Value Investing

Investors’ Expertise, Personality Traits And Susceptibility To Behavioral Biases In The Decision Making Process

Investors’ Expertise, Personality Traits And Susceptibility To Behavioral Biases In The Decision Making Process

Marcin Rzeszutek

University of Finance and Management – Faculty of Management and Finance

Adam Szyszka

Warsaw School of Economics

Monika Czerwonka

Warsaw School of Economics (SGH) – Department of Finance and Management

September 30, 2015

Contemporary Economics, Vol. 9, No. 3, pp. 237-352, 2015


The aim of this paper is to investigate the degree of susceptibility to behavioral biases (the certainty effect, the sunk cost fallacy, and mental accounting) among people of various levels of expertise in market investments and to determine whether this susceptibility is correlated with certain personality traits (impulsivity, venturesomeness, and empathy). The study included 200 participants: 100 retail investors who regularly invest in the Warsaw Stock Exchange and 100 students of the Warsaw School of Economics who are casually involved in investing. In this study, employing a survey methodology, we conducted a laboratory experiment that allowed us to isolate behavioral biases and personality traits and measure their influence on investors’ decision-making processes. The participants filled out questionnaires containing two parts: 1) three situational exercises, which assessed susceptibility to behavioral biases, and 2) the Impulsivity, Venturesomeness, Empathy Questionnaire (IVE) Questionnaire which measures three personality traits (impulsivity, venturesomeness, and empathy). Statistical analyses demonstrated that susceptibility to behavioral biases depends on the level of expertise in market investing such that expertise increases susceptibility to behavioral biases. Some personality traits influenced the participants’ likelihood of displaying these biases.

Investors’ Expertise, Personality Traits And Susceptibility To Behavioral Biases In The Decision Making Process – Introduction

There is a vast literature dedicated to showing that neoclassical finance theory does not properly depict the real behavior of an investor in a stock market and that the investment decision-making process is greatly shaped by psychological factors, such as moods, emotions and personality traits (Akerlof & Schiller, 2009; De Bondt & Thaler, 1987; Kahneman 2012; Szyszka & Zielonka, 2007; Todd & Gigerenzer, 2003). Abundant evidence from psychological research that suggests that humans have restrained cognitive possibilities, are controlled by  emotions, and succumb to mob mentality while making choices in risky and uncertain situations, drew financial behaviorists’ attention to the drawbacks of the homo economicus assumption and the hypothesis about the market’s efficiency (Fama, 1970; 1991; Markowitz, 1952; Von Neumann & Morgenstern, 1944) and the susceptibility of investors to so-called behavioral biases resulting from cognitive biases and heuristics as well as emotions (Agnew, 2006). These biases disrupt the rationality of the process of making investment decisions and contribute to inefficient market reactions to information and, as a result, to asset mispricing (Coval & Shumway, 2005; Rzeszutek & Czerwonka, 2011). Szyszka (2010) proposed the Generalized Behavioral Asset Pricing Model, which shows how asset prices can be influenced by various behavioral biases and how prices may deviate from fundamental values due to investors’ irrational behavior. The model distinguishes three behavioral variables that are linked to errors in understanding and transforming information signals, problems with representativeness and probability judgment, and unstable preferences. In this paper, we investigate three examples of behavioral phenomena that are captured by this model: the certainty effect, the sunk-cost fallacy, and mental accounting. In particular, we look at how these three important behavioral phenomena manifest among investors depending on their level of expertise and personality traits, such as impulsivity, venturesomeness, and empathy.

1.1 Certainty Effect

Daniel Kahneman and Amos Tversky noted many anomalies in how individual preferences are shaped in situations of uncertainty and risk (1973; 1979; 1984). One such anomaly is the certainty effect: the tendency to overweight outcomes that are certain compared with outcomes that are highly probable. For example, Kahneman (2012) observed that a substantial majority of participants prefer a certainty of winning $850 to a 90% probability of winning $1,000, although the expected value of the latter option is actually higher. Overweighting a certain win over a highly probable option, as in the example above, prompts people to choose an option with a lower expected value. Therefore, the certainty effect was shown to lead to potentiallyless profitable investment  decisions in the capitalmarket (Agnew, 2006).

1.2 Sunk-Cost Fallacy

Making decisions in conditions of risk and uncertainty is also dependent on the sunk cost fallacy, which describes the influence of costs incurred in the past on future investment decisions (Arkes  & Blumer, 1985). According to neoclassical finance theory, only an analysis of current and future losses and profits should influence these decisions (Bernstein, 2007). However, investors all too often attach importance to outlays made in the past toward a given investment, and these past costs significantly influence both present and future decisions (De Bondt & Makhija, 1988). On the stock market, this overweighting of past costs often leads to retaining positions that generate costs for too long and sometimes even to purchasing more shares after declines (Friedman et al., 2007). In doing so, investors seek to reduce the average price of purchasing a share in the hopes that they will be able to record profits more quickly after a small economic upturn (Connolly & Zeelenberg, 2002; McAfee, Mialon, & Mialon, 2010).

1.3 Mental Accounting

Mental accounting is a process of mentally coding, categorizing, and evaluating cash flow, i.e., recording particular expenditures and revenues in various mental accounts (Thaler, 1999). The mental accounting effect undermines the principle of sustainability, which claims that money has no label, i.e., that the  source of funds is irrelevant in the spending of them (Haigh & List, 2005). Stock market investors do not follow this principle but rather display mental accounting  and treat profits attained as dividends (cash) differently from identical “paper” profits—those resulting from an increased exchange rate (Winnett & Lewis, 1994). It has also been observed that investors are incapable of closing losing positions and investing funds from those losing shares in new endeavors because these shares are treated as a separate mental account (Odean, 1998). Instead, many hope for changing trends to make up for those losses in the future, which leads to a progressive reduction in the worth of their investment portfolio.

Behavioral Biases

Behavioral Biases

See full PDF below.

Get our newsletter and our in-depth investor case studies all for free!