Thursday, April 2, 2015

Guest post: Are Australian investors (relatively) conservative?

Naomi Fink, CEO and founder of Europacifica Consulting, is my guest today, writing about the risk preferences of Australian investors.

In one of the preliminary documents leading to Australia’s Financial System Inquiry, authors speculated that the abundance of overseas financing for Australia might owe to a gap in risk preferences between domestic and foreign investors (no supporting evidence or parameter calibration was cited).

Anecdotally, yet consistent with this viewpoint, many players within the domestic financial sector tout about the supposed conservatism of Australian domestic investors.  But is there empirical evidence of such conservatism?

Firstly, following the argument made in passing in the preliminary FSI documents, if divergent risk preferences were the best explanation for Australia’s chronic current account deficits, they would explain Australia’s investment income deficit (the largest component of Australia’s external deficit), given the sensitivity of investment rather than trade to relative risk preferences.

The argument implies, first, that foreign investors should be categorically more risk-tolerant than Australians, who pay higher premiums to compensate for the higher risk of capital they export than what they receive on their lower-risk investments overseas.

The second implication of the argument is less obvious.  Risk preferences in financial economic models are typically parametric rather than variable. Extending this logic, Australia’s investment income deficit is the result of more consistently conservative attitudes among domestic investors in comparison to consistently risk-tolerant overseas counterparts.  This may seem to be splitting hairs, but the distinction is non-trivial.

Risk premiums may wax and wane alongside risk perception, while risk preferences among rational investors are typically more consistent over time.  But if this were so, we would expect to see behavioral evidence of consistently greater risk-aversion among Australian investors than their overseas counterparts.

We took it upon ourselves to perform our own stylised version of the missing calibration; a comparison of risk preferences among OECD countries (using equity market participation, per Vissing-Jorgenson (1997), Guiso (2002), and Guiso et al. (2008)).

This basic examination of parametric measures of relative risk tolerance undermines the hypothesis that Australian investors are relatively risk-averse.

Our results, shown in the chart below, not only argue against the notion that Australia is more risk-averse than the rest of the world: they show that Australia is one of the most risk-loving players in the OECD.  In this light, it is highly doubtful that relative risk preferences somehow structurally rationalize Australia’s income deficit.

Note: Arguments that Australia pays a higher premium on its debt because Australians are more risk-averse than the rest of the world fail to hold up to our calibration.
Source: Europacifica, OECD

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