Behavioral Economics: A Primer

Behavioral Economics: A Primer


People make rational decisions
People are unbiased towards new information


Traders ought to be aware of this. The value of a particular financial instrument depends heavily on the perception of it’s value. How is value determined? Again, we feel this is simply a matter of relying on objective mathematics. Numbers are not enough to describe investor decision making. Take a simple coin toss. Ellen Langer showed that people are more willing to bet on the outcome before the coin is flipped than after. People behave as if their involvement makes a difference in value. You’re thinking, “How foolish, I’d never make that mistake”. If you’re like most college students, you think you are above average. As a matter of fact, 82% of them do, according to a classic study by Ola Svenson. Overconfidence is a consistent bias humans show, and it shows up in the markets.



What counts as a gain or a loss is also relative to prior prices, not considered as independent of an investor’s attention. A stock acquired at $50 and and acheives a year-end value of $100. A few months into the new year it is sold at $75. While this is objectively a $25 gain, the investor likely feels as if there was a loss. One classic decision-making bias Nobel Laureate Daniel Kahneman and Amos Tversky identifed is this effect, called anchoring and adjustment. Meir Statman asked subjects this question



The tenets of behavioral economics have profound implications for biases traders have not predicted by mainstream models of valuation and pricing. Ove the coming years these concepts will become better known and produce not only better predictive financial models but allow individuals to become better investors. Cognitive illusions and biases cannot be erased, just as one can’t help but imagine the lights dancing on a movie screen as real people, but making humans critically aware will produce better decision making in the markets.

Khurram Naik is a derivatives broker at Infinity Futures in Chicago. He is a graduate of Carnegie-Mellon and has worked in research in cognitive science and education at Princeton, Harvard and Carnegie-Mellon University. He is also a former field director for a political campaign. He maintains a blog on literature and cognitive science. He can be reached at k.naik@infinitybrokerage.com

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