Current Risk Profiles Don’t Capture the Effect of COVID-19 on Investor Risk Appetite

Current Risk Profiles Don’t Capture the Effect of COVID-19 on Investor Risk Appetite

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By Emily Allen, MSc graduate, Utrecht University

The use of questionnaires in creating risk profiles is considered best-practice and complies with regulatory framework. But is an investor’s risk profile accurately captured by a questionnaire? Different behavioral biases, experienced by investors in response to an event which lies outside their expectations, are demonstrated using the Covid-19 pandemic, and provide an explanation as to why questionnaires alone do not result in a complete risk profile.

Emily Allen, MSc graduate, Utrecht University

Classical finance theory assumes that investor decisions can be modelled based on rational expectations. Under this assumption, investors form their risk tolerance beliefs with the knowledge of all current and future events, and their corresponding riskiness. Therefore, it is expected that investor risk tolerance will not decrease following the occurrence of a risk tail event, such as the COVID-19 Pandemic. Emily Allen, MSc graduate, Utrecht University, has used data from the risk profiling questionnaire of a wealth management firm in the Netherlands to explore the relationship between risk tolerance and macroeconomic conditions. She demonstrates an overall decrease in investor risk tolerance. The inclusion of investor characteristics and market indicators in the regression analysis suggests that this decrease in risk tolerance may be explained by the fluctuation in macroeconomic conditions.

 

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