Chapter 2 Literature Review has afforded the pertinent information which pertaining to the factors influencing the investors’ preference. In this chapter, every factor was discussed in depth and proved through other researchers’ opinions and findings.

Investors’ preference

Because of the global growth of economy, more people are involved in the investment nowadays. In recent year, a considerable amount of attention has been directed in the question of the investment behavior and portfolio performance of the investors. Due to the financial markets are expected to be volatile, this environment is prompting the investors to spread their investment and capital and to look for new asset classes that provide stability. The individual investors are searching for a type of investment which can satisfy their various requirements and the investors’ preference will influence the investors to choose the companies’ shares or bonds at the same time. Thus, the investors’ preference might be changed based on their own sentiments and requirements.

(Robert.A.Jarrow, 1988) has showed that:

Investors are assumed to have preferences defined over the traded assets. Choosing an arbitrary investor, his preferences are represented by a complete and transitive relation over M, denoted by p. Complete means that given any two traded assets x and y, either x p y or y p x. The symbol (x p y) should be read “x is preferred to or indifferent to y.” Transitive means that for traded assets x, y, and z, if x p y and y p z, then x p z. The preference relation p is said to be strictly increasing if for any traded limited liability asset m and any traded asset y,

(y + m) p y.

This statement reads that the portfolio (y + m) is strictly preferred to the portfolio y. This condition is justified by noting that since m is of limited liability,

P(y + m-y) = 1 and P(y + m > y) > 0

That is, the portfolio (y + m) dominates the portfolio y in terms of the asset’s payoffs at time.

According to (David Cass and Joseph E. Stiglitz, 1969) Tobin showed that under certain conditions the investor’s portfolio allocation decision could be considered as a two stage process: The investor first decides in what proportions to purchase the available risky assets, and then he decides how to divide his total investment between risky and safe assets. (Francisco J. Gomes, 2003) has considered a general equilibrium model with two types of investors: one type with power utility and another type exhibiting loss-aversion. Both of the risk and liquidity of investment play important roles in decision making of individual investors. Many people think that the higher the risk, the higher the return. But the higher risk of investment might perturb the investors as well. The investment with the great liquidity will let the investors gain their income and return faster and more effective. As a result, individual investors must act at their deliberation before choosing the investment which they want.

Besides, the empirical review of Franco and Merton clarified that the economic theorist concerned with explaining investment behavior at both the micro and macro 1evels. (Franco and Merton, 1958) They tended to push investment to the point where the marginal yield on physical assets is equal to the market rate of interest. This proposition can be shown to follow from either of two criteria of rational decision-making which are equivalent under certainty, namely (1) the maximization of profits and (2) the maximization of market value. Whatever type of investment they choose, they certainly want to get maximum profit from it. Investors’ preference and their decision making also depend on the profit earnings. The higher return rate can give the investors more confidence in investing their income and savings.

In addition, there are other factors will affect investors for their decision making. For instance, if the company or product’s reputation and image is great, investors will have more interest in that particular investment. Some investors make their choices through the brokers and agents’ suggestions. So those are the factors that we need to go through and explore why they will affect the investors preference and decision making.

Risk

There have many factors that may influence the investors’ decision making. Any stock markets are full of snares for individual investors. The risk or uncertainty is an intrinsic factor of investment returns. Risk is the chance of not fulfilling the investors’ investment objectives because of returns and profits uncertainty. So risk will be arises from the expected volatility in asset returns to put it away. Investors will face the risk unless they place their funds in a bank.

In accordance with (Frank and Edgar, 2006), risk sources can be classified as either systematic or asset- specific. Systematic risk affects the economic or financial “system” hence the name; its effect is pervasive throughout the economy. Examples of systematic risk include changes in interest rates, the economic growth rate or changes in taxes. Asset- specific risk deals with the characteristics of a type of asset or security issuer rather than broad economic factors. Examples of asset-specific risk include poor management decisions, labor strikes, deterioration of product or service quality, and the rise of new competitors.

In finance, risk is the probability that an investment’s actual return will be different than expected. This includes the possibility of losing some or all of the original investment. Some regard a calculation of the standard deviation of the historical returns or average returns of a specific investment as providing some historical measure of risk. (Wikipedia) On the other hands, individual investors also may face liquidity risk, the possibility of not being able to sell an asset for fair market value. A risky investment has let the investors to be in a blue funk. (Robert and W. Michael, 1990) pointed out that “futures are fast moving, risky investment vehicles that are unsuitable for anyone who can’t afford to lose and who doesn’t have time to pay close attention to trading positions.” Individual investors must think over their ability to afford the investment risk before injecting their funds into the stock markets. They are worry about making the improper decisions and suffering the losses. So they may compare the various types of stock and decide the lowest risk’s investment.

Investors can diversify the risk of any one risky asset by combining it with other risky assets in a portfolio. An asset will earn a risk premium only to the extent that it affects the uncertainty of the overall portfolio return. (Marc and Janet, 1983) The overall risk of individual investors’ investment can be decreased by forming well diversified portfolios. That is why the individual investors must prepare all the information before involving in the investment, form the portfolio in a desirable models. Because of this reason, some of the individual investors are become the risk- averse investors, prevent and avoid the investment risk thoroughly.

In consonance with (Eugene and James, 1973), investors are assumed to be risk averse and to behave as if they choose among portfolios on the basis of maximum expected utility. A perfect capital market, investor risk aversion, and two- parameter distributions imply the important “efficient set theorem”: The optimal portfolio of any investor must be efficient in the sense that no other portfolio with the same or higher expected return has lower dispersion of return. Risk aversion is the tendency of investors to avoid risky investments. Thus, if two investments offer the same expected yield but have different risk characteristics, investors will choose the one with the lowest variability in returns. If investors are risk averse, higher-risk investments must offer higher expected yields. Otherwise, they will not be competitive with the less risky investments. (David, 2003) So the individual investors will look into their investment portfolios’ details and select the most suitable, affordable and minimize- risk’s choices. The companies’ operation stabilization may reflect on their stock markets performance. Well performance can reduce their stock’s risk and give their stockholders a shot in the arm. A risky investment will let individual investors suffer the losses. Thus, risk-averse investors may choose the risk-free investment such as Treasury bills. (John Lintner, 1965) has shown that investors operating on his “Safety First” principle (i.e. make risky investments so as to minimize the upper bound of the probability that the realized outcome will fall below a pre-assigned “disaster level”) should maximize the ratio of the excess expected portfolio return (over the disaster level) to the standard deviation of the return on the portfolio.

The demographic of investors also will influence their alternative of risky investment. For instance, (Richard, Wilbur, Ronald, Gary, 1975) shown that married individuals appear to invest smaller pro-portions of their portfolios in risky assets than do single individuals, other things being equal. It may because they are necessary to ponder about their individual and household financial situation and go on the investment without giving rise to the financial problems. Besides, the younger people can withstand the riskier financial assets compare with the older one. Young people are more willing to take risk for earning the higher return and profit. Female are more discreet and will not input their funds rashly. But male are more audacious and they are able to take on their obligation to face the losses. In addition, the education level, occupation even the income also will influence the individual investors to make their decisions.

On the contrary, financial market decision maker and participants generally quote increased ‘risk appetite’ as a crucial driver of the recent downward trend yield spreads and risk premiums. Risk appetite is the willingness of individual or institution investors to bear and endure the risk. As reported by (Prasanna and Nicholas, 2005), risk appetite reflects investors’ willingness to hold risky assets and, as such, depends on their attitudes to risk as well as the size of other risks they carry on their balance sheets, such as that relating to employment. There have been concerns among policymakers th