Abstract

Lower Partial Moments As Measures of Perceived Risk - An Experimental Study

Matthias Unser

PricewaterhouseCoopers

The paper reports the results of an experiment on individual investors’ risk perception in a stock market context. Its purpose is to examine experimentally private investors’ risk perception in financial decision making. Even though many models in finance theory are based on variance as risk measure there has always been much discontent with this proposal. The symmetrical nature of variance does not capture the common notion of risk as something undesired. Lower partial moments (LPM) seem to be more appropriate in this respect. The paper focuses on the correspondence of people’s risk perceptions with specific LPMs.

First, it is shown that symmetrical risk measures like variance can be clearly dismissed in favor of shortfall measures like LPMs. Second, the reference point of individuals for defining losses is not a distribution’s mean but the initial price in a time series of stock prices. Third, the LPM which explains risk perception best is the LPM₀ (the probability of loss). Fourth, the framing of price distributions (histograms versus charts) exerts a significance influence on average risk ratings. Fifth, positive deviations from an individual reference point tend to decrease perceived risk.