Antecedents Identification and Scale Development of Cognitive Biases Prevailing In Investors

Abstract

This study explores, investigates and explains few cognitive biases that influence investors world over. In addition, this study discovers the possible reasons/ antecedents behind the generation and existence of biases and the degree to which they affect the decisions of investors. Furthermore, this study develops measures for cognitive biases to help humans/ individuals in general and investors in particular to diagnose biases and their antecedents. Cognitive biases involve decision making based on established facts or rules of thumb that may or may not be accurate. Antecedents of cognitive biases cloud/ erode an investor’s decision-making abilities preventing them from making wise or rational decisions and are yet to receive due attention, especially, in Pakistan’s context. In the first phase of this research, most prevalent cognitive biases are explored for developing an initial understanding. For that reason, a detailed review of literature is conducted, whereas professionals and experts of financial markets of Pakistan are interviewed through semi-structured interviews. NVivo is used to generate a word cloud and list of antecedents. Scale is developed by testing content and context validity, after approval by 5 market and 5 language experts each. For the refinement of the scale in the second phase, the self-developed scales are floated among investors to collect additional data by conducting a series of tests. The test battery constitutes a simple check for outliers, the Kaiser-Meyer-Olkin test, Bartlett’s test of sphericity, Exploratory factor analysis and Confirmatory factor analysis for various purposes. The resultant scales of second phase are floated among a relatively smaller group of investors for further refinement of scale. In third phase, data is tested by applying inter-item correlation among items in order to get even more refined scales. Scales resulting from third phase are floated fourth time to a more smaller sample size than the third float for even more refined data and scale verification. The test battery set for fourth phase of data analysis and scale refinement constitutes factor reliability, correlation and regression. Principal component analysis is applied on conclusive scales vii derived from data of questionnaire floated at the last phase. Only 20 antecedents are substantiated out of 47; confirming 2 - 3 antecedents in each bias. Misconception of chance, misuse of faith in intuition and overwhelmed by recent information are found to be the antecedents of representativeness bias; forced decision making, excessive belief of self and forced compliance behavior are found to be the antecedents of cognitive dissonance bias; high self-esteem and lack of analysis ability are found to be the antecedents of self-attribution bias; familiarity with area of investment, excessive belief of self and lack of analysis skill are found to be the antecedents of illusion of control bias; illusion of control, lack of market knowledge and lack of market analysis skill are found to be the antecedents of recency bias; lack of analysis skill, belief in past values and experiences and risk averse behavior are found to be the antecedents of conservatism bias; and finally lack of market analysis skill, overconfidence and impulsiveness are found to be the antecedents of hindsight bias. Conclusively, this study strongly recommends conduction of regular workshops and seminars by SECP and SBP officials to create awareness among individuals and potential investors to educate and develop their understanding for self-assessment of biases and their moderation. This will ultimately lead to a move towards efficient markets and a developed economy. To revitalize and expand the financial markets, it is necessary for investors to understand cognitive biases.