1 . Sherman D. Hanna, Professor, Consumer and Textile Sciences Department, The Ohio State University, 1787 Neil Ave., Columbus, OH 43210-1295. Phone: 614-292-4584. Fax: 603-457-6577. E- m a i l : h a n n a . 1 @ o s u . e d u 2 . Michael S. Gutter, Assistant Professor, Department of Consumer Science, University of Wisconsin-Madison, 1300 Linden Drive Room 370F Phone: 608-262-5498 Fax: 608-265-6048. Email: msgutter@facstaff.wisc.edu 3 . Jessie X. Fan, Associate Professor, Department of Family and Consumer Studies, University of Utah, 225 South 1400 East, Room 228 AEB, Salt Lake City, UT 84112-0080. Phone: 801-581-4170. Fax: 801-581-5156. E-mail: fan@fcs.utah.edu ©20 01, A ssociation for Fina ncial C ounselin g and P lanning Educ ation. All rights of reproduction in any form reserved. 53 A Measure Of Risk Tolerance Based On Economic Theory Sherman D. Hanna 1 , Michael S. Gutter 2 and Jessie X. Fan 3 Self-reported risk tolerance is a measurement of an individual's willingness to accept risk, making it a valuable tool for financial planners and researchers alike. Prior subjective risk tolerance measures have lacked a rigorous connection to economic theory. This study presents an improved measurement of subjective risk tolerance based on economic theory and discusses its link to relative risk aversion. Results from a web-based survey are presented and compared with results from previous studies using other risk tolerance measurements. The new measure allows for a wider possible range of risk tolerance to be obtained, with important implications for short-term investing. Key words: Risk tolerance, Risk aversion, Economic model Malkiel (1996, p. 401) suggested that the risk an investor should be willing to take or tolerate is related to the househ old sit uati on, l ifecycle st age, a nd su bjective factors. Risk tolerance is commonly used by financial planners, and is discussed in financial planning textbooks. For instance, Mittra (1995, p. 396) discussed the idea that risk tolerance measurement is usually not precise. Most tests use a subjective measure of both emotional and financial ability of an investor to withstand losses. Mittra mentioned different factors related to risk toleran ce includin g net worth , income, knowledge, sophistication, and proximity to retirement. Mittra suggested tests should determine emotional responses to varying situations about money and decisions one might make in a given financial circumsta nce. The level of risk tolerance is a crucial part of individual choices about wealth accumulation, retirement, human capital investmen t, portfolio al location, a nd ins uran ce, as well as to policy decisions that are dependent on this behavior. For instance, Bajtelsmit and Bernasek (1996) discussed the differences between men and women in investing and risk tolerance. The increasing reliance on individual investment choices for retirement funds makes it clear that some groups in society may be at risk for inadequate retirement income if they are very averse to risk. However , ri sk tole ran ce meas ures u sed by financial planners are not based on rigorous economic concepts. The purpose of this paper is to present a measure of risk tolerance based on economic theory, and to describe some preliminary patterns of risk tolerance based on the measure. The results suggest that there is a wide variation of risk tolerance in people, but no systematic patterns related to gender or age have been found. Literature Review There are at least four methods of measuring risk tolerance: asking about investment choices, asking a combination of investment and subjective questions, assessing actual behavior, and asking hypothetical questions with carefully specified scenarios. Investment Choice Measures A good example of the fir st method is the Federal Reserve Board’s Surveys of Consumer Finances (SCF). The SCF have since 1983 asked a risk tolerance question related to how much risk a respondent is willing to take for investments. Researchers using the SCF risk toler ance d ata fou nd th at on ly a min orit y of respondents are willing to take above average risks to make an above average return on investments. Sung and Hanna (1996) analyzed a subset of the 1992 SCF households, with employed respondents aged 16-70. Only 4% of the sample were willing to take substantial risks on investments in order to make a substantial return, and 40% were not willing to take any financial risks. Risk tolerance increased with education and incom e, and female headed h ouseholds had lower risk tolerance than otherwise similar married couple and male headed h ouseholds. Household s meeting t hree