Probabilities and predictions – How heuristics and biases influence private investor behavior

Abstract

Classic economic theory supposes that its agents are rational in their decision making and action. Various empirical studies, however, indicate that individuals are by no means perfect rational utility maximizers. Evidence from cognitive psychology shows where humans abandon the rational path in decision making and utilize simple heuristics to draw conclusions quicker. These heuristics can potentially bias individual investor behavior and create situations in which investors are worse off because they do not follow the rational postulates of classic economic theory. This thesis investigates the influence of heuristics and biases on individual investor behavior. Thereby, it examines various empirical studies concerned with investor behavior that contradicts the principles of classic economic theory. Explanations that stem from the area of cognitive psychology and the discipline of Behavioral Finance are utilized to explain this counterintuitive investor behavior. Indeed, empirical studies suggest that individuals are subject to heuristics and biases also when conducting investments. However, it remains difficult to determine the degree to which psychological factors influence investor decision making.