Can people become rational investors? Or, is there something humans do which prevents them from consistently making sophisticated financial decisions?

Questions concerning human motives and fears are now being recognized as an inherent part of investor behavior. How people invest, what stocks or funds they select, and their attraction to risky investments, are among the factors being examined as part of the path investors walk between objectively evaluating financial advice and succumbing to psychological traps which cause financial losses.

Today, the area of study known as behavioral finance has identified some key tendencies, which can affect rational decision-making by thoughtful individuals and turn this process into actions marred by bias, overconfidence and unchecked emotions.  When this happens, it reduces the chances of making profitable investing decisions.

Behavior Finance Gaining Recognition

Behavioral finance moved to the international forefront of economic study when the Nobel Prize was awarded to Daniel Kahneman, a psychologist, and Vernon Smith, an experimental economist, in 2002 for their work in developing tools to study individual investor behavior.

This recognition prompted additional work into the study of individual behavior patterns that people use when making investment decisions. 

Psychologists are now using behavioral finance to solve some financial puzzles, such as explaining grossly overpriced markets, or why sophisticated investors make some very bad investment decisions.

According to Hersh Shefrin, professor of finance at the Leavey School of Business, Santa Clara University,  some basic human behaviors affect investment decision making. 

At the individual level, the driving factors are framing, overconfidence, confirmation bias and the illusion of control.  At the group level, committees and boards tend to amplify individual errors through the “groupthink” process.

Here are the definitions of these key concepts in behavioral finance:

Framing. When individuals make investment decisions, emotion and reason work together, but they produce very different emotional results depending on whether the investment made or lost money.

For example, according to Shefrin, people tend to feel losses much more strongly than the pleasure of making a comparable gain.  This emotional strain is magnified when the person assumes responsibility for the loss.  This guilt feeling then produces an aversion to risk.  But this level of guilt can be changed depending on how a financial decision is framed.  For example, if an investor lost money buying a stock, they could justify the loss by saying the stock also paid a dividend. 

Group and individual dynamics.  Boards of directors are commonly entrusted to make investment decisions because they have good judgment and are objective.  When hiring a new manager or adopting a new asset class exposure, Shefrin said groups typically outperform the average individual when deciding objective questions.

However, groups typically tend to amplify the prevailing emotion by sharing a “group think” mentality when it comes to making decisions that require a consensus.  When trying to arrive at a consensus, groups try to determine their members’ confidence levels.  When this happens, the group overreacts, so they think that other members strongly agree with the prevailing position. But studies found this is a mistake, especially when the board discovers they have made a very bad decision.  Shefrin calls this the “illusion of effectiveness.”

Identifying “Group Think” Traps

Shefrin said examples of “group think” that support an “illusion of effectiveness” at the committee level are common. 

In some well-publicized cases involving the W.K. Kellogg Foundation, David and Lucille Packard Foundation, Walter and Flora Hewlett Foundation, Robert H. Woodruff Foundation and Coca-Cola, investment committees members agreed on the benefits of holding a diverse equity portfolio, but they also insisted on holding majority positions in their own company stock.  Shefrin said these situations often occur when the board or investment committee’s confirmation bias is amplified because not enough board members want to speak out about the problems they foresee.

To help avoid these situations, Shefrin recommends the following:

• Look at the culture of the committee to see if it encourages people to express opposing viewpoints.  The former chairman of General Motors, Alfred Sloan, used to advise his committees to reach a consensus, but then think about that decision over the weekend to try and discover its flaws. Committees should make an additional effort to re-examine any preconceptions they hold about complex issues.
• Heighten self-awareness.  People should become more aware about their own prejudices, so these prejudices do not creep into a committee’s collective decision making.
• Don’t be overconfident.  Shefrin says this overconfidence bias, called the “illusion of effectiveness,” is “absolutely rampant” at the committee level.  Group over-exuberance can be held in check by increasing self-awareness about a person’s preconceived views. Committee members should recognize their own confirmation bias, which only supports existing views, but overlooks evidence which may challenge prevailing ideas.  Effective committees should take the time to evaluate and even solicit opposing ideas.
• Look for improved ways to share ideas, as opposed to striving for superficial committee diversity.

While behavioral finance can help explain instances of “irrational exuberance” at the individual and group levels, its main benefit is to help identify how psychology affects financial decision making.  The challenge, Shefrin says, is to recognize the psychological traps people use when making investment decisions, so they do not derail the actual investment process.