CHAPTER 1
Investor Behavior: An Overview
INTRODUCTION
In the 1990s, the terms behavioral finance and behavioral economics started to appear in academic journals for finance professors, practitioner publications for investment professionals, investing magazines for novice investors, and everyday newspapers read by the general public (Ricciardi and Simon 2000). The foundation of behavioral finance and the subtopic of investor behavior, however, can be traced back throughout financial history in events such as the speculative behavior during tulip mania in the 1600s. Books published in the 1800s and early 1900s about psychology and investing marked the beginning of the theoretical basis for today's theories and concepts about investor behavior (Ricciardi 2006). Finance and the role of money are fundamental underpinnings of many important events throughout history (Ferguson 2008) and the development of financial innovations (Goetzmann and Rouwenhorst 2005). For example, Bernstein (1996) provides an extensive time line of risk throughout history and its application in the world of finance. Another important work in this arena is Rubinstein (2006), who depicts a historical anthology of investment theory. In recent times, the Internet stock market bubble of the late 1990s and the financial crisis of 2007 and 2008 demonstrate the importance of understanding investment behavior (Reinhart and Rogoff 2011).
Relevant Books in the History of Finance and Investment Thought
Understanding the history of finance and the development of investment theory is important for all types of investors. Goetzmann and Rouwenhorst (2005), Rubinstein (2006), and Ferguson (2008) offer extensive discussions of books and other publications in financial history and investment theory. The next section provides a discussion of important books in the history of finance and the natural progression of understanding investor theory and behavior. Exhibit 1.1 provides a chronological timeline of a sample of noteworthy books in financial history and investment theory from 1841 to 1978. This list of books is merely illustrative of classic or seminal works.
Period: 1841 to 1912
Initially published in 1841, Extraordinary Popular Delusions and the Madness of Crowds (MacKay 1980) depicts the role of bubbles and panics that is still applicable for investor psychology. Published in the late 1800s, The Crowd: A Study of the Popular Mind (Le Bon 1982) describes the role of group behavior in different environments and markets. Published in 1903, Trust Finance: A Study of the Genesis, Organization, and Management of Industrial Combinations (Meade 2003) describes the importance of trust in a wide range of areas including corporate finance, financial services, and investments. Where the Money Grows and Anatomy of the Bubble (Garrett 1998), published in 1911, presents the role of different stakeholders involved in the investment management process on Wall Street. The Psychology of the Stock Market (Selden 1996), published in 1912, represents one of the first books that applied psychology to the decision-making process of investors. Selden's book describes the behavioral and emotional issues that influence traders and investors in the stock market.
Period: 1922 to 1938
Published in 1922, The Stock Market Barometer (Hamilton 1998) discloses the approach known as the Dow Theory, which is based on stock price movements as a predictive investment tool. Published in 1923, Reminiscences of a Stock Operator (Lefèvre 1994) depicts the life of a Wall Street trader and different approaches to trading in the markets. The author interviews traders to build the portrait of the fictional stock trader in the novel. The Common Sense of Money and Investments (Rukeyser 1999), published in 1924, provides a discussion of various personal finance and investment topics that are still relevant. Published in 1930, The Art of Speculation (Carret 1997) offers a thorough discussion of the speculation process involving financial markets and investment products. Only Yesterday: An Informal History of the 1920s (Allen 2010), first published in 1931, provides a general narrative description of life during the 1920s and also examines that decade's bull market, stock market crash, and the early years of the Great Depression.
In 1934, Graham and Dodd (1996) published Security Analysis in which they developed the foundation for value investing by identifying undervalued companies based on accounting information and financial statements. The Battle for Investment Survival (Loeb 2010), published in 1935, provides an extensive approach for investing in all types of financial securities and markets. Published in 1938, The Theory of Investment Value (Williams 1997) describes how to value financial assets based on accounting data such as cash flow and profits. In particular, this approach uses the distribution of dividends as forecasting the stock price of a company known as stock valuation.
Period: 1940 to 1958
First published in 1940, Where Are the Customers' Yachts? or a Good Hard Look at Wall Street (Schwed 2006) depicts the questionable investment practices of Wall Street firms toward their clients. In 1949, Graham (2005) published The Intelligent Investor, which reveals the approach known as value investing (i.e., a method for evaluating and identifying stocks that an investor considers underpriced based on different types of accounting or financial information). Today, value investing is one of the most important investing strategies. Published in 1951, Other People's Money: A Study in the Social Psychology of Embezzlement (Cressey 1951) uses psychological theories to explain why individuals commit financial crimes and violate the trust of the public. Galbraith's (2009) The Great Crash 1929, published in 1954, serves as a reminder even today of how financial history repeats itself in understanding the financial crisis of 2007 and 2008.
Other notable books during this period include The Art of Contrary Thinking (Neill 1992), published in 1954, which describes why consensus investor group decision-making is sometimes wrong and how investors can use contrary strategies or trends to profit in the stock market. Published in 1957, Stock Market Behavior: A Descriptive Guidebook for the New Investor (Sargeant 1957) provides a perspective of the psychology underlying the stock market for novice investors. In 1958, Fisher (1997) published Common Stocks and Uncommon Profits, in which he reveals how to evaluate a firm's business prospects and financial health based on accounting data and financial statement information.
Period: 1969 to 1970
In the book first published in 1969, Once in Golconda: A True Drama of Wall Street 1920–1938 (Brooks 1999a) describes the time of economic expansion of the 1920s, the crash of 1929, and the aftermath of the 1930s Great Depression. The Winning Habit: How Your Personality Makes You a Winner or a Loser in the Stock Market (Appleman 1970) discloses an array of different personality types and connects them to how investors make decisions about stock investing. Published in 1970, Why Most Investors are Mostly Wrong Most of the Time (Scheinman 1991) describes the author's perspective of crowd psychology and the role of contrary opinions within the stock market during the 1960s.
Period: 1973 to 1978
In 1973, Brooks (1999b) authored The Go-Go Years: The Drama and Crashing Finale of Wall Street's Bullish 60s, in which he describes the speculative behavior during the bull market of the 1960s and the stock market crash in 1970. Malkiel (1973) published his highly popular A Random Walk Down Wall Street in which he discloses the importance of the random walk theory. Malkiel contends that investors cannot outperform stock market indexes on a regular basis because prices are random. Dreman's (1977) Psychology and the Stock Market: Investment Strategy beyond Random Walk depicts the importance of crowd psychology and group behavior within the stock market by highlighting topics such as bubbles, the social psychology of groups, groupthink, and herd behavior. This book also offers a counter argument to the random walk theory and efficient market hypothesis. First published in 1978, Manias, Panics and Crashes: A History of Financial Crisis (Kindleberger 1996) provides an extensive financial history of bubbles, frauds, crashes, contagions, and crises.
Investor Behavior
What is investor behavior? The field of investor behavior attempts to understand and explain investor decisions by combining the topics of psychology and investing on a micro level (i.e., the decision process of individuals and groups) and a macro perspective (i.e., the role of financial markets). The decision-making process of investors incorporates both a quantitative (objective) and qualitative (subjective) aspect that is based on the specific features of the investment product or financial service. Investor behavior examines the cognitive factors (mental processes) and affective (emotional) issues that individuals, financial experts, and traders reveal during the financial planning and investment management process. In practice, individuals make judgments and decisions that are based on past events, personal beliefs, and preferences.
Since 1995, an increasing number of books on investor behavior have been published in tandem with the emerging research literature within the overall discipline of behavioral finance. Exhibit 1.2 provides a chronological time line of investor behavior books published between 1995 and 2012. This compilation of books covers different subject matter including: stock market inefficiencies (Haugen 1995; Shleifer 2000), stock market psychology (Warneryd 2001; Schindler 2007), speculative behavior (Shiller 2000), anomalies (Zacks 2011), neuroeconomics and neurofinance (Peterson 2007; Zweig 2007), money behaviors (Furnham and Argyle 1998), money disorders (Klontz and Klontz 2009), investor personality (Pompian 2012), behavioral investment management (De Brouwer 2012; Davies and de Servigny 2012), psychological trading strategies (Lifson and Geist 1999), trader psychology (Oberlechner 2004; Fenton-O'Creevy et al. 2005; Shull 2012), investor emotions (Tuckett and Taffler 2012), and investor behavior or psychology (Belsky and Gilovich 1999; Shefrin 2000; Nofsinger 2002; Geist 2003; Pompian 2006; Montier 2007; Baker and Nofsinger 2010; Wood 2010; Statman 2011). This collection of books and other academic literature, such as published academic papers, working papers, conference presentations, and dissertations, serves as a reference point for developing the current content in this book in order to identify the most important emerging topics in investor behavior and psychology.
The importance of documenting the past and current research is to assist individual investors and their financial advisors about these biases and improve the decision-making process in selecting investment services, products, and strategies. As a result of the financial crisis of 2007 and 2008, the discipline of psychology began to focus even more on the financial decision-making process of individuals. This renewed interest by the social sciences and business disciplines has spurred new research on investor behavior including financial therapy, money counseling, financial psychology, consumer finance, investor personality, and household finance.
Purpose of the Book
This book's main purpose is to provide readers with the emerging theoretical trends about investment behavior within the ever-changing and growing financial services and investment management industry. Readers of Investor Behavior—The Psychology of Financial Planning and Investing will gain an in-depth understanding of the major types and the latest trends within the field of investor behavior. The book features empirical evidence and current literature about each investment issue. Cited research studies are presented in a straightforward manner focusing on the comprehension of study findings, rather than on the details of mathematical frameworks. Authors contributing chapters consist of a mix of academics and practitioners.
Distinctive Features of the Book
Investor Behavior—The Psychology of Financial Planning and Investing has the following distinctive features.
- The book provides a detailed discussion of investor behavior including empirical evidence and practice within the various topics covered. It attempts not only to blend the conceptual world of scholars with the pragmatic view of practitioners, but also to synthesize relevant research studies including recent developments in a succinct and clear manner.
- The book contains contributions from numerous authors, which assures a variety of perspectives and a rich interplay of ideas.
- When discussing the results of empirical studies that link theory and practice, the objective is to distill them to their essential content so that they are understandable to readers. Theoretical and mathematical derivations are included to the extent that they may be necessary and useful to readers.
- The end of each chapter contains four to six discussion questions that help to reinforce key concepts with guideline answers presented at the end of the book. This feature should be especially important to faculty and students using the book in classes.
Intended Audience
The book should be of interest to various groups including academics, practitioners, investors, and students. Academics can use this book not only in their undergraduate and graduate investment courses but also to understand the various strands of research emerging from this area. The book can help practitioners navigate through the key areas in investor behavior. Individual and institutional investors can use the book to expand their knowledge base. They can also apply the concepts contained within the book to the management of their portfolios. The book can serve as an introduction to students interested in investor behavior. Finally, Investor Behavior—The Psychology of Financial Planning and Investing can be of interest to members of such organizations as the Academy of Behavioral Finance & Economics, Financial Therapy Association, Association for Financial Counseling and Planning Education, Financial Planning Association, The CFA Institute, Academy of Financial Services, Society for the Advancement of Behavioral Economics (SABE), American Accounting Association: Accounting, Behavior, and Organizations Section (Behavioral Accounting Group), International Association for Research in Economic Psychology (IAREP), and Society of Judgment and Decision Making.
ORGANIZATION OF THE BOOK
The remaining 29 chapters are organized into six sections. A brief synopsis of each chapter by section follows.
Part I: Foundations of Investor Behavior
Besides this introduction, Part I consists of two other chapters. Chapter 2 focuses on the basic principles of traditional (standard) finance and behavioral finance. Chapter 3 examines behavioral economic approaches to decision-making.
Chapter 2: Traditional and Behavioral Finance (Lucy F. Ackert)
The purpose of this chapter is to compare and contrast traditional and behavioral finance. In traditional finance, which has been the dominant paradigm for several decades, investors make rational choices leading to maximizing expected utility. The fundamental issues of traditional finance are classical decision theory, rationality, risk aversion, model portfolio theory (MPT), the capital asset pricing model (CAPM), and the efficient market hypothesis (EMH). However, evidence shows that many of the assumptions and findings associated with traditional finance are invalid. Thus, behavioral finance researchers turned to observed behaviors to develop models that describe how investors actually reach their decisions. Behavioral finance uses insights from the social sciences to better understand the investor behavior of individuals, groups, and markets. Among the foundation topics in behavioral finance are behavioral decision theory, bounded rationality, prospect theory, framing, heuristics, overconfidence, regret theory, and mental accounting. The emerging areas of research are behavioral portfolio theory, the behavioral asset pricing model (BAPM), and the adaptive markets hypothesis.
Chapter 3: Behavioral Economics, Thinking Processes, Decision-Making, and Investment Behavior (Morris Altman)
This chapter provides a critical review of behavioral economic approaches to decision-making with a focus on the thinking processes of investors. It discusses the bounded rationality approach to decision-making as compared to the errors and biases approach for better understanding decision-making processes and outcomes. The latter focuses on the importance of cognitive illusions and biases whereas the former pays more attention to the optimality of institutional design and the limited information processing capacity of the human brain. Both approaches attempt to make sense of and explain why decision-making outcomes tend to be inconsistent with the predictions of the conventional economics wisdom, especially regarding the efficient market hypothesis. The chapter also extends the analyses of the behavioral understanding of decision-making, especially from the bounded rationality modeling perspective.
Part II: Personal Finance Issues
Part II consists of Chapters 4 through 10. The section explores such important areas as financial literacy and education (Chapter 4) and household investment decisions (Chapter 5). It also examines the role of personality traits (Chapter 6), demographic and socioeconomic factors (Chapter 7), and religion (Chapter 8) on investor behavior. The final two chapters investigate money and happiness (Chapter 9) and motivation and satisfaction (Chapter 10).
Chapter 4: Financial Literacy and Education (Michael S. Finke and Sandra J. Huston)
Financial literacy is a form of human capital that includes knowledge and skills related to personal finances including mathematical ability, knowledge of financial instruments and financial theory, and the ability to apply knowledge effectively. This chapter reviews how financial literacy has been conceptualized and measured in the literature. Financial literacy is related to many positive financial outcomes. Newer studies focus on identifying the pathways between financial literacy and asset accumulation, portfolio selection, and credit choice. Evidence shows that financial education can improve financial literacy and decision quality, but also questions whether financial literacy education is effective or socially efficient. Low levels of financial literacy among consumers suggest a need for increased high school financial literacy education and policies that provide simplified disclosure and high quality defaults.
Chapter 5: Household Investment Decisions (Vicki L. Bogan)
Within the area of finance, most basic theoretical models do not fully describe true household investment decision-making behavior. This is due in large part to the fact that most traditional finance models are based on the assumptions that financial markets operate without frictions and that all people make perfectly rational decisions. Yet, when considering how academic models are applied in the real world, these fundamental assumptions do not always hold. This chapter discusses how market frictions and specific behavioral biases actually influence household investment behaviors.
Chapter 6: Personality Traits (Lucia Fung and Robert B. Durand)
Personality captures a person's essence. Understanding one's personality helps explain and predict the decisions an individual makes and what a person will do. This chapter focuses on the predominant structural model of personality—the Five-Factor Model—which encapsulates personality using five higher-order traits: Extraversion, Agreeableness, Conscientiousness, Neuroticism, and Openness to Experience/Intellect. The Five-Factor Model is rooted in biology and is genetically based. Personality traits are a major aspect of risk taking and overconfidence behaviors. Understanding personality can improve decision-making if it helps to regulate and override dispositional tendencies leading to suboptimal outcomes.
Chapter 7: Demographic and Socioeconomic Factors of Investors (James Farrell)
Examining the demographic and socioeconomic factors in investor behavior is important to understanding how investors choose their portfolios. The extant literature suggests that men invest more aggressively than women and white investors invest more aggressively than African American investors. The reasons for the differences include income, wealth, age, education, risk preference, and background. Although studies try to explain away the differences attributable to gender and race, these differences persist. The chapter includes theories about how psychological differences help to explain losses and intergenerational transfers of wealth. It also examines recent research on the roles of gender and race in investment preferences. The analysis confirms that white males are the most aggressive investors and African American men take a more active approach to their investments. By contrast, white women tend to default into more conservative investments.
Chapter 8: The Effect of Religion on Financial and Investing Decisions (Walid Mansour and Mouna Jlassi)
Religion has a major impact on people's daily life and is closely connected with their economic condition. The purpose of this chapter is to discuss the connection between religion and economic factors and to show how religion affects investment and financing decisions. It focuses on this interplay by emphasizing various corporate and personal facets. For instance, the chapter analyzes the effect of religious beliefs on investors' preferences, risk perception, ethical values, and psychological behavior. This aspect is often missing in academic finance including the behavioral paradigm. Furthermore, the chapter discusses how religious beliefs can conflict with financial theory involving making financial and investing decisions.
Chapter 9: Money and Happiness: Implications for Investor Behavior (Jing Jian Xiao)
This chapter provides a synthesis of the research literature on the relationship between money and happiness. Money refers to income and income-related factors. Happiness is typically measured by life satisfaction, but also by daily happiness and living a meaningful life. Based on research evidence, personal income increases happiness to a certain degree in a nonlinear fashion. In the range from low to middle income, income has a strong positive relationship with happiness. From middle to high income levels, the positive association between income and happiness diminishes. People living in richer countries are happier. Unhappiness results from seeking materialist goals. Most research studies examine whether income increases happiness. The emerging academic literature examines the reverse causality and explores whether happier people make more money, which is gaining empirical support. The chapter provides a discussion of the implications of these research findings for investor behavior.
Chapter 10: Motivation and Satisfaction (Lewis J. Altfest)
This chapter attempts to answer the question, “What motivates people and can they be helped to achieve life satisfaction?” It transitions from classical economic theory to behavioral economics, which includes the behavioral life cycle hypothesis, and on to humanistic thoughts. Each theory presents differing views of motivation and satisfaction. The centerpiece of the chapter is Maslow's hierarchy of needs, which ranges from basic needs to highly sophisticated aspirations. Maslow's humanistic emphasis places it in conflict with classical economic beliefs. The chapter presents an approach that strives to integrate classical theory and Maslow-influenced humanism within a personal financial planning framework.
Part III: Financial Planning Concepts
This seven-chapter section begins by discussing policy-based financial planning (Chapter 11). Next, it turns to evolving topics such as financial counseling and coaching (Chapter 12), financial therapy (Chapter 13), and transpersonal economics (Chapter 14). The section then focuses on advising the behavioral investor (Chapter 15) and the contributions of behavioral finance and behavioral economics to retirement planning (Chapter 16). The final chapter in this section discusses how to use a scorecard approach to improve medical and financial outcomes.
Chapter 11: Policy-Based Financial Planning: Decision Rules for a Changing World (Dave Yeske and Elissa Buie)
Financial planning policies are compact decision rules that can act as a touchstone for both clients and their advisors and allow for rapid decision-making in the face of a changing environment. Good policies represent the distillation of client goals and values, as well as the relevant financial planning best practices, in a form that can both anchor the client to a consistent course of action and save the advisor from the necessity of “crunching the numbers” every time a question arises. Evidence suggests that the process of developing policies involving the client is largely associated with higher levels of client trust and relationship commitment. Further, trust and commitment are associated with qualities predictive of a successful financial planning engagement, including higher client satisfaction and retention, with a greater propensity to reveal personal and financial information and to implement planning recommendations.
Chapter 12: Financial Counseling and Coaching (John E. Grable and Kristy L. Archuleta)
Financial counseling is generally conceptualized as a short-term process concerned with helping people change their financial behavior through applied education and guidance. Counseling typically involves helping people clarify issues, explore options, assess alternatives, make decisions, develop strategies, and plan courses of action in an effort to change financial attitudes and behavior. Similarly, financial coaching blends aspects of financial counseling, financial planning, and personal coaching to help clients establish and reach long-term financial goals through directed behavioral change. This chapter discusses the history of financial counseling and financial coaching, theoretical approaches commonly used in financial counseling, and the current state and professional directions of counseling and coaching.
Chapter 13: Financial Therapy: De-Biasing and Client Behaviors (Joseph W. Goetz and Jerry E. Gale)
This chapter introduces an emerging field of study and practice called financial therapy. Financial therapy has applications in furthering the knowledge base around money psychology and addressing maladaptive financial beliefs and decisions of individuals and families. In contrast to traditional finance, financial therapy assumes individuals and couples often fail to make the rational financial decisions that lead to expected utility maximization. It also assumes that individuals' financial choices are strongly influenced by their financial socialization, cognitive biases, emotional factors, and their past experiences with money within various social systems. Foundational topics in financial therapy covered in this chapter include the concept and history of financial therapy, theoretical and conceptual frameworks that provide a basis for financial therapy practice and research, and the need for evidence-based financial therapy interventions.
Chapter 14: Transpersonal Economics (Renée M. Snow)
The need for economic stability has received considerable attention during the past few years as a result of the severity of the global recession. Financial pathology arises from personal, cultural, and transpersonal influences that comprise belief systems. In turn, these belief systems inform thoughts, emotions, and behaviors. Examining the historical roots of Western misidentification with wealth creates awareness and provides space for new choices. The wisdom tradition of Jainism illustrates the ability to be mindful of the ecology while creating economic prosperity. A study of Certified Financial Planners (CFPs) who scored high in transpersonal awareness reveals the same essential practice and soul recognition as Jains employ. These participants experience higher client retention and job satisfaction rates than those who score lower in transpersonal awareness. This research suggests the possibility of improving economic performance through exploring and implementing practices rooted in transpersonal psychology.
Chapter 15: Advising the Behavioral Investor: Lessons from the Real World (Gregg S. Fisher)
According to behavioral finance theory, investors are not the rational actors that economic theory describes. Rather, they are human beings whose decision-making can be driven by cognitive and emotional factors. Research evidence shows innumerable examples of investors behaving in ways that are counter to their own best interests. But there is good news about behavioral investors. First, many ways are available in which financial advisors can help their clients stay rational when the markets are not, thus improving their chances of staying with a well devised long-term investment strategy and realizing its ultimate benefits. Second, investment strategies can be constructed that actually profit from the bias-driven decisions of other market participants. Thus, investors can learn and profit from others' mistakes. The purpose of this chapter is to apply the theory in behavioral finance and economics by exploring the practical, observable manifestations of investor behavior and to quantify their impact on investment results.
Chapter 16: Retirement Planning: Contributions from the Field of Behavioral Finance and Economics (James A. Howard and Rasoul Yazdipour)
An important challenge facing employees and societies is saving and investing sufficient funds for a comfortable retirement. Research shows that human financial decision-making behavior is not always rational and that public trust in the economy can be lost. Surprisingly, neither better disclosure of financial services and products nor education has had a discernible effect in motivating individuals to effectively plan and save for transitioning out of the workforce. The fields of cognitive psychology and neuroscience identify many behavioral obstacles individuals face in taking the needed steps to save and invest more for the future. A host of behavioral issues influence an individual's decision-making about retirement including biases, heuristics, framing, hyperbolic discounting, self-awareness, and self-control. The emerging works on trust also add to understanding the retirement planning system. Exploring these findings and strategies for mitigating financial decision-making errors can make a substantive contribution to achieving a more secure retirement.
Chapter 17: Knowing Your Numbers: A Scorecard Approach to Improved Medical and Financial Outcomes (Talya Miron-Shatz and Stephanie Gati)
Health literacy is the ability to obtain, process, and understand basic health information needed to make appropriate health decisions and follow instructions for treatment. Financial literacy is its equivalent in the financial domain, facilitating decisions on investments, retirement, health insurance, and more. This chapter proposes to overcome the medical and financial consequences of poor health literacy with a short, simple, and motivating digital scorecard for maintaining health and controlling chronic disease such as diabetes. The scorecard aggregates medical and lifestyle indicators that are easily interpretable without mediation by a physician, thereby informing the public of health-promoting behaviors. A pilot study project and surveys done at Carnegie Mellon University demonstrate the competitive strengths of a scorecard approach versus existing tools. Drawing parallels between health and financial literacy, the chapter illustrates the cost of low financial literacy and proposes that it can be improved through this approach, thereby strengthening financial decision-making.
Part IV: Investor Psychology
Part IV consists of seven chapters involving investor psychology. The section begins by examining risk perception and risk tolerance (Chapter 18). Next, it examines the important topics of emotions (Chapter 19), human psychology and market seasonality (Chapter 20), and neurofinance (Chapter 21). The remaining three chapters investigate diversification and asset allocation puzzles (Chapter 22), behavioral portfolio theory and investment management (Chapter 23), and post crisis investor behavior (Chapter 24).
Chapter 18: Risk Perception and Risk Tolerance (Victor Ricciardi and Douglas Rice)
This chapter provides an overview of the research literature and the important issues regarding risk perception and risk tolerance. The academic literature reveals that various disciplines provide an assortment of perspectives in terms of how to define, describe, and analyze risk. The behavioral finance perspective encompasses the subjective and objective factors of risk within the domains of risk perception and risk tolerance. Risk perception is the subjective decision-making process that an investor uses when evaluating risk and the amount of uncertainty. Risk tolerance is the degree of risk that an investor is willing to endure in the pursuit of a financial objective. A major problem within the risk tolerance literature is the lack of general agreement about issues such as a standard definition, a uniform theory or model, measurement discrepancies, and the growing number of questionnaires. Academic researchers and practitioners are only now starting to study and understand the long-term effects of the financial crisis in 2007 and 2008 on investor risk-taking behavior.
Chapter 19: Emotions in the Financial Markets (Richard Fairchild)
Standard or traditional finance research is based on the rational choice model that assumes market participants are fully rational, unbiased, emotionless, self-interested maximizers of expected utility. Recent research in behavioral finance recognizes that real-world investors and managers are not fully rational because they are affected by psychological biases and subject to conscious emotions in their decision-making. In a paradigm shift, emotional finance considers the effect of investors' and managers' unconscious emotions and infantile phantasies on market behavior employing a Freudian psychoanalytical framework. This chapter reviews this research and considers a formal modeling framework for emotional finance.
Chapter 20: Human Psychology and Market Seasonality (Lisa A. Kramer)
Evidence suggests that human psychology plays a role in individuals' financial decisions, with economically meaningful consequences observed even at the aggregate market level. This chapter considers many instances whereby human mood induced by exogenous factors is associated with economically large, statistically significant effects in financial markets. Some regularities covered by this chapter arise due to environmental factors. For instance, a relationship appears between seasonal length of day and stock returns, working through seasonal changes in depression and risk aversion. This chapter also considers financial market regularities that are consistent with mood changes due to events in the news, such as terrorist attacks, and forms of entertainment such as sporting events. In most cases, authors of the original studies apply extensive robustness checks to explore alternate hypotheses, namely that the phenomenon may arise for non-psychological reasons. The body of research builds a compelling case that human mood can markedly affect markets.
Chapter 21: Neurofinance (Richard L. Peterson)
Biology can have both constructive and damaging effects on investment decision-making. Both research and clinical evidence confirm that subtle shifts in neurochemistry affect financial decision-making. These alternations in brain functioning are driven by events as mundane as the weather and as intense as images from a riot. Despite the individual nature of financial decision making, an understanding of neurobiology can also be applied at the group level. Exogenous shocks and the endogenous environment affect both individuals and the crowds of financial decision makers of which they are a small part. The decisions of such crowds shift global asset prices. This chapter explores research into the biology of financial decision-making and demonstrates how many of the most successful financiers have built decision processes that strengthen vulnerabilities identified by neurofinance researchers.
Chapter 22: Diversification and Asset Allocation Puzzles (Dimitris Georgarakos)
Asset allocation and portfolio diversification decisions have important welfare and policy implications. This chapter reviews studies that examine three key aspects of financial investing: participation in stock markets, portfolio diversification, and trading behavior. Standard finance theory predicts the optimal investment behavior of rational agents with reference to each of these three aspects. Yet, empirical studies document that observed behavior of investors largely deviates from theory predictions. The chapter also provides a discussion of empirical regularities that point to these deviations such as the limited stock market participation, the poor diversification and preference for domestic securities, and the contrast between excess trading activity of a few wealthy investors and considerable trading inertia exhibited by the majority of the population. These issues become increasingly topical as investors face a richer menu of complex financial instruments and gradually assume higher responsibility for retirement financing.
Chapter 23: Behavioral Portfolio Theory and Investment Management (Erick W. Rengifo, Rossen Trendafilov, and Emanuela Trifan)
This chapter focuses on the attitude of investors toward financial gains and losses and their decisions on wealth allocation, and how these changes are subject to behavioral factors. The focal point is the integration of behavioral elements into the classic portfolio optimization. Individual perceptions are modeled according to four separate frameworks that build on each other: prospect theory, safety-first portfolio theory, security-potential/aspiration (SP/A) theory, and behavioral portfolio theory. SP/A theory evolves from safety-first portfolio theory and the introduction of aspiration level. The behavioral portfolio theory integrates the idea of mental accounts from prospect theory with the portfolio optimization framework of the SP/A theory and in this way it creates a unified model. The last part of the discussion addresses the behavioral asset pricing model (BAPM).
Chapter 24: Post-Crisis Investor Behavior: Experience Matters (Joseph V. Rizzi)
The historic financial crisis in 2007 and 2008 seriously affected investors. In general, stock market values declined by about 50 percent but largely recovered from pre-crisis levels by the end of 2012 due in part to unprecedented stimulus efforts. Nonetheless, the cumulative return on stocks over the five-year period was close to zero. Investors are likely to learn from this experience and may adjust their investment behavior. Both individual experience and the collective behavior of groups sharing the same historical event influence risk tolerance. Recent studies highlighting a collective memory effect support this notion, which has important implications on investor asset allocation decisions. This chapter illustrates how a lingering generational effect influences the risk appetite and equity allocations of younger investors.
Part V: Trading and Investing Psychology and Strategies
Part V consists of three chapters. The first two chapters deal with various aspects of trading and investing psychology (Chapters 25 and 26) and the third chapter examines strategies (Chapter 27).
Chapter 25: The Psychology of Trading and Investing (Julia Pitters and Thomas Oberlechner)
In contrast to the assumption of standard economic theories, human beings cannot always make rational investment and trading decisions. Thus, psychological explanations are needed to shed light on the complexity of actual decision-making processes. The purpose of this chapter is to provide an overview of relevant psychological perspectives to explain trading and investment decisions. Starting on the individual level, the chapter examines how personality, mood, affect, and cognitive biases shape investment and trading decisions. Next, the chapter moves to the societal level and discusses how herding, social norms, cultural norms, and ethics play a role in financial decisions. Finally, the chapter shows how news, rumors, and market mood influence trading behavior on the macro level.
Chapter 26: The Surprising Real World of Traders' Psychology (Denise K. Shull, Ken Celiano, and Andres Manaker)
Trading psychology offers a unique look at unexpected factors in risk decisions made in uncertain circumstances. Traders, by definition, constantly make judgment calls and face a roller coaster of positive and negative feedback via the authority figure of price. Emanating from the historically dominant theories of efficient markets, human rationality, and the cognitive-behavioral school of psychology, conventional wisdom teaches that success emerges from accurate quantitative analyses. Multidisciplinary research in perception, judgment, and decision-making under uncertainty combined with qualitative evidence from hundreds of client interviews and coaching sessions with traders about investment performance reveal a different story. Unconscious affective contexts stemming from historical and current social milieus and revealed in what today's brain scientists call “embodied cognition” paint a more accurate picture.
Chapter 27: Trading and Investment Strategies in Behavioral Finance (John M. Longo)
The chapter describes investment and trading strategies rooted in behavioral finance that historically have generated superior profits. The failure of traditional finance models, such as those based on purely rational behavior, to explain how markets work has enabled behavioral finance to move into the foreground among practitioners. Most investors are fraught with behavioral biases and their investment performance reflects this unfortunate fact. However, hope exists for those seeking to improve investment performance. Investment analysts will become akin to doctors analyzing the vast complexity of the human genome. An individual may be susceptible to a specific disease based on his or her genetic makeup, but something, such as an environmental trigger, must activate it. Similarly, successful investment analysts should examine not only the fundamental and technical aspects of securities but also the behavioral factors that ultimately influence their market prices.
Part VI: Special Investment Topics
The final section presents a discussion of three diverse but highly relevant topics. The first topic involves an engaging discussion of ethical and socially responsible investing (Chapter 28). The next topic is an examination of behavioral issues involving mutual funds and individual investors (Chapter 29). The final topic deals with psychological biases involving investing in real estate (Chapter 30).
Chapter 28: Ethical and Socially Responsible Investing (Julia M. Puaschunder)
The chapter describes the various forms and emergence of ethical investing and discusses investor motives to engage in socially responsible investment (SRI). Ethical investing and SRI are derived from historical incidents, legislative compulsion, and stakeholder pressure in response to social, environmental, and political deficiencies as well as humanitarian crises in recent decades. Private investors choose socially conscious screenings, shareholder advocacy, community investing, and social venture capital funding for efficiency and long-term competitive considerations coupled with altruistic and personal social responsibility, entrepreneurial endeavors, and self-expression. The chapter also provides a synthesis of research on the performance of SRI funds relative to conventional stock mutual funds. Finally, the chapter provides a discussion of international financial social responsibility practices and standardization attempts throughout the international arena as well as the potential of SRI to avert future financial market downfalls in the aftermath of the global financial crisis.
Chapter 29: Mutual Funds and Individual Investors: Advertising and Behavioral Issues (John A. Haslem)
The chapter reviews important interactions between mutual funds and individual investors in choosing equity mutual funds. An important question is why both sophisticated and unsophisticated investors continue to invest in actively managed funds that generally underperform. Actively managed funds have histories of high levels of spending on advertising because they know it works in increasing assets under management. Fund managers have learned that investors chase past performance in the mistaken belief that the past predicts future performance. Funds further take advantage of investors by increasing advertising when current past performance is high. Advertising encourages individual investors to make fund choices in specific funds because they are generally unsophisticated, uninformed, and have low financial literacy, including a lack of knowledge of both transparent and opaque fund expenses and fees. Any persistence in high fund performance is also much more likely due to luck than portfolio manager skill. The Securities and Exchange Commission (SEC) has also failed to prohibit performance advertising or to require it to be unambiguous.
Chapter 30: Real Estate Investment Decision-Making in Behavioral Finance (Eli Beracha and Hilla Skiba)
The real estate market displays many of the behavioral biases documented in the traditional financial markets. During bull markets, investor overconfidence, optimism, representativeness, and self-attribution bias among others drive prices far above their fundamental values. Conversely, during bear markets, loss aversion, false reference points and anchoring, and familiarity bias drive prices below their fair values. Combining these behavioral biases with severe limits to arbitrage including the illiquid nature of the market, high transaction costs, and short sale constraints can magnify the effect of psychological biases on real estate valuations. As a result, real estate prices in the short and medium time horizon often deviate from their fundamental values and price adjustments are slow. This chapter reviews common psychological biases in the context of real estate and the consequences of these biases to markets.
SUMMARY
Although traditional finance has been the recognized theory of academic finance since the 1960s, the field of behavioral finance offers a new perspective of investment psychology for finance professors, financial practitioners, individual investors, and finance students. In the early to mid-1990s, the academic literature on investor behavior began to emerge that questioned many of the tenets and theories of traditional finance. The foundation for this new body of knowledge has developed over the past 150 years as demonstrated with the publication of books and other academic literature on financial history and investment theory. In the aftermath of the financial crisis of 2007 and 2008, behavioral finance has a wider acceptance among financial practitioners and individual investors. However, a strong level of resistance to behavioral finance still exists within academic finance among those trained in and proponents of traditional finance.
A unique aspect of this book is that many of the emerging topics in the forthcoming chapters focus on the psychologically oriented subject matter of the individual decision maker, also known as microbehavioral finance. This perspective is especially important for understanding and improving the client-advisor relationship between individual investors (clients) and investment professionals (advisors). Although financial planners, investors, and others can't change the past, they can learn from it and move forward. This book provides guidance on leaving old, well-trodden paths and venturing forward to follow new ones. Enjoy the journey!
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ABOUT THE AUTHORS
H. Kent Baker is a University Professor of Finance in the Kogod School of Business at American University. Professor Baker has authored or edited 20 books of which his most recent with Oxford University Press are Portfolio Theory and Management (2013), International Finance: A Survey (2013), and Survey Research in Corporate Finance (2011). His most current books with John Wiley & Sons are Market Microstructure in Emerging and Developed Markets (2013), Alternative Investments: Instruments, Performance, Benchmarks, and Strategies (2013), and Socially Responsible Finance and Investing: Financial Institutions, Corporations, Investors, and Activists (2012). As one of the most prolific authors among finance academics, he has published more than 150 refereed articles in such journals as the Journal of Finance, Journal of Financial and Quantitative Analysis, Financial Management, Financial Analysts Journal, Journal of Portfolio Management, and Harvard Business Review. He has consulting and training experience with more than 100 organizations and serves on six editorial boards. Professor Baker holds a BSBA from Georgetown University; MEd, MBA, and DBA degrees from the University of Maryland; and MA, MS, and two PhDs from American University. He also holds CFA and CMA designations.
Victor Ricciardi is an Assistant Professor of Financial Management at Goucher College. He teaches courses in financial planning, investments, corporate finance, behavioral finance, and the psychology of money. He is the editor of several eJournals distributed by the Social Science Research Network (SSRN) at www.ssrn.com, including behavioral finance, financial history, behavioral economics, and behavioral accounting. He received a BBA in accounting and management from Hofstra University and an MBA in finance and Advanced Professional Certificate (APC) at the graduate level in economics from St. John's University. He also holds a graduate certificate in personal family financial planning from Kansas State University. He can be found on Twitter @victorricciardi.