Professor Stefan Zeisberger talks to us about the psychological pitfalls in the decision-making process, which is still an underexposed topic in the world of finance.

Professor Stefan Zeisberger
University of Zurich / Radboud University

Stefan Zeisberger is Professor at Radboud University (Netherlands) and at the University of Zurich (Switzerland). Previously he held positions at, among others, the California Institute of Technology and Stony Brook University in New York where he founded and directed the Center for Behavioral Finance. Stefan’s research focuses on investor psychology, in particular risk preferences and perception. Alongside his academic career, Stefan works as a consultant for financial institutions. The typical mistakes he and his fellow researchers observe amongst financial professionals are often the same other professionals and laypeople make. That shows how difficult psychological factors are to grasp in making decisions that have a large (financial) impact on the business. In most organizations, the psychological component in decision-making processes is still underexposed.  

At the Amsterdam Institute of Amsterdam, Zeisberger teaches the program Psychology of Risk in which he helps decision-makers to understand their own thinking and behavior better. This leads to a higher general quality of decision-making and contributes to preventing painful losses. 

What got you interested in the field of psychology of risk?  
“I started out more as a numbers person. I was even writing a thesis on credit risk, purely technical stuff. Then the older I got, the more intrigued I became by how our psychology shapes our decisions and how systematic this is. As the years went on, I found out that people who believed they were very rational decision-makers, like most finance people and investors, are actually prone to very similar and consequential mistakes. That discovery and biased self-image of professionals excited me and it still does today. There is a lot open to explore in this area.”

As the topic is becoming more mainstream and well-researched, do companies and investors nowadays pay more attention to the psychology of risk than before? 
“In academia, the field of behavioral economics is getting significant attention. In business practice, we are going in that direction and people are more and more aware of the fact that we are human, and humans make mistakes. However, we are very far from systematically incorporating these ideas into our decision-making processes or even being conscious of them. I think most people in the field are not yet aware of what an extremely important element the psychological factor is in everyday life decisions, and in financial decisions in particular. So, I am not afraid I will lose my job or get bored in the coming decade.”

Psychology of Risk AIF

Are you involved in research on this topic? 
“Yes, very much. I have the fortune to be able to pick my own research topics so I concentrate on what excites me most. I analyze the behavior of financials, what kind of mistakes they make, why they make these mistakes and how we can help them avoid these cognitive pitfalls. Although I mostly study investors who are active in trading, the underlying psychological mechanisms also affect other professionals, like bankers, CFOs, CEOs and other executives in their decision-making.”

There are many case studies published about business decisions, like mergers and acquisitions, whereby psychological factors negatively affected the outcome like overpaying for a target… 
“Yes absolutely, we find reasons within psychology why people do so. We call it the winner’s curse. Overpaying typically happens in auction settings, where you will only acquire something like a company if you are the one whose willingness to pay is the highest. If this does not come with particular synergies, you often overpay. That is also why many M&A transactions are suboptimal.”

When you look at traders and investors, what are typical biases you see amongst these types of professionals?
“There are many. One very dominant observation is that most investors are overconfident. They believe they have better skills than they actually have, and therefore they make too many trades. When you believe you have superior skills and you are able to pick the next Google, Facebook (bad example these days), Microsoft or the next crypto currency (to continue with bad examples), it is often the case that this doesn’t pan out. As researchers we are digging deeper into why people are overconfident. One reason we found is that people have a biased memory. As humans, we tend to remember good decisions and good outcomes more than bad and unfortunate ones as we suppress bad events. This is a survival strategy. This biased memory further fosters your overconfidence because you look into the past and you tell yourself what a great investor you are, even though you are not. 

Another typical bias is loss aversion, which is being afraid of incurring losses. Even in situations where financials have multiple decisions or multiple investments, they tend to focus on the potential loss of any one of those investments rather than looking at the whole picture. A similar behavior is that while people have a long investment horizon, they look too much only at the next month or the next quarter. This reduces their investment strategy potential. Sometimes this misbehavior is fueled by institutional constraints such as short performance periods.

A third prominent bias is having a wrong risk perception. This refers to assessing the risks incorrectly, either too high or too low, which results in sub-optimal decisions.”

Can you estimate how much is lost because of the psychological factor? 
“In the investment domain, we have lots of trading data and we can therefore analyze what individual investor X, Y and Z did. We can see how many people make similar mistakes and that most of the individual investors are doing worse than they could be doing. The average investor loses approximately one to two percent per year compared to what would be a good strategy. This adds up to substantial amounts of money over time.” 

When you look at organizations, do they have measures in place for these types of biases? Is it part of their risk management?  
“The risk management measures I generally see are often not systematic and a bit ad hoc. Often action is only taken after something went wrong. Also, frequently the measures are not really targeted at the psychology and behavior of people. So, we find basically in our research that professionals make similar mistakes as laypersons. They suffer from the same cognitive biases and use the same heuristics as non-professionals. Maybe to a lesser extent, but sometimes not even that. That tells us how big this problem probably is. Any measure should take into account the incentives of involved people. Also, different people and organizational units can have different incentives, which leads ultimately to frictions and bad outcomes.”

What would your advice be for financials or for companies that want to implement measures?
“If we could just switch those biases off as professionals, we would, but we can’t. They are inherent to being human. Therefore, as a first remedy I would create awareness. If you are simply aware of potential mistakes and if you have heard about them a few times, then you will be better able to spot potential risks in the decision-making. So, knowing about the mistakes is already walking half the way. Creating more awareness could be done in training like the AIF-program or in-house courses. For investors, you can document what you have been doing. So, if you write down what you have decided and why you have decided in a certain direction, then you cannot trick yourself afterwards. Some financials do that, keeping a sort of diary, which can help them because it’s written down. This measure is especially useful for financials who make a lot of similar types of decisions. For companies I advise to carefully look at the incentives that are created. Most people and professionals do not per se behave in suboptimal ways, but they simply react to incentives and culture that a company creates. Setting the right measures and incentives will help creating a healthier work environment. It is the task of the upper management to reduce potential frictions between different units that might have different incentives.”

Is there a difference, you think, between the investor group and the corporate group in making major decisions for organizations, e.g., in acquisition processes? 
“Our research has demonstrated that the underlying psychology of humans is surprisingly similar. We see, for example, that professionals and laymen often do similar basic mistakes. In the investment domain a lot of data is available compared to managerial and other decisions and hence it is often easier to quantify the outcomes of mistakes. Nonetheless, very similar underlying heuristics and biases are at place for managerial decisions. These include overconfidence, group-thinking and biased risk-taking behavior, which often also lead to overpaying for acquisitions, as one example.”

How is the AIF-program on the Psychology of Risk structured? What can participants expect?
“What I try to do is to provide participants with though-provoking and useful knowledge from research about psychology that is relevant to them in their own domain. So, instead of having to read 200/300 papers, you get a summary – hopefully nicely presented – of all the aspects that I perceive as relevant. And what we’re also going to do is experience making a lot of decisions. So, I will frequently ask the participants to make their own decisions during the program, be it investment decisions or otherwise, and then we will discuss them together and see what we think about them. Were they rational or were there biases involved? This experiential setting has proven to be very effective, participants can learn a lot from being forced to make decisions in a safe environment.”

Do you also look at the role of personality? Because financial services attract certain types of people. Maybe that’s changing a bit now, but it used to be very male-oriented with probably quite a lot of dominant personality types. Is that something you see reflected in the research?
“Yes, what we try to do more and more often is trying to link personalities with certain behaviors or decisions. Very generally speaking, the rational calculator as we assume a typical financial to be doesn’t prevent him or her from making consequential mistakes. That is the overarching message of this field of study. But it’s also interesting to dig a bit deeper. For example, males versus females in terms of decision-making. For investment decisions, we certainly see that males are more overconfident. They trade more, while they are a little bit less successful in their investments. And women are being a little bit more risk averse on average. Generally, what we also see is that entrepreneurs are kind of like a unique type of person. They are typically high-risk takers in many domains. So, these people seem to differ to a certain extent. And they need a little bit of overconfidence otherwise they wouldn’t start the next thing.”

They make mistakes and learn from these experiences…
“Right, and they are not being discouraged by them. That makes them unique in a sense. My parents will never invest in stocks anymore. They did it once for a year and it didn’t go well… I cannot convince them, no matter what I say. Even having a son as a finance professor doesn’t help. A stream of research shows that what you learn in your early lifetime sticks with you forever to some extent. So, if you have a negative experience early on, this will then influence your decision-making and expectations for the rest of your life. E.g., people who were born during the great financial crisis have a different attitude towards risk, on average, than people born afterwards. Similarly, if you grew up in a time with high inflation, you will more likely think that inflation is generally a higher risk than other people. Just the age structure might tell you something about the behavior.” 

When you look at the regulatory authorities today, do they take psychological factors of risk more into account? 
“Yes, although it is still mostly focused on consumer protection. Many regulators have nowadays a behavioral unit. They are aware of the mistakes that are commonly made and try to protect consumers accordingly. Of course, banks and other financial institutions know a bit about psychology as well, so they might create incentives for products based on profitability rather than suitability. Therefore, there are regulations in place and discussions about suitability requiring you to ask an investor about her risk preference and so on.”

Do you think companies should have their own behavioral unit? 
“As long as the size allows it, absolutely, because it enables them to prevent mistakes in decision-making and to improve their products and services. Rather than relying on gut feeling, the online world allows us to test different offerings these days. For example, a bank can test different onboarding procedures and see which version works best and so on. Nowadays companies are able to test many aspects, especially in an online world. Generally, it proves fruitful to incorporate behavioral aspects systematically and have this enabled by the organization, like installing a Chief Behavioral Officer. I know of organizations that incorporate behavioral insights very strategically, and they often perform better than their competitors.”

Stefan Zeisberger teaches the program Psychology of Risk at Amsterdam Institute of Finance. Learn more & reserve your place here.

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