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Behavioral Bias & Its Influence in Finance

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Behavioral Bias & Its Influence in Finance ELK ASIA PACIFIC JOURNAL OF FINANCE AND RISK MANAGEMENT ISSN 2349-2325 (Online); DOI: 10.16962/EAPJFRM/issn. 2349-2325/2015; Volume 10 Issue 1 (2019) www.elkjournals.com …………………………………………………………………………………………………………………………………………… BEHAVIORAL BIAS & ITS INFLUENCE IN FINANCE, INVESTMENT & DECISION – MAKING Joydeep Dass Assistant Professor in Finance International School of Management Excellence E-mail: [email protected] , [email protected], Ph. 9175360870 Abstract Behavioral finance has gained popularity in the last decades. The subject uses the research made in psychology and analyses the understanding of human behavior in financial decision making by considering observed human behavior. Most of us are aware that human behavior and emotions significantly affect investment decisions. Human nature is a complex web of greed, fear, temptation, impulse and other emotions, which makes them, react to different market situations. Psychological research has proved that there are various forms of bias which affect decision making and majority of these decisions are related to money, finance & investing. Behavioral bias and motivation is the main driving force in making investment choices. Behavioral biases attempts to relate the information processing to an Investors decision choices and preferences. The subject also claims through various research that an Investor should be in control of his emotions apart from having independent thinking, reasoning and analytical capabilities, market knowledge, and dynamics of investing if he wants to succeed in making a good investment decision. These biases are deeply embedded in human psyche and an essential part of human nature. Influence of these biases affect all investors no matter how professional or novice they are. Behavioral finance is a study of the effect of cognitive and emotional factors and an attempt to extend the role of these biases in financial decision-making & Investment. KeyWords: Cognitive, Bias, Investor, Investment Decision-Making, Risk, Optimal, Sub- conscious, Estimation. Psychological. Anchor, Irrational. INTRODUCTION knowledgeable in taking financial decisions. The assumption that emotions do not play Over the last couple of years traditional any role in financial decision-making is finance theories assumed that, investors are erroneous and in reality, it is not. Behavioral well informed, careful, consistent, and 1 ELK ASIA PACIFIC JOURNAL OF FINANCE AND RISK MANAGEMENT ISSN 2349-2325 (Online); DOI: 10.16962/EAPJFRM/issn. 2349-2325/2015; Volume 10 Issue 1 (2019) finance has grown exponentially in the last and why. Behavioral counsellors are also able few years as researchers are of the opinion to guide their clients and help them overcome that finance theories should account for these biases for their benefit. The following observed human behavior. Some theorists paragraph contains a comprehensive outline have categorized behavioral finance in two of some of these biases. sub-topics – Behavioral Finance Micro & Anchoring bias Behavioral Finance Macro. The former explains the irrational behavior and biases of This occurs when an individual relies on a individual investors and the later explains particular piece of information irrespective of that abnormal market behaviour. These weather that information is correct or occurs because individuals demonstrate incorrect. His future decisions are based on different behavior at different times. this information regardless of its outcome. Behavioural Scientists assume that each That piece of information is termed as investor is a constituent of that market and the “Anchor” and all his investment decisions are market is efficient. Behavioral scientist have based or centered around that Anchor. Once interfaced research with psychology to an anchor is fixed, judgements are made by develop the subject of Behavioral finance. In adjusting or interpreting information around other words, the use of psychology to that anchor [66]. For example, an Investor understand how people arrive at a decision feels that the price of a stock at which he will and research in psychology have developed buy will be Rs 500 when it is low for the last several such behavior called biases. These 52-week period. Now suppose the price of biases have significant impact in earning the stock falls to Rs 600, he will not buy it money from investments and they outline the because he has anchored it at Rs 500. Now, if process of individual decision-making & the the price of the stocks go up, he might lose preferences they choose from the out of a potential good investment alternatives. Study of these biases help opportunity & benefit of capital appreciation. investors make better financial decisions. In business, for example if the management Financial advisors, planners & analysts are decides to buy a used machinery, the initial able to understand distorted decisions, quotation received might be an anchor for the financial market behavior, improve rest of the decision on purchase or performance and correlate what went wrong negotiation on price. 2 ELK ASIA PACIFIC JOURNAL OF FINANCE AND RISK MANAGEMENT ISSN 2349-2325 (Online); DOI: 10.16962/EAPJFRM/issn. 2349-2325/2015; Volume 10 Issue 1 (2019) Affinity bias in behavioural finance [67]. A share broker for e.g. may judge a Company’s stock based A common human tendency where people on few characteristics ignoring the better tend to make irrational investment decisions ones. This bias occurs when there is a need to based on how a stock he or she perceives to come to a decision quickly and the best way be of value. An investor might show an to overcome it is to study the whole aspect eagerness to buy domestic stocks or foreign holistically and do own research and analysis. stocks also known as “Home country bias” or Confirmation bias “Foreign Country bias”. An investor might buy Company stocks, which work towards This is another type of bias where an environmentally viable projects because he individual stick to pre-existing beliefs feels that by doing so he will be contributing without verifying its correctness and to the betterment of the planet even if these authenticity. There is a tendency to justify companies are not foreseen to be profitable in and prove that the beliefs are true where in future. Similarly, Affinity bias occurs when fact it is not. They might try to substantiate investors invest in Companies, which invests false information to support their beliefs. in social projects when he believes that the This bias is mostly unintentional and causes Company will do greater good to the society to draw conclusions from incorrect [88]. information [36]. For example, an investor might have an illusion that a particular stock Halo effect will go up in future if purchased within the next 3 months. He will then try to collect This bias is commonly known as the “First information to prove the point that the price impression” bias or halo effect. Halo effect is of the stock will go up and it might happen a cognitive tendency to evaluate a thing based that the stock has suffered losses. He will still on impression of particular aspect, which continue and go with investing in the stock leads to a positive impression of the overall with the hope that the price will rise and than product. Judgements based on small amount he will make a profit out of it. The reverse of information could be disastrous and tendency to critically analyze and contradict understanding of halo effect is very important prior beliefs is known as disconfirmation bias in real life. The bias was first discussed by [68]. Edward Thorndike and now popularly used 3 ELK ASIA PACIFIC JOURNAL OF FINANCE AND RISK MANAGEMENT ISSN 2349-2325 (Online); DOI: 10.16962/EAPJFRM/issn. 2349-2325/2015; Volume 10 Issue 1 (2019) Overconfidence bias – human tendency to treat various pools of money differently depending on the source This is the most catastrophic of all the biases. and how it is planned to be used [37]. For Here the investor feels that the investment example, an investor has a certain amount of decisions he makes is the best of all his other funds to be invested in equities and fixed counterparts. They believe that are better and income securities. He comes across a few wiser than others are while making financial stocks worth $50000 and bonds worth decisions. Most of the time it happens that the 150000$.Suppose the broker says that he can decisions they made proved to wrong or procure both the equities and bonds at a counterproductive. This bias usually occurs reduced price of 10000$ early next week. The when the investor makes a profit on few investor would prefer to wait for the equities successful investments in the past and he until next week as the savings of 10000$ is develops a feeling of overconfidence that all seen by him as larger than the investment in his decisions in future will earn him a profit bonds even though both the savings are the no matter how bad the decision is [34]. For same. Another example could be an investor Example an investor purchases a stock which feels that a dividend from equities is a huge was all time low during the last few years and source of income and ignores the bonus almost dead and he invests in that stock with shares received even though the source of the hope that some day it will rise and earn both is the same from equity holdings. Tax him a profit. Over ranking bias is a type of refunds, bonuses, lottery winnings, gifts are confidence bias where people rate themselves perfect examples, where the money is not superior than that of others. In business & factored in financial planning. The amount Investing, this often leads to taking too much when received is considered a windfall and risk-taking ad finally leading to disastrous the money is recklessly spent in impulsive consequences. Timing optimism is another purchases.
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