Scoring and Predicting Risk Preferences

Ertek, G., Kaya, M., Kefeli, C., Onur, Ö., Uzer, K. (2012) “Scoring and predicting risk preferences”
in Behavior Computing: Modeling, Analysis, Mining and Decision. Eds: Longbing Cao, Philip S.
Yu. Springer.

Note: This is the final draft version of this paper. Please cite this paper (or this final draft) as
above. You can download this final draft from http://research.sabanciuniv.edu.

Scoring and Predicting Risk Preferences

Gürdal Ertek1, Murat Kaya1, Cemre Kefeli1, Özge Onur1, and Kerem Uzer2

1Sabancı University, Faculty of Engineering and Natural Sciences,

Orhanli, Tuzla, 34956, Istanbul, Turkey.

2Sabancı University, School of Management,

Orhanli, Tuzla, 34956, Istanbul, Turkey.abanci University

Scoring and Predicting Risk Preferences

¨
G¨ rdal Ertek1 , Murat Kaya1 , Cemre Kefeli1 , Ozge Onur1 , and Kerem Uzer2
u
1 Sabancı University, Faculty of Engineering and Natural Sciences,
Orhanli, Tuzla, 34956, Istanbul, Turkey. ertekg@sabanciuniv.edu
2 Sabancı University, School of Management,

Orhanli, Tuzla, 34956, Istanbul, Turkey.

Abstract. This study presents a methodology to determine risk scores of individ-
uals, for a given financial risk preference survey. To this end, we use a regression-
based iterative algorithm to determine the weights for survey questions in the
scoring process. Next, we generate classification models to classify individuals
into risk-averse and risk-seeking categories, using a subset of survey questions.
We illustrate the methodology through a sample survey with 656 respondents.
We find that the demographic (indirect) questions can be almost as successful
as risk-related (direct) questions in predicting risk preference classes of respon-
dents. Using a decision-tree based classification model, we discuss how one can
generate actionable business rules based on the findings.

1 Introduction

Financial institutions such as banks, investment funds and insurance companies have
been using surveys to elicit risk preferences of their customers3 . They analyze the col-
lected data to categorize their customer pool and to offer customized financial services.
For instance, the institution can emphasize safety and predictability of investments for
customers who are categorized as risk-averse, whereas it can emphasize potential gains
to customers who are categorized as risk-seeking. Determining customers’ risk prefer-
ences is a prerequisite for developing healthy financial plans. For this purpose, leading
financial institutions often integrate the survey results into their Customer Relations
Management (CRM) systems.
While the use of financial risk preference surveys is popular in practice, the survey
questions are rarely determined using scientific reasoning. In addition, when risk scores
are calculated for survey respondents, questions are often given identical weights. Eval-
uating 14 risk surveys in France, [26] determines that “Only a minority of the ques-
tionnaires in our sample rely on scoring techniques that attribute points for each an-
swer. Furthermore, the questionnaires under review that do rely on scoring techniques
generally fail to use sufficiently sophisticated econometric methods when setting their
scoring rules. . . . Consequently, the classification of investors is still based on subjective
judgments, rather than on data and quantified findings. ”. [26] also finds weak correla-
tion between the risk scores of different surveys. That is, different financial institutions
might be providing different financial advice to the same individual.

3 See, for example http://www.paragonwealth.com/risk_tolerance.php

These observations indicate the need for scientific quantitative approaches for cal-
culating risk scores using survey data. In this research, we offer a methodology to de-
termine weights for the questions of a given risk survey, applying a regression-based
iterative algorithm. Using these weights, we calculate a risk score for each survey re-
spondent, which can be used for classification purposes.
Risk preference surveys include questions on two sets of respondent attributes: (1)
Direct attributes, such as a choice between different hypothetical investment options,
that are directly related to risk preferences; (2) Indirect attributes, such as demographic
information, that are not directly related to risk preferences. The questions on direct
attributes presumably provide more valuable information on respondents’ risk prefer-
ences. However, since these questions aim at sensitive information and involve hypo-
thetical scenarios, it may be difficult to elicit truthful information from respondents.
This is particularly the case when the questions are numerous and framed too broadly. In
contrast, indirect data is often readily available or can be collected easily. Our research
offers a method to classify individuals based on their answers to indirect questions. One
can use this classification to ask more tailored direct questions, if necessary.
The definition of risk, and risk preferences is context-dependent. Risk can be de-
fined in many ways, including expected loss, expected disutility, probability of an ad-
verse outcome, combination of events/consequences and associated uncertainties, un-
certainty of outcome of actions and events, or a situation or event where something of a
human value is at stake and the outcome is uncertain [3]. In this study, we focus on risk
preferences of individuals in the context of financial investments.
The contributions of this work can be summarized as follows:
– We develop a novel behavior computing [5] methodology for scoring and prediction
of risk preferences. The two main components of the methodology are:
• Risk scoring algorithm: Given a risk survey, this iterative algorithm determines
which questions (attributes) to use and the weights for each direct question,
and calculates risk scores for all respondents based on these weights.
• Classification model: This model classifies respondents based on a set of (di-
rect, indirect or both sets) attributes.
– We illustrate the use of methodology on a sample survey with 23 direct and 9 indi-
rect questions applied to 656 respondents.
– We derive actionable business rules using a decision-tree-based classification model.
These results can be conveniently integrated into the decision support systems of
financial institutions.
In this section of the chapter, the study was introduced and motivated. In Section
2, an overview of the basic concepts in related studies is presented through a concise
literature review. In Section 3, the proposed five-step methodology is presented and the
methodology steps are illustrated through a sample survey study. In Section 4, the study
is concluded with a thorough discussion of future research directions.

2 Literature
A number of researchers have evaluated the use of risk surveys by financial institutions
to score the risk preferences of individuals and to classify them into categories. [26]’s

evaluation of 14 risk surveys (questionnaires) used in France finds that only one third of
the surveys try to quantify risk aversion, and those who quantify risk aversion fail to use
sufficiently sophisticated econometric methods. Less than half of the institutions have
developed scoring rules for the purpose of classification, and for most cases, classifica-
tion is conducted based on subjective judgment rather than proper analytical methods.
In addition, computed classes are only weakly correlated between different surveys.
Our study addresses some of these issues.
Researchers have long discussed whether indirect attributes can be used effectively
in classifying individuals into risk preference categories. See, for example, [13]. In par-
ticular, being male, being single, being a professional employee, younger age, higher
income, higher education, higher knowledge in financial matters and having positive
economic expectations are shown to be positively related to higher risk tolerance. How-
ever, blindly adopting such heuristics in classifying customers has its drawbacks. There
is no consensus among researchers about the validity of these heuristics, which indicate
the need for additional research (see [14] and the references therein). For example, us-
ing a survey with 20 questions, [13] finds older individuals to be more risk tolerant than
younger ones, and married individuals to be more risk tolerant than single ones, which
contradicts the common expectations. In a similar study, [14] uses the 1992 Survey of
Consumer Finances (SCF) dataset, which contains the answers of 2626 respondents.
Seven of the eight indirect attributes are found to be effective in classifying respon-
dents into three risk tolerance categories. The level of attained education and gender
are found to be the most effective attributes; whereas the effect of age attribute is found
to be insignificant. Other related studies include [31] and [16].
A different but related problem is the credit scoring problem. Credit scoring can be
defined as the application of quantitative methods to “predict the probability that a loan
applicant or existing borrower will default or become delinquent” [22]. Credit scoring
models are popular in finance, due to increasing competition in the industry and the
high cost of bad debt. [11] presents a review of credit scoring models based on statisti-
cal techniques and learning techniques, and their applications. [33] provides a review of
credit scoring and behavior scoring models, where the latter type of models use data on
the repayment and ordering history of a given customer. Numerous novel credit scoring
models have been published after the reviews of [11, 33], and are based on a variety
of techniques; including neural networks [34], self-organizing maps [18], feature selec-
tion, case based reasoning, support vector machines (SVM) [19], discriminant analysis,
multivariate adaptive regression splines (MARS), clustering, and combinations of these
techniques [6]. [30] develops a credit scoring framework and an expert system based on
neuro-fuzzy logic to assess creditworthiness of an entrepreneur.
Different from our study, the mentioned studies do not focus on the individual’s
attitude towards risk, namely, his/her risk preference. Risk preference and being risky
from a lender’s perspective are different issues. For example, an individual who is very
much risk-seeking may or may not have a high credit score (low credit risk). Also, these
studies do not provide an algorithm for determining scores in the absence of a learning
set.
Another research stream consists of the literature on customer segmentation as a
part of Customer Relationship Management (CRM). [24] presents a summary of the

research on supervised classification for CRM. [20] employs decision tree models for
not only generating business rules regarding behavior patterns of customers, but also
for dynamically tracking the changes in these rules.
We develop a numerical score for representing risk preferences with regards to fi-
nancial decision making, using data from a field survey. However, risk preferences can
also be estimated through controlled field experiments [17]. These experiments often
identify deviations in human behavior from theoretical predictions, which is studied in
the behavioral finance literature [4].

3 Methodology and Results

Our methodology is outlined below. In the following subsections, each step of the
methodology is presented alongside the results we obtain based on our sample survey
data.

1. Survey design
2. Survey conduct
3. Risk scoring
4. Classification
5. Insight generation

3.1 Survey Design

We investigated the risk scoring surveys of a number of financial institutions available
on the Web, and developed our survey by choosing 23 direct (risk-related) and 9 indirect
(demographic) questions among the popular ones. Appropriate selection of the direct
attributes for a survey directly affects the risk scores and the subsequent data mining
study, and hence is very important.
The questions in the survey were designed such that the choices given to respon-
dents are sorted according to (hypothesized) risk preferences. For example, in the sur-
vey questions with three choices, selecting choice (a) is assumed to reflect risk-averse
behavior, whereas selecting choice (c) is assumed to reflect risk-seeking behavior.
Examples of the questions on direct attributes include the number of times a person
plays in the stock market, the investment types that a person would feel more comfort-
able with, and the most important investment goal of that person. A number of sample
direct questions is provided in Appendix A. The complete survey (English version) is
provided in Appendix A of the supplementary document for this chapter [10].
We used the following nine indirect attributes in our study:

– Gender: male or female
– IsStudent: whether the person an employee or a student
– StudentLevel: undergrad, masters
– IncomeType: fixed salary, incentive based, or both
– SoccerTeam: the soccer team that the person supports
– HighschoolType: public, private, public science, private science, other

– EnglishLevel: the level of English language skill
– GermanLevel: the level of German language skill
– FrenchLevel: the level of French language skill
The other indirect questions in the survey, such as the department that a student
studies in, were not included in the scoring and prediction phases of the study because
they were open-ended.

3.2 Survey Conduct
The survey was conducted in Turkish language on 656 respondents, with balanced dis-
tribution of working people (346) vs. students (250 undergraduates and 60 graduates),
and gender (283 females vs. 373 males), from a multitude of universities and work en-
vironments. Among the working participants, 71 work only for commission, 204 work
for fixed income and 71 work for both commission and fixed income. The distribution
of values for the attributes are given in Appendix B of the supplementary document
[10].
One challenge faced while conducting the survey was the communication of finance
and insurance concepts, and the choices available to respondents. This is important for
ensuring valid answers to the survey questions and hence improving the reliability of the
sample study. To this end, all surveys were conducted through one-to-one interaction
with individuals by our research team. One drawback of this approach is that commu-
nication may influence respondents’ risk preferences. For example, [27] observes that
farmers in Netherlands exhibit more risk-seeking behavior when they understand and
trust the insurance tools through one-to-one interaction. The results of [27] confirm ear-
lier findings in India, Africa, and South America. We do not analyze the effects of such
a bias.
Once the survey was conducted, the data was assembled in a spreadsheet software
and cleaned following the guidelines in the taxonomy of dirty data in [21]. Also at the
data cleaning stage, data was anonymized, so that it can be shared with colleagues and
students in future projects.

3.3 Risk Scoring
The survey data is fed into the risk scoring algorithm in the form of an I × J sized
matrix, representing I respondents and J attributes. This algorithm determines which
direct attributes are to be used in scoring, the weights for each attribute, and based on
these, the risk scores for each respondent. The mathematical notation and the pseudo-
code of the scoring algorithm are given in Appendix B.
The initialization step in the algorithm linearly transforms ordinal choice data into
nominal values between 0 and 3. For example, if a question has five choices (a, b, c,
d, e), the corresponding numerical values would be (0.00, 0.75, 1.50, 2.25, 3.00). This
linear transformation is used for simplicity; however, there is no guarantee it is the most
accurate representation.
Following the initialization phase, quantitative attribute values are fed into a regression-
based iterative algorithm. The algorithm operates as a multi-pass self-organizing heuris-
tic, which aims at obtaining converged risk scores. The stopping criterion is satisfied

when the average absolute percentage difference in risk scores is less than the threshold
provided by the analyst. At each iteration of the algorithm, the value vector for each
of the selected attributes is entered into a linear regression model as factor, where the
response is the incumbent risk score vector. Weights for the attributes are updated at
the beginning of each iteration, such that the sum of the weights is equal to the num-
ber of included attributes. The algorithm allows for change in the direction of signs
when the choices for an attribute should take decreasing -rather than increasing- values
from choice (a) to the final choice. Hence, the algorithm not only eliminates irrelevant
attributes, but also suggests the direction of risk preferences for the choices of a given
attribute. The algorithm is an unsupervised algorithm, as it does not require any class la-
bels or scores from the user. It is also a self-organizing algorithm [2], as it automatically
converges to a solution at the desired error threshold.
After the risk scores are calculated for all respondents, a certain top percentage of
them are labeled as risk-seeking and the rest as risk-averse. This is used in the subse-
quent classification step of the methodology.
The algorithm was coded in Matlab computational environment [25]. The mapping
of the ordinal values O = [oi j ]656×23 to nominal values in the initialization step was
performed in the spreadsheet software, and the Matlab code was run with the obtained
matrix of nominal values A = [ai j ]656×23 . The parameters for the algorithm were se-
lected as E = 0.1 and α = 0.05. Running time for the algorithm was negligibly small
(less than one second) for this sample.
Results on scoring algorithm:
The average absolute percentage change ek in risk scores is shown in Fig. 1. We
observe ek to halve in only two iterations, and to get very close to zero after the first
10 iterations. The algorithm converges to the given threshold E rapidly, in only 19
iterations.
Fig. 2 shows the weights obtained for each of the 23 direct attributes. Five of the 23
direct attributes (Q20, Q21, Q22, Q38, Q40) are assigned a weight of 0 by the algorithm.
That is, the algorithm removes these five questions from the risk score computations,
because they fail to impact the scores in a statistically significant way, given the pres-
ence of the other 18 attributes. The positive weights are observed in the range (0.2792,

Fig. 1. The convergence of the algorithm, based on the average percentage change in risk scores

1.6320). The hypothesized directions of choice ranks are found to be correct for all the
attributes (Γj = 1, ∀ j ∈ J).

Fig. 3 illustrates the histogram of the risk scores we calculate, labeling 20% of
the respondents as risk-seeking and the rest as risk-averse. While the risk scores seem
to exhibit normal distribution, Shapiro-Wilk test for normality [29], carried out in R
statistical package [32], resulted in p = 3.2E − 7 0.05, very strongly suggesting a
non-normal ﬁt.

Fig. 2. Calculated weights for the direct attributes in the case study

Fig. 3. Risk score histogram and the deﬁnition of (risk) class labels

3.4 Classification
The next step in the methodology investigates whether risk preferences can be predicted
through only direct, only indirect or both sets of attributes. To this end, we use five
classification algorithms from the field of machine learning for predicting whether a
person is risk-seeking or risk-averse, as labeled by the scoring algorithm of step 3.
These algorithms, also referred to as learners, are Naive Bayes, k-Nearest Neighbor
(kNN), C4.5, Support Vector Machines (SVM), and Decision Trees (DT)4 [8].
In classification models, a learning dataset is used by the learner for supervised
learning to later on predict the class label for new respondents. The predictors can have
nominal or categorical values, whereas the predicted class attribute should have cat-
egorical (class label) values. The success of a learner is measured primarily through
classification accuracy on a provided test dataset, besides a number of other metrics.
Classification accuracy is defined as the percentage of correct predictions made by the
classification algorithm on the test dataset.
Fig. 4 illustrates the generic classification model we construct for risk preference
prediction, as well as the widgets for decision tree analysis in the Orange data mining
software [35]. In the classification model, some of the attributes in the full dataset are
selected as the predictors and the risk-preference attribute (taking class label values of
risk-seeking or risk-averse) is selected as the class attribute.
Classification accuracy is computed through 70% sampling with ten repeats. In
other words, for each learner, ten experiments are carried out, with a random 70% of

Fig. 4. Classification model for predicting risk preference behavior, together with the decision
tree analysis widgets.
4 also referred to as classification trees

Table 1. Classification accuracies of the models for predicting risk preferences

Learner Model Model Model Model Model Model
1a 2a 3a 1b 2b 3b
1 Naive Bayes 0.9635 0.7888 0.9650 0.9467 0.8954 0.9452
2 kNN 0.9279 0.7675 0.9091 0.9391 0.8756 0.9452
3 C4.5 0.9279 0.8020 0.9269 0.9198 0.8985 0.9173
4 SVM 0.9528 0.8020 0.9452 0.9650 0.8985 0.9584
5 DT 0.9142 0.7741 0.9030 0.9239 0.8919 0.9137

the sample being used as the training dataset each time, and the remaining used as the
test dataset.
Results on classification models:
Table 1 presents the classification accuracy results of the six models. We observe
that in Model 1a, Naive Bayes learner successfully classifies (on the average) 96.35%
of the respondents in the test dataset. This is not surprising, since the direct attributes
that Model 1a uses were used in the computation of risk scores in the first place, which
are eventually transformed into the risk preference class labels. Therefore, high clas-
sification accuracy for Model 1a is expected. What is surprising is the relatively high
(around 80%) classification accuracy that the learners in Model 2b achieve. This find-
ing suggests that indirect attributes can be almost as successful as direct attributes in
predicting risk preference.
Another surprising outcome is the poor performance of Models 3a and 3b, which
use both direct and indirect attributes. Model 3a is outperformed by Model 1a with
all but one learner. The comparison between Models 3b and 1b is also similar. This
observation suggests that if one is already using the direct attributes, adding indirect
attributes can deteriorate the classification performance of learners.
While not yielding the highest classification accuracy in any of the models, decision
tree (DT) may be preferred over other (black-box) learners due to its strong explana-
tory capacity, in the form of explicit rules it generates. We discuss one decision tree
application in the following step.

3.5 Insight Generation

In this step of the methodology, we aim to determine whether the answers to direct or
indirect questions convey information about the risk preferences of respondents. To this
end, a decision tree is constructed in the Orange model.
Decision trees summarize rule-based information regarding classes using trees. As
opposed to the black-box operation of machine learning algorithms, decision trees re-
turn explicit rules, in the form “IF Antecedent THEN Consequent”, that can easily be
understood and adopted for real world applications. For example, in the context of risk,
[23] gives an example rule which states that credit card holders who withdrew money

at casinos had higher rates of delinquency and bankruptcy. Such rules can also encap-
sulate the domain knowledge in expert systems development, in the form of rule bases
[12]. Wagner et al. [36] state that knowledge acquisition is the greatest bottleneck in
the expert system development process, due to unavailability of experts and knowledge
engineers and difficulties with the rule extraction process. Our methodology offers a
recipe for this important bottleneck of expert systems development.
In decision trees, branching is carried out at each node according to a split crite-
rion and a tree with a desired depth is constructed. At each deeper level, the split that
yields the most increase in the split criterion is selected. [7] gives a concise review of
algorithms for decision tree analysis, explaining the characteristics of each algorithm.
In our decision tree analysis, we use the ID3 algorithm [28] in Orange software [35]
that creates branches based on the information gain criterion. Each level in the decision
tree is based on the value of a particular variable. For instance, in Fig. 5, the root node
of the decision tree contains 656 respondents and the branching is based on question
34 (Q34). In each node of this decision tree, the dark slice of the pie chart shows the
proportion of risk-seeking participants, and the remaining portion of the pie shows risk-
averse respondents in that sub-sample. In decision trees, we are especially interested
in identifying the nodes that differ significantly from the root node with respect to the
shares of the slices, and the splits that result in significant changes in the slices of the
pie chart compared to the parent node (the node above the split).
Fig. 5 shows the decision tree for Model 1a, where only the direct attributes are
used. We observe a significant branching based on the answer given to Q34 (question
34). When Q34 takes the value a, the percentage of risk-seeking respondents drops
significantly from 20.00% (Definition “a”) to just 1.53% (2 out of 130 respondents).

Fig. 5. Decision tree for Model 1a, where only direct attributes are used and the respondents with
the top 20% highest scores are labeled as risk-seeking

Similarly, even if Q34 takes a value in {b, c, d, e}, if Q32 has the value of a, then again,
the chances of that person being risk-seeking in this sample is much lower (actually 1,
out of 109 respondents) than the root node (that represents the complete sample). Rule
1 and Rule 2, labeled on Fig. 5, reflect the aforementioned findings as below:

Rule 1: “IF Q34 = a THEN Proportion(RiskSeeking) = 1.53%.”

Rule 2: “IF Q34 ∈ {b, c, d, e}∧Q32 = a THEN Proportion(RiskSeeking) = 0.92%.”

As Q34, Q32, and Q23 (questions with five choices) take values in {b, c, d, e} (any
value but a), and Q42 (a question with four choices) takes a value in {b, c, d}, the pro-
portion of the risk-seeking respondents continues to increase compared to the root node.
The next three splits are again related with these questions, and hence these four ques-
tions are the most important risk-related questions when deriving rules for Model 1a.
Q34 and Q32 also had the largest weights in the scoring algorithm (as seen in Figure 2),
but Q23 and Q42 did not have the next two largest weights. This tells us that the weights
obtained by the scoring algorithm are related, but not perfectly aligned with the results
of the decision tree analysis. These questions ask about the volatility level that the per-
son would be willing to accept (Q34), top investment priority (Q32), a self-assessment
of risk preference compared to others (Q23), and the most preferred investment strategy
(Q42).
The rules that corresponds to the splits marked with Rule 3 and Rule 4 in Fig. 5 are
as follows:

Rule 3: “IF Q34 ∈ {c, d, e} ∧ Q32 ∈ {c, d, e} ∧ Q23 ∈ {b, c, d, e} ∧ Q42 ∈ {b, c, d}
THEN Proportion(RiskSeeking) = 68.21%.”

Fig. 6. Decision tree for Model 2a, where only indirect attributes are used and the respondents
with the top 20% highest scores are labeled as risk-seeking

Rule 4: “IF Q34 ∈ {c, d, e} ∧ Q32 ∈ {c, d, e} ∧ Q23 ∈ {b, c, d, e} ∧ Q42 ∈ {c, d}
THEN Proportion(RiskSeeking) = 86.72%.”
The only difference between Rules 3 and 4 is that in Rule 4, Q42 takes values of c
or d, rather than a value in {b, c, d}.
Next, we discuss the decision tree for Model 2a, where only the indirect attributes
are used. As the decision tree in Fig. 6 suggests, FrenchLevel and HighschoolType
are the attributes that result in the most fundamental splits. A significant change takes
place in the pie structure when HighschoolType = b (public science high school5 ),
given that FrenchLevel ∈ {b, c, d}. Specifically, in the mentioned split, the pie slice that
corresponds to risk-seeking respondents becomes much smaller (3 respondents out of
41) compared to its parent node. This is Rule 5, labeled in Fig. 6 and stated below.
Rule 5: “IF FrenchLevel ∈ {b, c, d} ∧ HighschoolType = b THEN
Proportion(RiskSeeking) = 7.31%.”
A similar split takes place when HighschoolType = c (private science high school),
again resulting in a low proportion (4 out of 38) of risk-seeking respondents:
Rule 6: “IF FrenchLevel ∈ {b, c, d} ∧ HighschoolType = c THEN
It is striking that respondents who graduated from public and private science high
schools are much more risk-averse, compared to other sub-groups. This has impor-
tant implications for the business world: Our finding suggests that it is unlikely for
respondents with a strong science background in high-school to establish risky busi-
nesses, such as high-technology startups. However, such startups are highly critical in
the development of an economy, and are dependent on the know-how of technically
competent people, such as professionals with a strong science background beginning in
high school. Therefore, there should be mechanisms to encourage risk-taking behavior
among science high school alumni, and to establish connections between graduates of
science high schools and those with an entrepreneurial mindset.
In Fig. 6, another major split takes place in the split labeled as Rule 7. Here, the
question that creates the split is FrenchLevel = b (French level is intermediate), given
that HighschoolType ∈ {d, e} (private high school, and state high schools with foreign
language). FrenchLevel = b results in a very high proportion (7 out of 14) of risk-
seeking respondents. Yet, the number of respondents in the mentioned sub-sample is
very small, only 14, and this rule has to be handled with caution.
Rule 7: “IF HighschoolType ∈ {d, e} ∧ FrenchLevel = b THEN
Upon further querying, we find that only 3 out of 17 respondents (17.65%) that have
FrenchLevel = a are risk-seeking, whereas 8 out of 18 respondents (44.44%) that have
FrenchLevel = b are risk-seeking. Risk-seeking behavior is minimal (9.33%) among
the 75 respondents that have FrenchLevel = c. What could be the explanation for such

5 Science high school: specially designated high schools that heavily implement a math- and

science-oriented curriculum

a pattern? One possible explanation might be the following: In Turkey, individuals that
have FrenchLevel = a typically come from wealthy families and learn French in expen-
sive private high schools. Individuals that have FrenchLevel = b typically have strived
to learn French by themselves, without going to such schools. They have aspirations to
rise socio-economically, and are ready to take the risks needed to achieve their aspira-
tions. Definitely, the true explanation for this pattern is a research question for the field
of sociology.

4 Conclusions
In this study, we develop a scoring algorithm, implement it with real world survey data,
and obtain significant insights through mining risk scores for the sample. In particu-
lar, we find that demographic attributes of individuals can be used to predict their risk
preference categories. This result has important practical implications: Without asking
any risk-related questions, but by only obtaining demographic information, one can
estimate with reasonable accuracy whether a particular respondent is risk-seeking or
risk-averse. The data for those indirect attributes is often routinely collected on the In-
ternet when registering for web sites. This would eliminate the need to collect extensive
finance-related information or sensitive personal information [37] from customers. An-
other advantage is that, respondents would typically not distort their answers to indirect
questions, whereas they could do so with direct ones. Hence, our methodology can fea-
sibly be implemented in practice, and has the potential to bring significant predictive
power to the institution at minimal effort.
Classification of customers into risk preference categories is an important prob-
lem for financial institutions. As argued in [14], incorrectly classifying a risk-averse
customer as risk-seeking may later cause the customer to sell investments at a loss;
whereas the opposite mistake may cause the customer to miss his investment objec-
tives. Using our methodology, the institution can make a pre-classification of customers
into risk-averse and risk-seeking categories. If necessary, these customers can then be
given surveys with more tailored direct (risk-related) questions. The computational na-
ture of our methodology makes it easy to be integrated into existing CRM systems in
terms of data use and result feed.
The methodology and the scoring algorithm proposed in this work are actually plat-
forms on which better methodologies and algorithms can be designed. There exists a
rich possibility of future research on this area, mostly regarding the algorithm:
– The algorithm assumes that the risk score of each respondent can be computed
with the same set of attribute weights. However, different weights may apply to
different subgroups within the population. This can be analyzed by incorporating
cluster analysis [38, 39] into the current study.
– The numeric values assigned to the ordinal values of the attributes were assumed
to be linear and equally spaced; whereas the real relation may be highly nonlin-
ear. Linearizable functions [9] or higher order polynomials can be assumed for
attributes as a whole, or each attribute may be modeled flexibly to follow any of
these functional forms. As an even more general model, weights can be computed
not only for attributes, but for each choice of each attribute.

– In scoring, statistical techniques for feature selection and dimensionality reduction
that exist in literature [15] may be adopted to obtain approximately the same re-
sults with fewer direct questions. This problem can be solved together with the
outlier detection problem, as in [1], where the authors present a hybrid approach
combining case-based reasoning (CBR) with genetic algorithms (GAs) to optimize
attribute weights and select relevant respondents simultaneously.
– The scoring algorithm can be developed such that consistent results are obtained
for different samples. For example, in the ideal case, a respondent who answered
the same question in a particular sample should have same score if he was a part
of another sample. In our presented algorithm, each respondent’s risk score is de-
pendent on the answers of the whole sample. This will not pose a problem when
the methodology is applied to large data sets, such as all customers of a financial
institution.
– The proposed methodology eliminates irrelevant direct attributes in computing the
risk scores, but it does not eliminate indirect attributes that are irrelevant or do not
provide significant information. All the potential indirect attributes are considered
in the classification models. Dimensionality reduction techniques can be used in
this step of the methodology. This would allow asking as few indirect questions as
possible, but still being able to predict risk preference with a high accuracy.

Acknowledgement
The authors thank Sabancı University (SU) alumni Levent Bora, Kıvanc Kılınc, Onur
¸
¨
Ozcan, Feyyaz Etiz for their work on earlier phases of the study, and students Serpil
Cetin and Nazlı Ceylan Ers¨ z for collecting the data for the case study. The authors
¸ o
also thank SU students Gizem G¨ rdeniz, Havva G¨ zde Eksio˜ lu and Dicle Ceylan for
u o ¸ g
their assistance. This chapter is dedicated to the memory of Mr. Turgut Uzer, a leading
industrial engineer in Turkey, who passed away in February 2011. Mr. Turgut Uzer
inspired the authors greatly with his vision, unmatched know-how, and dedication to
the advancement of decision sciences.

Appendix A: Selected Survey Questions
Following are selected direct (risk-related) questions from the survey of the case study,
which constitute the corresponding direct (risk-related) attributes.

Q34. Over the long term, typically, investments which are more volatile (i.e., that tend to
fluctuate more in value) have greater potential for return (Stocks, for example, have high volatil-
ity; whereas government bonds have low volatility). Given this trade-off, what would be the level
of volatility you would prefer for your investment?

a Less than 3%
b 3% to 5%
c 5% to 7%
d 7% to 13%
e More than 13%

Q32. What is your most important investment priority?

a I aim to protect my capital; I cannot stand losing money.
b I am OK with small growth; I cannot take much risk.
c I aim for an investment that delivers the market return rate.
d I want higher than market return; I am OK with volatility.
e Return is the most important for me. I am ready to take high risk for high return.

Q23. Compared to others, how do you rate your willingness to take risk?

a Very low
b Low
c Average
d High
e Very high

Q42. What is your most preferred investment strategy?

a I want my investments to be secure. I also need my investments to provide me with modest
income now, or to fund a large expense within the next few years.
b I want my investments to grow and I am less concerned about income. I am comfortable with
moderate market fluctuations.
c I am more interested in having my investments grow over the long-term. I am comfortable
with short-term return volatility.
d I want long-term aggressive growth and I am willing to accept significant short-term market
fluctuations.

Appendix B: ScoringAlgorithm
Following is the mathematical presentation of the developed scoring algorithm:
Sets
I: set of respondents (observations, rows) in the sample; i = 1, · · · , I
J: set of attributes (questions, columns); j = 1, · · · , J
V: set of ordinal values for each attribute; v = 1, · · · ,V . For the presented case
study, V = (a, b, c, d, e), where a ≤ b ≤ c ≤ d ≤ e

Inputs
O = [oi j ]I×J : matrix of ordinal values of all attributes for all respondents
m j: number of possible ordinal values for attribute j; m j ≤ 5 in this study

Internal Variables
A = [ai j ]I×J : matrix of numerical (nominal) values of all attributes for all respondents
yi : temporary adjusted risk score for respondent i, to be used in regression

Parameters
E: threshold on absolute percentage error (falling below this value will terminate
the algorithm)
α: threshold for type-1 error (probability of rejecting a hypothesis when the hy-
pothesis is in fact true)
M: a very large number
B: transformation matrix for converting the ordinal input value matrix O into the
numerical (nominal) value matrix A

Outputs
z j: whether attribute j is to be included in computing the risk score; z j ∈ {0, 1}
w j: weight for attribute j; w j ≥ 0
β0 j : intercept value for attribute j
β1 j : slope value for attribute j
Γj : sign multiplier for attribute j; Γj ∈ {−1, 1}
xi : risk score for respondent i

Functions
f (v, n) : (V, {2, · · · ,V }) → [0, 3] : mapping function for an attribute with n possible
values, that transforms the ordinal value v collected for that attribute to a nominal value
bv,n−1 .

f (v, n) = bv,n−1
where, for V = 5,
 
0.00 0.00 0.00 0.00

 3.00 1.50 1.00 0.75 

B = [bvn ]V ×(V −1) = 
 · 3.00 2.00 1.50 

 · · 3.00 2.25 
· · · 3.00

regression(y, a )
solve regression model y = β0 + β1 a + ε for vectors y and a
return (p, β0 , β1 ), where p is the p-value for the regression model

preprocess()
// transform ordinal attribute values to nominal values
ai j = f (oi j , m j ) ; ∀(i, j) ∈ I × J

Iteration-Related Notation

k: iteration count
N: number of attributes included in risk score computations at a given iteration
W: sum of weights for attributes
εk : absolute error at a given iteration k
ek : absolute percentage error at a given iteration k
ek : average absolute percentage error at a given iteration k

ScoringAlgorithm (O, m j )

BEGIN
// perform pre-processing to transform ordinal data to nominal data
preprocess()
// initialization:
// initially, all attributes are included in scoring,
// with unit weight of 1 and sign multiplier of 1.
// all of the regression intercepts are 0.
z j = 1, w j = 1, Γj = 1, β0 j = 0; ∀ j ∈ J
N = ∑j zj
// begin with iteration count of 1
k=1
Begin Iteration
// standardize the weights, so that their sum W will equal to N
W = ∑ j w jz j
w j ← (Nw j )/W ; ; ∀ j ∈ J
// compute the average of the intercepts
β 0· = (∑ j β0 j z j )/N
// compute/update the risk scores at iteration k,
// which is composed of the average intercept value
// and the sum of weighted values for attributes
xik = β 0· + ∑ j Γj w j ai j ; ∀i ∈ I
// compute total absolute error
εk = ∑i xik − xi,k−1
// correction for the initial error values
if k = 1 then

ε0 = ε1
// termination condition
if εk = 0 then
go to Iterations Completed
// compute absolute percentage error,
// and then its average over the last two iterations
x·k = ∑i xik /I
ek = 100εk /x·k
ek = (ek + ek−1 )/2
// if the stopping criterion is satisfied, terminate the algorithm
if ek < E then
go to Iterations Completed
// otherwise, continue with the regression modeling for each attribute j,
// and then go to next iteration
∀j ∈ J
// if the attribute is included in the risk score calculation
if z j = 1 then
// first remove the attribute value from the incumbent score
// to eliminate its effect
yi = xik − ai j ; ∀i ∈ I
// then define the vectors for the regression model of that attribute
y = (yi ) ; a = (Γj a· j )
(p, β0 , β1 ) = regression(y, a )
// if the regression yields a high p value
// that is greater than the type-1 error,
// this means that attribute j does not contribute significantly
// to the risk scores
if p > α then
// and the attribute should not be included in risk calculations
zj = 0
else
// else it will be included (will just keep its default value)
zj = 1

// and weight for the attribute will be the slope value
// obtained from the regression
w j = β1
// the sign of the slope is important;
// if it is negative, this should be noted
if β1 < 0 then
// record the sign change in the sign multiplier
Γj = −1
else
Γj = 1
// advance the iteration count and begin the next iteration
k++
go to Begin Iteration
Iterations Completed
xi = xik
return xi , z j , w j ,Γj , β 0 j
END

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