Chapter 2 Literature Review has afforded the pertinent information which pertaining to the factors influencing the investors’ preference. In this chapter, every factor was discussed in depth and proved through other researchers’ opinions and findings.

Investors’ preference

Because of the global growth of economy, more people are involved in the investment nowadays. In recent year, a considerable amount of attention has been directed in the question of the investment behavior and portfolio performance of the investors. Due to the financial markets are expected to be volatile, this environment is prompting the investors to spread their investment and capital and to look for new asset classes that provide stability. The individual investors are searching for a type of investment which can satisfy their various requirements and the investors’ preference will influence the investors to choose the companies’ shares or bonds at the same time. Thus, the investors’ preference might be changed based on their own sentiments and requirements.

(Robert.A.Jarrow, 1988) has showed that:

Investors are assumed to have preferences defined over the traded assets. Choosing an arbitrary investor, his preferences are represented by a complete and transitive relation over M, denoted by p. Complete means that given any two traded assets x and y, either x p y or y p x. The symbol (x p y) should be read “x is preferred to or indifferent to y.” Transitive means that for traded assets x, y, and z, if x p y and y p z, then x p z. The preference relation p is said to be strictly increasing if for any traded limited liability asset m and any traded asset y,

(y + m) p y.

This statement reads that the portfolio (y + m) is strictly preferred to the portfolio y. This condition is justified by noting that since m is of limited liability,

P(y + m-y) = 1 and P(y + m > y) > 0

That is, the portfolio (y + m) dominates the portfolio y in terms of the asset’s payoffs at time.

According to (David Cass and Joseph E. Stiglitz, 1969) Tobin showed that under certain conditions the investor’s portfolio allocation decision could be considered as a two stage process: The investor first decides in what proportions to purchase the available risky assets, and then he decides how to divide his total investment between risky and safe assets. (Francisco J. Gomes, 2003) has considered a general equilibrium model with two types of investors: one type with power utility and another type exhibiting loss-aversion. Both of the risk and liquidity of investment play important roles in decision making of individual investors. Many people think that the higher the risk, the higher the return. But the higher risk of investment might perturb the investors as well. The investment with the great liquidity will let the investors gain their income and return faster and more effective. As a result, individual investors must act at their deliberation before choosing the investment which they want.

Besides, the empirical review of Franco and Merton clarified that the economic theorist concerned with explaining investment behavior at both the micro and macro 1evels. (Franco and Merton, 1958) They tended to push investment to the point where the marginal yield on physical assets is equal to the market rate of interest. This proposition can be shown to follow from either of two criteria of rational decision-making which are equivalent under certainty, namely (1) the maximization of profits and (2) the maximization of market value. Whatever type of investment they choose, they certainly want to get maximum profit from it. Investors’ preference and their decision making also depend on the profit earnings. The higher return rate can give the investors more confidence in investing their income and savings.

In addition, there are other factors will affect investors for their decision making. For instance, if the company or product’s reputation and image is great, investors will have more interest in that particular investment. Some investors make their choices through the brokers and agents’ suggestions. So those are the factors that we need to go through and explore why they will affect the investors preference and decision making.

Risk

There have many factors that may influence the investors’ decision making. Any stock markets are full of snares for individual investors. The risk or uncertainty is an intrinsic factor of investment returns. Risk is the chance of not fulfilling the investors’ investment objectives because of returns and profits uncertainty. So risk will be arises from the expected volatility in asset returns to put it away. Investors will face the risk unless they place their funds in a bank.

In accordance with (Frank and Edgar, 2006), risk sources can be classified as either systematic or asset- specific. Systematic risk affects the economic or financial “system” hence the name; its effect is pervasive throughout the economy. Examples of systematic risk include changes in interest rates, the economic growth rate or changes in taxes. Asset- specific risk deals with the characteristics of a type of asset or security issuer rather than broad economic factors. Examples of asset-specific risk include poor management decisions, labor strikes, deterioration of product or service quality, and the rise of new competitors.

In finance, risk is the probability that an investment’s actual return will be different than expected. This includes the possibility of losing some or all of the original investment. Some regard a calculation of the standard deviation of the historical returns or average returns of a specific investment as providing some historical measure of risk. (Wikipedia) On the other hands, individual investors also may face liquidity risk, the possibility of not being able to sell an asset for fair market value. A risky investment has let the investors to be in a blue funk. (Robert and W. Michael, 1990) pointed out that “futures are fast moving, risky investment vehicles that are unsuitable for anyone who can’t afford to lose and who doesn’t have time to pay close attention to trading positions.” Individual investors must think over their ability to afford the investment risk before injecting their funds into the stock markets. They are worry about making the improper decisions and suffering the losses. So they may compare the various types of stock and decide the lowest risk’s investment.

Investors can diversify the risk of any one risky asset by combining it with other risky assets in a portfolio. An asset will earn a risk premium only to the extent that it affects the uncertainty of the overall portfolio return. (Marc and Janet, 1983) The overall risk of individual investors’ investment can be decreased by forming well diversified portfolios. That is why the individual investors must prepare all the information before involving in the investment, form the portfolio in a desirable models. Because of this reason, some of the individual investors are become the risk- averse investors, prevent and avoid the investment risk thoroughly.

In consonance with (Eugene and James, 1973), investors are assumed to be risk averse and to behave as if they choose among portfolios on the basis of maximum expected utility. A perfect capital market, investor risk aversion, and two- parameter distributions imply the important “efficient set theorem”: The optimal portfolio of any investor must be efficient in the sense that no other portfolio with the same or higher expected return has lower dispersion of return. Risk aversion is the tendency of investors to avoid risky investments. Thus, if two investments offer the same expected yield but have different risk characteristics, investors will choose the one with the lowest variability in returns. If investors are risk averse, higher-risk investments must offer higher expected yields. Otherwise, they will not be competitive with the less risky investments. (David, 2003) So the individual investors will look into their investment portfolios’ details and select the most suitable, affordable and minimize- risk’s choices. The companies’ operation stabilization may reflect on their stock markets performance. Well performance can reduce their stock’s risk and give their stockholders a shot in the arm. A risky investment will let individual investors suffer the losses. Thus, risk-averse investors may choose the risk-free investment such as Treasury bills. (John Lintner, 1965) has shown that investors operating on his “Safety First” principle (i.e. make risky investments so as to minimize the upper bound of the probability that the realized outcome will fall below a pre-assigned “disaster level”) should maximize the ratio of the excess expected portfolio return (over the disaster level) to the standard deviation of the return on the portfolio.

The demographic of investors also will influence their alternative of risky investment. For instance, (Richard, Wilbur, Ronald, Gary, 1975) shown that married individuals appear to invest smaller pro-portions of their portfolios in risky assets than do single individuals, other things being equal. It may because they are necessary to ponder about their individual and household financial situation and go on the investment without giving rise to the financial problems. Besides, the younger people can withstand the riskier financial assets compare with the older one. Young people are more willing to take risk for earning the higher return and profit. Female are more discreet and will not input their funds rashly. But male are more audacious and they are able to take on their obligation to face the losses. In addition, the education level, occupation even the income also will influence the individual investors to make their decisions.

On the contrary, financial market decision maker and participants generally quote increased ‘risk appetite’ as a crucial driver of the recent downward trend yield spreads and risk premiums. Risk appetite is the willingness of individual or institution investors to bear and endure the risk. As reported by (Prasanna and Nicholas, 2005), risk appetite reflects investors’ willingness to hold risky assets and, as such, depends on their attitudes to risk as well as the size of other risks they carry on their balance sheets, such as that relating to employment. There have been concerns among policymakers that a build-up of risk appetite may have led to a ‘search for yield’, whereby investors demand more risky assets in pursuit of higher yields. The more risk you are willing to take, the more potential your savings have to grow over the long term. The risk appetite will be declined because of the contagion and financial instability. Besides, in adverse circumstances, the higher excess expected returns will be expected by the investors to keep each unit of risk and the risk appetite will be lower.

Return

The return of investment is one reason that affecting the individual investors’ preference. Investment return is the percentage change in value of the investment over a given period of time. Indeed, the potential return is the main consideration when choosing investments. It is because the higher the return, the faster the investments will rise and the sooner the target will achieve. But the higher the underlying returns also mean that the higher investment risk. The sources of investment returns consist of income and changes in price or value. The income includes the investment periodically generates cash for the investors in the form of bonus, interest, dividends, and etc. The changes in price or value are the market price of an investment asset can rise or fall over time. (Frank and Edgar, 2006)

Conforming to (W. Scott Bauman, 1969), the purpose for holding risky investments (as distinct from holding cash) is to receive an income or profit. Alternative objectives might possibly be stated: (1) to maximize the rate of return of capital over a time period by the assumption of some specified maximum acceptable level of uncertainty, (2) to obtain some specified target rate of return with the assumption of a minimum level of uncertainty, or (3) to maximize the investor’s present wealth by holding securities possessing an optimal combination of future returns and amounts of uncertainty. At the same time, the motives of investors in investing are to obtain returns and to restrict size of uncertainties related to such returns. That is why the individual investors would like to choose the higher return investment. They can earn the profit faster and more efficient through their investment portfolio.

The individual investors who choosing the investment portfolios depend on the dividend payout is called investor clienteles. (John and Alok, 2004) mentioned that firms attract investor clienteles based on their dividend payout policy. Firms that pay lower (higher) dividends attract investors who dislike (like) dividend income, and this creates the potential for an optimal match between the dividend policy of a firm and the dividend preferences of its stockholders.

The firms will give the returns to their shareholders in the form of dividend. (Malcolm and Jeffrey, 2007) described that Premium Dividend-paying stocks resemble bonds in that their predictable income stream represents a salient characteristic of safety. The first price-based measure we mention here is therefore the “premium” for dividend-paying stocks, which may be inversely related to sentiment. (Stephen and John,2005) showed that presenting past information in terms of fund values (based on an index) or percent returns or yields significantly affects the fund preference and risk perceptions of individual retail investors. Individual investors are concern about the investment performance and its profitability. They will find out the past performance of the investment and do the assumption about its future. Of course, the findings that past performance tells the investor little about the future apply to only to one characteristic of performance – the expected trend in return or yield. In contrast, past performance charts may be able to convey valuable information about other factors of performance including volatility, seasonality, and the risk of adverse movements. (Stephen and John, 2005) Individual investors may make their decision for choosing the investment portfolios based on that past performance and believe that profitability can maintain even mount up.

On the other hand, the investors demographic may influence the profit requirement as well. For example the age, sexual, status, income level and education level of investors. As stated in (Ming Dong and Chris, 2004), old investors, low-income investors, and investors without university education all have a preference for dividends because of transaction costs. On the other hand, young investors and investors with a high income and/or university education have less interest in dividends based on transaction costs. For each of these categorizations the difference in means between the groups is significant. For the income and education categories the difference in the median scores is also significantly different from zero. The authors also found that older investors consume more out of their regular salary than younger investors. Apart from the older and low-income investors it is clear that most investors do not consume out of their dividends. It may because of higher income and university education investors’ economic capability is likely better than others. So the dividends which pay from the firms may immaterial to those investors. According to(Wilbur, Ronald and Gary, 1977), the older the investor, whether male or female, the progressively less the reported interest in short-term capital gains as a portfolio goal. The research revealed that the concern with dividends increases with age but diminishes with family income level, and that at all income levels greater age produces greater expressed relative interest. Thus, an individual who already enjoys substantial annual income should have less need for additional immediate cash returns from his investment portfolio, and the heavy tax burden that would be imposed on those receipts further reduces their attractiveness.

Examining the determinants of investors’ changing style preferences, (Alok Kumar, 2009) found that those shifts are sensitive to past style returns, past earnings momentum differentials (EMDs), and the differential style-level sentiment shifts among investment newsletter analysts. Individual investors grow more bullish about the style that is favored relatively more heavily by newsletters in the previous month. This behavior generates a pattern of strongly persistent preference shifts that can be predicted using past style return differentials. Furthermore, the strength of return comovements within a particular style increases when investors move into or out of the style with greater intensity. Besides, the author found that those shifts are sensitive to past style returns and earnings differentials. Those changing preferences are also influenced by the differential style-level sentiment shifts among investment newsletter analysts. Investors will concern the investment past return rate and assume the future cash flows. Investors are looking forward to the funds which they injected can get a good deal of returns.

(Robert A. and Robert W, 1994) have described that competing theories have argued that investors seek investments that maximize geometric mean return. In this research, authors also made mention of Baker, Hargrove and Haslem find that investors behave rationally, taking into account the investment’s risk/return tradeoff. In this research, authors’ result showed that first; most of the variables ranked significant are classical wealth-maximization criteria such as “expected earnings,” “diversification needs” and “minimizing risk.” Second, however, no wealth- maximization criterion or any other item was considered significant by more than half the respondents. This confirms the impression held by many experienced retail brokers that investors employ diverse decision criteria when choosing stocks. Third, it is also apparent that contemporary concerns such as international operations, environmental track record and the firm’s ethical posture are given only cursory consideration by experienced stock investors, although some mutual funds specializing in such stocks have been successful in attracting investors.

Corporate image and reputation

In addition, the firm’s image and reputation may impact the investors’ decision making as well. A corporate image is representation which the company creates about itself with the help of advertising. It is forms favorable opinion at target audience. And it is opinion of consumers, clients, partners and the public about prestige of the company, quality of its goods and services, reputation of heads of the company. A corporate image refers to how a corporation is perceived. It is a generally accepted image of what a company stands for. Typically, a corporate image is designed to be appealing to the public, so that the company can spark an interest among consumers, create share of mind, generate brand equity, and thus facilitate product sales. Reputation is the sum of impressions held by a company’s stakeholders. In other words, reputation is in the “eyes of the beholder”. It need not be just a company’s reputation but could be the reputation of an individual, country, brand, political party, and industry. But the key point in reputation is not what the leadership insists but what others perceive it to be. For a company, its reputation is how esteemed it is in the eyes of its employees, customers, investors, talent, prospective candidates, competitors, analysts, alumni, regulators and the list goes on.(Wikipedia) The image and reputation on behalf of the company’s credibility and success. Incidents which damage a company’s reputation for honesty or safety may cause serious damage to finances.

A high goodwill and great reputation and image of the companies can give the investors more confidence to inject their funds. (Cathy, Cynthia and Naveen, 1995) An investor’s confidence in his expectations about the financial returns of a particular company’s stock becomes another variable of interest to us. Investors have a financial motivation for extracting the value of a brand name from the value of a firm’s other assets. As stated in (Jaakko and Henrikki, 2010), typical behaviors elicited by positive brand evaluations include purchase of the brand’s products and positive word-of-mouth about the brand. Nevertheless, the behavioral implications of affective (brand) evaluation have recently been recognized by investment psychology research, as well, with respect to individuals’ investment behavior. Individuals will use their overall, readily available affective impressions such as brand evaluations as mental shortcuts to reach decisions, especially when the required judgment or decision is complex and/or mental resources are limited – as is the case with investments. In the research of (Jaakko, 2009), the personal relevance that an investor attaches to a certain life domain has positive effect on his familiarity with products that are perceived to represent or support the domain. Besides, the researcher described that images and affective evaluations of companies may be a major basis on which individuals make investment decisions as well.

The corporate image and reputation also include the company product’s brand and performance. According to the research of (Jaakko and Henrikki, 2009), since companies can be considered to be represented as corporate brands in individuals’ minds, the discussion of brand relationships and attachments can inform finance about how individuals’ feelings and affect towards companies may be created. These potential sources of individuals’ affect towards companies imply that the means of traditional marketing of products and brands, including their development, design, and promotion – as well as favorable representation of the company through corporate communications, sponsorships, and public relations – are very important also in the sense of “marketing” the company and its stocks in financial markets. The promotion of company can increase the popularity and recognition of the company’s image and investors may feel more familiar to that company’s stock. A well-known company can raise the investor’s more confidence to invest into the company and let the investor easier to get the information.

Broker and Agent recommendation

Investment brokers are individuals who bring together buyers and sellers of investments. They need a license to operate. They act on behalf of buyers and sellers of stock. They charge a commission on trades that they execute on such instructions from buyers and sellers. (Wikipedia) The investment broker plays an important role between company and investors. Investment brokers arrange for the buy or sale of shares, bonds, and other securities on behalf of the customers. The brokers work with potential and current clients and suggest the best portfolios to invest in as well as implement risk strategies that may help the clients reach the investment goals. Through the maze of investment opportunities that are available, brokers steer customers to those that best suit their needs. Broker recommendation is an opinion given by an analyst to his/her clients about whether a given stock is worth buying or not. The analysts typically look at the company’s fundamentals and then build financial models in order to project future trends, most notably future earnings. They then use these projections as a basis for issuing broker recommendations on whether or not they think the stock should be bought or sold. Each brokerage has its own terminology, which makes it difficult to compare broker recommendations between brokerages, but the most common ratings are strong buy, buy, hold, and sell, also called recommendation.(InvestorWord.com) Some of the investors will ask the investor broker to give recommendation for investing. So the broker’s suggestions and advices also may alter the investor’s choices and decisions of investment.

(David and Jeremy, 1990) showed that investment decisions reflect agents’ rationally formed expectations; decisions are made using all available information in an efficient manner. The researcher described that investors may be reluctant to act according to their own information and beliefs, fearing that their contrarian behavior will damage their reputations as sensible decision makers. Investment decisions may require and expect different information inputs. A conservative individual investors will look into the company bonds and stocks’ information, take into account own financial ability and consider the risk before investing in. At this time, investment broker is a medium that provides the several of information and gives some recommendation for the clients. But the investors must be cautious when choosing the brokers because of the fraud and disloyalty. For instance, (Edward and Carl, 1973) has given the allocation practices of investment advisers have rarely been the subject of litigation, and even the litigated cases have generally involved situations where the adviser or the adviser’s personnel were dealing with information in a manner that benefited their own accounts on a preferential basis. It may cause the government regulates investment adviser distributes research information to clients to come under increasing scrutiny and criticism. Investors cannot believe the brokers absolutely and view with a healthy dose of reality. Use the recommendations to confirm the own research and company picking.

In accordance with (Robert A. and Robert W, 1994), the researchers found that there has the “”advocate-recommend” factor which may influence the individual investor’s preference. This factor includes purchase recommendations from broker- age houses and individual stock brokers. Recommendations from friends or coworkers marginally loaded on this factor as well. Each of these information sources could be construed as a recommendation from sources with vested interests in the investor’s ultimate actions. Although many investors obviously rely on professional expertise, most investors in the sample are apparently wary of these information channels. (Jiang, 1995) said that when the financial market is, a representative agent can be constructed whose marginal utility under the given process of aggregate consumption determines the equilibrium security. However, the preference of the representative agent is in general quite complicated even when the preferences of individual investors are simple. It should be derived from the primitives of the economy such as the individual preferences as part of the equilibrium analysis, instead of being assumed.

In the research of (Domenico and Fernando, 2000), the researcher showed that the representative agent’s utility function can be recovered from knowledge of the equity risk premium at the terminal date and obtained a partial differential equation that must be satisfied by the relative risk premium for it to be consistent with the representative agent optimally holding the risky asset.

Liquidity

Additionally, some of the investors may pick the company stocks and bonds based on the stock’s liquidity rate. Liquidity is the ability to buy or sell an asset quickly and in large volume without substantially affecting the asset’s price. Shares in large blue-chip stocks like General Motors or General Electric are liquid, because they are actively traded and therefore the stock price will not be dramatically moved by a few buy or sell orders. However, shares in small companies with few shares outstanding, or commodity markets with limited activity, generally are not considered liquid, because one or two big orders can move the price up or down sharply. A high level of liquidity is a key characteristic of a good market for a security or a commodity. Liquidity also refers to the ability to convert to cash quickly. For example, a money market mutual fund provides instant liquidity since shareholders can write checks on the fund. Other examples of liquid accounts include checking accounts, bank money market deposit accounts, passbook accounts, and Treasury bills. (AllBusiness.com)

(Dimitri, 2004) has described that illiquid assets become riskier, in the sense that their market beta increases. In this research, the researcher has showed that the investors have the strong preference for holding liquid assets. The researcher modeling investors as fund managers subject to performance-based withdrawals generates a natural link between volatility and preference for liquidity. During the volatile time, the probability that performance falls below the threshold increases, and withdrawals become more likely. Thus, managers are less willing to hold illiquid assets during those times. It is because longer the period of investment, the riskier the investor needs to bear. They cannot assume that the future situation of the financial market. If the financial market has a tremendous change, either rises or falls, may causes the investor bear the unnecessary losses and pay more fees on the transactions.

One of the factors leading investors to prefer the equity issues of firms is the concept of portfolio liquidity. Based on (Marvin, 1974) research, when other things being equal, it is easier to buy and sell a given dollar amount of an issue of high market value than one of low market value. Thus a portfolio may be more liquid if it is predominately made up of issues of high market value. However, market value by itself is a simplistic measure of liquidity. Proportions of the outstanding shares traded during a given period of time. And the measurement of liquidity is the turnover rate. The greater the turnover (other things being equal) the easier it is to buy or sell a given proportion of the outstanding shares. These measures may be used to gauge the liquidity of individual portfolios. That is why the risk-averse investor would like to invest Treasury bill rather than bond and stock. Investor can gain the profit and return faster and use it to repurchase other portfolio of investment. The investors can gain more money through this way and take on the less risk of the investment.