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Portfolio Theory and Management$
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H. Kent Baker and Greg Filbeck

Print publication date: 2013

Print ISBN-13: 9780199829699

Published to Oxford Scholarship Online: May 2013

DOI: 10.1093/acprof:oso/9780199829699.001.0001

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PRINTED FROM OXFORD SCHOLARSHIP ONLINE (oxford.universitypressscholarship.com). (c) Copyright Oxford University Press, 2021. All Rights Reserved. An individual user may print out a PDF of a single chapter of a monograph in OSO for personal use. date: 03 December 2021

Assessing Risk Tolerance

Assessing Risk Tolerance

Chapter:
(p.99) 5 Assessing Risk Tolerance
Source:
Portfolio Theory and Management
Author(s):

Sherman D. Hanna

Michael A. Guillemette

Michael S. Finke

Publisher:
Oxford University Press
DOI:10.1093/acprof:oso/9780199829699.003.0005

Assessing risk tolerance is an important part of advising clients about portfolio selections. The expected utility approach underlying portfolio advice based on financial economics assumes that a household has some level of risk aversion that determines its utility from different wealth or consumption levels. Therefore, a household's risk aversion or its inverse—risk tolerance—is a key factor in determining the optimal portfolio for a household. Risk tolerance measures that offer choices without context as to how potential consumption would change do not provide estimates that measure the concept of risk aversion assumed in standard expected utility analyses of portfolio choices. Behavioral finance approaches, including prospect theory, may better explain household investment choices, but a consensus does not exist in regard to how to incorporate these approaches into rigorous portfolio recommendations. Risk capacity, based on human wealth and the investment horizon, is also crucial in determining optimal portfolio advice. This chapter provides a discussion of methods for estimating risk tolerance and the limitations of alternative measures.

Keywords:   risk tolerance, expected utility approach, behavioral finance approach, risk capacity, prospect theory

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