PORTFOLIO MANAGEMENT BEHAVIOR OF INDIVIDUAL INVESTORS: HOW THEY MANAGE THEIR PORTFOLIOS?

DO THEIR BIHAVIORAL TRAITS AND BIASES CAST AN IMPACT?

a b

Hayat, M. Awan

Khuram Shahzad Bukhari

c

Bushra Ghufran

a,b, c

Institute of Management Sciences, Bahauddin Zakariya University, Multan

ABSTRACT This research is an attempt to understand the portfolio management behavior of individual investors by identifying different determinants of portfolio management behavior and their relative importance. Then the impact of investment behavior of individual investor on portfolio management behavior is studied. We collected data by obtaining direct responses from 28 brokers and 246 individual investors having their brokerage accounts maintained with brokers listed with KSE. First we identified recurring themes of determinants of investment behavior of individual investors through preliminary interviews with the investors and brokers. After identifying recurring themes we developed research instruments administered at individual investors selected using random sampling technique from four cities: Lahore, Islamabad, Karachi and Multan. We categorized individual investors on the basis of demographics, level of investment and investment objectives and conducted analysis of variance among responses. Responses obtained from individual investors based on structured questionnaire were analyzed quantitatively. Different statistical tools e.g. AHP, ANOVA, Means, Cross tabulation, Frequencies and Regression are used to obtain the results of the study. The software packages used are SPSS 17.0, and Spread sheet. We regressed investment behavior and portfolio management behavior of individual investor and found that dimensions of investor involvement and risk attitude are significantly related to portfolio management. That suggests that behavioral dimensions of involvement and their risk preferences basically have an impact in determining their portfolio management behavior. Key Words: Portfolio Management, Investor Behavior, Risk Preferences

IINTRODUCTION EMH as well as much experimental indication undermines the practical significance of active portfolio management. According to conventional theory active portfolio management does nothing but adds to the cost to the investor. So traditional theory recommends buy and hold strategy for portfolio management. In an efficient market, investors would be rational, unbiased and consistent. They would make investment decision without emotion or passion. Their choices would be based on a single goal of maximizing their expected utility while contemporary researches reveal the aspect that the investment selection process is more human than analytical. Feeling of loss, pride and regret often override rationality. Traditional finance theory assumes investor to be fully rational who evaluates all possible choices before making an investment decision. They make decisions consistent with expected utility theory and hold well diversified portfolios. However, behavioral theory depicts different picture, it states that an investor cannot be rational all the time. Research confirms disposition effect, active management of portfolios, representativeness and existence of less diversified portfolio that is not explained with the help of traditional theories of finance.

The research problem in hand is that what are the determinants of investment behavior of individual investor? What is the impact of determinants of investor behavior on portfolio

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management? So our research aims to study the portfolio management behavior of the individual investor. Our purpose is not only identifying the determinants of portfolio management behavior but also the relative importance of the determinants in shaping overall portfolio management behavior is also analyzed. This research also seeks to validate the relationship between investment behavior of individual investor on his portfolio management behavior. So the
objectives of the present study are, To identify the determinants of portfolio management behavior and their relative importance. To study the impact of determinants of investor behavior on portfolio management

If the investment behavior and consistent human flaws can be predictable then it can be exploited for profit. Moreover by identifying the cognitive biases and errors in portfolio management process individual investors can improve their investment behavior and can avoid making mistakes during portfolio allocation thus and can make optimum portfolio management. LITERATURE REVIEW "Switching from security to security accomplishes nothing but to increase transactions costs and harm performance. Thus, even if markets are less than fully efficient, indexing is likely to produce higher rates of return than active portfolio management. Both individual and institutional investors will be well served to employ indexing for, at the very least, the core of their equity portfolio, (Malkiel, 2005). While behavioral literature focuses on how individual investors manage their portfolios and that how an active portfolio management offers various strategies for beating the benchmarks. Among investors a common tendency of holding losers for long and selling winners quickly has been pointed out by Shefrin and Statman (1985). They named it as the disposition effect. They related their findings to the concepts of loss aversion, the issue of self-control, mental accounting, and the aspiration to avoid regret. Odean (1998) found that a particular group of investors sells winners more readily than losers. Even when the other rational motivations are controlled for, these investors carry on selling winners and holding losers. Their actions are in accordance with two behavioral hypotheses: the prospect theory, and an erroneous conviction that winners and losers will mean revert. This investor behavior appears not to be motivated by a desire to rebalance portfolios or by a reluctance to incur the higher trading costs of low priced stocks. It is also not justified by subsequent performance, as, in fact, it leads to lower returns (Odean, 1998). Investors trade too much due to their overconfidence. Successful investors can exhibit overconfidence through self-attribution bias, i.e. they have conviction that their successful trade activity is a mere result of their specific skills and abilities. Samuelson and Zeckhauser (1988) defined the status quo bias. It is also related to the influence of default option on choices. The status quo is related to loss aversion (framing as gains and losses) in the sense that current position (status quo) is refereed as the reference point. Other explanations, such as anchoring, sunk costs, regret avoidance, the desire for uniformity, the avoidance of cognitive dissonance, and the illusion of control, may contribute to the perseverance of the status quo bias and all this leads towards poor management of portfolio. The status quo, familiarity bias, inclination for stable returns, poor diversification and not making the proper adjustment in the portfolio with the arrival of new information are the factors that result in less than optimal investment outcomes. A similar heuristic manifests itself in one of the most important financial decisions: the construction of peoples investment portfolios. Constructing an investment portfolio is a complex phenomenon and demands people to look into the relations and statistical alliance between them instraed of looking into

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individual assets. Baltussen and Post (2007) find that, investors cannot perform this task of portfolio construction in accordance with economic theory and instead adopt simplifying heuristics in practice and tend to focus on the marginal distributions of assets, while largely ignoring the influence of individual assets on their total portfolio. Subsequently, people tend to divide available funds equally between the alternatives that are selected by their attractiveness in isolation. It simply leads to inefficient or nonpreferred investment portfolios (and thereby to non-optimal financial positions), since it ignores diversification benefits. Goetzmann and Kumar (2001) studied diversification in the light of demographic variables and found that investors who are non-professionals and have low income usually hold less diversified portfolios as they fail to do proper portfolio allocation. Modern Portfolio Theory (MPT) describes the portfolio allocation from the normative point of view (Markowitz, 1959), while behavioral finance studies the individual investors and that how they do portfolio allocation and thus follows a descriptive perspective. Diversification and risk-management techniques are crucial concepts in the portfolio theory. However mostly investors fail to diversify their portfolios properly. It is because they determine risks at individual asset level instead of determining at portfolio level, (DeBondt, 1998). Benartzi and Thaler (2001) investigated diversification strategies from the view point of defined contribution saving plans, and observed that investors have the tendency to spread their contributions uniformly across existing investment possibilities. Though it may be a logical for a few investors but it is not necessary to be useful for all investors with different risk preferences and thus may result in less than optimal portfolio allocation. . 1/n heuristic can produce a portfolio that is close to some point on the efficient frontier; however the exact point might not match investors risk preferences - which can create a significant ex ante welfare costs. The strategy can also generate significant ex post disappointment in case the returns differ from historical norms, (Benartzi and Thaler, 2001). Furthermore, Benartzi and Thaler (2001) in discussing the concept of mental accounting stated that when company stock is not in the array of available investment options, the contributions are divided evenly (nearly 50-50) between equities and fixed-income securities. However, when company stock is included, it captures around 40 percent of the assets, and the rest is divided about evenly between other equities and fixed-income securities. The total exposure to equities is 70 percent, as opposed to 50 percent when company stock is not available. It seems that company stock is given a separate mental account different from the rest of equity classes. Home bias is another crucial concept related to portfolio allocation. French and Poterba (1991) writes, despite the advantages of inter- national portfolio diversification, the actual portfolio allocation of many investors is too concentrated in their domestic market. Barber and Odean (2000) studied the trade data from discount brokerage firm and found that average no. of stocks hold by the investors at that brokerage firm was just 4.3 stocks per head. They also stated that when investors deviate from the status quo choice it basically result in strong aversion to uncertainty and as a result they do not well-diversify their portfolios as they do not feel it to be beneficial and thus keep on holding the under-diversified portfolios. Hirshleifer et al. (2009) studied the same phenomena and came up with the conclusion that it is basically the fear of unknown that keep investors from properly diversifying their portfolios because they think that any decision that result in deviation from status quo will result in minimization of their wealth. They further explained that investors do not add un-familiar stocks to their portfolios because there is a need of huge gain from diversification to offset the aversion of purchasing un-known stocks. METHODOLOGY In this study we followed the same methodology as is used in research on investment behavior and its impact on investment decisions. Again we picked the Karachi Stock Market, to study the portfolio management behavior of individual investors and collected data randomly from four cities; Karachi, Lahore, Islamabad and Multan. In our research Unit of analysis are:

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i)

Prime unit of analysis is Individual investor having an account maintained with the broker listed with KSE ii) Secondary unity of analysis are the brokers who are listed with KSE We applied both quantitative as well as a qualitative method for analysis. We opted for qualitative approach, in defining the determinants of investment behavior and factors that may affect their financial decisions, by conducting face to face and telephonic interviews with the brokers. In our study quantitative method refers to the survey we implemented in the form of questionnaires, which are directed at individual investors. Different statistical tools and techniques e.g. AHP, ANOVA, Means, Cross tabulation, Frequencies and Regression Models are used to obtain the results of the study. The software packages used are SPSS 17.0 and Spread sheet. Data Collection Data for our study is primarily collected through preliminary interviews with the 20 individual investors and 5 brokers to identify determinant of portfolio management behavior. Based on the determinants of portfolio management identified from preliminary interviews and secondary research we developed two research instruments for survey purpose. We conducted survey in form of two questionnaires one in the form of open ended questions for in-depth interviews with the brokers and the other one more structured form for investor survey. We have obtained 246 complete survey responses from individual investors and 28 successful interviews with the brokers in four major cities. The questionnaires were distributed among individual investors in four cities. 500 surveys were distributed to individual investors during the period of September 2010-November 2010. Some questionnaires were mailed to the respondents via courier. An electronic version was also sent via e-mail. In few cases the survey was self administered while in most of the cases we facilitated the respondents while getting response from them. 290 individual investors responded, for a response rate of 58 percent. However; several questionnaires were incomplete as many questions had been left unanswered. It happened mostly in self-administered surveys. We used 246 questionnaires for analysis purpose. The response rate obtained from brokers was 100 percent. DATA ANALYSIS DISCUSSION OF INTERVIEWS WITH BROKERS Majority of brokers confirmed the presence of disposition effect among investors. They clearly stated that investors have the propensity to hold on to their loser stocks just in order to avoid the regret of making a bad investment decision and to sell the winner stocks quickly to avoid the regret of losses if the prices fall later on. They also revealed that if investors have the capacity they try to inject further money up to some extent in order to average out losses by spreading it over more number of stocks but if they have already make 100 percent of their investment then of-course they would not be having capacity to inject more money to average out losses and such investors suffer more. Some brokers pointed out that investors commit mistakes by not defining the decline limit till which they should hold the stocks and due to this they make losses over their investments. According to brokers there are few investors who withdraw their investments when prices fall and book their losses while majority hold on to loser stocks. Some brokers stated that investors formulate their views about the future prospects of the company and make decisions accordingly. If they are hopeful about the bright future prospects of the company theyll ride on loser stocks for long otherwise they withdraw their investments and switch to some other investment option. Moreover it depends on their investment objectives as well if investors have short term investment objectives they prefer to sell stocks on losses even while investors with long term investment horizons have greater propensity to hold on to loser stocks. To sum up we can say that most of the investors have the disposition to sell their winner stocks quickly while they hold on to loser stocks for long but there can

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be variation in responses on the basis of their investment objectives and their capacity to inject further money to average out losses. According to brokers investors mostly concentrate their investments in 4 to 5 different types of stocks. They also revealed that even there are few investors who go for over diversification and keep their investments in so many different stocks with little proportion of investment in each and it becomes hard for them to manage the portfolio thus they fail to make profits that they could have realized otherwise. According to some brokers very few hold a fairly diversified portfolio of investments even a brokers stated that, only 30% of the investors hold a fairly diversified portfolio. Brokers also stated that small investors and mostly jobbers or day traders tend to concentrate their investments in one or two different stocks while big investors tend to diversify their investments after proper evaluation they try to invest in different attractive sectors e.g. oil, energy, cement, fertilizer etc. instead of concentrating their investments in a few stocks. INVESTOR SURVEY Secondary research and the preliminary in-depth interviewed helped us identify following six dimensions of portfolio management, Disposition Effect Representativeness Diversification Return Specification Decline Limit Specification Adjustment

AHP helped us identify the relative importance of each of the six dimensions in the overall portfolio management. We got the following hierarchical order and relative weights for each of the dimensions of portfolio management,

AHP Ranking of Behavioral Dimensions of Portfolio Management

Decline Limit Specification Diversification Representativeness Adjustment Return Specification Disposition Effect 8.97% 10.29% 11.35% 15.99% 25.06% 28.34%

Figure 1: Weights for each factor of Portfolio Management (In percentage)

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It shows that among all dimensions, the dimension of disposition effect has greater impact on the portfolio management. The dimension of portfolio management is divided into two factors, Selling Winners Holding Losers

AHP Ramking of factors of Disposition Effect

Selling Winers Holding Losers 33.20% 66.80%

Figure 2: Weights for sub-factors of Disposition Effect (In percentage)

Again we applied analytical hierarchical process to find the relative weights of these factors. The factor of selling winners is given first rank with weights 66.80% while holding losers is at second rank with weights 33.20% On the basis of these six dimensions we formulated following statements. Investors were asked to rate the following seven statements from 20.1 to 20.7 on a 1 (Least Important) to 7 (Most Important) point likert scale. 20.1 I set a specific amount of return to be earned from each transaction 20.2 I decide about limit of decline in stock price till which I can hold the stock 20.3 I quickly adjust the portfolio to new information received 20.4 I add those stocks in the portfolio that have performed good recently 20.5 I hold fairly diversified portfolio 20.6 I rush to sell winner stock 20.7 When the stock price falls below my purchase price, I usually wait for the price to come back to my purchase price before I sell.
Table 1: Frequency Results for determinants of Portfolio Management Behavior Statements 20.1 20.2 20.3 20.4 1 4.1 11.4 3.7 10.6 2 8.5 20.3 8.9 10.2 3 8.9 15.0 10.2 8.1 4 13.0 19.1 15.9 4.1 5 20.3 4.5 14.2 9.8 6 23.6 10.6 19.9 37.4 7 21.5 19.1 2.2 19.9 Total Frequency 100% 100% 100% 100%

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20.5 20.6 20.7

1.2 0.4 4.9

5.3 4.1 6.9

13.0 10.2 6.9

29.3 13.4 10.6

37.8 20.7 13.4

11.8 26.0 16.7

1.6 24.8 40.7

100% 100% 100%

In response to statement no. 20.3, 27.2% of the investors strongly agreed with the statement depicting that they quickly adjust their portfolio to new information received while just 3.7% of the respondents strongly disagree with the statement. On the whole 61.3% of the investors agreed with the statement and gave rating of 5 or above depicting that majority of the investors believe that they do adjustments in portfolio as they receive new information. Investors were asked do they set a specific amount of return to be earned from each transaction. 21.5% of the investors strongly agreed with the statement while 4.1% of the investors strongly disagreed with the statement. 65.4% of the investors agreed with the statement and gave rating of 5 or more. 20.3% (highest frequency) of the investors disagreed with the statement that they decide about the decline in stock price till which they can hold the stock. 65.8% of the investors gave ratings of 4 or less. That shows majority of the investors response revealed that they do not specify the decline limit that is basically the reason that they do not get out of loser stocks and losses continued Investors were asked that when the stock price falls below purchase price, do they usually wait for the price to come back to my purchase price before they sell. 40.7% of the investors strongly agreed with the statement while just 4.9% of the investors strongly disagreed with the statement. 70.8% of the investors gave ratings of 5 or above. It basically shows generally investors have the tendency to hold on loser stocks. This is also consistent with the theory of disposition effect proposed by Shefrin and Statman (1985). 24.8% of the investors strongly agreed with the statement that they rush to sell winner stocks while just 0.4% of the investors strongly disagreed. Majority (71.5%) of the investors agreed with the statement by giving rating of 5 or above. 19.9% of the investors strongly agreed with the statement that they add those stocks to the portfolio that have performed good recently while 10.6% of the investors strongly disagreed. 37.4% (highest frequency) of the investors gave a rating of 5. Majority of the investors agreed with the statement while few showed disagreement. Investors were also asked about portfolio diversification. 37.8% (highest frequency) gave a rating of 5. Majority of the investors agreed with the statement. We also calculated descriptive statistics that is summarized in the table below,
Table: Descriptive Statistics Mean Statements 20.1 20.2 20.3 20.4 20.5 20.6 20.7 Statistic 4.9390 3.9309 4.9675 4.8415 4.3902 5.2927 5.3333 Std. Error .11066 .13046 .11505 .12963 .07270 .09421 .11894 Std. Deviation Statistic 1.73568 2.04623 1.80446 2.03321 1.14024 1.47762 1.86555 Variance Statistic 3.013 4.187 3.256 4.134 1.300 2.183 3.480 Skewness Statistic -.628 .244 -.523 -.755 -.476 -.592 -.894 Std. Error .155 .155 .155 .155 .155 .155 .155 Statistic -.576 -1.260 -.850 -.894 .266 -.505 -.379 Kurtosis Std. Error .309 .309 .309 .309 .309 .309 .309

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Our research also probed into different behavioral biases related to portfolio management. That are discussed below. Investing in local stocks?: Findings suggest that 88.62% of the investors make 100% of their investment in local stocks, 0.8% of the investors invest totally in foreign stocks while 16.58% of the investors have different combinations of their investments in local and foreign stocks but the each combination carries greater proportion of their investment in local stocks as compared to foreign stocks. Selling or holding the loser/winner stocks: Our research findings suggest that most of the investors (73.6%) had the disposition to hold on to loser stocks while very few (26.4%) of the investors opted for selling the loser stocks. We further find that 76% of the investors have the tendency of selling the winner stock so early so that gains could be realized so early while 24% of the investors had the tendency to gamble over winner stocks and to hold the winner stocks in anticipation that stock prices will further appreciate. Tendency of Investing in a Winner Stock: In a situation where stock price of a certain company has risen by 20% and even the future for the stock looks bright, a higher proportion, 50.8% of the investors consider the stock worth-buying. 26% of investors consider the information to be insufficient for making an investment decision. However, 23.3% of investors replied the stock is not worth buying. Our findings refer to the winner-loser and representativeness dilemma. The results indicate that there is a significant amount investors who would make an investment based solely on favorable price movements. Mental Accounting: The last two questions were targeted to measure the phenomena of mental accounting. Investors were presented with the situation that if they are holding the stocks of certain company with bright long term prospects but has faced a decline in the share prices because of poor performance of the past quarter then will they opt to buy more shares of the same company. In this particular situation 63% of the investors showed that they will purchase more shares while just 37% of the investors preferred not to purchase more shares. Investors were again presented with the same situation as in the previous question that the stock price of the company with bright long term prospects has faced decline because of poor quarterly performance but with the difference that this time investors do not hold any share of the company. Again customers were asked about their preferences to buy or not to buy the stocks of the company. In this particular situation most of the investors showed that they will not prefer buying the stock that has faced price decline while few showed willingness to buy such stock. Majority of investors (58%) of investors were of the view that they will not sell loser stock.

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To analyze the impact of the determinants of investor behavior on portfolio management behavior we fitted regression model. We used the findings of the previous research conducted on the determinants of investor behavior of individual investor. We used the data on determinants of investor behavior (overconfidence, involvement, optimism and risk preferences) from an earlier research conducted on the subject of understanding investor behavior by Awan et. al., (2011).

Source: Awan et al., (2011) Regression model helps us identify that whether investment behavior of an individual investor has an impact on the portfolio management or not. Moreover it the model tells us that out of four broad dimensions of investor behavior which dimension is most closely related to the portfolio management and that what are the behavioral dimensions has greater impact on the overall portfolio management behavior of an individual investor.

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Table 4: Regression Results showing the Relationship between Determinants of Behavior and Portfolio Management Explanatory variables Unstandardized Coefficients SE of Coeff. Beta t value p value Intercept Involvement Risk Attitude Optimism Overconfidence R square Adjusted R square F value Durbin-Watson Degrees of freedom Significant at 5% level. 2.762 .219 .135 .026 .028 .270 .258 22.276 2.018 245 .294 .027 .046 .035 .038 .464 .168 .042 .042 9.395 8.136 2.947 .735 .723 .000 .000 .004 .463 .470

Findings of the regression model suggest that the behavioral dimensions of investor involvement and risk attitude are significantly associated with the portfolio management as the p values for these dimensions (.000 and .004) are less than the alpha value (.05) that supports our argument that investor behavior has an impact on the portfolio management. If we look into the values of R square and adjusted R square we can state that investor behavior casts an impact of up to 25 to 27 percent on the overall management of the portfolio of investments. We also analyzed the variance of responses of investors from different age groups regarding portfolio management. We found that investors with ages <30 years and 30-50 years have greater tendency to add those stocks to the portfolio that have recently performed good, as compared to those with 50+ years. It also shows that they (<30 and 30-50) are under the influence of representativeness more than those with ages above 50 years. Investors with ages above 50 years are found to have greater tendency to hold on to loser stocks usually wait for the price to come back to their purchase price before they sell as compared to investors with ages below 30 years. We found that investors at Matriculation-Intermediate and BachelorMasters level of education have greater tendency to sell winner stocks as compared to those at PrimaryMiddle level of education. We also observed the responses of investors having different gross annual income levels, we did not find significant variation in their responses regarding portfolio management except that investors with incomes >30 lac have greater tendency to add those stocks in their investments portfolio that have performed good recently as compared to investors with incomes 10-30 lac. When we observed the responses of investors belong to different occupation groups, significant differences of responses of the investors from different occupation groups came into notice. I have put all the significantly different responses in one table that are shown below, Analysis of variance of the responses of investors belonging to different occupation categories revealed that salaried individuals are more actively manage their portfolios of investments as compared to other investors from other occupation groups as they specify the return to be earned from each transaction,

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specify the decline in price of stock till which they hold the stocks, hold diversified portfolios as compared to other investors particularly self-employed and retired. However they are more prone to representativeness heuristic as well because they prefer adding those stocks in their portfolios that have recently performed well that can lead to less than optimal investment decision. We also observed the representativeness bias among self-employed individuals. All investors other than students believe that they hold well diversified portfolio of investments. We also found that retired and salaried individuals tend to sell their stocks more quickly as compared to self-employed individuals. We also analyzed the responses of investors at different levels of investment experiences. We found that investors with investment of experience <10 years have greater tendency to sell the winner sells quickly as compared to investors with investment experience of 10 to 20 years. Other than that no significant differences came into notice. FINDINGS AND CONCLUSION This research also studies the portfolio management behavior of individual investors. Findings about portfolio management behavior of individual investors suggest that there exists disposition effect among investors that is also consistent with the theory proposed by Shefrin and Statman (1985) and interviews with the brokers also confirmed the existence of the phenomena. They are found to have the disposition to sell their winner stocks quickly and to hold on to loser stocks for long just to avoid the regret of making bad investment decision. Findings also revealed that investors have the tendency to add those stocks to their investment portfolio that have performed good recently that suggest that majority of the investors is prone to representativeness heuristics as is suggested by behavioral finance theories. Our research confirms the existence of local bias among investors that means they have the tendency to invest in local stocks. Our findings suggest that majority of investors hold under-diversified portfolios that is also confirmed by brokers. We also found that majority of investors fail to properly specify decline limit in the price of the stock till which they can hold the stock that is the reason that they do not book their losses on time and losses continue and they fail to establish an efficient portfolio. When we related portfolio management behavior with the determinants of investment behavior to check if there is some association between the two we found that dimensions of investor involvement and risk attitude are significantly related to portfolio management. That suggests that the level of involvement and their risk preferences basically have an impact in determining their portfolio management behavior. Our research also confirms that investor behavior plays an important role in shaping portfolio management behavior.

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