Risk preferences for financial decisions: Do emotional biases matter?

• Published date: 01 May 2022
• Author: Ritika ,Nawal Kishor
• Date: 01 May 2022
• DOI: http://doi.org/10.1002/pa.2360

ACADEMIC PAPER

Risk preferences for financial decisions: Do emotional

biases matter?

Ritika | Nawal Kishor

School of Management Studies, Indira Gandhi

National Open University, New Delhi, India

Correspondence

Ritika, School of Management Studies, Indira

Gandhi National Open University, 93, Maidan

Garhi Road, Maidan Garhi, New Delhi, Delhi

110068, India.

Email: ritikaaneja.aneja@gmail.com

The aim of this article is to evaluate the effect of emotional biases (namely over-

confidence bias, self-control bias, loss aversion bias, and regret aversion bias) on risk

preferences of individual investors. A structured questionnaire is developed by taking

excerpts from various existing studies to evaluate emotional biases and the construct

of risk preferences is adopted from “domain specific risk-taking scale”(DOSPERT).

The data are analyzed using structural equation modeling. The findings reveal that

overconfidence bias and self-control bias have significant positive relationship with

risk preferences, whereas with loss aversion bias and regret aversion bias, a signifi-

cant negative relationship of the risk preferences is found. The study contributes to

the existing literature by examining the effect of feelings and emotions on risk. The

findings of the study further confirm that risk is influenced by emotions and feelings.

The results of this study will be of great use to policy makers, investment consultants,

retail investors, regulators, and various other stakeholders associated with preparing

and suggesting investment strategies for their own or for others.

1|INTRODUCTION

The standard finance is based on the assumption that investors take

all investment decisions rationally after analyzing all the available

information (Kumar & G oyal, 2015). It also assumes that the risk

preferences of the in vestors are according to the norms as desc ribed

by expected utility the ory and mean variance anal ysis. It augments

that investors perce ive their risk correct ly and their risk prefe rence

is not influenced by heuristics or behavioral biases. But behavioral

finance researcher s view risk taking fro m a different angle as co m-

pared to traditional finance researchers. The proponents of behav-

ioral finance have time and again showed that people employ

heuristics in taking decisions under situation of risk or uncertainty

(Antony, 2020; Barnes, 1984; Schwenk, 1984; Strong, 2007). Deci-

sions under risk and uncertainty in the field of behavioral finance are

examined with the help of prospect theory advocated by Kahneman

and Tversky (1979). This t heory departs from th e assumption of

complete rationali ty (as devised by class ical economic theor ies) and

focuses on cognitive an d emotional limitat ions of decision make rs

(Edwards, 1995;Olsen,1997; Ricciardi, 2005). Accord ing to this the-

ory, human beings are risk averse in case of profits and risk takers

regarding losses. They make financial decisions keeping in mind, the

value of possible gains and losses without considering the final

outcome.

Investors employ various heuristics to evaluate the gains and

losses of their financial decisions. Empirical evidence suggests that

risk preferences of investors are affected by various emotions such as

anger, worry, and others (Campos-Vazquez & Cuilty, 2014; Kugler,

Connolly, & Ordóñez, 2012). But the role of emotional biases in decid-

ing the risk preferences of the investors is less known. Also, it is cru-

cial to understand about the emotional forces leading to biased

investment decisions. The present research aims to bridge this gap

related to the effect of emotional biases on risk. The study contributes

to the existing literature concerned with “risk as feeling hypothesis”

put forth by Loewenstein, Weber, Hsee, and Welch (2001).

2|LITERATURE REVIEW AND

HYPOTHESES DEVELOPMENT

2.1 |Heterogeneity of risk

Risk is defined as the possibility of happening of undesirable events

(Sitkin & Pablo, 1992). Risk can be defined along various dimensions

Received: 16 June 2020 Revised: 3 August 2020 Accepted: 5 August 2020

DOI: 10.1002/pa.2360

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https://doi.org/10.1002/pa.2360