Investor Behavior: The Psychology of Financial Planning and Investing

CHAPTER 18

Risk Perception and Risk Tolerance

Victor Ricciardi

Assistant Professor of Financial Management, Goucher College

Douglas Rice, CFP®

Assistant Professor of Business and Management, Notre Dame de Namur University, Registered Investment Adviser, and President, Institute for Financial Planning Education

INTRODUCTION

Risk is a topic area that has application in a wide variety of circumstances. This subject has diverse definitions, measurements, and explanations among individuals, organizations, and disciplines. Researchers have investigated the risk-taking behavior of individuals and groups at length within the decision sciences and business arena (Ricciardi 2008a, 2008b, 2010) and the fields of behavioral finance, financial psychology, and behavioral accounting (Ricciardi, 2004). The literature reveals that risk researchers from different disciplines offer various viewpoints in terms of how to define, explain, and assess risk.

In academic finance, the well-established and accepted viewpoint of risk is known as traditional finance (Ricciardi 2008a). A major aspect of traditional finance is the objective aspects of risk (e.g., standard deviation). Traditional finance focuses on the quantitative measure of risk. The foundation of this approach is the macro-level assessment of risk incorporating all investors within financial markets. The basis of the traditional finance viewpoint of risk is classical decision-making (also known as the normative model) and the premise of