Understanding the Investor

A Maltese Study of Risk and Behavior in Financial Investment Decisions

Antonietta Bonello, Simon Grima, Jonathan Spiteri

• Publisher: Emerald Publishing Limited
• Year: 2019
• Print ISBN: 9781789737066
• eBook ISBN: 9781789737073
• Topic: Personal Development
• Subtopic: Investments & Securities

In finance, understanding investors and their motivations is key for any business and policy-maker. Analyzing financial decisions and investor behavior can shed light on the major characteristics and variables behind trading decisions, giving researchers and investors a better understanding of the influences that affect the stock market. 

Understanding the Investor: A Maltese Study of Risk and Behavior in Financial Investment Decisions offers a nuanced view of the Maltese investor and the Malta Stock Exchange. In this in-depth study, author Antonietta Bonello explores the major risk appetite and tolerance characteristics of decision-taking for local financial investors. With foreign direct investment (FDI) growing by around 21% between 2014-2017, Malta's investment activities can be seen and used as an example of actual investment decisions taken by active investors. Looking across investor expectations, return of income, risk and loss aversions, disposition effect, financial literacy and overconfidence, Bonello offers an exciting perspective on investors in Malta, and the implications of this on the wider financial world. 

For individual investors and researchers in the area of personal finance, this new case study offers an in-depth look at investor behavior, allowing readers to understand the motivations behind emerging investment trends and to draw far-reaching conclusions on how best to prepare for upcoming challenges in financial investment.

Chapter 1

An Introduction

Background to the book

Determining factors and traits in decision-making is a subjective matter, and researchers differ in their views as to what constitutes a “factor” in the investor’s decision-making, especially with issues concerning the investor’s behavior (Klement, 2015). Understanding the profile of an investor involves more than just studying his/her portfolio. It requires a deeper analysis of his/her needs, expectations, knowledge, fears, and perceptions both in terms of return on investment and in terms of risk. This is because emotions are said to be linked with trading performance (Lo, Repin, & Steenbarger, 2005) and concepts of volatility, tolerance, and risk take a new dimension when dealing with human emotions, fears, and personal experiences (Mooreland, 2014).

Investors’ profiling thus becomes a very important aspect of retail wealth management. For the retail investor, every financial decision carries an element of risk (Riffin & Ahmad, 2012) which can bring high profits or equally high losses, hence, the need to gauge and evaluate each decision. Through risk profiling, one can obtain the optimal level of investment risk acceptable to the investor, taking into account all the factors affecting the asset risk, the investor’s risk appetite, and the investor’s risk capacity (Klement, 2015).

Traditional theory has indicated that the investor is (1) “completely rational,” (2) able to deal with complex choices, (3) is risk averse, and (4) wants to maximize his/her own wealth (Fama, 1970; Baker, Hargrove, & Haslem, 1977; Christie & Huang, 1995; Devenow & Welch, 1996; Von Neumann & Morgenstern, 1944). Rational investors are known to assess the risks and returns of available investments to obtain the investment portfolio that best suits their objectives (Barber & Odean, 2011; Rabin, 1998). Yet investors are not always rational as evidenced by the studies of Kahneman and Tversky, (1982), Tversky and Kahneman (1992), and Shleifer & Summers (1990).

The most common rules of the theory (of rational choice) are commonly violated by decision makers. (Tversky & Kahneman, 1986, p. 252)

Instead of the ideological investor following normative behavior, modern theory sees investment decision-making as a “maximization process” (Tversky & Kahneman, 1986, p. S251), a process based on options, preferences, expectations, and evaluation.

Every person is faced with different amounts and kinds of risks (Lunt, 1996) and every investor ascribes a weight or value or level of risk to each variable effecting a decision, with the aim of either maximizing gains or minimizing losses (Tversky & Kahneman, 1992). Similarly, every individual absorbs the same given risk or prospect differently depending on how one “represents” the problem, limitations, and objectives and lastly on the context in which one evaluates the risk (Tversky & Kahneman, 1992).

Thus, financial choices would depend on one’s objectives and perception of risk and on one’s evaluation of the possible outcomes or prospects. Concurrently, the possibility of a loss looms over the prospect of a gain (Rabin, 1998), and investors seek refuge in practices of their own making in an attempt to safeguard themselves from loss (e.g., cutting losses when an investment underperforms, being risk averse in probabilities of gain and becoming risk takers when faced with a possible loss) (Rabin, 1998; Toma, 2015; Tversky & Kahneman, 1992).

In pursuing their objective, investors adopt different strategies. Some use models to explain and predict asset prices (Kraus & Stoll, 1972). Other investors focus on risk, and investment performance (Modigliani & Modigliani, 1997), while others still, try to predict outcomes (Black, Jensen, & Shleifer, 1972; Sharpe, 1964). In the process, some aspects are common to a multitude of investors For example, many investors are motivated by portfolio diversification, generation of new cash, and/or straightforward speculation (Entrop, Fischer, Mckenzie, & Wilkens, 2016). Other common considerations include dividends, expected returns, and the firm’s financial stability (Baker & Haslem, 1974; Entrop et al., 2016).

Similarly, some factors such as return on investment, available income, time horizon, and benchmarks affect the investor’s risk tolerance (Barberis, 2000; Entrop et al., 2016; Rabin, 1998; Tversky & Kahneman, 1979), while past experiences, perceptions, and expectations determine the investor’s behavior to risk (risk appetite) (Barberis, 2000; Cervellati, Ferretti, & Pattitoni, 2014; Furtenberg, 1990).

In turn, both risk tolerance and risk appetite are influenced by other factors, such as information at hand, marketing, advice received, and the country’s culture (Barber & Odean, 2001; Black, 1986; La Blanc & Rachlinski, 2005; Shleifer & Summers, 1990). These last factors are external to the financial and personal aspects of the investor, yet still have a significant weight on the outcome of the investor’s decisions. Ultimately, the outcome of one decision is likely to have an impact on the investor and, by consequence on his/her future decisions, thus creating a vicious circle of experiences, decisions, and outcomes (Grima, Romānova, Bezzina, Chetcuti Dimech, 2017; Raab, 2003).

Thus, it can be seen that investor behavior need not be rational nor predictable. Nonetheless, behavior reflects the sentiment of the investor at that point in time and, consequently, has an impact on the investor’s decision-making, also leaving ripple repercussions on market liquidity and asset pricing (Amihud, 2002; Liu, 2015; Shleifer & Summers, 1990). Taking the right decision is very important in investment as it would reduce possible future losses and increase future returns (Alaf & Sarwar, 2016; Baker & Haslem, 1974; Entrop et al., 2016; Raab, 2003; Tversky & Kahneman, 1979; Veld & Veld-Merkoulova, 2008).

All decisions involve risk: the greater the risk, the greater the probability of gains or losses (Barber & Odean, 2008; Merton, 1969; Okuyama & Francis, 2006; Tversky & Kahneman, 1979). Moreover, the perception of what constitutes a risk and the gravity of the risk differ by gender (Barber & Odean, 2001; Croson & Gneezy, 2009; Hallahan, Faff, & Mckenzie, 2004; Kasilingam, 2013; Merkle, Egan, & Davies, 2015), race (Finucane, Alhakami, lovic, & Johnson, 2000; Montalto, Gutter, & Fox, 1999; Praba, 2011), age (Palsson, 1996; Purkayastha, 2008; Reyna, 2004; Viceira, 1999), and status (Baker & Haslem, 1974; Barber & Odean, 2001; Praba, 2011; Purkayastha, 2008).

In summary, the financial sector offers multiple opportunities but when faced with choices and risk, matters become more complicated and different people tend to make different decisions (Paulsen, Platt, Huettel, & Brannon, 2012; Reyna, 2004; Warren, 1990). The risks taken up by investors need to be understood and managed in the best interest of the same investor and of society as a whole (Pompian, 2016). There are various factors or issues that can influence an investor’s ability and willingness to risk. Modern theories show that such factors can be economical as well as behavioral (Nevins, 2004).

The reasons behind researching the Maltese investor trading on the Malta Stock Exchange

This book will be analyzing aspects of decision-making and risk management practices adopted by the Maltese investor trading on the Malta Stock Exchange (MSE).

Malta, a small island state situated in the heart of the Mediterranean, has a population of over 430,000 people (National Office of Statistics, 2016). Like other “small states,” Malta faces “special handicaps and (is) economically vulnerable to external shocks as a result of (its) small size” (Kisanga, 2004). Small size and insularity expose small states like Malta to particular hardships and “negative impacts.” These setbacks arise from their inherent characteristics and trade openness that leaves the small states highly dependent on the outside world (Briguglio, 2015).

Though considered a micro state, Malta “has never resigned itself to smallness” (Pace, 2006, p. 33), and has developed “appropriate economic policies that have been instrumental in enabling … (it) … to cope with some aspects of … (its) … inherent vulnerability” (Kisanga, 2004). This was done by taking advantage of the requirements for membership into the European Union to restructure the economy and increase efficiency through internal competition, diversification, and updated regulation (Pace, 2006). Though run by a centralized government, Malta’s Constitution provides for various checks and balances that promote democracy, and accountability (Pirotta, 2001). Moreover, local firms have developed effective “risk management mechanisms (that) allow for a strong risk culture, defined risk management goals, accountability and continual improvement” (Bezzina, Grima, & Mamo, 2014, p. 587).

The largest in an archipelago of five small islands, Malta is a reputed platform for international businesses and is known to offer “stability, predictability, and security” (Finacemalta, 2014). Malta is said to be among the top six countries to have a “highly stable” banking system that, since 1970 has been both credit abundant and crisis free (Calomiris, 2015). Assets of local banks represented 56.8% of Malta’s GDP in late 2015, while those of the core domestic banks accounted for 23.8% of GDP (Grima, Romānova, Bezzina, & Chetcuti Dimech, 2016; MFSA, 2016).

After joining the European Union in 2004, Malta “prides itself on being one of the best performing Eurozone economies, registering healthy economic growth and low unemployment” (Financemalta, 2015, p. 7). Though being the smallest economy in the Union, Malta has been resilient in the face of adversity and global recession. Low debt to GDP ratio, sound financial and banking sectors, good governance, and plenty of flexibility are the factors that make Malta a “self-made,” consistent success story in the resilience index (Briguglio, Gordon Cordina, & Farrugia, 2006; Briguglio, 2015).

Malta stands alone as an oasis of financial prosperity in a Europe desiccated by the financial crisis. From a financial standpoint, Malta is proof that you do not have to be a big country to be a big player. (FinanceMalta, 2015, p. 7)

Malta’s financial market is a key pillar in the island’s economy, accounting for 13% of Malta’s GDP and providing employment for 10,000 people (FinanceMalta, 2015).

The MSE in particular has earned a high reputation for itself and for the country. Currently, processing over 30,000 trades per year, the MSE’s performance over the past 25 years has been more than just positive. Since the turn of the century, MSE annual turnover has doubled and market capitalization has tripled (Table 2.5).

This level of confidence in the market by investors combined with the increasingly entrepreneurial private sector has created an environment that allows the capital market to co-exist with the traditional banking sector. Pace (2016).

MSE Index is said to be one of the world’s best performing indices (Pace, 2016). Thus, it is not surprising that the Maltese financial sector has recently been recognized as the “Best International Financial Centre” for 2017 (FinaceMalta, 2017).

To this author, choosing Malta as the ground for this book was not simply a convenience sampling technique deemed to facilitate work and reduce research costs (Saunders, Lewis, & Thornhill, 2016). Irrespective of the familiarity and convenience aspect, the author has chosen Malta because it sets an example in financial markets and is a good model for research.

Statement of the problem

Financial services in Malta have been set up in the 1980s with the formation of a financial services center. Actual trading operations as a platform commenced in 1992 with the setting up of the MSE. As young as the Maltese financial market is, local financial risk profiling is a relatively new concept. Existing local literature includes studies associated with pension funds (Aquilina, 2013), hedge funds (Meilak, 2015), protection of the investor (Grech, 2012), investor’s confidence in investment services (Scicluna, 2014), and investor perceptions (Xerri, 2015; Zammit, 2016). Moreover, the existing local studies cover one or two variables at a time, but do not present a holistic profile of the local investor and of his/her willingness to risk. With this research, the author aims to fill this gap by delineating, as much as possible the many factors underlying the local investor’s decisions and by producing a valid, in-depth, and reliable database of results that presents a clear and detailed profile of the Maltese investor trading on the MSE.

Aim and objectives of the book

This book focuses on the investor, his/her choices, the reasons and risks behind these choices, and the effect of these choices on the investor’s portfolio. Many of the factors have already been discovered in existing literature, some having been the basis of new theories. The scope will now be to determine which of these known factors pertain to the Maltese investor and to possibly uncover new variables. The book also seeks to find out whether the difficulties faced by investors as depicted in literature are evident with the local investor, particularly in terms of women’s participation in financial investment.

Previous studies revolve around the Maltese investor’s risk appetite and tolerance and/or the investor’s portfolio. With this research, the author aims to take a more holistic approach into the study of the Maltese investor by analyzing his/her profile, habits, behavior, needs, fears, expectations, tolerance, and perceptions. In combining the aspect of the investor as a “human,” to the analysis of his/her “monetary” portfolio, this research will be providing a better understanding of the investor’s preferences (Kahneman & Tversky, 1982); his/her risk profile and the resulting outcome on the investor’s performance and on the local trading market.

Another objective of this book is to address directly and solely the Maltese investor. By addressing active investors, the researcher will be seeking answers directly from the “source.” In addition, this strategy aims at reducing the fallouts of replies by non-investors, whose replies would distort the results and interfere with the scope of the research: namely to delineate the profile of the Maltese investor.

This research will possibly determine how far a Maltese investor is likely to go in terms of investment risk and also how s/he relies on the guidance of his/her financial advisor. The research shall consider the perceptions of the individual investor on the current advisory services, to then question how financial advisors and brokers are using their privileged position.

Another aim of this book is to change the focus from the normative view of investor finance (what an investor should do) to a positive perspective showing what the Maltese investor actually does in this current age and why she/he does so (De Bondt & Thaler, 1994; Jensen, 1993; Kourtidis, Sevic, & Chatzoglou, 2011; Nofsinger, 2014).

The research questions

(1) What are the determinants behind the Maltese investor’s buy-and-sell decisions and what impact do they have on the investor’s risk appetite and tolerance?

(2) How does the role of the financial advisor effect the financial decisions of the Maltese investor?

Propositions

The following are a number of propositions the author will use to uncover some of the factors underlying the investor’s risk appetite and influencing the investor’s decision-making.

(1) Expectations and Perform...

Table of contents

• Cover
• Title
• Chapter 1. An Introduction
• Chapter 2. Literature Review
• Chapter 3. Methodology
• Chapter 4. Analysis
• Chapter 5. Conclusion
• Appendices
• References
• Index