Two-stage financial risk tolerance assessment using data envelopment analysis

• Published in: European journal of operational research 2014-02, Vol.233 (1), p.273-280
• Main Authors: Cooper, W.W., Kingyens, Angela T., Paradi, Joseph C.
• Format: Article
• Language: English
• Subjects: Advisors; Assessments; Data envelopment analysis; Finance; Financial planners; Investment analysis; Mathematical models; Men; Operations research; OR in banking; Risk; Risk assessment; Risk management; Stereotypes; Studies; Tolerances
• ISSN: 0377-2217; 1872-6860
• DOI: 10.1016/j.ejor.2013.08.030

•Data envelopment analysis can used to assess relative financial risk tolerance.•Risk tolerance is a multidimensional concept.•Risk is characterized by 4 elements: attitude, propensity, capacity, and knowledge.•Women may perceive risk differently than men. Typical questionnaires administered by financial advisors to assess financial risk tolerance mostly contain stereotypes of people, have seemingly unscientific scoring approaches and often treat risk as a one-dimensional concept. In this work, a mathematical tool was developed to assess relative risk tolerance using Data Envelopment Analysis (DEA). At its core, it is a novel questionnaire that characterizes risk by its four distinct elements: propensity, attitude, capacity, and knowledge. Over 180 individuals were surveyed and their responses were analyzed using the Slacks-based measure type of DEA efficiency model. Results show that the multidimensionality of risk must be considered for complete assessment of risk tolerance. This approach also provides insight into the relationship between risk, its elements and other variables. Specifically, the perception of risk varies by gender as men are generally less risk averse than women. In fact, risk attitude and knowledge scores are consistently lower for women, while there is no statistical difference in their risk capacity and propensity compared to men. The tool can also serve as a “risk calculator” for an appropriate and defensible method to meet legal compliance requirements, known as the “Know Your Client” rule, that exist for Canadian financial institutions and their advisors.