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Self-reported risk tolerance is a measurement of an individual's willingness to accept risk, making it a valuable tool for financial planners and researchers alike. Prior subjective risk tolerance measures have lacked a rigorous connection to economic theory. This study presents an improved measurement of subjective risk tolerance based on economic theory and discusses its link to relative risk aversion. Results from a web-based survey are presented and compared with results from previous studies using other risk tolerance measurements. The new measure allows for a wider possible range of risk tolerance to be obtained, with important implications for short-term investing.
Key words: Risk tolerance, Risk aversion, Economic model
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Malkiel (1996, p. 401) suggested that the risk an invest or should be willing to take or tolerate is related to the househ old situation, lifecycle stage, 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 includin g 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 circumsta nce.
The level of risk tolerance is a crucial part of individual choices about wealth accumulation, retirement, human capital investment, portfolio al location, a nd 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 increasin g reliance on individual investment choices for retirement funds makes 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 plann ers 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 patt erns of risk tolerance based on the measure. The results suggest that...