Review of Behavioural Finance

Behavioural finance: the role of psychological factors in financial decisions

Gulnur Muradoglu, Nigel Harvey,
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RBF INTRODUCTION/GUEST EDITORIAL

4,2
Behavioural finance: the role
of psychological factors in
68 financial decisions
Gulnur Muradoglu
Cass Business School, London, UK, and
Nigel Harvey
University College London, London, UK

Abstract
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Purpose – The purpose of this paper is to introduce the special issue of Review of Behavioural
Finance entitled “Behavioural finance: the role of psychological factors in financial decisions”.
Design/methodology/approach – The authors present a brief outline of the origins of behavioural
economics; discuss the role that experimental and survey methods play in the study of financial
behaviour; summarise the contributions made by the papers in the issue and consider their
implications; and assess why research in behavioural finance is important for finance researchers and
practitioners.
Findings – The primary input to behavioural finance has been from experimental psychology.
Methods developed within sociology such as surveys, interviews, participant observation, focus
groups have not had the same degree of influence. Typically, these methods are even more expensive
than experimental ones and so costs of using them may be one reason for their lack of impact.
However, it is also possible that the training of finance academics leads them to prefer methodologies
that permit greater control and a clearer causal interpretation.
Originality/value – The paper shows that interdisciplinary research is becoming more widespread
and it is likely that greater collaboration between finance and sociology will develop in the future.
Keywords Decision making, Psychology, Behavioural finance, Research work
Paper type Research paper

Review of Behavioral Finance
Vol. 4 No. 2, 2012
pp. 68-80
r Emerald Group Publishing Limited
1940-5979
DOI 10.1108/19405971211284862
1. Introduction
According to Glaser et al. (2004, p. 527): “Behavioural finance as a subdiscipline of
behavioral economics is finance incorporating findings from psychology and sociology
into its theories. Behavioral finance models are usually developed to explain investor
behaviour or market anomalies when rational models provide no sufficient
explanations”.
Modern economics assumes that people choose between alternatives in a rational
manner (von Neumann and Morgenstern, 1944) and that they know the probability
distribution of future states of the world (Arrow and DeBreu, 1954). Modern finance
assumes that markets are efficient and that agents know the probability distribution of
future market risk (Markowitz, 1952; Merton, 1969). Research has been geared towards
searching for a better risk factor/pricing model.
In parallel with these theoretical developments, psychologists studying decision
making were collecting data that suggested that individuals do not always make
decisions in an optimal manner that those working in finance and economics assumed
(e.g. Edwards, 1954, 1955). After a large corpus of data had accumulated, Bell et al.
(1988) argued that it is worth making a conceptual distinction between normative
 models of decision making that identified optimal ways of making decisions, The role of
descriptive models that identified how people actually make decisions under different psychological
conditions, and prescriptive models that identified ways of improving decision making
when no normative models were available. They argued that economists may have factors
been unwise to assume that normative models are descriptive.
For many years, this behavioural research had little impact on economics.
Behavioural economics did not exist. Kahneman (2011) argues that it originated in the 69
early 1970s when Richard Thaler, then a graduate student in economics, demonstrated
that one of his professors was highly susceptible to the cognitive bias that is now
known as the endowment effect. Arguably, behavioural economics came of age
when Kahneman and Tversky (1979) published prospect theory and matured
after Kahneman’s receipt of the Nobel Prize for Economics in 2002 demonstrated that
economists considered behavioural research as worthy of inclusion in their field of
study.
Although Slovic (1972) drew the attention of those working within finance to the
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relevance of research on behavioural decision making to their concerns, behavioural

finance was slower to develop than behavioural economics. The work of De Bondt and
Thaler (1985, 1987) can be seen as a landmark that triggered expansion of the field.
Later, Thaler (1999) went on to argue that research in the area would soon come to an
end because financiers would be so convinced by the behavioural findings that they
would adopt reasonable assumptions. However, although those working in finance
may be more sympathetic to the notion of basing their theories on realistic
assumptions than those working in other areas of economics, there is, as yet, little sign
that the field is contracting.
Good reviews on the development of the field of behavioural finance include those
by De Bondt et al. (2010), Daniel et al. (2002), Glaser et al. (2004) and Gärling et al. (2009).
These reviews indicate that much behavioural finance uses the corpus of work that
demonstrates biases in human judgment and decision making (Kahneman et al., 1982)
to explain investor behaviour and market anomalies. There is, however, increasing
recognition that we need to move towards a theoretical framework that accounts not
just for the circumstances that produce inefficient information processing but also for
those that produce efficient information processing (Shefrin, 2005).
There have been other developments too. Tversky and Kahneman (1974) argued
that cognitive biases occur because people use heuristics (mental “rules of thumb”).
They use them because they do not have the cognitive resources to carry out the
procedures necessary to make normative decisions. Although Tversky and Kahneman
(1974, p. 1131) argued that “these heuristics are economical and usually effective”, they
pointed out that their use leads to biases under certain circumstances. They focused on
those circumstances because doing so allowed them to cast light on the nature of the
heuristics that produce them – in much the same way that vision scientists study
visual illusions in their attempts to understand the visual system. However, this
strategy resulted in many people gaining the impression use of heuristics leads to
irrational decisions.
To counter this view, Gigerenzer et al. (1999) instigated a programme of research
geared to demonstrating that heuristics often produce exceedingly good outcomes.
They have demonstrated that, in out-of-sample tests, simple models that ignore some
information or weight different types of information equally can outperform more
complex models, such as those based on multiple regression. For example, selecting
who will win a tennis match purely on the basis of choosing the player whose name is
 RBF recognised is a strategy that outperforms the rankings produced by the Association
4,2 of Tennis Professionals (Serwe and Frings, 2006; Scheibehenne and Broder, 2007).
Similar findings have been reported in other fields, such as medicine (Gigerenzer
and Kurzenhäuser, 2005), policing (Snook et al., 2005) and marketing (Wübben and
von Wangenheim, 2008).
Within finance, simpler strategies have been found to be superior to more complex
70 ones for selecting stocks (DeMiguel et al., 2007). More recently, Haldane (2012),
Executive Director for Financial Stability at the Bank of England, has applied
Gigerenzer’s approach to bank regulation. He has reported a number of analyses that
demonstrate that bank regulators would be better able to predict bank failure by using
much simpler models than they do at present. He argues that the current regulatory
regime based on the Basel III Accords should be radically simplified if it is to increase
its effectiveness: “Modern finance is complex, perhaps too complex. Regulation of
modern finance is complex, almost certainly too complex. That configuration spells
trouble. As you do not fight fire with fire, you do not fight complexity with complexity.
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Because complexity generates uncertainty, not risk, it requires a regulatory response

grounded in simplicity, not complexity” (Haldane, 2012, p. 19). These examples demonstrate
that behavioural finance can provide us with prescriptions as well as descriptions.

2. Experimental work in finance

Experimentation is a mainstream methodology within psychology whereas it has been
less common within finance. Here, we shall briefly outline some of issues that those
working within finance initially studied non-experimentally but that have more
recently been subject to experimental research.
Researchers within finance have been aware of the potential importance of
psychologists’ work on cognitive biases for some time. For example, the disposition
effect (Shefrin and Statman, 1985) refers to the finding that investors are likely to sell
shares that have increased in price but tend to keep those that have dropped in price.
It is an anomaly that is consistent with what would be expected on the basis of
prospect theory and with what we know about cognitive biases (e.g. the endowment
effect). It has been demonstrated empirically by a number of researchers (e.g. Barberis
et al., 2001; Coval and Shumway, 2005; Frazzini, 2006; Odean, 1998a). However,
experiments related to this effect have been comparatively rare: Thaler and Johnson
(1990) and Post et al. (2008) report two relevant experimental studies.
Similarly, the implications of overconfidence for finance (e.g. frequent trading) have
been investigated by a number of authors, including Odean (1998b, 1999), Gervais
and Odean (2001), Daniel et al. (1998) and Bloomfield et al. (2003). However, few
experiments have been conducted as direct tests of the financial effects of
overconfidence: they include those carried out on stock market professionals by
Biais et al. (2005), Muradoglu (2002), Muradoglu and Önkal (1994) and Önkal and
Muradoglu (1994).
In finance, judgment is often used to make forecasts from time series data. Its
effectiveness can depend on forecasters’ beliefs about the presence of regime shifts in
those data. Historically, those working in finance have examined size of errors in real
forecasts but such studies did not permit researchers to examine the features of time
series that make forecasting difficult. Experiments allow factors that affect both
judgmental forecasting (De Bondt, 1993; Lawrence et al., 2006; Harvey and Reimers,
2012; Reimers and Harvey, 2011) and beliefs about regime change (Bloomfield and
Hayes, 2002; Speekenbrink et al., 2012) to be studied systematically.
 Failure to ignore sunk costs is an issue in finance: for instance, it is likely to have The role of
a role in producing the disposition effect. The phenomenon has been demonstrated psychological
experimentally in both children (Krouse, 1986; Webley and Plaisier, 1998) and
adults (Arkes and Blumer, 1985). It has even been possible to investigate whether in factors
non-human animals (in the context of which it is known as the Concorde fallacy):
Dawkins and Carlisle (1976) concluded that animals suffer from the fallacy whereas
other researchers have failed to find any evidence that they are susceptible to it 71
(Dawkins and Brockman, 1980; Maestripieri and Alleva, 1991). These latter results
led Arkes and Ayton (1999) to question whether humans behave less rationally than
lower animals.
Within finance, there is a concern about the validity of studies that have used
participants drawn from the general population. Conclusions drawn from such studies
may need some modification if they are to be applied to investors, either individual or
corporate. Thus, Burns (1985) argues that finance professionals’ behaviour may differ
from non-professionals’ behaviour due to training, reputation, etc. Similarly, Haigh and
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List (2005, p. 524) argue that Locke and Mann (2000) take the argument a step further
by suggesting that any research that ignores the use of professional traders is likely
to be received passively because “ordinary” individuals are unlikely to have any
substantial impact on market price since they are too far removed from the price
discovery process. Similar views have been expressed by Christensen-Szalanski and
Beach (1984) and Frederick and Libby (1986).
Of course, the similarity in the behaviour of finance professionals and lay people is
actually an issue that needs to be addressed via empirical studies. What have such
studies shown? In one of the first experimental papers to be published in the Journal of
Finance, Haigh and List (2005) reported an experiment using 54 professional futures
and options pit traders from the Chicago board of trade and showed that traders
exhibited more myopic risk aversion than students. Önkal and Muradoglu (1994, 1995,
1996) conducted a series of experiments comparing finance professionals and novices
in a task requiring probabilistic forecasting of stock prices. They found that finance
professionals were more over confident than novices but that they could reduce this
bias if they were given feedback. Thus, at least in certain financial tasks, differences
between professionals and lay people occur. So the research shows that, at least in
some financial tasks, conclusions drawn from studies of lay people do need to be
modified if they are to be applied to professionals. However, they need to be modified in
a surprising direction: biases have been found to be larger not smaller in professionals.
Clearly, experience does not always produce expertise.
This issue need not concern us when the finance tasks of interest are ones that are
normally carried out by lay people. Thus, for example, two of the papers in the current
issue are concerned with credit markets: they examine factors that influencing the use
of credit by lay people. Here sampling participants from the general population is
clearly the most appropriate approach. Furthermore, lay people now have increasing
access to stock markets via the internet. The distinction between individual investors
who are professional and those who are not is much less clear than it has been in the
past. Even in stock investment tasks, such as that reported in third paper in this
special issue, non-professional participants validly represent a section of the general
population that invests in stock markets.
More generally, experimenters are increasingly adopting web-based
experimentation (e.g. Lo and Harvey, 2012; Lo et al., 2012; Reimers and Harvey,
2011; Harvey and Reimers, 2012). Links to an experiment are posted in various forums.
 RBF This allows participants to be drawn from a much broader demographic than that
4,2 provided by local students. It is even possible to carry out studies on specific
populations drawn from various countries by selecting particular forums on which to
post the web link to the experiment. For example, studies reported by Lo and Harvey
(2011) used this approach to show that availability of credit cards differentially
affects purchasing behaviour of compulsive and non-compulsive shoppers in the UK
72 and Taiwan.
In this issue, we have two papers that use experimental methods. The first paper is
written by Maria Andersson, Tommy Gärling, Martin Hedesström and Anders Biel
from the University of Gothenburg. They studied impact of the length of a time series
on the predictions of stock prices and investment decisions. The effectiveness of
judgment as a means of making forecasts from time series and as a basis for making
decisions using those forecasts is a well-researched area (Harvey and Bolger, 1996;
Lawrence et al., 2006). However, Andersson and colleagues were interested in it because
of their concern about short termism in financial markets (Stiglitz, 1989). They define
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short termism as a preference for actions in the near term that have detrimental
consequences in the long term. They argue that bonuses based on the performance
over the last year or even over the last quarter are signs of short termism. In three
experiments, they investigate the effect of longer evaluation intervals on financial
decisions.
In their first experiment, on students from the University of Gothenburg, they
conducted a laboratory experiment that lasts about 30 minutes. Participants played the
role of an investor employed by a company. They were presented with price series for
nine shares over five, ten or 15 days. Trends in the price series were systematically
varied. Participants were asked to make a prediction about the price before making
a purchase decision for up to 100 shares. No significant effects of the length of the price
series were observed either in predictions or in investments. In Experiment 2, the
authors added graphs of the price information because it is known that visually
displaying the data can make trends more salient. This time, they observed that the
predictions based on the longer price series of ten to 15 data points yielded smaller
prediction errors but there was no impact on investment decisions. Finally, in
Experiment 3, the authors added a condition intended to reduce participants’
information processing load: in this condition, each of five points represented
aggregated data over three days, thereby lowering the number of data points that had
to be processed. Price prediction errors were smaller in this condition than in
conditions in which either five or 15 non-aggregated points were presented and risk
taking for investments was closer to optimal.
Their paper is important for its policy implications in the context of the current
debate on bonuses. People are in general myopic. Graphs may counteract the myopic
tendency to a certain extent by defocusing the attention from the most recent
information. When the number of data points is reduced and averages are presented to
reduce local variation, both prediction and investment performance are improved.
Thus, to distract investors from myopic decisions, aggregation over time is a useful
strategy.
Our second paper is written by Sandie McHugh and Rob Ranyard from the
University of Bolton. They examined the effects of information about the long-term
financial consequences of different types of loans on credit repayment decisions. They
conducted two experiments with a random sample of 2,000 people from a high street
bank’s database of personal account customers. They processed 242 replies for the
 paper that they present here. Two credit repayment scenarios, one with a credit card The role of
balance of £1,500 and one involving re-mortgage of a property loan of £40,000, were psychological
devised. In these scenarios, participants selected a monthly payment level when
given either no additional information, total cost information, loan duration factors
information, or both total cost and loan duration information. Controlling for
demographic information, the authors showed that provision of additional information
produced higher repayment levels. 73
In their second experiment, McHugh and Ranyard again examined the effects of
provision of information about the long-term consequences of repayment decisions.
However, in this experiment, which was conducted just after the 2008 financial crisis,
they used a wider variety of credit repayment scenarios. They also added questions
asking participants to estimate the likelihood that redundancy or illness would lead to
repayment difficulties, to assess levels of worry this likelihood would produce, and
to assess their levels of worry arising from the possibility of future rises in the cost of
living. Higher estimates of the likelihood of personal circumstances leading to
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repayment difficulties and worry about future increases in the cost of living reduced
repayment levels. In contrast, higher levels of education and worry about personal
circumstances causing repayment difficulties raised repayment levels.
The policy implications of the paper are important for retail banks. If they
provided information on the cost and duration of debt repayments, they could
speed up the repayment of loans, credit cards debts or mortgages. Selecting a lower
payment plan is associated with worry about a change in personal circumstances
causing repayment difficulties. Maybe lower repayment levels can be used as a means
of credit risk management and be associated with taking payment protection
insurance.

3. Use of surveys in finance

Use of surveys in finance does not have a long history. In one relatively early study,
Muradoglu (1989) surveyed about 500 stock investors in Turkey. At the time, there was
much discussion in the country about the possibility of privatisation promoting
demand among workers and about the possible effects of privatisation of companies on
inhabitants in the neighbourhoods in which they were located. “The typical
stockholder is from the upper social class [y] Stock demand increases as education,
income, savings and wealth increases” (p. 167). Some of the findings have since been
confirmed by the literature on home bias: “[y] those investors who have personal and
business relations with the management of the companies invest more in those
companies because they feel confident in their action” (p. 169) and by research on
mental accounting: “Turkish investors do not sell the stocks when the price is falling
but they do not hesitate to sell them when the price is rising. They do not want to
realise losses due to price movements. They can internalise losses only in the case of
catastrophic situations” (p. 171). Yet others have been supported by work on corporate
governance: “[y] investors prefer to buy the stocks of companies that are owned by
a well-known group or individual” (p. 173). Among the many recommendations was
the suggestion that “Further research may [y] be conducted by savings surveys just
like the consumer surveys” (p. 179).
Nowadays, such surveys are carried out in much of the world, with high quality
data available from the USA, the UK, and Scandinavia and other European countries.
These include household level data on consumption and savings and debt. Mostly, it is
economists who work in this area. However, as the third paper in this issue
 RBF demonstrates, financial survey research includes an agenda that can be addressed by
4,2 those working in behavioural finance.
This paper by Stefano Cosma and Francesco Pattarin focuses on the role of attitudes
in the use of consumer credit. They report a survey of 2,000 Italian households that
was conducted in 2009. They distinguish consumer credit users from non-users.
Importantly, their definition of consumer credit refers to institutional credit involving a
74 request by a household that the banker considers solvent. This is contrasted with
consumer debt which refers to debts that arise when someone does not fulfil their
repayment obligations against their intentions and those of their creditor.
The survey covered households in both the north and south of Italy and included
different household sizes and different income earners in each household. Age,
education and gender of credit users and non-users were reasonably well balanced.
The questionnaire collected information about psychological characteristics as well as
details of cognitive, emotional and behavioural attitudes towards consumer credits.
First, Cosma and Pattarin show that cognitive and behavioural components of
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attitudes towards consumer credit differentiate credit users and non-users. These
results were robust to the needs of the household. Second, they show that, as credit
users’ attitude towards credit becomes more positive, they are more likely to finance
consumption with credit cards or point-of-sale lending than by using personal bank
credit or salary loans. In contrast, as the attitude of non-users becomes more favourable
towards credit, they increasingly prefer point-of-sale lending to credit cards. Finally,
Cosma and Pattarin show that the probability of taking on debt increases as the
attitude towards debt becomes more favourable. The probability of using credit cards
also increases as the number of income earners in the household increases and when
there are strong expectations that income will rise.
The paper is important in showing that, among the many determinants of credit
use, attitude plays a significant role. The cognitive component which determines
the individual’s decision-making framework is crucial. The psychological profile of the
borrower is an important factor in consumer credit decisions.

4. Why is work in behavioural finance important for finance?

Behavioural finance is used to make recommendations to finance professionals about
how to change their behaviour or how to communicate with their clients. Kahneman
and Riepe’s (1998) list of recommendations includes the following:
. keep track of instances of your overconfidence;
. communicate realistic odds of success to your clients;
. resist the natural urge to be optimistic;
. ask yourself whether you have real reasons to believe that you know more than
the market;
. make sure the frame chosen has relevance for the client; and
. assess how risk averse your client is.
Further suggestions to financial advisors on how to take findings from behavioural
finance into account have recently been outlined by Benartzi (2011).
As we have seen, simple (fast-and-frugal) heuristics can provide an effective means
of making complex decisions (Gigerenzer et al., 1999). We mentioned Haldane’s (2012)
application of them to the problem of bank regulation above. They can be useful in
 others areas of finance as well, such as in the expectation formation processes The role of
underlying selection of the contents of portfolio. Thus, for example, Muradoglu et al. psychological
(2005) examined the effectiveness of an expectation formation process heuristically
based on the subjective forecasts of finance professionals. The portfolio performance of factors
subjective forecasts was superior to that of standard time series modelling.
More generally, Ricciardi and Simon (2000) have argued that behavioural finance
enables those who invest in stock and mutual funds to avoid common “mental mistakes 75
and errors” and develop effective investment strategies. Others have argued that
knowledge of behavioural finance should enable investors to become aware of how
potential biases can affect investment their decisions and thereby to avoid such errors.
This, in turn, should act to promote the efficiency of the market and so limit the need
for regulation and improve information dissemination (Daniel et al., 2002). Similarly,
awareness of findings in behavioural finance may lead to a change in working practices
that improve performance: for example, use of feedback and a change in the way
information is presented can improve forecasting performance (Harvey and Bolger,
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1996; Önkal and Muradoglu, 1995, 1996).

A common objection is that incorporating behavioural data into theories of
finance would produce results that would be too complex to be useful in practice. Thus,
Bloomfield (2006) has argued: “No behavioural alternative will ever rival the
parsimony and power of traditional efficient markets theory, because, psychological
forces are too complex” (p. 11). Even Thaler (2000, p. 140) has seen this as a problem:
“One reason economics did not start this way is that behavioural models are harder
than traditional models”. We have two responses to this objection.
First, during the early development of traditional economic theory, the processes
involved were seen as too complex to allow them to be described formally. Thus, when
he wrote the Wealth of Nations, Smith (1776/1976) had to describe those processes in
terms of an invisible hand; he could not describe them formally in the way we do today.
The invisible hand was a metaphor that he used to communicate his view of an
economic reality in which people act in their own self-interest but in which the
market has the ability to correct itself without intervention. It was not until
the late nineteenth century that Walras (1874/1954) modelled these economic
processes in a rigorous manner and not until the mid-twentieth century that the
law that he identified was proved formally. Behavioural finance is still in its early
days: the path along which it develops may result in it becoming a more rigorous
discipline.
Second, we acknowledge that psychological processes are highly complex and those
involved in the social cognition underlying financial behaviour especially so. Neuro-
economics and social neuroscience are still in their infancy. However, as we have seen,
responses to complexity need not themselves be complex: in fact, they are more likely
to be effective if they are simple (Åstebro and Elhedhli, 2006; Gigerenzer et al., 1999;
Haldane, 2012; Holte, 1993). The problem is in identifying the simple solutions that are
appropriate for dealing with complex problems. Succeeding in this is still likely to
require the development of a more rigorous approach.
Finance has always borrowed methodologies from other disciplines. Methods
developed in mathematics, physics and economics are now standard in finance.
Methods developed in psychology have been imported more slowly. There are
probably a number of reasons for this. For example, experiments are difficult and
costly to conduct with investors and market professionals because their participation
in experiments requires funds that exceed those available under standard finance
 RBF academic research budgets. Nevertheless, although progress has been slow, work has
4,2 been done and more will be done.
The primary input to behavioural finance has been from experimental psychology.
Methods developed within sociology such as surveys, interviews, participant
observation, focus groups have not had the same degree of influence. Typically,
these methods are even more expensive than experimental ones and so costs of
76 using them may be one reason for their lack of impact. However, it is also possible that
the training of finance academics leads them to prefer methodologies that permit
greater control and a clearer causal interpretation. Nevertheless, interdisciplinary
research is becoming more widespread and it is likely that greater collaboration
between finance and sociology will develop in the future.
Academics often cross disciplinary boundaries. They may simply borrow a single
idea or concept from another discipline. They may work with those from another
discipline but with only limited integration between disciplines taking place. Both
of these are examples of multidisciplinary research (Klein, 1990). However, in true
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interdisciplinary research, disciplines or research methods are integrated into a new

field of study (Mitchell, 1995). Behavioural finance may have started as a
multidisciplinary endeavour but it is now an interdisciplinary field with its own
learned societies, journals and conferences. However, it is still developing and continues to
borrow methods and ideas from other disciplines. This bodes well for its future.

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Further reading
Ricciardi, V. and Tomic, I. (2004), “An introduction to mutual fund investing: a practical approach
for busy people”, unpublished book.
Tversky, A. and Kahneman, D. (1981), “The framing of decisions and the psychology of choice”,
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Science, Vol. 211 No. 4481, pp. 453-8.

Corresponding author
Gulnur Muradoglu can be contacted at: g.muradoglu@city.ac.uk

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