Behavioural Finance Implications on Personal Investment Decisions - Essay Example

? Behavioural Finance Implications on Personal Investment Decisions 14th March Introduction Decision-making is a vital yet a complex practice. Effective decisions cannot be made by only considering composite models and personal resources that do not take regard of the situation (POMPIAN, 2006: p12). The manager’s cognitive psychology arbitrates the investigation of the variables of the issue in which it occurs. Decision-making is described as the procedure of selecting an alternative from a set of alternative decisions. The managers are required to keep themselves aware of the multidimensional fields in order to achieve the desired results in the aggressive and dynamic business environment. This calls for better understanding and insight of the nature of human in the current global outlook, plus advancement of fine skills and the capability to achieve the best from investments. Furthermore, investors need to develop foresight, positive vision, drive and perseverance (BAKER, & NOFSINGER, 2010: p23). Investors vary in all features due to factors such as demographic factors, which entail educational achievement level, socio-economic background, sex, age, and race. The most critical hurdle faced by investors is in the region of investment choices. The most favourable investment decision is a vital consideration and should be proactive in nature. During the design of the investment portfolio, of key consideration should be their financial objectives, the level of risk tolerance, as well as other restrictions. Furthermore, they have to forecast the product mean-variance optimization. This procedure is best appropriate for institutional investors, and more often than not fails for people, who are vulnerable to behavioural prejudice. In the current circumstances, behavioural finance is increasingly attaining an integral position in the decision-making procedure, since it increasingly affects the performance of investors (SHEFRIN, 2007: p77). Investors can better their performance by identifying errors and biases of judgement, which are common to every human being. Comprehending the behavioural finance will play a vital role in enabling the investors to adopt a better investment mechanism and evade future repetition of costly errors. The relevant issues of this investigative study are how to reduce or abolish the psychological prejudices in investment decision procedure. According to the conventional financial theory, makers of decisions are logical. On the contrary, modern theories propose that the decision- making carried out by investors are not propelled by due deliberations (POMPIAN, 2012: p45). The decisions carried out by the investors are also frequently inconsistent. In other words, decisions made by humans are prone to numerous cognitive illusions. They are categorised into two types heuristic decision process and process theory. Heuristic decision theory is a decision criterion through which the investors discover things for themselves. It refers to thumb rules, which people utilize to make decisions in uncertain and complicated situations (SCHINDLER, 2007: p86). In reality, the decision-making criteria of investors are not completely reasonable. This may be so even when the investors have gathered the necessary information and purposefully investigated, in which the emotional and mental aspects are entailed. They are not easy to distinguish. Though it may be beneficial sometimes, numerous times it may cause uninformed decision outcomes. First, it includes representativeness. The recent accomplishments of investors tend to proceed into the future (POMPIAN, 2012: p82). The propensity of investors to come up with decisions based on history experiences is called stereotype. Recent analyses are leaning towards the failure or success, in their profit projections, the nature of stereotype choices. Secondly, overconfidence is another factor. Several points of views surround confidence, as it accords more courage and is perceived as a key to prosperity. Even though, confidence is celebrated and supported, other factors trigger success. Analytical and vigilant investors can easily be successful, while the risk-averse investors are forced to withdraw. Still self-confidence is usually perceived as a positive character trait. Occasionally, the investors miscalculate the prognostic abilities or assume they have knowledge that surpasses what they have in reality. This sometimes results to excessive trading. Thirdly, in this category is anchoring. This trait illustrates the ordinary human nature to depend too heavily, or anchor on a single trait or information source in the decision-making process (BAKER, & NOFSINGER, 2010: p165). The investors tend to change, even when issued with fresh information, or the value of their decision criteria is controlled by current observations. The investors anticipate the drift of earning to conform to historical trend, which may result in likely under reactions to alterations in trend. Gamblers fallacy is another trait of investors. This occurs when investors, unfortunately, forecast information that will reverse normal operations; it may lead to expectations of poor or good end. Availability bias is another trait. The investors attach unnecessary weight for deciding on the most accessible data. This is a common occurrence and causes reduced return, or deprived results. An additional theory is the Kahneman and Tversky prospect theory. According to Kahneman, there are different mindsets that influence investor during decision-making (SHEFRIN, 2007: p183). The vital notions that Kahneman discussed are discussed below. Loss aversion is a vital psychological notion that faces swelling attention in economic examination. An investor is a risk-taker when viewing the possibility of losses and is risk-averse when highly likely to enjoy profits. This occurrence is known as risk aversion. The other explanation is the regret aversion notion. This results from the investors’ yearning to avoid pain of regret emanating from a meagre investment choice. Regret aversion develops a tax inefficient investment policy since investors can diminish their taxable income by incurring asset losses. Mental accounting is comprised in the prospect theory. Mental accounting is a combination of cognitive functions employed by investors in order to classify, assess and monitor investment activities (BRUCE, 2010: p123). Of critical attention are three elements of mental accounting. The first component deals with how outcomes are professed and experienced, and how decisions are arrived at and consequently evaluated. The second component entails the apportioning of activities to precise accounts. Both mental and real accounting systems entails maintaining track of the origins and uses of money. The third component considers the incidence, which is used to assessed accounts and ‘choice bracketing’. Balancing of accounts may occur on a daily basis, weekly, annually, and so on, as well as being either classified broadly or narrowly. Every component of mental accounting affects defies the economic standard of fungibility. Therefore, mental accounting should be considered greatly since it influences decision. The last theory under prospect theory is self-control. This principle calls for all investors to evade losses and guard their investments (ACKERT, & DEAVES, 2010: 134). Investors are constantly prone to temptation, and they seek tools to enhance self-control. By psychologically differentiating their financial resources into expenditure and capital, investors can manage their urge to consume over the budget. In recent studies, researchers have been employing MRI technology to analyze investors’ neurological reactions to making profits, enduring losses, confirming prospects, or familiarising with surprises (POMPIAN, 2012: p129). The research reveals that cognitive reactions to some investments are comparable to experiences of an addict indulging in drugs or a gambler succeeding in a bet. The field does not gain from evolutionary biology closeness that assists in explaining the vital role played by heuristics, which in some circumstances may lead to “illogical” decision making, in survival since they assist people evade tragic outcomes. There are some challenges that are yet to be addressed in the field of behavioural finance. The field is still deficient of a set of merging principles that combine human behaviour observations and cognitive abilities in a way that describes behaviour and can be employed to develop corrective deeds or lucrative trading opportunities (ALTMAN, 2006: p163). Behavioural finance indeed develops profitable business opportunities. Numerous existent mutual funds employ a certain level of behavioural economics in their operations and investment plans. Overall, the field of value investing is largely based on behavioural theories of finance. Implementing a contrarian investment or stringent value-based philosophy may call for outstanding courage, especially in unpredictable markets where it may be hard to persuade investors of its wisdom. However, there are certain lessons that managers can learn as regards behavioural economics. First, the managers should consider reducing leverage, upholding liquidity, and developing other cushions in expectation of likely market stress (SCHINDLER, 2007: p145). In the case of "illogical" investor conduct generating opportunistic mispricing, the situation may worsen before getting better. Second, assuming stringent behavioural finance investment schemes are not very successful; managers might increase their current strategies to evade over-reaction, herding, regret aversion, as well as other behavioural biases that hamper their successful implementation. Conclusion Though all the mentioned examples of illusions are extensively experienced, behavioural finance does not support the opinion that the illusions will occur to all the investors instantaneously. The vulnerability of an investor to a specified illusion is probable to be a product of several variables. For instance, there is implied evidence that investor experience plays a descriptive function in his view with less experienced investors highly susceptible to extrapolation (representativeness) whereas more experienced investors perpetrate gambler fallacy. Likewise, behavioural aspects play a crucial role in the process of investor decision making. Therefore, investors have to undertake necessary actions to avoid or diminish the effect of illusions in their investment decision-making procedures. Bibliography POMPIAN, M. M. (2006). Behavioral finance and wealth management: how to build optimal portfolios that account for investor biases. Hoboken, N.J., Wiley. ACKERT, L. F., & DEAVES, R. (2010). Behavioral finance: psychology, decision-making, and markets BAKER, H. K., & NOFSINGER, J. R. (2010). Behavioral finance: investors, corporations, and markets. Hoboken, N.J., Wiley.. Mason, OH, South-Western Cengage Learning. WOOD, A. S. (2010). Behavioral finance and investment management. [Charlottesville, Va.], Research Foundation of CFA Institute. POMPIAN, M. M. (2012). Behavioral finance and investor types: managing behavior to make better investment decisions. Hoboken, NJ, Wiley. SHEFRIN, H. (2007). Behavioral corporate finance: decisions that create value. Boston, McGraw-Hill/Irwin. SCHINDLER, M. (2007). Rumors in financial markets: insights into behavioral finance. Chichester, England, John Wiley & Sons. ALTMAN, M. (2006). Handbook of contemporary behavioral economics: foundations and developments. Armonk, N.Y., M.E. Sharpe. POMPIAN, M. M. (2012). Behavioral finance and wealth management: how to build investment strategies that account for investor biases. Hoboken, N.J., Wiley. BRUCE, B. R. (2010). Handbook of behavioral finance. Cheltenham, Edward Elgar. Read More