Are the Chinese Really More Risk Averse? A Cross-Cultural Comparison of the Risk-Return Relationship

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1 Are the Chnese Really More Rsk Averse? A Cross-Cultural Comparson of the Rsk-Return Relatonshp Cha-Hsn Cheng, Department of MIS, Kang-Nng Junor College of Medcal Care and Management, Tawan ABSTRACT Bowman s rsk-return paradox (1980 suggests that the management s atttude towards rsks and returns changes accordng to the company s stuaton. Ths paper ntends to compare dfferent cultural backgrounds n the context of the same poltcal and economc envronments, as well as the same market benchmarks, n order to examne whether Western and Chnese management teams demonstrate the same degree of rsk aversons. It also ams to nvestgate the atttudes of Chnese-owned companes toward rsk-related decson makng. Ths study samples the fnancal reports of lsted companes n Tawan and the US from 1987 to 00. Ths approach can overcome the shortcomngs of Bowman s (1980 emprcal study, as ts concluson cannot valdate whether the result s based due to the samplng perod. In order to compare the dfferences n the atttudes of Western and Chnese management teams toward rsks, ths approach elmnates varances n systems, busness cycles, and markets by samplng the accountng data based on the same Generally Accepted Accountng Prncples (GAAP. The emprcal fndngs ndcate that Chnese companes are more rsk averse than Western companes to ensure earnngs. However, Chnese companes are less senstve than Western companes regardng rsk-reward relatonshps. Ths s even more pronounced for well-performng Chnese companes based on market benchmarks. Ths study reflects the smlartes and dfferences between Chnese and US companes n the cross-cultural base where the East meets the West. The fndngs suggest that Chnese companes may have target levels or reference ponts other than earnngs evaluatons. Keywords: rsk-return relatonshp, cross-cultural comparson, accountng nformaton INTRODUCTION Bowman s rsk-return paradox (1980 ndcates that the management s atttude toward rsks and returns changes along wth companes stuatons; scholars have snce been dscussng the condtons requred for the management to change ther atttude. Although Fama and French (199 argued that there s no obvous correlaton between rsks and returns n securtes markets, the popular economcs concept stll holds that there should be a postve correlaton between rsks and returns: rsky nvestments should offer hgh returns and vce versa. Bowman s rsk-return paradox argues that when a company s well-postoned n the busness envronment, the management team generally acknowledges that hgh returns are accompaned by hgh rsks. Ths s the rsk-averse decson atttude. However, when a company s poorly postoned, the management often makes rsky decsons because they can undertake hgher rsks even for lower returns. Thus, the management team shows the rsk-preference atttude. In other words, the management s decsons change n accordance wth the poston of ther company. When n a better stuaton, the correlaton between rsks and returns s postve; otherwse, the correlaton between rsks and returns s negatve. By examnng dfferent cultural backgrounds wthn the same poltcal and economc envronments, ths paper seeks to verfy whether management teams n the US and Tawan demonstrate the same level of rsk averson or rsk preference. As current lterature s mostly set n the market envronments of Western countres, ths paper deepens the understandng of the varances n management teams decson atttudes due to cultural dfferences. However, ths study does not sample accountng data n Chna for two reasons. Frst, Chna s stll a communst socety and thereby dfferent from the captalstc economy of the US. Ths dfference wll cause nterpretaton bases n the emprcal results. On the other hand, the market mechansm and accountng envronment n Tawan are smlar to those of the US. Thus, a cross-country comparson of Tawan and the US can focus on cultural dfferences rather than system varances. Second,

2 Chna opened ts market mechansm late compared to Tawan, whch started ts own n the 1950s. Ths s hghly relevant to the nformaton dsclosure of decsons made by companes. Such nformaton n Tawan s more comprehensve than n Chna. Snce Horowtz et al. (000 ndcated that the rsk-reward relatonshp can only be establshed wth tests on sub-perods, consderng the nformaton qualty and sample perods of fnancal reports, ths study uses accountng data from Tawan (a pure Chnese economy because t has more relablty than that of Chna. Accountng data from lsted companes n Tawan and the US from 1987 to 00 are sampled n ths study. Ths samplng perod s an extenson of Bowman (1980. Ths study performs an emprcal comparson of all of the ndustres n these two countres except the fnancal ndustry. Horowtz et al. (000 found that the nfluence of sze effects on the rsk-return relatonshp has been gradually declnng snce the 1980s. Thus, ths study assumes that the samplng perod s relatvely ndependent from sze effects. Also, the frst eght years ( and the last eght years ( were an economc boom and recesson, respectvely. The valdaton of these sub-perods can make the relablty of ths study s emprcal results more robust. LITERATURE REVIEW AND RESEARCH HYPOTHESIS Kahneman and Tversky (1979 proposed prospect theory, whch deals wth the reference level formulated by decson makers to assess rsks. When returns are lower than the reference level, most decson makers tend to prefer rsk. When returns are hgher than the reference level, they tend to avod rsks. The ratonal actor model proves that corporate actvtes are smlar to ndvdual decsons (Allson, 1971; thus, scholars can examne whether companes demonstrate smlar behavor when facng the rsk-return relatonshp. The emprcal fndng of Bowman (1980 s one such example. Early emprcal results approve (or dsapprove the correctness of Bowman s rsk-return paradox. Ovatt and Bauerschmdt (1991 and Baucus, Golec, and Cooper (1993 are the opposng scholars. However, an ncreasng number of emprcal results and theoretcal arguments dentfed by Deephouse and Wseman (000 support Bowman s rsk-return paradox wth ther emprcal research on organzatonal behavor. Based on a lterature revew, Nckel and Rodrguez (00 suggested that the level of rsk preference on the part of management changes along wth the envronment. The same management may be rsk averse under some crcumstances and may show rsk neutralty, or even a rsk appette, under other crcumstances. Bowman (1980 sampled the fnancal data of the 85 sectors n the US from 1968 to The data s from the relatvely dstant past, and the emprcal fndngs can only prove the characterstcs of the decsons made by US management teams. Further nvestgatons must demonstrate whether management teams n other countres or envronments follow the same patterns. Fegenbaum & Thomas (1988 sourced a wde range of accountng data under dfferent accountng systems, and ther fndngs were consstent wth Bowman s (1980. Jegers (1991 and Snha (1994 sampled non-us data by sourcng nformaton from Brazl and Australa. Ther emprcal results also supported the explanatons of Bowman (1980 regardng prospect theory (other emprcal explanatons of prospect theory are avalable n Nckel & Rodrguez, 00. LaPorta (000 ndcated that corporate fnancal decsons are subject to the nfluence of external envronments (e.g. laws and regulatons, legal complances, and cultures. It s necessary to conduct a cross-cultural comparson n order to reconfrm the emprcal concluson above. Some scholars argue that the accuracy of accountng data or databases may nfluence the correctness of Bowman s rsk-return paradox. Davs (1996 found that f survvorshp bas s overlooked, explanatory varables based on accountng nformaton wll be over-estmated n the emprcal results and explanatory power. Some lterature sources come from Compustat Database and therefore have a survvorshp bas problem for data before Chou, Chou, and Ko (009 sampled data to correct the bas problem from Compustat Database, and ther fndngs stll support Bowman s (1980. Fegenbaum and Thomas (1988 and Fegenbaum (1990 suggested the followng hypotheses for the valdaton of the management s atttude toward the rsk-return relatonshp. H1: There s a negatve correlaton between rsks and returns (of earnngs for the companes below target levels or reference ponts.

3 H: There s a postve correlaton between rsks and returns (of earnngs for the companes above target levels or reference ponts. The above hypotheses hghlght the key ssues addressed by prospect theory. How are the benchmarks determned n the market? Do they vary n dfferent cultural backgrounds? Prospect theory argues that the management s rsk averse when the company s performng well, but shows a rsk preference when the company s performng poorly. In accordance wth Fegenbaum and Thomas (1988, Fegenbaum (1990, Jegers (1991, and Snha (1994, ths study adopts the medums of the annual return on equty (ROE numbers as market benchmarks because medums are not subject to the mpacts of extreme values. Ths approach attempts to avod the nfluence of local market partculartes. Based on the annual market benchmarks, ths study dvdes the samples of both countres nto two groups: well-performng companes (above the benchmarks and poorly-performng companes (below the benchmarks. By followng the model desgn and analytcal method proposed by Chou, Chou, and Ko (009, ths study performs a regresson analyss on the two sample groups wth the followng model: Rsk a b * Re turn where Rsk s the rsks of the -th company durng the samplng perod, represented by the standard devatons of the annual ROE of that company across dfferent years of the samplng perod; Re turn s the returns of the -th company durng the samplng perod, represented by the mean of the annual ROE of b If that company across dfferent years of the samplng perod; s the slope of the rsk and return of the -th company durng the samplng perod. b s postve, t means that there s a postve correlaton between rsks and returns. If b s negatve, t means that there s a negatve correlaton between rsks and returns. Usng dfferent cultural backgrounds n the same poltcal and economc envronments, ths paper refers to Bowman s rsk-return paradox to verfy whether management teams n the US and Tawan exhbt the same level of rsk averson (or rsk preference. In addton to comparng the b values of dfferent groups, ths paper also compares the rsk-return coeffcents n the model n order to understand the dfference n the correlaton between rsks and returns for the management vew n these two countres. EMPIRICAL PROCESS Ths study sources the accountng data of the US companes from Compustat and the accountng data of the Tawanese companes from the Tawan Economc Journal Database (TEJ. As TEJ s a database collated by a regonal and authortatve company n Tawan, t can reflect the unqueness of management decsons n Tawan. The samples are the ROE numbers dsclosed n the fnancal reports of the lsted companes n the US and Tawan from 1987 to 00. Fnancal nsttutons are excluded from the samplng pool n order to ensure comparablty of accountng nformaton and bases due to ndustral peculartes. Horowtz et al. (000 suggested that the rsk-return relatonshp can only be establshed wth tests on sub-perods. In order to ensure the relablty of the emprcal results, ths study dvdes the samples nto two sub-perods: 1987 to 1994 (economc growth and 1995 to 00 (economc recesson. The number of observatons of ndvdual companes s screened durng the samplng perod to ensure that only companes wth at least half of the entre observatons n the sample perod are ncluded. Ths s to ensure that the means and standard devatons of ndvdual companes durng the samplng perod are representatve. Table 1 summarzes the fnal number of samples of the lsted companes n Tawan and the US from 1987 to 00 based on the above sample screenng prncples. However, as the number of lsted companes, ndustry scales, and ROE observatons n Tawan are all sgnfcantly smaller than ther counterparts n the US, the applcaton of the regresson analyss developed by Chou, Chou, and Ko (009 at the ndustral level wll make the emprcal fndngs from Tawan

4 not representatve. 1 Gven the smaller samplng pool n Tawan compared to the US, ths study apples a regresson analyss to the overall market level for both countres n order to establsh an unversal understandng of the varyng atttudes of management teams n dfferent cultural backgrounds toward the rsk-return relatonshp. Countres Tawan U.S.A. Table 1: Constructon of the samples n Tawan and the US from 1987 to 00 Perod Below the market benchmarks Above the market benchmarks frms observatons frms observatons , , , , ,766 4,647 3,767 6, ,93 3,813 5,93 35, ,04 46,404 4,04 49,939 RESULTS AND DISCUSSION Table below shows the emprcal results of the cross-cultural rsk-return relatonshp n the Tawanese companes and the US companes. These results are dscussed by four ways: the regresson of well-performng and poorly-performng groups, the comparson of Tawanese and US companes n the same performng group or n the rsk-return correlaton, and the comparson of coeffcents of the two performng groups n Tawan and the US. Table : the cross-cultural rsk-return relatonshp n the Tawanese companes and the US companes Countres Perod Below the market benchmarks Above the market benchmarks a b R a b R * * 4 (0.11 (6* (0.57 (.69* Tawan * -1.4* * 4 (8.49* (3.4* (0.08 (6.91* * -1.39* * 8 (1.15* (9.93* (0.0 (5.4* * -.16* -0.14* 1.96* 6 (5.8* (.8* U.S.A * -* -0.6*.33* 8 (.34* (5.67* * -.85* * 11 (6.37* ( * ndcates sgnfcance at the 1 percent level, respectvely. P-value s n parentheses. Regresson of Well-performng and Poorly-performng Groups durng Dfferent Sub-perods Both the Tawanese and the US companes show a sgnfcantly negatve slope ( b < 0 representng the rsk-return relatonshp for poor-performng companes (below the market benchmark. In contrast, there s a sgnfcantly postve slope ( b > 0 representng the rsk-return relatonshp for well-performng companes (above the market benchmark. These results are largely consstent wth the argument that management teams n both countres change ther atttudes toward the rsk-return relatonshp accordng to ther stuatons n the marketplace and that such changes move n the same drecton. Therefore, H1 and H are accepted n the cross-cultural comparson. 1 Accordng to TEJ s classfcaton, there are 16 ndustres for the lsted companes n Tawan. The number of companes n the automoble manufacturng ndustry and the paper manufacturng ndustry was less than eght between 1987 and 00. Ths means that there wll be only four poor performers and four good performers. Ths number s too small to represent the varances n performances and wll hurt the representatveness of the emprcal results.

5 Comparson of Tawanese and US Companes n the Same Performng Group The absolute values of the coeffcents of the rsk-return relatonshp for the US companes are greater than those of Tawanese companes ( b b, ndcatng that the trade-off between rsks and returns for Tawanese USA Tawan companes s narrower than n the US. Compared to the US companes, Tawanese companes are more rsk averse. Comparson of Tawanese and US Companes n the Rsk-Return Correlaton Both n the whole samplng perod and n the sub-perods, the US companes show a hgher correlaton than ther Tawanese counterparts wth hgher R. For the well-performng group (above the mean of the market benchmark, the US companes report an average of 0.96 coeffcents for the rsk-return relatonshp, whereas the Tawanese companes show an average of 0.55 coeffcents. For the poorly-performng group (below the mean of the market benchmark, the US companes show an average of 0.99 coeffcents (almost entrely postvely correlated for the rsk-return relatonshp, whle the Tawanese companes show an average of 0.90 coeffcents. Although the correlaton for the poor performers n Tawan s not as hgh as ther US counterparts durng the same perod, the movement s n the same drecton. As a result, Tawanese companes are less senstve to the rsk-return relatonshp n the management decson-makng process. They may thereby be regarded as more rsk neutral. Comparson of Correlaton Coeffcents of the Two Performng Groups n Tawan and the US The two performng groups n the US report smlar correlaton coeffcents n ther atttude toward the rsk-return relatonshp. However, the correlaton coeffcents of poor performers n Tawan have over 35% hgher coeffcents than ther well-performng counterparts. Ths demonstrates dfferent responses of the management teams to the rsk-return relatonshp n dfferent cultural backgrounds. CONCLUSIONS Cross-country comparsons should pay attenton to lmtatons such as dfferences n cultures, legal systems, and market envronments. Hence, there are conflctng results n cross-cultural comparsons of companes n the East and the West. Through a questonnare survey on nvestments n the context of personal fnance, Weber and Hsee (1998 found that people of dfferent cultural backgrounds have dfferent degrees of rsk preference. Hsee and Weber (1999 also conducted a questonnare survey on subjects n Chna and the US by nferrng that Chnese are less rsk averse n personal fnance, but more rsk averse n non-personal fnance than Amercans, because the communst system can provde fnancal assstance n a tmely manner. Fan and Xao (006 performed an emprcal study on rsk tolerance for people n the US and Chna, and confrmed the results of Weber and Hsee (1998. However, Brumagm and Xanhua (005 conducted a questonnare survey on Chnese companes regardng the management s atttude toward rsks and found that Chnese management teams show a rsk preference. Ye (008 further explaned the over-confdence and nvestment decsons of the management teams n Chna. Accordng to the emprcal fndngs of ths study, Tawanese companes, whch survve n a pure Chnese captalstc economy, are more conservatve n rsk decsons than US companes. Ths result s smlar to that of Weber and Hsee (1998. Snce ths emprcal study s based on a sample of Chnese companes operatng n a market mechansm that s the same as n the West, ths approach can purely reflect the cultural varances n the East and the West. Ths cross-country comparson fnds that Chnese companes are more conservatve toward rsks than US companes under ther respectve market stuatons. Yet, the results refer to those companes that are evaluated only based on earnngs. If there are other target levels or reference ponts for Chnese companes (e.g. poltcal relatonshps, emprcal fndngs regardng atttude toward rsks based on a sngle performance metrc (.e. earnngs s not as obvous as wth the proftablty-drven US companes. Another contrbuton of ths paper s ts comparson wth exstng academc dscussons. After elmnatng system varances and market dfferences, ths paper valdates the levels of rsk preference of management teams wth accountng data. As the accountng data n Tawan and the US are subject to the regulatons of the same accountng For Tawanese companes from 1987 to 00: the than R comparson of poor performers and good performers s equal to 0.96/0.71, whch s larger

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