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The Complementary Nature of Financial Risk Aversion and Financial Risk Tolerance

Author

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  • John Grable

    (Department of Financial Planning, Housing and Consumer Economics, University of Georgia, Athens, GA 30602, USA)

  • Abed Rabbani

    (Personal Financial Planning, Division of Applied Social Sciences, University of Missouri, 125A Mumford Hall, Columbia, MO 65211, USA)

  • Wookjae Heo

    (Division of Consumer Science, White Lodging-J.W. Marriot Jr. School of Hospitability & Tourism Management, Purdue University, West Lafayette, IN 47907, USA)

Abstract

Financial risk aversion and financial risk tolerance are sometimes considered to be ‘opposite sides of the same coin’, with the implication being that risk aversion (a term describing the unwillingness of an investor to take risks based on a probability assessment) and risk tolerance (an investor’s willingness to engage in a behavior based on their subjective evaluation of the uncertainty of the outcomes) are inversely-related substitutes. The purpose of this paper is to present an alternative way of viewing these constructs. We show that risk aversion and risk tolerance act as complementary factors in models designed to describe the degree of risk observed in household investment portfolios. A series of multivariate tests were used to determine that financial risk aversion is inversely related to portfolio risk, whereas financial risk tolerance is positively associated with portfolio risk. When used in the same model, the amount of explained variance in portfolio risk was increased compared to models where one, but not the other, measure was used. Overall, financial risk tolerance exhibited the largest model effect, although financial risk aversion was also important across the models analyzed in this study.

Suggested Citation

  • John Grable & Abed Rabbani & Wookjae Heo, 2024. "The Complementary Nature of Financial Risk Aversion and Financial Risk Tolerance," Risks, MDPI, vol. 12(7), pages 1-16, July.
    • Handle: RePEc:gam:jrisks:v:12:y:2024:i:7:p:109-:d:1427490
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    References listed on IDEAS

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    1. Robert B. Barsky & F. Thomas Juster & Miles S. Kimball & Matthew D. Shapiro, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 112(2), pages 537-579.
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