Making decisions or selecting between two or more alternatives is a challenge faced in every field of work. In financial markets the investors face a problem of choosing between which assets to invest in, or, deciding which combination of two or more assets to invest in to maximise the returns, while minimising the risks. Investment decisions are perhaps the most important, yet most delicate decisions facing an investor. A fairly minor change in the estimations, upon which investors support their decisions, can change the balance between a project’s acceptability or otherwise.
The Risk element in concept of investment decision is an imperative factor in the valuation of likely investments. Risk and risk management are at the core of an investment’s success. Risk refers to the volatility of unexpected outcomes, usually relating to the value of assets or incomes gained from them (Jorion and Khoury, 1996; McLaney, 2003). In simple words, risk refers to a measure of the possibility of being ‘surprised’. A key concern for financial institutions and investors is the enormous issue of market risks.
Risk can be categorised into number of types but a clear understanding of Financial Risk is beneficial in evaluation and monitoring of investments. Financial Risk is the variability in the investor’s returns. Investors can considerably reduce the variation in returns by carefully investing in two or more assets. The decision to invest in a particular asset is based on the assessment of the asset’s returns, which are compared with the risk associated with that asset. The investors’ preference of the degree of risk associated with an asset, effects their decision about the choice of assets.
Most investors prefer less risk to more for a given return, and are referred to as Risk Averse. Tversky and Wakker (1995) and Kahneman and Tversky (1979, 2000) support this by stating that the predominance of risk averse investors is most generalised. They prefer a sure outcome to a gamble that has higher or equal expectation. If an investor prefers the asset with more risk attached, among the assets with equal returns, he is referred as Risk Loving. He prefers a gamble of lower or equal expectation to a sure outcome.
If an investor is indifferent to risk of an asset and risk does not effect his decision, he is said to be Risk Neutral. Most financial theories generally assume investors to be risk averse. The expected utility theory explains that as the wealth of a risk averse investor increases, the benefit received from each additional unit of wealth increases with a diminishing rate. Daniel Bernoulli primarily rooted this theory in 1738, where he attempted to explain the concept of decreasing utility with increasing wealth.
In the expected utility framework, risk preference is regarded as the risk attitudes that are obtained from people’s choices. Risk attitudes describe a concave utility function for risk aversion because individuals with such utility will accept certain returns below the expected value of return. An investor is said to risk averse if he prefers the certain asset to any risky asset with equal returns (Kahneman and Tversky, 1979). The investor derives less utility in gaining 1,000 than he foregoes in losing 1,000 (Pike and Dobbins, 1989). The utility in losses is steeper than the utility in gains.
Kahneman and Tversky (1979) argued that the Expected Utility Theory is not adequate descriptive model and proposed an alternative model accounting for choice under risk. Brabazon (2000) also supported the argument. The Prospect Theory (Kahneman and Tversky, 1979) is one of the most promising utility models that permitted descriptive deviations from rationality, and is the most promising model presently available (Chateauneuf and Wakker, 1999). This theory proposes an explanatory framework for the way people make decisions under conditions of risk and uncertainty. The theory suggests that an investor’s choice is affected by various factors.
The mental framework of an investor when presented with the choices, in relation to risk, has separate implications. The theory also suggests the inability of the investors to assess the probability of an event occurring (Smullen, ) and it considers ‘value’ against losses and gains, instead of ‘utility’ in utility theory. The investors evaluate losses against gains and losses instead of wealth. The investors are said to be risk loving in losses and risk averse in gains. They get discouraged if they suffer any losses and any gain from their investments encourages them.
The value function of losses is convex and much steeper than the function during gains, which is convex. This implies that the investors are more sensitive to the losses that to the gains. as compared to concave and less steep function in utility function. The Prospect Theory differs from Utility Theory in few areas (Levy et al. , 2003). The definition and perception of risk arise particularly because the events, which are to be happened in the future, are unknown, even if one imagines the future might be pretty much like the past. The decision making under uncertainty affects the choice of two assets A and B by an investor.
This paper studies how an investor’s choices are affected under different conditions and how various measures of risk affect their decision-making. A limited data relating to the returns of two assets, A and B, over the last 24 years is provided and understood to be perfect representation of distribution of return in the future (Appendix 1). Risk is present in every choice of asset in the market but what matters is how you handle it. The measurement of risk is a vital aspect in estimation of wealth. The flow of returns of any particular financial asset is uncertain.
In respect of these uncertainties the estimation of the deviation of actual results from the desired path, that is the asset’s risk, is necessary. Researchers in finance have recently begun to recognise importance and accuracy of risk measurement. Due the extensive study on this subject in the recent years, many new measures of risk have emerged but most have certain level of shortfall or criticism attached to them. The types of measures, which have achieved a considerable degree of popularity, include Value at Risk, Expected Tail Losses and Downside moments, amongst others.