Literature Review About The Definition Of Risk Perception Finance Essay
To illustrate the literature review, a brief discussion will be discussed on behavioral finance, conceptual definition of dependent variable (risk perception), independent variables (information asymmetry, demographic factors, overconfidence and expert knowledge) and the relationship between dependent variable and independent variable.
2.2 BEHAVIORAL FINANCE THEORY
Behavioural finance is a part of finance that there is involvement in psychological decision processes. Investor behaviour and stock market are closely related in behavioural finance. Ricciardi and Simon (2000) studied the behavioural finance explaining the emotional process which influences investor in decision making process.
Behavioural finance is a field of finance that proposes psychology-based theories to explain stock market anomalies. It is assumed that the information structure and the characteristics of market participants systematically influence one’s investment decisions as well as market outcomes. Behavioural finance attempts to fill the void that market hypothesis cannot captured plausibly in models based on perfect investor rationality. Behavioural finance has two building blocks: cognitive (how people think) psychology (too confident with their experience) and the limits to arbitrage (predicting in what circumstances arbitrage forces will be effective and ineffective or when markets will be inefficient).
Psychological factors (Ricciardi and Simon, 2000) included in the behavioural finance theory where psychological factors influence the financial decision making process of individuals. Knowledge is a part of psychological factor that influence investors to make decision. Types of information determine the investor to seek and understand where the stock market is going. Thus, he or she will decide to make decision to purchase stock.
Emmanuel, Harris, and Komakech (2010) mentioned on cognitive psychology in terms of investors’ beliefs and preference during decision making. Investment portfolio in stock market will be judged by investors and decide whether portfolio market is beneficial to them. Experience and memory to search information are the components that determine the investors to make decision. Additionally, personal knowledge provides opportunity when making comparison and will be evaluated.
For instance, behavioural finance described psychological biases influence investor behaviour and stock prices (Nik, 2009). Investors refer to past performance to evaluate the present performance in stock market. They do not involve all asset categories. The perspective will change when making decision as investors have make comparison the period of time. In addition, investors behave aggressively when purchasing stock as they do believe that high profit gain. On the other hand, investors who do not have confident are only to purchase the small amount of stock.
Ritter (2003) stated that the cognitive psychology include overconfidence where investors are confident on their abilities. In entrepreneurship context, entrepreneurs are overconfident because they believed participate in market industry do face risk and as a return, they earn high profit. In finance, an example illustrate in the study which is too little diversification, investors only invest in one item rather than two or more items. Because of that, they invest too much in stock company.
Besides that, Ricciardi (2004) stated that psychology influence a person perceive risk of activity. Personality traits and demographic play an important role which differences among survey respondents.
2.3 CONCEPTUAL DEFINITION OF RISK PERCEPTION
Risk is the matter of perception that is related to problems in business and economics (Brachinger and Weber, 1997). People assumed risk is a negative preference and bad outcome. However, Brachinger and Weber (1997) stated that risk increase when gamble appears many times and risk decreases when there are positive translations. For instance, risk is used to evaluate and predict choices under uncertainty.
In finance, risk is the main determinants of investment decision (Ozer, Ergeneli and Karan, 2004). Investors act irrationally and concerned all information when making decision process. Limited information expose to individual investors in risk perception. Understanding the risk perception is vital of how risk perception is measured. Therefore, psychological factors are relevant in risk perception among investors.
Ricciardi (2007) focused on the risk perception in behavioural finance. In the literature review, behavioural approach is used in the risk to evaluate through laboratory experiment and questionnaire instrument. Risk is classify as subjective and contained the beliefs, attitudes and feelings towards risk.
Ricciardi (2007) mentioned the risk tolerance where investors feel better with the natural risk given type of investment. Investors do not change their mind and consider what they perceived. Risk increases when investors invest more assets in investment (Kendirl and Tuna, 1999).
Willingness to take risk is depending on how investor tolerates the risk. Some investors are conservative that they afraid to lose money. Risk perception is that what is the maximum risk exposure that they want to take and comfortable with. They can make portfolio mix by doing ratio between stocks and fixed income. This could be the best method that can decrease the risk exposure (Chambers and Rogers, 2004).
Several studies found that risk perception is influence by psychological factors. For example, McConnel, Gibson and Haslem (1985) examine the knowledge towards risk taking behaviour. The shareholders are the respondent and are answered through mailed questionnaire. It was to access to see whether the investors’ knowledge is positively correlated with specific risk-return preferences. Three risk-return preferences were utilized for calculating risk preference.
Also, in 2000, Houghton, Simon, Aquino and Goldberg introduce the three independent variables (laws of numbers, illusion of control, and overconfidence) to investigate the risk perception decision making. A surveyed was conducted with business college students. The findings showed that the laws of numbers and illusion of control decreased in risk perception and overconfidence was not correlated in risk perception.
Yip (2000) investigated the financial risk tolerance as a psychological trait. Students were participated on-line trading simulation and risk tolerance was measured through pre competition, post competition and takes up eight weeks after the competition. Financial experience and knowledge do not affect the stability of risk tolerance. In trading strategies, males are more risk than women. Therefore, financial risk tolerance is considered as a trait.
Besides that, different level of risk was examined by Grable and Lytton (1999) to investigate the demographic, socioeconomic and attitude on individual behaviours. A survey is located in Southeastern United States and divided into two category respondents (above average versus below average risk tolerance investors). Statistical method discriminant analysis was utilized in grouping investors into risk tolerance.
Walia and Kiran (2009) studied an analysis of investors’ risk perception towards mutual funds services. The investors’ purchase decision for mutual funds is influenced by chain of factors. Investor should opt for investment avenue are determined by the risk and expected return. Structured questionnaire were designed with 5 point Likert scale used to measure the risk perception towards various financial avenues. Respondents were investors who had experience of mutual fund investment. Ranking and raking methodology was also followed to prioritize the investor’s preferences.
Veld and Merkoulova (2008) studied the risk perceptions of individual investors. The purpose of this paper is to test which risk measures influence the individual investors’ decision making. Experimental questionnaire were tested based on 2226 members of a consumer panel. Questionnaire contains experimental questions in the form of pairwise comparisons and also tested whether the answer to the experimental questions are related to demographic of the respondents. The result showed a comparison of stock and bond investments is interesting for our purposes, since these two categories not only have a different amount of risk associated with them, but also differ in their risk profile; respondents with a preference for the semi-variance as a risk measure are more likely to hold individual stocks. Overall, results of these regressions show that the different types of risk attitudes among individual investors, found in the previous parts of the paper, directly translate into their investment behaviour.
Sung and Hanna (1996) investigated that financial risk has on effect of financial and demographic variables. Employed respondents were participated in the 1992 Survey of Consumer Finances. To measure this, logistic regression analysis showed that female headed household were risk tolerant compare to male head or a married couple. In this research, gender, marital status, ethnic group and education found different in understanding of the nature of risk.
Hence, in this study, risk perception is conceptualized because they are measurable, and can be self rated by respondents. The risk perception as dependent variable is in line with Walia and Kiran (2009) and Grable and Lytton (1999). The definition is also in line with the focus on individual risk perception as proposed by Ricciardi (2007).
2.4 DEFINITION OF INFORMATION ASYMMETRY
Information asymmetry is the private information where one party receive more or better information than the other. It is crucial because it create imbalance of power transaction. Private information causes to unequal information refer to information asymmetry that investors know more about firm’s fundamental value (Lu, Chen and Liao , 2010).
Cheng (2003) defined information asymmetry as the important sources in stock markets. Disclosure information gives impact to the investors on irrational investment decision. The paper illustrates information influence the value of stock which categorized as subjective risk derived from investors’ risky behaviours.
Rose and Marquis (2006) stated that financial information cannot easily access its quality at the time they must pay for it. Therefore, incentive exists for sellers of information to make wild claims about the quality and value of the information they are selling. In contrast, Ross, Westerfield, and Jaffe (2010) explained that manager in the stock company does know more than typical investors. They can estimate the worth of the company while investors become careful when invest the stock.
Previous has found Ithat there is negative relationship between voluntary disclosure based on U. S. GAAP with certification of a credible audit firm and the variation of risk adjusted returns (Du and Lam, 2004). For instance, Wang, Shi and Fan (2006) found that level of risk perception among Chinese investor is low and lack of investment knowledge and skills. Information asymmetry restrict from insufficient information sharing result in negative outcome (Clarkson, Jacobson and Batcheller, 2007).
On the other hand, Lu, Chen and Liao (2010) stated that information asymmetry and information uncertainty has the effect on corporate bond yield spreads. It is to found that information uncertainty and information asymmetry play important role. Corporate bond investors are willing to pay at high risk premium when information asymmetry and information uncertainty is high. The authors assumed that there is positive relationship between information asymmetry and firm’s fundamental value risk. Investors prefer to have information asymmetry and this effect on quality of public information (Alford and Jones, 1998).
According to Epstein and Freedman (1994), respondents (investors from shareholders) reported that they are interested in collecting their company report on certain aspects of social activities. In addition, they insist the company to provide other information such as report ethics, employee relations and community involvement. Furthermore, a high demand appear when respondents using social information for investment decisions. Investors are willing to pay high price to obtain information asymmetry in which the information provided is protected and the quality is better (Drobetz, Gruninger, Hirschvogl, 2010).
For the purpose of this study, information asymmetry is conceptualized as uni-dimension variable which includes the general aspects of financial information among investor stock market in Kota Kinabalu. Since information asymmetry is an important aspect of people’s to determine whether the information asymmetry is valuable to evaluate on risk perception. The current conceptualization is in line with the study by Cheng (2003).
2.6 DEFINITION OF OVERCONFIDENCE
Investors tend to be overconfidence when making decisions which also influence the risk perception (Skale, 2008). Overconfidence can illustrate the individual investor overestimate their abilities (Ricciardi and Simon, 2000). According to Odean (1999), overconfident described as investor who overestimates the accuracy of his information signals.
Barber and Odean (2001) stated that men are more overconfident than women. In the literature review, psychologists find that finance men are more overconfidence than women. Men trade more and their performance decrease if trade excessively. Men are overconfident to make financial decisions and thus expect men to make common stock investments. Investors believe on their own valuations, concern themselves less about the beliefs of others (Odean, 1999).
Investors’ confidence has greater ability to beat market (Doran, Peterson, and Wright 2010) Evidence provides that confidence give an impact to decision risk behaviour (Haleblian, Markoczy, McNamara, 2004). Personal attributes such as confidence is examined on the effect of risk taking behaviour (Haleblian et al., 2004).
Confidence is importance of investors and situational factors in affecting risk taking behaviour (Haleblian, et al., 2004) Young investors do affect the risk perception as they are overconfident compare to elderly (Kovalchik, Camerer, Grether, Plott and Allman, 2003). The result showed that there is significant between confidence and risk taking behaviour (Haleblian et al., 2004).
Dittrich, Guth and Maciejovsky, (2001) assumed that investors have well in evaluation on portfolio choice. For example, risky portfolios are those that investors are willing to take risk and have intention to invest more (Nosic and Weber, 2010). They described investors are risk taker as risky effect on overconfidence in the stock.
Investors believed that they have confident in selecting portfolio (Dittrich et al., 2001). Furthermore, investors’ overconfidence might show relationship with risk tolerance (Pan and Statman, 2010). Investors on risk perception reduce when they have high confidence (Dittrich et al., 2001).
On the other hand, other research such as Dorn and Huberman (2005) did not found there is significant between overconfidence and risk taking. Houghton, Simon, Aquino and Goldberg (2000) surveyed 154 business college students and result showed that there is negative relationship between overconfidence and risk perception. The difference between overconfidence and less confidence is that high confidence among investors perceived risk as lower (Pan and Statman, 2010).
Pan and Statman (2010) suggest that investors should seek financial advisor as they might prefer trade stocks and choose in market timing. However, investors who trade aggressively (overconfidence) are dissatisfied when financial advisor give suggestion.
2.7 DEFINITION OF WORRY
Women and men are different in how they react on their judgment process. A research such as Plant, Hyde, Ketlner and Devine (2000) stated that females are more emotional than males. Level of financial worries can influence the risk perception where investor tend to worry their investment that they invest could loss (Hira and Mugenda, 1999). Perceived risk is judge greater that investors might worry about their investments (Ricciardi, 2004).
Grable and Joo (2001) studied the financial worries influence of experiencing an investment loss. Manager with more complex decision making tend to worried needed to delay making decision rather than group (Sawers, 2005). Many of the studies has been conducted between worry and risk perception (Baron, Hershey and Kunreuther, 2000; Constans, 2001; Rundmo, 2002).
MacGregor, Slovic, Berry and Evensky (1999) studied the relationship between worry and risk perception. Multiple regression analysis were utilized in which perceived risk as dependent variable. The main findings were significant to significant indicator namely worry. As age increased, investors are worried about their retirement wealth in long run compare to their savings and pension funds (Cutler, 2001). There is significant factor between perceived risk and worry which has explained 98% of r-square (MacGregor, Slovic, Berry and Evensky, 1999).
2.5.4 FINANCIAL KNOWLEDGE
Information about risk can increase risk perception. Psychology show changes in the level of a person’s knowledge result in an adjustment in their risk perception of a specific activity. Ricciardi (2004) stated that level of knowledge might influence an investment professional’s risk perception. Type of information is related to risk perception (Schawrzkopf, 2007). Investors received different information determines their changes in risk perception.
Previous study has shown that behavioural accounting utilized behavioural risk indicators comprise a knowledge characteristic from risky activities in psychology (Koonce, McAnally and Mercer, 2001; Koonce, McAnally and Mercer, 2003).
Knowledge does not catch attention for investors. For example, Lawson and Hershey (2005) focused on the knowledge of retirement planning and risk tolerance. It is to found that financial knowledge is less interaction with risk tolerance.
Increasing knowledge leads to changes in investors’ behaviour (Hilgert, Hogarth and Beverly, 2003). Therefore, providing information such as financial education is very important to help investors for making investment decision. Moreover, investors’ knowledge enhances them to participate investment and leads to improvement in financial management practices (Hilger et al., 2003).
2.7.1 THE RELATIONSHIP BETWEEN EXPERT KNOWLEDGE AND RISK
Several issues of knowledge has been done by Fischhoff, Slovic, Lichtenstein, Read, and Combs (1978) and Rao and Monroe (1988). There is connection between psychology of knowledge and risk perception (Ricciardi, 2004).
Level of understanding on risk perception is still very low (Cheng et al., 2009). There is 33% of respondents are lack of knowledge (Cheng et al., 2009). A research has been done by Cheng et al (2009) that education is important to investors that affect their risk perception.
Financial knowledge refers to investors who know better than others (Pellinen et al. 2011). A result found that knowledge levels have consistency with risk perception (Pellinen et al., 2011). For instance, Investors prefer to choose low risk investment instruments if they have low ability (Pellinen et al., 2011).
Dionne and Triki (2005) mentioned that financial knowledge is vital for investors. Invest stock is beneficial if investors received financial information. As mentioned by McConnel, Gibson and Haslem (1985), risk increase when investor gain more knowledge. Moreover, there is high level of financial knowledge with risk tolerance (Lawson and Hershey, 2005). It is to found that knowledge was positively related to risk tolerance (McConnel, Gibson and Haslem, (1985). Grable and Joo (2000) found that risk factors most significant psychological factors namely financial knowledge.
2.5 DEFINITION OF DEMOGRAPHIC FACTORS
Demographic factors are an important part in this study to identify the respondent’s characteristics which includes the personal information like gender, age, income, education, marital status and job position. For this current study, age, gender, education level, marital status and financial knowledge are chosen as the modetor which affect between independent variable and dependent variable.
Gender differences investors for investment decision. Perspective between male and female has dissimilarity in risk perception. Most of the researchers found that women are more risk averse (Loible and Hira, 2007; Lascu, Babb, and Phillips, 1997). Women are cautious when making decision and they assumed that invest heavily in investment will affect their profitability.
For instance, Graham, Stendardi, Myers and Graham (2002) reviewed the gender differences in investment strategies from an information processing perspective. Also, selectivity model theory and investor behaviours differences in risk aversion and confidence. Male investors will tend to focus on the most salient cue in the investment situation, in most cases being the expected return of the investment. Female investors would be more likely than male investors to incorporate risk and other secondary information cues in their processing of credibility was less valued in the non-financial performance measurement context than in the earnings estimate setting.
In a different point of view from gender scenario, Maxfield, Shapiro, Gupta and Hass (2010) explored that women’s risk taking and reasons for stereotype persistence in order to inform human resource practice and women’s career development. Female managers are surveyed using Simmons Gender and Risk Survey database. Result found that even women take risks, their risk taking remain concealed.
Gender and environment factors such as individual experience and the shared family environment or social interactions are focused in this study (Barnea, Crongvist, Siegel, 2009). The results showed that gender, age, height, and parental background have an economically significant impact on willingness to take risks (Dohmen, Falk, Huffman, Sunde, Schupp, Wagner, 2009). Sung and Hanna (1996) female headed household were risk tolerant compare to male head or a married couple. In this research, gender, marital status, ethnic group and education found different in understanding of the nature of risk (Sung and Hanna, 1996).
Findings showed that genetic component accounts for a very substantial proportion of the variation compared to other individual characteristics such as age, gender education and wealth (Barnea et al, 2009). However, age and gender were not significant to risk tolerance compare to other significant factors (Grable and Lytton, 1999). The findings showed that willingness to take risks is negatively related to female (Dohmen et al, 2005). Ahmad et al. (2009) showed that gender is the least important in market fundamental.
Dohmen et al (2005) suggest that field experiment measure is a good predictor of actual risk-taking behaviour. Furthermore, changes of large population of elderly are predicted to be conservative group of investors that influence macroeconomic performance.
In this study, gender is conceptualized as a moderator factor in demographic factors to test its relationship between independent variables and dependent variables. As suggested by Barnea, Crongvist, Siegel (2009), age could be an indication of the respondent’s which could affect the independent variables and dependent variables. The longer an investor invests, the longer he or she gain experience they are than younger investor.
Ricciardi (2004) clarify that age difference such as younger and older population in demographic. Age differences in risk preference, risk perception and risky decision making do not have consistent evidence that young investors are less risk adverse than the conservative investors (Gardner and Steinberg, 2005).
Different age among investors determine risk perception for investment decision (Junkus and Berry, 2010). According to Ahmad et al. (2005), a study showed that age have significant role in advisor’s perception. Grable and Joo (1999) stated that younger persons are more risk tolerant than older persons.
Dohmen et al. (2009) stated that age have significant impact on willingness to take risks. A study showed that there is significant between age and risk attributes (McInish, 1987). However, there is negative relationship between age and willingness to take risk (Dohmen et al. 2005). Age does not explain any significance on risk tolerance behaviour of sampled respondents (Grable and Joo, 2000). Other research would be McInish and Srivataba (1984) investigated the nature of individual investors’ heterogeneous expectations that age does not explain logical differences in investors’ expectations of stock returns.
In this study, age is conceptualized as a moderator factor in demographic factors to test its relationship between independent variables and dependent variables. As suggested by Dohmen et al. (2009), gender could be an indication of the respondent’s which could affect the independent variables and dependent variables. The male investor tends to invest more compare to woman investor. Thus, male investor on risk perception reduces when he collected information asymmetry.
2.5.3 EDUCATION LEVEL
Most of the research showed that there is positive correlation for education. For example, Ahmad et al. (2009) stated that education have significant role in determining the investment style of investor. In this research, education found different in understanding of the nature of risk (Sung and Hanna, 1996).
Investors who have educational background tend to have positive impact on their ability on analyzing risk perception (Yiminh Hu et al., 2008). Better educated provide understanding on the risk perception in the stock market (Junkus and Berry, 2010).
Grable and Lytton (1999) there is positive relationship between educational level connected with risk tolerance and claim that educational level is the best predictor of risk tolerance behaviour. Dohmen et al. (2005) found that there is significant between education and willingness to take risk. Dohmen et al. (2009) showed education have significant impact on willingness to take risk.
Need help with your literature review?
Our qualified researchers are here to help. Click on the button below to find out more:
In addition to the example literature review above we also have a range of free study materials to help you with your own dissertation: