A Theory Based Measure of Risk Tolerance


Introduction of paper presented
at the 1998 AFS conference

A Theory Based Measure
of Risk Tolerance

Sherman Hanna, Ohio State University(1)
Michael Gutter, Ohio State University

Jessie Fan, University of Utah


Malkiel (1996, p. 401) suggested that the risk an
investor should be willing to take is related to the household situation,
lifecycle state, and subjective factors. Risk tolerance is commonly used
by financial planners, and is discussed in financial planning textbooks.
For instance, Mittra (1995, p.396) discussed the idea that risk tolerance
measurement is usually not precise. Most tests use a subjective measure
of both emotional and financial ability of an investor to withstand losses.
Mittra mentioned different factors related to risk tolerance including
net worth, income, knowledge, sophistication, and proximity to retirement.
Mittra suggested tests should determine emotional responses to varying
situations about money and decisions one might make in a given financial
circumstance.

The level of risk tolerance is a crucial part of
individual choices about wealth accumulation, retirement, human capital
investment, portfolio allocation, and insurance, as well as to policy decisions
that are dependent on this behavior. For instance, Bajtelsmit and Bernasek
(1996) discussed the differences between men and women in investing and
risk tolerance. The increasing reliance on individual investment choices
for retirement funds make it clear that some groups in society may be at
risk for inadequate retirement income if they are very averse to risk.
However, risk tolerance measures used by financial planners are not based
on rigorous economic concepts. The purpose of this paper is to present
a measure of risk tolerance based on economic theory, and to describe some
preliminary patterns of risk tolerance based on the measure. The results
suggest that there is a wide variation of risk tolerance in people, but
no systematic patterns related to gender or age have been found.


 


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citation of abstract as published:

Hanna, S. & Gutter, M. (1998). A theory
based measure of risk tolerance.
Proceedings of the Academy of
Financial Services,
p. 10-1.

If you cite complete paper, cite as working paper,
1999.


 

(note: Jessie Fan helped with the literature review and other sections
of the paper after it was submitted for the conference)

1. Correspondence to: Sherman Hanna, Professor, Dept.
of Consumer Sciences, Ohio State University, 1787 Neil Ave.,
Columbus, Ohio 43210, FAX  603-457-6577, Phone 614-292-4584, E-mail:
hanna.1@osu.edu