Financial literacy and behavioural biases of individual investors: empirical evidence of Pakistan stock exchange.
| Autor | Rasool, Nosheen |
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Introduction and literature review
According to Lusardi and Mitchelli (2007), the importance of financial literacy has developed widely, with the escalating complication of financial products and the growing significance of financial selection, made by households. During recent years, the advent of innovative financial products and instruments has encouraged individual investors to participate actively in financial markets (Calvet et al., 2004). However, these financial products are substantially complex instruments, which require the investors to be financially literate for optimal investment selection and emerging investment avenues. By following this phenomenon, financial literacy has attained the huge attention of researchers globally. The recent research of Lusardi and Mitchell (2014), highlighted the appropriate improvement methods that have been carried out around the world and concentrated particularly on access to financial understanding and financial literacy. Clark et al. (2017) defined financial literacy as
[...] the public understanding and information that covers financial services, administration of the financial investments, and various perspectives that appear to be most crucial for the cognizance of household investors, so there would be no asymmetrical information problems associated to the various financial terms - i.e. the interest rates risks, inflation.
Zucchi (2018) argued that not only developing countries have financial literacy problems, but the investors, from highly developed financial markets, have also faced financial losses due to ineffective planning, and the inability to identify market uncertainties and risk associated with it. The depiction of these flaws can be highlighted during the financial crises of 2008 (Klapper et al, 2013).
The actual importance of the financial literacy was raised during the financial crises of 2008 (Klapper et al, 2013). On one side, the global financial crisis 2008, well-known as the subprime mortgage crisis, was the main cause to bring the need for financial understanding in front of market players. The other reason was the two key issues that contributed to the financial literacy's importance (Agnew et al, 2007). Firstly, the wide range of financial products, which were mostly complex and not comparable, raised the necessity of understanding financial problems (Mandell and Klein, 2009). On the other hand, previous change in social security, all around the world, necessitated individuals to actively participate in their financial management (Aren and Aydemir, 2014).
One of the crucial assumptions, observed in financial crisis, was irrationality (Friedman and Kraus, 2011) among the financial behaviour of investors due to lack of financial knowledge, which has been highlighted particularly in the field of behavioural finance. In traditional financial theories, it is assumed that financial markets and its participants are rational in decision-making (Ackert, 2014), such as modern portfolio theory by Markowitz (1999), capital asset pricing model by Sharpe (1977), and two factor or three-factor model by Fama and French (Womack and Zhang, 2003). In contrast, Barberis and Thaler (2003) argued that behavioural finance is a relatively modern financial subject, seeks to summarize the combination of behaviour and cognitive factors that influences irrational financial decisions. It is also based on the exceptional idea that the majority or at least a significant minority of investors are influenced by their behavioural biases, which leads to less rational or fully irrational decision-making. These biases are empirically acknowledged under cognitive psychological theories; one of them is "Prospect Theory" proposed by Kahneman and Tversky (1979) that shows the patterns of decision-making and portfolio selection in risk prevailing situations.
Many types of research on financial literacy have been exercised globally, on behalf of different countries, to scrutinize financial literacy. The Global financial survey conducted by World Bank Financial Governance Consumer Protection in Financial Services Program ("Report on the Key Findings of the Survey prepared for the World Bank", 2010) studied the improvement levels of consumer protection and financial literacy, thereby, supporting investor confidence in the financial areas.
President's Advisory Council on Financial Literacy (PACFL) clarified financial education as the ability of an individual to devour learning and financial skills to oversee financial assets competently for monetary welfare. PACFL also clarified financial skills as a capacity to make utilization of investor's intelligence and aptitudes to successfully oversee and productively manage monetary assets over a lifetime to accomplish budgetary welfare (Schwab etal, 2008).
The study of Awais et al. (2016) stated that some of the households lacked the most common observable information while taking crucial financial decisions for their well-being. However, Reich and Berman (2015) raised various questions about the extent of the effectiveness and influence of financial learning on financial literacy. Thus, Sayinzoga et al. (2016) highlighted the contradiction that exists between the efficiency of financial education in enlightening financial literacy and its ultimate influence on investor's short-term and long-term behaviour. Moreover, Sundarasen et al. (2016) expressed that financial literacy accelerates the efficiency of cash flow management, credit risk management, saving and investment with higher extent.
To discover the measures of financial literacy, Remund (2010) inspected the majority of the measures of financial literacy and recognized the absence of typical measures, for clarifying and estimating financial education and demonstrated financial literacy as a degree to which one has the capacity to comprehend common and crucial financial ideas. Whereas, Fernandes et al. (2014) measured the relationship between financial literacy and financial education in association with financial behaviours by using meta-analysis.
Volpe et al. (1996) measured investment knowledge by forming 10 multiple choice questions (Ergun, 2018). Hilgert et al. (2003) evaluated the level of financial literacy by using 28 true/false financial skills questions with investment, spending, saving, cash inflow and outflow and other macro factors as variables. Furthermore, Clark et al. (2017) empirically evaluated financial knowledge from 3 questions on Portfolio Diversification, Real and nominal interest rates, and the time value of money.
In Pakistan, the project named Access to Finance Survey 2008, conducted by Fin-Mark Trust in support with the State Bank of Pakistan was the initial step towards financial literacy measuring financial knowledge and patterns of household investment. This study concluded that only 14 per cent of the experimental population formally participated in the stock markets, while the other 40 per cent were not part of any formal or informal financial activities. It also concluded that a higher level of education, as well as a higher level of income, is the biggest source of enhancement in accessing broad financial education.
In some cases, understanding behavioural finance, in an ostensible sense, directly highlights the relationship between financial education and different characteristics of financial behaviour (Ates et al, 2016). A survey, conducted on Turkish monetary clients on their acquiring behaviour, suggested that financial clients with a higher degree of financial education are rather more anticipated to use their credit cards in a sufficient and educated way (Sevim etal, 2012).
Previous studies, such as modern portfolio theory, have shown that investors are riskaverse, which means that among two investment alternatives, the investor will choose the one with lower risk (Calvo-Silvosa et al, 2017). To choose optimal investment portfolio, which occupies the efficient parts of the risk-return spectrum, another term introduced in modern portfolio theory known as "Efficient Frontier", also named as "Markowitz Bullet" (Lee and Yoo, 2017). The financial economists Fama and French (1993) mentioned the need for efficient market theory named "Efficient Capital Markets".
As shown by Ritter (2003), behavioural factors are dependent on attitudes just as human judgment procedures have been dependent on several cognitive illusions and biases. Those illusions are distributed in two categories:
(1) biases produced from heuristic judgment procedure; and
(2) illusions, embedded in the implementation of mental structures, categorized in the prospect theory (Bakar and Yi, 2016).
The most significant cognitive bias is heuristics. Heuristics are characterized as the rule of thumb, which resolves the basic decision-making problems, particularly in complicated and problematic conditions (Ritter, 2003), by decreasing the unpredictability of evaluating probabilities and anticipating values of simpler judgments (Reason, 1990). Tversky and Kahneman (1974) are the ones, who initially focused on heuristics and recognized three heuristics to be specific representativeness, availability bias and anchoring (Tversky and Kahneman, 1974). Waweru et al. (2008), likewise, list two elements named Gambler's fallacy and Overconfidence into heuristic theory (Waweru et al, 2008).
Modern finance perspective indicated that investors do not always act irrationally, and they contribute their funds by examining the risk and reward and face a lot of psychological and sentiment biases (Kahneman and Tversky, 2013). Kahneman and Tversky (1979) defined prospect theory as a substitute to standard models, which gives a superior image of practical behaviour. Prospect theory depicted few perspectives influencing decision-making behaviour including regret aversion, loss aversion, and mental accounting (Waweru et al, 2008). Regret aversion is a feeling that happens after individuals...
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