Several determinants play a critical role in why some individuals become value-oriented investors and others become growth-oriented investors.
With so much research being done on various aspects of investing, surprisingly little effort has been made to explain the factors that influence individual investors’ decision making. The authors (Nerik Cronq, Stephan Siegel, and Frank Yushow) whose published work was in the ‘Journal of Financial Economics’ shows that an investor’s investment style (i.e., value versus growth) can be derived from two sources: a genetic or biological predisposition and environmental factors. The authors reference several previous studies and provide their own analysis to contribute a new perspective about why investors gravitate toward value or growth investments.
Differences in individual investor behavior stem from:
- Genetic predispositions and
- Environmental factors
Several factors explain an individual investor’s investment preference for either value- or growth-oriented portfolios. The authors estimate that genetic differences account for approximately 26% of the orientation when measured by Price/Earnings ratio and 27% when measured by Morningstar’s Value-Growth Score. This result is consistent with the findings of previous researchers, who have shown that approximately 30% of the cross-sectional variation in financial risk preferences is explained by genetic predispositions. In addition to biological considerations, the analysis demonstrates that particular individual life experiences have a large impact on investment styles.
For example:
- Experiences in early adulthood can have profound implications on preferences later in life, according to social psychology and neuroscience.
- A person’s core beliefs seem to crystallize during this early period of great neuroplasticity, and those beliefs remain consistent throughout a person’s life.
- Researchers have shown that neural pathways and synapses can dramatically change during these formative years as a result of a person’s environment, behavior, emotions, and even injury.
Significant macroeconomic events (think of Global Financial Crisis, Dotcom Bubble, etc.) that investors experience can also have long-term and persistent effects on that individual’s behavior much later in life.
- The authors find that individual investors who experienced difficult economic conditions and grew up in lower-income homes develop a more value-oriented investment style later in life.
- People who grew up during the Great Depression subsequently favor value-oriented, or “cheaper,” portfolios. These investors hold portfolios with an average P/E that is 11% lower.
- The research also reveals that the timing of an individual’s entrance into the labor market can affect that individual’s future investment decisions. If an investor enters the labor market during a severe recession, they favor more value-oriented portfolios in the future.
Conversely and consistent with previous studies, the research find that investors with:
- More education
- More disposable income, and
- Whose income is correlated with GDP favor growth investments.
Additionally,
- Investors who exhibit more behavioral biases, such as the overconfidence bias, opt for growth investments.
- Individuals who exhibit more behavioral biases are found to have portfolios with a 10% higher P/E at the median.
This research contributes to and supports the growing body of evidence regarding behavioral finance, which demonstrates that life experiences, behavioral biases, and genetics have a dramatic impact on investors’ behavior.
This research, coupled with the growing body of literature on cognitive biases can be extremely helpful for individual investors to help understand their tendencies and why they may lean toward various investment strategies or products. By digging a bit deeper and learning more about ourselves, we can make better informed decisions.
-Paul R. Rossi, CFA