Taking Stock of Stockbrokers: Exploring Investor Decision Strategies Via Verbal Protocols

EXTENDED ABSTRACT - How do professional security analysts manage investment portfolios over time? This is the core question explored in the present research. Despite its prominent role in contemporary American society, surprisingly little is known about the information processing and decision making strategies both of individual investors and security analysts. Traditional finance theory assumes that the stock market consists of a set of identical, rational, utility maximizers who trade stocks that reflect their true economic value (Bodie, Kane and Marcus 1999). According to this framework, stock markets are assumed to be information efficient, which is often referred to as the efficient market hypothesis (EMH). One of the implications of EMH is that it is not possible to predict the future direction of stock prices and thus it is not possible to construct investment portfolios that will systematically earn higher than average market returns (unless one is willing to invest in stocks that exhibit greater than average price volatility). Do most professional analysts subscribe to this philosophy and its decision strategy implications?

Citation:

Maureen Morrin, Jacob Jacoby, and Gita Venkataramani Johar (2002) ,"Taking Stock of Stockbrokers: Exploring Investor Decision Strategies Via Verbal Protocols", in NA - Advances in Consumer Research Volume 29, eds. Susan M. Broniarczyk and Kent Nakamoto, Valdosta, GA : Association for Consumer Research, Pages: 164-165.

Advances in Consumer Research Volume 29, 2002     Pages 164-165

TAKING STOCK OF STOCKBROKERS: EXPLORING INVESTOR DECISION STRATEGIES VIA VERBAL PROTOCOLS

Maureen Morrin, University of Pittsburgh

Jacob Jacoby, New York University

Gita Venkataramani Johar, Columbia University

Xin He, University of Pittsburgh

Alfred Kuss, Freie Universitat

David Mazursky, Hebrew University

EXTENDED ABSTRACT -

How do professional security analysts manage investment portfolios over time? This is the core question explored in the present research. Despite its prominent role in contemporary American society, surprisingly little is known about the information processing and decision making strategies both of individual investors and security analysts. Traditional finance theory assumes that the stock market consists of a set of identical, rational, utility maximizers who trade stocks that reflect their true economic value (Bodie, Kane and Marcus 1999). According to this framework, stock markets are assumed to be information efficient, which is often referred to as the efficient market hypothesis (EMH). One of the implications of EMH is that it is not possible to predict the future direction of stock prices and thus it is not possible to construct investment portfolios that will systematically earn higher than average market returns (unless one is willing to invest in stocks that exhibit greater than average price volatility). Do most professional analysts subscribe to this philosophy and its decision strategy implications?

A more recent, alternative framework, behavioral finance theory, suggests that, because of individual decision makers’ psychological biases, stocks may be temporarily over- or under-priced relative to their true economic value (e.g., Shiller 1993a). Because of these tendencies, contrarian investors often expect that stocks that have fallen in value will rebound, and that stocks that have risen in value will fall. Momentum investors, on the other hand, expect to observe positive serial correlations in stock prices, which implies that if a stock price has recently risen [fallen], it is more likely to rise [fall] than fall [rise] in the next period (e.g., Urrutia 1995, Frennberg 1993). Both contrarian and momentum strategies are at odds with the fundamental tenets of traditional finance theory. What types of behavior do actual security analysts tend to exhibit when choosing stocks for investment?

We attempt to answer this question using a verbal protocol technique (e.g., Ericsson and Simon 1993; Lee and Olshavsky 1995). In this study, we presented 9 practicing security analysts with an array of six stocks each with 3 types of fundamental factor information (e.g., earnings per share, sales, etc.). The analysts’ task was to create a portfolio of securities that would maximize return on investment over a period of four consecutive quarterly periods. Subjects were instructed to think aloud while processing the stock information and making their investment decisions (Ericsson and Simon 1993). These verbalizations were tape recorded for later transcription and analysis.

An idiographic analysis of the verbal protocol data was conducted (Mick and Buhl 1992, Thompson, Locander, and Pollio 1990, Fournier 1998). The goal was to develop overall impressions of each analyst’s investment style and the steps involved in his or her decision making process. Three of the analysts were classified as momentum investors, on the basis of their responses to decision feedback. They tended to ride the market by buying winners and selling losers and generally expected recent price trends to continue. They also tended to trade stocks fairly heavily and constructed less diversified and more volatile stock portfolios. As a whole, they did not spend inordinate amounts of time calculating ratios from fundamental factor information. Instead, they utilized a fairly simple heuristic that involved following price trends. We found some variations of the standard momentum investor such as one that also looked for peaks and troughs in price trends and one that focused their momentum strategy only on small, higher risk stocks.

Two of the investors were classified as contrarian investors based on their responses to decision feedback. They looked for bargains, that is, stocks they believed to be temporarily undervalued due to the market’s overreaction to negative news. This group tended to buy stocks that had recently fallen in value, and to sell those that had recently risen in value. This group also traded heavily, but in contrast to momentum investors, they looked for companies on the basis of solid fundamental factor information. Contrarians were extremely disciplined decision makers, as even in the face of repeated price falls, they continued to make their decisions on the basis of their fundamental factor based formulas.

The remaining four analysts were classified as Efficient Market investors since all exhibited inertia in response to price changes of stocks held in their portfolios. However, analysis of these investors’ verbalizations suggested that the underlying reason for such inertia was not a strong belief in efficient markets. Instead, such inertia was often found to be based on fear and uncertainty as well as anticipated regret. This group exhibited a lesser tendency to trade stocks over time and tended to maintain a large proportion of their investment dollars in a cash account returning low but guaranteed returns.

From a cross-case analysis of the verbalizations, we derived four major themes combining the belief systems of 9 stock analysts: (1) they often construct inferences to explain stock price movements, (2) most analysts believe they can beat the market (in startling contrast to traditional finance theory), (3) they interpret risk in a multitude of ways, and (4) they believe that the growth of the internet is likely diluting the added value that analysts have traditionally afforded their clients. In conclusion, our results suggest that security analysis decision making process is heterogeneous and multifaceted in nature and that individual decision making behavior in this domain does not conform to many of the presumed tenets of traditional finance theory.

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