Psychological Factors and Investment Decision Making

Dr. Ahmed Imran Hunjra1 Salman Ali Qureshi2 Lubna Riaz3

Psychological Factors and Investment Decision Making: A Confirmatory Factor Analysis ABSTRACT In the current days, behavioral finance, a new financial sub discipline has ignited a wave in explaining the investment decisions behavioral aspects and is becoming a necessary part of the decision making process because of its great impact on decision making behavior of investors’. The current study aim is to check the questionnaire validity which is used to measure the main determinants of decision-making of investment such as Propensity of Risk, Framing of Problem, Information Asymmetry, and Perception of Risk. 100 investors from Islamabad Stock Exchange depending upon their expert opinion were requested to rate the 39 items initial scale. By using AMOS version 16, after applying confirmatory factor analysis, the instrument of twenty two items is finalized. Future research may be conducted to test the model by using the data collected by this refined instrument in Pakistani Scenario. Keywords: Confirmatory Factor Analysis, Validity, perception of Risk, propensity of risk, information asymmetry, investment decisions. 1

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Assistant Professor, UIMS-PMAS- Arid Agriculture University, Rawalpindi, Pakistan. Email: [email protected] Assistant Professor, Department of Business Administration, Allama Iqbal Open University, Islamabad, Pakistan. MS Scholar, UIMS-PMAS- Arid Agriculture University, Rawalpindi, Pakistan.

Journal of Contemporary Management Sciences: Volume 2, Issue 1, Spring 2016

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Dr. Ahmed Imran Hunjra, Salman Ali Qureshi and Lubna Riaz

 Introduction

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ehavioral finance as compared to standard finance takes a dissimilar viewpoint of risky decision making. It claims that the individuals frequently act in a fewer than a completely rational manner and for a given risk level, they do not seek to maximize their anticipated returns; rather they want to maximize a satisfying strategy (Sortino, 2001). Theory of prospect, presented by Kahneman and Tversky (1979) about the behavior of risk-taking assumes that there are persistent biases driven by a behavior of individual’s, emotions of individual’s and individual’s mental processes that affect the decision making of investors in risky conditions. It states that the risk averse behavior tend to be shown by decision makers when they faced with potential gains; whereas risk seeking behavior tend to shown by those who faced with potential losses, that is, to avoid loss they will give more importance than to achieve gain (Olsen, 1997; Ricciardi and Simon, 2000; Ricciardi, 2003). Therefore, in the field of financial economics the work on theory of prospect made a revolution by stating that psychological and behavioral biases are better descriptions of in the risky situations how numerous decisions are made (Naughton, 2002). In the initial years, investment was based on forecasting about the market timing, the performance of investor’s etc. which made very ordinary results; also among the actual and the expected returns there was a gap. To search for the reasons for such kind of results the need was identified. In decision-making process, it is observed that the mistakes made by them are the failure reasons i.e. irrational decisions made by them about their investments. To avoid them for optimal decisions of investment by recognizing their mistakes and means, the impact of psychology in investment decisions was realized by them. In a wider sense financial decision making is the duty of each individual; these decisions outcome has a strong influence on near future and the long term overall situation of life. Financial decisions are, as the decision maker has to deal with uncertainty, choice overload, risk and complicated contracts, though, mostly related with higher difficulty; for financial professionals this is challenging. The process of assessing and alternate selecting from a number of available alternatives is decision-making. Decision-making is an inexplicable phenomenon 67


was believed by Culters, Poterba and Lawrence (1989); being a difficult activity, in a vacuum decision-making cannot be done through complicated models and personal resources, in which actual situation is not considered. Variables analysis of the difficulty, in which it arises, by an individual psychology, is affected. Because of several factors, each individual is different from others, which contain demographic factors, race, sex, age, social background, economic background and education level. Investors have the same case; investments decision is the greatest serious challenge faced by them which play a vital and significant role. For future benefits investment is current sacrifice, thus different things have to be kept in mind while making investment decisions as it is affected by their fundamentals as well as depend on different elements. Thus, recognizing important elements affecting decision of individual investor’s to make alternate choices is significant to know their different behavior of investment. Normally, objectively investors cannot assess risks and return; rather while making decisions they act expressively i.e. their perception is the result by their decisions towards expected returns and risks (Azwadi, 2011). Nosic and Weber (2007, 2010) and Dominitz and Manski (2011) pointed out that the investor behavior central determinants are expected returns and risk perceptions. In the theory of economic utility the investment decision of individual is viewed as a tradeoff among consumption instantly and consumption lately. The benefits of today consumption against the benefits that would be gained by investing unconsumed funds individual investor assesses so as to get higher consumption in the future. Individual will choose portfolio that will maximize his enduring satisfaction, if he selects to delay consumption. The theory of utility essence axiomated by Neumann and Morgenstern (1944) state that with difficult choices investors deal, they want to maximize their wealth, are risk-averse and are completely rational. A critical factor of the making investment decision is the subjective factor of observed risk by the investors rather than completely the objective risk is assumed by behavioral finance, as highlighted by standard scholars of finance. Therefore, by identifying individuals risk perception subjective nature as an addition to the traditional measures of the objective risk extends and increases the understanding and complete risk measurement/judgment area. Investment professionals and 68


scholars of finance recognize that how risk is perceived by individuals that might affect investment in the stock market. According to Farrelly and Reichenstein (1984), it is the perception of individual’s and their response to risk that influences their decisions about investment. Therefore, actual risk is not the only factor; rather how investors perceive that risk and how respond to that risk is also an important aspect. Researchers are using behavioral finance while making analysis of the stock market because it has become an important area (Rana et al., 2011). They studied in the individual’s decision-making process, how subjective behavioral elements introduce distortions; therefore giving an awareness about the elements that forecast investors behavior of risk taking. Various scholars have focused on the direct influence of one or two investor behavior determinants in risky circumstances of investment but it does not completely reflect the difficult set of effects on behavior of investor’s. Therefore, the key aim of current study is to authenticate a scale of measurement for the main elements that affect investors’ behavior of risk taking.

 Review of Literature How an individual observes risk might affect his intention investment in stock market is identified by finance scholars (Farrelly and Reichenstein, 1984). Therefore, actual risk is not the only aspect; rather how it is observed and responded to that risk is also an important element. On the understanding of perceived risk, work of several decades has been devoted. Psychometric Paradigm is the one distinct theory practiced in the psychology disciplines and decision sciences. Within this approach risk is inherently subjective is the most significant assumption; it does not independently exist out there, waiting to be measured (Slovic, 1972); rather it is affected by a number of cultural, and social psychological elements. Antonides et al. (1990) stress that: “Decision-making of investment can be seen as the result of the conflict among expectations and preferences. Our beliefs and information decide the potential consequences and their subjective likelihoods, and our desires or needs decide the potential consequences value; after all, psychological factors governed the economic phenomena perception”. 69


Risk perceptions in the decisions making play a prominent role, in the sense that variances in perception of risk lie at the heart of differences about the finest alternate between different course of actions (Slovic, 2000, Singh and Bhowal, 2010;). Scholars in finance and psychology discuss that the third significant factor is the risk perception for choice behavior (Pennings and Wansink, 2004). Therefore, the way investors observe the investment risk appears to predict their activities. On the perceptions of risk of an investor, risk propensity has a greater impact as recommended by Sitkin and Pablo (1992). In a specific state, an investor with great propensity of risk may undervalue the risks associated with a condition and give additional weight to the positive consequences (gains) showing risk perception low levels. In contrast, a risk averse investor will give additional weight to the negative consequences (losses), leading to great risk perception levels (Vlek and Stallen, 1980; Brockhaus, 1980; Schneider and Lopes, 1986;). Thus, we can say that, an investor’s risk perception increases as the level of risk propensity decreases, thus affecting the behavior of investment decision making (Rana et al., 2011). Several scholars have focused on the direct influence of one or two elements of behavior of investor in risky conditions of an investment but it does not completely reflect the difficult set of effects on behavior of investor’s. Investors usually make decisions and choices between different types of investment options (for example, how much to invest) (Du and Budescu, 2005). However, financial experts and advisors may not be able to provide reliable information on the exact probabilities for future returns on investments. Thus, investors’ attitudes become quite important in terms of making investment decisions. Prior research has shown that the attitude towards risk may be a significant forecaster of behavior of investment (Kuhn and Budescu, 1996). Investors are more probable to be challenged with investment opportunities which are probable to have unpredictable likelihoods, returns and consequences (Du and Budescu, 2005). Potential investors can be very sensitive to risk, which may be affected by the perception of individual’s or valuation of the fear of investment loss, due to its riskiness. Indeed, Ganzach et al. (2008) contended that in its prescriptive sense, an uncertain position for instance investments may include threats and opportunities, potential for losses and

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gains, positive as well as negative factors, and likelihoods for achievement or collapse. Kim and Nofsinger (2008) suggested that in behavioral finance important role is played by cognitive psychology. In making financial decision investors are found to be affected by any inevitable behavioral and cognitive bias. Kahneman and Tversky (1984) developed the theory of prospect that explained between others, effect of disposition, one of the behavioral biases. In determining the best alternate between different decisions of investment, subjective role is played by risk perception (Slovic, 2000). Individual and situational variances in selecting between alternatives of risky decision have been shown to be related with dissimilar investment risks perceptions, rather than with variances in the inclination to admit or to avoid the substitutes of investment which were perceived as riskier (Weber and Milliman, 1997; Weber, 2001; and Singh and Bhowal, 2008;). Framing is another problem associated to the behaviour of the investor’s in behavioral finance; it is the selecting of specific words to present a given set of details; it can affect the investors’ decision making choices. Based on how the problem is being framed, to make different decisions, framing is significant to understand as it reflects the propensity of an investor. On risky decision making research indicates that the decisions framing in terms of losses (negatively) and gains (positively) affects how a maker of decision answer (Kahneman & Tversky, 1979), as it causes difficulties to be watched in unlike ways therefore leading to unlike choices of decision (Slovic, 2000; Edwards et al., 2002; Chou et al., 2010; Singh, 2012;). Wang et al. (2006) showed that in behavioral finance, the influence of asymmetry of information on the investor behavior is one more important factor. Myers and Majiluf (1985) found that a significant part is being played by the asymmetry of information in determining financing and investment decisions while investigating information asymmetry among investors and management in the financial market. It is anticipated that the information excellence is being reflected by the excellence of decision made. By the excellence of the decision made by using the information by the investors, the information value may be determined; therefore showing that the asymmetry of information significantly affects investment decisions and financial decisions of an investor’s (Abosede and Ezekiel, 2011). 71


 Methodology To expand knowledge all scholars have the general purpose of gathering data. To be exact, research study has one of the two main purposes: to test the hypothesis or to collect purely descriptive data. On the basis of iterature review, a questionnaire for the five variables of 39-items was adapted and used in this study. From Wood et al. (2004) and Pasewark and Riley (2010) items of investment decisions were adapted to measure the investment decisions; and from Byrne et al. (2007), Mayfield et al. (2008), Vlaev et al. (2009), Grable et al. (1999), Wang et al. (2006) and Nosic and Weber (2010) the items for perception of risk, propensity of risk, asymmetry of information and framing of problem were adapted. For the variables of the study a Likert scale of 5 point was used taking series from strongly disagree (1) to strongly agree (5). Confirmatory factor analysis is a factor analysis of special form, to check whether construct measures are consistent with the nature of that factor/construct, used in social sciences research. Before conducting a research, to certify appropriate investigation of the data of research, authentication of the scale of measurement is of higher importance. For measurement scale validity, to exclude or include the items from variable the items which have less than 0.4 estimates, this is the minimum criterion, are not been incorporated in the constructs (Cua et al., 2001). To check whether the data fit a hypothesized model of measurement is the objective of confirmatory factor analysis and it is conducted to evaluate the authenticity of construct along with other data psychometric properties. In this study, confirmatory factor analysis was done by using AMOS Software and from Islamabad Stock Exchange 100 financial investors were randomly selected for data gathering. To the selected respondents the questionnaires were personally handed over and depending upon their expert opinion, respondents were requested to rate each question.

 Results and Discussion All the items regression weights against each variable are shown in tables.

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Sr. No. 1 2 3 4 5 6 7

Table 1: Convergent Validity of Risk Perception Standard Reliability δ=1-Item Items Estimate Decision (λ²) Reliability (≥0.4) PR1 0.67 Included 0.4489 0.5511 PR2 0.91 Included 0.8281 0.1719 PR3 0.70 Included 0.49 0.51 PR4 0.50 Included 0.25 0.75 PR5 0.16 Excluded PR6 0.06 Excluded PR7 0.08 Excluded ∑ λ1= 2.78 ∑(λ²)= 2.017 ∑ δ = 1.983

AVE of PR = 2.017/4 = 0.50425 CR of PR = (2.78)²/(2.78)² + 1.983 = 7.7284/9.7114 = 0.795807

Table 1 shows the risk perception (PR) standardized estimates and including or excluding of seven items of risk perception (PR) in its CFA. For seven items of risk perception (PR) factor loadings of four items are above 0.4 so three are excluded from questionnaire for final questionnaire and are practically significant. The loading factors values for included items are 0.67, 0.91, 0.70 and 0.50. However AVE value for risk perception (PR) is greater than 0.50 which represents the observance of convergent validity. Similarly, the value of construct reliability for risk perception (PR) is above 0.70 which shows better reliability. AVE and CR values are 0.50425 and 0.795807 respectively. Table 2: Convergent Validity of Problem Framing Items Sr. No. 1 2 3 4 5 6

Items PF1 PF2 PF3 PF4 PF5 PF6

Standard Estimate (≥0.4) 0.72 0.38 0.78 0.50 0.65 0.73 ∑ λ1= 3.38

Decision

Reliability (λ²)

Included Excluded Included Included Included Included

0.5184 0.6084 0.25 0.4225 0.5329 ∑(λ²)= 2.3322

δ=1-Item Reliability 0.4816 0.3916 0.75 0.5775 0.4671 ∑ δ = 2.6678

AVE of PF = 2.3322/5 = 0.46644 CR of PF = (3.38)²/(3.38)² + 2.6678 = 11.4244/14.0922 = 0.81069

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Table 2 shows the problem framing (PF) standardized estimates and including or excluding of six items of problem framing (PF) in its CFA. For six items of problem framing (PF) factor loadings of five items are above 0.4 so one item is excluded from instrument for final instrument and are practically significant. The loading factors values for included items are 0.72, 0.78, 0.50, 0.65 and 0.73. However AVE value is little bit lower than 0.50 which suggests that convergent validity is poorly observed. While in case of construct reliability its value is higher than 0.70 which indicates the better reliability. However AVE and CR values for problem framing (PF) are 0.46644 and 0.81069 respectively. Sr. No. 1 2 3 4 5 6 7 8

Table 3: Convergent Validity of Risk Propensity Items Standard Reliability δ=1-Item Items Decision Estimate (≥0.4) (λ²) Reliability RP1 0.96 Included 0.9216 0.0784 RP2 0.47 Included 0.2209 0.7791 RP3 0.17 Excluded RP4 0.38 Excluded RP5 0.30 Excluded RP6 0.17 Excluded RP7 0.25 Excluded RP8 0.55 Included 0.3025 0.6975 ∑ λ1= 1.98 ∑(λ²)= 1.445 ∑ δ = 1.555

AVE of RP = 1.445/3 = 0.481667 CR of RP = (1.98)²/(1.98)² + 1.555 = 3.9204/5.4754 = 0.716002

Table 3 shows the risk propensity (RP) standardized estimates and including or excluding of eight items of risk propensity (RP) in its CFA. For eight items of risk propensity (RP) factor loadings of three items are above 0.4 so five items are excluded from instrument for final instrument and are practically significant. The loading factors values for included items are 0.96, 0.47 and 0.55. However AVE value is little bit lower than 0.50 which suggests that convergent validity is poorly observed. While in case of construct reliability its value is higher than 0.70 which indicates the better reliability. However AVE and CR values for risk propensity (RP) are 0.481667 and 0.716002 respectively. Table 4: Convergent Validity of Information Asymmetry Items 74


Sr. No. 1 2 3 4 5 6 7 8

Items IA1 IA2 IA3 IA4 IA5 IA6 IA7 IA8

Standard Estimate (≥0.4) 0.62 0.50 -0.02 0.02 0.13 0.87 0.70 0.65 ∑ λ1= 3.34

Decision

Reliability (λ²)

Included Included Excluded Excluded Excluded Included Included Included

0.3844 0.25 0.7569 0.49 0.4225 ∑(λ²)= 2.3038

δ=1-Item Reliability 0.6156 0.75 0.2431 0.51 0.5775 ∑ δ = 2.6962

AVE of IA = 2.3038/5 = 0.46076 CR of IA = (3.34)²/(3.34)² + 2.6962 = 11.1556/13.8518 = 0.805354

Table 4 shows the information asymmetry (IA) standardized estimates and including or excluding of eight items of information asymmetry (IA) in its CFA. For eight items of information asymmetry (IA) factor loadings of five items are above 0.4 so three items are excluded from instrument for final instrument and are practically significant. The loading factors values for included items are 0.62, 0.50, 0.87, 0.70 and 0.65. However AVE value is little bit lower than 0.50 which suggests that convergent validity is poorly observed. While in case of construct reliability its value is higher than 0.70 which indicates the better reliability. However AVE and CR values for information asymmetry (IA) are 0.46076 and 0.805354 respectively. Table 5: Convergent Validity of Investment Decisions Items SR. Standard Items No. Estimate (≥0.4) 5. Investment Decisions (ID) 1 ID1 0.65 2 ID2 0.80 3 ID3 0.98 4 ID4 0.71 5 ID5 0.58 6 ID6 0.01 7 ID7 -0.13 8 ID8 0.01 9 ID9 0.27 10 ID10 0.33 ∑ λ1= 3.72

Decision

Reliability (λ²)

δ=1-Item Reliability

Included Included Included Included Included Excluded Excluded Excluded Excluded Excluded

0.4225 0.64 0.9604 0.5041 0.3364 ∑(λ²)= 2.8634

0.5775 0.36 0.0396 0.4959 0.6636 ∑ δ = 2.1366

AVE of ID = 2.8634/5 = 0.57268 CR of ID = (3.72)²/(3.72)² + 2.1366 = 13.8384/15.975 = 0.866254

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Table 5 shows the investment decisions (ID) standardized estimates and including or excluding of ten items of investment decisions (ID) in its CFA. For ten items of investment decisions (ID) factor loadings of five items are above 0.4 so five are excluded from questionnaire for final questionnaire and are practically significant. The loading factors values for included items are 0.65, 0.80, 0.98, 0.71, and 0.58. However AVE value for risk perception (PR) is greater than 0.50 which represents the observance of convergent validity. Similarly value of construct reliability for risk perception (PR) is above 0.70 which shows better reliability. AVE and CR values are 0.57268 and 0.866254 respectively. Movement of material like government bodies, media news made decisions, affects the prices of stock to move up or down. Stock investors make their investment decisions, because of this stock market behavior and because of new information, (Warneryd, 2001). The basic investment knowledge like information asymmetric, biases of investors’, and risk in the environment of investment for the investors should be required (Wang et al., 2006); therefore allowing them to rapidly obtain private information and make decisions based on accurate and fair stock market evaluation. Daniel et al. (2002) have also sustained that conventions of clearly reporting of complete related information, enhanced rules for enhanced knowledge and healthier disclosure of investment should be adopted. It is found in the previous research study that the investor’s level of risk perception plays a very significant part that influences an investor behavior about investment (Singh, 2010; 2008). Risk perception, as shown by Wang et al., (2006) in their study, played an important part in the psychological mechanisms of Chinese individual investors’ behaviors. Hence, for the constant and continuous stock markets development, investors’ risk perception controlling and management are considered to be very significant. Traditionally, problem framing impact has been assessed by using simple scenarios in very controlled settings, with the manipulation of losses and gains to decision makers made very salient. The current study implies that investor who wishes to either decrease or increase the risk taking attitude can successfully attain his aim by examining framing of problem and other risk perception determinants.

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 Conclusion Several researchers have focused on the direct influence of one or two elements of behavior of investor in risky conditions of investment but it does not completely reflect the complex set of effects on behavior of investor’s. Therefore, the key purpose of the current research study is to authenticate a scale of measurement for the main elements that affect investors’ behavior of risk taking. The main determinants of investment decision-making are propensity of risk, framing of problem, asymmetry of information and perception of risk. The instrument has been refined by using AMOS version 16, after applying confirmatory factor analysis and twenty two items are finalized of the initial instrument containing thirty nine questions. Risk perception have four questions, problem framing: have the five questions. There are three valid items of risk propensity, information asymmetry is refined by five items and the finalized statements of investment decisions are five. The good conclusion of our investigation is: investors act more rational than they are often said to; on risk preferences they base their decision, like risk perception and risk attitude and, at least those with a great financial literacy, behave in accordance to personal situations like their planned investment horizon or the invested amount. Future research may be conducted to test the model by using the data collected by this refined instrument in Pakistani Scenario.

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APPENDIX PSYCHOLOGICAL FACTORS AND INVESTMENT DECISION MAKING: A CONFIRMATORY FACTOR ANALYSIS SD= Strongly Disagree; D= Disagree; N=Neutral; A=Agree; SA=Strongly Agree Please Tick () your responses using the following scale: S.N Variables I Risk Perception: SD D N A SA I associate the word “risk” with the idea of 1 “opportunity” 2 I view risk in investment as a situation to be avoided I would show my willingness to take risks in financial 3 decisions Where there is risk involved, it is much more 4 acceptable if risk is confined to my potential for gains from taking the risk II 1 2 3 4

5

6

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Problem Framing: I feel investment losses are felt more than gains I will invest in a situation where there is relatively high potential that I will gain return on my investments If I am asked to choose between 50% chance to lose Rs.1000 and a 50% chance to lose nothing, I will choose the risky alternative. I feel the investment is risky if there is a 50% chance that my investment will earn a return below than what I have expected. If I have been given Rs.10,000 and two options to choose: A sure gain of Rs.500 OR 50-50 chance to gain Rs. 1,000 and to gain nothing. I will prefer first option. If I have to choose between „a sure gain of Rs.1000‟ AND „50-50 chance to lose Rs. 1,000 and to lose nothing‟. I will prefer second option.

SD D N A SA


III 1 2 3 4 5 6 IV 1 2 3 4 5 V 1 2 3 4 5 6

Risk Propensity: I avoid risk while choosing stock for investment I generally look for safer investments, even if that means lower returns I am willing to take substantial investment risk to earn substantial returns I prefer to invest in low risk / high return stocks with a steady performance I‟d rather take chances with higher risk investments than increase the amount I‟m saving I am prepared to opt for the possibility of initial losses in order to earn greater future returns

SD D N A SA

Information Asymmetry: Lack of knowledge about particular investments has an impact on investment decision making Information asymmetry does not exist in stock markets Information asymmetry has great impact on my investment decision I think individuals, who believe they have more knowledge of risk and risky situations, tend to undertake greater financial risks I think that people cannot detect omissions in risk information they receive

SD D N A SA

Investment Decisions: SD D N A SA Fluctuations in the stock market does not concern me I intend to put at least half of my investment money into the stock market I think the benefits provided by the company for making a risky investment affect the investment decision I would choose less risky alternatives to ensure financial security I would choose riskier alternatives to maximize potential gains My investment in stocks has demonstrated increased revenue / cash flow growth in past 05 years 83