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Effect of Representativeness Bias on Investment Decision Making

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Waqar Badshah at Istanbul University
Waqar Badshah
Shoaib Irshad at University of the Punjab
Shoaib Irshad
Usman Hakam
Usman Hakam
Usman Hakam
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Abstract and Figures

This study is conducted to find out the effect of representativeness bias on investment decision by using self administered questionnaires and circulated 160 questionnaires in Islamabad stock exchange and 120 questionnaire collected back, the questionnaire used in this study is taken from research paper of Chun and Ming (2008). This study used regression analysis to find out the effect of representativeness bias and results of this study show that investors are affected by representativeness bias in Islamabad Stock Exchange. Investors in Islamabad stock exchange are using past performance as representative of future and investing with representativeness bias.
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Online Access: www.absronline.org/journals
*Corresponding author: Waqar Badshah,
MS-Finance Scholar, Anadolu University, Eskiehir, Turkey
E-Mail: waqar.badshah@gmail.com
26
Management and Administrative Sciences Review
Volume 5, Issue 1
Pages: 26-30
January 2016
e-ISSN: 2308-1368
p-ISSN: 2310-872X
Effect of Representativeness Bias on Investment Decision
Making
Shoaib Irshad1, Waqar Badshah2*, Usman Hakam3
1. PhD-Business Administration Scholar, Middle East Techinal University, Ankara, Turkey
2. MS-Finance Scholar, Anadolu University, Eskiehir, Turkey
3. MS-Finance Scholar International Islamic University, Islamabad, Pakistan
This study is conducted to find out the effect of representativeness bias on investment
decision by using self administered questionnaires and circulated 160 questionnaires in
Islamabad stock exchange and 120 questionnaire collected back, the questionnaire used in
this study is taken from research paper of Chun and Ming (2008). This study used regression
analysis to find out the effect of representativeness bias and results of this study show that
investors are affected by representativeness bias in Islamabad Stock Exchange. Investors in
Islamabad stock exchange are using past performance as representative of future and
investing with representativeness bias.
Keywords: Representativeness bias, Islamabad stock exchange
INTRODUCTION
Traditional finance argues that people are rational
and they think rationally when making any
decision or passing any judgments. Behavioral
finance on other hand is relatively a new field and
argues that in many cases our emotions affect our
decisions and due to those emotions and
psychological influences people make irrational
decisions. When people make decisions and
judgments, they mostly use rule of thumbs or
mental shortcuts. People do not think rationally or
they do not have enough time to process all of
information to make any decision so that’s why
they often use heuristics to reach to final judgment.
One of the heuristics is representativeness that
people use while making any decision. According
to Tversky and Kahneman, (1974)
representativeness bias is mental shortcut and is
defined as the tendency to irrationally attribute one
characteristic to imply another. Again Shefrin,
(2001) defined representativeness heuristics as
relying on stereotypes that are used to form quick
but irrational opinions.
In Pakistan there is not enough literature available
on this area of finance and there is no any research
available on this heuristics of behavioral finance so
a research gap is there that can be filled. This
research is trying to find out effect of
representativeness bias on investment decision
making in Islamabad Stock Exchange. This research
has significance for investors investing in
companies registered on Islamabad stock exchange
Manag. Adm. Sci. Rev.
e-ISSN: 2308-1368, p-ISSN: 2310-872X
Volume: 5, Issue: 1, Pages: 26-30
27
and findings of this research will be helpful for
investors in a way that they will objectively analyze
their investments and will go for it after assessing
the intrinsic worth of their proposed investment.
LITERATURE REVIEW
From more than two decades behavioral finance
challenge the traditional finance and its argument
that investors behave rationally. A lot of
experimental as well as theoretical evidence suggest
that there are various heuristics that affect
decisions. Yates, (1990) argues that people make
decisions using mental shortcuts and people do not
process all of available information and do not
engage in complex analytical processing. For
instance when buying a second hand bike we may
think that a neat and clean body and outlook of a
bike is a indicator of a well maintained and well
running bike, but here we simply ignore that
neatness and cleanliness is only a physical
characteristic. Representativeness heuristics can
affect investor’s decisions in two different ways,
first similar information may be interpreted as a
pattern, by doing this people give more weight to
recent news about a firm and they overreact when
they estimate about future performance of a
company, second effect is that individuals can
expect a reversion to mean if they face a series of
similar information even if series is too short to
apply that law (Kaestner 2006).
Tversky and Kahnman (1974) say that decisions
made by investors can be biased because investors
often use mental shortcuts and heuristics when
making investment decisions. Again Hirshleifer
(2001) argues that representativeness bias can affect
investment decisions. Representativeness bias
affect investors decision making and hence affect
stock prices, an investor might attribute a single
factor to a company’s growing stock hence ignoring
other factors and he then might overreact and
decide irrationally (Antunovich and Laster 1998).
People give more weightage to the noticeable
information and they try to associate that
information with company’s success or failure
ignoring other factors that might be more important
for making rational decision ( Kirs, Pflughoeft and
Kroeck 2001).
Most of the time people decide on basis of rule of
thumb, based on past events and past decisions
made by them lead them to decide accordingly, in
that way they ignore other factors that might be
directly or indirectly contribute to rational decision.
The Representativeness heuristic can be defined as
tendency to organize events in different segments
on the basis of only noticeable or visible
characteristics. The investors due to
representativeness bias investors become over
confident and they ignore sample size and mean
reversion. Kim and Byun, (2011) argues that due to
representativeness bias investors view a small
sample as a representativeness of whole population
ignoring the sample size and ultimately ignoring
the law of probability. Investors often invest in
those stocks that have high abnormal returns in
near past and investor choose those stocks because
of the representativeness bias (Dhar & Kumar 2001).
There is a lot of literature available that support the
argument that representativeness does affect
investment decision making, among them most
prominent researches are of (Chandra and Kumar,
2011, Sohani, I., 2012). Again another research by
Hirshleifer (2001) found that investment decisions
may be affected by representativeness bias and this
research provides an extensive review of this
literature.
METHODOLOGY
This study used convenient sampling method to
collect the data from investors of Islamabad Stock
Exchange. The questionnaire used in this research
was taken from the research paper Chun and Ming
(2008). This study is trying to find out the effect of
representativeness bias on the investment decision
making so for that purpose self-administered
questionnaires were distributed among 160
investors of Islamabad Stock Exchange. From those
160 questionnaires we received 120; the response
rate was 75%.
Demographic Characteristics
TABLE 1 HERE
Measurement
Alpha (∝) Reliability
The alpha (∝) reliability of representativeness bias
questionnaire is (.71) and the alpha (∝) reliability of
questionnaire of investment decision making is
(.79). This research used Five point Likert Scale in
Manag. Adm. Sci. Rev.
e-ISSN: 2308-1368, p-ISSN: 2310-872X
Volume: 5, Issue: 1, Pages: 26-30
28
questionnaire, according to which (1=Strongly
Disagree, 2=Disagree, 3=Neutral, 4=Agree and
5=Strongly Agree). The structure of questionnaire is
that there are total of 16 questions in questionnaire
of which 13 questions are related to investment
decision making and 3 questions are of
representativeness bias.
There is a significant relationship between the
representativeness bias and investment decision
making. The relationship is significant at .01. The
value of the t-stat is 6.72. The results of this study
show that representativeness bias is present among
the investors in Islamabad stock exchange. The
coefficient of determination is .276 that means
representativeness bias is explaining approximately
28% of total variation in investment decision. The
value of coefficient of variation is pretty low
because there are some other biases like
(Availability bias, over confidence bias) that also
affect investment decision but these are kept
constant because these are beyond the scope of this
study.
CONCLUSION
This study found that there is a significant effect of
representativeness bias on the investment decision
making among investors in Islamabad Stock
Exchange. This study used sample size of 120. There
is a lot of past literature available that found that
representativeness bias has a positive significant
effect on investment decision and that supports our
results, among them most prominent studies are
Sohani, I., (2012), Hirshlefer, D., (2001) and Merikas
et.al (2004). The results shows that investors are not
investing rationally but they are affected by
representativeness bias.
Limitations
This study used a single independent factor to find
out its effect on investment decision. Due to
sometime considerations this study used single
independent factor but there are many other biases
that also affect investment decision among them are
over confidence bias, Availability bias and
Anchoring bias. This study used a small sample size
so, so researchers can use these factors to find out
there effect on investment decision and there is a
gap for future research.
REFERENCES
Antonovich, P. and D. Laster, 1998, Do Investors
Mistake a Good Company for a Good
Chun. W, W and Ming. L,M (2008). Investor
behavior and decision making style: A
Malaysian perspective. Journal of IBBM.
Dhar, R. & Kumar,A. (2001). A non-random walk
down the main street: impact of the price
trends on trading decision of individual
investor. International center for finance,45.
Hirshleifer, D. (2001). Investor Psychology and
Assets Pricing. The journal of Finance, 56, 4,
1533-1597.
Investment? Federal Reserve Board, New York –
Working Paper.
Kim. K and Byun. J, (2011). Studies on Korean
capital market from the perspective of
behavioral finance. Asian review of financial
research. 24, 3.
Kirs. P., Pflughoeft. K., and Kroeck. G. (2001). A
process model cognitive biasing effects in
information system development and
usage. Information & management journal,153-
165
Merikas, Anna, A, Vozikis, S and Prasad, D (2004).
Economic Factors and individual investor:
The Greek stock exchange. Journal of Applied
Business Research. 20, 4.
Shefrin, H. (2001). Behavioral corporate finance.
Journal of Applied Corporate Finance 14, 113–
124
Sohani, I, (2012). Behavioral finance of an inefficient
market. Global journal of management and
business research. 12, 14.
Tversky, A. and Kahnman, D. (1974). Judgment
under uncertainty: heuristics and biases.
Science, 185, 1124-1131.
Yates, J. F. (1990). Judgment and decision making.
Englewood Cliffs, NJ: Prentice Hall.
Manag. Adm. Sci. Rev.
e-ISSN: 2308-1368, p-ISSN: 2310-872X
Volume: 5, Issue: 1, Pages: 26-30
29
APPENDIX
Table 1: Characteristics of Respondents
Frequency
Percent (%)
Gender
Male
110
91%
Female
10
09%
Education
Graduates
40
34%
Undergraduates
80
66%
Experience in Stock Market
8 to 10 Years
35
29%
5 to 8 Years
60
50%
Less than 5 Years
25
21%
Table 2 Correlation:
Standard
deviation
Investment
Representativeness
bias
Investment
.621
(.778)
.525**
Representativeness
bias
.897
.525**
(.704)
**. Correlation is significant at the 0.01 level (2-tailed).
There is a positive correlation between representativeness bias and investment decision making. There is a
significant relation at .01 and p-value is .000
Manag. Adm. Sci. Rev.
e-ISSN: 2308-1368, p-ISSN: 2310-872X
Volume: 5, Issue: 1, Pages: 26-30
30
Regression Analysis:
Variable
Beta
t-value
p-value
Representativeness
bias
.526
6.722
.000
R2=0.276, Adjusted R2= 0.272,
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