Impact of Cognitive Biases in Investment Decisions of Individual Investors in Stock Market

Impact of Cognitive Biases in Investment Decisions of Individual Investors in Stock Market Dr. Joychen Manuel*, George Mathew.** *Associate Professor, Department of Business Administration, St.Berchmans. College, Changanacherry ** Post Graduate Participant, Berchmnas Institute of Management, Changanacherry ABSTRACT Individuals decision on investment in stock market is affected by so many factors which are influenced by their day to day affairs. Behavioural biases may creap into their investment decisions such as Representativeness Bias, Illusion of Control Bias, Hindsight Bias, Cognitive Dissonance Bias, Self-attribution Bias, Loss Aversion Bias, Regret-Aversion Bias, Over-optimism Bias and Herding Bias etc. The present study focussing on the extent to which these behavioural and cognitive factors influencing the investors investment decisions. The extent of influence has been found to be significant in this study. Key Words : Cognitive Biases, Behavioural Biases, Investment Decisions. INTRODUCTION For a long time everybody thought that traditional finance theory is accurate because it states that investors think rationally and make deliberate decisions, based on various estimations or using economic models. However after a number of investigations, it was noticed that human decisions often depend on their nature, intuitions, and habits, cognitive or emotional biases hidden deeply at the back of one s mind. The new discipline behavioral finance have began to develop after gathering enough information that confirm particular human behavior which is contrary to traditional finance theory. Behavior finance is the study of how psychology affects financial decision making process and financial markets. Since psychology explores human judgment, behavior and welfare, it can also provide important facts about how human actions differ from traditional economic assumptions. The traditional finance paradigm seeks to understand financial markets using models in which investors are rational. Even though many traditional theories of varying complexities and explanatory power have existed and evolved over the past several decades, the rationality of investors is a central assumption all and sundry. The field of finance has evolved over the past few decades based on the assumption that people make rational decisions and that they are unbiased in their predictions about the future. Investors are thought of as a rational lot that take carefully weighted economically feasible decisions every single time. A rational investor can be defined as a one that always (i) updates his beliefs in a timely and appropriate manner on receiving new information; (ii) makes choices that are nor matively acceptable (Thaler,2005) Investors may be inclined toward various types of behavioural biases, which lead them to make cognitive errors. People may make predictable, non-optimal choices when faced with difficult and uncertain decisions because of heuristic simplification. Behavioural biases abstractly are defined in the same way as systematic errors are in individual s judgment Due to the positive correlation between stock market and economy, the rise of stock market will positively affect the development of the economy and vice versa. Thus, the decisions of investors on stock market play an important role in defining the market trend, which then influences the economy. To understand and give some suitable explanation for the investors decisions, it is important to explore which behavioral factors influencing the decisions of individual investors and how these factors impact their investment performance. It will be useful for investors to understand common behaviors, from which justify their reactions for better returns. Security organizations may also use this information for better understanding about investors to 531 Dr. Joychen Manuel, George Mathew

forecast more accurately and give better recommendations. Thus stock price will reflect its true value and stock market becomes the yardstick of the economy s wealth. STATEMENT OF THE PROBLEM Much of the economic and financial theories presume that individuals act rationally in the process of decision making, by taking into account all available information. But there is evidence to show repeated patterns of irrationality in the way humans arrive at decisions and choices when faced with uncertainty. Behavioural finance, a study of the market that draws on psychology, throws light on why people buy or sell stocks and why sometimes do not buy or sell at all. The most crucial challenge faced by the investor is in the area of investment decisions. The profit made, or losses incurred by an investor can be attributed mainly to his decision-making abilities. There is a huge psychology literature documenting that people make systematic errors in the way that they think; they are over confident, they put too much weight on recent experience etc. this preference may create distortion. The field of behavioural finance attempts to investigate the psychological and sociological issues that influence investment decisions making process of individual and institutions SIGNIFICANCE OF THE STUDY Behavioral finance is the study of psychology on the behavior of financial practitioners and the subsequent effect on markets. It attempts to better understand and explain how emotions and cognitive errors influence investors. Much of economic and financial theories presume that individuals act rationally and consider all available information in the investment decision-making process. There is evidence to show repeated patterns of irrationality, inconsistency and incompetence in the way human beings arrive at decisions and choices when faced with uncertainty. There is also emerging evidence that institutional investors behave differently from individual investors, in part because they are agents acting on behalf of the ultimate investors. Studies have shown that the individual and institutional investors are affected by emotions and cognitive influences when making investment decisions. OBJECTIVE OF THE STUDY The study aims to check, if the average individual investor participating in the stock market is rational at all times: 1) The objective of the study is to probe into various factors of behavioural biases on investment decisions of individual investors. 2) To determine the emotional biases &cognitive biases that affect investor decisions 3) To check the relationship between behavioural biases and investment decisions. RESEARCH METHODOLOGY Descriptive studies aims at portraying accurately the characteristics of a particular group or situation. This study therefore generalized the findings to individual investors in Kerala. The main focus of the study will be quantitative. The collected data is analysed. All data were collected from the primary sources. For the purpose of this study, the population was all individual investors in Kerala. The study targeted a convenient sample of respondents. The respondents were targeted by using convenient sampling technique. The study referred to the secondary source available on individual s risk adjusted returns and employed questionnaire to collect primary data. Questionnaires are appropriate for studies since it collect information that is not directly observable as it inquire about feelings, motivations, attitudes, accomplishments as well as experiences of individuals. The questionnaire comprised of both open and close ended questions. The study generated quantitative data which was coded and entered into Statistical Packages for Social 532 Dr. Joychen Manuel, George Mathew

Scientists (SPSS) and analyzed using descriptive statistics including percentage analysis, mean score and standard deviation, of correlation etc. BEHAVIORAL BIASES: Psychology systematically explores human judgment, behaviour, and well-being; it can teach us important facts about how human beings differ from traditional economic assumptions. Standard economics assumes that each person has stable, well-defined preferences and that agents rationally maximize those preferences. Singh (2010) portends that the concept of behavioral finance is built upon limits to arbitrage and psychology. The author explains that arbitrage in economic and finance context, is the practice of taking advantage of a price differential between two or more markets. It is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; thus, risk free profit. Arbitrage is limited by the fact that whenever there is any deviation of the price from the fundamental price caused by the less rational traders, it will be corrected by the rational traders, consistent with the efficient market hypothesis. Behavioral finance considers how various psychological traits affect how individuals or groups ac as an investors, analysts, and portfolio managers. Heuristics can be defined as the use of experience and practical efforts to answer questions or to improve performance. However when faced with uncertainty, people rely on heuristics or rules of thumb to subjectively assess risks of alternatives, which reduces the complex tasks of assessing probabilities and predicting values to simpler judgmental operations. Representativeness Bias According to Pompian (2012), representativeness bias is a belief perseverance bias in which people tend to classify new information based on past experiences and classifications. They believe their classifications are appropriate and place undue weight on them. Research shows that this bias occurs because people attempting to derive meaning from their experiences tend to classify objects and thoughts into personalized categories. When confronted with new information, they use those categories even if the new information does not necessarily fit. They rely on a best-fit approximation to determine which category should provide a frame of reference from which to understand the new information. Although this perceptual framework provides an expedient tool for processing new information, it may lead to statistical and information processing errors. The new information superficially resembles or is representative of familiar elements already classified, but in reality it can be very different. Illusion of Control Bias According to Pompian (2012), illusion of control bias is which people tend to believe that they can control or influence outcomes when, in fact, they cannot. A review by the author indicated that choices, task familiarity, competition and active involvement can all inflate confidence and generate such illusions. This may lead investors to either trade more than is prudent or inadequately diversify portfolios, for instance, because of familiarity due to, for instance, having worked in the company. Individual investors prefer stocks with high brand recognition, supporting the familiarity hypothesis. Hindsight Bias According to Pompian (2012), hindsight bias occurs when people see past events as having been predictable and reasonable to expect. People tend to remember their own predictions of the future as more accurate than they actually were because they are biased by the knowledge of what has actually happened. Thus people view things that have already happened as being relatively predictable. People thus may overestimate the degree to which they predicted an investment outcome, thus giving them a false sense of confidence. This may cause investors to take an excessive risk, leading to future investment mistakes. Investors have an easier time realizing that the markets were over or underpriced in the past but are encountering problems seeing the same for current events. Cognitive Dissonance Bias According to Pompian (2012), when newly acquired information conflicts with pre-existing understandings, 533 Dr. Joychen Manuel, George Mathew

people often experience mental discomfort a psychological phenomenon known as cognitive dissonance cognitions, in psychology, represents attitudes, emotions, beliefs or values and cognitive dissonance is a state of imbalance that occurs when contradictory cognitions intersect. The term cognitive dissonance encompasses the responses that arise when people struggle to harmonize cognitions and thereby relieve their mental discomfort. As a result of cognitive dissonance bias, cognitive dissonance can cause investors to hold losing securities positions that they otherwise would sell because they want to avoid the mental pain associated with admitting that they made a bad decision. Razek (2011) contends that for investors, the issue is especially dangerous because it may cause them to hold on to a position long after disconfirming facts are available. In addition, the author notes that it makes investors vulnerable to sources of information that confirm our preexisting ideas. Self-attribution Bias Self-attribution bias is the tendency of individuals to ascribe their successes to innate aspects such as talent or foresight, while more often blaming failures on outside influences such as bad luck. Therefore, self-attribution investors can, after a period of successful investing, believe that their success is due to their acumen as investors rather than to factors out of their control. This can lead to taking too much risk due to confidence. Loss Aversion Bias Pompian (2012) illustrates that in prospect theory, loss aversion occurs when people tend to strongly prefer avoiding losses as opposed to achieving gains. Loss aversion leads people to hold their losers even if an investment has little or no chance of going back. Investors may as a result hold investments in a loss position longer than justified by fundamental analysis. This confirms the argument that consistent with prospect theory; people do not always behave rationally. Prospect theory is a descriptive theory of choice under uncertainty based on the outcome of numerous experimental psychological studies. Loss aversion can prevent people from unloading unprofitable investments, even when they see little to no prospect of a turnaround. Regret-Aversion Bias Pompian (2012) defined regret -aversion bias as an emotional bias in which people tend to avoid making decisions that will result in action out of fear that the decision will turn out poorly. That is, people tend to avoid the pain of regret associated with bad decisions. This bias can either make a person to be reluctant to sell because they fear that the position will increase in value and then they will regret having sold it, or, it can keep investors out of a market that has recently generated sharp losses or gains. Having experienced losses, our instincts tell us that to continue investing is not prudent. Yet periods of depressed prices may present great buying opportunities. Razek (2011) explains regret as the emotion by comparing a given outcome or state of events with the state of a forgone choice. Thus, investors may avoid selling stocks that have gone down Over-optimism Bias According to Agrawal (2012), optimism is about expecting a favorable outcome irr espective of the actual effort or skills devoted by individual to bring about the outcome. Over-optimism is the tendency to overvalue the possibility of desired outcomes and undervalue the occurrence of unfavorable events. The authors note that investors earnings forecast errors are significantly optimistic for buy recommendations and significantly pessimistic for sell recommendations. An empirical study find negative relations between returns and past volume and argues that this is driven by optimistic investors generating volume and their optimism getting reversed in subsequent periods. Herding Bias Herding in financial markets can be defined as mutual imitation leading to a convergence of action. This is the most common mistake where investors tend to follow the investment decisions taken by the majority. That is why, in financial markets, when the best time to buy or sell is at hand, even the person who thinks he should take action experiences a strong psychological pressure refraining him to do so. The main reason for this is pressure from or influence by peers. 534 Dr. Joychen Manuel, George Mathew

ANALYSIS AND INTERPRETATION Table -1 : Determination of the Effect of Behavioral Biases on Investment Decisions of Individual Investors Influence of Behavioural Biases Strongly Agree (%) Agree (%) Neutral (%) Disagree (%) Strongly Disagree (%) Representativeness Bias 19.40 32.30 16.10 9.70 22.60 Cognitive Dissonance Bias 29.00 19.40 6.50 22.60 22.60 Over-Optimum Bias 48.40 22.60 19.40 6.50 3.20 Herd Instinct Bias 48.40 9.70 12.90 16.10 12.90 Illusion of Control Bias 29.00 48.40 9.70 6.50 6.50 Loss Aversion Bias 22.60 35.50 9.70 19.40 12.90 Hindsight Bias 38.7 29.0 16.10 12.9 3.2 Self attribution Bias 54.80 12.90 9.70 6.50 16.10 Regret Aversion Bias 38.70 22.60 12.90 16.10 9.70 Impact of Emotional Biases on the Investment Decisions Table 2: Mean and Standard Deviation of Emotional Biases Emotional Biases N Mean Std. Deviation 1. Herd Instinct Bias 2. Loss Aversion Bias 3. Regret Aversion Bias 3.65 3.35 3.65 1.527 1.368 1.392 Table 2 shows that emotional biases have very high impact on individual investors investment decision : Herd Instinct Bias (mean:3.65, std. deviation:1.527), Loss Aversion Bias(mean:3.35, std. deviation:1.368) and Regret Aversion Bias (mean:3.65, std. deviation:1.392) Impact of Cognitive Biases on the Investment Decisions Table 3: Mean and standard deviation of Cognitive Biases Cognitive Biases N Mean Std. Deviation 1.Representativeness Bias 2. Cognitive Dissonance Bias 3.Over-optimism Bias 4.Illusion of Control Bias 5.Hindsight Bias 6.Self-attribution Bias 3.16 2.84 4.06 3.87 3.87 4.35 1.581 1.451 1.114 1.109 1.166 1.103 535 Dr. Joychen Manuel, George Mathew

Table 2 shows that cognitive biases have very high impact on individual investors investment decision : Representativeness Bias (mean:3.16, std. deviation:1.451), Cognitive Dissonance Bias (mean:2.84, std. deviation:1.581), Over-optimism Bias(mean:4.06, std. deviation:1.114), Illusion of Control Bias(mean:3.87, std. deviation:1.109), Hindsight Bias (mean:3.87, std. deviation:1.166), Self-attribution Bias(mean:4.35, std. deviation:1.103). Among the cognitive biases Over-optimism and Self-attribution biases are having high impact on investors decision making (high mean value and low std. deviation), where as Cognitive-dissonance having least impact on investors investment decisions Table 4: between Behavioural Biases and Investment Decisions Pearson s Average Return for the past five (5) years (Investment decisions) Average Return for the past five (5) years (Investment Decisions) Sig. (2-tailed) 1 Past history influences present investment decisions (Representativeness Bias) Holding to one s investment because selling them would be painful to hime since it will would incur loss (Cognitive Dissonance Bias) When it comes to trusting people, one can usually rely on his gut feelings (Over- optimism Bias).478** Sig. (2-tailed).007.546** Sig. (2-tailed).001.479** Sig. (2-tailed).006 Thinking hard and for a long time about something gives little satisfaction (Herd Instinct Bias).528** Sig. (2-tailed).002 Investor is informed about all the fundamentals of the company that he is confident in making his investments (Illusion of Control Bias) Investor intends to sell his investments immediately it goes back to the acquisition price (Loss Aversion Bias).358** Sig. (2-tailed).048.505** Sig. (2-tailed).004 The previous profits generated from similar investments by the.431** company made it very attractive to one to invest in it (Hindsight Bias) Sig. (2-tailed).016 536 Dr. Joychen Manuel, George Mathew

The last investment was more of a bad luck than it was his own poor judgment (Self Attribution/Overconfidence ))Bias).490** Sig. (2-tailed).914 Holding to his investments because he know the prices will revert soon (Regret Aversion Bias).467** Sig. (2-tailed).008 In this table, the relationships between individual investor decisions and behavioral factors are analyzed. Table shows Pearson s s with alpha at.01 levels. The table shows outcomes of individual investor decisions were significantly correlated to: representativeness bias (r=.478, p<.01); Illusion of Control bias (( r=.358, p<.01); Cognitive Dissonance bias ( r=.546, p<.01); Herd Instinct bias ( r=.528, p<.01); and Hindsight bias (r=.431, p<.01), loss aversion bias (r=.505, p<.01); Self attribution bias (r=.490, p<.01); regret aversion bias (r=-.467, p<.01); over-optimism bias (r=.479, p<.01). These statistically significant correlations suggest that these dimensions of behavioural factors influence individual investor decisions FINDINGS The various factors contributing to the behavioural biases on investment decisions of individual investors are Representativeness Bias, Illusion of Control Bias, Hindsight Bias, Cognitive Dissonance Bias, Selfattribution Bias, Loss Aversion Bias, Regret-Aversion Bias, Over-optimism Bias and Herding Bias The extent of effect of emotional biases & cognitive biases that affect investor decisions: Emotional biases have very high impact on individual investors investment decision : Herd Instinct Bias (mean:3.65, std. deviation:1.527), Loss Aversion Bias(mean:3.35, std. deviation:1.368) and Regret Aversion Bias (mean:3.65, std. deviation:1.392) Cognitive biases have very high impact on individual investors investment decision. Representativeness Bias (mean:3.16, std. deviation:1.451), Cogniti ve Dissonance Bias (mean:2.84, std. deviation:1.581), Over-optimism Bias(mean:4.06, std. deviation:1.114), Illusion of Control Bias(mean:3.87, std. deviation:1.109), Hindsight Bias (mean:3.87, std. deviation:1.166), Self-attribution Bias(mean:4.35, std. deviation:1.103). Among the cognitive biases Over-optimism and Self-attribution biases are having high impact on investors decision making (high mean value and low std. deviation), where as Cognitive-dissonance having least impact on investors investment decisions. The correlation between behavioral biases and investment decisions were significant to: representativeness bias ( r=.478, p<.01); Illusion of Control bias (( r=.358, p<.01); Cognitive Dissonance bias ( r=.546, p<.01); Herd Instinct bias (r=.528, p<.01); and Hindsight bias (r=.431, p<.01), loss aversion bias (r=.505, p<.01); Self attribution bias (r=-.490, p<.01); regret aversion bias (r=-.467, p<.01); over-optimism bias (r=.479, p<.01). These statistically significant correlations suggest that these dimensions of behavioral factors influence individual investor decisions CONCLUSION One word, which has dominated the world of financial stock markets since 2008, has been Volatility. Extreme movements in global indices and stock prices because of fear and anticipation has, as it is supposed to, made life tough for a rational investor. Market sentiments have been observed to sway wildly from positive to negative and back, in the shortest timeframes like weeks, days and hours. In this context, understanding 537 Dr. Joychen Manuel, George Mathew

irrational investor behavior deserves more importance that it has ever had. Behavioral finance - a relatively new field that came into relevance in the 1980s studies the effect of psychology on financial decisionmaking. It studies how investors interpret new information and act on it to make decisions under uncertainty. The science does not try to label traditional financial theories as obsolete, but seeks to supplement the theories by relaxing on its assumptions on rationality and taking into consideration the premise that human behavior can be understood better if the effects of cognitive and psychological biases could be studied in context where decisions are made. REFERENCES 1. Agrawal, K., (2012)., A Conceptual Framework of Behavioural Biases in Finance, The IUP Journal of Behavioural Finance, IX (1), 7-18. 2. Kahneman, Fama,& Eugene, F.,( 1969), The Adjustment of Stock Prices to New Information, International Economic Review,10. 3. Rozeff, S., & Kinney,Jr., (1976), Capital Market Seasonality: The case of stock returns, Journal of Financial Economics 3(4): 379 402. 4. Shleifer, Andrei., (2000), Inefficient Markets: An introduction to Behavioral Finance,New York: Oxford University Press. 5. Shiller, J., 2002, Efficient Markets Theory to Behavioral Finance, Journal of Economic Perspectives 17(1): 83 104. 6. Subrahmanyam, A.,(2007), Behavioural Finance: A Review and Synthesis, European Financial Management, (14)1, 12-29. 7. Thaler, R. H.,(2005), Advances in Behavioural Finance, Princeton University Press 8. Thaler, Richard,H., (1988), Anomalies: The Winner s Curse, Journal of Economic Perspectives 2(1): 191 202. 9. Razek, Y. H., (2011), An Overview of Behavioural Finance and Revisiting the Behavioural Cycle Hypothesis,The IUP Journal of Behavioural Finance, (VIII)3, 7-24. 538 Dr. Joychen Manuel, George Mathew