[THE VIEW]Approximation and Superstition: Behavioral Biases in Investment

More Buy Orders at 1 Cent Below Rounded Dollar Prices
High-Frequency Investors Show the Opposite Trend
Profiting Through Algorithmic Trading

The term ‘approximation’ refers to expressing a complex number more simply by marking certain digits from the units place onward as zero. For example, writing 900 instead of 899 is an approximation; although it is an estimate, it is used to facilitate faster calculations or intuitive understanding. However, there is also a left-digit effect. For instance, if the price of a product is 19,900 won, it is 100 won cheaper than 20,000 won, but people tend to perceive the difference between 20,000 won and 20,100 won as smaller than that 100 won difference. This is because the leftmost digit in the ten-thousands place differs, and for this reason, psychological pricing strategies have become widely used in marketing.

This psychological pricing method arises from the fact that consumers are not perfectly rational, but what about investors in financial markets? An empirical analysis of the U.S. stock market found that among investors consuming liquidity, there were more buy orders at prices 1 cent lower than rounded dollar prices, and more sell orders at prices 1 cent higher.

While such investment behavior may be rational, examining subsequent price changes showed otherwise. At prices 1 cent lower, the probability of the price falling further after 24 hours was higher, whereas at prices 1 cent higher, prices were more likely to remain unchanged or rise after 24 hours. These results provide evidence that investors exhibit biased investment behavior toward rounded and near-rounded prices.

So, do all investors exhibit such behavior? According to recent research, high-frequency investors in the U.S. stock market show the opposite investment behavior. High-frequency investors often trade using algorithms, which lack behavioral biases, so they can profit by taking opposite positions when irrational investors display behavioral biases related to rounded prices.

Behavioral biases related to numbers are not limited to approximations. In Chinese-speaking regions, the number 4 is avoided because its pronunciation is the same as the word for ‘death (死, si),’ while 8 is considered a lucky number because its pronunciation matches the word for ‘wealth or prosperity (發, fa).’ An analysis of investors at the Taiwan Futures Exchange showed that individual investors placed more limit orders at prices ending in 8 than those ending in 4, whereas institutional investors did not. Furthermore, analyzing individual investment performance revealed that investors who placed more orders at prices ending in 8 than 4 recorded greater investment losses.

Since people are human, perfectly rational investing can be difficult. However, recognizing and correcting these biases can lead to better investment outcomes. The analysis of Taiwan Futures Exchange investors showed that with increased investment experience, biases toward 4 and 8 diminished.

Professor Park Sung-kyu, Willamette University, USA