Journal Article

Cost of decisionmaking influences individual selections

Abstract: Market prices are often driven by choices later viewed as mistakes. Waves of optimism or pessimism sometimes dramatically move prices; a burst bubble of euphoria can bring significant macroeconomic consequences. ; A sudden change of sentiment may occur when a large number of stock market professionals consistently err by holding on to stocks for too long when they should sell, or by selling equities too quickly when they should be holding on to them. Yet, these individuals are specialists with every incentive to evaluate stocks correctly. ; Behavioral experiments show that in laboratory conditions, people behave like market participants.[1] When faced with the same question repeatedly within any single experiment, they frequently change their minds. ; Why are people so inconsistent? Do rational people blunder? Theories on how individuals and groups reach decisions don?t provide a satisfactory answer. By and large, the mystery of costly human errors remains unsolved. Understanding why such mistakes occur can help researchers interpret change in observed behavior and carries implications for the behavior of financial markets. ; Weighing the cost of making decisions may provide an answer.[2] A rational person may be willing to err if the cost of making a mistake is less than the cost of a precise and correct evaluation of each option. A rational person balances the gain from a consistently beneficial choice with the cost of paying attention?that is, the cost of being precise. ; Though information is abundant, not all of it is necessary to make a well-informed choice. In attention to some information is a perfectly rational response in these circumstances.

Keywords: Prices; Risk; Stock market;

Bibliographic Information

Provider: Federal Reserve Bank of Dallas

Part of Series: Economic Letter

Publication Date: 2012

Volume: 7

Order Number: 10