Key decision making biases

The purpose of this section is to review key concepts in investor decision making and key decision making biases. The sections that follows presents a brief outline of prominent decision making biases.

Prospect theory

Kahneman and Tversky (1979) presented a critique of expected utility theory as a descriptive model of decision making under risk and developed an alternative model called prospect theory. Kahneman and Tversky (1979) reviewed several empirical effects which appeared to invalidate expected utility theory as a descriptive model and presented an alternative account of individual decision making under risk, called prospect theory (Kahneman and Tversky 1979, p. 274). Prospect theory suggests the hypothesis that investors display a disposition to sell winners and ride losers when standard theory suggests otherwise (Shefrin and Statman 1985, p. 779).

Mental accounting

Mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities (Thaler, 1999, p: 183). ‘The main idea underlying mental accounting is that decision makers tend to segregate different types of gambles they face into separate accounts and then apply prospect theoretic decision rules to each account by ignoring possible interaction’ (Shefrin and Statman, 1985, p 780) . ‘Mental accounting serves to explain why an investor is likely to refrain from readjusting his reference point for a stock. When the stock is purchased, a new mental account is opened. A running score is then kept in this account indicating gains or losses relative to a purchase price’ (Shefrin and Statman, 1985, p 780). Thaler and Johnson (1990) argue that decision makers encounter considerable difficulty in closing mental accounts at a loss.

Hedonic editing

An aspect which is missing from the mental accounting theory is why would an investor create separate mental accounts? In answer to this question Thaler (1985; 1999) introduced the hedonic editing hypothesis. He states (1999, p. 187) “One possible place to start in building a model of how people code combinations of events is to assume they do so to make themselves as happy as possible.” The hedonic editing hypothesis argues that not only do people create separate mental accounts but they also separate gains and integrate losses to maximise happiness.

Loss aversion

Much of the preceding discussion emphasises a marked aversion for loss realization. ‘Losing $100 hurts more than gaining $100 yields pleasure….The influence of loss aversion on mental accounting is enormous’ (Thaler 1999, 185). ‘The positive counterpart to regret is pride. While closing a stock account at a loss induces regret, closing at a gain induces pride. The quest for pride, and the avoidance of regret lead to a disposition to realize gains and defer losses,’ (Shefrin and Statman, 1985: p.781-82). However, there is asymmetry between the strength of pride and regret and losses loom larger than gains (Kahneman and Tversky, 1979). Asymmetry between the strength of pride and regret (regret is stronger) leads inaction to be favoured over action (Kahneman and Tversky, 1979; Thaler, 1985). Thus, investors who are prone to this bias may be reluctant to realize both gains and losses (Shefrin and Statman, 1985, p 782).

Disposition effect

Shefrin and Statman (1985) sought to determine whether investors exhibit a reluctance to realize losses (disposition to “ride losers) even when the prospects of standard theory prescribe realization (Shefrin and Statman 1985, p. 777-8). They developed a positive (descriptive) theory of capital gain and loss realisation in which investors tend to “sell winners too early and ride losers too long” and referred to this tendency as the “disposition effect” (Shefrin and Statman 1985, p. 778).

A further consideration is capital gains tax which suggests that losses should be realized while they are short-term, while gains should be realised only when they are long-term. However, the disposition to sell winners too early and ride losers too long operates in the opposite direction (Shefrin and Statman 1985, p.785). In particular they find that tax considerations alone cannot explain the observed patterns of loss and gain realization, and that the patterns are consistent with a combined effect of tax considerations and a disposition to sell winners and ride losers (Shefrin and Statman 1985, p.788). Namely, that a reversal of the disposition effect occurs in the month prior to the tax year end (Odean 1998).

Overconfidence

The notion of overconfidence stems from cognitive calibration research which compared a person’s confidence in and performance at certain tasks. If a person predicts that they are more often correct than actually prove to be, they are deemed to be overconfident. Research has found that in an experimental setting the majority of people are overconfident, or in other words, perceived ability is a lot higher than actual performance (for a review see Lichtenstein et al., 1982). In a review of overconfidence research from a behavioural finance perspective, Glaser et al. (2004) outlined different aspects of overconfidence: miscalibration (Biais et al., 2005, Glaser and Weber, 2007), the better than average effect (Glaser and Weber, 2007; Oberlechner & Osler 2008), and excessive optimism (Langer & Roth 1975). Of these the better than average effect (BTA) seems of most relevance to traders.

The BTA effect is where traders “rate their own abilities too highly compared to others” (Odean, 1998). Originally, the concept stemmed from Svenson’s (1981) research which found that 82% of drivers believe their skills and ability are in the top 30%. Taylor & Brown (1988) have found that people may need to have unrealistically positive views of themselves to maintain a positive self image. In a study of over 400 traders Oberlechner & Osler (2008) found that currency traders were prone to the BTA and that experience did not attenuate this. Furthermore, Glaser and Weber (2007) found that the BTA correlated with increased trading volume, a commonly theorised effect of overconfidence (Odean, 1998; Barber & Odean, 2001).

Illusion of control

In situations where a person may have little control over events they may tend to foster illusions to believe that chance events are within their realm of control. People deprived of a sense of control make active efforts to restore it cognitively (Fiske & Depret, 1998). Langer (1975) conceived the term illusion of control to describe this tendency and showed through a series of experiments that people act as if chance events are subject to personal control. Langer (1975) demonstrated not only the prevalence of the illusion of control, but also that people would behave as if they could exercise control in a chance situation where ‘skill cues’ were present. By skill cues, Langer meant properties of the situation more normally associated with the exercise of skills, in particular the exercise of choice, competition, familiarity with the stimulus, and involvement in decisions.

Fenton-O’Creevy et al. (2003) argue that the conditions in which traders operate are antecedents to the illusion of control. Specifically, stress (Friedland et al. 1992), competition (Langer 1975), implemental mind set (Gollwitzer and Kinney, 1989) and choice, involvement and familiarity (Langer 1975) induce an illusion of control and are common place in the trading environment (Kahn & Cooper, 1989; Fenton O’creevy et al. 2005). Fenton-O’Creevy et al. (2003) found that some traders were susceptibility to the illusion of control and this was negatively correlated with performance.