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Risk tolerance and financial literacy

Risk tolerance and financial literacy
Risk tolerance is the level of risk exposure with which an individual is comfortable; an estimate of the level of risk an investor is willing to accept in his or her investment portfolio.

Risk tolerance is the level of risk exposure with which an individual is comfortable; an estimate of the level of risk an investor is willing to accept in his or her investment portfolio.

Aversion to risk is what makes the study of capital markets interesting. Without risk aversion, all capital assets would be priced based on their expected payout and duration. Bonds would have the same yield over time as stocks and portfolio construction would simply be an exercise in organizing the timing of expected asset payoffs.

Underlying the preference for reduced variation in returns is the notion that each additional dollar earned provides a little less happiness than the last. As our incomes increase, the satisfaction gained from consuming each additional $100 declines.

When faced with an investment whose payout is variable, a risk-averse investor will require some added compensation for accepting uncertainty.

During our lives we experience circumstances that impact our willingness to accept investment uncertainty. A young family may see the loss of $5,000 as a serious event that requires sacrifices to meet a budget and compromises financial security. The same family later in life may have built up an investment portfolio large enough that the loss of $5,000 has little impact on their lifestyle.

The perceived consequences of a loss may also vary among investors of the same means. Some have the ability to shrug off a loss to their portfolio while others fret during a bear market and become stressed after reading a negative quarterly statement. Every financial planner who adheres to standard financial planning practices must assess the risk tolerance of a client in order to make informed portfolio recommendations. The process of risk tolerance assessment is in its infancy.

Households in the United States have substantial levels of noninvestment wealth, and investment portfolios typically amount to small proportions of total wealth. For over 80% of U.S. households in 1998, investment assets amounted to less than 20% of total wealth. The median proportion of investment assets to wealth increased with age, but was small even for those aged 65 and over.

Consumers lack the financial literacy necessary to make important financial decisions in their own best interests. However, questions exist concerning the effectiveness of financial education in improving financial literacy.

Therefore, a paradox exists between the efficacy of education in improving financial literacy and the impact of education on short-and long-term
financial behavior. How can education, which is correlated to financial literacy, improve financial behavior without first improving financial literacy?

Deregulation of the U.S. financial service industry since the 1970’s has created both opportunities and problems for American consumers. On the positive side, those with assets can obtain higher interest rates on their investments and lower fees for services. Individuals have enhanced choices for virtually every financial product. On the negative side, consumers are faced with increased costs. Banks have eliminated interest rate ceilings on debt and charge greater fees on low-balance accounts. Over the years, the financial services industry has become more complex.

Individuals are increasingly put in charge of their financial security after retirement. Moreover, the supply of complex financial products has increased considerably over the years. However, we still have little or no information about whether individuals have the financial knowledge and skills to navigate this new financial environment.

Are individuals well-equipped to make financial decisions? Do they possess adequate financial literacy and knowledge?


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Featured video on risk management in personal financial planning. How to be reasonable and take moderate risks with money.


About the author:

Personal Finance Made Easy

Hi, I am Leblon Blue. Mid-thirties senior manager on a large corporation. Happily married for seven years and waiting for my first kid. I have dedicated my past 15 years to build an engineering background and a stable career. After working in Europe, Scandinavia, and Latina America, I am now based in the Persian Gulf, where I manage the performance of a large corporation that operates in the region.

Find more about Leblon Blue.


Sources:

THE CONCEPT OF RISK TOLERANCE IN PERSONAL FINANCIAL PLANNING, Journal of Personal Finance. Sherman D. Hanna, Professor, Consumer Sciences Department, The Ohio State University

The Impact of Financial Literacy Education on Subsequent Financial Behavior. Lewis Mandell and Linda Schmid Klein.

FINANCIAL LITERACY AND STOCK MARKET PARTICIPATION. Maarten van Rooij, Annamaria Lusardi, Rob Alessie. WORKING PAPER 13565.

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Written by Leblon Blue

Career manager with engineering background. Finance enthusiast. Recently started this blog. Enjoying financial freedom.

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