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Volatility, Investment and Disappointment Aversion

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  • Joshua Aizenman
  • Nancy Marion

Abstract

This study uncovers a statistically significant negative correlation between volatility and private investment over the 1970-93 period in a set of almost fifty developing countries and provides a possible interpretation of this result by using the disappointment- aversion expected utility framework first described by Gul (1991). We consider a number of different volatility measures related to domestic policies or to external factors. As the various volatility measures tend to be positively correlated, we do not claim to identify a unique measure as the dominant source of volatility. Instead, we demonstrate that for a number of different measures, volatility reduces private investment in developing countries. We then show that the disappointment-aversion framework provides a useful way of illustrating the adverse first-order effects of volatility. When agents are disappointment-averse, they put more weight on 'bad' outcomes and less weight on 'good' outcomes than in the standard case. The asymmetric weighting of outcomes introduces additional concavity into the utility function and causes volatility to have significant, negative effects on economic performance. The large, negative effects of increased volatility continue to hold even if the coefficient of relative risk aversion approaches zero (that is, even if the marginal utility of income is constant so that agents are risk neutral in the conventional sense).

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5386.

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Date of creation: Dec 1995
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Publication status: published as (Published as "Volatility and Investment") Economica, Vol. 66 (1999): 157-179.
Handle: RePEc:nbr:nberwo:5386

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  1. Segal, Uzi & Spivak, Avia, 1990. "First order versus second order risk aversion," Journal of Economic Theory, Elsevier, vol. 51(1), pages 111-125, June.
  2. Joshua Aizenman, 1995. "Investment in New Activities and the Welfare Cost of Uncertainty," NBER Working Papers 5041, National Bureau of Economic Research, Inc.
  3. Barro, Robert J, 1991. "Economic Growth in a Cross Section of Countries," The Quarterly Journal of Economics, MIT Press, vol. 106(2), pages 407-43, May.
  4. Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-86, May.
  5. Robert S. Pindyck & Andrés Solimano, 1993. "Economic Instability and Aggregate Investment," NBER Chapters, in: NBER Macroeconomics Annual 1993, Volume 8, pages 259-318 National Bureau of Economic Research, Inc.
  6. Levine, Ross & Renelt, David, 1991. "A sensitivity analysis of cross-country growth regressions," Policy Research Working Paper Series 609, The World Bank.
  7. Hartman, Richard, 1972. "The effects of price and cost uncertainty on investment," Journal of Economic Theory, Elsevier, vol. 5(2), pages 258-266, October.
  8. Pfeffermann, G.P. & Madarassy, A., 1992. "Trend in Private Investment in Developing Countries," Papers 14, World Bank - International Finance Corporation.
  9. David Schmeidler, 1989. "Subjective Probability and Expected Utility without Additivity," Levine's Working Paper Archive 7662, David K. Levine.
  10. Caballero, Ricardo J, 1991. "On the Sign of the Investment-Uncertainty Relationship," American Economic Review, American Economic Association, vol. 81(1), pages 279-88, March.
  11. Harless, David W & Camerer, Colin F, 1994. "The Predictive Utility of Generalized Expected Utility Theories," Econometrica, Econometric Society, vol. 62(6), pages 1251-89, November.
  12. Aizenman, Joshua & Marion, Nancy P, 1993. "Policy Uncertainty, Persistence and Growth," Review of International Economics, Wiley Blackwell, vol. 1(2), pages 145-63, June.
  13. Ramey, Garey & Ramey, Valerie A, 1995. "Cross-Country Evidence on the Link between Volatility and Growth," American Economic Review, American Economic Association, vol. 85(5), pages 1138-51, December.
  14. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, vol. 73(1), pages 228-33, March.
  15. Gilboa, Itzhak, 1987. "Expected utility with purely subjective non-additive probabilities," Journal of Mathematical Economics, Elsevier, vol. 16(1), pages 65-88, February.
  16. Dow, James & Werlang, Sergio Ribeiro da Costa, 1992. "Uncertainty Aversion, Risk Aversion, and the Optimal Choice of Portfolio," Econometrica, Econometric Society, vol. 60(1), pages 197-204, January.
  17. Pfeffermann, G.P. & Madarassy, A., 1992. "Trends in Private Investment in Developing Countries," Papers 16, World Bank - International Finance Corporation.
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Citations

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Cited by:
  1. Saman, Corina, 2010. "Macroeconomic Uncertainty and Investment – Empirical Analysis for Romania," Journal for Economic Forecasting, Institute for Economic Forecasting, vol. 0(2), pages 155-164, July.
  2. Serven, Luis, 1998. "Macroeconomic uncertainty and private investment in developing countries - an empirical investigation," Policy Research Working Paper Series 2035, The World Bank.
  3. Cherif, Reda & Hasanov, Fuad, 2011. "The volatility trap: why do big savers invest relatively little?," MPRA Paper 31286, University Library of Munich, Germany.
  4. Bayraktar, Nihal & Fofack, Hippolyte, 2007. "Specification of investment functions in Sub-Saharan Africa," Policy Research Working Paper Series 4171, The World Bank.
  5. Hjalmar Boehm & Michael Funke, 2000. "Optimal Investment Strategies under Demand and Tax Policy Uncertainty," CESifo Working Paper Series 311, CESifo Group Munich.
  6. Mark J. Koetse & Henri L.F. de Groot & Raymond J.G.M. Florax, 2006. "The Impact of Uncertainty on Investment: A Meta-Analysis," Tinbergen Institute Discussion Papers 06-060/3, Tinbergen Institute.
  7. Aymo Brunetti & Beatrice Weder, 1998. "Investment and institutional uncertainty: A comparative study of different uncertainty measures," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 134(3), pages 513-533, September.
  8. repec:asi:ajoerj:2013:p:633-653 is not listed on IDEAS
  9. Serven, Luis, 2002. "Real exchange rate uncertainty and private investment in developing countries," Policy Research Working Paper Series 2823, The World Bank.
  10. Serven, Luis, 1997. "Uncertainty, instability, and irreversible investment : theory, evidence, and lessons for Africa," Policy Research Working Paper Series 1722, The World Bank.
  11. Desbordes, Rodolphe, 2007. "The sensitivity of U.S. multinational enterprises to political and macroeconomic uncertainty: A sectoral analysis," International Business Review, Elsevier, vol. 16(6), pages 732-750, December.

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