Many investors—who are by definition in the business of generating high returns—opt out of profitable investments just because of the associated risks, however minimal those risks might be. Nobel Laureate in Economics Daniel Kahneman and Amos Tversky attribute this behavior to our natural psychology of decision making that assigns more weight to losses than to gains. This is why investors generally prefer to operate in the debt market (characterized by relatively fixed but lower returns) rather than in the equities market (characterized by the possibility of high returns over longer periods of time).
The kind of risk sharing prevalent in the equities market formed the cornerstone of Islamic finance. Over the years, however, the popularity of the risk sharing feature in Islamic financial markets seems to have been on the decline. Saad Azmat and M. Naiman Jalil, along with Michael Skully and Kym Brown, are the first to offer an explanation for this phenomenon from a behavioral perspective in a research article accepted in the Journal of Economic Behavior & Organization (2016).
Using theoretical modelling to study investor behavior, the authors were able to find that Shariah-sensitive investors who were loss-averse and who followed up on their investment returns frequently (weekly or monthly) preferred Islamic debt bonds (Sukuk) over risk sharing instruments. Also, while investors who followed up on their investment returns less frequently did not necessarily behave similarly towards Islamic debt bonds, they seemed to prefer Islamic equities over the original risk sharing instruments.
It is because of this pattern of behavior on the part of Shariah-sensitive investors that risk sharing in Islamic finance markets has shrunk colossally, as greater investments in Islamic debt bonds and Islamic equities have jointly crowded it out. This has resulted in a situation whereby Islamic instruments that share important features with conventional financial products are causing the popularity of risk sharing to decline.
Azmat, Saad, Jalil, M. Naiman, Skully, Michael, & Brown, Kym (2016). Investor’s Choice of Shariah Compliant ‘Replicas’ and Original Islamic Instruments. Journal of Economic Behavior & Organization.
ABOUT THE AUTHORS
Saad Azmat is Associate Professor and Associate Dean (Research) at the Suleman Dawood School of Business, LUMS. He teaches courses in corporate financial management, financial markets, and Islamic banking and finance. He is the director for the executive program on Developing Future Leaders and the chair of the LUMS Center for Islamic Finance. His work has been published in the Pacific-Basin Finance Journal and the Journal of Economic Behavior & Organization.
M. Naiman Jalil is Associate Professor at the Suleman Dawood School of Business, LUMS. He teaches courses in project management, supply chain management, and decision analysis. His research has been published in the International Journal of Production Economics and the Journal of Economic Behavior & Organization.