Overconfidence heuristic-driven bias in investment decision-making and performance: mediating effects of risk perception and moderating effects of financial literacy

Abstract

PurposeThis paper aims to show how overconfidence influences the decisions and performance of individual investors trading on the Pakistan Stock Exchange (PSX), with the mediating role of risk perception and moderating role of financial literacy.Design/methodology/approachThe deductive approach was used, as the research is based on the theoretical framework of behavioural finance. A questionnaire and cross-sectional design were employed for data collection from the sample of 183 individual investors trading on the PSX. Hypotheses were tested through correlation and regression analysis. The Baron and Kenny method was used to test the mediation effect of risk perception and the moderation effect of financial literacy. The results of mediation and moderation were also authenticated through the PROCESS and structural equation modelling (SEM) technique.FindingsThe results suggest that risk perception fully mediates the relationships between the overconfidence heuristic on the one hand, and investment decisions and performance on the other. At the same time, financial literacy appears to moderate these relationships. The results suggest that overconfidence can impair the quality of investment decisions and performance, while financial literacy and risk perception can improve their quality.Practical implicationsThe paper encourages investors to base decisions on their financial capability and experience levels and to avoid relying on heuristics or their sentiments when making investments. It provides awareness and understanding of heuristic biases in investment management, which could be very useful for decision makers and professionals in financial institutions, such as portfolio managers and traders in commercial banks, investment banks and mutual funds. This paper helps investors to select better investment tools and avoid repeating the expensive errors that occur due to heuristic biases. They can improve their performance by recognizing their biases and errors of judgment, to which we are all prone, resulting in better investment decisions and a more efficient market. The paper also highlights the importance on relying on professional knowledge, giving it greater weight than feelings and biases.Originality/valueThe current study is the first to focus on links between overconfidence, financial literacy, risk perception and individual investors' decisions and performance. This article enhanced the understanding of the role that heuristic-driven bias plays in the investment management, and more importantly, it went some way towards enhancing understanding of behavioural aspects and their influence on the investment decision-making and performance in an emerging market. It also adds to the literature in the area of behavioural finance specifically the role of heuristics in investment strategies; this field is in its initial stage, even in developed countries, while, in developing countries, little work has been done.

The stock market as a casino: Associations between stock market trading frequency and problem gambling

“…In the present research this link became insignificant once financial literacy was included in the model. This suggests that financial literacy could protect against poor investment choices driven by overconfidence, as a previous study also suggests (Ahmad & Shah, 2020). This helps support the international evidence base on the importance of financial literacy (Goyal & Kumar, 2021).…”

Does underconfidence matter in short-term and long-term investment decisions? Evidence from an emerging market

“…They also documented that disciplined enforcement of heuristics in investment strategies will evade the common pitfalls of cognitive heuristic biases. Ahmad and Shah (2020) argue convincingly, financial literacy plays an important role in overcoming the negative effect of heuristics factors. If investors used heuristics with the inclusion of financial knowledge negative effect of heuristic factors will reduce as a result investors can be positively utilized heuristics in their investment management activities.…”

“…Recent work in behavioral finance has revealed a number of behavioral biases that influence investors' decisions (Itzkowitz and Itzkowitz, 2017). According to behavioral finance scholars, unavoidable behavioral biases exist in the personality of every individual that prevents them from making rational decisions, as well as having bad consequences on investment decisions, investors' performance (Ahmad and Shah (2020) and on market efficiency (Shah et al , 2018).…”

The role of heuristic-driven biases in entrepreneurial strategic decision-making: evidence from an emerging economy

“…Entrepreneurs often used heuristics causing a number of behavioral biases when taking decisions related to a new venture. The latest research by Shah et al (2018) asserts that when business actors used heuristics their technical knowledge and reasoning faculties are impaired, leading to errors in judgment, as a result, make irrational decisions, which in turn adversely affect their performance (Ahmad and Shah, 2020). Tversky and Kahneman (1973) argue that due to these heuristics and biases, systematic errors occur which lead to adverse outcomes (Barnes, 1984).…”

“…availability, anchoring, overconfidence and representativeness are heuristic-driven biases which entrepreneurs rely on due to bounded rationality, to reduce the risk of losses in unpredictable situations. When entrepreneurs use heuristics, their technical knowledge and reasoning faculties are impaired, leading to errors in judgment (Ahmad and Shah, 2020). As a result, entrepreneurs make irrational decisions, which in turn adversely affect their entrepreneurial strategic decisions.…”