A Behavioral Systems Theory of Investor Decision-Making under Market Stress: A Narrative Analysis of Interacting Behavioral Biases

Abstract

Psychological biases affecting investor behaviour in financial markets have gained traction over the years but little has been published about their interactions when uncertainties arise. This paper proposes a theoretical Behavioral Systems Theory (BST) of investor behaviour as a complex system defined by the cognitive, emotional and social behavioral finance biases, particularly loss aversion, overconfidence effect, anchoring bias, herd behaviour and systems theory is employed to understand cognitive dissonance and bias during economic turmoil. Qualitative narrative methodology is used to study the outcomes of investor behavior during the Global Financial Crisis of 2008, COVID19-induced market crash and speculative post-pandemic growth (2021-2025). Combination theory provides the basis for hypothesizing the numerous structural interaction possibilities for the bias system: at most six for two-way, four for three-way interactions and one for four-way interactions. Investor irrationality as revealed by the interactions functions as a feedback-loop system exhibiting recurring cognitive dissonance, emotional and social bias. Its effects are observable in the forms of speculative bubbles, panic-selling, procrastinating recovery, volatility expansion, clustering of trading activity and financial contagion. BST yields new contribution to behavioral finance as a system theory and a discovery of the dynamics that govern investor behavior during uncertainties. This theory also has practical implications for investors allocating to different asset classes, financial institutions, regulators and policymakers in maintaining order in the financial system, professional financial advisers to their clients. Quantitative and mixed-method research design is prescribed for future testing of the BST theory.