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Behavioural Aspect of Investment Decision

Bishal Shrestha
* MPhil. Scholar, Kathmandu University School of Management
Jul 03, 2019
Behavioural Aspect of Investment Decision

Behavioural Aspect of Investment Decision

   An investment decision is a very complex cognitive process which is peculiar to each individual investor. The pursuit of understanding those underlying factors affecting individual investment decision is a rather intricate endeavour, if not impossible. The investment decision process has evolved greatly over the few decades in terms of the way the investment decisions are made. Tools, techniques and standard models are predominantly being used for investment and financial decision making. Use of these sophisticated tools, techniques, and models would be of limited use in the absence of behavioural and contextual understanding of both individual investors and their investment environment.

    Adam Smith (1972, p.13) stated in his book Super Money, “ We have the most elaborate machinery possible for tracking prices, but that is like bending over buffalo tracks and saying “ Yes, many buffalo pass this way.’ Very good if there are a lot of buffalo all going in that same direction…but knowledge is still spotty. Further, no one has paid much attention to people. The assumption is that price behaviour and volume equal people behaviour.” This statement emphasizes the value of ‘people aspect’ of looking at investment and its decision-making process. So far, studies have focused only on ‘what aspect’ of investment, and in doing so one important aspect of ‘why’ people invest and ‘how’ they arrive at such investment decision focusing on ‘people aspect’ of investment has much been ignored or at least under-emphasized. Exploring the behavioural aspect of individual investor comes along with the inherent characteristics of an individual. Each individual investor differs in terms of coming up with different investment decision.

   Various factors affecting the investment decision might have a different degree of impact on different investors. Some investors might be risk averse meanwhile, some might be risk seeker. Some investor tends to buy the stock while other sales in differing market condition. Some prefer to buy small-cap stock while other hunts for large-cap stock. Some investor opts for capital appreciation while others seek to maintain regular revenue income. Some investor highly values information while others do not. In most of the cases, different investors tend to have a different opinion regarding investment choices despite using similar sort of analytical tools and technique. Given these differing observed outcome, an interesting question that comes to my mind is “why?”

    In the quest of developing the understanding of individual investor’s behavioural aspect, many authors agree that our lack of knowledge about the market experience      of different investor groups is much wider than the gaps in the available data on the performance of the stock markes as a whole (Lease, Lewellen, & Schlarbaum, 1974). An individual’s behaviour cannot be understood in the absence of their context. Context is particularly important because it is what defines the situation and makes it what it is (Myers, 2013). Individual investors’ behaviour and attitude are shaped and formed over the period of time which is affected by its culture and environmental context. Getting to know these contextual perspective helps to better understand the contemplated perceived factors affecting investing decisions. Not only these understanding will help to make an informed investment decision, but also enables an individual investor to become aware of behavioural biases and stigmas which would otherwise be hidden in plain sight. It    is of crucial importance for a financial planner or adviser to have an understanding of the behavioural aspect of investors. Understanding how these behavioural finance issues apply to investor behaviour can provide investment professionals and advisers with additional knowledge to help their client make better judgment and decisions. There is a growing interest in understanding the behavioural aspect of investment decision-making and how we make a choice between financial assets.

    It is very intuitive to state that there exist innumerable factors affecting individual investor’s investment decision. Moreover, it is not just a single distinguishable factor that clearly explains the investment decision making phenomena. It is an intricate process involving many factors which are peculiar to a particular investor at a given point of time. Even investors themselves differ in terms of chosen factors over the period of time which they considered to be prominent when arriving at a particular investment decision. Thus, perceived factors of individual investor’s investment decision itself is a fluid concept. However, attempts have been made to identify the factors that have bearing on an individual’s investment decisions. Consideration of behavioural aspect in investment and finance discipline did not gain much attention until recently. It has been only a few decades, that behavioural aspects have been recognized and studied in investment and financial domains.

   Modern academic finance literature has mostly dominated by large-scale quantitative studies, both in absolute term and relative to other disciplines in the broad accounting and finance area (Burton, 2007). If we expand our empirical sources of data to include what people have to say, write and how they behave can be just valuable to decipher the underlying significance of investor’s behaviour (Kaczynski, Salmona, & Smith, 2014). A benefit to finance is further enhanced if we expand our empirical sources of data to include what people have to say, which then allows us to explore the complex reasoning behind those acts and conversation. In this article, I have tried to sum up some of theexisting ideas uncovered in extant literature with respect to the behavioural aspect of decision making under differing context.

   Human being engages in a continual process of interaction and exchange with their context- receiving, interpreting, and acting on the information received, and in so doing creating a new pattern of information that effects changes in the field as a whole (Morgan & Smircich, 1980, p. 495). Any pursuit of understanding behavioural aspect independent of context does not yield complete understanding. There have been many studies exploring factors affecting individual investor (Murphy & Soutar, 2004; Nagy & Obenberger, 1994; Baker & Ricciardi, 2015). The behavioural economics literature indicates that individuals often do not arrive at an investment decision with firm preferences which again may be attributed to contextual differences on which such decisions are being made.

   Many financial theories assume that the investor’s risk-return trade-off influence the investment decision. Investor tends to choose the investment with a higher return for a given level of risk or with a lower risk for a given level of return (Markowitz, 1952). The expectation of future earnings (Haslem & Baker, 1973) is one of the widely accepted criteria for an investment decision. Ability to allocate capital based on expected future earning which reduces the uncertainty was cited as an argument in favour of this criteria. Although stock prices were subject to many other factors, the earnings potential was regarded as one of the primary factory underlying the market behaviour of securities. These research findings suggest that investor evaluates expectation of future earnings as reference for market price movement when evaluating their investment decision.

   Fisher and Statman (1997) stated investor choosing to invest only on the basis of risk and return is analogous to the consumption decision considering for only cost and nutrition. Financial models building upon various assumptions shows that in a frictionless market, the difference in risk preferences and wealth are the main sources of variations when it comes to equity investment (Samuelson, 1969; Merton, 1969). The investment philosophies and aptitude for risk and return differ over the different stages of lifecycle (Gitman & Joehnk, 2013). Their result showed that most young investors are growth- oriented whereas middle-age people focus on consolidation and at the retirement years the focus shifts towards having a stable income. Findings by Baker et. al (2015) showed tradeoff relationships for sub-classes of the gender, age and marital status characteristics of the individual investor in common stock. Risk preference varied across gender in respect of dividend preferences and capital-gain preferences.

   Research in psychology and finance has suggested internal behavioural factors such as an individual’s knowledge of themselves, and external behavioural factors, such as the way an investment decision is presented or framed also greatly affects the investor’s attitude to financial and investment decisions ( Sherfrin, 2000; Shleifer, 2000). Murphy and Soutar (2004) in their study identified the company’s management was highly valued by an investor as opposed to investor’s knowledge of the company which ranked last. Contrary to established contention of investor relying their decision based on quantitative facts and figures, their study showed dividend, price-earnings ratio, yield having an only mediocre contribution on investment decision. Relying on those subjective factors which differ across different investors when it comes to interpretation, application, and action based on such, not necessarily lead towards optimum investment decision. Based on this, conventional contention of investor being rational and make their investment decision based on risk-return trade-off, in fact, may not be entirely valid in real life context. They argue that today’s investor has a wide choice of investment products but, to date, there has been limited research into the way choices are made between various alternatives (Murphy & Soutar, 2004).

   Behavioural aspects in combination with external stimuli affect the investor’s decision. Warneryd (2001) postulated reasoning that ‘those who make short-term investments to save up for not too distant tend to lose or make lower gains, due to short-term variation in stock rates and bond interest rates. Similarly, speculators are in few cases end up very rich, but in many, cases lose everything. Warneryd used financial and psychological reasoning to elucidate a fundamental underlying humane aspect of investment analysis which was long ignored or to a greater extent underemphasized by conventional financial discipline. Risk and risk attitude, fast and heuristic decision-making tendency, social influences, feeling of optimism and self-confidence are some of the key factors affecting investor decision making as outlined by Warneryd.

   Campbell (2006) states that it is a well-documented empirical fact in the finance literature that there is significant heterogeneity across individuals in investment behaviours such as the decision to invest in the stock markets and the choice of assets allocation. Followed by a couple of important but usually overlooked questions; Are individual investors genetically predisposed to certain behaviours and born with a persistent set    of abilities and preferences which affect their decisions in the financial domain? Or      is investment behaviour to a significant extent shaped by environmental factors, such   as parenting or individual-specific experiences? These questions are  fundamental  to any financial analyst to elucidate the underlying phenomenon guiding the investment behaviour. Examining the detailed discourse of behavioural aspect coupled with the quantitative dimension of the financial decision will lead to a greater understanding of investors’ behaviour in a given context.

   Ricciardi (2015) pointed out heuristic, disposition effect, mental accounting, overconfidence versus status quo, trust and control, self-control bias and framing, familiarity bias, risk and return, worry, risk-taking behaviours and anchoring effect as some of the key behavioural aspects of investor affecting their investment decisions.

Financial planning and investing are cited as an overwhelming, intimidating and scary task for an investor to tackle those tasks on their own (Baker & Ricciardi, 2015). Further, states that investors are fearful of making costly mistakes that could affect their present and future financial well-being. This sense of trepidation could be one of the key factors refraining investor from being rational as postulated by conventional investment theories. Trepidation was cited as a function of lack of background, education, or experience to help them substantiate their investment decision. Successful financial planning and investing are much more than crunching numbers, listening to popular opinion, and understanding the latest market. Ben Graham, the father of value investing noted: “Individual who cannot master their emotions are ill-suited to profit from the investment process.” According to old investment adage, an investor can make money as a bull or a bear but not as a pig. These behavioural aspects of investing which involve emotional processes, mental mistakes, and individual personality traits somewhat explain much of the erratic history of investment and financial markets from time to time. It is comforting to state that the information structure and the characteristics of market participants influence both individual’s investment decision and market outcomes. Real people are not totally rational or irrational when making investment and other financial decisions.

    As Charles Ellis, a leading American investment consultant once stated: “Las Vegas is busy every day, so we know that not everyone is rational.” The observed persistent deviations from theoretical prediction provide useful information about how and why people make decisions. Sometimes facts and figures are no match for human emotions. As Fisher (2014) notes, “One of the greatest services a financial advisor can provide to clients is helping to ensure that in times of market turbulence; reason, discipline and objectivity triumph over emotions such as fear, greed, and regret.” Investor prefers to invest in a stock whose price has been rising over a stock whose price has been falling, Blume and Friend’s (1978), suggests that investors were less likely to buy a stock whose price had moved down for no reason than one whose price had moved up for no apparent reason. Stockbrokers were seen as the preferred source of recommendation. Recommendation from the financial press was also highly regarded, however, suggesting people also use their own reading and research when making investment decisions. The very low value placed on rumors is consistent with the low appeal of speculative stocks and this suggests a majority of respondents were investors, rather than speculators.

    Investors showed a preference for sectors with a history of slow, but steady growth, although emerging industry sectors also had some appeal which indicates that investors are conservative and inclined to avoid volatility. However, they would be willing to accept good investment opportunities when they arise (Murphy & Soutar, 2004). Existing research has shown that stock market participation is determined by factors that allow an individual to overcome entry barriers, such as wealth, education, cognitive abilities, social interaction, and trust as well as individual’s risk aversion and background risks (Barnea, Cronqvist, & Siegel, 2010). Background risk factors usually constitute labor income risk, entrepreneurial activity, health status, and marital status. Kahenman and Tversky (1979) stated that individuals may take mental short cuts to reach a decision, particularly when there is time pressure or when other factors (such as lack of understanding) make it difficult to assess the available choices. Tapia and Yermo (2007) cite that individuals are affected by inertia or procrastination (i: e: - they put off a decision until tomorrow) when faced with the decision about investment.

    All aforementioned instances were the research findings in a context that is different than ours. Having seen these heterogeneities of factors and their implication on effective investment decision making; it compels us to carefully consider those behavioural factors that would otherwise be most often ignored or overlooked.


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