Editors' pick: Originally published Jan. 27.
Mainstream economic theories long have assumed that people consider only their personal welfare and search for the best available information to make decisions.
These theories rely on the notion of homo economicus, a self-interested decision maker who allocates and optimizes resources efficiently in order to reach the best result.
For example, the capital asset pricing model, which Nobel Prize-winning economist William Sharpe helped to develop, assumes that investors have to a large extent the ability to analyze and compare a wide range of investments to make the best choice.
Behavioral economics takes a different approach, by exploring how people act in the real world, how they make decisions within a limited time when there is uncertainty, and how their perceptions of information are influenced by how that information is framed or structured.
Behavioral economics reveals that there are serious limits on how market participants behave on a daily basis. It looks into the regularity -- and predictability -- of people's irrational choices, whereas the homo economicus model considers irrational choices to be anomalies.
Several studies have shown that when people face complex problems that require time and cognitive effort, it's difficult for them to make optimal decisions. Because of the complexities of dealing with so much information and so many choices, people implement mental shortcuts or heuristics to reach decisions that are just "good enough," instead of being optimal.
These shortcuts lead us to the issues of biases.
Researchers in behavioral finance have classified biases either as emotional (caused by feelings, attitudes, aspirations, etc.) or cognitive (involving errors of memory, mainly related to information processing).
Let's start our discussion of biases with something known as the status quo bias. This is a preference for an existing situation and a fear of the regret that might come about if one takes steps to change that situation.
Status quo bias is often associated with something known as the endowment effect, in which the knowledge of owning an asset makes the owner assign greater value to that asset than if he/she didn't own it.
In the 1988 paper, "Status Quo Bias in Decision Making," published in the Journal of Risk and Uncertainty, William Samuelson of Boston University and Richard Zeckhauser of Harvard offered several examples of tests they conducted for status quo bias. In one, subjects received a questionnaire telling them to imagine that they are serious readers of financial news but haven't had much money to invest. They are then told that they have inherited a large amount of money from a great uncle and have the following investment choices:
- a) Invest in moderate-risk company "A," which has a .5 chance of increasing 30% in value in a year.
- b) Invest in high-risk company "B," which has a .4 chance of doubling in value during the same period, a .3 chance of being unchanged and a .3 chance of losing 40% of its value.
- c) Invest in Treasury bills with an almost certain return of 9%.
- d) Invest in municipal bonds with a tax-free return of 6% in one year.
In the first trial, the subjects were informed only about the amount of money received without any information about how the great uncle would have invested the money.
In the second trial, the subjects were told that they had inherited a portfolio from the uncle and that a significant portion of it was invested in company "A," the one with moderate risk.
Company "A" was far more popular in the second trial, when it was shown as an asset already owned, than in the first trial, when none of the investment choices were already owned.
"Status quo bias influences all types of financial decisions," said Victor Ricciardi, a finance professor at Goucher College and co-editor of the book Investor Behavior: The Psychology of Financial Planning and Investing. "For example, people delay decisions and exhibit inertia about paying off credit card debt, saving for retirement and starting a budget."
According to Colin Camerer, a professor of behavioral finance and economics at the California Institute of Technology, there are several sources of status quo bias. They include loss aversion. If a person associates a change with a potential loss then he or she will prefer the status quo.
They also include what's known as the assymetry of experienced regret. This means that people tend to regret bad outcomes resulting from their own actions more than they regret outcomes stemming from not acting. A real world example is an investor holding a losing investment too long.
"People procrastinate from selling losing securities because they do not want to admit a mistake and then experience the emotional loss of regret," Ricciardi said.
There is no universal solution for overcoming our biases and our sometimes irrational behavior, but there are some steps that we can take in order to address them. They include taking extra time to make the right investment choice and avoiding doing it under pressure.
In one study on defaults and status quo bias, conducted by Niels van de Ven of the Tilburg Institute for Behavioral Economics Research in the Netherlands, 82% of subjects chose the default when pressed to make a prompt decision, but only 55% went for it after a delay.
So, when you're making investment decisions, take your time, look at the options and be conscious of how you might succumb to status quo bias.