Sample Financial Decision Making Behaviour Assignment

Financial Decision Making Behaviour Assignment Sample

Description

Advisors must be aware of the range of behavioural biases, including ones that they exhibit themselves, so as facilitate a better client-advisor relationship. Accordingly, this research assignment gives students an opportunity to engage with the behavioural finance perspective of investor behaviour, and to deeply reflect on what biases and why the student themselves exhibit in relation to decision-making. The writing style of this assignment includes both formal (passive) research writing, as well as reflective writing which may include pronouns (I, my, etc).

Assessments questions:

You should include in your assignment:

- An synopsis of the differences between traditional finance and behavioural finance perspectives on financial decision-making behaviour

- An overview of the various cognitive and emotional biases, with references to seminal academic papers and/or theories

- An analysis of biases that may influence your own financial decision-making

- Provide insight as to why you may have these biases

- Describe what can be done to mitigate the negative impact of these biases when making financial decisions.

SOLUTION

INTRODUTION

Decision making is measured as one of the most dynamic activity for selection an alternative option from the conditions that reflect good profitability to investors. The primary objective of the investor is to maximize return at minimum risk. For Assignment Help Considering this aspect, present study mainly explains about the behavioural finance perspective of behaviour of investor, and deeply reflects about biases and the manner in which it impacts financial decision.

DISTINGUISH BETWEEN TRADITIONAL FINANCE AND BEHAVIOURAL FINANCE IN THE CONTEXT OF FINANCIAL DECISION – MAKING BEHAVIOUR

It has been noted that, distinct theories has been advanced and have widely categorized the financial market into two aspects such as traditional finance and behavioural finance, which gives contrasting views in financial decision-making behaviour (Kapoor, &Prosad, 2017).

Traditional finance theory is founded on the notion that investors act in the rational manner, whose objective is to maximize their return and they are normally risk averse, which is based on classical decision theory and risk aversion theory. Notably, traditional finance emphasis on the theory of Efficient Market Hypothesis, which proposes that competitiveness between investors between desiring abnormal return influence prices to their reliable values (Valaskova, Bartosova, &Kubala, 2019). On the other side, it has been assumed under behavioural finance that financial market in some conditions informationally inefficient. Moreover, it can be said that, behavioural finance focuses on sociological and psychological elements of the investor’s decision making behaviour. The cited theory stresses on the market anomalies and inefficiencies. Some of the main differences between the traditional finance and behavioural finance are explained as follows –

• Behavioural finance is more of identifying the usual trend of the financial decision implemented by the investors, while traditional finance is considered as more rational that emphasis on mathematical computation, economic models, as well as identification of the market behaviour. Traditional finance is also applied Modern Portfolio Theory, which shows the manner in which risk averse investors could create portfolio for maximization of return on provided level of risk.

• Behavioural finance is the identical technique applied by forecaster of climate, forecaster of economic situation that handles the comprehensive conditions for the financial decisions, while traditional finance is founded on several theories, models, as well as assumptions for taking decision (Chandra, &Thenmozhi, 2017).

• Behavioural finance creates the distinct assumptions with respect to the behaviour of investors and market by making observation, while traditional finance is more of taking into account that markets are efficient with the all provided information that supports investors for taking financial decisions.

• As per the traditional finance, investors obtain infinite knowledge, information, and data, which is perfect. Such information is carefully processed by the investors, so there is rationality in the complete manner. Whereas, in the behavioural finance, investors have bounded rationality, by which entire information is not processed by all information (Taffler, Spence, &Eshraghi, 2017).

• It has been stated under traditional finance that there is efficient market and is a demonstration of the true value of financial market. This argument is founded on the fact that, it has been believed in traditional finance that investors possess self-control, while it has been believed by behavioural finance that market is volatile and therefore there is existence of market anomalies. So, self-control is not possessed by investors in perfect manner, and there is existence of limitation.

Overall, it has been concluded that, behavioural science is primarily concerned with examining the psychology and sociology element of investors. It reduces the assumption of rationality as stated under traditional finance theory and explains the psychological biases that create impact on investor’s decision making in real life (Schoenmaker, &Schramade, 2019).

OVERVIEW OF SEVERAL COGNITIVE AND EMOTIONAL BIASES

Cognitive biases normally consist of decision making on the basis of determined principles that may be accurate or not. Precisely, cognitive bias is a mistake that taken place in reasoning by individual at the time of taking decision, which is blemished through personal faith. Some of the cognitive biases are explained as follows.

Confirmation bias: In this aspect, normally individual give more burden on the opinion of those who asset with them. Investors also do such things as well. In can be noted that, confirmation bias is founded on the notion that individual seek out information and data that assures their pre-existing ideas, and therefore the contrary information is overlooked by them (Yuan, Tian, Huang, Fan & Wei, 2019).

Risk-Averse bias: The bull market is active and even a number of investor has not attained the rally due to the fear that it would reverse course. Such type of bias usually assists investors to emphasis more on bad news relative to good news. This type of investor usually like to invest in safe environment, conservative investment and seeks to such investment in more active manner while markets are strong (Zahera, &Bansal, 2018). Potentially, risk-averse bias could cause the impact of risk to hold more weight as compared to the probability of reward.

Bandwagon effect: It has been noted that, Warren Buffett is one of the most successful investor in the whole world through resisting the bandwagon effect. Their famous suggestion is that, investors should be greedy when others are fearful and they should be fearful when others are greedy. By considering the confirmation bias, investors would feel better at the time when they make investment along with crowd, but Buffett has proven the contrary mentality and prove profitable.

Further, emotional biases usually arise spontaneously on the basis of the personal feeling of the investors at the time of decision making. It is also rooted in-depth manner in personal experience that also creates impact on decision-making. Emotional biases are generally taken place in the psychology of investors and could usually be typical to overcome as compared to the cognitive biases. Some of the sorts of emotional biases are explained as follows –

Loss-aversion bias: In this bias, investors are usually tended to avoiding losses in comparison to the obtaining gains. It has been identified in number of studies that, psychologically losses are more powerful relative to gains.

Endowment bias: In this emotional bias, investors value assets more when rights are hold by them as compared to when they do not. The securities that has been already own by investors, hold by them in irrationally, which is specifically quite reliable with respect to their inherited investment. The outcome of the cited bias is that investors fail to sell off some assets and replace other assets (Dowling et al. 2020).

Overconfidence bias: In this, individuals reflect unwarranted believe in their own judgements. Such overconfidence may assists towards overestimation of knowledge level, access of data, and capabilities.

Familiarity bias: This enforces making investment which is accustomed rather than choosing best available alternative. In simple words familiarity bias means providing preference to remain confined to what is familiar.

ASSESSMENT OF BIASES WHICH MIGHT INFLUENCE MY FINANCIAL DECISION-MAKING

The biases which might influence my financial decision making in context with cognitive biases are Bandwagon effect and Confirmation. As being an investor; it feels reassured in case trading or investing decision is taken same as many others (Leiblein,Reuer& Zenger, 2018). I do not prefer accepting higher risk; thus before making any decisions an underlying reason should necessary exist for making same. The bandwagon affect could be an underlying reason which can be used as an investor. Thus, prior making any investment decision I would do market analysis for comparing my decision with others and would not move on if it is not the one accepted by majority of investors. Confirmation bias is considered as psychological principle with do affect financial decision making capabilities. The reason behind same is that it enforces decision maker to negate information which contradicts with pre-existing biases and believes of information which does validate their position. In simple words, decision is not taken on the basis of all available information but limited information considered to be relied. Being an investor, I make effort to confirm evidence rather than taking decision on the basis of only evaluating information. The main issue which I have to deal while complying same is that the decision is taken on the basis of information which is confirmed by preconceived ideas relating to investment and it eventually leads to biased financial decisions (Ady, 2018).

Being reserved in nature and not attaining access to available opportunities as they are attached with high risk; loss aversion is one of emotional bias would influence my financial decision to significant extent. The fact cannot be denied that pain of losing is psychologically twice the pleasure of profits or gain (Shrestha et al, 2019). As while making investment decision I do not opt for alternatives which are risky even though the reward potential is high. Even though this bias prevents from making riskier decision; it also prevents from acceptance of innovative and partially riskier solutions due to which best available option is not chosen. Further, familiarity bias is another emotional bias which would affect financial decision making (Leiblein, Reuer & Zenger, 2018). The reason behind same is that I prefer opting investment relating to which I am well aware; rather than exploring new options as it could be more risky; thus I prefer making decision in safe zone rather than taking higher risk. Familiarity bias can be in context with home country, company with which one work and companies which are preferred over other. In my case I could say it is both companies which I like and biased with home country.

PROVIDE INSIGHT AS TO WHY YOU MAY HAVE THESE BIASES

Decision making is a crucial activity for process of selecting alternative option from a situation which represents good results to individual and investors (Ady, 2018). One of the main insights of dealing with cognitive biases such as bandwagon effect is fear of being let out of the stock; as rise is being assessed in a stock. Thus, rather than analysing fundamentals of company; investment is made in ‘hot stock’ as it is popular. For instance IPO’s cannot be specified as bandwagon effect in practice. As the announcement relating to of offerings are made with huge publicity; thus investor is overenthusiastic for trading as it is suspected that price of stock are rise (Shan et al, 2019). Further, being motivated by wishful thinking, before making investment decision I do confirm the details or prejudices in order to ensure that it is true. However, due to same sometime I ignore information which causes doubt on same as I do trust the source from which information has been gathered. Another main reason of confirmation and loss averse bias is experience of heavy loss in stock exchange market by my parents as they do make frequent investment in security. I have witnessed them dealing with loss in case they do not having faith in contradictions available against our belief on the basis of which decision is made. Thus, I think being bought in specified experience I do have cited biases.

Cognitive bias can be referred as our brains natural way to provide assistance in decision making (Oehler et al, 2018). The cited bias is dependent on our nature and emotions applied to make any investment decision. Thus, as I do not prefer high risk investment alternative due to which I have to deal with Bandwagon effect bias. I believe that it is not wrong to be part of winning side and for same one has to assess the opinion of group or society to ensure what is right or acceptable. Due to same I do prefer or apply group opinion rather than individual thoughts in order to reduce probability of loss. However, it sometimes leads to Bandwagon effect bias and I have to suffer loss being part of group (Valaskova, Bartosova&Kubala, 2019).

ANALYSIS OF MITIGATION OF NEGATIVE IMPACT OF THESE BIASES AT THE TIME OF MAKING FINANCIAL DECISION

Cognitive and emotional biases are common issues for investment success.it is essential for the investors to manage and put efforts towards reduction of such biases as it would help in making rational judgement and avoid costly tools. In order to mitigate the negative impact of confirmation bias, investors are required to maintain information channel open and seek for manner that challenge their ideas. They should identify the pros and cons for a balanced perspective and alternative information from distinct sources. In addition to this, they should also consider evaluate the proposition from several perspectives to restrict from failing into the snare of confirmation bias (Ahmad, Ibrahim, &Tuyon, 2017). Further, loss aversion assists investor to avoid taking minor risk that could support diversification of portfolio for wealth building and probable profits in the long term period. In order to overcome such type of bias, investor should not leave it on the emotions and fear of losses over looking for profitability. It is advisable for the investors to build a robust investment plan as per their suitability and accept some risk within tolerance through taking into account assets that is performed in well manner (Oehler et al, 2018).

The best way to combat with bandwagon effect of cognitive biases is to make investment deliberately against the decision taken by majority. It does require independent thought and confidence but it does assist in attaining desirable results (Sedliacikova et al, 2021). As cited effect does raise barriers for making objective analysis and enforce investor to be influenced by the judgement of others; thus before being dependent on others action, it is necessary to make research regarding the fundamental of option being chosen for investment. Confirmation Bias which is part of cognitive bias could be mitigated to significant extent through acknowledging that it does exists in order to overcome its effects. It can be done through viewing alternating provided by independent third party and analyse information objectively (Ademola, Musa & Innocent, 2019). Even assistance of artificial intelligence can be taken for developing unbiased views and evaluating decision on overall basis. Further, for attaining appropriate results one can ask questions which support bias so that the negative impact of bias could be mitigated or reduced to certain extent.

Emotional bias is connected with behaviour and preferences made by investor while making any decision (Aprayuda, Misra & Kartika, 2021). Familiarity bias is part of same and it can be in form of bias to country, bias to company which we like or any other preferred parameters. It is possible to mitigate its negative impact through checking investing approaches in continue manner along with taking advice of financial advisor so that investment plan or portfolio could be analysed in better manner. With same one could succeed in attaining desired long term result from investments. Even efforts could be made to explore wider opportunities i.e. being aware of all available alternatives and analyse risk along with performance (Aprayuda, Misra & Kartika, 2021).

CONCLUSION

It can be concluded from above analysis that cognitive and emotional biases do affect financial decision of investor. However, it is possible to mitigate negative impact of cited biases through assessing the nature and impact of specific biases in detail. One of the methods which could be useful for emotional as well as cognitive bias is making decision with assistance of financial advisor so that investment plan or portfolio could be analysed in better manner. . Lastly, investors should make effort to assess risk and rewards in detail so that they could take logical and rational decision rather than decision base of cognitive and behavioural biases.

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