How Do Investors Judge the Risk of Financial Items?

Abstract

This paper proposes and tests a new risk model that explains how investors perceive financial risks. The model combines conventional decision theory variables - probabilities and outcomes - with variables from psychology research by Slovic (1987). The latter includes variables such as the extent to which a risky item is new, causes worry, and is controllable. To test our model, we conduct two studies in which financial statement users judge the risk of a broad range of financial items. Our results indicate that both decision theory and Slovic variables are important in explaining investors' risk judgments. Further, we demonstrate that loss outcome information contained in mandated risk disclosures not only directly influences investors' risk judgments but also indirectly affects such judgments via its effect on select Slovic variables. These results provide new theoretical insights that should be useful to accounting and psychology researchers studying how people judge risk. Our results also imply that to fully understand the effects of current and future accounting risk disclosures, managers and regulators must consider the effects of these disclosures on decision theory and Slovic variables.

Keywords: risk perception, risk disclosure, decision theory, psychology

JEL Classification: M41, M44, G12