Understanding Financial Risk Tolerance: A Risk Management Assessment of Institutional, Behavioral and Normative Dimensions

This book revolves around the concept of financial risk tolerance and its role in financial markets. Bridging different literatures and reviewing in detail the impact of European regulation on the evolution of risk tolerance assessment, this book discusses the intersection of scholarly research, practitioner experience and current and likely normative developments. In particular, the book focuses on the evolution of the debate on the suitability questionnaire – a key tool introduced with the Markets in Financial Instruments Directive (MiFID) and further developed with MiFID’s successor - comparing it with empirical evidence on financial risk tolerance determinants, spanning from sociodemographic to behavioral components and life events. The book also looks at the future evolution of the normative framework post MiFID2 addressing in detail two key trends that are already affecting the way in which risk tolerance is dealt with in European financial markets – sustainable development and fintech and roboadvisory. The book includes an original survey run with financial market experts to assess the perceptions regarding these two trends and includes commentaries by a professional financial advisor on the key topics discussed. Preface 6 Acknowledgments 8 Contents 9 About the Authors 12 List of Figures 14 List of Tables 15 1 Financial Risk Tolerance: Where Does It All Start From? 16 1 A Crossroad: Why Looking at Risk Tolerance? 17 1.1 The Economists’ View 17 1.2 The Macroeconomic Perspective 18 1.3 The Regulator’s View 20 2 Trends in Financial Risk Tolerance 24 2.1 Definitions of Risk Tolerance 25 2.2 Risk Tolerance Determinants 26 2.2.1 Socio-Demographic Factors 26 2.2.2 Economic Factors 33 2.2.3 Personality Psychology 34 2.3 Measurement Tools 35 2.3.1 Choice Dilemmas 39 2.3.2 Expected-Utility-Based Tools 39 2.3.3 Objective Measures 41 2.3.4 Heuristic Methods 41 2.3.5 Self-Reported/Subjective Risk Measures 42 2.3.6 Risk-Behavior Scales 42 3 Conclusions and Roadmap of the Book 45 References 46 2 Risk Tolerance Tools: From Academia to Regulation and Back 54 1 The Market in Financial Instruments Directive (MiFID) and its Impact on Risk Tolerance Measurement 54 1.1 Introducing MiFID 55 1.1.1 A Brief History, Context, and Content 55 1.1.2 Classification of Clients, Disclosure Obligations, Assessment of Appropriateness and Suitability 57 1.2 MiFID and the Suitability Questionnaire 58 1.2.1 Questionnaire Overview 58 1.2.2 Implementing the Directive: Empirical Evidence and Practitioners’ Views 60 2 The Academic Debate After MiFID 64 2.1 Socio-Demographic Variables 66 2.2 Life Events 68 2.3 Behavioral and Personality Factors 68 2.4 Risk Tolerance: Stable Trait or Adaptive Feature? 69 3 The Market in Financial Instruments Directive 2 (MiFID2) 69 3.1 MiFID2, Context and Content 70 3.2 Suitability and MiFID2 71 3.3 Implementing the Directive: Empirical Evidence and Practitioners’ Views 72 4 The Academic Debate After MiFID2 74 4.1 Socio-Demographic Factors 75 4.2 Life Events 81 4.3 Behavioral and Personality Factors 82 4.4 Risk Tolerance: Stable Trait or Adaptive Feature? 83 5 Taking Stock and Looking at the Challenges Ahead 87 References 88 3 Challenges and Opportunities in the Regulation of Financial Instruments Post-MiFID2—Sustainable Finance 94 1 Sustainable Finance in a Sustainable Union 94 1.1 Sustainable Development in the European Union Legislation 94 1.2 From Theory to Action: The EU Action Plan on Sustainable Development 95 1.3 Setting the Plan into Action 97 1.3.1 Goal 1—Re-Orienting Investment Toward Sustainable Finance 97 1.3.2 Goal 2—Sustainability in Risk Management 102 1.3.3 Goal 3—Fostering Transparency and Long-Termism 107 1.4 The Action Plan and Investor Protection: Taking Stock and Moving Forward 109 2 Investing in Sustainability—Investor Preferences, Risk Tolerance, and Investment Behavior 110 2.1 Sustainability Investment—Where Does Europe Stand? 110 2.2 Sustainable Investors—Who Are They and Why Do They Choose Sustainable Products? 112 2.2.1 Demographic Characteristics 113 2.2.2 Economic Reasons 113 2.2.3 Social Reasons 116 2.3 Are Sustainable Investors Biased? 122 2.3.1 Updating Information and the Role of the Past 123 2.3.2 The Disposition Effect and Emotions 124 3 Implications for Financial Risk Tolerance and Investment Choices 126 References 128 4 The Digital Challenge: How Are New Technologies Shaping the Financial Industry? 133 1 The Technological Revolution of the Financial Services Industry 133 1.1 The Digitalization and Open Challenges 134 2 Fintech 134 2.1 A Definition 135 2.2 Fintech Users 136 2.3 Fintech Services 136 2.4 The Academic Point of View on Fintech 138 3 Open Banking and Open Finance 140 3.1 A Definition of Open Banking 141 3.2 The Evolution of Open Banking: Toward Open Finance 143 3.3 The Academic Point of View on Open Banking 143 4 Robo Advisory 146 4.1 A Definition of Robo-Advisory Services 146 4.2 Business Models for Robo Advisory 148 4.3 The Academic Point of View on Robo Advisory 149 5 The Regulatory Framework 155 5.1 The Payment Services Directive (PSD2) 156 5.2 The Revised Guidelines on Suitability by ESMA (2018) 158 6 Conclusions 161 References 161 5 Challenges and Opportunities for the Future Investor: A Practitioner’s Guide 166 1 The Survey 167 1.1 Some Reasons Why 167 1.2 Survey Structure and Participant Pool 167 1.2.1 General Information 167 1.2.2 The Sustainable-Finance Section 168 1.2.3 Robo Advisory and Open Finance 169 1.2.4 Socio-Demographic Characteristics 171 2 Survey Results 171 2.1 Participants Overview 171 2.2 Sustainable Finance 172 2.3 Robo Advisory and Open Finance 175 3 Final Discussion and Conclusions 183 Appendix: The Questionnaire 184 Index 192 This book revolves around the concept of financial risk tolerance and its role in financial markets. Bridging different literatures and reviewing in detail the impact of European regulation on the evolution of risk tolerance assessment, this book discusses the intersection of scholarly research, practitioner experience and current and likely normative developments. In particular, the book focuses on the evolution of the debate on the suitability questionnairea key tool introduced with the Markets in Financial Instruments Directive (MiFID) and further developed with MiFIDs successorcomparing it with empirical evidence on financial risk tolerance determinants, spanning from sociodemographic to behavioral components and life events. The book also looks at the future evolution of the normative framework post MiFID2 addressing in detail two key trends that are already affecting the way in which risk tolerance is dealt with in European financial marketssustainable development and fintech and roboadvisory. The book includes an original survey run with financial market experts to assess the perceptions regarding these two trends and includes commentaries by a professional financial advisor on the key topics discussed. Caterina Cruciani is an Assistant Professor in Financial Markets and Institutions at the Department of Management, Ca Foscari University of Venice, where she also received a PhD in Economics. She is the Operating Director of the Center for Experimental Research in Management and Economics (CERME) and a member of the Risk-Lab at Ca Foscari University of Venice. Gloria Gardenal is Associate Professor of Corporate Finance and a member of the Risk-Lab and the Center for Experimental Research in Management and Economics (CERME) at Ca Foscari University of Venice, where she also received a PhD in Business. Giuseppe Amitrano is the Founder and CEO of WieldMore Investment Management