A conceptual model of individual investors behavior in decision making process by abdul lathif
A Conceptual Model of Individual Investors Behavior in Decision Making
S. ABDUL LATHIF, Assistant Professor, Dept. of Business Administration, Jamal
Mohamed College, Trichy – 620 020.
The decision making process is a cognitive process which results in the selection of a
course of action among several alternatives. Every decision-making process produces a final
choice. The output can be an action or an opinion of choice. Investment decisions made today
often are critical for financial security in later life, due to the potential for large financial loss and
the high costs of revising or recovering from a wrongful investment decision. Most of the
investors do not have the sufficient knowledge of basic economic concepts required to make
investment decisions. This conceptual model can be used to build stylized representations of
Indian (classes of) individual investors, and further studied using the paradigm of agent-based
artificial financial markets. By allowing us to implement individual investor behavior, to choose
various market mechanisms, and to analyze the obtained asset prices, agent-based models can
bridge the gap between the micro level of individual investor behavior and the macro level of
aggregate market phenomena.
Keywords: Individual Investor Behaviour, Decision Making, Cognitive Model,
Behavioural Finance, Investments.
The decision making process is a cognitive process which results in the selection of a
course of action among several alternatives. In this process, the emphasis is on thinking things
through and also on weighing the outcomes and alternatives before arriving at a final decision.
Every decision-making process produces a final choice. The output can be an action or an opinion
of choice. This paper presents a conceptual model of the individual investor. By taking a
descriptive point of view, we focus our attention on how investors make their investment
decisions in a real world setting, as opposed to rational/optimal behavior proposed by normative
financial theories. This conceptual model incorporates results of the research on investment
decisions from fields of behavioral finance and cognitive psychology. It is based on a review of
existing studies, which themselves were conducted using various research methods. It particularly
draws on the heuristics and biases strand of behavioral finance literature, as well as the dual-
process theories of human cognition. In the rapidly growing field of behavioral finance it becomes
more difficult to devise a unifying taxonomy of all the behavioral phenomena, as they arise from
various mechanisms, manifest on different levels of behavior and cognition, and have been
discovered using various methodologies. However, a conceptual model that presents some of the
most important findings from the existing research on investor behavior, and provides a
parsimonious description of how individual investors make their investment/trading decisions is
relevant from a theoretical point of view. The main motivation for building this conceptual model
is that on the basis of this conceptual model a computational model of the individual investor (or
stylized classes of various market participants) can be implemented.
For a long time, it was believed that the decisions of an individual investor were based on
the modern portfolio theory and the efficient market hypothesis. However, it has proved that most
individual investors do not pick their stocks and portfolio based solely on the three criteria of
modern portfolio theory. In fact the individual investor’s portfolio practices, investor investing
process, buying decision process, behavioural biases, pattern of investment, their awareness level,
factors affecting their investment behavior and the problems faced by them need to be analyzed in
order to understand the individual investor behavior.
Individual investor behaviour in the stock market is factored by their income, education,
reading habits, cognition levels, etc. Investor perception differs with respect to alternative
investment avenues, assets and market segments in the securities market. The investment motives
also vary through capital gains, dividends, bonus, rights, tax benefits and other relevant factors.
Economists have developed behavioural models to explain the decision-making process of
individuals. The interdependence of the inherent risk and uncertainty about any course of action
are provided by the theory of games. Game theorists call the stock market a ‘Positive sum game'.
But the money game of the stock market may not yield uniform returns to all its participants.
There are various investment avenues. When one investment opportunity is chosen, other
opportunities may be given up. So, opportunity cost of an investment is the possible income from
the next best alternative. Rational decision-making demands technical knowledge and practical
experience. Investor behaviour approaches investing as a rational decision - making process in
which the investor attempts to select a portfolio of securities. Rational investors form rational
expectations about asset returns, motivated by the maximizing principle. They collect available
and relevant information for making decisions. Some investors make decisions on inadequate
information and such decisions may go wrong.
Investor Investing Process:
Every investor should have a process. This applies whether or not they are value investors. An
investment process helps keep investors focussed and on track, and prevents the investor from going
off the rails emotionally when making investment decisions. Emotional investment decisions are bad
for returns and can really ruin a portfolio as you will more often than not find yourself buying and
selling stocks at the worst possible time – buying when the price is high and selling when the price is
low rather than vice versa. With a clear investment process that you consult at every buy/sell decision,
you go through each step and tick the boxes methodically rather than making emotional knee-jerk
buy/sell decisions as a result of news or outside influences – “For indeed, the investor’s
chief problem – and even his worst enemy – is likely to be himself.”
There are two types of investing process – top down and bottom up. A top down approach to
investing looks at broad market conditions, interest rates and other macroeconomic data in order to
decide which sector or sectors may benefit. Then a stock or several stocks may be picked from those
sectors. Bottom up investing is favored by value investors. Macroeconomic data and general market
conditions are ignored. The focus is solely on stock selection based on the attributes and value of a
company from balance sheet information, with little or no regard to the normal business cycle of the
market or sector.
A typical value investing process would take the following format:
1. Establish minimum criteria for stock picks,
2. Generate Investment Ideas From Stock Screen,
3. Perform Detailed Financial Analysis,
4. Evaluate The Business And Its Potential,
5. Construct Portfolio.
Investment ideas are taken from stock screeners where the screen criteria match your process’s
minimum criteria for stock picks. Once you have generated some ideas by running the screen, select a
few that you want to investigate – not necessarily those that appear at the top of the screen or are a
“best match” – rather, select several stocks from different. A detailed financial analysis of each stock
is a must; this is part of what is called “due diligence”. You must go through each company’s balance
sheet with a fine-tooth comb and make sure the numbers all add up, and there are no financial
shenanigans. Evaluate cash flow, return on equity, earnings growth, earnings stability, revenue growth,
return on invested capital, etc. Evaluate the business. Is the company in a niche market. How big is
their moat? Is there demand for their products? Is this demand affected by current market conditions
on a long or short-term basis? Call the company if you can for more information – be sure to ask if
they are aggressively hiring; sometimes this can mean there is pent-up demand. Whittle down the
number of picks based on your answers to the above; and construct your portfolio. Don’t be
discouraged if you whittle down to a single stock. Repeat the process in a month, two months, three
months, etc., and build your portfolio over time.
Investor Buying Decision Process
Investing in shares is like investing into ownership of a company, which no other
investment instrument can give. Unlike any other investment instrument that either gives fixed
income or meager returns and no ownership in the same, investment gives an opportunity to
become a part of the company ownership and also gives regular returns on investment as dividend
income or through appreciation in share price. Investment allows investor to enjoy the flexibility
of staying invested as long as he/she wish to, take advantage of the price movements and thus
utilize the liquidity. The figure 1 shows the steps or the process of individual investors’ decision-
making process of investment.
Insert Figure 1 here
Step 1: Investible Surplus: Generally, an individual earns more than he/she can spend. The
amount of money an individual is able or willing to keep aside for investments is referred as
surplus investible. The investible surplus plays a vital role in selecting from various asset classes
as the minimum investment amounts differ and so do the risks and returns.
Step 2: Sources of Investment Information search: At this stage, investor wants to find out the
information about the financial products, return, risk involved and tax-benefit. Investor collects
the information from different sources like Personal sources such as Family, friends, co-workers,
and Public sources such as mass media and credit rating agencies.
Step 3: Evaluation of stocks: After collecting the information, investors arrive at some
conclusion about which companies stock can be purchased. At this stage, investor compares
different stocks on set parameters, which he/she thinks required. The evaluation process varies
from investor to investor.
Step 4: Choosing a Stock: After evaluating the stock based on various factors the investor
chooses the one.
Step 5: Purchasing a Stock: At this stage investor purchases the most preferred stock.
Behavioural Biases on Investment Decisions:
The major behavioural biases that can work against us having a positive investment
• Overconfidence – most people think they are smarter than others, meaning their portfolio
will undoubtedly perform better than most.
• Hindsight bias – rises and falls in markets appear obvious after the fact, therefore many
think the future must also be predictable.
• Familiarity bias – only investing in securities we ‘understand’ or ‘know’ can breed a false
sense of control over our investments and lead to highly concentrated portfolios.
Unfortunately, the market doesn’t reward investors for familiarity.
• Regret Avoidance – not allowing ourselves to make the same mistake again. If we lost
money in bank stocks in late 2008, we may decide never to buy bank stocks again.
• Self-attribution bias – we give ourselves credit for being smart when successful, but
attribute failures to externalities beyond our control.
• Extrapolation – we rely too heavily on recent facts to make decisions on our future, or
only pay attention to data that supports our bias and ignore data that refutes it. So when
markets fall, we think markets will continue to fall and therefore avoid entering markets,
even though the expected rate of return of stocks has increased. So many investors do the
opposite of what they should do.
Factors Affecting their Investor Behaviour:
Stock Market participants have for a long time relied on the notion of efficient markets
and rational investor behaviour when making financial decisions. However, the idea of fully
rational investors who always maximize their utility and demonstrate perfect self-control is
becoming inadequate. During the recent years, examples of market inefficiency in the form of
anomalies and irrational investor behaviour have been observed more frequently. By
understanding the human behaviour and psychological mechanism involved in financial
decision-making, standard finance models may be improved to better reflect and explain the
reality in today's evolving markets.
Ten Things to Consider Before You Make Investing Decisions:
1. Draw a personal financial roadmap.
Before make any investing decision, sit down and take an honest look at your entire
financial situation -- especially if you’ve never made a financial plan before. The first step to
successful investing is figuring out your goals and risk tolerance – either on your own or with the
help of a financial professional. There is no guarantee that you’ll make money from your
investments. But if you get the facts about saving and investing and follow through with an
intelligent plan, you should be able to gain financial security over the years and enjoy the benefits
of managing your money.
2. Evaluate your comfort zone in taking on risk.
All investments involve some degree of risk. If you intend to purchase securities - such as
stocks, bonds, or mutual funds - it's important that you understand before you invest that you
could lose some or all of your money. The reward for taking on risk is the potential for a greater
3. Consider an appropriate mix of investments.
By including asset categories with investment returns that move up and down under
different market conditions within a portfolio, an investor can help protect against significant
losses. Historically, the returns of the three major asset categories – stocks, bonds, and cash –
have not moved up and down at the same time. Market conditions that cause one asset category
to do well often cause another asset category to have average or poor returns. By investing in
more than one asset category, you'll reduce the risk that you'll lose money and your portfolio's
overall investment returns will have a smoother ride.
4. Be careful if investing heavily in shares of employer’s stock or any individual stock.
One of the most important ways to lessen the risks of investing is to diversify your
investments. Its common sense: don't put all your eggs in one basket. By picking the right group
of investments within an asset category, you may be able to limit your losses and reduce the
fluctuations of investment returns without sacrificing too much potential gain.
5. Create and maintain an emergency fund.
Most smart investors put enough money in a savings product to cover an emergency, like
sudden unemployment. Some make sure they have up to six months of their income in savings so
that they know it will absolutely be there for them when they need it.
6. Pay off high interest credit card debt.
There is no investment strategy anywhere that pays off as well as, or with less risk than,
merely paying off all high interest debt you may have. If you owe money on high interest credit
cards, the wisest thing you can do under any market conditions is to pay off the balance in full as
quickly as possible.
7. Consider dollar cost averaging.
Through the investment strategy known as “dollar cost averaging,” you can protect
yourself from the risk of investing all of your money at the wrong time by following a consistent
pattern of adding new money to your investment over a long period of time. By making regular
investments with the same amount of money each time, you will buy more of an investment when
its price is low and less of the investment when its price is high. Individuals that typically make a
lump-sum contribution to an individual retirement account either at the end of the calendar year or
in early April may want to consider “dollar cost averaging” as an investment strategy, especially
in a volatile market.
8. Take advantage of “free money” from employer.
In many employer-sponsored retirement plans, the employer will match some or all of
your contributions. If your employer offers a retirement plan and you do not contribute enough to
get your employer’s maximum match, you are passing up “free money” for your retirement
9. Consider rebalancing portfolio occasionally.
Rebalancing is bringing your portfolio back to your original asset allocation mix. By
rebalancing, you'll ensure that your portfolio does not overemphasize one or more asset
categories, and you'll return your portfolio to a comfortable level of risk.
10. Avoid circumstances that can lead to fraud.
Scam artists read the headlines, too. Often, they’ll use a highly publicized news item to
lure potential investors and make their “opportunity” sound more legitimate. It best recommends
that you ask questions and check out the answers with an unbiased source before you invest.
Always take your time and talk to trusted friends and family members before investing.
Investment decision process is considered critical decision for every individual investor,
especially when investing in portfolio as it involves high risk and the returns are not certain. The
individual’s decision to invest in the portfolio is greatly influenced by the variety of benefits each
individual wants from owning a particular stock. This paper has examined published theoretical
framework for individual investor behavior in decision making process. The Investor buying
process, pattern of investment, awareness level, factors affecting their individual investment
behavior, understand the ten things of investments have been studied in order to individual
investor behavior. It is suggested that understanding the behavior of individual investors could be
of great help to explain the stock market anomalies and to help the policy makers, the investment
agencies, the researchers as well as managers of firms to prepare themselves to respond to the
varying moods of an investor.
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