Behavioral effects on individuals' decision-making process using the prospect theory:A case of investors at the NSE

Abstract

Financial economics has evolved and grown in importance in the last 30 years. Models have been developed and the level of sophistication has increased. One of the many stylized models of market behavior is the Efficient Market Hypothesis statistically tested by the Capital Asset Pricing Model (CAPJI.·1). Twenty years of experimental and empirical research has demonstrated that markets are not as efficient as one might assume. Investors are not as rational and risk preferences are stochastic. In addition to this, prospect theory criticized the standard expected utility hypothesis used to describe utility and investor performance preferences. Kahnernan and Tversky (1979) propose a new framework to model the utility and risk preferences of investors. This new "value function" is concave for gains and convex for losses, which implies loss aversion of agents as the primary feature. This study examined investment scenarios with individual investors indicating that the process of making investment decisions is based on the behavioral economics theory which uses the fundamental aspects of the prospect theory developed by Kahnernan and Tversky (1979). The following effects have been tested and identified 1) endowment effect, that makes the participants not to sell the received assets, no matter if better investment options are available; 2) the disposition effect, that refers to the pattern that people avoid realizing paper losses and seek to realize gains; 3) framing, that modifies the investment decision depending on the perspective given to the problem and 4) loss aversion that refers a scenario where greater utility is lost when losing x amount of money than the utility that is gained when obtaining the exact same amount. The study concluded that the endowment, the disposition and the framing effects influenced the decisions by individual investors. Individual investors had their investment decisions affected by loss aversion.