Behavioral Bias in Decision Making

Student name: Pragya Dhawan

Student Id: 21412958
Abstract:
There are certain aspects that need to be considered before implementing proper decision-
making models. The decision-making aspect is reliant on Bias. These biases are essential in
propagating the overall financial decisions and implanting and making policies. The present
study discusses the bias based on the effectiveness of information present in the expected utility
model and other alternative models. The different aspects of the models have been evaluated
based on the critical arguments and the overall project discusses the essential components of
bias in the decision-making in the financial realm.
 Table of contents

Introduction to bias and its explanation of the chosen bias in the financial context 4
Description 5
Critical evaluation of the principles of the standard model of individual decision-making with respect
to EUT and its alternatives. Policy interventions are directed at reducing bias. 6
Conclusion 10
Reference 12
Introduction to bias and its explanation of the chosen bias in the
financial context

Introduction:
Behavioral bias or cognitive bias is the psychological factor that influences the money
decisions and financial aspects in the decision-making prospect of an individual. It helps in
understanding the bias concerning policy implications in finance to create a better framework.
In the present study, “Loss Aversion bias” has been studied in the financial context. Bias is a
concept that deals with the psychological factor of loss (Gal and Rucker, 2018). It has been
observed that the psychological impact of loss is greater than the pleasure of gains. The loss
feels worse and loss aversion refers to an individual’s tendency to avoid losses in acquiring
assets or gains. Loss aversion can result in underperformance of the clients. As the heuristic
aspect is considered, Loss aversion is a deepseated impulse that indicates the brain to avoid the
pain of loss. Thus, in the financial context where the investors try to buy or sell loss aversion
affects the financial decisions of the individual. In financial aspects, Loss Aversion is also
called lost potential in financial terms. In this context, the expected utility model can be
described. The model defines that there is some utility that needs to be calculated by taking the
weighted average. The investors can take up loss aversion with clear consequences that can
help them to remove the constraints effectively.

Weakness of EUT

The expected utility model is an important tool that describes the situations when an individual
take decisions in an uncertain condition. The fear of loss in the market aspect makes individuals
more cautious about not investing the money properly and that can create a loss of potential
among the participants. Due to this factor of the behavioral aspect of loss, individuals lose
opportunities in the market and may hold onto an investment. The investors, who suffer from
the loss Aversion, often try to hold on to the investments for a longer period of time and end
up losing more than what is expected. Thus, the expected utility models have some limitations.
The limitations are mainly the deviation from the behavior which has been predicted by the
model that inaccurately captures the behavior and provides no proper result. The standard
model does not provide any predictions of the investment at all.
The Background of the topic
The background discusses the behavioral bias that helps the individual make financial decisions
and also in assessing the risks and significant policy implication in finance. The natural instinct
to avoid losses leads to a proper decision-making process in the financial context. It is always
a pleasurable experience to gain $10 than lose (Sokol-Hessner and Rutledge, 2019). Based on
the risk and the decisions in finance are made. However, loss aversion is an undeniable attribute
of human psychology, it is important to think about a baseline for making financial decisions.
A larger gain is often ignored by a minor loss over a short period. Thus, loss aversion should
be managed properly in financial decisions (KremerRao and Schilbach, 2019). To maintain a
possible gain in a financial context, an individual should be aware of the strategy, risks, and
consequences. These three things can help in creating more profitable aspects.

Description
Policy implications in case of financial decision making

As the tendency of Loss Aversion is studied, the policy implication in finance by Loss aversion
is that the feeling of loss is more powerful than gains. As per the documented study by (Xiao
and Porto, 2019) on policy implications, it has been seen that the investors in the market tend
to hold on to an investment that incurs a loss in the long run. To avoid the physical and mental
agony the implications are made. There are different implications that need to be discussed.
For example: while investing in low-return programs, promising investment procures higher
risks than the guaranteed investments. Holding on to a stock in a market that will provide a loss
in long run is also a consequence of Loss Aversion. Thus, it is important to minimize the risks
to create a better understanding of loss aversion that helps to mention proper profit aspects.
As the heuristic evaluation goes, the emergence of loss aversion can be traced back to the
prospect theory where the concept has been regarded as an omnipresent psychological aspect.
To determine the values and their implications on policymaking hedging an existing
investment by creating a second investment can help in correlating to the first investment. The
financial implications should make an investment in some products that provide guaranteed
returns like insurance or government bonds. Low volatility should be given priority. The risk
assessments should be maintained, and low price volatility will ensure better investment
aspects. Some companies maintain a strong balance sheet. Thus, it is important to invest in
such companies that can generate cash flow and create more diligence in the overall aspects.
To determine the overall policy-making implications, the illusion of loss aversion should
also be considered. Loss is viewed at different points in time differently. The measurements of
the coefficients are mandatory while interacting and tallying the gains and losses with the
portfolio volatility. The investor should be prepared to consider a higher volatility portfolio to
understand the investment behavior and financial implications.

Critical evaluation of the principles of the standard model of

individual decision-making with respect to EUT and its alternatives.
Policy interventions are directed at reducing bias.

Expected Utility models violations to the bias and whether it is accounted for by the standard
model?

The expected utility model is an important decision-making model that deals with an expected
value of an action and the possible outcome of the action by the probability. The concept of
excepted utility is used to elucidate the decisions that are made under the conditions of risk.
The expected utility is helpful in estimating proper profits and losses in a financial context.
There are two violations that can be accounted for by the standard model and that has been the
Allais paradox where the situation in which the extreme underweighting of the high
probabilities has been considered. Which falls short of certainties.
The other violation is the absence of predictions in the case of certainties. The first violation
deals with other biases like the availability heuristic which deals with information while
making the decision. As depicted by (Gigerenzer, 2018), it influences the decision to create an
outsized influence. The EUT also violates the bias of representative heuristics where the
heuristics are present already in the mind and it tends to compare it with the other.
Another violation is bias in ‘Gambler's fallacy’ where the individual thinks that already the
event has occurred and the probability of the event is low. This, Loss aversion bias also is
affected by such violations when in the market the event has already been done and the
investors think that it is less likely to make a profit from that. EUT doesn't mention that. ‘The
hot hand effect’ is another bias that is based on the fact that when a person has gained
continuously, the person will be gaining to create a continuous success. However, it is a
violation of the EUT as the probability of the utility has been determined in the standard model
(Socol et al. 2019). Over and under-confidence can create a less likely aspect of utilization and
thus, it has been considered a violation. The behavioral bias of loss aversion is mainly dealt
with optimism and pessimism. Thus, it also violates the standard model of EUT and it creates
an overall aspect of creating more importance. Thus, EUT doesn’t account for the violations.
The violations impact the individual decision through different aspects which have not been
documented within UET.

Critical discussion of the impacts on individual decision-making indicating the policy

implications.

Financial decision-making in case of risk conditions is characterized by principles of decision

making and the quality of the decision. In technically optimal situations the full potential of
maximized utility. However, the policy implications should be based on the practice of
marketing aspects and other maximized concepts of utility. In the case of the bias of Loss
aversion, which is a behavioral bias, it impacts the decision-making mainly in the case of
investment aspects of the individuals (Gabaix, 2019). The overall outcomes of consideration
mainly use the estimation of the likelihoods. Certain violation aspects also need to be
considered while making the decisions. Although the concept of expected utility is important
in studying the financial aspects of decision-making, there have been other factors that help in
creating a choice for significant decisions. The critics are bound by rationality that helps in
policy-making aspects. The evaluations of the bias that are involved in determining the
expected utility of economic decisions are also helpful in creating policy decisions. The
concept of maximizing the expected utility aspects represents a complete guide that provides
proper decision-making aspects concerning bias. As per the perspectives of He, and (Natenzon,
2019), the rule of maximizing the utility concept represents a consequentialist form of
reasoning that measures the potential outcomes. The functional aspect of the utility theory in
decision-making is used to explain the risk-averse and risk-neutral or risk-loving character that
undertaking the decision of overall aspect of utility prospects, the individual’s optimum
decision will be impacted in the might be an example of undertaking the decision of
policymaking for providing an optimum satisfaction. In other aspects, according to (Małecka,
2020), the application of the expected utility in economic aspects which involves the policy
decisions has created inappropriate valuations. The monetary units in this case are used to scale
the non-monetary outcomes that can create an overall impact on the overall decision-making.
In decision-making, EUT is a standard model which is seen as the normative theory of
behavior. The EUT model was devised for various games and gambles to maximize the
objective of probability. However, with a new probability in the financial sector, the EUT
behavior has been deemed with certain irrationalities that create an overall aspect risk
assessment to determine the impact on policymaking (Felder and Mayrhofer, 2022). The
policies in financial segments have strict procedures which are structured methodologically to
resolve the paradigm of decision-making and create a better prospect. Thus, it is important to
consider the aspects of risks and their consequences while making the policies that impact the
financial decision-making and also describe the bias. The decision-making process and the
corresponding components create a new model that judges the bias based on the probability
concept, and that the main policy is based with the objective of creating a combination of
behavioral strategic impulse and bais which mentions the overall effectiveness. Thus, the
subject of probability in decision-making with respect to EUT is often used in a real-life
scenario in theoretical aspects in the case of implementing the policies.

How the bias has been dealt with in the theory and practice?
Loss Aversion is a cognitive bias that has been used to deal with the case of decision-making
in respect to finances. The bias has been dealt with in standard model theory, alternative
models, and also in practice. The development of decision under risk is a new concept that has
been generalized by Quiggins's theory by adding the loss aversion aspect as a new component
of risk attitude.

As mentioned by (Pan, 2019), the prospect theory and utilization theory use the concept for
proper observation of behavior in reality and the case of theoretical aspects. The bias of loss
aversion is observed in sensitivity cases where the loss is more than the gain. The phenomenon
has different studies and it has many applications (Dibb et al. 2021). The index of loss aversion
mentions the exchange between the loss and the gains in utility aspects. The proposal leads to
a view of risk attitude into three different components - Basic utility, Loss aversion, and
Probability weighting.

The utility functions are used in the financial aspects where there are difficulties in loss
aversion. The decision-making aspects of risks that reflect the sensitivity of the consumers to
decrease the loss aversion reflect the enhancement of profit and it provides an insight into the
enhancement of the overall financial aspects and its evaluation. If loss aversion is assumed in
the theoretical respect, the probability weighting and its implications are to be used in the same
parameter (Hirsh et al. 2018). The loss aversion aspects are analyzed based on the parameters
of utility where the theory of prospects has been denoted to create an overall reference point.
The prospect theory is where the losses and gains are placed and are analyzed based on the
uncertainties.

In reality, Loss aversion is used in the making of financial decisions. Kahneman and Tversky
proposed an alternative descriptive model called prospect theory which provides an analysis of
the individual choices that can help to create a prediction of individual choices (Wang et al.
2020). The prospect theory too relies on the utility aspects, as it acts like a kink at the origin
which maintains the slope of the loss that is steeper than the slope of gain. In the ens prospects,
it has been analyzed that the utility function of prospect theory as a result of an experimentation
that has utilized it as a behavioral component in maintaining specific decision making in the
financial aspects.

How has it been accounted for in alternative decision-making models?

The alternative decision-making models like the Cumulative Prospect theory and loss aversion
are mainly attributed to the overall aspect of the main idea that it is concerned with losses loom
larger than gains. The equal probability aspects where individuals choose to preserve their
wealth, the prospect theory takes a hint from the overall aspect about how loss aversion is used
in risk-seeking and risk-averse behavior. The certainty aspect of prospect theory is mainly an
outcome of probability. As per the documented study by (Smith, 2019), the reflective effect,
on the other hand, is the positive gains that people give greater weightage to a small gain over
a larger gain.

Prospect theory and Expected utility theory are two different models of decision-making that
help in financial policy making. The behavioral bias like loss aversion allows the individuals
to make decisions to maximize the utility and create different aspects that consider maximizing
utility aspects. The choice of risks under the risk assumes a different attribute which enhances
the overall parameter to maintain an overall analysis to provide a proper aspect to increase the
importance of financial aspects. While loss aversion is about psychological prospects of
avoiding losses to maintain again, which determines the differences between the EUT and CPT
in the financial realm. As per the study by (Eckhouse et al. 2019), the development of the
alternative theory is the empirical aspect where the outcomes of the ranks have been addressed.
The accumulated experience in the alternative theory was empirical where the development of
the evolution of the EUT creates a cumulative prospect theory that represents the situational
prospects in loss aversion bias. The probability weighting starts with the estimation of the
alternative aspects that creates an overall prospect which occurs with the estimation of the
decision-making aspects in the EUT on the normative theory. The difference between the two
theories predict a positivist aspect and measure predictive accuracy. Thus, the overall
perspective analysis is built through alternative analysis.
Policy interventions at counter-acting the bias
There are certain interventions that create an insight of the insights used from the psychological
and behavioral aspects which forms the regulatory and non-regulatory prospects in the
policymaking. As the bias of Loss aversion is concerned, nudging has been designed to steer
the people in a particular direction that can help the people to choose the right path to make
independent decision-making in the financial realm (Ruggeri et al. 2020). Behavioral science
in this respect provides an aspect that boosts the competence level to create an overalls analysis
of the main choices which is essential for the overalls misconception that provides the boost of
financial literacy. The importance of nudge is to provide assistance to the aspects of behavioral
policymaking that can create an overall prospect in maintaining the overall decision-making
aspects. The empirical nudging has successfully created a prospect that creates interventions.
While the policymakers are aware of the maximization of the utility, the intervention designs
the behavioral aspects of the monetary policy interventions. The overall prospects of the
nudging are to boost the confidence in the decision-making process which counteracts the
impact of bias and creates a behavioral aspect that preserves the freedom of choice.

Conclusion
To conclude, it can be said that the overall analysis of the objects being the evaluation process
through the interventions of the decision-making helps to create a better paradigm. The proper
decision-making aspect has been analyzed throughout the study and it has also ensured a better
proposition of space within the influence of bias and its effectiveness. The main prospect of
further research should be based on more factors of interventions that can create evidence and
improvement in the policy-making aspect. The capacity to use the main area of crisis and tools
to evaluate the EUT model and other alternatives that can create a better analysis of the
objectives in the overall study. Financial interventions may relate to different financial
decisions like taxes, investments, and other aspects which need to be properly catered to create
an overall perception of the analysis. In my view, the nudging intervention is most important
because it preserves the financial freedom of the decision-maker, Alongside it's important that
the policy aspects should have proper projections that can create an overall analysis to maintain
the evaluation into a better prospect of category in the financial realm.
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