Content area
Full Text
Among an array of techniques to assess individual investors' risk tolerance, the simplest method is the risk questionnaire. As the type of questions included in different questionnaires varies greatly, this study examines how consistently they assess the risk tolerance of the same investor. Administering six questionnaires from various sources in our MBA classes, we found relatively low correlations among different questionnaires, as well as wide variation in both the significance levels and the coefficients of determination, leading us to conclude that some questionnaires can perform adequately in gauging risk tolerance, whereas others cannot. These results imply that great care is needed in designing a questionnaire that can be a valid and reliable method of assessing risk tolerance. Further examination of the types of questions indicates that a good questionnaire addresses both risk attitude and risk capacity.
The objective of asset allocation analysis is to find the best feasible combination of expected return and risk in the investment opportunity set that best suits an investor's preferences. Identifying an investor's optimal investment mix requires formating the investment opportunity set and the indifference curve. The method is standardized for constructing the investment opportunity set based on knowledge of opportunities in the capital markets (each asset's expected rate of return and expected risk along with correlation among assets). But the construction of the investor's risk-return indifference curve (risk tolerance function), and asset allocation based on the indifference curve, is not as simple a task. It requires a full understanding of the investor's circumstances and risk preferences (attitude toward risk). It also requires a method for quantifying this understanding so that advisors can derive a risk tolerance function unique to the investor.
Although risk tolerance evaluation is a key input in the formulation of individualized portfolios, academics and practitioners have not yet paid much attention to this variable. Few papers have appeared in either practitioner-oriented publications or academic journals. As Harlow and Brown (1990) note, a lack of understanding about the determinants of risk aversion may be the primary reason for this deficiency. Understanding human behavior relating to the unique personal nature of risk aversion is beyond the realm of conventional finance research. It requires collaborative research among scholars in the fields of finance and psychology. Furthermore, financial advisors...
