For decades, economists and social scientists have debated economic decision-making. Economists argue that people are rational and selfish— and that human behavior is driven by rational decision-making that increases utility and maximizes returns. Emotions are not part of rational decision-making equations applied to making optimal financial decisions. Behavioral economists, on the other hand, passionately argue that emotions and irrational behaviors drive many purchase decisions and investment allocations.
I won’t argue that normative economic theories cannot be beneficial in investing. They are. Normative economics combined with the insights provided by psychologists and behavioral economists can provide you with a competitive edge in investing. If you learn how to control your decision-making—which stems from your cognitions and emotions—you will learn how to flourish as an investor. Psychologists can aid you in this process.
Many behavioral economists and psychologists have shown that economic decision-making is far from rational. Nobel Prize winner Daniel Kahneman has effectively shown that many economic decisions are indeed driven by emotions. In collaboration with Amos Tversky, Kahneman developed the Prospect theory. This theory proposes that human beings assign different perceived values to gains and losses. If financial decision-making is indeed rational, then profits and losses are perceived as being equal. However, emotions are involved when profits are made or losses are incurred. A practical application of this theory is that many stock traders often have the tendency to sell too early when they are making a profit and refuse to cut their losses when they are losing money.
The Ebay Effect: Investor Irrationality
What are some other examples of behavioral economics and irrational decision-making that show we often fail to maximize utility? Martin Shubik of Yale University invented the dollar auctioning game. The game is played by asking a group of people to bid for a $20 bill. The auction price can only increase by $1 per bid. Players are lured into bidding by the possibility of an easy profit. After all, the final bid can be less than what the bill is worth. One rule of the game is that both the second highest and highest bidder must pay the full amount of their bid. This reduces the chance of making a risky bid and losing money, so you would think.
Most of the time, the $20 dollar bill is auctioned for well over its actual value. There have been accounts of participants paying well over $50 for a $20 bill. When this occurs—since both the highest and second highest bidder have to pay—the auctioneer can easily make $80 ($50 + $49 – $20). Obviously, this is not an encouragement to con people out of their hard-earned money. Rather, this experiment uncovers what Shubik calls the “escalation of commitment.” People are prone to having emotions get in the way of rational behavior.
Another example of behavioral economics related to the psychological commitment to monetary gains or products is shown by Robert Thaler’s research on the endowment effect. His seminal research suggests that people, after owning a product, have the tendency to demand a substantially higher price for the product than what they would be willing to pay for it before taking ownership. Participants in Thaler’s studies were presented with a cup and asked how much they would be willing to pay for it. Then they were given the object. After about half an hour, the participants were invited back into the room. Researchers inquired about the price they were willing to pay. The price was considerably higher. Let’s say someone initially thinks the cup would be worth $5. A day later, someone offers $6. Rational decision-making would inadvertently lead to selling the cup. However, most people would probably not sell the cup. Main takeaway, emotions distort rational thought processes and behaviors.
Fool’s Gamble: Post-Purchase Dissonance
Similarly, our sense of self-worth can influence the perceived value of a financial instrument or an object after we purchase it. A phenomena known as post-purchase dissonance—extensively studied by Joel Cohen and Marvin Goldberg in the 1970s—is often employed by purchasers of financial instruments or other products to overlook any known risks or defects. This cognitive bias can also help people feel good about a purchase even when they know they have paid too much. In essence, conflicting knowledge about poor purchases is threatening to one’s sense of self-worth. Thus, in order to feel good about oneself, the purchase is rationalized by negating conflicting information and reaffirming the positive attributes of the product. Rational decision-making might perhaps suggest that a consumer would return a product—or even sell it with a small loss—when he/she discovered that the decision would not increase utility. However, people often prefer rationalizing the purchase and ignoring any warning to protect their sense of self-worth, even when this means that portfolios are decreasing in value.
The knowledge uncovered by behavioral economists and psychologists can empower you as an investor, but be aware of your emotions. De-escalate your commitment to financial instruments you have purchased when investments go south. Try to notice how ownership of financial instruments influences your thinking and trading behaviors. Do not rationalize! Reallocate funds and adjust your portfolio when your investments do not perform as you had hoped.
About the Author: Yardane Niessink
Disclaimer: The opinions expressed in this blog are not to be considered financial advice of the Society of Colleagues of Dr. Richard H. Wexler, Inc.