1Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Martin Weber

University of Mannheim

Risk Taking

2Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Motivation

(MiFID, 2006/73)

Markets in Financial Instruments Directive - MiFID

Investment firms need to make sure that an investment

meets the investment objectives of the client in question

and is suitable for him (MiFID, 2004/39)

What are investment objectives?

• “…information on the length of time for which the client wishes to

hold the investment,

• his preferences regarding risk taking,

• his risk profile

• and the purposes of the investment.”

3Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Motivation

• Legal necessity

• Marketing strategy

- Fill out form and file

- Fill out form and use for advisory

- Fill out form online and use at discount brokers

Reasons to know more about your customer

4Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Elicitation of “preferences regarding risk taking” and “risk profiles”

Motivation

SOEP (2008) (Socio-Economic-Panel of the DIW)

(approx. 22,000 individuals)

5Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Motivation

SOEP (2004) (Socio-Economic-Panel of the DIW)

Elicitation of “preferences regarding risk taking” and “risk profiles”

6Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Motivation

Some German Bank (Private Wealth Management)

Elicitation of “preferences regarding risk taking” and “risk profiles”

7Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Modeling Risk Taking

Risk Taking (Investing) = f ( Return, Risk)

≙ (Perceived Return) – (Risk Attitude) (Risk Perception)(Investing)

Risk Taking

(see e.g Markowitz, JF, 1952)

(see e.g Sarin/Weber, EJOR, 1993, Jia et al., MS, 1999 and E. Weber et al., 2004, JBDM)

8Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Modeling Risk Taking

RiskTaking

PerceivedReturn≙ Risk

Attitude- . PerceivedRisk

How is this link affected by:

• Different domains of risk taking?

• Different ways of measuring risk attitudes?

• Different ways of measuring perceived risk/return?

• Subjects level of overconfidence?

Analyze this link in a questionnaire study with 78 students(Nosic/Weber, How Risky Do I Invest: The Role of Risk Attitudes, Risk Perceptions and Overconfidence, 2008)

9Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Design: Risk Taking

50%

50% +9.000 Euro

+12.000 Euro

+10.000 Euro

10

20

30

40

50

60

Nov. 01 Nov. 02 Nov. 03 Nov. 04 Nov. 05 Nov. 06

TakingPerceived

Return≙ RiskAttitude- . Perceived

RiskRisk

(State certainty equivalent)Lottery 2 Risk taking

50%

50% 0 Euro

10.000 Euro

Stocks(Divide 10,000 Euros between a lottery and a risk free asset repeat for 5 different stocks)

Risk taking

(Divide 10,000 Euros between a lottery and a risk free asset)

Lottery 1 Risk taking

10Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Design: Risk Taking

50%

50% +9.000 Euro

+12.000 Euro

+10.000 Euro

10

20

30

40

50

60

Nov. 01 Nov. 02 Nov. 03 Nov. 04 Nov. 05 Nov. 06

TakingPerceived

Return≙ RiskAttitude- . Perceived

RiskRisk

Lottery 2

50%

50% 0 Euro

10.000 Euro

Stocks

Lottery 1 Mean = 58.75% (Median = 60%)

75% of all subjects in range: (40% - 100%)

Mean = 4144.73 (Median = 4000)

83% of all subjects in range: (3000 - 5000)

Mean Avg. stocks = 43.64% (Median Avg. stocks = 40%)

75% of all subjects in range: (28% - 100%)

11Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Design: Perceived Return

Historical Return Past return of each stock

Expected Return (Stock) State expected price for each stock (and transform this into return estimates)

RiskTaking Return

RiskAttitude

. PerceivedRisk

Perceived -≙

10

20

30

40

50

60

Nov. 01 Nov. 02 Nov. 03 Nov. 04 Nov. 05 Nov. 06

12Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Design: Risk Attitude

1 low willingness to take risk≙ …. 5 high willingness to take risk≙

Subjective Risk Attitude

RiskTaking

PerceivedReturn≙

Attitude- . Perceived

RiskRisk

Mean = 2.59 (Median = 2.5)

91% of all subjects in range: (2 - 4)

Risk Attitude (Lottery 2)

50%

50% 0 Euro

10.000 Euro (elicit certainty equivalent and transform it into risk aversion parameters u(x) = xα)

Mean = 0.86 (Median = 0.76)

83% of all subjects in range: (0.58 - 1)

13Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Design: Perceived Risk

Historical Volatility Past volatility of each stock

Risk perception State risk perception on Likert scale • Lottery 1 (Mean = 4.1)• Lottery 2 (Mean = 7.11)• Each stock individually (Mean = 5.43)

Expected Volatility (Stock)State upper/lower bound for each stock (and transform this into volatility estimates)

RiskTaking

PerceivedReturn≙ Risk

Attitude- .Risk

Perceived

14Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Results: Correlation analyses

First evidence for domain specificity

Subjective risk attitude is better & more general predictor of risk taking behavior

(Expected Return – Historical Return)

Expected VolatilityHistorical Volatility

Risk Taking (Lottery 1) Risk Taking (Lottery 2) Risk Taking (Stocks)

Subjective Risk Attitude 0.427 0.445 0.350(0.000)*** (0.000)*** (0.000)***

Risk Perception (Lottery 1) -0.460 -0.313 -0.008(0.000)*** (0.006)*** (0.949)

Risk Perception (Lottery 2) -0.329 -0.504 -0.023(0.004)*** (0.000)*** (0.847)

Risk Attitude (Lottery 2) 0.359 0.034(0.002)*** (0.770)

Mean Optimism (Stocks) 0.001 0.130 0.046(0.990) (0.263) (0.692)

Mean Miscalibration (Stocks) -0.083 -0.129 -0.256(0.476) (0.266) (0.025)**

15Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Results: Disggregated regressions (clustered OLS)

Domain specificity

More overconfident take more risk

Subjective risk attitude vs. lotteries

Subjective vs. objective risk/return

Risk taking (stocks)Subjective Risk Attitude 10.087 9.514 9.225 9.236

(0.000)*** (0.001)*** (0.003)*** (0.003)***Risk Perception (Lottery 1) 0.297 0.226

(0.826) (0.866)Risk Perception (Lottery 2) -0.218 -0.231

(0.874) (0.866)Risk Attitude (Lottery 2) -0.730 -0.291

(0.905) (0.962)Historical Return (Stocks) 2.569 4.339

(0.654) (0.387)Historical Volatility (Stocks) -50.558 -30.484

(0.004)*** (0.119)Expected Return (Stock) 24.622 30.851

(0.018)** (0.004)***Optimism (Stocks) 33.690

(0.001)***Risk Perception (Stocks) -3.723 -3.398 -3.280

(0.000)*** (0.002)*** (0.003)***Expected Volatility (Stock) -26.530 -28.292

(0.003)*** (0.007)***Miscalibration (Stocks) 11.215

(0.003)***Controls No No Yes Yes

Stock Dummies No No No Yes

Constant 34.449 46.521 30.057 1.409(0.000)*** (0.000)*** (0.418) (0.969)

Observations 380 377 352 352Adjusted R-squared 0.136 0.260 0.262 0.271

16Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Conclusion

Historical Return

Expected Return

Subjective Risk Attitude

Risk Attitude Lottery 2

Risk Taking is a function of risk and return! However:

• Domain specificity is important

• Subjective risk/return measures are better predictors than historical risk/return

• Subjective risk attitudes are more adequate than lotteries

• More overconfident more risk taking

RiskTaking

PerceivedReturn

≙ - . PerceivedRisk

RiskAttitude

Historical Volatility

Expected Volatility

Risk Per-ception

17Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Outlook

• How to elicit risk attitudes

- Single, subjective score

- More complex psychometrically validated methods (self-assessments)

- Computerized, graphical approaches (see e.g. Goldstein et al., Journal of Consumer Research, 2008 or the following tool)

• How often to elicit determinants of risk taking?

- Changes in perceived return

- Changes in risk attitudes

- Changes in perceived risk