Submodelo vía de Influencia indirecta

The objective of this section is to shed light on the influence of psychology on finance as a building block of behavioural finance. Investor psychology can help to explain investor financial decision-making and its influence on irrational behaviour. Psychology is a scientific field of study that examines the impact of an individual’s physical, mental and external environment on their behaviour (Rabin, 1998).

Most often, in decision-making individuals base their judgment on heuristics due to limited knowledge of the particular probability that would lead to the best outcome (Gigerenzer, and Gaissmaier, 2011). From a behavioural finance perspective, heuristics is referred to as a

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simple means of making complex decisions using the rule of the thumb. In other words, mental shortcuts taken by an investor confronted with different choices in uncertain conditions. Although heuristics aids decision-making, it could result in biases (Khaneman and Tversky, 1973). Biases are intuitive thinking patterns originating from observation and generalisations that may lead to inaccurate judgment (Khaneman and Tversky, 1973). Biases, in turn, stem from beliefs and preferences (Barbeis and Thaler, 2003). Relevant beliefs and preferences are discussed in the proceeding section.

2.2.2.2. Beliefs

Beliefs have been considered by many studies, thus, there exists a vast amount of literature that discusses it. As a result, this section focuses on beliefs that are more directly linked to herding.

Representativeness

Kahneman and Tversky (1972), define representativeness as a heuristic that formulates probability around uncertain events of a general population. Essentially, decisions are made based on stereotypes rather than a detailed evaluation of probabilities (Shefrin and Staman 2000). Representativeness can result in two major biases: base rate neglect and sample size neglect. Base rate neglect results from putting too little weight on background information when estimating the likelihood of an event. An example of ignoring base rate is when the luck of fund managers in picking investment is equated to skill. Indeed, a study by Wermers (2000) found that the US actively managed mutual funds, only outperformed the market benchmark index on a net return level. The second bias: sample size neglect sometimes also referred to as the law of small numbers occurs when an individual makes a judgement based on a sample without taking the sample size into consideration (Rabin, 2002). This means that they incorrectly assume that few data points are representative of the entire data set. For example, an investor might think that a financial analyst with three good stock picks in the

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previous month is skilled, whereas, this assessment is the only representative of a small sample size (Barberis and Thaler, 2003).

Representativeness is also associated with two other biases: the gambler’s fallacy and the ‘hot hand’. Gambler’s fallacy is a mistaken belief that two events are statistically dependent whereas, the occurrence of one is independent of the occurrence of the other. For example, when observing the toss of a fair coin, people erroneously believe that after a consecutive outcome of heads, the next toss is likely to be a tail. The gambler’s fallacy stems from the belief in the law of small numbers, where people believe that a small sample must be representative of a larger population. Hence, an event like the toss of a coin is a self- correcting process, a deviation in the direction of tails is required to restore equilibrium for it to be representative of the population (Rabin, 2002). In contrast, sometimes people mistakenly believe that previous success generated by a ‘hot hand’ is more likely to be replicated rather than reversed when, however, the successes are entirely random. Using the example of tossing a fair coin, people who believe that consecutive heads are generated by a ‘hot hand’ expect that heads will persist. These biases are applicable in finance. Research by Shefrin and Statman (1985) and Odean (1998) show that investors prone to gambler’s fallacy are likely to sell stocks past winning stocks because they believe that the performance will reverse. Other researchers (see, Cahart, 1997 and Sirri and Tufanno, 1998) show that fund managers buy fund shares with prior superior performance. These findings suggest that investors base their purchase decision on the belief that certain fund managers have ‘hot hands’.

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Overconfidence

Psychologists argue that people are generally overconfident and overestimate their abilities (see Lichtenstein, Fischhoff, and Phillips, 1982). Barber and Odean (2001) state that overconfidence drives individuals to be overly optimistic resulting in two major illusions: the illusion of knowledge and the illusion of control. First, the illusion of knowledge is the tendency of individuals to believe that their ability to make accurate decisions increases with the amount of information that they possess. For instance, the illusion of knowledge could come from the internet, tips from colleagues or friends and financial analysts’ reports or opinions, however, it is difficult to ascertain if the information is true and complete. Indeed, research by Tumarkin and Whitlaw (2001) provides evidence that for the internet service sector, information embedded in user ratings did not predict trading volume or exhibit abnormal industry-adjusted returns, and consequently had no effect on stock prices.

Second, the illusion of control is defined as “An expectancy of a personal success probability inappropriately higher than the objective probability would warrant” (Langer, 1975, pp. 313). Consequently, individuals behave as though an event were based on skill and they can control the outcomes of chance events, especially when it entails factors relating to skill, such as competition, choice, and familiarity (Taylor and Brown, 1988). Hence, the presence of these factors increases confidence and risk taking. In a seminal experiment, Langer (1975) provides evidence that people valued lottery tickets they selected by themselves more highly than randomly selected ones. In reality, the sale of lottery tickets in Massachusetts increased significantly when people could choose their lucky number instead of being given a random number as in the old system (Perlmuter and Monty, 1977). The illusion of control is widespread and influences investment decisions, many new investors

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prefer to trade by themselves rather than through a broker as it gives them an inflated sense of control over the performance of their trades (Barber and Odean, 2001).

Barber and Odean (2002) analysed investors who changed from phone-based to online trading and find that they made more profit before than after the switch. They also find that these investors traded more actively, aggressively and speculatively after going online because they become overconfident and tend to overestimate the control they have over their successes. In addition, they propose that this overconfidence is partly due to the illusion of knowledge and illusion of control as they had access to large quantities of information, mostly manage their portfolios and could trade with ease. However, the resultant overtrading violates the traditional finance paradigm assumption of rationality. If investors were indeed rational, they would know that overtrading would rarely lead to greater profits as excessive transaction costs are also incurred with a corresponding increase in risk. Research by Barber and Odean (2000) of over 66,000 households demonstrate that the most active traders underperformed the market benchmark. Thus, despite the compelling evidence not to overtrade, it is apparent that investors execute trades beyond what they should if they were indeed rational.

Psychologists and behavioural economists have identified that self-attribution bias is a common source of overconfidence (Kahneman and Tversky, 1996). Self- attribution bias is an individuals’ tendency to give themselves credit for positive outcomes and credit external factors or bad luck for negative outcomes. Hirshleifer (2001) argues that self-attribution makes people overconfident rather than accurately evaluate themselves, as a result, those who become wealthy through successful investment decisions tend to become more overconfident.

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Overconfidence can also be expressed in the hindsight bias. Hindsight bias or ‘The knew it all along effect” refers to an inflated certainty in predicting the probability of occurrence of a past event prior to its occurrence (Fischhoff, 1975). In essence, in hindsight, individuals inflate the accuracy of their foresight, thus they believe an outcome is predictable even before it occurs. For example, an individual who is told to guess the outcome of a fair coin toss before it is tossed guesses a head and a tail is obtained. If after the toss, the individual states that he/she knew that it would be a tail, then he/she has expressed the hindsight bias.

The hindsight bias is a robust phenomenon evident in many fields including finance. Biais and Weber (2008), report that hindsight biased investment bankers were unable to remember the extent of their uncertainty when asked to select initial estimates before observing outcomes, and therefore made lower volatility estimates than their unbiased peer. Also, these bankers earned far less than their peers, hence the bias created a discrepancy between their actual performance and perceived performance.

The effect of overconfidence becomes more severe, especially in bull market conditions. Bull markets are characterised by rising security prices and investors tend to become overconfident that the prevailing conditions will persist. However, this collective overconfidence may contribute to a subsequent economic crisis. In an analysis of the recent global financial crisis, Avgouleas (2009) argues that the enormous credit expansion led to the crisis. Moreover, the author suggests the credit expanded because market regulators became increasingly overconfident that the market would continue to be liquid for the foreseeable future.

Optimism (and wishful thinking)

Optimism (and wishful thinking) stems from overconfidence. Most people tend to hold optimistic albeit unrealistic views about their abilities and the future (Thaler, 2000). Another

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belief related to this bias is systemic planning fallacy: individuals often have a tendency to underestimate the completion time for a task (Barberis and Thaler, 2003).

Many economic phenomena originate from optimism; it can lead to under-reaction of stock prices to public news, over-reaction to good or bad news (Barberis, Shleifer and Vishny, 1998), an inflation of asset prices in the presence of short-sales restrictions (Chen, Hong, and Stein, 2002) and agents overestimating the return on their investment in portfolio selection (Brunnermeier and Parker, 2005).

Cognitive Dissonance

Cognitive dissonance theory posits that people like to act in a way that is in line with their beliefs and values and as such may be uncomfortable in maintaining inconsistencies (Festinger, 1957). Consequently, individuals have a tendency to either alter their past values or beliefs or attempt to rationalize their choice. In the financial investment context, this theory can apply when investors seek to justify contradictory behaviours so that they flow from personal beliefs. For instance, recently more investors have altered their beliefs from traditional forms of investing to ethical investment strategies. Goetzmann and Peles (1997) examined the empirical implication of cognitive dissonance on mutual fund investors. They find that these investors may be subject to psychological influences like cognitive dissonance specifically in making buy or sell decisions and portfolio selection.