Two-Factor Risk Preference for Investment Market and Credit Card Risk

Abstract

This study proposes a new “two-factor” risk preference metric and assesses its effectiveness in predicting financial satisfaction under two risk domains: investment market risk and credit card risk. The factors in our two-factor assessment are risk tolerance and financial self-efficacy (FSE), both of which have other theoretical and empirical support as measures of risk attitudes. We explore a range of specifications for the two-factor risk preference (TRP) metric and find it to be effective in predicting financial satisfaction under uncertainty. Within the TRP framework, FSE emerged as a robust predictor of the financial satisfaction of credit card users regardless of respondents’ risk tolerance level; similar results were found for investment market equity owners. Overall, this study presents evidence that suggests risk tolerance and FSE capture different aspects of risk attitudes and are more effective at predicting risk preferences together than either one alone. Results suggest that financial planners can more accurately predict client responses to risk by assessing client FSE and risk tolerance levels. Financial planners can then improve client service by using the assessment results as a basis for investment portfolio allocation and credit market participation recommendations.