381 INVESTMENT BEHAVIOUR AND BIASES OF INVESTOR: AN ANALYTICAL REVIEW OF
BIHAR
Dr. Suryakant Kumar
Assistant Professor, Institute of Business Management, Lalit Narayan Mithila University, Darbhanga
Abstract - In recent times, capital markets are attracting the attention of retail investors across the globe and this number is increasing due to diversified reasons like declining interest rates, insecurity and volatility amongst fixed income securities, increasing awareness about investment options, trading through the proper means, increasing role of technology in capital markets and their tech savvy investors etc. However, to understand this whole process, behavioural finance acts as a catalyst and helps us as a medium both for reasons and causes for those reasons. Behavioural finance refers to the psychology of finance and people dealing in finance. This subject contributes and affects finance in multiple ways as it evaluates human desire and the motivating factors of desire in making investment, there by contributing to value maximization of investments made. It is an interdisciplinary subject with flavours of psychology, economics and sociology. The purpose of this paper is to develop a conceptual understanding and presenting a framework in the field of behavior finance & biases. The paper has drawn outline of theory as well as practical implication in the field i.e. financial decision-making process and the factors affecting the behavior.
Keywords: Behavior finance, Behavior biases, investment, Efficient market hypothesis, Financial decision making process, Prospect theory.
1 INTRODUCTION
Decision making is considered as one of the intellectual procedures of human.
During the process of decision making, from many alternatives, based on certain criteria, a favored option is selected (Wang, 2007).
Deciding a specific zone and ground for investment is the toughest part in investment decision making. We need to consider the condition of market, risk bearing capacity, and various other conditions while investing money.
The investor needs to calculate perfectly and to captivate all the data confined in the market and need to make optimal and rational decisions. But many investors have diverse views in receiving the information and they are irrational in investment decision-making process because of the presence of biases.
Tversky & Kahneman (1979), proposed that investors tend to escape threats at the right time, and choose to adopt a higher risk of losing. Hence, depending on the views and opinions, this research work is aimed at reducing the risk of understanding for decision- making. In most research studies, it has been shown that old finance theories are not able to define the craziness of the
investors while making investment decisions (Chang, 2008). Bondt & Thaler (1985), argued that investors are tempted by several cognitive prejudices that cause ridiculous behavior. Simon (1956), researched about the reasons for irrational decision making. According to him, the reason for behaving irrational during investment decision making is deficiency of information and memory errors. Various cognitive biases and theirimpact on decision making were recognized through empirical evidences.
According to early investment theories, investors are rational and make their decisions on optimizing returns while minimizing the risks. However, recent theories challenge these suggestions and assumptions. It is not possible for people to think always rationally. People‟s investment decisions can be influenced by many emotional factors such as greed, fear excitement and anxiety. Numerous psychological procedures initiate people to investment decision making (Slovic, 1972). (Belsky & Gilovich, 1999) researched about why people make irrational decisions during investing and spending. In the view of Chaudhary
382 (2013), several behavioral differences
influence human beings.
Hence individuals take decisions which are contradicting the wealth maximization principles. Investment decision making depend upon many constraints related to wealth optimization, return, socioeconomic, age, education, and capital invested profession, etc. These parameters are helpful in determining the biases that arise due to the behavior of the investors.
1.1 Origins of behavioural finance:
Behavioural Finance emergence is based on three aspects namely psychological origin, economic origin and financial origin. The psychological origin seems to be clear in the minds of theoreticians Thaler and Mullainathan (2000), who explain clearly that behavioural finance;
comes from an interdisciplinary field of finance where cognitive psychology and economics, together yield effective results.
The main paradigm of psychology is cognitive psychology, social psychology, behavioural aspects, Freudian psychology and socio linguistics.
Cognitive psychology studies about internal mental process such as problem solving, language and memory (De Mijolla, 2002). It includes various aspects such as perception psychology or memory learning study. This concept was used in Gestalt psychology in 20th century by Max Wertheimer and Wolfgang Kohler. Through this concept, people can understand the objects and scenes in the simplest manner. It is also referred to as
“Law of Simplicity”. Authors from behavioural finance clearlymentioned that this field of research comes from cognitive psychology. Behavioural finance should be considered to be similar to the paradigm of behaviour, which means a collection of assumptions based on comprehending the process of learning in terms of behavioural principles and these two are based upon experimental approach that will not exhibit the results in the same way.
Behavioural paradigm arrives from the internal human mind, without recourse of internal introspection.
Psychology refers to thought of, something esoteric in its methods. “If
anyone fails to reproduce other‟s thoughts or findings, it is not due to fault in their approach or the research procedure followed or their equipment or in control of the stimulus; rather, it is due to the fact that introspection of the researcher is untrained” (Watson, 1913, p.163).
Neglecting the subjective dimensions of human behaviour and by focusing only on the results of behaviour, the behaviourist approach would probably be closer to neoclassical finance (Lewin,1996).
The economic origin of Behavioural Finance deemed to happen in 1950s and slowly developed as a discipline by 1970s.Behavioural approach claims to be more descriptive than neo classical approach (Solvic et al., 1982);
while prospect theory which can be seen as the first theoretical foundation of behavioural finance (Kahneman and Tversky, 1978). Perseverance of psychological approach by economists started after 1920s only; however, psychology concepts have not developed enough clarifications through its theories to fulfil all the questions that arouse due to the emergence of a cognitive approach in economics (Coats, 1976). Behavioural economics concerns with how feelings and human attitude structure affect the decision-making process (Anger and Lowenstein, 2007).
2 REVIEW OF LITERATURE
The researchers wants to understand the behaviour of an investor investing in a market which is not developed but developing by considering all important relevant factors and important aspects through the lens of Behavioural Portfolio Theory (Shefrin and Statman, Ahamed Ibrahim and Tuyon, 2017).
The findings summarized in their Behavioural Portfolio Theory (BPT) by Hersh Shefrin and Meir Statman (2000) are in accordance with the more general psychological theory on the hierarchy of needs as formulated by Abraham H.
Maslow (1943) and this has already been noted by Philippe De Brouwer, 2006). The study by Maslow shows that need hierarchy theory is sufficient to obtain a framework of behavioural portfolio theory and many practitioners can make use of it.
383 In his research, the authour
utilized behavioural portfolio theory to explain the needs of people and their emotional and cognitive shortcuts. People are normal, according to Behavioural Finance Theory they build a portfolio as mentioned in Behavioural Portfolio Theory, where the portfolio of individuals wants to go beyond high expected returns and low risk, such as social status and social responsibility. People save and spend as defined in the theory of behavioural life cycle, where barriers such as weak self-control make it challenging to discover and pursue the right way to save and spend (Meir Statman, 2017). The researcher used behavioural portfolio theory method to understand the perception of investors has a strong andsignificant impact on financial decision making by using case study and descriptive analysis method (Raza, 2014).
Depending on behavioural portfolio theory, the idea of behavioural finance seeks to add some cognitive psychological elements based on investor and manager behavioural observation and examination, using advanced mathematical and statistical prototypes of modern corporate finance. The model used here in finance and economics should be different from the other models and techniques being used in physics and other natural sciences. This study had been used to understand the psychological and cognitive thoughts of individuals in investment activity and their portfolio selection based on continuous observation and examining them (Todorovic, 2011).
The American psychologists introduced a new concept of "cognitive dissonance theory" in social psychology.
When the psychologists performed behavioural evaluations, they witnessed that the cognitions were inconsistent and proceeded to understand if this could result in cognitive dissonance and eventually realized that if the dissonance experience was unpleasant, the person may try to reduce it by modifying his or her beliefs. (Leon Festinger, Riccken and Schachter, 1956).
Investors will have cognitive and emotional weakness which affects their decision making towards investment
activity. Scientifically, this study shows how investors do not act rationally and clearly explores the relationship between different demographic factors and investors‟ personality (Manish Mittal Vyas, 2008).
Based on the investor‟s rationality, investment managers should consider the psychology of a person that plays a substantial role in the behaviour in financial market. Cognitive and motivational factors affect the decision making of investors such that the investment managers can understand the context of their client (individual investors) better and thereby help the clients better and bring in a positive change in their investment decision making based on demographic factors such as age, gender, marital status, level of satisfaction towards investment, annual income, occupation and number of dependents (Mugdha Shailendra Kulkarni, 2014).
The authours focused on prospect theory and examines that when people making financing decisions, they consider the riskiness and risk free alternatives, and how it helps to make a better choice in investment activity (Shefrin, Kahneman and Tversky, 1971 and 2001).
The cognitive psychologists in behavioural finance and behavioural economics are Daniel Kahneman and Amos Tversky. In 2002, for his contributions to the theory of rationality in economics, Kahneman received the Nobel Memorial Prize in Economics. Both Daniel Kahneman and Tversky have based much of their work on cognitive biases and heuristics, which implies problem solving strategies that lead people to engage in unexplained irrational behaviour. Their research work involves loss aversion and prospect theory. In 1979, Kahneman and Tversky focused specific towards behavioural portfolio theory and prospect theory, which helps for making better investment choices. Due to the factors of cognitive bias and heuristics, investors make irrational decisions. Because of use of mental shortcuts, intuitive judgment made by investors in investment activity by following certain strategy or rule of thumb, which leads to cognitive bias. The
384 result of their study is that the attitude of
investors varies when they face uncertain loss or gain.
2.1 Objective of the Study
With the changing time, money resource, preferences, options in market, risk taking levels and returns expectations of investors of diversified class and gender, it is impetus to learn the change over time such that an effective investment decision can be made by individuals while constructing their investment portfolio.
Hence this study gives clarity about the portfolio selection trend studies over decades.
3 ROLE OF BEHAVIOURAL PATTERN OF INVESTORS IN INVESTMENT DECISION MAKING PROCESS
Investor behavior often deviates from logic and reason, and investors display many behavior biases that influence their investment decision-making processes.
Few most frequently found behavior biases are explained below which affect the rational thinking of investor:-
The Disposition Effect: Investors tend to retain losing securities for too long a period. On the contrary, they tend to sell off profitable securities too soon.
Mental Accounting: Investors often ignore the fungibility of money. They irrationally and illogically assign different values to money obtained from different sources and also on the basis of intended use. Investors often save money in low-interest bearing accounts for a purpose they perceive to be more important while they are still having loan to repay and thus reduce their wealth. Money received from gift, windfall gains or bonus is considered to be cheaper than earned money. Thus such
―unearned‖ money is spent more than earned money.
Herd Instinct: Investors often blindly follow the action of a larger group without judging the rationality of such an action. This behavior is inbuilt in human nature.
Such an instinct is attributable to the natural inclination in human
beings to be desire to be better accepted by a group he / she belongs to. Leon Festinger (1957) opined that when dependence on physical reliability is low, the dependence on social reliability is high. Ben McClure (2002) observed that when the, market undulates, investors are subject to a fear that others have more information and as a consequence, they generate a strong tendency to do what others are doing. This experience is usually observed in investors having limited experience in investing. Banerjee (1992) has formulated a model of herd behavior.
Confirmation BIAS: Investors willfully look for such information which supports his / her idea about any security. They shun or do not look for any information to the contrary. Thus, decisions are often taken on incomplete information leading to erosion of wealth.
Hindsight BIAS: The investor believes that some past event was predictable though in fact it was not.
Such faulty belief or bias may lead to establishing false causal relationships which may end up in incorrect oversimplifications.
Gamblers’ Fallacy: The investors believe that if something has happened recently, the probability of an opposite phenomenon increases and the probability of a similar phenomenon increases.
Anchoring: This behavior is associated with the tendency of the investor to attach his / her thoughts to a particular reference point without any logical explicable cause therefore. Gifting of a minimum amount ofphysical gold, to the newly married couple is an age-old tradition in India. This compulsion reduces the wealth of the parents as well as thrusts a cost burden onto the giftees which might take the form of locker rent in banks or wealth tax liability.
Overconfidence: Investors often overly over-estimate themselves and consider themselves to smarter than
385 other investors. This biased sense
and the resultant erroneous stock- picking often reduces the return on their assets. This fact was propagated by Terence Odean (1998).
Over-Reaction BIAS: Investors may react in a more than proportionate way to any information
Availability BIAS: Investors tend to allot more importance to recent information than on relatively past information. Thus they focus on the short-term perspective and miss out on the long—term picture. Thus they are willing to assume more risks after a gain. On the contrary they are willing to assume les risks after a loss.
Representativeness: Investors may be too quick to detect a pattern which in fact is random. They may also mistake past performance of an asset as the indicator of its performance in future. This bias also induces investors to underweight long-term averages (Jay R. Ritter 2003).
Familiarity: Investors are often found to be familiar with securities they are familiar with i.e. their employer companies. Local and domestic companies. This stems from the inherent fear of uncertainties about the unknown.
Aversion to Ambiguity: Investors tend to steer clear of situations about which they have little information. They exhibit a preference for known risks to unknown risks.
Innumeracy: Investors may have a phobia about numbers. They usually want to avoid numerical processing of data. This robs them off the quantitative analytical tools which are so essential for successful investing.
Narrow Framing: Instead of focusing attention over change of their total wealth over their investment horizon, investors take a parochial approach and end up focusing on a cross sectional as well as a temporal sense.
Conservatism: When situations change, some investors under-react due to the natural tendency of being slow to adapt to changes. Thus the bias of conservatism is contrary to the over-reaction bias.
Heuristics: Investors often resort to rules of thumb which makes their decision making process easier.
Benartzi & Thaler (2001) detected that many investors follow the 1/N rule which encompasses the simple rule of thumb that when there are N alternatives for investment, 1/N amount of money should be invested in each of the alternatives.
Regret Theory: Regret theory of choice under uncertainty was put forward by Graham Loomes &
Robert Sugden (1982). When applied to investor behavior, this theory postulates that in case of losses due to erroneous decisions, investors regret more if the loss was due to an unconventional decision rather than a conventional decision.
Cognitive Dissonance: This very influential theory of social psychology was put forward by Leon Festinger (1957). Cognition of persons refers to their ideas, notions, beliefs etc. It is human nature to seek consistency among the cognitions. In case any two cognitions contradict, the person feels discomfort and chooses one among the contradicting cognitions by changing the other one.
Burkhard Drees and Bernhard Eckwert (2005) cited examples of mispricing of assets due to cognitive dissonance as investors were found to be discarding unfavorable information.
Self Attribution BIASES: Investors who suffer from self-attribution bias tend to attribute successful outcomes to their own actions and bad outcomes to external factors.
They often exhibit this bias as a means of self-protection or self- enhancement. Investors afflicted with self-attribution bias may become overconfident, which can lead to overtrading and
386 underperformance. Keeping track of
personal mistakes and successes and developing accountability mechanisms such as seeking constructive feedback from others can help investors gain awareness of self-attribution bias.
Trend-Chasing BIASES. Investors often chase past performance in the mistaken belief that historical returns predict future investment performance. Mutual funds take
advantage of investors by increasing advertising when past performance is high to attract new investors.
Research evidence demonstrates that investors do not benefit because performance typically fails to persist in the future. For example, using a sample of 1,020 domestic actively managed mutual funds, Soe and Luo (2012) show that using past performance as a strategy fails.
PROCESS & IMPLICATION OF INVESTMENT DECISION AND BIASES
Source: Compiled from various studies
Need for Investment
Investor’s education, income,age, occupation, marital status
Personal goal & desire and social status
Choice of investment product/Instrument
BASIC DECISION SUPPLIMENTARY DECISION
Investment in Life Insurance Investment in house Real estate Fixed deposit Saving account deposit as buffer Gold investment
Investment in Mutual funds. Investment in equity SIP and Combo plan launched by different banks & investment houses. Customerised investment plan
Decision taken by OWN because it is basic need of investor
Decision taken by Financial advisors on behalf of investor by considering their requirement
Family members Friends/
colleague Bankers UC agents etc
Expected return, risk taking appetite &
Investment horizon of investor. Advice
and recommendation of
brokers/advisors/financial analyst Influential Factors
Impact of behavior Biases
Less impacted b/c basic needs are for security which must attain before next lucrative investment plan. As the investor achieve it, there after switch to next.
High impact b/c advisor’s biases directly affect the return and recommendation made. Biased decision never be rational and positive return that match the market portfolio.
387 Categorizing biases like this helps us
consider whether people are making mistakes. Errors in beliefs or decision- making can often be clear-cut. For example, people may have beliefs about the likelihood of an event that contradicts objective probabilities. But if people„s preferences are inconsistent (and so not
fully rational), it can be difficult to say that these preferences are wrong; they are after all what people want, at least at the time. If people are not making mistakes, intervening to prevent them from acting on these preferences can make them worse-off.
CATEGORIZATION OF BIASES BASE ON DECISION MAKING PROCESS
Source: Occasional Paper no.1, April 2013, Financial Conduct Authority and Various studies
4 CONCLUSION
This study provides an empirical analysis of the investment behavior of investors in different countries and scenario. The growing earning & safe investment scenario in India provides a huge opportunity for investment in customized financial products and instruments. This paper researched available literature on behavior finance and biases and how it affects the investment decision making process. Through this literature review we can conclude that Investor either
Individual or Institutional affected by various psychological and sociological factors while making investment decision.
These factors in finance termed as behavior biases. The degree of deviation depends on expertise, skill, knowledge and experience in the field of finance. If an investor identifies these biases in early stage of investment that would help in better investment decision and tends toward market portfolio as described by Fama in Efficient market hypothesis. The financial market is in its reformative
Preference Beliefs Decision making
What we want? What we believe are
the facts about our situation?
Which option gets us closest to what we
want?
Influenced by emotions &
psychological expectations
Rule of thumb can lead to incorrect beliefs
Use short-cuts when assessing available
information
⁃ Reference biases
⁃ Loss Aversion
⁃ Anchoring
⁃ Cognitive dissonance
⁃ Regret
⁃ Self attribution Biases
⁃ Innumeracy
⁃ Overconfidence
⁃ Over reaction
⁃ Disposition effect
⁃ Hind sight biases
⁃ Gambler fallacy
⁃ Availability biases
⁃ Familiarity
⁃ Heuristics
⁃ Trend chasing bias
⁃ Framing, Silences and limited attention
⁃ Mental accounting
⁃ Narrow framing
⁃ Persuasion and Social influence
⁃ Hard Instinct
⁃ Confirmation biases
⁃ Aversion of ambiguity
388 phase where the scenario is shifting from
product orientation to customer orientation and to customization of products/services. Even public-sector entities are drastically changing their work culture & way and approach to customer with wide range of product specification. It is very important for customer as well as service provide to understand the behavior of each other. As my work is on institutional investor;
therefore, must quote that
―understanding the margin of success and failure of my investment completely depend on the institutional investor investment behavior and biases which surround them vide different channel.
REFERENCES
1. Benartzi, S., & Thaler, R. H. (2007). Heuristics and biases in retirement savings behavior. The journal of economic perspectives, 81-104.
2. Ben-David, I., & Doukas, J. (2006).
Overconfidence, trading volume, and the disposition effect: Evidence from the trades of institutional investors. Working Paper, University of Chicago and Old Dominion University.
3. Daniel, K., Hirshleifer, D., & Subrahmanyam, A.
(1998). Investor psychology and security market under‐and overreactions. the Journal of Finance, 53(6), 1839-1885.
4. Fama, E. F. (1998). Market efficiency, long-term returns, and behavioral finance. Journal of financial economics, 49(3), 283-306.
5. Goetzmann, W. N., & Massa, M. (2003).
Disposition matters: volume, volatility and price impact of a behavioral bias (No. w9499).
National Bureau of Economic Research.
6. Gorter, J., & Bikker, J. A. (2013). Investment risk taking by institutional investors. Applied Economics, 45(33), 4629-4640.
7. Hoffmann, A. O., Shefrin, H., & Pennings, J. M.
(2010). Behavioral portfolio analysis of individual investors. Available at SSRN 1629786.
8. Jagullice, E. O. (2013). The effect of behaviourial biases on individual investor decisions: a case study of initial public offers at the Nairobi Securities Exchange (Doctoral dissertation, University of Nairobi,).
9. Kahneman, D., & Riepe, M. W. (1998). Aspects of investor psychology. The Journal of Portfolio Management, 24(4), 52-65.
10. Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk.
Econometrica: Journal of the Econometric Society, 263-291.
