1. Background
Behavioural finance is regarded as an emerging discipline in finance, which is also rapidly expanding. The behavioural finance emerged in the 1980s as a new concept in finance which combines behavioural and psychological aspects of financial decision-making. It challenges the traditional finance to understand why investors behave in a particular manner while investing in financial assets. The standard finance or traditional finance is based on various theories and principle arbitrage principles of Miller & Modigliani; the portfolio principles of Markowitz; the capital asset pricing theory of Sharpe, Lintner & Black; and the option-pricing theory of Black, Scholes & Merton, these theories and principle assumes that market participant behaves rationally so the market is efficient and systematic. The investors are theoretically considered to be rational regarding the investment decision by traditional finance; in other words the mainstream finance believe that the investor assumes that the investment decision is made with rational expectation, furthermore, whenever a new information arrives the investor updates their belief and that is reflected through the investment decision which is to maximize their expected return at a given level of risk.
On the other hand, the behavioural finance
incorporates behavioural biases and intellectual psychological component
accompanied by economics and finance so that the viable supportive argument can
be drawn for the irrational behaviour of people during the financial decision (Javed,
Bagh, & Razzaq, 2017). DeBont's and Thaler's (1985) paper on stock market
overreaction provides initial ground for behavioural finance. The behavioural
finance deals with the human decision process which is subjective to the
cognitive illusion which has been discussed by various scholars (e.g. -
Illiashenko, 2017; Ritter, 2003). According to Barberis and Thaler
(2003), even though the investors are able to process all the available
information accurately, not all the investor are rational, their investment
related decision has behavioural preconceptions. Thaler (1994) coined the term
'quasi-rational' which indicate for much less than the full rational situation.
In the word of Ritter, (2003) the behavioural finance believes in the
asymmetric distribution of financial information. The investor’s decision to
invest in a particular stock is an investment decision which is subject to
several cognitive illusions, one among these illusions is caused by a heuristic
decision process.
Behavioural finance challenges the
efficient market perspective and helps to understand why an investor behave in
a particular manner while investing in financial assets. The participant of the
Stock Market has been relying on the idea that the market is always efficient
and investor always tends to show rational investment behaviour. However, the
recent studies made in the field of finance and from behavioural finance
perspective shows that even though the investors want to maximize their options
rationally in their investment decisions, to vary their portfolios and to avoid
risk, the investor fails to fulfil those in their investments. According to
Kahneman and Tversky (1979), human behaviour doesn’t depend always on a logical
base stipulated by conventional financial theories and may move away from
rational behaviours in time. In general, behavioural finance studies the
psychological aspect of financial decision-making and explains the
irrationality of investors in investment decision-making. Usually, the
investor’s behaviour deviates from making rational or logical decisions and
leans towards being influenced by various behavioural biases
2. Investment Decision Making
The allocation of resources for short,
medium or long term with the expected effect to recover the investment with the
high return by the help of not only with financial resources but also with
material and human resources is regarded as an investment (Virlics, 2013).
However, in an economic environment is not certain for the expected return in
investment or in other words, the risk exists in the investment can create the
uncertainty that the cost of the investment will be recovered and profit will
be accomplished. Decision-making, on the other hand, is associated with various
aspects of life and is a technical process that involves various steps; it is
also believed that decision-making is not made in complete desolation.
Decision-making, however, is a cognitive or mental process which results in the
selection of the best alternative situation among the available alternative
situation. The nature of the decision can be simple or complex, lower impact or
higher impact, economic or non-economic, routine or non-routine or so on. In
the context of stock investment decision, it is regarded as a decision having
an economic, non-routine, complex, and higher financial impact in nature,
hence, the decision of the investor to invest is subjective. Various studies
suggests that investment decision-making is affected by psychological emotions
and behavioural factors so that investment decisions are guided by their
desires, goals, prejudice, and emotion. (Kahneman & Tversky, 1979; Evans,
2006; Waweru et al. 2008). An effort has been made to analyse the
behavioural pattern and emotions regarding the investment decision of the
investor in behavioural finance perspective.
3. An overview of Behavioural Bias
Financial Investment consists of various
kinds of risk and equity share is no exception to this. Each individual has a
different level of risk tolerance. The behavioural finances argue on the
differences in each individual’s decision-making process with reference to the
risk tolerance capacity. Various behavioural factors affecting institutional
investors' decision making have been previously tested by several scholars
(e.g., Kengatharan & Kengatharan, 2014; Metawa, Hassan, Metawa, & Safa,
2018; Qureshi, Rehman, & Hunjra, 2012; Waweru, Munyoki, & Uliana, 2008;
Zahera & Bansal, 2018). Those scholars examined the influence of factors
such as Heuristic Variables (HV), Prospect Theory (PT), Herding Effect (HE),
Home Bias (HB) etc. on institutional investors' and individual investor’s
decision making. On the other hand, variables such as get rich quickly, earn a
higher rate of return, and diversify risk to measure have been identified as
the factors affecting individual investors’ decision making by the scholars
Gill, Biger, Mand, and Gill (2011). Similarly, cash flow, earnings, risk, the
degree of safety, and revenue growth are the factors tested by Pasewark and
Riley (2010), whereas, higher return and diversification are the factors tested
by scholars Gill and Biger (2009).
The previous study by various scholars
(e.g., - Kengatharan & Kengatharan, 2014; Kumar & Goyal, 2015; Qureshi,
2012; Virlics, 2013; Waweru et al., 2008; Zahera & Bansal, 2018)
studied the relation of investment decision making with equity share and/or
institutional investor, etc. Regarding equity share and other financial
instruments previous research supports that the investment decision of investor
is positively affected by Heuristic Variable (HE), Prospect Theory (PT), Use of
Financial Tool (UFT), and Herding Effect (HE) (Kengatharan & Kengatharan,
2014; Qureshi et al., 2012; Waweru et al., 2008), whereas Investor Sentiment
(IS) found to mediate the investors’ financial decision in Egyptian Stock
market (Metawa et al., 2018). The perception of the investors varies regarding
various investment alternatives, such as; the sociological and psychological
factors have the dominating influence over economic factor in the investment
decision inequity share (Shanmugham 2000; as cited in Nayak, 2013). The
investor decides to invest in stock is an investment decision which is subject
to several cognitive illusions. The illusions caused by the heuristic decision
process and the illusions caused by the adoption of the metal frame is
assembled on prospect theory (Waweru et al. 2008). These two categories, as
well as Herding and Home Bias, have been presented below.
4. Factors affecting Investment Decision
Following are the major behavioural factors
influencing in the investment decision making;
4.1 Heuristic Variable (HV)
If
the complex task of the investment decision-making is done by the rule of thumb
by the investor then it is referred to the heuristic. The heuristic
decision-making process is useful when there is limited time and the decision
maker also have limited accessibility to the resources, this can also reduce
the complexities of the problem by assessing the probabilities and predicting
values for a simpler judgement (Tversky & Kahneman, 1974). Rule of thumb
leads to make decisions based on individual judgement rather than processing
any information (Qureshi, 2012) so it may result in the poor decision (Waweru
et al., 2008). According to Ritter (2003), Heuristic decision-making is simple
to use in an uncertain and complex environment. Tversky and Kahneman (1974) study
on HV and introduced three factors namely availability bias,
representativeness, and anchoring. Kempf and Ruenzi (2006) also discussed
another HV called Gambler’s fallacy, Waweru et al. (2008) discussed one more
variable in heuristic called overconfidence.
Availability Bias
The weight kept by an investor on easily
available information helps to emerge availability bias (Barberis & Huang,
2001; Waweru et al., 2008) the investor doesn’t examine the other alternative
information and procedures. An investor of the stock market is also influenced
by the information they receive, their preferences change according to the
available information and sometimes even irrelevant information also influence
an investment decision (Javed, Bagh, & Razzaq, 2017). The previous study
that investor feels comfortable if they feel that their information in the
decision-making process is superior (Weber, 2009).
Representativeness
The representativeness is the following the
previous pattern by the investor which may cause serious mistake of arrangement
in everyday life (Thaler & Sunstein, 2009). It can manifest when an
investor based on past information buys hot stock and avoid poorly performed
stock (Kempf & Ruenzi, 2006). Barber and Odean (1999), investigate the impact
of representative bias on buying decision and found that the investor buys the
attention-grabbing stock which manifested the significant impact of
representative bias in their investment decision.
Anchoring
Anchoring refers to the judgement made by
the investor on the basis of initial information they receive or “anchor” on
one trait or piece of information when making decisions. The anchoring bias was
introduced by Tversky and Kahneman in 1981. When an investor is presented with
new information, the investors tend to be slow to change or the value scale is
fixed or anchored by recent observations (Zaiane, 2015). When a product's’
value is presented earlier to an individual that affects people when they are
to estimate an unknown similar product, which then, will be close to the value
that was considered before the estimation. An example of the anchoring effect
is how you get influenced by the asking price when buying a house (Kahneman,
2011).
Gambler’s fallacy
Gambler’s fallacy occurs when people tend
to estimate the likelihood of an event by taking into account how well it
represents its parent population, i.e. a sequence of the same outcome (given
two possible options) must be followed by the other outcome in order to
equilibrate the proportion. Gambler’s fallacy is referred to “Monte-
Carlo fallacy or the Maturity of Chances fallacy” and is studied under
behavioural finance. It is the conviction that if divergences/deviations from
probable behaviour are experiential in recurring independent tests of some
unsystematic procedure then these divergences/deviations are likely to be
evened out by contrary deviations in the future. Tversky and Kahneman (1974)
interpret gambler’s fallacy to mean that people believe that short sequences of
random events should be representative of longer ones, specifically in that
deviations from average should balance out. According to Qureshi et al., (2012)
Gambler’s fallacy results in poor market return because of improper anticipation.
Whereas, the evidence from empirical works that the gambler’s fallacy is also
present in the stock market. Andreassen and Kraus (1990) found that investors
exhibit gambler’s fallacy in the presence of modest stock price fluctuations.
Overconfidence
De Bondt and Thaler (1985) argued that “the
key behavioural factor to understand the trading puzzle is overconfidence.” It
is a well-established and common bias that makes people too confident about
their knowledge and skills and hence ignore the risk associated with the
investment decision (Kumar & Goyal, 2015). The individual generally rates
themselves above average to their abilities. Furthermore, with the presence of
overconfidence, the individual also underestimates others ability or difficulty
of the task. This ‘better than average’ effect has been identified by Svenson
(1981). The illusion of control is regarded as another aspect of overconfidence
(Langer, 1975) where people generally think that they can hold more control
over the events than they actually have. An overconfident investor emphasizes
that the individual hold and under-emphasizes the public resources that can be
available either free of cost or with some cost from the economic environment.
So, the overconfident investor, despite correcting their private information by
publicly available information, they believe heavily in private information
which they own. The overestimation of the probability of a good event happening
to the investor may create an entire problem, the financial instability is
underestimated. Overconfidence in stock investment decision also arises with
the past experience of the investor. An experimental study of Dittrich, Guth,
and Maciejovsky (2005) on overconfidence in investment decisions result that in
the event of sub-optimal choices and complex decision the overconfidence is
positively associated whereas it is negatively associated with age and decision
uncertainties.
4.2 Prospect Theory (PT)
The behavioural ability for the risk
tolerance of the investor in investment decision making is described by
Prospect theory. The two approaches for decision making are Expected Utility
Theory (EUT) and Prospect Theory are mentioned by various scholars (e.g. -
Kengatharan & Kengatharan, 2014; Waweru et al., 2008). The prospect theory
is heavily influenced by investor's value system has and it has the major focus
on subjective decision making whereas the EUT focuses on the rational
expectations of the investors (Filbeck et al. 2008, as cited in Waweru et al.,
2008). The investor tries to avoid the risk is risk aversion; this kind of
behaviour of the investor was discussed in the earlier days by Gupta &
Govindarajan (1984).
"Investors
are risk averse and they make the investment decision for maximizing their
wealth and claim to be rational but contrary to this investor show various risk
tendency” (Neumann & Morgenstern, 1947, as cited in Qureshi et al., 2012,
p. 282).
The primary view on risk in finance
and economics is through the expected utility approach (Neumann and Morgenstern,
1947, as cited in Mayfield, Perdue, & Wooten, 2008). According to Keller
& Siegrist (2006), the affinity for money matters varies from risk seeker
investor to risk avoider investor, these risk seeker investors' attitude
towards the financial risk is positive and is willing to accept investment
risk. Regret aversion, Loss aversion, and Mental accounting are some of the
situation of mind which affect investors decision-making process (Waweru et
al., 2008).
Regret Aversion
The emotional reaction of the people after
they make a mistake is regret. It was invented in three different paper. (Looms
& Sugden, 1982; Bell 1982; Fishburn 2013, as cited by Zahera &
Bansal, 2018). The regret of a particular decision has a significant impact on
the future decision that could be made by the individual. This can be
two-directional, first, they can be motivated to take more risk and second they
avoid to take the risk. This is generally done to avoid any feeling of regret
in the future.
Loss Aversion
Loss Aversion is based on the observation
that people feel much more pain for their loss than the pleasure from an
equivalent gain (Kahneman & Tversky, 1979). Various scholars indicate
the mental penalty of the individual at a different level is more for the loss
of then for the reward of similar size (e.g. - Barberis & Huang, 2001;
Shiller, 2000 as cited in Waweru et al., 2008). The loss aversion configures
the decision makers’ tendency of being more sensitive in the loss they can make
then the same amount of gain that they can make from an investment. The choice
of risk behaviour is thus made either by the maximisation of the utility
expectation or by the feeling of loss aversion (Vigna & Licalzi, 1999).
Mental Accounting
Mental accounting was initially proposed by
Thaler (1985) and implies that the investor divides their investment in the
various portfolio on the basis of the number of categories that they hold. In
the words Barberis and Huang (2001), Mental accounting is the process which
allows the individual to consider and examine their financial activities. It is
the situation where individual start to organize their world into separate
metal account, the investor separates their portfolio into a separate account
(Ritter, 2003). The investor uses separate investment policies for each mental
account so that the specific purpose of the investment such as; maximisation of
profit, minimisation of risk could be attended by the investor. This could
eventually result in the selection of those portfolios that are not profitable
yet they satisfy the emotions of the investor (Zahera & Bansal, 2018).
3.3 Herding Effect (HE)
Herding indicates the situation when a
rational investor starts behaving irrationally by imitating others judgement
for making a decision or in other words of Kengatharan and
Kengatharan (2014) the tendency of the investors' behaviour to follow other
behaviour is without having individual judgement is described as herding effect
in the financial market. The impact on stock price change influence the
investment decision of the investor followed by the changes on risk/return
models and this can have the impact on the perspective of theories of assets
pricing (Tan, Chiang, Mason & Nelling, 2008, as cited in Kengatharan &
Kengatharan, 2014). In the words of Waweru et al. (2008), HE can
drive stock trading to create new momentum in the financial market.
Furthermore, Waweru et al. (2008) also argued that the decisions such as;
buying, selling, choice of stock, length of time to hold stock, and volume of
stock to trade are the investor's decision that an investor can be impacted by
other. Shiller and Pound (1986) empirical study on herding behaviour on the
stock market shows that the influence of information by professionals on
investment of major institutional investor in the stock market. Furthermore,
regarding the consequences of the neglecting the intrinsic value of the stock
by the investor the market tends to be an inefficient market. Benerjee (1992),
illustrates an empirical model for the asymmetric information in an inefficient
market showing herding behaviour.
4.4 Home Bias
Home Bias was first introduced by French
and Poterba (1991) which refers to the situation where the individual of the
institution prefers to hold on domestic securities rather than foreign
securities in their portfolio (Kumar & Goyal, 2015). The feeling of
belongingness of the investor towards their domestic companies over foreign
companies, even though the domestic company has a lower return than the foreign
company is home bias (Zahera & Bansal, 2018). The possible reasons behind
home bias may be investment barriers, transaction costs, information asymmetry,
inflation hedging, and non-tradable assets. Various research studies have
elucidated that there are no conclusive explanations for home bias, so it
remains a puzzle among market participants. Coval and Moskowitz (1999), Lewis
(1999), Tesar and Werner (1995) have also contributed by giving insightful
meaning in the area of home bias.
4.5 Other kinds of Bias
The other kind of bias that has not been
mentioned above are;
Disposition Effect: This is a behavioural
bias that occurs whenever an investor is prone to sell winning stock and tend
to hold loss-making stock.
Confirmation Bias: When people generally,
have a pre-convinced impression about something or some information, they rely
heavily on this information and confirmation bias occurs.
Framing: When information is provided in
the positive frame then investor seeks to profit on the trading based on this
information and if the same information is provided in the negative frame then
they are ready to take the risk to avoid loss.
Hindsight Bias: It occurs when an investor
believes that happening of some event can be predicted through another event.
An investor can be sometimes irrational by connecting the uncorrelated events.
Self-attribution Bias: People attribute
their success to their hard work, intelligence and so on whereas they blame
their failure to others or some outside factor.
Conservatism Bias: It occurs when an
investor does not accept outside information and stick on their own belief.
Familiarity Bias: It is the shortcut that
mind uses to filter information and make decisions which consist of the
tendency to believe in and prefer things that are already familiar to us.
Regency: If the investment decision is
based on recent information, such as news, and avoid past information which is
helpful in decision making then such bias is called Regency.
6. Conclusion
The field of behavioural finance has grown
considerably in the past few decades. The traditional finance theorists and
behavioural finance economists are constantly at head-to-head with each other.
The traditional theorist argues that the behavioural financial theories are incomplete
and doesn’t lead to a destination of objective decision whereas the behavioural
theorist argues that it is extremely important to understand that biases in
behaviour and psychological differences play a key role in the investment
decision-making process. It gives several possible reasons as to why anomalies
occur in an efficient market and why stock prices divert from their fundamental
values, however, it doesn’t negate the efficient market hypothesis completely.
Also, many important literature studies have been done in behavioural finance
except including some landmark studies by (Kahneman & Tversky, 1979) in
developing the Prospect Theory.
As a fundamental part of human nature,
behavioural biases affect all types of investors, both institutional and
individual. The heuristic decision making, which consists of anchoring,
overconfidence, availability bias, gamblers fallacy, and representativeness
occurs during the investment decision-making and these factors influence the
decision-making of the investor without having prior knowledge in it. The
prospect theory, herding effect and home bias are the other behavioural
variables that seem to influences on the investment decision making. Various
studies have shown that these variables, however, doesn't occur simultaneously.
So, if the investor understand them and their effects, they may be able to
reduce their influence and learn to work around them.
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