Financial Services Review

We review the field of behavioral finance as it relates to investors. Specifically, we examine common investment mistakes caused by an investor's cognitive and emotional weaknesses and group these mistakes into two categories: how investors think and how investors feel. Although most recent research deals with these psychological influences in investor decision-making, we also discuss social factors that affect financial decisions. We suggest five steps that investors can take to help overcome common investor mistakes. Finally, we present some thoughts on further behavioral research involving investors. © 2002 Academy of Financial Services. All rights reserved. JEL Classification: D10; G10 Keywords: Behavioral finance; Investor psychology 1. Introduction Although cognitive and emotional weaknesses affect all people, traditional or standard finance ignores these biases because it assumes that people always behave rationally (Statman, 1995). One of the central propositions of financial theory for the past three decades is that markets are efficient. Efficiency means that the price of each security coincides with fundamental value, even if some investors commit errors due to biases or frame dependence (e.g., how they view a decision problem). Although a case can be made against efficient markets, existing evidence does not generally support the ability of investors to consistently produce excess returns. That is, although market inefficiencies may exist, they are generally not easy to exploit. If stock prices are efficient and transaction costs and taxes are ignored, investors should not do serious harm to their wealth if they trade frequently or follow specific investing strategies. Therefore, traditional finance has developed in a normative manner. That is, traditional finance concerns the rational solution to the decision problem by developing ideas and financial tools for how investors should behave. As a consequence, traditional finance typically does not focus on actual investor behavior and its consequences. ...

Psychological Biases of Investors