As attributed to John Maynard Keynes, “there is nothing so disastrous as a rational investment policy in an irrational world”. Normative theories of financial behaviour still model fully-rational individuals that make optimal investment decisions, based on the trade-off between objective returns and volatility. These models often predict that individuals will invest a positive fraction of their wealth in the stock market and will hold a large, diversified investment portfolio. So why is the prevalence of risky financial holdings so limited among households, even though most of them own sufficient deposits and savings assets?
A growing body of empirical research shows that households often deviate from the normative benchmark and that financial behaviours are heavily influenced by emotions, intuition, beliefs, and the environment in which people live (Campbell 2016, Hirshleifer 2015). Risk attitude is one of the most important personal preferences that influences financial decisions (Kahneman and Riepe 1998, Nosic and Weber 2010, Shiv et al. 2005, Shum and Faig 2006, Weber et al. 2013, Hoffman et al. 2015).
In a recent article (Ferreira 2018), we study the differences in risk attitudes and risk perceptions across 13 European countries, the US, and Australia with regards to investments in shares, mutual funds, and bonds. Using microdata from the ING International Survey on Savings, conducted on approximately 15,000 individuals in 2016, we estimate individual measures of risk propensity from hypothetical questions asked to individuals about the likelihood of investing 10% of their total savings in different investment products, as well as their perceptions about the financial risks and benefits involved with each form of investment.
We analyse how individuals differ in their personal beliefs regarding financial risks and how individual risk propensity influences the holding of risky assets, after controlling for individual characteristics and objective measures of markets performance and volatility. This analysis shows that there are significant differences in attitudes to financial risk across the 15 countries. People living in Germany, Austria, and the Netherlands are the most risk-averse, while those in the US, Turkey, Australia, and the UK are more accepting of risk. Moreover, we find that subjective risk preferences have approximately a ten times greater explanatory power on risky-investment holdings than short- and long-term objective measures of financial market performance and volatility.
Perceived risks and expected benefits of financial investments
Financial models that focus on the trade-off between objective returns and volatility lead to the standard conclusion that higher returns are expected in compensation for riskier investments and, therefore, individuals behave in such a way that they maximise their returns for the level of risk they are willing to accept. This rationale, however, does not seem to explain individual perceptions of the risks and benefits associated with financial assets.1 We find that the normative positive risk-benefit correlation does not fit well with individual beliefs. The estimated linear coefficient is not statistically significant (0.069; s.e. 0.043), whereas the quadratic estimates suggest that these perceptions only correlate positively at the highest end of both distributions (Figure 1).
Figure 1 Correlation between perceived financial risks and benefits, 15 countries
Note: The figure plots data and a quadratic correlation, controlling for observable covariates and country-fixed effects. Standardised values of individuals’ perceived risks and benefits for three risky investments are included: shares, mutual funds, and bonds.
More interestingly, significant country differences arise. Institutional and cultural factors seem to have a substantial influence on the formation of individual risk-benefit perceptions associated with financial investment. Figure 2 suggests, for instance, that people living in the Netherlands, Austria, and Germany think that investments in shares, mutual funds, and bonds are on average extremely risky whilst their expected returns are very low. In contrast, those in the US, Turkey, UK, and Australia tend to have the exact opposite belief, that is, investing in financial assets can be highly beneficial, with a risk below the mean of all other countries.
Figure 2 Average perception of financial risks and benefits by country
Note: The figure plots country standardised values of individuals’ perceived risks and benefits toward investments in shares, mutual funds, and bonds.
More detailed country-specific correlations reveal further across-country heterogeneity, as shown in Figure 3. Strikingly, in the Netherlands, Belgium, Czech Republic, and Turkey, there is no significant pattern in the way people construct their perceptions of financial risks and benefits. Moreover, people living in Germany, Austria, and Poland seem to have the counterintuitive belief that the riskier the investment, the lower the expected benefits will be. The latter finding supports the low-volatility anomaly as researched in behavioural finance.
Figure 3 Country-specific correlations between perceived financial risks and benefits
Note: The figure plots estimations that control for observable covariates and country-fixed effects.
Risk seeker or risk averse?
We find a significant negative association between financial risk perception and risk propensity (-0.172; s.e. 0.034), suggesting that people are, on average, risk aversetowards risky investments across the 15 countries in our sample.2
More interestingly, our estimations suggest that subjective risk perception is as important as objective country measures of financial market volatility3 when explaining individual risk propensity. Specifically, one standard deviation increase in risk perception reduces individual risk propensity by 17% of a standard deviation, on average. Simultaneously, the increase of one standard deviation in market volatility during the preceding year and the preceding ten years respectively decreases the personal risk propensity by 10% and 13% of a standard deviation.4 This finding supports existing literature conjectures (e.g. Ricciardi 2004, Wang et al. 2017) that individual judgements relating to financial instruments incorporate both behavioural risk perceptions and financial risk indicators; therefore, a particular risk may have a different meaning for different people and in different contexts.
We also find that risk attitudes are not uniform across or within countries. First, as Figure 4 shows, the negative association between perceived financial risks and risk-taking propensity holds for all countries but three clear groups can be identified. Countries in group A are relatively more risk-prone and countries in group C are most risk-averse. Second, as shown in Figure 5, we find large heterogeneity in risk preferences within countries. Individual risk attitudes spread widely between the two extremes of risk-averseand risk-taker personalities; however, most country distributions are skewed to the left, that is, towards risk aversion. The US, Turkey, Australia, and the UK stand out as the countries where people tend to be subjectively more accepting of financial risks.
Figure 4 Country-specific correlations between financial risk propensity and perceived risk
Note: This figure plots country estimations that control for observable covariates and country-fixed effects.
Figure 5 Histogram of predicted financial risk attitude by country
Note: zero in this figure denotes the risk indifference point.
Personal risk attitude determines investment holdings
Finally, we test whether our individual subjective measure of risk attitude influences the holding of risky assets. As shown in Figure 6, we find that individual attitudes towards risk are a strong predictor of the low prevalence of financial investment products. At the individual level, results indicate that one standard deviation increase in risk-taking attitude relates to a 14 percentage point higher probability of holding assets in either shares, mutual funds, or bonds. This finding is in line with previous literature (e.g. Guiso et al. 2013, Hoffman et al. 2015, Shum and Faig 2006) that finds a significant relationship between risk propensity and financial assets ownership.
Figure 6 Average risk propensity and % of individuals holding investment products by country
Moreover, our analysis supports the behavioural view that psychological and cultural factors rooted in national environments strongly affect portfolio choice. When we examine how individual risk preferences correlate with the willingness to invest in risky assets, we find thatrisk propensity has approximately a ten times greater explanatory power on risky-investment holdings than short- and long-term objective measures of market performance and volatility.5 This finding relates to recent work by Wang et al. (2017), which suggests that cross-cultural and subjective dimensions may lead to heterogeneity in beliefs that matter more than macroeconomic variables in explaining risk aversion.
Our study indicates that personal perception of risk and risk attitudes differ from what standard financial investment models portray as risk. Both subjective risk propensity and objective indicators of risk contribute to explain household investment behaviour; however, risk aversion seems to play a more relevant role. Moreover, institutional, cultural, and geographical factors seem to influence substantially the formation of individual risk preferences toward financial investments.
This has important implications. First, it leads to challenges in the financial industry to taking a more comprehensive approach to understand households’ true and complete risk profiles. Second, it is possible that individuals take too little risk or structure portfolios that will make it difficult to meet their own long-term goals. Since risk aversion is so high, behavioural factors (e.g. loss aversion, inertia in saving/investment, and poor knowledge of financial planning) need to be considered more carefully when designing and offering investment products. Third, there is still much to learn about the formation and stability of financial risk attitudes and how the substantial cross-country differences we observe are explained by institutional and cultural factors. Improving our understanding of risk preferences will throw new light onto individual financial behaviour.
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 For this analysis, we follow the psychological risk-return framework of risky choice (Weber et al. 2002) in which risk attitude reflects a trade-off between the personal perceived risks and perceived benefits of each of the three investment products (shares, mutual funds, and bonds).
 Our estimates on other determinants of risk taking are consistent with the related literature (e.g. Luigi and Paiella 2008, Dohmen et al. 2011). Regarding financial risks, females are more risk averse than males; people become more risk averse with age but more risk-seeking with higher education and income; having children increases risk aversion; employed individuals are more risk-seeking than those unemployed and retired; and homeowners are more risk-seeking than renters.
 In these estimations, we include country-level annualise data on return indexes and volatility of risky assets, corresponding to: (1) the year 2015, (2) the preceding five years, and (3) the preceding ten years.
 These estimates are all significant with 95% confidence.
 Specifically, the increase of one standard deviation in the individual risk-taking attitude increases the probability of owning risky assets (shares, mutual funds, or bonds) by 19 percentage points. At the same time, national markets volatility during the preceding year and during the preceding ten years respectively decreases the likelihood of financial assets ownership by just 1.9 and 1.3 percentage points. The results also indicate that one standard deviation increase in the annualised country-returns index during the preceding year and preceding ten years raises the individual investment holdings probability by 4.2 and 3.2 percentages points, respectively.