Behavioural Finance Theories Influencing Individual

Investors’ Decision Making In Stock Market

Dr. Umakant S,
Associate Professor, Center for Management Studies, Jain (Deemed-to-be) University, Bengaluru, India

Neelam Shah,
Student, Center for Management Studies, Jain (Deemed-to-be) University, Bengaluru, India

ABSTRACT

Investors' sentiments have been one of the key factors in determining the market movement. Various
study in the different parts of the globe were conducted on the behavioural aspects of investors to understand
how behavioural biases influence investors investment decision making. The major objective of this paper is
to find out the validity of behavioural finance theories influencing individual investors’ decision making in
Indian Stock Market. The data was collected from investors through a structured questionnaire. The results
showed that the behavioural factors influenced the investors investment decision making.

KEYWORDS: Behavioral finance, behavioral factors, behavioral biases, investment decision making

INTRODUCTION

Through developing an understanding about the behavior of the market and individual it would be helpful in
modifying the behaviors and adapting to these changes so that market output can be improved. Shefrin
(2000) says that behavioral finance is a rapidly growing area, psychological influence on the behavior of
financial practitioners & behavioral finance deals with this phenomenon.

Ricciardi and Simon (2000) say that a person who wants to understand behavioral finance must understand
the basic concepts of psychology, sociology and finance because these are interrelated with each other. It
combines behavioral and psychological theories with conventional financial theories to explain why people
make irrational decisions. It also explains the market anomalies.

REVIEW OF LITERATURE

Psychologists have found several judgment biases. Sewell (2007), states that “Behavioral finance is the
study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on
markets.” Ritter (2003), states that behavioral finance is based on psychology which suggests that human
decision processes are subject to several cognitive illusions, which is further divided into two groups:
illusions caused by heuristic decision process and illusions rooted from the adoption of mental frames
grouped in the prospect theory (Waweru et al., 2008).

➢ Heuristics Theory: Heuristics are the rules of thumb which makes decision making easier in an
uncertain and complex environment by reducing the complexity of assessing probabilities and
predicting values to simpler judgment. These heuristics are useful when time is limited but
sometimes lead to biases. Kahneman and Tversky were the first to introduce three heuristic factors
namely representativeness, availability bias and anchoring. Besides that Waweru et al also listed two
factors namely Gambler’s fallacy and Overconfidence in heuristic theory. Kahneman & Tversky,
1974, Ritter, 2003, Waweru et al., 2008

➢ Representativeness: Representativeness refers to the degree of similarity that an event has with its
parent population or the degree to which an event resembles its population. This bias results as
people put too much weight on recent experiences and ignore the average long term rate. This bias
also leads to “sample size neglect” which occurs when people try to infer from too few samples.
Representativeness is applied when investors buy hot stock instead of poorly performed ones. This
behavior is an explanation for investor overreaction. Kahneman & Tversky, 1974., DeBondt &
Thaler, 1995, Ritter,2003, Barberis & Thaler, 2003, Waweru et al., 2008

➢ Overconfidence: When people overestimate the reliability of their knowledge and skills, it is the
manifestation of overconfidence. Overconfidence: Too Much Trading, the individuals who traded
most fared worst, underperforming the index by 500 basis points. Investors are overconfident in their
abilities and in addition to that people tend to be overconfident in their predictions. Overconfidence
results in high volume of trade as observed in the speculative market. Investors and analysts are often
overconfident in areas that they have knowledge. overconfidence can help to promote professional
performance. Further It can enhance others perception of one’s abilities, which may help to achieve
faster promotion and greater investment duration. DeBondt & Thaler, 1995, Shiller (2000), Shefrin
(2000), Hvide, 2002, Oberlechner & Osler, 2004, Evans, 2006

➢ Gambler's Fallacy: This bias arises due to the belief that a small sample can resemble the parent
population from which it is drawn. More precisely, in the stock market Gamblers’ fallacy arises
when people predict inaccurately the reverse points which are considered as the end of good (or
poor) market returns. In addition, when people are subject to status quo bias, they tend to select
suboptimal alternatives simply because it was chosen previously. Statman, 1999, Rabin, 2002,
Barberis & Thaler, 2003, Kempf and Ruenzi, 2006, Waweru et al., 2008

➢ Availability: When people are asked to assess the frequency of a class or the probability of an event,
they do so by the ease with which instances or occurrences can be brought to mind. Availability is a
cognitive heuristic in which we rely upon knowledge that is readily available, rather than examine
other alternatives or procedures. That is, decision making is carried out on how easily things come to
mind. Availability bias comes into play when people make use of easily available information
excessively. TVERSKY, and KAHNEMAN, 1973, Waweru et al., 2003, Martin Sewell, 2011
➢ Anchoring: Anchoring arises when people in some situations use some initial values to make
estimation, which are biased toward the initial ones as different starting points yield different
estimates. Anchoring in the financial market arises when a value scale is fixed by recent
observations. Investors always refer to the initial purchase price when selling or analyzing. Thus,
today prices are often determined by those of the past. Anchoring makes investors define a range for
a share price or company’s income based on the historical trends, resulting in under-reaction to
unexpected changes. Anchoring has some connection with representativeness as it also reflects that
people often focus on recent experience and tend to be more optimistic when the market rises and
more pessimistic when the market falls. Kahneman & Tversky, 1974, Ariely et al. (2003) Nunes
Boatwright (2004), Simonson and Drolet (2004), Waweru et al., 2008, Bateman et al.(2008), Cricther
and Gilovich (2008), Adaval and Wyer (2011),Sudgen et al. (2013),

➢ Prospect theory: Prospect theory suggests that people respond differently to equivalent situations
depending on whether it is presented in the context of a loss or a gain. Theory describes some states
of mind affecting an individual’s decision-making processes including Regret aversion, Loss
aversion and Mental accounting. Khaneman and Tvernsky 1979, 1981, 1986, Waweru et al., 2003

➢ Loss Aversion: Loss aversion – the psychological propensity that losses loom larger than equal-sized
gains relative to a reference point – can occur in riskless and risky choices. Loss aversion refers to
the difference level of mental penalty people have from a similar size loss or gain. Risk aversion can
be understood as a common behavior of investors, nevertheless it may result in bad decisions
affecting investor’s wealth. Kahneman and Tversky 1979; Tversky and Kahneman 1991, Odean,
1998a Barberis & Huang, 2001, Barberis & Thaler, 2003

➢ Regret Aversion: Regret with people’s emotional reaction to having made an error of judgment. To
avoid regret, investors refuse to sell decreasing stocks and are willing to sell the increasing stocks.
Moreover the investors regret more holding stock for a long time and selling the winning stocks very
soon. Larrick, Boles, 1995, Lehenkari & Perttunen, 2004 Forgel & Berry, 2006

➢ Mental Accounting: It is a set of cognitive operations used by individuals and households to

organize, evaluate, and keep track of financial activities. It is also referred to as a process by which
people think about and evaluate their financial transactions. Further it allows investors to organize
their portfolios in a separate account. Thaler, 1999, Barberis & Huang, 2001, Barberis & Thaler,
2003, Ritter, 2003

➢ Herding Effect: In financial markets herding is defined as mutual imitation leading to a convergence
of action. The most common mistake by investors is by following the investment decisions of the
majority. Investors experience herd behaviour as they are concerned about what others will think of
their investment decision. Scharfstein and Stein, 1990, Welch, 2000, Hirshleifer and Teoh, 2003,
Caparrelli et al., 2004, Tan, Chiang, Mason & Nelling, 2008, Waweru et al. 2008, Goodfellow, Bohl
& Gebka, 2009, Kostakis and Philippas , 2010, Kallinterakis, Munir & Markovic, 2010

➢ Market Factors: Financial markets can be affected by investors behaviour as explained by

behavioural finance. As explained by behavioural finance, investors may have over- or
under-reaction to price changes or news; extrapolation of past trends into the future; a lack of
 attention to fundamentals underlying a stock; the focus on popular stocks and seasonal price cycles.
These market factors, in turns, influence the decision making of investors in the stock market. Below
are the factors of the market that have an impact on investors’ decision making: Price changes,
market information, past trends of stocks, customer preference, over-reaction to price changes, and
fundamentals of underlying stocks. DeBondt & Thaler, 1985, Odean 1998a, 1999, Barber and Odean
2000, Lai, 2001, Waweru et al. 2008

RESEARCH METHODOLOGY

STATEMENT OF PROBLEM: To study the correlations of major stock investment strategies & the most
common behavioral finance models affecting the investors’ behavior. The relevant behavioral finance
models addressed are Anchoring Theory, Herding Theory, Prospect Theory & Regret Theory or Regret
Aversion.

OBJECTIVES OF STUDY: In order to reach the target, the aim is divided into minor objectives.
➢ The first objective is to reveal the main issues of individual stock investors & examine whether they
can be explained with the behavioral finance theories mentioned above.
➢ The second objective is to expose the implications of individual stock investors being affected by
behavioral finance models & the effect of illogical investor behavior on money markets.
➢ The third objective focuses on how poor decision-making effects on an individual level & whether it
has an impact on the future investment decisions in terms of compounding misleading information.
➢ The final objective addressed is studying whether there are any positive correlations between major
stock investment strategies & behavioral finance theories.

SCOPE OF THE STUDY: The concept of behavioral finance theories are relatively new & complex. The
amount of existing studies is limited. However, behavioral finance has a major impact on investors' everyday
decisions regarding their purchasing habits. In the field of investments the direct & indirect implications of
behavioral finance are remarkably strong. Therefore, examining investor behavior in order to understand the
fluctuations of money markets is essential. This information may provide significant advantages in the
future.

Studying the corcrelations of investment strategies & behavioral finance theories enhances investors to be
aware of the issues related to the investment strategy they have implemented. In the long-term identifying
these issues may ease the distortions on money markets.

TYPE OF RESEARCH: Descriptive, Applied, Qualitative & Quantitative research.

PERIOD OF REFERENCE: The period of reference conducted to compare & analyze different behaviors
of investors’ decision making with respect to the stock market is 122 days (November 2019 to January
2020).

DATA COLLECTION
SOURCES OF DATA: The data collected for this study is both Primary & Secondary Data.

PRIMARY DATA: Primary data is data that is collected by a researcher from first hand sources, using
methods like surveys, interviews, or experiments. Primary data was collected using a structured
questionnaire which was given to the targeted respondents. The primary data collected was based on
Behavioral finance theories influencing individual investors’ & its sub-components. The researcher used a
unique method of collecting data through Google Forms in order to avoid any manipulation in the process of
collecting data.

SECONDARY DATA: The researcher has also used secondary data. Secondary data is data gathered from
studies, surveys, publications, journals & newspapers or experiments that have been run by other people or
for other research.

ANALYSIS AND INTERPRETATION

The data collected was analyzed. The data was tabulated and percentage was calculated based on the
Number of Respondents which was collected using a Questionnaire.

Table 4.1: Showing the number of respondents of different Gender

GENDER RESPONDENTS PERCENTAGE %

Male 249 71.14

Female 95 27.14

Prefer not to respond 6 1.71

TOTAL 350 100

AGE RESPONDENTS PERCENTAGE %

Less than 20 9 2.57

20-40 162 46.29

40-60 140 40.00

 60 & Above 39 11.14

TOTAL 350 100

Income [Per Annum]

Less than Rs.300,000- Rs.500,000 - Rs.10,00,000 Grand

Rs.300,000
Respondents Rs.500,000 Rs.10,00,000 & more Total

Female 23 22 31 19 95

Male 32 31 99 87 249

Prefer not to
respond 5 1 6

Grand Total 60 53 131 106 350

Are you interested in the Stock investments?

Grand
Respondents
Maybe No Yes Total

Female 8 18 69 95

20 – 40 5 4 42 51

40 – 60 12 24 36

Less than 20 3 2 3 8

Male 7 16 226 249

20 – 40 5 3 97 105

40 – 60 12 92 104

60 & above 2 37 39
 Less than 20 1 1

Prefer not to respond 6 6

20 – 40 6 6

Grand Total 15 34 301 350

Course in Stock Exchange

Respondents No Yes Grand Total

Female 70 24 94

20 – 40 43 7 50

40 – 60 22 14 36

Less than 20 5 3 8

Male 174 75 249

20 – 40 53 52 105

40 – 60 83 21 104

60 & above 37 2 39

Less than 20 1 1

Prefer not to respond 1 5 6

20 – 40 1 5 6

Grand Total 245 104 349

Amount of time you've been participating in the stock market

Less None of
1-3 3-5 5 - 10 than a the over 10 Grand
Respondents years years years year above years Total
 Female 20 3 19 12 22 19 95

Homemaker 2 1 3

Professional 2 7 9

Salaried 20 2 13 3 12 50

Self - 4
Employed 1 11 16

Student 2 5 10 17

Male 25 49 68 20 33 54 249

Employed
for 1
wages 1

Others 1 1

Professional 3 2 4 16 13 38

Retired 3 3

Salaried 13 31 51 15 11 23 144

Self -
Employed 3 14 13 3 1 15 49

Student 4 2 2 5 13

Prefer not
to
respond 6 6

Salaried 6 6

Grand Total 45 52 87 38 55 73 350

What is the amount of corpus you'll like to invest in stock market [Per Annum]
 Rs. Rs. Rs.

Less 10000 - 100000 - 50000 - Rs.

than Rs. Rs. Rs. Rs. 500000 &

Grand

Respondents 10000 50000 500000 100000 more

Total

Employed for
wages 1 1

Homemaker 2 1 3

Others 1 1

Professional 3 18 2 22 2
47

Retired 2 1 3

Salaried 65 44 19 45 25
198

Self -
Employed 3 16 5 37 3
64

Student 22 6 1 1 30

Grand Total 94 86 30 106 31

347

Agree Agree Disagree Strongly

Total Strongly % Somewhat % Neutral % somewhat % Disagree %

Risk 350 52% 23% 9% 5% 11%

Returns 350 67% 13% 14% 1% 6%

Capital Appreciation 350 30% 42% 19% 6% 3%

Regular Income +
Capital Appreciation 350 35% 34% 22% 8% 1%
Percentage of 350 53% 29% 9% 4% 4%
Returns

Percentage of Risk 350 43% 28% 14% 10% 4%

5 - Very 1 - Very
Total High 4 – High 3 - Medium 2 - Low Low

Interest/Dividends 350 43% 23% 17% 11% 6%

Capital Gains 350 63% 13% 11% 11% 1%

Liquidity 350 53% 15% 18% 12% 2%

Capital
Preservation 350 32% 26% 27% 14% 1%

Regular Income 350 30% 20% 35% 10% 6%

Tax Benefits 350 52% 19% 17% 11% 1%

Retirement 350 48% 13% 19% 10% 10%

80% - 60% - 40% - 20% - 0% -

Total 100% 80% 60% 40% 20%

Banks/Financial
Institutions 338 6% 28% 37% 22% 8%

Angel/Venture funds 329 1% 1% 39% 13% 46%

Other Brokers 326 6% 4% 10% 33% 48%

PE funds (Private Equity

Funds) 325 0% 4% 7% 36% 53%

Group Financing 318 0% 1% 6% 37% 56%

Internal financing 326 1% 1% 24% 30% 45%

Less than Rs. 10000 - Rs. 50000 - Rs. 100000 - Rs. 500000
Total Rs. 10000 Rs. 50000 Rs. 100000 Rs. 500000 & more
 Government
security bonds 326 34% 41% 16% 6% 2%

Derivatives & option 334 36% 46% 16% 1% 1%

Treasury bonds 302 23% 52% 16% 9% 1%

Commercial Paper 296 32% 49% 11% 8% 1%

Negotiable
certificates of
deposits. 253 42% 33% 15% 9% 1%

Mutual funds 340 32% 48% 9% 6% 4%

Asset backed
securities 303 24% 49% 21% 6% 1%

Table 4.24: Showing the respondents portfolio.

80% - 60% - 40% - 20% - 0% -
Total 100% 80% 60% 40% 20%

Exchange-traded funds 323 1% 1% 5% 28% 67%

(ETFs)

Equity Stocks 341 13% 18% 46% 16% 8%

Derivatives 331 2% 0% 10% 45% 43%

Mutual funds 341 3% 4% 4% 47% 42%

Bond funds 324 1% 0% 6% 26% 68%

Real Estate Investment

Trusts
(REITS) 329 0% 2% 9% 43% 46%

Fixed Interest 332 4% 3% 36% 39% 18%

Commodities 332 1% 4% 39% 19% 38%

Cash & cash equivalents 331 1% 40% 25% 18% 16%

Table 4.27: Showing the reasons for low participation of respondents in Stock Market.
5 - Most Likely 4 3 - Neutral 2 1 - Less likely
Total % (%) % (%) %

Safer Alternatives
Available 350 50% 17% 9% 15% 9%

No Guaranteed Returns 350 44% 12% 25% 14% 5%

 Fear of Losing Money 350 69% 8% 8% 9% 5%

Volatility 350 65% 11% 5% 15% 4%

Lack of CG 350 41% 23% 14% 13% 10%

Accounting Malpractice 350 46% 26% 6% 13% 10%

Market Manipulation 350 64% 13% 7% 6% 9%

Table 4.30: Showing the reaction of respondents to rumors in Stock Market.

Total Always Sometimes Never

Consequently, we must act. 350 4% 83% 14%

The rumors come from speculators. 350 24% 69% 7%

Leaders who guide the market. 350 15% 73% 12%

No action is taken 350 7% 69% 25%

Table 4.32: Showing the reasons for buying shares by respondents.

5 - Most 3- 1 - Less
Likely Neutral likely
Total % 4 (%) % 2 (%) %

The information disseminated by

the company. 350 15% 47% 17% 16% 5%

The past performance of the

company. 350 68% 12% 7% 11% 1%

The personal intuition based on

the company prospects. 350 47% 17% 18% 8% 10%

The behavior adopted by mutual

funds. 350 15% 11% 42% 28% 5%

Table 4.34: Showing the behavioral factors influencing the investment decisions.
Agree Agree Disagree Disagree
Total Strongly Somewhat Neutral somewhat Strongly

Other investors' decisions of

choosing stock types have impact
on my investment decisions 350 16% 47% 11% 16% 11%
Other investors' decisions of the
stock volume have impact on my
investment decisions. 350 18% 35% 24% 17% 6%

Other investors' decisions of

buying
& selling stocks have impact on
my investment decisions. 350 9% 56% 17% 8% 9%

I usually react quickly to the

changes of other investors'
decisions
& follow their reactions to the
stock market. 350 14% 29% 36% 7% 13%

Other investors’ decisions have

no impact on my decisions. 350 10% 7% 15% 33% 34%

Table 4.36: Showing the anchoring & ability bias factors.

5- 3- 1-
Most Neutra Less
Total Likely 4 l 2 likely

I prefer to buy local stocks than

international stocks because the information
of local stocks is
more available 350 27% 38% 13% 16% 6%

I forecast the changes in stock prices in the

future based on the recent stock prices? 350 31% 33% 17% 15% 4%

I react quickly when I receive new 350 19% 21% 40% 15% 5%
information

I usually follow my first intuition 350 36% 24% 19% 15% 6%

Table 4.39: Showing the change in behavior when the investor loses money on a value.
5 - Most 3- 1 - Less
Total Likely 4 Neutral 2 likely

You never reinvest on it. 350 13.14% 12.57% 39.43% 16.86% 18.00%

Try to regain with it quickly. 350 9.14% 19.71% 41.43% 17.14% 12.57%

You look from time to time to see

the evolution of its price without
doing anything. 349 12.61% 21.78% 40.69% 16.33% 8.60%
Table 4.41: Showing Overconfidence & Gambler’s fallacy factors.
 3-
5 - Most 4 Neutral 2 1 - Less
Total Likely % (%) % (%) likely %

I believe that my skills & knowledge of

stock market can help me outperform
the market? 350 20% 34% 22% 16% 8%

I am normally able to anticipate the end

result of a stock? 350 20% 22% 31% 20% 7%

While investing in a stock, I see long

term historical data 350 25% 26% 25% 16% 9%

While investing in a stock, I see short

term
Trends 350 23% 29% 31% 13% 5%

Table 4.43: Showing market factors.

Strongly Strongly
Total Agree Agree Neutral Disagree Disagree %

Putting past trends of stocks under

your consideration before an
investment? 350 25% 42% 17% 8% 7%

I consider carefully the price changes

of stocks that I intend to invest in? 350 38% 29% 24% 9% 0%

Market information is very

important for my stock investments 350 42% 31% 20% 6% 1%

Table 4.45: Showing Prospect factors.

Strongly
Strongly Disagree
Total Agree Agree Neutral Disagree %

I avoid selling shares that have

decreased in value & readily sell
shares that have increased in value? 350 24% 42% 19% 4% 10%

I ignore the connection between

different investment possibilities? 350 13% 3% 36% 43% 6%

After a prior loss, I become more

risk averse. 350 33% 39% 18% 5% 4%
 I feel satisfied with my investment
decisions in the last year (including
selling, buying, choosing stocks, &
deciding the stock volumes). 350 19% 37% 29% 13% 2%

CONCLUSION

Through this study we understood the behavior of the investors in the stock market & the influence of
psychology on the behavior of investors to determine the most important factors that affect the stock market
& explain the anomalies that persist in this market. We conclude the presence of behavioral biases on the
decisions of investors' in the stock market. We found that the bias of loss aversion, representativeness,
availability & anchoring are the most important that affect the stock market. We have tried to identify the
most important biases that strongly affect the behavior of investors. For doing this, we have considered
many criteria such as education, socio-professional category, age & the amount invested.

Mitigating the biases: Having discussed the field of behavioural finance & its implications for investing &
financial planning. There is a range of deep-seated behavioural biases, which, although they might serve us
well in various circumstances, tend to detract from investment success. These biases can affect the
decisions we take on particular investments & the way we construct portfolios. Individual investors can fall
prey to the biases, but as a part of human nature, professional investors & advisers are also vulnerable. We
cannot cure the biases, but we can attempt to mitigate their effects. Using techniques such as feedback,
audit trails for decisions, checklists, & ‘devil’s advocates’ can help us take decisions in a more rational
manner & improve the chances of investment success.

LIMITATIONS

Every study faces limitations that may hinder the course of the research process. Following are some of the
limitations that were faced during the course of this study:
➢ Time Constraints: The study had to be completed within a specific period of time which did not
permit a more detailed analysis.
➢ Resource Constraints: The study undertaken is done with limited resources in terms of money &
data.
➢ Excludes corporations’ investment strategies: This study does not cover behavioral finance
models concerning corporations’ investment strategies. A majority of large & medium sized
corporations invest their funds via several channels. Therefore, the decision-making process of large
companies is more complex as there are a large number of people involved.

FURTHER SCOPE OF STUDIES

From the study, the present model on factors influencing investment decisions of investors can be extended
by adding more behavioral biases, besides the behavioral biases the model can also be extended by adding
emotional biases to cover a wider perspective of the behavioral & emotional biases affecting the investors’
investment decision.

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