Why do investors sometimes make bad investment choices?

Individual investors sometimes make decisions that are “irrational”—   mistakes they know they shouldn’t be making. So what causes investors to make these mistakes? What causes some investors to be less prone to biased investment decision making and others to be more susceptible to it? Is there anything that can be done to moderate such behavior? Research by visiting finance professor Stephan Siegel considers whether genetics may have a role.

Individual investors sometimes make decisions that are “irrational” -- mistakes they know they shouldn’t be making. Holding onto a losing stock because “a turnaround is just around the corner!” trading excessively, basing decisions on past performance, not diversifying enough, and preferring lottery-type stocks -- these five “irrational” behaviors or mistakes are investment biases that are quite widespread, and often costly. So what causes investors to make these mistakes? What causes some investors to be less prone to biased investment decision making and others to be more susceptible to it? Is there anything that can be done to moderate such behavior? Those are questions that Stephan Siegel, a visiting professor at the W. P. Carey School of Business, and Henrik Cronqvist, a professor at Claremont McKenna College, addressed in a recent paper, “Why Do Individuals Exhibit Investment Biases?” Presenting the paper at the ASU Sonoran Winter Finance Conference, Siegel explained that, starting out, he and Cronqvist hypothesized that genetics plays a role in investment biases.

“What we were trying to do is determine where investment biases come from -- to what extent they’re determined by nature and to what extent it’s nurture -- and why some investors exhibit stronger biases than others,” he explained. Understanding where investment biases come from is essential in designing effective ways to help investors overcome those biases. In a world in which environment -- an individual’s parents, education, experiences, and incentives -- is seen as the driver of investment bias, then it makes sense to focus on giving investors more information and better tools (education) so that they may overcome their biases. “But if we find that biases are innate, that has important implications for the design of policy,” Siegel said. Then it might be more reasonable to spend money on designing and implementing programs that would, in essence, protect investors from themselves.

Investment biases among Swedish twins

One increasingly popular way in finance research to study the role of genetics as a determinant of our behavior is by studying people who have the same genes: identical twins. For that, Siegel and Cronqvist turned to the Swedish Twin Registry for detailed data on both identical and fraternal twins, and to Statistics Sweden for detailed data on individuals’ investments.

Studying pairs of identical twins who grew up together alongside fraternal twins who grew up together allowed the professors to separate the role of the environment from the role of genetics. If genetics plays a significant role in an individual’s investment decisions, then the investment biases of identical twins who share 100 percent of their genes should be more similar than the investment biases of fraternal twins, who have roughly half the other’s genes.

Siegel and Cronqvist set up the study to measure the effect of three variables on the variation in investment bias between identical and fraternal twins: 1) genetics; 2) common environment (e.g., parenting); and 3) individual-specific environment (experiences not shared by both twins). They also included a control variable for socioeconomic characteristics like income and education, as well as gender and age.

What causes investment biases? The role of genes

Siegel and Cronqvist found that identical twins are much more similar in their investment decisions than fraternal twins, a finding that points to a strong genetic component in investment biases. Across all five types of biases, Siegel and Cronqvist found that the socioeconomic control factors explain less than 1 percent of the variation. Most of it, from 55 to 74 percent, can be explained by that individual-specific environment factor -- “experiences that have made the twins different from one another.” But, Siegel explained, there is also a “significant and substantial” genetic component, which explains 26 to 45 percent of variation in investment decisions. The extent to which investment biases might be explained by genetics varied a bit across the five types of biases:

• 45 percent of the variation in under-diversification and home biases (“investors overweight familiar securities, and invest little to nothing in ambiguous securities”) can be explained by genetics, 0 percent by shared environment, and 55 percent by individual-specific experiences
• 26 percent of the variation in excessive trading biases (“investors trade much more than may be justified on rational grounds”) can be explained by genetics, 0 percent by shared environment, and 74 percent by individual-specific experiences
• 30 percent of the variation in loss aversion biases (“investors are reluctant to realize losses on their investments”) can be explained by genetics, 0 percent by shared environment, and 70 percent by individual-specific experiences
• 31 percent of the variation in performance chasing biases (“investors often extrapolate recent good stock or fund performance even when it shows little to no persistence”) can be explained by genetics, 10 percent by shared environment, and 59 percent by individual-specific experiences
• 28 percent of the variation in skewness biases (a preference for lottery-type stocks that have a “small probability of a very large payoff”) can be explained by genetics, 0 percent by shared environment, and 72 percent by individual-specific experiences

“We draw several conclusions from the evidence,” Siegel and Cronqvist explained in the paper. “First, we are to a significant extent born with these investment biases. Second, the notion that children learn investment biases from their parents is inconsistent with the data. Finally, we find that over 50 percent of the variation across individuals is attributable to individual-specific experiences.”

So what can moderate biases?

Many of the biases observed in financial decisions represent general tendencies that determine an individual’s behavior in general. Evolutionary biologists believe that these behaviors, as well as variation among individuals with respect to these behaviors, are the outcome of natural selection. That is, biases such as overconfidence might have helped humans to survive and reproduce. But in today’s financial world, overconfidence can lead to excessive trading in the stock market, which typically reduces the investors’ wealth. While overcoming these biases in the financial market will not affect the investor’s survival, it could clearly make her better off. “While genetic effects are important, they are not destiny,” Siegel said. In fact, understanding why investors make the decisions they do -- the role of genetics as well as an individual’s experiences -- can help determine how to moderate the effects of genetic predisposition on investors’ decisions.

To date, financial literacy education has been the default method for attempting to reduce investment bias. Yet Siegel and Cronqvist found no evidence that general education is an important moderator of genetically-driven investment behavior. In other words, “genetic predispositions to investment biases cannot be easily educated away.”

Working in a finance-related occupation, on the other hand, does appear to moderate the role of innate investment bias. “For four of the five investment biases we find that the genetic variance goes down and actually becomes insignificant,” Siegel explained. “That suggests that while general education does not seem to have a moderating effect, very specific and sustained exposure to financial decision making does seem to moderate the genetic predisposition.”

Designing policies to protect us from ourselves

The finding that general education doesn’t moderate the role of genetic in investment biases is an important one in terms of devising policies and programs to help investors make smart decisions. “Our evidence suggests that policy should recognize that many individuals indeed exhibit investment biases, and that altering such biases can be difficult,” explained Siegel and Cronqvist.

Siegel suggested creating a default asset management contract, certified by a trustworthy third party, which allows investors to easily delegate many financial decisions to an experienced professional. Siegel proposed treating innate investment biases in much the same way we treat poor eyesight. “Charles Manski, an economics professor at Northwestern University, has argued that knowing behaviors have a genetic component is not very useful.

He gives the example of eyesight, which is largely genetically determined. We give people glasses and the problem is solved, so for Manski knowing that eyesight is genetic is not helpful. But I would argue the exact opposite: the fact that we treat poor eyesight with glasses -- we don’t treat it with classes on how to see better -- is exactly because we understand that it’s largely genetic.” Siegel’s proposed default asset management contract would be like the optical shop. “The government makes sure that when I go to the optical shop I can get a reliable product to fix my eyesight” he said. “There’s no reason we can’t do something similar for investors.”

Bottom line

• In a recent paper, Stephan Siegel, a visiting professor at the W. P. Carey School, and Henrik Cronqvist, a professor at Claremont McKenna College, demonstrated that investment biases can be explained by both genetics and an individual’s experiences.
• Siegel and Cronqvist find little evidence that general education is a significant moderator of genetically-driven investment behavior.
• Working in a finance-related occupation, on the other hand, does appear to moderate the role of innate investment bias.
• Instead of attempting to “educate away” innate investment biases, Siegel suggested creating a sort of default asset management contract, certified by a trustworthy third party and run according to the best practices.