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.
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