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 between economic and behavioral and demographic variables. Examination of the various utility-maximization and behavioral variables under- lying individual investor behavior provides a more comprehensive understanding of the investment decision process.
These variables can be grouped into seven summary factors that capture major investor considerations. Data collected from a questionnaire sent to a random sample of individual equity investors with substantial holdings in Fortune 500 firms reveal that individuals base their stock purchase decisions on classical wealth-maximization criteria combined with diverse other variables. They do not tend to rely on a single integrated approach.
Economic utility theory views the individual's
investment decision as a tradeoff between im- mediate consumption and deferred consumption.The individual investor weighs the benefits of consuming today against the benefits that may be gained by investing unconsumed funds in order to enjoy greater consumption at some point in the future. If the individual chooses to defer consump- tion, he will, according to theory, select the port- folio that maximizes long-term satisfaction.
The axioms of utility theory, developed by Von Neumann and Morgenstern, argue that inves- tors are (1) completely rational, (2) able to deal with complex choices, (3) risk-averse and (4) wealth-maximizing.' Utility theory further as- sumes that investors maximize expected utility- measured in terms of anticipated returns and vari- ances from these expectations (the mean/variance approach).2 That is, each investor selects the port- folio that maximizes expected return while mini- mizing risk.
Other theories of investor preference have made less stringent assumptions about how inves- tors make choices. Competing theories have ar- gued that investors (1) seek investments that max- imize geometric mean return, (2) concentrate on avoiding "bad" outcomes (safety-first models) or
(3) make investment decisions free of assumptions about utility functions or probabilities (stochastic dominance).
BACKGROUND
The literature on utility theory does not typically address individual investor decision processes.
Rather, it focuses on the development and refine- ment of "macro" models that explain aggregate market behavior. However, some empirical stud- ies of individual investor behavior have examined utility theory constructs focusing on individual rather than aggregate investor profiles. Baker and Haslem, for example, find that dividends, ex- pected returns and the firm's financial stability are critical considerations for individual investors.3 Baker, Hargrove and Haslem find that investors behave rationally, taking into account the invest- ment's risk/return tradeoff.4
A relatively new financial subdiscipline, be- havioral finance, has achieved impressive strides in explaining the behavioral aspects of investment decisions. Behavioral finance investigates choice under uncertainty. Three major elements frame behavioral finance-Prospect Theory, regret aver- sion and self-control.5 Each element captures be- havioral attributes of individual investors.
Empirical studies of the behavior of individual investors first appeared in the 1970s. The Wharton Survey, one of the more comprehensive studies of investor behavior, examines how demographic
Robert A. Nagy is Associate Professor of Finance at the University of Wisconsin-Green Bay. Robert W. Obenberger is Associate Professor of Marketing at the University of Wisconsin-Green Bay.
Financial Analysts Journal / July-August 1994 63
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variables influence the investment selection and portfolio composition process. Blume and Friend provide an excellent overview of the results and implications of the study.6 Cohn et al. provide tentative evidence that risk-aversion decreases as investor wealth increases.7 Riley and Chow find that risk-aversion decreases as age, wealth, income and education increase.8 LeBaron, Farrelly and Gula counter that individuals' risk-aversion is largely a function of visceral rather than rational considerations.9
Lewellen, Lease and Schlarbaum determine that age, sex, income and education affect investor preferences for capital gains, dividend yield and overall return.10 Barnewell finds that individual investor behavior can be predicted by lifestyle characteristics, risk-aversion, control orientation and occupation.11 Warren et al. predict individual investment choices (e.g., stocks, bonds, real es- tate) based upon lifestyle and demographic at- tributes. 12
This evidence might lead one to question the relative importance of various economic and be- havioral motivations. This article examines which factors have the greatest influence on the individ- ual 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 ques- tions. First, what relative importance do decision variables have for individual investors making stock purchase decisions? Second, are there homo- geneous groups of variables that form identifiable constructs that investors rely upon when making equity investment decisions?
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 impor- tance 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 divi- dends, perceived risk, diversification needs) and others addressing more contemporary concerns (firm's environmental record, perceived firm eth- ics, etc.). Respondents noted whether each vari- able was (1) a significant item used to make invest- ment decisions ("Act On"), (2) a secondary item
("Consider") or (3) an item ignored in the invest- ment decision process ("No Influence").
We ranked the variables according to how frequently they were placed in each response cat- egory and used factor analysis to examine how they interacted. Factor analysis takes large num- bers of variables (34 items in this case) and identi- fies similarities between them, making interpreta- tion of the results easier.
RESULTS
We focused first on determining the relative im- portance of the variables to individuals making investment decisions. Table 1 ranks the variables by the frequencies with which respondents consid- ered 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 wealth- maximization criterion or any other item was con- sidered significant by more than half the respon- dents. 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, envi- ronmental track record and the firm's ethical pos- ture are given only cursory consideration by expe- rienced stock investors, although some mutual funds specializing in such stocks have been suc- cessful in attracting investors.
Table 2 ranks the variables by the frequency with which respondents ignore them when mak- ing stock purchases. The results can be summa- rized as follows. First, the survey group was non- provincial in outlook; local operations are clearly not important to experienced stock investors. Sec- ond, most respondents are highly self-reliant and ignore inputs of family members and coworkers when choosing stocks. Surprisingly, the recom- mendations 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 clearly related to wealth-maximization (eco- nomic utility theory) and which are not directly related, some observations can be made. It is encouraging to note that investors rely mostly on decision criteria predicted by classic economic util-
64 Financial Analysts Journal / July-August 1994
Table 1. Frequency Distribution of Variables that Signifcandy Influence Investor Decisions
Rank Item Frequency Per Cent
1 Expected Corporate Earnings 62 46.6%
2 Diversification Needs 58 43.6
3 Feelings for Firm's Products and Services 54 40.6
4 Condition of Financial Statements 52 39.1
5 Firm Status in Industry 49 36.8
6 Reputation of Firm 48 36.1
7 Past Performance of Stock 46 34.6
8 Attractiveness of Non-Stock Investments 44 33.1
9 Minimizing Risk 43 32.3
10 Time Before Funds are Needed 39 29.3
11 Tax Consequences 39 29.3
12 Expected Stock Market Performance 38 28.6
13 Gut Feeling on Economy 36 27.1
14 Perceived Ethics of Firm 32 24.1
15 Expected Dividends 31 23.3
16 Competing Financial Needs 30 22.6
17 Past Performance of Investor's Stock Portfolio 26 19.5
18 Affordable Share Price 23 17.3
19 Data in Reports & Prospectuses 20 15.0
20 Current Economic Indicators 19 14.3
21 Use of Valuation Equations 19 14.3
22 Stock Broker Recommendation 19 14.3
23 Investment Advisory Service Recommendation 18 13.5
24 Institutional Holdings 15 11.3
25 Recent Price Movements of Firm's Stock 15 11.3
26 Coverage in Financial Press 15 11.3
27 Brokerage House Recommendation 13 9.8
28 Family Member Opinions 9 6.8
29 Coverage in General Press 8 6.0
30 Exchange Listing 7 5.3
31 Local Operations 6 4.5
32 Environmental Record 6 4.5
33 Friend or Coworker Recommendation 4 3.0
34 International Operations 3 2.3
ity theory. At the same time, however, it is appar- ent 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 vari- ables most important to investors form homoge- nous groups. As there did not 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 underly- ing constructs that represent a synthesis of inves- tor concerns.
We analyzed the 34 variables using the vari- max algorithm of orthogonal rotation, the most commonly used method.13 Evaluation of the re- sulting constructs is largely subjective. The reader is encouraged to bear with the authors' labeling efforts and to recognize that empirical factor for-
mation and identification is rarely definitive. Table 3 summarizes the results of the factor identification process.
Indivdual 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 ad- visory 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 fac- tors, 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 new data,
Financial Analysts Journal / July-August 1994 65
Table 2. Frency Distibuffon of Varibs tat Least Influence In or
Rank Item Frequency Per Cent
1 Local Operations 108 81.2%
2 International Operations 81 60.9
3 Family Member Opinions 81 60.9
4 Exchange Listing 80 60.2
5 Environmental Record 80 60.2
6 Friend or Coworker Recommendation 77 57.9
7 Affordable Share Price 66 49.6
8 Institutional Holdings 63 47.4
9 Coverage in General Press 60 45.1
10 Valuation Equations 52 39.1
11 Brokerage House Recommendation 51 38.3
12 Stock Broker Recommendation 48 36.1
13 Time Before Funds Will Be Needed 43 32.3
14 Perceived Ethics of Firm 41 30.8
15 Coverage in Financial Press 40 30.1
16 Competing Financial Needs 38 28.6
17 Data in Reports & Prospectuses 36 27.1
18 Expected Dividends 35 26.3
19 Recent Price Movements of Firm's Stock 35 26.3
20 Investment Advisory Service Recommendation 35 26.3
21 Expected Stock Market Performance 33 24.8
22 Tax Consequences 32 24.1
23 Attractiveness of Non-Stock Investments 30 22.6
24 Past Performance of Investor's Stock Portfolio 30 22.6
25 Gut Feeling on Economy 22 16.5
26 Current Economic Indicators 18 13.5
27 Minimizing Risk 16 12.0
28 Feelings for Firm's Products and Services 15 11.3
29 Past Performance of Firm's Stock 13 9.8
30 Diversification Needs 13 9.8
31 Condition of Financial Statements 9 6.8
32 Firm Status in Industry 8 6.0
33 Reputation of Firm 7 5.3
34 Expected Corporate Earnings 5 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 financial statements, data found in annual reports and pro- spectuses, the results of valuation techniques (e.g., P/E and market-to-book) and expected cor- porate 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 indi- vidual.
In that all but firm ethics rank highly as investment considerations, it might be concluded that many investors choose stocks based on qual- itative criteria. This presents a formidable chal- lenge 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, affordability of share price, tax consequences and risk-minimization. Each of these is a "textbook"
(i.e., classic wealth-maximization) investment cri- terion. Surprisingly, these variables received me- diocre ratings by investors, despite their domi- nance of the economic foundations of most theories of investor behavior.
"Social-relevance" factor: The firm's environ-
66 Financial Analysts Joumal / July-August 1994
Table 3. Factors Influencing the Equity Seletion Process of lndMdual In rs
Label Key Variables
Neutral Information Financial Press Coverage
General Press Coverage Recent Price Movements
Information from Investment Advisory Services Accounting Information Financial Statements
Annual Reports Prospectuses Valuation Techniques Expected Earnings Self-Image/Firm-Image Coincidence
Firm Reputation Firm Status
Feelings about Products/Services Perceived Ethics of Firm
Classic Expected Dividends
Share Price Affordability Tax Consequences Risk Minimization Social Relevance
Environmental Record Local Operations International Operations Advocate Recommendation
Recommendations from:
Brokerage House Individual Stock Broker Friends/Coworkers Personal Financial Needs Competing Financial 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 signifi- cant influence on the investment decision.
The "advocate-recommendation" factor: This factor includes purchase recommendations from broker- age houses and individual stock brokers. Recom- mendations from friends or coworkers marginally loaded on this factor as well. Each of these infor- mation sources could be construed as a recommen- dation from sources with vested interests in the investor's ultimate actions. Although many inves- tors obviously rely on professional expertise, most investors in the sample are apparently wary of these information channels.
The "personal-financial-needs" factor: The sev- enth and final factor is dominated by consider- ations 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 indepen- dent entities.
CONCLUSIONS
Our findings suggest that classical wealth-maximi- zation 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 recom- mendations 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 Analysts Joumal / July-August 1994 67
homogenous groups of variables that influence individual investor behavior. The investment de- cision process appears to incorporate a broader range of items than previously assumed. Further- more, 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 Neumann and 0. Morgenstem, 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 Ha- ven: Yale University Press, 1959).
3. H. K. Baker and J. A. Haslem, "Toward The Development Of Client-Specified Valuation Models," Journal of Finance 29 (1974), 1255-63.
4. H. K. Baker, M. B. Hargrove and J. A. Haslem, "An Empirical Analysis of the Risk-Return Preferences of Indi- vidual Investors," Journal of Financial and Quantitative Anal- ysis, September 1977.
5. There are many excellent primers in behavioral finance. For example, see M. Statman and D. Caldwell, "Applying Behavioral Finance to Capital Budgeting: Project Termina- tions," Financial Management, Winter 1987; D. Kahneman and A. Tversky, "Prospect Theory: An Analysis of Decision Under Risk," Econometrica, March 1979; and D. Kahneman and A. Tversky, "The Psychology of Preferences," Scientific American, January 1982.
6. 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 In- vestment Portfolio Composition," Journal of Finance, May 1975.
8. W. B. Riley and K. V. Chow, "Asset Allocation and Individual Risk Aversion," Financial Analysts Journal, No- vember/December 1992.
9. D. LeBaron, G. Farrelly and S. Gula. "Facilitating a Dia- logue on Risk: A Questionnaire Approach," Financial Ana- lysts Journal, November/December 1992.
10. W. G. Lewellen, R. C. Lease and G. C. Schlarbaum,
"Patterns Of Investment Strategy And Behavior Among Individual Investors," Journal of Business 50 (1977), 296-333.
11. M. M. Barnewell, "Psychographic Characteristics of the Individual Investor," in Asset Allocation for the Individual Investor (Homewood, Ill.: 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 Journal, March/April 1990.
13. Factor analysis is used extensively in financial modeling, marketing research and other disciplines that employ com- plex data bases. For an intriguing application, see N. F.
Chen, "Some Empirical Tests of the Theory of Arbitrage Pricing," Journal of Finance, December 1983.
68 Financial Analysts Journal / July-August 1994