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Decomposing the Age Effect on Risk Tolerance
Postprint.
For published article see:
Yao, R., Sharpe, D. L., & Wang, F. (2011). Decomposing the age effect on risk tolerance.
Journal of Socio-Economics, 40(6), 879-887.
Abstract
The importance of investment portfolio allocation has become more apparent since the
onset of the late 2000s Great Recession. Individual willingness to take financial risks affects
portfolio decisions and investment returns among other factors. Previous research found that
people of different ages have dissimilar levels of risk tolerance but the effects of generation,
period, and aging were confounded. Using the 1998 to 2007 Survey of Consumer Finances cross-
sectional datasets, this study uses an analytical method to separate such effects on financial risk
tolerance. Aging and period effects on financial risk tolerance were statistically significant.
Implications for researchers and financial planning practitioners and educators are provided.
JEL Classification
D12, D14, G11
Keywords
Attitudes, Generation, Period effect, Risk tolerance, Survey of Consumer Finances
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1. Introduction
Several researchers have concluded that Americans are not saving enough to fund their
retirement (Warshawsky & Ameriks, 2000), especially members of the baby boomer generation
(VanDerhei & Copeland, 2011). Although it is without argument that investments have an
important place in retirement planning, selection of appropriate investments and investment
strategies can be challenging for consumers.
The emergent sub-prime mortgage crisis in the 2000s and the consequent rapid decline in
equity value made many investors painfully aware of the importance of having a realistic
understanding of financial risks and their own investment risk tolerance. Even seasoned investors
saw substantial decreases in their portfolio value. Some decided to take the loss and move to
cash. Others, fearing further decline in equity prices as well as weakening currency values
moved to gold as a safe haven (Frangos, 2011), driving up the price of gold almost 475%
between 2001 and 2010 (Gold Trades, 2011). Whether moves such as these are prudent
resolutions depends on individual situations. It is clear, however, that the deep and prolonged
recession that has occurred in the wake of the financial crisis has decreased job security and
increased the potential for job loss or salary cutbacks, further increasing financial vulnerability
(Bricker, et al., 2011; Keen, 2009).
Retirement safety nets exist in the United States. Nine out of ten retired individuals
receive Social Security. For over half of those individuals, Social Security provides 50% or
more of their retirement income (Social Security Administration, 2010). Many retirees also
receive monthly payments from a defined benefit plan. These retirement safety nets are
shrinking, however. By year 2036, the combined assets of the Social Security Trust Funds will
be exhausted (Social Security Board of Trustees, 2011), which implies that future retirees may
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receive less benefit from Social Security. Defined benefit plans are becoming less common
today since many employers are switching to defined contribution plans. Consequently, wealth
accumulation via market investment has become an essential source of retirement income and
retirement planning has become more important than ever.
Research has identified several key factors that can affect wealth accumulation. These
factors are broad in scope, ranging from the effect of economic cycles to societal trends, social
policies, and individual characteristics. For example, economic conditions change over time,
moving from expansion to recession and back again. A tightened credit market can force
consumers to save to achieve important financial goals (Bunting, 2009). On an individual level,
behavioral economists have identified a number of heuristics and cognitive biases that can
adversely influence investment choice and behavior (Tversky & Kahneman, 1974; Pompian,
2006). Desire to spend on conspicuous consumption can slow wealth accumulation (Yamada,
2008).
Generational effects also exist. Each generation experiences a unique demographic,
political, and socioeconomic environment during their formative years. Differing experiences
shared by a generation may contribute to dissimilar attitudes towards financial risks between
those in different generations. For instance, many of those who experienced the Great
Depression tended to remain risk averse for the remainder of their lives (Malmendier & Nagel,
2009). In contrast, due to sustained government intervention in U.S. financial markets, many
members of Generation X had never experienced a down market until the recent Great Recession
(Keen, 2009).
Variations in risk preferences may also lead to differences in portfolio allocations that
eventually result in wealth inequality. Accurate assessment of risk tolerance is another important
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element in helping to prevent over participation in the market that may result in unnecessary
losses, or inadequate market participation that may lead to high opportunity costs, or other
financial mistakes such as cashing out when market returns decline and investing when market
returns are high.
According to the theory of reasoned action (Fishbein & Ajzen, 1975), attitudes affect
behavior. Investment returns are directly influenced by an individual’s portfolio allocation
(behavior), which, in turn, should be affected by their willingness to take financial risks
(attitudes). Therefore, whether investors are willing to take financial risks; who are more likely
to take these risks; how much risk are they willing to take; and what factors affect individuals’
willingness to take financial risks become important issues for researchers to investigate.
Researchers have long been aware of the differences in financial risk tolerance of
individuals of various ages. These differences have typically been labeled as “the age effect”.
But this “age effect” is really a combination of three effects: aging, generation, and period. The
collective analyses of age, cohort/generation, and period have been employed in marketing
research (e.g. Chen, Wong & Lee, 2001; Rentz & Reynolds, 1991). The studies that focused on
financial risk tolerance have failed to separate these effects, however (e.g. Chaulk, Johnson, &
Bulcroft, 2003; Grable, 2000). What was attributed to an “age effect” may be due to: 1) the
decrease of investment horizons and depreciation of human capital as people age (the aging
effect); 2) socioeconomic environments that influence different generations and do not change
with age (the generation effect); or 3) socioeconomic environments that influence individuals of
all ages over time (the period effect). The purpose of this study is to examine the true age effect
by decomposing it into these three effects. The following is a review of literature on “the age
effect” on risk tolerance and a discussion of the limitations of this prior work.
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2. Literature Review
2.1 The Age Effect on Risk Tolerance
Much has been written about the effect of age on financial risk tolerance. These studies
have adopted different measures of financial risk tolerance. Several studies have used objective
measures such as the proportion of risky assets to overall wealth (Ameriks & Zeldes, 2004;
Bertaut, 1998; Bertaut & Starr-McCluer, 2000; Guiso, Jappelli, & Terlizzese, 1996; Hui &
Hanna, 1997), whereas other studies used subjective or situational measures such as self-reported
risk tolerance level (Chaulk, et al., 2003; Grable, 2000; Hallahan, Faff, & Mckenzie, 2003; Yao,
Gutter, & Hanna, 2005). Despite the vast amount of research on the effect of age on financial
risk tolerance, no consensus has emerged regarding the strength or sign of the relationship.
Most prior research shows that risk tolerance decreases with age (Grable & Lytton 1998;
Morin & Suarez, 1983; Yao, Hanna, & Lindamood, 2004; Yao et al., 2005). Morin and Suarez
(1983) used the 1970 Canadian Survey of Consumer Finances dataset to study household
demand for risky assets. Age was included as a categorical variable (35 to 44; 45 to 54; 55 to 64;
and over 65). They concluded that risk tolerance decreased uniformly with age. Yao et al. (2004)
combined the 1983-2001 Survey of Consumer Finances (SCF) cross-sectional datasets and
investigated changes in self-perceived financial risk tolerance over time. Similar to Morin and
Suarez, age was measured as a series of categorical variables and was found to be negatively
related to risk tolerance.
Grable and Lytton (1998) used age as continuous variable and found that self-perceived
risk tolerance is negatively related to age. Using the 1983-2001 SCF datasets, Yao et al. (2005)
also analyzed the effect of race and ethnicity on subjective financial risk tolerance, measuring
age as a continuous variable. The authors concluded that, on average, each additional year
increase in age decreased the probability of taking some, high, or substantial risk by 2%.
