What Matters to Individual Investors? Evidence from the Horse's Mouth

• Author: JAMES J. CHOI,ADRIANA Z. ROBERTSON
• DOI: http://doi.org/10.1111/jofi.12895
• Date: 01 August 2020
• Published date: 01 August 2020

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 4 •AUGUST 2020

What Matters to Individual Investors? Evidence

from the Horse’s Mouth

JAMES J. CHOI and ADRIANA Z. ROBERTSON∗

ABSTRACT

We survey a representative sample of U.S. individuals about how well leading aca-

demic theories describe their financial beliefs and decisions. We find substantial sup-

port for many factors hypothesized to affect portfolio equity share, particularly back-

ground risk, investment horizon, rare disasters, transactional factors, and fixed costs

of stock market participation. Individuals tend to believe that past mutual fund per-

formance is a good signal of stock-picking skill, actively managed funds do not suffer

from diseconomies of scale, value stocks are safer and do not have higher expected

returns, and high-momentum stocks are riskier and do have higher expected returns.

THE FINANCE LITERATURE OFFERS NO shortage of theories about investor moti-

vations and beliefs, which translate into choices that in aggregate determine

asset prices. However, testing these theories with observational data has been

difficult. Finding empirical variation in a hypothesized factor that is incontro-

vertibly uncorrelated with potentially relevant unobserved variables is often

impossible. If we instead evaluate models based primarily on their ability to

match endogenous moments in the data, we run up against the difficulty that

∗James J. Choi is with the Yale School of Management and NBER. Adriana Z. Robertson is

with the University of Toronto. We thank Ravi Bansal; Nicholas Barberis; Sebastien Betermier;

Hector Calvo Pardo; John Campbell; Raj Chetty; Joao Cocco; Lorenzo Garlappi; Richard Evans;

Vincent Glode; William Goetzmann; Luigi Guiso; Jonathan Ingersoll; Ravi Jagannathan; Marcin

Kacperczyk; Panu Kalmi; Raymond Kan; Alina Lerman; Tobias Moskowitz; Stefan Nagel; Monika

Piazzesi; Jonathan Reuter; Thomas Rietz; Harvey Rosen; Robert Shiller; Tao Shu; Paolo Sodini;

Matthew Spiegel; Adam Szeidl; Richard Thaler; Selale Tuzel; Raman Uppal; Annette Vissing-

Jørgensen; Jessica Wachter; Stephen Wu; Amir Yaron; Jianfeng Yu; and seminar participants at

the American Finance Association Annual Meeting, Canadian Economic Association Annual Con-

ference, CRC Workshop on Individual Heterogeneity, Baruch, Baylor, CEPR Household Finance

Workshop, Cornell, Drexel, FIRS Conference, FSU SunTrust Beach Conference, Helsinki Finance

Summit on Investor Behavior, University of Miami, NBER Behavioral Finance Meeting, NYU,

USC, and Yale for their comments. All shortcomings in the survey and analysis are our own. The

authors have no relevant or material financial interests related to the research in this paper.No or-

ganization had the right to review this paper prior to publication. IRB approval was obtained from

YaleUniversity. This research was supported by a Whitebox Advisors research grant administered

through the Yale International Center for Finance.

Correspondence: James J. Choi, YaleSchool of Management and NBER, 165 Whitney Ave., P.O.

Box 208200, New Haven, CT 06520-8200; e-mail: james.choi@yale.edu.

DOI: 10.1111/jofi.12895

C2020 the American Finance Association

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1966 The Journal of Finance R

predictions of competing models are often similar or identical (Fama (1970),

Cochrane (2017), Kozak, Nagel, and Santosh (2018)).1

In this paper, we take a different approach: we ask a nationally representa-

tive sample of 1,013 U.S. individuals in the RAND American Life Panel (ALP)

how well leading academic theories describe the way they decided what frac-

tion of their portfolio to invest in equities, their beliefs about actively managed

mutual funds, and their beliefs about the cross-section of individual stock re-

turns. Our questions aim to test key assumptions of leading theories about

investor motivations and beliefs more directly than the usual method of trying

to infer the validity of these assumptions by examining downstream outcomes.

Because we test a wide range of theories on the same sample using the same

research design, it is easier to make apples-to-apples comparisons of different

theories. High-wealth investors constitute only a small fraction of our sample,

so our results are more informative about individual choices and beliefs than

asset prices.2

We find substantial support for many of the factors that have been hypothe-

sized to affect portfolio equity share. Forty-eight percent of employed respon-

dents say that the amount of time left until their retirement is a very or

extremely important factor in determining the current percentage of their in-

vestable financial assets held in stocks, and 36% of all respondents say the

same about the amount of time left until a significant nonretirement expense.

Background risks such as health risk (47% of all respondents), labor income

risk (42% of employed respondents), and home value risk (29% of homeowners)

are frequently rated as very or extremely important. Many people say that

discomfort with the market is a very or extremely important determinant of

their equity share, citing lack of trust in market participants (37% of all respon-

dents), lack of knowledge about how to invest (36% of all respondents), and lack

of a trustworthy adviser (31% of all respondents). Transactional considerations

that have received scant attention in the academic literature—needing to have

enough cash on hand to pay for routine expenses (47% of all respondents) and

concern that stocks take too long to convert to cash in an emergency (29% of

all respondents)—are salient. Personal experience of living through stock mar-

ket returns and personal experience investing in the stock market are rated

as very or extremely important by 27% and 26% of respondents, respectively.

Nonparticipation in the stock market is frequently driven by the fixed costs

of participation (49% of nonparticipants) and not liking to think about one’s

finances (37% of nonparticipants).

Moving to motives coming from representative-agent asset pricing models,

we find particularly strong support for rare disaster theories, with 45% of

1Distinguishing between models that are observationally equivalent in existing data can be

important because they may have different welfare or policy implications. For example, knowing

that the stock market’s expected returns vary because of irrational cash flow forecasts instead of

rational time-varying risk aversion would have profound implications.

2Bender et al. (2019) administer a survey similar to that in this paper on a sample of wealthy

individuals.

What Matters to Individual Investors? 1967

all respondents describing concern about economic disasters as a very or ex-

tremely important factor. However, there is also significant evidence for the

importance of long-run aggregate consumption growth risk (30%), long-run

aggregate consumption growth volatility risk (26%), consumption composition

risk (29%), loss aversion (28%), internal habit (27%), and ambiguity/parameter

uncertainty (27%). Consumption commitments, which can be a microfounda-

tion for a representative agent who has external habit utility,garner significant

support as well (36%). The stock market’s contemporaneous return covariance

with the marginal utility of money—the fundamental consideration in many

modern asset pricing and portfolio choice theories—is rated as very or ex-

tremely important by 35% of respondents. Similar numbers describe return

covariance with contemporaneous aggregate consumption growth (30%), with

contemporaneous aggregate consumption growth volatility shocks (29%), and

with their own marginal utility of consumption (29%) as very or extremely

important.

Although many factors appear to determine portfolio equity shares, the im-

portance of each factor is not distributed haphazardly within an individual.

Among the 34 factors that were rated by every respondent, only six principal

components suffice to explain 54% of the variance in whether they were rated

as very or extremely important. These components can be roughly interpreted

as corresponding to (i) neoclassical asset pricing factors, (ii) factors related to

return predictability and retirement savings plan defaults, (iii) factors related

to consumption needs, habit, and human capital, (iv) factors related to discom-

fort with the market, (v) factors related to advice, and (vi) factors related to

personal experience.

Turning to mutual funds, 51% of those who have purchased an actively man-

aged equity mutual fund says that the belief that the active fund would give

them a higher average return than a passive fund was very or extremely im-

portant in that purchase decision. However, 27% of active fund investors say

that a hedging motive—the belief that the active fund would have lower uncon-

ditional expected returns than the passive fund but higher returns when the

economy does poorly—was very or extremely important. The recommendation

of an investment adviser was very or extremely important for 48% of active

fund investors’ decision to buy an active fund. Consistent with Berk and Green

(2004), 46% of all respondents agree or strongly agree that a fund having out-

performed the market in the past is strong evidence that its manager has good

stock-picking skills. But inconsistent with Berk and Green (2004), only 18%

agree or strongly agree that funds have a harder time beating the market if

they manage more assets.

Finally, collective expectations about the cross-sectional relationship be-

tween stock characteristics and expected returns do not always match his-

torical correlations. Twenty-eight percent of respondents expect value stocks

to normally have lower expected returns than growth stocks, a proportion not

statistically distinguishable from the 25% who believe the reverse. On the

other hand, consistent with the historical relationship, more respondents ex-

pect high-momentum stocks to normally have higher expected returns than