Behavioral Biases and Investment Decisions: The Mediating Role of Risk Perception Through the Lens of Prospect Theory

Abstract

This study investigates the intricate relationships between behavioral biases, risk perception, and investment decision-making through the lens of Prospect Theory. It aims to assess how cognitive and psychological factors influence financial decisions, focusing on individual investors in Pakistan's stock market. A quantitative approach was employed using survey data collected from 500 investors. Validated scales were used to measure behavioral biases, risk perception, and investment decision-making. Structural Equation Modeling (SEM) was applied to evaluate direct and mediated effects within the proposed framework. The findings reveal that behavioral biases significantly impact both risk perception and investment decision-making. Risk perception mediates the relationship between biases and decisions, emphasizing its role as a critical intermediary. The model demonstrated robust explanatory power and excellent fit indices, confirming its validity. These results align with established behavioral finance theories, such as Prospect Theory, highlighting the interplay between cognitive biases and subjective risk assessments. The study contributes to existing literature by addressing gaps in understanding how these factors operate in emerging markets. The study validates the proposed model and achieves its objectives, offering insights for investors, policymakers, and financial advisors. Future research should explore cultural and technological influences on decision-making and develop interventions to reduce cognitive biases.

Keywords: Investor, Behavioral Biases, Risk Perception, Investment Decision-Making, PSX