The Psychology of Risk

Abstract

The topic of risk incorporates a variety of definitions within different fields such as psychology, sociology, finance, and engineering. In academic finance, the analysis of risk has two major perspectives known as standard (traditional) finance and behavioral finance. The central focus of standard finance proponents is based on the objective aspects of risk. The standard finance school uses statistical tools such as beta, standard deviation, and variance to measure risk. The risk-related topics of standard finance are classical decision theory, rationality, risk-averse behavior, modern portfolio theory, and the capital asset pricing model. The behavioral finance viewpoint examines both the quantitative (objective) and qualitative (subjective) aspects of risk. The subjective component of behavioral finance incorporates the cognitive and emotional issues of decision-making. The risk-oriented subjects of behavioral finance are behavioral decision theory, bounded rationality, prospect theory, and loss aversion. The assessment of risk is a multi-dimensional process and is contingent on the particular attributes of the financial product or service.