What determines risk tolerance

AbstractIt is important for financial planners to understand what drives risk tolerance as it directly influences the portfolio allocation preference of clients. We hypothesize that habit formation, loss aversion and investor sentiment account for significant variation in risk tolerance. We analyze average monthly scores from a widely used risk tolerance questionnaire. We find that the habit formation, loss aversion, and sentiment proxies account for -1.06%, 38.51%, and 13.21% of the variation in average monthly risk tolerance, respectively. Habit formation did not account for additional variation in average monthly risk tolerance when controlling for loss aversion and sentiment. © 2014 Academy of Financial Services. All rights reserved.JEL classification: D81Keywords: Risk tolerance; Loss aversion; Habit formation; Sentiment(ProQuest: ... denotes formulae omitted.)1. IntroductionIt is important for financial planners to understand what factors account for variation in risk tolerance. Knowledge of these factors will help planners identify what types of economic situations might affect clients' preferences for risky assets. According to Modern Portfolio Theory assets with a higher variance should have a higher expected return (Markowitz, 1952). This corresponds to the concave form of a typical investor's utility function. The greater the concavity of someone's utility function, the less willing they are to accept variation in consumption over time. More risk averse individuals must be compensated with a higher expected return, compared with those who are less risk averse, to accept greater consumption variation. The degree of risk aversion determines the optimal mix of risky and risk-free assets within an investor's portfolio.The three primary theories that help explain willingness to take investment risk include habit formation (Abel, 1990), loss aversion (Kahneman and Tversky, 1979), and investor sentiment (Baker and Wurgler, 2007). Habit formation might explain why client risk tolerance shifts when a job loss or a sudden windfall is experienced. Many financial planners are aware that clients become more willing to take investment risk after experiencing prior investment gains and less willing to take risk after successive market declines. Loss aversion and the house money effect have been used to explain this behavior, but to what extent does it drive client risk tolerance? Many financial planners recall the euphoria clients experienced in the late 1990s when technology stocks were climbing to record highs. Retail investors piled into tech stocks during this period of extraordinarily high sentiment, but many who did lost significant wealth when the bubble popped. The extent to which sentiment drives risk tolerance will help financial planners understand how client preferences for risky assets might change in relation to the economic outlook.The next section of this article provides an overview of the literature on factors that have been used to explain variation in risk tolerance. The literature review also helps to explain why different proxies were selected for habit formation, loss aversion, and investor sentiment. Section 3 outlines the conceptual framework and hypothesis. Section 4 describes the methodologies used to construct measures for habit formation, loss aversion, and investor sentiment. The article concludes with the results and practical implications for financial planners.2. Literature reviewConsumption-based asset pricing models are based on the covariance between asset returns and consumption growth. Individuals prefer a smooth consumption path over their lifecycle to maximize expected lifetime utility, which results in a low covariance between asset returns and consumption growth (Campbell, 2003). In this case it is difficult to explain the equity premium without an unrealistically high coefficient of relative risk aversion (RRA) (Campbell, 2003). …