What Drives Risk Perception? A few questions to Utz Weitzel on the impact of his research in times of crisis

The paper is based on a large-scale survey experiment with finance professionals and lay people, where the drivers of financial risk perception were investigated. While the most common measure of financial risk – the standard deviation (volatility) of returns – does not influence participants’ risk perception, the authors provide evidence that risk is strongly associated with the probability of incurring losses and the skewness of returns.

Why are your findings of interest to the general public?

Despite extensive research on decision-making under risk, little is known about how risks are actually perceived by financial professionals. The way in which people perceive risk shapes their behavior in a world with uncertain outcomes, and it is of vital importance for financial investments and the allocation of capital to economic activities at large. Financial advisors often inform clients about the risk associated with investment opportunities by referring to the volatility of their historical returns, and many financial institutions survey the risk appetite of their clients with volatility-related questionnaires. In fact, regulation requires them to do so. Yet, our results suggest that the most common measure of risk in finance – return volatility – does not capture what people actually perceive as being risky.

Give an example of novelty and impact of this research

The main insight of this research is that the perception of financial risk, even by financial professionals, is not so simple as often assumed. This has direct implications for financial advice to private investors and consumers and how risks should be communicated to them. Currently risk is communicated mono-dimensionally: a financial product either has high or low risk, according to the volatility of its past returns. Such a reduction of risk to variance can be compared to reducing nutrition facts to calories. Just as food contains multiple ingredients, financial products contain multiple dimensions of risk that are, as we show, important and perceived very differently by investors. In the spirit of the “nutrition facts label” for food, we therefore advocate the use of a “risk facts label” for financial products. This “risk facts label” should not only show the variance of returns but also skewness and, most importantly, loss probabilities. With this multi-dimensional description of risk we reduce the chance that people will be disappointed by the performance of their investment when they find out that they were exposed to a type of risk they actually care about but which has not been communicated or taken into account.

What is the key outcome of the paper?

There is one element in risk that most people seem to try to minimize: the probability of a loss. Just the probability: not how much is at risk, but only how likely an even relatively small loss is going to happen. This is surprising, because we also tested many other, more complicated measures of risk that are used in banking and finance, for example, value at risk and fat tails (“black swans”). But they all seem to be far less important for the perception of risk than loss probabilities and skewness of returns. The results are surprisingly robust across lay people and professionals, but also across countries (representing 50% of the world’s population and more than 60% of the world’s gross domestic product), and even across most job functions in finance within the group of professionals.

How can that outcome be translated to the current crisis across the globe?

The discrepancy between the common definition of risk and the actual perception of risk is potentially harmful, particularly in the current crisis. In turbulent times where return volatility, skewness, loss probabilities, and many other components of financial risk move into all directions, investment advice that primarily accounts for volatility as risk is bound to neglect a large part of what investors actually consider to be risky. Moreover, the allocation of urgently needed financial resources is directly tied to the riskiness of the investment. Therefore, the proper definition of risk is crucial for investments into companies to survive and kick-start out of the crisis.

Who should read this paper carefully?

Our results have important implications for financial regulation, particularly for the communication of risks to investors. Many regulations and directives still rely to a large extent on return volatility as a measure of risk. Given that neither financial professionals nor lay people seem to perceive the volatility of returns as the defining moment of risk, measures that include skewness and loss probabilities should be given more attention in financial regulation.

The paper is based on a large-scale survey experiment with more than 2,200 finance professionals and more than 4,500 lay people in nine countries (Brazil, China, Germany, India, Japan, Russia, United Kingdom, United States, and South Africa). In the experiment, participants were exposed to return distributions which systematically differ in the statistical moments that define the distributions’ characteristics (standard deviation, skewness, and kurtosis).

Article Citation: Felix Holzmeister, Jürgen Huber, Michael Kirchler, Florian Lindner, Utz Weitzel, and Stefan Zeisberger, 'What Drives Risk Perception? A Global Survey with Financial Professionals and Laypeople.' Management Science, published online: 16 April, 2020. doi.org/10.1287/mnsc.2019.3526