What Is The Impact Of Loss Aversion On Speculative Small Investors Decision-Making?

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Executive Summary

This behavioral finance research project intends to investigate how loss aversion affects speculative small investors’ decision-making and performance. The project is achieved through a critical review of the literature on behavioral science. The paper has four sections, which include the introduction, literature review, results, and conclusion.

The introduction offers background information about the study. It focuses on the development of behavioral finance and its significance in loss aversion. This section also offers the objectives and research questions that guide the research. It highlights the key aspects addressed by the research, including the general provisions and how they influence decision making among individual investors.

The literature review focuses on analyzing the behavioral research theories and how they relate to loss aversion and investment. The theories are discussed and interpreted in the context of how they influence decision-making among small speculative investors. The discussion is coupled with examples that highlight the effect certain behavioral aspects on investors and the decisions they make.

The results offer insights emerging from the review of the literature to address the research questions and objectives. It draws the implications that certain behaviors have on how individual investors make decisions in relation to loss aversion.

The conclusion offers a recap of the study and highlights the considerations the investors should make to engage in effective decision-making.

What Is The Impact Of Loss Aversion On Speculative Small Investors Decision-Making?

Introduction

The modern business environment requires different stakeholders to engage proactively due to its dynamic and competitive nature. Effective decision-making has become an imperative aspect of achieving business success (Sultana & Pardhasaradhi, 2012). Nevertheless, the process of decision-making remains a complex activity for both experienced and small investors. Notably, researchers allude that decisions cannot be made in a vacuum where individuals rely on limited personal resources. Rather, there is an increasing need to employ complex models that consider different factors, which are often not available to small investors (Talha, Ramanakumar, & Neelakantan, 2015).

Recent technological advancements have made technological solutions a key aspect of this process in assisting in the analysis of various variables and engaging in complex computations that facilitate data-driven decision-making. At the same time, researchers are increasingly focusing on the role of cognitive psychology in the decision-making process. In this context, the researcher argues that the decision-making process entails not only addressing a specific problem faced by the individual but extends to factors influenced by their experiences in the business environment. The decision-making process is defined as the process of analyzing and selecting a particular alternative from different alternatives (Jagongo, 2014). Arguably, it is an activity that successes a clear and well thought out evaluation of all alternatives. Individuals making the decision need to update themselves in multidimensional aspects that contribute to achieving the desired results or objectives in a competitive business environment. Premised on this argument, researchers suggest that there is a need for businesses, entrepreneurs, and other stakeholders to gain better insights and understanding about human nature, drawing from the experiences of the global perspective.

Additionally, these individuals need to develop the necessary skills and abilities that influence positive outcomes in investment ventures. Arguably, small investors need to develop a positive vision, perseverance and drive for them to engage in a dynamic, competitive, and challenging business environment. Each investor is different from the other in all aspects. This includes the demographic factors such as social-economic background, educational achievements, age, race, region, gender, among others. A key challenge faced by all investors is the ability to make appropriate and effective investment decisions (Talha et al., 2015). These challenges emerge in the development of investment portfolios, setting financial goals, risk tolerance, and other business constraints. Drawing from these insights, this paper intends to investigate the behavioral factors that influence individual investors' decision-making and performance in the context of loss aversion.

Loss aversion is a key ideology linked with the prospect theory, and it highlights and integrates critical behavioral finance factors. It is centered in the context that losses loom larger than gains. Suggestively, the psychological pain associated with loss is twice powerful that experienced when one makes a gain. This notion explains why people are willing to take risks that will help in avoiding loss. In this light, investigating loss aversion explains the differences among people in risk-seeking and aversion behaviors. Drawing from the insights of risk aversion, the behavioral aspects associated with endowment effect and determining the aspects that influence the status quo.

Investors venturing in different business concepts are perceived to make investment decisions by engaging different financial tools. These tools include conducting fundamental analysis, technical analysis, and effective judgment of situations. Many researchers in the past have assumed that information structure and factors emerging from the target market systematically influence personal investment decisions and performance outcomes. Nevertheless, there is a realization that the investors' behavior is critical because it shapes rational thinking and alludes to the psychological principles associated with decision-making (Levišauskaitė & Kartašova, 2011). Suggestively, the actions individuals take in business are influenced by their feelings, fantasies, moods, and sentiments about a particular investment. These conceptualizations emerge in various publications about behavioral finance since the 1980s. These scholars present an array of empirical findings that show consistency in behavioral impacts with how investors acted in the business and the subsequent performance of their decisions in advancing the business objectives (Jagongo, 2014). These findings initially faced resistance among proponents of the traditional finance concepts, who argued that these concepts were anomalies (Bloomfield, 2011).

Researchers have found that the investors' psychology has had a substantial impact on the outcomes of the portfolio employed by stock market investors, which has helped in comprehending the underlying decision-making criteria among individual investors in the stock market (Jagongo, 2014). On the same note, behavioral finance psychological principles have been employed in researching the activities experienced in the stock markets, which offers an opportunity to understand loss aversion among small investors (Talha et al., 2015). It has also contributed substantially in highlighting the challenges and complications in developing an improved financial decision-making approach that is often a complex undertaking for small speculative stock market investors.

A review of neo-behavioral economics studies highlight that there is a substantial level of complexity that exists in the real world, which limits the potential for investors to make substantial investment decisions. Resultantly, the information asymmetry experienced creates an advantage for some individuals who have access to insights about the market dynamics. Contrary, those who lack such insights are at a disadvantage, creating challenges that impact on their intuition when making investment decisions. Drawing from behavioral finance offers an opportunity to understand how different psychological traits influence the personal capacities among investors to make appropriate business decisions (Jagongo, 2014). Furthermore, financial psychology highlights that people are irrational when making decisions to make investments in the stock market. This is supported by the notion that psychological factors, which include endowment effect, disposition effect, fear of regret, and framing effects, influence an individual’s rationality in making investment decisions (Levišauskaitė & Kartašova, 2011). Resultantly, this makes loss aversion a reasonable approach to understanding the decision making evident in the deviation of stock prices due to the tendency of investors to overreact or underreact to the situations experienced in the stock market.

Loss aversion implies that there is a deviation in the rational decision-making process due to the influence of psychological biases that influence the investment decisions. The fact that individual investors engage in news from newspapers and media as well as public discourse when making investment decisions shows that there is a substantial contribution of behavioral finance among the small investors. This is contrary to the reliance of fundamental and technical analysis that is conducted by professional investors and organizations (Hoffmann & Post, 2014). From this perspective, small speculative investors are people exposed to a constant flow of information that includes financial data and news from mass media and opinions that emerge in social interactions as well as recommendations. Despite this, it is difficult for these individuals to process all this information, especially for people who are less savvy with how stock markets operate. Resultantly, the individual behaviors influenced by consumption of different forms of information affect how decisions to invest are made (Sultana & Pardhasaradhi, 2012). The availability of information and opinions due to the increased interaction among people via internet platforms as well as increased coverage of mass media has contributed to the increased engagement in investment without the use of analysis of the sophisticated information and data about markets (Rubaltelli, Agnoli, & Franchin, 2016). This has increased the impact of proponents of behavioral finance have on the decision-making among stock market investors.

The making of investment decisions is based on the predefined fundamental and technical analysis that incorporate an acceptable level of risk in the portfolio. Despite this, it is evident that the financial decisions are influenced by the shortsightedness, lack of understanding of the financial sophistication, and lack of self-regulation (Jagongo, 2014). In this light, individuals faced with the uncertainty often rely on heuristics or the rules of thumb that facilitate subjective assessment of risks and alternatives that are aimed at reducing the complex nature of the tasks. This implies that loss aversion is a key attribute associated with small speculative investors. Resultantly, this helps in assessing probabilities and predicting the complex issues by making them simpler judgmental activities.

Research Objectives

The general objective of the study is to determine the effects of behavioral finance on individual investors. The specific objectives include:

• To determine the association between behavioral biases and loss aversion in making financial decisions among small speculative investors

• To investigate how loss aversion influences the investors’ decision to invest

• To investigate the link between regret aversion and loss aversion in decision-making among small speculative investors

• To investigate the relationship between emotions and loss aversion in decision-making among small speculative investors

Research Questions

• What is the association between loss aversion and behavioral biases in making financial decisions?

• What is the impact of loss aversion in decision making among small and speculative investors?

• What is the link between regret aversion and loss in decision-making among small investors?

• What is the role of emotions and loss aversion in the decision making the process by individual investors?

Literature Review

The rational decision-making is associated with a reasonable thought process. Engaging in rational decision-making can help the decision maker because the knowledge required is available and specific. The theoretical concept of rational choice is premised on the different alternatives that a small speculative investor might face in the attempt of making a decision. In conducting the analysis, most people engage in a set of restricted alternatives that are considered important or appropriate for the process compared to the rest of the alternatives.