Why Do Investors Invest?: An Analysis of Factors Influencing Investor Portfolio Choice and Behavior

Abstract

The divergence of investor portfolio holdings from the theoretical optimum has been an anomaly that scholars have struggled to adequately explain for decades. In a globalized financial world, traditional explanations for local and home bias are less justifiable. My research paper contributes to the scholarly discussion by analyzing new drivers of investor choice and re-examining researched variables using more complete, up-to-date data. Using linear and quadratic logarithmic models and instrumental variable regressions with standardized coefficients and fixed effects on panel data, I investigate drivers behind investor behavior (deviations between the actual and optimal portfolio choice) and seek to explain why the mean-variance theory is not practically applied in real life.

Beginning with bilateral variables, I show that familiarity biases, distance, and polity regime similarity are robust and statistically significant drivers of investor choice (with the greatest explanatory power), suggesting that investor deviations are strongly driven by mismanaged perceptions of a country's risk and return. Additionally, control of corruption, technological development, and insolvency resolution of the issuer are robust determinants of investor choice (although with less explanatory power than bilateral variables), indicating that certain country-level attributes capture expected risk and return better than historical returns. I further find that investors actively care about ethical factors, like an issuer's human rights record, corruption level, and environmental impact, irrespective of risk and return considerations (albeit with the least explanatory power). My findings also indicate that countries consistently exhibit strong home bias in equity investments, which points to explicit domestic political economy constraints.

After I empirically prove gravity model relations in equity holdings (greater distance between the investor and issuer country leads to less equity holdings), I find that gravity model relations in portfolio holdings are largely explained by a strikingly strong ‘familiarity bias.’ I also, surprisingly, find evidence that bilateral trust is not a robust or significant determinant of investor holdings, supporting Spring and Grossman (2016)'s critique of Guiso et al. (2009)'s work.

Overall, I find that investors are attracted to closer countries with greater familiarity, technological development, insolvency resolution ability, and bilateral polity similarity. Investors avoid countries with less human rights protection, more corruption, and less eco-friendliness.