INVESTMENT PSYCHOLOGICAL BIASES IN THE UNITED STATES AND ITALY.

• Author: Wong, Alan
• Position: Report

INTRODUCTION

Traditional finance is rooted on works expounding rationalization and the maximization of expected utilities. However, traditional finance theories have sometimes failed empirical tests with presence of anomalies. A relatively new field, behavioral finance, argues that some of these financial anomalies can be explained by the presence of psychological investment biases in decision makers.

Human psychological biases can be affected by factors such as traditions, geography, culture, religion and others. Many of these factors are different between countries and these factorial differences might contribute to varying levels of investment biases between countries. A few recent works have pointed out that there are national differences in various investment biases. For example, Czerwonka (2017) finds that Polish students are less susceptible to anchoring bias than those from India possibly because Indian students think in a more holistic manner. Contrary to past evidence, the author also finds that Poles are less susceptible to overconfidence bias than students in India possibly due to their more individualistic attitude. Jlassi, Naoui, and Mansour (2014) also find that Asian investors are subject more to overconfidence bias in a study of 27 stock exchanges in different countries. A comprehensive work by Chang & Lin (2015) indicates that stock markets in 50 countries have shown evidence of differences in herding behavior. Countries under the influence of Confucian philosophy and less developed countries tend to show more herding bias.

This study is an exploratory study and it aims to explore 10 such investment biases in behavioral finance and related issues across two countries--the United States (U.S.) and Italy. The investment objective is to determine whether the U.S. and Italy display different investment behavioral biases and the extent to which they are different. There are very few studies that examined differences of investment biases across different countries. This study attempts to fill the gap

REVIEW OF LITERATURE

The literature review is divided into two sections. The first section discusses research related to behavioral finance. In the second section, the review dwells on a few works done on the relationships between national differences and behavioral finance.

Finance and Behavior

The paradigm of traditional finance is rooted on notable works which include the Market Efficiency Hypothesis (Fama, 1965), Modern Portfolio Theory (Markowitz, 1952), and the Capital Asset Pricing Model (Treynor, 1962; Sharpe, 1964). These works, expounding rationalization and the maximization of expected utilities, sometimes failed empirical tests with presence of inefficiencies (Park & Sohn, 2013). Werner, De Bondt, and Richard Thaler (1985) find evidence of market inefficiency in the form of overreaction and Ritter (2003) discovers that the stock market bubbles in the U.S., Japan, and Taiwan could not be explained by assumptions of rational maximization of expected utility in an efficient market.

The problem with many of these assumptions is they leave out the psychological aspects of human decision making which can cause systematic deviations from expected utility models. Lee, Shleifer, and Thaler (1991) find evidence that human nature does affect asset values. Behavioral finance argues that these financial anomalies can be explained using models in which some decision makers are not fully rational. For a good overview and history of behavioral finance, see Sewell (2010) which includes major works and important heuristics. Behavioral finance is built on two blocks (Barberis & Thaler, 2003).

One building block is psychology which helps to explain deviations from expected rationality. In one of the seminal works on psychology associated with behavioral economics, a pair of psychologists (Tversky & Kahneman, 1974) developed a theory on heuristics that explain how decision-makers use mental shortcuts to solve problems. For example, the availability heuristic allows people to make decisions based on what is readily available in their memory. The representativeness heuristic allows people to make decisions based on comparison to the most representative mental example. The anchoring heuristic allows people to make decisions based the first piece of information relayed to the decision maker.

Unfortunately, these heuristics often lead to cognitive biases and decisions that are often not optimal. In 1979, Kahneman and Tversky developed the Prospect Theory which argues that the decisions are not based on an absolute net wealth as expounded by the expected utility theory. Rather, decisions are made in regard to terms of a potential gain or loss as deviation from a reference point. The value function for loss is steeper than the value function for gain, thus the negative impact of a loss is felt much greater than the positive impact of a similar amount of gain. Odean (1998) provides evidence that investors tend to sell winners and hold losers, supporting the Prospect Theory and its implications of loss aversion and disposition effect (Shefrin & Statman, 1985)

Other works that dwell on the psychology of decision-making include Thaler (1999) who expounds the concept of mental accounting. The concept contends that people divide and categorize their funds into different non-exchangeable mental accounts. Each account is looked at as a separate entity and not part of a portfolio of accounts, even though they all draw from the same economic resource. This psychological phenomenon has implications for investment and spending decisions. Riff and Yagil (2016) reveal that the market anomaly of home bias is a violation of what the international portfolio theory advocates as optimal. Persistent home bias behavior has been a puzzle for many decades.

The authors developed experiments to test whether "familiarity" and "fluency" (pronunciation ease) affect the selection of home stocks in a portfolio. Their experiments indicate that subjects tend to be more conservative with picking unfamiliar, foreign, or non-fluent securities for their portfolios. The tendency increases greatly when unfamiliar, foreign, and non-fluent assets are presented together versus when only one is presented.

The other building block of behavioral finance is arbitrage limits which can make it challenging for rational agents to reverse the impact caused by less rational agents. Factors such as risk aversion and agency problems can impose limits on arbitrage (Schleifer & Vishny, 1997; Shleifer; 2000). Just because there is a mispricing, it does not necessarily mean that it is a riskless arbitrage opportunity to be taken advantage of. First, the ever present information cost and risk (e.g., the absence of same assets) to arbitrageurs do not make arbitraging a riskless endeavor. Second, the arbitrage market is dominated by professional arbitrageurs and outside investors who generally do not know much about it.

Simple logic implies that greater price dislocations attract more funds for arbitrageurs but reality may not reflect that. Because investors have limited knowledge of the arbitrage market, the resources they supply to it will be limited, especially during times of extreme mispricing when investors' anxiety levels are already high. Thus, limited funds, due to agency problem, means that arbitrageurs might not be able to effectively and completely reverse price dislocations, leading to persistent price anomalies.

National Differences and Behavioral Finance

There are hundreds of studies of national impacts on business and management but few are done in finance and...