What determines risk tolerance?

Abstract

It is important for financial planners to understand what drives risk tolerance as it directly influences the portfolio allocation preference of clients. We hypothesize that habit formation, loss aversion and investor sentiment account for significant variation in risk tolerance. We analyze average monthly scores from a widely used risk tolerance questionnaire. We find that the habit formation, loss aversion, and sentiment proxies account for -1.06%, 38.51%, and 13.21% of the variation in average monthly risk tolerance, respectively. Habit formation did not account for additional variation in average monthly risk tolerance when controlling for loss aversion and sentiment.