UNIT 6: Psychological aspects in investment decision making

In the last decade, the compelling evidence linking psychology and emotions to
financial and investment choices has gained widespread acceptance. Both psychologists
and economists now acknowledge the potential for irrationality among investors, leading
to predictable decision errors that impact market dynamics. Recognizing and
comprehending the psychological biases influencing actual investor behavior is crucial, and
this chapter explores key aspects and characteristics in this context.

Learning Outcomes

After completing this unit, the student will be able to:

• Describe the perceptions of investment risk, mental accounting and investing.
• Determine the emotions and investment decisions of investors.

Pretest
Discussion:
1. What is the psychological approach to investment decisions?
2. What are the psychological factors in financial decision-making?

Congratulations, and thank you for taking the test. The following section contains the unit's
content. It involves important psychological aspects and characteristics of investors’
behavior.
 Content

I. Introduction

A few decades' worth of financial and investment decisions were made under the
presumption that people are impartial in their forecasts of the future and make logical
decisions. However, it is common knowledge that occasionally people behave in blatantly
illogical ways and make mistakes when making predictions about the future. Investors may
exhibit irrational behavior. People are typically risk averse, but investors will accept the risk if
the expected return is high enough. The evidence that psychology and emotions play a role in
financial and investment decisions has grown stronger over the years. These days, economists
and psychologists alike concur that investors may exhibit irrationality. Additionally, the market
fluctuations may be impacted by predictable decision errors. Therefore, it is crucial to
comprehend the behavior of real investors as well as the psychological biases that influence
their choices. This chapter discusses some significant psychological elements and traits of
investor behavior.
A. Overconfidence
People who are overconfident tend to overestimate their abilities, risks, and
knowledge. It's interesting to note that when people believe they have control over the
outcome, even though this is merely an illusion, they tend to become more overconfident.
This perception also applies to investing. People think their stocks will perform better than
stocks they do not own, even in the absence of information.
Owning stock, however, merely creates the appearance of control over the stock's
performance. Investors typically anticipate a return that is higher than average. Investing is a
challenging endeavor. It entails obtaining data, analyzing that data, and making decisions in
light of that data. On the other hand, overconfidence leads us to overestimate our ability to
analyze the data and misinterpret its accuracy. It happens after someone has some degree of
success. The bias in self-attribution makes people think that while failure is the result of bad
luck, success is the result of skill. Following a period of market success, investors may become
overconfident.
Overconfidence can cause investors to make bad trading decisions, which frequently
show up as excessive trading, taking on too much risk, and eventually losing money on their
portfolios. They trade more because of their overconfidence, which makes them overly certain
of their beliefs. Investors' opinions are based on their perceptions of the reliability and
interpretability of the information they have access to. Overconfident investors care less
about other people's opinions and have a stronger belief in their own assessment of a stock.
Think about an investor who is very skilled at interpreting accurate information that is
provided to them. Due to their skill and the quality of the information, the investor should see
high returns from their frequent trading. Actually, these yields ought to be high enough to
offset trading expenses and outperform a straightforward buy-and-hold strategy. However, if
the investor is simply overconfident rather than possessing superior ability, the high turnover
rate will not produce portfolio returns large enough to outperform the buy-and-hold strategy
and cover expenses.
Investing based on overconfidence can be risky when trying to build wealth. Excessive
trading is not the only issue that results in high commission costs. It has been noted that
overconfidence results in both excessive trading frequency and buy the incorrect stocks. Thus,
an investor who is overconfident may also sell a well-performing stock to buy a poorly
performing one.
Overconfidence also affects investors’ risk-taking behavior. The goal of rational
investing is to minimize risk and maximize returns. Overconfident investors, however,
misjudge the amount of risk they assume. In the end, if a shareholder is certain that the chosen
stocks will yield a substantial return, then what risk exists? Investors who are overconfident
will have higher risk in their portfolios for two reasons. The first is the propensity to buy stocks
with greater risk. Sticks with higher risk typically come from smaller, more recent businesses.
A propensity to under diversify their portfolio is the second explanation. A number of metrics
can be used to quantify prevalent risk, including portfolio volatility, beta, and firm size. The
amount of ups and downs the portfolio experiences is measured by portfolio volatility.
Portfolios with high volatility show significant price fluctuations and are a sign of inadequate
diversification. A higher beta value for the portfolio denotes a higher level of risk and volatility
for the security compared to the overall stock market.
Overconfidence comes partially from the illusion of knowledge. This speaks to the
propensity for people to think that having more information will make their forecasts more
accurate; in other words, having more information will increase one's knowledge and help one
make better decisions. Today's investors can access vast amounts of information by using the
Internet. This information includes current data, like real-time news and prices, as well as
historical data, like past prices, returns, and the operational performance of the firms.
Nonetheless, the majority of individual investors are less qualified to understand how to
interpret this data since they lack the professional investors' training and experience. That is
to say, because they lack the necessary training to properly interpret the information, they do
not have as much knowledge about the situation as they believe. A growing number of
individual investors turn to the Internet for assistance after realizing they are not very good at
interpreting investment information.
The illusion of control is another crucial psychological component for investors.
Individuals frequently think they can affect how uncontrollable events turn out. An investor
feels more in control when early results are positive than when they are negative. Investors
who acquire more information also seem to have a greater sense of control.
B. Disposition Effect
Individuals typically steer clear of regrettable decisions and instead pursue proud
actions. The emotional suffering that results from understanding that a prior choice was not
the best one is known as regret. The feeling of delight that arises when one realizes that a
choice has turned out nicely.
People's decisions are influenced by their desire for pride and their avoidance of
regret; investors are no exception. Shefrin and Statman (1985) were the first economists to
demonstrate that investors' desire for pride and fear of regret lead to prone to riding losers
(stocks with declining market prices) for extended periods of time and selling winners
(potential stocks with rising market prices) too soon. This effect is known as the disposition
effect.
The disposition effect implies that losers are retained too long and winners are sold
too soon in addition to forecasting the selling of winners. What impact might such investor
behavior have on the possible returns on his investments? Giving away winners too soon
implies that the stocks will perform well even after they are sold, and that holding losers for
an extended period of time will indicate that the stocks will perform poorly. Investors' wealth
can be impacted by the fear of regret and the desire for pride in two ways: first, they pay more
taxes due to their inclination to sell winners rather than losers; second, they receive a lower
return on their portfolio because they sell the winners too soon and hold poorly performing
stocks that continue to show declining market results.
The findings of a few other interesting studies (Nofsinger, 2001) examined how
individual investors reacted to news about the company and the economy. Investors are
prompted to sell stock (selling winners) when positive news about the company raises the
price of its shares. And, contentiously, negative news regarding the company does not
persuade investors to cash in on their losses. This is in line with seeking pride and avoiding
regret. Nonetheless, economic news does not encourage trading among investors. Following
positive economic news, investors are less likely than usual to sell winners, and these findings
are inconsistent with the disposition effect. How might one explain these kinds of results?
Because investors have a strong sense of regret associated with the disposition effect, their
actions are consistent with the disposition effect for company news. Investors experience less
regret when it comes to economic news because they believe they have no control over the
outcome. This results in behaviors that deviate from the disposition effect's predictions.
C. Perceptions of investment risk

Risk perception seems to differ amongst people. People are willing to take more risk
after making profits and less risk after suffering losses, so past performance is a crucial
consideration when assessing a risky decision that they are making now. People are more
inclined to take on greater risk after making a gain or profit. Those who win large sums of
 money from gambling tend not to fully claim the winnings as their own. Thus, they behave as
though they are gambling with when they are taking on more risk. We refer to this as the
"house-money" effect. According to the "house-money" effect, investors are more inclined to
buy riskier stocks after locking in a profit by selling them at a higher price.
Those who have suffered a financial loss are less inclined to take chances. This
phenomenon is known as the "snakebite" effect because it causes people to become cautious
and remember it for a long time. In a similar vein, individuals frequently feel they avoid taking
risks in their investment decisions and will also fail in the future. For instance, adding new
stocks to an investor's portfolio can improve portfolio diversification. However, if the newly
acquired stocks experience a sharp price decline, the investor may experience the snakebite
effect and become apprehensive about adding new stocks to his portfolio in the future.
Those who don't stand to gain or lose a lot of money would rather not take the chance.
It is necessary to consider the endowment effect when examining investor risks. When people
demand significantly more for a product than they are willing to pay for it, this is known as the
endowment effect. The status quo bias, or the tendency of individuals to try to hold onto what
they have rather than trade it for something else, is closely linked to the endowment effect.
What is the impact of status quo bias or endowment on investors? Individuals tend to hold
onto the investments they already own.
With an increase in investment options comes an increase in the status quo bias. In other
words, the more intricate the more imperative the investment decision, the more probable it is
that the individual will opt to take no action. In the real world, investors have thousands of
companies to choose from when buying stocks, bonds, and other financial instruments. The
investors may be impacted by all of these scenarios, which is why they frequently decide against
changing. This could be especially problematic if the investments have experienced a loss. We
have seen this kind of investor behavior in recent years.
Memory is discussed as one of the factors which could affect the investors’ behavior too.
Memory can be understood as a perception of the physical and emotional experience. These
experiences for different people could be different. Memory has a feature of adaptively and can
determine whether a situation experienced in the past should be desired or avoided in the future.
Usually, the people feel better about experiences with a positive peak and end. And lastly, the
recollection of the significant loss of the time is linked to more intense emotional suffering. For
instance, the investor becomes more confident in the stocks in his portfolio that see a sharp price
increase at the end of the term and becomes less confident in other stocks that prices increased
steadily over the whole time. Consequently, the investor may be overly optimistic when making
decisions regarding these stocks for the upcoming period. The stock that produces positive short-
term results but is overly negative about its continuous growth.
Close related with the memory problems affecting the investors behavior is
cognitive dissonance. Cognitive dissonance is based on evidence that people are
struggling with two opposite ideas in their brains: “I am nice, but I am not nice”. Consequently,
the investor may be overly optimistic when making decisions regarding these stocks for the
upcoming period the stock that produces positive short-term results but is overly negative about
its continuous growth. People used to reject or ignore any information that went against their
positive self-image in order to prevent psychological pain. Two factors can influence an investor's
decision-making process when trying to avoid cognitive dissonance. Investors may firstly fail to
make crucial choices because it is too uncomfortable to think things through. Secondly, the
filtering of fresh data makes it harder to assess and keep an eye on investors' choices. Investors
try to lessen psychological suffering by changing their perceptions of the performance of previous
investment choices. For instance, when an investor decides to purchase stocks in N company and
learns over time that the company's results are positive and support their previous decision, they
feel like "I am nice." However, when the company they chose has poor results, they try to
minimize their cognitive dissonance. The investor's mind will minimize or filter out the
unfavorable details about the business and concentrate on the positive details. Regardless of the
actual performance, the investor keeps in mind that they performed well. Furthermore, it is
evident that when past performance is assessed with an upward bias, it is challenging to assess
the progress made toward the investment goals in an objective manner.
D. Mental Accounting and Investing
People use financial budgets to control their spending. The brain uses mental budgets to
associate the benefits of consumption with the costs in each mental account. Mental budgeting
matches the emotional pain to the emotional joy. We can compare the costs (pain) involved in
making purchases of goods and services to the anguish of suffering financial losses. The joy (or
benefits) of acquiring money is comparable to the pleasure (or benefits) of purchasing goods and
services.
Individuals prefer not to pay off debt associated with items they have already used. For
instance, taking out debt to pay for the vacation is not a good idea as it results in long-term costs
rather than short-term gains. Individuals express a preference for balancing the duration of
payments with the duration of use of the products or services.
Economic theories predict that people will consider the present and future costs and
benefits when determining a course of action. Contrary to these predictions, people usually
consider historic costs when making decisions about the future. This behavior is called the “sunk-
cost” effect. The sunk cost effect might be defined as an escalation of commitment – to continue
an endeavor once an investment in money or time has been made. The sunk costs could be
characterized by size and timing. The size of sunk costs is very important in decision making: the
larger amount of money was invested the stronger tendency for “keep going”. The timing in
investment decision making is important too: pain of closing a mental account without a benefit
decreases with time negative impact of sunk cost depreciates over time. Decision makers tend
to place each investment into separate mental account. Each investment is treated separately,
and interactions are overlooked. Mental budgeting compounds the aversion to selling losers. As
time passes, the purchase of
 the stock becomes a sunk cost. It may be less emotionally distressing for the investor to sell
the losing stock later as opposed to earlier. When investors decide to sell a losing stock, they
have a tendency to bundle more than one sale on the same day. Investors integrate the sale of
losing stocks to aggregate the losses and limit the feeling of regret to one time period.
Alternatively, investors like to separate the sale of the winning stocks over several trading
sessions to prolong the feeling of joy (Lim, 2006).
Mental accounting also affects investors’ perceptions of portfolio risks. The tendency to
overlook the interaction between investments causes investors to misperceive the risk of adding
a security to an existing portfolio. In fact, people usually don’t think in terms of portfolio risk.
Investors evaluate each potential investment as if it were the only one investment they will have.
However, most investors already have a portfolio and are considering other investments to
add to it. Therefore, the most important consideration for the evaluation is how the expected
risk and return of the portfolio will change when a new investment is added. Unfortunately,
people have trouble evaluating the interactions between their mental accounts.
Individuals have distinct psychological profiles for every investment objective, and the
investor is prepared to assume varying degrees of risk for every objective. Each mental account's
investments are chosen by looking for assets that fit the account's expected risk and return. There
is a certain amount of money set aside in each mental account for that specific objective.
Therefore, according to Markowitz portfolio theory, investor portfolio diversification originates
from the investment goals diversification rather than from a deliberate asset diversification. This
indicates that the majority of investors do not have efficient portfolios and that they are taking
on excessive risk relative to the expected return.
E. Emotions and Investments
To what extent do investors' emotions influence their decisions? Risk and uncertainty are
present in the complex investment decisions. Economists and psychologists have both studied
how emotions influence decisions in recent years. Creating stronger emotional reactions appear
to influence people's financial decisions. According to some researchers, emotions have a greater
influence on decisions in complex and uncertain situations. Investment decisions can, of course,
also be influenced by one's background emotions or mood.
The mood affects the predictions of the people about the future. People often misattribute
the mood they are in to their investment decisions. This is called misattribution bias. People who
are in bad mood are more pessimistic about the future than people who are in a good mood.
Translating to the behavior of investors it means that investors who are in good mood give a
higher probability of good events/ positive changes happening and a lower probability of bad
changes happening. So, good mood will increase the likelihood of investing in riskier assets and
bad mood will decrease willingness to invest in risky assets. Even those investors who use
quantitative methods such as fundamental analysis must use some assumptions estimating fair
value of the stock. Given the influence of mood on uncertain decisions, the expected growth rate
taken for estimations of value of the stock using DDM (dividend discount models, see chapter 4)
may become biased and affect the overall result of estimated value of the stock. An investor who
is in good mood may overestimate the growth rate and this would cause the investor to believe
the stock is worth more than the believe of unbiased investor. As a consequence, for the
optimistic investor in this case might be his decision to buy the stock which is underestimated
based on his calculations, when in reality it is not. Similar, the investor who is in bad mood may
underestimate growth rate and stock value based on his calculations shows the stock is
overestimated, when it is not in reality. So, the investors making biased and mood-driven
decisions might suffer losses.
Investors who are in a good mood can also suffer from too optimistic decisions. Optimism
could affect investors in two ways: first, investors tend to be less critical in making analysis for
their decisions investing in stocks; second, optimistic investors tend to ignore the negative
information about their stocks (even then they receive information about negative results of the
company they were invested in they still believe that the company is performing well). This is
why the price of the stock is frequently set up by the optimistic investors. The market may have
an equal number of pessimistic and optimistic investors, but the optimists' optimism drives up
the stock price through their purchasing, as pessimists don't take action. Optimistic investors
typically determine the stock price of companies with a high level of uncertainty and hold onto it
until the uncertainty is cleared. Large, well-established companies' futures are less uncertain, and
their stock prices are typically more indicative of real prospects than of investors' optimistic
prospects.
It is evident that people's moods are influenced by the weather. People generally feel better
and think more positively when there is sunshine, and they suffer when there isn't any. A few
investigations were conducted to address the query of how the investor behavior may be
impacted by the weather (Hirshleifer, Shumway, 2003). The daily returns on sunny days are
higher than the daily returns on cloudy days, the researchers discovered. The researchers found
that the daily returns for sunny days are higher than the daily returns for non-sunny days. The
results of this research allow to conclude that sunshine affects the investors that they become
more optimistic and are used to buy rather than sell the stocks.
The investors’ behavior might be influenced by other factors which affect the emotions.
Sport is investigated as one of such factors). The research results of Edmans, Garcia, Norli (2007)
showed that stock market reaction to soccer game loss day after for losing team stock market
was negative (decreasing). And the stock market reaction was stronger in countries which have
positive historical results in soccer.
But over time, the general degree of optimism and pessimism or social mood shifts. as
Nofsinger (2005) demonstrated in his study. When the market is at its highest point, investors
are typically the most optimistic, and when it is at its lowest, they are typically the most
pessimistic. Market sentiment is the term used to describe this varying social mood.
Understanding the phenomenon of market sentiment may make it possible to forecast market
returns when investors grow overly optimistic about the state of the market or overly negative
when the market hits its lowest point.
A market bubble could be explained by the situation when high prices seem to be generated
more by investors (traders in the market) optimism then by economic fundamentals. Extreme
prices that seem to be at odds with rational explanations have occurred repeatedly throughout
history

Thank you for reading the content. You may do the succeeding learning activities. If you have
questions regarding the activity, you may contact me to the number indicated in the course
guide.

Learning Activity

A. Discussion. Answer the following:

1. Why the portfolios of overconfident investors have a higher risk? Give the reasons.
2. Why do the investors tend to sell losing stocks together, on the same trading
session, and separate the sale of winning stocks over several trading sessions?
3. Give the characteristic of the overconfident investor.

Assessment

A. Discussion. Answer the following:

1. How do you understand the disposition effect? Explain how mental accounting is related
with the disposition effect?
2. Give the examples how “snakebite effect” influence the investors behavior
3. The behavior of the people when they demand much more to sell thing than they
would be willing to pay to buy it is understood as:
a. Snakebite effect
b. House-Money effect
c. Endowment effect
d. Disposition effect

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