 54%
11 A 61 92% * 148 45%
B 5 8% 181 55%
12 A 20 30% 109 33%
B 46 70% * 220 67% *
Probabilistic insurance 13 A 19 20% 106 32%
B 76 80% * 223 68% *
Isolation 14 A 31 22% 76 23%
B 110 78% * 253 77% *
15 A 11 16% 110 33%
B 59 84% * 219 67% *
16 A 47 69% * 173 53%
B 21 31% 156 47%
Value function 17 A 12 18% 112 34%
B 56 82% * 217 66% *
18 A 45 70% * 206 63% *
(continued)
Cognitive Biases in the Investment Decision Process 193

Table 1 (continued)
Original study Empirical study
Effect Question Option N Result Sig N Result Sig
B 19 30% 123 37%
Weighting function 19 A 52 72% * 184 56%
B 20 28% 145 44%
20 A 12 17% 130 40%
B 60 83% * 199 60% *
“*” p-value observed is less than 0.01

Table 2 presents the results of this empirical study for the effects of the
prospect theory regarding the non-investor/investor profile and familiarity or not
(knowledgeable/non-knowledgeable) with the concept of behavioral finance.
Regarding the certainty effect, the investors’ responses converge with the
responses of the overall sample (cf. Table 1) of the empirical study and with the
responses of the original study, except for the lack of statistical significance of
response 4. In the case of non-investors, answers 2 and 6 loose significance, although
they maintain the same preference of choices.
In the reflection effect, question 9 stands out, where non-investors and investors
choose significantly different options. The investors’ answers converge with the orig-
inal study and confirm the reflection effect. In addition to the loss of significance,
the frequency of responses to question 11 diverges from the original study.
Probabilistic insurance remains unattractive for these two groups of respondents,
as it did for the overall sample of the empirical study and the original study.
In the isolation effect, we highlight the loss of significance of the investors’
responses to question 15 and the change in frequencies between the non-investors
and investors’ responses to question 16.
Regarding the value function, the answers of the two groups of respondents
converge with the answers of the global sample of the empirical study and with
the answers of the original study.
Considering the weight function, question 20 stands out, in which the investors’
answers lose statistical significance.
The changes in the frequency of responses to questions 4, 9, and 16 suggest that
non-investors are more risk-averse and that investors are more risk-prone.
About the certainty effect, the responses of the non-knowledgeable converge with
the responses of those knowledgeable about the concept of behavioral finance. In
question 2, the significance of the answers of these two groups of respondents coin-
cides with the investors, and in question 6, the lack of significance of the answers of
these two groups of respondents coincides with the non-investors.
In the reflection effect, question 9 stands out, where the frequencies of choices
change but without significance between those not familiar (non-knowledgeable) and
those familiar (knowledgeable) with the concept of behavioral finance.
Probabilistic insurance remains unattractive for these two groups of respondents.
Table 2 Effects of the prospect theory regarding the investor profile and knowledge of behaveoral finance
194

Non-investor Investor Non-knowledgeable Knowledgeable

Effect Question Option Result Sig Result Sig Result Sig Result Sig
Certainty 1 A 28% 27% 27% 30%
B 72% * 73% * 73% * 70% *
2 A 58% 85% * 62% * 68% *
B 42% 15% 38% 32%
3 A 24% 17% 19% 28%
B 76% * 83% * 81% * 72% *
4 A 50% 62% 52% 56%
B 50% 38% 48% 44%
5 A 23% 21% 20% 27%
B 77% * 79% * 80% * 73% *
6 A 53% 71% * 57% 59%
B 47% 29% 43% 41%
7 A 22% 10% 19% 19%
B 78% * 90% * 81% * 81% *
8 A 67% * 79% * 71% * 69% *
B 33% 21% 29% 31%
Reflection 9 A 46% 65% * 48% 53%
B 54% 35% 52% 47%
10 A 47% 44% 45% 49%
B 53% 56% 55% 51%
(continued)
P. Silva et al.
Table 2 (continued)
Non-investor Investor Non-knowledgeable Knowledgeable
Effect Question Option Result Sig Result Sig Result Sig Result Sig
11 A 44% 47% 43% 48%
B 56% 53% 57% 52%
12 A 36% 23% 33% 34%
B 64% * 77% * 67% * 66% *
Probabilistic 13 A 35% 23% 31% 35%
insurance B 65% * 77% * 69% * 65% *
Isolation 14 A 24% 21% 20% 29%
B 76% * 79% * 80% * 71% *
15 A 30% 45% 29% 44%
B 70% * 55% 71% * 56%
Cognitive Biases in the Investment Decision Process

16 A 49% 63% 50% 57%

B 51% 37% 50% 43%
Value function 17 A 35% 31% 35% 31%
B 65% * 69% * 65% * 69% *
18 A 60% * 72% * 61% * 66% *
B 40% 28% 39% 34%
Weighting 19 A 55% 60% 56% 56%
function B 45% 40% 44% 44%
20 A 38% 44% 36% 46%
B 62% * 56% 64% * 54%
“*” p-value observed is less than 0.01
195
196 P. Silva et al.

In the isolation effect, question 15 stands out, in which the answers of those
familiar with the concept of behavioral finance lose statistical significance, as in the
case of investors.
Regarding the value function, the answers of the two groups of respondents
converge with the answers of the overall sample of the empirical study, with the
answers of the groups of investors and with the answers of the original study.
Concerning the weight function, question 20 stands out, in which the responses
of those familiar with the concept of behavioral finance lose statistical significance,
as in the case of investors.
Overall, the answers are consistent between the group of non-knowledgeable and
the group of knowledgeable of the concept of behavioral finance.

4 Conclusion

The study of human behavior in decision-making in markets that involve risk is of

great importance since understanding biases and heuristics that affect these decisions
can help improve judgments and reduce losses resulting from irrational choices [23].
The results of the present study show that respondents’ behavior is affected by
effects (certainty, reflection, probabilistic insurance, isolation, value function, and
weighting function), grounded by prospect theory, that influence decision making.
On the other hand, it is possible to conclude that the behavior of the respondents
is different depending on their profile. Differences were observed in the responses
between non-investors and investors, but consistency in the responses were found
between those not familiar and those familiar with the concept of behavioral finance.
The frequency changes in some responses denote that non-investors are more risk-
averse and that investors are more risk-prone.
The findings of this study are important for risk profilers as they might contribute
to the definition and improvement of financial literacy strategic plans.
For future research, we suggest deepening the study of cognitive reflection in the
investor profile and looking for the existence of groups with higher/lower cognitive
aptitude.

Acknowledgements This work is financed by Portuguese national funds through FCT—Fundação

para a Ciência e Tecnologia, under the project UIDB/05422/2020.

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