What is Risk? How Investors Perceive Risk in Return Distributions

Abstract

Most finance literature assumes that risk is defined as volatility. Academics, financial advisors and regulators use this definition alike and build models and policy around it. However, whether this is how investors actually perceive risk has barely been assessed. In a comprehensive series of ten experiments, we elicit the risk perception and investment propensity of investors by exposing them to a variety of return distributions. We identify an investment’s loss probability as the main influence factor. Volatility plays a less important role. Our findings are robust regarding various factors, including different investor types, personal characteristics, investment experience, and the presentation format.

Keywords: Behavioral finance, risk perception, risk communication, investment risk, investment propensity

JEL Classification: D81; G11; C91