An investigation into risk propensity in bull and bear markets

Abstract

This paper addresses the primary contribution of prospect theory against the landscape of an individual’s self‐attributed risk propensity. Risk propensity is captured using the IPI psychometric questionnaire for a sample of 521 participants. Participants are also presented with probability‐based decisions, that are framed as both negative and positive prospects. Results show that personality constructs, specifically risk‐taking, become a consistent and emerging factor in decision‐making within the positive domain. In the negative domain, personality constructs associated with risk become more muted and are less likely to be a factor in decision‐making.

Keywords:

• risk propensity
• decision‐making
• prospect theory

Notes

1. In 2003, Warren Buffett identified the rapid growth in the use of derivatives as a potential threat to the stability of the global financial markets. His prophecy of a ‘mega‐catastrophic risk’ for the economy as a result of derivatives may not be entirely inaccurate, given the scale of the current credit crisis.

2. The psychometric questionnaire is available on http://ipip.ori.org/.

3. This method of sub‐grouping was decided upon so as to split the groups as evenly as possible. Another method would be to divide as per score, that is lowest (14) to 25, 26 to 37, 38 to highest (48). Either method is acceptable in the SPSS literature.

4. The Spearman’s correlation shows that Risk Aversion and Risk Taking are significantly negatively correlated. It is thus sufficient to report the Risk Taking scores here. The Risk Aversion scores are available from the author on request.

5. This trend is statistically significant (X ² = 12.590; p < .01).

6. The results for Risk Aversion are also significant (X ² = 14.610; p < .01).

7. Hypotheses 4 and 5 are supported for Problems 1 and 3.

8. Kahneman and Tversky (1979) also proposed that when considering probabilities, individuals will apply a decision weighting to the outcome of the presented options; however, for this analysis it is assumed that subjects adopted the stated values of probability and that no other external factors influenced their weighting.

9. Overconfidence is one of the most common human characteristics. It reflects the very prevalent tendency for people to overestimate their own abilities, their own prospects for success, the probability of positive outcomes, the accuracy of their own knowledge, and to perceive themselves more favourably than they perceive others (Cheng 2007, 60).