Economic utility theo.i:y views the individual's

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1 Factors Influencing Individual Investor Behavior Robert A, Nagy and Robert W. Obenberger Previous studies of retail investor behavior have examined motivation from economic perspectives or studied relationships betrveen economic and behavioral and demographic variables. Examination of the various utility-maximization and behavioral variables underlying individual investor behavior -provides a more comprehejisive understanding of the investment decision process. These variables can be grouped into sei^en sumnumj factors that capture major investor considerations. Data collected from. a. questionnaire sent to a random sample of individual equity investors vnth substantial holdings in Fortune 500 firms reveal that individuals base their stock purchase decisions on classii::al 'wealth-maximization criteria combined with diverse other variables. They do not tend to rely on a single integrated approach. Economic utility theo.i:y views the individual's investment decision as a tradeoff between immediate consumption and deferred consuraption. The individual investor weighs the bene.fits of consuming today against Ihe benefits that may he gained by Investing uiiconsumed funds in order to enjo3'" greater consumption ai some point in the future. If the individual chooses to defer consumption, he will, according to theorj', select tlte portfolio that maximizes Iong-tenri satisfaction. The axiom.3 of utility theoiy, developed by Von Neumann and Morgenstern, argue that investors are fl) completely rational, (2) able to dea.t. wit^h complex choices, (3) risk-averse and (4) wealth-maxiinizii^g.' Utility Iheorj' fiirtlser assumes that investors maximize expected utility measured in terms of anticipated.returns and variances from these expectations (the meart/'variance approach).^ Thai: is, each investor selects the portfolio that maximizes expected return v^'hiie minimizing risk. Otiier theories of investor preference have made less sm.ngent assurapticns about how investors make choices. Competing theories have argued that investors (1) seek investments that maximize geometric mea.n return,, (2) concentrrate on avoiding "bad" outcomes (safet^r-fixst rriodels) or RobsH A. Nagy is Associate Professor of Financa ai the 'Jniversitii c/ \Nisconsin-Green Sjjy. Robert W. Obenberger is Ajfxciah Profesior of haarliiing at the University of Wisconsin-Greeii. Bay. (3) make investment decisions free of assumptions about utility functions or probabilities (stochastic do'm.mance). BACKGROUND The literature on utility theory does not t5'pically.address individual investor decision processes. Rather, it focuses on the development and refinement of "macro" models that explain aggregate market behavior. However, some empirical studies? of individual investor behavior have examined utiiit;v theory constructs focusing on individual rather than aggregate investor profiles. Baker and Haslem, for example, find that dividends, expected returns and the firm.'s financial stability are critical considerations for individual investors.^ Baker, Hargrove and Haslem find that investors behave rationally, taking into account the investment's risk/return tradeoff,* A relatively new finandai subdisdpline, behf vioral fina.nce, has achieved impressive strides in explainmg the behavioral aspects of investment decisions. Behavioral finance investigates choice under uncertainty. Three major elements frame behavioral finance Prospect Theory, regret aversion and self control.^ Each element captures behavioral attributes of indi\adual investors. Empirical studies of the behavior of individual ini.'estors first appeared in the 1970s. The Wharton 3r rvey, one of the more comprehensive studies of investor be.havior, examines how demographic Financial Anaiysts Journal / JulyrAugust

2 variables influence the investment selection and portfolio composition process. Blume and Friend provide an excellent overview of the results and implications of the study.^ Cohn et al. provide tentative evidence that risk-aversion decreases as investor wealth increases.^ Riley and Chow find that risk-aversion decreases as age, wealth, income and education increase.^ LeBaron, Farrelly and Gula counter that individuals' risk-aversion is largely a function of visceral rather than rational considerations.^ Lewellen, Lease and Schlarbaum determine that age, sex, income and education affect investor preferences for capital gains, dividend yield and overall retum. ^ Barnewell finds that individual investor behavior can be predicted by lifestyle characteristics, risk-aversion, control orientation and occupation.^^ Warren et al. predict individual investment choices (e.g., stocks, bonds, real estate) based upon lifestyle and demographic attributes.'^^ This evidence might lead one to question the relative importance of various economic and behavioral motivations. This article examines which factors have the greatest influence on the individual stock investor. The factors considered include elements from many of the prevailing theories, as well as other "popular" criteria that have largely escaped empirical scrutiny. Specifically, we address two research questions. First, what relative importance do dedsion variables have for individual investors making stock purchase decisions? Second, are there homogeneous groups of variables that form identifiable constructs that investors rely upon when making equity investment dedsions? METHOD We mailed questionnaires to 500 experienced shareholders whose names were obtained from a proprietary source involved in financial marketing research. There were 137 usable responses {27.4% response rate). Participants were asked to evaluate the importance of 34 variables, which had been identified by extensive testing as potentially influencing equity investment decisions. The variables included some from the traditional sphere (e.g., expected dividends, perceived risk, diversification needs) and others addressing more contemporary concerns (firm's environmental record, perceived firm ethics, etc.). Respondents noted whether each variable was (1) a significant item used to make investment decisions ("Act On"), (2) a secondary item ("Consider") or (3) an item ignored in the investment decision process ("No Influence"). We ranked the variables according to how frequently they were placed in each response category and used factor analysis to examine how they interacted. Factor analysis takes large numbers of variables (34 items in this case) and identifies similarities between them, making interpretation of the results easier. RESULTS We focused first on determining the relative importance of the variables to individuals making investment decisions. Table 1 ranks the variables by the frequencies with which respondents considered them to have significant influence on stock purchase decisions. Several observations can be made. First, most of the variables ranked significant are classical wealth-maximization criteria such as "expected earnings," "diversification needs" and "minimizing risk." Second, however, no wealthmaximization criterion or any other item was considered significant by more than half the respondents. This confirms the impression held by many experienced retail brokers that investors employ diverse decision criteria when choosing stocks. Third, it is also apparent that contemporary concerns such as international operations, environmental track record and the firm's ethical posture are given only cursory consideration by experienced stock investors, although some mutual funds specializing in such stocks have been successful in attracting investors. Table 2 ranks the variables by the frequency with which respondents ignore them when making stock purchases. The results can be summarized as follows. First, the survey group was nonprovincial in outlook; local operations are clearly not important to experienced stock investors. Second, most respondents are highly self-reliant and ignore inputs of family members and coworkers when choosing stocks. Surprisingly, the recommendations of brokerage houses and individual stock brokers do not fare much better. Finally, almost 40% of the respondents apparently do not make use of valuation models, even one as readily available as the price/earnings (P/E) ratio. While it is difficult to identify which variables are dearly related to wealth-maximization (economic utility theory) and which are not directly related, some observations can be made. It is encouraging to note that investors rely mostly on dedsion criteria predicted by dassic economic util- 64 Financiai Analysts Joumai / Juiy-August 1994

3 Table 1. FiBquerK^ Distribution of Variables thaft Signtfk^nUy Influence Invests Decisions Rank Item Frequency Per Cent 1 Expected Corporate Earnings 2 Diversification Needs 3 Feelings for Firm's Products and Services 4 Condition of FinanciaJ Statements 5 I'iro Status in Industry 6 Reputation of Firm 7 Past Perfonrance of Siock 8 Attractiveness of Muri-Stock Investments 9 Mininuzing Risk 10 Ti:T!.e 3e.fore Funds are Needed 11 Tax Consequences 12 Ei<pected Stock Market Performance 13 Gut Feeling on Economy 14 Perceived EfchJcs o?'.pirra 15 Ei.:pected Diwdends 16 Co.-npeting Financial Needs 17 P.;.s' Perfonnancc of Investor's Stock Portfolio 18 Affordable Share Price 19 IJaia in Reports -k Prospectuses 20 Current Economk indicators 21 Use ct Valuation Equ.ntions 2.2 S;3!jk Broker Recommendation 23 Inveslment Advisory Service Recommendation 24 Institutiona! Hold::rigs 25 Recent Price MoveEnents of Firm's Stock 26 Coverage ir. Finandai Press 27 Brr:ike.rage House Recommendation 28 Family Meraber Opinions 29 C.r.rverE.ge in GeriejaL.'?ress 30 Exchange Listing 31 Local Operations 32 E n V ij: c tnme n tal Record 33 Frie.n.d or Ccvi'orjctr Recommendation 34 International Operations i % ity theory. At the same time, however, it is apparent that investors use diverse criteria, rather than a single, integrated approach. Many respondents do not approach investment decisions in a normative fashion. Our second focus was on whether the vadablesmost important to investors form homogenous groups. As the.re did npt appear to be a single set of variables investors used consistently to make stock purchase decisions, we employed factor analysis to determine whether there are underlying constructs that represent a synthesis of investor concerns. We analyzed the 34 variables using the varimax algorithm of orthogonal rotation, the most commonly used method. ^'^.Evaluation of the resulting constructs is largely subjective. The reader is encouraged to bear widi the authors' labeling efforts and to recognize that empirical factor formation and identification is rarely definitive. Table 3 summarizes the results of the factor identification process. Individual Factors The "neutral-information" factor: Variables that loaded heavily on this factor include coverage in the financial and general press, recent stock index returns and recommendations by investment advisory services. Each of these variables represents an outside source of information that is perceived to be unbiased. Although factor analysis does not permit a rank ordering of the importance of aggregate factors, it is noteworthy that none of the variables that comprise this neutral-information factor is ranked important by investors in the aggregate. Given the market's rapid response to nev/ data. Financiai Analysts Joumai / July-August

4 Table Z Frequency Distribution of Variabies tiiat Least influence investor Decisions Rank Item Frequency Per Cent 1 Local Operations 2 International Operations 3 Family Member Opinions 4 Exchange Listing 5 Environmental Record 6 Friend or Coworker Recommendation 7 Affordable Share Price 8 Institutional Holdings 9 Coverage in General Press 10 Valuation Equations 11 Brokerage House Recommendation 12 Stock Broker Recommendation 13 Time Before Funds Will Be Needed 14 Perceived Ethics of Firm 15 Coverage in Finandai Press 16 Competing Financial Needs 17 Data in Reports & Prospectuses 18 Expected Dividends 19 Recent Price Movements of Firm's Stock 20 Investment Advisory Service Recommendation 21 Expected Stock Market Performance 22 Tax Consequences 23 Attractiveness of Non-Stock Investments 24 Past Performance of Investor's Stock Portfolio 25 Gut Feeling on Economy 26 Current Economic Indicators 27 Minimizing Risk 28 Feelings for Firm's Products and Services 29 Past Performance of Firm's Stock 30 Diversification Needs 31 Condition of Financial Statements 32 Firm Status in Industry 33 Reputation of Firm 34 Expected Corporate Earnings % , :3 3.8 investors may view this information as dated and of limited usefulness. The "accounting-information" factor. Variables that loaded heavily on the accounting-information factor include the condition of the firm's finandai statements, data found in annual reports and prospectuses, the results of valuation techruques (e.g., P/E and market-to-book) and expected corporate earnings. Two of the items included in the accounting-information factor expected earnings and the condition of financial statements are highly important to investors. Apparently most investors in the sample value these traditional stock valuation considerations. The "self-image/firm-image coincidence" factor: Variables that loaded heavily on this construct include firm reputation, firm status, feelings about the firm's products and services, and perceived ethics of the firm. Each of these variables is a value statement about the firm, generated by the individual. In that all but firm ethics rank highly as investment considerations, it might be concluded that many investors choose stocks based on qualitative criteria. This presents a formidable challenge to an investment community accustomed to quantitative analysis and communication of the relative values of securities. The "classic" factor: Variables that loaded heavily on this factor are expected dividends, affordabnity of share price, tax consequences and risk-minimization. Each of these is a "textbook" (i.e., classic wealth-maximization) investment criterion. Surprisingly, these variables received mediocre ratings by investors, despite their dominance of the economic foundations of most theories of investor behavior. "Social-relevance" factor: The firm's environ- 66 Financial Anaiysts Joumai / Juiy-August 1994

5 Table 3. Factors influencing the Equity SdecUon Process of individuai investors Label Neutral Information Accounting Information Selif-Image/Firm-Image Coinddence Qassic Sodal Relevance Advocate Recommendation Personal Finandai Needs Key Variables Finandai Press Coverage General Press Coverage Recent Price Movements Information from Investment Advisory Services Finandai Statements Annual Reports Prospectuses Valuation Techniques Expeded Earnings Firm Reputation Film Status FeeBngs about Products/Services Perceived Ethics of Firm Expected Dividends Share Price Affordability Tax Consequences Risk Mirtimization Environnieiital Record Local Operations International Operations Recommendations from: Brokerage House Individual Stock Broker Friends/Coworkers Competing Finandai Needs Time before Funds are Needed Diversification Needs mental record, a substantial presence near the potential investor's residence and international operations dominate this factor. Although such corporate attributes have been highlighted by the financial press, none of these variables was judged by more than 5% of the sample to have a significant influence on the investment dedsion. The "advocate-recommendation" factor: This factor includes purchase recommendations from brokerage houses and individual stock brokers. Recommendations from friends or coworkers marginally loaded on this factor as well. Each of these information sources could be construed as a recommendation from sources with vested interests in the investor's ultinmate actions. Although many investors obviously rely on professional expertise, most investors in the sample are apparently wary of these information channels. The "personal-financial-needs" factor: The seventh and final factor is dominated by considerations for competing financial needs, period of time before invested funds will be needed for other purposes, and diversification requirements. Of these items, diversification needs was the second most important criterion (after expected earnings) for individual investors. The other variables in this factor were of less importance to respondents. Perhaps sophisticated investors view investment capital and consumption expenditures as independent entities. CONCLUSIONS Our findings suggest that classical wealth-raaximization criteria are important to investors, even though investors employ diverse criteria when choosing stocks. Contemporary concerns such as local or international operations, environmental track record and the firm's ethical posture appear to be given only cursory consideration. The recommendations of brokerage houses, individual stock brokers, family members and coworkers go largely unheeded. Many individual investors discount the benefits of valuation models when evaluating stocks. There appear to be at least seven relatively Financial Anaiysts Joumai / Juiy-August

6 homogenous groups of variables that influence individual investor behavior. The investment decision process appears to incorporate a broader range of items than previously assumed. Furthermore, each investor may view the seven broad criteria differently in terms of relative importance. The principle of customer orientation would suggest that the investment community provide potential investors with information that better addresses the seven factors and their constituent variables. Investment professionals who deal with retail clients may benefit by incorporating the factors discussed in this article when gauging and addressing individual investor concerns. FOOTNOTES 1. See J. Von Netunann and O. Morgenstern, Theory of Games and Economic Behavior (Princeton: Princeton University Press, 1947). 2. There are many excellent descriptions of the role of utility theory in portfolio formation. However, the seminal work remains that of the father of modem portfolio theory. See H.M. Markowitz, Portfolio Selection: Efficient Diversification of Investment (Cowles Foundation Monograph 16) (New Haven: Yale University Press, 1959). 3. H. K. Baker and J. A. Haslem, "Toward The Development Of Client-SpedBed Valuation Models," Joumai of Finance 29 (1974), H. K. Baker, M. B. Hargrove and J. A. Haslem, "An Empirical Analysis of the Risk-Return Preferences of Individual Investors," Journal of Financial and Quantitative Analysis, September There are many excellent primers in behavioral finance. For example, see M. Statman and D. Caldwell, "Applying Behavioral Finance to Capital Budgeting: Project Terminations," Financial Management, Winter 1987; D. Kahneman and A. Tversky, "Prospect Theory: An Analysis of Dedsion Under Risk," Econometrica, March 1979; and D. Kahneman and A. Tversky, "The Psychology of Preferences," Scientific American, January M. E. Blume and Irwin Friend, The Changing Role of the Individual Investor (New York: John Wiley and Sons, 1978). 7. R. A. Cohn, W. G. Lewellen, R. C. Lease and G. G. Schlarbaum, "Individual Investor Risk Aversion and Investment Portfolio Composition," Joumai of Finance, May W. B. Riley and K. V. Chow, "Asset Allocation and Individual Risk Aversion," Financial Analysts Joumai, November/December D. LeBaron, G. Farrelly and S. Gula. "Facilitating a Dialogue on Risk: A Questiormaire Approach," Finandai Analysts Joumai, November/December W. G. Lewellen, R. C. Lease and G. C. Schlarbatun, "Patterns Of Investment Strategy And Behavior Among Individual Investors," Journal of Business 50 (1977), M. M. Barnewell, "Psychographic Characteristics of the Individual Investor," in Asset Allocation for the Individual Investor (Homewood, 111.: Dow Jones-Irwin, 1987). 12. W. E. Warren, R. E. Stevens and C. W. McConkey, "Using Demographic and Lifestyle Analysis to Segment Individual Investors," Financial Analysts Joumai, March/April Factor analysis is used extensively in financial modeling, marketing research and other disdplines that employ complex data bases. For an intriguing application, see N. F. Chen, "Some Empirical Tests of the T'heory of Arbitrage Pridng," Joumai of Finance, December Financiai Analysts Joumai / July-August 1994

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