Without reopening the efficient markets/rational agents can of worms, anyone who has risked money in the markets is aware, on some level, how emotions can play a significant — sometimes deciding — role in trading and investment decisions.
Behavioral finance, along with the related fields of neuroeconomics and neurofinance, looks at financial decisions through the lenses of psychology and brain science. Serious researchers and academics in these disciplines go beyond the “my mom hated me so I punish myself with bad trades” pop psychology to look at the ways human psychology and brain function shape the way we look at risk and make financial decisions.
A new book, Investor Behavior: The Psychology of Financial Planning and Investing (Wiley, 2014), is a compendium of behavioral finance research contributed by more than 40 authors, spanning 30 chapters and more than 600 pages. Coedited by Victor Ricciardi and H. Kent Baker, the book contains material geared to financial professionals as well as individual traders and investors, with topics ranging from personal finance and planning to trading and investing psychology and strategies.
Ricciardi, 45, is a Finance Professor at Goucher College in Baltimore, where he focuses on current trends in behavioral finance. He is also coordinator of behavioral and experimental research for the Social Science Research Network (www.ssrn.com), where he edits eJournals on behavioral finance, financial history, behavioral economics, risk, and behavioral accounting.
Ricciardi, who earned an undergraduate degree in accounting and an MBA in finance, was introduced to behavioral finance when he was a graduate student. He began his career as a mutual fund accountant, working on Wall Street for six or seven years at Dreyfus and Alliance Capital Management.
Although Ricciardi says behavioral finance is “highly accepted and applied” by financial planners and financial analysts, and is making inroads in other areas of the financial industry, he’s somewhat concerned about its growing popularity.
“My concern is that because it’s such a buzzword right now, there are people who are latching onto the field who are not necessarily experts in it,” he says. “I would warn people that, like anything else, when something becomes a hot topic, suddenly everyone’s an ‘expert.’”
We spoke to him in early June about the new book.
AT: What was your goal in putting together this book?
VR: The objective was to develop the first comprehensive behavioral finance book that integrates the financial planning process and investment management based on the emerging research findings.
The vast majority of the content in the book focuses on the decision-making process of the individual. This micro-behavioral finance viewpoint gives readers extensive new research for understanding their mental mistakes, and offers individual investors and traders methods for improving the decision-making process.
We really tried to pare out a lot of the equations and academic studies and hone in on the most important findings in the field, to try to help people with best practices and strategy so they can become better decision makers.
AT: What do you think are the most important ideas in your book for self-directed investors and traders?
VR: For long-term investors, an important lesson is to understand the specific mental mistakes and emotional issues they suffer from and then develop a disciplined strategy. A major lesson is to balance an active strategy with a passive strategy that is rebalanced on a yearly basis.
For traders, a major issue is to understand the difference between trading and investing strategies in behavioral finance. Examples of trading strategies are momentum, earnings surprises, investor sentiment indicators, and observing the herding behavior of hedge funds in Form 13F filings.
Investing approaches are long-term price reversals associated with the concepts of mean reversion, contrarian investing, value strategies such as the “Dogs of the Dow,” and various stock market anomalies such as the “January Effect.”
AT: What’s the herding behavior associated with 13F filings you refer to?
VR: The SEC requires that all institutional investors with over $100 million in assets under management disclose a portion of their holdings in Form 13F on a quarterly basis. The filings for Form 13F provide important holdings of the top portfolio managers, including those managed by hedge funds. Traders and sophisticated investors follow these filings and demonstrate herd behavior by purchasing the securities held by these institutional investors in the pursuit of higher investment returns.
AT: Were there any unexpected revelations from your contributors — ideas or perspectives you hadn’t considered before, or saw in a new light?
VR: A major finding from the book for me was the unique polar opposition of traders vs. investors.
Traders tend to trade too much because they are overconfident, and this reduces their profits at times.
Investors in retirement accounts demonstrate the opposite behavior. Retirement savers tend to be “status quo” investors who suffer from inertia and a lack of activity, which can negatively impact an individual’s risk tolerance and asset-allocation strategy.
AT: Because of the key role emotions play in trading and investing, do you — or any of your contributors — feel the pitfalls of emotional decision-making are best avoided by using a systematic or mechanical approach? Or is there a positive role emotions can play in the trading or investment process?
VR: The answer to both questions is yes. The chapter contributors demonstrate both viewpoints by separating the trader and investor categories — there are certain biases that might affect traders and others that might impact long-term investors. Another important factor is the role of personality within the decision-making process and how an individual perceives risk.
AT: Can you give an example of a situation where emotions would be a positive rather than a negative?
VR: In the risk-taking domain some researchers make an assumption of a positive relationship between emotion and risk known as the Affect Infusion Model. The premise of this model is a positive mood increases a person’s risk tolerance. For example, a trader in a happy or positive mood would more likely invest in a risky asset such as a stock.
AT: If you had to pick one key behavioral bad habit investors should try to understand and avoid, what would it be?
VR: The notion of “anchoring” has a detrimental influence on all categories of investors. The anchoring bias is the strong preference we all have to latch on to a viewpoint that may or may not be true, and use it as a reference point for future decisions.
For example, if a trader lost money on a technology stock in the past, the anchoring bias might prevent someone from buying a technology stock in the future. Unfortunately, even when a person realizes he or she is suffering from anchoring bias, it’s difficult for them to lift the “anchor” if the past decision was very traumatic.
AT: Did working on the book help you better understand your own mental mistakes?
VR: Yes, I am always learning new things about myself. I tend to be overconfident, a risk-taker, and a worrier at times. I suffer from regret and the anchoring bias, and I hate realizing a loss.
AT: What directions do you think behavioral finance will be headed in the coming years?
VR: A newer area of study is the role of our subconscious. For example, the subconscious of an individual watching a negative news story on television might influence a person’s mood, resulting in that trader paying a higher price for a stock.
Another interesting area is neurofinance, in which our biology influences our decision-making process. Observing our brain patterns might one day identify our investing and spending patterns. Finally, many professionals are starting new practices and firms for providing investors with financial counseling for “money disorders,” and giving traders psychological coaching to make better decisions.