A Comparison of Risk Tolerance and Risk Capacity among College Finance Students

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ABSTRACT

The concept of risk aversion has been well-researched, and the prevailing wisdom for some time has been that most investors prefer to reduce the amount of risk required to obtain a given rate of return. This paper measures the difference between this aversion to investment risk (defined as risk tolerance) and an individual's capacity for investment risk. A questionnaire measuring both tolerance and capacity is given to 167 undergraduate and graduate students enrolled in a variety of Finance courses. It is hypothesized that for most participants, the risk tolerance score will be lower than the risk capacity score. It is further hypothesized that male students will have higher capacity and higher tolerance than female students, and that higher risk tolerance will be found among students enrolled in advanced finance and investing classes.

INTRODUCTION

All investors must deal with several types of risk in making their choices. One key element of financial theory is the concept of risk aversion; in other words, most people will try to minimize the amount of risk required for a given return, or conversely, maximize the return expected for a given level of risk (Gitman & Joehnk, 2005).

People differ significantly, however, in how much risk they can absorb, for reasons that are economic as well as emotional (Gollier & Pratt, 1996). These differences have broadly been categorized into risk tolerance and risk capacity. The two terms are often used interchangeably. More recently, however, Kitkes (2006) and others have stated a need to define and measure each term separately in order to obtain a more useful investor profile. Cordell (2001) proposed a tool he called RiskPACK as an instrument to separate and measure different components of an individual's attitude toward risk. Cordell defined four such components: Propensity, Attitude, Capacity, and Knowledge, thus creating the PACK acronym. Based on his further research, Cordell later suggested that risk could be usefully viewed in just two dimensions: capacity and tolerance (Cordell, 2002).

Capacity for risk can be determined somewhat objectively, based on the individual's income, age, financial stability, family situation and similar quantifiable factors. Tolerance for risk is more of an attitudinal measure, and is thus more subjective than risk capacity. Two individuals might have identical incomes, ages, etc, and therefore have identical capacity for risk. But it would not be surprising to find that one of them can tolerate more risk, despite the similarity of their situations. Risk capacity, then, is more quantitatively measurable; risk tolerance less so. This becomes more of an issue when trying to measure both these factors simultaneously (Roszkowski, Davey & Grable, 2005).

MEASURING RISK TOLERANCE VS. MEASURING RISK CAPACITY

Risk tolerance questionnaires have been widely used since their introduction in the mid 1980's (Droms & Strauss, 2003). However, many researchers question whether such instruments provide a good measure of what they are supposed to measure. Yook and Everett (2003) found differing and sometimes contradictory results from the same pool of investors. Furthermore, Bouchey (2004) contended that many of the questions found on risk tolerance questionnaires were actually better measures of asset allocation or investment goals as opposed to true measures of risk tolerance. Roszkowski and others pointed out as long ago as 1989 (Roszkowski & Snelbecker, 1989) and as recently as 2005 the difficulties in many of the questionnaires in current use and suggested a method for improving their effectiveness.

The keys to any questionnaire's success include its validity and its reliability (Cooper & Schindler, 2006). The concept of reliability is that the better-designed the questions, the more likely results from separate administrations of the instrument will be consistent. …