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Investigating how personal experience distorts perception of future risk

We are all biased in our experience of the world. Our past personal experiences constantly influence how we perceive what’s going on around us, and how we choose to act. An EU-funded project takes a closer look at the mechanisms behind this bias and how it distorts decision-making.

Society

Gains and losses (also known as pay-offs) of past personal experiences play a significant role in influencing future behaviour. For example, it has been documented that winning experiences in the stock market boost willingness to invest. In the field of behavioural finance, this way of acting has implications for other behavioural patterns in financial decision-making, such as herding. However, little is known about the underlying mechanism of these effects of experiences and how they distort beliefs about subsequent actions. Taking on this challenge, the PBDM project, with support from the Marie Skłodowska-Curie Actions programme, investigated the effects of personal pay-offs on decisions in circumstances requiring repeated decision-making under uncertain conditions, such as in the financial sector.

Bringing theory into the real world

As a starting point, a theoretical framework was created and experimentally validated to show how experienced pay-offs distort beliefs. After some initial challenges with bridging theory and practice, an experiment was carried out and its results published in The Economic Journal. A key takeaway from the experiment is its elucidation of a common problem faced by many actors making decisions in situations of uncertainty: previous gains and positive experiences can prevent individuals from acknowledging negative new information, thereby making them overly optimistic about the future. Project coordinator Peiran Jiao explains that the theoretical model has key practical implications: “It shows that in the stock market, for instance, investors should be careful not to be influenced by personal gains and losses when viewing stocks. More specifically, they should pay attention to the potential underlying randomness in the problem at hand, and the fact that their own experience is just one sample, and very likely biased sample, from the whole underlying distribution.” This is a challenge that relates to a broad range of actors in the financial sector and beyond. While an investor may become overly optimistic about a stock after making gains, a consumer can likewise become overly attached to a brand after good experience with it. “Once knowing the potential of such a bias, people should be careful when forming and updating beliefs about real-world problems,” says Jiao.

Broad application potential – yet further research needed

While the project results have the potential to contribute to multiple disciplines, they are especially valuable for improving individual investors’ welfare. Specifically, the results provide financial intermediaries – banks, funds and brokerage firms – with tools to improve their clients’ performance on the stock market. They also give governments, NGOs such as the European Federation of Investors and Financial Services Users, and investor protection schemes the required basis for designing investor education programmes that can raise awareness of the payoff-based belief bias. While the project results made significant contributions to understanding the effects of experience on subsequent beliefs and decisions, Jiao believes there is a crucial step yet to explore. “When researchers investigate this issue, they typically assume that the actual experience and experienced pay-offs influence subsequent decisions. However, when people make decisions, they rely on their memory of past experience, and memory is not an accurate and unbiased repository of past information.” Jiao will continue his research in this area and produce results relevant to a broad spectrum of societal interactions dependent on personal experience.

Keywords

PBDM, pay-offs, personal experience, bias, decision-making, investors, behaviour, finance

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