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Working Paper Risk
15.06.2010

The perception of investment risk

Published 

15 June, 2010

> 10 minutes
15.06.2010
The perception of investment risk
Published 

15 June, 2010

> 10 minutes

The way investment risk is perceived by the actors on the capital markets strongly depends on the hypotheses and conventions that have been adopted as standards in the measurement of risk. The fact that certain standards have been used since long doesn’t necessarily mean that they are the most adequate and accurate. This paper points at a number of those standards that are liable to lead to a misperception of risk. Conventions are being reviewed that are profoundly inscribed in the theory and practice of investment management. It is not new to alert for the limits of financial modelling. Shortcomings in financial models and concepts are much discussed in the literature, and are regularly subject of debate. In most studies the limitations of a model are of secondary order though after the presentation of the model itself. Few research projects have been undertaken that assess the validity of the standard axioms in finance as the primary objective. Such study makes one realise to what extent the perception of investment risk is shaped by the conventions that have been established over time. It helps to explain why the investment industry seems weak to respond to novel circumstances and why it is prone to systemic failure. The goal of this paper is this, to help understand the weaknesses in the finance industry in terms of risk perception. Analyses underlying this paper have been carried out in a traditional investment setting. Common risk concepts are analysed that apply to common investments instruments. No derivatives, credit risk vehicles or other structured investment products are considered, for which the profit-and- loss profile is not directly intuitive. Well-established finance models are used as the reference for defining the investment risk, notably the Capital Asset Pricing Model (CAPM) introduced by Sharpe (1964) and the Arbitrage Pricing Theory (APT) introduced by Ross (1976). It is not evident to perceive risk; even less is it easy to perceive risk perception, as the act of perception is in the same time subjective, irresolute and unequivocal. Perception is a cognitive experience that starts by a form of measurement which necessarily simplifies the world such that it enables an analytical assessment which eventually leads to some form of judgment.

 

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