Measuring financial risk tolerance is not always simple as many over or underestimate their true risk tolerance. What does this mean for investors and financial planners? That’s where the research of University of Missouri professor is coming in.
Abed Rabbani, assistant professor in personal financial planning (PFP), teaches undergraduate and graduate courses in the department, along with performing research in risk tolerance.
“Risk management is a broad topic,” said Rabbani. “My specific area focuses on the measurement of risk tolerance and risk literacy. I look mostly at investment risk but also insurance risk.”
Risk tolerance is the willingness to take risk when it comes to financial decision-making. Investment risk tolerance is your willingness to invest in a stock or bond. There are thousands of stocks, some of which are risky, and some are not.
“Risk is associated with your investment return. The more risk you take, the more you will reap in the long run especially in the investment world.
“Part of my research agenda is to measure the risk tolerance of clients so their investment matches with the amount of risk they take.”
Rabbani most recently published the paper, Can portfolio risk be described with estimates of financial risk tolerance calibration? in the journal Finance Research Letters. The purpose of the study was to analyze the degree in which categories of financial risk-tolerance miscalibrations are associated with choices made by financial decision-makers.
“Risk tolerance is a behavioral, psychological construct. It is a little bit fluid when it comes to measurement. People’s perceptions change at different times.
“If market value is going down, your willingness to take risk isn’t as high if the market value is going up.”
Rabbani tested these assumptions of under and over estimating people’s risk to how they compare with the people who are consistent in their risk tolerance. By comparing, it will tell if the over-estimating people are taking more risk in their portfolio or under-estimating are taking less risk in their portfolio.
To determine over estimation and under estimation, risk tolerance can be broken into two different areas, subjective and objective. Subjective risk tolerance targets feelings, while objective risk tolerance is based on decision making. If a person’s subjective and objective match, they have a consistent measurement, which is calibrated. If it does not match, where your subjective risk tolerance is higher than your objective you tend to over-estimate and if it is less, you tend to under-estimate.
In this study, decision makers who systematically under-estimated their financial risk tolerance held portfolios less risky than those who were able to match their self-assessed risk tolerance. The portfolio risk of those who over-estimated their financial tolerance generally matched the portfolio risk of who were calibrated.
Rabbani has future plans to test other assumptions related to risk tolerance, such as if confidence level has anything to do with how much risk one takes.
“From the literature, people who are under-estimating they are actually going through some under confidence. We haven’t tested it, but that will be a future test to see if our assumption is correct.”
A free assessment to identify your risk tolerance can be found on PFP’s website.
Personal Financial Planning (PFP) joined the College of Agriculture, Food and Natural Resources (CAFNR) this past summer in the Division of Applied Social Sciences.
PFP covers Certified Financial Planner Board Registered Program (CFP®) curriculum, such as retirement planning, tax planning, estate planning, risk management and investment planning. They also teach courses like personal finance and financial counseling.