The efficient market hypothesis is based on the concept that investors are rational and as a result stock prices are valued rationally, that investors process all available information when making investment decisions, and maximize expected utility accurately.
Of recent there has been a lot of literature that has documented observations of anomalies in the stock market (e.g. January effect).The presence of such anomalies suggests that the underlying principle of EMH i.e. rational behavior of investors is not correct. It has become apparent that in reality investors may in fact think and behave irrationally; although these departures from rationality are sometimes random they are often systematic. This behavior is explained by a field of study known as behavioral finance. Behavioral finance is an application of psychology to finance that considers the idea that investors may at times act less than rationally. It basically explains how investors are influenced by cognitive errors and emotions when making their decisions.
These systematic errors and behavioral biases that investors portray have serious implications to both the investors themselves and the market. As a result of imperfect rationality, there is mispricing of stock that leads to misallocation of resources. Furthermore investors that are inclined to behavioral biases when making investment decisions can do serious harm to their wealth e.g. Barber & Odean (2000) show that investors who are overconfident have poor net returns.
1.2Research problem
What are the factors that affect individual investor behavior?
1.3 Research Objectives
In order to address the research questions posed earlier, the following objectives are established:
To review the different literature streams that are relevant to the study
To develop a profile of sample Malaysian individual investor in terms of their demographics
To identify the objective of investment of a Malaysian individual investor
To identify the behavioral biases that affect Malaysian investors
To study the relationship between investor gender and investor behavior
1.4 Justification for Study
Initial motivation to conduct the study arose from a need to have a deeper understanding of financial decision making of individuals from a behavioral point of view.
Although there has been various research done on investor behavioral tendencies most of them were overwhelmingly quantitative, and used aggregated market-based data to explain such behavior.
Past studies examining factors affecting individual investors behavior tend to have inconclusive results when it comes to identifying which factors are most or least influential.
Lastly, there is a lack of research on individual investor behavior in Malaysia.
1.5 Definition of Terms
Individual investor: an individual who purchases small amounts of securities for him/herself. They are also known as a small or retail investor.
1.6 Conclusion
The overall purpose of this study is to explore investor behavior and the key factors that influence them .In order to achieve the research objectives and to answer the research questions, this study is organized in a number of different chapters:
Chapter 2 reviews current literature and other relevant sources that guide our understanding of individual investor behavior.
Chapter 3 The research methodology and methods utilized are then discussed in detail. Steps taken in carrying out the actual research are outlined along with the relevant data analysis methods used.
Chapter 2 -LITERATURE REVIEW
2.1How do investors behave?
According to Daniel, et al. (2001), when making investment decisions investors generally
do not participate in all asset and security categories, exhibit loss-averse behavior, behave on status quo, use past performance as an indicator of future performance in stock purchase decisions, trade too aggressively, do not always form efficient portfolios, behave parallel to each other, and are influenced by historical high or low trading stocks.
Investors trade too much
Barber and Odean (2000) examined the trading activity of 66465 households from 1991 to 1996 based on their accounts at a discount brokerage firm. They found out the average return of investors (after taking trading costs into account) in their sample was below the standard return level. The lower returns are as a result of higher transaction costs (e.g. Odean, 1999).
The excessive trading of investors is attributed to overconfidence: investors overestimate their information knowledge abilities and future outcomes. According to Larrick et al (2007) individuals who believe they are better than average are also more likely to be overconfident. Overconfidence is a problem when individuals don't recognize their limitations and therefore, make faulty decisions based on wrong premises. There are several factors that contribute to overconfidence namely: the illusion of control (The tendency of people to believe they have influence over the outcome of uncontrollable events), illusion of knowledge (People believe that they know more than they actually do) as well as self attribution bias (attributing one's successes to one's own abilities, even when such attribution is unwarranted).
Investors often do not participate in all asset and security categories
This can be attributed to the fact that people prefer and believe in what is familiar to them. In investing, most investors tend to choose to invest in stocks of companies that they know rather than another even if the second might be of better value. This is related to familiarity bias. Familiarity bias can be seen in lack of diversification, preference for local stocks, preference for professional proximity and preference for cultural proximity. The behavior is a problem because in buying what is familiar there is a tendency to underestimate the risk of the investment. Investors tend to buy a disproportionate amount of securities from their home country, despite well documented gains from international diversification, this is known as home bias e.g., Daniel et al(2001). This is also the case for U.S. investment managers who exhibit a strong preference for firms that have local headquarter in their domestic portfolios Coval and Moskowitz (1999).a preference for professional proximity is evidenced by Huberman(1999) who found out that employees tend to invest in their own firm's stocks and perceive this stock as low risk.
Individual investors exhibit loss-averse behavior
Loss aversion refers to the fact that for most people, the fear of losing money is greater than the joy of potentially making money. That is we prefer to avoid loss about as twice as much as acquiring gains. As noted by Daniel et al. (2001) individual investors tend to be more likely to sell their winners than their losses (disposition effect). They hold onto their losses in hopes that prices will eventually recover. An implication of loss aversion is that individuals have a strong tendency to remain at the status quo, because the disadvantages of leaving it loom larger than advantages (status quo bias).
Investors behavior is parallel to each other
This is known as herding; various researches have been able to provide evidence of the existence of such behavior. According to Daniel et al. (2002), investors tend to follow the consensus behavior, regardless of whether the decisions are right or wrong. This may be due to the fact that we have a belief that all people could not be wrong. In a study of crisis related behavior in the Jakarta stock exchange using daily trade data from January 1997- December 1999 (monthly data) Bowe and Domuta (2004) found evidence of investor herding. They also found out that foreign investors herd more than locals, foreign herding increases during the crisis, while domestic herding reducing from the onset of the crisis.
Investors are influenced by historical high or low trading stocks
Daniel et al. (2001) suggests that investors may make assumption of how the market works based upon irrelevant historical values which is somewhat equivalent to making decisions based upon mental accounting with respect to arbitrary reference points.
Investors use past performance as an indicator of future performance in stock purchase decisions
According to Daniel et al.(2001) investors naively extrapolate past price trends even though empirical evidence suggests that there is little or no persistence in performance.This reliance on past performance implies that investors fail to take expected returns and risk into account. This behavior is explained by representativeness and availability heuristics. Representativeness is defined as the tendency to irrationally attribute one characteristic to imply another, while availability heuristic is the tendency to make decisions based on readily available information.
2.2What factors affect individual investor behavior?
In a study examining the factors that influence Greek investor behavior Maditinos et al.(2007) used both questionnaire and a series of interviews. They found out that individual investors rely more on the media and noise in the market while professional investors rely more on technical analysis and portfolio analysis when making investment decisions.
These findings are contrary to Merikas et al. (2003) who carried out a mail survey in studying factors that affect Greek investor behavior and employed frequency analysis and factor analysis. The results of their study indicated that when making decisions investor investors employ diverse criteria although a classic wealth maximization criterion is considered very influential whilst newspaper or media is considered least likely to influence investor decisions.
Based on the aforementioned studies it is apparent that investors have broad view on relative importance of factors that affect their decision making.
Sultana(2010) employed a modified questionnaire which included factors like religious beliefs as well as creation of organized financial markets in studying factors that influenced investor behavior in the UAE. Their findings were consistent with Merikas et al.(2003) in that a mix of financial and non-financial influences were discovered. Religious beliefs and creation of well organized financial markets were one of the least influential factors.
2.2.1Demographics and investor behavior
There are several studies that have assessed the relationship between demographic factors and investor behavior.
Baber and Odean (2001) using account data for over 35,000 households from a large discount brokerage analyzed the common stock investments of men and women from February 1991 through January 1997 in order to test if men are more overconfident than women. They found out that men trade 45 percent more than women. Trading reduces men's net returns by 2.65 percentage points a year as opposed to 1.72 percentage points for women. This suggests that men are indeed more overconfident than women.
In a study assessing the investor behavior of Indians, Sultana (2010) carried out a survey (questionnaire) with a sample size of 150.He documented that gender and risk tolerance are independent, and that the older an investor the less risk tolerant. He also assets that the older the investor the better his/her performance seemed, this is in contrary to Rui et al(2004) who in studying account data from china and found that investor sophistication does not necessarily mitigate behavioral biases nor improve trading performance.
Merrill Lynch investment managers (2005) documented women make fewer investment mistakes than men and make them less often - despite the fact that, on average, they tend to know less about investing and enjoy investing less than men.
Table 1.1 presents a summary of a set of 20 empirical studies conducted between 1999 and 2010, which includes country of study, methodology, objectives and findings of the research.
Table 1.1 A brief framework of the related finance literature on investor behaviour
Author
objective
Methodology
Al Tamimi H.(2005)
What are the factors that influence UAE investors behavior?
Barber &Odean(2000)
Examine the Investment perfomance of common stocks?
Barber &Odean(2001)
does overconfidence lead to excessive trading?
Chen G.,Nofsinger R.J. ,Kim K.A. ,Rui M.O. (2004)
How does investor experience influence investor behavior and trading performance?
Daniel, K., Hirshleifer, D., & Teoh H, S. (2001).
how psychological biases affect investor behavior and prices
Literature review
De Bondt, M.F.W(1998)
How do small individual investors trade stocks
Literature review
Domuta D. & Bowe M.
(2003)
what are the investment behavior of foreign and domestic investors during the financial crisis
Gebka B .,Bohl T. M.& Goodfellow C.(2009)
Is there herding in the polish stock market
Grinblatt M.& Keloharju M.(2000)
Which investor groups exhibit momentum and contrarian behavior?
Huberman, G., (1999)
Do people prefer to invest in the familiar?
Merikas, A. A., Merikas, G. A., Vozikis, S. G., & Prasad, D. (2003)
#What are the factors that influence investment choices of individuals?
#Factor analysis-Orthogonal rotation
Merrill Lynch Investment Managers. (2005)
Does gender influence investor behavior
Nofsinger R.J. & Kim K.A.(2007)
Are individual investing behaviors related to market conditions?
Sorting and regression analysis
Odean T.
Do investors trade too much?
Ranganathan K.
To evaluate the fund selection behavior of MF investors
Shive.S(2010)
Does social influence affect the individual investors trading
Sultana,T.S
(2010)
#What is the influence of demographic factors (age and gender) on risk tolerance?
#Correlation
#Chi square test of independence
Vissing-Jorgensen A.(2003)
Does "Irrationality" Disappear With Wealth
Wei S. & Kim W.(2002)
The trading behavior of foreign portfolio investors in Korea before and during the currency crisis
Maditinos D.I,Sevic Z. &Theriou N. G.
What methods and techniques are used by Greek investors in making investment decisions
2.3CONCLUSION
From the review of the literature on behavioral finance since the 1999, which is summarized in table 1, it is clear that the recent evidence available suggests that investors are not rational, as many financial economists believed and maintained. When making investment decisions investors are susceptible to cognitive and emotional biases: they think they are better decision makers than they really are, they are loss averse, trade too much, follow the crowd, put too much weight on recent experiences, prefer to invest in companies they know or think they know.
There are various factors that have been documented to influence investor behavior. It is apparent that investors do not rely on a single approach but on many categories of factors. There is some inconsistency when it comes to the influence of media on investor behavior, Maditinos et al. (2007) and Merikas et al. (2003) document contrasting ideas of the relative importance of media on investor's decision although both were studying Greek individual investors. This may be because the results reported are sensitive to the methods employed (interview & questionnaire versus questionnaire only) also the year of study is different. Also it is interesting to note that although UAE is a Muslim nation investors were documented to not be influenced by religious reasons when make investment choices
It has also been made apparent that there are differences in demographic variables effect on investment behavior.
Chapter 3 - METHODOLOGY
3.1 Introduction
The main aim of this study is to critically examine and analyze the factors that influence investor behavior, with focus of individual retail investors in Malaysia. This chapter provides the theoretical framework of the study that is meant to provide more clarity about the relationship between the variables employed in the study. It further provides a description and hypotheses development that clearly states sets of hypotheses to be tested. The research approach has also been discussed to explain what kind of approach was used to carry out this research. This chapter also gives an explanation of the design of the questionnaire that was used. Finally, there is also the discussion about the statistical properties of the data along with the relevant data analysis techniques used.
3.2 Theoretical framework
Accounting information
Personal information
Investor behavior
Neutral information
Advocate recommendation
Personal financial needs
gender
IV
DV
3.3 Hypothesis development
3.4Data
To find out the factors that affect investor a questionnaire was developed and administered. The survey was administered as a paper version to retail investors in the Malaysian stock market. The number of distributed questionnaires was 160.
3.5Research instrument
The questionnaire includes closed ended questions and scaled-response questions investigating the dependent variable and the independent variables of the research.
The questionnaire was divided into two sections that are section A and B. In the first section of the questionnaire respondents were asked to complete questions concerning their personal background information. The demographic information included gender ,age ,race ,marital status ,educational level .annual personal income ,employment status, years of investment experience and number of people the respondent was responsible for.
The second section of the questionnaire encompasses 2 sub parts ranging from part I to part ii. In part I the respondents are asked the objective behind their investment as well as asked to evaluate the importance of 26 items, as identified from literature Merikas et al. (2004) that influenced their investment decisions. Responses were marked on a 5 point likert scale. In order to asses the investor behavioral bias categories: overconfidence, herding, loss aversion in part ii the respondents were asked to mark their responses on a 5 point likert scale anchored by "strongly disagree"(1) to "strongly agree"(5).Each behavioral bias had a maximum of 5 questions in the questionnaire.
3.6 Statistical properties
Sampling issues
Sampling design
Sampling is the process of obtaining information from a subset of a larger group, statistical representative of the whole population. The results from the sample are then used to make estimates of the characteristics and views of the larger group.
For the purpose of this study, simple random sampling is used as the sampling method to analyze the findings. In simple random sampling, every element in the population has a known and equal chance of being selected as a subject. Simple random sampling is used because it has the least bias and offers the most generalizability.
Sample size
In choosing a sample size one has to ensure that the chosen sample size is both valid and reliable, this will enable one to generalize the findings from the sample to the population. Sample sizes larger than 30 and less than 500 have been deemed appropriate for most research. Also if samples are to be divided into subsamples for investigation a minimum sample size of 30 for each category is necessary. In a multivariate research, the sample size should be several times as large as the number of variables in the study i.e. preferably ten times or more.
Questionnaire design issues
Validity of survey instruments
Validity refers to the degree to which a study accurately reflects or assesses the specific concept that the researcher is attempting to measure. It is concerned with whether the right concept is measured.
There are several types of validity tests that can be conducted to assert the goodness of measure of data namely: content (ensures that the items on the test represent the entire range of possible items the test should cover)., criterion (the test differentiates individuals on a criterion it is expected to predict) and construct validity (shows how well the test scores fit the theories in which the tests where based. Construct validity can be established through correlation analysis and factor analysis.
Reliability of survey instruments
Reliability refers to the extent to which a test produces the same result on repeated trials i.e. whatever a test measures, it measures it consistently. Reliability is concerned with both stability and consistency of the test.
There are several tests of validity that can be used namely: test retest reliability (the degree to which a test, given at different times, gives the same results), parallel form reliability (the degree to which the results of two tests constructed in the same way from the same content domain given at the same time remains the same) and internal consistency reliability (the degree to which a test items that measure the same construct give the same results).
3.7 Statistical tests
Goodness of measure
In assessing the validity of the questionnaire confirmatory factor analysis will be used. Factor analysis is used to determine whether items are tapping into the same construct. During factor analysis, factors with an Eigen value of more than one are retained for further analysis. To reduce the problem of cross loading, if the differences of loadings of any item across factors were less than 0.50 than the items will be deleted.
In order to assess the reliability of the test, Cronbach's alpha coefficient analysis will be used. The Cronbach's alpha determines the internal consistency or average intercorrelations of items measuring the same concept. The closer the Cronbach's alpha to 1, the higher the internal consistency reliability, a value of 0.6 and above is considered reliable.
Test of relationship
To study if there is a relationship between the factors and investor behavior,the chi square test will be conducted at 5% significance level.In order to assess the direction and strength of the relationship between investor behavior and factors named the spearman correlation test will be conducted.the assessment of the correlation at this point gives an early indication of what to expect from the multivariate analysis.
