Impact of Behavioral Biases on Investment Decision;

Moderating Role of Financial Literacy

Amir Hayat
Faculty of Management Sciences,
International Islamic University Islamabad, Pakistan
amir.msfin615@iiu.edu.pk
Muhammad Anwar*
Working Paper. September, 2016

Abstract
This study focus to check the influence of behavioral biases in investment decision making
with moderating role of financial literacy in Pakistan. Theories in traditional finance consider that
the individual investor is rational because he makes all decision on the bases of all available
information to maximize his wealth. On the other hand behavioral finance is totally opposed this
theory and consider that the individual have some psychological impact toward his investment.
A simple survey questionnaire is used to collect data from 158 investors trading in Pakistan Stock
Market. The results show that disposition effect, overconfidence and herding have significant
positive impact on investment decision. Financial literacy has negative moderating role in herding
bias and positive moderating role of overconfidence bias in investment decision. Results conclude
that active investors show more overconfidence bias while passive investors show more herding
bias. This study will help financial advisors to better advice their clients. The one more way to
overcome these biases may be the training of investor and education. Research culture must be
promoted and investor must have ability of technical analysis.
Keywords: Investment Decision, Overconfidence Bias, Disposition Effect, Herding Bias,
Financial Literacy

*. Corresponding Author: Department of Business Administration, International Islamic

University Islamabad Pakistan. Email. m.anwar.ims@gmail.co m

Electronic copy available at: https://ssrn.com/abstract=2842502

Introduction
Although finance has been studied from many centuries and theories in traditio na l
finance considered that investor is rational because he makes investment decision on all available
information. But behavioral finance is totally opposed the theories of traditional finance because
in behavioral finance the investor is psychological biased which effects the individual human
behavior regarding investment decision and it is quite new area. In traditional finance we use
different models to evaluate all available information like CAPM etc. and these models considere d
that all investor have same optimal risk portfolio.
Actually these models ignores the impact of emotions of investor regarding investment decision
(Sanfey, Rilling, Aronson, Nystrom & Cohen, 2003). Investors show irrational behavior due to
different situations, distortion in perception and wrong judgments while traditional finance and
financial theories consider that individual investor as perfect rational human being (Babajide &
Adetiloy, 2012). Behavioral Finance is totally against these theories and opposed the concept of
perfect market efficiency due to psychological and emotional biases and their impact on investor
investment decision. Assumption of rational man who maximize his wealth is no more significa nt
due to lack in empirical evidences (Bondt et al., 2013). Researcher suggested that every investme nt
statement must be based on investor profile and it is an effective path to manage individ ua l
behavioral biases (Pompian, 2008). One of these biases is the disposition effect which can affect
the profit of investors (Odean, 1998). Frydman and Rangel (2014) show that disposition effects is
weak when the purchase price of stock is apparently displayed.
Recently, there are many ups and downs in Pakistani stock market and many investor blame that
big investor do manipulation. So it is necessary to develop and study an individual investme nt
decision regarding investment and to develop appropriate financial advisory services and policies
for strong and secure financial system. Many investors have lack of knowledge and have no
technical skill which are required to do investment in stock market. And they are totally dependent
on experienced investors and brokers for investment decisions. Therefor a complete profile
analysis of an investor is required for advice in better investment decision. Many of studies are
conducted in this regards in western countries. So it is necessary whether behavioral biases exist
in Pakistani stock markets and what are impact of investor’s behavioral biases on investme nt
decision and moderating role of financial literacy in Pakistani stock markets.

Electronic copy available at: https://ssrn.com/abstract=2842502

Objectives of the study is to check overconfidence bias, herding bias and disposition effect in
Pakistani stock markets. And what is the impact of these biases on individual investment decision.
And last one is to determine the moderating impact of financial literacy on relationship between
investment decision and these behavioral biases. The present study is contribute in available
literatures by adding new evidence from an emerging economy Pakistan. It can be beneficial for
investors who engage in trading. The study also examined the importance of financial literacy in
investment decisions not only for emerging investors but developed economies investors also
beneficial and can make good decision in their respective stock markets.

Literature Review

Investment Decision
“Efficient market is the market where average returns cannot be greater than what are warranted
for its risk despite whatever investment strategy is applied” (Barberis & Thaler, 2003, p.1054).
Markowitz suggested Portfolio Modern Theory in 1950’s. He studied that the decision maker finds
alternative choices for investment and compare them to make relationship in these choices.
According to Efficient Market Hypothesis (EMH) all investors are not rational but the markets are
supposed to be rational. Despite this theory behavioral finance suggested that sometimes the
markets are not efficient in information (Ritter, 2003).
Investment decisions has become very important because like an business has main purpose to
earn profit, similarly, an investor has main aim to make good decision and earn maximum. But
some investors rely on their personal judgment while some make decisions on the basis of
education and evidences.

Herding Bias and Investment Decision

“Herd behavior describes how individuals in a group can act collectively without centralize d
direction” (Braha, 2012). It is seen that in the time of fear and uncertainty many investor dispose
their stocks because of other investors who have more information about the market behavior. And
it is actually due to two things that is greed and fear of lose (Landberg, 2003). In this era of
uncertainty the best thing is to copy others information and relay on them so mostly investors do
the same thing and mostly they follow the mangers of the company when they sale stock then

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investors also do and when they purchased the stock the lazy and less educated investors also do
the same(Persaud, 2000).
H1: Herding bias has significant and positive influence on investment decision making

Overconfidence Bias and Investment Decision

“Another measure of risk is when people consider themselves better and superior relative to
others” (Larrick, Burson & Soll 2007). Too many people overvalue what they are not and
undervalue what they are (Malcolm S. Forbes). Overconfidence is basically the overestimation of
investor abilities because they think that they can do better decision as compared to others but
actually it is not (Soll 2007). There are two main implications of overconfidence with respect to
investor point of view, one is failure to generalize the information and second is to do extra trading
due to this failure (Shefrin 2000).
H2 : Overconfidence has significant and positive influence on investment decision making

Disposition Effect and Investment Decision

“The disposition effect is an anomaly discovered in behavioral finance. It relates to the tendency
of investors to sell shares whose price has increased, while keeping assets that have dropped in
value” (Boebel andTaylor, 2000). Investors hold the stock when its prices comes down but the y
sell it immediately as soon as the prices goes up from par value because they are lose averse and
generate capital gains quickly (Shefrin and Statman, 1985). Summers and Duxbury (2012) said
that there are some emotions which are responsible of disposition effect like regret is the main
reason due to which the investor sell their stock when they seems some capital profit in it.
H3 : Disposition effect has significant and positive influence on investment decision making

Financial Literacy and Investment Decision

“Financial literacy is the ability to understand how money works in the world: how someone
manages to earn or make it, how that person manages it, how he/she invests it (turn it into more)
and how that person donates it to help others” (Giesler and Veresiu, 2014, p. 850). Financia l
literacy with respect to gender, work experience, class rank and education is different. Males have
more financial literacy with respect to females and same case in remaining cases more work
experience, more education and high class rank have more financial literacy as compared to less

4
work experience, less education and low class rank. People of USA have more financial literacy
as compared to other countries (Chen and Volpe 1998). There are different study who examined
that financial literacy has significance and positive influence on investment decision.
H4 : Financial Literacy has significant positive influence on investment decision making

Moderating role of Financial Literacy on Behavioral Biases and Investment Decision

With reference to the relationship between the level of financial literacy and investment decisions,
it has been observed that highly literate investors prefer and use different techniques when making
an investment decision than low-literacy investors. Highly literate investors prefer to use financ ia l
publications, whereas low-literacy investors relay more on advice from family, friends, and
stockbrokers. Due to this investors mostly show overconfidence, herding behavior and dispositio n
effect because they were illiterate so they was unable to do and decision and they do same thing
as other investors when other investors sell the stock they sell when they seek little profit in stock
they immediately dispose it and don’t wait for more increase in price same they show
overconfidence while picking up the stock and do wrong decisions (Tamimi and Kalli, 2009).

H5 : Financial Literacy has moderating role in relationship between herding bias and Investment
Decision Making
H6 : Financial Literacy has moderating role in relationship between overconfidence bias and
Investment Decision Making
H7 : Financial Literacy has moderating role in relationship between disposition effect and
Investment Decision Making

Conceptual Framework
Financial
Literacy

Overconfidence Bias

Investment
Herding Bias
Decision Making

Disposition Effect 5
Research Methodology

Sample and data collection:

The purpose of this study is to identify the “Impact of Overconfidence Bias, Herding Bias and
Disposition Effect on Investment Decision by keeping in mind the Moderating role of Financia l
Literacy. In order to achieve the purpose of study, a structure questionnaire was design to collect
the data for further statistical test. The target population for this research was to collect data from
those peoples who have investment in Karachi Stock Exchange and Islamabad Stock Exchange
Pakistan. The sampling technique which is used in this research paper is to collect informa tio n
from people who were most appropriately available is non probabilistic method. The reason to use
this technique is to gather large number of information easily and also the cost is very low. The
respondent participate voluntarily and it was assured their responses will be keep confidential and
only will only be used for this research.
Keeping 5% error margin and 95 confidence level, a total 220 sample size was selected and
questionnaires were distributed. From 230 distributed questionnaires 180 were received back and
out of them 22 questionnaires were filled improperly and 158 were useable for this research. So
the respondent rate is 72%. The questionnaires were distributed by hand to different investors,
brokerage house, and organization and from some users online data was collected who had access
to internet.

Demographic detail of the respondents:

As mention above total response of sample size was 158. Out of these major portion of sample
consist male which is 127 (80.4% of total sample size) and 31 respondent were female which is
19.6%. We divided our population into two main groups; one that have investment in Karachi
Stock Exchange, they were assign code 1. And those who have investment in Islamabad Stock
Exchange they were assign code 2. Majority of the responded fell in class 1 that is 53.2% of the
total population and 46.8% of respondents were from Islamabad Stock Exchange. 55.7% of the
respondent that were youth and between 18 to 25 ages. 34.8% of those respondent who were 26 to
35 years old and only 9.5% fall in the 36 to 45 years old section. As majority fall under between
18 to 25 ages so most of the respondent were unmarried, that were 69% of the total sample size

6
and 30.6% respondent were married and only 0.6% is divorced. 55.1% of the total sample were
having master level qualification whereas 34.8% were having graduate. 7% participant were below
to under graduate and 3.2% having Ph.D. degree. 57% of the participant were those who have done
stock market course while rest of the 43% respondent didn’t have any stock exchange course.
34.1% participant have under Rs. 2 lac investment, 32.3% have more than Rs. 2 lac but below Rs.
4 lac, 22.8% have more than Rs. 4 lac but less than Rs. 10 lac, 4.4% have more than Rs. 20 lac but
below Rs. 30 lac, 3.8% have more than Rs. 30 lac and only 0.6% have more than Rs. 10 lac but
below Rs. 20 lac investment in year 2015.

Questionnaires and scale:

The designed questionnaire has been divided into six main sections. The first five sections are
related to our main study which explains the effect of three independent variables i.e. dispositio n
effect, herding bias and over confidence bias, one dependent variable which is investment decision
while financial literacy is playing a moderating role in this study. The last section recognizes the
demographic features of the respondents like Gender, age, marital status, education, income,
experience and investment level current and last year. First five sections of the questionna ires
contain thirty two (32) items. Five point Likert scale is used to measure the relationship between
independent and dependent variable where 1= strongly disagree and 5 for strongly agree for first
10 questions. For the next 10 questions two options were given accept and reject and results are
being concluded on this base. Rest of the 12 questions were assessed through multiple choice
questions technique. The language which is used for this research is English because English is
taught from very beginning in Pakistani schools.
Out of these thirty two (32) items that were used in questionnaire, scale of dependent variable
investment decision have 3 items were adopted from Phuoc et al., (2011). One sample item is “You
feel satisfied with your investment decisions in the last year (including selling, buying, choosing
stocks, and deciding the stock volumes)”. The scale containing 7 items of first independent
variable i.e. herding bias is adopted as suggested by Kengatharan and Kengatharan, (2014). One
sample items is “Other investors’ decisions of buying and selling stocks have impact on your
investment decisions”. The second scale of independent variable is disposition effect and it
comprise 10 items. This scale was adopted from Rau (2015) and one sample item is “If the coin
shows “heads” you will lose Rs. 7000; if it shows “tail” you will win Rs. 10000” The third scale

7
of independent variable is over confidence bias having 6 was adopted from Pompian (2011) and
one sample item from this scale is “How much control do you believe you have in picking
investments that will outperform the market”?. And the scale for moderator financial literacy was
adopted from Van Rooij et al., (2011) and one sample item from this scale is “Suppose you had
Rs.100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you
think you would have in the account if you left the money to grow”?

Control variables:
The current study used a few control variables related to investor demographic such as gender,
age, income, current year investment, last year investment and duration of stock market visit was
considered as control variable while running regression test. These variables were found from
ANOVA as we observed P .05 so it suggest significance effect of these variables on independent
and dependent variables. And these all play role in dependent variable investment decision.

Results:
Reliability
Reliability Analysis is used to examine internal consistency of the observed factors. This analysis
is measured by Cronbach’s alpha. According to Swkaran (2000) Cronbach alfa is actually a
reliability that is used to identify the relationship of different items to one another. Above 6 scale
is considered as acceptable scale for reliability analysis. In our study we have 5 different variable
having 32 items. Cronbach’s alpha of all these variables were above 6 which means that there
strong internal reliability among the items. For 3 items of investment decision the scale was
observed .775, for 7 items of herding bias it was .635, disposition effect include 10 items and the
reliability scale was .716, for 3 items of financial literacy it was .60 and rest of 6 items was belong
to overconfidence bias observed for these items were 0.773.

Correlation
Table 1 show the Mean, Standard deviation, Correlation and reliability of the factors. Mean of
Investment Decision is 4.0717, mean score of Herding Bias was 3.9846, Disposition Effect was

8
1.2924, Financial Literacy was 1.5738 and Overconfidence Bias was 1.9114. It means on average
respondents response to satisfy to all the factors.
Pearson correlation was used to found the relationship between independent variables (Herding
Bias, Disposition Effect and Overconfidence Bias), moderator Financial Literacy and dependent
variable Investment Decision and Table 1 suggest us that Herding Bias have significant positive
relation with Investment Decision (r = .530, P =0.000).

Table 1
Means, Standard Deviations, Correlations, and Reliabilities

Mean Std. Deviation 1 2 3 4 5

1. Investment Decision 4.0717 .78318 --
2. Herding Bias 3.9846 .50232 .530 --
3. Disposition Effect 1.2924 .18183 -.041 .039 --
4. Financial Literacy 1.5738 .55660 -.330 -.131 -.145 --
5. Overconfidence Bias 1.9114 .51574 -.517 -380 -.054 .422 --
Note. N = 158; alpha reliabilities are presented in parentheses

Regression
This table 2 explain the effect of independent variable (Herding Bias, Disposition Effect, and
Overconfidence Bias) and moderator (Financial Literacy) on dependent variable (Investme nt
Decision). We perform different linear regression analysis to test the hypothesis. In the first step
gender, age, income, total time spend in stock market, current year investment and last year
investment were entered as control variables. The result show that there is strong positive effect of
herding bias on investment decision (β= .534, P .05) and thus the hypothesis 1 is supported.
Furthermore overconfidence bias have negative effect on investment decision (β= -4.95, P .05)
but the hypothesis 2 is statistically insignificant. The disposition effect was also negative effect on
investment decision (β= -.144 p>.05) but not supported the hypothesis 3. Result shows that
financial literacy also have negative effect on investment decision (β= -4.95* p.05) and
Hypothesis 4 is also statistically insignificant. In step 3 results were showed that hypothesis 5 (β=
-.050, P .05) is not supported but hypothesis 6 (β= .389* p.05) is supported because result was
significant and positive for this and hypothesis 7 (β= .254, P .05) was also not supported.

9
 Table 2
Result of Regression analysis of independent variables with financial literacy and
investment decision
Independent
Variable β R² ∆R²
Step 1
Control Variable .201 .201
Step 2
Herding Bias HE .629*
Disposition Effect DE -.144 .623 .421
Financial Literacy (Moderator) FL -2.31*
Overconfidence O -4.95*
Step 3
HE x FL -.050
DE x FL .254 .644 .021
O x FL .389*
Note: n = 158, HE= Herding Bias, DE= Disposition Effect, FL= Financial Literacy and O=
Overconfidence Bias
Control variables were Gender, Age, Income, Market Visit, Investment C, Investment L
P* < .05.

The graph shows that when investor was highly literate about financial theories then he shows
more overconfidence bias as compared to illiterate investor. So, financial literacy have positive
relation with overconfidence while doing any investment decision regarding the stock picking or
disposition of stock.

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 5
4.5
Performance 4
3.5
3 Low Financial
Literacy
2.5
High Financial
2 Literacy
1.5
1
Low Overconfidence High Overconfidence

Discussion
This study is done to assess the role of herding bias, disposition effect and overconfidence bias in
investment decision and moderating role on financial literacy in Karachi Stock Exchange and
Islamabad Stock Exchange. If we see with the view of theories of traditional finance then we
conclude that investor make decision after assessing and evaluating the all available informa tio n
relating to the stock and after that they do investment and maximize their wealth and utility.
However, behavioral finance totally oppose these theories and suggested that it is impossible that
markets are perfectly rational and there is no concept of strong form of efficiency in market where
all investors have the same information and they all are highly literate and do decision on the basis
of experience, qualification and their own judgement. So, behavioral finance identified some
psychological biases and their impact on investor decision making.
A survey questionnaire is designed and is used to collect responses using convenience sampling
techniques from a sample of 158 investors of Karachi Stock Exchange and Islamabad Stock
Exchange. Results shows that herding bias exist in Karachi and Islamabad Stock Exchange while
Overconfidence Bias have statistically insignificant it means that overconfidence have negative
impact on investment decision because when investor shows overconfidence about picking the
stock, mostly he does wrong decision. Financial Literacy have also statistically insignifica nt
relation with investment decision, of course mostly investor in Pakistan is financially illiterate and
they even don’t know the basic concept of traditional finance theories i.e. interest rate calculatio n,

11
inflation rate calculation, net present value, future value, coupon rate, annuity etc. So, they show
negative impact on investment decision.
One hypothesis is not supported and that is disposition effect have negative effect on investme nt
decision. Past research shows that it is possible due to short term investment, because investor
shows disposition effect when they do long term investment. And second reason is that when the
qualification level of investor is high then there may be no disposition effect in the stock market
(Dhar, R., and Zhu, N. 2002). So, the reason behind this hypothesis is that most of participants in
sample are master qualified and investment is also short term in Pakistani stock market.

Practical Implications
Many investor do investment on other advice and they don’t have their own opinion in investme nt
decision. So, there should be stock market courses for the investor before doing and investment in
the stock market and to become able them that they do technical analysis of the market. Financia l
decision are very important for social and human life of an investor and poor financial decision
have strong impact on social and human life so it is necessary to avoid these biases. There are also
lot of other biases exist in the market which may affect the investor investment decision so it is
better to give technical education to the investor that how can they overcome these biases and how
can they avoid from such decision which may lead them to face the huge financia l loss in future.

Limitation and Direction for Future Research

This study is conducted through survey questionnaire which is always criticized due to
generalization problem. The responses are too limited for this study and respondent may bias in
their response which may lead inaccurate results. Therefore, results are totally dependent on
respondent honesty and fair response. People also don’t show their correct income and correct
investment so it is very difficult to find the true results. Time is also constraint while conducting
this research.
There is possibilities to use other method to conduct this research and researcher can also use other
moderating or mediating variable in future. To conclude the better result researcher can also use
greater sample size and do research on this base. Qualitative research method can better estimate
the results and also the behavior of the investor.

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