Behavioural theories of decision making
Introduction.
Human beings are emotional and people and therefore more often than not, the decisions that they make, be it personal, relationship or financial, may be influenced by the emotions that they may be experiencing at that particular time. According to a study done by Loewenstein (2000426), postulate that, at the time of decision making, the emotion and feelings that are experienced often drive behaviour in the opposite direction away from the decision that would have been made if long term costs and benefits had been weighed. For instance, pricing of equity requires that requires consideration of long-term benefits as well as costs. It is, therefore, safe to allude that investor’s feelings and emotions have an influence of equities and priced(Metawa 32). The relationship between feelings and decision making has been of great interest in recent times. For example, in the stock market, two areas of research have articulated the effect of emotions and feelings on decision making by investors. The first area is commonly known as mood misattribution, which examines, the effects of environmental factors like weather and social factors in determining the price of equity. The second area of research looks is known as the impact of image of the decision-making process of investors, which entails the study of the effects of emotions and feelings in influencing the decisions of investors. Therefore, it is clear that emotion has an impact on how investors make investment decisions. This paper is going to investigate the assertion that feelings are bad for decision marking and performance. Therefore, investors need to eliminate emotions and act calmly and rationally when making their investment decisions in the financial markets (Kishore 105).
Behavioural theories of decision making.
Various theories have been advanced that can be used to explain the behavioural investment making decisions. The first theory is the behavioural fiancé theory. It is a theory that operates on the assumption that investors actions are always rational, and before they make any decision, they consider available information before the decision-making process. This assumption, therefore, implies that the investment markets will be efficient, and thus the prices of securities will be a true reflection of the assets’ intrinsic values. The theory also assumes that the investors’ actions to new information will be prompt. Therefore prices of securities will be updated within and process that is a normatively acceptable process. Under this theory, the investment market returns are assumed to follow a random pattern, and therefore it is difficult to predict them (Kishore 2).
Aminand Syed (2) further point out that another behavioural theory of decision making that can explain investment decision making is what is commonly known as the theory of arbitrage. This theory postulates that the rational investors will be able to undo the price deviation away from the fundamental values, in a quick way and through this they will be able to maintain the equilibrium in the market. Therefore, under this theory, the prices are said to be ‘right’, and the prices reflect all the available information in the market, and therefore there is no ‘free lunch’. In this case, therefore, no investment strategy has the potential of earning an excess free rate of return that is greater than what its risk can warrant.
The above behavioural theories are examples of what is commonly known as the traditional paradigm. Due to the difficulties that have emerged due to the traditional paradigm, the behavioural paradigm has emerged whose main argument is that it is not always possible to make investment decisions based on full rationality. This paradigm understands the investment market by relaxing the beliefs in the traditional paradigm. They assert the fact that agents in the market will more often than not fail to update their beliefs correctly and there is always a deviation that is systematic from the normative process in making investment choices (Aminand Syed4).
The human cognitive-behavioural theories can also be used to elucidate the investment decisions that investors make. For instance, the prospect theory that was developed by Tversky and Kanheman (1979), explains how investors manage risk and uncertainty. Under this theory, it difficult to separate human behaviour form investment decision making, and therefore, human behaviour is always present when investors are accessing risk and uncertainty. The theory postulates that human beings are not always risk-averse, but they are rather risk-averse gains. However, they are risk-takers when it comes to losses. This theory, therefore, explains that people will always put much weight on those outcomes that they consider to be more certain than those outcomes that they may consider to be more probable. This feature is commonly known as the ‘certainty effect’ (Aminand Syed, 4).
From the explanation of the above theories, it is evident that behaviour and feeling are an integral part of decision making and sometimes may not be able to separate emotion from decisions. Under uncertainty, people are bound to be overconfident. According to Alpert and Raiffa (1982), human beings are poorly calibrated in terms of making estimations of probabilities, and often they overestimate their accuracy and ability to do well. There is also a tendency for people to be overconfident that good things are bound to happen in the future. Lastly, when referring to the past, people are bound only to remember their success more and forget what went wrong(Aminand Syed 5).
When people are making judgement under uncertainty, there is also the issue of fear and regret. People always tend to have a feeling of fear or pain when they make errors. Therefore, in a bid to avoid this pain and regret, they tend to alter their behaviour, and this alteration of behaviour may end up being irrational at times. We can also link the aspect of ‘cognitive dissonance’ which is usually explained to be the mental suffering that human beings undergo when evidence is put before them that their past beliefs and actions may have been wrong (Aminand Syed 6).
Emotions and investment decision making.
It from the analysis of theories of human behaviour, it is evident that behaviour, feelings and emotion influence decision making. Therefore, this paper supports the assertion that Emotions are bad for investors’ decision-making and performance. Therefore, investors need to eliminate emotions and act calmly and rationally when making their investment decisions in the financial markets. This can be supported by evidence that can be deduced for a study that was done by Javedand Saira (103), on the effect of emotion and feelings on the decisions of investors in the Pakistani Stock Market. They pointed out that psychological factors and individual behaviours at the time when investment decisions are being made are essential in influencing the outcome of the decisions. The research finding of Javedand Saira (112), concluded that indeed, behavioural factors influence investment decision making. Therefore, if this is not taken into account, then investors are bound to make decisions that may adversely affect their investment.
At the Pakistani Stock exchange market, the behaviours that affected decision making included the overconfidence factor, prospect factors and behavioural factors. In terms of behaviour factors, the investors in the Pakistani stock exchange market believed that with their skills and knowledge of the market, they could be able to outperform the market, a belief that was often detrimental. Therefore, investors must strive to uphold rationality at all times, when making investment decisions (Javedand Saira 103)
Also borrowing from theory, it has been proved that even though emotion and behaviour are an integral part of human decision making, it is evident that human emotions can not be trusted to make investment decisions. Applying decision making under uncertainty, it was found out that when people are uncertain, they are bound to be overconfident, of the outcomes of their choices. Human beings are poorly calibrated in terms of making estimations of probabilities, and often they overestimate their accuracy and ability to do well. If they go to invest with this kind of mindset, they are bound to make bad investment decisions and therefore, they should uphold rationality at all times. People also tend towards being overconfident that good things are bound to happen in the future. This can also be a dangerous feeling that cannot be relied on to make investment decisions. Analysis and projections based on empirical data should be used to make investment decisions and not gut feelings. Behavioural theory has also shown that people are bound only to remember their success more and forget what went wrong (Aminand Syed 5). However, investors should always be reminded to learn from their past mistakes and make rational, informed decisions.
Lastly, People always tend to have a feeling of fear or pain when they make errors. Therefore, in a bid to avoid this pain and regret, they tend to alter their behaviour, and this alteration of behaviour may end up being irrational at times. (Aminand Syed 6). Investors should not make decisions out of fear but always engage rationality.
A practical example where emotions were used to make decisions, is in 2009 during the great financial fall in the US. The economists at that time failed to predict the most dramatic fall in the financial markets and the losses that happened made investors to emotionally move to invest in a haven like cash and gold. At this time, the portfolio loses hit beyond 25%, and this adverse impact on the market stirred the basest human emotion, and that is the survival instinct. Investors were just investing emotionally. At this time, there was no amount of investment and financial information that could convince the investors to be rational (Smith 74-79).
Conclusion
Indeed, the behaviour is an integral part of decision making, and more often than not, investment decisions are no exception. However, investors have to devise means that they incorporate rationality in every investment decision that they make. From theory and practice, it has been proved that relying on human emotions may have adverse effects that have negative impacts on investment decisions. Therefore, emotions are bad for investors’ decision-making and performance! Investors need to eliminate feelings and act calmly and rationally when making their investment decisions in the financial markets.
Work Cited
Loewenstein, George. “Emotions in economic theory and economic behaviour.” American economic review 90.2 (2000): 426-432.
Amin, Saba, and Syed Shahzaib Pirzada. “Theory of Behavioral Finance and Its Application to Property Market: A Change in Paradigm.”
Javed, Muhammad Aslam, and Saira Marghoob. “The effects of behavioural factors in investment decision making at Pakistan stock exchanges.” Journal of Advanced Research in Business and Management Studies 7.1 (2017): 103-114.
Smith, Brenda. “The emotional intelligence of money: A case for financial coaching.” The International Journal of Coaching Organisations 4 (2009): 78-94.
Metawa, Noura, et al. “Impact of behavioural factors on investors’ financial decisions: a case of the Egyptian stock market.” International Journal of Islamic and Middle Eastern Finance and Management (2019).
Kishore, Rohit. “Theory of behavioural finance and its application to property market: a change in paradigm.” Australian Property Journal 38.2 (2004): 105.