International Journal of Transformation in Accounting, Auditing & Taxation

Vol. 1, Issue 1 - 2017

IMPACT OF OVERCONFIDENCE AND LOSS AVERSION BIASES
ON INVESTMENT DECISION: MODERATING
ROLE OF RISK PERCEPTION
ANILA RAFIQUE KHAN*, MAHWISH AZEEM*, SALMAN SARWAR*

ABSTRACT

The purpose of this study is to investigate the influence of behavioural biases

overconfidence and loss aversion on the decision making behaviour of individual
equity investor by considering the risk perception as moderator. Behavioural
finance suggests that human decision making involves a combination of cognitive
and affective dimensions. The results of study are helpful for the policy makers,
financial advisor, equity investor, finance teacher and finance students. To
conduct the study, questionnaires were issued to the investors of Islamabad
stock exchange and Lahore stock exchange a total of 250 questionnaires were
distributed of which 160investors responded of which 90% were men and 10%
were women. The results indicated that investors are affected by overconfidence
and loss aversion biases. Loss aversion bias has significant effect because 70% of
the investors were affected and overconfidence bias has significant effect.

The measure with the reworded items is shown in the Appendix 1.

KEYWORDS: Overconfidence, Loss Aversion, Investment Decision, Risk

Perception.

INTRODUCTION

A person who sacrifices his present benefits for
the hope of getting some gain in future is called
investor (Bashir et al. 2013). According to
traditional finance theory individual investors are
suppose to be rational but the prospect theory
explained some biases who leads investors to
irrational behaviour. Bias is unfairness or
propensity to make decisions while already being
influenced by a fundamental belief (Shefrin,
2001). There are several biases which effect the
investor’s decision but this study presents
overconfidence bias and loss aversion bias which
*
Research Scholar, Capital University of Science and Technology, Islamabad, Pakistan.
Correspondence E-mail Id: editor@eurekajournals.com
affect the decision making behaviour. History of
research and debate show that overconfidence is
a common decision making bias among
individuals and groups (Farsi et al. 2014). It is the
systematic overvaluation of one’s decisions and
the accuracy of one’s knowledge (Dittrich et al.
2005). Overconfidence is the propensity for
people to overestimate their knowledge,
cognitive abilities and the precision of their
information (Bhandari & Deaves, 2006). It is
observable that men are more confident than
women (Muthukrishna et al. 2014).

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Impact of Overconfidence and Loss Aversion Biases on Investment Decision: Moderating role of Risk Perception
Anila RK et al.
Overconfident investor in order to gain more
returns will use his superior skills and abilities
(Chen et al. 2007). It is obvious from many
evidences that overconfidence is predominant in
team oriented skills such as leadership than
decision making and planning (Giambatista &
Hoover 2014). While “when an investor makes it
sure not to face loss even earning less profit
percentage it is called loss aversion”. It related to
the individual’s desire to avoid losses than
comparable profits. Loss aversion bias was
developed by Kahneman and Tversky (1979) as
part of the original prospect theory. It is the
tendency that people generally feel a stronger
impulse to avoid losses than to acquire gains.
Risk perception is defined as an individual's
assessment of how risky a situation is in terms of
probabilistic estimates of the degree of
situational uncertainty, how controllable that
uncertainty is, and confidence in those estimates
(Baird & Thomas, 1985; Bettman, 1973).There are
two essential ways in which the risk is interpreted
and acted upon. Risk as feelings refers to our
spontaneous and Impulsive reactions to danger
and risk as analysis brings logic, reason, and
scientific consideration to bear on risk
assessment and decision making (Slovic et al.
2006).The construction of a return-risk trade-off
is out of reach, it is possible to make suggestions
relating to the way investment study clubs’
decision making is affected by different financial,
economic-psychological and investor-specific
factors (Antonides Van 1990).
A reasonable amount of studies are conducted on
the relationship of biases and investment
decision but there is still gap to introduce new
moderators and mediators in order to avoid
irrational decisions. Risk perception is an
important moderator of the present study which
is not tested before in such underlying
mechanism. Most of the studies in developed
countries have linked biases with the investment
decision, but there are fewer empirical studies
conducted in developing countries including
© Eureka Journals 2017. All Rights Reserved.
24
Pakistan. Pakistani culture is different from the
western culture, so there is a need of empirical
research on these biases to reduce the irrational
decision making behavior of individual investors.
This study has theoretical as well as contextual
contribution. Theoretically this paper will
contribute in prospect theory which represents
the investors behaviours are linked with their
prospects mean biases and contextually, there
are fewer studies available in Pakistan’s culture
and context. Pakistan includes in developing
countries where financial markets are inefficient.
Investors get abnormal gains as well as loss due
to several reasons. This study examines the
impact of overconfidence and loss aversion bias
on investment decision with the moderating role
of risk perception.
The prospect theory related to it as the
marginal utility of a loss is strictly greater than
the marginal utility of a comparable gain
(Tversky & Kahneman, 1992). However, Prospect
Theory holds that the risk perceptions of
individuals are more risk averse in dealing with
potential gains than losses (Rabin and Thaler,
2001). Risk aversion causes a dispositional effect
whereby investors tend to let go of winning
shares too early and hold on to loosing stocks for
too long. Although we have acknowledged that
prospect theory does not explicitly consider risk
perceptions, Sitkin and Pablo (1992) suggested
that the findings of prospect theory research are
consistent with a negative relationship between
perceived risk and making risky decisions.
LITERATURE REVIEW
According to conversional financial theory,
investors are the most rational person in order to
make the financial decisions. However, there are
many instances where emotion and psychology
influence our decisions, causing us to behave in
unpredictable or irrational ways. behavioral
finance states that the nature of human is
irrational based on traditions, belief and norms,
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 International Journal of Transformation in Accounting, Auditing & Taxation
25
the divergence of human beings from it proves it
to be imperfect in the decision making (Tversky &
Kahneman, 1974). Nikiforow (2010) in his study
on fund managers found that even the more
effective training cannot change the irrationality
of human in their decision somehow emotion will
be always there.
The impact psychological biases vary from person
to person, due to difference in the personality
(Gross et al., 1997; Mroczek & Kolarz, 1998;
Charles, Reynolds, & Gatz, 2001; Orgeta, 2009;
Yeung, Wong, & Lok, 2011).In other words bias is
unfairness or propensity to make decisions while
already being influenced by a fundamental belief
(Shefrin, 2001; Chen, Lakshminarayanan, &
Santos, 2006).
OVERCONFIDENCE BIAS AND INVESTOR
DECISIONS
Overconfidence investor behavior in financial
markets is typically characterized by
overestimation by the average rate of return
from a portfolio and underestimation of its
unpredictability (Bagchi, S.2011; Fischoff, Slovic,
& Lichtenstein, 1977).
Overconfidence in predictive success of an
innovation facilitates additional acceptance in
both the persuasion and decision stages when
predictions are most likely to occur, whereas
during implementation and confirmation, the
best practice is evolving into a real time
alternative rather than forecasted event (Smith,
Kisamore, Stone, Jawahar, 2010; Ben-David,
Graham,& Harvey, 2007). Overconfidence
investors trade more aggressively. Past returns
leads investors to become overconfident (Sheikh
& Riaz, 2012; Zaiane, 2013; Qadri & Shabbir,
2014).A manager must estimate the possibility of
success or failure of the innovation. Research
suggests that people turned to overestimate the
degree to which their actions will assure a
desired outcome (Miller & Ross, 1975, Inaishi,
Toya, Zhai, & Kita, 2010).
© Eureka Journals 2017. All Rights Reserved.
Vol. 1, Issue 1 - 2017
Overconfidence increases with the deviation of
actual from optimal investments, indicating that
the less accurate their investment decisions are
the more prone are participants to exhibit
overconfidence (Dittrich, Guth & Maciejovsky,
2005; Boukas & Petmezas, 2007).Overconfident
investors overreact to private and under react to
public signals (Daniel, Hirshleifer &
Subrahmanyam, 1998; Libby & Rennekamp,
2012). Overconfidence bias was measured by
four factors: self control, market knowledge,
stock selection ability and specific skill. The
studies revealed that most investors were
overconfidence about their knowledge of equity
market because of their number of years working
in stock market (Kruger, 1999; Alicke et al., 1995;
Garcia, Sangiorgl, & Urosevic, 2007).
Soll and Klayman (2004) investigated that having
appropriate confidence was important for making
appropriate risky decisions, for knowing when to
seek advice and information, and for
communicating one’s knowledge. According to
Hilton, Regner, Cabantous, Charalambides, &
Vautier, (2011) being too confident in our abilities
could lead to overcrowding out of new evidence
or alternative perspectives. The other
overconfident phenomenon is the overestimation
of the preciseness of knowledge, which leads
managers to become overly optimistic about
favorable outcomes. Overconfidence leads
investors to witness surprises sometimes positive
& sometimes negative making the financial
market inefficient based on their wrong forecasts
because of their trap with overconfidence
(Shefrin & Thaler 1988; Niu, 2010; Sin & Regev,
2013).
H1: Overconfidence bias is positively associated
with the investor’s decision.
LOSS AVERSION BIAS AND INVESTMENT
DECISION
The concept Loss aversion bias was developed by
Kahneman and Tversky (1979) making an addition
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Impact of Overconfidence and Loss Aversion Biases on Investment Decision: Moderating role of Risk Perception
Anila RK et al. 26

to the prospect theory. Loss aversion is H2: Loss aversion bias is positively associated
characterized by three properties. To begin with, with the investor’s decision.
riches is measured in respect to a given reference
point. Second, the reduction in utility intimated MODERATING ROLE OF RISK PERCEPTION
by a negligible loss with respect to the reference
Sitkin and Pablo (1992) examined a number of
point is constantly bigger in supreme quality than
potentially appropriate individual, organizational,
the increment in utility coming about because of
and problem characteristics that have been
a minimal increase (Mcgraw, Larse, kahneman, &
recognized as predictors of risky individual
Schkade 2010; Gomes, 2005). Third, in spite of
decision making. Decision risk is a used to
the fact that people are risk unwilling in the area
illustrate the alternatives faces of a decision
of increases, they are danger cherishing in the
maker. Risk can also be used to characterize an
area of losses (kahneman and Tversky 1992;
overall decision how risky it is compared to other
Abdellaoui, Bleichrodt, & Paraschiv, 2007). So the
alternatives (Lan & Ozorio, 2014). Malmendier
investors who have more loss averse attitudes
and Nagel (2011) proposed that bad risk
will take least risky decisions this theory
experiences can decrease investors’ willingness
concludes that the tendency of people is
to take risks by decreasing their risk tolerance
generally stronger to avoid losses than to acquire
(i.e., the preference channel).Risk perception is
gains (Thaler, Tversky, Kahneman& Schwartz,
likely to be affected by cognitive biases that arise
1997; Zamir, & Ritov, 2012).
out of ways of thinking known as heuristics
Loss aversion is usually referred to individual’s (Diacon, 2004; Holt & Laury, 2002; Charness &
trend to ease losses as much as possible to Gneezy, 2010).It hints at the fact that people
acquire gains (Kahneman, Knetsch, &Thaler, believe they are above average and that
1991; Kermer, Driver, & Wilson, & Gilbert, 2006). individuals have unrealistically positive
Previous Studies recommend that, perceptions of themselves (Taylor and Brown,
psychologically, losses are two times as influential 1988, Cooper et al., 1988; Sharpe, 1964; Rovison
as gains. Therefore loss aversion direct to risk & Marino, 2013; Vombardini & Treppi, 2012). The
aversion when investor assess the likely gain, a errors made by the professionals are related to
risk aversion individual when will prefer those the length of their confidence intervals.
options in their decisions having low level of risk,
Risk perception is defined as an individual's
this is because most slightly than make gains,
assessment of how risky a situation is in terms of
they would rather stay away from losses
probabilistic estimates of the degree of
(Benartzi & Thaler, 1993; Harinck, Vandigk, Van-
situational uncertainty, how controllable that
Best, & Mersmann, 2007; Kahleman, Knetsch,
uncertainty is, and confidence in those estimates
&Thaler, 1991). However traditional finance
(Baird & Thomas, 1985; Bettman, 1973;
consider this ‘‘endowment effect’’ people are
Kahneman & Teverasky, 1979).Risk perception
keen to pay more to keep for something they will
and overconfidence strongly impact the risk-
own than to obtain something possess by
taking behavior of professionals (Broihanne et al.
someone else and any other conclusion of loss
2014; Simon, Houghtn, & Aquino, 2000).Decision-
aversion is irrational (Heidhues & koszegi, 2008;
makers exhibiting overconfidence, treat their
Tovear, 2009). Koszegi and Rabin (2006) stated
assumptions as facts, they may not see the
that investors do not fully integrate decisions at
uncertainty associated with conclusions
hand with other decisions and events, but the
stemming from those assumptions.
loss aversion attitude of the investor will affect
their investment in the financial market.

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 International Journal of Transformation in Accounting, Auditing & Taxation
27
They, therefore, may inaccurately conclude that a
certain action is notrisky (Scholleova, Fotr, &
svecova, 2010; Bohme & Danielsen, Kumar, &
Soresc, 2009) .The overconfidence bias lowers an
individual’s perception of the riskiness of
astrategy (Barnes 1984; Russo & Schoemaker
1992; Biais& Weber, 2009)
There is some evidence that overconfidence plays
an especially important rolewhen one considers
whether to start a venture. Busenitz and Barney
(1997) found entrepreneurs display greater
overconfidence than managers do. Although their
study examined entrepreneurs after they started
THEORETICAL FRAMEWORK
Risk Perception
Overconfidence Bias
Loss Aversion Bias
METHODOLOGY
Data was collected using questionnaires through
convenience sampling. The sample consisted of
the investors of Islamabad and Lahore stock
exchange and brokerage houses. We selected this
sample because most of the investors are there in
stock exchange and brokerage houses. The
questionnaire explaining the purpose of the study
assured respondents of strict confidentiality and
that participation in the study was voluntarly.250
questionnaires were distributed of which 160
were returned, making the response rate
approximately 64percent. Scoring for each
construct was done using a five-point likert scale
with 5 representing “very much” agreement/
satisfaction and 1 representing “very much”
disagreement/ dissatisfaction with each item.
© Eureka Journals 2017. All Rights Reserved.
Vol. 1, Issue 1 - 2017
a venture, a tendency towards overconfidence
may have affected these entrepreneurs when
they were initially evaluating the ventures’
riskiness.
H3a: Risk perception moderates the relationship
between overconfidence bias and investment
decision in such a way that higher the risk
perception strengthen the relationship.
H3b: Risk perception moderates the relationship
between loss aversion bias and investment
decision in such a way that higher the risk
perception strengthen the relationship.
Investment Decision
Linear Regression & correlation analysis use for
statistical analysis.
MEASURES
Overconfidence bias was measured with 10 items
scale developed by Simon, Houghton, and Aquino
(2000). A sample item was ‘I prefer complex to
simple problems’. Cronbach’s Alpha of the scale
was 0.820. 4 items scale developed by Hassan,
Khalid, and habib (2014) used to measure loss
aversion bias. A sample item was ‘If I lost Rs. 1000
in a game then I will stop game doing more.’
Cronbach’s alpha value of scale was 0.758.
For measurement of investment decision making
the 7 item scale used adopted from Hiran and
Loibl (2008). Sample item was ‘The uncertainty of
whether the market will rise or fall keeps me
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Impact of Overconfidence and Loss Aversion Biases on Investment Decision: Moderating role of Risk Perception
Anila RK et al. 28

from buying stocks’. Value of Cronbach’s alpha the stock market’ and the Cronbach’s alpha value
was 0.874. was 0.899.

14 item scale of Simon, Houghton, and Aquino RESULTS

(2000) was used for risk perception
measurement. Sample item of risk perception is Table 1 presents mean, standard deviation,
‘It is always easy to determine the credibility of Pearson correlations and reliabilities among the
variables.

Table 1.Mean, Standard Deviation and Correlation Analysis

Variables Mea S.D 1 2 3 4 5 6 7 8
1. Gender 1.218 .4147 1
2. Age 2.875 .6418 .157* 1
3.Qualification 2.862 .8278 .106 .252* 1
4. Experience 3.475 .8463 -.065 .677* .390* 1
5.Overconfidence 3.960 .5702 -.152 .349* .043 .285* 1
6. Loss Aversion 3.504 .9690 .214* .153 .065 .229* .469* 1
7.Investment Decision 3.642 .9076 .047 -.022 .170* -.011 .328* .180* 1
8. Risk Perception 3.600 .8128 -.028 .022 .250* .176* .109 .255* .175* 1
N=160; *p < .05, ** p < .01, S.D for Standard Deviation

The results in Table 1 shows that Overconfidence has the largest mean (3.96) and loss aversion has
has significantly positive influence on investment the smallest mean in variables of study (3.50).
decision (r = .328**).Loss Aversion has positive Results of (table1) also show the standard
association with investment decision (r= .180*,). deviations of variables, loss aversion has the
The risk perception has also significant positive largest standard deviation (.9690) and
association with investment decision (r=.175*). overconfidence has the smallest standard
Results of (table 1) shows that overconfidence deviation (.5702).
Table 2.Results of Regression Analysis for Outcomes and Moderation
Predictors Investment Decision
β R² ΔR²
Step 1
Control Variable .029
Step 2
OC .504*
LA .426 *
RP .371* .147 .118*
Step 3
OCxRP.294*
LAxRP .183* .175 .028

The regression analysis in (table 2) shows that outcomes also shows that lose aversion has
overconfidence bias has significant positive significant positive impact on investment decision
impact on investment decision with (β=.504*, (β=.426*, p<.05).
p<.05).The results of regression analysis for

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 International Journal of Transformation in Accounting, Auditing & Taxation
29
The risk perception has also significant positive
impact on investment decision (β=.371*, p<.05).
The regression analysis results for moderation in
(table 2) shows that risk perception moderate the
relationship between overconfidence, loss
aversion and investment decision with (β=.294*,
p<.05) and (β=183*, p<.05) respectively.
DISCUSSION
The first hypothesis of my study is
overconfidence bias is positively associated with
the investor’s decision is accepted. Our study
shows more the overconfidence lead to reliable
investment decision. Past research shows that
overconfidence investors invest more because
they get more returns in past (Zaiane, 2013).
According Soll and Klayman (2004) investigated
that the appropriate confidence is important for
making risky decision. So our result is consistent
with past researchers.
The second hypothesis of my study is loss
aversion bias is positively associated with the
investor’s decision it also accepted our study
explain that loss averse investors avoid in
investment because they want to save from loss.
Past research shows that the more loss averse
investors attitudes will take less risky investment
decision and this theory make a decision that the
leaning of people is stronger to avoid losses then
to acquire increments.(zamir , &Ritov, 2012)
The third hypothesis of my study is risk
perception moderate the positive relationship
between overconfidence bias and investment
decision it is accepted. Our study shows that
when our confidence is more about our abilities
of investment so we invest more. Past research
shows that overconfidence and risk perception
strongly influence the risk-taking attitude and
behavior of professionals (Broihanne et al.2014).
The fourth hypothesis of my study is risk
perception strengthen the relationship between
loss aversion and investment decision it is also
© Eureka Journals 2017. All Rights Reserved.
Vol. 1, Issue 1 - 2017
accepted. Our study shows that when investors
are loss averse than they invest less., Malmendier
and Negel (2011) proposed that bad and worse
risk experiences can decrease investors’
willingness to take risks by reducing their risk
tolerance
IMPLICATIONS
Managers should take the appropriate and
reliable decision relating to investment. These
decisions must relate to current situation of
market and economic condition of the country.
For making more profitable and affective to
organization the managers should need to
compare their performance with other
organization. In this way they bring suitable,
affective and reliable changes for their
organization and also make better economic
condition of the country. Sometime managers
show the overconfidence attitude towards their
investment decision and this attitude create the
situation of biasness. They believe on their
abilities and invest without taking precautionary
measures. But the actual situation is
contradicting it because their past abilities are
not enough for present condition of running the
organization in best way. Past returns lead
investors to become more confident for future
(Sheikh &Riaz, 2013).
Managers should give consideration at
ratification phase to guarantee that experience is
entrap in a feedback loop to avoid and save
mistakes in upcoming and in future decision
(Smith, Kisamore, Stone & Jawahar , 2010). On
the other hand, some investors and managers are
risk averse at this stage people avoiding losses to
acquiring gains. So mangers should also be the
loss averse to save from big losses. Risk
perception is also important factor for managers,
because risk can be used to characterize an
overall decision how it is risky and compare with
other alternatives (Lan & Ozario, 2014).
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Impact of Overconfidence and Loss Aversion Biases on Investment Decision: Moderating role of Risk Perception
Anila RK et al.
LIMITATIONS AND FUTURE DIRECTIONS
The sample size of the study is not sufficient for
more efficient and reliable findings and the data
is also taken from some regions and investors.
The questionnaire was distributed for collection
of data in which the common bias was involved
and further studies need to avoid these
limitations. Future researchers should also
expand their research work for risk perception by
adding additional outcomes variables into their
studies like risk aversion and risk tolerance and
show the separate impact on investment decision
in one framework. The researcher should explore
additional reaction of behaviour of the investors
to expand their studies. This study can be done
on other sectors also because in this study focus
was only on brokerage houses and stock
exchange of Islamabad and Lahore but we also
collect data from other brokerage houses and
stock exchange like Karachi stock exchange and
brokerage houses. Mix method for collecting data
can be used that is interviews etc. Future
researcher should also need to expand their
sample size in this way data would be reliable and
final results will be according to our study.
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 International Journal of Transformation in Accounting, Auditing & Taxation
35 Vol. 1, Issue 1 - 2017

APPENDIX 1
OVERCONFIDENCE
1. Thinking hard and for a long time about something gives me little satisfaction.
2. I trust my initial feelings about people.
3. I prefer to do something that challenges my thinking abilities rather than something that requires
little thought.
4. I believe in trusting my hunches.
5. I prefer complex to simple problems.
6. I try to avoid situations that require thinking in depth about something
7. When it comes to trusting people, I can usually rely on my "gut feelings".
8. My initial impressions of people are almost always right.
9. I don't like to have to do a lot of thinking.
10. I can usually feel Well when a person is right or wrong even if I can't explain how I know.

LOSS AVERSION
1. I am risk averse.
2. If I have Rs.500, 000 excess, I would prefer to invest in risky alternative.
3. If I lost Rs. 1000 in a game then I will stop game doing more.
4. If I inherited Rs. 2000, 000; I would prefer to choose less risky investment option.

INVESTMENT DECISION
1. Money is most important goal of my life.
2. It is the more satisfying to save than to invest money.
3. Stock market are unpredictable that’s why I would never in stocks.
4. I would invest a larger sum of money in stock.
5. The uncertainty of whether the market will rise or fall keeps me from buying stocks.
6. I prefer to save money because I am never sure when things will collapse and I will need money.
7. I budget my money very well.

RISK PERCEPTION
1. I usually have a fear to invest in stocks that have a sure gain.
2. I am hopeful when undertaking investment in stocks that have exhibited a sure loss.
3. I am cautious about stocks which show sudden changes in price or trading activity.
4. I usually have worry investing in stocks that have had a past negative performance in trading.
5. My investment in stocks is largely based on investment knowledge, experiences and education.
6. I am always attracted to investing in stocks.
7. I usually consider the credibility of brokerage firms that provide the financial services.
8. I can easily ascertain the expertise of the brokers offering service.
9. It is always easy to determine the credibility of the stock market.
10. I can easily tell the reputation of brokerage firms staffing service.
11. I feel that the idea of participating in a buy/sell on the stock market is appealing.
12. I am usually at ease with the stock trading system on the KSE.
13. I am often not afraid to invest in stocks that have shown a past positive performance in trading.
14. I feel regret of a drop in the price of a stock I have purchased.

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