Cécile Carpentier* and Jean-Marc Suret** March 18, 2012

Transcription

1 FINANCIAL KNOWLEDGE AND RATIONALITY OF CANADIAN INVESTORS Cécile Carpentier* and Jean-Marc Suret** March 18, 2012 *Professor, Laval University, CIRANO Fellow and associate researcher with the Investors Group Chair in Financial Planning. **Professor, Laval University, CIRANO Fellow, associate researcher and member of the governing committee of the Investors Group Chair in Financial Planning. The authors thank the Fonds pour l éducation et la saine Gouvernance of the Autorité des marchés financiers, the Ministère des Finances du Québec and the Investors Group Chair in Financial Planning of Laval University for making the implementation and dissemination of the study possible. The views expressed are those of the authors, and not necessarily those of the Autorité des marchés financiers and the Ministère des finances du Québec.

2 Table of contents Executive summary... 1 Introduction Background Literacy Rationality Survey and respondents Survey Respondents Characteristics of respondent portfolios Respondents knowledge Past return of asset classes Basic concepts related to returns Notions related to risk Risk-return relationship Diversification Investors financial decisions Investors knowledge score Investors scores and characteristics Investor rationality Perspective theory Availability bias Overconfidence bias Self Attribution Preference for lottery stocks Familiarity bias Conclusion Tables and Figures Appendix 1 Questions used to calculate the score Bibliography

3 EXECUTIVE SUMMARY Investors financial skill rests on two elements: 1) literacy, which is the financial knowledge itself and the skill required to use the knowledge, and 2) rationality, which refers to the lack of major biases such as overconfidence. To estimate the level of investors knowledge and rationality, we administered an online survey to 1814 investors in Québec and Ontario who manage their own stock portfolios. Their average portfolio is valued at $200,000, mostly invested in stocks of large or small listed companies. We measured knowledge using scores and compared these scores with investors evaluations of their knowledge in various areas, to examine the dimension of rationality. We also tried to identify several other behavioral biases. Canadian investors financial knowledge is limited. On average, they obtain a mediocre knowledge score; only 5% score above 66%. The vast majority of respondents scored between 40% and 57%. Significant gaps were noted regarding knowledge of risk and return of asset categories. Knowledge of past returns of the main asset categories is abnormally low, particularly for equity, an area where all of the respondents are involved. Mediocre knowledge of the performance of categories and of the concept of risk premium calls into question investors financial planning ability. One out of five investors is unaware that the return of a small growth company comes not from dividends, but rather from a capital gain. One-third of investors are certain that they will receive future dividends from a company that usually pays them. Almost 30% of respondents are unaware that stock indices are greatly influenced by the returns of the largest capitalization stocks. Three-quarters of investors do not systematically compare the return on their portfolio with that of a stock market index. Half of the investors do not clearly grasp the link between lack of liquidity and share value. Many investors do not know that if they invest in the stocks of small companies listed on the TSX Venture Exchange, they might lose all their capital. The risks associated with shareholding are largely underestimated. The majority of investors think that there is no systematic risk-return relationship. Nearly all investors are convinced that some stocks offer a high return coupled with low risk. A significant portion of investors does not clearly grasp what portfolio diversification is, and 35% of investors do not know how to diversify. One out of five investors does not know that it is possible to diversify a stock portfolio using mutual funds. One third of investors do not know that one must scrutinize the financial information of small issuers. Only one out of five investors knows that there is no reliable means of detecting overvalued or undervalued stocks. 42% of investors are unaware that buying the shares of a company with negative earnings incurs a very high risk. About 30% of investors do not base their decisions on the allocation of their wealth. The same proportion does not systematically analyze a stock s risk and return before buying it. The overall level of financial expertise is thus mediocre. The second half of the questionnaire measured the extent that Canadian investors are subject to behavioral biases. They seem to strongly overestimate their abilities. They generally consider themselves skilled at selecting stocks, and knowledgeable about market trends and the timing of their stock trading decisions. However, perceived expertise does not correspond to the knowledge measured using scores. A large proportion of investors prefer lottery 1

4 stocks, which is consistent with our observation of negative returns on small capitalization stock issues. In addition, a very large proportion of investors exhibit a familiarity bias. The most surprising result lies in the expectations of individually managed portfolio returns. Even if they view themselves as generally more skilled than their peers, most individual managers expect to achieve returns that are less than or equal to those of the market index. Overconfidence is exhibited when it comes to detecting exceptional stocks: 77% of investors say they can identify an exceptional stock within a set of 20 stocks. Another example of overconfidence is that most investors consider that the average projections by experts are false. Lastly, half of investors largely overestimate the probability of obtaining an exceptional return when they invest in a company on the TSX Venture Exchange. Our observations therefore confirm the presence of behavioral biases, the main one being overoptimism and exaggerated confidence in the knowledge and skills required to obtain high returns. In particular, investors overestimate their ability to select winning stocks. 2

5 INTRODUCTION To manage their savings effectively, individuals need basic knowledge and the skills to apply it to make sound decisions. These two dimensions make up the current definition of financial literacy (Huston 2010 p.307). Investors must also exhibit rationality. Their financial behaviors must not be influenced by major biases (de Meza et al. 2008). If behaviors are biased, financial decisions will be unsound even if the investors knowledge is adequate. Following their analysis, conducted for the Financial Service Authority of London, de Meza et al. note that differences in financial competence observed between investors arise more from behavioral problems than from knowledge gaps. The dimension of rationality therefore cannot be neglected. Given investors limited rationality, the considerable efforts deployed to improve financial literacy may be ineffectual (de Meza et al. 2008; Willis 2008). Numerous authors have examined the financial knowledge of youth, households and future retirees (Huston 2010). However, with the exception of Deaves et al. (2006) and of some professional reports, 1 few researchers have looked at the level of knowledge of individual investors. Research has highlighted the importance of specific biases among groups of investors or students (de Meza et al. 2008). Nonetheless, few global analyses of rationality exist, and even fewer works have simultaneously addressed the dimensions of knowledge and rationality of investors who actively make management decisions. This study presents an analysis of knowledge and rationality of Canadian investors who personally manage their stock portfolios. The Canadian situation is particularly interesting for several reasons. Canada is one of the countries with the largest proportions of shareholders (37.52%), far exceeding the rates in the United States and the United Kingdom (Grout et al. 2009). Given the very low minimum standards for listing on an exchange, Canadians can acquire the shares of many small businesses that would be excluded from stock markets elsewhere. Lastly, Canadian investors earn paltry rates of return, particularly when they hold stocks listed on the TSX Venture Exchange (Carpentier et al. 2010a; Carpentier and Suret 2010; Carpentier et al. 2011). We therefore concentrated on this important category of agents, which is our first contribution. To investigate the dimensions of knowledge and rationality simultaneously, we developed a series of questions covering the most important points related to rationality of investors decisions; this is our second contribution. Lastly, we study the extent that language and province of origin are related to investors financial skills, in addition to characteristics generally studied in this type of analysis such as level of income or education. In the first part of the paper, we situate our research relative to previous studies. Part 2 describes the characteristics of the survey and the respondent population. We summarize the survey results in terms of knowledge (Part 3) and rationality (Part 4). The last section concludes the paper. 1 Investor Protection Trust The MoneyTrack/IPT Investing Secrets Survey. NASD Investor Literacy Research NASD Investor Literacy Research: Executive Summary. ation/p pdf 3

6 1 BACKGROUND 1.1 Literacy Financial literacy is a timely topic. The OECD published the first international study on financial education in 2005 (OECD 2005). In 2007, the Financial Consumer Agency of Canada put in place a branch intended to help Canadians improve their financial knowledge. In September 2008, a Canadian conference on financial literacy was held in Montréal. Social and Enterprise Development Innovations called for the creation of an independent task force assigned to study the problem in depth and make proposals. In June 2009, the federal government launched the task force on financial literacy, which would recommend a strategy to the Finance Minister. 2 Several countries staged national survey campaigns on this theme. Australia, Japan, Korea, the United Kingdom and the United States tried to measure financial knowledge. 3 Statistics Canada conducted a study of 20,000 respondents in 10 provinces in The OECD (2005) concluded that countries are increasingly aware of the importance of financial knowledge and have implemented a large variety of initiatives. Many of the efforts have targeted diverse clienteles such as students or low-income households. The general finding is that the population s level of financial knowledge is limited (SEDI 2005). Most of the works on financial literacy conducted to date assess the level of basic knowledge of personal finance management and retirement planning, and sometimes perception, in the case of fraud and regulatory bodies (Canadian Securities Administrators, or CSA). Nonetheless, in most countries, very few initiatives are aimed at investors. Canada has devoted significant attention to investors financial knowledge, 4 perhaps because this country has one of the highest rates of individual shareholding, 5 Cakebread (2006) notes that in Canada, information and education are considered key components of investor protection (p. 366) and that many resources are made available to investors by regulatory bodies and other organizations (Cakebread 2009). These resources are dedicated to information and investor training. CSA has developed the CSA Investor Index, which measures knowledge at a general level according to various dimensions: Canadians investment behavior, and knowledge of provincial securities regulators, and fraud. If securities commissions have developed many programs and information documents, limited data have been gathered on the reasons that individual investors generally seem to make poor decisions. In contrast to most previous studies, we are interested in the technical knowledge of shareholders exclusively. In our previous research, we observed that individual Canadian 2 The task force s report is available at: This report examines individual investors (retail investors) exclusively. We refer to them as investors. 5 In Canada, the proportion of the population holding stocks was 37.52% in Comparable values are 21.20% in the United States, 15.09% in the United Kingdom and 14.97% in France (Grout et al. 2009). 4

7 investors, including qualified investors, obtain abnormally low returns, particularly when they purchase stocks of companies listed on the Venture Exchange. The finding of poor performance of individual investors has also been established in the United States, particularly among active traders (Barber and Odean 2000b). The portfolios of individuals who are members of investment clubs generally perform worse than those of other individuals (Barber and Odean 2000a). This may be linked to the fact that members of such clubs engage in more aggressive and active management than do isolated investors. It seems that the transactions of individual investors systematically result in large losses (Barber et al. 2009). Nonetheless, the paucity of individual investors knowledge may not suffice to explain their mediocre performance. Here is where rationality comes into play. 1.2 Rationality Individual investors do not manage their portfolios according to the basic rules of finance (Broihanne et al. 2005; Broihanne et al. 2006; Séjourné 2006). They obtain rates of return that are generally inferior to those of the reference indices (Barber and Odean 2000b) and the returns are lower for investors who actively manage their portfolios (Barber and Odean 2000a). Individual investors are very active in the small capitalization sector, which institutional investors tend to avoid (Nofsinger and Varma 2009). They actively participate in the small capitalization issue market where they obtain on average extremely low rates of return. This situation is particularly apparent in the case of investments in small companies listed on the TSX Venture Exchange, and holds for both public issues and private placements (Carpentier et al. 2010a; Carpentier and Suret 2010; Carpentier et al. 2011). Several authors seriously call into question the value of investor literacy programs (Williams 2007; Willis 2008; Willis 2009), attributing the poor performance observed to individuals irrationality and to a set of biases that literacy programs alone cannot correct. As Shefrin (2002) writes, People are imperfect processors of information and are frequently subject to bias, error, and perceptual illusions. De Meza et al. (2008) conclude that differences in financial expertise among investors originate more from behavior problems than from knowledge gaps. Despite the importance of the subject, Deaves et al. (2006 p.256) assert that knowledge of individual investors decision-making process is very limited. In the academic literature, biases are generally analyzed independently; very few works have examined biases and knowledge simultaneously. This study is designed to fill this gap. 2 SURVEY AND RESPONDENTS 2.1 Survey The 40-question survey was administered by Vision Critical/Angus Reid, an institute specializing in Internet surveys, between May 26 and June 10, 2011, to 1814 people: 910 in Québec and 913 in Ontario. The respondents had to hold shares of listed companies and be responsible for decisions related to these stocks. 5

8 2.2 Respondents Males make up 72% of the respondent population. This proportion is identical in Québec and Ontario. The proportion of English speakers is 100% in Ontario and 34% in Québec. 6 Almost 58% of respondents are over age 55, whereas less than 9% are under age 35. Respondents in the oldest age class (over 55) are proportionately fewer in Québec (55%) than in Ontario (60%). These differences are statistically significant. Most respondents are working full-time, but one-third are retired (Table 1). Income, disclosed by 89% of respondents (Table 2), is at least $50,000 per year for almost 82% of respondents. Only 18.4% have income below $50,000 per year. About 44% of respondents have annual income situated in the $50,000-$100,000 bracket, in both Québec and Ontario. In Ontario, 45% of respondents have income higher than $100,000, versus 31% in Québec. The significantly higher income in Ontario is consistent with Statistics Canada data. 7 66% of respondents have a university education, compared with 23% whose highest level of education is college. 2.3 Characteristics of respondent portfolios This section covers the general characteristics of portfolios held and managed by respondents. It paints a profile of the asset categories and the number of stocks each portfolio contains. However, one cannot draw compelling conclusions regarding diversification, because most respondents hold mutual funds. The proportions of respondents who hold shares of large companies, small companies and mutual fund units are 91%, 53% and 74% respectively (Table 3). 58% of respondents hold fixed income securities in addition to shares of listed companies. About 11% of respondents selected the Other investment category. It notably consists of cash, private company shares, options and precious metals. About 69% of respondents hold stock in a self-directed RRSP, which 96% of respondents manage themselves. Over 78% of respondents hold shares in a portfolio outside an RRSP. Close to 31% of respondents hold shares in a portfolio that they do not manage, in addition to holding shares in at least one of the two previous categories. Table 4 shows that respondents invest most of their portfolios (67%) in shares of large companies (43%) and small companies (24%) listed on an exchange. Respondents also invest a large portion of their portfolio in mutual funds (38%) and fixed-income securities (30%) respondents estimated the total value of the financial assets in their portfolios, corresponding to 75.3% of the sample (Table 5). The average value is $427,000. Half of the respondents have a portfolio whose value exceeds $200,000 (Panel A) and 36% of the respondents have a portfolio valued at below $100,000 (Panel B). 6 English speakers in Québec, who represent 13.4% of the population according to data from the official languages commission, are overrepresented in this sample. 7 Statistics Canada, Income in Canada 2007, Catalogue no X, 2009 (p.10), notes a gap of about $11,500 (17.3%) between median household income in the two provinces, in Ontario s favor: 8 The proportions reported are the means of percentages indicated in response to Question 1a. In some cases respondents mentioned that they hold an asset category but attribute a miniscule percentage to it (0%). These values are retained. 6

9 More than 41% of responders invested in fewer than five stocks of large companies, and 65% of respondents hold fewer than nine stocks of large companies (Table 6). Their median holdings are 4 to 5 stocks of small companies listed on an exchange (Table 7). 70% of respondents hold fewer than nine stocks of small companies. Question 3 concerns the proportion of the portfolio invested in the respondent s employer's stock. This type of investment represents an additional risk in that human and financial capital is invested in the same place. 70% of respondents do not hold these stocks, and 80% of respondents have invested less than 10% of their portfolio therein. In contrast, 56 respondents invested their entire portfolio in such stocks and 7.90% of investors placed more than 50% of the value of their portfolio in the employer s stock. Not only are these respondents insufficiently diversified, but they assume substantial risk. We noticed significant differences between respondents by province. Table 3 shows that more respondents from Ontario (93%) than from Québec (88%) hold shares of large companies. The same pattern is seen in mutual funds (79% versus 69%). Whereas 73% of Québec respondents hold shares in a self-directed RRSP, only 65% of Ontarians do. When the shares are in a portfolio outside an RRSP, Ontario investors seem more involved in managing their stocks (98%) than Quebecers (95%). Quebecers invest more in small companies stocks, fixed-income instruments and other securities categories than Ontarians do (Table 4). Ontario investors portfolios have greater value (median $250,000) than those of Quebecers ($140,000, Table 5). More than 44% of Quebecers have a portfolio valued at less than $100,000, compared with only 29% of Ontarians. At the other extremity of the distribution, 80% of Quebecers have a portfolio below $400,000, versus 69% of Ontarians. In Québec, 39% of respondents hold more than nine stocks of large companies, compared with 32% in Ontario. If we assume that one needs at least 10 stocks to diversify a portfolio, more Quebecers are adequately diversified. However, it should be noted that many respondents also hold the shares of small companies and mutual fund units (Table 6). RRSPs represent 65% of respondents portfolios in Québec, 55% in Ontario and 60% on average. The relative importance of RRSPs confirms the importance of the study: management errors would have a significant effect on the retirement income of most people surveyed. 3 RESPONDENTS KNOWLEDGE We analyze the dimensions related to return, risk, the risk-return relationship, diversification and financial decision-making. We evaluate the extent that investors know the basic facts regarding asset categories and securities, and that they have mastered rudimentary concepts related to risk and return, as taught in basic finance textbooks. 3.1 Past return of asset classes Between 1991 and 2010, the returns of Treasury Bills, government bonds and the S&P/TSX index were 4.20%, 10.4% and 11.3% 9 respectively in Canada. We expect that 9 The relatively small variance observed between the return on bonds and that on stocks is not unusual. It has been 2.5% on average for 207 years. 7

10 investors can rank these returns in order of size and situate the returns relative to one another, especially because returns on Treasury Bills and stocks over the last 10 years have remained fairly stable since If we accept an error of 100 basis points, 10 slightly more than half of investors have an accurate vision of the return on Treasury Bills (Table 8). About 23% of investors largely underestimate this return, situating it at 1% to 2%, whereas 26% of respondents overvalue this rate, sometimes considerably. About 13% of respondents situate this return at 7% to 10%, whereas 5% estimate it at 11% or higher. 36% of people surveyed could not answer this question. Fewer than 4% of respondents can state the rate of return on government bonds in the last 10 years (between 9% and 11%), and a large proportion (36%) of respondents could not situate this return at all (Table 9). Of those who replied, 91% undervalued the return, sometimes with very significant variance. Almost one-third of respondents (32%) could not situate the return of the S&P/TSX index in the last 10 years (Table 10). Fewer than 15% of investors surveyed correctly situated this return with a margin of error of less than 100 basis points. The proportion of correct responses is higher in Ontario (16.65% vs %). where the proportion of nonresponses is lower. The proportion of respondents who undervalue the stock return is very high (62.74%). A significant number (11% or 137 out of 1240) of respondents estimate this return at 16% or higher. Many investors (19% of people who gave an answer) situated this return at 5% or under. The statistical test indicates provincial differences. If 21.5% of Quebecers with an opinion estimate the return of the S&P/TSX at under 5%, only 16% of Ontarians shared this view. At the other extremity of the distribution, 12% of Ontarians estimate this return at 12% or higher, as opposed to 10% of Quebecers. For long periods, the return of all bonds (the universe) can equal or surpass that of stocks (Arnott 2009). Table 11 shows that only 44% of respondents in Ontario and 41% in Québec are aware of this. This result confirms the mediocre knowledge of relations between returns of asset classes, which may impede retirement planning and fund allocation across investment categories. 20% of investors claimed they could not answer this question. Overall, the level of knowledge of past returns of major asset categories is abnormally low. 3.2 Basic concepts related to returns Companies with strong growth often need funding, and seldom issue dividends. Most (81%) of the people who answered the question knew that the anticipated return from this type of company comes from the capital gain realized during resale (Table 12). A significant proportion (19%), however, estimated that most of the return will come from dividends. 78 people did not know the answer. In the total sample, 22% of respondents (403 people) did not know exactly where the return of this type of company comes from. 67% of the total of people who had an opinion correctly replied that they were not 10 If the rate of return observed is 4.2%, all answers situated between 3% and 5% are considered accurate. 8

11 certain to receive dividends in the future from a company that usually issues them (Table 13). 33% of respondents therefore take it for granted, mistakenly, that dividends will be distributed in the future. A significant difference was noted between the provinces. Close to 40% of Ontario respondents were certain that dividends would be distributed versus only 26% of Quebecers. About 8% of respondents claimed they did not know the answer. Therefore only 61.52% of respondents answered this question correctly. About 19% of people admitted that they did not know whether stock market indices are influenced or not by the returns of stocks of the large companies (Table 14). More than 88% of respondents who had an opinion know that stock indices are indeed influenced by the behavior of large capitalization stocks. Only 12% wrongly believe that this is not the case. The overall correct response rate was 71%. The concept of risk premium plays a central role in finance; professionals use it regularly. The risk premium determines the rate of return that one can expect from the stock market. It is thus a very important element that should be considered during the financial planning process. Nearly 41% of the people surveyed did not know that the expected market return is the sum of the risk-free rate (that of government bonds) and a market risk premium (Table 15). Fewer than 30% of the respondents answered this question correctly: 31% in Ontario and 29% in Québec. The proportion of non-responses is particularly high in Ontario, at 43% versus 38% in Québec. Table 16 shows the distribution of investors estimates of market risk premium. Most professionals and academics situate this premium at between 4% and 5% (Damodaran 2010). Surprisingly, 48.3% of investors replied that they had no idea about this premium, although they manage their stocks. Fewer than 18% of the respondents provided correct answers. A large proportion of respondents who provided estimates (22%) situated this premium at higher than 8%, which is unrealistic, and 28% estimate the premium at 3% or under. It is better to buy when markets are low and sell when they are high to realize a gain. 81% of investors in Québec and 70% in Ontario did not know this principle (Table 17). The difference between the two groups is significant. Only 6% of respondents were unable to answer this question. Evaluating the performance of one's portfolio regularly and rigorously is one of the conditions for proper management. This evaluation entails benchmarking the portfolio s return against the market. The majority of investors do not benchmark their performance regularly: 53% mentioned that they do it sometimes and 25% never do it at all. Only 22% of investors do this comparison on a regular basis (Table 18). Statistically significant provincial differences were noted: 24% of Ontario investors calculate their abnormal return regularly, versus 20% of Quebecers. 57% of Quebecers sometimes do this exercise, compared with 50% of Ontarians. As a whole, the results indicate that a significant proportion of investors have major knowledge gaps pertaining to stock market returns. 3.3 Notions related to risk A rarely traded security is risky because of its lack of liquidity. The premium associated with this risk, for companies listed on US exchanges, is estimated at about 3% per year 9

12 (Liu 2006). If a liquid stock has an expected rate of return of 10% a similar but less liquid stock should command a rate of 13%. 11 This difference directly affects share value, a fact of which many investors seem unaware. Question 12 asked about this effect: You have the choice between two listed stocks with the same risk level. Stock A is traded every day, while stock B is traded once a month. Stock A is selling for $10. How much would you pay for stock B? The share price of stock B should be about $7 to $8, based on American estimates. Almost 42% of respondents gave this answer (Table 19). 31% of people surveyed could not answer this question, and 23% suggested a price equal to or higher than $10. They estimate that the lack of liquidity has no effect on the value or even commands a premium, which is patently incorrect. There seems to be a difference between the provinces among people who have an opinion: nearly 69% of Quebecers apply this discount, compared with only 65% of Ontarians. Table 20 shows that 81% of respondents who have an opinion know that they may lose the whole amount invested in small capitalization companies listed on the Venture Exchange. We observed a statistically significant provincial difference: 78% of Ontarians answered correctly versus 71% of Quebecers. Nearly 22% of Ontario investors (29% of Quebecers) think it is not possible to lose the entire amount invested in a few stocks of exchange-listed small businesses or could not answer the question. The risk measure used in portfolio management is complex and refers to volatility and systematic risk. We used an intuitive measure of risk--the probability of obtaining a negative return during the coming year. For each of the asset categories we estimated this proportion using historical returns: this proportion was zero for Treasury Bills between 1991 and 2009, and 7% and 32% for bonds and stocks respectively. Regarding Treasury Bills, Table 21 shows that 18% of investors surveyed have no idea of the magnitude of this probability. 40% of investors answered correctly (zero probability). Nonetheless, about 15% of investors estimate that this probability is above 30%. Statistically significant provincial differences were observed. 55% of Quebecers correctly estimate that this probability is 5% or under, versus 52% of Ontarians. At the other extremity of the distribution, 16% of Ontarians wrongly believe that this probability is higher than 30%, compared with 14% of Quebecers. Table 22 indicates a very low proportion of correct answers related to bonds (7%). 269 out of 1814 respondents (15%) could not answer the question. Of investors with an opinion, 15% estimate this probability at between 6% and 30%. Most (60%) situate this probability at 5% or lower. Nonetheless, 10% think it is higher than 61%. We also noted statistically significant differences between the provinces. 48% of Quebecers wrongly estimate that this probability is zero, versus 38% of Ontarians. Bond risk seems to be poorly known, similar to bond return. The probability of obtaining a negative return by holding an index fund is generally underestimated (Table 23). 29% of respondents situate this probability at between 31% and 50%. Even by greatly expanding the bracket of correct answers to include the class of 11 If a security earns $.80 in perpetuity for a capital cost of 8%, it is worth 0.80 /0.08 = $10. If a premium for lack of liquidity of 30% raises the cost of capital from 8% to 11% per year, the value becomes: 0.8/0.13 = $6.15. The net effect on price depends on the initial assumptions, but an estimate between $6 and $8 would be accurate. 10

13 21% to 30%, the proportion of correct answers is below 42%. Surprisingly, 35% of investors who supplied an answer said that this probability was 20% or less. This trend is most common in Québec, where 39% of investors answered this way, as opposed to 31% of Ontarians. Equity risk therefore seems to be strongly undervalued. In general, approximately one investor out of two does not have a clear idea of the link between lack of liquidity and share price, and one investor out of five does not know that they could lose their entire investment if they purchase the stocks of small companies listed on the TSX Venture Exchange. Many investors largely underestimate the risks of holding government bonds and stocks. 3.4 Risk-return relationship Only 41% of respondents affirm the positive risk-return tradeoff (Table 24). The remainder disregards this relationship or does not consider it systematic, which is incorrect. 12 This finding corroborates De Bondt s (1998, p.840) assertion that most Americans investors deny the risk-return relationship. In Canada, 59% of investors think there is no such relationship or have no opinion on this question. The difference between Québec and Ontario investors is significant. In Québec, 47% of investors think that one can obtain a high return only if one assumes a high risk. This proportion is only 34% in Ontario. The conviction that the relationship between risk and return is not systematic also appeared during the analysis of the results of question 15 (Table 25): more than 64% of investors think that some stocks listed on the TSX are bargains, that is investments with a high return and low risk, but that these stocks are rare. If we add the investors who believe that this is true (19%), a total of 83% of investors think that the TSX offers bargains with a high return and low risk. 7% could not answer the question. Only 10% of investors know that this statement is false. 15% of Quebecers hold this view, compared with only 5% of Ontarians. This difference is statistically significant. The impact of risk on share prices was addressed in the following question (Table 26). More than 14% of the respondents did not know what impact risk would have on stocks. Only 58% of investors knew that the price of a risky stock would be lower than that of a less risky stock. The proportions of correct answers were 66% in Ontario and 51% in Québec, a statistically significant difference. To summarize, the majority (59%) of investors think there is no systematic relationship between risk and return of stocks. Nearly all investors (83%) are convinced that there are low-risk stocks that yield a high return. 3.5 Diversification Diversifying a stock portfolio can eliminate a portion of the risk without decreasing the expected return. Table 27 illustrates that 82% of respondents rightly believe that this statement is true. 14% of the respondents consider this statement false. The majority of investors have a clear idea of what diversification is, even if they do not fully grasp the means of applying it. The nonresponse rate is very low (4%). Fairly evident statistically 12 The search for undervalued stocks, which offer a higher return at an equal risk, is the rationale behind fund managers financial analysis. If they do appear, such stocks meet great demand that increases their price, which reaffirms the risk-return relationship. 11

14 significant differences appear between the provinces: 87% of Québec investors who answered did so correctly, as opposed to 83% of Ontarians. Basic finance textbooks set the number of stocks from different sectors required to diversify a portfolio at 20. The strict minimum is 10, if they are carefully selected to ensure they are not interrelated. 35% of Ontarians and 25% of Quebecers have no idea about the minimum number of stocks required to diversify a portfolio (Table 28). Further, 35% of respondents claim that 1 to 9 stocks is sufficient. Only 35% of the respondents gave an acceptable answer, i.e. between 10 and 50 stocks, and the proportion of entirely correct answers (20 to 50 stocks) was 6%. Investing in mutual funds is a good way to diversify an equity portfolio. Table 29 shows that 218 respondents did not know this, and 114 thought that this statement is false. Therefore, 20% of the people surveyed did not think it is possible to diversify a stock portfolio through mutual funds. Whereas the concept of diversification seems relatively well understood, only a small proportion of people surveyed know how to effectively diversify a portfolio. 3.6 Investors financial decisions Before investing in small capitalization stocks, particularly as part of issues or placements, it is important to meticulously analyze the information about the stocks, which are often overvalued. Table 30 shows that 24% of people surveyed have no opinion on this question, whereas 11% found the statement false. More than one in three respondents answered this question incorrectly. Only one out of five respondents is aware there is no reliable means of systematically identifying undervalued or overvalued stocks (Table 31). The difference between provinces is significant: 89% of Ontarians that have an opinion on this question answered incorrectly, compared with 74% of Quebecers. Buying the stock of a company with negative earnings implies assuming a high level of risk. Table 32 shows that nearly 42% of people surveyed consider this assertion false (444) or do not know (309). Only 58% of investors are therefore aware of the risk of investing heavily in a company with negative earnings. More investors from Ontario than Quebec answered this question incorrectly: 33% of Ontarians with an opinion on the topic wrongly believed that the statement was false, as opposed to 26% of Quebecers. This difference is statistically significant. Investment decisions should be made according to overall asset allocation. The distribution of answers appears in Table 33, which shows that 32% of respondents did not answer this question correctly. 18% think that asset allocation is irrelevant. These investors consider that the main element of portfolio management is stock selection. Before buying a stock for the first time, one should analyze information related to its risk level and expected return. Panel A of Table 34 indicates that most investors perform this analysis well. However, almost 29% of investors do not consider analyzing the information important, or do not do so systematically. Panel B of Table 34 shows that 30% of investors in the sample do not have financial advisors. Therefore, 70% of investors who make decisions on portfolio management use the services of a financial advisor. However, nearly 81% of these investors analyze the recommended stocks as closely as if they had picked them themselves, which is a sound approach. 12

15 On average, the return obtained by mutual fund managers is below or equal to the market return, before management fees (Lortie 2011; Sundgren and Svanström 2011). Only 47% of people surveyed think this return will be below the market return (Table 35). A significant proportion (21%) of respondents could not answer the question. About 33% of respondents think that the institutional investor s return will be identical to or higher than the market s performance. 3.7 Investors knowledge score To summarize the results of the responses related to knowledge, we calculated knowledge scores. The details of the 28 questions used in this calculation along with the points attributed to each question are presented in Appendix 1. The total maximum score is 56 points. Our method is inspired by that used in a similar context by several researchers (Volpe et al. 2002; Lyons et al. 2007). Figure 1 illustrates the distribution of responses. The median and average score is 26 out of 56 points. The scores range from 0 to 44 points, but 50% of the scores fall between 21 and 31 points. Whereas only 5% of respondents scored higher than 37, 10% of respondents scored below 16. Despite the many existing programs dedicated to financial education, investors obtained only an average score when their knowledge is tested. Only 5% of investors received a score higher than 66%, corresponding to a passing grade in a university course. We have tried to link the scores to respondents characteristics. Because these characteristics are not totally independent, they will be examined simultaneously. 3.8 Investors scores and characteristics Table 36 presents the analysis of the financial knowledge score, expressed as a percentage, according to respondents characteristics. The explanatory variables are defined as follows: Sex: takes the value of 1 if the respondent is male, and 0 otherwise. College: takes the value of 1 if the respondent has a college education, and 0 otherwise. University: takes the value of 1 if the respondent has a university education, and 0 otherwise. Age_35_54: takes the value of 1 if the respondent is between age 35 and 54, and 0 otherwise. Age_55: takes the value of 1 if the respondent is 55 or older, and 0 otherwise. Income_50_100: takes the value of 1 if the respondent's annual income is between $50,000 and $100,000, and 0 otherwise. Income_100: takes the value of 1 if the respondent's annual income is over $100,000, and 0 otherwise. Québec_Eng: takes the value of 1 if the respondent is an English-speaking Quebecer, and 0 otherwise. Québec_French: takes the value of 1 if the respondent is a French-speaking Quebecer, and 0 otherwise. 13

16 Most of the coefficients are statistically significant. Financial knowledge is highest for men, and the level of significance is high. A higher level of education increases the knowledge score. The reference level is the lack of college education. Holding a college diploma does not influence knowledge significantly. Nonetheless, having a university education it is very significant and positively related to knowledge. The score is 2.27 percentage points higher for this investor category. High income is also positively associated with the knowledge score: the two variables associated with this dimension are statistically significant. The reference level is that of investors with income below $50,000. The group with income of between $50,000 and $100,000 has a score 1.25 percentage points higher than this reference level, whereas investors with the highest income exceed the base score by 2.26 percentage points. Most of the relationships clarified are intuitive, and are in line with the results of previous studies. There seem to be differences related to language, which we cannot explain. These differences warrant more in-depth analysis. 4 INVESTOR RATIONALITY In this section we examine elements related to investor behavior. Isolating each of the elements of behavioral finance calls for a rigorous protocol and the use of large samples in an experimental situation. This was not the objective of this analysis. Rather, we sought to evaluate the extent that Canadian investors are influenced by the best-known behavioral biases. 4.1 Perspective theory There is ample proof that presentation of choices influences decisions. The situation presented first will generally be overweighted relative to alternatives presented subsequently. If this is the case, the sequence of information produced on a stock, company or market may unduly influence agents decisions. For example, the risk factors of a prospectus are presented in order, and the main factors appear after less significant ones. To analyze the extent that risk perception is influenced by the order of presentation of information, the survey contained questions with the same answer, but whose presentation differed. Replies were interpreted in pairs. The first pair of question was as follows. Q26 How much would you be willing to pay for a share in AB Inc. that has 1) a one in a hundred chance of generating a profit of $1,000, and 2) a total loss in all other cases? Q39. How much would you be willing to pay for a share in AB Inc. that has 1) a 99% chance of generating a total loss, and 2) a 1% chance of generating a $1,000 profit? Question 26 presents the large gain first, whereas Question 39 begins by mentioning the total loss. Because the choices are identical, we should observe similar distributions for each of the two questions. The expected value of the lottery is $10 (i.e x 0.01) in each case. Perfectly rational individuals should therefore offer $10 per share. The preference for asymmetry should lead some to offer more than this amount. Most of the respondents would not buy the lottery stock proposed, which seems to illustrate a level of risk aversion that is not observed in the small capitalization stock market (Table 37). A small proportion of respondents who had an opinion (4% to 6% depending on whether question 26 or question 39 is analyzed) appeared to prefer 14

17 asymmetry, and offered more than $10 for this share. Few respondents offered the price that represents the mathematical expectation, or $10: almost 8% for Question 26 and 4% for Question 39. A sizable proportion of respondents (12% to 15%) did not know how much to offer for such a stock. Regarding Question 26, more than half of the respondents (53%) claimed they would offer nothing for the stock and 71% would offer $5 or less. These proportions are higher in response to Question 39, which presents the loss first: 59% of respondents would offer nothing at all and 80% would offer less than $5 for the stock. The order of presentation thus influences the answers, albeit to a limited extent. The second pair of answer concerns valuation of the risk of a biotechnology company when the order of presentation of risk factors is inverted. The third pair pertains to the perception of risk of the TSX Venture Exchange according to whether the winning stocks are presented first or not. In either case, the order of presentation of the information has very little influence on the answers, and we did not describe the results in detail. 4.2 Availability bias We tested the proposition that investors are interested in stocks that have experienced strong variations in price, and tend to extrapolate the pattern observed. Accordingly, a stock that has yielded a high return should be preferred to a stock whose price has changed little. However, there is ample proof that past returns are no indication of future returns. Table 38 shows that 69% of investors who answered correctly could not judge the better purchase based on the past return of two stocks. 21% of investors replied that the best stock to buy is the one that had a higher return than the market, and only 10% opted for the stock with a low return. Investors thus tend to extrapolate from a past positive return, but this attitude is not generalized. 73% of Ontarians answer correctly versus 64% of Quebecers, a significant difference. 4.3 Overconfidence bias Overconfidence refers to investors tendency to overestimate their knowledge and abilities and the accuracy of their information. Overconfident agents undertake actions for which they lack the necessary skills. To estimate the presence of this effect, we first used the risk premiums established by specialists. An average realistic investor should have confidence in the average projections established by all experts and not consider them optimistic or pessimistic. This question lets us verify the coherence of the respondents answers. Question 9 asked investors to estimate this premium. Table 39 illustrates the results. The columns total Ontario, total Québec and total present the distribution of answers by province, for all respondents, whereas the previous columns report the answers according to the level of risk premium estimated in Question 9. Panel A shows the number of responses and Panel B their proportion. Only 110 respondents out of 1814 (6%), consider the estimated risk premium realistic and therefore trust the specialists. Many respondents (43%) consider this estimate pessimistic: they feel that the market should deliver a return higher than 7%. Conversely, 27% of respondents consider the estimate too optimistic. 24% of respondents did not specify whether the premium was realistic or not. Note that in Question 9, soliciting the estimation of the premium, 876 investors, or nearly half of the sample, checked the box I 15

18 don't know. More respondents from Ontario than Québec admitted that they did not know the answer to this question. Surprisingly, only 4% of respondents who chose a risk premium of 3% to 4% consider the experts forecast realistic, even though both they and the specialists arrived at the same result. The replies to various questions thus indicated incoherence. The majority of respondents who chose a higher premium consider the projection pessimistic, in line with expectations. For example, 57% of respondents estimate the premium at between 5% and 6% and consider the estimate of 3% to 4% pessimistic. However, 25% of these investors think the premium is optimistic, which is surprising. Similarly, only 38% of respondents who estimate the premium at between 0 and 2% think that the estimate of 3% to 4% is optimistic, whereas one would expect to observe a percentage closer to 100%. The respondents therefore seem to have a very unclear grasp of the size of the risk premium, given that their responses vary greatly depending on the question. Questions 30 and 30a (Table 40) reflect investors ability to detect overvalued or undervalued stocks. As Clarke et al. (2001) note, the chances of systematically detecting over- or undervalued stocks are low, and the probability that an investor will systematically beat the market for several periods is slim. Responses are expressed in percentage of success. A random choice would give, on average, a rate of selection of winning stocks of 50% because they represent half of the stocks available. The probability of choosing an exceptional stock would be 5% (one chance out of 20). Panel A presents the distribution of answers and Panel B the percentage of answers compared with the entire sample. Table 40 indicates a very high proportion of non-responses: more than one out of three respondents did not know the odds of selecting a winning stock, and one out of five could not specify their chances of selecting an exceptional stock. Only 17% of respondents think their chances of selecting winning stocks is identical to that of a random choice, at 50%. Oddly, 23% of respondents indicated a lower probability of a correct choice (fewer than five winning stocks out of 10) than what chance would allow. 25% of investors think they can select more than 5 winning stocks out of 10, and therefore exhibit overconfidence. This phenomenon thus seems to be relatively uncommon within the sample. Overconfidence is more evident concerning the chances of identifying exceptional stocks. Whereas we expected most of the investors to give a probability of 10% or less, only 23% of respondents chose this answer. For 77% of investors surveyed, the chances of detecting a winning stock are greater than 2 out of 20. These investors clearly exhibit a trend toward overconfidence. 20% of Ontarians rightly estimated that they have about a 50% chance of identifying winning stocks, compared with 14% of Quebecers. In addition, 25% of Ontarians correctly estimated their chances of identifying a winning stock at 10% or less, compared with 22% of Quebecers. The interprovincial differences are significant. Valuing a startup technology stock is a complex process, with huge margins of error, even for professionals. Venture capital investors often make costly mistakes because a significant portion of their investments fail. We attempted to determine whether investors admit that it is very unlikely to obtain a high return (300% over three years) by holding such stocks. We estimated this probability at 5%. This figure was observed, for example, 16

19 in the case of initial public offerings and reverse takeovers between 1993 and The only companies that provide a high return over three years are those that graduate from the venture exchange to the main exchange (Carpentier et al. 2010b). These highperforming companies represent less than 8% of newly listed companies. About 10% of stocks in a given year consist of new listings. The probability of selecting such a winning stock can therefore be situated at between 0 and 5%. Table 41 presents the distribution of respondents estimated probabilities. Nearly 15% of investors could not state this probability. Only 41% of investors rightly believe that this percentage is 5% or less. Half of investors therefore largely overestimate the probability of obtaining an exceptional return. On average, respondents estimate the probability of obtaining an exceptional return at 14%, and 15% in Québec. Ontarians seem to be slightly less optimistic than Quebecers: 58% estimate this probability at 10% or less, compared with 54% of Quebecers. Investors thus overestimate the probability of realizing exceptional returns. We asked respondents to evaluate their skill in three important elements of portfolio management: stock selection, market trends and timing of stock buying and selling decisions. The survey structure lets us compare these opinions with skill measured by scores. Although this measure is admittedly imperfect, 14 it indicates the correct response rate to the question on knowledge, presented in Part 3. For each group and response, we recalculated the respondents median score. Table 42 presents the distribution of answers. Regarding stock selection, 53% of investors consider themselves competent, 28% not very competent, about 10% not competent at all, and 10% very competent (Panel A). There are nonetheless differences between the provinces: 59% of Ontarians say they are competent, compared with 47% of Quebecers, and 15% of Ontarians say they are very competent, versus 6% of Quebecers. The last column of Table 42 indicates the median distribution of the competence scores of investors in each group. In terms of stock selection, investors obtain a median score of 19 out of 38: 50% of investors score below this limit. The global level of skill measured is therefore average. The score increases as the level of perceived competence increases: investors who do not feel competent at all obtain a score of 13, whereas investors who consider themselves very competent obtain a score of 21. Note that 50% of investors who thought themselves very competent obtain a score below 21 out of 38. These investors are therefore optimistic when they judge their ability to select stocks. It is in this area that respondents feel that they are most competent. When they assess their ability to predict the overall evolution of the market, 46% of investors say they are not very competent, and 19% are reportedly not competent at all (Panel B). This high proportion of respondents who do not consider themselves very competent at anticipating market trends reflects the difficulty inherent in this exercise, even for specialists. Nonetheless, 32% of respondents said they were somewhat competent, and investors from Ontario were more likely to report feeling competent than 13 The probability of realizing a positive return in a given year is 43% (Carpentier and Suret 2008). The probability of earning a rate of return of 300% or more one year and positive or zero returns in the two following years is therefore below 5%. 14 We could not verify all the aspects of investors financial knowledge. 17

20 Quebecers. This difference is statistically significant. The score obtained by all respondents is 4 out of 14, which is below the average. Median scores measured for the two groups who think they are somewhat competent or not very competent are identical. At 5, the score of investors who consider themselves very competent falls short of the average of 7 out of 14. Investors in these categories probably overestimate their abilities. Panel C of Table 42 illustrates skill at timing stock buying or selling decisions. 81% of investors feel not very competent or somewhat competent at choosing the right time. The median score obtained by investors is 10 out of 18, or slightly above the average. Investors who consider themselves most competent did not obtain a better score than investors in the other groups (except for those who thought they were not at all competent). In general, investors thought they were more skilled than they actually were based on our estimators. However, only a small minority of respondents said they were very competent. They represent only 3.42% of the sample. However, the scores obtained did not indicate that these investors are particularly skilled. Investors affected by the overconfidence bias think they can outperform the market return. To measure the extent of this bias among the investors, we asked respondents to forecast the return of individual investors given a specific projection of the index return, along with the return of their own portfolio. We report the variance directly: - The Investor-Market Gap (IMG) is the difference between the respondents estimated return for all investors and that of the market. Analyses conducted on various markets indicate that the average return of individual investors is below that of the market (Barber and Odean 2000b). - The Respondent-Investor Gap (RIG) is the difference between the return respondents expected on their own portfolio, and what they expect for individual investors overall. - The Respondent-Market Gap (RMG) is the difference between the expected return on the respondent s portfolio and the market return. Table 43 reports the distribution of these gaps for each group of respondents in both provinces. Over 39% of respondents consider that overall, individual investors will realize a return 300 basis points or more below the market (IMG indicator). If we add the 18% of investors who consider that this gap will be less than 100 or 200 basis points to that number, almost 57% of respondents think that individuals will realize returns below that of the market. About 22% of respondents think that individual investors will obtain a return equal to or higher than that of the market. More than 21% of respondents could not answer this question. The RIG indicator shows that 18% of investors estimate that their own portfolio will generate a return identical to that projected for all investors. However, a very large proportion (45%) of investors think that their own portfolio will earn a better return than that of their peers. About 63% of investors therefore believe they can attain a return at least equivalent to that of other individual investors. Only 15% of respondents think they will obtain a lower return than that of their peers. A statistically significant difference was observed between the provinces: many more Ontarians (65%) than Quebecers (60%) think they can attain a return identical to or better than their peers. Respondents therefore consider themselves more skilled than their peers. 18