PREMISES OF BEHAVIORAL FINANCE IN RATIONAL DECISION-MAKING

Abstract

One cannot separate decision from psychology of human being. People see world by perception and this leads to various ways of understanding even the most concrete or certain things. Financial literature reflects the subjective nature of human being in making decisions by classifying decision-making process into being 'rationally' oriented or the opposite, 'irrational', according to individual’s attitude towards risk – 'appetite' or 'aversion'. Process of understanding risk associated with future financial returns implies attaching mental probabilities to it. This activity is always affected by human nature of agents that take financial decisions, therefore bearing risk. Psychological factors such as perception, framing effect, information asymmetry, irrationality, emotions are accompanying every financial decision. Paper intends to study the direct relationship between psychological traits of a human being playing the role of a decisional agent in financial context. Financial decisions are always accompanied by the notion of probability in defining what we call as 'expected' returns that translate into risk associated with financial investments. Empirical analysis done on the financial market reflects that agents use their perception on risk of gaining or losing from a certain financial transaction to decide whether to invest or not. The notion of 'expected utility' has been complementary used with the one of 'prospect value' as financial literature evolved over time and researchers brought new insights into the mechanism of financial decision. This paper studies direct relationship between psychological traits of a human being according to classical and rational decision-making process in the light of the prospect theory and risk attitude regarding financial outcome of decisions. In this sense, an econometric model is tested on the international financial market in order to find out what kind of subjective factors lie hidden in an investor`s mind and test the degree of irrationality lies beneath a rational financial decision. The result is incorporated in a decisional model describing how agents use their perception on risk of gaining or losing from a certain financial transaction.

Keywords

• irrationality, financial risk, decision, psychological factors