Behavioural Biases in Retail Investment Decisions

Abstract

Retail investors do not consistently use rational or complete information processing to make their investment decisions. Behavioral biases (systematic errors in decision-making) have a significant impact on retail investor’s decisions regarding security selection, portfolio design, trading frequencies, and risk-taking. This paper will examine how overconfidence, loss aversion, herding, anchoring, confirmation bias, and the disposition effect influence retail investor’s decision-making process. The research method utilized for this paper was a qualitative literature review. Peer-reviewed literature reviews and foundational theories of behavioral finance were analyzed using thematic analysis. Thematic analysis focused on how each bias influences investment behaviors. The analysis suggests that overconfidence is linked to increased trading activity and unrealistic views of an individual’s ability to perform well in the marketplace. Loss aversion may cause individuals to react negatively to a loss differently from a gain. The disposition effect may lead individuals to sell winning investments prematurely and hold on to losing investments longer than necessary. Herding occurs primarily when there is uncertainty about available information and/or when investors base their decisions on what other investors have done. Anchoring and confirmation bias may limit an individual’s ability to objectively analyze incoming information. The paper concludes that although financial education may help reduce behavioral biases, it is likely that developing better decision-making processes, diversifying portfolios, establishing pre-commitment rules, and reflecting deliberately will be more effective ways of minimizing the negative impacts of behavioral biases. Due to the fact that this study was conducted using existing literature, the results should be considered a conceptual synthesis rather than estimates derived from a survey of investors.