A conceptual model of individual investors behavior in decision making process by abdul lathif

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A conceptual model of individual investors behavior in decision making process by abdul lathif

  1. 1. A Conceptual Model of Individual Investors Behavior in Decision Making Process S. ABDUL LATHIF, Assistant Professor, Dept. of Business Administration, Jamal Mohamed College, Trichy – 620 020. Abstract 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. Introduction 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
  2. 2. 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. Conceptual Framework: 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. Investor Behaviour 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
  3. 3. 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.
  4. 4. 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.
  5. 5. 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 experience are: • 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:
  6. 6. 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 investment return. 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.
  7. 7. 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 savings.
  8. 8. 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. Conclusion: 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. References: 1. Kannadhasan K 2008, (Faculty, BIM, Trichy) “Role of behavioural finance in investment decisions” "behavioural finance". 2. Khan, M.Y. Indian Financial System: Theory and Practice- Vikas Publishing House Pvt. Ltd., New Delhi-1980. 3. John Ameriks, Tanja Wranik, Peter Salovey (2009), “Emotional Intelligence and Investor Behavior”. 4. Jay R. Ritter “Behavioral Finance” - the Pacific-Basin Finance Journal Vol. 11, No. (September 2003) pp. 429-437. 5. Alleyene and Broome, An exploratory study of factors influencing investment decisions of potential investors, Central Bank of Barbados Working Paper, 2010.
  9. 9. 6. Doskeland, T., and H. Hvide (2011), “Do Individual Investors Have AsymmetricInformation Based on Work Experience?c Journal of Finance, 66:1011-1041. 7. 7. N. C. Barberis and R. H. Thaler. A survey of behavioral ¯nance. In G. M. Constantinides. M. Harris, and R. M. Stulz, editors, Handbook of the Economics of Finance, volume 1, pages 1.1053 - 1128. Elsevier, 1 edition, 2003.

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