Risk tolerance: Essential, behavioural and misunderstood
Abstract
An understanding of an investor's risk tolerance is essential to determining investment suitability and yet there is no universally agreed definition of what risk tolerance is. The authors discuss the need for a holistic approach to measuring risk tolerance that provides a consistent framework for constructing efficient multi-asset allocation and ensuring a suitable aggregate level of risk and return, given the investor's personality and financial circumstances. Risk tolerance is only stable when considered as a personality trait, which can be measured effectively using holistic psychometric scales. Attempts to measure risk tolerance at lower levels of granularity are unstable, they accentuate, rather than mitigate short-term behavioural distortions and cannot be meaningfully aggregated to provide an overall level of risk that is appropriate given the investor's risk capacity. This implies that the recent move towards mental accounting, goal-based, assessments of risk tolerance is misguided and exposes institutions to risks associated with providing unsuitable advice.
The full article is available to subscribers to the journal.
Author's Biography
Greg B. Davies leads a global team of behavioural and quantitative finance specialists, and is responsible for the design and global implementation of Barclays’ Investment Philosophy. He is an Associate Fellow at Oxford University’s SaÏd Business School and his first book, Behavioral Investment Management, was published in January 2012. He has authored papers in multiple academic disciplines and is a frequent media commentator on Behavioural Finance. He holds an undergraduate degree from the University of Cape Town, an MPhil in Economics and a PhD in Behavioural Decision Theory, both from Cambridge University. Greg’s co-created ‘reality opera’ Open Outcry, which turns the behaviour of a functioning trading floor into a musical performance, received its premie` re in London in November 2012.
Peter Brooks is Vice President and behavioural finance specialist working at Barclays. His focus is on the psychology and attitudes of investors in emerging economies. Peter has done much research on how investor attitudes are affected by prevailing market conditions. He frequently shares these insights with the leading business newspapers and news channels across Asia. He holds an MSc in Economics and Econometrics, and a PhD in Behavioural and Experimental Economics, from the University of Manchester. Peter has previously held a research fellowship at the University of East Anglia in Norwich.
Citation
Davies, Greg B. and Brooks, Peter (2014, March 1). Risk tolerance: Essential, behavioural and misunderstood. In the Journal of Risk Management in Financial Institutions, Volume 7, Issue 2. https://doi.org/10.69554/OVZT4879.
Publications LLP