IMPACT OF BEHAVIORAL FINANCE IN INVESTMENT DECISION MAKING

Transcription

1 International Journal of Civil Engineering and Technology (IJCIET) Volume 9, Issue 6, June 2018, pp , Article ID: IJCIET_09_06_130 Available online at ISSN Print: and ISSN Online: IAEME Publication Scopus Indexed IMPACT OF BEHAVIORAL FINANCE IN INVESTMENT DECISION MAKING Kanan Budhiraja Research Scholar, Amity University, India Dr. T.V. Raman Professor, Amity University, India Dr. Gurendra Nath Bhardwaj Professor, NIIT University, India ABSTRACT Traditional finance theories suggest that individuals make rational investment decisions after carefully considering risk and return factors to maximize their gains while limiting their losses. Behavioral finance challenges the traditional financial theory and suggests that multiple biases impact individual investment decisions. These include heuristic biases such as anchoring, representativeness, gamblers fallacy and more; and regret aversion, framing and disposition effect as elaborated under prospect theory. The research paper aims to understand how these biases impact investment decision making process and what steps can be taken by individual investors to make rational decisions. Analyzing how practical considerations limit individual decision making, the paper concludes that individual investors need to carefully mine data and consider external factors before undertaking investments. Key words: prospect theory, heuristic biases, behavioral finance, traditional finance theories, investment. Cite this Article: Kanan Budhiraja, Dr. T.V. Raman and Dr. Gurendra Nath Bhardwaj, Impact of Behavioral Finance in Investment Decision Making, International Journal of Civil Engineering and Technology, 9(6), 2018, pp INTRODUCTION Early investment theories suggest that investors are rational and base their decisions on maximizing returns while limiting the risks. However, recent theories challenge these suggestions and assumptions. Human mind does not always think rationally and neither do the markets always perform efficiently. Psychological factors such as greed and fear among others can influence the investment decisions of people. While rational thinking might suggest that investing in say, the stock market is ideal for a particular kind of investor. However, fear of losing money and having met a peer who has lost money in the stock market editor@iaeme.com

2 Impact of Behavioral Finance in Investment Decision Making might influence the decision of the investor. Hence, behavioral finance became an important field of study. Behavioral finance is a field of study that suggest that investment decisions are influenced by psychological and emotional factors to a large extent. According to (Olsen, 1998), behavioral finance not only incorporates traditional finance paradigms that relate to rational investment decision making and growing investment returns but also considers individual behavior as a factor to investment. (H.H.Shefrin, 1988) noted that behavioral finance studies the impact of psychology on financial decision making and financial markets. Traditional finance theory assumes that humans are rational and that economic models work efficiently and in isolation. However, the more people have studied financial decision making, the clearer it is becoming that human emotions, intentions, intuitions and habits play a large role in all financial decisions. (Slovic, 1972) has highlighted in his research that traditional financial theories are not enough and that several psychological processes drive individuals to investment decision making. (Belsky & Gilovich, 1999) have likened behavioural finance to behavioural economics stating that behaviour economics combines both psychology and economics to explain why individuals make irrational decisions while investing, saving, earning and spending. (Chaudhary, 2013) argues that human beings are influenced by several behaviour anomalies which lead them to take decisions that go against basic wealth maximization principles. 2. BEHAVIORAL BIASES (Agrawal, 2012) observes that biases in behavior have been and will always have an impact on the judgement of investors. Though it isn t possible for an investor to completely eliminate them, it becomes important to avoid specific behavior biases in certain situations. (Rayenda Khresna Brahmana, 2012) reiterate the fact that stock price anomalies and financial decision making are impacted by psychological factors and explain the factors that lead to irregularities in such decisions. Many cognitive biases have been established by psychologists in the process of understanding human behavior and decision making. Some of these are as follows: 2.1. Heuristics (Kahneman D., 2003) defines heuristics as cognitive shortcuts or rule of thumb that help people take decisions by eliminating a difficult question and replacing it with an easier one. Individuals make quick decisions and judgements by developing strategies from personal experience, train and error or just simple experiments. While heuristics might be good for decision making at times, most often than not, they are not the right approach for financial decision making since they tend to ignore or take into account important factors affecting investment. Heuristic decision processes are influenced by several behavioral biases. These include: Representativeness Investors tend to stereotype. Financial decisions that have been successful in the past influence investors future decisions as well and they tend to see a pattern where actually none exists. This means that investors do not consider the law of averages or place any bets on long-term trends. Short-term trends such as an increase in the price of a current stock or an industry that has been performing better than others in the market in the recent past, get more importance. If markets were supposed to be fully rational, any recent changes in stock prices should not have any impact on the future prices of that stock. However, that s not the case editor@iaeme.com

3 Kanan Budhiraja, Dr. T.V. Raman and Dr. Gurendra Nath Bhardwaj The same has been confirmed by (Bondt, 1998) who stresses that investor analyses are generally based on recent successes and failures and the same bias their judgement towards future investments. Anchoring Investors tend to focus on on a single figure or fact while making investment decisions. The reasons for these could be multiple too much data to process, not enough time, or simply a lack of understanding. Relying heavily on a single trait or anchoring might lead to significant under-earning or loss of potential earnings. By ignoring important pieces of information and adjusting financial decisions based on a single fact, investors tend to bias their investments and might lose out in the long-run. (G.Hoguet, 2005) in his study established that investors tend to anchor to a specific information when asked to define a quantum, like the future expectation of a stock price. That is why investors tend to under-react to new information. Overconfidence While confidence in an individual s ability to be able to predict and secure above-average returns is valuable, over-confidence can be detrimental to investment decisions. Overconfidence bias creeps in when investors overestimate their ability to evaluate a particular stock, company or industry as a potential investment. Due to this, they might ignore any signs to the contrary and may also indulge in excessive trading in a particular stock. Since these investors don t study past trends, or future expectations from a particular stock and rely excessively on their personal judgement, the results from investment may be skewed. Gamblers Fallacy The judgement of investors that leads them to believe that trends will reverse is referred to as gamblers fallacy. This is quite similar to what a gambler at a casino might face. While playing roulette, if the die has been landing on black numbers for the last few turns, the gambler places his bets on a red number believing that the trend will reverse. Similarly, while investing funds, individuals tend to believe that a stock that has been underperforming for a long time will have a trend reversal making it a good investment. According to (Cai, 2016), it is an individual s mistaken belief of a probable outcome based on the occurrence of an event or a series of events. Availability Bias People tend to take decisions based on the most easily available information. The same has been observed in investors. While making investment decisions, investors tend to rely on certain heuristic approaches and use information that has been recently in the news or has been heard from his peers. Information that can be easily recalled at the time of making investment decisions may not be the correct one, and is most likely to lead to an incorrect decision making. According to (Qawi, 2010) the more current and significant an event is, the higher is the likelihood for it to influence decision making process. Conservatism The tendency to revise your belief insufficiently when presented with new information is referred to as conservatism bias. This simply means that when trends change, people might under-react to such changes and may be slow to adjust to them. They anchor themselves to existing situations and react to things like they used to. (Singh S., 2012) states that the conservatism bias is in loggerheads with the representativeness bias. When things change, investors might be slow to react to such changes due to conservatism bias. However, if there is long-term pattern, investors will adjust to such trend and may even over-react leading to incorrectly judging the long-term averages editor@iaeme.com

4 Impact of Behavioral Finance in Investment Decision Making 2.2. Prospect Theory According to economists, utility is the usefulness that an individual gains from a particular object or service. Traditional finance theories suggest that the net benefit from any investments is a sum of the gains and losses that the individual receives from it in the long term. However, individuals are seldom rational and the same was proved in a theory developed by (Kahneman & Tversky, Prospect Theory: An Analysis of Decision under Risk, 1979). According to the prospect theory, people process probable gains and losses differently, and give preference to probable gains instead of probable losses, even when the net result from both the options is the same. So, options expressed in probable gains are always given preference over those given in probable losses. There are several biases that contribute to this behavior. These include: Framing In behavioral finance, framing refers to the set of words that are used to frame a particular problem/ solution at hand. When investors are faced with different choices for investing their money, they will prefer ones that talk about probable gains rather than the ones which are expressed in terms of probable losses. Individuals are more distressed by probable losses rather than probable gains. This means that a Rs.500 loss will be twice as distressing for an individual investor than a Rs.500 gain. (Levin & Schneider, 1998), describe framing in three different forms: risky choice framing the risk involved in loosing 10 of 100 lives rather than saving 90 of 100 lives; attribute framing preferring 75% lean meat over 25% fatty meat; and goal framing letting go of a gain for the common good is easier than suffering a loss for the same. Loss Aversion Individuals prefer to avoid loss rather than getting equivalent gains; losses seem to be twice as powerful as the same amount of gains. For e.g., in a gamble, an individual when faced with the prospect of gaining $500 or losing $450, will not accept the bet since the impact of the loss is perceived to be much higher than the impact of the gain even when the gains are higher than the associated loss. This means that if investors are loss averse, they might use the law of averages and purchase more poorly performing stock to recover prior losses. (Gächter, Orzen, Renner, & Starmer, 2009) use loss aversion to explain why, at times, penalty works better than positive rewards for motivating individuals. Regret Aversion It is the tendency of individuals to regret decisions when the outcome isn t favorable. This means that if an investor has lost in the stock market, the regret of having made a poor decision is more than the actual loss suffered. Investors might end up feeling responsible for having made the decision to invest in a poor stock that ultimately, led to losses. This may lead to certain incorrect financial decisions investing in stocks that have recently performed well; avoiding investment in stocks that have not done well in the recent past; or simply investing in stocks that everybody invests in so as to be a part of the herd and not feel left out when they lose their money. Such individuals are unable to take investment decisions because they feel that whatever decision they might take, they will regret it in hindsight. (Zeelenberga, Beattieb, Pligta, & Vriesa, 1996) elaborate on the role of regret in choice behavior and suggest that individuals always make risk-minimizing decisions. Mental Accounting According to the mental accounting bias, individuals separate their money and investments in separate categories (or different mental accounts) based on certain criteria like source of earning and use of the money. Individuals or investors might use mental accounting as a means of self-control. Since investors have imperfect knowledge about the market, they may editor@iaeme.com

5 Kanan Budhiraja, Dr. T.V. Raman and Dr. Gurendra Nath Bhardwaj divide their money into investments and expenditure pools in order to ensure that they don t over-spend. By doing so, they treat both these mental accounts as completely unconnected and let go of the benefits of portfolio diversification. (Thaler, 2008) suggests that investors treat the money earned from different sources differently i.e. what is earned as part of salary and what is received as capital gains. Investors tend to treat capital gains as more favorable and are willing to take greater risks on those rather than on their salaried income. Disposition Effect The disposition effect suggests that individuals seek to realize paper gains and avoid realizing paper losses. This means that if an investor bought a stock at say, $100 and the stock later falls to $85 before going back up to $95, most investors will not want to sell the stock unless it goes above $100. Hence, investors have a tendency to sell stocks whose value has increased while keeping assets whose value has dropped holding losers for long and selling winners too soon! (Chen, Kim, Nofsinger, & Rui, 2007) suggest that in investors in emerging markets like China tend to suffer from disposition effect by selling stocks that have appreciated in price rather than those that have depreciated in price. 3. IMPLICATIONS FOR FINANCIAL MARKETS The supporters of EMH suggest that biases do not impact markets and any anomalies will always automatically be adjusted to drive stocks to their fundamental prices. According to them, the changes in the market happen for a variety of reasons and cannot be attributed to behavioral biases. They believe that if we sufficiently analyze any stock and read past trends and current news, it ll be easy to find that the market changes are just a matter of chance and not a product of individual behaviors. Presence of anomalies in the financial markets was the reason why behavioral finance came in to the picture. The behavior of these anomalies continue to violate the fundamental behavior of the financial markets which assumes that all investors are rational and logical. These anomalies can be summarized as follows: January Effect Average monthly return for a small firm is uniformly higher in January than any other month in the year which is completely opposing to the efficient market hypothesis. Winner s Curse Traders or gamblers tend to pay more than the true value of the asset in auction bids. This is against the EMH which suggests that investors will be aware of the true value of an asset and will pay or bid according to that. Equity Premium Puzzle Conventional theorists suggest that the equity premium for stocks should be much lower than what is currently prevalent in the market. However, behavioral finance suggests that loss aversion bias requires high premium to over compensate investors for their aversion to loss. Proponents of behavioral finance suggest that while most of these biases will not be simultaneously present in all investors, some or the other bias will be prevalent impacting the financial market in general. For example, heuristic biases such as representativeness and anchoring may make investors over optimistic about stocks that have performed well in the past and over pessimistic about stocks that have performed poorly in the given time frame, thus causing the actual share prices to deviate from their fundamental prices. These biases can lead to several issues that can be listed down as follows: Over or under reactions to any news about changes in price Ignoring the information regarding the fundamentals of stock price Using past trends to extrapolate future trends Undue preference to hot stocks editor@iaeme.com

6 Impact of Behavioral Finance in Investment Decision Making 4. SUGGESTIONS FOR INVESTORS While it isn t possible for investors to completely let go of such biases and have the inherent realization that such biases are present, a few things can be kept in mind to ensure rational decision making that maximizes returns and minimizes loss. Awareness: Well-read investors that are aware of the biases present while making investments are in a better position to tackle such biases. Find Data: Investors aren t alone in the market. It s important to find out sources that think differently than they do and then correspond data and reasoning with them to come to a conclusion. Chances are that the investor will end up making a much more informed decision. Diversify: A great investor will always diversify. As the old saying goes, don t put all your chickens in one basket. Diversification across industries and sectors ensures that investors realize higher returns while at the same time minimize risk of losing their entire investment. Investment Goals: It s important that individuals realize and quantify their investment goals before leaping on to the investment bandwagon. This gives clarity of thought and helps investors avoid behavioral biases while making short-term changes for achieving those longterm goals. Analyze Trends: While past winners seem to be a good choice for investing, the law of longterm averages tends to ensure that last year s best performing assets may not perform that well this year. Hence, it s important to not place undue importance on past performance and expect the success to continue in the current year as well. Track Mistakes: Everybody ends up making errors. Traders and investors may find themselves at the bottom of the pit multiple times and may feel that this is it. However, it s important to learn from those mistakes and get back on track keeping in mind the learnings so as to avoid the same in the future. 5. CONCLUSIONS Traditional finance theorists and behavioral finance economists are constantly at loggerheads with each other. While much has been said and written about behavioral finance as a field, there is no formal one writing that has been able to completely identify and conclude that stock market anomalies are a by-product of behavioral biases. However, many important literature studies have been done in this field including some landmark studies by (Kahneman & Tversky, Prospect Theory: An Analysis of Decision under Risk, 1979) in developing the Prospect Theory and (Kahneman, Knetsch & Thaler, 1991) in developing the Endowment Theory. The field of behavioral finance has grown considerably in the past decade. That said, it does not negate the efficient market hypothesis completely. It does, however, give several possible reasons as to why anomalies occur in an efficient market and why stock prices divert from their fundamental values. Behavioral financial theories are extremely important for individual investors since biases in behavior and psychological differences play a key role in investment decision making process. REFERENCES [1] Olsen, R. A. (1998). Behavioral Finance and Its Implications for Stock-Price Volatility. Financial Analysts Journal, 2(54), [2] H.H.Shefrin. (1988). The Behavioural Life Cycle Hypothesis. Economic Enquiry, 26(4), editor@iaeme.com

7 Kanan Budhiraja, Dr. T.V. Raman and Dr. Gurendra Nath Bhardwaj [3] Slovic, P. (1972). Psychological Study of Human Judgement: Implications for Investment Decision Making. Journal of Finance, 27, [4] Agrawal, K. (2012). A Conceptual Framework of Behavioral Biases in Finance. The IUP Journal of Behavioural Finance, 9(1), [5] Rayenda Khresna Brahmana, C.-W. H. (2012). Psychological factors on irrational financial decision making: Case of day-of-the week anomaly. 28(4), [6] Belsky, G., & Gilovich, T. (1999). Why Smart People Make Big Money Mistakes And How To Correct Them: Lessons From The New Science Of Behavioral Economics. New York: Simon & Schuster. [7] Chaudhary, A. K. (2013). Impact of behavioral finance in investment decisions and strategies a fresh approach. International Journal of Management Research and Business Strategy. [8] Kahneman, D. (2003). Maps of bounded rationality: Psychology for behavioral economics. The American Economic Review, 93, [9] Bondt, W. F. (1998). A Portrait of the Individual Investor. European Economic Review, 42, [10] G.Hoguet. (2005). How The World Works: Behavioral Finance and Investing In Emerging Markets. State Street Global Advisors Essays and Presentations. [11] Cai, W. (2016). How To Be A Successful Investor: Strategies To Help You Tame The Bear And Ride The Bull (2nd ed.). Singapore: Cai Tiancai William. [12] Qawi, R. B. (2010). Behavioral Finance: Is Investor Psyche Driving Market Performance? [13] Singh, S. (2012, February). Investor Irrationality and Self-Defeating Behavior: Insights from Behavioral Finance. The Journal of Global Business Management, 8(1), [14] Kahneman, D., & Tversky, A. (1979, March). Prospect Theory: An Analysis of Decision under Risk. Econometrics, 47(2), [15] Levin, I. P., & Schneider, S. L. (1998, November). All Frames Are Not Created Equal: A Typology and Critical Analysis of Framing Effects. Organizational Behavior And Human Decision Processes, 76(2), [16] Gächter, S., Orzen, H., Renner, E., & Starmer, C. (2009). Are experimental economists prone to framing effects? A natural field experiment. Journal of Economic Behavior & Organization, 70, [17] Zeelenberga, M., Beattieb, J., Pligta, J. v., & Vriesa, N. K. (1996, Feb). Consequences of Regret Aversion: Effects of Expected Feedback on Risky Decision Making. Organizational Behavior and Human Decision Processes, 65(2), [18] Thaler, R. H. (2008). Mental Accounting and Consumer Choice. Marketing Science, 27(1), [19] Chen, G., Kim, K. A., Nofsinger, J. R., & Rui, O. M. (2007, February). Trading performance, disposition effect, overconfidence, representativeness bias, and experience of emerging market investors. Journal of Behavioral Decision Making, 20(4), [20] Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1991). Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias. Journal of Economic Perspectives, 5(1), editor@iaeme.com