Note: This question was written for the weekly topic challenge.
Many asset allocation funds presume the investor knows his target risk level, typically on some spectrum from conservative (mostly G7 fixed income) to aggressive (mostly equities, commodities, emerging markets). Other types of asset allocation funds, known as target date funds, continuously vary the risk exposure as a function of age, or years left until retirement.
Besides deep introspection (e,g, answering questions such as "do you lay awake at night thinking about your investments?"), how can one figure out his risk tolerance? What advice can we offer to clients as to what their target risk level should be beyond simple rules of thumb such as "invest a percentage of assets in low risk assets equal to your age" or "60% equity / 40% fixed income for all working age adults"? Is anyone familiar with quantitative work on measuring "optimal" risk tolerance as a function of other life circumstances, such as expected future income, current savings (both liquid investments and illiquid assets such as housing), expected future expenses (e.g. children's schooling), etc? Even empirical work, measuring observed risk tolerances as a function of these characteristics, may be hugely beneficial (wisdom of crowds).