Behavioral effects on individuals' decision-making process using the prospect theory:A case of investors at the NSE
Abstract
Financial economics has evolved and grown in importance in the last 30 years. Models
have been developed and the level of sophistication has increased. One of the many
stylized models of market behavior is the Efficient Market Hypothesis statistically tested
by the Capital Asset Pricing Model (CAPJI.·1).
Twenty years of experimental and empirical research has demonstrated that markets are
not as efficient as one might assume. Investors are not as rational and risk preferences are
stochastic. In addition to this, prospect theory criticized the standard expected utility
hypothesis used to describe utility and investor performance preferences. Kahnernan and
Tversky (1979) propose a new framework to model the utility and risk preferences of
investors. This new "value function" is concave for gains and convex for losses, which
implies loss aversion of agents as the primary feature.
This study examined investment scenarios with individual investors indicating that the
process of making investment decisions is based on the behavioral economics theory
which uses the fundamental aspects of the prospect theory developed by Kahnernan and
Tversky (1979). The following effects have been tested and identified 1) endowment
effect, that makes the participants not to sell the received assets, no matter if better
investment options are available; 2) the disposition effect, that refers to the pattern that
people avoid realizing paper losses and seek to realize gains; 3) framing, that modifies
the investment decision depending on the perspective given to the problem and 4) loss
aversion that refers a scenario where greater utility is lost when losing x amount of
money than the utility that is gained when obtaining the exact same amount.
The study concluded that the endowment, the disposition and the framing effects
influenced the decisions by individual investors. Individual investors had their investment
decisions affected by loss aversion.
Sponsorhip
University of NairobiPublisher
School of Business, University of Nairobi