Do individual investors actually trade on their stated beliefs? In their February 2011 paper entitled “Do Investors Put Their Money Where Their Mouth Is? Stock Market Expectations and Trading Behavior”, Christoph Merkle and Martin Weber compare quarterly risk and return expectation survey responses to actual trading data and portfolio holdings for a group of self-directed individual UK investors. Using this investor data, along with contemporaneous measures of actual FTSE All-Share Index returns and volatility during 2008 through 2010 (first survey in September 2008 and last in September 2010), they find that:
- Of 617 total survey respondents (at least 130 per survey iteration), 394 participate multiple times.
- Average (median) trading frequency of respondents is roughly eight (three) trades per quarter. Average (median) quarterly portfolio turnover is 68% (19%). Trading peaks during the financial crisis, with the percentage of buys at that time suggestive of investors seeking to exploit low market valuation.
- Most respondent portfolios are more volatile than the UK market portfolio, apparently driven by idiosyncratic risk due to low diversification (median market beta is only about 0.8).
- Respondents tend to be more optimistic about returns for their own portfolios than returns for the market (see chart below), and they tend to underestimate stock market risk. Volatilities implied by their stated return expectation confidence intervals are much lower than option-implied volatility.
- The numeric market return expectation at the time of a survey has little effect on subsequent buy-sell behavior, but survey-to-survey increases in numeric market return expectation relate positively to the buy-sell ratio. Separately, investors viewing prices as qualitatively “cheap” tend to buy stocks.
- Inexplicably, investors who hold negative portfolio return expectations exhibit no greater propensity to sell than other investors. In fact, higher portfolio return expectations make selling more likely. Realized portfolio returns relate positively to selling behavior, in accordance with the disposition effect.
- Consistent with financial theory, actual portfolio risk metrics relate positively (negatively) to numerical market return expectations and risk tolerance (numerical risk expectations, age and and wealth). In other words, portfolio volatilities tend to rise (fall) when return expectations rise (fall). The relationship is weakest for short-term volatility, indicating that investors manage their portfolios based on long-term volatility.
The following chart, taken from the paper, shows boxplots of market (mk) and portfolio (pf) return expectations for all nine survey iterations. Each box with variability range denotes the 5th, 25th, 50th, 75th and 95th percentiles of responses. Return expectations rise during the financial crisis and then revert to the lower pre-crisis level. Investors tend to be more optimistic about their portfolios than about the market, with distributions of portfolio return expectations always at least as high and often higher than market return expectations.
In summary, evidence from belief surveys and associated trading records indicates that it is hard to predict immediate trading activity from stated investor expectations due to confounding factors such as the disposition effect, price-anchoring and liquidity needs. Higher return (risk) expectations do lead to elevated (reduced) risk taking.
Findings appear to undermine general belief that investor sentiment is a reliable short-term stock return predictor.
Frequently Asked Questions
What are stated investor beliefs and how do they differ from actual trading behavior?
Stated investor beliefs are the market return and risk expectations that investors report in surveys, while trading behavior is what they actually do, as recorded in trades and portfolio holdings. The Merkle and Weber study compared quarterly survey responses from 617 self-directed UK investors with their trading records from 2008 to 2010 to see whether the two align.
Do individual investors trade based on their stated market return expectations?
Individual investors only weakly trade on their stated market return expectations. In the 2008–2010 UK sample, the numeric market return expectation at the time of a survey had little effect on subsequent buy-sell behavior, though survey-to-survey increases in expectations related positively to the buy-sell ratio. Investors who viewed prices as qualitatively "cheap" also tended to buy stocks.
How do researchers compare investor survey expectations with actual trading behavior?
Researchers match investors' quarterly risk and return expectation survey responses to their actual trading data and portfolio holdings. Merkle and Weber used nine survey iterations from September 2008 to September 2010, with at least 130 respondents per survey and 394 of 617 respondents participating multiple times. They also compared the responses with contemporaneous FTSE All-Share Index returns and volatility and with option-implied volatility.
Are investors' expectations for their own portfolios the same as their expectations for the overall market?
No, investors' expectations for their own portfolios are generally more optimistic than their expectations for the market. In the nine survey iterations, the distributions of portfolio return expectations were always at least as high as, and often higher than, market return expectations. Investors also underestimated market risk, since the volatilities implied by their confidence intervals were much lower than option-implied volatility.
Why is it hard to predict investor trading from sentiment or survey expectations?
Predicting immediate trading from stated expectations is hard because of confounding factors such as the disposition effect, price-anchoring and liquidity needs. For example, investors with negative portfolio return expectations were no more likely to sell, and higher portfolio return expectations made selling more likely. The findings, from 617 UK investors over 2008–2010, appear to undermine the view that investor sentiment is a reliable short-term stock return predictor.