Chapter-1 Introduction

Background

The goal of “behavioral finance” is to investigate how cultural norms and individual psychology impact economic behavior. The term “behavioral finance” refers to the study of the psychological and social influences on financial decisions. Because of the importance of behavioural elements in determining investors’ investment decisions, behavioral finance has become a crucial aspect of the development of return on investment (ROI) theories (Kanan, 2018).

Due to the merging of psychological and cognitive frameworks, “behavioral finance” is a relatively new field within the financial sector. The field of behavioral finance looks at the emotional and cognitive factors that influence financial decisions. The psychological, social, and cognitive theoretical intersections make investing a difficult and time-consuming endeavor (Kumari, 2015).

According to Sewell (2007), behavioral finance is the study of how the irrational decisions of investors and bankers impact international financial markets. He continued by saying that behavioral finance piques his interest since it may help to explain why certain markets are less efficient than others.

Behavioral Biases

(Agrawal, 2012) highlights the fact that investors’ decision-making has always been and always will be impacted by their own behavioral biases. Although it’s impossible for an investor to completely free oneself of biases, there are situations in which doing so is essential. (Rayenda Khresna Brahmana, 2012) reiterate the fact that irrational human psychology plays a role in stock price anomalies and economic decision making, and elaborate on the factors at play.

Heuristic Behavior

Due to the uncertainty and volatility of the market, investors are forced to make decisions via trial and error or by relying on accepted standards. The incorporation of cognitive and emotional components in evaluating investment possibilities may, however, remove rational behavior in the decision-making process.

(Kahneman D., 2003) defines decision-making is aided by heuristics, which are “cognitive shortcuts” or “rules of thumb” that reframe a complicated problem as a simpler one. Through trial and error or even just simple experiments, people create strategies for generating quick decisions and assessments. Heuristics are useful in certain contexts, but they are seldom the optimal approach when it comes to making financial choices since they overlook important details. Heuristics are susceptible to a variety of cognitive biases.

Representativeness

The financial market is rife with hasty assessments made by investors based on a small number of presumptions. The success of past financial decisions might lead investors to incorrectly infer a trend in the present and future. Investors are not placing wagers based on long-term trends or even considering the rule of averages. Short-term trends are given more weight, such as an increase in the price of a presently traded stock or an industry that has been exceeding the market averages recently. To ensure the smooth operation of completely rational markets, it is essential that previous stock price variations have no influence on the future performance of the stock in issue. (Jacob, 2017)

Adapting strategy based on investment returns If an investor’s earlier decisions were beneficial, that investor is more likely to make similar decisions in the future without giving much thought to the many uncertainty patterns that might have contributed to his or her success. This is the same as reaching conclusions with insufficient evidence. It is a type of representational bias on the part of investors to overreact and buy popular stocks despite their bad record. (Goyal, 2015).

Overconfidence

Adielyani and Mawardi (2020) stated that by considering their own investment portfolio and their own personal beliefs, as well as the results of the aforementioned study, an investor may be better able to make wise financial decisions. but (Rahman and Gan, 2020) argues that this bias has a negative effect on investment decisions by lowering returns, increasing the likelihood of making a poor investment choice, and decreasing portfolio diversification.

Gamblers Fallacy

Gamblers fallacy refers to the mistake made by investors who bet on a rapid reversal of the market’s present trend. Those involved are in a similar position to a gambler at a casino. A player at roulette can elect to bet on a red number if he or she detects that the die has been constantly landing on black numbers. Similarly, when allocating funds, it’s common to wager that a stock’s recent losing streak will end abruptly, allowing for a winning purchase. Investors lose money when they make decisions based on faulty predictions. However, when investors make accurate predictions, the returns may be substantial. (Bhattacharya, 2012)

Availability Bias

In order to execute trades with a lower anticipated rate of return, investors assign relative priority weights to different pieces of information before making decisions based on these weights, accepting the risk of suffering losses along with the potential for a lower expected rate of return. The ability of an event to influence thinking and action grows in proportion to its timeliness and relevance. (Qawi, 2010)

Conservatism

“Conservative bias” refers to the failure to adequately update one’s beliefs in light of fresh information. This indicates that people are slow to react to and adjust to new developments. Potentially risk-averse investors may be slow to respond to shifting market conditions because of their conservative nature. It’s possible for investors to misjudge the long-term average when they observe a long-term trend and overreact to it. (Singh S., 2012).

Role of Personality

We make decisions based in part on our personalities and our innate prejudices. Decision-makers seldom agree on a course of action when confronted with comparable situations because of their divergent personalities (Shanmugasundaram, 2011). A person’s evaluation, knowledge, and experience matter more than their personality attributes while making decisions.

Extroversion

When making investments, an extrovert is affected by things like what other people know about potential prospects. Extraverted people are more likely to place more stock in the judgments and views of others around them and less on their own abilities for introspective analysis. Extroverted individuals are more likely to make snap decisions because they live in the moment rather than according to a set of predetermined guidelines. Extroverts may suffer financial setbacks because they lack the self-control, intellect, and desire necessary to succeed in the investment world. (Rasoul, 2011)

Agreeableness

A person’s agreeableness may be measured by how much they value the input of others who have a personal stake in the outcomes of their decisions. In making judgments, he always prioritizes the needs of others around him, as seen by his candor and openness. The presence of these positive qualities is critical when selecting whether or not to invest in a business partnership. (Rasoul, 2011)

 Neuroticism

Investors who are prone to anxiety act according to their wants and requirements. They are so self-absorbed and focused on themselves that they never consider anybody else while making decisions. Those people are fully capable of acting independently of cultural pressures and making decisions based only on their own self-evaluations and self-interests. (Rasoul, 2011)

One’s Capacity to Gain Knowledge from Past Errors Investors who have a taste for risk tend to reap more rewards. Investors were enticed to put money into high-risk new businesses by the prospect of a substantial financial return on their investment. A person who is eager to learn and grow will always be on the lookout for fresh experiences. People with this outlook are involved in many different aspects of society, including the political, ideological, perceptual, cultural, and economic spheres, and as a consequence, they bring a variety of knowledge and experience from these areas to bear on the decisions they make in their daily lives. (Rasoul, 2011)

Feelings and Emotions

Emotions may have a big role in the decisions of investors, according to recent research. Moods integrate environmental factors like temperature, the body’s biorhythms, and sociocultural influences, and this translates into stock price swings. Emotional cues from the environment, such as the weather, the body’s biorhythms, and the social milieu, facilitate the best decision-making (Brian and Lucey, 2005).

Problem Statement

To what extend Heuristic Behavior, role of personality and feeling &emotions can influence the investment decisions making

Research objectives

The objective of this study is to critically analyze the behavioral finance Biases and its effect on investment decision-making. Specifically, this study investigates the impact of heuristics and Role of personality, feeling and emotion on investment decision

Research questions

• What is the influence of Heuristic Behavior on investment decision?
• What is the influence of Role of personality on investment decision?
• What is the influence of feeling and emotion on investment decision?

Significance

The Pakistan stock market is one of the most important emerging markets in Asia due to its high trading volume, and researchers hope that by identifying the most important behavioral finance factors that may affect their decisions when investing in stocks, they can help individual investors make better choices.

Chapter 2  

Literature Review and Theoretical Framework

While the focus of this literature review will be on behavioral finance and related topics, a solid understanding of the “Standard Finance” that paved the way for this area of research is nevertheless required. Those that invest in the market are assumed to be rational individuals, the market is assumed to be fully efficient, and complete and accurate information is assumed to be easily available to all market participants. This section will provide a concise overview of the financial concepts and limits discussed.

‘Behavioral finance is a discipline of finance that analyses how the conduct of agents in the financial market are impacted by psychological aspects,’ writes Subash (2012). Stock prices are influenced in turn by the actions of individual investors in the market for buying and selling securities. “Behavioral finance shows that investors do not always behave rationally when making investment choices,” as suggested by Babajide and Adetiloye (2012).