A study on Maltese investor behaviour : the effect of prospect theory and loss aversion

Abstract

With the emergence of Behavioural Finance as a contradiction to Neoclassical Finance, understanding investor behaviour has been a key element for ensuring financial success. This study focuses on the psychological phenomenon of Loss Aversion which is a cornerstone of Prospect Theory created by Daniel Kahneman and Amos Tversky in 1979, as a psychologically more precise description of investor decision making as opposed to the Expected Utility Theory. Prospect Theory illustrates how individuals value differently, potential gains and losses, and leads to Loss Aversion which states that individuals’ sensitivity is greater towards losses, than towards gains. The objective of this study was to establish whether Prospect Theory and Loss Aversion feature within Maltese investor behaviour, and whether such biases affect their decision making. This study also aimed to explore and test the idea that when faced with losses, individuals tend to become risk seeking, in the hope of avoiding such loss. This study started off by examining previous literature on Prospect Theory and Loss Aversion, with the foundation of the study being the theories developed by Kahneman and Tversky and their conclusions on such biases. Research was conducted through quantitative and qualitative methods to be able to analyse investor behaviour from the point of view of investors and from the perspective of experts working in the field and giving the advice. The results confirmed that Prospect Theory and Loss Aversion feature in Maltese investor behaviour. The study also concluded that the theory that investors seek more risk when faced with losses and avoid risk when faced with gains, held true and this was illustrated through statistically significant results. This study further recommends that more education is needed so that Maltese investors understand further the concept of risk and return, rather than solely basing their decision on the value of perceived gains. A greater understanding of investor behaviour would facilitate the establishment of trust and maintain confidence and faith between the financial advisor and the investor.