Do Investors Put Their Money Where Their Mouth Is? Stock Market Expectations and Investing Behavior

There is a large gap between what finance models predict for individual investor behavior and what can be observed in their actual behavior. Portfolio theory assumes that investors form expectations about return and risk of securities and select portfolios according to their expectations and risk preferences. As a consequence they should hold broadly diversified portfolios and trade very little. But instead, private investors have been shown to hold underdiversified portfolios, to trade frequently, to take high idiosyncratic risk, and to gamble in the stock market. To understand this striking differences the investment process itself needs greater scrutiny. How do real investors use their beliefs and preferences in investing decisions? We examine this question using a panel survey of self-directed online investors at a UK bank. The survey asks for return expectations, risk expectations, and risk tolerance of these investors in three-month intervals between 2008 and 2010. We combine the survey data with investors' actual trading data and portfolio holdings. We find that investor beliefs have little predictive power for immediate trading behavior. However, portfolio risk levels and changes are systematically related to return and risk expectations. In line with financial theory, risk taking increases with return expectations and decreases with risk expectations