How Does The Risk Appetite of Islamic Finance Investors
How Does The Risk Appetite of Islamic Finance Investors Differ from
Its Conventional Counterparts? 1
Orhan Erdem2, 3 , Zamir Iqbal4
This study aims to analyze whether there is a behavioral difference between Islamic finance
investors and conventional investors. We first define an Islamic finance investor and how to
differentiate them from conventional ones. Secondly, we differentiate their trading behaviors
by means of a risk appetite index, RISE. RISE is an index which measures investors’
tendency to invest in risky securities. By means of this index, we find out the similarities and
differences between their trading behaviors. The results indicate that Islamic finance investors
differ from others once the markets get risky. Lastly, we try to figure out the underlying
reasons of differences.
Thanks to its emphasis on risk sharing, equity-based contracts, and prudence, Islamic
finance (IF) has received a warm welcome in the last years not only from Muslim investors,
but also from the broader financial system as well (Asutay (2011)). Most of the studies, if not
all, on IF focus on the instruments or institutions of the IF system.They mostly try to measure
the prudence of the IF institutions (REF), or contrast the performance of conventional and
Islamic financial instruments (REF). Thus, they try to capture the differences based on the
conventional finance and IF. However there are not many studies investigating the investors’
side. Who are IF investors? What kind of behavior do they exhibit? How does their risktaking behavior differ from conventional finance investors? We believe that, IF system can be
built on a stronger ground only by understanding thebehavior of IF investors.
Even after conducting extensive investigation, we reached the decision that the amount of
existing research and studies in these particular fields, are very meager both in quantity and
This paper was presented both in Islamic Finance Conference Series - I “Implications of Participation Model in
Finance” which was held in Borsa Istanbul on March 4th 2014 and 6th International Conference on Islamic
Banking and Finance which was held in Boğaziçi University, Istanbul. We also sincerely thank to attendees and
Zeynep Sarıbaş for their contributions.
Corresponding Author. Đstanbul Bilgi University, Department of Economics [email protected]
Bogazici University Center for Applied Research in Finance (CARF)
World Bank, [email protected]
quality. While there are a number of ongoing studies throughout the globe, only few have
been completed and reached meaningful conclusions. It’s obvious that the topic requires more
focus and tangible results, which could lead to critical insights and practices in today’s
financial environment both for the developed and the emerging economies in the world.
This study aims to fill this gapsimply byemploying the trade data of a specific stock
exchange, namely Borsa Istanbul. By using an index, abbreviated as RISE, we measure the
risk appetite of investors who are categorized into two groups: Islamic Finance and nonIslamic Finance investors.
The results show that Islamic Finance Investors differ from others when the markets get
riskier.What this study suggests is that the massive stress of ongoing market volatility, could
lead two investor types to act in a different manner.The results are consistent with (Asutay
Our analysis indicate that during normal times Islamic finance has become not only a
part, but also a very close follower of the conventional financial markets, leading way
to asset bubbles, speculation, and divergence from the real economy. These results
also imply that, Islamic finance, despite its strong ethical and moral foundations, is
still prone to the most important weakness of the conventional finance; information
asymmetry and principal-agent problem, in other words, incentives, governance and
The study proceeds as follows: Section 1 reviews the literature. In section 2, we describe the
data of investors trading in Borsa Istanbul. Moreover, we explicitly define how we
differentiate the Islamic Finance and non-Islamic Finance investors. In Section 3, we explain
our methodology. Section 4shows the results and Section 5 concludes.
2. Literature Review
Before delving into the question of how investors’ risk appetites change over time, we need to
elucidate on what we mean by risk appetite. The problem with the term is that it is often used
interchangably with ‘risk premium’, ‘risk aversion’ and ‘risk tolerance’ which indeed
represent related but different concepts. Here, “Risk appetite” is supposed to mean—the
willingness of investors to bear riskthe emphasis should be on risk aversion which can be
defined as “ reluctance of a person to accept a bargain with an uncertain payoff rather than
another bargain with a more certain, but possibly lower, expected payoff.”
There is a wide literature on investor behavior in terms of their risk aversion however it
is almost impossible to reach a concensus since this is a relatively subjective area of study.
For the sake of the research at hand, we focus on how Islamic Finance investors’ risk appetite
differ from that of other investors. The relationship between religion and financial behvior has
been extensively investigated in the literature. For instance, Guiso et al. (2003) claimed that
religiosity generally results in good economic outcomes, i.e. higher GDP per capita and
So, next step is to look at religion’s effect on risk aversion. Noussair et al. (2013: 174)
finds a positive relationship between risk aversion and current religiosity in a study conducted
among Dutch population. However, this does not derive from the religious beliefs themselves
but rather from “the social aspects of belonging to, and being exposed to the doctrines and
institutions of, a religious group” (Noussair et al. 2013: 177). In a similar fashion Hilary and
Hui (2009: 455) observe that “firms located in counties with higher levels of religiosity
display lower degrees of risk exposure, as measured by variances in equity returns or returns
on assets.” However these studies do not provide sufficient insight on whether individual
investing decision is based on religiousity but instead measures risk aversion by exposing the
participants to a lottery and reveals institution level data, respectively.
Within the literature there are studies at individual level and take financial decisions into
account when refering to risk aversion. Hess (2012) focuses on personal financial behavior as
indicated by credit scores, credit card balances, foreclosures, and bankruptcies as
representative factors of individual risk aversion and finds that “individuals located in areas
with higher levels of religiosity take less risk and display higher ethical standards.”
Another deficiency in the literature is that there is no individual study on the
relationship between Islam and risk aversion. Yet, in some studies in which the sample also
contains Muslims, this issue is touched upon. Islamic doctrines are reluctant to risk taking in
financial activities. The Qur’an seeks to restrict the riskiness of finance-related behaviour by
prohibiting gambling not only in the sense of games of chance, but also in the sense of
investment in risky assets (Bartke and Schwarze 2008): “O, you who have believed, indeed,
intoxicants, gambling, [sacrificing on] stone alters [to other than Allah], and divining arrows
are but defilement from the work of Satan, so avoid it that you may be successful.” (Qur’an
5:90). Even the fair gamble with an expected value of zero is rejected with the promoted risk
aversion. In addition to the prohibition of investment in forbidden products, like alcohol,
tobacco, pork, weapons or pornography, Islamic law prohibits gharar: speculative economic
transactions (Leon and Pfeifer 2013: 3). Hence, it bans investing in extremely hazardous or
highly risky assets where details with respect to the traded item are unknown or uncertain.
The Qur’an itself forbids trades that are considered to have severe risk due to uncertainty.
Furthermore, taking interest (Riba) is prohibited, since it is seen as a form of usury. ‘In the
modern world, that translates into an attitude toward money that is different from that found
in the West: Money cannot just sit and generate more money. To grow, it must be invested in
productive enterprises’ (Saleh Ambah, 2008). In summary, religious rules explicitly show
how much financial risk taking is allowed and in which assets adherents are permitted to
Another study which takes Muslims into consideration finds that “religious faith in
particular shows a strong influence on risk propensity. It frames our perceptions of risk, and
restricts our set of behavioural responses towards risk.” (Bartke and Schwarze 2008: 3). Using
data from the German Socio-Economic Panel (SOEP) the authors reach the conclusion that
individuals with a religious affiliation are significantly less risk-tolerant than atheists. And
also willingness to take risks decreases with the strictness and comprehensiveness of
behavioural rules, that is, higher risk aversion among Muslims than Protestants (Bartke and
Schwarze 2008: 12).
Investigating the period between January 2007 - October 2011, Dorn and Weber (2013)
show that the overall equity allocation of investors remains fairly stable. Retail investors even
increase their aggregate stake in equities, indicating that they do not lose their appetite for risk
Hoffmann et al. (2013) examine monthly survey data and related trading record in order
to reach an understanding of how individual investor perceptions change and drive trading
and risk-taking behavior during financial crisis. Though the financial crisis temporarily
decreases individual investors’ return expectations and risk tolerance, and increases their risk
perceptions, these variables quickly recover. Furthermore, investors continue to trade and do
not de-risk their investment portfolios during the crisis. Investors also do not try to reduce risk
by shifting from risky investments to cash.
Thaler and Johnson (1990) as well as Barberis (2013) find that experiencing a number
of consecutive losses reduces investors’ subsequent willingness to take risks.
The dataset of this analysis is mainly based on the trading of individual investors in Borsa
Istanbul. The data are recorded and deposited by Central Securities Depository of Turkey,
MKK. MKK calculates a risk appetite index, RISE, based on the trading actions of investors
and webcasts the index in their website5. The index RISE is formed using weekly data for
more than 840,000 investors. Each investor who had 5,000 Turkish Liras (TL) or more equity
balance at Borsa Đstanbul at any one of the weekends since 2006 is available in this dataset.
On average, approximately 1000 new investors are included to the data each week. The
calculation is mainly based on the equity holding levels of investors. If investors buy(sell)
stocks, they are assumed to increase (decrease) their risk. A buying action is assumed to show
the tendency to increase risk.
A. How are the investors categorized?
This index is formed both for the Islamic Finance investors and others. Of course it would
be very difficult to differentiate the IF investors from others. However, traders who have
islamic concerns are mainly using a specific brokerage company, namely BMD. Moreover
BMD declared a shariah-complaint market index which serves as a benchmark for IF
investors. Concerning also the fact that all participation banks6 are using this brokerage
company which is not used by other commercial banks, we decided to refer the customers of
BMD as IF investors. Therefore the RISE index is calculated for both type of investors,
namely, IF investors and the others. The idea of the analysis is based on the comparison of
these two indices. The table below presents the current (as of 10 January 2014) numbers of
investors in two groups their total holdings as percentage:
The data shown in the above table includes not only the individuals but also the funds and
corporations. Below is the statistics of the individual investors.
Some participation banks only recently established their own brokarage house companies whose investor base
is very limited.
4. The Model and the Methodology
Once we differentiate the investors, the RISE indices for both type of investors are
used. As MKK puts it “RISE is calculated weekly. The model calculates risk appetite scores
(RAS) for every single investor at the stock market first and then average them for the whole
market. The averaging is based on weights. Weights are calculated for each investor, dividing
her total risky asset holdings by her total risky asset holdings of the related group.” What we
do here is to ask MKK to calculate the RISE for the above defined investors and average them
to give as two different indices: IF and non-IF investors. The calculation of the RAS and the
RISE index is described in the Appendix.
We examine the RISE indices for the two investor types, namely islamic and
conventional investors, in Figure 1. The definition of Islamic Investors is given in Section
2A. Each investor type is composed of both the individuals and the institutions. As it can be
seen from the Figure 1, the risk appetite indices do not deviate much from the beginning of
2008 until September 2011. From September 2011 to August 2012 two indices deviate from
each other. That is, the risk appetite of Islamic Finance investors decreases with respect to
conventional investors. This time period corresponds to beginning of Eurozone debt crisis.
The difference between two indices is clear in Figure 2.
Figure 1: The Risk Appetite Index for Islamic and Conventional Investors (Individuals and
However there is deviation between the end of 2011 and the end of 2012. This period covers
the time between the beginning of Eurozone debt crisis and Outright Monetary Transactions.
We first take the difference of these indices and check whether there is a significant difference
between the risk appetite indices of these two types of investors? Below the difference of
these two indices is drawn. As it can be seen the difference shifts to a positive level around
the end of 2011.
OMT increases the financial assistance to meet the problems of the Eurozone debt crisis. This
may lead to more sterilized market conditions. We suspect that these new market conditions
may have been more attractive for risk-averse investors.
Figure 2: The Difference of Risk Appetite Indices for Islamic and Conventional Investors
(Individuals and Institutions)
After regressing the difference to a constant
we check whether there is a breakpoint in the regression. For this purpose a Chow breakpoint
test is used. The Chow test in Figure 6 shows that the null hypothesis that a breakpoint exists
cannot be rejected. Moreover, the F-statistic of the test reaches its maximum when the
breakpoint is 2 September 2011 which corresponds to the beginning of the Eurozone debt
Figure3 andFigure 4 show the same case for the individual investors only. The Chow break
point test reveals the same results for this case too.
Figure3 The Risk Appetite Index for Islamic and Conventional Investors (Individual Investors)
Figure 4The Difference of Risk Appetite Indices for Islamic and Conventional Investors
Figure 5 The correlation between the “Difference of 2 Indices” and “VIX”
Here the main problem is the increase in VIX/CDS in 2009 is not reflected in the difference
Possible Reason Analysis
Here, we divided the stocks into three categories according to their Debt/Market Value: High,
The weight is defined as follows: Weight is the ratio of the balance invested on that specific
stock to the total balance invested on all stocks. Then we summed the “weight” of each group
of stocks (high, medium, low) according to investor category, namely Islamic and
For example if Islamic investors investor 1000$ to APPLE and the total invested money of all
Islamic investors in the market is 5000$, then the weight of APPLE is 0.2.
We calculated these summed weights for two time periods: June 2011 and December 2012.
Here are the results:
Weight (June 2011)
Conventional (all exl isl)
Weight (December 2012)
Conventional (All exc isl) 0,2524
RISE index of Islamic Finance investors and others are not significantly different in normal
However, it might differ significantly during turbulent times (depending on the origins of the
turbulence) indicating that Islamic Finance investors act in a more risk averse way in this
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Figure 6: The Chow Break Point Test F-Statistics for Different Dates