ACCOUNTING THEORY

Do Investors Exhibit Behavioral Biases in Investment Decision

Making?

Natasha Johansen 130518003 (Y)

Fanny Agustina 130518018 (Y)

Faculty of Business and Economics

University of Surabaya
 Purpose: describe several biases in investment decision-making

- Investing is an opportunity to get the optimal return from both CF (dividend)

and capital gain in a long term. Many people think that investing is a complex
procedure because of the volatility of the markets or behaviour of the stock
markets. Actually, the fundamental reason for this complexity decision are
participants who have varied emotion and behavioural patterns while making
an investment decision.
- There is a gap between theory and reality, classical finance theory or efficient
market Hypothesis said that stocks market are efficient which means share
price incorporate all the available information
- Modern portfolio theory said that there are uncertainties in the security market
and the investor preference cannot be quantified without the help pf mean and
variances return makes several theory born
a. Expected utility theory
Concerned with the choice among the alternatives that have uncertain
outcomes. The aim is to attain a tradeoff between risk and return.
b. Markowitz approach
Helps an investor to achieve his optimal portfolio position and explains
how the diversification reduces the risk
c. Capital asset pricing model
Helps to ascertain the relationship between the systematic risk and
expected return of an asset.
- Those 3 theories considered the market to be efficient and investors to be
rational. But actually there are still anomalies in the market like the market
bubble because there are behavioural changes in investors that will make
them make irrational decisions. ​A market bubble occurs when securities are
traded at prices considerably higher than their *intrinsic value, followed by a
‘burst’ or ‘crash’, when prices tumble. Thus, when there is an economic
bubble, prices constantly change to a point where supply and demand can no
longer set the price.
- Rational investor able to attain the benefits by investing in those profitable
securities and beneficial opportunities that are not recognize by the irrational
investors. Rational Investors should be able to act differently in different
 situations and able to balance their consideration to emotional and potential
outcomes.
- Emotions and cognitions of investors can affect the investment strategies to
make investment decisions. For example, when we want to invest in a certain
company it could be influenced by our relatives. Irrational investor can be
influenced because of several behaviour biases
1. Overconfidence
Highly optimistic people tend to be overconfident about the information
they are getting for investing in a certain firm. In fact, when an investor is
paying too much attention about what they can, they will suffer a huge loss
in the future.
2. Disposition effect
Investors have a tendency to avoid the risk of loss too much rather than
realize the gain. The final decision of investors should be based on the
perceived gains not loss.
3. Herding effect
Investors have a tendency to follow other people in terms of what to invest.
This kind of behaviour is currently trending since nowadays there are a lot
of influencers who try to influence other people to invest in a certain stock.
4. Mental Accounting
Investors try to divide their investment in various portfolios. This makes
investors believe that diversification of portfolio will maximize the return
and minimize the risk. This bias will usually result in a not profitable
portfolio yet investors are emotionally satisfied.
5. Confirmation Bias
People usually have first impressions about a certain information and tend
to rely on their impressions. This bias will adjust the future information into
their “perfect” opinion.
6. Hindsight Bias
Investors believe they can reasonably predict the happening of an event.
Thus, it will form a belief of cause and effect even when the events are not
related at all.
7. House Money Effect
 When an investor gains so much profit, the investor has a tendency to take
a bigger risk. This can happen in vice versa.
8. Endowment Effect
An Investor stuck in what they hold and do not want to change their
position even though they know the investment is no longer profitable.
9. Loss Aversion
People react differently to assured loss and gain. In simple words, they
value the certainty of loss more than uncertainty of loss. When they face a
certain profit, they do not want to take the risk. But when there are
probabilities to face loss, they are willing to take a greater risk.
10. Framing
Investors have different behavior when facing positive and negative
information. When faced with positive information, they consider it should
be profitable and avoid risk at any cost. But when faced with negative
information, they are ready to take any risk to avoid losses.
11. Home Bias
Feel of belonging to their country. So, investors invest in domestic
company even the return is lower than the international company
12. Self-attribution Bias
When they succeed, they will appreciate their intelligence and capabilities.
If they fail, they blame it on the other parties.
13. Conservatism
People stick to their beliefs and will not accept new information.
14. Regret Aversion
When people regret their decision, it will impact on the future decision.
Either they will take greater risk or avoid to take the risk.
15. Recency
The decision is based on recent news and neglects the useful past
information.
16. Anchoring
Make decision or judgement based on the first or initial information they
receive
17. Representativeness
 Assess the similar characteristics of the event makes people consider if it
is likely to happen or not
- Irrational decision making is often caused by people who are biased on
disposition effect, overconfidence, and herding bias.
- These behavioral biases may be solved with:
o To counter the bias that may be employed by investors, they need to
know the pros and cons in the decision they make, which is why
accountants need to make a substantial improvement in the type, form
and mode of communication of information about financial products.
o Forecast error needs to be minimized by reducing the information
asymmetry.
o A framework written by Avgouleas helps in removing investors’ bias by
reducing framing, herd behavior of fund manager, and shifting the
focus from the activities that can cause a market bubble.
o A heuristic model (OS heuristics) written by Otuteye helps in the
cognitive bias and avoiding problems in making decisions.
- Financial decision making of institutional investor and an individual may be
impacted by psychological and investment bias.
- In educating the customers regarding mutual funds about the strategies of
investing in capital markets to avoid any unsuccessful investment decisions,
behavioral bias factors such as emotions, moods, and heuristics may be used
as the foundation of the education.