How Do Investors Judge the Risk of Financial Items?

Why do investors find certain financial endeavors riskier than others? You might think that strict analysis of probabilities and outcomes gives investors clues to the market. It seems logical that investors would use only the clearest rationales to assess risk and create investment strategies. But new research conducted by Texas A&M associate professor of accounting Mary Lea McAnally is breaking the assumptions held by investors and analysts alike.

McAnally and fellow researchers Lisa Koonce of the University of Texas and Molly Mercer of Emory University have discovered that investors judge risk by using analysis methods related to outcomes and probabilities as well as using their own intuition and perceptions. The research comes fresh to an industry long perceived as both analytical and whimsical.

In their paper “How Do Investors Judge the Risk of Financial Items,” the authors tested two contrasting mathematical models that deal with the risk-perceptions issue. These include a decision-theory model, which relies on analyzing outcomes and probabilities, and a behavioral model based on psychology research by Paul Slovic. Two studies were conducted on selected groups of investors to discover which model proved a more reliable explanation of investors’ risk assessments. The paper’s results show that combining the best of each model more accurately explains why investors judge particular endeavors as riskier than others.

“We asked which risk model prevails when it comes to financial instruments and stock markets and derivatives,” McAnally said. “We really thought the decision/theoretic would prevail because we’re trained as accountants to be analytical. But, it turns out that neither of those models alone is as good as a combined model.”

This research ties into previous risk-assessment research, but is groundbreaking in its attempt to unravel the psychology behind the field of risk and investment. The work combines different accounting research techniques with a psychological study and is the first in a series of studies the authors hope to pursue concerning how investors judge risk in investments.

— Alycia Zuehlke