1. Martin Weber University of Mannheim Risk Taking

2. Motivation(MiFID, 2006/73)

Markets in Financial Instruments Directive - MiFID

Investment firms need to make sure that an investmentmeets the investment objectives of the client in questionand 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.

3. 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 4. Elicitation of preferences regarding risk taking and risk profiles MotivationSOEP (2008) (Socio-Economic-Panel of the DIW) (approx. 22,000 individuals) 5. MotivationSOEP (2004) (Socio-Economic-Panel of the DIW) Elicitation of preferences regarding risk taking and risk profiles 6. MotivationSome German Bank (Private Wealth Management) Elicitation of preferences regarding risk taking and risk profiles 7. Modeling Risk Taking 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) (Perceived Return) (Risk Attitude) (Risk Perception) (Investing) Risk Taking 8. 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) 9. Design: Risk Taking (State certainty equivalent) Lottery 2 Risk taking Stocks (Divide 10,000 Euros between a lottery and a risk free assetrepeat for 5 different stocks) Risk taking (Divide 10,000 Euros between a lottery and a risk free asset) Lottery 1 Risk taking 10. Design: Risk Taking Lottery 2 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)MeanAvg. stocks= 43.64%(MedianAvg. stocks= 40%) 75% of all subjects in range: (28% - 100%) 11. 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) 12. Design: Risk Attitude 1 low willingness to take risk . 5 high willingness to take risk Subjective Risk Attitude 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 parametersu(x) = x ) Mean = 0.86 (Median = 0.76) 83% of all subjects in range: (0.58 - 1) 13. 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) 14. 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 Volatility Historical Volatility 15. Results: Disggregated regressions (clustered OLS) Domain specificity More overconfident take more risk Subjective risk attitude vs. lotteries Subjective vs. objective risk/return Risktaking (stocks) 16. ConclusionHistorical 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 overconfidentmore risk taking

Risk Taking Perceived Return - . Perceived Risk Risk Attitude Historical Volatility Expected Volatility Risk Per-ception 17. 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