Assessing risk tolerance is an important part of advising clients about portfolio selections. The expected utility approach underlying portfolio advice based on financial economics assumes that a household has some level of risk aversion that determines its utility from different wealth or consumption levels. Therefore, a household's risk aversion or its inverse—risk tolerance—is a key factor in determining the optimal portfolio for a household. Risk tolerance measures that offer choices without context as to how potential consumption would change do not provide estimates that measure the concept of risk aversion assumed in standard expected utility analyses of portfolio choices. Behavioral finance approaches, including prospect theory, may better explain household investment choices, but a consensus does not exist in regard to how to incorporate these approaches into rigorous portfolio recommendations. Risk capacity, based on human wealth and the investment horizon, is also crucial in determining optimal portfolio advice. This chapter provides a discussion of methods for estimating risk tolerance and the limitations of alternative measures.
The purpose of this study is to investigate whether a professional designation affects consumer choice behavior within the area of investment decision making. Forty-six participants were endowed with real money and received hypothetical investment advice from a certified financial planner (CFP) Professional and a stockbroker. Among low-income households, advice from a CFP altered investor choice behavior within hypothetical education and retirement savings accounts. When participants made investment decisions using education funds and received advice from a CFP, the mean expected value of their investment choices was $43,913, compared to $25,870 given advice from a stockbroker. When investment decisions were made using retirement funds, the average expected value given advice from a CFP and a stockbroker was $53,424 and $33,207, respectively. If an investor was risk-neutral or risk-seeking, investment choices were improved when advice was rendered by a CFP relative to a stockbroker.
A variety of risk assessment questionnaires are used within the financial planning profession to assess client risk preferences. Evidence indicates that the average person overweighs losses relative to an arbitrary reference point. This paper evaluated risk assessment questions on how well they correlate with monetary loss aversion. Twenty-nine Western Texas residents between the ages of 27 and 56 participated in experimental research and filled out several risk assessment questionnaires. Two weeks later their levels of loss aversion were measured using monetary gain and loss scenarios. The individual risk assessment questions were placed into three categories: expected utility theory, prospect theory and self-assessment. Composite measures were created for within-group and between-group comparisons. Statistically significant correlations were found between monetary loss aversion and different composite measures. The results provide financial planners with a group of risk assessment questions that capture loss-averse preferences.
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