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1 July 2015 CFA Institute Journal Review

How Investor Perceptions Drive Actual Trading and Risk-Taking Behavior (Digest Summary)

  1. Sandra Krueger, CFA

In an examination of the investment decision-making process, the authors suggest that investor perceptions are capable of explaining actual trading and risk-taking behavior. They find that investors with higher levels of return expectations are more likely to trade, have higher turnover, trade larger amounts per transaction, and use derivatives. Additionally, investors with higher levels of risk tolerance are more likely to trade, use limit orders more frequently, and hold riskier portfolios.

What’s Inside?

Previous behavioral research focused on how investors’ perceptions affect hypothetical trading. The authors focus on whether changes in these perceptions affect actual trading and risk-taking decisions. They combine monthly survey data with matching brokerage records to construct a panel dataset that allows the simultaneous examination of the perception and behavior of investors. Their results show that the levels and changes in investors’ perceptions contribute significantly to their actual trading decisions.

How Is This Research Useful to Practitioners?

Investment advisers are sometimes hired by clients who need a more disciplined approach to investing. By understanding biases and tendencies in investment decision making, the adviser can serve clients by preventing unnecessary turnover and risk taking.

Strong predictors of investor behavior include not only risk variables, such as risk tolerance, but also subjective beliefs about expected stock market returns, which drive trading. Investors are more likely to trade the when their return expectations and risk tolerances are high. Upward revisions in return expectations are associated with larger amounts per transaction and higher buy-to-sell ratios. Higher levels of perceived risk also make investors more likely to trade, but when they trade, their buy/sell ratios decrease.

How Did the Authors Conduct This Research?

The authors’ analysis is based on a dataset first used by Hoffmann, Post, and Pennings (Journal of Banking and Finance 2013). This dataset consists of a sample of 1,376 clients of a discount broker in the Netherlands, clients who primarily trade equity and derivatives, and matching monthly survey data from April 2008 to March 2009.

The survey had 13 questions based on return expectations, risk tolerance, and risk perception. Return expectations reflect a participant’s optimism in his or her investment return. For example, the participants rate the following statement: “Next month, the future of my investment portfolio looks good.” Risk tolerance reflects a participant’s like or dislike of risky situations. Risk perception reflects a participant’s interpretation of the riskiness of the stock market and is measured by questions asking agreement with the following statement: “I consider investing to be dangerous next month.”

Regressions that include investor perceptions as explanatory variables in their one-month lagged levels and changes from that month are used to infer how perceptions at the start of a month influence behavior.

Because prior investment literature identified gender, age, account tenure, income, portfolio value, and house value as drivers of investment decisions, the authors control for these variables and find their results regarding these control variables are consistent with past research. For example, investors are less likely to trade if they are wealthy, and therefore, turnover is lower for these investors.

Abstractor’s Viewpoint

The authors used a dataset obtained during the financial crisis from investors in the Netherlands. It would be interesting to repeat the study using global investors during a period of sideways or flat equity market performance. This type of analysis could also be expanded to include behavioral research on investor confidence. For example, if investor perception is proven correct three months in a row, does trade size increase (or decrease) if proven incorrect? Many possibilities exist to extend this initial research.

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