THREE ESSAYS ON RISK TOLERANCE AND LOSS AVERSION UNDER COGNITIVE LOAD
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The first essay reviews the literature on risk tolerance assessment and how risk tolerance questions are justified based on validity and reliability or psychometric testing. However many questions that are used are not grounded in theory and there has been little research examining the relation between questions and actual investor portfolio behavior. This study examines risk tolerance questions based on economic theory, prospect theory and self-assessment to determine the extent to which they account for variation in portfolio allocation preference and recent investment changes. I conclude that risk tolerance questions based on loss aversion and self-assessment should be used when determining the portfolio allocation of clients. While questions based on economic theory should theoretically be the best measure of a client’s preference for risky assets, the results of this study indicate that these questions are not very useful when both loss aversion and self-assessment questions are included in a risk tolerance questionnaire. Simple changes such as waiting until the end of meetings to discuss returns and de-emphasizing quarterly returns are other ways which may help keep clients in portfolios that are in alignment with their preferences. The second essay provides an analysis on whether monetary loss aversion is altered when individuals are placed under a higher level of cognitive load. Recent research provides evidence that loss aversion can be altered by mating motives, self-protection motives and even thinking like a stock trader. A recent study finds that small-stakes risk aversion increases under cognitive load when participants choose between two uncertain monetary choices within a gain domain. This study analyzes whether loss aversion is altered when individuals are placed under a higher level of cognitive load under gain, loss and mixed domains. If it is, it could have consequences for financial decisions related to equity participation and asset allocation. I measure the coefficients of monetary loss aversion for 30 participants under low and high cognitive load. Forward digit span is used to manipulate cognitive load. Participants’ skin conductance is measured to quantify emotional responses to gains and losses. I do not find statistically significant evidence that loss aversion is altered when individuals are placed under a higher level of cognitive load. Results are consistent when analyzing whether a higher level of cognitive load alters an individual’s physiological response to absolute and relative gains and losses. This study also finds no statistically significant evidence that risk aversion, as measured by an individual’s willingness to accept uncertain monetary choices, is altered under a higher level of cognitive load. Implications for financial planners are discussed. There is strong evidence that habit formation, loss aversion, investor sentiment, or some combination of these factors drives time-varying risk aversion and accounts for most of the variation in the equity premium. The third and final essay describes the research that supports time-varying risk aversion and explores the extent to which external habit formation, loss aversion and sentiment account for variation in monthly risk tolerance scores during the Global Financial Crisis (January 2007 - December 2010). External habit-based preferences are modeled separately using lagged relative consumption and wealth. In the third model a loss aversion proxy is created using a prospect theory utility function. Prior monthly gains or losses affect the weighting to account for the house money effect. The forth model contains a sentiment index that includes the monthly change in the closed-end fund discount, detrended log turnover, the number of IPOs, the first day return on IPOs, the dividend premium and the equity share in new issues as factors. I find that the external habit, sentiment and loss aversion proxies account for 38.85%, 51.92% and 60.63% of the variation in risk tolerance, respectively. External habit formation does not account for additional variation in risk tolerance when controlling for loss aversion and investor sentiment. Implications for risk tolerance assessment and the financial services industry are discussed.