2.11 Behavioural Factors Influencing Investment
Decision-Making
It has been observed that the behaviour of investors is more
dynamic. This behaviour has been a call for concern for numerous researchers in
different backgrounds especially within the behavioural and social sciences.
However, while sociologists try to explain investors' behaviour by looking at
the impact of their social environment, psychologists concentrate on individual
characteristics of the investors and economists focus on the rationality and
irrationality of investors in the investment decision-making process. All these
are geared towards the point that, contrary to the classical finance school of
thought, investors are not economically rational and utility maximising.
Behavioural finance is defined by Lintner (1998) as:
«the study of how humans interpret and act on information to make
informed investment decisions? while Olsen (1998) on his part asserts that
`behavioural finance does not try to define rational? behaviour
or label decision making as biased or faulty; it seeks to understand and
predict systematic financial market implications of psychological decision
processes.»
Behavioural finance challenges most of the assumptions of the
EMH. It shows that human decision- making process is subject to a number of
factors. The behavioural finance scholars use the findings of the so-called
Psychology of Choice and Judgement which is considered by them to be the first
pillar of the Behavioural Decision Theory. The heuristic factors (the
most important findings of the Psychology of Choice and Judgement) claim that
the decision making process is not always strictly rational. Here, when all
relevant information is collected
and objectively evaluated, the decision maker tries to take
shortcuts. Heuristics can therefore be viewed as rules of
thumb where decisions are made in situations involving high degree of risk
and uncertainty. These shortcuts are mostly derived from some past experiences
and they most of the time lead to wrong directions and poor decisions being
arrived at. This is because, in trying to adopt these shortcuts in the
decision-making process, relevant facts which should normally be included are
being ignored. Typical examples of illusions resulted from the use of
heuristics in the decision-making processes include
overconfidence, gambler?s fallacy and availability bias.
Overconfidence can be described as the belief in
oneself and one's abilities with full conviction. This has to do with the way
decision-makers believe in their predictive skills and abilities. In some
cases, it leads investors to overestimating their predictive skills thereby
conceiving the belief that they can `time' the market. The reasons for the
existence of overconfidence within experts in their decision-making
process include the failure to contemplate that human make mistakes, failure to
pay attention to how technology systems perform as a whole, failure to predict
how people response to safety procedures and the exhibition of
overconfidence in existing scientific knowledge. Investors turn to
exhibit to the heuristic of overconfidence when they consider
themselves not vulnerable to a specific risky activity.
Anchoring involves a decision making process of
thought. This is to say people solve problems by selecting an initial reference
point. This occurs when we create a value scale based on recent observations.
Once the reference point has been created, there is the tendency that we turn
to adjust to correct the solutions that differ from the initial conviction. The
anchoring bias is very complex because it is like an addiction so much
so that even when the individual realise that they are anchoring, they
will still find it hard to quite. Massimo (1994) summarises the whole
heuristic idea of anchoring in the following words:
«revising an intuitive, impulsive judgment will never
be sufficient to undo the original judgment completely. Consciously or
unconsciously, we always remain anchored to our original opinion, and we
correct that view only starting from the same opinion».
(p127).
Gambler?s fallacy occurs when an individual assumes
that a departure from what happened in the long term will be corrected in the
short term. Here, people turn to have every poor intuition about the behaviour
of random event thereby expecting a reversal of the event to occur more
frequently than it actually happened. Secondly, people always turn to have
strong reliance on the representativeness.
Availability bias is a human cognitive bias which
causes the individual to overestimate the probabilities of an event associated
with memorable occurrences. This causes people to base their judgement and
decisions on the most recent and meaningful event they can remember. A case in
point is one getting involved in a car accident in the course of the week. It
is obvious for the person to drive with some degree of care and caution for
some time. But with the passage of time, there is a likelihood that the
person's driving will go back to the original state. As a result of this
availability bias, investors turn to focus primarily on the short term
events relating to the immediate past and completely disregarding the long term
events. Unfortunately, availability bias can result in investors
developing a false sense of security as it can cause people to think that
events which have great media attention are more important and pertinent, which
is not always the case.
In addition to the above, sometimes in order to make some
investment decisions, these investors need to be risk-tolerant. The
prospect theory tries to explain how behavioural factors influence
risk-tolerance during the investment decision-making process. With the
prospect theory, value is assigned to gains and losses with the
weights of the decision being replaced by probabilities. This theory best
explains why investors are often more attached to
insurance and gambling. The theory came up with
the conclusion that investors usually weigh the probable outcomes when compared
with certain outcomes.
This prospect theory looks at different states of mind that
are expected to influence the individual in the decision-making process and
include concepts such as regret (emotional reaction worn by people
upon making a mistake), loss aversion (associating greater mental
penalty with loss) and mental accounting (attempting to arrange the
business into separate accounts).
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