Testing Factors Affecting The Investors Risk Preferences Finance Essay
The purpose of Behavioral Finance field of study is to explain why market participants make systematic errors. The market participants can be institutional investors or individual investors.
This thesis focuses on analyzing the individual investors and the factors affecting their financial decisions such as social, cognitive and emotional.
The development throughout this thesis has been based on a survey in the Egyptian market.
Risk management has always been practiced informally, it is practiced almost by everyone. From ancient times to now, people struggle with risks initiatively or passively and risk awareness develop with time. The history of formal organizational risk management is of shorter duration and a narrower scope.
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities. Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary. The strategies to manage risk include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk
Risk management techniques were first developed by, and for, banks. They are now adopted by most firms specially financial institutions (organizations that deal with the management of money such as insurance companies, stock brokerages, investment funds etc..). shareholders make pressure to adopt a better financial risk management strategy. There are six important Categories in investment related risks: Market risk, credit risk , Liquidity risk, Operational risk , Legal risk and Human Factor risk.
This is called “Enterprise Risk Management” it is a framework for management to effectively deal with uncertainty and associated risk and opportunity, and thereby enhance its capacity to build value ref 1
In term of risk, there is a difference between comparing individual investors to institutional investors . Individual investors differ from institutions in their investment horizons, how they define risk and how they behave in response to changes in the economy and investment markets. This does not mean that individual investors are any less successful than institutional ones at investing , just that their style of investing presents unique challenge. While institutional investors define risk quantitatively, individuals tend to base risk only on how much money they have lost. This adds a qualitative perspective to risk tolerance and moves the entire category of risk into losses. On the other hand, when an individual makes a significant amount of money in a short time period, he will often ignore this same risk and the unpredictability that has made him gains.
Types of Investors
There are multiple attempts that have been made to categorize the characteristics of individual investors; the Bailard, Biehl and Kaiser (BB&K) model has defined individual investor types as follows:
Individualist: careful, confident and often takes a do-it-yourself approach
Adventurer: volatile, entrepreneurial and strong willed
Celebrity: follower of the latest investment trend
Guardian: highly risk averse; wealth preserver
Straight Arrow: shares the characteristics of all the above equally
Other researchers only tend to divide the individual investor types into 3 categories:
Risk averse: the investor needs an incentive to voluntarily accept risk
Risk neutral: the investor demand no relationship between risk and return
Risk taker: the investor is willing to pay to take risk. Ref 2
Investors tend towards risk aversion to ensure the stability of profits but they can change their attitude to risk depending on the situation they face.
In traditional financial theory, investors are considered to tend towards risk aversion all the times. They behave in a rational manner and that all the existing information is used in the investment decision . it ignores the psychological aspects in the investor decision making process.
But, researchers have been questioning this assumption and providing evidence that rational behavior is not always maintained. Behavioral finance attempts to understand and explain how human emotions influence investors in their decision-making process.
Regret, theory deals with the emotional reaction people experience after realizing they've made an error in judgment. i.e. when selling a stock, investors become emotionally affected by the price at which they purchased the stock. So, they avoid selling it as a way to avoid the regret of having made a bad investment and making a loss.
Regret theory can also happen for investors when they discover that a stock they had only considered buying has increased in value. Some investors avoid the possibility of feeling this regret by buying only stocks that everyone else is buying. Oddly enough, many people feel much less embarrassed about losing money on a popular stock than losing on an unknown or unpopular stock.
Humans have a tendency to place particular events into mental compartment, and the difference between these compartments sometimes impacts our behavior more than the events themselves.
An investing example of mental accounting is best illustrated by the hesitation to sell an investment that once had monstrous gains and now has a modest gain. During an economic boom and bull market, people get accustomed to healthy, albeit paper, gains. When the market correction deflates investor's net worth, they're more hesitant to sell at the smaller profit margin. They create mental compartments for the gains they once had, causing them to wait for the return of that gainful period.
It doesn't take a neurosurgeon to know that people prefer a sure investment return to an uncertain one - we want to get paid for taking on any extra risk. That's pretty reasonable.
Here's the strange part. Prospect theory suggests people express a different degree of emotion towards gains than towards losses. Individuals are more stressed by prospective losses than they are happy from equal gains. An investment advisor won't necessarily get flooded with calls from her client when she's reported, say, a $500,000 gain in the client's portfolio. But, you can bet that phone will ring when it posts a $500,000 loss! A loss always appears larger than a gain of equal size - when it goes deep into our pockets, the value of money changes.
Prospect theory also explains why investors hold onto losing stocks: people often take more risks to avoid losses than to realize gains. For this reason, investors willingly remain in a risky stock position, hoping the price will bounce back. Gamblers on a losing streak will behave in a similar fashion, doubling up bets in a bid to recoup what's already been lost.
So, despite our rational desire to get a return for the risks we take, we tend to value something we own higher than the price we'd normally be prepared to pay for it.
The loss-aversion theory points to another reason why investors might choose to hold their losers and sell their winners: they may believe that today's losers may soon outperform today's winners. Investors often make the mistake of chasing market action by investing in stocks or funds which garner the most attention. Research shows that money flows into high-performance mutual funds more rapidly than money flows out from funds that are underperforming.
In the absence of better or new information, investors often assume that the market price is the correct price. People tend to place too much credence in recent market views, opinions and events, and mistakenly extrapolate recent trends that differ from historical, long-term averages and probabilities.
In bull markets, investment decisions are often influenced by price anchors, prices deemed significant because of their closeness to recent prices. This makes the more distant returns of the past irrelevant in investors' decisions.
Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic during downturns. A consequence of anchoring, or placing too much importance on recent events while ignoring historical data, is an over- or under-reaction to market events which results in prices falling too much on bad news and rising too much on good news.
At the peak of optimism, investor greed moves stocks beyond their intrinsic values. When did it become a rational decision to invest in stock with zero earnings and thus an infinite price-to-earnings ratio (think dotcom era, circa year 2000)?
Extreme cases of over- or under-reaction to market events may lead to market panics and crashes. (For more reading on the subject, see The Greatest Market Crashes.)
People generally rate themselves as being above average in their abilities. They also overestimate the precision of their knowledge and their knowledge relative to others. Many investors believe they can consistently time the market. But in reality there's an overwhelming amount of evidence that proves otherwise. Overconfidence results in excess trades, with trading costs denting profits.
Counterviews: Is Irrational Behavior an Anomaly?
As we mentioned earlier, behavioral finance theories directly conflict with traditional finance academics. Each camp attempts to explain the behavior of investors and the implications of that behavior. So, who's right?
The theory that most overtly opposes behavioral finance is the efficient market hypothesis (EMH), associated with Eugene Fama (Univ. Chicago) & Ken French (MIT). Their theory that market prices efficiently incorporate all available information depends on the premise that investors are rational. EMH proponents argue that events like those dealt with in behavioral finance are just short-term anomalies, or chance results, and that over the long term these anomalies disappear with a return to market efficiency.
Thus, there may not be enough evidence to suggest that market efficiency should be abandoned since empirical evidence shows that markets tend to correct themselves over the long term. In his book "Against the Gods: The Remarkable Story of Risk" (1996), Peter Bernstein makes a good point about what's at stake in the debate:
"While it is important to understand that the market doesn't work the way classical models think - there is a lot of evidence of herding, the behavioral finance concept of investors irrationally following the same course of action - but I don't know what you can do with that information to manage money. I remain unconvinced anyone is consistently making money out of it."
One important factor of risk preference is the previous experience, It is considered a valuable anchor for investment decision making. When the investor has experience he would be more optimistic and confident in taking his investment decisions, and thus his risk tolerance is higher
H1: More experienced investors have higher risk preferences than less experienced investors.
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