This chapter explores biases impacting stock and mutual fund investments—cognitive, affective, and behavioral. It examines digital financial literacy (DFL), highlighting social media's role in information sharing. Stressing the merging financial and digital literacies, it addresses risks in online financial behavior. Discussions cover DFL measures, online activities' correlation, and biases in decision-making. Recognizing uncertainty in the digital era is crucial for informed financial decisions amidst evolving landscapes.
Top1. Introduction
A structured and reasoned thought process is traditionally associated with rational decision-making in financial markets. As a result of the overwhelming complexity of all possible actions, rational choice theory begins by considering a set of alternatives. Using rational decision-making, one can make rational decisions based on available information and preferences and maximize utility or value. Rational decision-making is the basis of traditional finance theories such as the Efficient Market Hypothesis (EMH) and the Capital Asset Pricing Model (CAPM). It assumes individuals act in their best interests in order to achieve their goals. The theory suggests that market participants will make decisions that result in efficient market outcomes where prices reflect all available information (Ackert & Deaves, 2010).
The same information can be interpreted differently by investors, resulting in diverse perceptions and behaviors. Financial decision-making is influenced by cognitive skills (Spaniol & Bayen, 2005). People do not consistently behave as expected, resulting in numerous behavioral phenomena impacting financial markets As a critique of expected utility theory, prospect theory was introduced, which asserts that decisions are based on potential losses and gains rather than final outcomes. The perception of gains influences decision-making among investors. In addition to overconfidence, investors overestimate the precision of economic signals and overreact to private signals (Kahneman & Tversky, 1981). Mispricing and distorted perceptions of factor payoffs affect securities linked to these factors. The disposition effect, as the reluctance of investors to sell assets at a loss, leads to suboptimal decisions (Henderson, 2012). The narrow framing involves investors looking at individual investments rather than their portfolio as a whole (Bailey et al. 2011). Financial decisions are influenced by behavioral phenomena such as prospect theory, overconfidence, disposition effect, and narrow framing. These biases also lead to behavioral anomalies such as market excess volatility, overreactions, and underreactions. Conservatism and representativeness heuristics contribute to these anomalies. Investors in an idealized rational world aim to maximize their risk-return tradeoff based on comprehensive information about expected returns and risks. In traditional financial models, such as the Capital Asset Pricing Model (CAPM), securities are valued for their fundamental net present value of future cash flows minus associated risks. Investment decisions, however, tend to deviate from rational behavior, according to modern theories. Generally, investors exhibit risk-seeking behavior, interpret outcomes differently, and harbor biased expectations, challenging conventional wisdom. An overconfidence bias, disposition effect, or narrow framing is one of the behavioral biases that contribute to complexities in decision-making (Lam, Liu, & Wong, 2008).