EXAMINING THE EFFECTS OF PSYCHOLOGICAL BIASES AND RISK TOLERANCE ON INVESTMENT DECISION-MAKING USING STRUCTURAL EQUATION MODELING

Abstract

This study empirically tests a structural equation model that explains how individual psychological characteristics influence investor decision-making by looking at the effects of psychological biases and risk tolerance on investment decisions. Investment decisions are rarely based solely on financial data, expected returns or market conditions. They are also influenced by perception, emotion, personal experience and attitude to uncertainty. Therefore, the study examines major psychological biases such as overconfidence, herding tendency, loss aversion, anchoring and confirmation bias, considering risk tolerance as an important individual-level variable that influences investment behavior. A conceptual framework is developed to investigate the direct and interrelated relationships between these behavioral characteristics and investment decision making. Primary data collection can take place through surveys of individual investors. In order to collect data related to investors' demographics, investment experience, behavioral traits, risk attitudes, and decision-making behavior, a survey can be prepared. Using the Structural Equation Modeling approach allows testing the measures of the constructs and the model of relationships between variables. Such an approach allows distinguishing observable indicators from behavioral constructs as well as investigating multiple relationships between psychological biases, risk attitudes and investment decisions. Psychological biases are expected to have significant impact on the process of investors' information processing, assessment of gains/losses, market signals interpretation and investment alternatives selection. Overconfident investors are expected to underestimate uncertainty and overinvest; those who are loss-averse may miss out on profitable investment opportunities due to fear of losses. In the same way, heaving and confirmation bias may lead to the decision making being driven either by the consensus view or the way the investors interpret information in a way that is consistent with their previous knowledge or beliefs. The behavior of the investors is expected to be driven not only by their attitude to the risk but also by the combination of psychological and risk attitudes; therefore, investors with different attitudes towards financial risk may make their decisions in different ways in the same market conditions. The paper makes a contribution to behavioral finance through combining psychological and risk attitudes in one structure. The results of the research may provide valuable information for financial advisers, financial institutions, policymakers, and individual investors who wish to understand the behavioral aspects of investing in order to make their investment decisions more rational and consistent.