Investor Attitudes and Behavior towards Inherent Risk and Potential Returns in Financial Products Shyan-Rong Chou Department

of Money and Banking, National Kaohsiung First University of Science sand Technology Taiwan, ROC Gow-Liang Huang Department of Money and Banking, National Kaohsiung First University of Science and Technology Taiwan, ROC Hui-Lin Hsu Doctoral Program in Management, National Kaohsiung First University of Science and Technology Department of Finance, Fortune Institute of Technology, Taiwan, ROC E-mail: linda023@center.fotech.edu.tw Tel: +886-935-847726 Abstract This study attempts to establish a model by which to measure attitudes and behavior towards investment risk. A sample of Taiwanese investors are surveyed to determine their past investment experience as an anchor, and to record their responses when exposed to economic signals. This was implemented to form a framework (framing) for interpretation of their respective attitudes and behaviors. Empirical results found no difference by gender to investor propensity to take risk, nor in cognitive perception of such. However, higher and lower perceptions of risk were indicated by investors according to their personal

investment experience. Investors with little experience in stocks and structured notes were found to have significantly heightened perception of risk. Thus the model proposed is relevant in finding a positive correlation between experience and propensity of risk, though the understanding of such remains uncertain. In respect to financial products other than mutual funds, investor propensity and perception of risk tend to show a negative correlation. Similarly, investor perceptions of risk and expected returns indicate a significant negative correlation. Finally, when positive information is presented, investor perception on structured notes is lower with higher expected remuneration. Keywords: Risk propensity, Risk perception, Behavior finance, Decision making 1. Introduction The subprime mortgage crisis of 2008 and the global financial crisis of 2009 have caused investors in financial products serious losses. This and the risks inherent to financial products have given rise to a more cautious attitude towards such investments. Faced with the series of financial events leading to the current turmoil, unpleasant investor experience has become common and these personal experiences and reports of such are demonstrated in risk and attitudes to risk. This situation creates a International Research Journal of Finance and Economics - Issue 44 (2010) 17 factor impacting investors in respect to returns expectations whereby high risk financial assets must be reassessed. This simultaneously alters investor behavior and the distribution profile of investment in assets. This study uses a questionnaire to investigate investor behavior and attitudes in Taiwan.

Investor experience is viewed as an anchor effect, and the financial news and alternate reports form a frame in which to consider investor attitudes and behavior. In traditional financial theory, Famas (1970) definition of efficient market hypothesis (EMH) states that investors are rational, therefore on receipt of new information, they logically update their commitment towards their investment. Following the principle of expected utility maximization through rapid decision amended, investors assets maintain a reasonable value. Thus, even if assets deviate from a reasonable valuation, through arbitrage they return to a reasonable price. However, in 1980 many empirical studies found that EMH does not fully support the efficient market and there are numerous anomalies such as the well-known January effect and the weekend effect to name two examples. In fact, traditional financial theory ignores psychological aspects in the investor decision-making process. For this reason, much investor behavior cannot be explained in the context of traditional finance theory. Kahneman and Tverskey (1979) proposed the use of a psychological point of view in the well-known Prospect theory to explore the psychological behavior of investors, and the Value Function to replace the traditional expected utility theory. Value Function holds that a different attitude to risk prevails amongst investors when facing the prospect of either gain or loss. Facing gain, investors tend towards risk aversion to ensure the stability of profits. Facing the prospect of loss, investors choose to take more risk. Thus investors change their attitude to risk

depending on the situation they face. However, in traditional financial theory, investors are considered to tend towards risk aversion at all times. This paper follows studies conducted with investors to examine investor attitudes and behavior towards inherent risk and potential returns in financial products. Over the past decade, financial institutions have designed financial products having varying degrees of risk to meet differing investor preferences. These products range from very simple time deposits to complex structures with linked notes, all of which can vary significantly in their degree of risk. Naturally potential returns vary similarly. Thus investors are able choose an investment with potential risk and returns to suit their own preferences. However, at the time of purchase, investor behavior is formed by factors including expert advice from management consultants, and reference to past investment experience. Investors who have experienced loss make new investment decisions bearing such in mind. Additionally, investors refer to financial news and other information sources as basis for their assessment of risk in products they are considering. All these factors affect investor perception of risk, and aversion of risk. Through the formation of their risk attitude, investors build their forecast of potential return on financial products. Products of lower potential profit are tolerated when the risk associated with those products is similarly low. Ordinarily, higher risk products are acceptable to investors when the premiums are more attractive. When the assessment of risk and

potential returns is appropriately balanced in the investors view, a purchase will ensue. Therefore financial institutions need to understand how investors assess risk and how their attitudes to risk are informed by the relationship of risk and potential return. Thus financial institutions can develop and package their products according to investor needs. Unfortunately, investors are often snared by excessive marketing and packaging of financial products and this can be exacerbated by a paucity of information, over-optimistic assessment of returns and an underestimation of risk leading to inefficient portfolio configuration. In the past there have been few studies on the subject described therefore this paper attempts to establish a model by which to evaluate risk attitudes towards financial products and estimate the significance of alternative information sources such as the prevailing degree of optimism about the broad economic outlook. Through attention to risk perception and risk propensity which are mediators in attitude transaction, financial institutions can comprehend the effects on investor behavior and their returns expectations. The first section of this paper is the introduction, the second section is the 18 International Research Journal of Finance and Economics - Issue 44 (2010) literature review, the third section establishes hypothesis model, the fourth section presents the study results and the fifth section is the conclusion and recommendations. 2. Literature Review Consumer behavior research began in the 1960s but there have been few studies on consumer decisionmaking under risk about financial service industry. The purchase of financial products based goods and

intangibles are frequently transacted in the absence of adequate information. This sets these goods apart from purchases made under the learning response model. Financial products investors often purchase investment products by drawing on experience or through the investment appraisal process (Harrison, 2003). Therefore, past investment experience and expertise of investors provides them with risk awareness and so have become important commodity risk assessment factors in future. Some personal traits such as risk preference, and personal experience affect risk assessment and awareness. The propensity to build up risk can further affect actual behavior, where risk refers to how far decisionmakers are prepared to extend their exposure to risk (Sitkin and Pablo, 1992). Risk perception forms the basis of risk communication which means that people facing uncertainty and ambiguity in the available information, construct inferences and draw conclusions for them. In short, the risks people are prepared to take are related to their attention, and interpretation and memory processes. These faculties determine peoples attitude to risk and their behavior in risk related decisions. Sitkin and Pablo (1992) defined risk perception as risk assessment in uncertainty. Risk perception is determined from the questions investors ask, their familiarity with organizational and management systems etc. all of which are important factors. Risk perception and propensity to risk have a strong negative correlation. In fact, prospect theory does not deal with the effects of past investor experience on future

investment behavior. Sitkin and Pablo (1992) developed a model of determinants of risk behavior. In this model, personal risk preferences and past experiences form an important risk factor in which to frame the problem, and social influence also affects the individuals perception. Sitkin and Weingart (1995) extend the Sitkin-Pablo model leading to the definition that risk perception and propensity are the mediators in risk behaviors of uncertainty decision-making. In this hypothesis, past investment establishes the frame for the propensity to risk, risk transfer, and risk awareness which impact decision-making behavior. Thus risk orientation and risk perception are reduced to antecedent variables in decision-making behavior under risk. Investment experience is an important factor influencing behavior. Investors with more experience have relatively high risk tolerance and they construct portfolios of higher risk (Corter and Chen, 2006). The success or failure of past investor experience influences the tendencies of investors towards risk and risk perception, and further affects decision-making behavior. Kathleen Byrne (2005) shows that risk and investment experience tend to indicate a positive correlation and past experience of successful investment increases investor tolerance of risk. Inversely, unsuccessful past experience leads to reduced tolerance to risk. Therefore past investment behavior affects future investment behavior. The impact of behavioral differences by gender is also an important variable. Female investors more of often than their male counterparts tend towards risk aversion which is demonstrated by their

more conservative investment behavior. This claim is evidenced by a smaller number of market enquiries, lower trading volume and lower frequency of transactions attributable to females (Fellner and Maciejovsky, 2007). Ronay and Kim (2006) have pointed out that there is no difference in risk attitude between individuals of different gender, but between groups of such, males indicate a stronger inclination to risk tolerance. That is, no gender difference was found at an individual level, but in groups, males expressed a stronger pro-risk position than females. Investor perception of risk affects the expected return on investment. In traditional concepts of finance, it is understood that investors do not welcome risk but that investments with higher expected rates of return are also understood to bear higher levels of risk. Thus risk and reward are in positive correlation. However, not all investors possess this knowledge. Despite a wealth of literature and International Research Journal of Finance and Economics - Issue 44 (2010) 19 trained professional opinion supporting the existence of a positive correlation between risk and return, some novice traders and unskilled investors perceive expected return to be in negative correlation to risk (Muradoglu, 2005) (Byrne, 2005). Despite risk perception and the tendency of such to be transmitted and influence the decisionmaking behavior, people continue to make investments in the face of uncertainty. This decisionmaking under risk is reflected in the individual investors portfolio construction. That is, risk perception affects return expectations and asset allocation behavior simultaneously. Therefore the expected utility theory based on a traditional finance perspective cannot explain the anomalous

investment behavior of irrational people. Since this incongruity was noticed, Kahneman and Tversky have proposed prospect theory as a reasoned theoretical explanation for this phenomenon. Normal investors are affected by cognitive bias and emotions in decision-making behaviors, rational investors are not (Statman, 2005). Behavioral Finance scholars have already proven that the act of engaging in risky decision-making in uncertain circumstances cannot be considered rational and that this descriptor should best be replaced with the more appropriate heuristic in that such decisions are by rule of thumb (they are experience based). Thus decision-making in such circumstances may be understood without cognitive bias. Heuristics is an important feature of the individual decision-making process which may be considered to include thought representativeness heuristics (Tverversky and Kahnemen, 1972, 1973, 1974 and 1982) and availability heuristics (Tversky and Kahneman, 1973 and 1979). It is important here to understand that there is anchoring bias in the decisionmaking process which arises due to factors such as overconfidence, loss aversion, status quo bias, mental accounting, framing and so on. Investors in the process of assessing the risks and returns are influenced by this anchor effect (Tversky and Kahneman, 1974). Kahneman and Tversky claim that in the process of assessment, people use certain starting values as reference points, and that these reference points may be volatile values to which subjects add necessary adjustments. The KT experiment demonstrates that

this adjustment is usually not reliable and people confronted with different situations produce different anchor values. Perceptions of risk are affected by anchors, which lead investors to raise their returns expectations when given a bias/anchor of a higher value (Jordan and Kass, 2002). Behavior Finance scholars believe in objective consideration of investment risk and return because these factors can be strongly impacted by subjective framing influences. Decision-making processes relying on frames often cause problems to be viewed in different ways, which leads to different choices. Investors in financial markets receive a spectrum of reports which can be interpreted differently making cognition a factor in the final decision-making response. Shefrin and Statman (1994) found that noise traders have a greater cognitive bias than informed traders. Overconfidence and optimism are further forms of bias. De Bondt (1993) found that individuals rely on their personal past experience as a foundation and it is from this that excessive self-confidence in decision-making can originate. Such investors make inappropriate decisions with insufficient information due to this personal trait (Shefrin and Statman, 1994). In addition to Overconfidence bias, optimism is an Achilles heel leading to investment losses. Individuals with this failing often feel they possess an innate talent and in their optimism, over-rate their own assessment ability (Kahneman and Riepe, 1998). Having overconfidence and optimism causes people to further overestimate their own knowledge, underestimate risk, and it even reduces risk recognition. 3. Methodology

3.1. Research hypotheses An important factor of risk propensity is based on past experience (Pablo and Sitkin, 1992). Past investment experience can be treated as an anchor value in investment decisionmaking. When investors have more investment experience, this is representative of their optimistic investment behavior meaning that their risk tolerance is higher. This willingness to engage actively in investment 20 International Research Journal of Finance and Economics Issue 44 (2010) transactions is characteristic of investors with a high degree of risk orientation. More conservative traders are inclined to lower risk tolerance, therefore this study will test the following hypothesis: H1: More experienced investors have a higher propensity to risk; less experienced investors have a relatively lower to propensity risk. People who tend towards lower risk behavior are less willing to engage in risky adventurous behavior due to their low risk tolerance. That is, this kind of investor has a high degree of risk perception in financial products. On the contrary, investors who tend towards higher risk are more adventurous and so are willing to attempt high-risk, high reward investments. Therefore these investors perception of risk in financial products appears relatively low. Sitkin and Weingarts (1995) model for decision-making confirms such a relationship, therefore this paper will establish the following hypothesis: H2: Investor perception to risk and investor propensity to risky investment are in negative

correlation. A framework of thought affects investor perception of risk according to different informational stimulation. In prospect theory, K-T describes how individuals place their own interpretation on analysts reports and media news. When investors receive pessimistic reports, such as that of the closure of financial institutions or a drop in the stock price index, is their response to such consistent with their response to optimistic reports? If it is, then how does this consistency relate to the risk perception and return expectations investors assess of financial products? This study employs differing types of market reports as a frame from which to classify response to such. Two types of report are tested; one type includes optimistic news for the economy, and the other pessimistic. Then the risk perception responses of these reports are measured for different groups of investors. H3: Investors informed by optimistic market reports have a lower perception of risk; investors informed by pessimistic reports perceive a higher degree of risk to be present. H4: Investors informed by optimistic market reports have higher returns expectations; investors informed by pessimistic market reports have lower returns expectations. Each investor has unique personal risk tendencies, investment style, and level of risk awareness. These characteristics, in addition to the expectation of returns, help investment decisionmaking and portfolio construction. In the view of traditional finances capital asset pricing model, due to investor risk aversion, rational investors understand that increased investment risk demands compensation with a higher premium. Conversely, less risky investments are expected to pay lower

returns. Therefore perceptions of risk and returns expectations are in positive correlation. A further significant factor is investment experience as investors use their past investment performance as the basis or anchor for their future results expectations. More experienced, overoptimistic and overconfident investors also expect relatively higher returns. Investors use market reports to assess a starting point value (Kahneman and Tversky, 1974) and heuristics to adjust their assessment according to their own synthesis of the reported information. So, the importance of psychological factors in investment decision-making is significant. The importance of past experience and its effect on returns expectations is the focus of this study