The Psychology of Money

Abstract

The author describes how to design an effective risk-tolerance questionnaire that can be used to assist individual investors select appropriate investment portfolios. The article starts with a brief history of behavioral finance, specifically focusing on the difference between standard finance (or the so-called expected utility theory) and behavioral finance (or the so-called prospect theory). The author argues that the distinguishing feature of standard finance is that it is a prescriptive (it is built on assumptions of how people should behave, rather than how they actually do behave), rather than descriptive theory. The author then considers behavioral finance from the perspective of the long-term, strategic investor, looking at a few practical applications of behavioral finance. He discusses behavioral finance, psychometrics, risk assessment and a simulation technique that “maps” each risk score onto a precise standard deviation value, and argues that the approach, known as absolute mapping, ensures that the investor is recommended portfolios of equal risk, independent of the other portfolios that are available.