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How the Knowledge of Investor Biases and Heuristics Can Be Used To Invest Money Successfully

INTRODUCTION

Organisations, both governmental and non – governmental, should be able to influence people’s behaviour while allowing them to make their own decisions (Ana et al. 2021). In both the government and industry, minor nudges can assist people susceptible to making these systemic errors at little or no cost to the more educated decision-makers, according to Bernoseter et al. (2018). Put another way, libertarianism paternalism is a middle ground that seeks to satisfy paternalism and market autonomy. Investment firms are not immune to behavioural finance biases. According to research, even people who are experts in their domains are susceptible to cognitive biases (Chaudary, 2019). When making judgments, advisers and wealth managers need to be mindful of their prejudices and mental shortcuts. People can reduce and prevent future mistakes by understanding the subtleties of observed market behaviour. The following behavioural finance tenets explain the flaws in conventional economic theory and show how to correct them (Kartini et al. 2015).

Behavioural Finance

Raut (2020) discussed two aspects of rational behaviour. When investors receive new information, they will accurately and appropriately revise their beliefs. Second, the investor will make the correct decisions in line with the description of traditional financial theories based on their new views. Investing decisions will not be influenced by personal prejudices, as each investor is presumed to be capable of choosing the best selections from a wide range of alternatives based on accurate calculations. “Are investors always rational?” is a fundamental question by some behavioural finance theorists. Shefrin and Statman, Shefrin and Statman, and Shiller are all examples of researchers who have studied the effects of cognitive biases on decision-making (Mabsout et al. 2018). Investor rationalism is not easily met; they argue because investors make judgments based on risk, likelihood, and unpredictability when provided with options. It is not uncommon for people to make decisions based on their evaluation estimates to determine various possibilities (or prospects). They also claim that financial decision-makers use a combination of logical and rational thinking and sometimes irrational and intuitive psychological factors in their decisions. Thus, it may vary from the assumption of rationality. It is the study of psychology related to the economic judgement processes of people and institutions. There are systemic deviations from rationality revealed by investors in behavioural economics (Raut, 2020).

Due to human biases, financial markets are plagued by inefficiencies and abnormalities resulting from human error (Al-Mansour, 2020). Complex situations necessitate selecting the most excellent possible solution from several available alternatives (Shafi, 2019). This makes it easier for investors to arrive at the appropriate conclusions because of its intricacy (Sinyard et al. 2020). As a result, the quality of the information gathered and the capacity of investors to comprehend the information is greatly influenced by their ability to make sound investment decisions. According to Wynes (2021), behavioural biases are primarily a result of investors’ inability to assess information and their emotional role in decision making.

According to behavioural finance theory, humans are social and intellectual animals that use their minds and emotions to make decisions. Behavioural finance can be defined as “A study of cognitive mistakes and feelings in financial decisions” by Sinyard et al. (2020). They said that behavioural finance is the study of financial decision-making influenced by cognitive and emotional elements. Two types of decision-making biases were identified by Pompian (2006) — cognitive and emotional biases, respectively. The former is a bias involved with thinking, whereas the latter is linked to emotions and sentiments. As indicated by Asri (2013) categorised cognitive bias into three groups:

Heuristic bias refers to oversimplifying decision-making processes by applying “rules of thumb.” To put it another way, when faced with a complex or uncertain decision, heuristics come in handy. An example of a framing effect is the tendency to react to information following its presented context, known as the availability bias (Goncalves et al. 2021). An example of the framing effect is when people decide on the connotation of choices, such as a loss or gain. As a result of framing bias, people make decisions based on the information given to them rather than relying just on the facts themselves. If the same facts are given in two distinct ways, people may make different decisions or judgments. Traditional finance has long overlooked the significance of framing and the substance itself. An extreme reaction, authoritarianism, grounding, and confirmatory biases are all part of this category (Khan, 2017).

Prior bias refers to an investor’s tendency to overestimate the value of new information and then overreact to changes in the market price. Market inefficiency results from price deviations from fundamental value due to previous prejudice, hermeneutic bias, and the framing effect. Overconfidence and behavioural finance biases are part of this category. According to Sha and Ismail (2020), investors base their decisions on the information they have access to, and the difficulty is how they construct their perceptions of that information. Here, investors need to know about cognitive biases and how they might contribute to better or worse outcomes (Khan, 2017).

According to their findings, investors are affected by cognitive biases depending on their gender. According to Kartini and Nuris (2015), biases can be harmful since they can contribute to a risk miscalculation. Because these biases are invisible and closely linked to mental processes involving feelings or sentiments, they are challenging to alter. As a result, Schnellenbach et al.(2019) cautioned that the primary objective of behavioural finance is to understand the influence of psychological elements on the financial sector so that everyone may be more careful in decision making. When making investment decisions, one must consider historical returns and predicted future returns when choosing between various investment options (Subash, 2012). Investors make investment decisions in two ways: rationally and irrationally. Investors that are rational base their decisions solely on facts and data regarding the investment opportunity. On the other hand, irrational investors make decisions based on their emotions, which leads to biases in their investments.

Aspects of the Future

Ana et al. (2021) emphasised the concept of “prospect theory” (1979). Investors’ decision-making processes are described in generic terms. Individuals, in their opinion, make unequal assessments of their perspectives on loss and gain. Unlike the expected utility theory, which assumes rational agents make rational decisions, the prospect theory focuses on how individuals behave. They discovered that losses harm us more than profits do. As a result, people are more sensitive to losing something than to gaining something of the same value. Loss aversion refers to the belief that the pain of losing is psychologically about twice as potent as the pleasure of winning (Khan, 2017).

Additionally, people tend to take more significant risks to minimise losses rather than taking greater risks to make money. Investors will be risk-averse when they see gains, but risk-takers when they see losses, to put it another way. According to Raut (2020), a rational investor will behave consistently regardless of whether he or she is risk-averse or risk-taking. This finding goes against Markowitz’s expectations.

Historiographical Theory

Virigineni (2017) focused on the term “heuristic” to explain how people make judgments in complicated and uncertain situations based on their views about the likelihood of events. Uncertainty in events refers to the inability to predict whether a specific event will occur. Thus, people tend to employ rules of thumb to speed up the decision-making process based on these beliefs. According to Wynes (2021), individuals (investors) have a bias in their beliefs that influences their thinking and decision-making.

When it comes to heuristics, Mabsout et al. (2018) defined them as “the application of experience and practical efforts,” which attempts to comprehend information rapidly by depending on experiences and intuitive reasoning. Decision making under uncertainty is explained in this article. Investing decisions are typically tainted by investors’ employment of irrational rules of thumb. There are advantages and disadvantages to adopting a heuristic approach. This method may lead to systematic biases or inaccuracies.

Theory Framing

After dealing with heuristics, the debate turns to cognitive bias. Traditional finance presupposes that framing is visible, according to Frensidy (2016). As a result, investors have a hard time understanding it clearly because many frames are not as straightforward as they should be. Decisions will be heavily influenced by how the information is communicated. Frensidy (2016) used the same knowledge on two different groups, groups A and B, in the initial experiment to describe someone (let us say Budi) in a different way. While in group A, Budi is defined as a brilliant, impetuous, and critical person who is also stubborn, he is characterized as a jealous, stubborn, and critical person in group B. It turns out that presenting Budi’s attributes in reverse order has a substantial impact on the results of the groups’ evaluations. According to the findings, the results show that the traits mentioned early have a more significant impact than those mentioned later.

Conclusion

As a result, behavioural finance has become a highly respected field. Many behavioural finance proponents predict that it will be impossible to distinguish between it and other forms of finance and economics soon. Research findings from behavioural and psychological fields must be included in economics to make progress because the macroeconomic paradigm of rational agents is no longer accepted. Human conduct may seem irrational in some situations; nonetheless, it is still possible to analyse and study the regular deviations from complete rationality in human behaviour. Advisers and asset managers can get an advantage over their rivals by making better selections and wiser choices through behavioural finance.

REFERENCES

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