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Risk Taking. Martin Weber University of Mannheim. Motivation. Markets in Financial Instruments Directive - MiFID
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Risk Taking Martin Weber University of Mannheim
Motivation • 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.” (MiFID, 2006/73)
Motivation Reasons to know more about your customer • 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
Motivation Elicitation of “preferences regarding risk taking” and “risk profiles” SOEP (2008) (Socio-Economic-Panel of the DIW) (approx. 22,000 individuals)
Motivation Elicitation of “preferences regarding risk taking” and “risk profiles” SOEP (2004) (Socio-Economic-Panel of the DIW)
Motivation Elicitation of “preferences regarding risk taking” and “risk profiles” Some German Bank (Private Wealth Management)
Modeling Risk Taking ≙ (Perceived Return) – (Risk Attitude) (Risk Perception) Risk Taking (Investing) Risk Taking (Investing) = f ( Return, Risk) (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)
Modeling Risk Taking • 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)
Design: Risk Taking (Divide 10,000 Euros between a lottery and a risk free asset) Lottery 1 Risk taking Lottery 2 (State certainty equivalent) Risk taking (Divide 10,000 Euros between a lottery and a risk free asset repeat for 5 different stocks) Stocks Risk taking
Design: Risk Taking Lottery 1 Mean = 58.75% (Median = 60%) 75% of all subjects in range: (40% - 100%) Lottery 2 Mean = 4144.73 (Median = 4000) 83% of all subjects in range: (3000 - 5000) Stocks Mean Avg. stocks = 43.64% (Median Avg. stocks = 40%) 75% of all subjects in range: (28% - 100%)
Design: Perceived Return Past return of each stock Historical Return State expected price for each stock (and transform this into return estimates) Expected Return (Stock)
Design: Risk Attitude Subjective Risk Attitude 1 ≙ low willingness to take risk ….5 ≙ high willingness to take risk Mean = 2.59 (Median = 2.5) 91% of all subjects in range: (2 - 4) Risk Attitude (Lottery 2) (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)
Design: Perceived Risk Past volatility of each stock Historical Volatility Risk perception • State risk perception on Likert scale • Lottery 1 (Mean = 4.1) • Lottery 2 (Mean = 7.11) • Each stock individually (Mean = 5.43) State upper/lower bound for each stock (and transform this into volatility estimates) Expected Volatility (Stock)
Results: Correlation analyses Expected Volatility Historical Volatility First evidence for domain specificity Subjective risk attitude is better & more general predictor of risk taking behavior (Expected Return – Historical Return)
Results: Disggregated regressions (clustered OLS) Risk taking (stocks) Subjective risk attitude vs. lotteries Domain specificity Subjective vs. objective risk/return More overconfident take more risk
Conclusion Risk Attitude Lottery 2 Subjective Risk Attitude Risk Perceived Risk Perceived ≙ . - Taking Return Attitude Risk Expected Volatility Risk Per-ception Expected Return Historical Volatility Historical Return • 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
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