Doctor of Philosophy
School of Accounting & Finance - Faculty of Commerce
Subedar, Zaffar, Evaluation of subjective risk tolerance categorisation methods used by financial advisors: evidence from a psychometric financial risk tolerance questionnaire, PhD thesis, School of Accounting & Finance, University of Wollongong, 2007. http://ro.uow.edu.au/theses/39
This thesis examines the effectiveness of Financial Advisors’ subjective categorised risk tolerance assessment methods. Research in this field is scarce and unequivocal, with little guidance on best practice for professionals in the industry. This research provides empirical evidence on an increasingly important issue, given recent regulatory changes in Australia and abroad. Data used in this thesis is drawn from two sections of a psychometrically validated risk tolerance assessment tool. Prior studies examining issues regarding financial risk tolerance use relatively small samples, students, hypothetical investors or respondents of large-scale surveys that cover several financial and lifestyle aspects of individuals. The data set used in this thesis is advantageous as it overcomes these undesirable characteristics, with the majority of respondents being real investors seeking financial advice. The first issue examined is the effectiveness of Financial Advisors’ use of subjective risk tolerance categorisation (heuristic) methods in statistically differentiating categories of risk tolerance. Heuristics are rules of thumb or short cuts used when making complex decisions. The existing literature examining the directional relationships of demographic characteristics to predict an investor’s risk tolerance provides the basis for selecting Financial Advisors’ heuristics. Results, while similar to previous studies, indicate investors can be classified into four and five categories of risk tolerance, as opposed to three in previous research. This finding illustrates that Financial Advisors’ heuristics are approximations that are not statistically effective as the level of categorisation increases. The second issue examined compares Financial Advisors’ subjective (heuristic) categorised risk tolerances to an investor’s actual categorised risk tolerances. Limited prior research demonstrates substantial variation in Financial Advisor’s interpretation of hypothetical investor statements. Thus, if Financial Advisors’ heuristics are effective in categorising an investor’s risk tolerance, no difference between an investor’s responses to direct questions and Financial Advisors’ categorised heuristic risk tolerances should exist. To determine if there are differences, various forms of categorisation are used for comparison. Using two sections of a psychometrically validated risk tolerance assessment instrument, Financial Advisors’ categorised heuristic risk tolerances are constructed and compared to investors’ actual responses to direct questions. A statistically significant difference is found between Financial Advisors’ subjective (heuristic) categorised risk tolerances and investors’ actual categorised risk tolerances, consistent under the various forms of categorisation. The third issue examined is the likelihood of an investor having the same categorised subjective risk tolerance as their response to direct risk tolerance questions. Investors’ responses are compared to two measures of subjective categorised risk tolerances using multivariate analysis established in the literature. The two measures are (i) Financial Advisors’ subjective categorised risk tolerance (as established in chapter four) and, (ii) investors’ self-assessed categorised risk tolerances (as established in chapter three). Results suggest that the type of direct question is an influencing factor in the misclassification of investors’ risk tolerance categorisation. Quantitative direct-type questions result in investors being more risk-tolerant when facing choices that are quantitative, as opposed to qualitative, in nature. Also, as the level of categorisation increases, the effectiveness of Financial Advisors’ subjective risk tolerance assessments is reduced. This thesis empirically illustrates three important results regarding the effectiveness of Financial Advisors’ subjective categorised risk tolerance assessment methods. First, Financial Advisors’ heuristics are not effective as the level of risk tolerance categorisation increases. Second, in comparison to direct objective measures, there is a significant difference between Financial Advisors’ subjective categorised risk tolerances and investors’ responses to direct questions. Third, using different direct question types, Financial Advisors’ subjective methods become ineffective as the level of categorisation increases. Results of this thesis provide Financial Advisors, investors and regulators with an understanding of the complex nature of risk tolerance categorisation. Further, these findings support a move towards formal risk tolerance categorisation procedures that are effective under several levels of categorisation.
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