How much risk can I handle? The role of experience sampling and graphical displays on one's investment risk appetite and comprehension

Financial professionals have a great deal of discretion concerning how to relay information about the risk of financial products to their clients. This paper examines how different risk presentation modes influence how well investors understand the risk-return profile of financial products and how much risk they are willing to accept. We analyze four different ways of communicating risk: (i) numerical descriptions, (ii) experience sampling, (iii) graphical displays, and (iv) a combination of these formats in a ‘risk tool simulation’. Participants receive information about a risky and a risk free fund and make an allocation in an experimental investment portfolio. We find that risky allocations are elevated in both the risk tool simulation and experience sampling conditions. Greater risky allocations are mediated by decreased risk perception, increased confidence in the risky fund, and a lower estimation of the probability of a loss. Despite these indicators of optimism about the risky fund, participants in the risk tool simulation underestimate the probability of a high gain and are more accurate on comprehension questions on the expected return and the probability of a loss. We find no evidence of greater dissatisfaction with returns in these conditions and observe a willingness to take on similar levels of risk in subsequent allocations. Our paper has important implications for the current debate about regulating the communications between financial advisors and their clients.