An Investigation of Investor Risk Attitudes in Trinidad and Tobago
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An Investigation of Investor Risk Attitudes in Trinidad and Tobago
Marla DukharanBBF4 Conference
Trinidad HiltonJune 23rd, 2011
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OutlineMotivationLiterature ReviewThe ApproachThe ModelThe DataThe MethodThe ResultsConclusion and next steps
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Mainstream Finance AssumptionsALL •Rationality
•perfect information•risk aversion
Expected utility theory •Rationality•maximizing expected utility•risk aversion•constant risk preferences
Efficient-market hypothesis
•rational market•perfect information
Rational Expectations •Rationality•perfect information•risk aversion
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Trini RealityDomestic equity market not well understood scientifically
Found to be underdeveloped; narrow, thin and inefficient (Singh 1995) as a limited number of entities are publicly traded (Bourne 1998)
70% of shares are held by institutional investors and are not actively traded (Nicholls, Leon and Sergeant 1996)
Returns are highly non-normal, and compared to the Jamaican and Barbados stock exchanges, presents the highest return and the lowest risk and, consequently, the largest Sharpe ratio (Watson 2008)
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Behavioural FinanceA marriage of finance and psychology, growing in
acceptance
Behavioural Finance – dominant finance’s deficiencies are based on The way our brains workThe way the market really works
Contradictions to assumptions of rationality, perfect information, risk aversion
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(Im)perfect (mis)information
All available information is assumed to be accurately reflected in prices (Samuelson 1965)
Available to whom?
How ‘accurately’ is information truly reflected?
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Cognitive PsychologySources of irrationality
cognitive biases and overall emotional reactivity
We mentally overweight - information confirming our expectationsmore recent / memorable information
Overconfidence - We overestimate (underestimate) our role in
our successes (failures)We underestimate our information needsWe overestimate the precision of our estimates
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Biases
Biases make us blind to alternatives
Biases and heuristics affect the majority of the population
Biases are not static
Psychology is silent on the magnitude and (in)consistency of these biases
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Investor BehaviourInvestors are risk loving
Experts are equally prone to overconfidence
Successful traders were found to be the most overconfident
October 1987 stock market crash was precipitated by a decline in the market
Herding - investors mimic other investors
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Prospect Theory - AssumptionsCertainty effect Loss aversionNon-linear preferencesHouse money effectIrrationality
Critique - Prospect theory does not suggest what the market’s reaction to or interpretation of a specific economic event would be
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ApproachTest the Trinidad and Tobago Composite Index
(TTCI) to determine investor risk attitudes
Test risk attitudes over time, and across varying reading results
Test to determine whether risk preferences determine the index value (as expected utility theory holds)
Conduct a survey of Trini finance professionals and investors to verify empirical results
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ModelV(x)=maxi EU(XT)
i=-(u-r)Vx / σ2 Vxx
Where:i= Trinidad and Tobago Composite IndexV= indirect utility function or value functionU= direct utility functionx= initial wealthXT= terminal wealthσ2 = variance, volatility of the indexu= moving average rate of return on the indexr= risk free rate of returnVx = the marginal utility of wealthVxx = the second derivative of wealthVx / Vxx = Ω (the coefficient of risk attitude)
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The DataTrinidad and Tobago statistics
Trinidad and Tobago Composite Index (TTCI) Stock Exchange data – CBTT
Risk free rate - 90 day Treasury Bill rates – CBTT
Survey dataShort multiple choice survey on domestic
investor risk attitudes and behaviours
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The TTCI
Jan-00
May-00
Sep-0
0Jan
-01
May-01
Sep-0
1Jan
-02
May-02
Sep-0
2Jan
-03
May-03
Sep-0
3Jan
-04
May-04
Sep-0
4Jan
-05
May-05
Sep-0
5Jan
-06
May-06
Sep-0
6Jan
-07
May-07
Sep-0
7Jan
-08
May-08
Sep-0
8Jan
-09
May-09
Sep-0
9Jan
-10
May-10
Sep-1
00
200
400
600
800
1000
1200
1400
T&T composite index
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The MethodWe conduct non-linear least squares
regressions on e-views, using the model and data discussed
We test the TTCI for risk attitude, and the effect of investment time horizons
Survey data – 36 responses from local investors, portfolio managers, traders etc., to a short survey
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TTCI – Values for Ω
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The Empirical Results
TTCI investors are risk loving – whether gains / losses being realized
TTCI investor preferences are dependent on the value of the index, but the converse is not true
Risk appetite increases at a decreasing rate over the investment time horizon
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Trinidad Survey ResultsRisk Averse 48%Not risk averse 52%Adopt a risk-loving attitude 19%Adopt a risk-averse attitude 23%Exit loss-making trades 52%Increase investment in loss-making trades 6%Macroeconomic and financial data 52%Overall market sentiment / risk attitude 27%Your own risk attitude 21%
Macroeconomic / financial data 27%
Overall market sentiment / risk attitude 73%
3 Which one has the most influence on your investment decisions?
4Which ONE is generally more significant in influencing overall market movements?
1 In general, you consider yourself to be
2 On average, when faced with losses, you
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ConclusionInvestors are risk loving across trading results
We refute dominant finance theories and Prospect theory
Preferences of investors depend on the value of the index, but the converse is not true
Risk appetite increases over the investment time horizon, at a decreasing rate
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Next Step
Prediction of index direction based on quantification of Ω
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Any questions?