Looking behind the numbers - The role of Psychology in Financial decision making 

Author

Michael O'Neill

Analyst II

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January 2018
Technology

Since the financial crash of 2007-2008, there has been a dramatic shift in the way financial institutions consider risk.

 

In the aftermath of bank failures and multiple bank fines, risk management within the investment bank structure is at the forefront of how these banks now operate with an emphasis on having an effective risk strategy and culture within their organisation. The damage to the reputation of a firm breaching regulation is not only limited to a specific bank, it will also affect the credibility of the wider financial market. Many of these large financial institutions have faced billions of dollars in fines due to breaches in regulation since the crash, which can be seen on figure 1, below. 

 

As a result, financial institutions have adapted their risk departments to mitigate the frequency and severity of these large costs. Trade surveillance, as a function of risk, has developed to encapsulate risk throughout the banking divisions which is now expected as the norm.

Without an effective trade surveillance function, a market may become disorderly which would have an impact on investments and inhibit economic growth. It is important to consider the behaviour behind trader activity and therefore a need to understand if it is greed, pressure to make money or is it the interaction with other traders that impact their decision making?

How Psychological Bias Shapes individual decision making

The requirement for trade surveillance is to be involved in the prevention and investigation of abusive, manipulative or illegal trading activity across various asset classes. However, trade surveillance currently does not consider the behaviours of each individual trader, and why they make their decisions.  According to conventional financial theory, one of the most basic assumptions is that people are rational so that they can maximise their wealth to improve their well-being. "Traditional" or "Modern" descriptions of finance are based on rational and logical theories, such as the Capital Asset Pricing Model (CAPM) or the Efficient Market Hypothesis (EMH). These theories assume that people tend to behave in a rational and predictable manner and that emotions and other external factors do not influence them, when it comes to making economic choices. For a long time, the theoretical and empirical evidence suggested that the CAPM, EMH and other sound financial theories accurately predicted and explained certain events. However, there are cases in which emotions and psychology can influence decisions, making them become irrational and unpredictable. Behavioural finance aims to combine behavioural and cognitive psychological theories with traditional economics and finance, to help us understand what influences investors that make irrational decisions [1]. 

A study from Vanguard, discusses how the mind affects investment success, and the impact of human decision making. Vanguard state that behavioural finance holds out the prospect of a better understanding of the financial market, so investors can make better decisions and understand potential pitfalls. Vanguard document a range of decision-making behaviours called biases which relate to the processing of information to reach decisions. [2]

Some examples of biases include;

 

  • Overconfidence and over optimism—investors overestimate their ability and the accuracy of the information they have. 

  • Representativeness—investors assess situations based on superficial characteristics rather than underlying probabilities.

  • Availability bias—investors overstate the probabilities of recently observed or experienced events because the memory is fresh. 

  • Regret aversion—individuals make decisions in a way that allows them to avoid feeling emotional pain in the event of an adverse outcome.

 

There have been multiple studies on how ‘overconfidence’ had a role to play in the lead up to the financial crisis. The Journal of Financial Economics, stated that banks with overconfident CEOs and senior managers, were more likely to weaken lending standards and increase leverage than other banks in advance of a crisis, making them more vulnerable to the shock as a result. During 2007-2008, those banks with overconfident views experienced more increases in loan defaults, greater drops in operating and stock return performance, greater increases in expected default probability, and higher likelihood of CEO turnover or failure, compared to other banks throughout the crisis [3]. Journalist Malcom Gladwell, spoke at the New Yorker summit in May 2009, on the collapse of Bear Stearns and the causes of the financial crisis in general. Gladwell stated, ‘What’s going on on Wall Street isn’t the result of experts failing to act as experts: it’s the result of experts acting exactly like experts act. It’s not a result of incompetence, it’s a result of overconfidence.’ [4]

 

How Psychological Bias Shapes Financial Regulation

Following the financial crisis, regulators wanted to ensure the industry would not face the same problems again. Regulation has been constantly changing, therefore banks and financial institutions are under constant pressure to keep up to date with the latest regulation. The implementation of MiFID II in January 2018, has added further complexity for regulators and financial services companies alike. As an EU Directive, it aims to improve market transparency, strengthen investor protection and reduce systematic risk. 

To be able to set appropriate regulation it is important to understand human psychology and group dynamics. These are important aspects of the professional skills of effective regulators, but they are often overlooked. Similarly, understanding what motivates the politicians who are responsible for establishing the legal frameworks within which regulators operate, can inform regulators on national decision-making processes. The impact of headlines, politics and tactics on policy-making can often be detrimental to the resulting statutory frameworks. [5]

Most applications of behavioural finance to regulation, focus on alleviating the adverse effects of individuals’ biases and cognitive constraints. A study from David Hirshleifer, argues that it is equally important to understand how psychological bias can cause a collective dysfunction. He proposed the psychological attraction theory of financial regulation – that regulation is the result of psychological biases on the part of political participants – voters, politicians, bureaucrats, and media commentators; and of regulatory ideologies that exploit these biases. The psychological attraction theory predicts a general tendency for overregulation, and for rules to accumulate as an increasing drag on the economy.  The theory suggests that loosening financial regulation, for good or ill, is most feasible during boom period and pressure for regulation becomes more intense during downturns. [6]

More generally, an understanding of how psychology affects individual decision making can potentially help improve the rationality of political and regulatory decisions. Therefore, the changes within the regulatory environment will require risk departments and thus trade surveillance, to be more proactive to seek to eliminate breaches. To increase financial transparency, efficiency and oversight there is a need to have a clear forward-thinking strategy which considers the impact of psychological biases on financial decision making. 

References 

1 - http://www.forex-central.net/behavioural-finance-theory.php

2 - https://www.vanguard.co.uk/documents/portal/literature/behavourial-finance-guide.pdf

3 - https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=2656520 

4 - http://blogs.reuters.com/felix-salmon/2009/05/05/overconfidence-and-the-financial-crisis/

5 - http://www.tavinstitute.org/projects/understanding-the-psychology-of-regulation/

6 - http://sites.uci.edu/dhirshle/how-psychological-bias-shapes-accounting-and-financial-regulation/

 

 
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