Impact of Behavioral Biases on Risky Decision making

Snawer GillMS-Finance

Topic:

Behavioral Finance Behavioral Finance (BF) is an emerging discipline that represents a collection of alternative approaches to refine the classical finance definition of economic rationality. In particular, BF draws on the psychology and cognitive science literatures to examine why individual decision-making often deviates from rational choices in systematic ways.

Behavioral Finance

Behavioral finance studies how subjective behavioral elements

introduce distortions (twist) in the individual’s decision-making

process.

Behavioral BiasesThe existence of most of the particular cognitive biases listed has been verified in psychology experiments.

AbstractHow the decision making is effected by behavioral elements.Outcomes of empirical study.Decision-making and behavioural biases.Behavioral Biases: (A list of B.B has been studies)My Research Gape

The correlation of Overconfidence, confirmation and gambling biases. This study will check the simultaneous effect of these biases on rational decision making.

D.V Decision MakingI.V Over-confidence,

Confirmation Bias Gambler’s Fallacy

IntroductionResearchers have proved that investors make unreasonable investment decision.Overconfidence bias is an affecting component of the decision making process.The overconfidence upshot is a well-established bias. According to Shefrin, overconfidence “pertains to how well people understand their own abilities and the limits of their knowledge” (Shefrin, 2007).The tendency for explanations of other individuals' behaviours to overemphasize the influence of their personality and underemphasize the influence of their situation.Overconfidence is an unrealistic positive views of one’s self and one’s performance.

Over Confidence BiasOverconfidence=

Expected performance > Actual PerformanceOverconfidence (-ve) Decision Making

Over-ConfidenceOverconfidence is considered the most robust finding in the psychological finding of judgment. (Bondt and Thaler, 1995).

Scenario I: Your real performance or result would be given to check-up in 10 minutes.Scenario II: Your real performance or result would be given to check-up next week.

It’s natural that you will be less overconfident in the first one. Now why? Your reality principle of loss aversion or overconfidence avoidance is activated now. You ovoid the overconfidence state and you know that your real performance is given up. You preferto see yourself as an under confident subject than overconfident. The under confidence sate makes you happier!

How does it affect investors’ decision?

Overconfidence causes investors to misinterpret the accuracy of our information and overestimate our skill in analyzing them. This can lead to poor investment decisions, excessive trading (Odean 1999), risk taking, and ultimately losses.

Confirmation BiasConfirmation Bias is a psychological phenomenon that explains that why people tend to seek out information that confirms their existing opinions and overlook or ignore information that disproves their beliefs.

Confirmation bias is also a cognitive bias. Its tendency to affect decision making is greater in males as compare to females (Zipporah, 2014).

Confirmation Bias

Gambling Bias: Forming portfolios Gambler’s Fallacy is the tendency to think that future probabilities are altered by past events, when in reality they are unchanged. The expectation of growth in the future is related to another bias called gamblers’ fallacy.

Introduction

Gambling Bias: Forming portfolios to implement portfolio theory, expected return, risk, and correlations are needed. However, mental accounting makes it difficult to view these factors accurately

Introduction

Gambling Bias: Forming portfolios So far, overconfidence and gambling biases have a simultaneous impact on investment decision making. This study also contributes into literature that gambler’s fallacy leads decision makers in a negatively auto- correlated decision making.

Introduction

Gambling Bias: Forming portfolios For example, in a fair coin toss people may believe that a sequence of coin flips as “HTHTHTH…..” is more likely to occur than a sequence of “TTTTTH” (Daniel Chen, Tobias J. Moskowitz, & Kelly Shue, 2014)

Introduction

Introduction

Probability

=INT(2*RAND())

Considering the past People use their past outcome as a factor in evaluating a current decision. People are willing to take more risk after gains (house money effect) and take less risk after losses (snake bite or risk aversion).

Daily KIBOR Rates as on 27thMay 2015

Daily KIBOR RatesAs on 27th May, 2015

27th Jan 27th Feb 27th Mar

27th Apr 27th May

1-Week 8.85 % 8.40 % 7.91 % 7.59 % 6.83 %2-Week 8.84 % 8.47 % 7.93 % 7.74 % 6.84 %1-Month 8.84 % 8.50 % 7.91 % 7.81 % 6.84 %3-Month 8.63 % 8.44 % 7.94 % 7.76 % 6.78 %6-Month 8.63 % 8.70 % 7.95 % 7.74 % 6.78 %9-Month 8.90 % 8.68 % 8.20 % 7.97 % 7.06 %

12-Month

8.96 % 8.76 % 8.20 % 7.95 % 7.14 %

2-Years 8.14 % 8.26 % 8.30 % 7.52 % 7.34 %3-Years 8.42 % 8.34 % 8.41 % 7.61% 7.58 %

2012-13

2013-14

Actual Previous Highest Lowest Dates Unit Frequency

7.00 8.00 20.00 7.00 1992 - 2015

percent Daily

2014-15

1H-FY2015 2H-FY2015

Objectives of study

The objectives of this study are;To investigate the relationship of overconfidence with gambling bias.To investigate the relationship of confirmation bias with gambler’s fallacy.To investigate the simultaneous influence of overconfidence, confirmation and gambling biases on decision making.

Literature Review

Experiment conducted by Zipporah, 2014 shows that human beings are influenced by a set of cognitive biases including overconfidence, confirmation and disposition biases. Women are affected by confirmation bias as compare to men. Decision taker is beyond this

phenomenon that each time there is a new probability (Daniel Chen, Tobias J. Moskowitz, & Kelly Shue, 2014).

Literature Review

Fundamentally, all the investors make such propositions and predictions before they go in to the process of stock investment. For example; the stock price will remain the same or go up? The low level of stock exchange graph has a gambling effect on the investors to predict that stock prices will rise up (Zipporah, 2014)

Literature Review

This study concludes that overconfidence level in men and women differently influence the decision making. Women tend to be less overconfident as when compare to the men. The empirical results of this study elaborate that men are more over confident than women (Pulford, & Colman, 1997).

Theoratical Framework

Overconfidence

Confirmation Bias

Gambling Bias

Decision Making

Hypotheses

OverconfidenceHa: Overconfidence affects investor’s decision making while investing in stock market.H0: Overconfidence doesn’t affect investor’s decision making while investing in stock market.

H2

Confirmation BiasHa: Confirmation affects investor’s decision making while investing in stock market.H0: Confirmation doesn’t affect investor’s decision making while investing in stock market.

H3

Gambler’s FallacyHa: Gambler’s Fallacy affects investor’s decision making while investing in stock market.H0: Gambler’s Fallacy doesn’t affect investor’s decision making while investing in stock market.

MethodologyResearch MethodologyThis study will be done on the basis of direct questionnaires presented to the individual investors. Research questions will be designed in such a manner that the respondents do not understand that their biasness level is going to be checked or empirically tested. Pearson’s Co-efficient of correlation will be used to analyze the correlation between overconfidence, confirmation bias, gambler’s fallacy and investor’s decision making. Chi-square test will be done to check out the relationship among these biases.

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