International Journal of Civil Engineering and Technology (IJCIET)

Volume 9, Issue 6, June 2018, pp. 1151–1157, Article ID: IJCIET_09_06_130

Available online at [Link]
ISSN Print: 0976-6308 and ISSN Online: 0976-6316

© 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. 1151–1157
[Link]

1. 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

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 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. ([Link], 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.

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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. ([Link], 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.

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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 50-50 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

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 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

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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 long-
term goals.
 Analyze Trends: While past ‘winners’ seem to be a good choice for investing, the law of long-
term 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.

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