Review paper on impact of behavioral biases in financial decision- making

Abstract

Traditional finance is constructed on four principles which are portfolio principles of Markowitz, the arbitrage principles of Miller and Modigliani, the capital asset pricing model of Sharpe, Lintner and Black and the option-pricing model of Black, Scholes, and Merton, These principles conclude that the market is efficient and competent. Patrons of traditional finance recommend that individual behavior frequently reflect rationality. EMH of Samuelson also explains that people behave rationally, maximize their expected utility and process all available information. EMH states that stock prices reflect all the available information. It is impossible to “beat the market” consistently on a risk adjusted basis since market price should only react to available information. Proponents of traditional finance state that the market and investors who access the market are rational. But in reality investors cannot act rationally all time. They are frequently influenced by psychological factors like state of mind, emotions, trading theories, values and interpretation of information, which mislead them to act as irrational investors, (Kahneman and Tversky). Daniel Kahneman and Amos Tversky were known as the fathers of behavioural finance. Though, many literary works are carried out by them in behavioural finance. Proponent were advocate that investors behavior influence by psychological bias. From the above findings, it concludes that Most of the standard finance theories give more importance to fundamental factors instead of give importance to decision making process of individuals. Therefore, there is necessitating developing modern finance to study these irregularities. The main aim of this paper is to study how psychological factors influence the investment behavior of individuals through review of literature from secondary sources like Journals, Magazines, Books etc. The study also has tried to discover the relationship between the behavioral biases and the investment decisions of the individual investors of stock market. The result of the study will help investors to improve their decision making process through identifying the most important behavioural finance factor.