Evaluation of Risk Perception and risk preference in Financial Decisions

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Evaluation of Risk Perception and risk preference in Financial Decisions

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Contents

1.Introduction

2.Literature Review

3.Research Gap

4.Research Question

5.Relevance and Hypotheses

6.Research Methodology

a.Source and Description of Data

b.Statistical Methods

7.References:

8.Appendix

1. Introduction

Risk is an inherent feature in any type of decision making process as it represents the degree of variation of the expected outcome of the decision and the actual outcome. This evaluation is restricted to financial decision making by individual investors who range from being amateurs to experts through experience. Before starting with the literature review, it is vital to state that for different investors, the perception of risk would differ based on the type of underlying investment which make them either risk averse or risk lovers. So is the case with the risk preferences. When we say this, it is clear that for a given investment, there are multiple risks associated, arising from different sources. Investors might not be known about all the risks associated with their investments according to Centre for Economic and Entrepreneurial Literacy (2009). But based on the knowledge about risk known to them, investors make the financial decisions. The type of decisions made, the ways in which risk is perceived and the manner in which preference is assigned to different risk options have been discussed at length in the literature and is reviewed in the next section. Based on this, the gap in the research is identified and research question is framed followed by laying the hypotheses and research methodology.

2. Literature Review

The extent of knowledge about the risks associated with an investment decision might not be the same for every investor. No matter the data being provided with respect to the risks is same for all, the way in which risk is perceived by people (read as investors) vary by and large. Generally individual investors seek help of professional advisors. But as per the research, there are certain aspects that still make the investors make sub- optimal decisions due to improper perception of risk and more stable risk preferences. These financial decisions for a given person would not be the same for different time periods for an underlying investment option. There are many factors that are a part of the final decision which are reviewed at length in this section. To start with, many researchers have indulged in understanding the definition and perception of risk for investors. Superficially, everyone comes up with almost similar know- how about risk but very few have got the right insight into the actual implications of these definitions (Benartzi, 2002). This implies that all the various kinds of risks are but abstract in nature for the investors. The different perceptions of risk (and their measures) by investors are enlisted below:

  • Risk is volatility, as stated most commonly by the investors. It is perceived to be the differences observed in the actual and expected returns.
  • Risk is the degree of liquidity and transparency in the system according to some investors.
  • Risk is being able to take into account the worst case performance of the investments being made or being able to understand the value- at – risk of the investments which is the minimal probability of the amount that is at risk

There are many more perceptions of risk. Investors get to read a lot of material before opting for particular investments. But such data is generally full of terms and conditions and policies specific to that particular investment and investors only flip through these papers. It is difficult to comprehend the level of information that has been retrieved from the papers. Besides this source of risk information, consultants and other means of professional help are also available. But the manner in which information is dished out to the investors does not guarantee cent per cent absorption by the investors. This is specific to general population and not expert fund managers. In wake of this, the attitude of investors towards risk, degree of investments in varying nature of risks has been studied by the researchers (Stewart, 2006). It was found that despite being cognizant about the mutual dependency of investment decisions and the risks involved thereby, generally people commit the similar mistakes in the following investments as in the first one. Considering the ignorance of the investors towards financial decisions, some of the Governments have also taken measures to educate people about the decision making heuristics. But there is no conclusive rationality observed among the decision makers. As a matter of fact, this can require rigorous number of trials to achieve equilibrium from the rationality perspective in decision making amongst the investors. To overcome such hurdles, the ways to resent the information for layman investors have always been a tough task for the issuing companies, fund managers, advisors or other professional entities.

The reaction of people towards risk is very subjective. This is grounded on the available investment options at a given point of time (Vlaev, 2006). However, they can be related in nature. The preferences of risk are driven by the available options to the investors. Another major factor that drives the selection of investment options is the sensitivity to change in wealth. It has been observed empirically that investors are more sensitive to the wealth reductions than increments in the same. Therefore, they tend to opt for stable risk profiles in the short run. Another observation reveals that the tendency of people to pick riskier options is more when the investments are long term in nature. Such decisions illustrate that people tend to set up certain unwritten rules while making the investment decisions. However, these rules might not be all pervasive and tend to make sub optimal decisions. The opting of risk preferences and decision making thereby can appear to be an easy one, but the fuzziness underlying the process may lead to the formation of various sets of rules that differ marginally from one another. People tend to change the preferences as the circumstances are not static or standard per say (Koonce, 2005). They might not meet the standard conditions either. Fund allocation is also based on the risks assigned with the investment options. This implies that the way risk information is presented to the investors impact the following financial decisions taken by the investor based on the preferences assigned to the different options based on the degree of risk or uncertainty that is determined from the information presented before.

So what are the key contributors or parts of the overall risk that impact the decision of the investors? This depends on the way risk is perceived by an investor. Research has been carried to understand the important aspects of risk perception in financial decision making. There also is a study on the comparison of a financial expert’s perception of risk and that of an investor’s perception which is discussed hereby. Most importantly, there has also been study to understand the contributory aspects of risk perception that influence the intent to invest. Again, like risk preference, risk perception for lay people is a subjective aspect. But from the perspective of both the investors and financial experts, there is a conclusive decision about what risk is comprised of – quantitative factors that can be measured like probability of loss i.e. value- at- risk, volatility i.e. variance in the returns and the loss amount; qualitative factors that influence the risk perception include degree of knowledge, anxiety about future, etc. (Vlaev, 2009) It has been observed that the factor ‘worry or anxiety’ overrides the other factors in contributing to the overall risk perception. This is the major factor on which investors base their decision. Amongst the various factors, based on another study, the power of prediction of each of these factors was analysed to understand their role in decision making. The leading factors in chronological order were control over the investments, magnitude of capital loss, variances in actual returns below expected returns and the understanding or knowledge about the risk. So, this order as well remained same for both the lay investors and the experts. One of the problems in the research study can be the selection of sample population chosen to study the relevance of factors. This implies that the sample needs to be strong enough to represent the investors in the best possible way. To overcome this drawback, another study revealed that there is a difference in the way risk judgment is constructed or risk is perceived by the two sets of people – the investors and the advisors (Nosic, 2010). The study revealed that the uncertainty for investors was related to volatility as well as protection; whereas in case of adversity, the driving force was the potential losses or negative consequences that are unexpected. However, from the point of view of advisors, the driving force for both these factors is the same; which justifies the construct of risk perception of investors and the advisors (Diacon, 2004).

Irrespective of the many studies and research being done on the subject matter, the evaluation of risk perception is a complex matter from the stand of investors and advisors (Veld, 2008). This in fact requires more distinct and exhaustive study, on a more concentrated sample population to form more conclusive results. There were further studies however, on this subject that led to similar results but also unleashed other important parameters that impact the risk perception of the investors. One such very important factor is the existing economic conditions and the corresponding market sentiments. Another important factor that could influence this parameter was the level of financial knowledge the investor has. However, the degree of relevance and the load aspect for the gained knowledge would differ for an advisor and an investor. An investor would still want to be very safe and try to reduce volatility but they have less control and protection over the investments. On the contrary, for advisors the scenario is exactly opposite. Thus, for same factors, the risk perception differs for investors and advisors. Experience is also one factor that plays a role in influencing the risk perception of the people. However, studies have shown that both are correlated, but negatively. Demographic influence is also very scant in financial decision making. However, the age factor influences the risk preference (Harris, 2006). Older people prefer stable risk whereas younger people have an appetite of more risk.

All the studies done are based on the population average. Sampling plays a very critical role in these studies as bad samples can shift the bias considerably, leading to wrong understanding of risk preference and risk perception amongst the investors and the advisors. There are marginal disparities observed in the standpoints of the advisors and investors for understanding and implementing the concept of risk preference and risk perception. However, having common knowledge level can help address this problem. This implies that the evaluation of the literature for both risk perception and risk preference leads to a common result of having some provision to impart financial knowledge to the common people (Sachse, 2012).

3. Research Gap

There has been extensive yet not exhaustive research in the field of risk preference and risk perception. Both are inter-linked in a way as consequences in each aspect have mutual dependence on the other. This is vivid in the literature review conducted above. However, while evaluating the literature, it was observe that mostly studies did not consider the two aspects together and there were only individual studies carried out to understand the consequences of risk preference and risk perception (Duxbury, 2004). For both these aspects, studies revealed the importance of financial training for an investor unanimously. However, there exists a gap here as there is no work or research done to evaluate the impact of financial training explicitly on the investment decision making of investors. Besides, there are no studies on evaluating the best means possible to make an investor understand the risks linked to an investment in such a way that the investor is well informed about its consequences and the entire investment trading is transparent to him or her. Reading through leaflets and company brochures is not always helpful to the investor and most of the times, a layman simply skips some important terms and conditions that increases the investment risk. It is definitely important to overcome this gap by finding ways and means to make investors capable of making right investment decisions by taking into consideration all the aspects, factors and weighing them appropriately.

4. Research Question

From the above discussion about the literature and the identified research gap, the research questions are as mentioned below:

Given a domain of risk for an investment, how best can the investor be able to understand and perceive the different aspects of risk? What are the means of helping an investor – layman, understand the impact of the underlying risks? Is mandating learning of the financial knowledge a viable option to bring the investors at par with the advisors?

5. Relevance and Hypotheses

The previous studies and research work done to understand the risk preference and risk perception aspects of financial decision making have a common outcome – which the investors should be provided with financial training. However, to what extent will this training be relevant is not sure. More so, how the sessions should be conducted to arrive at more rational decision making is also not very sure. Besides, if this is a success, then with a background of finance, investors are now equipped to make informed decisions. They are able to understand the risks associated in the better way. So this should lead to making better investment decisions that move towards optimum investments for the investor. However, if they are unable to participate in the finance training, then the ways and means to help them understand the risk associated with investments should be find out. In wake of this, the plausible hypotheses for this research are:

Hypothesis 1: Financial Training is conducted successfully and investors’ decision making moves towards optimum level.

Hypothesis 2: Financial Training is not a success and there is disparity in the way investors react to investment options

Hypothesis 3: No financial training available. Best way to help the investors understand the concept, relevance and impact of risk preference and risk perception in financial decision making.

6. Research Methodology

The research methodology best suitable for such type of studies is to have primary data as the main source whereas secondary data for some more information that can help in carrying out the quantitative as well as qualitative research on the proposed research questions. Quantitative analysis is objective in nature whereas qualitative analysis is subjective in nature. Both the analyses need to be considered as the factors to be evaluated are of both quantitative as well as qualitative nature.

a. Source and Description of Data

The primary data collection is planned to be retrieved from online surveys and questionnaires mailing to a selected list of population. Here, picking up the sample is very critical to avoid any bias. The sample should comprise of literate people as well as illiterate people, active investors, amateurs, demographically balanced such that all eligible age groups, genders are taken into consideration, investors that have partial training in decision making, etc. (Kolbe, 2011). After finding out the results, instead of taking the entire sample population, sub- group results would be collated to have a better understanding of the investment patterns, risk perception and preference, knowledge level of the population. An important line of item in the questionnaire would be the focus on having financial lessons for layman investors.

The secondary data will be collected from online sites where active trading is facilitated directly by the investors. Case studies are also another useful source of getting secondary data for various factors under consideration from the perspective of the investors as well as the advisors. This will mainly be to ascertain the pattern or trend of the investments made by the investors. Also, the qualitative factors would be analysed through this data by understanding direct involvement of investors, involvement through advisors, and protection to these investors and the degree of right decisions made by them.

b. Statistical Methods

Representation of the collected data in the form of graphs and charts help in revealing information and details about the different factors involved. It is an easy and user friendly way that can be comprehensible even to the layman. Regression analysis is a more sophisticated technique to evaluate the relationship between the various factors for both investors and advisors separately. This is to analyse primary data. For qualitative data analysis, bar or Venn diagrams are very illustrative and useful.

Once the data is collected and applied statistical tools and techniques, it is important to analyse the information so as to retrieve the information that can benefit the investors in the long run by taking into consideration all the test cases. Verifying of the data collected is also important.

7. References:

  1. Benartzi, S. e. (2002). How much is investor autonomy worth? Journal of Finance , 1593- 1616.
  2. Diacon, S. (2004). Investment risk perceptions. Do consumers and advisers agree? The International Journal of Bank Marketing , 180-198.
  3. Duxbury, D. e. (2004). Financial risk perception. Are individuals variance averse or loss averse? Economics Letters , 21 - 28.
  4. Harris, C. e. (2006). Gender differences in risk assessment: Why do women take fewer risks than men? Judgment and Decision Making , 48- 63.
  5. Kolbe, R. (2011). Ergebnis: überwiegend desaströs. Portfolio International , 20 - 22.
  6. Koonce, L. e. (2005). How do investors judge the risk of financial items? The Accounting Review , 221-241.
  7. Literacy, C. f. (2009). In the midst of economic crisis, new survey finds majority of Americans confused about personal finance. Retrieved June 1, 2014, from http://econ4u.org/blog/2009/03/31/in-the-midst-of-economic-crisis-new-survey-finds-majority-of-americans-confused-about-personal-finance/.
  8. Nosic, A. e. (2010). How Risky Do I Invest: The Role of Risk Attitudes, Risk Perceptions, and Overconfidence. Decision Analysis , 282- 301.
  9. Sachse, K. e. (2012). Investment risk - The perspective of individual investors. Journal of Economic Psychology , 437 - 447.
  10. Stewart, N. (2006). Decision by Sampling. Cognitive Psychology , 1 - 26.
  11. Veld, C. e. (2008). The risk perceptions of individual investors. Journal of Economic Psychology , 226 - 252.
  12. Vlaev, I. e. (2009). Dimensionality of risk perception: Factors affecting consumer understanding and evaluation of financial risk. Journal of Behavioral Finance , 158 - 181.
  13. Vlaev, I. e. (2006). Game Relativity: How Context influences Strategic decision making. Journal of Experimental Psychology , 131- 149.

8. Appendix

The sample questionnaire will contain the following questions (answers are both objective and subjective in nature):

  1. What is your age, sex and occupation?
  2. Do you invest directly or with help of an advisor?
  3. Are you interested in gaining basic financial training to make more informed decisions?
  4. What is your idea about risk?
  5. What are the main factors that matter to you while making investment decisions?
  6. Any specific remarks with respect to risk understanding and making financial decision?

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