Exploring the Role of Behavioral Finance in Investment Decisions - Free Paper Example

Introduction

When it comes to money and investing concepts, humans will not become rational as they will always think. We end up depicting strange behaviors. Behavioral finance can be applied to understand where, as an investor, one should belong in investment decisions. Behavioral finance suggests that psychological biases and influences impact investors' financial behaviors and financial practitioners. Further, biases and influences are potentially the sources of explanation regarding all market anomalies types, especially in the stock market (Das & Panja, 2019). for instance, the influences and biases explain falls and increases in stock price.

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Behavioral finance seeks to combine the theory of finance with observed investor behaviors to understand the relationship that exists between markets. Typically, the sector pertaining to financial services has exhibited diversification while simultaneously providing the investor with a wider variety of investment opportunities. Investors may invest in the same avenue, but their goals and objectives are not similar. With legitimate speculation procedures and budgetary arranging, financial specialists can build individual riches, which will add to higher monetary development. Financial development is among the essential components influencing the personal satisfaction that individuals lead in a nation (Boda & Sunitha, 2018). Three factors that measure the development of an economy are Income, savings, as well as investing. Investor data and behavior is a critical concept in behavioral finance. When it comes to money, investors are said not to be rational, contrary to how they think as they display strange behavior.

Current Research

The current state of research is indicated by the planned utility theory, which sees the individual investor's decision as a tradeoff between deferred and immediate consumption (Duxbury, 2015). However, people don't generally incline toward, as indicated by the classical hypothesis of economics. Ongoing investigations on investors' behavior have indicated that they don't act soundly, rather a few components impact their venture choices in securities exchange (Boda & Sunitha, 2018). The current examination looks at this hypothesis of investors' irrationality and explores their conduct identifying with investment choices. We analyze whether some contextual and psychological factors influence investor behavior and, if yes, which variables impact most. Extrapolating from past writing on financial aspects, psychological and financial research, individual investors were surveyed to discover what and how much influences their venture conduct (Filbeck et al., 2017). The reasonable examination, observational discoveries, and the viewpoint structure that was created current investigation produce five central points that can impact investors' behavior in a financial exchange. The discoveries can be helpful in profiling financial specialists and structuring fitting speculation systems as per their qualities, along these lines, empowering them ideal profit for their ventures.

Investor Regret Theory

Regret theory maintains that the majority of investors consider the possibility that they will ultimately regret the decisions they make in investment. Regret spectre is likely to have varying impacts on different individuals. For instance, the spectre of regret is likely to motivate a given investor to take more risks as they would regret if they fail to do so when the price of securities increases to significantly a great deal (Vohra & Davies, 2020). In contrast, it is likely to motivate a different investor to depict risk-averse character since the investor would regret if he or she bought some stocks, and the price drops significantly.

The fear of regret typically deals with the emotional reaction that individuals face after they understand that they have made a mistake in their judgment. Investors are faced with the prospect of selling a stock, and they become emotionally influenced by the price when they made a stock purchase. As a result, these investors tend to avoid selling the stock as an approach to avoid the regret of making a poor investment decision (Sumera & Reddy, 2019). They also do so to avoid the embarrassment that comes after they report a loss from the sale. It is common for humans to hate making wrong decisions.

Investors need to ask themselves in the event they want to make a sale of their stock the repercussions of repeating similar purchases when the security was already liquidated and whether they would still reinvest. When they find their answer is “no” to the above questions, the investors need to sell the stock to avoid regretting buying the losing stock. They also need to sell to avoid the regret of failing to sell when it was clear that a poor decision to invest was made.

Besides, regret theory is true for the investors, especially when they establish that a stock they took into consideration to purchase had witnessed value increase. Some of the investors tend to avoid the possibility of experiencing the regret where they follow the conventional understanding. They, therefore, buy only stocks that all other investors are buying. As a result, investors usually rationalize their decisions based on the fact that everyone else was doing the same.

The majority of human beings tend to place certain events into mental compartments. The difference between the compartments in certain circumstances influences humans' behavior more than how the events influence us.

Prospect Theory

The prospect model explains that individuals usually express the varying extent of emotion toward the gains than the losses. People are typically stressed by prospective losses compared to how happy they become from equal benefits. A loss would always seem more significant than a gain of similar magnitude. Besides, the prospect model describes the reason investors are likely to hold onto losing stocks. In most cases, individuals are found to take more risks to ensure that they avoid losses than how they would realize gains (Barberis et al., 2016). Therefore, investors willingly remain in a sock position considered risky because they hope the price will ultimately bounce back. So, regardless of the rational desire to gain a return for the risks taken, humans tend to value their own higher than the price that they would typically be ready to pay for the given thing.

According to the loss aversion theory, there are the different rationale of why investors are likely to choose to hold their losers and engage in selling their winners. Investors are likely to believe that losers toady will soon outperform winners of today. In most cases, investors make a mistake of chasing the market's action through the investment in funds or stocks that have garnered the most attention (Barberis et al., 2016). It is found that money flows, especially into high-performance mutual funds, more rapidly than money flows out from underperforming funds.

Investor Anchoring Behaviors

In the absence of new or better information, in most cases, investors tend to assume that the prevailing price at the market is the correct price. Individuals have the tendency to place too much credence in the current views, events, and opinions of the market (Ling et al., 2016). they mistakenly extrapolate the current trends that are found to be different from the long run, historical probabilities, and averages. Investment decisions in the bull markets are, in most cases, impacted by the price anchors (Ling et al., 2016). The price anchors are perceived as significant since they are close to the current prices. As a result, it makes the more distant returns of the previous irrelevant in investors' decisions.

Investors also demonstrate overreaction and underreaction. They get optimistic in the event market experiences an upward trend. They assume that the market will proceed to go up in the future. In contrast, investors also become mostly pessimistic when downturns show up. A repercussion of anchoring, or the placement of extreme significance of the prevailing events, which is found to result in the fall of prices extremely on the bad news (Ling et al., 2016). it also rises immensely during the presence of good news. When investors are at the peak of optimism, their greed usually moves their stocks past their intrinsic values.

Investors also demonstrate overconfidence. Individuals in general rate themselves, such that they are above average in the abilities they possess. Besides, they overestimate their knowledge’s precision and their understanding in relation to other people (Ling et al., 2016). The majority of investors tend to believe that they are capable of consistently timing the market. Nevertheless, the reality is that there is an overwhelming amount of evidence used to prove it otherwise. Overconfidence typically contributes to excessive trades, where the trading costs dent profits.

The concern arises whether irrational behavior is an anomaly. Theories of behavioral finance are found to directly conflict with the traditional fiancé academics. Those who studied behavioral fiancé hold different explanations of investor behavior and the implications the particular behavior has. Some of the theories argue against behavioral finance, such as the efficient market hypothesis. Proponents of EMH usually say that the events, as seen in behavioral finance, are merely short-run anomalies or an opportunity outcome (Fakhry, 2016). They argue that the anomalies tend to disappear over the long run when there is a return to the efficiency of the market.

Behavioral finance is a reflection of some of the attitudes found to be embedded in the investment system. Behaviorists usually argue that in most cases, investors tend to behave irrationally, where they ultimately produce inefficient markets and result in mispriced securities (Evstigneev et al., 2016). The adherents of behavioral finance usually take into consideration the social, emotional as well as cognitive elements that allow the investors to experience a shift from their rational conduct. The concept maintains that investors typically find themselves into the foreseeable sequence characterized by destructive behavior. This means that they tend to repeat similar errors over and over again. Among the roles of behavior, finance is found in Prospect theory. The model explores how individuals tend to maximize utility, primarily through their selection of available alternatives that possess some threat (Evstigneev et al., 2016). The theory holds that when people want to measure utility based on certain conditions of uncertainty, the investors will likely pay more attention o the incremental losses and gains. The next behavioral finance model explained the overconfidence of investors (Evstigneev et al., 2016). It is the emotion among the majority of investors that is likely to result in numerous investment errors. Investors perceived as overconfident are impacted by the type of fraud occurring the given investment. Sentiments of human beings form part of the role of behavioral finance. It holds investors in most cases, possesses wishful ideas instead of having logical concepts.

Investors may depict reluctance to invest. The reason people will never invest is in numerous issues, including financial stability. Individuals with limited financial literacy are found to less likely to invest, especially in stocks. Financial literacy is crucial for making investment decisions. Individuals who have financial literacy are more likely to invest in stocks since they have knowledge of the market trends (Evstigneev et al., 2016). The next reason that people depict reluctance to invest is due to a lack of trus...