Measuring Financial Investor’s Risk Aversion Guillaume Cousin, Be-Partner Philippe Delquié, INSEAD INFORMS San Antonio, November 2000.

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Presentation transcript:

Measuring Financial Investor’s Risk Aversion Guillaume Cousin, Be-Partner Philippe Delquié, INSEAD INFORMS San Antonio, November 2000

Informs NovemberCousin(Be-Partner) – Delquié (INSEAD)2 Risk aversion and other criteria Objectives Time Horizon Age Available income Market products Taxes, fees Yes Deterministic Consumption planning Is there any investment possible for you ? No Reconsider criteria Consider Risk Aversion

Informs NovemberCousin(Be-Partner) – Delquié (INSEAD)3 Our context Asset managers describe portfolio with annual expected returns and standard deviation For one investor, identify the best point on the efficient frontier Expected returns Volatility Most Risky Least Risky Efficient Frontier Best Portfolio for the investor Investor’s iso-utility curve

Informs NovemberCousin(Be-Partner) – Delquié (INSEAD)4 General Framework Psychology Economics Finance Return Risk U(W) W

Informs NovemberCousin(Be-Partner) – Delquié (INSEAD)5 Basic Elements Investment amount, time horizon Efficient frontier Family of lognormal distributions of final wealth $ 5000 for 5 years Return Risk = + Outcomes Probability of outcomes

Informs NovemberCousin(Be-Partner) – Delquié (INSEAD)6 Approaches to capturing Preferences Optimization Indifference Return Risk Best Portfolio ? ? Return Risk

Informs NovemberCousin(Be-Partner) – Delquié (INSEAD)7 Optimization Method Adjustable Lottery Return Risk $ -3000$ -1700$ 0$ 1000$ 2500 Investor modifies both return and volatility to find best distribution These are two extreme references

Informs NovemberCousin(Be-Partner) – Delquié (INSEAD)8 Indifference Method Investor adjusts gains or probabilities to create indifference Probabilities Gains Return Risk Reference lottery Adjustable Lottery We confront Investor with risk increase or return decrease Gains

Informs NovemberCousin(Be-Partner) – Delquié (INSEAD)9 Outcomes Adjustment Investor uses scroll-bar to shift Gains. Probabilities are constant. 50% 40% $ -3337$ -2354$ 0$ 3495$ % 6% Gains These values depend on lognormal distribution

Informs NovemberCousin(Be-Partner) – Delquié (INSEAD)10 Probabilities Adjustment Outcomes are fixed. Probabilities adjusted so as to keep a lognormal distribution. Both expected returns and volatility are affected. 2% 6% 50% 40% Maximum loss (Market) Maximum loss acceptable by investor $ -5000$ -1000$ 0 No gain, no loss Investor’s goal $ 5000$ 7000 Maximum gain (Market) Investor

Informs NovemberCousin(Be-Partner) – Delquié (INSEAD)11 Challenges Consistency between different approaches ? Validation of the link between observed Portfolios and ”true” risk preferences ? Risk W U(W) Return ? What is the right link between Psychology and Financial Engineering ? Extreme concavity