Vol 10, No 4 - Financial Planning Association of Malaysia

INDUSTRY
October - December 2010
A Behavioural View of How People Make
Financial Decisions
By Keith Redhead
Executive Summary
The paper provides a guide to
the implications of behavioural
finance for financial advisers.
The focus is on the process
of financial decision-making.
Financial decision-making is
seen to be subject to behavioural
biases at three stages:
1. The perception of
information
There is a difference between
objective information and
perceived information.
Decisions are based on
perceived information.
Selectivity, interpretation
and closure affect
perceptions. These
processes are affected by
behavioural biases, such
as narrow framing and the
availability bias along with a
wide range of motivational,
attitudinal, social, and
emotional factors.
2. Cognition
Thought is not entirely rational and
is influenced by bounded rationality,
the extent of cognitive reflection,
mental accounting, illusions and selfdeception
along with other cognitive,
emotional and social factors.
3. Motivation
Decisions may be made but not
implemented. Procrastination and
mistrust can inhibit the activation of
decisions.
A behavioural finance view of the financial
decision-making process is depicted by
Figure 1.
Perceived Information
Figure 1
There is a distinction between objective
information and perceived information
(objective reality and perceived reality).
What people perceive is influenced by how
they select information to process. People
are incapable of absorbing all information,
and are therefore selective as to what
Objective
Information
Perceived
Information
Information
Processing
Decisions
Activation
Action
A behavioural finance view of the
financial decision-making process
Historical Prices / Public Information /
Private Information / Noise
Selectivity / Interpretation / Closure
Information overload could terminate
the process
Satisficing subject to heuristic
simplification, selft-deception, social
influence, emotion and mood
Buy / Sell / Hold
Procrastination / Inhibition
Decision Implemented
information receives their conscious
attention. The process of selection
may occur largely at an unconscious
level. They need to distinguish between
reliable information and noise; and to
select the most important pieces of
reliable information. Noise is irrelevant
or inaccurate information, such as
misleading rumours.
Each person will interpret information
differently. Their interpretations of
information are influenced by their
motives, their knowledge, their
experience, their feelings, and by a
multitude of other cognitive, emotional,
and social influences.
There is also a closure process. Where
information is incomplete, people tend to
fill the gaps in order to obtain a complete
story. Additional “information” is used to
supplement what is perceived in order
to obtain closure. Some information may
be disregarded if it is inconsistent with
the perceived “story.” The factors that
influence closure are similar to those
that influence the interpretation of
information. What one person sees
can be very different to what another
person sees, even though the objective
information is the same (Litterer 1965;
Ricciardi 2008).
Decisions are made on the basis of
perceived information. A financial
adviser should be alert to the possibility
that a client has inaccurate perceptions,
which may need to be challenged.
DiFonzo and Bordia (1997) showed that
rumours affect investment decisions,
even when the rumours come from
sources that lack credibility. There is
evidence that people make decisions
based on stories constructed around
information, rather than on the
information itself (Mulligan and Hastie,
2005). If a rumour is consistent with
such a story or provides a story (an
explanation of events), it may be more
readily believed. People are prone to
accept information from unreliable
sources if such information is believable
and consistent with their existing
perceptions of events (Evans and Curtis-
Holmes, 2005).
Psychological Biases
There are cognitive biases that can
cause an exaggerated perception of risk.
Narrow framing entails focus on shortterm
investment performance when the
investment is long-term. An example
is the person who is concerned about
quarterly pension fund returns when
retirement is 30 years in the future. Short
investment horizons are much more likely
to show losses than long horizons. A shortterm
focus can cause an exaggerated view
of the probability of losses, and hence an
increased reluctance to contribute to a
pension plan.
Diacon and Hasseldine (2007) found that
clients were more likely to invest when
shown presentations of performance
over long periods than when they
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