Which factors guide investors' decisions on asset allocation?

By LARRY SWEDROE

The financial literature is filled with a “zoo” of theories about investor motivations and beliefs that affect asset prices. However, testing these theories with observational data has been difficult. James Choi and Adriana Robertson contribute to our understanding of what criteria are important to individuals when they make investment decisions with their September 2019 study, What Matters to Individual Investors? Evidence from the Horse’s Mouth.

In order to test key assumptions of leading theories about investor motivations and beliefs, Choi and Robertson asked a nationally representative sample of 1,013 U.S. individuals in the RAND American Life Panel (ALP) how well leading academic theories describe the way they decided what fraction of their portfolio to invest in equities, their beliefs about actively managed mutual funds and their beliefs about the cross-section of individual stock returns. Thus, their survey measures how individuals consciously perceive themselves to be making financial decisions. They noted this caveat: “High-wealth investors constitute only a small fraction of our sample, so our results are more informative about individual choices and beliefs than asset prices.”

Among their findings was that there is substantial support for many of the factors that are consistent with financial theory in how they affect portfolio equity share. For example:

48 percent of employed respondents say the amount of time left until their retirement is a very or extremely important factor in determining the current percentage of their investible financial assets held in stock.
Other factors rated as very or extremely important are health risk (47 percent of all respondents), work income risk (42 percent of employed respondents) and home value risk (29 percent of homeowners).
36 percent report that the amount of financial wealth they have relative to expected future wages is a very or extremely important factor.
Discomfort with the market is a very or extremely important determinant of equity share, citing lack of trust in market participants (37 percent), lack of knowledge about how to invest (36 percent) and lack of a trustworthy adviser (31 percent).
Having enough cash on hand to pay for routine expenses (47 percent) and concern that stocks take too long to convert to cash in an emergency (29 percent) are salient.
45 percent describe concern about economic disasters as a very or extremely important factor. There is also significant evidence for the importance of long-run aggregate consumption growth risk (30 percent), long-run aggregate consumption growth volatility risk (26 percent), consumption composition risk (29 percent) and loss aversion (28 percent).
35 percent describe the stock market’s contemporaneous return covariance with the marginal utility of money — the fundamental consideration in many modern asset pricing and portfolio choice theories — as very or extremely important. Similar numbers describe return covariance with contemporaneous aggregate consumption growth (30 percent), with contemporaneous aggregate consumption growth volatility shocks (29 percent) and with their own marginal utility of consumption (29 percent) as very or extremely important.

Following is a summary of other key findings:

Despite evidence to the contrary, 46 percent of individuals tend to believe that past mutual fund performance is a strong signal of stock-picking skill.
Despite evidence to the contrary, individuals believe that actively managed funds do not suffer from diseconomies of scale.
High-wealth respondents are substantially more likely than low-wealth respondents (56 percent versus 41 percent) to believe that high past returns are strong evidence of skill, and are moderately more likely to believe in decreasing returns to scale (25 percent versus 15 percent).
27 percent of active fund investors say that a hedging motive — the belief that the active fund would have lower unconditional expected returns than the passive fund but higher returns when the economy does poorly — was very or extremely important. Again, there is no evidence to support this belief.
Individuals tend to believe value stocks are safer than growth stocks (44 percent versus 14 percent who believe the reverse is true), though they believe they do not have higher expected returns.
Individuals tend to believe that high-momentum stocks are riskier (25 percent versus 14 percent who believe the reverse is true) and have higher expected returns.
Stock market returns before the respondent’s birth, advice from peers and media, rules of thumb and a failure to follow through on intentions to invest in stocks are particularly unlikely (16 percent of respondents or less) to be rated as very or extremely important.
49 percent of nonparticipants say their wealth being too small to invest in stocks is a very or extremely important factor. Surprisingly, 19 percent of nonparticipants with at least $100,000 of investible assets feel this way.
Consistent with theory, people are much more likely to report decreasing their equity allocation or becoming less likely to invest in equities rather than increasing their equity allocation or becoming more likely to invest in equities in response to a fall in their material standard of living compared to what they are used to (42 percent versus 8 percent), or a fall in their material standard of living compared to what everyone around them has experienced recently (47 percent versus 12 percent).

Summary

In their survey of primary household financial decision-makers in the U.S., Choi and Robertson found that individuals consider a wide variety of factors that have been hypothesised in the academic literature when deciding what fraction of their portfolio to invest in stocks. They found particularly strong support for background risks, investment horizon, rare disasters, transactional factors and fixed costs of stock market participation. Many other factors garner significant support as well.

The largest drivers of investing in active equity mutual funds are, contrary to the evidence, a belief that they will provide higher average returns than passive funds and the advice of a professional investment adviser.

Households also tend to believe that past fund performance is a good signal of stock-picking skill. Again, this is contrary to the evidence. In addition, they do not generally believe that funds suffer from diseconomies of scale. This too is contrary to the evidence.

Regarding the cross-section of stock returns, households tend to believe that value stocks will be safer and (contrary to historical data) do not have higher expected returns, and that high-momentum stocks will be riskier and (consistent with historical data) have higher expected returns.

Are your beliefs consistent with economic theory and the evidence?