1. 1 Prof. Martin Weber UNIVERSITÄT MANNHEIM October 10, 2008 Martin Weber University of Mannheim Risk Taking

2. 2 Prof. Martin Weber UNIVERSITÄT 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.”

3. 3 Prof. Martin Weber UNIVERSITÄT 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

4. 4 Prof. Martin Weber UNIVERSITÄT 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)

5. 5 Prof. Martin Weber UNIVERSITÄT MANNHEIM October 10, 2008 Motivation SOEP (2004) (Socio- Economic-Panel of the DIW) Elicitation of “preferences regarding risk taking” and “risk profiles”

6. 6 Prof. Martin Weber UNIVERSITÄT MANNHEIM October 10, 2008 Motivation Some German Bank (Private Wealth Management) Elicitation of “preferences regarding risk taking” and “risk profiles”

7. 7 Prof. Martin Weber UNIVERSITÄT 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)

8. 8 Prof. Martin Weber UNIVERSITÄT MANNHEIM October 10, 2008 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. 9 Prof. Martin Weber UNIVERSITÄT MANNHEIM October 10, 2008 Design: Risk Taking (State certainty equivalent) Lottery 2 Risk taking 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

10. 10 Prof. Martin Weber UNIVERSITÄT MANNHEIM October 10, 2008 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) Mean Avg. stocks = 43.64% (Median Avg. stocks = 40%) 75% of all subjects in range: (28% - 100%)

11. 11 Prof. Martin Weber UNIVERSITÄT 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)

12. 12 Prof. Martin Weber UNIVERSITÄT MANNHEIM October 10, 2008 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 parameters  u(x) = x α ) Mean = 0.86(Median = 0.76) 83% of all subjects in range: (0.58 - 1)

13. 13 Prof. Martin Weber UNIVERSITÄT 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)

14. 14 Prof. Martin Weber UNIVERSITÄT 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 Volatility Historical Volatility

15. 15 Prof. Martin Weber UNIVERSITÄT 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)

16. 16 Prof. Martin Weber UNIVERSITÄT 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 Risk Taking Perceived Return ≙ -. Perceived Risk Attitude Historical Volatility Expected Volatility Risk Per- ception

17. 17 Prof. Martin Weber UNIVERSITÄT 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