Errors in Individual Risk Tolerance

Abstract:     
This paper focuses on risk tolerance which clearly influences financial decision making. We explore the emotional side of a risk taking behaviour, comparing alternative measures of financial risk tolerance resulting from the consilience of various disciplines. We wonder whether we financially act as we are or as we are supposed to be. Thus we measure first, an unbiased risk tolerance (UR), which is obtained from the psycho physiological reactions of individuals taking risk in laboratory experimental settings; second, a biased risk tolerance (BR) obtained through a psychometrically validated questionnaire. Finally we compare these indicators with risks assumed in the real-life. Our findings confirm that people tend to behave coherently to their self-representation and almost in stark contrast to what they feel. Nevertheless, experiments conducted on more than 440 individuals, with a large presence of trader and asset managers allow us to prove evidence of an ‘unconscious sleeping factor’ which is remarkable when the unbiased risk is much higher than the risk assumed in real life but, at the same time, higher than the self-evaluation. Our findings induce us to propose a model of mental functioning that places rationality and emotion side by side to a third factor: the counterfactual thinking and the wandering mind. The sleeping factor is totally absent in traders and asset managers.

Number of Pages in PDF File: 28

Keywords: Investment Decisions, Risk tolerance, Individual Behavior, Iowa Gambling Task, Financial education

JEL Classification: G11, C91, I22

working papers series