Analyzing Loss Aversion's Influence on Portfolio Choices

This report delves into the field of behavioral finance, focusing on the impact of loss aversion on investor decision-making. It explores the theoretical framework, including prospect theory, to understand how investors react to potential gains and losses. The report examines the concept of loss ...Read More

Running Head: BEHAVIOURAL FINANCE AND DECISION-MAKING
BEHAVIOURAL FINANCE AND DECISION-MAKING
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Table of Contents
Introduction................................................................................................................................2
Research Questions....................................................................................................................3
Research Hypothesis..................................................................................................................3
Literature Review.......................................................................................................................3
Theoretical Framework..........................................................................................................3
Behavioral Finance.................................................................................................................4
Loss Aversion and its effect on Investor’s Decision-Making................................................4
Research Methodology...............................................................................................................8
Conclusion..................................................................................................................................8
Reference..................................................................................................................................10

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Introduction
Over past few decades, financial theories and research studies were developed for
establishing better understanding of financial markets by using models that described
investors as “rational”. It indicates that usually there are tradeoff of risk and return in all
types of the financial decisions, particularly in decisions of stock investments. There are quite
few financial theories that assumes that there is little difficulty faced by investors in making
decisions regarding investment of stocks because investors are consistent, careful and well-
informed (Schleich et al. 2019).
The two key financial theories, CAPM and Modern portfolio theory reveals that the
investors are not confused by the manner they get information and are not controlled by the
behavioral finance factors. However, outcomes of the applied research in developed global
capital markets found that there are various phenomena relating to decisions regarding stock
investment that cannot be described. There had been growth in behavioral finance because
investors rarely behave in accordance with the assumptions that have been suggested in these
financial theories. The behavioral finance domain seeks for better understand as well as
explains the way decision-making of investors has been influenced by the factors of
behavioral finance, as good understanding of these factors helps investors in selecting better
decision-making policy of investment (Rau 2014).
There are reasonable research studies conducted on the relationship of different
behavioral biases and the decisions of investment; however, there still exist gap in explaining
relationship between loss aversion and the investment decisions and its impact on the
investors. Hence, this paper aims to analyze effect of the loss aversion on investors’ decision-
making for investing in different portfolios.

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Research Questions
This research study aims to answer following question:
 What is effect of the loss aversion on investors’ decision-making for investing in
different portfolios?
Research Hypothesis
The hypothesis is prepared in accordance with the research problem. Hence, for
solving the research problem, null and alternate hypothesis is established, which includes
following:
 H0- There is no effect of the loss aversion on the decision-making of investor.
 H1-There is major effect of loss aversion on the decision-making of investor.
Literature Review
Theoretical Framework
It is important for providing theoretical framework for enabling to understand
significance of recruitment of manpower. One of the most appropriate theoretical frameworks
for this research study is as follows:
The Prospect Theory
This research study relates to prospects theory that represents how behaviors of
investors are linked with their prospects such as biases. This theory relates it as marginal
utility of the loss is usually greater in comparison to marginal utility of the comparable gain.
However, prospects theory holds that individuals’ risk perception is more risk averse in order
to deal with the potential gains than the losses. Risk aversion creates disposition effects,
where investors tends to let go too early the winning shares and hold on too long to loosing

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stocks. This theory is consistent with the negative relationship between the perceived risk and
making the risky decisions (Morrison and Clark 2016).
Behavioral Finance
Behavioral finance studies the psychology of making financial decision. Over last
twenty years, study on behavioral science has been increasing because investors rarely
behave in accordance with the assumptions made on the economics theory and traditional
financial theory. The emotions of most of the people affects their decisions of investment.
Fear and greed play major role in driving the stock markets. Moreover, behavioral finance
analyzes biases role in the decision-making, for instance simple rule of the thumb use for
making the complex decisions of investment. It takes insights of the psychological research
and then applies them to make financial decisions (Meng and Weng 2018).
Behavioral researchers take view of finance theory and takes account of the observed
behavior of human. They use research from the psychology for developing financial decision-
making understanding and creating behavioral finance discipline. There are ranges of
behaviors of the decision-making that is known as biases. It affects all kinds of decision-
making; however, it is having particular implications relating to investment and the money.
These biases are associated with how information is processed for reaching out the
preferences and decisions one is having (Lee and Veld-Merkoulova 2016).
Loss Aversion and its effect on Investor’s Decision-Making
Loss or risk aversion is behavioral bias in accordance with which impacts of loss
creates more pain or discomfort in comparison to pleasure from gain realization. It is referred
to one’s preference to avoid loss associated pain is more compared to reward felt from the
gain, which means losing single dollar feels twice as bad as winning single dollar feels great.
Loss aversion includes low participation of market. The concept “loss aversion” explains

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more sensitivity to the losses compared to the gains. In addition, the expected negative
feeling linked with the loss is more compared to expected positive feeling with the gain of
equal sizes. It is not certainly judgement error, but it might represent emotional overreaction
towards the losses that are driven by fear. Loss aversion is prominent characteristic in the
prospect theory that formalizes various empirical observations in the choice behavior
(Kengatharan and Kengatharan 2014). Further, in the prospect theory, function of value is
more for the losses compared to the gains, which represents greater sensitivity to the losses. It
includes matter that gain and the losses are not perceived in the similar way by the investors.
The moment investors realize that the securities hold by them would result in giving loss,
then they are subject to loss aversion and they want to sell those shares for quickly realizing
gains from it (Schulreich, Gerhardt and Heekeren 2016). This step is taken by investors
because price evolves quite rapidly in stock market; hence, he sells assets that worth less in
the market by price in which he had bought it. Moreover, significance of this bias is because
of his influence on decision-making of investor in sale and purchase of the securities (Gal and
Rucker 2018).
The emotional investors tend to make the decisions for avoiding pain of losses. For
instance, during last two pull-backs of market such as Dot Com Bust in 2002 and Global
Financial Crisis from 2007-2009, the investors got panicked and they pulled their money out
from the market. This contributed to large increases in the cash and the cash equivalents. In
order to avoid more such losses after market crash, the fearful investors are more tempted for
moving their investments to place they perceives to be safe such as cash equivalents, cash or
other means. However, investors do not realize that this particular perceived security comes
at the cost (Füllbrunn and Luhan 2017).
There is tendency of human to feel pain of regret, in case they had made errors and
even for the small error, they wish to avoid regret of pain. This can be explained with one

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example that is Maria owns the share of company A. Last year, she was thinking to sell them
for buying shares of company B, but she had dropped this idea. If she had pursued with the
idea of buying shares of the company B, then she would have earned $30,000. Santa owns
shares of company B that he sold for buying the shares of company A. In case, she had kept
company B shares then he would have been richer by $30,000. In this, first investor is a risk
averse because she does not want to sell shares and the second investor is not subject to the
loss aversion because he sold the shares. Normally, the second investor should be less happy
(Frino, Lepone and Wright 2015). Mentally, effect of the loss on behavior of investor is more
significant compared gain effect, which characterizes loss aversion and it explains investor’s
pessimism that is subject to the bias of risk aversion (Shi et al. 2015). Hence, when investors
are more sensitive to the losses then in that case, they always try to avoid this by influencing
their decision-making. If strategic selling and buying decisions of the securities of investors’
are focused, winning shares are sold much more compared to the losing of shares because this
states fear sentiments of the losses, which can affect investors (Easley and Yang 2015).
There is significant gap between returns of the bonds and stocks. In risk premium
context, determination of the portfolio valuation makes the investor indifferent between
having stocks portfolio by making the assumption loss aversion. The valuation interval has
great impact on feeling of loss aversion of investors (Wen et al. 2014). If there is more
narrow evaluation interval, then there would be more chances of loss aversion and the
securities would lose more power for attracting the investors. Further, prices of assets are
realized in the economy, where direct utility is derived by investors from not only
consumptions but also from the fluctuations in their financial wealth’s value (Cronqvist and
Siegel 2014). Hence, over these fluctuations, investors are loss averse and the loss-aversion
degrees depends on their performance of previous investment. Moreover, loss aversion
degree depends primarily on the previous outcome, when it is regarding loss and gain such as

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when investors realized that profits as previous outcomes, then this becomes weakly averse to
the loss; however, when there are losses, the investor becomes strongly averse to the loss.
The loss aversion insists the investors for keeping the losing investments as well as not
selling it in the hope that the things will get lost once again. However, besides this, it helps in
motivating investors for selling their stocks that are profitable because these investors’ fears
from losing their profits (Bodnaruk and Simonov 2016).
The investors do not make chooses of the circumstances in which there is uncertain
probability distribution of game. This particular behavior is expressed as vagueness version,
which is at the origin of the behavioral biases of investors. Moreover, there is problem of
investor’s portfolio, who are required to make choice between foreign and home equities in
asymmetric co-movement presence in returns. It is quite surprising in the home bias puzzle
context that the investors, who are loss-averse behave in the same way as to those with the
standard expected preference of utility as well as plausible levels of the risk aversion
(Yechiam 2018). Further, optimal distribution of dividend under the inconsistent preference
of time and the loss aversion is entirely different from the distribution without the
psychological factors and combination of these factors produces different patterns of the
distribution of dividend. There is emergence of endogenous optimism and loss aversion,
when information incompleteness degrees reach some threshold and then both of it grow to
be more prominent, after information become thinner (Bakar and Yi 2016).
The other research studies support notion of the ambiguity notion, which explains and
justifies existence of all the behavioral biases, which can have influence on any of the
investor. In addition, other study suggests that investors are risk averse over the relative
consumption, which means they suffers from the loss of utility when there is less
consumption by them in comparison to reference groups (Zakamouline 2014). This results in
incentives for holding same risky asset’s portfolio as reference group. Hence, risk premia

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could be supported in the equilibrium, which diverges from obtained risk premia without the
loss aversion over the relative consumptions. The people in general as well as investors
prefers known to the unknown due to fear of taking risks, which exists in the various
probabilities and degrees (Arora and Kumari 2015).
Research Methodology
The sources of data selected for this study is secondary sources of data. This includes
analysis of already collected data by primary means. Hence, this present study is cross-
sectional study with the descriptive nature because research has been already conducted in
this particular area. The method adopted for this research study is qualitative and descriptive
approach for collecting data as well as answering questions. The attempt has been made to
describe characteristics of phenomenon regarding effect of the loss aversion on decision-
making of the investors for their investment portfolio. Further, for achieving desired purpose
of this research study, various valuable information is gained from the relevant journal
articles, books, viewing stock market performance of companies on major announcement
made by the companies and by other relevant sources. Moreover, this study has maintained
confidentiality of information provided by the participants involved, while conducting the
research (Andersson et al. 2016).
Conclusion
Therefore, this paper indicated that the behavioral finance factor such as loss aversion
have significant effect on stock decision of the individual investors. The survey of literature
based on prospect theory depicted that how loss aversion bias has great influence on decision-
making of the investor as well as his strategies of investments. The sentiments of investor and
performance of corporate are the two significant factors, which may be having strong
connection. Hence, loss-aversion bias can have greater impact on performance of firm,

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particularly through the assets of company. Further, behavior of loss aversion significantly
affects the reaction of stock market. The investors are much more concerned with the gains
and losses in their decisions of investment that ultimately causes reach of stock market. The
stock brokers and investors needs to be aware of loss aversion behavior for ascertaining
abnormal returns in stock market. The behavior of loss aversion leads to moving of stock
price from the fundamental values that causes abnormal returns that results in variations in
return. This paper analyzed that the investors feels pain of the losses far greater compared to
the pleasure of gains. They not only experience disappointments, when they check their
investment portfolios with the greater frequency but also feel panic and sell the stock as pain
of losses are not tolerable to them.
This paper is the pioneering studies in domain of the behavioral finance at regional
and local levels. This paper will contribute to benefit investors for gaining understanding
regarding effect of the behavioral finance on the decision-making. It will also provide
introduction, which can be considered as more realistic to study effective factors in the
investment decision-making of stocks at the stock exchange. Moreover, the information
provided by this paper will be beneficial for the mangers and the investors, who are involved
basically in the processes of investment either individually or institutionally. This information
will help investors for understanding how investment can be done, taking risk on
investments, generating investment portfolio for achieving desired set of results.
The limitations of this research include time limitation, which means that this study
was too limited in considering all aspects. This study has considered only one behavioral
factor, however, there are various other factors that have effect on decision-making of
investor. It is because the weak financial knowledge of most of the investors involves
different biases that affects investment decision-making and ultimately there is sufficient loss
on the investment.

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