Online Access: www.absronline.org/journals

*Corresponding author: Waqar Badshah, MS-Finance Scholar, Anadolu University, Eskiehir, Turkey E-Mail: waqar.badshah@gmail.com

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Management and Administrative Sciences Review

Volume 5, Issue 1

Pages: 26-30

January 2016

e-ISSN: 2308-1368

p-ISSN: 2310-872X

Effect of Representativeness Bias on Investment Decision Making

Shoaib Irshad1, Waqar Badshah2*, Usman Hakam3

1. PhD-Business Administration Scholar, Middle East Techinal University, Ankara, Turkey 2. MS-Finance Scholar, Anadolu University, Eskiehir, Turkey 3. MS-Finance Scholar International Islamic University, Islamabad, Pakistan

This study is conducted to find out the effect of representativeness bias on investment decision by using self administered questionnaires and circulated 160 questionnaires in Islamabad stock exchange and 120 questionnaire collected back, the questionnaire used in this study is taken from research paper of Chun and Ming (2008). This study used regression analysis to find out the effect of representativeness bias and results of this study show that investors are affected by representativeness bias in Islamabad Stock Exchange. Investors in Islamabad stock exchange are using past performance as representative of future and investing with representativeness bias.

Keywords: Representativeness bias, Islamabad stock exchange

INTRODUCTION

Traditional finance argues that people are rational and they think rationally when making any decision or passing any judgments. Behavioral finance on other hand is relatively a new field and argues that in many cases our emotions affect our decisions and due to those emotions and psychological influences people make irrational decisions. When people make decisions and judgments, they mostly use rule of thumbs or mental shortcuts. People do not think rationally or they do not have enough time to process all of information to make any decision so that’s why they often use heuristics to reach to final judgment. One of the heuristics is representativeness that people use while making any decision. According to Tversky and Kahneman, (1974)

representativeness bias is mental shortcut and is defined as the tendency to irrationally attribute one characteristic to imply another. Again Shefrin, (2001) defined representativeness heuristics as relying on stereotypes that are used to form quick but irrational opinions.

In Pakistan there is not enough literature available on this area of finance and there is no any research available on this heuristics of behavioral finance so a research gap is there that can be filled. This research is trying to find out effect of representativeness bias on investment decision making in Islamabad Stock Exchange. This research has significance for investors investing in companies registered on Islamabad stock exchange

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and findings of this research will be helpful for investors in a way that they will objectively analyze their investments and will go for it after assessing the intrinsic worth of their proposed investment.

LITERATURE REVIEW

From more than two decades behavioral finance challenge the traditional finance and its argument that investors behave rationally. A lot of experimental as well as theoretical evidence suggest that there are various heuristics that affect decisions. Yates, (1990) argues that people make decisions using mental shortcuts and people do not process all of available information and do not engage in complex analytical processing. For instance when buying a second hand bike we may think that a neat and clean body and outlook of a bike is a indicator of a well maintained and well running bike, but here we simply ignore that neatness and cleanliness is only a physical characteristic. Representativeness heuristics can affect investor’s decisions in two different ways, first similar information may be interpreted as a pattern, by doing this people give more weight to recent news about a firm and they overreact when they estimate about future performance of a company, second effect is that individuals can expect a reversion to mean if they face a series of similar information even if series is too short to apply that law (Kaestner 2006).

Tversky and Kahnman (1974) say that decisions made by investors can be biased because investors often use mental shortcuts and heuristics when making investment decisions. Again Hirshleifer (2001) argues that representativeness bias can affect investment decisions. Representativeness bias affect investors decision making and hence affect stock prices, an investor might attribute a single factor to a company’s growing stock hence ignoring other factors and he then might overreact and decide irrationally (Antunovich and Laster 1998). People give more weightage to the noticeable information and they try to associate that information with company’s success or failure ignoring other factors that might be more important for making rational decision ( Kirs, Pflughoeft and Kroeck 2001).

Most of the time people decide on basis of rule of thumb, based on past events and past decisions

made by them lead them to decide accordingly, in that way they ignore other factors that might be directly or indirectly contribute to rational decision. The Representativeness heuristic can be defined as tendency to organize events in different segments on the basis of only noticeable or visible characteristics. The investors due to representativeness bias investors become over confident and they ignore sample size and mean reversion. Kim and Byun, (2011) argues that due to representativeness bias investors view a small sample as a representativeness of whole population ignoring the sample size and ultimately ignoring the law of probability. Investors often invest in those stocks that have high abnormal returns in near past and investor choose those stocks because of the representativeness bias (Dhar & Kumar 2001).

There is a lot of literature available that support the argument that representativeness does affect investment decision making, among them most prominent researches are of (Chandra and Kumar, 2011, Sohani, I., 2012). Again another research by Hirshleifer (2001) found that investment decisions may be affected by representativeness bias and this research provides an extensive review of this literature.

METHODOLOGY

This study used convenient sampling method to collect the data from investors of Islamabad Stock Exchange. The questionnaire used in this research was taken from the research paper Chun and Ming (2008). This study is trying to find out the effect of representativeness bias on the investment decision making so for that purpose self-administered questionnaires were distributed among 160 investors of Islamabad Stock Exchange. From those 160 questionnaires we received 120; the response rate was 75%.

Demographic Characteristics

TABLE 1 HERE

Measurement

Alpha (∝) Reliability

The alpha (∝) reliability of representativeness bias questionnaire is (.71) and the alpha (∝) reliability of questionnaire of investment decision making is (.79). This research used Five point Likert Scale in

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questionnaire, according to which (1=Strongly Disagree, 2=Disagree, 3=Neutral, 4=Agree and 5=Strongly Agree). The structure of questionnaire is that there are total of 16 questions in questionnaire of which 13 questions are related to investment decision making and 3 questions are of representativeness bias.

There is a significant relationship between the representativeness bias and investment decision making. The relationship is significant at .01. The value of the t-stat is 6.72. The results of this study show that representativeness bias is present among the investors in Islamabad stock exchange. The coefficient of determination is .276 that means representativeness bias is explaining approximately 28% of total variation in investment decision. The value of coefficient of variation is pretty low because there are some other biases like (Availability bias, over confidence bias) that also affect investment decision but these are kept constant because these are beyond the scope of this study.

CONCLUSION

This study found that there is a significant effect of representativeness bias on the investment decision making among investors in Islamabad Stock Exchange. This study used sample size of 120. There is a lot of past literature available that found that representativeness bias has a positive significant effect on investment decision and that supports our results, among them most prominent studies are Sohani, I., (2012), Hirshlefer, D., (2001) and Merikas et.al (2004). The results shows that investors are not investing rationally but they are affected by representativeness bias.

Limitations

This study used a single independent factor to find out its effect on investment decision. Due to sometime considerations this study used single independent factor but there are many other biases that also affect investment decision among them are over confidence bias, Availability bias and Anchoring bias. This study used a small sample size so, so researchers can use these factors to find out there effect on investment decision and there is a gap for future research.

REFERENCES

Antonovich, P. and D. Laster, 1998, Do Investors Mistake a Good Company for a Good

Chun. W, W and Ming. L,M (2008). Investor behavior and decision making style: A Malaysian perspective. Journal of IBBM.

Dhar, R. & Kumar,A. (2001). A non-random walk down the main street: impact of the price trends on trading decision of individual investor. International center for finance,45.

Hirshleifer, D. (2001). Investor Psychology and Assets Pricing. The journal of Finance, 56, 4, 1533-1597.

Investment? Federal Reserve Board, New York – Working Paper.

Kim. K and Byun. J, (2011). Studies on Korean capital market from the perspective of behavioral finance. Asian review of financial research. 24, 3.

Kirs. P., Pflughoeft. K., and Kroeck. G. (2001). A process model cognitive biasing effects in information system development and usage. Information & management journal,153-165

Merikas, Anna, A, Vozikis, S and Prasad, D (2004). Economic Factors and individual investor: The Greek stock exchange. Journal of Applied Business Research. 20, 4.

Shefrin, H. (2001). Behavioral corporate finance. Journal of Applied Corporate Finance 14, 113–124

Sohani, I, (2012). Behavioral finance of an inefficient market. Global journal of management and business research. 12, 14.

Tversky, A. and Kahnman, D. (1974). Judgment under uncertainty: heuristics and biases. Science, 185, 1124-1131.

Yates, J. F. (1990). Judgment and decision making. Englewood Cliffs, NJ: Prentice Hall.

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APPENDIX

Table 1: Characteristics of Respondents

Frequency Percent (%)

Gender

Male 110 91%

Female 10 09%

Education

Graduates 40 34%

Undergraduates 80 66%

Experience in Stock Market

8 to 10 Years 35 29%

5 to 8 Years 60 50%

Less than 5 Years 25 21%

Table 2 Correlation:

Mean Standard

deviation

Investment Representativeness

bias

Investment 3.003 .621 (.778) .525**

Representativeness

bias

3.456 .897 .525** (.704)

**. Correlation is significant at the 0.01 level (2-tailed).

There is a positive correlation between representativeness bias and investment decision making. There is a

significant relation at .01 and p-value is .000

Manag. Adm. Sci. Rev. e-ISSN: 2308-1368, p-ISSN: 2310-872X Volume: 5, Issue: 1, Pages: 26-30

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Regression Analysis:

Variable Beta t-value p-value

Representativeness

bias

.526 6.722 .000

R2=0.276, Adjusted R2= 0.272,