What Determines Risk Tolerance?

Abstract

It is important for financial planners to understand what drives risk tolerance as it directly influences the portfolio allocation preference of clients. Possible explanations for determinants of risk tolerance include habit formation, loss aversion and investor sentiment. We hypothesize that these three factors account for significant variation in risk tolerance. We analyze average monthly scores from a widely used risk tolerance questionnaire that spans the global financial crisis (January 2003 - December 2010). We find that the habit formation, loss aversion, and sentiment proxies account for -1.06%, 38.51% and 13.21% of the variation in average monthly risk tolerance, respectively. Habit formation did not account for additional variation in average monthly risk tolerance when controlling for loss aversion and sentiment. Implications for financial planners are discussed.