European Journal of Social Sciences Volume 20, Number 2 (2011)

Behavioral Implications of Investors for Investments in the Stock Market

Iqbal Mahmood International Islamic University, Islamabad, Pakistan E-mail: iqbal.phdfin14@iiu.edu.pk Tel: +923219669885 Habib Ahmad International Islamic University, Islamabad, Pakistan E-mail:habib.msfin26@iiu.edu.pk Tel: +923335339752 Abdul Zahid Khan International Islamic University, Islamabad, Pakistan E-mail: forzkhan@yahoo.com Mansoor Anjum International Islamic University, Islamabad, Pakistan E-mail: mansooranjum2000@yahoo.com Abstract The behavioral finance has been recognized as an important area in the study of recent finance literature. Its implicit objective is to discover and remedy the deviations from the rational decision making in the investment process. The purpose of this study is to examine the role of various socioeconomic, demographic and attitudinal factors affecting the investment decision of investors in the market. A psychological based investment model has been developed which describes the impact of past investment experience of investors, variations in regulatory policies and asymmetric information, their marital status, gender, sensation seeking, on reinvestment intentions of investors and their return expectations through mediating role of risk propensity and risk perception.

Keywords: Risk perception; risk propensity; Sensation seeking; Behavioral finance

1. Introduction
Investors of the stock market are rational and they efficiently respond to new information regarding the stock market products. In other words, investors decisions in the market fully reflect the effects of any information revealed. There are no chances of abnormal returns in the market in the long run, even if the assets prices are not properly valued, they will come to reasonable price level through arbitrage (Fama, 1970). Various empirical investigations conducted during 1980 revealed that market is not efficient as explained by efficient market hypothesis (EMH) of traditional finance theories, because of certain anomalies of the market like small firm effect, January effect etc. etc. Thus traditional finance theories of neoclassical finance ignore the importance of investors behavior in the decision making. Due to this ignorance, the investors behavior is not covered within the frame work of traditional
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European Journal of Social Sciences Volume 20, Number 2 (2011) finance. Sometimes, the investors make irrational decisions and do not behave rationally because of their limitations of capacity to process the information (Simon, 1986). Study of Kahn man and Tversky (1982) explains that representative ness and anchoring heuristics are some times present in the decision making of an investors in an uncertain situation where the investors use their judgment in order to facilitate the process of dealing with vague and complicated information. The heuristics mentioned here may lead to some cognitive biases due to employing wrong judgment. They also proposed that prospect theory which is well known in the behavioral studies due to discussion of psychological attitude of investors should be used to understand the psyche based investors behaviors. The prospect theory replaced the traditionally used theory of utility maximization. The prospect theory holds that attitude of investors is not consistent when dealing with prospects of gain or loss, but will be opposite in these prospects. This inconsistency in the behavior of investors is against the hypothesis of neoclassical finance which states that Investors attitude is consistent in profit or loss prospects. This prospect theory ultimately became the cause of rendering Nobel Prize to them in 2002. To study the financial markets, the researchers have adopted the use of behavior approach in order to overcome the lacking of traditional neoclassical finance approach. The basic difference between prospect theory and traditional finance theory is that investors who prospect profits or gains tend to become risk averse in order to stabilize their gains but become risk takers in the prospects of loss, whereas according to traditional theory of finance investors are all the time risk averse. There are many investment products which are available for investment to investors in the stock market ranging from bonds to options. These products vary with regard to risk factor involved and the return. Investors choose the investment products which have matching to their risk tolerance. Moreover, investor make up their mind regarding risk factor involved in any investment based on the financial information they receive from different Channels/ Sources. Moreover, knowledge of investors regarding financial market and their past experience contribute a lot towards the risk assessment in various products .Investors who have experienced loss in the past formulate new investment decision having kept in mind their past experience. These factor along with some other factors constitute the risk aversion and risk perception of the investors. After formulating risk attitudes the investors formulate their potential returns from that investment. Low return products are accepted if the risk attached with them is low and high risk products are selected if risk premium associate with risk level is offered to investors. Investors will invest in those products which offer the return suitable with the risk level of those products. The aim of behavioral finance is to analyses the phenomena of market keeping in view the psychological factors involved in the behavior of investors. There have been few studies on the subject in the past. This paper aims at formulating a psychological base model for knowing the mechanism of behavior of investors in the stock market. Study of this model will help in understanding the investors expectations about the return through risk perception. The remaining paper has been organized as follows: Section 2 explains the theoretical back ground of the study. Section 3 presents the research methodology and proposed model. Section 4 discusses the practical implications of the study and section 5 explains the future research directions.

2. Research Theory and Design

New information becomes the cause of fluctuations in stock market prices. So, change in decisions of investors take place on the basis of their expectations regarding flooding of new information, Warneryd (2001). It means that spread of different types of information in the stock market act as externally penetrated stimulus for the investors of stock market due to its power to effect the decisions of investors. Information regarding effects of regulatory policies on companies listed on exchange, effects of monetary policy on interest rates and rules about listed companies in the country have an impact on the decision of investors to invest in the stock market. Keeping in view the important of these factors, we have included one of the independent variables in this study in the name of changes in
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European Journal of Social Sciences Volume 20, Number 2 (2011) regulatory policies. Further, due to lacking in the regulations about proper disclosure of information, all information is not available to all investors. Some have more information than others. This asymmetric information becomes the cause of irrational decisions while investing in the stock market. The significant power of this factor induces to include it as another independent variable in this study. In order to determine the risk behavior of investors, a model was developed by Skitin and Pablo in 1992. They postulated that past experiences of the investors and risk tolerance are important risk factors for framing the problem. Their model also indicates that perception of the individuals is also effected by the social influence. If investors are having more experience of investing, their level of risk tolerance will be high and less experience investors will possess low risk tolerance level. Investors constitute their investment portfolio based on their risk tolerance level. High risk tolerant investors will constitute a portfolio of relatively high risk and low risk tolerant investors will constitute low risk securities portfolio (Cortor and Chen, 2006). Risk propensity and risk perception of the investor are influenced by their past experience. Kathleen Byrne (2005) indicates that investors risk tolerance increases if they have successful past experience and decrease in case of having unsuccessful experience of past. It means that positive correlation exists between investment experience and level of risk tolerance. Future investment behavior of the investor is affected by their past behavior. It is contrary to prospect theory because this theory does not cover the aspect of past investment experience effects on future behavior of investment. Risk perception is defined as assessment of risk in an uncertain investment environment. Skitin & Pablo (1992). Investors invest in an uncertain environment by developing certain inferences about the results of their investment by drawing certain conclusions from those inferences. Risk propensity is the tendency of investors to tolerate the risk involved in investing. So, there is relationship between propensity to risk and risk perception. Gender is an other important variable having its behavioral implications which affects the attitude of investors in the stock market. It is evident from the studies that female adopt more conservative behavior and risk averse style while investing in the stock market as compared to the male investors. (Fellner and Maciejovsk 2007).An other study of Ronay and Kim (2006) states that attitude towards risk by two genders is the same on the individual level, but at group level male groups are found to be more risk takers as compared to female groups. Sensation seeking behavior of individuals in the general life is also evident while investing in the stock market. Risk taking and risk averse attitude are characterized by the general traits of personality of individuals. (Eysenck and Eysenck , 1978). Zukerman (1983, 1984) states that sensation seeking is part of the general personality traits of individuals. He further claimed that this attitude also prevails in the financial decision making. Sensation seeking has been defined as consent to accept various types of risk for the sake of making new and complex experiences. Some other studies as by Morse (1998) have shown no evidence of relationship between sensation seeking and risk preferences of investors. Wong and Carducci (1991) have also described that higher risk tolerance tendency of the individuals also prevailed in the financial decisions of those individuals. Marital status of investors also plays an important role in determining the risk perception of investors in the market. It has been proved by several studies that married investor have less risk perception due to being more experienced as compared to unmarried investor. It was further proved that among married individuals, those who are relatively old time married have more risk tolerance due to having more disposable income which can be invested Chou and Huang (2010). Grable (2000) has also found that risk tolerance of married investors on average is higher than unmarried investors. Although, few studies have been conducted in this area previously, we have made an effort to develop a more comprehensive psychological based model which includes the various factors affecting the expectations of investors about return and intentions to reinvest through mediating role of risk propensity and risk perception. Investors make investment decisions on basis of their expectations that investment will become at lower level of risk and will ultimately provide high level of returns. It signifies the role of risk perception as an mediating variable in the investment decision making process. (Bodie, Kane and Marcus 2001). Risk Perception is the intuitive judgment of an investor regarding
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European Journal of Social Sciences Volume 20, Number 2 (2011) uncertainty involved in an investment decision. This judgment may or may not actually prove because of many factors (Douglas and Wildavstry, 1982).

3. Proposed Model
In this paper reinvestment intention and return expectation of investors have been taken as dependent variables due to their importance in stabilizing the stock market. While investment experience, variations in regulatory policies (i.e., about stock markets, interest rates and listed companies) information asymmetry, marital status of investors, their gender and sensational attitude are taken as independent variables. Risk perception and risk propensity due to their mediating role in investment process have been taken as mediating variables. Effects of independent variables on dependent variables will be checked through mediating effect of mediators. The objective of this paper is to present an expanded model which explains the risk perception features of different explanatory variables and their effect on reinvestment intentions and return expectations of investors. Past experience of investors results in anchoring value which becomes the case of optimistic investment behavior due to over confidence of investors. If investors have past experience about the behavior of stock market, their risk tolerance will be high and they will be willing to invest in high risk oriented securities. Whereas, the investors with low or no past experience of investment will be reluctant to invest in high risk securities. In other words, investors having past investment experience have tendency to tolerate high risk as compared to the investors having no previous investment experience. Therefore, the hypothesis to be tested is that: H1: Past investment experience and risk propensity are positively correlated. i.e, Investors having past experience have higher level of risk propensity and investors having little or no past experience have low risk propensity. Investors who have tendency to accept more risky projects are having high level of risk tolerance. They involve in risky investments for the sake of earning higher returns. Their risk perception is low. While the investors possessing tendency of low risky investment are actually having low risk tolerance and high risk perception. The other hypothesis to be tested is that: H2: Risk perception of the investors and their risk propensity are negatively correlated. Spontaneous changes in regulatory policies by the concerned authorities regarding stock market, listed companies and interest rates also affects the risk perception of investors. If there are more changes or variations in the policies, it will result in increased risk perception and if they are less chances of variations in the policies relating to the above risk sources, it will tend to decrease in risk perception of investors. Third hypothesis will be that: H3: Variations in policies relating to risk sources i.e., stock markets, interest rates and listed companies) and risk perception are positively correlated. If information about stock market and listed companies is at symmetric level, it means that all the investors have same level of information which plays an important role in investment-decision making process of the investors. If, there is asymmetric information i.e., some information is available to few investors but not to others, it will affect the risk orientation of investors and the following hypothesis has been developed for testing in this perspective: H4: Information asymmetry and risk perception of investors are positively correlated. Marital status of investors also becomes the base for determining the investors risk tolerance. Married investors have belief of having more knowledge about financial and investment market. They have high level of risk tolerance as compared to unmarried investors. Their propensity to risk is also high due to being having more disposable income in case of senior married investors as indicated by various studies. So, the hypothesis is that: H5: Married investors have low risk perception; unmarried investors have high risk perception.

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European Journal of Social Sciences Volume 20, Number 2 (2011) Investors with an attitude to take more risk have tendency to accept high risk investment opportunities because of the general trait of their personality as compared to other investors who are risk averse by their nature. The hypothesis to be tested regarding it is: H6: Sensation seeking attitude is negatively correlated with risk perception. Risk tolerance level of male and female investors is also different. Male investors are more risk tolerant than female investors who are risk averse. The following hypothesis is designed in this paper for testing: H7: Risk perception of male investors is less; risk perception of female investors is high. If risk perception of investors in the stock market is high, they will expect high returns and will not be willing to reinvest. Whereas, if risk perception is low, the return expectations of the investors will be low and they will be having intention to reinvest in the market. Therefore hypothesis to be tested is that: H8: Risk perception is positively correlated with return expectations; negatively correlated with reinvestment intentions. All these hypotheses are reflected in psychological based investment model presented below in figure 1.
Figure 1: Psychological Based Investment Decision Model

Past Investment Experience

Risk Propensity

Variations in Regulatory policies

Reinvestment Intention

Risk Perception Information Asymmetry Return Expectation

Sensational Attitude

Marital Status

Gender

4. Discussion and Policy Implications

The goal of this paper is to develop an investment decision model based on various psychological factors influencing the expectations of investors regarding return and reinvestment intentions. It is evident from the psychological based investment mechanism model that risk perception performs a key role in the investment decision process. An interview of semi-structured nature can be framed based on the conceptual framework hypothesized in this paper and then a questionnaire should be developed keeping in view the behavioral aspects of the investors and findings obtained from the semi structured
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European Journal of Social Sciences Volume 20, Number 2 (2011) interview. As Grable (2000) suggested in his study that investment knowledge becomes the cause of increase in risk tolerance of investors. Moreover, it is a complicated process. Its understanding is not very much simple and cannot be understood based on the socio economic factors only. Corter and Chen (2006) explained that risk tolerance of investors in the investment market is a situation specific trait which varies among individuals and it can not be generalized. Variations in the government policies related to various sources of risk can impact the risk perception of investors in the market. Investors give more importance to policies relating to the risk sources instead of intrinsic value of the shares in the market. This phenomenon is described by Wang (2003) as Policy Market. It is recommended that stable policies should be developed which should continue with consistency. Our model hypothesizes the relationship between asymmetric level of information and risk perception of investors. Therefore, we recommend that regulations should be made to force the listed companies to release all the financial and non financial information timely in a transparent way for all the users so as to reduce the risk level of the investors. The model explains that investment experience of the investors and their risk propensity are also correlated. We recommend that in order to develop and improve the investment skill of investors regarding securities risk management, necessary education should be provided to the investors by some government/non government agencies. In order to help out the investors to escape from permanent loss of capital, Daniel et al, (2002) have also recommended that conventions of transparently reporting of all relevant information, improved rules for better disclosure and increased investment knowledge should be adopted. Training of investors regarding the basic knowledge of investment like asymmetric information, diversification, investors biases, risk in the investment environment should be required for an investor while entering in the investment market for the first time (Forbes and Kara 2010). Thaler and Sunstein (2003) have also emphasized the importance of investment training required for the investors so that choice freedom of individuals may not be impeded.

5. Concluding Remarks
In order to understand irrational behaviors of investors in the investment market, we have conceptualized and then developed a risk perception centered model in this study. Different socio economic and attitudinal variables have been incorporated in the model. Impact of these variables on the dependent variables of reinvestment intentions and return expectations can be tested. It has been recommended in the study that there should be stability and consistency in policies relating to various risk sources, transparent and timely spread of information about listed companies for all the investors at the symmetric level and development of mechanism for the training of new investors. Researchers are encouraged to test the hypothesis of the study. The investment professionals should take these factors into account while designing portfolio of their clients. This study is restricted to the development of model only and has limitation of empirical testing which can be done in future. The study can be further expanded in the future by using various socioeconomic, demographic and attitudinal factors not discussed in this study.

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