COGNITIVE BIASES AND INSTABILITY OF PREFERENCES IN THE PORTFOLIO CHOICES OF RETAIL INVESTORS.
POLICY IMPLICATIONS OF BEHAVIOURAL FINANCE
Working Paper No. 66 (January 2010)
JEL Classifications: D03, G11, G18, G28

Nadia Linciano
CONSOB, Divisione Studi Economici
e-mail: n.linciano@consob.it

Abstract
Classical financial theory assumes that individuals are perfectly rational and act by using complete and homogeneous information sets. For a long time, this has been used both on descriptive and normative grounds. However, empirical research has shown that investors systematically commit reasoning or preference errors hard to reconcile with the rationality assumption. These errors are reflected in "behavioural anomalies" that lead retail investors to low participation in the equity market, perception errors of the risk-return relationship, poor portfolio diversification and excessive trading. This paper surveys and discusses the insights of behavioural finance that help us to understand observed anomalies using the theoretical apparatus of cognitive psychology and experimental evidence. These insights, by providing a review of the real perceptions of phenomena and the psychological and irrational components at the basis of individual choices, may be helpful to strengthen the efficiency of financial regulation and supervision. In particular, financial education in a behavioural vein can be used to improve investors' capacity to judge and to raise their understanding of the most serious behavioural "traps". The contents and presentation format of disclosure on the characteristics of financial products also lay themselves open to be geared to the prescriptions of behavioural finance. Finally, financial advice is an indispensable supplement for guiding investors to make decisions that best serve their interests and for strengthening the efficiency of financial regulation; financial advisors should therefore endeavour to help customers to contain the most common behavioural errors. The purpose of this work is to stimulate debate on the behavioural analysis of the above mentioned policy issues, in order to strengthen the efficiency of instruments made available to investors to understand the characteristics of financial products.