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Investor Behavior: The Psychology of Financial Planning and Investing



As behavioral concepts pervade more and more areas of practical finance, it can be increasingly difficult to keep track of the explosion of new ideas and applications. Investor Behavior draws together a huge range of specialist thinkers and practitioners to help us navigate, and apply, this burgeoning field to improving real world financial decision making.

--Greg B. Davies, Head of Behavioral Finance, Barclays

Baker and Ricciardi have put together the first scholarly book that captures the psychology, cognitive errors, and behaviors that permeate the financial planning industry. Financial planning is not just about efficient portfolios. It is also about client motivation and happiness when they often don't really know what they want. This book reveals the emotions, beliefs, personality, and biology that impact their decisions. Planners can know themselves and their clients better. Each chapter is a must read for all financial planners, financial advisors, and wealth managers... or anyone wanting to enter the industry.

--John Nofsinger, Seward Chair in Finance, College of Business and Public Policy, University of Alaska Anchorage

Professors Baker and Ricciardi have provided an essential book on the emerging trends in investment behavior as it relates to the dynamic nature of the investment management industry. Readers of Investor Behavior: The Psychology of Financial Planning and Investing are treated to a deep treatment of empirical evidence and current literature on the subject of behavioral finance in an easy-to-read manner. The collection of academic and practitioner talent contributing to this book is to my knowledge unprecedented. I highly recommend the book to both investors and financial market participants.

--Michael Pompian, Author of Behavioral Finance and Wealth Management

Readers of this book should come away with an appreciation of the factors that make the tasks of financial planning and investing so very complicated. Baker and Ricciardi have assembled a volume that documents our existing knowledge about investing from so many different angles. Beyond broad disciplinary perspectives such as economics, psychology, sociology, and neurology, the book informs us about all kinds of phenomena impacting investment behavior, such as reliance on fast and frugal heuristics, biases stemming from reliance on heuristics, seasonal affective disorder, personality types, demographics, and religion. Of special interest are the chapters that discuss how this interdisciplinary perspective can translate into meaningful advice to help investors make sensible decisions in a complex world.

--Hersh Shefrin, Mario L. Belotti Professor of Finance, Santa Clara University

The past several decades have seen remarkable contributions to knowledge about investor psychology and behavior within the burgeoning field of behavioral finance. This comprehensive book gives readers a solid grounding in theoretical and practical insights from this research essential for wise investment decision making.

--Paul Slovic, Professor of Psychology, University of Oregon

Star Treks' Mister Spock was the rational, unemotional agent whom Captain Kirk of the Starship Enterprise depended on. Homer Simpson was the opposite, hardly the person to whom you would entrust your well-being. Spock would embrace this book. Homer, perhaps pried by a Duff Beer, would discover that relying on this book to improve his choices is his only choice for Marge and the kids. Baker and Ricciardi have done a masterful job of selecting learned authors, selecting the right material for comprehensive coverage. The backbone of sound financial planning and investing, namely to understand how and why mistakes are propelled by psychology, is revealed in the pages of this book. Teachers, students, planners, investors, no matter how educated, should benefit from this book. Practicing its lessons and wisdom will make you infinitely better off for it.

--Arnold Wood, President and Chief Executive Officer, Martingale Asset Management

H. KENT BAKER is University Professor of Finance at American University's Kogod School of Business in Washington, DC. As one of the most prolific finance academics, he has authored or edited 21 books and published more than 150 refereed articles. He has consulting and training experience with more than 100 organizations, serves on multiple editorial boards, and is the Past President of the Southern Finance Association. Professor Baker holds eight earned degrees including three doctorates as well as CFA and CMA designations.

VICTOR RICCIARDI specializes in current trends in behavioral finance. As Assistant Professor of Financial Management at Goucher College in Baltimore, Maryland, he has made important contributions to understanding the psychology of investing. Professor Ricciardi also serves as Coordinator of Behavioral and Experimental Research for the Social Science Research Network (SSRN). He edits several SSRN eJournals related to behavioral finance, financial history, behavioral economics, risk-taking behavior, and behavioral accounting.

Acknowledgments xv

Part One - Foundations of Investor Behavior

Chapter 1 - Investor Behavior: An Overview 3
H. Kent Baker and Victor Ricciardi

Introduction 3

Organization of the Book 11

Summary 20

References 21

About the Authors 23

Chapter 2 - Traditional and Behavioral Finance 25
Lucy F. Ackert

Introduction 25

Traditional Finance 26

Behavioral Finance 31

Summary 39

Discussion Questions 39

References 39

About the Author 41

Chapter 3 - Behavioral Economics, Thinking Processes, Decision-Making, and Investment Behavior 43
Morris Altman

Introduction 43

Behavioral Economics, Heuristics, and Decision-Making 44

Investment Heuristics and Investing in Financial Assets 45

The Trust Heuristic and Decision-Making 48

Other Critical Decision-Making Heuristics 49

Rational Investor Decision-Making in a World of Complex Information 56

Summary 58

Discussion Questions 59

References 59

About the Author 61

Part two - Personal Finance Issues

Chapter 4 - Financial Literacy and Education 65
Michael S. Finke and Sandra J. Huston

Introduction 65

Examples of Financial Literacy Measures 68

Financial Literacy and Behavior 71

Financial Literacy Education 75

Summary 77

Discussion Questions 78

References 78

About the Authors 81

Chapter 5 - Household Investment Decisions 83
Vicki L. Bogan

Introduction 83

Financial Market Participation 83

Market Friction Effects on Household Investment Behavior 85

The Effects of Behavioral Biases on Household Investment Behavior 87

Summary 93

Discussion Questions 94

References 94

About the Author 98

Chapter 6 - Personality Traits 99
Lucia Fung and Robert B. Durand

Introduction 99

A Structural Model of Personality 100

Risk-Taking Behavior 103

Overconfidence 104

Personality and Gender 105

Personality as a Guide for Investors 107

Summary 108

Discussion Questions 109

References 109

About the Authors 114

Chapter 7 - Demographic and Socioeconomic Factors of Investors 117
James Farrell

Introduction 117

Literature Review 118

Case Study: The Florida Department of Education Employees 122

Summary 131

Discussion Questions 132

References 133

About the Author 134

Chapter 8 - The Effect of Religion on Financial and Investing Decisions 135
Walid Mansour and Mouna Jlassi

Introduction 135

Religions and Economic Factors: Dependence or Bifurcation? 136

Religion and Individual Investing Behavior 138

Summary 147

Discussion Questions 147

References 147

About the Authors 151

Chapter 9 - Money and Happiness: Implications for Investor Behavior 153
Jing Jian Xiao

Introduction 153

Can Money Buy Happiness? 154

Can Happiness Buy Money? 162

Implications for Investor Behavior 164

Summary 165

Discussion Questions 165

References 166

About the Author 169

Chapter 10 - Motivation and Satisfaction 171
Lewis J. Altfest

Introduction 171

Classical Economic Motivation 171

Behavioral Economic Motivation 173

Maslow’s Hierarchy of Needs 175

Criticism of Maslow’s Hierarchy of Needs 177

Higher Level Motivation 179

Humanism 181

Maslow and Investment Management 182

Personal Finance Integration 183

Summary 185

Discussion Questions 186

References 187

About the Author 188

Part Three - Financial Planning Concepts

Chapter 11 - Policy-Based Financial Planning: Decision Rules for a Changing World 191
Dave Yeske and Elissa Buie

Introduction 191

Managing Behavioral Biases in the Financial Planning Engagement 194

A Process for Developing Financial Planning Policies 195

Applicability of Financial Planning Policies 199

Policy-Based Financial Planning: The Strategic Perspective 201

Example of Policies Derived through Stochastic Modeling 202

Sample Case Applications 203

Summary 205

Discussion Questions 206

References 206

About the Authors 207

Chapter 12 - Financial Counseling and Coaching 209
John E. Grable and Kristy L. Archuleta

Introduction 209

Financial Counseling: A Historical Perspective 210

Theoretical Approaches: A Financial Counseling Perspective 215

Financial Counseling in the Twenty-First Century 221

Summary 223

Discussion Questions 224

References 225

About the Authors 226

Chapter 13 - Financial Therapy: De-Biasing and Client Behaviors 227
Joseph W. Goetz and Jerry E. Gale

Introduction 227

What Is Financial Therapy? 229

Brief History of Financial Therapy 231

Theoretical Foundations for Financial Therapy 232

The Practice of Financial Therapy 237

Future Research and Practice 240

Summary 240

Discussion Questions 241

References 241

About the Authors 243

Chapter 14 - Transpersonal Economics 245
Renée M. Snow

Introduction 245

Historical and Spiritual Overview of Money 248

The Western Eco/House 252

An Alternative Perspective 254

The Open Eco in Financial Planning 256

Summary 260

Discussion Questions 261

References 261

About the Author 264

Chapter 15 - Advising the Behavioral Investor: Lessons from the Real World 265
Gregg S. Fisher

Introduction 265

Risk, Return, and the Investor: A Complex Relationship 266

Investments with People Problems 269

The Impact of Investor Behavior on Portfolios 272

How Advisors Can Help the Behavioral Investor 275

Turning Bias into Benefit: How to Profit from Investor Behavior 278

Summary 281

Discussion Questions 281

References 282

Disclosure 283

About the Author 283

Chapter 16 - Retirement Planning: Contributions from the Field of Behavioral Finance and Economics 285
James A. Howard and Rassoul Yazdipour

Introduction 285

A Life Cycle Financial Planning and Wealth

Management Model 286

Demographic and Macroeconomic Context 287

Biases, Heuristics, and Framing Effects on Retirement Planning 288

Hyperbolic Discounting 291

The Role of the Brain in Financial Decision-Making 293

Financial Decision-Making Quality and Age 295

The Role of Self-Awareness and Self-Control 296

Trust and Retirement Saving and Planning: The Basics 297

Trust and Retirement Saving and Planning: The Decision 298

Trust-Based Implications for Retirement Saving and Planning 299

Discussion Questions 302

References 303

About the Authors 305

Chapter 17 - Knowing Your Numbers: A Scorecard Approach to Improved Medical and Financial Outcomes 307
Talya Miron-Shatz and Stephanie Gati

Introduction 307

The Need for Better Control of Chronic Diseases 309

The Scorecard Approach 310

Target Population and Advantages 311

Content of the Take Care Scorecard 311

Considerations for Health and Financial Literacy Scorecards 313

Limitations 318

Implications for Financial Literacy 318

Summary 319

Discussion Questions 320

References 320

About the Authors 324

Acknowledgment 324

Part Four - Investor Psychology

Chapter 18 - Risk Perception and Risk Tolerance 327
Victor Ricciardi and Douglas Rice

Introduction 327

Risk Perception 328

The Relationship between Risk Perception and

Risk Tolerance 329

An Overview of Risk Tolerance 329

Measurement of Risk Tolerance 332

The Role of Emotion in Risk Perception and Risk Tolerance 334

Risk-Taking Behavior: The Influence of Market Moods, Business Cycles, and Economic Shocks 336

Unresolved Issues in the Risk Domain 340

Summary 341

Discussion Questions 342

References 342

About the Authors 345

Chapter 19 - Emotions in the Financial Markets 347
Richard Fairchild

Introduction 347

Behavioral Finance and Prospect Theory 348

Emotions 350

Emotions in the Financial Markets 351

Emotional Finance and Unconscious Emotions 353

Emotional Corporate Finance--A Formal Model 356

Summary 360

Discussion Questions 361

References 361

About the Author 364

Chapter 20 - Human Psychology and Market Seasonality 365
Lisa A. Kramer

Introduction 365

Moods, Emotions, and Sentiment 366

Weather, Mood, and Markets 366

Daylight, Mood, and Markets 367

Daylight Saving Time Changes, Mood, and Markets 373

Elation, Deflation, and Markets 374

Summary 376

Discussion Questions 377

References 377

About the Author 380

Chapter 21 - Neurofinance 381
Richard L. Peterson

Introduction 381

Neuroscience Primer 382

Research Methods 385

The Neuroscience of Financial Decision-Making 387

The Implications of Neurofinance Research for Practitioners 395

Summary 397

Discussion Questions 398

References 398

About the Author 401

Chapter 22 - Diversification and Asset Allocation Puzzles 403
Dimitris Georgarakos

Introduction 403

Household Stock Market Participation 404

Changes in Household Portfolios across Time 407

Differences in Household Portfolios across Countries 408

Portfolio Diversification 410

Household Stock Trading Behavior 412

Summary 415

Discussion Questions 416

References 416

About the Author 420

Chapter 23 - Behavioral Portfolio Theory and Investment Management 421
Erick W. Rengifo, Rossen Trendafilov, and Emanuela Trifan

Introduction 421

Prospect Theory and Expected Utility Theory 421

Safety-First Portfolio Theory 426

SP/A Theory 427

Behavioral Portfolio Theory 430

Behavioral Asset Pricing Model 432

The BAPM, CAPM, and Three-Factor Model 432

Summary 435

Discussion Questions 435

References 435

About the Authors 438

Chapter 24 - Post-Crisis Investor Behavior: Experience Matters 439
Joseph V. Rizzi

Introduction 439

Behavioral Finance Framework 440

History Dependent Risk Tolerance: The Collective Memory Hypothesis 446

Summary 452

Discussion Questions 453

References 453

About the Author 455

Part five - Trading and Investing Psychology and Strategies

Chapter 25 - The Psychology of Trading and Investing 459
Julia Pitters and Thomas Oberlechner

Introduction 459

Personality Variables 461

Affect and Cognition 463

News, Rumors, and Market Mood 470

Summary 471

Discussion Questions 471

References 472

About the Authors 476

Chapter 26 - The Surprising Real World of Traders’ Psychology 477
Denise K. Shull, Ken Celiano, and Andrew Menaker

Introduction 477

What Science Reveals about How People Think 478

I Need to Be a Hero Again 485

The Heart of a Quant 487

Summary 489

Discussion Questions 490

References 490

About the Authors 493

Chapter 27 - Trading and Investment Strategies in Behavioral Finance 495
John M. Longo

Introduction 495

Distinction between Trading and Investment Strategies 496

Active versus Passive Investment Strategies and Behavioral Finance 496

Average Investors Suffer from Behavioral Biases 498

Problems with Traditional Investment Strategies 499

Short-Term Behaviorally Based Trading Strategies 503

Long-Term Behaviorally Based Investment Strategies 508

Current and Future Trends in Behavioral Finance Strategies 509

Summary 510

Discussion Questions 511

References 511

About the Author 512

Part Six - Special Investment Topics

Chapter 28 - Ethical and Socially Responsible Investing 515
Julia M. Puaschunder

Introduction 515

Socially Responsible Investment 515

Historical Emergence 517

International Differences 520

Institutional Harmonization of FSR 523

SRI in the Post 2008−2009 World Financial Crisis

Era of Globalization 524

Summary 525

Discussion Questions 527

References 527

About the Author 532

Chapter 29 - Mutual Funds and Individual Investors: Advertising and Behavioral Issues 533
John A. Haslem

Introduction 533

Advertising and Performance 534

Advertising, Expenses, and Flows 535

Advertising, Emotions, and Choice 536

Behavioral Persuasion In Advertising and Choice 539

Education, Financial Knowledge, and Choice 540

Emotions, Behavior, and Choice 542

Emotions, Behavioral Finance, and Choice 543

Financial Literacy and Active Management 544

Price and Performance Sensitivity and Repricing 546

Sentiment Contrarian Behavior and Actual Performance 548

Summary 550

Discussion Questions 552

References 552

About the Author 553

Chapter 30 - Real Estate Investment Decision-Making in Behavioral Finance 555
Eli Beracha and Hilla Skiba

Introduction 555

The Real Estate Market and the General Economy 556

Real Estate Market and Financial Market 556

Inefficiencies and the Real Estate Markets 557

Observed Inefficiencies in Real Estate Markets 563

Summary 569

Discussion Questions 569

References 570

About the Authors 572

Answers to the Discussion Questions 573

Index 615