Behavioral Finance

In traditional finance, people make decisions by maximizing a utility function in which all the available information and preference are already included and weighted appropriately. “Efficient Market Hypothesis (EMH)” says that all available information already reflects the stock price which will help the rational investor to make decision based on risk and return. However, investors will not always process the information correctly as they have behavioural biases that causes them to act irrationally.

Breakthrough in behavioural finance is something that has resulted in a change in the way the investor think about traditional finance in order to regain and sustain the profit. The first major that have significant breakthroughs in behavioural finance is gender. Each gender tends to have different vitality on making decision. When making decision, men usually are quick in making conclusion while women tend to take time to explore all the various aspects of the problem which are too slow towards the action.

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Based on study of “Gender Differences in Decision Making When Faced with Multiple Options by Kallie Reiter”, this experiment is to observe how female and male student take time to make decision when making a selection of food in their own campus cafeteria or opposite cafeteria. From this research, men make decision pretty quick and efficiently while women takes a longer time and prefer to explore all the different outcomes and possibilities in each situation.

Based on journal “Gender Differences in Risk Behaviour in Financial Decision Making” we can conclude that there is gender difference in risk behaviour relevant to the making decision as women had lower risk preference, more cautious and less confidence in making decisions compared to men. This is because in traits theory, men tend to have more experience and stronger role identification. Women usually tend to describe “risk” before making decision as women looked for visual patterns, consistent while men usually looked on numerical information which is the return.

As a conclusion, women is more conservatism when react to the information and belief as well as when address to the risk where women have a lower preference for risk than males especially when tasks are framed in term of “risky losses vs risky gains”. This will lead others investor exploit the opportunity if the women’s investor taking a longer time in making decision or if the prediction on risky losses is not accurate. Research has shown that, emotion can fundamentally change the way decisions are evaluated and the success depends on how investor overcome and interpret it.

Investor who experience negative emotions tend to not making a precise decision as negative emotions response in a simple and quick way which does not involve lots of cognition. Based on “The effect of affect: Decision Making in the Emotional Context of Healthcare by Marc L. Resnick”, all negative information cause a narrowing attention and could also increase the chance of error. Negative information are more related towards sadness and anger. Anger can lead to higher risk tolerance while, sadness is linked to a failure which will lead to conservative decisions.

For example, when investors making a decision whether to invest in the Company Z who have already making loss for the first time, its give an alert to the investor to further evaluate the company’s performance. Investor tend to blame themselves for the loss incurred which fall under the regret avoidance and there’s a probability for investor might not conclude the deal again with the Company Z. There’s also probability for the Company Z to gain profit in future as well , therefore investor should not playing with the negative emotion since there is also opportunity in market.

Meanwhile, positive emotional system can give an advantage in decision making as its increase the creativity, flexibility and efficiency. Positive emotion give confidence about the future or successful outcome and decrease the risk perception. As a conclusion, positive and negative emotions can have an unconscious but also a powerful impact on the decision making. Subsequently, the attractiveness of the choice has been major contributions in changing the way of the rational decision made.

Based on “Effects of the “What is Beautiful is good” Stereotype on Perceived Trustworthiness by Erin Shinners” the results indicated that attractiveness individuals were seen as more trustworthy rather than unattractive individuals. Attractiveness can be explained by “halo effect” as people have tendency for a single attributed perception. This “halo effect” leads to systematic human perceptual biases, inaccurate judgemental and attribution errors since the attractiveness cannot be measure as well as can be manipulated. In this study, people believe attractive people are more likely to possess all the good quality.

For example, during the interview session, a good grooming of applicants tends to have high probability in hiring even though the interviewer claimed that appearance just played a small role in their choices thus the influences on attractiveness on a certain choice is a clear example of bias. Additional to the traditional finance, it can be conclude, too much weight placed on recent experience or certain unphysical information will lead to forecasting errors. Investor also should not make a quick decision or judgement based on the unphysical information as the information might be wrong and lead to behavioural biases.

Based on “Positive Illusions and Forecasting Errors in Mutual fund Investment Decisions”, Investor tends to switch their funds that have recently performed poorly. Attractiveness can be defined when investor has the ability to pick investments that will deliver higher returns rather than dart-throwers. Mutual funds has performed very well in past, however majority of mutual funds investor has to pay management fees to fund manager who select investments that underperform in market which lead to unattractive investment. This encourages investor to switch to other investment which is more attractive and promising.

Positive illusions can be illustrated by the tendency of investors who see themselves as more intelligence in forecasting the outcomes which contribute towards the unrealistic optimism concerning future events. If the fund is successful in the past, investor has a propensity to forecast that it will continue generated profit in future. However, the market can be irrational where stocks that have performed well in the past can be likely underperform in future and stocks that have performed poorly in past can be outperform in future.

Therefore, infer a pattern or trend from past experience may cause the investor to overestimate their precision of their forecasting without referring to the empirical data. In addition, knowledge is also one of the reason that influence decision making. Knowledge can be gained through analyst option, training, reports or internet. The illusion of knowledge is behaviour that leads directly to overconfidence where there is tendency to believe that with the expertise in a certain area may contribute to greater accuracy in decision making.

According to “Bruin et al. 2007” people who have less knowledge tend to focus more on past experience which are more at risk to experience negative life events as they make poor decision. In “Journal of Finance, Haigh and List (2005)” the study shows traders exhibited more myopic risk aversion than students. The professionals were more confident than beginners in concluding the decision as they have a higher expertise in investment area. Its shows that the beginner’s idea is not important as they have less knowledge.

Therefore, its biases clearly project that experience does not always produce expertise. Referring only to the past event will result in false decision as market can be irrational. Having knowledge in finance academics leads the investor to be more experience with lots of scenario and be able to predict future more accurately with clearer casual interpretation. However, they will become more and more problem during the technology era as online trading have publicly exposed to the public investor.

Overconfidence in making decision lead to poor investment since the investors tend to believe their decisions will always project income and therefore, investors tend to forgone the possibility of losses. Lastly, belief in personal relevance also resulted in a change in the way traditional finance work. Investor’s hold or trust on something that have tendency to make conclusions due to believable rather than logically valid. Based on “Danna Torrens, 1999”, magnitude of belief bias effect can be predicted based on the number of models that reasoners were able to generate.

In this study, people who generated fewer alternatives were more biased by beliefs rather than people who generated more alternatives. It happens due to the reasoners fail to consider others alternatives. Switching from low risk to the high risk could not attribute to the beliefs but related to changes in preference. Beliefs is more related on something that investor hold such as beliefs in the propensity to take risks will increase the positive outcomes affect and decrease the outcomes by the negative affect.

Beliefs are generated by past experience therefore, belief in each investor will be different. A decision made through beliefs is when the new information matches with the investor’s belief and goals. Any beliefs that matches with the new information may contribute to the satisfaction level and boost up the confident in identify the alternatives or available investment options that project more attractive return whereas if the information does not match, people will ignore about the investment options and tend to follow the belief that investors hold.

Based on the experiment “The Influence of Effect on Beliefs, Preference and Financial Decision”, investor who choose and beliefs that certain investment types will bring the investment more attractive after the choice has been made eventhough the outcomes still uncertainty. As investor hold their beliefs, they tend to ignore information that is not attractive with their choice which leads to poor investment decisions. Beliefs however, do not always project the result correctly, therefore, it can turns out to be a good investment or bad investment.

As a conclusion, people need to make decisions whether big or small in a rational way so that investor will not experience any losses. Each of the breakthroughs plays a significant role in how the investor perceive the nature of a decision with the available options. Regardless of how mature an investor, investor tend to deal with behavioural biases that cause them to make irrational decision. Emotion, gender, beliefs, attractiveness as well as knowledge are the most significant breakthrough in behavioural finance.