Factors influencing financial risk tolerance
Depending upon personal liking, people accept or reject risk. Financial risk tolerance is a concept of a person accepting the risk factor involved with a view to obtain extra profits.
According to Irwin (1993), there are a number of factors affecting financial risk tolerance. In a research conducted by Irwin, it was found that there are many demographic, socioeconomic, attitudinal and psychological factors that determine an individual’s risk-taking ability. This can be highlighted in the diagram below:
Some of these factors are studied in brief in this chapter in order to relate them to the secondary objectives of this study. We have identified two determinants as those of paramount importance, as they may be directly or indirectly related to financial risk tolerance. Although we do not conduct in-depth research of the supporting elements/ determinants of risk tolerance, they are understood briefly to relate them to risk-tolerance apart from personality and self-esteem.
The main determinants of risk-tolerance considered in this study are Personality and Self-Esteem. Personality and self-esteem, which also play a predominant role in determining the risk tolerance potential of an investor, are relatively less- explored domains.
They are explained briefly in this section, followed by an in-depth research in the next.
In a research conducted by Wong and Carducci, it was found that the relationship between personality and financial risk taking is providing increasing evidence that financial risk tolerance depends on factors such as the individual’s psychology, personality, aptitude, intelligence, values and attitudes. It defined as distinguishable, or relatively way in which one person differs from other one.
McCelland (1985) stressed the importance of personality traits i.e. individual differences as an important determinant of risk-tolerance. Global financial giant Barclay’s wealth management division also identifies financial personality in order to create customized portfolio for every customer. It takes into consideration several elements like psychology, behavioral finance, the emotional aspects of decision-making and the objectives of the investor in order to understand him/her better (Website, Barclayswealth). Levisohn (2009) reported that the firm used a 36-item questionnaire to measure the personality aspects of an investor. Davey (Website, riskprofiling) states that personality plays a role not only in the individual but also in an organizational context. An organization is likely to drive investment sub-optimal choices if it has individuals who feel strongly about certain perceived risk positions.
On the other hand, Self-esteem can be described as a multi-dimensional trait of personality that encompasses attributes like goodness, worth, appearance, health, social competence and skill (Baumeister et al, 2003; Liao et al, 1995). Opinions about the impact of self-esteem on personality have been varied. For instance the self-consistency theory states that individuals are likely to behave in a particular fashion that is consistent with the self-worth as perceived by them (Korman, 1970). A detailed study of the impact of self-esteem and personality is done later in this chapter.