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BEHAVIOURAL BIASES IN FINANCE: A LITERATURE REVIEW

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© 2022 IJRAR March 2022, Volume 9, Issue 1 www.ijrar.org (E-ISSN 2348-1269, P- ISSN 2349-5138)

BEHAVIOURAL BIASES IN FINANCE: A

LITERATURE REVIEW
1. Dr. C. S. Joshi, 2. Sneha Badola
1. Professor and Head of Commerce Department, 2. Research scholar

Department of Commerce
M.B Govt. P.G. College, Haldwani, Uttarakhand.

Abstract: Behavioural biases are known to disturb the judgement of any investor in the area of finance.
This fact has been acknowledged in the past has, however, there is insufficient understanding on the
behaviour of an individual investor in the existence of such biases. To shed light on the investor’s
irrationality, a literature review of emotional bases is conducted. The present study is the first attempt to
provide a systematic and comprehensive compilation of all six emotional biases, namely, Loss Aversion bias,
Optimism Bias, Self-Control Bias, Status quo bias, Regret Aversion Bias and Endowment Bias. Covering
such biases is a crucial aspect to strengthen the investment decision making of an individual investor and to
improve the investment decision making process.
Key words: Behavioural finance, Behavioural biases, Individual investor, Investment decision,
Literature review

Introduction
Finance is a discipline primarily dealing with two foremost activities, firstly, how to find money and
secondly, to take the right decisions to allocate and manage money efficiently. Human-being’s financial
decision making has been the subject of much research with the primary aim of distinguishing the influence
of psychological, behavioural, and sociological aspects on decision making (Costa et al., 2019). From this
perspective, a scientific theoretical framework has emerged, described as behavioural finance, which aims to
integrate psychological aspects into economic and financial decision-making processes. Over the past three
decades, a debate about the efficiency of the stock market has captured the attention of every scholar who
studies stock returns and the movement of returns. Behavioral finance is a new discipline that integrates
behavioral and psychological theories with conventional finance and economics. The concept of stock
markets running efficiently goes back in the past to late 1960s when Eugene F. Fama proposed efficient
market hypothesis (EMH) in 1970.
The efficient market hypothesis framework was based on the theory of expected utility assuming efficient
markets and rational investors. Although, it quickly gained wide acceptance and is still observed for asset
pricing decisions, it fails to explain some of the unexpected phenomena that appeared in the stock market.
Internet bubble of the late 1990s and the Great Recession of 2008 remains unanswered by traditional finance.
Furthermore, with an increase in the number of individual investors, investment also show a tendency to
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deviate from their fundamental values. Researchers these days are adapting to behavioral finance as a more
credible explanation for stock returns and other phenomena. It has been accepted that stock markets are
inefficient systems and investors are irrational and biased (Starmer, 2000). The concept of market efficiency
is defined by financial theories based on the assumptions of rational investors and efficient markets. In
contrast, the behavioral finance believes that investors are not purely rational, but a normal individual who
acts and makes decisions under the influence of emotions and cognitive errors. Behavioural Finance
identifies the causes of various market anomalies and identifies human errors at the source of these anomalies.
In Behavioural Finance, it is assumed that information and attributes of market agents have a great influence
on investors' investment decisions and market outcomes. As a result, when making investment decisions,
investors act irrationally making suboptimal decisions. These suboptimal decisions affect capital market
efficiency and individual wealth (Sharma, 2019).
Investment activities in current period has turn out to be widespread not only in terms of institutional
investors, also in terms of individual investors also (Sun et al., 2020). Decisions related to finance generally
depend upon the data and its estimated financial position, but many a time short-term price changes also push
the financial market and its participants. Such changes in the market are not always established around logic
but at times are inspired by mood or promptly received information, which creates irregularities presented in
the investor’s behaviour (Zahera & Bansal, 2018).

2. Literature Review
2.1 Behavioral biases and investment decisions
Behavioral Finance is not just a part of finance, rather is broader and wider in scope and consists of insights
from finance, psychology and sociology to create a concept known as behavioral finance. It has emerged as
a completely innovative topic, producing new credibility especially with the falling-out of the tech-stock
bubble which took place in March of 2000 (Pompian & Wood, 2006). Financial academicians and behavioral
psychologists recognized numerous behavioral biases that are related to investors. The investors are not
always rational, and the concept of standard finance could not deliver adequate information required for
investors to take informed decision-making related to their investments. Many investors are susceptible
toward several kinds of behavioral biases (Bhatia et al., 2020). Biases frequently act as major influential
factor behind the irregularities discovered in the financial market. The investors who are the clients of such
markets are human beings surrounded by complicated emotions (Quaicoe & Eleke-Aboagye, 2021). In order
to identify a person`s funding choices, there is an utmost need to recognize diverse behavioral biases that are
related to their selection-making process (Sahi et al., 2013). For more than twenty years, use of behavioral
aspects to give an explanation for stock price movements had been increasing (Corredor et al., 2015). Chen
et al., (2004) discovered that irrationality in financial markets displayed behavioral biases and led investors
take inadequate investment decisions. When analyzing the financial market, behavioral finance takes the
view that markets are not absolutely efficient. This lets to the observation of how psychological factors can
influence the buying and selling of stocks. Broadly, behavioral finance theories have additionally been used
to offer clearer motives of stock market irregularities like bubbles and deep recessions. Behavioral finance
is a modern school of thought that deals with the effect of behavior and psychology on the behavior of
investors and its subsequent impact on stock markets (Sewell, 2007).
2.2 Emotional bias
An emotion is a spontaneous response instead of an aware thinking. It could be seen as a psychological state
that develops as a consequence of intuitive decisions rather than rational decision. Such biases are difficult
to modify or remove as they generally originate from impulsive behaviour. Emotions are related to insights
or beliefs about entities or associations and in the realm of investment, such feelings could result in investors
making decisions that are inefficient. It is therefore, beneficial for investors to identify their personal
emotional bias and discover ways to modify or adapt with it instead of trying to remove them completely.
Biases categorised under emotional biases (Pompian & Woods, 2006) are optimism bias, loss-aversion bias,
regret aversion bias, endowment bias, status quo bias and self-control bias.
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2.2.1 Loss Aversion bias

Loss aversion bias has been obtained from prospect theory which shows that investors are more motivated
to prevent financial losses rather than looking for gains. This bias led to investors to opt for risky or loss-
bearing investment even when there are not many prospects of investment price rising again. This loss also
leads to loss-avoidance, where investors prefer a low return portfolio instead of selecting a risky investment
that may result into a loss. Investors respond to losses and profits in different ways (Koszegi & Rabin 2006).
Some individuals are inclined to overreact in case of losses, and they are more focused on preventing losses
than earning profits (Ainia & Lutfi, 2019). Individual investors overstate the probability of loss (DellaVigna,
2009). Investors influenced by loss aversion bias are so apprehensive with regard to losses suffered that at
times they even tend to avoid investments with a fear of incurring loss (Khan et al., 2017). Investors are
irrational in taking investment decisions and loss aversion bias affects different investors differently while
they are taking financial decisions (Gachter et al., 2021).
2.2.2 Optimism Bias
Optimism can be defined as the overestimation in the occurrence of positive events and undermining the
probability of bad events (Marwan & Sedeek, 2018). This bias explains that individuals display a higher level
of confidence in their own reasoning, access to information, judgement, knowledge level and cognitive
abilities. Many investors are likely to look at the financial market situations with unnecessary optimism
thinking that bad investments won't happen to them (Banerji et al., 2020). Investors tend to be excessively
positive regarding the financial system and its pleasant performance (Brahmana et al., 2012). Moderate
occurrence of optimism bias is found to have a positive impact on investors while they make investment
decision making (Akinkoye & Bankole, 2020). (Abreu & Mendes, 2020) found positive effect of optimism
bias on investment trading and decision making.
2.2.3 Self-Control Bias
Self-control bias reflects the behavioral tendency of investors to save a lesser amount for future and spend
more at present (Pompian & Wood, 2006). Investors generally overlook the requirement of adequate savings
in their long-term (Kishor, 2020), which leads to higher risk-taking to earn additional money in order to
manage expenditure (Lusardi & Mitchell, 2007). Researchers have associated higher risk-taking behavior
with reduced self-control (Freeman & Muraven, 2010). Investors can control their desire to overspend by
rationally allocating their financial resources into ‘long term investment’ and ‘available for expenditure’
groups (Kannadhasan, 2006).
2.2.4 Status quo bias
Status quo bias is defined as an investment decision which is attached to the current state regardless of
outcomes (Pompian, 2008). Generally, investors tend to be more comfortable maintaining a fixed portfolio
rather than making changes. This affects the ability of investors to look for opportunities in circumstances
that requires change even when it is beneficial (Agnew et al., 2003). Also, it could result into investors
unknowingly maintaining a portfolio that has inappropriate risk characteristics (Rubaltelli et al., 2005). They
find it difficult to take financial decisions and try to put such decisions on hold (Filiz et al., 2018). Many
investors attempt to buy and sell securities for better returns, but do not achieve their highest earnings, as
they continue to hold on to the same set of stocks in their portfolio (Brown & Kagel, 2009). SQB influences
investment decisions of individual investors (Freiburg et al., 2013), the subject has been studied by different
scholars from time to time (Toumia & El Harbi, 2020; Barber & Odean, 2001).
2.2.5 Regret Aversion Bias
Regret Aversion bias explains the human inclination to feel pain due to the disappointment for taking wrong
financial decisions. This bias is a form of emotional bias where people tend to avoid making decisions for
fear of potentially bad outcomes. Investors with an aversion to regret often avoid decisive action out of fear
(Pompian & Wood, 2006). It results into holding onto losing stock for too long so as to prevent admitting
fault or mentally acknowledging losses on security (Connolly & Zeelenberg, 2002). When individuals regret
their past choices, it has more impact on their future investment decisions (Akinkoye & Bankole, 2020). To
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avoid any feeling of disappointment in the future, investors prefer to take on more risk or avoid risk altogether
(Zahera & Bansal, 2018). Investors affected by the regret aversion bias become pessimistic about financial
decisions (Fogel & Berry, 2006) and end up investing in risky investments.
2.2.6 Endowment bias
Endowment bias explains that losses have a greater value and weight than gains. The existence of endowment
bias leads to lower investment and greater risk aversion (Holden & Tilahun, 2020). People who exhibit
endowment bias value an asset more when they hold property rights to it than when they don’t (Pompian,
2008). Investors often place undue importance on the securities they currently hold and do not want to change
their mind. This rigidity in investment choice often causes investors to overlook the worthiest investment
prospects (Zahera & Bansal, 2018). Studies have shown that beneficial growth opportunities/prospects are
always available in the market, but individual investors are still deprived due to the effects of preference bias
(Horowitz & McConnell, 2002).

3. Conclusion
This paper provides an extensive review of the behavioral finance as a separate field of study. Mostly,
research papers on behavioral finance have indicated towards the presence of behavioural across various
types of investors. Limited articles provide resolutions to reduce these biases. This paper has proposed an
important solution to this issue. The paper has already discussed some of the literature about the causes of
biases of investors when they make investment decisions. This section gives a quick glimpse of few papers
that have suggested some solutions for reducing the effects of these biases. This paper is a summary into the
vast universe of the literature published in the area of behavioral finance. Up to this point, this is a single
study in the literature extensively reviewed and collected seventeen different types of biases into a single
paper. These biases are Loss Aversion bias, Optimism Bias, Self-Control Bias, Status quo bias, Regret
Aversion Bias, Endowment bias.
Behavioural Finance join in sociology and psychology with finance discipline. This novel area has led to
gain more insights into the financial markets. The Efficient Market Hypothesis theory was based on the
premise of rationality. This belief of rationality was somewhere a key shortcoming of Efficient Market
Hypothesis, resulting into market anomalies. Behavioural Finance aims to investigate these anomalies or
irregularities by clarifying what, why and how of investment from the perspective of a human being.
Behavioural Finance theories helps investors and finance professionals to rectify their own mistakes and also,
that of others which are related to investment and financial decision making. As an end result, investors can
gain a deeper understanding of the emotional aspects of their own investment decisions. As the impulsiveness
of financial markets is increasing, the research on behavioural finance becomes the need of an hour.

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