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INDIVIDUAL INVESTORS BEHAVIOR TOWARDS FINANCIAL DECISIONMAKING: A CONCEPTUAL MODEL

Heena Kothari*

Abstract

Investor’s rationality is determined by several demographic, economic, and cognitive factors. Inbehavioral finance, the information structure and the characteristics of market participantssystematically influence individuals’ investment decisions as well as market outcomes.

Investment of hard earned money is made by investors for financial security in future on suchinvestments. But before taking any investment decision and choosing any financial avenue, theyfollow a process of cognitive decision making which guides them towards selection of avenue.Investors sometimes are not having knowledge about different avenues available and thus faceproblems to make a good investment decision. This conceptual model can be used to buildrepresentations of individual investors. This model can bridge the gap between the micro level ofindividual investor behavior and the macro level of aggregate market phenomena. This paperwill present the concepts that help illustrate the investment decision making process and theinvestment behavior of individuals.

Keywords: Behavioural Finance, Investments, Investor Behaviour, Cognitive DecisionMaking

Introduction

Investment is giving your money to a company or enterprise, hoping that it will be successful and payyou back with even more money. Individuals that has surplus of cash are looking after an investmentopportunity that satisfy the highest return during the investment period with reasonable associated riskon the expected return after maturity. The decision making process is a cognitive process which resultsin the selection of a course of action among several alternatives. In this process, the emphasis is onthinking things and weighing the outcomes and alternatives before arriving at a final decision. Everydecision-making process produces a final choice. The output is an action or a choice. This paperpresents a proposed 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.

Heena Kothari* Asst. Professor*, Altius Institute of Universal Studies, Indore

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Altius Shodh Journal of Management & Commerce

Environmental variables which have effect on individual decision making are ambiguity, clarity of theinformative stimulus and reliability of the source of information. The individual cognitive profile is depictedby the cognitive style, ambiguity tolerance, etc... “Behavioral finance, as a part of behavioraleconomics, is that branch of finance that, with the help of theories from other behavioralsciences, particularly psychology and sociology, tries to discover and explain phenomenainconsistent with the paradigm of the expected utility of wealth and narrowly defined rationalbehavior. Behavioral economics is mostly experimental, using research methods that arerarely applied in the traditional mainstream finance literature” (Frankfurter and McGoun,2000)

Information that is knowledge of financial options plays an essential role in the decision making. Investorshave a perception regarding the uncertainties involved in any investment based on the information theyreceive from different sources (Mahmood et al., 2011). In the same vein, Statman (1999) denies thatbehavioral finance introduced psychology into finance, since psychology was never out of finance. Onthe same grounds, Oberlechner and Hocking (2004) states that empirical research based on psychologicalaspects contributes to a better understanding of actual information in markets by considering marketparticipants attitudes and exploring the role of the sources of information and their influence on investors’behaviour.

Barber and Odean (2002) states that the buying decisions may be a result of an attention effect. Whenmaking a decision of stock purchase, people may not find a good stock to buy after consideringsystematically the thousands of listed securities. They normally buy a stock having caught their interestand maybe the greatest source for attention is from the tremendous past performance, even good orbad.

Conceptual Framework:

It was believed that the decisions of an individual investor were based on the modern portfolio theoryand the efficient market hypothesis. But many individual investors do not pick their portfolio basedsolely on the criteria of modern portfolio theory. In fact the individual investor’s investing process andhis buying decision process along with behavioral biases, pattern of investment, their awareness level;factors affecting their investment behavior and the problems faced by them need to be analyzed in orderto understand the individual investor behavior.

Practical experience and technical knowledge is required for rational decision making. Investor behaviourapproaches investing as a rational decision - making process in which the investor attempts to select aportfolio of securities. Maximizing principle becomes the motivation for rational investors. They collectavailable and relevant information for making decisions and sometimes they make decisions on inadequateinformation which may go wrong.

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Investor Investing Process:

Every investor should have a process. An investment process helps keep investors focused and ontrack, and prevents them on making wrong investment decisions. Emotional investment decisions arebad for returns and can really ruin a portfolio. The investor can either look at broad market conditions,interest rates and other macroeconomic data in order to decide where to invest or ignore such facts andfocus solely on attributes and value of a company from balance sheet information with no regard tomarket business cycle.

A typical value investing process should make a Financial Plan which includes theanswering of these questions:

1. What are the things you want to save and invest for? That is home, car, marriage, etc.2. Know your current financial situation? That is you’ll be creating a “net worth statement.” On one

side of the page, list what you own. These are your “assets.” And on the other side list what youowe other people, your “liabilities” or debts.

3. Know your income and expenses? The next step is to keep track of your income and yourexpenses for every month. Write down what you and others in your family earn, and then yourmonthly expenses.

4. Pay yourself or your family first? Include a category for savings and investing. What are youpaying yourself every month?

5. Finding money to save or invest? If you are spending all your income, and never have money tosave or invest, you’ll need to look for ways to cut back on your expenses. When you watchwhere you spend your money, you will be surprised how small everyday expenses that you cando without add up over a year.

Investor Behaviour

Investor’s behaviour is made by many influences either in the form of information gathered or certaininfluencing factors which affect their decision making. Investor perception differs with respect to alternativeinvestment avenues, assets and market segments in the market. The investment motives also can bevaried.

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Factors affecting the investment decision:

1. Amount of investment (wealth) The total resources owned by the investor. The increase in wealth raises the quantity demand on an asset.

2. Expected return from the investment The expected return from the investment over the next period. An increase in an asset’s expected return relative to that of an alternative asset raises

the quantity demanded for that asset.

3. Investment risk Investment risk occurs when the expected investment return is not realized. It is common that the higher the risk associated with the investment the higher the return

that can be realized and this occur in the stock market where there is unlimited level ofprofit and on the other side there is a possibility of losing the invested money in case ofmajor down of the exchange during financial crisis like the one that started last year whichled to a decline of CASE 30 index by more than 50%, this serious situation led to hugecapital losses to the investors.

Risk adverse investor will go after the investment with lower risk investment like treasurybills.

Money market instruments have the no risk since the banks bears all the risk of theinvestment.

A diversified portfolio of assets can eliminate the non-systematic risk and minimize thesystematic risk of the total investment portfolio.

Holding everything constant, if an asset’s risk rises relative to that of alternative assets, itsquantity demanded will fall.

4. Liquidity The ease and speed with which the asset can be turned into cash. The more liquid an asset is relative to alternative assets, holding everything else constant,

the more desirable it is, and the greater will be the quantity demanded.5. Time Value of Money (TVM)

This concept refers to the fact that a pound in hand today is worth more than a poundpromised at some time in the future, it can be used also to compare investment alternatives.This concept compares the future return of an investment to the present cost paid today inthat investment. The investor is willing to pay if the present value of the investment is lessthan its future value.

This concept is the most important concept used by financial managers and investors toassess the investment opportunity.

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On the basis of the above concepts an investor can select an investment instrument from the availableinvestment markets as follows:

I. Safe Investment options available are: Fixed Deposit

Fixed deposit in banks form a major vote in terms of the safest investment in India. Themost important reason for this is its ability to provide reasonable returns & the moneyinvested is locked in safely. You can always be assured of the returns. The time period foran FD may range from 15 days to more than five years.

Insurance Policy InvestmentAfter fixed deposits in banks, another popular choice of people in the list of the bestinvestment options in India for 2014 is Insurance Policy Investment. An excellent featureabout this option is that you can get profits which are risk free. Insurance policies rangefrom a variety of types & provide different types of coverage. Insurance policieslike LIC, Home insurance, car insurance & Health insurance are few examples of suchtype of investment options.

Public Provident Funds has High ReturnsPublic Provident Fund (PPF) is also a good option to invest money securely for futureperiods. The primary reason is the high rate of returns mainly for people who are under30% tax brackets. The rate of interest returns on PPF can be as good as 9%. However,the time span of investment can be as high as 15 years. However, with almost no riskoptions & good returns makes this a pretty feasible option to choose.

National Saving Certificate (NSC) is a Widely Common OptionNational Saving Certificate (NSC) is another favorite investment options of people inIndia. This investment option comes with six year time span & with the ease of Governmentsubsidies. Hence, all these characteristics make this option secured in every sense. A personcan begin with as small as Rs.100/-. The rate of interest is 8% which is calculated twotimes in one year. You can benefit from tax deductions till up to Rs. 1- lakh on NSCreturns. Now you can learn about another good investment options and those are mutualfunds.

II. Money mark

This market has instruments with short terms to maturity less than 1 year with the least price fluctuationsand the least risky instruments; follow the main money market instruments:

a) Treasury bills:

Issued by government for up to 6 months maturity, the most liquid instrument in the moneymarket with no risk associated.

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b) Bank certificate of deposit (CD): Pay interest at certain times and pay back the full certificate amount at maturity, issued by

commercial banks, corporations, mutual funds, government agencies, etc... It is considered a secure investment for a range from 3 to 5 years.

c) Commercial papers.

III. Capital market

This market has debt and equity instruments with maturities of greater than 1 year; they have far wideprice fluctuations and are considered to be risky investments.

Follow the main instruments in capital market:a) Stocks:

It is an equity claims on the net income and assets of a corporation, Stocks have thefollowing advantages:

Relatively low commission costs, easy to buy and sell, on the spot priced Can gain dividends and has potential capital gain. It has a proven track record of being rewarding investment over time. It is considered a risky investment with unlimited profit potential.

b) Corporate bonds: Long term bonds issued by corporations with strong credit ratings, interest paid once/

twice a year and face value upon maturity.c) Government securities:

The most liquid security traded in the capital market.d) Government agency securities:

Long term bond that issued by various government agencies.e) State and local government bonds:

Long term debt instrument issued by state and local government, it is tax exempted.

After the above analysis of factors an investor can select and ask certain questions to the investmentbeing made, in order to get the surety of favorable returns in future.

How will the investment make money?

• How is this investment consistent with my investment goals?

• What must happen for the investment to increase in value?

• What are the risks?

• Where can I get more information?

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Thus the proposed chart illustrates the investment decision roadmap for selecting the suitablefinancial investment instruments from different available avenues present in the market.

FIGURE 1: Proposed Model of Investor Decision Making

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Conclusion:

Investment decision process is an important analytical and critical decision for every individual investor.The decision to invest is influenced by the variety of benefits each individual wants from the selectedavenue of investment. This paper has published theoretical framework for individual investor behaviorin decision making process. The Investor investment process, factors affecting the individual investmentbehavior, avenues available has been studied in order to examine the investor behavior. It is revealedfrom the understanding of the concept that the investor has different financial plans and thus shouldchoose accordingly from the avenues available. The behavior of individual investors should be understoodthoroughly as it will help the investment companies, policy makers as well as managers of firms toprepare the financial products according to the needs and thus meet the investor’s demands at large.

References

1. Barber, B. and Odean, T.(2002). All that glitters: the effect of attention and news on the buyingbehavior of individual and institutional investors. Working Paper(University of California, Berkeley,CA).

2. Frankfurter,M and Mc Goun, E.G. (2000). Market eûciency or behavioral ûnance: The nature ofthe debate. The Journal of Psychology and Financial Markets, 1(4):200–210.

3. Khan, M.Y. Indian Financial System: Theory and Practice- Vikas Publishing House Pvt.Ltd.,New Delhi-1980.

4. Mahmood, I., Ahmad, H., Khan, A.Z., Anjum, M. (2011). Behavioral implications of investorsfor investments in the stock market. European Journal of Social Sciences, 20(2), 240-247.

5. Oberlechner, T., Hocking, S. (2004). Information sources, news, and rumors in financial markets:Insights into the foreign exchange market. Journal of Economic Psychology, 25, 407-424.

6. Statman, M. (1999). Behavioral finance: Past battles and future engagements. Financial AnalystsJournal, 55(6), 18–27.

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