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Irrational behaviour prevents optimal investing

by LLB Editor
9th Jun 23 9:01 am

A new research report published in the Journal of Behavioral Finance finds that investors non-consciously use the amount of an initial investment as an anchor. When the initial amount is small, it causes people to underinvest in the future. According to the researchers, these “accidental” investing behaviors affect overall investment size.

Jennifer Itzkowitz, Ph.D., Associate Professor of Finance at Seton Hall University, Jesse Itzkowitz, Ph.D., Behavioral Scientist at Ipsos, and Andrew Schwartz, Ph. D., Assistant Professor at Seton Hall University looked at the investment behavior of more than 150,000 individuals in their app-based stock brokerage accounts. Among their key findings:

The amount of all subsequent investments is strongly influenced by the initial investment amount.
After the initial stock purchase, 19% of stock purchases are for the exact value as the first stock trade.
Anchoring is prevalent among all groups of people including, men and women, young and old, people in all parts of the country.

Over one year, a $1 increase in the amount of an investor’s initial stock purchase results in a $4.63 increase in the total amount that an investor contributes to their investment account, all else equal.
According to researchers, the amount of money you choose to make your first investment irrationally biases later investment amounts. This behavior, known as “anchoring”, occurs when exposure to a number non-consciously influences subsequent decisions. This is contrasted against a purely rational strategy in which people decide how much money to invest based on their income and spending habits.

App-based trading platforms encourage users to start trading with extremely small amounts of money. For example, Stash advertises, “Investing made easy. Start with just $5.”  Although the amounts of money discussed here are small, the cumulative effect of many small-stakes decisions is large. If you start small, repeating the same investment amount causes suboptimal investment in the long run.

“Anchoring,” said Jesse Itzkowitz, “is extremely common and entirely accidental. It has been shown to affect all kinds of other decisions including jury sentencing, art auction prices, and real estate valuation. People have no idea they are doing it.”

To confirm that investment amounts were based on irrational decisions and attributable to anchoring rather than rational decisions, the researchers observed the behavior of people who were given gift cards redeemable for stocks. A gift card’s value is determined by the gift giver not the investor. The gift amount creates an irrelevant number for the investor to anchor on. The results confirmed that people anchored on the gift card value making later investments for at or near the same amount as the original gift card.

“A small change in the first amount of money that someone invests can have large differences in the long-run,” said Jennifer Itzkowitz. Because people continue to invest the same amount of money as their first investment, starting off with a small amount leads to people investing less over time.”

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