Relationship between risk tolerance and socioeconomic characteristics of individual investors Grace Piggott

JuniorUniversity of Wisconsin Stout

Advisor Dr. Fassil Fanta

IntroductionRisk tolerance is defined as the degree of variability in investment returns that an individual is willing to withstand.

High risk tolerance: Investors are more aggressive in their investments. They are happy with higher risk levels in exchange for possibly making higher returns. They are also willing to take higher losses believing they will make more in the long run.

Low risk tolerance: Investors are less aggressive in their investments. They tend to feel more comfortable knowing their low risk investments could equate to lower returns.

Most people are not willing to take above average risks to obtain above average returns on their investments (Avery & Elliehausen, 1986).

Why does this matter?Knowing what socioeconomic characteristics affect one’s risk tolerance would allow for financial advisors and others to understand why some people are more or less cautious about investments than others. Having this information will likely allow financial advisors to give more accurate investment advice based off an investors characteristics.

What socioeconomic characteristics determine the risk tolerance of individual investors?

Hypothesis: Individual investors risk tolerance is influenced by socioeconomic characteristics such as income, education, and family structure.

Benefits to knowing what characteristics impact risk tolerance:1. Allows for financial advisors and economists to gain a better prospective on the

matter.2. Allows financial advisors to give more accurate investing advice.3. Gives individuals a better understanding of how their socioeconomic characteristics

may impact their investment options.

Literature review» In the Federal reserve bulletin Bricker et al. (2012) stated, “Family’s finances are affected

by both their own decisions and the state of the broader economy.”

» Sulaiman (2012) stated, “An investors ability to handle risk may be related to demographic features such as age, gender, marital status, occupation, income, time horizon, liquidity needs, portfolio size, investment knowledge, and attitude towards price fluctuations”.

» Grable and Lytton (1998) however felt that assuming someone’s age impacts their risk tolerance could create potential problems.

» Both Sudaiman (2012) and Grable and Lytton (1998) said that it is commonly believed men will take more risks than woman. Women tend to live longer, tend to have lower lifetime earning potential, and are more likely to be single parents than men so Grable and Lytton (1998) felt that woman had a larger need to increase their risk in order to assure they could meet their financial needs.

» Finke and Huston (2003) felt that those with higher education tend to have a higher risk tolerance because they commonly have more financial knowledge.

Data and methodology» The data I used for this research was collected

from consumer finance surveys between 1992 and 1998. The dollar amounts were all converted to thousands 2010 dollars.

» I also reviewed data from the Federal Reserve Bulletin titled Changes in US family finances from 2007 to 2010: Evidence from the consumer finance published in June of 2012.

Variables Definitions

Percentile income Percent of others earning less than you.

Age Years since date of birth.

Family structure Relationship status, children or no children.

Education Amount of schooling completed

Race Categorizing by similar biological traits.

Percentile income» The Percent of others earning less than you.

Mean % of families Mean % of families Mean % of familiesIncome that saved income that saved income that saved

Percentile of incomeLess than 20 9.9 30.2 9.4 31.4 10.5 32.120 - 39.9 24.1 50.0 24.9 43.3 26.9 44.940 - 59.9 41.2 58.4 42.7 57.1 45.3 56.160 - 79.9 65.6 70.2 65.6 67.1 72.4 68.680 - 80.9 97.4 71.0 98.6 70.2 106.1 73.490 - 100 228.1 82.0 248.9 83.8 291.6 82.0

Year 1998Year 1995Year 1992

Year 2007Transaction acct. CD Savings bonds Bonds Stocks Pooled inv. Funds Retirement Cash value life insur.

Percentile incomeLess than 20 74.9 9.4 3.6 5.5 3.4 10.8 12.820-39.9 90.1 12.7 8.4 7.8 4.6 35.8 16.440-59.9 96.3 15.5 15.2 14 7.1 55.6 21.660-79.9 99.3 19.3 20.9 1.4 23.2 14.6 74.3 29.480-89.9 100 19.9 26.2 1.8 30.5 18.9 86.9 30.690-100 100 27.7 26.1 8.9 47.5 35.5 89.6 38.9

Transaction acct. CD Savings bonds Bonds Stocks Pooled inv. Funds Retirement Cash value life insur.Percentile incomeLess than 20 76.2 5.7 3.6 0.1 3.8 2.1 11.2 10.720-39.9 91.1 11.1 6 6 3.5 30.5 17.240-59.9 96.4 11.7 10.8 11.7 5.8 52.8 19.560-79.9 98.9 15.8 16 1.3 17.3 8.8 69.7 22.880-89.9 99.8 12.1 23 2 25.7 14.6 85.7 25.890-100 99.9 21.5 24.4 8.3 47.8 32.1 90.1 30.9

Year 2010

Age» Years since date of birth.

Mean % of families Mean % of families Mean % of familiesincome that saved income that saved income that saved

AgeLess than 35 46.0 59.1 44.2 56.4 48.2 53.035–44 70.7 56.9 69.1 54.3 80.0 57.345–54 86.0 58.9 93.8 58.0 92.8 57.855–64 75.3 59.3 76.5 58.0 95.3 60.965–74 44.0 54.1 53.1 50.0 62.0 56.375 or more 35.4 49.4 37.5 51.7 38.7 48.6

Year 1992 Year 1995 Year 1998

Transaction acct. CD Savings bonds Bonds Stocks Pooled inv. Funds Retirement Cash value life insur.Ageless than 35 87.3 6.7 13.7 13.7 5.3 42.1 11.435-44 91.2 9 16.8 0.7 17 11.6 57.8 17.545-54 91.7 14.3 19 1.1 18.6 12.6 65.4 22.355-64 96.4 20.5 16.2 2.1 21.3 14.3 61.2 35.265-74 94.6 24.3 10.3 4.2 19.1 14.6 52.7 34.475 and more 95.3 37 7.9 3.5 20.2 13.2 30 27.6

Year 2007

Transaction acct. CD Savings bonds Bonds Stocks Pooled inv. Funds Retirement Cash value life insur.Ageless than 35 89 5.7 10 10.1 3.6 41.1 9.635-44 90.6 5.7 11.6 0.4 12.1 7.7 52.2 12.345-54 92.5 10 15 1.4 16 9.6 60 19.855-64 94.3 14.6 14.3 2.4 19.5 11.3 59.8 25.765-74 95.8 20.6 9.1 3.4 16.1 11.1 49 28.475 and more 96.4 27.2 10.1 3.6 20.1 11.9 32.8 32.4

Year 2010

Family structure» The relationship status and age of someone and

whether or not they have children.

Mean % of families Mean % of families Mean % of familiesincome that saved income that saved income that saved

Family structureSingle with child(ren) 31.9 45.1 29.8 36.9 33.7 39.0Single, no child, age less than 55 40.4 52.3 37.7 51.1 41.1 52.0Single, no child, age 55 or more 28.7 46.8 31.5 44.4 34.9 48.0Couple with child(ren) 84.9 62.1 85.8 60.1 96.4 59.1Couple, no child 74.5 65.2 82.9 65.6 92.6 65.9

Year 1992 Year 1995 Year 1998

Transaction acct. CD Savings bonds Bonds Stocks Pooled inv. Funds Retirement Cash value life insur.Family structuresingle w/ child 81.1 9 10.9 7.1 6.8 35 21.4single no child less than 55 87.4 9.9 9.4 18 8.9 46.7 10.2single no child older than 55 94.6 24 9.6 2.1 13.5 10.8 36.7 22couple w/ child 94.3 12.5 24 1.2 18.9 12 62.1 23.6couple without child 95.7 22.5 11.6 2.9 24.1 14.4 62.6 30.2

Year 2007

Transaction acct. CD Savings bonds Bonds Stocks Pooled inv. Funds Retirement Cash value life insur.Family structuresingle w/ child 84.9 6.7 6.3 6.9 3 34 11.1single no child less than 55 88.3 6 6.3 10.7 5 40.2 9.8single no child older than 55 92.8 20.1 8 2.5 11.9 9.5 33.7 23.5couple w/ child 94.3 10.4 18.9 1.2 17 9.1 60.1 18.9couple without child 95.9 15.8 12.4 2.9 20.9 12.4 61.6 27.9

Year 2010

Education» The amount of schooling completed

Mean % of families Mean % of families Mean % of familiesincome that saved Income that saved income that saved

EducationNo high school diploma 26.4 38.1 29.6 42.8 29.0 39.5High school diploma 45.6 56.8 49.6 50.6 49.4 53.7Some college 56.2 59.5 57.5 54.1 67.7 56.6College degree 99.4 68.1 101.2 68.2 113.8 65.6

Year 1992 Year 1995 Year 1998

Transaction acct. CD Savings bonds Bonds Stocks Pooled inv. Funds Retirement Cash value life insur.EducationNo high school diploma 75.7 9.5 3.4 3.9 2.2 21.6 12.6High school diploma 90.9 14.1 11.5 0.6 9.3 5.8 43.3 22.6Some college 93.9 14.1 16.4 1.2 17.4 8.9 53 23.4College degree 98.7 21.6 21.6 3.3 31.5 21.4 73.9 27.2

Year 2007

Transaction acct. CD Savings bonds Bonds Stocks Pooled inv. Funds Retirement Cash value life insur.EducationNo high school diploma 77.4 6 2.7 2.2 17.1 11.9High school diploma 90 10.8 9.1 0.2 8.1 3.2 40.6 19.8Some college 94.6 11.8 11.7 1 11.3 5.4 48.6 17.3College degree 98.4 15.8 11.7 3.6 27.2 17.6 70.5 23.3

Year 2010

Race or ethnicity» Categorizing based on biological traits or culture.

Mean % of families Mean % of families Mean % of familiesincome that saved income that saved income that saved

Race or ethnicityWhite non-Hispanic 67.1 61.0 69.6 59.1 78.8 60.0Nonwhite or Hispanic 41.3 44.9 41.4 41.7 44.3 42.3

Year 1992 Year 1995 Year 1998

Year 2007

Transaction acct. CD Savings bonds Bonds Stocks Pooled inv. Funds Retirement Cash value life insur.Race/ethnicityWhite 96.5 15 14.8 2.3 18.6 11.6 58.1 22.6non white or hispanic 84.3 6.5 6.3 0.2 7.9 2.6 34.4 13.7

Year 2010

Transaction acct. CD Savings bonds Bonds Stocks Pooled inv. Funds Retirement Cash value life insur.Race/ethnicityWhite 95.5 19.4 17.8 2.1 21.4 13.7 58.5 25.3non white or hispanic 83.9 8.2 7.8 9.4 9.4 5.8 39.5 17.6

Conclusion» Based off the data I have noticed some trends…

It appears that percentile income and risk tolerance are positively related. The higher a persons percentile income the higher their average income was, the higher the percentage of families who saved was, and the more percent of assets they held.

As for age I did not feel there was strong enough evidence to make any reliable conclusions.

When examining family structure it appears couples have higher risk tolerance than those who are single, specifically couples without children.

Conclusion» It also seems that education and risk tolerance are positively

related to one another. The more education someone had the larger their average income was, the higher the percent of families who saved was, and the more percent of assets they held was.

» As for race it appears that whites have higher risk tolerance than non whites. Whites had higher average incomes, higher percentages of families that saved, and higher percentages of assets held. However I feel that data could have been represented in a better way that would give more reliable results. I did notice also that between 1992 and 1995, Whites average income increased by 3.6% while non whites income only increased by 0.2%. I also noticed that between 1992 and 1995, whites percent of savings only fell by 3% while non whites fell by 7.1%.