Behaviour Finance Baker Et 2017-Dikonversi

Financial Behavior
FINANCIAL MARKETS AND INVESTMENTS SERIES

H. Kent Baker and Greg Filbeck, Series Editors
Portfolio Theory and Management

Edited by H. Kent Baker and Greg Filbeck
Public Real Estate Markets and Investments
Edited by H. Kent Baker and Peter Chinloy
Private Real Estate Markets and Investments
Edited by H. Kent Baker and Peter Chinloy
Investment Risk Management
Edited by H. Kent Baker and Greg Filbeck
Private Equity: Opportunities and Risks
Edited by H. Kent Baker, Greg Filbeck, and Halil Kiymaz
Mutual Funds and Exchange-Traded Funds: Building Blocks to Wealth
Edited by H. Kent Baker, Greg Filbeck, and Halil Kiymaz
Financial Behavior
PLAYERS, SERVICES, PRODUCTS, AND MARKETS
H. KENT BAKER
GREG FILBECK
and
VICTOR RICCIARDI
1
1
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Library of Congress Cataloging-in-Publication Data

Names: Baker, H. Kent (Harold Kent), 1944- editor. | Filbeck, Greg, editor. | Ricciardi, Victor,
editor.
Title: Financial behavior : players, services, products, and markets / [edited by] H.
Kent Baker, Greg Filbeck, and Victor Ricciardi.
Description: New York City : Oxford University Press, 2017. | Series: Financial
markets and investments series | Includes index.
Identifiers: LCCN 2016036009 | ISBN 9780190269999 (hardcover)
Subjects: LCSH: Investments—Psychological aspects. | Investments—Decision making. | Finance—Psychological
aspects.
Classification: LCC HG4515.15 .F56 2016 | DDC 332.601/9—dc23 LC record
available at https://lccn.loc.gov/2016036009
987654321
Printed by Sheridan Books, Inc., United States of America
Contents
List of Figures ix
List of Tables xi
Acknowledgments xiii
Acronyms and Abbreviations xv
About the Editors xix
About the Contributors xxi
Part One FINANCIAL BEHAVIOR AND PSYCHOLOGY

1. Financial Behavior: An Overview 3
H. KENT B AKER, GREG FILBECK, AND VI CT OR RI CCIARDI
2. The Financial Psychology of Players, Services, and Products 23

V I CT OR R I C C I A R D I
Part Two THE FINANCIAL BEHAVIOR OF MAJOR PLAYERS

3. Individual Investors 45
HENRIK CRONQVI ST AND D ANLING JIANG
4. Institutional Investors 64
ALEXANDRE SKIB A AND HILLA SKIB A
5. Corporate Executives, Directors, and Boards 79

J O H N R. N O F S I N G E R A N D P A TT A N A P O R N C H A T J U T H A M A R D
v
vi Contents
6. Financial Planners and Advisors 97
BENJ AMIN F . CUMMINGS
7. Financial Analysts 118

SU S AN M. Y OUNG
8. Portfolio Managers 135

ERIK DEVOS, ANDREW C. SPIELER, AND JOSEPH M. TENA GLIA
9. Financial Psychopaths 153

DEBORAH W. GREGORY
Part Three FINANCIAL AND INVESTOR PSYCHOLOGY

OF SPECIFIC PLAYERS
10. The Psychology of High Net Worth Individuals 173

R E B E C C A L I - HU A N G
11. The Psychology of Traders 192

DUCCI O MARTELLI
12. A Closer Look at the Causes and Consequences of Frequent

Stock Trading 209
MI CHAL STRAHILEVITZ
13. The Psychology of Women Investors 224
MARGUERIT A M. CHENG AND S AMEER S. SOMAL
14. The Psychology of Millennials 241
APRIL RUDIN AND CA THERINE MCBREEN
Part Four THE PSYCHOLOGY OF FINANCIAL SERVICES
15. Psychological Aspects of Financial Planning 265
D A VE YESKE AND ELI SS A BUIE

Contents vii
16. Financial Advisory Services 285
JEROEN NIEBOER, P A UL DOLAN, AND IVO VLAEV
17. Insurance and Risk Management 302

J A M E S M . M O T E N J R . A N D C. W. C O P E L A N D
18. Psychological Factors in Estate Planning 318
JOHN J. GUERIN AND L. P A UL H OOD JR.
19. Individual Biases in Retirement Planning

and Wealth Management 337
J AMES E. BREWER JR. AND CHARLES H. SELF III
Part Five THE BEHAVIORAL ASPECTS OF INVESTMENT

PRODUCTS AND MARKETS
20. Traditional Asset Allocation Securities: Stocks, Bonds, Real

Estate, and Cash 359
C H R I S T O P H E R M I L L I K E N , E H S AN N I K B A K H T ,
A N D A N D R E W C. S P I E L E R
21. Behavioral Aspects of Portfolio Investments 378

NA THAN MA UCK
22. Current Trends in Successful International M&As 397

NANCY HUBB ARD
23. Art and Collectibles for Wealth Management 422
PETER J. MA Y
Part Six MARKET EFFICIENCY ISSUES
24. Behavioral Finance Market Hypotheses 439
ALEX PLASTUN
25. Stock Market Anomalies 460
STEVE Z. F AN AND LIND A YU

viii Contents
26. The Psychology of Speculation in the Financial Markets 481
V I CT OR R I C C I A R D I
27. Can Humans Dance with Machines? Institutional Investors,

High-Frequency Trading, and Modern Markets Dynamics 499
IRENE ALDRIDGE
Part Seven THE APPLICATION AND FUTURE

OF BEHAVIORAL FINANCE
28. Applications of Client Behavior: A Practitioner’s Perspective 523
HAROLD EVENSKY
29. Practical Challenges of Implementing Behavioral

Finance: Reflections from the Field 542
GREG B . D A VIES AND PETER BROOK S
30. The Future of Behavioral Finance 561
MI CHAEL DOWLING AND BRIAN LUCEY
Discussion Questions and Answers 579

Index 611
List of Figures
11.1 Main Types of Bias Affecting Traders’Investment Decisions 194

14.1 Views of the American Dream, by Age Group 243
14.2 Knowledge Level for Investors by Age Group and Income 244
14.3 Survey Responses to Question about Retirement Planning 246
14.4 Degree of Advisor Use, by Age Group and Income 248
14.5 Generational Criteria for Making Investment Decisions 251
14.6 Client Familiarity with Investment Terms 257
14.7 Likelihood of Client Use of Financial Services via Technology 258
15.1 fte Holon in Financial Planning 271
15.2 Components of Trust and Commitment 274
15.3 Major Factors for Building the Trust and Commitment Relationship 274
15.4 Technical Quality, Functional Quality, and Communication Effectiveness 275
15.5 Satisfaction and Trust as Antecedents to Commitment 276
20.1 Performance of U.S.,International, and Emerging Market Stock Indexes 370
22.1 Reasons Given for Most Recent Acquisition from Executives of 50 International
Companies 403
22.2 Views on Amount of Shareholder Value Gained from Most Recent Acquisition
406
22.3 Views on Competitive Advantage Gained from Most Recent Acquisition
407
22.4 Advance Planning Time for Domestic and International Acquisitions 411
22.5 Comparison ofTimeSpentonSynergistic Evaluations, Domesticand International
Acquirers 412
22.6 Anticipated Synergies for Domestic and International Acquisitions 413
22.7 Top ftree HR Concerns after Acquisition by Cross-Border Company 414
22.8 TimeNeeded to Appoint Senior Management after Company Acquisition
416
22.9 Stated Reasons for Acquisition Success 417
24.1 Randomly Generated Values 441
24.2 Gold Prices for ftree-Month Period, 2006 442
24.3 Movement of DJIA between 2000 and 2013 449
25.1 Time Series of Annual Returns for Two Asset Growth Portfolios 466
ix
x List of Figures
25.2 Comparison of IPO/SEO Annual Returns and Matching Annual Returns of Non-issuing
Companies 467
25.3 Returns of a Long–Short Portfolio Formed on Accruals 469
27.1 Buy-sideAvailableLiquidityExceeding Sell-sideLiquidity 501
27.2 Impact of “Flickering Quotes” on Buy Offers 501
27.3 Impact of Aggressive HFT Orders on Bid–Ask Spreads 503
27.4 Placement of Passive HFT Order 504
27.5 Number of Order Messages per Each Added Limit Order 509
28.1 fte Relation Between Risk and Return 524
28.2 fte Efficient Portfolio 524
28.3 Anchoring on the Efficient Frontier: Risk Tolerance Exceeds Risk Need
526
28.4 Anchoring ontheEfficient Frontier:RiskNeedExceeds Risk
Tolerance 527
28.5 Risk Reduction through Diversification 528
List of Tables
14.1 Social Media Most Likely to Be Used for Specified Activities 256
20.1 Correlation Matrix of U.S., International, and Emerging Market Stock Indexes
371
21.1 Annual Cash Flows in U.S. Mutual Funds, Based on ICI Data 380
21.2 Annual Cash Flows in U.S. Index Mutual Funds, Based on ICI Data 381
21.3 Annual Cash Flows and Total Assets of ETFs, Based on ICI Data 386
22.1 Financial and Intangible Factors for Market Attractiveness, According toExecutives
from 50 International Companies 401
22.2 Irrational Reasons Citedfor Acquisitions 405
22.3 Comparison of Due Diligence Undertaken by Domestic and Cross-border Acquirers 409
24.1 Comparative Characteristics of the Efficient Market Hypothesis and the FractalMarket
Hypothesis 447
24.2 Reasons forInvestorOverreactions 451
25.1 SummaryStatisticsforAbnormalReturnsofZero-costPortfoliosby Countryand
Anomaly 462
25.2 Returns of Portfolios Formed Based on Previous Stock Returns 468
27.1 Average Aggressive HFT Participation in Equities on August 31, 2015 503
27.2 Sample from Level III Data (Processed and Formatted) for GOOG on October8,2015
506
27.3 Distribution of Order Sizes in Shares Recorded for GOOG on October 8, 2015 507
27.4 Distribution of Difference between Sequential Order Updates for All Order Records for
GOOG on October 8, 2015 508
27.5 Size and Shelf Life of Orders Canceled in Full, witha Single Cancellation for GOOG on October
8, 2015 509
27.6 Distribution of Times between Subsequent Order Revisions for GOOG on October8,2015
511
27.7 Distribution of Duration of Limit Orders Canceled with an Order Message Immediately
Following the Order Placement Message 512
27.8 Market Order Executions (Message Type “E”) and Other Order Type Dynamics at 10-
Message Frequency 514
xi
xii List of Tables
27.9 Hidden Limit Order Executions (Message Type “P”) and Other Order Type Dynamics at 10-
27.10 Market Order Executions (Message Type “E”) and Other Order Type Dynamics at 300-
27.11 Hidden Limit Order Executions (Message Type “P”) and Other Order Type Dynamics at 300-
28.1 Attributes of Investing 531
28.2 Projected Return and Risk Exposure under Different RiskLevels 533
29.1 Effect of Approaches to Behavioural Change on Knowledge, Engagement, and Emotional
Comfort 555
30.1 Scopus Article Count for “Behavioral Finance” and “Investor Psychology” Keywords
564
30.2 CountofArticlesinSSRN BehavioralandExperimentalFinance eJournal
565
Acknowledgments
fte simpler you say it, the more eloquent it is.

—August Wilson
Publishing a book requires the involvement of many people. Although acknowledging everyone who
participated in the process would be difficult, we would like to single out the following individuals. First,
we greatly appreciate the helpful comments of the anonymous reviewers of our book proposal that helped us
fine-tune our proposal.
Second, the chapter authors merit special thanks because without them this book would not have been
possible. We firmly believe that every writer needs an editor, because self-editing can be difficult and often
leads to missed mistakes. Our task as editors is to help our authors convey content in the most effective manner
possible. fte difference between the right word and nearly the write word can be enormous. As Arthur Plotnik
once said, “You write to communicate to the hearts and minds of others what’s burning inside you, and we edit
to let the fire show through the smoke.” We also adhere to the notion expressed by E. B. White that “fte best
writing is rewriting.” fterefore, based on our edits and comments, most authors rewrote their chapters at least
twice. ftey did so without complaint—at least without any complaints expressed directly to us. Perhaps J.
Russell Lynes wascorrect:“Noauthor dislikes tobe edited as muchas he dislikes not to be published.”
ftird, our partners at Oxford University Press performed in the same highly professional manner that they
have throughout the Financial Markets and Investments Series. Scott Parris, Anne Dellinger, and Cathryn
Vaulman helped steer the book through the early stages of the process while David Pervin and Emily
MacKenzie played important roles later in the process. Special thanks also go to Rajakumari Ganessin
(Project Manager), Carole Berglie (Copyeditor), and Claudie Peterfreund (Indexer). ftese are just a few of
the people who played important roles in this book project.
Fourth, we appreciate the research support provided by our respective institutions: the Kogod
School of Business at American University, the Behrend College at Penn State Erie, and the Business
Management Department at Goucher College.
Finally, we thank our families for their encouragement and support and dedicate the book to them: Linda and
RoryBaker; Janis,Aaron,Kyle,andGrantFilbeck;andJaymie, Kristin, and Julianna Lunt.
xiii
Acronyms and Abbreviations
AAII American Association of Individual Investors ACA

Affordable Care Act of 2010
ACT acceptance and commitment therapy ADL
activity of daily living
AFS Academy of Financial Services
AHEAD Asset and Health Dynamics among the Oldest Old AI
appreciative inquiry
AICPA American Institute of CPAs AIM
Affect Infusion Model AMH
adaptive market hypothesis
APD antisocial personality disorder AUM
assets under management BLS
Bureau ofLaborStatistics
BM book-to-market
CALIS Covariance Analysis of Linear Structural CAPM
capital asset pricing model
CBOE Chicago Board Options Exchange
CCAPM consumption CAPM
CD certificate of deposit
CEA Council of Economic Advisers CEO
chief executive officer
CF/P cash flow-to-price
CFA Chartered Financial Analyst CFO
chief financial officer
CFP Certified Financial Planner
CFTC Commodity Futures Trading Commission COT
commitment of trader
CPA Certified Public Accountant CPI
consumer price index
CPT Cumulative Prospect fteory CRD
Central Registration Depository
CRM customer relationship management
xv
xvi Acronyms and Abbreviations
D/P dividends-to-price
DB defined benefit
DBT dialectical behavioral therapy DC
defined contribution
DJIA Dow Jones Industrial Average E/P
earnings-to-price
EFFH extended functional fixation hypothesis EMH
efficient market hypothesis
EPS earnings per share
ETF exchange-traded fund
FCA Financial Conduct Authority
FCAA Financial Counseling Association of America FDNA
Financial DNAAssessment
FEARS Financial and Economic Attitudes Revealed by Search FINRA
Financial Industry Regulatory Authority
FMH fractal market hypothesis
FPA Financial Planning Association FPSB
Financial Planning Standards Board FPSM
Financial Planning Strategy Modes FTA
Financial fterapy Association GAO
Government Accountability Office GDP
gross domestic product
GNH gross national happiness
GWAS genome-wide association studies HFT
high-frequency trading
HNWI high net worth individuals HO
homeowners insurance
HRS Health and Retirement Study HWM
high watermark
IAFP International Association for Financial Planning IAPD
Investment Adviser Public Disclosure
IAR Investment Advisor Representative
IARD Investment Adviser Registration Depository
IBCFP International Board for Standards and Practices for Certified Financial Planners
IBD independent broker-dealers
ICAPM intertemporal capital asset pricing model ICFP
InstituteofCertifiedFinancialPlanners IOC
immediate orcancel
IPO initial public offering
IPS investment policy statement IRA
Individual Retirement Account IRS
Internal Revenue Service KMV
key mediating variable
LOP law of one price
Acronyms and Abbreviations xvii
M&A merger and acquisition MBS

mortgage-backed security
MEC modified endowment contract MFO
multi-family office
MI motivational interviewing
MMF money market fund
MMH mood maintenance hypothesis MPT
modern portfolio theory
MRI magnetic resonanceimaging MS
mortality salience
MVO mean-variance optimization
NAIC National Association ofInsurance Commissioners NAPFA
National Association of Personal Financial Advisors NASD
National Association of Securities Dealers
NBBO national best bid and offer
NEFE National Endowment for Financial Education NEST
National Employment Savings Trust
NFCC National Foundation for Credit Counseling NFIP
National FloodInsurance Program
NLSY National Longitudinal Survey of Youth NPV
net present value
NYSE New York Stock Exchange
OCIE Office of Compliance Inspections and Examinations OECD
Organization of Economic Cooperation andDevelopment OPT
option pricing theory
PCL [Hare] Psychopathy Checklist PFS
Personal Financial Specialist
PMI Purchasing Managers’ Index
QDIA qualified default investment alternative RCT
randomized control trial
Red FD Regulation Fair Disclosure
Reg NMS SEC Regulation National Market Systems REIT
real estate investment trust
RIA Registered Investment Adviser SAA
strategic asset allocation
SAD seasonal affective disorder SCF
Survey of Consumer Finances
SEC Securities and Exchange Commission SEO
seasoned equity offering
SIP Securities Information Processor
SML security market line
SOA Society of Actuaries
SRO self-regulatory organization
SSRN Social Science Research Network SVI
Google Search VolumeIndex
xviii Acronyms and Abbreviations
SWF sovereign wealth fund TAA

tactical asset allocation
TBW Taylor,Bean &Whitaker Mortgage Corporation TMT
terror management theory
UHNW ultra-high net worth UX
user experience
VIX CBOE Volatility Index
About the Editors
H. Kent Baker, CFA, CMA, is a University Professor of Finance in the Kogod School of Business at
American University. Professor Baker is an author or editor of 26 books, including Investor Behavior—
The Psychologyof Financial Planningand Investing, Behavioral Finance—Investors,
Corporations, and Markets, Portfolio Theory and Management, Survey Research in
Corporate Finance, and Understanding Financial Management: A Practical Guide. As one of
the most prolific finance academics, he has published more than 160 peer-reviewed articles in such
journals as the Journal of Finance, Journal of Financial and Quantitative Analysis, Financial
Management, Financial Analysts Journal, and Journal of Portfolio Management. He has
consulting and training experience with more than 100 organizations. Professor Baker holds a BSBA
from Georgetown University; M.Ed., MBA, and DBA degrees from the University of Maryland; and an
MA, MS, and two PhDs from American University.
Greg Filbeck, CFA, FRM, CAIA, CIPM, PRM holds the Samuel P. Black III Professor of Finance and
Risk Management at Penn State Erie, the Behrend College, and serves as the Interim Director for the Black
School of Business. He formerly served as Senior Vice- President of Kaplan Schweser and held academic
appointments at Miami University and the University of Toledo, where he served as the Associate Director
of the Center for Family Business. Professor Filbeck is an author or editor of seven books and has published
more than 90 refereed academic journal articles in the Financial Analysts Journal, Financial Review, and
Journal of Business, Finance, and Accounting among others. Professor Filbeck holds and conducts
training worldwide for candidates for the CFA, FRM, and CAIA designations. Professor Filbeck holds a BS
from Murray State University, an MS from Penn State University, and a DBA from the University of
Kentucky.
Victor Ricciardi is 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 a
leading expert on the academic literature and emerging research issues in behavioral finance. He co-edited
Investor Behavior— The Psychology of Financial Planning and Investing. Professor Ricciardi is
the editor of several eJournals distributed by the Social Science Research Network (SSRN) at
xix
xx About the Editors
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.
About the Contributors
Irene Aldridge is the Managing Director, Research and Development, AbleMarkets. com and ABLE
Alpha Trading LTD, where she designs, implements, and deploys proprietary trading strategies. She is
also President of AbleMarkets.com, a platform of predictive market microstructure analytics. Ms.
Aldridge is the author of High- Frequency Trading: A Practical Guide to Algorithmic
Strategies and Trading Systems. Before joining ABLE Alpha, she taught graduate quantitative finance
courses at several
U.S. universities. She has contributed to many government regulatory panels, including the U.K. Government
Foresight Committee for Future of Computer Trading and the
U.S. Commodity Futures Trading Commission’s Subcommittee on High-Frequency Trading. Ms.
Aldridge holds a BE in Electrical Engineering from Cooper Union, an MS in Financial Engineering from
Columbia University, and an MBA from INSEAD. She has also studied in two PhD programs, including
IEORatColumbia University.
Michal Strahilevitz is a Visiting Associate Professor at fte Center for Advanced Hindsight at
Duke University. Previously, she was a faculty member at Golden Gate University, University of Arizona,
University of Miami, and University of Illinois. She was also a visiting faculty member at the University of
Michigan, and University of California at Berkeley. She has published in the Journal of Consumer
Research, Journal of Marketing Research, Journal of Consumer Psychology, Journal of
Business Research, and Journal of Nonprofit & Public Sector Marketing. Much of her published
research focuses on how emotions affect decision making in areas related to investing, shopping, and
donating to charity. She blogs for Psychology Today and consults for-profit and nonprofit companies.
Professor Strahilevitz received an MBA from Tel Aviv University and a PhD from the University of
California at Berkeley.
James E. Brewer Jr. is President of Envision Wealth Planning and Envision 401(k) Advisors. He
works with individuals and small businesses to incorporate their values into their financial vision using a
holistic, behavioral financial planning process. He is a Certified Financial Planner professional, Accredited
Investment Fiduciary, Chartered Retirement Planning Consultant, and Professional Plan Consultant. Mr.
Brewer was a Top 100 Social Media Financial Advisor in the United States from 2013 to 2015. His thought
leadership has been featured or cited in U.S. News and World Report, The Wall
xxi
xxiv About the Cont rib uto rs
Street Journal, Voices: James Brewer, on Using ERISA 3(38) Investment Managers, and
Forbes. He holds an M.S. from the Massachusetts Institute of Technology.
Peter Brooks is a Behavioral Finance Transformation Director with Barclays. He joined Barclays in March
2007 and works with a team of experts to develop and implement commercial applications drawing on
behavioral portfolio theory, the psychology of judgment and decision making, and decision sciences. He
has worked in London and Singapore, and his current position focuses on bringing the best of behavioral
finance to self-directed investors through Internet channels. Dr. Brooks has published in the Journal of
Risk and Uncertainty, Theory and Decision, and contributed to the Wiley Encyclopedia of
Operations Research and Management Science. He has been a regular contributor to the leading
print and television media on topics related to investing private wealth. He holds a PhD in behavioral and
experimental economics from the University of Manchester. His doctoral thesis focused on experimental
research into individual attitudes to monetary gains and losses.
Elissa Buie, CFP, is CEO of Yeske Buie, and holds an appointment as Distinguished Adjunct Professor
in Golden Gate University’s Ageno School of Business, where she teaches the capstone case course in the
financial planning program. She is a past chair of both the Financial Planning Association and the Foundation
for Financial Planning, the latter being the only nonprofit devoted solely to fostering and supporting the
delivery of pro bono financial planning services to those in need. She is also a dean in the FPA’s residency
program. She has published in the Journal of Financial Planning and contributed chapters to the first and
second editions of the CFP Board’s Financial Planning Competency Handbook and Investor
Behavior: The Psychology of Financial Planning and Investing. She holds a BS in commerce from
the University of Virginia’s McIntire School and an MBA from the University of Maryland.
Pattanaporn Chatjuthamard is an Associate Professor of Finance at Sasin Graduate Institute of
Business Administration of Chulalongkorn University, Bangkok, ftailand. Before joining the faculty at
Sasin, she was an assistant professor at Texas A&M International University in Laredo, Texas, between
2002 and 2006. She was also a visiting professor at Levin Graduate Institute, the University at Buffalo, in
2006. Her primary research interests include corporate finance, corporate governance, and international
financial markets. She has published in leading scholarly and professional journals, including the Journal
of Financial Intermediation, Journal of Corporate Finance, Journal of Banking and Finance,
Journal of Financial Research, Journal of Business Ethics, and International Review of
Economics and Finance. Professor Chatjuthamard received a PhD from the University of
Wisconsin Milwaukee.
Marguerita M. Cheng is the Chief Executive Officer at Blue Ocean Global Wealth. Before co-
founding Blue Ocean Global Wealth, she was a Financial Advisor at Ameriprise Financial and an
analyst and editor at Towa Securities in Tokyo, Japan. Ms. Cheng is a spokesperson for the AARP
Financial Freedom Campaign, a regular columnist for Kiplinger, and former Financial Planning
Association (FPA) national board member. As a Certified Financial Planner Board of Standards (CFP
Board) Ambassador, Ms. Cheng helps educate the public, policymakers, and media about the benefits of
competent, ethical financial planning. She is a CFP professional, a Chartered
About the Contributors xxiii
Retirement Planning Counselor, a Certified Divorce Financial Analyst, and Retirement Income Certified
Professional.
C. W. Copeland is an Assistant Professor of Insurance for fte American College of Financial Services.
He has 18 years of college teaching experience and nearly 20 years as a financial services practitioner. He is
a registered representative with Cape Securities and an Investment Advisor Representative with Cape
Investment Advisors and maintains a Series 65, Series 7, Series 6, Series 63, Life and Health, Property and
Casualty Insurance licenses in multiple states. He co-authored Applications in Financial Planning II, and
edited McGill’s Life Insurance, 10th Edition, Essentials of Life Insurance Products, 4th Edition,
Essentials of Disability Income Insurance, 4th Edition, and Financial Services Overview: FP99
Financial Services Practicum. Professor Copeland holds a PhD in financial planning from the
University of Georgia with a research focus on behavioral finance. He also holds the Retirement Income
Certified Professional (RICP) designation, Chartered Financial Consultant (ChFC), and Chartered Life
Underwriter professional designations.
Henrik Cronqvist is Professor of Finance at the University of Miami, where he conducts interdisciplinary
research and teaches finance, entrepreneurship, and management. His research involves behavioral finance
and corporate finance. His work has been published in top journals in economics, including the
American Economic Review and Journal of Political Economy, as well as in finance, including the
Journal of Finance, Journal of Financial Economics, and Review of Financial Studies. He is often
invited to give seminars at academic conferences and to executives and public policymakers around the
world. Several of his research papers have been recognized with best paper awards at international conferences,
and have been sponsored by competitive research grants. His work has been featured in BusinessWeek, The
Economist, Financial Times, The Wall Street Journal, and on CNBC and CNN. Professor Cronqvist
received a PhD in finance from the University of Chicago.
Benjamin F. Cummings, CFP®, is an Associate Professor of Behavioral Finance at the American
College of Financial Services. Before his current position, he was an Assistant Professor at Saint Joseph’s
University in Philadelphia, PA and a Scholar in Residence at CFP Board in Washington, DC. Professor
Cummings also worked for FJY Financial, a fee-only financial planning firm in Reston, Virginia. He has
completed award-winning research on the use and value of financial advice, and has worked on funded
projects related to the regulation of professional financial advice. Professor Cummings received a PhD in
personal financial planning from Texas Tech University.
Greg B. Davies recently founded Centapse, a firm dedicated to applying sophisticated behavioral insight
to design, develop, and deploy solutions across industries to help people and organizations make better
decisions. Over the last decade, as head of Behavioral-Quant Finance at Barclays, Dr. Davies built and led
the world’s first applied behavioral finance team, implementing behavioral design into the bank’s tools, systems,
propositions, products, andorganizationalprocesses. Heisan Associate Fellowat Oxford University’s Saïd
Business School, and his first book, Behavioral Investment Management, was published in 2012. He has
authored papers in multiple academic disciplines, and is a frequent media commentator on behavioral
finance. Dr. Davies co-created the
xxiv About the Cont rib uto rs
“reality opera” Open Outcry, which turns the behavior of a functioning trading floor into a musical
performance, which received its première in London in November 2012. He holds an undergraduate degree
from the University of Cape Town, and an MPhil in economics and PhD in behavioral decision theory, both
from Cambridge University.
Erik Devos is the JP Morgan Chase Professor in Business Administration and Professor of
Finance at the College of Business Administration of the University of Texas El Paso. He previously
taught at Ohio University and Binghamton University (SUNY). He has published in finance and
accounting journals such as Review of Financial Studies, Journal of Accounting and
Economics, Journal of Corporate Finance, Financial Management, and Journal of
Banking and Finance. He has also published in real estate journals such as Real Estate
Economics, Journal of Real Estate Economics and Finance, and Journal of Real Estate Research.
Professor Devos serves as an associate editor for the Financial Review. He received a master’s degree
in financial economics from Erasmus University in Rotterdam and a PhD in finance from
Binghamton University (SUNY).
Paul Dolan is an internationally renowned expert on happiness, behavior, and public policy. He is
currently Professor of Behavioural Science in the Department of Social Policy at the London School of
Economics and Political Science, and Director of the new Executive MSc in Behavioural Science. In
2010, he co-authored the Mindspace report published by the U.K. Cabinet Office, advising local and
national policymakers on how to effectively use behavioral insights in their policy setting. He received a PhD
from the University of York.
Michael Dowling is an Associate Professor of Finance in ESC Rennes School of Business in
France, where he primarily researches behavioral asset pricing, especially in energy markets. He has
published in such journals as Energy Economics and Energy Policy and Economics Letters. Professor
Dowling is currently the Co-Editor-in-Chief of the Journal of Behavioral and Experimental
Finance, which concentrates on rigorously investigating the extent to which behavioral principles
drive financial behavior. He received a PhD from Trinity College Dublin.
Harold Evensky is Chairman of Evensky & Katz/Foldes Financial, a 30-year-old wealth
management firm, and Professor of Practice at Texas Tech University. He has served as chair of the CFP
Board of Governors and the International CFP Council and he is the research columnist for the
Journal of Financial Planning. Mr. Evensky has been named by Investment Advisor as one of the “25
most influential people in the financial planning industry,” by Financial Planning as one of five “Movers,
Shakers and Decision Makers, fte Most Influential People in the Financial Planning Profession,” and by
Investment News as one of the “25 Power Elite” in the financial services industry. He co-authored New
Wealth Management, Wealth Management, and co-edited The Investment Think Tank:
Theory, Strategy, and Practice for Advisors and Retirement Income Redesigned: A Master
Plan for Distribution. He received his BCE and MS degrees from Cornell University.
About the Contributors xxv
Steve Z. Fan is an Associate Professor of Finance at the College of Business and Economics,
University of Wisconsin Whitewater. Before his career in finance, he worked as a research assistant
professor at Marquette University. Professor Fan’s research focuses on equity anomalies, corporate
governance, and institutional investors. He has published in Multinational Finance Journal,
International Journal of Business and Finance Research, and Journal of Finance and
Accountancy, among others. Professor Fan received a BS in mechanical engineering from Zhangzhou
University, China, a PhD in biomedical engineering from a joint program from University
Tennessee and University of Memphis, and a PhD in finance from the University of Wisconsin
Milwaukee.
Deborah W. Gregory is an Assistant Professor at Bentley University in Waltham, Massachusetts.
As a certified Jungian psychoanalyst (IAAP, C.G. Jung Institute, Boston) and Chartered Financial Analyst
(CFA). Professor Gregory’s research focuses on the behavioral aspect of individuals’ relation to money. She
received a scholarly award from Bentley for her book Unmasking Financial Psychopaths: Inside
the Minds of Investors in the Twenty-First Century (2014). She has published in the Journal of
Finance, Financial Analysts Journal, NYU Salomon Brothers Monograph Series, Journal of
Business and Economic Studies, Journal of Financial Crime, and Journal of Behavioral
Finance & Economics, among others. Professor Gregory received a PhD in finance from the
University of Florida.
John J. Guerin is the owner of Delta Psychological Associates, P.C. He has more than 30 years of
experience in the practice of both clinical and organizational psychology. Experience with both group
dynamics and family systems has allowed him to effectively coach individuals in organizations and to work
with groups in corporate and family- based businesses. With more than 20 years of experience in
mediation and forensic practice, he has demonstrated skills in forging consensus in challenging situations and
helping organizations navigate difficult adversarial situations and cultural transitions. Dr. Guerin is an
expert in organizational, team, and individual assessment, using high standards in scientific assessment
methodology. He is active in emergent efforts to collaborate across professional boundaries and develop
more effective tools for diagnosis and intervention. He is a Licensed Psychologist in independent practice
in Pennsylvania and New Jersey, and collaborates with organizational consulting firms as an independent
consultant. He received an M.A. degree from the University of Chicago and a PhD from Temple University
in Philadelphia.
L. Paul Hood Jr. is the Director of Planned Giving at fte University of Toledo Foundation. He
previously served as Director of Gift Planning for fte University of Montana Foundation. A self-styled
“recovering tax lawyer,” Mr. Hood practiced tax and estate planning law for 20 years in Louisiana. He is the
author or co-author of five books on estate planning, charitable planning, buy-sell agreements, and business
valuation and is a frequent speaker and writer on estate planning and business valuation. fte father of two
teenaged boys, he enjoys reading, but his passion is baseball. Mr. Hood served as President of the Toledo Area
PartnershipforPhilanthropic Planningin2014.
xxvi About the Cont rib uto rs
He obtained his undergraduate and law degrees from Louisiana State University and a LL.M. in taxation
from Georgetown University Law Center.
Nancy Hubbard holds the Miriam Katowitz Chair in Management and Accounting at Goucher College,
Maryland. She is also a member of the faculty of Moscow’s School of Management, SKOLKOVO (Russia)
and the University of Marseilles (France). She is a former lecturer at the SaÏd Business School and Associate
Fellow at Oxford University (Templeton College), as well as a management consultant with Spicer &
Oppenheim (which is part of Booz, Allen & Hamilton) and KPMG. She has published in the Human
Resources Management Journal, Journal of Professional HRM, and European Retail Digest,
among others. She has published several books, including Acquisition: Strategy and
Implementation and Conquering Global Markets: Secrets from the World’s Most Successful
Acquirers. She holds a BS in business from Georgetown University and a MS and PhD from Oxford
University in management.
Danling Jiang is the Associate Professor of Finance at the College of Business, Stony Brook University.
Her research involves studying investments, corporate finance, and financial decision-making from
behavioral approaches. Her research integrates economics, psychology, political science, and sociology
into finance. Professor Jiang’s work has been published in leading journals spanning the fields of
finance, management, accounting, and judgment and decision-making, including the Review of
Financial Studies, Management Science, Organizational Behavior and Human Decision
Processes, Journal of Financial and Quantitative Analysis, Review of Finance, and Review
of Accounting Studies, among others. She has served as a reviewer for many journals in finance,
economics, management, and psychology as well as various publishers and international funding agencies.
She serves on the Advisory Council for the Financial Analysts Journal and in various roles for many
conferences and associations. Professor Jiang received a PhD in finance from the Ohio State University.
Rebecca Li-Huang is a wealth advisor to high net work individuals. In addition to wealth
management and investment advisory practices at Merrill Lynch, her professional experience includes
capital markets, equity research, corporate finance, and project management at other financial services and
technology firms. She is the author of Green Apple Red Book: A Trial and Errors, which was
honorably mentioned in London, New York, San Francisco, and Paris Book Festivals. She has
undergraduate study at the University of Science and Technology of China, a Master of Science in
electrical engineering from Purdue University, and an MBA in finance and international economics from the
University of Chicago Booth School of Business.
Brian Lucey is Professor of Finance in Trinity College Dublin. He has more than a 100 peer-reviewed
publications across the spectrum of behavioral finance and beyond. Professor Lucey has published in such
journals as the Journal of Banking & Finance, Small Business Economics, and Quantitative
Finance. He is currently Editor-in-Chief of International Review of Financial Analysis and
Finance Research Letters, and Associate Editor of the Journal of Banking & Finance. He received
a PhD from the University of Stirling.
About the Contributors xxvii
Duccio Martelli is an Assistant Professor of Finance at the University of Perugia (Italy) and summer
school professor at Harvard University. He has also been a visiting professor of finance at the University of
Applied Sciences in Augsburg, Germany. Professor Martelli teaches undergraduate and graduate courses in
behavioral finance, corporate finance, private banking and financial markets. His main research interests
include behavioral and neurofinance, financial education, real estate finance, and asset management. He has
presented his research at national and international conferences and has published in European
Financial Management and Journal of Economics and Business. He also serves as a referee on several
peer-reviewed finance journals. Professor Martelli advises firms and not-for-profit organizations in the areas of
financial education and asset management. He received a BA cum laude from Bocconi University and a
PhD in banking and finance from University of Rome “Tor Vergata.”
Nathan Mauck is an Assistant Professor of Finance at the Henry W. Bloch School of Management,
University of Missouri-Kansas City. His research focuses on sovereign wealth funds, mergers and
acquisitions, payout policy, corporate finance, and behavioral finance. He has published in Journal of
Banking & Finance, Journal of Behavioral Finance, Journal of Corporate Finance, Journal of
Financial Intermediation, Journal of Financial Research, and Journal of International
Business Studies, among others. Professor Mauck is the recipient of the American Real Estate Society
Best Paper in Real Estate Portfolio Management (2015) and multiple teaching awards, including the UMKC
Chancellor’s Early Career Award for Excellence in Teaching (2015) and Bloch Favorite Faculty Member
of the Year (2014). He received a BS in finance from Kansas State University and a PhD in finance from
Florida State University.
Peter J. May, CFP, is an independent wealth advisor. He created and manages “Art Solutions…Best in
Practice,” a LinkedIn discussion group with more than 4,300 members from professionally and
geographically diverse backgrounds across the globe. Mr. May also developed “fte Personal Wealth Spectrum,”
an integrated educational tool to assist clients in better understanding multi-generational risk mitigation. He has
been a frequent speaker and contributor to articles on financial planning and art preservation techniques for
individuals and families. Mr. May received a BS in accounting from St. Louis University, a JD from Capital
University Law School, and an LLM in taxation from Villanova University School of Law. He passed
the Uniform CPA Examination and the NASD Series 7.
Catherine McBreen is the Managing Director of Spectrem Group, a market research and consulting
firm specializing in the affluent and retirement markets. Ms. McBreen is President and Editor of Spectrem
Group’s website, Millionaire Corner, which presents original research and reporting and feature stories to
meet the informational needs of both new and seasoned investors. She is a member of the American Bar
Association, Illinois Bar Association, and Chicago Bar Association. Ms. McBreen is a frequent speaker
at industry conferences and has been widely quoted by the print and broadcast financial media, including
The Financial Times, The Wall Street Journal, CNBC Closing Bell, Neal Cavuto at Fox
Business News, and ABC and CBS radio. She coauthored Get Rich, Stay Rich, Pass It On: The
Wealth-Accumulation Secrets of America’s Richest Families.
xxviii About the Cont rib uto rs
She has a BS summa cum laude from Northwestern University and a JD from DePaul University School of
Law.
Christopher Milliken, CFA, is an industry professional and Vice President of Hennion & Walsh Asset
Management’s Portfolio Management Program. Hennion & Walsh is a Registered Investment Advisory firm
that uses ETFs to construct investment strategies. Mr. Milliken works under the chief investment officer,
conducts research on capital markets and asset allocation strategy, and oversees the sales and trading
desk. He received a BS in business administration with a focus in finance from Marist College.
James M. Moten Jr. is an Assistant Professor of Finance at East Central University. He has more than 10
years of college teaching experience. Professor Moten is a financial advisor, representative, and registered
principal for PFS Investments and still maintains a Series 26, Series 65, Series 6, Series 63, Life and Health and
Property and Casualty Insurance Licenses. BVT published his book, Introductory Financial
Management: Theory and Application, second edition, in 2014. He received an MS in finance, MS in
accounting, and MS in economics, all from Texas A&M University Commerce; an MBA from Cameron
University; Graduate Certificate in Financial Planning from Kansas State University; an MS in acquisition
and contract management from Florida Institute of Technology; and a PhD in business administration with
a financial management concentration from Northcentral University. Professor Moten also holds the
Certified Financial Planner (CFP), Chartered Financial Consultant (ChFC), Chartered Retirement
Planning Counselor (CRPC), Chartered Mutual Fund Counselor (CMFC), and Retirement Income Certified
Professional (RICP) professional designations.
Jeroen Nieboer is a behavioral economist specializing in financial decisions and decision-making
under risk and is currently based at the London School of Economics and Political Science. His research
originated using experimental methods to study financial risk taking in groups. He actively collaborates with
financial advice charities such as StepChange and the Citizens Advice Bureau, and has acted as a consultant to
many companies in the finance and insurance sectors. He obtained his PhD from the University of
Nottingham.
Ehsan Nikbakht, CFA, FRM, is Professor of Finance in the Frank G. Zarb School of Business at
Hofstra University and previously served as department chair and Associate Dean. He served on the Advisory
Board of the International Association of Financial Engineers and Chair of Derivatives Committee of the
New York Society of Security Analysts. Professor Nikbakht currently serves on the editorial board of
Global Finance Journal. He authored Finance and Foreign Loans and Economic Performance.
Professor Nikbakht received a BA from the Tehran School of Business, an MBA from the Iran Center for
Management Studies, and a DBA in finance from the George Washington University.
John R. Nofsinger is the William H. Seward Endowed Chair in International Finance at the College of
Business and Public Policy at the University of Alaska Anchorage. He is one of the world’s leading experts on
behavioral finance. He has authored/coauthored 10 finance trade books, textbooks, and scholarly books that
have been translated into 11 languages. Professor Nofsinger is a prolific scholar who has published more
than
About the Contributors xxix
50 articles in peer-reviewed journals, including prestigious scholarly journals such as the Journal of
Finance and Journal of Financial and Quantitative Analysis and practitioner journals such as the
Financial Analysts Journal and Journal of Wealth Management. He is often quoted in the financial
media, including the The Wall Street Journal, Financial Times, Fortune, Business Week, Smart
Money, Money Magazine, Washington Post, Bloomberg, Nightly Business Report, and CNBC,
and other media from fte Dolans to fteStreet. com. Professor Nofsinger received a PhD from
WashingtonState University.
Alex Plastun is Associate Professor and the Chair of Accounting and Auditing at the Ukrainian
Academy of Banking (UAB). Before joining the UAB, he was a trader and analyst in several investment
companies, including Admiral Markets Ltd, ForexService Ltd., and SumyForexClub Ltd. He still trades in the
different financial markets using his own trading strategies. Professor Plastun tries to reconcile his experience
as a trader with the academic theory and is constantly searching for market inefficiencies. He has
published in such outlets as the Journal of Economics and Finance, Computational Economics,
and Corporate Ownership and Control. Professor Plastun holds a PhD in finance from the
Ukrainian Academy of Banking.
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 a
leading expert on the academic literature and emerging research issues in behavioral finance. He co-edited
Investor Behavior—The Psychology of Financial Planning and Investing. Professor Ricciardi 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.
April Rudin, Founder of fte Rudin Group, is an acclaimed financial services/wealth management
marketing firm. Her expertise centers on wealth, millennials, and technology/fintech. fte Rudin Group,
founded in 2008, designs bespoke marketing campaigns for some of world’s most important financial
services firms. Ms. Rudin is a regularly featured source of expert commentary to international
news/business outlets and trade publications. She has also created and maintains an extensive thought
leadership domain featured on Huffington Post, American Banker, CFA Enterprising
Investor, Family Wealth Report, Wealthmanagement.Com, and many other trade publications. Ms.
Rudin is a judge for Family Wealth Report’s Annual Wealth Management Industry awards, a member of
the PAM (Private Asset Management) Advisory board, and serves on the Global Board of Directors for
the Hedge Fund Association (HFA). She also heads the editorial board for NexChange, a global financial
services’ networking start-up.
Charles H. Self III, CFA, is Chief Operating Officer and Chief Investment Officer of iSectors, a
provider of outsourced investment management services. He has experience in portfolio management and
working with clients. He conducts interviews in various
xxx About the Cont rib uto rs
media, including Fox Business News, Bloomberg Radio, and The Wall Street Journal. Mr. Self
hasan MBAin statisticsand finance fromthe University of Chicago.
Alexandre Skiba is an Assistant Professor at the Department of Finance and Economics at the
University of Wyoming. He teaches international economics and business, macroeconomics, and
econometrics. His research interests are in the areas of international trade and finance, institutional
investors, and real estate finance. Specifically, his work deals with product quality of internationally
traded goods and the effects of trade barriers on trade, as well as specializing and trading choices and
performance of institutional trades. Professor Skiba has published in such journals as the Journal of
Political Economy, Journal of Development Economics, and Review of International Economics.
Professor Skiba received a PhD from Purdue University.
Hilla Skiba is an Assistant Professor at the Department of Finance and Real Estate at Colorado State
University. She teaches courses in real estate, investments, and international finance with behavioral
finance applications. Her research interests are mainly in the areas of international finance, institutional
investor performance, and real estate finance. Specifically, her work deals with cultural influences on
financial decision making, under-diversification and performance, and the behavior of real estate market
participants. Professor Skiba has published in such journals as the Journal of Financial Economics,
Journal of Banking & Finance, and Journal of Corporate Finance. Her research has earned several
awards, including the best paper award at the Asian Finance Association meetings. Professor Skiba received a
PhD in finance from the University of Kansas.
Sameer S. Somal is the Chief Financial Officer at Blue Ocean Global Wealth. Before co- founding Blue
Ocean Global Wealth, he was a Senior Investment Analyst at fte Bank of Nova Scotia and a Financial
Advisor and Intermediary at Morgan Stanley and Merrill Lynch & Co. Mr. Somal serves on CFP Board’s
Council on Education and is a Women’s Initiative (WIN) Advocate. He is an active member at CFA Institute, a
Board Advisor at the iPlan Education Institute (New Delhi, India), and serves on the Board of Directors of the
Philadelphia Tri-State Financial Planning Association (FPA). Mr. Somal is a CFA Charterholder, a CFP
professional,andaChartered AlternativeInvestmentAnalyst.
Andrew C. Spieler, CFA, FRM, CAIA, is a Professor of Finance in the Frank G. Zarb School of
Business at Hofstra University. He has published in Real Estate Economics, Journal of Real Estate
Finance and Economics, Journal of Real Estate Portfolio Management, Journal of Applied
Finance, among others. He served as chair of the Derivatives Committee at the New York Society
of Securities Analysts. Professor Spieler also serves as co-director of the annual real estate conference
sponsored by the Wilbur F. Breslin Center for Real Estate Studies. He received undergraduate degrees in
math and economics from Binghamton University (SUNY), an MS in finance from Indiana University,
and an MBA and PhD from Binghamton University (SUNY).
Joseph M. Tenaglia, CFA, is an Emerging Markets Portfolio Specialist at Emerging Global Advisors,
which is a boutique emerging and frontier markets asset management firm that offers core and thematic
exchange-tradedfunds. Mr.Tenagliais a member of
About the Contributors xxxi
the firm’s Investment Strategy Team and is responsible for creating content around the emerging markets
environment while also promoting the firm’s research and strategies to institutional investors. He previously
worked at Bank of New York Mellon Asset Management in several roles. Mr. Tenaglia graduated from
Boston College with a BS in finance and marketing. He is a member of the New York Society of Security
Analysts.
Ivo Vlaev joined Warwick Business School as a Professor of Behavioural Science in 2014. He
previously worked at the University of Warwick, University College London, and Imperial College London.
He studies decision making from the perspectives of psychology, neuroscience, and economics. In 2010,
he co-authored the Mindspace report published by the U.K. Cabinet Office, advising local and national
policymakers on how to effectively use behavioral insights in their policy setting. He received a DPhil in
Experimental Psychology from St. John’s College, Oxford.
Dave Yeske, CFP, is Managing Director at Yeske Buie and financial planning program director at Golden
Gate University’s Ageno School of Business, where he holds an appointment as Distinguished Adjunct
Professor. He is a past chair of the Financial Planning Association, where he has also chaired the
political action committee, Research Center Team, and Academic Advisory Council. He now serves as
Practitioner Editor of FPA’s Journal of Financial Planning. Professor Yeske has published in the
Journal of Financial Planning and contributed chapters to the first and second editions of CFP
Board’s Financial Planning Competency Handbook and Investor Behavior: The Psychology
of Financial Planning and Investing. He holds a BS in applied economics and MA in economics from
the University of San Francisco, and a DBA from Golden Gate University.
Susan M. Young is an Associate Professor at the Gabelli School of Business, Fordham University.
Before joining the faculty at Fordham University, Professor Young held academic positions at CUNY
Baruch College and Emory University. Before her academic career, Professor Young held positions in
public, private, and nonprofit accounting. She has published in the Accounting Review, Journal of
Business, Finance and Accounting, Accounting Horizons, Journal of Management
Accounting Research, Review of Behavioral Finance, and Human Resource Management.
Professor Young earned a BS from California State University Stanislaus, an MBA from California State
University Sacramento, and a PhD from the University of Southern California.
Linda Yu is a Professor of Finance at the College of Business and Economics, University of Wisconsin
Whitewater. Before joining the University of Wisconsin, she worked as an assistant professor at the State
University of New York Institute of Technology. Professor Yu’s research focuses on fixed income, equity
anomalies, corporate governance, and socially responsible investing. She has published in Financial
Management, Review of Quantitative Finance and Accounting, Journal of Fixed Income,
International Review of Financial Analysis, and Multinational Finance Journal, among others.
Professor Yu received a BA in British literature from Jilin University China, an MBA from Pittsburg State
University, anda PhDin Financefromthe University of Memphis.
Part One
FINANCIAL BEHAVIOR
AND PSYCHOLOGY
1
Financial Behavior
An Overview
H. K E N T BA K E R
University Professor of Finance
Kogod School of Business, American University
GREG FILBECK
Samuel P. Black III Professor of Finance and Risk Management
Penn State Erie, The Behrend College
VI CT OR RI C C I A R D I
Assistant Professor of Financial Management
Goucher College
Introduction
Two major branches in finance are the well-established traditional finance, also called standard finance, and
the more recent behavioral finance. Traditional finance is based on the premise of rational agents making
unbiased judgments and maximizing their self- interests. In contrast, behavioral finance studies the
psychological influences of the decision-making process for individuals, groups, organizations, and markets.
Both schools of thought play important roles in understanding both investor and market behavior. Ackert
(2014) provides a comparison of traditional and behavioral finance.
Traditional finance theory assumes normative principles to model how investors, markets, and others
should act. In traditional finance theory, investors are supposed to act rationally. Additionally, this normative
approach assumes that investors have access to perfect information, process that information without cognitive
or emotional biases, act in a self-interested manner, and are risk-averse. According to Bloomfield (2010,
p. 23), traditional finance
sees financial settings populated not by the error-prone and emotional Homo sapiens, but by the
awesome Homo economicus. fte latter makes perfectly rational decisions, applies unlimited
processing power to any available information, and holds preferences well-described by
standard utility theory.
Traditional finance theory is based on classical decision making in which investors make economic decisions
using utility theory by maximizing the benefit they receive from an
3
4 FINANC IAL BEHAVIOR AND PSYCHOLOGY
action, subject to constraints. In utility theory, investors are assumed to make decisions consistently and
independently of other choices. Utility theory serves as the foundation for standard finance theories based on
modern portfolio theory and asset pricing models. A major tenet of traditional finance is fundamental analysis
incorporating statistical measures of risk and return. A primary aspect of this macro-driven model is the study
of investors within the financial markets, and the underlying assumption of investor risk aversion (i.e.,
investors must be compensated with higher returns in order to take on higher levels of risk). Notable
examples in traditional finance include portfolio choice (Markowitz 1952, 1959), the capital asset pricing
model (CAPM) (Sharpe 1964), and the efficient market hypothesis (EMH) (Fama 1970).
Modern portfolio theory (MPT) provides a mathematical framework for constructing a portfolio of
assets such that the expected return is maximized for a given level of risk, as measured by variance or
standard deviation. MPT emphasizes that risk is an inherent part of higher reward. An important insight
provided by MPT is that investors should not assess an asset’s risk and return in isolation, but by how it
contributes to a portfolio’s overall risk and return.
Further developments revealed that investors should not be compensated for risk that they can diversify
away, which is called unsystematic or diversifiable risk. Instead, they should only be compensated for non-
diversifiable risk, also called market or systematic risk. ftis insight led to the development of the CAPM.
ftis model describes the relation between risk, as measured by market risk or beta, and expected return, and is
used for the pricing of risky securities. Although a cornerstone of modern finance, the CAPM, as a single-factor
model, cannot pick up other risk factors. Consequently, the CAPM does not perform well in explaining the
cross-section of returns across stocks. Hence, others suggest that returns depend on other factors besides the
market. For example, Fama and French (1996) identity two additional factors: firm size and the book-to-
market ratio. Carhart (1997) extends the Fama–French three-factor model by including a momentum factor,
which is the tendency for the stock price to continue rising if it is going up and to continue declining if it
is going down.
fte EMH states that asset prices fully reflect all available information. An implication of this dominant
paradigm in traditional finance of the function of markets is that consistently beating the market on a risk-
adjusted basis is impossible. Fama (1970) sets forth three versions of the EMH. According to weak form
efficiency, prices on traded assets reflect all market information, such as past prices. fte semi-strong form of the
EMH asserts that prices reflect all publicly available information. fte strong form of the EMH states that current
asset prices reflect all information, both public and private (insider). Numerous research studies report anomalies,
which are situations when a security or group of securities performs contrary to the notion of efficient markets.
ftis stream of research was a drivingforceleadingtothebirthandgrowthofbehavioralfinance(Ackert2014).
Although the traditional approach provides many useful insights, it offers an incomplete picture of
actual, observed behavior. fte normative assumptions of traditional finance do not apply to how most
investors make decisions or allocate capital. Normative models often fail because people are irrational and
the models are based on false assumptions.
By contrast, behavioral finance offers insights from other sciences and business dis- ciples to explain
individual behavior, market inefficiencies, stock market anomalies, and
Financial Behavior: An Overview 5
other research findings that contradict the assumptions of traditional finance. Behavioral finance examines the
decision-making approach of individuals, including cognitive and emotional biases. Behavioral finance makes
the premise that a wide range of objective and subjective issues influence the decision-making process. Various
laboratory, survey, and market studies in behavioral finance show that individuals are not always rational and
apply the descriptive model from the social sciences that documents how people in real life make judgments and
decisions. A basis of the descriptive model is that investors are affected by their previous experiences, tastes,
cognitive issues, emotional factors, the presentation of information, and the validity of the data. Individuals
also make judgments based on bounded rationality. Bounded rationality is the premise that a person
reduces the number of choices to a selection of smaller shortened steps, even when this oversimplifies the
decision-making process. According to bounded rationality, an individual will select a satisfactory
outcome rather than the optimal one.
In the 1960s and 1970s, the origin of behavioral finance and financial psychology was founded on seminal
research from theorists in cognitive psychology, economics, and finance. During the 1980s, behavioral finance
researchers began combining the research methods of psychology and behavioral economics with specific
investment and financial subject matter. Since the mid-1990s, behavioral finance has been emerging as an impor-
tant field in academia. For example, some notable developments in behavioral finance include work on
prospect theory (Kahneman and Tversky 1979; Tversky and Kahneman 1974, 1981); framing effects, which are
rooted in prospect theory; heuristics and biases (Kahneman, Slovic, and Tversky 1982; Gilovich, Griffin, and
Kahneman 2002); and mental accounting (ftaler 1985). Baker and Nofsinger (2010) and Baker and Ricciardi
(2014) provide a synthesis of the literature on behavioral finance and investor behavior. In 2002, Daniel
Kahneman and Vernon Smith, behavioral finance pioneers, received the Nobel Memorial Prize in
Economics for their research in behavioral economics and psychology from the area of judgment and
decision making. ftis prestigious award was a major turning point for the discipline because it provided wider
acceptance within the financial community. ften, the financial crisis of 2007–2008 demonstrated the
weakness of standard finance, with behavioral finance subsequently receiving even more attention and
acknowledgment by academics and practitioners. In 2013, Robert
J. Shiller, a noted behavioral economist, shared the 2013 Nobel Memorial Prize in Economic Sciences
for empirical analysis of asset prices.
A Further Look at Behavioral Finance

Behavioral finance is an interdisciplinary subject based on the themes, theories, and research methods from
a wide range of decision-making fields, such as psychology, behavioral accounting, economics, and
neuroscience. In the early 1980s, researchers began to blend the research ideas and methodologies of
psychology with specific investment and financial theories (Ricciardi 2006). Behavioral finance focuses on
important cognitive factors and emotional influences during the judgment and decision-making process by
individuals, groups, organizations, and markets. When individuals make judgments, they must develop,
evaluate, and select among a series of choices or options, in which the final decision is based on a degree of risk
and uncertainty (Ricciardi 2008a,
2010). In a rational setting, investors select the optimal choice. However, if qualitative and quantitative
complexities are too intense, cognitive and emotional biases will influence the final outcome to a satisfactory
choice. Another important premise of behavioral finance is that people are often irrational or quasi-
rational (known as bounded rationality), and individuals make financial decisions based on past
experience, values, mental mistakes, cognitive factors, and emotional impulses.
PROSPECT THEORY, LOSS AVERSION, AND

THE DISPOSITION EFFECT
Kahneman and Tversky (1979) provide a unique behavioral theory about risk-taking behavior and
uncertainty known as prospect theory, in which the stated probabilities and the diverse choices are provided.
ftis theory posits the notion that people do not make decisions based on classical rationality; rather, they make
judgments based on the premise of bounded rationality. A key tenet of prospect theory is that people assess
choices on an individual basis and then use a reference point or anchor to make their choices, rather than decide
within the context of an overall portfolio. Another principle underlying prospect theory is that individuals are
loss averse, in which they place greater weight on losses than gains. ftat is, individuals apply more importance
and mental effort to avoiding a loss than to achieving a gain.
Kahneman and Tversky (1979) asked subjects to review a pair of choices and to select one of the
options:
Consider a decision between these two choices:

Choice A: A sure gain of $7,000 or
Choice B: An 80 percent chance of earning $10,000 and a 20 percent chance of receiving $0.
Question: Which choice would give you the best prospect to increase gains?
fteir evidence shows that a solid majority of respondents select Choice A, which is the sure gain. ftese findings
demonstrate that most individuals suffer from risk aversion when given the choice of a certain gain, and they find this
outcome satisfactory. Although people tend to prefer Choice A because of the promise of a $7,000 gain, this should
be the less favored option. If they select Choice B, their preference is to consider the optimal choice because an
overall cumulative increase in wealth of $8,000 occurs. For a traditional finance portfolio, the answer is calculated as
($10,000 × 0.80) + (0 × 0.20) = $8,000. Most people dislike Choice B because of the 20 percent probability of
earning nothing.
Another aspect of Kahneman and Tversky’s (1979) study is to investigate the influence of losing, in
which people assess the following two options:
Choice C: A realized loss of $7,000 or

Choice D: An 80 percent chance of losing $10,000 and a 20 percent chance of losing nothing.
Question: Which option would provide you the best prospect to reduce losses?
Most subjects prefer Choice D. ftey prefer the 20 percent probability of not losing any money, even though
this choice has more risk because within a portfolio framework
the result would be an $8,000 loss. In other words, Choice C is the rational choice. In the behavioral finance
domain, Oberlechner (2004) reports in a comparable study with traders in a foreign exchange setting showing
that more than 70 percent select the risk- seeking option (or the equivalent of Choice D).
fte results of these experiments demonstrate the concept known as loss aversion, in which people assign
more importance to a loss than to an equivalent gain. fte typical finding is that a gain on the upside of $2,000 is
about twice as painful on the downside and feels like a $4,000 loss. ftis logic is contrary to the premise of
traditional finance, which equates a $2,000 gain to a $2,000 loss within a diversified portfolio. For example,
individuals tend to focus on downside risk when they own common stock. When people suffer an actual
loss, they incur not only an objective loss in dollar terms but also a subjective loss in terms of an “emotional
loss.” ftis feeling can remain for a long time. Many investors who realize major losses during a market
downturn subsequently avoid riskier asset classes such as stocks.
Another important aspect of loss aversion is that an “individual is less likely to sell an investment at a loss
than to sell an investment that has increased in value even if expected returns are held constant” (Ricciardi
2008b, pp. 99–100), based on the disposition effect. fte disposition effect refers to the tendency of selling
securities that have appreciated in value over the original investment cost too early (or winners) and of
holding on to losing securities too long (or losers). ftis bias is detrimental to the wealth of individuals because it
can increase their capital gains taxes or can reduce investment returns even before taxes.
Olsen and Troughton (2000) examine the different meanings between uncertainty (ambiguity) and risk
attributed to the work of Knight (1921). fte study assesses several psychological factors, such as familiarity
bias and loss aversion behavior. An expert group of more than 300 money managers completed a survey
questionnaire about stocks. According to them, the two most important aspects of the assessment of risk
are (1) downside or catastrophic risk (i.e., the probability of realizing a large loss); and
(2) the role of ambiguity (i.e., the uncertainty about the actual distribution of potential returns in the
future).
HEURISTICS
When individuals face complex judgments, information overload, or incomplete information, they
often rely on conventional wisdom based on their personal experiences, known as heuristics, which
reduce the decision to a simpler choice (Tversky and Kahneman 1974). Heuristics are straightforward, basic
tools that people use to explain a certain category of choices under a high degree of risk and uncertainty.
Heuristics are a “cognitive mechanism” for reducing the time commitment by simplifying the decision-
making process for investors. Even though this type of cognitive approach sometimes results in satisfactory
outcomes (also known as satisficing), heuristic judgments often result in inferior decisions. Satisficing is
a decision-making strategy or cognitive heuristic that entails searching through the available alternatives
until an acceptability threshold is met. Plous (1993, p. 109) states:
For example, it is easier to estimate how likely an outcome is by using a heuristic than by
tallying every past occurrence of the outcome and dividing by
the total number of times the outcome could have occurred. In most cases, rough
approximations are sufficient (just as people often satisfice rather than optimize).
Many stock brokers make fast purchase and sell decisions about equities by using heuristics because they are
under strict time restrictions and have the objective of earning large short-term gains within the markets.
Under such circumstances, these experts focus on a narrow amount of information and rely on previous
experience to make final judgments. In many instances, these individuals are unaware they are employing
these types of cognitive issues. Within an investment management setting, people use a tool known as the 1/N
heuristic when allocating retirement funds (Benartzi and ftaler 2001, 2007). For instance, an individual with
five mutual funds will equally distribute 20 percent of the money invested into each fund for his monthly
contribution to a 401k plan. ftis method is attractive to retirement savers because of its simplicity.
THE AVAILABILITY HEURISTIC

fte availability heuristic reveals an inclination individuals have to be biased by information that is easy
to recall, widely available, and highly publicized, which results in over-weighting or misinterpreting this
information (Tversky and Kahneman 1973). As Schwartz (1998, p. 64) notes, “Biases may arise because
the ease which specific instances can be recalled from memory affects judgments about the relative frequency
and importance of data.” According to Ricciardi (2008b), the main aspects of the availability heuristic that
influence a person’s judgments and decisions are (1) choices that induce affective reactions; (2) activities that
are extremely dramatic; and (3) recent events, which have a tendency to be more readily available in an
individual’s memory. For example, investors overrate the importance of recent investment news and discount
older information when evaluating a common stock. When a blue chip stock releases quarterly earnings
above estimates and this information is reported online or on other financial news media, this may
dramatically increase the company’s short-term stock price. However, once the news fades from the memory
of investors, the stock’s volatility returns to its historical average.
OVERCONFIDENCE
Individuals are inclined to be overconfident about their skills, expertise, and intelligence. fte subject matter of
overconfidence is an important finding in behavioral finance because different categories of investors suffer from this
bias. Overconfident investors believe they can influence the final outcome of a decision based on certain superior
attributes when compared to the average investor. In the domain of finance, many people believe they are above
average in their aptitude, overall decisions, and capability (Ricciardi 2008b). People are highly confident in their
judgments formed under the application of heuristics and are inattentive to the actual method used to form
their final judgments.
BarberandOdean(2001) explorethetradingpsychology betweenmenandwomen for 35,000 accounts of
individual investors over a six-year period. fte study reveals
that men are more overconfident than women about their financial skills and that men trade more within their
investment accounts. Men are prone to sell common stock at an incorrect point in time and also to incur
higher trading costs than women. Women are predisposed to trade less, employing a buy-and-hold approach
that results in lower investment expenses. Men trade 45 percent more frequently than women, and single men
trade 67 percent more frequently than single women. Trading costs reduce the net investment performance
of men by 2.65 percentage points a year compared to only
1.72 percentage points for women. In other words, for the six-year period of the study, women earned 1
percentage point a year more than did men. ftis finding has even more dramatic consequences if the 1 percentage
point yearly difference is applied over a 30 to 40-year time horizon because to the effects of
compounding.
STATUS QUO BIAS

Individuals are inclined to experience status quo bias, in which they tend to default to the same choice or
to accept the current decision. People find changing the behavior of procrastination or inertia entails strong
incentives. ftis bias happens when individuals fail to revise their financial plans despite potential benefits from
doing so. Retirement savers have the same behavior, such as holding onto an underperforming mutual fund
instead of selling it. Employees delay contributing to their company retirement plan or procrastinate in seeking
the advice of a financial planner to learn about different retirement options. After starting to contribute to a
company retirement plan, many employees do not actively monitor their accounts.
For example, Agnew, Balduzzi, and Sunden (2003) evaluate 7,000 retirement accounts between
April 1994 and August 1998. fte authors report that most asset allocation choices are extreme or possess
disproportionate diversification into risky securities (i.e., an individual who has multiple holdings in stocks or
invests 100 percent of his assets in stocks) and retirement savers suffer from inertia or status quo bias regarding
their asset allocation decisions. fte study also finds exceptionally low portfolio turnover rates and asset
rebalance transactions in these accounts, which further demonstrate status quo behavior.
About This Book

PURPOSE OF THE BOOK
ftis book provides a synthesis of the theoretical and empirical literature on the financial behavior of major
stakeholders, financial services, investment products, and financial markets. Compared with traditional finance, the
book offers a different way of looking at financial and emotional well-being and of the processing of beliefs,
emotions, and behaviors related to money. It provides important insights about cognitive biases and emotional
issues that influence various financial decision makers, services, products, and markets. ftis volume is a
“contributed chapter” book in which noted academic researchers and practitioners provide chapters in their
areas of expertise. ftus, readers can gain an in- depth understanding about this topic from experts from
aroundtheworld.
In today’s financial setting, the discipline of behavioral finance is an area that continues to evolve at a rapid
pace. ftis book takes readers through not only the core topics and issues but also the latest trends, cutting-edge
research developments, and real-world situations. Additionally, discussion of research on various cognitive
and emotional issues is covered throughout the book. ftus, this volume covers a breadth of content from
theoretical to practical, while attempting to offer a useful balance of detailed and user-friendly coverage.
ftose interested in a broad survey will benefit, as will those searching for more in-depth presentations of
specific areas within this field of study. As the seventh book in the Financial Markets and Investment Series,
Financial Behavior: Players, Services, Products, and Markets offers a fresh look at the fascinating area
of financial behavior.
DISTINGUISHING FEATURES
Financial Behavior: Players, Services, Products, and Markets has several distinguishing features.
• fte book examines highly relevant and timely aspects of financial behavior and blends the
contributions of noted academics and practitioners who have varied backgrounds and differing
perspectives. fte book also reflects the latest trends and research from a unique perspective, as the content
is organized by major players, financial services, investment products, and markets. By contrast, other
books in behavioral finance and investor psychology often organize chapters by a specific subject matter
ortopicarea,suchasacognitiveissue,emotionalbias,ortheory.
• fte results of empirical studies are presented in a user-friendly manner to make them
understandable to readers with different backgrounds.
• fte book provides discussion questions and answers to help to reinforce key concepts.
INTENDED AUDIENCE
fte book’s content and distinctive features should be of interest to a wide range of groups including
academics, researchers, professionals, investors, students, and others interested in financial behavior.
Academics can use this book not only as an integral part of their undergraduate and graduate finance courses but
also as a way of understanding the various aspects of research emerging from this area. fte book can help
professionals navigate through the key areas in financial behavior. Individuals and financial planners can use
the book to expand their knowledge base and can apply the concepts to managing the entire financial
planning process. fte book can serve as an introduction to students interested in these topics.
Structure of the Book

fte 30 chapters in this book are grouped into seven parts. A brief summary of each part and chapterfollows.
PART ONE: FIN A NC IA L BEHAVIOR AND PSYCH OLOG Y

Chapter 1 Financial Behavior: An Overview (H. Kent Baker, Greg Filbeck,
and Victor Ricciardi)
As you have seen, chapter 1 offers an enhanced discussion of behavioral finance and a description of this
book.
Chapter 2 The Financial Psychology of Players, Services, and Products

(Victor Ricciardi)
ftis chapter provides an overview of the emerging cognitive and emotional themes of behavioral finance that
influence individual behavior. ftebehavioral finance perspective of risk incorporates both qualitative
(subjective) and quantitative (objective) aspects of the decision-making process. An emerging subject of
research interest and investigation in behavioral finance is an inverse (negative) relation between perceived
risk and expected return (perceived return). ftis chapter highlights important topics such as
representativeness, framing, anchoring, mental accounting, control issues, familiarity bias, trust, worry, and
regret theory. It also examines the role of negative affective reactions on financial decisions. Financial worries
and negative emotions influence all types of individuals including children, investors, and financial
professionals. A host of biases that depend on specific aspects of the financial product or investment service
influence the judgment and decision-making process of financial players.
PART TWO: THE FINANCIAL BEHAVIOR OF MAJOR PLAYERS

fte second part has seven chapters involving the behavior of various players in the financial markets:
individuals; institutional investors; corporate executives, directors, and boards; financial planners and
advisors; financial analysts; portfolio managers; and financial psychopaths.
Chapter 3 Individual Investors (Henrik Cronqvist and Danling Jiang) Traditional

financeexplainsindividualinvestors’ behaviorandfinancialdecision-making based on economic incentives and
rationality Modern finance, however, takes a holistic view and searches not only for economic but also for
biological, psychological, and social factors that shape decision-making and investor behavior. In this new
approach, genetics, life experiences, psychological traits, social norms, and peer influences, as well as
beliefs, values, and culture in general, determine stock market decisions, share of equity holding, frequency of
trading, extent of diversification, and preferences that make up the investment styles of individual investors.
fte collective preferences and actions of individual investors exert an impact on asset pricing and corporate
decisions.
Chapter 4 Institutional Investors (Alexandre Skiba and Hilla Skiba)

A large body of behavioral finance literature focuses on the behavioral biases of individual investors in their
trading choices. Research also shows that sophistication is related to the level at which behavioral biases
influence investors’ trading choices. ftis chapter reviews the literature on institutional investors’ trading
behavior and finds that, consistent with the level of investor sophistication, institutional investors are less
subject to
the common behavioral biases. However, some behavioral biases are present in institutional trading and more
so among less sophisticated investor types. Evidence also shows that institutional investors engage in some
trading choices, such as herding, momentum trading, and under-diversification, that could be symptoms of
behavioral biases. Based on the reviewed research, these trading behaviors are not value reducing. Overall, the
evidence indicates that institutional investors are less subject to behavioral biases, making markets more
efficient.
Chapter 5 Corporate Executives, Directors, and Boards (John R. Nofsinger

and Pattanaporn Chatjuthamard)
ftis chapter assesses the behavior of corporate managers and boards of directors within the framework of
agency theory, stewardship theory, and psychological biases. In agency theory, a chief executive officer
(CEO) is motivated to act in his own best interest rather than that of the shareholders. Stewardship theory
posits that a CEO is a self- actualizing individual seeking to grow and reach a higher level of achievement
through leading an organization. A CEO exhibits self-interested behavior in managing the firm. A CEO also
exhibits optimism, overconfidence, and risk aversion behaviors that are not optimal for the firm. In the context
of agency theory, the board of directors should enact incentive structures and monitoring to control these
behaviors. However, directors also suffer from self-interests and cognitive biases. Specifically, boards may suffer
from group dynamic problems such as social loafing, poor information sharing, and groupthink.
Chapter 6 Financial Planners and Advisors (Benjamin F. Cummings)

An increasing number of households use financial planners or advisors. ftis chapter seeks to provide
insight into these professionals, their potential motivations, and their interactions with clients. fte various
regulatory regimes of financial planners and advisors are discussed, including the most common types
of firms: registered investment advisors, broker-dealers, and insurance firms. Agency costs associated
with employing a financial planner are also discussed, with emphasis on the potential conflicts of interest
that can arise from various compensation structures that advisory firms typically use. Common areas of
consumer confusion are highlighted. fte chapter also discusses the empirical evidence on the use and value of
financial advice. It concludes with some recommendations for consumers about selecting a financial
planner or advisor.
Chapter 7 Financial Analysts (Susan M. Young)

Financial analysts are important players in the marketplace. Analysts’ reports, which include forecasts of
earnings and stock recommendations, move market prices. Investors, both large and small, rely on the
information in reports when forming their investment decisions. Given the relevance of financial analysts’
research, understanding whether their reports are biased is important because relying on them could harm
investors using the information in these reports to inform their decisions. Despite an increase in market
regulation, evidence suggests that analysts’ reports are biased. fte research also finds that analysts’ bias
increases when information uncertainty is high. ftus, investors should understand the possible dangers in
blindly relying on research by financial analysts.
Chapter 8 Portfolio Managers (Erik Devos, Andrew C. Spieler,

and Joseph M. Tenaglia)
In the oversight of most funds, the portfolio manager holds the key decision-making power. Often regarded
as the foundation of the investment process, a few select managers can attract billions of dollars from
investors, giving the managers increased prominence, credibility, and compensation. Despite their stature,
portfolio managers are not immune to the same behavioral biases as other investors, which can distort the
portfolio management process. ftis chapter offers an overview of portfolio management and compares
characteristics of different fund types that portfolio managers oversee. It also reviews several important
behavioral biases that portfolio managers display, as well as the consequences that each bias has on portfolio
construction: overconfidence, herd mentality, risk-taking behavior, and the disposition effect. fte chapter also
contrasts the gender differences of portfolio managers and reviews the ramifications on their respective
portfolios.
Chapter 9 Financial Psychopaths (Deborah W. Gregory)

fte term financial psychopath emerged after the financial crisis of 2007–2008. Its media usage
appears to have been intended as a term of derision for financial professionals, rather than an actual
clinical profile. fte expression succinctly conveys the post-2008 widespread public anger and resentment
toward those in the finance profession, particularly on Wall Street, held responsible for damaging the
world economy and destroying the personal wealth of many people. In the decades before the financial
crisis, multiple factors had come together to change the operating structure of the financial landscape. ftis
new environment was conducive to investment professionals’ engaging in transactions bearing the
hallmarks of psychopathic behavior, raising the critical questions: What defines a financial psychopath?
Does it lie in the individual’s personality traits, the behavioral edicts dictated by the environment
within which he or she works, or both? ftis chapter attempts to answer these questions.
PART THREE: FINANCIAL AND INVESTOR PSYCHOLOGY OF

SPECIFIC PLAYERS
fte third part has five chapters on the financial and investor psychology of specialized players, including high
net worth individuals, traders, women, and millennials.
Chapter 10 The Psychology of High Net Worth Individuals

(Rebecca Li-Huang)
ftis chapter takes an economic view of the investment behavior of high net worth individuals (HNWIs),
including the psychological aspects of private wealth and the practice of wealth management, current trends
affecting the players and markets, and empirical findings on wealth creation and distribution that have fueled
policy debates. Wealth concentrations and scarcity of skills have granted institutional advantages to HNWIs
and the highly skilled, including higher returns on their physical and human capital investments. Besides
achieving financial returns, HNWIs want to use their private wealth to have a social impact. Wealth
managers respond to the attitude and
behavior of HNWIs by shifting the focus from investment products and transactions to holistic investing and
goal-based wealth management.
Chapter 11 The Psychology of Traders (Duccio Martelli)

In recent decades, trading has become very popular among retail investors, mainly due to the widespread use of
technology and a reduction in transaction costs. However, the growing amount of information available to
individuals and the higher complexity of financial markets have led these investors to make psychological
mistakes more easily. fte objective of this chapter is to describe the main types of behavioral bias that affect
individual investors, especially retail traders who frequently churn their portfolios. fte chapter compares
momentum and contrarian trading strategies used by such traders. It also discusses the impact of new
information on market sentiment and its effect on trader psychology. Finally, the chapter examines the main
behaviors of novice traders, followed by a summary of various studies that analyze the conduct of novice
investors in the course of investment challenges and trading simulations.
Chapter 12 A Closer Look at the Causes and Consequences of Frequent

Stock Trading (Michal Strahilevitz)
ftis chapter examines the phenomenon of frequent stock trading. Specifically, it covers the ample research
demonstrating the negative effects of frequent trading on investor returns, as well as several possible
underlying causes for this irrational behavior. Among these possible causes of frequent trading are
overconfidence, risk seeking, gambling addiction, frequency of negative emotions, and emotional instability.
fte chapter also examines gender differences. Although the vast body of research shows that frequent trading
is bad for returns, many investors continue to trade too often for their own good. fterefore, besides discussing
potential causes of frequent stock trading, this chapter also stresses the need for future research to identify
effective methods of helping investors reduce this financially harmful behavior.
Chapter 13 The Psychology of Women Investors (Marguerita M. Cheng

and Sameer S. Somal)
fte role of financial decision maker in a household has evolved over time. Decades ago, women held traditional
roles of caregiver, housekeeper, and wife. Today, more women are pursuing higher education, and female
professionals and entrepreneurs are making great strides in business. Understanding what today’s women value in
all these roles helps to bridge the gap between financial literacy and its application. Training and mentoring
women should be a priority for every financial institution, as women expect customized service and clear
communication from financial experts. ftis chapter discusses the financial, psychological, and personal needs
of women clients. It also explains how financial advisors should communicate with women to create a
favorable client experience.
Chapter 14 The Psychology of Millennials (April Rudin

and Catherine McBreen)
ftis chapter focuses on the financial mindset and behaviors of millennials, and how they interact with financial
advisors. Millennials have surpassed baby boomers as the most
productive generation and are projected to be the wealthiest. At 80 million strong, they are poised to leave their
imprint on the financial services industry as well, which will have to adapt if it wants to engage a generation that
communicates and invests differently from its predecessors. Millennials are often identified with unflattering and
stereotypical portrayals, but financial advisors ignore this group at their peril. ftis generation is more apt to
conduct its financial and investment affairs in nontraditional ways, laying the ground- work for their secure
financial future.
PART FOUR: THE PSYCHOLOGY OF FINANCIAL SERVICES

fte fourth part has five chapters on the psychological aspects of financial planning, financial advisory
services, insurance and risk management, estate planning, and retirement planning and wealth
management.
Chapter 15 Psychological Aspects of Financial Planning (Dave Yeske

and Elissa Buie)
ftis chapter discusses personal financial planning, which is an interdisciplinary practice that employs a six-
step process to develop integrated strategies for individuals and families hoping to mobilize their human and
financial capital to achieve their life goals. Financial planning draws from various disciplines, including
counseling, psychology, finance, economics, and law. It includes budgeting and cash flow planning, risk
management, insurance planning, investment planning, retirement and employee benefits planning, tax
planning, and estate planning. fte strategic process involves developing integrated strategies that draw from all
these fields in pursuit of client goals is the professional’s unique domain. Heuristics and mental biases to
which clients may be prone often overlay the entire financial planning process. Financial planners should
understand and consider these issues in shaping recommendations uniquely suited to each client,
maximizing the probability that the client will embrace and implement the recommended strategies.
Chapter 16 Financial Advisory Services (Jeroen Nieboer, Paul Dolan,

and Ivo Vlaev)
Evidence from the behavioral sciences, notably economics and psychology, has pro- foundly changed the
way policymakers and practitioners present expert advice to consumers. ftis chapter examines the evidence in
regard to financial advice and explores its implications for the financial advisory profession. fte authors
explain how consumers of retail financial advice respond to certain aspects of the advice process in predictable
ways, sometimes exhibiting behavioral biases or following certain conventions in their decision making. By
recognizing and anticipating these responses, financial advisors can offer a more complete service, extending
benefits beyond the strictly financial return to advice. But the behavioral needs of consumers may also provide
advisors with incentives that are not strictly aligned with their clients’ financial interests. Finally, the authors
review the increasing role of technology and how it will play an important role in shaping the financial
advisory services of the future.
Chapter 17 Insurance and Risk Management (James M. Moten Jr.

and C. W.Copeland)
According to modern portfolio theory (MPT), rational market participants make most decisions and seek to
be compensated for additional risk. However, behavioral finance shows how investors sometimes behave
irrationally due to preconceived notions and biases based on past experiences. ftis chapter explores how
individuals make decisions to buy different types of insurance even when faced with predicable outcomes
involving the frequency and severity of the loss. ftat is, individuals appear to buy insurance only when the
frequency of loss is low and the severity of loss is high; otherwise, they self-insure.
Chapter 18 Psychological Factors in Estate Planning (John J. Guerin

and L. Paul Hood Jr.)
As an area of behavioral finance, estate planning is less concerned with systematic, cognitive errors than it
is focused on a core, emotional ambivalence about mortality. fte chapter explores the dynamics of the
professional/client relationship in financial planning and estate planning, as well as the emotional conflicts
concerning mortality in light of research about mortality salience and terror management theory. Additionally,
including marital, family, and family business issues introduces inherent complications to efforts at estate
planning, which may in turn affect succession planning, inheritance, heir preparation, and family dynamics.
However, recent developments in assessing financial style/personality may enhance progress in estate
planning. Tools for facilitating the process are discussed in this chapter, along with observations for
further development in the field. Models in other areas of psychotherapy show the potential to inform this
area of practice.
Chapter 19 Individual Biases in Retirement Planning and Wealth Management

(James E. Brewer Jr. and Charles H. Self III)
Around the globe, the gradual move from defined benefit pensions to defined contribution pensions has
increased the need for individual retirement planning. Examples of this need include U.S. savings rates being at
historic lows, poor retirement prospects for citizens in various developed countries, and DALBAR analyses
that disparage the gap between investor returns and market returns. Research indicates that individuals working with
a financial advisor generally receive better results than those who do not. Working with a Certified Financial
Planner (CFP) gives an added level of security, because a CFP takes an oath to keep the client’s interests ahead of
his or her own business interests. ftis chapter promotes use of nudges to help individuals close the savings,
investing,and behavior gaps, thereby improving their total wealth and wealth transfer picture.
PART FIVE: THE BEHAVIORAL ASPECTS OF INVESTMENT

PRODUCTS AND MARKETS
fte fifth part has four chapters focusing on the behavioral aspects of traditional securities, pooled investment
vehicles, international mergers and acquisitions, and the art and collectibles markets.
Chapter 20 Traditional Asset Allocation Securities: Stocks, Bonds, Real Estate,

and Cash (Christopher Milliken, Ehsan Nikbakht,
and Andrew Spieler)
Asset allocation models have evolved in complexity since the development of modern portfolio theory, but
they continue to operate under the assumption of investor rationality, in addition to other assumptions that do
not hold in the real world. For this reason, academics and industry professionals try to understand the
behavioral biases of decision makers and the implications these biases have on asset allocation strategies.
ftis chapter reviews the building blocks of asset allocation, which involve stocks, bonds, real estate, and cash. It
also examines the history and theory behind two of the most popular portfolio management strategies: mean-
variance optimization and the Black-Litterman model. Finally, the chapter examines five common behavioral
biases that have direct implications on asset allocation: familiarity, status quo, framing, mental accounting, and
overconfidence. Each behavioral bias discussion contains examples, warning signs, and steps to correct the
emotional or cognitive errors in decision making.
Chapter 21 Behavioral Aspects of Portfolio Investments (Nathan Mauck) Investors

are inextricably linked to financial institutions, money managers, and the products they market. Mutual
funds, exchange-traded funds (ETFs), hedge funds, and pension funds manage or hold roughly $55
trillion in combined wealth. ftis chapter examines these topics with a behavioral finance approach that
focuses on two main themes. First, the chapter reviews the performance and rationality of each group;
second, the chapter examines the behavioral biases that relate to individuals’ selection of particular
investments within each group. Research indicates actively managed mutual funds and hedge funds
underperform passive investments. Pension funds generate alpha of roughly zero on a risk-adjusted basis.
fte fees involvedin investing in such funds exacerbate the observed underperformance in mutual funds and
hedge funds. Behavioral biases provide one perspective on sources of underperformance. Further,
individuals exhibit a wide range of behavioral biases that may lead to suboptimal asset allocation, including
the selection of mutual funds, ETFs, and hedge funds.
Chapter 22 Current Trends in Successful International M&As

(Nancy Hubbard)
fte worldwide landscape of merger and acquisition (M&A) activity has changed dramatically in the past
decade. Acquirers, acquisition trends, and strategies behind those transactions now differ dramatically.
Acquisition success rates also appear to be different, with recent research indicating that international
acquisitions are more successful than they were previously. Successful acquisitions involve a complicated
combination of melding systems and employees in an environment of cultural contrasts. Successful
acquisitions on an international level also require financial rigor and discipline combined with an
understanding of human behavior and motivation. ftis chapter examines both the changing trends and the key
success factors for M&As in terms of financial inputs and behavioral elements so as to better understand the
complex M&A process and identify indicators for future success.
Chapter 23 Art and Collectibles for Wealth Management (Peter J. May)

ftis chapter examines different psychological biases in the area of art and collectibles, which are part of every
client’s world to some degree. Wealth management has a tradition of management by silo with each silo guided by its
own revenue stream. In a changing world guided by disrupting evolution due to the availability of big data,
yesterday’s knowledge and information are today’s commodities. ftis evolution has escalated as information is
now accessible globally by almost anyone with a mobile device. Wealth management must adjust its current client
service model to leverage the informational commodity of art and to incorporate this commodity into its daily
conversations. With the proliferation of social media and web-based resources, art and collectibles are now an asset
class option.
PART SIX: MARKET EFFICIENCY ISSUES

Part six has four chapters that explore the behavioral finance market hypothesis, stock market anomalies,
speculative behavior, and high-frequency trading.
Chapter 24 Behavioral Finance Market Hypotheses (Alex Plastun)

Although the efficient market hypothesis (EMH) is the leading theory describing the behavior of financial
markets, researchers have increasingly questioned its efficacy since the 1980s because of its inconsistencies
with empirical evidence. ftis challenge to the EMH has resulted in the development of new concepts and
theories, and these new concepts rejecting the assumption of investor rationality. fte most promising and
convincing among these concepts are the adaptive markets hypothesis, overreaction hypothesis,
underreaction hypothesis, noisy market hypothesis, functional fixation hypothesis, and fractal market
hypothesis. ftis chapter provides a brief description of these theories and proposes using a behavioral
perspective to analyze financial markets.
Chapter 25 Stock Market Anomalies (Steve Fan and Linda Yu)

Stock market anomalies representing the predictability of cross-sectional stock returns are one of most
controversial topics in today’s financial economic research. ftis chapter reviews several well-documented and
pervasive anomalies in the literature, including investment-related anomalies, value anomalies, momentum
and long-term reversal, size, and accruals. Although anomalies are widely accepted, much disagreement exists
about the underlying reasons for their predictability. ftis chapter surveys two competing theories that attempt
to explain the presence of stock market anomalies: rational and behavioral explanations. fte rational
explanation focuses on the improvement of existing asset pricing models and/or searching for additional risk
factors to explain the existence of anomalies. By contrast, the behavioral explanation attributes the predict-
ability to human behavioral biases in collecting and processing financial information, as well as in making
investment decisions.
Chapter 26 The Psychology of Speculation in the Financial Markets

(Victor Ricciardi)
ftis chapter discusses the role of speculation within financial markets that influences individual and group
behavior in the form of bubbles and crashes. fte chapter highlights behavioral finance issues associated
with these bubbles, such as overconfidence,
herding, group polarization, groupthink effect, representativeness bias, familiarity issues, grandiosity,
excitement, and the overreaction and underreaction of prices in markets. fte issues are important for
understanding past financial mistakes because history often repeats itself. fte chapter also examines the
aftermath of the financial crisis of 2007–2008 on investor psychology, including the impact of a severe
financial downturn, the anchoring effect, recency bias, worry, loss averse behavior, status quo bias, and
trust. fte aftermath of the financial crisis might have negative long-term effects on investor behavior in which
some investors remain overly risk averse resulting in under- investment in stocks and over-investment in
cash and bonds.
Chapter 27 Can Humans Dance with Machines? Institutional Investors,

High-Frequency Trading, and Modern Markets Dynamics (Irene Aldridge)
ftis chapter examines high-frequency trading (HFT), including core groups of strategies and their resulting
impacts. Using order-by-order market data analysis, the chapter shows that much of what is often construed to
be useless noise of order cancellations actually represents meaningful order revisions, part of the real-time
market bargaining. fte chapter further shows that a small fraction of the order cancellations are a product of
purely toxic liquidity. Market participants of different frequencies tend to react differently to such toxic
orders, with higher-frequency traders largely ignoring them and lower-frequency investors interacting
with toxic liquidity.
PART SEVEN: THE APPLICATION AND FUTURE OF

BEHAVIORAL FINANCE
Part seven includes three chapters that explore applications of client behavior, implementing behavioral
finance, and the future of behavioral finance.
Chapter 28 Applications of Client Behavior: A Practitioner’s Perspective

(Harold Evensky)
fte purpose of this chapter is to discuss various behavioral concepts and strategies that can help clients avoid
behavioral errors, with the result of increasing the probability of a successful plan design and
implementation. fte chapter discusses how the concepts introduced by research in behavioral finance have
become integrated throughout Evensky & Katz/Foldes Financial’s practice. fte chapter begins with framing
for new clients, which is part of the firm’s approach to retirement planning called “anchoring on the efficient
frontier.” fte “anchoring” refers to basing the client’s return requirement at the intersection of a capital needs
analysis and the client’s risk tolerance. Framing is introduced as a powerful behavioral management tool for
the practitioner. fte chapter discusses how behavioral finance lessons are integrated into the risk tolerance
and return discussions, as well as the reporting process.
Chapter 29 Practical Challenges of Implementing Behavioral

Finance: Reflections from the Field (Greg B. Davies and Peter Brooks)
Behavioral finance is only useful if it can be applied to help people make better decisions. ftis chapter offers
reflections on the good, the bad, and the ugly of a practical application of behavioral finance in a commercial
banking setting. It explores the difficulties of
non-experts who experiment with behavioral finance, and how effective applications require a unique mix of
expert knowledge and an ability to effect change. Principles of good applications of behavioral finance are presented,
along with information on how to start using behavioral finance within an organization. fte chapter also discusses
the importance of senior management’s acknowledging that behavioral finance practitioners do not necessarily
knowthecorrectanswersandthattheywill needtouserandomizedcontroltrialsto help discoverthem.
Chapter 30 The Future of Behavioral Finance (Michael Dowling

and Brian Lucey)
Any positive future for behavioral finance necessitates that research areas of corporate finance and investor
psychology develop richer models of financial decision-making. Behavioral corporate finance requires
expanding the focus from chief executive officer to the entire top management team, and also involves greater
understanding of organizational theory. ftere needs to be a clearer focus on cross-cultural factors and how these
factors interact with behavioral influences. Investor psychology requires a more comprehensive theory of the
drivers of investor behavior and better data. Investor sentiment research offers potential for advancing an
understanding of the psychological influences on asset pricing. ftis chapter expands on these ideas and discuss
the context for future philosophical development of behavioral finance, with its inevitable push for greater
openness, replicability, and reliability in research.
Summary and Conclusions

Traditional finance assumes that investors make rational decisions. Behavioral finance acknowledges the
contributions of traditional finance, but also recognizes cognitive and emotional biases that result in a decision-
making process contradicting the assumptions of standard finance. ftus, behavioral finance examines the decision-
making approach of individuals, including cognitive and emotional biases. Financial Behavior: Players,
Services, Products, and Markets seeks to weave the contributions of both academics and practitioners into a
singlereviewof important but selectivetopicsrelatedtobehavioralfinance.
Behavioral finance affects the investment process on both micro and macro levels. fte presence of
investors who are influenced by behavioral biases can result in security and market pricing that deviates
substantially from intrinsic values based on traditional finance. Such decision-making frameworks can also
affect financial professionals and professional–client relationships. By better understanding financial
behavior, readers can distinguish the contributions of investor psychology and the role investor behavior has
on influencing the types of products and services offered, as well as judge the impact such behavior has on
market efficiency.
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Victor. 2006. “A Research Starting Point for the New Scholar: A Unique Perspective of
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2
The Financial Psychology of Players,
Services, and Products
Assistant Professor in Financial Management
Goucher College
Introduction
Behavioral finance explains how cognitive and affective processes influence the decisions of individuals
about financial issues. When people make financial choices, a collection of information, including both
objective and subject factors, affects their final judgment. ftis chapter brings together themes within the
behavioral finance literature that provide a strong foundation for understanding the issues influencing their
decisions and client behavior.ftefollowingareasarefundamentaltopicsandissuesinbehavioralfinance:
• Prospect theory: Investors assess different options of losses and gains based on a subjective
reference point (or anchor) in dollar terms based on the premise of loss averse behavior.
• Loss aversion: When assessing individual financial transactions, people assign more importance to a
loss than to achieving an equivalent gain.
• Disposition effect: Investors sell securities with gains too quickly and hold investments with
losses too long.
• Heuristics: Individuals use fundamental, realistic guidelines to assess information based on mental
shortcuts because of information overload, time constraints, or other categories of pressures.
• Availability heuristic: Individuals have an inclination to favor information that is simple to recall
and quickly accessible, a predisposition to information that is well known or recent and
overemphasize this information.
• Overconfidence: Investors tend to overestimate their expertise, talent, and forecasts for
investment performance.
• Status quo bias: Individuals suffer from inertia by defaulting to the same judgment or tolerating the
present situation, and this involves robust reasons or inducements to modify these activities.
ftis chapter provides a discussion of the emerging cognitive and affective issues of behavioral finance that
determine the decision-making process of individuals. fte first
23
section offers an overview of risk perception advocated by behavioral finance, including the inverse relation
between perceived risk and return. Next, the chapter examines important biases such as representativeness,
framing, anchoring bias, mental accounting, control issues, familiarity bias, and trust. fte next section focuses
on negative emotions, such as worry and regret theory, within the financial domain. fte last section
offers a summary and conclusions.
The Psychology of Risk

Risk is applicable across a wide variety of circumstances, events, and situation. ftis topic has a variety of
definitions, dimensions, and descriptions by individuals and organizations. Experts have studied the risk-
taking behavior of individuals and groups in great detail within the social sciences and business domains
(Ricciardi 2006, 2008a, 2008b, 2010) and the fields of behavioral accounting, financial psychology, and
behavioral economics (Ricciardi 2004). fte academic literature shows that risk has different meanings,
explanations, and measurements across many disciplines.
Risk perception is the subjective aspect of the decision-making process that individuals apply
when evaluating risk and the amount of uncertainty. Perceived risk includes both objective and
subjective factors that influence how people make judgments about all types of financial services and
products. In terms of the objective aspects of risk, Ricciardi (2008a) reports more than 150 financial
and accounting proxy variables from the risk perception literature as potential risk factors. Behavioral
finance also incorporates a subjective aspect of risk and risk-taking (e.g., cognitive and emotional factors)
that influences individual and group psychology in how people define, assess, and describe risk. Ricciardi
(2004, 2008b) presents an extensive list of more than 100 behavioral risk factors from the behavioral finance
literature andmore than 10 behavioral risk attributes from the behavioral accounting literature.
fte assessment of perceived risk is based on a descriptive model that explains how investors make actual
choices and decisions. Risk perception is based on the tenets of bounded rationality, satisficing, loss aversion,
and prospect theory (Ricciardi and Rice 2014). Bounded rationality is the idea that individuals reduce the
number of choices to a smaller, abbreviated set based on past experiences, values, mental shortcuts, and
emotions, even though this approach might oversimplify the final decision. Under the conditions of risk and
uncertainty, individuals often select a satisfactory rather than the optimal choice, which is known as
satisficing.
INVERSE RELATION BETWEEN RISK AND RETURN

A major tenet of traditional finance is the notion of a positive (linear) relation between historical risk and
return. ftis association is mainly based on the assumption of risk aversion in which individuals only invest
in higher-risk investments such as stocks if they expect to earn a higher return. However, this positive risk–
return relation does not always exist. For example, Haugen and Heins (1975, p. 782) reveal “over the long
run, stock portfolios with a lesser variance in monthly returns have experienced greater average returns than their
riskier counterparts.” Within behavioral finance, an emerging
The Financial Psychology of Players, Services, and Products 25
research topic is the exploration of the inverse (negative) relation between perceived risk and return
(Ricciardi 2008a). fte social sciences academic literature documents this inverse association in the form of
perceived risk and perceived gain (benefit).
Although the notion of an inverse association has recently become more common in the behavioral
finance academic literature, this relation has been an area of substantial interest in strategic management since
the early 1980s. With accounting data from Value Line, Bowman (1980) reports a negative risk-return trade-
off for 10 of 11 industries. ftus, Bowman’s paradox indicates that corporate managers undertake higher risk
despite expecting to earn lower returns. Bowman (1982) reveals that financially troubled companies take
more risk during times of financial difficulty, resulting in higher risk-taking behavior and lower rates of
return. fte author attributes this negative association between risk and return to the principles of
prospecttheory.
Diacon and Ennew (2001) investigate the risk perceptions of U.K. consumers for various personal
financial products. fte authors administer a questionnaire to 123 respondents to measure their perceived risk
for various financial items. For each of the 20 financial products, the questionnaire asked them whether they
currently owned or previously owned any of the products to assess the potential investment ownership judgment.
fte 25 risk characteristics in the study are mainly behavioral in nature (e.g., issues of losses, knowledge, and
time) with a few financial risk indicators. Diacon and Ennew use factor analysis to classify the 25 risk attributes
into five main risk dimensions: (1) mistrust of the investment product or source (i.e., a salesperson), (2) dislike
for adverse outcomes, (3) distaste to the volatility of a financial product, (4) inadequate knowledge of a
financial item, and (5) the failure of regulation. ftese factors account for 59.5 percent of an individual’s risk
perception. Diacon and Ennew (2001, p. 405) also explore the notion of an inverse association between
perceivedriskand return andcommentas follows:
Although investors need to be compensated for some aspects of perceived risk (such as the
possibility of adverse consequences and poor information) this does not apply to all dimensions
of perceived risk. In particular there is little evidence that individual investors want compensation
for volatility of returns.
Financial Biases Influencing Judgment

and Decision Making
Individuals suffer from a wide range of documented biases that influence their financial judgments and
decisions. ftis section focuses on some important psychological issues, including representativeness,
framing, anchoring bias, mental accounting, control issues, and familiarity bias. ftese biases have a
detrimental impact on how individuals perceive and process all types of information.
REPRESENTATIVENESS
fte representativeness bias is a heuristic based on the idea that people have an automatic predisposition to
advance a belief about a specific event and overrate how much this
situation reminds them of other familiar circumstances. ftis bias is based on the notion that individuals are
inclined to have a skewed belief about a financial event and then overestimate how much this situation is
similar to other ones in the past. According to Busenitz (1999, p. 330), people are willing “to develop broad,
and sometimes very detailed generalizations about a person or phenomenon based on only a few attributes of
the person or phenomenon.”
Representativeness results in investors’ classifying a financial investment as good or bad based on its recent
investment returns. For example, an individual may buy technology stocks after prices have risen, forecasting
that these increases will continue into the near future and ignoring blue chip stocks when their prices are lower
than their intrinsic valuations. As Ricciardi (2008b, p. 100) notes, another example of this bias is when
“investors frequently predict the performance of an initial public offering by relating it to the previous
investment’s success (gain) or failure (loss).”
Shefrin (2001) offers an example of representativeness bias within the context of an inverse association
between risk and return. Using a questionnaire, he conducts several studies over a five-year period with the
same group to examine the risk–return relation among student or expert investment groups. Shefrin assumes
that behavioral finance is based on the belief of a negative relation between expected return and perceived risk
(beta). He suggests this notion of an inverse relation is based on the premise that investors depend on the
representativeness heuristic to explain why individuals relate higher perceived returns from safe stocks (lower
perceived risk for stocks). Shefrin describes safer stocks as good stocks/good companies in which individuals
view higher-quality stocks based on such traits as the quality of the stock (e.g., financial soundness) and the
perceived goodness of the firm (e.g., management reputation). Shefrin (2001, pp. 179–
180) provides this perspective of the study:
Why do characteristics like book-to-market equity provide additional information over and
above the information conveyed by beta? I suggest that the answer to this question involves
the representativeness-based heuristic “good stocks are stocks of good companies.” Because
good companies are associated with characteristics such as low book-to-market equity, repre-
sentativeness will induce investors to expect higher returns from the stocks of good companies.
In particular, representativeness will lead investors to associate higher long-run returns with
low book-to-market equity. However, because the sign of the relationship between expected
returns and each characteristic is opposite to that between realized returns and the characteristic,
investors’ perceptions are erroneous.
FRAMING
An individual exhibits a “framing effect” when an identical or equivalent description of an outcome results in
a different final judgment or answer. As Kahneman and Tversky (1979) note, the framing process has two
important components: (1) the setting or framework of the decision, and (2) the format in which the
question is framed or phrased. For example, Weber (1991) illustrates the role of framing in the context of a
new business venture by asking whether individuals prefer:
Option A: Wouldyouinvestallyour moneyinanewbusinessifyouhada 50 percent

chance of succeeding brilliantly?
Option B: Wouldyou investallyourmoneyinanewbusinessifyouhada 50 percent
chance of failing miserably?
As Weber (1991, p. 96) notes, most individuals select the “success-frame in A makes it seem more appealing
than the failure-framed B, although the probability of success versus failure is the same for both.” fte reason for
selecting Option A is that the choice is a “positive frame,” which people find more psychologically comforting
and satisfying rather than Option B as the best option.
Roszkowski and Snelbecker (1990) investigate the role of framing within the context of gains and losses,
using an investment case study with 200 financial planners. Although financial planners often suffer from similar
framing effects, they are more conservative in their approach to managing their client’s money than their own
investments. Experts who chose the positive frame in the form of a gain demonstrate an inclination for risk
avoidance, and other professionals who favor the negative frame in the form of a loss are predisposed to risk-
seeking behavior.
ANCHORING
Anchoring is the tendency to apply a belief as a subjective reference point for making future judgments.
People often base their financial assessments on the first information they receive (e.g., an original purchase
price of a stock) and have difficulty adjusting their evaluation to new data. fte process of anchoring is an
example of when a certain piece of information influences an investor’s heuristic judgments and this
cognitive decision-making mechanism controls their final decision.
Even when aware of this anchoring bias, individuals have difficulty overcoming the anchoring effect
(Ricciardi 2008b). Piatelli-Palmarini (1994, p. 127) makes the following comments about the anchoring
process:
Revising an intuitive, impulsive judgment will never be sufficient to undo the original
judgment completely. Consciously or unconsciously, we always remain anchored to our
original opinion, and we correct that view only starting from the same opinion.
Investors are sometimes inclined to focus on a specific piece of information, which then serves as a reference
point that influences their decisions. For instance, many investors view a stock market decline as a
negative reference point or anchor. ftey may remember the value of their portfolios at market highs, before
the market declined, and become intent on getting back to the previous highest stock price of the past. When
people anchor on a bad investment memory, they might suffer higher levels of risk and loss aversion, which
results in higher levels of worry and leads to under-investing in stocks and over-weighting cash within their
portfolios. For instance, Kaustia, Alho, and Puttonen (2008) examine the role of anchoring involving a sample
of college students and investment professionals by evaluating stocks as an investment. fte authors finda very
large anchoring effectfor the college students inwhich they base their long-term
forecasts for stock performance on the original investment market value. Investment professionals also
suffer from the anchoring bias, but to a smaller degree.
MENTAL ACCOUNTING
Mental accounting is a heuristic process in which people split their investments into different categories,
groupings, or mental compartments. For instance, if an individual has a negative total return for the year on a
corporate bond, he will use a cognitive judgment approach that focuses on the positive aspect of the
financial security, such as a high current yield or the semi-annual coupon payment, by separating it into a
pleasurable mental account. Behavioral finance academics view the mental accounting bias as a negative
aspect of the decision-making process because the individual is not assessing their entire investment
portfolio.
Shafir and ftaler (2006) evaluate how individuals allocate assets across different financial mental
accounts. fteir evidence reveals that an advanced purchase such as a bottle of wine is identified as an investment
transaction rather than as a spending entry. If the buyer consumes and uses a product as anticipated, such as
drinking wine at a meal, the buyer considers the item “on the house” (i.e., free or complimentary) or in certain
instances labeled as a savings account. Shafir and ftaler (2006, p.694) note:
However, when it is not consumed as planned (a bottle is dropped and broken), then the
relevant account, long dormant, is resuscitated and costs associated with the event are
perceived as the cost of replacing the good, especially if replacement is actually likely.
In the financial-planning domain, financial practitioners consider mental accounting as having favorable
characteristics for managing their clients. Yeske and Buie (2014) recommend labeling certain mental
accounts, such as savings for a children’s college education, as “buckets.” According to Baker and Ricciardi
(2015, p. 24), “If clients treat these accounts as long-term investments that should not be disturbed, they are
more likely to reach their financial goals.”
CONT ROL ISSUES

Another bias that influences an individual’s decision-making process is the issue of control. One major type is
locus of control, which consists of external and internal controls (Rotter 1971). Locus of control describes
the degree to which someone perceives the ability to exert control over his own behavior and personal
outcomes of a specific decision. External locus of control provides a person with the idea that chance or
outside factors affect one’s judgment or final outcome of a decision event. Internal locus of control is the
notion or belief that an individual controls his own fate in terms of the outcome of a decision or situation.
Langer (1983, p. 20) provides this viewpoint on psychology of control (perceived control) as the “active
belief that one has a choice among responses that are differentially effective in achieving the desired
outcome.” Even in circumstances when control
of an outcome is in short supply, an individual believes that he has control over the outcome of a decision
is known as illusion of control (Langer 1975). Illusion of control is a prevalent bias within the behavioral
finance academic literature. Individuals acknowledge a desire to control a specific circumstance, with the
main purpose of influencing the results or outcomes in their favor. Strong (2006, pp. 273–274) presents this
perspective of illusion of control within a gambling setting:
Casinos are one of the great laboratories of human behavior. At the craps table, it is observable
that when the dice shooter needs to throw a high number, he gives them a good, hard pitch to the
end of the table… . We like to pretend we are influencing the outcome by our method of
throwing the dice. If you force the issue, even a seasoned gambler will probably admit that the
dice outcome israndom.
fte hot hand fallacy is the conviction or belief that an individual who had achievement or success with a
chance past situation has a greater probability of additional success. For example, a basketball player believes
he is more likely to make a basket based on the success of his previous shots or a hot streak (Gilovich, Vallone,
and Tversky 1985). Many experts or professionals believe a “hot hand” influences an individual’s assess-
ment or perception of success. Traders make a connection of a “hot hand” based on the previous success of
selecting winning stocks, and they develop the belief that they are more likely to select additional
“winners” in the future.
Self-control bias is the propensity that causes individuals with an overwhelming impulse to focus on
the short term. According to Shefrin (2005, p. 114), many investors suffer from “self-control problems that cause
inadequate savings.” In the short term, bad behavior, such as overeating that results in being overweight,
influences individuals. In the investment domain, individuals focus on spending more money today at the cost
of not saving money for the future. According to Baker and Ricciardi (2015, p. 125), “fte high level of credit
card debt and the generally inadequate level of retirement savings that many individuals face provide
support for this self-control bias.”
FAMILIARITY BIAS
Familiarity bias is prevalent when individuals have an overwhelming fondness for well- known financial
securities regardless of the benefits based on portfolio diversification. Nofsinger (2002, p. 64) contends that in
most circumstances, “people prefer things that are familiar to them. People root for the local sports teams.
Employees like to own their company’s stock.” Investors prefer familiar local investments, which results in
owning suboptimal portfolios. Investors perceive these securities as having an inverse relation between risk
and return because they perceive highly familiar assets as possessing lower risk and higher return (Ricciardi
2008a). At the same time, they perceive unfamiliar assets as producing a higher risk and lower return.
Wang, Keller, and Siegrist (2011) evaluate the risk perception of more than 1,200 individuals from a
German-language area of Switzerland about financial products. fte study’s major result is that
respondents perceive less complicated (i.e., easier to
understand) investments as having lower risk, which is consistent with familiarity bias. Participants also reveal
a positive affective reaction to familiar financial securities. For financial advisors, Wanget al. (2011, p. 18) offer
the following observation: “fte clients might overestimate the risk of a certain investment due to their lack of
knowledge or underestimate the risk due to their overconfidence of the self-perceived knowledge. To fill the
knowledge gap is important for effective risk communication.”
Financial Emotions that Influence Decisions

Emotional issues can also influence the financial judgment and decision-making process. Finucane, Peters,
and Slovic (2003) provide this perspective about the differences among emotion, mood, and affect. An
emotion is a state of consciousness related to the arousal of feelings. A mood or feeling is any subjective
reactions, whether pleasurable or unlikable, that a person might experience from a specific circumstance or
event. Affect is the emotional complex (i.e., positive or negative feelings) linked with an idea or thought.
However, these terms are applied interchangeably within this chapter. Shefrin (2005,
p. 10) provides the following perspective of affective (emotional) issues within finance:
Most managers base their decisions on what feels right to them emotionally. Psychologists use
the technical term affect to mean emotional feeling, and they use the term affect heuristic to
describe behavior that places heavy reliance on intuition or “gut feeling.” As with other
heuristics, affect heuristic involves mental shortcuts that can predispose managers to bias.
Grable and Roszkowski (2008) use a mailed questionnaire to evaluate how an individual’s mood
influences financial risk tolerance. fteir study examined two different perspectives: (1) the Mood
Maintenance Hypothesis (MMH), which states if a person is in a positive (negative) mood, this deceases
(increases) risk tolerance; and (2) the Affect Infusion Model (AIM), which is based on the premise that a
positive (or negative) mood increases (decreases) an individual’s risk tolerance. Based on the AIM premise,
the authors find that individuals between 18 and 75 years old who are in a positive (or happy) mood exhibit a
higher level of financial tolerance.
Rubaltelli, Pasini, Rumiati, Olsen, and Slovic (2010) investigate how individuals’ affective reaction to
different categories of mutual funds influences their judgment to sell this investment. After examining a
socially responsible fund and a typical mutual fund, participants are asked to provide a response of what price
they would be willing to sell the mutual fund. fte authors report that selling prices influence how individuals
feel about the funds, which reveals a subjective aspect to risk. Individuals with negative emotional responses
about their funds (socially and non-socially responsible types) have the highest selling prices. ftis outcome
demonstrates that only individuals initially having negative expectations toward a financial security are
inclined to systematically counter the disposition effect. However, individuals having positive responses
about the non-socially responsible fund anchor on their first impressions. Consequently, they cannot sell the
losing investment as quickly as individuals with negative emotions.
Using a questionnaire involving more than 400 individual investors located in northern Europe, Aspara
and Tikkanen (2011, p.78) assess how emotional responses about a firm might increase motivation to invest
a company’s stock and find that
most investors had affect-based, extra motivation to invest in stocks, over and beyond
financial return expectations. fte more positive an individual’s attitude towards the company
was, the stronger was his extra investment motivation.
fte authors assign this strong positive connection to the firm’s stock to a self-affinity bias, which asserts
that the stronger a person’s self-identification with a product or a company, the more likely this individual
will buy the firm’sproduct/service or invest in the company’sstock.
Burns, Peters, and Slovic (2012) assess the impact of the financial crisis of 2007– 2008 in order to
examine the change in risk perception during the crisis period. fte study uses seven questionnaires
administered between September 2008 and October 2009. More than 600 individuals responded to each
survey, and more than 400 participants completed all seven questionnaires. fte findings reveal that a person’s
perceptions of risk declines mainly throughout the early stages of the crisis and then starts to become
stable. fte most significant factor attributing to increases in perceived risk among respondents is negative
affect toward the crisis. fte authors credit this result to the risk as feelings effect (i.e., the notion that people
make quick, intuitive judgments about risky decisions attributed to their emotions).
TRUST
Trust between a financial professional and a client plays an important role in the financial-planning
process. According to Howard and Yazdipour (2014), trust is a major component within the retirement-
planning process and investment management. An important characteristic of the financial-planning
process is developing a balance between trust and control issues within this client–advisor relationship (Baker
and Ricciardi 2014a, 2014b, 2015). Clients who overly trust financial professionals or assign too much
control about financial decisions might endure a bad outcome; Ponzi schemes are a major example of this
result. Conversely, clients who reveal a lack of trust or who are excessively controlling may not listen to a
financial planners’ guidance. Experts should focus on fostering a balanced relationship of trust and
control with their clients.
Within the risk domain, Olsen (2012) examines the connection among trust, individual risk
perception, and cumulative market risk premiums. Based on survey responses from more than 600
members of the American Association of Individual Investors (AAII), the study discloses an inverse
relation between trust and perceived risk in a financial environment. Olsen (2012, p. 311) also reports that on
an economic countrywide basis, “ex-ante estimated common stock risk premiums and ex-post market interest
rates vary inversely with national trust levels. In countries with greater interpersonal trust, risk premiums and
interest rates are lower.”
Negative Emotions Within Financial

Decision Making
Negative feelings and money management have a long historical tradition and importance in the area of
financial judgment and decision making. Emotional financial processes influence how people assess and
make final decisions. ftis section provides a discussion of affective issues from different perspectives, such
as money sickness, the role of different groups, the retirement domain, and neurofinance. ftis section also
presents the negative emotions of worry, worry and perceived risk, and regret in behavioral finance.
MONEY SICKNESS
During the 1950s, William Kaufman, a psychosomaticist (i.e., an expert in medical science specializing
in the interrelations of the mind and the body) coined the term “money sickness” in reference to the
detrimental association between money and feelings (Anonymous 1954). Kaufman (1965) proposes a
balanced emotional approach to money, recognizing a difference between the positive aspects described as
“money health” versus the negative qualities known as “money sickness.” Kaufman (1965, pp. 43−44)
offers the following viewpoint:
Inappropriate use of money becomes a serious emotional threat when the person is faced with
the conflict between his desires and his conscience and with the consequences of his aberrant
money behavior. Deep unconscious motivations may prevent him from spontaneously using
money in constructive ways.Such people… often develop one of the most commonpsycho-
somatic illnesses of our time: money-sickness.
Even today many individuals are reluctant to admit they might have an emotional money disorder, which
leads to negative feelings such as nervousness, worry, or stress.
Henderson (2006), an expert in stress management and mental health, conceptu- alizes the disorder
known as the money sickness syndrome. For this type of syndrome, individuals exhibit symptoms of
stress occurring from the worry and anxiety produced by feelings of not having control of their money or
limited knowledge of their financial circumstance. AXA, an investment and insurance firm, sponsored
Henderson’s research survey of 1,022 U.K. adults over the age of 16. fte study finds that 43 percent of the
respondents exhibit the symptoms associated with money sickness syndrome. ftese results imply that the
equivalent of 10.75 million of the U.K. population experience money worries and reveal the warning signs
linked with this psychological condition (AXA 2006). For example, physical symptoms of the disorder
include headaches, nau- sea, indigestion, palpitations, lack of appetite, and poor sleeping habits. Otherwise,
the psychological indicators include mood changes, irritability, general anxiety, negative feelings, reduced
concentration, poor memory, and inferior judgments. ftis condition is a noteworthy example of the
emerging importance of the role of negative affect (emotion) and financial decision making. fte behavioral
finance literature reveals the
evolving role of negative affect (emotion) within the judgment process in different areas, such as
individual psychology, expertise of decision makers, retirement issues, and neurofinance
(neuroeconomics).
INDIVIDUAL PSYCHOLOGY
ftis first grouping of research studies emphasizes the importance of negative feelings (e.g., financial worries)
and individual psychology. For instance, Hira and Mugenda (1999, p. 78) investigate the role of perceived
self-worth and worry, reporting the following results:
Respondents with low self-worth compared with those with high self-worth exhibited concerns
about their financial situation. A significantly larger proportion of respondents with low self-
worth (63%) than those with high self- worth (29%) reported that they often worried about
their finances often. On the other hand, three times as many respondents with high self-worth
(23%) than those with low self-worth (7%) reported that they never worried about their
finances.
Grable and Joo (2001) examine the financial worries (stressors) of 406 individuals by presenting them with a
collection of “stressor event items” such as the potential decline in income, concern over declaring personal
bankruptcy, and influence of experiencing an investment/business loss. fte authors find an association
between several factors in which individuals who reveal better financial behaviors and higher levels of
financial confidence are more satisfied with their current financial circumstances. ftose reporting less
stressor events rank higher in terms of their level of self-esteem. Öhman, Grunewald, and Waldenström
(2003) evaluate 200 pregnant women’s worries in 16 areas and find that the major worry categories are the
baby’s health, birth and miscar- riage troubles, and financial issues such as money and employment problems.
In terms of the emotional aspects of decisions, Leahy (1992) uses a case study to describe the role of negative
feelings and the narcissistic tendencies of his Wall Street clients.
EXPERT DECISION MAKERS

fte following collection of research studies investigates the role of negative affect and financial judgments in
terms of how these emotional issues influence the assessment of expert decision makers. Criddle (1993)
suggests that within the financial and investment sectors, individuals experience a higher degree of stress
connected to competitive tension, which results in episodes of anxiety and worry. Criddle (1993, p. 19) also
comments about the role of a financial expert or investment professional as an “infinitely more dangerous
‘emotional mine field’ than the world of the amateur investor!” Garman and Sorhaindo (2005) examine the
most important concepts of a “personal financial well-being construct” in the framework of a financial
distress scale. An expert subject matter review panel unanimously identifies the two top-rated issues as
worrying about the ability to meet monthly living costs and surviving on a paycheck-to-paycheck basis.
Within a capital budgeting framework, Kida, Moreno, and Smith (2001) demonstrate
that managers incorporate both affective (emotional) issues and financial statistics when assessing the
utility of an investment option. Individuals evade financial choices connected with negative interpersonal
responses. Moreno, Kida, and Smith (2002,
p. 1331) report the following findings:
Managers were generally risk avoiding for gains in the absence of affective reactions, as
predicted by prospect theory. However, when affect was present, they tended to reject
investment alternatives that elicited negative affect and accept alternatives that elicited positive
affect, resulting in risk taking in gain contexts. fte results also indicate that affective reactions can
influence managers to choose alternatives with lower economic value.
Sawers (2005) conducts a capital budgeting study that examines the role of negative affect (emotions)
related to the investment judgments of 120 executives. fte study reports that managers presented with
more complex decisions describe feeling more apprehensive, worried, and uncomfortable and reveal an
increased need to delay making the judgment than members in the control group.
RETIREMENT ISSUES
Several studies examine the influence of worry (anxiety) and financial retirement issues. For example,
Loewenstein, Prelec, and Weber (1999, p. 242), who evaluate the money anxiety involved in retirement
issues, note:
Before retirement, one has largely adapted to one’s current income, and therefore its impact
on well-being is slight. Moreover, one is not yet sure whether savings will be sufficient for
retirement. All of this might increase overall money anxiety and, simultaneously, disconnect
that anxiety from objective financial circumstances.
Cutler (2001) documents that individuals with incomes between $35,000 and $100,000 and the age categories
of 35–43, 44–53, and 55–64 are more worried about squandering all their retirement wealth on long-term health
care than about merely outlasting their savings and pension funds. Owen and Wu (2007) report households that
acknowledge unfavorable financial pressures, worry more about the sufficiency (adequacy) of their financial
situation in retirement, even after accounting for the influence of financial pressures (shocks) on overall wealth.
Owen and Wu (2007, p. 515) comment: “we find supporting evidence that suggests that at least part of the
increased worry about retirement is due to general pessimism rather than changes in an individual’s own
circumstances.”
NEUROFINANCE
An emerging area of research within the behavioral finance literature involves negative affect (emotion)
and neurofinance, also known as neuroeconomics (Glimcher 2004; Peterson 2007, 2014; Zweig 2007). Shiv,
Loewenstein, Bechara, Damasio, and Damasio (2005) assess the financial judgments made by people who
are incapable of feeling
emotions as a result of brain lesions. fte study reveals that individuals with specific types of brain damage
generate more profits investing (i.e., produce higher gambling returns) than the normal and control groups.
Evidence shows that because the brain- injured subjects cannot experience emotions such as worry, anxiety
or fear, they are more inclined to accept risks with high rewards and are less likely to exhibit affective
(emotional) reactions to prior gains or losses. ftus, these individuals are less likely to exhibit loss-averse
behavior.
WORRY
For many investors, worrying is a regular occurrence. Worrying makes them feel as if they are reliving a past
event or living out a future one, and individuals cannot stop these types of thoughts from happening
(Ricciardi 2008b). Worry causes investors to reflect upon bad financial memories and produces mental
pictures of futures that change short-term and long-term judgments regarding their finances. For instance,
Ricciardi(2011) disclosesthatalargemajorityofinvestorsidentifythewordworry with stocks (70 percent of
the survey sample) compared to bonds (10 percent of the survey sample), based on the response of nearly 1,700
participants. A higher level of worry for a financial instrument such as common stocks increases its perceived
risk, lowers the level of risk tolerance for investors, and increases the probability of not buying this asset.
Snelbecker, Roszkowski, and Cutler (1990) examine the factors that influence an investor’s risk tolerance
and return expectations so experts can provide better investment advice and clients can receive a more
accurate risk-tolerance profile. fte authors contend that financial planners base too much advice regarding
risk tolerance and return expectations on the investment products and services, rather than on the client’s
personal characters such as feelings and attitudes about investment decisions. fte authors conduct two studies
that investigate risktolerance and investment return prospects: one study involves 49 financial planners and
the other involves 801 potential investors. On a group level, the financial planners demonstrate some
uniformity about interpreting theoretical clients’ statements. Yet, the study reveals significant differences
in individual respondents’ interpretations of the identical client statements.
In the second study, Snelbecker et al. (1990) conduct a telephone survey for a much larger sample of
individual investors who receive a questionnaire with four sets of client statements of risk and return. fte
two client statements with the highest level of importance about the association between risk tolerance and
return involve worry and a desire for an investment return above inflation. fte survey measures the worry risk
component using a question about whether a person is losing sleep worrying about his investments. fte
findings demonstrate how prevalent worrying is among individual investors. fte authors conclude that
financial professionals should consider such evidence when communicating and advising their
clients.
WORRY AND RISK PERCEPTION

fte study of worry and risk-taking behavior started in the social sciences and eventually appeared in the
behavioral finance literature (Ricciardi 2008b). In the social science domain, the association between worry
and perceived risk is an important area of
investigation (Ricciardi 2004). Loewenstein, Hsee, Weber, and Welsh (2001) propose that judgments of risky
behaviors and hazardous activities incorporate a component of negative emotions (feelings) such as dread,
concern, worry, anxiety, depression, sadness, or fear. fte foundation for the behavioral (psychological)
factors of risk- perception studies in behavioral finance, accounting, and economics stem from the earlier
endeavors on risky behaviors and hazardous activities in nonfinancial domains (Ricciardi 2004).
Decision Research, an organization founded by Paul Slovic, conducted ground- breaking research on
risky and hazardous activities. ftis research documents specific behavioral risk factors that today are applied
within a financial and investment decision- making context (Ricciardi 2010). fte seminal work by Decision
Research uses factor analysis to classify an extensive collection of risk indicators into two main risk con-
structs (dimensions) for nine standard behavioral risk characteristics and survey questions (Fischhoff,
Slovic, Lichtenstein, Read and Comb 1978). fte first factor is dread risk, measuring various risk-taking
behaviors such as possessing catastrophic potential, severity of consequences, risk to future generations,
and controllability of consequences. As Ricciardi (2008a) notes, this first factor documents an emotional
response of worry or concern toward risk, which eventually became known as dread or dreadness, which
affects an individual’s perception of risk for a specific risky activity or hazardous behavior.
In a study from the behavioral accounting literature, Hodder, Koonce, and McAnally (2001) propose that
dread risk might influence an individual’s perception of risk for complex investment products such as
derivative securities. Ultimately, negative affect (emotion) influences a person’s risk perception during the
financial and investment judgment process.
A study from the behavioral finance risk-perception domain by MacGregor, Slovic, Berry and Evensky
(1999) examines the connection between the decision-making process and various aspects of
investments/asset classes, especially expert’s perceptions of returns, risk, and risk/return associations. fte
authors use completed surveys from 265 financial advisors involving their assessment of a series of 19 asset
classes for 14 specific variables. Some of these 14 characteristics are behavioral in nature (i.e., attention,
knowledge, and time horizon) while others are judgment related to perceived risk, perceived return, and
likelihood of investing. fte main finding reveals three significant factors—worry, volatility, and knowledge—
as explaining 98 percent of the expert’s risk perception. fte study demonstrates that risk is a multi-factor
decision-making process across a wide range of investment classes. Finucane (2002, p. 238) further comments
on these findings as follows:
Perceived risk was judged as greater to the extent that the advisor would worry about the
investments that the investments had greater variance in market value over time, and how
knowledgeable the advisor was about the investment option.
Since the 1970s, researchers have conducted hundreds of risk-perception studies in nonfinancial areas across
a wide spectrum of disciplines (Ricciardi 2004, 2010). A noteworthy subject matter within the risk-perception
literature concerns worry because this
emotion might influence an individual’s perception of risk. Ultimately, all types of individuals differ in their
perceptions of worry and risk-taking behavior within the decision- making process. ftis perspective of
behavioral finance is based on the assumption that the process of worry encompasses both cognitive and
affective (emotional) issues. Negative emotions, especially worry, are an important risk indicator and this
reaffirms the notion that risk is a multidimensional decision-making process across a range of accounting,
financial, and investment settings (Ricciardi 2004, 2008a, 2008b).
REGRET THEORY
Regret aversion explains the emotion of regret encountered after making a decision that results in either an
unfavorable or a second-rate choice. Individuals who are predisposed by projected regret are induced to take less
risk because doing so reduces the prospect of bad outcomes. ftis regret bias helps explain why individuals possess
a reluctance to sell “losing” investments because they do not want to admit a bad decision. Many individuals
avoid selling securities that have declined in price to avoid feelings of regret and the distress of disclosing
the loss.
For example, Strahilevitz, Odean, and Barber (2011) examine how individuals’ past experiences with a
stock influences their willingness to repurchase that the same investment. fte study reveals that people are
hesitant to buy back stocks previously sold for a realized loss and stocks that have increased in price subsequent to
past sale transactions. Investors are dissatisfied when they sell stocks for a loss and experience regret for hav-
ing purchased them originally. ftis negative affective reaction discourages them from later buying back stocks
they sell for a loss. Because they sold such stocks, individuals are disenchanted if the stocks continue to increase
in price and display regret for having sold them the first time. ftis negative affect prevents them from buying
back stocks that increase in value after being sold. According to Stahilevitz et al. (p. S102), “investors engage
in reinforcement learning by repurchasing stocks whose previous purchase resulted in positive emotions and
avoiding stocks whose previous purchase resulted in negative emotions.”
As evidence in this section shows, negative feelings play an important role within the realms of financial
and investment judgments. In the domain of finance, negative emotions have real-world importance for
many different aspects of investing. For example, the news media sometimes support the notion of worrying in
the minds of stock market investors by focusing too much of their news coverage on market declines or bad
financial news in a short period of time. ftis media coverage is communicated and over- whelms
investors across various forms such as online new stories, print newspapers, and business segments of television
news (Ricciardi, 2008b). Financial worries and negative feelings influence all types of individuals.

Behavioral finance attempts to describe and improve an individual’s knowledge of the cognitive processes
and affective reactions that shape financial outcomes. Risk perception involves the objective and subjective
judgments that individuals apply to evaluate
risk and the degree of uncertainty for all types of situations. fte notion of an inverse (negative) connection
between perceived risk and return is of growing importance. fte chapter discusses a wide collection of biases
that influence the judgment and decision- making processes of individuals, including representativeness bias,
framing, anchoring affect, mental accounting, control factors, familiarity bias, trust, worry, and regret
theory. fte chapter also presents a detailed overview of the important influence of negative emotional
issues within the financial judgments. Money worries and negative affect have detrimental impacts on the
financial decisions of all types of people, including families, individual investors, and financial experts. ftese
are important behavioral finance themes that financial professionals should use to better advise their clients.
In effect, financial judgments are a situational, multidimensional decision-making process that depends on
the specific traits of the financial product or service.
DISCUSSION QUESTIONS
1. List and explain some fundamental issues of behavioral finance.
2. Provide an overview of the behavioral finance perspectives of risk.
3. Definetheheuristicbiasesofrepresentativeness,anchoring,and mentalaccounting.
4. Define and describe the process of worrying within the finance domain.
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Zweig, Jason. 2007. Your Money and Your Brain: How The New Science of Neuroeconomics Can Help
Make You Rich. New York: Simon & Schuster.
Part Two
THE FINANCIAL BEHAVIOR

OF MAJOR PLAYERS
3
Individual Investors
H E N R I K C R O N Q V I ST
Professor of Finance
School of Business Administration, University of Miami
D ANLING JIANG
SunTrust Professor and Associate Professor of Finance
College of Business, Florida State University
Introduction
Over the past two decades, our understanding of individual investor behavior has changed dramatically.
fte traditional paradigm that focuses on economic incentives and rationality has been replaced by a new,more
holistic paradigm that includes additional factors influencing investor behavior. ftese additional factors
include investors’ genetics, life experiences, nonstandard beliefs and preferences, societal norms and culture,
and group identities. fte holistic approach provides a more comprehensive perspective of what defines and
shapes the decision-making process of individual investors, and whether their behaviors and decisions
collectively matter for asset prices and corporate policies. ftis chapter examines recent advances in finance
research along these dimensions that define individual investor behavior and have implications for asset pric-
ing and corporate decisions. Owing to limited space, the chapter only reviews some representative work
in each topic.
Innate and Learned Investor Behavior

fte traditional paradigm in finance does not attempt to explain the origins of investors’ preferences and beliefs.
However, an emerging body of research attempts to do exactly that by tracing the heterogeneity in investor
behavior back to genetic factors, cognitive ability, and various personal experiences.
GENETIC FACTORS AND NEURAL FOUNDATIONS

fte longstanding debate in behavioral genetics and psychology about whether “nature” (i.e., genetic factors) or
“nurture” (i.e., the environment) shapes individual traits has recently made its way into research on investor
behavior. Barnea, Cronqvist, and Siegel
45
46 THE FINANCIAL BEHAVIOR OF MAJOR PLAYERS
(2010) and Cesarini, Dawes, Johannesson, Lichtenstein, Sandewall, and Wallace (2010) combine data on
identical and fraternal twins and data on portfolio allocations from tax registers, enabling them to decompose
the cross-sectional variation in investor behavior into genetic and environmental components. ftey find that
genetic factors explain about one-third of the variation in investment decisions. fte authors interpret these
results as evidence of innate differences in factors affecting stock market participation costs, as well as genetic
variations in risk preferences. Experimental evidence in economics supports these studies (Cesarini, Dawes,
Johannesson, Lichtenstein, and Wallace2009; Zyphur,Narayanan,Arvey, and Alexander 2009).
Cronqvist and Siegel (2014) extend the notion that genetic factors may be responsible for heterogeneity in
investment behavior by showing that several well-documented investment biases, such as the disposition
effect, performance-chasing behavior, and a preference for skewness, are partly genetic. ftey interpret these
results as implying behaviors that may result in investment mistakes may have been advantageous in evolu-
tionary ancient times, in the sense that these behaviors resulted in greater “fitness” (i.e., reproductive success)
andthereforebecamemorecommoninthepopulation.
A related string of research in neuroscience examines the neural foundations of investment behavior (Kuhnen
and Knutson 2005). Evidence finds specific genes to be related to investor behavior. For example, the DRD4
gene explains financial risk preferences (Dreber, Rand, Fudenberg, and Nowak 2008), the monoamine
oxidase A (MAOA) gene is related to risk-taking (Frydman, Camerer, Bossaerts, and Rangel 2011; Zhong,
Israel, Xue, Ebstein, and Chew 2009), and two genes that regulate dopamine and sero- tonin
neurotransmission (5-HTTLPR and DRD4) determine risk-taking in the investment domain (Kuhnen and
Chiao 2009). fte same brain areas involved in processing emotional states also process risk preferences and
payoff beliefs (Kuhnen and Knutson 2011). Candidate gene studies and genome-wide association studies
(GWAS) have both promises and potential pitfalls (Benjamin, Cesarini, Chabris, Glaeser, Laibson,
Guonason, Harris, Launer, Purcell, and Smith 2012).
C OG NITIV E AB IL ITY AND IQ

Several studies find that cognitive ability partly explains investor behavior. Using data from 11 European
countries, Christelis, Jappelli, and Padula (2010) find that differences in individuals’ cognitive ability partly
explain the propensity to participate in the stock market. In a series of studies (2011, 2012, 2016), Grinblatt and
his coauthors show that individuals with higher intelligence quotient (IQ) scores make better investment deci-
sions. Higher IQ investors are more likely to participate in the stock market, diversify by holding mutual funds or
a greater number of stocks, assume less risk, earn higher Sharpe ratios, display fewer investment biases, exhibit
better timing and stock-picking skills, and avoid high management fees when selecting mutual funds
(Grinblatt, Keloharju, and Linnainmaa 2011, 2012; Grinblatt, Ikaheimo, Keloharju, and Knupfer 2016).
Recent related research also pays close attention to the relations among aging, cognitive ability, and investor
behavior, which are increasingly important with an aging population responsible for its own investments.
Aging causes a well-documented decline in people’s cognitive ability, but it also increases investment
experience. fte adverse effect of aging, however, empirically dominates any experience effect; older investors
exhibit worseinvestment skillseventhough theyaremoreexperienced(KorniotisandKumar
Individual Investors 47
2011). In fact, financial mistakes appear to follow a U-shaped pattern, with the fewest mistakes made around
age 53 (Agarwal, Driscoll, Gabaix, and Laibson 2009). Although aging decreases cognition and financial
literacy, it is not associated with a drop in confidence in managing one’s own finances (Gamble, Boyle, Yu,
and Benett 2015).
PERSONAL LIFE EXPERIENCES

Life-course theory suggests that both early and late personal experiences in life may explain behavior later in
life. As a result, an investor’s behavior may be path dependent. In fact, one’s first life experiences take place
during the prenatal period, as an unborn fetus in the mother’s womb. According to Cronqvist, Previtero,
Siegel, and White, (2016), higher prenatal exposure to testosterone is associated with elevated risk-taking and
trading in adulthood. Individuals with higher birth weight or a general measure of prenatal life experience are
more likely to participate in the stock market. Additionally, investors with lower birth weight tend to prefer
portfolios with higher volatility and skewness. Both pieces of evidence are consistent with compensatory
behavior.
Later in life, individuals may be shaped by other personal life experiences, including macroeconomic
experiences that influence many individuals simultaneously, such as the Great Depression of the 1930s or the
financial crisis of 2007–2008. As Malmendier and Nagel (2011) show, individuals’ long-term experiences with
stock and bond markets determine their propensities to participate in those markets. ftey also show that macro
experiences affect beliefs, rather than risk preferences, because experienced higher stock returns are associated with
more optimistic beliefs about future stock returns. Weber, Weber, and Nosić (2013) and Guiso, Sapienza, and
Zingales (2013), however, find that risk aversion increased substantially in the immediate aftermath of the
financial crisis of 2007–2008, even among investors who did not suffer any losses. ftat is, negative macro
experiences result in increasedrisk aversionor less optimistic beliefs about future stockreturns.
As Knüpfer, Rantapuska, and Sarvimäki (2016) report, workers who experienced adverse labor market
conditions during the Finnish Great Depression in the early 1990s are less likely to participate in the stock
market later in life. Cronqvist, Siegel, and Yu (2015) find that individuals who experienced more adverse
macroeconomic conditions are more likely to favor value stocks as opposed to growth stocks.
Individual experiences related to the stock market also explain subsequent investor behavior. For
example, individual investors who experienced higher returns from subscriptions of initial public offerings
(IPOs) are more likely to subscribe to future IPOs in Finland (Kaustia and Knüpfer 2008) and Taiwan
(Chiang, Hirshleifer, Qian, and Sherman 2011). fte evidence is consistent with naïve reinforcement
learning, wherein individuals become overly optimistic after experiencing good returns. Consistent
with the notion of “once burned, twice shy,” Strahilevitz, Odean, and Barber (2011) find that investors
are reluctant to repurchase stocks previously sold for a loss and that have risen in price subsequent to that
sale. ftis behavior reflects investors’ attempts to distance themselves from negative emotional experiences
such as disappointment and regret. As Greenwood and Shleifer (2014) find in multiple surveys of
individual investors, expected returns are all highly correlated with recent market returns, but are negatively
related to the implied expected returns that are computed from aggregated data on dividends,
consumption, and market valuation measures, as well as future market returns. A conclusion from these
studies is that
individuals appear to over-weight their personal experiences in the stock market with insufficient
consideration of all available data.
Nonstandard Investor Preferences

fte traditional paradigm summarizes investor preferences with respect to risk aversion and wealth. However,
recent research introduces nonstandard preferences related to other factors—for example, prospect theory,
mental accounting, realization utility of gains and losses, and preferences for skewness and
familiarity.
THE DISPOSITION EFFECT, PROSPECT THEORY, MENTAL

ACCOUNTING, AND REALIZATION UTILITY
Shefrin and Statman (1985) propose the disposition effect, which refers to the behavior of investors to
sell winner stocks more readily than loser stocks. ftey suggest several explanations for this effect,
including prospect theory (Kahneman and Tversky 1979) and the reluctance to close mental accounts
with a loss (ftaler 1985).
Weber and Camerer (1998) offer evidence of the disposition effect using an experimental approach.
Odean (1998a) tests the disposition effect by using brokerage account data and finds that individual investors
on average realize about 15 percent of paper gains but less than 10 percent of paper losses. He focuses on the
prospect theory explanation, which predicts that prior gains elicit risk aversion, whereas prior losses elicit
risk seeking. In Taiwan stock markets where individual investors dominate, 84 percent of the investors sell
winners faster than losers (Barber, Lee, Liu, and Odean 2007). fte strength of the disposition effect varies
across investors. More sophisticated investors, such as wealthy individuals with professional occupations or
more trading experience and who execute more clustered trades, exhibit a weaker disposition effect (Dhar and
Zhu 2006; Feng and Seasholes 2005; Kumar and Lim 2008).
However, Barberis and Xiong (2009) show theoretically that prospect theory cannot easily generate the
disposition effect in a dynamic setting. Instead, Barberis and Xiong (2012) and Ingersoll and Jin (2013)
suggest that investors receive utility by realizing paper gains and disutility by realizing paper losses—
consistent with a mental accounting that involves a narrow framing of gains and losses. In a recent experimental
study, Frydman, Barberis, Camerer, Bossaerts, and Rangel (2014) document the neural foundations of such
realization utility. However, when investors can transfer a mental account from one stock to another by selling
and buying on the same day, they exhibit no reluctance to sell the initial losers (Frydman, Hartzmark, and
Solomon 2016).
Additionally, some propose cognitive dissonance, which is the psychology of feeling discomfort
when one recognizes one’s own mistakes or own incorrect beliefs as an explanation for the disposition effect.
For example, individual day traders in Finland are unwilling to close their losing-day trades, and such
unintended positions hurt their portfolio performance in subsequent months (Linnainmaa 2005). Although the
disposition effect is present when trading individual stocks, it reverses when trading mutual funds for the
same investor and at the same time, as investors can blame the managers in regard to the portfolio delegation
(Chang, Solomon, and Westerfield 2016).
Whether the disposition effect is the determining factor in investors’ selling decisions remains an active
area of research. Evidence by Kaustia (2010) shows that selling propensity jumps at zero returns, but is
insensitive to the magnitude of gains and losses. As Ben-David and Hirshleifer (2012) show, the probability
of selling as a function of profit is V-shaped (i.e., at short holding periods, investors are more likely to sell
bigger losers than smaller ones). Similarly, Hartzmark (2015) uncovers the rank effect in which investors are
more likely to sell the extreme winning and losing stocks in their own portfolio. None of these findings can
be easily reconciled with the disposition effect driven by prospect theory or the realization utility.
PREFERENCE FOR SKEWNESS

fte idea that individuals prefer to gamble when making investment decisions emerged nearly 70 years ago,
starting with Friedman and Savage (1948) and Markowitz (1952). Researchers propose several theoretical
reasons for individuals exhibiting a skewness preference. Shefrin and Statman (2000) suggest that a preference
for lotteries or lottery- type securities is a necessary consequence when investors aspire to move up in social
status. Brunnermeier, Gollier, and Parker (2007) model the preference for skewness as an outcome of
investors’ being overly optimistic about the probability of good states of the world. Mitton and Vorkink (2007)
model investors to have heterogeneous preferences for skewness. Barberis and Huang (2008) show that
investors are willing to pay for skewness as they over-weight the probability of extremely rare events, a
feature of the cumulative prospect theory (Tversky and Kahneman 1992).
A large body of empirical work supports conjectures that investors have a skewness preference. As Kumar
(2009) shows, the portfolios of retail investors—but not those of institutional investors—over-weight
lottery-type stocks, which are characterized by low price, high idiosyncratic volatility, and high idiosyncratic
skewness. fte demand for lottery-type stocks increases during economic downturns, and socioeconomic
factors that induce greater expenditure on lotteries are also associated with greater investment in lottery-type stocks.
As Doran, Jiang, and Peterson (2012) show, the Las Vegas gaming revenues and interstate lottery sales surge at the
turn of the year, and simultaneously investors are bullish on lottery-type stocks and options. Dorn, Dorn, and
Sengmueller (2015) and GaoandLin (2015) provide evidence consistent with investors’ alternating between play-
ing the lottery and gambling in financial markets. Kumar, Page, and Spalt (2011) use the ratio of the Catholic to
Protestant adherents in a region in the United States to capture the gambling-tolerant culture; they show that in
regions with higher Catholic to Protestant ratios, local investors exhibit a stronger propensity to hold lottery-
typestocks.
PREFERENCE FOR FAMILIARITY

fte mere-exposure effect in psychology implies that people have a strong preference for the familiar, even in the
absence of information (Zajonc 1968). Indeed, the investment literature repeatedly documents a preference for the
familiar. For example, Huberman (2001) shows that a regional Bell operating company’s shareholders tend to live in
the same region as the companyserves. Massa and Simonov(2006)report that individual investors donot hedgebut,
rather,investin stockscloselyrelatedtotheirnonfinancialincome.
Individual investors tend to over-weight local stocks in their portfolios, where local stocks are of
companies whose headquarters are located geographically close by. Ivković and Weisbenner (2005) find
that individual investors earn higher average returns on local rather than nonlocal holdings, whereas
Seasholes and Zhu (2010) find that local stocks purchased by individual investors generate future average
returns inferior to local stocks sold by these investors, suggesting suboptimal decisions regarding trading
local securities.
Stock inone’sowncompany andin producers of consumer products are alternative sources of familiarity in
the investment domain. Individuals have a strong preference for investment in their own company’s stocks,
although they do not have any information advantage (Benartzi 2001). Employees in standalone companies
significantly over- weight their own company’s stocks more than employees in conglomerate firms, which is
consistent with loyalty-influencing portfolio choice (Cohen 2009). Furthermore, a company’s long-term
customerstendtobeloyalinvestorsinthatcompany (Keloharju, Knüpfer, and Linnainmaa 2012).
Investor Psychology
Investor psychology plays a minimum role in the traditional paradigm that relies on rational optimization
of expected utilities and Bayesian updating. However, the new paradigm, especially the development of
behavioral finance, highlights the importance of heuristics and psychological traits in understanding
individual behaviors. Several specific heuristics or rules of thumb have spurred considerable finance
research.
OVERCONFIDENCE
Overconfidence refers to investors’ tendency to overestimate their own signal precision or their personal
ability to do well in trading. It is probably the most established psychological trait in theory and empirical tests
of finance research. Earlier models (Daniel, Hirshleifer, and Subrahmanyam 1998, 2001; Odean 1998b;
Scheinkman and Xiong 2003) establish the powerful insights of overconfidence to help understand excess
trading, excess volatility, over- and underreactions, and event-based return predictability. Models of Daniel
et al. (1998) and Gervais and Odean (2001) highlight the persistence of overconfidence when investors
exhibit biased self-attribution.
In a series of empirical studies using individual trading records from a large U.S. brokerage house, Barber
and Odean, together with their coauthors, uncover intriguing evidence that supports the theory of
overconfident trading. Stocks sold by individual investors outperform stocks they purchase (Odean 1999).
Investors who trade more have worse cost-adjusted trading performances (Barber and Odean 2000a).
Males engage in more active trading than females, but suffer from worse returns (Barber and Odean 2001). In
Finland, more overconfident investors, revealed by a standard psychological assessment upon induction into
mandatory military service, tend to have higher portfolio turnover later in life (Grinblatt and Keloharju
2009).
In other words, active trading is the most important manifestation of overconfidence. However, it
comes with considerable cost. In Taiwan, active trading by individual investors results in a loss of 3.8 percent in
their aggregate portfolio, which is equivalent to 2.8 percent of their total personal income and above 2 percent of
the country’s gross domestic product (GDP) (Barber, Lee, Liu, and Odean 2009). Individual day traders
account for 17 percent of the trading volume, but only 20 percent of them earn positive net returns in a
given year and less than 1 percent do so in two consecutive years (Barber, Lee, Liu, and Odean 2014). French
(2008) estimates that investors pay a net cost of 67 basis points of the aggregate market value a year as a result
of attempting to beat the U.S. market.
fteories of overconfident trading and biased self-attribution lead to discoveries of market regularities.
ftey include, for example, the positive correlation between turnover and lagged returns (Statman, ftorley,
and Vorkink 2006), the existence of systematic mispricing that can be captured by firm external financing
(Hirshleifer and Jiang 2010), the ability of the cross-sectional dispersion in firm valuation ratios to negatively
forecast future aggregate returns ( Jiang 2013), and the outperformance of stocks with upward continuing
overreactions relative to stocks with downward continuing overreactions (Byun, Lim, and Yun 2016).
LIMITED ATTENTION
Individual investors have limited attention and limited processing power; thus, they can be attracted to, or
distracted by the content, salience, and amount of news, as well as by activities outside the financial
domain.
When selecting mutual funds, individual investors pay attention to the more salient front-end loads and
recent fund performances, as opposed to the less salient operating expenses (Barber, Odean, and Zheng
2005). In establishing selection criteria, individual investors are net buyers of stocks that grab their
attention, such as those with high abnormal trading volume or extreme one-day returns (Barber and Odean
2008). In China, stocks that hit their upper price limits are associated with high investor attention as measured
by high volumes and more news coverage, but return reversals follow in the subsequent week (Seasholes and
Wu 2007). On the day following a market-wide attention event, such as a record level for the Dow Jones
Industrial Average (DJIA), individual investors sell more equity holdings (Yuan 2015).
ftis limited attention by individual investors leads to predictable returns and market reactions to news.
Reactions to earnings announcements are weak, but subsequent drift is strong when earnings are announced on
Fridays (DellaVigna and Pollet 2009), when many competing announcements occur in the same industry
(Hirshleifer, Lim, and Teoh 2009), and when there is intensive industry-wide news ( Jacobs and Weber
2016). Return shocks to large customer-product firms slowly diffuse to the stock prices of their supplier firms
(Cohen and Frazzini 2008). Return shocks to straightforward (stand-alone) firms precede the return
shocks to complicated (conglomerate) firms (Cohen and Lou 2012). Gradual, small changes in prices are
accompanied by strong price momentum, whereas large, sudden changes are not (Da, Gurun, and Warachka
2014). When investors focus on earnings as opposed to cash flows, the firms with high
net operating assets, which measure the cumulative differences between earnings and cash flows, on average
earn low subsequent returns (Hirshleifer, Hou, Teoh, and Zhang 2004). Managers attract investor attention
through advertisements to boost short- term stock prices; the timing of their advertisements coincides with
insider trading (Lou 2014).
MOOD, EMOTION, AND SEN T IMEN T

Mood and emotion, which are the states of feelings at the time of decision making, may influence investor
behavior (Loewenstein, Weber, Hsee, and Welch 2001). Positive emotions lead to investor optimism and
increased willingness to take risk (Kuhnen and Knutson 2011). Numerous empirical findings support such a
hypothesis. For example, Hirshleifer and Shumway (2003) report evidence consistent with “emotional
misattri- bution,” in the sense that weather conditions such as sunshine and cloud cover affect investor
behavior. Edmans, Garcia, and Norli (2007) study changes in investor mood and behavior during sports
events. Similar studies show that negative mood depresses stock markets, such as those involving aviation
disasters (Kaplanski and Levy 2010). Investors do not exert any influence over these moderators of their
moods, suggesting a causal interpretation.
Evidence also shows mood effects for reoccurring and predictable events. For example, Kamstra,
Kramer, and Levi (2003) report that the number of hours of daylight drives investor behavior. Frieder and
Subrahmanyam (2004); Białkowski, Etebari, and Wisniewski (2012); and Bergsma and Jiang (2016) study
stock market behavior during cultural and religious holidays, and they conclude that festive mood is an
explanation for some market movements.
Evidence by Karabulut (2013) shows that the Facebook’s Gross National Happiness (GNH) index is a
positive predictor of the next day’s stock market returns. Da, Engelberg, and Gao (2015), who
developed the Financial and Economic Attitudes Revealed by Search (FEARS) index as a proxy for negative
mood state, show that higher returns today but lower returns the next day accompany increases in the FEARS
index. Some evidence by Kaustia and Rantapuska (2016) shows that weather-based mood proxies, such as
sunniness, temperature, and precipitation, are significantly related to the trading behavior of individual
investors, who also exhibit seasonal behavior across days of the year and the week before holidays.
Related to mood is a large strand of literature on investor sentiment, which usually refers to
collective, incorrect beliefs and preferences, and this can be thought of as a measure of investor affect state.
Baker and Wurgler (2006) show that a sentiment index constructed from, for example, the closed-end fund
discount, trading volume, initial public offering (IPO) first-day returns, and volume predicts the cross-
sectional returns on hard-to-arbitrage stocks in the following year. Hwang (2011) finds that investor sen-
timent regarding a certain country causes changes in that country’s closed-end fund discount. Both
sentiment and mood measure the collective optimism versus the pessimism of investors toward market states
and asset values. A possible difference between the two is, perhaps, that mood is tied to emotions that can vary
frequently(dailyoreven hourly),whereassentimentistiedtoattitudesthatarerelativelyslowmoving.
More generally, firms that elicit positive affect receive a greater portfolio weight or a pricing premium,
including those with euphonious (Alter and Oppenheimer 2006; Andersson and Rakow 2007) or patriotic
(Morse and Shive 2011; Benos and Jochec 2013) names, and admired companies (Statman, Fisher, and
Anginer 2008). In contrast, the market discounts stocks that elicit negative affect, such as those associated
with tobacco, alcohol, gaming, firearms, military sales, and nuclear operations (Hong and Kacperczyk
2009; Statman and Glushkov 2009).
In turn, firms seem to exploit the investor affect. For example, dual-class companies strategically label
their inferior voting shares as “Class A” but their superior voting shares as “Class B” and thus gain from IPOs
(Ang, Chua, and Jiang 2010). fte effect of investors’ attitudes toward certain company characteristics can
fade or even reverse when the macroeconomic environment changes. During the dot-com boom of the late
1990s, companies that changed to dot-com type names experienced positive market reactions (Cooper,
Dimitrov, and Rau 2001). Yet, when the dot-com bubble burst in the early 2000s, the companies that switched
to a conventional name experienced positive market reactions (Cooper, Khorana, Osobov, Patel, and
Rau 2005).
Social Context
Individuals do not make investment decisions in isolation; rather, they make their decisions in the context of a
variety of important social factors. Such factors include social interaction, social identity, social norms, and
social capital, as well as more general culture effects.
SOCIAL INTERA C T ION AND PEER EFFECT

Individuals have social networks that include family, friends, co-workers, neighbors, and others. People in
these networks may influence others’ investment behaviors. fte behavior of family is of the first order,
understandably. Evidence by Li (2014) indicates that an investor’s likelihood of entering the stock market
within the next five years is 20 to 30 percent higher if the individual’s parents or children have entered the stock
market during the prior five years.
Importantly, social interaction effects extend beyond the family. Evidence shows that the behavior of
peers—friends, neighbors, and co-workers—partly drives the decision to participate in the stock market
(Hong, Kubik, and Stein 2004; Guiso and Jappelli 2005; Brown, Ivković, Smith, and Weisbenner 2008;
Hvide and Östberg 2015). Shive (2010) applies a disease epidemic model and finds that the transmission rate
of financial rumors through social contact predicts investor behavior.
However, the forces driving investor network effects such as simple imitation, herding, or biased
information transfer remains unclear (Ozsoylev, Walden, Yavuz, and Bildik 2014). Evidence by Kaustia
and Knüpfer (2012) shows that the investment performance of one’s peers influences an individual’s
decision to enter the stock market. ftis social learning is truncated when a peer’s returns fall below zero, which
is consistent with the theoretical predictions by Han and Hirshleifer (2015), who model the
self-enhancing transmission bias in social interactions leading to biased information sharing.

Group dynamics is a specific source of social interaction. Barber and Odean (2000b) find that investment
clubs underperform the market even more than individuals. Furthermore, both clubs and individuals are
more likely to invest in stocks that are associated with a good reason, such as a company on a most-admired
companies list, but groups favor such stocks more than do individuals, despite the fact that such reasons do not
improve performance (Barber, Heath, and Odean 2003).
SOCIAL IDENTITY AND SOCIAL NORMS

Evidence by Akerlof and Kranton (2000) and Bénabou and Tirole (2011) shows that an individual’s social
identity (i.e., personal sense of self) affects his or her investment behavior. Specific examples of social identity are
civic engagement and political orientation. Politically active individuals, irrespective of their political affiliation,
spend about 30 minutes more on acquiring news daily and are more likely to participate in the stock market
(Bonaparte and Kumar 2013). According to Kaustia and Torstila (2011), moderate left voters are about 20
percent less likely to invest in stocks compared to moderate right voters, controlling for wealth and other
individual characteristics. fteir evidence is consistent with the notion that personal values affect investment
decisions, in this case leading to “stock market aversion.” Individual investors perceive stock markets as less risky
and more undervalued when “their” party is in power (Bonaparte, Kumar, and Page 2012). Interestingly, a
reverse effect of stock ownership exists in regard to political behavior. Plausibly exogenous demutualizations in
certain regions in Finland resulted in an increase in the right-of-center vote share in those regions (Kaustia, Knüpfer,
and Torstila 2015).
Social norms and values may also influence investors. For example, investors may have social
preferences, implying that they internalize the utility of others in society. As Hong and Kostovetsky (2012)
show, professional investors who donate primarily to the Democratic Party in political campaigns over-weight
stocks of socially responsible firms, but avoid stocks in industries such as defense, gun manufacture, and
tobacco. Some emerging evidence also shows that individual investors who exhibit prosocial behavior in
experiments are more likely to invest in socially responsible mutual funds (Riedl and Smeets 2014). ftis
research raises the question of whether social identity or norm- constrained investors underperform (i.e., paya
price for their behavior). Evidence by Hong and Kacperczyk (2009) shows that “sin” stocks earn higher than
expected returns. Yet, other evidence suggests that the more socially responsible or employee-friendly firms
deliver higher abnormal returns (Derwall, Guenster, Bauer, and Koedijk 2005; Edmans 2011).
SOCIAL CAPITAL AND TRUST

Trust refers to the confidence in receiving fair returns from economic transactions. As Guiso, Sapienza, and
Zingales (2008) show, trusting individuals in the Netherlands are more likely to participate in stock markets and
invest more in risky assets. Similar results are reported for the United States whereas more trusting individuals and
households are better at managing investments (Balloch, Nicolae, and Philip 2015) and debts (Jiang
and Lim 2016). Trust influences individual investment risk perceptions and equity premium (Olsen
2012), and it may also explain the specific securities that individuals select. Kelly (2014) finds that less
trusting individuals have a preference for dividend- paying as opposed to non-dividend-paying stocks.
Some recent research shows that the behaviors of individual investors reflect changes in trust. As Giannetti
and Wang (2016) show, stock market participation declines in a
U.S. state after revelation of a prominent corporate fraud case in that state. Individuals decreased their holdings
in non-fraudulent firms located in that state, even if they did not hold stocks in the fraudulent firms. Similarly,
Gurun, Stoffman, and Yonker (2015) studied the effects of trust on investor behavior by exploiting the
geographic dispersion of victims in the Bernie Madoff scandal. fteir results show that investors in communi-
ties that were more exposed to the fraud withdrew their assets from their investment advisers and increased
their cash deposits in banks.
Trust is an important component of social capital. In general, social capital refers to our connections
with each other, and it can be measured by the general networks of those in a community that promotes
social and political engagement (Putnam 2000). ftat is, sociability promotes investing. Guiso, Sapienza,
and Zingales (2004) show that communities with higher social capital have better financial development,
including more investments in stocks and less in cash. Georgarakos and Pasini (2011) and Changwony,
Campbell, and Tabner (2015) also find that trust, and social engagement more generally, explains
individuals’ participation in stock markets.
CULTURE
Culture affects various economic outcomes (Guiso, Sapienza, and Zingales 2006). Cultural norms and
proximity also affect behavior among individual investors. Evidence by Grinblatt and Keloharju (2001) shows
that investors in Finland are more likely to trade stocks in companies that communicate in the investor’s
native tongue and that have a chief executive of the same cultural background. As Kumar, Niessen-Ruenzi, and
Spalt (2015) show, financial managers with foreign-sounding names have 10 percent less annual fund flows,
and for funds run by those managers, investors exhibit greater sensitivity to bad performance.
Cultural norms reflect values that change only very slowly over time, as they are transmitted from one
generation to the next. Findings by D’Acunto, Prokopczuk, and Weber (2015) indicate that investors are less
likely to participate in stock markets in counties of Germany where Jewish persecution was higher in the
Middle Ages and the Nazi period. fteir evidence is consistent with a persistent cultural norm of distrust in
finance that varies regionally.
TECHNOLOGY
Technology can be considered an environmental factor that builds the venues and platforms for investing. In
recent decades, technologic innovations have drastically changed how individual investors invest. Because
technology has made investing more accessible and less costly, it has been beneficial. However, when
technology interacts with behavioral biases, it can be detrimental.
Barber and Odean (2000a) show that the availability of online trading causes significant increases in
trading volume, but investors who switch to online trading suffer from poor trading performance. Although
Choi, Laibson, and Metrick (2002) find that web access by investors doubles the trading frequency, they find no
evidence that online trading leads to higher returns.
With such technological innovations, information becomes more accessible, which enables measurement
of investor attention and information acquisition more directly. Using the Google Search Volume Index (SVI)
to capture individual investor attention, Da, Engelberg, and Gao (2011) show that this index predicts high
subsequent returns within the next two weeks that are followed by a reversal. Leung, Agarwal, Konana,
and Kumar (2016) use the search behaviors of individuals who visit the Yahoo!Finance website to identify
return co-movement among stocks within the search clusters.

Within the last two decades, there has been a transformation from the traditional paradigm to a new approach
that takes a broader view toward understanding individual investor behavior and financial decision making.
ftis new paradigm attempts to understand the behavioral origin (genetics and neural roots), behavioral
formation (personal life experiences), and behavioral motivation (psychology and preference), as well as the
behavioralcontext(society,environment,andculture)ofindividualinvestors.
fte growth of knowledge in this new paradigm recognizes the complexity of individual decision
making and its collective influence on financial markets and company decisions. Hirshleifer (2015) refers to
this new paradigm as “social finance,” a more advanced form of behavioral finance. Moving forward, finance
research is likely to continue expanding by integrating knowledge from other disciplines into the understand-
ingofindividualinvestorsandtheirimpactson marketsandcompanies.
1. Discuss the main differences between the traditional and the modern finance paradigm in
understanding the behavior of individual investors.
2. Explain the broad implications of studies of genetics, neural roots, and personal life experiences for
understanding the behavior of individual investors.
3. Discuss the disposition effect and the proposed explanations for this effect.
4. Identify the social factors that influence individual investor decisions and discuss the importanceof
considering the socialcontext whenmakinginvestment decisions.
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4
Institutional Investors
ALEXANDRE SKIB A
Assistant Professor of Economics
Department of Economics of Finance, University of Wyoming
HILLA SKIB A
Assistant Professor of Finance and Real Estate
Department of Finance and Real Estate, Colorado State University
Introduction
Behavioral biases in the financial markets are well documented. For example, evidence shows that investors are
overconfident, prone to the disposition effect, exhibit loss aversion, demonstrate familiarity bias, and are
driven by mood and sentiment. Although investors show tendencies toward cognitive and emotional biases,
the literature also documents that the extent of the biases differs among investors. One of the most important
differences is investor sophistication, so that less sophisticated investors make poorer choices with their
investment decisions, which also leads to market underperformance, especially after considering trading costs.
Less sophisticated investors are usually considered to be individual or retail investors, whereas more
sophisticated investors are professional money managers and traders. fte vast majority of behavioral studies
focus on the behavioral biases of individual investors.
ftis chapter’s purpose is to review the literature on behavioral biases. fte chapter specifically examines
how behavioral biases may influence more sophisticated investors (i.e., institutional investors). An
institutional investor refers to a variety of professional investors, including banks, insurance companies,
pension funds, endowment funds, mutual funds, and hedge funds, as well as investment professionals such as
investment advisors and wealth managers. ftis chapter compares behavioral biases between institutional and
individual investors. It also investigates whether differences exist among types of institutional investors, given
the disparity between the objectives and the skill levels of such investors.
Although the literature on the behavioral biases of institutional investors is limited, it documents that
institutional investors engage in trading behaviors that could be a symptom or a consequence of various
behavioral biases. For example, institutional investors engage in herding, whereby their buying and selling
behavior is correlated with other institutional investors’ trades; they hold under-diversified, especially home-
country biased, portfolios; and they use a momentum strategy in which they appear to buy past winners.
64
Institutional Investors 65
ftis chapter investigates the literature on these various trading behaviors and whether the behaviors are value
reducing and/orwhether theydestabilizefinancialmarkets.
fte evidence from the extant literature suggests that the behavior of institutional investors is rational
compared to that of individual investors. Cognitive and emotional mistakes that individuals make are largely
absent among institutional investors. Yet, some contrarian evidence exists. Mood seems to drive institutional
investors. Also, cultural differences influence trading and portfolio allocation of institutions, but to a lesser
extent relative to the individual investors. Although some behavioral biases are present among the professional
moneymanagers,overalltheinstitutionalinvestorstrulyare“smart.”
Trading behaviors that could be a symptom of some behavioral bias are actually value generating for the
institutions. For example, herd behavior seems to be information driven rather than based on fear and greed,
or other behavioral factors. In fact, herding by institutional investors appears to be price stabilizing rather than
price destabilizing. Similarly, recent empirical literature shows that portfolio under-diversification among
institutional investors generates positive risk-adjusted returns.
fte chapter has the following organization. fte first section reviews the literature on behavioral biases of
institutional investors. fte next section investigates differences in behavioral biases across types of institutions,
specifically based on the sophistication of the institutional managers. fte following section reviews three
trading behaviors of institutional investors that could be symptoms of behavioral biases: herding, momen-
tum trading, and under-diversification. fte chapter then reviews the literature on each of the documented trading
behaviors, shows how institutional investors engage in these trading behaviors, and explains how the behavior
affects institutional returns and market efficiency.
fte chapter concludes by investigating whether institutional investors take advantage of individuals prone to
behavioral biases. Institutions are becoming increasingly educated about behavioral finance, which is now
included in university curriculums and textbooks worldwide. Behavioral finance is also a part of professional
education, such as the Chartered Financial Analyst (CFA) curriculum. A growing body of literature documents
that institutions are profiting from stock market anomalies and systemic changes in securities prices, caused by
behavioral biases. For example, institutions appear to profit from post-earnings announcement drifts. Also, during
extreme swings in the market, such as during market bubbles and consecutive market crashes, institutions,
unlike individuals, appear to exit their positions from overvalued securities before the market turns.
Behavioral Biases of Institutional Investors

fte literature documents that sentiment, fads, and emotions drive less experienced individual
investors (Shiller, Fisher, and Friedman 1984; De Long, Shleifer, Summers, and Waldmann 1990).
Because of poor decision making, individuals underperform the market both before and after fees
(Barber and Odean 2001). Because professional investors are generally on the other side of these poor
trades, they appear to trade rationally and profit at the expense of individual investors. fte finance
literature documents some compelling evidence to support this claim. For example, Barber, Lee, Liu,
and Odean (2009) find that in the Taiwanese market,
individual investors lose 3.8 percentage points annually and it is institutional investors who mainly
harvest this loss. fte following sections discuss the most commonly studied behavioral biases
(overconfidence, disposition effect, and familiarity bias) and how the empirical evidence for these biases
differs for institutions and individual investors.
OVERCONFIDENCE
Much of the seminal work on overconfidence in behavioral finance is based on samples of individual investors and
is typically proxied by gender (Barber and Odean 2001; Gervais and Odean 2001). Evidence on the
overconfidence of institutional investors is less available, perhaps because finding a suitable proxy is more
difficult. Chuang and Susmel (2011) investigated overconfidence among traders in Taiwan, and show that
Taiwanese individual investors are much more prone to overconfident trading behavior compared to the
institutional investors. Chou and Wang (2011) also examine overconfidence among different types of
investors in Taiwan. ftey find that overconfidence is present among both individual and institutional investors,
but the level of overconfidence among institutional investors is much lower. However, institutional investors buy
more aggressively after they have experienced gains, which is consistent with overconfidence hypothesis.
Chen, Kim, Nofsinger, and Rui (2007) study overconfidence in a sample of Chinese trading accounts, which
includes both individual and institutional investors. After split- ting their sample into individual (less
sophisticated) and institutional (more sophisticated) investors, they find that although overconfidence bias is
present in both groups, the bias is strongerin the sampleof less sophisticated, individual investors.
Gender Bias
Another stream of literature compares trading choices between male and female professional money
managers. Although these studies are not always tests of the overconfidence of professional investors, the
results are still consistent with the more direct overconfidence studies previously discussed. Barber and
Odean (2001) were the first to document that male investors make poorer trading choices than female
investors. ftey attribute this to overconfidence. Several other studies have investigated gender differences
among professional money manager. Atkinson, Boyce, Frye, and Frey (2003) study how gender affects
mutual fund management, and they find no real differences between the genders. ftey suggest that
perhaps differences between the genders, documented among individual investors, change when factoring
in experience and sophistication. Similarly, Bliss and Potter (2002) hypothesize that female mutual fund
managers are less overconfident compared with their male counterparts; but contrary to their prediction, they
find no difference in the turnover rates of female managers. Beckmann and Menkhoff (2008) also find in
their sample of 649 fund managers from the United States, Germany, Italy, and ftailand, that
overconfidence among female and male mutual fund managers is not statistically significantly dif-
ferent. Overall, gender differences in overconfident tendencies do not seem to exist among professional
managers. ftis evidence may suggest that experience and investor sophistication eliminate, or at least
lessen, common behavioral biases, a conclusion that is similar to other evidence discussed in this
section.
DISPOSITION EFFECT
fte disposition effect is an investor’s tendency to sell winning securities too soon and to retain losing
securities too long. Most studies document the disposition effect among individual investors, but some
studies also use samples of either institutional investors or both types of investors. fte results are similar to
those in the overconfidence literature previously reviewed.
Chou and Wang (2011) study the disposition effect among both individual and institutional trades
in Taiwan. fteir evidence shows that the disposition effect holds true only among individual investors.
Similarly, in a study of individual and professionally managed accounts in Israel, Shapira and Venezia
(2001) find that the disposition effect is present among both types of investors, but is much stronger
for individual investors than for professionally managed accounts. Feng and Seasholes (2005) study
investors’ sophistication, trading experience, and the disposition effect; the authors report strong evidence
that investors’ sophistication, combined with trading experience, eliminates the reluctance to sell losing
stocks. Experience and sophistication also reduce the propensity to realize gains too soon. Although their
sample consists only of individuals, this finding still supports the idea that more sophisticated institutional
investors with long trading experience are less likely to suffer from the disposition effect.
O’Connell and Teo (2009) investigate institutional investors’ disposition effect in U.S. markets and
find little evidence that institutions are prone to the disposition effect. However, the authors find evidence
that past performance affects investors so that they lower their risk-taking after losses and increase their
risk-taking after gains, which is consistent with dynamic loss aversion and overconfidence. Statman,
ftorley, and Vorkink (2006) study overconfidence and the disposition effect in
U.S. markets and find evidence for both. Specifically, their evidence shows that stocks with large historical
gains experience larger trading volume in subsequent time periods. Interestingly, the relation of past
returns and volume is strongest in the earlier part of the sample and in smaller securities. ftis finding
suggests that stocks dominated by individual rather than institutional investors show greater evidence of
both behavioral biases. Similar to the U.S. result, Chen et al. (2007) find that in a Chinese sample of
individual and institutional trading accounts, evidence exists for similar results regarding overconfidence
and the disposition effect is present in both groups of traders. However, the bias is stronger in the sample of less
sophisticated individual investors.
By contrast, Frazzini (2006), conducting a study of U.S. mutual fund holdings and the disposition effect,
finds that U.S. mutual fund managers exhibit the disposition effect and that such behavior also negatively affects
their returns. However, the evidence still aligns with findings that more sophisticated investors are less subject to
behavioral biases. Specifically, Frazzini reports that successful mutual fund managers are more likely to sell their
losers than are underperforming managers. Coval and Shumway (2005) finds that
U.S. futures trades suffer from loss aversion, which refers to people’s tendency to strongly prefer avoiding losses
over acquiring gains. Also, Locke and Mann (2005) study professional U.S. commodities traders and find that
professional traders hold onto their losers for longer than their winners, but the behavior does not seem to produce
lower than average returns, contrary to the findings by Coval and Shumway (2005).
FAMILIARITY AND REPRESENTATIVENESS BIAS

In a large universe of securities, investors must narrow the set of available investment options. One way
investors can to do this is by using mental shortcuts and heuristics, which can ultimately lead to mean-
variance inefficient portfolios. Familiarity and representativeness biases are examples of such heuristics.
Familiarity bias is the tendency of investors to invest in what they know or what is familiar to them.
Representativeness bias is often linked to investors’ tendency to extrapolate probabilities for future events
from past or recent outcomes. Similar to overconfidence and the disposition effect, familiarity and
representativeness bias studies often use samples of individual investors (Huberman 2001), but little empirical
researchisavailableoninstitutionalinvestors.
In a direct comparison study of individual versus institutional investors, Barber and Odean (2008)
find that individual investors are much more likely to be drawn to attention-grabbing stocks, such as stocks
in the news or those with large price swings. Individual investors do not possess the same resources as large
institutions. Because of their limited attention, individual investors need to narrow the set more than do institu-
tions, and consequently they are much more likely to choose attention-grabbing securities. Limited attention
and resources are also major reasons for a familiarity bias-based portfolio construction.
Similar to the evidence for overconfidence and the disposition effect, Chen et al. (2007) find that in the
Chinese sample of individual and institutional trading accounts, representativeness bias is present in both
groups of traders. However, the bias is stronger in the sample of less sophisticated individual investors.
Studies involving familiarity bias often examine investors’ portfolio composition, because familiarity
bias can result in under-diversified portfolios; for example, these are often home-biased portfolios, in which
investors over-weight the familiar home market. (ftis chapter discusses equity home bias and its consequences
for institutional investors in more detail in a later section.) fte evidence shows that institutional investors
also hold home-biased portfolios. Further, some research links home bias with familiarity bias. Ke, Ng, and
Wang (2010) study investments in foreign markets made by mutual funds, and find that managers prefer to
invest in firms in foreign markets that have a presence in their domestic markets. fte authors rule out an
information advantage as a possible explanation for this finding, concluding that familiarity bias is likely to be
the driver. Chan, Covrig, and Ng (2005) find that home bias and foreign market under- weighting by
mutual funds are associated with economic development and familiarity variables. fte authors proxy
familiarity by a common language between the investors’ home market and foreign markets, geographic
distance, and bilateral trade flows.
Heterogeneity Among Types

As investor sophistication increases from individual investors to institutional investors, the existing research
shows that behavioral biases decrease and even disappear. Large heterogeneity exists in the sophistication
level among different institutional investors. For instance, hedge fund managers earn the highest
compensation and attract the top talent, and thus are likely to be the most sophisticated investors, followed by
managers
of other actively managed, well-compensated institutions such as mutual funds, independent investment
advisors, pension funds, and endowments. fte less sophisticated managers are then in the more passive
institutions, such as insurance companies and banks (Lerner, Schoar, and Wongsungwai 2007; French 2008;
Choi, Fedeia, Skiba, and Sokolyk 2016). Based on this finding, studies that examine the trading behavior of
different institutional types are likely to find fewer behavioral biases among hedge fund and mutual funds
managers compared to the passive investor types.
fte research in this area is limited. Barber, Lee, Liu, and Odean (2007) study the disposition effect in the
Taiwanese stock market among different groups of investors. fteir evidence shows that the disposition effect
exhibits a strong presence in the market. Besides individual investors, corporate investors (private and
government-owned firms) and dealers (financial firms) are subject to the disposition effect. By contrast,
mutual funds and foreign investors (foreign banks, insurance companies, securities firms, and mutual
funds) are not subject to the disposition effect.
Although research that directly investigates behavioral biases among institutional types is limited, several
papers have examined how institutional investors’ heterogeneity is reflected in the level of their
sophistication and performance. Lerner et al. (2007) examine different institutional types including
investment advisors, banks, pension funds, insurance companies, and endowments. ftey find that
endowments earn the highest returns, specifically in their private equity investments. Similarly, Bennett,
Sias, and Starks (2003) document a difference between raw returns among different types of institutional
investors, so that mutual funds and advisors earn larger returns compared with managers at banks and in
insurance. According to Choi et al. (2016), investor sophistication is related to information advantage and
subsequent performance, thus, hedge funds, mutual funds, and advisors, followed by endowments
and pensions and then by banks and insurance companies, earn the highest risk-adjusted returns on their
global portfolios. fte fact that the level of investor sophistication and returns is positively related, and
that behavioral biases are more common among less sophisticated investors, suggests that behavioral
biases might at least partially explain the observed differential in risk-adjusted returns between
institutional types.
Institutional Trading Behavior

As previously discussed, the research on behavioral biases among institutional investors is limited but
increasing. However, large streams of literature exist on the trading behaviors of institutional investors
that could be symptoms of some underlying behavioral biases. fte following sections provide a review of
these well-documented trading behaviors and discuss the consequences of each to market efficiency
and/ or investors’ risk-adjusted performance. fte trading behaviors include the following: (1)
momentum trading by institutions, which could be driven by representativeness bias, self-attribution,
and/or overconfidence, and would have a destabilizing effect on the financial markets; (2) herding, which could
be driven by behavioral motivations, such as fads, fear, or greed, or reputational concerns, and would have a
destabilizing effect onthefinancial markets;and(3) portfolio under-diversification, which could be
a symptom of overconfidence or familiarity bias, both which would most likely result in lower risk-adjusted
returns to the investor.
MOMENTUM TRADING
Since Jegadeesh and Titman’s (1993) seminal work, others have documented momentum in
security prices across various asset classes and markets. Momentum in security prices is usually linked to
market inefficiency, and the result is correlation in security returns from one period to another.
Momentum can be present in two ways. Prices either are pushed away from their fundamental values
because of fear and greed or are extrapolated from past returns to predict the future. Alternatively, markets
fail to incorporate information into the prices efficiently but, rather, over extended periods of time.
Institutional investors tend to be momentum traders on a large scale (Grinblatt, Titman, and Wermers
1995; Nofsinger and Sias 1999; Wermers 1999; Badrinath and Wahal 2002). Empirical evidence
supports the following explanations about momentum: (1) institutions chase past winners and
extrapolate past outcomes into the future; or (2) institutions take advantage of market inefficiency
upon discovering that some fundamental information is slow to incorporate, and hence institutional
trading helps push the security prices toward their fundamental values.
Evidence has documented momentum trading among all types of institutions. Nofsinger and Sias
(1999) find that institutions are momentum traders when they examine the intra-period trades of
individual securities. Momentum trading is also present in mutual funds (Grinblatt et al. 1995; Wermers
1999). Badrinath and Wahal (2002) investigate institutional investors’ entry and exit decisions into and out of
securities. ftey find that institutions trade on momentum when they initiate positions in securities. Yet,
some variation in momentum trading exists across institutional investors. Evidence by Badrinath and Wahal
shows that investment advisors are more likely to be momentum traders than are pension funds and banks.
Lakonishok, Shleifer, and Vishny (1992) investigate pension funds’ momentum trading and find little
supporting evidence.
fte evidence generally shows that the price impact of momentum trading by institutional investors is
overall price stabilizing. ftis observation supports the notion that institutional investors do not trade on
momentum because of greed, fear, overconfidence, or representativeness bias but, rather, because of
fundamental reasons. For example, in a sample of institutional investors, Badrinath and Wahal (2002) find
little evidence for price-destabilizing effectsof institutional momentum trading.
Hvidkjaer (2006) conducts a trade-level study that provides support for institutional investors stabilizing
momentum trading. Based on an analysis of large and small trades, the author finds that small traders’
underreaction may be a reason for the observed momentum effect. In contrast, institutional investors do not
underreact. Choe, Kho, and Stulz (1999) discover similar evidence in the Korean markets, while
specifically examining trading behavior by foreigners and Korean institutional investors versus Korean
individual investors. fte authors find that institutions in Korean markets are largely momentum traders.
Again, no evidence indicates that the traders would have a price-destabilizing effect on the Korean
market.
HERDING BEHAVIOR
Much evidence shows that institutional investors tend to herd or to follow each other’s trades (Lakonishok et al.
1992; Sias 2004). Herding in asset markets occurs within individual securities, within industries, and within
entire markets. Herding, at least in the popular media, is often associated with some irrational behavior,
where investors are chasing fads (Shiller et al. 1984) and are motivated by fear and greed or other behavioral
reasons. Institutional investors may also have reputational concerns; consequently, they would rather be wrong
within a group than on their own (Scharfstein and Stein 1990; Trueman 1994). If the reasons for herding are
irrational or behavioral in nature, then herding should destabilize asset prices and push them away from their
fundamental values. However, herding could be rational behavior if it results in more efficient markets and/or
higher risk-adjusted returns for investors.
fte empirical evidence shows a large propensity by institutions to herd in and out of securities and
markets. fte vast majority of evidence supports information-based reasons for such herding. ftese
information-based, rational reasons for herding include cascading and investigative herding. In about half of
the studies, the documented herding occurs because of informational cascades. Informational cascades
occur when institutional investors intentionally follow each other from security to security, but only
because they infer information from each other’s trades. fte other half of the studies find that herding
behavior is investigative in nature. ftis is when institutional investors analyze the same underlying
fundamental information and draw the same conclusions about the securities’ fair values, and they trade
similarly; yet, the observed movement in and out of securities is unintentional and based only on underlying
information. fte consequence of both information-based herding tendencies is that prices adjust faster to
fundamental information. In other words, herding is information-based and thus increases market
efficiency rather than destabilizes the markets.
Evidence documents herding by institutional investors across markets, asset classes, and different types of
institutional investors. Sias (2004) finds that at the security level, institutional investors in the United States
follow each other from security to security, or that their trades are correlated with their own and other
institutions’ lagged trades. He alsofinds that institutions are momentum traders. However,momentum trading
only partially explains the herding. According to Sias, the most likely explanation for herding is that institutions
follow each other’s trades, but that herding is information-based and institutions infer information from others
(cascading) rather than are just chasing fads. Grinblatt et al. (1995) report widespread herding behavior among
managers at U.S.- based mutual funds. In support of a rational explanation of herding, the authors find little
evidence for herding that was intentionally following others. Kim and Nofsinger (2005) study the Japanese
market and herding by its institutional investors. fte authors also documented that institutions herd in Japan,
but to a lesser extent than they do in
U.S. markets. Herding in Japanese markets is more likely to be investigative, and the price impact of herding
is generally positive, so that investors’ herding speeds up the price adjustments, rather than destabilizes
them.
Nofsinger and Sias (1999) report a positive relation between changes in institutional ownership and
returns on securities. ftus, momentum in security returns also appears to be related to institutional herding.
ftatis,a positiverelation exists between
institutional demand and contemporaneous security returns. fte authors also report little evidence of mean
reversion in the security returns after periods of positive demand and positive security returns. ftis finding
suggests that institutional demand and momentum in securities incorporates information faster into the
security prices, instead of irrational return chasing by institutions. In other words, institutions help to create
faster price adjustment and greater market efficiency.
PORTFOL I O UNDER- DIVE RSIF ICAT I ON

AND EQUITY HOME BIAS
fte finance literature documents the phenomenon of portfolio under-diversification. According to the
traditional asset pricing theory stemming from the work of Markowitz (1952), investors should hold
diversified portfolios. Evidence exists, however, that investors, including institutional investors, do not
always do this. For example, studies document under-diversification with respect to investors’ domestic and
foreign holdings, so that investors have a tendency to over-weight their home market relative to its
capitalization weight (i.e., investors have a home bias).
Equity home bias is widespread in international portfolio investment. For example,
U.S. institutional investors hold about 86 percent of their assets in domestic equities, whereas the U.S. share
of the world portfolio is only about 40 percent. ftis difference means that U.S. investors hold a 46
percentage point over-weight in their domestic market. Similar figures occur across the globe (Chen et al.
2007; Anderson, Fedenia, Hirschey, and Skiba 2011; Choi et al. 2016). Also, the small portion of the
portfolio invested in foreign countries is usually allocated to countries that are the most similar and the
most correlated with the investor’s home market (Tesar and Werner 1995; Chan et al. 2005; Anderson et
al. 2011).
Evidence documents equity home bias across all investor groups. Many reasons led to an equity home bias
in the past that are no longer valid. Capital controls, new investment vehicles, and ease of trading over the
Internet now make foreign equity markets accessible to all investors. Although the persistent equity bias
presents a puzzle, various behavioral reasons provide possible explanations. In the behavioral finance
literature, portfolio under-diversification is often a symptom of some behavioral bias. For example,
evidencelinks overconfidence andfamiliarity toportfolio under-diversification.
French and Poterba (1991) were the first to document equity home bias. ftey offer several explanations for
it, including over-optimism about the prospects of the domestic securities. Based on survey evidence,
Strong and Xu (2003) find that institutional managers are more optimistic about domestic equities. ftis
relative optimism implies a positive bias toward domestic equities and a negative bias toward foreign equities.
In turn, these biases would lead to over-weighting domestic equities and under-weighting foreign equities.
Based on survey evidence from institutional managers from the United States, United Kingdom, Japan, and
continental Europe, Strong and Xu also find evidence of familiarity-based asset allocation by
institutional investors.
To investigate whether the observed under-diversification is irrational behavior driven by
familiarity bias, over-optimism, overconfidence, or a rational choice, researchers have investigated the
performance consequences of under-diversification specific to institutional investors. First, several authors of
theoretical papers contend
that under-diversification can also be a rational strategy. fte seminal papers in this area include Merton
(1987), Gehrig (1993), Levy and Livingston (1995), and more recent work by Van Nieuwerburgh and
Veldkamp (2009, 2010). If under-diversification is a rational strategy driven by information advantage, then it
should not deteriorate performance.
Although individual investors with under-diversified position also underperform the market even
before accounting for excessive trading and related fees, the same is not necessarily true for institutional
investors. Choi et al. (2016) find that under- diversified positions relative to the optimal efficient world
market portfolio earn higher risk-adjusted returns than do globally diversified portfolios. ftis evidence suggests
that under-diversified portfolios can be value enhancing. fte authors also report that more skilled investors are
more likely to deviate from the optimal portfolios, providing further evidence that under-diversification can be
optimal behavior if it derives from a rational, information-based process. Coval and Moskowitz (2001) find
similar evidence in the United States. Studies have documented local bias in U.S. equities across investor classes
and often have linked it to familiarity bias in investment choices. ftus, investors choose to irrationally invest in
familiar securities (Huberman 2001). Coval and Moskowitz also find that institutional investors, especially
mutual funds, actually outperform when they hold locally concentrated portfolios and outperform in nearby
securities. ftis finding provides further evidence that under-diversification, if motivated by some information
advantage, can be optimal.
Other Drivers of Institutions’ Trading Behavior

ftis section reviews two emerging streams of literature in behavioral finance that deal with how mood and
national culture influence investor behavior. Many of the papers in these streams use institutional investors as
their subjects. fteir results show that institutional investors are often moody traders and that the national
culture of the investors’ home markets influences their trading behavior.
MOOD
Investor mood is an important determinant of security returns and it affects stock markets around the world.
For example, Hirschleifer and Shumway (2003) show that the amount of sunlight, associated with the positive
mood of investors, has a corresponding positive effect on market returns. Kamstra, Kramer, and Levi (2003)
find that seasonal affective disorder (SAD), which results from people’s experiencing fewer hours of day-
light during certain times of the year, is related to an increase in investor risk aversion and security returns. fte
impact is also stronger in higher latitudes, where the hours of daylight fluctuate more from season to
season.
fte evidence on behavioral biases consistently shows that more sophisticated investors are less
susceptible to psychological influences. However, the evidence also shows that mood affects the trading
behavior of institutional investors. Goetzmann and Zhu (2005) study weather patterns, comparing it to the
stock market trading activity of individuals across different cities. fteir findings show no relation between
cloud coverage
and trading activity. fte authors suggest that, instead of traders, perhaps market makers and other professional
agents located in the cities of the stock exchanges may be driving the effect. In a more direct study of
institutions and mood, Goetzmann, Kim, Kumar, and Wang (2015) examine weather patterns and they show
that relative overpricing of securities of the Dow Jones Industrial Average (DJIA) increases on cloudier
days, as does the securities-selling propensities of institutional investors. fte authors also construct a stock-
level mood proxy from the institutional investors’ holdings, and find that this mood proxy is positively related
toastock’sreturns, especiallyinmore difficult-to- arbitrage securities.
CULTURE
Culture and finance have become a popular topic in recent finance literature. Studies of samples of both
different investors and markets show that culture influences economic exchange, such as saving and
investment decisions, market participation rates, and cross-border investment and trade (Guiso, Sapienza,
and Zingales 2009). In many of these culture studies, institutional investors are the main subjects, with
evidence showing that culture influences institutional investors.
In a study of investors’ decision making in Finland, Grinblatt and Keloharju (2001) find that the proximity,
language, and cultural similarity of investors and the chief executive officers (CEOs) of the companies are all
significantly related to an investor’s allocation decision. fte authors’ dataset contained both individual and
institutional investors. fte authors find that both groups behave this way, but the bias toward culturally similar
firms is greater for individual investors. Furthermore, Grinblatt and Keloharju document the differences in
institutional investors, in which the less savvy institutional investors, specifically nonprofits and governmental
organizations, exhibit stronger preference for culturally similar firms compared to more financially savvy
Beracha, Fedenia, and Skiba (2014) show that institutions’ trading frequency declines when shifting
from home markets to culturally similar foreign countries, and on to culturally distant environments. fte
authors also find that institutional investors from cultures marked by lower levels of trust toward others, as
well as higher levels of ambiguity aversion, generally trade with lower frequencies, perhaps because of their
lower levels of faith in market-based finance generally.
Aspreviouslydiscussed, institutionsholdhome-biasedportfoliosandunder-diversify their foreign holdings.
Although many variables can explain these under-diversification patterns, one answer concerns national
culture. For example, portfolio allocation studies by Anderson et al. (2011) on institutional investors and by
Beugelsdijk and Frijns (2010) on mutual funds across the global markets find that national culture is signifi-
cantly related to the heterogeneity in an institution’s level of home bias. More specifically, these papers
investigated the effect of Hofstede’s (1980, 2001) uncertainty avoidance, masculinity, and individualism on
home bias, and they find that uncertainty avoidance is positively related to the level of home bias. Moreover,
evidence by Anderson et al. (2011) shows that a cultural similarity of the investor’s home market to the asset’s
home market is positively related to the level of asset holdings. Cultural distance, as measured along Hofstede’s
primary dimensions of culture, decreases cross-border portfolio allocation, so that institutional investors
prefer culturally similar markets.

ftis chapter provides a synthesis of the literature on institutional investors’ trading behavior. fte chapter
initially investigated whether common behavioral biases— overconfidence, the disposition effect,
familiarity, and representativeness biases—are present in the trades of financial institutions. As discussed,
overall the literature provides little evidence that institutions make the same behavioral mistakes as do
individual investors in their trades. fte chapter also investigated how behavioral biases can explain institutions’
trading behavior—herding, momentum trading, and under-diversification. As shown, the literature finds that
institutional trading behavior is rational and mainly driven by information-based motivations. Institutional
investors apparently benefit from their strategies and make markets more efficient. ftus, the literature suggests
that sophisticated investors make rational decisions in their trading choices and are free of the common
behavioral downfalls documented as befallen individual investors.
Institutional investors are becoming increasingly educated about behavioral finance and the inefficiencies
that behavioral biases can create in the stock markets. Institutions are apparently aware enough of potential
biases as to take advantage of them For example, Ke and Ramalingegodwa (2005) show that transient
institutional investors (i.e., those investors with a shorter-term view and with active engagement) take advan-
tage of the post-earnings announcement drift in their trades. Cohen, Gompers, and Vuolteenaho (2002)
show that institutional investors are, on average, on the right side of trades when trading on market
underreaction to cash-flow surprises, Furthermore, institutions seem to exploit such trading at the expense
ofindividualinvestors.
fte evidence also shows that institutional investors construct trading strategies based on mood. For
example, Bollen, Mao, and Zeng (2011) find that mood in social media predicts DJIA returns; several
hedge funds developed a strategy based on this research paper. Also, many hedge funds employ
psychologists on their management teams, because sophisticated investors understand the importance of
mood and sentiment to security prices.
Behavioral biases also affect institutional investors through the underlying investor base. A perfectly
rational institutional manager with perfect ability to analyze securities’ risk and return characteristics still needs
to be aware of underlying investor tendencies for behavioral bias. Indeed, understanding the underlying investor
base is an especially important topic in the field of wealth management. Different models of individual
behavior help wealth managers understand the wide range of clients and how to best serve their individual
needs. For example, Pompian (2012) has divided clients into four distinct groups: preservers, followers,
independents, and accumulators; each group has its unique characteristics, as well as displays the most likely
behavioral biases. Pompian’s work has become a centerpiece of attention for the behavioral finance sections of
the CFA program, taught to the future institutional managers.
1. Discuss whether institutional investors are subject to behavioral biases to the same extent as individual
investors.
2. Explain whether mood, not directly related to financial fundamentals, affects institutional investors.
3. Discuss whether evidence showing that institutions herd with their trades supports irrational (market
destabilizing) or rational (market stabilizing) reasons for institutional herding.
4. Identify how institutions can exploit behavior biases of individual investors’ in their trading choices.
5. Discuss how institutional agents can use behavioral finance to benefit their clients.
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5
Corporate Executives,
Directors, and Boards
J O H N R. N O F S I N G E R
Professor and William H. Seward Endowed Chair in International Finance
University of Alaska Anchorage
P A TT A N A P O R N C H A T J U T H A M A R D
Associate Professor of Finance
Chulalongkorn University
Introduction
ftis chapter examines the financial decision-making behavior of corporate managers and members of
boards of directors. Traditionally, academics assumed that decision makers would be rational when
making important financial decisions. Over the past few decades, scholars have discovered that decisions can
better be framed as being normal. But what is normal versus irrational behavior? To some extent, whether the
behavior of corporate leaders differs from the norm depends on the expectations of others. fterefore, this
chapter begins by assessing the leadership behavior that is expected, based on two main theories of corporate
management: agency theory and stewardship theory. Agency theory depicts the chief executive officer (CEO)
as a self-interested agent who makes decisions that are personally beneficial. Stewardship theory describes a
CEO as a benevolent shepherd seeking higher corporate achievement. ftese two management theories,
which are described in more detail in the next section, put this topic into a framework that enables assessing
corporate leadership behavior.
Besides viewing managerial behavior from agency and stewardship perspectives, the chapter also
examines some psychological biases and traits of CEOs. For instance, managers exhibit optimism bias and
overconfidence, and these biases can impact a manager’s perception of the company’s growth or a project’s
chances of success. fterefore, biased perceptions could lead to decisions that affect investment and capital
structure. Similarly, managers can be risk averse, which might influence the company’s investments and
capital structure.
In the stewardship framework, a primary function of the board of directors is to enable the CEO by
providing resources, direction, and advice as needed. However, in the agency framework, the directors act to
control the CEO. Because the agency CEO acts in a self-interested manner and exhibits both behavioral biases and
too much risk aversion,
79
the board must provide incentives to overcome the agency problem, as well as the biases and risk aversion. fte
board must monitor the CEO’s decisions and represent the shareholders’ interests. In many instances, this duty
suffers, because boards themselves exhibit biases and self-interested behavior. Specifically, boards may suffer
from group dynamic problems,suchas socialloafing, poor information sharing,andgroupthink.
fte first section of this chapter describes the agency and stewardship theories, and identifies the key areas
where they have different outcomes. ften the chapter describes the self-interested behavior, risk aversion, and
psychological biases of top management. fte behavior of the board of directors is illustrated next, including
some individual and groupdynamics.ftefinalsectionoffersasummaryandconclusions.
Theories of Management
Many studies attempt to explain the relationships between ownership and management of a company. fte
classic framework of agency theory by Jensen and Meckling (1976) describes how individual self-interest
utility motivates the conflict of interests between shareholders (principals) and management (agents),
resulting in the potential problems of opportunism and the solutions of incentives and monitoring. ftis
framework has been the dominate theory in the finance and economics literature. However, an alternative
model of managerial motivation and behavior has also been popular in the management literature. It is
known as stewardship theory (Donaldson and Davis 1991, 1993) and is derived from psychological
and sociological factors.
AGENCY THEORY
During the 1960s and 1970s, economists explored risk-sharing among individuals or groups (Wilson 1968;
Arrow 1971). ftis literature described the risk-sharing problem as one that arises when cooperating parties have
different attitudes toward risk. Agency theory broadened this risk-sharing literature to include what is now
called the agency problem, which occurs when cooperating parties have different goals and division of
labor (Ross 1973; Jensen and Meckling 1976). Specifically, this theory is directed at the pervasive agency
relationship in which one party delegates work to another agent, who performs that work. In describing this
relationship using the metaphor of a contract, agency theory suggests that the firm can be viewed as a nexus of
contracts (loosely defined) between the principal and the agent.
Agency theory attempts to deal with two specific problems: (1) aligning the goals of the agent so that
they are not in conflict with the principal (agency problem); and
(2) reconciling the principal and agent differences in risk tolerances. Further, it explores the ownership structure
of the corporation, including how equity ownership by managers aligns managers’ interests with those of
owners. Fama (1980) discusses the role of efficient capital and labor markets as information mechanisms
used to control the self-serving behavior of top executives. From an agency perspective, Fama and Jensen
(1983) describe the role of the board of directors as an information system in which the stockholders in large
corporations could implement to monitor the opportunism of top executives. When boards provide richer
information, top executives are more likely to engage in behaviors that are consistent with stockholders’
interests. Jensen (1984) and
Corporate Executives, Directors, and Boards 81
Jensen and Ruback (1983) extend these ideas to controversial practices, such as golden parachutes and
corporate raiding. A golden parachute is a large payment to a CEO as a result of the firm’s being merged or
acquired by another firm. Corporate raiding refers to a large block of shares purchased to pressure the firm to
enact novel business measures that contrast with current management practices.
According to agency theory, an important component of the solution to the agency problem is to
artificially bring management goals in line with shareholders goals. ftis goal is typically accomplished by
structuring management incentives in such ways that they align management behavior with shareholder goals.
For example, the shareholders could give the CEO shares or options of stock that vest over time, thus inducing
long- term behavior and deterring short-run actions that harm future company value. When the interests of top
management are brought in line with those of shareholders, agency theory argues that management will fulfill
its duty to shareholders, not only because of any moral sense of duty to shareholders but also because of the
incentivestomaximize their own utility (Donaldson and Davis 1991).
Agency theory often uses the word control, meaning that the board of directors (as a proxy
representation for the shareholders) must control top management. A major function of the board is to curtail
such managerial “opportunistic behavior,” including shirking and indulging in excessive perquisites at the
expense of shareholder interests (Williamson 1985; Donaldson and Davis 1991). Although incentives are
one solution to the agency problem, another solution is monitoring and oversight. fte board conducts this
oversight of management to further counter the agent’s propensity to engage in opportunistic behavior.
Besides providing monitoring of CEO actions on the behalf of shareholders, the board also offers inputs
into decisions at the top management level. ftus, the behavior and decisions of the board affect the firm
through the incentives created for management, the monitoring of management, and large corporate
actions.
STEWARDSHIP THEORY
Although agency theory is built from an economics model, stewardship theory is derived from a
psychology and sociology framework. Stewardship theory applies when managers choose the interests of
shareholders over their own personal motivations or incentives. Generally, stewards are motivated by a need
to achieve and excel in their work, and can distinguish between their work and the compensation for it.
Further, stewards generally gain intrinsic satisfaction through successfully performing inherently challenging
tasks. Stewards also often have a need to exercise responsibility and authority to gain recognition from peers
and board members, or to obtain sufficient empowerment to get the job done properly. fterefore, an important
aspect of stewardship theory occurs in the mind of the manager—a belief that a CEO steward is the owner
of the company in proxy and fulfills his responsibility even when that responsibility conflicts with his
personal interests.
fte literature on stewardship focuses on enabling managers, rather than controlling them. Managers whose
needs are based on achievement, growth, and self-actualization, and who are intrinsically motivated, will gain
greater utility by accomplishing organizational rather than personal goals. fterefore, with this theory, the
board of directors is a sounding board and resource for a steward CEO rather than a controlling body.
Stewardship theory also involves a high level of principal trust (Davis, Shoorman, and Donaldson 1997).
FACTORS DIFFERENTIATING AGENCY AND

STEWARDSHIP THEORIES
Davis et al. (1997) explain various dimensions on which agency theory assumptions differ from those of
stewardship theory. ftese dimensions are characterized as either the subordinate’s psychological attributes or
the organization’s situational characteristics.
Psychological Factors
According to agency theory, top managers are viewed as rooted in economic rationality and individualistic self-
serving behaviors. However, stewardship theory is motivated by the model of a person in top management as
self-actualizing and someone who needs to grow beyond his or her current state to reach a higher level of
achievement. fte following assumptions reflect these differences.
• Motivation. Agency theory focuses on quantifiable extrinsic rewards or measurable market
motivation. ftis reward system aims to reduce the agency conflicts by aligning interests. Additionally,
some incentive rewards, such as medical insurance, savings, and retirement plans, are control
mechanisms to reduce the likelihood of the CEO’s leaving the firm. Alternatively, stewardship theory
focuses on nonquan- tifiable intrinsic rewards, such as opportunities for growth and responsibility for
doing the work. Achievement, affiliation, self-actualization, self-efficacy, and self- determination are
important components. ftese intrinsic motivations relate to the importance of a shared
organizational vision.
• Identification. In agency theory, managers may externalize organizational problems to avoid blame. By
avoiding incriminating evidence, these self-serving managers may make organizational problems worse
because they avoid accepting responsibility and avoid making decisions to rectify the problems (D’Aveni
and MacMillan 1990). In stewardship theory, managers identifying with their organization will work
toward the organization’s goals, solve problems, and overcome barriers in order to help their organizations
succeed (Mowday, Porter, and Steers 1982; Smith, Organ, and Near 1983; O’Reilly and Chatman 1986).
ftese managers have high identification with and high value commitment to their organization.
• Use of Power. Gibson, Ivancevich, and Donnelly (1994) separate power into institutional and
personal power. In agency theory, institutional power includes reward, legitimate, and coercive power
(Adams, Almeida, and Ferreira 2005). Appropriate reward systems and the recognition of authority in the
principal are pooled to create the required control level in the principal–agent relationship. Coercive poweris
used as a severe method of agent monitoring. Alternatively, in stewardship theory, personal power combines
both expert and referent power. Top management is more likely to use personal power as a basis for
influencing ina principal–stewardrelationship.
Situational Factors
Managing an organization includes many interactions among top leaders, middle management, and staff.
ftese interactions can be structured with different levels of control,
empowerment,andtrust.fte situationalfactors are oftendependent onthe prevailing culture.
• Management philosophy. Lawler (1986) categorizes management philosophy into control-

oriented and involvement-oriented management approaches. Agency theory tends toward a control-
oriented system, which is designed to avoid vulnerability and the need to trust. Management
implements greater controls to reduce risk or uncertainty. fterefore, this system works best in a stable
environment. Unlike agency theory, an involvement-oriented philosophy allows stewardship theory to
build the relationships that help management deal with increased uncertainty and risk through more
training, empowerment, and trust in workers.
• Culture. Cultures are often measured on an individualism–collectivism scale. Individualism culture
emphasizes personal objectives over group goals and is generally common in Western culture.
Individualism fosters agency theory. Collectivism culture defines self as a part of the group and prefers a
long-term relationship. ftis culture enables stewardship theory. Another common measure of cultural
dynamics is the distribution of power within a country or within its institutions and organizations. fte
term power distance describes this distribution. A high power distance culture indicates a more
narrow distribution of power and is conductive to the development of principal–agent relationships
because it supports and legitimizes the inherent inequality between shareholders and management.
Conversely, a lower power distance culture is more conducive to the development of principal–steward
relationships because all members emphasize a shared power system.
Summarizing the Theories

Sundaramurthy and Lewis (2003) show the underlying differences in assumed managerial and board
behaviors between these two approaches. Agency theory assumptions include behavior that stems from
individualism, opportunism, extrinsic motivation, conflict of interests, and distrust that lead to a control
approach. By contrast, stewardship theory assumes behaviors that come from collectivism, cooperation,
intrinsic motivation, goal alignment, and trust that lead to a collaborative approach. According to these
assumptions, each approach suggests certain board roles and structures. A controlling board of directors acts as
an ultimate internal monitor over management, whereas a collaborating board simply acts as an advisor and a
supporter to management. In summary, although agency theory looks at top management as individualistic
utility maximizers, stewardship theory perceives top management as collective self-actualizers caring about firm
success. fte next section examines managerial behavior with these two management theories in mind.
Corporate Executives and Their Financial Behavior

fte CEO plays the most important role and bears the most significant responsibility, as well as has the
greatest accountability and authority within a corporation. fte CEO has the responsibility for the overall
success of the organization and makes the financial decisions, but still reports to the corporation’s board of
directors. Given the leadership position of the CEO, much research has been dedicated to studying how
CEOs make
their decisions. ftese studies identify traits and psychological biases, and then have determined how those
behaviors are related to compensation, financing choices, investing decisions, and firm performance.
MANAGERIAL TRAITS
Various studies identify specific managerial characteristics and attempt to explain which traits matter. Bertrand
and Schoar (2003) study managers who move from one firm to another firm, and report evidence consistent
with different managers having different styles, behavior, and performance. Bloom and Van Reenen
(2007) find that various management practices are related to performance. Both Stulz and Rohan (2003)
and Huang and Darren (2013) show that gender and religion have a strong influence on managers’ mindsets,
which is reflected in corporate decisions. ftey show that male managers exhibit overconfidence in important
corporate decision-making relative to women. Additionally, Chatjuthamard, Lawatanatrakul, Pisalyaput, and
Srivibha (2016) find that culturally based managerial mindsets affect firm risk. ftey show that practices
consistent with the Sufficiency Economy Philosophy in ftailand, rooted in Buddhism, are less risky, but not
less profitable. Furthermore, some studies attempt to identify the most important characteristics. Schoar and
Zuo (2016) and Graham and Narasimham (2004), for example, find that CEO actions are related to
measures of conservatism. According to Malmendier and Tate (2005, 2009), Ben-David, Graham, and
Harvey (2013), and Graham, Harvey, and Puri (2013), CEO decisions and outcomes are related to
measures of overconfidence, optimism, risk aversion, and time preference.
In corporate finance, the standard assumption is that managers are fully rational and make optimal decisions.
Although behavioral finance assumes managers are normal, that may not always mean they are rational.
According to behavioral finance, managers make decisions based on the notion of bounded rationality.
Bounded rationality assumes that individuals are influenced by past decisions, values, cognitive biases, and
emotions that result in people’s making only satisfactory choices. Behavioral corporate finance criticizes the
rationality hypothesis of managers and investors, and explores the effect of such criticisms on a company’s
decision making. Psychological biases may drive those decisions. For example, managers are not fully
rational; instead, they may have too much confidence in their ability and judgment, a characteristic called
overconfidence. Managers may also be too optimistic about future forecasts (Hackbarth 2008). Optimistic
managers tend to overestimate the growth rate of earnings, a characteristic called growth perception bias,
whereas overconfident managers tend to underestimate the riskiness of earnings, a characteristic known
as risk perception bias.
Optimism
Contrary to the traditional corporate finance literature, managers do not always act rationally. ftey may
present some optimism or overconfidence biases that influence company decisions. De Long, Scheifer,
Summers, and Waldmann (1990) and Goel and ftakor (2000) describe the difference between optimism
and overconfidence. According to them, optimism is an overvaluation of the likelihood of favorable
future events. Specifically, CEOs may be optimistic about the success of their decisions. By contrast,
overconfidence is an underestimate of the risk of future events. Sometimes
overconfidence is also described as a better-than-average belief. Weinstein (1980) defines managers as

optimistic when they overestimate the probability of good company performance and underestimate the
probability of bad company performance. Heaton (2002) suggests that optimistic managers believe the
capital market underval- ues risky securities owned by the firm. Optimistic managers also overvalue their
firm’s investment opportunities, leading to investment in negative net present value (NPV) projects. ftis
process occurs because managers overestimate the project’s cash flows and underappreciate its risks. Graham
et al. (2013) find that more optimistic managers use more short-term debt in their capital structure, because
their optimism leads them to avoiding using more expensive long-term capital.
Managerial optimism can help explain the need for independent directors and a board chair who does
not serve as the CEO for the monitoring purposes. According to Kahneman and Lovallo (1993),
organizational optimism is best alleviated by introducing outsiders, because these outsiders can draw
managerial attention to information that might indicate their perceptions are wrong. Additionally, Parades (2005)
maintains that corporate governance should be reformulated in order to enlarge its scope to control the CEO’s
optimism. However, an optimal level of CEO optimism may maximize company value. Campbell,
Gallmeyer, Johnson, Rutherford, and Stanley (2011) show that low levels of optimism lead to
underinvestment, whereas high levels of optimism lead to overinvestment.
Overconfidence
Shefrin (2006, p. 6) describes the better-than-average aspect of overconfidence as “People make mistakes
more frequently than they believe and view themselves as better than average.” Bernardo and Welch (2001)
incorporate this concept into managerial theory by building an informational cascades model and by
suggesting that overconfident individuals act on their own information while ignoring the actions of others
in the group. According to psychology and behavioral economics literature, a common source of
overconfidence is self-attribution bias, in which managers over-credit their role in bringing about good
outcomes and over-credit external factors or bad luck for bad outcomes. ftis leads to managers believing they
are better than the average manager. Hirshleifer (2001) explains that self-attribution causes individuals to
learn to be overconfident rather than converging to an accurate self-assessment. ftus, overconfidence persists
over time. Other finance professionals also exhibit this bias. For example, Gervais and Odean (2001) suggest
that self-attribution causes traders to become overconfident. Hilary and Menzly (2006) find evidence that
self-attribution bias leads analysts with recent short-term success to become overconfident.
How do managers become overconfident? fte source of the overconfidence has implications for
corporate governance. fte base case is that managers may be born overconfident. In this explanation,
companies can avoid overconfident managers by not hiring them. Alternatively, managers develop
overconfidence through experience as CEOs. In this explanation, companies might adjust their monitoring and
incentives to guard against overconfidence developing (Parades 2005). Lastly, Gervais, Heaton, and Odean
(2011) show how managerial overconfidence can result from the selection bias when hiring a manager. ftey
explain that someone who is overconfident is more likely to be selected as a manager, because people who tend
to apply for managerial posts are
more likely to be very confidence about their own abilities. Goel and ftakor (2008) also find that
overconfident managers are more likely to get promoted and outperform others.
Managerial Risk Aversion

Risk aversion is an important managerial trait. Risk aversion is the behavior that characterizes people
seeking to reduce risk and uncertainty. Risk-averse CEOs are willing to accept the lower returns that
accompany lower-risk projects. Many theoretical papers (Friedman and Savage 1948; Pratt 1964; Coase
1973; Kahneman and Tversky 1979; Caballero 1991; Sitkin and Pablo 1992; Parrino, Poteshman, and
Weisbach 2005) explain the role of managerial risk aversion in corporate decision making. fte different
levels of risk aversion among managers can explain the differences in managers’ reactions to decisions
involving uncertainty. According to several recent studies, differences in managerial risk aversion affect
corporate decision making and actions in general. For example, Graham et al. (2013) find that less risk-averse
CEOs make more acquisitions. When firms try to control managerial risk-taking in an agency framework,
Chava and Purnanandam (2010) find that providing risk-taking incentives leads to higher financial
leverage and lower cash balances, while avoiding such incentives leads to lower leverage and higher cash
balances. In contrast, Low (2009) reports that an increase in managerial risk aversion leads to lower
company valuation, and thus firms may want to provide risk-taking incentives.
Top executives have different management styles with regard to investment, financing, and strategic
decisions. ftis raises the question whether managerial attitudes and behavior might explain corporate decision
making and actions. Many studies suggest that managerial characteristics indeed matter for corporate
policies.
MANAGERIAL ATTRIBUTES AND COMPENSATION

In agency theory, the executive compensation package is designed to give managers a pattern of rewards so
as to align their interests more closely with shareholders. ftis kind of incentive, usually in the form of stock
options, is important to company performance (Fenn and Liang 2001; Hermalin and Wallace 2001).
However, a limitation on this incentive is that managers tend to receive the incentive pay during a generally
rising stock market (Bertrand and Mullainathan 2001). Paredes (2005) confirms this view and also shows
that the incentive governance mechanism can lead to overconfidence bias, because managers get high
rewards from a rising market and attribute those rewards to their ability and performance.
Are managerial traits related to compensation? Graham, Li, and Qiu (2012) find that more aggressive
managers appear to be remunerated for taking additional risk. Evidence by Graham et al. (2013) shows that risk-
taking CEOs are paid with a higher proportion of performance-based incentives and relatively lower cash
salary. ftey also find that CEOs who are more impatient receive proportionately more in salary. Of course,
determining if higher risk-taking managers will ask for more stock options or if CEOs given more
performance sensitivity pay are induced to take more risk is difficult. Indeed, Smith and Stulz (1985) and Guay
(1999) contend that the boards award equity-based compensation to managers to overcome managerial risk
aversion and to induce optimal
risk-taking behavior. Low (2009) supports their conjecture, and shows that companies that experience a
decrease in risk are concentrated among firms with low managerial equity-based incentives.
CEO BEHAVIORAL BIASES AND FIRM CAPITAL STRU C TU RE

Hackbarth (2008) suggests that growth and risk perception biases are important factors for corporate capital
structure decisions. Managers with a growth perception bias are considered to be optimistic. Specifically,
their optimism causes them to overestimate the company’s future earnings growth rate, which leads them to
perceive a larger cost for issuing equity than debt. Additionally, managers with risk perception bias are consid-
ered to be overconfident. ftey tend to underestimate the future earnings’ risk and also favor issuing debt rather
than equity. Recent articles support this view that managerial optimism and overconfidence lead to a greater
debt financing. For example, Graham et al. (2013) show that more optimistic CEOs use more short-term
debt, whereas Malmendier, Tate, and Yan (2011) find that overconfident managers view external
financing to be costly and prefer to use cash.
CEO TRAITS AND CORPORATE INVESTMENT DECISIONS

According to Heaton (2002), managerial optimism is evidently bad, causing either over- or under-
investment. Common distortions in corporate investment may be a result of manager biases. Building on
Roll (1986) and Heaton (2002), Malmendier and Tate (2005) contend that one important link between
investment levels and cash flow is the tension between beliefs about the company’s value of the CEO
versus the market. Empirically, Malmendier and Tate (2005, 2008) find that overconfident CEOs have
higher investment cash flow sensitivities and are more likely to engage in value-destroying mergers.
Moreover, Goel and ftakor (2008) show that a rational and risk-averse CEO under-invests in corporate
projects and this under-investment reduces company value. Alternatively, they also present a model in
which a moderately overconfident risk-averse CEO increases company value by reducing the under-
investment problem. fte reason for this is that the overconfident CEO overestimates the accuracy of private
information and overreacts to it. Although a moderately overconfident CEO reduces under-investment and
increases company value, a highly confident CEO generates over-investment and reduces company value.
Campbell et al. (2011) complement Goel and ftakor’s work by showing that a manager’s optimism can
beneficially offset the effect of the individual’s aversion on the investment level chosen.
Roll’s (1986) hubris hypothesis, which now seems to be labeled as overconfidence, suggests that
managers engage in acquisitions with an overly optimistic opinion of their ability to create value. He suggests
that overconfidence motivates many corporate takeovers. Furthermore, Doukas and Petmezas (2007) show
that overconfidence is a fundamental component of corporate acquisitions. Recent studies confirm this
view; for example, Liu and Taffler (2008) provide evidence that overconfident CEOs are more likely to
conduct mergers and acquisitions (M&As) than are rational CEOs. Graham et al. (2013) report that more
risk-tolerant CEOs make more acquisitions.
Billett and Qian (2008) explore managerial self-attribution bias in M&As by looking at the sequence of
deals made by individual CEOs. ftey suggest that CEOs with self- attribution bias become overconfident.
fteir evidence shows that acquirers’ first deals should have non-negative wealth effects. Acquirers who
become overconfident from successful acquisition experience are then more likely to acquire again, and their
future deals, driven by overconfidence, will result in poor wealth effects. Also, experienced acquirers who
become overconfident are more likely to exhibit greater optimism about company prospects and exhibit such
optimism when trading their companies’ stocks. fte evidence for this behavior is pervasive. For example, Li
(2010) shows that a manager’s self-attribution bias affects corporate policies. Gervais and Odean (2001),
Barber and Odean (2002), Doukas and Petmezas (2007), and Billett and Qian (2008) all find that CEOs tend
to become overconfident after successful acquisitions. As a result, these CEOs are more likely to follow those
successful acquisitions with other acquisitions that negatively impact their company’s stock price.
Bolton, Brunnermeier, and Veldkamp (2013) develop a theory of leadership that contrasts managerial
resoluteness with communication and listening skills. Resoluteness is a form of overconfidence that arises
when CEOs are unresponsive to outside information. More resolute and overconfident CEOs tend to perform
better than CEOs who are better listeners and communicators in situations requiring greater coordination. ftis
finding suggests a positive relation between resoluteness and overconfidence and company performance.
Directors, Boards, and Their Financial Behaviors

Boards of directors are an integral part of the governance of large organizations, including all corporate and
many nonprofit organizations. fte firm’s stockholders elect the directors to govern the organization and
guard the stockholders’ interests. fte board’s main roles are to hire the CEO and to assess the overall direction
and strategy of the business. Many finance and economics studies discuss whether the board of directors can
help solve the problems associated with this separation of ownership and control. ftese studies examine all
aspects of a board of directors and how its characteristics affect the company. However, this section focuses on a
subset of this literature—specifically, how the behavior and characteristics of a board affect CEO
behavior.
ROLES AND STRU C T URES

Boards of directors are an important topic of research in management studies, economics, finance, business
strategy, and sociology as well as legal areas. Adam Smith (1776) was the first economist to address boards of
directors in an agency context. fte studies of Fama (1980) and Fama and Jensen (1983) suggest that boards
of directors can alleviate the agency conflict of goals and interests between the owners and the managers.
Generally, boards are composed of both insiders and outsiders. Inside directors are employees and therefore
thought to be dependent on the CEO, whereas outside directors (sometimes called independent directors) are
not employees and lack any business ties to
the company. fte roles of inside and independent directors are examined in the context of monitoring
management.
E MP IR IC AL EX AMINAT IONS OF BOARDS OF DIRE CTORS

Are boards effective at monitoring their managers and controlling their managers’ behavioral biases? How
can this effectiveness be determined? fte primary mechanism for measuring the monitoring capability of a
board is the proportion of outside to inside directors. fte more directors who are independent of the CEO, the
more likely they will be effective monitors. If they are successful at creating the right incentives and monitoring
management, then the company should perform better. ftus, studies often examine whether more
independent boards lead to greater company performance.
Board Independence and Company Performance

Different ways are available to measure company performance. Hermalin and Weisbach (1991), Mehran
(1995), Klein (1998), and Bhagat and Black (2002) report an insignif- icant association between accounting
performance measures, such as return on equity, and the proportion of outside directors on the board.
Another measure of company performance is Tobin’s Q, which is the market value of a company’s assets (as
measured by the market value of its outstanding stock and debt) divided by the replacement cost of the
company’s assets (book value). Morck, Shleifer, and Vishny (1988), Hermalin and Weisbach (1991), and
Bhagat and Black (2002) all use Tobin’s Q to reflect the value added by intangible factors, but they find no
noticeable relationship between the proportion of outside directors and company performance. Bhagat and
Black also examine the effect of board composition on long-term stock and accounting performance, but do not
find any significant relation.
Does this mean that boards do not effectively control manager behavior? Possibly, but measurement errors
could exist. Morck (2008) suggests that many directors classified as independent are actually associated with
the firm’s CEO. Specifically, the CEO recruits them through personal contacts or friendships. As more stringent
definitions of independence are applied, though, a clearer relationship may emerge. Morck also suggests the
possibility that behavioral constraints on board independence are high; if so, genuinely independent directors
and board chairs may require institutional investors and public shareholders to nominate candidates for
directorships. Such measures could entail corporate governance risks, in that they assume good governance
is possible within institutional investors and shareholder rationality.
Boards, Their Monitoring Roles, and CEO Turnover

Other characteristics may affect a board’s ability to control manager behavior. For example, do the
attributes of the board, such as inside/outside composition, size, or compensation, directly influence the
board’s monitoring role? Besides examining board characteristics, various studies focus on board
responsibility in choosing and monitoring a company’s CEO. One way to assess a board’s effectiveness is to
analyze the quality of those decisions. Numerous studies illustrate a positive relation between CEO turnover
and poor organization performance (Coughlan and Schmidt 1985; Warner, Watts,
and Wruck 1988; Weisbach 1988; Barro and Barro 1990; Jensen and Murphy 1990; Kaplan 1994; Denis
and Denis 1995; Huson, Parrino, and Starks 2001; Eldenburg, Hermalin, Weisbach, and Wosinska 2004).
Namely, when company performance is poor, the board is more likely to find the current CEO unacceptable
and make a change.
In particular, Weisbach (1988) shows that CEO turnover after poor performance is more likely in firms
with more independent directors. Boards controlled by outside directors do a better job of monitoring the
CEO than do boards controlled by inside directors. Rosenstein and Wyatt (1990) support the view that
independent directors seem to affect at least some governance effectiveness, and they show that stock prices
rise on news of outsiders joining boards.
Working in groups, such as boards of directors, can lead to the free rider problem, also known as social
loafing. When more people are in a group, individuals in the group may believe that others will do the work
required and thus they shirk their responsibilities. Although no studies of boards directly examine whether
social loafing occurs, some studies use the size of the board as a proxy for the possibility of shirking. Smaller
boards are purported to have less shirking, and thus be more effective in monitoring managers. Yermack (1996)
and Wu (2000) examine CEO turnover and board size as it relates to firm performance. Both studies find that
companies with smaller boards have a stronger likelihood of CEO turnover after poor performance. ftis
finding is consistent with the view that smaller boards are more effective overseers of their CEOs than are
larger boards.
Finally, Perry (2000) examines the relation between CEO turnover and company performance by
showing whether the outside directors are paid using incentives. If incentive compensation is an effective
tool in aligning CEO interests with the company’s interests, then it might also work for the directors. Perry
finds that outside directors who receive incentive pay tend to have a professional, rather than a personal,
relationship with the CEO, and thus they are relatively more independent.
Boards and the Takeover Market

According to Harford (2003), understanding the reaction of boards to takeover bids requires a recognition
of the incentives governing the directors. Harford’s evidence shows that outside directors have strong
financial incentives to resist a takeover bid. He also finds that, on average, the gain on the small amount of equity
they hold in the company is too small to compensate them for their loss of directorship income. fterefore,at the
margin, these personal financial considerations lead outside directors to resist possible acquisitions, even
when those acquisitions are in the shareholders’ interest.
Behavioral Biases of Boards of Directors

fte board of directors is, by definition, a group setting. Scholarly research shows that groups often amplify the
cognitive biases of individuals. To illustrate this point, consider a study conducted with both individuals and
groups (Whyte 1993). When presented with a bad capital budgeting project for evaluation, 71 percent of the
individual decision makers correctly terminated the project, as did a similar 74 percent of the groups. In the
next round of experiments, Whyte adds an additional piece of information: a non- recoverable investment
already spent on the project. Because people are averse to a sure loss, such as this sunk cost, they incorrectly
include the sunk cost in their evaluation.
ftus, only 31 percent of the individual decision makers correctly reject the project, a result of loss-aversion
bias. Did the groups do better? No, they did worse; only 24 percent of the groups correctly reject the project.In
fact, thegroups seem tobe evenmore affected by the sure loss aversion.
Because meetings of the board of directors are private, few scholarly studies directly measure their
interactions and biases (Forbes and Milliken 1999). However, many studies analyze group behavior in
general. Hopefully, what is known from group behavior can be extrapolated to uncover potential problems
in boards of directors.
So, why do group decisions often result in worse performance than individual decisions? Specifically,
why are behavioral biases often magnified in groups? ftree processes occur in group dynamics that are not
factorsforanindividual:(1)socialloafing,
(2) poor information sharing, and (3) groupthink.
Social loafing, as mentioned earlier, is also known as the free rider problem ( Jensen 1993), in which
members of a group might not put in a high level of effort because they assume others will do the work. fte
motivation for this behavior is a person’s feeling that he or she will not get much individual recognition for
the success of the group (Linck, Netter, and Yang 2008). Instead, the social loafer puts more effort into
other activities. Social loafing is more prevalent when responsibilities within the group are vague and
diffused, and when the group’s outcome is not linked well with individual efforts.
Boards of directors can be formed with members having different knowledge or skills. fte hope is that each
member shares with the rest any specialized knowledge. However, groups often display poor information
sharing (Boivie 2016). Two factors can influence this information sharing: a feeling of power and an initial
prevailing view. First, a feeling of power occurs when one person has information that others do not; sharing
that information reduces that feeling of power. Second, if some members believe that other members favor a
specific decision, they may withhold information that contradicts that view; this behavior is the group version
of confirmation bias. Confirmation bias refers to selective thinking, whereby one searches for and interprets
information that confirms prior beliefs while simultaneously ignoring or discounting relevant information
that contradicts those beliefs.
When a group is formed to make a decision, it eventually needs to achieve a consensus. fte drive to
achieve that consensus can crowd out serious discussion of alternatives. ftis situation is another group
form of confirmation bias, called groupthink. fte group characteristics that foster groupthink are: (1) a strong
or charismatic leader, (2) a friendly atmosphere, (3) no clear procedure for making the decision, (4) an overt
desire for conformity, and (5) a stressful decision that has to be made. Boards of directors are likely to
experience at least some of these characteristics, and thus be susceptible to groupthink (Zhu 2013).

Agency theory is the prevailing model of CEO behavior in the finance and economics literature. ftis
theory describes CEOs as self-interested agents who make decisions based on what is best for them, even if it is
not in the best interests of the shareholders.
By contrast, stewardship theory describes CEOs as benevolent shepherds of the company, seeking higher
achievement by leading the firm. fte expected behavior of management spans the two theories; therefore,
each theory specifies different roles for the board of directors.
Evidence indicates that CEOs tend to be optimistic, overconfident, risk averse, and self-interested.
Optimistic and overconfident CEOs overestimate future earnings growth and underestimate the earnings’ risk,
thereby perceiving a larger cost for issuing equity than debt. ftese biased CEOs are also more likely to engage in
wealth-destroying investments, particularly M&As. Lastly, risk-averse CEOs may choose to use too lit-
tle debt financing or under-invest, holding high cash balances. With these behaviors, boards should provide
incentives to control these behavioral biases and increase risk- taking, as well as align their CEOs with
shareholder interests.
Besides these rational roles of boards, directors have their own self-interests, and so boards can suffer from
group dynamic biases. Specifically, boards may display social loafing, poor information sharing, and
groupthink. ftese problems may make the boards less effective in controlling their top management. However,
far more research is needed in this area; although many studies investigate these group biases, few focus on the
board of directors.
1. Identify and explain three psychological factors that differentiate CEOs in the agency and
stewardship frameworks.
2. Discuss how CEO optimism might lead to poor capital investments.
3. Explain how a CEO might become overconfident.
4. Identify and explain group dynamic biases that might affect a board of directors.
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6
Financial Planners and Advisors
B E N J A M I N F. C U M M I N G S
Associate Professor of Behavioral Finance
The American College of Financial Services.
Introduction
A growing number of individuals use financial advisors to provide guidance in navigating an
increasingly complex financial marketplace. Using data from the Survey of Consumer Finances, Hanna
(2011) reports that 21 percent of households used a financial planner in 1998, which increased to 25 percent in
2007. More recently, the Certified Financial Planner Boards of Standards, Inc. (CFP Board) (2015) estimates
that 28 percent of consumers used a financial advisor in 2010, increasing to 40 percent in 2015. fte Society of
Actuaries (SOA) (2013) estimates that 55 percent of retirees and 48 percent of pre-retirees use financial
advisors tohelp them make financial decisions.
fte increasing demand for professional financial advice is accompanied by an increasing demand for talent in
financial planning, which can be an attractive career. In 2012, CNN Money (2012) ranked financial advisors
as the sixth best job in America. More recently, U.S. News and World Reports (2016) ranked the job of a
financial advisor as the fourth best business job. fte College for Financial Planning (2014) finds that 90 percent
of survey respondents are extremely satisfied with their choice to pursue a career in financial advice. Additionally,
the number of financial advisors is projected to grow for the foreseeable future. fte Bureau of Labor Statistics
(BLS) (2015) estimates that the number of personal financial advisors will grow by 30 percent over the next
decade, suggesting good prospects for individuals who are considering the financial advice profession.
ftis chapter seeks to provide insight about the role of financial planners and advisors in helping others
manage their financial resources. Particular attention is given to the behavior of and incentives for various
players within the financial advice profession, especially to areas where financial planners and advisors may
present behavioral biases. Bias can be described as a partiality for or against someone or something, often as
a result of varying influences, incentives, or constraints. fte incentives for financial planners and advisors
ought to be considered when analyzing their role in a client–planner relationship. For example, the incentives
tied to compensation structures may bias financial professionals. ftese professionals may also be biased by
regulatory constraints or incentives. How incentives may affect the behavior and recommendations of finan-
cial planners and advisors is a primary focus in this chapter.
97
fte first section of this chapter reviews the regulation of financial advice and the types of firms that
exist, with particular attention given to registered investment advisers, broker-dealers, and insurance firms. fte
next section discusses agency costs as they relate to financial advice and addresses potential conflicts of interest
that arise in regard to various compensation structures. fte third section covers a few issues within the
financial advice profession that can confuse consumers. fte fourth section considers the empirical evidence
about the use and value of financial advice. fte final section summarizes the chapter and its main points
before concluding with advice for consumers about selecting a financial professional.
The Regulation of Financial Advice

Different firm structures exist within the financial advice industry. ftese firms vary considerably in terms of
service, business models, regulatory requirements, and standards of care. Before describing the most common
types of firms that provide financial advice, this section offers a discussion of financial advisors and financial
planners soas topro- vide a context for examining the various firm structures.
REGULATION OF FINANCIAL PLANNERS

Although financial planners are not regulated as a distinct profession, the Government Accountability Office
(GAO 2011) suggests that most activities a financial planner may perform are regulated. However, CFP
Board has long advocated regulating financial planners distinct from any other existing regulatory regimes
(CFP Board 2016). CFP Board (2016, Why Does Regulation Matter? section, para. 2) also states that
fragmented regulation creates legal “loopholes” and conflicting standards of conduct for the
different components of financial planning, allowing providers to choose the standard that is
most financially advantageous to them, rather than what is best for the client.
fte Financial Planning Coalition, consisting of CFP Board, the Financial Planning Association (FPA),
and the National Association of Personal Financial Advisors (NAPFA), has also expressed concern
about the lack of federal regulation of financial planners. In 2014, the Financial Planning Coalition released a
white paper highlighting evidence that the lack of federal regulation of financial planners harms consumers
(Financial Planning Coalition 2014). For example, many practitioners who identify themselves as a
financial planner do not actually provide financial planning services. fte Financial Planning Coalition (2014,
p. 17) also cites data of from Cerulli Associates that “only 38 percent of the self-identified financial planners
actually had financial planning focused practices.”
REGISTERED INVESTMENT ADVISERS

Registered Investment Advisers (RIAs) are firms established primarily to provide investment advice.
Although other financial professionals may focus on the transaction
Financial Planners and Advisors 99
of financial products, RIAs concentrate on advice related to investment decisions. As such, they are
compensated not for transacting financial products but for providing advice related to investment strategies,
philosophies, and/or ongoing investment management. Advisors of RIAs are known as Investment Adviser
Representatives(IARs).
Regulation of RIAs dates back to the Investment Advisers Act of 1940. Despite some exceptions, an
investment advisor is defined as follows:
any person who, for compensation, engages in the business of advising others, either directly
or through publications or writings, as to the value of securities or as to the advisability of
investing in, purchasing, or selling securities, or who, for compensation and as part of a regular
business, issues or promulgates analyses or reports concerning securities. (Investment Advisers
Act of 1940, Section 202(a) (11), p. 3)
fte Securities and Exchange Commission (SEC) and state securities regulators oversee investment
advisers throughout the country. Historically, the respective responsibilities of the SEC and state
securities regulators were not completely clear. Congress clarified those responsibilities with the
Investment Advisers Supervision Coordination Act, which was part of the National Securities Markets
Improvement Act of 1996 (Macey 2002). To reduce redundancy in regulation, this act prohib- ited
firms from registering with the SEC unless or until they had at least $25 million in assets under
management (AUM), and firms had to register if they had at least $30 million of AUM. ften the Dodd-
Frank Wall Street Reform and Consumer Protection Act of 2010 increased the AUM threshold so that, in
general, firms with over $100 million of AUM register with the SEC, and firms must register if they
have at least $110 million of AUM (Securities and Exchange Commission 2011c). Additionally, all
investment advisers based in Wyoming also register with the SEC, because Wyoming does not regulate
investment advisers (Macey 2002). fte division of the SEC that is responsible for oversight of
investment advisers is the Office of Compliance Inspections and Examinations (OCIE). According to
the Securities and Exchange Commission (2014), as of March 2014 the OCIE oversees more than 10,000
firms that collectively manage over $48 trillion of AUM.
All RIAs are required to file a Form ADV as part of their registration with the SEC or state securities
regulator (Securities and Exchange Commission 2011a). Form ADV consists of two parts, both of which are
intended to provide regulators and consumers with relevant information about the firm. Part 1 of Form
ADV includes specific information about the firm, such as its main address, ownership, number of
employees and clients, types of clients the firm serves, and any disciplinary actions. Part 2 provides
information relevant to clients and potential clients. It includes a brochure used to communicate the
services offered, the fees charged, any conflicts of interest and disciplinary actions, and information about
the management and key personnel of the firm (Securities and Exchange Commission 2011a). Once firms
are registered, they must provide their clients and regulators with an annual update of any material changes
in their Form ADV. Form ADV for any firm is publicly available through the Investment Adviser Public
Disclosure (IAPD) database, whether the firm is registered with the SEC or with one or more state securities
regulators (Securitiesand Exchange Commission 2016).
IARs must submit Form U4 (the Uniform Application for Securities Industry Registration or
Transfer) as part of their registration with the SEC or with state securities regulators (Financial Industry
Regulatory Authority 2009). IARs typically file these forms electronically with the Investment Adviser
Registration Depository (IARD) (Securities and Exchange Commission 2011b). IARs are urged to
amend or update any material changes in the information reported on the Form U4 in a timely manner.
B ROKER - D EAL ERS

As in other industries, brokers serve consumers by connecting buyers and sellers of a particular product or
products. In the financial services industry, brokers typically provide transactional support for buyers and
sellers of financial securities. fte Securities Exchange Act of 1934 (1934, Section 3(a)(4)(A), p. 4) states
that “fte term ‘broker’ means any person engaged in the business of effecting transactions in securities for the
account of others.” In contrast, dealers sell products from their inventory. fte Securities Exchange Act (Section
3(a)(5)(A), p. 10) states that “fte term ‘dealer’ means any person engaged in the business of buying and
selling securities … for such person’s own account through a broker or otherwise.” Many firms involved in
transacting financial products provide services as both broker and dealer, either by connecting a buyer with a
potential seller of a financial security or by connecting a buyer with a financial security that the firm has within its
own inventory. Because these firms often perform both types of services, today they are commonly
known as broker-dealers.
Individuals who work for a broker-dealer are commonly known as registered representatives of a
broker-dealer, or by the nickname, registered reps, or even more simply, stockbroker or broker. A registered
representative may be either an employee of the broker-dealer or an independent contractor. Regardless of
the employment arrangement, broker-dealers are required to supervise the activities of their representatives
(Colby, Schwartz, and Zweihorn 2015). As with IARs, representatives of a broker- dealer must also file
Form U4 electronically except they do so through the Central Registration Depository (CRD) as part
of their registration process (Financial Industry Regulatory Authority 2009). Information recorded
on Form U4 is publicly available online through FINRA’s BrokerCheck website (Financial Industry
Regulatory Authority 2016b).
A self-regulatory organization (SRO) oversees broker-dealers and their registered
representatives. The Maloney Act of 1938 amended the Securities Exchange Act of 1934 to create the
National Association of Securities Dealers (NASD) as an SRO to provide oversight to the brokerage
industry. In 2007, the NASD merged with the regulatory division of the New York Stock Exchange
(NYSE) to form the Financial Industry Regulatory Authority (FINRA) (Financial Industry Regulatory
Authority 2007). FINRA now provides regulatory oversight of almost 4,000 securities firms and
over 600,000 representatives (Financial Industry Regulatory Authority 2016a). Although FINRA
operates as a self-regulatory organization, the SEC oversees FINRA with considerable cost. In a
report released by the Boston Consulting Group (2011), the SEC employs an examiner to oversee
about every
2.2 FINRA examiners.
INSURANCE FIRMS
Insurance products are often a component of a comprehensive financial plan. In addition, agents who sell
personal lines of insurance frequently provide financial advice. Insurance agents typically focus on one or a
few lines of insurance. For example, an insurance agent may focus on property and casualty insurance for
individuals and families. ftese property and casualty insurance agents work to secure for individuals and
families insurance policies that will protect them in case of a financially catastrophic loss, whether from loss
of property or from liability claims for damages or injuries. For most households, these insurance products
typically include automobile insurance and homeowner’s insurance, and may also include umbrella
insurance, which is extra liability insurance designed to help protect individuals from major claims and
lawsuits. Depending on the type of property and the risks to which the household is exposed, other
insurance policies may also be purchased, like insurance for watercraft or recreational vehicles.
Insurance agents may focus on other risks to which households may be exposed, such as a premature
death or an unexpected disability. ftese agents, often called life insurance agents, provide advice about the
appropriateness of life insurance and disability insurance policies. ftey may also offer guidance about
health insurance, or an agent may focus specifically on health insurance, although these agents commonly focus
their services on employers who provide access to health insurance for their employees. Other insurance agents
may focus on risks specifically dealing with a particular profession or professional role, such as professional
liability insurance, malpractice insurance, errors and omissions (E&O) insurance, and volunteer involvement,
such as directors and officers (D&O) insurance.
Unlike other sources of financial advice, the regulation of insurance rests solely at the state level. States have
regulated insurance since the 1850s, emphasized as a state right in 1869, in Paul v. Virginia, in which the
Supreme Court ruled that insurance policies were not transactions of commerce and, therefore, not under the
purview of Congress. In 1944, the Supreme Court reversed Paul v. Virginia in United States v. South-
Eastern Underwriters Association by declaring that insurance is considered commerce and is subject to
federal oversight. In response, Congress passed the McCarran-Ferguson Act of 1945 to legislatively allow
states to regulate insurance and establish licensing requirements. As such, insurance is regulated by state
insurance commissions. fte need to support state insurance commissioners in fulfilling their responsibilities
led to the creation of the National Association of Insurance Commissioners (NAIC) (2016). Individual
insurance agents must also be licensed in any state in which they sell insurance products, and these licensing
requirements may vary depending on the state.
OTHER SOURCES OF FINANCIAL ADVICE

Besides the firms and affiliated individuals previously discussed, other firms and individuals may
provide financial advice. For example, many accountants offer tax preparation and tax planning, as well
as broader financial advice. Certified Public Accountants (CPAs) can obtain the Personal Financial
Specialist (PFS) designation from the American Institute of CPAs (AICPA) as a way to distinguish
themselves as an
accounting professional who provides financial advice. Attorneys may also offer financial advice,
especially relating to legal matters such as estate planning.
Other professionals may focus on other aspects of personal and family finance. Financial counseling
and credit counseling firms often help individuals seeking to avoid bankruptcy or desiring assistance with debt
and cash-flow management concerns. Most reputable firms that offer credit counseling services are established
as nonprofit organizations and are members of the National Foundation for Credit Counseling (NFCC)
and/or the Financial Counseling Association of America (FCAA).
Other providers of advice may be housed within other financial institutions, such as a local bank or
credit union. Although these types of advisors may be employees or independent contractors working withor
for the banks or credit unions, they are often registered representatives of affiliated broker-dealers or IARs, or
both. ftey may also be licensed life and disability insurance agents affiliated with a life insurance firm.
Another source of financial advice can come from a financial therapist, who most often falls under one
of the previously mentioned providers of financial advice. fte Financial fterapy Association (FTA)
defines financial therapy as the “integration of cognitive, emotional, behavioral, relational, and economic
aspects that influence financial well-being, and ultimately, quality of life” (Financial fterapy Association
2015, para. 1). In essence, financial therapists extend the perspective of the client–planner relationship beyond
the financial decisions involved as they consider the broader behavior and psychological picture of the
individual and family.
Agency Costs in Financial Advice

Because of the nature of the service, consumers may have difficulty determining the quality of the financial
advice they receive from a financial professional. With search goods, consumers can make comparisons and
research the products to determine quality before making a purchase (Nelson 1970). Even with experience
goods, such as a haircut or a massage, consumers can at least determine the quality of the good or service after
they have experienced it. However, with credence goods, such as medical procedures or vehicle repairs,
consumers often have difficulty determining quality even after receiving the good or service (Darby and Karni
1973). Because credence goods largely rely on the specialized knowledge of an expert, the expert knows more
about the quality of the good or service than do the consumers (Dulleck and Kerschbamer 2006). As such,
unscrupulous professionals who provide low-quality goods or services can exploit consumers of credence
goods. Financial products and recommendations could also be considered credence goods because consumers
rely on the expert knowledge of a financial professional. Additionally, the results of financial
recommendations are often not realized until years in the future.
In a principal–agent relationship, a principal delegates specific responsibilities or tasks to an agent. Often,
the delegated responsibilities are tasks that the principal either does not want to perform, does not have time to
perform, or does not have the knowl- edges, skills, abilities, or tools to perform. In the case of financial
planning, the principal is a client who hires an agent who is a financial advisor to perform some array of duties
related to the financial affairs of the principal.
As in other agency relationships, using a financial professional can create agency conflicts ( Jensen and
Meckling 1976). In other words, the interests of the advisor may not be the same as the interests of the client. In
such cases, the advisor may act in self- interested ways to the detriment of the client. ftree types of agency
costs that arise in thesetypes ofrelationships are monitoring costs, bonding costs, andresiduallosses.
Monitoring costs refer to the responsibility of the principal to monitor the efforts performed by the
agent. ftat is, the principal needs to perform due diligence to ensure that the hired agent is competent and
ethical. In situations in which the agent possesses specialized knowledge that the principal does not have,
adequate monitoring can be challenging. ftis information imbalance often provides the justification for
government regulation, thereby outsourcing at least some of the monitoring responsibilities to a governmental
entity that can hire a competent regulator to perform some monitoring functions on behalf of all principals who
employ a particular agent. fte previous section provided a discussion of government regulators who offer
monitoring services of financial planners and advisors. Most notably, the SEC, FINRA, state securities
regulators, and state insurance commissions provide oversight of many professionals who provide financial
advice.
Although regulators provide monitoring services, agents still have a responsibility to perform monitoring
functions. For example, consumers can check the public records of advisors with whom they are considering
trusting with their financial affairs. ftese records are available through the SEC’s IAPD, FINRA’s
BrokerCheck, and certifying organizations, such as CFP Board.
Bonding costs is another form of agency cost, in which the interests of the agent are bonded in some way
to become more closely aligned with the interests of the principal. Unlike monitoring costs, which are typically
borne by the principal, the agent generally bears bonding costs, often in an effort to demonstrate to consumers
that there is commitment to a higher moral principle. In financial planning, an example of a bonding cost
is a certification. For example, financial planners may work to achieve the Certified Financial Planner (CFP)
certification to signal to the public that they have acquired considerable knowledge related to financial
planning, are committed to abiding by CFP Board’s Code of Ethics, and are willing to suffer the
consequences if they violate the code.
Another example of a bonding cost is the standard of care to which an advisor is held. For example, IARs are
held to a fiduciary standard of care, in which they are obligated to act in the interest of their clients.
Conversely, registered representatives of a broker- dealer are merely held to a suitability standard, which
requires that a financial product is suitable for a particular client. Given that some financial
recommendations may be suitable for a client but not in the interest of the client, these standards of care may
yield different advice, depending on the regulatory regime of the advisor.
Lastly, despite the best efforts of the principal to incur adequate monitoring costs and to find an agent who
has incurred bonding costs, the principal may still experience a loss. Jensen and Meckling (1976) call these
losses residual losses. Unfortunately, unscrupulous advisors may exploit investors while maintaining a
clean public record before someone discovers unethical concerns with their practices; as a result, consumers
may lose considerable sums of money. Residual losses can also represent the losses experienced by
consumers who rely on advice from advisors who have conflicts of interest.
In 2015, the White House (2015) released an analysis by the Council of Economic Advisers (CEA),
which estimates that conflicted advice on retirement assets costs Americans roughly $17 billion each
year.
COMPENSATION STRUCTURES AND AGENCY COSTS

As with any profession, providers of financial advice are compensated for the services they provide, although
many advisors also provide pro bono advice for individuals and families who cannot afford it. However, the
form of compensation can create a conflict of interest in which the interests of the principal (i.e., client) and the
agent (i.e., advisor) may not be fully aligned. Although all forms of compensation can give rise to conflicts of
interest, some forms of compensation may be more prone to conflicts than others. ftat said, honest, trustworthy
financial advisors can operate under each of these compensation structures, and no compensation method is
completely free of conflicts of interest.
Commissions
Broadly speaking, a commission is a fee paid to a firm, or an agent or employee of a firm, often as a form of
compensation for providing or assisting in the transaction of a good or service. As related to financial
decisions, commission-based compensation typically focuses on the transactions of financial products, but it
can be arranged in various ways. Commissions in financial services are also known as sales charges or loads.
ftey are often assessed when purchasing investments through broker-dealers and when purchasing insurance
policies through insurance agents.
An example of one of the most common commission structures is a front-end load on an investment
product. When an investor determines an amount of money to invest in a product that has a front-end load, the
amount invested is reduced by the amount of the front-end load. For example, if someone invests $1,000 with a
registered representative of a broker-dealer, and the mutual fund in which he or she wants to invest has a front-
end load of 5 percent, then the amount actually invested is $950. fte remaining $50 is a commission that goes to
the brokerage firm, with a portion of it going tothe registered representative as a form of compensation.
Other commission structures exist. Another example of a load is a back-end load, also known as a
deferred sales charge or a contingent deferred sales charge. A deferred sales charge occurs when an
investor pays a set percentage when the product is sold or sur- rendered. fte size of the sales charge may decrease
over time so that if the investor owns the product long enough he or she might be able to avoid the deferred
sales charge. However, waiting until the sales charge ends does not mean that the investor pays no sales
charge. ftese products also typically include a level load, in which they charge an ongoing fee separate from
the front-end or back-end load. For example, 12b-1 fees are a level load assessed by mutual fund companies
and are used to compensate advisors for distributing shares of the mutual fund.
Not surprisingly, commission-based compensation includes conflicts of interest in which the interests of
the client and the registered representative may not be aligned. Because commissions are based on
transactions, advisors may be incentivized to encourage more transactions that may not be optimal for a
client. Excessive trading in an effort to generate commissions is called churning. Not only do front-end
loads have
conflicts, other forms of commission also have conflicts. For example, because back-end loads discourage
investors from selling the investment, an advisor may be incentivized to sell an investment that includes both
an ongoing level load (e.g., a 12b-1 fee) and a back-end load (i.e., a deferred sales charge). ftus, investors are
discouraged from selling the investment, even if it may be advantageous to do so, yet the advisor continues to
receive the level load.
Commissions on other financial products can also generate conflicts of interest. For example, commissions
on life insurance products may incentivize advisors to encourage individuals to purchase more insurance than
is optimal for them. Similarly, they may promote insurance products that have higher commissions, even
when those types of products may not be best for a particular client.
Commissions can also be quite opaque, which increases the potential for conflicts of interest. Consumers
may not realize the size of the commissions they pay and may assume that the services they receive are free of
charge. Inderst and Ottaviani (2012) created a model suggesting that when commissions are not disclosed,
they tend to be higher than if consumers are told the amount of the commission. Other commissions come
directly from firms, so consumers do not directly see the costs associated with the commissions, and likewise,
they mayassume they are not bearing the cost of compensating an advisor.
Assets under Management

Firms managing investments for clients on an ongoing basis may charge a fee based on the size of the managed
portfolio. ftese fees may be structured as a percentage of AUM, a flat percentage, or tiered with lower rates
charged per managed dollar for larger portfolios. For example, a consumer with $2 million of investable
assets who works with a firm charging a flat 1 percent of AUM annually will pay $20,000 per year for the
services performed by the firm. Alternatively, a firm with a tiered-rate schedule, which charges 1 percent of
AUM on the first million dollars of AUM and 0.75 percent of AUM on the second million dollars, would
charge that same consumer $17,500 per year. Most firms with an AUM-based fee bill quarterly, either directly
to the client or by deducting the fees from the investment account. Because asset values tend to fluctuate
throughout the year, individual firms specify the process of calculating each quarterly payment.
Although AUM-based compensation is most common among investment advisors, others, such as dually
registered advisors, may charge based on AUM as part of a wrap account or a separately managed account. A
wrap account allows investors to be charged a single fee for their managed account rather than paying
commissions on each transaction. Separately managed accounts allow for personalized portfolio
management and investment decisions that are separate from other investors.
At first glance, compensation based on AUM may appear to properly align incentives. A financial
advisor is rewarded with a larger asset base to manage when the client’s investment portfolio performs well,
which is often a goal for clients. However, as with any form of compensation in a principal–agent relationship,
conflicts of interest can arise from a compensation structure based on AUM. Because the fee scales with the
size of the portfolio, AUM-based advisors are incentivized to maintain and even increase the amount of
investable assets. Although such a goal may seem aligned with the client’s interests, this may not always be the
case. Forexample,a household maybe
averse to holding debt and may want to pay off a mortgage using assets from their investment portfolio, but an
AUM-based advisor might discourage such a decision. Likewise, an AUM-based advisor might discourage a
client from withdrawing money from his or her portfolio at a rate that could maximize lifetime utility for a
household.
Further, even when other financial products may be optimal to greater ensure lifetime income (e.g.,
annuity products), AUM-based advisors may be discouraged from recommending such products unless
those products could still be included as part of the managed investment portfolio. ftese advisors are also
discouraged from spending much time managing a particular client’s portfolio because their compensation is
not largely tied to the amount of time they spend managing the assets. As such, they may be tempted to spend
minimal time on a particular client’s portfolio. AUM-based advisors often suggest that because they do not
charge commissions, they can provide financial advice that is free of conflicts of interest. However, such
advisors often forget about the conflicts that exist within their own compensation structure.
Hourly
Some financial advisors who provide comprehensive financial planning advice view their value
proposition much more broadly than merely providing investment advice and services. As such, they may be
concerned about tying their compensation to only one aspect of their services (e.g., transacting financial
products or managing investment portfolios) when the value they provide their clients includes many other
aspects of their clients’ financial lives. Because of their concerns with commission-based and AUM-based
compensation, some financial advisors instead choose to charge hourly. ftis arrangement typically
involves assessing an hourly fee for time spent meeting with an advisor and time the advisor spends
working on a client’s financial plan. Many advisors who work with clients on an hourly basis do not manage
assets. Instead, they often provide recommendations that clients can implement on their own.
Although many advisors contend that hourly compensation is free of conflicts of interest, this
compensation structure can also have misaligned incentives. Charging on an hourly basis may motivate an
advisor to take longer on a particular client’s case than is actually needed. Charging on an hourly basis also
increases the saliency of the cost of advice for clients. ftus, clients may be less inclined to rely on the
services of their financial advisor because of concerns about the incremental cost incurred each time they
contact their financial advisor. As a result, clients may seek less advice than may be appropriate for them
because of their price sensitivity to the hourly rate.
Retainer
Some financial advisors recognize the conflicts inherent in commission-based and AUM-based
compensation structures, so they may choose instead to charge a monthly, quarterly, or annual retainer. Retainer
fees are also attractive because they can provide a steady stream of income for a firm that depends neither on the
number of transactions incurred (as is a commission-based compensation) nor on the performance of invest-
ment markets (as is an AUM-based compensation). As with other forms of compensation, the retainer model
may also have conflicts of interest. Because advisors receive the same compensation regardless of the amount of
time they devote to a particular client,
they may be tempted to shirk their responsibilities and spend as little time as possible focusing on each
client.
Project-Based Fees
With a desire to align the services that an advisor provides with the fees that clients pay, some firms charge
project-based fees. ftese fees are often associated with the creation of a financial plan or an extensive review
of a particular aspect of a client’s financial situation. Because of the temporary nature of this form of
engagement, advisors may encourage clients to continue the engagement under a different compensation
structure. For example, if a client pursues ongoing investment management after completing the initial
project, the fee arrangement could include a discount. As with all other compensation structures, charging
project-based fees can also give rise to conflicts of interest. An advisor may be tempted to overestimate the
amount of resources a particular project will require or, conversely, intentionally complete the project using
fewer resources than initially outlined, thereby charging the client more than they otherwise might charge.
C ONFL IC TS OF INT EREST IN FIN A N C IA L PLANNING

All compensation structures can create conflicts of interest; such is the nature of principal–agent
relationships. However, the existence of a conflict of interest does not imply that no advisors will act in the
interests of their clients. Many financial advisors provide fair and ethical financial planning services for clients
regardless of the compensation structure and despite these conflicts. To deal with these inherent conflicts,
advisors should disclose such conflicts to their clients.
CFP Board (2013) stresses the importance of disclosing conflicts of interest in writing and not just
conflicts that arise owing to compensation structure. Conflicts may also arise owing to the nature of the planner–
client relationship, and advisors may be swayed for personal interests and benefits. Conflicts may also occur
between a client and the advisor’s firm, not just between a client and the advisor. Toproperly mitigate any con-
flicts, CFP Board encourages financial planners to disclose any known conflicts at the beginning of the client–
planner engagement and to promptly disclose any conflicts that arise during the engagement.
Consumer Confusion
With different regulatory regimes and multiple compensation structures, consumers can easily be
confused about the advice they are receiving. A study sponsored by the SEC reports considerable
consumer confusion resulting from the use of generic terms such as financial advisor (Hung, Clancy,
Dominitz, Talley, Berrebi, and Suvankulov 2008). For example, consumers do not realize that important
regulatory distinctions in the industry generate different standards of care. ftis section highlights some
areas of consumer confusion related to using professional financial advice.
FINA NC IA L PLA NN ERS AND FIN A N C IA L A DV ISORS

Many individuals use the financial advisor and financial planner terms synonymously, without clearly
distinguishing between them. Although the terms may represent financial professionals with slightly
different concentrations, the use of this terminology is not consistent across all individuals.
Financial advisor describes a professional whoprovides guidancerelated tofinancial decisions. Many
financial advisors have acquired considerable knowledge relevant to household financial decisions, with
which they can provide their clients with specialized guidance for their unique situations. Because the term is
unregulated, some individuals may use the term without having requisite knowledge. ftat is, they may use the
term financial advisor as a marketing tool despite lacking any specialized financial knowledge. Financial
planner typically describes a specific subset of financial advisors who give particular attention to financial
decisions across time in order to reach future financial goals. Under this distinction, most financial planners
could also be considered financial advisors, but some financial advisors may not be financial planners. Further,
some individuals who claim to be financial advisors or financial planners may actually be neither
type of financial professional.
ADVISERS AND ADVISORS

Two different spellings of advisor are commonly used to describe providers of financial advice. Adviser with
an “e” is the spelling used in the Investment Advisers Act of 1940 and is often associated with RIAs.
Advisor with an “o” is often the spelling used in the more generic and unregulated term, financial advisor.
Although this spelling distinction is commonly employed, consistency in this spelling distinction is difficult
and rare. Even the SECwebsite includes both spellings, which are commonly usedinterchangeably.
MULTIPLE REGULATORY REGIMES

A confusing aspect of the financial advice industry is that a single advisor may operate under multiple
auspices. In other words, a financial advisor may be a registered representative of a broker-dealer and an
investment adviser representative. Advisors who are affiliated with a broker-dealer and with a RIA are often
described as having a dual registration or as being dually registered. To further complicate matters, the same
dually registered advisor may also be licensed to sell insurance products. As a result, consumers may
understandably have difficulty identifying the regulatory regime of a financial professional.
The Use and Value of Financial Advice

Various studies examine the use and value of financial advice. Studies focusing on the use of financial advice often
seek to identify the characteristics of individuals who employ the services of a financial planner or financial
advisor. Other studies seek to identify factors that lead someone to begin using the services of a financial
professional. Attempting
to quantify the value of financial advice is another common research initiative, whereas identifying qualitative
factors that contribute to the value of financial advice is also beneficial. ftis section discusses each of these
aspects of the use and value of financial advice.
SURVEY QU EST ION S ABOUT FIN A N C IA L ADVICE

Although various nationally representative datasets include questions about the use of financial advice, these
questions differ considerably in wording and purpose. As a result, the measurement of who uses of a financial
advisor differs depending on the dataset. For example, the National Longitudinal Survey of Youth (NLSY)
includes the following question that focuses on retirement preparation and the use of a financial plan-
ner: “People begin learning about and preparing for retirement at different ages and in different ways. Have you
(or your spouse/partner) consulted a financial planner about how to plan your finances after retirement?” fte
Asset and Health Dynamics among the Oldest Old (AHEAD) once included a broader question in its
survey: “Do you havea financial advisor who helps make decisions?” Yet,the AHEAD, now mergedwith the
Health and Retirement Study (HRS), has not asked about using a financial advisor since the early 1990s. fte
Survey of Consumer Finances (SCF) asks about using various financial professionals in its triennial survey. fte
SCF asks two separate questions about sources of information in making financial decisions. fte first question
focuses on borrowing or credit decisions, and the second question deals with savings and investment
decisions. fte second question asks: “I am going to read you a list. Please tell me which sources of information
do you (andyourfamily) use to make decisions about saving and investments?” A financial planner is the
twelfth item on the list.
THE USE OF FINANCIAL ADVICE

Using empirical data from the 1998 Retirement Confidence Survey, Joo and Grable (2001) find that among
pre-retirees, women are more likely to seek professional retirement planning help than men. fte authors also
find that income, better financial behaviors, proactive retirement attitudes, and risk tolerance are positively
related to seeking professional retirement planning help. In 2006, the Investment Company Institute
sought to learn more about the use of investment advice among mutual fund shareholders (Leonard-
Chambers and Bogdan 2007). fte authors find that about two-thirds of mutual fund shareholders engage the
ongoing services of a financial advisor. Using data from a German bank, Bluethgen, Gintschel, Hackethal,
and Müller (2008) find that users of financial advice tend to have more diversified investment portfolios.
Users of professional financial advice are generally more educated (Hanna 2011), have higher net worth
(Chang 2005; Bluethgen et al. 2008; Hanna 2011), have higher income ( Joo and Grable 2001), and are older
(Bluethgen et al. 2008; Hanna 2011) than those who do not use professional financial advice.
SEEKING FINANCIAL ADVICE

An analysis of those who use a financial advisor is somewhat different from an analysis of those who are likely
to seek financial advice, which can be further differentiated by
analyzing those who seek professional financial advice. Using a random sample of cleri- cal workers, Grable
and Joo (1999) provide insights about financial help-seeking behavior, broadly defined as seeking help
from different sources such as a financial planner, attorney, credit counselor, friend, relative, and co-worker.
Not surprisingly, the authors find that recently experiencing more financial stressors influences seeking
financial advice from others. Exhibiting fewer positive financial behaviors is also related to seeking financial
advice. Additionally, younger individuals and renters are more likely to seek advice from others. Women
also tend to be more likely to seek financial advice than are men ( Joo and Grable 2001; Bluethgen et al.
2008).
Using data from the 1998 Survey of Consumer Finances, Chang (2005, p. 1469) finds that “social
networks are by far the most frequently used source of saving and investment information; however they
are used most often by those with the least wealth.” Chang also reports that wealthier households are more
likely to rely on multiple sources for financial guidance, including financial professionals and media. Hanna
(2011) suggests that the likelihood of using a financial advisor peaks in the mid-forties. ftis finding suggests
that many individuals may wait until retirement decisions appear more pressing before seeking professional
financial advice. Experiencing major life changes, including losing a spouse (Leonard-Chambers and
Bogdan 2007; Korb 2010; Cummings and James 2014), declining cognition (Cummings and James 2014), or
having a sudden change in income or net worth (Leonard-Chambers and Bogdan 2007; Cummings and
James 2014), can also induce someone to seek financial advice from a professional.
MEETING WITH A FINANCIAL ADVISOR

A growing area of research includes psychophysiological economics, which can provide insights about
the psychological and physiological responses during a meeting with a financial professional (Grable
2013). In a clinical intervention pilot study of college students, Archuleta, Burr, Carlson, Ingram, Kruger,
Grable, and Ford (2015) find that meeting with a financial counselor can not only improve psychological well-
being and financial behavior but also decrease financial distress. Individuals meeting with a financial advisor
also present considerable discrepancy between objective and subjective measures of financial stress,
suggesting that few individuals can accurately assess the impact of their financial stress during a meeting
with a financial advisor (Grable and Britt 2012). Grable, Heo, and Rabbani (2014) study the interaction of
financial anxiety and physiological arousal; they find that individuals with low financial anxiety but moderate
to high physiological arousal are most likely to seek professional financial advice. ftose with high financial
anxiety are less likely to seek professional financial help because the anxiety may cripple their ability to
seek help.
THE VALUE OF FINANCIAL ADVICE

Analyses of the value of financial advice often focus on the quantitative, financial benefits of using a
professional financial advisor. However, the value of financial advice extends beyond merely financial
benefits. Hanna and Lindamood (2010) recognize the difficulty of quantifying many of the financial
benefits of using a financial
planner. fte benefits of sound financial advice can also include qualitative considerations. For
example, consumers often seek the services of various professionals, not in an attempt to save money
but because they find value in the advice they receive, which can help them make decisions with
greater confidence. fte advice of knowledgeable professionals can also dispel fears and concerns about an
unknown future. As related to financial advice, Leonard-Chambers and Bogdan (2007) report that using
an advisor provides fund owners with greater peace of mind, and James (2013) finds evidence that
individuals who rely on a certified financial professional are less likely to second guess the expertise of
their advisor during periods of market underperformance.
Evidence is mixed when focusing solely on portfolio metrics as a benefit of using a financial advisor.
In a study of German investors, individuals who use a financial advisor tend to have more diversified
portfolios that also include more asset classes (Bluethgen et al. 2008) However, these same individuals tend
to turn over their portfolios more often and subsequently pay more transaction fees. An analysis of Dutch
investors also suggests greater diversification in portfolios of individuals who use financial advisors, but
these portfolios do not have significantly superior risk-adjusted performance (Kramer 2012). However,
using the NLSY, Grable and Chatterjee (2014) find that on average, individuals with financial planners
have superior risk- adjusted performance. Other studies suggest that investors who use financial advi-
sors experience lower portfolio returns (Hackethal, Haliassos, and Jappelli 2012; Karabulut 2013).
Differing agency costs inherent in financial planning relationships may create varying incentives to act in
the interest of investors, hence the mixed results about the value of financial advice in portfolio management.
Using trained auditors who met with financial advisors, Mullainathan, Noeth, and Schoar (2012) find that
financial advisors tend to encourage investment behavior and options that favor the advisor’s interests. ftese
findings suggest the importance of properly aligned incentives when working with a financial
professional.
Other studies focus on the benefits of financial advice where the value may be more difficult to quantify.
For example, households using a financial planner are more likely to have adequate life insurance protection
(Finke, Huston, and Waller 2009) and are more likelytouse RothIndividual Retirement Arrangements(IRAs)
(Smith, Finke, and Huston 2012; Cummings, Finke, and James 2013). ftese findings suggest that a financial
planner can help households acquire and maintain helpful risk-management tools and tax-sheltered vehicles,
but quantifying the value of adequate insurance protection and optimal tax sheltering is challenging.
Winchester, Huston, and Finke (2011) show that investors who use a financial advisor during a recession are
more likely to maintain a long-term focus, suggesting that advisors can help investors maintain focus on their
financial goals. Among individuals in their forties, Finke (2013) reports that using a financial planner is
positively related to net worth and accumulated retirement assets. Although the direct effect of this relation is
unclear, the evidence could suggest that financial planners may play a role in helping investors determine
and implement tax advantageous accumulationstrategies.
Several studies attempt to quantify the overall value of financial advice. An advisor can provide
substantial value to clients through a combination of benefits, such as
using low-cost investments, appropriate asset allocation and location, and portfolio rebalancing (Kinniry,
Jaconetti, DiJoseph, and Zilbering 2014). ftis value creation is captured in what the authors term Vanguard
Advisor’s Alpha, which when all components are implemented, the gain in net returns to clients is
estimated to be about 3 percentage points (300 basis points). Perhaps one of the most notable contributions
an advisor can make is behavioral coaching, which accounts for the value of an advisor in helping clients
maintain their long-term investment objectives when markets are volatile. fte authors estimate that
behavioral coaching alone can provide about 150 basis points in net return.
Blanchett and Kaplan (2013) quantify the value of intelligent investment decisions, which they
term gamma. Advisors can provide value for their clients by helping them implement intelligent
investment decisions, such as optimal asset allocation, tax-efficiency considerations, and appropriate
portfolio withdrawal strategies. ftese authors estimate that gamma can generate a superior retirement
income strategy, essentially equivalent to increasing the annual return by 159 basis points. ftis gamma
estimate is within the same range as the Vanguard Advisor’s Alpha estimate.
Advisor Biases
As mentioned previously, financial planners and advisors may present behavioral biases in response to the
incentives that exist for them. For example, financial advisors may receive kickbacks from portfolio
managers, which allows for higher fees and lower net returns for investors (Stoughton, Wu, and Zechner
2011). Del Guercio, Reuter, and Tkac (2010) find evidence that suggests mutual fund families target either
clients who value brokerage services or do-it-yourself investors, but rarely do fund families target both types
of clients. Mutual fund investors of broker-sold funds tend to pay higher fees and have lower risk-adjusted
returns than investors who purchase funds directly without a broker (Bergstresser, Chalmers, and Tufano
2009). Further, actively managed broker-sold funds tend to underperform index funds (Del Guercio and
Reuter 2014), and clients with brokers tend to earn lower risk-adjusted returns than similarly matched target-
date funds (Chalmers and Reuter 2012).
Because of the potential for conflicting interests, clients may be willing to compensate advisors
whom they trust. Because of this trust, fees for financial advice are higher than costs, and managers tend to
underperform the market after accounting for fees, yet investors often prefer to rely on a professional rather
than invest on their own (Gennaioli, Schleifer, and Vishny 2015). Being somewhat financially literate
increases trust, but higher levels of financial literacy also decrease trust (Lachance and Tang 2012). As
mentioned previously, disclosure is a commonly proposed solution to combat conflicted advice, thereby
requiring advisors to disclose potential conflicts, but evidence suggests that disclosures do not discourage
clients with low financial literacy from acting on conflicted advice (Carmel, Carmel, Leiser, and Spivak 2015).
Although unbiased advice may be beneficial, few investors take advantage of it when it is offered, and even
fewer actually follow the advice (Bhattacharya, Hackethal, Kaesler, Loos, and Meyer 2012).

Financial planners and advisors provide financial advice in various business models, regulatory regimes,
and compensation structures. RIAs, broker-dealers, and insurance firms tend to be the most common types
of firms where households seek financial advice, but other providers also exist. Advisors often play multiple
roles and fall under different regulatory regimes, which can be confusing for consumers. A simplified regu-
latory structure that provides similar protections for consumers under each regulatory regime is warranted to
reduce this confusion.
Regardless of the business model, all compensation structures contain potential conflicts of interest, and
advisors and consumers ought to be cognizant of these potential conflicts. Investors can find ethical advisors
within each regulatory regime and compensation structure. To increase the likelihood of using an ethical
advisor, consumers have a responsibility to perform their own due diligence, rather than relying solely on
government regulators. Seeking advisors who have incurred bonding costs can reduce agency conflicts.
Consumers ought to ask questions of potential advisors and check publicly available records about them.
By working with a financial planner or advisor with properly aligned incentives, consumers are likely to
benefit both financially and psychologically.
1. Explain the various regulatory regimes that encompass financial planners and advisors, and identify
when a particular advisor would fitunder each regime.
2. Discuss the agency costs involved in receiving professional financial advice and how to mitigate those
costs.
3. Describe the common compensation structures used by financial advisory firms, and identify potential
conflicts of interest within each compensation structure.
4. Discuss the characteristics of individuals who typically employ the services of financial planners and
advisors.
5. Discuss empirical evidence about the value of financial advice.
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7
Financial Analysts
S U S A N M . YO U N G
Associate Professor of Accounting
Gabelli School of Business, Fordham University
Introduction
A wealth of academic research examines financial analyst behavior during the past 30 years. ftese studies
use many different approaches to determine how analysts make decisions. For example, a recent survey
investigates the “black box” of equity analysts (Brown, Call, Clement, and Sharp 2015). Various
experiments also examine analyst behavior (Young 2009). More commonly, researchers use data now
widely available through the ftomson Reuters I/B/E/S database to examine analysts’ decision pro-
cesses (Clement 1999). ftis database allows researchers to measure many individual characteristics of the
analysts who are included in the database. ftese characteristics are associated with the accuracy and bias in
analysts’ forecasts and recommendations. Examples of these analyst characteristics include past forecast
accuracy and bias, brokerage house size, and forecasting experience.
Financial analysts, similar to other decision makers, are subject to many of the same biased judgments. For
example, they are limited in their capacity, ability, and resources during their forecasting tasks. However, given
their expertise in analyzing firms, they could be less biased or more accurate than the average decision maker.
Early studies in analyst expertise have established that analysts are more accurate than basic random- walk
models and become more accurate as their experience in forecasting increases. For example, Brown, Griffin,
Hagerman, and Zmijewski (1987) compare the accuracy of analysts’ forecasts to basic time-series models
based on historical earnings data. ftey find analysts’ forecasts to be more accurate and attribute this finding to
both the informational and the timing advantage of analysts above and beyond a simple mapping of historical
earnings. Mikhail, Walther, and Willis (1997) find that analysts become more accurate in their forecasts of
earnings per share (EPS) as they build experience in the forecasting task. Evidence also shows that analysts are
optimistic in both their forecasts and their recommendations (Francis and Philbrick 1993; Lim 2001).
Studies typically measure forecast bias as the observed, signed difference between the analyst’s forecast
and the observed actual EPS of the firm. Accuracy in forecasts is measured as the absolute difference between
an analyst’s forecast and the ex-post realization of the firm’s EPS. Biases in recommendations are measured
by forming trading portfolios based on analysts’ recommendations. Ex-post returns, both short and long
118
Financial Analysts 119
term, are then measured to determine whether excess positive or negative returns are realized from relying on
analysts’ reports. Interestingly, one analyst can produce both more accurate and more biased forecasts than
another analyst. For example, if Analyst A issues two forecasts that are both two cents more than the actual
EPS, and Analyst B issues one forecast that is three cents more and one forecast that is three cents less than the
actual EPS, Analyst A is considered more accurate, but also more optimistically biased. ftis chapter focuses on
the biasinanalysts’ reports, withoccasional mention of how this relates to analyst accuracy.
Prior research provides evidence that analysts “add value” or are informative to the market as information
intermediaries. Studies find that analysts’ forecasts and recommendations move stock prices, measured as
the stock price reaction and changes in trading volume in response to changes in analyst outputs, such as
earnings forecasts, recommendations, target price forecasts, and cash-flow forecasts. For example, Cheng
(2005) finds that analysts’ forecasts explain 22 percent of the variation in market-to- book ratios not captured
by other information variables. However, research also finds that analysts may produce biased reports in
certain situations, which may be predictable, and certain types of analysts may be more likely to be biased in
their reports.
Analysts have competing incentives in their jobs. ftey benefit from having accurate reports, which can
increase their reputation and lower job turnover. However, analysts also want to please management with
optimistic long-term forecasts, price targets, and recommendations. As a result, they curry favor with managers
to obtain access to better information and encourage more trading and banking deals, which lead to higher ana-
lyst compensation. Given the context of the analyst’s work environment, disentangling analyst bias from
economic incentives (rational or purposeful bias) versus behavioral bias (nonrational or unintentional bias)
due to environmental factors is difficult.
Research on whether the market understands and incorporates these biases is mixed. fte following sections
examine the research related to these topics. fte first section presents adiscussion of the role of equity analysts in
the market. ftis section also reviews some regulations enacted in the early 2000s relating to the conflicts of interest
among financial analysts, brokerage house structure, and the managers of publicly traded firms. fte second
section discusses the psychological theories that explain bias in decision making. fte third section explores the
relation between information uncertainty in a forecasting task and analyst bias. fte fourth section examines
whether certain analyst characteristics can moderate analyst bias. fte penultimate section discusses whether
decision makers cande-biastheirjudgments.ftechapterthenconcludes withasummary.
Role of Financial Analysts and Market Regulation

As information intermediaries, sell-side financial analysts play a critical role in analyzing, interpreting, and
distributing information to market participants about the prospects of publicly traded firms. fte main outputs
of their analyses include quarterly and annual EPS forecasts and recommendations on the firms they follow:
buy recommendations for those firms they believe are undervalued, hold recommendations for those they
believe are appropriately valued, and sell recommendations for those they believe are overvalued. Analysts
also provide a monitoring role, which positively influences
market efficiency by reducing agency costs (Chung and Jo 1996). fte empirical literature provides evidence
that changes in analysts’ trading recommendations and EPS estimates affect financial market valuations
(Ramnath, Rock,andShane 2008).
In response to large market failures such as Enron and WorldCom beginning in 2000, market
participants, including the U.S. Congress, called for regulation that would increase analyst objectivity and reduce
bias in analysts’ reports by reducing or eliminating analyst conflicts of interest. In late 2000, the Securities
and Exchange Commission (SEC) issued Regulation Fair Disclosure (Reg FD) to address some of these
concerns. Reg FD barred management from selectively disclosing material nonpublic information to select
analysts, thereby reducing the incentive for analysts to bias reports in order to gain access to privileged
information. Following the release of Reg FD, the National Association of Securities Dealers (NASD) and
the SEC enacted further rules to mitigate what they considered a significant optimistic bias in analysts’
reports.
During 2002 and 2003, the SEC approved a series of rules to address possible conflicts of interest for
equity analysts. ftese rules included a strict separation of investment banking from equity research activities.
fte rules also required changes in analysts’ compensation arrangements, as well as more informative
disclosure by analysts who own shares in the companies they follow. Also in 2003, the New York Stock
Exchange (NYSE), the SEC, NASD, and the attorney general of New York announced that 10 of the top
brokerage houses in the nation had settled an enforcement action relating to conflicts of interest between
research and investment banking, referred to as the Global Settlement. fte brokerage firms paid fines and
penalties in excess of $1.3 billion. Although the Global Settlement enforcement issues only applied to the 10
investment firms, it virtually established new precedents for the limits to conflicts between banking and
research infull-service brokerage firms. fte SECaccepted NASD Rule 2711, NYSE Rule 472, in addition tothe
Global Settlement in late 2002 and early 2003. ftese regulations further addressed analysts’ conflicts of
interest and limited information transmission between analysts and brokerage house investment banking
branches. In summary, the banks agreed to implement a series of reforms to address the pervasive concerns
related to conflicts of interest and optimistic analyst research.
Subsequently, in July 2007, Financial Industry Regulatory Authority (FINRA) was created by
consolidating the NASD and the NYSE. FINRA is responsible for rule writing, firm examination,
enforcement, arbitration, and mediation functions, along with all functions previously overseen solely by
the NASD.
OPTIMISM IN EARNINGS FORECASTS

Much of the empirical research finds that before these regulations, analysts were excessively optimistic in both
their earnings forecasts and their stock recommendations. For example, Lim (2001) asserts that management
prefers optimistic forecasts because these forecasts increase market valuations and therefore management
compensation. Lim proposes that analysts may be willing to bias their forecasts upward in order to receive
preferred treatment from management and therefore obtain better nonpublic information about the firm. Lim’s
results show that firms exhibiting higher uncertainty, which is proxied by the standard deviation of weekly
excess stock returns, are associated with more optimistic analyst earnings forecasts. Das, Levine, and
Sivaramakrishnan
(1998) suggest that analysts are more likely to require nonpublic information to develop an accurate
forecast of EPS for firms with low earnings predictability and this higher demand for information causes
analysts to be more optimistic to please firm management. fteir assumption is that analyst optimism will
assist with access to management’s nonpublic information. fterefore, analysts should optimally provide
optimistic forecasts to improve the amount, timing, and type of information they receive from
management. fte authors’ results show a consistent negative relation between earnings predictability and
forecast optimism, which confirms their management relations hypothesis.
OPTIMISM IN STOCK RECOMMENDATIONS

In addition to the literature that provides evidence of optimism in analysts’ forecasts, the evidence also shows
optimism in analysts’ recommendations. For example, Womack (1996) finds that analysts are seven times
more likely to issue a new buy recommendation than a new sell recommendation. Mikhail, Walther, and
Willis (2004) find that sell recommendations constitute only 6 percent of their sample of recommendations,
whereas buy and hold recommendations make up the remaining 94 percent. Several rational, economic
factors may influence analysts’ incentives and cause them to avoid sell recommendations. For instance,
analysts’ desire to maintain access to important management-provided information may cause them to take
actions to curry favor with management, making them reluctant to issue sell recommendations. Sell
recommendations may also jeopardize the investment banking business of the analysts’ employers (Lin
and McNichols 1998), or they may adversely affect commissions generated from customer trading
transactions (Michaely and Womack 1999). An optimistic bias in recommendations may also improve an
analyst’s chances of being promoted by his employer (Hong and Kubik 2003).
Francis and Philbrick (1993) find that analysts’ earnings forecasts are more optimistically biased for
sell and hold recommendations than for buy recommendations. ftey conclude that this pattern is consistent
with analyst incentives to improve management relations and is inconsistent with the economic incentives of
trade boosting. Trade boosting assumes that equity analysts are driven by the economic incentive to increase
trading in the stocks they cover and therefore to increase their compensation. In contrast to these findings,
Eames, Glover, and Kennedy (2002) show that analyst earnings forecasts are optimistic for buy
recommendations and pessimistic for sell recommendations. ftese results support the presence of both a
trade boosting incentive and a behavioral explanation: analysts unintentionally bias their output of forecasts
stock recommendations to achieve consistency between the two.
BEHAVIOR OF ANALYSTS ACROSS THE PRE- AND

POST- REGULATION PERIODS
Given that the goal of the increased regulation was to reduce analyst conflicts of interest, many studies
examine the behavior of analysts across the pre- and post-regulation periods in an attempt to determine
whether the regulatory goals were achieved. To the extent that optimism in analysts’ reports is due to conflicts
of interest that regulation
reduced, the expectation would be to see analyst optimism also reduced or eliminated. However, if analyst
optimism is due to behavioral reasons (as discussed in the next two sections), the regulation may not have
achieved these goals.ftefollowing isa brief survey of the post-regulation research.
Gintschel and Markov (2004) study whether Reg FD reduced the informativeness of analysts’ forecasts
and recommendations, which implies that Reg FD was effective in reducing or curtailing selective disclosure
to certain analysts. fteir findings support this conjecture. ftey find that in the post-Reg FD period, the
absolute price impact of analyst information was 28 percent lower than the pre-regulation level. fte authors
also report that the drop in price impact varied systematically with brokerage house and stock characteristics.
For example, the difference in price impact between optimistic analysts and non-optimistic analysts in the
post-Reg FD period is 50 percent lower compared to its pre-regulation levels.
Ertimur, Sunder, and Sunder (2007) also compare analyst recommendations issued before and after Reg
FD and they find that the integrity of “buy” and “hold” recommendations improved post-regulation; the
change is more pronounced for analysts they expected to be more conflicted. fte authors measure the
intensity of conflicts of interest by classifying analysts into three groups: (1) firms with no investment bank-
ing business (nonconflicted firms), (2) firms with a relatively low reputation in the investment banking
business (medium conflicted), and (3) firms with a high reputation in the investment banking business
(highly conflicted). ftey find that regulation increased the relation between earnings forecast accuracy and
recommendations of profitability for buy recommendations with regard to those analysts expected to be the
most conflicted. Additionally, Ertimur et al. find that treating hold recommendations as sells results in
significantly negative mean abnormal returns after regulation. ftis finding is in contrast to the positive returns
earned from such a recommendation strategy before Reg FD, indicating that post-regulation, analysts reduced
the optimism in their recommendations.
Kadan, Madureira, Wang, Zach, and Bathala (2009) find that conflicts of interest, defined as the past
presence of an underwriting relationship between the brokerage house and the firm the analyst is following, is
a key determinant of stock recommendations before regulation. After regulation, however, the distribution of
analysts’ reports became more balanced and less optimistic. ftey report that conflicted analysts are no longer
more likely to issue optimistic recommendations than unaffiliated analysts, but are still less likely to issue
pessimistic recommendations.
Chih-Ying and Chen (2009) also examined the impact of regulation on analyst behavior. ftey find a
significantly stronger relation between recommendations and analysts’ earnings forecasts relative to stock
prices after the regulation came into effect. fteir evidence also shows a weaker relation between stock
recommendations and proxies for analyst conflicts of interest (net external financing and amount of under-
writing business) after implementation of the regulation. Further, they find that stock recommendations issued
by analysts with greater potential conflicts experience a larger decrease in bias after this regulation.
Barniv, Hope, Myring, and ftomas (2009) show that regulations have strengthened the relation between
residual income valuations of firm equity and analyst recommendations. ftey also find evidence of increased
usefulness of analysts’ earnings forecasts
for investors. Additionally, their evidence shows that residual income valuations have an increasingly
positive association with future returns after the adoption of Reg FD and additional regulations (NASD Rule
2711, NYSE Rule 472, and Global Settlement). Lach, Highfield, and Treanor (2012) examine the long-run
performance of analyst ratings of initial public offerings (IPOs) following regulation to assess changes in
bias during this period. ftey find a reduction in the amount of positive bias contained in analysts’ reports
after regulation.
Lee, Strong, and Zhu (2014) also hypothesize that the series of regulations occurring between 2000 and
2003 strengthened the information environment of U.S. capital markets. fteir findings show that these
regulations reduced mispricing and increased market efficiency. ftese results are more pronounced among
higher information uncertainty firms. fte authors use several proxies for firm information uncertainty,
including accruals quality, firm size, firm age, analyst coverage, analyst forecast dispersion, and cash flow and
stock return volatility. Lee et al. find forecast accuracy also improved in these firms and conclude that this is
consistent withanimprovedinformationenviron- ment after the regulations took effect.
Some research, however, continues to find evidence of remaining conflicts of interest among analysts. For
example, Brown et al. (2015) administered a survey and conducted interviews with more than 350 analysts. ftey
note that management relationships and the underwriting business continue to be very important to analysts’
compensation. Brown et al. (p. 4) state:
In spite of regulators’ efforts, 44 percent of our respondents say their success in generating
underwriting business or trading commissions is very important to their compensation,
suggesting conflicts of interest remain a persistent concern for users of sell-side research.
Additional studies report that a majority of recommendations continue to be biased upward toward buy
recommendations (Agrawal and Chen 2008) and that analysts continue to rarely issue sell recommendations
(Shon and Young 2015). Groysberg, Healy, and Maber (2011) find that the buy recommendations of sell-side
analysts underperform the buy recommendations from buy-side analysts by 5.8 percent. Buy-side ana-
lysts usually work for a pension fund or mutual fund, whereas sell-side analysts typically work with a brokerage
house. According to Chen and Matsumoto (2006), access to manager-provided information is
important even in the post-Reg-FD era.
In summary, much of the empirical research shows that the regulations reduced, but did not eliminate, the
amount of bias in analyst recommendations following regulation. However, additional research continues to
find evidence of bias related to analysts’ conflicts of interest. fte following two sections discuss the behavioral
theories that hypothesize the explanation for the observed optimism in analysts’ reports.
Psychological Theories About Analyst Bias

fte cognitive psychology literature suggests that individuals generally tend to be over-optimistic
(Armor and Taylor 2002). For example, as Helweg-Larsen and
Shepperd (2001) note, individuals believe that they are less likely to be victims of auto accidents, crime,
and earthquakes and that they are less likely than others to suffer from illness, depression, unwanted
pregnancies, or a host of other negative health events (Weinstein 1980). fte psychology literature further
suggests that uncertainty in a task affects the decision maker’s level of judgment and may exacerbate this
optimistic bias.
H EU RISTICS
Based on a series of experiments, Tversky and Kahneman (1974) report that people rely on heuristic
principles, or short-cuts, to reduce complex and uncertain tasks of predicting values to simpler
judgments. ftese heuristics may lead to severe and systematic errors. Uncertainty in forecasting may
result from a low perceived reliability in the task (i.e., the information provided for the task is
inconsistent) or a low perceived validity in the task (i.e., the information may not properly reflect true
values) (Ganzach 1994). Studies report that decision makers become more optimistic as a task
becomes more uncertain, and that this is robust across a number of tasks (Kahneman and Tversky
1973; Markus and Zajonc 1985; Ganzach and Krantz 1991).
Both financial analysis and forecasts of a company’s earnings and future performance are complex,
unstructured tasks that vary across industries and across firms within industries. As such, forecasting tasks
naturally vary across firms on both the perceived reliability (e.g., high variance in past earnings) and the
perceived validity (e.g., presence of earnings management) of the information used. For example, consider an
evaluation of two companies based on two equally important variables, such as last year’s earnings and
management’s forecast of this year’s earnings. fte two companies have the same mean across the two
variables, but one has two moderate numbers whereas the other has one high number and one low number. fte
results of this research suggest that the more inconsistent company would receive a higher, or more optimistic,
forecast or recommendation from a financial analyst.
One explanation in the psychology literature for this optimism under uncertainty is the leniency heuristic,
whereby people have a tendency to give the benefit of the doubt when predicting performance (Kahneman
and Tversky 1973). In other words, when cues are inconsistent, a decision maker will under-weight
negative information and over-weight positive information, thereby leading to an optimistic judgment. In
accordance with these cognitive models, Kahneman and Tversky find the optimism bias is an increasing
function of task uncertainty.
Durand, Limkriangkrai, and Fung (2014) find related results when examining the herding behavior of
financial analysts. fte authors examined analysts who lag behind their analyst cohort in forecasting for
individual firms (laggards). fteir evidence shows that as the forecasting task becomes more difficult to
analyze, the laggards are more likely to move away from the consensus forecast (anti-herding). Durand et al.
also find that as the laggards become more confident (measured as the analyst’s forecast frequency), they
are also less likely to anti-herd. fte authors conclude that these results indicate that laggard analysts
havelowermeta-cognitive skills.
CONFIRMATION BIAS
A complementary theory for optimism under uncertainty suggests that an individual’s preferences can
influence the manner in which a person processes information and forms beliefs (Kahneman and Tversky
1979). ftis preference is known as confirmation bias, which suggests that people over-weight
information that confirms their prior beliefs and under-weight information that runs counter to their prior
beliefs. ftis preference applies to both analysts and investors. A similar theory is motivated reasoning,
which suggests that investors are more likely to arrive at conclusions that they prefer and that this preference
encourages using strategies that are most likely to yield the desired results (Kunda 1990).
Tests of these optimism theories include observing analyst forecasts and recommendations. Studies such
as Odean (1998) report that investors over-weight information that confirms their prior beliefs and under-
weight information that is contrary to their prior beliefs. In his survey of investor psychology as a determinant of
asset pricing literature, Hirshleifer (2001, p. 1549) states, “People tend to interpret ambiguous evidence in a
fashion consistent with their own beliefs. ftey give careful scrutiny to inconsistent facts and explain them as
due to luck or faulty data gathering.” Similarly, Hales (2007,
p. 613) states “when people are presented with information that is counter to their directional preferences,
they are motivated to interpret it skeptically.” An experiment conducted by Hales shows that investor
subjects automatically agree with information that suggests they will make money and disagree with
information that suggests they will lose money, which is consistent with confirmation bias. fte theory of
confirmation bias is also consistent with Eames et al. (2002), who find that analyst forecasts are significantly
optimistic for buy recommendations and pessimistic for sell recommendations.
To summarize, based on these theories, analysts are likely to exhibit optimistic bias in their reports even
after Reg FD and the Global Settlement. Given that research confirms that these behavioral biases are intrinsic
to the analysts’ tasks of forecasting earnings and issuing recommendations, optimism should be even more
likely in situations that are more ambiguous or uncertain.
Information Uncertainty and Analyst Bias

Much of the literature conducted before Reg FD finds that as uncertainty in a firm’s information environment
increases, optimism increases in equity analysts’ earnings forecasts. Das et al. (1998) and Groysberg et al. (2011)
both suggest that the observed optimism in analysts’ reports is primarily due to the economic incentives of the
analysts (i.e., analyst compensation is based to a large extent on trading volume and investment banking
business). fte post-regulation research provides some evidence that this optimism is reduced, because some
conflicts of interest have been removed from the analysts’ environment. As previously discussed, the
effectiveness of regulation in reducing analyst bias depends on the origin of the bias. To the extent that analysts’
optimism for high uncertainty firms stems from cognitive biases in their decision making, the effects of
regulation such as those enactedwill not completelyeliminate the optimism in analysts’reports.
To isolate the cause of the observed bias in analysts’ reports, Young (2009) used an experimental
setting to remove economic incentives from the analyst’s decision process. fte results of her experiment
show that an increase in the analyst’s perceived uncertainty of the forecasting task results in significantly lower
relative optimism in the analyst’s earnings forecasts. ftis finding indicates that regulation to remove conflicts of
interest may have the ability to reduce optimism in analysts’ forecasts. Her evidence also shows that relative
forecast optimism bias is positively related to the level of the analysts’ recommendations. ftis finding is
consistent with behavioral theories that analysts process information in a manner that supports their goals.
Regulation would not resolve this behavior.
Research on analyst decision making under uncertainty uses many proxies for information uncertainty,
including poor credit quality, high accounting accruals, and dispersion in analyst forecasts. Grinblatt, Jostova,
and Philipov (2016) use poor credit quality as a proxy for information uncertainty. fte authors acknowledge
that analyst recommendations and forecasts move market prices; therefore, they examine whether these
price movements are justified by analysts’ superior information (the efficient market perspective) or are
unmerited and based on investors’ blindly following expert opinions (the behavioral perspective). fteir results
show significantly higher optimism in analysts’ earnings forecasts for low-credit-quality firms and no
significant relation between analysts’ forecast bias and stock returns for higher-credit-quality firms, supporting
the behavioral perspective. fteir evidence also shows that firms with more optimistic consensus in analyst
forecasts subsequently earn lower risk-adjusted returns, also consistent with the behavioral perspective.
Bradshaw, Richardson, and Sloan (2001) find that an over-optimistic analyst forecast is greater for firms
with high accruals. fte authors interpret this finding as analysts’ not fully incorporating the predictable
earnings reversals of the accruals.
Zhang (2006) used dispersion in analysts’ forecasts as a proxy for information uncertainty. fte
author finds that greater information uncertainty leads to more positive (or negative) forecast errors and
subsequent forecast revisions following good (or bad) news. ftese results imply that information
uncertainty appears to delay the absorption of uncertain information into the analysts’ forecasts. Zhang also
discovers that these effects are much stronger following bad news than following good news. In general,
analysts underreact to new information and underreact more when information uncertainty is greater.
Additional studies examine the motives behind analysts’ overly optimistic reports. A sample of these
motives include investment banking relationships (Chan, Karceski, and Lakonishok 2007; Ljungqvist,
Marston, Starks, Wei, and Yan 2007; Agrawal and Chen 2012), career or reputation concerns (Hong and
Kubik 2003; Ertimur, Muslu, and Zhang 2011), better access to management’s private information (Ke
and Yu 2006; Westphal and Clement 2008), and other behavioral reasons (Willis 2001; Hales 2007). In
general, these studies report higher levels of optimism when these motives are present.
In summary, the research finds evidence of optimistic bias in analysts’ reports across many situations and
that the level of optimism increases in situations of high information uncertainty. fte next section provides a
discussion of the research that examines whether certain analyst characteristics, such as experience, can
reduce optimism.
Analyst Characteristics as Moderators of Optimism

Cognitive psychology research reports that increased experience and ability can lead to decreased optimism
in forecasts and estimates. ftis research suggests that performance feedback and experience with the task
moderate the tendency toward optimism. fterefore, analysts with more experience are likely to develop
superior private information about a company’s economics the longer they follow the firm. ftis is
supported by the findings of Mikhail et al. (1997). Ertimur et al. (2007) and Bowen, Chen, and Cheng
(2008) who also find that analysts’ ability increases with experience. Further, evidence presented by Ke
and Yu (2006) shows that analysts improve their effectiveness in translating earnings forecasts into
recommendations as their experience increases.
Additional research identifies analyst-specific factors that have the potential to reduce the bias in
analysts’ reports. Drake and Myers (2011) examine whether analyst characteristics may reduce the relation
between optimism in analyst forecasts and firms with high accounting accruals. fteir evidence shows that
analysts with more general experience and analysts following fewer firms have lower accrual-related over-
optimism. Stickel (1992) finds that Institutional Investor magazine’s all-star analysts supply forecasts
more often than other analysts. More frequent forecasts can be more advantageous for the generation of
recommendations because they can incorporate the latest earnings-relevant information and will be less
optimistic. Results obtained by Lim (2001) show that less experienced analysts produce more optimistic
forecasts in order to build access to management.
Cao and Kohlbeck (2011) examine whether analyst characteristics are associated with analysts’
effectiveness in processing public information and in avoiding optimistic bias. fte authors hypothesize that
high quality analysts can more easily attract new banking business owing to their high reputations, and they
are therefore more likely to reflect bad news in their reports on a timely basis, whereas low quality analystshave
incentives to remain optimistic to please management, even in the face of bad news. Using a sample of large
price changes, the authors find an asymmetric reaction in the analyst response to large positive and large
negative information shocks. Cao and Kohlbeck also find that their proxy for analyst quality is inversely
associated with the probability of recommendation downgrades after large negative price shocks, indicating a
reduction in asymmetry as analyst quality improves. ftey conclude that their findings are consistent with
the asymmetry being associated with a general information processing bias among lower-quality analysts.
Such a bias affects superior analysts less often, owing at least in part to their effectiveness in translating
earnings forecasts into recommendations. ftese findings are consistent with studies that find more expert ana-
lysts issue more profitable stock recommendations than do less expert analysts (Stickel 1995; Mikhail et al.
2004).
However, a few early studies do not find a difference between experience levels and bias in analyst
forecasts. For example, Mikhail et al. (1997) report an increase in accuracy but no change in forecast bias as
experience increased. In summary, the majority of the literature consistently finds that some analyst
characteristics, such as experience, may help reduce analyst bias.
Analyst Bias and the Impact on Market Reactions

fte literature provides mixed results on the effect of analyst bias on investors. Although some studies report that
analyst conflicts of interest do not have a systematic impact on investors (Mehran and Stulz 2007; Agrawal
and Chen 2008), other studies find that analysts’ biased reports adversely affect investors.
Several studies establish bias in analysts’ reports. For example, evidence presented by Barber, Lehavy, and
Trueman (2007) shows that buy recommendations from independent research firms outperform those from
investment banks by roughly 8 percent. However, investment banks’ hold and sell recommendations
outperform those from independent firms by approximately 4.5 percent. ftis finding is consistent with recom-
mendations from investment banks being positively biased, resulting in sell recommendations containing
more information.
Additional studies differentiate the effects of this bias on institutional and retail investors. ftese
studies tend to find that individuals are less aware of bias than are institutional investors and they are more
susceptible to it. For example, Michaely and Womack (1999) present evidence that the market does not fully
account for analyst bias. For instance, stocks that underwriter analysts recommend perform more poorly than
buy recommendations made by unaffiliated brokers. fte authors estimate the mean excess return for IPOs
recommended by underwriter analysts is −18 percent after two years, compared with +45 percent for
recommendations made by unaffiliated brokers.
Further, Malmendier and Shanthikumar (2007) find that large traders (a proxy for institutional investors)
adjust their trading response downward to analysts’ reports, but small traders (a proxy for retail investors) do
not, suggesting that individuals may be unaware of analyst bias. fte authors show that an investment strategy
of strictly following analyst recommendations produces negative abnormal returns for a buy-and-hold
strategy, which may harm small investors.
Baker and Dumont (2014) also analyzed the performance of buy-and-hold ratings and surveyed
retail investors about their reliance on analyst recommendations. Although the authors find that buy ratings
of firm equity significantly underperform hold ratings, retail investors report that they rely on these
recommendations when making investment decisions.
Mikhail, Walther, and Willis (2007), who use trade size to distinguish between large (sophisticated) and
small (unsophisticated) investors, find that large investors respond more to the information contained in
recommendation revisions, whereas small investors respond more to the occurrence of a recommendation and
trade more in response to upgrades and buys. As a result, the authors find that in the five days after recom-
mendation revisions, large traders earn an average raw return of 5.1 percent, whereas small traders earn −1.8
percent. De Franco, Lu, and Vasvari (2007) examine 50 events in which analysts issued misleading reports.
According to the authors, small investors are differentially affected. Small traders lost $2.2 billion—two-and-
a-half times as much as largetraders.
Cheng, Liu, and Qian (2006) present evidence suggesting that institutional investors are more likely to
rely on buy-side analysts than on potentially conflicted sell-side
analysts. In summary, substantial evidence indicates that analyst bias may harm small and unsophisticated
investors.
De-Biasing the Bias

Can financial analysts improve their judgment and decision making by reducing the bias in their reports?
Analysts should be motivated to reduce their optimistic bias if this bias reduces their reputation and
therefore reduces their compensation. However, they would not be motivated if the optimistic bias helps with
management relations and therefore increases their compensation. Research shows that analysts have
incentives tobuild andmaintain areputationfor objectivitythroughout their career(Ljungqvist, Marston, and
Wilhelm 2006; Hugon and Muslu 2010). Research also provides evidence that analysts who have been
identified as superior performers are more likely to experience favorable career outcomes, such as moving up
to a high-status brokerage house (Hong, Kubik, and Solomon 2000; Hong and Kubik 2003). If a
reduction in optimism ties into a higher reputation, cognitive psychology suggests several remedies. According
to cognitive psychology research, repetition, feedback, and experience tend to mitigate judgmental biases
(Einhorn and Hogarth 1978; Kagel and Levin 1986; Rose and Windschitl 2008). For example, Kagel
and Levin find that subjects who overbid in early rounds of an auction become less optimistic in their bids as
they gain experience. Outcomes that indicate a large discrepancy between forecasted and actual
performance are expected to motivate the decision maker to increase effort, adjust performance
expectations, or both. Ericsson, Krampe, and Tesch-Romer (1993) and Radhakrishnan, Arrow, and Sniezak
(1996) confirm that these corrections should improve the accuracy and reduce the optimism of future
evaluations. fterefore, introducing new information or knowledge, which is used in future judgments and
decisions, reduces optimism (Shepperd, Oullette, and Fernandez 1996). ftis reduction in optimism would
occur for analysts as they receive feedback that is accurate and timely (i.e., actual quarterly and annual reported
EPS), adjust their performance, and learn from
general experience with the task.
Analyst studies find that several different variables can mitigate optimism, including reputation concerns
(Fangand Yasuda 2009; Bradley, Clarke, and Cooney 2012), competition (Hong and Kacperczyk 2010; Sette
2011), the presence of independent analysts (Gu and Xue 2008), or the presence of institutional investor-
owners (Ljungqvist et al. 2007; Gu, Li, and Yang 2013). Ability may also be a mitigating factor. Evidence by
Cao and Kohlbeck (2011) shows that analysts of particularly high skill and reputation are less likely to issue
overly optimistic recommendations or to overreact to news. In general, analysts can reduce their optimistic
bias, and they do so in many situations.

fte bias in financial analysts’ reports has been a concern of investors and regulators for several decades.
Some have alleged that analysts’ reports lack independence and
objectivity, due to the conflicts of interest between the equity analyst function in the brokerage house and the
banking side. Investors have complained that managers of publicly traded firms are providing select material
information to a chosen group of analysts, who in turn, disclose this to their preferred clients. fte results of this
behavior harmed investors by excluding them from these inner circles. To address these conflicts, several
pieces of regulation were put into place in the early 2000s. fte object of these regulations was to eliminate
this selective disclosure of information and thereby level the playing field across investor categories.
Although the market environment changed with Reg FD and the additional regulations, several studies
find that a relation with management still appears to be important for today’s analysts. Evidence shows that
the bias in analysts’ reports, despite being somewhat reduced, still remains. Further, this bias may hurt small
or unsophisticated investors. In light of these findings, regulators should consider the sources of analyst
bias when evaluating what regulations would help to eliminate this bias and achieve regulatory goals.
Investors should also consider both the source of analyst bias and the analyst characteristics, which may
help them to select less optimistic analysts’ reports.
1. Discuss whether regulation solves the problem of bias in analysts’ reports.
2. Identify two incentives or environmental factors that increase analyst bias.
3. Identify analyst characteristics that reduce analyst bias.
4. Discuss whether the market recognizes and adjusts for the bias in analysts’ reports.
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8
Portfolio Managers
ERIK DEVOS
JP Morgan Chase Professor in Business Administration and Professor of Finance
College of Business Administration, University of Texas - El Paso
A N D R E W C. S P I E L E R
Frank G. Zarb School of Business, Hofstra University
J O S E P H M. T E N A G LI A
Emerging Markets Portfolio Specialist
Emerging Global Advisors
Introduction
Portfolio managers are professional investors who oversee and control discretionary pools of capital
known as funds, which are available for investment to a larger base of investors. Portfolio managers often
employ a team of analysts and junior portfolio managers who report to them. fte analysts help provide ideas
to managers and perform research on possible investments for the fund. Ultimately, however, the final
decision- making power typically lies solely with portfolio managers. A single fund could potentially have
millions of investors, with each of them counting on the portfolio manager to achieve a specific goal, such as
income or growth. With so many stakeholders involved, the portfolio manager needs to develop and adhere to a
plan when managing the fund. fte portfolio management process may vary depending of the type of fund, but
generally follows the same basic steps: (1) setting the investment objective, (2) developing and
implementing the portfolio strategy, and (3) monitoring and adjusting the portfolio(Maginn, Tuttle,
McLeavey,and Pinto 2007). Inthe first step,the portfolio manager selectsabenchmarktowhichhecompares
thefund,bothincompositionandinperfor- mance. If the manager seeks a targeted level of outperformance
relative to that benchmark, that goal is set during this step. Any constraints to which the fund must comply
are also established here. fte constraints can range from restrictions on the fund’s risk, such as that no allocation
can exceed 5 percent of the fund, to its composition, such as
that only invest in companies with minority chief executive officers (CEOs).
In the second step, the portfolio manager details a plan as to how he manages the fund to achieve the pre-
established goals. For example, this could be a “top-down” investment allocation, in which the manager identifies
macro trends and broadly allocates the fund among asset classes. ftis approach contrasts with a “bottom up”
security selection, in
135
which the research and picking of individual securities drive the investment process. At thisstage,themanager
selectsandinvestsinsecuritiestocreatethedesiredportfolio.
Lastly, the manager constantly monitors the fund and makes necessary adjustments. For example, if one of
the securities in the portfolio has increased in value to the point where the manager believes it no longer has
sufficient upside potential, the manager may elect to sell and replace the security. ftis stage of the portfolio
management process is continuous. ftat is, the portfolio manager must continuously monitor many factors and
analyze the impact on every security in the fund. fte magnitude of this daunting task and the sustained
success of so few in being able to do it well help explain why portfolio managers can sometimes be referred to as
the “rock stars of the financial world” (Myers 2008). ftis chapter explores the behavioral tendencies of
portfolio managers at asset management firms,as well as those responsible for institutional portfolios.
Asset management is a service in which an investment management company uses capital provided
from investors to implement an investment strategy, and offers a product in which the investors own a
participation stake (Concannon 2015). Often referred to as the buy side, asset managers purchase securities on
behalf of their clients in order to assemble an investable portfolio. fte flip side is the sell side, in which firms
perform research on securities in order to sell their work to asset managers or use it to generate business for
their brokerage arm (Maginn et al. 2007). fte portfolio manager of the fund that is created by the asset
manager then taps into the global capital markets and allocates the investors’ capital into securities that the
manager finds attractive.
Asset managers cater to two investor types: individuals and institutions. Individual investors are often
referred to as retail investors, and they include private families or individuals who are looking to reach their
retirement and financial goals. Institutional investors can represent entities such as the ongoing support fund of
a university or the pool of all retirement funds of a government’s employees. Both individual and institu-
tional investors provide the asset manager with capital, and in turn, the portfolio managers at these firms seek to
generate a return on the capital. For this service, asset managers receive a fee for their efforts, with the implication
that the portfolio manager is creating value that the investor otherwise cannot create. Within asset management,
firms generally fall into one of two categories: traditional and alternative. Differentiating between the two
types is important because the structure of each firm plays a large role in the financial behavior of the
respective portfolio manager.
Traditional asset management firms offer investment products and earn fees based on a percentage of the
total assets under management (AUM). ftese firms offer products such as mutual funds or exchange-traded
funds (ETFs), which typically take long- only positions in conventional securities such as stocks and bonds. A
longtime staple of retirement plans and brokerage accounts, mutual funds totaled more than $15.8 trillion in
assets at the end of 2014 (Investment Company Institute 2015). fte appeal of mutual funds is that they provide
exposure to financial markets via a diversified portfolio, where the decision to buy and sell securities is
delegated to a professional money manager. Additionally, the pooling of investors’ capital in mutual
funds enables the fund to achieve economies of scale, helping reduce its total costs, as opposed to owning
each of the individual underlying securities outright (Baker, Filbeck, and Kiymaz 2015). ftese products are
regulated under the Investment Company Act of 1940 and are required to register with the Securities and
Exchange Commission (SEC). fte purpose of the registration is to minimize conflicts of interest and to
disclose information about the
Portfolio Managers 137
fund and its objectives to the investing public. fte act requires the fund to provide its financial condition and
investment policies to its investors on a regular basis (Securities and Exchange Commission 2016a). As a result
of the SEC regulation, portfolio managers of mutual funds are relatively restricted in the types of securities in
which they can invest, the size and nature of their positions, and how they advertise to the public. With scrutiny
from regulators, coupled with the overall simplicity of most strategies, traditional asset management firms
typically are more tailored to the demands of the retail investor audience.
Alternative asset managers, similar to traditional asset managers, also earn fees based on a percentage of their
AUM. Many of these funds include hedge funds and private equity funds. One important distinction,
however, is that alternative managers also receive a portion of the profits (i.e., incentive) of the strategies they
manage (Concannon 2015). Although incentive fees have been compressed in recent years, hedge funds have
historically charged an annual management fee of 2 percent of the fund’s assets managed, as well as 20
percent of the fund’s profits over its high water mark (HWM), which is a continuous running tally of the
fund’s maximum AUM level. fte fees levied by hedge funds are substantially higher than those charged by
most mutual funds, which had an average expense ratio of 0.70 percent in 2014 (Investment Company
Institute 2015). Performance incentives provide portfolio managers at alternative firms with additional
motivation to generate returns and outperform their benchmarks; the better the portfolios perform, the more
money the portfolio managers make.
Besides fees, the portfolios managed by alternative firms sharply differ from those by their traditional
counterparts in other ways. First, hedge funds are subject to considerably less regulation than mutual funds.
Hedge funds are not required to register with the SEC, so the financial condition and investment policies
followed are less transparent to investors than those of mutual funds.
Next, perhaps related to the lack of regulation, the investment strategies of alternative funds tend to be more
complex in nature than traditional funds. Although many different substyles of hedge funds are available, most
have the ability to invest in publicly and privately traded securities in all global financial markets, such as
derivatives, as well as engaging in the short-selling of securities. Short-selling is the sale of a security that is not
owned by the seller, or that the seller has borrowed. Short-selling is motivated by the belief that a security’s price
will decline, enabling the seller to buy it back at a lower price to make a profit. Some hedge funds take a small
number of sizable positions in their portfolios, which can pay off when the gambles taken by the portfolio
managersucceed.
Lastly, to ensure that the only investors in alternative funds such as hedge funds can bear the economic risk
of investing in unregistered products, certain funds are only available to “accredited investors.” fte SEC
defines accredited investors as certain types of firms and their directors (e.g., banks, savings and loan
associations, investment advisers, and insurance companies) and individuals whose net worth (or combined
with their spouse) exceeds $1 million (Securities and Exchange Commission 2016b). Whereas individuals
can invest in some mutual funds for as little as $100, hedge funds investors are required to reach a minimum
level of annual income or net worth in order to invest, limiting their availability to sophisticated and wealthy
investors. For purposes of this chapter, however, the major difference between traditional and alternative firms
relates to the performance fee at alternative firms, as it drives much of the financial behavior of its portfolio
managers.
Outside of asset management firms, portfolio managers may also directly oversee pools of money for
institutional entities, such as pensions. A pension fund is a pool of money managed on behalf of the
employees of a corporation or government that provides employees with payments upon their retirement.
Also known as defined benefit (DB) plans, pension funds promise to pay a specific dollar amount to each
beneficiary on an ongoing basis after they retire. Defined contribution (DC) plans are also available
whereby the beneficiary makes the investment decisions and hence bears the risk. ftis chapter primarily
focuses on DB plans.
Employees in civil service positions, such as firefighters, policemen, and teachers, rely primarily on their
pensions as their source of retirement funding. fte pension payment to the beneficiary depends on an actuarial
formula that includes inputs such as the number of years the beneficiary worked at the employer and salary in
the final year of employment. In anticipation of the future payments that the fund must distribute, the
employer makes regular contributions to the pension fund. fte employer needs these contributions to
sufficiently grow to satisfy the fund’s future obligations, which is why the pension fund manager is
paramount in the process.
Using assumptions and future projections of the formula’s inputs, the pension fund manager establishes a
target rate of return that it must achieve. fte portfolio manager has two goals: to grow the contributions so that
all obligations to current and future beneficiaries are satisfied, and to maintain enough liquidity to make
payments to current beneficiaries. Although the mandatory growth of the contributions allows the
fund’s portfolio manager to have a long-term investment horizon, the annual distribution requirement forces
the manager to balance the portfolio with a short-term mindset. Many public and private pension plans have
operated for decades, and beneficially invest billions and sometimes trillions of dollars under management.
As supervisors of the retirement funds of potentially thousands of individuals, pension fund portfolio
managers may find themselves as some of the most influential investors in the world.
Another type of institutional entity that relies on a portfolio manager to oversee its investments is an
endowment. An endowment is a gift of money or income-producing property to a public organization such
as a hospital or university for a specific purpose, such as research or scholarships. fte endowed asset is usually
kept intact and only the income generated by it is consumed. Endowments represent the permanent funds of
an organization and are responsible for providing money to support the operations of the institution in
perpetuity (Swensen 1994). Similar to a pension fund manager, the endowment manager’s goals are twofold:
preserve the purchasing power of the assets in the endowment over time, and provide resources to the
institution to help fund operations in the present.
Because their existence is assumed perpetual, the structure of an endowment allows the portfolio
manager to invest in riskier and less liquid securities with higher return profiles, mindful that the endowment
canrecoup most large capital losses over time. fte manager must also balance the risk-taking portion of the
portfolio with enough short-term liquidity to make payments to support the institution. fte impact of the
performance of the portfolio manager has ramifications beyond the financial universe. For example, if the
endowment fund of a hospital cannot make the full payments it requires, and the hospital’s operations are
not fully funded as a result, the consequences could be catastrophic. ftus, the investment manager in
charge of an endowment portfolio plays an incredibly pivotal role in the organization’s viability.
Behavioral Biases in Portfolio Management

Contrasting the types of portfolios in the previous section is necessary because each contains particular
nuances that act as catalysts for the financial behavior of the portfolio managers. Particular behavioral biases
are inherent in nearly all portfolio managers to some degree, but the nature of the fund being managed can
also provide a clear delineation in behavior. Many factors can drive the behavior of a portfolio manager out-
side those typically thought to drive the assumed rational investment decision-making process.
OVERCONFIDENCE
Overconfidence bias is an unwarranted faith in one’s intuitive reasoning, judgments, and cognitive
abilities. In short, overconfidence bias deduces that investors think they are smarter than they truly are and
have better information than they actually do (Pompian 2006). Psychologically, people in general tend to
overestimate their own abilities. Specific to portfolio managers, overconfidence can impact decision
making because portfolio managers are professional investors who are in their respective positions because
of their perceived skills in managing money. In fact, professionals who are overconfident in their own skills
are hardly limited to the field of portfolio management. Psychologists, doctors, engineers, entrepreneurs,
lawyers, and other professionals have all consistently displayed overconfidence in their judgments and abilities
(Odean 1998). For any population, by definition, half the constituents must be below average. Not surprising,
professionals are more likely to consider themselves to be above average at their job than below average.
Ironically, the adept abilities that helped professional portfolio managers earn their positions could also be the
sources of the bias for which they are much more susceptible than the average investor.
Investing has two main types of overconfidence: prediction overconfidence and certainty
overconfidence. Prediction overconfidence occurs when an investor assigns too narrow a confidence
interval to his investment forecasts. ftat is, an investor believes that his prediction of the future value of
a security must lie within a tight band because he is confident in the accuracy of his prediction. ftis
phenomenon leads investors to be surprised when outcomes vary greatly from predictions. As a result,
they often underestimate the downside risks. As related to portfolio managers, prediction overconfidence
may cause them to build portfolios that are unprepared for large losses. If a manager expects a security’s
performance to fall within a narrow band and the actual performance of the securityfalls short ofthe manager’s
predicted worst-case scenario, the portfolio may be substantially more risky than the manager anticipated.
Certainty overconfidence occurs when investors assign too high a probability to their prediction and
have too much confidence in the accuracy of their own judgments. fte effects of certainty overconfidence can
appear in several forms during the portfolio management process. Odean (1998, p. 1888) contends that
increased trading activity is the “most robust effect of overconfidence.” Investors who are overconfident in the
precision of their forecasted values of securities are likely to trade more often. Believing they have better
information than other investors, overconfident investors place a greater weight
on their own opinion and think that they can beat the market by increasing the number of trades that they place.
Increased trading activity drives up transaction costs, creates the opportunity for taxable events, and can reduce
the total return of a portfolio. Odean focuses on individual investors, but studies show that the phenomenon
of overconfidence leading to increased trading activity and poor performance also holds true for
professional portfolio managers. For example, Chuang and Susmel (2011) report that institutional traders in
Taiwan exhibit overconfidence, albeit less than individual traders. In the context of mutual funds, Carhart
(1997, p. 67), who finds that a portfolio’s turnover is significantly negatively correlated to its performance,
states that “the turnover estimate implies transactions costs of 95 basis points per round-trip transaction.”
Further, Bogle (2006) reports that mutual funds in the top quartile of their universe in portfolio turnover
between 1996 and 2006 underperformed the funds in the bottom quartile of turnover by 1.7 percentage points
on an annual basis. Additionally, the funds in the top quartile of turnover are 27.1 percent more volatile than the
bottom quartile funds. ftese findings are consistent with the notion that the portfolio managers who are most
confident in their abilities to beat the market are among the worst at doing so on both an absolute and a risk-
adjusted basis.
Another consequence of overconfidence bias by portfolio managers in the portfolio construction
process is concentration. If portfolio managers are very confident in assessing a security’s forecasted value,
they may allocate a greater weight to that security within a portfolio. Fund managers who are willing to make large
bets on a small number of securities increase the risk of under-diversifying the portfolio. Concentrated posi-
tions in only a few securities reduce the diversification benefits inherent in the structure of a portfolio and can
increase the fund’s overall volatility. If the reason behind a portfolio’s concentration is the portfolio manager’s
overconfidence, the manager may be associated with poorer risk-adjusted performance (Baks, Busse, and
Green 2006). However, evidence suggests that portfolios with a degree of concentration tend to outperform
their benchmarks on both an absolute and a risk-adjusted basis (Yeung, Pellizzari, Bird, and Abidin 2012).
Studies also suggest that managers who manage concentrated portfolios display some skill in correctly
picking stocks (Baks et al. 2006). Although most mutual fund managers fail to outperform their respective
benchmarks over the long term (Soe 2015), the confident ones managing concentrated portfolios may stand
the best chance of outperformance.
HERDING BEHAVIOR
Herding refers to disregarding one’s opinion or analysis in order to follow the crowd. Individuals may be
unwilling to take a stance against a popular opinion for fear of being incorrect and facing reputational harm as a
result (or worse). As Keynes (1936, p. 158) notes, “Worldly wisdom teaches that it is better for reputation to
fail conventionally than to succeed unconventionally.” Herd behavior is a behavioral phenomenon present in a
many social situations, but is particularly prevalent in financial markets. Studies report that investors
typically do not fire the portfolio managers of funds who are merely mediocre relative to their peers.
Rather, a manager must significantly underperform both his benchmark and his peers before the fund
experiences substantial outflows (Sirri and Tufano 1998). ftis phenomenon may be a major derivation of
herding
behavior because it provides the portfolio manager with a strong incentive to follow the herd or be left behind
and face the consequences.
A key repercussion of herding behavior by portfolio managers is the creation of financial bubbles and
crashes. When a new financial innovation or “disruption” occurs in an industry, such as the rise of Internet
companies or the advent of securitization, investors try to profit from it. Often, the potential growth of these
assets may not yet be fully understood by investors, and thus cannot be accurately measured, providing seem-
ingly unlimited growth potential. Initially, the gains in the prices of these assets can be gradual and the
valuations they achieve may be justified. As prices continue to rise when more investors attempt to capitalize on
its momentum, portfolio managers may observe their peers investing in these assets and be incentivized to invest
in them as well. Recall that portfolio managers with average performance do not tend to see redemptions from
investors. However, as investors continue to chase trends by purchasing an investment, the asset’s market value
can wildly exceed its fundamental value and its lofty valuations can no longer be supported. At this point a
bubble has formed.
Investors often fail to realize that a bubble exists until it is too late (Brunnermeier and Oehmke 2013).
Some type of event eventually triggers the bursting of the bubble. Whatever the catalyst may be, investors
realize that the asset is overvalued and decide to sell their stake in it, driving down its price. Seeing the decline in
price, portfolio managers want to salvage the maximum value possible for their ownership and sell the asset
as soon as they can, exacerbating the fall. A crash is now under way. Few investors may be willing to buy the
asset, and the lack of demand further reduces its market value. Frequently, a spillover effect into other related
and even unrelated assets can occur. ftis contagion effect may affect a large portion of the overall marketplace.
Regardless, portfolio managers who are left holding the asset at the end of a crash are likely to suffer severe
losses and create unhappy investors as a result.
Portfolio managers face a conundrum pertaining to herd behavior. If they do not follow the herd, they
risk trailing behind their peers. However, if they follow the herd, they may get caught on the wrong side of an
artificially attractive trade opportunity. Consider the case of two hedge fund managers during the technology
bubble of the late 1990s. One manager refused to invest in technology stocks during their rise, believing them
to be overvalued. Despite a successful track record for almost two decades before- hand, the manager had to
dissolve the fund in 2000 because it did not keep up with the high returns from technology companies and
the competing funds that invested in them. Conversely, a different hedge fund manager heavily invested in
technology stocks during their boom. As the dot-com bubble popped and technology stocks fell precipi-
tously, the fund faced massive losses. Even though the portfolio manager had strong performance for 12 years
before the crash, he resigned from the fund in 2000 (Pompian, McLean, and Byrne 2011). Portfolio managers
must carefully weigh their options when facing a herd-driven environment.
Aside from the competitive pressures, herd behavior can also arise from emulation. Many social and
financial situations may enable and encourage a person to “follow the leader” when presented with an
opportunity to do so. In the portfolio management universe, if a portfolio manager sees that one of his peers
is performing exceptionally well, he may be incentivized to copy what the successful manager is doing. In this
fashion, either the “copycat” fund performs in line with the best funds in the universe, or
it is not alone should its performance falters. Indeed, several studies show that copycat behavior is
pervasive among mutual fund managers (Phillips, Pukthuanthong, and Rau 2014; Lesmond and Stein
2015). Interestingly, the top-performing mutual funds most frequently mimicked typically end up
underperforming in subsequent periods. Additionally, portfolio managers who run copycat funds also lag
the average mutual fund.
Although following the leader has not benefited mutual fund portfolio managers, managers of
endowments are currently experiencing a wave of successful imitations, albeit in a much different fashion.
Rather than mimicking stock picks from the top managers, endowment managers are electing to hire away
the personnel from the top funds. David Swensen, Chief Investment Officer of the Yale University endowment,
was among the first endowment managers to embrace alternative funds and stray outside of the securities
typically associated with traditional asset allocation, such as equities and fixed income. In what became
known as the “Yale Model,”Swensen used the structure of an endowment fund to his advantage by investingin
less liquid and instruments with lower correlations, such as private equity, real estate, and timberland. fte
fund was the top-performing endowment of all colleges and universities from 2004 to 2014 (Yale 2014). Given
such successful results, other colleges and universities hired many of the analysts who worked under Swensen
to manage their endowments. In 2015, Yale’s endowment, along with each of the endowments managed by
five of Swensen’s former protégés, outperformed the average university endowment benchmark by at least
3.0 percentage points (McDonald and Lorin 2015). Perhaps mutual fund managers would be more
successful if they were to hire their peers rather than tryto copy them.
Herd behavior varies by the type of fund managed. In particular, the previous example of herd behavior by
hedge fund managers during the technology bubble had negative consequences. Wermers (1999) finds that
among mutual funds, those managing growth-focused stock mutual funds are most likely to engage in
herding, particularly in smaller stocks. In fact, Wermers concludes that mutual fund portfolio managers who
herd have a better chance of being profitable than those who do not. Conversely, managers of pension funds
do not display herding behavior in stocks (Lakonishok, Shleifer, and Vishny 1992). ftis lack of herding is
perhaps attributed to the structure of the pension fund. Because pension funds have a longer-term
investment horizon, managers have more leeway in that they are unlikely to face a backlash or outflows from
investors if their funds underperform over a short time frame. As endowments only have a singular
investor, they also do not face the short-term pressures that normally drive herd behavior. Nevertheless,
portfolio managers of all types constantly face an evolving market with opportunities to seize new trends.
How exactly they manage their portfolios when a herd opportunity presents itself can dictate a portion of their
overall success.
RISK- TAKING BEHAVIOR

fte concept of moral hazard is one of frequent debate, particularly in the years following the financial crisis of
2007–2008. Moral hazard stems from the principal–agent conflict and is a situation in which one party (the
agent) is responsible for the interests of another party (the principal). fte interests of both parties are unlikely to
becompletely aligned, and the agent may be incentivized to place his own interests before those of the
principal. If the agent knows that the majority of the total costs lie with the principal, the agent may be
incentivized to take excessive risks while performing the task at hand. Because the agent has limited personal
downside risks, this situation creates a convex payoff structure for the agent and encourages risky behavior. In
the end, either the agent succeeds and is compensated for that accomplishment, or the agent fails, with the prin-
cipal disproportionately bearing the consequences. ftis situation is summarized with the euphemistic coin
flip: “Heads, I win; tails, you lose” (Dowd 2009).
Much recent discussion about moral hazard is based on the actions of financial institutions leading
up to the financial crisis of 2007–2008. fte question at hand is whether top bank executives knowingly took
excessive risks with their capital and lending requirements. ftat is, because lenders believed that if their loans
were to go bad and their assets lost value, the Federal Reserve, and ultimately American taxpayers, would bail
out their banks. Although this belief presents a common explanation, predatory borrowers who secured loans
they were unable or unsure they could repay also share the blame. Yet, moral hazard clearly extends beyond
banking to portfolio managers.
As previously discussed, traditional asset management firms earn fees based on a percentage of AUM. As a
result, these traditional firms have an incentive to maximize the total amount of assets managed. Portfolio
managers can increase the size of their portfolio either by investing the fund’s assets in securities that grow or
by earning additional inflows from investors into the fund. As discussed shortly, portfolio managers who are
adept at the former typically benefit from the latter. However, the stated objective of a mutual fund may not
necessarily be to seek maximum growth. For example, consider a short-term government bond fund whose
goal is to outpace inflation. fte fund’s portfolio manager would likely be violating the mandate by investing in
the stocks of small-cap companies, even if the stocks generate higher total returns than the short-term bonds.
Even though portfolio managers want the highest possible positive return, risk is a crucial component.
Consumers generally invest in a mutual fund because they trust the portfolio manager’s judgment in
maximizing the fund’s risk-adjusted returns, not just the total returns (Chevalier and Ellison 1995). ftis
incongruent objective between the portfolio manager and investor creates a situation in which the portfolio
manager may beincentivizedtoincreasethefund’sriskprofilebeyond itstypicalstandards.
Interestingly, situations may also arise in which portfolio managers are incentivized to reduce the risk levels
of their funds. Chevalier and Ellison (1995) examine the relation between mutual fund performance and flows
by analyzing the behavioral tendencies of mutual fund investors. fte authors find that a mutual fund’s year-
end performance heavily influences investors, owing to the availability of year-end information and other
factors. A strong relation exists between a fund’s excess return against its benchmark in a given year and the
fund’s flows in the following year. Of the funds that outperform their benchmarks, a sharp increase tends to
occur in inflows for those funds that have an excess return greater than 15 percent. Although funds that slightly
trail their benchmarks do not see disastrous outflows, evidence of an acceleration of outflows occurs from
the funds that trail by more than 15 percent. ftis finding is consistent with the conclusions from Sirri
and Tufano (1998).
Assume a portfolio manager is conscious of how his fund compares to its benchmark during a given
year, and he is aware that flows in the following year are related to performance. As the year-end approaches,
will the fund’s performance relative to its
benchmark affect the way the manager adjusts the portfolio before year-end? According to Chevalier and
Ellison (1995), portfolio managers of mutual funds adjust the riskiness of their portfolios from October
through December, depending on their relative positions at the end of September. Managers who substantially
outperform their benchmarks for the year-to-date period through September tend to de-risk their portfolios
at year-end. ftis defensive measure will track the index and “lock in” the fund’s excess return, which would
enable the manager to reap the benefits of strong inflows in the next year. Conversely, managers whose
portfolios lag their benchmarks by a sizable margin through September tend to increase their portfolio’s
systematic risk, hoping to close the gap below its benchmark before the end of the year and avoid potential
outflows in the upcoming year. As a result, the end of the year in the mutual fund industry tends to have a divide
between portfolio managers who avoid risk and those who actively seek it. According to Baker (1998), the
choice of benchmark is not the only factor that matters in determining a fund manager’sattitudes torisk. A series
of interviews with fund managers shows that managers also state that the timing of performance evaluation
affects fund managers’ attitudes toward risk and that quarterly performance evaluations lead to a short-term
attitude and approach to fund management.
Given their restrictions relative to alternative asset management firms, the fact that portfolio managers at
traditional asset management firms engage in risk-seeking behavior to raise their AUM, and subsequently their
fees, or to attract inflows from investors may surprise some. However, due to the fee structure at alternative
asset management firms such as hedge funds, the possibility of the portfolio manager’s taking excessive risks
should be more obvious. Recall that the fee structure at alternative firms is two- pronged: a management fee
on a fund’s AUM and a performance fee for profits above the fund’s HWM. Similar to mutual fund portfolio
managers, hedge fund managers have an inherent incentive to maximize the amount of assets managed. fte
way in which they attempt to accomplish this goal differs. Hedge fund managers are generally not
constrained by a mandate in the types of securities in which they can invest and how they invest in them.
fterefore, the previous example of a portfolio manager adjusting a fund’s risk profile by adding small-cap
stocks to a short-term government bond fund may not be interpreted as irregular. Also, hedge funds may
contain a “lockup” provision that restricts investors from withdrawing their capital for a specific period of
time. As a result, the average investor’s holding period of hedge funds tends to be much longer than that of the
average mutual fund. ftis relation implies that the flow-seeking behavior displayed by mutual fund portfolio
managers at year-end is less prevalent in hedge funds. A strong relation still exists between past performance
and flows, but the flows are more highly correlated with performance persistence over several years rather than
the performance in the most recent calendar year (Agarwal, Daniel, and Naik 2004).
Prior performance also affects the choice of risk level. For example, fund managers who recently
completed a successful year for their portfolio tend to take on more risk in the following calendar year. To be
specific, they increase volatility, beta, and tracking error, and they assign a higher proportion of their portfolio
to value stocks, small firms, and momentum stocks. Poor-performing fund managers switch to passive
strategies (Ammann and Verhofen 2007). However, evidence also suggests that declining performance
does not necessarily lead the fund manager to raise the volatility of the fund’s return (Chen and Pennacchi
2009).fteresearchersreportatendencyfor mutualfunds
to increase the standard deviation of tracking errors, but not the standard deviation of returns, as their
performance declines. ftey also find that this risk-shifting behavior is more common for managers with
longer tenure.
Ultimately, the management fee aligns the interests of the manager and the investors, as the manager is a de
facto equity investor in the fund (Lan, Wang, and Yang 2011). Instead, the most important cause of risk-
taking behavior by a hedge fund manager comes from the performance fee. On its face, a performancefeewith
a HWM provision appeals to both the hedge fund manager and the investors. Investors find comfort in the fact
that unless their investment makes a profit, the manager will not receive a bonus (i.e., a performance fee), and
must fully recover previous losses before being eligible to receive the bonus (Goetzmann, Ingersoll, and Ross
1997). For the manager, the attrac- tion is simple: perform well and be compensated handsomely. However,
the AUM and performance combined fee structure essentially acts as a series of call options for the portfolio
manager, with a floor on the downside risk (i.e., the management fee), with unlimited upside potential (Lan
et al. 2011). ftis asymmetrical payoff feature clearly encourages the hedge fund manager to increase
portfolio risk.
Consider a hedge fund that has recorded several consecutive years of negative returns. As the fund
falls further away from its HWM, receiving a bonus for performance becomes less likely for the manager.
In this situation, little downside exists for the manager to engage in risk-seeking behavior. If the fund’s added
risk pays off and the manager succeeds, he may regain the opportunity to earn a hefty performance bonus. If the
manager fails, he still receives an AUM fee. In the worst-case scenario, if the fund’s added risk causes it to fall
further, and the manager completely loses hope of reaching the HWM, he can elect to simply close the
fund and start a new fund with a more realistic and attainable HWM. In baseball terms, trailing the HWM gives
the manager a chance to swing for the fences: the manager either hits a home run or goes down swing- ing.
fterefore, the presence of a performance fee creates an incentive for an alternative investment portfolio
manager to increase a portfolio’s riskiness particularly when the fund is below its HWM.
A similar question to whether portfolio managers exhibit specific risk-taking behavior is how portfolio
managers perceive risk. Whether this perception of risk differs from theoretical models of risk and return
and/or other investors is unclear. A substantial literature investigates this issue. In the 1970s, McDonald and
Stehle (1975) analyze responses from financial analysts and portfolio managers about their risk perceptions.
Despite anecdotal evidence suggesting the contrary, the study finds that historical risk measures, such as
historical beta and non-market risk, are highly correlated to the perceived risk as described by institutional
investors. In a different survey of portfolio managers, Gooding (1978) reports that risk expectations based on
company risk, beta, and standard deviation of returns are all important components of analysts’ risk analysis.
In a more recent survey of sophisticated investors including portfolio managers, Olsen (1997) reports that the
principal risk attributes appear to be the potential for a below- target return, the potential for a large loss, the
investor’s feeling of control, and the level of knowledge about an investment.
In a related survey, Olsen and Troughton (2000) document that finance professionals are ambiguity
averse. ftis aversion is important because traditional asset pricing models, such as the capital asset pricing
model (CAPM) do not incorporate this type of
ambiguity. ftis failure to incorporate ambiguity aversion may account for the relatively large discounts in
initial public offers (IPOs) and the observation that required returns on large, non-routine, capital expenditures
are set relatively high. Similar in spirit are the findings by Worzala, Sirmans, and Zietz (2000), who report that
when portfolio managers are asked to rank investment alternatives by risk and return, these managers tend to
not rank these alternatives (e.g., large cap, small cap, and bonds) consistent with the idea that risk and return are
positively correlated. fte authors suggest that this oversight may explain why actual investment portfolios are
inconsistent with theoretically suggested portfolios. Finally, Muradoglu (2002) investigated portfolio
managers’ forecasts of risk and return using business students and finance professionals in an experimental
setting, and found differences between finance professionals and students. fte latter group tends to be more
optimistic, but hedges its optimism better.
A related question is how finance professionals form their opinions of ex-ante risk. Mear and Firth (1988)
find that accounting reports are an important source of information that professionals use to infer ex-
ante risk. In another experiment, Cooley (1977) finds that portfolio managers seem to care about both the
first-order moment of returns and the second-order moment (i.e., concern with downside risk) involving
perceived risk.
DISPOSITION EFFECT
On the opposite side of the spectrum from risk-seeking behavior, risk avoidance is when investors actively
seek to remove the potential for losses in their portfolios. Whereas risk-averse investors take additional risk as
long as they are compensated with sufficient return, investors engaging in risk avoidance try to avoid risk,
regardless of the potential returns being offered. Occasionally, the divide between risk-seeking and risk-
avoiding behavior can blur. In fact, a portfolio manager may exhibit both of these behaviors in monitoring a
single security in a portfolio.
Kahneman and Tversky (1979) find that investors treat the gains and losses in their portfolio differently.
Prospect theory, which is a more popular term for the disposition effect, posits that investors weigh all gains
and losses against a particular reference point, and their behavior depends on which side of the point their position
lies. Because investors feel more strongly about losses than they do about gains, the pain experienced in a
losing investment far outstrips the utility of an equal-sized profit. ftus, the investor’s utility function takes an
asymmetrical S-shape, with gains in a concave shape above the reference point and losses forming a steep
convex shape below. Given that investors do not want to realize a loss, they may hold onto an investment
that has dropped substantially in value, hoping to recover their investment. Alternatively, investors overly focus
on avoiding losses, so they often lock in any gains and sell positive positions. fte result is that the investor
engages in risk-seeking behavior when experiencing losses and risk-avoidance behavior when experiencing
gains (Pompian 2006). ftis is known as the disposition effect, which is the desire to sell winners too early and
ride losers too long (Shefrin and Statman 1985).
Although mutual fund managers are less likely to exhibit disposition-driven behavior than individual
investors, studies report strong evidence for the disposition effect among such managers (Ammann, Ising,
and Kessler 2011). Unlike the other biases
discussed in this chapter, the consequences on the portfolio management process are not necessarily negative.
Mutual funds run by managers who have a higher disposition effect tend to have less systematic risk than
their peers (Cici 2010). Little evidence suggests a negative impact occurs on the fund’s performance
(Ammann et al. 2011). Evidence also shows that hedge fund managers show the disposition effect, particularly
when they engage in short-selling (von Beschwitz and Massa 2015) or after they personally experience a
marriage or divorce (Lu, Ray, and Teo 2015). Unlike the performance of mutual fund managers, the
performance of hedge fund managers falters as a result of this bias.
fte disposition effect is not limited to equity markets. Researchers identify the disposition effect within a
real estate investment trust (REIT), which is a professionally managed sector of the real estate market.
Specifically, a REIT is an investment vehicle that aggregates properties into an investable portfolio. Similar to a
mutual fund, a REIT is a pooled fund with shareholders who participate in the fund’s gains and losses and a
manager who decides which properties to buy and sell. In the case of a REIT, the portfolio manager is
typically the company’s CEO. Changes in the values of the underlying properties dictate a REIT’s value.Crane
and Hartzell (2010) find evidence of the disposition effect among REIT managers, particularly those who
manage smaller properties. By holding onto properties that continue to lose value and selling winning
properties at lower prices than other relative properties, the manager’s behavior has negative implications on
both the REIT and its investor base. In summary, although each portfolio manager type displays evidence of
the disposition effect, the impact of the performance differs.
GENDER DIFFERENCES
Women now play a larger investing role in U.S. households. In fact, they are the primary provider in more than
40 percent of American households, a startling increase from 11 percent in 1960 (Wang, Parker, and Taylor
2013). Within American households, the percentage of couples where women are the primary decision
maker of long-term retirement plans has more than doubled, from 9 percent in 2011 to 19 percent in 2013
(Fidelity Investments 2013). However, this trend has hit a ceiling and does not appear at the professional
portfolio manager role. Among the entire universe of U.S.-listed mutual funds, women represent only 9
percent of fund portfolio managers. Further, only 2.5 percent of all mutual funds exclusively have women
portfolio managers, and the funds that they do manage represent less than 2 percent of all mutual fund assets
(Lutton 2015). Based on these findings, the potential exists for more female managers to enter this market
and capture more AUM.
Within mutual funds, Lutton (2015) finds that funds managed by female portfolio managers perform in
line with those managed by men. Interestingly, funds with mixed- gender teams of portfolio managers fared the
best. In the hedge fund universe, empirical evidence indicates that female portfolio managers perform better
than average. From 2007 to 2015, the average women-led hedge fund generated a return of 59.4 percent,
trouncing the industry average return of 36.7 percent (KPMG 2015).
Why does this performance disparity exist between male and female portfolio managers? Jones (2015)
posits several reasons for female portfolio managers performing
better than males. fte recurring theme is that women are less likely to suffer overconfidence bias than men.
By gender, evidence shows that both males and females display overconfidence in their abilities
(Lundeberg, Fox, and LeCount 1994). However, although both genders are guilty of this bias to a degree,
men are consistently more overconfident than women in their predictions, particularly when related to
financial decisions (Barber and Odean 2001). Additionally, in the absence of certainty, Lenney (1977) finds
that women have lower opinions of their abilities than men. Following this logic, Barber and Odean note that
women display less confidence in their abilities in investing in the market than men.
Earlier, this chapter reviewed the negative consequences of overconfidence bias in the portfolio
management process. Overconfidence leads to increased trading activity, concentrated positions, and a
decreased emphasis on the downside protection of a portfolio. Jones (2015) contends that male portfolio
managers participate in each of these activities more than females, potentially explaining why only a few can
match the performance of their female counterparts. As related to overconfidence bias, Lundeberg et al. (1994)
find a difference in the confidence of predictions of men and women involving when their respective
predictions are incorrect. In contrast to men, women are more self-aware of their potentially incorrect
predictions than are men, and are less confident in their forecasts as a result. In contrast, when their predictions
are incorrect, men show inappropriately excessive confidence in their answers. fte ramifications of this
behavior on portfolio management relate to a fund’s downside protection. ftat is, female managers are more
likely than men to admit mistakes. A female portfolio manager is less afraid of capping her losses and exiting
a position from an investment that did not meet expectations. ftis enhances the drawdown protection infemale-
ledfunds and may help explain why they outperform male-led funds.
Besides overconfidence bias, Jones (2015) also suggests that one possible reason female-led funds have
return patterns that are superior to the general fund universe is that female managers are less likely to display
herd behavior. Because female managers represent such a minority portion of the portfolio manager population,
they may be less vulnerableto the pitfalls of groupthink than are their more homogenized male peers.
As the investing public further recognizes the superior track records of female portfolio managers, more
opportunities may materialize for women in the future. As the sample size of female portfolio managers
expands, the behavioral differences relative to male managers are likely to manifest themselves more
prominently. A related question is whether risk-taking behavior crosses over into other activities. For
example, do portfolio managers who like to take risks in other activities, such as skydiving or flying airplanes,
also exhibit more risk in picking portfolios? Although theoretical arguments exist in either direction,
experimental evidence suggests that risk taking does not appear to cross activities (Belcher 2010).

In the asset management world, portfolio managers occupy highly important and visible positions.
Consequently, both investors and outside stakeholders can feel shock- waves from their work. ftey must
constantly keep track of many moving parts and
quickly make adjustments. Failing to properly do so can severely damage their performance record,
reputation, and level of compensation. To fully understand the actions of portfolio managers requires
considering the behavioral biases that provide motives for their behavior.
fte overconfidence bias displayed by portfolio managers has both negative (increased trading
activity) and positive (concentrated portfolios) effects. Herd mentality can trace its roots to social behavior
and can lead in extreme cases to creating financial bubbles and crashes. Risk-taking behavior is most prevalent
in alternative asset managers, who are incentivized to seek the highest return possible because of perfor-
mance fees. fte disposition effect is prevalent among mutual fund, hedge fund, and real estate portfolio
managers, but it has differing effects on their respective performance. Lastly, female portfolio managers are
less likely to fall victim to both overconfidence bias and herd behavior, an assertion supported by their superior
performance records.
Owing to the structure of certain funds, completely removing particular biases from the mindset of a
portfolio manager is difficult. However, as long as the manager is cognizant of the presence of a specific bias
at hand, reducing the impact of the bias on the portfolio is possible.
1. Describe the primary steps of the portfolio management process.
2. Compare the structure of traditional and alternative asset management firms and identify biases that
may arise as a result of their differences.
3. Describe the disposition effect and how it affects portfolios based on an investor’s utility.
4. Contrast the different biases displayed by male and female portfolio managers and the consequences of
each on their respective portfolios.
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9
Financial Psychopaths
DEBORAH W.GREGORY
Assistant Professor
Bentley University
Introduction
Mention financial psychopaths and for many people, two pop-culture characters immortalized by
Hollywood spring to mind: Patrick Bateman, the iconic Wall Street investment banker who stars in the
1980s novel adaptation, American Psycho (2000); and more recently Jordan Belfort, the so-called and self-
named “Wolf of Wall Street” ’ (Belfort 2008), in the film of the same name (The Wolf of Wall Street
2013). Bateman’s character in the first film is purely fictional. He is a man borne of the Wall Street culture
during the 1980s, who differs from his colleagues in his proclivity for literally killing people. fte latter film,
adapted from Belfort’s memoir, depicts his lifestyle on Wall Street from the late 1980s through the mid-
2000s. It is replete with details of illegal financial deals involving corruption and fraud, drug usage, and his
extreme fluency in foul language, sexual promiscuity, and violence. Belfort’s self-depiction as a self-aggran-
dizing person apathetic to the negative consequences of his actions on others is not fiction—rather, it is a
close rendering of his actual life and character.
Does either or bothof these characters qualify as financial psychopaths? Bothwork on Wall Street and engage in
excessive drinking, drugs, general debauchery, and deceptive practices to achieve financial gain. Moreover, neither
Bateman nor Belfort cares about the effects of their actions on the people with whom they interact. ftat Bateman’s
character additionally enjoys manslaughter might mark him as a traditional psychopath, but that alone does not
answer the question: Is Bateman better described as a financial psychopath? Similarly, is Belfort really a
financial psychopath, or is he a psychopath who works in the financial sector? Another possibility might be that
Belfort is not a psychopath at all but, rather, a clinically diagnosable sociopath. Although the shared behavioral
characteristics of both men would suggest they are likely deserving of a clinical diagnosis of some form of
antisocial personality disorder (APD), determining whether either might be considered a financial psychopath
requires a deeper examination of what precisely differenti- ates a financial psychopath from all other forms of
antisocial behavioral patterns.
Away from the silver screen, other real-life former financial professionals, such as Nick Leeson of
Barings Bank and Turney Duff of Galleon Group, Argus Group, and
J. L. Berkowitz, have written exposés of their own time while embedded in the Wall Street environment
(Leeson 1996; Duff 2013). Belfort, Leeson, and Duff all worked
153
during the last part of the twentieth century, with Duff and Belfort’s tenures extending into the beginning of the
twenty-first century as well, a time when financiers were the envy of many outside the profession owing to
their ability to generate massive incomes for themselves, seemingly with ease. Leeson and Duff’s tales weave
together many of the same threads as Belfort’s—excessive and regular drug use, promiscuous sex, and
fraudulent and illicit financial dealings. Only Belfort has been called to task publicly for engaging in
“psychopathic behaviors” by the adult child of his former business associate, Tom Prousalis (McDowell
2013). fte strongest acknowledgment of Leeson’s fraudulent dealings and his hand in the demise of
Barings, a venerated, centuries-old investment bank, has been his placement on the lists of “top” or “worst”
rogue traders by multiple news organizations such as The Guardian (Hawkes and Wearden 2011) and CNN
(ftompson 2011). Duff’s behavior warrants even less public interest. His recent online publicity stresses
how he strayed while working under the influence of Wall Street, reassuring the public that he is no longer
held in its thrall by having returned to a life of normalcy (Duff 2015).
Placing aside provocative publicity purposefully designed to elicit greater book and DVD sales, a
commonality exists among all three men’s experiences working in the modern financial
trading/investment sector. ftese shared qualities suggest that the Wall Street environment has been
accepting of and even condoning behaviors viewed by the general public as psychopathic in nature. Given
this, clearly defining what constitutes a financial psychopath becomes necessary to understand these men’s
behaviors and their resultant impact on the wider financial industry and society. Once determined, the possibility
exists to investigate whether the environment of finance attracts such individuals and/or if the environment
itself encourages and shapes financially oriented psychopathic behaviors in those who remain inculcated.
Defining Financial Psychopaths

ftose working in the financial sector on Wall Street and its environs have come under extensive public and
governmental scrutiny since the financial crisis of 2007–2008. ftat the clinical term of “psychopath” has
been appropriated to apply to financial professionals in the aftermath of the crisis speaks volumes about the
depth of the global damage on all strata of societies caused by those in the financial industry. Until recently,
psychopaths were usually identified as being like Patrick Bateman—someone who acts violently by
killing and physically harming victims without any remorse for his or her actions. At no other time in
history—including the dramatic stock market crash of 1929—have financial professionals been labeled
with such a term as one usually reserves for the most violent of criminals with no moral capacity. By first
outlining the clinical indicators for classical psychopaths, it then becomes possible to establish a base- line that
leads to an explicit definition of observed behaviors constituting appropriate labeling of an individual as a
financial psychopath.
fte primary source for guidelines when making a psychiatric diagnosis and developing a treatment plan
is the classic Diagnostic and Statistical Manual of Mental Disorders, which is now in its fifth edition
(American Psychiatric Association 2013), referred to as DSM-5. fte DSM-5 classifies hundreds of mental
disorders in a system that corresponds
Financial Psychopaths 155
with that used by the World Health Organization and insurance companies. By providing behaviors and
symptoms associated with a particular disorder, clinicians are guided in formulating the most appropriate
diagnosis for an individual.
Before delving into this diagnostic checklist, noting a description of psychopaths written in plain
English is worthwhile because it helps to understand the core personality of people so diagnosed.
Robert I. Simon, a forensic psychiatrist, describes psychopaths as:
people who have severe antisocial impulses. ftey act on them without regard for the
inevitable and devastating consequences… . [T]hey are the predators among us, chronic
parasites and exploiters of the people around them… . [ftey] are unable to put themselves in
other people’s shoes, any more than a snake can feel empathy for its prey. (Simon 2008, p. 34)
In other words, psychopaths have total disregard for other people and focus solely on themselves. Although
people are naturally concerned about themselves, some have personality structures that require constant
feedback from others about how great they are in order to feel good about themselves. Psychopaths are narcissistic
to such a degree that they are harmful to those within their reach.
ftis pathological excessive emphasis on oneself is also a feature of narcissistic personality disorder, as
well as a component of Asperger’s syndrome (now subsumed under autism in the DSM-5), so care must be taken
to ensure making a correct diagnosis. What would constitute a suitable treatment plan or strategy for managing
interactions with a person displaying pathological narcissistic symptoms would be vastly different for
psychopaths than for narcissistic personalities or autistic-inclined individuals, given the wide variances in the
expectedoutcomesforeachdiagnosedpersonalitytype.
ROLE OF SUBSTANCE ABUSE

An important external factor that also needs to be considered when making any clinical diagnosis is the use
of drugs and alcohol by an individual. fte presence of any mind-altering substance can obfuscate an
accurate assessment of a person’s underlying personality attributes. Addiction of any kind must be ruled out
before making a diagnosis of psychopathy. Smith and Newman’s (1990) study of incarcerated men shows
92.9 percent of psychopaths are addicted to alcohol and 73.5 percent are addicted to drugs, which is
significantly higher than for the control group. A co-morbidity study of psychopathy and addiction by Regier,
Farmer, Rae, Locke, Keith, Judd, and Goodwin (1990) estimates 75 percent of psychopaths are addicted to
alcohol and 50 percent abuse other drugs. Different schools of psychological thought attribute this high level
of co-morbidity to different factors. At the core of the issue is the psychopathic need for constant
stimulation, which canbe met byself-medicating withalcohol anddrugs.
Although little academic literature exists about drug use in the finance industry, anecdotal evidence
suggests that it is prevalent and has been for decades (Dealbook 2007; Schuster 2009; Inside Job 2011).
Belfort, Leeson, and Duff became heavily involved with drugs, particularly cocaine, while working in the
investment/trading arena. Both Leeson and Duff did not intend to start using drugs, but found stopping
difficult once
they started participating at parties with colleagues and clients. ftis tolerant attitude toward drug use serves to
reinforce and could even exacerbate impulsive behavior, one of the hallmarks of psychopathy. In his memoir,
Duff (2013) discusses at length the impact his drug misuse had on his personal and professional life.
Some research studies examine the impact on the brain physiology of both cocaine and money.
Interestingly, functional magnetic resonance imaging (f MRI) shows that cocaine use lights up the same
pleasure centers of the brain as money (Goldstein and Volkow 2002). Further study reveals that cocaine
addicts register activity in the pleasure centers of the brain from smaller amounts of monetary rewards than
non-cocaine addicts (Goldstein et al. 2003). In other words, non-cocaine addicts do not receive the same
type of pleasurable experience for smaller amounts of monetary rewards as those who are addicted. fte
consequence of intensive cocaine abuse, even after periods of abstinence, includes “more marked deficits
in … executive control, visuo- spatial abilities, psychomotor speed and manual dexterity” (Rogers and
Robbins 2001, p. 252). For those working on Wall Street, these actions portend a future with diminished
cognitive capacity, impairing a person’s ability to make sound deals.
Additional studies that compare the brain physiology of psychopaths to the areas of the brain affected by
drug use show a similar dysfunction occurring in two identical regions of the brain. ftose two affected areas
are related to the ability to be socialized and to “frustration-based aggression” (Blair 2005, p. 885). ftis
finding again underscores the need to be circumspect when making a psychopathic diagnosis, as the addict
may still have moral and empathic abilities intact—traits that will be lacking in the psychopathic
individual.
PSYCHOPATHY
Contrary to what most non-clinicians might expect, the DSM-5 does not include a separate entry for
psychopaths. Instead, the diagnosis is grouped under the classification of APD, which is a broad category that
also encompasses sociopathy and psychopathy. To diagnose APD requires a pervasive life-long pattern of
problematic behaviors originating before the age of 15 and relates to the person’s disregard for other people and
other sentient beings. fte primary features—of which only three must be met to diagnose— include
deceitfulness, impulsivity, irritability and aggressiveness, reckless disregard for the safety of self or others,
consistent irresponsibility, and lack of remorse (American Psychiatric Association 2013).
An often-overlooked feature of psychopathy is the charming nature of those with the diagnosis; such
behaviors are known to catch otherwise well-informed clinical practitioners and others off-guard. fte
response to uncovering a heinous deed performed by a previously known-to-be charming individual is often
disbelief: “No way! He [or she] is such a great person.” fte atrocity of the deed is subsequently discounted
because of the dissonance between the outer behavior of the “charming” person and the observed result of his
or her heinous action. ftis discord between perception and reality frequently enables psychopathic
individuals to continue behaving with impunity until they are literally caught in the act. Even then,
psychopaths might avoid major repercus- sions for their actions owing to the dissonance between their
charming public persona and the severity of their actions.
Robert D. Hare, a Canadian psychologist, developed the Hare Psychopathy Checklist (PCL) in the late
1970s based on his work with violent criminals and later revised it in the 1990s. Both long and short
versions are available. Professionals use the PCL to ascertain whether a person is psychopathic rather than
simply antisocial. Hare and Paul Babiak, his co-researcher on corporate psychopathic behavior and a
management- oriented psychologist, estimate that approximately 1 percent of the general population is
psychopathic (Babiak and Hare 2006). ftis statistic compares with 3 percent given by the DSM-5 for the
incidence of antisocial personality disordered individuals occurring in the general population. According to
Babiak and Hare (p. 19), those who lie on the sociopathic spectrum can be differentiated from psychopaths by
the sociopaths’ “sense of right and wrong based on the norms and expectations of their subculture or group.”
fte distinction between these two types within the APD classification emphasizes the awareness of
group cultural norms by a sociopath, but not so for psychopaths. ftose individuals who are following
group norms in the financial sector cannot thus be deemed psychopathic purely for adhering to practices
that their firm and/or colleagues condone. Because most financial employees are aware of group cultural
norms, the possibility arises that some people in the financial sector could be sociopathic, provided they
meet the other criteria for APD. Certain behaviors might not be considered aberrant within the subculture
of finance, whereas those same behaviors might be deemed antisocial by society at large. Excessive or extreme
drug use can serve as an example: Within the general society, such behaviors would be considered deeply antiso-
cial with the potential for great harm. In the Wall Street culture of the last two decades of the twentieth century,
such behavior might not have been considered aberrant, provided a person’s financial performance
was unaffected.
fte DSM-5 emphasizes that “criminal behavior undertaken for gain that is not accompanied by the
personality features characteristic of this disorder [psychopathy]” (American Psychiatric Association 2013,
p. 663) does not provide sufficient grounds for making a psychopathic diagnosis. fte mental health
professionals who developed the DSM-5 are aware that behavior resulting in criminal charges does not
necessarily signify the presence of severe psychopathology. Rather, what the DSM-5 does stress is that the
observed psychopathic personality traits be, “inflexible, maladaptive, persistent and cause significant
functional impairment or subjective distress” (American Psychiatric Association 2013, p. 663). For example,
when considering whether a financial professional could be considered a financial psychopath owing to his
manipulating financial markets in such a way that it results in enormous monetary gains for himself or his firm,
such a behavior alone is an insufficient basis for a psychopathic diagnosis based on DSM-5 criteria. Instead, the
underlying personality structure of the individual is the key to the psychopathic portion of the diagnosis,
notthefinancial venue.
Technological advances in both brain imaging and genetics have enabled further identification of
psychopathic individuals based on physiological and DNA characteristics, rather than relying on behavioral
characteristics alone. Results from studies using functional MRIs to scan brain physiology indicate the regions
of the brain responsible for indicating the presence or absence of specific behaviors associated with
psychopathy. For example, the center in the brain responsible for empathy does not light up in the brains of
psychopaths (Kiehl, Smith, Hare, Mendrek, Forster, Brink, and Liddle 2001). A more recent study by
Motzkin, Newman, Kiehl, and Koenigs (2011) confirms
that the ventromedial prefrontal cortex, which controls emotions such as empathy and guilt, does not
communicate properly with the amygdala, which is responsible for fear and anxiety, in psychopaths. Finally,
Glenn, Raine, Schug, Young, and Hauser (2009) find that increased activity in the prefrontal cortex, which is
the region of the brain that provides cognitive control to offset emotional responses to moral dilemmas,
increases in psychopaths when making emotional moral decisions. ftis activity is positively associated to the
“impulsive lifestyle” and “antisocial” factors of psychopathy. Glenn et al. (p. 910) note a possible implication
of their findings is “afailure to link moral judgment to behavior with appropriately motiving emotions.”
fte genetic component for psychopathy is currently recognized as being somewhere between a third and a
half, with the remaining proportion attributable to environmental or other causes. Epigenetics, the study of
genetics and environment, shows that genes contain coded information and also a switch or “promoter,” cues
in the cell itself, as well as the outer environment, activating the promoter and hence the information in the
gene. ftus, if someone has a high genetic propensity toward psychopathy, whether it becomes prominent
depends on internal and external environmental cues (Roessler 2012). Because cues are not one-time
switches, an affected individual could theoretically become psychopathically “activated” when placed in an
appropriate environment that elicits and rewards psychopathic behavior.
ftese new tools enableidentifying psychopaths insettings other than where violent crimes have occurred or
in prisons. Physiological tests are confirming earlier behaviorally based assertions that psychopaths can be
more frequently found among those who are well educated and held in high regard by society, such as doctors,
lawyers, and businesspeople (Smith 1978; Hare 1993; Stout 2005; Babiak and Hare 2006). Boddy (2010)
focuses on the incidence of psychopathy among Australian managers and discovers more in financial
service companies and the civil service. Both Hare and Simon individually suggest that Wall Street is a prime
location for finding nontraditional psychopaths. Simon (2008, p. 44) states “if one wants to study
psychopaths, one should go to Wall Street. Sometimes it is hard to tell the successful person from the
psychopath.” In fact, Hare states that the stock exchange itself would be his preferred location to study
psychopaths outside the prison environment (Dutton 2012, p. 112).
DIAGNOSING IN THE BUSINESS ENVIRONMENT

Together, Babiak and Hare (2006) developed a more specific diagnostic tool that focuses on identifying
noncriminal psychopaths in the general corporate sector. fteir Business-Scan 360 (B-scan 360) is not in either
clinical or commercial use at the time of this publication, but is being employed in research studies with
businesses to test its validity. From their research, Babiak and Hare identified three distinct subsets of corporate
psychopaths: (1) corporate manipulators or cons (more passive), (2) bullies (more aggressive), and (3) puppet
masters who display both manipulative and bullying behaviors. fte latter category is likened to the dangerous
violent criminal psychopath known through the DSM-5. Manipulators and bullies both display the same traits
as their corresponding criminal psychopathic counterparts.
Using results from administering Hare’s PCL short version to 200 high-potential executives, Babiak
and Hare (2006) report that seven, or 3.5 percent, of the executives
fit the psychopathic profile using the short version of the PCL. Contrasting this with the general incidence of
psychopathy in the population at large of 1 percent, this group of executives exhibits a higher rate of
psychopathy. Babiak and Hare also note that only two of the 200 executives fell in the bully category and none in
the puppet master category. ftis finding suggests that the proportion of violent, psychopathic individuals who
are employed in the corporate sector is on par with the national proportion. fte majority of psychopathic
corporate executives are known as “passive” psychopaths. Earlier research (Cleckley 1988/1941; Babiak and
Hare 2006; Simon 2008; Brown 2010) shows that this type of psychopath is less likely to be involved in legal
conflicts resulting from their manipulative behavioral patterns and if they are prosecuted, receive little or no
punishment for their offenses.
According to Hare (1993), what renders white-collar crime so appealing to psychopathic
personalities is the array of high-payoff opportunities coupled with historically limited punishments if they
are caught. Instead of a possible maximum of 20 years for his role in defrauding banks of $23.5 million, the
authorities eventually sentenced John Grambling Jr. in 1987 to six months of jail time. Hare (1993, p.
104) identifies Grambling as a psychopathic individual and comments that this case:
is a model for using education and social connections to separate people and institutions
from their money without using violence… . [T]he deceit and manipulation of these
individuals are not confined to simply making money; these qualities pervade their dealing
with everyone … including family, friends, and the justice system.
fte financial damage inflicted by Grambling was extensive, but the punishment meted out was light. Not much
has changed since Grambling’s time. As reflected in the clean- up phase of the financial crisis of 2007–
2008, the authorities sentenced very few financial executives to time in prison for their role in defrauding
the public. Apuzzo and Protess (2015) report on a September 9, 2015, memo issued by the Department of
Justice changing their approach to dealing with financial malfeasance. According to Apuzzo and Protess (p.
1), the new rules confirm what the public had already observed, namely that “the Justice Department often
targets companies themselves and turns its eyes toward individuals only after negotiating a corporate
settlement. In many cases, that means the offending employees go unpunished.”
A job or occupation that provides a high-payoff opportunity is insufficient for a psychopathic individual
to be successful. fte position also needs to make the best use of psychopathic behavior traits. For example, a
person who likes to bully others and kill people may do well in a setting that includes warfare. In such a setting, the
person’s behavior would be lauded and not condemned. Hare (1993, p. 109) notes that occupations most
likely to attract psychopathic personalities are those in which, “requisite skills are easy to fake, the jargon is easy
to learn, and the credentials are unlikely to be thoroughly checked”; additionally, “the profession also places a
high premium on the ability to persuade or manipulate others.” ftese criteria fit positions available on Wall Street
and other financial sector work environments. Lewis (1989) describes young male traders working in investment
banks during the heydays of the late 1980s in language that conveys many accepted behavioral characteristics.
Lewis (p. 9) first allows that they are “masters of the
quick killing,” a phrase that brings psychopaths to mind. Lewis (p. 61) then attributes the young traders’ ability
to make great quantities of money quickly, despite their lack of experience, to being “less a matter of skill and more
a matter of intangibles—flair, persistence, and luck” when talking with potential buyers on the telephone.
Successful traders possess certain attributes, many of which match psychopathic traits. For example, the
psychopathic trait of impulsivity may display in a successful trader as a willingness to take high degrees of
risk in a situation when others think it would be foolish, such as when the market has taken an unexpected
plunge. However, the non-psychopathic trader may in fact be well prepared and waiting for such an oppor-
tunity to present itself. In actuality, he is not acting impulsively, but from the outside perspective it may
appear so. Differentiating between the two is not as simple as watching their outer behaviors.
Trading skills evolve over time and an outer personality develops to present to the world at large. fte
purpose of this outer personality or persona is to enable a person to engage in the world, and may or may not
accurately reflect the trader’s true inner personality. fte trader in this case may not want people to know
what he is actually intending and may present with charming banter that is totally unrelated to the trading
opportunity closest to his heart. ftus, this fictitious trader displays two more psychopathic traits: deception
and a charming persona. Based on the guidelines given in the DSM-5 earlier, these characteristics are all in
service of obtaining financial gain and are not life-long, inflexible traits. fte trader is not pathologically
psychopathic.
GENDER BIAS
ftus far, the discussion of psychopathy has focused solely on men. ftis bias exists in the literature because
women are underrepresented in both the disorder and the financial sector, so very little has been written about
them in this regard. Researchers are finding that psychopathy displays differently in women (Kreis and Cooke
2011; Wynn, Høiseth, and Patterson 2012), which may account for the lower percentage present in the gen-
eral population. Kreis and Cooke (p. 644) describe a “prototype” female psychopath as “manipulative,
deceitful, self-justifying, self-centered, domineering, detached, uncaring, antagonistic, insincere, and self-
aggrandizing.” Many of their descriptors reflect the traditional psychopath checklist developed with male
subjects. Like her male counter- part, she also lacks empathy. Yet, as Kreis and Cook (p. 614) note, the prototype
female psychopath also could be “more manipulative, emotionally unstable, and have a more unstable self-
concept.” Women, however, show a distinct preference for using relationally oriented techniques, such as
flirting, to abuse their victims (Forouzan and Cooke 2005). Given no obvious physical abuse is generally
associated with sexual promiscuity or flirting, pinpointing the more aggressive psychopathic behavioral trait
in women is more difficult than for men.
Financial Psychopaths
A possible shape and face can now be formulated for a potential financial psychopath. Although many
perceive psychopaths as charming individuals, they display a variety of
pervasive, life-long anti-social traits, such as deceitfulness, narcissistic orientation, consistent irresponsibility,
and a lack of remorse. A subset within the general psychopathic designation is the corporate psychopath. Most
corporate psychopaths are primarily passive types who do not display obvious violent behaviors, as would
be found in the general psychopathic population. ftey tend to exploit and manipulate others for their own
gain, and in so doing, they behave in such a way as to avoid becoming entangled with the legal system.
Because finance is part of the business environment, a financial psychopath may be considered a subgroup
of corporate psychopaths.
First, a financial psychopath is far more likely to be male. ftis observation is due partly to the presence
of fewer women who are currently in positions to control finances owing to prevailing sociocultural biases,
and also owing to the lower incidence of women diagnosed as psychopaths overall. Psychopathic women
tend to use their sexu- ality to manipulate people. As a result, they would be far less likely to be caught holding
the “smoking gun” of financial manipulation and instead be censured for their sexual behaviors.
Second, violence is not a normal or primary attribute of the corporate psychopath. However, it cannot be
ruled out completely. Babiak and Hare’s (2006) research indicates that a very small minority of bully and
puppeteer corporate psychopaths use physical violence when manipulating others.
Differentiating between the corporate and financial psychopath narrows the focus to the resources over
which each has control. fte primary responsibility of corporate executives is the strategic management of a
company, not the handling of money belonging to other people on a short- or long-term basis. fte exception to
this is the chief financial officer (CFO), who can be considered eligible for the financial psychopath
diagnosis. However, McKinsey & Company notes (Agrawal, Goldie, and Huyett 2013) that not all CFOs
have backgrounds in finance. Accounting and general MBA backgrounds are more prevalent, but a
change has occurred since 2009. Approximately one-third of CFOs hired to “grow” a company have had
Wall Street careers in investment banking and related sectors. ftus, the proportion of CFO financial
psychopaths may very well be much smaller than for corporate executives in general, with the potential for an
increasing trend in certain segments.
Trust has been placed in financiers of all types to honor their implied or explicit fiduciary duty to manage
that money wisely. When others perceive financial professionals as violating that trust by not acting prudently on
behalf of clients, and instead taking care of their own financial needs first, this should sound an alarm.
Furthermore, if investment professionals are unremorseful and callous about financial outcomes from their
dealings, particularly if the outcomes are negative, then a key psychopathic feature has become apparent.
ftus, distinct and separate from the corporate psychopath, a financial psychopath is a predator who ruins
the lives of others through activities involving financial transactions; this person is emotionally detached,
narcissistic, and shows no remorse, perhaps even taking pleasure in the destruction of the lives of others. His or
her outer demeanor may be charming. Tobe considered a financial psychopath also requires meeting the basic
criterion from the DSM-5—doing harm to others must be a pervasive, life-long pattern, not isolated to
when adulthood is attained and having access to financial resources. Recognizing that in early childhood money
is not an easily controllable instrument for a
child, infliction of physical or emotional pain to others without accompanying remorse would need to be
present. Incorporating the findings from epigenetics that environmental cues may trigger underlying
psychopathic tendencies, DNA testing may be necessary for confirmation if no early pattern of inflicting harm
to others is otherwise evident.
Instead of using guns and other weapons of destruction to kill, financial psychopaths use the tools of their
trade—computers and financial transactions—to purposefully harm others. Financial psychopaths are not
limited by geography because they do not need to operate locally. In fact, financial psychopaths have the
ability to inflict more harm to a greater proportion of the population globally, without resorting to physical
violence, because they require no personal relationship with intended victims and can carry out damage
anonymously. Moreover, no blood needs to be spilled—any damage can be inflicted from arm’s length. As
with other passive types of psychopaths, financial psychopaths are less likely to become entangled with the law
and might escape discovery and punishment for their crimes.
IDENTIFYING FINANCIAL PSYCHOPATHS

Based on the preceding discussion, Bateman’s character in American Psycho can be classified as a traditional
psychopath. Although he happens to work in the financial industry, according to this working definition he is
not a financial psychopath. Belfort, by contrast, does not present as a classic psychopath. Whether his
personality is best described as a financial psychopath or as a person who works in the financial sector and
displays sociopathic tendencies needs further clarification.
To find other financial practitioners who have exhibited behaviors that might indicate they are financial
psychopaths requires in-depth investigation into their lives and actions. fte media have highlighted many
financial professionals since 2007 for fraud and mismanagement of money. Few have been prosecuted. One
high-profile case was Bernie Madoff, accused of running a Ponzi scheme that defrauded investors of billions
of dollars over decades. Diane Henriques spent hours interviewing Madoff in prison and concluded he was
psychopathic. She found him to be charming and not the least remorseful for what he had done. Without
formal clinical training, Henriques (2012) had followed the guidelines in the DSM-5 and formulated a
diagnosis.
Madoff’s case illustrates the ease with which someone in the right situation with the appropriate
connections and tools can take money from others. Another person inad- vertently caught in the fallout from the
mortgage securitization debacle is Lee B. Farkus, former chairman and owner of Taylor, Bean & Whitaker
Mortgage Corporation (TBW), a mortgage-processing firm based in Ocala, Florida. Farkus also used
financial transactions and took advantage of low-grade computer technology to make enormous sums of
money while defrauding banks, government agencies, and homeowners. When his firm was shut down in 2009,
TBW’s books showed a portfolio valued by the Federal Home Loan Mortgage Corporation, known as Freddie
Mac, at more than $51.2 billion, but no real assets backed up the paper. fte failure of TBW badly damaged the
economy of Ocala, Florida, as TBW had been a major employer that paid relatively well. Gregory (2014)
details Farkus’s background and subsequent behaviors using financial instruments and transactions to
perpetrate his crimes.
Farkus’s profile more closely corresponds to the description of a financial psychopath outlined in this chapter
than does Madoff. However, both men were culpable of wreak- ing havoc on the lives of people they knew—
as well as countless others with whom they had no relationship—simply by using financial transactions,
enabled by low-grade computer technology.
Emergence of Psychopathy in
the Financial Environment
In the aftermath of the financial crisis of 2007–2008, the general public worldwide became informed
through media stories about the activities of financiers in the period leading up to the crisis. Most people did
not understand the financial instruments or strategies that financial practitioners used to leverage returns, but the
general public did comprehend that average people were now suffering. ftey attributed the cause of their pain
to the actions taken by those affiliated with Wall Street and its environs. Forgotten were the immediately
preceding years of record increases in 401(k)s and other retirement plans, as well as the meteoric rise in
housing prices that increased household wealth and homeownership rates.
Financial practitioners suddenly became pariahs. Across the globe, they had devoured people’s
dreams of stability and future financial security through their greed. What caused even more outrage was the
perception by the general public that financial professionals did not appear to be suffering to the same extent. In
fact, many practitioners seemed to be benefiting from the crisis and making money and taking care of them-
selves, which is a narcissistic quality of psychopaths. fte majority of observers outside Wall Street perceived
the attitude of these professionals toward the damage they had incurred to be callous and uncaring, which are
both psychopathic qualities. As Gapper (2012, p. 13) notes, “the culture of the trading floor is remarkably
immune to shame.” fte response of many in the financial sector to allegations of imprudent behavior was
evasive of accepting responsibility for causing global harm. Consistent irresponsibility is yet another
psychopathic trait. ftese incongruent perceptions of the behaviors engaged in by financial professionals are
indicative of a lack of agreement over what constitutes acceptable and expected behavior when involved with
professional money management.
fte general public expects those in the financial sector who are tasked with managing money on behalf of
others to do so in a prudent and responsible manner. In short, they are expected to act as fiduciaries. Many
other individuals engaged in the financial sector do not act in a fiduciary capacity, and as such, do not have the
same responsibility to the average person. From the viewpoint of the general public, all these financial prac-
titioners fall under the same umbrella. Differentiating one from the other is difficult as an outsider. Given the
hostility and resulting lack of trust that emanated from the fallout of the financial crisis, the term “financial
psychopath” was coined in an effort to capture the despicability of the actions of certain financiers whose
actions bore the hallmarks of psychopathy.
Until 2008, the media portrayed investment practitioners who had been caught manipulating financial
markets as “rogue traders.” Jérôme Kerviel of BNP Paribas and Nick Leeson of Barings Bank serve as prime
examples of this classification. From the outside, their actions could be construed as simply not following the
written protocol of their respective banks. fte resulting financial turmoil from their actions was restricted to
losses among large and well-funded banks, although Kerviel’s actions had the possibility of inflicting
severe damage to the general financial system, given the size of his original position (Matlack 2008). fte
average person, however, saw no direct effect on his or her 401k or bank statement.
Conversely, smaller scale financial scams have been in existence since recorded history, with cautionary
tales to warn people to be careful about where and with whom they trust their life savings. Con artists and
swindlers are commonly applied terms within the financial sectors to denote people who are untrustworthy
in handling others’ money. No term so pejorative or personally pathological as “financial psychopath”
existed until 2008. fte expression itself suggests no possible redemption. It infers that these particular financial
professionals should be removed from society for the safety of all, as is the case for traditional psychopaths. Yet,
for centuries, swindlers of all sorts have been involved with financial scams. What is different about thistime that
provoked the emergence of a new label? Was it the size of the meltdown? Was it the attitude of those who were
accused of causing the problem? Was it fear of financial annihilation and lack of control over future
resources on the part of the average citizen?
IDENTIFYING KEY CHANGES IN

THE FINANCIAL ENVIRONMENT
Many facets of the financial environment have changed since the 1980s. Most of these changes are not brought
to public awareness unless a negative event occurs that is broadcast in the general media, such as the Flash
Crash of 2010. fte flash crash occurred during the afternoon of May 6. U.S. share and futures indices went
into a seemingly inexplicable tailspin and fell 10 percent in a matter of minutes. Stock indexes, such as the
S&P 500, Dow Jones Industrial Average, and Nasdaq 100, collapsed and rebounded very rapidly. fte short-
lived plunge raised questions about whether trading rules had failed to keep up with markets that now
handle orders in milliseconds.
fte biggest factors from the past 40 years that have influenced the investment/trading sectors of finance are
advances in technology and computing ability. fte ripple effects of these rapid advancements reach far into the
regulatory arena and how the markets function, as well as the type of person employed in the financial industry.
fte impact in each of these areas has incurred consequences, some of which could not have been easily predicted.
Taken together, a new financial environment evolved that has allowed for a change regarding who is operating in
the sector, resulting in psychopathic-like behaviors being condoned in a desire to maximize return on investment
usingfastertechnology.
Overarching the impact from technological advances has been the shift in the approach to the
economic environment within which financial practitioners operate. According to Chandler (1994),
“industrial capitalism” defines the period from 1945 to 1980, a time during which the Northern Hemisphere
was rebuilding from the ravages of World War II. Financial markets were instrumental in helping to reallocate
capital from
investors to companies that were establishing themselves in peacetime. Relational skills between financial
professionals and individuals at the helm of corporations were paramount to solidifying deals. Physical
assets underlay much of the financing required. fte financial markets were physical locations where traders and
brokers met face-to-face to make deals and discover information—again, relational skills were critical to being
successful. Because people met regularly and worked together in close physical proximity, those who were
psychopathically inclined could not sustain a façade that would enable them to maintain “normal” everyday
interactions with the same people. Less opportunity was thus available for a financial psychopath to be
successful over the long term, as behaviors were more closely monitored by peers.
During this time period, a new, modern theory of finance was also introduced that would have
resounding implications for decades to come. Modern portfolio theory (MPT) and the efficient markets
hypothesis (EMH) both originated during this era, as did the concept that the goal of the financial manager
is to maximize shareholder wealth by maximizing the value of the firm. Another major contribution to
financial theory during this period was the capital asset pricing model (CAPM). One of its basic assumptions,
as with many economic models of the time, was that all participants act in an economically rational manner.
Taken together, these theories helped to shape not only how people approached markets but also the type of
person who would succeed financially. Logical, analytical people who could spot inefficiencies and take
advantage of them before they were no longer available did well. fte processing speed of computers was slow
enough and markets were not as electronically connected. Enough time was available to discover mispriced
assets and make profitable trades before other market participants would notice the mispricing and arbitrage it
away, returning markets to an efficientstate.
By 1980, the pace of the markets had quickened with the advent of faster technologies, along with a
loosening of regulations that governed the markets. Neal (1993) describes this time period as the start of
“financial capitalism,” which lasted until 2008. Financial firms began to focus more on how they could
profit from these changes rather than on providing capital where it was needed. fte most sought after
employees became those with superior mathematical and computer skills, who could effectively write
trading programs to take advantage of the rapid computer speeds now available. Technology-driven
platforms provided new venues for trading, circumventing the old, more relationally based exchanges
with higher fees and slower processing times. Financial markets of all kinds across the globe became more
intertwined in this fast- paced electronic network.
During this phase, U.S. workers became responsible for their own retirement accounts with the
introduction of defined contribution retirement plans. Whether they manage the money themselves or rely on a
financial professional, the ability for almost all workers to fund their retirement now depends on their
personal ability to invest in the financial markets. Before this time period, average individuals did not
directly interact with Wall Street unless they chose to participate in the market for investment or speculative
reasons. Investment professionals managed company-sponsored pension plans, known as defined benefit
plans. Employees would be told how much they would be receiving when they retired. Most workers did not
understand where or how a financial professional would invest money earmarked for retirement funds; they
simply
knew how much they could expect to receive when they retired. Vesting periods became increasingly
important. A vesting period is the length of time someone has to stay with a company before being eligible to
receive pension benefits. With the change to defined contribution plans, average citizens became far more
aware of how much their personal financial life was inextricably linked with activities on Wall Street. Later,
they would understand that the financial markets were the provinces of financial professionals who may or
may not be working in the best interests of all people.
fte financial theories that had been developed during the period of industrial capitalism continued to be
refined during the next 30 years. For example, Lo (2005, p. 39) furthered the EMH with his adaptive markets
hypothesis, based on the assumption that “individuals act in their own self-interest,” as well as rationality.
Simply because people act rationally and in their own best interest does not imply they make decisions that are
not damaging to the greater society. To the contrary, the outcome of Lo’s evolutionary- based model that the
richest survive, lends support to the contention that individuals in the financial sector who embrace the
tenets of this model may be narcissistic and predatory in nature.
Risk management became more prominent with further development of the option pricing theory (OPT)
made possible by the advances in computing technology. Investment and speculation in derivative
instruments became widespread, relieving the need for tangible, physical assets as proof of ownership. Many
financial instruments became disconnected from the physical form they had assumed for millennia, thus
enabling the less scrupulous and more psychopathically inclined individuals to thrive in this new
environment.

ftis brief synopsis of key changes indicates that the professional financial environment has been
transformed from the more relational, personally connected milieu that existed for many centuries. fte
enhanced speed with which information is delivered globally and ingested into trading strategies that are
carried out in nanoseconds has shifted the ages-old objective of maximizing returns into a pure numbers
game. Individuals seeking to maximize returns for themselves or their firm, regardless of what happens to other
participants, can inflict more damage (whether intentional or not) to a wider swath of global economies, in a
shorter time than previously. ftis environment offers abundant opportunities for financial psychopaths to be
successful. Additionally, the possibility exists of hiding a disruptive internal psyche structure behind a façade
of polished respectability and social decorum, which makes exposing and prosecuting financial psychopaths
more difficult. fte power that accompanies control of large sums of money further exacerbates this
problem.
fte two potential financial psychopaths identified earlier, Madoff and Farkus, differ greatly from the
Hollywood depictions of Bateman and Belfort, both of whom have been held up as Wall Street psychopaths.
Both Madoff and Farkus escaped public detection and prosecution for years. fte impact of their financial
misdoings affected a much wider range of people in all walks of life. Only through chance coincidences was
either discovered. Had they been able to continue, the damage would have been even greater.
Despite now being able to clearly differentiate a financial psychopath, the problem remains that any type
of passive psychopath functions in society in such a way as to avoid prosecution. Rarely are the more
insidious psychopaths caught and prosecuted. Instead, less powerful and influential individuals in the financial
sector, many of whom are not psychopathic and are not personally responsible for the most egregious financial
crimes, bear the brunt of any investigation and face prosecution.
1. Identify the distinguishing characteristics of a traditional psychopath.
2. Explain how traditional and financial psychopaths differ.
3. Discuss the key changes in the economic and financial environment that facilitated an increase in the
psychopathic-like behavior exhibited by financial professionals.
4. Explain why correctly identifying financial psychopaths is important.
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Part Three
FINANCIAL AND INVESTOR

PSYCHOLOGY OF SPECIFIC PLAYERS
10
The Psychology of High Net
Worth Individuals
R E B E C C A L I - HU A N G
Wealth Advisor
Introduction
ftis chapter explores the economic and psychological aspects of private wealth and the practice of wealth
management from a holistic perspective. It focuses on the investor psychology and investment behavior of
individuals or households with more than
$1 million in investable assets, commonly known as high net worth individuals (HNWIs). HNWIs, or
simply the wealthy, constitute 0.7 percent of the world’s adult population, but they own 45.2 percent of
global wealth, as of 2015. fte wealthy also control most of the world’s power. According to Piketty (2014, p.
277), the top percentile of wealth holders occupies a very prominent place in any society and “structures the
economic and political landscape.” Deaton (2013, p. 212) observes that “the rapid growth in top incomes can
become self-reinforcing through the political process that money can bring.” Stiglitz (2015, p. 91)
describes the political landscape in the United States as “wealth begets power, which begets more wealth.”
Regardless of ideological persuasions and political motivations, observers and stakeholders agree that the
current economic system favors the top income earners and wealth holders.
ftis chapter highlights the classical economic frameworks of wealth creation. It also examines recent studies
and empirical findings on wealth accumulation and distribution that have increased the policy debate. fte
distribution of income and wealth is widely discussed globally and has increasingly become politically charged
and partisan in policy debate in the United States, where average wealth has increased but not equally over the past
50years.Astatementsuchas“thetop1percentofAmericansown40percentofthe nation’swealth” is in stark
contrast to “the bottom 80 percent own only 7 percent” and the phrase “the disappearing middle class.” fte global
trend is similar in that the share of income and wealthgoingtothose at the verytophasrisen sharply overthe last
generation, marking a return to a pattern that prevailed before World War I. fte world’s top 1percentof
wealthholdersnowowns half ofall householdwealth(CreditSuisse 2015). HNWIs havevaried psychological
andbehavioral responses tothe inequity debate and anti-rich rhetoric among populists. In the United States,
HNWIs increasingly direct their investment according to their personal beliefs or family values, and they
play a
173
174 FINANC IAL AND INVESTOR PSYCHOLOGY OF SPECIFIC PLAYERS
large role in public life through philanthropy and politics. At 1.4 percent of gross domestic product (GDP), “tax
breaks with a social purpose” are the largest in the United States where private spending on social welfare is four
times the average in advanced economies (Organization for Economic Cooperation and Development
2014). At the pinna- cle of the wealth pyramid, billionaires Bill Gates, Warren Buffett, and Mark Zuckerberg
pledge the majority of their wealth to tax-advantaged charitable entities founded, funded, and directed by
themselves or their representatives. ftey urge their cohorts to invest their wealth in public good in their own
visions, such as “advancing human potential and promoting equality” advocated by Zuckerberg, not that of
the governments. At the other end of ideological spectrum, self-claimed billionaire and political outsider
Donald Trump runs the most powerful government. Ironically, Trump’s promise to use his own private wealth
to acquire political power has become part of the populist appeal to his economically disadvantaged
supporters. Despite the debate that philanthropy and political activism both serve to return yet more power to
the super-wealthy, driving social impact holds broad appeal for a cross-section of HNWIs globally, who
are increasingly focused on leaving a legacy by giving back to society, as well as generating a financial return
on investment. fte holistic returns on cultural, environmental, social, and political causes are gaining
importance in wealth management. fte trend toward helping HNWIs address their personal aspirations and
social-impact needs is part of a broader wealth management industry transition toward giving holistic wealth
advice.
HNWIs are prone to behavioral biases and judgment errors in decision-making processes. fteir
behaviors and attitudes toward the future cannot be encapsulated in a single, inexorable psychological
parameter. fte luck of inherited wealth (for some) aside, HNWIs have not all won the evolutionary lottery in
possessing the genetic traits of the perfectly rational, utility-maximizing, unemotional Homo
economicus, which is the economic behavioral role model for Homo sapiens. Even though case studies
and legends abound for entrepreneurs and investors who become self-made millionaires or billionaires by
exploiting their fellow human’s “irrationalities” and market inefficiencies, HNWIs are humans with biases, not
a homogenous group of rational agents as prescribed by traditional economic model. Research in
behavioral finance has uncovered a lengthy list of psychological biases, but offers few tools for investors to
correct the persistent errors in their investment decision-making process. An age-old strategy to overcome
cognitive illusions and biases is to avoid the groupthink. Wealth managers add value by bringing objective
but goal-based inputs to the decision-making process.
HNWIs are inundated with choices in every decision they make, from consumption and investment
of private and public wealth as stakeholders and policy makers, to family life and social impact as private
and global citizens. fteir decision choices for any given goal, in the pursuit of wealth, health, and happiness,
depend on personal motivations and satisfactions, family expectations and limitations, peer influences, and the
social, cultural, and institutional environment. Financial investment is but one component in the “well-lived
life” portfolios and its importance varies depending on the life stages of HNWIs. Investment in publicly
traded securities as consumer of financial products is not the primary contributor of initial wealth accumulation
for most HNWIs. Stanley (2001) reveals that only about one in eight millionaires indicated that “investing in the
equities of public corporations” was a very important factor in explaining their economic success. Many
HNWIsaresuccessfulintheirownfieldsofexpertise,butfew
The Psychology of High Net Worth Individuals 175
can distinguish luck from skills in investing in public financial markets. Chhabra (2015) finds that concentration
and leverage are often the building blocks of substantial private wealth. Nevertheless, investment in diversified
markets and tax-efficient strategies are essential for HNWIs to preserve and generate income from wealth.
Since these investors experienced the brunt of the financial crisis of 2007–2008 and other market “failures,”
HNWIs’ needsfor a full spectrum of wealth management services havegrown.
Wealth managers increasingly focus on HNWI behaviors, and they translate the significance of
current events in terms of clients’ needs and goals. With a behavioral focus, wealth management practice is
transitioning from portfolios and markets to individuals and objectives, and from products and transactions to
advice and relationships. With competition from technology-based new entrants, not only transactions but
also basic asset allocation and investment services are becoming increasingly commoditized. Wealth managers
adapt to the new landscape by focusing on the human aspect of the advisory relationship and reorienting their
role toward delivering goals-based financial planning and addressing HNWIs’ holistic investing needs.
Many anecdotes and much literature are available with examples of spectacular financial ruin as the
result of poor investments or conspicuous consumptions on an individual level. Yet, on a collective and
long-term basis, HNWIs are the most successful in both preserving and growing their numbers and total
wealth in absolute and relative terms, especially in the countries and regions with the highest economic
growth in recent decades. As Piketty (2014) shows, the rate of return of capital has outpaced the rate of
economic growth, and the rate of return is persistently higher for the HNWIs than that for the less wealthy. He
credits the concentration of wealth and the service of private wealth managers as the primary sources of the
outperformance for HNWI.
Economic policies continue to shape the global wealth landscape. Asset allocation and human capital
investment are the most important long-term factors determining overall investment returns and wealth
accumulations. Led by the United States and now China, global trade and economic growth have been the
main forces in creating, and to some extent reshuffling, the wealthy class in the twenty-first century. In the
United States, monetary policy set by the Federal Reserve and the tax code by Congress directly affect financial
asset prices and real incomes, especially those of HNWIs and corporations, and they implicitly project
the outlook for economic output, rate of return on investment, and income and wealth distribution. To the
extent that the wealth of HNWIs and corporate profits are intertwined, and the size of wealth correlates with
the power to influence policy, the collective investment behavior of HNWIs resembles that of corporations
and institutional investors more than that of retail investors.
As a case in point, HNWIs with institutional-size wealth are “activist” investors whose investment
decisions move the price and affect the return of publicly traded securities (Cohan 2013). fte investor
psychology of an activist investor who has “skin in the game” and faces known risks is by institutional design
more forward-looking, calculating, and profit-maximizing than that of a price-taking individual investor who
faces uncertainties. fte beneficial tax treatment and legal structure of limited liability corporations further
insulate HNWIs from individual behavioral biases such as risk aversion. HNWIs sometimes exhibit
investment behavior that is more rational than that of corporations or organizations managed by agents with
distorted incentives. Examples are Warren Buffett’s “vote of confidence” investment in Goldman Sachs and
HNWprivate
investors’ cash buying of bank-owned properties amid the widespread foreclosures between 2008 and
2010.
fte first section of this chapter defines HNWI and introduces the players and markets of the private
wealth management industry. Drawing on the industry’s HNWI and wealth manager surveys, as well as
empirical research, the next section identifies the trends related to HNWI attitudes and investment behaviors,
shifting demographics of private wealth, and evolving expectations and needs of HNWIs. fte next section
then highlights relevant behavioral finance research and applications to lay a foundation for the holistic
investing and goal-based wealth management practice trend. With the third section, the chapter takes an
economic view of behavior and wealth by presenting the macro factors that affect HNW investor behavior on
a long-term and aggregated basis. fte fourth section presents the theoretical framework and empirical
findings of economic researchers of different historical times and ideological persuasions, and the final
section summarizes and concludes the chapter.
The World of HNWI and Wealth Management

Wealth has varied connotations and subtexts in social, economic, political, and historical contexts. As a
source of finance for future consumption, wealth is one of the key components of the economic system.
fte wealth management industry is primarily concerned with the financial assets of wealthy individuals
and households.
WEALTH AND HNWI DEFIN ED

Although wealth has various definitions, one involves net worth. As defined in the World Wealth Report
(Gapgemini Consulting and RBC Wealth Management 2015), net worth is synonymous with investable
assets excluding one’s primary residence, collectibles, consumables, and consumer durables. High
net worth (HNW) refers to an individual or household with more than $1 million in investable assets.
However, some private banks use a higher net worth threshold to denote HNWIs. Also, depending on the
market segmentation of a wealth manager or surveyor, the ultra-high net worth (UHNW) designation
usually refers to net worth above $30 million. When accounting for illiquid and nonmarketable assets such as
real estate and land, physical commodities, art and collectibles, business ownerships and partnership interests,
a HNWI’s total wealth is often higher than net worth.
On a global basis, having $1 million net worth puts an individual in the top 1 percent, as HNWIs
account for 0.7 percent of world’s adult population. In the United States, being in the top 1 percent club
takes $380,000 annual income (Dewan and Gebeloff 2012) or $8.4 million net worth (Gebeloff and
Dewan 2012) to qualify, according to a 2012 demographic profile of the top earners and wealth holders by
the New York Times. Income and wealth are different measures, but they often go hand in hand. fte
U.S. tax code is more favorable for investment income than for wages, especially for those already at or
near the top at either category. Although the top earners (based on census data) and top wealth holders
(based on Federal Reserve data) are not exactly the same group of people, Dewan and Gebeloff report that
the
two measures overlap by half, and “most 1 percenters were born with socioeconomic advantages.”
In contrast to the top 1 percent, those with a net worth between $1 and $5 million are considered
entry-level HNWIs in the United States and are often referred as the “millionaires next door.” With data
spanning 20 years from the 1970s, Stanley and Danko (1996) contend that wealth accumulation is more often
the result of a lifestyle of planning, perseverance, discipline, and hard work, instead of consumption, inheri-
tance, advanced degrees, or even high intelligence. Wealth earned through entrepreneurship and hard work,
not through inheritance or aristocracy, is at the core of the American ideal of dynamic capitalism.
Paradoxically, China’s HNWIs today, a group almost entirely self-made, fit the characteristics describing their
American counterparts two decades earlier. Although the commonsensical rule of wealth accumulation does
not change fundamentally in the “new economy,” social media algorithms exacerbate human cognitive biases
from the self-selection of “likes” and the like-minded to the systemic overexposure of outliers.
WEALTH MA NAG EMENT : PLAYERS AND MARKETS

Wealth management is a relationship between an advisor and an individual or household. A financial
advisor is the general title for the profession, whereas a wealth manager or private banker is often someone who
works exclusively with HNWIs or UHNWIs. Wealth managers are also broadly defined as financial
institutions serving HNWIs with banking, investment, lending, and other financial services.
In Western Europe, wealth managers are commonly known as private banks and take the form of
onshore boutiques, onshore universal banks, or offshore banks. Private banks generally observe multi-
jurisdictional fiscal rules. Historically dominated by Swiss banks, offshore banks offer secrecy, low-tax
jurisdiction, and protection against political instabilities. Two prominent jurisdictions for offshore banking are
Switzerland and the Cayman Islands. Starting in 2007, Switzerland lost its “tax haven” and secrecy appeal to
wealthy U.S. taxpayers as a result of the enforcement of the Internal Revenue Service (IRS) rules for offshore
assets of U.S. citizens held at Swiss banks. Paradoxically, a few states in the United States are becoming
offshore jurisdictions for the private wealth of non-U.S. residents who seek secrecy and political stability
(Drucker 2016).
In Asia, private wealth management is extremely fragmented, combining offshore private banking hubs in
Hong Kong and Singapore with different sizes of onshore markets. Asian HNWIs have a relatively strong
risk appetite for alternative and offshore assets, as shown by the surge in cross-border real-estate investments
made by wealthy Chinese. In response to the upswing in new wealth particularly from China and India, the ex-
Japan Asia market is growing rapidly, while the new Chinese onshore market alone is expected to
account for more than half of all growth in ex-Japan Asia. With high saving rates, wealth management in China
is still largely a product-driven market spurred by the proliferation of bank wealth management products offered
by large state- controlled banks. Myriad shadow banks are filling the wealth management demand gap and
becoming a source of private lending and unregulated investment vehicles in China. In the United States, wealth
managers are well regulated and have a variety of business models including full-service broker-dealers
(wirehouses), independent broker-dealers
(IBDs), independent Registered Investment Advisers (RIAs), private banking, and multi-family offices
(MFOs). Broker-dealers cover the broadest client base and are regulated by Financial Industry
Regulatory Authority (FINRA). fte largest national broker-dealers are integrated with an investment bank or
commercial bank or both, and offer a large variety of services, such as research, investment advice, order
execution, retirement planning, and lending. Financial advisors employed by or affiliated with broker-
dealers serve the mass-market affluent (i.e., those with investable assets between
$250,000 and $1 million) to HNW clients. ftey are compensated on a fee basis (by a percentage of client
assets under management, or AUM) or commission basis (by transactions). Financial advisors are often
licensed with relevant state regulators to sell insurance products such as viable life and annuities, and long-term
care insurance.
RIAs offer investment advice on a fee-only basis and are regulated by the Securities and Exchange
Commission (SEC) or relevant states. In the RIA model, client assets are “held away” with a third-party
custodian that often offers its own discount brokerage and investment services to do-it-yourself clients.
Although many independent financial advisors focus on insurance products with investment components such
as variable life and annuities, and provide financial planning to less affluent clients, some investment advisors
specialize in managing portfolios of securities for HNWIs and institutional clients. Since the financial crisis
of 2007–2008, RIAs have gained market share in both the number of practitioners and client AUM.
Private banks in the United States usually operate as the private wealth management subsidiaries of
integrated universal banks, as independent trust companies, or as MFOs. Private banks typically offer a full
range of services, including investment, family office, wealth structuring, and trust and philanthropy services
to HNWIs with investable assets of more than $5 million. By contrast, some boutiques cater exclusively to
private foundations or UHNWIs with investable assets of more than $30 million. fte private bank model
emphasizes personalized long-term relationships between the relationship manager (i.e., the private banker or
client advisor) and the client. Client investment portfolios are generally managed on a discretionary basis
based on client-specific investment policies developed by a team of specialists, including portfolio managers
and trust officers. Private banking relationships often last for decades and cover several generations.
A multi-family office (MFO) is a commercial enterprise that typically caters to UHNWIs with a
net worth above $50 million. MFOs provide various family office services, including investment, tax, trust,
estate planning, and foundation management. Some MFOs offer lifestyle and personal services such as
concierge and household staff management. In the United States, MFOs can operate as RIAs, trust
companies, accounting or law firms, or other combinations depending on their niches.
GLOBAL HNWI AND WEALTH TREND

Since 2005, substantial growth has occurred in the number of HNWIs and total wealth. Gapgemini
Consulting and RBC Wealth Management (2015) provide the following statistics about HNWIs and total
wealth. Global HNWI wealth is forecast to cross $70 trillion by 2017, growing at an annualized rate of 7.7
percent from the end of 2014 through 2017. Wealth is concentrated in a similar pattern at the top among
HNWIs: UHNWIs—those with more than $30 million of investable assets—make up only 1 percent of
all HNWIs, but account for roughly 35 percent of HNWI wealth. UHNWIs are also major drivers of global
wealth growth, as wealth has been growing at higher rates with higher concentration. Geographically,
Asia-Pacific and North America drive the majority of growth. In 2015, Asia-Pacific overtook North
America to become the region with the largest HNWI population at 4.69 million, compared to North
America’s 4.68 million. fte top four HNWI markets—the United States, Japan, Germany, and China—
account for the majority (60.3 percent) of global HNWI population and also generate the majority (67
percent) of growth in 2014, with the greatest increase occurring in China (17 percent) and the United States (9
percent). Together, the United States and China drive more than half the global HNWI population growth. fte
two most populous countries with high economic growth rates, China and India, are expected to be the
biggest engines to drive global HNWI growth during the next few years.
CHANGING NEEDS OF HNWIs

HNWIs have complex financial needs and they do not all want to be involved in the daily management of
their investments. Instead of an investment product, a new generation of HNWIs today wants a higher level of
advisory experience and a relationship with their wealth managers that focuses on their concerns, goals, and
dreams. fte advice required by HNWIs today is more comprehensive than the transactional and product-
centric relationship that was prevalent decades ago, when financial advisors were synonymous with stock
brokers.
CHANGING LANDSCAPE OF WEALTH MANAGEMENT

Many forces are changing the wealth management landscape. ftese include more diverse clients with
more complex needs, new technology-based advisory service entrants, increasing regulations, and
evolving global markets; and these are just the tip of the iceberg. As basic asset allocation, investment
advisory, and risk-profiling services become commoditized, the value proposition of wealth managers is
transitioning from security selection and investment management to goals-based financial planning and a
holistic wealth management model characterized by personal relationships and customized advice. HNWIs
are offered integrated financial planning and wealth management advice and solutions encompassing
investment, lending, tax and estate planning, insurance, philanthropy, and succession planning, both for
businesses and for personal wealth.
Goals-based wealth management with holistic investing has now become an industry standard,
particularly among younger HNWIs. Goals-based wealth management differs from traditional wealth
management by taking into account the short, intermediate, and long-term personal theme of HNWIs and
helping them prioritize their goals holistically. Success is measured by how clients are progressing toward
their personalized goals against the broad range of needs and concerns versus the traditional approach of
measuring performance based on relative returns against benchmark market indices.
CHANGING ATTITUDES AND INVESTMENT

BEHAVIORS OF HNWIS
One important theme of holistic investing is philanthropy. Although tax and estate incentives are
integral to philanthropic planning, the majority of HNWIs express the desire to drive social impact and
give back to society as part of a holistic life goal. According to Gapgemini Consulting and RBC Wealth
Management (2015), 92 percent of HNWIs identify some level of importance to driving social impact,
which refers to making a positive impact on society by way of thoughtful investments of time, money, or
expertise. HNWIs are looking to their wealth managers for support and advice, such as setting goals and
defining their personal role in their areas of interest, identifying and structuring investments, and measuring
the outcomes of their social impact efforts. Wealth managers respond to these needs by providing access to a
team of experts such as tax and philanthropy specialists, and educating their clients with seminars and discus-
sions, which in turn drive marketing and prospecting opportunities for the sponsoring wealth managers.
Cash and credit are two major themes related to HNWI asset allocation behavior (Gapgemini
Consulting and RBC Wealth Management 2015). Regional and demographic differences in risk
attitudes aside, overall HNWIs keep larger amounts of cash in their investment portfolios than what are
optimal for their lifestyle needs and risk profiles. Yet, HNWIs are more inclined than the less wealthy
investors to use credit or leverage. Nearly one-fifth of HNWIs globally use leverage, and 60 percent consider it
a key criterion in choosing a wealth manager. Younger, wealthier, and emerging markets HNWIs—the
demographicgroupswiththehighestgrowthrate—oftenhavethegreat- est interest in using leverage.
VALUE OF WEALTH MANAGEMENT ADVICE

An open question is whether and to what extent financial advisors add value. Researchers have produced mixed
findings on the retail side that cover smaller investors. A study by Foerster, Linnainmaa, Melzer, and Previtero
(2014) of 800,000 Canadian retail investors finds that financial advisors tend to encourage retail investors to
accept more risk, which in turn increases investors’ earning expectations. Although this increase in risk may
raise yield, the extra yield tends to be offset by the 2.5 percent in fees that clients pay to their advisors.
Beyond risk, the study finds that advisors’ stock picking and market timing have no impact on returns.
Nevertheless, as Foerster et al. (p. 5) note, “households display a strong revealed preference for using
financial advisors, which suggests that many expect the benefits to outweigh the costs.” fte authors posit
that financial advisors add value by mitigating psychological costs, such as reducing anxiety rather than
improving investment performance, and clients benefit from their relationship with the advisor, specifically
through financial planning and advice on savings and asset allocation.
On a higher wealth level, the majority of HNWIs are satisfied with their financial advisors. According
to Gapgemini Consulting and RBC Wealth Management (2015), HNWIs are mostly satisfied with the
service they receive from their wealth managers, giving them a satisfaction rating of 72.5 percent globally.
Not surprisingly, HNWIs
who have been with their primary wealth managers for the longest time period (at least 21 years) are the
most satisfied, registering a satisfaction rating of 84.3 percent. Regionally, HNWIs in North America are the
most satisfied (82.1 percent), followed by those in Latin America (75.6 percent) and Asia-Pacific
excluding Japan (72.7 percent). Among HNWIs who place high importance on their wealth needs, the
average satisfaction level with the ability of wealth managers to fulfill these needs is 86.4 percent. To earn
their HNW clients’ satisfaction, wealth managers must understand HNWI concerns and risk tolerance, deliver
strong investment performance, and provide fee transparency.
A U.S. survey of HNWIs reveals overall satisfaction consistent with that found by Gapgemini
Consulting and RBC Wealth Management (2015). fte Spectrem Group (2015) reports the level of
satisfaction varies by occupation: 86 percent of senior corporate executives and 74 percent of business
owners are satisfied with their advisors. Regarding fees, 55 percent of HNWIs are comfortable with the fees
they are paying to their advisors. In fact, 33 percent of HNWIs are unconcerned about the fees they are
paying as long as their assets are growing.
Why are HNW investors more satisfied with their wealth managers than retail or the less wealthy investors
are with their financial advisors? fte size of the wealth explains most, if not all of the difference. First, HNWIs
pay lower fees as a percentage of AUM because of management-fee break points. Other than alternative
investments such as hedge funds or private equity, a $1 million or higher managed account is rarely charged a
fee of 2.5 percent by regulated wealth managers in the United States, thanks to the prevailing competition.
Except for the hourly fee–based financial planners, the vast majority of wealth managers are not directly
compensated for hours worked; larger accounts are generally more profitable for the same amount of routine
work. Second, HNWIs receive higher-quality service because fee-based compensation ties wealth managers’
incentives with that of their clients—to grow assets. Wealth concentration in fewer accounts creates
economies of scale that improve the overall productivity of wealth managers, whose higher service
output—measured qualitatively—is reflected in the higher satisfaction rate from their HNWI clients.
Are wealthy investors more satisfied because they get higher returns? Surprisingly, investment
performance is not the top priority, but is rated third in HNWI overall satisfaction ratings (Gapgemini
Consulting and RBC Wealth Management 2015). Does wealth concentration increase the rate of return on
wealth? Financial market participants contest any definitive answer to this question. Piketty (2014) finds
that wealthier investors obtain higher average returns on their capital than less wealthy investors, despite
conventional economic models that assume the return on capital is the same for all owners, regardless of the
size of the wealth. Ideological debate notwithstanding, the primary reason behind the long-term higher return is
that the wealthy have greater means to employ wealth management consultants and financial advisors, not
because they take more risks. Evidence by Piketty shows the first explanation “more important in practice”
than the second.
Wealth managers hardly expect an unsolicited endorsement from an economist, much less a
proponent of global tax on wealth. Yet, many HNW clients do expect tax and estate planning advice if
Piketty’s findings prompt government interventions through progressive taxation and other wealth
distributional measures. As Piketty
(2014, p. 294) notes, “Europe in 1914–1945 witnessed the suicide of rentier society, but nothing of the sort
occurred in the United States.”
Rentiers are those who live off income from property rather than labor. ftey do not get good press in
continental Europe, where the members of a “rentier society” are regarded disapprovingly as property owners
who “do nothing” to create value for society to earn their profits—rent, in economic terms. In the United States,
however, to live off one’s own saving and wealth—regardless of the solvency of a government sponsored social
safety net—is exactly what retirement planning is all about. Not only is private property ownership revered but
earnings from investments are generally taxed at lower effective rates than wages. fte complexity of tax code further
advantages those who employ professional services to plan and prepare their tax returns. Specifically, Scheiber
and Cohen (2015) find that the wealthiest Americans “pay millions” for such services to devise sophisticated tax
strategies to “save billions.” Unless mandated by clients, wealth managers do not discriminate against wealth by
ideology. Based on Piketty’s (2014) observations, wealth managers have done well by their HNW clients, especially
in the United States. Benjamin Franklin’s famous two certainties in life—death and taxes— substantially affect
privatewealthand areprofessionallymanagedfor manyHNWIsthroughtaxandestateplanning.
Behavioral Themes
Behavioral economics has gained relevance as a field seeking to explain and predict investment and
consumption behavior. Behavioral economists observe that humans, when left to their natural devices, are
not good at making optimal decisions as prescribed by traditional economic models. ftis section covers
representative themes of HNWI investment behavior.
TRADITIONAL VS. BEHAVIORAL FINANCE

fte traditional finance model, drastically simplified, is based on the existence of a perfect market for capital,
in which each owner of capital receives a return equal on the highest marginal productivity available in the
economy. On investor psychology and behavior, the standard rational-choice model assumes that investors
are completely rational, emotionless, self-interest maximizers of expected utility with stable preferences.
Furthermore, it assumes that investors are a homogenous group with identical information sets and
expectations.
In contrast, behavioral finance recognizes real human behaviors and focuses on cognitive biases and
heuristics. In a behavioral model, real-world investors make decisions based on a rationality bounded by
personal values and preferences. ftey also select satisfactory options rather than optimal ones, and they have
emotions. Behavioral finance combines psychology with financial theory to understand the interplay between
markets and human emotions, personality and reason.
Complete coverage of the cognitive biases and heuristics recognized by behavioral finance requires more
than a book. However, this subsection selectively describes the most relevant features for HNWI investment
behavior and the wealth management advisory relationship.
THE EMOTIONAL INVESTORS

Investors are affected by psychological biases and are subject to conscious emotions in their decision
making. Psychologists observe physiological and psychological symptoms that point to varying levels of
stress during the decision-making process. Mann, Janis, and Chaplin (1969) observe marked increases in
stress, as indicated by a sharp increase in heart rate when a decision maker is required to choose between
alternatives, both of which are known to have some unpleasant consequences. Janis and Mann (1977) find
that the intensity of that stress depends upon the perceived magnitude of loss the decision maker
anticipates. fte stress is a pathological factor for a human being’s loss aversion—the tendency to weigh
potential loss more heavily than potential gain—as diagnosed by behavioral economists.
Financial markets are vastly more complex than a controlled experiment. Investors’ decisions under any
market conditions are seldom limited to two alternatives with known risks. Investors often deviate from
long-term objectives and from making optimal investment decisions when they encounter fluctuations
along the investment journey, especially during periods of market exuberance or turmoil. ftey leave large
portions of wealth in “safe” instruments such as cash during a bear market, are overconfident and overactive
during a bull market, and inevitably capitulate to a strong psychological tendency to buy high and sell low.
Although many investors can recite the basic rules of investing, among which “to be fearful when others are
greedy and greedy only when others are fearful” (Buffett 2005), few could implement this advice if left to their
own devices. Buffett captured the phenomenon amid the market turmoil in 2008: “So wild things happen in
the markets. And the markets have not gotten more rational over the years. ftey’ve become more followed. But
when people panic, when fears take over, or when greed takes over, people react just as irrationally as they
have in the past.”
fte irrationality results because human beings, programmed as they are with emotions and unconscious
motives, as well as limited cognitive abilities, seldom can approximate a state of emotional detachment
when making investment decisions. Much anxiety arises from emotional responses independent of risk.
Investment decision making has emotional costs that standard investment risk-return analysis does not take
into account. fte empirical evidence suggests that investors’ need for emotional comfort costs the average
investor around 3 percentage point a year in lost investment return (Barclays 2015) and two-thirds of total
return in comparison with a market index for the 30-year period between 1984 and 2013 (Chhabra
2015).
fte additional cost of stress is a loss of time, productivity, and life quality. Recent research in behavior
finance challenges the traditional assumption that investors want the best risk-adjusted returns. According to
those findings, what investors really want is the best returns they can achieve for the level of stress they have to
experience. Barclays (2015) finds that actual investor returns are improved by focusing on achieving the best
anxiety-adjusted returns, which are the best possible returns relative to the anxiety, discomfort, and
stress they have to endure during the volatile investment journey.
Unlike the emotionless Homo economicus, investors—especially HNWIs—practice “emotional
inoculation” by outsourcing the part of the investment decision-making process that induces stress. ftis
explains why some successful wealth management advisors characterize their value to their HNW clients as
modeled after psychologists
and therapists, and this is also why the low-fee emotionless technology-driven robo- advisors have not
replaced (and unlikely will fully replace)human advisors.
HUMAN VS. ROBO- ADVISORS

Among the major disruptors of the wealth management industry are automated advisory services,
commonly referred as virtual advisors or robo-advisors, which eschew personalized advice in favor of
algorithm-based asset allocation and basic investments in low-fee index and exchange-traded funds (ETFs).
Robo-advisors tap into the growing prominence of digital and self-service tools, which are of particular
interest to younger or less wealthyindividualswho areattractedto theconvenienceandlowcost.
Human advisors are skeptical of their virtual competitors, noting that robo-advisors forgo the personal
relationships that enable wealth managers to build trust and deliver tailored advice and solutions. Although the
value of robo-advisors has yet to be tested in a full market cycle, automated advisory services do not appear to be
a passing trend and HNWI interest in them has been underestimated. Globally, 48.6 percent of HNWIs say they
would consider using them, compared to only 20 percent of wealth managers who think HNWIs would
consider using them. fte HNWI propensity to use an automated service is particularly high in Asia-Pacific
(excluding Japan) and Latin America, whereas interest is lowest in North America (Spectrem Group
2015).
Why does this difference occur? In the United States, online investment services are not yet built to
address the depth and variety of financial planning needs and concerns of investors who have a fair
understanding of the relative value of human vs. robo- advisors. Among the 6 percent of investors of the
abovementioned 20 percent who do use robo-advisors, only 47 percent say they are satisfied overall with these
virtual advisors. In contrast, the 90 percent of investors who use a human advisor report an 85 percent
satisfaction rate (Spectrem Group 2015).
TRUST HEURISTIC
Heuristics are decision-making shortcuts that save time and money in a world of uncertainty. Investors
employ the trust heuristic in their investment decision-making process. For example, they assume that
portfolio managers are relatively better informed in a world of complex and often misleading information.
Emotional and intuitive variables affect the trust heuristic (Altman 2014). According to the Spectrem Group
(2015) survey of U.S. HNWI and wealth managers, HNWIs put higher trust than the less wealthy retail
investors in their financial advisors. Instead of past investment performance or standard professional
credentials, honesty and trustworthiness are the primary factors that HNWIs consider when selecting new
financial advisors. ftis does not suggest that professional credentials and competence do not matter in these
investors’ minds. In fact, the performance, capabilities, and reputations of the wealth management firms and
those of the individual financial advisors are the necessary but not sufficient parameters in the initial advisory
relationship selection process. Constrained by limited time and resources for due diligence, investors employ
the trust heuristic, assuming that the category leaders are among the fittest in a highly regulated and
competitive market, and that the advisors referred by family members or friends and acquaintances are
among
the best available to them. Indeed, referral is by far the most common source of new relationships in the
wealth management industry. Aside from standard quantitative performance measures, trust is the main
qualitative measure in a wealth management relationship that can survive the setbacks in investment
performance or market downturns. HNWIs use proxies for trustworthiness, defining trust as a financial advisor’s
looking out for clients’ best interests, being proactive in contacting clients to inform important developments,
charging reasonable fees that reflect the value of the services provided, making no mistakes inthe workthey
perform, and admitting when theyare wrong. fte HNWI’s trust in a financial advisor tends to increase with age.
Although the size of the wealth is not a major factor in how HNWI investors define trust as it relates to working
with a financial advisor, there are marked differences by occupation. Business owners are the most likely to
define trust as mistake-free work, whereas corporate executives aremostlikelytodefineitasanadvisor’s
looking outfortheirbestinterests(Spectrem
Group 2015).
INVESTOR PSYCHOLOG Y: NUDGE OR PRED IC T?

Investor psychology is an emerging field that uses the psychology field to understand how investors make
decisions. Devotees of the rational ideology of traditional finance criticize investor psychology for merely
exploring abnormality and biases, but failing to deliver robust tools or “cures” to improve investment
decision making en masse. Psychologists find that the assumptions about human behavior, including
perfect rationality and homogeneity, are false. In essence, the conflict between behavioral and traditional
finance is misplaced. Each has a different approach and has different accomplishments in studying human
behavior: behavioral finance proponents use an evidence-based approach to observe and “nudge,” whereas
traditional finance advocates apply normative models to predict.
Reality emerges from the interactions of many different agents and forces, including blind luck, often
producing large and unpredictable outcomes (Tetlock 2006). Like weather forecasts during a Northeast U.S.
winter, normative finance models are not always accurate but are relied on for guidance; for example, they
help an Uber driver decide whether to work, or a hardware store manager how many snow shovels to stock. In
contrast, the behavioral analysis can help a ski resort price its season tickets regardless of snowfall outcome,
and it explains why neither the Uber driver nor the hardware store should raise prices during a storm based
simply on thefundamental supply-and- demand principle (ftaler 2015).
All investment decisions are forward-looking. fte idea that the future is unpredictable is undermined
every day by the ease with which the past is seemingly explained. fte illusion that people understand the past
fosters an overconfidence in their ability to predict the future (Taleb 2010). As Kahneman (2011, pp.
224−225) concludes, “to maximize predictive accuracy, final decisions should be left to formulas,” because
complexity more often than not reduces validity and “humans are incorrigibly inconsistent in making
summary judgments of complex information.” fte simplified and unrealistic assumption about individual
rational behavior has provided the analytical power to enable classical finance to predict aggregated human
investment behavior in systematic ways. Imperfect as the existing models and algorithms are, they are the
best available and are the most useful for investment decision making involving the future.
The Economic Way of Looking at Behaviors

fte behavioral basis described here is central to modern economics. Economic theories and models explain
how the market works, how wealth is created and distributed, and how people allocate resources that are scarce
and have many alternative uses. According to Sowell (2014, p. 4), “economics studies the consequence of
decisions that are made about the use of land, labor, capital, and other resource.” Economics has evolved as an
intellectual genus and is anything but a settled body of thought. In a holistic sense, economics embraces many
principles. Yet, an analytical framework entailing mathematics is firmly embodied in modern economic
analysis.
To an economist, mathematical tools are just the means to study human behavior, which remains too
complex to perfectly fit any computational models developed by humans. Intuitive assumptions about
behavior are only the starting point of systematic analysis.
THE WEALTH OF NATIONS IN THE EIGH TEENTH CENTU RY

Many regard Adam Smith as the father of modern economics. Smith established the behavioral basis for
economic analysis in The Wealth of Nations, initially published in 1776. According to Smith (1976, p.
449), political economy is “a branch of the science of a statesman or legislator.” He postulated that the division
of labor allows the greatest production, and that economic activity, income, and wealth are morally
beneficial to human. fte fundamental explanation of human behavior, in Smith’s view, is found in the
rational, persistent pursuit of self-interest. In the preface to the 1976 bicentennial edition of The Wealth of
Nations, Stigler (1976, p. xi) notes that modern economists label the drive of self-interest as
“utility-maximizing behavior.”
HUMAN CAPITAL IN THE TWENTIETH CENTURY

Becker (1964) “humanized” economic analysis by challenging the assumption that the prospect of selfish and
material gain was the sole motivation for individuals. Instead, Becker asserts that a much richer set of values
and preferences drives behavior, including altruism, loyalty, and spite. He assumes that individuals try as best
they can to anticipate the uncertain consequences of their actions. Forward-looking behavior may still be
rooted in the past, though, because the past can exert a long shadow on one’s attitudes and values. Actions are
constrained by time, income, cognitive capacities, and opportunity costs determined by the actions of other
individuals and organizations. Different constraints are decisive for different situations, but the most
fundamental constraint is limited time. “So while goods and services have expanded enormously in rich
countries,” Becker (1996, p. 3) argues that “the total time available to consume has not. ftus wants remain
unsatisfied in rich countries as well as in poor ones.” Becker’s forward-looking statement has predictive
accuracy on consumer behavior toward “unanticipated” new
products, such as the Apple watch that came to market after his time; that is, gadgets- rich consumers remain
unsatisfied.
Becker (1964) pioneered human capital analysis on investments in education, skills, and knowledge. His
economic approach interprets marriage, divorce, fertility, and relations through the lens of utility-
maximizing, forward-looking behavior. Human capital analysis starts with the assumption that individuals
decide on their education, training, medical care, and other investments in knowledge and health by weighing
the benefits and costs of each. Benefits include cultural and other nonmonetary gains along with
improvement in earnings and occupations, whereas costs depend mainly on the forgone value of the time
spent on these investments.
Even though Becker’s analysis incorporates the rising value of time owing to economic growth, tuition
and medical care costs were not nearly as important factors in the original benefit versus cost analysis. To
approach schooling as an investment rather than as a cultural experience was considered “unfeeling and
extremely narrow” before Becker developed the human capital analysis, which was considered controversial
when he presented it in the 1960s.
One of the conclusions of the human capital analysis was not intuitive at the time, but has become
axiomatic: families gain from financing all investments in the education and skills of children that will yield a
higher rate of return in aggregate than the return on savings. ftat is, both parents and children are better off when
parents make investments in their children, as that yields a higher return than savings invested for bequests.
CAPITAL IN THE TWENTY- FIRST CENTURY

A half century after Becker’s introduction of human capital theory, Murphy, Piketty, and Durlauf (2015) explain
different causes and solutions to inequality in a panel discussion that was brought together by the Becker
Friedman Institute and held on the University of Chicago campus.
Murphy focused his analysis on human capital, which “you take home with you when you go home at night.
It affects your skill at raising children, at maintaining your own health, at running your financial life”
(Murphy et al. 2015). Returns on human capital go up when demand for skills grows faster than supply. People
respond to the incentives when demand outgrows supply, invest more in their human capital, and are rewarded
with even higher wages. ftis effect is especially important in an intergenerational context, where the skills and
resources of high-income families beget greater human capital investment in their offspring.
For HNW families, resources allocated for human capital investments are higher than the less endowed
in both absolute and relative terms. Besides more financial resources, their higher investment allocation
in human capital includes better input and more involvement in education, access to superior schools,
interactions with comparably advantaged peers, and other institutional advantages, such as the contro-
versial legacy admissions at elite institutions that perpetuate intergenerational human capital accumulation.
fte human capital investment premium is empirically evident in the United States, where highly skilled
individuals enjoy rapid and sustained income growth, whereas the unskilled have stagnated since the mid-
1970s. fte incentive of advantaged investors to acquire even more human capital has driven up the price of
higher education sharply. According to Bloomberg (2012), college tuition and fees have surged 1,120 percent
since such recordkeeping began in 1978, four times faster than the increase in the consumer price index
(CPI).
Evidence by Murphy and Topel (2014) shows that human capital investment responds to an
increase in the “price” of skills. ftey observe that skill-biased technical change or other shifts in economic
fundamentals, such as a decline in the price of physical capital, drive the steadily rising demand for skills.
Greater incentives to invest in human capital, owing to a higher price of skills, also raise the returns for using
human capital intensively, which in turn increases the returns on investment. ftat is, the “able” investors benefit
disproportionately from an increase in the relative scarcity of skilled labor because they are well positioned to
exploit the resulting higher returns on human capital investment and utilization. Increased skill utilization
causes yet a higher rate of return for the most skilled. ftis human capital concentration effect is similar to
that of wealth concentration. Murphy concludes that market fundamentals favoring more skilled workers
are the driving force behind rising inequality, to which he proposes policies that encourage or enable the
acquisition of skills as a solution (Murphy et al. 2015). Focusing on physical capital for causes, Piketty’s
analysis of inequality does not take full account of human capital. Piketty (2014) posits that the global rate of
return on capital depends on many technological, psychological, social, and cultural factors, which result in
a return of roughly 4 to 5 percent, which is distinctly and persistently greater than the economic growth rate
of 1 percent. Piketty takes this observation to be a historical fact, not a logical necessity by existing rational
economics models which would predict the increased competition on capital accumulation to cause global
return on capital to fall until equilibrium emerges. He believes that the difference between the rate of return on
capital and economic growth can explain the logic of wealth accumulation that accounts for a very high
concentration of wealth. Piketty, a French economist, contends that the inequality has nothing to do with market
imperfections, and will not disappear as markets become freer and more competitive. He concludes that
wealth concentration,instead ofthe scarcityof skilled labor,isthe cause of inequality, andhe
proposes a global tax on wealth.
fte difference in the analyses and policy recommendations between French economist Piketty and his
American counterparts is telling: different sets of data and different ways are available to interpret the same
data, even among the economists who use the same set of mathematical tools and hold the same basic
assumptions about human behavior. Economists speak different languages, literarily and figuratively, to
interpret the past and attempt to predict the future. As Yogi Berra is reputed to have said, “It’s difficult to make
predictions, especially about the future.” fte most likely future will be in the vision of those who can
“predict” the past convincingly.

HNWI attitudes toward the future and their investment decisions not only determine their individual life goals
on a micro level but also disproportionally affect the economy and the collective investment return on a
market level. Economists’ past predictions imbedded in investment decisions and their policy
“prescriptions,” right or wrong,
intended or not, have shaped the present wealth and power landscape. Sound economic analyses of the past
continue to influence investors’ attitudes toward the future.
Wealth concentrations and the scarcity of skilled labor have contributed to the institutional advantages of
HNWIs, including higher returns on physical and human capital investments. Although not immune to
heuristics and cognitive biases on the individual level, the investment behavior of HNWIs resembles that of
corporations and institutional investors more than that of retail “consumer” investors. HNWIs are
collectively successful in both growing their numbers and growing total wealth. Empirical studies show that
the rate of return on capital has outpaced the rate of economic growth, and the rate of return is persistently
higher for HNWIs. Some credit the service of wealth managers for this collective and long-term success.
Wealth has increased disproportionally at the very top during the past 50 years. Additionally,
inequality has driven global policy debate. HNWIs are increasingly focused on driving social impact, as
well as on generating a financial return on investment. fte holistic returns on health, culture, environment,
as well as their social and political causes, are gaining importance in wealth management.
fte wealth management industry increasingly focuses on investor psychology and behavior of HNWIs. As
basic transaction and asset allocation has become commoditized, the value proposition of wealth managers is
transitioning from products and markets to goals-based financial planning and a holistic wealth management
model characterized by personal relationship,frequenthumaninteraction, and customizedadvice.
1. Define HNWIs and discuss the demographic trend.
2. Identify the key players in the wealth management industry in the United States.
3. Discuss the different assumptions and approaches of behavioral vs. traditional finance.
4. Describe goal-based wealth management and holistic investing.
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In H. Kent Baker and Victor Ricciardi (eds.), Investor Behavior: The Psychology of Financial Planning and
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11
The Psychology of Traders
DUCCI O MARTELLI
Assistant Professor of Finance
University of Perugia
Introduction
Professional traders differ from retail traders. Professional traders often possess privileged information and
knowledge, which allows them to take advantage of market imperfections. In contrast, retail traders (i.e.,
individual investors who buy and sell securities for their personal accounts) are usually noise traders who lack
the means and skills to exploit market anomalies. According to the efficient markets hypothesis (EMH), the
price of each asset essentially moves in a random pattern as prices rapidly incorporate new information (Fama
1970). ftus, professional traders can use arbitrage strategies to realign current market prices to the real value of
securities. Such profitable behavior for professionals is at the expense of retail traders, who eventually leave the
market because of recorded losses or become sophisticated investors by learning from their past mistakes. Many
studies relating to behavioral finance show that markets are not completely efficient and that information
asymmetries exist. Traders, even retail investors, can generate profits by exploiting an information advantage
derived from such sources as the availability of more accurate information about the value of the underlying,
morereli- able models of asset value measurement and a better understanding of the behavior of market actors.
Nevertheless, distinguishing between new market information and noise is difficult. Traderswhoperform better
than the market average over time can use this
ability to their advantage.
A trader’s basic task is to make decisions under conditions of uncertainty. ftese types of choices are difficult,
given the complexity and the amount of information needed, the limited amount of time and resources
available to make those choices, and the consequences of the decisions. ftus, successful traders are
generally people who have the necessary intellectual abilities and personal characteristics to allow them to
survive and be profitable (Fenton-O’Creevy, Nicholson, Soane, and Willman 2007). Yet, cognitive and
motivational factors affect their operations. fte automatic nature of their decisions represents a danger to
traders.
According to Kahneman (2012), this way of thinking involves two systems. fte first systemisfast,
automatic, andalwaysactive, basedonunconsciousandemotionalaspects, and it requires a limited effort. fte
secondsystemisslow,laborious,andactivatedwhen
192
The Psychology of Traders 193
needed, based on personal experience, and it requires much concentration. People use the first system when
performing automatic tasks and the second system when there is a need to focus on something specific or
perform a challenging task. Given the general aversion to making decisions, people are inclined to use the first
system, even in making complex decisions, because that system requires limited effort and generates a decision
more quickly than does the second.
Traders need to gain new knowledge and skills and to develop the analytical capabilities to understand
market dynamics. Traders must also be able to handle emotional stress during both the initial phase and in
managing a new position. A portfolio’s fluc- tuating performance often leads to much emotional upheaval.
Although being a trader may appear to be a solitary career, this is not the case. Peers play a particularly impor-
tant role by facilitating an exchange of opinions on the state of the markets and by confirming a trader’s
views. New technologies have increased the importance of these relationships among traders. Traders face
substantial change because future market developments and shifts in their peers’ strategies. fterefore,
becoming a trader means acquiring new knowledge to apply to the market and adapting knowledge from
past events and personal experience to anticipate likely future developments.
Algorithmic trading has completely changed the daily business of traders. Algorithmic trading is the
process of usingcomputers that havebeen programmed tofollow a defined set of instructions for placing a trade
so as to generate profits at a speed and frequency that is impossible for a human trader to accomplish. Onlythose
traders who have managed to adapt and be flexible are likely to be profitable. Traders who remain firm in their
decisions and who follow an outdated line of reasoning are likely to suffer losses and ultimately to leave
the market.
Biases Affecting a Trader’s Decision-Making Process

According to the neoclassical theory of financial decision making, individuals behave rationally to reach
the optimal solution (Von Neumann and Morgenstern 1944; Markowitz 1952). However, since the late
1970s, considerable evidence contradicts this theory. For example, individuals tend to acquire and process
information using approximate rules, resulting in satisficing rather than optimizing behavior. Simon (1956)
used the term satisficing (satisfactory/sufficing) to explain the behavior of decision makers under
circumstances in which they lack the necessary cognitive resources to reach an optimal decision. Given that
people rarely know the exact probability distribution of events, they have difficulty in accurately evaluating
all possible outcomes. People’s memories are also weak and unreliable. ftey tend to settle on a suitable solution,
rather than seek the best alternative. ftus, people rely on mental shortcuts and use general rules or heuristics
to reduce both the perceived complexity of a problem and the time involved in making a decision.
As Tversky and Kahneman (1974) note, such behavior can result in errors. In particular, the mistakes
that individuals tend to make in their financial decisions may result from internal conditioning or external
factors. fte former are errors associated with the psychology of the subject, consisting of cognitive and
emotional biases. Cognitive bias
Behavioral bias
Internal factors External

factors
Cognitive bias Emotional bias Social bias
Collection of
Processing of information
information
› Availability heuristic › Representativeness bias › Regret aversion › Conformity effect

› Familiarity bias › Anchoring effect › Disposition effect › Availability cascade
› Home bias › Gambler’s fallacy › Loss aversion › Herding behaviour
› Illusion of knowledge › Mean reversion › Break even effect
› Illusion of control › Mental accounting › House money effect
› Cognitive dissonance › Endowment effect
› Confirmation bias › Status quo bias
› Overconfidence
› Self-attribution bias
Figure 11.1 Main Types ofBiasAffecting Traders’Investment Decisions. ftefigure shows several types
of bias affecting traders’ investment decisions. Source: Adapted from Alemanni, Brighetti, and Lucarelli (2012).
results from a limited way of thinking and manifests itself in both collecting and processing data. By contrast,
emotional bias typically occurs during the processing of the data collected. External bias is primarily due to
social conditioning, in that it induces individuals to behave according to the judgment they expect to receive
from their community. ftis conditioning, similar to emotional bias, influences the information-
processing phase, thus affecting the individual’s final decision. Figure 11.1 shows the main types of bias that
affect traders’ investment decisions.
Errors in the Information Collection Phase

As mentioned, cognitive bias refers to behavioral mistakes in the information collection phase. ftis type of error
arises from an individual’s mental structure taking intellectual or heuristic shortcuts to compensate for one’s
cognitive limits (Simon 1955; Tversky and Kahneman 1974; Gabaix and Laibson 2000). In other words,
heuristics are approximate modes of reasoning that allow the individual to collect and process information in
a short time and with limited processing effort.
A typical error that traders commit in the information gathering phase is the availability heuristic
(Kahneman and Tversky 1973). fte ease with which individuals can recall information from memory can
influence their behavior. Consequently, individuals tend to consider frequent events that they can easily
remember. Events that individuals remember more easily, as well as those that occur more often, tend to
arouse the strongest emotions, as well. In particular, the familiarity of investors with one or more events and
the belief that they have a more thorough understanding of certain events are common features among
traders. Familiarity bias induces investors to concentrate their investments in companies they consider less
risky. Home bias refers to the tendency to concentrate investments in specific geographic areas, such as in
domestic
rather than foreign stocks (Kilka and Weber 2000; Huberman 2001). Investors choose nearby investments
owing to an excessive sense of confidence with and security about the available information for these
investments. ftey consider such information as more reliable than for “distant” investments in foreign
companies (Lewis 1999).
Cognitive limits can also lead traders to commit various errors involving illusions. fte illusion of
knowledge refers to the amount of information available. Counter- intuitively, collecting a
considerable amount of information does not guarantee either the quality or the correct use of this
information in arriving at an optimal decision. In the presence of too much information, investors tend to
prefer and take account of the information they understand better, thus arriving at suboptimal decisions
(Barber and Odean 2001). Using the Internet to collect information and having the availability of financial
databases amplify the tendency of investors to focus on readily understandable information. Unfortunately,
recent changes in the financial markets such as algorithmic-trading techniques do not necessarily provide
the most relevant information. Algorithmic means, or algo-trading, encompasses trading systems that
heavily rely on complex mathematical formulas and high-speed computer programs to determine trading
strategies. Using easily understood information can create the perception that individuals can influence
events that are actually beyond their control (Langer 1975). ftis illusion confirms, especially among
novice and small traders, their ability to determine their success in the markets, thus they neglect the impor-
tance of random factors; this is termed illusion of control.
Errors in the Information Processing Phase

Figure 11.1 shows that traders often commit cognitive or emotional errors during the information-processing
phase. Cognitive errors are usually the result of investors’ making decisions based on stereotypes (termed
representativeness heuristic) or they fail to alter their initial decisions, even when new information reaches
the market (termed anchoring heuristic). fte representativeness heuristic leads investors to draw conclusions
based on limited information. Indeed, this heuristic is the basis of two common mistakes among traders:
applyingbase rateneglect, and followingthelawofsmallnumbers.
Base rate neglect results from the inability of individuals to estimate the probability of an event. When
attempting to estimate probability, they neglect important information and depend on beliefs developed from
personal experience and social stereotypes. Tversky and Kahneman (1974) present a sample of individuals
in a case format to illustrate these points. For example, Linda, a single woman aged 31 with a philosophy
degree, who as a student participated in demonstrations against nuclear power, was deeply concerned with
issues of discrimination and social justice. fte researchers asked respondents to choose which alternative is
more likely in their opinion: (1) Linda is a bank teller; and (2) Linda is a bank teller and is active in the
feminist movement. Although the second option is incompatible with Bayes’s theorem, which describes how
the probability of two joint events is always less than the probability of the individual events, the majority of
respondents chose option 2. Linda’s behavior at the university led the sample to pay limited attention to the
basic information—namely, that Linda working in a bank is present in both alternatives.
The law of small numbers refers to an inability to take into account the size of a sample and applying
rules to small groups that are only apparent in much larger sample sizes (Rabin 2002). One example of this is
the gambler’s fallacy, in which people believe that a random event is more likely to occur simply because it
has not occurred for a certain period, such as the eventual selection of a certain number in a lottery. Another
example is mean reversion, which is the tendency of individuals to ignore that extreme events usually
tend to return to their average value. Such biases mean that traders tend to overestimate or underestimate the
performance of stocks that have achieved results either above or below the market average in the recent past.
However, as De Bondt and ftaler (1985) show, stocks that have performed better or worse than the market
during the prior three years tend to record results that are worse or better, respectively, than the average in the
following three years.
With the high number of transactions carried out over a certain period by an individual trader, another
typical error is their subdivision into mental accounts. Mental accounting consists of classifying operations
separately according to their result (profit or loss) or the desired objectives, such as protecting invested
capital and generating income (ftaler 1985). fte separate management of investments in multiple mental
accounts often creates the impression that the trader’s activities are profitable most of the time, as the
profitable trades are over-weighted from a psychological perspective. ftis attitude remains unchanged, even
after several years and especially when unsuccessful traders keep alive their memories of the few operations
that generated substantial profits. ftey tend to forget or understate the weight of the many operations that
closed with substantial losses.
fte anchoring effect refers to the habit of traders to take past information, usually the carrying value of
securities in the portfolio, as a reference point for the future. Although the securities may have dropped in price,
the anchoring effect helps traders maintain their initial conviction, despite the availability of new
information. fte difference between the trader’s initial decision and the contrasting market performance
creates an unpleasant feeling for the trader when faced with evidence that the original belief was wrong. ftis
uneasy feeling is cognitive dissonance, or the discomfort that emerges when beliefs and actions conflict
with market behavior. Although the more rational way to reduce an uncomfortable feeling is to align one’s
convictions with the market scenario, traders may act irrationally. For instance, traders may avoid new
information thatis inconsistent withtheir original ideas or theymaydevelopfancifularguments to justify their
old opinions. Such behavior is termed confirmation bias (McFadden 1999). Besides the errors resulting
from cognitive bias, mistakes arising from emotional bias also play an important role in a trader’s decision-
making process. Among the many emotions that a trader feels when buying or selling a financial instrument,
regret is one of the strongest involving investment decisions. Although regret is a feeling that occurs after a
decision is made, fear of making the wrong choice, which might lead to regret, can be strong enough to halt the
trader and prevent him or her from making the most
appropriate decision.
fte aversion to regret is the basis of a classic error known as the disposition effect, in which traders
tend to sell winners too early and hold on to losers too long (Shefrin and Statman 1985). fte disposition
effect results from other biases discussed earlier. For example, assume a trader bought a stock whose price
declines immediately after
purchase. In the trader’s mind, the purchase price continues to represent an anchor of reference, leading him to
ignore information suggesting the immediate sale of the security. fte trader continues to hold the stock,
hoping its price will return to levels close to the purchase price. Often, however, the price continues to drop. In
these situations, cognitive dissonance comes into play, generated by the incongruity between the investor’s
initial expectations and the market’s actual behavior.
Toease an uncomfortable feeling, the trader sees the drop in stock price as a profit opportunity to reducethe
book value of his portfolio. By buying new securities at lower prices, the trader reduces the average carrying
price of the individual assets, but simultaneously increases the concentration and hence the portfolio’s risk.
Such behavior usually recurs whenever the trader can invest new resources in this position. ftis irrational
behavior occurs because the theoretical gain achieved by the trader represents an anchor of reference. Less profit
generates a level of emotional stress much greater than the regret the trader would feel for having closed a
position that might increase future performance (Kahneman, Slovic, and Tversky 1982).
fte weighing of costs and benefits of closing the position at a profit or leaving the way open for
further gains, but also possible losses, causes the trader to opt for the former option. To limit such irrational
behavior as allowing losses to accumulate and closing profitable positions early, most expert traders have
learned to use stop- loss orders. A stop-loss order sets a price at which to sell (or buy) a security so as to
limit any loss should the security decline (or increase) in price. fte most advanced traders use stop-loss
orders to avoid allowing their emotion to overcome their reason. ftus, a stop-loss order represents a
trader’s implicit admission of the possibility of committing an error when buying a stock. By instituting
a stop-loss order, the trader is admitting the possibility of psychological discomfort similar to cognitive
dissonance.
Determining which cognitive or emotional biases have the greatest influence on a trader’s decision-
making process is difficult. An inappropriate use of stop-loss orders reflects a particularly strong emotional
bias called loss aversion. Loss aversion is the behavior of avoiding regret; that is, a loss is experienced as
greater than a gain, hence is best avoided.
A particularly interesting aspect of trader behavior occurs when investors experience negative performance.
One might expect that the degree of risk aversion would rise after incurring losses. In practice, however, past
losses, particularly if substantial, can encourage further risk-taking behavior in an attempt to recover the loss
and restore the initial level of wealth. ftis behavior is termed the break-even effect (ftaler and Johnson
1990). Two other phenomena closely linked to loss aversion are the house-money effect and the
endowment effect. Individuals experiencing the house-money effect are more likely to risk money that
has resulted from a win or investment returns than money earned through work. ftus, individuals perceive
the funds as other people’s money rather than their own. fte endowment effect is the tendency of individuals
to give greater value totheir own possessions than tothose of others. ftis shows up as a possible delay in
liquidating existing positions because the current market price does not reflect the perceived value of those
assets. fte endowment effect can also influence traders who do not have open positions in the market. An
open position is any trade that an investor hasentered but hasnot yetclosed withanopposing trade.Such
traders are inclinedto
waitfor a drop instockprices because theyassign a value thatis usually lower than the market price, as they do
not own these stocks.
Another psychological attitude that characterizes how traders operate is a general reluctance to alter
positions taken in the past. ftis behavior, known as status quo bias, is closely related to regret that comes
from realizing that a prior change in position has not generated the expected results, and that maintaining the
original position would have offered better performance (Samuelson and Zeckhauser 1988). Overconfidence
is the main limitation that characterizes most traders, especially retail traders (Chuang and Susmel 2011). ftis
attitude stems at least partially from combining the illusion of knowledge and the illusion of control.
Overconfidence induces investors to overestimate their knowledge and their capability to influence
events. Overconfident investors presume they have superior skills compared to other market participants
(the better-than-average effect) and underestimate both the risks of the investments intheirportfoliosandthe
real distribution of the probability of events (termed miscalibration). One way to demonstrate this latter
phenomenon is by asking investors to define a range they are strongly convinced contains the correct answer
to a question. In most cases, the correct answer lies outside the interval selected, because overconfidence makes
the investor too certain and thus he or she opts for a too narrow range.
Investors are most overconfident when they perceive that they can influence the outcome of events. One
example is a coin toss. Individuals tend to bet larger amounts of money if the coin has yet to be tossed. If the
coin been already tossed but the result remains unknown, they tend to bet lower amounts because they
perceive they can no longer influence the results (Langer 1975). In the trading world, the phenomenon of
overconfidence is a common feature among investors, leading them to believe that their investment decisions
are correct in most cases and thus produce a return superior to others.
Barber and Odean (2000) demonstrate how the portfolios of overconfident individuals have a higher
level of risk owing to a greater concentration of investments in a limited number of stocks. ftese traders
strongly believe that the securities included in their portfolios will register a better performance than
those they chose not to purchase. Hence, they perceive that portfolio diversification is a waste of resources,
given that it encourages some investment in underperforming securities. Barber and Odean also highlight
how overconfident investors engage in more trading. Although the gross performance is higher for
overconfident traders, the net performance when transaction costs are considered is generally higher for
traders who are not overly self-confident.
Barber and Odean (2001) find that men are generally more overconfident than are women, leading
male investors to trade more frequently. Online trading systems have amplified the phenomena related to
overconfidence, including loss aversion and the break-even effect. Such systems have a greater speed of
execution and lower transaction costs. ftis change has caused a large increase in transactions carried out by
individual traders and, ultimately, a reduction in net performance (Barber and Odean 2002).
Herding and Contrarian Behaviors

In addition to internal biases (cognitive and emotional errors), there are social biases, which are forms of
conditioning originating in the fear of judgment by others or the desire to obtain social approval. fte
influence of the decisions and opinions of others in one’s group affect individual behavior, especially in
situations marked by a high degree of uncertainty (Ghosh and Ray 1997). ftis is one reason individuals may
manifest the conformity effect, which is the tendency to fall in line with the “average” judgments and
behaviors of other individuals in one’s group (Bond and Smith 1996). Shiller (1999) confirms that
investors tend to pay more attention to ideas or facts when supported by conversations, habits, or symbols
(known as availability cascades).
fte main type of social bias is herding, which refers to behavior that induces investors to abandon their own
convictions so as to go along with those of a group, even when the group’s beliefs seem erroneous (Christie
and Huang 1995; De Bondt and Forbes 1999). fte phenomenon of herding is due in part to self-
attribution bias, which is the inclination to look for an external cause to which to attribute responsibility for
wrong choices, while profitable decisions remain attributable solely to the individual trader’s merit. In fact,
the tendency to go along with the behavior of the group not only reduces dissatisfaction and recriminations that
might arise from having made wrong decisions independently, but it also generates less psychological and
reputational damage than the prejudice caused by the individual’s error. As the saying goes, a trouble shared is a
trouble halved (Caparrelli, D’arcangelis, and Cassuto 2004).
Herding originally described the foolish behavior of masses. Recently, though, scholars have clarified that
herding is not necessarily irrational if individuals prefer to follow the decisions of those whom they believe
are best informed or who are endowed with superior decisional capacities (Chang, Cheng, and Khorana
2000; Demirer and Kutan 2006).
Jegadeesh and Titman (2001) document how trading rules based on momentum- type strategies (i.e.,
those linked to purchasing high-performing stocks and simultaneously selling less stellar ones) show
positive performance, and they demonstrate that the profitability of such rules has persisted over time. From a
behavioral point of view, the profitability of momentum strategies is linked to expectation extrapolation
(De Long, Shleifer, Summers, and Waldmann 1990) and conservatism in expectations (Barberis,
Shleifer, and Vishny 1998). In general, traders who want to exploit momentum strategies look for major
movements affecting markets (Menkhoff and Schmidt 2005). As Nofsinger and Sias (1999) note, profitable
momentum strategies challenge the efficient market hypothesis.
Understanding the causes of profitable strategies by analyzing the various types of operational
approaches that institutional investors and retail traders can employ is meaningful. ftose following
momentum strategies may be able to take advantage of temporary strong-trending market situations in
which quotations differ substantially from base stock values. However, retail traders tend to buy toward market
peaks, owing to optimism and excessive confidence in their own abilities. ftey also tend to close their position
during market bottoms with heavy losses because of behavioral biases, such as
the disposition effect. fte loss then makes the trader delay opening buyer positions in the future, when the
markets are once again positive.
ftis frame of mind is due to the snakebite effect, a psychological state strongly con- ditioned by a prior
negative experience, such as a financial loss. fte effect usually has the most impact on those who feel regret and
have less financial education. Such traders tend to delay opening long positions in rising market situations
because they are still smarting from losses suffered as a result of a recent market collapse. In fact, the disposi-
tion effect hinders retail traders from closing unprofitable positions at the opportune moment, leaving them
exposed to even greater losses. Not until such traders feel a sense of frustration and a desire to abandon the world
of investing do they close those positions. Yet, stocks are most likely to bounce back at this moment.
Recent disgust and frustration impede the trader from reacting by opening positions consistent with new
market scenarios. Analogous behaviors, but with opposite effects to those just described, are seen when traders
have long positions open in markets that have reached their peak and are most likely to correct themselves in the
near future. In these situations, the disposition effect, in conjunction with an anchoring effect, leads the trader
to hold positions open even when they are showing negative performance, in the trader’s hope they will achieve
the heights reached in the past. fte consequence of such behaviors is that only a small percentage of investors in
the market make money.
A few studies suggest that, on average, only between 15 and 30 percent of investors make money through
their investments (Barber, Lee, Liu, and Odean 2009, 2014). ftis means that even though momentum strategies
perform well under certain conditions, traders should consider using investment strategies that run contrary to
those followed by the majority of investors who incur losses. ftat is, investors should consider contrarian
strategies. Employing a contrarian strategy does not mean moving in the opposite direction to the majority in
all market conditions. Contrarian strategies largely characterize markets; operating contrarily to the
majority of investors would mean systematically incurring negative performance. Traders who want to use a
contrarian strategy profitably must be capable of identifying areas of inversion in which behavioral errors
might lead most investors to make the wrong choices.
According to Neill (2003), when people think the same way, they are likely to be wrong. Adopting a
contrarian strategy requires understanding human behavior and markets, experience, patience, and the
ability to manage one’s own emotions. ftese latter two characteristics are fundamental, because no market
situations are exactly alike, despite history and investor behavior sometimes repeating themselves. ftis fact is
true particularly when strong variations occur in a stock’s market price compared to its fundamental value (i.e.,
speculative bubbles). Objectively recognizing a difference in value is a relatively simple task. fte problem is
identifying the exact moment when the bubble is about to burst. Especially in periods of very bullish markets,
investors tend to exhibit gregarious behaviors, prompted by the financial success of other members of the
group. In these situations, thinking differently from the majority is difficult. Yet, as Neill suggests, the basis of
a contrarian strategy is mentally training oneself to think independently and to move in the opposite direction
from the group, taking into due consideration factors that may alter the current trend.
Investors can use this way of thinking in both bull and bear markets. For example, assume that all investors
are bullish. fte lack of selling investors serving as counterparts
to buyers would result in no new sales. A stock’s price cannot continue to rise and eventually will fall. fte
opposite situation occurs during strong downward market phases. In those situations, once all the sellers have
liquidated their positions, the stock market prices will increase.
fte difficulty in correctly applying contrarian strategies is not in understanding the methodology but in
managing the emotions a trader feels throughout the decision process. In fact, traders will find themselves
alone when they believe a point of inversion is imminent. In bullish phases, traders will be the only ones
hypothesizing bearish scenarios. An analogous case occurs when a contrarian trader expects an inversion of a
bearish trend. As noted earlier, investors typically do not like living in solitude; most people prefer to
reducetheirpsychologicalrisks by imitating the behaviorofothers.
Some contrarian strategy skeptics see the method’s popularity as a potential limit to its profitability. If all
investors adopted a contrarian view, the methodology would no longer be profitable. Citing Neill (2003),
one of the founding fathers of this strategy, Pring (1995, p. 133) states “the theory of contrary opinion will
never become so popular that it destroys its own usefulness. Anything that you have to work hard at and to
think hard about, to make it workable, is never going to become common practice.” Yet, contrarian strategies
have become popular owing partly to the development of technology that allows for keener and timelier
analysis of the beliefs and behaviors of the majority of investors, or what is termed market sentiment.
Investor Sentiment and the Role of the Media

Many traders believe that a combination of factors leads to market movements. Investors often refer to “market
psychology,” confirming the fact that markets have their own way of thinking. ftis psychological state of the
market or market sentiment allows traders to anticipate its bullish or bearish movements. Market
sentiment is a summary of how investors perceive the market. ftese feelings are clear as new market tops or
bottoms are imminent, and most investors are strongly optimistic or pessimism reigns. Investor sentiment is
more complex in intermediate situations, when markets do not show a defined trend.
Sentiment indicators usually fall into two broad groups: the opinion style and the action style. Opinion-
style indicators reflect the expression of surveys of opinions of one or more categories of investors, such as
advisors, consumers, and companies. Action- style indicators summarize the behaviors that investors have
taken in the markets, such as open interest and cash flows.
Some of these indicators represent leading indicators of market psychology. Perhaps the best-known
sentiment index is the Commitments of Traders (COT). fte COT reports show the positioning of traders
with opposite purposes (speculative or commercial) in different futures markets. fte U.S. Commodity
Futures Trading Commission (CFTC) issues weekly reports, and investors can freely download the
documents from the CFTC’s website. Traders use three items in the reports to decide their own trading
strategies: (1) open interest, (2) net speculative positions and (3) net commercial positioning. Open interest
is the total amount of all futures contracts that investors have entered not offset by a transaction, delivery, or
exercise. Net speculative positions show
whether investors have bullish or bearish expectations in the markets, depending on the predominance of
purchases or short sales within their portfolios. Traders analyze potential differences between the positioning of
commercial traders such as farmers and multinational corporations, the latter which use derivatives for hedging
purposes, and the positioning of noncommercial investors such as large individual traders and hedge funds,
who by contrast use futures purely for speculative aims. ftese two basic groups of futures traders usually have
opposite investment styles, which helps retail traders better understand the market phase in which they are
operating. Speculators are more trend- followers, whereas commercial traders appear to adopt a contrarian
strategy, holding the largest long or short positions in proximity to market bottom or top turns.
Besides the COT, retail traders use several other indicators depending on their investment style. For
example, the CBOE Volatility Index (VIX) measures the 30-day implied volatility priced into S&P 500
index options. Many traders consider the VIX as one of the most important measures of sentiment in the stock
markets, because it serves as a proxy for investors’ risk appetite as market volatility increases or decreases.
Although action-style indicators are perhaps the most used in practice, traders also adopt some opinion-
style measures as inputs to their trading strategies. For instance, market participants use indices of consumer or
business confidence to estimate market sentiment. For example, the University of Michigan Consumer
Sentiment Index surveys consumers to gather their expectations about the overall economy. fte Purchasing
Managers’ Index (PMI), which is provided by the Institute for Supply Management, results from several
hundred interviews conducted among purchasing managers in major companies operating at a
national level.
Over the years, traders havelearned to shift their focus from classic market data to the media. Cover stories
still provide one of the best indicators of the psychology of the general population by identifying trend
reversal points in the market. Publication on the front page of a newspaper signals that the publisher
considers that story particularly important to investors and the public. As already discussed, extreme
emotions expressed by general public are usually associated with market turns. Newspapers often publish strong
positive front-page news as markets reach their top. By contrast, strong negative news is usually associated
with the approach of a market bottom. ftis principle usually applies regardless of the type of market or the
instrument considered by traders, because the investors’ way of reasoning follows similar patterns. fterefore,
traders can exploit different investment strategies, depending on whether they consider the market tobeinan
intermediatephaseorclosetoaturn-around.Inthefirstsituation,bothgood news and bad news are not
particularly meaningful; they become relevant in the second situation, when markets are near making a turn. In
this case, financial news stories are more frequent and have a more incisive tone, whether positive or negative.
Considering the influence on prices of news stories in the traditional media only (i.e., television, radio, and
print media) would prove to be not only limiting but also counter-productive. fte majority of bothretail and
institutional investors devote increasing attention to the analysis of comments and opinions posted on
newsgroups or in specialized chat- rooms, as well as on social media platforms such as Twitter, Facebook,
and LinkedIn. Social media have a double role. On the one hand, by reading messages left by other investors,
traders can get an idea of market sentiment. On the other hand, as each investor can post his own opinions about
future economic and financial scenarios, traders
can directly influence market psychology. fte social media enable investors to reach a much larger number of
peers than do traditional media, with an information transmission speed unimaginable only a few decades
ago. fterefore, understanding how to measure the market sentiment in a proper way represents a challenge that
all traders have to face today. For this reason, more researchers are focusing their studies on issues closely related
to market sentiment. fteir aim is to identify advanced methodologies for estimating market sentiment and to
verify whether the market psychology, as determined by analyzing messages posted on different social media
platforms, directly influences financial market performance.
Regarding the latter aspect, Bollen, Mao, and Zen (2011) found a high correlation between the tone of
messages left on Twitter and short-term equity market returns. An increasing number of traders believe that
considering market sentiment as part of their trading strategies is an essential strategy to remain profitable in the
market. Not surprisingly, specialized companies have created proprietary methodologies to estimate and
disclose to their clients the levels of sentiment as they relate to specific markets, countries, and securities.One
company in this sector is MarketPsych, which launched with ftomson Reuters a series of indices (ftomson
Reuters MarketPsych Indices) in 2012 based on an analysis of news and social media messages. fte purpose
was to provide investors with information specific to certain countries, securities, or economic sectors. Zhang
(2014) discusses how to use market sentiment in trading strategies and summarizes some quantitative
methodologies to correctly measure and profitably apply investor sentiment to trading strategies.
Over time, more traders will have adopted sentiment indicators, purchased from external providers or
created internally, for their investment decisions. fte use of technology aims to increase the capacity and
speed of analysis of relevant high-frequency data and is likely to have a greater influence on trading
profitability. fte effective application in the financial sector of methodologies related to Big Data,
combined with an increasing use of high-frequency investment algorithms (high-frequency trading), is
now the most important challenge that retail traders face.
The Role of Simulations and the Behavior

of Novice Traders
Successful high-earning traders have above-average knowledge, aptitude, and skills. Because each trader’s
personal history and experiences seem to be indispensable elements for success in the markets, authors have
increasingly sought to verify whether simulated trading activities can help investors in their professional
careers.
A simulation is a method based on probable situations. Compared to traditional learning
methodologies, simulations bridge the gap between theoretical concepts and real-life decision making (Kumar
and Lightner 2007), and they help participants learn from the empirical results of different strategies (Tiwari,
Nafees, and Krishman 2014). fte use of simulations in the field of finance is an effective financial education
teaching method (Alonzi, Lange, and Simkins 2000). Although use of simulations has grown
substantially, the results of laboratory experiments remain inconclusive and are often
contradictory. According to Alonzi et al., students participating in a simulation involving the use of
derivatives obtain benefits in terms of learning. Camerer and Hogarth (1999) counter that the learning
process can only occur in the long term; further, such learning is insufficient to eliminate individual
behavioral biases.
Several studies continue to fuel the debate. For example, Ascioglu and Kugele (2005) assert that experience
and time can help investors to curb nonrational behaviors. Yet, Duggal and Meyer (2008) find no significant
empirical relation between the use of a trading simulation based on bond buying and selling and students’
level of understanding, even though the game helped participants to grasp the theoretical concepts studied in
class.
Nevertheless, experience is a critical factor in successful trading operations (Gervais and Odean 2001;
Nicolosi, Peng, and Zhu 2009). ftis evidence does not imply that subjects behave in a rational manner
simply because they have become more experienced. Indeed, the majority still has some biases that
affect performance.
Martelli (2013) attempts to verify whether using simulation with students could help novice traders
overcome or limit the cognitive errors, especially overconfidence, to which they may have been subject in the
early phases of competition. He based his research on analyzing data from trading games played with real
money, in which 44 teams from different universities participated during a six-month period. fte behavior
of simulation participants shows no signs of reducing overconfidence, which would have led to improvement
in the teams’ performance during the course of the game. In fact, most teams seem to demonstrate increasingly
speculative or, rather, opportunistic behaviors as the simulation drew nearer to conclusion. Martelli asserts that
the cause of such opportunistic behaviors is mainly an asymmetry in the distribution of final performance
results. Although the teams benefited from any capital gains realized at the end of the simulation, the process
allocated any capital losses entirely to the initiative’s spon- sor. ftis sort of a lack of penalty in the case of
negative results directly influenced the poorly performing teams, leading them to increase
speculative/opportunistic behavior. ftese conclusions may apply to other simulations carried out in the
financial markets, which present asymmetry in the final phase of a remuneration of the various
participants. However,this does not mean that these types of simulations and trading games are useless or non-
educational because of the participants’ opportunistic behaviors. Moffit, Stull, and McKinney (2010)
compared participants’ scores before and after an online trading stock market simulation and they show a
significant improvement in students’ learning. fte authors conclude that stock market simulations are an
effective tool for increasing students’ financial knowledge, but the topic requires further study. Although
some participants may fail to show improved performance during simulation periods, their progress is
measurable once the game has ended. Such improvements are due both to a new awareness gained and to
participants’ analysis of their own past errors. Martelli (2013) suggests several possible solutions that limit
participants’ behavioral anomalies. For example, one solution is the sharing of participant profits/losses with
thesubject promotingthetradinggame.fteseproposed remediesseemtoshow initial
positive effects and reduce participants’ speculative behaviors.
Dal Santo and Martelli (2015) examine a competition in which participants could neither see the
other competitors’ performance nor calculate the distance between them. fte preliminary results show
that such a solution can be more useful
in educating that year’s novice traders than those participating in past editions of the same competition
in which these new rules were not present. fte authors stress that not all students exploit the benefits of a
simulation. A few participants, especially lower-ranked ones, may feel a sense of growing frustration
that leads to irrational behaviors. At the same time, such students’ motivation tends to decrease. As
Gentner, Lowenstein, and ftompson (2003) demonstrate, individuals, regardless of their experience, have
difficulty extrapolating and applying learning from past contexts to new situations. fte resulting risk is
that prior inappropriate behaviors may continue over time, even among expert traders. ftis finding confirms
that experience alone is insufficient to make individual investors into successful traders. To become
successful, traders require continuous learning and the flexibility to handle changing market situations.

fte trading profession has dramatically changed during the last decade. For example, technology has
undergone profound innovations. Traders can now analyze huge amounts of data and clearly identify
investor sentiment. Only those traders who can adapt their investment strategies to new market scenarios
will likely be profitable, whereas the others will ultimately leave the market. Although gaining some
experience by participating in trading simulations before investing in real markets is useful, investment
challenges do not usually take into account possible opportunistic behaviors that participants can use to
win the competitions.
1. Define overconfidence and give some examples of how overconfidence affects trading strategy.
2. Describe the main differences between gregarious and contrarian investment strategies.
3. Explain the meaning of investor sentiment and provide some examples.
4. Definepossible solutions to mitigateopportunistic behavior in trading simulations.
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12
A Closer Look at the Causes
and Consequences of Frequent
Stock Trading
MI C H A L S T R A H I L E V I T Z
Visiting Associate Professor
The Center for Advanced Hindsight, Duke University
Introduction
A wide body of research clearly indicates that frequent stock trading negatively affects investor returns. For
example, Barber and Odean (2000) investigate portfolios held between 1991 and 1996 and find that frequent
traders pay a huge financial penalty, earning an average of 7.1 percent less than infrequent traders. fte authors
attribute this loss of return primarily to the high commissions associated with intensive trading. More recent
research also finds that individual investors lose by trading (Barber, Lee, Liu, and Odean 2009).
After accounting for trading costs, individual Taiwanese investors who trade frequently generally
underperform relevant benchmarks such as the TAIEX, a value weighted index of all listed securities on
the Taiwan Stock Exchange. After controlling for all other variables, the more often investors trade, the more
money they lose. Despite the level of knowledge and experience of investors, little chance exists that frequent trad-
ing is more profitable than following a buy-and-hold strategy (Schlomer 1997; Talpsepp 2011; Hoffmann,
Post, and Pennings 2013).
Meanwhile, investor overtrading is an epidemic. For their sample of clients of a discount brokerage in
the United States, Barber and Odean (2000) report an average annual turnover of 75 percent. Perhaps even
more alarming, the quintile of most active traders exhibits an average annual portfolio turnover rate of more
than 250 percent. More recently, the turnover on the New York Stock Exchange (NYSE) reached over 150
percent in 2015 (World Bank 2016).
Researchers demonstrate that rational reasons, such as portfolio risk-rebalancing needs, tax
considerations, and liquidity reasons do not explain even half of the turnover (Barber and Odean 2002;
Dorn and Sengmueller 2009). In short, agreement exists among top researchers in finance that frequent trading
is both pervasive and irrational. Such trading is both bad for individual investors who engage in it and the stock
market asa whole.Still,thereislittleagreementonwhyinvestorsengageinfrequenttrading.
209
fte purpose of this chapter is to review research that is relevant to understanding both the causes and
consequences of frequent stock trading. fte chapter starts with reviewing several published articles that
examine frequent trading both in terms of the financial costs and psychological causes. fte next section
discusses unpublished research that looks more closely at the emotional side of frequent trading, going beyond
the financial costs to consider the psychological consequences as well. fte chapter ends by suggesting directions
for future research that may help identify ways frequent traders can stop engaging in this irrational andpotentially
quiteharmfulpatternofinvesting.
Does Investor Overconfidence Lead

to Frequent Trading?
Barber and Odean (2001a) propose that an irrational sense of overconfidence is the main driver of frequent
trading. ftey contend that investors’ beliefs that their abilities are better than average make them think they
can outperform the market indexes. Overconfidence means that these investors believe their trades are
smarter than the trades of most other investors (De Bondt and ftaler 1995; Odean 1999; Gervais and Odean
2001). Yet, Markiewicz and Weber (2013) maintain that overconfidence is unlikely to be the main reason
some people trade far more often than they should. ftey offer an alternative explanation.
Specifically, Markiewicz and Weber (2013) note that Barber and Odean’s (2001a) explanation for
frequent trading is inconsistent with many empirical findings (Glaser and Weber 2003, 2007; Biais, Hilton,
Mazurier, and Pouget 2005). Glaser and Weber (2003) used a questionnaire to elicit nine proxies for
overconfidence in a sample of 200 German discount brokerage customers, and then related those
overconfidence proxies to actual portfolio turnover. None of the proxies accounted for the average monthly
portfolio turnover. Additionally, in trading experiments with students, Biais et al. report little or no relation
between proxies for overconfidence and observed trading activity. Markiewicz and Weber suggest that Barber
and Odean (2000) did a relatively poor job of supporting their argument that frequent trading is about
overconfidence. ftey note that Barber and Odean talked about overconfidence without actually measuring
overconfidence. Instead, Odean and Barber use whether the investor is male or female as a proxy for
overconfidence, contending that men are more confident than women when investing. A problem with this
view is that gender is correlated with many other variables as well, including risk-seeking tendencies
(Charness and Gneezy 2010, 2012).
Studies by other researchers that have tried to directly assess the degree of investor overconfidence show
an inconsistent relation between investor overconfidence and trading volume. Although some studies have
found an association between overconfidence and high trading frequency (Dorn and Huberman 2005;
Graham, Harvey, and Huang 2009), others fail to find such a relation (Dorn and Sengmueller 2009). Glaser
and Weber (2007) are only able to observe a correlation between overconfidence and frequent trading if they
exclude the most active of the frequent traders from their analyses. fteir evidence suggests that something
other than overconfidence drives the frequent traders who trade the most often. One possibility is that the
extremely frequent
Causes and Consequences of Frequent Stock Trading 211
traders see selling a stock after buying it as “undoing” a mistake. ftey are in effect second-guessing
themselves, which is more indicative of low confidence than of high confidence. Another possibility is that
because trading frequency hurts performance, these ultra-frequent traders perform so badly that it affects their
confidence in their ability to trade wisely.
Another challenge with the overconfidence explanation is that multiple methods are available to
measure overconfidence (Moore 2007; Markiewicz and Weber 2013). Not all the same methods of measuring
overconfidence yield the same results. In other words, someone could be rated as highly overconfident using
one measure of overconfidence, but not particularly confident using another measure. To illustrate, Moore
and Healy (2008) find significant gender differences in overconfidence when they defined overconfidence as a
better-than-average effect, but not when they define overconfidence as miscalibration, which is the inability to
assess one’s own performance accurately (Grinblatt and Keloharju 2009). When overconfidence is
defined as miscalibration, little support exists for Barber and Odean’s (2001a) proposition that
overconfidence drives frequent trading.
As Glaser and Weber (2007) report, overconfidence using the miscalibration approach has no
influence on investors’ trading volume for the most active investors in their study. Similarly, Biais et al. (2005)
find that miscalibration reduces financial performance, but does not affect trading volume. Other studies also
find no relation between overconfidence and trading frequency (Dorn and Huberman 2002; Oberlechner and
Osler 2008). As Markiewicz and Weber (2013) note, overconfidence may play a role in some excessive
trading, but it is unlikely tobe the primary reason so many investors trade more often than they should.
Are Risk-Seekers More Likely

to Be Frequent Traders?
Several authors report an association between frequent trading and higher levels of risk- taking. For example,
Grinblatt and Keloharju (2009) find a correlation between the number of recent speeding tickets male Finnish
investors received and their stock trading volume. Speeding involves risk, because it increases both the chance of
receiving a traffic ticket and of being in an accident. ftis finding thus suggests that people who are most
comfortable with danger―both financially and in terms of safety―may be most likely to trade more often.
Some researchers suggest that substitutes may be available for satisfying the thrill some investors derive from
frequent trading. Specifically, Barber, Lee, Liu, and Odean(2009) suggest thatthe introduction of anationallottery
in Taiwanmayhave contributed to a sizable drop in the turnover volume on the Taiwanese Stock Exchange at the
same time. ftey propose that some investors may view investing and gambling as substitutes, so the
introduction of the chance to win a lottery may have reduced the desire to trade so often. In other words, similar to
speeding or gambling, frequent trading may be a way for those who love to take risks to satisfy their desires
for risk.
Similar conclusions can be drawn from research by Dorn and Sengmueller (2009), which shows
that investors who enjoy gambling turn over their portfolios
at twice the rate of their peers. fte authors suggest at least three possible motives for frequent trading: (1) the
recreation/leisure motive, which treats active investing as a source of fun; (2) the aspiration for riches
motive, which treats investing like a lottery that provides a very small chance for a possibly huge payoff;
and (3) the sensation-seeking motive, which uses trading with its uncertainties as providing the stimulation
and novelty some people may require to feel that their life is not boring.
According to Dorn and Sengmueller (2009), two categories of investors—hobby investors and
sensation seekers—trade for emotional reasons. ftis view suggests that the motives for investing and trading
often may vary among investors, with some making rational calculations and others trading for emotional
reasons. fteir work implies that motives for trading may influence how often individual investors trade.
Hence, Dorn and Sengmueller offer that some investors may trade simply because theyfind it entertaining.
Building on Dorn and Sengmueller (2009), Markiewicz and Weber (2013) contend that risk-
seeking behavior drives frequent trading. ftey build on the notion that some association exists between
personality and risk-taking (Zaleskiewicz 2001) and stress that risk-seeking has multiple dimensions. Dorn
and Sengmueller (2009) agree with other researchers who note that risk involves several domains that should
be considered, such as financial, social, and safety (Weber, Blais, and Betz 2002; Figner and Weber 2011).
Markiewicz and Weber (2013) also reiterate Dorn and Sengmueller’s (2009) emphasis on understanding
different motives. Specifically, they maintain that a sensation or stimulation-seeking motive exists
whereby the driver of the action is the thrill of taking a risk. ftis might be considered a hot motive with
fast thinking (Figner and Weber 2011; Kahneman 2013). Markiewicz and Weber (2013) explain that the
stimulation motive is distinct from the instrumental motive, the latter which is considered cold and slow
(Figner and Weber 2011; Kahneman 2013). Cognition and deliberation drive cold and slow decisions,
whereas emotions drive hot and fast decisions. With the instrumental motive, the primary driver is the
possible achievement of material returns. Markiewicz and Weber (2013) find that only emotion-
driven risk-taking predicts trading frequency. In other words, those who are taking risks for profit may be
wise enough to realize that their profits will not improve from trading more often.
Markiewicz and Weber’s (2013) research suggests that investors who focus more on excitement and less
on the possible financial rewards may be most likely to become frequent traders, or even day traders. ftis group
pays greater transaction fees, spends more time on investing, and still manages to underperform compared to
their less frequent trading counterparts. For this group of traders, gambling risk propensity (i.e., the hot
need for stimulation) is significantly related to the extent of their day-trading activity. ftis finding is in line
with prior work suggesting that some traders simply find trading to be fun (Glaser and Weber 2007;
Anderson 2008; Dorn and Sengmueller 2009; Kumar 2009). Although day trading may seem a time-
consuming, costly, and financially risky way to be entertained, recent research supports the notion that fre-
quent traders find trading to be more exciting than buying and holding (Strahilevitz, Harvey, and Ariely
2015).
Is Frequent Trading Motivated by Emotions

or Rational Thinking?
According to several researchers who have examined risk-seeking and trading frequency, a desire for stimulation
may drive frequent trading. Researchers in the areas of psychology and decision making have made similar
suggestions about risky behavior (Belsky and Gilovich 2000). In their acclaimed work on risk as feelings,
Loewenstein, Weber, Hsee, and Welch (2001) note that emotion often drives much risk-taking behavior. ftey
point out that the basis of prior theories used to explain risk-taking was the assumption that rational thinking
underlies decisions. Loewenstein et al., however, maintain that an expectation-based calculus is not what
drives all risk-seeking behavior. ftey propose a new theoretical framework, which they call the risk-as-
feelings hypothesis. Drawing on research from clinical, physiological, and other subfields of psychology,
they show that emotional reactions to risky situations often diverge from cognitive assessments of those risks.
When such divergence occurs, emotional reactions often drive behavior. ftey present evidence showing that
the risk-as-feelings hypothesis explains a wide range of phenomena that have resisted interpretation in
cognitive consequentialist terms. Although Loewenstein et al. (2001) do not discuss stock trading, based on
their theoretical framework, emotions could logically drive frequent trading as much, if not more than,
rational calculations.
Additionally, Loewenstein et al. (2001) propose that the emotions experienced at the moment of
decision making have an enormous influence on that decision. Others have noted that emotions drive
much of compulsive behavior (Faber and O’Gunin 1989, 1992; Faber and Vohs 2011). Applying the
risk-as-feelings hypotheses to frequent trading, the risk of making yet another trade may involve some sort
of thrill, and for some investors, that emotional thrill may influence their behavior even more than thinking
about expected outcomes.
Strahilevitz, Odean, and Barber (2011), who also address the emotion-based argument for financial decisions,
find that traders generally buy stocks on which they previously made a profit, whereas they avoid buying stocks
on which they previouslylost money. ftis behavior is not for rational reasons, because it does not improve returns.
Avoiding past losers and buying past winners is really about avoiding previous bad feelings and repeating
previous good feelings. Strahilevitz et al. (2015) contend that emotional responses, not rational thinking,
condition this pattern. Although this pattern was pervasive, it did not improve the traders’ performance. ftis
research also found that investors deliberately attempt to reduce regret, even when the actions they take do not
improvetheirreturns.
How Do Day Traders Behave?

Although day traders are an extreme form of frequent traders, few researchers have examined the drivers of
day trading. Day traders pay higher transaction fees overall, but did not get higher profits than others in a study
conducted by Barber et al. (2005). To
understand drivers of this behavior, using a student population with trading simulations, Markiewicz and
Weber (2013) find that a gambling risk propensity predicts a day-trading propensity.
Markiewicz and Weber (2013) also looked at financial risk-taking propensity regarding two motives:
gambling and investing. ftey defined these two motives as follows:
(1) gambling is a stimulation or sensation-seeking motive that has the process of taking a risk as its goal; and
(2) investing is an instrumental risk-taking motive that focuses on the potential financial outcome of the
risky choice (i.e., the achievement of material returns) as its goal. ftey find that these two measures are not
significantly correlated and that only gambling risk-taking propensity predicts trading volume. In other
words, in their sample, a desire for stimulation drove the day traders more than a desire to make money. ftey
conclude that day traders are thrill-seekers more than profit-seekers.
According to Markiewicz and Weber (2013), compared to other investors, day traders spend more
money, in the form of transaction fees, and more time, in the form of hours spent trading. Nevertheless, as
with previous analyses (Barber et al. 2005), day traders show lower profits for their efforts than do those who
are not day traders. ftis finding is consistent with research in general on frequent trading. fte more frequently
investors trade, the more time they spend, the greater their transaction fees, and the lower their profits.
Financially, day trading is clearly a losing proposition.
Does Frequent Trading Involve

Gender Differences?
Gender is not a cause of frequent trading. However, research suggests that men and women behave
differently as investors, including how often they trade. ftus, a review of literature that looks at gender
differences can illuminate the world of frequent trading.
According to Barber and Odean (2001a), men are more confident than women especially in the
financial domain, and therefore men trade more frequently than their female counterparts. fte authors
suggest that more frequent trading among males stems from overconfidence. fte problem with this
explanation is that overconfidence is not the only relevant gender difference. Specifically, men are more
impulsive and have greater risk-seeking tendencies (Charness and Gneezy 2010, 2012).
Evidence shows that all these factors influence trading frequency, and they are not just stereotypes. In
fact, some research suggests that hormones could affect investing behavior. Coates and Herbert (2008) find a
positive relationship between the testosterone levels of male stock traders and their financial returns.
Similarly, Coates, Gurnell, and Rustichini (2009) find that the presence of another masculine hormone,
prenatal androgen, increases the risk preferences of high-frequency stock traders.
In short, although women trade less often than men, the reasons for this are not totally clear. What is
clear is that frequent trading is more common among men, but it is potentially financially harmful to both
genders. ftus, any insights to help frequent traders to trade less often are likely to help both men and
women.
Frequent Trading and Gambling

Given that Barber et al. (2009) view trading as another form of gambling, examining the nature of the gambling
disorder as well as who is most likely to suffer from it is worthwhile. Gambling disorder is currently
recognized as a psychiatric condition and is part of the fifth edition of the American Psychiatric Association’s
Diagnostic and Statistical Manual of Mental Disorders, DSM-5 (American Psychiatric Association 2013;
Reilly and Smith 2013). Below are the official diagnostic criteria from the Diagnostic and Statistical
Manual of Mental Disorders (DSM-5):
Gambling Disorder: Diagnostic Criteria 312.31 (F63.0)
A. Persistent and recurrent problematic gambling behavior leading to clinically significant impairment or
distress, as indicated by the individual exhibiting four (or more) of the following in a 12-month period:
1. Needs to gamble with increasing amounts of money in order to achieve the desired
excitement.
2. Is restless or irritable when attempting to cut down or stop gambling.
3. Has made repeated unsuccessful efforts to control, cut back, or stop gambling.
4. Is often preoccupied with gambling (e.g., having persistent thoughts of reliving past gambling
experiences, handicapping or planning the next venture, thinking of ways to get money with which
to gamble).
5. Oftengambles whenfeeling distressed (e.g.,helpless, guilty,anxious, depressed).
6. After losing money gambling, often returns another day to get even (“chasing” one’s losses).
7. Lies to conceal the extent of involvement with gambling.
8. Has jeopardized or lost a significant relationship, job, or educational or career opportunity
because of gambling.
9. Relies on others to provide money to relieve desperate financial situations caused by
gambling.
B. fte gambling behavior is not better explained by a manic episode.
According to the DSM-5 manual, in many cultures, individuals gamble on games and events, and they do
this generally without severe negative consequences. However, some individuals develop substantial
impairment related to their gambling activities. fte manual stresses that the essential feature of gambling
disorder is persistent and recurrent maladaptive gambling behavior that disrupts personal, family, and/or
voca- tional pursuits (Criterion A). A gambling disorder is defined as a cluster of four or more of the
symptoms listed in Criterion A, occurring at any time in the same 12-month period. fte manual also
notes that although some behavioral conditions that do not involve ingestion of substances have similarities
to substance-related disorders, only one disorder—gambling disorder—has sufficient data to be included in the
non-substance- related disorders section of DSM-5.
fte manual also states that overconfidence can be present in individuals who have a gambling disorder,
and that those with a gambling disorder can be impulsive, competitive, energetic, restless, and easily
bored. fte manual notes that those suffering from disordered gambling may be overly concerned with the
opinions of others. ftey
can also be depressed and lonely, and they may gamble when feeling helpless, guilty, or depressed. ftis evidence
is consistent with the findings of research on eating disorders, which shows that binge eating often occurs
when one is depressed (Kemp, Bui, and Grier 2011).
Gender differences have also been found in the context of disordered gambling. Specifically, in line
with Odean and Barber’s research on gender differences, males are more likely than females to suffer from
gambling disorder (Martin, Usdan, Cremeens, and Vail-Smith 2014). According to the DSM-5 (American
Psychiatric Association 2013), males start gambling at a younger age and tend to develop gambling disorder
earlier in life than females, who are more likely to begin gambling at an older age and to develop gambling
disorder ina shorter timeframe. Among those with gambling disorders, females seek treatment sooner than
men (American Psychiatric Association 2013). Although multiple researchers have suggested that the thrill
of gambling motivates some frequent traders (Dorn and Sengmueller 2009; Jadlow and Mowen 2010;
Markiewicz and Weber 2013), and that others view frequent trading as a substitute for gambling (Barber et al.
2009), no published work has addressed the possible addictive disordered dimension of frequent trading.
However, new unpublished research (Strahilevitz et al. 2015) has investigated whether frequent trading
might also have an addictive component. Specifically, Strahilevitz et al. (2015) have identified strong con-
nections between trading frequency and both emotional vulnerability and a sense of feeling addicted to
trading. ftey also find that frequent trading is correlated with both considering oneself to be anadrenaline
junkie and viewing trading as stimulating and exciting. Furthermore, Strahilevitz et al. (2015) also find
trading frequency to be correlated with impulsivity, risk-seeking in multiple domains and the frequency of
experi- encingawiderangeofnegative emotions.fteyalsofindfrequenttradershavea higher
levels of confidence in their skill as investors.
fte findings linking adrenaline, stimulation, and excitement to frequent trading reinforce the risk-as-
feelings argument (Loewenstein et al. 2001). ftis suggests that emotion rather than rational decision making
drives many of the risk-seeking behaviors seen across domains. In ongoing research, Strahilevitz et al. (2015) are
adapting much of the DSM-5’s diagnostic criteria to further explore the similarities between frequent trading
and gamblingdisorder.
THE CONNECTION BETWEEN GAMBLING, IMPULSIVITY, AND

NEGATIVE EMOTIONS
Given that researchers including Barber et al. (2009) and Markiewicz and Weber (2013) note that frequent
trading is sometimes just another form of gambling, some understanding of frequent trading can be achieved
by closely reviewing the literature on compulsive gambling. Results of various studies on gambling suggest that
impulsivity, as well as several emotional variables, may play a role in problem gambling (Williams, Grisham,
Erskine, and Cassedy 2012; von Ranson, Wallace, Holub, and Hodgins 2013; Andrade and Petry 2014; Grant
and Chamberlain 2014; Canale, Vieno, Griffiths, Rubaltelli, and Santinello 2015). ftese studies all stress
that impulsivity is a core issue underlying many addictive behaviors, including problem gambling. In terms
of emotions, and
examining different populations, Barrault and Verescon (2013); Holdsworth, Nuske, and Breen (2013); and
Martin et al. (2014) find that problem gambling is linked to depression. Similarly, Dowling et al. (2016)
provide a meta-analysis of research showing a connection between problem gambling and clinical anger.
Self-esteem may also be an issue related to gambling addiction. According to Rockloff, Greer, Fay, and Evans
(2011), individuals who think negatively about themselves are more likely to gamble more intensively.
Ferentzy, Skinner, and Antze (2006) note that sponsorship organizations such as Gamblers
Anonymous give people a safe place to express and handle their emotions, without resorting to compulsive
gambling. ftis suggests that although casual gambling can be fun, compulsive gambling is a painful disorder
(Blume 1986; Rachlin 1990). In describing the addictive nature of gambling, Rantala and Sulkenen
(2012, p. 8) explain: “players do get hooked. fte feelings of competence go away, Lady Luck turns her back,
and excitement and joy disappear.”
NEGATIVE EMOTIONS AND FREQUENT TRADING

Although research demonstrates that frequent trading is bad for one’s wealth, Strahilevitz et al. (2015)
suggest that it may also affect one’s well-being. Besides the self-identified addiction and impulsivity
components found commonly among frequent traders in their sample, the authors also see differences in
emotions. Specifically, when compared to infrequent traders, frequent traders report that their performance in
the stock market has strong effects on their self-esteem, relationships with others, and overall happiness.
Frequent trading is also positively correlated with negative emotions including feeling depressed, being sad,
feeling stupid, experiencing regret, being angry with oneself, and feeling angrier about things in general.
Finally, a positive correlation also exists between frequent trading and feelings of social isolation. Further
evidence connecting trading behavior to emotional distress comes from Coates and Herbert (2008), who
find a positive correlation between levels of the stress hormone cortisol in stock traders and their
financial uncertainty, the latter measured by the difference between economic return and expected market
variance. Surprisingly, Kandasamy et al. (2014) find that when traders experience high levels of cortisol, they
become more risk-averse.
According to Strahilevitz et al. (2015), research on self-regulation and self-control (Vohs and Faber 2007;
Hedgcock, Vohs, and Rao 2012; Hofmann, Baumeister, Förster, and Vohs 2012; Hofmann, Luhmann, Fisher,
Vohs, and Baumeister 2014; Greenaway, Storrs, Philipp, Louis, Hornsey, and Vohs 2015; Hofmann et
al.2015), and particularly work on the self-regulation of emotion (Koole, van Dillen, and Sheppes 2010;
Faber and Vohs 2011), may offer promising suggestions for ways to help frequent traders trade less often.
Vohs, Mead, and Goode (2006); Vohs and Baumeister (2011); Vohs, Baumeister, and Schmeichel (2012);
and Vohs (2015) also suggest a connection between time spent thinking about money and both unhappiness
and competitiveness. Because trading involves thinking about making and losing money, this may explain
why Strahilevitz et al. (2015) find frequent traders to be less happy and more competitive than infrequent
traders.
fte results of Strahilevitz et al.’s (2015) work suggest that solving the problem of frequent trading may
require more than simply informing investors that frequent trading is bad for their financial well-being.
Indeed, if an emotionally charged addictive component is present in frequent trading, interventions may need
to go beyond merely educating investors about the financial downside of frequent trading. Indeed, such
interventions may need to be similar to those used for treating compulsive gambling and otheraddictions.
THE TRADING IMPLICATIONS OF MOBILE TECHNOLOGY

Mobile technology is rapidly changing the world. With global smartphone usage now in the billions, most
investors are likely to own a smartphone. Tablet usage is also very high. ftis increase is accompanied by a rise in
mobile applications that provide access to market information, detailed research, and trading platforms.
Despite considerable research on frequent stock trading and problem gambling, little research is available on the
effect of new mobile technologies. What has been the emotional and behavioral effect of the huge
increase in the use of mobile technology?
La Plante, Nelson, and Gray (2014) and Gainsbury, Russell, Wood, Hing, and Blaszczynsi (2015)
find higher rates of disordered gambling among Internet gamblers than among land-based gamblers.
Similarly, Phillips, Ogeil, Chow, and Blaszczynsi (2013) show that with the evolution of the Internet and
mobile devices, problem gamblers have gained access to new forms of gambling. ftus, the ubiquity of mobile
devices is likely to increase the tendency that some investors have to indulge in overtrading. Basically, the
more opportunities to gamble, the more likely someone is to engage in disordered gambling (Lester 1994;
Campbell and Lester 1999; Breen and Zimmerman 2002). Barber and Odean (2001b) note that Internet trading
has greatly increased trading volume; however, mobile trading platforms are even more recent. Although
some research suggests that mobile usage can increase trading frequency (Strahilevitz et al. 2015), and
others are proposing to do additional research in this area (Zhang and Teo 2014), much remains to be learned
about the effect of mobile devices on trading frequency.

Researchers tend to agree that frequent trading is financially unwise, given both the time and the transaction
costs involved. An implication is that those engaging in trading stocks regularly should modify their behavior.
fte evidence shows that a far better path for achieving financial success in the stock market is to buy and hold a
highly diversified portfolio that is composed of low-fee index-tracking funds. fte balance of stock-related
investments to other assets should reflect an investor’s financial and emotional risk tolerance. Frequent trading
is like playing with fire; it may seem exciting, but the possibility of getting burned is high.
Although researchers agree that frequent trading is both irrational and common, they fail to agree on why
so many investors still engage in this practice. One possibility is that investors may view themselves as smarter
than they actually are. Other explanations
are that some investors hunger for risk, have impulsivity issues, enjoy gambling, or suffer some sort of
addiction. Regardless of the underlying reason, frequent trading is an issue that is worthy of future research.
Research examining a potential addictive component of the phenomenon of frequent trading, which falls in
line with the psychiatric condition of gambling disorder, may be particularly promising (Strahilevitz et al.
2015). Given the complexity of the problem of frequent trading, future research should focus not only on
understanding what drives frequent traders but also on how researchers in this area can best help frequent
tradersstop this irrational way of investing.
1. Explain why frequent stock trading is bad for investor returns.
2. Identify the major factors that might drive frequent trading.
3. Differentiate among recreational, aspirational, and sensation-seeking motives for investing, and
explain which of these motives lead to the greatest trading frequency.
4. Identify and explain the gender differences that exist in investing and gambling behavior.
5. Discuss how mobile technology is likely to affect frequent trading.
6. Discuss the prevalence of frequent stock trading.
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13
The Psychology of Women Investors
M A R G AU E R I T A M. C H E N G
Chief Executive Officer
Blue Ocean Global Wealth
S A M E E R S. S O M A L
Chief Financial Officer
Blue Ocean Global Wealth
Introduction
Women are integral members of corporate America and the global business landscape. fteir emergence as
leaders, entrepreneurs, and innovators has made them an indispensable part of the economic environment and
the future of global enterprise. Women are assuming greater professional and leadership responsibilities while
still managing their personal and family finances. fte increasing availability of education to women is not only
changing their lives but also reshaping public attitudes toward gender differences and equality. Traditional
gender roles no longer retain much currency in contemporary households. fte women’s colleges that opened
starting in the late 1800s trained for careers that were acceptable for women to enter at the time, such as nursing
and teaching. Today these institutions and many others offer degrees in business, law, medicine, psychology,
and other professions, once thought of as work for men only. ftis demographic and societal evolution,
particularly rapid in the last several decades, has produced a new set of gender-based competitive advantages,
enabling women to emerge as influential leaders in fields such as business and finance. Women are now an
essential and integrated part of the global economy. By leveraging their strengths and expounding upon their
skillsandexperience,womenwillcontinuetorealizesuccessandcreatevalue.
The Emerging Influence and Affluence of Women

Accordingtoasurveyofinvestorsacrossvariousearningcategories(Fidelity Investments 2015b), the
demographics of the emerging affluent look very different from those of previous generations of upper-
middle-income individuals. More than two-thirds are female and one-fourth are nonwhite. Women have
surpassed men and now control more than half of all wealth in the United States (Gorman 2015). Women
own nearly one-third of all private enterprises, employing an estimated 7.8 million Americans. fte influence
of women in the business arena is expected to grow in the future.
224
The Psychology of Women Investors 225
ftis rise of female entrepreneurs and executives coincides with an increase in the number of women
pursuing higher education. Presently, women outnumber men in American colleges and universities.
Differences in educational attainment by gender have changed over the preceding decades, with female
attainment rates higher than those of males.
fte reason for these differences in educational attainment stems from needs or motivations (Gage and
Brijesh 2012). A motivational model cites four basic components: (1) needs (motivations), (2) behaviors
(activities), (3) goals (satisfaction), and
(4) feedback. Motivations are factors that trigger a person to carry out an action. Money is a major motivational
factor and need in society; few things occupy as central a place in people’s lives as money. Money plays a special
role in personal and social lives, exerting more power over human lives than any other commodity (Oleson
2004). Increasingly, women are motivated to enter careers requiring higher levels of education, such as the
medical and business management fields. Women strive to earn more money and attain a sense of personal
achievement,justastheirmalecounterpartsalwayshave.
fte educational attainment of women between the ages of 25 and 64 in the labor force has increased
substantially since the 1970s. In 2011, 37 percent of these women held college degrees, compared with 11
percent in 1970. About 7 percent of women had less than a high school diploma in 2011, down from 34
percent in 1970 (Bureau of Labor Statistics 2013).
Improved educational opportunities for young women have contributed to increased influence and
affluence. Women are acquiring individual wealth through corporate employment, as well as
entrepreneurial pursuits. In terms of earning power, women are now the primary breadwinners in 17.4 million
U.S. families, more than double the number from 30 years ago. Families with two working parents have
become the standard. In 1979, women working full time earned 62 percent of what men did; today, women’s
earnings are only 22 percent less than full-time male employees. fte wage gap is smaller for younger workers
than for older workers, but clearly opportunity for improvement still exists (Bureau of Labor Statistics
2008). According to Wang, Parker, and Taylor (2013, p. 1), “Four in 10 American households with children
under age 18 now include a mother who is either the sole or primary earner for her family. ftis share, the highest
on record, has quadrupled since 1960.”
Two-thirds (66 percent) of young women between the ages of 18 and 34 rate professional success as “very
important” or “one of the most important things” in their lives. Conversely, only 59 percent of their male
counterparts cite professional success as a life priority.WhenthePewResearchCenterissuedthissurvey,morethan
half (56 percent) of young women cited career success as a top priority (Patten and Parker 2012). fte fact that this
reorganization of life priorities has occurred within a single generation is remarkable.
THE LEADERSHIP OF WOMEN

fte continued struggle of women for success in professional settings is well documented. However,
with today’s greater exposure to the workplace and more opportunities for career advancement, female
professionals and entrepreneurs are securing positions in previously male-dominated industries.
Women are obtaining executive and board positions in Fortune 500 companies and being appointed
to top government posts. A record number of women (104) were
sworn in to the 114th U.S. Congress. Canadian Prime Minister Justin Trudeau assem- bled the first cabinet
with an equal number of male and female representatives. In the legal and medical professions, women are
achieving parity with their male colleagues. Women now hold 52.2 percent of all managerial and professional
positions compared with 30.6 percent in 1968 (Pew Research Center 2015).
Currently, women manage $14 trillion in personal wealth, and that number could reach $22 trillion by
the end of the decade. By the year 2030, women are expected to control approximately two-thirds of the
national wealth. ftis projection is a product of both organic growth rates and impending transfer of wealth
between spouses and family members (BMO Wealth Institute 2015).
WOMEN ENTREPRENEURS
Female entrepreneurs are establishing new businesses at more than twice the rate of men. fte number of women-
owned businesses with more than $10 million in revenue has increased by 40 percent since 1997. Small and
mid-size companies led by women employ more workers than all Fortune 500 enterprises combined. Women
entrepreneurs also have more success in growing their primary businesses, with an average $9.1 million in
annualsales, comparedto $8.4 million for maleentrepreneurs(Grace2014).
Women are well positioned to become the new economic leaders. ftey are likely to create half of the nearly
10 million small-business jobs by 2018. A bright spot during the past several years has been the job growth
spurred by women-owned firms, especially in the retail marketplace. Since 2007, private companies owned by
women have added an estimated 340,000 jobs. Firms owned by women now account for nearly one-third of all
enterprises and are only expected to continue their upward ascent (American Express Open 2015).
In terms of innovation or introducing products that are new to some or all consumers, women
entrepreneurs outperform their male counterparts. ftis trend is not limited to the United States and Europe,
because various emerging markets and underdeveloped countries also exhibit this trend (BMO Wealth
Institute 2015).
Although the United States is ranked as the most favorable environment for female entrepreneurs,
followed closely by Canada, Australia, and Sweden, the private sector is still a work in progress. fte most
common concern for women is securing financing for their fledgling enterprise. Nearly three-fourths of
women cite financial capital as a critical challenge to launching their firms (Robb, Coleman, and Stangler
2014). In 2013, a Senate committee found that women lack sufficient access to loans and venture capital
(Powell 2014). In fact, male entrepreneurs are more than three times as likely to secure equity financing
through an angel investor or venture capitalist than women (14.4 percent compared to 3.6 percent). Men
also have more success utilizing networks of close friends and business associates. For most female
entrepreneurs (55.4 percent), bank financing is their sole source of capital. Robb and Coleman (2009)
find that men start with almost twice as much capital as women entrepreneurs. ftis disadvantage affects both
the growth trajectory and the employment potential of women-owned firms. President Susan Sobbott of
American Express Open warned that enterprises between one-fourth and half a million dollars in
revenues are at a turning point in their development (American Express Open 2015). Until this sizable
gap in financing is resolved, women entrepreneurs will fall short of maximizing their full economic
potential.
TRANSFER OF WEALTH
Besides personal income, women of the baby boomer generation are expected to inherit wealth from two
other sources: their parents and their spouses. Baby boomers are poised to inherit as much as $15 trillion over
the next 20 years (Nielsen 2012). Of married American women, 7 out of 10 will eventually become widows
and at the relatively early age of 59. ftough life expectancy has risen for both men and women due to
childhood immunization, improved health infrastructure, better living conditions, and other factors, a long-
lasting discrepancy in life expectancy still exists between men and women. Statistically, women outlive men
by an average of 5 to 10 years. Among those age 100 or older, 85 percent are women. In 2010, 40 percent of
women over age 65 were widows, compared to just 13 percent of men. Nearly 50 percent of women age 75 or
older lived alone. With women surviving their partners, much of this accrued wealth will fall under their
control (Blue 2008).
According to AARP, individuals over the age of 50 possess 79 percent of all financial assets, 80 percent of
money in savings accounts, and 66 percent of all money invested in the stock market. fte looming transfer of
wealth, in size and scope, has no precedent in contemporary American history (Brennan 2009).
Contrary to wealth transfers in past generations, today’s beneficiaries are unlikely to reside in the same
community as their parents and family members. ftis is likely to result in much reshuffling for small and
mid-size financial companies, as children can no longer be counted on to remain with the same advisors
and financial institutions as their parents. ftis outcome is especially true of women, who in surveys
have expressed dissatisfaction with the financial industry as a whole. Despite their rising affluence, the
financial service professionals, the majority of whom are men, often overlook women. According to State
Farm Insurance (2008), only one in three women trusts financial services professionals, and three in four
women are skeptical when initially meeting with a financial professional. A study by the Boston Consulting
Group (2010) find that men are 1.7 times as likely as women to be approached by a financial advisor.
Financial professionals should view the expanding influence of women as a business opportunity for
increasing their client base and assets under management (AUM).
The Psychology of Women Investors

Every investor has unique wants and needs. Research shows that women value personal relationships and
big picture thinking more than men. Studies also show that men tend to be more competitive than women in
deal making. According to Larimer and Hannagan (2010, p. 43), “Women prefer altruistic, reciprocal
relationships and men prefer competition and struggle.” Women investors value financial advisors who recog-
nize their needs as part of a whole, as opposed to framing discussions in purely monetary terms.
Women often grew up assuming that men handle financial responsibilities. As a result of their
limited opportunity set, they did not develop a financial knowledge framework. ftat knowledge gap has
tended to lessen women’s confidence in money matters. Because of a lack of financial literacy, women have
often refrained from discussing finances and have deferred questions to the male in the family (Fidelity
Investments 2015a).
Women think and behave differently from men in terms of the evaluation and decision-making
processes. Compared to men, women consider more factors, raise more questions, and consult with more
people, such as online groups, friends, and colleagues, before making an educated decision. fteir methods
diverge when measuring results, as well. Men focus more on symbols of power and success, whereas women
need to understand how power and success affects the financial position of their families and themselves.
Women want to understand how their decisions influence other areas of their lives. ftey do not focus on
performance numbers because they are on their continued progress toward achieving their life goals. ftis
observation lends credence to the fundamental divergence between men and women in terms of their
competitivenature.
Moreover, women communicate differently from men. Researchers at the University of Texas, Austin,
conclude that both genders speak about the same number of words each day—women at 16,215 words and
men at 15,669. fte research also notes that women talk more about other people, whereas men discuss
objects in their environment (Newman, Groom, Handelman, and Pennebaker 2008).
Women are typically drawn to advisors who can hold an engaging conversation and cultivate an
environment that invites broader discussion of their work and family life. ftey need financial professionals
who can empathize with their needs and respect their points of view. Clear and straightforward language is
preferable to jargon-heavy dialogue. Financial decision making is a multifaceted and emotion-invoking
process. People sense the likely interactions of others and act based on that assessment. In that regard, women
often prominently display nonverbal responses. ftey are more attuned to eye contact, facial expressions, and
hand gestures, using these cues as a means to decipher both mood and meaning.
For women, listening skills require consistent eye contact and nonverbal feedback. For example, when a
couple is buying a house, if the real estate agent is inattentive and has poor eye contact, the wife may feel
uncomfortable about buying from this person—a lack of eye contact and attention could jeopardize the sale.
Conversely, men do not consider eye contact and feedback as measures of effective listening. Numbers and facts
speak louder than facial expressions. Accordingly, men are more comfortable talking side by side, whereas
womenstronglypreferdirect,face-to-facecontact(Newmanetal.2008).
Although various stereotypes exist about gender and emotions, many factual differences exist in the
ways males and females function emotionally. ftese differences include the extent to which each recognizes
emotions in others and expresses individual emotions through facial and vocal expressions, words, physiological
arousal, and behaviors such as aggression. ftese gender differences vary according to the particular situation
involved and the cultural background ofthe participants (Levinson, Ponzetti, and Jorgensen 1999).
Women have a natural affinity for details, and their “checklists” often result in a more comprehensive
decision-making process. However, they may place less emphasis on details such as numbers, facts, and
figures, and prefer to focus on articulating their vision for life after retirement and how their portfolio needs to
be oriented toward achieve this lifestyle. “Women continue to pursue a diverse range of long-term financial
goals. According to the Pew Research Center (2015, p. 1), “they want to save enough money to maintain their
lifestyle through retirement, cover health care expenses and avoid becoming a financial burden to loved ones.”
For these women, the importance of financial independence even after retirement is the driving force. Rather
than prestige, this ability of not having torely on others motivates the investment planning.
Women want to understand how their decisions influence other areas of their lives. Men are used to
thinking that mutual funds or stocks are either green with life (when they are up) or red with death (when
they are down). Women typically are not as focused on performance numbers as they are on their continued
progress toward their life goals. ftis observation lends credence to the fundamental divergence between men
and women in terms of their competitive natures. Women prioritize long-term goal achievement rather than
current performance numbers. Conversely, women prefer consistency and measured progress toward achieving
their financial objectives or goal. Women tend to value the progress they are making toward their life goals and
the context of investment returns.
CUSTOMER LOYALTY
Customer loyalty has been the object of interest for businesses, and it is situated at the heart of customer
relationship management (CRM). Women exhibit mixed loyalty toward individual service providers and
corporations. fte difference in cognitive processes and behavior of male and female consumers is reflected in
the widespread use of gender as a segmentation variable in marketing practices.
According to Durukan and Bozac (2011), customers reflect three types in terms of customer loyalty:
(1) those who are not loyal, (2) those who are forced to be loyal because of some factors such as switching
costs, and (3) those who are fiercely loyal with no intentions of changing brands, services, or firms. fte third
type is the ultimate goal for any business, because such customers have no negative feelings and obtain
information by word of mouth. People are loyal to products that offer high satisfaction rates, as well as
competitive prices and positive company image. Customers want to be remembered and have products
that meet their needs.
However, research reveals that women are not necessarily more loyal clients than men. It is important to
provide some clarity on the context of loyalty. Although women tend to be more loyal to individual services
providers, they are less loyal than men to grouplike entities, such as a particular company or institution
(Melnyk, VanOsselaer, and Bijmolt 2009).
ftis observation is encouraging news for financial advisors who work closely with women clients on a
one-on-one basis. Actually, women tend to refer an advisor more often to their families and friends,
especially if they feel genuinely engaged and connected to the advisor’s communication style and
performance.
Women share their experiences with others, meaning that they tell many—family, friends, colleagues,
and even strangers—about their financial advisor experience. fte word-of-mouth marketing or referral
marketing benefits financial advisors by improving client satisfaction and retention. ftis first-hand
testimony creates loyalty to a brand by sharing these personal, relatable experiences. fte concept of
loyalty presents a compelling opportunity for financial professionals to make their female client
engagements memorable, because these clients will then communicate their excitement with ease. If done
thoughtfully, referrals can come with enhanced velocity and purpose. According to Blaney (2010, p. 18),
“Women rarely try to compete with the advisor, or think they know better. A women trusts her advisor, she
can be a powerful source of referrals. Men by contrast, often like to keep a great advisor for themselves.” ftis
statement shows the fundamental difference in the thought processes of women and men. Women want to
share their success, whereas men tend to fear that sharing the information will cost them in some way.
Women’s lower risk preference makes them a natural fit to focus on managing risk and capital preservation
as part of their written financial plan. By extension, a lower risk tolerance leads to a more diversified
portfolio preference to mitigate loss potential for women, rather than the more risky preference for men in
general.
Women are generally relationship driven, whereas men are typically results driven. Consequently,
women prioritize the client experience over pure results. ftey value the experience of being heard,
respected, and valued. A survey by Prudential Financial (2015) concluded that women face challenges in
trying to meet their long-term financial goals. fte research shows that women are confident in their
knowledge of day- to-day financial matters. In fact, the study reports that 33 percent of women evaluate
themselves highest on their knowledge of managing debt and 7 percent rank themselves lowest on their
knowledge of investing. In terms of knowledge of managing money or debt, women grade themselves as a
B or B minus. fte survey also found that 27 percent of married women are relatively confident in their
knowledge of key financial decisions, such as securing financing for a home and purchasing life
insurance. Although the study indicated that women feel confident to handle financial planning and
decision making on their own and feeling more financially secure, only 31 percent are now using a financial
professional. fte study suggests that companies can meet their needs by fine-tuning, rather than
reinventing, their approach to serving women clients.
THE INVISIBLE PARTNER

A lack of confidence about their personal finance decisions has long been a source of frustration for
women, hindering their ability to take greater control of family finances. As young women and girls, they
often hear the message that money is a man’s responsibility. ftat idea paved the way for women not to worry
as much about what would happen if they needed to take on multiple caregiver roles and/or be financially
independent.
Women are becoming financially and psychologically independent from their husbands at an increasing
rate, while also gaining greater confidence in personal finance and wealth management. Yet, in many cases,
women are neglected in their conversations
with an advisor when their husbands are present. Because of this disadvantaged position, women generally
need more time to gather information, especially from top influ- encers such as their husbands, parents, and
close friends. In today’s digital age, women are using the Internet to familiarize themselves with financial
terminology and products. According to a study by Prudential Financial (2015, p. 10), “a third of women
count financial company websites (31 percent) and financial news websites (29 percent) as tools for
researching and learning about financial products.” In terms of social media, women consumers use
Facebook over other social media platforms.
A thoughtful financial professional needs to respect a woman’s time and give her the space to make an
informed decision. Advisors should clearly articulate their messages and not offer solutions until their clients
fully understand their options. Offering more information to a female client than just facts and figures will give
them a greater comfort and confidence in their decision-making abilities and their ability to plan. A positive
trait of women clients is that they tend to have a better and more comprehensive picture of their family’s
financial position than do men because women often assume the dual roles of caregiver of family members
and manager of household expenses. ftus, consulting the female head of household before beginning a
financial planning engagement makes sense. For this reason, an advisor should not dismiss or ignore the
needs and opinions of the wife, even when the husband is present.
D IFFERENC ES B ETWEEN THE MALE AND FEMALE BRAIN

Women process and receive information differently from men. ftrough advances in neuroscience,
researchers now understand that women depend more heavily on certain regions of the brain. Female brains
are generally connected across the right and left hemispheres, whereas male brains forge a stronger connection
between the front and back lobes. Women tend to use both sides of the brain, whereas men primarily employ
the left side—the lobe that controls logic and reason—when making decisions or performing tasks
(Ingalhalikar et al. 2014).
fte most striking difference between the male and female brain is the corpus callosum, a stretch of
tissue connecting the right and left hemispheres of the brain. fte right hemisphere is the nexus of emotion and
creativity. fte left hemisphere processes data in a more linear and mathematical fashion (Ingalhalikar et al.
2014). Although both men and women possess right and left hemispheres, women can shuttle information
between the two sides more effectively than can men, as a result of being graced with a larger corpus callosum.
For this reason, women can draw connections between words and emotions more easily and intuitively
than men (Niu 2014).
Additionally, women tend to be more comfortable multitasking than men. Women are more sensitive to
sound and language and have an easier time expressing their emotions verbally. Although a larger inferior-
parietal lobule helps men excel in mathematics, women have a more complex limbic system, making them
better attuned to their own feelings and the emotions of those around them. Because of this difference, women
adopt a more holistic and inclusive approach to decision making. Men struggle to understand emotions when
not clearly stated; their decision-making process is narrower, focusing on precise issues and dismissing
information they deem superfluous to the matter at hand.
Finally, men are more amenable to risk than are women. fteir brains receive a greater rush of
endorphins when presented with a risk or challenge. ftis knowledge is absolutely critical to understanding
the psychology of women investors and will be discussed further in the next section.
RISK TOLERANCE
Wealthholds a different meaning for menandwomen. A study byFidelityInvestments (2015b) finds that the
majority of women (54 percent) connect wealth with security. Conversely, men generally associate the
term with status or power. ftis distinction shapesthe way menand womenapproach andthink about
investing. Menoften havea short-term perspective, whereas women value relationships and long-term goal
setting. However, the notion that women are more risk-averse than men has been somewhat overstated. For
example, Nelson (2012) performs a statistical review of existing studies on gender and risk tolerance. He finds
that the difference in risk-aversion is considerably weaker than previously thought. In fact, Nelson reports
that some studies show no
difference.
Rather than consider women as risk-averse, financial professionals would be better served to think of
them as “risk-aware.” Women need a firm understanding of the risk before proceeding. When making a major
investment decision, they desire some clarity on the potential trade-offs. Additionally, women require more
time when making an investment decision. ftey are collaborative decision makers and prefer to consult close
friends, wealth experts, and other financial resources. Perhaps a more accurate term to describe men is “risk-
enthusiasts.” In a survey conducted by Prudential Financial (2012), 70 percent of men expressed a
willingness to assume some risk in exchange for greater financial reward. Also, 40 percent of men said that
they enjoy the “sport of investing,” compared to just 22 percent of women.
Hormones, specifically testosterone, may play a role in the willingness of men to assume additional
risk. Neuroscientist John Coates conducted an experiment with 17 high-volume traders from the London
financial district. Twice a day, they reported their gains and losses and provided Coates with a sample of saliva.
His results show that above-average gains correlate with higher testosterone levels, whereas market volatility
affects cortisol levels. As Coates and Herbert (2007, pp. 4−5) note,
Cortisol is likely, therefore, to rise in a market crash and, by increasing risk aversion, to
exaggerate the market’s downward movement. Testosterone, on the other hand, is likely to rise
in a bubble and, by increasing risk-taking, to exaggerate the market’s upward movement. ftese
steroid feedback loops may help to explain why people caught up in bubbles and crashes often
find it difficult to make rational choices.
fte fact that women have substantially less testosterone than men may explain their diligent and measured
approach to risk-taking. Rational thought influences their investment decisions more than chemical
processes. Women are, therefore, less likely to succumb to market panic or “irrational exuberance.” ftis
difference may be one reason a lower percentage of women dumped equities during the Great Recession,
which
officiallylastedfrom December 2007 toJune 2009. ftis“look before you leap”approach to investing canbeboth
a blessing and a curse for the female investor. Although women may take more time to review the information
before making a decision, their decisions are less haste and more long term. Once they decide on a course of
action, they prefer to see it through.
WOMEN AND FINANCIAL LITERACY

Basic financial knowledge helps women make financial decisions with greater confidence. Whether
men actually have a more complete understanding of financial product or women suffer the effects of
low self-esteem from generations of social conditioning is unclear. In either case, with the increasing
number of single-mother households, women must feel confident in their financial literacy. ftis
development has both a short- and long-term effect on their lives and households. By increasing women’s
financial literacy, the change can become permanent and also can be passed on to future generations.
ftis change to social conditioning is likely to occur over time. However, today’s financial advisors
can drive such change by providing guidance toward supporting the understanding of finance. Guidance
includes encouraging clients to read books about people who have overcome financial obstacles. Also, offering
several workshops for vari- ousfinancialliteracylevels—beginners,intermediate,andexpert—canhelp.
Financial literacy is the ability to comprehend basic features of personal finance, such as credit, debt, and
consumer protections. ftis includes the capacity to make informed decisions about saving, budgeting,
investing, and managing money. Evidence shows that a large portion of the population possesses low financial
literacy skills, which makes building and protecting personal wealth challenging. Despite the prevalence of
financial education classes, the average American is still critically deficient in his or her basic financial
knowledge. According to a Harris Poll (2014), only 39 percent of U.S. adults keep close track of their
spending and 32 percent do not place any portion of their income into a retirement savings account.
Poor financial literacy can be especially costly for women, who endure more pronounced economic
challenges than men, such as greater longevity and its attendant healthcare costs. Caregiving and familial
responsibilities can also impede their ability to conserve and grow their wealth. Because of childbirth and
responsibilities associated with parenting, women are more likely than men to have transitioned out of the
workforce at some point in their lives. By the age of 62, 90 percent of men have at least 35 years of earning
history versus 30 percent of women at that age. For this reason, women must make a concerted effort to
remain financially “fit.” To achieve this, women must understand their financial position, investment
opportunities and risks, and how much they need to save to ensure a comfortable retirement.
Forsomewomen, moneyremainsanuncomfortabletopicofconversation. According to Fidelity Investments
(2015b), 80 percent of women report refraining from discussing finances with those close to them. Less than
half of the women surveyed indicate they would feel confident discussing money with a qualified
professional. Yet, 77 percent indicate they would feel confident discussing medical issues with a doctor. In
certain cases, their reluctance to discuss money with close friends and financial professionals
prevents them from gathering important financial information. ftis underscores the need for increased
financial literacy for women. Although their lack of comfort talk- ingtofinancial professionals maybea
result of socialconditioning, itcanbeovercome through increased understanding of the goals and decision-
making process for women. Women under the age of 35 are dealing with unexpected hardships. fte Great
Recession and the rising cost of education have made advancement especially difficult forthem.fteyhavethe
highestunemploymentrateofanyagegroupandthelowestrate of financial product ownership. According to
Prudential Financial (2012), 22 percent of women under 35 lack a checking or savings account. Additionally, 67
percent of those surveyed depend on family or friends for financial support. Although this demographic is also
the most eager for financial information, financial professionals must to a better job educating younger women
in order to prevent them from accruing debt and ruining theircredit.ftisgroupofwomenmorethantheir
predecessorsseesthevalueandneed for financial literacy and stability. However, reaching them must be done on
their terms. As previously stated, this demographic relies heavily on the word of friends, family, and social
media sources such as Facebook. fte ability to gather information from these
sources is paramount to them.
D EFINING SUCCESS AND FAILURE

As men and women define success differently, they also have contrasting views of failure. Although both
male and female business owners state that hard work is the key factor in recovering from a business failure,
men are much more likely than women to ascribe the recovery to self-confidence (33.3 percent versus 17.5
percent) (Robb et al. 2014). When a man fails, he points to factors like “didn’t study enough” or “not inter-
ested in the subject matter.” When a woman fails, she is more likely to believe that failure results from an inherent
lack of ability. In situations in which a man and a woman each receive negative feedback, the women’s self-
confidence and self-esteem drop by a much greater degree. fte internalization of failure and the insecurity it
breeds hurt future performance, so this pattern has serious long-term consequences (Sandberg 2013). ftis
difference means that men recover from failure and are quickly ready to move forward and even take risks
again. Yet, women tend to feel the failure and need a longer period of time before moving forward. ftis
characteristic can also result in decreased risk tolerance for women. During this post-failure period it is
imperative for women to have more support to overcome these effects on their self-esteem and self-
confidence.
Men possess a more positive opinion of their capabilities as entrepreneurs. Despite similar levels
of education and experience, less than half of women (47.7 percent) express confidence in their ability to
start a business, compared with nearly two-thirds (62.1 percent) of men. In Japan, where women assume
a secondary role to men, only 5 percent of women surveyed believe they have the requisite skills to
launch a business (Clifford 2013). However, this social engineering and conditioning can be overcome.
Supporting women entrepreneurs during the early stages of a business venture is critical to their success.
Talented women should be encouraged to return to entrepreneurship-related activities after initial setbacks
and develop new opportunities for future success. Helping women understand the cause of the setback by
providing practical education can help them return to entrepreneurship. ftis period of growth can
also be a catalyst for their future achievement, because they will carry this information forward and help
inform future decisions.
GENDER INEQUALITY IN FINANCE

In the financial industry, women continue to be severely underrepresented. Although finance organizations
now recognize the need for greater diversity in the workplace, progress has moved at a very slow pace. As
Chandler (2015) reports, women constitute just 9 percent and 6 percent of senior management in venture capital
and private equity firms, respectively. Women occupy just 3 percent of senior positions in hedge funds.
Although the figures have improved from a decade ago, they have not kept pace with other industries. To
rectify this imbalance, financial companies must identify talent early and implement plans to prepare female
professionals for future leadership positions. A study by Bardon, Devillard, and Hazelwood (2015) reveals that
gender diversity was a top 10 strategic priority for just 28 percent of companies. One-third of companies sur-
veyedhad no plansfor improving gender diversity within their structures or culture.
According to the Bureau of Labor Statistics (2015), financial planning is expected to be one of the
fastest-growing fields in the United States, yet the number of women joining practices has stagnated. Only 23
percent of Certified Financial Planners (CFPs) are women, even as the number of CFPs has increased
(Certified Financial Planner Board of Standards, Inc. 2015). A report by the Certified Financial Planner
Board of Standards, Inc. (2014) shows that 42 percent of CFP® professionals believe that more women would
be drawn to the profession if firms used a salary-based pay model instead of commissions or pay based on
AUM. According to Kingsbury (2015, p. 4),
It is a myth that women are not interested in their financial lives. ftey’re interested, but they
want a female-friendly advisor who will coach and educate them about how to best navigate
the twists and turns of their financial lives. Not one that just sells products.
Women are especially well suited for careers in financial planning. ftey tend to be good listeners, forward
looking, and holistic in their approach to planning. Although married and single women rarely express a gender
preference, one in four women who are wid- owed or divorced strongly prefer a female advisor (Ettinger and
O’Connor 2011). For this demographic, the driving forces in the decision on choosing an advisor are comfort
and relatability. To remain competitive, senior partners must do a better job advocating for gender balance in
the workplace.
Gender equality in finance will be realized only when public and private institutions make a commitment
to foster a more inclusive corporate culture. Even after decades of progress, many companies still lack gender
diversity. Consequently, balancing the scales involving gender diversity and equality is likely to take time.
FINA NC IA L C ONCERNS FOR WOMEN

fte thought of running out of money in their later years is a concern shared by many successful women.
Even those with considerable financial knowledge often fear they may not have enough money set aside to
support their families after retirement.
fte pressures of caregiving can compound these worries. Many women assume full responsibility for
caretaking needs, which takes both an emotional and a financial toll. Adults over the age of 50 who look after
their parents lose roughly $3 trillion in wages, Social Security, and pensions. fte financial cost is higher for
women, who exhaust an estimated $324,044 as a result of caregiving—$40,328 more than men in
caregiving roles. Rising healthcare costs threaten to only exacerbate the problem. Additionally, women are
more likely than men to sacrifice career ambitions to care for others: 16 percent of women take less
demanding jobs (compared to 6 percent of men) and 12 percent give up work entirely (3 percent of men).
A total of 70 percent of working caregivers report difficulties at work because of their responsibilities at
home (Family Caregiver Alliance 2012).
Between caregiving and increased life expectancies, the financial concerns of women are justified.
ftese uncertainties force women to be more cautious and prag- matic when planning for retirement. Men
approaching retirement age tend to focus narrowly on the needs of their partners, whereas women
consider all members of their extended family: grown children, grandchildren, parents, siblings, and
other relatives.
Although women still save less for retirement than their male counterparts, their attitudes toward saving
and planning are changing. In a survey by Fidelity Investments (2015b), 74 percent of female respondents said
that they are proactive about saving for the future. Additionally, 81percent said that they have become more
involved in their long-term financial planning over the past five years, and 83 percent want to become more
involved within the coming year.
Closing the Gender Gap in Financial Wellness

Studies on financial wellness demonstrate tangible results. For example, an annual survey by Financial
Finesse (2015) reports a 4.2 percent increase between 2012 and 2014 in the number of women who
consider themselves on track for retirement. For men, this figure dropped 1.5 percent over the same
time span (Hannon 2015), Women professionals are taking greater control of their personal finances and
reaping the rewards.
fte number of women who have placed money in an emergency fund has also increased. ftough
women are doing a better job preparing for the future, they still trail behind their male colleagues in money
management and investment practices. Men tend to be more confident in their investment strategy. Only 34
percent of women feel confident that their investments are properly allocated compared to 48 percent of men.
Similarly, 55 percent of men say they have taken a risk-tolerance assessment; just 40 percent of women offer
the same response (Financial Finesse 2015).
According to the U.S. Census Bureau (2015), women are losing an average of
$10,672 in annual income due to gender-based wage discrimination. A more aggressive and diversified
investment strategy could help counterbalance this income disparity. Yet, the cautiousness of women
investors often keeps them from committing to more proactive investment plans.

Women often unintentionally neglect their personal finances because of other responsibilities. An increasing
number of women find themselves in the “sandwich generation,” simultaneously responsible for raising their
own children and caring for their elderly parents. In many cases, women have to coordinate care for the
whole family, such as for both an 8-year-old daughter and an 80-year-old father. Some women are struggling
to balance their careers with their family responsibilities. As a result of feeling overwhelmed,
overextended, and overworked, many women pay less attention to financial planning. Often this causes
women to set aside their jobs to fulfill these responsibilities. Consequently, this leads to a loss in future
financial planning opportunities.
A pressing need exists to educate financial professionals on the psychology of women investors. Firms
should instruct professionals on how to ask better questions, listen more attentively, and read verbal cues and
body language. Professional communication courses should become a prerequisite for advisors. ftis will ensure
a level of service that opens the door to long-term relationships and enhanced client satisfaction. Moreover,
the precise skills that strengthen relationships with female investors—such as patience and empathetic
listening—will facilitate improved communication and understanding. Financial professionals who continue to
ignore the individual values, motivations, and needs of women investorscanexpect toseetheir businesses
gradually decline. Instead, increasing the number of women clients should be considered a business opportunity
to expand the client base and Assets Under Management (AUM). As women assume a larger role in the
global economy, firms should consider adapting their client service and/or business model. fte one-size-fits-all
approach is no longer an appropriate solution. Women expect customized service and clear communication
from financial experts. Womenwhohaveexperiencedmajorlifeevents,suchasdivorceordeathofaspouse,will
undoubtedly have unique needs and preferences. Firms committed to building strong, personal ties with their
female clients will enjoy improved client retention and acquisition. Training and mentoring talented women
should be a priority for every financial institution. A diverse workplace is a more adaptable, marketable,
and profitable one. Women add value to companies through their intuitive and collaborative approach to
client relationships. With women inheriting a greater share of wealth, the demand for
female financial advisors and wealth professionals will only grow.
To bridge the confidence gap, financial professionals must improve how they engage women with low
financial literacy before providing them with the necessary tools to manage their money with greater ease.
ftey need to remember that women clients often want more time to consider their decision. By making a
commitment to better serve women clients, financial professionals will help their clients safeguard their
money and gain confidence at any stage of their lives.
1. Explain how men and women view investing differently and why advisors should know this.
2. Explain why women often lack confidence about financial matters and how this may affect their
financial decisions.
3. Identify several important financial concerns of women.
4. Discuss how the caregiver role affects investing.
5. Discuss how advisors should treat women.
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14
The Psychology of Millennials
APRIL RUDIN
Founder and President
Rubin Group
CA T H E R I N E M C B R E E N
Managing Director
Spectrem Group
Introduction
fte premiere episode of the 41st season of Saturday Night Live in October 2015 featured a parody of a
commercial for a new TV workplace drama called “fte Millennials.” Crammed into this short sketch was
perhaps every stereotype attached to a generation deemed to be self-absorbed, entitled, and irritating. For
instance, one character demands a promotion after having worked at the company for three days. Others engage in
obses- sively texting on their phones, oblivious to all around them. A third character needs “perspective”
and tells her boss she will no longer come to work, but that she is not quitting. fte boss, who has spent 25
years working and sacrificing to “claw his way to the top” of this company, sums up his disdain for this new
generation of workers: “I hate these kids.” fte show has never done similar generational parodies about baby
boomers or Gen Xers. But millennials seem to be a major target, especially by their elders.
In his Time magazine story profiling the demographic of young adults born between 1980 and 2000, Stein
(2013) reflects on what he calls the “Me Me Me Generation.” ftis barbed portrait casts millennials in the
worst light as coddled, lazy, and above all, narcissistic. Yet, regarding how millennials will shape the financial
services industry and the future of advisor–client relationships, maybe the attention is all about them—if not
today, then certainly tomorrow and for decades to come. To paraphrase Bob Dylan, the times are changing
once again.
Currently, baby boomers dominate the ownership of investment assets. ftey also represent the largest
percentage of investors to currently reply on financial advisors. Millennials, at 80 million strong, have
surpassed baby boomers as the largest generation. In 2015, millennials represented more than one-fourth
of the U.S. population (Census Bureau 2015) and represented more than one in three American workers
(Fry 2015a). By 2020, millennials will constitute about 46 percent of all U.S. workers (Brack and Kelly
2012). ftis group also has the potential to become the wealthiest generation sofar.
241
ftis chapter discusses qualitative and quantitative age and wealth-segment research of millennials by the
Spectrem Group and the investment attitudes and behaviors of millennials by the Rudin Group. It
specifically examines how the financial crisis of 2007–2008 helped shape their attitudes toward personal
financial situations, the overall financial services industry, and financial advisors. ftis research indicates that
millennials, as were the boomers before them, are poised to leave their imprint on the financial services
industry, changing business as usual in the way they interact with advisors, whether human or robo, and whether
they use twenty-first-century tools and resources to shape their financial futures.
Millennials and Boomers—Two Different Worlds

fte rules of engagement by which financial advisors conduct business with their baby boomer clients is
unlikely to be as effective with the millennials, who grew up during financially unstable times.
According to Facebook IQ (2016), a little over half, or 53 percent of millennials feel they have no one they can
trust for financial guidance, and in fact only 8 percent trust financial institutions for such advice. fte
Facebook study reports that millennials drive 40 percent of the financial conversations on the social network,
generating 6.5 million posts, comments, likes, and shares. Baby boomers are the TV generation, but
millennials are not bound by one screen; they are “cutting the cord” and viewing the media on their own terms
and schedules. More tech-savvy than baby boomers, millennials are also more responsive to the latest
gadgets and are quicker to integrate them into their daily lives. Similarly, they are not utilizing the traditional
communication platforms; for example, two-thirds of millennials do not have landlines.
But millennials do share their elders’ concept of the American dream as envisioned by Pulitzer Prize-
winner James Truslow Adams, who coined the term in 1931. He saw America as a land of equal opportunity
that would allow people to attain to the fullest stature of which they are innately capable, regardless of the
circumstances of birth or position (Adams 1931). Similarly, 6 in 10 millennials define the America dream as
“equal opportunity for all people.” fte second highest percentage of millennials (56 percent) believe that the
American dream translates to educational opportunities, whereas 44 percent see it as owning one’s own
home (Spectrem Group 2015a).
For many financially beleaguered millennials, however, this goal is a dream deferred. Among non-
millionaire millennials, ownership of a principal residence is down considerably from 2014—from 62
percent to 50 percent. Nearly half (46 percent) see the American dream as having sufficient retirement
assets. ftis finding indicates that despite financial challenges, millennials view the American dream as
aspirational. Figure 14.1 shows the generational divide on how millennials view the American dream as
compared to their older counterparts.
MILLENNIALS AND FINANCIAL LITERACY

Several studies provide information about the financial literacy of American millennials. For example, Tang,
Baker, and Peter (2015) find that when presented with three basic questions about stocks, interest rates, and
inflation, only one-fourth of respondents could answer all three correctly. Furthermore, only 2 percent of
respondents show consistently
The Psychology of Millennials 243
By Age
63%
An equal opportunity for all people 57%
71%
79%
44%
Owning a home 42%
4 3%
47%
46%
Having sufficient retirement assets 51%
55%
58%
41%
43%
Job security 47%
45%
49% 56%
Educational opportunities 55%
61%
Future generations will do better than the 46%

53%
current generation 55%
55%
32%
30%
Being able to retire when i want 37%
36%
2% 8%
None of the above
5%
2%
Under 40 41–50 51–60 61 and over
Figure 14.1 Views of the American Dream, by Age Group. ftis figure shows survey- based data on what
the American Dream means to millennials compared to previous generations. Source: Spectrem Group
(2015a).
responsible money management behavior in three categories: paying off debts in a timely manner, setting and
sticking to a budget, and saving toward retirement; the average survey respondent exhibited responsible
behavior in only one of these categories. fte study also showed a disconnect between financial knowledge and
money management behavior, in that millennials make poor financial choices even though they may know
better.
A study by T. Rowe Price (2015) finds a generation that is practicing good financial habits, especially
compared with baby boomers. fte study also reports that millennials are saving nearly as much for
retirement as did baby boomers, but that more millennials have increased their 401(k) savings. fte study
also found that 75 percent of millennials carefully track their expenses, compared with 64 percent of baby
boomers. According to the study, nearly 9 in 10 millennials indicate they are “pretty good” at living within
their means, while roughly three-fourths profess being more comfortable saving and investing their extra
money than spending it. According to a Wells Fargo
I am very
knowledgeable 17%
about
financial
25%
products and
investments
I am fairly
knowledgeable, 41%
but still have a
great deal to 54%
learn
I am not very
knowledgeable
about financial 39%
products and
investments, 21%
but i do
understand...
Millennials with
I am not at all less than $1MM
knowledgeable 3% net worth
about financial
products 0% Millennials with
and investments more than $1MM
net worth
Figure 14.2 Knowledge Level for Investors, by Age Group and Income. ftis figure shows survey-based data
on how non-millionaire and millionaire millennials perceive their financial literacy regarding financial products
and investments. Source: Spectrem Group (2015i).
(2014) study, 8 out of 10 millennials report that the Great Recession taught them to save “now” to prepare
in case of future economic problems.
According to a study by Bank of America/USA TODAY (2015), nearly 7 in 10 millennials (68
percent) learned about money from their parents. Although 60 percent feel their parents did a good job teaching
them about finances, almost half (47 percent) wish they had started talking to them about money sooner.
Contrary to the common stereotype, millennials have few illusions about their financial literacy.
Among non-millionaire and millionaire millennials, the highest percentages consider themselves only fairly
knowledgeable, with still much to learn about financial products and investments (Spectrem Group 2015i), but
millionaires are more likely than non-millionaires to describe their financial knowledge this way than non-
millionaires (54 percent vs. 41 percent). Figure 14.2 shows the confidence levels of non- millionaire and
millionaire millennialsregarding theirfinancialknowledge.
THE MILLENNIAL MINDSET

Millennials came of age during the financial crisis of 2007–2008, the worst economic crisis since the Great
Depression. During this period, many of the largest and most
recognized financial institutions folded, including Lehman Brothers, Bear Stearns, and Countrywide. Younger
millennials witnessed the devastation that the financial crisis inflicted on their parents’ financial situations,
while older millennials entering the workforce found the job market rife with layoffs and
unemployment.
ftefinancialcrisiswasaprofoundrealitycheckformillennials. Sevenin 10 Americans believe that a college
education is very important (Newport and Busteed 2013); interestingly, in 1978, when Gallup first asked this
question in a survey, only 36 percent considered a college education to be very important. According to the
Council of Economic Advisors (2014), though, millennials are the most educated generation, with almost
half (47 percent) having earned some postsecondary degree, compared to nearly one- third of baby boomers
who reached that same milestone. Millennials with a net worth of at least $1 million are more apt to credit their
education, rather than hard work, as their primary wealth-creation factor, compared to Gen Xers, baby boomers,
and seniors, who rank their education as second behind hard work (Spectrem Group 2013).
According to an analysis of government data, half of today’s college graduates are either unemployed or
underemployed in jobs for which they are either overqualified or not in their field of study (Yen 2012). fte
national unemployment rate for young adults ages 18 to 34 years old reached a recession height of 12.4 percent
in 2010, but by the first half of 2015 this rate had dropped to 7.7 percent, yet it was still well above the national
average of roughly 5.5 percent for the same period (Fry 2015b).
According to Patten and Fry (2015), millennial men are not only less likely than their Gen X
counterparts to be employed but also less likely to be employed compared with baby boomers and seniors
when they were the same age (primarily in the 1970s and 1980s). Millennial women are also less likely to be
employed compared with Gen Xers, but they are in a better position employment-wise than their baby
boomer and so-called silent generation forebears (women of previous generations who more commonly
stayed home and raised a family). Many millennials are compelled to delay important long-term life
decisions, such as starting a family and buying a house, because of the financial challenge of unprecedented
student debt, which is reported at more than
$1 trillion (Kantrowitz 2016).
ftis pattern has earned millennials the sobriquet of “boomerang children”—young adults waiting out a
constrained job market or otherwise unable to afford a place of their own, and having returned home to live with
their parents. In 2015, 15.1 percent of 25- to 34-year-olds were living at home (Matthews 2015), which is the
fourth straightannual increase for this group.
In fact, U.S. Census Bureau data show that 36.4 percent of millennial women ages 18 to 34 lived with
their families in 2014, the highest percentage since 1940. ftese young women are more likely to be college
educated and unmarried than earlier generations of American women in this age group, as they struggle with
economic issues such as student debt, high cost of living, prolonged economic downturn, and a chal-
lenging job market. As for millennial men, the data show that 42.8 percent lived with their parents or relatives
in 2014, but this was below the 47.5 percent recorded for men in 1940 (Fry 2015c).
Besides getting room and board, 35 percent of millennials report receiving parental financial assistance
(Bank of America/USA TODAY 2015). At least 20 percent get financial help to pay their cellphone bills,
groceries, and unexpected expenses. Further,
80 percent of those who receive help from the “bank of mom and dad” report that they know many friends
their age receiving similar assistance.
A ROSIER LONG VIEW

Despite their difficult circumstances, millennials are relatively optimistic about their short- and long-term
financial futures. Rather than living only for today, as exemplified in some of the harsher media portrayals,
many are proactively planning for their retirement. A generation that has never known a day without the
Internet is using mobile devicestomanagetheirfinances,aswellastoincreasetheirfinancialliteracy.
ftree-fourths of non-millionaire millennials with a net worth of at least $100,000, excluding a primary
residence, report that their financial situation is currently better than it was one year ago (Spectrem Group
2015c). ftis observation is on a par with Gen Xers and well above the 60 percent of those surveyed who ages 45
and up. Eight in 10 of non-millionaire millennials and their Gen X cohorts are equally confident that their
financial situation will be stronger one year from now than at present.
Millionaire millennials with a net worth between $1 million and $5 million, excluding a primary residence,
offer a more cautious view of their present and future financial situations, with 6 in 10 indicating that they are
better off now than one year ago, and three- fourths expecting to be in a stronger position financially one year
from now (Spectrem Group 2015h). ftis same trend exists for their ultra-high net worth (UHNW) counter-
parts, or those with a net worth between $5 million and $25 million. Six in 10 of them report they were better
off financially in 2015 than in the previous year, whereas about 7 in 10 expect to be better off in the next 12
months (SpectremGroup 2015k).
Of the non-millionaire millennials, 71 percent indicate that they fully expect to have sufficient income to
live comfortably during retirement. ftey are not alone in their guardedly optimistic forecasts. Of non-
millionaire Gen Xers, 64 percent feel similarly, along with 62 percent of baby boomers and a more confident 78
percent of the seniors. Millionaire millennials are less confident than previous generations that they will have
sufficient income to live comfortably during retirement (Spectrem Group 2015i). Figure 14.3 shows
how non-millionaire and millionaire millennials gauge their retirement security.
I Fully Expect to Have Sufficient Income to Live Comfortably During Retirement
Less than $1MM Net Worth Greater than $1MM Net Worth
71% 68%
64% 70%
Agree
62% 84%
78% 93%
Millennials Gen X Baby Boomers WWII
Figure 14.3 Survey Responses to Question about Retirement Planning. ftis figure shows survey-based
data about how millennials view their retirement security compared to previous generations. Source: Spectrem
Group (2015i).
A majority of young adults are confident they will be able to live comfortably in retirement on their
income. ftis situation represents an opportunity for financial advisors to engage them on financial planning.
As millennials embark on their careers, a primary concern is seeking adequate help that will allow them to reach
their financial goals.
NATIONAL AND PERSON AL C ONC ERNS

Financial advisors seeking to engage millennials should know what national and personal issues weigh
most on their minds. On the national front, young adults with a net worth of less than $1 million are most
concerned about tax increases, followed closely by the fractious political environment. At least two-thirds
rank the federal deficit as the national issue most on their minds. Additionally, 6 in 10 identify low interest
rates on savings, inflation, and stock market performance as concerns. On the personal front, non-
millionaire millennials are most concerned about two of the most pressing financial matters they will face in
their lifetimes: financing their children’s education, and being able to retire when they want to. ftese concerns
eventakeprecedenceovermain- taining their current financial situation (Spectrem Group 2015i).
Millennials recognize that health concerns could have a direct impact on their retirement savings. A
majority of them express concern about taking responsibility for their aging parents, a percentage on a par with
the Gen Xers and baby boomers. Roughly 4 in 10 non-millionaire millennials cite their own health, the healthof
their spouse, a family health catastrophe, and spending their final years in a healthcare facility as their primary
personal concerns (Spectrem Group 2015c).
On two financial issues, non-millionaire millennials express even greater concern than their older
counterparts. fte first involves using their wealth to help others, while the second is about business revenues
for an entity they own. fte latter speaks to another generational difference. Unlike previous generations,
whose careers followed the traditional 9-to-5 route at a company, millennials want to start their own busi-
nesses. Nearly one-third (32 percent) of millennials who are self-employed are running their own start-
ups, compared to just 9 percent of their baby boomer cohorts (TD Ameritrade 2015).
Millennials and the Use of Financial Advisors

Millennials represent a strong growth opportunity for financial advisors. As Figure 14.4 shows, young adults
with a net worth of less than $1 million are more likely than older investors to identify themselves as self-
directed, meaning they make all their financial and investment decisions without the guidance of a professional
advisor. Increasing age is generally associated with greater wealth and more instances in which investors seek a
financial advisor. Figure 14.4 shows how millennials engage financial advisors compared to older
households.
Figure 14.4 shows that millennials eschew using a financial advisor primarily as a matter of frugality and
a perception that financial advisors would not deem them worthwhile clients. Almost half (46 percent) of non-
millionaire millennial households believe they cannot afford a financial advisor, and at the same time they
consider their assets
Less than $1MM

Millennials 51% 38% 11%
Net Worth
Gen X 47% 37% 13% 4%
Baby Boomers 37% 32% 18% 13%
WWII 34% 29% 26% 11%
$1MM Net Worth

Millennials 38% 38% 10% 14%
Greater than
Gen X 43% 35% 16% 6%
Baby Boomers 28% 31% 27% 14%
WWII 28% 32% 25% 15%
Self-Directed Event-Driven Advisor-Assisted Advisor-Dependent

Investors make their Investors make most of their own Investors regularly consult with Investors rely on an
own investment decisions but use an investment an investment advisor regarding investment professional
decisions without the advisor for specialized needs such as most investment needs, but or advisor to make most
assistance of an retirement planning, asset allocation make most of the final decisions or all investment decisions
investment advisor advice or selecting alternative
investments
Figure 14.4 Degree of Advisor Use, by Age Group and Income. ftis figure shows how Millennials engage
financial advisors compared with older households. Source: Spectrem Group (2015i).
insufficient to justify using one. Tellingly, their wealthier counterparts in millionaire and UHNW households
indicate they do not use financial advisors primarily because they feel they can do a better job (Spectrem
Group 2015b, 2015f, 2015j).
According to Bond (2015), millennials do not trust financial planners, for several reasons. One is the
negative reputation of the financial industry as a result of the financial crisis of 2008. Additionally, reasons
include the income inequality debate, confusing jargon, high fees, cultural differences, and Internet or media
access to free financial planning information such as on Yahoo! Finance, CNN Money, and MSN Money.
And if many millennials are not seeking the advice of a financial advisor, the feeling seems to be mutual.
Only 30 percent of financial advisors are actively looking for clients in this age demographic. fte belief is that
younger individuals have lower income and less wealth. And generally speaking, older households have more
assets and most advisors get paid on a percentage of those assets. Older baby boomers own 22 times more in
assets than households under age 35, so financial advisors understandably want to focus their attention on this
older demographic (Steverman 2015).
However, according to Andree (2015), millennials possess some valuable qualities. For example, they
have an entrepreneurial spirit and want to leave their mark on the world. Additionally, millennials are well
informed and tech-savvy. ftey also want to build community and often seek information, especially
online.
THE IMPETUS FOR SEEKING FINANCIAL ADVICE

What would compel millennials to consider using an advisor? Regardless of their wealth level, a majority cite
three scenarios: (1) receiving a windfall of money with which they would need help investing; (2) a
specific financial situation for which they would
seek professional advice, such as creating a financial plan; and (3) a situation in which they could receive a
financial advisor’s services for what they perceive to be a fair price (Spectrem Group 2015b, 2015f, 2015j).
Non-millionaire millennials are much more likely than their older counterparts to consult a financial
advisor in these situations. Nearly 4 in 10 (38 percent) would consider using an advisor following a change in
their household status, such as marriage or a new baby, compared with 8 percent of Gen Xers, 16 percent of
those ages 45 to 54, and 9 percent of baby boomers. ftey are also at least twice as likely as older households to
consider using an advisor should they tire of managing their investments (Spectrem Group 2015b). Under
these circumstances, millionaire millennials would be more likely than their older cohorts to consider
engaging a financial advisor. As their wealth increases, the percentage of millennials who might consider
using a financial advisor also increases if they no longer want to manage their investments.
HOW MILLENNIALS VIEW A FINANCIAL ADVISOR

Despite the popularity of technology, this age demographic finds advisors through referrals, which older
generations also use. According to Johnson and Larson (2009, p. 66), consumers generally “use word-of-mouth
referrals [because] they trust the people they are asking to give them a good recommendation, and consumers
trust friends, relatives, and experts they know in a related field.” Regardless of their wealth level, millennials
are most likely to be referred to an advisor by a family member or friend (Spectrem Group 2015b, 2015f,
2015j).
Millennials seek specific characteristics from their advisors and place the highest premium on perceived
honesty and trustworthiness. ftis first generation of digital natives, whose homes likely contain at least one
computer and who post and tweet about their personal lives on Facebook, Twitter,and other social media, lives
by transparency and expects similar openness from a financial advisor. Indeed, millennials place less empha-
sis on fees or commissions charged, or whether the advisor’s firm is well known, than on the advisor’s
investment track record or the quality of referrals.
When they use them, millennials enter into a working relationship with a financial advisor armed with
preferences and prejudices. First and foremost, they expect their advisors to respond promptly to inquiries
and questions. ftey also prefer to work with one advisor who handles all facets of their wealth. ftat their
advisor has professional registrations and licenses is less important than it is for older households, but millen-
nials place more importance on their advisor’s regularly outperforming the market. Nearly 6 in 10 non-
millionaire millennials rate their advisors on whether they regularly outperforms the market, compared with
53 percent of millionaires and 42 percent of UHNW households (Spectrem Group 2015b, 2015f, 2015j).
Are financial advisors biased toward certain investment groups or products? A majority of millennials think
so. Toa lesser extent, they also feel that advisors are more concerned with selling products than with helping
their clients. According to a study by the Pew Research Center (2014), this skepticism is perhaps endemic
to millennials. fte study reports that only 19 percent of millennials believe that most people can be trusted,
compared with 31 percent of Gen Xers, 37 percent of seniors, and 40 percent of baby boomers.
TRUST ISSUES FOR MILLENNIALS

Among affluent investors, trust in one’s financial advisor increases with age. ftis is not surprising. On a scale of
from 0 to 100, with 100 equaling “great trust,” non-millionaire millennials rate their trust of financial
advisors at only 69, compared to 75 for Gen Xers, 79 for those ages 45 to 54, 82 for baby boomers, and 83
for seniors. Although the scores are relatively higher for millionaire and UHNW millennials, they nonethe-
less express less trust in financial advisors than do their older counterparts (Spectrem Group 2015b).
How do millennials define trust as it pertains to a financial advisor? fte highest percentage consider trust
to mean that the financial advisor is looking out for the client’s best interests, followed by an advisor’s
admission if he is wrong. Also, millennials are much more likely to express these views than would their
older cohorts. ftey are also most likely to see the advisor–client relationship as one in which the advisor can
be countedonto makeno mistakes(Spectrem Group 2015b,2015f,2015j).
Millennials are less likely than older investors to insist that the advisor contact them regularly. ftey are also
generally less likely to expect the advisor to relay important information pertaining to their investments.
ftat is, financial advisors find that millennials are engaged investors who may be less inclined to be actively
involved in the day-to-day management of their investments, but who enjoy investing and would not want to
give it up. Non-millionaire and millionaire millennials prefer advisors to contact them on a quarterly or at least a
semi-annually basis (Spectrem Group 2015b, 2015f).
RISK TOLERANC E AND IN V EST MEN T P REFERENC ES

As might be expected, millennial investors have a higher tolerance for risk than do older investors. Somewhat
more than half (54 percent) of non-millionaire millennials indicate that they are willing to take substantial
investment risk on a portion of their investments so as to earn a high return, compared with 44 percent of
investors ages 45 to 54, 37 percent of baby boomers, and 27 percent of seniors ages 65 and up (Spectrem
Group 2015c). ftis evidence does not suggest that millennials invest without regard to risk, however.
Regardless of their wealth level, millennials consider the risk associated with an investment as the most
important factor in investment selection, followed by an investment’s tax implications and the diversity of
the investment (Spectrem Group 2015b, 2015f, 2015j).
According a separate study, non-millionaire millennials are more likely to consider an investment’s track
record as an investment selection factor (79 percent) than are their millionaire (53 percent) and UHNW
(54 percent) counterparts. ftey are also more impressed by the reputation of the firm making their
investments. ftree-fourths of non-millionaire millennials consider the firm’s reputation when selecting an
investment, compared with 62 percent of millionaire and 65 percent of UHNW millennials investors
(Spectrem Group 2015c, 2015h, 2015k).
As Figure 14.5 shows, the social responsibility of an investment tends to have a higher priority among
younger investors than among older households. More so than other generations, millennials are inclined to
choose companies that are not only “performing well” but that also are “doing good.” But across all wealth
segments and all age
77%
Tax implications 67%
of investments 74%
69%
81%
Level of risk associated 84%
with investments 90%
85%
72%
Diversity of investments 84%
85%
85%
40%
Social responsibility
35%
of investments
36%
31%
79%
Past track record 72%
of investments 77%
78%
75%
Reputation of companies 79%
where investments are made 81%
82%
Millennials Gen X Baby Boomers WWII
Figure 14.5 GenerationalCriteria forMaking InvestmentDecisions. ftisfigure shows survey-based data

indicating the factors millennials consider to be the most important in selecting an investment, compared with
previous generations. Source: Spectrem Group (2015i).
groups, less than 50 percent cite social responsibility as a primary investment selection factor. Millennials are
no different than older generations; the highest percentage of them consider their investment objectives to
be purely financial.
HOUSEHOLD MONEY MANAGEMENT

In terms of financial planning, there are several ways for financial advisors to engage millennials. One major
category of millennials’ concern is debt. Across all wealth segments, millennials make up the highest
percentage of respondents who indicated concern about the amount of debt their households currently
carry.
Debt is a real and growing concern. Whether the debt involves student loans, home mortgages, or car
payments, two-thirds of millennials of ages 23 to 35 in 2012 reported having at least one source of outstanding
long-term debt. ftirty percent indicated more than one loan, and 81 percent of college graduates mentioned
having at least one source of long-term debt. One-third of millennials with annual household income
above
$75,000 doubt they will be able to repay their student loans. And besides student loans, or long-term debt,
millennials carry short-term debt, mostly credit card balances. More
than half of millennials who used credit cards in 2015 reported carrying a balance in the previous 12 months—a
balance for which they were charged interest (Scheresberg and Lusardi 2015).
How are millennials handling their household finances? As have their elders, millennials are most likely
to pool finances as a household (Spectrem Group 2015c, 2015h, 2015k). However, the number of millennial
households that make their financial decisions jointly decreases with an increase in wealth. Seven in 10 non-
millionaire millennial households make their decisions jointly, compared with 61 percent of millionaire
households and just 35 percent of UHNW households. ftat is, the number of millennial households in whichthe
husband makes most of the financial decisions increases with wealth, from just 15 percent of non-millionaires
to 35 percent of millionaire and 59 percent of UHNW millennials. Accordingly, the rate of spousal agreement
about finances is higher among non-millionaire millennials than it is for their wealthier counterparts. But
between spouses and financial advisors, the latter are credited with being more helpful in making financial
decisions as a household’s net worth increases. Non-millionaire millennials scored financial advisors at 61 on
a scale of 0 to 100, on which 100 equaled “very helpful.” In comparison, they scored their spouses at 69.
Millionaires gave their financial advisors a score of 60 and their spouses a 56 on the helpfulness scale, whereas
UHNW millennials gave their financial advisors a 61 versus a 60 for their spouses.
fte degree of wealth is a factor in how millennials engage financial advisors. Non- millionaire
millennials report that they control 73 percent of their assets without any professional help, compared with
millionaires, who control 53 percent of their assets and UHNW Millennials, who report controlling 52 percent.
Across all wealth segments, older investors tend to cede more control of their assets to an advisor. Millionaire
millennials have financial advisors controlling over the highest percentage of their assets— 20 percent versus
9 percent among non-millionaires and 13 percent among UHNWs. fte latter consult with a financial
advisor, but make the final investment decisions themselves for over 35 percent of their assets, compared
with 27 percent for millionaires and 18 percent for non-millionaires. Non-millionaire millennials are most
likely to turn to a discount broker or independent financial planner, whereas their wealthier counterparts are
more likely to engagethe services of a full-service broker (Spectrem Group 2015b, 2015f, 2015j).
The Role for a Financial Advisor

What advice does an financial advisor most likely provide to millennials? Among non- millionaires, the
likelihood of receiving advice about creating a financial plan increases with age. Millennials are twice as likely
as earlier generations to receive this advice from someone other than a primary financial advisor. ftis means they
are turning to lawyers, accountants, or even the Internet for this type of advice. Millionaire and UHNW mil-
lennials are also more likely than older generations to have received this advice from someone other than
their primary advisor (Spectrem Group 2015b, 2015f, 2015j).
What do these affluent young adults think is most important to include in their financial plan? For
non-millionaire and millionaire millennials, the most important items are the investment rate of return
needed to meet their financial goals, as well as
how to calculate their present net worth. Besides these factors, UHNW millennials think their financial
plan should include tax-planning advice and guidelines (Spectrem Group 2015b, 2015f, 2015j).
Additionally, non-millionaires and millionaires in this age group are more likely than their older
counterparts to indicate a willingness to seek advice in the future about a wider range of issues. ftese issues
include diversifying their assets; selecting individual stocks, bonds, and mutual funds; implementing tax-
advantage financial strategies; seeking alternative investments such as hedge funds; using credit effectively;
and establishing retirement income streams. Currently, these millennials are the most likely to indicate they are
already receiving advice about these issues from someone other than a primary advisor. Generally this
means they are turning to family members or friends for advice, as well as researching topics on their own on
the Internet (Spectrem Group 2015b, 2015f, 2015j).
As non-millionaire millennials are more likely than wealthier households to identify themselves as self-
directed investors, they make up the highest percentage of millennials who would be “likely” (54 percent) to
use an advisor in the future. In comparison, 25 percent of millionaire and UHNW millennials indicate they
would “likely” use an advisor in the future (Spectrem Group 2015b, 2015f, 2015j).
ADVISOR SATISFACTION
Are millennials harder to please than older investors? Regardless of their wealth level, roughly half of all
millennials report that overall they are satisfied with their advisors. fte percentages increase with age.
Specifically, among surveyed non-millionaires, millennials are less likely than their older counterparts to
express satisfaction with their advisor’s knowledge and expertise (57 percent), responsiveness to requests
(54 percent), and performance (45 percent). Millionaire and UHNW millennials are the least satisfied
with their advisor’s performance in comparison to older households (Spectrem Group 2015b, 2015f,
2015j).
fte greatest concern of the millennial investors who work with a financial advisor is a failure to
communicate. Yet, this is just one of the reasons millennials would switch advisors, in contrast with older
generations. Among non-millionaire millennial investors who do use an advisor, nearly 7 in 10 indicate they
would fire their advisor if their phone calls were not returned in a timely manner (e.g., by at least the next day).
Only 50 percent of non-millionaires ages 36 to 44 feel likewise, as do 54 percent of those ages 45 to 54, with
roughly two-thirds of baby boomers and seniors agreeing with that sentiment. Similarly, non-millionaire
millennials are slightly more likely than older generations to indicate they would switch if their advisors did
not return e-mails in a timely manner (Spectrem Group 2015b).
Non-millionaire millennials would also be more likely than older generations to change their
financial advisors after losses accrued over the span of one, two, or five years, and if the advisor is
underperforming compared to the overall stock market. Older investors express a willingness to change
advisors because of a lack of proactive contact, as well as if their advisors talked to them only about
investments and seemed not concerned about their overall financial situation.
Regarding fees, non-millionaire and millionaire millennials are more likely than older generations to
consider the services of a professional advisor to be expensive; UHNW millennials feel less so in this
regard. Especially, non-millionaire millennials do not adopt the mindset of being unconcerned about the fees
they pay as long as their assets are growing. In fact, roughly one-fourth express being unconcerned about the
fees they pay as long as their assets are growing, compared with 32 percent of Gen Xers, roughly 30 percent of
baby boomers, and one-third of seniors. Among all surveyed non- millionaire and millionaire investors,
millennials constitute the highest number who prefer to pay fixed fees for financial and investment advice
(Spectrem Group, 2015b, 2015f, 2015j).
In fact, millennials consider fee-only planners more likely to possess the trustworthiness, honesty, and
thoroughness they seek in an advisor ( Johnson and Larson, 2009). fte highest percentage of UHNW
millennials prefer that the cost of financial advice be tied to product performance. Yet across all wealth
segments, millennials’ comfort level with the fees they pay is on a par with their older counterparts.
fte actions that financial advisors take with their millionaire millennial clients seem to be working, because
42 percent of those millennials state they are more satisfied with their advisor today than they have been in the
past, compared with 29 percent of Gen Xers, 31 percent of those ages 36 to 44, 37 percent of baby boomers, and
36 percent of seniors ages 65 and up. Non-millionaires and UHNW millennials are the least likely across all
age groups to report they are currently more satisfied today than in the past with their advisor. Additionally,
millionaire millennials are more likely than their older counterparts to believe their financial advisors are very
professional or knowledgeable; UHNW millennials are the least likely to express this opinion (SpectremGroup
2015b, 2015f, 2015j).
What do millennials expect from their financial advisors? Regardless of wealth level, millennials put the
highest premium on an advisor who offers products from different companies, has professional registrations
and licenses, and responds promptly to their inquiries and questions. Although having their advisor call them
regularly is less a priority across all wealth segments, this service is more important to millionaire millennials
(42 percent) than it is for their non-millionaire (24 percent) and UHNW counterparts (33 percent)
(Spectrem Group 2015b, 2015f, 2015j).
Millionaire millennials indicate they are most in agreement with their advisors. For example, 84 percent
feel their advisor understands their appetite for risk, compared with 68 percent of non-millionaires and 71
percent of UHNW households. How does this translate to a referral? On a scale of 0 to 10, with 10 equaling
“highly likely,” the highest percentage of millennials who scored between 0 and 6 on whether they would
recommend their primary advisor to a friend or colleague were non-millionaire and UHNW households.
Millionaire millennials are more likely than older investors to score between 7 and 8 (Spectrem Group
2015f).
Not surprisingly, millionaire millennials express more loyalty to their financial advisors than do non-
millionaires or UHNW households. When asked what they would do if their advisor left the firm for another,
58 percent of millionaires said they would move with their advisor. In comparison, 41 percent of non-
millionaires and 46 percent of UHNW responded similarly. With the exception of Gen X millionaires, non-
millionaire and UHNW millennials indicate they would be most likely across the generations to
stay with the firm, indicating that changing would be too much of a hassle (Spectrem Group 2015f).
TECHNOLOGY AND FINANCIAL INFORMATION

Complicating the financial advisor–client dynamic, but representing yet another opportunity to engage young
adults, is the Internet and mobile technology that put store- houses of news and information just a click away.
According to the Council of Economic Advisers (2014), millennials are more connected to technology than
older generations, and one-fourth of millennials believe that relationship to technology is what makes their
generation unique. According to the Council of Economic Advisers (p. 7), “While all generations have
experienced technological advances, the sheer amount of computational power and access to information that
Millennials have had at their fingertips since grade-school is unparalleled.”
Not surprisingly, millennials more than older age segments consider traditional news channels and
platforms such as the telephone, newspapers, and television to be outdated, and are more apt to rely on social
media to communicate and to obtain their information. Millennials, more than previous generations, indicate
a greater likelihood of using their smartphones for activities such as corresponding with their financial advisors
and obtaining market updates (Spectrem Group 2015d, 2015g, 2015l). But the pervasiveness of social
media and mobile technology has not yet translated into widespread use of technology for financial activities
beyond checking account balances, making purchases, and paying bills. Table 14.1 provides a sampling of
current social media usage conducted by non-millionaire households for a variety of financial activities.
Young adults express the most interest in the prospect of reading financial blogs posted by financial or
investment firms, preferably on the websites of major financial media outlets. ftey are also interested in
reading blogs that pertain to financial topics (Spectrem Group 2015d, 2015g, 2015l).
Tech-savvy young adults would be considerably more interested than older affluent households if their
financial service firms provided information via social media and through apps. ftey would also be more
inclined to use a financial product or service they saw advertised or discussed on a social media platform.
Tech-savvy young adults are more than twice as likely as older households to consider choosing a new
financial advisor or provider based in part on how much that advisor communicates using social media
(Spectrem Group 2015d, 2015g, 2015l).
Just as millennials have come of age accustomed to watching what they want, when they want, and on the
portable screen they want, they are most open to watching videos on financial websites. Four in 10 non-
millionaire millenials report having done so, compared with 35 percent of Gen Xers and fewer than 3 in 10 of
baby boomers and seniors. fte most commonly watched videos on the financial websites are financial
information videos, followed by videos on current financial events and stock tips, as well as videos
featuring financial commentators (Spectrem Group 2015d).
In gathering financial information, millennials share some of their older counterparts’ old-school
preferences for talking to someone in person and in reading an article. Yet, pertaining to communication with
a financial advisor, millennials are the most likely age demographic to prefer email over the telephone or in
person contact. Again,
Table 14.1 Social Media Most Likely to Be Used for Specified Activities
Facebook LinkedIn Twitter YouTube None or Not

% % % % Applicable %
Researching investment 1 3 1 4 91
information
Finding a financial or 2 7 0 1 90
investment advisor
Obtaining market updates 3 2 2 2 91
Reading articles about 8 7 1 2 81

financial topics
Watching videos about 7 3 1 21 67
financial topics
Note: ftistable shows survey-based data on the overall usage of social networks bynon-millionaire investors for
conducting their financial activities.
Source: Spectrem Group (2015d).
the percentages are small (less than one-fourth), but millennials have taken the lead in communicating with
their financial advisors via Facebook, LinkedIn, Twitter, and Snapchat. Among all age segments, millennials
are most likely to consider using a smartphone or e-reader to have a video chat with or meeting with a financial
advisor. Nearly all millennials surveyed report having a smartphone, and almost three-fourths use a tablet
(Spectrem Group 2015d, 2015g, 2015l).
Although older individuals are more likely to follow the news via their devices, millennials are the most
likely to indicate they use such devices to research information on financial products and services
(Spectrem Group 2015d, 2015g, 2015l). fte highest percentages of millennial Twitter users follow family or
friends, followed by movie stars, but they are more likely also to follow financial and/or investment
commentators on Twitter than are older generations. Additionally, they are more frequent daily and weekly
online buyers and sellers of stocks.
With this technology at their disposal, how tempted will millennials be to bypass human advisors and
opt for a virtual or robo-advisor? Spectrem Group (2015b, 2015f, 2015j) indicates that, for now, human
advisors can rest easy. For a wide range of services, including establishing a financial plan, obtaining
insurance to meet personal needs, adjusting investments in conjunction with status changes, selecting
investments for a retirement plan, and picking stocks that align with their risk tolerance, the highest percentage
of investors regardless of age think a personal advisor would do a better job. Financial advisors should consider
that among the comparatively fewer who think a robo-advisor would do a better job, the highest percentage are
millennials. According
Familiarity with Terms

(0 = Not at all familiar, 100 = Very familiar)
24.27
21.88
18.71
15.23
12.82
Robo-Advisor
≤ 35 36–44 45–54 55–64 ≥ 65
Figure 14.6 Client Familiarity with Investment Terms. ftis figure shows survey-based data about the
familiarity of affluent millennial investors with the term
“robo-advisor.” Source: Spectrem Group (2015i).
to Observer (2015), robo-advisors are a possible “gateway to millennials.” fte Journal of Financial
Planning article quotes a CNBC piece in which Adam Nash, founder of Wealthfront, a robo-advisor
wealth management firm, observes that the financial advice industry has large ignored young people because
servicing them is not economical. Technology changes that debate because helping young people with their
money can now be economical. Figure 14.6 shows that familiarity with the term “robo-adviser” is low
overall but highest among millennials.
Millennials embarking on that long road to a secure financial future are more inclined to seek advice
and counsel from a professional in the future. Yet, the hurdles they face now—debt, a volatile market, an
uncertain economy and job market, and “sandwich generation” responsibilities caring for their fledgling
households and their aging parents—represent strong arguments for employing a financial advisor, whether
human or technology-based. Figure 14.7 illustrates that millennials are more likely than previous generations to
consider using a service that is either 100 percent technology- based or uses platforms such as Skype or
FaceTime.
MILLENNIAL INVESTOR PROFILES

As with any generation, advisors should avoid painting millennials with one broad brushstroke. No
“typical” millennial household exists; one-size-fits-all financial planning models are outmoded for this age
segment. Nevertheless, some generalizations can be made. Based on interviews and surveys, Spectrem Group
(2015e) has identified five millennial investor profiles that vary on demographics, wealth status, and
investment mindset:fteClimber,OnMyOwn,NoWorries,Family Matters,andtheWorrier.
• The Climber is the most aggressive investor among his peers. Climbers tend to hold high-profile, high-
income jobs such as attorneys, consultants, or information technology professionals and are the most
advisor engaged.
• On My Own is the least wealthy millennial investor, but this type has a strong work ethic and
conscientiously saves its money. Two-thirds are women. ftey are the most likely to prioritize getting advice
to reach their financial goals. Nearly 7 in 10 of these
Likelihood of usage
(0 = Not at all likely, 100 = Very likely)
42.07
35.23
A service that is 100% technology based where I
provide my information and the service 31.56
recommends a portfolio for me to invest in.
24.27
16.73
40.69
32.55
A service where I communicate with my advisor
through Skype/FaceTime video or on-line chat 27.09
communication and do not meet in person with
the advisor. 20.68
16.73
≤ 35 36–44 45–54 55–64 ≥ 65
Figure 14.7 Likelihood of Client Use of Financial Services via Technology. ftis figure shows survey-based
data involving a generation gap in interest about using a virtual advisor or communicating with an advisor via
technology. Source: Spectrem Group (2015i).
investors consider themselves fairly or very knowledgeable about financial products and investments, and so
they identify themselves as moderate to aggressive investors.
• No Worries are the wealthiest of the millennial investor personas with half crediting their wealth to
receiving an inheritance and 67 percent to being in the right place at the right time. ftis group tends to be
ethnically diverse and has the highest percentage of two-income households. ftey prefer regular financial
advisor contact and are big users of technology in their dealings with them. In terms of investing, they are
more likely than their peers to invest in pharmaceuticals and construction, and have the largest portion of
their investible assets in equities.
• Family Matters are older millennials who have a “married with kids” mindset that influences their financial
decisions. Concerns about retirement and health issues make frugality an important theme. With a moderate to
aggressive risk tolerance, 21 percent of their investible assets are in fixed income and almost half (48 percent)
are in equities. Less than half (44 percent) have an advisor. fte primary reasons they give for not using an
advisor are that they do not know whom to use, they get help from friends or family, and concerns that an
advisor willnotlookoutfortheirbestinterests.
• The Worrier, not surprisingly, is more likely than his or her peers to self-report being either “fairly” or
“not very” knowledgeable about financial products and investments. Eight in 10 identify their risk
tolerance as moderate. Although they tend to be well educated, they have the second lowest net worth of
all millennial personas, just above the On My Own millennial. Paradoxically, more than half indicate
they enjoy investing. Just over half (54 percent) have an advisor. Others who do not have an advisor believe
they cannot afford one or that they do not have enough assets to warrant using an advisor.

How will the millennials impact the financial services industry? Given the financially volatile times in which
they grew up, millennials can be cautious about its practitioners. ftey have witnessed the bursts of the dot-
com and housing bubbles, the Enron and Bernie Madoff scandals, and the financial crisis of 2007–2008, its
subsequent recession, and its prolonged economic recovery.
Non-millionaire and millionaire millennials profess to have a more moderate to aggressive risk
tolerance than older investors. fte largest percentage of their investable assets is in equities, but the next largest
percentage is in cash and liquid assets.
As for the industry and its practitioners, millennials cannot be taken for granted. fte Millennial Disruption
Index (2015), a three-year survey by Scratch, an in-house unit of Viacom that identifies the industries “most
likely to be transformed by Millennials,” reports that banking is at the highest risk of disruption. Nearly 7 in 10
millennial respondents predict that in five years the means by which they access money and pay for things will
be completely different.
fte title of a Time magazine story by Kadlec (2014) indicates the generation gap in thinking about
financial institutions. “Why Millennials Would Choose a Root Canal Over Listening to a Banker” reports
the perception that banks do not address millennials’ unique financial challenges “in a relevant way… . ftis
generation is loaded with student debt that’s difficult to refinance; grossly underemployed without access to
capital to start a business … and hungry for financial guidance that isn’t self-serving. Millennials also want to
conduct their affairs on a smartphone, not go to a bank branch—ever.” According to the Millennial
Disruption Index (2015), nearly half of millennials are counting on tech start-ups to overhaul the way banks
operate, and nearly three-fourths of them indicate they would be more excited about a new financial services
offering from Google, Amazon, Apple, PayPal, or Square than from their own banks. One-third of this
group does not think they will need a bank.
To engage this wary and independent-minded generation, financial advisors will need to prove their
worth. Advisors must recognize how millennials differ from their older counterparts in regard to financial
professionals. Communication is important to millennials, whether they use traditional channels such as
the telephone or the increasingly digital landscape. Financial advisors will need to more widely use social
media and the Internet for communicating with investors. ftey havethe responsibility
for engaging these younger clients with the communication platforms they are most comfortable using.
Even the less advisor-assisted millennials can be encouraged to turn to advisors to answer the questions
they cannot find on Google or via a computer algorithm. A robo- advisor cannot fully project how financial
decisions will affect their lives. Instead, millennials will turn to advisors who have reached out to them and have
established their trust. Although millennials tend to do their own research on potential investments, they are
seeking advice. According to LinkedIn (2015), about 34 percent of affluent millennials say that financial
advisors are a “must-have,” compared to 27 percent of affluent Gen Xers. Financial advisors who look beyond the
millennial stereotypes will be better positioned to nurture enduring relationships and help put millennials in
the most advantageous position for the success to which their popular culture indicates they feel entitled.
Discussion Questions
1. Explain why millennials are distrustful of the financial services industry.
2. Explain how millennials differ from baby boomers other than age.
3. Discuss how financial advisors can engage millennials.
4. Explain how the money habits of millennials disprove the stereotype that they are a lazy and an entitled
generation.
References
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Part Four
THE PSYCHOLOGY
OF FINANCIAL SERVICES
15
Psychological Aspects
of Financial Planning
D AV E Y E S K E , C F P ®
Managing Director, Yeske Buie
Distinguished Adjunct Professor, Golden Gate University
EL I SS A B U I E , C F P ®
CEO, Yeske Buie
Distinguished Adjunct Professor, Golden Gate University
Introduction
Personal financial planning is a process for uncovering client goals and values, and for developing
integrated strategies to best utilize all a client’s human and material resources in pursuit of those goals in a way
that is consistent with that client’s personal values and preferences. Change is a conceptual lens through
which to view financial planning. Specifically, financial planners help their clients adapt to environmental
changes, including death, disability, divorce, and inheritance, or to affect volitional changes, including
retirementand financingchildren’seducation.Change canbe challenging.
According to the World Health Organization (WHO), depression is the leading cause of disability
worldwide (Moussav, Chatterji, Verdes, Tandon, Patel, and Ustun 2007). fte WHO also notes that one of the
biggest sources of clinical depression is an inability to adapt to unexpected change, or even, in many cases,
“important and normal” life transitions. Other studies show that the incidences of ulcers, headaches, and
depression are threetofive times higher for those individuals under financial stress(Choi2009). Tothe degree that
it can help facilitate life transitions and mitigate financial stress, the financial planning process carries the potential
to improve a person’s mental and physical health.
Far fewer people will face a debilitating disease or legal crisis than will experience a bad financial outcome
during their lifetimes. fterefore, financial planning holds more promise to deliver individual and societal
benefits than many of the traditional professions, such as medicine and law.ftis chapter describes the natureof
the financial planning process, discusses the challenges associated with effecting positive financial change in the
lives of individuals and families, examines the nature of the underlying relationship between planner and
client, and analyzes the behavioral challenges that financial planners must overcome when developing
financial planning strategies to help their clients achieve their life goals.
265
266 THE PSYCHOLOGY OF FINANC IAL SERVICES
The History and Development of Personal

Financial Planning
On December 12, 1969, Loren Dutton laid the foundations upon which financial planning would emerge as a
distinct professional practice, when he convened a gathering of 13 financial services industry leaders at a
hotel near O’Hare Airport in Chicago. As a result of this meeting, the Society for Financial Counselling
came to serve as the umbrella for a membership organization, the International Association for Financial
Planning (IAFP), and an educational arm, the College for Financial Planning (Brandon and Welch 2009). fte
first graduating class of the college, in turn, formed the Institute of Certified Financial Planners (ICFP) in
1973. Before then, personal financial planning had existed largely in university home economics
departments, where the focus was on teaching individuals how to use and protect their personal financial
resources. Although a growing number of individuals engaged in the sale of financial products had already
begun to cross traditional boundaries, cross-licensing in both insurance and securities, the IAFP, the ICFP,
and College for Financial Planning created a focal point around which the financial planning profession would
begintocoalesce(Brandon and Welch 2009).
In 1971, the College for Financial Planning developed a curriculum intended to prepare individuals
to give financial advice to the public. It also created a credential, the Certified Financial Planner (CFP)
designation, which would identify those individuals who had completed a series of five courses. fte
study guide for the first course, “Counseling the Individual—Basic Financial Planning,” was divided into
six sections: (1) Fundamentals of Financial Counseling, (2) Money Management and Personal
FinancialReports,(3) Reviewing Financial Media,(4)fteInvestmentModel,
(5) Considerations in Effective Financial Planning, and (6) Counseling and Consumer Behavior.
Lesson 2 of this original curriculum enumerated the services of the financial planner as follows: collecting
and evaluating financial and personal information, counseling on financial objectives and alternations,
installing the financial program, coordinating the elements of the financial plan that involve others, and
keeping the long-range financial plan current in light of internal and/or external changes (Brandon and
Welch 2009). ftis foundation would later become the six-step financial planning process.
In 1985, the rights to the CFP trademarks became part of the newly formed nonprofit
International Board for Standards and Practices for Certified Financial Planners (IBCFP), later
renamed CFP Board of Standards (CFP Board), as part of transitioning control of the CFP trademarks to
a new, nonprofit standards-setting body. Any institution of higher learning can now register a financial
planning education program with CFP Board and qualify its graduates to take the CFP exam. What had
been a series of six three-hour exams became a 10-hour exam administered over two days. In 2014, CFP
Board moved to a six-hour exam administered electronically via testing centers and designed to be
psychometrically comparable to the former 10-hour exam. fte number of colleges and universities with
educational programs registered with CFP Board grew from 20 in 1987 to 225 in 2014. ftese registered
institutions offer certificate, bachelor’s, master’s, and doctoral degree programs. In
Psychological Aspects of Financial Planning 267
the meantime, the College for Financial Planning became one of many among the various registered
programs. In 1992, the college created the National Endowment for Financial Education (NEFE), which
eventually became the parent entity for the college; and in 1997, NEFE sold the College for Financial
Planning to the Apollo Group. ftereafter, NEFE became solely devoted to providing financial education
to consumers.
In 1990, Australia became the first member of the International CFP Council and in 2004, CFP
Board transferred the rights to the Certified Financial Planner and CFP trademarks outside the United States
to the Financial Planning Standards Board (FPSB). As of 2015, the FPSB had 26 nonprofit organizations as
members offering the CFP trademark in their respective territories.
The Financial Planning Process

Both standard-setting bodies for Certified Financial Planners—CFP Board in the United States and
Financial Planning Standards Board in all other countries—define the financial planning process as the
following six steps (Certified Financial Planner Board of Standards 2015):
1. Establishing and defining the client-planner relationship.

2. Gathering client data including goals.
3. Analyzing and evaluating the client’s current financial status.
4. Developing and presenting recommendations and/or alternatives.
5. Implementing the recommendations.
6. Monitoring the recommendations.
Financial planners draw from the following six primary subject areas or knowledge domains when
advising clients:
1. Financial statement preparation and analysis including cash flow analysis/planning and budgeting.
2. Risk management and insurance planning.
3. Investment planning.
4. Income tax planning.
5. Retirement planning.
6. Estate planning.
CFP Board and FPSB member organizations both employ a certification process for financial plans that
revolves around what the organizations refer to as the “Four Es.” ftese consist of the following:
• Education. A specified course of study covering topic areas and competencies specified by CFP Board
and FPSB. Educational institutions must register their programs for them to satisfy this requirement.
Candidates for certification must also hold a bachelor’s degree.
• Examination. Candidates must pass an extensive certification exam designed to test applied knowledge.
• Experience. Candidates must havethree years ofrelevant professional experience to become certified.
• Ethics. Both candidates and CFP professionals must agree to abide by an extensive code of ethics and
professional conduct. Failure to do so may result in public or private censure, suspension of the right touse
the marks,andpermanentrevocation.
The Strategic Dimension of Financial Planning

As might be expected in a practice-oriented profession, the financial planning literature has generally been
dominated by material that is topical in nature and contingent on the current state of applicable laws and
regulations, as well as on prevailing economic conditions. Certain themes can be seen to emerge from the
more conceptual offerings, especially related to the financial planner’s role as strategist.
QUANTITATIVE TECHNIQUES BORROWED FROM

FINANCE AND ECONOMICS
Many of the more enduring insights that emerged from the early planning literature came from the
application of traditional finance tools in new ways to better plan for individuals. Warschauer (1981), for
example, offers a uniform risk-liquidity balance sheet approach to accounting for obtaining a client’s
true financial position. ftis framework went well beyond the traditional balance sheet for individuals by
reflecting the embedded taxes in appreciated capital assets and the net present value (NPV) of employment-
related benefits like pensions and Social Security. Rudd and Siegel (2013) later expanded on this concept
with their “lifetime balance sheet.” ftis extension explicitly included not just the present value of Social
Security on the asset side of the ledger but also measures of “human capital,” including the NPV of future
earnings and bonuses. In this framework, the liability side of the statement includes the NPV of future
goals including retirement spending and college funding. ftis process allows calculating net resources (i.e., the
difference between total resources and total goals), and a margin of safety (i.e., net resources expressed as a
percentage of total resources). Such an approach also allows for a more complete risk analysis of a family’s
total portfolio of assets and liabilities. For example, one’s fixed income portfolio will consist not just of
bonds, certificates of deposit (CDs), and money market funds (MMFs) but also mortgages, deferred taxes,
and Social Security. fte financial planner can then analyze the sensitivity of this rather exotic but more accurate
fixed-income portfolio to various risks using traditional analytical tools such as duration analysis, which is
the average life of a financial instrument such a bond.
As would be expected, such quantitative approaches to analyzing client needs and circumstances have
only grown in number and sophistication. ftese tools most often represent the application of techniques from
other fields to the realm of the individual. For example, Hopewell (1997) introduces stochastic modeling,
especially Monte Carlo
analysis. Hopewell observes that most of the analyses performed by financial planners, from calculating life
insurance needs to estimating the cost of financing retirement or a child’s education, involve uncertainty. ftese
uncertainties can include future rates of return, inflation rates, and the timing and duration of future needs,
among other things. Simple deterministic approaches can provide a point estimate or, at best, a series of
point estimates allowing one to illustrate best and worst-case scenarios. However, as Hopewell (1997, p. 85)
notes “such analyses show what is possible, but not what is probable.” fte author observes that although
Bayesian probability analysis, decision trees, and Monte Carlo simulations have appeared in the business
literature for 40 years, none of these techniques had previously made an appearance in the financial planning
literature.
Following Hopewell (1997), stochastic modeling became a regular topic in the literature, including
further forays by Kautt and Hopewell (2000) and Kautt and Wieland (2001). fte shortcomings of the
technique also drew scrutiny, as when Nawrocki (2001) observed the dangers of assuming that variables
are normally distributed and uncorrelated when using Monte Carlo analysis. He suggests an alternative
“exploratory simulation” technique that involves fewer assumptions.
Meanwhile, Daryanani (2002) offers “sensitivity simulations” as a faster alternative to Monte Carlo, and
Brayman (2007) proposes an algorithmic approach to creating a “reliability forecast.” Besides requiring less
iteration to produce a result, this latter approach is useful in generating a matrix illustrating multiple “success
factors” as opposed to the single success factor generated by the Monte Carlo technique.
Another quantitative technique that has emerged and grown in popularity is scenario planning.
Ellis, Feinstein, and Stearns (2000) introduced this technique, originally developed by Royal Dutch
Shell, to financial planners and it rapidly gained wide acceptance. Scenario planning involves
identifying bundles of events that are likely to occur together and creating stylized “scenarios” from
these bundles. The planner then analyzes these scenarios in terms of the appropriate strategic response
that each would require (Stearns 2006). Other similar techniques include sensitivity simulations
(Daryanani 2002) and discrete event simulation (Houle 2004). Other tools and perspectives
borrowed from the fields of finance and economics have included life-cycle finance (Bodie 2002;
Basu 2005) and real options (Kautt 2003).
DECISION RULES AND POLICY- BASED

FINA NC IA L PL AN N ING
Another thread running through the financial planning literature involves process- oriented techniques.
ftese techniques often take the form of decision rules (Kautt 2002) that are meant to provide a framework
for rapid decision making in the face of changing external circumstances. Financial planners have adopted tools
and techniques developed in other fields, including the use of investment policies (Boone and Lubitz 2004).
An extension of the investment policy concept is policy-based financial planning, a concept first proposed
byHallmanandRosenbloom(1987)andlaterdeveloped by Yeske and Buie (2006, 2014).
Policy-based financial planning involves the development of statements (policies) that capture what
clients intend to do and how they intend to do it in terms not limited to the present circumstances. Among
the characteristics that mark a good financial planning policy are that it must be both broad enough to
encompass changing external circumstances and time-specific enough to provide a clear answer. Policies are
intended to be enduring touchstones that keep clients anchored to an appropriate course of action,
especially when buffeted by turbulent environments. To be effective, policies must reflect to a large degree
not only a client’s explicit financial goals and the financial planning principles related to those goals but also a
client’s belief system and preference structure.
One can think of the sequence within which policies arise as follows: client beliefs or values give rise to
goals and objectives, which are then formulated as policies that embody the relevant financial planning best
practices, and the policies in turn dictate specific actions in the face of a particular set of external circumstances.
If and when the external circumstances change—and assuming the client’s underlying beliefs and goals have
not changed—the policies will return new answers without repeating the entire analysis. Of course, if clients
do not see their beliefs and values reflected in their policies, they are less willing to be guided by them. For this
reason, the initial “data gathering” done by the financial planner must be expanded into an extensive
“discovery” process. ftis extended discovery process is aimed at uncovering the personal history, beliefs,
and values that ultimately give rise to a client’s stated goals.
Another branch of this process-oriented work has developed around the concept of safe withdrawal rates.
A safe withdrawal rate refers to the maximum rate at which individuals can spend from the investments
earmarked for retirement to minimize the risk of prematurely consuming the entire principal. Bengen (1994,
1997, 2001) was the first to address this question in a rigorous manner, building upon theoretical founda-
tions previously developed by pension actuaries. Recent developments have brought this area more fully into
the policy-driven realm by incorporating active decision rules that can be used to support higher initial
withdrawal rates (Guyton 2004; Guyton and Klinger 2006; Klinger 2007). As with policy-based financial
planning, and unlike circumstances involving static withdrawal rates, the decision rules developed by
Guyton and Klinger are most efficacious with the active understanding and participation of clients.
INTERIOR DIMENSION AND FINANCIAL LIFE PLANNING

As previously noted, more financial planning techniques require both a deeper understanding of clients’
underlying motivations and their active engagement in the process itself. Fortunately, a growing body of work
addressing this issue has evolved, almost entirely since 2000. Some refer to this area as interior finance,
financial life planning, and life planning, with the last phrase garnering the greatest number of citations. fte
beginning of this body of work can be traced to a conference presentation given by Dick Wagner and George
Kinder at the Institute of Certified Financial Planners (ICFP) 1994 Retreat at Cheyenne Mountain in
Colorado. Titled “Money and the Meaning of Life,” Wagner and Kinder’s presentation offered more
questions than answers. fte standing- room-only attendance on all three days that the session was offered
attested to the fact
that the two presenters were not alone in thinking the time was right to address the interior (i.e., subjective
and humanistic) dimension of money.
As a direct consequence of this now-famous gathering, an informal think tank called the Nazrudin Project
(namedfor a Sufi mystic) emerged. Many of the original members of “Naz” went on to develop techniques and
conceptual frameworks for dealing with the interior dimension of the financial planning process. ftese
works include Wagner (2002) in the area of interior finance, which is a term he coined, Kinder’s (2000) The
Seven Stages of Money Maturity, Kinder and Galvan’s (2005) EVOKE system, and Kahler’s
(2005) financial integration framework. Carol Anderson and Mitch Anthony coined the term “financial life
planning” and much work has been done under that label (Diliberto and Anthony 2003; Anthony 2006;
Diliberto 2006).
Wagner’s work was notable for the novel way it used the integral framework of Wilbur (2001) to position the
financial planning process. Wilbur’s integralism is built around the concept of the holon, which is intended to
represent the individual perspective of a human being. A holon is a process which is both a whole and a
part.
Figure 15.1 shows that the holon is divided into quadrants with the two on the left representing the interior
dimension and the two on the right representing the exterior dimension. fte two top quadrants encompass
the individual dimension and the two lower quadrants represent the collective dimension. When viewing a
financial planning client from this perspective, the upper-left or individual-interior quadrant represents a
client’s values, beliefs, goals, and objectives, whereas the upper-right or individual- exterior quadrant
encompasses all those objective facts about a client, including education, occupation, income,
expenses, assets, and liabilities. fte lower-left, or collective-interior, quadrant shows the beliefs and values
that are collective, derived from family or society. Finally, the lower-right, or collective-exterior, quadrant
indicates all the objective facts about the world, including tax rates, inflation rates, stat of the economy,
and the financial markets.
For most of its history, financial planning has emphasized the two exterior quadrants, focusing primarily on
powerful quantitative tools often applied to solve highly stylized goals and without much reference to a client’s
preference structure. fte growing awareness that has led the planning profession to begin exploring the interior
dimension with
Figure 15.1 fte Holon in Financial Planning. ftis figure indicates the four lenses through which humans
view and evaluate the world. Source: Wilbur (2001) and Wagner (2002).
such vigor is that simply finding financial solutions that are technically feasible is insufficient. For maximum
success, the planner must choose from the many alternatives those strategies that are best matched to a client’s
personality, belief system, and personal history. ftese strategies have the highest probability of success, in part
because they enlist a client’s “bureaucracy of habits” (Heller and Surrenda 1995) in achieving the desired
change.
Besides offering new perspectives, another notable aspect about the work being done on the interior
dimension is that it generates specific tools and techniques for improving the discovery process and other
elements of the financial planning process (Kinder and Galvan 2005). Although financial planners have
previously addressed the interior dimension in their work with clients, what is undeniably new is the
development of systematic approaches that can be applied successfully by planners of varying abilities and
experience. Kinder’s (2000) The Seven Stages of Money Maturity spawned two-day, week-long, and
multi-week workshops that provide planners with new tools for exploring interior issues with clients.
Besides worksheets of various types, these tools include questions designed to progressively strip away clients’
preconceptions about the role of money in their lives and to allow a deeper understanding by the planner of
the client’s preference structure. With this deeper understanding, planners can do a better job of developing
meaningful alternatives for clients. Others have developed formal systems for improved discovery,
including Carol Anderson (“Money Quotient”), Mitch Anthony (Financial Life Planning), Lucerne and
Colman Knight (Imagination Made Real), Diliberto (Financial Life Planning), and Klontz and Kahler
(Insite).
C ONNEC TING THE IN TERIOR AND EX TERIOR

Yeske (2010) suggests that, when viewed as a whole, the more conceptual portion of the financial planning
literature naturally falls into the following three categories: (1) quantitative tools, (2) process-orientation,
and (3) interior dimension. From this observation, Yeske proposes the Financial Planning Strategy Modes
(FPSM) model as a way of organizing the skills, tools, and techniques used by financial planners around these
three themes and in terms of the degree of relative involvement by planner and client in the planning process.
It posits five modes of strategy making along this degree of involvement spectrum, beginning with the
planner-driven mode and progressing through data- driven (quantitative tools), policy-driven (process
orientation), relationship-driven (interior dimension), and client-driven mode at the other extreme. In
empirical testing, Yeske finds that the policy-driven mode is most highly correlated with measures of client
trust and relationship commitment, constructs that are discussed at greater length in the next section.
Client Trust and Commitment

Client trust and commitment have emerged in the financial planning research literature as two important
predictors of a successful financial planning engagement. A client’s trust in the financial planner and
commitment to the financial planning relationship can
lead directly to several positive outcomes, including high acquiescence, a low propensity to leave, a high
degree of cooperation, and functional conflict, which is the ability to maintain a highly functional
relationship even when conflicts arise (Morgan and Hunt 1994). ftese qualities in turn tend to lead to long-
lasting relationships for which financial planners have both a process motive and a profit motive.
fte process motive arises from the nature of personal financial planning itself, which involves multiple,
integrated steps that must unfold over time, often requiring a period of years to successfully formulate,
communicate, and implement (Christiansen and DeVaney 1998). Higher levels of commitment and trust are
associated with client retention, client satisfaction, increased client openness in disclosing personal and
financial information, and a greater propensity to implement financial planning recommendations
(Anderson and Sharpe 2008).
According to Christiansen and DeVaney (1998), the profit motive arises from the fact that retaining existing
clients costs much less than attracting new ones, which makes long- lasting relationships more profitable than those of
shorter duration. Relationships exhibiting high trust and commitment are also associated with a greater client
propensity to make referrals (Anderson and Sharpe 2008). ftus, financial planners should know what they can do
tofosterclienttrustandcommitment,andthusreapthesemanybenefits.
Answering this question is difficult because financial planning, similar to other professional services,
has high credence properties, meaning consumers have difficulty judging the quality of the service even after
it has been rendered (Sharma and Patterson 1999). One need only consider that financial planners are
routinely asked to recommend strategies for attaining goals that are years or even decades in the future to see
how this concept applies.
Notwithstanding the consumer’s difficulty in directly assessing the value of high- credence services,
many antecedents to trust and commitment in the context of professional services are available. ftese
include switching costs, relationship benefits, shared values, communication, opportunistic behavior
(Morgan and Hunt 1994; Christiansen and DeVaney 1998), client perception of technical and functional
quality (Sharma and Patterson 1999), client satisfaction (Sharma and Patterson 2000), and communication
tasks, skills, and topics (Anderson and Sharpe 2008). ftese antecedents are not unique to financial
planning, but are present in almost any professional service relationship.
FACTORS INFLUENCING THE TRUST AND

COMMITMENT RELATIONSHIP
fte concept of client trust and commitment as key mediating variables first arose in the relationship marketing
literature, notably in the work of Morgan and Hunt (1994). In the Morgan and Hunt model, illustrated in Figure
15.2, anything that leads to increased client trust and commitment is associated with positive outcomes such as
high acquiescence, low propensity to leave, high cooperation, high functional conflict, and low
uncertainty. Among their proposed antecedents to trust and commitment are relationship termination costs
(i.e., switching costs), relationship benefits, shared values, communication, and opportunistic
behavior.
Relationship Switching
Relationship Benefits Commitment
Shared Values
Communication
Trust
Opportunistic Behavior
Figure 15.2 Components of Trust and Commitment. ftis figure shows the major factors that most
influence client trust and commitment to the relationship during the financial planning process. Source:
Morgan and Hunt (1994).
Relationship Switching
Relationship Benefits Commitment
Shared Values
Communication Trust
Opportunistic Behavior
Figure 15.3 Major Factors for Building the Trustand Commitment Relationship. ftis figure shows that
communication most influences client trust, which in turn
drives the commitment to the relationship between the client and the financial planner. Source:
Christiansen and DeVaney (1998).
Morgan and Hunt (1994) test this model with independent tire dealers and their suppliers and
validated all the proposed linkages except the hypothesized link between relationship benefits and
relationship commitment. Path analysis shows that relationship termination costs, relationship
benefits, and shared values act directly on relationship commitment, whereas communication and
opportunistic behavior act on trust, which in turn influences relationship commitment. Morgan and
Hunt also tested an alternative, non-parsimonious model in which no indirect relationships were
allowed and they found far fewer significant relationships than their “key mediating variable” or KMV
model. fteir data demonstrate that trust and commitment are the key mediating variables, not just two
among many independent variables.
Christiansen and DeVaney (1998) apply this same model to financial planners, drawing data from
members of three professional planning groups in the United States. ftey employed path analysis using the
CALIS (Covariance Analysis of Linear Structural equations) procedures in the SAS statistical software.
Figure 15.3 shows their findings that relationship termination costs, relationship benefits, and shared values are
all antecedents of commitment, whereas shared values, communication, and opportunistic
Relationship
Communication
Functional Quality Trust
Technical Quality
Figure 15.4 Technical Quality, Functional Quality, and Communication

Effectiveness. ftis figure shows that communication affects trust and commitment both directly and indirectly
through its impact on client perceptions of the technical and functional quality of the financial planner’s
services. Source: Sharma andPatterson (1999).
behavior are all antecedents of trust, which itself is an antecedent of commitment. ftese results match those of
Morgan and Hunt (1994).
Interestingly, as an antecedent to commitment, trust has twice the explanatory power of any other
variable. Shared values have a low significance as an antecedent to trust, and opportunistic behavior is not
statistically significant. Communication has three times more explanatory power than shared values as an
antecedent to trust and is highly significant. Christiansen and DeVaney conclude that communication is the
single most powerful antecedent to trust and commitment, acting directly on trust and through trust on
commitment.
Sharma and Patterson (1999, 2000) also addressed the question of which antecedents most influences
client trust and commitment. As noted previously, they observed that financial planning is a “high credence”
service that unfolds over time, leaving clients hard pressed to judge the quality of the advice in the present
moment. As Sharma and Patterson (1999, p. 151) observed, “After all, if clients have trouble evaluating out-
comes, then it seems reasonable that interactions (“how” the service is delivered) and all forms of
communications will take on added significance as clients seek to minimize dissonance and uncertainty
about the adviser they have chosen.”
Sharma and Patterson (1999, 2000) also explored the links between perceptions of technical quality,
functional quality, and communication effectiveness, on the one hand, and relationship commitment, on the
other. Figure 15.4 illustrates their model. Technical quality refers to “what” is being delivered, and
functional quality refers to “how” it is delivered. Sharma and Patterson included trust as an “endogenous
mediating construct.” ftey report that a client’s perception of the technical and functional quality of the
planner’s advice is positively correlated with the client’s level of trust in the planner. Higher levels of trust, in
turn, are associated with higher levels of commitment to the relationship. Communication effectiveness acts
both directly on trust and commitment and indirectly through its effect on perceived technical quality and
functional quality. Although communication effectiveness has the smallest direct effect on commitment, it
has the greatest total impact when including its indirect effects.
THE ROLE OF SATISFACTION

Sharma and Patterson (2000) later returned to analyzing the antecedents of relationship commitment,
examining the role of trust and a new variable: satisfaction.
Switching Costs, Available Alternatives, and Client’s Prior Experience are LOW
Satisfaction
Relationship Commitment
Trust
Switching Costs, Available Alternatives, and Client’s Prior Experience are HIGH
Satisfaction
Relationship Commitment
Trust
Figure 15.5 Satisfaction and Trust as Antecedents to Commitment. ftis figure shows that satisfaction drives
client commitment when switching costs are perceived to
be low, whereas trust drives commitment when switching costs are perceived to be high. Source: Sharma and
Patterson (2000).
They tested the impact of trust and satisfaction on commitment in light of three contingencies:
switching costs, availability of attractive alternatives, and prior experience. As Figure 15.5
illustrates, trust has the greatest impact on commitment when switching costs are high, available
alternatives are low, and/or prior experience is low. In situations where switching costs are low, available
alternatives are high, and/or prior experience is high, satisfaction is the dominant antecedent to
commitment. The fact that financial services companies routinely try to raise switching costs by
imposing surrender charges and deferred sales charges (back- end loads) on many of their financial
products suggests that clients understand the role of this contingency.
THE COMMUNICATION DIMENSION

Anderson and Sharpe (2008) extend the work of Christiansen and DeVaney (1998) and Sharma and Patterson
(1999, 2000) by focusing solely on the communication dimension. If communication is the single most
significant antecedent to trust and commitment, what particular types of communication would have the
greatest impact? ftey derived the communication elements to be examined from the life planning literature
and organized them into three dimensions: (1) communication tasks, (2) communication skills, and (3)
communication topics. According to Anderson and Sharpe, the following tasks, skills, and topics are most
highly correlated with higher levels of trust and commitment among financial planning clients:
• Communication tasks. Systematic process to clarify goals and values; explaining how advice
reflects goals and values.
• Communication skills. Eyecontact, body language,verbalpacing,andfacilitating difficult
conversations about money.
• Communication topics. Client values and quality of life and initiating conversations about
life changes.
Anderson and Sharpe (2008, p. 77) correlate these activities with relevant CFP Board practice standards related
to uncovering clients’ goals and communicating planning recommendations, noting that “our findings give
strong support for the value of the specific financial planning communication tasks identified in these
standards.” Although the original development of practice standards resulted from capturing and codifying
“established norms of practice,” Anderson and Sharpe provide an empirically derived foundation for at least
some of them.
Knowledge and Evidence-Based

Financial Planning
Researchers have not revalidated many theoretical and practical approaches adapted from other fields.
Moreover, many of the profession’s “best practices” result from trial and error and accepted norms that possess
intuitive appeal but lack empirical foundation. According to Buie and Yeske (2011, p. 39),
Financial planning best practices also arise from both deductive and inductive reasoning.
Some have developed from “self-evident” propositions and their natural implications, while
others have arisen from a slow accumulation of observations that ultimately seem to form a
pattern. ftat our best practices arise in ways that mirror the deductive/inductive methods of
science shouldn’t be a surprise; humans have evolved to think that way. As Albert Einstein
put it, “the whole of science is nothing more than a refinement of everyday thinking.” Of course,
that word “refinement” is critical. Our trouble as a profession is that most of our best practices
stop at the formation of a belief (the case study presented below, for example, involves a best
practice that existed for decades before eventually being empirically-tested). And we’re quite
comfortable stopping there because our personal experience and the experience of colleagues
will often seem to confirm and reinforce those beliefs (the field of behavioral finance calls this
“confirmation bias”). However, such informal “evidence” is properly termed anecdotal and cannot
be the foundation of a truly learned profession’s best practices. Instead, we must take the next
step: we must form our beliefs into hypotheses, then gather appropriate data and formally test those
hypotheses. Only then can we say with confidence that our “best” practices are founded upon the
“best” evidence:
A recent development in this area is the partnership between the Financial Planning Association (FPA) (US)
and the Academy of Financial Services (AFS), the latter being a professional association founded in 1982 to
serve the needs of professional academics teaching and researching in the area of financial planning. fte purpose
of the new partnership is to facilitate a deeper connection between practitioners and academics. fte
practical manifestations of this partnership include the following:
• A forum—fte fteory into Practice Knowledge Circle—that serves as a clearing- house for practitioners
to share with academics topics or questions for research that
would substantially affect their work with clients and for academics to seek feedback and data from
practitioners for financial planning research initiatives.
• A joint research track at the FPA’s annual conference for presenting juried research papers by members of
AFS, including prizes in the areas of theoretical and applied research.
• Joint publication of FPA’s practice-oriented Journal of Financial Planning and AFS’s
Financial Services Review, with the latter being made available to FPA’s members.
In another development, CFP Board of Standards, the standard-setting body for CFPs in the United States, has
launched a series of programs also aimed at deepening the profession’s academic roots. ftese efforts include
the following initiatives:
• Center for Financial Planning. CFP Board is exploring the creation of a center that would serve as a
credible source of research that advances the financial planning professional in these core areas:
• Influencing and supporting academic research that is dedicated to helping financial planners better
serve the public;
• Supporting diversity within the profession so that it better mirrors the American public; and
• Building capacityforthe next generation ofcompetentandethicalfinancial planners to meet public
demand.
• New Academic Financial Planning Journal. John Wiley & Sons and CFP Board are
collaborating on a peer-reviewed academic journal focused exclusively on financial planning. With this
journal, the CFP Board will be creating an academic home for those faculty members who are teaching
and conducting research in financial planning. fte journal will be available free of charge to all CFP
professionals (Iacurci 2015).
The Behavioral Dimension of Financial Planning

As previously noted, a major role of financial planners is to help clients adapt to change, whether environmental
(imposed from without) or volitional (motivated from within). Among the many challenges that planners
face in this role is the reality that financial planning clients are as subject to behavioral biases and
heuristics as anyone else. Heuristics are mental shortcuts or rules of thumb individuals utilize to process
information. ftese biases and heuristics often lead them to make suboptimal choices or to ignore financial
planning recommendations altogether. In their work with clients, financial planners encounter most of the
mental or cognitive biases identified by researchers in behavioral finance, such as mental accounting,
representativeness, anchoring, overconfidence, loss aversion, and availability.
MENTAL ACCOUNTING
Mental accounting refers to the tendency for people to separate their money into separate accounts based on
different subjective criteria, such as the source of the money and
the intent for each account (Kahneman and Tversky 1979). Mental accounting may cause financial
planning clients to spend differently, based on the size of the account or “bucket” from which the funds are
supplied. For example, clients might spend more when using a debit card linked to a large brokerage account
than when using a debit card linked to a much smaller checking account. Financial planners often discourage
clients from choosing brokerage debit cards in lieu of automatic systems for moving budgeted funds
electronically from brokerage to checking, where the smaller balances at any given time have a higher
propensity to keep spending better aligned with budgets.
REPRESENTATIVENESS HEURISTIC
fte representativeness heuristic refers to a propensity to see patterns, even where they do not exist (Tversky
and Kahneman 1974). ftis tendency can cause financial planning clients to trade excessively in employer
shares because they believe they have observed a pattern of regular reversal points in the company’s stock price
movements. As a result of this bias, individuals often ignore important information that should be included in
the decision-making process.However,thenewdataorinformationaredisregarded.
OVERCONFIDENCE, ANCHORING, AND LOSS AVERSION

Overconfidence, anchoring, and loss aversion can combine in ways that lead to a series of bad decisions
(Fischoff, Slovic, and Lichtenstein 1977; Kahneman and Tversky 1984). Overconfidence is highly
prevalent among investors, in which individuals overestimate their own abilities and predictions for
success. For instance, overconfidence can lead employees to hold too much in employer shares, believing
they have insider insights that are superior to market signals. Anchoring is the process by which individuals
hold on to a belief and then apply this viewpoint to a specific reference point in time for making future
judgments. Loss aversion is when clients apply greater weight to a loss than to an equivalent gain. Anchoring
and loss aversion can cause these clients to continue to hold employer shares even when a reversal in the
company’sfortunes or those of its industry causes its stock price to fall (Shefrin and Statman 1986).
AVAILABILITY HEURISTIC
Availability bias refers to the propensity to be influenced by information that is easier to recall (Ricciardi
2008), such as highly impactful or more recent memories. A client’s willingness to buy long-term care
insurance frequently depends on whether he personally knew someone who had received home healthcare
assistance or lodging at a skilled nursing facility. Personal experience of long- or short-lived relatives may
influence the willingness to plan for a long retirement.
STRATEGIES FOR OV E RC OMING BIASES

IN FINA NC IA L PL AN N IN G
Although engaging in the financial planning process and being in a professional relationship with a financial
planner can positively affect client behaviors, researchers and
practitioners continue to develop extensions of the traditional six-step process in an attempt to better
overcome the forgoing biases and heuristics. Among the suggested extensions are the EVOKE (Exploration,
Vision, Obstacles, Knowledge, and Execution) model (Kinder and Galvin 2005). ftis framework proposes a
greater focus on uncovering deeper goals, objectives, and values, as well as a more explicit examination of
potential obstacles to implementation. Yeske and Buie (2014) propose using Policy-Based Financial
Planning as a form of “decision architecture,” along the lines of ftaler and Sunstein’s (2008) concept of
“choice architecture.”
Financial planning policies represent compact decision rules that embody both a distillation of
financial planning best practices in a given planning realm and the client’s goals and values. To the degree
that the planner can craft policies in which the clients can see their goals and values clearly reflected, they are
more likely to embrace those policies as their own and be guided by them. ftis is consistent with the findings of
Anderson and Sharpe (2008), who find that client trust and relationship commitment are higher when clients
receive financial planning recommendations that are clearly connected to their values and goals.
Jacobson and Stearns (2013) propose appreciative inquiry as a way of dealing with behavioral finance
issues, including in combination with the following “power tools” for overcoming the well-documented
negativity bias (Kanouse 1984). Jacobson and Stearns (2013, pp. 25–29) provide the following
explanations:
Possibility mindset
People with a possibility mindset believe that positive outcomes are achievable, tune their
radar to detect and highlight positive possibilities, poten- tials, and opportunities in new
information and circumstances, and mobilize proven strengths, resources, and successes, as well
as the potential in people and organizations. ftey don’t dwell on mistakes, unskillful acts, and
unfavorable outcomes. While they accurately detect downsides, their mindset allows
them to lead with the positives to create upward spirals of effective thinking, productive
conversation, and collaborative teamwork.
Realistic optimism
A planner practicing realistic optimism collects and assimilates all relevant information,
identifies and weighs its implications, and rather than planning for the lowest-risk, most-likely, or
most favorable outcome, selects and plans for the best plausible outcome—the outcome that
has both a significant probability of occurring and a significant payoff.
Positive conversational skills
Positive conversational skills include:

• acknowledging others’ concerns, fears, and anxieties without prematurely citing factual
grounds for optimism.
• asking positivequestionsandguiding conversationstoidentifyandmobilize positive forces(such

as strengths, resources, lessons learned, and wisdom gained from mastering previous challenges) to
craft workable action strategies and plans.
Emotional self-management
Emotional self-management (ESM) … has two principal domains… . ESM related to

one’s inner experience includes awareness of one’s moment- to-moment emotions and the events
that trigger them (such as market gyra- tions, clients’ responses to ST information, and one’s
own thoughts); and managing these emotions appropriately and effectively, neither denying
them, suppressing them, nor giving them unfettered expression… . ESM in the interpersonal
realm includes detecting others’ emotions in response to ST information and remaining steady in
the presence of these emotions, neither avoiding nor ignoring them nor attempting to combat
them with facts.
Empathy and compassion
Empathy entails accurately perceiving others’ emotional reactions, internally experiencing
something akin to their emotions (albeit a less intense version), and as appropriate, conveying
one’s understanding, non-verbally and/or verbally.
fte financial planner’s inevitable role as a change agent means that the search for new
perspectives, tools, and techniques to help mediate the impact of clients’ mental biases and
heuristics is a never-ending enterprise.

As a professional practice, financial planning arose about 1970 as a process for helping clients most
efficiently use all of their human and financial resources in achieving personal goals and objectives. Financial
planning is a six-step process that draws upon diverse knowledge domains to offer clients integrated strategies
accounting for all the interlocking elements of their financial lives. In developing and implementing these
strategies, financial planners must work to overcome clients’ natural biases and heuristics that can derail or
stall effective action and positive change. Because the financial planning process is both systematic and
incremental in nature, it can be effective in helping clients understand the financial forces in their lives and the
path toward achieving goals. In many cases, however, financial planners must use additional techniques as
part of the process. ftese techniques could include appreciative inquiry, coaching, and policy-based financial
planning, among others. A growing thread in the financial planning literature is devoted to helping clients
effect positive change and how planners might help to overcome mental and emotional obstacles to that
change. Considering the centrality of the financial planner’s role as change agent, this trend is likely to con-
tinue to grow in the future.
1. List the six steps of the financial planning process as defined by CFP Board of Standards and
Financial Planning Standards Board.
2. Explain why financial planning clients tend to rely on secondary markers of quality when judging the
advice they receive from their advisors.
3. Discuss how the availability heuristic can affect a financial planning client’s perception of financial
planning recommendations and/or propensity to act on them.
4. Describe how the mental biases of overconfidence, anchoring, and loss aversion can interacttocause
financialplanning clientstomakesuboptimaldecisions.
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16
Financial Advisory Services
JEROEN NIEBOER
Research Fellow in Behavioural Science,
London School of Economics and Political Science
P A UL DOLAN
Professor in Behavioural Science
London School of Economics and Political Science
IVO VLAEV
Professor in Behavioural Science
University of Warwick
Introduction
Makingwell-informedfinancial decisionsis difficult. Consumersface an overwhelming choice of financial
products, each with its own benefits, quirks, and conditions offered by a variety of product providers. On top of
tackling the complexity of the retail financial landscape itself, consumers have to predict their own wantsand
needs in the distant future, make trade-offs over time, and consider various types of uncertainty. Perhaps
unsurpris- ingly, a substantial market for financial advice has developed, served in most countries by alegionof
educatedfinanceprofessionals.ftefinancialadvicemarketis highlycompeti- tive, yet persuading consumers to
part with their money in this industry requires not only knowledge of financial products but also a keen
understanding of people’s psychology involving money. ftis chapter presents empirical evidence on the role of
financial advisors, not just as knowledge providers but also as decision-making experts and persuaders. fte
chapter pays special attention to behavioral science research, which documents how psychological factors
influence people’s choices in ways that may seem irrelevant from a strictly financial perspective. fte
behavioral sciences are disciplines that test hypotheses about human behavior by systematically observing
people in different settings, producing evidence that allows replacing some of the more implausible assump-
tions inthe dominanttheoriesofdecision makingwithbehaviorallyinformed ones.fte behavioral science
literature on giving and receiving advice has expanded considerably inrecent years,most ofitinthefields of
behavioralfinance, economics,andsocial psychology. fte contributions surveyed in this chapter range from
controlled laboratory experiments to field studies based on surveys or audit exercises, reflecting the richness
and diversity of this interdisciplinary science.
285
Behavioral science research reveals countless ways in which an individual’s financial choices
systematically diverge from models of rational decision making. People are greatly influenced by details in the
decision-making context that have no impact on the financial outcomes of their choices. ftey also frequently
make decisions through heuristics, which are general rules that are thought to have evolved to allow the human
brain to cope with complex choice environments (Gigerenzer and Todd 1999). Although heuristics and
other decision-making shortcuts save the brain from computational overload, they can also lead to
predictable mistakes, called biases (Kahneman and Tversky 2000; Kahneman 2003), particularly in the
domain of financial decisions (Kahneman and Riepe 1998). Furthermore, consumers are often unaware of
these influences. By mitigating the effects of context, heuristics, and biases whenever such influences are
costly to consumers, financial advisors can provide a valuable service. But advisors have their own incentives,
and as will be discussed later, the jury is still out on whether financial advisory services act as bias
mitigating.
fte presence of behavioral influences on decision making also means that well- intended products
and policies aiming to improve choices solely by providing extra information to the decision maker often
fail to deliver (Webb and Sheeran 2006). Rather than assuming that the consumer makes the best use of
the information provided, a more realistic approach to product and policy design would be to put this
assumption to the test. Based on existing evidence, people do not always pay sufficient attention to important
messages such as the disclosure of conflicts of interest between the advisor and client (Inderst, Huck, and
Chater 2010). On the positive side, timely reminder messages carefully designed to combat consumer inertia
seem to hold promise (Karlan, McConnell, Mullainathan, and Zinman 2010; Financial Conduct Authority
2013). More generally, behaviorally informed approaches to financial decision making can claim some
notable successes. ftese approaches include increasing participation and contributions in retirement plans
(Madrian and Shea 2001; ftaler and Benartzi 2004), reducing the use of expensive credit products (Bertrand,
Karlan, Mullaninathan, Shafir, and Zinman 2010; Bertrand and Morse 2011), and improving timely payment
of taxes (Coleman 1996; Hallsworth, List, Metcalfe, and Vlaev 2014). Similar opportunities may exist for
behaviorally informed financial advisory services, with technology playing a key role.
Although the focus of this chapter is on retail advice services, many of the insights from the behavioral
science literature also apply to wholesale financial advice. fte extent to which professional decision makers
are subject to the same behavioral biases as the general public is still largely an open, empirical question,
although evidence from experimental studies suggests that professionals are certainly not immune to bias.
ftis chapter starts with a summary of the evidence on the supply of financial advice. fte next section
discusses the characteristics of financial advice consumers, and is followed by a section on how these
consumers respond to “behavioral” aspects of the advice process. ften, an exploration of how financial
advisors may respond to the behavior of their clients is presented considering not only the opportunities for
advisors to improve their clients’ decisions but also the incentives created by different types of client behavior.
fte concluding section reflects on how a better understanding of the psychology of money affects both the
nature of financial advice services and the traditional distinction between products and services.
Financial Advisory Services 287
Financial Advice—The Supply Side

ftis section introduces the supply side of financial advice: the professionals who offer these services, a brief
description of the services offered, and some perspectives on the purpose served by financial advice in the retail
market.Adiscussion ofevidenceonthe financial return on using financial advice follows.
WHO OFFERS FINANCIAL ADVICE?

Various types of professionals offer financial advice. First, there is the financial advisor, who may also use
the title financial planner. However, in most countries, the latter title is reserved for those who have earned a
certification from a professional standards body affiliated with the Financial Planning Standards Board or a
comparable body. Other certificates and titles may be available, depending on the country. In many countries,
these qualifications are a legal requirement for opening a financial advice practice. Besides being qualified to
give financial advice, individuals may also have earned a license to sell or recommend certain financial products
requiring specialist knowledge, such as insurance products. Some individuals acting as financial advisors
have accorded themselves titles such as wealth manager or investment advisor, but these titles are often not
acknowledged by a professional body or are even unregulated.
Historically, financial advisors have operated independently of banks and fund providers, as is still
largely the case. ftis means that, unlike brokers, financial advisors typically do not represent the firms whose
products they recommend and sell. Furthermore, and again unlike brokers, most countries require by law that
financial advisors put their clients’ interests ahead of their own, which is referred to as their fiduciary duty.
Despite this duty, financial advisors may still receive commissions based on sales of certain financial
products. Another common arrangement is vertical integration or a tie-up between advisors and fund
providers, which means that the advisor is restricted to recommending products from the provider. Although the
law stipulates that clients be made aware of such financial arrangements, this practice blurs the line between
financial advisors and brokers. To resolve this ambiguity, the chapter defines brokers (or salespeople) as those
whose variable earnings are entirely made up of commissions for sales and trades. By contrast, financial advisors
may also receive income from charging for advice and con- tracting services, or receive fees based on assets under
management or portfolio returns.
WHAT IS THE PU RP OSE OF FIN A N C IA L ADVICE?

Financial advice given to consumers can cover any aspect of the client’s finances. Most advice concerns
investment, income security, and retirement planning, although some advisors also offer ad hoc advice on
credit and mortgages.
At the start of the advice process, the advisor may help clients articulate their goals by asking a series of
questions about their current finances and their plans for the future. As part of this process, the advisor also gauges
how comfortable the client is with different levels of investment risk. Based on the information received from the
client, the advisor then gives the client advice on saving, credit, taxation, the choice of financial products from
different providers, investment opportunities, and various wealth and income risks. Key considerations are the
suitability and costs of the different options. Regarding investment and savings, the stated objective is helping clients
construct a well-diversified portfolio that reflects their appetite for risk, in line with modern portfolio theory
(Markowitz 1952).
So, what purpose does this process of financial advice serve? fte traditional economic explanation of
markets for expertise, such as financial advisors, focuses on the returns on the information search (Stigler
1961). fte consumer benefits from delegating the search for information to an advisor, who specializes and
thus spreads the cost of acquiring such information across all clients. Because financial advice often concerns
one-off decisions with high stakes, clear gains arise from specialization. ftis explanation, in its most basic
form, assumes that consumers know how to evaluate the information they receive from advisors. Moreover,
for the market to deliver good outcomes to consumers, those consumers need to understand the value
proposition of different advisors. Whether these assumptions are warranted depends crucially on the
consumer’s sophistication, such as the individual’s financial literacy and awareness of advisor incentives.
Advisors may thus not have clear incentives to continue their information search until the client’s marginal
benefit equals marginal cost. In other words, the advisor may offer a suboptimal off-the-shelf solution
without the client noticing. ftis situation is reminiscent of other markets for experts, such as doctors, lawyers,
and car mechanics.
A related perspective is that consumers use financial advisors to protect themselves against their own
cognitive biases, as argued by Bluethgen, Gintschel, Hackethal, and Mueller (2008). Financial advisors can
identify and correct some cognitive biases, thus adding value by reducing costly mistakes. fte authors cite the
disposition effect (Shefrin and Statman 1985), or the tendency to sell winning stocks too soon and hold on to
losers for too long, as a prominent example of the type of bias that advisors can correct. Conversely, advisors
may guard against myopia by mitigating their clients’ tendency to withdraw from the stock investment in a
bear market. ftese examples show how an advisor may not only act as a purveyor of information but also
provide guidance based on experience and by virtue of not being as emotionally involved as the client. fte advi-
sor can also act as a teacher, correcting mistakes to enable clients to make better choices for themselves. For
example, McKenzie and Liersch (2011) show that the majority of participants in a laboratory study expect
savings to grow linearly, rather than exponen- tially, through interest compounding. Highlighting the
exponential nature of capital growth to these participants increases their motivation to save for retirement.
THE ADDED VALUE OF FINANCIAL ADVICE

Computing the added value of advisory services is challenging. fte essential question is: Knowing the full,
long-term costs and benefits of financial advice to a particular investor, is it in the investor’s best interested to use
an advisor? One approach to answering this question is to focus strictly on the financial benefits and to compare
the portfolios of advised and non-advised investors. Chalmers and Reuter (2012), using data on U.S. university
employees, and Hackethal, Haliassos, and Jappelli (2012), using data on customers of a German retail bank,
both found that advised retirement portfolios carry more risk than self-directed portfolios and also
underperform self-directed portfolios. By contrast, Kramer (2012) and Kramer and Lensink (2012) find that
the advised retirement
portfolios of Dutch entrepreneurs were better diversified and achieved better risk-adjusted returns. ftese studies
controlled for the endogenous choice of using an advisor, thus rul- ing out selection effects (i.e., certain types of
investorsaremorelikelytoreceiveadvice).
In an attempt to reconcile these contradictory results, we need to highlight two differences between the former
and the latter studies. First, all clients in the samples used by Kramer and Lensink (2012) had previous exposure to
financial advice, potentially making them more sophisticated consumers of advice. Second, the financial advisors in
the Kramer and Lensink study received a fixed wage, whereas those in the Chalmers and Reuter (2012) and Hackethal,
Haliassos, and Jappelli (2012) studies receivedfeesand commissions.
In an audit study, Mullainathan, Noeth, and Schoar (2012) provide controlled evidence on financial
advisors’ actual advice strategies. ftey randomly assigned professional auditors to unwitting financial
advisors to ask for advice on a pre-designed investment portfolio. Instead of endowing all the auditors with
well-diversified, low- cost portfolios, the authors purposely designed some of the fictional portfolios of their
auditors to mimic common investment biases. ftey report that the recommendations of their studied financial
advisors were in line with some of the predictions of portfolio theory, such as advising married clients to hold
less liquidity and advising against holding employer stocks. ftey also note that the financial advisors were
most supportive of those clients with a low-cost, well-diversified existing portfolio. But they also report that
financial advisors often recommended actively managed funds with higher fees and that many financial advisors
told clients to make changes even if they have low-cost, efficient portfolios. fte latter result could reflect
overzealous advice giving, but it does suggest that not all advice is strictly financially beneficial.
The Consumer of Financial Advice

ftis section examines the role of the consumer as the financial advice client, starting with an overview of the
evidence on the relationship between individual characteristics and the demand for financial advice,
followedbyadiscussionoftheroleoftrust.
WHO LOOKS FOR FINANCIAL ADVICE?

Many studies find that women are more likely to seek financial advice than men ( Joo and Grable 2001; Loibl
and Hira 2011). ftis pattern may be due to women’s preference for personal service rather than anonymous
advice. Consistent with this explanation, Loibl and Hira report that women spend less time looking for
financial information online or through other media.
An important factor is people’s financial literacy, which is typically strongly positively correlated with
experience and wealth. Using a large representative sample of the
U.S. population, Lee and Cho (2005) report that financial advice clients are typically richer, older, better-
educated, and more experienced investors. Using a large survey of German retail bank customers, Hackethal
et al. (2012) also report that richer, older investors are more likely to have a financial advisor. Using survey
data on customers from an Italian retail bank, Calcagno and Monticone (2015) find that wealthy and high
financially literate individuals are more likely to consult advisors, whereas low financial
literacy individuals are more likely to delegate the management of their portfolio or manage their own
portfolio without advice. ftey also report that high financially literate individuals are more likely to invest
in risky assets, such as stocks.
People’s demand for advice is also affected by their psychology and emotional state. Meier and Sprenger
(2013) report that individuals assigning greater value to the future are more likely to use financial advice. Gino,
Brooks, and Schweitzer (2012) found that people who experience anxiety are more likely to seek out and rely
on advice. ftey also report that anxious individuals are less able to discriminate between good and bad advice, a
result that underlines the responsibility financial advisors have toward anxious clients. However, some anxiety
about the future might be good for people’s financial decisions. For example, Dolan and Metcalfe (2012) found
that people with a negative attitude are more likely to open a savings account. Along similar lines, Hershfield,
Goldstein, Sharpe, Fox, Yeykelis, Carstensen, and Bailenson (2011) find that presenting individuals with a
computer-agedimage of their future selves increases their pension contributions.
THE ROLE OF TRUST

What role does trust play in the advice process? In a large, pan-European survey, Georgarakos and
Inderst (2014) included a measure of general trust in judging the advice given by financial institutions.
ftey report that trust is positively related with holdings of risky assets for households with lower
levels of education and self-reported financial literacy. Yet, for more educated households, trust in
advice is less important, especially relative to their trust in the country’s legal institutions. Calcagno and
Monticone (2015) used a survey of customers of a large Italian bank. ftey measured the level of trust in
the bank’s financial advisor, which yielded both intuitive and surprising results. As might be expected,
greater trust in the advisor increases the likelihood of delegating management of one’s portfolio and
decreases the likelihood of going it alone, but no significant relationship exists between trust and the
likelihood of consulting an advisor. fte survey respondents approached the bank’s advisor regardless of
their level of trust—this situation may have been due to the preexisting exclusive relationship with the
advisor. When advice was instead offered “out of the blue,” as in a field study on a random sample of
customers of a German brokerage firm reported by Bhattarchaya, Hackethal, Kaesler, Loos, and Meyer
(2012), customers will be wary of the quality of the advice. Only 5 percent of customers in the field study
accepted the offer of advice provided by email and over the telephone.
fte level of trust in an advisor also changes during the interaction between advisor and prospective client.
Little evidence exists from the field, but experimental research on advisor–advisee interaction provides some
clues. First, people are more likely to follow more experienced advisors (Harvey and Fischer 1997). Second,
advisor–advisee similarity matters; Gino, Shang, and Croson (2009) report that individuals in a telephone
survey experiment were more likely to follow advice from advisors that are similar to them in terms of
gender, education, age, region, and political affiliation. fte financial advisor’s interest may therefore be
served by highlighting such similarities before giving advice. Morris, Nadler, Kurtzberg, and ftompson
(2002) report that business
transactions are more likely to succeed when the initiating party highlights things that the two parties have in
common before any negotiation occurs.
Trust is also a function of how the advisor communicates. Joiner and Leveson (2006) find that clients give
higher ratings to financial advisors who use less technical language and investment jargon. Furthermore, more
confident advisors do not always have a bigger impact. Although some evidence suggests that people are
more likely to follow advisors with extreme and confident judgments (Price and Stone 2004; Van Swol and
Sniezek 2005), this bias tends to disappear when information on advisors’ accuracy is available (Tenney,
Spellman, and MacCoun 2008). Moreover, Karmarkar and Tormala (2010) present experimental evidence that
experts are actually perceived as more persuasive if they admit some uncertainty about their
recommendations.
Yet, there may be a dark side to trustworthiness. Laboratory experiments on conflict- of-interest scenarios
suggest that simply disclosing a conflict of interest does not make it go away. Paradoxically, advisors who
disclose a conflict of interest to clients thereby build so much trust that their clients follow biased advice that is
in their advisor’s best interest but not their own (Loewenstein, Cain, and Sah 2011). Further experiments
show that this social conflict is somewhat mitigated if the disclosure is done by a third party, or when the client
is given time and privacy to make the advised decision (Sah, Loewenstein, and Cain 2013).
Behavioral Aspects of the Advice Process

fte preceding section introduced some aspects of consumer psychology that determine consumers’
demand and their perceptions of advisor trustworthiness. In this section, the advice process itself is
unpacked, highlighting evidence on contextual factors and details that are not considered in typical models of
financialadvice, but whichmay substantially alter consumers’ response to advice.
CHOOSING THE CHANNEL

Ciccotello and Wood (2001) experimentally simulated the process of procuring advice on investment
scenarios through different communication channels, in this case using either live advisors (student
participants) or online sources. ftey report that the variance in recommendations from both sources of advice
is similar, but note that live advisors are better at taking the particularities of wealthy clients into account.
However, the authors do not present any results on how clients perceive the advice. Evidence that people
consider face-to-face advice more appropriate comes from a study on health advice by Labarère, Torres,
Fourny, Argento, Gensburger, and Menthonnex (2003). fte authors report that people prefer face-to-face
contact because it allows them to better explain the particularities of their situation.
Riegelsberger, Sasse, and McCarthy (2005) present laboratory participants with financial advice that
was provided through different channels: video, audio, virtual chat, text only, and text accompanied by a photo
of the advisor. ftey find that participants prefer audio and video advice, but that their financial risk-taking
is sensitive to any
form of advice provided. Obviously, the latter result may not arise in real-world settings where investors have
access tomore thanone type ofadvice andtypically choose their own preferred channel.
Another prominent channel is on-line advice. Sillence and Briggs (2007) report survey evidence that
consumers’ evaluations of online advice are highly sensitive to indicators of trustworthiness. ftese indicators
include known financial brands or personal recommendations, website design in line with the rest of the
financial sector, and paral- lels with the off-line advice process (tailored information, personal involvement in
the advice process, and identifiability of the people behind the website). Pi, Liao, and Chen (2012) find that
perceptions of transaction security, reputation, design quality, and ease of navigation influence consumers’
level of trust in advice websites.
ADVICE PACKAGING, FRA MING, AND PRIMING

How financial advisors “package” their advice is another key factor. ftese effects can be very subtle. For
example, Brown, Kling, Mullainathan, and Wrobel (2008) show that the majority of individuals prefer a
savings account to a life annuity when the choice is framed as an investment decision, but this pattern reverses
when the choice is framed as a future consumption decision. Differences in presentation also affect the
willingness to invest in riskier assets, such as stocks, that would give them greater returns on their investment.
Recent laboratory and field studies suggest that the extent to which this happens depends on how portfolio
risk is presented. Anagol and Gamble (2013) report that people select riskier portfolios when asset portfolio
data are presented as aggregates instead of as a list of individual assets. Bateman, Eckert, Geweke, Louviere,
Satchell, and ftorp (2014) report that individuals choose riskier portfolios when the risk is presented in a
graph rather than when expressed as text percentages. fte authors also report that people with lower financial
literacy are more susceptible to presentation effects. Furthermore, Kaufmann, Weber, and Haisley (2013)
show that letting people “experience” risk by having them draw sample returns from a historical returns
distribution leads them to choose riskier portfolios, without increasing regret or anxiety afterwards.
People’s financial decisions are also greatly sensitive to what is presented to them as the default option.
According to Madrian and Shea (2001), 71 percent of savers in a U.S. retirement plan choose the default
fund. Data from pension system reforms in Sweden presented by Engström and Westerberg (2003) tell a
similar story. Despite the presence of many alternatives, aggressive advertising by fund providers, and a
nationwide information campaign, 33 percent of Swedes stick to the default investment option provided by the
government. Defaults are not just effective because they signal endorsement; they also capitalize on an
individual’s inertia (also known as status quo bias). An example of using inertia “for good,” in combination
with the basic human tendency to discount future cash flows, is the Save More Tomorrow program by ftalerand
Benartzi (2004). In this program, people pre-commit to contributing higher percentages of future wages
to a pension scheme whenever they receive a wage increase. ftaler and Benartzi report an increase in the
contribution rate from 3.5 percent to 11.6 percent over a 28-month period.
Another subtle influence on decisions is what is termed peer effects: people often mimic their peers.
Duflo and Saez (2003) show that individuals are more likely to enroll in a university pension plan when their co-
workers attend retirement benefits information fairs. As Bursztyn, Ederer, Ferman, and Yuchtman (2014)
show, investors are more likely to invest in a new investment vehicle offered by their brokers when others have
done so or have simply indicated a desire to do so. However, providing information on peer choices does
not always move people toward the planned or socially desirable outcome. Beshears, Choi, Laibson,
Madrian, and Milkman (2015) find that informing employees of a U.S. manufacturing firm of their co-workers’
savings rates actually lowers the chance that these employees will subsequently enroll in their employer’s
pension plan. fte authors attribute this surprising result to the demotivating effect of upward social
comparisons.
PAYING FOR ADVICE

A final aspect of financial advice that can be presented and packaged in different ways is its price. fte most
common model of paying for advice is indirect, through sales commissions paid by product providers to
advisors. Inderst, Huck, and Chater (2010) provide evidence from a large pan-European survey that
consumers often underestimate the potential conflicts of interest generated by a commission-based
compensation model. Owing to policymakers’ concerns about these conflicts of interest, some
jurisdictions have now moved to a fee-based advice model. According to Hoffman, Franken, and
Broekhuizen (2012), this solution may exclude some individuals from the benefits of financial advice
because people are reluctant to pay for advice before they see the benefits. But over time, consumers may
become accustomed to paying for advice up front. Evidence from experiments suggests that people may
even attribute a specific value to paid-for advice: they are more likely to follow advice they paid for
than follow free advice (Sniezek, Schrah, and Dalal 2004; Patt, Bowles, and Cash 2006).
Godek and Murray (2008) report results from a laboratory experiment showing that people pay more for
advice when they are primed to think about future investment decisions than when they are primed to think
about past decisions. Although speculative, this pattern of behavior may extend to the more general question
of framing cost over time. ftat is, people are more likely to pay a fee when it is framed as a cost of expected
benefits than for benefits already realized.
Behaviorally Informed Financial Advice

ftis section returns to the supply side of the market. fte approach here can be summed up in the following
question: Assuming that advisors are aware of the consumer characteristics and behaviors presented in the
preceding two sections, how might advisors position themselves in the market? It will be insightful to
compare some of the possible outcomes described here to the current situation in markets, or to the
theoretical perspectives on financial advice presented in the first section. One outcome that seems
consistent with at least a casual observation of markets is the intangible value of advice— the idea that many
people value financial advice for more than just its expected financial return.
TOOLS FOR TAKING RISK

Much of the academic literature on investments highlights the fact that stocks have historically outperformed
other asset classes. However, prospective investors will have to be comfortable with the greater level of risk
associated with investing in stocks. One important role that financial advisors can play in this process is
making their clients feel more comfortable with this risk, thus unlocking higher returns. fte preceding section
on consumer behavior has highlighted various tools that the advisor can use for this purpose, such as different
ways of presenting investment risk and experiential simulation. Advisors may also feel that setting defaults
and using “social proof” and “peer effect” type strategies will help to convince their clients to invest in stocks.
As effective as these strategies may turn out to be, advisors should continue to educate their clients on the risk
associated with these investments. Using persuasion strategies that prompt the client to engage with risk is
muchmore(legally)defensiblethanstrategiesthattemptthe client to blindly follow others.
SCREENING FOR UNSOPHISTICATES

Much of the survey evidence shows that the likelihood of having a financial advisor is positively related to
financial literacy, itself positively correlated with education and wealth. Calcagno and Monticone
(2015) present an explanation for this pattern, starting from the premise that advisors will find that
providing high-quality advice is only worthwhile to well-informed and wealthy investors. If
consumers anticipate they will be screened on this basis, advice will only serve a purpose for better-
informed and relatively wealthy consumers. Consumers with lower levels of financial sophistication and
wealth can still use financial intermediaries for portfolio management, but the relationship will not be
based on the transmission of information or knowledge. fte evidence reviewed here suggests that less
sophisticated consumers are more likely to select their advisor on trust. In this segment of the market, a
problem of asymmetric information may occur because the less sophisticated investor may be unable
to verify whether advice is trustworthy. Inderst and Ottaviani (2012) show that investors who lack
awareness of advisor commissions face similar challenges.
A related issue is that people value a personalized service, tailored to their needs and taking the
peculiarities of their situation into account. For the wealthier investor, providing personalized service
may be worth the advisor’s time if the advisor can recoup his or her costs in fees. But for investors with less
wealth, the extra time spent on personalization may have to be recouped some other way. If the client is
loath to pay fees, then the only alternative for the advisor may be to recommend products with higher
commissions.
THE INTANGIBLE VALUE OF ADVICE

Evidence shows that financial advisory services do not only have financial value but also provide clients with
some intangible psychological benefits. Del Guercio and Reuters (2011) pursue this line of argument in their
discussion of the U.S. mutual funds market. ftey contend that two types of retail investors exist: those who
only care for fund returns, and those who derive intangible benefits of making advised investments. Del
Guercio and Reuters present data that support the notion that mutual funds target these two consumer
segments separately. Providing evidence from market outcomes, Bergstresser, Chalmers, and Tufano (2009)
report that broker-sold funds deliver significantly lower risk-adjusted returns than do direct-sold funds. fte
authors point out that this difference may be due to the intangible benefits of broker services. However,they do
not exclude the possibility that brokers’ sales commissions play a role in generating the difference.
A clever observation by Canner, Mankiw, and Weil (1997) highlights another way in which advisors’
recommendations may be tailored to provide intangible benefits. ftey note that one of the key implications of
the influential capital asset pricing model (CAPM) is that investors can diversify their portfolio for a givenrisk
appetite by changing the allocation of cash and a “market portfolio” comprising stocks and bonds. But a
survey of advisors’ advertised portfolio recommendations for investors with different risk profiles shows that
the recommended portfolio ratio of stocks to bonds goes up as investor risk appetite increases. ftese results
suggest that financial advisors consider factors other than the historical return data necessary for
recommending portfolios on the efficient frontier. ftese factors may be intangible and “behavioral” in nature,
such as clients’ need to be convinced that the suggested portfolio matches their risk appetite. Further
support for this notion comes from survey research of financial advisors themselves. A study by
MacGregor, Slovic, Berry, and Evensky (1999) finds that the variance in financial advisors’ perceptions of the
risk of certain asset classes is 98 percent explained by three factors: volatility, knowledge, and worry.
Some experimental evidence indicates that the intangible benefits of advice can actually be measured
in the brain. Engelmann, Capra, Noussair, and Berns (2009) conducted a neuroscience experiment and find
that financial decisions are less taxing for individuals who receive advice. ftese findings raise questions
especially concerning the outcomes of consumers who have a particularly strong preference for advised
decision making. Clients who are anxious and/or value peace of mind particularly highly, for example, may
be less sensitive to the costs of financial advisory services. If so, financial advisors may market specific
products and services to these clients. Portfolio churning, or the excessive (and expensive) rebalancing of
client portfolios by financial advisors, may be one such “service.”
THE PRICE POINT

Although this chapter has highlighted various aspects of pricing financial advice, it is worth considering two
final aspects of pricing. First, some fees may be more visible to
consumers than others. Using the pricing of printers and printer cartridges as an example, Gabaix and Laibson
(2006) show that people pay more attention to visible up-front costs than hidden expenses that occur later. In
pricing financial advisory services, advisors may have an incentive to keep the fee of the initial advice
relatively low, instead increasing less prominent fees such as ongoing management and administration fees.
Another type of fee that maybe left out of consumers’ calculations is the exit charge for certain investment funds.
Although these charges typically decrease over time, consumers may still overestimate the time they will
hold a particular fund.
To reduce consumers’ focus on a single cost or return figure, financial advisors may thus want to
operate several different charges. Note that it is not just a question of whether costs are incurred immediately
or later, or whether one-off larger expenditures are more likely to attract the consumer’s attention. As the
experimental findings of Godek and Murray (2008) illustrate, an incentive may also exist to frame ongoing
charges as related to future investment gains instead of to current planning activity. Clients’ evaluation of
advice fees may be influenced by framing that suggests the fees belong in a certain “mental account”
(ftaler 1985).

Advising people on their financial decisions requires a high level of detailed knowledge and skill. ftis chapter
reviewed extensive evidence that this skill set comprises more than just financial expertise and that giving
advice to clients goes beyond a review of their options, personal situation, and stated objectives. Contextual
factors, decision- making frames, and perception of risk are just some of the behavioral aspects that feed into
clients’ overall assessment of the value of advice. fte financial advisor seeking use the wealth of behavioral
insights will be spoiled for choice. A useful starting point would be a more specific behavior-change
framework as a checklist to explore the options available. Examples of such frameworks are Nudge (ftaler
and Sunstein 2008) and Mindspace (Dolan, Elliott, Metcalfe, and Vlaev 2012).
fte picture that emerges from this chapter is that of a sector of experts who do not serve simply as
purveyors of information to those who need it. Certainly, a substantial segment of sophisticated consumers are
willing to pay for advisory services and appear to benefit financially from receiving advice. For less
sophisticated advisors, whether advice always delivers financial benefits is less clear. Especially in markets
where commission payments from product providers are relatively large, consumers may be worse off with an
advised portfolio. When financial advisors also offer education and planning services that compensate for
common investment mistakes and consumer inertia, the balance may again tip in favor of advised portfolios.
Evidence suggests that advisors actively help consumers eliminate common mistakes, helping them to lower
expenses and create more diversified investment portfolios. Conversely, incentives exist for advisors to
leverage some of the trust earned for generating profits through higher ongoing fees and more frequent
transactions.
An important change in the sector is the increase in technologically driven financial advice. Robo-
advisors, or online investment platforms that provide consumers with an online equivalent of a financial
advice consultation, is a rapidly growing global
phenomenon. ftey often provide a combination of financial advice and products because many of the funds they
offer to clients are managed in-house. Because robo-advisors have a low marginal cost per extra client consulted,
their business model allows them to reach out to consumers who might not have the means to access a traditional
financial advisor. Some have raised the concern that such platforms will be unable to educate consumers
sufficiently in the process. Some of these platforms do, however, offer educational content to appeal to more
financially literate consumers, or offer private banking services beyond their automated advice. In fact, some
robo-advisors are actively trying to establish a reputation for mitigating investor biases by building in features
that protect against bias-driven behaviors. ftis is an interesting development, where the scale advantages of
technology might bring behaviorally informed investing to consumers in ways that traditional financial advice
would be unable to do. Although most advised clients will, for the foreseeable future, prefer to have a person in
charge of their finances, dismissing online financial advice as a low-quality mass-market commodity is
premature. Additionally, many hybrid forms of technological and personal advice may develop. A key
question is whether robo-advisors will simply shift profits from the intermediary to the fund provider, or
whethertheywilldeliversuitableadviceatalowercosttoconsumers.
To advance the field, note three particular topics that would benefit from more investigation. First, there is a
need for more detailed evidence on how advice reduces common investors’ biases, not only at the point of
portfolio composition but also throughout the advisor–investor interaction. Second, consumers’ willingness to
pay for advice services is underexplored—there is a lack of empirical evidence on how consumers respond to
different pricing models. ftird, many of the topics covered in this chapter might well have to be reevaluated in
the context of the growing role of technology in financial decision making, which is slowly turning financial
services into products across much of the sector. Understanding the impact of this process on firms,
policymakers, and consumers is perhaps the greatest and most relevant challenge.
1. Explain the difference between financial advisors and brokers.
2. Discuss the purpose of financial advice to consumers.
3. Describe the types of consumers who are more likely to look for financial advice.
4. Explain why high-quality financial advice may not reach those who would benefit the most from it.
5. Describe characteristics of financial advisors that affect the degree to which consumers follow their
advice.
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17
Insurance and Risk Management
J A M E S M. M O T E N J R . , C F P ® , C H F C ® , RI C P ® , C R P C , C M F C
Assistant Professor of Finance
East Central University
C. W . C O P E L A N D , C H F C ® , RI C P ® , C LU
Assistant Professor of Insurance
The American College of Financial Services
Introduction
Economics is predicated on human decision-making processes. Traditional economic theory suggests that
individuals make decisions that are in their own best interests and are consistent in their preferences. ftat is,
they do not intentionally make decisions that would make them worse off. Individuals often seek assistance
from advisors to help them accumulate assets for building wealth, thereby also improving their financial deci-
sion making. However, part of an advisor’s responsibility is helping clients protect their accumulated wealth.
ftis goal makes thembetter offfinancially, but is seldomcommu- nicated in such a manner.
ftis chapter explains how individuals make insurance purchasing decisions using risk management
techniques within the constructs of behavioral finance. First, the chapter describes the types of risk, then
surveys the most common types of insurance for individuals. Following is a brief survey of behavioral finance,
leading to a discussion of the interactions of behavioral finance, insurance, and risk management. fte chapter
concludes with a summary and conclusions.
Insurance and Risk Tolerance

Insurance is a contract protecting against risk and containing four elements—offer and acceptance,
consideration, competent parties, and a lawful purpose—that provides an individual or entity protection
against financial losses caused by perils (Moten 2014). Purchasing insurance is based on the principle of
indemnification, which involves compensating a party for a loss or damaged property to make the party
whole again. To spread the cost of paying claims, insurance is also based on the law of large numbers. fte law
of large numbers is a statistical assessment stating that the larger the number of homogeneous exposure
units independently exposed to loss, the greater is the
302
Insurance and Risk Management 303
probability that the actual loss occurred will equal the expected loss. fte law of large numbers contrasts with
the law of small numbers, which is a judgmental bias based on the belief that a sample population can be
accurately predictedfromasmallnumberof observations. Insurance is a misunderstood commodity.
Later in this chapter, the topic of framing is discussed. At its core, framing concerns how to communicate
with a client. Documentation shows that the perception of a problem not only depends on its presentation but
also on the mindset of the decision maker. Advisors encounter people on an emotional roller-coaster desiring to
achieve financial security. Insurance is rarely at the top of clients’ lists, but when faced with their own mortality or
that of a loved one, there’sa shift in attention. Although insurance is relevant for all clients, its level of importance
tends to increase with age. Advisors can guide clients seeking different types of insurance. Because clients differ,
advisors need to improve their skills at presenting relevant information to different types of clients. When they
frame insurance properly, its merits become clear to clients. As an economic tool, consumers can use insurance
to build, protect, and pass on wealth. By framing insurance in this manner, consumers may better understand its
benefits and not view it as a commodity.
THE NATURE OF RISK

Risk has different meanings to different people and varies with the individual (Yazdipour and Neace 2013). For
example, Markowitz (1952), who developed modern portfolio theory (MPT), indicates that risk-averse
investors attempt to develop a portfolio that maximizes their return for a given level of risk. Others view riskas
a condition in which a possibility of loss exists. Insurance serves as a hedge against pure risk. Pure risk is a risk in
which a chance of loss or no loss exists. No chance of gain exists, as there is the case of speculative risk;
examples ofspeculativeriskare playingthelotteryandgambling.
fte two primary types of risk that can affect an investment are systematic risk and unsystematic risk.
Systematic risk, also called nondiversifiable risk, is the uncertainty inherent in the entire market.
Unsystematic risk, also called diversifiable risk, is risk that is specific to a company. Diversification is useful
in hedging against unsystematic or company-specific risk. For example, if workers of a company went on
strike, the strike would only impact the company or possibly its industry; this is unsystematic risk. In
contrast, a major terrorist attack such as the September 11, 2001, attack on Twin Towers in New York City or the
Federal Reserve Bank’s sudden raising of interest rates could affect the entire market, and hence are
systematic risks (Moten 2014).
Risk can also be defined as possessing characteristics of objective risk and subjective risk. Objective risk has
quantitative aspects that are numerical or statistical components and thus is well defined and measurable.
Subjective risk has qualitative factors whereby the assessment of risk is based on perception, cognitive issues,
and emotions, which are less defined and unmeasurable.
Insurance allows consumers to protect themselves from large losses for a relatively small premium. Perils
are the causes of a possible loss resulting from such events as fires, lightning, explosions, aircraft damage, riots,
smoke, and terrorism. Hazards are conditions that increase the likelihood that a loss will occur; the three
primary types of hazards are physical, moral, and morale. Physical hazards are environmental conditions
that affect or enhance the frequency and severity of a loss. Moral hazards involve dishonest
behavior that causes loss. Morale hazards leads to attitudes of negligence and careless- ness that dominate
because of the existence of insurance.
fte four primary responses to risk are risk avoidance, risk retention, risk reduction, and risk transfer. Of
course, an individual may avoid the risk of loss by not engaging in an activity or owning property. Risk
retention is the most common method of handling risk, however, and should be those risks that lead only to
small losses. Risk reduction may be accomplished through loss prevention and loss control. When one party
transfers the chance of loss to another party, that is a popular form of risk handling; purchasing insurance is
a form of risk transfer.
BEHAVIORAL RESPONSES TO RISK

Insurance provides a framework for studying actual investor behaviors, such as rationality, bounded rationality,
and prospect theory. Rationality refers to a decision in which the decision maker intentionally attempts to
optimize utility. Alternatively, bounded rationality refers to limitations of the decision maker in access to
information, cognitive ability, and available time (Copeland 2015). Prospect theory describes how real-world
decisions involving risk can deviate from the rational decisions of expected utility theory. According to Simon
(1955), individuals sometimes make decisions that appear to be irrational based on current information, situation,
capability, and the environment in which they operate. An individual typically retains a risk when both its severity
and frequency are low. An example would be paying out of pocket to replace a Blu-ray disk; the cost of the disk has
dropped substantially over time, and if damaged, is minimal to replace it. An individual typically reduces a risk when
both the severityandthe frequencyare high. An example would be wearing a seatbelt while driving; auto accidents
frequently happen and their results can be severe.fte opportunitytoavoida risk is rare. Additionally,anindividual
typicallytrans- fersariskiftheseverityishighandthefrequencyislow.Anexampleisbuyinghomeowners insurance
to protect against catastrophic incidents; the cost of replacing a home is high, but the frequencyof a fire is low,so
consumers buy insurance whenthey want to transferthe
risk of incurring placement costs from themselves to an insurance company.
Basic Types of Insurance

Five main types of insurance are available for individuals:
• Disability. ftis insurance replaces a portion of the insured’s salary if the individual cannot work for a
period of time owing to illness or injury.
• Life. ftis insurance protects a family or business from loss of income owing to the breadwinner’s death.
• Property and casualty. ftis insurance protects against property losses to a business, home, or car
and against the liability that mayresult from injury or damage to others.
• Health. ftis insurance pays for covered medical expenses.
• Long-term care. ftis insurance helps to pay for services such as assisted-living facilities, home healthcare,
and/or nursing home stays.
fte commonality among all these types of insurance is that they are designed to transfer risk and to protect
income and/or assets.
DISABILITY INSURANCE
Disability insurance is intended to replace lost earnings owing to a disability, as defined by the policy.
Choosing a disability policy requires considering the following parameters: (1) when coverage is
triggered, (2) when benefits begin, (3) how much is paid,
(4) when coverage ends, (5) what terms exist for policy renewal, (6) what is not covered, (7) what
additionalbenefitsandridersareavailable,and(8) howdisabilityinsur- ance income is taxed.
Disability coverage is a subform of health insurance and falls into four categories: total disability, partial
disability, presumptive disability, and residual disability. Totally disability occurs when individuals cannot
perform the duties of their “own occupation” for a specific period of time. Another version of total disability is
“any occupation,” and that is the form used by the Social Security Administration. Partial disability is the
inability to perform one or more important duties of an insured’s occupation. Partial disability benefits are
usually 50 percent of the total monthly benefit. Presumptive disability involves the loss of sight, hearing,
speech, or two limbs. fte benefits for presumptive losses are usually provided and payable for a length of the
benefit period or lifetime. Residual disability refers to an income replacement provision due to loss wages
that result from a disability. Residual disability benefits provide a reduced monthly benefit in proportion
to an insured’s loss of income when he or she has been working again after a disability, but at reduced
earnings (Moten 2014).
LIFE INSURANCE
Life insurance is a contract in which the insurer agrees to pay a stipulated amount to a designated
beneficiary upon the occurrence of a contingency defined in the contract, usually that of death of the insured
(Moten 2014). Among the various types of life insurance policies are term, permanent, and endowments.
Term life insurance is a policy that provides protection for a limited number of years for a fixed premium.
Whole life insurance provides permanent protection for an individual’s life for a fixed premium.
Universal life insurance, which is a variation of whole life insurance, provides permanent protection with a
flexible premium. Variable life insurance is a form of permanent life insurance contract whereby the
benefits vary with the investment performance of an underlying portfolio of securities, with fixed premiums or
flexible premiums with a variable universal life. A modified endowment contract (MEC) is a life insurance
policy whose premiums exceed what would have been paid to fund a similar type of life insurance policy
with a given number of annual premium payments.
A traditional reason for purchasing life insurance is income replacement; consequently, it can be
strategically positioned as a tool for retirement. A particular strategy of interest is pension maximization.
ftis strategy is typically used to obtain more current pension benefit without denying the widow(er)
future benefits. A joint and survivor annuity is an insurance product that continues regular payments as
long as one of the annuitants is alive. Married couples who want to guarantee that a surviving spouse will
receive regular income for life often select this type of annuity. Instead of taking the typical joint-and-
survivor option, a couple can also choose to take the single life annuity option to get the higher pension benefit
and use some of those gained resources to buy a life insurance policy to protect the surviving spouse once the
other party dies. After evaluating the income needs of the surviving spouse and looking at available sources
of income, having life insurance to replace the loss of income may be appropriate. ftis example can be
considered a good application for a first-to-die policy, given that the need is income replacement for the
remainder of the single spouse’s life. One of the merits of life insurance that is often considered in wealthy
households, but bypasses those with less money, is guaranteeing a legacy.
Some people spend too much of their assets, while others limit their spending. A common concern
about over spending is that doing so may not leave a legacy to family members. When this is the case,
guaranteeing a legacy by buying life insurance can free consumers to enhance their current lifestyle—
possibly even providing more for their families both during their lifetimes and after death. For retirees with
extra funds that they want to leave to children, grandchildren, or even a charity, the amount gifted can be
leveraged by purchasing life insurance. Of course, the amount of the death benefits depends on the individual’s
age and health. Cash value life insurance also allows the retiree to retain flexibility, so that funds are still available
to meet retirement needs, or as discussed previously, even be available for long-term care.
PROPERTY AND CASUALTY IN SU RA N C E

fte most prominent forms of property and casualty insurance are homeowners (HO) and automobile
insurance. Homeowners insurance is a type of insurance that includes property and liability coverage.
Regardless of the HO form, two sections of the contract are section I (coverages) and section II (liability).
Section I of homeowners insurance covers the dwelling, other structures, personal property, and loss of use
or damages. Section II of homeowners insurance covers personal liability and medical payments to others.
Automobile insurance is a state requirement that typically provides a minimum amount of liability
coverage (Moten 2014). fte insurance satisfies a requirement needed to own and operate a motor vehicle.
Insurance is also tied to the ability to register a vehicle. Factors influencing the cost of automobile insurance
are the operator’s age, gender, and driving record, as well as the vehicle’s intended use. Automobile insurance
covers six basic areas: (1) bodily injury liability, (2) medical payments or personal injury protection, (3)
property damage liability, (4) collision, (5) comprehensive, and
(6) uninsured and underinsured motorist coverage.
HEALTH INSURANCE AND LONG- TERM CARE INSURANCE

Health insurance and long-term care insurance are designed to provide protection in the event of a medical
loss that could be short term, but catastrophic in nature or prolonged when a person is older and cannot
perform at least two activities of daily living (ADLs) or is cognitively impaired. fte six most common
ADLs are (1) bathing,
(2) dressing, (3) eating, (4) using the toilet, (5) transferring from a bed to a chair, and
(6) caring for incontinence.
A Survey of Behavioral Finance

According to traditional finance or economics, individuals should behave in a rational manner. Investors can
typically be placed in one of three different types of risk attitudes. Most investors are risk averse, which means
that when faced with two investments with a similar expected return but different risks, the investor prefers the
one with the lower risk. Investors with low risk aversion often prefer investing in money market mutual
funds or certificates of deposit. Individuals who are risk-seekers are on the opposite end of the spectrum.
Risk-seekers select investments with the highest level of risk for a chance at a high return. Even if a history of
low returns exists, risk-seekers still invest in volatile or risky assets. By contrast, risk-neutral investors are in
the middle, indifferent to the level of risk and concerned only with their desired rate of return.
ftese three risk attitudes explain the way rational investors react to risky situations. However, psychology
and behavioral finance explain how consumers make purchasing decisions based on perceived risk.
Specifically, behavioral finance explains why market participants make irrational systematic errors that are
contrary to the way rational markets participants should behave. Some experts divide behavioral finance theory
into three subcategories: biases, heuristics, and framing (Shefrin 2007).
BIASES
A bias is a tendency toward particular methods of thinking that can lead to bad judgment and irrational
decision making. fte following are biases, with a general example, a finance example, and an insurance
example.
Excessive Optimism
Excessive optimism is the inclination to downplay the possibility of a negative outcome or to
overemphasize the possibility of a positive outcome. Individuals with this bias think they are less likely
than others to experience an unfavorable event.
• General example: “I don’t have to wear a seatbelt when driving the short distance to my friend’s
house.”
• Finance example: “fte government bailed out Bear Stearns so we obviously don’t have to follow
Henry Paulson’s advice to find a buyer for our firm.”
• Insurance example: “I don’t need life insurance now because I don’t expect to die any time soon.”
Overconfidence
Overconfidence is the propensity for individuals to believe their skills, knowledge, and abilities are better
than they actually are. It also indicates a resistance to admit mistakes.
• Simple example: “I amsmarter than everybody else so I don’tneed to study for my final exam.”
• Finance example: “I know my calculations for the value of Apple stock must be correct, soI’ll invest
all my money in that company rather than diversify my portfolio.”
• Insurance example: “Insurance is a ‘rip-off.’ I can do better by saving and investing my money in the market
instead of giving it to the insurance company.”
Confirmation Bias
Confirmation bias asserts that individuals look for data and information to verify their beliefs. Hence,
they tend to ignore conflicting evidence. ftus, they tend to keep information that helps their case, but
ignore information when it does not.
• Simple example: “Even though Sam bought me roses and diamond earrings for my birthday, he must
not love me because I didn’t get the new Mercedes I’ve been wanting.”
• Finance example: “Despite economic sluggishness in China and Europe, the Federal Reserve should raise
interest rates because the unemployment rate is near 5 percent.”
• Insurance example: “I don’t trust life insurance companies. My dad paid on his life insurance policy
for year and it lapsed before he got a chance to benefit from it.”
Illusion of Control
Illusion of control occurs when individuals tend to believe that they can control more than they actually
can. In other words, people perceive that they have influence over things they do not.
• Simple example: When rolling dice in craps, which is a dice game in which the players make wagers on
the outcome of the roll, or a series of rolls, of a pair of dice, evidence shows that people tend to throw
harder for high numbers and softer for low numbers.
• Finance example: When investors use strategies such as limit orders to gain a sense of control over
investments, even though the overall success of their portfolio is based on factors such as company
performance, which are beyondtheir control.
• Insurance example: “I’ll wait until I get closer to needing insurance before I buy it.”
Status Quo Bias

Status quo bias occurs when individuals prefer to do nothing or maintain decisions they have made in the past.
ftey tend to prefer the current state of affairs.
• Simple example: “I have always bought iPhones in the past so I guess I will buy another iPhone
when it’s time for my upgrade.”
• Finance example: “My father told me that mutual funds were a safe investment so I plan to buy
mutual funds.”
• Insurance example: “I talked to my dad about his insurance and he felt that a burial policy was all I
needed.”
Hindsight Bias
Hindsight bias occurswhenindividualsunrealisticallybelievetheywouldhavepredicted an event that
occurred even though it would have been nearly impossible toforesee.
• Simple example: “I should have expected rain today because I washed my car yesterday.”
• Finance example: “I had a feeling that the chief executive officer was embezzling money from the
company.”
• Insurance example: “Buying into the guaranteed insurability option would have been awasteofmoney
becauseI’vehadthispolicyfor40yearsandnotbeensick.”
Recency Bias
Recency bias is the illogical tendency to make decisions based on what has happened in recentmemory.
Individualsthinkthatwhathasbeenhappeningwillcontinue.
• Simple example:“fte football teamhas not losta regular season game in morethan nine years so I bet
you $100 they will beat the next opponent.”
• Finance example: “Because housing prices typically rise over time, we don’t have to worry about buying
a house that is out of our price range because we can always sell it if we have trouble making the
payments.”
• Insurance example: “Because the rate of returns on permanent insurance policies has been low, I would
have been better off investing my money elsewhere.”
Conservatism
Conservatism occurs when forecasters cling to prior beliefs in the face of new information (Byrne and
Brooks 2008).
• Simple example: “ftat’s the way that we have always done it.”
• Finance example: “fte efficient market hypothesis explains everything that we need to know about how
the market works.”
• Insurance example: “Single people shouldn’t buy insurance because it is a waste of money.”
Mental Accounting
Mental accounting is a method by which individuals allocate wealth using separate mental accounts while
ignoring how they relate to other financial decisions.
• Simple example: “I have made big plans for my tax return!”

• Finance example: “I don’t want my child to have to take out student loans so I am going to take the
money from my 401(k) plan.”
• Insurance example: “Since I have cash value in my life insurance policy, I will use that money instead of
maintaining a savings account.”
Regret Aversion
Regret aversion is a method in which individuals make decisions or refuse to make decisions so they can
avoid feeling any emotional pain in the future due to making poor decisions.
• Simple example: “fte best strategy for me is not to get involved.”

• Finance example:“I lost money in thestock market in thepast, so I’mgoing tokeep my money in the
bank.”
• Insurance example: “I once had a permanent insurance policy, but it only earned 3 percent interest. I
couldhaveinvested my moneyinabetteropportunity.”
HEURISTICS
A heuristic is a general rule or mental shortcut that helps increases the speed of decision making. ftese
shortcuts present a problem when they hinder the ability to develop new ideas or when someone faces
anomalous circumstances. fte following biases are examples of heuristics, including representativeness,
availability, and anchoring.
Representativeness
Representativeness is a way of thinking that places thoughts into categories. Individuals make judgments
based on how well something fits into their preconceived notions based on categorization. ftis style of
thinkingcloselyresemblesstereotyping.
• Simple example: “David is reserved, wears glasses, enjoys video games, and watches sci-fi movies. I bet
he is a math or science major.”
• Finance example: An investor who only owns oil-based stocks may believe the entire stock market is
currently struggling. However, the reality is that his stocks are suffering because of falling oil prices.
• Insurance example: “Stock market returns are so good that buying term insurance and investing the
difference has to be a good strategy.”
Availability
Availability is the mental shortcut of relying on what most readily comes to mind when making decisions.
Individuals mistakenly think that if they can recall something easily, it must be important and, therefore,
servesasagoodbasisfordecision-making.
• Simple example: “John is scared to ask Suzy to the prom because he still painfully remembers how
Mary turned him down last year.”
• Finance example: “Both producers and consumers hesitated to take advantage of record-low interest
rates as the economy recovered because the memory of the financial crisis was fresh in their minds.”
• Insurance example: “When a member of my church died, her family had to collect money to bury
him; therefore, I am going to buy as much life insurance as I can afford.”
Anchoring
Anchoring is the propensity to rely on the first number or piece of information (an anchor). Individuals
then make subsequent judgments by adjusting the anchor to reflect new information. ftis heuristic can
become a problem when they wrongly interpret new information through the lens of the original
anchor.
• Simple example: Used car salesmen use anchoring to their advantage during negotiations. Once an initial
price is given, any lower price sounds better to the buyer even if it is still more than the car is worth.
• Finance example: During the tech bubble of the late 1990s, investors continued to speculate and expect
technology-based stocks to grow at a rapid rate although such growth was unsustainable in the long
term.
• Insurance example: “My parents bought a permanent life insurance policy for me when I was young
and by the time I was grown, it had considerable cash value. I am going to buy this type of policy for my
children.”
Affect Heuristic
Affect is the mental shortcut when individuals rely on their emotional response to a situation to make a
decision. If they have positive feelings about the situation, they are more likely to perceive it as less risky.
Affect is the “gut feeling” heuristic.
• Simple example: People are typically more afraid of airplanes than riding in automobiles because
airplane crashes create a more emotional response.
• Finance example: “I believe that financial markets are more likely to increase on sunny days than on cloudy
days because people generally havea more positive outlook.”
• Insurance example: “My friend just died and his lack of a life insurance affected his family. I need to
buy life insurance as soon as possible.”
Causality
Causality occurs when individuals wrongly attempt to infer cause from an effect. For examples,
individuals tend to associate correlation and causation.
• Simple example: “fte amount of drowning deaths increases when ice cream sales also increase.” It
would be wrong to infer that rising ice cream consumption causes drowning deaths because the more likely
explanation is that individuals eat more ice cream and swim more during the summer months.
• Finance example: “Increased economic growth in the United States causes more financial
development.” ftis relationship could easily be reversed: financial development could cause economic
growth. Individuals need to be aware of reverse causality and third-partcauses.
• Insurance example: “My health insurance was so expensive that I couldn’t afford it, so I dropped the
policy. Two weeks later, I had to go to the hospital. I bet if I had not dropped my health insurance, I
wouldn’t have had to go to the hospital.”
Attribution Substitution
Attribution substitution occurs when individuals have to make a decision about something more
complex and instead make a decision about a similar, easier substitute.
• Simple example: Someone who has been thinking about his relationships and then is asked about his
happiness might substitute how happy he is with his relationships, rather than answer the question.
• Finance example: When domestic stocks are down, people often move their money into cash, as
opposed to diversifying with international stocks or bonds or alternative investments.
• Insurance example: Anecdotal evidence suggests someone could be offered insurance against her
death in a terrorist attack while on a trip to Europe, while another person could be offered insurance that
would cover death of any kind on the trip. fte first person is willing to pay more even though “death of
any kind” includes
“death in a terrorist attack.” fte person is substituting the attribute of fear for the total risks of travel.
FRAMING EFFECTS
fte framing effect is an example of cognitive bias in which people react to a particular choice in different
ways depending on how it is presented, such as a loss or as a gain. Individuals tend to avoid risk when
presented in a positive frame but seek risks when presented in a negative frame.
• Simple example: fte glass is half-empty versus the glass is half-full.

• Finance example: Some people would rather risk doubling their money than losing half of their
money, although the odds might be the same.
• Insurance example: Selling insurance to parents if a child to cover funeral costs is difficult because they
do not want to think about their child’s mortality and believe the odds are low for premature death.
However, selling insurance to parents on their child is easier if it is to their child’s future insurability and
build cash value for the future and has a non-increasing premium.
Loss Aversion
Loss aversion occurs when individuals feel losses more strongly than they do gains. ftis situation becomes a
problem when it causes them to go to irrational lengths to avoid taking risks. Another problem of loss aversion is
that once people have invested time or money, they become irrationally risk tolerant to avoid feeling the loss
(aversionto a sure loss).
• Simple example: Losing $20 that a person earned has a greater impact than losing $20 that the person
found.
• Finance example: Risk-averse investors often choose low-risk investments despite offering lower
expected returns than more risky investments.
• Insurance example: Most individuals buy the “state minimums” on auto insurance to save on
premiums without thinking about the risk associated with being underinsured.
Herd Mentality
Herd mentality occurs when the behavior of others irrationally influences another. ftis bias is similar to
“peer pressure.” Individuals do not like to be left out, so they behave in ways contrary their normal
behavior.
• Simple example: A non-coffee drinker may pour another beverage into a Starbucks cup because of the
brand’s popularity.
• Finance example: Bernie Madoff pulled off the largest Ponzi scheme in U.S. history because investors
heard about his phenomenal returns from others and eagerly jumped on board.
• Insurance example: Insurance companies sometimes use celebrities to “sell” insurance in their
commercials because they believe that the status and influence of celebrities convince many consumers
to follow their example.
Disposition Effect
fte disposition effect occurs when investors are less willing to recognize and acknowledge losses more
quickly than gains. Similar to loss aversion, investors do not like to experience a loss so they may
irrationally refuse to accept it.
• Simple example: A football player continues to play on an injured knee and causes permanentdamage
becauseheavoidedtakingadequatecareoftheinjury.
• Finance example: Investors tend to sell stocks too early that increased in value and hold on to stocks
too long that decreased in value.
• Insurance example: Some men are unwilling to buy insurance because they do not want “some other
man living off their money” as opposed to being responsible and taking care of their family.
Money Illusion
Money illusion occurs when someone has difficulty factoring the effects of inflation into purchase
decisions.
• Simple example: “Bread is now very expensive. I once could buy a loaf for a dollar.”
• Finance example: “I previously could get enough interest from my money market account to pay my
car note. Now the interest generated is too small to buy lunch.”
• Insurance example: “My health insurance is 20 percent more than it was three years ago. I don’t
understand why it keeps increasing.”
Behavioral Finance, Insurance,

and Risk Management
Both traditional finance and the concept of rationality are based on the belief that when individuals receive new
information, they make choices that follow normative decision- making techniques (Barberis and ftaler
2003). In traditional finance, these individuals are considered to be rational maximizers. A rational
maximizer is an individual who rationally considers the pros and cons of a given purchase decision.
Behavioral finance describes a different set of rules in which individuals sometimes make irrational deci-
sions even when faced with seemingly rational choices. ftis irrationality leads them to make less than
optimal decisions. Behavioral finance helps to explain biases that are inconsistent with rational behavior.
Behavioral finance theories often serve as a framework for determining individual behavior in risk
management decisions.
Belbase, Coe, and Wu (2015) study which behavioral finance theories explain an employee’s decision
to buy life insurance. ftey examined mental accounting, money illusion, and the role of defaults. fte
authors conducted 24 telephone interviews with employees who had to choose the amount of life
insurance they wanted to buy. Specifically, their study examined employee perceptions about the threat of
premature death, financial consequences of their premature death, and how to minimize the cost through
mental accounting. Belbase et al. asked survey participants about their choice to buy voluntary supplemental
life insurance benefits available to them through
their workplace. fteir objective was to determine how these benefits are presented to employees, what features
are attractive, and what barriers exist for those who choose not to buy the insurance coverage.
fte responses show that most respondents understand the purpose of life insurance but admitted that
determining the proper amount of coverage needed was difficult. Over 40 percent of the respondents
reported that they spent less than 30 minutes to determine the amount of insurance needed. fte behavioral
finance theory of mental accounting is the most widely used method for determining the proper amount.
ftis preference occurs because mental accounting involves the tendency for individuals to separate money
into distinct, separate accounts based on subjective criteria. fte respondents’ budget was the main factor
used to find what amount of life insurance would be required to adequately replace the lost wages without
regard to what was really necessary to maintain the family’s current standard of living. fte issue of affordability
was more of an issue than an analysis of what they actually needed. fte results identify the need to provide
complementary educationtohelpinmakingchoices.
According to Fisher (1928), individuals sometimes think in terms of nominal rather than real
monetary value. A nominal monetary view ignores inflation, which affects one’s purchasing power. As
Shafer, Diamond, and Tversky (1997) note, if this theory holds, then it contradicts the maximization
paradigm that is prevalent in economic theory. ftey cite research in cognitive psychology suggesting that
when faced with the same risky situation, multiple responses are available. When individuals only have a
chance to gain more of an asset, they tend to choose the most risky proposition. However, consistent with loss
aversion, when faced with the prospect of loss and gain, they prefer the safer bet. When individuals think in
terms of monetary value, they demonstrate contradictory views of mental accounting when valuing their
possessions. ftis narrow view could lead them to undervalue their possessions when determining the
amount of property and casualty insurance or life insurance needed to maintain their current standard of
living.
Liebman and Zeckhauser (2008) study the deficiencies in traditional economic models, which are
very similar to traditional financial models when individuals face decisions to buy health insurance. fte
recent proliferation of healthcare choices has made this decision more difficult. fteir study focused on two
choices involving health insurance: (1) the type of insurance to select, and (2) when to buy insurance. ftey
found that once customers decide to buy insurance, the more risk-averse individuals buy more insurance. ftis
choice follows a rational decision-making model. Additionally, those expecting more health problems based
on family medical history also tend to buy additional insurance. However, even when individuals identify
that they need to buy more life and health insurance, they fail to conduct the proper analysis to adequately
address the risk. fte observed behavioral economics theory was “underestimation.” Consumers who
underestimate future events do not buy an adequate amount of health insurance because they concentrate on
their present condition. Overall, Liebman and Zeckhauser found that underinsurance is a factor of inertia
because of the complexity of coverage choices.
According to Kunreuther and Pauly (2014), consumers do not act rationally when making a decision to
buy insurance. ftey also point out that individuals with insurance
coverage act irrationally because they rely on intuition and emotions, rather than careful thought or proven
research. Traditional economic theory suggests that risk-averse consumers should be willing to pay a small
premium for a specified level of protection. However, Kunreuther and Pauly’s empirical evidence suggests
that even when facing low-probability and high-consequences scenarios, intervention is needed by public
and private institutions to shape consumer behavior. fte authors also find that many individuals select default
options rather than actually assessing their risk management and insurance needs. Many consumers use
intuition in the face of uncertainty, but this intuition is not based on research; rather, it is based on their narrow
experience with purchasing insurance. When consumers take an active role and truly assess their needs, the
benefits are widespread. Insureds suffer from underestimation.
Kunreuther and Pauly (2014) discuss an example involving the risk of terrorism. Even though actuaries
and underwriters are mathematical experts, they underestimate the damage that could be caused by events
such as the terrorist attack on the Twin Towers in New York City on September 11, 2001. ftis example
further illustrates a company’s failing to adequately account for low-probability and high-consequence
events.
Two notable pieces of legislation that attempt to address the shortcomings in the decision-making
process involve the purchase of insurance. Both the Biggert-Waters Act of 2012 and the Affordable Care
Act of 2010 (ACA) attempt to address the issue of insurance shortfalls. fte Biggert-Waters Flood
Insurance Reform Act of 2012 extends the National Flood Insurance Program (NFIP) for five years,
while requiring substantial program reform. fte purpose of the Affordable Care Act (ACA) of 2010 is
to make health insurance more affordable for those with little or no coverage. Many provisions of the ACA
are meant to control the costs of insurance premiums and out-of-pocket costs for health care and access to
insurance. fte intent of both acts is to encourage or entice organizations and individuals to implement risk-
reducing measures. Proposals for other forms of governmental intervention may reduce the risk to
society at large.
Huber (2012) conducts a four-part study to determine the effects of contract elements, price
presentation, company ratings, and consumer attitudes and perceptions on an individual’s decision to buy
certain levels of life insurance. fte first part of the study tried to ascertain whether the decision to buy life
insurance is based on guaranteed return or subjectivity willingness to pay, which is a financial pricing
approach. fte results suggest that even when faced with a guaranteed return, participants still deviate from the
norm.
fte second part of the study looked at the perceived value of life insurance based on different ways to buy
insurance, including bundling, partial bundling, and unbundled. fte results of the second part suggest that
consumers do not alter their purchasing habits based on the bundling of the insurance product. Huber (2012)
further suggests that the reason different individual decisions are not statistically significant is due to the
complexityoftheproduct and nottheperceptionofan actualpricedifference.
fte third part of the study examined the ratings of the insurance company and its effect on individual
purchasing decisions. Huber (2012) studies whether individuals make purchasing decisions based on ratings
and certifications of companies performed
by third parties. fte results suggest that company ratings and certification have a statistically significant
impacton productevaluation and on riskperception.
fte fourth part of the study focused on consumer attitudes and perceptions, and their influence on
whether to buy or not to buy insurance. Huber (2012) tests the hypothesis using a unit-linked life insurance
product without any guaranteed components. fte results of study suggest that underlying attitudes
significantly affect product perceptions. Huber (p. 169) points out that “risk avoidance presents a rather
emotional component while uncertainty avoidance is rather analytical.”

According to MPT, people have complete information about the likelihood of possible outcomes and can
articulate their preferences about those possible outcomes. Hence, they should be able to maximize their
expected utility. According to proponents of behavioral finance, individuals do not always operate
rationally.
Regarding insurance, consumers often respond differently from what “makes sense.” Stalwarts of the
insurance industry advocate that individuals should buy life insurance if anyone associated with them would
suffer financially if the individual were no longer around. fte general thinking is that the income
contribution being lost needs to be replaced and assets that have been accumulated need to be preserved. As
related to insurance, behavioral finance helps explain why consumers’ actions are different from what is
expected, given the issues regarding risk. Behavioral finance stipulates that consumers exhibit behaviors that
can be categorized as biases, heuristics, and framing references. Biases are a tendency toward particular
methods of thinking that can lead to bad judgment and irrational decision making. Heuristics are general
rules or mental shortcuts that help people make decisions faster. Framing effects are created by the way an idea
is presented.
Each of these behavioral finance concepts helps provide a better understanding of the why, when, and
how people buy insurance. Consumers are not motivated to buy insurance simply for protection. fteir
rationale (the “why”) is largely due to status quo, the recent occurrence of an event, a desire to avoid a loss, anda
lack of understanding of inflation or causality. Behavioral finance can also help provide understanding of the
“when” in the purchasing decision. fte “when” is often premised on the availability of a substitute option or
how insurance fits into a predetermined category. fte “how” of insurance decision making can be associated
with confirmation of previous beliefs and/ or the effect of emotion.
Generally, insurance sales have not decreased since 2009. By contrast, property and casualty insurance
sales are up, owing to state law. Sales of health insurance have increased as a result of changes in federal law.
Long-term care insurance has likely increased owing to more understanding of the preponderance of
Alzheimer’s cases and the frailty associated with longevity. Life insurance sales are actually down, even though
the availability of information has increased several fold. Many use insurance as a risk management
technique, but it cannot be confirmed that the reason is that consumers make smart buying decisions
(LIMRA 2013).
1. Explain the four primary responses to risk.
2. Discuss the three primary types of hazards associated with risk management.
3. Discuss the three most prevalent risk attitudes.
4. Identify and discuss the five main types of insurance for individuals.
5. Discuss three subcategories of behavioral finance theory.
REFERENCES
Barberis, Nicholas, and Richard ftaler. 2003. “A Survey of Behavioral Finance.” In George M. Constantinides,
Milton Harris, and René M. Stulz, Handbook of the Economics of Finance, Volume 1, 1052–1121. North
Holland: Elsevier.
Belbase, Anek, Normal B. Coe, and April Wu. 2015. “Overcoming Barriers to Life Insurance Coverage: A Behavioral
Approach.” Working Paper, Center for Retirement Research, Boston College. Available at http://crr.bc.edu/wp-
content/uploads/2015/06/wp_2015-5.pdf.
Byrne, Alistair, and Mike Brooks. 2008. Behavioral Finance: Theories and Evidence. Charlottesville, VA:
Research Foundation of the CFA Institute.
Copeland, C. W.2015. Applications in Financial Planning II. Bryn Mawr, PA: American College Press. Fisher, Irving.
1928. The Money Illusion. Toronto: Longmans.
Huber, Carin. 2012.“Behavioral Insurance: Essaysonthe Influence of Ratingsand Price Presentation on Consumer Evaluation,
Risk Perception and Financial Decision-Making.” Dissertation, University of St. Gallen, School of Management,
Economics, Law, Social Sciences and International Affairs. Available at
http://www1.unisg.ch/www/edis.nsf/SysLkpByIdentifier/ 3959/$FILE/dis3959.pdf.
Kunreuther, Howard, and Mark Pauly. 2014. “Behavioral Economics and Insurance: Principles and Solutions.” Working
Papers #2014-01, Wharton School, University of Pennsylvania. Available at
http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.645.8939&rep=rep1&type= pdf.
Liebman, Jeffrey, and Richard Zeckhauser. 2008. “Simple Humans, Complex Insurance Subtle Subsidies.” NBER Working
Paper 14330. Available at https://www.hks.harvard.edu/fs/rzeck- hau/SimpleHumans_website_version.pdf.
LIMRA. 2013. “U.S. Retail Individual Life Insurance Sales (3Q2013).” Available at http://www.
limra.com/Posts/PR/News_Releases/LIMRA__Individual_Life_Insurance_Sales_
Experience_Strong_Fourth_Quarter_Growth.aspx.
Moten, James. 2014. Introductory Financial Management: Theory and Application. Second Edition.
Redding, CA: Best Value Textbook (BVT) Publishing.
Shafer, Eldar, Peter Diamond, and Amos Tversky. 1997. “Money Illusion.” Quarterly Journal of Economics, 12:2,
341–374.
Shefrin, Hersh. 2007. Behavioral Corporate Finance: Decision that Create Value. New York.
McGraw-Hill Irwin.
Simon, Herbert A. 1955. “A Behavioral Model of Rational Choice.” Quarterly Journal of Economics
69:1, 99–118.
Yazdipour, Rassol, and William P. Neace. 2013. “Operationalizing a Behavioral Finance Risk Model: A fteoretical
and Empirical Framework.” Journal of Entrepreneurial Finance 12:2, 1–32.
18
Psychological Factors in Estate Planning
J O H N J. G U E R I N
Owner
Delta Psychological Associates, P.C.
L. P A UL H OOD JR.
Director of Planned Giving
The University of Toledo Foundation
Introduction
fte dialogue between an estate planner and a client, whether from the legal or the financial planning
profession, has a unique characteristic that distinguishes it from all other financial conversations.
Regardless of the details of the consultation, there’s a time when the results of the work will be tested. Alas,
that testing will occur when the client is no longer present to rework the plan. ftat irrevocability of the
estate plan thus creates a demand that the professional consider many possible resulting scenarios as a
product of the planning process. Because all possible scenarios cannot be exhaustively anticipated,
there’s often room for error when developing an estate plan.
Along with the need to draft as comprehensive plan as possible, there is a substantial barrier also not
present in many other forms of financial and life planning. ftat is, the formulation of an estate plan
implicitly involves thoughtful consideration of the distribution of wealth. Along with this plan can be a
statement of the feelings that accompany the distribution, or it can reflect a broad survey of the decedent’s
values, life stories, and worries. Such reflections are also sometimes contained in wills or in a separate
document commonly known as an ethical will (Reimer and Stampfer 1991; Baines 2006).
ftis chapter explores the complexity inherent in the estate planning process, including its tentative
relationship with behavioral finance. Included in this broad view is a discussion of common communication
problems encountered in estate planning and a look at the effects in particular of discussions of mortality. ftis
is followed by a review of models from clinical psychology that might be applied to estate planning, as well
as some interview techniques that could facilitate planner–client discussions. Finally, the chapter ends with an
overviewofcurrentandpotentialcollaborationsbetweenthe fields of psychology and financial planning.
318
Psychological Factors in Estate Planning 319
Considerations for Estate Planning

Today, the process of estate planning has transmuted into a primary concern about being taxed on wealth for
which taxes have already been paid. fterefore, the main issue in estate planning is one of tax avoidance, such that
the issue of mortality actually often becomes a secondary consideration. Adding to this, the estate planner must
acknowledge that most people have a low tolerance for discussions about their own mortality. Hence, both
client and planner frequently “dance” around the issue, with the discussion characterized by euphemisms
and with “gallows humor.”
At the same time, there has been anevolution in the parlance of estates. fte common term for arranging one’s
postmortem affairs has been called writing a “Last Will and Testament.” ftis label suggests that not only does one
distribute one’s earthly possessions but also one provides a rationale for that distribution. ftat this framework may
contribute to wealth stratification on a social level is usually not a consideration (Harrington 2012). fte current focus
of estate planning as tax liability avoidance and asset protection planning is not surprising, then, considering that the
estate planning professional is usually an attorney. However, discussions about legacy and wealth transfer may also take
place with a financial planner. But whether it happens in the office of an attorney or that of a financial planner, the practical
and numerically definable nature of tax minimization makes it an attractive target for the work of an expert. ftis
expert’s input can offer a clear “value proposition,” showing the impact of financial planning by demonstrating
performance withand without suchassistance.
Additionally,estateplanningisanareaofdirectclientservice,yetit doesnotfiteasily into a field of scientific
research. For instance, psychologists and other mental health professionals may either consume or generate
research that can apply to financial planning. Yet,borrowingthe principlesof humanbehaviorinrenderingthese
much-neededfinan- cial services requires that the planning professional select theories that seems to apply to
directservices.ftis incorporatesconceptualmodelsfrompsychologythathavevarying degrees of credible
research to support those ideas. fte metaphor that aptly captures the situation is of service professionals attempting
to construct an automobile while driving it. Nevertheless, the rising interest in behavioral finance has made
discussion of money and wealth a mainstream concern for psychologists and other mental health professionals.
Although behavioral finance has established itself as a productive area of research, it is almost exclusively
studied in academic and research settings. To date, mental health professionals are rarely adequately conversant
with financial and/or legal issues to give
any advice or direction that would impact financial and estate tactics.
For the service professional, there needs to be a clear link between psychology and finance. However, the
nature of that link—or more precisely, the incorporation of that link into the practices of financial and psychological
professionals—remains weak. Attorneys and financial planners know the importance of fuller, deeper, and more
meaningful conversations about wealth, including an awareness that wealth is also measured in nonfinancial
terms. Should the conversation take a turn toward emotional or psychological issues, or toward marital, family, or
relationship dynamics, however, and the financial professional is beyond his or her sphere of expertise or competence.
After all, this scenario risks professional liability exposure, as well as the loss of a client if the conversation
deviates from a discussion of financial well-being. Indeed, the call to have more extensive discussions with
clients adds a burden to the estate planner attorney, who has a formidable list of potential barriers with which to
contend, including issues of confidentiality. A crisis may precipitate an individual’s need for estate planning.
Family dynamics may inhibit meaningful planning. Factors of jealousy, financial illiteracy, addictions, mental
health issues, spending difficulties, and other barriers can restrict decision making and impair the client’s
judgment and cause discomfort for the planner (Foord and Ebersole 2007).
fte estate planning attorney must also acknowledge the evolving nature of families (Allianz
Insurance 2015). fte traditional family has given way to blended families, single-parent households,
same-sex partnerships/marriages, and older parents. According to Allianz, the number of traditional
families has dwindled to about 28 percent of U.S. households. Some studies have considered the
effects of these blended or modern families (Bernstein and Collins 1985; Hood and Bouchard 2012; Hood
and Leimberg 2014). However, the vast majority of estate planners are still operating with a traditional
model as their benchmark. Status quo bias or inertia may result because using the traditional family as the
template for financial planning is simpler, requiring less effort and sophistication.
Recognizing such challenges, it is essential for an estate planner to understand the relationship dilemmas
that can arise. Possessing some knowledge of the psychological research that may have studied client behavior
is, therefore, important in the estate planning process. For example, clients may need to discuss matters that
bear on mortality; knowing the extant clinical research on this can be of help. Furthermore, tools that psy-
chologists use in other areas of clinical and consulting work may prove useful in discussions of planning. Of
course, any research into behavioral issues in estate planning must consider the confidentiality owed to the
client.
The Complexity of the Estate Planning Process

Because of the inherently sensitive nature of estate planning, the heightened emotional pitch of this discussion
can have major therapeutic or anti-therapeutic effects. fte estate planner has to be consistently aware of this
possibility. Also, the meetings tend to be complex, given the many purposes of the process. Hood and
Bouchard (2012) provide a list of some of these issues:
• fte estate planner must gather a large amount of information, which may involve layers of complexity,
such as when an estate involves partial or full interests in businesses, or families are blended or
otherwise nontraditional. fte information gathered must be both accurate and complete.
• In the service of completeness, issues often arise that need to be recognized as tan- gential, so a refocus
may need to occur on multiple occasions.
• fteestateplanner mustengender bothasenseofcomfortandofcompetenceforthe client.
• fte estate planner must recognize and address the fact that estate planning involves a discussion of the
client’s mortality.
• If the client is more than one person, such as a couple, the estate planner must balance attention to both
and attend to relationship dynamics as they arise. fte complexity expands with the involvement of
other family members.
• Client motivations have to be recognized. Both explicit and hidden agendas may be involved in the
planning process.
• Family histories may be complex and delicate, particularly involving a blended family.
• fte estate planner must gauge theclient’s mental status or competence toengagein planning. ftat assessment
of mental status may include the possibility that another party could be attempting to exert undue
influence.
Other considerations may be present as well, both at the outset and during the remainder of the
planning process. First, since the planner’s work is often billed on an hourly basis, the client may wish to move
as quickly as possible, expressed directly or evident in some pressure applied. fte planner sometimes sees this
pressure as conflicting with a duty for completeness and adequate detail, and is obliged to inform the client of
estimatedcosts, even though complexities may arise that affect the ultimate cost of the work. ftat is, checking the
accuracy and/or completeness of the information supplied by the client sometimes calls for due diligence, and
therefore affects the time estimates.
Second, an implicit imbalance exists in the planner–client relationship, given the planner’s knowledge
of and expertise in the process. ftis disparity can drive the planner into beginning to address the “how to” of an
estate plan, rather than the “why” of the process.
ftird, a potential for conflicts of interest arises in estate planning. fte wealth holder is the client who must be
served; however, the success of an estate plan is measured by the views of the beneficiaries. ftus, the estate
planner must predict in the present how the plan will affect the beneficiaries later on, and whether the purposes
and ideals of the benefactor will be served.
Although an estate planner may make a reasonable attempt to forecast the feelings of the client’s survivors,
the manner in which grieving takes place can be unpredictable. Conflicts can easily arise among beneficiaries
over seemingly small matters, such as positive or negative feelings about the deceased or difficulties
confronting their own mortality. Although these issues are daunting challenges in the process of estate
planning, substantial evidence exists that a well-done estate plan can reinforce family cohesion and harmony,
and that a well-conducted planning process can have a positive, growth- enhancing outcome for the client
(Shaffer 1970; Glover 2012).
Planner–Client Communications
In part, as a result of the pressure to provide answers, the estate planner may assume the role of “expert,”
resulting in taking charge of the process and the conversation (Hood and Bouchard 2012). Especially
among professionals who have constructed numerous estate plans, a tendency exists to “plug in the tape.”
ftat is, a professional may begin answering a question before the client has fully articulated it, in the belief
that the question is already understood and a ready answer is appropriate. However, a client may read this
behavior as a lack of understanding or concern. Remember, listening involves not just refraining from
prematurely issuing advice but also employing concentration, inquisitiveness, acknowledgment, validation,
summarization, and empathic concern.
Added to the complexity of listening and responding is the need to address emotional channels of
communication, whether they are verbal, nonverbal, or paralinguis- tic. Indeed, the more important aspects of
communication may be nonverbal. Where mixed do messages occur (i.e., where the nonverbal messages are
incongruent with the verbal communication), the planner’s attention to this discrepancy may open the door to
deeper interaction.
THE EMOTIONAL CONTRACT

In psychotherapy, the initial stages may have an emotional contract focusing on the therapeutic relationship.
ftis contract goes beyond elaborating the services that will be provided and covering issues such as
confidentiality. However, the relationship dynamics in estate and financial planning are less likely to occur at
the outset, yet they are an important part of managing the client’s expectations that go beyond provision of
the professional services. According to Hood and Bouchard (2012), some questions that are likely to arise
for the estate planner are as follows:
• How available should the planner expect to be for any given client?
• What are the boundaries of the relationship?
• What are the client’s expectations?
• What are the boundaries that the client expects the planner to honor in terms of spousal or family
involvement?
• How much attention or “hand-holding” is the client going to need?
• Will the client allow work to be handled at a lower level of the organization, as in using clerks,
paralegals, and junior associates?
• What are the specifics of confidentiality in this case?
• How educated or sophisticated is the client, and how will this drive client involvement in the process?
• Will the client suggest or demand services that compromise the planner’s integrity or professional ethics?
Conversely, the client may be considering the following aspects of the emotional contract:
• Do I feel comfortable in the presence of and speaking with this planner?

• Does the planner appear to be competent to complete the work?
• Will the planner be loyal to my goals and needs?
• Will the planner be personally available when needed?
• Will the planner hear me out before advising?
• Does the planner pick up on nuances and nonverbal channels?
• Does the planner listen to me in a discerning manner?
• Is the relationship collegial rather than authoritative?
• WilltheplannerunderstandanyquestionsthatIhaven’tphrasedinproperlegalform?
• How long will the process take?
• How much will the plan cost?
C OUNTER- T R ANSF ER ENC E

As previously stated, the planner needs to listen on a deep level, and must be willing to enter into thorough
discussions if the interaction goes in that direction. However, intensifying the interaction can move the
planner into a discussion of matters he or she does not feel prepared for or trained to carry through.
Additionally, emotional or psychological dynamics may insinuate themselves into the professional
relationship. Such dynamicscanariseontheplanner’sendoftherelationship,ontheclient’send, orboth. For
example, a conversation about mortality typically occurs at an intellectual level.
However, if the client’s deep engagement disarms the planner and disrupts that formal or strictly intellectual
talk of mortality, the planner’s own feelings on the matter may enter the discussion, whether consciously or
not. ftis phenomenon occurs frequently in the field of psychotherapy and is labeled counter-transference, or
the disruption of the therapeutic process based upon feelings toward the client or issues that the client’s input or
behavior evokes in the professional.
Counter-transference is generally viewed as an impediment to effective progress in therapy (Cerny 1985),
whereas others view it as a potential tool (de Fries 2007). Still other researchers have sought to develop
concepts of what qualities professionals need to possess or to develop so as to minimize the adverse impact or
occurrence of counter- transference. Similarly, whether seen as a tool or impediment, these feelings may arise
in both the client and the planner regarding mortality, but also may be evoked by those necessary discussions of
using medical technology and life support, pain management, powers of attorney, advance directives, living
wills, do not resuscitate (DNR) orders, and other relevant factors. fte planner may indeed find aspects of the
client’s life that resonate with his or her own history or relationships, and will tend to view them from his or
her own perspective. fte estate planning context is especially vulnerable to the counter-transferential
phenomenon, owing to the imbalance in knowledge leading to a quasi-parental positioning of the planner. fte
professional mandate for “zealous representation” of the client may also promote such reactions (Hamel and
Davis 2008).
Researchers have extensively studied the phenomenon of counter-transference. Various attempts have
also been made simply to understand what counter-transference is, what causes it, and how to integrate its
various concepts (Rosenberger and Hayes 2002). Because of this complexity, the typical estate planner would
probably be unable to remain current with the research; however, this should not discourage the estate planner
from resolving to incorporate such basic understanding into the planning process (Scott 1973).
TRANSFERENCE
Along with counter-transference can come transference. Transference is the projection onto the
professional of the feelings and attitudes the client has and had in an earlier relationship in life. ftis
relationship is more likely to occur with a client whose experiences include having had a primary caretaker
earlier in life, an authority figure, or a close sibling relationship. Some view the occurrence of a transferential
reaction as an important event in psychotherapy, in that it enhances one’s self-understanding. However, such
insight is seldom helpful in the estate planning process. It is, in fact, more likely to be
a disruptor, distorting the client’s judgment. Nevertheless, the “expert” position of the planner increases the
likelihood that the client will view him or her, consciously or not, as a parental or authority figure. Alas, because
few estate planners are familiar with the phenomenon of transference, they are unlikely to notice when it
occurs; consequently, a client’s transferential reaction is likely to sidetrack or truncate the estate planning pro-
cess, so it is best to be on guard.
Mortality and Other Client Fears

As mentioned earlier, the estate planning attorney needs to assess a client’s competence to engage in the planning
process. And this assessment may not be exclusive to the client’s mental capacities at the time of developing
the plan. Additionally, the liability of the attorney may extend to the client’s beneficiaries. Despite the fact that
a planner has a primary responsibility to the wealth-holding client, there is no clear starting line indicating
where consideration of the interests of non-clients begins. Additionally, consideration of any ongoing
capacity of the client to amend or adjust the estate plan over time should be addressed.
Some evidence indicates that judgment and decision-making capacity may vary in some settings,
such as hospice care (Burton, Twamley, Lee, Palmer, Jeste, Dunn, and Irwin 2012). In those situations,
systematic measurement apparently uncovers various deficits that are undetectable through clinical
observation. Also, as a person ages, there are increasing levels of risk for undue influence (Peisah, Finke,
Shulman, Melding, Luxenberg, Henik, and Bennett 2009). Similarly, the testamentary capacity of a dying
person may be substantially compromised (Peisah, Luxenberg, Liptzin, Wand, Shulman, and Finkel 2014;
Schneiderman 1983).
Many individuals consider themselves unique in their ability to be aware of their mortality. Yet,
individuals have variable tolerances for their abilities to be aware of that mortality, on both intellectual and
emotional levels. When estate planners consider their general obligation to assess a client’s competence,
there is recognition that doing purposeful planning with an engaged awareness of mortality will alter the
quality of thinking that takes place, in terms of both process and outcome.
MORTALITY SALIENCE
Mortality salience (MS) is the general term used to describe the present awareness of mortality that a
person has at any given time. As James (2013) notes, the defense against feelings of mortality can result in the
“five D’s”: distraction, differentiation, denial, delay, and departure.
Distraction occurs when a client says that he is “too busy” to attend to estate planning. Differentiation
takes place when the client thinks that confronting issues of mortality is not required at the time because she
is in good physical health, has a genetic heritage of longevity, and sees himself well beyond the average range of
life expectancy. Denial may take the form of believing that fears of mortality are overblown. fte delay
defense frequently occurs when the client says that he is going to tend to the planning
at a later date. Finally, some clients “depart” from mortality discussions by simply discounting them off
when they begin.
A body of research has examined the changes that take place for an individual as a result of MS. Chief
among the considerations of MS is the contention that awareness of mortality may be a core motivator inhuman
behavior (Kesebir and Pyszczynski 2011; Koca-Atabey and Oner-Ozkan 2014). Other investigators see
mortality fears at the core of personality (Landau and Sullivan 2014). fte centrality of the fear of death is
also posited to lead to behaviors that reduce risk to the individual as an evolutionary mechanism (Leary and
Schreindorfer 1997; Lerner 1997).
Some investigators, such as Bozo, Tunca, and Yeliz (2009), have examined the link between death
anxiety and health-promoting behaviors. Anglin (2014) notes a shift in motivation to repair troubled
relationships. Appeals for donations may also be more effective under conditions of heightened mortality
salience (Cai and Wyer 2015). Dood and Handley (2007) also detect a tenacity in maintaining values. In some
cases, emotional awareness and proximity to death can result in mood alterations that are reflec- tive of
depression, and goal-directed behavior may then be reduced (Hayes, Ward, and McGregor 2016). Long-held
beliefs in an afterlife or mind–body dualism may promote comfort rather than depression (Ai, Kastenmüller,
Tice, Wink, Dillon, and Frey 2014; Heflick, Foldenberg, Hart, and Kemp 2015). Lunn, Wright, and Limke
(2014) discuss the role of attitudinal shifts in how MS affects perceptions of one’sdeity.
Still other investigators have found a link between enduring factors, such as self- certainty and
uncertainty, in the emotional responses to MS (Hohman and Hogg 2015). Investigators also have noted
that the contemplation of death enhances positive word use (Kashdan, DeWall, Schurtz, Dechman, Lykins,
Evans, McKenzie, Segerstrom, Gaillot, and Brown 2014), and that MS increases personal optimism in
people who have high self-control (Kelley and Schmeichel 2015). Others have found changes in social
attitudes and perceptions (Khoo, See, and Hui 2014), as well as allocations of time and money (Lin and
Ling 2014).
At the methodology level of many of these studies is some ambiguity about the effectiveness of measures
taken to treat MS in an experimental setting (Mahoney, Saunders, and Cain 2014). Typically, researchers prime
the subjects by introducing experiences that are presumed to raise MS on either a supraliminal or subliminal
level. fte effectiveness of this technique on the subliminal level has resisted operational definition, as well as in
other areas of psychology where subconscious factors are presumed to play a role. As such, just how effective
these methods are for inducing the experimental condition is unclear.
Given the variability that MS can introduce into a person’s thoughts and feelings, those thoughts and
feelings can apparently be a moving target when MS is introduced. ftis relationship may not affect legal
definitionsofcompetence,butitmayinfluencethe quality of the plan designed under those conditions.
TERROR MANAGEMENT THEORY

Linked to MS, terror management theory (TMT) (Solomon, Greenberg, and Pyszczysnki 2015) posits
thatthefear of deathis atthecore of one’spersonality and/or awiderange
of decisions and behaviors, because the instinct for self-preservation is a basic, universal drive in life (Leary and
Schreindorfer 1997). Some assume the centrality of TMT to be an evolutionary development, but others
counter that this view is inconsistent with the tenets of evolutionary theory (Kirkpatrick and Navarette 2006).
Still others see TMT in simpler terms—that MS evokes a basic need for control of outcomes (Snyder 1997),
which extends the explanatory power of TMT to include voluntary suicide in terminal conditions.
Regardless of whether TMT is an evolutionary development, its relationship to attitudes and behaviors has
led to studies of its effect on one’s defenses (Koca- Atabey and Oner-Ozkan 2014).
ADDITIONAL CLIENT FEARS

Additional sources of resistance and barriers exist that crop up in the planning process (Hood and
Bouchard 2012). ftese issues have not been directly addressed in the psychological research literature, but
they may make a regular appearance. In general, clients:
• Fear making a mistake in the plan.

• Experience trepidation about the future, whether in the realm of wealth or health, and that may paralyze
the planning process.
• Worry or exhibit anxiety about hurting the feelings of their inheritors.
• Commit assets to the estate irrevocably and then outlast their ability to live well or pay their medical
expenses.
• Have current estate plans that may have been solidified and then new laws may compromise that plan.
• Have a commitment to one plan that may engender feelings of a loss of flexibility to make future choices.
• Recognize that committing an estate plan to written documents requires disclosing financial and
personal matters that may sacrifice privacy.
As a result of the client’s heightened anxiety, worry, or fear, the estate planner can expect several emotional
reactions. First, as discussed, the process of engaging in estate planning brings up the matter of mortality,
which may affect cognitive capacity and judgment. ftis fear of death may be compounded by a concern with
making poor decisions under conditions of emotional arousal (Glover 2012). fte prospect of mortality
may also bring separation anxiety about leaving one’sloved ones.
Second, the client may procrastinate in concluding the estate work, as though finish- ing it might hasten his
demise. ftis is similar to thinking that discussing suicide with a depressed person will precipitate a suicide
attempt. A client may also avoid examining any life regrets by upgrading her view of her life to an ideal state.
Alternatively, the client might move toward grandiosity in his self-perception. Still other clients may use the
planning process to bargain with a higher power in eleventh-hour negotiations. ftis bargaining phenomenon is
consistent with the stages of coping with mortality as described by Kübler-Ross (1969).
Expanded Complexity: Marital

and Family Dynamics
As though the client’s emotional responses to estate planning and mortality awareness were not enough, the
estate planner should acknowledge that the planning takes place within a larger context that may include the
client’s spouse, children, close friends, and community. Perhaps as a result of that complexity, and the lack of
well-developed tools in the professions, a natural and perhaps unconscious tendency exists to focus on the
single client.
As Kingsbury (2013) notes, when a male client predeceases his wife, the woman changes financial
planners more than 75 percent of the time. One observation taken from this statistic is that the woman has not
felt included as a full partner in the planning process, and perhaps for a substantial amount of time. If one partner
actively plans and the other is either silent or absent, the estate planner may draw the erroneous conclusion
that the silence signals tacit approval.
When the greater complexity is acknowledged, orchestrating the input of an entire family in the estate
planning process becomes quite difficult. ftere are no working models to accomplish this goal within the
professional practice guidelines of the legal profession. So, adopting some knowledge gained inpsychology isa
naturalmovetoconsider.
Using Tools from Psychology

In using the field of psychology to inform the planning process, the estate planner will immediately encounter
some difficulties, in that the most applicable is in clinical psychology. ftere have been substantial efforts to
move toward practice models that are evidence and research based; still, many models focus on theory,
assessment, and treatment in clinical practice.
SOME RECENT CL IN ICAL MODELS

Use of models became popular practice because they were so effective in clinical practice. Acceptance and
commitment therapy (ACT) is a form of cognitive-behavior therapy or of clinical behavior analysis. fte
Gottman Method (Gottman and Silver 1999) and Imago Relationship fterapy (Hendrix and Hunt 1988) are
just two of many extant models used for couples therapy. Family therapy uses more than a dozen models. If
estate planning includes the disposition of a family business, some of organizational psychology’s
assessment and intervention methods may be pertinent or helpful.
For a clinical professional to be proficient in any given model, let alone a few different models,
requires a fair amount of training and practice. It is clearly unrealistic to expect an estate planner to learn and
become proficient with any of these models. ftere is a place for some inter-professional collaboration here,
though coordinating the two professionals presents some other complexities that are addressed later in this
chapter.
TOOLS FOR INDIVIDUAL ASSESSMENT

Although practitioners use many instruments for psychological assessment, other tools are available that focus
on behavioral finance, financial style, and the fit between the financial styles of two or more people. With an
enhanced awareness of the psychological aspects of the estate planning process, a financial planner or attorney
can responsibly utilize these various tools to raise the quality of service. ftis goal can be accomplished while
minimizingthepossibilityofgoingbeyondone’sscopeofexpertise.
Mostoftheseinstrumentshavebeendevelopedfromtheexperience oftheparticu- lar test developer. As
such, they often have a high degree of face validity, which means that the assessment instrument seems to be
measuring the desired outcome. Despite face validity being helpful, it is only one of many psychometric
factors necessary to satisfy the psychometric conditions for a valid research instrument. Alas, very few of the
available assessment tools on the market have been subjected to stringent examination. At the same time, using
these assessment instruments has strong appeal for both financial and estate planners because they can give
some measure of insight into a person’s financial style. ftis insight can then give the planner a basis for
decision making,
rather than relying on personal perceptions of the client.
For instance, using an assessment instrument can be a nonjudgmental means for approaching
discussions about psychological and/or emotional barriers. It can also give the planner something to refer
to when such encountering barriers, making the discussions nonconfrontational. For example, when a
disagreement surfaces between the judgments of the planner and the client, the planner may well be able to refer
to the results of the assessment instrument, presenting the situation as a difference in style, rather than one
party being correct and the other incorrect.
Assessment instruments can also provide an intermediary function, so that the approach to sensitive
and emotionally loaded discussions is eased by via the vehicle of test results. Discussions that bear on
mortality, for example, may be initiated with a focus on a test’s “objective” results.
Many valid and reliable instruments for assessing personality and interpersonal style are available.
However, to apply any assessment findings to the planning process requires extrapolation from the
intended purpose of the instrument, and that can extrapolation can lead to difficulties. Conversely, a few
instruments have been developed specifically for use in fields involving financial style. fte Financial
DNA Assessment (FDNA) (Massie 2006) and the Fina Metrica assessment have not been reviewed in
Carlson, Geisinger, and Janson (2015), but both have been developed in a psychometrically sound manner.
Both instruments assess an individual’s style, but they can also have a second administration to another person
so as to compare results; consistencies between two individuals, such as marital partners, can then be evaluated.
Additionally, the match or mismatch between a client and planner can be gauged. Both of these instruments
consider the evolving field of behavioral finance, and this distinguishes them from most of the
psychometrically robust instruments in common use for psychological assessment.
fte FDNA describes traits that lie along a continuum running between two poles of a characteristic, with
low, medium, and upper ranges. fte instrument supposedly measures innate traits as opposed to learned
behavior. fte testing method is a forced-choice
format and scores are computed for 12 main characteristics. fte results can also be translated into suggested
portfolio structures that are consistent with measures of both risk tolerance and loss avoidance. Conversely,
Fina Metrica focuses more closely on issues of risk tolerance and loss avoidance, rather than on a wide range of
characteristics. Both instruments have been widely used in both the United States and other countries, and both
have been subjected to tests of validity and reliability to a greater degree than many similar instruments.
When using these instruments with a larger group, the estate planner should acknowledge the limits
to conclusions drawn from a group scoring, because composite scores are averages of scores across
participants; this dilutes the ability to detect outliers from the group, which in estate planning might be crucial
knowledge to have. ftat is, knowing who may have tendencies that run contrary to the family norms may
help the planner anticipate later disturbances in what is supposed to be a consensually validated plan.
An estate planner can use both instruments without having to rely on a psychologist to interpret the data, so
long as he or she has familiarity with the instrument and its interpretations. Using the instrument can open
up a discussion of how a client’s personal style comes into play. ftis gives the client a perspective that allows
him or her to step back from what is a natural tendency or inclination and make decisions that might be better
informed.
TOOLS FOR FAMILY ASSESSMENT

Psychologists employ more than a dozen major schools or conceptual systems for family therapy, with each
based on a different empirically developed model of family functioning. Each school or system has its own
methods of assessment and practice, as well. When an estate planner is faced with the task of dealing with a
family, there are few conceptualmodelstobefollowed,beyondone’sownexperienceandinstincts.
In this field of family assessment, some instruments are some useful tools, such as the FACES-IV, which
takes a systems perspective and evaluates families along dimensions of cohesion and flexibility (Olson
2011). ftese instruments can assist a family with self-assessment in a manner that is integrated with its wealth,
estate planning, and philanthropic goals. fte Family Roadmap (Fowler 2002) is an inventory for assessing
families along a number of dimensions bearing on family culture. Although it functions primarily as an
assessment tool, it can prompt family members to reflect on their goals and arrive at a self-identity and
definition.
Jaffe and Allred (2015) develop a family assessment system specifically targeting families who own
businesses. fte tool is specifically targeted toward wealth preservation across generations; hence, it offers an
approach to matters of succession. Jaffe and Allred’s tool also focuses on the personal motivations for wealth
transmission across the generations, and so it can assist in establishing a meaningful rationale for the transfer of
wealth.
Family assessment tools generally sidestep the issues of mortality salience and fears of death by
focusing on continuity for the family and family business. Whether the values discussion will also awaken
the mortality salience for the wealth creator is unclear.
LIMITATIONS ON THE USE OF PSYCHOLOGICAL TOOLS

One of the difficulties that estate planners often encounter when they want to use an assessment tool is an
appearance of critical or negative judgments. In a clinical setting, some of the value of psychological testing is
in targeting pathology. Unfortunately, this aspect of psychological assessment sometimes makes using such
instruments undesirable in an estate planning context.
Instruments developed within the model of positive psychology, however, assess individuals from a
strength-based perspective. Positive psychology is the scientific study of human flourishing and is an
applied approach to optimal functioning. ftis branch of psychology uses scientific understanding and
effective intervention to aid people in achieving a satisfactory life. Unlike some other frameworks in
psychology, positive psychology focuses on personal growth, rather than on pathology.
As yet, there are no assessment instruments for wealth and financial style within the positive psychology
community. Seligman (2002) has examined whether money contributes to happiness, and he found that
increases in wealth do correlate with measures of happiness, but only to the point where one’s wealth meets and
slightly exceeds one’s basic needs. ftat is, additional wealth does not increase one’s happiness beyond that
point. ftis finding can be useful in discussions of estate planning, giving perspective to clients when
assessing the advisability of passing along wealth and making bequests (Bradley 2000).
Interview Methodologies from Psychology

fte field of psychology has several methods of interviewing that can be considered by estate planners as ways
to enhance discussion and encourage decision making.
APPRECIATIVE INQUIRY
Organizational psychology is a specialty that focuses on the organization, group, or company as the locus
for development and change. Although pathology may be a factor, many aspects of the practice are strength-
based, such as appreciative inquiry (AI). ftat is, AI follows a format that focuses on strengths rather than
pathology. As an organizational tool, AI can be used in a group effort to construct a shared vision. Also, it
can be an element of discussion for a family or family business discussion concerned with continuing the
intention and vision of the wealth creator or present holder.
MOTIVATIONAL INTERVIEWING
fte ambivalence toward discussions of mortality that has been mentioned earlier may open up interesting lines
of inquiry. Good methods of interviewing will recognize and validate the inherent conflicts involved in the
change process. Techniques such as motivational interviewing (MI) have emerged from the addictions and
chemical dependency specialties of psychology, and has also been medical compliance issues, as well as
other areas that are typically addressed in counseling and psychotherapy (Miller and
Rollnick 2013). Given that the change process often involves resistance or ambivalence, MI articulates a
methodology that enhances discussion and decision making in the direction of change.
In clinical psychology, a common belief is that the decision and timing of change come from the client
rather than the service provider. fte technique recognizes that common conversations between an addict and
either a professional or family member take the form of trying to convince the addict to change behavior. MI
is a methodology that is somewhat counterintuitive, but it is both simple and sensible, guiding the addict to
arrive at a decision to change. ftis procedure has proved more effective than attempts to push a person toward
change. As a set of practical interviewing tools, MI may provide the estate planner with a set of techniques for
mortality discussions that can overcome the ambivalence about mortality.
DIALECTICAL INTERVIEWING
A treatment modality from clinical psychology that recognizes the need to balance conflicting emotional
forces is dialectical behavioral therapy (DBT). DBT is a well-structured approach that combines
cognitive-behavioral therapy with mindfulness practice. fte treatment targets specific areas of concern, such
as self-harm or relationship difficulties, and combines individual treatment with psychoeducational group
work. Although DBT was developed specifically to address problems encountered by clients with
borderline personality disorder, a main tenet of the treatment involves enhancing the individual’s ability to
hold two opposing emotional states or emotions simultaneously (hence, the term “dialectic”).
For the estate planner, the treatment focuses on mindfulness principles, requiring the observation of inner
emotional experience in an observational manner, without judgment. fte concept of holding two opposing
emotional states at the same time may be applied in the financial setting when addressing conflicting desires to
both discuss and avoid issues of mortality.
Looking Ahead: Collaboration Among

the Professions
fte current status of estate planning generally appears to be bifurcated into research and practice. fte research
is theoretical, emerging from psychoanalytic models that do not easily lend themselves to operationalization
or clear outcome measurements. Yet, research in behavioral finance by Ariely (2008) and Kahneman (2011)
possesses a field research quality that lends itself to both applied settings and outcome measures. fte
complications that emerge in designing useful research in the area of estate planning appear to result in part
from the sensitivity that surrounds the issue of mortality. ftis distinguishes the estate planning effort from
simple measurement of human decision making and its foibles. However, specific techniques from clinical
practice reveal the merits of using different practices in the field. Indeed, there is a need to develop more
scientific knowledge in the area of estate planning.
Along with the need to develop scientific knowledge in the study of estate planning, an inherently
interdisciplinary nature of the practice presents ongoing challenges to service providers in psychology, law,
finance, and business. fte collaboration of these disciplines is an undertaking that has been developing only in
recent decades, and involves setting guidelines of practice that serve the public while retaining the standards
and integrity of each profession. Given the importance of money and finance in our lives, and the recognition
that all of the involved disciplines deserve a voice, such a collaborative development is likely to continue
into the foreseeable future.
In fact, holistic approaches to financial and estate planning uniformly endorse the collaboration of
different professions and are viewed as necessary for rendering a high level of service to clients. ftis need to
customize the estate planning service is partly a result of the proliferation of increasingly sophisticated
computer- and Internet-based investment and planning services offered at greatly reduced costs. Rendering
such highly individualized service is one way planners can reduce the impact of this com- moditization of
their services, where price competition has become a driving force.
A related issue is that each financial advisor has a professional perspective that is considered essential to the
estate planning process. An element of competition can minimize the value of the aforementioned
collaboration, whether recognized or not. Each professional desires to be the “most trusted advisor” to the
client.
Nevertheless, cross-professional collaboration appears to be the wave of the future, although the details on
how this will best take place remain unclear. Several inherent conflicts render the process of collaboration
difficult. For example, distinct differences in practice exist between psychology and financial or estate planning.
Professional standards differ between the fields. Additionally, the proper rendering of services in one pro-
fession can be unsettling to the client relationship in the other profession. For example, the discovery process in
psychology may cause a surfacing of conflicts or emotional disruptions. An estate planner can see this
development as potentially threatening the client relationship. Conversely, the psychologist may recommend, on
the basis of psychological observations, that issues or items be included in an estate plan that are legally complex or
even untenable. For example, the psychologist could recommend bequests that are con- ditioned upon future
states, such as sobriety, or based on judgments of the differing psychological needs of the beneficiaries. fte
psychologist may make distinctions between what is an equal split of wealth and what might be a more equitable
split, based on needs. fte models for this collaboration often appear to be those that will evolve over time among
lawyers, financial planners, and mental health professionals. A philanthropy professional could also be in the
mix. Already, several financial institutions and banks have formalized the organization of interdisciplinary
collaboration within their organizations, usually to serve ultra-high net worth clients and client families. Under
the umbrella of the firm, the orchestration of services could reduce competition among professionals.
Additional models for collaboration could occur in the family office enterprises that provide varying levels
of concierge services for financial, estate, philanthropic, and fam-
ily dynamics and business issues, often oriented toward legacy planning.
fte creation of forums for interdisciplinary collaboration among planners, attorneys, and mental health
professionals has been occurring on a national and international level. Organizations such as the Purposeful
Planning Institute, Family Firm Institute, Naz Rudin, and the Financial fterapy Association focus on the
overlaps among law,
psychology, and finance while employing a family dynamics perspective to research and development in what
will be an ever-expanding body of knowledge in the field. No consensually accepted “best practices” are
available in the field as models evolve over time.

ftis chapter explored the possibility of stronger connections between psychology and estate planning, first by
discussing the psychology that underlies the planner–client relationship, and then by offering models for
assessment and enhancement of the discussions that are so pertinent to estate planning. Lastly, the chapter
opens the door to the future possibility of collaboration among the professions, leading to greater insights and
enlarged service to clients in need of estate planning.
1. Identify the issues that create differences between estate planning and other areas of financial planning that
can impede or prevent progress.
2. Discuss the dimensions that differentiate estate planning from other areas of financial planning and
wealth management in terms of the emotions accompanying decision making.
3. Explain why estate planning calls for collaboration between the planner and client, as well as between
the client and inheritors.
4. Discuss how estate planning presents unusual challenges for the legal or planning professional.
5. Explain how transference or counter-transference might play a role in professional engagement.
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19
Individual Biases in Retirement Planning
and Wealth Management
J A M E S E. B R E W E R JR .
President, Envision Wealth Planning
C H A R L E S H. S E L F I II
Chief Investment Officer, iSectors
Introduction
People often live in the moment during most of their lives, including in regard to their money. Present bias is
the tendency to overvalue immediate rewards at the expense of long-term intentions. For example, a child
may want the “must have” toy. fte parent may say no, focusing on paying the private school education, but the
grandparent may choosetobuythetoytoexperiencetheimmediatejoyonthatgrandchild’sface.
According to Statman (2011), an individual’s relationship with money can take a utilitarian,
emotional, or expressive form. Historically, the study of economics and finance has focused on the
utilitarian, which is the ability for a service or good to satisfy needs and wants. Rapper Snoop Doggy Dogg
(1993) says it this way: “I’ve got my mind on my money and my money on my mind.” An emotional
relationship focuses on achieving peace of mind, whereas an expressive relationship concentrates on the
role money plays in defining an individual.
However, what about an individual’s long-term best interests? In a fast-paced world, individuals often do
not have the natural ability or the time to become experts in a topic and to execute the knowledge they possess.
Recall the cardiologist who is overweight and smokes. Having someone to look out for the best interests of
others and to provide a little nudge can promote better behavior.
ftaler and Sunstein (2009) introduce the concept of nudging, also known as paternal libertarianism
(ftaler and Sunstein 2003). ftis concept describes how corporations, governments, or institutions can
develop policies or tools to influence the behavior of individuals by changing their decisions toward outcomes
that would not occur without the nudge. ftat is, the organization establishes the context in which people make
decisions. For instance, financial planning policies based on nudging encourage people to
337
save and invest more money. Howardand Yazdipour(2014, p. 195) provide an instance of this:
In the example of a worker contributing to a defined contribution or 401(k) plan, the employee
would be automatically enrolled to contribute the required amount to receive the maximum
employer match. fte employee could opt out by selecting an alternative contribution or by
withdrawingfrom the plan.
Another example of nudging is the default settings for software—these choices are made for someone
unless he or she selects a customized option. Nudging does not actually limit choice, but it suggests that
someone with expert knowledge has already made the suitable choice.
Few people get a passing grade on the Financial Industry Regulatory Authority’s (FINRA) financial
literacy test. ftis finding is not surprising, considering that personal financial literacy is not a core curriculum
subject in U.S. schools. Nevertheless, individuals benefit from a nudge toward making better choices about
their financial decisions. In a Forbes interview with Peter Ubel (2015), Richard ftaler states, “A nudge, as
we will use the term, is any aspect of the choice architecture that alters people’s behavior in a predictable way
without forbidding any options or significantly changing their economic incentives. Tocount as a mere nudge,
the intervention must be easy and cheap to avoid.” In the context of finance, working in someone’s best interest
takes on a legal status known as a fiduciary. Employers along with fiduciary financial planning and invest-
ment advisors can develop nudges, such as opting people into the company retirement plan and selecting
professionally managed model portfolios for them.
Kinniry, Jaconetti, DiJoseph, and Zilbering (2014) estimate that working with a certain type of financial
advisor using the Vanguard Advisor’s Alpha Framework can add 3 percentage points (300 basis points) a
year in net return. fte framework includes suitable asset allocation using broadly diversified exchange-traded
funds (ETFs), cost- effective implementation (expense ratios), rebalancing, behavioral coaching, asset loca-
tion (tax-efficient investing), spending strategy (withdrawal order), and total return versus income investing.
Vanguard attributes half of that return to behavioral coaching. Morningstar suggests that a financial planner can
add 1.59 percentage points (159 basis points) in return from certain retirement planning advice (Blanchett and
Kaplan 2013). ftischapterbeginsbyexaminingsomefinancialpitfalls,includingpeople’salltoocom- mon reliance
on intuition, biases, and irrational behavior regarding their finances. ftese pitfalls create the individual’s need for
financial planning, which leads to evaluating whether to hire a professional, accept employer nudges, or utilize a
combination of advice and nudges from a Certified Financial Planner™ (CFP ®) or CFA professional. ften, the
chapter
highlights how nudges can enhance wealth, and concludes with a chapter summary.
Biases Create the Need for Financial Planning

REL IANCE ON IN TU IT ION
According to Nobel Prize recipient Daniel Kahneman, people use two systems for thinking (Kahneman
2011): the fast system, which is intuitive and emotional, and the
Individual Biases in Retirement Planning and Wealth Management 339
slow one, which is deliberate and logical. Given Kahneman’s view, should people trust their intuition? fte
intuition of a child differs from the intuition of her parents. fte education and greater life experience of parents
should improve their intuition, but does the intuition of parents in their mid-years differ from the intuition
ofseniors?
Kahneman offers two basic conditions for evaluating the validity of an intuitive judgment: (1) there
needs to be an environment sufficiently regular to be predictable, and (2) there needs to be an opportunity to
learn these regularities through prolonged practice. When a situation meets both conditions, a person’s
acquired skills often serve as the basis for his or her intuition. Yet regardless of age, someone who has earned
an academic degree or industry designation in investments is likely to be more skilled than someone who does
not have that credential.
“ UN B I A SED ” SELF- A SSESSME N T S

Many people attempt to assess their own financial needs. Often they simply rationalize the status quo, failing
to see the biases in their thoughts:
• “I don’t need an advisor.” Often the bias is anti-accountability. An advisor may want to change a behavior
the client enjoys. Another bias—status quo or inertia—is one in which the client does not want to
change what is currently working. ftis bias, also known as the ostrich effect, is one in which a client
keeps his head in the sand and avoids action of any type.
• “I’ll think about retirement later. Just give me what I want today.” ftis statement represents present bias.
People who make such assertions think that the future will take care of itself by meeting their
current needs.
• “I won’t die.” Spending money on life insurance premiums takes away from the plea- sures of vacations and
hobbies. Alternatively, focusing on financial obligations upon death saddens clients to think that they
will not be young forever.
• “I won’t get disabled.” People do not want to think about becoming impaired and dependent on others.
ftis statement also suggests that a person has control over undesirable events, known as the illusion of
control. Further, burying one’sheadinthe sand (ostrich effect) could be harmful to loved ones.
• “None of my friends are doing it.”Although the herd may not be right, it offers a pleasant pack to emulate. Clients
sometimes feel that their situation is not complicated and lends itself to self-diagnosis without specialized
knowledge. Discovering additional complications might require an investment of both time and emotionsto
addressthem.
• “I save enough to get the employer’s match in my retirement plan.” People tend to focus on the match
rather than calculating the needed amount to retire comfortably. Individuals prefer to focus on the most
recognizable features: free money, which is a salience bias.
IRRATIONAL FINANCIAL BEHAVIORS

An individual’s financial behavior often does not present a logical pattern of thought to the academic or
financial professional, but it is perfectly coherent to the individual. ftis includes behaviors such as milestones,
anchoring onnames,money emotions,and
money languages. ftese behaviors support the need for employer and advisor nudges, which are discussed
later in the chapter.
Financial Milestones
Many people think in terms of a milestone-based, linear financial planning process: first secure a job, then get
married, buy a house, start a family, plan for college education expenses for the children, and, finally plan for
retirement. Individuals often associate with a peer group that holds similar views. When workers have a
defined benefit pension plan, the employer contributes the most money; sometimes, the plan requires
employee contributions or permits voluntary contributions. For workers with these plans, the pension
system pays expected benefits when they are needed at a later time. Conversely, workers with elective plans or
defined contribution plans, such as 401(k) plans, make their own contributions and investment decisions,
following their peer group or hiring someone to help them. Even when they are proactive in these matters,
there is great uncertainty about the amount of projected benefits upon retirement.
Anchoring on Investment Names

When venturing into unfamiliar territory, individuals often seek a familiar label, such as identifying themselves
as conservative or aggressive investors. Not surprisingly, mutual funds include descriptors such as
“conservative” or “aggressive” and some people are attracted to these funds because of those descriptors.
However, the portfolio manager’s notion of what is conservative may differ from that of investors’.
Depending on the risk, return, and expenses charged by the fund, the fund might look conservative but its risk
profile is actually aggressive. ftis situation cancreate anxiety if return volatility is present.
Some see the target-date fund strategy as the answer for all participants in 401(k) plans. A target-date
fund is a mutual fund that automatically resets the asset mix of stocks, bonds, and cash equivalents in its
portfolio according to a selected time horizon that is appropriate for particular investors. Participants and
sometimes the employer’s 401(k) decision makers believe that target-date funds promise a specific account
balance on the date of the target-date strategy’s name. Although called a target-date fund, the year does not
refer to the adequacy of the account balance; it refers only to the fact that the fund becomes more conservative
over time. Its returns do not contain a guarantee but, rather, depend on how the market performs. Some target-
date funds are at the most conservative asset allocation at the target (stated) year. Yet, others could become the
most conservative 15 or 20 years after the stated date, given that retirees may depend on the fund’s balance for
decades. Hence, the name “target-date fund” can be confusing.
Money Emotions
People have self-expressive desires. Both inexpensive and luxury automobiles provide a mode of
transportation, but the impression they have on others differs. Saving money has little self-esteem appeal;
others may be unaware that an individual has $5 million in the bank. Many people use consumer debt to
obtain the appearance that they are wealthy; however, given the many sudden bankruptcies of high-profile
figures, this image can be just an illusion. Individuals acting on the need for self-esteem disproves the notion
of rational behavior.
Doctors, lawyers, and other highly skilled professionals often suffer from money shame. Brown
(2012) discusses the physical and psychological tolls that shame can exact. ftese high-income earners fall
prey to the same self-esteem and emotional challenges as experienced by less wealthy individuals. fteir
resources allow them to buy bigger homes in more affluent neighborhoods and to join exclusive clubs; their
need to feed their self-esteem and keep up with their peers often drives their behavior. As Belsky (2010) notes, if
these individuals find themselves subsequently teetering on a financial brink, they may ask, “How can I be in
this situation? What does this say about me? I am smart so I can resolve this issue. Who can I trust to not
expose my situation to my peers?” Although logical answers are available to these questions, individuals may
lack the knowledge to recognize them or be unable to regulate their emotions and behavior. One option is to
turn to a financial professional. According to Statman (2000), the true value of a financial planner or financial
advisor lies in managing the investor, not the investments.
fte word smart might result in detrimental financial decisions for clients. Everyone wants to be smart,
yet people may label some children “dumb,” at home or at school. fte shame that these children feel about this
labeling could last a lifetime, and certainly can affect their emotions about money. Away from those giving
grades or critiques, they can now assess themselves as smart. Although they may be skilled in music, art, or some
other talent for society, quantitative analysis may not be their area of expertise. When a predatory financial
“professional” calls them “smart,” these individuals receive affirma- tion based on what they want to hear. ftey
mayperceive that person as trustworthyand willing to accept their advice.
In fact, some investment providers like to incorporate the word smart into the names of their funds or
analytic descriptors. Although beta refers to exposure to the broad market, these providers use the term “smart
beta” to describe investing in securities that are highly correlated with a factor in the market such as low volatility
or high dividend yield. ftese providers want investors to feel intelligent when investing in their products. Who
would want a “dumb beta” when you could have “smart beta?”
Money Languages
Gender and marital status often contribute to money language. Money language is applied to how
influences such as parental, ethnic, and religious cultures help shape our relationship with money. For
example:
• “I’m a man; therefore, I’m good at numbers.”

• “Women are the caregivers.”
• “Our people’s wealth comes from owning property. ftat’s what our group does.”
• Wife: “What’s our retirement plan?” Husband: “Don’t worry, it is under control, trust me.”
Not surprisingly, men often exhibit overconfidence because they consider confidence a positive
behavior. They do not want to be asked questions about the decisions they make. Some even want to
play “stump the financial planner.” This show of bravado behavior is an attempt to exhibit their
masculinity to a spouse or significant other.
Some men say they are aggressive investors while actually being just as concerned about market swings
as women. What they mean is that they want to earn better than average market gains when the market is up and
want to switch to cash to avoid losses when the market is down. ftis market timing behavior is often very
costly.
Additionally, men often do not want to think about either their mortality or an eventual decline in their
health. fteir partners are concerned about their mortality, however, if they count on the man’s income for a
large portion of household income. Men may reject purchasing more life insurance, using excuses such as:
the advisor only wants to make money selling insurance, none of his friends carry that much insurance, or the
family could be using that money for more productive purposes.
Women have the practical challenge of longer expected life spans than men have. ftis greater longevity
means that women need to save more than men of the same age and income. In many married households, the
husband rather than the wife drives the retirement planning decision. As these conversations are often
emotionally charged, many couples want to avoid them.
Women may forgo investing in their 401(k) plans so as to invest in their spouse’s retirement plan or to
help pay for their children’s education. If the couple is contributing to the spouse’s 401(k) plan, a natural
question is whether a different risk position appears in the portfolio that would be wise for the wife. If not, and
divorce occurs, then she might receive less than what she otherwise would have received using a more mod-
erate investing approach.
Anchoring and herd behavior influence individuals according to the norms of their race and culture.
Anchoring is a cognitive bias that describes the tendency to rely too heavily on the first piece of information
offered (the “anchor”) when making decisions. Herd behavior describes how individuals in a group can
act collectively without centralized direction. Although not obviously true in all cases, Dutch Americans
have a reputation for being frugal, whereas African Americans often receive a label of being spenders. If
African Americans anchor or believed these stereotypes, then they would spend. A person who does not
follow cultural norms can be emotionally uncomfortable, feeling himself to be an outlier.
Another misconception is when African Americas choose to save, they are purposely conservative
investors (Natella, Meschede, and Sullivan 2014). Prudential (2015) attributes conservative behavior to a lack
of exposure, education, and information, which is availability bias. Availability bias refers to making
decisions based on limited information. ftus, the relative lack of information and exposure of many
African Americans may predispose them to more conservative investing behavior. According to Prudential,
many financial services firms do not actively seek out African American investors, which could otherwise
improve this group’s risk taking ability.
Biases in Deciding Whether to Hire a Professional

fte decision of whether to hire a financial professional should at least include evaluating the areas of
someone’s own financial literacy regarding the following current situation: (1) evaluating advisor
competency and fiduciary status; (2) financial status, including the mix of credit and debt; (3) retirement
planning; (4) college financing
for children; (5) insurance policies; (6) tax management; (7) estate planning; and
(8) investment strategy. Although most people elect to coordinate their own financial plans, research from the
Financial Industry Regulatory Authority (FINRA 2013) reveals that 61 percent of U.S. respondents could not
answer more than three of the following five questions correctly:
1. Suppose you have $100 in a savings account earning 2 percent interest a year. After five years, how much
would you have?
2. Imagine that the interest rate on your savings account is 1 percent a year and inflation is 2 percent a year.
After one year, would the money in the account buy more than it does today, the same, or less than
today?
3. If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no
relationship?
4. True or false: A 15-year mortgage typically requires higher monthly payments than a30-yearmortgage,
butthetotalinterestoverthelifeoftheloanwillbeless.
5. True or false: Buying a single company’s stock usually provides a safer return than a stock mutual fund.
ftere is much confusion about the term “financial advisor.” No such professional designation exists. People
who work with investments and insurance products might call themselves financial advisors because the
term sounds better than “agent,” “broker” or “financial salesperson.” However, a working definition for a
financial advisor would include those who provide advice inthe best interests of the individual, which is legally
known as a fiduciary; who holds an industry designation that minimally includes retirement planning,
investment planning, and insurance planning; and who maintains an industry designation requiring
continuing education. A CFP ® professional fits this definition, having successfully completed extensive
coursework and having practical experience in financial foundations, risk and insurance planning, retirement
planning, investment planning, tax planning, and estate planning. fte individual has also taken a fiduciary
oath.
Beyond these particulars of training and knowledge, there are personal characteristics that people look
for when considering a financial advisor.
TRUST
Trust for some people may reflect a good feeling about that person. In her TED talk, Onora O’Neill (2013)
states: “I would aim to have more trust in the trustworthy but not in the untrustworthy… . Intelligently
placed and intelligently refused trust is the proper aim.” She provides a structure for evaluating trust that applies
to the CFP ® professional, indicating that the judgment of trust for professionals requires determining
whether they are competent, honest, and reliable.
COMPETENCY
Most people have had no formal introduction to those involved in the financial planning industry. ftey often
identify a financial advisor and financial planner as synonymous
terms. Although commonly used, these may be self-appointed terms, as indicated earlier. ftat is why asking
about registrations, licenses, and professional designations is important. Some who identify themselves as
financial advisors may be mortgage agents or professionals who sell products, as oppose to offering advice.
Many who call themselves a financial planner do not have the comprehensive planning competency of a
CFP ® professional.
Others mistake a professional’s total assets under management (AUM) as an indicator of competency. fte
AUM is the total market value of the investments managed by a mutual fund, money management firm, hedge
fund, portfolio manager, or other financial services company. Many firms in the financial services industry
like to tout their size in terms of their AUM. ftey want investors to believe that because of the size of the assets
they manage, they know what they are doing. But the AUM does not mean their clients are on track to
reach their goals.
HONESTY
Most people prefer to hire people who will work in their best interests. Unless the professional is required to
work in the client’s best interests, such as is the case with a CFP ® professional, potential clients should remain
doubtful. fte individuals who work in the client’s interests can better frame a client’s issues from a holistic
financial standpoint, which includes the “Aspects of Financial Planning” explained in the next section.
RELIABILITY
As mentioned, the finance industry often touts AUM as an indicator of reliability and good results. However,
there are better methods for evaluating the reliability of a financial profession. For example, a potential client
could survey a few of the planner’s clients on how the individual handles various situations. ftose situations
might be retirement income planning or education planning for blended families. Another assessment tool is
the FINRABrokerCheck, which provides the regulatory record of advisors.
Aspects of Financial Planning

Any categorization of the broad topic of financial planning will differ depending on one’s perspective. fte
following are two major ones, helping to highlight the services of a CFP® or CFA charterholder. When taken
together, these areas represent this chapter’s definition of wealth management.
FINANCIAL STATUS AND STABILITY

fte financial status of different individuals can vary dramatically. For example, some people do not have an
emergency fund; perhaps they feel that emergencies will not happen to them. Others have large credit card
balances, making their financial survivability difficult if they miss several paychecks. Some people’s risk-
management strategy is to hope that calamities do not happen to them. Car owners have auto insurance because
it
is legally required to drive an automobile, not because they want to hedge the financial risk of an accident. fte
rationale for these decisions is born of optimism and the ostrich effect. We all tend to create narratives
concerning risk that is based on our intuition rather thandeliberation.
Individuals take this intuitive framework with them when as employees they select options on their
employer’s health insurance or disability income protection. ftey have them in mind when they think about life
insurance or an elective employer-sponsored defined contribution retirement plan. Although most people
feel that health care is a necessity, they reject many other benefits because electing them will further reduce
their take-home pay, another instance of present bias. Some people elect to continue with the health
insurance plan they had the prior year, rather than investigate other options, revealing a status quo bias.
Many people do not like the high premiums of long-term care insurance. ftey typically focus on the
premium, rather than the cost if they were to pay for nursing care completely out of pocket. In fact, most
people do not have the cash for long-term care, or would rather risk the well-being of their loved ones to pay
those costs. Some make incorrect, uninformed yet optimistic assumptions about the role of Medicare
and Medicaid in covering long-term care. In short, people often create hopeful narratives that support their
overall judgment, resulting in a denial of the facts in order to avoid negative emotions.
Narrow framing can seriously affect an individual’s financial status. It especially becomes an issue
when someone sees only part of the picture and not the whole. For instance, many people equate having $1
million in income to having $1 million in the bank. However, they have not calculated the taxes due, as well
as other fees that may lower that amount. First-time recipients of large sums of money, such as lottery winners
and athletes, often spend the money even before they receive the funds.
RETIREMENT PLANNING
Planning for retirement can be an emotional challenge. Many associate it with a loss of vibrancy and even
impending death. Others see retirement as a time of financial freedom, a time to do the things they have been
denying themselves while they were working. ftese people often have lived frugal lives and they leave their
jobs at the earliest possible moment so they can enjoy themselves in their retirement.
Present bias has many people delaying their retirement planning until they reach their 50s or 60s. fteir
social groups and peers influence their thoughts about whether retirement planning is a priority.
Additionally, in their considerations, they often discount the power of small savings and compounding
interest, as research conducted by Ibbotson, Xiong, Kreitler, Kreitler, and Chen (2007) shows. Yet knowing
the power of small savings could help them build their retirement funds.
Let’s look at an example of the savings required for someone to live on 80 percent of a $60,000 gross
income during retirement. Based on the Ibbotson et al. research, a 25-year-old would need to save 12 percent
of her income until she retired at age 65. If she waits until age 50 to save, her savings rate should climb to 50
percent. ftese savings rates assume the investor will achieve certain investment returns, which may vary
from those projected. ftose returns may not be what the retirement investor actually
earns. Obviously, a 25-year-old can more easily save a smaller percentage of income for a longer time than can a
50-year-old save a larger amount. Ibbotson et al. also show that as a person’s income goes up, so does the rate of
savings required to replace the same 80 percent of gross income.
Many individuals with access to workplace retirement savings plans do not participate in those plans.
Because many of these plans offer some matching contribution from the employer, the workers are “leaving
money on the table.” Why would someone not take “free money?” Researchers at the National Bureau of
Economic Research have concluded that employees often “follow the path of least resistance” (Choi,
Laibson, Madrian, and Metrick 2015).
Some people view their 401(k) plans as a general savings account, rather than a tax- deferred, retirement
savings account. ftey withdraw funds for current needs, without much thought about how that action will affect
their retirement funds. In most cases, they would be better off using a simple savings account and reserving their
401(k) plan, thereby avoidingtheearlywithdrawalpenalty,incometaxobligation,andpotentialmarketrisk.
Similarly, many people are anxious to access their Social Security benefits as early as possible. ftey
believe that they are simply receiving the money owed to them and some have concerns about their
longevity. Unfortunately, maximizing a Social Security benefit is not a straightforward decision; delaying any
claim for Social Security benefits can add $10,000s, if not $100,000s, over a lifetime. fte reality is that more
people will live longer than expected, as medicine and medical procedures continue to improve. Following a
deliberate decision-making process for building one’s retirement savings, rather than an intuitive or wishful
one,mayhelppeopleavoidpovertyinoldage.
People are prone to oversimplification, which leads to narrow framing or considering too few factors in
making decisions. ftis bias emerges from a lack of time or information, leading to suboptimal decisions.
Consider, for example, how some large financial institutions advertise that they can help people with 401(k)
plan roll over the funds into their individual retirement accounts (IRAs). ftis assumes that an individual would
be better off rolling over her 401(k) plan funds, rather than leaving them at her former employer. But is she
moving her funds to a better investment? What makes that rollover better? And is the rollover consistent with
her overall retirement plan? Additionally, is the ease of completing the paperwork the most important
consideration? A slower, deliberative decision process might offer greater retirement benefits.
Earned income is taxable for Social Security purposes up to a set amount. ftose who exceed this
income cap often view the excess as “found” money (known as mental accounting), and not as an
opportunity to save for retirement. ftis scenario is a framing situation: many people like the ego boost it
provides and let others know they have exceeded the income cap. Others enjoy spending the money for fun
pursuits or luxuries.
Investment Strategies
Investment planning comprises having an investment plan, asset allocation, value determination, selection of
investments, market timing, regular review of investments, and tax planning. Let’s consider the biases and
typical investor behaviors that lead to faulty financial planning.
ONE- SIDED INVESTMENT PLANS

Investment planning is a multifaceted, often emotional pursuit. Based on mutual fund flows, the strategy
followed by a majority of people is to chase investment returns and pursue market timing. Some find the
pursuit of outperformance to be exhilarating; however, Portnoy (2014) points to the futility of attempting to
pick funds that consistently outperform others.
Central to understanding and resolving the investor’s paradox is recognizing that investing is a matter of
choice as much as it is a matter of finance and statistics. As mentioned earlier, people prefer simple solutions.
When they see their portfolio balance go down, references to dollar cost averaging and long-term investment
strategies are not what they want to hear. Yet, an evidenced-based, optimal strategy uses broadly diversified
asset allocation.
LIMITED DIVERSIFICATION
A basic tenant of Modern Portfolio fteory (MPT) is that the most efficient portfolios have the highest
expected returns for the risks taken. According to Markowitz (1952), by knowing the assets’ expected returns,
volatility, and correlations, a set of portfolios will emerge that represents the most efficient available, known
as the efficient frontier. Markowitz shows that efficient portfolios consist of low-correlated assets, which
result in diversified portfolios.
Subsequent erroneous implementation of MPT led Markowitz (1959, 1991) to suggest
enhancements to MPT. fte creation of Post-Modern Portfolio fteory (Post- MPT), first devised by Rom
and Ferguson (1993), addresses some of these errors by:
• Creating a set of investment choices having low correlations between them.

• Using 21st-century computational resources and statistical processes not dependent on historical
returns, standard deviations, and correlations to generate efficient frontiers.
• Defining risk in more precise terms than volatility to reflect human behavior.
• Considering investment vehicles and trading costs when establishing portfolios.
Few individual investors can create these truly diversified portfolios on their own, however. ftey believe that
investing in multiple mutual funds achieves full diversification. On the contrary, financial advisors often
have access to tools and investment vehicles that can create such efficient portfolios for their clients.
CONFLICTING SOCIAL VALUES

Clients often hold strong social values, yet investing may take them outside those values. Do clients know the
nature of their investments? Do they want to invest consistently within their social values to reach their
financial goals? Are issues such as sustainability, religion, gender equality, or income gap important tothem? As
both Kinnel (2015) and Roberts (2015) show, there is a difference between the returns an investor receives and a
comparable index return. Furthermore, investments in mutual funds, on average, fail
to attain the funds’ expected returns. Investor behavior accounts for much of this result. ftey often trade their
account based on emotion. ftis leads to harmful behaviors such as buying high and selling low. However,
working with an advisor that helps them invest in a values and goals based way can help calm their nerves.
Investing in companies that are aligned with the investor’s social and religious values could help these
individuals stay with an investment strategy during volatile times.
FAULTY INVESTMENT SELECTION

Most people select their investments based on desired returns rather than a desire to avoid risk. Not all people
who invest may realize that company cash flows vary over time, sales fluctuate, and demand for products
can change, based on the general economic condition. Additionally, investors often listen to those who tell
them what they want to hear, rather than those with opposing views. Some listen to con artists such as Bernie
Madoff and have become victims, failing to question how he could deliver far higher returns than the
market was producing.
Many investors watch pundits on television and listen to radio shows in search of forecasts and hot tips.
Although some of the pundits are logical in their approach, others are not much more than entertainment. In
contrast, companies such as Morningstar and Lipper use rating systems to help investors assess mutual
funds. Many of these assessments employ historical data to base their ratings. Remember, though, that
mutual funds carry a warning label saying that “past performance may not be indicative of future returns.” Yet,
historical performance is the basis that many people use when evaluating investment returns. Who has time
to look at the small print, anyway?
Similarly, when investing in the company’s retirement plan, many employees assume that the employer has
carefully preselected the 401(k) menus. ftat is, a single person or investment committee has agreed with the
company’s selected providers. Yet the investment menu may reflect a profit incentive given to the selected
providerandnotbeinthe best retirement interests of the participants.
Many employees, 401(k) savers, make hasty selections because the process seem overwhelming. Some
feel ashamed that they do not understand the complexity of the selection process. Others look for patterns of
performance that often do not exist. ftey focus on the recent winners, take an equal percentage of each
selection, or accept the default choice that could be a low return, cash equivalent fund. Others are overcon-
fident in their ability to choose the funds. For many people, fund selection is based on historical
performance; they want the past returns of the fund, not necessarily its future returns, which are
uncertain.
STRESS ON MARKET TIMING

fte pursuit of increasing returns via market timing comes loaded with an unending number of questions.
Market timers focus on determining the optimal time to enter or exit the market, yet this decision hangs on
predicting the answers to a variety of questions. Will the Federal Reserve change interest rates? Will investors
listen to the pundit with his opinion on the matter? How will the foreign markets react? Will what happens
in foreign markets that affect markets in the United States? What should we do and when should we do it?
Individuals want to appear smart, so they often quote various news sources. Without a solid background in
economics or finance, though, these investors may not be able to evaluate what the experts are saying. ftey
may discuss the news with peers who also want to show their intelligence and this cycle of groupthink can
lead to unnecessary trading. Timing the market correctly can provide huge self-expressive benefits. fte pundit
gets bragging rights of saying “I told you so.” And it can engender feelings of regret if one heard the advice
and did not act on it.
Few investors understand the negative impact of management fees and trading costs on their returns. ftat is,
trading costs decrease profits unless one can earn higher returns to overcome those costs. Nevertheless, frequent
trading can give an investor feelings of empowerment, as in controlling one’s own destiny. fte evidence shows,
however, that over the long-term, frequent traders lose more, on average, than they win (Barber and Odean
2000).
UNBALANCED INVESTMENT REVIEW

After creating their portfolios, many investors evaluate their performance based on whether the account
balance has increased. fte typical investment statement reports only present performance, without
presenting the client’s risk exposure. ftis type of presentation can lead an investor to trade on emotion. fte
most important evaluation of investment performance is whether it is consistent with the required returns in
the financial plan, based on an individual’s savings over a specific time period.
As mentioned, many retail investors use “expert” commentary from the media in making their
financial decisions. fte trustworthiness of these “experts” is based on being a media professional, rather
than a credentialed financial professional. What is the real basis for their expertise? Asking that question
requires research and deliberation, while interrupting the pleasure of satisfying of one’semotions.
Are these media “experts” actually investment advisors? ftey often speak in hyper- bole, and they report
the overall direction of a market index, such as the S&P 500. Yet some investors do not understand the
implications of the S&P 500 index; they do not even know it is only a subset of the total investable universe.
For example, if half of an investor’s portfolio consists of bonds that track an intermediate bond fund index, then
the S&P 500 index alone is not a good barometer of performance. Further, some experience positive or
negative emotions based on the performance their investments compared to the S&P 500 index. Much of this
stresswouldbeavoidediftheyhadknowledge of proper benchmarks for their holdings.
INADEQUATE TAX PL AN N ING

Tax planning is an often-overlooked area of financial planning. Unfortunately, many people mentally
frame the matter as tax preparation versus tax planning. Moreover, they don’t understand tax brackets in
the U.S. tax system or capital gains taxes vs. income taxes. Decreasing the amount of those taxable dollars can
increase one’s wealth.
Unfortunately, most people do not think about taxes until April 15 is near. fteir opportunity to save on
their taxes mostly ended on December 31 of the prior year. fte urgency of the tax deadline is a huge motivator,
but procrastination is always looming. Few people pursue a knowledgeable tax professional who can help
them find ways to saveon their taxes, such as starting a 401(k) or health savings account.
Some individuals prefer a sense of control or think they can easily prepare their own tax returns. Many use a
software program and/or online tax forms, believing they can do the work of a Certified Public Accountant
(CPA). For others, their tax situation is simple and is merely an exercise in following directions. Yeta CPAcan
provide bothtax planning and tax return preparation.
Most people prefer getting a tax refund rather than finding they owe the government a check. ftis attitude
illustrates the concept of loss aversion. Loss aversion stems from an individual’s strong desire not to take
losses;typical investorsfeel aloss more emotionally than they do a gain.
Some people use their tax refund as a forced savings program. In many cases, that refund becomes more of
a “slush fund,” as it is put toward vacations and other pursuits. Many people overpay their taxes out of fear that
they might owe at the time of their filing and not have sufficient funds to make the payment. Or, they may not
give, insure, save, or invest the bonus, citing the unavailability of the funds to do so, even with refund in hand.
ftus, an entire industry of tax preparers exists that has attached value to getting individuals a tax refund.
Enhancing Wealth Through Nudges

People need help in avoiding the self-expressive and emotional issues that can over- whelm their rational
thinking. Qualified financial professionals can deliver this help. Yeske and Buie (2014, p. 195) point to the
value of nudging as part of the financial planning process, that it is a method of reframing the conversation and
drawing “the client’s attention to a different aspect of the situation, one that transcends the present moment, or
enlists client heuristics to nudge them into a healthy direction.” Basically, there are two major types of
professional nudges.
EMPLOYER NUDGES
Most employees have difficulty calculating their needed savings rates and returns, and then translating this
information into retirement income. Benartzi (2012) highlights the importance of intelligent defaults to help
employees with retirement planning. fte most important is for employees to enroll automatically in a plan.
Such a conclusion should not come as a surprise, given that most full-time employees experience auto-
matic enrollment in Social Security. Another is to establish a default contribution rate, such as 6 percent, and
then continue to increase it—to say, 10 percent—in annual incre- ments. Given that employees typically know
little about proper asset allocation, having a professionally managed portfolio is critical. An employer can
provide the professional management through the qualified default investment alternative (QDIA) safe
harbor.
According to U.S. Department of Labor regulations, if employers properly select and monitor their QDIA
choice, they will receive relief (safe harbor) from liability for their employees’ investment outcomes. fte
operative word is properly, as some employers have taken this to mean that all target-date funds qualify. But
eachpotentialQDIAfund needs to be analyzed separately to see if the QDIA definition is met.
Using that same thinking, employers should consider defaulting or nudging employees into the maximum
health, disability, life, and long-term care insurance plans, if available. Rather than make employees become
experts, employers should make the choice easy for them. New employees are unlikely to view these actions
as reductions from their take-home pay (losses). Ideally, enrollment or benefits kick-off meetings can help
inform employees about changes in the benefit selection and explain the philosophy behind the changes. ftis
process can temper the emotions of people who may want to opt out.
At these meetings, employers can provide their employees with a retirement gap analysis or
personalized retirement plan. Calculating the required savings rates and considering the inflation rates,
expected returns, and time horizons are complicated. Besides being a cognitive challenge, this task can be
emotionally draining; yet, people with a plan are more confident overall. Implementing such a program can
reduce work disruptions, as well. Employees confident of their finances will spend less time thinking about and
working on them during work hours. Employers can also offer employees the help of a financial professional
through a workplace program.
FINANCIAL PLANNER NUDGES

fte first task a financial planner should undertake when meeting with a prospective client is to establish
trust, using O’Neill’s (2013) three-factor model mentioned previously: competence, honesty, reliability.
fte planner should present how her credentials benefit the prospective client. She should educate the
individual about the requirements of her various licenses, registrations, and designations. In the case of the
Certified Financial Board of Standards, these requirements are passing college-level courses in financial
fundamentals, retirement, tax, investments, and estate planning; passing a two-day exam; and delivering
financial planning to clients for at least three years. Presenting a clean regulatory record with FINRA, the
Securities and Exchange Commission (SEC), and the CFP board highlights a planner’s honesty.
Professionals can bolster their reliability by providing contacts that clients can access to check their
experiences.
Financial professionals should use a meeting process that allows new clients to get to know them personally.
Website and imagery showing the human side of the service can demonstrate how financial planning can help
the client achieve his or her desired goals. Total wealth optimization (wealth management) is a
multidisciplinary approach with priorities, trade-offs, emotions, and self-expressions. Its intention is to balance
the many areas that can affect financial life.
fte financial planner should ask questions that address the client’s entire self: goals, interests, values,
relationships, financials resources, and the desired number/type of planner contacts. ftese answers can
uncover the underlying drivers for the client’s
expected outcomes or can establish needs. Are issues such as sustainability, religion, gender equality, and
income gap important to the client? How might clients want to incorporate their social values into
investments, giving, and activism?
After clarifying the client’s goals, the financial planner should assess the client’s resources and
provide a plan based on standards that optimize the client’s total wealth. Examples of these standards
could be having a six-month cash reserve, maximum disability coverage (60 or 70 percent of current
income), life insurance to cover human economic value, and Social Security benefits beginning at age
70, as well as consideration of the inflation rate, expected return targets for the time period, savings
constraints, and if applicable, optimizing the use of employer-sponsored retirement plans.
Achieving these standards takes time. Part of the financial planning implementation is to help clients
redirect their spending to areas that will help them advance toward their financial goals. fte planner can
reframe a cash-flow plan or budget from being a constrainer to becoming a tool that increases total wealth.
For example, some budgets only support negative emotions, such as “I no longer can buy whatever I want.”
Instead, clients may experience positive emotions by associating a specific dollar amount with a desired client
goal— “Save 10 percent of your earnings” does not have the same feel as “Save $600 a month so that you can
confidently maintain your lifestyle after taking an early retirement at age 61.” It is easier to change behavior
when present happiness and future joy are equal concerns.
Most people seek to avoid immediate pain, such as obtaining negative investment returns. Investors
often view these investment returns in isolation because they have not calculated the return needed to reach a
specific goal. ftis tunnel focus can be at the expense of other areas of their financial plan. However,
automating the income redirection helps address the loss of current discretionary spending and soothes the
client’s emotions accompanying this loss. Typically, employees view payroll deduc- tions as forgone pain
(passing up a bigger check) rather than an outright loss (paying into savings “out of pocket”). fte planner
should direct the client toward the joy of seeing all of his or her financial goals funded. fte financial
professional and the client can then celebrate the milestones reached along the way. ftose milestones
may include paying off existing debt, enrolling in the company’s retirement plan, or achieving 20 percent of
theclient’sretirement goal.ftesecelebrations boosthappyemotions and self-expression.
Planning professionals might reframe the retirement savings around the concept of “lifetime income
smoothing.” ftat is, would clients like to have an uninterrupted source of income that sustains their current
lifestyle for the rest of their lives? In fact, like most defined benefit plan payments, this will be the default
choicefor most clients.
In making the investments, planners should focus on taking no more risk than is necessary to reach the
client’s goals. fte choice should be minimum risk; heightened risk tolerance may not help the client reach her
goals. Determining the client’s tolerance of risk via a questionnaire can yield faulty results, based on her
financial knowledge or emotional state at the time.
fte financial planner needs to explain investment risk and expected investment return. fte risk
expectations are then used as guardrails for ongoing client reviews. And
the reviews should be clear and useful. For example, it is more important for a client to understand that an equity
portfolio’s likely annual return range has been between −18 percent and +38 percent for the year than it is to
know that the average rate of return has been 10 percent. Using analogies that resonate can enhance the client’s
understanding. For instance, people buy on performance and sell on risk. fterefore, the investment reviews
should focus on the planner’s investment process. Did the portfolio stay within the client’s risk
expectations?
Similarly, returns, either positive or negative, should be the reason a client considers making a change. As
previously mentioned, Kinniry et al. (2014) highlight the 150 basis points of investor return that can be
realized by helping the client stick with the plan through volatile markets. Ultimately, client behavior drives the
returns they realize when undertaking the fiduciary investment process.

Emotions that arise from uncertainty and the need for immediate self-expression challenge the financial
planning and investment process. FINRA and other research organizations have reported a general lack in
people’s financial literacy. Without such a foundation, people often let their emotions rule their behavior
and find comfort in being part of the herd. ftis chapter has reviewed some of the emotion-charged behaviors
that ill-serve investors. But, as suggested, carefully selecting and working with a qualified financial planner
can help avoid such behaviors and ensure a stable financial life with a good retirement future.
ftrough nudging, employers can help create positive default choices for retirement, health,
disability, life, and long-term care. Forward-thinking employers can provide one-on-one financial
wellness support for their employees, as well. Similarly, financial advisors are most effective using a
default option for corrective behavioral actions rather than having people opt in to benefits about which
they know very little.
Behavioral finance in the financial planning process starts when an individual evaluates whether to change
his or her current behavior. When the person realizes the need for change, the next question is whether to make
the change personally or to seek professional help. A CFP ® or, if the need is investment related, a Chartered
Financial Analyst (CFA) represents a source of such help.
Especially, financial planners can help their clients by developing a default system designed to nudge
them toward optimizing their total wealth. By assessing the client’s knowledge, emotions, self-expressions,
and resources, the financial planner can establish a deliberate process that helps them understand
themselves and their financial needs holistically. Financial planning should be an ongoing process that
celebrates milestone achievements.
More research needs to be done to address behavioral aspects of financial planning beyond investing.
Federal and local policymakers should move toward bolstering high school and college education programs to
include personal finance. ftis would benefit individuals and the market, as a whole.
1. Discuss the biases individuals have when considering their need for financial planning.
2. Discuss the rationale for hiring and the criteria for selecting a financial professional.
3. Discuss several biases that individuals should overcome in the financial planning process.
4. Explain how employers can nudge employees toward financial security.
5. Describe how financial planners can nudge clients toward financial security.
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Part Five
THE BEHAVIORAL ASPECTS

OF INVESTMENT PRODUCTS
AND MARKETS
20
Traditional Asset Allocation Securities
Stocks, Bonds, Real Estate, and Cash
C H R I ST O P H E R M I L L I K E N
Vice President, Portfolio Management
Hennion & Walsh Asset Management
EH S AN N I K B A K H T
A N D R E W C. S P I E L E R
Introduction
Asset allocation is an investment strategy that selects different securities organized into mutually exclusive
groups (i.e., asset classes), which exhibit different returns, risks, and pair-wise correlations (Securities and
Exchange Commission 2009). In general, an asset class will have high intra-asset class correlation but low inter-
class correlation. fte objective of asset allocation is to achieve a balance between risk and return that meets an inves-
tor’s goals, ability, and willingness to bear risk. Many view Harry Markowitz as the founder of the modern approach
to asset allocation and the first to quantifiably measure the benefits of including asset classes that exhibit different
return paths. He developed modern portfolio theory (MPT) during the 1950s and incorporated the
relationships between expected risk, return, and correlation among securities. Markowitz’s (1952) breakthrough led
to Sharpe (1964), Lintner (1965), and Mossin’s (1966) Capital Asset Pricing Model (CAPM), a linear equation
that incorporates systematic risk that continues to be widely taught and extensively studied. Further discussion
follows about the foundation of asset allocation and the pricing models that arose after the introduction of
MPT.
Professional money managers use countless asset allocation models today, but all incorporate the core
tenets of risk and return. A consistent characteristic of these models is an attempt to describe the optimal way to
allocate assets to achieve the most desirable return distribution. ftese models vary widely and the principles
upon which most are built are explored in more detail throughout the chapter. fte inputs of these models all
include some measure of standard deviation (risk), expected return, and the paired
359
360 BEHAVIORAL ASPECTS OF INVESTMEN T PRODUCTS AND MARKETS
correlation of the individual securities. fte less than perfect correlation of a portfolio’s underlying holdings is
the main factor that reduces the overall risk of a portfolio and the reason that the standard deviation of a multi-
asset portfolio is not the weighted average of the individual securities’ standard deviations. In simple terms, the
firm-specific risk of individual securities offsets each other leaving only systematic (market) risk in a large
portfolio. ftis concept is why asset allocation is said to be “the only free lunch in finance.” Extensive academic
research has examined the importance of asset allocation and how much a portfolio’s return can be
attributed to it. Brinson, Hood, and Beebower (1986)attempt toquantifythe portion ofreturn for whichthe
asset allocation decision is responsible and concluded that the mix of mutually exclusive asset groups
explains
93.6 percent of a portfolio’s return. Additional research has failed to reach clear consensus on this issue. Despite
the continuing debate, the asset allocation decision appears at least partially responsible for the risk and return
associated with aportfolio.
When building a portfolio and considering an asset allocation strategy, an investor must define the
available asset classes and securities. fte most common and perhaps fundamental building blocks are stocks,
bonds, real estate, and cash. Other securities such as options, futures, and structured products can add
diversification benefits and exhibit different risk and return characteristics, but these extend beyond the scope
of this chapter and hence are not included in the discussion.
fte basis of most decisions in finance rests heavily on balancing risk and reward, and the asset
allocation decision is no different. An investor must decide on both a return objective and an overall level
of risk. As related to the objective of the portfolio, the investor’s target return mainly determines the
portfolio’s asset mix. For example, a portfolio created for the goal of wealth preservation typically contains
a relatively higher percentage of assets that exhibit low volatility, such as fixed income and cash, and a
relatively lesser percentage of volatile securities such as stocks. Conversely, a portfolio with the objective of
capital appreciation uses a higher percentage of equities compared to relatively less risky fixed income
and cash asset classes.
Real estate adds diversification benefits to both conservative and aggressive return objectives, and can be
a stable allocation in most strategies. fte relationships among stock, fixed income, and real estate returns
historically exhibit low correlation, and combining all three, rather than viewing each in isolation, creates a
more efficient risk and reward trade-off. Besides considerations of target return, both the ability and the
willingness of an individual to assume risk play roles in determining an asset allocation strategy. fte ability to
tolerate risk is a function of several factors, including time horizon, wealth, and liquidity needs, whereas the
willingness totake risk is afunction of an investor’s behavioralcharacteristics.
Current market conditions may also determine the asset allocation policy developed and maintained for a
specific portfolio. ftis relationship results from the availability of certain assets and the fact that correlation,
risk, and return expectations are nonstation- ary. ftat is, in certain periods, some assets may become illiquid,
creating challenges for investment or divesture objectives. A prudent asset manager considers these factors and
finds assets that can serve as suitable replacements.
ftis chapter offers a high level overview of asset allocation including several common asset allocation
models and their benefits and drawbacks. A discussion of investor behavior considers the effects of both
cognitive and emotional biases. ftis topic is an integral part of the allocation policy because the models
reviewed assume rational
Traditional Asset Allocation Securities 361
investors who can operate with unbiased processing of information in addition to other constraints that
affect the efficiency of the decision-making process.
Behavioral biases are both cognitive and emotional. In theory, cognitive errors are more easily corrected
than emotional biases, which are ingrained in a person’s emotional psyche. fte research on the cognitive
behavioral biases of individuals acknowledges that mental shortcuts such as heuristics, mental
accounting, framing, and processing errors drive errors in the decision-making process. Errors are also
driven by the investor’s emotional state during the decision-making process. ftus, separating these two
primary groups―cognitive and emotional―is appropriate when discussing the reasons individuals fall
victim to these errors and when reviewing the impact on an investment policy and asset allocation
strategy.
Whether intentional or unintentional, the initial asset allocation and structure of a portfolio greatly shapes
the future distribution of returns. Although asset allocation is not the sole determinant of portfolio
performance, it certainly is its largest determinant. For this reason, the methodology a portfolio manager
chooses to use, such as mean- variance optimization or the Black-Litterman Model, is of utmost
importance and drives the future realized risk and return.
A large amount of academic literature supporting traditional portfolio construction methods assumes a
universe of rational, efficient decision makers. An increasing focus is on human behavior and inherent investment
biases. fte chapter thus begins by reviewing the building blocks of an asset allocation strategy, including stocks,
bonds, real estate, and cash, and then examines the asset allocation models commonly used by portfolio
managers before discussing behavioral biases and their implications on asset allocation.
As financial products continue to advance and change the medium used to deploy investment capital,
the focus remains on models to determine the allocation across mutually exclusive groups of securities.
Investment professionals can no longer ignore considerations of human behavior and flaws in decision making
whendevelopingacli- ent’s risk-return profile.
Asset Classes
In today’s increasingly complex financial world, the number and variety of available asset classes is continually
growing. In the early 1900s, an asset manager primarily chose among equities, debt (fixed income), and cash. ftese
three mutually exclusive asset classes exhibit unique risk and return profiles with correlations that are less than
perfect (+1), in some instances even less than zero, which provides for diversification potential. Today, however, asset
managers have not only the traditional three asset classes but also numerous derivatives, such as futures, options,
and swaps, as well as alternative investments that include real estate, hedge funds, private equity, and collectibles.
ftis expanded universe of asset classes has greatly increased the ability of investors to find diversification opportunities
and toimprovea portfolio’srisk-rewardprofile.Let’sconsidereachoftheseassetcategories.
EQUITIES
When the headline reads “GM Falls 5 Percent” the journalist is referring to the common equity issued by
General Motors. Equity refers to an ownership claim in a publicly
traded firm that can be bought or sold on a market with high liquidity and anonymity. Private equity involves
investments in companies that are not publicly traded, but such an asset class is not discussed in this
chapter.
Equity ownership includes voting rights and entitles the owner to a proportionate share of the profits.
Investors can use blocks of equity to control a company by amassing a majority stake in its outstanding shares.
For the retail investor, the benefits of equity ownership include participating in the profits and growth of
the firm (McFarland 2002). For example, ownership of 10 percent of the equity shares of a company entitles an
investor to both 10 percent of the company’s votes and its profit or loss. Equity owners can also receive
dividends, payments of cash, or additional shares.
Equities are exposed to higher risk than fixed-income securities, which are primarily concerned with return
of principal and interest. ftus, the performance of equity securities is closely tied to a firm’s profitability and
exhibits the most variability. Additionally, equities have the lowest priority to receive payback or assets in the
event of bankruptcy and come after creditors, employees, liens, and government claims. Often the shareholders
of a bankrupt firm receive nothing. Tosummarize, the characteristics of the equity asset class are that they: (1)
offer relatively higher expected risk and return, (2) provide capital appreciation and sometimes income, and (3)
represent ownership in a company.
BONDS
Bonds, or fixed-income securities, are loans to corporations and other entities. When a corporation issues a
bond, it asks for a loan from the investing community. fte loan increases both cash (assets) and debt
(liabilities) on the borrower’s balance sheet. Fixed-income securities provide an investor with the
opportunity to earn interest on the money loaned. fte amount of capital and the payment schedule are
predetermined, and the interest rate that is charged is typically quoted on an annual basis with semi- annual
payments. At the end of the predetermined period, the investor receives the initial investment and the final
interest payment (TD Ameritrade 2015).
Because fixed-income investors provide companies with funding, they are considered creditors and
in most cases have a direct claim against a company’s assets in the event of a bankruptcy. Fixed-income
investments traditionally serve as a means of generating income and preserving principal. Consequently,
investors view it as a more defensive security relative to stocks. For this reason, a heavier allocation to bonds
is common in a portfolio with an objective of generating current income or reducing risk. Fixed-income
investments have limited upside—the best case is the return of principal and interest on borrowed funds. To
summarize, characteristics of fixed-income investments include (1) lower expected risk and return than
stocks; (2) a focus on income, not capital appreciation: and (3) lower volatility than equities.
REAL ESTATE
Real estate in the framework of an individual investor’s portfolio most commonly is the home in which the
individual lives; and owing to the large relative value of homes for individuals, it often makes up the single
largest holding in a portfolio. Some investors
may also own additional real estate in the form of land, investment properties, vacation homes, and
securities such as real estate investment trusts (REITs). To a lesser extent, individuals may have exposure to
real estate through mortgage-backed securities (MBS) and other varieties of securitized debt, but these
alternative frameworks are more common for institutional investors. fte return structure of real estate
holdings, whether physical assets such as homes and land or securities such as REITs and MBS, has
historically been a low correlation with both stocks and bonds. ftis relationship is a great benefit to investors
because it can theoretically lower the overall risk of the portfolio without sacrificing return potential.
However, real estate does pose challenges for individual investors. fte primary challenge is the lack of
acknowledgment that the home or other property is in fact an investment and should be considered part of the
overall portfolio. ftis mental barrier is less common for holders of REITs and real estate securities, but must be
overcome to fully comprehend the asset allocation in place and the risk–reward profile of the portfolio.
CASH
Cash refers to deposits that are considered risk free in a local currency that do not fluctuate in value.
Technically, no asset is free of risk, but in the short term, inflation and liquidity concerns are ignored. Besides
the physical notes, examples of cash alternatives include checking or savings account deposits, money market
funds, and short-term U.S. Treasury bills (Morningstar 2015). Holding cash equivalents are most common
for a portfolio manager because they earn a positive return.
Cash plays an important role in managing a portfolio when regular withdrawals are required. If the
investment policy states that a fixed amount of funds must be withdrawn on a monthly basis, then holding a
certain percentage of assets in cash offers flexibility for portfolio managers because they will not have to
liquidate other investments to fulfill the distribution requirement. ftis strategy benefits the investor by
minimizing capital gains taxes for positions that have appreciated in value and prevents the unnecessary
liquidation of securities that have fallen in value in what potentially may be an inopportune time to liquidate.
Because cash is a “risk free” asset, it has a zero correlation with stock, bond, and real estate holdings in a
portfolio. ftus, increasing the allocation to cash serves to reduce a portfolio’s risk.
During times of market stress, cash alternatives are often in high demand as traders seek to reduce
exposure to risky assets such as stocks and low credit-quality fixed income. Certain portfolio management
strategies also call for cash holdings when securities trading below intrinsic value cannot be found or
identified. When opportunities present themselves, cash allows the manager the flexibility to purchase
securities without the unnecessary liquidation of other assets (“buy on dips”). Although cash offers the
aforementioned benefits, the downside to holding this asset is return drag. Return drag is the
opportunity cost associated with the money’s not being invested in other securities or assets during
periods of increasing prices, which in turn lowers the portfolio’s overall return. In summary, cash is a
risk-free asset that reduces a portfolio’s risk and offers flexibility, but has return drag reducing a portfolio’s
return.
THE RISK– RETURN TRADE - OFF

Risk and return are two key considerations in constructing a portfolio and finding the most efficient balance, is
the major objective of asset allocation models. An investment policystatement(IPS) typically contains the
riskandreturn parametersfor the objectives of the invested funds outlined by the investor, as well as the
investor’s ability and willingness to take risk. Assessing the investor’s risk tolerance is important because it
could be less than the investor typically expresses. In a portfolio management context, a common measure of
risk is a portfolio’s standard deviation. ftis measure provides insight into how much invested capital could
be lost relative to the average return of the market. A more detailed IPS could assign probabilities to the
portfolio distribution. Whendetermining risk tolerance, afinancial advisortypically profiles the client to gain
insight into his or her investing experience, stage of life, comfort with swings in market value, and other
important considerations. Investors who have less experience, are older or retired, or express discomfort with
quick changes in market value often have a lower risk tolerance. Conversely, experienced, or younger investors
who can accept
significant changes in market value tend to have a higher risk tolerance.
Clarifying the distinction between portfolio risk and return is of paramount importance. fte portfolio
return calculation is intuitive, it involves taking the weighted average of the individual asset’s return, usually
on a historical basis. Calculating a portfolio’s standard deviation is complicated and must explicitly incorporate
paired correlations between all assets.
Return objectives within a portfolio contain two parts: (1) the frequency of cash flow distributions,
and (2) the annualized total return. For example, income investors require a steady flow of dividends or
interest payments, which they can use to cover expenses. By contrast, growth investors often have a longer
investment time horizon and they focus more on the appreciation of an account’s value and less on intermittent
cash flows. Growth and income investing styles are not necessarily mutually exclusive.
Although MPT requires an investment manager to consider all the investable assets when designing the
asset allocation strategy, many individuals exhibit a behavioral bias called mental accounting, which is the
mental separation of assets into “buckets” to help keep their finances organized. Phung (2007) defines
mental accounting as “the tendency for people to separate their money into separate accounts based on a
variety of subjective criteria, like the source of the money and intent foreach account.”
In any case, whether investing for growth, income, or some combination, the earnings of the account are
measured in percentage units and they estimate, on average, the capital growth on an annualized basis. To
put this discussion on risk and return into context, consider the following example. If a manager invests
$1,000 in a portfolio that follows a normal distribution with an expected rate of return of 4 percent, a risk
(standard deviation) of 6 percent implies that at the end of the year the manager would expect earnings to fall
between about −2 percent and +10 percent with a 68 percent probability.
Owing to the unique needs, preferences, and circumstances for each investor, there is no single objective
measure that defines the appropriate return or risk level for all investors. However, the Sharpe ratio is the excess
return per unit of risk as measured by a portfolio’s standard deviation. It measures the efficiency of the risk–
reward profile. ftis
ratio divides the return of the portfolio less the return of the risk-free rate (i.e., excess return) by the portfolio’s
standard deviation. All else equal, investors prefer a higher Sharpe ratio because it points to a more efficient
blend of risk and return. Sharpe (1994,
p. 56) summarizes his measure:
All the same, the ratio of expected added return per unit of added risk provides a
convenient summary of two important aspects of any strategy involving the difference
between the return of a fund and that of a relevant benchmark. fte Sharpe Ratio is designed
to provide such a measure. Properly used, it can improve the process of managing
investments.
As this section shows, risk refers to the standard deviation of a portfolio’s returns. Another measure of
risk is systematic risk, or beta. Systematic risk is the aggregate risk associated with investing in the stock
market and it cannot be diversified away. fte first model to frame risk in the context of the overall market
was the CAPM. Based on Markowitz’s (1952) MPT, the developers of this model are Treynor (1999),
Sharpe (1964), Lintner (1965), and Mossin (1966). Perold (2004, p. 16) discusses the CAPM: “It is
the relationship between expected return and risk that is consistent with investors behaving according to the
prescriptions of portfolio theory.” Equation 22.1 represents the CAPM formula:

R  RF    R M  RF  (22.1)
where RF is the risk-free rate, β is a measure of systematic risk, and RM is the expected return of the market.
According to the CAPM, investors are compensated in two ways: time value of money and
exposure to market risk. fte risk-free rate represents the time value of money and compensates investors
for investing capital over a given time period. fte risk term, represented by   R M  RF , determines what the
investor requires to take on additional systematic risk inherent in the asset.
According to the CAPM, the required return of an asset or portfolio is equal to the risk-free rate and a
risk premium. If the expected or forecasted return is greater than the required return, the investment is
undervalued and represents a bargain. fte graphic representation of the CAPM for different betas is called
the security market line (SML). fte SML permits assessing the risk profile of individual securities or
portfolios (Rosenberg 1981).
ALLOCATION MAINTENANCE
An important and perhaps underappreciated aspect of portfolio management is the procedures for and
protocol to maintain and rebalance the investments. Strategic asset allocation (SAA) refers to the
establishment of and adherence to a long-term target allocation among equity, fixed income, and cash. fte
allocation between stock and bond asset classes is determined based on a long-term expected return, risk, and
pair- wise correlations. For example, if equities have historically returned 10 percent a year
and fixed income has returned 5 percent a year, a portfolio combination of 50 percent equities and 50 percent
fixed income would yield an expected return of 7.5 percent a year over a full market cycle. ftese return, risk,
and correlation estimates are referred to as capital market assumptions (or estimates) and they assume the
average return when considering periods of expansion and contraction in the business, credit, and market
cycle (Benz 2013).
Tactical asset allocation (TAA) represents a more active approach to weighting different asset
classes. ftat is, TAA allows for a more flexible portfolio relative to SAA. fte portfolio manager over-
weights or under-weights the allocations based on an assessment of current and expected economic
conditions. ftis process allows for potential outperformance relative to the benchmark if short- and
intermediate-term opportunities arise that warrant an increased exposure to the asset class expected to
outperform or a decreased exposure to the asset class expected to underperform. TAA allows the portfolio
manager temporarily to unbalance or rebalance a portfolio to take advantage of these exceptional
opportunities. ftis flexibility adds a market-timing component to the portfolio, which permits participation in
those asset classes with favorable prospects. Investment professionals consider TAA to be a relatively active
strategy that requires the willpower, discipline, and confidence to be able to return to the pre-set asset mix once
the short-term opportunity has passed.
REBALANCING STRATEGIES
Several rebalancing strategies exist ranging from the very simple buy-and-hold to more sophisticated ones.
fte most simplistic approach is the buy-and-hold strategy, which does not rebalance the initial allocation.
ftis asset allocation strategy is set at inception, but not adjusted. ftus, securities increasing in value represent a
relatively larger portion of the account and securities decreasing in value represent a relatively smaller portion.
Implementation is easy and increases exposure to investments that have performed well while reducing
exposure to those that have not. Yet, a buy-and-hold strategy not only can alter the account’s risk-return profile
but also can lead to an eventual allocation inconsistent with the original IPS.
Calendar rebalancing is another rudimentary approach to rebalancing in which the investor simply
sets a date, or several dates, throughout the course of the year that dictate when to place buy and sell orders to
return the portfolio’s allocation to its targets. One simple suggestion is to rebalance once a year on the investor’s
birthday. Although this approach maintains the target asset allocation, it may also force trades at what may
be inopportune times while ignoring potentially beneficial trades in between rebalancing dates.
A more active rebalancing approach is the constant mix strategy. fte constant mix strategy requires
buying securities that have decreased in value and selling securities that have increased in value. ftis process
forces the target asset allocation strategy to remain fixed, but often can incur large transaction costs and taxes
if rebalancing is frequent. ftis strategy forms a contrarian strategy in which investors or portfolio managers buy
during falling markets and sell during rising markets. For these reasons, most managers set bands around asset
class weights so the rebalancing only needs to occur when allocations drift outside the initial target
allocation.
Modern Portfolio Theory

As previously discussed, Harry Markowitz (1952) develops a theory of portfolio construction and
eventually received the Nobel Memorial Prize in Economics for his seminal work in 1990. Although the
basic tenets of MPT remain, the model has been expanded dramatically over time and has become more
complex. fte pioneering theory describes the steps a “rational investor” should use to build a portfolio that
opti- mizes return based on a stated level of risk. It focuses on increased risk leading to higher return. According
to Markowitz, forming an “efficient frontier” of optimal portfolios was possible that maximized the
expected return for any level of risk.
MPT has served as the backbone of academic finance for decades, but it rests on unrealistic
assumptions. fte overarching assumption is that investors focus on optimizing the risk–reward trade-off for a
given portfolio. fte following assumptions are necessary for the MPT to hold:
1. Investors are rational, risk-averse, non-emotional beings, who solely focus on maximizing risk-
adjusted return. MPT assumes that all investors are identically programmed computers that follow a
pre-set action–reaction matrix. Day-to-day interactions with others indicate that this assumption is
false, but it is required for the model to be internally consistent.
2. All investors have perfect and equal access to information and have accurately calculated, in advance, an
asset’s riskiness, and their perception of the return distribution forms a normal distribution. MPT
assumes that asset prices reflect private and inside information and that risk can be accurately determined
ex-ante. Again, although this assumptionis false, itmust be heldfor internal consistency.
3. All correlations between asset pairs are constant over time. MPT assumes that events do not change
the relationships between assets. Observations of global markets show this assumption is also false
because contagion occurs during market shocks and crises, and correlations often increase
dramatically.
4. Returns are normally distributed and tail risk events occur no more frequently than expected from a
normal distribution. In practice, returns tend to deviate from assumptions of normality based on
observations. Tail risk events, or extremely low probability observations that lie in the “tails” of a bell
curve, have historically occurred more than predicted by normal distribution.
5. Investors operate in a world of no transaction costs and taxes, and no minimum lot size exists for an
investment. Contrary to these assumptions, all markets have transaction costs, including commissions and
bid–ask spreads; also, investors face capital gains and/or income taxes as their investments produce
income or appreciate in value. Furthermore, MPT assumes the ability to buy fractional shares, which is
not a reasonable assumption for some investments.
6. Investors are price takers in the classic economic sense. ftat is, they can buy and sell any amount of shares
without affecting the price. However, supply and demand have an effect on asset prices in the market.
7. Investors can lend and borrow unlimited amounts at the risk-free rate. ftis assumption is not literally true,
as in comparing the return on savings deposits to mortgage rates from the same institution. Additionally,
the cost and availability of risk-free
assets change during adverse market conditions or periods when the financial markets are under
stress.
Clearly, the MPT is flawed and not directly applicable to the behavior and realities of capital markets.
However, owing to a lack of alternatives, it has nevertheless formed the basis for many portfolio management
strategies that attempt to correct or offer additional explanatory power using the same concepts as outlined in
MPT. fte most important assumption that needs to be discussed is that investors always behave rationally.
fte field of behavioral finance attempts to address this issue, but it has been unable to develop or adapt a
universal solution.
MEAN- VARIANCE OPT IMIZ AT ION AND

THE BLACK- L IT T ERMA N MODEL
MPT sets forth the concepts that allow for the modeling of theoretically efficient portfolios. fte actual
mathematical framework for using risk, return, and correlation to create these portfolios is called mean-
variance optimization (MVO). fte complicated and time-consuming calculations necessary in MVO
require using a computer to determine the optimal allocation. fte inputs include risk and return data that are
user-defined but typically ex-post in nature (i.e., they use historical data to suggest the future characteristics
of each security).
A portfolio developed using MVO typically suffers from an overconcentration of assets into a few
securities or asset classes and is highly input sensitive. Small changes in one or more of the risk, return, or
correlation parameters can cause dramatic differences in the resulting allocations. Another drawback of this
approach is the reliance on historical data. fte historical returns and level of risk associated with each of the
securities are unlikely to remain constant over the investor’s time horizon. For these reasons, most portfolio
managers use the MVO framework as a guide and incorporate constraints around asset classes that force the
output to have a minimum or maximum investment in a set of asset classes. For example, the user forces the
allocation to exhibit, say, a minimum of 40 percent and a maximum of 70 percent to equities. fte ultimate
allocation to stocks in this example falls inside the range and considers the most efficient level of equity
exposure given the target return or level of risk. ftis result is tantamount to determining the optimal
allocation mix under constrained optimization as opposed to unconstrained optimization, which is the
MVO solution.
Perhaps the most accepted adjustment to MVO is the Black-Litterman Model (Idzorek 2004). ftis
model addresses the input sensitivity assumption of the MVO model and changes the parameters to give a
view that is not solely based on historical data, but also on the investors’ views. fte Black-Litterman Model
overcomes the problem of high asset class concentration, input sensitivity, and estimation error associated
with the traditional MVO model. Bytaking the market weights on the asset classes into consideration and using
the CAPM, a reverse optimization calculation is performed to generate an expected return. Users of this model
have the ability to express their views on asset classes by adjusting the returns calculated to suggest an over- or
underperformance relative to the calculation. fte resulting asset allocation strategy produced is a
more diversified portfolio relative to MVO. Although the assumptions must continue to be held, the
sensitivity of the inputs is greatly reduced, resulting in a more stable portfolio.
Behavioral Biases in Asset Allocation

fte models and concepts discussed in the previous section fall under the category of traditional finance and
assume that investors are rational. ftat is, investors make every decision in the context of their overall portfolios
and goal of maximizing self-interests. Although some investors might be able to remove affective
(emotional) biases from their decision making, others allow feelings, emotions, and moods to influence
their investment decisions, often subconsciously. When investors make a decision based on an emotion,
they suffer from an emotional behavioral bias. Other factors beyond emotions limit human decision
making as well. Limitations in cognitive abilities and mechanical errors known as heuristics or mental
mistakes also create behavioral biases that prevent investors from allocating assets efficiently.
A common example of this flaw to which investors fall victim is the 1/N heuristic. ftis bias refers to
the tendency for investors to allocate assets evenly across the investment choices that are available to them. To
imagine this in practice, consider employees who have 10 investment options available in their 401(k) plan. In
an attempt to diversify, they may place 10 percent of their funds in each security. Although Huberman and
Jiang(2006) suggestthatthis type ofallocationis not oftenfollowedtothespecification in this example, the line
of thinking is not uncommon. Morrin, Inman, Broniarczyk, Nenkov, and Reuter (2012) take this notion a
step further and determined that a connection exists between the number of funds available to 401(k)
participants and the tendency to allocate evenly. When investors face a large number of products from which to
choose, they become overwhelmed by the decision and are more likely to simplify the process by allocating
the investment dollars in small (often not equal) percentages across a large number of funds. ftis outcome is
the result of a cognitive limitation.
Empirical evidence suggests that certain behavioral biases have a direct effect on aggregate asset pricing
and can lead to excessively over- or undervalued asset classes (Baker and Ricciardi 2014). In the extreme,
this collective behavior of investors can cause bubbles. Although researchers have identified many
cognitive and emotional biases, this section of the chapter focuses on five that play an important role in
the asset allocation decisions of investors. Familiarity, status quo, framing, mental accounting, and
overconfidence biases all prevent investors from operating rationally and forming efficient portfolios.
FAMILIARITY BIAS
fte familiarity bias occurs when investors place greater value, or expresses a preference for, holding securities
they understand or with which they have a connection (Baker and Ricciardi 2014). Investors who hold a
large percentage of their net worth in their employer’s stock exhibit this bias because they are confident they
know the company
better than other investors and believe the stock is perpetually undervalued. Benartzi (2001) investigates the
effects of past performance of company stock and the allocation of employee discretionary funds to company
stock in 401(k) plans. He suggests that there is a positive correlation between strong recent stock
performance and a greater allocation of employee 401(k) assets to company stock. ftis logic is also irrational
from a concentration perspective, because an investor’s total wealth, which includes labor income and
financial wealth, now represents an even larger portion of his or her portfolio. Familiarity is also expressed
through a preference for owning domestic stock over international stock, which is also called home asset
bias (Stammers 2011).
Portfolios that are over-allocated to a single security carry unnecessary additional company-specific or
nonsystematic risk. Enron is a tragic example of this flaw. By one estimate, Enron employees invested nearly
60 percent of their 401(k) assets in Enron stock. Enron’s bankruptcy amid a massive accounting scandal
subsequently wiped out this investment (Weinberg 2003). On a wider scale, familiarity with domestic securities
prevents an investor from reaping the benefits of a portfolio with international diversification. As Figure
20.1 shows, international stocks are historically less than perfectly correlated with the U.S. stock market.
120%
100%
80%
60%
40%
20%
0%
March 2011
March 2012
March 2013
March 2014
March 2015
December 2010
September 2011
December 2011
September 2012
December 2012
September 2013
December 2013
September 2014
December 2014
June 2011
June 2012
June 2013
June 2014
June 2015
–20%
–40%
–60%
Morningstar Diversified EM (Price)
S&P 500 TR USD (Price)
MSCI ACWI Ex USA NR USD (Price)
Figure 20.1 Performance of U.S., International, and Emerging Market Stock Indexes. ftis figure shows
the historical relationship of monthly returns for domestic
U.S. stocks (S&P 500 TR USD Price), developed international stocks (MSCI ACWI Ex USA NR USD
Price), and emerging markets (Morningstar Diversified EM Price)
from December 31, 2010 through August 31, 2015. Source: Bloomberg Terminal as of August 31, 2015.
Table 20.1 Correlation Matrix of U.S., International, and Emerging Market Stock
Indexes
Index S&P 500 TR MSCI ACWI Ex Morningstar

USD (Price) USA NR USD (Price)* Diversified EM (Price)
S&P 500 1.00
MSCI ACWI Ex US 0.86 1.00
Morningstar 0.73 0.90 1.00
Diversified EM
Note: ftis table shows that the greatest diversification benefits come from assets exhibiting a negative correlation. However,
including assets in a portfolio whose correlations are less than perfect (+1) also creates efficiencies in the risk and
reward profile.
*MSCI ACWI Ex USA NR USD (Price) return taken from Bloomberg.
Source: Authors’ calculations.
ftis type of relationship creates diversification opportunities and can improve a portfolio’s Sharpe
ratio by lowering the portfolio’s standard deviation. For example, Table 20.1 considers the correlation
matrix of the MSCI All Country World Index, the S&P 500 index, and the Morningstar Emerging
Markets Index.
Familiarity bias is not unique to individual investors. Using survey data from Merrill Lynch, Strong and
Xu (2003) studied fund manager sentiment in the United States, continental Europe, the United Kingdom,
and Japan. ftey found that relative to equity markets, fund managers view domestic prospects more
optimistically when compared to international counterparts. However, this result may not be a cognitive
error but, rather, a conscious business decision. Parwada (2008) points out the informational advantage
fund managers have when investing in domestic stocks versus international stocks. Choosing to hold a higher
percentage of local versus international equities reduces research expenses.
At a high level, familiarity with broad asset classes can be an impediment to forming an efficient portfolio.
Investors who have historically purchased equities but not fixed- income securities may be hesitant to invest in
bonds because they may not understand how bonds function or see the benefits of introducing a fixed-income
security to their stock portfolios. fte opposite could also occur for investors who have only invested in fixed
income and believe that stocks are too risky. In either case, the portfolio is unlikely to achieve the investor’s long-
term goals—certainly not as quickly or as safely as when using a proper asset allocation strategy.
STATUS QUO BIAS

Status quo bias affects investors who cannot build up enough momentum to change their asset
allocation, even when doing so is in their best interests, because they exhibit high levels of inertia or
procrastination. fte reason for their inability to change may stem from loss aversion, which is the
unwillingness to sell a position at a loss. A rational
investor judges an investment based on its expected future performance, not its recent history, and can sell
regardless of an investment’s cost basis. Investors often comment that a loss is only a “paper loss” until a
position is sold; this view is incorrect because a security is only worth its selling price at a given moment
plus the opportunity cost of funding the investment. ftus this line of thinking can result in the poor decision
of holding a security whose fundamentals suggest continued underperformance relative to the market.
fte low number of trades in retirement accounts suggests that this bias exists on a broad scale. For
example, Ricciardi (2012) reports that over a two-year period, about 80 percent of participants in his study
made very few or no trades. Agnew, Balduzzi, and Sunden (2003) investigated retirement accounts over a four-
year period from 1994 to 1998. ftey found that although trading activity varies depending on the characteristics
of the participants, in aggregate the study’s participants made fewer than one trade a year. To overcome the
status quo bias, investors should ask themselves: “If I held cash instead of the security in question, would I
buy it today?” ftis forces an analysis of expected return, rather than a view of the decline or appreciation in
value. Another way to overcome this bias is to adopt a rebalancing approach that requires making trades either
annually or after the portfolio has deviated from the target asset allocation strategy (Baker and Ricciardi
2014).
Besides there being a lower number of trades taking place within retirement accounts, many savers who are
automatically enrolled in company 401(k) plans make no initial change away from the default fund in which
they were placed at the outset. Madrian and Shea (2001) explored the status quo bias in this context and found
that the majority of 401(k) participants, who were enrolled automatically, maintain the default asset allo-
cation. Considering the default fund and the asset allocation are likely inappropriate for every participant,
this status quo bias causes an inefficient allocation of both pre- tax income and the assets within the plan.
Bilias, Georgarakos, and Haliassos (2010) find that in following large market downturns, participants do not
reduce their equity holdings, suggesting that acquiring new information is not resulting in asset allocation
adjustments owing to inertia.
FRAMING
Framing biases are common not only in asset allocation and behavioral finance but also in other aspects of
human decision making. Framing is the tendency to behave differently depending on how information is
presented (Barclays 2007). For example, consider presenting two portfolios, A and B, to an investor as
follows: portfolio A has a 75 percent chance of returning 10 percent and a 25 percent chance ofreturning 0 per-
cent, whereas portfolio B is expected to have a fixed return of 8 percent. An investor who chooses portfolio
A makes the decision to do so because he perceives the high probability of earning 10 percent as more
attractive than the lower 8 percent yield. Mathematically, portfolio B yielding 8 percent is more attractive
from a risk–reward standpoint. Steul (2006) recognizes this type of behavior and goes further to describe how
the type of distribution and the investor’s own understanding of risk influence the framing effect. fte
author concludes that the effects of framing are present under both positively correlated portfolios and
ambiguous risk. In other words, when the
dispersion of returns of the individual securities that make up a portfolio are correlated, and when risk is
ambiguous, framing is present.
Using a controlled experiment, Diacon and Hasseldine (2007) determined that the format used to present
past performance to investors alters their view of the investment’s potential risk and reward. Specifically,
observers prefer viewing the return of an equity fund when expressed in an “index of fund values” format
rather than a percent return format. Investors must not only be aware of the way projected future returns are
presented but also the way past returns are expressed.
Investors who want to buy a stock or bond for their portfolios must also be aware of the way the relevant
information about the security is presented. For example, before the issuance of an initial public offering
(IPO), investment bankers and the company’s management team go on a “road show” designed to generate
interest in the company by brokerage houses. fte investment bankers are likely to frame information about
the company in the best light possible. Consequently, analysts and future investors might want to consider
all available information, including filings to the Securities and Exchange Commission (SEC), and not
simply rely on information presented by the parties with possible conflicts of interest.
ftis bias can alter a portfolio’s asset allocation strategy by influencing investors to deviate from an
efficient blend of stocks, bonds, real estate, and cash to a mix that appears attractive based on the
presentation of the information. When investors receive a call from a financial advisor who describes a
great stock or bond trade, they should make the buy decision in the context of their existing asset allocation
strategy and not simply on the merits of the security alone. Investors should be aware of this flaw in
decision making and avoid basing their investment decisions on information that presents securities in a
positive light but neglects what may be their fundamental weaknesses.
MENTAL ACCOUNTING
Mental accounting refers to the cognitive organizational technique many investors employ by separating
their investments into different buckets, without considering the overall asset allocation. More broadly, mental
accounting can also be used in the context of a mental separation of personal finances and budgeting. For
example, evidence shows that mental accounting plays a role in personal budgeting, not only in a monetary
sense but also in terms of time and energy. For example, Heath and Soll (1996) discuss how individuals’
labeling of expenses (i.e., for business or a personal hobby) affects the value they place on the expenditures,
whether that value be money, time, or energy. Mental accounting affects a person’s view of his or her current
expenditures as it relates to monetary outlays. For instance, individuals have a tendency to separate expenses
used for immediate consumption from those to be used later (Shafir and ftaler 2006).
Mental accounting in the context of asset allocation can potentially have a negative impact on a portfolio.
For example, if an investor experiences an unrealized capital loss, but places too much importance on the
dividend received, then the portfolio may be inefficiently allocated (Baker and Ricciardi 2015). Similarly,
individuals who own real estate display mental accounting by not considering the real estate property as part
of their overall portfolio. For this reason, individuals are more likely to sell property valued
above its purchase price and less willing to sell when facing a loss (Seiler, Seiler, and Lane 2012).
In the context of asset allocation, mental accounting can cause investors to focus on the ratio of stocks
to bonds in an account-by-account basis, without considering their entire exposure in stocks versus bonds.
For example, an investor can structure his retirement account more aggressively with a 70 percent stock and
30 percent bond allocation, and a less risky nonqualified account with an asset allocation of 70 percent
bonds and 30 percent stocks. Although the investor may feel good about having the aggressive funds in the
retirement account and conservative funds in the taxable account, the reality is that the portfolio would have
the same level of risk and return potential if the investor had both accounts with a single 50/50 portfolio
(assuming equal dollar values of both accounts and ignoring taxes). Choi, Laibson, and Madrian (2009)
investigated this issue empirically by comparing the asset allocation strategies of 401(k) participants’ own
contributions and their employer contributions. ftey found that when employers control the investment of
their contributions, participants do not adjust their contributions (whose asset allocation is under their
control) to reflect the employer’s investment choices. ftis suggests that individuals do not incorporate the
allocation of all their accounts when selecting investments. Simply focusing on the asset allocation in each
account is inappropriate. Investors can overcome this bias by considering the asset allocation strategy
associated with the overall portfolio, and not on an account-by-account basis.
OVERCONFIDENCE
According to Parker (2013), overconfidence has two components: overconfidence in the quality of the
information received and overconfidence in one’s ability to act on that information. fte previously discussed
asset allocation models assume that rational investors create theoretically correct portfolios. Overconfident
portfolio managers and investors canrelytoo heavily onthese models, and this bias can cause overreliance on
the output the model produces. Relying too heavily on the inputs of these models is another source of
overconfidence bias that negatively weighs on a portfolio’s efficiency.
Overconfident investors can also have inefficient trading patterns, moving in and out of positions too
quickly in the belief that they can outperform the market. ftis excessive trading incurs heavy transaction costs
and potential taxable events, and can lower the portfolio’s overall return (Koesterich 2013). For example,
increases in trading activity are typical for individual investors following bull markets. fte recent positive past
performance of equities during a bull market cycle brings the individual investor’s attention to the
perceived opportunities that exist and leads to increases in trading activity (Chuang and Susmel 2011).
Certified Financial Planners (CFPs) also fall victim to overconfidence. Using survey data, Cordell,
Smith, and Terry (2011) compared the confidence levels of financial professionals who only earned the CFP
certificate with those held both the CFP and Chartered Financial Analyst (CFA) designations. ftey found that
those only having the CFP designation are more confident in their overall abilities to give investment advice
than are those with both designations. Individuals, arguably less skilled than either a
CFP certificate holder or a CFA charterholder, should take special note to approach investment decisions
humbly.
Investor confidence must be balanced with an understanding of the limits of a given model or an investor’s
cognitive abilities. fte latter is a much harder mental barrier for investors to overcome, but placing too much
weight ontheabilities of anyone decision maker often leads to costly mistakes.

To create a model that incorporates the risk and return characteristics of securities, as well as the correlations
between asset classes, Markowitz (1952) assumed that all investors are rational and emotionless. fte pricing
and asset allocation models that followed, including the CAPM and the Black-Litterman Model, also
generate outputs that are theoretically sound according to Markowitz’s world.
Behavioral finance attempts to incorporate human nature into capital market pricing and portfolio-level
allocation decisions. Behavioral biases represent the emotional and cognitive errors that are so common in
decision makers. Investors should take steps to identify and correct these often subconscious biases to avoid
misallocating their capital. For instance, familiarity bias can directly lead to under-diversification. Status quo
bias, which is a common problem with investors saving for retirement, can lead to an unusu- ally lowturnoverin
an investor’s accounts. As a result, investors often fail to rebalance their portfolios. Framing can generate
inefficient allocation of assets owing to this cognitive constraint. Mental accounting can be beneficial to
investors who use it as a tool to keep funds organized; however, this bias can hurt investors who make asset
allocation decisions on a “bucket-to-bucket” basis and do not consider the asset allocation of their entire
portfolio. Finally, overconfidence has the potential to impact an investor’s portfolio with negative side effects
of placing too much faith in both historical data and the ability to make sound decisions with this data.
Overconfident investors can rely too heavily on models that use traditional finance assumptions and trade too
often, believing they can outperform the market.
fte five behavioral biases reviewed in this chapter serve as an example of some of the most common
errors in decision making. Although avoiding these mistakes on a subconscious level might be difficult,
investors should make an effort to identify them and understand the effects they have on their overall asset
allocation policy or trading behavior.
1. Define tactical asset allocation (TAA) and discuss the advantages and disadvantages relative to strategic
asset allocation (SAA).
2. Discuss the assumptions used in modern portfolio theory (MPT) and traditional finance models.
3. Discuss the shortfalls of mean-variance optimization (MVO) portfolios and how the Black-
Litterman Model attempts to address these shortfalls.
4. Distinguish between cognitive and emotional errors, and provide an example of each.
5. Discuss the advantages and disadvantages to mental accounting and how investors can manage this
cognitive error.
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21
Behavioral Aspects
of Portfolio Investments
NA T H A N MA UCK
Assistant Professor
University of Missouri – Kansas City
Introduction
Traditional finance theory suggests that individuals entrust their investments to financial institutions in an
effort to increase expected returns and/or to reduce risk. Although many individuals manage all or part of their
wealth independently, they must still work with existing financial products. Furthermore, many individuals
use the services of professional money managers. Indeed, the sheer volume of assets under management
(AUM) by financial institutions signals their importance. According to the Organization of Economic
Cooperation and Development (OECD 2014), mutual funds represent the largest such of this investment
group as of 2014, with roughly $30 trillion in AUM. Other important institutional investors and money-
management products by size include exchange-traded funds (ETFs), hedge funds, and pension funds, with
an estimated $2.3 trillion, $2.5 trillion, and $20 trillion of AUM, respectively.
fte relative importance of these institutions in the market has increased tremen- dously over time.
Blume and Keim (2012) show that the proportion of U.S. publicly traded equity held by institutions
increased from around 8 percent in 1950 to nearly 67 percent in 2010. On average, then, institutional
investors should be more sophisticated, skilled, and rational than retail investors. In fact, although many
reasons exist for the growth in absolute size and relative importance of institutional investors, one
perceived benefit is professional asset management skills.
However, non-wealth-maximizing or irrational institutional investor behavior could explain outcomes that
do not matchtheseinstitutions’perceivedrational superiority.fte first suchdisconnect—thatbetweenthe perceived
benefits of institutions and reality—is the underperformance on average of those institutional investors. A potential
driving force behind this underperformance may be behavioral biases of institutional investors. In short, an a priori
expectation is that institutional investors are rational and wealth-maximizing investors, but this assumption may
be incorrect. In truth, professional money managers demonstrate such biases as overconfidence, optimism,
familiarity, home bias, herding, limited attention, disposition effect, and escalation of commitment, among
others.
378
Behavioral Aspects of Portfolio Investments 379
fte second disconnect—that between investor expectations of institutions and reality—is related to
the rationality, or lack thereof, of those individuals who are selecting the institutions. Specifically, regardless
of the rationality of institutional investors, retail investors are likely to exhibit the usual biases whether they are
selecting individual assets or products from institutions such as mutual funds and hedge funds. For instance,
research has shown that retail investors chase the mutual funds and hedge funds with the highest returns. Yet,
doing so appears suboptimal, based on the observation that fund returns are largely unpredictable. ftis trend-
chasing may be attributed to behaviors such as a representative bias, which holds that investors over-
weight recent experience when forming their expectations of future outcomes, leading them to chase high
returns by seeking out recent high performers. Additional individual investor biases are documented in the
context of specific money managers and their products, discussed in this chapter.
fte rationales for forming mutual funds, ETFs, hedge funds, and pension funds differ, as do their
respective levels of regulatory oversight. Such differences in products warrant a close examination of each
type. fterefore, the purpose of this chapter is to explore the financial behavior of each of these important
classifications of investments. For each type of money manager and/or product, the chapter presents evidence
of the rationality of both its investor group and the retail investors who demand that service. Collectively, the
evidence suggests that actual performance and practices of these investment instruments and their managers do
not match the traditional finance expectations of wealth maximization and rational participation.
fte first section of this chapter describes mutual fund size, performance, and rationality, followed by a
discussion of the emergence of ETFs and evidence of their ability to enhance market efficiency. ften there is a
section on the performance and investor biases for hedge funds, and a subsequent section on evaluating
pension fund performance and the potential behavioral biases of pension fund managers. fte chapter ends
with a summary and conclusions.
Mutual Funds
fte amount of AUM in mutual funds is impressive. According to the Investment Company Institute
(ICI 2015), mutual funds control $16 trillion in U.S. assets alone as of year-end 2014. Table 21.1 displays the
annual inflow/outflow of cash for U.S. mutual funds between 2000 and 2014, based on data from ICI. fte
average annual inflow is
$196 billion, even with the net outflow period associated with the financial crisis that persisted between 2009
and 2011. Investor demand and the desire of investors to meet financial objectives, including return
maximization and risk management, are driving forces underlying the huge size of mutual funds. According
to ICI, roughly half of all mutual fund allocations are to publicly traded equity, with bond funds and money
market funds making up about 40 percent of allocations.
Roughly 89 percent of mutual fund assets come from households. Based on the sources of mutual
fund assets and the objectives of investors in mutual funds, the primary question of interest is whether the
expectations of these households are being met.
Table 21.1 Annual Cash Flows in U.S. Mutual Funds, Based on ICI Data
Year Net New Cash Inflow (Outflow) in $Billions

2000 388
2001 504
2002 75
2003 –48
2004 53
2005 254
2006 472
2007 879
2008 412
2009 –150
2010 –281
2011 –96
2012 198
2013 175
2014 102
Note: ftis table presents the yearly net new cash inflow or outflow of U.S. mutual funds between 2000 and2014.
Source: ICI (2015).
ACTIVE VERSUS PASSIVE

One useful distinction to make in evaluating mutual fund performance is between active and passive
management. Although overall AUM remains much larger for actively managed funds, passive funds such as
index funds have increased in popularity. In particular, ICI data indicate that index funds account for roughly
$2.1 trillion of the $16 trillion in U.S. mutual fund assets. Of particular note is that index funds added
nearly $150 billion in 2014, compared to an overall inflow of only $100 billion for the industry overall in
2014. ftus, a net outflow of AUM in actively managed funds occurred in 2014, which was offset by an
inflow into passively managed index funds. Table 21.2 displays the annual cash inflows into U.S. index
mutual funds between 2000 and 2014. fte relative increase in importance of index mutual funds is consistent
with investors’ becoming more interested in passively tracking the market versus attempting to pick money
managers who beat the market.
Table 21.2 Annual Cash Flows in U.S. Index Mutual Funds, Based on ICI Data
Year Net New Cash Inflow (Outflow) in $Billions

2000 26
2001 27
2002 25
2003 35
2004 40
2005 28
2006 33
2007 61
2008 35
2009 56
2010 58
2011 55
2012 59
2013 114
2014 148
Note: ftis table presents the yearly net new cash inflow or outflow in U.S. index mutual funds between 2000 and
2014.
Source: ICI (2015).
MUTUAL FUND PERFORMANCE

Much research is available on the performance of actively managed mutual funds, and this research
typically documents underperformance. In a seminal study, Jensen (1968) examines 115 mutual funds and
found that they were unable, on average, to outperform the market. In a particularly startling result, Jensen
finds that mutual funds cannot recover their expenses. ftus, investors generally pay fees only to achieve lower
performance than passively holding the market. More recent research, including Gruber (1996), French (2008),
and Fama and French (2010) also documents the negative after-fee alphas for actively managed U.S.
equity mutual funds. Alpha refers to risk- adjust returns (i.e., return not explained by risk).
Considerable debate surrounds the rationality of retail investor demand for actively managed mutual
funds, which ultimately fail to outperform the market on a risk- and fee-adjusted basis. Investor demand is
even more difficult to explain, considering the relatively large compensation and fees that accrue to financial
intermediaries.
CHASING RETURNS
fte literature is divided on whether it is rational for investors to pay mutual fund managers who fail to
generate alpha. Yet, Gruber (1996) finds that investors chase performance, and that performance is
partially predictable. ftese findings suggest that investors may be more rational than the initial evidence on
mutual fund performance and return-chasing in particular would indicate. Similarly, Berk and Green (2004)
developed a model showing that the observed characteristics of the mutual fund industry are mostly consistent
with a rational and competitive market. A key insight gained from the model is that competition in the mutual
fund industry is responsible for the failure of active fund managers to beat the market. In short, their model
suggests that mutual fund managers have different levels of ability. Investors chase performance, and their
influx of money ensures that future returns of successful managers will be competitive. ftus, investors
cannot predict which managers will havethe greatest skill.
Fama and French (2010) suggest that their empirical evidence contradicts the Berk and Green model.
Specifically, they found that gross fund returns are zero, and that negative alpha is equal to the fees of the
fund. ftus, investors do not earn zero alphas by investing in actively managed funds but, rather, earn
negative alpha on average. Nonetheless, some interpret Fama and French as supportive of Berk and Green.
BEHAVIORAL ISSUES
Some researchers suggest that the underperformance of mutual funds may be due to behavioral biases and
irrational investment choices on the part of fund managers. One of the first behavioral biases linked to mutual
fund managers is herding (Wermers 1999), which is the tendency to follow others when trading. Herding
could be rational if following others led to generating alpha, but the literature indicates that this is not the case.
Another behavioral bias related to mutual fund performance is the familiarity bias, which also manifests itself
in mutual funds through the home bias, or the tendency to invest in assets that are geographically close to fund
headquarters (Baker and Nofsinger 2002).
L IMITED ATTENTION AND D ISP OSIT ION EFFECT

Fang, Peress, and Zheng (2014) examined two behavioral explanations for mutual fund investment
selection and performance, focusing on the role of media in mutual fund stock selection. fteir first
hypothesis relates to limited attention. As developed in Kahneman (1973), limited attention is a bias related
to the observation that individuals’ time is scarce and that this lack of unlimited attention may lead to certain
biases. In the context of mutual fund managers, investors are more likely to notice and potentially select
stocks that receive media coverage, regardless of whether doing so is wealth maximizing. Media attention may
explain fund underperformance, given that the motivation for stock selection is not based on skill or
superior information.
Similarly, fund managers may be less prone to the behavioral bias of limited attention and may instead
exploit this bias among individual investors. In short, mutual fund managers would still trade in high media-
coverage stocks, but their superior skill and ability to identify the mispricing caused by biased individual
investors would result in
superior performance. fte results of Fang et al. are consistent with mutual fund managers’ suffering from the
same limited attention biases as do individual investors rather than with exploiting mispricing owing to
retail investors’ biases.
Othersexaminethedispositioneffect, whichisrelatedtoprospecttheory(Kahneman and Tversky 1979) in
the context of mutual fund underperformance. fte disposition effect is the tendency to gamble more with
losses than with profits. Hence, investors tend to sell winners and hold losers. Lin, Fan, and Chi (2014) study the
disposition effect in mutual fund managers and find that it negatively affects the performance of the funds. fte
observed escalation of commitment is related to self-attribution, optimism, and cognitive dissonance.
Self-attribution suggests that individuals assign success to their skill and failure to bad luck. Optimism is
related to individuals who are biased in their forecasts and overestimate their potential outcomes. Cognitive
dissonance is the state of having inconsistent thoughts, beliefs, or attitudes, especially as relating to
behavioral decisions and attitude changes. Collectively, this bias may lead to an escalation of commitment
whereby a fund manager may stick to a losing investment strategy and thus could exacerbate
underperformance. fte survey evidence presented in Goetzmann and Peles (1997) is consistent with cognitive
dissonance, as the authors find a positive bias involving mutual fund investors’ memory of past
returns.
BEHAVIORAL BIASES IN SELECTING MUTUAL FUNDS

Mutual funds tend to underperform on average, and some portion of the underperformance could result from
behavioral biases. ftis observation leads to the second major theme of this chapter, which is the behavioral
biases of individuals who select such funds. In particular, why it is that investors demand costly financial
instruments that fail to beat passive strategies is a puzzle that has been addressed by the literature. Much early work
in behavioral finance and individual investor biases has focused on stock picking rather mutual fund
selection; however, two early results from the behavioral literature and mutual funds stand out. First, investors
choose funds with high fees despite exacerbating underperformance (Gruber 1996; Barber, Odean, and
Zheng 2005). Second, investors chase past performance when selecting mutual funds (Sirri and Tufano 1998;
Bergstresser and Poterba 2002; Sapp and Tiwari 2004). As noted previously, Gruber (1996) documents this
pattern, but interprets the relation as relatively rational, given that he finds mutual fund performance to be
partially predictable. Subsequent literature, however, does not typically concur with the predictability
conclusion. fte behavioral literature instead suggests that return chasing in this context is irrational and the
result of agency problems (Chevalier and Ellison 1997). Overall, this finding suggests that investors continue
to demand actively managed mutual funds partly because they observe some funds outperforming passive
strategies and they believe they can earn similar superior returns in the future by “chasing” these
funds.
Bailey, Kumar, and Ng (2011) provide one of the few behavioral studies linking individual
characteristics to mutual fund selection. ftey examined a wide range of the behavioral biases found in
individual stock selection in the context of mutual fund selection, using thousands of brokerage accounts for
U.S. retail investors. In particular, the authors focused on the disposition effect. Bailey et al. created a
disposition effect proxy based on individual investors’ actual realization of gains and losses. ftey also
examined
the role of narrow framing in mutual fund investing. Narrow framing is the tendency to focus on individual
investments without considering the portfolio more generally. ftis tendency is measured by identifying
investors with less clustered trades, which are more likely to suffer from framing. Another behavioral bias
considered is overconfidence, which manifests itself in this case as the tendency to trade too frequently, but
unsuccessfully. fte authors proxied this bias using portfolio turnover and a dummy gender variable.
Familiarity was measured by local bias, which was the distance between the investor’s home and the fund’s
headquarters. fte investor gambling preference was examined by identifying lottery stocks, which are low-
priced stocks with both high idiosyncratic volatility and idiosyncratic skewness (based on Kumar 2009).
Finally, they examined investor inattention to earnings news and macroeconomic news.
Bailey et al. (2011) find that behavioral factors are related to selecting investments. In particular, investors
who exhibit biases tend to choose high-fee funds and avoid low- fee index funds. Mutual fund investors also
trade more frequently and are more likely to chase trends. Given that this investment type exhibits particularly
poor investment returns, the evidence is inconsistent with that indicating investors chase returns based on
rational criteria. In short, behavioral biases of the individuals could explain the puzzling demand for
underperforming active mutual funds.
Another possible explanation for the return-chasing observed in the retail investor selection of
mutual funds is the hot-hand fallacy (Kahneman and Riepe 1998). Gilovich, Vallone, and Tversky
(1985) examine the hot-hand fallacy in the context of basketball. ftey note that both basketball fans and
players believe that players have periods in which they are particularly “hot,” meaning their performance
positively deviates from their long-term average performance. fte authors conclude that this belief is an
illusion, because the number of actual deviations from long-term averages is within the bounds of what should
be expected based purely on chance. In the context of mutual fund selection, then, the hot-hand fallacy refers
to investors’ observing a “hot” streak by a given fund that has recently had strong performance and incorrectly
inferring that the fund will continue to outperform in subsequent periods.
INDEX MUTUAL FUNDS

Although the popularity of actively managed funds despite their underperformance seems irrational, the
index fund market presents another puzzle. Despite the fact that index mutual funds for a given asset should
all have similar future returns (subject to tracking error), the fees of such funds vary widely. Tracking error
is a measure of how closely a portfolio follows the index to which it is benchmarked. ftis observation
appears to violate the law of one price (LOP), which states that identical goods should have identical prices.
Choi, Laibson, and Madrian (2010) find that S&P index funds in the CRSP mutual fund database have fees
ranging from 0 percent to 5.75 percent. As Elton, Gruber, and Busse (2004) show, high-fee passive funds still
generate largefund inflows.
Although investors hold large positions in high-fee funds in general (Gruber 1996; Barber et al. 2005), the
result is particularly striking in index funds. fte literature has identified potential explanations that are
generally behavioral, including financial literacy (Elton et al. 2004; Choi et al. 2010), return chasing
(Sirri and Tufano 1998;
Sapp and Tiwari 2004; Choi et al. 2010; Bailey et al. 2011), search costs (Hortacsu and Syverson 2004), and
marketing (Khorana and Servaes 2012).
Mauck and Salzsieder (2015) provide experimental evidence suggesting that the diversification bias
could be partially responsible for investor selection of high-fee index funds. According to the diversification
bias, which is based on Simonson (1990), people tend to diversify when making simultaneous choices.
Read and Loewenstein (1995) coined the term diversification bias to describe this behavior, which others call
the diversification heuristic. ftaler (1999) contends that though diversification may be rational, it is not
necessarily utility maximizing.
An experiment conducted by Mauck and Salzsieder (2015) asks subjects to allocate a hypothetical
portfolio among four different S&P 500 index mutual funds with fees and returns. fte authors changed the
fees and historical returns in various conditions. fte results indicate that investors chase past returns that
differ only due to reporting “since inception” returns, which do not correspond to the same time period for all
funds and do not predict future differences in returns. However, even when holding historical returns
constant for all four funds, investors do not focus their investments on the lowest-fee funds and instead
diversify their holdings, even though doing so is suboptimal. In short, even in the absence of return-chasing,
individuals do not minimize fees.
A possible explanation of the demand for money management services that fail to beat a passive strategy
is that individuals are not solely interested in wealth maximization. As Gennaioli, Shleifer, and Vishny
(2015, p. 92) note, “We … propose an alternative view of money management that is based on the idea that
investors do not know much about finance, are too nervous or anxious to make risky investments on their
own, and hence hire money managers and advisors to help them invest.” In short, neither retail nor
institutional investors are solely concerned with returns when selecting money managers (Lakonishok,
Shleifer, and Vishny 1992).
Gennaioli, Shleifer, and Vishny (2015) use the analogy of medical doctors: patients need guidance on their
treatment, and investors need guidance on their investments. Trust is an important component when selecting
both doctors and financial advisors. As trust increases, the advisor can charge higher fees. Higher trust is
likely required in higher-risk investments. According to this model, advisors are incentivized to cater to
investors, leading money managers to adopt the biases of their clients. For example, fund managers had a
strong incentive to reallocate to high-technology stocks during the late 1990s, despite the appearance of
overvaluation resulting from the returns- chasing biases of their customers. ftus, the emotional and
psychological needs and wants of individuals may partly explain the puzzling demand for both active and
passive mutual funds.
Exchange-Traded Funds
Many exchange-traded funds (ETFs) are similar to index mutual funds, in that they are designed to track an
underlying index or benchmark, and to provide a relatively low-fee product for investors. Most ETFs are similar
to open-end funds, and many track indices such as the S&P 500. However, ETFs also allow exposure to
commodities, currencies, and various strategy-based investments. ETFs differ from index funds in that
investors
Table 21.3 Annual Cash Flows and Total Assets of ETFs, Based on ICI Data
Year Net New Cash Inflow Total Assets in $Billions

(Outflow) in $Billions
2003 N/A 151
2004 75 226
2005 70 296
2006 112 408
2007 172 580
2008 –84 496
2009 207 703
2010 188 891
2011 48 939
2012 278 1,217
2013 394 1,611
2014 307 1,918
Note: ftis table presents the yearly net new cash inflow or outflow and total assets in ETFsbetween 2000 and2014.
Source: ICI (2015).
can trade them directly on an exchange. Table 21.3 presents the annual cash flows into ETFs, as well as the
overall size of ETFs between 2003 and 2014, based on data from the ICI (2015). fte table indicates an average
annual cash inflow to ETFs of $161 billion for the period, with nearly $2 trillion in total assets by the end of
2014. fte annual average cash flow growth for E TFs compares similarly to mutual funds’ average cash flow
growth of $164 billion over the same period. Given that only $17 billion of the nearly
$2 trillion in ETFs is actively managed, ETFs generally follow passive strategies, as suggested by
proponents of market efficiency.
According to the literature, the introduction of ETFs is generally efficiency enhancing. For example,
Kurov and Lasser (2002) have documented improved futures pricing efficiency in terms of both the size and
the frequency of violations in price boundaries. Some view this relation as resulting from increased
arbitrage trading (Hegde and McDermott 2004), and another possible explanation for the improved efficiency
is the improved liquidity of the underlying stocks (Madura and Richie 2007). ftese results indicate that
ETFs may be generally efficiency increasing. ftis conclusion is consistent with Gleason, Mathur, and Peterson
(2004), who do not find evidence of investor herding in the ETF market. ftis result stands in contrast to the
herding behavior that has been observed among institutional investors.
INVESTOR SENTIMENT
Although evidence shows that introducing ETFs has improved market efficiency, the literature also
documents the presence of behavioral bias in ETF markets. In particular, investor sentiment has received
much attention. Investor sentiment is the tendency of investors to have changes in risk tolerance or to
become either optimistic or pessimistic with respect to future projections. Baker and Wurgler (2006,
2007) find that investor sentiment is related to future stock returns. Sentiment also appears to affect both
individual and institutional investors (Edelen, Marcus, and Tehranian 2010). Chau, Deesomsak, and Lau
(2011) study three large U.S. ETFs: the S&P 500 SPDR, the Dow Jones Industrial Average ETF
“Diamond,” and the Nasdaq-100 ETF “Cubes.” fteir results indicate that investor sentiment has a strong role in
feedback trading (i.e., momentum) in ETFs. Furthermore, they found that this relation is stronger during bull
markets than during bear markets.
OTHER BEHAVIORAL ISSUES

As Madura and Richie (2004) note, ETFs should be efficiency enhancing because they provide liquidity
and opportunities to arbitrage away any mispricing. However, the tradability of ETFs may result in ETF price
movements that are unrelated to price movements of the underlying assets. Consistent with this latter
observation, Madura and Richie find that ETF prices overreact, and thus create inefficiency and opportuni-
ties for feedback traders.
Padungsaksawasdi and Daigler (2014) examine the return–volatility relation in the context of ETFs.
fteir study highlights an advantages of ETFs—namely, direct investability in both equity and
commodity markets. Additionally, ETFs allow for a different perspective on existing behavioral
theories. fte authors relate representativeness, affect, and the extrapolation bias to the return–volatility
relation. For instance, if investors with a representative bias observe a recent downward price
movement, they may incorrectly believe the market is ready to decline. ftis conclusion may result in
buying out-of-the-money put options as a hedge against price drops regardless of the cost of such puts,
which would in turn create a higher VIX value. VIX is the ticker symbol for the Chicago Board
Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility.
It is constructed using the implied volatilities of a wide range of S&P 500 index options. Similarly,
affect created by the success or failure of a past trade could influence future investor decisions. If investors
fear downward movements in the market, they may buy put options. A subsequent increase in the VIX,
then, creates a negative return– volatility relation.
Finally, extrapolation bias describes a tendency of investors to treat past events as predictors of
future events. ftus, when prices drop, these investors buy puts, which will bid up the price of insuring
against downside risk. fte empirical evidence indicates that these behavioral explanations best fit the
negative return–volatility relation in commodity ETFs.
OVERALL ETF EFFICIENCY

Collectively, the evidence indicates that ETFs are generally efficiency enhancing. fte prices of ETFs are
subject to the behavioral biases of the investors selecting the ETFs, but compared to other investment types
considered in this chapter, ETFs appear to be relatively efficient. Coupled with relatively lower fees and
typically passive strategies, ETFs have increased in popularity. Given the relatively shorter period for the data,
how longer-term performance of ETFs will manifest itself is unclear. Yet, early evidence indicates that ETFs
are likely to continue to be an important investment option.
Hedge Funds
Hedge funds share some features with mutual funds, in that they invest in portfolios of assets and have discretion
in selecting those assets. A major difference between the two fund types is that neither the Securities and
Exchange Commission (SEC) nor any similar regulatory institution generally regulates hedge funds. As a
result, the range of possible assets and strategies available to hedge fund managers is greater than that for mutual
fund managers. Given the unregulated nature of hedge funds, data on such investments are more difficult to
identify than for mutual funds. However, current estimates place the size of global hedge fund holdings at
around $2.5 trillion (OECD 2014).
MISVALUATIONS
Although institutional investors potentially improve market efficiency, perhaps no group is more
ascribed this ability than hedge funds. Given that hedge funds have a wider range of assets and strategies at
their disposal, this circumstance should allow them to take advantage of any mispricing.
As Ritter (2004) notes, two general forms of misvaluation exist. One form is recurrent and can be
arbitraged, whereas the other does not repeat and is longer term in nature. Hedge funds are often viewed as
arbitrageurs. Regarding recurrent misvaluations, Ritter (2004, p. 433) comments that “Because of this,
hedge funds and others zero in on these, and keep them from ever getting too big. ftus, the market is pretty
efficient for these assets, at least on a relative basis.” Similarly, Brunnermeir and Nagel (2004, p. 2014) state that
“Hedge funds are among the most sophisticated investors— probably closer to the ideal of ‘rational
arbitrageurs’ than any other class of investors.”
Hedge funds can better exploit potential market inefficiencies than mutual funds owing to differences in
the constraints faced by the funds. According to Fung and Hsieh (1997), mutual funds often face constraints
on the number of assets, types of asset classes, use of leverage, and other strategies such as short selling. fte
authors further note that hedge funds differ from mutual funds with respect to these constraints; hedge funds
can use more dynamic strategies with relatively fewer limitations.
One view of the hedge fund’s role in correcting mispricing is that it trades against mispricing. Consistent
with this view, Kokkonen and Suominen (2015) find that hedge fund trading at least partially corrects market-
wide mispricing. Yet, Brunnermeir and Nagel (2004) find that hedge funds followed the technology bubble
rather thantraded
against it. Further, they find that hedge funds anticipated the eventual decline in technology stock prices and
sold them accordingly. Overall, hedge funds were able to detect a bubble, presumably owing to investor
sentiment rather than to rational forces, and they profited from this knowledge.
INVESTMENT PERFORMANCE
fte research has documented that, similar to mutual funds, hedge funds typically underperform their
benchmarks, or at least fail to generate positive alpha (Malkiel and Saha 2005). Hedge funds often fail to beat
the market, but some evidence indicates that they outperform mutual funds (Ackermann, McEnally, and
Ravenscraft 1999), although the difference may not be statistically significant (Griffin and Xu 2009). In fact,
hedge funds that outperform benchmarks cannot generally repeat the effort (Brown, Goetzmann, and
Ibbotson 1999). Yet, Fung, Hsieh, Naik, and Ramadorai (2008) find that hedge funds that generate alpha
are more likely to survive than those that do not.
fte actual returns realized by hedge fund investors are lower than those reported in raw hedge fund returns,
owing to fees. After considering the fees, Dichev and Yu (2011) find that actual returns for hedge fund investors
are between 3 and 7 percent lower than for a simple buy-and-hold benchmark. Early hedge fund fees
typically followed the “2 and 20” structure, whereby investors pay a 2 percent fee for assets managed and a
20 percent fee on returns. French (2008) find that annual hedge fund fees from 1996 to 2007 averaged 4.26
percent of assets. Based on this high fee structure, hedge funds must generate significant annual abnormal
returns to match a passively held portfolio. Furthermore, Garbaravicius and Dierick (2005) find that
correlations between hedge funds and markets have increased, which Stulz (2007) partly relates to an
observation that some hedge funds havebecome de facto mutual funds with higher fees.
In short, as with mutual funds, the continued and increasing popularity of hedge funds appears to
challenge a rational view of investors who are seeking to maximize their wealth. ftus, why investors
continue to invest in hedge funds despite their high fees and typical inability to beat the market is
puzzling.
According to Agarwal and Naik (2004), hedge funds may provide investors with different risk exposures
than do mutual funds, despite their investing in similar assets. fte difference in risk is due to hedge funds’ taking
both long and short positions and sometimes using shorter investment horizons. ftus, investors may
demand hedge funds owing to their individual risk preferences.
BEHAVIORAL ISSUES
Besides rational risk-based explanations, the literature contains behavioral explanations for the investor demand
for hedge funds and their relatively high fees. As noted in the mutual funds section of this chapter, Gennaioli et
al. (2015) develop a theoretical model that focused on trust as a determinant in the financial consumer’s
selection of funds. In particular, their study showed that investors are concerned with both wealth maximiza-
tion and the anxiety that results from making risky decisions about a topic for which they lack
understanding. ftus, investors are willing to pay fees for professional money management even when doing
so results in underperformance. However, the role of
trust is even more pronounced in higher-risk investments. In these cases of higher trust, fees are also expected to
be higher, and this seems to explain the perplexing demand for hedge funds. In particular, hedge funds have both
relatively high fees and high risk, yet they underperform passive strategies, particularly on an after-fee basis.
fte features of a hedge fund, particularly its high risk, mean that a relatively high degree of trust in the money
manager is prerequisite for investing in that hedge fund.
Collectively, the evidence indicates that hedge funds may be efficiency enhancing, although this function
does not serve to generate positive fee-adjusted alpha for hedge fund investors. Hedge funds differ from mutual
funds mainly in the assets and strategies available to them, although some hedge funds are becoming de facto
mutual funds with hedge fund fees.
Pension Funds
Employers typically establish pension funds for the purpose of investing employee retirement funds.
Pension funds are the second largest group examined in this chapter, with current assets of around $20
trillion. Pension funds share characteristics with some sovereign wealth funds (SWFs) (Dewenter, Han, and
Malatesta 2010). SWFs are government-owned investment vehicles often charged with the preservation of
national wealth. However, this chapter excludes SWF research, which generally indicates that SWFs differ in
both determinants and performance relative to other institutions (Kotter and Lel 2011; Knill, Lee, and Mauck
2012a, 2012b; Johan, Knill, and Mauck 2013; Bortolotti, Fotak, and Megginson 2015). Although the choice
of omission is subjective, the implication is not trivial, because SWFs control an estimated additional $7
trillion (Bortolotti et al.).
Pension funds may invest in all the other investor groups covered in this chapter— namely, mutual funds,
ETFs, and hedge funds. For instance, Agarwal and Naik (2004) note that pension funds such as CALPERS and
Ontario Teachers have historically held both mutual funds and hedge funds in their portfolios. ftis allocation
may be related to a desire for exposure to various risk premia. However, CALPERS discontinued its hedge
fund program in 2014 (Aitken 2015). According to CALPERS’s interim chief investment officer, hedge
funds are no longer a viable option because of their complexity, cost structure, and inability to scale to
size.
According to the OECD (2015), pension funds have 51.3 percent, 23.8 percent, and
9.6 percent of their assets in bills/bond, equities, and cash, respectively. fte report also notes a shift to
nontraditional investments beginning around 2012 in a search for greater yield, including hedge funds,
private equity, and derivatives.
WINDOW DRESSING
As Lakonishok, Shleifer, ftaler, and Vishny (1991) note, some pension funds manage their investments
in-house, but others use outside money managers. Regardless of which method is chosen, they note that
pension fund managers face important annual performance reporting. fteir evidence indicates that pension
funds engage in “window dressing” by selling losers before the end of the year, so they are not forced to explain
the inclusion of “loser” stocks in the portfolio. ftis end-of-the-year selling is not based on rational criteria but,
rather, on the desire to avoid scrutiny. Lakonishok et al. (1992) find that outside managers who invest pension
fund assets do not exhibit signs of herding, feedback trading, or passive trading. ftey conclude that such
managers are “neither the stabilizing nor the destabilizing image” that is sometimes portrayed for such funds.
INVESTMENT PERFORMANCE
Andonov, Bauer, and Cremers (2012) study overall pension fund performance, including those with equity, fixed
income, and alternatives. Importantly, unlike many prior studies that focus on the performance of outside
managers, their sample included both internal and external managers. ftey note that pension funds have different
motives from mutual funds—motives that could affect investment behavior. In particular, the mutual fund
manager’s pay is a function of the assets managed, which could in turn be strongly related to relative performance. In
contrast, pension funds view actuarial factors as influencing fund inflows. fte lack of incentive for short-term
performance should lead to an ability to pursue less liquid investments relative to mutual funds. Yet, Andonov
et al. note that the a priori relation between greater liquidity and subsequent return is unclear. Overall, they found
that pension funds outperform the market, with positive abnormal returns of 89 basis points a year. ftis result is
partly driven by the relatively greater exposure to alternatives, which are correspondingly associated with
higher returns.
FEES AND PERFORMANCE

Bauer, Cremers, and Frehen (2010) document that pension funds achieve significantly lower cost levels than
mutual fund fees. In particular, they estimate that pension fund fees are around 27 to 51 basis points a year,
whereas mutual fund fees are roughly around 150 basis points a year, on average. Furthermore, pension funds
outperform mutual funds despite not generating a positive alpha. fteir analysis indicates that smaller pen-
sion funds, especially those with small-cap mandates, can beat their benchmarks.
RISK EXPOSURE
Andonov, Bauer, and Cremers (2015) compare U.S. public pension funds to private and public pension
funds in the United States, Canada, and Europe. In particular, they noted that U.S. public pension funds can
understate their liabilities by taking on riskier asset allocations. fteir evidence shows that funds taking on
greater risk for these purposes underperform other pension funds, which is mostly due to lower returns on the
riskiest assets, specifically equities and alternatives. fte authors conclude that the regulatory environment
provides incentives for pension funds to act counter to the best practices recommended by financial
theory.
PENSION FUND ACTIVISM

Another much discussed feature of pension funds is their tendency to be activist investors. Wahal
(1996) examines firms targeted by shareholder activism on the part
of the following pension funds between 1987 and 1993: California Public Employee Retirement System,
California State Teachers Retirement System, Colorado Public Employee Retirement System, New York
City Pension System, Pennsylvania Public School Employee Retirement System, State of Wisconsin
Investment Board, College Retirement Equities Fund, Florida State Board of Administration, and New York
State Common Retirement System. fte results indicate that these pension funds are relatively successful
at having their proposals adopted. However, the adoption of pension fund proposals is not associated with
improved firm performance as measured by either the market response or long-term performance. Del Guercio
and Hawkins (1999) find no evidence that pension funds are motivated by anything other than fund value
maximization. An, Huang, and Zhang (2013) examine corporate sponsors of defined benefit pension plans.
ftey note that such funds take on relatively low (or high) risk when they have low (or high) funding ratios
and high (orlow) default risk.
BEHAVIORAL BIASES
Overall, the literature documents some differences between pension funds and other classes of money
managers. Collectively, the evidence suggests that pension funds generally underperform passive
benchmarks, which is consistent with evidence on mutual funds and hedge funds. However, the literature also
has explored potential sources of pension fund underperformance specific to pension fund managers. For
example, Gort, Wang, and Siegrist (2008) find that Swiss pension fund managers are overconfident. In
particular, the pension fund managers provided too narrow confidence intervals when asked to do so for past
returns. However, the pension fund managers were less overconfident than the laypeople control group.
Additionally, the authors find that younger and better-educated fund managers are less overconfident.
Overconfidence might also explain the belief of pension fund managers that they can either internally
generate alpha or select outside managers who can do so (Barberis and ftaler 2003). Additionally, marketing
efforts may influence pension fund managers to incorrectly believe they can pick alpha-generating outside
money managers (Barber et al. 2005). However, given that Bauer et al. (2010) find that some pension funds,
specifically smaller funds with small-cap mandates, can generate alpha, some classes of pension fund
managers might have such skill. Foster and Warren (2015) develop a model that incorporates both rational
and behavioral explanations for money management selection. ftey find that the optimism bias can lead to
substantiallosseswhenselecting money managers.
In summary, the literature indicates that pension funds can generally outperform mutual funds and have a
much lower fee structure, but that pension funds still do not generate alpha. Additionally, pension fund
managers exhibit similar biases as other investors, including overconfidence.

Professional money managers and products such as mutual funds, ETFs, hedge funds, and pension
funds control a staggering amount of wealth, at approximately
$55 trillion as of the end of 2014. In general, these investors and products cannot produce alpha.
Additionally, the fees charged for managing such investments range from modest (ETFs) to high
(hedge funds). Combining the observed lack of alpha with the reality of investor fees makes the
continued demand for such assets puzzling.
ftis chapter has documented the specific return characteristics and observed rationality of each
investment group. fte chapter also examined the rationality of those choosing to invest in such assets.
Overall, both professional money managers and those paying for their services exhibit many behavioral biases
that are seemingly at odds with a traditional view of wealth-maximizing financial theory. Perhaps in
recognition of this observation, the observed trends in rising demand for these various assets seem to indicate a
move toward more logical investor choices. In particular, the relative popularity of passive and low-fee assets
such as index mutual funds and ETFs have increased tre- mendously since 2000.
1. Explain the observed return performance of mutual funds, hedge funds, and pension funds.
2. Explain the similarities and differences between mutual funds and hedge funds.
3. Identify the behavioral biases demonstrated by fund managers.
4. Identify the behavioral biases demonstrated by those selecting money managers and related products.
5. Explain the trends in relative demand for active and passive strategies by both mutual funds and
ETFs.
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22
Current Trends in Successful
International M&As
NANCY HUBB ARD
Miriam Katowitz (’73) Endowed Chair in Management and Accounting
Goucher College
Introduction
Hubbard (2013) surveys financial executives from 162 companies who discussed their latest acquisitions. fte
nationalities of those companies included the United States, United Kingdom, Netherlands, France,
Germany, Italy, Spain, Russia, Japan, China, India, Korea, Canada, and Brazil. Each country in the survey
had at least one cross- border transaction for the studied period, for a total of 54 transactions. ftese transac-
tions ranged in size from $75 million to $12.36 billion. fte questionnaire asked the participants about the
rationale for the acquisition, their synergy assessments, pricing valuations, due diligence, planning, any human
resources issues that occurred after the transaction, and the overall success of the venture. fte results of this
survey will be explored in more depth in this chapter.
Hubbard (2013) conducts further in-depth interviews at 50 international companies, including their
chief executives, board chairs, and senior directors, who discussed the issues, challenges, and successes
involved in overseas expansion. fte participants were from 16 countries, including the United Kingdom,
France, Germany, Spain, Switzerland, Israel, Sweden, the United States, Caribbean, Brazil, South Africa,
Nigeria, China, Japan, Australia, and India. ftey included executives from BP, Ford Motor Company,BT,
Lafarge, Bank of China, JBS, Bayer, SAP, Sony, Hitachi, ABB, Santander, Cadbury Schweppes, Bae,
Cargill, AB Group, and Teva. ftis chapter provides additional findings related to this research; the data are
best understood in the context of current trends.
Current Trends: Economic Downturn Meets

Global Risk Refocus
Four important business trends exist that are increasingly affecting international mergers and acquisitions
(M&As): (1) the developing world’s growth activity, (2) the
397
resulting rise of the developing world acquirer, (3) the pursuit of lower degrees of integration with targets, and
(4) global focusing. ftis chapter discusses each of these trends. fteeconomic tumultassociated withthefinancial
crisisof 2007–2008brought with
it an unexpected shift in M&A activity. Whereas previous acquisition activity, at least in large “mega deal”
acquisitions of more than $1 billion, took place primarily in the developed world, the stagnation of those
economies led organizations to turn instead to the rapidly developing economies for their growth
opportunities. ftis situation, combined with infrastructure privatizations and a relaxing of overseas
investment, created unprecedented opportunities in the nonindustrialized world (Chen and Findlay 2003),
resulting in a dramatic increase in acquisition activity in these regions. In fact, by 2012 over one-third of all
mega deals involved a developing world target, an acquirer, or both (Hubbard 2013).
Even within this arena, the demographics are changing. Organizations previously based in industrialized
economies used to make acquisitions in the developing world. But transactions are increasingly occurring
where both the target and the acquirer are in the developing world. fte number of developing-world giants now
actively acquiring in the industrialized world is also increasing, focusing on recognized brands and technol-
ogy to supply both developed and emerging markets. Recent successful examples of this include acquisitions by
JBS (Brazil) of Pilgrim’s Pride, Lenovo (China) of IBM Personal Computers, Tata (India) of Jaguar, and
Mittal (India) of Accelor. Even as economic growth slowly returns, the scope of activity in the developing
world in terms of overall growth, consumer demand, and globalization means that this trend will continue for
some time
A by-product of this activity has led to the second trend mentioned above: the growth of the
developing-world acquirer. In fact, as of 2013 almost 20 percent of the world’s largest companies now hail
from nonindustrialized Europe, North America, and Japan, compared to 6 percent only 10 years ago
(Hubbard 2013). Developing-world acquirers pose a new and considerable threat to Western industrialized
companies, as these “new entrepreneurial giants” often operate their multi-billion-dollar behemoths as if they
were a fraction of that size. ftey are familiar with the nuances of operating in the developing world, with its
uncertainty and the flexibility that it entails, and they are innovative, able to do more with fewer resources. Yiu,
Lau, and Bruton (2007) find that developing-world companies are more resourceful and able to stretch their
technology further than their industrialized counterparts. For example, developing-world giants use technology
and shallow organizational structures to facilitate fast decision making—a prerequisite for operating in the
developing world’s immature markets. ftis change has been borne out of necessity; previously, these
companies did not have the resources to build bureaucratic systems, instead relying on their lean structures to
reduce costs. ftey are more flexible in their partnering options, often pursuing “coopetition” (i.e., working with a
competitor in one market only to compete in another), a concept often foreign to industrialized giants simply
because ithas never been required (Luo2004).
When these developing-world globalizers make acquisitions internationally, they are forced to use existing
target management, as their lean and flat organizational structures have not had employees to replace them. ftus,
many of these businesses’ integrations are highly decentralized, with a strong “hands off ” approach. ftey target
those few business areas for collaboration and investment, and leave the rest of the operations alone
Current Trends in Successful International M&As 399
(Luo and Tung 2007). fte end result of this approach, known as partnering, is one in which acquired
employees often feel they are in a joint venture with the acquirer, rather than acting as a subsidiary (Kale and
Singh 2009). With lower degrees of integration and less cultural overlay between acquirer and target, the
acquired company’s employees are less affected by the acquisition and thus more likely to remain with the
acquiring firm (Hubbard2013).
Previously, some viewed this approach as a weakness. Now, when combined with sophisticated
communication structures, this leanness promotes agility and innovation (Hubbard 2013). An increasing
body of academics finds that emerging world entrepreneurial giants have used many characteristics of what
had traditionally been a disadvantage—liability of newness—and transformed them into a competitive advan-
tage (Autio, Sapienza, and Almeida 2000; Zahra, Sapienza, and Davidsson 2006; Wood, Khavul, Perez-
Nordtvedt, Prakhya, Dabrowski, and Zheng 2011).
Some developing-world acquirers have begun adopting this approach with their increased market-entry
activity. fte end result is a marked shift toward using a “lighter touch” during acquisition implementation, as
opposed to the traditional, immediately implemented integration plan. ftis shift is logical, because less
opportunity exists for integration with existing operations when entering a new market. Some acquirers
indicate that this approach is key to reducing any cultural conflict and for enhancing retention of target
employees, which are the two primary concerns associated with international acquisitions. As will be
discussed, the senior executives interviewed for this chapter identified using a lighter touch as the greatest
reason for a successful acquisition.
THE RISE OF GLOBALFOCUSING

After losing their domestic divisional diversification, companies in the developed world began spreading their
risk geographically, buying related businesses overseas. ftis trend is called globalfocusing (Meyer 2006).
Starting in the mid-1980s, these companies also began a process of de-mergering, or dismantling and selling
off their unrelated divisions. Repeatedly, diversified conglomerates with high-performing divisions were
acquired by break-up specialists, who sold those divisions to related companies from which the acquirer
could secure substantial operational synergies. ftese “Noah’s Ark” acquisitions—where the combined
organizations have two of everything, including finance departments, information technology (IT) systems,
head offices, manufacturing locations, and branches—were ripe for rationalization and large cost savings.
fte divisional targets were worth more to their related companies because of these cost savings than their cash-
generative value was to their previous parent company conglomerates. ftis trend continued through the 1990s,
ushering in a new millennia of engulfing businesses with divisional diversification. In fact, by 2001, more
than one-third of Britain’s largest 100 companies were de-merging (Hubbard 2001). ftis trend continued
domestically until only a handful of true industrialized conglomerates remained. Indeed, GE, a bastion of
conglomerate performance, has onlyrecently gone back to its industrial roots, eschewing much of its previous
diversification (Krauskopf 2015).
Globalfocusing continues today both in the developed world and increasingly in the emerging
economies. fte large-scale de-merging process meant that highly
attractive related targets were available—prestigious brands that simply did not fit into their divestor’s
industry. fte Adams confectionary group, including the Chiclets gum brand, highlights this journey. Adams
began the 1990s as a division of the pharmaceutical giant Pfizer. Pfizer’s executives decided to concentrate on
its core pharmaceutical business, and as a result divested Adams in 2003. In turn, Cadbury Schweppes bought
Adams, adding a Latin American footprint that complemented Cadbury’s U.K. coverage. Cadbury
Schweppes then decided to focus on confectionary and de-merged their Schweppes division in 2008, which
then became the Dr Pepper Snapple Group. Kraft ultimately acquired Cadbury in a hostile bid in 2010, thus
globalfocusing themselves (Cadbury 2015).
Globalfocusing continues to offer organizations compelling opportunities that are capable of
instantaneously enlarging that organization’s geographic profile. ftese opportunities are called
transformational acquisitions (Hubbard 2013). Hubbard finds as many as 15 percent of large multinational
acquisitions are considered geographically transformational, propelling these organizations into new regions
quickly and with substantial scale. While the extent of complementary geographic fit varies among organiza-
tions as they are juxtaposed, these often become target opportunities for more than one acquirer. As such,
defensive acquisition of potentially transformational acquisitions for competitors has also become
increasingly prevalent.
Interestingly, globalfocusing appears to be a Western multinational phenomenon, as Asian companies
continue to pursue diversified business group profiles. Chaebols in South Koreaand kerietsus in Japan—
bothrepresentingtheantithesisofglobalfocusing— have existed for decades, and now government-sponsored
business groups in China are increasingly becoming the norm (Lee and Jin 2009). ftus, no indication
exists that Asian companies will follow the Western pattern of globalfocusing in the foreseeable future.
Whether globalfocusing is a stage of corporate evolution or a proactively viable long-term business strategy is
unknown at this point. But for now, it remains the norm rather than the exception.
fte move toward globalfocusing partly explains the shift in what international acquisitions are seen to achieve.
Since the 1990s, international expansion secured a reduced cost base primarily by lowering manufacturing costs or,
in a few cases, creating economies-of- scale consolidations with an existing operation—an international version
of the Noah’s Ark acquisition (Kogat 1985; KPMG Management Consulting 1997). Since the mid- 2000s,
though, organizations have begun pursuing overseas acquisitions not for potential cost savings but to increase
revenue, as they attempt to reach the developing world’s potential consumers with their rapidly increasing
purchasing power. Extending the work of Hubbard (2013), and based on her original survey, this chapter shows
that almost half (48 percent) of cross-border acquisitions have been completed for market entry— findings
supported by other researchers(Peltier2004; Staples2008).
The Attractiveness of Foreign Direct

Investment Markets
fte survey results (Hubbard 2013) has revealed what makes this new potential market so attractive. fte
responses included both financial and intangible measurements,
which when combined offered an assessment of a market’s attractiveness from which the respondents
could rank opportunities. Some criteria, such as growth of gross domestic product (GDP) and overall
potential customer market size, are obvious and self-explanatory. Others, such as maturity of the stock
market and availability of local resources, are less apparent and measurable. Table 22.1 provides a compre-
hensive list of CEO responses in terms of their criteria for market attractiveness and is uniform across all
those interviewed unless otherwise noted; as noted earlier, the respondents operate in a global capacity,
although their relative importance differs per respondent.
To begin, several intangible indicators of market attractiveness warrant further clarification. Executives
identified stock market maturity as important for two reasons: First, it provides an existing exit route via
floatation if they consider divestment in the future. Second, and more important, it dictates the extent to which
potential acquisition targets are available through public offering. In cases of immature or underdeveloped
stock markets, few if any targets are available except through private purchase, thus greatly impeding the
ability to acquire.
Table 22.1 Financial and Intangible Factors for Market Attractiveness, According
to Executives from 50 International Organizations
Financial/Economic Factors Intangible Factors

GDP size Extent ofnationalism
Growth of GDP Difference in local country culture to
existing operations
Cost and availability of raw materials Necessary product tailorization for local
differences
Size of local consumer market Maturity ofbanks
Maturity and existing demand for Maturity of stock market
product/local markets
Existing competition Complexity of local regulations, taxes and
tariffs/bureaucracy of local governments/
Labor market cost and availability Ability to acquire human capital (specific to
Japanese respondents)
Infrastructure levels and cost Supply chainavailability
Proximity to other potential export markets
Corruption
Note: ftis table outlines the responses given by senior executives of 50 global businesses when asked, in an open-ended
question: “What made a new international market attractive?” fte answers are grouped into financially or economically based
factors and intangible factors. Financial and economic factors are those considered to finite and measurable. Intangibles are more
subjective in nature.
fte executives also noted the maturity of the banking industry as critical for ensuring working capital. ftey
also viewed unique local cultures as more challenging. In such cases, if the opportunity is great enough,
executives enter markets despite local cultures, although modifying their mode of entry. In these cases, joint
ventures and acquisitions are more attractive than greenfield investments. Greenfield investment involves
entering a market organically with no partners while building new facilities and/or local relationships.
Nationalism is a factor in certain jurisdictions and industries, especially energy, natural resources, and
infrastructure delivery. Almost all Japanese company respondents mentioned the ability to acquire human capital
as a key measure of a market’s attractiveness. Interestingly, executives from no other nation mentioned this
attribute as a factor.
Some factors that do not appear as important are somewhat surprising. In terms of economic and
financial factors, the executives did not mention exchange rates and exchange restrictions as major
impediments to entering a market. Neither is ownership restrictions seen as reducing market attractiveness; in
fact, executives rarely ruled out a market’s attractiveness because of an inability to own the operation outright.
In fact, the opposite occurred: if a market was deemed attractive, the executives find a way in which to enter
that market, whether or not by acquisition, joint venture, or greenfield investment.
As for intangible factors, the executives surveyed considered a corrupt government a minor barrier to
investment, with the vast majority of respondents indicating that avoiding corrupt practices is just part of
doing business globally. Similarly, respondents spoke of political instability in the same manner; with the
increase in economic globalization comes the inevitable possibility of civil unrest—it is just part of doing
business in less developed jurisdictions.
The Reasons for Acquisitions

For those companies choosing to expand internationally, acquisition remains the most preferred method over
both joint ventures and greenfield investment when entering a new market (Hubbard 2013). Control was not
identified as the greatest benefit but, rather, the ability to enter a market quickly with the requisite size,
complete with intact supply and distribution chains. Indeed, control appeared to be a secondary benefit overall,
albeit it was of primary concern in certain industries such as IT (Chen and Findlay 2003; Hubbard 2013).
Although providing the same level of control, greenfield investment appears to be too slow, especially when
entering fast-paced or changing markets. Similarly, some viewed joint ventures as slower than acquisitions,
with the added concern of often not possessing clear control in many cases. ftus, as Chen and Findlay
(pp. 25–26) suggest,
For a latecomer to a market or a new field of technology, cross-border M&As can provide a way to
catch up rapidly. With the acceleration of globalization, enhanced competition and shorter
product life cycles, there are increasing pressures for firms to respond quickly to opportunities
in the fast changing global economic environment. Cross-border M&As can provide a way
to catch up rapidly.
ftus, the rationale for acquisition falls clearly into both meeting financial/strategic objectives and some
irrational considerations. As discussed in the following sections, the research has shown that numerous
acquisitions occur for irrational reasons. Included in this irrational behavior are activities such as overinflating
the purchase prices and underestimating the potential synergies.
Figure 22.1 illustrates the rationales given by the surveyed executives for their last acquisition. fte
respondents offered both financial and intangible reasons, with market entry being the overwhelming one
for cross-border acquisition. Combining market entry with transformational acquisitions—those
transactions that instantly take the organization to the next level, with a substantial increase in geography—
accounts for almost 60 percent of their rationale for acquisitions. Top-line growth, following a client into a
new geography, takes the total of “revenue-enhancing acquisition objectives” to almost 70 percent. Cost-
savings acquisitions, either through cheaper sourcing or economics of scale, account for only 8 percent.
Although all respondents indicated that revenue-enhancing acquisition objectives factored into their
decision making, only the
45
40
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Percentage
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Percentage
Figure 22.1 Reasons Given forMost Recent AcquisitionfromExecutives of50 International Companies.
This figure highlights the reasons given by 50 senior
executives for their last international acquisition. Respondents could provide more than one reason for an
acquisition. The results demonstrate that market entry is the
overwhelming reason given for most international acquisitions. When combined with other revenue-
producing rationale, such as introducing a new product into an existing market and following a client, top-
line growth is clearly the foremost acquisition
strategy at present.
Japanese respondents indicated that cost savings factored into their decision-making process.
fte intangible reasons for acquisition varied, especially among Japanese and developing-world
respondents. In fact, every non-European and non-American respondent gave at least one intangible reason
for an acquisition. ftese reasons include gaining access to new technology, natural resources, and
management; diversification; and defensive acquisitions. Although executives from all nations indicated
that acquiring new technology is an important reason for acquisitions, there were key differences mentioned in
the other areas of intangibility, based on nationality. Japanese respondents were the only nationality
represented to list acquiring key management resources as a major objective. ftey were also the only ones to
indicate that differentiation from key competitors and diversification are key acquisition objectives. In fact,
all the Japanese participants indicated differentiation factors in their decision making in some form,
whereas no European or American firms indicated this factor in their decision making.
Despite its being important in understanding transformational acquisitions, only a small number of
participants mentioned defensive acquisitions. As discussed previously, pending acquisitions could be
transformational for more than one acquiring company. In these cases, securing the target for the acquisition
not only serves to transform the acquiring business but also keeps a competitor from accomplishing the same.
IRRATIONAL REA SONS FOR A CQU ISIT IONS

Although no respondents indicated irrational reasons for making acquisitions, other studies have painted a
long and vivid history of irrational behavior in justifying acquisitions. Hunt, Lees, Grumbar, and Vivian
(1987) find that irrational or nonstrategic reasons motivated well over half of U.K. acquirers, as illustrated in
table 22.2. Subsequent research finds that managers instigated 26 percent of international acquisitions by
U.S. firms for their own utility, as opposed to creating value for shareholders (Seth, Song, and Pettit 2000).
Further research also supports this finding (Barclay and Holderness 1989; Hietala, Kaplan, and Robinson
2003; Gondhalekar, Sant, and Ferris 2004).
Several theories have been attempted to explain the irrational motivators behind this kind of behavior,
including envy theory, free cash flow theory, defensive behavior, and the hubris hypothesis.
• Envy theory. Envy theory suggests that chief executives see their counterparts as conducting large
transactions and getting greater remuneration for it. ftey in turn try to emulate that behavior (Goel and
ftacker 2009), creating a manifestation of the principal–agent problem in which executives maximize
their own utility and opportunity above that of shareholders (Seth et al. 2000; Zalewski 2001; Kummar
2006). Executives are rewarded primarily based on the size of their company, rather than by its profitability,
further encouraging this behavior (Coeurdacier, De Santis, and Aviat 2009; Goel and ftacker 2009).
• Free cash flow theory. ftis theory suggests that executives may not want to relinquish funds to
shareholders via dividends, instead opting to spend the money even on value-destroying acquisitions
(Lang, Stulz, and Walkling 1991; Servaes 1991).
Table 22.2 Irrational Reasons Cited for Acquisitions
Irrational Reasons for Acquisition Dominant or Primary Secondary

Motivation (%) Motivation (%)
Sending the right signals to the 20 40
financial markets
Chairperson’s insistence 8 35
Retrieve “face” 5 18
Rise in technology perception 0 15
Impress competition 3 8
Buying a tradition 0 8
Cash cow for other bids 3 5
Sort out another problem 0 3
Note: ftis table highlights the findings of Hunt et al. (1987) when they interviewed executives from large U.K.
organizations as to their reasons for acquiring. In cases of both domestic and international acquisitions, Hunt et al. find that
irrational—that is, nonfinancial or strategic— reasoning was given as a primary reason for almost 40 percent of acquisitions.
Secondary motivations were even more prevalent when respondents were able to give more than one reason for acquiring. ftis
evidence suggests that while financial and strategic reasoning for acquisitions dominates motivation, irrational motivations
still need to be taken into account.
• Defensive behavior. Some executives engage in acquisitions to grow the business purely for personal
defensive means—“eat or be eaten” or a “good defense is a strong offense” as the case may be (Gorton,
Kahl, and Rosen 2009). ftus, executives acquire a target firm before it can buy their firm, which could
otherwise result in executives subsequently losing their jobs.
• Hubris hypothesis. A long-established and much-tested theory of irrationality in acquisition
objectives, this is otherwise known as chief executive overconfidence. First put forward by Roll
(1986), the theory holds that chief executive officers (CEOs) overestimate their own abilities in
achieving acquisition synergies and other financial objectives, leading them to complete the transactions
even when presented with new and less favorable information and especially when it applies to potential
cost savings and synergies (Bogan and Just 2009). As a result, the acquirer often pays too much for the target
(Roll 1986; Eccles, Lanes, and Wilson 1999; Schmidt 1999; Lanes, Stewart, and Francis 2001;
Cartwright and Schoenberg 2006).
Acquisition Success and Failure

No matter how the research is analyzed, the unavoidable truth is that acquisitions are not guaranteed to create
value for internationalizing firms; in fact, it may be quite the contrary. Rostand (1994) finds that, at best, 45
percent fail to deliver their strategic
objectives; at worst, between 60 and 70 percent do not reach their intended financial performance (Rostand
1994; Lasfer and Morzaria 2004; Stahl and Voight 2008). fte majority of research agrees with countless
studies finding the ability to generate value is inconsistent, with a 50/50 chance of being successful in creating
shareholder value (Lubatkin, Srinivasan, and Merchant 1997; Brouthers, van Hastenburg, and van den Ven
1998;AgrawalandJaffe2000;Conn,Cosh,Guest,andHughes2001).
Figures 22.2 and 22.3 illustrate that, in the survey of 162 participants, respondents indicated they are more
successful in acquiring than has been reported in previous surveys of both domestic and international
acquisitions. Although self-reported success runs the risk of being more favorable than other forms of testing,
previous research finds that self-reported responses are on a par with other forms of empirical testing (Hunt et
al. 1987; KPMG 1999). ftis finding corresponds with the executive interviews, who also indicated greater
levels of acquisition success (Hubbard 2013). Although such evidence bodes well for creating shareholder
value via acquisition, it may be more related to how acquisitions are implemented than any deep lessons
learned by acquirers.
fte shift in the acquisition landscape toward market-entry objectives requires a different skill set for
the acquisition success. In economies-of-scale acquisitions, success requires a systematic ability to
implement complex operational integrations— combining systems and procedures, firing employees,
retraining those who remain, and melding organizational cultures into a new, cohesive organization. Strong
human
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10
0
Strongly agree Somewhat agree Somewhat disagree Strongly disagree Don't know
Domestic International
Figure 22.2 Views on Amount of Shareholder Value Gained from Most Recent Acquisition. The survey
asked respondents about their most recent acquisition and whether it created shareholder value. The 108 domestic
acquirers and 52 international acquirers indicated relatively uniformly that their latest acquisition did create value.
More than 60 percent of both domestic and international acquirers strongly agreed that this is the case. The
only area not seeing some differentiation is in the category of “somewhat disagreeing,” in which
international acquisitions were almost twice as likely to answer in this manner.
50
45
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15
10
0
Strongly agree Tend to agree Tend to disagree Strongly disagree Don't know
Cross border Domestic
Figure 22.3 Views on Competitive Advantage Gained from Most Recent Acquisition ftis figure indicates the
160respondents’ answers whenaskedif their most recentacquisition made the company more competitive. Both
the 108 domestic respondents and the 52 international respondents strongly agreed with that statement. More
international respondents indicated that their acquisitions made their company more competitive compared
to domestic acquirers, which had a higher percentage indicating that
the acquisition did not make their company more competitive.
resource and IT departments, bolstered by program management expertise and often supported by specialist
consulting firms who bring with them time-tested processes, are necessary for achieving the requisite
organizational synergies. In the vast majority of cases, these gains simply fail to materialize as anticipated.
Many examples exist in which the acquisition process not only failed to deliver its intended value but also
damaged the acquirer’s underlying business, owing to an overextension of resources. For example, Daimler’s
acquisition of Chrysler, Morrison’s acquisition of Safeway, and Bank of America’s acquisition of Countrywide
all show how value-creating, economies- of-scale acquisitions destroyed value. As Fitzpatrick (2012) notes,
the initial purchase price of Countrywide was $2.5 billion, but the estimated acquisition cost to Bank of
America was more than $40 billion—to date. Acquisition success relies on a combination of financial rigor
and human resource expertise for implementation; the sheer size and complexity of the process often makes
success unachievable.
In this new world of international acquisitions, success is still derived from financial rigor and human
resources (HR) expertise—it is the implementation of strategic objectives with a financial and human
perspective. fte areas being affected differ, however. Whereas managers achieved previous acquisition
objectives through cost cutting, the current trend is for seeking gains in market share, not reductions in
overlapping operations. Managers achieve their objectives through revenue growth opportunities, with
synergies centered on creating value through intra-firm collaboration; this can be seen in cross-selling
products in the new geographies and introducing new products into existing markets.
Little if anything exists to integrate economies-of-scale objectives, and the complex issues they bring are
simply irrelevant today. Success relies on retaining existing expertise and using it throughout the organization,
rather than on reducing costs. In other words, success depends on collaboration and retention, rather than
reduction and harmonization. fte skills are still financial in rigor and human resources and in IT for delivery,
but they differ. Success depends on the acquired management remaining in place so as to achieve clear and
measured organizational goals. ftese goals are achieved by managing the acquired unit’s employees in a hands-
off, almost partnering approach, supported by effective horizontal communication and decision-making
channels. In other words, the acquiring companies achieve success by using a “lighter touch” in
implementation. fte next section provides a discussion of these elements.
Reasons for Acquisition Success

KPMG (1999) serves as an excellent template for understanding the complexities involved in achieving
acquisition success internationally. fte study conducted in 1999 asked executives at 107 large publicly traded
companies what activities they undertook before acquiring internationally. fte companies’ performance was
then tracked to ascertain performance differences versus their industrial peers.
As the transactions were large, they should have affected performance. Of those companies undertaking six
key activities, all experienced increased performance versus their industrial peers. Only one of those that
undertook some but not all of the six activities experienced an increase in relative performance. ftose six
activities were a combination of financially based and behaviorally oriented reasons. fte three financially based
activities were (1) conducting due diligence beyond financial and legal indicators, (2) having a rigorous
pre-acquisition plan, and (3) undertaking thorough synergy papers. fte three behaviorally oriented activities
were: (1) having a process for dealing with cultural differences between the target and acquirer, (2) introducing
strong internal communication process, and (3) deciding the top team early.
fte types of acquisitions undertaken when this KPMG survey was conducted differ in intent from the
majority of acquisitions being undertaken today. KPMG conducted the survey at the height of the economies-
of-scale acquisition wave, whereas today most acquisitions are targeting top-line growth. Yet activities
undertaken then are still relevant today. Following is an examination of these activities, with data provided
by the Hubbard (2013) study of 54 international and 108 domestic survey respondents, as well as her 50
in-depth senior executive interviews.
FINANC IALL Y BASED SU CCESS FACTORS

fte three financially based activities undertaken by acquirers before the transaction that added value are:
(1) conducting due diligence beyond financial and legal indicators, (2) having a rigorous pre-acquisition
plan, and (3) undertaking thorough synergy papers. Synergy papers are pre-acquisition synergy analyses
required for British acquisitions in publicly quoted transactions as a way of ensuring the cost-saving benefits
are considered reasonable. Conducting due diligence before a transaction is normal, but successful acquirers
conducted due diligence that went beyond purely financial and
legal aspects. Successful acquirers also undertook extensive pre-acquisition planning often based on
comprehensive synergy paper analysis. ftis process occurred even if the target was neither a publicly traded
company nor located in a jurisdiction where this was legally required. Each activity will be discussed in
turn.
Holistic Due Diligence

fte KPMG (1999) survey finds a relationship between holistic due diligence and international acquisition
success. Logic suggests that any additional knowledge gathered on the target before an acquisition would be
beneficial in terms of both valuing the target and increasing the understanding of strategic fit. When asked about
the key reasons for acquisition success in their last acquisition, the senior executives gave extensive due dili-
gence as the equal highest response (Hubbard 2013). As seen later in this chapter, this suggests that those who
pursueadditional informationappreciate itsvalue.
Surprisingly, companies conduct little due diligence before international acquisitions in many cases. Table
22.3 displays findings from the large-scale survey, which asked the 54 cross-border respondents about the
types of due diligence undertaken before the
Table 22.3 Comparison of Due Diligence Undertaken by Domestic and Cross-

border Acquirers
Domestic Cross-border
Acquisitions Acquisitions (%)
Financial 72 78
Commercial 61 63
Legal 56 57
Operational 57 52
Strategic 43 48
Information Technology 72 33
HR 47 19
Technological 1 4
Environmental 4 0
Tax 0 2
Other 3 7
None 3 4
Note: ftis table highlights the findings of a 162-company survey in which executives of 108 companies discussed their
domestic acquisitions and 54 participants discussed their international acquisitions. Financial due diligence is the most
common due diligence undertaken by both domestic and cross-border acquirers. Commercial, legal, operational, and strategic
due diligence is also undertaken by roughly half of respondents in both domestic and international acquisitions. fte biggest
differences between domestic and international acquirers is revealed in their information technology and human resource due
diligence. In both cases, domestic acquirers are far more likely to pursue due diligence when compared to their
international counterparts.
transaction. Respondents reported that they completed 22 percent of overseas acquisitions without any
financial due diligence, and 43 percent pursued no legal due diligence. Respondents reported conducting 7
percent of acquisitions with no due diligence.
Although almost all acquisitions should necessitate undertaking the financial and legal due diligence,
KPMG (1999) finds an association between collecting information in other business functions and greater
acquisition success. ftese areas include commercial due diligence, strategic due diligence, HR due diligence
including information on the target middle and senior management, and IT due diligence. With the majority of
international acquisitions pursuing top-line growth, the lack of commercial due diligence is surprising,
although its dearth mirrors domestic due diligence activity. fte two areas where the due diligence undertaken in
overseas acquisitions differs substantially from domestic acquisitions involve HR and IT. International
transactions are less than half as likely to have pursued this information when compared to their domestic
counterparts. With “soft issues” being mentioned as key for cross-border acquisition success, the lack of due
diligence in this area can be detrimental and these findings are paradoxi- cal when overseas acquirers report
greateracquisitionsuccessthanbefore.
As many targets in the developing world are privately held, one relevant area of due diligence is an
understanding of the expectations of the target’s owners. In many cases, the owners are not selling to the highest
bidder but, rather, to the organization that best meets its business philosophy and fit (Hubbard 2013). Regardless,
their support is critical to completing the transaction; understanding their aspirations, expectations and
concerns is paramount for ensuring the transaction is completed successfully.
Pre-acquisition Planning
Researchers repeatedly associate pre-acquisition planning with overall acquisition success (Buono and
Bowditch 1989; Hubbard 1999; Lasfer and Morzaria 2004; Stahl and Voight 2008). Pre-acquisition
planning was a key to their success, according to the senior executives interviewed (Hubbard 2013).
Adequate planning provides the basis for virtually all other activities, including the synergistic fit with the
acquirer’s business; what, if any, of the target’s assets are to be divested; key external and internal commu-
nication messages; top team selection; and pricing. It serves as the foundation for the synergy evaluations
that follow.
fte large-scale survey (Hubbard 2013) asked both domestic and international acquirers if they had a
clear post-deal strategy before completion. As figure 22.4 shows, a combined 72 percent responded that they
did, with 20 percent declining to answer the question and 8 percent responding that they did not. ftere was little
differentiation between domestic and international acquirers. When the participants were asked when they
began their planning, international acquirers indicated their planning was begun earlier than domestic
acquirers, with 40 percent of the former beginning their planning at least five months before completing the
transaction—over twice the percentage of domestic acquirers planning at that stage. In fact, almost 20
percent of international acquirers reported not planning until after completion of the transaction (a percentage
also higher than among the domestic acquirers). ftis results is a residual effect delaying the synergy evaluation,
communication, and other HR issues, and makes addressing such matters in a timely manner
practically impossible.
35
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25
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10
0
Greater than 6 5-6 months 3-4 months 1-2 months At completion After completion
months
Domestic (%) International (%)
Figure 22.4 Advance PlanningTime forDomesticandInternationalAcquisitions. fte figure reports the

results of a survey asking 160 respondents when they began their planning before the acquisition completion.
fte 108 domestic acquirers and 52 international acquirers had differing approaches. A large percentage (28
percent)
of international acquirers began their planning well in advance of the transaction’s completion, compared to
only 11 percent of domestic acquirers. In contrast, domestic acquirers were more likely to begin their planning
in the four months before the transaction’s completion. In both cases, a small but meaningful number of acquirers
did not engage in planning before the acquisition.
Synergy
Understanding the financial costs and benefits to be derived by an acquisition is important for transactions of
publicly held companies. Although not required for privately held company transactions, understanding the
synergistic benefits, according to some researchers, considering the costs and time frames of a potential
acquisition is critical for success (Lasfer and Morzaria 2004; Stahl and Voight 2008). With this in mind, the
Hubbard survey asked both international and domestic respondents how much time they devoted to
synergistic evaluations before completing the deals. As Figure 22.5 shows, almost half of all respondents
reportedinvesting little or notime inquantifying the synergies between the two organizations.
As previously discussed, recent international acquisitions have increasingly targeted top-line revenue
opportunities—acquiring new markets and customers for existing products. fte survey asked both domestic
and international acquirers about what synergies they anticipated in their most recent acquisition. As Figure
22.6 shows, synergies being sought by international businesses focus on marketing (24 percent compared to
none in domestic transactions), and less so on operations, back office, procurement, and property-cost
reductions. Headcount reductions in which 60 percent of domestic acquirers anticipate synergies accounted
for only 2 percent of international transactions. ftus, cost-reduction synergies across the board are less
pursued in international acquisitions. ftis finding has a domino effect for HR. As discussed in the
following
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0
A great deal A reasonable amount Just a little None
Figure 22.5 Comparison of Time Spent on Synergistic Evaluations, Domestic and International
Acquirers. ftis figure highlights the different approaches taken by those acquiring domestically and
internationally. Researchers asked respondents how much time they spent undertaking synergy evaluations. fte
108 respondents undertaking domestic acquisitions were more likely to spend some time on synergy evaluation
work, withalmosttwo-thirdsindicatingtheyspenteitherareasonableorjustalittle time
on that activity. fte 52 international acquirers, however, were more skewed at both ends of the spectrum,
indicating they either spent a great deal or time or no time at all on synergy evaluations when compared to
domestic acquirers.
section, the HR implications for top-line revenue synergies differ dramatically from cost-reduction
synergies—retention and collaborationbecomeparamount.
One opportunity that globalfocusing has provided internationalizing organizations is the ability to acquire
sizable blue chip divisions that simply do not fit the divestor’s new strategic direction. In many cases, the
divested divisions were often starved of management time and resources, as they did not support the
organization’s core business thrust and as a result suffered from “orphan syndrome”—being unwanted and
unap- preciated by their parent company. If acquired in a transformational acquisition, these divisions
immediately become integral to the acquirer’s main business direction and can experience a radical
rejuvenation. It is a golden opportunity for both the target and the acquirer.
BEHAVIORALLY BASED SUCCESS FACTORS

fte KPMG survey (1999) reports three qualitative or behavioral elements considered critical to acquisition
success: (1) having a process for dealing with cultural differences between the target and acquirer, (2)
introducing a strong internal communication process, and (3) identifying the top team early. Additional
research supports these activities as essential for acquisition success (Hubbard and Purcell 2001; Schweiger
and Goulet
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70
60
50
40
30
20
10
Figure 22.6 Anticipated Synergies forDomestic and International Acquisitions. ftis figure highlights the
differences in anticipated synergies between domestic and international acquisitions. fte survey asked the
108 domestic acquirers what synergies they expected upon completing their acquisition. ftey indicated they
expected synergies in terms of headcount, procurement, and operations in at least 60 percent of domestic
acquisitions. When asked the same question, only 2 percent of the 52 companies acquiring internationally
foresaw headcount reductions, with substantially lower indications of other operationally based cost savings.
Instead, almost one-fourth of them anticipated marketing savings, compared to none of the domestic
acquirers.
2005; Cartwright and Schoenberg 2006; Lodorfos and Boateng 2006). Each of these findings is discussed
in the following sections.
Cultural Differences
Culture can be defined as the systems and processes that lead to accepted behavior in an organization.
Cultural differences exist between countries, organizations within the same country, and divisions and
functions within one company.
Cultural differences, or “culture clashes” between the target and the acquirer, can be major impediments
to acquisition success (Schmidt 1999; Applebaum and Gandell 2003; Weber and Camerer 2003; Badrtalei
and Bates 2007). Walter (1985) suggests that culture conflicts account for as much as a 25 to 30 percent drop
in performance after acquisition implementation. Other research finds that the performance drop does not
result from the actual difference in culture, but from how the acquirer has addressed the cultural differences
(Hubbard 1999; Hubbard and Purcell 2001; Applebaum and Gandell 2003; Rottig 2009). KPMG (1999)
supports this position, suggesting that the cultural differences do not cause the problems, but that a lack of
proactively managing those differences does. Companies acknowledging the cultural differences pre-
emptively manage those disparities and experience success.
Recent research continues to highlight the perceived importance of culture, especially in cross-border
acquisitions. fte KPMB survey (1999) asked respondents to indicate their three biggest HR concerns post-
acquisition. Figure 22.7 shows that for the Hubbard survey, almost 70 percent of cross-border acquirers
reported that cultural differences are among their three top concerns, and was noted as the top response by
almost twofold. Domestic acquirers were half as likely to indicate they felt cultural issues are a potential
problem, suggesting that the acquisition’s international aspect is the main cause of cultural concern.
Although cultural differences complicate cross-border transactions, the degree of integration can be a
mitigating factor. Put simply, as the degree of integration decreases, cultural differences affect fewer
employees. Conversely, as the degree of integration increases, more employees are exposed to the differences.
In cases of high cultural dis- similarities, some acquirers opt for a lower degree of integration, thereby reducing
the number of employees affected by the cultural difference. In doing so, they are borrowing the “partnering”
approach previously discussed.
fte increase in market-entry acquisition strategies reduces the frequency of fully integrated targets,
again reducing potential cultural impact. Some organizations facing unavoidable cultural differences use
more specialized coping tools, such as internal cultural facilitators who assist affected executives in operating
in both organizations’ cultures, introducing widespread cultural training tools, and employing culture
audits—all designed to assist affected employees in becoming culturally “bilingual” (Hubbard 1999).
70
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50
40
30
20
10
0
Primary HR concern Secondary HR concern Tertiary HR concern
Figure 22.7 Top ftree HR Concerns after-Acquisition by Cross-Border Company. ftis figure highlights the
human resource concerns identified by international acquirers.
ftesurvey asked respondentsto identify theirthree majorHR concerns during the acquisition
implementation. fte top two responses of cultural differences and employee retention outpaced other responses,
with the latter being the overwhelming primary concern. fte operating model, communication, terms and
conditions, and recruitment were also important concerns. Retention issues may be exacerbated, given the
tardiness in achieving appointments at the department-head level.
Strong Internal Communication

Besides KPMG (1999), other studies have highlighted the role of internal communication in acquisitions
(Piekkari, Vaara, Tienari, and Säntti 2005; Lodorfos and Boateng 2006; Stahl and Voight 2008). Yet,
adequate internal pre-acquisition communication often is neglected, for several reasons. First, such
communication relies on senior executives to craft and deliver the message at a time when they are usually
involved in the deal negotiation and execution. Second, secrecy surrounding these transactions means that the
executives often exclude all but a few insiders; thus, HR personnel are not given adequate time to prepare
communications. Finally, and perhaps most important, accurate communication depends on pre-acquisition
planning for its content. As previously mentioned, inadequate planning is endemic to various transactions.
Without content, internal communications are ineffective.
International acquisitions bring with them other communication complications as well. For example,
there is the need to translate key documents in a timely manner. Another is the potential of
misunderstandings between colleagues when communicating in a language other than the native tongue.
Also, those involved in the acquisition may be fluent in the language, but may not understand the cultural
ramifications or linguistic nuances of what they are saying, let along how the other party interprets their
communications (Piekkari et al. 2005). Finally, communication barriers can make cross-organizational
collaboration more difficult unless organizations adopt a single corporate language (Ranft and Lord
2002).
After an acquisition, good communication serves two distinct purposes. From the acquiring company,
effective communication can reduce the anxiety and ambiguity felt by employees of the acquired company,
and in doing so, can create a sense of shared belonging (Buono and Bowditch 1989; Hubbard 1999; Ranft and
Lord 2002; Schweiger and Goulet 2005). ftis relationship can aid in retention and productivity during a time
when organizations are most vulnerable to their best employees leaving—those personnel who have the
opportunities and potential motivation to move elsewhere. Second, effective communication can build the
bridges that facilitate internal knowledge sharing (Ranft and Lord 2002). ftis intra-firm collaboration and
knowledge sharing is what many revenue-enhancing acquirers want to achieve, yet it often remains elusive.
If intra-firm collaboration is critical for acquisition success, “rich communication” is fundamental for
encouraging the necessary flow of information throughout the firm (Daft and Lengel 1986). Rich
communication can be achieved by face-to-face meetings, cross-company project specific teams, site visits to
and from the target and acquirer, social events, and cultural audits. Initial face-to-face meetings facilitate trust and
encourage collaborators to use further technology to continue the ongoing communication. Yet, using
technologically based communication without the initial personal interactions can be ineffectual (Ranft
and Lord 2002). fte geographic and cultural divide of international acquisitions can exacerbate a lack of
communication and collaboration. Ranft and Lord (p. 438) suggest that “rich communications were not only
helpful for establishing a favorable climate between the two organizations, but were essential for the actual
exchange of knowledge across post-acquisition internal organizational boundaries, particularly when the
acquiredfirmsmaintainedsubstantialautonomy.”
Top Team Selection

According to KPMG (1999), the final activity that successful acquirers undertake before the
transaction’s completion is to select the target’s top team. Having the top team in place means that effective
leadership is available to drive the implementation forward. ftis process is especially important in many
developing-world economies, which are experiencing unprecedented growth and, therefore, have very
competitive job markets. In markets where employees can switch jobs easily, securing key employees is even
more important, as the ability to quickly leave a job for another is intensified.
Securing key employees does not seem to be a priority in many cross-border acquisitions, however. As
Figure 22.8 shows, among the Hubbard survey respondents, more than one-fourth of international acquirers
took three to six months to have a fully working management team in place at the department-head level,
meaning that middle management appointments below that level took even longer to be finalized. ftis degree
of management ambiguity can exacerbate employee retention issues, as affected managers leave the company in
search of more concrete employment opportunities. Figure 22.7 shows that the survey evidence bears this
out; retaining key staff is the second most often cited HR concern following acquisition.
As previously discussed, the increasing move toward partnering with the acquisition target can also
improve retention rates among acquired employees. ftis partnership is
More than 2 Years
1-2 Years
6 Months-1 Year
3-6 Months
1-3 Months
Less than 1 Month
0 10 20 30 40 50 60
Cross Border Domestic
Figure 22.8 Time Needed to Appoint Senior Management after Company Acquisition. This
figure outlines the amount of time needed for acquirers
to place senior management into senior roles, in both domestic and international acquisitions. The
survey asked respondents the amount of time needed to make appointments to the level of department
head. The 103 domestic respondents
indicated making about two-thirds of appointments to department-head positions within the first three
months, with almost half of appointments occurring within one month. Although the 52 foreign
respondents indicated that more than half
of their appointments occurred in the first three months, almost 30 percent
of appointments to department-head level took between three and six months. This delay in
appointments means that middle management appointments take even longer, which may be exacerbating
retention issues, especially in overheating international markets.
critical when the acquirers do not want to lose that imbedded knowledge. ftis observation can be especially
important when entering a new and substantially different market. To lose those knowledgeable employees
would heighten the acquirer’s “liability of foreignness” in that market, thereby increasing its inherent risk (
Johanson and Vahlne 2009).
OVERALL ACQUISITION SUCCESS FACTORS

Although the KPMG study was published in 1999, the pre-acquisition activities identified in that survey
remain relevant today. When the Hubbard survey asked senior executives about the key factors for
successful acquisitions, their responses, as shown in Figure 22.9, included many of the same responses as
appeared in the KPMG survey, despite the passage of time. On the financial side, extensive due diligence,
making strategic sense, clear planning, and a robust process are all important. On the behavioral front, the
right leadership and dealing with cultural issues both figure prominently. Hubbard respondents viewed using a
lighter touch in implementation as fundamental, which demonstrates the changed nature of cross-border
market entry strategy and the
16
14
12
10
8
6
4
2
0
Reasons for acquisition success (%)
Figure 22.9 Stated Reasons for Acquisition Success. This figure indicates the reasons for success as
given by executives from 50 global businesses when discussing
acquisition. The survey asked executives togive three keyfactors for successful acquisitions. The
respondents mentioned successes in both financial (due diligence) and people-based actions
(right leadership), as well as in a strong
process. Respondents identified a lighter touch on integration as being a top-three response, which
contradicts previous research findings. Although management
urgedpast acquirers to make changes immediately, a softer and slower integration was found to be more
effective, especially when employee retention was
mentioned as critical for future acquisition success.
lower degree of integration being undertaken. Even though international transactions have shifted from full
integration to revenue-enhancing acquisitions, success continues to rely on a melding of financial and
behavioral factors.

Investors interested in growth companies that are internationalizing their businesses by pursuing acquisition
strategies should consider several key factors. First, transformational acquisitions, which represent
opportunities to radically reshape an organization’s geographic footprint, can uniquely and rapidly
revolutionize an organization. Such acquisitions bode well for investors, because little overlap exists for
integration issues to arise and subvert the organization’s attention and efforts as it quickly gains global size. fte
opportunities are infrequent but attractive when they arise.
Second, some acquirers have built a track record in successfully acquiring overseas using a methodology
that clearly works. As long as the type of acquisition remains consistent, those companies with proven track
records warrant attention. ftus, companies that have pursued market-entry strategies with success should find
that the process can be replicated across borders. Finally, those organizations that can articulate their strategic
plans and demonstrate that they follow the six key activities previously discussed are far more likely to be
successful than those that do not. In a changing world, nothing is foolproof. In the case of acquisitions, the
merger of financial and behavioral processes greatly enhances the odds of success.
1. Identify several irrational reasons for acquisitions.
2. Discuss how globalfocusing can reduce risk the way conglomeration did previously.
3. Explain how HR issues during acquisition have changed since 2000.
4. Explain the reasons the success rate of international acquisitions has improved.
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23
Art and Collectibles
for Wealth Management
P E T E R J. MA Y
Independent Wealth Advisor
Introduction
ftis chapter explores the different aspects of buying and selling and collecting fine art and objects that are
termed collectibles, viewed from a wealth management perspective. Wealth management in this context
refers to the act of combining personal investment management, financial advisory, and planning
disciplines directly for the benefit of high net worth (HNW) clients. fte chapter opens with a review of the
literature on behavioral aspects of collecting fine art and collectible objects. fte section that follows identifies
issues and items that collectors and wealth managers encounter in such wealth management, then expands to a
section on the passion for acquiring, holding, and dis- posing of such assets. A discussion on fine art as an asset
class follows. fte chapter then moves into the effect of social media use and online aspects of wealth
management and ownership, with a focus on education about art, global acquisition of art and collectibles,
and give suggestions for how wealth managers can keep pace with developments in this rapidly changing arena.
Finally, the chapter includes a summary and conclusions.
A Review of the Literature

Belk (1995) reports survey results based on 200 interviews with collectors that examined the advantages and
drawbacks of the collecting process for individuals and households. fte study found that, in severe cases,
collecting items can be highly addictive and may cause dysfunction for the individual collector and his or her
family. However,Belk notes that, overall, collecting is a favorable experience for individual investors.
Baker and Gentry (1996) interview groups of children about their collecting habits. fte authors report that
children collect items for the pleasure of experiencing the collection process, as a way to avoid boredom, to
learn about the collecting field, to satisfy an emotional passion for certain items, to distinguish themselves
from other people, and for connecting emotionally with family members and friends. Most adult investors
develop a bias against viewing a collectible such as rare stamps as part of a diversification
422
Art and Collectibles for Wealth Management 423
strategy. Instead, they view such collecting from a nonfinancial perspective. However, Grable and Xuan (2015,
p. 78) report that “in general, collectible stamps do a relatively good job hedging inflation and declines in gold
prices… . [fteir] findings also suggest that those who invest in stamps need a very long time horizon and
favorable market conditions in order to generate a profit.”
AFFECTIVE REACTIONS IN THE COLLECTING PROCESS

Apostolou (2011) examines the role of collecting in eBay-based auctions for sales of fos- silized dinosaur eggs,
and found that collecting is largely based on the desirability of the item. fte author reports that the desirability of
the collectible piece is positively associated with its scarcity, size, and aesthetic pleasantness. Dimson and
Spaenjers (2014) evaluate the long-term investment returns for collectibles, including fine art, stamps, and
violins, and classified them as “emotional assets.” ftey report that collectibles outperform gold, Treasury bills,
and government bonds over the long investment horizon. Nevertheless, the expense of investing in rare
collectibles is high and investors incur many potential risks. Dimson and Spaenjers (p. 20) report that
“Emotional assets are particularly attractive to some high-net-worth investors. fte need for vigilance makes it
hard to justify the inclusion of emotional assets in the portfolios of most institutional investors.”
McAlister and Cornwell (2012) examine the emotional role played by collectible toys, and how
offering premiums connected with food purchases influences the food choices and eating habits of children.
One part of their study examines the influence of toy collectibles offered as premiums with a food purchase.
fte findings reveal that these collectible toy premiums influence a child’s viewpoint about unhealthy
and healthy meal choices. ftey found that children prefer a healthy meal when it is accompanied by a toy
collectible, but otherwise make an unhealthy food choice when there is no premium offered. Additionally,
one could reflect on the impact on the purchasing parent. ftey may not care about the toy, yet the
compromise was worth the healthy outcome.
Moods also influence the desire for collecting art. De Silva, Pownall, and Wolk (2012) investigated the role
of mood changes on subjective risk and prices at art auctions in London between 1990 and 2007. De Silva et
al. (p. 167) report the following results:
Using a unique data set that includes presale estimates for paintings sold through Sotheby’s
and Christie’s auction houses, as well as weather data for London from the British Atmospheric
Data Centre, we find that the lower part of the price distribution is populated with paintings with
a relative high private value, whereas in the upper part, prices are driven primarily by the
common value characteristics.
Indeed, behavioral biases are often revealed in the collection of fine art. Beggs and Graddy (2009)
demonstrate how both the price of a painting sold during an art auction and its pre-sale valuation by experts are
anchored on the sold prices of other paintings with the same quality over the same time span. fte study’s major
finding is the anchoring effect for buyers, sellers, and auctioneers. ftis can be based on either the “expecting
anchoring” which is based on the buyer judgments or revealing anchoring biases in and of themselves.
ftecollectionoffineartcanalsointroduceagencyproblems. Meiand Moses(2005,
p. 2409) evaluate the connection between auction house estimates of pre-sale values for art and the long-term
returns for those art pieces:
We find that the price estimates for expensive paintings have a consistent upward bias over a
long period of 30 years. High estimates at the time of purchase are associated with adverse
subsequent abnormal returns. Moreover, the estimation error for individual paintings tends to
persist over time. ftese results are consistent with the view that auction house price estimates are
affected by agency problems and that some investors are credulous.
Nordsletten and Mataix-Cols (2012) examine similar and different aspects of hoarding and collecting
behavior. By reviewing the literature on collecting, they find that (p. 165) “for the majority of collectors, a
diagnosis of Hoarding Disorder is likely to be effectively ruled out. For a minority of ‘extreme’ collectors, a
diagnosis may potentially be adequate.” According to McIntosh and Schmeichel (2004, p. 86), “collectors
are drawn to collecting as a means of bolstering themselves by setting up goals that are tangible and attainable,
and provide the collector with concrete feedback of progress.”
SOME POPULAR TYPES OF COLLECTING

Carey (2008) indicates that people have an innate desire to collect items for both financial and nonfinancial
reasons, so multiple reasons exist for building collections. Carey develops a model to explain how attempting
to complete a set of collectibles influences a person’s behavior; eventually, it brings higher value. For instance,
a complete set of a collectible has greater value in the secondary market than the totaledvalue oftheindi- vidual
items. ftat is, the act of collection, when completed, brings additional value.
Art and Wine Collections

Agnello (2002) examines the relationship between risk and return for a sample of paintings by U.S. artists for
sale at auction between 1971 and 1996. His findings reveal that total returns for investments in paintings are
low, but large differences in annual performance exist. ftat is, paintings considered of higher quality post the
largest gains, just behind equities, and returns are not compensated for higher risk. fte author suggests that
buying higher-quality paintings by famous artists is the best type of investment approach.
Wine may also serve as an option for return enhancement. Coffman and Nance (2009) note that wine
as an investment has a long history in Europe, and is starting to emerge as an important asset class in the
United States. To provide proper advice to clients, financial planners should be able to assess different
types of investment- grade wines, understand the importance of the cellar log to make sure the wine has
been appropriately stored and transported, identify highly regarded vendors to prevent counterfeit purchases,
and value the different markets for collectible wine. Wine quality
judgments and investment decisions are based on numerous factors: the geography where the grapes were
grown and the year of harvest, the winery doing the aging and bottling, the vintage rating assigned by wine
experts, and prices of prior vintages. fte authors state that wine is an important asset within a client’s portfolio
for reducing volatility and a potential way to earn solid long-term returns.
Sports Cards, Especially Baseball

Baseball cards have merit in an investment portfolio. Haley and Van Scyoc (2010) examine the
differences between book values and eBay prices for 30 1960s-era baseball cards that appeared on more than
870 auction listings. A general finding was that lower-quality baseball cards sell above their book values and
higher-quality cards sell below their book values. Another finding was that when buyer insurance is
offered by the seller, the number of bids on an item increases the price on eBay compared to the item’s
book value, and both the reputation of the seller and the number of bids increase the chances that the
eBay item will be sold at a higher price than its book value.
Regoli, Primm, and Hewitt (2007) assess whether performance or race determined the numerical
classification used by the baseball card manufacturer Topps to identify the top player baseball cards,
also known as “royalty of the diamond,” between 1956 and 1980. fte authors conclude that player
performance was the major determinant of the Topps baseball card numbering system. Additionally,
Primm, Piquero, Regoli, and Piquero (2010a, p. 865) report that “card availability and, to a lesser extent,
player performance is the most important factor affecting the value of a player’s card, while importantly, a
player’s race is not a significant contributor to card value.” In a related study, Primm, Piquero, Regoli,
and Piquero (2010b,
p. 129), who examined the role of race for cards of more than 1,200 white and black football players,
report that “controlling for other factors, race has no effect on the value of players’ rookie cards, whereas
cardvintageexerted themostinfluenceonthe value of players’cards.”
Celebrity Possessions and the Death Effect

Newman, Diesendruck, and Bloom (2011) investigated the reasons individuals buy items that had
previously been owned by celebrities: (1) direct association, (2) greater market demand, and (3) contagion (i.e.,
the belief that these objects contain some rem- nants of their previous owners). fte items subsequently became
collectibles. Market demand has a partial influence on price, but the contagion factor is the most important,
influencing the value of possessions previously owned by celebrities.
Death may play a role in the value of certain art and collectibles. Matheson and Baade (2004) study
how the value of a work of art or the memorabilia of celebrities increases after the death of the artist or
celebrity. ftey point to previous literature identifying the “death effect.” fte basis for the “death effect” is the
expectation of collectors that the supply is now limited, hence grows in desirability. However, this finding
is based on the market for sports memorabilia. As Matheson and Baade (p. 1151) add, “the increase in prices
is instead due to a ‘nostalgia effect’ as a result of the media attention that surrounds the death of a
prominent public figure.”
Seeing the Client’s Passion from a Wealth

Management Perspective
Passion often drives the acquisition of fine art and collectibles. Interest in a particular painting or admiration for
a collectible baseball card often leads to the initial purchase. Subsequent purchases of similar items can then
shape an individual into a collector. fte competition among institutions to manage the assets of high net
worth (HNW) and ultra-high net worth (UHNW) clients is fierce, as firms attempt to expand their services and
evolve their platforms. A key question they face is how to further those relationships with value-added
relationships and services. Art and collectibles maybe the answer.
Introducing art and other collectibles to an investor may allow a manager to expand that client’s investment
options beyond the traditional choices. When taking this approach, however, wealth managers need to understand
the nature of the markets involved and the various businesses surrounding them. It requires understanding the subject
and the nature of the collector’s passion: the who, what, where, why, and when. With this knowledge, though,
wealth managers can better open the doors of an expanding relationship. fte POV does shift for specific reason:
the manager should consider introducing collecting, because it allows a conversation to take place that often does
not.ftis conversationhelps theclienttomakethe bestcollectiondecisionsfroman investmentviewpoint.
Introducing the idea of collecting as an investment option may ignite a passion for your clients. What are
the client’s investment needs? Who are the experts and third- party or family office service providers who
can back up your recommendations? Acquiring this knowledge means working with the client in a close
relationship. Online art markets enable individuals to more easily become acquirers and are proliferating on a
daily basis. fte financial manager should know that art acquisition, for example, and discussed later herein, is
increasingly an important part of that world. Ideally, the wealth manager needs to integrate the client’s collectible
assets with his or her investments and wealth reality. Identifying and navigating the obstacles that get in the way a
client’s passion can sometimes be as simple as applying parental authority in a friendly and sugges- tive way
such that the client will come to the wealth advisor more often than in the past when art and collecting was not
part of the conversation. With sufficient knowledge and leadership skills, the wealth manager can guide the
client along the best path, helping him or her make the best collection decisions from an investment
viewpoint.
Collecting for Investment Value

How does the wealth manager integrate a client’s collection into his or her financial balancesheet?ftegoal of
wealth managementisto keepaclient’s portfolio simpleand concise. ftis includes creating a balance sheet and
filling in the assets and liabilities. But what start as simple assets and liabilities can quickly become difficult
to catego- rize. fte asset side grows segmented, with current, short-term, and long-term assets. Personal
tangiblepropertyandinvestmentsareonlyafewofthemanycategorytypes. Some clients buy art because they
like collecting art. Others buy art because they consider art part of their investment portfolio. fte difference
between collecting art
and investing in art is more a journey than an exact differentiation. For example, more than 30 million
collectors worldwide enjoy collecting stamps, and they spend (invest) billions of dollars to assemble their
collections. Because stamps do a relatively good job of hedging inflation, the evidence suggests that collectible
stamps may be a useful alternative investment within a portfolio (Grable and Chen 2015). If collectors are
acquiring art as a possible investment, how do wealth managers make sure they understand the client’s
needs?
Motivation is multifaceted, with collectors motivated primarily during the acquisition phase. So,
identifying that motivational focus and the driving reasons for it should be foundational for wealth managers.
ftere are conferences and seminars on this aspect of investing, as well as features of continuing education
programs and business development courses. A simple Internet search points to articles, lectures, seminars, and
events on the subject. Additionally, art advisors, collectors, and art consultants ask wealth managers to educate
their clients on the nature of collecting, and they offer their services to incorporate art into their investment
offering or investment platform. Family offices are often best positioned to integrate art into overall client’s
portfolio management, as it provides a way to preserve a family’s collection. Applying the expertise of
both internal and external teams to assess the future attractiveness and investment value of collectibles calls
for a decision-making framework of sound governance (Zorloni and Willette 2014). Indeed, the financial
industry as a whole, from wealth management to investment brokerage, is assuming a strategic view of art as an
asset class. In addition to aiding individual clients and families, there are opportunities for expanding the
industry conversation with additional methodologies for integrating art as an asset class into investment
management. ftese areas include art lending, art philanthropy, and art in the context of estate planning.
Especially, the art lending world continues to evolve and innovate, people increasingly buy fine art with the
idea of borrowing money against its value.
Recently, art lending has become a “strategic focus,” which implies that wealth managers are being
asked to accommodate requests from important clients. Although many institutions, as part of their general
marketing, indicate they now have more confidence in art as collateral, often the reality is that they merely
extend client lines of credit. Nevertheless, as traditional lending institutions provide fewer loans and require
additional collateral, art lending has surfaced as a financing vehicle without creating covenant-busting
realities. Art lending is clean, simple, timely, and focused on providing value-added benefits.
Art philanthropy is another aspect calling for wealth management. Fine art may serve as a charitable
gift, for example, that requires client discussions, including the recipient institution so that an art
preservation plan can be created (Zorloni and Willette 2014). In a word, instead of selling their art, some
investors find a charity, museum, or foundation to take it, display or store it until a later time when the insti-
tution can sell the art either privately or at public auction. Alternatively, a collector might consider
transferring either part or all of a collection to a trust or foundation, which may call for review of state laws
and disclosure requirements. Lastly, estate planning remains important as part of the wealth management
process. ftrough all of these aspects of collecting as investment, wealth managers must consider the
valuations, planning, and taxation.
Clients have personal, individual needs, and wealth managers must recognize these needs and see the
means for meeting them as a business opportunity. Why should a traditional wealth management firm
recognize and include art and collectibles in its portfolio management process? Because art represents a large
part of the asset pool of some investors and as such affects their assets under management. fte more an advi-
sor knows about a client’s interests and financial needs, the less likely he or she will be surprised to receive call
from that client for an immediate transfer of funds to cover a recent art purchase.
As previously discussed, McAlister and Cornwell (2012) note the use of toys and other collectible
objects as premiums for selling fast-food meals. fte objects are highly sought after by children and often cause
parents to alter or reconsider their choices or behaviors. If you extrapolate from that, you see that the
possibilities are endless for wealth management. All aspects of art and collectibles should be integrated into
client discussions, lest those conversations occur in the future at a competitor’s office.
Additionally, entertainment and social events frequently center on art and collectibles, adding the
emotional touch. Banks and wealth management firms have long supported the arts and offer events as part of
corporate sponsorship and patronage. Frankly, these events both target the people with money to invest and are
ways to show mutual interest. Wealth managers can create goodwill by inviting clients to events with an art
theme. Art fairs and lectures with art historians or museum receptions with participating artists are similar
examples of ways to solicit new clients and expand investment options for existing clients. Expanding the
conversation, creating educational opportunities and innovative awareness for the client, and the client
conversation continues to create value, which in the end is the wealth manager goal.
The Care, Management, and Disposition

of Art Assets
ART LENDING
Lending is a mainstay of the banking side of wealth management. Loans and deposits are a natural and basic
banking function. As a result, banking services should consider art lending. However, these transactions are
complicated by the ability and/or capacity of the lending institution to take possession of the collateralized art.
Works of art need careful transport, while the lending institution needs to be able to assume possession. With
that possession comes responsibility for protected facilities with secure access and monitoring. ftese details of
art lending create additional risks. An additional hurdle is that of the transfer of insurance liability, which can
sometimes derail an acquisition.
ESTATE PLANNING AND ART ASSETS

Estate planning often overlooks the consequences that occur when a tax clause is not structured properly.
Indeed, the wealth manager often does not pay attention to or get paid for anticipating “what could go wrong.”
Often, also,the client may not reveal his or her complete holdings to the attorney or wealth manager. Whether by
accident or not,
tangible personal property such as art sometimes disappears without a documented chain of ownership. In
that case, conflict may arise among heirs.
Several key areas, including valuation, taxation, inheritance, and succession planning, need to be
incorporated into the estate planning when art or collectibles are involved. For instance, the planning
should consider a cost/benefit analysis of gifting options versus bequests. Valuations should be considered for
successive generations when determining the possession and control of the art alongside the rest of the finan-
cial wealth. Each of these areas of expertise are well documented within the subject matter of income and
estate taxes, yet too often wealth managers do not want to stretch the conversation with their clients to
include these topics.
MANAGEMENT AND REPORTING

If the client is busy collecting art, then who takes responsibility for the management and reporting of those
assets? fte wealth manager could and should assume that role. fte wealth manager then integrates the collection
or collectibles into a comprehensive asset management and reporting structure. When performed correctly and in
timely manner, the reporting structure can create dependency on the wealth manager; indeed, providing
periodic and ongoing valuations should be on every wealth manager’s task list.
Is the wealth manager in the best position for providing an unbiased service? Or, in the ever evolving
and innovating world of online services, are dot.com providers more apt to provide this service? New tools
are being created and improved for tracking inventory, pricing, and insurance. Are wealth managers prepared
to evolve with the industry that is currently outside their regulatory bias? Can they remain current within the art
world that compliance has yet to recognize? fte core services of an art advisory might be best left to those with
subject matter expertise. ftis area is one in which clients often come to the table with their own
specialist or expert.
Art investment funds tend to be outside the traditional realm of wealth management, but they are an
excellent option for those who want to own art, albeit indirectly. Much of the funding for the arts comes from
non-U.S. sources. Many service providers and collectors believe that wealth management firms should be
offering these funds, or at a minimum, be able to comment and advise on their suitability, as well as their
strengths and weaknesses. Keeping abreast of developments within the art world should be a key job of wealth
managers, if for no other reason than for basic business development.
ART AS AN ASSET CLASS

Should art be considered a separate asset class? Many say yes, although it does not fall within the guidelines of
the Securities and Exchange Commission (SEC). Some wealth advisors avoid the subject for fear of not
understanding how to assimilate art into a client’s portfolio. Compliance issues such as the lack of regulatory
oversight by the SEC are raised when an art balance sheet item is listed on the same page and is financially pre-
sented by a wealth manager in the context of a portfolio of traditional investments. Also, the art and art market
continue to be unregulated. fte risk of a wealth management firm dealing with a largely unregulated industry
and products remains a major concern and seemingly a barrier to entry for purposes of advising clients.
However, for those willing to move into this field, there are numerous art indexes providing within
their own parameters some estimates and measurements of the correlation of returns for purposes of
financial decision making. fte Mei-Moses index, which is available at www.artasanasset.com, is but one
example. fte question for wealth managers is “How does the client’s art collection correlate with the cur-
rent investment portfolio?” Most wealth managers have difficulty responding with a coherent answer.
fte failure to provide a coherent response is not because no answer exists; rather, it is because internal
compliance restricts their doing so. Art as investment is complex in nature. By its very nature, wealth managers
must recognize the heterogeneity of the asset class. Yet, art can be an important consideration in any portfolio
diversification strategy. For wealth managers to be able to present clients with a balanced portfolio, they
must explain how art fits into that client’s portfolio and the role it plays in an asset diversification strategy. As
the value of fine art continues to increase, it has become an increasingly important portion of some clients’ total
net worth. Traditionally, assets are measured for their total return within acceptable levels of risk
tolerance.
The Influence of Social Media

on Wealth Management
Knowledge ownership has transitioned from research and text to Internet-based searches that are
available to almost everyone. Technological advances have led to a shift in decision-makingprocesses.
Knowledge, trust, and service are still critical components for the wealth management process, but they
are being replaced by information on social media outlets. Such outlets have become a common commodity
that can be easily acquired or searched. Knowledge, trust, and service have largely been relegated to another
easily accessible “commodity.” Pre-social media, those who taught, studied, and learned largely con-
trolled the knowledge and had the subject matter expertise. Experts went to class, studied hard for long hours,
earned a degree, and passed examinations. ftey got paid to share their knowledge with the public at large. In a
similar fashion, trust was the product of long relationships, contacts, affiliations, and associations. People
earned trust over time. Clients appreciated service, which was unique just like the delivery channel. Great
service earned a star, a rating, and feedback.
ftis environment changed with the entry of social media. During a relatively short period, that knowledge
or subject matter expertise was transformed from a protected, valued, and precious resource into a simple,
easily obtainable commodity. fte conversation and related research still takes place online, or may require
multiple searches with coordinated follow-up. ftink of the devices and services that can be done individu-
ally or with a smartphone. What started as a “simple” industry has exploded within the online world. fte
technologies are new and were virtually nonexistent five years ago. Transparency has improved and the
opportunity for growth, expansion, and innovation is now largely limitless.
fte most important aspects of this evolution, innovation, and revolution are the ability for increased
awareness, access, and interest, as well as the passion for social media. When it comes to a desire to acquire art,
most desires, addictions, and art afflic- tions are only a click away, and all are within the convenience of a
smartphone, tablet, or computer. Clients today are finding, learning, and challenging what was unattainable
only a few years ago. For example, even within the confines of social media websites such as LinkedIn, there
are numerous discussion groups sharing information, posting articles, and allowing for member-to-member
communications that can only continue the process of “shrinking the world” as it relates to online access,
communication, and data retrieval.
So why do typical wealth advisors fail to use these sources of data to benefit their clients? Initially, the
answer involved an issue of compliance and its related formalities. Compliance officers neither saw nor had a
business-development reason to see a causal association between information on art and a lasting client
relationship.
PREVIOUSLY LOCAL IS NOW GLOBAL— ART WORLDWIDE

Globalization is an often a misinterpreted and misunderstood term within the context of art and collectibles.
Investments in one country may be unacceptable within the confines of another state or jurisdiction.
Completing a transaction across geographical markets can increase the risk, and these risks can present
themselves in forms including legal jurisdiction, title, and authenticity, not to mention rights and their
enforcement. Such associated risks are similar to those that apply to the world of wealth managers and their
related investment portfolio managers.
Current technology has increased people’s access to art. What was once limited by geography, cost, and
access is now practically attainable by all through technology. A need to see, touch, and discuss art in order to
understand it remains, but the images, events, and experience can now be shared and used to educate the client
experience. To stay ahead of the curve, wealth managers need to be even more knowledgeable—or at a
minimum, be able to reach out to clients instead of waiting to react and respond to questions.
As the infrastructure and the tools of the Internet continue to increase at an fast pace, keeping up with
globalization will become more difficult. Although the art market will always innovate and disrupt, it
presents even better opportunities for wealth managers to show leadership in their client relationships. E-
commerce now allows crossing borders with ease, but it also creates its own set of issues that existed with the
local art dealer. fte client can go from dealer to dealer “across the globe” with a point and click.
So how do wealth managers provide leadership for their clients? ftey do so by recognizing their
needs and current reality as well providing guidance. Consider the issues of differing legal jurisdictions,
authenticity, condition, defective title, rights, and enforcement. Additional issues include import, export,
value added taxation, and the moving the art, which as mentioned earlier involves shipping, packing, and
storing, as well as a cost-benefit analysis. Each of these items represents an opportunity to lead and
guide the conversation through obtaining applicable knowledge, which creates a greater value added
opportunity to service clients.
Online Art Education

With the continuing advancement and creation of online education, new and established art and collectible
followers, just like those within the wealth management arena, can now be educated without limit. fte key to
success is the ability to be interactive, with an emphasis on media. Point-and-click solutions allow
seemingly limitless possibilities. ftis change is positive, but can also be daunting. fte only limit to what can
be offered online is that which exists within and the constraints of current business models and regulators.
Given the ability, intent, and interest of universities, museums, public institutions, and individuals to
educate online, the initiative has great potential. fte explosion of online tools will continue to strengthen the
infrastructure used to supply information, including art information. ftink of the number of art indexes, news
sites, pricing databases, and analytical tools that already exist and continue to be created or discovered.
Individuals who travel to a website often observe a separate tab or page dedicated to “helpful links” or
“useful tools” or some other descriptor. Build the connectors/ links and they will follow. Wealth
managers need to work more closely with outside/ online information, subject to the requisite compliance
limitations, and educational and industry experts so that their offering is the most complete offering. fte
only limitation is the self-imposed compliance-related restriction that the wealth management firm is not in
that business. Wealth managers should no longer see themselves as product providers but as problem
solvers, especially when it comes to art and collectibles.
Online Auctions and Other Marketplaces

As online auctions continue to receive increased investment attention, wealth managers should consider the
thought process as part of their deliverable for investments and connectivity. If the investment world is
attentive and the online auctions continue to grow, then the wealth client, especially the HNWs and
UHNWs, will want to know more. fte competition to provide data will increase.
New art marketplaces have been created out of the need for “virtual” brick and mortar sources. Online
consumers need to acquire art from online stores. It was only a matter of time before the click-and-buy
platform would be built in the art world. Yet, the online marketplace model is simply an intermediary. Go no
further than to recall how Black Friday morphed into Cyber Monday.
IS C2C THE NEW B2B?

Although business to business (B2B) was a once a priority, consumer to consumer (C2C) has the
potential to disrupt current business models. Entrepreneurs and traditional market players are now being
left out of the discussion. C2C is the newest way to eliminate the proverbial middleman who has been the
mainstay of how business was conducted previously.
C2C eliminates long-established relationships and enables consumers to work directly with other
consumers. It basically reduces costs, so that the service or product can be exposed and introduced to the
public. A community of participants thus is created that has been exposed to the opportunity to have
limitless interactions and communications with the world at large.
ftis new the competitive landscape opens avenues to those previously at a disadvantage. fte change
may be good or bad depending on the side represented. Coupling the C2C and B2B environments results in a
multidimensional thought process that can expand current thinking. Meanwhile, the B2B can fix and patch
what the C2C may be unable to initially identify and make professional adjustments. For example, the busi-
ness broker can expand on the transaction options where the initial consumer may not.
E-commerce
fte role of e-commerce within the art community continues to evolve and expand similar to other businesses
that are looking to expand their client base beyond the traditional geographic and connect-based models. fte
world is getting smaller but is also extending its reach. fte Internet and online activity have become the
general population’s answer to “How do I get there?” Individuals are no longer limited by geography, finance, or
even language. ftey can find, obtain, and explain almost anything within a category of subject matter by
searching the Internet.
Better Tools Mean Better Data

Fee structure presents challenges for both wealth firms and innovative online ideas. For some services, such
as consultation and information services, subscription fees for different levels of participation are possible.
Wealth relationships should embrace the opportunity to know the location of such services, how they exist,
and the best way to include them within their wealth platform offering. If a client can gain access to better tools
for data management, wealth managers should become aware and begin to interact accordingly.
ONLINE B U SIN E SSES AND T RAN SPA RENC Y

fteonline business world for markets and service providers is transforming the creation, delivery, and
application of knowledge, as well as some services, into a commodity- based product that continues to lose
its intellectual advantage. Entry of online businesses into business models that have been based on high
profit margins and lack of transparency continues to grow, as evidenced by the innovative ways that new
products and services such as inventory tracking are created and delivered. fte online platform has less
overhead and reduced transaction costs. ftis fact should enable this platform to compete with established
businesses and models.
Increased transparency in the form of increased education and access is here to stay. More people are
sharing more information about more art, especially at the lower and mid-ranges of the art market. ftis change
does not mean that all information will become available to everybody all the time. fte more expensive
auction houses and private transactions will not become accessible to the general population.
As more information becomes available online by more people from more global geographies,
additional information will be shared among people. ftus, wealth managers cannot cite lack of
transparency as a limiting factor. ftis change continues to reinforce the need for wealth managers to grow
past the biases and blockers that limit their participation with clients to bring art services and consulting into
their wealth platforms.
COLLECTION MANAGEMENT TOOLS ARE REALLY WEALTH

TOOLS
Given that liquidity is part of many business models, it should also be part of every art model or
collection. Online services and access to information and data can only expand the reach to find and acquire
new clients and new art. New clients would necessarily mean a growing market share and growing
revenue.
Collection management tools such as inventory tracking and online education should be priority
items or very soon to be items for integration into the wealth advisory service offering. Most tools are cloud
based and are part of a quickly expanding art service, art support business model that can be used as a lead to
other art related services or as a protector for current client based businesses. Helping clients collect and benefit
from the accumulation and access to all information about everything he owns allows for greater prediction
of the next steps with some relative ease.

To meet fiduciary approaches to the wealth management, wealth managers must determine how best to collect
and disseminate information about art to their clients. Some may want to say that the fiduciary standard does
not apply unless it falls within specific regulatory facts and circumstances. In today’s world of social media
overload and the accompanying ability to access almost anything at any time, wealth managers can no longer
hide behind the curtain of convenient unintelligence when managing wealth, especially when the wealth
includes art.
1. Explain how passion plays in a portfolio containing art.
2. Elaborate on how a client might view adding art as an asset class to a current portfolio.
3. Discuss the role of risk mitigation for art investments.
4. Discuss the role of social media in information dissemination as related to art.
5. Justify the increasing use of “commodities” as a term to describe holdings.
REFERENCES
Agnello, Richard J. 2002. “Investment Returns and Risk for Art: Evidence from Auctions of American Paintings.”
Eastern Economic Journal 28:4, 443–463.
Apostolou, Menelaos. 2011. “Why MenCollectftings? ACase StudyofFossilised Dinosaur Eggs.”
Journal of Economic Psychology 32:3, 410–417.
Baker, Stacey Menzel, and James W. Gentry. 1996. “Kids as Collectors: A Phenomenological Study of First and Fifth
Graders.” Advances In Consumer Research 23:1, 132–137.
Beggs, Alan, and Kathryn Graddy. 2009. “Anchoring Effects: Evidence from Art Auctions.” American Economic Review
99:3, 1027–1039.
Belk,RussellW.1995.“CollectingasLuxuryConsumption:EffectsonIndividualsandHouseholds.”
Journal of Economic Psychology 16:3, 477–490.
Carey, Catherine. 2008. “Modeling Collecting Behavior: fte Role of Set Completion.” Journal of Economic
Coffman, Brett A., and Robert J. Nance. 2009. “Wine: fte Illiquid Liquid Investment Asset.” Journal of Financial
Planning 22:12, 61–70.
De Silva, Dakshina G., Rachel A. J. Pownall, and Leonard Wolk. 2012. “Does the Sun ‘Shine’ on Art Prices?” Journal of
Economic Behavior and Organization 82:1, 167–178.
Dimson, Elroy, and Christophe Spaenjers. 2014. “Investing in Emotional Assets.” Financial Analysts Journal 70:2, 20–
25.
Grable, John E., and Chen Xuan. 2015. “Collectible, Investment, or Both: Evaluating the Attractiveness of
Collectible Stamps.” Journal of Financial Service Professionals 69: 5, 78–87.
Haley, M. Ryan, and Lee Van Scyoc. 2010. “Adverse Selection, Seller Reputation and Buyer Insurance in Online
Auctions for 1960s-Era Collectible Baseball Cards.” Applied Economics Letters 17:13–15, 1341–1345.
Matheson, Victor A., and Robert A. Baade. 2004. “‘Death Effect’ on Collectible Prices.” Applied Economics 36:11,
1151–1155.
McAlister, Anna R., and T. Bettina Cornwell. 2012. “Collectible Toys as Marketing Tools: Understanding
Preschool Children’s Responses to Foods Paired with Premiums.” Journal of Public Policy & Marketing
31:2, 195–205.
McIntosh, William D., and Brandon Schmeichel. 2004. “Collectors and Collecting: A Social Psychological
Perspective.” Leisure Sciences 26:1, 85–97.
Mei, Jianping, and Michael Moses. 2005. “Vested Interest and Biased Price Estimates: Evidence from an Auction
Market.” Journal of Finance 60:5, 2409–2435.
Newman, George E., Gil Diesendruck, and Paul Bloom. 2011. “Celebrity Contagion and the Value of Objects.” Journal of
Consumer Research 38:2, 215–228.
Nordsletten, Ashley E., and David Mataix-Cols. 2012. “Hoarding versus Collecting: Where Does Pathology Diverge
from Play?” Clinical Psychology Review 32:3, 165–176.
Primm, Eric, Nicole L. Piquero, Robert M. Regoli, and Alex R. Piquero. 2010a. “Racial Bias in Baseball Card
collecting Revisited.” Social Science Journal 47:4, 865–874.
Primm,Eric,Nicole L.Piquero,Robert M.Regoli, andAlexR. Piquero.2010b.“fte Role of Race in Football Card Prices.”
Social Science Quarterly 91:1, 129–142.
Regoli, Robert M., Eric Primm, and John D. Hewitt. 2007. “Where o’ Where Did My Baseball Cards Go?: Race,
Performance,andPlacementintheToppsERA,1956–1980.”Social Science Journal 44:4, 742–750.
Zorloni, Alessia, and Willette, Randall. 2014. “Managing Art Wealth: Creating a Single Family Office ftat Preserves
and Protects the Family Art Collection.” Journal of Wealth Management 16:4, 9–17.
Part Six
MARKET EFFICIENCY ISSUES

24
Behavioral Finance Market Hypotheses
ALEX PLASTUN
Associate Professor
Ukrainian Academy of Banking
Introduction
No single approach exists to explain the role of behavior in the financial markets. fte existing concepts are
not only contradictory but also based on different assumptions. For many years, the dominant economic
theory that attempted to explain the behavior of financial markets was the efficient market hypothesis
(EMH) (Fama 1965; Samuelson 1965). Fama (1965) points out that an efficient market is one in which the
availability of information on current market prices corresponds with the intrinsic value of the asset. However,
the many inconsistencies between the EMH and empirical observation led to the development of the
behavioral finance market hypotheses. Behavioral finance does not assume the rationality of the investors,
whichis abasic assumption of the EMH, with empirical evidence to support this stance.
De Bondt and ftaler (1985) show that investors overvalue recent information and undervalue past
information, resulting in market mispricing. Black (1985) introduces the concept of noise traders—irrational
investors whose trades are not based on sound logic. ftese irrational investors can cause prices to deviate from
their true value. Ijiri, Jaedicke, and Knight (1966) provide another reason for the irrationality: a habitual
response to a familiar stimulus (termed functional fixation). As Mandelbrot (1972) shows, prices in the
financial markets are not random, and he provides evidence of price persistence.
ftis chapter offers a synthesis of research on the behavior of financial markets and discusses the most
popular behavioral finance market hypotheses. fte first section explores the EMH, including its basic
assumptions and key provisions, as well as presenting a short literature review. Also discussed is the random
walk hypothesis, which serves as the basis for the EMH. fte second section introduces behavioral financial
market hypotheses and explores Lo’s (2004) adaptive market hypothesis (AMH), with a view toward its
basic assumptions and practical implications.
fte third section presents the fractal market hypothesis (FMH), which is popular among practitioners.
ftis theory denies the randomness of the price dynamics and general rationality of the investors; instead, it claims
that financial markets are persistent and investors with different horizons are present in the markets. ftis section
also provides comparative characteristics of the EMH and the FMH. fte fourth and fifth sections then
examine one of the most popular anomalies of the EMH and theories based on
439
440 MARKET EFFICIENCY ISSUES
them—the overreaction and underreaction hypotheses. ftese sections present a brief description, supportive
empirical evidence, and some theoretical explanations of these overreaction and underreaction effects. fte
sixth section deals with the noisy market hypothesis (NMH), which divides investors into rational and
irrational investors, with noise explaining most of EMH anomalies. fte final section explains the functional
fixation hypothesis, which is based on a habitual response to a familiar stimulus, resulting in irrational
actions and decisions.
The Efficient Market Hypothesis

fte EMH is an economic theory that describes the behavior of financial markets. Work by Bachelier (1900) is
the basis for this theory, and both Fama (1965) and Samuelson (1965) independently formulated the EMH
hypothesis. Fama (1965) points out that an efficient market is one in which, owing to the availability of
information, current market prices correspond to an asset’s intrinsic value.
RANDOM WALK H YPOT HESIS

fte random walk hypothesis (RWH) led to the emergence of the EMH. According to the RWH, an asset’s
price at a given moment does not depend on its earlier prices. As a result, the study of past price changes is not a
way to determine the direction of future price movement.
Despite some controversy about this hypothesis (i.e., asset prices have a fundamental basis and are a
monetary valuation of these factors), the RWH has found support on both practical and theoretical levels.
Figure 24.1 models the dynamic process, using randomly generated prices. Figure 24.2 is a graph of daily gold
prices. fte two graphs are almost identical, yet such a situation is not unique. Similar examples can be found
for other assets when comparing their price dynamics with randomly generated graphs. ftis indirect
evidence offers support favoring the RWH.
Lo and MacKinlay (1987) reexamine the RWH, rejecting it for weekly indexes of
U.S. stock returns from 1962 to 1985. Moreover, Lo and MacKinlay (1999) observe that after the
publication of their research, several other studies also rejected the RWH.
EFFICIENT MARKET HYPOTHESIS: BACKGROUND

According to the EMH, all participants of financial markets are rational economic individuals who operate
under conditions of free access to information that allows them to accurately predict future prices. fte prices
of assets under these conditions are fully consistent with their intrinsic values, a position which prevents
abnormal profits in financial markets. ftus, markets in which prices of financial assets are equal to their
intrinsic values are absolutely efficient.
As one of the founders of the EMH, Samuelson (1965) notes that in an information- ally efficient market,
price changes cannot be forecasted, assuming they fully incorporate the information and expectations of all
market participants. According to Jensen
Behavioral Finance Market Hypotheses 441
40
30
20
10
0
1 75 149 223 297 371 445 519 593 667 741 815 889 963
–10
–20
–30
–40
–50
Figure 24.1 Randomly Generated Values. ftis figure shows the results of some randomly generated
dynamics with a probability of 0.5. fte horizontal axis displays the number of the experiment and the vertical
axis shows the cumulative result
of returns generation.
(1978), a market is efficient if, with respect to information set N, making economic profits by trading on
the basis of information set N is impossible.
ftus, greater market efficiency implies that price changes are more randomly generated by the market.
Indeed, the most efficient market is the one in which price changes are completely random and unpredictable.
ftis conclusion is based on the fact that price is a direct result of many actions of market participants
attempting to profit from information. ftat is, investors are constantly trying to use even the smallest
informational advantages to gain profits. In doing so, they incorporate information into those market prices
and quickly eliminate the profit opportunities that motivate their actions. If this situation occurs
instantaneously, prices should always fully reflect all available information. fterefore, no profits can be
obtained from information-based trading, because such profits have already been captured.
EFFICIENT MARKET HYPOTHESIS: ASSUMPTIONS AND

PROVISIONS
fte EMH is based on several key assumptions:
• All new market information is quickly and almost instantly reflected in the security prices.
• Only rational economic agents are acting in the financial markets.
• Financial markets exhibit perfect competition.
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646.440
641.680
636.920
632.300
627.540
622.780
618.020
613.400
608.640
603.880
599.120
594.500
589.740
584.980
580.220
575.600
570.840
566.080
561.320
556.700
2006 2 Oct 2006 6 Oct 2006 12 Oct 2006 18 Oct 2006 24 Nov 2006 30 Nov 2006 3 Nov 2006 9 Nov 2006 15 Nov 2006 21 Nov 2006 29 Nov 2006 5 Dec 2006
Figure 24.2 Gold Prices for ftree-Month Period, 2006. ftis figure is a candlestick chart, which shows a portion of daily gold prices (vertical axis) during October and November 2006
(horizontal axis). fte box is clear if the closing price is higher than the opening price, or is filled if the close is lower than the opening price. Source: MetaTrader Trading Platform.
Available at http://www.metaquotes.net/en/metatrader4.
• Expectations of market participants are homogeneous (i.e., all investors evaluate the likelihood of future
asset returns in the same way).
• Asset prices change according to the “law of a random walk.”
Based on these EMH assumptions, the following key provisions can be formulated: (1) market
prices equal the corresponding intrinsic values of assets; and (2) economic decisions that allow obtaining extra
profits are impossible. Empirical observations in the financial markets do not universally support the
assumptions that underlie the theory of efficient markets. fte same applies to the main provisions of the
EMH.
DIFFERENT FORMS OF THE EFFICIENT

MARKET HYPOTHESIS
fte presence of market anomalies and some practical inconsistencies in the basic theoretical assumptions of
the EMH have led to the emergence of three forms of market efficiency—weak, semi-strong, and strong—
based on different types of available information. fte weak form of efficiency (past price and volume
history) is freely available. fte semi-strong form of efficiency (public information) results from all
information that is publicly available, including past price and volume history of the market. fte strong
form of efficiency (private information) reflects all information from the previous groups, plus any inside
information not available to most market participants.
EFFICIENT MARKET HYPOTHESIS: PROS AND CONS

According to Jensen (1978), no other proposition in economics exists that has more empirical support.
Kothari and Warner (2007) study scientific publications that support the EMH. According to their analysis,
more than 500 publications in top economic journals confirm rational investor behavior and the efficient
response to new information. Nevertheless, empirical data from the financial markets show that the
assumptions underlying the EMH do not always correspond with practice. For example, as Ball (2009)
notes, the list of differences between observations and the EMH is long and includes both overreactions
and underreactions to certain information; extreme volatility and seasonal increases in returns; and yield
dependence on different variables, including market capitalization, dividend rate, and market rates. Although
the EMH had been the dominant economic theory explaining the behavior of financial markets, many
inconsistencies between the EMH and the empirical evidence led to the development of alternative
concepts and theories.
The Adaptive Markets Hypothesis

Based on dissimilar preconditions and assumptions, behavioral finance and EMH view the financial markets
differently. fte major variance is the assumption of rationality on the part of market participants. EMH
assumes participants are rational, whereby their financial decision is the optimal choice, whereas behavioral
finance assumes that
participants might exhibit semi-irrational behavior based on the notion of bounded rationality. Bounded
rationality is the premise that individuals are influenced by their tastes, values, past judgments, and limits
of their cognitive process, resulting in a satisfactory outcome.
Andrew Lo (2004) introduces a new theory that attempts to reconcile the EMH with behavioral
finance, called the adaptive market hypothesis (AMH). According to Lo (2004), irrationality can be
explained by the fact that individuals adapt to changing environments. fte basic idea of the AMH is the
application of evolutionary principles such as competition, natural selection, adaptation, and reproduction
to financial markets.
ftis idea is consistent with trading activity in the financial markets. No trading strategy can constantly
generate profits in the financial markets because those financial markets are always changing. For example,
innovations such as Internet trading have dramatically changed the behavior of financial markets. As a result,
investors need to constantly be searching for changes and evolve their strategies accordingly. fte evolu-
tionary idea of economic behavior is not new, however. For example, Wilson (1975) systematically applies
the principles of competition, reproduction, and natural selection to human social interactions. Sociobiology
is a field of scientific study based on the hypothesis that social behavior results from evolution, and it attempts
to explain and examine social behavior within that context. According to Wilson, evolutionary processes,
along with his sociobiology concept, depend on social behaviors such as altruism, aggression, fairness,
religion, morality, and ethics..
Whereas Wilson (1975) uses sociobiology to explain social behaviors, Niederhoffer (1997) applies
evolutionary theory to the behavior of financial markets. He considers financial markets as a unique
ecosystem, with herbivores (dealers), carnivores (speculators), and decomposers (distressed investors).
Similarly, Luo (1998) explores the implications of natural selection for futures markets. He argues that natural
selection allows for long-term survival in the futures markets because the irrational traders lose their money
and quickly leave the market. As a result, the best predictors of market movements generate better
decisions and the markets gain efficiency.
THE SPECIES FOUND IN THE FINANCIAL MARKETS

Lo (2004) expands on the previous research by formulating the AMH to show that prices reflect as much
information as are dictated by the combination of environmental conditions and number and nature of market
participants, or species in the economy. Species in this context are distinct groups of market participants,
each behaving in a common manner. For example, market makers, hedge funds, pension funds, and private
investors can be thought of as separate species. ftese species are neither perfectly rational nor completely
irrational; rather, they are bounded in their degree of rationality. ftey make choices based on past experience
and their perception of what might be optimal in a given situation, based on the concept of bounded
rationality. Lo (2004,
p. 22) describes the behavior of market participants: “Individuals make choices based on experience and
their best guesses as to what might be optimal, and they learn by receiving positive or negative reinforcement
from the outcomes.” Understanding of the environment, the nature of their species, and the prevailing species
types helps investors comprehend the market.
A keyinsight provided bytheAMH isthat market equilibrium is neither guaranteed nor likelytooccuratany
point of time. ftis is because the relationship between risk and reward changes over time. Different factors can
influence this relationship, including the relative sizes and preferences of various populations in the market,
which may include ecology and institutional aspects such as the regulatory environment and tax law. Shifts in
these factors over time are likely to affect any risk–reward relationship. For example, during periods of
uncertainty and instability, investors usually reduce the amount of risky assets in search of “safe havens,” and
they act rationally. But then there are periods of collective greed or fear, when bubbles form and crashes occur
and these are times when many investors act irrationally.
THE EVOLU T ION OF THE FIN A N C IA L MARKETS

Neely, Weller, and Ulrich (2009) use the foreign exchange (forex) market as their example to demonstrate
the evolutionary process of financial markets. fte authors analyzed excessive returns in the forex market, and
they show that the surplus returns of the 1970s and 1980s were real, not just the result of data mining. However,
these profit opportunities disappeared by the early 1990s for models based on filter and moving- average
rules. fte investment landscape is also changing. Lo (2012) contends that the environment of the last decade is
substantially different from that of the previous seven decades. He says that today’s markets are larger, faster,
and more diverse than at any other point in history.
fte degree of market efficiency depends on conditions that characterize certain types of financial markets. If a
large number of species fight for limited resources, the competition is high; in this case, markets such as the U.S.
stock markets or forex will be efficient or at least reasonably efficient. Yet, if the number of species is small and the
resources are abundant, some markets, such as emerging markets, can be inefficient. Environmental factors
including the number of competitors in the market, adaptability of market participants, and magnitude of
available profit opportunities influence market efficiency.
Another important aspect of the AMH is the presence of arbitrage or profit opportunities—the
possibility to beat the market. Profit opportunities are the result of market changes and evolution; however,
these opportunities are not constant and they disappear as traders exploit them.
fte AMH recognizes the existence of different forms of market dynamics: trends, cycles, “flats,”
bubbles, and crashes. Each of these forms requires different investment strategies. As a result, investment
strategies may perform well in some environments and poorly in others.
ADAPTIVE MARKET HYPOTHESIS: ASSUMPTIONS AND

PRACTICAL IMPLICATIONS
fte assumptions of the AMH are:
• Individuals act in their own self-interest, make mistakes, learn and adapt.
• Competition drives adaptation and innovation and natural selection shapes market ecology.
• Evolution determines market dynamics.
fte main implications of the AMH include the following:
• A relationship between risk and reward exists, but it is unlikely to be stable over time because
individual and institutional risk preferences are unlikely to be stable over time.
• Profit opportunities do exist occasionally.
• Investment strategies (based on technical or fundamental analysis) can perform well, but only in
certain environments.
• Asset allocation can add value byexploiting the market’spathdependence andsys- tematic changes in
behavior.
• Market efficiency is not an all-or-nothing condition, but is a characteristic that varies continuously over
time and across markets.
• fte primary objective of any market participant is survival, for which the catalysts are innovation and
the ability to adapt to market changes.
One of the most crucial differences between the EMH and the AMH is return predictability. According
to the EMH, return predictability is impossible, but the AMH accepts the possibility of it, based on
empirical observations. Kim, Shamsuddin, and Lim (2011) find strong evidence that changing market
conditions drive return predictability. Zhou and Lee (2013) cite similar conclusions that market conditions
influence return predictability and that market efficiency varies over time. Charles, Darné, and Kim (2012)
provide evidence favoring the AMH: the return predictability of foreign exchange rates occurs from time to
time, depending on changing market conditions. Todea, Ulici, and Silaghi (2009) analyze the profitability of
moving average strategies and conclude that their profitability is not constant in time; they also conclude that
the degree ofmarketefficiency variesthrough time, andthisevidence supportstheAMH.
More empirical research is required before the AMH can serve as a viable alternative to the EMH.
Additional findings will determine the evolutionary dynamics of financial markets and investor behavior
across time and circumstances. Nevertheless, the AMH helps to reconcile the EMH and behavioral finance,
explaining different anomalies of the EMH while not denying its entire hypothesis. For example,
Urquhart and McGroarty (2014) find that calendar anomalies support the AMH and that the AMH offers a
better explanation of the calendar anomalies than the EMH.
The Fractal Market Hypothesis

A basic assumption of the EMH is the randomness of pricing processes, based on the RWH and the absence
of memory in price movements. However, financial time-series patterns persist, including those of a short-
and long-term nature.
Mandelbrot (1972) is among the first to provide evidence of the persistence of long memory in the
financial markets. Later, Greene and Fielitz (1977) find long-term dependences in stock prices on the New
York Stock Exchange (NYSE). Booth, Kaen, and Koveos (1982) also report that some financial series have
long memories. Helms, Kaen, and Rosenman (1984) find long memory properties for the price of futures.
As a result, Peters (1991, 1994) proposes an alternative nonlinear conception of financial
Table 24.1 Comparative Characteristics of the Efficient Market Hypothesis and

the Fractal Market Hypothesis
Criterion EMH FMH

fte rationality Investors always act Investors choose strategies within
of market rationally and try to short-termorlong-term horizons
participants maximize their income. that are subject to psychological
factors, but investors do not always
act rationally.
fte degree of None of the market Equilibrium prices areformed as
competition in participants can a result of a combination of short-
the market significantly affect prices, term technical trading and long-
which equal the intrinsic term fundamental valuation.
value of assets.
Price distribution Prices are normally Markets can demonstrate a positive
distributed and show price correlation (indicative of a
Brownian motion. trend), a persistent series (more
often),anda negative correlation
or anti-persistent series (rarely).
Assumptions Price is the result of Price reflects the “intrinsic value”
about pricing collective rational only for the selected investment
assessments and reflects horizon and can be subjected to
the existing fundamental both fundamental and technical
information. analysis.
markets, called the fractal market hypothesis (FMH). fte basic assumptions of the FMH are the concept
of fractals (presence of patterns in price movements) and the existence of different investment horizons, in
which some investors make decisions based on short-term horizons while others base them on long-term
horizons.Table24.1 presents the main differences between the FMH and the EMH.
THE IMPORTANCE OF PERSISTENCE

According to the FMH, a key characteristic of the financial time series is persistence, which is the
characteristic of something that outlives the process that created it or the continuance of an effect after its
cause is removed. Persistence means that prices may not be random and that trends are typical for a
financial time series.
fte EMH excludes the application of technical analysis, whereas the FMH operates numerous indicators
that set the basis of its fractal technical analysis. Technical analysis, according to the FMH, can be an instrument
to predict future prices. ftat is, it offers arbitrage opportunities for extra profits from trading in the
financialmarkets.
One of the most applied aspects of the FMH is the presence of specific indicators for measuring the level
of market efficiency, such as the fractal dimension and the Hurst
exponent (Los 2003). It allows identifying markets with different levels of efficiency; an efficient market is a
special case of the FMH.
Analysts have examined the persistence of financial data time series for different types of financial
markets, such as stock markets, forex, and commodities, with mixed empirical results. For example, Greene
and Fielitz (1977), Peters (1991), and Onali and Goddard (2011) found statistically significant evidence of
long-term memory in the financial markets. However, Lo (1991), Jacobsen (1995), Crato and Ray (2000),
and Serletis and Rosenberg (2007) all conclude that the price fluctuations are random, indicating the absence
of long-term memory in the financial markets. Differences in methodology, time periods, and research
objectives can explain these different conclusions. Two other aspects of these differences are the instability of
both financial market behavior and a market persistence level (Mynhardt, Plastun, and Makarenko 2013;
Caporale, Gil-Alana, Plastun, and Makarenko 2014b; Oprean, Tănăsescu, and Brătian 2014).
The Overreaction Hypothesis

fte EMH states that prices in the financial markets are generated randomly. Yet, situations in the market
occur that cannot be simulated by random generation. For example, figure 24.3 shows that random
generation fails to display the patterns that took place between 2008 and 2010 in the U.S. stock market; this
illustrates an example of overreaction.
Since the 1980s, researchers have paid more attention to overreactions in the financial markets.
Overreactions are generally substantial deviations in prices of assets compared to their average (typical)
values during certain time periods.
A REVIEW OF THE LITERATURE ON OVERREACTION

As De Bondt and ftaler (1985) show, investors overvalue more recent information and undervalue past
information. ftis results in an anomaly in which portfolios with the worst (or best) dynamics during a
three-year period show the best (or worst) results during the subsequent three years. ftis anomaly led to the
formation of the overreaction hypothesis.
Various studies have examined the overreaction hypothesis. For example, Brown, Harlow, and Tinic
(1988), who analyze NYSE data between 1946 and 1983, reached conclusions similar to De Bondt and
ftaler (1985). Zarowin (1989) finds the presence of short-term market overreactions. Atkins and Dyl
(1990) reported overreactions in the NYSE after significant price changes in one trading day, especially in
the case of falling prices. Ferri and Min (1996) confirm the presence of overreactions by using S&P 500
Index data between 1962 and 1992. Larson and Madura (2003) use NYSE data between 1988 and 1998,
and also show the presence of overreactions. Overreactions in other stock markets have been
documented internationally, including those in Spain, Canada, Australia, Japan, Brazil, China, Greek,
Turkey, and Ukraine (Mynhardt and Plastun 2013). According to Clements, Drew, Reedman, and
Veeraraghavan (2009), the overreaction anomaly has not only persisted but also has increased since the
1990s.
Figure 24.3 Movement ofDJIA between2000 and2013.ftisfigureshowsthedynamicsoftheDow JonesIndustrialAverage (DJIA)Index(vertical axis) between 2000 and 2013 (horizontal
axis). Data between 2008 and 2010 illustrate an example of overreaction that took place in the U.S. stock market. Source: Historical Chart Gallery: Market Indexes. Available at
http://stockcharts.com/freecharts/historical/djia2000.html.
REASONS FOR OVERREACTIONS

According to the overreactions theory, the irrational behavior of investors results as overreactions to new
information. ftis leads to significant deviations in asset prices compared to their fundamental values. Table
24.2 shows the reasons for such overreactions, which can be psychological, technical, or fundamental in
nature.
If an overreaction results from a combination of psychological, technical, and other nonrational factors,
instead of being achievement of a new level of fair price, should those overreaction prices achieve
equilibrium at the end of the overreaction? Bremer and Sweeney (1991) demonstrate that after a very strong
negative price movement, there is a positive price movement, and this movement exceeds ordinary
movements. Analyses of negative daily changes exceeding 10 percent have shown that the next day those
prices increase by 1.77 percent, on average. ftis phenomenon can be explained by a fixation on profits (closing
the opened positions generates profits) and a reassessment of the information by investors.
fte overreaction hypothesis finds validity not only on the theoretical and empirical levels but also in
the realm of real trading. Lehmann (1990) and Jegadeesh and Titman (1993) find that a strategy based on
overreactions can generate abnormal profits. However, Caporale, Gil-Alana, and Plastun (2017), who
analyzed different financial markets, find that a strategy based on counter-movements after overreactions does
not generate profits in the forex and the commodity markets, but does remain profitable in the large-cap U.S.
stock market. fte authors identify a new anomaly based on the overreaction hypothesis, called the inertia”
anomaly, in which on the day after an overreaction, prices tend to move in the same direction.
The Underreaction Hypothesis

As explained previously, the overreaction hypothesis deals with an unexpectedly strong investor reaction to
certain events, with negative correlation in returns over the long run. ftus, contrarian movements appear after
overreactions. However, an opposite situation could exist in which investors show little reaction to an event
during its appearance but react actively in the next period. ftis phenomenon is a positive autocorrelation,
by which a positive change today leads to positive changes tomorrow, and vice versa, in short-term returns;
this is called the underreaction hypothesis.
Cutler, Poterba, and Summers (1991) and Bernard and Abarbanell (1992) both offer empirical evidence
supporting underreaction. ftey find that stocks with announcements of higher earnings earned higher
returns in the period after the announcements, which indicates that the market underreacts to earnings
announcements (information wasn’t incorporated at once—at the day of the announcement). Shleifer (2000, p.
427) states “the key idea that generates underreactions is that investors typically (but not always) believe that
earnings are more stationary than they really are.” Jegadeesh and Titman’s (1993) study of the underreaction
hypothesis find that stock returns are positively autocorrelated over a six-month horizon. ftey show that a
strategy of buying a portfolio of stocks with the highest positive return in the previous months (winners),
and selling those with the lowest returns (losers), can generate abnormal returns during
Table 24.2 Reasons for Investor Overreactions
Overreaction Description
Cause
Psychological • Investors act based on emotions (Griffin and Tversky 1992; Madura and
reasons Richie 2004).
• Purely psychological characteristics of investor’sbehavior are panic and
crowd effects.
• Representativeness effect: If a particular market or market sector is growing
rapidly over time, it forms a positive image among investors. Accordingly, investors
begintopreferassetsofthissector.
• Overconfidence and biased attitude: Investors often
overestimate their ability to analyze the market situation.
Technical reasons • Executionofstop-losses(“stops”).fteseareorderstoclose openedpositions
whenreachingacertainlevel oflosses(Duran and Caginalp 2007). Executing
stop-loss orders acts as a movement catalyst or accelerator andleads to
increasesinthe scale of basic movement and loss of control over its size. fte most
typical example of overreaction caused by stops execution is the collapse of the
Dow Jones Industry Average(DJIA) in1987 (Black Monday), when the DJIA
lost 22.6 percent of its value.
• Margin-call theory: In case of large and unexpected movement in the
market, a margin-call mechanism often comes into action, closing the most
unprofitable position of the client to release the margin (Aiyagari and Gertler
1999).
• Technicalanalysis methodology is based on the previous price fluctuations in
forecasts offuture prices. A widely heldbelief is that current movement in asset
prices can generate specific trading signals from various technical indicators that will
lead to massive operations/trading inthe current movement direction and will
strengthen it causing overreaction
Fundamental • According totheprice-ratiohypothesisproposed byDreman (1982),

reasons companies with low price/earnings ratios are undervalued. However,
few investors want to buy stocks of these companies because investors still have
strong memories of
previous negative attitudes toward these companies. Nevertheless, whennegative
newsofsuchcompaniesends andpositivenews becomes dominant, the demand
for shares increases, leading to abnormal movements. fte opposite situation is
observed for overvalued shares.
Existence of noise Irrational investors are those who make investment decisions on fragmentary
traders information and current price fluctuations.
Other reasons fte lack of liquidity in the market can cause situations when even a small number and
amount of transactions can lead to substantial price fluctuations ( Jegadeesh and
Titman 1993).
Source: Mynhardt and Plastun (2013).

the following months. fte authors explain this phenomenon as investors’ adapting to new information
(positive or negative) too slowly; as the result, there is a momentum effect. Chan, Jegadeesh, and Lakonishok
(1996) and Rouwenhort (1997) offer further evidence supporting the underreaction hypothesis.
REASONS FOR UNDERREACTION

A possible reason for the underreaction phenomenon is conservatism bias, which describes
investors who are anchored to previous information about a company or financial asset. When there is
new information, they view it in accordance with their prior stance. If this information is inconsistent with
their earlier views, they may even ignore it. As a result, an inappropriate reaction to fundamentals occurs. A
chance also exists that those investors might simply under-weight that new information, particularly a change
in dividend policies or surprised earnings.
Another psychological reason for underreaction is representativeness, which describes how investors can
see patterns in random processes. For example, investors might believe that earnings are more stationary
than they really are (Shleifer 2000). ftey draw conclusions about new information such as an earnings
announcements based on their interpretation of reality, which is not necessarily correlated with observation. A
third possible reason for underreaction involves different types of investors. Some investors might make
decisions based on fundamentals, whereas other investors might make decisions based on technical
analysis. Some use a short-term perspective, but others use a long-term perspective. As a result, different
investors make different investment decisions in the same situation: some might buy a certain asset because in
the long run it will rise and fundamental factors provide evidence favoring this action; others might buy the
asset because there are signs of a downtrend and the technical analysis indicators confirm this action.
Opportunities resulting from underreaction could generate profits or arbitrage, which is inconsistent
with the EMH. For example, Bernard and ftomas (1989) show that a trading strategy based on
underreaction generates positive returns. Frazzini (2006) builds an event-driven strategy based on
underreaction. Jegadeesh, Chan, and Lakonishok (1996) provide a comprehensive analysis of investment
strategies based on the underreaction and of evidence favoring the underreaction hypothesis.
The Noisy Market Hypothesis

A critical feature of the EMH is the assumption that all market participants are rational subjects. fte FMH
identifies at least two types of investors: those with a short-term orientation and those with a long-term
perspective. ftese different investment horizons can lead to different decisions.
Black (1985) introduces the concept of noise trading. In the financial markets, rational investors trade
on information, but noise traders do not. Shleifer and Summers (1990) further develop the concept. ftey
explain that noise traders are not fully rational and they base their decisions on their own beliefs or
sentiments. ftese beliefs and sentiments could be responses to pseudo-signals, such as following market
gurus and
forecasters, using technical analysis, believing they can identify price patterns, and other judgment biases such as
extrapolating from past prices. Typical features of noise traders are over-optimism and overconfidence. If
the beliefs of different noise traders correlate during a certain time, the aggregate demand for an asset can
shift, resulting in a price change. ftese price changes can then produce deviations from fair (true) values.
Summarizing the noise concept, Black (1985, p. 534) states: “Noise creates the opportunity to trade
profitably, but at the same time makes it difficult to trade profitably.”
Noise traders are important because they provide liquidity to the markets. fte effects of noise trading
generally are short term and possibly an increase in price volatility. If the number of noise tradersis sufficiently
large andthe direction of their actions is the same, though, price bubbles may appear; in this case, the effect may
become long term. Siegel (2006) classifies market participants using a different decision-making basis:
speculators and momentum traders, hedgers and insiders, institutional investors and banks, and others. Each of
these participants has reasons for its decision making, such as diversification, asset management, tax
optimization, speculation, and liquidity. As a result, many participants with different trading rationales can
influence prices, which can then result in deviations from fundamental values during certain periods.
Siegel (2006, p. A14) explains the noisy market hypothesis (NMH) as follows:
Prices of securities are subject to temporary shocks that I call “noise” that obscure their true
value. ftese temporary shocks may last for days or for years, and their unpredictability makes
it difficult to design a trading strategy that consistently produces superior returns. To
distinguish this paradigm from the reigning efficient market hypothesis, I call it the
“noisy market hypothesis.”
fte NMH can explain some anomalies of the EMH, including the size and value of anomalies,
overreactions, and underreactions.
One result of NMH development is a fundamental indexing investment strategy in which an investor
forms a portfolio using one or more factors—such as book value, cash flow, revenue, sales or dividends—
instead of a standard capitalization-weighted indexed approach where the weight of each stock in the index
is proportional to the total market value of its shares (Arnott, Hsu, and Moore 2005). fte NMH explains
why prices cannot always be at their true value: they may contain pricing errors, caused by “noise.” A
lingering question is how to measure both of these pricing errors and noise.
The Functional Fixation Hypothesis

Behavioral finance maintains that investors cannot be fully rational. Irrationality is caused by many
factors, with some clearly psychological in nature such as fear and greed, overconfidence, and anchoring.
ftese factors might lead to nonrational behavior that results in price bubbles, overreactions, underreactions,
and other anomalies.
Habit is certainly psychological aspect that can affect investor behavior. Habits are a result of an inability
to change behavior, even when a situation has changed. In the
academic literature, such a situation (termed a habitual response to a familiar stimulus) is called functional
fixation, first documented by Ijiri et al. (1966, p. 194):
People intuitively associate a value with an item through past experience, and often do not
recognise that the value of an item depends, in fact, upon the particular moment in time and
may be significantly different from what it was in the past.
Functional fixation can occur at all three stages of the decision-making process: input (source and form of the
information available to decision makers), processing (acquiring information, evaluating the relevance of
different items of information, and weighting the importance of specific items for the decision task), and
output (decision stage) (Ghani, Laswad, Tooley, and Kamaruzaman 2009).
CAUSES OF THE FUNCTIONAL FIXATION

Functional fixation is a direct result of the habits formed by work experience, familiarity with the technologies
used in the decision-making process, and personal characteristics such as gender, confidence and cognitive
style (Nouri and Clinton 2006). Decision makers mentally acquire knowledge of similar or related information
or situations, and they then tend to overlook information those situations. ftey also tend to assume that a
particular interest or practice is always treated similarly (Ghani et al. 2009). Functional fixation also occurs
when someone is unable to think in a different or adaptive way. Ambiguity is one of the more important
cause of functional fixation.
Ijiri (1967) summarizes the main reasons for functional fixation as follows:
• Lack of knowledge about a change in accounting method.

• Lack of timely feedback that would enable individuals to infer that a change has occurred.
• No expectation of a different payoff.
• Response in a manner consistent with induced expectations of superiors.
• Habitual response to information.
• Presence of ambiguity about the object.
FU NC TIONA L FIXATION IN THE FIN A N C IAL MARKETS

Functional fixation can be applied to the financial markets as an inability of investors to change their decision-
making process in response to a change in how the information they receive has been collected or presented.
Empirical evidence suggests that financial analysts and investors fail to adjust fully when there have been
changes in accounting methods that affect stock prices (Hand 1990; Sloan 1996; Maines and McDaniel 2000).
ftis reluctance to adjust yields differences in their evaluations of the same results.
ftere has been extensive discussion of the phenomenon of functional fixation and its accounting
implications in regard to investment (Hirst and Hopkins 1998; Maines and McDaniel 2000; Luft and Shields
2001;Libby,Bloomfield,andNelson2002;Ghani
et al. 2009). Findings show that investors exhibit functional fixation when they compare financial statements of
firms using different accounting policies. Many years ago, May (1932, p. 337) describes this situation as
follows:
We accountants know how varied are the methods commonly and legiti- mately employed,
how great the effect of a difference of methods on the earnings of a particular period may
be… . Investors give the same weight to profits of companies in the same business without
knowing whether the profits to which their calculations are applied have been computed on
the same basis or how great the effect of a difference in method might be.
Hand (1990), who proposes and tests the extended functional fixation hypothesis (EFFH), offers
another view of the concept. For Hand, the EFFH states that investors might react to certain information in a
manner consistent with the EMH (as a rational investor) or in a manner consistent with functional
fixation.
POTENTIAL SOLUTIONS TO FUNCTIONAL FIXATION

Possible solutions to overcome functional fixation are as follows:
• Providing instructional learning (Luft and Shields 2001).

• Using an appropriate format for presenting information (Anderson and Kaplan 1992; Ghani et al.
2009).
• Usingsearch-facilitatingtechnologies(Hodge,Kennedy,andMaines2004).
Functional fixation may lead to mispricing in the financial markets. As a result, investors who understand a
company’s real situation, and are not influenced by functional fixation, can trade better than those ones who
are “functionally fixated.” Functional fixation might also lead to anomalies in the financial markets, such as
overreactions and underreactions.

fte EMH was a dominant economic theory explaining financial markets for many years. It influenced the
development of economic theory, such as modern portfolio theory, and the formation of financial markets,
such as exchange-traded funds. Yet, restrictive assumptions and empirical inconsistencies have led to
alternative hypotheses, and the most powerful among these is behavioral finance.
According to the EMH, investors are fully rational, yet a main postulate of behavioral finance is that investors
can sometimes act irrationally. ftat irrationality leads to market anomalies and other situations that are
inconsistent with the EMH. Various explanations these anomalies include differing investment horizons, presence
of short- and long-term memory in the financial markets, noise traders, adherence to habit, and other purely
psychologicaleffects.fte presenceofanomalieshas ledtothe developmentofdifferent
theories, concepts, and hypotheses to explain the markets and their behavior, including adaptive markets
hypothesis, fractal market hypothesis, overreaction hypothesis, underreaction hypothesis, noisy market
hypothesis, and functional fixation hypothesis.
ftese theories try to explain the empirical findings and cannot be viewed as a general theory of the
financial markets. Refuting a theory such as the EMH involves exploring alternative frameworks. Although
still popular, the EMH should be used only with great caution, because its assumptions and resultant anomalies
are inconsistent with reality. ftus, a need exists to develop a general economic theory that explains financial
market behavior.
Discussion Questions
1. Identify the necessary conditions for a market to be classified as efficient.
2. Discuss why no theory has emerged to fully replace the EFH.
3. Provide several examples to illustrate the evolution of the financial markets.
4. Discuss whether efficient markets exhibit return persistence and possible measures of market efficiency.
5. Explain whether the behavior of financial markets is consistent with theEMH.
References
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Anderson, John, and Steven Kaplan. 1992. “An Investigation of the Effect of Presentation on Auditors’ Non
Investigation Region Judgments.” Advances in Accounting Information Systems 1:1, 71–88.
Arnott, Robert, Jason Hsu, and Phil Moore. 2005. “Fundamental Indexation.” Financial Analyst Journal 61:2, 83–
99.
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25
Stock Market Anomalies
STEVE Z. F AN
Associate Professor of Finance
University of Wisconsin Whitewater
LIND A YU
University of Wisconsin Whitewater
Introduction
Equity anomalies are empirical relations between stock returns and firm characteristics that cannot be explained
by classical asset pricing models such as the capital asset pricing model (CAPM) (Sharpe 1964; Lintner
1965) or multi-factor models (Fama and French 1993; Carhart 1997). In other words, cross-sectional stock
returns are predictable by different company characteristics. Return predictability has become the heart of the
market efficiency debate and a focal point in asset pricing studies. In the traditional theory of market efficiency,
in which investors are rational and security prices incorporate all relevant information, a security’s price
equals its fundamental value. fterefore, only “surprises” can move a security’s price. Market efficiency predicts
a lack of predictability in future stock returns, yet the discovery of equity anomalies directly contradicts the
market efficiency theory. Not surprisingly, equity anomalies have become one of the most controversial topics
in financial research, with widespread disagreement on the underlying reasons for this predictability.
Recent literature usually attributes the existence of anomalies either to an inadequacy in underlying
asset pricing models or to market inefficiency. fte inadequacy in asset pricing models is usually called the
rational explanation. It builds on the traditional risk–return framework with assumptions that investors are
perfectly rational and the market is efficient. Anomalies are the consequences of shortcomings in current
pricing methods or of missing risk factors. Market inefficiency, then, attributes the existence of anomalies to
investors’ irrational behaviors and is referred to as the behavioral explanation. Within the framework of the
behavioral explanation, investors do not collect and/ or process available information rationally, because they
suffer from cognitive biases that result in mispriced securities. fte stock return predictability thus represents
systematic mispricing in the equity market.
Understanding these anomalies has become increasingly important in asset allocation, security analysis,
and other investment applications. Researchers have explored
460
Stock Market A n o m a li es 461
anomalies both in the United States and internationally. Hou, Xue, and Zhang (2015) examined 73 anomalies
spread over six categories—momentum, value versus growth, investment, profitability, intangibles, and
trading frictions—and compared their q-factor model to the Fama and French model. fteir results show that
their q-model outperforms the five-factor model (Fama and French 2014), especially in capturing price and
earnings momentum and profitabilityanomalies. Fan, Opsal, and Yu(2015), who exam- inedseveralanomaliesin
43countries,foundthatthe anomaliesexistin mostequitymar- ketsover a longtime period. Table25.1 summarizes
theseanomaliesaroundthe world.
Because the scope of studies in anomalies is massive, this chapter focuses on two main objectives in making
the topic manageable. First, the chapter reviews some well-known and widely accepted anomalies that have
been documented in the finance literature. ftese anomalies include investment-related anomalies, value
anomalies, momentum and long-term reversal, size, and accruals. ften, the chapter presents recent studies that
attempt to explain the existence of these anomalies, including rational and behavioral explanations for their
existence. fte chapter ends with a summary and conclusion.
Equity Anomalies
An anomaly is typically discovered from empirical tests. With the rapid growth in the amount of data and
computational power, there has been an explosion in discoveries of anomalies. Some researchers express
concerns about the “over-discovery” of anomalies and data snooping (Lo and MacKinlay 1990). Although
the concerns are legitimate, accumulated evidence seems to show that some anomalies are robust across equity
markets and occur during different time periods.
In a typical empirical test, a long–short trading strategy using portfolios formed on different company-level
characteristics would generate a positive abnormal return. ftis abnormal return could not be explained by current
asset pricing models. fte most frequently used models for anomaly empirical tests are the traditional asset pricing
models such as CAPM (shown in equation 25.1), multi-factor models such as the Fama-Frenchthree-factor model
(shown in equation 25.2), and four-factor models as shown in equation 25.3:
Rit  Rft  i  0 i RMt it 25.1
Rit  Rft  i  0 i RMt  1iSMBt  2 i HMLt  it 25.2
Rit Rft  i  0 i RMt  1iSMBt  2 i HMLt   3i MOMt  it 25.3
Foreachofthese,Rit Rft istheexcessreturnfromthelong–shorttradingstrategy.

In a test of anomalies, an abnormal return is usually represented by a significant αi and RMt, SMBt, HMLt,
and MOMt stand for the market, size, value, and momentum factor, respectively. Given that summarizing all
the discovered anomalies is a daunting
task, the next section discusses only some well-known and well-established anomalies in the literature,
including investment anomalies, value anomalies, momentum and long-term reversal, size, and
accruals.
Table 25.1 Summary Statistics for Abnormal Returns of Zero-cost Portfolios by Country and Anomaly
Country AG BM IA MOM NSI SIZE TA
H-L t-value H-L t-value H-L t-value H-L t-value H-L t-value H-L t-value H-L t-value
Australia 0.978 3.62 1.081 4.56 0.383 1.32 0.884 3.75 0.532 2.02 2.098 6.36 –0.079 –0.19
Austria –0.134 –0.31 0.837 1.98 0.246 0.58 0.938 4.16 0.438 1.58 0.09 0.32 0.44 0.76
Belgium 0.252 0.83 0.355 1.09 0.495 1.83 1.04 6.00 0.471 1.68 –0.222 –0.99 0.824 1.66
Canada 1.082 3.19 0.741 2.05 0.756 2.01 0.469 2.35 0.76 2.41 2.74 8.74 0.587 1.45
Denmark 0.666 2.60 0.875 2.91 0.528 1.91 1.057 4.96 0.428 2.00 0.835 3.39 0.578 1.97
Finland 0.617 1.41 0.858 1.86 0.088 0.23 0.814 2.67 0.269 0.87 0.549 1.77 0.115 0.31
France 0.942 3.48 1.044 3.71 0.329 1.01 0.815 4.07 0.419 1.84 0.716 3.81 0.468 1.40
Germany 0.936 2.71 0.73 3.48 0.818 2.31 0.932 4.30 0.579 2.54 0.564 2.34 0.926 3.05
Greece 0.725 1.81 1.103 2.56 –0.435 –0.73 1.212 2.57 0.336 1.15 1.203 2.10 0.444 0.37
Hong Kong 0.96 2.30 1.061 2.80 0.368 1.18 0.62 2.22 0.88 2.50 1.982 4.31 1.079 2.39
Ireland 0.485 0.99 0.68 1.52 –0.148 –0.31 1.018 3.34 0.115 0.22 0.545 1.19 -0.465 -0.57
Israel 0.006 0.01 1.57 2.06 0.259 0.50 0.725 1.75 0.91 1.37 1.685 4.04 0.066 0.12
Italy 0.058 0.24 1.234 4.79 –0.085 –0.29 0.844 3.66 0.414 2.67 –0.036 –0.14 1.098 2.69
Japan 0.303 1.71 0.607 3.28 0.064 0.37 0.033 0.15 0.309 2.12 0.631 2.59 0.111 0.51
Luxembourg 0.639 0.91 0.489 –0.84 0.761 0.83 0.447 1.44 –0.12 –0.24 0.073 0.17 –2.646 –1.83
Netherlands 0.334 1.01 0.628 1.88 –0.012 –0.04 0.953 4.30 0.888 3.43 –0.417 –1.91 –0.326 –0.65
NewZealand 0.14 0.30 0.581 1.10 0.057 0.16 1.055 2.70 0.069 0.17 0.44 1.09 0.449 0.93
Norway 0.088 0.23 0.823 1.95 –0.345 –0.88 1.047 3.81 0.55 1.73 0.523 1.53 0.41 1.05
Portugal –0.059 –0.11 2.097 3.45 0.21 0.45 0.129 0.46 0.376 1.28 1.476 3.49 0.642 1.33
Singapore 0.363 1.01 0.541 1.62 –0.038 –0.14 0.223 0.67 0.238 0.93 0.88 2.11 0.242 0.70
South Korea 0.344 0.97 1.798 3.97 0.693 2.18 0.232 0.65 0.96 3.64 1.208 2.19 0.428 0.89
Spain 0.069 0.22 0.527 1.89 –0.064 –0.23 0.865 2.43 0.146 0.73 0.229 0.74 0.238 0.22
Sweden 0.868 2.24 0.66 1.74 0.322 0.94 0.709 2.59 0.699 1.91 –0.105 –0.43 0.106 0.31
Switzerland 0.232 1.01 0.559 2.20 0.348 1.35 0.742 4.25 0.374 2.06 –0.138 –0.70 0.16 0.65
Taiwan 0.115 0.24 0.861 1.47 –0.016 –0.05 0.065 0.18 0.509 1.45 0.486 1.01 0.328 0.93
United 0.704 3.84 0.714 3.36 0.26 0.96 0.835 4.84 0.811 4.39 0.043 0.29 -0.151 -0.26
Kingdom
United States 1.305 2.19 0.936 2.07 0.13 2.19 1.036 4.67 2.686 1.70 2.44 7.17 2.16 1.76
Developed 0.501 6.55 0.85 11.04 0.238 3.34 0.719 11.59 0.47 7.85 0.671 10.18 0.327 3.36
Countries
Argentina 1.336 2.10 1.548 2.13 0.186 0.35 -0.298 -0.40 0.329 0.60 0.964 0.67 0.947 1.07
Chile 0.462 1.31 0.709 2.17 -0.15 -0.60 0.706 2.75 -0.067 -0.26 0.081 0.20 0.006 0.02
China 0.005 0.01 0.618 0.66 –0.949 –1.24 0.129 0.22 –0.106 –0.20 1.482 2.06 0.745 2.02
Egypt –0.88 –1.14 1.069 1.09 –1.40 –1.37 1.192 2.17 0.368 0.38 0.924 0.73 0.47 0.44
Hungary 1.824 1.53 3.929 2.73 1.669 1.40 0.526 0.88 1.069 1.10 3.101 2.42 –1.152 –1.01
(continued)
Table 25.1 Continued
Country AG BM IA MOM NSI SIZE TA
H-L t-value H-L t-value H-L t-value H-L t-value H-L t-value H-L t-value H-L t-value
India 1.231 2.33 1.474 2.52 1.224 3.38 0.482 1.03 0.242 0.66 1.319 1.65 0.419 1.23
Indonesia –0.655 –0.78 0.998 1.14 0.073 0.14 0.021 0.04 1.061 1.80 0.164 0.23 0.161 0.19
Malaysia –0.211 –0.78 1.173 3.37 0.219 0.95 0.463 1.26 –0.018 –0.07 1.045 2.33 0.088 0.11
Mexico –0.191 –0.34 1.299 2.23 –0.436 –1.10 0.689 1.46 1.2 2.47 –0.351 –0.80 –0.729 –1.04
Pakistan –0.304 –0.54 1.113 1.63 0.742 1.98 0.179 0.42 0.47 0.78 0.136 0.20 0.399 0.57
Peru 0.252 0.28 3.379 3.17 0.95 1.44 0.897 1.92 –0.277 –0.32 1.209 1.85 1.421 1.33
Philippines 0.757 1.24 2.193 3.38 1.109 2.23 –0.07 –0.14 0.36 0.81 2.13 3.06 –0.021 –0.03
Poland 1.016 1.33 2.183 1.93 1.365 2.94 1.523 1.68 –1.208 –0.60 –0.181 –0.19 1.237 1.64
South Africa 1.519 4.13 1.636 4.21 0.106 0.32 0.861 3.48 0.602 1.93 1.331 4.88 1.003 1.95
ftailand 0.471 1.30 2.028 4.66 0.197 0.79 0.101 0.29 0.014 0.04 1.334 2.99 1.307 2.91
Turkey 0.198 0.41 1.491 1.90 0.447 0.97 –0.571 –1.13 –0.199 –0.32 1.3 2.10 0.192 0.15
Emerging 0.375 2.45 1.608 8.80 0.316 2.38 0.43 3.34 0.271 1.67 1.051 5.34 0.346 1.76
Note: Table presents mean values of monthly abnormal returns and corresponding t values from the zero-cost strategy. In June each year t, we sorted all stocks in an ascend- ing order from the most overvalued to the most
undervalued into quintiles based on rankings of asset growth (AG), book-to-market (BM), investment-to-assets (IA), net stock issues (NSI), market equity (size), and total accruals (TA) in calendar year t−1. We calculated
equal-weighted portfolio returns from July of year t to June of year t+1. Following Jegadeesh and Titman (1993), we used the “6/1/6” method to construct MOM portfolios. “H-L” denotes monthly returns of the zero-
investment strategy (the high-minus-low portfolios—i.e., undervalued-minus-overvalued portfolios). fte sample period was between 1989 and 2009.
Source: Adopted from Fan et al. (2015).
Stock Market Anomalies 465
INVESTMENT ANOMALIES
Investment anomalies is a term referring to the stock return predictability from company characteristics
related to its investment activities. Studies report that companies with high investment activities earn lower
average returns than those with low investment activities. fte q-theory (Cochrane 1991, 1996) provides a
theoretical background of how investment can serve as a predictor for future stock returns. Many studies have
used that test and verify that company-level measures of investment indeed have a power to predict future
stock returns. ftese investment-related anomalies include asset growth (Cooper, Gulen, and Schill 2008),
investment growth (Xing 2008), net stock issues (Fama and French 2008), investment-to-assets (Lyandres,
Sun, and Zhang2008), and abnormal corporate investment (Titman, Wei, and Xie 2004).
Cooper et al. (2008) discover that companies with high asset growth earn lower aver-
agereturnsthanthosewithlowassetgrowth. fteyshowthatstandardrisk–returnmodels, including the conditional
CAPM, do not explain the effect. ftey also find that investors overreact to past company growth rates and the
asset growth effect is weaker in times of increased corporate oversight. Figure 25.1 shows the annual returns
from a buy-and- hold trading strategy for both equal-weighted (panel A) and value-weighted (panel B)
portfolios sorted by past asset growth rates. Watanabe, Xu, Yao, and Yu(2013) and Fan et al. (2015) both report
similar asset growth effect in international equity markets.
In their influential study, Loughran and Ritter (1995) document that returns after stock issues, whether as
an initial public offering (IPO) or a seasoned equity offering (SEO), are low. As Figure 25.2 shows, long-run
returns of nonissuers outperform the long-run returns of IPOs and SEOs (Loughran and Ritter 1995).
Pontiff and Woodgate (2008) report that share issuance exhibits a strong cross- sectional ability to
predict stock returns, and that its predictive power is more statistically significant than the predictive power
of size, value, and momentum. Fama and French (2008) define net stock issues as the annual change in the
logarithm of the number of shares outstanding. ftey find that companies issuing new equity underperform
those with similar characteristics; according to Fama and French, net stock issues are one of the most
pervasive anomalies. Daniel and Titman (2006) also show a negative relation between net stock issues
and average returns.
VALUE ANOMALIES
Value anomalies refers to findings that ratios of value-related accounting measures to market value can
predict future stock returns. fte book-to-market (BM) ratio is one of the most studied value anomalies.
Other value anomalies include earnings-to-price (E/P), dividends-to-price (D/P), and cash flow-to-price
(CF/P) ratios. Many studies show that high BM stocks (or those using other measures) earn higher average
returns than low BM stocks. Basu (1983) is among the first researchers to discover a value anomaly. He
found that companies with a high E/P ratio earn greater positive abnormal returns than companies with a low
E/P ratio. More recent studies of U.S. equities confirm that value stocks (i.e., stocks with a high BM ratio) on
average outperform growth stocks (i.e., stocks with a low BM ratio) (Rosenberg, Reid, and Lanstein 1985;
Fama and French 1992). Other studies find similar results in international equity markets (Fama and
French 1998; Liew and Vassalou 2000).
Panel A: Equal-weighted portfolios

200%
150%
100%
50%
0%
–50%
–100%
1968
1970
1972
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
1974
1976
Decile 10 (High growth) Decile 1 (Low growth) Spread (1–10)
Panel B: Value-weighted portfolios

200%
150%
100%
50%
0%
–50%
–100%
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
Decile 10 (High growth) Decile 1 (Low growth) Spread (1–10)
Figure 25.1 Time Series of Annual Return for Two Asset Growth Portfolios. In this figure, panel A plots
the annual buy-and-hold returns for equal-weighted portfolios. Panel B plots the annual buy-and-hold returns
for value-weighted portfolios. Portfolios are sorted by past asset growth rate, with decile 1 referring to firms with
lowest rate and decile 10 referring to firms with highest rate. Source: Adapted from Cooper et al. (2008).
Fama and French (1992, 1993) contend that value (as measured by the value of common stock) and
size are two risk factors missing from the CAPM. However, Daniel and Titman (1997) suggest that BM and
size are not risk factors in an equilibrium pricing model, because these characteristics dominate the Fama-
French size and BM risk factors in explaining the cross-sectional pattern of average returns.
MOMENTUM AND LONG- TERM REVERSAL

Momentum anomalies are perhaps the most famous in the equity market. Stocks that perform well in
recent months continue to earn higher average returns in future months
Annual percentage return
20
15
10
5
Non-issuers
0 IPOs
First Second Third Fourth Fifth
Year Year Year Year Year
Annual percentage return
20
15
10
5
Non-issuers
0 SEOs
First Second Third Fourth Fifth
Year Year Year Year Year
Figure 25.2 Comparison of IPO/SEO Annual Returns and Matching Annual Returns of Non-issuing
Companies. ftis figure shows the annual returns of initial public offerings (IPOs)and their matching firms(non-
issuers) (top)and the average annual returns
of seasoned equity offerings (SEOs) and their matching non-issuing firms (bottom). fte time period is from
1970 to 1990. All returns are calculated as the equal-weighted average buy-and-hold return during the next
year.
than stocks that perform poorly. Jegadeesh and Titman (1993) present a trading strategy that simultaneously
takes a long position in past winners and a short position in past losers to generate significant abnormal returns
over holding periods of 3 to 12 months. fte abnormal return is independent of market, size, or value factors.
Table 25.2 shows the returns of portfolios formed based on past returns. As Jegadeesh and Titman (2001) show,
the momentum effect continued into the 1990s after the anomaly’s discovery. ftis later evidence suggests
thattheiroriginalresultswerenotaproductofdatasnoop- ing bias.
As one of the most pervasive anomalies, momentum exists in most of the equity markets around the world
and has persisted during different time periods (Rouwenhorst 1998; Hou, Karolyi, and Kho 2011; Fan et al.,
2015). As Carhart (1997) shows, market, size, and value cannot be explained by the momentum factor. Since
the Carhart study, this four-factor model has become a widely accepted model to test market efficiency and
mutual fund performance. Table 25.2 demonstrates the momentum effect with the returns of the trading
strategy proposed in Jegadeesh and Titman (1993). It presents the average monthly returns of portfolios
formed basedonprevious six-monthreturns
Table 25.2 Returns of Portfolios Formed Based on Previous Stock Returns
All S1 S2 S3 Β1 Β2 Β3
P 0.0079 0.0083 0.0047 0.0082 0.0129 0.0097 0.0052

(1.56) (1.35) (0.99) (2.22) (2.92) (2.01) (0.95)
P2 0.0112 0.0117 0.0102 0.0098 0.0140 0.0128 0.0086
(2.78) (2.29) (2.54) (3.08) (4.38) (3.37) (1.83)
P3 0.0125 0.0152 0.0125 0.0105 0.0132 0.0133 0.0102
(3.40) (3.23) (3.34) (3.53) (4.59) (3.77) (2.28)
P4 0.0124 0.0163 0.0130 0.0105 0.0134 0.0128 0.0110
(3.59) (3.59) (3.58) (3.66) (5.02) (3.82) (2.50)
P5 0.0128 0.0164 0.0134 0.0109 0.0135 0.0135 0.0121
(3.87) (3.74) (3.83) (3.85) (5.14) (4.15) (2.86)
P6 0.0134 0.0174 0.0146 0.0102 0.0135 0.0142 0.0122
(4.14) (4.08) (4.22) (3.66) (5.23) (4.38) (2.92)
P7 0.0136 0.0175 0.0143 0.0109 0.0136 0.0142 0.0126
(4.19) (4.13) (4.12) (3.90) (5.09) (4.43) (3.01)
P8 0.0143 0.0174 0.0148 0.0111 0.0143 0.0146 0.0132
(4.30) (4.11) (4.16) (3.86) (5.12) (4.44) (3.15)
P9 0.0153 0.0183 0.0154 0.0126 0.0165 0.0156 0.0141
(4.36) (4.28) (4.11) (4.17) (5.34) (4.56) (3.28)
P10 0.0174 0.0182 0.0173 0.0157 0.0191 0.0176 0.0160
(4.33) (3.99) (4.11) (4.41) (5.17) (4.53) (3.50)
P10 − P1 0.0095 0.0099 0.0126 0.0075 0.0062 0.0079 0.0108
(3.07) (2.77) (4.57) (3.03) (2.05) (2.64) (3.35)
F-statistic 2.83 2.65 4.51 4.38 2.51 1.99 1.69
p-value (0.00) (0.00) (0.00) (0.00) (0.01) (0.04) (0.09)
Note: Table shows the average monthly returns of portfolios formed based on previous 6-month returns and held for 6
months. Portfolio P1 refers to an equal-weighted portfolio of stocks with the lowest past return decile. Portfolio P10 is the
equal-weighted portfolio of stocks with the highest past
return decile. S1, S2, and S3 stand for small, medium, and large firms, respectively. β1,β2,and β3stand for firms with small,
medium, and large CAPM betas, respectively.
Source: Adapted from Jegadeesh and Titman (1993).
and held for six months for different sample groups. As the table shows, the winning portfolios
outperformed the losing portfolios across all sample groups.
De Bondt and ftaler (1985, 1987) show that for portfolios of U.S. stocks formed based on returns for
the past three to five years, losers outperform winners by 25 percent for the next three years. ftis
phenomenon is called long-term reversal. Many studies corroborate the finding, such as Chopra,
Lakonishok, and Ritter (1992).
SIZE
fte size anomaly is among the earliest discovered anomalies. Banz (1981) and Reinganum (1981)
show that small market capitalization companies earn higher average returns than those with large market
capitalization. Fama and French (1992, 1993) report that the size combined with the BM ratio captures the
cross-sectional return variation. Griffin (2002) find that the size anomaly also occurs in international equity
markets. Hawawini and Keim (2000) report that researchers have observed the size anomaly during
many sample periods and in most equity markets across countries.
ACCRUALS
fte accruals anomaly refers to the negative relation between accounting accruals (the non-cash
component of earnings) and subsequent stock returns. As Sloan (1996) shows, investors fixate on
corporate earnings when valuing stocks. Owing to this bias, companies with high accruals earn lower
average returns than those with low accruals. Figure 25.3 shows the returns of the accrual strategy for a
sample of 40,679 company-year observations between 1970 and 2006, based on Sloan’s (1996) study.
Pincus, Rajgopal, and Venkatachalam (2007) extend Sloan’s study to international equity markets,
showing that the accruals anomaly exists in three other countries in addition to the United States
(Australia, Canada, and the United Kingdom). ftey also found that the accruals anomaly is likely to occur
both in common law countries and in countries allowing extensive use of accrual accounting and having a
lower concentration of equity ownership. According to Hirshleifer, Hou, and Teoh (2012), the
40
30
Hedge Portfolio Return (%)
20
10
–10
–20
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
Year
Figure 25.3 Returns of a Long–ShortPortfolios Formed on Accruals. ftis figure shows theannualreturnsof
a portfoliothat takes a longposition in thestocksoffirmsin the lowest decile of accruals and a short position in
the stocks of firms in the highest decile of accruals. Source: Adapted from Sloan (1996).
accruals anomaly persists and, even more strikingly, its magnitude has not declined over time.
Why Anomalies Exist

fte discovery of anomalies has generated numerous competing theories to explain their existence. Two main
ideas have emerged in the literature. fte first is the rational explanation, which builds on the foundation of
traditional risk–return tradeoff theory. ftat is, a rational explanation explains these return patterns as resulting
from shortcomings in the existing asset pricing models. fterefore, many studies strive to find better models or
additional risk factors. fte second theory attributes the return patterns to irrational investor behavior owing
to human cognitive biases. Indeed, behavioral finance has become a main stream of thought in modern
finance since its introduction more than 30 years ago. fte remainder of this chapter summarizes the current
research on these two types of theories.
THE RATIONAL EXPLANATION

Some notable models providing a rational explanation of the failure of the CAPM are the intertemporal
capital asset pricing model (ICAPM) (Merton 1973); dynamic asset pricing models (Hansen and Richard
1987); consumption CAPM models (CCAPM) (Rubinstein 1976; Lucas 1978; Breeden 1979); and multi-
factor models, including the Fama-French three-factor and four-factor models (Fama and French 1993;
Carhart 1997), liquidity factor model (Pastor and Stambaugh 2003), and investment-based model (q-
theory model) (Cochrane 1991, 1996; Hou et al. 2015).
fte ICAPM (Merton 1973) extends the CAPM by using a different assumption about investor
objectives. In the ICAPM, investors worry not only about their end-of- period payoff but also about the
opportunities they will have to consume or invest the payoff. Maio and Santa-Clara (2012) apply ICAPM
criteria to eight multi-factor models to test size and value effects. ftey show that only a small portion of their
tests is consistent with the ICAPM theory.
Financial economists have criticized the CAPM for its incomplete description of asset prices due to its
static nature, and consequently they have proposed a dynamic version of the CAPM. For example, Hansen and
Richard (1987) show that a dynamic version of the CAPM could be valid. Gomes, Kogan, and Zhang
(2003) develop a general equilibrium model that can capture the ability of the BM to describe the cross-
sectional stock returns. Avramov and Chordia (2006) propose a framework that allows a stock’s beta to vary
with company-level size and BM, as well as with some macroeconomic variables. ftey apply the framework to
test whether some well-known asset pricing models can explain the size, value, and momentum anomalies;
their findings show that none of the models examined captures any of the market anomalies with a constant
beta. However, when beta is allowed to vary, these models often explain the size and value effects, but not
the momentum.
Chen, Roll, and Ross (1986) propose a model to describe the cross-sectional stock return with five
macroeconomic factors. Since this influential study, many researchers
have developed various multi-factor models. In general, these factor models can be roughly divided into
models with macroeconomic factors and models with factors associated with company characteristics.
Pastor and Stambaugh (2003) investigate whether market-wide liquidity is a state variable that is
important for asset pricing. ftey found that expected stock returns are related to liquidity after adjusting
for exposures to market, size, value, and momentum factors. Sadka (2006) demonstrates that liquidity risk
is important for asset pricing anomalies. fte author decomposes company-level liquidity into variable
and fixed price effects, and find that unexpected systematic (market-wide) variations of the variable
component are priced within the context of momentum and post-earnings-announcement drift.
Fama and French (1993) suggest that cross-sectional differences in average returns are determined by
company size and BM, in addition to market risk. Fama and French (1996) show that, except for the
momentum effect, the impact of security characteristics on expected returns can be explained within a
risk-based multi-factor model. According to Vassalou and Xing (2004), the size effect is, in fact, a default
risk, and the BM effect is partially due to default risk. However, Daniel and Titman (1997) point out that
uncertainty still exists about whether risk factors or non-risk company characteristics explain expected
returns.
Zhang (2005) suggests that the value anomaly arises naturally in the neoclassical framework with
rational expectations. Owing to the reversibility and countercyclical price of risk, value assets are riskier than
growth options, especially when the price of risk is high. As Liu and Zhang (2008) show, temporarily higher
industrial production loadings (a macroeconomic risk factor) on winners more than losers primarily drive the
momentum anomaly.
Hou et al. (2015) develop an empirical q-factor model consisting of market, size, investment, and
profitability factors. ftey found that this model largely summarizes the cross-sectional stock returns, showing that
the model can explain about half of nearly 80 anomalies; the model outperforms the Fama and French (1993)
three-factor and the Carhart (1997) four-factor models in explaining anomalies. Using dynamic investment-
based models, Zhang (2005) captures the return patterns associated with the value anomaly. Wu, Zhang, and Zhang
(2010) show that capitalinvestment helps explain the accrual anomaly.
Despite great efforts and recent progress in the research, finding a rational risk-related explanation for
anomalies has proved difficult, hence various researchers offer a behavioral explanation. For more than 30
years, behavioral finance has accumulated enough evidence to prove that human behavior is a key component
in determining stock prices. fte next section summarizes recent developments in developing a behavioral
explanation of anomalies.
THE BEHAVIORAL EXPLANATION

Behavioral finance recognizes that investors have behavioral biases in collecting and processing financial
information, as well as in making investment decisions. ftese behavioral biases are pervasive and persistent,
and can introduce systematic mispricing in asset valuation. Because mispricing cannot be hedged away
owing to the limits of
arbitrage, various cross-sectional return patterns (anomalies) exist in the equity market. ftis section reviews the
limits of arbitrage and then discusses several important behavioral biases and their impact on stock
prices.
Limits of Arbitrage and Idiosyncratic Risk

fte behavioral explanation acknowledges that mispricing is not due to missing risk factors in the CAPM
model. fterefore, one would have to ask why these anomalies are not arbitraged away. Pontiff (1996, 2006)
and Shleifer and Vishny (1997) suggest that arbitrageurs bear both systematic and idiosyncratic risk.
Systematic risk is the risk attributable to market-wide risk sources. Idiosyncratic risk is risk that is specific
to an asset. Because idiosyncratic risk cannot be diversified away, it presents a high cost to arbitrageurs.
According to Shleifer and Vishny, rational investors do not drive away equity anomalies owing to this
cost (i.e., the limits of arbitrage).
In a review of the limits of arbitrage, Gromb and Vayanos (2010) point out that the study of limits
of arbitrage is evolving into an emphasis on the role of financial institutions and on agency frictions
for asset prices. fteoretically, arbitrage is the risk-free exploitation of opportunities when some assets
are overvalued relative to others. In a perfect market, these profit opportunities attract rational investors
to correct the market mispricing, with no requirement for capital investment and risk. However, in
reality, rational investors encounter constrains on implementing an arbitrage strategy.
Gromb and Vayanos (2002) study how leverage constraints prohibit arbitrageurs from eliminating the
mispricings and they provide liquidity to outside investors. Some consider institutional money managers as the
rational market corrector, but because of institutional constraints, most professional investors cannot sell
short. Nagel (2005) investigates how this short-sale constraint on institutional investors affects cross-
sectional stock returns, helping to explain cross-sectional stock return anomalies such as the value anomaly.
Other studies suchas Hirshleifer et al. (2011) alsoexplain short- sale constraints.
Shleifer and Vishny (1997) suggest that idiosyncratic risk plays an important role in limiting arbitrage
activities. Idiosyncratic risk is expected to be correlated with stock returns; however, considerable
controversy exists about the empirical relation between idiosyncratic risk and expected return. Some
studies report that the market does not price idiosyncratic risk (Bali, Cakici, Yan, and Zhang 2005;
Huang, Liu, Rhee, and Zhang 2010). Other studies document both negative (Ang, Hodrick, Xing, and
Zhang 2006, 2009; Guo and Savickas 2010) and positive relations (Goyal and Santa-Clara 2003;
Malkiel and Xu 2006; Diavatopoulos, Doran, and Peterson 2008; Fu 2009).
Some studies suggest that idiosyncratic risk should be priced. Because the relative supply of the
stocks that constrained investors cannot hold is high, the price of those stocks must be relatively low.
Therefore, an idiosyncratic risk premium can be rationalized for such “unbalanced supply.”
Additionally, if constrained investors cannot hold all securities, the “available market portfolio” for
unconstrained investors will automatically become less diversified (Malkiel and Xu 2006). The risk
premium of the “available market portfolio” would be higher than the actual
market portfolio in the traditional CAPM model; therefore, the market would price idiosyncratic risk.
Behavioral Finance
Many excellent survey articles are available on behavioral finance (Rabin 1998; Shiller 1999; Hirshleifer
2001; Daniel, Hirshleifer, and Teoh2002; Barberis and ftaler 2003;
Campbell 2006; Benartzi and ftaler 2007; Subrahmanyam 2008; Kaustia 2010). ftis section is not intended
to provide a full review of behavioral finance; instead, it focuses on the impact of some well-documented
human behavioral biases regarding stock returns. ftese biases include overconfidence and self-attribution,
limited attention, disposition effect, and investor sentiment.
Overconfidence and Self-Attribution

People are usually overconfident about their own judgments, feeling they are right subjectively rather than
objectively. De Bondt and ftaler (1995, p. 389) state that “perhaps the most robust finding in the psychology of
judgment is that people are overconfident.” Another human behavioral trait, self-attribution, is closely related
to overconfidence. Self-attribution describes how people tend to credit themselves for past successes, but
blame other factors for past failures. Researchers often use overconfidence and self- attribution to explain
various anomalies.
As Daniel, Hirshleifer, and Subrahmanyam (1998) show, investors over-weight their private
information (overconfidence) and underestimate their public information, owing to self-attribution. As a
result, investors overreact to private information and underreact to public information. ftis asymmetric
response of overconfident investors can explain momentum and long-term reversal in stock returns. As
Odean (1998) reports, overconfidence influences the financial market and causes investors to trade more
aggressively. Lakonishok, Shleifer, and Vishny (1994) provide evidence that value anomalies yield higher
returns because contrarian investors bet against the overpriced “glamour” stocks created by the suboptimal
behavior of typical investors (excessive extrapolation of past performance owing to overconfidence), and
not because these value stocks are fundamentally riskier.
Daniel, Hirshleifer, and Subrahmanyam (2001) offer a model that includes both covariance risk and
misperceptions of companies’ prospects. In this model, some investors overestimate stock information owing
to overconfidence; the overconfidence introduces pricing errors; the mispricing persists because arbitrageurs
are risk averse. fte authors show that their model can explain several well-known anomalies, including
value and size.
As Hribar and Yang (2013) show, chief executive officer (CEO) overconfidence affects
management forecasting, and this could be related to the accruals anomaly. Overconfidence tends to be
stronger when uncertainty is higher. ftis then implies that overconfidence would be stronger in stocks having
more valuation uncertainty. Jiang, Lee, and Zhang (2005) show that companies with high information
uncertainty earn lower future returns and the momentum effects are much stronger for these companies. fteir
findings agree with theoretical models from Daniel et al. (1998). fte evidence thus indicates that high
information uncertainty exacerbates investor overconfidence and limits rational arbitrage.
Limited Attention
Limited attention is the tendency of people to neglect salient signals and to overact to relevant or recent
news (Camerer, Ho, and Chong 2004). Hirshleifer and Teoh (2003) found that limited investor attention
leads to market underreaction.
Because attention is a scarce cognitive resource (Kahneman 1973), investors have to be selective in
processing information when they are making investment decisions, given the vast amount of information
available and the inevitability of limited attention. As Peng and Xiong (2006) show, investors focus on market
and sector-wide information more than on company-specific information, and this is known as category
thinking. fte authors model limited attention and study the impact of this limited attention on stock returns.
fteir model captures the return co-movement that is otherwise difficult to explain using standard rational
expectations models.
Hong and Stein (1999) and Hong, Lim, and Stein (2000) show that limited attention can explain the
momentum anomaly. ftey also find that momentum is stronger for low-attention stocks such as small stocks
and stocks with low analyst coverage. Limited attention, such as neglecting the distinction between accruals and
cash flows in earning components, could help to explain the accruals anomaly (Sloan 1996). As George and
Hwang (2004) report, a 52-week high stock price affects the behaviors of the company and its investors, and it
explains a large portion of the momentum anomaly. ftis finding is consistent with framing theory, a human
behavior trait showing that the way a concept is presented in words or numbers affects the decision-making
process of individuals. Hirshleifer and Teoh (2003) and Hirshleifer, Teoh, and Yu (2011) study the effect
of limited attention on how investors process accounting information and its impact on stock returns. ftey
conclude that both the value anomaly and the accruals anomaly result from limited attention more
than from risks.
Disposition Effect and Prospect Theory

fte disposition effect is the tendency of investors to sell assets that have risen in value rather than to sell
those that have fallen (Shefrin and Statman 1985). According to Odean (1998), no conventional
financial theories can fully explain the disposition effect. ftus, researchers have turned to prospect theory
for an explanation. Kahneman and Tversky (1979) initially proposed prospect theory, and Tversky and
Kahneman (1992) later extended it. Prospect theory describes investors’ behaviors in such a way that
they evaluate outcomes according to their perception of gains and losses relative to a reference point,
typically the purchase price. Within the framework of prospect theory, investors are more sensitive to losses
than to gains (loss aversion), and investors are risk-averse for gains and risk seeking for losses (diminishing
sensitivity). Researchers use the loss-aversion component of prospect theory to explain the historical high
equity premium (Benartzi and ftaler 1995; Barberis and Huang 2001, 2008a).
fte disposition effect can generate price momentum because it creates a gap between a stock’s
fundamental value and its equilibrium price. Because this effect could lead stock prices to underreact to
information (Grinblatt and Han 2005; Frazzini 2006; Birru 2015), recent past stock performance could
continue in the short term. Barberis and Huang (2008b) study asset prices in a one-period economy within the
framework of prospect theory. fteir model generated a new prediction that the market prices a security’s
skewness in the distribution of its returns. ftey show that the skewness
prediction from prospect theory can shed light on some well-known anomalies, such as net stock issues,
described earlier in this chapter.
Sentiment
According to Baker and Wurgler (2006), investor sentiment is the propensity to speculate. More
specifically, market-wide sentiment is the difference between the beliefs of sentiment-driven traders and
correct objective beliefs (Delong, Shleifer, Summers, and Waldmann 1990). Baker and Wurgler (2006) find
that the cross-sectional of future stock returns is conditional on beginning-of-period proxies for
sentiment. When sentiment is low, small stocks, unprofitable stocks, nondividend-paying stocks, high-
volatility stocks, extreme growth stocks, and distressed stocks tend to earn relatively high subsequent returns.
Stambaugh, Yu, and Yuan (2012) explore the role of investor sentiment in 11 equity anomalies in cross-
sectional stock returns. ftey find that each anomaly is stronger (i.e., its long–short strategy is more profitable)
after high levels of sentiment.

Equity anomalies have become an increasingly important topic in asset pricing. ftis chapter discussed
recent developments in this area and reviewed various investment- related anomalies, value anomalies,
momentum, long-term reversal, size, and accruals. fte discovery of anomalies has prompted the search for both
new asset pricing models and additional risk factors. ftese efforts have dramatically improved our
understanding of market efficiency and asset pricing. fte discovery of anomalies has also prompted study of
behavioral finance. As the ultimate executors in security trading, the behavioral biases of investors have a
profound impact on security valuation. fte many studies mentioned in this chapter show how investor
behavior plays an important role in explaining stock return patterns. fte findings suggest that an approach
solely relying on either a rational or a behavioral explanation fails to produce a completely convincing result.
Combining the approaches may be promising.
1. Explain equity anomalies.
2. Discuss the major explanations of why equity anomalies exist.
3. Identify some behavioral biases of investors that can be attributed to anomalies.
4. Define an investment anomaly and identify some documented investment anomalies.
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26
The Psychology of Speculation in
the Financial Markets
Assistant Professor in Financial Management
Goucher College
Introduction
ftroughout financial history, cognitive and emotional biases have driven investor behavior and
influenced the financial markets in the form of bubbles. A stock bubble occurs when a substantial divergence
exists between a financial asset’s current market price and its intrinsic value. A bubble is distinguished by an
extreme increase in the price or market of the financial security or asset, followed by a steep decline in price.
ftese episodes of severe volatility and extreme risk-taking behavior within the financial markets have a
detrimentalimpactoninvestment performanceandeconomicconditions.
According to traditional finance, excessive speculation in the form of bubbles should not exist in the
marketplace. Speculative behavior provides support against the efficient market hypothesis (EMH) espoused
by traditional finance theory. fte EMH is based on the premise that financial markets are efficient in the
sense that investors in these markets process information instantaneously and that stock prices completely
reflect all existing information (Ricciardi 2008a). Behavioral finance provides evidence for why
speculative bubbles occur in the financial markets.
ftis chapter discusses major cognitive and affective issues of behavioral finance that influence the
decision making of individuals and groups during times of speculation. fte first section offers a brief
presentation of aspects of speculative behavior in the financial markets. Next, the chapter examines several
psychological issues prevalent during bubbles, including overconfidence, herd behavior, group polarization,
groupthink, representativeness bias, familiarity bias, grandiosity, excitement, and overreaction and
underreaction to market prices. fte next section focuses on the aftermath of the financial crisis of 2007–2008
and the specific behavioral finance issues that investors exhibit for an extended time period after the catastrophe
event, such as the influence of economic shocks, anchoring, recency bias, worry, loss aversion, status quo bias,
and mistrust. fte last section offers a summary and conclusions.
481
A Brief History of Speculation

Speculation, bubbles, manias, and crashes such as the Tulip Mania in the 1600s, the South Sea Bubble in the
1700s, the Panic of 1907, the stock market crashes of 1929 and 1987, the Nifty-Fifty stocks of the early 1970s,
the Internet bubble (also called the dot. com bubble) of the late 1990s, and the financial crisis of 2007–2008
occur throughout financial history. For example, in reaction to the stock market crashes of 1929 and 1987,
the Dow Jones Industrial Average (DJIA) fell almost 12 percent on October 29, 1929, and nearly 23 percent
on October 19, 1987 (Schwartz 1995). ftese two stock market crashes illustrate the inefficiency of prices
and the irrational group behavior of individuals.
Bubbles occur in financial markets when there are dramatic and unsustainable price increases as a result of
overly optimistic and irrational excitement among investors. fte circumstances surrounding bubbles happen
in a similar fashion when markets have excessive price valuations above historical averages, such as the
overvalued Internet stocks of the late 1990s. For the financial crisis of 2007–2008, the DJIA exceeded 14,000 in
October 2007 and then declined to 6,600 in March 2009, representing more than a 50 percent decline in value.
ftroughout financial history, these speculative events often result when there is a new technology that people
claim will change the world (Ricciardi 2017). For example, new inventions and innovations such as airplanes,
automobiles, and radio underlay the stock market bubble of the 1920s. Another example is the Internet
economy of 1990s, during which new investment approaches emerged to grant value to Internet stocks with no
earnings profits or large losses. In the bubble stage of the Internet stocks, the investment approaches or tools of
the past no longer apply such as earnings performance or stock valuation models based on dividends or
earnings.
As Ricciardi (2010, pp. 143‒144) points out, a major reasonfor the financial crisis of 2007–2008 was that
traditional finance “embraced the complex innovations and exotic instruments of financial risk management
… which contributed to the September/ October2008financialcontagion.”ftishistoricepisodedemonstrates
theimperfections in the assumptions and theories of traditional finance and contributes to the increased
acceptance of behavioral finance. fte tendency in financial markets for bubbles and crashes is evidence of the
value of behavioral finance—because history often repeats itself. Bubbles appear in academic studies involving
laboratory experiments, not just in the real-world laboratory of financial markets. Laboratory experiments
conducted with stock market stimulations demonstrate the misjudgments and irrational behavior of subjects
during bubble and crash cycles, especially among novice investors and inex- perienced traders (Smith,
Suchanek, and Williams 1988). Bubble behavior also occurs among experienced traders and professional
investors. Interestingly, there is a learning curve before subjects start to change their irrational bubble behavior.
Caginalp, Porter, and Smith (2000) provide the following important finding from the academic literature
on stock market bubble experiments:
One of the replicable results from the experiments described earlier is that once a group
experiences a bubble and crash over two experiments, and then returns for a third experiment,
trading departs little from fundamental value.
The Psychology of Speculation in the Financial Markets 483
Whether in a laboratory environment or in real-world financial markets, individual biases and crowd
psychology are inherent in contributing to the repeated and frequent bad decision making that takes place
during speculative times.
Behavioral Aspects of Speculation

fte existence of speculative behavior in the form of bubbles happens based on a wide range of individual and
group biases evident within the financial markets. ftis section focuses on overconfidence, herd behavior,
group polarization, groupthink, representativeness bias, familiarity bias, grandiosity, excitement, and the
overreaction and underreaction of market prices.
OVERCONFIDENCE
Overconfident behavior is an important bias that occurs during highly speculative times in the markets.
Investors reveal overly positive views of their ability to control investment gains or forecast the
performance of financial markets. Many investors believe they are above average in their intellect, overall
judgment, and financial expertise (Ricciardi 2008b). According to Shefrin (2005, p. 6), “People who
are overconfident about their abilities think they are better than they actually are. People who are
overconfident about their level of knowledge think they know more than they actually know.” For
example, the historic bull market of the 1980s and 1990s created a long-term feeling of overconfidence,
optimism, and euphoria in which it was felt that stock prices would continue to increase forever. Adams
and Finn (2006,
p. 48) state:
From 1982 to 1999, the U.S. experienced an impressive bull market. Especially towards
the latter half of that time period, much of the growth in market equity was due to the
proliferation and rapid growth of technology and internet firms. As the Dow Jones Industrial
Average increased ten-fold over 17 years, the NASDAQ composite index, teeming with
tech stocks, increased thirty-fold.
A speculative case study of overconfident psychology is the Internet bubble of the late 1990s. First-time
investors were unaware of the market valuation of initial public offerings (IPOs) of the Internet stocks and
its connection with overconfidence, extreme enthusiasm, and the influence of crowd psychology (Ricciardi
2017). fte major causes for this speculative bubble were the availability of online trading accounts, excessive
margin loans balances, and the fascination of the general public and media with the fad of stock market
investing (Ricciardi 2017). fte Internet bubble burst and produced a severe bear market in the early 2000s.
In October 2002, the value of the NASDAQ Composite fell below 1,200 from its historic high of 5,100
during the bubble only two and half years earlier. ftis change was the equivalent to more than a 75 percent
downturn in stock prices during this period.
HERD BEHAVIOR
Another type of speculative financial behavior, herding or herd behavior explains how individuals in a group setting
interact devoid of a premeditated or an intended outcome. ftat is, people like to join a crowd of investors who
endorse their purchase and sell judgments for all types of financial assets, based on signals from the external
marketplace. Herding occurs when a group of individuals such as novice investors and investment experts all
make the same financial decisions based on a specific piece of information, while simultaneously ignoring other
important data such as financial news or new earnings releases by corporations. Siegel (1998, p. 230) describes the
herd urging as “it’s better to fit in with the crowd―even if the crowd is wrong―than to risk being off on their
own.”
People who experience specific behavioral issues such as overconfidence, representativeness, excessive risk-
taking behavior, anchoring bias, and negative emotions tend also to enhance the herding influence within groups
(Ricciardi 2017). ftis herding behavior even amplifies the biases of individual investors to higher levels of
extreme behavior. As Norton (1996, p. 43) states, “the herd minimizes risks and prevents loneliness… .
[T]he result of herd behavior on stock prices is that they get bid higher or lower without regard to valuation.” fte
size of the herd might eventually grow into many thousands of people trading the same security over a long
period. External factors such as news coverage about a new investment philosophy or fad sometimes also lead
toherdbehavior. Rizzi (2014, p.444) provides this additional perspective on herd behavior:
Herding occurs when a group of individuals mimics the decisions of others. ftrough herding,
individuals avoid falling behind and looking bad if they pursue an alternative action. Herding
is based on the social pressure to conform and reflects safety by hiding in the crowd. In doing
so, someone can blame any failing on the collective action and maintain his reputation.
Herd behavior often transpires over different time spans, ranging from weeks to years. Herding is a major
psychological condition during a bubble, when investors buy investments on stock price momentum while
disregarding other important issues such as financial data, historical stock valuations, and economic statistics.
Investors experiencing herd behavior within the group also overstate or amplify the positive factors of price
performance and develop incorrect assumptions about the upside potential of the markets. When the bubble
ruptures or starts to deflate, panic ensures and individuals reveal their herding behavior by exiting and selling
all the stocks in their portfolio, based on high levels of negative emotions (Ricciardi 2017). MacKay (1980,
pp. ix–x) provides an example of speculation and crowd behavior in the historic bubble of Tulip Mania.
Tulips, in the fourth decade of the seventeenth century in Holland, became the object of such
insane and unreasoning desire that a single bulb—about the size and shape of an onion—
could fetch a small fortune on any of the several exchanges that had sprung up to trade
them.
Major trends in the financial markets start and finish with extreme periods of volatility based on emotion
and the irrational behavior of investors. Over the entire market
process, this herd behavior occurs on the upside of prices (overbuying of financial securities during bubbles)
and on the downside (overselling of financial securities during crashes) because crowd psychology moves in
the same direction when large groups of individuals drive investor sentiment. Financial history has a
predisposition to repeat itself, with events of herding occurring during times of bubbles and crashes (Ricciardi
2017).
GROUP POLARIZATION
In the 1960s, Stoner (1961, 1967) first developed the concept of the risky-shift effect, in which people within
a group often make judgments after extensive discussion that differ from the final decisions that someone
would formulate on an individual basis. For example, many research studies in the social sciences show that
groups in formal settings make riskier decisions than individuals; this is the risky-shift phenomenon. Stoner
(1977, p.333) provides the following perspective on the risky-shift effect:
It is popularly assumed that groups are more conservative and cautious than individuals.
Considerable evidence shows that in some situations groups make riskier decisions than
individuals. In those situations group solutions tend to represent “risky shifts” from solutions
that might be offered by individual group members. For example, in dealing with a
hypothetical case in which an individual must decide whether to stay in a secure job or leave for
one that is less secure but offers a higher salary, groups have been more likely than individuals to
recommend the riskier option.
ftis risky-shift effect is associated with historic events such as NASA’s decision to launch the space shuttle
Challenger without testing the rubber O-rings, which then failed and caused the shuttle to explode; or the
Soviet Union’s invasion of Afghanistan without careful review of Mujahldeen insurgent activity.
Myers and Lamm (1976) modify the risky-shift phenomenon into a more general concept and named
it group polarization. fte group polarization concept is the notion that group conversation or debate
results in shifts in the direction to more extreme opinions or views about final decisions among group
members. However, research findings sometimes report that group discussion produces a change or shift in
opinions of individual members that do not always result in greater risk-taking behavior. According to
Wrightsman and Deaux (1981, p. 466), “It has been shown that, if the initial opinions of the group tend toward
conservatism, then the shift resulting from group discussion will be toward a more extreme conservative
opinion.”
A premise of the group polarization concept is that groups can move in two different directions: groups may
move either to extremely risky decisions or behaviors (known as the risky shift) or to very risk-averse decisions
or behaviors (known as a cautious shift). fte cautious shift demonstrates that some group judgments result in
more conservative assessments than those of individuals. Yet, this finding contradicts the initial premise of
Stoner’s (1961) risky-shift effect. According to Stoner, group polarization takes place within a formal
organizational structure, such as a nonprofit, government body, or corporation. fte members of the group have
specific management responsibilities,
communicate with each other directly, and have a group size ranging from four to eight members (Ricciardi
2017).
A notable study from the area of behavioral accounting demonstrates how groups might shift in different
risk-taking directions. Carnes, Harwood, and Sawyers (1996) investigate the influence of group discussion
on the probability of tax professionals’ taking tax return positions preferred by taxpayers as “gray areas” of
the tax law. In the first experiment, the authors offer six ambiguous situations to 68 tax professionals. fte
researchers divide the participants into groups and instruct them to assess each situation before and after a
group conversation. Generally, their findings confirm the premise that group dialogue leads to either risky or
cautious shifts in tax professionals’ judgment. In the first experiment, conversations led to a risky “pro-
taxpayer shift” in all three high-probability cases and a cautious “pro-IRS shift” in two of three low-
probability situations. Overall, then, group discussion results in higher, more risky tax return positions in
situations defined as high probabilities of tax return position requested by the client. fte evidence shows a
cautious shift for lower, more conservative tax return positions in situations identified as having low
probability.
fte notion that groups sometimes make riskier decisions also occurs within the financial setting.
Slovic (1972) discusses the risky-shift concept as a central aspect of group psychology within the
investment management domain. fte problem with a major change in judgment by group members is that the
risk assessment often results in a problematic and irrational financial decision by the group. For instance, groups
sometimes select an outcome that has a larger payoff but a lower chance of achievement. According to
Ellis and Fisher (1990, p. 55), “If a group and its individual members were to place bets on a horse, for example,
the group would more likely bet on 100-to-1 shot than would any of the individuals deciding alone.”
Stephens and Silence (1981) examine the risky-shift effect among 35 commercial loan officers at five
Texas banks. fte authors provide the subjects with an imaginary loan application for an established bank
customer who has a strong credit history at a time of economic uncertainty. ftey designed the loan
application to raise “some concerns” but not so inappropriate as to be rejected immediately. fte findings
support the premise of the risky-shift effect, in that the loan officers rejected the loan application
individually butapproved itonagroupbasisoracommittee level.
McGuire, Kiesler, and Siegel (1987) assess whether a difference in the type of communication delivery
exists between face-to-face discussions and computer-mediated discussions about decision making on risky
choices, on both individual and group bases. fte authors evaluate 48 business managers individually and in
three-member groups in which the subjects made risk assessments of investment alternatives. fte authors place
the subjects in both face-to-face discussions and real-time computer-oriented dialogues. In each setting, the task
is to make two group decisions. McGuire et al. (p. 917) find that after face-to-face discussions, the groups “were
risk averse for gains and risk seeking for losses, a tendency predicted by prospect theory and consistent with
choice shift.” In contrast, the computer-mediated group dialogues did not reveal a shift in decisions or the
existence of prospect theory behavior.
Inferior group decisions occur in times of speculative behavior and bubble situations. Burton,
Coller, and Tuttle (2006) find that investors who subsequently have the most excessive price valuations
influence the market to a greater extent than do
investors possessing the most conservative beliefs. As Burton et al. (p. 107) note, these results also imply “that
participation in a market will accentuate risk preferences so that good news produces a cautious shift in prices
(i.e., toward lower prices) whereas bad news produces a risky shift (i.e., toward higher prices).”
GROUPTHINK BEHAVIOR
fte groupthink effect is an emerging topic within behavioral finance (Hayat 2015). In the early 1970s, Irving
Janis first developed the idea of the groupthink effect (Sunstein and Hastie 2015). Groupthink behavior has
been connected to several historical events in which members of a group do not have the desire to upset group
consensus or harmony by stating an opposing view (Ricciardi 2017). Groupthink was first applied to
President Kennedy’s judgment to use military action by invading Cuba, known as the Bay of Pigs incident.
Although President Kennedy’s foreign policy advisors opposed his choice, they were highly tentative in
expressing a contrary viewpoint about his decision. Janis (1971, p. 44) provides the following perspective of
thegroupthinkeffect:
fte symptoms of groupthink arise when the members of decision-making groups become
motivated to avoid being too harsh in their judgments of their leaders’ or their colleagues’
ideas. ftey adopt a soft line of criticism, even in their own thinking. At their meetings, all the
members are amiable and seek complete concurrence on every important issue, with no
bickering or conflict to spoil the cozy, “we-feeling” atmosphere.
A major aspect of groupthink behavior is the notion of conformity. Regarding conformity in groups, Asch
(1952) reports that differences of opinion cause people to search and find harmony in a final group decision
that enables the individual decision maker to reduce the affective reactions of anxiety and fear. As Janis
(1972, 1982) notes, the high levels of group pressure and feelings of anxiety among individuals to conform
during a groupthink situation become overwhelming, resulting in a final group decision of consensus. Each
person in the group experiences a personal aversion to depart from the final group’s consensus opinion or
majority outcome.
Groupthink events often occur within a formal setting among different types of organizations, such as
nonprofits, government agencies, and corporations. In the field of behavioral corporate finance, Shefrin
(2005) identifies the groupthink effect as a major cause of the past accounting scandals and corporate
bankruptcies of WorldCom and Enron. Regarding the financial crisis of 2007–2008, Shefrin (2016) attributes
the poor risk management practices and financial problems of AIG, Freddie Mac, and Fannie Mae to
groupthink behavior. In particular, the organizational structure of many large organizations is faulty and
bureaucratic, which stifles innovation (Schiller 1992, 2002). Schiller (1992, pp. 74‒75) provides the following
perspective about institutional investors:
Group-decision difficulties … mitigated to some extent by the fact that their objective
performance has always been observed on a regular basis … getting feedback on the success of
their investment strategies. But, of course
… the short-run immediate feedback on their quarterly investment performance may not
awaken a bureaucracy to long-term strategic issues; there is room for “groupthink” to arise.
For many organizations, possible conditions exist for groupthink behavior because mistakes during the
decision-making process influence all types of group behavior, especially financial issues. For example,
Cici (2012) identifies this potential groupthink effect among investment management teams, and Puetz and
Ruenzi (2011) point out the same behavior among mutual fund managers. For a research sample of 77 stock mar-
ket professionals, Wright and Schaal (1988) report that these experts suffer from groupthink and that this
behavior results in poor investment returns. All these expert groups suffer from groupthink behavior because
the group’s members arrive at absolute agreement without diligently evaluating financial recommendations or
investment information. Additionally, a leader with an outgoing and assertive personality influences the
group’s overall risk-taking behavior (Shefrin 2008). fte final outcome of the group is sometimes
attributed to the risky-shift phenomenon (Ricciardi 2017).
Wright and Schaal (1988, p. 42) explain the association between individual and group decision
makers in a finance setting:
An investment committee will have a series of norms and attitudes that may be called “current
policy.” ftis includes views on economic conditions and the course of the markets. fte more
important the group is to the individual, the greater the likelihood each professional believes the
policy is correct. He or she is not simply complying … but has internalized the committee poli-
cies so they are now the professional’s own.
For the members of an investment committee, the majority position might change an individual’s own opinion. A
person might reveal a tendency toadhere to the current investment policy instead of stating any opposition, resulting
in sustaining the status quo judgment and reinforcing groupthink behavior (Ricciardi 2017). Moreover, group
members often respond to the people who challenge their viewpoints with disbelief and misgiving.
Groups applying groupthink use substandard financial strategies when making their final assessments and
decisions. Groups might have access to too much information, inaccurate statistics, or flawed information that
leads to inferior decision-making results. fte typical behavior of a groupthink episode is that group members do
not make a few minor mistakes in judgment; rather, the group tends to make catastrophic errors and decisions
over an extended period. Ricciardi and Simon (2000) identify an example of potential groupthink in the
mismanagement and bad financial decisions made by trustees at Eckert College. In August 2000, a news story
read “Eyes Wide Shut: How Eckerd’s 52 Trustees Failed to See Two-ftirds of Its Endowment Disappear.” fte
theme of the news story concerned how Eckerd College’s endowment fund fell from $34 million to
$13 million, much to the dismay of the student body, faculty, administration, and trustees. As Pulley (2000,
p. A31) notes:
At Eckerd College here, those who have been trying to figure it out point to the Board of
Trustees, whose own leaders concede that they didn’t ask
many questions, and allowed policies and practices that led to the financial fiasco… . Several
trustees have likened the fiasco to the complex circumstances behind manmade disasters… .
Over the years, Eckerd has suffered from poorly executed real-estate projects, questionable
investments, an inability to provide the financial data needed to issue bonds to pay for capital
projects, an understaffed financial office, antiquated accounting systems, and a college president
who always seemed to have the answers.
fte influence of group psychology is apparent in the history of finance as seen through the lens of speculative
psychology: manias, bubbles, panics, and crashes, as well as herding, group polarization, and groupthink. All
have some similar characteristics, because each involves an affective reaction within the group and aspects of
crowd or mob psychology (Ricciardi 2017). Dreman (1977, p. 100) shows the association of groupthink to
stock market psychology:
fte mindless conformity and the excessive risk taking that Janis describes in smaller groups are
precisely the major symptoms that Le Bon pinpoints in larger crowds. Curiously enough, these
symptoms, and the relaxed, chummy atmosphere often found in cohesive group decision making
were also found to a significant degree in … speculative bubbles.
Dreman makes the point that a historical event can demonstrate a groupthink effect among a small group of
investors, and then over time it broadens to a much larger group of individuals who start to follow a much
larger herd (Ricciardi 2017). For instance, Nofsinger (2014, p. 135), who identifies the real estate bubble of
2001–2006 as a groupthink event, states: “Real estate became thought of as a speculative and tradable asset for
some people, instead of an investment.” fte complete acceptance of all group members, the existence of extreme
levels of overconfidence, and the presence of overly optimistic investors may lead to individuals’ rejecting
anything that might be considered evidence or beliefs contradictory to the final group judgment.
REPRESENTATIVENESS BIAS, FAMILIARITY BIAS,

GRANDIOSITY, AND EXCITEMENT
An important bias that individuals reveal during the initial phase of a bubble is representativeness
bias, which is a tendency to have an unrealistic view of a financial circumstance and then to over-weight
how much this current situation is similar to past experiences. With this decision-making bias, investors
incorrectly conclude that stock prices will continue to new highs based on a small sample of stocks. For instance,
during a bubble, investors may see prices continuing to rise into the future. Representativeness bias accelerates
the herd’s risk-taking behavior to much higher levels, based on group psychology (Ricciardi 2017).
Familiarity bias is evident when people have a preference for and invest in familiar assets based on the
name or reputation of the company. Investors prefer to invest in familiar local stocks (known as local
bias) and over-invest in portfolios of domestic securities (known as home bias) (Baker and Ricciardi
2014a, 2014b, 2015). Investors
also tend to underestimate and miscalculate the risk of familiar investments. For example, in the early 1970s,
a bubble developed in a group of growth stocks known as the “Nifty-Fifty.” ftese stocks consisted of 50
familiar large-cap blue chip stocks, such as IBM and Disney. fte bubble eventually burst. Investors
focused on blue chip stocks that received much media attention, which increased their familiarity and raised
their prices. fte investors incorrectly assessed these overpriced stocks as less risky and with producing a
higher return, but the opposite was true.
Individuals experience high levels of greed when a stock market bubble is accel- erating and investors
want to join the crowd (Ricciardi 2017). ftey also suffer from extreme grandiosity. Lifton and Geist (1999,
p. 24) describe this grandiosity as, “when prices continue to escalate, investors … feel like Icarus—they feel
increasingly excited and capable of flying higher and higher.” Indeed, the feeling of grandiosity makes inves-
tors feel invincible, coupled with extreme enthusiasm. As a result, they make irrational predictions of stock
market performance returns and disregard risk and uncertainty (Ricciardi 2008a, 2008b).
fte feeling of grandiosity that characterizes bubbles is connected with how excitement influences the
speculative behavior in financial markets. Andrade, Odean, and Shengle (2016, p. 11) describe the role of
excitement in bubble situations:
We document, in an experimental setting, that magnitude and amplitude of bubbles is greater

when, prior to trading, traders experience the high- intensity, positive emotion of
excitement… . [T]he excitement generated by rapidly rising prices in real-world markets may
trigger emotions that lead to larger asset pricing bubbles.
Individuals often disregard rational thinking and replace it with euphoric expectation, characterized by
overconfidence and optimism about future investment performance. ftey focus on the short term and ignore
the long-term investment horizon. fte speculative bubble continues to expand until investors stop buying the
stocks, in which case the market can no longer sustain the impracticable increase in price valuations and the
bubble implodes.
OVERREACTION AND UNDERREACTION

During a bubble or crash, some investors overreact to new information while others underreact.
Overreaction occurs when the stock price movement to the downside or upside happens too quickly (De
Bondt and ftaler 1985). By contrast, underreaction occurs when the stock price movements to the downside
or upside happen too slowly (Cutler, Poterba, and Summers 1991). ftere is a relatively short-term time
horizon during which investors process new financial data—perhaps several hours, days, weeks, months, or
even years. All types of investors over- or underreact to good or bad news which the market may perceive as
positive (valuations increase) or negative (valuations decrease).
Investors often experience an exhilarated degree of overconfidence and optimism during a bubble, when
stocks post strong increases in price. According to Dissanaike
(1997, p. 27), this overreaction occurs when “if stock prices systematically overshoot as a consequence of
excessive investor optimism or pessimism, price reversals should be predictable from past price
performance.” For example, suppose a sector or industry repeatedly reports above-average earnings
performance each quarter for an entire year. Investors overreact to this positive financial news, feeling
excessively confident and optimistic about future earnings expectations; as a result, the stock prices are then
mispriced or artificially overstated (Mynhardt and Plastun 2013). Eventually, those prices see a market
sector correction and decline when there is news about industry groups such as below-average earnings
performance. Negative sentiments take over. Conversely, when investors are overly negative about a sector
or industry, its stock prices lead to excessive reactions to the downside, as happened with Internet stocks in
the early 2000s and most all stocks during the financial crisis of 2007–2008 (Mynhardt, Plastun, and
Makarenko 2013).
Other investors might underreact to financial news and respond too slowly (De Bondt and ftaler
1985). For example, investor sentiment is sometimes slow to change after a bubble bursts. Some individuals
are slow to reacting to the change or fail to recognize that the market has moved from bull to bear market cycle.
Further, some investors prefer to avoid the emotional pain of realizing an actual financial loss and suffer the
accompanying regret of admitting an investment mistake.
Behavioral Biases Evident After

the Financial Crisis
Every generation of investors has experienced a stock market bubble and a major bear market crash after the
bubble bursts. ftis section examines behavioral finance issues in the aftermath of the financial crisis of
2007–2008.
After a bubble bursts, investors display several biases. In particular, the collective memory hypothesis
suggests that recent economic shocks influence an individual’s risk tolerance and change investor behavior
(Rizzi 2014). Especially, the affective reactions of investors to recent economic distress have greater influence
on investor judgment and decision making than do long-term historical investment performance data and
other objective information. Although temporary, the change in expected long-term influence on risk
tolerance and risk perception is likely to be lasting and negative. Nagel (2012) believes that younger individuals
are more sensitive to recent negative performance than older investors, because the younger generation has a
shorter investment history. For example, millennial clients are more prone to behavioral changes based on
recent returns than are older investors such as baby boomers, who have had decades of experience. ftis was
the case following the bear market of the early 2000s and the financial crisis of 2007–2008.
LASTING INFLUENCE OF ECONOMIC SHOCKS

Malmendier and Nagel (2011) examine the role of economic disruptions on individual investor and risk-taking
psychology, using data from the Survey of Consumer Finances
(SCF) between 1960 and 2007. ftey find that investors who have experienced inferior stock market performance
during their lifespan have a lower financial risk tolerance, are less willing to invest in common stocks, have a lower
percentage of their overall portfolio in stocks, and are less optimistic about future stock performance. For safer
assets such as bonds, people who experience lower bond returns are less likely to own bonds. For instance,
millennials are a younger generation that has suffered a severe economic downturn, making them more
cautious toward risky securities. However,their reaction may not be as severe as the cohort group born after the
stock market crash of 1929 known as the “Depression Babies” generation. In order to overcome these eco-
nomic shocks, investors should take a long-term perspective of investing. Over the long- term asset classes
performance are based on the concept known as reversion to the mean. ftis is the premise that prices and
investment returns eventually move back toward
their historical averages for each asset class.
Bricker, Bucks, Kennickell, Mach, and Moore (2011) examine the impact of the financial crisis of
2007–2008 on family households, using questionnaire data from the SCF before and after the crisis. Based on
interviews done between mid-2009 and early 2010, the data reveals a transformation toward a more cautious
financial psychology of the family unit after experiencing the financial shock. fte families report a lower invest-
ment risk tolerance and a higher level of precautionary savings (i.e., a greater desire for safer cash
instruments while reducing total household spending).
A NC H ORING , REC ENCY BIAS, AND WORRY

Individuals may suffer several biases after a bubble bursts, including anchoring bias and recency bias, as well as
negative emotions such as worry or depression. Anchoring is the tendency to hold onto a belief and then apply
it as a reference point for making future judgments. People often make judgments based on initial
information and have difficulty altering or changing their viewpoints when they receive new information. In
this way, many investors still employ a negative anchor after a financial crisis or stock market crash. Similarly,
investor experience that focuses on recent financial performance has a strong impact on later judgments and
decisions. ftis negative anchor is called recency bias. According to Rizzi (2014, p. 440), “Risk estimates
become anchored on recent events. Overemphasis on recent events can also produce disaster myopia … as
instruments are priced as if another crisis will occur.”
As Ricciardi (2012) states, high levels of worry remain for years after a bubble or a crash. Consequently,
investors tend to under-weight or avoid stocks within their portfolios because of extreme risk and loss
aversion. ftey have strong negative emotions, including depression, anxiety, regret, or fear that affect their
judgment. Based on an online questionnaire of more than 1,700 investors in 2010, Ricciardi (2011) finds that
a much larger percentage of individuals associate the worry phrase with stocks (70 percent of respondents)
than those who associate worry when compared to bonds (10 percent of respondents). Individuals who have
higher levels of anxiety about investments in stocks tend to raise their risk perception and lower their risk
tolerance. ftese higher levels of negative emotions and the anchoring effect caused by the financial crisis of
2007–2008 resulted in many investors avoiding individual stocks or stock mutual funds for several years.
LOSS AVERSION
Investors tend to focus on downside risk when they lose money after a stock market crash. When they
experience this loss, the outcome not only results in an objective loss in dollar terms but also a subjective
aspects as an emotional loss. In particular, when evaluating specific investment transactions, individuals
allocate more importance to a loss than to earning an equivalent gain. ftis feeling of losing money can
remain for a very long time. Many investors who realized severe losses during a financial crisis tend to avoid
the riskier asset classes such as common stocks for an extended period.
STATUS QUO BIAS

After a bubble bursts, individuals suffer status quo bias, in which they no longer want to invest in stocks or avoid
making decisions about their investment portfolios all together. fte feeling of investment distress, which is
based on other biases such as anchoring, worry, and loss aversion, further deepens the status quo bias by further
delaying current financial decisions. Investors no longer want to manage their investments because they want to
avoid reliving these bad experiences. After a financial crisis, many of these investors have portfolios that
under-weightstocksandover-weightcashandbonds.
TRUST AND MISTRUST IN A FINANCIAL SETTING

Trust is a key element in society, needed to develop complicated social, psychological, and economic
relationships. Trust and trustworthiness are functions of our dependence on or confidence in the truthfulness,
accuracy, value, or worth of a person, organization, or matter. Trust is critical for establishing personal (e.g., a
couple dating for the first time) and professional relationships (e.g., an individual investor and a financial
advisor). For example, Joiner, Leveson, and Langfield-Smith (2002) evaluate the perceptions of trust between
financial planners and their clients. Using 186 undergraduate business students, Joiner et al. investigate how trust
factored into decisions to use expert language during the financial planning advisement process, as well as
judgments on the quality of advice received, impressions of the planner’s trustworthiness, knowledge and honesty,
and pros- pectsof consumerstoseeksuchexpertadvice.Joineretal.(p.25) reportthefollowing:
fte results indicate that the overuse of technical language in a lay client consultation reduces
clients’ understanding of the advice offered. Lowered advice understandability negatively
affects clients’ perceptions of the professional adviser’s expertise and trustworthiness and,
subsequently, client’s intention to seek the professional’s advice.
Other aspects of trust are essential to fostering confidence in organizations (e.g., the credibility of
government institutions) or markets (e.g., confidence in international stock markets). According to
Doost and Fishman (2004, p. 623):
Recent corporate scandals, fraud, and misuse of resources involving top executives and
multi-billion dollar companies such as Sunbeam, Tyco,
Medco, Enron, Worldcom, the NYSE and others—not to mention accounting giant, Arthur
Andersen, threaten the viability and continued success of the U.S. economy, the global
economy, and world-wide political stability. Stock markets, employees’ pension funds,
national employment rates, and the ability of citizens to trust in economic systems are all
adversely affected.
People’s overall trust in the private and public sectors began to decrease (i.e., a trend toward increased
mistrust) in the late 1960s (Slovic 1993, 1999), and this extends to financial planning and advice. For
example, the higher the level of mistrust individual possess in the financial experts, who may be informing the
public about risky behavior, the more anxiety or worry people feel about the financial crisis or bursting bubbles.
As Opdyke (2007, p. D1) comments, “a growing number of people who have spent years building a
relationship with a trusted financial advisor are having to start over again with someone new.” Olsen (2004, p.
190) relates this mistrust to the dot.com bubble of the late 1990s:
First and foremost, the stability of the market was being undermined by conflicts of interest
in the accounting and financial analysis professions… . Second, many stock option plans
allowed managers to cash in their options after very short holding periods (less than a
year)… . [S]ome managers’ behavior, while not overtly illegal or unethical, resembled
gamblers playing with the “house money.” ftat is, since they had not paid for their options,
they behaved as if they had little to lose but a lot to gain by taking bigger risks with the firm’s
funds. Finally, trust in the official regulatory process was undermined by revelations of budget
reductions among regulatory agencies and widespread public exposure of a cavalier and
“public be damned” attitude on the part of many corporate executives and professional money
managers.
Developing a strong level of trust takes a long time for investors. However, trust can quickly turn into
mistrust, especially in the aftermath of a financial crisis. And once that mistrust takes hold, repairing and
restoring trust can be difficult.

fte speculative behavior associated with bubbles, manias, panics, and crashes are occasional, random, and
severe events in financial history. Behavioral finance helps to explain that speculative behavior, based on
cognitive processes and affective reactions that influence decision making. ftis chapter discusses various
biases that influence the speculative psychology of investors during bubbles. ftese biases include
overconfident behavior, herding, polarization, groupthink, representativeness bias, familiarity bias,
grandiosity, excitement, and overreaction and underreaction to prices in financial markets. fte chapter also
presents a detailed overview of what happens in the aftermath of the financial crisis of 2007–2008 and the
biases that influence some investors for an
extended period, including the detrimental effect of repeated economic shocks, anchoring bias, recency effect,
worry, loss aversion, status quo bias, and mistrust.
ftese are all important financial behaviors and characteristics about which financial professionals should be
aware. By gaining such awareness, they can better understand and manage the behavior of their clients, because
bad financial mistakes have a tendency to repeat themselves, especially during bubbles and crashes. In particular,
some clients may experience negative long-term biases after market crashes that influence their overall
judgment and decision making. fte aftermath of the recent financial crisis resulted in many investors exhibiting
lower levels of risk tolerance and higher levels of worry and risk perception, which in turn resulting in
underinvesting in stocks and overinvesting in bonds and cash.
1. Define the term stock bubble.
2. List and describe four major causes of speculative behavior.
3. List and explain four major biases that investors exhibit in the aftermath of the financial crisis of 2007–
2008.
4. Discuss the influence of investor psychology in the aftermath of a financial crisis or when a bubble
bursts.
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27
Can Humans Dance with Machines?
Institutional Investors, High-Frequency Trading,
and Modern Markets Dynamics
IRENE ALDRIDGE
Managing Director, Able Alpha Trading, Ltd. and Able Markets,
Director, Big Data Finance
Introduction
In October 2015, the U.S. Securities and Exchange Commission (SEC) counted 18 national security
exchanges registered with the SEC under the Securities Exchange Act of 1934 (Securities and Exchange
Commission 2015). fte SEC-registered exchanges include the NYSE, NYSE Arca, NYSE MKT (formerly
NYSE AMEX and the American Stock Exchange), BATS, BATS Y, EDGA, EDGX, BOX Options,
Nasdaq, NASDAQ OMXBX,NASDAQOMXPHLX,C2Options,CBOE,ChicagoStockExchange,
ISE, ISE Gemini, Miami International Securities Exchange, and the National Stock Exchange. fte SEC-
registered exchanges are often referred to as “lit” exchanges, in comparison with “dark” trading venues
such as dark pools. According to Financial Industry Regulatory Authority (FINRA) Alternative Trading
System (ATS) Transparency Data, the number of dark pools in the United States stood at 35 as of October 5,
2015, and included entities with names such as Aqua, Bids Trading, and Crossfinder. Several dark pools can be
recognized as those operated by large banks, including Citi Cross, Barclays
ATS, and JPM-X.
Perhaps not surprisingly, many institutional investors are concerned about innovations in the current
market structure of the equity markets. For instance, D’Antona (2015) reports that 67 percent of U.S. and
European buy-siders want natural blocks, which are the pools of liquidity where hedge funds, asset managers,
and wealth managers can seamlessly execute large orders without retaining personnel or specialty firms to
manage their order execution, as in the long-gone days when only one exchange existed. ftis chapter discusses
developments in today’s equity markets, touching upon regulatory measures, competitive dynamics, and
new entrants. Most important, the chapter shows that some of the fears surrounding modern microstructure
may be true and require additional investigation. In particular, the chapter documents that institutional
investors’ fear of toxic liquidity may be warranted in today’s equity markets.
499
Modern Market Structure and Liquidity

Despite the proliferation of trading venues, the market landscape is not necessarily a “Wild West,” as
there are many similarities among trading venues. Two types of orders facilitate the majority of trading
across all exchanges: market orders and limit orders. A market order specifies the quantity of a given
financial instrument that the trader desires to buy or sell, but not the price. fte market order is then
executed or filled immediately upon reaching an exchange at the best available price, provided the best price
satisfies the national best bid and offer (NBBO) requirements, which is the best (lowest) available ask
price and the best (highest) available bid price to investors when they buy and sell securities. A limit order is an
order containing the price at which the trader would like to sell or buy a given quantity of stock. Unlike
market orders, limit orders are executed only when they become the best-priced orders on the market, which
happens when other better-priced limit orders are executed first or cancelled. Other, more complex order
types tend to be aggregates of limit and market orders with various additional characteristics.
Furthermore, all U.S. equity trading venues deploy the centralized limit order book to record and match
the orders. Also known as the double-sided continuous auction, the limit order book is a repository of
orders organized by price levels. One limit order book typically exists for each financial instrument traded
on a given exchange. fte limit orders stored in the limit order book are “added” by traders much like the
manufacturers of food may add their wares to the shelf of a grocery store. Some limit orders, known as day
limit orders, expire at the end of the trading day, but others, the good till cancel orders, may last longer.
Similar to a grocery supplier, the limit order trader specifies the size of the limit order and the desired trading
price. By setting limit orders, traders add liquidity to the exchange. fte resulting liquidity can be consumed by
market order traders and other limit order traders who match the price of resting limit orders.
Liquidity is a complicated topic. Liquidity refers to the market’s readiness to trade. fte deeper the
liquidity, the larger is the order the market can absorb immediately without noticeable market movement.
Immediate market execution is accomplished using market orders. In order for a buy or sell market order to be
fulfilled, the market order needs to be matched with one or more limit orders of the opposite direction—buy
market orders being matched with sell limit orders and vice versa. As more limit orders are available for
matching the arriving market order, the larger the market order can be. ftus, in technical terms, liquidity is
the set of all available limit orders that can be used for immediate execution. Demsetz (1968) first defined
liquidity as immediacy of execution. Figure 27.1 is a snapshot of a limit order book, containing “displayed”
liquidity: resting buy orders (“bids”) and sell orders (“offers”), aggregated by price from lowest to the
highest. Besides displaying liquidity, most exchanges offer the opportunity to send in “hidden” limit orders
that, similarly to traditional dark pools, are not revealed until they are executed.
According to folklore, modern liquidity has two subsets: “natural” liquidity and “toxic” liquidity.
Natural liquidity isthoughttoconsistofdependablelimitordersreadyto be matched with the incoming
market orders or liquidity, for instance, placed by traders
Can Humans Dance with Machines? 501
Last trade price
Price
Bids Offers (asks)
Figure 27.1 Buy-side Available Liquidity Exceeding Sell-side Liquidity. fte figure illustrates that an
incoming market buy order faces a sparser limit order book, and hence a less certain execution, than an
incoming market sell order.
“Flickering quote”
Last trade
103.25 103.85 104.20 105.90 106.50

Price
Bids Offers
Figure 27.2 Example of impact of “Flickering Quotes” on Buy Offers ftis figure shows that a trader using a
market buy order observes the best quote at price 105.90, but is filled at 106.50 because the 105.9 quote is canceled
before the market buy order reaches the exchange, resulting in worse execution.
“who generally plan to hold the position for longer than one day” (Pragma 2011, p. 3). Toxic liquidity, also
referred to as opportunistic liquidity, comprises the limit orders that are not dependable or stable. Just as
the toxic market order flow leaves market makers at a disadvantage in a process referred to as adverse selection
(Easley, Lopez de Prado, and O’Hara 2012), toxic liquidity can be disadvantageous to non-market-making
participants such as institutional portfolio managers. Toxic limit orders are often cancelled, only to be
promptly replenished by another set of identical limit orders. fte goal of such on/off flickering is to be
intentionally harmful to the markets along the following dimensions:
• Some market participants believe that flickering quote behavior is present to deceive market participants
about the depth of the order book.
• Others believe that flickering quotes are used to prompt large traders into revealing their true position
execution sizes. Such information mining on behalf of entities deploying flickering orders is known
as “phishing” or “pinging.”
• Overall, flickering or disappearing liquidity can to be toxic because it can exacerbate the market impact
of incoming orders. Figure 27.2 shows an example of market toxicity.
Several researchers compare the toxicity of some exchange characteristics such as fee structure.
Although all exchanges are obligated to observe the SEC Regulation National Market Systems (Reg
NMS) that mandates all market orders to be executed only at NBBO prices or better quotes, owing to the
competitive nature of the modern trading landscape, exchanges differentiate themselves by deploying
different pricing and matching combinations. As Aldridge (2013a) discusses, some equity exchanges offer
traders monetary incentives to provide liquidity in an attempt to attract limit orders, and thus to deepen
available liquidity. Exchanges doing so are known as “normal” and offer “rebates” for providing liquidity
(posting limit orders), while charging fees for taking liquidity (placing market orders). Other
exchanges, known as “inverted,” do the opposite. ftey charge for limit orders and pay for market orders.
fte NYSE is an example of a normal exchange and the Boston OMX is an inverted exchange.
A few exchange firms have offerings in each category. For example, BATS has normal and inverted
exchanges in the firm’s portfolio. According to Sofianos and Yousefi (2010), Aldridge (2013b), and
Battalio, Corwin, and Jennings (2015), fees and other properties of exchanges affect the toxicity of their
liquidity. For instance, Battalio et al. found that, on average, the fees across all the exchanges are in equilibrium,
balancing the explicit fees with implicit costs, such as observed spreads. fte lower the fee imposed on
“liquidity makers” providing the limit orders, the higher is the observed spread on a given exchange,
potentially implying higher toxicity levels. Aldridge found that order cancellation rates are lower on exchanges
with lower liquidity maker fees (higher liquidity taker fees), also indicating lower toxicity levels.
Owing to the often-intense speed of flickering observed in toxic limit orders, some consider toxic
liquidity to be generated by machines more so than humans, because of human traders’ physical constraints in
observing and clicking the orders. In contrast, human market makers and institutional market participants
generate the most natural liquidity. As a direct consequence, the presence of toxic liquidity has prompted
debates about the usefulness of high-frequency trading (HFT) as market making (Markets Media 2013).
fte next section discusses strategies deployed by high-frequency traders and their activities in the
markets.
High-Frequency Trading
High-frequency trading (HFT) refers to a category of computer programs designed to process vast
arrays of market information and trade the markets, typically in an intraday framework, only occasionally
holding positions overnight. Aldridge (2013a) provides a detailed classification of HFT strategies. Broadly
speaking, all HFT can be split into two large groups: aggressive HFT and passive HFT. fte key difference
between the two categories is their built-in impatience. Aggressive high-frequency traders (HFTs) tend to
trade on time-sensitive information and typically prefer to use market orders that deliver immediate
execution at the best available price. Most successful aggressive high-frequency traders require ultra-fast
connectivity and speed of execution to reach the markets ahead of their competition. In contrast, passive
high-frequency traders
Aggressive buy order arrives, takes out liquidity
Price
Figure 27.3 Impact of Aggressive HFT Orders on Bid–Ask Spreads. ftis figure illustrates that an
arriving aggressive order wipes out the best limit order(s) on the opposing side of the limit order book,
widening spreads and increasing volatility through larger bid–ask bounce.
Table 27.1 Average Aggressive HFT Participation in Equities on August 31, 2015
Lowest Aggressive HFT, out of the S&P 500 Index

Percent (%)
ZNGA 7.4
VVUS 8.3
RAD 9.8
Highest aggressive HFT, out of the S&P 500 Index
GOOGL 39.6
AMZN 38.1
GOOG 37.6
Note: ftis table shows the average proportion of aggressive HFT in the order flow of selected securities.
Source: AbleMarkets (2015).
engage in market making and other less time-sensitive strategies. As a result, passive high-frequency
traders mostly use limit orders.
As a natural consequence of aggressive HFT market-taking activity, aggressive high- frequency traders tend
to wipe out limit orders in the direction that they trade, increasing bid–ask spreads and resulting in higher
realized volatility (defined by Andersen, Bollerslev, Diebold, and Labys 2002) from the bid–ask bounce.
Figure 27.3 shows the basic mechanics of how aggressive HFT increases bid–ask spreads. fte average pro-
portion of aggressive high-frequency traders in stocks varies from stock to stock, but changes little over
time.
Table 27.1 shows the daily average aggressive HFT participation in selected S&P 500 Index stocks on
August 31, 2015. As table 27.1 shows, although the mechanics may
follow all market-taking orders, two key issues pertaining to aggressive HFT behavior may particularly
exacerbate available liquidity:
• Aggressive high-frequency traders tend to execute bursts of market orders at once, potentially deeply
affecting the liquidity onone side of thelimit orderbook.
• Aggressive HFTs often act in response to major market announcements, using their infrastructure to reach
the markets just ahead of competing institutional traders, substantially worsening execution for the
latter.
Several studies confirm the aggressive HFT impact on market volatility. For example, Zhang (2010) and
Cliff, O’Hara, Hendershott and Zigrand (2011) find that aggressive HFTs are more active during the periods
of high market volatility, potentially causing said volatility. Aldridge and Krawciw (2015) estimate that stocks
with higher aggressive HFT display consistently higher volatility.
Conversely, passive HFTs tend to reduce volatility by propping up the limit order book and reducing
spreads and the bid–ask bounce of prices. Of course, traders deploying passive HFTs can cancel their limit
orders, as can everyone else placing limit orders. However, they cannot run away once their orders have been
selected for matching by the exchange.Inother words, just by placing a limit order,a passive HFT is committing
to honor that order in the period of time before the order may be cancelled. No matter how soon the order
cancellation may be sent, if the limit order is the best-priced order on the market, and if a market order arrives in
the time span between the placement of the limit order and its cancellation, the limit order will be executed.
Stated differently, any limit order always has a positive probability of execution. Figure 27.4 summarizes the
actions of passive HFT’s provision of liquidity.
Brogaard (2010) supports the passive HFT–lower volatility connection. Although other researchers
find that HFT boosts liquidity (Linton and O’Hara 2011; Moriyasu, Wee,andYu2013;JarnecicandSnape
2014),HFTsmaybetooquicktowithdrawliquid- ity during uncertainty, resulting in extreme liquidity
shortages and inducing crashes (Kirilenko,Kyle,Samadi,andTuzun2011;LintonandO’Hara 2011;
Hasbrouck2013). A particular concern surrounding passive HFT has been a perceived rise in fast order
cancellations and the resulting toxicity of liquidity in the markets. Hautsch and Huang (2011) and Hasbrouck
and Saar (2013) document that 95 percent of all limit orders
Passive buy order arrives, adds liquidity
Price
Figure 27.4 Placement of Passive HFT Order Placement. ftis figure shows that
an arriving passive limit order enhances liquidity, adding depth to the limit order book.
on the NASDAQ are cancelled, most within just one minute of order placement. Such unexplained behavior
of limit orders has been troubling for traders, exchanges, and other market participants, resulting in claims
that the observed cancellations are part of some market-manipulation schemes. Exchanges have experienced
clogs in their networks, in which large portions of network bandwidths are taken over by order cancel-
lations, delaying information transmittal for other orders, quotes, and trades. fte sheer volume of the
cancellations has baffled regulators, academics, and broker-dealers.
fte remainder of this chapter closely examines the intraday limit order dynamics, including order-by-
order analysis of the limit order book evolution. As the analysis shows, basic order-cancellation counts
often erroneously incorporate activity by institutional investors in their estimates of the toxic
liquidity.
A Limit Order Book Under a Microscope

A typical exchange may offer dozens of order types to traders of all categories, including institutions and
HFTs. As of September 2015, the NYSE had 25 active order types, including six types of immediate or
cancel (IOC) orders constituting variations of a market order, five types of displayed limit orders, and four
types of non-displayed or hidden limit orders (Intercontinental Exchange 2015). Out of all the order types,
the NYSE IOC market-order types make up 32.61 percent of all orders in aggregate, displayed limit orders
of all stripes account for 41.51 percent of all orders, and non-displayed limit orders total just 2.46 percent of all
orders. By comparison, the follow is the distribution of orders on BATS exchanges in September 2015: BATS
IOC, including vanilla market orders, occurred 13.84 percent of the time, with displayed limit order variations
submit- ted 48.91 percent of the time, and non-displayed orders accounting for 37.26 percent of the total order
count (BATS Global Markets 2015). fte differences in order prevalence by type may be a function of market
structure divergences among exchanges. However, most exchange order types have at least one commonality:
the structure of order transmission to and from the exchanges.
fte commonalities in order transmission are not to be confused with the language of transmission, formally
known as transmission protocol. As Aldridge (2013a) describes, many exchanges use FIX
communication protocol to transmit messages. Yet, some other exchanges, such as the NASDAQ, have
proprietary data transmission models that allow information exchange to be faster and more reliable than
FIX. However, most protocols deploy a message structure that includes message additions, message cancel-
lations, and message executions, with individual messages often linked by unique order identifiers to track
theorderarrivalsandexisting order modifications.
For instance, Table 27.2 shows a stylized excerpt from a message log recorded for GOOG on October 8,
2015, by BATS BYX exchange. fte fields included in Table 27.2 are Unique Limit Order ID, used to
identify all limit order additions and subsequent executions and revisions; the time the message was sent out
by the exchange; the time when the original limit order was added; the size of the original limit order or
revision; and the price of the original limit order. Table 27.2 shows two order types: “A” for a new limit order
addition and “X” for a limit order cancellation. Additional order message
Table 27.2 Sample from Level III Data (Processed and Formatted) for GOOG
on October 8, 2015
Unique Order ID Message Time Symbol Original Order Order Limit Order
(ET) Placement Time Size Price Type
C91KT9003TDS 9:39:01.688 GOOG 9:39:01.688 100 637.33 A
C91KT9003TDS 9:39:02.790 GOOG 9:39:01.688 100 637.33 X
C91KT9003UU4 9:39:09.213 GOOG 9:39:09.213 100 629.23 A
C91KT9003UU4 9:39:10.212 GOOG 9:39:09.213 100 629.23 X
C91KT9003W7J 9:39:16.794 GOOG 9:39:15.799 100 648.45 X
C91KT9003OBR 9:39:19.967 GOOG 9:39:00.270 100 641.00 X
Note: ftis table presents a snippet of detailed order flow for GOOG recorded on October 8, 2015, by BATS. “A” messages
represent limit order additions and “X” messages are limit order cancellations.
types may include partial or full executions of limit orders, market orders, and hidden order executions.
In the snippet of messages shown in Table 27.2, the first two messages pertain to order ID
C91KT9003TDS. fte first C91KT9003TDS message is an addition of the limit order with price 637.33
recorded at 9:39:01.688 am ET. (fte timestamp originally was reported in milliseconds following
midnight, but was converted into regular time for reader convenience.) fte second message pertaining to the
same order ID—a cancellation—arrived just more than one second later. A similar pattern occurs with the
next order ID, C91KT9003UU4. fte message to add the 100-share order, this time with a price of 629.23,
occurred at 9:39:09:213, while the exchange recorded the message to cancel the same order at 9:39:10:212,
just 999 milliseconds later. fte last two messages displayed in Table 27.2 are cancellations of orders placed earlier
in the day and not shown in the table.
On October 8, 2015, GOOG had 50,274 messages that were of one of the following types: (1) limit order
additions, (2) full or partial limit order cancellations, (3) regular limit order executions, and (4) hidden
order executions. Of those messages, 24,824 (49.3 percent) were limit order additions, 24,750 (49.2 percent)
were limit order cancellations, 139 (0.3 percent) were limit order executions, and 561 (1.1 percent) were
records of hidden order executions. Table27.3 summarizes the size properties of each category of orders. Of all
the added limit orders, only 49 were greater than 100 shares, and the maximum order size was 400 shares. fte
posted limit orders exclude hidden or dark orders that are now available on most public exchanges (“lit”
markets).
Afteralimit orderisadded(messagetype“A”),itcanbecancelledorexecutedinpart or in full, or it can remain
resting in the order book until its expiry, typically at the end of the trading day or “until cancel.” fte trader who
places the order completely determines the cancellation. fte execution is a combination of factors: a resting
limit order is executed when it becomes the best available order and a matching market order arrives, given that
the order is not cancelled before the market order’s arrival. A limit order may
Table 27.3 Distribution of Order Sizes in Shares Recorded for GOOG

on October 8, 2015
A E P X
Average 94.27 87.37 68.50 94.21

Standard deviation 21.40 40.30 102.45 21.38
Maximum 400.00 300.00 2283.00 400.00
99% 100.00 207.56 138.79 100.00
95% 100.00 100.60 100.00 100.00
90% 100.00 100.00 100.00 100.00
75% 100.00 100.00 100.00 100.00
50% 100.00 100.00 86.50 100.00
25% 100.00 74.00 20.00 100.00
10% 80.00 37.30 5.00 80.00
5% 47.00 5.50 2.00 47.00
1% 2.00 3.00 1.00 2.00
Minimum 1.00 2.00 1.00 1.00
# Messages 24,824.00 139.00 561.00 24,750.00
Total Size 2,340,128.00 12,144.00 38,426.00 2,331,811.00
Note: ftis table illustrates distribution of order sizes for orders of different types. Order types are: “A”—add limit
order, “E”—resting limit order executed, “P”—hidden limit order executed, and “X”—limit order cancellation.
cancelled all at once or in several cancellation messages, each message chipping away at the limit order’s initial
size. Similarly, a limit order may be executed in full if the matching market order size is greater or equal to
that of the limit order. If the limit order is larger than the matching market orders, it will be partially
executed.
Table 27.4 summarizes the distributional properties of time since the last record of each order appeared.
For additions of limit orders, as well as for executions of hidden orders, the times are identically zero. Limit
order cancellations average 8.3 seconds following the last action on the order ID: at the order placement or
previous partial cancellation. fte time distribution is highly skewed, with the median time between the last
order action and the following order cancellation being just a half a second. Executions (order types “E”) on
average occur 18 seconds since the last order action, with the executions following limit order additions
just 3 seconds at the median value.
Of 24,824 limit orders added to GOOG on October 8, 2015, 21,698 (87 percent) were cancelled in full
with just one order cancellation. On average, single cancellations arrived just five seconds after the limit
order was added to the limit order book. fte
Table 27.4 Distribution of Difference between Sequential Order Updates for All
Order Records for GOOG on October 8, 2015
A E (ms) P (ms) X (ms)
Average 0 17,932.87 0 8,299.75

Standard deviation 0 82,984.99 0 211,621.90
Maximum 0 687,989.00 0 18,326,189.00
99% 0 496,794.70 0 29,535.60
95% 0 33,518.00 0 11,545.15
90% 0 25,900.00 0 6,599.40
75% 0 10,049.00 0 2,237.00
50% 0 3,010.50 0 567.00
25% 0 626.00 0 68.00
10% 0 29.90 0 4.00
5% 0 0.00 0 1.00
1% 0 0.00 0 0.00
Minimum 0 0.00 0 0.00
Note: ftis table shows the duration of time (in milliseconds) since the last order update for each given order ID for various
order types. Order types are: “A”—add limit order, “E”—resting limit order executed, “P”—hidden limit order executed, and
“X”—limit order cancellation. “A” and “P” type orders are first recorded when added and executed, respectively.
median shelf life of a limit order with a single cancellation was even shorter: just more than half a second.
Table 27.5 illustrates that most of the orders were 100 shares or smaller. As Davis, Roseman, Van Ness,
and Van Ness (2015) first pointed out, there is little evidence to show that order cancellations are a result of
single-share liquidity pinging—a “canary in a coal mine” theory that purports to describe some of the HFT
activity. As Table 27.5 shows, most of the orders were in 100-share lots.
fte limit orders not cancelled in full with a single order cancellation can be subsequently executed or
cancelled at a later time. Figure 27.5 displays a histogram of the number of order messages for each added
limit order when the order messages exceed two (typically, addition and cancellation, or addition and
execution). As Figure 27.5 shows, some limit orders end up withas many as 50 limit ordercancellations.
fte most interesting part of the limit order dynamics could be in the intraday evolution of orders. Until
9:28 am ET, limit orders arrive and are promptly cancelled, without any limit orders visibly resting in the
limit order book for longer than five minutes. Displayed limit orders alternate between buys and sells and
various price levels. ften, at 9:28:30.231 am ET, two orders arrive—a buy at 596.57, order ID
C91KT9000RU8; and a sell at 684.27, order ID C91KT9000RU9. fte buy order is left untouched until
11:52:25.912 am, at which point the buy order is modified through a simultaneous
Table 27.5 Size and Shelf Life of Orders Canceled in Full, with a Single
Cancellation for GOOG on October 8, 2015
Size Time Until Cancel (ms)
Average 93.51 5,210.67

Standard deviation 22.56 154,922.70
Maximum 400.00 18,326,189.00
99% 100.00 27,946.44
90% 100.00 6543.00
75% 100.00 2284.00
50% 100.00 630.00
25% 100.00 97.00
10% 80.00 30.00
5% 47.00 1.00
1% 2.00 0.00
Minimum 1.00 0.00
Note: ftis table shows the summary statistics for limit orders canceled in full, as opposed to partial order cancellations.
600
500
400
300
200
100
0
3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 4143 45 4749 51
Figure 27.5 Histogram of umberof Order Messages per Each Added Limit Order. ftis figure shows the
number of order messages for each added limit order excluding order additions, followed by single order
cancellations. Addition of the limit order (“A” message) is included in the total order count, displayed on X
axis. fte Y axis shows
the number of order IDs corresponding to each message count.
cancellation message and another added with the same order ID and size, at 590.16. At 14:59:30.895, the
same order ID is in play again, this time receiving a simultaneous cancellation message and an “A” message
with a price of 596.64. At 16:00:00, the limit order is finally cancelled. fte sell order C91KT9000RU9 is
updated via a simultaneous cancellation and an order addition at 9:49:44.619, when the price is reset to 677.88,
and then 11:56:21.674, when the price is reset to 671.49, and then 14:39:58.082, when the price is changed to
677.95. ftis order, too, is finally cancelled at 16:00:00.000 by the exchange, probably because it was a
day limit order.
When a limit order is adjusted, it is recorded not as a separate message but as a sequence of two
messages with the same order ID: an order cancellation followed by an immediate order addition
with revised characteristics. In GOOG data for October 8, 2015, 4,794 messages existed pertaining to
limit order adjustments, making up 9.5 percent of the total message traffic. An average revision occurred
30 seconds after the last order update, indicating likely human direction. Of all the revisions, 99.0 percent
occurred within 40 seconds of the original order addition or last revision. Table 27.6 summarizes the
distribution of inter-revision times for limit orders on GOOG on October 8, 2015.
Of all order revision traffic messages, only 488 (10.2 percent) referred to singular order updates; the
remaining (89.8 percent) of revised orders incurred several sequential revisions in a row. For example, the
limit sell order C91KT9003EDZ was revised five times within six seconds from 9:38:05.139 to 9:38:11.424,
with the limit sell price dropping with each consecutive order from 641.26 to 641.25, to 641.14, to 641.07,
to 641.05. For the 3,244 messages pertaining to the sell order revisions, the price on 95 percent of the orders
was revised downward (i.e., improved with each revision). Similarly, for the 1,550 buy order revision
messages, the price was raised to be closer to the market in 96 percent of cases. In other words, the vast
majority of the 9.5 percent of all limit order traffic comprising limit order revisions was beneficial: the limit
order updates tightened spreads.
Unlike order revisions, 6,168 messages, or 12.3 percent of the 50,274 total order messages for GOOG
recorded on October 8, 2015, were short-lived flashes of liquidity that can be considered “flickering liquidity.”
For example, a 100-share buy limit order C91KT9000W09 is placed at 9:30:02.763 for 632.55, only to be
cancelled 678 milliseconds (ms) later without a simultaneous replacement. At 9:30:09.376, another buy
limit order C91KT9000XZ0 arrives for a higher price of 638.01, and is held for a precise 1,000 ms, at
which point it is also cancelled without an immediate replacement. Two more buy orders turn on and off
sequentially, first for 636.55 at 9:30:11.403 for 1,001 ms, and then for 629.09 at 9:30:14.422 for 5,352 ms,
before a hidden order execution trade print arrives: 23 shares at 642.27 executed at 9:30:47.035. A similar
dance of short-lived quotes followed by hidden order executions continues throughout much of the trading
day. Of the flickering orders, 1,622 message pairs (each flickering order comprises an order addition and an order
cancellation) pertain to sell limit orders, and 1,462 pairs are on the buy side of the limit order book. Table 27.7
summarizes the distribution of the shelf life of orders that are cancelled without immediate replacement and
can, therefore, be considered flickering.
Although the flickering orders identified in Table 27.7 are likely candidates for “pings” in the Pragma
(2011) sense and“canaries”according toDavis et al.(2015),the
Table 27.6 Distribution of Times between Subsequent Order Revisions

for GOOG on October 8, 2015
Shelf Life of Limit Orders between

Subsequent Revisions (ms)
Average 31,119.40
Standard deviation 469,658.70
Maximum 11,224,983.00
99% 40,072.72
95% 10,763.80
90% 5,458.00
75% 1,201.00
50% 45.00
25% 1.00
10% 0.00
5% 0.00
1% 0.00
Minimum 0.00
Message count 4794.00
% of all messages 95.36
Note: ftis table shows the distribution of time (in milliseconds) between subsequent order revisions.
results present a drastically different picture from that of some previous studies on the dynamics of limit
orders, namely Hautsch and Huang (2011) and Hasbrouck and Saar (2013), who both find that 95.0 percent of
limit orders are pings cancelled within one minute of their addition. At the same time, neither makes any
mention of order revisions, potentially counting order revisions as simple order cancellations. Of course, pos-
sibly, order revisions may be treated differently in the dataset that Hautsch and Huang and Hasbrouck and
Saar studied—NASDAQ TotalView. Either way, the results from the BATS data analysis presented in this
chapter lead to a drastically different conclusion: only a small fraction (12.3 percent) of all message traffic
had characteristics of potential pings, or toxic order flow—a far cry from the 95 percent reported in the earlier
studies.
Of the remaining 78.2 percent of the entire message traffic not accounted for in order revisions and
pings, only 700 orders (1.3 percent of the total daily message traffic) were order executions. Of those, only
139 orders (0.3 percent) were executions of limit orders displayed in the limit order book, message type
“E.” fte remaining 561 executions (1.11 percent of total message traffic) were type “P” messages—matches
of
Table 27.7 Distribution of Duration of Limit Orders Canceled with an Order

Message Immediately Following the Order Placement Message
Shelf Life of Flickering Limit Orders (ms)
Average 1,293.19
Standard deviation 7,682.14
Maximum 268,397.00
99% 11,430.36
95% 4,960.80
90% 2,633.70
75% 1,001.00
50% 196.00
25% 4.00
10% 0.00
5% 0.00
1% 0.00
Minimum 0.00
Message count 6,168
% of all messages 12.27
Note: ftis table shows the distribution of visibility of flickering limit orders.
market orders with hidden limit orders, or special order types that do not appear in the centralized limit order
book.
fte finding that most order executions are accomplished with hidden limit orders is not entirely surprising.
Yao (2012) studies NASDAQ data in 2010 and 2011, and finds that hidden orders accounted for 20.4 percent
of all executions. ftis percentage has probably increased, as “lit” exchanges are moving toward structures akin
to dark pools.
Order-Based Negotiations
According to Yao (2012) and other recent research, market participants may use “lit” limit orders to signal
their willingness to buy and sell at specific prices. Most of the execution, however, happens in the interaction
with hidden or dark liquidity that cannot be directly observed in the limit order book. A swift negotiation may
follow an indication of interest, resulting in a hidden order execution. An alternative, less positive, yet popular
hypothesis can be that the institutions and other market-order and hidden-order
traders are influenced by flickering, suboptimal liquidity provided by high-frequency traders. ftis section
presents simple tests of the quality of the orders in today’s markets. Totest the interaction of various order
types, each order message within the data set is first separated and labeled as one of the following categories: a
message revision, a ping, a regular limit order addition, and a regular limit order cancellation. fte message
revision orders are picked out by matching the limit order IDs of sequential orders where the order addition
follows the order cancellation with slightly different parameters. Pings are identified as order cancellations
following order additions with the same order ID without subsequent order additions. All order types are
assigned indicator functions with {0, 1} set of outcomes, depending on which subset of order types the
order messages belong. Finally, 10-message and 300-message moving average series are created for each order
type to serve as dependent variables in the analysis of those order
type impacts on “lit” and hidden order execution.
fte observed impact of various order types appears to change considerably from high frequency to
lower frequency. On average throughout the day, 10 exchange messages were timestamped every five
seconds, with a median time of two seconds and the lowest decile of sixty-seven milliseconds. Conversely, 300
messages were processed every 2.5 minutes, on average, with a median processing time falling to 1.8 minutes
and 10 percent of all 300-message blocks crowding into 1 minute. Although a human trader can theoretically
follow every 10 trading messages in just two seconds, a more likely scenario is that actions at that speed are
processed by a machine, whereas human traders would more likely observe data at a minute scale (i.e., 300-
messagehorizon).
At 10-message frequencies, both regular market order executions and hidden order executions exhibit
dependence on the dynamics of other order types. Using the indicator functions to denote the occurrences of
market order and hidden order executions, and regressing the obtained values on prior 10-order moving
average proportions of other order occurrences, a statistically significant relation can be deduced of the follow-
ing nature:
1. At high frequencies, flickering orders bear little impact on the execution of hidden orders. However, they
have a negative impact on the execution of market orders, potentially deterring market order traders
from sending in the market orders.
2. At high frequencies, limit order revisions have no impact on market order execution, but have a positive
impact on hidden order execution. Potentially, limit order revisions serve to identify hidden order
locations andapproach hiddenorderlocations faster, resulting in matching.
3. At high frequencies, regular limit order placement and cancellation has the greatest impact on the
execution of both market orders and hidden orders. Surprisingly, in the cases of market orders and hidden
orders, the impact of new limit order arrivals and cancellations is negative: the more regularly (non-
revision, no-flicker) that limit order arrivals and cancellations are observed in the limit order book, the
fewer market orders and hidden orders are executed. Potentially, new limit orders are alternative
actions to market orders, with traders choosing limit orders whenever the impending market movement
is not perceived as urgent. Similarly, additions and cancellations of regular limit orders may delay hidden
order discovery, reducing the hidden order cancellation rates.
Table 27.8 Market Order Executions (Message Type “E”) and Other Order Type
Dynamics at 10-Message Frequency
Model 1 Model 2 Model 3 Model 4
Intercept 0.0026 0.0033 0.0397 0.0367

(10.279) (10.523) (20.043) (18.650)
Limit order revisions, 0.0021 – – –
10-orderMAofindicator (0.904)
function, preceding limit
order execution
Flickering orders, 10-order – –0.0024 – –
MAof indicatorfunction (–1.739)
Regular limit order – – –0.0735 –
additions, 10-order MA of (–18.469)
indicator function
Regular limit order – – – –0.0676
cancellations, 10-order (–17.051)
MAofIndicatorfunction
Adjusted R2 −0.0000 0.0000 0.0086 0.0073
Note: ftis table shows the results of regressions examining prevalence of market order executions following limit order
revisions (Model 1), flickering orders (Model 2), regular limit order additions (Model 3), and regular limit order cancellations
(Model 4) within the following 10 messages (median time of 2 seconds).
Tables 27.8 and 27.9 summarize the statistical results of analyses of the impact of order types on hidden and
“lit” order executions at the 10-order message horizon. As these tables show, at the 10-message frequency
both hidden and “lit” order execution are significantly determined by factors unrelated to the order messages
immediately preceding execution. ftis finding is indicated by the statistical significance of the intercept in all
models shown. fte findings serve to illustrate the relative importance that market participants place on the
occurrence of flickering limit orders.
At the 300-message frequency, there is a much stronger dependency of order execution on the preceding
pings and order revisions. Specifically, Tables 27.10 and 27.11 show the following:
• At lower frequencies, flickering orders have a strong impact on market and hidden order execution.
Specifically, an increase in pings leads to an increase in market orders and hidden order executions with 99.9
percent confidence. ftis finding starkly contrasts with findings about the flickering order impacts at higher
frequencies when the execution of market orders declines with increases in flickering quotations.
• At lower frequencies, limit order revisions present a much stronger influence on increased market
order and hidden order execution than at higher frequencies.
Table 27.9 Hidden Limit Order Executions (Message Type “P”) and Other
Order Type Dynamics at 10-Message Frequency
Intercept 0.0107 0.0118 0.1219 0.1269

(20.789) (18.399) (30.932) (32.516)
10-order MA of indicator (1.708)
order execution
Flickering orders, 10-order – 0.0035 – –
MA of indicator function (1.259)
Regular limit order additions, – – –0.2187 –
10-order MA of indicator (–27.624)
function
cancellations, 10-order MA (–29.199)
of Indicator function
Adjusted R2 0.0000 0.0000 0.0190 0.0212
Note: ftis table shows the results of regressions examining prevalence of hidden order executions following limit order
revisions (Model 1), flickering orders (Model 2), regular limit order additions (Model 3), and regular limit order cancellations
(Model 4) within the following 10 messages (median time of 2 seconds).
• At lower frequencies, the impact of regular order addition on market and hidden order executions is
present, but it is less statistically significant than that observed at higher frequencies.
fte divide in how market participants perceive and interpret flickering quotes is informative on many
levels. First, it could reveal a weakness in the centralized quotation system, known as Securities Information
Processor (SIP), administered by the SEC. fte routine operation of SIP involves gathering quotes from various
trading venues, finding the best bid and the best offer among the quotes, and then redistributing the best quotes
back to market participants. Trading venues might use SIP to determine which exchange to forward a market
orderin the absence of best quotes on a given exchange.
fte presence of flickering quotes on a particular exchange could cause SIP to post the flickering order as
the best nationwide quote, and cause a spike in market order rout- ings to that exchange. As a result, the routed
market orders may or may not be filled up at best prices. Alternatively, human traders watching market data on
screens could perceive the flickering quotes as the true available liquidity and attempt to execute against the
quotes using either market or hidden orders. Finally, flickering orders could be pure pings seeking to identify
pools of hidden liquidity within the spread in a given limit
Table 27.10 Market Order Executions (Message Type “E”) and Other Order
Type Dynamics at 300-Message Frequency
Intercept 0.0021 0.1275 0.1511 0.1413

(7.159) (330.659) (8.348) (9.395)
order execution
additions, 10-order MA of (–8.157)
indicator function
cancellations, 10-order MA (–9.165)
Adjusted R2 0.0002 0.0349 0.0017 0.0021
Note: ftis table shows the results of regressions examining prevalence of market order executions following various order
types at300-message frequency (median timeof nearly 2 minutes).
order book. In this case, a small match of a flickering order with a hidden order establishes the location of a
potential liquidity pool in the limit order book.
Inthecontextofsignaling, bothhypothesespostulatedatthebeginningofthissection appear to hold true: (1)
machine traders identify and filter behavior of other machines, disregarding issues such as flickering quotes or
pings; and (2) lower-frequency traders appear to interact with flickering liquidity. Although the results presented
here are a case study of an individual stock—GOOG, on just one trading day, October 8, 2015—the results
areeasilyextendedtoalarger stockuniversewheresimilarconclusions hold.

As this chapter shows, contemporary equity markets are evolving to best meet institutional investors’ needs.
Some issues, however, particularly those pertaining to the collaboration of human and machine traders,
remain unresolved. Most regulated (“lit”) exchanges are accommodating the demand for block trading by
converging to a model that supports large hidden block orders, producing substantial liquidity readily available
to execute institutional investors’ mandates. In BATS data, for instance, the vast majority of order executions
are conducted withhidden limit orders and just a smallfraction are carried on with market orders.
Table 27.11 Hidden Limit Order Executions (Message Type “P”) and Other
Order Type Dynamics at 300-Message Frequency
Intercept 0.0076 0.0030 0.6243 0.4465

(13.019) (2.993) (17.651) (15.167)
order execution
additions,10-orderMAof (–17.271)
indicator function
cancellations,10-orderMA (–14.710)
Adjusted R2 0.0018 0.0023 0.0076 0.0055
Note: ftis table shows the results of regressions examining prevalence of hidden order executions following various order
types at300-message frequency (median timeof nearly 2 minutes).
Furthermore, the chapter has demystified HFT activity and shows that the kind of HFT market-making,
often considered the worst owing to the “flickering” liquidity it delivers, comprises only a small fraction of
available liquidity. Although not as copious as previously thought, flickering liquidity appears to have a dual
impact at distinct frequencies. At high frequencies, the flickering liquidity is mostly detrimental to itself, as it is
readily observed and avoided by other high-frequency market participants. At lower frequencies, however, the
flickering liquidity appears to attract execution of both market and hidden orders, potentially causing order
routing toward flickering order books by the SEC’s consolidated tape via SIP and thus disadvantaging
humantraders.
ftis chapter also has presented the first study of the impact of limit order revisions on market activity.
Like flickering liquidity, limit order revisions appear to have a dual impact on order executions, depending on
the frequency at which the orders are observed. At high frequencies, visible limit order revisions appear to
credibly signal a willingness to negotiate and are followed by a higher number of hidden order executions
than other order types. At lower frequencies, however, limit order revisions appear to stem market and
hidden order executions.
Finally, the chapter has shown that regular limit order additions and, separately, cancellations appear to
deter the execution of market and hidden orders. fte observed negative impact of order additions and order
cancellations is more statistically significant at higher frequencies. Traders observing the markets may want to be
aware of the market’s
responses to individual orders and reconsider their processing of market data, as well as their placement of
orders, with the market signaling context in mind.
1. Discuss the main differences among various equity exchanges operating in the United States.
2. Discuss the key types of HFT.
3. Explain how exchanges distribute market information.
4. Describe how exchanges record various order types.
5. Identify the liquidity considerations that market participants need to consider.
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Part Seven
THE APPLICATION AND FUTURE

OF BEHAVIORAL FINANCE
28
Applications of Client Behavior
A Practitioner’s Perspective
H AR OLD E V E N S K Y , CFP
Chairman, Evensky & Katz/Foldes Financial
Professor of Practice, Texas Tech University
Introduction
Advising clients about their investments is a challenging endeavor. fte investment universe involves many
complexities and often counter-intuitive aspects. Additionally practitioners often misapply various behavioral
finance concepts. Understanding the behavioral errors of clients and knowing the techniques that might help mitigate
such errors forms a useful knowledgebasefor thefinancialadvisor.fte purpose of this chapteris todiscuss various
behavioral concepts and strategies that can help clients avoid behavioral errors, with the result of increasing the
probability of asuccessful plan design and implementation. fte chapter begins with a discussion of the importance
of client education in establishing a long-term relationship. Next, the chapter explains the value of framing
the planning process,followed bya section onbehaviorally basedclientmanagement.fte
final section offers a summary and conclusions.
Aspects of Client Education

Educating the new client about the advisor’s planning and investment philosophy is a critical step in
establishing a sound, long-term relationship. fte following section provides examples that have proved
successful in practice.
FRAMING THE PROCESS: ANCHORING ON

THE EFFICIENT FRONTIER
Many practitioners used to introduce the planning process by presenting the classic Markowitz efficient
frontier graphics, accompanied by a high-level discussion of the optimization process, including such
concepts as standard deviations, correlations, and nonlinear programming. Advisors were so entranced with
their knowledge that they failed to see their clients’ eyes glaze over as they tuned out of the presentation. One
day,
523
524 THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE
Deena Katz, a founder of Evensky & Katz/Foldes Financial (hereafter called “the firm”), observed that “when
you go to the doctor, you don’t expect … a lecture on the development of the medicine … prescribed for
you.” Given that insight, the firm recognized that it was misframing the discussion. Instead of a formal and
intimidating technical presentation, advisors at the firm now frame the educational process in an informal,
nonthreatening way using the following approach.
Current practice is to work in teams, whereby an associate supports a senior advisor in the client meetings.
After completing the “meet and greet” ceremonies, the senior advisor starts the meeting with an introduction
such as “Okay, let’s get started, I’m going to give you a quick overview on modern portfolio theory and explain
how we’re going to help you figure out how you should be invested to enjoy your retirement. ftis is going to
be fun.” fte advisor then turns to the associate and says “Have you got an extra sheet of paper?” At which point
the associate tears a page from a notepad and gives it to the senior advisor. fte advisor then draws the simple
graph illustrated in Figure 28.1 and explains: “ftis is a picture of possible investments showing the balance
between risk and return. Down on the lower left corner is cash or money market instruments with minimal
risk and minimal return. High up on the right is an all-stock portfolio with high risk and high potential return,
and somewhere in the middle is an all-bond portfolio with moderate risk and moderate return.”
Even with just three investment choices, the advisor can design many portfolios. For example, one
portfolio could consist of 1percent bonds and 99 percent stocks; 99 percent bonds and 1 percent stocks; 20
percent cash, 40 percent bonds, and 40 percent stocks, and so forth. Figure 28.2 illustrates various
combinations of investment choice. Figure28.2illustratestheefficient frontier,whichisasetoftheoretically
optimal portfolios that offer the highest expected return for a given level of risk, or the lowest risk for
Return
Stock
Bond
Cash
Risk
Figure 28.1 fte Relation Between Risk and Return. ftis figure shows the relation between risk and return in
a way thatinvestors can easily understand.
I want this one

Return
But the real world is somewhere

under this efficient frontier
I Risk
Figure 28.2 fte Efficient Portfolio. ftisfigure shows a large number of possible portfolios within a
constrained universe of possibilities.
Applications of Client Behavior 525
a given level of expected return. Investors desire a portfolio that will give them a high return with as little risk
as possible, but the actual projected performance results fall somewhere along and under that curve. fte
importance of the curve is to show that no one “best” portfolio exists for everyone. fte best portfolio depends
on the risk–return preference of each investor. A major responsibility of the advisor is to assist in determining
the most appropriate portfolio for an investor by using two criteria: (1) the long- term return needed to
supply the funds necessary to achieve client goals; and (2) an assessment of personal risk tolerance, which
is the degree of variability in investment returns that an investor is willing to withstand.
When financial planners mention risk, they are generally referring to the potential loss in an investment
portfolio that often results from a market downturn. Unfortunately, similar to many terms in the financial world,
“risk” has numerous meanings. Risk capacity describes how much investment risk clients might take
based on their financial resources (i.e., how severe a financial loss clients might sustain and still have the
financial resources to meet their goals). Many investors have ample financial resources and can afford to take
considerable market risk, but that does not necessarily mean they are emotionally prepared to live with that
risk. Risk requirement is the level of return that clients need to meet their financial goals. Although a
financial planner considers both risk capacity and risk requirement, risk tolerance is also a critical element in
developing an allocation recommendation. As Guillemette, Finke, and Gilliam (2012, p. 42) note,
In such times as these [global financial crisis] … the assessment of how clients will react toa
severe market downturn will be critical in determining whether they continue to follow his
planner’s recommendations. If a risk tolerance questionnaire fails to accurately measure a
client’s portfolio allocation preference, it is more likely that client will want to shift his or
her portfolio to cash during market downturns.
Unfortunately, no universal agreement exists on the definition of “risk tolerance” or its measurement
(Roszkowski, Dalaney, and Cordell 2009). Despite considerable discussion and debate about the differences in
risk tolerance, risk perception, risk aversion, and loss aversion, no practical guidance is available for choosing the
appropriate asset allocation for clients. From a practitioner’s perspective, as Guillemette et al. (2012) imply, the
only useful definition of risk tolerance is the threshold for emotional pain—that point at which a client calls
the advisor during a painful bear market and says, “I can’t stand it. Sell the securities in my portfolio and place
the funds in cash.” fte advisor’s goal is to design a portfolio that will keep the risk below that threshold.
During the initial educational process, the advisor explains the importance of using a computer-based
analysis know as a capital needs analysis to determine the unique return required to achieve a client’s goals
with a high probability. ftis analysis takes into consideration: (1) the client’s unique goals, such as caring for
aging parents, funding grandchildren’s’ college, and/or paying off a mortgage; (2) the timing and costs of
reaching those goals; (3) the importance and priority of each goal; (4) where the money is invested, such
as in personal accounts and tax-deferred accounts; and (5) taxes, investment expenses, and inflation. With this
information, a financial advisor canestimate a required portfolio return.
Return B
A
Risk
Figure 28.3 Anchoring on the Efficient Frontier: Risk Tolerance Exceeds Risk
Need. ftis figure demonstrates that when a client’s risk tolerance exceeds his or her risk need, two possible “best”
portfolios are available. One portfolio provides the best return for the client’s risk tolerance and another provides
the return that the client needs at the lowest risk.
With an estimate of the client’s return requirement and risk tolerance, the advisor can then determine the
most appropriate portfolios. In describing viable options, the advisor adds two lines to the risk-return graph.
Figure 28.3 shows that one line reflects the risk required to achieve a required portfolio return and the other
reflects the client’s risk tolerance.
Next, the advisor explains that, based on this information, two “right” answers are available: one reflects a
portfolio with an acceptable risk and the other reflects a portfolio with the required return. A major cognitive
bias that the financial professional likely employs is called anchoring, which is when an investor holds on
to a belief and then applies it as a subjective reference point for making future decisions. fte advisor applies
this anchoring bias to identify the client’s risk tolerance.
Portfolio B seems most appropriate because it provides the highest return for its level of risk; however,
Portfolio A, which is the portfolio that provides the client with the return needed to achieve his goals, has
lower risk. Although both are correct answers, the next step is to determine the more appropriate option to
recommend to the client. ftis choice depends on the advisor’s professional experience and philosophy. An
advisor who is less confident in the accuracy of the risk tolerance estimate might opt to recommend Portfolio
A, with a lower return, because the advisor expects it to meet the client’s return needs and provide some cushion
for risk tolerance. An advisor who is more confident in estimating the client’s risk tolerance might recommend
Portfolio B, in the belief that the higher thereturn, the more financial flexibility the client will haveover time.
If an advisor believes that the client should be encouraged to consider Portfolio A, the advisor may
introduce the concept of Pascal’s wager, a classic philosophical construct devised by the seventeenth-
century French philosopher, mathematician, and physicist Blaise Pascal. fte following scenario illustrates
how an advisor might present this concept to clients.
“Suppose you were told that the probability God exists is only 20 percent. Youcould decide that with those
odds you would ignore morals and ethics and live a guilt-free immoral life. Of course, despite the low odds
that God exists, you would face fire and brimstone if that were wrong. Conversely, if you choose to live a
moral life and God does not exist, you will have had a nice life, but if God does exist, you would have a
wonderful afterlife.”
Return
A
B
I Risk
Figure 28.4 Anchoring on the Efficient Frontier: Risk Need Exceeds Risk
Tolerance. ftis figure demonstrates that when the client’s risk need exceeds his or her risk tolerance, two
suboptimal choices are available. One choice provides the return the client needs at a risk exceeding his
tolerance, and another offers a return below that needed to meet all the client’s goals at a risk within the level
of tolerance.
What’s the point? People often focus on probabilities and forget to look at consequences. Even if a high
probability exists that the advisor identifies the correct risk tolerance and invests accordingly but is wrong, the
client might panic and sell everything in a severe bear market and never recover. Or, if the advisor invests at a lower
stock exposure based on meeting the client’s goals, the client’s heirs might receive less money but the client
will have enjoyed achieving those personal financial goals.
Figure 28.4 shows another possible result: the client’s return objective requires a stock exposure higher
than what is compatible with the identified risk tolerance. If this is the case, the client has two choices: eat less
well or sleep less well. When markets are reasonably stable, clients can easily think, “Well, okay, I’ll take a bit
more risk so I can do everything I want.” Unfortunately, if the portfolio later drops precipitously in a bad
market, the client is likely to forget that resolve to weather the storm and might sell (Lowenstein 2000).
Again, the potential consequences may far outweigh the possible benefits.
THE BASICS OF CLIENT EDUCATION

Given that the client has been introduced to the concept of anchoring on the efficient frontier, the advisor can
then discuss some basic investment concepts in a manner that a nonprofessional can understand so as to build
a strong foundation for professional investment recommendations.
Modern Portfolio Theory

According to Markowitz (1952), risk is as important as return in designing an investment portfolio. Figure
28.5 shows two alternative investments. Although both investment A and investment B are highly volatile,
their return patterns are opposites of each other, though both trend upward over time. In this simple example,
allocating 50 percent to each investment results in the effective canceling out of portfolio volatility. ftis
simple chart demonstrates why combining two risky investments can result in a safer portfolio, although
achieving this goal is difficult in practice.
Return
7
4 Investment A
Investment B
3
50% A and 50% B
2
0
1 2 3 4 5 6 7 8 9 10
Time
Figure 28.5 Risk Reduction through Diversification. ftis figure shows two volatile investments, A and
B. Although they both trend up over time, their peaks and troughs tend to be in opposite directions. By
placing half of a portfolio’s assets in each investment, the variation in the portfolio’s value is substantially
reduced because the volatility of the individual investments tends to cancel each other out.
Capital Asset Pricing Model

Next, the advisor might introduce the concepts of systematic and unsystematic risk, as well as the capital
asset pricing model (CAPM) (Sharpe 1964). Investing in a single company may result in a total loss because
of such factors as mismanagement or the company’s being in the wrong place at the wrong time. In both cases,
the result might be potential bankruptcy. A useful example is an investment in the rental of a single-family
house versus a 10-unit apartment complex, with all units having the same monthly rental. A vacancy in
the home means a 100 percent loss of income; the vacancy in an apartment means a 10 percent loss.
fte critical point is that an individual investment is subject to unsystematic risk, also called
diversifiable risk, which is risk that is specific or unique to the company. Unsystematic risk cannot be
anticipated; One example includes the Tylenol scare in the early 1980s, when Tylenol capsules laced with
potassium cyanide killed seven people in the Chicago area. ftis incident almost put Johnson & Johnson, the
manufacturer of Tylenol, out of business. ftat tampering incident then inspired hundreds of copycat
incidents. Another example is the Deepwater Horizon oil spill, which began April 20, 2010, in the Gulf of
Mexico on the BP-owned Transocean-operated Macondo Prospect. After the explosion and sinking of the
Deepwater Horizon oil rig, a sea-floor oil gusher flowed for 87 days, until being capped on July 15, 2010. As of
February 2013, criminal and civil settlements, and payments to a trust fund, has cost the company $42.2 billion
(Fontevecchia 2013). A discussion of unsystematic risk leads to a discussion of diversification as a risk
management solutionforreducing unsystematic risk.
After the advisor educates the client on the importance of diversification to reduce unsystematic risk, the
advisor can then introduce the concept of systematic risk, also
known as undiversifiable risk, which is the risk endemic to the entire market or market segment. ftese risks
include market risk, interest rate risk, reinvestment risk, and inflation risk. Market risk is the risk that the
entire market, or a particular market segment, will experience an economic downturn. For example, a client
might invest in the S&P 500 Index, which is a U.S. stock market index of 500 large company stocks listed onthe
NYSE or NASDAQ. Many regard this index as the best single gauge of performance for large-cap U.S.
equities. When the market is down, this means that an investment included in the S&P 500 Index is also
down.
A typical response from self-styled conservative investors is “ftat’s why I avoid stocks and invest in
bonds.” If so, the advisor can ask what happens to the “conservative” portfolio of bonds when interest rates rise.
Many investors realize that rising interest rates lead to a decline in the value of their bond portfolios. fte
client has now been introduced to interest rate risk, which is the chance that an increase in interest rates will
negatively affect the value of a fixed-income investment such as bonds. fte naïve investor’s default response is
to suggest managing that risk by investing in short-term bonds. In a low-interest-rate environment, the client
recognizes that is a “solution” with a low return; the risk in a high-interest-rate environment is less obvious. In
this case, a brief history lesson on reinvestment risk is in order.
In 1981, the return on U.S. Treasury bills was 14.7 percent. One year later, it decreased 30 percent to 10.5
percent. By 1987, the return fell to 5.5 percent. ftose changes meant the income on a $100,000 investment
dropped from $14,700 in 1981 to $5,500 in 1987, which is a loss of $9,200 in income. ftis scenario is a classic
example of confusing “certainty” with “safety.” ftat is, the client’s corpus was protected, but that did not
ensure safetybecausehisstandard oflivingmayhavebeennegatively affected.
As the client absorbs that lesson, the advisor can then introduce the concept of purchasing power risk,
which is the risk that inflation will erode the value of the dollar. Even the most conservative retiree investors
are aware of this inflation risk. fte advisor might conclude the discussion by noting that no single investment will
protect the client from these multiple systematic risks, and that the only “safe” strategy is to diversify among
the assetclasses.
Asset Allocation
fte advisor can begin a discussion of portfolio selection by explaining that the three most important
considerations in managing an investment portfolio are asset allocation, security selection, and market
timing. According to a study by Brinson, Hood, and Beebower (1995) and Ibbotson (2000), asset allocation
is a critically important factor driving portfolio performance. fteir findings help to explain why financial
advisors develop an asset allocation that is best suited to the client’s circumstances and “anchor” the client on
the efficient frontier.
Framing the Planning Process

In behavioral finance, the framing effect is an example of cognitive bias, in which people react to a particular
choice in different ways depending on how it is presented, such as a loss or a gain. Attention focuses, then, on
how to appropriately anchor risk through risk
coaching and on anchoring the return through a capital needs analysis. However, clients who engage in
improper anchoring become fixated on past information, and they use that information to make inappropriate
investment decisions. Instead, their ideas and opinions should also be based on relevant and correct facts so as
to be considered valid. However, this is not always so. fte concept of anchoring draws on the tendency of
investors to attach or “anchor” their thoughts to a reference point, even though it may have no logical relevance to
the decision at hand. In the financial world, investors who base their decisions on irrelevant figures and statistics
can experience mistakes because of this cognitive bias (Phung 2015).
ANCHORING THE RISK: RISK COACHING

As previously noted, the concept of risk tolerance is still being debated. In fact, some challenge the
possibility of determining, in advance, a client’s risk tolerance in a bear market. Such debates are irrelevant for
the financial advisor. As mentioned earlier, the only relevant risk measure is that threshold of emotional pain
just before the client calls the advisor and says “I can’t stand it anymore. Sell my portfolio [and put me in
cash]!” Having the ability to predict that threshold with certainty is unrealistic. Practitioners are aware that
when the markets are trending up, a client’s risk tolerance is higher; and when they are trending down, the
client’s risk tolerance decreases. Unfortunately, advisors cannot simply throw up their hands and say, “It’s
impossibletodetermineaclient’s risk tolerance.”
Planning for a client’s long-term financial health requires making asset allocation recommendations.
Although financial planners might be unable to predict a client’s risk tolerance with certainty, they must do
the best they can. Over the years, using lessons from behavioral finance, Evensky & Katz/Foldes Financial
developed a risk-coaching questionnaire to assist the firm’s advisors in estimating a client’s risk tolerance. fte
term coaching is not used in the sense of guiding clients’ responses but, rather, to describe a process that
includes both educational and framing concepts that assist in arriving at a credible result. fte following
discussion offers some examples.
Advisors emphasize that investing requires a long-term horizon. fte discussion focuses on funds that
the client is unlikely to need for at least five years. A major aspect of the risk coaching process is to obtain client
buy-in by stressing this long-term concept. fte discussion and questionnaire starts by clarifying what the
client considers to be a retirement investment nest egg. Specifically, the questionnaire asks:
• What is the approximate value of this investment portfolio?

• What percentage of your total investments is represented by this portfolio?
• Is there animmediate or near term(i.e., withinfive years)needfor income from this portfolio? If yes,
when will it become needed?
• Approximately how much will be needed in after-tax dollars annually?
• “Do you plan to make substantial cash withdrawals over the next five years?
If the client answers yes to either of the last two yes/no questions, the advisor then adjusts the answer to
the approximate value of the investment portfolio.
For example, suppose the client originally indicated that the investment portfolio was $1 million. If the
client needs $50,000 next year to relocate a parent to a new house, the advisor then explains that he will
allocate the $50,000 needed into a cash flow reserve account (to be discussed later) and adjust the
investment portfolio base from
$1 million to $950,000. If the client indicates that “We also need about $10,000 in three years for a special
anniversary trip,” the advisor takes $10,000 for the cash flow reserve and adjusts the investment portfolio
base to $940,000.
fte next question also emphasizes a long-term strategy asking, “What is the portfolio’s investment time
horizon?” Investment time horizon refers to the number of years the client expects the portfolio tobe invested
before dipping into the principal. An alternative question is “How long will the goals for this portfolio
continue without substantial modification?” fte advisor asks the client to indicate the number of years of the
investment time horizon. If the time horizon is less than 10 years, the advisor then asks the client to
explain when the funds will be needed.
Next, the advisor presents the client with a list of investment attributes, as shown in Table 28.1. ftese
attributes are not moral issues. ftey are neither good nor bad, but simply investment attributes. fte point is to
discover how important the client considers each attribute. fte client can answer with all 6s (most
important), all 1s (least important), or any combination of scores. fte advisor instructs the client to answer
these questions assuming that over the next 20 to 30 years, the client achieves those long-term
investmentgoals.
Clients typically answer the attribute “capital preservation” by marking either 5 or
6. A ranking of high importance is expected. In 30 years of practice, Evensky & Katz/ Folds Financial has
never had a client state a goal of losing the corpus, so this allows the client to forcefully document long-term
preservation of capital as a primary concern. Regarding “growth,” almost all clients, including very
conservative investors, typically
Table 28.1 Attributes of Investing
Attribute Most Least
Capital preservation 6 5 4 3 2 1
Growth 6 5 4 3 2 1
Low principal volatility 6 5 4 3 2 1
Inflation protection 6 5 4 3 2 1
Current cash flow 6 5 4 3 2 1
Aggressive growth 6 5 4 3 2 1
Note: ftis table assists in engendering a discussion with a client about the difference in investment attributes, such as capital
preservation and principal volatility, and the contradictory nature of goals, such as the desire for both capital preservation and
inflation protection. For each of the following attributes, circle the number that most correctly reflects your level of concern. fte
more important, the higher is the number. You may use each number more than once.
pick a number between 4 and 6. fte advisor explains to the client that this is a “gotcha” question. fte client
quickly recognizes that investments in cash, money market instruments, or Treasury bills, which are the only
investments that ensure the preservation of the corpus, will not result in long-term growth. ftis response
emphasizes the client’s conflicting goals.
fte response to “low principal volatility” helps distinguish between loss of corpus and interim volatility.
If a client selects 4, 5, or 6 for this, the advisor continues the discussion so that the client understands that
such a short-term volatility constraint may have a large negative impact on being able to achieve those long-
term goals. fte “inflation protection” attribute is another “gotcha” question. Again assuming that the client
neither adds nor withdraws from the portfolio, this question helps identify the importance that the
value of the investments would enable the client to buy a specific amount of goods and services in
today’s dollars. ftis question tests the client’s sensitivity to inflation. Even the most conservative retirees
generally select a 5 or 6 because they recognize that “safe” investments such as certificates of deposit and
short-term bonds, subject to inflation erosion, will be insufficient in the long term to meet financial goals.
For “current cash flow,” the only correct answer is 1. If the client selects any other number, the advisor
asks “What did we miss?” Responding to the quizzical look on the client’s face after this response, the
advisor reminds the client that earlier he had been asked about his short-term need for both cash flow and
lump-sum expenses. fte advisor has moved these funds out of the investment portfolio, allocating funds to the
cash flow reserve portfolio. If something has been missed, the opportunity is now available to increase the
allocation to the cash flow reserve and reduce the allocation to the investment portfolio. fte client can then
comfortably select 1 as the answer.
fte attribute “aggressive growth” does not mean high growth such as in emerging markets but, rather,
strategies such as using naked puts and buying on margin. A naked put, also called an uncovered put, is a put
option whereby the option writer or seller may not have sufficient liquidity (cash) to cover the contracts in
case of assignment. Buying on margin refers to using borrowed money to purchase securities, which increases
both the client’s leverage and potential risk and return. Most clients select 1, which is fine, because the firm
does not recommend such strategies. fte idea behind the question is that the client has been able to select 6 for
capital preservation and 1 for aggressive growth, helping to frame and establish his comfort level with the
overall process.
fte questionnaire also asks several redundant questions, such as “What percent of your investments are
you likely to need within five years?” “Up to what percentage of this portfolio can be put into long-term
investments?” By this point, the client recognizes that the answers of 0 percent and 100 percent, respectively,
anchor their commitment to long-term investing.
To frame the client’s risk and return balance, the advisor asks him to select the portfolio that best
represents his comfort level. fte first column in Table 28.2 describes portfolio risk. fte first term (i.e., low,
moderate, and high) describes short-term risk of less than five years, and the second describes long-term
risk of over five years. fte second column is the firm’s projected return for the portfolio. An inflation
assumption is included to provide the basis for a discussion about the difference between nominal and real
return.
Table 28.2 Projected Return and Risk Exposure under Different Risk Levels
Overall Projected Hypothetical Risk Exposure

Risk Level Total Return “Worst Case”* Bear Market**
(Inflation = 3%) (12 months) (10/07–2/09)
Low/Low 6.0% –4.0% –10.6%
Low/Low 6.8 –7.0 –14.5
Moderate/Low 7.2 –9.0 –16.2
Moderate/Low 7.4 –10.0 –20.1
Moderate/Low 7.6 –11.0 –22.9
Moderate/Low 7.8 –13.0 –25.7
High/Moderate 8.0 –14.0 –29.1
High/High 8.8 –22.0 –40.8
High/High 9.0 –24.0 –45.9
High/High 9.4 –-27.0 –50.9
Note: ftis table allows the client to select a portfolio that meets his comfort level where the return expectations and portfolio
risks are related and explicitly displayed. Several portfolio performance projections are listed below, including hypothetical
potential losses for these portfolios. In the right column, check the portfolio that most nearly reflects the goal of your
portfolio.
* A two standard deviation estimate.
** fte Great Recession.
ftethird column is the theoretical “worst case” risk over a 12-month period. It is actually the loss estimate
based on the firm’s two standard deviation estimate. Unfortunately, the experience of the financial crisis of 2007–
2008 demonstrates that reality may be far greater than two standard deviations, which prompted adding a
column to reflect the actual loss during the bear market of the financial crisis. fte advisor explains that he
knows the client would like to select diagonally for low risk and high return, but reality requires that he look
horizontally, thus helping frame the relationship between risk and return. ftis discussion is based on one of the
few quantifiable questions that helps establish an acceptable bond-to-stock ratio.
fte final question deals with the behavioral aspects of prospect theory and loss aversion (Kahneman and
Tversky 1979; Tversky and Kahneman 1992), but the advisor presents it in a less formal manner. fte advisor
gives the client the following scenario:
“You’ve just stepped through the door of a huge gambling casino and a band strikes up a rocking medley.
ftousands of people surround you hollering and cheering, and balloons and confetti stream down from the
ceiling. As you stand there bewildered, a
gentleman in a tuxedo walks up to you and says ‘Congratulations! You’re our 10 mil- lionth customer and
you win! Now this is Vegas, so you have a choice.’ He points to his outstretched right arm holding what looks
like bills going to the ceiling and says, ‘ftis is $800,000. Point to my right arm and it’s yours! But, because this
is Vegas you have a choice. In my left hand I have a brown bag with 10 Ping-Pong balls, 8 white and 2 black. Put
your hand in and pick a white ball and you win $1 million. Pick a black ball and you win nothing. What will it
be?’ ”
ftis question has been used for over a decade, and less than 5 percent of clients select taking a chance.
fte follow-up scenario is, “Sorry, I made a mistake, you’re not in Vegas, but you’re in Hell. fte devil walks up to
you and says ‘No surprise but you lost; however, I’m a gambling man so you have two choices.’ He holds out
his right arm and says ‘See, it’s empty. Point to that arm and you owe me $800,000. In my left hand I havea brown
paper bag with 10 ping-pong balls, 8 white and 2 black. Put your hand in and pick a black ball and you owe me
nothing, pick a white ball and you owe me $1 million. What will it be?’ ” fte results are consistently just the
opposite, in that more than 90 percent of clients say they will take a chance.
Advisors use these scenarios to frame the difference between risk aversion and loss aversion. As an
example, the advisor at a brokerage firm might view a client’s portfolio as too conservative and suggest moving
half the funds into the market to earn a higher return. In that case, the “conservative” client might leave.
Evensky & Katz/Foldes Financial might make the same recommendation, but for a different reason. Ifanadvi-
sor recommends increasing the stock allocation, the reasons are not to make the client richer but, rather, to
avoid a client’s losing his standard of living in retirement. A conservative investor gains a new perspective and
now understands and reconsiders revising his investments to increase the stock allocation.
A NCH ORING THE RETU RN : CAPITAL NEEDS ANALYSIS

Given that the first anchor has been applied to the client’s risk tolerance, the next anchor is an estimate of the
required return necessary to accomplish the client’s goals. fte capital needs analysis considers the four primary
elements of each goal: cost, timing, priority, and importance. For example, if a client wants to provide for a
grandchild’s college education, the advisor would need to determine the year the expenditure would begin,
number of years to be funded, annual cost, expected tuition inflation, and priority of that goal relative to all
other client goals. Although these seem easy questions to answer, a client often has difficulty providing the
necessary information without guidance. fte traditional solution is to provide the client with a data-gathering
questionnaire that lists various goals. An example is the form for a college funding goal from Pie Technologies
MoneyGuide Pro (https://cdn.moneyguidepro.com/Pdf/ClientTools/College_ Zoomer.pdf).
Unfortunately, clients often find a comprehensive data-gathering package overwhelming and either
return an incomplete package to the advisor or simply decide that the process is too intimidating and terminate
their planning efforts at this stage. To deal with this potential planning barrier, Bob Curtis, principal of
PIEtech, developed the Goal Card Game. Reframing the data-gathering process as a fun card game is a simple
but effective strategy.
To reframe the data-gathering process as a positive experience, the advisor introduces the card game
with “Let’s have fun and play cards.” fte advisor offers the client a deck of cards, each with a picture reflecting
a possible goal, such as funding college, travel, purchasing a second home, providing support for a friend or
family member, starting anew business, orreplacing acar.fte presentation continueswiththeadvisor saying:
“We are going to develop a plan for the rest of your life. ftis is really exciting, but to ensure the life you want
to live, we need to determine when and where you will need to use your financial resources. So what I want you
to do now is take this deck of cards and make two piles. ftose goals that have nothing to do with your future go
into the first pile. Inthe secondpile, I wantyou to put the cards that mayresonate with you.”
fte process is interactive, especially when a couple is involved, because envisioning their future with
pictures of possible goals in front of them engenders a lively discussion. For example, one person might pick up
the home remodeling card and aggressively slap it into the “no interest pile,” only to have the other grab the card
and move it to the “We need this” pile, commenting, “You promised I could remodel the kitchen!”
After sorting all the cards, the advisor and client focus on the cost, timing, and importance of the
goals selected. fte advisor then gives the client a set of the selected goal cards along with the data-gathering
questionnaire to complete as time permits. ftis process not only reframes the potentially unpleasant
experience to one that is fun but also results in the client’s emotional ownership of the outcome.
When the client returns the completed questionnaire, the advisor, using capital needs software, can
integrate that information with his capital market expectations and determine the portfolio allocation necessary
for the client to achieve the unique goals. fte advisor can then provide a definitive recommendation for the
client’s investment policy statement (IPS).
Behaviorally Based Client Management

Advisors often believe that their clients are at risk of making bad decisions. In such cases, techniques and
responses based on behavioral theory can be effective tools in guiding those clients to better decisions. fte
following are examples that can lead to successful conclusions.
MARKET TIMING
fte client may believe that he or a selected advisor can accurately predict when to exit the equity market before
a major correction. Although academic research suggests the unlikelihood of this strategy over an extended
period, referencing that research often fails to persuade an investor enamored with his own ability (Sharpe
1975; Chang and Lewellen 1984: Jeffrey 1984; Malkiel 2004). fte following framing technique can be
successful in having the client reconsider his commitment to a market timing strategy.
fte client is asked if he can name the top 10 artists of all time or the top 10 movies or the top 10 songs, or if a
sports fan, the top 10 athletes. A client typically responds “Of course.” fte advisor follows up with the
observation that although some disagreement
might exist about who belongs on the list, coming up with the 10 names should not be a problem. fte advisor then
asks, “Name the top 10 market timers of all time.” fte typical response is silence. fte follow-up question is,
“Well, name the top five.” Again, the client does not respond. fte advisor concludes with, “Name one top
market timer.” With a final no response, the advisor has clearly made his point. If successful market timers
were available, people should know their names. Because the person draws a complete blank, the client
realizes that the strategy may not be as obvious a solution as the individual previously believed. Hence, the
person is likely to reconsider whether to engage in market timing.
WOULD YOU BUY THAT STOCK TODAY?

A client might present a portfolio to an advisor that has a large position in a stock with a substantial unrealized
loss. If the advisor determines that the position is inappropriate for the client’s portfolio, then the advisor
should recommend selling the stock. fte client often responds that he plans to sell the stock as soon as the price
recovers to the point that the individual does not face a sizable loss. Despite the advisor’s explanation of why
holding the stock is inadvisable, the client often remains unwilling to sell. fte following framing technique
is often successful in getting the client to reconsider.
With this strategy, the advisor asks the client, “Would you buy that stock today?” fte response is frequently
no. fte advisor then explains that if the client gives his permission to sell, the proceeds of that sale would be in
the client’s account the next morning. fterefore, by keeping the stock, the client is actually making a decision to
buy the stock at today’s price. When reframed as a purchasing decision instead of a sale decision, the client
often elects to sell.
A HOT INVESTMENT
In this scenario, the client approaches the advisor anxious to buy an investment recommended by his
neighbor, a family member, or friend or based on a story in the media. If the advisor believes the investment is
inappropriate, the financial professional might provide a thoughtful and fundamentally sound explanation
about the potential risk of the investment, the inappropriateness of the investment as a part of the total
portfolio, and a lack of information the client has about the investment or other sound objec- tions.
Unfortunately, the client is often so excited and enamored about this hot tip that he disregards the advisor’s wise
counsel. In this case, several framing techniques might prove useful.
fte first technique recognizes that the client may discount what the advisor says and thus transfers control to
the client. “ftat sounds like a very exciting investment, but I am unfamiliar with that investment. Tell me more
about it.”ftis strategy allows the client to share his excitement and to expound on all the possible benefits of the
investment. fte advisor then follows up with, “As I said, I am unfamiliar with that investment so I was
wondering what might go wrong?” ftis question triggers the client’s mind to focus on risk, not just potential
return. ftis novice investor may say, “Well, government approv- als are needed that might not come through
and the firm needs to get its financing in place that might also fall through.” By the time the client has refocused
hisattention on
what might go wrong instead of solely on the excitement of everything going right, he may elect to pass on
the investment or at least reduce his commitment.
Another technique is also based on reframing the client’s attention from the upside to the consequences.
“Your idea sounds like a very exciting and potentially rewarding one, so I updated your financial plan to see
what such an investment might do for you. I found that if successful, you can not only take that expensive
two-week Caribbean cruise you and your wife have been planning but also take the three-month world cruise.
However, if it fails, I estimate you would have to continue working two years past your current planned
retirement date.” ftis strategy prevents many clients from making inappropriate investments with a
substantialportionoftheirretirementsavings.
fte prior examples are based on reframing a client’s focus from the expected positive outcome to the
potential negative result. ftis strategy can be a powerful tool in many circumstances and is based on Pascal’s
wager, discussed previously. An advisor might also use such a strategy as a framing device for his longevity
assumption. It can be presented in this manner.
“When developing your retirement plan, a critical factor is estimating how long you are likely to
live. Based on the fact that you are a nonsmoker, your current health and your parents’ and siblings’
health history, I might recommend planning until age 93.” If the client responds, “No, that’s too long. I
don’t think I’ll make it past my mid-80s,” the advisor then reminds the client about Pascal’s wager as
follows: “Although you could die by 85, if you plan to that age and you live until 93, the quality of
your life for those last eight years is likely to be greatly compromised.” Discussing the concept of Pascal’s
wager with clients can be a powerful educational and framing tool in many aspects of the client
relationship, helping the client to look beyond probabilities, avoid behavioral errors, and make rational
decisions in the retirement planning process.
BEHAVIORAL THEORY IN PRACTICE: AN EXAMPLE

A major risk facing retirees is known as sequence of return risk, which is the relations between the order
in which investment returns occur, the timing of withdrawal of funds in retirement, and the impact on portfolio
value. As Bengen (1994) demonstrates, even if returns average out in the long term, early market declines
combined with ongoing withdrawals can result in a client’s retirement spending shortfall.
For financial advisors, managing this risk has both practical and behavioral components. fte design of an
implementation plan that mitigates the sequence of return risk is an example of a practical component. fte
management of client emotions and actions in a volatile market environment is an example of a behavioral
component. ftese issues and an investor’s tendency to think in terms of mental accounts (which refers to the
tendency for individuals to mentally separate their money into distinct accounts based on subjective criteria
such as the source or use of funds [Shefrin and ftaler 1988]) led Evensky to develop the Evensky & Katz
Cash Flow Reserve strategy in the early 1980s (Evensky1997),which was updated in2013(Pfeiffer,Salter,and
Evensky 2013). Today, this plan would be described as a two-bucket strategy. Implementation of the strategy
involves bifurcation of the client’s total portfolio into a cash flow reserve portfolio (the short-term portfolio)
and an investment portfolio (the long-term portfolio).
fte cash flow reserve portfolio is funded for two possible short-term client goals. fte first funding goal
is any lump-sum expenditures the client anticipates within the next five years. fte basis for the five-year
time frame for lump-sum needs is the historical market record. fte risk of investment loss for short periods
is substantial. For known short-term needs, the client’s goal is to have a specific dollar payout available.
Although a market investment may result in a higher return, it may also result in providing inadequate funds
when the short-term goal requires funding. As an example, this need for funding might include college
funding for a grandchild, a special anniversary trip, or home remodeling. fte second potential reserve would
be one year’s worth of funds required for the client’s annual living expenses. For example, a client anticipat-
ing a need for a gross cash flow of $100,000, including taxes with an annual income from Social Security
and pension of $70,000, would fund the cash flow reserve with the $30,000 shortfall. ftis amount would
not generally exceed 4 percent of the total portfolio. Although 4 percent is consistent with Bengen’s 4 percent
rule (Bengen 1994), the firm’s recommended maximum withdrawal is not based on any arbitrary rule; rather, it is
limited to an amount that a capital needs analysis concludes can be sustained over the client’s life span. fte
balance of the assets would fund the long-term investment portfolio.
fte basis for the one-year cash flow allocation is both behavioral and practical, whereas the five-year
lump-sum allocation is primarily related to the practical management of withdrawal risk. Although an obvious
opportunity cost exists for the funds allocated to the cash flow reserve portfolio, the investment portfolio’s
equity allocation may be modestly increased to offset this opportunity cost.
Before retirement, most clients are used to receiving a consistent salary income, the “paycheck syndrome.”
In retirement, when that consistent cash flow stream disappears, this often results in angst on the retiree’s part. To
simulate his prior experience, the advisor would arrange with the portfolio custodian to provide the client
monthly payments equal to 1/12 of the supplemental cash flow reserve. fte custodian makes the payment to
the client’s personal checking account thus replacing the “paycheck.” Typically, cus- todians do not charge
for the service
Having separated out short-term cash flow needs, the investment portfolio can be designed and managed
as a long-term, total return portfolio. As time passes and the investment portfolio requires rebalancing, the
advisor takes the opportunity to refill the cash flow reserve portfolio to its original target amount. For
example, assume the following:
Initial Allocations
Total portfolio $1,000,000

Cash flow reserve (supplemental $40,000
living expenses)
Investment policy 50 percent fixed income/50 percent equity
Investment portfolio $960,000
Fixed income $480,000
Equity $480,000
18 Months Later (Bear Market)
Total portfolio $910,000

living expenses)
Investment policy 50 percent fixed/50 percent equity
Equity $380,000
At this stage, the advisor would rebalance the portfolio, selling fixed income and buying equity. If no cash flow
reserve is available, that would entail selling $60,000 of fixed- income securities and buying $60,000 of
equity. In this example, in which a need exists to fund the cash flow reserve, the advisor would sell $65,000
of fixed income, buy
$55,000 of equity, and transfer $10,000 to the cash flow reserve portfolio.
Rebalanced Portfolio
Total portfolio $910,000

living expenses)
Investment policy 50 percent fixed income/50 percent equity
Equity $435,000
fte result is a portfolio balanced in accordance with the investment policy statement and a fully funded cash
flow reserve account, all without having to sell equities at a substantial loss.
According to Evensky (1997), this approach is useful tool. fte practical benefits of this strategy are as
follows:
• Providing substantial control over the timing of investment liquidations can eliminate most cash flow
related volatility drain.
• Making an investment portfolio for the long term can improve tax and expense efficiency.
• Having alargereserve ofliquidfunds providesflexibilityinmeeting the uniqueand changing needs of
clients.
Besides these practical benefits, the most important benefits are behavioral:
• Having a consistent and dependable cash flow, independent of market volatility and changing dividend and
interest rates, enables effectively managing the paycheck syndrome by providing comfort to the client
during turbulent markets.
• Having the source of the client’s short-term cash flow needs visible and reliable in bear markets enables
clients not to panic because they know that their “paycheck” will continue and they will not have to sell
investments at a sizable loss.
• Knowing that the strategy was in place and has been tested during the October 1987 Black Mondaycrash,tech
bust, and financial crisis of 2007–2008, and has been uniformly successful, enables clients to remain fully
invested and weather these turbulent market periods.
REPORTING
One final application of behavioral management involves reporting. Although advisors generally encourage
their clients to focus on long-term performance, client reporting typically focuses on performance and
includes performance metrics for the last quarter and year-to-date, typically benchmarked to some index
such as the S&P 500. As an alternative, advisors should consider revising their standard reports to frame the
information provided to clients in a manner consistent with long-term planning. Asset allocation primarily
determines a client’s long-term investment success (Brinson et al. 1995). ftus, the first element of the report
should be the policy, not the performance.
Portfolio performance should also focus the client on the long term. Improperly framing performance
by providing short-term return metrics encourages investors to react in the short term, ultimately
undermining their long-term goals. fterefore, the shortest time period reflected in the report should be one
year. Finally, the goal of clients’ investment portfolio as reflected in the IPS is to help them provide the real
cash flow necessary to accomplish their goals, not to beat the market. As a result, performance should be
benchmarked to the consumer price index (CPI), not the S&P 500 Index. Individual managers should be
benchmarked to an investable index, such as exchange-traded funds, reflecting the manager’s
investment style.

Behavioral finance provides a rich source of insights into client behavior, enabling practitioners to
empower their clients to make better decisions. fte use of these concepts begins with framing and the new
client’s education, plus introduction to the concept of anchoring on the efficient frontier. fte advisor
continues with tools such as the MoneyGuidePro Card game to help capture the complexity of client goals
and evaluate the client’s risk tolerance, such as the Evensky & Katz Risk Coaching process. Before
implementation, preparing a thoughtful IPS helps frame the client’s expectations and provides a road map
for the actual implementation and ongoing management. Introducing clients to behavioral concepts such as
overconfidence and anchoring helps them manage their tendency to make behavioral errors. Revising
quarterly reports to properly emphasize the long-term nature of investing and appropriate benchmarking
keep clients focused on the important aspects of their investment returns. Finally, behavioral based strategies
such as the Cash Flow Reserve enable clients to weather unpleasant volatile markets.
1. Distinguish between risk capacity and risk requirement.
2. Discuss the meaning of risk tolerance.
3. Explain how to present the various elements of a client’s quarterly report.
4. Describe framing and how a financial advisor might use it.
REFERENCES
Bengen, William P. 1994. “Determining Withdrawal Rates Using Historical Data.” Journal of Financial Planning
7:4, 171–180.
Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower. 1995. “Determinants of Portfolio Performance.”
Chang, Eric C., and Wilbur G. Lewellen. 1984. “Market Timing and Mutual Fund Investment Performance.” Journal
of Business 57:1 Part 1, 57–72.
Evensky, Harold. 1997. Wealth Management—The Financial Advisor’s Guide to Investing and Managing
Client Assets. New York: McGraw-Hill.
Fontevecchia, Agustino. 2013. “BP Fighting a Two Front War as Macondo Continues to Bite and Production Drops.”
Forbes, February 5. Available at www.forbes.com/sites/afontevecchia/ 2013/02/05/bp-fighting-a-two-front-war-as-
macondo-continues-to-bite-and-production- drops/.
Guillemette, Michael A., Michael Finke, and John Gilliam. 2012. “Risk Tolerance Questions to Best Determine Client
Portfolio Allocation Preferences.” Journal of Financial Planning 25:5, 36–44. Ibbotson, Roger G., and Paul D. Kaplan.
2000. “Does Asset Allocation Policy Explain 40,90, or
100% of Performance?” Financial Analysts Journal 56:1, 26–33.
Jeffrey, Robert H. 1984. “fte Folly of Stock Market Timing: No One Can Predict the Markets Ups and Downs over a Long
Period, and the Risks of Trying to Outweigh the Rewards.” Harvard Business Review July-August, 102–110.
47:2,263–291.
Lowenstein, George. 2000. “Emotions in Economic fteory and Economic Behavior.” American Economic Review
90:2,426–432.
Malkiel, Burton. 2004. “Models of Stock Market Predictability.” Journal of Financial Research 27:4, 445–459.
Pfeiffer, Shaun, John Salter, and Harold Evensky. 2013. “fte Benefits of a Cash Reserve Strategy in Retirement
Distribution Planning.”Journal of Financial Planning 26:9, 49–55.
Phung, Albert. 2015. “Behavioral Finance: Key Concepts—Anchoring.” Investopedia. Available at
http://www.investopedia.com/university/behavioral_finance/behavioral4.asp?he.
Roszkowski, Michael J., Michael M. Delaney, and David Cordell. 2009. “Intraperson Consistency in Financial Risk
Tolerance Assessment: Temporal Stability, Relationship to Total Score and Effect on Criterion-related Validity.”
Journal of Business Psychology 24:4, 455–467.
Sharpe, William. 1964. “Capital Asset Prices—A fteory of Market Equilibrium under Conditions of Risk.” Journal of
Finance 19:3, 425–442.
Sharpe, William. 1975. “Likely Gains from Market Timing.” Financial Analyst Journal 31:2, 60–69. Shefrin, Hersh, and
Richard ftaler. 1988. “fte Behavioral Life-Cycle Hypothesis.” Economic Inquiry
26:4, 609–643.
Tversky, Amos, and Daniel Kahneman. 1992. “Advances in Prospect fteory: Cumulative Representation of
Uncertainty.”Journal of Risk and Uncertainty 5:4, 297–323.
29
Practical Challenges of Implementing
Behavioral Finance
Reflections from the Field
G R E G B . D AV I E S
Founding Partner, Centapse, London
Associate Fellow, Oxford, Säid Business School
PETER BROOK S
Behavioral Finance Transformation Director
Barclays, London
Introduction
Taken in isolation, the ideas and concepts that make up the field of behavioral finance are of limited
practical use. Indeed, many of the attempts to apply these ideas amount to little more than a trite list of
biases and pictures of human brains on PowerPoint slides. Talking a good game in the arena of behavioral
finance is easy, which often leads to the misperception that it is superficial. Indeed, making behavioral
finance work in practice is challenging: it requires integrating these ideas with working models,
information technology (IT) systems, business processes, and organizational culture.
ftis chapter reviews some of the common misperceptions of applied behavioral finance and the
problems of implementing behavioral ideas, based on experience gained in leading a functioning corporate
behavioral finance team for nearly a decade. fte chapter is intended to be neither an academic discussion on
methodological rights and wrongs of human behavior nor an instruction kit for practical application—the range
of environments and applications is too broad. Instead, the goal is to provide an overview of themes that result
in poor implementation or outcomes, or in misguided applications to commercial problems.
fte first section addresses some misconceptions commonly held by aspirant practitioners, including
more than a few academics trying their hand at commercial applications, about the nature of behavioral
finance. fte second section looks at some of the common problems or barriers to successful utilization of
behavioral principles in practice. fte third section offers some constructive principles on how to
approach
542
Practical Challenges of Implementing Behavioral Finance 543
application. fte final section concludes with some more practical suggestions on how to bring this rich body
of knowledge to life within an organization.
Misconceptions in Commercial Practice

About Behavioral Finance
Before discussing the difficulties of practical implementation, it is often necessary to persuade practitioners of
the need to consider behavioral approaches at all. ftis task has become much easier since the turn of the
century, as terms such as behavioral finance, behavioral economics, and decision science are now much
more familiar and less daunting. ftis change has been helped considerably by the explosion of accessible
popular science books on various aspects of the field, as well as by various mainstream journalists covering the ideas
innews stories.fte sharing ofthe NobelMemorial Prize inEconomicSciences in 2002 by Daniel Kahneman and
Vernon Smith dramatically increased public awareness. fte financial crisis of 2007–2008 further enhanced
the credibility of behavioral finance, as it provided a painful reminder that emotion and psychology are
fundamental to how the financial system functions. ftis increased credibility was particularly true in contrast to
other areas of economic research—behavioral economics was about the only field of economics that came out of
the financial crisis with more credibility than it had going in. fte attention paid to the field of behavioral
economics by governments,partic- ularlyinthe UnitedStatesandthe UnitedKingdomfollowing the publication
of the book Nudge (ftaler and Sunstein 2008), and regulators, with the United Kingdom’s Financial Conduct
Authority(FCA)leadingtheway,hasfurtherincreaseditsacceptance.
fte commercial world is now much more open to behavioral thinking. ftis openness can lead to
misconceptions and skepticism, sometimes to the point where it risks appearing a management fad rather than
a serious body of academic knowledge. Most unfortunate among these misconceptions is the notion that
behavioral finance consists of nothing more than a list of psychological biases. ftis perception is unfortunate
because the thoughtful categorization of a complex field into a number of distinct heuristics and biases, each
accompanied by compelling examples, has helped to make the field more understandable, accessible,
and popular.
THE “BIAS” BIAS

Today, extremely long lists of biases are available, which do little to convey the underlying sophistication,
complexity, and thoroughness of more than half a century of highly robust experimental and theoretical
work. ftese lists provide no real framework for potential practitioners to deploy when approaching a
tangible problem. And many of these biases appear to overlap or conflict with each other, which can make
behavioral finance appear either very superficial or highly confused.
fte easily accessible examples that academics have used to illustrate these biases to wide audiences have
sometimes led to the impression that behavioral economics is an easy field to master. ftis misrepresentation
then leads to inevitable disappointment when categorizing biases proves not to be a panacea. A perception of
the field as “just
anecdotes and parlor games” reduces the willingness of the commercial world to put substantial investments
of time and resource into building applications grounded on the underlying ideas. Building behavioral
finance ideas into commercial applications requires both depth and breadth of understanding of the theory
and, in many cases, large resource commitments. Having broad guiding frameworks, such as the notion of
“two systems of reasoning” (Sloman 2002) enables users to approach the somewhat chaotic multitude of
behavioral findings in a practical way, rather than to have a lengthy list that provides no conceptual framework
with which to apprehend the complexity.
BEHAVIORAL IS NOT IN CONFLICT WITH TRADITIONAL

A second misconception is that behavioral finance necessarily conflicts with traditional finance (also called
classical or standard finance). ftis concern raises barriers to acceptance, particularly among those who have
built their careers on understanding and deploying the tools, models, and ideas of traditional finance, and
has often been per- petuated by behavioral proponents seeking to advance their ideas by focusing on areas
where traditional finance is deficient. Again, these “anomalies” have been an effective way of demonstrating
that any attempt to understand financial systems without considering behavioral aspects is incomplete, but
have sometimes led to the impression that behavioral approaches are entirely antagonistic to traditional
financial models.
ftis combative approach and academic debate of the two schools of financial thought is not useful
when trying to solve practical problems: it is off-putting to those in industry and risks entire systems being
dismissed based on problems with specific details. Implementation of behavioral ideas requires building on
what already exists by understanding traditional financial theory and frameworks. Couching language in terms
that those in the industry can easily understand and accept is essential. Recognizing that behavioral finance is not
in opposition to traditional finance but, rather, a generalization of it, is crucial. fte tools and models of
traditional finance in many ways provide the “right” answer. fte descriptive inadequacy of Homo
economicus does not mean dismissing all the normative models of classical finance but, rather, requires
thinking about how to adapt them for the complex reality of real people and multifaceted environments.
Behavioral finance should help to make traditional finance more relevant, because it shows how to relax the
overly narrow normative assumptions to adapt these models to the real world, providing better solutions
for real people.
THE COST OF “LABELS”

A final source of misconception comes largely from within the academic field itself: the endless debates about
what it is and what it is not; continual attempts to define and label subsets of research findings as “behavioral
finance” or “behavioral economics”, “social psychology”, or “decision science”; and methodological
debates about what should be excluded. ftis labeling and quarreling may be of academic interest, but it
leads to considerable confusion among practitioners and makes the field as a whole look disconnected and
internally inconsistent. ftis situation, in turn, leads to concerns that, whatever it is called, behavioral finance
is not sufficiently developed and coherent to be practically useful.
Among these debates are those about whether deviations from the normative models should be classified
as “biases”, or whether heuristics are reasonable responses to complex choice environments, including the
concern as to whether they are “eco- logically rational” (Todd and Gigerenzer 2012). fte purist
interpretations often lead to straw-man definitions of what is “in” and “out” of the broad field, drawing
artificial boundaries and divisions and casting doubts on potentially valuable tools and ideas as being
somehow outside the fold.
A commonly expressed concern, at least in the mainstream press, is that there exists no grand unified
theory of behavioral economics, and that the field is thus merely a chaotic collection of unconnected and
often contradictory findings. For the purpose of practical implementation, the notion that this is, or needs to be,
a clearly defined field should be eliminated, reducing the desire to erode it with arbitrary labels and defini-
tions. Human behavior operates at multiple levels, from the neurological to complex social interactions.
Any quest for a grand unified theory to mirror that of physical sciences may well be entirely misguided,
together with the notion that such a theory is necessary for the broad field to be useful. Much more effective is
an approach of treating the full range of behavioral findings as a rich toolbox that can be applied to, and tested
on, a range of practical concerns.
Challenges of Applying Behavioral Finance

The use of behavioral finance often falls prey to superficial approaches or inappropriate
applications of financial theory. This section explores concerns with the practical implementation of
behavioral finance by both industry practitioners and academic consultants, who often resort to a “lift
and drop” of techniques between different domains of choice with little understanding of the context of
those choice domains. The section includes examples of recent successes in applying behavioral finance.
SUPERFICIAL APPROACHES
fte first major challenge is that behavioral finance is not particularly effective if applied superficially. Yet,
superficial attempts are commonplace. Some seek to do little more than offer a checklist of biases, hoping that
informing people of poor decision making can solve the problem. Instead, a central theme of decision science is
the consistent finding that merely informing people of their adverse behavioral proclivities is very seldom
effective in combating them.
Because behavioral finance is both topical and fascinating to many people, it attracts “hobbyists” who can
readily recite a number of biases, but who have neither the depth of knowledge of the field overall nor a solid
grasp of the theoretical underpinnings of the more technical aspects of the field. For example, some refer to the
behavioral concepts of loss aversion or prospect theory, without truly understanding the foundations
and shortcomings. Even Cumulative Prospect fteory (CPT) (Tversky and Kahneman 1992), a framework
containing many powerful insights central to behavioral research and arguably the most accepted alternative to
the traditional Expected Utility fteory, is
frequently both misunderstood and misstated outside, and sometimes inside, academia. CPT is further
discussed in the next section.
ftis chapter is not an attempt to erect barriers to entry among behavioral practitioners and claim that
only those with advanced degrees in the field should be taken seriously. On the contrary, the effect of greater
academic training can cause its beneficiaries to hold on too closely to narrow and technical interpretations
of the field to make them effective practitioners. Indeed, some of the most effective practitioners do not have
an extensive academic background in the field. However, they have invested considerable time and effort in
getting to know and deeply understand the breadth and depth of the field. ftey understand how new insights
intersect with traditional theory and approaches, and reflect on how this body of knowledge applies to a wide
range of practical problems and decision environments.
Limited study of behavioral finance through reading the popular books on the topic may equip one to sound
knowledgeable and appear convincing. However, as this field is a relatively new one, the purchasers of
behavioral expertise are seldom equipped to know the difference and may be unable to tell a superficially
convincing approach from approaches that embody true understanding. ftis leaves the field open to
consultants peddling “behavioral expertise” but having in their toolkit little more than a list of biases that they
apply sequentially and with little variation to each problem encountered. Warning flags should go up
whenever the proposal rests heavily on catalogues of behavioral biases or contains a preponderance of
pictures of brains.
Superficial application of behavioral finance leads to a particular tendency to take a behavioral principle or
“ bias” in isolation and then implement something based on this process, without considering the broader
complexities of the environment. A specific problem may arise in part from a particular identified bias, but it
does not necessarily follow that resolving this bias will either resolve the problem or that the intervention
itself will not cause additional unforeseen problems of its own. Human behavior is complex and is influenced
by a multitude of simultaneous effects—some internal, some social, and some environmental. ftese multiple
factors all interact. Trying to understand and change behavior by going through a list of “biases” one by
one in isolation fails to account for this complexity.
Many examples exist of nudges that have effectively addressed a specific problem, often by focusing on a
particular behavioral finding. However, many examples of unsuccessful nudges are also available. Changing
behavior in a desired direction often requires a sophisticated program of experimentation and testing to see
what works and what does not. It requires thoughtful consideration of all the aspects of the environment and
behavior that requires substantially more depth and breadth than simply ticking off a list of biases. For
example, the recently launched incomeIQ test from Schroders (2015) assesses respondents’ propensity to
display a number of behavioral biases indicating areas of improvement. Although customers may appreciate
the helpful tips, this test may do little to alter anyone’s behavior.
By contrast, the Save More Tomorrow program for increasing pension contribution rates is an
example of a good behavioral design (ftaler and Benartzi 2004). ftis behavioral approach has been
developed through sophisticated and thoughtful understanding of many aspects of human behavior. It
shows a clear understanding of both
the environment in which the strategy will be deployed and the objective the nudge is trying to achieve.
An example of a behavioral intervention, seemingly used without fully weighing up the associated costs,is
the design of the default pension solutions in the UK’s National Employment Savings Trust (NEST). To
encourage those new to pension contributions to participate over time and stay invested, the default solutions
are invested at reduced risk levels early on to ensure that the investors’ early experiences with investing are com-
fortable and they do not get put off by experiencing too much market volatility early in the process.
Superficially, this seems like a good idea because emotional comfort with investing decisions plays a huge role
in long-term investing success, and bad experiences early on may have long-term harmful consequences.
However, this approach reduces risk at exactly the time when investors are most financially capable of taking
risk. ftat is, their investment portfolios are small and their time horizons are long, which limits the long-term
effects of early losses. Although this strategy has emotional benefits, it also has considerable financial costs.
As a result, this strategy should be used only in those circumstances and for those investors for whom the
benefits outweigh the costs. It might, for example, make sense for nervous investors with regard to their regular
investments, but pension investments are the one area in which investors tend not to pay much attention
to short-term performance. ftus, the strategy is very likely to commit investors to expected financial costs in a
set of circumstances with few compensating emotional benefits.
Fidelity recently announced the launch of a “people like me” approach to investing, in which investors
can enter personal details such as their age and the value of their holdings as a basis of comparison for
investment decisions that have been taken by others with similar characteristics. ftis approach can have
powerful effects on behavior in many domains, leading people to reduce energy usage or exercise more. In the
field of investing, however, it primarily encourages investors to copy other people’s poor investment
decisions.
ACADEMIC “LIFT AND DROP”

fte flip side of superficial approaches from untrained commercial practitioners, which usually occur in the
consulting field, is that of applications marketed by highly trained academics who often fail to consider the
realities of commercial life outside the laboratory. Academics tend to build what they consider to be real-
world applications within academe and then seek to “lift and drop” these into commercial or policy
applications. A core concern is that those in the commercial world seeking behavioral solutions frequently
have little expertise by which to evaluate the proposals and can be easily won over by impressive-
sounding academic credentials.
Academic findings are not always easily transferable, at least not without substantial effort to tailor them to
be effective in a real-world environment. ftere are often con- founding environmental variables or
unintended consequences from well-intentioned behavioral interventions. ftree particular types of misguided
attempts to implement academic behavioral ideas are (1) to base an implementation on a single behavioral ten-
dency that is valid when observed in controlled experimental conditions, but which has
potential costs in a real-world setting; (2) to deliver highly technical solutions, which are over-engineered
and thus not suitable to the practical problem they are trying to address; and (3) to offer behavioral alternatives
to how things are already done without truly understanding the traditional approaches or the language and
beliefs of existing practitioners.
Many of the suggested behavioral approaches to goals-based investing and attempts to build this into
practical investment tools exemplify the first type of a misguided attempt (Das, Markowitz, Scheid, and
Statman 2010). Goals-based investing is frequently justified using the notion of mental accounting,
arguing that individuals do not typically see money as completely fungible, but instead compartmentalize
their financial situation into mental accounts (ftaler 1999). A valid implication of this framework is that
investors find financial decision making easier and more comfortable if they can conceive of their wealth in
“pots.” Furthermore, investors tend to be more motivated if they are pursuing specific goals for which they are
saving. fte recommendations of this strand of the literature generally lead to the suggestion that investments
should be managed in a series of “buckets,” each connected to a specific future goal and each with its own
time horizon and risk profile.
Mental accounting brings benefits to investors insofar as it makes decision making easier and more
contained. However, this approach also largely fails to consider the con- comitant costs. Mental accounting
reduces financial and psychological flexibility, tying investors to a particular structure of goals and preferences
that may be spuriously precise reflections of their actual fuzzy aspirations. As a result, investors are relatively less
able to adapt to changing circumstances and preferences over time. In short, this strategy commits the
naturalistic fallacy of deriving “ought” from “is.” Much of the academic research in behavioral finance is
descriptive in that it describes how people actually behave, not how they should behave. ftis approach of goals-
based investing delivers both the benefits and the costs of mental accounting. By contrast, a method truly
designed to address the problem would seek to build systems that incorporate the benefits while minimizing the
costs (Davies and Brooks 2014).
An example of over-engineered technical solutions is in the area of portfolio optimization. fte behavioral
literature shows that investors do not exhibit expected utility theory preferences when making decisions.
Instead, their decision making is more closely approximated by non-expected utility models such as CPT
(Tversky and Kahneman 1992). Optimizing a portfolio for CPT preferences is not an easy task because the
optimization is non-convex. However, He and Zhou (2011) address the issue and find that computing a
portfolio that would be optimally held by an individual whose preferences are described by CPT is possible.
Although this process is possibly an interesting mathematical exercise, why would any investor ever want to
hold this portfolio? Investing is a long-term activity. Yet, this process incorporates within portfolio solutions
the very features that arise from behavioral responses to the immediate context (e.g., reference dependence
and loss aversion), extrapolating them to portfolio choices influencing long-term outcomes of the
investor’s total portfolio. In short, CPT as a practical implementation commits the naturalistic fallacy: it
confuses descriptive preferences for normative preferences, and thus commits investors to all sorts of
choices that in the long term they are likely to wish they had not made. Observed human choice in small frames
is certainly not always optimal in broader long-term frames.
At least two other problems exist with this approach to portfolio optimization. First, it assumes that an
individual investor’s preferences can be specified precisely using a sophisticated model such as CPT. ftis
model can have up to five parameters to be estimated—one governing loss aversion, two relating to the value
function curvature in gains and losses, and two associated with some specifications of the probability distor-
tion function. Moreover, the behavioral parameters, calibrated on immediate revealed preferences or
hypothetical choices, are assumed to be stable over time and appropriate to long-term preferences for total
wealth. Insofar as emotional responses to the current context, environment, emotional state, and frame induce
behavioral proclivities, they are unlikely to be stable. Rather, they will exhibit large fluctuations in strength
depending on whether the decision maker is reflecting calmly on broader frames and longer horizons or
anxiously focused on narrow problems. So, even if applying a descriptive model to a normative solution
were appropriate, accurately fixing this model becomes unlikely. Hence, users might exhibit spurious
confidence and precision in a solution inappropriate to the problem at hand.
Yet, such approaches are increasingly available in commercial applications: systems putting investors
through a sequence of questions that aim to elicit specific individual revealed preferences for risk attitudes,
time preferences, ambiguity aversion, loss aversion, probability distortion—sometimes among other features.
Advisors then use these results to calculate recommended individually tailored portfolio recommendations that
somehow “optimize” the portfolio for all these “revealed preferences.”
ftis sort of approach is fundamentally misguided. It begins with spuriously precise measurements of
descriptive features of an investor’s point in time decision pattern, which are likely to be highly unstable, or at
the least to evolve over time. fte approach then applies these preferences from one specific decision frame to
another one entirely. However, the biggest problem with this approach is the notion that these descriptive
features of someone’s choices are those that should be applied to a recommended solution. ftoughtful
investors should repudiate many of these revealed preferences as being inappropriate for their long-term wealth
outcomes. For example, it is near impossible to rationalize why any investor would logically choose to use
distorted probabilities when selecting an optimal investing strategy. fte same goes for any specifications that
are frame dependent, as are most of the features of CPT.
A similar difficulty faces those goals-based portfolio construction approaches that use aspiration-based
preferences such as Shefrin and Statman (2000). ftese approaches assume that an investor’s ability to specify a
target outcome for an individual goal today should be taken as an accurate expression of long-term
preferences. Such preferences would imply that the goal is fixed, certain, and absolute, so that investors
would give up substantial upside rather than accept any reduction in the chance of reaching this goal.
However, the goal may instead simply be an easy way for an investor to express something that is in reality
fuzzy and uncertain. Treating such preferences as “optimal” or accurate is likely to incur a large potential
cost for little gain.
fte essential problem with all these approaches is that they take a descriptive academic model that
explains choice behavior with reasonable accuracy in specific circumstances, and then apply it much more
broadly than can be reasonably justified to quite different real-world situations. Normative models should be
used if the goal is to help guide behavior. fte goal of practical implementations of behavioral insight should be
to help decision makers mitigate deviations from these normative theories, within the constraints imposed by
the human need for immediate emotional comfort with situations and decisions (Davies and Lim 2014).
End users of such tools often havelittle experience that would enable them toevalu- ate whether a particular
approach is fit for a specific purpose or over-engineered. ftis problem is exacerbated in academic “lift and
drop” applications relative to the superficial approaches discussed in the previous section. ftat is, the
academic pedigree and apparent sophistication and precision can give a strong illusion that the approach is at
the cutting edge of behavioral science, rather than a spurious application of unstable solutions that could lead
to investors’ locking short-term emotional preferences into important long-termchoices.
fte fact that many behavioral practitioners are critical of existing traditional approaches, without
truly understanding them, makes this concern more problematic. ftey also often arrive without
understanding the assumptions, knowledge base, and common language of the commercial world and as such
fail to communicate effectively, potentially resulting in considerable misunderstanding. Offering the
commercial world an alternative to an established approach requires the ability to communicate the new
ideas in terms that those in the industry clearly understand.
LACK OF TAILORING TO FIT THE PROBLEM AND

ENVIRONMENT
Effective behavioral implementation needs to be highly tailored and attuned to the precise environment
and the practical realities of the problem at hand. ftis requires considering both the increased complexity
and noise of decision making outside the laboratory, as well as the organizational realities of getting the
solutions implemented, accepted, and used. Tailoring the design and organizational deployment are at least as
important as the behavioral aspects if the implementation is to be effective.
fte process of achieving these goals often fails on several levels. First, the implementation is frequently
unsuccessful because it is not accepted into the organization at the outset, leading to skepticism and low
usage. Gaining acceptance requires senior sponsorship. Acceptance also requires extensive efforts to ensure
that the proposed approach fits into the organizational structure, existing processes, technology and systems,
and regulatory requirements. Additionally, educating, preparing, and training the users are essential to ensure
both initial acceptance and continued usage, which in turn requires ongoing support. Consideration of an
organization’s culture is a vital part of this process.
Second, some devote insufficient thought to user experience (UX) design and ease of use, often adding
steps or elements to existing processes. ftese may lead to better outcomes if used, but can also make employee
or client tasks more time-consuming or difficult. Poor user experience hampers both acceptance and use of a
behavioral tool, and also often makes the behavioral insights themselves less effective. A clever behavioral
intervention is of no value if not used.
ftis limitation is particularly true for both technology and software-based implementations, but also
of other behaviorally designed processes such as client profiling and fact-finding tools, sales processes, and
product-approval processes. An example of such a limitation is the deployment of decision journaling
systems to help individuals
document the rationale behind their decisions to combat hindsight and confirmation biases, and thus to
facilitate improved decision making. ftis approach is widely advocated by the behavioral literature and
should be a feature of any good decision support tool or system. However, unless well designed to fit with the
specific needs of the user, the details of the decisions they make, and the organizational environment in
which they operate, decision makers will simply fail to use the tool effectively. ftey may also reject outright
the broader behavioral system of which it is a component. For many decision makers, the additional task of
having to document even a one-sentence rationale for frequent decisions can be perceived as too onerous,
regardless of how effective it might be.
Perhaps a better initial approach is twofold: (1) automate the capture of as many features of the decision as
possible, and (2) design a series of questions that the individual can quickly answer and which capture some
essential features of the decision maker’s emotional state at the time, to be used later to combat hindsight bias.
For example, simple multiple-choice response scales capturing the decision maker’s level of confidence and
emotion when making the decision may provide useful data at very low effort. fte crucial element of the
process is that the design is intimately linked to the needs of the decision maker and his or her
willingness to engage.
EXECUTIVE RELUCTANCE
A final concern with practical implementation is that many executives are reluctant to fully embrace
behaviorally grounded approaches, even given considerable evidence supporting their effectiveness.
Fortunately, this discomfort with novelty is no longer as prevalent as it was, but other sources of reluctance
persist, forming barriers to adoption. Some of this reluctance is related to the perceptions of superficiality
previously noted.
Many sophisticated executives have read popular books and articles in the field. ftey are rightly suspicious of
others overselling simplistic approaches that offer no deeper insights than methods currently used. Another
perception is that behavioral approaches are useful only for trite or trivial problems. Discussions with senior
executives should start by pointing out the many failings of superficial approaches, and being deliberately
critical is often necessary to get sufficiently over their skepticism to move forward.
A related problem is that many successful executives assume that implementing behavioral ideas is
simple and does not need to be tackled systematically and deeply. ftis attitude is an example of
overconfidence that also leads to perceptions that behavior can be changed simply by reading about or
discussing biases, without the need to laboriously build this knowledge into tools and organizational
design.
A particular reluctance in the finance industry lies in openness to behavioral findings on framing of
information and data design. Reframing financial information to align the frame to broader objectives, rather
than narrow details and myopic horizons, can lead to substantially better decision making. Lower complexity is
usually beneficial. Benartzi (2015) offers an approachable recent summary of our behavioral knowledge
with regard to digital design. However, the finance industry is typically quantitative in nature. ftis creates great
reluctance to genuinely believe that shielding ourselves, employees, or clients from too much information and
reducing the detail andfrequency ofdata are things that should be pursued.
A final area of executive reluctance is an often surprising unwillingness to engage with experimentation,
and with testing behavioral approaches using randomized control trial (RCT) designs, which deploy
rigorous application of scientific methods to truly establish what works and what does not. Some of this
reluctance comes again from overconfidence. In the commercial world, individuals are usually rewarded for
having a clear idea, believing in it, and pushing it to implementation. ftis mindset is not conducive to
admitting a lack of conviction or to design through experimentation.
fte corporate world is certainly becoming more open to RCT approaches, but currently these are often
used to test relatively small aspects of design, such as the placing of design elements on the screen or the use of
different fonts or colors. Such aspects are worth testing and can sometimes make a surprisingly large
difference. Yet, even more valuable would be testing larger aspects of behavioral design that require executives
to admit they do not know which path to take. ftis admission requires considerable cour- age, and being able to
generate sufficiently interesting solutions, filter them, and then design alternatives for testing requires
considerable effort, knowledge, creativity, and commitment. It also requires substantial investment in
resources to build prototypes and rapidly deploy and test them. RCT approaches are more expensive than
fiddling with numerous shades of blue on a web page, but the potential upside of transcending the limits of
traditional corporate innovation is also substantially greater.
THE GOOD NEWS

Despite drawing attention to the challenges of implementation, over the last decade industry and
policymakers have become more open to behavioral insights, with many examples of good implementation
and good behavioral design. ftese successes include automatic enrollment in pensions in various parts of the
world, which has led to millions saving for their retirement that would not have otherwise been doing so. fte
United Kingdom’s Behavioural Insights Team has, among others, used RCT designs to increase tax
compliance and the effectiveness of job centers. In the United Kingdom, the FCA has been pioneering
behavioral approaches to financial regulation to improve outcomes for customers, and many companies and
start-ups are using gamification techniques to encourage better health and financial behaviors. A small number
of sophisticated behavioral consultancies are also helping companies and governments address commercial
and social problems with substantial rigor and credibility. Barclays has spent nearly a decade building
behavioral approaches into IT systems, sales process, profiling tools, investment solutions, and many other
ways of helping people to make better financial decisions, including a recent launch of a behavioral
framework to encourage impact investing and philanthropy (Davies 2015).
Behavioral findings are more widely known and accepted than they were previously. ftey are being piloted
and explored in an ever-wider range of industries and applications. Furthermore, advances in digital
technology and data analytics are opening up new vistas for application and making personalization, testing,
and delivery cheaper and easier. With that said, industry and government are still only in the initial stages of
building the decades of robust academic behavioral research into practical applications. Much still needs to be
learned and tried.
Applying Behavioral Finance

fte previous section presented illustrations of good and bad applications of behavioral finance. ftis section
offers a set of principles that should be considered when applying behavioral finance.
PRINC IPL E 1: BEHAVIORAL FINA NC E IS ALMOST

ALWAYS USELESS IN ISOLATION
Consider the most isolated application of behavioral finance: simply educating people about their biases.
Awareness may lead to a small improvement in actions and decisions, but any effect is likely to be short-lived, as
the stimuli for the biased action have not been changed or removed. Successful applications of behavioral finance
require an approach to people, processes, and technology. ftey also require an acknowledgment that the
traditional approach to any scenario may not be wrong. Corporate executives and others should not repudiate
traditional thinking but, rather, embrace and augment it with an understanding of behavior.
fte financial crisis of 2007–2008 brought much criticism of traditional portfolio management
practices. ftis required organizations to reexamine their asset allocation techniques to evaluate possible
improvements. Using volatility as a portfolio risk measure is computationally convenient, but is incongruous
with how individual investors think about risk, and it leads to unreasonable conclusions about the preferences
of investors (Egan, Davies and Brooks 2011). Is there a way of measuring portfolio risk that better reflects how
individuals think about risk—that is, that is focused on the downside and allowing for better than expected
outcomes to reduce portfolio risk? Along with quantitative financial analysts, Davies and De Servigny (2012)
create a behavioral measure of portfolio risk that can be included in a traditional risk and return optimization
framework with the objective function of minimizing behavioral risk subject to a given level of return. ftis
Behavioral Modern Portfolio fteory recognizes that behavioral finance is part of the solution, but not the
whole solution. In their model, the departure from the traditionally used form of modern portfolio theory
(MPT) is relatively small. It still allows investment practitioners to talk about efficient frontiers and asset
allocation in a manner that is consistent with their professional training, and yet is linked to client measures
of risk tolerance (Davies and Brooks 2014) that are stable and do not suffer from false precision or over-
engineering. fte importance of ingrained knowledge should not be underestimated when trying to drive
adoption of behavioral finance in a large organization. ftis belief leads to a second principle.
PRINCIPLE 2: BEHAVIORAL FINANCE IS A COMPANION TO

TRADITIONAL APPROACHES
A recommended mindset is to start with the belief that there are probably good reasons for why things are as
they are, but to understand traditional approaches deeply enough to challenge the status quo. fte implication is
that behavioral finance is only ever part of the solution and needs to complement traditional approaches.
Today, successful
behavioral finance practitioners need to be specialists in behavioral finance and general- ists in many other areas.
ftey cannot operate in isolation from other specialists within an organization.
PRINCIPLE 3: BEHAVIORAL FINANCE IS NOT

JUST NUDGES
Although all behavioral finance applications attempt to change behavior in some way, the wide array of
tactics tend to align to a few broad options: educate people about their biases; rely on decision inertia with
passive nudges such as changing the default option; and go beyond passive nudges by critically assessing how
to present an active choice. Simply educating people about their biases is ineffective. As a result, there has
been an increase in nudge techniques because evidence shows them to be effective at changing behavior in
many situations (ftaler and Sunstein 2008). However, a nudge is a blunt tool and may not always result in
good individual decisions. Furthermore, although nudges may be effective in addressing specific, isolated
behaviors, they are not particularly useful in helping people make confident, informed choices in complex deci-
sion environments.
Returning to the example of auto-enrollment in company pension plans, such a program may or may
not lead to better outcomes. By auto-enrolling employees in a pension scheme, the total amount of
pension savings will increase within society. Yet, are people saving more appropriately for their
retirement? ftis is far from certain. fte nudge takes one decision away from savers—whether or not to
join the company pension plan—but it does so by making one-size-fits-all assumptions on other
decisions. fte bluntness of this nudge comes from the employees’ likely perception that all decisions
related to their pension savings have been addressed. fte default rate of contribution and the default fund
selection act as safety nets for those who would not make a decision for themselves. Rather than
employees’ reviewing their contribution rate and investment fund, which are much more difficult assess-
ments for novice investors, most succumb to inertia and contribute the default amount into the default
fund with no assessment of whether this is appropriate for their type of retirement. A single default, no
matter how well chosen to be approximately right for most, is always going to be precisely wrong for many.
In effect, a valuable nudge on one decision has created more questionable nudges on two additional
decisions. Although people are saving more for retirement in the United Kingdom, it is unlikely that
most are saving the appropriate amount for their retirement as a result of auto-enrollment.
ftis assessment is not a criticism of auto-enrollment; it is an effective nudge. But more should be done
to engage people with the choices that they still need to make. Although debate continues about whether
the libertarian paternalistic approach of manipulating choice through nudges is an affront to free choice, this
debate misses a more important concept of asymmetric paternalism, which refers to policies designed to
help people who can’t or won’t behave so as to advance their own interests—for example, by constraining
options or nudging toward default options while encouraging more active engagement and less fettered choice
for those who are willing and able to decide themselves.
Under asymmetric paternalism, practical applications of behavioral finance focus equally on those who
cannot or will not make a decision, and those who could or would engage with making their own choices given an
accessible opportunity to do so. Practical applications of nudges have tended to be overly focused on those who
would not otherwise do something that is in their better interests, often to the detriment of those who are
capable of making the decision. Behavioral finance practitioners need to do more to apply their skills toward
engaging decision makers and helping them make confident and informed decisions in complex
environments, as much as to finding defaults that work well for the passive majority.
PRINCIPLE 4: ASYMMETRIC PATERNALISM SHOULD BE A

GUIDING PRINCIPLE
In practice, this principle means using a full toolbox of behavioral approaches. For example, if the goal is
confident and informed decision making, then the individual needs three things at the point of decision:
(1) the knowledge required to make the decision, (2) engagement with the decision, and (3) the emotional
comfort to enact it. Table 29.1 reflects how effective various approaches are at achieving these three
requirements.
Simple information disclosure and traditional education accomplish little with respect to these
approaches (Fernandes, Lynch, Jr., and Netemeyer 2014). Nudging can change behavior, but may actually have a
harmful effect on knowledge and engagement because the comfort that knowing someone has thought about
the problem is also an invitation for people to disengage. Only by bringing the full behavioral toolkit to bear
can a fully engaged, informed, and confident choice emerge.
Table 29.1 Effect of Approaches to Behavioural Change on Knowledge,

Engagement, and Emotional Comfort
Knowledge Engagement Emotional Examples

Comfort
Disclosure Little or none None None Disclaimers Caveat
emptor
Traditional Little or none Little or none Littleornone Seminars Classes
Education
Nudges None or negative None or negative Some Auto-enrollment
Defaults
Engaged Yes Yes Yes Just in time
Choice education
Gamification
Note: ftis table shows how different behavioral tools contribute to the forming confident and engaged decision
makers.
P R INC IP LE 5: GOOD APPLICATIONS OF BEHAVIORAL

F INANCE SHOULD C OMBINE AN UNDER STANDING OF
HOW P R OC E SSE S AND PEOPLE INTE RACT TO INDUCE
BETTER D EC ISION S
Many people fail to make decisions because they feel they do not understand the complexity of what they
need to consider, or because arriving at and enacting any decision are just too difficult. Applications of
behavioral finance that take advantage of these individuals reflect dishonorably on the discipline. Sadly, the
finance industry has a large number of examples of failures in this regard. fte use of teaser rates on credit cards
and savings account products are among the most pervasive.
A common practice in the United Kingdom and the United States credit card industry is to offer an
extended period of zero percent interest for individuals who transfer an existing balance from another credit
card and pay a small percentage as a transfer fee. ftis opportunity can be advantageous for those who are
disciplined in their finances. However, the way that people and process interact in this example means that
many are set up to fail.
At the end of the interest-free period, the interest rate reverts to a level much more typical of unsecured
lending. If the borrower fails to remember that the interest-free period is coming to an end and does not clear
the debt, either by making regular payments or by transferring to a new interest-free deal, the rate the borrower
ends up paying is typically punitive compared to the most competitive standard rates. Although banks now
have a responsibility to alert customers to the end of teaser rate deals, ample opportunity to profit from the
inertia of ill-disciplined customers remains.
fte central role of behavioral finance should be to reinforce good behaviors and help people make better
financial decisions. It should not be used to profit at the hands of customers who do not recognize their own
behavioral biases. ftus, behavioral finance fits well with the growing emphasis banking regulators are giving
to conduct risk, which can loosely be defined as any commercial conduct that causes customer detriment.
Behavioral finance provides the insights and toolkit to ensure that customers are treated fairly, but this
requires understanding how people interact with the processes that are put in front of them. fte following are
some examples to ponder of whether some specific decision frames are designed to account for potential
behavioral bias.
• When a user interface designer recommends shortening the number of available lines on an investment
fund selection document so that it fits on fewer pages, is the designer aware that the form is providing a
subtle nudge to customer choices and that this might limit portfolio diversification (Benartzi and
ftaler 2007)?
• Can customers be expected to read and understand a lengthy exclusions and disclosures document on a
travel insurance policy without any information on the typical costs of obtaining medical treatment
abroad to help judge the value of the policy? fte framing of maximum limits on policy payouts does not
describe the risk the insured customer still carries. Insurance policies often suffer intangible information
asymmetries that make judging good value very difficult for consumers.
• What is the best way to inform pension savers whether they are on track for the kind of retirement they
want? Can monetary forecasts be translated into lifestyle
desires? Is showing the current lifestyles that the pensions are forecast to be able to provide a better way to
frame the information, and can it spur workers toraise their contribution rates?
• Why do online investment platforms often show customers their daily returns and returns since purchase
for each investment when displaying the portfolio? Daily return is not aligned to the typical customer’s
time horizon and increases perceptions of risk, and return since purchase creates an irrelevant performance
anchor that can trigger the disposition effect. Both can result in detrimental customer decision making. Is
a better approach to broaden the frame to show portfolio-level past performance measured over an
appropriately long time horizon?
Behavioral finance practitioners need to accept a role in helping people make better decisions, and not simply
identify biases or promulgate those biases for corporate profit. ftis goal requires the integration of behavioral
finance within organizations.
How to Make Behavioral Finance Work in

an Organization
fte practical application of behavioral finance within an organization is tricky, particularly in large
organizations. How can an organization start to take knowledge that is concentrated in a few individuals
and make it usable by all?
fte FCA’s focus on using behavioral finance has been beneficial, but also arguably somewhat harmful to
the practical application of behavioral finance in UK financial institutions. Beneficial, because it highlights
and legitimizes a body of academic knowledge that has rarely been applied in the real world. However, as a
consequence, the first areas in financial institutions to become awakened to behavioral finance have often been
the regulatory control functions, which have typically scrambled to learn something so that they are not
behind their regulator in knowledge. Although any application of the field should be encouraged, trying to
convince senior decision makers of the value of behavioral finance by focusing on lowered compliance risk
has the effect of limiting the perceived scope of benefits and applications. Hiring specialists is necessary, but to
be truly effective in changing the organization they need to be part of business strategy, customer insight, and
proposition designteams,andnotjustwithincontrolfunctions.
Putting practical applications of behavioral finance in the hands of nonspecialists requires an assessment
and redesign of tools and processes, and widespread adoption of behavioral finance within large organizations
requires thoughtful design. For example, the Behavioural Insights Team, which was formerly part of the UK
Cabinet Office, published their EAST (easy, attractive, social, and timely) framework for using behavioral
insights (Behavioural Insights Team 2014). Behavioral interventions should be:
• Easy (E): includes harnessing the power of defaults, reducing the “hassle factor” of taking up a service,
and simplifying messages.
• Attractive (A): includes attracting attention and designing rewards and sanctions for maximum effect.
• Social (S): includes showing that most people perform the desired behavior, using the power of networks,
and encouraging people to make a commitment to others.
• Timely (T): includes prompting people when they are most likely to be receptive, considering the
immediate costs and benefits, and helping people plan their response to events.
Examples that cohere to this framework include pension auto-enrollment, which uses the power of defaults;
donating a set amount to charity via a text message, which provides a default donation and removes the hassle
of finding someone’s bank card details; and providing the details of average household energy usage with
utility bills, which prompts people to use less.
fte EAST framework provides a useful guide for nonspecialists when thinking about how to harness
behavioral finance. However, it should not be construed as reducing behavioral finance to a checklist of
biases and actions that, if avoided or implemented, mean that someone has done a good job. ftese tools of the
behavioral specialist are not a substitute for that specialist’s knowledge. fte Behavioural Insights Team also
recognizes that “it cannot be applied in isolation from a good understanding of the nature and context of
the problem.” A trained behavioral finance specialist should be involved in the “behavioral audit” of existing
and new processes to determine areas of possible improvement. ftis forms a final principle to consider when
applying behavioral finance.
PRINCIPLE 6: ATTEMPTS TO MODIFY BEHAVIOR

USING BEHAVIORAL FINANCE TOOLS REQUIRE A DEEP
UNDERSTANDING OF THE OBJECTIVE AND CONTEXT
OF THE DECISION PROBLEM
Digital services are growing in importance and popularity in various industries. ftis growth represents the
next frontier for behavioral design and excellence. Benartzi (2015) provides a description of the challenges
of influencing behavior on small-screen devices. ftese challenges provide not only an opportunity to make
behavioral excellence a priority but also a strong position from which behavioral finance can influence
other offline areas of organizations.
Striving for behavioral excellence takes time. While a team is establishing itself and its influence in an
organization, senior management must support the initiative for it to be effective.
A second element of necessary senior management support is their acceptance that behavioral finance is
as much art as it is science. Some behavioral interventions are likely to fail. ftese failures should not be seen
as a weakness of the practical application of the discipline but, rather, as an additional opportunity to
learn in an empirical setting. Marketing strategies typically embrace an experimental approach in which
theories are tested and adapted. Behavioral finance needs the same approach. Well- intentioned behavioral
interventions could lead to unexpected customer responses. As conduct risk increases the focus on customer
detriment, demonstrating strong behavioral rationale for an intervention is critical, despite the possibility that
it fails toassist disadvantaged customers. Regulated organizations need to be confident that they will
not be sanctioned because of failed experimentation aimed at helping customers make better decisions.

Great potential exists for behavioral finance approaches to improve the financial decision making of individuals,
groups, and organizations. However, harvesting this potential must include an asymmetric paternalistic
approach. Most important, this requires more knowledge of the field than can be garnered through reading
popular science books. Untrained practitioners are driving an overreliance on nudge as a technique to the detri-
ment of clients and customers. In our example of a behaviorally motivated alternative to modern portfolio
theory, understanding how clients behave is deeply embedded in the portfolio optimization. ftese kinds of
implementations require specialist knowledge and are the true vanguards of the discipline. If organizations
are serious about making the fullest use of behavioral finance, they need a core team of specialists within the
business that has enough support from senior management to effect improvements at all levels of
organizational teams and processes. An organization can achieve this in many ways, but many examples are
available of both failed and successful attempts to embed behavioral finance. Although no perfect model of
applied behavioral finance exists, the discipline still has many opportunities to grow and mature, and there
are many com- mercially valuable untapped insights in the decades of rigorous academic research that
underpins the field.
1. Explain how nudging alone constitutes a narrow use of behavioral finance knowledge.
2. Discuss the features of good and bad applications of behavioral finance.
3. Discuss an example of behavioral finance supplementing traditional approaches.
4. Explain asymmetric paternalism.
REFERENCES
Behavioural Insights Team. 2014. EAST: Four Simple Ways to Apply Behavioural Insights.
London: Behavioural Insights Team.
Benartzi, Shlomo (with Jonah Lehrer). 2015. The Smarter Screen: What Your Business Can Learn from the
Way Consumers Think Online. London: Piatkus.
Das, Sanjiv, Harry Markowitz, Jonathan Scheid, and Meir Statman. 2010. “Portfolio Optimization with Mental
Accounts.” Journal of Financial and Quantitative Analysis 45:2, 311–334.
Davies,GregB.2015.The Value of Being Human: A Behavioural Framework for Impact Investing and
Philanthropy.London:Barclays–WealthandInvestmentManagement.
Davies, Greg B., and Antonia Lim. 2014.“Managing Anxietyto Improve Financial Performance: Don’t Let the Best Be the
Enemy of the Achievable.” In Andrew Rudd and Stephen Satchell (eds.), Quantitative Approaches to High Net
Worth Investment, 69–98. London: Risk Books.
Davies, Greg B., and Arnaud De Servigny. 2012. Behavioral Investment Management: An Efficient Alternative
to Modern Portfolio Theory. New York: McGraw-Hill Professional.
Davies, Greg B., and Peter Brooks. 2014.“Risk Tolerance: Essential, Behaviouraland Misunderstood.”
Journal of Risk Management in Financial Institutions 7:2, 110–113.
Egan, Daniel, Greg B. Davies, and Peter Brooks. 2011. “Comparisons of Risk Attitudes Across Individuals.” In James
J. Cochran, Louis Anthony Cox, Jr., Pinar Keskinocak, Jeffrey P. Kharoufeh, and J. Cole Smith (eds.), Wiley
Encyclopedia of Operations Research and Management Science, 1–13. Hoboken, NJ: John Wiley & Sons,
Inc.
Fernandes, Daniel, John G. Lynch Jr., and Richard G. Netemeyer. 2014. “Financial Literacy, Financial Education and
Downstream Financial Behaviors.” Management Science 60:8, 1861–1883.
He, Xue Dong, and Xun Yu Zhou. 2011. “Portfolio Choice under Cumulative Prospect fteory: An Analytical
Treatment.” Management Science 57:2, 315–331.
Schroders. 2015. “Schroders incomeIQ.” Available at http://incomeiq.schroders.com/en/uk/ investor/.
Shefrin, Hersh, and Meir Statman. 2000. “Behavioral Portfolio fteory.” Journal of Financial and Quantitative
Analysis 35:2, 127–151.
Sloman, Steven A. 2002. “Two Systems of Reasoning.” In ftomas Gilovich, Dale Griffin and Daniel Kahneman
(eds.), Heuristics and Biases: The Psychology of Intuitive Judgment, 379–396. New York: Cambridge
University Press.
ftaler, Richard H. 1999. “Mental Accounting Matters.” Journal of Behavioral Decision Making 12:3, 183–206.
ftaler, Richard H., and Shlomo Benartzi. 2004. “Save More Tomorrow: Using Behavioral Economics to Increase Employee
Saving.” Journal of Political Economy 112:1, 164–187.
Happiness. New Haven, CT: Yale University Press.
Todd, Peter M., and Gerd Gigerenzer. 2012. Ecological Rationality: Intelligence in the World.
New York: Oxford University Press.
Tversky, Amos, and Daniel Kahneman. 1992. “Cumulative Prospect fteory: An Analysis of Decision under
Uncertainty.” Journal of Risk and Uncertainty 5:4, 297–323.
30
The Future of Behavioral Finance
MI CHAEL DOWLING
Associate Professor in Finance
ESC Rennes School of Business
BRIAN LUCEY
Trinity Business School, Trinity College Dublin
Introduction
fte future of behavioral finance requires understanding more about its philosophy, gaining a deeper
understanding of the drivers of financial behavior, and ensuring rigorous research. ftis field of study is just at its
beginning stages when it comes to understanding the influences of human behavior as applied to an individual,
firm, groups, or institutions making financial decisions. fte initial anomalies in traditional finance that inspired
the birth of behavioralfinancein the 1980shavegivenwaytothe current sampling of clearer behavioral biasesfrom
the literature on decision making and psychology. fte next step of deeper engagement in more complex behavioral
understanding will be more difficult, but the path is well established in many other business fields. ftis chapter
providesapotential roadmapfor thisdevelopmentofbehavioralcorporatefinanceandinvestorpsychology.
Behavioral corporate finance is perhaps the most obvious candidate to begin this journey. fte current
focus in behavioral corporate finance is on chief executive officer (CEO) traits and sometimes chief financial
officer (CFO) or board of director characteristics as the primary means for introducing behavioral biases into
the firm’s financial decision making. ftis focus should be replaced by a more comprehensive understanding
of top management teams and the institutional influences on financial decision making within corporations.
New research approaches, such as grounded theory and other qualitative tools, are necessary for this
developmenttoprogress.
In research on asset pricing investor psychology, an area of behavioral finance subject to heavy
criticisms of data mining, a need exists for much richer models of investor behavior and the social
psychology of groups of investors. fte current research on behavioral asset pricing has allowed that prices can
predictably move in pricing patterns owing to widely experienced decision-making biases. However, these
patterns are based on rather simple models of the drivers of behavior and are heavily restricted as to how these
biases must be proxied, owing to data restrictions. fte future of behavioral asset pricing needs researchers to be
more comfortable using the rich new behavioral and
561
social datasets that online media offer for building a more holistic and targeted understanding of the drivers of
investment behavior. ftere is also a need to work closely with experimental finance and data science
researchers to design, model, and measure the behavior of groups of investors so as to form realistic
representations of how groups of investors in a market make investment decisions and how this influences
pricing. A particular “prize” for investor psychology is in understanding sentiment as an overall measure of
psychological influence on asset pricing.
Although this chapter focuses on behavioral corporate finance and investor psychology, it broadens to
include the philosophical underpinnings of behavioral finance and the need for ensuring robust
investigations of behavioral patterns. fte chapter begins with an evaluation of the philosophical development
of behavioral finance and it extrap- olates, based on other fields, the next steps in this development of an overall
philosophical approach to behavioral finance research. fte, the chapter discusses the reliability of
behavioral finance research in the context of research methods in psychology and economics, referencing
the rigor and replicability of findings inthoseareas.
The Philosophy of a Future Behavioral Finance

Frankfurter (2007) remarks on the general disdain for philosophical discussion in finance. He relays the
story of a former student who attempted, in a PhD seminar, to discuss the philosophical implications of the
ubiquity of utility theory in finance and was told that “this is a finance course and not a philosophical course”
(p. 49). Such a comment would be anathema to researchers in other disciplines, even those closely aligned
with finance such as management or mathematics. Also, a disdain for philosophical discussion does not
preclude the influence of philosophical perspectives on the conduct of finance and behavioral finance
research.
Guba and Lincoln (1994, p. 105) argue for the primacy of philosophical perspective in conducting research
because “questions of method are secondary to questions of paradigm.” ftis perspective generally acknowledges that
the research perspective influences the selectionof methodsandproblems.Beforecommencinganyempirical
inquiry,researchers must address their ontological and epistemological assumptions and, indeed, consider how
such assumptions align with their research question and their methodological choices. Ontologydescribesreality,
whereasepistemologyis therelationbetweenrealityandthe investigator, with the methodology being the technique
used to discover such relationship. ftis pointiscrucial inbeginning anyexploration ofthefuture of behavioral
finance.
By understanding the philosophy of research in behavioral finance, the researcher can learn more about the
development of the behavioral finance research paradigm, how theory should be built, and how research
questions fit into the paradigm and research program. Researchers can then extrapolate how the “knowing” in
behavioral finance will progress, based on how the research philosophy has developed. ftis section starts with
a brief summary of the philosophy of science perspectives of ftomas Kuhn and Imre Lakatos, and then
places behavioral finance within these frameworks.
ftomas Kuhn popularized the commonly used terms “paradigm,” “paradigm shift,” “normal science,” and
“anomalies” in the discussion of how science is conducted and progresses. According to Kuhn, science is
conducted within paradigms, with a paradigm
The Future of Behavioral Finance 563
being a collection of core frameworks, terminology, and methodologies that researchers use to solve problems
within a particular area (Kuhn 1970). Bird (2013), in his analysis of Kuhn’scontribution, gives the function ofa
paradigmasthatof supplying puzzlesfor scientists to solve and providing the tools for their solution.
Working within a paradigm, scientists can engage in normal science, which is the everyday process
of solving problems in an area of research. As anomalies, or counter- examples, arise, scientists attempt to
place these within the confines of the paradigm. Sometimes the anomalies are just ignored, as the importance
of normal science is considered paramount to paradigm rejection, or scientific revolution. Only when an
anomaly arises that cannot be explained and that threatens the core methods or rejects the core theories can a
paradigm rejection or paradigm shift occurs. Kuhn (1970, p. 68) terms this a “crisis.” fte anomaly makes
normal science impossible, and thus a change must occur. If researchers do move to a new paradigm, this
new paradigm must not only have the explanatory and problem-solving power of the old paradigm but must
also offer new and exciting research opportunities.
Lakatos (1978) proffers a similar perspective to that of Kuhn, but focuses more on how research progresses. His
views are insightful for determining a plausible future philosophy for behavioral finance. Lakatos prefers the
term “research program” to “paradigm.” He views a research program as a collection of theories used by
researchers in a particular area of study. ftese theories are divided into a “hard core” and “auxiliary hypotheses.”
fte hard-core theories are the deeply held beliefs shared by researchers involved in a particular research
program. fte auxiliary hypotheses emanate from hard-core theories. Auxiliary hypotheses represent the “work in
progress,” the testable hypotheses, and the less firmly held beliefs of the researchers. fte auxiliary hypotheses
also serve as protection against attacks on the hard core from those outside the research program. Auxiliary
hypothesescanbeadjusted,orevenrejected,inordertoprotectthehardcore.
Lakatos (1978) addresses the issue of theory succession by dividing research programs into two
categories: progressive and degenerative. A progressive research program offers exciting research
opportunities and appears to offer new findings. In contrast, a degenerative research program is one that
researchers constantly have to defend from attack (perhaps, by adjusting the auxiliary hypotheses) and one
that is unable to generate new and exciting findings. Eventually, researchers in a degenerative program switch
into more exciting research programs.
ftese perspectives on the philosophy of science allow the charting of the development of a philosophy for the
behavioral finance research program. fte anomalies literature of the 1980s represented an initial criticism of the
traditional finance assumptions of rational investors and efficient markets. Traditional finance responded bymaking
increasing adjustments to their theories, as predicted by Kuhn (1970) and Lakatos (1978). For example, the
single-factor capital asset pricing model (CAPM) has evolved into a five-factor model (Fama and French 2015)
and a wide range of competing models, most of which fail to adhere to the rigorous statistical tests for data
mining (Harvey, Liu, and Zhu 2015).
Moving beyond the initial phase of identifying anomalies in traditional finance, behavioral finance
can be described as a research program in its own right. A key feature of this new research program is a clear
focus on using the concepts of bounded rationality, in which people’s cognitive constraints impose limits
on the extent to which they can be “rational” in their decision making and the influence of psychology to
develop
Table 30.1 Scopus Article Count for “Behavioral Finance” and “Investor
Psychology” Keywords
180
160
140
120
100
80
60
40
20
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Note: ftis table tracks the annual number of articles appearing in Scopus-covered economics and financejournalsthat
have“behavioralfinance” or“investorpsychology” keywords.
Source: fte author’s work using the Elsevier Scopus database.
testable hypotheses of financial decision making. ftere is now a reduced focus on criti- cizing traditional
finance. Researchers in behavioral finance are increasingly debating the most appropriate behavioral theories
to explain financial behavior. ftat it is a progressive research program is evident from the rise in behavioral
finance research being published. Table 30.1 provides a time series of articles published in Scopus-covered
economics and finance journals since 2001 with the keywords “behavioral finance” and “investor
psychology.” Table 30.2 is a count of working papers appearing in the Social Science Research Network
(SSRN) Behavioral & Experimental Finance eJournal, also suggesting a vibrant research area with the
upward trend indicating its progressive nature.
Given the recent nature of this rise in behavioral finance research, as opposed to research on anomalies
in traditional finance, which began in the 1980s, this field seems clearly to be in the early stages of becoming a
progressive research program. fte challenge for the future of behavioral finance is that work must continue to
be both theoretical and empirically progressive. ftat is, researchers in behavioral finance must advance new
theories and be able to empirically investigate and continue to develop these theories.
Normal behavioral finance research as it currently exists usually investigates confirmed theories from
the field of psychology, examining their applicability to financial behavior. Researchers usually make
adjustments to these theories to make them suitable from a finance perspective. However, this process is, at best,
just the beginning of how a core theory of behavioral finance should appear. fte future will require much richer
Table 30.2 Count of Articles in SSRN Behavioral and Experimental Finance

eJournal
1200
1000
800
600
400
200
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Note: ftis table counts the number of yearly submissions to the SSRN Behavioral and Experimental Finance eJournal, which is
the primary depository for working papers and accepted paper abstracts in this area.
Source: fte author’s work using SSRN Behavioral and Experimental Finance eJournal data.
finance-specific behavioral theories. One key issue, however, is how few outlets exist for publishing pure
theoretical research on behavioral finance, or even more generally on finance, unlike the economics or
business fields. Being a primarily empirical field means there is a limited section in each research paper devoted
to small theoretical development. A progressive research program will need more cognizant of the
importance of rewarding purely theoretical research so as to have a solid core of theories upon which to draw.
Both the Journal of Behavioral & Experimental Finance and the Journal of Behavioral Finance
welcome theoretical papers, albeit neither of these journals is particularly highly ranked at present. Higher-
ranking finance journals do not normally publish behavioral finance theory papers. fte rare, purely theoretical
papers that have been published, such as Mehra and Sah (2002), need to find a home in economic
journals.
Empirical work also needs to have the right tools to appropriately investigate theories of behavioral
finance. However, the profession is currently hampered by an almost exclusively positivist quantitative
approach to research. A move away from these purely positivist quantitative methodologies is likely to
feature in the future of behavioral finance, as it will be necessary to investigate the validity of new behavioral
theories.
Two epistemological paradigms that are the focus of scientists’ view of reality are the positivist and the
interpretivist perspectives. fte positivist perspective is based on a scientific principle consisting of an
objective social reality that can be identified. ftus, quantitative approaches, but not limited to quantitative,
can effectively enable identifying patterns of this assumed social reality. fte interpretivist perspective, by
contrast, assumes
that reality is a social construct that cannot be studied outside of the social actors who create that reality.
fterefore, a focus is on methodologies that enable an understanding to be built of the social actors’ view, role,
and influence in this social world (Livesey 2006). fte methodologies most appropriate to this interpretivist
perspective tend to be qualitative, but qualitative methodologies are largely ignored in finance, including
behavioral finance.
Interpretivist methodologies start as close as possible to the idea of no theory, and then use appropriate
methodologies to build theories based on data. ftis approach is in contrast to positivist research, which largely
focuses on testing theory (Walsham 2006). If behavioral finance is to continue to develop into a progressive
research program, it needs interpretivist methodologies that allow rich theories to be built and new test-
able hypotheses to be developed. Sample interpretivist methodologies applied in the analogous field of
management include ethnographic, action research, and grounded theory, where the researcher is directly
involved in the group being studied, and indirect methods such as building case studies through, for
example, interviews.
ftere has been strong philosophical progress in advancing from anomalies-based attacks on traditional
finance to the beginnings of a vibrant progressive research program in behavioral finance. fte next steps
call for developing a core of theory rather than borrowing one from another discipline. Integrating more
interpretivist methodologies allowsthesetheoriesto bedevelopedand appropriatelytested.
The Future of Behavioral Corporate Finance

Baker and Wurgler (2012) outline the two main current perspectives of behavioral corporate finance as (1)
focusing on rational managerial actions to account for the biases of investors, and (2) investigating whether
behavioral biases influence managerial financial decisions. In the first perspective, the firm is a relative bastion
of financial rationality that times financing decisions based on an understanding of investor psychology and
frames decisions with this same psychology in mind. fte second perspective allows managers to run firms
with some of the same behavioral biases as investors, and these biases influence an organization’s
financial decision-making process.
Both approaches have some validity but also some problems. A reasonable assumption is that managers
can rationally use their superior information and expertise to efficiently finance the firm and better frame
financing decisions than a group of investors with limited time for analysis and bounded rationality, and
when an individual firm is just one of a portfolio of investments. Ikenberry, Lakonishok, and Vermaelen
(1995) show that when companies repurchase their own shares in the market, those repur- chased shares
outperform in subsequent periods compared to benchmark indices and to similar firms. ftus, companies
presumably can use their superior internal information to better identify intrinsic firm value than can
investors and they use this to make positive financial decisions that benefit overall shareholder value.
ftis first rationalist perspective of behavioral corporate finance is very much wed- ded to a traditional
behavioral finance perspective of noise traders versus smart money (Black 1986). Managers are positioned as
smart money, whereas investors are positioned as noise traders allowing identifiable mispricing to exist in
stock prices. Various
problems exist with this perspective that suggests it will not play a strong role in the future of behavioral
corporate finance research. One problem is that this research largely rests on very minimal investigation of a
company’s motivations to undertake this type of behavior. Single-question anonymous surveys of company
executives, usually the CFO, are the most common source of claims that companies react to their perception
of market over- or undervaluation of their stock (Graham and Harvey 2001). Yet, little is known about how
companies identify mispricing or what valuation models are used and how these differ from those of
investors. ftus, researchers cannot know if executives’ motives are truly rational.
A second, more fundamental issue is the lack of knowledge about whether management is reacting to
investor behavioral bias–driven irrationality or just investor mispricing. Rational management responses
to investors making fundamental errors of valuation is not “behavioral” in the sense that it does not use
psychological theories to advance understanding of financial decision making. Although richer information
on how firms make these decisions canovercome thefirst problemofa lackof knowledge about managerial
motivations, the second problem restricts the potential for behavioral insights to play a role in the future of this
aspect of modern behavioral corporate finance. fte second perspective, whereby managers might be subject to
behavioral biases that influence their financial decision making, offers a more productive avenue for the future
development of behavioral corporate finance. fte research to date has largely investigated the overconfidence
and optimism of CEOs with various approaches for measuring overconfidence, and links the presence of
overconfidence to risk taking in the company’s financial decisions. For example, Malmendier and Tate (2005)
measured overconfidence by the holding of in-the-money, own-company options by CEOs. fte premise is
that CEOs who hold undiversified portfolios through large own-company investments or unexercised in-the-
money options are overconfident. Recent research has developed this further by refining the measurement of
overconfidence. For example, Huang and Kisgen (2013) draw on the greater likelihood of males being
overconfident to show that males make more acquisitions. Graham, Harvey, and Puri (2013) used psychometric
testing to determine the optimism of CEOs, and they link this to their attitudes on risk taking. Other
research, beyond the scope and purpose of this chapter, has expanded the range of CEO characteristics
investigated, such as humility (Ou, Waldman, and Peterson
2016) and narcissism (Aktas, De Bodt, Bollaert, and Roll 2012).
An issue with the current primary focus on the behavioral influence of the CEO is that much
management research contends the CEO plays only a small role in the overall direction of the firm. Quigley
and Hambrick (2015) report that CEO influence accounts for about 20 percent of the variability in
performance of U.S. companies in recent years. ftis variability is measured by variability in profit as a
percentage of sales, profit as a percentage of assets, and market-to-book ratios. ftis finding represents an
increase from about 10 percent influence on variability in performance from the 1950s, so CEOs have
apparently become more influential over time. Still, CEOs only explain about one-fifth of performance, and
a natural question arises as to whether behavioral finance is focusing too narrowly by concentrating on a
person who explains a relatively small percentage of performance. In the same analysis, general company
characteristics explain about 30 percent of performance variability and 50 percent of the explanation for
performance variability is simply “unknown.”
A further issue is that current behavioral corporate finance studies of the CEO seek to identify single
behavioral facets of those CEOs, so researchers are not capturing much of these individuals’ decision-
making perspective. fte influence of the CEO on company direction in other countries differs from that
which happens in the United States. Crossland and Hambrick (2007) find that the influence of the CEO is
much less in Germany and Japan compared to the United States, which raises questions as to the international
applicability of the U.S.behavioral corporate finance focus on the CEO.
Continuing with Hambrick’s body of research, the seminal paper by Hambrick and Mason (1984)
contends that CEO characteristics matter, but that focusing on the wider top management team (the
“upper echelons”) is probably more important, and the modern focus of research on strategic corporate
decision making takes place here. In a later review of his 1984 article, Hambrick (2007, p. 334) summarizes
the impact of the paper as creating a consensus of “attention to executive groups, rather than to individuals,
often yield[ing] better explanations of organizational outcomes.” Papadakis and Barwise (2002) offer an
example of this research, having investigated whether CEO characteristics or top management team
characteristics matter more in explaining 70 strategic decisions made by Greek firms across different
strategic areas. fteir results show that focusing on the top management team is a much more useful clue in
explaining such decisions.
ftus, behavioral corporate finance research needs to become more familiar with the influence of not just
the CEO and maybe the CFO but also the rest of the top management team if researchers want to move in line
with accepted management wisdom on how companies actually make strategic decisions. ftis seems
particularly important for strategic corporate finance decisions that are not purely financial, such as
acquisitions, but probably oflessimportanceformorecorefinancial decisions onhowtofinancethe company.
Ultimately, the future of behavioral finance also needs to become more familiar with organizational
theory, which is the holistic view of how the company is organized and how this influences its decision
making. DiMaggio and Powell (1983) provide the classic reference on the sociology of the corporation,
arguing that three institutional factors—coercive, mimetic, and normative isomorphism—work together to
determine decision making and create similarity between companies. Coercive isomorphism refers to
external cultural influences on the company; mimetic isomorphism is the imitation of other companies’
practices in the face of uncertainty; and normative isomorphism is based on standards and norms that
influence company behavior. Imagining how these factors would influence corporate financial decisions is
easy; yet, the actual implementation of this theory is far from straightforward. As mentioned earlier,
implementation requires researcher familiarity with interpretivist qualitative methodologies, such as action
research and grounded theory.
A final large gap in modern behavioral corporate finance research needing to be addressed is a greater
understanding of how cultural differences and behavioral biases interact to influence corporate financial
decisions around the world. Behavioral corporate finance is largely U.S. based at the moment. Unlike
research in similar disciplines such as management, researchers have not yet made a sufficient effort to focus on
cross- cultural differences in behavior. Evidence shows there are cross-cultural differences in a wide range of
corporate finance behaviors, such as dividend pay-outs (Fidrmuc and
Jacob 2010), corporate governance (Bushman, Piotroski, and Smith 2004), and cash holdings (Ramirez and
Tadesse 2009). However, the interaction between culture and psychological theories is complex.
Lucey and Dowling (2014), using emerging markets as an example, examined each of the main
psychological theories and how they differ across cultures, and they found significant cultural influences. A
summary of the analysis in that work suggests that of the three main psychology fields applied in finance
(cognitive, emotion, and social), social psychology is the most likely to vary across countries owing to their
strong cultural influence. Emotional effects are largely universal, and cognitive biases need to be individually
assessed, because there is an important interaction between actual cognitive biases and levels of experience that
differs across countries. ftese findings suggest much more work needs to be done to make behavioral corporate
finance have international relevance. International studies need to determine appropriate interactions between
cultural effects and psychological influences on corporate financial decision making.
The Future of Investor Psychology

and Asset Pricing
Investor psychology involves the application of cognitive, emotion, and social psychology theories to an
understanding of investor decision making (Hirshleifer 2001). fte field of cognitive psychology provides
decision-making biases that can explain how investors might make suboptimal investment decisions.
Emotion psychology explains the role of feelings in investor decision making, whereas social psychology
offers some explanation for how collectives of investors might make jointly influenced and biased
investmentdecisions thatarepricedinthecross-sectionofassetprices.
One fundamental issue that needs to be addressed for the future of behavioral asset pricing is the evident
failure of the field to develop productive research. fte limited evidence suggests that many identified asset
pricing findings are just not real, using robust statistics. fte influential Sullivan, Timmerman, and White
(1999) study, for example, finds that most technical trading rules simply have no statistical support after
making appropriate robustness adjustments. More recently, Harvey et al. (2015) claim that most asset
pricing models do not stand up to scrutiny after applying a different, but similar, set of robustness checks
for data mining, fte models checked were predomi- nantly based on traditional finance principles rather than on
behavioral ones, suggesting a wider problem with the entire field of asset pricing. ftese findings are likely to be
only a small indication of a wider problem, as the robustness adjustment techniques usually take account
only of published research. A known bias in publishing exists toward accepting papers with statistically
significant findings.
If the asset pricing researchers continue to produce large volumes of research that is, at least indirectly, a
product of data mining, then it will necessarily become a degenerative research program. ftis situation is a
challenge for researchers in investor psychology, but also an opportunity because advances are possible in
understanding investor psychology and its influence on asset pricing. fte remainder of this section contains
potential waysforthe fieldtoreverse itscurrentdownwardtrajectory.
fte first, large opportunity is in sentiment modeling. ftere has been a proliferation of sentiment models in
recent years as new approaches to, and data for, measuring investor sentiment have become available. ftese
models range from the fundamental data approach of Baker and Wurgler (2006) to modern attempts to
capture the emotions of groups of investors through social media sources, such as the Twitter sentiment model
of Bollen, Mao, and Zeng (2011). fte exponential growth of competing models suggests that
understanding sentiment is in its infancy, with new models appearing on the market on a daily basis that are
touted as the latest cure-all for understanding sentiment. Yet, sentiment modeling does offer the best potential for
behavioral asset pricing to integrate both psychological influences on investors and the social psychology
group effect of many investors experiencing those influences.
An issue at the moment is the theoretical nature of the current sentiment measures. Even the seminal Baker
and Wurgler (2006) model uses six variables without strong justification for how the authors selected those
six variables out of an almost infinite universe of possible sentiment measures. fte authors put these six
variables in a principal component analysis to extract factors, thus involving more judgment as to what the
factors actually represent. Finally, they made an adjustment for what they consider “rational” sentiment and
“irrational” sentiment. Once again, the authors do not seriously explore what rational sentiment might
mean or consider whether rational and irrational sentiments can possibly be disentangled from an investor
perspective, even if a statistical tool technically allows the procedure to be done. Such a data-driven exercise
imbuedwithjudgmentateachstageisunlikelytooffer acoretheory for sentiment models goingforward.
In the future, investor sentiment models need to have a core of fundamental theory to guide the building of
the model. Otherwise, this area of study runs the risk of having a wide range of competing models that are
simply statistically compared, often using very limited datasets, rather than fundamentally coherent models.
Two possible ways for developing this fundamental theory include (1) understanding the nature of sentiment
better through experimental finance, and (2) collaborating with computer science researchers to better capture
the data needed to measure sentiment and advance sentiment theories.
Sentiment is the residual influence of groups of investors making trading decisions based on shared
opinions. Although those shared opinions are likely to be predomi- nantly rational expectations about the
prospects for investment, there’s also a role for feelings such as optimism and pessimism. Overconfidence and
other cognitive biases might likewise be important if decision makers widely experience their heuristic
influence. Experimental finance probably offers some of the best potential to model the real influence and
nature of sentiment, and it already has a wide range of studies in this area, such as Smith, Suchanek, and
Williams (1988) and Haruvy, Lahav, and Noussair (2007). Yet, a need exists for such experimental studies
to create more realistic market environments, perhaps in a field setting, and to focus more on the nature of
sentiment. ftis should foster greater understanding of the complexity of how sentiment is seeded and
evolves, including the foundational psychological and financial factors that interact to create and drive
sentiment. Behavioral finance researchers in the sentiment area need to collaborate with experimental finance
teams to create such models.
Collaboration with data scientists from the computer sciences is necessary to understand how to model the
data that is now available to measure sentiment, such as data from Twitter and other social media sources.
Researchers have been largely content to keep such data analysis reserved for behavioral finance researchers,
despite this not being an area of obvious expertise. Sharing the analysis with researchers who are experts in
handling the data and determining its meaning is a necessary next step. Expecting behavioral finance
researchers to be as familiar with interrogating what is often multiple terabytes of social data as they are with
developing behavioral theories is unrealistic. ftis shift means more behavioral finance research will need to
find a home in computer science journals as a way of demonstrating that the data approaches are considered valid
within computer science.
Experimental finance in general offers strong potential to inform theory building in asset pricing. Indeed,
it already performs this role to some extent, such as the aforementioned sentiment models. However, barriers
exist between experimental finance and behavioral finance that limit idea sharing. Noussair (2016) speaks to
these issues in his Presidential Address to the Society for Experimental Finance in 2015, suggesting it is
something about which experimental finance exhibits awareness. fte first issue that Noussair raised was that
experimental finance emerged from experimental economics and so it did not explicitly originate to work
within behavioral finance. ftis origin is not a problem with experimental finance but, rather, speaks to
potentially different motivations within the two disciplines of experimental and behavioral finance. ftesecond
issue is that experimental finance researchers do not sufficiently collaborate with researchers in other finance
subdisciplines. A similar comment could easily be made about the need for behavioral finance researchers to
collaborate with experimental finance researchers in order to build valid behavioral finance theories. fte fact that
some researchers bypass experimental finance research and go straight to psychological theories that might be
inapplicable in a finance context seems perverse. According to Noussair, about half the research presented at the
2015 Society for Experimental Finance annual conference was on asset pricing, and another 36 percent of the
papers involved investor characteristics, so the current lack of deep integration between experimental finance
and behavioral asset pricing is surprising, given the similarity of interest.
Other approaches to improve robustness involve researching outside of equity pricing in the application
of behavioral theories. Cummins, Dowling, and Lucey (2015) applied behavioral principles to the pricing
of nonferrous metals, representing a first study in these markets. fte fact that researchers conducted in 2015
the first investor psychology study of the huge aluminium, nickel, copper, tin, lead, and zinc financial
markets suggests the discipline is confined to equity pricing. To what other markets might sets of behavioral
theories apply? Expanding behavioral asset pricing research outsideofequitypricingislikelytobeafeaturein
thefuture,and isalreadyunder way. fte potential to explore historic datasets for evidence of behavioral
influences on asset pricing figures prominently in future research efforts. In recent years, researchers have
constructed retrospective stock prices for the eighteenth and nineteenth centuries that are broadly uninvestigated
from an investor psychology perspective. For example, the Global Financial Data database provides stock
price data as far back as 1693 and commodities pricing data as far back as the thirteenth century. Investigating
cognitive biasesonsuchhistoricaldataislikelytobe oflimited use,owingtothefactthatmodern
investors are not cognitively comparable to investors in those previous eras. However, such data offer the
potential for research into the influence of emotional and social psychology on investing, given that
emotional and social psychology influences are likely to be innate factors in investor behavior (Lucey and
Dowling 2014).
One recent feature of markets—the increase in cross-market contagions owing to the “financialization”
of markets (Flassbeck, Bicchertti, Mayer, and Rietzler 2011)— also offers new potential for behavioral asset
pricing researchers, in a context similar to that of exploring new financial markets. fte rise of financialization
should increase the contagion of behavioral principles across markets and thus offers a rationale for
exploring new markets with which behavioral equity market researchers currently lack familiarity.
Another issue that may become more prominent in the future of investor psychology research is the need to
incorporate culture into investor behavior models. ftis issue is similar to the need in behavioral corporate
finance. With a cultural behavioral asset pricing perspective, investor psychology research largely dominated
by the study of Anglo- Saxon culture countries is likely to be increasingly viewed as merely regional studies
of phenomena that probably differ across countries. Asset pricing behavioral patterns such as momentum are
culturally determined. For example, Ji, Zhang, and Guo (2008) find that Chinese investors are more likely to
predict a reversal from short-term price patterns, whereas Canadian investors are more likely to predict a
momentum pattern.
Improving the Reliability of Behavioral

Finance Research
Much of behavioral finance research relies on survey or experimental evidence. Many other papers rely on
proprietary or otherwise “secret” data. In common with much of finance and economics, concerns about
replicability and reproducibility are increasing, albeit from a low base. Cochrane (2015), who is a leading
empirical financial economist, has recently breathed new life into this debate. Mapping Cochrane’s
arguments to a behavioral and experimental perspective appear worthwhile.
One item of note is the apparent lack of concern with reliability in current behavioral finance research.
A Scopus search for “replication” or “replicability” combined with “behavioral finance” or “experimental
finance” yields few results. At a high level, that of publication, a dearth of interest exists in the issue. Counter
this with psychology, in which there has been a very active debate on reliability and replication for several years.
As psychology is a contributing founding paradigm of behavioral finance, this gap is all the more
worrisome. One wonders whether behavioral finance researchers are even aware of the replicability of
theories selected from psychology. ftis section explores three issues: (1) the debate started by Cochrane
(2015) from a behavioral perspective,
(2) the psychology debate, and (3) a proposal drawn from areas including behavioral science as to how to
improve the reliability of behavioral finance research.
Cochrane is one of the most cited and respected economists of his generation. Yet, he clearly has felt
uneasy for some time about the proliferation of papers that are, to all intents and purposes, not replicable. He
commences with a discussion of data errors
and data fragility, noting, for example, the coding errors in the influential Reinhart and Rogoff (2010) paper,
the highly sensitive nature of many other papers to data or coding specification, and the challenges of
identification. He adds that the absence of data and code accompanying published research makes true
replication of reported results impossible. Particularly problematic are secret data, which are confidential
or proprietary data. Cochrane advocates various solutions, but all distill to the proposition that what is valued
matters. Unless and until finance research values explicitly the reproducibility and replicability of empirical
results, via the editorial, tenure, and hiring processes, little incentive exists to be open.
Within economics, a widespread reason exists to be concerned about the lack of replication and
robustness. Yet, a recent set of studies suggest a widespread lack of interest in the same. Vlaeminck and
Herrmann (2015) find that even when journals are nominally committed to having a data-sharing or data-
openness policy, enforcement is inconsistent and unreliable. Duvendack, Palmer-Jones, and Reed (2015),
who presented the results of a large-scale study on the issue, report that only 27 of 333 economics journals
regularly (i.e., defined as over 50 percent of papers published in a journal) publish data and methods files
alongside published papers, and only 10 explicitly welcome replication studies. Indeed, replication is not a
consideration for most journals, editors, or authors. fte Goettingen University replication network
(Replication Wiki 2016) lists several hundred replication studies, but few are pure replications in a narrow
sense. Researchers have not carried out similar studies in finance, suggesting that the finance field has not even
started to contemplate applying these issues as a central research design approach.
Researchers are only beginning to ask whether economics, and by extension finance, has a replication crisis.
Based on an examination of 13 leading journals and 60 papers, Chang and Li (2015) conclude that replication
is generally impossible. Brodeur, Le, Sangnier, and Zylbergerg (2016) raise the issue of “p-hacking” in which
researchers use different models to obtain ideal results and fail to disclose the full set of tests. Harvey (2015, p.
37) contends that “many of the factors discovered in the field of finance are likely false discoveries.” fte latter
arises from poor inferential statistics—in particular, the failure to control for false discovery rates and
multiplehypotheses.
What of behavioral finance? Little sense of urgency exists in the field, as in much of economics and
finance. Clemens (2015) indicates that a standard metric for measuring a paper’s reliability or replicability
does not exist. Although the foundations of behavioral finance are situated in psychology, the same degree
of concern does not follow. ftis is evident from the publication of the Open Science Collaboration study
(Open Science Collaboration 2012), which sought to systematically replicate all papers published in three
leading psychology journals in 2008. fte study shows that the results in terms of replicability are essentially
the same as reported in Chang and Li (2015).
fte first section of this chapter identified behavioral finance as being at the beginning stages of a
progressive research program but in need of a solid core of theory and appropriate methodologies in order to
continue to grow. fte reliability of behavioral finance research is, therefore, critical at this stage of its
development. Reliable research requires reliable theories; otherwise an excessive number of theories emerge
and valid research has to compete with research that cannot stand up to rigorous replication. ftis situation
distracts researchers from pursuing the most fruitful avenues for future
research. Now is the time to create a social norm for methodologies that incorporate method and data
openness so as to encourage replication.
Next, there are three broad solutions for ensuring reliable behavioral finance research. fte first is
institutional. Cochrane’s (2015) arguments on the need for schools and institutes to take seriously data
issues in their hiring and promotion process are worthwhile, but such a culture change is likely to take a
long time. Journals also need to make changes. Harvey (2015) offers an interesting perspective on the
three main finance journals, in which he describes a frustrated attempt by the editors to enforce a degree of
replicability. Apart from the argument on proprietary, or what Cochrane calls “secret” data, there is a fear
even at the top-tier journals that this replication standard would damage the comparative reputations of the
journals, in that some wouldnot havesucha policy,makingtheir paperslesscitableandless“notable.” First, in
the interests of research, journals need to insist that their authors make available their datasets and clear
methodology files. Researchers should welcome such transparency, because it promotes the robustness of the
field. If data cannot be made available, then perhaps editors can publish papers accompanied by a note stating
that some results involve some degree of “trust.” Editors could possibly place such papers in a separate section
of their journals. Calling the section “Non-Replicable Research” presumably would rapidly overcome even the
most fervent researcher protests. Second, consideration is needed for pre-experiment research protocols and
registered replication reports. ftese studies would be multi-unit in nature, following the same template as to
how to proceed, the results of which would be published simultaneously, allowing comparison and a sense of
the “true” effect. ftis framework is currently being rolled out
in psychology.
ftird, there also needs to be consideration of improving the communications infrastructure of behavioral
and experimental finance. For good or ill, the double-blind peer review for a journal remains the dominant
paradigm. fte relatively few journals that focus on behavioral and experimental areas could consider a degree
of hybrid reviewing. In some open-access areas, reviews are done post-publication, as well. Opening up the
behavioral finance journals to an explicit aim of open-post replication review might yield benefits. Although
scientists are sensitive to replication that fails (Fetterman and Sassenberg 2015), it would be a greater loss not to
be open to identifying potential failures. Another approach would be to integrate meta-analysis and
structured literature reviews with replication issues. Structured reviews in medical and cognate disciplines lay
the foundation for further research; these are known as Cochrane Reviews in the medical sciences. Examples
of this approach are increasing in medicine (Pharoah, Tsai, Ramus, Phelan, Goode, Lawrenson, and Buckley
2013) and psychology (Nieuwenstein, Wiergenda, Wicherts, Blom, Wagenmakers, and van Rijn 2015), in
which the meta- analysis is the first stage that informs the subsequent replication. Finally, a newly developed
bibliometric tool, the R-Index (Schimmack 2012, 2014), could provide “a doping test for science” (in the
words of its creator) in the form of a statistical test for bias in a series of studies. A behavioral finance equivalent
of this would allow insight into which subareas are most likely to provide the potential for fruitful future
research.

ftis chapter has offered a personal view of the future concerning many aspects of modern behavioral finance
and has attempted to unify this perspective around a common core. ftat is, behavioral finance needs to
recognize that it is just beginning to be a progressive research program in a philosophical sense. ftat
perspective necessitates a strong focus now on developing a robust common core of theory and reaching
agreement on the nature of valid methodologies. Borrowing theory from psychology and methods from
traditional finance were a necessary compromise in developing behavioral finance as a discipline. However,
ignoring the core parts of a vibrant research program is unacceptable as the field becomes more
established.
fte issues these compromises raise can be viewed from the selected focus of both the behavioral
corporate finance and investor psychology sectors. Behavioral corporate finance currently rests on the “rational
manager/irrational investor” perspective, which is both poorly specified from a behavioral theory view and
unlikely to offer progressive research. fte other main focus—CEO characteristics—is out of touch, in that
management research has taken a more holistic view of organizational decision making. fte influence of
investor psychology on asset pricing is probably the weakest part of modern behavioral finance. Its main
potential contribution—the modeling of sentiment—is mired in competing theoretical approaches that only
offer confusion, owing to a proliferation of measurements. ftere is a need in investor psychology research to
collaborate with disciplines that complete the skillsets needed to appropriately investigate asset pricing
phenomena such as sentiment; this is primarily accomplished by working with researchers in the computer
sciences and experimental finance to build theory and test new complex datasets.
Although this chapter is critical of the current state of behavioral finance, behavioral finance has undeniably
made astonishing progress from its start in the 1980s, when it primarily involved checking for different returns
at different times of the week, month, and year. Most behavioral finance research now considers theory as a
building block for any quality empirical paper. fte problem is to make sure the most appropriate theories
and the most informed empirical approaches are used.
1. Discuss the extent to which behavioral finance has progressed philosophically since the 1980s anomalies
literature, and how it might develop in the future.
2. Discuss problems with the “rational managers/irrational investors” research stream in behavioral
corporate finance.
3. Discuss whether characteristics of top management teams are likely to be featured in future research on the
drivers of corporate financial behavior.
4. Identify and explain key issues that need to be resolved concerning current measures of investor
sentiment.
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Discussion Questions and Answers

(Chapters 2–30)
Chapter 2 The Financial Psychology of Players,

Services, and Products
1. List and explain some fundamental issues of behavioral finance.
Four major tenets of behavioral finance are loss aversion, heuristics, overconfidence, and status quo bias.
Loss aversion is when people evaluate specific financial choices in which they allocate more importance to
a loss than to earning a gain. Heuristics are mental shortcuts people use to process information because of
too much data, time limits, or other pressures. Overconfidence is the inclination to overrate one’s level of
expertise, skills, or abilities in order to predict investment returns. Status quo bias is when people suffer
from inertia by defaulting to the same decision or accepting the current circumstance. Adjusting such
behavior often requires major incentives.
2. Provide an overview of the behavioral finance perspectives of risk.
fte behavioral finance viewpoint of risk is based on both the objective issues and the subjective factors in
assessing risk for a specific financial service or investment product. A major premise is the notion of loss-
averse behavior, in which individuals allocate more weight to losses than to gains. Consequently, they
may select satisfactory rather than optimal outcomes. An emerging subject in behavioral finance
concerns an inverse (negative) relation between perceived risk and return.
3. Define the heuristic biases of representativeness, anchoring, and mental
accounting.
Representativeness is a bias in which individuals have an instinctive tendency to develop a viewpoint
about a specific experience and over-weight how much this circumstance reminds them of other
familiar decisions. Anchoring is the inclination for individuals to latch on to a piece of information or
past experience as a reference point for making judgments and final decisions. Individuals frequently
make a financial judgment on the first information they are presented and have problems
579
580 Discussion Questions and Answers (Chapters 2–30)
changing their assessment to new data. Mental accounting is a decision-making approach in which
individuals split their financial assets into different mental categories or compartments.
4. Define and describe the process of worrying within the finance domain.
fte process of worrying is a regular and widespread human experience, especially about finances.
Financial worries induce past memories and mental pictures of future episodes that can influence
decision making. An individual may have negative feelings, such as high levels of worry toward risky
investments, which may result in avoiding certain types of financial securities. ftis behavioral perspective
of financial worry is how an individual might respond to a specific condition or judgment that results in
higher levels of depression, dread, regret, or unhappiness about their personal finances.
Chapter 3 Individual Investors

1. Discuss the main differences between the traditional and the modern finance
paradigm in understanding the behavior of individual investors.
fte traditional finance paradigm assumes that individual investors make rational decisions and respond
only to economic incentives. However, the modern finance paradigm takes a more holistic approach by
recognizing the complexity of individual decision making and its collective influence on financial
markets and firm decisions. In the modern paradigm, biological roots, personal life experiences, psy-
chology, nonstandard preferences, and behavioral context such as social norms and culture shape
individual investors’ behavior.
2. Explain the broad implications of studies of genetics, neural roots, and personal
life experiences for understanding the behavior of individual investors.
Studies show that investor behaviors and preferences have biological roots and life-course
determinants. Although many tend to describe behavioral biases or nonstandard preferences as
suboptimal, such behavioral traits and preferences may be the result of optimal learning in evolutionary
ancient times or in personal life. ftus, studies of genetics, neural roots, and life experiences in finance
offer powerful insights for understanding the existence and heterogeneity of behavioral traits among
individual investors.
3. Discuss the disposition effect and the proposed explanations for this effect.
fte disposition effect refers to the tendency of investors to sell winner stocks more readily than loser
stocks. Some experts propose that the dual-risk attitude embedded in prospect theory generates risk
aversion in the main domain and risk seeking in the loss domain, leading to a greater tendency to realize
capital gains. Others suggest that investors experience realization utilities, which promote the realizing
gains more than the realizing losses. Some show that cognitive dissonance is partly responsible for the
disposition effect. When investors can blame their investment managers, they exhibit no disposition
effect in mutualfund redemption decisions.
Discussion Questions and Answers (Chapters 2–30) 581
4. Identify the social factors that influence individual investor decisions and dis-
cuss the importance of considering the social context when making investment
decisions.
Every individual belongs to social networks from which they acquire information, process information,
and reference their own behavior. ftus, the group members, group norms, and societal cultures influence
investor decision making. Social interaction may facilitate wiser investment decisions. However, when
information sharing among groups is incomplete, biased, or distorted, suboptimal decisions may
prevail. Culture has a distinct, powerful, and long-lasting impact on investor decision making.
Understanding these social factors can help provide a better understanding of group investing behavior,
societal trends about investing platforms, and the role of fashion and fads in investment ideas.
Chapter 4 Institutional Investors

1. Discuss whether institutional investors are subject to behavioral biases to the
same extent as individual investors.
Empirical evidence suggests that individual investors are much more likely to trade based on behavioral
biases. Some evidence suggests that institutions are subject to the disposition effect and overconfidence,
but generalizing this evidence is limited due to small sample sizes.
2. Explain whether mood, not directly related to financial fundamentals, affects
Institutional investors seem to be less subject to mood, unrelated to market fundamentals, compared
to individual traders. However, some mood-based trader behavior seems to exist among institutions. For
example, a study of weather patterns shows that relative overpricing of securities on the Dow Jones
Industrial Average increases on cloudier days at the same time as does institutional investors’ selling
propensities of the securities. A stock-level mood proxy from institutional investors’ holdings is positively
related to a stock’s returns, especially in more difficult to arbitrage securities.
3. Discuss whether evidence showing that institutions herd with their trades sup-
ports irrational (market destabilizing) or rational (market stabilizing) reasons
for institutional herding.
Empirical evidence documents a strong tendency of institutions to herd. Various behavioral reasons
could drive such herding. In the case of the institutional traders, herding appears information based. For
cascading, evidence shows that institutions follow each other’s trades because they infer information
from each other. Because institutions trade on the same information from the underlying funda-
mentals, herding occurs unintentionally. Both cascading and investigative herding speeds up
incorporating fundamentals into security prices and thus increases market efficiency.
4. Identify how institutions can exploit behavior biases of individual investors’ in

their trading choices.
Institutions can exploit individual investors’ behavioral biases by being on the winning side of the
trades. For example, institutions could take advantage of market underreaction to earnings
announcements. Earnings surprises, both positive and negative, are followed by a drift because of the
market’s initial underreaction to the surprise. Institutional investors are aware of the drift and profit from it in
their trades.
5. Discuss how institutional agents can use behavioral finance to benefit their
clients.
Understanding basic behavioral characteristics can help financial advisors construct financial plans and
portfolio allocations for their clients. For example, financial advisors could administer a simple
questionnaire to better understand if their clients are likely to suffer from overconfidence or loss aversion.
Using the tools from behavioral finance, advisors can educate their clients, construct and customize
clients’ portfolios to fit their investment personalities, and guide clients during periods of market
turmoil.
Chapter 5 Corporate Executives, Directors, and Boards

1. Identify and explain three psychological factors that differentiate CEOs in the
agency and stewardship frameworks.
ftree factors differentiating CEOs are motivation, identification, and use of power. fte motivation of
agent CEOs comes from an economic self-interest and leads to behaviors and decisions that they
perceive as improving their economic being. Alternatively, steward CEOs are motivated by intrinsic
rewards and acts to enhance their achievements and self-efficacy. Identification refers to taking
responsibility and blame within an organization. Agent CEOs externalize the company’s problems to
avoid blame and may exacerbate them by not taking responsibility. fte steward CEO views the
problems as an opportunity to work toward the common goals and earn achievements. Finally, the use
of power in a company in the agency framework is institutional in nature to control and influence the
CEO. In the stewardship framework, power is on a personal level and derives from expertise, respect,
andloyalty.
2. Discuss how CEO optimism might lead to poor capital investments.
Optimistic managers overestimate an investment’s cash flows and underestimate its risk. ftus, some
projects may appear to have a positive net present value when they really do not. ftis bias leads to
investing in poor projects.
3. Explain how a CEO might become overconfident.
Managers tend to over-credit their own role for successes and blame bad luck for poor outcomes. ftis
self-attribution bias leads to overconfidence through experience. ftis overconfidence leads to being
more likely to apply for higher-level management positons, so overconfident managers are
promoted more often.
4. Identify and explain group dynamic biases that might affect a board of directors. Groups
sometimes suffer from social loafing, poor information sharing, and groupthink. Social loafing, or the
free-rider problem, occurs when board members fail to put in a high level of effort and still get credit for
the successes of the group. ftey believe others will do their portion of the work. Poor information
sharing occurs when a board member has specialized knowledge but fails to share it because of the power
of knowing something that others do not. Also, a board member may fail to share information that is
contradictory to the consensus belief as a confirmation bias. Groupthink is a failure to explorealternative
options bynotseriously discussing them in an effort to achieve consensus.
Chapter 6 Financial Planners and Advisors

1. Explain the various regulatory regimes that encompass financial planners and
advisors, and identify when a particular advisor would fit under each regime.
Financial planners and financial advisors are not regulated as distinct professions. Instead, they are
regulated depending on the functions they perform. Financial advisors who are compensated for
providing investment advice are typically regulated as Investment Advisor Representatives (IARs) and
are affiliated with a Registered InvestmentAdvisor(RIA).IARsareheldtoafiduciarystandardofcare,
wheretheir recommendations must be in the best interests of their clients. fte Securities and Exchange
Commission (SEC) oversees large RIAs and state securities regulators oversee small RIAs. Financial
advisors who are compensated for helping individuals buy and sell financial products are typically
regulated as a registered representative of a broker-dealer (BD). As such, theyare held to a suitability
standard of care, in which the products they sell must be suitable for their customers. fte Financial
Industry Regulatory Authority (FINRA) is a self-regulatory organization (SRO) that oversees
broker-dealers, and the SEC oversees FINRA. State insurance commissions regulate financial
advisors who sell insurance products.
Financial advisors may be licensed to provide multiple services for clients. As a result, they may fall
under multiple regulatory regimes. For example, an advisor may be an IAR, a registered representative of
a BD, and an insurance agent. As such, FINRA, the SEC (and/or state securities regulators), and the state
insurance commissions of anystate where the advisor does business would oversee the advisor.
2. Discuss the agency costs involved in receiving professional financial advice and
how to mitigate those costs.
Agency costs include monitoring costs, bonding costs, and residual losses. Monitoring costs
involve a principal managing the work performed by an agent. In financial planning, this arrangement
involves a client managing the work of his or her financial advisor. ftis monitoring can be achieved through
regulation by relying on knowledgeable regulators to oversee the work of financial advisors. Bonding
costs that advisors typically incur can include the standard of care to which an advisor is held, such as the
fiduciary or suitability standard. Bonding costs can also include rigorous certifications that can serve as a
public signal that an advisor has acquired
adequate financial knowledge to be considered a competent professional and is willing to abide by a
particular ethical code of conduct. Residual losses include any additional losses that may be incurred,
despite thebesteffortsof theprincipal.
Individuals can mitigate agency costs by using an advisor who is willing to incur adequate bonding
costs. ftey can also check public records to ensure that no regulators or certifying organizations have
disclosed any disconcerting information about the advisor or the advisor’s firm.
3. Describe the common compensation structures used by financial advisory firms,
and identify potential conflicts of interest within each compensation structure.
Financial advisory firms can be compensated through commissions, a percentage of assets under
management (AUM), an hourly rate, a retainer fee, project-based fees, or some combination of these
methods. Commission-based compensation may entice an advisor to buy and needlessly sell
financial products or to recommend products with larger commissions. Advisors with AUM-based
compensation may seek ways to increase the amount of managed assets, either by incurring more
investment risk than is optimal or by discouraging withdrawals from the portfolio of managed assets.
Charging an hourly rate may encourage advisors to spend unnecessary time working on a particular
client’s situation, while retainer fees may encourage the opposite, in which advisors may shirk in their
responsibilities. Lastly, project-based compensation may entice advisors to overestimate the time and
other resources that a project requires or to short-change the resources actually used. Although conflicts
of interest may exist regardless of the compensation structure, ethical and competent financial advisors
canoperate within anyformof compensation.
4. Discuss the characteristics of individuals who typically employ the services of
financial planners and advisors.
Individuals who use a financial advisor tend to be wealthier and have more income. ftey also are prone to
have better financial behaviors with proactive attitudes about retirement. Such individuals are more likely
to be older and have more education than those who do not use a financial advisor. Women are also more
likelythanmen to report using a financial advisor.
5. Discuss empirical evidence about the value of financial advice.
fte value of financial advice can include both quantitative and qualitative factors. Regarding
quantitative factors, individuals with a financial advisor tend to have more diversified portfolios
with more asset classes. ftey also tend to have higher portfolio turnover, incur more fees, and
experience lower portfolio returns. fte negative impacts of using a financial advisor may result
from misaligned incentives between the client and the advisor and may be avoided by
mitigating agency costs.
Qualitatively, financial advisors may help clients acquire adequate insurance protection and
favorable tax-sheltered accounts. Financial advisors may also help clients maintain a long-term focus,
which can be particularly beneficial during reces- sions. Some estimate the value of using a financial
advisor to be between 1.5 and 3 percentage points (150 and 300 basis points).
Chapter 7 Financial Analysts

1. Discuss whether regulation solves the problem of bias in analysts’ reports. Regulation
solves the problem of bias in analysts’ reports only to the extent that the regulations remove bias
driven by conflicts of interest. If the bias also results from behavioral factors, such as confirmation bias
or the leniency heuristic, then regulation can only reduce but not eliminate bias. Information uncertainty
fills the environment in which financial analysts form their forecasts and recommendations. As such, the
possibility of behavioral biases driven by this uncertainty is high.
2. Identify two incentives or environmental factors that increase analyst bias.
Incentives to curry favor with the firm managers the analysts are following to get better information can
increase analyst bias. fte incentives to please firm managers to increase trading and investment banking
business for their brokerage house can also increase bias. Each of these responses should also lead to
increased compensation for the analyst.
3. Identify analyst characteristics that reduce analyst bias.
Some studies show that experience in forecasting may reduce analyst optimism. Additional research
finds that analysts who follow fewer companies and those who forecast more frequently are less
optimistic in their forecasts.
4. Discuss whether the market recognizes and adjusts for the bias in analysts’
reports.
Much evidence finds that optimism in analysts’ reports harms smaller and less sophisticated
investors. Several studies show that larger investors understand and adjust for the bias in analysts’
reports.
Chapter 8 Portfolio Managers

1. Describe the primary steps of the portfolio management process.
fte first step in the portfolio management process is to establish the fund’s goals along with its
constraints. Next, the manager develops and implements the portfolio strategy, which includes determining
an investment strategy to undertake and select the fund’s investments. fte last step is to monitor and
adjust the portfolio, which is an ongoing process to ensure that the fund continues to follow the
established objectives.
2. Compare the structure of traditional and alternative asset management firms
and identify biases that may arise as a result of their differences.
Traditional asset management firms manage relatively straightforward, traditional financial products and
are compensated based on a percentage of their assets under management (AUM). Alternative asset
managers receive both a fee based on AUM and a performance fee for returns above their high-water mark.
Because hedge fund managers receive both management and performance fees, they may be incentivized to
engage in risk-taking behavior to maximize their potential compensation.
3. Describe the disposition effect and how it affects portfolios based on an inves-
tor’s utility.
fte disposition effect is a phenomenon where investors feel more strongly about losses than they do
gains. ftat is, a gain followed by an equal-size loss generates negative utility. fterefore, investors hold onto
losing investments because they do not want to realize a loss (risk-seeking behavior), but quickly sell
winning investments to ensure that any gains are not eliminated (risk-avoidance behavior). In a portfolio
context, portfolio managers tendto sell winners tooearlyand holdlosers too long.
4. Contrast the different biases displayed by male and female portfolio managers
and the consequences of each on their respective portfolios.
Female portfolio managers are less likely to display overconfidence bias than are male portfolio
managers, which has ramifications on trading activity and concentrated positions. Women also have a
greater ability to admit mistakes and to sell losing investments. Further, women are less likely to engage in
herding behavior and their portfolios have differentiated return patterns as a result.
Chapter 9 Financial Psychopaths

1. Identify the distinguishing characteristics of a traditional psychopath.
fte distinguishing characteristics of a traditional psychopath include a pervasive, life-long pattern of
problematic behavior, deceitfulness, impulsivity, irritability and aggressiveness, reckless disregard for the
safety of self or others, consistent irresponsibility, lack of moral compass, and absence of remorse.
Psychopaths usually present a charming demeanor.
2. Explain how traditional and financial psychopaths differ.
Financial psychopaths are a subset of corporate psychopaths. As such, they display most of the traits of
traditional psychopaths, but tend to be “passive” in nature. ftat is, financial psychopaths prefer to
manipulate and exploit others through tactics other than physical violence. Financial psychopaths have
control over financial resources rather than managing entire companies. As such, they use financial instru-
ments and financial transactions to inflict damage on others in pursuit of financial gains for themselves,
experiencing no remorse for the consequences of their actions.
3. Discuss the key changes in the economic and financial environment that facili-
tated an increase in the psychopathic-like behavior exhibited by financial
professionals.
fte biggest factor that changed the financial environment is the continued and rapid advancement in
computer technology. Other key factors include more mathematicians and computer-skilled
people employed in the financial sector, shifting the personality profile of the sector, transition to
off-exchange trading platforms, less relationally based trading venues, financial theories that empha-
size maximizing financial returns, and loosening of regulations governing financial markets.
4. Explain why correctly identifying financial psychopaths is important.

Correctly identifying financial psychopaths is important because they have the potential to topple the
financial system if left unchecked. Successful financial psychopaths, such as Bernie Madoff and Lee B.
Farkus, can operate over long periods without detection. Operating in this manner enables them to build
up enormous liabilities from their financial schemes, which are usually linked to nonexistent securities so
nothing is backing the liabilities. At the same time, the financial psychopath appears to be prospering with
excess money. fte increased linkage of financial systems globally makes this situation even more
precarious.
Chapter 10 The Psychology of High Net Worth

Individuals
1. Define HNWIs and discuss the demographic trend.
HNWIs, or high net worth individuals, are individuals or households with more than $1 million in net
worth, which is investable assets excluding primary residence, collectibles, consumables, and consumer
durables. fte global number of HNWIs and their total wealth has grown substantially. Wealth is not only
concentrated to the top 1 percent of the world population; it also enjoys the highest growth rate at the very
top. Asia-Pacific and North America drive the majority of growth. China and India are expected to
drive global HNWI growth over the next fewyears.
2. Identify the key players in the wealth management industry in the United States.
fte key players in the wealth management industry in the United States are full- service broker-dealers
(wirehouses), independent broker-dealers (IBDs), independent Registered Investment Advisors
(RIAs), private banking, and multi-family offices (MFOs).
3. Discuss the different assumptions and approaches of behavioral vs. traditional
finance.
Behavioral finance recognizes real human behaviors and focuses on cognitive biases and heuristics. fte
behavioral finance model combines psychology with financial theory to understand the interplay
between markets and human emotions, personality, and reason. fte behavioral approach is evidence
based. fte traditional finance model assumes a “perfect” market for capital where investors are completely
rational, emotionless, self-interested maximizers of expected utility with stable preferences. fte
traditional approach is normative.
4. Describe goal-based wealth management and holistic investing.
Goal-based wealth management considers the short, intermediate, and long-term personal theme of
HNWIs to help them prioritize their goals holistically. Success is measured by how clients are
progressing toward reaching their personalized goals against the broad range of needs and concerns,
versus the traditional approach of measuring performance based on relative returns against benchmark
market indices. Holistic investing is characterized by personal relationships, frequent human
interactions, and customized advice. HNWIs are offered integrated financial planning and wealth
management advice and solutions encompassing investment, credit, tax, estate planning, insurance,
philanthropy, and succession planning, both for businesses and for personal wealth.
Chapter 11 The Psychology of Traders

1. Define overconfidence and give some examples of how overconfidence affects
trading strategy.
Overconfidence is one of the most severe biases affecting trader behavior. Formally, overconfidence is the
tendency for someone, such as a trader, to perceive his or her knowledge and skills better than they
actually are. In practice, overconfidence induces traders to believe that they possess superior information
than other market participants (the better-than-average effect) or to underestimate the actual riskiness of
their portfolios (miscalibration). ftis misperception is popular especially among male traders, leading
them to hold undiversified portfolios and to trade more than advisable. Overtrading implies a higher amount
of transaction costs and thus a reduction in the trader’s net performance.
2. Describe the main differences between gregarious and contrarian investment
strategies.
A gregarious investment strategy is the tendency of traders to follow others’ beliefs instead of their own.
ftis behavior can be both rational and irrational. fte former situation appears when traders prefer to
follow the decisions of those whom they believe are more informed or possess superior trading skills.
Herding behavior can also be irrational when investors follow the group’s beliefs, even when they clearly
seem erroneous. In this situation, the approach is to reduce potential mental discomfort deriving from
wrong individual trading decisions. As several studies suggest, only a low percentage of traders are
profitable. ftus, even though gregarious behaviors (i.e., momentum-type strategies) perform well when
markets are trending, investors should revise their strategies and use an approach that is the opposite
of the majority of investors before the market cycle changes. But employing a contrarian strategy does
not mean systematically moving in the opposite direction to the trend in all market conditions. ftus,
traders who want to profitably adopt a contrarian strategy have to identify areas where high uncertainty
can lead most investors to make wrong decisions. ftis usually happens when stock market prices
substantially differ from their fundamental values (e.g., close to market tops or bottoms). Identifying
those areas in practice can be difficult because emotions play a critical role in influencing trading
decisions. Hence, following a profitable contrarian strategy requires strong mental discipline.
3. Explain the meaning of investor sentiment and provide some examples.
Investor sentiment is the attitude of traders toward the market not justified by changes in
fundamentals. Sentiment is clear as markets approach tops (or bottoms) when most traders are optimistic
(or pessimistic). Yet, the prevalent market feeling can be difficult to determine when prices do not show
a defined trend.
Two broad categories of sentiment indicators are available: the opinion-style and the action-style
indicators. fte former group collects all indexes based on surveys or judgments of specific categories of
investors about future market scenarios. An example of an opinion-style indicator is the University of
Michigan Consumer Sentiment Index, which surveys consumers to gather expectations about the overall
economy. Action-style indicators include all indicators describing the actual behaviors put in practice
by market participants. Examples of action-style indicators are the Commitments of Traders (COT),
which details the positioning of investors on different futures markets, and the CBOE Volatility Index
(VIX), which measures the 30-day implied volatility priced into S&P 500 index options.
4. Define possible solutions to mitigate opportunistic behavior in trading
simulations.
Trading simulations are useful tools to increase experience and improve the knowledge and skills of
novice traders. Unfortunately, participants can also be induced to adopt opportunistic behaviors just to
win the competition, such as investing only in high-volatile assets and concentrating their portfolios.
To mitigate unrealistic behaviors that participants can exhibit, several options can make trading challenges
more realistic. ftese options include having participants share their profits and losses with the subject
promoting the competition and not allowing participants to directly observe other teams. Such actions
could improve the quality of investment simulations and help overcome cognitive errors affecting
novicetraders.
Chapter 12 A Closer Look at the Causes and

Consequences of Frequent Stock Trading
1. Explain why frequent stock trading is bad for investor returns.
Although academic researchers may not all agree on what drives frequent stock trading, they do agree
that frequent trading is detrimental to returns. fte inferior performance of frequent traders is largely due
to their paying more commissions and generally spending more on transaction costs. In fact, the more
oftenfrequent traders trade, the more it costs them.
2. Identify the major factors that might drive frequent trading.
Research indicates that various factors might drive some people to trade more often than others, including
high risk seeking, overconfidence, gambling addiction, and emotional issues. Of these factors, risk
seeking seems to have the most evidence as a factor contributing to frequent trading. Research suggesting
that frequent trading may be a form of compulsive gambling is more recent.
3. Differentiate among recreational, aspirational, and sensation-seeking motives
for investing and explain which of these motives leads to the greatest trading
frequency.
Recreational or leisure motives treat active investing as a source of fun. Investors motivated mainly by
this purpose actually enjoy investing. fte aspiration for riches motive views investing similar to a
lottery, providing a verysmall chancefor
possibly huge payoffs. ftese investors may not enjoy investing, but they are very focused on the
potential outcome. Basically,theyare hoping tobecome wealthy.fte sensation-seeking motive focuses on
how the act of trading, with all its uncertainties, provides the stimulation and novelty some people may
feel they need to keep their life exciting. fte thrill of both the potential gain and the potential loss drives
investors motivated by sensation seeking. Two of these groups—the recreational and sensation-seeking
investors—trade for emotional rather than rational reasons. However, only the sensation-seeking, risk-
taking motive actually predicts frequent trading. In other words, only investors who enjoy gambling (the
third group) turn over their portfolios at a much higher rate than other investors.
4. Identify and explain the gender differences that exist in investing and gambling
behavior.
Males generally trade more frequently than females, resulting in men having lower returns than female
investors. Women are more fiscally conservative than men and tend to invest in less risky assets. Both risk
seeking and overconfidence are more common in men than in women. Overconfidence and risk
seeking are also correlated with more frequent stock trading. Of course, different types of risk and over-
confidence exist. Compared to women, men seek greater risk both financially and otherwise. Men tend
to be more impulsive. Compared to women, men are more likely to be overconfident in terms of
believing their skills are better than average across domains.
In terms of gambling, males are more likely than females to suffer from gambling disorder. Males start
gambling at a younger age and tend to develop gambling disorder at a younger age than females, who are
more likely to begin gambling at an older age and to develop gambling disorder in a shorter time frame.
Among those with gambling disorder, females seek treatment sooner than men. ftis is also true of other
psychological disorders.
5. Discuss whether mobile technology is likely to affect frequent trading.
fte rapid increase in mobile device adaptation and usage continues to affect the global economy. fte
global proliferation of smartphones and other mobile devices is likely to increase the pervasiveness of
frequent stock trading. Researchers find that compulsive gamblers gamble more when new gambling
platforms become available to them. ftus, the widespread use of the Internet and mobile devices is likely to
also increase the tendency of some investors to indulge in overtrading. However, in the context of
investing in stocks, additional research is needed to understand the effect of mobile usage on trading
frequency.
6. Discuss the prevalence of frequent stock trading.
Frequent trading is a common problem. In fact, some consider investor overtrading as an epidemic. To
illustrate, the turnover rate on the New York Stock Exchange (NYSE) reached nearly 100 percent in
2004. Moreover, researchers find that rational reasons, such as portfolio risk-rebalancing needs, do not
explain this high rate of turnover. fte problem is particularly serious for the most active traders, who
trade much more than the average trader and realize even larger losses for trading too often.
Chapter 13 The Psychology of Women Investors

1. Explain how men and women view the topic of investing differently and why
advisors should know this.
Historically, women have been raised without having much knowledge about money and have
deferred to men in the household to make decisions. Some females may be cautious about taking control of
finances; women often want security and a sense of belonging. Men view investing as a competitive
endeavor, in which high risk to reward is acceptable. Understanding the motivations of clients can help
advisors better serve their clients.
2. Explain why women often lack confidence about financial matters and how this
may affect their financial decisions.
Women are not raised to have high financial confidence, due to societal pressures that allow the men in
their lives to control the financial decisions. ftis negatively affects women’s comfort and understanding
about investing, as well as other financial matters. Sometimes, women’s preference for low risk or “safe”
investments can negatively affect their ability to accumulate wealth.
3. Identify several important financial concerns of women.
Women have several important financial concerns. For example, many women struggle to balance
their careers with their family responsibilities and feel overwhelmed, overextended, and overworked.
Many are concerned about being able to provide for their loves ones in the long term, even after
retirement.
4. Discuss how the caregiver role affects investing.
As the traditional caregiver, women look for lower-risk investments that allow long- term returns with
smaller upfront investments. ftey spend short-term monies as part of their caregiver roles. Women have
to fund longer time frames in retirement with a shorter work history. fteir shorter work history or gaps in
employment often resultinsmaller defined-pension benefits andsmaller retirementplanbalances.
5. Discuss how advisors should treat women.
Women need their advisors to be able to connect with them. Women also need to know that they are heard
and understood. Women want someone to work with them to understand the impact that one decision may have
on other areas of their financial lives.
Chapter 14 The Psychology of Millennials

1. Explain why Millennials are distrustful of the financial services industry. Millennials
came of age in financially unstable times and many saw their parents’ financial situation compromised. ftey
witnessed the dot-com and housing bubbles burst, the Enron and Bernie Madoff scandals, and the financial
crisis of 2007–2008, as well as the subsequentrecessionandprolongedeconomicrecovery.A 2016Facebook
white paperreportsthathalf of Millennialsfeeltheyhavenoone theycantrustforfinancial guidanceand
fewer than 10 percenttrust financialinstitutions for this guidance.
2. Explain how Millennials differ from Baby Boomers other than age.
One key generational difference between millennials and baby boomers is that Millennials have
always had access to the Internet. Although Boomers are “the TV generation,” Millennials are not
restricted to just one screen. ftey are taking the lead in integrating mobile technology and the Internet into
their lives and thus are changing the way they consume entertainment, shop, bank, and invest.
Millennials who do not use a financial advisor use these tools and resources to educate themselves about
money management and financial planning.
3. Discuss how financial advisors can engage Millennials.
Millennials are now the largest generation to date, surpassing Baby Boomers at 80 million strong.
Although Boomers currently hold the greatest amount of wealth, Millennials are poised to become the
wealthiest generation. Financial advisors must communicate using the language and the tools that
Millennials use, which means having a vital social media presence and a user-friendly website, blogs,
videos, and content aimed at demystifying wealth management and investing.
4. Explain how money habits of Millennials disprove the stereotype that they are a
lazy and an entitled generation.
Several studies indicate that the unique financial challenges Millennials face, such as student debt,
have compelled them to adopt responsible money habits. Millennials are opting to save and invest
their money rather than overspend. Millennials are not only contributing to employer-sponsored
retirement plans but also using online tools to track their expenses, live within their means, and control
their wants.
Chapter 15 Psychological Aspects of Financial

Planning
1. List the six steps of the financial planning process as defined by CFP Board of
Standards and Financial Planning Standards Board.
fte six steps in the financial planning process are: (1) developing and defining the client-planner
relationship, (2) collecting client data including goals, (3) analyzing and evaluating the client’s current
financial status, (4) developing and providing recommendations and/or different options, (5)
implementing the recommendations, and (6) monitoring the recommendations.
2. Explain why financial planning clients tend to rely on secondary markers of qual-
ity when judging the advice they receive from their advisors.
Financial planning has high credence properties, meaning consumers have difficulty judging the quality of
the service even after being rendered. To minimize cognitive dissonance, clients look tothings theycan
directly observe,suchasallforms of communication.
3. Discuss how the availability heuristic can affect a financial planning client’s
perception of financial planning recommendations and/or propensity to act
on them.
Availability refers to the propensity to be biased by information that is easier to recall such as highly
impactful or more recent memories. For instance, a client’s willingness to buy long-term care insurance
often depends on whether this individual personally knew someone who had received home health care
assistance or lodging at a skilled nursing facility. Personal experience of long- or short-lived relatives could
influence the willingness to plan for a long retirement.
4. Describe how the mental biases of overconfidence, anchoring, and loss aversion
can interact to cause financial planning clients to make suboptimal decisions.
Anchoring bias, overconfidence, and loss aversion can result in poor decisions and outcomes.
Overconfidence often results in employees holding too much in employer stockor options, believing
they haveinsider insights that are superior to market signals. Loss aversion and the anchoring bias can
influence these employees to continue to hold employer stock and options even when a reversal in the
company’sfortunes or those of itsindustry causes its stock price to decline, confirming the wisdom of
broad diversification.
Chapter 16 Financial Advisory Services
1. Explain the difference between financial advisors and brokers.

Brokers often represent the firms whose products they recommend and sell, whereas financial advisors
operate independently of these firms. Furthermore, unlike salespeople and brokers, financial advisors in
most countries are required by law to put their clients’ interests ahead of their own. Although financial
advisors may receive some commissions based on sales of certain financial products, the variable earnings
of brokers consist entirely of commissions.
2. Discuss the purpose of financial advice to consumers.
Financial advisors help their clients articulate their financial goals and implement steps to achieve these
goals by providing advice on saving, credit, taxation, the choice of financial products from different
providers, investment opportunities, and various wealth and income risks. Also, consumers may delegate
management of their investments and pensions to financial advisors.
3. Describe the types of consumers who are more likely to look for financial advice.
Women are more likely to seek out financial advice than men. In laboratory settings, less financially
literate consumers are more likely to look for financial advice, although those actually receiving financial
advice outside of the laboratory are typically richer, older, better educated, and more experienced
investors. People who are more future oriented and anxious are also more likely to use financial advice.
4. Explain why high-quality financial advice may not reach those who would ben-
efit the most from it.
Financial advisors may find providing high-quality advice only to well-informed and wealthy
consumers because these advisors believe that (1) less sophisticated consumers could have a lower
willingness to pay for advice because they are unable to distinguish between good and bad advice, and
(2) poorer consumers are less profitable due to their smaller portfolios and less wealth. When consumers
pay for financial advice with upfront fees and not by commissions, those with less experience and
financial sophistication might be reluctant to paybefore they can see the benefits.
5. Describe characteristics of financial advisors that affect the degree to which con-
sumers follow their advice.
Consumers value financial advisors with more experience, but they prefer advisors who use less
technical language and investment jargon. Although confidence is important, advisors who admit some
uncertainty about their recommendations tend to be more persuasive. Consumers take more advice
from advisors deemed trustworthy, which is also related to a degree of tailoring and personal involvement
in the advice process. Consumers are also more likely to be persuaded by advisors similar to them in terms
of gender,education,age,region, andpoliticalaffiliation.
Chapter 17 Insurance and Risk Management

1. Explain the four primary responses to risk.
fte four primary responses to risk are risk avoidance, risk retention, risk reduction, and risk transfer. Risk
avoidance is a response to risk in which individuals avoid the activity altogether. Risk retention is a form
of self-insurance in which individuals retain the risk and pay for some of the loss themselves. Risk
reduction is a response to risk in which individuals take precautionary measures to reduce the likelihood or
severity of a loss. Risk transfer is a response to risk in which individuals transfer a portion of potential
risk to a third party.
2. Discuss the three primary types of hazards associated with risk management. fte
three primary types of hazards are physical, moral, and morale hazards. Physical hazardsarisefromthe
condition oruseofthe propertyitself. Anexample ofaphysi- cal hazard is ice on a stairway. Moral hazards
involve dishonest behavior in which the individual causes the loss intentionally. A morale hazard
involves attitudes of negligence andcarelessness. An example of a morale hazard is whenanindividual
leavesasparekeyunder thedoor matbecauseheknows hehasinsurance.
3. Discuss the three most prevalent risk attitudes.
fte three most prevalent attitudes toward risk are risk neutral, risk adverse, and risk seeking. Risk-neutral
investors are more concerned about the expected return from an investment regardless of the risk. Risk-
adverse investors require a higher return when taking a higher level of risk. Risk-seeking investors accept
higher levels of risk even when uncertainty about the return exists.
4. Identify and discuss the five main types of insurance for individuals.
fte five main types of insurance for individuals are:
• Disability: Some disability policies guarantee income replacement of 50 to 60 percent of the
policyholder’s income. fte cost of disability insurance is based on many factors, including age,
occupation, and health.
• Life: ftis type of insurance protects a family or business from loss of income due to death.
• Property causality: ftis type of insurance protects against property losses to a business, home, or car
and against the liability that may result from injury or damage to others.
• Health insurance: ftis type of insurance pays for covered medical and surgical expenses. fte
insured can be reimbursed for expenses or the care provider can be paid directly to the care
facility.
• Long-term care: ftese policies reimburse policyholders a daily amount for services to assist them with
activities of daily living, such as bathing, dressing, continence, transferring from bed to chair, or
eating. fte cost of the policy depends on an individual’s age, benefits chosen, and health at the time
the policy is issued.
5. Discuss the three subcategories of behavioral finance theory.
fte three subcategories of behavioral finance theory are biases, heuristics, and framing references. Bias is a
tendency toward particular methods of thinking that can lead to bad judgment and irrational decision
making. Common behavioral finance biases include chasing trends, overconfidence, and a limited attention
span. Heuristics are mental shortcuts that help people make decisions faster. Commonly used heuristics
include availability and representativeness. Framing is an example of cognitive bias in which people react
to a particular choice in different ways depending on how it is presented, such as a loss or a gain.
Individuals tend to avoid risk when presented with a positive frame, but seek risk when presented in a
negative frame. Some common framing effects are regret aversion, disposition effect, and anchoring.
Chapter 18 Psychological Factors in Estate Planning

1. Identify the issues that create differences between estate planning and other
areas of financial planning that can impede or prevent progress.
Several differences between estate planning and other areas of financial planning can affect progress. For
example, estate planning involves a discussion of mortality, which is an uncomfortable discussion for
both planners and clients. fte effectiveness of an estate plan is often measured after the demise of
theclient.
2. Discuss the dimensions that differentiate estate planning from other areas of
financial planning and wealth management in terms of the emotions accompa-
nying decision making.
Several dimensions involving emotions that accompany decision making differentiate estate
planning from other areas of financial and wealth management. For example, discussions involving
mortality are very difficult for many people. Family and marital dynamics can also influence the
planning process. Clients may have
difficulty relinquishing their wealth, even after death, and may consider plans that attempt to control
their wealth after death.
3. Explain why estate planning calls for collaboration between the planner and cli-
ent, as well as between the client and inheritors.
Although an attorney has an obligation to represent his client, estate planning requires considering
the impact of the estate on beneficiaries, and the planning process may require involving family
members and others who may serve as inheritors. ftis consideration is necessary to address issues
related to legal issues and tax-related planning.
4. Discuss how estate planning presents unusual challenges for the legal or plan-
ning professional.
Estate planning presents several unusual challenges for the legal or planning professions. For example,
the planner may need to include other parties in the planning process, which may produce difficulties
around issues of confidentiality and privilege. Including other parties may also require a level of skill in
managing the emotional dynamics of a family, which may be beyond the planner’s sphere of pro-
fessional competence.
5. Explain how transference or counter-transference might play a role in profes-
sional engagement.
Transference or counter-transference could affect the professional engagement in several ways. Whether
or not the professional has dealt with his own issues of mortality, any of that individual’s unresolved
conflicts may play a role in the interaction, on either a conscious or an unconscious level. Additionally,
discussing an estate plan could mobilize feelings about the relationship of the client to his family and
touch on feelings the planner has for the people in his life.
Chapter 19 Individual Biases in Retirement Planning

and Wealth Management
1. Discuss the biases individuals have when considering their need for financial
planning.
Individuals exhibit many biases when assessing whether they need financial planning. For example,
they often rationalize their status quo and feel that they are fine handling their money. However, this
can be a consequence of wanting to use money for emotional and self-expressive pursuits. Even when
feeling that the current situation is not optimal, they choose to keep their head in the sand, exhibiting the
ostrich effect. Planning involves thinking about the future, which contrasts with the present bias,
which focuses on living for today. Often, people follow the herd. If their friends are managing their
finances in a certain manner, then they may conclude that the herd is right. Additionally, people
often suffer from the bias of available information when determining the best financial course of action.
Discovering more complications might require an investment of both time and emotion.
Many people spend to boost their self-esteem. Friends can own their cars and houses, but may have
low bank balances. Some of the need for greater self-esteem may emerge from one’s culture or race.
Stereotypes often exist about gender and marital status. Not following these expectations can be
emotionally taxing. ftus, following the herd is often easier than going against it.
2. Discuss the rationale for hiring and the criteria for selecting a financial
professional.
Many people think in terms of a milestone-marked, linear financial planning process: secure a job, get
married, buy a house, start a family, plan for children’s college, and finally, plan for retirement. Individuals
often associate with a peer group that holds the same view. For example, when teachers join a school system
with a defined- benefit pension plan, the employer is the predominant contributor. Sometimes, the plan
requires employee contributions or permits voluntary contributions. For these and many other public
employees, the pension plan is designed to pay expected benefits when needed. Workers with elective plans,
such as 401(k) plans, however, must make their own contribution and investment decisions, follow their
peer group’s action, or hire someone to help them. Even when they are proactive in these matters, these workers
face great uncertainty concerning projected benefits upon retirement. fte decision whether to hire a
professional should at least include evaluating the following areas of financial literacy: (1) ability to evaluate
an advisor, (2) financial status, including the mix of credit/debt, (3) retirement planning, (4) college plan-
ning, (5) insurance planning, (6) tax planning, (7) estate planning, and (8) invest-
ment planning.
Much confusion exists over the term “financial advisor.” Because no professional financial advisor
designation exists, a wide range of professionals who sell investment and insurance products call
themselves financial advisors. Financial advisor sounds better than agent, financial recommender, or
financial salesperson. A professional financial advisor:
• Acts as fiduciary and gives advice in the best interests of the individual.
• Holds an industry designation that includes retirement planning, investment planning, and
insurance planning.
• Maintains an industry designation requiring continuing education.
Choosing a trusted advisor is important. Unfortunately, individuals often base this choice on limited
information or without delving into the advisor’s credentials. Some advocate that trust should be based on
credentials, honesty, and reliability. Others focus on a financial professional’s claim of large assets
under management and ascribe talent or fiduciary oversight (working in their best interests) to this
claim. ftis leads people to assume, rather than confirm, that their financial professional is working as a
fiduciary.
3. Discuss several biases that individuals should overcome in the financial planning
process.
Many individuals would rather spend money on fun today than think about their future. ftis requires
them to change from a completely present bias to one that
considers their long-term financial health. Money saved for a potential future emergency or insurance
that may or may not be used reduces the available cash to spend today. People often underestimate the
probabilities of realized adverse events and assume negative incidents will not occur. Proper risk-
planning techniques lead clients to recognize their mortality and that they do not fully control their
lives.
In determining how much to contribute to a retirement plan, some workers believe that they can
retire comfortably if they match the maximum employer contribution. Many pursue beating the market
with their retirement money rather than considering the risk reduction of a broad asset allocation, which is
indicative of an overconfidence bias. fte media gives investors overconfidence in their ability to
outperform the market.
4. Explain how employers can nudge employees toward financial security. Employers
can use intelligent defaults to facilitate increasing the retirement savings of their employees. Most
important, all employees should be defaulted into participating in the plan. Inertia will work toward
the benefit of having most employees stay in the plan. Employers engaging qualified financial
professionals to provide employees a retirement gap analysis could also help promote retirement. Most
employeesdonothavetheabilitytocalculatetherequiredsavingsandrateof return targets to retire
comfortably. A financial professional not only can help them with these calculations but can also act as a
coach during the plan’s implementation, which may last 20 to 40 years. Employers can also expand
guidance on all employee benefits including health, disability, life, and long-term care insurance.
5. Describe how financial planners can nudge clients toward financial security.
Much confusion exists about the various registrations and designations of retail financial professionals. CFP
professionals represent one of the few accredited designations, according to the Financial Industry
Regulatory Authority (FINRA). Using the FINRAwebsiteandothertools,CFPprofessionalscaneducate
clientsaboutthe kind offinancialprofessionalbestmatchingtheneedsoftheindividualinvestor.Similarto an
engaged doctor, CFP professionals listen to symptoms, ask questions, and perform diagnostic tests to get a
better indication of an individual’s true goals and needs. ftis process can be overwhelming to some. fte
planner can turn all this information into clear specific financial goals to attain and create a mutually agreed-
upon priority list.
Many individuals have difficulty changing their spending habits. A financial planner can
thoroughly analyze a client’s spending pattern to see ways to reallocate expenses that may not be apparent
to the individual. fte greatest value for many individuals is having an accountability partner who can
empathize with their situation. Many individuals have no formal knowledge of investing. Investment
risk is known to be one of the more emotional issues faced by individuals. A financial professional
using a risk and reward evidence-based methodology can educate clients on the available options for
managing investment risk. Finally, in knowing that financial management is an emotional process, the
advisor helps the client celebrate attaining certain milestones, providing positive reinforcement.
Chapter 20 Traditional Asset Allocation Securities:

Stocks, Bonds, Real Estate, and Cash
1. Define tactical asset allocation (TAA) and discuss the advantages and disadvan-
tages relative to strategic asset allocation (SAA).
TAA allows for greater flexibility in deviating from target weights over the short to intermediate term.
ftese deviations usually result from a change in risk and/or return assumptions due to the economic or
market environment. Because of the deviation from the target weights, a portfolio that uses TAA has
the potential to outperform the benchmark if the assumptions are correct and the adjustments are
executed properly. If, however, the assumptions are incorrect and/or the execution is poor, the portfolio
may underperform the benchmark.
2. Discuss the assumptions used in modern portfolio theory (MPT) and tradi-
tional finance models.
Traditional finance describes a theoretical market environment in which the participants act solely
for their own benefit and maximize economic utility. fte assumptions that must be upheld for MPT
include the following: (1) all investors have perfect and equal access to information; (2) correlations
between assets remain constant over time; (3) returns are normally distributed; (4) no transaction
costs or taxes are applicable; (5) investor buying and selling does not affect price; and (6)
investors can borrow and lend unlimited amounts at the risk-free rate.
3. Discuss the shortfalls of mean-variance optimization (MVO) portfolios and how
the Black-Litterman model attempts to address these shortfalls.
fte shortfalls of the MVO model are its high sensitivity to inputs and overreliance on historical data. fte
resulting asset allocation strategies are usually heavily concentrated in only a few assets or securities. fte
Black-Litterman model uses CAPM and a reverse-optimization process with market weights to generate
forward-looking assumptions, rather than relying on historical returns. fte result is less reliance on
historical data in isolation and portfolios with more diversified asset allocation strategies.
4. Distinguish between cognitive and emotional errors, and provide an example
of each.
Cognitive errors are based on heuristics, which are mental shortcuts. They result from imperfections
in human decision making. For example, the decision to hold an equal weight of all securities in a
portfolio because an investor assumes this creates a diversified portfolio is called the 1/N heuristic.
Emotional biases are mistakes that investors make based on their feelings toward a decision. An
example of an emotional bias is familiarity in which investors place greater value on or express a
preference for holding securities they understand or have a connection, such as a common stock
inherited from a family member.
5. Discuss the advantages and disadvantages of mental accounting and how inves-
tors can manage this cognitive error.
Mental accounting is the act of allocating capital to different buckets based on the end use. For example, an
individual may have a savings account for a family vacation and an investment account to fund retirement.
In the context of asset allocation, an investor may have multiple accounts with different allocations to
stocks, bonds, and cash. Each account appears properly allocated, but deviates from the overall portfolio
level. ftis deviation might cause an over-concentration in one or more securities and an inefficient blend of
capital. Mental accounting can help an investor separate funds for his designated purposes and increase the
investor’s likelihood of achieving long-term savings goals. fte key to mental accounting’s successful use is
not to follow this strategy unintentionally. Although an investor can use multiple accounts, he should pay
attention to the asset allocation of the overall portfolio.
Chapter 21 Behavioral Aspects of Portfolio

Investments
1. Explain the observed return performance of mutual funds, hedge funds, and
pension funds.
Evidence shows that mutual funds, hedge funds, and pension funds earn, on average, non-positive alphas.
Although hedge funds and pension funds outperform mutual funds, hedge fund outperformance is
less clear on an after-fee basis.
2. Explain the similarities and differences between mutual funds and hedge funds. Mutual
funds and hedge funds are both portfolios of assets designed to provide investors with places to
deploy their capital and earn returns. Mutual funds are regulated, face relatively strict reporting
requirements, and are limited in terms of assets and strategies available. Hedge funds are generally
unregulated, face little to no reporting requirements, and have a much broader range of assets and trading
strategies available, including short sales, leverage,and derivatives.
3. Identify the behavioral biases demonstrated by fund managers.
Fund managers demonstrate herding bias by which they follow the trades and trends of others in the market,
even when doing so does not generate alpha. Additionally, fund managers demonstrate overconfidence
and optimism in how they believe they know things with greater precision than they do and also expect
outcomes to be better than they are. Other biases of fund managers include familiarity, home bias,
limited attention, disposition effect, and escalation of commitment.
4. Identify the behavioral biases demonstrated by those selecting money managers
and related products.
Investors selecting money managers exhibit the same biases as professional fund managers, including
herding, overconfidence, optimism, familiarity, home bias, limited attention, disposition effect, and
escalation of commitment. Herding is the tendency to follow other investor actions. Overconfidence
describes a bias in decision
making in which individuals believe they know something with greater certainty than is actually the
case. Optimism relates to biased in forecasts that overestimate potential outcomes. Familiarity bias is the
tendency to invest in companies or funds that are known to an individual. Home bias is the tendency to
invest in assets that are geographically close to fund headquarters. Limited attention is a bias related to the
observation that individuals’ time is scarce and that this lack of unlimited attention may lead to certain
biases. Disposition effect describes the tendency to gamble more with losses than profits. Escalation
of commitment may result in a fund manager’s remaining in a losing investment strategy, which in turn
could exacerbate underperformance.
Individuals also exhibit the representativeness bias, hot-hand fallacy, financial illiteracy,
search costs, diversification bias, affect, and extrapolation bias. Representativeness bias holds that
investors over-weight recent experience when forming expectations of future outcomes. fte hot-hand
fallacy is the illusion of short-term outperformance, which in reality is within the bounds of expected
performance. Financial illiteracy describes a lack of understanding about personal finance and
investing concepts. Search costs refer to the time and effort required to identify investments.
Diversification bias is the tendency to diversify even when doing so is suboptimal. Affect is an
emotional association with a decision. Extrapolation bias is a tendency of investors to treat past events
as predictors of future events.
5. Explain the trends in relative demand for active and passive strategies by both
mutual fund and ETFs.
Between 2000 and 2014, the demand for passive strategies increased relative to that for active strategies. In
particular, demand for index mutual funds, which follow passive strategies, disproportionately drives the
net cash inflow into all mutual funds. fte growth of ETFs has been impressive, with average annual cash
inflows roughly equal to that of mutual funds between 2003 and 2014.
Chapter 22 Current Trends in Successful

International M&As
1. Identify some of the irrational reasons for acquisitions.
Four main reasons exist for irrational acquiring: (1) envy theory, (2) free cash flow theory, (3) defensive
behavior, and (4) the hubris hypothesis. Envy theory suggests that executives see their cohorts acquiring
and getting greater benefits. ftey then engage in acquisitions to seek the same benefits. Free cash theory
suggests that executives spend net income to acquire companies rather than return funds to share-
holders. Defensive behavior research suggests executives acquire other firms to keep from being acquired
themselves. Finally, the hubris hypothesis suggests that executives perceive that their skills are better than
they really are. Consequently, they continue to make unwise acquisitions believing that they can be
successful despite a low likelihood of that occurring.
2. Discuss how globalfocusing can reduce risk the way conglomeration did
previously.
Organizations previously reduced risk by pursuing a diversification strategy. ftus, by being in multiple
industries within a given geographic area, organizations reduced the impact of seasonal and industrial
fluctuations. With globalfocusing, organizations lost that ability by taking on a narrower industrial
focus. To counter that and to reduce risk, these organizations internationalized, thus spreading their
country exposure and reducing risk.
3. Explain how HR issues during acquisition have changed since 2000.
Previously, the majority of acquisitions occurred for economies-of-scale synergies. fte acquisition
process required combining organizations, reducing staff numbers and harmonizing systems, management
styles, and organizational cultures. Carrying out this process required HR departments that were strong in
organizational structuring, terminations, training, and harmonization. Acquisitions now take place for
marketing entry where little integration with current operations exists. fte necessary HR skills are
retention and facilitation of horizontal cross-company communication, and intra-company
collaboration.
4. Explain the reasons the success rate of international acquisitions has improved.
Acquisitions previously occurred for economies of scale, which created considerable organizational
upheaval. Few acquirers could fully capitalize on those cost savings. Recent acquisitions rely more on
enhancing revenue through geographic expansion. Consequently, a prolonged and disruptive
implementation phase has less impact on organizations. Instead, acquirers use lighter touch integration.
Consequently, employees feel less change with success coming through intra-organizational coop-
eration and increased market coverage for existing products.
Chapter 23 Art and Collectibles for Wealth

Management
1. Explain how passion plays in a portfolio containing art.
Passion can be a driving force behind an art collection. Understanding that the passion can become
problematic is critical for wealth managers. Such knowledge equips them to better relate to the “I gotta have
it” mentality that can grip a collector. ftis allows managers to empathize with their clients and provide
better leadership with their wealth and collection.
2. Elaborate on how a client might view adding art as additional asset class to a cur-
rent portfolio.
Portfolio objectives related to risk and return must be assessed in conjunction with investor constraints.
Next, asset allocation choices can consider the role of art in a potential portfolio. fte client and the
wealth manager must recognize that art should be viewed through a different lens. Like many
alternative assets, an active secondary market does not exist for art, which may present a challenge for
clients with higher liquidity needs. If art is included in the asset allocation mix, wealth
managers need to benchmark art appropriately and understand that the art is not a silo on the balance
sheet.
3. Discuss the role of risk mitigation for art investments.
Risk mitigation is the ability to spot, identify, and quantify any decision that may affect financial status.
Understanding and integrating art and finances requires a client to look beyond the obvious and identify
the collateral issues that others may miss. Inadequate liability insurance can put an art collection at risk
because the investment portfolio does not consider art as a separate asset class.
4. Discuss the role of social media in information dissemination as related to art.
fte social media have moved art and collectible investing beyond the local level as potential art investors
now haveaccess to outline outlets. Despite lacking a formal secondary market, a wider exposure to art
creates a marketplace where art can be more readily compared and proxies for fair market value can be
better determined.
5. Justify the increasing use of “commodities” as a term to describe holdings.
Knowledge has become accessible at levels never foreseen. fte days of the knowledge-based
classroom and brick and mortar are becoming limited. Wealth managers who invest their time in
listening and leading are likely to be better equipped toattract more clients,assets, andopportunities.
As art becomes a more readily accepted asset choice, and as trading outlets become more numerous, art
begins to resemble more conventional commodity assets. Such assets are increasingly being
considered part of the portfolio holdings of investors.
Chapter 24: Behavioral Finance Market Hypotheses

1. Identify the necessary conditions for a market to be classified as efficient.
A market would be classified as efficient if it exhibits absolute equality of information, including a
total absence of insider information, full rationality of market participants, market liquidity, perfect
competition in the financial markets, and the same investment horizons and expectations for all
market participants.
2. Discuss why no theory has emerged to fully replace the EMH.
Financial markets are too complicated to be described with a single theory containing highly restrictive
assumptions. Such assumptions lead to inconsistencies with empirical observations. As a result, the
EMH remains only a theoretical model. Additional theories are needed that are more consistent with
empirical observation.
3. Provide several examples to illustrate the evolution of the financial markets.
An example of the evolution of financial markets is technological leaps, including advances in
computer capabilities, Internet trading, and high-frequency trading. Another example is the
appearance and development of the new economic theories such as the EMH. Additionally, changes
in securities regulation and changes in economic systems, such as the evolution from an industrial to a
post-industrial and information economy, can act as drivers for the evolution of the financial
markets.
4. Discuss whether efficient markets exhibit return persistence and possible mea-
sures of market efficiency.
Efficient markets should not exhibit persistence if evidence supports that they random walk. Persistence
implies the presence of price memory, implying that previous prices influence current values. If so, trends
can exist in the financial markets. ftis possibility gives opportunities for price prediction, which is
impossible in efficient markets because prices changes are random and unpredictable. In theory, market
efficiency can be measured using the level of persistence. If no persistence exists in prices, the market
can be treated as efficient. fte reasons for persistence focus on the irrationality of the investors,
existence of noise traders, and technical and fundamental analysis.
5. Explain whether the behavior of financial markets is consistent with the EMH. fte
behavior of financial markets is generally consistent with the EMH. Predicting future prices and
generating profits from trading is difficult. Nevertheless, situations exist that the EMH cannot explain.
Empirical observations, called market anomalies, provide arguments against the EMH. Because
behavioral finance explains these anomalies well, providing a synthesis of these theories is important to
give a fuller explanation of the financial market behavior.
Chapter 25 Stock Market Anomalies
1. Explain equity anomalies.

Equity anomalies are empirical relations between future stock return and company characteristics that
cannot be explained by classical asset pricing models such as the CAPM or multi-factor models. In other
words, cross-sectional stock returns are predictable by different company characteristics.
2. Discuss the major explanations of why equity anomalies exit.
Recent literature usually attributes the existence of anomalies to either an inadequacy in underlying
asset pricing models or market inefficiency. fte inadequacy in asset pricing models is usually called the
rational explanation. It builds on the traditional risk–return framework under assumptions that investors
are perfectly rational and the market is efficient. Anomalies are the consequences of short-comings of
current pricing methods or missing risk factors. Market inefficiency attributes the existence of anomalies
to the irrational behavior of investors and is usually called a behavioral explanation. Under the framework
of the behavioral perspective, investors do not collect and/or process available information rationally
because they suffer from cognitive biases, so securities are mispriced. fte stock return predictability
represents systematic mispricing in the equity market.
3. Identify some behavioral biases of investors that can be attributed to anomalies. fte
behavioral biases include overconfidence and self-attribution, limited attention, disposition effect, and
investor sentiment. People are usually overconfident about their own judgments being right subjectively
rather than objectively. Self-attribution refers to when people tend to credit themselves for past successes,
but blame other
factors for failures. Limited attention is the tendency of people to neglect salient signals and overact to
relevant or recent news. fte disposition effect is the tendency of investors to sell assets that have risen in
value rather than to sell those that have fallen. ftat is, investors tend to sell winners and hold on to losers.
Investor sentiment is the propensity to speculate. Researchers often use these behavioral biases to
explain various anomalies.
4. Define an investment anomaly and identify some documented investment
anomalies.
An investment anomaly refers to the stock return predictability resulting from company characteristics
that relate to its investment activities. Studies report that companies with high investment activities earn
lower average returns than those with low investment activities. fte q-theory provides a theoretical
background of how investment can serve as a predictor for future stock returns. fte following stud-
ies test and verify that company-level measures of investment indeed have power to predict future stock
returns. ftese investment-related anomalies include asset growth, investment growth, net stock issues,
investment to assets, and abnormal corporate investment.
Chapter 26 The Psychology of Speculation in

the Financial Markets
1. Define the term stock bubble.
A stock bubble occurs when market participants drive stock prices considerably above their intrinsic
values. ftus, a bubble is an unexpected and dramatic increase in the price of the financial asset or
investment ultimately resulting in an extreme decline in price.
2. List and describe four major causes of speculative behavior.
Four major causes of speculative behavior are overconfidence, herding, representativeness bias, and
familiarity bias. Overconfidence is the tendency of an investor to overestimate his level of skills,
expertise or accuracy when forecasting future stock market performance. Herding is exhibited when a
group of investors makes the same investment judgments about a specific piece of information and
decides this information is likely to lead to increased stock prices. Representativeness bias is when
people are inclined to develop a belief about a current experience and over- weight the importance of this
information. During a bubble, investors conclude that stock prices are likely to continue to increase based
on a small sample of initial stock price data. Familiarity bias is evident when investors demonstrate a
preference for and invest in familiar securities. During a bubble, investors perceive familiar stocks as
being less risky with the possibility of achieving higher returns.
3. List and explain four major biases that investors exhibit in the aftermath of the
financial crisis of 2007–2008.
Four major investor biases evident in the aftermath of the financial crisis of 2007– 2008 were anchoring,
loss aversion, status quo bias, and mistrust. Anchoring is the
inclination to hold a viewpoint and then apply it as a reference point for determining future decisions.
Investors often apply a negative anchor after a stock market bubble bursts. Loss aversion is evident when
investors assign more importance to a loss than to achieving an equivalent gain when assessing specific
financial transactions. fte experience of investors’ losing money might remain for an extended period.
Often individuals who realize losses during a financial crisis tend to avoid investing in the stock market.
After a financial crisis, investors may suffer from status quo bias, no longer wanting to invest in common
stocks or avoid managing their investment portfolios. After a financial crisis, the public often exhibits
mistrust of financial institutions and markets. Considerable time mayelapse before this trust is restored.
4. Discuss the influence of investor psychology in the aftermath of a financial crisis
or when a bubble bursts.
After a financial crisis, some investors may exhibit negative long-term biases that affect their overall
assessment and decisions about financial markets. In the aftermath of a stock market bubble, this
situation results in investors’ experiencing lower levels of risk tolerance and higher degrees of negative
emotion and perceived risk. Consequently, they tend to under-invest in risky assets such as common
stocks and over-invest in safer assets such as cash and bonds.
Chapter 27 Can Humans Dance with Machines?

Institutional Investors, High-Frequency
Trading, and Modern Markets Dynamics
1. Discuss the main differences among various equity exchanges operating in the
United States.
Equity exchanges in the United States differentiate themselves by fee structure. Some exchanges
charge fees for using market orders to take away liquidity. Such exchanges are often referred to as
“normal” exchanges and provide rebates to traders using limit orders to add liquidity. fte NYSE is
an example of a normal exchange. Another class of exchanges, known as “inverted,” do the opposite
by rewarding traders bringing in market orders with rebates and charge traders adding liquidity.
2. Discuss the key types of HFT.
All HFTs are either aggressive or passive. Aggressive HFTs tend to use market orders to capture
short-lived arbitrage opportunities. Passive HFTs use limit orders to provide liquidity in market-
making strategies.
3. Explain how exchanges distribute market information.
Exchanges distribute trading information via messages. Each exchange decides how to communicate with
its market participants. Some exchanges follow a standardized FIX trading message protocol, whereas
other exchanges develop their own proprietary communication protocols.
4. Describe how exchanges record various order types.

Typically, all exchanges send at least one message for each of the following market occurrences: limit
order addition, limit order cancellation, and order execution. fte messages typically contain an order id,
timestamp, security traded, order size, and order price.
5. Identify the liquidity considerations that market participants need to consider.
Analysis shows that traders at various frequencies respond differently to a wide range of market
dynamics, such as flickering limit orders, limit order revisions, and order additions and cancellations. For
example, HFTs appear to disregard flickering quotes, while lower-frequency traders appear drawn in by
flickering quotes. Order revisions also appear to polarize traders. For example, HFTs seem to view
limit order revisions as credible negotiation signals, while low-frequency traders avoid trading when
limit order revisions occur in the markets.
Chapter 28: Applications of Client Behavior: A

Practitioner’s Perspective
1. Distinguish between risk capacity and risk requirement.
Risk capacity describes how much investment risk a client might take based on his financial resources
(i.e., how severe a financial loss a client might sustain and still have the financial resources to meet his
goals). Risk requirement is the level of return a client needs to meet his financial goals.
2. Discuss the meaning of risk tolerance.
Risk tolerance is the amount of risk that an investor is comfortable taking, or the degree of uncertainty
that an investor can handle. Risk tolerance is often related to a client’s demographic characteristics,
such as age, gender, employment, and net worth. As investors tend to feel optimistic during bull markets
and pessimistic during bear markets, some contend that a client’s risk tolerance varies with market
performance. fte risk of basing recommendations on demographic factors is that a client may not be
representative of a specific demographic profile. fte advisor’s goal is to recommend an allocation that a
client will maintain during turbulent times. A variable measure of risk tolerance would be
counterproductive because it might incorrectly reflect the client’s risk tolerance at a major market
correction, resulting in the client’s liquidating financial assets at the wrong time.
3. Explain how to present the various elements of a client’s quarterly report. Typically,
a client’s quarterly report is solely performance focused, including short- term performance such as the
last quarter and year to date. Performance is also often measured against a market benchmark, such as the
S&P 500 Index. Given the importance of asset allocation to achieving long-term returns, having an
allocation graph or table showing both policy and current allocations would be an important
element in a quarterly report. To focus a client on long-term vs. short-term
performance, the report could delete information of less than 12 months. Because portfolios are rarely 100
percent invested in equity, a market benchmark could provide a misleading guide. Furthermore, a client’s
plan and resultant allocation recommendation are based on an estimated real return needed, so
benchmarking against the CPI could be more appropriate than using the S&P 500 Index.
4. Describe framing and how a financial advisor might use it.
Framing is a behavioral heuristic recognizing that people tend to reach conclusions based on how
information in the form of words and numbers are presented. By reframing issues, an advisor can assist
clients in avoiding behavioral errors and making better decisions. For example, asking questions such as
“Would you buy that stock today?” and “What might go wrong?” are potential framing questions that
might affect client behavior.
Chapter 29: Practical Challenges of Implementing

Behavioral Finance: Reflections
from the Field
1. Explain how nudging alone constitutes a narrow use of behavioral finance

knowledge.
fte success of nudging by using smart defaults in pension auto-enrollment and organ donation, or
through social comparisons in energy consumption, suggests that nudging can be the panacea for a
wide range of decision problems. ftis process excludes more creative uses of behavioral finance that
rest on features such as simplifying the decision, encouraging engagement, reducing the frictions between
deciding and implementing a decision, and pre-commitment to future actions. Nudging is just one
part of the behavioral finance toolkit and should not be the sole, or default, tool. Successful
applications of behavioral finance require a root and branch approach to understanding the possible
improvements to how decision makers interact with organizational processes.
2. Discuss the features of good and bad applications of behavioral finance.
A misconception exists that behavioral finance is nothing more than a list of biases, and that it is therefore
“easy” to do. As a result, many attempts to apply behavioral finance seek to do little more than offer a
checklist of biases. ftis process assumes that problems can be largely solved by informing people of
how they make poor decisions. Merely informing people of their biases is very seldom effective in com-
bating them. Approaches that are not easily transportable between domains can lead to overly
engineered solutions.
ftebest approaches to behavioral finance demonstrate a highly tailored approach to the problem. fte
program Save More Tomorrow is one such example. ftis program deals with the inertia or
procrastination that stops many people from joining their company’s pension plan by keeping initial
contribution rates low. Save More Tomorrow also addresses the loss aversion associated with raising
contribution
rates by getting the participant to pre-commit to future contribution increases out of future pay rises.
Although most effective in a period of rising wages, this process is still a highly tailored application of
behavioral finance that has led to demonstrable success in raising retirement saving.
3. Discuss an example of behavioral finance supplementing traditional approaches.
A criticism of modern portfolio theory for individual investors is that optimizing with volatility as a
risk measure is not behaviorally justified. fte implication that deviations away from the expected
return, both positive and negative, add to risk does not reflect how individuals either do, or should,
think about risk. Investors rarely state that getting more than they expect feels like a risk. Simply switching
the risk measure to something that can be behaviorally justified shows how an understanding of
individual behavior can supplement an ingrained traditional approach to investing.
4. Explain asymmetric paternalism.
Asymmetric paternalism is a dual-focused approach to help people make better decisions. Making
major financial decisions is difficult for many people. As a consequence, they typically make no
decision at all. fte application of smart defaults for this group can be helpful. fte default may not be a
perfect solution, but if well chosen, it can lead to a better financial outcome. However, many are
capable of making their own decisions and this should not be forgotten by simplistically applying a
default for all. ftey need to be actively engaged with financial decisions and helped to make the best
choice for their circumstances. Most individuals require some blend of paternalism and
engagement to suit their specific capabilities and circumstances. Asymmetric paternalism involves
default choices for those who would not or could not make their own decisions, but involves actively
engaging those who would or could make their own decisions (or, in practice, some blend of
nudges and active engagement for each decision-making, according to their need). ftis asymmetric
approach protects the most vulnerable financial decision makers while assisting the less vulnerable to
make the best decisions possible.
Chapter 30: The Future of Behavioral Finance

1. Discuss the extent to which behavioral finance has progressed philosophically
since the 1980s anomalies literature, and how it might develop in the future.
In a ftomas Kuhn philosophy of science perspective, the initial anomalies literature was firmly within
the traditional finance paradigm. Defenders of the core paradigm could dismiss the anomalies using the
tools and methodologies of traditional finance. Behavioral finance can now be categorized as a separate
research paradigm that has its own core theory and some of its own methodologies. It is also clearly a
progressive research program based on the growth in publications. fte challenge now is to strengthen the
core theory and utilize methodologies appropriate to these theories.
2. Discuss problems with the “rational managers/irrational investors” research

stream in behavioral corporate finance.
fte idea that financial decision making in a company is rational, but financial decision making outside
a company is not rational seems like an odd compromise. Minimal evidence exists that financial
decision making within organizations is rational and unbiased. ftis view assumes that companies
understand when investors are being irrational, even though this view has not been developed based
on case studies or other qualitative research of the companies making these decisions. More
fundamentally, if companies successfully engage in market timing of equity and debt issues, are they
responding to fundamental mispricing by investors or to investor irrationality?
3. Discuss whether characteristics of top management teams are likely to be fea-
tured in future research on the drivers of corporate financial behavior.
fte chief executive officer (CEO) influences perhaps 20 percent of the variability of a company’s
performance. ftus, ignoring the drivers of the other 80 percent of variability occurring in current
behavioral corporate finance seems perverse. Modern strategic management research prefers to focus on
the top management team as drivers of strategic decisions, and this focus should include corporate
finance decisions. ftus, behavioral corporate finance may start to emulate this practice. A move toward
integrating more organizational theory into behavioral corporate finance entails greater emphasis on the
wider firm outside of the CEO, including the top management team.
4. Identify and explain key issues that need to be resolved concerning current mea-
sures of investor sentiment.
Because a multitude of measures exist in investor sentiment, a greater cross-comparison of these is
needed moving forward to identify the most suitable measures. A dearth of understanding exists about
the fundamental drivers of investor sentiment—issues such as cultural influences and the extent to
which sentiment influences different types of investors. New data opportunities are on the horizon to
develop better measures of sentiment, but this development requires working with researchers in other
disciplines and not purely keeping the theory building and testing within the domain of behavioral
finance.
Index
(Page numbers in italics refer to tables (t) and figures (f) within the text.)
academic lift and drop. See “lift and drop” agency problems, art and collectibles, 424 agency theory,
application approach, academic 79, 80–81, 91
acceptance and commitment therapy (ACT), 327–328 agency problem, 80
accredited investors, defined by SEC, 137 accrual behavior assumptions, 83
anomaly, 469–470, 469f compensation, incentive-based, 80–81, 86 control,
ACT. See acceptance and commitment therapy definition of, 81
(ACT) differentiating factors, agency and stewardship theories,
action style indicators, 201–202 activist 82–83
investors opportunistic behavior, 81
high net worth individuals (HNWIs), 175–176 pension risk-sharing problem, 80–81
funds, 391–392 specific problems being dealt with, 80–81 stewardship
adaptive markets hypothesis (AMH), 443–446 assumptions theory, differentiating factors, 82–83
and practical implications, 445–446 bounded rationality, aggressive high-frequency trading, 502–504
444 algorithmic trading, 193
differences between EMH and, 446 evolution of alternative asset management, investment strategies, 137
financial markets, 445 alternative asset management firms, 144 ambiguity
species found in financial markets, 444–445 advice aversion
packaging, 292–293 functional fixation hypothesis, 454
advisers vs. advisors, 108 portfolio managers, risk-taking behavior, 145–146 American
advisory services. See financial advisory services affect dream concept, 242, 243f
heuristic, 311 American Psycho (movie), 153, 162
distinctionsbetweenemotion,mood,andaffect,30 Affect anchoring bias, 27–28, 310–311 art and
Infusion Model (AIM), 30 collectibles, 423–424 client
Affordable Care Act of 2010 (ACA), 315 agency education
costs in financial advice, 102–107 capital needs analysis, anchoring the return, 534–535
bonding costs, 103–104 efficient frontier hypothesis (EFH), anchoring on, 523–
compensation structures and conflicts of interest, 104–107, 527
113 risk coaching, anchoring the risk, 530–534 financial
assets under management (AUM), 105–106 crisis of 2007–2008 behavioral bias,
commission-based compensation, 104–105 impact of, 492
hourly compensation, 106 investment names, anchoring on, 340 irrational financial
project-based fees, 107 behaviors creating need for
retainer fees, 106–107 financial planning, 342
monitoring costs, 103 millennials, 27–28
principal-agent relationship, 102–103 personal financial planning, 279
residual losses, 103–104 traders, information processing phase errors, 195, 196
suitability standard, 103 types of
costs, 103–104
611
612 Index
anomalies. See stock market anomalies relationships, business to business (B2B) vs.
antisocial behavior, 153, 155 antisocial consumer to consumer (C2C), 432–433 types of
personality disorder (APD) collecting, 424–425
classification of, 153, 157–158 art collections, 424–425
psychopathic distinguished from antisocial, 157 APD. See baseball cards, 425
antisocial personality disorder (APD) application of celebrity possessions and the death effect, 425 return
behavioral finance. See practical enhancement, wine collections,
application of behavioral finance 424–425
appreciative inquiry, 330 sports cards, 425
arbitrage and stock market anomalies, 472–473 idiosyncratic wine collections, 424–425
risk, 472–473 art philanthropy, 427
systematic risk, 472 Asia, private wealth management, 177 aspiration
art and collectibles, 18, 422–434 based preferences approach, 549 asset allocation, 17,
art assets, 428–430 359–375. See also portfolio
art lending, 428 managers
as asset class, 429–430 allocation maintenance, 365–366
client’s collection passion, wealth management perspective strategic asset allocation (SAA), 365–366 tactical
of, 426 asset allocation (TAA), 366
collecting for investment value, 426–428 art anomalies. See stock market anomalies
philanthropy, 427 behavioral biases, 369–375
collecting and investing, differentiation, 426–427 emotional bias, 369, 375
emotional value, 423, 428 familiarity bias, 369–371, 375
financial and nonfinancial reasons for collecting, 424 framing, 372–373, 375
as investment option, 426 generally, 369
motivational focus, 427 home asset bias, 370 loss
portfolio management process, reasons for aversion, 371–372
recognitionofart and collectibles in, 428 mental accounting, 364, 373–374, 375 1/N
return enhancement, wine collections, 424–425 heuristic bias, 369 overconfidence, 374–375
strategic focus, 427 status quo bias, 371–372, 375
collecting process, biases, 423–424 agency client education, 529
problems, 424 definition of, 359
anchoring bias, 423–424 international and emerging market stock indexes correlation
emotional bias, 423, 428 matrix of the United States, 371, 371t performance of the
hoarding disorder, 424 United States, 370, 370f
mood changes, 423 portfolio management strategies, 360 Black-
nostalgia effect,425 Litterman model, 368–369
estate planning and, 428–429 financial and mean-variance optimization, 368–369 modern
nonfinancial reasons for portfolio theory (MPT), 359,
collecting, 424 367–369, 375
as investment option, 426 literature rebalancing strategies, 366
review, 422–425 management and buy-and-hold strategy, 366
reporting, 429 risk mitigation, 429– calendar balancing, 366 constant mix
430 strategy, 366
social media’sinfluenceon, 430–434 better return objectives, 360, 364–365
tools, better data, 433 risk–return trade-off, 364–365
collection management tools as wealth tools, investment policy statement (IPS), 364, 366
434 measuring risk, 364–365
e-commerce, role of, 433 return objectives, 360, 364–365 security
globalization, 431–432 holdings as market line (SML), 365 systematic
commodities, 430 online art education, risk, 365
432 asset classes, 361–366
online auctions and marketplaces, 432 online art and collectibles, 429–430 bonds/fixed
businesses and transparency, 433–434 income securities, 362 cash, 363
derivatives and alternative investments, 361 equities, 361–
362
Index 613
real estate, 360, 362–363 generational criteria for making investment decisions,
asset management firms, alternative, 144 asset 251f
management services impetus for seeking advice, 248–249 reliance
portfolio management, 136–137 traditional and on, 241
alternative management, risk tolerance and investment preferences, 250–251
distinguished, 136–137 asset role of, 254, 255
pricing technology and financial information, 255 use of, 247–
anomalies and alternative hypotheses to EMH. 252
See behavioral finance market hypotheses financialcrisis of2007–2008,impactof, 244–246,
behavioral research. See asset pricing, future of 492
investor psychology research financial literacy, 242–244, 259
efficient market hypothesis (EMH), 4, 440–443 asset financial crisis of 2007–2008, impact of, 244 knowledge level for
pricing, future of investor psychology investors by age group and
research, 561, 569–572, 575 approaches to income, 244f
improve robustness, 570–572 culture, incorporation in retirement savings, 243–244
investor behavior financial outlook, short and long term, 246–247 investment
models, 572 assets, ownership of, 241
emotion psychology, 569 personal and national concerns, 247 retirement
experimental finance, theory building, 570 planning, 246–247, 246f retirement savings, financial
financialization, 572 literacy, 243–244
historic databases, exploration of, 571–572 productive back-end load, 104
research, need to develop, 569 publishing bias, failure to baseball card collections, 425 Bateman, Patrick,
develop productive 153, 154, 162, 166
research and, 569 behavioral finance, 5–9
rational manager/irrational investor, 570, 575 researching application of. See practical application of behavioral
outside of equity pricing, 571 sentiment, defined, 570 finance
sentiment modeling, 570–571 basis of model, 5
social psychology, 569 origins of, 5
asset pricing models. See also stock market anomalies premises of, 5, 6
inadequacies, rational explanation, 460 behavioral finance market hypotheses
assets under management (AUM), 105–106 separately adaptive markets hypothesis (AMH), 443–446 fractal
managed accounts, 105 statistics, 378, 392–393 market hypothesis, 446–448, 447t functional fixation
wrap accounts, 105 hypothesis, 453–455
asymmetric paternalism noisy market hypothesis, 452–453 overreaction
as guiding principle in application, 555, 555t hypothesis, 448–450, 449f, 451t underreaction
nudges, 554–555 hypothesis, 450–452
attribution substitution, 311–312 Belfort, Jordan, 153, 154, 162, 166 Bernie
AUM. See assets under management (AUM) Madoff scandal, impact, 55 better-than-
automobile insurance, 306 average effect
availability bias, 23, 310 frequent stock trading, 211
aspects of, 8 traders, information processing phase errors, 198 “bias” bias,
irrational financial behaviors creating need for financial 543–544
planning, 342 biases. See also specific bias
personal financial planning, 279 complexities of, 546
traders, errors in information collection phase, 194 availability creating need for financial planning, 338–342,
cascades, 199 353
defined, generally, 97
Biggert-Waters Flood Insurance Reform Act of 2012, 315
baby boomers Black-Litterman model, 368–369
American dream concept, 242, 243f boardsofdirectors. See directorsandboardsof directors
compared to millennials, 242–247 financial bonding costs
advisors residual losses, 103–104
advisor satisfaction, 254 suitability standard, 103 bonds/fixed income
degree of advisor use, by age group and income, securities, 362
248f
614 Index
book-to-market equity, 26 risk-taking and incentive-based compensation, 86–87

“boomerang children,” 245 bounded role of
rationality concept current primary focus of research, 561, 567–568,
adaptive markets hypothesis (AMH), 444 defined, 575
5, 24 generally, 83–84
insurance purchasing decisions, risk tolerance, 304 traits and corporate investment decisions, 87–88 certainty
managerial traits, 84 vs. safety, 529
research programs, 563–564 Certified Financial Planners (CFPs)
break-even effect, 197, 198 broker- asset allocation, overconfidence, 374–375
dealers, regulation of, 100 brokers, designation, 266
defined, 287 personal financial planning, 266
bubbles. See financial bubbles; speculation in financial markets retirement planning, 338, 343–344, 351, 353 Certified
business to business (B2B) vs. consumer to consumer Financial Planners Board of Standards (CFP Board of
(C2C) relationships, 432–433 Standards), 266–267
initiatives, 278
certified public accountants (CPAs), 101 CFP. See
capital asset pricing model (CAPM) Certified Financial Planners (CFPs) charming persona,
certainty vs. safety, 529 psychopaths, 156 chartered financial analyst (CFAs),
client education, 528–529 374–375 churning, 104
development of, 4 client education, 523–529
interest rate risk, 529 asset allocation, 529
market risk, 529 basics, 527–529
purchasing power, 529 capital asset pricing model (CAPM), 528–529
systematic risk (undiversifiable risk), 528–529 capital needs diversification, risk reduction, 527, 528f efficient
analysis, 534–535 frontier hypothesis (EFH), anchoring
CAPM. See capital asset pricing model (CAPM) caregiving on, 523–527
responsibilities financialplanning process, framing,529–535 capital needs
women investors, 230, 231, 233, 236, 237 cash analysis, anchoring the return,
as asset class, 363 534–535
return drag, 363 data gathering process, reframing, 534–535 efficient frontier
cash-flow reserve portfolio client hypothesis (EFH), anchoring
management, 538–540 on, 523–527
casualty insurance,306 framing effect, 529–530
causality heuristic, 311 risk coaching, anchoring the risk, 530–534 modern
celebrity possessions and the death effect, collections of, 425 portfolio theory (MPT), 527–528 risk coaching,
CEOs anchoring the risk, 530–534
behavioral biases, 87–88 attributes of investing, 531–532, 531t
cultural bias, 74 conservative client, 534
optimism, 87–88 financialcrisisof2007–2008,impact of, 533
overconfidence, 87–88 investment time horizon, 531
resoluteness, 88 projected return and risk exposure under different risk
risk perception bias, 87 self- levels, 532, 533t
attribution bias, 88 prospect theory and loss aversion, 533–534 risk aversion
CEO turnover, 89–90 vs. loss aversion, 534
corporate takeovers and overconfidence, 87–88 cultural risk reduction through diversification, 527, 528f
similarity of investors to, 74 client interview methodologies, estate planning, 330–331
mergersandacquisitions (M&As),CEOs’biases, 87–88, 92 appreciative inquiry, 330
research and researchers dialectical interviewing, 331
CEO’srole as current primary focus of, 561, 567–568, motivational interviewing, 330–331
575 client management, application of behaviorally based,
recommendations, 568 535–540
risk aversion, 87, 92 cash-flow reserve portfolio, 538–540 client
emotions, 537
example, retirees, 537–540
Index 615
hot investments, reframing techniques, 536–537 investment conformity, 487–488

policystatement (IPS), 535, 540 directors, 91
investment portfolio, 538–540 individual and group decision makers,
market timing, 535–536 association between, 488–489
mental accounting, 537 institutional investors, 487–488 speculation in
paycheck syndrome, 538–540 financial markets, 487–489 substandard
quarterly reporting, 540 reporting, strategies, 488–489
framing and, 540 retirement motivated reasoning, 125
planning, 537 sequence of return traders, information processing phase errors, 196 conflicting
risk, 537 interests
Would you buy that stock today? 536 client’s compensation structures and, 104–107, 113
competence, estate planning, 319, 321 clinical depression, financial advisors, 112 conformity
sources of, 265 effect
coercive isomorphism, 568 groupthink behavior, speculation in financial markets,
cognitiveability andIQ ofindividual investors,46–47 cognitive 487–488
bias, 5. See also specific bias traders, 199
boards of directors, 90–91 conservation skills
traders, decision making process, 193–195 cognitive personal financial planning, strategies for
dissonance overcoming biases, 280–281
mutual funds, underperformance of, 383 nonstandard conservatism bias, 309
investor preferences, individual client education, framing financial planning process,
investors, 48 534
traders, information processing phase errors, 196 collectibles. in expectations, traders’ momentum type
See art and collectibles strategies, 199
collective memory hypothesis, 491 commission- managerial traits, 84
based compensation, 104–105 communications underreaction hypothesis, 452
clients, estate planning, 321–324 consumer confusion, 107–108 advisers vs.
client trust and commitment, personal financial planning, advisors, 108 financial advisors, 108,
276–277 113
internal communication, international mergers and financial planners, 108, 113 multiple
acquisitions (M&As), 415 regulatory regimes, 108
compensation consumers of financial advisory services. See
commission-based compensation, 104–105 financial advisory services contrarian
compensation structures and conflicts of interest, strategies
104–107, 113 gregarious and contrarian strategies,
hourly compensation, agency costs in financial advice, distinguished, 200–201
106 traders, 200–201 control
incentive-based, agency theory, 80–81, 86 relation issues bias, 28–29
to managerial traits, 86–87 externallocus ofcontrol,28 hot
compensation structures and conflicts of interest agency costs hand fallacy, 29
in financial advice, 104–107, 113 assets under illusion of control, 29 internal
management (AUM), 105–106 separately managed locus of control, 28 locus of
accounts, 105 control, 28
wrap accounts, 105 competence self-control bias, 29
client’s competence, estate planning, 319, 321 retirement corporate and financial psychopaths, distinction, 161
planning professional, biases in corporate management theories, 80–83 agency theory,
decision to hire, 343–344 79, 80–81, 91
conduct risk, 556 differentiating factors, agency and stewardship theories,
confidence. See overconfidence confirmation bias, 82–83
308 stewardship theory, 79, 81–82, 92
boards of directors, 91 corporate raiding, 81 corporate
financial analysts’ reports and forecast optimism bias, 125 takeovers
groupthink behavior, 487–489 CEOs, overconfidence, 87–88
characteristics that foster, 91 directors, 90
counter-transference, 323
CPT. See cumulative prospect theory (CPT)
616 Index
credit counseling firms, 102 criminal dialectical interviewing, estate planning, 331
behavior, psychopaths, 157 digital technology and data analytics advancements, behavioral
cross professional collaboration modeling estate planning, finance application opportunities, 552. See also
332–333 technology
crowd effect, 451t directors and boards of directors
cultural bias behavioral biases of boards of directors, 90–91 free rider
agency and stewardship theories, differentiating factors, 83 problem (social loafing), 90, 91 groups amplify
asset pricing, future of investor psychology research, cognitive biases of
572 individuals, 90–91
CEOs, cultural similarity ofinvestors to,74 individual groupthink, 91
investors,55 poor information sharing, 91 board
institutional investors, 74 independence and company
international mergers and acquisitions (M&As), 413–414, performance, 89
414f CEO turnover, 89–90
investment strategy leading to faulty planning, 347–348 empirical examinations of boards of
language, institutional investors, 74 proximity directors, 89–91
individual investors, 55 inside directors, 88, 89–91 monitoring
institutional investors, 74 recommendations for roles of board and CEO
increased familiarity, turnover, 89–90
568–569 outside directors (independent directors), 88–91 roles of, 88–
regional variations, individual investors, 55 religion, 84 89
social values, conflicting, 347–348 structures of board of directors, 88–89 takeover bids, 90
cumulative prospect theory (CPT) disability insurance, 305
academic lift and drop application approach, 548–549 disposition effect, 7, 23, 313
misunderstanding of, 545–546 financial advisory services, consumer bias, 288 individual
over-engineered technical solutions, 548–549 investors, nonstandard investor
preferences, 48, 49
information processing phase errors, traders, 196–197
data gathering process, reframing institutional investors, 67 heterogeneity
capital needs analysis, anchoring the return, 534–535 among types, 69 mutual funds, 67
defense behavior, 405 mutual funds
deferred sales charge (contingent sales charge), 104 defined institutional investors, 67
benefit plans, 340, 352 related to underperformance, 383
portfolio management, 138 psychopathy, selection of, 67, 383–384
emergence in financial underperformance of, 383 stock
environment, 165–166 market anomalies, 474–475 traders, 196–
defined contribution plans, 338, 340, 345 197, 200
portfolio management, 138 degenerative diversification bias, 347 index
research programs, 563 depression, sources mutual funds, 385
of, 265 institutional investors, 65, 72–73, 75 mutual
derivatives and alternative investments, 361 developing world funds
and international mergers and index mutual funds, 385 institutional
acquisitions (M&As), 397–400 investors, 73
growth activity, 397, 398 risk reduction, client education, 527, 528f
growth of developing world acquirer, 398 DSM-5. See Diagnostic and Statistical Manual of
Diagnostic and Statistical Manual of Mental Mental Disorders, 5th ed. (DSM-5)
Disorders, 5th ed. (DSM-5) duration analysis, 268
financial psychopaths, criterion, 161–162 gambling
disorder, criteria, 215–216 psychopaths, clinical
diagnosis, 154–155, earnings forecasts, excessive optimism, 120–121 EAST
156, 158 framework (UK), 557–558
efficient frontier hypothesis (EFH) anchoringon
clienteducation, 523–527
capital needs analysis, 525
Index 617
efficient portfolio, 524, 524f Mood Maintenance Hypothesis (MMH), 30 mutual

risk capacity, 525 funds, 30
riskneed exceeds risk tolerance, 527, 527f negative emotions, 32–37, 38 expert
risk requirement, 525, 526 decision makers, 33–34 individual
risk-return relationship, 524, 524f investors, 52–53
risk tolerance, 525 individual psychology and stressors, 33 money
efficient market hypothesis (EMH), 4, 440–443 anomalies sickness syndrome, 32–33 neurofinance
and alternative hypotheses. See (also known as
behavioral finance market hypotheses neuroeconomics), 34–35 regret
assumptions and provisions, 441, 443 aversion theory, 37 retirement issues,
background, 440–441 34
different forms of market efficiency, 443 pros and riskperceptionandworry,35–37 worry,
cons, 443 35
random walk hypothesis, 440, 441f, 442f overreaction hypothesis, 451t
rationality assumption, 441 pension contributions, increasing, 547 positive
risk aversion, 4 emotions, individual investors, 52–53 risk as feelings
speculation in financial markets, 481 trader effect, 31
behavior, 192 seasonal and weather related conditions, 73–74 self-affinity
EFH. See efficient frontier hypothesis (EFH) emerging bias, 31
and international market stock indexes stock investment, 31 strategies for
asset allocation, familiarity bias correlation matrix overcoming, 281
of the United States, trust between financial professional and client, 31
371, 371t emotional vs. expressive relationship, 337
performance of the United States, 370, 370f endowment effect, 197
emerging markets endowment model (Yale model), 142
cultural differences and behavioral biases, 569 EMH. See endowments
efficient market hypothesis (EMH) emotional bias, 5, institutional investors, 69
30–31. See also investor portfolio management, 138
sentiment portfolio managers, herding behavior, 142 Enron’s
affect heuristic, 30 bankruptcy, 370
Affect Infusion Model (AIM), 30 art and envy theory, 404
collectibles, 423, 428 epistemological paradigms
asset allocation, 369, 375 interpretivist perspective/methodologies, 565–566
asset pricing, future of investor psychology research, 569 positivist perspective, 565
client management, 537 equity analysts. See financial analysts
communications with clients, estate planning, 322 emotion, equity exchanges, generally. See also equity market
mood, and affect, distinctions developments
between, 30 distribution of market information, 506 FIX
“emotional inoculation,” 183–184 financial communication protocol, 506 inverted
advisory services, consumer bias, exchanges, 502
289–290 “lit” exchanges, 499
financial crisis of 2007–2008, impact of, 31 frequent normal exchanges, 502
stock trading, 212, 213 recording various order types, 505–512 SEC
hedge funds, institutional investors, 75 registered exchanges, statistics, 499 transmission
high net worth individuals (HNWIs), 183–184 individual protocol, 505–506, 506t
investors, 52–53 equity home bias, institutional investors, 72–73 equity market
institutional investors, 73–74, 75 data. See order-by-order market data equity market
irrational financial behaviors creating need for financial developments, 19, 499–518
planning, 340–341 high-frequency trading (HFT), 502–505
loss aversion, 6–7 aggressive HFT, 502–504
money shame, 341 defined, 502–503
mood passive HFT, 502–504
changes in, art and collectibles, 423 emotion, institutional investors, 499
mood,andaffect, distinctions toxicliquidity, 501–502, 504, 505
between, 30 limit order book, 500, 501f, 505–512
institutional investors, 73–74, 75
618 Index
equity market developments (Cont.) liquidity, 500– counter-transference, 323

502 emotional contract, 322
buy-side available liquidity exceeding sell-side liquidity, transference, 323–324
500, 501f complexityofplanning process,318,320–321 evolving
defined, 500 nature of families, 320
fee structures of exchanges, 502 flickering marital and family dynamics, 327
quotes on buy offers, 501, 501f limit orders, 500– considerations, generally, 319–320
502 client’s competence, 319, 321 evolving
modernliquidity, subsets of,500–501 natural nature of families, 320 potential
liquidity, 500–501 difficulties, 320
normal and inverted exchanges, 502 toxic limit value of financial planning, 319
orders, 501 cross professional collaboration modeling, 332–333
toxic liquidity, 500–501 marital and family dynamics complexity of
flickering, 502 planning process, 327 evolving nature of
institutional investors and, 501–502, 504, 505 families, 320
market orders, 500 ETFs. See exchange-traded funds (ETFs) ethical
modern market structure, 500 national wills, 318. See also estate planning Europe, private
best bid offer (NBBO), 500 order-based wealth management, 177 excessive optimism,
negotiations, 512–516 order-by-order market 307
data, 505–512 exchange-traded funds (ETFs), 385–388 assets under
cancellations, 506–507, 508, 509t, 510, 512t management (AUM), statistics,
executed orders, 511–512 378, 386, 386t, 392–393
flickering orders, 510–511, 512t, 514–516 hidden order behavioral issues extrapolation bias,
execution, 512–515, 515t, 517t interday evolution of 387
orders, 508, 510 investor sentiment, 387
“lit” limit orders, 512, 514 return-volatility relation, 387
market order execution, 514–515, 514t, 516t overall efficiency of, 388
number of order messages per each added limit excitement/euphoric expectation, 490
order, 508, 509f executives
order sizes, 506–507, 507t organizational application of behavioral finance senior
order types, statistics, 505 revisions/adjustments management, support of, 558–559 tailoring design
to orders, 510, 511t sequential order updates, and organizational
507, 508t deployment, 550–551 executives/senior
errors. See information collection phase errors, traders; management. See also CEOs;
information processing phase errors, traders directors and boards of directors executive
estate planning, 16, 318–333 art and reluctance, application of behavioral
collectibles, 428–429 finance, 551–552
behavioral therapy tools for estate planners, 327–330 attitude towards implementation of behavioral ideas,
acceptance and commitment therapy (ACT), 327–328 overconfidence, 551
family assessment tools, 329 individual openness on framing/reframing of
assessment tools, 328–329 limitations on use of, information and data design, 551
330 perceptions of superficiality, 551 unwillingness to
recent clinical models, 327 engage, 552
client concerns/fears, addressing, 324–326 additional expectation extrapolation, 199
sources of resistance and barriers, 326 generally, 324 experimental finance
mortality salience, 324–325 asset pricing research, theory building, 570 improving
terror management theory, 325–326 client reliability, communication
interview methodologies, 330–331 infrastructure improvements, 574 expert
appreciative inquiry, 330 decision makers, 33–34
dialectical interviewing, 331 expressive vs. emotional relationship, 337 external
motivational interviewing, 330–331 locus of control, 28 extrapolation bias, 387
communications with clients, 321–324
Facebook. See socialmedia

familiarity bias, 29–30
Index 619
asset allocation, 369–371, 375 home certified public accountants (CPAs), 101 credit
asset bias, 370 counseling firms, 102
international and emerging market stock indexes, 370– financial counseling firms, 102
371, 370f, 371t financial planners, 98
concept explained, 29–30 functional financial therapists, 102
fixation hypothesis, 454 institutional insurance firms, 101
investors, 68 investment adviser representatives (IARs), 99, 100
mutual funds, selection of, 384 speculation in multiple regulatory regimes, consumer confusion,
financial markets, 489–490 108
home bias, 489 personal financial specialists (PFS) designation, 101–102
local bias, 489 Registered Investment Advisers
familiarity preference, 49–50 (RIAs), 98–100
family dynamics, estate planning. See marital and family registered representatives, 100
dynamics, estate planning financial advisory services, 15, 285–297
Farkus, Lee B., 162–163, 166 consumer biases, 291–293
faulty investment selection advice packaging, 292–293
investment strategy leading to faulty disposition effect, 288
planning, 348 emotions/anxiety, 290
female investors. See women investors financial literacy, 289–290
fiduciaries, retirement planning, 338 framing, 292–293
financial advisors, 12, 97–113. See also millennials; robo- gender bias, 289–290
advisors;womeninvestors online advice, 292 paying
advisor biases, 112 for advice, 293 peer effect,
bias, defined, 97 293
conflicting interests, 112 priming, 292–293
agency costs in financial advice, 102–107 compensation risk-taking, 292
structures and conflicts of role of trust, 290–291
interest, 104–107, 113 consumer biases, strategies for overcoming, 293–296
principal-agent relationship, 102–103 types of financial literacy, screening for
costs, 103–104 unsophisticates, 294 intangible value
value of financial advice, 110–112 conflicting interests, of advice, 295
advisor biases, 112 consumer confusion, 107–108 pricing financial advice, 295–296 risk-
advisers vs. advisors, 108 financial taking tools, 294
advisors, 108, 113 robo-advisors, 296–297
financial planners, 108, 113 multiple technology driven
regulatory regimes, 108 advice, 296–297
incentives, 97 consumers of, 289–291
Investment Advisers Act of 1940, 99, 108 meeting behavioral biases, 291–293
with afinancial advisor, 110 communication, 291
regulation of. See financial advisors, regulation of retirement downside of trust, 291 role
planning professional, biasesin of trust, 290–291
decision to hire, 343 seeking who looks for advice, 289–290 online
financial advice, 109–110 supply side platforms, 292, 296–297 supply side
financial advice, 287 financial advice, 287–289
survey questions about financial advice, 109 technology. technology driven advice, 292, 296–297. See also
See robo-advisors robo-advisors
use and value of, 108–112 onlineplatforms, 292, 296–297 value
financial anxiety, 110 of
financial distress, 110 added value of advice, 288–289 estate
meeting with a financial advisor, 110 seeking planning considerations, 319 intangible value
financial advice, 109–110 of advice, 295 pricing financial advice, 295–
survey questions about financial advice, 109 use of 296
financial advice, 109 wealth management, high net worth individuals (HNWIs),
value of financial advice, 110–112 financial 176–182, 189
advisors, regulation of, 98–102, 113
broker-dealers, 100
620 Index
financial analysts financial crashes. See also financial crisisof2007– 2008,

prospecttheory, ambiguousevidence, 125 reporting. impact of
See financial analysts’ reportsand portfolio managers, herding behavior, 141 financial crisis
forecast optimism bias of 2007–2008, impact of
financial analysts’ reports and forecast optimism bias, 12, 118– behavioral biases evident following, 481, 491–494
130 anchoring, 492
analyst characteristics as moderators of optimism, baby boomers, 492
127 collective memory hypothesis, 491
competing incentives, 119 lastinginfluenceofeconomic shocks/risk- taking
earnings forecasts, excessive optimism, 120–121 incentives and, 491–492
competing incentives, 119 loss aversion, 493
stock recommendations, market millennials, 492
regulation, 121 precautionary savings, 492
investors, impact of analyst bias, 128–129, 130 market recency bias, 492 reversion to the
reactions, impact of analyst bias, mean, 492 status quo bias, 493
128–129, 130 trust and mistrust in a financial setting, 493–494
market regulation, increasing objectivity and reducing bias, worry, 492
119–123 client education, framing financial planning process, 533
excessive optimism in earnings forecasts, 120–121 financial emotions that influence decisions, 31 financial
pre-and post-regulation periods, impact on analyst’s bias psychopaths, 154–155
behavior, 121–123 individual investors, 47
Reg FD, 120, 122–123, 125, 130 international mergers and acquisitions (M&As), 398
in stock recommendations, 121 reducing bias major reason for/cause of, 482
Global Settlement, 120, 123, 125 millennials, 241–242, 244–246,492 moral
market regulation, increasing objectivity, 119–123 hazard concept, 142–143
motivational factors, 129 portfolio managers, risk-taking behavior, 142–143
variables, 129 psychopathy, emergence in financial
reputation of analyst, impact to, 119, 122, 126, environment, 163–164
127, 129 traditional portfolio theory, criticism of, 553 women
role of financial analysts, 119–120 stock investors, 232–233, 234
recommendations, market financial distress financial
regulation, 121 advisors, 110
analyst incentives, 121 financial help seeking behavior, 108–112 financial
economicincentivesoftradeboosting, 121 anxiety,110
uncertainty in forecasting and optimism financial distress, 110
confirmation bias, 125 meeting with a financial advisor, 110 seeking
herding behavior, 124 financial advice, 109–110
heuristics, 124 survey questions about financial advice, 109 use of
high information uncertainty, 125–126 leniency financial advice, 109
heuristic, 124 value of financial advice, 110–112
motivated reasoning, 125 financial industry
psychological theories, 123–125 careers, gender inequality, 235, 237
reputation of analyst, impact to, 119, 122,126, changing attitudes toward practical application of behavioral
127, 129 finance, 552
financial anxiety financial customer loyalty, 229–230
advisors, 110 dissatisfaction with, 227
financial behaviors, 88–91, 92 financialization, 572
financialbubbles. See also speculationinfinancial markets financial literacy
Internet bubble, overconfidence and, 483 portfolio managers, consumers of financial advisory services, strategies for
herding behavior, 141 overcoming biases, 294
“financial capitalism” period, 165–166 financial advisory services, consumer bias, 289–290
financial counseling firms, 102
Index 621
millennials, 242–244, 244f, 259 “industrial capitalism,” 164–165, 166

women investors, 233–234, 237 pension plans, 165–166
financial milestones, 340 financial technology, 164
planners Grambling, John, Jr., 159
consumer confusion, 108, 113 framing identification of
effect bias, 27 regulation of, 98 clinical diagnosis, 154–160
supply side financial advice, 287 generally, 162–163
financial planning. See estate planning; personal financial key changes in financial environment, 164–166
planning; retirement planning Madoff, Bernie, 162, 166
financial planning process financial therapists, 102
client education, framing, 529–535 financial therapy, 102
capital needs analysis, anchoring the return, 534–535 financial wellness, closing gender gap, 236 fine art.
datagathering process, reframing, 534–535 efficient See art and collectibles
frontier hypothesis (EFH), anchoring FIX communication protocol, 506 flickering
on, 523–527 orders, 510–511, 512t, 514–516 flickering quotes
framing effect, 529–530 on buy offers, 501, 501f
risk coaching, anchoring the risk, 530–534 financial forecast optimism bias. See financial analysts’ reports and
psychopaths, 13, 153–167 forecast optimism bias
antisocial distinguished from psychopathic, 157 401(k) plan, 338, 340, 342, 346, 348
appropriation of term, 154 fractal market hypothesis, 446–448 comparative
Bateman, Patrick, 153, 154, 162, 166 characteristics of EMH and,
Belfort, Jordan, 153, 154, 162, 166 447, 447t
clinical diagnosis, 154–160 persistence, 447–448
antisocial distinguished from framing effect bias, 26–27, 312–313
psychopathic, 157 asset allocation, 372–373, 375
charming persona, 156 client education, framing financial planning process,
clinical guidelines, 154, 157 529–530, 529–535
criminal behavior, 157 client management, application of
diagnosing in business environment, 158–160 gender behaviorally based
bias, 160, 161 hot investments, reframing techniques, 536–537
genetic component, 158 reporting, framing and, 540
Hare Psychopathy Checklist (PCL), 157 passive definition of, 312
psychopaths, 159 disposition effect, 313
physiological characteristics, functional MRIs (f MRIs), executive reluctance to application of behavioral finance,
157–158 openness on framing/ reframing, 551
“psychopathic behaviors,” 154 psychopathic financial advisory services, consumer bias, 292–293
distinguished from financial planners, 27
antisocial, 157 herd mentality, 312
substance abuse, role of, 155–156 corporate and hot investments, reframing techniques, 536–537
financial psychopaths, insurance purchasing decisions based on perceived risk,
distinction, 161 303
definition of, 161–162 loss aversion, 312
Diagnostic and Statistical Manual of Mental money illusion, 313
Disorders, 5th Ed. (DSM-5) narrow framing
criterion, financial psychopaths, 161–162 psychopaths, mutual funds, selection of, 384
clinical diagnosis, 154–155, 156, retirement planning and wealth management, 345, 346
158, 161–162 wealth management, 345, 346
examples of, 162–163 quarterly reporting, client management, 540 success
Farkus, Lee B., 162–163, 166 frame and positive frame, 27
financial crisis of 2007–2008, 154–155, 163–164 financial free cash flow theory, 404
environment, emergence in, 163–166 financial environment, free rider problem (social loafing), 90, 91
key changesin,164–166
“financial capitalism” period, 165–166 financial
crisis of 2007–2008, 154–155,
163–164
622 Index
frequent stock trading, 14, 209–219 as an financial advisory services, consumer bias, 289–290
epidemic, 209 frequent stock trading, 210, 211, 214 gambling disorder
cortisol, stress hormone, 217 and frequent stock
day traders, behavior of, 213–214 gambling disorder as trading, 216
possible cause of, human brain, male vs. female, 231–232
215–218, 219 institutional investors, 66
investor returns, 209, 212 irrational financial behaviors creating need for financial
irrationality, 209, 210, 218 planning, 341–342
mobile technology, trading implications of, 218 negative managerial traits, 84
emotions, 217–218 portfolio managers, 147–148, 149
possible causes/motives, 209–210 psychopaths, 160, 161
aspiration for riches motive, 212 better- traders, information processing phase
than average effect, 211 emotional errors, 198
reasons, 212 Generation X (Gen Xers), compared to millennials American
emotions or rational thinking, 213 dream concept, 242, 243f employment and
gambling, investing as substitute for,211–212 gambling unemployment, 245
disorder, 215–218, 219 financial advisors, role of advisor
gender bias, 210, 211, 214 satisfaction, 254
investing as substitute for technology and financial information, 255 financial
gambling, 211–212 advisors, use of
miscalibration, 210 degree of advisor use, by age group and income,
overconfidence, 210–211 248f
recreation/leisure motive, 212 generational criteria for making investment decisions,
risk-as-feelings hypothesis, 213 251f
risk-seeking behavior, 211–212 impetus for seeking advice, 248–249
sensation seeking motive, 212 risk tolerance and investment preferences, 250–251
testosterone and, 214 trust issues for millennials, 250 view of
prevalence of, 209, 218 financial advisors, 249
front-end load, 104 financial crisis of 2007–2008, impact of, 245 financial
functional fixation hypothesis, 453–455 ambiguity, 454 outlook, short and long term, 246–247 retirement
causes of the functional fixation, 454 familiarity bias, planning, 246–247, 246f
454 health concerns, potential impact of, 247 genetic
functional fixation in the financial markets, 454–455 component
potential solutions to functional fixation, 455 functional individual investors, 45–46
MRIs (f MRIs) psychopaths, 158
psychopaths, physiological characteristics, 157–158 globalfocusing
international mergers and acquisitions (M&As), 399–400
Global Settlement, 120, 123, 125 goal-
gambler’s fallacy, 196 based investing
gambling disorder and frequent stock trading, 215–218, 219 aspiration based preferences approach, 549 single
clinical criteria, 215–216 cortisol, behavior tendency, 547
stress hormone, 217 goal-based management
Diagnostic and Statistical Manual of Mental high net worth individuals (HNWIs), 180 golden
Disorders (DSM-5), criteria, 215–216 parachute, 81
gender bias, 216 Grambling, John, Jr., 159
impulsivity, 216–217 grandiosity, 490
investing as substitute for gambling, 211–212 negative Great Depression ofthe 1930s, 47
emotions, 216–217 greenfield investments, 402
overconfidence, 215 group dynamics, 54
possible motives for risk-seeking behavior, 211–212 group polarization (risky-shift effect), 485–487 groupthink
gender bias, 8–9 behavior, 487–489
estate planning, 327 characteristics that foster, 91
conformity, 487–488
directors, 91
Index 623
individual and group decision makers, association participation in equities, 503–504, 503t
between, 488–489 passive HFT, 502–504
institutional investors, 487–488 speculation in high net worth (HNW). See art and collectibles high net
financial markets, 487–489 substandard worthindividuals (HNWIs), 13–14,
strategies, 488–489 173–189
as activist investors, 175–176 behaviors,
economic view of, 186–188
Hare Psychopathy Checklist (PCL), 157 health human capital theory, 186–188
insurance, 306, 316 The Wealth of Nations, 186
hedge funds, 388–390 definition of, 173, 176–177 human
assets under management (AUM), statistics, 378, 388, capital theory, 186–188
392–393 inequity debate, varied responses to, 173–174, 189
behavioral issues, 389–390 institutional investment behavioral biases, 174, 175, 182–186
investors, mood and, 75 investment performance, “emotional inoculation,” 183–184
389 misvaluations, forms of, 388–389 emotional investors, 183–184 human
portfolio managers, 137 vs. robo-advisors, 184
trust, 390 investor psychology: nudge or predict, 185–186
herding behavior, 312 irrationality, 183
cascading/informational cascading, 71 loss aversion, 183
financial analysts’ reports and forecast optimism bias, 124 traditional vs. behavioral finance, 182 trust
financial bubbles, 141 information based heuristic, 184–185
reasons for, 71 institutional investors, 65, 71– ultra-high net worth (UHNW) designation, 176 wealth
72 accumulation, 174–175
irrational financial behaviors creating need for financial wealth management, 176–182, 189 advice,
planning, 342 value of, 180–182
pension funds, 142 Asia, private wealth management, 177 changing
portfolio managers, 140–142, 149 speculation in attitudes and investment
financial markets, 484–485 traders, 199 behaviors, 180 changing
Yale model, 142 landscape of, 179
heterogeneity among types changing needs of HNWIs, 179
institutional investors, 68–69 definitions, 176–177
heuristics, 7–8, 23, 310–312, 316 Europe, private wealth management, 177 global
affect heuristic, 30, 311 anchoring. See HNWI and wealth trend, 178–179 goal-based
anchoring bias attribution substitution, management, 180
311–312 availability. See availability bias high net worth (HNW) designation, 176 holistic
causality, 311 investing, 180
cognitive bias, 5. See also specific bias multi-family office (MFO), private wealth
financial analysts’ reports and forecast optimism bias, 124 management, 178
herding. See herding behavior philanthropy, 180
leniency heuristic, 124 players and markets, 177–178
1/N heuristic bias, asset allocation, 369 personal private wealth management, 177–178 social
financial planning, 278 representativeness. See impact efforts, 180
representativeness bias satisficing, 7–8 ultra-high net worth (UHNW) designation, 176
HFT. See high-frequency trading (HFT) hidden the United States, private wealth management, 177–178
order execution, 512–515 hindsight bias, 308–309
high-frequency trading (HFT), 502–505 HNWIs. See high net worth individuals (HNWIs) hoarding
aggressive HFT, 502–504 disorder
defined, 502–503 art and collectibles, 424 holistic
equity exchanges, developments, 502–505 order investing
placement, 504, 504f high net worth individuals (HNWIs), 180 holon in
orders on bid-ask spreads, 503, 503f financial planning, 271, 271f
home asset bias
asset allocation, 370
624 Index
home bias return chasing, 385

speculation in financial markets, 489 home- tracking errors, 384
biased portfolios individual investors, 11, 45–56
institutional investors, 68, 74 biases, 50–53
homeowners insurance, 306 emotions and mood, 52–53 limited
hormones attention, 51–52
cortisol, stress hormone frequent negative emotions, 52–53
stock trading, 217 market overconfidence, 50–51
volatility and, 232 positive emotions, 52–53
testosterone levels and risk-seeking behavior frequent stock sentiment/investor sentiment, 52
trading, 214 innate and learned investor behavior, 45–48 See also
individual investors, 47 financial crisis of 2007–2008, impact of
women investors, 232 hot cognitive ability and IQ, 46–47
hand fallacy financial crisis of 2007–2008, impact, 47 genetic
concept explained, 29 factors and neural foundations, 45–46 Great Depression
mutual funds, selection of, 384 of the 1930s, 47
hot investments, reframing techniques client life-course theory, 47
management, 536–537 personal life experiences, 47–48 testosterone and
retirement planning, 537 risk-seeking behavior, 47
hourly compensation institutional investors, comparisons to. See
agency costs in financial advice, 106 house institutional investors mutual
money effect funds, limited attention, 51
traders, information processing phase errors, 197 hubris nonstandard preferences. See individual investors,
hypothesis. See also overconfidence nonstandard investor preferences
international mergers and acquisitions, irrational reasons for, social context, 53–56
405 Bernie Madoff scandal, impact, 55 culture,
human brain 55
male vs. female, differences between, 231–232 human group dynamics, 54
capital theory online trading, 55–56
high net worth individuals (HNWIs), 186–188 strategic peer effect, 53–54
dimension of personal financial politically active individuals, 54
planning, 268 proximity, 55
regional variations, 55
social identity, 54
idiosyncratic risk, 472–473 social interaction, 53–54 social
illusion of control, 29, 308 norms and values, 54 stock market
concept explained, 29 aversion, 54 technology, 55–56
financial planning, 339 trust in receiving fair returns for economic transactions,
impulsivity, 216–217 54–55
incentive-based compensation agency social finance, 56
theory, 80–81, 86 sophistication level of, 64
managerial traits, 86–87 traditional finance vs. modern finance,
risk-taking, 86–87 differences, 45, 56
incentives. See also incentive-based compensation financial individual investors, nonstandard
advisors, 97 preferences, 48–50
financial analysts’ reports and forecast optimism cognitive dissonance, 48
bias disposition effect, 48, 49
competing incentives, 119 familiarity preference, 49–50 lottery-
stock recommendations, market typestocksand options, 49 mental
regulation, 121 accounting, 48
indemnification principle, 302 index prospect theory, 48
mutual funds, 384–385 realization utility of gains and losses, 49 retail
annual cash flowsin U.S.index mutual funds, based on investors, 49
ICI data, 381, 381t skewness preference, 49
behavioral bias diversification bias,
385
trust, 385
Index 625
individual psychology and stressors, 33 “industrial portfolio under-diversification, 73 prospect

capitalism,” 164–165, 166 theory
inequity debate, 173–174, 189 inertia. ambiguity aversion, culture and, 74 reputation
See status quo bias (inertia) informational concerns of, 71 sophistication level of
cascading, 71 generally, 64, 65, 75
information collection phase errors, traders, 194–198 information advantage and performance, 69 toxic
availability bias, 194 liquidity, 501–502, 504, 505
familiarity bias, 194 trading behavior, 69–74
heuristics, 194 culture, 74
home bias, 194–195 illusion equity home bias, 72–73 herding
of control, 195 illusionof behavior, 65, 71–72
knowledge,195 informational cascading, 71 information
information processing phase errors, traders, 194f, 195–198 based reasons for, 71 momentum trading, 70
anchoring effect, 196 mood, 73–74, 75
anchoring heuristic, 195 portfolio under-diversification, 65, 72–73, 75 seasonal
better-than-average effect, 198 and weather related
break-even effect, 197, 198 conditions, 73–74
cognitive dissonance, 196 value generating biases, 65
confirmation bias, 196 insurance, generally. See also insurance purchasing decisions
disposition effect, 196–197 definition of, 302
endowment effect, 197 elements of, 302
gambler’s fallacy, 196 sales, 316
gender bias, 198 types of insurance, 304–306 automobile
house money effect, 197 law of insurance, 306
smallnumbers, 196 loss disability insurance, 305
aversion, 197, 198 health insurance, 306
mean reversion, 196 homeowners insurance, 306
mental accounting, 196 life insurance, 305–306
miscalibration, 198 long-term care insurance, 306 property and
overconfidence, 198 casualty insurance, 306
regret aversion, 196 insurance agents, 101
representativeness heuristic, 195 status insurance firms, 101
quo bias, 198 insurance purchasing
stop-loss order, 197 decisions, 16, 302–316
inside directors, 88, 89–91 bounded rationality, 304 perceived risk,
institutional investors, 11–12, 64–75 decisions based on
behavioral biases, 65–68, 75 biases, 307–309, 316
disposition effect, 67 disposition effect, 313
familiarity bias, 68 framing effects, 303, 312–313, 316
gender bias, 66 herd mentality, 312
heterogeneity among types, 69 heuristics, 310–312, 316
overconfidence, 66 loss aversion, 312
representativeness bias, 68 money illusion, 313
definition of, 65 rational and irrational behavior, 313–316 bounded
endowments, 69 equity rationality, 304
exchanges individuals with insurance, 314–315 insurance
developments, 499 shortfalls, 315
toxic liquidity, 501–502, 504, 505 life insurance, decisions to purchase levels of, 315–316
groupthink behavior, 487–488 hedge nominal monetary vs. real
funds, mood, 75 heterogeneity among monetary view, 314
types, 68–69 home-biased portfolios, rationality, 304
68, 74 individual investors vs., 64–65 risk attitudes,307
mutual funds risk tolerance and, 302–304
disposition effect, 67
626 Index
insurance purchasing decisions (Cont.) synergy, 411–412

behavioralresponsestorisk, 304 bounded anticipated synergies, 411–412, 413f
rationality, 304 comparisonoftime spentonsynergistic
indemnification principle, 302 law of evaluations, 411, 412f
large numbers, 302–303 law of small Internet bubble, 483
numbers, 303 nature of risk, 303– intuition, evaluating validity, 338–339 inverted
304 prospect theory, 304 exchanges, 502
rationality, 304 responses to investing attributes, 531–532, 531t
risk, 304 investment adviser representatives (IARs), 99, 100. See also
traditional economic theory, 302, 315 Registered Investment Advisers (RIAs),
integralism, 271 interest regulation of
rate risk, 529 Investment AdvisersAct of 1940
internal locus of control, 28 advisers vs. advisors, 108
international and emerging market stock indexes asset RegisteredInvestmentAdvisers(RIAs), 99
allocation, familiarity bias investment advisor, 287
correlation matrix of U.S., 371, 371t investment names, anchoring on, 340 investment
performance of the United States, 370, 370f policy statement (IPS), 535, 540 investment time
international mergers and acquisitions, 17, 397–418 horizon, 531
behaviorally based success factors, 412–417 cultural investor sentiment
differences, 413–414, 414f strong internal action style indicators, 201–202 asset
communication, 415 pricing and, 570–571 exchange-traded
top team selection, 416–417, 416f funds (ETFs), 387 individual investors, 52
current trends, 397–400 “market psychology,” 201
developing world acquirer, growth of, 398 developing opinion-style indicators, 201–202 role of
world’s growth activity, 397, 398 financialcrisisof media, 201–203
2007–2008, impact of, 398 globalfocusing, rise of, sentiment indicators, 201–203 social
399–400 media platforms, 202–203 stock market
lower degrees of integration with targets, pursuit of, anomalies, 475
398–399 irrational behavior. See rational and irrational behavior
partnering, 399 isomorphism
transformational acquisitions, 400 financially based coercive isomorphism, 568
success factors, 408–412 mimetic isomorphism, 568
holistic due diligence, 409–410, 409t pre-
acquisition planning, 410–411, 411f synergy,
411–412, 412f, 413f knowledge and evidence-based financial planning, 277–278
foreign direct investment markets, attractiveness of, 400–402
banking industry, maturity of, 402 financial and
intangible factors, 401, 401t greenfield law of large numbers, 302–303 law of
investments, 402 small numbers
irrational reasons for acquisition, 404–405 defense insurance purchasing decisions, risk tolerance, 303
behavior, 405 traders, information processing phase errors, 196 leniency
envy theory, 404 heuristic
free cash flow theory, 404 hubris financial analysts’ reports and forecast optimism bias, 124
hypothesis, 405 level load, 104
reasons for acquisitions generally, 402– life-course theory, 47
405, 403f life insurance, 305–306
irrational reasons, 404–405, 405t purchasing decisions and risk management, 315–316
success and failure, generally, 405–408 sales of, 316
amount of shareholder value gained, 406, 406f “lift and drop” application approach, academic, 547–550
competitive advantage gained, 406, 407f aspiration based preferences approach, 549
successful acquisitions, 408–418
behaviorally based success factors, 412–417 financially
based success factors, 408–412 overall success
factors, 417–418, 417f
Index 627
goal-based investing managers. See also portfolio managers; wealth management

aspiration based preferences approach, 549 single organizational application of behavioral finance executive
behavior tendency, 547 reluctance, 551–552
over-engineered technical solutions, 548–549 cumulative senior management, support of, 558–559 tailoring design
prospect theory (CPT), 548–549 portfolio and organizational
optimization, 548–549 deployment, 550–551
single behavior tendency, 547–548 mental rationalist perspective of, 566–567 traits.
accounting, 548 See managerial traits
limited attention bias margin of safety, 268
mutual funds marital and family dynamics, estate planning complexity of
individual investors, 51 planning process, 327 evolving nature of families, 320
underperformance of, 382–383 stock family assessment tools, 329
market anomalies, 474 market data. See order-by-order market data market
limitorderbook. See order-by-ordermarket data LinkedIn. hypothesis. See behavioral finance market
See social media hypotheses
liquidity. See equity market developments “lit” limit “market psychology,” 201 market
orders, 512, 514 size anomaly, 469 market timing
local bias, 489 locus of client management, 535–536
control, 28 stress on, investment strategy leading to faulty planning,
long-term care insurance generally, 306 348–349
sales of, 316 M&As
loss aversion, 6–7, 23, 312 generally. See mergers and acquisitions (M&As) international
asset allocation, 371–372 M&As. See international mergers
client education, framing financial planning process, and acquisitions
533–534 mean reversion, 196
disposition effect, 7 mean-variance optimization, 368–369 media, role of.
emotional loss, 6–7 See also social media
endowment effect, 197 traders, investor sentiment, 201–203 mental
financial crisis of 2007–2008 behavioral bias, impact of, accounting bias, 28, 309, 313–314
493 academic lift and drop application approach, 548 asset
high net worth individuals (HNWIs), 183 house allocation, 364, 373–374, 375
money effect, 197 client management, 537
personal financial planning, 279 risk concept explained, 28
aversion vs. loss aversion, 534 individual investors, 48
traders, information processing phase errors, 197, 198 personal financial planning, 278–279 rational and
lottery-type stocks and options irrational behavior, 313–314 return objectives,
individualinvestors, skewnesspreference, 49 364
traders, information processing phase errors, 196 mergers
and acquisitions (M&As). See also
Madoff, Bernie, 162, 166 international mergers and acquisitions CEOs’
management theories, 80–83 biases, 87–88, 92
agencytheory,79,80–81,91 millennials, 14–15, 241–260
differentiating factors, 82–83 American dream concept, 242, 243f
stewardship theory, 79, 81–82, 92 anchoring bias and, 27–28
managerial traits, 84–86 baby boomers and, 242–247. See also baby
bounded rationality, 84 compensation, boomers
relation to, 86–87 conservatism, 84 financial advisors, role of, 252–259 advisor
gender bias, 84 satisfaction, 253–255
incentive-based compensation, 86–87 optimism, engagement, national and personal concerns of
managerial optimism, 84–85 overconfidence, 84, 85–86 millennials, 247
religion, influence of, 84 technology and financial information, 255–257
risk aversion, managerial risk aversion, 86 risk financial advisors, use of, 247–252 debt,
perception bias, 84 251–252
628 Index
millennials (Cont.) mimetic isomorphism

degree of advisor use, by age group and income, recommendations for increased familiarity, 568 mistrust.
248f See trust
generational criteria for making investment decisions, modern finance vs. traditional finance,
251f differences, 45, 56
household money management, 251–252 impetus for modern liquidity, subsets of, 500–501 modern portfolio
seeking advice, 248–249 referrals, 249 theory (MPT), 4, 367–369
risk tolerance and investment preferences, 250–251, assumptions under MPT, 367–368, 375 client
251f education, 527–528, 528f development of,
trust issues for millennials, 250 view of 359
financial advisors, 249 risk reduction through diversification, 527, 528f
financial advisors and ultra-high net worth (UHNW) momentum anomalies
millennials long-term reversal, 468–469
advisor satisfaction, 254 returnsofportfolios formedbased on previous stock
retirement planning, 246 returns, 467, 468t
role of, 252–253 momentum trading institutional
use of, 248, 249, 250, 252–253 investors, 70
financial crisis of 2007–2008, impact of, 242, momentum type strategies, traders, 199–200
244–246, 492 conservatism in expectations, 199 expectation
“boomerang children,” 245 employment and extrapolation, 199
unemployment, 245 financial literacy, 244 money illusion, 313
millennial men, 245 money languages
millennial women, 245 irrational financial behaviors creating need for financial
mindset, 244–246 planning, 341–342
financial literacy, 242–244, 259 money shame, 341
financial crisis of 2007–2008, impact of, 244 knowledge moneysicknesssyndrome, 32–33
level for investors by age group and monitoring costs, 103
income, 244f MonteCarlo analysis, 268–269 mood.
retirement savings, 243–244 See also emotional bias
financial outlook, short and long term, 246–247 Gen Xers changes in, art and collectibles, 423 emotion,
and. See Generation X (Gen Xers), mood,andaffect,distinctions
compared to millennials investor between, 30
profiles, 257–259 institutional investors, 73–74, 75
the climber, 257 Mood Maintenance Hypothesis (MMH), 30 moral hazard
family matters, 258 on concept
my own, 257–258 no portfolio managers, risk-taking behavior, 142–143
worries, 258 mortality issues
the worrier, 259 irrational financial behaviors creating need for financial
Millennial Disruption Index, 259 planning, 342
national concerns, 247 mortality salience
as percentage of U.S. workers, 241 personal estate planning, 324–325
concerns, 247 mortgage backed securities (MBS), 363
retirement planning, 246–247, 246f motivational interviewing
health concerns, potential impact of, 247 robo- client interview methodologies, estate planning, 330–331
advisor, 256–257, 257f, 260 MPT. See modern portfolio theory (MPT) multi-
social media, 255–256, 256t family office (MFO), private wealth
stereotype, 241, 244, 260 management, 178
technology and financial information, 255–257 likelihood of mutual funds, 379–385
clientuseoffinancial servicesvia active vs. passive management, 380–381, 381t
technology, 257, 258f millennial assets under management (AUM), statistics, 378,
investor profiles, 257–259 robo-advisor, 380t,392–393
256–257, 257f, 260 disposition effect institutional
“sandwich generation,” 257 investors, 67
social media used for specified activities, 255–256, 256t related to underperformance, 383 emotional
bias, 30
Index 629
financial emotions that influence neoclassical theory of financial decision making,

decisions, 30 193
index mutual funds, biases, 381, 381t, 384–385 neurofinance (also known as
diversification bias, 385 neuroeconomics), 34–35 noisy
return chasing, 385 market hypothesis, 452–453
tracking errors, 384 optimism, 453
trust, 385 institutional overconfidence, 453
investors nominal monetary vs. real monetary view, 314 nostalgia
disposition effect, 67 effect, 425
portfolio under-diversification, 73 limited novice traders, simulations and behavior of, 203–205
attention, individual investors, 51 performance nudging concept (also known as paternal
of actively managed funds, 381, 382 industry libertarianism)
competition, impact of, 382 application of behavioral finance, 554–555
portfolio managers, 136 asymmetric paternalism, 554–555
portfolio under-diversification, institutional investors, 73 employer nudges, 350–351
return chasing generally, 382, examples of successful and unsuccessful nudges, 546–547
384 financial planner nudges, 351–353
index mutual funds, 385 high net worth individuals (HNWIs), 185–186 pension
risk adjusted returns (alpha), 381, 382 selection of funds, plans
biases, 383–384 asymmetric paternalism, 554–555
disposition effect, 67, 383–384 auto-enrollment, 554, 555t, 558 increasing
familiarity bias, 384 hot contributions, successful and
hand fallacy, 384 narrow unsuccessful examples, 546–547
framing, 384 retirement planning, 337–338
overconfidence, 384 target employer nudges, 350–351
date fund strategy, 340 enhancing wealth through nudges, 350–353 financial
underperformance, biases related to, 382 cognitive planner nudges, 351–353
dissonance, 383 wealth management, enhancing wealth through nudges,
disposition effect, 383 350–353
limited attention bias, 382–383 optimism, 383
self-attribution, 383
objective and subjective issues influencing decision making, 5
1/N heuristic bias, 369
narrowframing. See also framing effectbias mutual one-sided investment plans, 347
funds, selection of, 384 online trading and investment platforms daily
retirement planning and wealth management, 345, 346 returns, display of, 557
wealth management, 345, 346 national financialadvisory services,292,296–297 individual
bestbidoffer (NBBO), 500 Nazrudin Project investors, social context, 55–56 novice traders,
(“Naz”), 271 negative emotions, 32–37, 38. simulations, 204 speculation, 483
See also trader’s overconfidence, impact on, 198 trading
emotional bias frequency, 56, 198
expert decision makers, 33–34 opinion-style indicators, 201–202
gambling disorder and frequent stock trading, 216–217 opportunistic behavior, 81
individual investors, 52–53 opportunistic liquidity. See toxic liquidity
individual psychology and stressors, 33 money (opportunistic liquidity)
sickness syndrome, 32–33 neurofinance optimism bias, 307
(also known as CEOs, 87–88
neuroeconomics), 34–35 regret excessive optimism, 307
aversion theory, 37 retirement issues, 34 forecast optimism bias. See financial analysts’ reports and
riskperceptionand, 35–37 worry, forecast optimism bias
35 managerial optimism, 84–85 mergers
and acquisitions, 87–88
mutual funds, underperformance of, 383
630 Index
optimism bias(Cont.) noisy market hypothesis, 453

noisy market hypothesis, 453 online trading, impact on traders, 198
pension funds,392 overreaction hypothesis, 451t pension
realistic optimism, 280 funds, 392
speculation in financial markets, 490 order-by- personal financial planning, 279
order market data, 505–512 portfolio managers, 139–140, 147–148, 149
cancellations, 506–507, 508t resoluteness, 88
message immediately following order speculation in financial markets, 483, 490 stock market
placement, 510, 512t anomalies, 473
size and shelf life of orders, single cancellation, 508, 509t traders
executed orders, 511–512 impact of online trading, 198 information
flickering orders, 510–511, 512t, 514–516 hidden processing phase errors, 198
order execution, 512–515, 515t, 517t interday over-engineered technical solutions
evolutionoforders,508,510 academic lift and drop application approach, 548–549
limit order book, 500, 501f, 505–512 overreaction and underreaction, 490–491 overreaction
“lit” limit orders, 512, 514 hypothesis, 448–450
market order execution, 514–515, 514t, 516t literature review, 448
number of order messages per each added limit order, 508, movement of DJIA (2000–2013), 449f
509f reasons for investor overreactions, 450, 451t
order-based negotiations, 512–516 order oversimplification
sizes, 506–507, 507t retirement planning and wealth management, 346 wealth
order types, statistics, 505 revisions/adjustments management, 346
to orders, 510, 511t sequential order updates, overtrading. See frequent stock trading
507, 508t
organizational application of behavioral finance executive
reluctance, 551–552 panic, 451t
senior management, support of, 558–559 tailoring paradigm shifting, 562–563
design and organizational deployment, epistemological paradigms, 565–566 interpretivist
550–551 perspective/methodologies,
organizational theory, 568 565–566
ostrich effect, 339 positivist perspective, 565 partnering
outside directors (independent directors), 88–91 international mergers and acquisitions (M&As),
overconfidence, 8–9, 23, 307–308 399
asset allocation, 374–375 passive high-frequency trading, 502–504 passive
CEOs, 87–88 psychopaths, 159
corporate takeovers, 87–88 paternal libertarianism. See nudging concept (also known as
executive reluctance, application of behavioral finance, 551 paternal libertarianism)
frequent stock trading, 210–211 gambling disorder Paul v. Virginia (Supreme Court case), 101
and frequent stock paycheck syndrome, 538–540
trading, 215 gender peer effect
bias financial advisory services, consumer bias, 293 individual
institutional investors, 66 men vs. investors, social context, 53–54
women, 8–9 portfolio managers, pension plans, 390–392
147–148 activism/activist investors, 391–392
hubris hypothesis, international mergers and acquisitions, assets under management (AUM), statistics, 378, 390,
405 392–393
individual investors, 50–51 asymmetric paternalism, 554–555
institutional investors, 66 auto-enrollment, nudges, 554, 555t, 558
Internet bubble, 483 behavioral biases, 392
irrational financial behaviors creating need for financial contributions, increasing
planning, 341–342 asymmetric paternalism, 554–555
managerial traits, 84, 85–86 men auto-enrollment, 554–555
vs. women, 8–9 emotions, 547
mergers and acquisitions, 87–88 mutual funds, nudges, examples of successful and unsuccessful,
selection of, 384 546–547
Index 631
defined benefit plans, 340, 352 financial life planning and, 270–272 holon in
portfolio management, 138 psychopathy, financial planning, 271, 271f integralism, 271
emergence in financial Nazrudin Project (“Naz”), 271 policy-
environment, 165–166 based planning, 269–270
defined contribution plans, 338, 340, 345 process-oriented techniques, 269–270
portfolio management, 138 quantitative techniques, 268–269
fees, 391 duration analysis, 268
401(k) plan, 338, 340, 342, 346, 348 human capital, 268 margin
herding behavior, portfolio managers, 142 nudges, 554– of safety, 268
555, 555t, 558 Monte Carlo analysis, 268–269 net
optimism bias, 392 resources, 268
overconfidence, 392 scenario planning, 269
performance, 391 sensitivity simulations, 269 safe
portfolio management, 138 withdrawal rate, 270
portfolio managers, herding behavior, 142 psychopathy, personal financial planning, client trust and commitment,
emergence in financial 272–277
environment, 165–166 building trust and commitment relationship, 274–275,
risk exposure, 391 274f
“window dressing” by selling loser stocks, 390–391 perceived communication dimension, 276–277
risk. See risk perception bias communication effectiveness,275, 275f
persistence, 447–448 components of trust and commitment,
personal financial planning, 15, 265–281. See also personal 273–274, 274f
financial planning, client trust and commitment factors influencing, 273–275
best practices, 277–278 functional conflict, 273
biases, strategies for overcoming, 279–281 emotional functional quality, 275, 275f
self-management, 281 empathy and high credence services, client difficulty assessing, 273
compassion, 281 positive outcomes, 273
positive conversational skills, 280–281 possibility referrals, 273
mindset, 280 satisfaction, role of, 275–276, 276f
realistic optimism, 280 biases satisfaction and trust as antecedents to
of clients, 278–281 commitment, 276, 276f
anchoring, 279 technical quality, 275, 275f
availability heuristic, 279 personal financial specialists (PFS) designation, regulation
heuristics, 278 of, 101–102
loss aversion, 279 perspective
mental accounting, 278–279 research and researchers, future of, 566–569 behavioral
overconfidence, 279 bias driven irrationality, 567 interpretivist
representativeness heuristic, 279 Certified Financial perspective/methodologies,
Planner (CFP) 565–566
designation, 266 paradigm shifting, 562–563
CFP Board of Standards, 266–267 depression/clinical positivist perspective, 565
depression, 265 primacy of philosophical perspective, 562 rationalist
financial planning process (steps),267–268, 281 perspective, manager’s, 566–567
history and development of, 266–267, 281 holon in philanthropy
financial planning, 271, 271f integralism, 271 art and collectibles, 427
knowledge and evidence-based financial high net worth individuals (HNWIs), 180 philosophy
planning, 277–278 of future behavioral finance research,
societal benefits, 265 standard 562–566. See also research and
setting bodies researchers, future of
best practices, 277–278 anomalies, identification of, 563, 566
generally, 266–267 epistemologocial paradigms, 565–566
strategic dimension, 268–272 general disdain for philosophical discussion in finance,
decision rules, 269–270 interior 562
dimension interpretivist perspective/methodologies, 565–566
connecting the interior and exterior, 272
632 Index
philosophy of future behavioral academic lift and drop application approach, 547–550
finance research (Cont.) normal digital technology and data analytics advancements, 552
science, 563 executive reluctance/senior management, 551–552
paradigm shifting, 562–563 good news and changing attitudes, 552 industry and
perspective, primacy of philosophical, 562 positivist policymakers, changing attitudes
perspective, 565 of, 552
publishing behavioral finance research, 564–565, superficial approaches/applications, 545–547 tailoring
564t, 565t design and organizational
research programs, 563–566, 575 politically deployment, 550–551 changing
active individuals, 54 portfolio choice, 4 attitudes
portfolio management. See asset allocation portfolio behavioral finance terminology, familiarity with, 543
managers, 13, 135–149 ofindustryandpolicymakers,552
behavioral biases, 139–148 cumulative prospect theory (CPT)
gender differences, 147–148, 149 misunderstanding of, 545–546
herding behavior, 140–142, 149 over-engineered technical solutions, 548–549 digital
endowments, 142 technology and data analytics
financial bubbles, 141 advancements, application
pension funds, 142 opportunities, 552
Yale model, 142 EAST framework (UK), 557–558 executive
overconfidence, 139–140, 147–148, 149 reluctance/senior management,
certainty overconfidence, 139–140 551–552
gender differences, 147–148 good application principles, 553–557 asymmetric
prediction overconfidence, 139 paternalism as guiding
prospect theory, 146–147 principle, 555
risk-taking behavior, 142–146, 149 alternative isolation, behavioral finance almost always useless
asset management firms, 144 ambiguity aversion, in, 553
145–146 nudges, behavioral finance is not just, 554–555
moral hazard concept, 142–143 traditional asset senior management support and organizational
management firms, application, 558–559
143–144 traditional approaches, behavioral finance as companion
herding behavior, 140–142, 149 to, 553–554
prospect theory, 146–147 understanding how processes and people interactto
realestateinvestmenttrusts (REITs),147 portfolio induce betterdecisions, 556–557
managers, regulation of industry and policymakers, changing attitudes of, 552
alternative asset management, investment strategies, 137 misconceptions in commercial practice, 543–545
hedge funds, 137 academic field, cost of “labels,” 544–545 “bias” bias,
mutual funds, 136 portfolio 543–544
optimization generally, 543
over-engineered technical solutions, 548–549 portfolio sources of, 543–545
under-diversification. See traditional and behavioral finance, 544 misguided
diversification bias attempts to implement academic
positive conversational skills, 280–281 positive behavioral ideas and examples, 547–550
frame, 27 nudges
positivist perspective, 565 application of behavioral finance, 554–555 asymmetric
possibility mindset, 280 paternalism, 554–555 examples of successful and
practical application of behavioral finance, 19–20, 542–559 unsuccessful
academic lift and drop. See lift and drop application nudges, 546–547
approach, academic asymmetric paternalism, 554– organizational application
555, 555t senior management, support of, 558–559
bias
“bias” bias, source of misconception, 543–544
complexities of, 546
challenges, good and bad
applications, 545–552
Index 633
tailoring design and organizational deployment, 550– Diagnostic and Statistical Manual of Mental
551 Disorders, 5th Ed. (DSM-5), 154–155, 156,
senior management 158, 161–162
executive reluctance, 551–552 financial psychopaths, criterion, 161–162 gender bias,
support and organizational application, 558–559 160
superficial approaches/applications, 545–547 biases, genetic component, 158
complexities of, 546 Grambling,John, Jr.,159
nudges, examples of successful and unsuccessful, 546– Hare Psychopathy Checklist (PCL), 157 passive
547 psychopaths, 159
tailoring design and organizational deployment, 550–551 physiological characteristics, functional MRIs (f MRIs),
technology, digital technology and data analytics 157–158
advancements and application opportunities, “psychopathic behaviors,” 154
552 psychopathic distinguished from antisocial, 157 substance
present bias abuse, role of, 155–156
financial planning, 339, 345 psychopathy, emergence in financial environment, 163–166. See
retirement planning and wealth management, 339, 345 also financial psychopaths
wealth management, 339, 345 financial crisis of 2007–2008, 163–164 key
priming, 292–293 changes, identification of, 164–166
principal-agent relationship, 102–103 “financial capitalism” period, 165–166 financial
private wealth management. See high net worth crisisof2007–2008,154–155,
individuals (HNWIs) 163–164
professional traders and retail traders, “industrial capitalism,” 164–165, 166
distinguished, 192 pension plans, 165–166
progressive research programs, 563, 564, 575 technology, 164
project-based fees, 107 pension plans, 165–166
property and casualty insurance, 306 prospect publishing behavioral finance research failure to
theory,6,23,313. See also develop productive research and
disposition effect publishing bias, 569
ambiguous evidence, 125 limitedoutlets forpublishing ofpurely
client education, framing financial planning process, theoretical research, 565
533–534 statistics, 564
cumulative prospect theory (CPT) count ofarticles in SSRN Behavioral and
academic lift and drop application approach, 548–549 Experimental Finance (ejournal), 564,
misunderstanding of, 545–546 565t
over-engineered technical solutions, 548–549 SSRN behavioral and experimental finance ejournal,
institutional investors, culture and, 74 article count, 564, 565t
insurance purchasing decisions, risk tolerance, 304 purchasing power, 529
nonstandard investor preferences, individual investors, 48
portfolio managers, 146–147
realestateinvestmenttrusts(REITs),147 role of, 7 randomness of pricing processes
stock market anomalies, 474–475 psychopaths, fractal market hypothesis and, 446–448, 447t
clinical diagnosis, 154–160. See also overreation hypothesis and, 448–450 random
financial psychopaths; psychopathy, walkhypothesis,440,441f,442f
emergence in financial environment random walk hypothesis, 440
antisocial distinguished from psychopathic, 157 charming gold prices in 3-month period (2006), 440, 442f
persona, 156 randomly generated values, 440, 441f
clinical guidelines, 154, 157 rational and irrational behavior
criminal behavior, 157 biases creating need for financial planning, 339–342
diagnosing in business anchoring, 342
environment, 158–160 anchoring on investment names, 340
availability bias, 342
financial milestones, 340
gender bias, 341–342
herding, 342
money emotions, 340–341
money languages, 341–342
634 Index
rational and irrational behavior (Cont.) money Registered Investment Advisers (RIAs), regulation of, 98–100
shame, 341 investment adviser representatives (IARs), 99, 100
mortality issues, 342 required filings, 99–100
overconfidence, 341–342 target role of, 99–100
date fund strategy, 340 use of the SEC and state regulators, 99–100 registered
word “smart,” 341 representatives, 100
women, longer life expectancy, 236, 342 bounded regret aversion, 309
rationality concept theory, 37
adaptive markets hypothesis (AMH), 444 traders, information processing phase errors, 196 REITs. See
defined, 5, 24 real estate investment trusts (REITs) religion, influence,
insurance purchasing decisions, risk tolerance, 304 84
managerial traits, 84 “rentiers” (Europe), 182
research programs, 563–564 reporting
frequent stock trading, 209, 210, 218 analysts reports. See financial analysts’ reports and forecast
high net worth individuals (HNWIs), 183 insurance optimism bias
purchasing decisions, 313–316 mental accounting, art and collectibles, management and reporting, 429
313–314 client management, framing and, 540
money emotions, 340–341 perspective pre-experiment research protocols and registered replication
behavioral bias driven irrationality, 567 manager’s reports, 574
rationalist perspective, 566–567 representativeness bias, 25–26, 310 book-to-
rationalist perspective, manager’s, 566–567 market equity and, 26 concept
rationality/irrationality assumption explained, 25–26
adaptive market hypothesis and, 443–446 efficient institutional investors, 68
market hypothesis (EMH), 441 fractal market overreaction hypothesis, 451t personal
hypothesis and, 446–448, 447t functional fixation financial planning, 279 risk-return
hypothesis, 453–455 noisy market hypothesis, 452– relationship, 26
453 speculation in financial markets, 489–490 traders,
rational manager/irrational investor, asset pricing, 570, 575 information processing phase errors, 195 underreaction
rational maximizer, 313 hypothesis, 452
stock market anomalies, 470–471 rational reputation concerns
maximizer financial analysts’ reports and forecast optimism bias, 119,
insurance purchasing decisions, rational and irrational 122, 126, 127, 129
behavior, 313 institutional investors, 71 research
real estate asset pricing. See asset pricing, future of investor psychology
asset class, 360, 362–363 research
mortgage backed securities (MBS), 363 realestate future of. See research and researchers, future of future
investmenttrusts (REITs),363 philosophy. See philosophy of future
real estate investment trusts (REITs), 363 portfolio behavioral finance research generally, 285–
managers, prospect theory, 147 286
realistic optimism improving reliability. See research data and
personal financial planning, strategies for methodologies, improving reliability
overcoming biases, 280 programs. See research programs
realization utility of gains and losses nonstandard investor publishing. See publishing behavioral finance research
preferences, individual research and researchers, future of, 20, 561–575 asset pricing
investors, 49 research, 561, 569–572, 575 current primary focus of
rebalancing strategies, asset allocation, 366 buy-and- CEO’s role, 561, 567–568, 575
hold strategy, 366 issues with, 567–568
calendar balancing, 366 constant mix experimental finance
strategy, 366 asset pricing research, theory building, 570 improving
recency bias, 309 reliability, communication
financial crisis of 2007–2008 behavioral bias, impact of, infrastructure improvements, 574
492 improving reliability, 572–574
Reg FD perspective, 566–569
financial analysts’ reports and forecast optimism bias, 120,
122–123, 125, 130
Index 635
behavioral bias driven irrationality, 567 interpretivist anchoring on investment names, 340
perspective/methodologies, availability bias, 342
565–566 financial milestones, 340
paradigm shifting, 562–563 gender bias, 341–342
positivist perspective, 565 herding, 342
primacy of philosophical perspective, 562 rationalist money emotions, 340–341
perspective, manager’s, 566–567 philosophy of future money languages, 341–342
behavioral finance, 562–566 money shame, 341
publishing behavioral finance research failure to develop mortality issues, 342
productive research and overconfidence, 341–342 target
publishing bias, 569 date fund strategy, 340 use of the
publishing of purely theoretical research, limited word “smart,” 341
outlets,565 women, longer life expectancy, 236, 342
statistics, 564, 565t ostrich effect, 339
recommendations for increased familiarity with CEO, present bias, 339, 345
CFO, and management team, 568 coercive salience bias, 339 status quo
isomorphism, 568 bias, 339
cultural differences and behavioral biases, 568–569 “unbiased” self-assessments, 339, 353 Certified
mimetic isomorphism, 568 Financial Planners (CFPs), 338,
organizational theory, 568 343–344, 351, 353
research programs, 563–566, 575 research data emotional vs. expressive relationship, 337 enhancing
and methodologies, improving wealth through nudges, 350–353
reliability, 572–574 employer nudges, 350–351 financial
availability of datasets and clear methodology, journal planner nudges, 351–353
authors, 574 fiduciaries, 338
communication infrastructure improvements, 574 hot investments, reframing techniques, 537 investment
insuring reliable research, solutions, 574 strategies, biases and behaviors leading to faulty planning,
pre-experiment research protocols and registered replication 346–350
reports,574 conflicting social values, 347–348 faulty
replication or reproducibility of research, issues concerning, investment selection, 348 inadequate tax
572–573 planning, 349–350 limited
secret data, 572, 574 diversification, 347
solid core of theory and improved one-sided investment plans, 347 stress on
methodologies, 573–574 market timing, 348–349 unbalanced investment
research programs, 563–566, 575 bounded rationality review, 349
concept, 563–564 degenerative research programs, 563 millennials, 243–244, 246–247, 246f
progressive research programs, 563, 564, 575 publishing of negative emotions within financial decision making,
purely theoretical research, limited 34
outlets, 565 nudging concept, 337–338
traditional finance, reduced criticism of, 564, 566 residual employer nudges, 350–351
losses, 103–104 enhancing wealth through nudges, 350–353 financial
resoluteness, CEOs, 88 planner nudges, 351–353
retail investors. See also individual investors skewness status quo bias, 9, 372
preference, 49 ultra-high net worth (UHNW) millennials, 246
sophistication level of, 64 utilitarian focus of economics, 337 women
retainer fees investors, 236
agency costs in financial advice, 106–107 retirees, client retirement planning professionals
management, 537–540 biasesindecision to hire, 342–344, 353
retirement planning, 16, 337–353. See also pension plans; competency, 343–344
retirement planning professionals generally, 342–343
biases creating need for financial planning, 338–342, honesty, 344
353 reliability, 344
illusion of control, 339 term “financial advisor,” 343 training
intuition, evaluating validity of, 338–339 irrational and knowledge, 342–343 trust, 343
financial behaviors, 339–342 Certified Financial Planners
anchoring, 342 (CFPs), 338, 343–344, 351, 353
return drag, 363
636 Index
return objectives idiosyncratic risk, 472–473

asset allocation, 360, 364–365 mental systematic risk, 472
accounting bias, 364 aversion. See risk aversion baby
return-volatility relation boomers, 492
exchange-traded funds (ETFs), 387 client management, 537
reversion to the mean, 492 conduct risk, 556
RIAs. See Registered Investment Advisers (RIAs), consumer biases, strategies for overcoming, 294 financial
regulation of advisory services, consumer bias, 292 financial crisis of
risk and return, inverse relationship, 24–25, 38 risk-as- 2007–2008 behavioral bias and,
feelings hypothesis, 31 491–492
frequent stock trading, 213 risk frequent stock trading, 211–212
aversion, 4 gambling disorder and frequent stock trading, 211–212,
attitudes towards, 304, 307 215–218, 219
capital asset pricing model (CAPM), hazards, 303
development of, 4 incentive-based compensation, CEOs, 86–87 millennials,
CEOs, 87, 92 492
efficient market hypothesis (EMH), 4 moral hazards, 303–304 nature
vs. loss aversion, 534 managerial of risk, 303–304 objective
risk aversion, 86 portfolio choice, 4 risk, 303
women investors, 232–233 risk perception. See risk perception bias perils,
capacity 303
efficient frontier hypothesis (EFH), anchoring on client physical hazards, 303
education, 525 portfolio managers, 142–146, 149
risk coaching. See client education risk precautionary savings, 492
exposure pure risk, 303 responses to
pension funds, 391 risk aversion. See risk aversion risk
risk management. See insurance purchasing decisions neutral,307
risk mitigation risk seekers, 307
art and collectibles, 429–430 risk risk transfer, 304, 305 reversion to the
perception bias, 24, 38–39 mean, 492
assessment of, 24 risk and return, inverse relationship, 24–25, 38 risk need
bounded rationality, defined, 24 CEOs, exceeds risk tolerance, 527, 527f
87 risk perception. See risk perception bias
defined, 24 subjective risk, 303
managerial traits, 84 testosterone levels and frequent stock
satisficing, 24 trading, 214 individual investors,
worry and, 35–37 risk 47
requirement women investors, 232 and
efficient frontier hypothesis (EFH), anchoring on client uncertainty
education, 525, 526 disposition effect, 7
risk-return tradeoff, 26 emotional loss, 6–7
asset allocation, 364–365 loss aversion, 6–7
efficient frontier hypothesis (EFH), anchoring on client prospect theory, 6
education, 524, 524f women investors, 232 risk-
rational explanation for stock market anomalies, 470–471 taking tools
representativeness bias, 26 risk- consumers of financial advisory services, strategies for
sharing problem overcoming biases, 294
agency theory, 80–81 risk-taking tools, strategies for overcoming biases, 294 risk tolerance
risk-taking behavior, 24–25. See also risk-return tradeoff; efficient frontier hypothesis (EFH), anchoring on client
risk tolerance; systematic risk (undiversifiable education, 525
risk) insurance purchasing decisions, 302–304
anchoringrisk.See clienteducation investment preferences and
applicability of, 24 millennials, 250–251, 251f
arbitrage, stock market anomalies, 472–473 women investors, 232–233
risky-shift effect (group polarization)
Index 637
speculation in financial markets, 485–487 robo- snakebite effect traders,

advisors 200
client familiarity with term, 257f social capital and trust, 54–55 social
consumers of financial advisory services, strategies for finance
overcoming biases, 296–297 individual investors, 56
financial advisory services, 296 social identity of individual investors, 54 social
high net worth individuals (HNWIs) and, 184 human interaction
advisors vs., 184 individual investors, social context, 53–54 social media.
millennials, 256–257, 260 See also technology
better tools, better data, 433 e-
commerce, role of, 433
safety vs. certainty globalization, 431–432
capital asset pricing model (CAPM), client influence on wealth management, 430–434 investor
education, 529 sentiment, 202–203
safe withdrawal rate millennials, 255–256, 256t
strategic dimension of personal financial planning, online businesses and transparency, 433–434
270 relationships, business to business (B2B) vs.
salience bias consumer to consumer (C2C), 432–433 social
financial planning, 339 psychology
“sandwich generation” asset pricing, future of investor psychology research, 569
millennials, 257 social values
women investors, 237 conflicting, investment strategy leading to faulty planning,
satisficing, 7–8 347–348
risk perception bias, 24 individual investors, 54
traders, decision making process, 193 scenario societal benefits of personal financial planning, 265 speculation
planning in financial markets, 18–19, 481–495
strategic dimension of personal financial planning, behavioral aspects, 483–491
269 efficient market hypothesis (EMH) and, 481
seasonal and weather related conditions. See also excitement/euphoric expectation, 490
emotional bias familiarity bias, 489–490
institutional investors, 73–74 grandiosity, 490
SEC registered exchanges, statistics, 499 self- group polarization (risky-shift effect), 485–487
affinity bias, 31 groupthink behavior, 487–489
self-assessments, “unbiased,” 339, 353 self- herd behavior, 484–485
attribution bias home bias, 489
CEOs, 88 local bias, 489
mergers and acquisitions,88 optimism, 490
mutual funds, underperformance of, 383 stock overconfidence, 483, 490
market anomalies, 473 overreaction and underreaction, 490–491
traders, 199 representativeness bias, 489–490
self-control bias, 29 financial crisis of 2007–2008, behavioral biases evident
sensitivity simulations following, 481, 482, 491–494
strategic dimension of personal financial planning, anchoring, 492
269 collective memory hypothesis, 491 lasting
sentiment. See investor sentiment short- influence of economic shocks,
selling, 137 491–492
single behavior tendency loss aversion, 493
academic lift and drop application approach, 547–548 recency bias, 492 status
goal-based investing, 547 quo bias, 493
mental accounting, 548 trust and mistrust in a financial setting, 493–494
sizeanomaly (marketsize anomaly), 469 skewness worry, 492
preference historical background, 482–483
individual investors, 49 Internet bubble, overconfidence and, 483 portfolio
lottery-typestocksand options, 49 retail managers, herding behavior, 141
investors,49
“smart” use of the word, financial planning, 341
638 Index
sports card collections, 425 investment advisor, 287 purpose

status quo bias (inertia), 9, 23, 308 of advice, 287–288
asset allocation, 371–372, 375 vertical integration or tie-up, 287 wealth
financialcrisisof2007–2008,impact of, 493 financial managers, 287
planning, 339 who offers advice, 287
loss aversion and, 371–372 systematic risk (undiversifiable risk) arbitrage, stock
retirement accounts, 372 market anomalies, 472 asset allocation, risk–return
retirement plans, 9 trade-off, 365 capital asset pricing model (CAPM),
traders, information processing phase errors, 198 stewardship client
theory, 79, 81–82, 92 education, 528–529
agency theory, differentiating factors, 82–83 behavior generally, 303
assumptions, 83 unsystematic risk, 303
stock market
developments. See equity market developments generally.
See equity exchanges, generally tactical asset allocation (TAA), 366
stock market anomalies, 18, 460–475 accrual takeovers
anomaly, 469–470, 469f behavioral CEOs, overconfidence, 87–88
biases directors, 90
arbitrage, limits of, 472–473 target date fund strategy, 340 tax
disposition effect, 474–475 planning, inadequate
idiosyncratic risk, 472–473 investment strategy leading to faulty planning, 349–350
limited attention, 474 technology. See also robo-advisors; social media digital
overconfidence, 473 technologyanddataanalytics
prospect theory, 474–475 advancements, application
self-attribution, 473 opportunities, 552
sentiment, 475 financial advisory services
identification ofanomalies, 563, 566 investment robo-advisors. See subheading
anomalies, 465, 466f, 467f momentum robo-advisors, below
anomalies, 468–469, 468t sizeanomaly (market technology driven advice, 292, 296–297 frequent
sizeanomaly), 469 stock trading, 218
summary statistics (by country & anomaly), 460–461, individual investors, social context, 55–56 millennials
462t–464t and financial information, 255–259 online trading and
types of, 460, 461–470 investment platforms
value anomaly, 465–466, 471 why daily returns, display of, 557
they exist, 470–475 financialadvisory services,292,296–297 individual
behavioral explanation, 471–475 investors, social context, 55–56 novice traders,
rational explanation, 470–471 stock simulations, 204 speculation, 483
market aversion trader’s overconfidence, impact on, 198 trading
individual investors, social context, 54 frequency, 56, 198
stock market data. See order-by-order market data stock psychopathy, emergence in financial environment, 164
recommendations, market regulation, 121 stock trading, terror management theory, 325–326 testosterone levels
frequent. See frequent stock trading stop-loss order, 197 and risk-seeking behavior
strategic asset allocation (SAA), 365–366 subjective and frequent stock trading, 214 individual
objective issues influencing decision investors, 47
making, 5 substance women investors, 232 toxic
abuse, role of limit orders, 501
psychopaths, 155–156 toxic liquidity (opportunistic liquidity), 500–501 flickering,
success frame and positive frame, 27 502
suitability standard, 103 institutional investors and, 501–502, 504, 505 tracking
supply side financial advice, 287–289 added errors
value ofadvice, 288–289 brokers, index mutual funds, 384
defined, 287 tradeboosting, economic incentives of, 121 traders, 14,
consumer biases, strategies for overcoming, 293–296 192–205, 194. See also frequent stock
financial advisor, 287 trading
financial planners, 287
Index 639
biases of vs. behavioral finance, high net worth individuals (HNWIs),

availability cascades, 199 cognitive 182
bias, 193–194, 194f conformity effect, capital asset pricing model (CAPM),
199 conservatism in expectations, 199 development of, 4
contrarian strategies, 200–201 efficient market hypothesis (EMH), 4
disposition effect, 200 vs. modern finance, differences, 45, 56
expectation extrapolation, 199 gregarious portfolio choice, 4
and contrarian strategies, reducedcriticism of,philosophy offuture
distinguished, 200–201 behavioral finance, 564, 566
herding, 199 risk aversion, 4
momentum type strategies, 199–200 self- utility theory, 3–4 transference
attribution bias, 199 communications with clients, estate planning, 323–324
snakebite effect, 200 transformational acquisitions
social biases, 194, 194f, 199–201 day international mergers and acquisitions (M&As), current trend,
traders, behavior of, 213–214 decision 400
making process transmission protocol, 505–506, 506t
algorithmic trading, 193 trust
biases affecting, 193–201, 194f client trust and commitment, personal financial planning,
cognitive bias, 193–195 272–277
emotional bias, 194, 195–198 building trust and commitment relationship, 274–275,
generally, 192–193 274f
neoclassical theory of financial decision making, communication dimension, 276–277
193 communication effectiveness,275,275f
satisficing, 193 components of trust and commitment,
social bias, 194, 199–201 273–274, 274f
disposition effect factors influencing, 273–275
information processing phase errors, 196–197 social functional conflict, 273
biases, 200 functional quality, 275, 275f
efficient market hypothesis (EMH), 192 high credence services, client difficulty assessing, 273
emotional bias, 194, 194f positive outcomes, 273
information collection phase, errors in, 194–198 information referrals, 273
processing phase errors, 194f, satisfaction, role of, 275–276, 276f
195–198 satisfaction and trust as antecedents to
investor sentiment commitment, 276, 276f
action style indicators, 201–202 “market technical quality, 275, 275f
psychology,” 201 consumers of financial advisory services downside of trust,
market sentiment, 201 291
opinion-style indicators, 201–202 role of role of trust, 290–291
media, 201–203 between financial professional and client, 31 hedge funds,
sentiment indicators, 201–203 social 390
media platforms, 202–203 high net worth individuals (HNWIs), 184–185 index
momentum type strategies, 199–200 mutual funds, 385
conservatism in expectations, 199 millennials and financial advisors, 250 mistrust in a
expectation extrapolation, 199 financial setting
novice traders, simulations and behavior of, 203–205 financial crisis of 2007–2008 behavioral bias, impact of,
professional traders and retail traders, 493–494
distinguished, 192 in receiving fair returns for economic transactions
traditional asset management firms portfolio individual investors, social context, 55 retirement
managers, risk-taking behavior, planning professional, biases in
143–144 decisiontohire, 343 role
traditional economic theory of trust
insurance purchasing decisions, 302, 315 traditional finance financial advisory services, consumer bias, 290–291
theory, 3–4
basic premise, 3
640 Index
12b-1 fees, 104, 105 social media’sinfluence on,430–434 better

Twitter. See social media tools, better data, 433
collection management tools as wealth tools,
434
ultra-high net worth (UHNW). See also art and e-commerce, role of, 433
collectibles; millennials globalization, 431–432 holdings as
designation, 176 unbalanced commodities, 430 online art
investment review education, 432
investment strategy leading to faulty planning, 349 online auctions and marketplaces, 432 online
“unbiased” self-assessments, 339, 353 illusion of businesses and transparency, 433–434 relationships,
control, 339 business to business (B2B) vs.
ostrich effect, 339 consumer to consumer (C2C), 432–433 wealth
present bias, 339, 345 managers, 287
salience bias, 339 status quo The Wealth of Nations, 186
bias, 339 weather and seasonal related conditions. See also
under-diversification. See diversification bias underreaction emotional bias institutional
hypothesis, 450–452 investors, 73–74
conservatism bias, 452 wills, 318. See also estate planning wine
positive autocorrelation, 450 reasons for collections, 424–425
underreaction, 452–453 representativeness, The Wolf of Wall Street, 153 women
452 investors, 14, 224–237
undiversifiable risk. See systematic risk (undiversifiable risk) emerging influence and affluence of, 224–227
United States, private wealth management, 177–178 acquisition of individual wealth, 225
United States v. South-Eastern Underwriters educational attainment, 225
Association (Supreme Court case), 101 female entrepreneurs, 226–227
utilitarian focus of economics, 337 utility leadership of women, 225–226
theory, 3–4 transfer of wealth, 227
financial advisors’ treatment of, 231, 238
communication courses for advisors, 237
value anomaly, 465–466, 471 value communication with, 228–229
generating biases as invisible partner, 230–231
institutional investors, 65 financial concerns for, 235–236
values. See social values caregiving, 230, 231, 233, 236, 237 hardships,
vertical integration or tie-up, 287 dealing with, 234
as head of households, 225, 231, 233
life expectancy, increased, 236, 342 retirement
wealth accumulation savings, compared to men, 236 “sandwich generation,”
high net worth individuals 237
(HNWIs), 174–175 wage discrimination, 236
wealthmanagement, 344–346. See also highnet worth financialcrisisof2007–2008,impactof, 232–233,
individuals (HNWIs); retirement planning 234
aspects of financial planning, 344–346 financial financial industry
status and stability, 344–345 narrow framing, careers, gender inequality, 235, 237
345, 346 customer loyalty, 229–230
oversimplification, 346 dissatisfaction with, 227
present bias, 339, 345 financial wellness, closing gender gap, 236
enhancing wealth through nudges, 350–353 employer investment psychology, 227–236
nudges, 350–351 cortisol, stress hormone, 232
financial planner nudges, 351–353 financial customer loyalty, 229–230
status and stability, 344–345 narrow framing, financial concerns, 235–236
345, 346 financial literacy, 233–234, 237
oversimplification, 346 generally, 227–229
present bias, 339, 345 lack of confidence, 230–231
male vs. female brain, differences between, 231–232
market volatility, 232
risk aversion, 232–233
Index 641
risk-seeking behavior, 232 financial crisis of 2007–2008 behavioral bias, impact of, 492
risk tolerance, 232–233 riskperceptionand,35–37 wrap
success and failure, accounts, 105
defining, 234–235
testosterone and risk-seeking
behavior, 232 Yale model (endowment model), 142
worry, 35
642 Index

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Financial Behavior

FINANCIAL MARKETS AND INVESTMENTS SERIES

Portfolio Theory and Management

© Oxford University Press 2017

You must not circulate this work in any other form

Library of Congress Cataloging-in-Publication Data

Part One FINANCIAL BEHAVIOR AND PSYCHOLOGY

2. The Financial Psychology of Players, Services, and Products 23

Part Two THE FINANCIAL BEHAVIOR OF MAJOR PLAYERS

ALEXANDRE SKIB A AND HILLA SKIB A

5. Corporate Executives, Directors, and Boards 79

6. Financial Planners and Advisors 97

BENJ AMIN F . CUMMINGS

7. Financial Analysts 118

8. Portfolio Managers 135

9. Financial Psychopaths 153

Part Three FINANCIAL AND INVESTOR PSYCHOLOGY

10. The Psychology of High Net Worth Individuals 173

11. The Psychology of Traders 192

12. A Closer Look at the Causes and Consequences of Frequent

13. The Psychology of Women Investors 224

MARGUERIT A M. CHENG AND S AMEER S. SOMAL

14. The Psychology of Millennials 241

APRIL RUDIN AND CA THERINE MCBREEN

Part Four THE PSYCHOLOGY OF FINANCIAL SERVICES

15. Psychological Aspects of Financial Planning 265

D A VE YESKE AND ELI SS A BUIE

16. Financial Advisory Services 285

JEROEN NIEBOER, P A UL DOLAN, AND IVO VLAEV

17. Insurance and Risk Management 302

18. Psychological Factors in Estate Planning 318

JOHN J. GUERIN AND L. P A UL H OOD JR.

19. Individual Biases in Retirement Planning

Part Five THE BEHAVIORAL ASPECTS OF INVESTMENT

20. Traditional Asset Allocation Securities: Stocks, Bonds, Real

21. Behavioral Aspects of Portfolio Investments 378

22. Current Trends in Successful International M&As 397

23. Art and Collectibles for Wealth Management 422

Part Six MARKET EFFICIENCY ISSUES

24. Behavioral Finance Market Hypotheses 439

25. Stock Market Anomalies 460

STEVE Z. F AN AND LIND A YU

26. The Psychology of Speculation in the Financial Markets 481

27. Can Humans Dance with Machines? Institutional Investors,

Part Seven THE APPLICATION AND FUTURE

28. Applications of Client Behavior: A Practitioner’s Perspective 523

29. Practical Challenges of Implementing Behavioral

30. The Future of Behavioral Finance 561

MI CHAEL DOWLING AND BRIAN LUCEY

Discussion Questions and Answers 579

11.1 Main Types of Bias Affecting Traders’Investment Decisions 194

fte simpler you say it, the more eloquent it is.

AAII American Association of Individual Investors ACA

M&A merger and acquisition MBS

SWF sovereign wealth fund TAA