Electronic copy available at: http://ssrn.com/abstract=2329573

1

Title of the Paper: Behavioural Finance: A Primary Analysis

Author: Dr. Jose Mathews

Designation: Sr. Lecturer, Gaeddu College of Business Studies

Royal University of Bhutan

Email id: josmathews@gmail.com

Electronic copy available at: http://ssrn.com/abstract=2329573

2

Abstract

Investment behaviour is primarily understood in the financial background of profit making. Recent researches in behavioural economics and behavioural finance have shed light on the psychological processes that govern this money-generating activity. The traditional approach to investment involves monetary considerations of profit and loss. However the act of investment is in a sense determined by specific behavioural processes of cognition, motivation and personality and emotional dynamics. Cognitive processes are characterised by cognitive structures and cognitive biases, the nature of which have a significant impact on the investment decisions made. Rational and irrational decisions made are influenced by the unique of constellation of personality traits and motivational processes. Personality constructs of locus of control, risk-taking, etc., have a profound influence on the pattern of investment decisions. Individuals are also differentiated based on their emotional experiences and moods. Pleasant and unpleasant moods have opposite effects on the decisions made. In this paper a primary analysis that attempts to understand the psychological processes that go into decisional processes are made suggesting the inadequacy of present day models of behavioural finance.

Key words: Behavioural finance Psychological processes Investment decisions

3

Behavioural finance attempts to explain the behavioural/psychological processes that go into the many forms of financial decisions that involve investment, for example in stock market. The large body of literature in behavioural finance discounts the objective considerations that are thought to be guiding a number of financial decisions. Overriding the rational/objective data, the psychological data in many instances explain a successful decision or an unsuccessful decision made by the investor.

The main contention of behavioural finance is that psychology sometimes and many times overtakes the data supplied by the financial market. The investment behaviour of individuals can be truly explained by different psychological processes.

THE BACKGROUND OF THE STUDY

The efficient market hypothesis which states that “ financial prices efficiently incorporates all public information can be regarded as optimal estimates of true investment value at all times” (Shiller, 2001) is to be substituted by a deficient market hypothesis, according to which prices do not reflect all available information ( Hirshleifer,2001) and that investor does not always make rational decisions. Jain (2012) thus states the need to study the human behavioural processes more particularly the cognitive processes that go into investment decisions. In other words it can be stated that deficient market hypothesis is a confirmed theory (Hirshleifer, 2001).

It is here that the significance of behavioural finance is noted and it becomes a widely studied branch of science. According to Ritter (2003) behavioural finance has two building blocks: cognitive psychology and the limits to arbitrage. The present-day studies in behavioural finance overemphasise the cognitive processes and give less importance other related psychological processes. However it is to be contended that to explain and to predict human behaviour accurately, the researcher has to look into more than the mere cognitive processes. Response or decision at any given time is the outcome of the sum total of the psychological processes. In the well-known S-O-R model of behaviour response is consequent to organismic processes. Thus adhering too much to the cognitive biases box is fraught with limitations and the work of a researcher is left undone and incomplete. The paper attempts to draw the attention of researchers to this vital area in the study of behavioural finance.

The exploratory model suggested includes besides the all important cognitive processes, the motivational and personality considerations and the emotional dynamics. The cognitive processes are further studied by analysing the automatic and controlled processing and the cognitive styles.

4

A GENERAL MODEL OF INVESTMENT

Cognitive Processes

Cognition means the mental operations/processes of thinking that includes many mental activities of reasoning, decision-making, conceptual formation, problem-solving and creativity.

The present-day study of the cognitive processes gives importance to the “systematic errors (biases) made by the people in the way they think and take decisions regarding their stock selection” (Jain, 2012). Systematic biases which are found to be operative in investment situations are well documented by researchers (for example, Hirshleifer, 2001; Ritter, 2003; Jain, 2012; Fromlet, 2001;Hubert,2001; Patricia,2006; Sadi, etal 2011). Cognitive biases defined as the distorted/irrational judgements that occur in everyday situations are ever-present in mental operations and their operation becomes obvious in modern-day fast moving financial transactions and internet trading (Hirshleifer, 2001). The important biases researched are mentioned here:

(Stock) Market Data

Personality andMotivational Processes

Cognitive Processes

Emotional Dynamics

Investment Behaviour

Fig.1 . A General Model of Investment

5

Overconfidence: It means individuals hold overrated opinion about themselves and that they think they are smarter than they/others think.

Mental Accounting: Separation and compartmentalisation of related activities exercised by individuals lead them to take erroneous or loss-making situations.

Framing: Gains and losses are framed in such a manner that they are forced to take a decision that purports to result in gains or avoid loss.

In anchoring heuristic people use a piece of information as reference points/standards to make decisions pertaining to the future.

In availability heuristic, the speed with which information comes to mind becomes the criteria of decision-making and the decision is based on the readily available information.

In representativeness heuristic, similarity of an object/event/people/outcome to a typical category becomes the criteria of inclusion in that category.

Escalation of commitment: It makes people to be havily and negatively committed to a decision that has gone wrong eventually.

Planning fallacy: It is the tendency to underestimate the required time of completion of a task/project/work.

Confirmation bias: Individuals pay exaggerated attention to information that confirms with the existing one.

Conservatism bias: This is the inability to accept new and incoming information and they continue to hold on the present.

Following the herd- always going with the winner or the majority.

Control illusion- an inaccurate belief that they can exercise control.

The significant other processes pertinent to the investment decisions, identified by the researcher are the following:

Distorted Thinking

Self-talk: Individuals frequently indulge in self-talk that justifies a decision. These self-talks which are heard in the head of the person force him in an impulsive way to a decision.

Memory devils/angels: The emergence of sour and sweet memories sometimes results in short-circuiting a decision process, that the individual fails to analyse the situation in terms of pros and cons and a decision is suddenly made. The intrusion of such memories are sometimes helpful and at other times they prove to be deceptive and disastrous.

Drawing inappropriate but misleading comparisons: An investor is prompted to draw a past stock market behaviour into the current behaviour of the market and the same may be used to

6

decide upon the present bullish/bearish market. The superficial comparison may prove to be costly or by chance gains may be made.

Investment Schemas

Schemas are cognitive structures that represent knowledge about the different facets of the investment environment or about different stimulus situations including the relations involved in the stimulus attributes, all of which constitute the cognitive representation that is generalized and abstracted in the given situation. These developed and acquired knowledge structures enable the person to interpret and understand the world in a standard and easy way.

Schemas are self-generated or they can be second-hand schemas (Fiske, 2000).Upon encountering incidents, individuals tend to form schemas that are embedded in the cognitive process of knowing the economic environment. The mounting similar experiences make schemas abstract, complex, organized, compact and resilient (Fiske, 2000). Encountering dissimilar and disconfirming information exert cognitive pressure on the person to change the existing schema or to fit the new information so that it becomes integrated with the schema. Creation or modification enables the person to deal with the stimulus attributes scanned in the environment.

Investment schemas represent generalized or specified knowledge structures that explain the nature of different patterns or forms of investment. The investment schemas thus acquired over a period of time are of the following types:

Investment Opportunities Schema: This schema stores information regarding the government supported investment schemes and the independent investment schemes open to the people. Opportunities further refer to the type of economic activity that can be undertaken in different sectors of the economy.

Profit-loss Analysis Schema: This form of knowledge structure does the work of assessing the profit/loss probabilities that are part of the investment. With this schema, the investor is able to make an accurate financial statement about the profits and loss that go with every investment.

Investment Process Schema: This schema tells the entire programme or procedures which are part of small or major investments, that is, the how, the where, and the what of investments. The steps to be followed in investment, the formalities to be completed, the consent to be obtained, the sequential activities involved and the groundwork to be completed are all contained in this schema.

Cognitive Styles

Cognitive styles invariably enter into the financial decisions of a wide range. According to Goldstein and Blackman(1978) cognitive style “ is a hypothetical construct that has been developed to explain the process of mediation between stimuli and resposes. The term cognitive style refers to characteristic ways in which individuals conceptually organise the environment”. Cognitive style is thus a stable orientation of the individual to organise and

7

set apart otherwise meaningless/disarrayed stimuli into meaningful pattern. Some of the commonly studied styles are:

Reflective-impulsivity

Cognitively impulsive individuals take a quick decisions without considering/analysing the decisional frame while cognitively reflective individuals go into a process of analysis and evaluation before making a decision.

Field dependence-independence

Field-dependent subjects are unable to distinguish/separate/free the stimulus elements from the field; they always perceive it in the fused state whereas field independent subjects can free elements from the field.

Holistic vs. Serialists

Holists tend to form a “big picture” of the situation and go for the overall impression along with the formulation of multiple hypotheses at a time and serialists proceed step-by-step in a guarded manner.

Narrow vs. Extensive Scanners

Extensive scanners work against stimulus adaptation and they are able to make a high degree of differentiation about the scanned data. Extensive scanners process high amount of information.

Motivation and Personality Processes

Personality basically connotes the intrapsychic dynamic organization within the individual that manifests in overt and covert behavioural patterns, which means that the thoughts, emotions, motivational tendencies and overt behavioural forms are the indicators of the personality.

Personality is understood in different ways ranging from the psychoanalytic theory of Freud that stresses the influence of unconscious processes in our behaviour, say risk taking, to person situation interaction models of cross-situational variable/invariable behaviour. In the person-situation interaction model, it is shown that individual processes of unique nature predispose individuals to behave in certain ways that is the outcome of many situational factors (Baron, etal.1998). Accordingly personality is the interactive result of individual processes and situational attributes. Personality is thus the sum of the unique psychological processes of an individual that in interaction with the situational variables result in consistent behavioural patterns across situations. According to Zimbardo and Ruch (2000) personality is the sum of the unique psychological processes of an individual that influences overt and covert behaviour patterns in consistent ways in different situations. In the economic arena the construct of economic personality may be defined as that personality processes manifesting

8

the economic behaviour in distinctive ways that are unique and wholly subjective. The main differences between the economic personality and the general nature of personality are in terms of the nature of the contents and contexts of behaviour.

Achievement motivated individuals behave in the following manner with respect to the pattern of investment:

-Seek out areas in agriculture, industry or service sectors that offer reasonable returns on investment.

-Takes moderate and calculated risks like trading in shares.

-Invest in areas that has long gestation period.

-Invest money in mutual funds or insurance plans that matures after a long period of time.

-Invest resources in areas that assure regular and stable income like real estate.

-Generally prefers individual investment but if the situation is conducive and favourable, goes all out for major group investments.

Locus of Control

In this personality processes the individual behaves based on one of the loci in which the centres of behavioural outcomes or efforts are placed within the individual or without the individual. Those individuals who place the source or locus within themselves believe in their ability and efforts and the outcomes or accomplishments are traced to themselves. And individuals those who place the source or locus without themselves believe in external agencies, forces and centres of influence. Internals focusing on their capacities and abilities behave in such a way that they project their inner strengths and solidified beliefs. Externals focusing on the erratic movement of factors and forces project the outer source that controls their behaviour. In short the internal has the generalized expectancy of behaving that is derived from the inner locus of the self whereas externals has the generalized expectancy of behaving derived from the outer sources like authority, agencies, institutions and other variables of control. The pattern of investment shown by internals is:

-Invest in areas where they can exercise direct supervision like manufacturing or farming or service sectors.

-Investment is characterized by lots of planning and deliberations.

-Investments are guided by subjective assessments and interpretations.

-Prefer areas where accurate estimations and predictions can be made.

-Highly enterprising individuals are internals in that they are moved by their own visions and perfected convictions.

9

-The self-directed and self-determining internals invest in turbulent and hostile environments.

Self-Awareness

It is a state of mind in which the focus is turned inward. Self-awareness generates self-reflection that moves either in the pleasant way or in the unpleasant way which is determined by the personal conceptions. Self-awareness characterised by unpleasantness and distraction can produce compensatory behaviours which may interfere with the task. Self-awareness that produce negative reactions thus drive away the attention from the current task and the individual may be led along the path of errors and the correctness of judgement is affected.

Goal Setting Orientation (GSO)

GSO provides a base for performance accomplishments which implies that goals have the nature of magic pills that motivate the investor to greater and greater activities.

Intentions of the investor get transformed into goal-directed behaviours which are essentially grounded at the combinatorial function of individual tendencies, economic interests, value creation and feasibility of goal realization indicated by the environment (Mathews, 2008). Intentions, following the activation of will and emotional arousal, once formed in the investor take the path of fixing upon a target, that is set as a goal to be accomplished choosing appropriate means and using the required resources.

The magic of goals in Locke’s theory is that goals provide a directional and focused nature to investor’s behaviour and once goals are formed they influence the thoughts and actions to one outcome rather than another or many to satisfy the emotions or to reduce the arousal or desires attached to goals thereby fulfilling the will behind goals.

The goal setting process of an individual investor is different from a group or firm in that the former is guided by individual intentions and individual’s own knowledge and personality processes mould the specific pattern of behaviour. The knowledge here implies the knowledge with respect to the opportunities provided by the economic environment specifically the financial institutions, industrial activities and the emerging trends in the service sectors. Personality processes determine the selection of a specific economic activity like investment in transport sector, leather industry or home appliances. In all probability, the goal setting orientation leads to the following pattern of investment:

Investment patterns that traverses through stages or phases of economic activity finally gives the investor a greater profit. That means the investor ‘sees’ a greater gain at the end of a long sequence of activities before actually initiating the investment.

10

Major and sub goals may be motivating the investor such that he may invest in developing a township along with the gains related to shopping and commercial activities, that is over and above the development of residential facilities.

Self-Efficacy

Self-efficacy in the personality process implies the expectation or the generalized belief that people have about their capabilities to carry out an action. Self-efficacy refers to belief in one’s ability with respect to a pattern of behaviour or the individual holds those behavioral sequences in his behavioral repertoire. Further action expectancy underlines the outcome expectation. Outcome expectation implies the belief of a person that a particular behavior will lead to a distinct outcome .An efficacy expectation points to the capability belief that necessary behavior can be enacted (Hall,et.al 1998).

Investment self-efficacy means the self-efficacy behavior pertaining to the capacity to bring about greater returns following investment. It is clear that this personality process clearly involves effective and efficient behavioral components intended to change the economic environment in favor of the investor. A useful distinction is made between means efficacy and self-efficacy in that the former is based on the person’s belief in the tools available to do the job and the latter is about internal factors that contribute to performance (Eden and Granat-Flomin, 2000).In the personality construct called investment self-efficacy, three components are thus identified: means efficacy, efficacy expectation, and outcome expectation. The availability of investment tools or facilities offered by the government or the nature of the investment climate all determine the means efficacy. Efficacy expectation refers to the person’s own belief in the individual capacities and processes contributing to actionable components. And outcome expectation are the positive belief in the generation of greater returns following investment.

The internal and external factors together make up investment self-efficacy. A person having high investment self-efficacy is prone to make greater and quicker investments compared to the person with low investment self-efficacy who may not make any substantial investment.

Risk taking

Taking risk is an individual personality characteristic that is differentially distributed so that there are those who take risks and those who do not take any risk at all. In operational and material terms risk involves the preparation on the part of the individual to loose a part or a substantial part of the resources for returns that are greater compared to the gains he may make in the ordinary behavioural acts.

It is the uncertainty and the unpredictability involved in the environmental contingencies that introduce risk in transactions. The economic activities are subjected to fluctuations, for example, share price, prices of oil, or other goods and services that in effect brings about the aspect of uncertainty and unpredictability in the environment. This being the case, the individual investor is to take risks if he wants to gain greater returns because the

11

favourability of the uncertain conditions may come about at any time. The individual processes contributing to the risk-taking behaviour can be positive or negative which implies that positive processes make the person risk taking and negative processes make the person no risk taking.

Emotional Dynamics

The experiential state of emotion influences the thought processes and the decisions made. There are situations in which emotion overtakes the cognitive processes and the individual is fixed so that he is incapable of any kind of information processing. When this is the case with negative emotions, in instances of positive emotions, individuals engage in productive and useful form of thinking.

The quality of the current mood state becomes significant in the interpretation of ambiguous stimuli. Positive affective state induces a favourable interpretation and negative affective state results in an unfavourable interpretation. It has also been found that creativity of the individual is enhanced by pleasant states.

Wright and Bowen (1992) have found in market situations that pleasant emotional states result in optimistic choices and judgements. Mood and emotions affect the tendency to take risk in investment behaviour (Hirshleifer, 2001).

Emotional states thus interfere with the thinking process and the investor who is faced with the monitor and the investor who processes the incoming market information is not an exception. Wittingly or unwittingly he is also influenced by the emotions carried forward from his personal life, family life and interactions with friends. Even the national mood the prevails with respect to political life, social life and more particularly the business have its own emotional impact at the close of the share market, in the conduct of business negotiations and related investment decisions.

AN INTEGRATIVE MODEL

The above discussion brings to the formulation of an integrative model that discounts the efficient market hypothesis and puts forward the deficient market hypothesis as the right model to explain the financial behaviour. Thus there is need to move awy from the traditional theories of financial decisions to a modern theory that incorporates nt only the objective data but also subjective data. The psychological processes of a person can swing the market in either direction and the volatility of the market cannot be simply explained away citing the market theories that do not consider the human factor.

12

DATA Information ProcessingEfficient market Hypothesis

Does this prove to be right?

NO

DATA INFORMATION

PROCESSING

Cognitive biases; Automatic and controlled processing; cognitive styles; Attentional Factors

Motivational and Personality Processes

Emotional Dynamics

Deficient Market Hypothesis

Observed irrational financial behaviours

Financial Remodelling

Fig.2.An Integrative Model of Behavioural Finance

13

References

Baron, R.A., Earhard, B., Ozier, M. (1998).Psychology (2nd ed.), Canada: Allyn and Bacon.

Eden, D.and Granat-Flomin, and R. (2000). Augmenting means efficacy to improve service

performance among computer users: A field experiment in the public sector, Paper presented

at the Annual Conference of the Society for Industrial and Organizational Psychology, New

Orleans, LA.

Fiske, S.T. (2000).Schemas, In A.E.Kazdin (Ed.), Encyclopedia of Psychology, Vol.7,

Oxford: OUP.

Fromlet, H.(2001). Behavioral finance-Theory and practical application, Business

Economics, 36(3), 63-69.

Goldstein, K.M. and Blackman, S.(1978).Cognitive styles: Five approaches and relevant

research.New York: Wiley and Sons.

Hall, C.S., Lidzey, J.B.and Campbell, G.C. (1998).Theories of Personality (4th ed.), New

York: John Wiley and Sons.

Hirshleifer, D. (2001).Investor psychology and asset pricing, MPRA, Retrieved from

mpra.ub.uni-muenchen.del5300.

Jain, V.(2012). An insight into behavioural finance models, efficient market hypothesis and is

anomalies,Journal of arts, science & commerce,Vol.3(1), 16-25.

Mathews, J. (2008).Entrepreneurial Process: A Personalistic –Cognitive Platform Model,

Vikalpa, Vol.33 (3), 17-34.

Patricia, S. (2001). Behavioral finance-not to be ignored,Trusts &Estates,Vol.145(46), 46-49.

Ritter, J.R. (2003).Behavioural finance, Pacific-Basin Finance Journal, Vol.11 (4), 429-437.

Sadi, R., Asl, H.G., Rostami, M.R., Gholipour, A. and Gholipour, F. (2011). Behavioural

Finance: The Explanation of Investors’ Personality and Perceptual Biases Effects on

Financial Decisions, International Journal of Economics and Finance, Vol.3 (5), 234-241.

Shiller, R.J. (2001), Human Behavior and the Efficiency of the Financial System, Cowles

foundation paper no. 1025 in economics: 1305-1335.

Wright, W.F.and Bower, G.H.(1992). Mood effects on subjective probability assessments,

Organisational Behaviour and Human Decision Process, 52, 276-279.

14

Zimbardo, P.and Ruch, F. (2000).Essentials of Psychology and Life (10th ed.), Illinois: Scott,

Foresman and Co.

15

16

17

18

19

20

21

22

23

24