How do investors assess the risk of investments? Traditional finance does not leave any room for discussion: variance of returns (volatility) is the one and only risk measure. However, concepts like loss aversion already indicate that investors care more about downside than upside potential. So, do investors primarily care, for example, about skewness, semi-variance or loss likelihood, to name just a few possible risk measures? This study explores the important questions of whether there is any objective risk measure that can best explain what investors implicitly have in mind when they assess the risk of investments, and how this affects their willingness to invest. Finding an answer to this research question is of high importance not only for researchers but for business practice and the financial regulator alike. For example, the understanding of what is risk for investors will considerably facilitate how risks can or should be communicated.

We conducted a series of five experiments and 1000+ participants in which we present participants with various different return distributions and ask them how risky they perceive these investments and how likely they would invest. By a careful experimental design we keep the expected return constant for all different return distributions, but we achieve pronounced differences in various risk measures. We thereby analyze a large variety of different measures: standard deviation (volatility), semi-variance, loss probability, skewness, kurtosis, maximum return, minimum return, value-at-risk.

We find that volatility, most frequently used by financial advisors and even the regulator, fails to explain how investors perceive risk. In contrast, our results highlight the crucial role that the probability of losing plays in determining the perceived risk by an investor. This measure alone can explain a very surprising 98% of the variations in the average perceived risk in our baseline experiment, and it is the only factor that delivers a non-zero explanatory power for the individual perceived risk. We further find that perceived risk is the main driver of investment propensity, affecting it negatively. We obtain very similar results in our four control experiments in which we control for the effect of color coding of gains and losses (Exp. 2), investor sophistication (Exp. 3), incentives for the investment task (Exp. 4) and exclusive focus on investment decision without asking for the riskiness of the investment (Exp. 5).

One of our conclusions, having shown that loss probability is the most important risk factor, which could lead to suboptimal decisions, is that (robo) advisors should out more effort in explaining to their clients the consequences of a loss, for example with simulation tools, which have been shown already to be effective in the case of mis-estimation of loss probability (see Kaufmann et al. 2013, Bradbury et al., 2015). The regulator should consider using alternative approaches to communicate the risks of investments. Our paper is intended to set the stage for a new research agenda in the field of investor risk perception and effective risk communication, to enable investors to make better and more informed decisions.