M1 rationality, behavioral finance

Differences Between Traditional and Behavioral acknowledges that investors are

Finance influenced by emotions, cognitive
biases, and social factors that lead to
2.1 Traditional Finance non-optimal decisions.

Traditional finance relies on several key ●​ Market Inefficiencies: In contrast to the

assumptions that define how financial markets and EMH, behavioral finance posits that
investors behave: markets are not always efficient. Prices
may deviate from their true value due to
●​ Rational Economic Agents: Investors investor biases, such as overconfidence
are presumed to be rational or herd behavior, which can lead to
decision-makers who maximize utility speculative bubbles or market crashes.
based on available information. This ●​ Cognitive Biases: Investors do not
rationality implies that investors make always make rational decisions. Biases
logical choices that optimize their such as overconfidence, anchoring,
financial outcomes. and loss aversion frequently lead
●​ Efficient Market Hypothesis (EMH): individuals to make financial decisions
The theory of EMH suggests that all that deviate from logic and result in poor
information, whether public or private, is financial outcomes.
reflected in stock prices. As a result, the ●​ Emotional Decision-Making: Emotions
market is always efficient, and no such as fear, greed, and regret play a
investor can consistently achieve significant role in investor behavior. For
returns greater than the market instance, fear of loss can cause
average. investors to sell off their assets too
●​ Risk-Return Tradeoff: Traditional early, while greed may lead them to take
finance posits that investors make excessive risks in the hope of higher
decisions based on the balance returns.
between expected returns and the risk
involved. According to the theory, higher
2.3 Key Differences
risk is associated with higher potential
returns, and investors are assumed to
Feature Traditional Behavioral
make choices that align with this Finance Finance
principle.
●​ Arbitrage Opportunities: If mispricing Investor Rational and Influenced by
Behavior utility-maximizi biases, emotions,
occurs in the market, rational investors
ng and social factors
will exploit these inefficiencies, causing
prices to return to their equilibrium state. Market Markets are Markets are often
Efficiency always efficient inefficient due to
irrational behavior

2.2 Behavioral Finance Asset Pricing Prices reflect Prices can

all available deviate from true
Behavioral finance challenges these assumptions information value due to
by incorporating psychological factors into the biases
analysis of financial decision-making. The field Decision Based on logic Influenced by
highlights several key aspects: Making and emotions,
optimization heuristics, and
●​ Psychological Influences: Unlike cognitive biases
traditional finance, which assumes Risk and Direct Risk perceptions
Return relationship can be distorted ●​ Nudge Theory: Thaler, along with Cass
between risk by biases Sunstein, developed the concept of
and return nudging, where small changes in the
environment can influence people’s
decisions without restricting their
Key Contributors to Behavioral Finance choices. For example, automatically
3.1 Daniel Kahneman and Amos Tversky enrolling employees in retirement
savings plans can significantly increase
Daniel Kahneman and Amos Tversky are participation rates.
considered the founding figures of behavioral
economics and behavioral finance. Their pioneering 3.3 Robert Shiller
work on cognitive biases and decision-making led Robert Shiller is best known for his work on
to the development of Prospect Theory and laid speculative bubbles and market psychology. His
the foundation for the field of behavioral finance. book Irrational Exuberance (2000) highlighted
●​ Prospect Theory (1979): This theory how emotional behavior, rather than rationality,
suggests that people perceive losses as drives financial bubbles and market crashes.
psychologically more painful than the ●​ Shiller’s work emphasizes the role of
equivalent amount of gains (loss social contagion and herd behavior in
aversion). As a result, individuals are the formation of bubbles. He argues that
risk-averse when it comes to gains but emotional factors, such as optimism and
risk-seeking when faced with losses. overconfidence, cause investors to
This theory helps explain why people disregard underlying risks and push
hold on to losing investments and sell asset prices far beyond their
winners too early. fundamental value.
●​ Cognitive Biases: Kahneman and 3.4 Hersh Shefrin
Tversky’s research identified several
cognitive biases that influence financial Hersh Shefrin has made significant contributions to
decisions, such as the behavioral corporate finance and is recognized
representativeness heuristic (basing for his work on the influence of cognitive biases on
judgments on stereotypes) and the managerial decision-making.
availability heuristic (relying on readily
●​ Shefrin’s research examines how biases
available information).
such as overconfidence and loss
3.2 Richard Thaler aversion impact corporate executives’
decisions, leading to inefficient
Richard Thaler is a key figure in the application of
strategies or overoptimistic project
behavioral insights to financial markets and policy.
assessments.
He is widely known for his contributions to mental
accounting and nudge theory.

●​ Mental Accounting: Thaler’s research 3.5 Summary of Key Contributors

shows that people treat money
●​ Kahneman & Tversky: Prospect
differently based on its source or
Theory, cognitive biases, and
intended use, which can lead to
decision-making under risk.
irrational spending and saving habits.
For example, individuals may be more ●​ Thaler: Mental accounting, nudge
willing to spend money from a tax theory, and market behavior.
refund than from their regular salary.
 ●​ Shiller: Market bubbles, investor 2.​ Illusion of Control
psychology, and the role of emotions in ○​ People believe they have
financial markets. more control over events
●​ Shefrin: Behavioral corporate finance than they actually do
and the impact of biases on managerial (Langer, 1975).
decisions. ○​ Traders often feel they can
"time the market" despite
evidence that market
M2 movements are largely
Overconfidence Bias unpredictable.
Overconfidence bias is a well-documented 3.​ Hindsight Bias
cognitive bias in behavioral finance, where ○​ After an event occurs,
individuals overestimate their knowledge, skills, or individuals perceive it as
ability to predict outcomes. This bias leads to having been predictable all
excessive risk-taking, misjudgment of probabilities, along (Fischhoff, 1975).
and suboptimal financial decisions. Overconfidence ○​ This can lead to
is particularly relevant in investment behavior, overconfidence in
corporate finance, and economic decision-making, forecasting future financial
influencing everything from stock market trading to trends.
entrepreneurial ventures. Impact of Overconfidence in Financial

Understanding Overconfidence Bias Decision-Making

Overconfidence bias manifests in several ways: 1. Excessive Trading and Investment Mistakes

●​ Overestimation – Believing one's ability ●​ Barber and Odean (2001) found that
is higher than it actually is. overconfident investors trade more
frequently, leading to lower returns due
●​ Overprecision – Having excessive to transaction costs and poor market
confidence in the accuracy of one’s timing.
knowledge.
●​ Overplacement – Ranking oneself ●​ Overconfident traders ignore
better than others in a given skill or diversification strategies, concentrating
knowledge domain (e.g., investors their portfolios in high-risk assets.
thinking they are better than the 2. Underestimation of Risk
average market participant).
●​ Overconfident executives may engage
in aggressive mergers and acquisitions,
Causes of Overconfidence Bias overvaluing synergies and
underestimating potential losses
1.​ Self-Attribution Bias (Malmendier & Tate, 2005).
○​ People tend to attribute ●​ Entrepreneurs often assume their
successes to their own skills startups have a higher chance of
and failures to external success than statistical reality suggests
factors (Miller & Ross, 1975). (Camerer & Lovallo, 1999).
○​ Investors who make
profitable trades often credit
their expertise rather than
market conditions, 3. Market Bubbles and Crashes
reinforcing overconfidence.
 ●​ The dot-com bubble (1990s–2000s) Anchoring occurs when individuals:
and the 2008 financial crisis were
●​ Establish a Reference Point: They
partly driven by overconfident investors
base their decisions on an initial value
and executives who underestimated
or piece of information.
risks and overleveraged assets (Shiller,
2005). ●​ Insufficiently Adjust: They make
inadequate adjustments from this
anchor when processing new
Strategies to Mitigate Overconfidence Bias information.

1.​ Awareness and Education For example, an investor might fixate on a stock's
initial purchase price and make future trading
○​ Recognizing overconfidence decisions based on that figure, regardless of
as a cognitive bias helps current market conditions.
investors make more rational
decisions.
2.​ Use of Data and Analytics
Causes of Anchoring Bias
○​ Relying on statistical models
and expert analysis rather 1.​ Cognitive Laziness: Relying on the first
than personal judgment can available information simplifies complex
reduce bias. decision-making processes.
3.​ Diversification and Risk Management
2.​ Uncertainty: In uncertain situations,
○​ Spreading investments
anchors provide a seemingly reliable
across different asset
starting point.
classes can prevent
3.​ Information Overload: With excessive
overconcentration in risky
data, individuals may default to the most
stocks.
prominent or recent information as an
4.​ Seeking Contradictory Evidence
anchor.
○​ Encouraging critical thinking
and playing "devil’s
advocate" can counteract
Impact of Anchoring Bias in Financial
overconfident assumptions.
Decision-Making

1. Investment Decisions
Anchoring Bias
Anchoring bias is a cognitive heuristic where ●​ Stock Prices: Investors may anchor to
individuals rely heavily on an initial piece of a stock's 52-week high or initial
information (the "anchor") when making decisions, purchase price, affecting their buy or sell
even if that information is irrelevant or misleading. decisions. This reliance can lead to
In the context of behavioral finance, this bias can holding onto losing stocks in anticipation
significantly influence investors' judgments and of a rebound to the anchored price.
lead to suboptimal financial decisions. 2. Real Estate Investments

●​ Property Valuations: Anchoring can

influence perceptions of property
values, leading investors to make
decisions based on past price peaks
rather than current market conditions.
Understanding Anchoring Bias
3. Corporate Finance disregarding or undervaluing evidence that
contradicts them. In the realm of behavioral
●​ Earnings Forecasts: Analysts might finance, this bias can lead investors to make
anchor on previous earnings reports, skewed decisions, as they may focus solely on data
leading to biased future earnings that supports their investment choices and ignore
projections. warning signs that suggest otherwise.

Recent Studies on Anchoring Bias

Understanding Confirmation Bias
●​ Investment Decision-Making: A study
found that anchoring bias significantly Confirmation bias manifests when individuals:
influences individual investors' ●​ Seek Supporting Information: Actively
decisions, leading to suboptimal look for data or news that aligns with
investment choices. their existing beliefs.
●​ Behavioral Biases in Real Estate: ●​ Interpret Information Favorably:
Research indicates that anchoring bias Perceive ambiguous information as
is prevalent in real estate investment supportive of their views.
decisions, affecting perceptions of ●​ Recall Confirming Evidence:
property values. Remember details that back their beliefs
●​ Mitigation Strategies: Recent more readily than opposing information.
advancements in Artificial Intelligence
For instance, an investor convinced of a particular
(AI) and Explainable AI (XAI) have
stock's potential may focus on positive news about
shown potential in mitigating the effects
the company and overlook negative reports,
of anchoring bias by providing decision
leading to an imbalanced assessment.
support systems that help individuals
make more informed choices.

Causes of Confirmation Bias

Strategies to Mitigate Anchoring Bias
1.​ Cognitive Efficiency: Processing
1.​ Awareness and Education: information that aligns with existing
Understanding the existence and effects beliefs requires less mental effort,
of anchoring bias can help individuals making it a default approach for many
recognize when they might be individuals.
influenced by irrelevant anchors. 2.​ Emotional Comfort: Accepting
2.​ Critical Thinking: Encouraging a information that supports one's beliefs
thorough analysis of all available provides psychological comfort, while
information before making decisions can contradictory information can cause
reduce reliance on initial anchors. cognitive dissonance.
3.​ Use of Decision Support Systems: 3.​ Social Reinforcement: Engaging with
Implementing AI-based tools can assist like-minded individuals or sources
in providing objective analyses, thereby reinforces existing beliefs, creating an
reducing the impact of anchoring. echo chamber effect.
Confirmation Bias Impact of Confirmation Bias in Financial
Confirmation bias is a cognitive tendency where Decision-Making
individuals favor information that confirms their
1. Portfolio Management
pre-existing beliefs or hypotheses while
Investors may become overconfident in their 3.​ Implement Decision-Making
strategies by focusing on information that confirms Frameworks: Structured approaches,
their decisions, potentially leading to such as checklists or decision matrices,
under-diversification and increased risk exposure. can reduce the influence of cognitive
biases.
2. Market Analysis
4.​ Leverage Behavioral Financial
Analysts might give undue weight to data that Advice: Financial advisors can utilize
supports their forecasts, resulting in biased market behavioral finance tools and techniques
assessments and suboptimal investment to help clients recognize and overcome
recommendations. their biases.

3. Risk Assessment
Availability Heuristics
By ignoring information that contradicts their
The availability heuristic is a mental shortcut that
beliefs, investors may underestimate potential risks,
leads individuals to assess the likelihood of events
leading to unexpected losses.
based on how readily examples come to mind. In
Recent Studies on Confirmation Bias behavioral finance, this heuristic can cause
investors to overemphasize recent or memorable
●​ Behavioral Finance Insights: A 2024 information, potentially leading to biased
report by Cerulli Associates highlights decision-making.
that confirmation bias significantly
impacts affluent investors'
decision-making processes. The study
Understanding the Availability Heuristic
suggests that financial advisors should
consider behavioral financial advice When employing the availability heuristic,
solutions to mitigate these biases. individuals:
●​ Investment Strategies: An article from
●​ Rely on Immediate Examples: They
Investopedia discusses how overcoming
assess the probability of events based
behavioral biases, including
on how easily instances are recalled.
confirmation bias, is crucial for
enhancing investment returns. It ●​ Overweight Recent Information:
emphasizes the importance of Recent events or information are given
recognizing these biases to implement more significance than older data.
more effective portfolio strategies. ●​ Focus on Vivid or Memorable Events:
Events that are striking or emotionally
charged are more likely to influence
Strategies to Mitigate Confirmation Bias judgments.
For example, an investor might overestimate the
1.​ Diversify Information Sources:
risk of a market crash after witnessing a significant
Consulting a wide range of perspectives
downturn, even if statistical data suggests such
can help counteract the tendency to
events are rare.
seek confirming evidence.
2.​ Engage in Critical Self-Reflection:
Regularly questioning one's
Causes of the Availability Heuristic
assumptions and seeking out
disconfirming evidence can lead to more 1.​ Cognitive Efficiency: Relying on
balanced decision-making. readily available information simplifies
complex decision-making processes.
 2.​ Emotional Impact: Emotionally 2.​ Implement Structured
charged events are more memorable, Decision-Making Processes: Using
making them more accessible in one's checklists or decision matrices can help
memory. ensure all relevant information is
3.​ Media Influence: Frequent media considered.
coverage of certain events can make 3.​ Seek Contrarian Views: Actively
them more salient in individuals' minds. looking for information that challenges
prevailing opinions can counteract the
Impact of the Availability Heuristic in Financial bias.
4.​ Educate on Cognitive Biases:
Decision-Making Understanding the availability heuristic
1. Investment Choices can help individuals recognize and
correct for its influence.
Investors may make decisions based on recent
news or events, leading to herd behavior and
potential market bubbles or crashes.
M3
2. Risk Assessment
Expected Utility Theory vs. Prospect Theory
The availability of recent market downturns can
lead investors to overestimate the likelihood of Decision-making under uncertainty has been a
future declines, causing overly conservative central topic in economics, psychology, and
investment strategies.
finance. Traditional economic models assume that
3. Market Reactions individuals make rational choices to maximize their

Companies experiencing recent positive events expected utility, a principle known as Expected
may see inflated stock prices due to investors' Utility Theory (Von Neumann & Morgenstern,
reliance on recent information, while those with 1944). However, empirical research has shown that
negative news may be undervalued.
real-world decision-making often deviates from
these rational predictions, leading to the
Recent Studies on the Availability Heuristic development of Prospect Theory by Kahneman

●​ Investor Behavior: Research indicates and Tversky (1979). This alternative framework
that investors often rely on the accounts for cognitive biases such as loss
availability heuristic when reacting to aversion, risk perception, and framing effects,
company-specific events, leading to
providing a more accurate representation of human
biased investment decisions.
behavior.
●​ Market Perceptions: Studies have
shown that the availability heuristic can
influence how investors perceive market
Expected Utility Theory is a normative model of
trends, often leading to an
overemphasis on recent events. decision-making that assumes individuals act

Strategies to Mitigate the Availability Heuristic rationally to maximize their expected utility. It is
based on the following principles (Mas-Colell,
1.​ Diversify Information Sources:
Consulting a broad range of data can Whinston, & Green, 1995):
provide a more balanced perspective.
 1.​ Rationality – Individuals make insurance if the expected utility of the
consistent and logical choices. policy outweighs the cost. Similarly, they
2.​ Independence – If a person prefers A would only gamble if the expected
over B, they should maintain that return was positive.
preference regardless of additional ●​ Prospect Theory Perspective: Many
options. people purchase insurance even for
3.​ Risk Neutrality or Preference – unlikely events because they
Individuals assess risks based on overweight small probabilities.
expected outcomes, with risk-averse, Conversely, people gamble despite
risk-seeking, or risk-neutral tendencies. negative expected returns because they
4.​ Mathematical Calculation – Choices overvalue the chance of winning.
are made by calculating the weighted 2. Investment Decisions
sum of possible outcomes, adjusted by
their probabilities. ●​ Expected Utility Theory Perspective:
Investors should choose portfolios that
maximize expected returns based on
Prospect Theory their risk tolerance.

Prospect Theory, introduced by Kahneman and ●​ Prospect Theory Perspective:

Tversky (1979), challenges the assumptions of Investors often hold on to losing stocks
Expected Utility Theory by incorporating (due to loss aversion) and sell winning
psychological biases in decision-making. The stocks too early, violating rational
theory suggests that individuals evaluate potential investment principles (Shefrin &
gains and losses differently, rather than solely Statman, 1985).
relying on expected utility calculations. Key features Marketing and Consumer Behavior
of Prospect Theory include:
●​ Expected Utility Theory Perspective:
1.​ Loss Aversion – Losses are perceived Consumers should choose the best
more intensely than equivalent gains product based on price and quality.
(Tversky & Kahneman, 1991).
●​ Prospect Theory Perspective:
2.​ Reference Dependence – Decisions Consumers are more sensitive to price
are evaluated relative to a reference increases (losses) than price reductions
point, not in absolute terms. (gains), leading to behaviors like
3.​ Diminishing Sensitivity – The impact reluctance to switch brands (Tversky &
of gains and losses diminishes as their Kahneman, 1981).
magnitude increases.
4.​ Probability Weighting – Individuals tend to
overweight small probabilities and
underweight large probabilities, leading to
irrational risk assessments.

Key Differences Between Expected Utility

Examples of Expected Utility vs. Prospect Theory and Prospect Theory
Theory
Aspect Expected Prospect Theory
1. Insurance and Gambling Utility
Theory
●​ Expected Utility Theory Perspective:
A rational individual would only buy
Decision-Making Maximization Evaluation relative ●​ Consumer retention tactics use
Basis of expected to a reference reference dependence (e.g., free trials
utility point
that convert into paid subscriptions).
Risk Perception Objective, Subjective,
based on influenced by
probabilities probability
distortions The Endowment Effect Theory
Treatment of Gains and Losses weigh
Gains vs. losses treated more than In economic decision-making, individuals often
Losses symmetrically equivalent gains exhibit a strong attachment to possessions, valuing
(loss aversion)
them more than identical items they do not own.
Probability Probabilities Small probabilities
Processing are weighted are overweighted, This discrepancy, known as the Endowment
linearly large probabilities Effect, plays a critical role in behavioral economics,
are underweighted
challenging traditional economic models that
Behavioral Assumes Explains irrational
Biases rational, behaviors assume rationality in valuation and exchange
consistent (framing, (Kahneman, Knetsch, & Thaler, 1990). The
choices endowment effect,
etc.) Endowment Effect can be observed in various
domains, including consumer behavior,
Implications of Prospect Theory negotiations, and legal disputes over
1. Behavioral Finance compensation. Understanding this cognitive bias is

●​ Helps explain financial anomalies like essential for better decision-making in both

the disposition effect, where investors personal and professional settings.

sell winning stocks too soon and hold The Endowment Effect refers to the phenomenon
onto losers too long (Barberis & Thaler, where individuals assign a higher value to items
2003). they own compared to identical items they do not
2. Public Policy & Decision-Making possess (Morewedge & Giblin, 2015). This
psychological bias leads to a disparity between:
●​ Policy-makers can structure incentives
using framing effects to encourage ●​ Willingness to Accept (WTA): The
desired behaviors, such as promoting minimum price at which a person is
retirement savings by emphasizing willing to sell an owned item.
future losses rather than present
●​ Willingness to Pay (WTP): The
contributions.
maximum price at which a person is
willing to purchase the same item if they
3. Business & Marketing
did not own it.
●​ Pricing strategies leverage loss aversion
Studies have consistently shown that WTA is
(e.g., limited-time discounts trigger
significantly higher than WTP, contradicting the
fear of missing out).
predictions of standard economic theory, which
assumes that individuals should value an item the
same way whether they own it or not (Morey,
2023). Causes of the Endowment Effect

Several psychological and behavioral mechanisms

Examples of the Endowment Effect explain why people overvalue owned items:

1. Consumer Behavior 1.​ Loss Aversion

In retail and online marketplaces, consumers who -​ Rooted in Prospect Theory, loss
receive free trials or samples of a product often aversion suggests that people feel
develop an attachment, making them more likely to losses more intensely than
purchase the item at full price (Maddux et al., equivalent gains (Kahneman &
2020). For example, software companies offering a Tversky, 1979). Giving up an owned
free month of service observe that customers item is perceived as a loss, making
hesitate to cancel, as they begin to view the service individuals reluctant to part with it
as part of their routine. unless compensated significantly.
2.​ Psychological Ownership
2. Real Estate and Housing Markets
-​ People develop emotional
Homeowners often overestimate the value of their attachments to objects, associating
property when selling, leading to higher asking them with personal experiences,
prices and longer selling times. Sellers tend to memories, or self-identity. This
perceive their home’s unique features as more attachment increases perceived
valuable than potential buyers do, which value (Strahilevitz & Loewenstein,
contributes to overpricing (Tomal, 2023). 1998).

3. Stock Trading and Investment Decisions 3.​ Status Quo Bias

-​ Individuals prefer to maintain their
Investors frequently hold onto losing stocks longer
current situation rather than make
than rational financial principles would suggest,
changes, leading to an overvaluation
simply because they own them. This reluctance to
of owned possessions simply
sell at a loss stems from an emotional attachment
because they are familiar
to the investment rather than objective market
(Samuelson & Zeckhauser, 1988).
analysis (Kahneman & Tversky, 1979).
4.​ Mere Ownership Effect
4. Legal Compensation Cases -​ Simply owning an object can

In legal disputes, plaintiffs often demand higher enhance positive feelings toward it.

compensation than what they would have accepted Studies show that even brief

if they were negotiating the same settlement before ownership (such as receiving a mug

experiencing the loss. This effect influences how in an experiment) increases

damages and settlements are structured in courts subjective valuation (Maddux et al.,

(Zeiler & Plott, 2005). 2020).

 these biases can make more rational

Mitigating the Endowment Effect choices (Morey, 2023).

Although the Endowment Effect is a deeply

ingrained bias, there are strategies to minimize its Framing Effect
impact on decision-making: People often make decisions based not only on the

1. Creating Emotional Distance actual information presented but also on how that
information is framed or structured. The Framing
●​ Individuals can reduce bias by reframing
Effect is a cognitive bias in which individuals react
decisions in third-person terms. For
differently to the same information depending on its
example, asking, “Would I pay this price
presentation—whether it is framed in terms of
if I were buying instead of selling?”
gains or losses (Tversky & Kahneman, 1981).
helps neutralize ownership attachment.
This effect is widely observed in economics,
2. Establishing Market Benchmarks behavioral finance, healthcare, and marketing,
●​ Relying on objective market data influencing choices in areas such as investment
instead of personal valuation helps decisions, risk assessment, and consumer
prevent overpricing. This is particularly behavior. Understanding the Framing Effect helps
useful in real estate, stock trading, and improve decision-making, prevent manipulation,
negotiations. and develop more effective communication

3. Deliberate Decision Delays strategies.

●​ Pausing before making a transaction,

such as waiting 24 hours before Definition of the Framing Effect

purchasing or selling an item, can help The Framing Effect refers to the psychological
mitigate impulsive decision-making phenomenon where individuals' decisions are
driven by the Endowment Effect influenced by how a choice or problem is
(Morewedge & Giblin, 2015). presented. Positive frames (focusing on gains)

4. Using Auctions and Competitive Pricing tend to encourage risk-averse behavior, while
negative frames (focusing on losses) often lead to
●​ Auctions expose sellers to external
risk-seeking behavior (Kahneman & Tversky,
pricing mechanisms, helping them
1984).
adjust unrealistic expectations about the
value of their owned items. For example, consider the following two
statements:
5. Training and Awareness

-​ Behavioral finance education can help ●​ Positive Frame: “This medication has a
individuals recognize and counteract biases 90% survival rate.”
in financial and business decisions. ●​ Negative Frame: “This medication has
Companies and investors who understand a 10% mortality rate.”
Even though both statements provide the same Studies show that individuals are more likely to
information, studies show that people are more take risks when investments are framed as
likely to prefer the medication when presented avoiding losses rather than securing gains (Shefrin
with the positive frame (Thaler & Sunstein, 2008). & Statman, 1985).

3. Marketing and Consumer Behavior

Examples of the Framing Effect Marketers use framing to influence consumer

1. Healthcare Decisions purchasing decisions. For example:

Doctors, patients, and policymakers make critical ●​ Discount Frame: “Buy now and get
health-related decisions based on how information 20% off!”
is framed. In a classic study, Tversky and ●​ Surcharge Frame: “Buy later and pay
Kahneman (1981) presented two treatment options 20% more.”
for a deadly disease to participants:
People are more likely to purchase immediately
●​ Program A (Positive Frame): “Saves when they perceive a loss (surcharge) rather than
200 out of 600 people.” a gain (discount) (Kahneman & Tversky, 1991).

●​ Program B (Negative Frame): “There 4. Political and Policy Framing

is a one-third probability that all 600
Politicians and policymakers frame issues to shape
people will be saved, and a two-thirds
public opinion. For instance:
probability that no one will be saved.”
●​ Pro-Environment Frame: "Protecting
Even though both programs are statistically
forests will save wildlife and reduce
equivalent, most participants preferred Program
carbon emissions."
A when framed positively but preferred Program B
when framed negatively. This illustrates how ●​ Economic Frame: "Restricting
people’s risk perception shifts due to framing. deforestation may reduce industry
profits and job opportunities."
2. Investment and Financial Decisions
Depending on the audience, different frames can
Investors react differently based on whether
change opinions and voting behaviors
financial outcomes are framed in terms of profits
(Druckman, 2001).
or losses.

●​ Gain-Framed: "This stock has grown by

30% over the past year." Causes of the Framing Effect

●​ Loss-Framed: "If you don’t invest now, 1. Loss Aversion

you could miss out on potential 30% People tend to weigh losses more heavily than
growth." equivalent gains (Tversky & Kahneman, 1991).
This explains why negatively framed messages 3. Use Decision Trees
often lead to more risk-seeking behavior. Structured decision-making tools, such as decision

2. Prospect Theory trees and cost-benefit analyses, help individuals

evaluate choices independently of framing
According to Prospect Theory, individuals evaluate
(Bazerman & Moore, 2013).
potential outcomes relative to a reference point
rather than absolute values, making them 4. Slow Down Decision-Making
susceptible to framing manipulations (Kahneman & Encouraging deliberate thinking instead of relying
Tversky, 1979). on intuitive judgments can reduce framing bias

3. Cognitive Heuristics (Stanovich & West, 2000).

People rely on mental shortcuts, such as the 5. Increase Financial and Statistical Literacy
availability heuristic (judging probabilities based Educating individuals about probability, risk, and
on how easily examples come to mind), which framing effects can enhance rational
makes them more susceptible to framing biases decision-making, particularly in areas like finance,
(Sunstein, 2003). healthcare, and public policy (Gigerenzer &

4. Emotional Reactions Gaissmaier, 2011).

Frames that trigger emotional responses (e.g., fear,

excitement, or urgency) can override rational The Sunk Cost Fallacy
thinking, leading to different choices depending on
People often struggle to walk away from past
how a situation is framed (Lerner et al., 2004).
investments, even when it is no longer beneficial to
How to Mitigate the Framing Effect continue. This tendency, known as the Sunk Cost

1. Reframe the Information Fallacy, occurs when individuals continue a

course of action simply because they have
One of the best ways to avoid framing bias is to
already invested resources (money, time, or
restate the information in a neutral way. Instead
effort) in it. This fallacy is prevalent in business,
of focusing on a positive or negative presentation,
personal decision-making, government
individuals should analyze the objective facts
spending, and relationships, often leading to
(Milkman et al., 2009).
inefficient or irrational choices (Arkes & Blumer,
2. Consider the Opposite Frame 1985). Understanding the Sunk Cost Fallacy helps

Decision-makers should actively ask: individuals and organizations make more rational
and forward-looking decisions rather than being
●​ “How would my decision change if the
trapped by past commitments.
information were presented differently?”

●​ “Would I still make the same choice if it

were framed in the opposite way?” Definition of the Sunk Cost Fallacy
The Sunk Cost Fallacy refers to the irrational ●​ Example: A government starts building
tendency to continue investing in a failing a bridge, but halfway through,
decision due to the reluctance to accept that the construction problems make the costs
previous investment cannot be recovered much higher than expected. Instead of
(Kahneman & Tversky, 1979). In economic terms, a stopping, they continue building to avoid
"sunk cost" is any cost that has already been "wasting" the money already spent.
incurred and cannot be refunded. Rational 3. Personal Decisions
decision-making should ignore sunk costs and
Individuals make irrational choices due to sunk
focus only on future benefits and costs.
costs in everyday life.
For example, if someone buys an expensive
●​ Example: A person continues watching
concert ticket but realizes they do not want to go,
a boring movie just because they paid
they may still attend simply because they already
for the ticket, even though leaving and
spent money, even though staying home would be
doing something else would be more
a better option.
enjoyable.

●​ Example: Staying in a toxic

Examples of the Sunk Cost Fallacy
relationship because of the “time
1. Business and Corporate Investments already invested” rather than
Companies often fall into the sunk cost trap by considering future happiness.
continuing projects that no longer have economic 4. Gambling and Investing
value.
The sunk cost fallacy also appears in financial and
●​ Example: A company spends $10 gambling behaviors.
million developing a product, but
●​ Example: An investor holds onto a
market research shows customers are
failing stock because they do not want
not interested. Instead of cutting losses,
to admit they made a bad investment,
the company invests more money to
even though selling it and reinvesting
“justify” the past spending, leading to
elsewhere would be more profitable.
greater losses.
●​ Example: A gambler who has lost $500
at a casino keeps betting, hoping to
recover the money, even though the
probability of winning remains low.
2. Government Spending
Causes of the Sunk Cost Fallacy
Governments frequently continue funding projects
due to sunk costs, even when evidence suggests 1. Loss Aversion

the project should be abandoned. People dislike losses more than they value gains
(Tversky & Kahneman, 1991). Accepting a sunk
cost means admitting a loss, which people try to ●​ “If this project does not reach
avoid psychologically. profitability within six months, we
will stop.”
2. Commitment and Consistency Bias
3. Use Pre-Commitment Techniques
Humans prefer to appear consistent in their
choices. Once they commit to a decision, they feel Making decisions before emotions take over

pressure to stick with it to avoid seeming helps reduce sunk cost bias. For example,

unreliable (Cialdini, 2009). investors can set automatic sell points for stocks
to avoid holding onto losing investments out of
3. Emotional Attachment
stubbornness.
Decisions are often influenced by emotions rather
4. Encourage Independent Reviews
than logic. If someone has invested time, effort, or
personal energy into something, it becomes harder Having an outside perspective can help reduce

to let go, even when logic suggests otherwise emotional attachment. Businesses can consult

(Ariely, 2008). third-party advisors or peer review decisions to

check for sunk cost bias.
4. The “Concorde Fallacy” (Escalation of
Commitment) 5. Accept Losses as Learning Experiences

The British and French governments continued Instead of seeing sunk costs as failures, view them

funding the Concorde jet project long after it was as lessons. Recognizing when to cut losses is a

clear that it would not be profitable. This is an strength, not a weakness.

example of "Escalation of Commitment", where

people double down on failing decisions due to
previous investments (Staw, 1981).

How to Mitigate the Sunk Cost Fallacy

1. Focus on Future Costs and Benefits

Decisions should be based on future outcomes,

not past investments. Ask:

●​ “If I were starting from scratch, would I

make the same decision?”

●​ “What is the best option moving

forward?”

2. Set Clear Exit Strategies

Businesses and individuals should establish cut-off

points before starting a project. Example: