Psychology, Financial Decision Making, and Financial Crises

It is understandable that people ask how the current financial crisis could happen. As the market actors appear irrational, it is also understandable that people—lay people and experts alike—believe that psychological factors play a decisive role. Is there evidence for such a role, and what is the evidence? This monograph reviews, evaluates, and discusses research—primarily psychological research —that can potentially increase our understanding of the psychological antecedents and consequences of financial crises. It also highlights important areas where more psychological research is needed to advance this understanding. Individuals generally use their cognitive and other resources in sensible ways, and collectively they have developed procedures that effectively regulate economic and other social transactions. But sometimes such transactions are so complex that they exceed the ability of individuals or groups to manage effectively. It is therefore essential that scientific knowledge of people’s cognitive and other limitations be brought to bear on the issue of how to improve decision making in these domains. Financial markets such as those for stocks and credit arguably are among those domains in which actors’ capacity to make rational judgments and decisions is frequently overtaxed. In product markets with full competition, prices more closely represent the true value of the products; uncertainty in such contexts is thus minimized and the conditions are relatively conducive for making good judgments. But in stock markets, stock prices, due to excessive trading, are more volatile than they would be if they reflected stocks’ true value. Psychological explanations of excessive trading include cognitive biases such as overconfidence and overoptimism, risk aversion in the face of sure gains and risk taking and loss aversion in the face of possible losses, and influences of nominal representation (the money illusion) of stock prices. If no cognitive biases (strengthened by affective influences) existed or only some actors were susceptible to such biases, individual irrationality in stock markets would possibly be eliminated. But evidence shows such biases are in fact pervasive. In order to understand stock market booms and busts, it is also necessary to take into account the tendency among actors to imitate each other. Furthermore, in destabilized stock markets, experts are less likely to lose money than are lay people, who lack skill in constructing stock portfolios that effectively diversify risk. Credit markets allow people to lend money for investments that will pay off in the future. Yet under extreme circumstances, credit lenders offer loans without appropriately considering the risk borrowers run of not being able to pay their monthly installments. Global credit excesses in general, and the current subprime mortgage crisis in particular, also show that households often accept risky loans. Furthermore, their preparedness to use credit has been increasing and credit is no longer solely a means of investing in the personal future. An example is that, in the new member states of the European Union, citizens having a desire for a Western living standard are increasingly prepared to use credit. Credit use is a process consisting of different stages of decision making, starting with purchasing a product for borrowed money and ending with paying back the borrowed money. Decisions to save now in order to buy a desired product in the future, or not to save but to borrow money and save later, are intertemporal choices with consequences at different points in time. The rewards of possessing a commodity immediately or in the future are traded off against the costs of paying back borrowed money in installments or paying the price all at once in the future. Purchase decisions involve two interacting choices preceded by information search: Choice of the product and choice of the method of financing. Only a small percentage of credit users search extensively for credit information prior to taking up credit. The probability of search increases with the borrowed amount, the amount of previously experienced debts, higher income, and higher educational level, and it also is higher for credit novices. Furthermore, credit users fail to correctly anticipate the decrease in the experienced pleasure from the credit-financed product. They also experience decreasing pleasure with the acquired product and increasing strains from