Fuzzy-Trace Theory & Financial Risk Tolerance

Meghaan Lurtz, Michael Kothakota, CFP®, & Dr. S. Heckman, PhD/CFP®

2018

Today’s Plan

• Why & Literature Review

• Theoretical & Study Goals

• Method & Analysis

• Results & Discussion – Part 1

• Next Steps – Part 2

• Questions

Why Financial Risk Tolerance?

It is challenging and confusing to measure, especially in financial planning.

• Purpose

– What are you trying to do with the risk information?

• Processing

– What is your client going to do or use to understand what you are telling them?

• Measurement

– What measure will you use?

Purpose?

Risk

• Risk Preference (Tolerance/Aversion)

• Risk Perception

• Risk Capacity

• Risk Composure

• Risk Literacy

• Risk Profile

Considerations

• Practitioners may only be interested in the amount of risk in portfolio, not preference.

• Economists and psychologists discuss risk preference, but in very different ways.

• Planners and researchers may care about different aspects of risk.

Processing?

• Economists: Expected Utility Theory– Consequential model, anticipated emotions

• Psychologists: Hazard Theory– Emotions leading up to decision, hopes and fears

– Care about perception of risk, probabilities

• Judgment & Decision-Making: Behavioral Economists + Psych– Risk Literacy

– Fuzzy-Trace-Theory

Measurement?

• Financial Planning: Risk Preference Tools• Grable & Lytton Investment Risk Tolerance

Questionnaire

• Income Gamble Questions– RiskAlyze: Based on Prospect Theory

• Simple Risk Questionnaires

A New Theory…• Background knowledge

– Financial Knowledge

– Risk Literacy

• Dual mental representation (verbatim & gist)

– Income Gamble

– Simple financial risk scale

• Retrieval of values

– Risk compared to friends and family

• Application of values in context

– Feelings about market risk

Fuzzy-Trace TheoryReyna (2008)

Being used primarily in medical decision-making

Direct link to implication and intervention development

Fuzzy Trace Theory Processing

Reyna, 2008

Method & Analysis

• Qualtrics Survey – N = 490

– Not using a financial planner

• Risk-inconsistency– How consistently do people report their risk across

two common measures?• Subtracted one risk score from the other – larger differences

represented larger/greater inconsistency

• Multinomial Logit– Risk inconsistency = f (knowledge, processing, values)

Study Goals/Hypotheses

• Do people answer inconsistently when looking at different risk measures?– Theory says, yes they will

• If so, what may be contributing to risk inconsistency?– Theory says: values and knowledge

• Risk literacy and financial literacy will both contribute to consistency

• Values will have their own unique contribution to consistency.

Measures: Dual Processing

Verbatim

• Income Gamble Questions

• Barsky, Juster, Kimball & Shapiro (1997)

• Based on Expected Utility Theory

Gist

• Simple Categorial Risk

• NLSY & SCF

• How much risk do you take when you…

We were interested in the difference between these two measures

Measures: Background Knowledge

Financial Knowledge

Big-5

• Lusardi & Mitchell (2007)

– Stocks vs. mutual funds

– Interest rates

– Interest over the life of the loan

– Inflation

– Interest and bonds relationship

• We also asked if people knew what the risk-free rate corresponded to; Treasury Bill

Risk Literacy

Berlin Numeracy Test

• Cokely, Galesic, Schulz, Ghazal, Garcia-Retamero (2012)

– Seven questions

– Tests whether people can correctly understand probabilistic trade-offs

Measures: Values

Reference Group

• How do you see your willingness to take risks compared to [peers, family]?– Much higher

– Moderately higher

– Slightly higher

– About the same

– Slightly lower

– Moderately lower

– Much lower

Context

• What is the future outlook of the economy?– Extremely good

– Somewhat good

– Neither good nor bad

– Somewhat bad

– Extremely bad

Result Highlights

• 65% of the sample gave an inconsistent answer– 33% were somewhat inconsistent– 17% were inconsistent– 15% were highly inconsistent

• Income Gamble Questions are not correlated with simple, categorial investment risk questions

• Numeracy was a significant predictor across all comparisons, but the direction it played was inconsistent

• Financial knowledge was not a significant predictor• Reference group only significant in a few places, and

changed direction

Discussion

• “People can get all the facts right, and still not derive proper meaning, which is key to informed decision-making” (Reyna, 2008, p. 850).

• We are not quite sure what to make of all of the sign changes, outside of the fact that thinking about risk is indeed confusing and measurement matters.

• Given the significance of risk literacy over financial knowledge it seems really important to consider measuring literacy along with whichever risk tolerance tool you use or employ in work or future studies

Next Steps

• 2-part investigation

• Currently interviewing, focused on clients of financial planners

• Helping us to take a deeper dive into value and values in context– Experience with financial planners seems less formative

than experience with financial educators and family

– People are thinking about risk differently across different domains

– People don’t like not having immediate access to funds

– Risk and luck are a part of a continuum

Implications

Risk

• Risk Preference (Tolerance/Aversion)

• Risk Perception

• Risk Capacity

• Risk Composure

• Risk Literacy

• Risk Profile

Considerations

• Practitioners may only be interested in the amount of risk in portfolio, not preference.

• Economists and psychologists discuss risk preference, but in very different ways.

• Planners and researchers may care about different aspects of risk.

Policy

• Under current regulations, planners and advisors must show whether they assessed client risk

• Policy should include risk literacy assessment prior to any assessment of risk tolerance

Questions

Thanks for listening!

Questions Used

• Financial Knowledge– Do you think that the following statement is true or false?

Buying a company stock usually provides a safer return than a stock mutual fund?

– Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?

– Imagine that the interest rate on your savings account was 1% per year and the inflation rate was 2% per year. After 1 year, would you be able to buy more than, exactly the same as, or less than today with the money in this account?• All from Lusardi and Mitchell

Results

H-Incon v. No Inconsistency

Incon vs. No Inconsistency

Some incon vs. No Inconsistency

Point Est.

Odds Ratio

Point Est. Odds Ratio Point Est. Odds Ratio

Numeracy -.27** .77** .25*** 1.29**** .25*** 1.28***

Fin. Know .005 1.005 .06 1.05 -.03 .97

VIF Conducted; c=.73; *=p<.1, **=p<.05, ***=p<.01

Results

H-Incon v. No Inconsistency

Incon vs. No Inconsistency

Some incon vs. No Inconsistency

Point Est.

Odds Ratio

Point Est. Odds Ratio Point Est. Odds Ratio

Peer – M Low 1.01 2.75 1.39** 4.03** .44 1.55

Peer – S. Low .95 2.59** .61 1.85 .55 1.74

Fam – M Low .21 1.23 -1.14* .32* -.34 .71

MO – Ext Dis .04* 1.04* -.58 056 .75 2.06

MO – SW Sat .52 1.68 -.32 .73 .81** 2.27**

VIF Conducted; c=.73; *=p<.1, **=p<.05, ***=p<.01

Questions Used Continued

• Financial Knowledge Continued– Do you think the following statement is true or false: A 15-

year mortgage typically requires higher monthly payments than a 30-year mortgage, but the total interest over the life of the loan will be less?

– If interest rates risk, what will typically happen to bond prices?

– What does the risk free-rate correspond to?• Interest rate on T-bill• Interest rate on T-bonds• Prime interest rate• Federal fund rate• I don’t know

Questions Used Continued

• Income Gamble– Double Pay vs. 1/3 Cut

• Suppose you are the only income earner in the family, but your current job is ending. You have to choose between two new jobs. The first job would guarantee your current family income for life. The second job is also guaranteed for life and possibly better paying, but the income is less certain. There is a 50/50 chance that the second job will double your current family income for life and a 50/50 chance that it will cut your current family income by 1/3 for life.

– Double Pay vs. ½ cut• Suppose the chances were 50/50 that the second job would double your

current income and 50/50 it would cut it in half

– Double Pay vs. 20% cut• Suppose the chances were 50/50 that the second job would double your

current family income and 50/50 that it would only cut it by 20%

• Always choose between job 1 or job 2, cannot chose current.

Questions Used Continued

• Specialized Risk – Financial, Major Life Change, Gamble

– People can behave differently in different situations. How would you rate your willingness to take risks in the following areas?

• 0 unwilling, 10 fully prepared

Questions Used Continued

• Imagine that we flip a fair coin 1000 times. What is your best guess about how many times the coin would come up heads in 1000 flips?– 50, 500, 1000

• In the BIG BUCKS LOTTERY, the chance of winning $10 prize is 1%. What is your best guess about how many people would win a $10 prize if 1000 people each buy a single ticket to BIG BUCKS?– 1, 10, 50

• Imagine we are throwing a 5-sided die 50 times. On average, out of these 50 throws how many times would this 5-sided die show an odd number? – 10, 20, 30

• In a forest 20% of mushrooms are red, 50% brown and 30% white. A red mushroom is poisonous with a probability of 20%. A mushroom that is not red is poisonous with a probability of 5%. What is the probability that a poisonous mushroom in the forest is red?– 4, 20, 50