An empirical investigation from a financial planning perspective of the factors that influence the financial risk tolerance of individuals

Publication Type:
Thesis
Issue Date:
2008
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NO FULL TEXT AVAILABLE. Access is restricted indefinitely. ----- When formulating an asset allocation, financial planners not only have a fiduciary obligation to be completely aware of the desired risk tolerance of their clients, but they are also required under the Financial Services Reform Act to assess the risk profile of their clients. Since the development of financial risk tolerance assessment methodologies, academic studies have attempted to determine the extent to which biological, demographic, socio-economic and psychological factors influence the financial risk tolerance attitudes of individuals. However, risk tolerance research often produces inconsistent and controversial findings, with the majority of studies also reporting low ·explanatory power and subsequent ineffectiveness in the factors that are assessed as predictors of financial risk tolerance. Through applied research, the aim of this thesis is to provide practitioners with a better understanding of financial risk tolerance, its assessment, and the factors that are related to financial risk tolerance. This thesis will enable financial planners to develop optimal asset allocations that accurately consider the financial risk tolerance profile of their clients. Due to the substantial inconsistencies in the findings of academic studies, I conduct three surveys to investigate financial risk tolerance. The first survey (Financial Planners Survey) is designed to determine the financial risk tolerance perception of financial planners by examining each of the most widely tested factors identified in the· existing financial risk tolerance literature. Based on their responses, as well as the findings of various academic studies, the second (Smart Investor Survey) and third (Risk Tolerance Survey) surveys regress these factors to financial risk tolerance scores. In the survey of financial planners, I find extreme inconsistencies in respondents' interpretations of a standard set of information concerning a hypothetical client. I propose that the inconsistencies are attributed to the fact that providing financial advice relies on subjective judgment, a process open to multiple interpretations based on the financial planner's own knowledge, experience, intuitions and skill sets. I find evidence of differences in the influence of variables on financial planners' clients, and conclude that inconsistencies in asset allocations can be attributed to a combination of intuition and knowledge gained from clients with similar demographic characteristics. The asset allocation process is further complicated by the existence of various behavioural biases, including overconfidence in the prediction of future return and risk estimates. Using the same survey dataset, I conclude that financial planners are not immune to overconfidence in their knowledge and ability to predict outcomes of financial markets. From the two risk tolerance surveys, financial risk tolerance is found to be related to a number of variables including gender, age, home ownership, income, wealth, entrepreneurship and financial knowledge, while it has no significant relationship to marital status, education and household size. Due to the low explanatory value of the majority of academic studies, the survey of financial planners also identifies additional and untested factors that could possibly influence financial risk tolerance. I incorporate a number of these suggestions, as well as several alternative factors that were investigated on an ad-hoc basis by previous academic studies, and conclude that a number of variables associated with an individual's current and future financial and investment circumstances, as well as several psychological and personality factors, are related to financial risk tolerance. Incorporation of these unexplored variables into a series of regression models results in substantially higher R2 and adjusted-R2 values compared to those of previous academic studies. As a result, the predictors of financial risk preferences identified in this thesis are more extensive than the previously assumed basic demographic constants and include attitudinal variables such as experiences, expectations and goals. Finally, I conclude that financial risk tolerance is a fixed psychological trait due to its positive relationship to anum ber of psychological variables. Minimal changes in annual financial risk tolerance scores are observed in a longitudinal analysis. Tills fixed trait conclusion is supported by the failure of a regression model developed from major demographic and socio-economic variables to predict changes in financial risk tolerance scores.
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