Question

What risk preference does financial theory assume investors have?

Answer 1

Investor’s risk preferences:

Financial theory assumes that investors are rational & when making investment decisions they are invariant in their risk preferences – risk averse.

According to prospect theory proposed by Kahneman & Tversky, they conducted experiments which suggest that inventors tend to be risk averse with gain & risk seeking with loss which has been confirmed by number of studies that was conducted subsequently.

Another example of Lughumm & Payne had evidence of 20 managers on risk choice performed risk averse for gains & risk seeking for loss. Similarly on a study conducted by Fernandez & Luiz investors were less willing to take risk when there were gains & take more risks when there were losses.

According to study conducted by Thaler & Johnson, investors risk preferences depend on their psychological value of return. Some other scholars suggested that investors required compensation for risk varied with prior period compensation, which means that investors current attitude for risk depend on their attitudes in the last period.

Hence investors risk preferences vary with time. With the influences of state of gain & loss, value of return & some other factors like prior period’s risk preferences & residual errors.