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Financial regulations, risk management and value creation in financial institutions: evidence from Europe and USA

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par Agborya-Echi Agbor-Ndakaw
University of Sussex - Master of Science 2010

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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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