Content area
Full Text
It is standard practice for financial institutions to formulate model portfolios or investment advice for a limited set of investor profiles. Individual investors are appointed the profile that best fits their balance between risk and reward, based on a number of standardized questions.
This approach potentially suffers from at least two shortcomings. First, questionnaires expect investors to predict their own future behavior. Nobel laureate Daniel Kahneman (2009) states that indeed “people are poor forecasters of their future emotions and future tastes.” Second, questionnaires restrict to the balance between dispersion of outcomes and average return, so-called risk preferences of an investor. Behavioral finance, and notably prospect theory, convincingly argues that investors in addition differ in their concern about losing money.
Regardless of the dispersion of outcomes, as a classical quantification of risk, investors tend to treat gains and losses differently. In general, people are more sensitive to losses than they are to commensurate gains. We refer to Kahneman and Tversky (1979) or Tversky and Kahneman (1992) for the original research and Camerer (2005) for practical arguments.
In this article we do restrict ourselves to an existing questionnaire. However, we will derive a more reliable anticipation of future behavior by processing the questionnaire data differently. We add a behavioral-based differentiating factor to the current risk-based profile definition. By doing so, we addresses the second shortcoming of the standard approach. Bodnaruk and Simonov (2016) show how the attitude toward loss of institutional investors impacts their investment allocations, investment performances, and career opportunities. It is fair to assume that the attitude toward loss is a differentiating factor among retail investors as well.
The outcome of our approach is a two-dimensional investor profile that combines risk and loss preferences. This compares with the two-dimensional approach toward individual psychology developed by Bailard, Biehl, and Kaiser (1986). Their model relates to all things in life, not only to investments, and defines personalities along two axes: level of confidence (from anxious to confident) and method of action (from careful to impetuous). Any combination describes a persona. Similarly in our approach, any combination of risk and loss preferences defines a homogeneous client group.
The remainder of the article is structured as follows. The first section overviews the existing questionnaire, which we use as a...