What is Risk? How Investors Perceive Risk in Return Distributions

Abstract

Most textbook finance literature assumes risk to be the standard deviation of returns (volatility), which is not only used by academics but also financial advisors, regulators and more. This paper comprehensively examines whether volatility is consistent with investors’ actual perception of risk. Our method is presenting investors return distributions with different risk characteristics for which they have to state their perceived risk and make investment decisions. Our results hint at the probability of losing being the main driver of risk perception and investment propensity. Volatility plays a less important role. Our findings are robust with regard to color-coding of return distributions, different investor types and personal characteristics including investment experience, the use of monetary incentives, and the return distribution presentation format.