Exploring Investor Decisions in a Behavioral Finance Framework

By Hayes, Suzanne K. | Journal of Family and Consumer Sciences, Spring 2010 | Go to article overview

Exploring Investor Decisions in a Behavioral Finance Framework


Hayes, Suzanne K., Journal of Family and Consumer Sciences


The first objective of this article is to increase awareness and understanding of individual decision-making biases. The second is to provide FCS professionals with strategies to improve consumer financial decisions. Individual decision biases are presented within the context of a seven-stage decision process. Proactive consumer educators using a behavioral finance, multi-dimensional approach have the opportunity to have a positive impact on individual financial behavior.

Individuals are assuming more responsibility for their future financial well-being and are increasingly making many financial decisions in a complex environment. At press time, millions of homeowners, retirees, and baby-boomers are facing uncertain financial situations and are experiencing losses. The need for financial education has never been greater. This article advocates an expansion of financial education programs to address the quality of investor decisions within a behavioral finance framework. Educators must focus on comprehensive financial counseling in which financial, psychological, and social aspects are considered simultaneously.

Behavioral Finance

The study of behavioral finance began in an effort to understand investor behavior that was not well described by the traditional finance theories. The objective of behavioral finance research is to explain financial market behavior and investor decisions with models in which decision-makers are not perfectly rational. In behavioral finance, an individual's social, psychological, and financial factors are considered simultaneously.

Research shows that psychological and social factors are important to financial decisions; investors do not consistently behave as rational agents. Individuals exhibit systematic biases in their decision-making processes and may use heuristics, or rules of thumb, to simplify their financial decisions. A complete literature review of this field of study is beyond the scope of this article but readers are referred to Barberis and Thaler (2003).

Decision Biases

The decision biases explored include overconfidence, representativeness, framing, mental accounting and narrow framing, loss aversion, and conservatism and anchoring.

Overconfidence

Are all investors above average in their abilities? Overconfidence is widely documented as a decisionmaking trait. On average, over 90% of individuals surveyed believe they are above average in terms of driving skill, humor, and congeniality (Buehler, Griffin, & Ross, 1994). Individuals overestimate their abilities to perform tasks well and have unrealistically high self- evaluations (Greenwald, 1980).

Psychologists have identified two biases that may lead to overconfidence. Self- attribution bias occurs when individuals tend to credit their successes to their personal talents, while failures are more likely to be assigned to chance or bad luck. For example, a driver narrowly missing a car accident may attribute the close call to their quickthinking and defensive driving skills. Conversely, the same driver who is later involved in a car accident likely will believe the situation was out of their control or the incident was unavoidable. Hindsight bias refers to the propensity of individuals, after an event has occurred, to believe they predicted the event. Repeated application of these biases encourages overconfidence in one's abilities.

Overconfidence is an explanatory factor for the relatively high levels of trading in equity markets, which leads to suboptimal results. Over the period of 1991-1996, Barber and Odean (2000) found high frequency traders earned 11.4% compared with a return of 18.5% for low- frequency traders and a return of 17.9% on the market. The authors found a greater level of overconfidence among men. Men traded 45 % more and earned less when compared with women (Barber & Odean, 2001).

Overconfidence leads to an increased emphasis on individual stock selection at the expense of diversification.

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