Authored by Matt Waters
Understanding risk tolerance in the context of investing is essential for crafting a well-rounded strategy that aligns with an investor’s objectives, financial situation, and psychological preferences. While the concept of risk is often discussed with prospects and clients at a general level, a deeper exploration into the theories and models that underpin risk management can help crystalize the importance of understanding risk as part of a holistic financial plan.
In this blog post, we will explore key risk theories, each of which has distinct implications for how investors perceive and respond to risk. We will analyze these theories and contextualize them as part of individual risk tolerance, drawing upon well-established academic frameworks such as Expected Utility Theory, Prospect Theory, Modern Portfolio Theory (MPT), and Behavioral Finance. Stick with us! We promise not to get too academic on you. We will use non-investment-related analogies to help illustrate the core principles of each risk theory.
1. Expected Utility Theory (EUT): The Classical Framework for Rational Decision-Making
Expected Utility Theory is a cornerstone of classical economics, emphasizing how individuals make decisions under uncertainty. The theory posits that individuals will choose between risky prospects based on the expected utility they derive from each outcome, rather than merely evaluating outcomes based on expected monetary value. This decision-making process assumes rationality and that individuals’ preferences are consistent and transferable.
In the context of investing, EUT suggests that investors will allocate their resources to maximize their expected utility, which is a function of both the monetary outcome and the individual’s subjective utility curve. The utility curve captures risk aversion, with more risk-averse individuals exhibiting concave utility functions—meaning the marginal utility of wealth decreases as wealth increases.
For example, consider an investor facing two options: a guaranteed $1,000 (no risk) or a 50% chance of winning $2,000 and a 50% chance of winning $0. An investor with a concave utility function (i.e., risk-averse) will likely prefer the guaranteed $1,000, even though the expected monetary value of the two options is the same ($1,000). This reflects the individual’s preference for reducing risk, a central aspect of risk tolerance.
Non-Investment Analogy: The Job Offer Dilemma
Imagine you receive two job offers. One guarantees a steady salary of $80,000 per year, and the other promises a 50% chance of earning $120,000 and a 50% chance of earning $40,000. Expected Utility Theory suggests that a rational decision-maker would weigh the potential outcomes of both jobs and choose the option that maximizes their expected utility.
However, a more risk-averse individual (who values the certainty of the $80,000 salary) would likely opt for the guaranteed offer, even though the expected monetary value of the risky job is the same ($80,000). This decision reflects a preference for stability and predictability, akin to an investor’s risk aversion in their portfolio choices.
2. Prospect Theory: The Asymmetry of Risk Perception
Developed by Daniel Kahneman and Amos Tversky in 1979, Prospect Theory challenges the assumptions of Expected Utility Theory by introducing the idea that individuals do not perceive gains and losses symmetrically. Specifically, Prospect Theory argues that people are loss-averse, meaning they experience the pain of losses more intensely than the pleasure of equivalent gains. This asymmetry in how individuals perceive risk has profound implications for their investment decisions.
In the framework of Prospect Theory, investors are more likely to take risks to avoid losses than to achieve gains of the same magnitude. For instance, an investor who has experienced a 10% loss in their portfolio may be more inclined to engage in risky behavior to recover that loss, even if it is not in their long-term best interest. This phenomenon is often referred to as the disposition effect, where investors are biased towards holding on to losing investments in the hope that they will rebound, while they are more likely to sell winning investments prematurely.
The psychological bias introduced by Prospect Theory suggests that investors’ risk tolerance is not constant, but rather dynamic and influenced by the framing of potential outcomes. The theory has important implications for portfolio management, suggesting that understanding an investor’s emotional responses to gains and losses is just as crucial as their financial goals.
Non-Investment Analogy: The Lost Wallet
Imagine you lose $50 from your wallet while walking down the street. The pain you feel from the loss is significant, and you may spend the next hour retracing your steps or asking strangers if they found it. Now, imagine you find $50 on the sidewalk the next week. While the $50 is the same, the happiness or satisfaction you feel from finding it is much less than the distress you experienced from losing it.
Prospect Theory suggests that the emotional impact of loss is much stronger than that of a gain of the same magnitude. This asymmetry influences not only personal decisions but also investment behavior, where people are more motivated to take on risk to avoid realizing a loss than to achieve a gain.
3. Modern Portfolio Theory (MPT): Diversification as a Risk-Reduction Tool
Proposed by Harry Markowitz in 1952, Modern Portfolio Theory revolutionized the way investors approach risk. MPT focuses on the concept of portfolio diversification to optimize risk-return trade-offs. According to MPT, the risk of a portfolio is not simply the sum of the risks of the individual assets within it, but rather the total risk is a function of the correlation between the returns of those assets. By diversifying across uncorrelated assets, investors can reduce the overall risk of their portfolio, potentially achieving a higher return for a given level of risk.
The key insight from MPT is the efficient frontier, which represents the set of optimal portfolios that provide the highest expected return for a given level of risk. Risk tolerance is crucial here: investors must determine their risk preferences to identify which portfolio on the efficient frontier aligns with their risk-return objectives. If an investor is risk-averse, they will select a portfolio closer to the lower-risk, lower-return part of the efficient frontier, whereas a more risk-tolerant investor might select a portfolio with higher risk and higher expected return.
However, MPT has its limitations, particularly when it comes to assumptions about normality in asset returns and investor rationality. These limitations have led to the development of more sophisticated theories, particularly in the realm of behavioral finance, which recognize the real-world complexities of human decision-making.
Non-Investment Analogy: Choosing Your Friends for a Road Trip
Imagine you’re planning a road trip, but you have to choose the people you’ll travel with. If you select a group of friends who all have the same interests—e.g., everyone loves hiking, music festivals, and extreme sports—you’re putting yourself at risk of being stuck in situations where you might all want to do the same activity at once, resulting in frustration and tension.
On the other hand, if you diversify your group by choosing people with different hobbies, tastes, and preferences, the trip can be more balanced and enjoyable for everyone. If one person prefers a quiet museum visit while another enjoys adventure sports, the different interests may balance out the overall experience, reducing the chance of conflict or boredom. Similarly, in investing, diversification across assets (stocks, bonds, real estate, etc.) reduces overall risk by mitigating the volatility associated with any single investment.
4. Behavioral Finance: The Impact of Cognitive Biases and Emotions on Risk-Taking
Behavioral finance integrates insights from psychology into finance, recognizing that individuals often act irrationally and are influenced by cognitive biases, emotions, and social factors in their financial decisions. In the context of risk tolerance, behavioral finance challenges the notion of a fully rational investor as presented in EUT and MPT.
Key concepts in behavioral finance include overconfidence, anchoring, and mental accounting, which can distort an investor’s perception of risk. For example, an overconfident investor might underestimate the risk of a particular asset class, leading to overly aggressive portfolio choices. Conversely, an investor with an availability bias might overweight recent market events, influencing their perception of the likelihood of future outcomes based on recent experiences rather than on historical or statistical data.
Additionally, mental accounting can lead investors to treat different pools of money as being psychologically distinct, even if they are part of the same overall wealth. For instance, an investor may be more willing to take risk with a bonus or inheritance (seen as “found money”) than with their regular income, despite the fact that all money is fungible from a rational perspective.
Non-Investment Analogy: The Overconfident Cook
Imagine you’re invited to a dinner party where you’re tasked with preparing a dish. You’ve cooked a few successful meals in the past, and you’re feeling confident. This time, you decide to make a challenging, complex dish that requires precise timing and skill. Despite your limited experience, you push ahead, thinking it’ll be fine—after all, you’ve made a few simple dishes before.
However, due to your overconfidence, you neglect key details like ingredient proportions and cooking times. The dish turns out poorly, not because it was fundamentally hard, but because you overestimated your abilities. In investing, overconfidence biases can lead investors to take unnecessary risks or overestimate their ability to predict market movements, which can result in suboptimal investment outcomes.
Risk Tolerance is Complicated
Risk tolerance is a complex, multifaceted concept that is shaped by a variety of factors, including individual psychology, market behavior, and economic theory. Whether through the lens of Expected Utility Theory’s rational framework, Prospect Theory’s insights into loss aversion, or the diversification principles of Modern Portfolio Theory, investors’ decisions around risk are influenced by a combination of mathematical models and psychological factors.
As investors, understanding these theories—and how they relate to your own emotional response to risk—can help inform a personalized investment strategy. Whether you are navigating the uncertain waters of a volatile market or making long-term decisions based on risk-return trade-offs, it is essential to recognize that your risk tolerance is not static; it evolves as your financial circumstances, goals, and psychological disposition change over time.
If you need help or want to chat with a financial advisor in our Denver office, we would love to talk to you about your specific situation.
