Risk Tolerance: Investments Versus Insurance

Cordell, David M.
January 2004
Journal of Financial Planning;Jan2004, Vol. 17 Issue 1, p30
Academic Journal
Over the past years, few financial planning topics have generated as much interest among practitioners and academics in the U.S. as risk tolerance. The Royal Swedish Academy of Sciences awarded the 2002 Nobel Prize in Economics to Daniel Kahneman, a psychology professor. Decades earlier, Harry Markowitz based his famous portfolio selection model on the notion that portfolio risk can be represented as variance or its square root, standard deviation. Kahneman and his collaborator, the late Amos Tversky, took issue with this basic precept. They pointed out something that should have been self-evident--when evaluating risk, investors are more concerned about outcomes below the expected value than outcomes above it. Kahneman's notion of emphasizing downside risk factor does not seem to matter when evaluating equity securities because conditions in active securities are sufficiently close to MPT assumptions that the emphasis on downside risk provides no improvement on the model. In short, financial planners have become comfortable with the idea of applying quantitative risk tolerance concepts to investments, but they take a seat-of-the-pants or rule-of-thumb approach when it comes to insurance.


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