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Centre for Risk Research

Centre for Risk Research Reveals a New Cognitive Bias in Financial Traders

Published: 9 October 2015

We often see prices that end just one penny or pound below a round number, such as £2.99 or £599, and we tend to perceive these prices as being significantly lower than the rounded version of the price (i.e. £3.00 and £600). This phenomenon has been shown to improve company revenues despite consumers being well aware of this pricing trick.

 

This bias has also been shown to affect the buying and selling behaviour of traders in financial markets. When market prices arrive at a round number, changing a significant left hand side digit in the price, there is a flurry of orders in the market, a so-called left-digit effect. However, new research from the CRR reveals that this effect on a trader’s decisions depends on whether they are in profit or loss.

 

The new study combines an experimental laboratory study and analysis of account data from spread traders to reveal that decisions involving losing investments result in far greater left-digit effects than those decisions involving gains. As Dr Fraser-Mackenzie explains, “experiencing loss, or even the prospect of experiencing loss, triggers some important emotional processes in the brain. We believe that this heightened emotional state in loss may exaggerate the feelings associated with the left-digit changes.”

 

Left digit changes can significantly affect trading decisions

Buy-sell imbalances as a result of the left digit effect have been shown to cost around $813 million a year on the New York Stock Exchange alone. Given that this effect is more likely to affect investors in loss, it is possible that this bias could be more pronounced during downturns in the market such as the recent financial crisis. The CRR researchers on the project, Dr. Fraser-Mackenzie, Professor Ming-Chien Sung and Professor Johnnie Johnson suggest that the psychological basis of the left digit effect means that improving traders’ awareness of the bias and its effects could be enough to dramatically reduce its impact in the market.

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