PEM106 Cognitive Psychology and Decision Making

The contribution of emotions to investor decision making: Is it all fear and greed?
Decision making and the related underlying processes have been extensively investigated from both economic and psychological perspectives. Neo-classical financial economic theories, for example the Efficient Market Hypothesis (EMH), propose a number
of assumptions about financial market behaviour, the most directly relevant of which
concerns the level of rationality present in market participants decision making process. The far-reaching influence of the EMH on academic theories and business practice
in general and the rationality assumption in particular, especially following the 20072009 crisis, have propelled the debate on whether financial markets, themselves consist
of economic agents with largely under-studied characteristics, are as efficient as neoclassical financial economics assumes them to be. Among such characteristics, the role
of emotions and affective states within decision making is one of the most hotly debated.
While the study of emotions has been integral to contemporary psychological research,
its position within economics falls directly outside of the rationality assumption of neoclassical theories. Take the EMH and its underlying assumptions as an example. The
classical version of the EMH, as outlined in several seminal papers by Fama (1970)
and Samuelson (1965), regards financial markets as informationally efficient: that is,
the pricing of market transactions fully reflects all available information. Within an
informationally efficient market, participants are assumed to be all actively engaging in
the process of information acquisition and utilising the entirety of information available
to them in order to maximise profit.
An interesting consequence of this type of efficiency is that the more efficient the
market, the more unpredictable the sequence of price changes generated by that market.
Initially this result may seem counter-intuitive, as one may assume that market participants should be able to maximise their profit and successfully predict the trajectory

PEM106 Cognitive Psychology and Decision Making

of price changes when all information is utilised. However, the nature of informationbased trading should be considered: if a participant acquires new market information
and trades based on this information, they have effectively incorporated the information
into the market and thus prevents others from profiting off it. According to the EMH,
then, new information is constantly aggregated and used to influence prices, thus making forecasting future price changes based on past prices untenable. Later extensions
to the EMH framework have taken into account risk aversion among investors, for example by using marginal utility-weighted prices (Lucas, 1978) that allows for assumed
decreased marginal utility among risk-averse investors, compared to risk-loving or riskneutral investors. However, the revised framework does not deviate far from the original
efficiency model: markets are benchmarked for efficiency based on the unpredictability
of price changes, and prices are still expected to reflect all information. As an initial
observation from a psychological perspective, the EMH does not take into account any
cognitive processes behind market participants acquisition, retention, and utilisation of
information. The important question is, should it?
Above all, the EMH framework does not hold without the crucial assumption that
market participants are rational economic agents, who can be reliably expected to act
in their self-interest and make optimal decisions. Optimal decisions can be considered
to be those that are statistically sound, based on correctly evaluated probabilities and
marginal utilities. It is this particular assumption that has proven reactionary, especially
among other branches of social sciences; even within economics itself. Research evidence
from cognitive neuroscience, social psychology, and experimental economics during the
last three decades has shed light on a host of potential factors involved in the decision
making process of market participants that may explain departures from the level of
efficiency expected by the EMH. For example, research in neuroscience highlights the

PEM106 Cognitive Psychology and Decision Making

inadequacies in characterising decisions as results of careful deliberation to the point of

deliberative equilibrium, a stage where no further reflection or evaluation of options
would improve such decisions (Camerer, Loewenstein, & Prelec, 2005). It is argued that
confining decision making purely to a question of rationality and deliberative thinking
fails to capture the extent to which decision making relies on automatic and emotional
processing. Automatic processes are defined as those which occur automatically without active control or attention from the individual and are associative in nature, i.e.
can be triggered by certain types of external input (Schneider & Chein, 2003). Automatic processing is often contrasted with controlled or systematic processing, which
is characterised by the presence of active control and attention, and is activated independent of external input. Bargh, Chaiken, Raymond, and Hymes (1996) argued that
automatic processing is a key underpinning of judgement and decision making in that it
was evolved to solve problems that have evolutionary importance, therefore relying on
a different set of axiomatic guidelines compared to those outlined in economic theories
of decision making. Thus, the behaviour produced by automatic processing could be
found to violate axioms of rationality that theories such as the EMH propose. This by
itself doesnt mean that the behavioural responses resulting from automatic processing
are irrational in nature; rather, it depends on whether the behaviour is evaluated from
an evolutionary or economically optimal perspective. Similarly, behaviour is argued to
be strongly influenced by emotions, which are represented by information structures in
memory. Emotional processing is governed by the modification of existing information
structures related to emotions, which is achieved by incorporating new information into
these existing structures, resulting in increased or decreased levels of emotional response
(Foa & Kozak, 1986). Emotional processing has a regulative impact on behaviour, especially on controlled/systematic processes (Camerer et al., 2005). If decisions are results

PEM106 Cognitive Psychology and Decision Making

of deliberative thought, i.e. results of systematic processing, then the influence of emotional processing should also be accorded an appropriate level of attention.
Research attempts have been made to elucidate the features of automatic processing
that might play a role in the decision making process. Kahneman and Tversky (1979)
identified a number of so-called heuristics and biases employed in judgement and decision making that may generate suboptimal or undesirable outcomes for participants
economic welfare. Biases such as loss aversion (Kahneman & Tversky, 1979; Odean,
1998), overconfidence (Russo & Schoemaker, 1992; Gervais & Odean, 2001) and hyperbolic discounting (Shane, Loewenstein, & ODonoghue, 2002) have all been found to be
sufficiently pervasive in decision making to contribute negatively to performance and
outcomes of decisions.
While the aforementioned heuristics and biases are largely cognitive in nature, i.e.
they are concerned with identifying the underlying thought processes behind decision
making and the potential pitfalls that these processes may encounter, the nature of
emotions is rather different and thus requires an alternative approach to fully capture.
While the presence of cognitive biases can be reliably identified using deceptively simple
methods, such as changing the framing of questions from positive to negative (Tversky
& Kahneman, 1981), emotions are inherently transient and therefore difficult to reliably
measure. Another aspect demonstrating the complexity of measuring emotions is the
multifaceted nature of mood states. By definition, emotions are highly specific, actionoriented, and usually triggered following contextual stimuli; whereas moods are more
general, cognitive-oriented, usually not triggered by single events, and may comprise of
a number of emotions (Scherer, 2005). Thus, it can be argued that the measurement of
emotions is especially difficult, no less because of the level of subjectivity of emotions.
Following a shared external stimulus, emotions elicited in individuals can easily vary

PEM106 Cognitive Psychology and Decision Making

from one person to the next, and are often influenced by the mood state the individual
is in. Due to this often fuzzy distinction between emotions and moods, it is difficult for
studies to confirm a causal relationship between specific emotions and performance in
decision making, especially when mood states and their influence on emotions can not
be easily distinguished from emotions themselves.
Another difficulty lies with the validity of measurement instruments. The most
common method to collect data on participants emotional states is self-report surveys,
which often involve forced-choice response formats to questions (Scherer, 2005). Scherer
(2005) provided a summary of two approaches specific to the collection of forced-choice
self-reports on emotions: the discrete emotion approach and the dimensional emotion
approach. The discrete emotion approach relies on the use of emotion terms to describe
emotional states, and participants are asked to indicate their responses on ordinal,
nominal, or interval scales. An example of this type of survey instruments is Izards
Differential Emotion Scale (Boyle, 1984). The dimensional emotion approach suggests
that emotions can be described in a two-dimensional spaces: valence (characterises how
pleasant or unpleasant the emotion is), and arousal (indicates how calm or excited
the individual experiencing the emotion feels). An example of this approach can be
found in the University of Wales Institute of Science and Technology Mood Adjective
Checklist (Matthews, Jones, & Chamberlain, 1990). The use of forced-choice format
responses is favoured over the free-response format (where participants can input their
own descriptors for emotional states) to allow for better control of experimental variables
and homogeneity of data, however, this method calls into question the validity of the
emotional terms used to construct the survey instruments. For example, it has been
argued that using a common scale item across individuals may lead to estimation errors
due to the highly subjective nature of emotions experienced by each individual, in

PEM106 Cognitive Psychology and Decision Making

that the meaning of each scale point can differ from person to person (Lo, Repin, &
Steenbarger, 2005).
Another data collection method makes use of indirect measurements of emotions,
which can be inferred from physiological responses of the autonomic nervous system
(Kreibig, 2010), autonomic responses such as sympathetic skin conductance response
(Critchley, Elliott, Mathias, & Dolan, 2000), cardiovascular data (Fenton-OCreevy et
al., 2012; Crone, Somsen, Van Beek, & Van der Molen, 2004), or body temperature and
electromyographic data (Lo & Repin, 2001). Physiological responses are not subjected
to the introspection process that self-report measures are, thus minimising potential
estimation errors and other individual biases in reporting. However, Lo et al. (2005)
argued that these indirect measures not as sensitive when participants do not experience
a well-defined set of specific emotions. This means that for certain emotional states,
for instance those not easily distinguishable as pleasant or unpleasant (e.g. surprise,
suspense) or mixed states, physiological measurements of emotions are less appropriate
compared to self-report measures. Physiological measurements are also less feasible for
large scale, field or quasi-experiments where participants can not be physically present
in a laboratory setting.
Nevertheless, there is ample evidence from research supporting the notion that emotions affect decision making performance, however whether the effect is positive or negative remains unclear. For example, a study by Shiv, Loewenstein, and Bechara (2005) on
how changes in neural structures could influence performance on investment tasks found
that participants with decreased emotional processing were less affected by negative outcomes of decisions. The study involved participants with substance dependence (N =
32), patients with stable lesions in areas of the brain that are directly related to processing emotional information (e.g. ventromedial prefrontal and insular/somatosensory

PEM106 Cognitive Psychology and Decision Making

cortex) (N = 12), and normal control participants (N = 19). Participants completed

a simple investment task with a $20 initial endowment, 20 rounds, an investment option of $1 per round, and payoffs determined based on a fair coin toss (heads result
in the loss of $1 invested, and tails result in a $2.50 gain). The investment task was
constructed so that the cumulative payoffs for gains, given a 50 percent probability
of winning, would be higher than not investing in every round. It was hypothesised
that participants with decreased emotional processing, either as a result of brain lesions
or substance dependence, would be more predisposed to taking risks due to the decreased aversive emotional reaction to potential losses (hyposensitivitiy to punishment)
and increased positive emotional reaction to gains (hypersensitivity to reward). Results
from the study confirmed this hypothesis, with control participants found to behave in
a suboptimal way due to prolonged conservative investment (i.e. not investing) after
losses.
The implications of these findings are twofold. First, it demonstrates the central
role of emotions in decision making by identifying significant differences in investment
strategy between individuals with normal levels of emotional processing and those with
decreased emotional processing. Second, it shows that emotions can be beneficial or
detrimental to decision making depending on the circumstances, and while naturally
occurring emotions can be adaptive in that they can accelerate the decision making
process (heat of the moment type decisions), under certain situations they must be
inhibited to give way for more deliberative cognitive processing (Shiv et al., 2005).
Prior to these findings, emotions and affective states have been routinely prescribed
as interferences with higher cognitive functions such as controlled processing (FentonOCreevy et al., 2012). However, evidence from neuroscience presents a convincing
case for the interlink between cognitive and emotional processes, especially focusing on

PEM106 Cognitive Psychology and Decision Making

the role of affective states that operate below the consciousness threshold (Camerer et
al., 2005). It is argued that emotions possess an action-oriented characteristic that may
have evolutionary roots - for instance, pain as an emotion triggers behavioural responses
to alleviate it, due to the aversive nature of pain (i.e. negative valence). By contrast
cognitive processes do not possess a dimension of valence; in other words, they are
not classified as inherently positive or negative but rather act as mechanisms to provide
answers to questions inferred from external cues or from emotional processes themselves.
In this respect, it can be argued that both cognitive and emotional processes must be
involved in producing behavioural responses: cognitive processes to define characteristics
of behaviour, and emotional processes to spur behavioural intent into action. Decision
making can be considered a type of question that cognitive processes provide answers
to, and thus can be assumed to also be influenced by emotional processing.
The question, then, concerns the extent to which emotional processing factors into
decision making. Research into decision making in fast-paced, information-rich and
high intensity situations such as live trading has shed light on the impact of emotional
processing on performance. (Lo et al., 2005) studied a cohort of online day traders (N
= 33) using measures of emotional states and five-factor personality traits. Participants
were asked to complete self-reports on anxiety levels, personality traits, demographics, strengths and weaknesses, locus of control, and their daily trading information.
Emotional states were captured using the UWIST Mood Adjective Checklist mentioned
earlier in this analysis. Results from this study indicated that participants whose emotional states were more highly correlated with their daily profits and losses also had
worse profits and losses records compared to those whose emotional states were less
correlated. In other words, traders who were more emotionally affected by profits and
losses tended to perform worse overall. From these results, the researchers concluded

PEM106 Cognitive Psychology and Decision Making

that there existed a definitive advantage in having lower levels of emotional reactivity
to outcomes of trading decisions, or keeping cool.
However, several other studies have found that emotional processing in decision making is not by and large detrimental to performance. Fenton-OCreevy, Soane, Nicholson,
and Willman (2011) employed qualitative methods in investigating the role of emotions
on decision making by interviewing traders from four London investment banks. The
responses given confirmed the prevalence of avoiding emotional influences on their trading decisions, for example from previous gains and losses. However, there was also
evidence of the practical difficulty of achieving this. Thus, it was concluded that due
to the integral role of emotions in decision making, the best course of action to improve
performance was to anticipate emotional responses to decision outcomes and regulate
them effectively. It was also found that emotional cues, i.e. gut feelings, could lead
to improved performance through a combination of deliberative analysis and emotional
cues arising from prior experience in similar situations. From this perspective, emotional
states could carry information relevant to decisions which may be utilised to supplement
the decision making process. This is in line with the definition of emotional processing as
proposed by Foa and Kozak (1986): emotions can be considered information structures
that can be modified based on new, relevant information, and can be used to inform
decisions.
In conclusion, research evidence has supported the notion that emotions and affective
states have an equally central role in decision making compared to the traditional notion
of the cognitively rational brain. The challenge for decision makers, for example traders
in a fast-paced environment, would then be to regulate emotions so that the influence
of emotions on decisions is monitored, while retaining the use of emotional cues which
may aid decision making.

PEM106 Cognitive Psychology and Decision Making

10

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The dark side of emotion

When individuals with decreased emotional reactions make

more advantageous decisions.

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