Evidence on Rationality and Behavioural Biases in Investment Decision

Making

Abstract

Purpose- The purpose of this paper is to investigate the relationship between rational
decision making and behavioural biases among individual investors in India, as well as to
examine the influence of demographic variables on rational decision making process and how
those differences manifests themselves in the form of behavioural biases.

Design/methodology/approach- Using a structured questionnaire, a total of 386 valid

responses have been collected from May to Oct 2015. Statistical techniques like t-test,
analysis of variance (ANOVA) and Fisher’s least significant difference (LSD) test have been
used in this study. The Structure Equation Modelling (SEM) has been used to analyse the
relationship between rational decision making and behavioural biases.

Findings- The findings show that structural path model closely fits to the sample data,
indicating investors follow a rational decision making process while investing. However,
behavioural biases also arise in different stages of decision making process. It further
explores that gender and income have a significant difference with respect to rational
decision making process. Male investors are more prone to overconfidence and herding bias
in India.

Research limitations/implications- The findings of the study have significant implication

for the individual investors. It is recommended that if individuals are aware about the biases,
they may become alert before taking irrational investment decisions.

Originality/Value- To best of our knowledge, present study is a first of its kind to investigate
the relationship between rational decision making and behavioural biases among individual
investors in India.

Keywords- Rational decision making, individual investors, overconfidence, disposition

effect, herding

Paper type- Research paper

 1. Introduction

Rational decision making is combined with a structured or logical thought process to achieve
an efficient and optimal result. A theory has been proposed to achieve the desired outcome of
a decision making process known as theory of rational choice. The theory of rational choice
asserts that decision makers consider a set of alternatives from different scenarios before
selecting a choice. To attain full rationality people necessitates unlimited cognitive
capabilities. Natures of human beings are quite different with limited cognitive capabilities.
Because of this reason, decision behaviour of people cannot follow the full rationality.
Afterward, Simon (1956) proposed a new concept of bounded rationality. It suggests that due
to lack of information and memory errors people make irrational decision. Bounded
rationality is the more realistic theory of the human decision making.
The standard finance theories are based on the assumptions that investors make decisions in a
rational manner. Efficient Market Hypothesis also believes that security prices reflect all the
available information in the efficient market condition (Fama, 1970). Traditional theory
assumes that investors’ decisions are based on the expected utility theory. Where the
Expected Utility theory believes on the concept of rationality and states that investors make
consistent and independent decisions among various available alternatives.
However, various research studies have documented that investors do not behave rationally
while making decisions. With this view, in 1980s a new concept i.e. behavioural finance has
emerged in the area of finance and economics. Behavioural finance is based on two building
blocks i.e. cognitive psychology and limits to arbitrage (Thaler & Barberis, 2002). Cognitive
psychology refers to the how people think, perceive and remember while limits to arbitrage is
the arbitrage opportunity that appears in the market and arbitrageurs may not be able to make
profit from market dislocations because of their irrational behaviour.
Kahneman & Tversky (1979) developed the prospect theory for decision making under the
uncertainty that is also a critique to the expected utility theory. Prospect theory believes that
some psychological factors influence the investors’ decision making and deviate them from
the rationality which supported to Simon’s (1956) argument of bounded rationality. These
psychological factors are termed as behavioural biases and would lead to decline in the
investment returns.
Investors’ rational decision making process includes the procedures of identification of
demand, search for the information and evaluation of the alternatives and then such the
investment decision will be considered as a rational investment decision. Practically,
investors’ do not follow the logical procedure due to the availability of limited information.
Research on investment behaviour of individual investors in various countries has shown that
most of the investors still actually display behavioural biases.

Existing studies have either identified the behavioural biases or analysed the impact of these
behavioural biases on the individual investors. But no prior attempt has been made to analyse
the relationship between behavioural biases and rational decision making process especially
in Indian context.

The main objectives of the study are as follows:

1. To establish the relationship between rational decision making process and

behavioural biases i.e. overconfidence, disposition effect and herding.
2. To test the effect of various demographic variables on rational decision making
process and how those differences manifest themselves in the form of behavioural
biases.

The remainder of the paper is structured as follows. Section 2 explains the literature review
related to behavioural biases and rationality in decision making process. In the section 3
researchers introduce the research methodology opted in the study. In the section 4
researchers outline the analysis and the main findings of the study. Finally, the section 5
summarizes and concludes the study.

2. Literature Review

The review of literature is focused on the theoretical and empirical research studies on
rational decision making process and behavioural biases that are considered for the present
study.

2.1 Rationality in decision making

Rational decision maker follow a logic and reason for making an optimised decision (Nozick,
1993). In the literature, research studies have proposed two basic models of decision making:
rational model and the bounded rationality model. For the rationality in decision making,
Mintzberg et al. (1976) provided a three stages model of strategic decision process that
includes; identification of problem, development of alternative solutions to the problem and
finally, the selection of the alternative for an optimal solution. Further, Schoenfeld (2011)
proposed six steps model for the rational decision making process. Practically, it is always
difficult to take a rational decision because of availability of limited information, inadequate
time and cognitive limitations. Therefore, Herbert Simon (1956, 1982) replaced the term
rationality with the concept of bounded rationality. Researchers suggest that bounded
rationality is not the irrationality and agents are also not irrational they are bounded rational.
Generally, because of the lack of complete information and knowledge, people use shortcuts
in the form of adopting the path of simple models that results in to a suboptimal decision. In
other words, individual investors involved in investment activities also analysed and evaluate
investment options that seems like a rational decision making process.

2.2 Behavioural biases in investment decision making

Behavioural finance deals with the behavioural and psychological aspect of the investment
decision making. Researchers found various anomalies in the investors’ behaviour that
deviates them from the rational and logical decisions and violate the standard financial
theory. These anomalies are the cognitive errors or the biases that influence the investment
decision making. Kahneman & Tversky (1979) developed the prospect theory and explained
the human judgement and decision making under risk and uncertainty. Prospect theory states
that people are risk- averse in the gains but becomes risk – seeker in the losses. In this study,
we have explained the relationship between three behavioural biases namely, overconfidence,
disposition effect, the herding behaviour and the rational decision making process.

2.2.1 Overconfidence

Overconfidence is a cognitive bias in which people have unwarranted faith in their intuitive
reasoning, judgments and cognitive abilities (Pompian, 2006). Overconfident people become
too confident about their skills and knowledge while underestimate the various risk
associated to the investment. Generally, overconfident investors overreact to the private
information signals while ignore the publicly available information (Daniel et al., 1998).
Odean (1999) proposed that overconfident investors may trade even when their expected
gains are not sufficient to offset the transaction costs. Barber & Odean (2000) collected a data
of 78,000 households for a period of 1991 to 1996 from a large discount brokerage house in
U.S. They documented that investors are overconfident and trade excessively and because of
the excessive trading gross returns (before accounting the transaction cost) earned by the
households were normal while net returns were very poor. Moreover, these results are
empirically consistent with (Statman et al., 2006 and Grinblatt & Keloharju, 2000).
Furthermore, in a study Barber & Odean (2001) analysed the common stock investment of
men and women by using a dataset of 35000 households from a large discount brokerage
house. They proposed that men are more overconfident and trade excessively than women.

2.2.2 Disposition Effect

Disposition effect is a phenomenon in which investors’ exhibit a tendency to realize the gains
while reluctant to realize losses (Shefrin & Statman, 1985). Firstly, Shefrin & Statman (1985)
developed a framework based on different elements (i.e. mental accounting, regret aversion,
self-control and tax consideration) and formally analysed the disposition effect. Most of the
empirical studies referred the Kahneman & Tversky’s (1979) prospect theory to explain the
disposition effect. Prospect theory states that people become more risk averse after
experiencing gains while risk seekers after suffering from the losses. Odean (1998) analysed
the 10,000 customers’ accounts from a nationwide discount brokerage house and also
empirically supported the implications of prospect theory. Further, they also reported that
because of tax consideration the investors are engaged in loss realized selling at the end of the
year i.e. December. A number of research studies have supported the existence of disposition
effect (Barber et al., 2007; Shapira & Venezia, 2001; Weber & Camerer, 1998; Grinblatt &
Keloharju, 2000; Jordon & Diltz, 2004). Barber et al. (2003) analysed the mutual fund’s
purchase and sale decision of investors. They found the evidence that investors sell those
funds which have realized positive returns and are reluctant to sell the loss making funds.
Furthermore, Shapira & Venezia (2001) documented that individual investors are more prone
to disposition effect than the professional investors. Dhar & Zhu (2006) analysed the
difference in the disposition effect among individuals and reported that nonprofessional and
the low income group investors exhibit more disposition effect than others. In an experiment,
Shafran et al. (2009) investigated that investors are prone to disposition effect but also
affected by the trading conditions. Goetzmann & Massa (2008) found a negative correlation
between the disposition effect and returns, volatility and trading volume.

2.2.3 Herding
Herding refers to the tendency of the individuals to imitating the judgements (rational and
irrational) of others. Thus, herding behaviour of investors is the primary cause of bubbles in
finance. Lee et al. (2004) suggested that individual investors are noise traders and trade for
the liquidity than the institutional investors. Fernandez et al. (2011) proposed an
interdependent relation between the information availability and the herd behaviour. They
found that when the information is uncertain, investors are more prone to imitate the
decisions of others or group. However, Lakonishok et al. (1992) documented that during the
trade of large stocks U.S. pension fund managers are less influenced to herd behaviour and
have no impact on the stock prices. Further, Grinblatt et al. (1995) also found weak evidence
of herd behaviour for U.S. mutual funds. Wermer (1999) found less evidence of herding for
the average stocks while high level of herding for the small and growth oriented stocks.
Trueman (1994) reported that analyst exhibit herding behaviour thus, ignore the available
information and release forecasts based on the other analysts’ previous decisions. Similarly
Sias (2004) proposed that trading behaviour of institutional investors is related to the position
of the previous trading. Further they also found that in large stocks herding behaviour
weakens by the time. Nofsinger & Sias (1999) documented that institutional investors’
herding affects the stock prices more than individuals’ herding in U.S.

2.3 Influence of demographic variables on rational investment and behavioural biases

In addition to the behavioural factors, investor’s demographic characteristics have significant

effect on the rational investment and behavioural biases of investors. For instance, Lin (2011)
analysed that individual investors follow the rational decision making process to select their
investment products and also prone to various behavioural biases. Mathuraswamy and
Rajendran (2015) found that family composition, biological make-up, psychological factors
and lifestyle of individual investors influence the investment rationality. Zaidi & Taumi
(2012) indicated that both age and education do not have any significant impact on
overconfidence bias. Moreover, there is a significant association between investment
experience and overconfidence bias. By using a survey of about 2,000 defined contribution
pension plan members, Bhandari & Deaves (2006) found that men are more confident than
the women. With respect to relationship between demographic characteristics and disposition
effect, Da Costa et. al. (2008) identified that males are more prone to disposition effect than
females. Further, Dhar & Zhu (2006) found that individuals employed in professional
occupations and high income earners have lower disposition effect. With respect to the
relationship between demographic characteristics and herding bias, Lin (2011) found that
females are more involved in herding behaviour than males. Moreover, they identified that
young investors are more prone to herd behaviour than older one.

2.4 Linkage between Rational decision making and behavioural biases

Rational decision theory states that decision makers follow a logical path or sequence. But
based on the concept of bounded rationality or limited rationality in decisions, Simon (1956)
suggested that individuals consider some threshold of satisfaction rather than maximizing a
utility function. Possible reason behind it could be that they usually lack information on the
definition of problem and so on. After that, Kahneman & Tversky (1979) extended the theory
of rational decision by introducing the prospect theory. Prospect theory includes the reference
position on evaluating the optimal decision. Tversky & Kahneman (1974) also presented that
people rely on a limited number of heuristics principles which can be quite useful, but
sometimes lead to severe and systematic error.

Although, it is possible that investors have evaluated the information objectively, but it is also
difficult to ignore the emotional and cognitive biases involved in each stage of decision
making process. Therefore, despite investors follow a logical process for the investment
decision but behavioural biases still exists in the mind of the investors.

3. Methodology

3.1 Research model and hypotheses development

In the present study, in order to understand the rational decision making process, three stages
model of Mintzberg et al. (1976) has been used. Following are the different stages of rational
decision making process. (i) the problem identification (ii) seeking essential information (iii)
evaluating alternatives solutions. The research model postulates six constructs (demand
identification, search information, evaluating alternatives, overconfidence bias, disposition
effect and herding bias). This study also examines the four demographic variables (gender,
age, income, occupation) that have varying influence on the primary constructs. The research
model tested in this study is shown in figure 1.
 Demand Overconfidence
Identification bias

Disposition effect
Search
Information

Evaluating Herding bias

Alternatives

Gender Age Income Occupation

Figure 1: Proposed Research Model

To achieve the objectives of the present study, the following hypotheses are framed:
Hypotheses
H1: Rational decision making process has a significant relation to the overconfidence bias.
H1a: Demand identification has a significant relation to the overconfidence bias.
H1b: Information search has a significant relation to the overconfidence bias.
H1c: Evaluating alternatives has a significant relation to the overconfidence bias.
H2: Rational decision making process has a significant relation to the disposition effect.
H2a: Demand identification has a significant relation to the disposition effect.
H2b: Information search has a significant relation to the disposition effect.
 H2c: Evaluating alternatives has a significant relation to the disposition effect.
H3: Rational decision making process has a significant relation to the herding bias.
H3a: Demand identification has a significant relation to the herding bias.
H3b: Information search has a significant relation to the herding bias.
H3c: Evaluating alternatives has a significant relation to the herding bias.
H4: Gender has an effect on rational decision making process.
H4a: Gender has an effect on demand identification.
H4b: Gender has an effect on information search.
H4c: Gender has an effect on evaluating alternatives.
H5: Gender has an effect on the behavioural biases.
H5a: Gender has an effect on overconfidence bias.
H5b: Gender has an effect on disposition effect.
H5c: Gender has an effect on herding bias.
H6: Occupation has an effect on rational decision making process.
H6a: Occupation has an effect on demand identification.
H6b: Occupation has an effect on information search.
H6c: Occupation has an effect on evaluating alternatives.
H7: Occupation has an effect on the behavioural biases.
H7a: Occupation has an effect on overconfidence bias.
H7b: Occupation has an effect on disposition effect.
H7c: Occupation has an effect on herding bias.
H8: Income has an effect on rational decision making process.
H8a: Income has an effect on demand identification.
H8b: Income on has an effect on information search.
H8c: Income on has an effect on evaluating alternatives.
H9: Income has an effect on the behavioural biases.
H9a: Income has an effect on overconfidence bias.
H9b: Income has an effect on disposition effect.
H9c: Income has an effect on herding bias.
H10: Age has an effect on rational decision making process.
H10a: Age has an effect on demand identification.
H10b: Age on has an effect on information search.
H10c Age on has an effect on evaluating alternatives.
H11: Age has an effect on the behavioural biases.
 H11a: Age has an effect on overconfidence bias.
H11b: Age on has an effect on disposition effect.
H11c Age on has an effect on herding bias.

3.2 Questionnaire Design

A survey questionnaire is used to identify the relationship between rational decision making
process and behavioural biases in India. The questionnaire is divided in to two parts. First
part included the questions for the three stage rational decision making process i.e. demand
identification, information search, evaluating alternatives and three proposed behavioural
biases that is overconfidence, disposition effect and herding. The other part included the
questions for the respondent’s profile. In the present study 18 measure items are developed
by referring past research tools (Lin, 2011). 6 point Likert scale with 1 set as ‘strongly
disagree’ and 6 set as a ‘strongly agree’ is used for all questions in the questionnaire to
collect the strength of relationship between rational decision making process and the
behavioural biases in investment decision making.

3.3 Data Collection and Methods Used

The population of the present study was the individual investors investing in Indian stock
market. A pilot test with 70 respondents was done to evaluate the reliability and the
consistency of the questionnaire. The questionnaires were distributed through personal
contacts, e-mails and also through the brokerage houses in some cases. The survey was
conducted from May 2015 to October 2015 by using judgment and snowball samplings. A
total of 386 valid respondents have been collected after eliminating the incomplete
questionnaires. After the data collection, data has been compiled and analysed by using
Statistical Package for the Social Science (SPSS) 20 and Amos 20 software. In this study,
cross- section analysis has been performed by using Structure Equation Modelling (SEM).
SEM constructs a comprehensive path and explores how the rational decision making process
of investment and behavioural biases are related. In SEM, relationships between theoretical
constructs are represented by regression or path coefficients between the factors (Hox &
Bechger; 1998). Further, In order to achieve the research objectives, t-test, analysis of
variance (ANOVA) and Fisher’s least significant difference (LSD) test have been used in this
study.
 4. Analysis and Results
4.1 Demographic profile

Table 1 summarises the respondent’s demographic characteristics, which indicates that

sample is composed of 266 males (68.9%) and 120 females (31.1%) respondents. Ages 25-35
(50.3%) account for the biggest portion of the sample, followed by ages less than 25 (26.9%),
ages 36–45 (12.4), ages 46-55 (6.2) and ages over 55 (4.1%). A total of 37.6% respondents
have finance- related occupations. Respondents with lower annual income (less than Rs 2
lakh) accounts for 24.1%, followed by Rs 2 lakh- 5 lakh (54.4%), Rs 6 lakh- 10 lakh (13.7%),
and less than Rs 10 lakh (7.8%).

Table 1: Summary of respondents characteristics (n= 386)

Variable Investor grouping Frequency Percentage

Gender Male 266 68.9
Female 120 31.1
Age (years) <25 104 26.9
25-35 194 50.3
36-45 48 12.4
46-55 24 6.2
>55 16 4.1
Occupation Finance Related 145 37.6
Others 241 62.4
Annual Income (Rs) < 2 lakh 93 24.1
2 lakh – 5 lakh 210 54.4
6 lakh – 10 lakh 53 13.7
>10 lakh 30 7.8
__________________________________________________________________________
4.2 Reliability and Validity of constructed model

Table 2 represents the means, standard deviation and reliability statistics for the constructs.
The Kaiser Meyer- Olkin Measure of Sample Adequacy (KMO) was 0.76 and satisfying the
assumptions of EFA. The Cronbach alpha for 3 stages of rational decision making process is
0.72, 0.81 and 0.76 respectively and the Cronbach’s alpha for the overconfidence, disposition
effect and herding is 0.74, 0.61 and 0.81 respectively that indicates that the reliability of the
study is accepted (Hair et al., 2010).

To assess the constructs’ validity the confirmatory factor analysis (CFA) is performed by
using AMOS 20. CFA is used to test the hypothesis that a relationship between observed
variables and the latent variables exists (Suhr, 2006). For construct validity, Hair et al. (2010)
suggested that standardised factor loadings for each item should be at least 0.5. Table 2
presents the standardised factor loading of individual item. In this study, standardised factor
loadings for all the items are more than 0.6 and the minimum factor loading is 0.64 for the
item O4. Moreover, table 2 also presents the composite reliability of the latent variables in
the model. Bagozzi & Yi (1988) suggested that value of composite reliability for the
individual latent variable should be above 0.6. In this study, the composite reliability for each
latent variables is higher than 0.6. These results show that constructs validity for the model is
accepted.

4.3 Model- fit

In the structure equation modelling, the model fit indices indicate that whether the model is
acceptable. Bentler & Hu (1991) suggested that value of χ2/ df should be in between 5 to 3
for the model to be fit and accurate. The overall model Chi-square is 372.19 with 108 degrees
of freedom. The χ2/ df is 3.44 that is close to 3 for the good fit of model. The overall value of
GFI (Goodness of Fit Index) is 0.91 and CFI (Comparative Fix Index) is 0.93. Bentler (1990)
recommended that the value of CFI should be greater than 0.9 for goof fit of model. The
value of RMSEA (Root Mean Square Error of Approximation) is 0.07. The suggested value
of RMSEA is between 0.05 and 0.08 for an adequate fit (Browne & Cudeck, 1993; Hu &
Bentler, 1995). These results prove that model has an adequate fit for further investigation.

4.4 Results of Structure Equation Modelling

Figure 2 presents the results of structure equation modelling by the path between latent
variables. The hypotheses (H1b and H2c) are strongly supported. However, hypotheses
(H1a, H1c, H2a, H2b, H3a, H3b and H3c) are not supported. The regression weights indicate
that demand identification have significant relation with the information search (β = 0.50, p
value < 0.05), means if the value of demand identification increases by one unit the
information search also increases with 0.50 unit. The positive sign indicates that the increase
in demand also increases the search for information. Similarly, information search also have a
significant relationship with the evaluation of alternatives (β = 0.51, p value < 0.05), implies
that if the value of information search increases by 1 unit the evaluating alternative increases
by 0.51 units. It indicates that different stages of decision making process are associated in a
sequential form. Additionally, analytical results indicate the relationship between decision
making process and behavioural biases. Regression weight indicate that only the second stage
of decision making process i.e. information search have significant relationship with the
overconfidence bias (β = 0.36, p value < 0.05). Evaluating alternatives have significant
impact on the disposition effect (β = 0.31, p value < 0.05). However, the stages of decision
making process have not any significant impact on the herding bias.
 Table 2: Internal Quality of Latent Variable

Latent Variables Item Mean Standard Factor Cronbach’s Composite Reliability

Deviation Loading Alpha

Demand Identification DI1 4.54 1.43 0.83

(DI) DI2 4.59 1.20 0.79 0.72 0.77
DI3 4.19 1.26 0.66

Information Search
(IS) IS1 4.46 1.21 0.77
IS2 4.34 1.17 0.80 0.81 0.76
IS3 4.60 1.18 0.81

Evaluating Alternative EA1 4.61 1.26 0.80 0.76 0.69

(EA) EA2 4.43 1.12 0.85

Overconfidence O1 3.89 1.43 0.73

(O) O2 3.75 1.42 0.81 0.74 0.83
O3 3.57 1.47 0.67
O4 4.08 1.53 0.64

Disposition Effect D1 3.88 1.37 0.79 0.61 0.73

(DE) D2 3.73 1.26 0.85

Herding H1 3.33 1.40 0.87

(H) H2 3.84 1.25 0.80 0.81 0.78
H3 3.32 1.45 0.86
Figure 2: The relationship of rational decision making process and behavioural biases

4.5 Results of t- statistics

t-test is used to analyse whether there are differences between respondent’s demographic
profile (i.e. gender and occupation) and rational decision making process; and how those
differences manifest themselves in the form of behavioural biases. For the mean difference
5% level of significance is used. Table 3 (in Appendix 1) shows the results of t-statistics for
gender difference in rational decision making process. It shows that gender has a statistically
significant difference during the information search and evaluation of alternatives stages of
rational decision making and supports the hypotheses (H4b and H4c). Results further indicate
that male investors search more information and evaluate more alternatives than female
counter parts. Table 4 presents the results of t-statistics on gender difference and behavioural
biases. The results indicate that male investors are more prone to overconfidence and herding
bias than females and support the hypotheses (H5a and H5c). However, there is no significant
difference among rational decision making and behavioural biases in terms occupation of
investors and the results do not support hypotheses (H6a, H6b, H6b, H7a, H7b and H7c).

4.6 Results of ANOVA and Fisher’s least significant difference

ANOVA is used to test whether there are differences between respondent’s demographic
profile (i.e. income group and age) and rational decision making process. Additionally,
Fisher’s LSD test is used for determining the strength of difference between respondent’s
demographic profile. Table 5 presents the results of ANOVA for respondent’s income
difference and rational decision making process. The results show that F-statistics is 3.433
which are statistically significant at a confidence level of 95% and support the hypothesis
(H8a). It indicates that a significant difference exists in demand identification stage of
rational decision making with respect to income of individual investors. However, there is no
significant difference exists in information search and evaluation of alternatives stages of
rational decision making process and the hypotheses (H8b and H8c) are not supported. In
addition to that, results of Fisher’s LSD test presented in Table 6 show that 2 out of 6 pair-
wise comparisons are significantly different at the 95% confidence level. Thus, both the
ANOVA and Fisher’s LSD tests show a distinctive difference between demand identification
and investors of different income group.
Table 7 shows the results of ANOVA for respondent’s income difference and behavioural
biases. The results show that F-statistics is 3.357 which are statistically significant at a
confidence level of 95% and support the hypothesis (H9a). It indicates that a significant
difference exists in overconfidence bias with respect to income of individual investors.
However, there is no significant difference exists in disposition effect and herding bias in
terms of income of investors. Therefore, results do not support the hypotheses (H9b and
H9c). In addition to that, results of Fisher’s LSD test shown in Table 8 show that 2 out of 6
pair-wise comparisons are significantly different at the 95% confidence level. Thus, both the
ANOVA and Fisher’s LSD tests show a distinctive difference between overconfidence bias
and income group of individual investors.
Age difference in terms of rational decision making process is tested by using ANOVA and
results are presented in Table 9. F-statistics is found to be insignificant that shows there is no
significant difference exists in rational decision making process with respect to the income of
investors and the hypotheses (H10a, H10b and H10c) are not supported. Table 10 shows the
results of ANOVA for respondent’s age difference and behavioural biases. The results show
that F-statistics is 5.083 which are statistically significant at a confidence level of 95% and
support the hypothesis (H11b). It indicates that a significant difference exists in disposition
effect with respect to age of individual investors. However, there is no significant difference
exists in overconfidence and herding biases in terms of age of investors. It indicates that the
hypotheses (H11a and H11c) are not supported. In addition to that, results of Fisher’s LSD
test shown in Table 11 show that 4 out of 10 pair-wise comparisons are significantly different
at the 95% confidence level. Thus, both the ANOVA and Fisher’s LSD tests show a
distinctive difference between disposition effect and age of individual investors.

5. Discussions and Conclusion

The purpose of this study was to analyse the relationship between rational decision making
process and behavioural biases of individual investors in India. India is an emerging economy
and investors are more prone to behavioural biases because of lack of financial awareness.
The results of the study indicate that investors follow a rational decision making process
while investing. Empirical evidence provides that there is a significant relationship between
each stage of rational decision making process. First of all, investors identify their investment
demand and analyse whether to invest in financial product will increase their wealth. After
the first stage of decision making investors move towards information search from various
sources like, suggestions from their friends and relatives, information from newspapers or
magazines and from their past experiences. After collecting the information, investors
evaluate all the available alternatives and choose an option. Results confirmed the study
hypothesis that rational decision making process have significant relationship with the
behavioural biases. Results confirmed that second stage of rational decision making i.e.
information search have positive relation with overconfidence bias. In other words, in the
context of present study this positive relation shows that once the investors identified demand
for the investment, they continue to search for the information. But based on the availability
of limited information and their past experience investors become overconfident and behave
irrationally. Literature also states that investors overreact to the private information than
public information (Daniel et al., 1998).
Furthermore, only the last stage of decision making i.e. evaluating alternatives significantly
contributes to the disposition effect. From the findings, it can be argued that during the search
for information investors become overconfident and rely on their past experiences and limited
information. Literature proposed that because of overconfidence investors get engaged in
excessive trading (Odean, 1999) and often causes the wrong decision. Moreover, Sun &
Hsiao (2006) argued that overconfidence is positively and significantly associated to the
disposition effect.
Additionally, findings implies that each stage of decision making process have no impact on
herding bias. It implies that herding behaviour is not directly related to the decision making
process but it could be related to some other factors like market conditions etc. Such a result
is also consistent with the findings of (Lin, 2011).
Further, this study also examined the effect of investors’ background on the rational decision
making process and those differences appear themselves in the form of behavioural biases.
Our results confirmed that gender is significantly different in terms of information search and
alternatives evaluation stages of rational decision making process. Moreover, it indicates that
after the demand identification male investors search more information from newspapers,
magazine and exchange the information with relatives and friends. But based on limited
information and private information they become more confident than females and these
results are consistent with previous studies (Barber & Odean, 2001; Bhandari & Deaves,
2006; Lin, 2011). In case of herding bias, males tend to follow other investors e.g. friends and
relatives during the information search; however, these results contradict the findings of (Lin,
2011). Moreover, results indicate that income of investors is significantly different in terms
of demand identification stage. It shows that investors with higher income have more demand
to invest in financial products that can help them to increase their wealth. Similarly, there is a
significant difference between overconfidence bias and income of individual investors.
Investors with higher income group are less confident than investors belong to low income
group. The results of this study show that age is significantly indifferent with respect to
rational decision making process. However, that young and middle age investors (25-45
years) are prone to disposition effect than aged investors. It clears that young age investors
who are less experienced are often reluctant to realise losses from their portfolio. Such a
result is consistent with the previous study (Talpsepp, 2013). However, occupation has no
significant effect on rational decision making process and behavioural biases.
In conclusion, our results show that investors follow a rational decision making process but
some psychological factors also involve in their investment behaviour. Present study is based
on the cross sectional data so it can also be concluded that investors’ behaviour can be change
according to the market conditions. For the future research more psychological biases can be
considered in different market conditions and interrelationship between different
psychological variables can also be analysed.

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Appendix 1: Table
Table 3: t-test for gender difference in rational decision making process
Item t df Significance Mean Standard 95% confidence interval
(two tailed) difference Error of the difference
Difference Lower Upper
Demand 1.411 384 0.159 0.162 0.114 -0.063 0.388
Identification
Information 4.111 384 0.000 0.447 0.108 0.233 0.662
Search
Evaluating 2.858 384 0.04 0.332 0.116 0.103 0.561
Alternative

Table 4: t- test for the gender difference among behavioural biases

Item t df Significance Mean Standard 95% confidence interval

(two tailed) difference Error of the difference
Difference Lower Upper

Overconfidence 3.149 384 0.002 0.376 0.119 0.141 0.611

Disposition -1.581 384 0.115 -0.191 0.121 -0.429 0.046

Effect

Herding 3.149 384 0.002 0.376 0.119 0.141 0.611

 Table 5: ANOVA for income difference in rational decision making process

Sum of Squares df Mean Square F Sig.

Between Groups 11.110 3 3.703 3.443 .017*
Demand
Within Groups 410.868 382 1.076
identification
Total 421.978 385
Between Groups 5.503 3 1.834 1.806 .146
Information
Within Groups 387.978 382 1.016
search
Total 393.481 385
Between Groups 4.661 3 1.554 1.364 .253
Evaluating
Within Groups 434.980 382 1.139
alternative
Total 439.641 385
*Significant at 95 percent confidence level

Table 6: Significance levels for income mean differences of demand identification

(Fisher’s LSD)

< 2 lakh 2 lakh – 5 lakh 6 lakh – 10 lakh >10 lakh

2 lakh – 5 lakh -.21 --
6 lakh – 10 lakh .21 .42* --
>10 lakh .20 .41 *
-.012 --

*Significant at 95 percent confidence level

Table 7: ANOVA for Income difference among behavioural biases

Sum of Squares df Mean Square F Sig.

Between Groups 11.954 3 3.985 3.357 .019*
Overconfiden
Within Groups 453.364 382 1.187
ce
Total 465.318 385
Between Groups 6.581 3 2.194 1.816 .144
Disposition
Within Groups 461.347 382 1.208
effect
Total 467.927 385
Between Groups 11.954 7.911 3 2.637 1.942
Herding Within Groups 453.364 518.804 382 1.358
Total 465.318 526.715 385
*Significant at 95 percent confidence level
 Table 8: Significance levels for income mean differences of overconfidence bias
(Fisher’s LSD)

< 2 lakh 2 lakh – 5 lakh 6 lakh – 10 lakh >10 lakh

2 lakh – 5 lakh -.027 --
6 lakh – 10 lakh -.53* -.50* --
>10 lakh -.12 -.09 -.41 --

*Significant at 95 percent confidence level

Table: 9 ANOVA for Age difference in rational decision making process

Sum of Squares df Mean Square F Sig.

Between Groups 5.467 4 1.367 1.250 .289

Demand
Within Groups 416.512 381 1.093
identification
Total 421.978 385
Between Groups 3.443 4 .861 .841 .500
Information
Within Groups 390.037 381 1.024
search
Total 393.481 385
Between Groups 2.392 4 .598 .521 .720
Evaluating
Within Groups 437.249 381 1.148
alternative
Total 439.641 385

Table 10: ANOVA for Income difference among behavioural biases

Sum of Squares df Mean Square F Sig.

Between Groups 10.577 4 2.644 2.216 .067
Overconfidence Within Groups 454.740 381 1.194
Total 465.318 385
Between Groups 23.706 4 5.927 5.083 .001
Disposition
Within Groups 444.221 381 1.166
effect
Total 467.927 385
Between Groups 4.794 4 1.198 875 .479
Herding Within Groups 521.921 381 1.370
Total 526.715 385
 Table 11: Significance levels for age mean differences of disposition effect (Fisher’s
LSD)

<25 years 25-35 years 36-45 years 46-55 years >55 years
25-35 years -.46* --
36-45 years -.29 .17 --
46-55 years -.25 .20 .031 --
>55 years -1.07 -.61* -.78* -.81* --

*Significant at 95 percent confidence level