Financial Literacy And Portfolio Diversification Accounting Essay

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In the field of finance and economics, many of the theories have an underlying assumption that investors are rational. Rational investors are risk averse and make decisions to maximize their expected utility of wealth (Scott, 2009). The expected utility of an investor relates to the expected payoff of a particular decision. Rationality theory also assumes that investors are risk averse and they are constantly making a risk/return tradeoff. They want maximum return for minimum risk. But in reality, investors may not always act in a rational manner and there may be other factors which come into play when an investor is faced with decision making other than rationality. After all, humans are emotional beings and at times their emotions may play more of a role in decision making than rationality. Emotions can at times take over investor decisions and cause them to make decisions which are irrational. Such behavior is apparent in market bubbles such as the high-tech bubble and the more recent subprime bubble. Investors acted in an irrational manner first causing momentum and later a collapse due to panic. Such instances highlight the notion that investors do not always act rationally.

Our approach

To further investigate whether investors are always rational, experts in the field of accounting were interviewed. The interviewees have many years of experience in their field and have had the opportunity to interact with all types of investors over the years. The interviewees could draw conclusions with regards to investor behavior as a result of their observations over a long period of time. These conclusions can be fairly used to represent investor behavior in the real world and can be compared to the existing theory in regards to investors and rationality. From these interviews, many differences between theory and reality are highlighted as discussed in this research paper.

Decision Usefulness Approach

Rational investors will make decision based on the highest expected utility (Scott 2009) but uncertainty is one of their major constraints. Investors will use information as one of their resources to make decision and revise their decisions based upon latest information.

The information: Through our interviews we observed that investor believe that they need to know everything about a company, its product, its management, its workers, its market, the future and other options to invest. They want to take as much of the unknown out of the equation. This is consistent with the decision usefulness approach. In other words this is how rational investors should make their investing decisions. The conceptual framework uses the same approach regarding financial information. For example CICA Hand Book says "the objective of financial statements is to communicate information that is useful to investors......in making their resource allocation decisions and/or assessing management stewardship.(Section 1000, .15)" Similarly, FASB in SFAC 1 wrote that financial reporting is intended to provide information that is useful to investors and creditors in making business and economic decisions (SFAC #1, FASB 1978 p.5). Lastly both FASB and IASB, in 2006 said that "The objective of general purpose external financial reporting is to provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions (IASB 2006). This follows that from SFACs to IFRS all the standard setters agree and are convinced that investors are rational. Therefore, they want the companies to disseminate the required information through financial statements proper, disclosures and MD&A.

Market efficiency

According to Efficient Market Theory, investors are able to absorb every bit of information that they have access to. The theory also indicates that it is hard to outperform the efficient market since the share prices always reflect everything that is publicly available about the future prospects of a business.

Our interviews showed the investors do agree that markets are efficient and explained that this is the reason that they invest in these markets. Thus investors are convinced that markets are efficient long before they make an actual investment in the market. If a risk averse investor doubts the efficiency, he will simply stay out of the market. Thus the interviewees thought that investors are price protected by efficient market. Investors incorporate the available information to 'estimate' and 'project' the returns. Thus our interviewees viewed the investors as risk neutral as opposed to risk averse. They want to maximize their return simply by relying on the market. This observation is primarily inconsistent with rationality theory.

Time lag in financial information: Our interviewees were of the opinion that markets are more efficient than we probably think. Especially, in the long run. Their argument was that market incorporates the information today that will be reported on financial statements tomorrow. This observation is consistent with Capital Asset Pricing Model (CAPM) (Scott 2009) CAPM describes the relationship between the market price of a security, its risk, and the expected return on the security. The model assumes that investors are rational in terms of their expectations about the future. They know the market risk i. e. beta and the expected return on market. In an efficient market, the expected returns from any investment will be consistent with the risk of that investment over the long term, though there may be deviations from these expected returns in the short term. This response is also consistent with the BB study (Ball and Brown) (Scott 2009) that 'prices lead earnings'. The only difference that our experts did not realize was that over wider window, may be 10 years, the association between share returns and earnings increases as the window widens. Easton, Harris and Ohlson (1992) also found that when we widen the window effect of lag between historical cost earnings and security returns decreases.

Expected cash flow: Based on Lowenstein's paper (Lowenstein 2005), a rational investor will hold their shares on short term basis because investors can predict company's future cash flow in short term. Lowenstein believes that it is hard to predict long-term expected cash flow; it is argued that people will be better off if they trade in short-term period. Short-term investors have to be more careful as they can meet extreme cases such as stock market bubbles. Stock prices can increasingly rise above rational values and it is hard to predict when it will end. One of our interviewee's prefers to hold his shares in long-term period rather than short-term period, and he thinks that it is more rational to do so. Investors tend to hold long-term investment because they tend to buy shares in companies that have a long track record and pay steady dividends. Since rational investors are believed to trade at short-term period, and our interviewees believe that in order to be a rational investor, investors should trade their shares at long-term period; therefore, there are differences between what Lowenstein argued and our interviewee's response. Rational investors usually buy shares based on firm's future cash flow (Scott, 145); and it is hard to predict firm's cash flow in long-term period. Hence, Lowenstein argued that it is better to hold shares in short-term period rather than long-term period. Our interviewees prefer to use other resources to make prediction such as company's reputation, company's stability, and liabilities to assets ratio rather than calculating company's future cash flow. There should be no problem if some investors prefer to hold their shares on long-term period. Even though market price is fluctuating in significant percentage daily, however in long term period (10 years or more) shares prices will be increasing. Higher risk will produce higher return. Our interviewees, they compared between shares and bond in long-term period, the result is shares will produce more return than bond. It does not matter whether investors hold their investment long-term or short term; it is based on their strategy to get return. Rational investors have their own strategy for holding-period term.

Speculation and excess market volatility: But it is naïve for our investors to assume that markets are fully efficient. Actually, excess stock market volatility investigated by Shiller (1981) reduces market efficiency. Generally, most investors select conservative investments with low volatility, and hold their investments for the mid- to long terms whereas, speculative investors, want higher returns on their investments. In order to achieve higher investment results, these investors tend to choose investments with high volatility. Although the higher volatility increases the potential for profit, it is a high-risk investment and is subject to potential fraud. Speculative investors also tend to trade more frequently, the time frame and vary from a few months to hours. The reduced trading time frame produces greater opportunities to realize profits but also increases the potential risk for losses. As we can see, speculation, on the one hand, it has increased the potential for higher investment return, and on the other, it has increased the potential for losses. Speculative investors do not act in accordance with rational-investor theory and are not considered as rational players in the market.

Behavioral Finance

A major detriment to market efficiency is behavioral finance or heterogeneity of rational investors. For many decades, economists have argued and had doubts about the concept of a rational investor, a person that is logical and makes the right financial choices, maximizes his wealth and utility. But psychologists have found it the opposite as to why they are not rational investors.

According to the study known as the behavioural finance an average investor is filled with inconsistencies and irrationalities. Investors are human and it is not surprising that financial markets reflect human frailties. They point to the frequency with speculative bubbles have formed in financial markers, as investors buy into fads or get-rich-quick schemes, and the crashes with these bubbles have ended, and suggest that there is nothing to prevent the recurrence of this phenomenon in today's financial markets. They have come to conclude that there are certain characteristics that an average investor inhibits such as social, emotional and cognitive biases that cause him to act irrationally.

Subjective nature of utility: Utility derived from the use of same good can be different for different people. An example of such a situation can be derived from our interview. There was a case that an investor that held shares of a particular company which he and his wife had purchased together. But after the death of his wife, he continued to hold onto these shares regardless of the fact that the company share price was declining and the company was undergoing some serious financial problems. The investor continued to hold onto these shares because he had an attachment to them and to this investor, it made sense to hold on to the shares. It increased his utility. Now, from the viewpoint of a rational investor, this does not make sense at all and the appropriate action to maximize utility would be to sell the shares. In his particular situation, the investor did what maximized his utility. His decision was an emotional one and obviously not based on rationality.

Different reaction to same information: It is not unusual that investors have both under and over reactions towards financial information released and corporate event announcement. In some cases, even highly experienced professional analysts tend to over/under react to good/bad earning news. According to "Investor Reaction to Corporate Event Announcement: under reaction or overreaction", firms that announce a corporate event after the release of good news earn higher long-run abnormal returns than firms that announce the event after the release of bad news, and investors appear to under react to prior information as well as to information conveyed by the event (Glaser, Noth and Weber 2003). However, the author does not give exact reasons for why investors under react in such situations. The article also suggests that investors tend to overreact to long-term trends and under react to short-term financial information; it concludes that unanticipated changes in long-run profit opportunities appear to be the key to mis-reaction. Although mis-reaction often affects the short term market conditions and increases the market volatility, over the long term, after all the information available (ignore the impact of inside information) reflected into the market, the impact of investors' mis-reaction will decrease and eventually be eliminated if the market is efficient. This observation was consistent with single person decision theory (Scott 2009).

All investors are not identical. If they are given the same information, they will interpret it differently and as a result will act in a different way. This is because some conservative investor's underweight new evidence (Barberis, Shleifer and Vishny, 1998) and investors have limited attention (Hirshleifer and Teoh, 2003). Even though these inefficiencies exist it is still hard to make profit from them due to limitations to arbitrage.

As Mark Rubinstein found that even if markets are irrational because prices are too volatile relative to fundamentals, there may be no way an investor can use that information to make profits. Or if a stock is overpriced but there are significant obstacles to short-selling or significant trading costs, an investor may not be able to do much about it. (Mark Rubenstein) Thus markets are not perfectly rational they are at least minimally rational: although prices are not set as if all investors are rational, there are still no abnormal profit opportunities for the investors that are rational

Self Attribution Game: Investors believe that when decision turns out well it is because of them and when the actual return are below their expectation it is out of their control, for example the states of nature, error in the information , and lack of full closure.

Over-Confident and Intuitive Thinking: Investor are too self confident and tend to be opinionated about things that they are not well informed on and make decisions based upon their opinions. Though investors are known to take risks and play with chance, they over exaggerate their own skill and judgement. In an illustrative study, Fischhhof, Slovic and Lichtenstein asked people factual questions, and found that people gave an answer and consistently overestimated the probability that they are right. In fact, they were right only about 80% of the time that they thought they were (Slovic, 1977). One of the key indicators of this over confidence is merely psychological. Human beings seem to have a propensity to hindsight bias, i.e., they observe what happens and act as it they knew it was coming all the time. Thus, you have investors that claim to have seen the crash in dot.com companies in the late 1990s coming during earlier years, thought nothing in their behavior suggests that they ever did. This observation is consistent with Psychological Theory and evidence produced by Brad M. Barber and Terrence Odean that individuals are over confident.

Herd Behavior: The herd behavior can be described as a desire to be part of the crowd as a means of an investor not wanting to miss out on an opportunity. This can be seen in the past in such bubbles as the Gold Bubble, housing bubble. While there is a tendency to describe herd behavior as irrational, it is worth noting that you can have the same phenomena occur in perfectly rational markets through a process called information cascade. All too often, in investing, investors at early stages in the process (initial public offering) pile into specific initial public offerings and push their prices up. Other initial public offerings are ignored and languish at low prices. It is entirely possible that the first group of stocks will be overvalued, while the latter are undervalued. Since herd behavior is made worse by the spreading of rumors it can be said that irrational investors affect market prices.

Quick to trade: Average investor wants to make a quick return as quickly as possible. Whereby statistics have shows that if an investment is held on a longer term, chances of having a higher return are greater than for short term. Investors that sell winners too soon, fail to recognize that winning stocks that get sold early continue to go up for months after the sale. Many believe that the more options an investor has more chances they have of a higher return than expected but unfortunately more options result in an investor being more stressful and confused and leads him to make irrational decisions.

Representativeness Bias: Sometimes representativeness bias causes investors to give too much weight to recent evidence and too little weight to evidence from the past. Investors are also more likely to buy stocks that represent desirable qualities. It is not uncommon that investors confuse a good company with a good investment. Classifying good stocks as firms with a history of consistent earnings growth ignores that fact that few companies can sustain the high levels of growth achieved in the past. The popularity of these "good" firms drives stock prices higher until the stock becomes overpriced. Overtime, investors become aware that they have been too optimistic in predicting a company's future growth and later the stick price of the company falls. Investors also commit representativeness bias when examining past stock returns. For example, stocks with poor (strong) performance during the past three to five years may be considered losers (winners). Some investors consider this past return to be representative of what they can expect in the future. In other words, such investors tend to be overly optimistic about past winners and overly pessimistic about past losers. This may not always be the case, De Bondt and Thaler (1985) shows that the losers tend to outperform the winners over the next three years by 30% in terms of stock return.

Using past as perdition of future: One of our interviewees was of the opinion that he makes investment decisions based on companies that have very long track records and have survived almost all outside market conditions or interest bearing investments that take almost all volatility out of consideration. However, whether this observation is a departure from rationality is not clear since there is no exact definition about rationality. He indicated that investors behave as a 'satisfiers' (Simon, H.). They rely only on the firm history and assumed that history will repeat itself. If the firm survived tough times in past it will do so in future. The actual question that a rational investor should be focusing is how that survival was made possible. The only merit this observation has for rationality is that investors are interested in persistence of earnings. But this persistence should be viewed along with CAPM model. This prevents the investor from making the rational optimal decision but rather a decision that meets their needs and satisfies their requirements.

Sunk cost fallacy: We as humans are much more willing to claim our successes than we are willing to face up to our failures. Investors have a tendency to hold on to the bad ones and sell off the good ones too quickly. It is very widespread and can cause systematic mis-pricing of some stocks. To an average investor what he has paid for the investment/share is very important. If he had paid a lot for the investment he will tend to hold on to it. This is merely due to the amounts that was paid for it and are in denial in admitting that they were wrong in their decision. A rational investor would have sold of a bad investment that was not profitable or did not yield a high return as expected. This is also known as the sunk cost fallacy.

Risk aversion vs. Tolerable risk: We found that in case of our interviewees, they try to assess return based on worst case scenario, what they can afford to lose. For them the only prior probabilities have to be based on a long period of time. This observation is consistent with Kahneman and Tversky (1979) behavioral theory that investors evaluate their investing decisions in terms of their effects on their total wealth.

Positively biased information: Our interviewees were of the opinion that financial advisors/interviewees behave under the irrational force of greed, for self-preservation because they need to make the sale to keep their job, or to get the investors money for their company to go on. These financial interviewees were proven so flawed in this latest economic downturn/recession. Information received from financial advisors is always viewed by investors with skepticism. They think that investors are unduly optimistic about their predictions; hence they do not revise their prior probabilities on the basis of information received from financial interviewees. This is another characteristic of behavioral finance. If they had a bad experience with these financial interviewees and any information coming from there on would be treated as "lemons" by the investors. Thus investors are unlikely to revise their expectations about future even if the information coming from these interviewees is relevant. The response is consistent with DLM study (François D. Sinopia AM, Sandrine Lardic, Karine M), which sheds light on the existence of a positive bias in interviewee's anticipations. The study found the 'herding' and bias are two of the main characteristics of expert behavior. They concluded that if these two characteristics are not overcome the earnings forecast can not be improved.

Bounded rationality: According to the rational model, all possible alternatives should be evaluated before an investment decision is made. However, in many situations the existing environment may not allow investors to assess all the possible alternatives and these investors have to make their decision in a short period of time, some times within minutes. It seems it's easier to find decision processes which consider few alternatives than ones which consider many alternatives. Some investors do not search for different alternatives because they feel that considering multiple alternatives evoke uncertainty, and uncertainty reduces motivation and commitment (Baker and Nofsinger 2002). Big organizations generally experience more rapid investment decision making processes than individual investors, this is mainly due to the fact that an organization are often exposed to heavier market competitive pressure than individuals. The rapid decision making process increases the chance to catch new investment opportunities, but it also at the same time increases the investment risk because it does not give investors enough time to assess the validity of the new investment proposals. Rapid decision making process does not act in accordance with rational investor theory. This observation is consistent with game theories, 'bounded rationality' definition (Herber Simon), which states that most people are partly rational actually, 'satisficers', they accept what satisfies them. They do not look for optimal solution.

Ideologies that facilitate actions: Ideologies describe both how things are and how they should be, and these two aspects are often strongly interdependent. Organizational ideologies interrelate closely with decisions, since they make it easier for people to agree on what objectives to pursue. Many organizational investment actions do not follow formal decision processes; this may suggest that organizational ideologies, at least to some extent, causes irrational decision making (Basil Blackwell 1982). Ideologies which are clear, narrow, differential, complex and consistent can provide good bases for rational decision making because they solve a large part of the choice problem (Brusson, 1989). Belief in a dominant ideology is strong under normal conditions, and the dominant ideology is questioned during crisis. When members in the organization gradually lose faith in a dominant ideology, they replace it with another; a new dominant ideology maximizes an organization's ability to act. The way how an organization's dominant ideology may affect the organizational investment decisions, in some cases this dominant ideology can contribute to an organization's investment irrationality. It is also likely that ideology has impact on individual investor's investment actions, although the degree of its influence is not fully known.

A good example of personal ideology would be religious association. In some religions such as Islam, charging interest on loans is prohibited (The Quran 2:275). Thus a practicing Muslim might not invest in a bond market even if the returns in bonds are higher as compared to equity market. This will be a departure from rationality because rationality does not incorporate any personal biases such as religion; it focuses on risk and return.

Measurement Approach

Financial reporting is becoming more important as the market is not fully efficient. In theory, rational investors are believed to use financial reporting to predict future value of a firm because it is believed that investors may be less biased by using companies' financial report before making any decision. Furthermore, financial reporting may reduce inefficiencies of share prices. However, it is suggested that individual's attention are limited to some available result such as bottom line. This makes financial reporting market more inefficient and this is consistent in reality (Preda. P. 360). When we asked whether our interviewees study company's financial statement before making any buying decision, we found that they were not specifically concerned with an individual account but to look over several years to see any large changes in an account from one year to the next, interest in year to year income versus yearly profit looking for about the same profit margin. After looking at a glance in corporation's financial statement, investors will make decision by their analysis which may be biased. Investors may do analysis based on financial reporting such as ratio analysis instead of just seeing bottom line (Net Income) as indicator of how corporate is doing.

Portfolio diversification

Rational investors are assumed to be risk-averse (Scott, 2009); this is also true. Rational investors will be careful to make buying decision. One way to lower risk is by using portfolio diversification (Scott, 2009). It is assumed that the most efficient investment portfolio is the one that is fully diversified. An important result of this approach is that, while the portfolio return equals the weighted average return of the assets that form it, the portfolio risk is not, in general, equal to the average of the risks of the assets included in it. As such, adding differentiated assets to a portfolio makes it possible, in general, to reduce portfolio risk in comparison with the average risk of the assets which compose the portfolio.

However, our interviewees do not use portfolio to lower his risk; he believes unless it is educated diversification, to just spread your investment in different sectors does not protect one from making bad investments in each sector. For our interviewees, diversification will result in losing more opportunity and result in lower return. Investment diversification suggests that by investing your money in different area, when one area is in bad situation, other area will better off. However, investors have to remember market risk as well; it is one risk that cannot be eliminated. Last housing market crash is one of many examples that will give effect in all sectors; most of shares prices are going down in significant percentage. Therefore, our interviewees argued that if investors place their money in proper investments, risk is lower as money will move from one area to another to maximize profits; but in reality investors are not just lessening opportunities and losing less, when their goal was to make as much as they can. There is difference between theory and reality. One way to solve this difference is by buying different class of assets instead of different market shares. In individual shares, your return might be big or not at all. Diversified investment actually does important things; however, instead of diversifying investment at different shares in different companies; investors can diversify their investment through different capital assets, such as gold or currencies. In fact, when shares prices are decreasing, most of the time gold prices will be increasing. The supply and demand theory is taking position in this situation. When economy is doing bad and shares prices are decreasing, people will have more confidence to put their money in real thing such as gold given that stock is just a piece of paper that can have zero value anytime. Another way to solve this problem is by using replicating portfolio; a portfolio that is mixed between shares and risk-free asset.

Lack of knowledge in Portfolio diversification

Investors' financial information and financial literacy plays a major role in explaining investor behavior (Abreu, 2005). In his paper, Abreu sought to identify those factors that influence the level of financial knowledge of Portuguese individual investors and to investigate the relationship between financial literacy and the behavior of agents, by focusing on portfolio diversification. The results reported lead to conclude that there is a general problem of a low level of information amongst individual Portuguese investors. In fact, two out of three investors show that they have an insufficient level of specific knowledge about financial issues. It was also concluded that married men of around 44 years of age, with an intermediate or higher educational level, were those with a higher level of information. The results also showed that the portfolios of Portuguese investors were generally under diversified. The average number of assets in the portfolio was 2.6, and a significant number of investors held only one security. This finding is consistent with the findings of other studies for European countries (Eymann and Borsch-Supan, 2002), and reveals an even greater problem of under-diversification than the US evidence shows (Barber and Odean, 2000). Our results show that financial literacy matters as far as diversification behavior is concerned. It is possible to infer that both the level of specific financial knowledge and the general educational level of investors have an influence on the number of assets they held.

Conclusion

Based on our research, it has been concluded that investors are not always rational due to various reasons. The decisions they make are sometimes the result of emotional behavior rather than rational. Behavioral finance outlines the different types of emotional behavior investors can exhibit which can ultimately influence how they make their decisions. It is not uncommon for such behavior to exist such as greed, for example in the case of herd behavior; it is human nature to not want to miss out on an opportunity. But doing something just because others are doing it may not lead to a rational decision. At times human nature may cause individuals to take a particular action which may not be in sync with rationality.

At times investors may not even be aware that they are acting in an irrational manner. Investors believe that the decisions they make are rational even though they may be far from it. They have an internal bias of considering themselves as rational which they are unaware of. Such internal biases are difficult if not impossible to get rid of. As a result, these biases will influence investor decisions and they may not always end up acting in a rational manner.

Even though investors are not always rational, investors believe that markets are efficient in the long run. If this were not the case, they would not invest in the market at all. So although their own personal behavior may or may not be rational, they expect that in the long run the market will be rational. Investors have the tendency to view themselves as rational and this is also what they wish to be reflected in the markets. As a result, they believe that the market reflects their rational behavior and is efficient in the long run. This may the reason why investors choose to hold investments for the long term rather than the short run. Investors want to participate in an efficient market and since they believe that the market is efficient in the long run, they hold investments for the long run.

In the short run, irrational investor behavior can cause glitches in the efficient market. Market bubbles are examples of short term inefficiencies in the market. But over the long run, irrational investors are cancelled out and only the rational investor behavior will be reflected in the market. This is why investors that view themselves as rational will invest for the long run when they believe their own rational behavior will be reflected in the market. Taking this into consideration, it is apparent that theory does not necessarily represent reality as investors in the real world are not always driven by rationality but rather by their personal emotions such as fear and greed.

References:

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