How Do Investors Judge the Risk of Financial Items?

TLDR

The paper proposes and tests a risk model explaining how investors perceive financial risks. The model integrates decision‑theory variables with behavioral factors from Slovic (1987) and is tested in two MBA‑student studies evaluating risk judgments of diverse financial items. Results show that both decision‑theory and behavioral variables predict risk judgments, and that disclosure of potential loss directly and indirectly shapes these judgments, suggesting implications for risk‑disclosure policy.

Abstract

This paper proposes and tests a risk model that explains how investors perceive financial risks. The model combines conventional decision-theory variables—probabilities and outcomes—with behavioral variables from psychology research by Slovic (1987), such as the extent to which a risky item is new, causes worry, and is controllable. To test our model, we conduct two studies in which M.B.A. students judge the risk of a broad range of financial items. Our results indicate that both the decisiontheory variables and Slovic's (1987) behavioral variables are important in explaining investors' risk judgments. Further, we demonstrate that information about the amount of potential loss outcome contained within mandated risk disclosures not only directly influences risk judgments, but also indirectly affects such judgments via its effect on some of Slovic's (1987) behavioral variables. By identifying this unintended consequence of current risk disclosures, these results have the potential to influence the way accounting regulators, firm managers, and academic researchers think about risk disclosure.