Establishing risk tolerance is a fundamental aspect of investing and sports betting. Doing so helps ensure that betting strategies align with an individual’s financial goals and comfort level, helping avoid sudden decisions which can lead to devastating losses.
Measuring risk tolerance can be challenging and research shows that different elicitation methods yield differing results.
Psychometric Tests
Psychometric tests used in the financial industry to measure risk tolerance take an econometric approach (or revealed-preferences assessment) by looking at current desires related to taking risks, known as their “state.” Assessments include questions regarding attitudes toward financial risk-taking (“risk propensity”), ability to bear financial losses (“risk capacity”) and knowledge regarding such behavior (“risk knowledge”).
Psychometric tests that have the best possible designs have an in-depth research foundation that ensures high criterion-related validity, such as being created by teams of psychologists in collaboration with finance professionals to create questions that make sense and don’t use jargon, cultural references or any other elements which may bias responses.
State-based assessments present unique challenges. Because their validity may not be permanent like traits are, frequent administration is necessary in order to remain valid. If, for example, clients score highly but become distressed when markets decline quickly may indicate poor criterion-related validity in their test.
Incentivized Decision-Making Tasks
One effective method of measuring risk tolerance is incentivizing decision-making tasks. When people are given financial rewards to make certain choices, they may be more inclined to hedge their bets and take risks, thus decreasing risk by giving themselves multiple chances at victory.
Studies have demonstrated that incentivized decision-making tasks may not provide as accurate of an assessment of risk tolerance as traditional tests; participants in such tasks are usually paid on only one trial rather than total sum, which could potentially distort results.
Incentivized decision-making presents another potential downside in terms of its difficulty to depersonalize success and failure. Kahneman and Tversky found that losses appear two times larger than gains, which can have an adverse impact on decision making. To alleviate this issue, it’s crucial that the outcome of projects be separated from their authors in order to facilitate more risk taking by individuals who might feel guilty over taking a chance on failure.
Confirmatory Factor Analysis
CFA requires researchers to construct an a priori theoretical measurement model that can explain relationships among a set of observed indicator variables. The model comprises continuous latent variables known as factors and observed variables constructed from these latent factors; such as test items or choice responses are then subjected to statistical fit criteria.
CFA is an established statistical technique used to estimate continuous latent variables from manifest variables observed by an experiment. It falls within the structural equation modeling family of techniques.
An experiment’s choice architecture can have a great impact on how cognitive abilities and risk tolerance relate. For instance, when participants are asked to choose between risky and EV-maximizing options, any positive correlation between higher cognitive abilities and risk tolerance might be misleading as people with lower cognitive abilities might make more erroneous selections in such tasks than expected. Furthermore, when structured so as to maximize risk by choosing less risky options simultaneously, working memory capacity/numeracy and risk tolerance might form an inverse relation.
Expectancy Theory
Comprehending the influences that shape your risk tolerance can help create greater insight into how decisions impact you. With this knowledge in hand, it may become easier for you to make more efficient choices when building a portfolio.
Expectancy Theory provides a useful framework to understand human motivational behavior, for instance when applied to students studying harder due to expectations that doing so will enhance academic performance (Expectancy) and valuing high grades as highly (Valence).
Advisors who use an approach to risk tolerance that helps them better understand client expectations when designing portfolios can use an individual’s net worth and risk capital – capital that can easily be converted to cash – as indicators for risk tolerance and their ability to absorb losses; those with larger net worths can take greater risks than those without available cash reserves.