Understanding Heuristics and Investor Behavior in Financial Markets

Abstract

The purpose of this study is to analyze the heuristic factors that drive investors to overreact or underreact to earnings information. Heuristics, as cognitive shortcuts used to simplify decision-making under uncertainty, often lead to systematic biases in investor behavior. These biases can cause investors to deviate from rational evaluations of earnings announcements, resulting in market inefficiencies. The study focuses on identifying key heuristic factors, such as representativeness, anchoring, and availability that contribute to exaggerated or subdued reactions to earnings data. By understanding these behavioral tendencies, the research aims to shed light on the psychological mechanisms influencing investor decisions and their subsequent impact on financial markets. The findings of this study could offer practical insights for improving investment strategies, reducing market volatility, and enhancing the accuracy of financial forecasting. This research employs a full factorial within-subject laboratory experimental design to explore the heuristic factors influencing investor reactions to earnings information. The experimental design allows for a comprehensive examination of the interaction effects between two independent variables, ensuring that each participant is exposed to all treatment conditions. By using students with foundational knowledge of accounting and financial management, the study ensures that participants possess the requisite understanding of financial statements and market dynamics, thereby enhancing the validity of the findings. This approach provides valuable insights into how cognitive heuristics affect decision-making processes in a controlled, replicable environment. The results of the study revealed that psychological heuristics play a significant role in influencing investor behavior. Specifically, the representativeness heuristic was identified as a key factor contributing to overreaction behavior among investors. This occurs when investors rely on stereotypes or patterns, assuming that recent earnings information is representative of long-term trends, leading them to make exaggerated adjustments to their investment decisions. Conversely, underreaction behavior was found to be driven by the anchoring-adjustment heuristic, wherein investors base their judgments on initial reference points and fail to adequately adjust their evaluations in response to new earnings information. This results in a muted or insufficient response to changes in financial data. These findings highlight the importance of cognitive biases in shaping market behaviors, suggesting that investor psychology plays a pivotal role in market inefficiencies. Understanding these heuristics can provide valuable insights for financial analysts, educators, and policymakers in designing strategies to mitigate the effects of such biases on investment decisions and market stability.