Martin Weber University of Mannheim

1Prof. Martin WeberUNIVERSITÄT

MANNHEIM October 10, 2008

Martin Weber

University of Mannheim

Risk Taking



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.”



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



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

Motivation

SOEP (2008) (Socio-Economic-Panel of the DIW)(approx. 22,000 individuals)



Motivation

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




Motivation

Some German Bank (Private Wealth Management)




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)



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)



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



Design: Risk Taking

50%

50% +9.000 Euro

+12.000 Euro

+10.000 Euro

10

20

30

40

50

60


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%)



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




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)



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



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)**



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



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≙ - . Perceived

RiskRisk

Attitude

Historical Volatility

Expected Volatility

Risk Per-ception



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

Martin Weber University of Mannheim

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