Measuring Risk Tolerance: Does The Methodology Matter?

Risk tolerance is widely used in the personal financial planning referring to an investor’s attitude towards risk. It is the amount of uncertainty or investment return volatility that an investor is willing to accept when making a financial decision. Risk tolerance scores are used (1) to examine the relationship between demographic characteristics and risk tolerance, and (2) to investigate the effects of risk attitude on predicting portfolio risk for different countries/cultures. In this respect, the methodology used in assessing individuals’ risk tolerance becomes an important issue. In literature, there are mainly two different approaches in measuring risk tolerance; lottery versus financial risk assessment technique (FRT). In the lottery approach, risk tolerance is measured using gambling scenarios, whereas the FRT measures risk tolerance using investment scenarios. This paper investigates whether lottery risk assesment technique and FRT differ in measuring the risk tolerance of individual investors. Moreover, it examines the differences in two well-known financial risk assessment techniques. The preliminary results obtained from asking questionnaires to the students showed that the individual risk attitudes differ when measured through lottery versus FRT (FRT measurement tend to result in more risk aversion). However, the two different FRT fall into the same line.