Risk Tolerance, Projection Bias, Vividness, and Equity Prices

Abstract

This article examines two hypotheses. First, investor risk tolerance fluctuates in part due to changes in the investment markets, and, second, investors tend to project stock market closing price data into the formation of risk-tolerance attitudes. Regression tests were conducted to determine the role of projection bias and vividness in the formation of risk attitudes among a convenience sample of internet survey respondents (N = 1,355). It was found that individuals who own securities tend to use recent and vivid stock market data when establishing risk attitudes. Further, risk attitudes, on average and in the aggregate, were found to fluctuate based on closing stock prices the previous week. Financial planners are cautioned that risk tolerance should not be used as a static input within asset allocation models.

TOPICS: Factors, risk premia, analysis of individual factors/risk premia