What is Risk?

Abstract

Most finance literature assumes that risk is synonymous with volatility, and that economic agents share this perception. This definition is also commonly used by financial advisors, professionals and regulators who shape models and policies accordingly. However, the extent to which individuals truly perceive risk as volatility has received limited attention. In a comprehensive series of ten experiments, we elicit people's risk perception and investment propensity by exposing them to diverse return distributions. We reveal that the primary factor that influences individuals' risk perceptions and investment decisions is the probability of experiencing losses in an investment. Volatility plays a comparatively less important role. Our findings remain constant across various factors, such as different personal characteristics, investment experience, and the presentation format. Consequently, we view our findings as posing a fundamental challenge to the validity of models in the field of financial economics.

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

JEL Classification: D81; G11; C91