Psychology and Financial Decisions: A Literature Assessment

Abstract

A common finding of many surveys of corporate financial management practice is that the actual usage of normative financial models is infrequent. This is mainly due to the complexity of the decision environment, the use of information processing heuristics by decision makers, and the presence of psychological factors that influence the decision maker's behaviour. This paper reviews certain psychological concepts and their effects on the validity of traditional fundamental analysis in finance. Second, it discusses how cognitive limitations of human information processing may interfere with the implementation of certain decision rules in financial management, especially when decision makers experience information overload. Third, it provides a review of the advances that have been suggested to overcome the cognitive limitations of human information processing and to evaluate whether such advances can circumvent the psychological biases inherent in human decision makers.

Behavioral research into heuristics and bias as an academic pursuit

“…Beaulieu and Diaz provide evidence that lenders and appraisers, two major participants in the real estate industry, deviate from prescribed decision models. This is further support for Kanaan's (1993) commentary on the need to redefine normative models and to determine what actually occurs when individuals make decisions. What is evident from these studies is that the human decision process is often simplified as data are determined to be either relevant or irrelevant within the context, or schema, of the decision environment.…”