Diagnosing Investment Decision Failures: A Forensic Behavioral Framework of Prospect-Related Biases, Cognitive Dissonance and Investment Decision Quality (IDQ)

Abstract

Investment decision failures are products of complex behavioural processes, and not cognitive errors in isolation. This paper builds upon Prospect Theory and Cognitive Dissonance Theory to construct and empirically test a mechanism-based behavioural model of how prospect-related biases impair the quality of investment decisions due to cognitive dissonance, and bias blind spot serves as a moderating factor. Prospect-related biases is conceptualized as a formative second-order construct, which consists of loss aversion, regret aversion, framing effect and sunk cost fallacy whereas Investment Decision Quality (IDQ) is also modelled as a formative second-order dependent variable, which includes process rationality, portfolio appropriateness and outcome satisfaction. Based on survey data of 540 individual investors, IBM SPSS Statistics and a partial least squares structural equation modeling (PLS-SEM), the study is aimed at testing a moderated mediation model with higher-order constructs. The findings indicate that prospect-related biases have a considerable negative direct influence on IDQ and a positive influential impact on cognitive dissonance that in turn has a resounding negative impact on decision quality. The connection between prospect-related biases and IDQ is mediated in part by Cognitive dissonance and the impact of prospect-related biases on dissonance is amplified by bias blind spot. The formative assessments indicate disproportionality in the contribution of the dimensions in both second-order constructs confirming their configurational nature and allowing reverse (forensic) inference. This paper combines an exploration of behavioural antecedents and decision outcomes as higher-order formative constructs to bring behavioural finance to a process-based and diagnostically valuable interpretation of investment decision failure. Notably, the framework allows forensic determination of behavioural weaknesses that cause repeated decision failures, by considering investment decision quality as a diagnostic measure, as opposed to a performance outcome.