How Do Past Behavioural Psychological Biases Affect Rationality Of Individual Investors’ Trading Behaviour

Abstract

The rationality of individual investor’s trading behavior is a significant area in financial choice and it is often driven by psychological factors against traditional economic theories. As per classical finance theory, they are assumed to be rational and make optimal decisions by considering all the available information to maximize their utility. Nevertheless, positive data reveals that people are not bias-free and their decisions are often irrational and indeed suboptimal in trading. Behavioural psychology indicates that these biases-due to cognitive and emotional constraints may materially impact the investment decision making of individual investors. Specifically, optimism bias, regret aversion, and mental accounting are significant sources of the irrationality of trading decisions coming from behavioral biases in the past.

The purpose of this paper is to understand the long-run effect of individual investors’ historical behavioral biases on their subsequent rationality, in terms of how their biases appear and how they impact their trading behavior. Optimism Bias is an established cognitive bias and can be found in investors, but it leads to feeling overly knowledgeable and skilled, which prompts investors to overtrade and take on more risk. One such principle of prospect theory, regret aversion leads investors to assign greater importance to potential losses than gains, thus causing them to act in behaviors that are risk averse or irrational in times of market risk and uncertainty. Mental Accounting, yet another cognitive bias, is when investors give too much weight to irrelevant data (like initial stock prices) and don’t update their expectations based on new information from the market. These biases, combined with the prior familiarity and historical performance make irrational behaviour self-reinforcing and damp the logical policy-making of investors acting in a fully-rational, utility-maximising way.

The current study is based on the extensive review of the literature regarding behavioral finance, empirical evidences and case studies to understand the psychological forces that make individual investors act in a particular way. In doing so, the study provides practical advice for individuals as well as the financial services industry to counter these irrational biases and enhance investment decision-making in the market. The results highlight the significance of psychological considerations in financial decisions and suggest the possibility of devising measures to improve market efficiency and benefit investors and the financial system overall.