Influences on Investment Decision-Making - Coursework Example

Behavioural Finance Evaluation of the Influence of Cognitive, Affective and Social Influences on Investment Decision Making Possible Causes of Inaccurate Perceptions of Risk Perception of risk is the conceptualisation of the expected risk that exists in making a certain investment by an investor. Investment decisions are normally influenced by psychological and sociological factors, leading to the creation of various biases in investment decisions. According to Nofsinger (2013), psychology affects investing. In terms of investment decision and portfolio management, it should be expected that cognitive, affective and social factors will have an influence on an investor. This influence is portrayed in terms of saving and investment schemes structures taken by an investor, in consideration of various behavioural finance insights. To establish the influence of cognitive, affective and social aspects on investment decision making, and the role of psychological and social factors in financial market behaviour, this essay discusses what might cause perceptions of risk to be inaccurate,. Risk is an amalgamation of the probability or frequency of occurrence of a distinct hazard and the magnitude of the consequences of the occurrence (Botterill & Mazur, 2004, p.1). It defines how often a particular harmful event is expected to occur and consequences that such an occurrence is expected to cause. In terms of investments, risk may be defined on the basis of the amount of loss expected to be incurred when an adverse occurrence happens or is expected to happen frequently. Therefore, perceptions of risk are constructed on the basis of individual beliefs, societal perceptions and expert perceptions. Most people perceive risk as a possibility of bad outcome, whenever a choice is made. Therefore, in many instances, risk taking is not regarded as a potentially positive activity. However, there are instances, though few, where risk taking is perceived as a positive activity, with the potential of creating benefits to an investor. There are significant gaps between perceived risk and measurable probabilities of risk. The evident widely acknowledged differences between perceived risk and actual risk suggests that in most cases; perceptions of risk are inaccurate. This is evident when significant differences are recorded in terms of what is perceived and what actually happens in terms of real investment risks (Botterill & Mazur, 2004, p.3). Therefore, various people understand and respond to risk in various ways, based on psychological and social factors surrounding them. One of the factors that influence perception of risk, and most probably leads to an inaccurate perception of risk is the characteristics of risk. An actual reaction towards risk, which is determined by pre-existing perceptions leads to inaccurate perception of risk (Botterill & Mazur, 2004, p.3). For instance, it is perceived that whenever one engages in a voluntary activity, the level of risk involved is less than that involved, if such a person was to engage in an involuntary activity. In addition, new ventures are perceived to incorporate new risks, which are regarded as more risky than familiar risks, associated with common ventures. However, in reality it may be evidently inaccurate to regard a voluntary activity as a less risky venture while attributing greater risk to an involuntary activity. The contrary may be the case, where an involuntary activity will involves less risk, compared to a voluntary activity. In terms of ventures, investment in new ventures may pose less risk, compared to familiar ventures. Thus a contrary observation will be made from such scenarios, depicting inaccurate perceptions of risk. Psychological aspects can also lead to wrong perceptions on risk. Decision making among many investors are based on formed opinions from previous experience (Botterill & Mazur, 2004, p.3). It should be noted that it is extremely difficult to change already formed opinions on risk because they are based on prior observations or experience. Therefore, based on demonstrable benefits or losses, risk can be accepted with greater receptivity or less receptivity, respectively. Investors associate an event with higher probable chances of occurrence, if such an event’s occurrence or some similar event can be recalled readily. However, this perception of risk may be wrong or inaccurate because there have been several cases, where the unexpected has always happened while the expected failed to happen. Speculation is another factor that contributes significantly to inaccurate perceptions on risk. In fact, almost all people, including investors base most of their assumptions and decisions on speculation (Botterill & Mazur, 2004, p.3). The use of speculative frameworks in making sense of the world is a common occurrence. Consequently, the types of judgements made in this case are selective. Investors respond to risk in light of their suppositions. This causes an inaccurate perception of risk because speculations are based on public or societal opinion. It is well known that public opinion on risk and expert perception on risk differs significantly. It is therefore, non-rational to base risk perceptions on speculations, which are also based on the opinion of the public. It denies investors opportunities of recognising or appreciating that such public opinion-based decisions on approaching risk are irrational, and are necessarily incorrect because they fail to demarcate the difference between how the public perceives risk and how experts perceive risk (Hunter & Fewtrell, 2001, 2001, p.223). Public perception of risk is deemed to be inaccurate due to the higher level of speculation incorporation while expert opinion or perception on risk is expected to be accurate because applicable and current underlying factors are considered. When an investor emphasises more focus on unknown effects of risky activities, an inaccurate perception of risk is made (Botterill & Mazur, 2004, p.3). For instance, most investors use public opinions as a benchmark to decide the investments that they associate with high risk and negative consequences. In such cases, the low probability of occurrence of risk is always not considered. This is incomplete analysis because, probability levels are vital in determining a more accurate perception of risk towards risk. Therefore, the use of public opinion by investors combined with disregard of probability levels leads to inaccurate perceptions of risk. Perceptions that do not correlate with measurable probabilities Representativeness, as a factor, contributes to formulation of an inaccurate perception of risk. This is because majority of investors make their investment decisions on the basis investment alternatives. This means that an investor would analyse the risk of an investment alternative and then decide, whether or not invest in a venture or an asset, based on risk tolerance and the extent to which the investment is expected to provide diversification benefits for its current portfolios. Individual perceptions on risk influence investment decisions through representativeness, which is an over-reliance on stereotypes. Consequently, recent trends are perceived as representatives of all underlying investments. Investors end up forming inaccurate expectations and risk perceptions. In fact, investors make inaccurate assessments on investment value and risk. Investors depend heavily on one piece of available information while they fail to update their expectations based on new information that becomes available as time goes by. For instance, most investors use initial purchase prices and existing market conditions in determining risk while ignoring new trends in prices and current prevailing market conditions and expected conditions and changes in prices. Overconfidence is an aspect that results from an individual’s character or habit of overvaluing his or her knowledge and abilities. Possible consequences from such scenarios include underestimation of risk and overestimation of an investor’s capability of winning over the market. This is commonly observed among women, who are said to be more adverse than men (Newfield, 2015, p.2). When an investor attaches greater value to his or her abilities and knowledge, s/he is most likely to make wrong estimations and evaluation of risk. The mentality that one is capable of beating the market contributes to wrong perceptions of risk. Overconfidence is also exhibited most commonly among expert individuals, who normally ignore or underestimate the odds of a risky undertaking. Inaccurate perceptions on risk are made because intuitive judgement is made, rather than statistics-based judgment. Separately, when an investor is filled with greed of gaining extraordinary profits from investments, he or she is expected to make or encourage excessive risk taking. Greed blinds foresight and the importance of analysing risk from various perspectives. Low probability but high impact events may occur (Ashby, 2010, p.16). Another factor that contributes to wrong or inaccurate risk perceptions is disaster myopia. This aspect is common among investors who have just-a-risk mentality. Such investors do not treat the issue of risk possibilities with the seriousness it deserves. For instance, such investors do not make use of available and current information to make any predictions about the future and revaluate their investments. In stead, they presume that everything will go on as normal, and no greater risk is expected, given that such occurrences have never been experienced in the past and in the present. Consequently, this leads to lack of acknowledgement of possible disaster or risk, and when adverse events happen, great losses are involved. A far as the perception of risk is concerned, some people exhibit a unique risk taking behaviour and approach to uncertainty, based on prospect theory. This aspect is based on cognitive limitations of human decision makers. Some investors are loss averse, demonstrating a hefty fear for loss (Garling, Kirchler, Lewis, & Raaij, 2010, p.14; Redhead, 2008, p.35). This means that they pay more focus and attention to losses than gains in evaluating risk. Consequently, it is expected that an individual investor would seek to evade loss at all cost when making an investment decision. The aspect of seeking a gain is never given much priority by individual investors who undertake risk analysis. Consequently, the perception of risk made by such individuals is inaccurate (Ricciardi, 2008, p.99). Investors also make wrong perceptions of risk by embracing familiarity bias. Essentially, people prefer familiar things to unfamiliar ones. This aspect acts as a prejudice or inclination that alters an individual’s perception of risk. People are only expected to be comfortable and tolerant to specific risky circumstances and activities that they are aware of (Ricciardi, 2008, p.100). Therefore, familiar risks are less feared than unfamiliar risks. This is a wrong perception of risk because unfamiliar risk my also be tolerated successfully yield into high returns or gains. The influence of worry also contributes to inaccurate perception of risk. Most investors and individuals are faced with high levels of worry whenever they are required to make decisions. Therefore, they attach greater value of risk to events or investments that they are most worried about (Ricciardi, 2008, p.102). This exaggerated risk value assigned to investments leads to inaccurate perceptions of risk. In addition, when a worried person makes a decision, anxiety and fear are expected to affect such a person. Therefore, such an individual has a mentality that he or she is reliving a past occasion or living a future occasion, both of which he or she cannot stop from happening. Consequently, inaccurate perceptions of risk are made (Ricciardi, 2008, p.102). Conclusion It has been established that various factors influence risk perceptions, and possibly lead to inaccurate perceptions of risk. It should be noted that we do not live in a perfect world. Therefore, it does not reward so much by acting perfectly rational, being risk averse or adverse and assuming that there are no transaction costs or informational asymmetries. In fact, in behavioural finance, economic and emotional market frictions influence the decisions of investors significantly. Factors such as exaggeration or minimization of risk according to the social cultural and moral acceptability of the underlying activities lead to inaccurate perceptions of risk. Personal experience and memory, which lead to ignoring of probability of occurrence contributes to inaccurate conceptualisation of risk. This is referred to as an individual risk thermostat, where people have a level of risk, with which they feel comfortable and demonstrate certain behaviour in the presence of safety measures. It is expected that affect or emotion can be incorporated to an investment decision making process, hence altering the risk perception attached. Financial decision makers and investors ought to have multifaceted preferences that are open to change, in consideration of existing and emergent conditions. Decisions should be made in light of seeking satisfaction not optimization. There is a need of being adaptive and sensitive to the environment within which investment decisions are to be made because the underlying risk influences the type of process to be followed and the perception of risk to be attached to the decision or investment. List of References Ashby, S., 2010. The 2007-09 Financial Crisis: Learning the Risk MAnagement Lesons. [Online] Available at:[Accessed 16 April 2015]. Botterill, L., & Mazur, N., 2004. Risk and Risk Perception: A Literature Review. Rural Industries Research and Development Corporation, 4(43), pp. 1-28. Garling, T., Kirchler, E., Lewis, A., & Raaij, F. v., 2010. Pschology, Financial Decision Making,and Financial Crises. Psychology Science in the Public Interest, 1-81. Hunter, P. R., & Fewtrell, L., 2001. Acceptable Risk. World Health Organization, pp. 207-227. Newfield, D., 2015. An Analysis of the Relationship between Dyslexia, Risk Perception and 401(k) Allocation Decisions. Journal of Behavioural Studies in Business, pp. 1-30. Nofsinger, J. R. 2013. The Psychology of Investing. Boston: Pearson Education Publishers Limited. Redhead, K., 2008. Personal Finance and Investments: A Behavioural Finance Perspective. Abingdon: Routledge Publications. Ricciardi, V., 2008. The Psychology of Risk:The Behavioural Finance Perspective. In Handbook of Finance: Volume 2: Investment Management and Financial Management, Frank J. Fabozzi, ed., John Wiley & Sons Press. [Online] Available at:[Accessed 16 April 2015]. Read More