At some level, all asset allocation techniques require a consideration of variables involving both capital market expectations and an individual’s tolerance for risk. Although the latter information is as important as the former, an evaluation of investor-specific risk aversion is typically done in an ad hoc fashion. Our understanding of financial risk tolerance can be extended by investigating the role of certain biological and psychological traits in the formation of economic preferences.
Specifically, a series of economic, psychological and biochemical tests were designed to establish individual-specific profiles. Risk-aversion estimates were obtained experimentally from observations of bidding behavior in computerized auctions using newly developed theoretical models. These measures were then compared with a psychometric assessment of “sensation-seeking” personality traits and with measures of neurochemical activity that have previously been found to be significantly related to human behavior. Individuals with neurochemical activity characterized by lower levels of the enzyme monoamine oxidase and with a higher degree of sensation-seeking are more willing to accept economic risk.
These results offer a theoretical link between risk tolerance and behavioral traits that is consistent with intuitions regarding economic preferences. They also provide quantitative support for some of the assessment practices currently in use. More importantly, a behavioral foundation for an individual’s tolerance for financial risk offers hope that future risk-assessment procedures can be extended in a way that broadens the set of tools available to the portfolio manager.
