Investment Banking: How Decision-making Is Affected by Psychology

Introduction: Decision-making

decision making concept on blackboard

Make the right decision or suffer the consequences!

I recently was talking to a few people in the finance industry. Of course, I couldn’t but take note of how often they mentioned the amount of work they did on a daily basis and intense their work is. Handling enormous amounts of data, constantly sharing their findings and making on-the-spot decisions with colleagues, and even taking risks they wouldn’t usually take—all of them inferred how normal and “part of the culture” these are.

At the end of the night, I started thinking about the idea of risk. I probed myself: “What do we mean when we say, ‘risk’? Are we referring to the uncertainty of an investment, or are we referring to how uncertain we feel about our decision-making skills?” My question may seem to highlight the same thing, but the difference is slight.

Investments refer to making decisions with the intent of increasing our money where uncertainty is involved. However, when we make decisions, we’re bound to encounter cognitive biases and heuristics. Therefore, risk can be two things: an investment or a bad decision that reflects our poor decision-making skills.

Now, the psychology of decision-making is well-researched, especially as it pertains to the finance industry. We know what cognitive biases are and understand that under pressure, we rely on quick decision-making techniques. However, how often do we use that research when making risky decisions? I mean, how useful is research when we’re not actually using it? And I don’t mean using it every now and then; I mean using it every single time we make a decision. How cognizant are we?

This blog entry will give you insight into decision-making, focusing specifically on when we make risky decisions. We will take a close look at the finance industry and take a peek at why our decision-making in that environment is skewed so often.

Cognitive Biases: What Are They?

As BusinessDictionary.com tells us, it’s a well-known fact among psychologists that all humans (yes, even you) have natural tendencies when thinking, whether at work or interacting with groups. These tendencies are a result of our likes, dislikes, experiences, beliefs, perceptions, and attitudes. We call these tendencies cognitive biases. Unfortunately, however, these biases too often cause us to make mistakes; they don’t help us.

To visualize how cognitive biases work, let me give you an example:

You don’t have a lot of money to buy a brand-new bike. Instead, you decide to build one on your own, so you buy the pieces and build one equivalent to the one you could’ve bought. Several weeks later, the bike, unfortunately, gets stolen, and you’re emotionally distraught.

So you call the local police. They can’t find it anywhere. You get so upset about it that you just will not stop talking about it, whether that be your family or friends—and they all get very irritated by the constant chatter. It’s all you think about.

Your reaction reflects a cognitive bias known as the IKEA effect. True, you bought the bike parts at a much lower cost relative to an already-assembled bike. However, you no longer care about the cost; you care about the amount of time and effort and tears and sweat to build that bike. You developed an emotional connection; it reflects your hard work. In your mind, what you built is worth much more anything you could’ve purchased.

Another well-known cognitive bias is the confirmation bias. It refers to our tendency to disregard information that contradicts our beliefs and attitudes and to search instead for information that confirms them.

When you tell your friend that you absolutely love Chex-Mix and have a lot of respect for the CEO for thinking up such a great snack. However, she starts telling you, “Well, did you hear that the CEO of the company was recently arrested for fraud?” You think for a minute and respond, “Oh, I’m sure the CEO was arrested for another reason, probably nothing related to the company.”

You and your friend continue talking about whether the CEO committed fraud. Whenever she mentions something that proves the CEO is guilty of fraud, you respond with a counterargument that disproves her argument. You are actually guilty of the confirmation bias: You’re actively seeking out information that proves your point and disproves your friend’s.

Why Are We So Biased?

Like many other cognitive biases, confirmation bias is grounded in psychological theory. In this case, it is due to cognitive dissonance. Cognitive dissonance refers to the situation when our attitudes and behavior are misaligned. The individual who loves Chex-Mix suddenly experienced an assault on his attitude, so his attitude became misaligned with his behavior. According to Festinger (1957), individuals are motivated to decrease dissonance, so the individual needs to find some way to handle the misaligned attitude and behavior. We expect him to simply stop eating the food or to lose respect for the CEO.

But there are many ways of handling cognitive dissonance. An individual can change their attitudes or behavior, adopt new beliefs that help them justify their behavior, or place less importance on their attitudes. In this case, the individual justified his or her behavior by adopting the belief that the CEO did not commit fraud.

Yet another well-known example is the representative bias. This refers to our tendency to make conclusions about an individual based on someone that best represents them. The representative bias typically serves as a heuristic as well, which refers to mental shortcuts that assist us in making decisions or conclusions.

Let’s say you meet someone wearing a pretty blouse and nice shoes. You immediately think to yourself, “This girl must be really traditional and even prude.” Where did you possibly come up with this conclusion? Well, the girls you typically have seen wearing dresses are prude. They serve as your representative in making that conclusion. You end up finding out that it’s quite the opposite, however.

first_impressions_3

Nice tie; not a nice conclusion

Your actions may not reflect just one cognitive bias; often, you may illustrate multiple. In addition to the representative bias, your actions reflect the halo effect. The halo effect refers to our tendency to make conclusions about all different aspects of an event, person, or group based on one characteristic. In our case, the individual used the halo effect by basing his or her conclusion on the clothing the girl wore.

For an in-depth look at cognitive biases, check out this article. In the meantime, let’s look at how cognitive biases and heuristics affect how we make investments.

Our Biases When We’re Trading

Trading Setups Review points out that confirmation bias constantly comes into play when we’re making deals at the bear and bullish markets. We come up with a proposition, and we insidiously stick with it, continuously checking for information that proves it. This is fatal. We should really be looking for information that proves and disproves our proposition, helping us revise our proposition. In the end, we may stick with a proposition that is incorrect, or at the least inaccurate, and we lose money.

Just take a look at the Stock Market Crash of 1929, which illustrates the overconfidence effect. The overconfidence effect refers to an individual’s overconfidence in their knowledge and judgments when they really should not be so confident about their decision-making skills at all. In the case of the 1929 Stock Market Crash, stock traders were overconfident that the market “was near a state of perfection, that the sky was the limit, that the market could go nowhere but up continue.” But boy, were they wrong. As we know, following the Crash, the US fell into a deep economic recession. Believing too confidently in one’s judgment can indeed be fatal.

But there’s more than just the confirmation and overconfidence biases. Let’s take a close look at some others.

A. Primacy & Recency Effects

When we change around where the placements of words, we respond differently. The primacy effect refers to our tendency to remember words at the beginning of a sentence; the recency effect, at the end.

These two biases are so important because you can easily be swindled as a result. If the person you’re negotiating with puts the most meaningful words in the middle of a document, you may end up missing important details of an agreement. This often happens in contracts. Contracts are often long and drawn-out, with details listed in the body. Because you’re focused on the beginning and end, you miss those important parts. You might end up making a poor decision because your competitor placed those words in the middle. Don’t fall for it.

B. Positive & Negative Framing

Plous (1993) and Tversky & Kahneman (1981) tell us a bit about two cognitive biases: positive and negative framing. Framing occurs when two equivalent investments are depicted in different ways. Positive framing occurs when one of those investments is shown in a positive manner; negative framing occurs when one of those investments is shown in a negative manner. Although the situations are exactly alike, our responses are different.

In the case of positive framing, we are more likely to choose the investment that is depicted positively; we avert the investment depicted with risk. In other words, we are risk-averse. On the other hand, in the case of negative framing, we are more likely to choose the investment that is depicted negatively; we seek the investment depicted with risk. In other words, we are risk-seeking. The reason may be due to how we perceive of gains and losses. With gains, we are afraid to lose something we know we will earn, so we avert it. On the other hand, with losses, we know that we will lose something, so we might as well take a risk.

The reasoning, however, is skewed. As you see in the chart below, in the case of positive framing, you may be able to earn $400 by taking a risk, but because of your fear of risk, you avert Investment B. And in the case of negative framing, taking a sure loss of $100 is much better than taking a risk of losing $400. Why would we take the chance when we can take a sure loss?

Do not let the framing of a situation catch you. Make a decision that is more logical.

*Note: E(X) refers to the expected value of the investment.

Framing/Investment Investment A Investment B
Positive => You seek Investment A and avert Investment B. You will earn $100.

E(X) = p1x1 = (1.00 x 100) = +$100

You have a 25% chance of earning $400 and a 75% chance of earning nothing.

E(X) = p1x1 + p2x2 + p3x3 = (0.25 x 400) + (0.75 x 0) = +$100

Negative => You seek Investment B and avert Investment A. You will lose $100.

E(X) = p1x1 = (1.00 x -100) = -$100

You have a 25% chance of losing $400 and a 75% chance of losing nothing.

E(X) = p1x1 + p2x2 + p3x3 = (0.25 x -400) + (0.75 x 0) = -$100

C. Certainty & Possibility Effects

Plous (1993) and Tversky & Kahneman (1981) also tell us a bit about probability with the certainty and possibility effects. The certainty effect refers to our tendency to choose an investment in which we are certain that we will earn something. On the other hand (and ironically), the possibility effect refers to our tendency to choose an investment in which there is some chance that we will earn a really large amount of money. Again, similar to the positive and negative framing situations, the expected values are equivalent, yet our decision-making is skewed.

The chart below shows two investments for both the certainty and possibility effects, with equal expected values. In the case of certainty, we are more likely to choose Investment A because we know that we will get $100; we do not want to risk it. On the other hand, in the case of possibility, we are more likely to choose Investment B because there is some chance that we will get a higher payoff than Investment A. (If the payoff in Investment B were even greater, and the expected values of both investments were still equal, we would be even more likely to choose Investment B.)

Be cognizant of how probability affects our decision-making. You may miss out on an investment that is much better.

*Note: E(X) refers to the expected value of the investment.

Probability/Investment Investment A Investment B
Certainty => You seek Investment A and avert Investment B. You have a 95% chance of earning $100 and a 5% chance of earning nothing.

E(X) = p1x1 + p2x2 = (0.95 x 100) + (0.05 x 0) = +$100

You have an 80% chance of earning $100, a 10% chance of earning $150, and a 10% chance of earning nothing.

E(X) = p1x1 + p2x2 + p3x3 = (0.80 x 100) + (0.10 x 150) + (0.10 x 0) = +$100

Possible => You seek Investment B and avert Investment A. You have a 20% chance of earning $100 and an 80% chance of earning $25.

E(X) = p1x1 + p2x2 = (0.20 x 100) + (0.80 x 25) = +$40

You have a 10% chance of earning $300 and a 90% of earning $100.

E(X) = p1x1 + p2x = (0.10 x 300) + (0.90 x 100) = +$40

Conclusion: What Should I Do?

As you can see, our investment-reasoning can be very skewed. Unfortunately, we end up making decisions, which are not in our best interest. Putting it all together, though, you can expect individuals to do the following when making negotiations and investments:

  • pay more attention to information at the beginning and end of a document (primacy and recency effects);
  • choose the investment that is depicted positively and avoid the investment that is depicted negatively (positive and negative framing);
  • avoid situations with probability, preferably taking actions that are certain (certainty effect), unless there is a large payoff (possibility effect);
  • seek large gains when they are available, even if the large gain is under circumstances equivalent to alternative scenarios (possibility effect);

You’re probably thinking to yourself, “What do I do to prevent this? In a culture as fast-paced as finance, aren’t I bound to make mistakes?” Forbes’s writer Peter Lazaroff provides some help. He uses a simple card rule that tests our logic:

Let’s say we’re given four cards: A, Q, 4, & 7. We’re trying to prove a proposition, and we can turn over two cards. The proposition is as follows: If the card has a vowel on one side, then it must have an even number on the other side.

2016-09-28-Confirmation-Bias-PL

This is our scenario

Which are you tempted to flip over, A and 4? I was, too. If we flip over A and we get 4 and we flip over 4 and get A, then we’ve proven the proposition, right? Not so fast.

Let’s say we’re given the opportunity to turn over one more card. Choosing Q won’t help us prove the proposition; not having a vowel doesn’t say anything about what the card on the other side will have. So we choose 7, and find a non-vowel. Why didn’t we choose the 7 as our second card? It would’ve disproven our proposition.

This situation illustrates a way of thinking that we need to use. Instead of always trying to prove a proposition, why don’t we try to prove and disprove it? By doing so, we can continuously revise our investments on the trade floor.

But how do you know if you’re not being logical when you’re moving so quickly? The environment is so fast-paced, so what are you to do? Here’s where time management becomes important. For many, time management refers to getting all your tasks done on time. In other words, we need to be efficient with our time. But maybe it should be about allocating your time effectively, too. Consider taking a break from work every few hours for just a few minutes to refresh your mind. Otherwise, you’ll get stuck in your usual ways of thinking, which, as we saw above, will lead to (sometimes fatal) mistakes.

If you want to make decisions that provide you with the outcomes you want, you need to take small steps to see the change occur.

Published: 07/30/17, 22:41

Last Revised: 08/09/17, 16:57

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