The dissertation aims to examine some significant features of behavioural finance that influence making of investment decisions by individuals in their private and official capacities.
The practice of buying shares or investing in businesses is centuries old and goes back to historic times. The growth of stock markets, which provides investment opportunities to people across the globe, is however a modern development that commenced in the 18th century and grew manifold over the course of the last fifty years. Investing in stocks and shares was and continues to be perceived by many people to be a risky activity because of the unpredictable and volatile nature of stock markets.
Whilst stock markets have gone through numerous cycles of booms and busts, investor enthusiasm continues to be high and bounces back soon after every market debacle. Experts like Fama and Miller and Modigliani have studied stock market behaviour in detail, their work leading to the development of important theories like the Efficient Markets Hypothesis that attempt to influence stock market behaviour in different conditions.
The EMH, whilst a defining theory of standard finance, has attracted much debate and experts have pointed out how stock market behaviour often does not adhering to its tenets. Such experts also argue that Fama's hypothesis does not explain why investors do not often behave rationally, even when they have knowledge of market information. Such behaviour results in illogical investment actions and in the behaviour of stock markets in ways opposed to EMH tenets. Behavioural finance attempts to investigate the behaviour of investors and financial decision making through application psychology. Behavioural finance is a subjective and interpretative theory that provides a counterpoint to the efficient markets hypothesis and attempts to understand the reasons behind illogical actions of otherwise well informed individuals when called upon to make investment decisions.
This dissertation examines the ways in which otherwise intelligent and informed individuals make illogical investment decisions that lead to economic losses. It specifically investigates how different types of social biases influence people to take investment decisions without appropriate research and thought. The investigation falls under the broad ambit of social research and is conducted with the help of qualitative and interpretative methods with the help of secondary information obtained through library research techniques.
1. Introduction
1.1. Overview
The practice of buying shares, or investing in business ventures through partial ownership is not exactly new and dates back to ancient Rome, where private businesses, recognised as publicani sold shares in order to generate capital (Slovic, 1972, p 779).
Whilst the desire for individuals to increase their wealth through appropriate investments has existed for centuries, the emergence of stock markets as an investment opportunity for millions of people around the globe is a modern phenomenon that emerged with the Industrial Revolution and grew progressively over the course of the 20th century (Mayer, 2008, p 617). Global stock markets, which are estimated to be worth more than USD 36 trillion, provide opportunities to invest in a range of instruments to millions of individual and institutional investors in order to add to their wealth (Mayer, 2008, p 617).
Such investments in stock markets were and to some extent are still perceived by many to be risk prone because of the unpredictable and volatile movement of shares and could easily lead to substantial losses. The stock market crash of the 1930s, when the Dow reached its lowest level of the 20th century, and the Great Depression, still brings about involuntary shudders among contemporary investors. Investor enthusiasm, it is however seen, strangely bounces back after the worst of stock market crashes and exists despite stock market volatility (Olsen, 1998, p 11). Experts have over the years studied the movements of stock markets and the behaviour of investors in detail. Eugene Fama developed the Efficient Markets Hypothesis (EMH) in 1970, a defining work that has ever since been used to explain the behaviour of stocks under different conditions. Fama's hypothesis on the behaviour of stock markets is grounded on the concept of investor rationality and essentially states that markets will behave in a random manner when investors are rational and information is freely available (Fairchild, 2004, p 7).
The EMH, whilst continuing to be a defining theory in stock market behaviour, has attracted much debate and critique, with experts pointing out numerous instances of stock market behaviour not adhering to its tenets. Contemporary behavioural experts state that Fama's hypothesis disregards the fact that investors, even when they have full access to market information, often do not behave rationally. Debont 1998 Such irrationality in behaviour leads to two different results, (a) investment actions in ways that are not logical and rational, and (b) the behaviour of stock markets in ways that contradict the EMH.
Behavioural finance theories attempt to investigate and analyse (a) the behaviour of financial practitioners, and (b) financial decision making through the application of psychology. Such theories argue that some financial phenomena can possibly be better understood with the use of models, wherein some agents are not completely rational (Baker & Nofsinger, 2002, p 97).
1.2. Definition of Problem
Whilst the EFM theory is extensively used by financial academics to explain the behaviour of stock markets, the numerous instances where stock markets have shown contrarian tendencies are leading to doubts, discussion and criticism on its basic assumption, namely the rationality of financial investors and practitioners (Bondt, et al, 2008, p 7). Most humans, including those who engage in financial investments, are not constantly rational in their decisions. Such irrationality often results in stock market developments like booms and busts, as well as in patently incorrect individual investment decisions that result in financial losses and economic distress (Baker & Nofsinger, 2002, p 97).
1.3. Aims and Objectives
The dissertation aims to investigate important aspects of behavioural finance that have significant bearing on the making of investment decisions in share markets.
The objectives of the dissertation are as under:
To examine the role of various aspects of human behaviour in making of investment decisions
To examine the ways in which such human behaviour can affect logical and rational investment decisions
To particularly examine how different social biases can adversely influence investment decisions
To recommend ways and means to overcome the influence of such biases for improvement of investment decisions
1.4. Purpose
This dissertation proposes to examine the ways in which individuals, who otherwise believe in their capacities of information assimilation and analysis, logic, and rationality make illogical decisions that lead to economic losses. It specifically examines how ingrained social biases lead people in their personal and official capacities to take wrong decisions. Such analysis should help readers, students of investment management and serious financial investors to examine and assess their own decision making systems and provide them with a theoretical framework as well as ways and means to locate the causes for illogical behaviour, control their actions and reduce mistakes that could lead to significant economic losses.
2. Research Method
The research method used for this dissertation begins with the framing of the research questions, which is then followed by an analysis of different research approaches and information sources, choice of research method and sources of information and a detailing of the ethical approach
2.1. Framing of Research Questions
The research questions for this dissertation aim to conduct the investigation in order to fulfil its stated purpose and are framed in accordance with its aims and objectives. The research questions are detailed as under:
Research Question 1
What is the role of human behaviour in the making of investment decisions?
Research Question 2
How does human behaviour affect the use of logic and reason in the making of investment decisions?
Research Question 3
How can social biases affect human behaviour and adversely influence investment decisions?
Research Question 4
How can individuals overcome the influence of such biases and improve their investment decisions?
2.2. Research Methodology
Research for the purpose of this dissertation comes under the broad ambit of social research. Social Research attempts to add to knowledge about social phenomena and society through the use of deliberately chosen and clearly defined methods for investigation and analysis (Bryman, 2004, p 78). Its main objects are to study social life, develop knowledge, clarify facts, predict human behaviour and help in improvement of human welfare (Bryman, 2004, p 78).
Social research is guided by positivist and interpretivist epistemologies. Positivist research combines deductive reasoning with accurate measurement of quantitative data in order to facilitate discovery and verification of laws for prediction of human behaviour (Bryman, 2004, p 78). Positivism shapes reality to be objective and free of opinion, bias or prejudice, and states that nature has one reality. The main objective of social research, with a positivist approach, is to elucidate social life and predict future events. The epistemological aspect of positivism perceives human behaviour to be patterned, methodical and comparatively stable (Bryman, 2004, p 78). Positivism has inspired the majority of prevalent social research methods, including the use questionnaires, surveys and statistical models, as well as large-scale sample surveys and experiments under controlled conditions (Bryman, 2004, p 78). These quantitative methods allow researchers to employ logical empirical and quantitative data in order to analyse issues and arrive at findings. Quantitative methods utilise facts, numerical data and universal laws for research (Bryman, 2004, p 78).
The use positivism in social research has often been criticised because quantitative methods are considered by many to be inappropriate for research of humans (Gomm, 2008, p 16). With individual being relegated to system outcomes rather than thinking and acting individuals, quantitative methods are felt to be flawed for excluding fundamental characteristics of social life and behaviour that cannot be predicted or assessed with numbers or universal laws (Gomm, 2008, p 16). With humans being acting individuals with individual perceptions and wishes, the nomological regularity of positivist research is felt to be inappropriate for social research. Whilst the application of quantitative methods is felt to be more relevant for the physical and not the social domain, its popularity, as social methodology, continues (Gomm, 2008, p 16).
The interpretivist methodology contradicts the strident claims of positivism and understands that humans cannot know the world independently of their minds (Maxwell, 2004, p 57). Interpretivism shapes reality to be subjective and connected to persona, emotions, prejudices and bias. It aims in social research to interpret and comprehend social life and to discover multiple layers of meaning in human action (Maxwell, 2004, p 57). Interpretivism uses qualitative methods, which aim to understand and not to measure people. It attempts to capture reality in interaction. Whilst qualitative methodology does not use quantitative measures or variables, it aims to understand issues and subjects through deep study and long and in-depth interviews (Maxwell, 2004, p 57). Whilst qualitative research satisfies many objectives of social research, it has several weaknesses. Qualitative research is time consuming and can lead to problems of reliability because of the subjectivity of the researcher and ethical issues like privacy (Maxwell, 2004, p 57).
Research Methodology also includes the examination and determination of information sources. Information for research broadly consists of two types, namely primary and secondary sources of information (Powell, 2007, p 34). Primary sources of information are created by the subjects under investigation and at the time of occurrence of events under enquiry. Such sources provide direct information that has not been altered or reinterpreted. They are by and large original and previously unpublished material (Powell, 2007, p 34). Primary information is obtained from direct interviews or from organisational papers or websites. Interviews given by subjects of study to reputable publications are also considered to be primary information sources (Powell, 2007, p 34).
Secondary information sources are prepared by people who are not connected with the research issues and are removed from events to which they relate. They provide analysed and interpreted information and are mostly available from existing publications (Gomm, 2008, p 16).
2.3. Choice of Research Method
This dissertation concerns the application of psychology to the behaviour of stock market participants and investors. Behavioural finance is essentially a subjective and interpretative issue. It provides a strong and valid counterpoint to the logic and rationality of the efficient markets hypothesis and attempts to understand the reasons behind the illogical and irrational actions of well informed and otherwise individuals when called upon to make investment decisions.
The adopted research method will necessarily have to be interpretative in nature and will use qualitative methods of analysis.
2.4. Choice of Sources of Information
The dissertation will be conducted with secondary sources of information through the use of library research. The subject is too complex for useful results to be obtained through primary interviews with a few investors in order to assess the motivating factors, including social biases, for their investment actions. There is a significant body of literature on behavioural finance and its review and investigation is expected to contribute significantly to relevant information on the research issue.
2.5. Ethics
Care has been taken to ensure adherence to the ethical norms of social research. The elimination of the process of obtaining information through interviews with respondents reduces ethical requirements significantly with respect to ensuring of privacy and the rights of participants in primary research to answer or not to answer questions (Powell, 2007, p 34). Care has however been taken to ensure appropriate acknowledgement of all information sources through in-text citations and listing of all information sources in the bibliography of this dissertation.
3. Literature Review
The main objective of engaging in investments is to make money and grow individually and institutional wealth. Investments in the past were essentially based on available knowledge about commercial organisations and tools like forecasting and market timing (Constantinides, et al, 2003, p 84). Such approaches however by and large produced very common place returns, living the investors with little wealth and a great deal of frustration. With the gap between available and actual returns being substantial, investors were forced to search for reasons for such dismal results (Constantinides, et al, 2003, p 84). Investigation into decision making processes led to the recognition of the occurrence of significant mistakes in decision making that came about mainly on account of irrational and illogical actions. Researchers commenced examination of the area of behavioural finance in order to understand and realise the psychological processes behind such errors (Constantinides, et al, 2003, p 84).
Whilst many investors have for long agreed on the important role of psychology in determining investor and market behaviour, formal studies in behavioural finance have occurred only recently, pioneered by papers by experts like Paul Slovic, Amos Tversky and Danile Kahneman on issues like individual misperceptions about risk and heuristic driven decision frames and decision biases. Whilst Lintner, (1998, p 7) describes behavioural finance to be "the study of how humans interpret and act on information to make informed investment decisions", others like Olsen (1998, p 10), feels that "behavioural finance seeks to understand and predict systematic financial market implications of psychological decision processes". It is important to understand that behavioural finance at this point of time does not have a unified theory. This literature review attempts through the investigation and examination of important publications on the subject, the ways in which psychological processes and social biases affect the investment decisions of individuals in their personal and organisational capacities. The works of a range of well known subject experts have been considered for this review. Care has been taken to ensure the inclusion of earlier seminal writings as well as recent publications. Individual aspects of behavioural finance, with specific regard to the specific issues under investigation have been taken up sequentially in order to build a cohesive and appropriately structured review.
3.1. Standard Finance and Behavioural Finance
Standard Finance represents the body of knowledge that is constructed on theories like the arbitrage principles advanced by Miller and Modigliani, portfolio principles formulated by Markowitz, the option pricing theory and the capital asset pricing theory (Downes & Goodman, 1998, p 142). These approaches are analytical and normative and essentially consider markets to be efficient. Modern financial theory works on assumptions that representative market actors are rational in two ways, namely (a) they make their decisions on the principles of expected utility theory and make unbiased future forecasts (Downes & Goodman, 1998, p 142). The expected utility theory states that persons are risk averse and the marginal utility of wealth diminishes. With asset prices being set by rational investors, market equilibrium is achieved on the basis of rationality (Downes & Goodman, 1998, p 142). The EMH argues that existing financial prices incorporate all accessible information and that prices can at all times be considered to be representative of true investment value. With people expected to behave rationally, process all available information and maximise expected utility accurately, price changes occur only on account of genuinely new information and for this reason are unpredictable (Downes & Goodman, 1998, p 142). With all information being contained in existing stock prices, it becomes impossible to make above average profits without taking excess risk (Downes & Goodman, 1998, p 142).
Behavioural finance is a recently developed financial paradigm that seeks to supplement standard financial theories through the introduction of behavioural features in decision making processes (Chan, et al, 2003, p 12). It attempts to realise and predict market implications of decision processes that are psychological in nature. It also includes the application of economic and psychological principles for enhancement of making of financial and investment decisions (Chan, et al, 2003, p 12). Market efficiency is being challenged by behavioural finance. A number of studies in the area point out market anomalies that cannot be comprehensively explained with standard financial theories. Such anomalies for example include abnormal movements related to stock splits, spinoffs, IPO's and mergers (Bondt, et al, 2008, p 7). Investors, such studies reveal do not react rationally to new information but alter their choices in the face of superficial alterations in presentation of information about investments. Biased media assessments are found to have led investors to making inappropriate investment decisions (Bondt, et al, 2008, p 7).
The fundamental principles of behavioural finance and their implications are presented in the next section.
3.2. Principles and Implications of Behavioural Finance
3.2.1. Heuristic Decision Process
Heuristic decision processes involve investors finding things out on their own, usually by trial and error and result in development of rules of thumb, which humans utilise to make decisions in uncertain and complex environments (Mukherji, et al, 2008, p 240). The uses of these processes imply that whilst investors collect relevant information and objectively evaluate them, it is difficult for them to eliminate mental and emotional factors (Mukherji, et al, 2008, p 240). Whilst the involvement of such factors may sometimes be good, it can often result in poor decision outcomes. Heuristic decision processes include (a) representativeness, (b) over confidence, (c) anchoring, (d) gamblers fallacy and (e) availability bias (Mukherji, et al, 2008, p 240).
Representativeness represents the tendency of investors to feel that their recent success will continue into the future. The tendency of investors to make decisions on the basis of past experiences is termed stereotype. Debont (1998, p 831), feels that stereotype decisions are based on analyses that are biased by recent successes or failures with regard to earnings forecasts.
Overconfidence has several dimensions. It provides investors with courage, which is often perceived to be important for success (Malmendier & Tate, 2005, p 651). Confidence is however not the only criteria for success and many investors who are analytical and cautious have been known to have achieved success, even as others have had to withdraw. Whilst self confidence is often perceived positively, investors are known to overestimate their predictive skills or their market knowledge, which often results in excessive training (Malmendier & Tate, 2005, p 651).
Anchoring describes the very common human tendency to rely on one piece of information during the making of decisions. Investors tend to be rather slow to change, when presented with fresh information, and their value scaled is anchored or fixed by recent observations (Langer, & Weber, 2004, p 31). Investors expect future earnings trends to conform to historical trends, which may possibly lead to under reaction to trend changes. Gamblers fallacy arises when investors inappropriately predict that trends will reverse (Langer, & Weber, 2004, p 31). Availability bias represents the tendency of investors to give undue emphasis to available information for making of decisions. This is a very common phenomenon and often leads to lesser results and poorer earnings (Langer, & Weber, 2004, p 31).
3.2.2. Prospect Theory
The prospect theory, developed by Kahneman and Tversky, concerns illusions and states of mind that can influence decision making, the key concepts of prospect theory are (a) loss aversion, (b) regret aversion, (c) mental accounting and (d) self control. Loss aversion represents a psychological concept, wherein investors are considered to be risk seekers, when they are faced with the prospects of financial or economic losses, even as such investors are risk averse when confronted with the prospects of obtaining gains (Barberis, et al, 2001, p 4). Investors characteristically hold on to loosing scripts but are apt to dispose of gaining scripts with comparable alacrity. Regret aversion arises from the desire of investors to avoid the pain of regret that can arise from poor investment decisions (Barberis, et al, 2001, p 4). Such aversion encourages them to continue to hold poorly performing shares because the avoidance of sale also leads to avoidance of recognition of associated losses and bad investment decisions. Such regret aversion results in the creation of tax inefficient investment strategies because appropriate realisation of capital losses can help investors in reducing their tax burden (Barberis, et al, 2001, p 4).
Mental accounting represents a set of cognitive operations that is used by investors for the organisation, evaluation and monitoring of investment accounting. Mental accounting has three important components. The first captures the ways in which (a) outcomes are viewed and experienced and (b) decisions are taken and evaluated. The second component involves assignment of actions to particular accounts (Barberis, et al, 2001, p 4). Both sources and utilisation of funds are labelled in both real and mental accounting systems. The third component concerns the frequency of evaluation and bracketing of choice. With each component of mental accounting violating economic principles of fungibility, mental accounting can influence choice. Self control requires investors to avoid losses and protect investments (Barberis, et al, 2001, p 4). Thaler and Shefrin (1981, p 392), state that investors are subject to various types of temptation, even as they seek tools to enhance self control. The mental separation of financial resources into different tools for use for different types of goods can for example help investors to improve their self control.
3.3. Social Biases in Behavioural Finance
Psychological research indicates that decision making, including decision making for investments is often influenced by biases (Baker & Nofsinger, 2002, p 97). Such biases can be individual, social or both in nature. Individual biases are an outcome of the socialisation processes of individuals and essentially stem from personal preferences, likes and dislikes towards specific issues or events (Baker & Nofsinger, 2002, p 97). Social biases on the other hand are essentially outcomes of the influence of cultures and societies on the decision making processes of individuals. With individual biases also being largely influenced by social and cultural issues over the lifetimes of individuals, it is common for individual and social biases to reinforce each other and strongly influence individual decision making processes (Baker & Nofsinger, 2002, p 97). It is proposed to examine and analyse different types of biases that are essentially social in nature, as well as their influence on decision making processes. Such biases have significant implications for decisions on the wisdom of investments in stock market instruments, as well as the nature and extent of such investments (Baker & Nofsinger, 2002, p 97). Such biases can certainly cause investors to engage in poor decisions or investment advisors to give inappropriate advice (Baker & Nofsinger, 2002, p 97).
3.3.1. The Social Dimension
Schachter, et al, (1987, p 259) examined the extent to which persons depend on the opinions and actions of others to make their own decisions. Social influence is felt to be strongest either in uncertain circumstances or in situations where self confidence is low. Such influence is also substantial when situations alter substantially and increase even as it is demonstrated that previously held views are incorrect (Barber & Odean, 2001, p 261). Experiments have been conducted to show that people displayed tendencies to follow others despite their feeling that the others were wrong. Such tendencies are known as conformity and express themselves, in investment decisions in the herding effect (Barber & Odean, 2001, p 261). The herding effect is one of the most common phenomena in stock market investments and occurs when investors tend to follow the actions of the crowd and depend on the direction of the crowd to take their own decisions. Such herding leads to frenzied buying and unfounded stock market booms like the famous Dot Com boom of the late 1990s. Hordes of investors followed the direction of the crown and invested in technology start ups without any rational investigation and assessment of the actual prospects of these Dot Com companies. The Dot Com bust that occurred shortly thereafter resulted in losses of millions of dollars to the members of this horde. The horde effect can also result in panic selling on the basis of rumours and inaccurate media reports, which can in turn result in significant losses to such investors (Barber & Odean, 2001, p 261). Hong, et al, (2004, p 138) found that US households that were social in nature and where the members interacted with their neighbours were much more likely to engage in stock market investments than non social households. Members of social households obtained information and formed opinions through talking with others and consequently became more interested in learning and investing than socially inactive households. Shiller and Pound, (p 47) found in the course of a 1989 study that investors pay more attention to stocks when other persons have talked about it and are also likely to speak about a particular stock to other people after purchasing it.
3.3.2. Influence of Mood and Emotion
Social psychological experts like Loewenstein, et al, (2001, p 267) and Slovic, et al, (2002, p 330) have found that investment decisions can often be influenced by totally unrelated events and emotions. A favourable sports result, or even good news about family members and friends can lead to the engendering of positive feelings, which in turn can influence investment decisions. The impact of emotions also increases with the uncertainties and complexities that surround decisions. Difficult investment decisions are thus quiet likely to be influenced by unrelated emotions (Kavanagh & Bower, 1985, p 507).
Behavioural experts like Wright and Bower (1992) found that individuals experiencing good moods are likely to be more optimistic about future prospects than others. Nofsinger (2005) states that people in good moods will tend to be more optimistic in their evaluation of investments and will be more apt to make risky investments than others.
Weather conditions and day light lengths can also affect the moods of people. Hirshleifer and Shumway (2003, p 1009) studied the impact of sunshine on stock market activity. They found that people feel good when the sun shines, which in turn can enhance optimism and influence investment decisions. With investors being more apt to purchase shares in sunny conditions, such purchases should lead to increases in stock prices. An investigation into the movement of stock prices in 26 cities revealed that price increases were significantly higher on sunny days. Kamstra, et al, (2003, p 324) investigated the relationship between daylight hours and stock market returns. Their studies revealed that stock markets performed comparatively poorly when daylight hours reduced during autumn and winter, particularly in the northern stock markets. Studies also found that such reduction in stock market performance occurred from October to December in the north and from April to June in the South. The finding of the study strongly supports the contention that sunlight enhances optimism and stock market returns.
Nofsinger, (2005, p 67) states that the transmission of moods, through social contact can lead to the formation of a social or collective mood, that can influence individual decisions and lead to the emergence of trends. Moods can at times dominate logic and reason in the making of decisions. Yuen and Lee (2003, p 17) found that depressed people are unwilling to take risks even as Kavanagh, et al, (1985, p 510) found that negative moods were associated with desires for safety and assert preservation. Both the Horde mentality and social mentality are said to be responsible for the tendency of people to buy when markets have risen and sell after their fall. Whilst common investment logic calls for buying of shares when markets are low and selling when they are high, actual investment decisions of the majority of people are often the opposite and lead to economic losses and sub optimal returns.
3.3.3. Role of Gender in Investment Decisions
A number of studies have examined the relationship between genders investment behaviour. Barber and Odean (2001, p 264) concluded in the course of an important and comprehensive study that men are more prone to overconfidence than women as a social group and this is reflected in their trading behaviour. The researchers found that men trading 45% more on average than women and that single men traded 67% more than such women. The study took place over six years and is regarded as a comprehensive treatise on the differences between men and women with regard to investment decisions. A further study by Pompian and Longo (2004, p 9) also provided some very revealing results. The researchers found that women, along with introverts and intutitives tolerate much lesser risk than their gender and type counterparts.
Empirical investigation on risk taking differences on account of gender specifically points towards lesser risk taking by women compared to men. Studies by Langer and Weber (2004, p 39) and Dreber and Hoffman (2007, p 76) corroborate that women tend to make smaller investments than men and appear to be more risk averse in their financial and investment decisions. Olsen and Cox (2001, p 30) also found that both male and female professional investors appeared to agree that women were less confident than men despite having similar experience and expertise. The researchers found that female financial professionals appear to be more risk averse than males and had greater tendencies not only to reduce risks but also to perceive investment as a risk.
4. Analysis
The detailed study of available literature, including theories as well as recent studies on the subject has resulted in the generation of a significant amount of relevant information. Such information is taken up for detailed analysis in this section. The analysis is conducted separately for each of the individual research questions in order to satisfy the objectives of the dissertation appropriately.
Research Question 1: What is the role of human behaviour in the making of investment decisions?
Individuals engage in investment activities in different areas for a variety of reasons. Whilst individuals engage in investments in their personal capacities in order to satisfy their needs of security and growth of personal wealth, their investment activities on behalf of their organisations are essentially ruled by organisational objectives.
With investments essentially being made to realise specific objectives, both in individual and organisational areas, they should essentially be shaped by logic and rationality. Individuals who invest for safety and security should thus invest in safe investments with average potential for return. Individuals seeking to grow their wealth should on the other hand take on some element of risk in investment decisions in order to achieve higher than average returns. Similar considerations should also apply in the taking of investment decisions in their organisational capacities.
Behavioural finance studies however reveal that individuals are influenced by a number of factors other than logic and reason. Such factors influence their investing behaviour and affect the quality of their investment decisions.
Research Question 2: How does human behaviour affect the use of logic and reason in the making of investment decisions?
Human behaviour is affected by a number of personal, collective and social factors. Such behaviour is often affected in the first place by personality traits like over level of confidence, the tendency for taking hasty decisions, tendencies to relate to immediately preceding events, optimism and pessimism, and even mood swings in response to environmental conditions like sunlight, warmth and cold. Tendencies for loss aversion and risk influence individuals to continue to hold on to loss making shares and dispose of profit making investments faster than warranted.
Individual behaviour is also often influenced by the opinions of groups on specific issues. Social factors like the herding effect, degree of sociability, social events like sports or news about families and friends and even gender can affect human behaviour. Such forces can strongly influence individual behaviour in the making of investment decisions and can play an active role in the buying and selling of investment instruments as well as other assets. Such forces can for example influence people to buy when shares have already risen to high levels and sell when their prices have fallen significantly. They can influence people to buy or not to buy shares of specific sectors or specific companies without appropriate investigation and research.
Research Question 3: How can social biases affect human behaviour and adversely influence investment decisions?
Social biases can come about on account of many reasons and are known to influence the behaviour of humans in various ways. Such biases can in the first place arise because individuals often tend to follow the direction taken by the majority of people even though they may know that such decisions are not necessarily right. . Social biases cause individuals to short circuit their research and reasoning activities and engage in heuristic processes for arriving at investment decisions.
Investors thus often go along with the tide and unwittingly give rise to the development of unwarranted booms and busts in the stock market. They buy when everybody is buying and sell when everybody is selling and in the process go against investment logic and suffer economic losses. Gender differences cause investment biases, with women as a group known to be less confident than men in their investment decisions. Whilst this results in lesser losses, it also deprives them of exploiting good investment opportunities.
Issues like weather and sunlight, which are known to influence general mood and emotions of populations shape investment sentiment, with individuals reducing their investment activity during very cold weather and during periods of lesser daylight.
Research Question 4: How can individuals overcome the influence of such biases and improve their investment decisions?
Individuals engaging in investment activity should be able to control the emergence of heuristic decision making processes and control the influence of moods, emotions and social factors by increasing their knowledge of behavioural and psychological processes and mechanisms. Greater education of behavioural finance issues and their implications on investment decisions can certainly help investors in recognising their weaknesses and proclivities and take proactive steps to increase their rational and logical thinking in making of investment decisions.
Greater stress on behavioural finance issues by investment advisers and in investment courses should also help investors in recognising such influences and in mentally overcoming them.
5. Conclusions
This dissertation examines the ways in which logical, rational and informed individuals make illogical investment decisions that could and sometimes do lead to economic losses. It specifically examines how social biases lead people to take investment decisions without adequate study and thought.
Standard Finance represents the body of knowledge built on theories like the arbitrage principles advanced by Miller and Modigliani, portfolio principles formulated by Markowitz, the option pricing theory and the capital asset pricing theory. These approaches are analytical and normative and essentially consider markets to be efficient. The EMH argues that as people are expected to behave rationally, process available information and maximise expected utility, price changes in the stock market occur only because of new information and are thus unpredictable
Behavioural finance is a contemporary financial paradigm that seeks to add to standard financial theories through the study of behavioural features in decision making processes. It challenges the tenets of the EMH and argues that its tenets are often not substantiated by actual stock market behaviour on account of behavioural reasons and psychological reasons.
This dissertation comes under the broad ambit of social research. Social research is guided by positivist and interpretivist epistemologies. Positivism shapes reality to be objective and free of opinion, bias or prejudice, and states that nature has one reality. The interpretivist methodology contradicts the claims of positivism and understands that humans cannot know the world independently of their existence. Interpretivism shapes reality to be subjective and connected to people, emotions, prejudices and bias. Behavioural finance is an interpretative issue and this study concerns the relevance of psychology to the behaviour of stock market investors. The adopted research method for this study is thus interpretative in nature and uses qualitative methods of analysis. The dissertation has been investigated with secondary sources of information through the use of library research.
The study of literature incorporated the study of a range of publications on behavioural finance including the reasons for individuals to engage in investment activity, heuristic decision processes, the prospect theory, and concepts like loss aversion, regret aversion, and mental accounting. The study revealed that decision making for investments is often influenced by biases that can be individual, social or both in nature. Social influence is felt to be strongest when circumstances are uncertain or where self confidence is low. Social influences very often lead to conformity and herd behaviour in investment decisions. Such herding leads to frenzied buying selling and results in unwarranted booms and busts.
The study also reveals that investment decisions are significantly influenced by unrelated factors like the gender of investors, the general mood of investors, the results of sports events, weather conditions and even hours of daily sunshine. Such factors cause significant changes in investment behaviour and can lead to wrong and irrational investment decisions with adverse outcomes. The researchers found that women, along with introverts and intutitives tolerate much lesser risk than their gender and type counterparts. It is important for investors to know about these influences, realise the possible impact of these influences on their behaviour and take proactive measures to overcome them.
Whilst the area of behavioural finance is witnessing a great deal of interest, much more research is needed in order to increase understanding and awareness about the subject. A focussed research study on the impact of social biases on investment with the use of both surveys and focus interviews of investors in the LSE could yield very useful and informative results.
