The Influence of Information Presentation, Psychological Mechanisms, and Personal Characteristics on Households’ Financial Decision Making

The thesis addresses several research questions, which can be formulated as follows: 1.Which demographical, behavioral and psychological factors determine the financial well being of households(Chapter 2)? 2. What is the best way to present information about the risk of investment products to private investors (Chapter 3)? 3. Does simplifying information by aggregating performance information over asset returns influence risk taking (Chapter 4)? 4. Do private investors see a relationship between risk attitude and the amount invested risky at all and do they adjust their investments if provided with different risk levels of the risky asset (Chapter 5)? Chapter 2 of the thesis investigates which demographical, behavioral and psychological characteristics determine how households get along with their income; more precisely, it is investigated who is in financial difficulties, how these difficulties are handled and who is able to get out of them. The financial situation, defined as how much of the income is left at the end of the month, a household faces influences several other upcoming financial decisions; households in a bad financial situation reduce their stock market participation, are more likely to be financially constrained in the future, whereas households with in a good financial situation are more likely to make good credit and investment decisions. Indeed, it is a lot more than economic factors influencing private households’ day to day financial decision making. Even if factors like income, wealth and outstanding credit are strong predictors of how well households get along, I find an important influence of financial literacy and cognitive abilities as well as psychological factors like the propensity to plan on the current financial situation as well as on the ability to handle and solve financial difficulties once they occur. In chapter 3 (joint work with Emily Haisley and Martin Weber) we investigate the question of how risk presentation format influences investing. This question is important as financial professionals have a great deal of discretion concerning how to relay this information about the risk of financial products to their clients. We examine how different risk presentation modes influence how well investors understand the risk-return profile of financial products and how much risk they are willing to accept. We analyze four different ways of communicating risk: (i) numerical descriptions, (ii) experience sampling, (iii) graphical displays and (iv) a combination of these formats in a ‘risk simulation’. Participants receive information about a risky and a risk-free fund and make an allocation between the two in an experimental investment portfolio. We find that risky allocations are elevated in both the risk simulation and experience sampling conditions. Greater risky allocations are associated with decreased risk perception, increased confidence in the risky fund and a lower estimation of the probability of a loss. Despite these favorable perceptions the risky fund, participants in the risk simulation underestimate the probability of a high gain and are more accurate on comprehension questions regarding the expected return and the probability of a loss. We find no evidence of greater dissatisfaction with returns in these conditions and observe a willingness to take on similar levels of risk in subsequent allocations. The results have important implications for the current debate surrounding how financial advisors assess the suitability of investment products for their clients. Chapter 4 (joint work with Martin Weber) deals with information aggregation as one way to simplify complexity in asset allocation decisions. Former research has shown that the degree of information aggregation has an influence on decision making resulting in a higher risk taking. Information in the financial context can be aggregated over asset returns, e.g., on an account balance sheet, where investors can look at each asset or their portfolio as a whole. In this paper we analyze the underlying mechanisms which cause higher risk taking in the case of aggregated information. Additionally, we explore the ex post decision evaluation of participants who take on more risk and also explore the effects of different risk presentation formats. We conducted three experiments, in which we ask subjects to allocate an endowment between a risky and a risk-free fund and use three treatments to test the effects of information aggregation. In line with former studies we find a higher level of risk taking for a higher degree of information aggregation over different investment amounts, different cultural background and different risky assets. The higher risk taking is accompanied by lower risk perception, more accurate estimation of the probability of a loss and by participants’ feeling more informed. Additionally, a higher degree of information aggregations result in consistent subsequent allocation decisions and a higher decision satisfaction for participants receiving a loss (outcome below the expected value). In other words, people take into account that a well considered ex ante decision might ex post have a negative outcome. In Chapter 5 (joint work with Christian Ehm and Martin Weber), we analyze investors ability to deal with risk in investment decisions. Following the classical portfolio theory all an investor has to do for an optimal investment is to determine his risk attitude. This allows him to find his point on the capital market line by combining a risk-free asset with the market portfolio. We investigate the following research questions in an experimental set-up: do private investors see a relationship between risk attitude and the amount invested risky at all and do they adjust their investments if provided with different risk levels of the risky asset? To answer these questions we ask subjects in a between subject design to allocate a certain amount between a risky and a risk-free asset. Risky assets differed between conditions, but could be transferred into each other by combining them with the risk-free asset. We find that mainly investors’ risk attitude, but also their risk perception and the investment horizon are good predictors for risk taking. Indeed, investors do not appear to be naive, but they do something sensible. Nevertheless, we observe a strong framing effect: investors choose almost the same allocation to the risky asset independently of changes in its risk-return-profile thus ending up with significantly different volatilities. Feedback does not mitigate the framing effect. The effect is somewhat smaller for investors with a high financial literacy. Overall, people seem to use two mental accounts – one for the risk-free and one for the risky investment with the risk attitude determining the percentage allocation, and not the overall volatility of the investment.