Loss Aversion Drives Risk Preference for Investors

Loss aversion is a significant driver of investors’ risk preferences for stocks, according to study results.

“There are a bunch of different risk tolerance surveys that financial planners use to assess risk tolerance and we were trying to determine what the driver behind an individual’s risk preference is,” Michael Guillemette, PhD, assistant professor and certified financial planner at the University of Missouri, told O&P Business News. “When you have more variation in spending, it causes people to become more risk averse, so people do not like fluctuations in spending. One of the things we test in this paper is, does having variation in spending drive changes in individuals’ risk preferences? The second thing we looked at was the concept of loss aversion or the tendency for clients to over-weigh losses relative to comparable gains. Finally, there has been evidence that investors’ sentiment or how they are feeling about the current and future economic outlook influences risk preferences. What we were trying to do is take these three factors that have been used to explain client risk preferences and determine which ones are the most important when trying to assess a client’s risk preferences.”

Risk tolerance preferences

Guillemette and colleague David Nanigian, PhD, associate professor of investments in the Richard D. Irwin Graduate School at The American College, measured risk tolerance using a questionnaire developed by FinaMetrica that included 25 risk tolerance questions. Data on monthly mean risk tolerance scores (MRTS) among 357,677 individuals surveyed in the United States and Canada were collected between January 2003 and December 2010.

When looking at average monthly risk tolerance, study results showed that changes in spending accounted for -1.06% of the variation, while loss aversion accounted for 38.51% and sentiment for 13.21%. Univariate regressions also showed the loss aversion proxy explains the greatest amount of variation in MRTS and loss aversion and sentiment contributed meaningfully to explaining variation in MRTS.

In another study, researchers analyzed MRTS for 2,327 individuals following the recent global financial crisis and found lower MRTS among individuals who perceived the stock market to be riskier than it was 2 years ago, as well as a positive relation between MRTS and positive stock market expectations. During the stock market crash of 2008-2009, study results showed MRTS was highly correlated with the S&P 500. Although risk tolerance was highly correlated with equity market returns, it declined 5% during the global financial crisis, according to study results.

“The results showed that overwhelmingly individuals’ loss aversion was the significant driver in risk preferences. We also found that investor sentiment did explain some of the variation in risk preferences as well,” Guillemette said. “Historically, when you look at economic theory the driver should be in individuals’ willingness to accept variation in spending. If they have more variation in spending, they should be more risk averse and this study kind of squashed that and said people are influenced by loss-averse tendencies. They treat losses and gains differently and that seems to be the driver.”

Importance of risk tolerance

If individuals want to feel more certain about the choices they are making in the stock market, hiring a certified financial planner can increase certainty among investors. However, according to Guillemette, it is also important for financial planners and advisors to assess risk tolerance for their clients correctly so they do not create a portfolio that is excessively risky. One piece of advice financial planners can provide to their clients to reduce loss aversion is to have a long-term time horizon when investing in stocks.

“We need to come to a uniform standard of assessing client risk preferences and based on the results that we found in the study everything is kind of pointing to making sure financial planners are measuring loss aversion or focusing on the loss aversion piece when they are giving these clients risk tolerance surveys,” Guillemette said. “It is so important when [financial planners] are using [surveys] to put a client into a portfolio that if they overlook the loss aversion piece it could be really detrimental to clients because they are not capturing their true preference for risk.” — by Casey Tingle

For more information:
Guillemette M, Nanigian D. Financial Services Review. 2014.

Disclosure: Guillemette has no relevant financial disclosures.

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