The Essentials of Human Psychology and Financial Decisions
In the late 1800’s, psychologist Wilhelm Wundt incorporated different scientific research methods to investigate the reaction times of his subjects. Wundt ultimately viewed these methods as the study of human consciousness and was eager to apply experimental methods to study mental processes. Since inception, the field of psychology has been explored in a variety of fields ranging from business to education. In recent years, behavioral finance and economics have become a fertile ground for many new research projects because of its recent acceptance within the field of traditional finance. Behavioral finance and economics attempt to combine human rationale and conventional finance and economics to further understand and explain why and how people make irrational financial and economic decisions.
As the fields of human psychology and finance have grown, it is essential to understand the findings of this field in order to make better financial decisions. Behavioral finance and economics are very significant because unlike conventional finance and economics, which assume humans act rationally (e.g. perceiving the same level of risk in identical decision-making scenarios), behavioral finance and economics take into account the repeated mistakes of an imperfect human decision-making model. Psychologists Daniel Kahneman and Amos Tversky emphasized this by presenting an idea known as “prospect theory,” which states that people value gains and losses differently. The theory further explains that losses have more of an impact on people than equivalent gains, otherwise known as loss aversion. This can be demonstrated by analyzing the following two cases: 1) A person receives $1000 2) A person receives $2000 but loses $1000. Although in both cases the result is a net gain of $1000, studies show that most people view the single gain more favorably. Experiments similar to this one further prove why behavioral finance and economics are so important to understand how humans make financial decisions.
Human psychological biases within economics, such as “prospect theory” pertain to several specific irrational financial decisions. As explained earlier, humans view financial losses in a much harsher fashion than financial gains, and this is evident in stock market transactions where the disposition effect often affects investor performance. The disposition effect is the tendency of investors to sell winning stocks prematurely in order to assure themselves of gains, despite the potential of the gains becoming much larger in the future, as well as the tendency to hold losing stocks in their portfolio with the hopes of them rebounding in order to avoid recognizing the prospective loss. The issue of loss aversion, which triggers the disposition effect, is also prevalent when investors contemplate which stocks to invest in. While it is clear that investors chase past performance, a study conducted by behavioral economist Richard Thaler demonstrated that stocks with a high mean return over the past few years typically had a subsequent low return, while stocks that exhibited poor returns had improved performance in the future. Because many investors focus their attention on past performance, their perception of the stock is altered. This recency bias ultimately leads investors to allocate money into stocks, that according to Thaler’s study, will perform worse in the future. This is where conventional finance and behavioral finance clash. Conventional finance assumes that nobody will follow this investing method because it is irrational for an outlook on a stock to depend on past performance. While Thaler’s studies suggest that poor stocks may perform well in the future, they do not indicate that investing in stocks based on previous performance is rational. Unfortunately, because humans are irrational beings, and therefore are often too caught up on past results, they are presented with an incorrect investing framework.
Regardless of the investments made, humans possess biases in the way that they process certain information and events. Within the field of behavioral finance, we are most often confronted by confirmation bias, optimism bias, and hindsight bias. Confirmation bias creates problems for investors because it causes them to gravitate towards information that will confirm their belief regardless of the information being good or bad. An example of optimism bias is when an investor's holdings are performing poorly; they will look for any news to support their belief that the holdings will recover. Optimism bias is when investors think that they are at less risk of experiencing negative results in relation to other investors. In my opinion, this bias is demonstrated by every investor today, because everybody thinks that their investments are “the best” and will outperform others’ investments. A few months ago, before the presidential elections took place, Wall Street, along with the majority of polls were sure that Hillary Clinton would become the 45th President of the United States. As the election results poured in and indicated that Donald Trump would become the next President, market futures suffered tremendously. Despite the mere few hours of market downfall, the market has performed excellently since Election Day. Most notably, the Dow Jones Industrial Average has surpassed the 20,000 mark for the first time in its history. Hindsight bias, which is the human inclination to believe that a certain outcome was predictable only after the outcome has occurred, is evidenced by people’s perception that they knew how well the market would perform in the months following the election. Furthermore, when it comes to investing in general, hindsight bias is the investor's tendency to say, “I told you so” when analyzing historical market performance.
The field of behavioral finance has and continues to expand substantially. In order for investors be successful in the market, it is essential to properly understand the way humans behave and explore our behavior within the realm of finance. By understanding ideas such as loss aversion, confirmation bias, optimism bias, and hindsight bias, investors can become more prosperous. If people succeed in doing so and focus on rationally valuing companies and the market, there is a greater chance that they will meet their future financial goals.