A New Approach to Financial Policies and Regulations
Edited by Riccardo Viale, Shabnam Mousavi, Barbara Alemanni and Umberto Filotto
Chapter 11: The psychology of financial incompetence: past, present and future
The chapter reviews several kinds of judgmental bias that have been documented by psychologists and show how each of these seems to have contributed to recent financial crises, notably the subprime mortgage crisis of 2007, but also other examples such as the collapse of Long-Term Capital Management in 1998 and the management of the Greek debt crisis from 2008. The biases reviewed are well-known to students of human judgment and decision-making and include judgmental overconfidence (including undersampling), positive illusions, temporal discounting, the affect heuristic and groupthink. We then ask how these cognitive biases can be corrected for in the future, and suggest that greater use of causal models may give finance and macroeconomics greater predictive power. We take our psycho-historical review as showing that the persistent evidence of irrationality in consumers, financial analysts and government experts means that markets cannot be left to regulate themselves, and that other means (education, training, choice design, regulation of compensation packages and so on) need to be explored.
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