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Pages 17-29
Pages 17-29
Averse Preferences
Michael A. Guillemette1, Rui Yao2, Russell N. James III3
A variety of risk assessment questionnaires are used within the financial planning profession to assess client risk
preferences. Evidence indicates that the average person overweighs losses relative to an arbitrary reference point. This
paper evaluated risk assessment questions on how well they correlate with monetary loss aversion. Twenty-nine Western
Texas residents between the ages of 27 and 56 participated in experimental research and filled out several risk assessment
questionnaires. Two weeks later their levels of loss aversion were measured using monetary gain and loss scenarios. The
individual risk assessment questions were placed into three categories: expected utility theory, prospect theory and self-
assessment. Composite measures were created for within-group and between-group comparisons. Statistically significant
correlations were found between monetary loss aversion and different composite measures. The results provide financial
planners with a group of risk assessment questions that capture loss-averse preferences.
Keywords: loss aversion, portfolio allocation, questionnaire, risk tolerance, skin conductance response
Journal of Financial Counseling and Planning Volume 26, Issue 1 2015, 17-29.
2015 Association for Financial Counseling and Planning Education. All rights of reproduction in any form reserved 17
risk tolerance will not account for the utility derived from Lindamood, 2004). However, none of these risk assessment
losses being different than gains. Therefore, an assessment surveys focus on measuring the risk preferences of loss averse
of both risk tolerance and loss aversion are needed when the individuals.
behavioral bias of loss aversion is present.
Loss Aversion: Definition and Measurements
Several studies have provided evidence emphasizing the Prospect theory modified the EUT concept of risk tolerance
importance of measuring loss aversion when assessing clients by overweighing the disutility experienced from losses below
risk preferences. Loss aversion explained more variation in an arbitrary reference point. Tversky and Kahneman (1992)
monthly risk preference scores during the 2008-2009 global estimated that the marginally decreasing aspect of the value
financial crisis compared to risk aversion or investor sentiment function is 0.88. People overweigh losses approximately 2.25
(Guillemette & Nanigian, 2014). Risk assessment questions times more than gains based on experimental findings, which
that measured loss aversion, as compared to risk aversion, means they are loss averse (Tversky & Kahneman, 1992).
explained more variation in individuals portfolio allocation Their value function over gains and losses is shown below:
scores and their recent investment changes (Guillemette,
Finke and Gilliam, 2012). The behavioral bias of loss aversion
can be better attenuated if it is accurately measured. This Prospect theory describes a clients value function as concave
study provides a unique contribution to the literature by in the gain domain and convex in the loss domain. This is
analyzing which types of risk preference questions capture referred to as the reflection effect and means that the average
individuals monetary loss-averse preferences. This research client is risk averse within the gain domain and risk seeking
question is important as risk assessment questions in the within the loss domain (Kahneman & Tversky, 1979).
prior literature either measure risk aversion (Hanna, Gutter
& Fan, 2001; Hanna & Lindamood, 2004) or do not solely Loss aversion has been defined and measured in various ways
measure loss aversion (Grable & Lytton, 2003; Roszkowski & in the prior literature. Loss aversion was originally defined
Grable, 2005). This exploratory analysis will provide insight by -U(-x) > U(x) for all x > 0 (Kahneman & Tversky, 1979),
into the strength and statistical significance of correlations which implies that loss aversion should be defined as the
between monetary loss aversion and different types of risk mean (or median) of -U(-x)/U(x) over the relevant values
assessment questions. This study should help the financial of x (Abdellaoui, Bleichrodt & Paraschiv, 2007). Tversky
planning profession move towards a more uniform standard of and Kahneman (1992) implicitly defined loss aversion as
measuring client risk preferences. -U(-$1)/U($1). Benartzi and Thaler (1995) stated that loss
aversion can be estimated by taking the slope of the value
Literature Review function in the loss domain and dividing it by the slope of the
Risk Assessment Questionnaires value function in the gain domain. Loss aversion has also been
A variety of questions are included in risk assessment surveys measured by estimating, and then comparing the likelihood of
to determine the risk preferences of clients (Chaulk, Johnson accepting comparable uncertain gambles under both the gain
& Bulcroft, 2003; Hartog, Ferrer-I-Carbonell & Jonker, and loss domains (Sokol-Hessner et al., 2009).
2002; Kimball, Sahm & Shapiro, 2008; Schubert, Brown,
Gysler & Brachinger, 1999). The prior literature has focused Estimating loss aversion by comparing choices to uncertain
on psychometric testing and the validity and reliability of gains and losses is one way that aversion to losses can be
questions when evaluating the quality of risk assessment measured. Loss aversion can also be measured by comparing
surveys (Callan & Johnson, 2002; Grable & Lytton, 2003; physiological arousal to gains and losses. Measuring
Roszkowski & Grable, 2005). Psychometric testing of risk physiological response to monetary gains and losses increases
assessment questionnaires usually involves an analysis of the the validity of a loss aversion measurement if participants
consistency of correlations among questions in the survey. respond physiologically to losses more than gains. Skin
Questions that measure a clients self-assessment of their conductance response (SCR), which is also referred to as
own risk preferences may be useful when developing a risk electrodermal or galvanic skin response, has been used to
assessment questionnaire (Roszkowski & Grable, 2005). estimate physiological arousal to gains and losses (Shiv,
Several risk assessment questionnaires already measure Loewenstein, Bechara, Damasio, & Damasio, 2005; Sokol-
the EUT concept of risk tolerance (Barsky, Juster, Kimball, Hessner et al., 2009). SCR is measured in units called
& Shapiro, 1997; Hanna, Gutter & Fan, 2001; Hanna & microsiemens (S). Latency is the time between the onset
SCRs were measured to make sure participants were AR = accept or reject uncertain monetary choice; gain = gain
responding emotionally to the monetary losses more than of the uncertain monetary choice; loss = loss of the uncertain
gains. Participants wore a Q Sensor 2.0 wrist band, developed monetary choice; certainty = certain monetary choice; PMO
by Affectiva, an emotional measurement technology company. = previous monetary outcome; HCL = high cognitive load
The sensor captured SCR response every 125 milliseconds.
Participants wore the sensor on their left wrist and were asked Equation 1 displays the model used to derive the coefficient
to type on the computer keyboard using their right hand. of loss aversion () for each participant. Equation 1 was
SCR could not be measured for one participant who was then used with data collected from the 312 questions for each
Slide 1
29
Slide 2
Using the keyboard, select which option you prefer.
$15
$0
-$10
A = certain B = 50/50
Slide 3
-$10
Slide 4
Type the last number sequence you were asked to remember in the order it was displayed.
for the EUT, prospect theory and self-assessment categories question. For the EUT category, the questions with the highest
were 0.61, 0.56 and 0.73, respectively. Every possible question Kendalls b correlation coefficients with the loss aversion
combination was summed within each of the three categories. rank included choosing between job security and a pay raise,
The within-group composite measures with the highest and a sure gain and an uncertain gain. The prospect theory
Kendalls b correlation coefficients were then selected from questions focused on choosing an acceptable loss level for an
each category. Finally, all 15 questions were pooled in order investment, asking what comes to mind first when someone
to determine the between-group composite measure with the thinks of the word risk, and the likelihood of selling a
highest Kendalls b correlation coefficient. The Cronbachs dividend-paying stock that is down 30% this year. The self-
alpha for the between-group composite measure was 0.53. assessment questions asked about current insurance coverage,
how your best friend would describe you as a risk taker and
Results recent investment changes.
The first quartile, median and third quartile for are -0.7989,
-1.1461 and -1.5535, respectively. Ten participants were risk The Kendalls b correlation coefficients for the within-group
seeking, three were gain-loss neutral and sixteen were loss composite measures are 0.3564, 0.3211 and 0.3693 for the
averse. Sokol-Hessner et al. (2009) reported similar results expected utility theory, prospect theory and self-assessment
when measuring loss-averse preferences. Physiological measures, respectively. There is a marginal benefit for every
response to gains and losses are reported in Table 1. The composite measure over using any single question within each
coefficient for the ALRL variable is approximately two category. All of the within-group composite measures are
times greater than the coefficient for the AGRG variable. statistically significant at p < 0.05.
Physiologically, SCR AMP is twice as strong for losses
compared to gains. This is consistent with the finding that the Table 3 displays the summation of between-group questions
dissatisfaction experienced from losses is approximately two that resulted in the highest correlation with loss aversion
times greater than the satisfaction derived from comparable rank (b = 0.4793; p < .01). The five-question between-group
gains. The AGRL variable is not statistically significant, composite measure provides a 29.79% marginal benefit from
which suggests that when participants experienced an absolute the self-assessment within-group composite measure.
gain, but a relative loss, they were conflicted and did not
consistently register a SCR. Conclusions
The purpose of this research was to identify risk assessment
The questions that were selected for each of the three within- questions that capture loss-averse preferences. Participants
group composite measures are displayed in Table 2. Kendalls answered risk assessment questions from different surveys.
b correlation coefficients are reported for each individual The questions were separated into three categories:
Journal of Financial Counseling and Planning Volume 26, Issue 1 2015 25
Table 3. Composition of Between-Group Composite Meaure
Description of Questions Kendalls b
FinaMetrica - Question 5 0.3495*
This question asks clients their preference for job security versus a pay raise.
The five choices range from definitely more job security with a small pay raise to
definitely less job security with a big pay raise.
FinaMetrica Question 24 0.3039*
This question asks clients how much insurance coverage they have in the follow-
ing domains: theft, fire, accident, illness and death. The four choices range from
very little to complete coverage.
FinaMetrica Question 19 0.204
This question asks clients how their personal investments have changed in recent
years. The five responses range from always toward lower risk to always toward
higher risk.
Grable and Lytton (2003) Question 6 0.200
When you think of the word risk which of the following words comes to mind
first?
a. Loss
b. Uncertainty
c. Opportunity
d. Thrill
Miscellaneous Question 2 0.134
Suppose you have owned a stock for several years that has a long-run expected
annual return of 8%, but 4% was from appreciation, and you had received a
check every quarter that made up the other 4%. If the market, and your stock, was
down 30% this year but the quarterly dividend checks were continuing as before,
how likely would you be to sell it?
a. I would definitely sell the stock
b. I would probably sell the stock
c. I would probably not sell the stock
d. I would definitely not sell the stock
* p < .05; ** p < .01
expected utility theory, prospect theory and self-assessment. question from all three of the categories was included in the
Participants levels of loss aversion were measured using final composite measure that had the highest correlation with
small-dollar gains and losses. On average, participants loss aversion. While self-assessment questions may provide
physiologically responded to losses more than comparable a benefit over solely using expected utility or prospect theory
gains. Kendall Tau correlations were analyzed between questions, all three categories of questions are useful when
individuals levels of loss aversion and their responses to the assessing client risk preferences.
risk assessment questions. The composite risk assessment
measures with the highest correlation with loss aversion were Implications for Financial Planners
captured to help improve risk assessment instruments. Financial planners should help clients overcome the behavioral
bias of loss aversion and make rational investment decisions.
The results of this study should help the financial planning However, subjective risk assessment typically occurs during
profession move towards a uniform standard of client the early stages of the planner-client relationship before a
risk assessment. There was a 15% marginal benefit when financial planner has had time to attenuate their clients loss-
moving from the prospect theory composite measure to the averse tendencies. This study provides financial planners with
self-assessment composite measure. However, at least one risk assessment questions that can help measure loss aversion