Errors in Individual Risk Tolerance

Abstract

This paper focuses on risk tolerance, which works as a relevant feature affecting financial decision-making. Specifically, financial risk tolerance may be defined as ‘the maximum amount of uncertainty someone is willing to accept when making a financial decision’ (Grable, 2008). Theoretically, financial risk tolerance depends upon different dimensions of risk. Weber et al. (2002) refer to risk attitude as ‘a person’s standing on the continuum from risk aversion to risk seeking’ (p. 222), and they contend that the degree of risk-taking is highly domain-specific. Risk-averse individuals in one domain (e.g., financial choices) may not behave consistently across other domains (sports, social skills...). In a word, risk taking behaviour is multidimensional. From the perspective of financial planners (Cordell, 2002; Boone and Lubitz, 2003), financial risk tolerance can be defined as a combination of both ‘risk attitude’ (how much risk I choose to take) and ‘risk capacity’ (how much risk I can afford to take). Nevertheless, these two components of risk tolerance are intrinsically different: risk attitude is a psychological attribute (Weber et al., 2002, also refer to it as a personality trait), whereas risk capacity is principally a financial attribute.