RMIT University, ACCT1080: Behavioral Finance in the Stock Market

This report delves into the realm of behavioral finance, examining the profound influence of psychological factors on investment decisions within the stock market. It begins with an executive summary, followed by an introduction that highlights the impact of behavioral factors on individual investor behavior. A comprehensive literature review explores behavioral finance, investor psychology, and the impact of biases on decision-making. The report investigates key behavioral factors like herding, market influences, and heuristics, including anchoring and representativeness biases. It also analyzes the impact of prospect theory, risk perception, and attitudes on investment choices. The paper concludes by emphasizing the significance of understanding these behavioral aspects for constructing effective investment portfolios and achieving desired financial objectives. The report aims to provide insights into the complex interplay between psychology and finance.

Running Head: FINANCIAL ACCOUNTING THEORY
FINANCIAL ACCOUNTING THEORY
Name of the University
Author Note

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Executive Summary
Behavioral finance is the study of influence of the psychology on investor’s behavior or the
financial analysts. Investors do not constantly behave rational, as they are influenced by their
biases. For gaining insights on this subject, this paper intends to discuss on influence of the
behavioral factors in making the decisions of investment. Hence, as it is concluded that
behavioral factors play great role in affecting investment decisions of share market, its
understanding will be helpful to the investors and other investment portfolios for constructing
an effective portfolio of investment for achieving the desired objective of investment.

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Table of Contents
Introduction................................................................................................................................3
Literature Review.......................................................................................................................3
Behavioral Finance and Investors..........................................................................................3
Behavioral Factors Influencing the Investors Decision-Making...........................................6
Behavioral Biases Influence on Investment Decision-Making and Performance................10
Conclusion................................................................................................................................12
Reference..................................................................................................................................13

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Introduction
In stock market, investment behavior of an individual investors is highly influenced
by various psychological factors. These psychological factors highly contribute to the
decisions of investor for allocation of surplus financial resources in different stocks and
instruments of stock market. The successful investors are those who make investment
decisions after doing cautious analysis of the company, industry and economy in process of
investing in share market. Most researcher in the capital market have found that
diversification result in the risk reduction to greater extent in the high volatile conditions of
market. The traditional theories have assumed that in the course of making decision of the
investment, investors behave rationally because individual does not always behave rationally,
as their decisions may be influenced by behavioral preconceptions (Kotlar et al. 2014).
The high volatility of share market put questions on the validity of “efficient market
hypothesis”. Behavioral finance is the new stream of the research study that make
justification of problems faced by the traditional investors. Generally, individual investors are
influenced by different behavioral factors that limit them for acting rationally in process of
the decision-making of investment as supported by the traditional theories of economics. The
behavior of individual and the emotional biases indicates direction for the different securities
as well as other relevant decisions of investment (Kengatharan and Kengatharan 2014).
Hence, this paper aims to discuss influence of the behavioral factors for making investment
decisions and the performance study on the investors of “Colombo Stock Exchange”.
Literature Review
Behavioral Finance and Investors
Behavioral finance is the famous field in finance, which suggests the theories based
on the psychology of human for explaining the anomalies of stock market concept that is

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consisting of extreme fall and rise in stocks prices. It suggests that information structure and
market participants characteristics play significant role in investor’s decision-making for the
three main reasons (Kumar and Goyal 2015). The first reason is that individuals capable of
recognizing flaws in their behavior are capable of enhancing their decision and are wise
enough for learning from their mistakes. The second reason is anomalies, which are
extremely significant part of the active management. The last reason is the individuals, who
thinks that the markets are rational and share price are inclusive of all kinds of availability of
the information, are in position to rely in the passive management (Nofsinger 2017).
For making best financial decisions that is free any kind of the emotions for the
financial investment, individuals are required for staying rational. Further, every individual is
economist deep inside. The economist in an individual, makes him to earn bread and butter
through working. Although, there are no individuals, who are born with the super powers to
remember all kinds of the information and making the decisions that is free from emotions.
One of the main problems with the individuals as well as their skills of decision-making is
that they are having desire for carrying out their entire devolvement history with them
(Maxwell and Lévesque 2014). This information regarding development was quite helpful
long ago; however, in this modern era, that kind of the information is irrelevant. In current
situation, it has become important for combining behavioral dynamics of old times with
logical thinking. Behavioral finance drives behavioral dynamics, which can be combined
with logical thinking. Moreover, today, if an individual understands and knows this
behavioral science then he or she is capable of knowing own abilities as well as take steps for
the improvement (Lin and Viswanathan 2016).
The main reason behind investors putting hard and limited earned money into
something is for getting benefits in terms of profit from it. However, these individuals are
very much aware that profit is not only the thing that they need to expect. Further, with each

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and every investment, there include great chances to meet loss as of profit. However, the
probabilities of profit or loss does not leave similar impact on investors. Moreover, it is tough
for them to accept the fact that the investment decisions made by them was bad, as they stick
to their decisions with the hope of getting their money with additional profit at the end of the
day. In these cases, they losses everything for once (Ngoc 2014).
Figure 1: Investor’s ratio of Excite to gain and Fear of Loss
The investors have greater tendency for completely ignore all bad news of
information around them and instead believe in what they would like to believe, despite if it
puts their investment at sake. They are more inclined towards quantity over quality. The
length of reports plays vital role in their process of decision-making.

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Figure 2: Investors’ Choice of Information
Behavioral Factors Influencing the Investors Decision-Making
Behavioral finance is based on the psychology that states that the process of human
decision is subject to various cognitive illusions. The illusions are divided into two different
groups. The first group is illusions caused by process of heuristic decision and the second
group is rooting of illusions from adaptation of the mental frames that is groups in prospect
theory. However, there are also other factors that significantly contributes in decision-making
of individual, some of which are as follows:
Herding Factor
In financial market, the effect of herding is identified as the tendency of the behavior
of investors for following the actions taken by others. In behavior perspective, herding factor
causes some kind of emotional biases, for instance, cognitive and congruity conflicts,
conformity, gossips and home bias. Herding is preferred by investor, if they believe they

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believes that it can helps them in extracting reliable and beneficial information (Huang and
Pearce 2015).
Market Factors
In behavioral finance, financial market is affected by the behaviors of investors. It
might be possible that investors under or over react to changes in the price or news, seasonal
cycle of price changes, focus on the popular stocks, lack of the attention on the fundamental
principles of underplaying stock and predicting future based on past trends.
Heuristic Theory
Heuristics are explained as rule of thumb that makes decisions easier, mainly in
uncertain and complex environments by decreasing complexity of assessing the probabilities
as well as predicting the values for simpler judgements. It is the mental shortcut, which
allows an individual for quickly and efficiently solving problems and making judgements.
These strategies of rule-of-thumb shorten the time of decision-making and allows the people
for functioning without thinking about next course of action (Hirshleifer 2015). As suggested
by winner of Nobel prize psychologist Herbert Simon that judgement of human is subject to
the cognitive limitations.
There are three factors that belongs to heuristics, which are anchoring,
representativeness and availability bias. The first factor, availability bias occurs when
individuals makes excessively use of information that is easily available. In the area of stock
trading, availability bias manifests itself by investment preference in local entities in which
the investors are acquainted with or the information is easily available, despite of thinking
about fundamental principle that includes diversification of portfolios for the purpose of
optimization. The second factor, representativeness bias is referred to degree of the similarity,
which an event is having with its population of parent. This factor may result in the certain

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biases, for instance, individual ignores average long-term rate and put much weight on their
recent experience (Hastings and Mitchell 2020).
The third factor, anchoring is the phenomenon, which is used in circumstances when
individual uses some of the initial values for making estimation that is biased towards initial
ones because different initial points gives different estimates. Moreover, in the financial
market, the anchoring bias arises when recent observation fixes value scale. This factor has
some relations with the representativeness bias because it indicates that individual often put
their focus on their recent experience, as when there is rise in market, they tend to be quite
optimistic and when there is fall in market then they are more pessimistic. When reliability of
skills and knowledge of the individual are overstated by them then it depicts their
overconfidence (Daniel and Hirshleifer 2015).
Prospect Theory
Theory of prospect focusses on subjective decision-making, which is influenced by
investors’ value system. It states some of the state of mind, which affects decision-making
process of the individual such as mental accounting, loss aversion and regret version.
Perceived Risk Behavior
Individual takes the economic risks with trading in the risky securities in stock
market, personal loans, mortgages, credits, accepting insecure jobs and purchasing risky or
inefficient products. The decisions of consumer are also related to the risk, as results are
mostly highly uncertain and its consequences may be serious. An individual, who chooses
risky financial products, there are more chances that it gets affected by recession or financial
crisis. However, taking risk is domain specific. Further, individual taking level of risk in one
domain has no or little relationship with the level of taking risk in another domain (Gomez–
Mejia et al. 2014).

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Risk Perception
Risk is defined as the subjective concept that is influenced by the way event is
understood. Therefore, it is differently perceived by the different individuals. An analysis of
the wat individual makes the decisions of investments confirms that the objective probability
assessment have only weak impact on process of making decision. The risk perception is
crucial component of the risk-taking behaviors and financial decision-making (Revelli and
Viviani 2015). This helps in understanding the decision-making of investment in share
market. It involves assessing degree of the situational uncertainty, confidence in the estimates
and controllability of uncertainty. Therefore, it is the result of mixture of the genuine
uncertainty, seriousness of likely consequences and lack of knowledge. Basically, it is
cognitive assessment; however, influenced by various factors, for instance, optimism, fear
and regret (Elliott et al. 2014).
Risk Propensity
Risk propensity is described as tendency of general behavior for avoiding or taking
risk in specific domain. This is frequently equated with and closely related to the actual
taking of risk. It was found that risk and benefits perception and not the attitude of risk are
associated with domain and gender differences in risk taking. The decision-makers, who
avoid risks are likely to weight the negative results and hence, loss probability is
overestimated relative to gain probability. Consequently, they require higher gain probability
for tolerating failure exposure. Risk propensity may be described as routine or habitual ways
of managing the risky conditions. The routine patterns have a tendency to continue over time.
The risk-averse decisions makers are expected to continue with the adventurous and risky
decisions. However, when proven unsuccessful, routine risk-taking pattern will not continue.

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The outcome knowledge, negative and positive reinforcement will be then affecting changing
circumstances adaptations (Bursztyn et al. 2014).
Perceived Risk Attitudes
Investment is considered to be risky and despite of having incomplete information,
individual on routine basis have to make the decisions. Hence, depending upon information,
which investors is having regarding securities determines their perception of risk. The degree
of perceived uncertainty by the individuals impacts their decisions in relation to investing,
saving and consumption. Perceptions involves emotional and psychological aspects that
subsequently guide decision-making and judgement. This makes investor’s perceived risk
attitudes more subjective compared to risky situation’s objective. Hence, the attitude one
forms or express is likely influenced by the emotions as well as cognitive assessment that is
more logical (Brooks et al. 2014).
Behavioral Biases Influence on Investment Decision-Making and Performance
Individuals uses past experience, rule of thumb or intuition for making present
decisions, as a result of which tin long term, it leads towards earning poor return. The
behavior of individual differs in accordance with situation and time because of certain
behavioral biases. The below are mentioned influence of such biases:
Familiarity
In case, if the required information is not available, then neutral connections in brain
processes the information by shortcuts for achieving desired goals and objective. For
processing such information, experience from past are used. For instance, individual who
plans to purchase house, usually compares prices of the other prices that are familiar with
them in nearby location for assessing property risk and investment’s future value. The
familiar values changes over period of time (Petkova et al. 2014). Human beings have a

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tendency to observe familiar events in comparison to the unaware events and then assigns
more significance for happening of such kind of events that leads to the reversal of belief.
The investors prefer buying stocks that are familiar to them that leads towards home bias and
deficit the diversification. The evidences suggest that the managers invest money in those
entities that are familiar to the investors, despite of the fact that it may yield less amount of
return (Bi, Liu and Usman 2017).
Overconfidence
Overconfidence includes over estimating one’s own abilities for achieving his or her
goals with the help of under estimating future uncertainties. The bias of over estimation
occurs when it is believed by the individual that judgement made by him or her is more
reliable compared to the others. The empirical evidence indicates that about 40 percent of
investors exhibits overconfidence in stock market, the investors who are overconfident, they
over react to the market information and they stick to the correct prediction regarding stock
market. Hence, there is positive relationship between the search of information and the
overconfidence bias (Baker and Ricciardi 2014).
Engagement Level and Investment Programme
For escaping from any kind of losses and risk, the investors generally, include mutual
funds, real estate, gold and pension funds in their investments. In current situations, most of
the common household make investment in the equities. About 47 percent of equities are held
by the households. Further, those individuals, who often does trade, they earn less in
comparison to those who doesn’t trade frequently. The return level in stocks majorly depends
on engagement level by the investor. The individuals who are more influenced by the
overconfidence have a tendency to involve in the active trading that results in less amount of
return. Any increase in trading volume of stock market is reflection of overtrading by