A critical review of literature on the determinants

Abstract

Risk tolerance is useful in summarizing an investor's perception about the trade off between risk and compensation required for bearing risk. It determines the appropriate composition of assets in a portfolio, which is optimal in terms of risk and returns relative to the needs of an individual. Risk tolerance refers to the degree to which an investor is willing and able to accept the possibility of an uncertain outcome to an economic decision. There is little evidence that fund managers and investment advisors adequately assess and take into account the factors that influence the degree of willingness of individual investors to accept risk when constructing their portfolios. This study therefore focuses on the determinants of investor risk tolerance. This study reviews literature on the factors which influence risk tolerance in order to establish the extent to which these factors contribute to the investor's willingness and ability to accept uncertain outcomes. The literature reviewed includes pertinent general and theoretical development to establish the fundamental and philosophical principles on which the concept of risk tolerance is built. The general literature reviewed includes knowledge development on the concept, risk tolerance determinants and theories on risk tolerance. Empirical studies that have investigated the determination of investor risk tolerance have been reviewed to establish possible knowledge and research gaps. The studies in question relate to the three broad categories under which such determinants are classified in the literature namely; biopsychological, financial and sociocultural factors. There are five key findings that emerge from the study. These include three pertaining to general aspects and two on knowledge gaps. With regard to general aspects the study Firstly establishes that an individual's age and gender contribute to risk tolerance levels. Young investors are more risk tolerant compared to older investors, most of whom exhibit dwindling health and shorter investment horizon. Secondly, risk tolerance of wealthy people is relatively lower than that of low income individuals because they are likely to lose more from a risky investment. Thirdly, investor risk tolerance increases with their level of education, whereby the higher the educations level the higher the risk tolerance. The fourth finding establishes that no studies have been undertaken to determine whether there is a relationship between an investor risk tolerance and their financial training and practice. Finally, the correlation between an investor's marital status in terms of whether they are single, widowed or divorced and their inclination to take risk has not been investigated