The Psychology of Financial Decision Making: A Case for Theory-Driven Experimental Enquiry

This paper has three main parts. We first present a brief survey of the behavioral anomalies in the finance literature classified as: price and return effects, volume and volatility effects, time series patterns and other miscellaneous effects. For each category, we find that the empirical literature offers a multitude of explanations. We then develop a theoretical information-processing framework to examine the psychology of financial decision making. Many extant behavioral anomalies noted in the finance literature can be derived from this framework. The theoretical framework comprises both cognitive and motivational antecedents of bias in financial decision making. The model posits five stages at which cognitive biases may arise: perception, memory-retrieval, information integration, making a judgment, and behavior. Motivational effects are theorized as either directly affecting the manner in which information is processed, or indirectly moderating the likelihood that cognitive biases will occur. Finally we present the main thesis of the paper that theory-driven experimental analysis enables clarification amongst competing explanations, and should complement existing empirical paradigms. We illustratively use the model to examine financial decision making biases in the choice between value and glamour stocks. Across a systematic series of 5 mini-experiments, we find support that the primary antecedent driving choices between value and glamour stocks is cognitive. Concluding thoughts reinforcing the need to examine the why of a seeming anomaly are offered for both finance theorists as well as practitioners. The Psychology of Financial Decision Making: A Case for Theory-Driven Experimental Enquiry