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INVESTOR BEHAVIOUR AND INVESTOR PROTECTION
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INVESTOR BEHAVIOUR AND INVESTOR PROTECTION
THE ROLE OF BEHAVIOURAL FINANCE IN REINFORCING INVESTOR PROTECTION
 
The study of behavioural finance is more important than ever before.
 
For many years, the science of finance has relied on the assumption that investors are rational beings who make decisions based on rational expectations for maximizing utility. In practice, however, investors unconsciously make irrational decisions, against their own interests, guided by psychological and emotional factors that prevail at the given moment.  
 
The role of psychology
 
Psychological factors that affect the procedure of investment decisions based on individual cognitive, include among other, overconfidence, uncertainty avoidance, conservatism, herd behaviour, over optimism-positive thinking, clinging on beliefs, as well as risk aversion. This phenomenon became widely known by the phrase “irrational exuberance” as stated by the President of the US Federal Reserve, Alan Greenspan, in a speech in 1996.
 
For instance, investors often overestimate their decisions and exaggerate on their abilities and predictions, creating the “control illusion”. This leads to being indifferent regarding new information which may subvert the data, as well as to taking higher risk than they can endure.
 
Another example is the avoidance of uncertainty, as investors are more averse to uncertainty than risk. This practically means that when they have to choose between two options of equally expected performance, they tend to choose the one that they know best, despite the fact that it may involve higher risk.  
 
Furthermore, it has been observed that when investors experience positive feelings regarding an investment, their positive attitude leads to excessive optimism.
 
This creates a belief that their decision is unlikely to achieve negative outcomes despite the fact that it is not the result of timely information. Consequently, investors accept that the benefits of the given investment outweigh the risks that they may incur. 
 
Something that should be taken in account by supervisors and regulators of contemporary capital markets is that fraudsters will most definitely take advantage of the above-mentioned psychological factors to serve their interests.
 
Behavioural Finance
 
These findings of researchers triggered the formation of the science of Behavioural Finance that combines various disciplines such as psychology, sociology and finance.  
 
The aim is to investigate the reasons that lead to investment decisions and to propose alternative interpretations to understand the behaviours observed in capital markets that cannot be explained by traditional theories of the efficient market hypothesis.
 
Behavioural Finance has developed explicit theories which aim to explain unorthodox investment behaviour. One of the best-known theories is “nudge theory” which examines, designs and uses subconscious influences on peoples’ way of thinking and decision-making procedure. Based on the reasons that people make unpredictable and irrational decisions, these specially designed “nudges” target to attract a persons’ attention or/and to guide them towards the right direction.
 
The theory may be applied to various sectors, one of which is public policy. In fact, effective nudges have been applied to reduce tax evasion, for energy savings in households and numerous social issues. Supervisors and regulators in financial markets, are exploring how nudge theory may affect the way that investment options are presented to investors, as well as how to provide more effective information.  
 
The crucial need for further research
 
Especially nowadays, in the era of digitization and the constantly emerging new financial products and additionally due to the stunts of fraudsters, it is imperative to investigate the behaviour of investors and the factors that guide it, with the aim to design and develop instruments that will empower, educate and protect investors.  
 
The design of financial education programs can greatly benefit from the findings of behavioural finance, to achieve more than adequate information and to develop new skills and self-improvement techniques, in the scope of investment behaviour.

Article by Dr George Theocharides
Chairman of the Cyprus Securities and Exchange Commission

11 November 2021 11:27
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