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2.3 Finance and Regulatory Focus Theory

Behavioural finance explores how investors make decisions, the use of regulatory focus theory to further comprehend the processes by which investors make these decisions and the underlying motivations behind these processes is the purported next step in the behavioural finance framework. At present, there has been limited research regarding an amalgam of regulatory focus theory and financial concepts, and this book aims to develop on existing research in this area (Zhou and Pham 2004).

The work by Zhou and Pham (2004) proposes that consumers' investment decisions involve processes of promotion and prevention regulation that are man- aged by varying mental accounts, with different financial products representative of promotion versus prevention orientations. It is postulated that different risk attitudes are by-products of promotion and prevention in environments where seizing opportunities and achieving gains increases risk and preventing mistakes and avoiding losses decreases risk. From a regulatory focus standpoint, the book demonstrates that promotion and prevention can be activated by the targets of judgement and decision, not only individual differences or situational factors, as with previous research.

From a financial standpoint, investors' goals may be determined by the invest-

ment opportunities underevaluation rather than being independent of these oppor- tunities, and that the returns and risks of each financial product are evaluated separately, rather than jointly, as proposed by classical finance theory. The experiments demonstrate that priming can affect the asset and account allocation process, and that the evaluation of financial products can serve as a prime for unrelated tasks, sensitive to prevention and promotion. Whilst the bidirectional causality between priming by unrelated tasks, asset and account allocation has been highlighted, along with extensions to financial theory, the method by which chronic prevention and promotion-focused individuals approach asset and portfolio allo- cation is unexplored.

The study by Scholer et al. (2010) explores the self-regulatory mechanisms that underpin risk-seeking behaviour under loss, via stock investment studies. The experiments explored how participants behaved when they had purportedly lost or gained in their investment, and what they would subsequently invest in, from a range of stock options presented. It was also studied whether priming would alter the nature of stock options selected, along with whether those of varying chronic regulatory foci would make differing selections. The results were that prevention-focused individuals, more than promotion-focused ones, chose the riskier stock after an initial loss than when compared to a situation with an initial gain. When participants were primed with either a prevention or a promotion focus, it was found that the prevention-primed individuals were more risk seeking when a risky option offered the only possibility of getting to the original investment amount, but when a conservative option was available, this option was selected. There was no observable effect for a promotion prime. The study was then repeated without the prime, and there were similar results, with chronic prevention-focused participants. Across the experiments, the prevention system, but not the promotion system predicted the extent of risky decision-making. There were no significant results for the promotion focus thus indicating the possibility that the chronic prevention system is stronger in situations that involve financial decision-making. Although stock investments are featured prominently, they seem to be more of a vehicle to explore risk seeking behaviour, rather than asset allocation.

Concepts drawn from both studies would be useful for exploring the regulatory

foci supporting investment decisions, as the Zhou and Pham (2004) study fails to explore how chronic regulatory focus interplays with financial choices, and Scholer et al. (2010) do not look into how different financial products and portfolios are affected by regulatory focus. Whilst behavioural finance attempts to explain various anomalies using theories from psychology and the decision sciences, there are still many modes of thought and fields of study that have not been explored, to answer the questions that are posed by finance. Prospect theory makes a distinction between various pursuing and not pursuing courses of action, but it does not take into account the motivations for goal pursuit (Idson et al. 2011), which is the aim of regulatory focus theory.

Regulatory focus theory has been applied to several fields, as diverse as politics

(Boldero and Higgins 2011) and medicine (Klenk et al. 2011), extending the knowledge base in these areas. Whenever people are involved in decision-making processes, it seems that regulatory focus has a part to play, no less in finance. Thus, further study should be embarked upon, with a regulatory focus lens, pushing both areas ahead. The section that follows outlines the theoretical framework that underlies the book, drawn from the extensive literature review conducted.


 
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