Influence of Psychological and Behavioral Aspects of the Individual on Exposure to Herd Investing

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Table of Contents

Psychological and Behavioral Biases of Individual Investors
Herd Behavior
Gender and Herd Behavior of the Investor
Experience and Herd Behavior
Demographics and Herd Behavior
References

An academically correct strategy for researching conceptual, theoretical ideas and the practices of their actual implementation is an extensive literature review combined with a critical analysis of the sources found. This synthetic method aims not only to systematize the available information but also to study in-depth the most relevant trends in the chosen field of knowledge. Given the high relevance of the general topic of this research work, the literature review will cover the mentioned advantages and qualitatively increase the level of reliability of the material.

Of primary importance is a broad discussion of the agenda, which served as the foundation for choosing the topics of this review. It should be recognized that the economic sciences have always been associated with the economic activity of the individual since at the core of any decision is a balance between profitability and costs. By now, it has been repeatedly recognized that an individual’s economic decisions should maximize benefits, but actual actions are often inconsistent with this belief (Al-Tamimi, 2006). On the contrary, individuals or groups tend to be guided by a broader set of factors and driving forces that determine decision-making strategies. Obviously, in the field of investing, these aspects play a crucial role since the proper management of the subjective, group and moderating aspects ultimately determines the investor’s performance.

The recognition of this fact served as the starting point for the creation of a new area of economic science called behavioral finance. In more detail, Amin & Pirzada (2014) recognized this type of financing as a natural form of behavioral economics development, in which personal beliefs and psychological factors determine the investor’s development vector. Thus, behavioral finance is appreciated as a relatively new branch of knowledge, and therefore it has not yet been critically examined within investment theory (Ahmad et al., 2017). Nevertheless, ignoring such important categorical influences in the study of investment procedures is a mistake and, therefore, should be measured in detail in this review.

Psychological and Behavioral Biases of Individual Investors

The study of psychological and personal behavioral biases that characterize an individual’s activity as an investor is of profound importance in the development of the indicated problem. In fact, researchers have repeatedly noticed the diversity of effects that have the potential to determine the financial literacy and investment efficiency of an individual investor. Thus, Dierick et al.’s scholarly work (2019) showed a negative relationship between investor mindfulness — and thus personality traits — and the use of disposition effects. It follows that improved personal awareness of financial literacy prevents rash and impulsive decisions related to the instant desire for short-term gains. On the other hand, Mahalakshmi & Anuradha (2018) studied that personal investor involvement and interest had a mediating effect on economic decision making, but nevertheless, it did. At the same time, Anjum et al. (2019), who studied the development of the psychological theory of investing, assessed a strong correlation between psychological factors and investor personality traits and their trading behavior. More specifically, it was shown that overconfidence and low self-control coupled with an individual’s openness to experience and general extraversion had a strong influence on the intensification of the disposition effect: the same findings were supported by Madaan & Singh (2019). Similar results were presented in Bakar & Yi (2016), who also argued for a strong association between individual overconfidence and risky economic decision making. Moreover, as was shown in the study of Koebel et al. (2016), such overconfidence is inherent in a large number of investors targeting significant returns, regardless of gender. According to Koebel et al., the nature of self-confidence is challenging to understand, but it has its origins in the development of an individual’s self-esteem. Specifically, the higher the self-esteem, the higher the self-confidence, and thus the higher the likelihood of ill-considered investment decisions. Din et al. (2020) drew attention to a similar relationship for the Islamic context, arguing that self-esteem combined with the illusion of control and access to broad information can be predictors for the development of herd behavior in investors.

It is interesting to note that researchers have repeatedly raised the issue of the connection between an individual’s psychological biases and personality traits. For instance, Malik & Elahi (2014) highlighted greed as the main driving force in the adoption of riskier ideas, which means that greedy investors tend to follow the ideas of the majority without critical reflection blindly. A study by Sahi (2017) supplemented this thesis with ideas about mentorship: the authors showed that dependence on experts has a positive effect on the level of financial satisfaction, which means that an indirect link can be seen between satisfaction and herd behavior. Taken together, the works mentioned above suggest that a bias effect in the implementation of investment strategies is present, and its categorical study is of priority value for this review.

H1: Psychological and behavioral biases have implications for investor trading behavior.

Herd Behavior

As it is known, the commercial success of trading in the stock markets depends not only on the investor having pronounced financial competence but also on the effect of crowd pressure, called herd mentality. Although biologically, this factor can be characterized as a natural urge of an individual to solidarity and grouping, within the framework of making critical investment decisions, the use of this mechanism might be a wrong strategy. In the context of behavioral finance, the herd behavior of an investor is appropriately perceived as a desire to follow the decisions of the crowd without a critical reflection on the benefits of one’s own actions.

The phenomenon of herd behavior causes an entire market to move in only one direction. In terms of investing, when one group starts selling shares of a particular company, herd behavior kicks in, and almost all individual investors try to follow the institutional ones, as confirmed by Merli & Roger (2013). In doing so, there is a legitimate effect of a stock price drop due to mass selling. Although the reason why the first group started selling the stock may be rational or irrational, herd followers seldom check the facts and blindly follow the herd (Nofsinger & Sias, 1999). This, in most cases, drives the market in one direction for no particular reason or reason. As shown by Madaan & Singh (2019), this statement is especially true for private, individual investors, who traditionally have limited knowledge and are more likely to make psychologically-based mistakes compared to institutional investors and entire funds. Nevertheless, earlier works by academics — and Grinblatt et al. (1995) in particular — make it clear that the existence of market funds, by contrast, is capable of triggering herd behavior. Such results have been derived from a study of the entrepreneurial activity of funds: in an attempt to perform more profitable actions, funds tend to buy the same securities continuously. In turn, individual investors have been shown by Nofsinger & Sias (1999) to tend to repeat actions after large institutional ones, which generates waves of herd behavior. Taken together, this leads to the conclusion that the phenomenon of herd behavior is crucial to individual investment decisions.

A fair strategy for a literary review implies a critical reflection on the sources found, and so it is appropriate to show some papers whose results contradicted the above evidence. In particular, Bakar & Yi (2016) showed that herd behavior had no effect on investment decisions in the Malaysian stock market context. This relationship has also been studied by other authors, and Alquraan et al. (2016) showed that herding behavior had less influence on investment decision making than other factors (which included behavioral aspects). Finally, in the context of the Arab market, Din et al. (2020) demonstrated that low financial literacy is the primary source of the desire to follow the crowd, and hence for regions where literacy is high, there may be a low herd behavior effect.

H2: Herd behavior in the stock market has a significant impact on the individual investor.

Gender and Herd Behavior of the Investor

On the question of investigating the relationship between investor behavioral characteristics and exposure to herd behavior, there are several categories, separate consideration of which is essential for making final decisions about the relationship of the variables in question. A great deal of academic material is based on the belief that investor gender identification is a crucial aspect of trading behavior. In more detail, Baeckström et al. (2021) showed a difference in behavioral investment strategies between men and women. Women tend to invest more in foreign exchange markets, while men are more likely to buy company securities. These claims are supported by a study by Barbeer & Odean (2001), which showed that women, in general, tend to do better in securities trading. Moreover, if a male individual female investor acts as a financial advisor, the decisions of this combination of individuals are characterized by less awareness and more risk than if a female advisor acts as an advisor. Consequently, this combination is more likely to follow herd behavior.

In general, the recognition of men’s riskier trading behavior is often traced in the sources. This has been acknowledged, for example, by Feng & Seasholes (2008): the authors showed that male investors are more prone to speculative decisions, and therefore the cross-section of women’s investment portfolios tends to be more significant. This aspect is pertinent to consider from another perspective. Whereas men appear to be riskier in terms of crucial investment decisions, the balance of stock markets in most developed and emerging markets is not biased in favor of either gender. Thus, contrary to preconceptions, men and women are roughly equally represented in the markets so that no discriminatory agendas can be claimed. Furthermore, Abudy et al. (2021) showed that the absence of women as active investors leads to a natural decline in the level of trading in the market and, consequently, a decrease in its intensification. This conclusion was made in recognition of the fact that women combined career and maternal functions, so the overall market dynamics declined in the first days of the school year.

Continuing with the study of gender-herd correlations, it is appropriate to critically evaluate the earlier thesis of a male counselor’s association with a significant commitment to the crowd’s decisions. Specifically, Salem (2019) showed that Arab women are more likely than men to exhibit rash investment decisions based only on cursory market analysis. At the same time, the authors of the study emphasized that Arab women, in general, are less financially literate, and therefore have less resilience and risk appetite. However, it is reasonable to assume that this effect is more accurate for Arab stock markets, where women have only recently begun to be perceived as full-fledged investment agents, while no similar effects were observed for the Chinese market (Feng & Seasholes, 2008). As a consequence, investor gender is generally associated with herd investing trends, with this relationship being more evident for the Arab market.

An intriguing wave in the study of the nature of herd behavior in the stock market is the study of molecular mechanisms of the connection. In more detail, Nofsinger et al. (2018) evaluated the relationship between investor testosterone and cortisol concentrations during crucial trading decisions. It was shown that an increase in testosterone levels relative to cortisol was unambiguously associated with riskier decision making. If one takes into account the biological nature of testosterone as a predominantly male endocrine hormone, one can further confirm the link between gender and the probability of losing sales in favor of risky and rash decisions. In addition, an exciting result of this bioeconomics study was the fact that testosterone increases markedly under conditions of increased competition: in other words, the probability of risky strategies increases under pressing conditions. A similar statement regarding banking systems is typical of the work of Albaity et al. (2019), which proved that a bank that is not highly competitive turns out to be more profitable in the long run. In the context of the private investor, this means maintaining profitability while not actively engaging in competitive deals.

H3: For the Arab market, the female investor is more prone to herd behavior in trading decisions.

Experience and Herd Behavior

An intriguing variable that appears to have a significant influence on exposure to herd behavior is personal investment experience. Primarily, it should be clarified that, as has been shown by Mikutowski et al. (2019), an individual’s investment portfolio has a cumulative effect, so in the case of long-term investments, it becomes possible to analyze the solvency and balance of current purchases. The experience has already been considered within the framework of cognitive dissonance theory, when it was recognized that disposition effects and investor mindfulness are negatively correlated (Dierick et al., 2019). Simultaneously, it has already been shown that having a financial advisor for a novice investor had a severe effect on herd commitment (Baeckström et al., 2021). In particular, the presence of an advisor (in combination with his or her gender) either increases or decreases the propensity to take risks and follows the herd’s decisions. Of particular importance in light of the intended relationship is consideration of the mechanisms of association of personal investing experiences in combination with the psychological characteristics of the individual. More specifically, Sabir et al. (2019) showed that if an investor has previously exhibited herd behavior when it comes to investing, it is most likely that this pattern will be relevant for future investment strategies. In this sense, it is crucial to limit the investing experience per se and the negative experiences associated with herd behavior. Whereas episodes of blindly following the crowd’s decisions have properties of recurrence, solid investing experiences per se have not been associated with adherence to such behavior. This was confirmed by Merli & Roger (2013), who showed that the more experienced the individual investor, the more likely a conscious rejection of collectivism. Consequently, nonconformism in investment behavior is directly related to improving one’s own financial performance. On the other hand, Prosad et al. (2015) measured that the most experienced investors are more susceptible to all biases in the Indian context. This suggests that experience is an essential predictor of herd mentality, but no formed inferences about the exact relationship between the two variables were found.

H4: An individual’s investment experience is a prerequisite for the development of herd behavior.

Demographics and Herd Behavior

Having examined in detail academic sources on the relationship between gender and the herd nature of investing, it is appropriate to conclude that other demographic attributes of an individual, whether age, education, or marital status, also have the potential to influence trading behavior strategies. This assumption easily forms the basis of an analytic study by Prosad et al. (2015), whose authors discussed that age and occupational background mattered most in the formation of trading biases. More specifically, an older group of investors is more likely than younger competitors to exhibit herd mentality. On the one hand, this statement seems logical and is supported by other studies: for example, Loang & Ahmad (2020) showed an unambiguously positive relationship between an aging society and herd trading behavior. In this regard, it seems evident that aging may be associated with a depletion of critical analysis, and instead of actual processing data, older investors rely on trust in the market. However, on the other hand, this statement contradicts the ideas of Merli & Roger (2013), in which the more experienced investor was less likely to herd following. A similar contradiction becomes apparent when analyzing the work of Alquraan et al. (2016), who also acknowledged that an individual’s age characteristics have only a minor influence on investment decisions.

While investor age is widely debated, other demographics are not as controversial. In particular, numerous studies have shown that neither ethnicity nor income level had an effect on the predisposition to herding behavior. More specifically, Loang & Ahmad (2020) found that the factors mentioned, combined with an investor’s occupational orientation to the industry, did not affect following the decisions of the crowd. The same statements are noticeable in Alquraan et al. (2016) with the exclusion of the education criterion, as the authors acknowledge that the level and quality of education are correlated with the nature of investment idea adoption. That said, the investor’s marital status is generally crucial as Mahalakshmi & Anuradha (2018) showed the moderating effect of a spouse on individual investment decision making. Having a family partner can adjust investment strategies to reduce risk and generate greater returns over the long term.

H5: Demographic traits, except for investor age and marital status, have little effect on adherence to herd behavior.

To summarize this literature review, it should be concluded that the herd behavior of the individual investor is a frequent practice for trading in the stock market. Nevertheless, this behavior is recognized to be dynamic and, therefore, strongly depends on psychological and behavioral aspects of the individual personality. The survey measured the relationship of such aspects and showed that investment experience, gender, age, and marital status are most often associated with more risky behavior in the stock market. However, psychological aspects of an individual are also significant predictors of commitment to herd behavior, although the role of gender in this context is not apparent. Without specification on a particular region, it is appropriate to state that men more often than women are inclined to herd behavior because of more risky investments.

Herd investing

References

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