Financial Behavior Analyst

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Financial Behavior

FINANCIAL MAKES AND INVESMENS SEIES H. Ken Baker and Greg Filbeck, Series Ediors Porolio Teory and Managemen Edied by H. Ken Baker and Greg Filbeck Public Real Esae Markes and Invesmens Edied by H. Ken Baker and Peer Chinloy Privae Real and Invesmens Edied by H.Esae Ken Markes Baker and Peer Chinloy Invesmen Risk Managemen Edied by H. Ken Baker and Greg Filbeck Privae Equiy: Opporuniies and Risks Edied by H. Ken Baker, Greg Filbeck, and Halil Kiymaz Muual Funds and Exchange-raded Funds: Building Blocks o Wealh Edied by H. Ken Baker, Greg Filbeck, and Halil Kiymaz

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Financial Behavior

PLA YERS, SERV ICES, PRODUCTS, AND MARKE

TS

H. KENT BAKER GREG FILBECK and VICTOR RICCIARDI

1

1 Oxord Universiy Press is a deparmen o he Universiy o Oxord. I urhers he Universiy’s objecive o excellence in research, scholarship, and educaion by publishing worldwide. Oxord is a regisered rade mark o Oxord Universiy Press in he UK and cerain oher counries. Published in he Unied Saes o America by Oxord Universiy Press 198 Madison Avenue, New York, NY 10016, Unied Saes o America. © Oxord Universiy Press 2017 All righs reserved. No par o his publicaion may be reproduced, sored in a rerieval sysem, or ransmited, in any orm or by any means, wihou he prior permission in wriing o Oxord Universiy Press, or as expressly permited by law, by license, or under erms agreed wih he appropriae reproducion righs organizaion. Inquiries concerning reproducion ouside he scope o he above should be sen o he ighs Deparmen, Oxord Universiy Press, a he address above. You mus no circulae his work in any oher orm and you mus impose his same condiion on any acquirer. Library o Congress Caaloging-in-Publicaion Daa Names: Baker, H. Ken (Harold Ken), 1944- edior. | Filbeck, Greg, edior. | icciardi, Vicor, edior. ile: Financial behavior : players, services, producs, and markes / [edied by] H. Ken Baker, Greg Filbeck, and Vicor icciardi. Descripion: New York Ciy : Oxord Universiy Press, 2017. | Series: Financial markes and invesmens series | Includes index. Idenifiers: LCCN 2016036009 | ISBN 9780190269999 (hardcover) Subjecs: LCSH: Invesmens Psychological aspecs. | Invesmens Decision making. | Finance Psychological aspecs. Classificaion: LCC HG4515.15 .F56 2016 | DDC 332.601/9 dc23 LC record available a htps://lccn.loc.gov/2016036009 9 8 7 6 5 4 3 2 1 Prined by Sheridan Books, Inc., Unied Saes o America

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Contents

Lis o Figures ix Lis o ables xi Acknowledgmens xiii Acronyms and Abbreviaions Abou he Ediors xix Abou he Conribuors xxi

Part One

xv

FINANCIAL BEHA VIOR AND PSYCHOLOGY

1. Financial Behavior: An Overview H. KENT BAKER, GREG

3

FILBECK, AND VICTOR RICCIARDI

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

23

VICTOR RICCIARDI

Part Two

THE FINANCI AL BEHAVIOR OF MAJOR PLA YERS

3. Individual Investors

45

HENRIK CRONQVIST AND DANLING JIANG

4. Institutional Investors

64

ALEXANDRE SKIBA AND HILLA SKIBA

5. Corporate Executives, Directors, and Boards JOHN R.

NOFSINGER AND

PA TTANAPORN CHA

79

TJUTHAMA

RD

v

vi

Contents

6. Financial Planners and Advisors

97

BENJAMIN F. CUMMINGS

7. Financial Analysts

118

SUSAN M. YOUNG

8. Portfolio Managers ERIK DEV TENAGLIA

135

OS, ANDREW C

9. Financial Psychopaths

. SPIELER

, AND JOSEPH

M.

153

DEBORAH W. GREGORY

FINANCIAL AND INVESTOR PSYCHOLOGY OF SPECIFIC PLAYERS

Part Three

10. The Psychology of High Net Worth Individuals REBECCA LI-

173

HUANG

11. The Psychology of Traders

192

DUCCIO MARTELLI

12. A Closer Look at the Causes and Consequences of Frequent Stock Trading 209 MICHAL STRAHILEVITZ

13. The Psychology of Women Investors MARGUERI

T A M. CHENG AND SAMEER S. SOMAL

14. The Psychology of Millennials APRIL RUDIN AND CA

Part Four

224

241

THERINE MCBREE

N

THE PSYCHOLOGY OF FINANCIAL SERVICES

15. Psychological Aspects of Financial Planning DAVE

YESKE AND ELISSA BUI

E

265

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Contents

16. Financial Advisory Services JEROEN NIEBOE

285

R, P AUL DOLAN, AND IVO VLAEV

17. Insurance and Risk Management

302

JAMES M. MOTEN JR. AND C. W. COPELAND

18. Psychological Factors in Estate Planning JOHN J. GUERI

N AND L. PA

318

UL HOOD JR.

19. Individual Biases in Retirement Planning and Wealth Management 337 JAMES E. BREWER JR. AND CHARLES H. SELF III

Part Five

THE BEHA VIORAL ASPECTS OF INVESTMENT PRODUCTS AND MARKETS

20. Traditional Asset Allocation Securities: Stocks, Bonds, Real Estate, and Cash 359 CHRISTOPHER MILLIKEN AND ANDREW C. SPIELER

, EHSAN

NIKBAKHT,

21. Behavioral Aspects of Portfolio Investments NA THAN MAUC

378

K

22. Current Trends in Successful International M&As NANCY HUBBARD

23. Art and Collectibles for Wealth Management PETER J.

Part Six

MA Y

MARKET EFFICIENCY ISSUES

24. Behavioral Finance Market Hypotheses ALEX PLASTUN

25. Stock Market Anomalies STEVE Z. FAN AND LINDA YU

460

439

422

397

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viii

Contents

26. The Psychology of Speculation in the Financial Markets

481

VICTOR RICCIARDI

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 HAROLD EVENSKY

29. Practical Challenges of Implementing Behavioral Finance: Reflections from the Field 542 GREG B. DA

VIES AND PETER BRO

30. The Future of Behavioral Finance MICHAEL DOWLING AND BRIAN LUCEY

Discussion Quesions and Answers Index 611

579

OKS 561

523

ix

List of Figures

11.1 14.1 14.2 14.3 14.4 14.5 14.6 14.7 15.1 15.2 15.3 15.4 15.5 20.1 22.1 22.2 22.3 22.4 22.5 22.6 22.7 22.8 22.9 24.1 24.2 24.3 25.1

Main ypes o Bias Affecing raders’ Invesmen Decisions 194 Views o he American Dream, by Age Group 243 Knowledge Level or Invesors by Age Group and Income 244 Survey esponses o Quesion abou eiremen Planning 246 Degree o Advisor Use, by Age Group and Income 248 Generaional Crieria or Making Invesmen Decisions 251 Clien Familiariy wih Invesmen erms 257 Likelihood o Clien Use o Financial Services via echnology 258 Te Holon in Financial Planning 271 Componens o rus and Commimen 274 Major Facors or Building he rus and Commimen elaionship 274 echnical Qualiy, Funcional Qualiy, and Communicaion Effeciveness 275 Saisacion and rus as Anecedens o Commimen 276 Perormance o U.S., Inernaional, and Emerging Marke Sock Indexes 370 easons Given or Mos ecen Acquisiion rom Execuives o 50 Inernaional Companies 403 Views on Amoun o Shareholder Value Gained rom Mos ecen Acquisiion 406 Views on Compeiive Advanage Gained rom Mos ecen Acquisiion 407 Advance Planning ime or Domesic and Inernaional Acquisiions 411 Comparison o ime Spen on Synergisic Evaluaions, Domesic and Inernaional Acquirers 412 Anicipaed Synergies or Domesic and Inernaional Acquisiions 413 op Tree H Concerns afer Acquisiion by Cross-Border Company 414 ime Needed o Appoin Senior Managemen afer Company Acquisiion 416 Saed easons or Acquisiion Success 417 andomly Generaed Values 441 Gold Prices or Tree-Monh Period, 2006 442 Movemen o DJIA beween 2000 and 2013 449 ime Series o Annual eurns or wo Asse Growh Porolios 466

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25.2 25.3 27.1 27.2 27.3 27.4 27.5 28.1 28.2 28.3 28.4 28.5

List of Figures

Comparison o IPO/SEO Annual eurns and Maching Annual eurns o Non-issuing Companies 467 eurns o a Long–Shor Porolio Formed on Accruals 469 Buy-side Available Liquidiy Exceeding Sell-side Liquidiy 501 Impac o “Flickering Quoes” on Buy Offers 501 Impac o Aggressive HF Orders on Bid–Ask Spreads 503 Placemen o Passive HF Order 504 Number o Order Messages per Each Added Limi Order 509 Te elaion Beween isk and eurn 524 Te Efficien Porolio 524 Anchoring on he Efficien Fronier: isk olerance Exceeds isk Need 526 Anchoring on he Efficien Fronier: isk Need Exceeds isk olerance 527 isk educion hrough Diversificaion 528

xi

List of Tables

14.1 20.1 21.1 21.2 21.3 22.1 22.2 22.3 24.1 24.2 25.1 25.2 27.1 27.2 27.3 27.4 27.5 27.6 27.7 27.8

Social Media Mos Likely o Be Used or Specified Aciviies 256 Correlaion Marix o U.S., Inernaional, and Emerging Marke Sock Indexes 371 Annual Cash Flows in U.S. Muual Funds, Based on ICI Daa 380 Annual Cash Flows in U.S. Index Muual Funds, Based on ICI Daa 381 Annual Cash Flows and oal Asses o EFs, Based on ICI Daa 386 Financial and Inangible Facors or Marke Atraciveness, According o Execuives rom 50 Inernaional Companies 401 Irraional easons Cied or Acquisiions 405 Comparison o Due Diligence Underaken by Domesic and Cross-border Acquirers 409 Comparaive Characerisics o he Efficien Marke Hypohesis and he Fracal Marke Hypohesis 447 easons or Invesor Overreacions 451 Summary Saisics or Abnormal eurns o Zero-cos Porolios by Counry and Anomaly 462 eurns o Porolios Formed Based on Previous Sock eurns 468 Average Aggressive HF Paricipaion in Equiies on Augus 31, 2015 503 Sample rom Level III Daa (Processed and Formated) or GOOG on Ocober 8, 2015 506 Disribuion o Order Sizes in Shares ecorded or GOOG on Ocober 8, 2015 507 Disribuion o Difference beween Sequenial Order Updaes or All Order ecords or GOOG on Ocober 8, 2015 508 Size and Shel Lie o Orders Canceled in Full, wih a Single Cancellaion or GOOG on Ocober 8, 2015 509 Disribuion o imes beween Subsequen Order evisions or GOOG on Ocober 8, 2015 511 Disribuion o Duraion o Limi Orders Canceled wih an Order Message Immediaely Following he Order Placemen Message 512 Marke Order Execuions (Message ype “E”) and Oher Order ype Dynamics a 10-Message Frequency 514

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xii

27.9 27.10 27.11 28.1 28.2 29.1 30.1 30.2

List of Tables

Hidden Limi Order Execuions (Message ype “P”) and Oher Order ype Dynamics a 10-Message Frequency 515 Marke Order Execuions (Message ype “E”) and Oher Order ype Dynamics a 300-Message Frequency 516 Hidden Limi Order Execuions (Message ype “P”) and Oher Order ype Dynamics a 300-Message Frequency 517 Atribues o Invesing 531 Projeced eurn and isk Exposure under Differen isk Levels 533 Effec o Approaches o Behavioural Change on Knowledge, Engagemen, and Emoional Comor 555 Scopus Aricle Coun or “Behavioral Finance” and “Invesor Psychology” Keywords 564 Coun o Aricles in SSN Behavioral and Experimenal Finance eJournal 565

xiii

Acknowledgments

Te simpler you say i, he more eloquen i is. Augus Wilson

Publishing a book requires he involvemen o many people. Alhough acknowledging everyone who paricipaed in he process would be difficul, we would like o single ou he ollowing individuals. Firs, we grealy appreciae he helpul commens o he anonymous reviewers o our book proposal ha helped us fine-une our proposal. Second, he chaper auhors meri special hanks because wihou hem his book would no have been possible. We firmly believe ha every wrier needs an edior, because sel-ediing can be difficul and ofen leads o missed misakes. Our ask as ediors is o help our auhors convey conen in he mos effecive manner possible. Te dierence beween he righ word and nearly he wrie word can be enormous. As Arhur Plonik once said, “You wrie o communicae o he hears and minds o ohers wha’s burning inside you, and we edi o le he fire show hrough he smoke.” We also adhere o he noion expressed by E. B. Whie ha “Te bes wriing is rewriing.” Tereore, based on our edis and commens, mos auhors rewroe heir chapers a leas wice. Tey did so wihou complain a leas wihou any complains expressed direcly o us. Perhaps J. ussell Lynes was correc: “No auhor dislikes o be edied as much as he dislikes no o be published.” Tird, our parners a Oxord Universiy Press perormed in he same highly proessional manner ha hey have hroughou he Financial Markes and Invesmens Series. Scot Parris, Anne Dellinger, and Cahryn Vaulman helped seer he book hrough he early sages o he process while David Pervin and Emily MacKenzie played imporan roles laer in he process. Special hanks also go o ajakumari Ganessin (Projec Manager), Carole Berglie (Copyedior), and Claudie Peerreund (Indexer). Tese are jus a ew o he people who played imporan roles in his book projec. Fourh, we appreciae he research suppor provided by our respecive insiuions: he Kogod School o Business a American Universiy, he Behrend College a Penn Sae Erie, and he Business Managemen Deparmen a Goucher College. Finally, we hank our amilies or heir encouragemen and suppor and dedicae he book o hem: Linda and ory Baker; Janis, Aaron, Kyle, and Gran Filbeck; and Jaymie, Krisin, and Julianna Lun.

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Acronyms and Abbreviations

AAII ACA AC ADL AFS AHEAD AI AICPA AIM AMH APD AUM BLS BM CALIS CAPM CBOE CCAPM CD CEA CEO CF/P CFA CFO CFP CFC CO CPA CPI CP CD CM

American Associaion o Individual Invesors Affordable Care Ac o 2010 accepance and commimen herapy aciviy o daily living Academy o Financial Services Asse and Healh Dynamics among he Oldes Old appreciaive inquiry American Insiue o CPAs Affec Inusion Model adapive marke hypohesis anisocial personaliy disorder asses under managemen Bureau o Labor Saisics book-o-marke Covariance Analysis o Linear Srucural capial asse pricing model Chicago Board Opions Exchange consumpion CAPM cerificae o deposi Council o Economic Advisers chie execuive officer cash flow-o-price Charered Financial Analys chie financial officer Cerified Financial Planner Commodiy Fuures rading Commission commimen o rader Cerified Public Accounan consumer price index Cumulaive Prospec Teory Cenral egisraion Deposiory cusomer relaionship managemen

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Ac r o n ym s a n d A b br e v i a ti on s

D/P DB DB DC DJIA E/P EFFH EMH EPS EF FCA FCAA FDNA FEAS FINR FMH FPA FPSB FPSM FA GAO GDP GNH GWAS HF HNWI HO HS HWM IAFP IAPD IA IAD IBCFP IBD ICAPM ICFP IOC IPO IPS IR IS KMV LOP

dividends-o-price defined benefi dialecical behavioral herapy defined conribuion Dow Jones Indusrial Average earnings-o-price exended uncional fixaion hypohesis efficien marke hypohesis earnings per share exchange-raded und Financial Conduc Auhoriy Financial Counseling Associaion o America Financial DNA Assessmen Financial and Economic Atiudes evealed by Search Financial Indusry egulaory Auhoriy racal marke hypohesis Financial Planning Associaion Financial Planning Sandards Board Financial Planning Sraegy Modes Financial Terapy Associaion Governmen Accounabiliy Office gross domesic produc gross naional happiness genome-wide associaion sudies high-requency rading high ne worh individuals homeowners insurance Healh and eiremen Sudy high waer mark Inernaional Associaion or Financial Planning Invesmen Adviser Public Disclosure Invesmen Advisor epresenaive Invesmen Adviser egisraion Deposiory Inernaional Board or Sandards and Pracices or Cerified Financial Planners independen broker-dealers ineremporal capial asse pricing model Insiue o Cerified Financial Planners immediae or cancel iniial public offering invesmen policy saemen Individual eiremen Accoun Inernal evenue Service key mediaing variable law o one price

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Acr on y m s an d A bb r e v i at i o n s

M&A MBS MEC MFO MI MMF MMH MP MI MS MVO NAIC NAPFA NASD NBBO NEFE NES NFCC NFIP NLSY NPV NYSE OCIE OECD OP PCL PFS PMI QDIA C ed FD eg NMS EI IA SAA SAD SCF SEC SEO SIP SML SOA SO SSN SVI

merger and acquisiion morgage-backed securiy modified endowmen conrac muli-amily office moivaional inerviewing money marke und mood mainenance hypohesis modern porolio heory magneic resonance imaging moraliy salience mean-variance opimizaion Naional Associaion o Insurance Commissioners Naional Associaion o Personal Financial Advisors Naional Associaion o Securiies Dealers naional bes bid and offer Naional Endowmen or Financial Educaion Naional Employmen Savings rus Naional Foundaion or Credi Counseling Naional Flood Insurance Program Naional Longiudinal Survey o Youh ne presen value New York Sock Exchange Office o Compliance Inspecions and Examinaions Organizaion o Economic Cooperaion and Developmen opion pricing heory [Hare] Psychopahy Checklis Personal Financial Specialis Purchasing Managers’ Index qualified deaul invesmen alernaive randomized conrol rial egulaion Fair Disclosure SEC egulaion Naional Marke Sysems real esae invesmen rus egisered Invesmen Adviser sraegic asse allocaion seasonal affecive disorder Survey o Consumer Finances Securiies and Exchange Commission seasoned equiy offering Securiies Inormaion Processor securiy marke line Sociey o Acuaries sel-regulaory organizaion Social Science esearch Nework Google Search Volume Index

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SWF AA BW M UHNW UX VIX

sovereign wealh und acical asse allocaion aylor, Bean & Whiaker Morgage Corporaion error managemen heory ulra-high ne worh user experience CBOE Volailiy Index

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About the Editors

H. Kent Baker, CFA, CMA, is a Universiy Proessor o Finance in he Kogod School

o Business a American Universiy. Proessor Baker is an auhor or edior o 26 books, including Invesor Behavior Te Psychology o Financial Planning and Invesing,Behavioral Finance Invesors, Corporaions, and Markes, Porolio Teory and Managemen, Survey Research in Corporae Finance, and Undersanding Financial Managemen: A Pracical Guide. As one o he mos prolific finance academics, he has published more han 160 peer-reviewed aricles in such journals as he Journal o Finance, Journal o Financial and Quaniaive Analysis, Financial Managemen, Financial Analyss Journal,and Journal o Porolio Managemen. He has consuling and raining experience wih more han 100 organizaions. Proessor Baker holds a BSBA rom Georgeown Universiy; M.Ed., MBA, and DBA degrees rom he Universiy o Maryland; and an MA, MS, and wo PhDs rom American Universiy. Greg Filbeck, CFA, FM, CAIA, CIPM, PM holds he Samuel P. Black III Proessor

o Finance and isk Managemen a Penn Sae Erie, he Behrend College, and serves as he Inerim Direcor or he Black School o Business. He ormerly served as Senior VicePresiden o Kaplan Schweser and held academic appoinmens a Miami Universiy and he Universiy o oledo, where he served as he Associae Direcor o he Cener or Family Business. Proessor Filbeck is an auhor or edior o seven books and has published more han 90 reereed academic journal aricles in he Financial Analyss Journal, Financial Review, and Journal o Business, Finance, and Accouning among ohers. Proessor Filbeck holds and conducs raining worldwide or candidaes or he CFA, FM, and CAIA designaions. Proessor BSUniversiy rom Murray Sae Universiy, an MS rom Penn Sae Universiy, andFilbeck a DBAholds romahe o Kenucky. Victor Ricciardi is Assisan Proessor o Financial Managemen a Goucher College.

He eaches courses in financial planning, invesmens, corporae finance, behavioral finance, and he psychology o money. He is a leading exper on he academic lieraure and emerging research issues in behavioral finance. He co-edied Invesor Behavior Te Psychology o Financial Planning and Invesing. Proessor icciardi is he edior o several eJournals disribued by he Social Science esearch Nework (SSN) a

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www.ssrn.com, including: behavioral finance, financial hisory, behavioral economics, and behavioral accouning. He received a BBA in accouning and managemen rom Hosra Universiy and an MBA in finance and Advanced Proessional Cerificae (APC) a he graduae level in economics rom S. John’s Universiy. He also holds a graduae cerificae in personal amily financial planning rom Kansas Sae Universiy. He can be ound on [email protected]orricciardi.

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About the Contributors

Irene Aldridge is he Managing Direcor, esearch and Developmen, AbleMarkes.

com and ABLE Alpha rading LD, where she designs, implemens, and deploys proprieary rading sraegies. She is also Presiden o AbleMarkes.com, a plaorm o predicive marke microsrucure analyics. Ms. Aldridge is he auhor o HighFrequency rading: A Pracical Guide o Algorihmic Sraegies and rading Sysems. Beore joining ABLE Alpha, she augh graduae quaniaive finance courses a several U.S. universiies. She has conribued o many governmen regulaory panels, including he U.K. Governmen Foresigh Commitee or Fuure o Compuer rading and he U.S. Commodiy Fuures rading Commission’s Subcommitee on HighFrequency rading. Ms. Aldridge holds a BE in Elecrical Engineering rom Cooper Union, an MS in Financial Engineering rom Columbia Universiy, and an MBA rom INSEAD. She has also sudied in wo PhD programs, including IEO a Columbia Universiy. Michal Srahileviz is a Visiing Associae Proessor a Te Cener or Advanced

Hindsigh a Duke Universiy. Previously, she was a aculy member a Golden Gae Universiy, Universiy o Arizona, Universiy o Miami, and Universiy o Illinois. She was also a visiing aculy member a he Universiy o Michigan, and Universiy o Caliornia a Berkeley. She has published in he Journal o Consumer Research, Journal , and o Markeing Research, Journal o Consumer Psychology, Journal o Business Research Journal o Nonprofi & Public Secor Markeing. Much o her published research ocuses on how emoions affec decision making in areas relaed o invesing, shopping, and donaing o chariy. She blogs or Psychology oday and consuls or-profi and nonprofi companies. Proessor Srahileviz received an MBA rom el Aviv Universiy and a PhD rom he Universiy o Caliornia a Berkeley. James E. Brewer Jr. is Presiden o Envision Wealh Planning and Envision 401(k)

Advisors. He works wih individuals and small businesses o incorporae heir values ino heir financial vision using a holisic, behavioral financial planning process. He is a Cerified Financial Planner proessional, Accredied Invesmen Fiduciary, Charered eiremen Planning Consulan, and Proessional Plan Consulan. Mr. Brewer was a op 100 Social Media Financial Advisor in he Unied Saes rom 2013 o 2015. His hough leadership has been eaured or cied in U.S. News and World Repor, Te Wall

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Sree Journal, Voices: James Brewer, on Using ERISA 3(38) Invesmen Managers , and Forbes. He holds an M.S. rom he Massachusets Insiue o echnology. Peer Brooksis a Behavioral Finance ransormaion Direcor wih Barclays. He joined

Barclays in March 2007 and works wih a eam o expers o develop and implemen commercial applicaions drawing on behavioral porolio heory, he psychology o judgmen and decision making, and decision sciences. He has worked in London and Singapore, and his curren posiion ocuses on bringing he bes o behavioral finance o sel-direced invesors hrough Inerne channels. Dr. Brooks has published in he Journal o Risk and Uncerainy, Teory and Decision, and conribued o he Wiley Encyclopedia o Operaions Research and Managemen Science. He has been a regular conribuor o he leading prin and elevision media on opics relaed o invesing privae wealh. He holds a PhD in behavioral and experimenal economics rom he Universiy o Mancheser. His docoral hesis ocused on experimenal research ino individual atiudes o moneary gains and losses. Elissa Buie, CFP, is CEO o Yeske Buie, and holds an appoinmen as Disinguished

Adjunc Proessor in Golden Gae Universiy’s Ageno School o Business, where she eaches he capsone case course in he financial planning program. She is a pas chair o boh he Financial Planning Associaion and he Foundaion or Financial Planning, he later being he only nonprofi devoed solely o osering and supporing he delivery o pro bono financial planning services o hose in need. She is also a dean in he FPA’s residency program. She has published in heJournal o Financial Planning and conribued chapers o he firs and second ediions o he CFP Board’s Financial Planning Compeency Handbook and Invesor Behavior: Te Psychology o Financial Planning and Invesing. She holds a BS in commerce rom he Universiy o Virginia’s McInire School and an MBA rom he Universiy o Maryland. Patanaporn Chajuhamard is an Associae Proessor o Finance a Sasin Graduae

Insiue o Business Adminisraion o Chulalongkorn Universiy, Bangkok, Tailand. Beore joining he aculy a Sasin, she was an assisan proessor a exas A&M Inernaional Universiy in Laredo, exas, beween 2002 and 2006. She was also a visiing proessor a Levin Graduae Insiue, he Universiy a Buffalo, in 2006. Her primary research ineress include corporae finance, corporae governance, and inernaional financial markes. She has published in leading scholarly and proessional journals, including he Journal o Financial Inermediaion, Journal o Corporae Finance, Journal o BankingReview and Finance, Journaland o Financial Research,Chajuhamard Journal o Business Ehicsa, and Inernaional o Economics Finance. Proessor received PhD rom he Universiy o Wisconsin Milwaukee. Margueria M. Cheng is he Chie Execuive Officer a Blue Ocean Global Wealh.

Beore co-ounding Blue Ocean Global Wealh, she was a Financial Advisor a Ameriprise Financial and an analys and edior a owa Securiies in okyo, Japan. Ms. Cheng is a spokesperson or he AAP Financial Freedom Campaign, a regular columnis or Kiplinger, and ormer Financial Planning Associaion (FPA) naional board member. As a Cerified Financial Planner Board o Sandards (CFP Board) Ambassador, Ms. Cheng helps educae he public, policymakers, and media abou he benefis o compeen, ehical financial planning. She is a CFP proessional, a Charered

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eiremen Planning Counselor, a Cerified Divorce Financial Analys, and eiremen Income Cerified Proessional. C. W. Copeland is an Assisan Proessor o Insurance or Te American College o

Financial Services. He has 18 years o college eaching experience and nearly 20 years as a financial services praciioner. He is a regisered represenaive wih Cape Securiies and an Invesmen Advisor epresenaive wih Cape Invesmen Advisors and mainains a Series 65, Series 7, Series 6, Series 63, Lie and Healh, Propery and Casualy Insurance licenses in muliple saes. He co-auhored Applicaions in Financial Planning II, and edied McGill’s Lie Insurance, 10h Ediion, Essenials o Lie Insurance Producs, 4h Ediion, Essenials o Disabiliy Income Insurance, 4h Ediion, and Financial Services Overview: FP99 Financial Services Pracicum. Proessor Copeland holds a PhD in financial planning rom he Universiy o Georgia wih a research ocus on behavioral finance. He also holds he eiremen Income Cerified Proessional (ICP) designaion, Charered Financial Consulan (ChFC), and Charered Lie Underwrier proessional designaions. Henrik Cronqvis is Proessor o Finance a he Universiy o Miami, where he conducs

inerdisciplinary research and eaches finance, enrepreneurship, and managemen. His research involves behavioral finance and corporae finance. His work has been published in op journals in economics, including he American Economic Review and Journal o Poliical Economy, as well as in finance, including he Journal o Finance, Journal o Financial Economics, and Review o Financial Sudies. He is ofen invied o give seminars a academic conerences and o execuives and public policymakers around he world. Several o his research papers have been recognized wih bes paper awards a inernaional conerences, and have been sponsored by compeiive research grans. His work has been eaured in BusinessWeek, Te Economis, Financial imes, Te Wall Sree Journal, and on CNBC and CNN. Proessor Cronqvis received a PhD in finance rom he Universiy o Chicago. Benjamin F. Cummings, CFP®, is an Associae Proessor o Behavioral Finance a he

American College o Financial Services. Beore his curren posiion, he was an Assisan Proessor a Sain Joseph’s Universiy in Philadelphia, PA and a Scholar in esidence a CFP Board in Washingon, DC. Proessor Cummings also worked or FJY Financial, a ee-only financial planning firm in eson, Virginia. He has compleed award-winning research on he use and value o financial advice, and has worked on unded projecs relaed o personal he regulaion o proessional financial Proessor Cummings received a PhD in financial planning rom exasadvice. ech Universiy. Greg B. Davies recenly ounded Cenapse, a firm dedicaed o applying sophisicaed

behavioral insigh o design, develop, and deploy soluions across indusries o help people and organizaions make beter decisions. Over he las decade, as head o Behavioral-Quan Finance a Barclays, Dr. Davies buil and led he world’s firs applied behavioral finance eam, implemening behavioral design ino he bank’s ools, sysems, proposiions, producs, and organizaional processes. He is an Associae Fellow a Oxord Universiy’s Saïd Business School, and his firs book, Behavioral Invesmen Managemen, was published in 2012. He has auhored papers in muliple academic disciplines, and is a requen media commenaor on behavioral finance. Dr. Davies co-creaed he

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“realiy opera”Open Oucry, which urns he behavior o a uncioning rading floor ino a musical perormance, which received is première in London in November 2012. He holds an undergraduae degree rom he Universiy o Cape own, and an MPhil in economics and PhD in behavioral decision heory, boh rom Cambridge Universiy. Erik Devos is he JP Morgan Chase Proessor in Business Adminisraion and

Proessor o Finance a he College o Business Adminisraion o he Universiy o exas El Paso. He previously augh a Ohio Universiy and Binghamon Universiy (SUNY). He has published in finance and accouning journals such as Review o Financial Sudies, Journal o Accouning and Economics, Journal o Corporae Finance, Financial Managemen, and Journal o Banking and Finance. He has also published in real esae journals such as Real Esae Economics, Journal o Real Esae Economics and Finance, and Journal o Real Esae Research. Proessor Devos serves as an associae edior or he Financial Review. He received a maser’s degree in financial economics rom Erasmus Universiy in oterdam and a PhD in finance rom Binghamon Universiy (SUNY). Paul Dolan is an inernaionally renowned exper on happiness, behavior, and public

policy. He is currenly Proessor o Behavioural Science in he Deparmen o Social Policy a he London School o Economics and Poliical Science, and Direcor o he new Execuive MSc in Behavioural Science. In 2010, he co-auhored he Mindspace repor published by he U.K. Cabine Office, advising local and naional policymakers on how effecivelyouse behavioral insighs in heir policy seting. He received a PhD rom heoUniversiy York. Michael Dowling is an Associae Proessor o Finance in ESC ennes School o

Business in France, where he primarily researches behavioral asse pricing, especially in energy markes. He has published in such journals as Energy Economics and Energy Policy and Economics Leters. Proessor Dowling is currenly he Co-Edior-in-Chie o he Journal o Behavioral and Experimenal Finance, which concenraes on rigorously invesigaing he exen o which behavioral principles drive financial behavior. He received a PhD rom riniy College Dublin. Harold Evensky is Chairman o Evensky & Kaz/Foldes Financial, a 30-year-old

wealh managemen firm, and Proessor o Pracice a exas ech Universiy. He has served as chair o he CFP Board o Governors and he Inernaional CFP Council and he isnamed he research columnis or he Mr. Evensky Journal Financial Planning. people has been by Invesmen Advisor as one o heo“25 mos influenial in he financial planning indusry,” by Financial Planning as one o five “Movers, Shakers and Decision Makers, Te Mos Influenial People in he Financial Planning Proession,” and by Invesmen News as one o he “25 Power Elie” in he financial services indusry. He co-auhored New Wealh Managemen, Wealh Managemen, and co-edied Te Invesmen Tink ank: Teory, Sraegy, and Pracice or Advisors and Reiremen Income Redesigned: A Maser Plan or Disribuion. He received his BCE and MS degrees rom Cornell Universiy.

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Seve Z. Fan is an Associae Proessor o Finance a he College o Business and

Economics, Universiy o Wisconsin Whiewaer. Beore his career in finance, he worked as a research assisan proessor a Marquete Universiy. Proessor Fan’s research ocuses on equiy anomalies, corporae governance, and insiuional invesors. He has published in Mulinaional Finance Journal, Inernaional Journal o Business and Finance Research, and Journal o Finance and Accounancy, among ohers. Proessor Fan received a BS in mechanical engineering rom Zhangzhou Universiy, China, a PhD in biomedical engineering rom a join program rom Universiy ennessee and Universiy o Memphis, and a PhD in finance rom he Universiy o Wisconsin Milwaukee. Deborah W. Gregory is an Assisan Proessor a Benley Universiy in Walham,

Massachusets. As a cerified Jungian psychoanalys (IAAP, C.G. Jung Insiue, Boson) and Charered Financial Analys (CFA). Proessor Gregory’s research ocuses on he behavioral aspec o individuals’ relaion o money. She received a scholarly award rom Benley or her book Unmasking Financial Psychopahs: Inside he Minds o Invesors in he weny-Firs Cenury (2014). She has published in he Journal o Finance, Financial Analyss Journal, NYU Salomon Brohers Monograph Series, Journal o Business and Economic Sudies, Journal o Financial Crime,and Journal o Behavioral Finance & Economics, among ohers. Proessor Gregory received a PhD in finance rom he Universiy o Florida. John J. Guerin is he owner o Dela Psychological Associaes, P.C. He has more han

30 years o experience in he pracice o boh clinical and organizaional psychology. Experience wih boh group dynamics and amily sysems has allowed him o effecively coach individuals in organizaions and o work wih groups in corporae and amilybased businesses. Wih more han 20 years o experience in mediaion and orensic pracice, he has demonsraed skills in orging consensus in challenging siuaions and helping organizaions navigae difficul adversarial siuaions and culural ransiions. Dr. Guerin is an exper in organizaional, eam, and individual assessmen, using high sandards in scienific assessmen mehodology. He is acive in emergen effors o collaborae across proessional boundaries and develop more effecive ools or diagnosis and inervenion. He is a Licensed Psychologis in independen pracice in Pennsylvania and New Jersey, and collaboraes wih organizaional consuling firms as an independen consulan. He received an M.A. degree rom he Universiy o Chicago and a PhD rom emple Universiy in Philadelphia. L. Paul Hood Jr. is he Direcor o Planned Giving a Te Universiy o oledo

Foundaion. He previously served as Direcor o Gif Planning or Te Universiy o Monana Foundaion. A sel-syled “recovering ax lawyer,” Mr. Hood praciced ax and esae planning law or 20 years in Louisiana. He is he auhor or co- auhor o five books on esae planning, chariable planning, buy-sell agreemens, and business valuaion and is a requen speaker and wrier on esae planning and business valuaion. Te aher o wo eenaged boys, he enjoys reading, bu his passion is baseball. Mr. Hood served as Presiden o he oledo Area Parnership or Philanhropic Planning in 2014.

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He obained his undergraduae and law degrees rom Louisiana Sae Universiy and a LL.M. in axaion rom Georgeown Universiy Law Cener. Nancy Hubbard holds he Miriam Kaowiz Chair in Managemen and Accouning a

Goucher College, Maryland. She is also a member o he aculy o Moscow’s School o Managemen, SKOLKOVO (ussia) and he Universiy o Marseilles (France). She is a ormer lecurer a he SaÏd Business School and Associae Fellow a Oxord Universiy (empleon College), as well as a managemen consulan wih Spicer & Oppenheim (which is par o Booz, Allen & Hamilon) and KPMG. She has published in he Human Resources Managemen Journal, Journal o Proessional HRM, and European Reail Diges, among ohers. She has published several books, including Acquisiion: Sraegy and Implemenaion and Conquering Global Markes: Secres fom he World’s Mos Successul Acquirers. She holds a BS in business rom Georgeown Universiy and a MS and PhD rom Oxord Universiy in managemen. Danling Jiang is he Associae Proessor o Finance a he College o Business, Sony

Brook Universiy. Her research involves sudying invesmens, corporae finance, and financial decision-making rom behavioral approaches. Her research inegraes economics, psychology, poliical science, and sociology ino finance. Proessor Jiang’s work has been published in leading journals spanning he fields o finance, managemen, accouning, and judgmen and decision-making, including he Review o Financial Sudies, Managemen Science, Organizaional Behavior and Human Decision Processes, Journal o Financial and Quaniaive Analysis, Review o Finance, and Review o Accouning Sudies, among ohers. She has served as a reviewer or many journals in finance, economics, managemen, and psychology as well as various publishers and inernaional unding agencies. She serves on he Advisory Council or he Financial Analyss Journal and in various roles or many conerences and associaions. Proessor Jiang received a PhD in finance rom he Ohio Sae Universiy. Rebecca Li-Huang is a wealh advisor o high ne work individuals. In addiion

o wealh managemen and invesmen advisory pracices a Merrill Lynch, her proessional experience includes capial markes, equiy research, corporae finance, and projec managemen a oher financial services and echnology firms. She is he auhor o Green Apple Red Book: A rial and Errors, which was honorably menioned in London, New York, San Francisco, and Paris Book Fesivals. She has undergraduae sudy a he Universiy o Science and echnology o China, a Maser o Science in elecrical rom Purdue Universiy, andSchool an MBA finance and inernaional economicsengineering rom he Universiy o Chicago Booh oinBusiness. Brian Lucey is Proessor o Finance in riniy College Dublin. He has more han a

100 peer-reviewed publicaions across he specrum o behavioral finance and beyond. Proessor Lucey has published in such journals as he Journal o Banking & Finance, Small Business Economics, and Quaniaive Finance. He is currenly Edior-in-Chie o Inernaional Review o Financial Analysis and Finance Research Leters, and Associae Edior o he Journal o Banking & Finance. He received a PhD rom he Universiy o Sirling.

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xxvii

Duccio Marelli is an Assisan Proessor o Finance a he Universiy o Perugia

(Ialy) and summer school proessor a Harvard Universiy. He has also been a visiing proessor o finance a he Universiy o Applied Sciences in Augsburg, Germany. Proessor Marelli eaches undergraduae and graduae courses in behavioral finance, corporae finance, privae banking and financial markes. His main research ineress include behavioral and neurofinance, financial educaion, real esae finance, and asse managemen. He has presened his research a naional and inernaional conerences and has published in European Financial Managemen and Journal o Economics and Business. He also serves as a reeree on several peer-reviewed finance journals. Proessor Marelli advises firms and no-or-profi organizaions in he areas o financial educaion and asse managemen. He received a BA cum laude rom Bocconi Universiy and a PhD in banking and finance rom Universiy o ome “or Vergaa.” Nahan Mauck is an Assisan Proessor o Finance a he Henry W. Bloch School o

Managemen, Universiy o Missouri-Kansas Ciy. His research ocuses on sovereign wealh unds, mergers and acquisiions, payou policy, corporae finance, and behavioral finance. He has published in Journal o Banking & Finance, Journal o Behavioral Finance, Journal o Corporae Finance, Journal o Financial Inermediaion, Journal o Financial Research, and Journal o Inernaional Business Sudies, among ohers. Proessor Mauck is he recipien o he American eal Esae Sociey Bes Paper in eal Esae Porolio Managemen (2015) and muliple eaching awards, including he UMKC Chancellor’s Early Career Award or Excellence in eaching (2015) and Bloch Favorie Faculy Member o he Year (2014). He received a BS in finance rom Kansas Sae Universiy and a PhD in finance rom Florida Sae Universiy. Peer J. May, CFP, is an independen wealh advisor. He creaed and manages “Ar

Soluions…Bes in Pracice,” a LinkedIn discussion group wih more han 4,300 members rom proessionally and geographically diverse backgrounds across he globe. Mr. May also developed “Te Personal Wealh Specrum,” an inegraed educaional ool o assis cliens in beter undersanding muli-generaional risk miigaion. He has been a requen speaker and conribuor o aricles on financial planning and ar preservaion echniques or individuals and amilies. Mr. May received a BS in accouning rom S. Louis Universiy, a JD rom Capial Universiy Law School, and an LLM in axaion rom Villanova Universiy School o Law. He passed he Uniorm CPA Examinaion and he NASD Series 7. Caherine McBreen is he Managing Direcor o Specrem Group, a marke research

and consuling firm specializing in he affluen and reiremen markes. Ms. McBreen is Presiden and Edior o Specrem Group’s websie, Millionaire Corner, which presens srcinal research and reporing and eaure sories o mee he inormaional needs o boh new and seasoned invesors. She is a member o he American Bar Associaion, Illinois Bar Associaion, and Chicago Bar Associaion. Ms. McBreen is a requen speaker a indusry conerences and has been widely quoed by he prin and broadcas financial media, including Te Financial imes, Te Wall Sree Journal, CNBC Closing Bell, Neal Cavuo a Fox Business News, and ABC and CBS radio. She coauhored Ge Rich, Say Rich, Pass I On: Te Wealh-Accumulaion Secres o America’s Riches Families.

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She has a BS summa cum laude rom Norhwesern Universiy and a JD rom DePaul Universiy School o Law. Chrisopher Milliken, CFA, is an indusry proessional and Vice Presiden o Hennion

& Walsh Asse Managemen’s Porolio Managemen Program. Hennion & Walsh is a egisered Invesmen Advisory firm ha uses EFs o consruc invesmen sraegies. Mr. Milliken works under he chie invesmen officer, conducs research on capial markes and asse allocaion sraegy, and oversees he sales and rading desk. He received a BS in business adminisraion wih a ocus in finance rom Maris College. James M. Moen Jr. is an Assisan Proessor o Finance a Eas Cenral Universiy. He

has more han 10 years o college eaching experience. Proessor Moen is a financial advisor, represenaive, and regisered principal or PFS Invesmens and sill mainains a Series 26, Series 65, Series 6, Series 63, Lie and Healh and Propery and Casualy Insurance Licenses. BV published his book, Inroducory Financial Managemen: Teory and Applicaion, second ediion, in 2014. He received an MS in finance, MS in accouning, and MS in economics, all rom exas A&M Universiy Commerce; an MBA rom Cameron Universiy; Graduae Cerificae in Financial Planning rom Kansas Sae Universiy; an MS in acquisiion and conrac managemen rom Florida Insiue o echnology; and a PhD in business adminisraion wih a financial managemen concenraion rom Norhcenral Universiy. Proessor Moen also holds he Cerified Financial Planner (CFP), Charered Financial Consulan (ChFC), Charered eiremen Planning Counselor (CPC), Charered Muual Fund Counselor (CMFC), and eiremen Income Cerified Proessional (ICP) proessional designaions. Jeroen Nieboer is a behavioral economis specializing in financial decisions and

decision-making under risk and is currenly based a he London School o Economics and Poliical Science. His research srcinaed using experimenal mehods o sudy financial risk aking in groups. He acively collaboraes wih financial advice chariies such as SepChange and he Ciizens Advice Bureau, and has aced as a consulan o many companies in he finance and insurance secors. He obained his PhD rom he Universiy o Notingham. Ehsan Nikbakh, CFA, FRM, is Proessor o Finance in he Frank G. Zarb School o

Business a Hosra Universiy and previously served as deparmen chair and Associae Dean. He served on he Advisory Board o he Inernaional Associaion o Financial Engineers and Chair o Derivaives Commitee o he New York Sociey o Securiy Analyss. Proessor Nikbakh currenly serves on he ediorial board o Global Finance Journal. He auhored Finance and Foreign Loans and Economic Perormance. Proessor Nikbakh received a BA rom he ehran School o Business, an MBA rom he Iran Cener or Managemen Sudies, and a DBA in finance rom he George Washingon Universiy. John R. Nofsinger is he William H. Seward Endowed Chair in Inernaional Finance a

he College o Business and Public Policy a he Universiy o Alaska Anchorage. He is one o he world’s leading expers on behavioral finance. He has auhored/coauhored 10 finance rade books, exbooks, and scholarly books ha have been ranslaed ino 11 languages. Proessor Nosinger is a prolific scholar who has published more han

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50 aricles in peer-reviewed journals, including presigious scholarly journals such as he Journal o Finance and Journal o Financial and Quaniaive Analysis and praciioner journals such as he Financial Analyss Journaland Journal o Wealh Managemen. He is ofen quoed in he financial media, including he Te Wall Sree Journal, Financialimes, Forune, Business Week, Smar Money, Money Magazine, Washingon Pos, Bloomberg, Nighly Business Repor, and CNBC, and oher media rom Te Dolans o TeSree. com. Proessor Nosinger received a PhD rom Washingon Sae Universiy. Alex Plasun is Associae Proessor and he Chair o Accouning and Audiing a he

Ukrainian Academy o Banking (UAB). Beore joining he UAB, he was a rader and analys in several invesmen companies, including Admiral Markes Ld, ForexService Ld., and SumyForexClub Ld. He sill rades in he differen financial markes using his own rading sraegies. Proessor Plasun ries o reconcile his experience as a rader wih he academic heory and is consanly searching or marke inefficiencies. He has published in such oules as he Journal o Economics and Finance, Compuaional Economics, and Corporae Ownership and Conrol. Proessor Plasun holds a PhD in finance rom he Ukrainian Academy o Banking. Vicor Ricciardi is an Assisan Proessor o Financial Managemen a Goucher College.

He eaches courses in financial planning, invesmens, corporae finance, behavioral finance, and he psychology o money. He is a leading exper on he academic lieraure and emerging research issues in behavioral finance. He co-edied Invesor Behavior Te Psychology o Financial Planning and Invesing. Proessor icciardi is he edior o several eJournals disribued by he Social Science esearch Nework (SSN) a www.ssrn.com including: behavioral finance, financial hisory, behavioral economics, and behavioral accouning. He received a BBA in accouning and managemen rom Hosra Universiy and an MBA in finance and Advanced Proessional Cerificae (APC) a he graduae level in economics rom S. John’s Universiy. He also holds a graduae cerificae in personal amily financial planning rom Kansas Sae Universiy. He can be ound on [email protected]orricciardi. April Rudin, Founder o Te udin Group, is an acclaimed financial services/wealh

managemen markeing firm. Her experise ceners on wealh, millennials, and echnology/finech. Te udin Group, ounded in 2008, designs bespoke markeing campaigns or some o world’s mos imporan financial services firms. Ms. udin is a regularly eaured source o exper commenary o inernaional news/business oules rade publicaions. She has creaed Pos, and mainains exensive houghand leadership domain eaured on also Huffingon American an Banker, CFA Enerprising Invesor, Family Wealh Repor, Wealhmanagemen.Com, and many oher rade publicaions. Ms. udin is a judge or Family Wealh epor’s Annual Wealh Managemen Indusry awards, a member o he PAM (Privae Asse Managemen) Advisory board, and serves on he Global Board o Direcors or he Hedge Fund Associaion (HFA). She also heads he ediorial board or NexChange, a global financial services’ neworking sar-up. Charles H. Self III, CFA, is Chie Operaing Officer and Chie Invesmen Officer o

iSecors, a provider o ousourced invesmen managemen services. He has experience in porolio managemen and working wih cliens. He conducs inerviews in various

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media, including Fox Business News, Bloomberg Radio, and Te Wall Sree Journal. Mr. Sel has an MBA in saisics and finance rom he Universiy o Chicago. Alexandre Skiba is an Assisan Proessor a he Deparmen o Finance and

Economics a he Universiy o Wyoming. He eaches inernaional economics and business, macroeconomics, and economerics. His research ineress are in he areas o inernaional rade and finance, insiuional invesors, and real esae finance. Specifically, his work deals wih produc qualiy o inernaionally raded goods and he effecs o rade barriers on rade, as well as specializing and rading choices and perormance o insiuional rades. Proessor Skiba has published in such journals as he Journal o Poliical Economy, Journal o Developmen Economics, and Review o Inernaional Economics. Proessor Skiba received a PhD rom Purdue Universiy. Hilla Skiba is an Assisan Proessor a he Deparmen o Finance and eal Esae

a Colorado Sae Universiy. She eaches courses in real esae, invesmens, and inernaional finance wih behavioral finance applicaions. Her research ineress are mainly in he areas o inernaional finance, insiuional invesor perormance, and real esae finance. Specifically, her work deals wih culural influences on financial decision making, under-diversificaion and perormance, and he behavior o real esae marke paricipans. Proessor Skiba has published in such journals as he Journal o Financial Economics, Journal o Banking & Finance, and Journal o Corporae Finance. Her research has earned several awards, including he bes paper award a he Asian Finance Associaion meeings. Proessor Skiba received a PhD in finance rom he Universiy o Kansas. Sameer S. Somalis he Chie Financial Officer a Blue Ocean Global Wealh. Beore co-

ounding Blue Ocean Global Wealh, he was a Senior Invesmen Analys a Te Bank o Nova Scoia and a Financial Advisor and Inermediary a Morgan Sanley and Merrill Lynch & Co. Mr. Somal serves on CFP Board’s Council on Educaion and is a Women’s Iniiaive (WIN) Advocae. He is an acive member a CFA Insiue, a Board Advisor a he iPlan Educaion Insiue (New Delhi, India), and serves on he Board o Direcors o he Philadelphia ri-Sae Financial Planning Associaion (FPA). Mr. Somal is a CFA Charerholder, a CFP proessional, and a Charered Alernaive Invesmen Analys. Andrew C. Spieler, CFA, FRM, CAIA, is a Proessor o Finance in he Frank G. Zarb

School o Business a Hosra Universiy. He has published in Real Esae Economics, Journal o Real Esae Finance and Economics, Journal o Real Esae Porolio Managemen, Journal o Applied Finance, among ohers. He served as chair o he Derivaives Commitee a he New York Sociey o Securiies Analyss. Proessor Spieler also serves as co-direcor o he annual real esae conerence sponsored by he Wilbur F. Breslin Cener or eal Esae Sudies. He received undergraduae degrees in mah and economics rom Binghamon Universiy (SUNY), an MS in finance rom Indiana Universiy, and an MBA and PhD rom Binghamon Universiy (SUNY). Joseph M. Tenaglia, CFA, is an Emerging Markes Porolio Specialis a Emerging

Global Advisors, which is a bouique emerging and ronier markes asse managemen firm ha offers core and hemaic exchange-raded unds. Mr. enaglia is a member o

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he firm’s Invesmen Sraegy eam and is responsible or creaing conen around he emerging markes environmen while also promoing he firm’s research and sraegies o insiuional invesors. He previously worked a Bank o New York Mellon Asse Managemen in several roles. Mr. enaglia graduaed rom Boson College wih a BS in finance and markeing. He is a member o he New York Sociey o Securiy Analyss. Ivo Vlaev joined Warwick Business School as a Proessor o Behavioural Science in

2014. He previously worked a he Universiy o Warwick, Universiy College London, and Imperial College London. He sudies decision making rom he perspecives o psychology, neuroscience, and economics. In 2010, he co-auhored he Mindspace repor published by he U.K. Cabine Office, advising local and naional policymakers on how o effecively use behavioral insighs in heir policy seting. He received a DPhil in Experimenal Psychology rom S. John’s College, Oxord. Dave Yeske, CFP, is Managing Direcor a Yeske Buie and financial planning program

direcor a Golden Gae Universiy’s Ageno School o Business, where he holds an appoinmen as Disinguished Adjunc Proessor. He is a pas chair o he Financial Planning Associaion, where he has also chaired he poliical acion commitee, esearch Cener eam, and Academic Advisory Council. He now serves as Praciioner Edior o FPA’s Journal o Financial Planning. Proessor Yeske has published in he Journal o Financial Planning and conribued chapers o he firs and second ediions o CFP Board’s Financial Planning Compeency Handbookand Invesor Behavior: Te Psychology o Financial Planning and Invesing. He holds a BS in applied economics and MA in economics rom he Universiy o San Francisco, and a DBA rom Golden Gae Universiy. Susan M. Young is an Associae Proessor a he Gabelli School o Business, Fordham

Universiy. Beore joining he aculy a Fordham Universiy, Proessor Young held academic posiions a CUNY Baruch College and Emory Universiy. Beore her academic career, Proessor Young held posiions in public, privae, and nonprofi accouning. She has published in he Accouning Review, Journal o Business, Finance and Accouning, Accouning Horizons, Journal o Managemen Accouning Research, Review o Behavioral Finance, and Human Resource Managemen. Proessor Young earned a BS rom Caliornia Sae Universiy Sanislaus, an MBA rom Caliornia Sae Universiy Sacrameno, and a PhD rom he Universiy o Souhern Caliornia. Linda Yu is a Proessor o Finance a he College o Business and Economics, Universiy

o Wisconsin Whiewaer. Beore joining he Universiy o Wisconsin, she worked as an assisan proessor a he Sae Universiy o New York Insiue o echnology. Proessor Yu’s research ocuses on fixed income, equiy anomalies, corporae governance, and socially responsible invesing. She has published in Financial Managemen, Review o Quaniaive Finance and Accouning, Journal o Fixed Income, Inernaional Review o Financial Analysis, and Mulinaional Finance Journal, among ohers. Proessor Yu received a BA in Briish lieraure rom Jilin Universiy China, an MBA rom Pitsburg Sae Universiy, and a PhD in Finance rom he Universiy o Memphis.

1

Part One

FINANCIAL BEHAVIOR AND PSYCHOLOGY

3

1 Financial Behavior An Overview H. KENT BAKER University Professor of Finance Kogod School of Business, American University GRE G FIL BEC K Samuel P. Black III Professor of Finance and Risk Management Penn State Erie, The Behrend College VICTOR RICCIARDI Assistant Professor of Financial Management Goucher College

Introduction wo major branches in finance are he well-esablished radiional finance, also called sandard finance, and he more recen behavioral finance.radiional finance is based on he premise o raional agens making unbiased judgmens and maximizing heir selineress. In conras, behavioral finance sudies he psychological influences o he decision-making process or individuals, groups, organizaions, and markes. Boh schools o hough play imporan roles in undersanding boh invesor and marke behavior. Acker (2014) provides a comparison o radiional and behavioral finance. radiional finance heory assumes normaive principles o model how invesors, markes, and ohers should ac. In radiional finance heory, invesors are supposed o ac raionally. Addiionally, his normaive approach assumes ha invesors have access o perec inormaion, process ha inormaion wihou cogniive or emoional biases, ac in a sel-ineresed manner, and are risk-averse. According o Bloomfield (2010, p. 23), radiional finance sees financial setings populaed no by he error- prone and emoional Homo sapiens , bu by he awesome Homo economicus. Te later makes perecly raional decisions, applies unlimied processing power o any available inormaion, and holds preerences well- described by sandard uiliy heory. radiional finance heory is based on classical decision making in which invesors make economic decisions using uiliy heory by maximizing he benefi hey receive rom an 3

4

FINANCIAL

BEHAVI OR AND PSYCHOLOGY

acion, subjec o consrains. In uiliy heory, invesors are assumed o make decisions consisenly and independenly o oher choices. Uiliy heory serves as he oundaion or sandard finance heories based on modern porolio heory and asse pricing models. A major ene o radiional finance is undamenal analysis incorporaing saisical measures o risk and reurn. A primary aspec o his macro-driven model is he sudy o invesors wihin he financial markes, and he underlying assumpion o invesor risk aversion (i.e., invesors mus be compensaed wih higher reurns in order o ake on higher levels o risk). Noable examples in radiional finance include porolio choice (Markowiz 1952, 1959), he capial asse pricing model (CAPM) (Sharpe 1964), and he efficien marke hypohesis (EMH) (Fama 1970). Modern porolio heory (MP) provides a mahemaical ramework or consrucing a porolio o asses such ha he expeced reurn is maximized or a given level o risk, as measured by variance or sandard deviaion. MP emphasizes ha risk is an inheren par o higher reward. An imporan insigh provided by MP is ha invesors should no assess an asse’s risk and reurn in isolaion, bu by how i conribues o a porolio’s overall risk and reurn. Furher developmens revealed ha invesors should no be compensaed or risk ha hey can diversiy away, which is called unsysemaic or diversifiable risk. Insead, hey should only be compensaed or non-diversifiable risk, also called marke or sysemaic risk. Tis insigh led o he developmen o he CAPM. Tis model describes he relaion beween risk, as measured by marke risk or bea, and expeced reurn, and is used or he pricing o risky securiies. Alhough a cornersone o modern finance, he CAPM, as a single-acor model, canno pick up oher risk acors. Consequenly, he CAPM does no perorm well in explaining he cross-secion o reurns across socks. Hence, ohers sugges ha reurns depend on oher acors besides he marke. For example, Fama and French (1996) ideniy wo addiional acors: firm size and he book-o-marke raio. Carhar (1997) exends he Fama–French hree-acor model by including a momenum acor, which is he endency or he sock price o coninue rising i i is going up and o coninue declining i i is going down. Te EMH saes ha asse prices ully reflec all available inormaion. An implicaion o his dominan paradigm in radiional finance o he uncion o markes is ha consisenly beaing he marke on a risk-adjused basis is impossible. Fama (1970) ses orh hree versions o he EMH.According oweak orm efficiency, prices on raded asses reflec all marke inormaion, such aspas prices. Tesemi-srong ormo he EMH assers ha prices reflec all publicly available inormaion. Tesrong ormo he EMH saes ha curren asse prices reflec all inormaion, boh public and privae (insider). Numerous research sudies repor anomalies, which are siuaions when a securiy or group o securiies perorms conrary o he noion o efficien markes. Tis sream o research was a driving orce leading o hebirh and growh o behavioral finance (Acker 2014). Alhough he radiional approach provides many useul insighs, i offers an incomplee picure o acual, observed behavior. Te normaive assumpions o radiional finance do no apply o how mos invesors make decisions or allocae capial. Normaive models ofen ail because people are irraional and he models are based on alse assumpions. By conras, behavioral finance offers insighs rom oher sciences and business disciples o explain individual behavior, marke inefficiencies, sock marke anomalies, and

5

Financial Behavior: An Overview

5

oher research findings ha conradic he assumpions o radiional finance. Behavioral finance examines he decision-making approach o individuals, including cogniive and emoional biases. Behavioral finance makes he premise ha a wide range o objecive and subjecive issues influence he decision-making process. Various laboraory, survey, and marke sudies in behavioral finance show ha individuals are no always raional and apply he descripive model rom he social sciences ha documens how people in real lie make judgmens and decisions. A basis o he descripive model is ha invesors are affeced by heir previous experiences, ases, cogniive issues, emoional acors, he presenaion o inormaion, and he validiy o he daa. Individuals also make judgmens based on bounded raionaliy.Bounded raionaliy is he premise ha a person reduces he number o choices o a selecion o smaller shorened seps, even when his oversimplifies he decision-making process. According o bounded raionaliy, an individual will selec a saisacory oucome raher han he opimal one. In he 1960s and 1970s, he srcin o behavioral finance and financial psychology was ounded on seminal research rom heoriss in cogniive psychology, economics, and finance. During he 1980s, behavioral finance researchers began combining he research mehods o psychology and behavioral economics wih specific invesmen and financial subjec mater. Since he mid- 1990s, behavioral finance has been emerging as an imporan field in academia. For example, some noable developmens in behavioral finance include work on prospecheory (Kahneman and versky 1979; versky and Kahneman 1974, 1981); raming effecs, which are rooed in prospec heory; heurisics and biases (Kahneman, Slovic, and versky 1982; Gilovich, Griffin, and Kahneman 2002); and menal accouning (Taler 1985). Baker and Nosinger (2010) and Baker and Ricciardi (2014) provide a synhesis o he lieraure on behavioral finance and invesor behavior. In 2002, Daniel Kahneman and Vernon Smih, behavioral finance pioneers, received he Nobel Memorial Prize in Economics or heir research in behavioral economics and psychology rom he area o judgmen and decision making. Tis presigious award was a major urning poin or he discipline because i provided wider accepance wihin he financial communiy. Ten, he financial crisis o 2007–2008 demonsraed he weakness o sandard finance, wih behavioral finance subsequenly receiving even more atenion and acknowledgmen by academics and praciioners. In 2013, Rober J. Shiller, a noed behavioral economis, shared he 2013 Nobel Memorial Prize in Economic Sciences or empirical analysis o asse prices.

A Further Look at Behavioral Finance Behavioral finance is an inerdisciplinary subjec based on he hemes, heories, and research mehods rom a wide range o decision-making fields, such as psychology, behavioral accouning, economics, and neuroscience. In he early 1980s, researchers began o blend he research ideas and mehodologies o psychology wih specific invesmen and financial heories (Ricciardi 2006). Behavioral finance ocuses on imporan cogniive acors and emoional influences during he judgmen and decision-making process by individuals, groups, organizaions, and markes. When individuals make judgmens, hey mus develop, evaluae, and selec among a series o choices or opions, in which he final decision is based on a degree o risk and uncerainy (Ricciardi 2008a,

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2010). In a raional seting, invesors selec he opimal choice. However, i qualiaive and quaniaive complexiies are oo inense, cogniive and emoional biases will influence he final oucome o a saisacory choice. Anoher imporan premise o behavioral finance is ha people are ofen irraional or quasi-raional (known as bounded raionaliy), and individuals make financial decisions based on pas experience, values, menal misakes, cogniive acors, and emoional impulses. PROSPECT

THEORY, LOSS

AVERSION,

AND THE DISPOSITION EFFECT

Kahneman and versky (1979) provide a unique behavioral heory abou riskaking behavior and uncerainy known as prospec heory, in which he saed probabiliies and he diverse choices are provided. Tis heory posis he noion ha people do no make decisions based on classical raionaliy; raher, hey make judgmens based on he premise o bounded raionaliy. A key ene o prospec heory is ha people assess choices on an individual basis and hen use a reerence poin or anchor o make heir choices, raher han decide wihin he conex o an overall porolio. Anoher principle underly ing prospec heory is ha individuals areloss averse, in which hey place greaer weigh on losses han gains. Ta is, individuals apply more imporance and menal effor o avoiding a loss han o achieving a gain. Kahneman and versky (1979) asked subjecs o review a pair o choices and o selec one o he opions: Consider a decision beween hese wo choices: Choice A: A sure gain o $7,000 or Choice B: An 80 percen chance o earning $10,000 and a 20 percen chance o receiving $0. Question: Which choice would give you he bes prospec o increase gains? Teir evidence shows ha a solid majoriy o respondens selec Choice A, which is he sure gain. Tese findings demonsrae ha mos individuals suffer romrisk aversion when given he choice o a cerain gain, and heyfind his oucome saisacory.Alhough people end o preer Choice A because o he promise o a $7,000 gain, his should be he less avored opion. I hey selec Choice B, heir preerence is o consider heopimal choice because an overall cumulaive increase in wealh o $8,000 occurs. For a radiional finance porolio, he answer is calculaed as ($10,000 × 0.80) +(0 × 0.20) = $8,000. Mos people dislike Choice B because o he 20 percen probabiliy o earning nohing. Anoher aspec o Kahneman and versky’s (1979) sudy is o invesigae he influence o losing, in which people assess he ollowing wo opions: Choice C: A realized loss o $7,000 or Choice D: An 80 percen chance o losing $10,000 and a 20 percen chance o

losing nohing. Question: Which opion would provide you he bes prospec o reduce losses?

Mos subjecs preer Choice D. Tey preer he 20 percen probabiliy o no losing any money, even hough his choice has more risk because wihin a porolio ramework

7

Financial Behavior: An Overview

7

he resul would be an $8,000 loss. In oher words, Choice C is he raional choice. In he behavioral finance domain, Oberlechner (2004) repors in a comparable sudy wih raders in a oreign exchange seting showing ha more han 70 percen selec he riskseeking opion (or he equivalen o Choice D). Te resuls o hese experimens demonsrae he concep known as loss aversion, in which people assign more imporance o a loss han o an equivalen gain. Te ypical finding is ha a gain on he upside o $2,000 is abou wice as painul on he downside and eels like a $4,000 loss. Tis logic is conrary o he premise o radiional finance, which equaes a $2,000 gain o a $2,000 loss wihin a diversified porolio. For example, individuals end o ocus on downside risk when hey own common sock. When people suffer an acual loss, hey incur no only an objecive loss in dollar erms bu also a subjecive loss in erms o an “emoional loss.” Tis eeling can remain or a long ime. Many invesors who realize major losses during a marke downurn subsequenly avoid riskier asse classes such as socks. Anoher imporan aspec o loss aversion is ha an “individual is less likely o sell an invesmen a a loss han o sell an invesmen ha has increased in value even i expeced reurns are held consan” (Ricciardi 2008b, pp. 99– 100), based on he disposiion effec. Te disposiion effecreers o he endency o selling securiies ha have appreciaed in value over he srcinal invesmen cos oo early (or winners) and o holding on o losing securiies oo long (or losers). Tis bias is derimenal o he wealh o individuals because i can increase heir capial gains axes or can reduce invesmen reurns even beore axes. Olsen and roughon (2000) examine he differen meanings beween uncerainy (ambiguiy) and risk atribued o he work o Knigh (1921). Te sudy assesses several psychological acors, such as amiliariy bias and loss aversion behavior. An exper group o more han 300 money managers compleed a survey quesionnaire abou socks. According o hem, he wo mos imporan aspecs o he assessmen o risk are (1) downside or caasrophic risk (i.e., he probabiliy o realizing a large loss); and (2) he role o ambiguiy (i.e., he uncerainy abou he acual disribuion o poenial reurns in he uure). HEURISTICS

When individuals ace complex judgmens, inormaion overload, or incomplee inormaion, hey ofen rely on convenional wisdom based on heir personal experiences, known as heurisics, which reduce he decision o a simpler choice (versky and Kahneman 1974). Heurisics are sraighorward, basic ools ha people use o explain a cerain caegory o choices under a high degree o risk and uncerainy. Heurisics are a “cogniive mechanism” or reducing he ime commimen by simpliying he decision-making process or invesors. Even hough his ype o cogniive approach someimes resuls in saisacory oucomes (also known as saisficing), heurisic judgmens ofen resul in inerior decisions. Saisficing is a decision-making sraegy or cogniive heurisic ha enails searching hrough he available alernaives unil an accepabiliy hreshold is me. Plous (1993, p. 109) saes: For example, i is easier o esimae how likely an oucome is by using a heurisic han by allying ever y pas occurrence o he ouc ome and dividing by

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he oal number o imes he oucome could have occurred. In mos cases, rough approximaions are sufficien (jus as people ofen saisfice raher han opimize). Many sock brokers make as purchase and sell decisions abou equiies by using heurisics because hey are under sric ime resricions and have he objecive o earning large shor-erm gains wihin he markes. Under such circumsances, hese expers ocus on a narrow amoun o inormaion and rely on previous experience o make final judgmens. In many insances, hese individuals are unaware hey are employing hese ypes o cogniive issues. Wihin an invesmen managemen seting, people use a ool known as he 1/N heurisic when al locaing reiremen unds (Benarzi and Taler 2001, 2007). For insance, an individual wih five muual unds will equally disribue 20 percen o he money invesed ino each und or his monhly conribuion o a 401k plan. Tis mehod is atracive o reiremen savers because o is simpliciy. THE AV AILABILITY

HEURISTIC

Te availabiliy heurisic reveals an inclinaion individuals have o be biased by inormaion ha is easy o recall, widely available, and highly publicized, which resuls in over-weighing or misinerpreing his inormaion (versky and Kahneman 1973). As Schwarz (1998, p. 64) noes, “Biases may arise because he ease which specific insances can be o recalled memory affecs judgmens he relaive and imporance daa.” rom According o Ricciardi (2008b),abou he main aspecs requency o he availabiliy heurisic ha influence a person’s judgmens and decisions are (1) choices ha induce affecive reacions; (2) aciviies ha are exremely dramaic; and (3) recen evens, which have a endency o be more readily available in an individual’s memory. For example, invesors overrae he imporance o recen invesmen news and discoun older inormaion when evaluaing a common sock. When a blue chip sock releases quarerly earnings above esimaes and his inormaion is repored online or on oher financial news media, his may dramaically increase he company’s shor-erm sock price. However, once he news ades rom he memory o invesors, he sock’s volailiy reurns o is hisorical average. OVERCONFIDENCE

Individuals are inclined o be overconfiden abou heir skills, experise, and inelligence. Te subjec mater o overconfidence is animporan finding in behavioral finance because differen caegories o invesors suffer rom his bias. Overconfiden invesors believe hey can influence he final oucome o a decision based on cerain superior atribues when compared o he average invesor. In he domain o finance, many people believe hey are above average in heir apiude, overalldecisions, and capabiliy (Ricciardi 2008b).People are highly confiden in heir judgmens ormed under he applicaion o heurisics and are inatenive o he acual mehod used o orm heir final judgmens. Barber and Odean (2001) explore he rading psychology beween men and women or 35,000 accouns o individual invesors over a six-year period. Te sudy reveals

9

Financial Behavior: An Overview

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ha men are more overconfiden han women abou heir financial skills and ha men rade more wihin heir invesmen accouns. Men are prone o sell common sock a an incorrec poin in ime and also o incur higher rading coss han women. Women are predisposed o rade less, employing a buy-and-hold approach ha resuls in lower invesmen expenses. Men rade 45 percen more requenly han women, and single men rade 67 percen more requenly han single women. rading coss reduce he ne invesmen perormance o men by 2.65 percenage poins a year compared o only 1.72 percenage poins or women. In oher words, or he six- year period o he sudy, women earned 1 percenage poin a year more han did men. Tis finding has even more dramaic consequences i he 1 percenage poin yearly difference is applied over a 30 o 40-year ime horizon because o he effecs o compounding. STA TUS QUO

BIAS

Individuals are inclined o experience saus quo bias, in which hey end o deaul o he same choice or o accep he curren decision. People find changing he behavior o procrasinaion or ineria enails srong incenives. Tis bias happens when individuals ail o revise heir financial plans despie poenial benefis rom doing so. Reiremen savers have he same behavior, such as holding ono an underperorming muual und insead o selling i. Employees delay conribuing o heir company reiremen plan or procrasinae in seeking he advice o a financial planner o learn abou differen reiremen opions. Afer saring o conribue o a company reiremen plan, many employees do no acively monior heir accouns. For example, Agnew, Balduzzi, and Sunden (2003) evaluae 7,000 reiremen accouns beween April 1994 and Augus 1998. Te auhors repor ha mos asse allocaion choices are exreme or possess disproporionae diversificaion ino risky securiies (i.e., an individual who has muliple holdings in socks or invess 100 percen o his asses in socks) and reiremen savers suffer rom ineria or saus quo bias regarding heir asse allocaion decisions. Te sudy also finds excepionally low porolio urnover raes and asse rebalance ransacions in hese accouns, which urher demonsrae saus quo behavior.

About This Book PURPOSE OF THE BOOK

Tis book provides a synhesis o he heoreical and empirical lieraure on he financial behavior o major sakeholders, financial services, invesmen producs, and financial markes. Compared wih radiional finance, he book offers a differen way o looking a financial and emoional well-being and o he processing o belies, emoions, and behaviors relaed o money. I provides imporan insighs abou cogniive biases and emoional issues ha influence various financial decision makers, services, producs, and markes. Tis volume is a “conribued chaper” book in which noed academic researchers and praciioners provide chapers in heir areas o experise. Tus, readers can gain an indeph undersanding abou his opic rom expers rom around he world.

10

FINANCIAL BEHAVIOR AND PSYCHOLOGY

In oday’s financial seting, he discipline o behavioral finance is an area ha coninues o evolve a a rapid pace. Tis book akes readers hrough no only he core opics and issues bu also he laes rends, cuting-edge research developmens, and real-world siuaions. Addiionally, discussion o research on various cogniive and emoional issues is covered hroughou he book. Tus, his volume covers a breadh o conen rom heoreical o pracical, while atemping o offer a useul balance o deailed and user-riendly coverage. Tose ineresed in a broad survey will benefi, as will hose searching or more in-deph presenaions o specific areas wihin his field o sudy. As he sevenh book in he Financial Markes and Invesmen Series,Financial Behavior: Players, Services, Producs, and Markes offers a resh look a he ascinaing area o financial behavior. DISTINGUISHING FEATURES

Financial Behavior: Players, Services, Producs, and Markeshas several disinguishing eaures. • Te book examines highly relevan and imely aspecs o financial behavior and blends he conribuions o noed academics and praciioners who have varied backgrounds and differing perspecives. Te book also reflecs he laes rends and research rom a unique perspecive, as he conen is organized by major players, financial services, invesmen producs, and markes. By conras, oher books in behavioral finance and invesor psychology ofen organize chapers by a specific subjec mater or opic area, such as a cogniive issue, emoional bias, or heory. • Te resuls o empirical sudies are presened in a user- riendly manner o make hem undersandable o readers wih differen backgrounds. • Te book provides discussion quesions and answers o help o reinorce key conceps. INTENDED AUDIENCE

Te book’s conen and disincive eaures should be o ineres o a wide range o groups including academics, researchers, proessionals, invesors, sudens, and ohers ineresed in financial behavior. Academics can use his book no only as an inegral par o heir undergraduae and graduae finance courses bu also as a way o undersanding he various aspecs o research emerging rom his area. Te book can help proessionals navigae hrough he key areas in financial behavior. Individuals and financial planners can use he book o expand heir knowledge base and can apply he conceps o managing he enire financial planning process. Te book can serve as an inroducion o sudens ineresed in hese opics.

Structure of the Book Te 30 chapers in his book are grouped ino seven pars. A brie summary o each par and chaper ollows.

1

Financial Behavior: An Overview

PART ONE: FIN

11

ANCIAL BEHAVIOR AND PSYCHOLOGY

Chaper 1 Financial Behavior: An Overview (H. Ken Baker, Greg Filbeck, and Vicor Ricciardi) As you have seen, chaper 1 offers an enhanced discussion o behavioral finance and a descripion o his book.

Chaper 2 Te Financial Psychology o Players, Services, and Producs (Vicor Ricciardi) Tis chaper provides an overview o he emerging cogniive and emoional hemes o behavioral finance ha influence individual behavior. Te behavioral finance perspecive o risk incorporaes boh qualiaive (subjecive) and quaniaive (objecive) aspecs o he decision-making process. An emerging subjec o research ineres and invesigaion in behavioral finance is an inverse (negaive) relaion beween perceived risk and expeced reurn (perceived reurn). Tis chaper highlighs imporan opics such as represenaiveness, raming, anchoring, menal accouning, conrol issues, amiliariy bias, rus, worry, and regre heory. I also examines he role o negaive affecive reacions on financial decisions. Financial worries and negaive emoions influence all ypes o individuals including children, invesors, and financial proessionals. A hos o biases ha depend on specific aspecs o he financial produc or invesmen service influence he judgmen and decision-making process o financial players. PART TWO: THE F

INANCIAL BEH

AVIOR OF MAJOR PLAYERS

Te second par has seven chapers involving he behavior o various players in he financial markes: individuals; insiuional invesors; corporae execuives, direcors, and boards; financial planners and advisors; financial analyss; porolio managers; and financial psychopahs.

Chaper 3 Individual Invesors (Henrik Cronqvis and Danling Jiang) radiional finance explains individual invesors’ behavior and financial decision-making based on economic incenives and raionaliy Modern finance, however, akes a holisic view and searches no only or economic bu also or biological, psychological, and social acors ha shape decision-making and invesor behavior. In his new approach, geneics, lie experiences, psychological rais, social norms, and peer influences, as well as belies, values, and culure in general, deermine sock marke decisions, share o equiy holding, requency o rading, exen o diversificaion, and preerences ha make up he invesmen syles o individual invesors. Te collecive preerences and acions o individual invesors exer an impac on asse pricing and corporae decisions.

Chaper 4 Insiuional Invesors (Alexandre Skiba and Hilla Skiba) A large body o behavioral finance lieraure ocuses on he behavioral biases o individual invesors in heir rading choices. Research also shows ha sophisicaion is relaed o he level a which behavioral biases influence invesors’ rading choices. Tis chaper reviews he lieraure on insiuional invesors’ rading behavior and finds ha, consisen wih he level o invesor sophisicaion, insiuional invesors are less subjec o

12

FINANCIAL BEHAVIOR AND PSYCHOLOGY

he common behavioral biases. However, some behavioral biases are presen in insiuional rading and more so among less sophisicaed invesor ypes. Evidence also shows ha insiuional invesors engage in some rading choices, such as herding, momenum rading, and under-diversificaion, ha could be sympoms o behavioral biases. Based on he reviewed research, hese rading behaviors are no value reducing. Overall, he evidence indicaes ha insiuional invesors are less subjec o behavioral biases, making markes more efficien.

Chaper 5 Corporae Execuives, Direcors, and Boards (John R. Nosinger and Patanaporn Chajuhamard) Tis chaper assesses he behavior o corporae managers and boards o direcors wihin he ramework o agency heory, sewardship heory, and psychological biases. In agency heory, a chie execuive officer (CEO) is moivaed o ac in his own bes ineres raher han ha o he shareholders. Sewardship heory posis ha a CEO is a selacualizing individual seeking o grow and reach a higher level o achievemen hrough leading an organizaion. A CEO exhibis sel-ineresed behavior in managing he firm. A CEO also exhibis opimism, overconfidence, and risk aversion behaviors ha are no opimal or he firm. In he conex o agency heory, he board o direcors should enac incenive srucures and monioring o conrol hese behaviors. However, direcors also suffer rom sel-ineress and cogniive biases. Specifically, boards may suffer rom group dynamic problems such as social loafing, poor inormaion sharing, and grouphink.

Chaper 6 Financial Planners and Advisors (Benjamin F. Cummings)

An increasing number o households use financial planners or advisors. Tis chaper seeks o provide insigh ino hese proessionals, heir poenial moivaions, and heir ineracions wih cliens. Te various regulaory regimes o financial planners and advisors are discussed, including he mos common ypes o firms: regisered invesmen advisors, broker- dealers, and insurance firms. Agency coss associaed wih employing a financial planner are also discussed, wih emphasis on he poenial conflics o ineres ha can arise rom various compensaion srucures ha advisory firms ypically use. Common areas o consumer conusion are highlighed. Te chaper also discusses he empirical evid ence on he use and value o financial advice. I concludes wih some recommendaions or consumers abou selecing a financial planner or advisor.

Chaper 7 Financial Analyss (Susan M. Young)

Financial analyss are imporan players in he markeplace. Analyss’ repors, which include orecass o earnings and sock recommendaions, move marke prices. Invesors, boh large and small, rely on he inormaion in repors when orming heir invesmen decisions. Given he relevance o financial analyss’ research, undersanding wheher heir repors are biased is imporan because relying on hem could harm invesors using he inormaion in hese repors o inorm heir decisions. Despie an increase in marke regulaion, evidence suggess ha analyss’ repors are biased. Te research also finds ha analyss’ bias increases when inormaion uncerainy is high. Tus, invesors should undersand he possible dangers in blindly relying on research by financial analyss.

13

Financial Behavior: An Overview

13

Chaper 8 Porolio Managers (Erik Devos, Andrew C. Spieler, and Joseph M. enaglia) In he oversigh o mos unds, he porolio manager holds he key decision-making power. Ofen regarded as he oundaion o he invesmen process, a ew selec managers can atrac billions o dollars rom invesors, giving he managers increased prominence, credibiliy, and compensaion. Despie heir saure, porolio managers are no immune o he same behavioral biases as oher invesors, which can disor he porolio managemen process. Tis chaper offers an overview o porolio managemen and compares characerisics o differen und ypes ha porolio managers oversee. I also reviews several imporan behavioral biases ha porolio managers display, as well as he consequences ha each bias has on porolio consrucion: overconfidence, herd menaliy, risk-aking behavior, and he disposiion effec. Te chaper also conrass he gender differences o porolio managers and reviews he ramificaions on heir respecive porolios.

Chaper 9 Financial Psychopahs (Deborah W. Gregory) Te erm financial psychopah emerged afer he financial crisis o 2007– 2008. Is media usage appears o have been inended as a erm o derision or financial proessionals, raher han an acual clinical profile. Te expression succincly conveys he pos-2008 widespread public anger and resenmen oward hose in he finance proession, paricularly on Wall Sree, held responsible or damaging he world economy and desroying he personal wealh o many people. In he decades beore he financial crisis , muliple acors had come ogeher o ch ange he operaing srucure o he financial landscape. Tis new environmen was conducive o invesmen proessionals’ engaging in ransacions bearing he hallmarks o ps ychopahic behavior, raising he criical quesions: Wha defines a financial psychopah? Does i lie in he individual’s personaliy rais, he behavioral edics dicaed by he environmen wihin which he or she works, or boh? Tis chaper atemps o answer hese quesions. PART THREE : FINANCIA OF SPECIFIC P LA YERS

L AND INVE

STOR PSYCHOLOGY

Te hird par has five chapers on he financial and invesor psychology o specialized players, including high ne worh individuals, raders, women, and millennials.

Chaper 10 Te Psychology o High Ne Worh Individuals (Rebecca Li-Huang) Tis chaper akes an economic view o he invesmen behavior o high ne worh individuals (HNWIs), including he psychological aspecs o privae wealh and he pracice o wealh managemen, curren rends affecing he players and markes, and empirical findings on wealh creaion and disribuion ha have ueled policy debaes. Wealh concenraions and scarciy o skills have graned insiuional advanages o HNWIs and he highly skilled, including higher reurns on heir physical and human capial invesmens. Besides achieving financial reurns, HNWIs wan o use heir privae wealh o have a social impac. Wealh managers respond o he atiude and

14

FINANCIAL BEHAVIOR AND PSYCHOLOGY

behavior o HNWIs by shifing he ocus rom invesmen producs and ransacions o holisic invesing and goal-based wealh managemen.

Chaper 11 Te Psychology o raders (Duccio Marelli) In recen decades, rading has become very popular among reail invesors, mainly due o he widespread use o echnology and a reducion in ransacion coss. However, he growing amoun o inormaion available o individuals and he higher complexiy o financial markes have led hese invesors o make psychological misakes more easily. Te objecive o his chaper is o describe he main ypes o behavioral bias ha affec individual invesors, especially reail raders who requenly churn heir porolios. Te chaper compares momenum and conrarian rading sraegies used by such raders. I also discusses he impac o new inormaion on marke senimen and is effec on rader psychology. Finally, he chaper examines he main behaviors o novice raders, ollowed by a summary o various sudies ha analyze he conduc o novice invesors in he course o invesmen challenges and rading simulaions.

Chaper 12 A Closer Look a he Causes and Consequences o Frequen Sock rading (Michal Srahileviz) Tis chaper examines he phenomenon o requen sock rading. Specifically, i covers he ample research demonsraing he negaive effecs o requen rading on invesor reurns, as well as several possible underlying causes or his irraional behavior. Among hese possible causes o requen rading are overconfidence, risk seeking, gambling addicion, requency o negaive emoions, and emoional insabiliy. Te chaper also examines gender differences. Alhough he vas body o research shows ha requen rading is bad or reurns, many invesors coninue o rade oo ofen or heir own good. Tereore, besides discussing poenial causes o requen sock rading, his chaper also sresses he need or uure research o ideniy effecive mehods o helping invesors reduce his financially harmul behavior.

Chaper 13 Te Psychology o Women Invesors (Margueria M. Cheng and Sameer S. Somal) Te role o financial decision maker in a household has evolved over ime. Decades ago, women held radiional roles o caregiver, housekeeper, and wie. oday, more women are pursuing higher educaion, and emale proessionals and enrepreneurs are making grea srides in business.Undersanding wha oday’s women value in all hese roles helps o bridge he gap beween financial lieracy and is applicaion. raining and menoring women should be a prioriy or every financial insiuion, as women expec cusomized service and clear communicaion rom financial expers. Tis chaper discusses he financial, psychological, and personal needs o women cliens. I also explains how financial advisors should communicae wih women o creae a avorable clien experience.

Chaper 14 Te Psychology o Millennials (April Rudin and Caherine McBreen) Tis chaper ocuses on he financial mindse and behaviors o millennials, and how hey inerac wih financial advisors. Millennials have surpassed baby boomers as he mos

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Financial Behavior: An Overview

15

producive generaion and are projeced o be he wealhies. A 80 million srong, hey are poised o leave heir imprin on he financial services indusry as well, which will have o adap i i wans o engage a generaion ha communicaes and invess differenly rom is predecessors. Millennials are ofen idenified wih unflatering and sereoypical porrayals, bu financial advisors ignore his group a heir peril. Tis generaion is more ap o conduc is financial and invesmen affairs in nonradiional ways, laying he groundwork or heir secure financial uure. PART FOUR: THE PSYCHOLOGY OF FINA

NCIAL SERVICES

Te ourh par has five chapers on he psychological aspecs o financial planning, financial advisory services, insurance and risk managemen, esae planning, and reiremen planning and wealh managemen.

Chaper 15 Psychological Aspecs o Financial Planning (Dave Yeske and Elissa Buie) Tis chaper discusses personal financial planning, which is an inerdisciplinary pracice ha employs a six-sep process o develop inegraed sraegies or individuals and amilies hoping o mobilize heir human and financial capial o achieve heir lie goals. Financial planning draws rom various disciplines, including counseling, psychology, finance, economics, and law. I includes budgeing and cash flow planning, risk managemen, insurance planning, invesmen planning, reiremen and employee benefis planning, ax planning, and esae planning. Te sraegic process involves developing inegraed sraegies ha draw rom all hese fields in pursui o clien goals is he proessional’s unique domain. Heurisics and menal biases o which cliens may be prone ofen overlay he enire financial planning process. Financial planners should undersand and consider hese issues in shaping recommendaions uniquely suied o each clien, maximizing he probabiliy ha he clien will embrace and implemen he recommended sraegies.

Chaper 16 Financial Advisory Services (Jeroen Nieboer, Paul Dolan, and Ivo Vlaev) Evidence rom he behavioral sciences, noably economics and psychology, has prooundly changed he way policymakers and praciioners presen exper advice o consumers. Tis chaper examines he evidence in regard o financial advice and explores is implicaions or he financial advisory proession. Te auhors explain how consumers o reail financial advice respond o cerain aspecs o he advice process in predicable ways, someimes exhibiing behavioral biases or ollowing cerain convenions in heir decision making. By recognizing and anicipaing hese responses, financial advisors can offer a more complee service, exending benefis beyond he sricly financial reurn o advice. Bu he behavioral needs o consumers may also provide advisors wih incenives ha are no sricly aligned wih heir cliens’ financial ineress. Finally, he auhors review he increasing role o echnology and how i will play an imporan role in shaping he financial advisory services o he uure.

16

FINANCIAL BEHAVIOR AND PSYCHOLOGY

Chaper 17 Insurance and Risk Managemen (James M. Moen Jr. and C. W. Copeland) According o modern porolio heory (MP), raional marke paricipans make mos decisions and seek o be compensaed or addiional risk. However, behavioral finance shows how invesors someimes behave irraionally due o preconceived noions and biases based on pas experiences. Tis chaper explores how individuals make decisions o buy differen ypes o insurance even when aced wih predicable oucomes involving he requency and severiy o he loss. Ta is, individuals appear o buy insurance only when he requency o loss is low and he severiy o loss is high; oherwise, hey sel-insure.

Chaper 18 Psychological Facors in Esae Planning (John J. Guerin and L. Paul Hood Jr.) As an area o behavioral finance, esae planning is less concerned wih sysemaic, cogniive errors han i is ocused on a core, emoional ambivalence abou moraliy. Te chaper explores he dynamics o he proessional/clien relaionship in financial planning and esae planning, as well as he emoional conflics concerning moraliy in ligh o research abou moraliy salience and error managemen heory. Addiionally, including marial, amily, and amily business issues inroduces inheren complicaions o effors a esae planning, which may in urn affec succession planning, inheriance, heir preparaion, and amily dynamics. However, recen developmens in assessing financial syle/personaliy may enhance progress in esae planning. ools or aciliaing he process are discussed in his chaper, along wih observaions or urher developmen in he field. Models in oher areas o psychoherapy show he poenial o inorm his area o pracice.

Chaper 19 Individual Biases in Reiremen Planning and Wealh Managemen (James E. Brewer Jr. and Charles H. Sel III) Around he globe, he gradual move rom defined benefi pensions o defined conribuion pensions has increased he need or individual reiremen planning. Examples o his need include U.S. savings raes being a hisoric lows, poor reiremen prospecs or ciizens in various developed counries, and DALBAR analyses ha disparage he gap beween invesor reurns and marke reurns. Research indicaes ha individuals working wih a financial advisor generally receive beter resuls han hose who do no. Working wih a Cerified Financial Planner (CFP) gives an added level o securiy, because a CFP akes an oah o keep he clien’s ineress ahead o his or her own business ineress. Tis chaper promoes use o nudges o help individuals close he savings, invesing, and behavior gaps, hereby improving heir oal wealh and wealh ranser picure. PART FIVE: THE BEHAVIORAL ASPECTS O PRODUCTS AND MARKETS

F INVESTME

NT

Te fifh par has our chapers ocusing on he behavioral aspecs o radiional securiies, pooled invesmen vehicles, inernaional mergers and acquisiions, and he ar and collecibles markes.

17

Financial Behavior: An Overview

17

Chaper 20 radiional Asse Allocaion Securiies: Socks, Bonds, Real Esae, and Cash (Chrisopher Milliken, Ehsan Nikbakh, and Andrew Spieler) Asse allocaion models have evolved in complexiy since he developmen o modern porolio heory, bu hey coninue o operae under he assumpion o invesor raionaliy, in addiion o oher assumpions ha do no hold in he real world. For his reason, academics and indusry proessionals ry o undersand he behavioral biases o decision makers and he implicaions hese biases have on asse allocaion sraegies. Tis chaper reviews he building blocks o asse allocaion, which involve socks, bonds, real esae, and cash. I also examines he hisory and heory behind wo o he mos popular porolio managemen sraegies: mean-variance opimizaion and he Black-Literman model. Finally, he chaper examines five common behavioral biases ha have direc implicaions on asse allocaion: amiliariy, saus quo, raming, menal accouning, and overconfidence. Each behavioral bias discussion conains examples, warning signs, and seps o correc he emoional or cogniive errors in decision making.

Chaper 21 Behavioral Aspecs o Porolio Invesmens (Nahan Mauck) Invesors are inexricably linked o financial insiuions, money managers, and he producs hey marke. Muual unds, exchange- raded unds (EFs), hedge unds, and pension unds manage or hold roughly $55 rillion in combined wealh. Tis chaper examines hese opics wih a behavioral finance approach ha ocuses on wo main hemes. Firs, he chaper reviews he perormance and raionaliy o each group; second, he chaper examines he behavioral biases ha relae o individuals’ selecion o paricular invesmens wihin each group. Research indicaes acively managed muual  unds and hedge unds under perorm passive invesmens. Pension unds generae alpha o roughly zero on a risk- adjused basis. Te ees involved in invesing in such unds exacerbae he observed underperormance in muual unds and hedge unds. Behavioral biases provide one perspecive on sources o underperormance. Furher, individual s exhibi a wide range o behavioral biases ha may lead o subopimal asse allocaion, including he selecion o muual unds, EFs, and hedge unds.

Chaper 22 Curren rends in Successul Inernaional M&As (Nancy Hubbard) Te worldwide landscape o merger and acquisiion (M&A) aciviy has changed dramaically in he pas decade. Acquirers, acquisiion rends, and sraegies behind hose ransacions now differ dramaically. Acquisiion success raes also appear o be differen, wih recen research indicaing ha inernaional acquisiions are more successul han hey were previously. Successul acquisiions involve a complicaed combinaion o melding sysems and employees in an environmen o culural conrass. Successul acquisiions on an inernaional level also require financial rigor and discipline combined wih an undersanding o human behavior and moivaion. Tis chaper examines boh he changing rends and he key success acors or M&As in erms o financial inpus and behavioral elemens so as o beter undersand he complex M&A process and ideniy indicaors or uure success.

18

FINANCIAL BEHAVIOR AND PSYCHOLOGY

Chaper 23 Ar and Collecibles or Wealh Managemen (Peer J. May) Tis chaper examines differen psychological biases in he area o ar and collecibles, which are par o every clien’s world o some degree. Wealh managemen has a radiion o managemen by silo wih each silo guided by is own revenue sream. In a changing world guided by disruping evoluion due o he availabiliy o big daa, yeserday’s knowledge and inormaion are oday’s commodiies. Tis evoluion has escalaed as inormaion is now accessible globally by almos anyone wih a mobile device. Wealh managemen mus adjus is curren clien service model o leverage he inormaional commodiy o ar and o incorporae his commodiy ino is daily conversaions. Wih he prolieraion o social media and web-based resources, ar and collecibles are now an asse class opion. PART SIX: MARKET EFFICIENCY ISSUES

Par six has our chapers ha explore he behavioral finance marke hypohesis, sock marke anomalies, speculaive behavior, and high-requency rading.

Chaper 24 Behavioral Finance Marke Hypoheses (Alex Plasun) Alhough he efficien marke hypohesis (EMH) is he leading heory describing he behavior o financial markes, researchers have increasingly quesioned is efficacy since he 1980s because o is inconsisencies wih empirical evidence. Tis challenge o he EMH has resuled in he developmen o new conceps and heories, and hese new conceps rejecing he assumpion o invesor raionaliy. Te mos promising and convincing among hese conceps are he adapive markes hypohesis, overreacion hypohesis, underreacion hypohesis, noisy marke hypohesis, uncional fixaion hypohesis, and racal marke hypohesis. Tis chaper provides a brie descripion o hese heories and proposes using a behavioral perspecive o analyze financial markes.

Chaper 25 Sock Marke Anomalies (Seve Fan and Linda Yu) Sock marke anomalies represening he predicabiliy o cross-secional sock reurns are one o mos conroversial opics in oday’s financial economic research. Tis chaper reviews several well-documened and pervasive anomalies in he lieraure, including invesmen-relaed anomalies, value anomalies, momenum and long-erm reversal, size, and accruals. Alhough anomalies are widely acceped, much disagreemen exiss abou he underlying reasons or heir predicabiliy. Tis chaper surveys wo compeing heories ha atemp o explain he presence o sock marke anomalies: raional and behavioral explanaions. Te raional explanaion ocuses on he improvemen o exising asse pricing models and/or searching or addiional risk acors o explain he exisence o anomalies. By conras, he behavioral explanaion atribues he predicabiliy o human behavioral biases in collecing and processing financial inormaion, as well as in making invesmen decisions.

Chaper 26 Te Psychology o Speculaion in he Financial Markes (Vicor Ricciardi) Tis chaper discusses he role o speculaion wihin financial markes ha influences individual and group behavior in he orm o bubbles and crashes. Te chaper highlighs behavioral finance issues associaed wih hese bubbles, such as overconfidence,

19

Financial Behavior: An Overview

19

herding, group polarizaion, grouphink effec, represenaiveness bias, amiliariy issues, grandiosiy, exciemen, and he overreacion and underreacion o prices in markes. Te issues are imporan or undersanding pas financial misakes because hisory ofen repeas isel. Te chaper also examines he afermah o he financial crisis o 2007–2008 on invesor psychology, including he impac o a severe financial downurn, he anchoring effec, recency bias, worry, loss averse behavior, saus quo bias, and rus. Te afermah o he financial crisis migh have negaive long-erm effecs on invesor behavior in which some invesors remain overly risk averse resuling in underinvesmen in socks and over-invesmen in cash and bonds.

Chaper 27 Can Humans Dance wih Machines? Insiuional Invesors, High-Frequency rading, and Modern Markes Dynamics (Irene Aldridge) Tis chaper examines high-requency rading (HF), including core groups o sraegies and heir resuling impacs. Using order-by-order marke daa analysis, he chaper shows ha much o wha is ofen consrued o be useless noise o order cancellaions acually represens meaningul order revisions, par o he real-ime marke bargaining. Te chaper urher shows ha a small racion o he order cancellaions are a produc o purely oxic liquidiy. Marke paricipans o differen requencies end o reac dierenly o such oxic orders, wih higher-requency raders largely ignoring hem and lower-requency invesors ineracing wih oxic liquidiy. PART SE VEN: T HE APPL ICA TION AND OF BEHAVIORAL FINANCE

FUTURE

Par seven includes hree chapers ha explore applicaions o clien behavior, implemening behavioral finance, and he uure o behavioral finance.

Chaper 28 Applicaions o Clien Behavior: A Praciioner’s Perspecive (Harold Evensky) Te purpose o his chaper is o discuss various behavioral conceps and sraegies ha can help cliens avoid behavioral errors, wih he resul o increasing he probabiliy o a successul plan design and implemenaion. Te chaper discusses how he conceps inroduced by research in behavioral finance have become inegraed hroughou Evensky & Kaz/Foldes Financial’s pracice. Te chaper begins wih raming or new cliens, which is par o he firm’s approach o reiremen planning called “anchoring on he efficien ronier.” Te “anchoring” reers o basing he clien’s reurn requiremen a he inersecion o a capial needs analysis and he clien’s risk olerance. Framing is inroduced as a powerul behavioral managemen ool or he praciioner. Te chaper discusses how behavioral finance lessons are inegraed ino he risk olerance and reurn discussions, as well as he reporing process.

Chaper 29 Pracical Challenges o Implemening Behavioral Finance: Reflecions fom he Field (Greg B. Davies and Peer Brooks) Behavioral finance is only useul i i can be applied o help people make beter decisions. Tis chaper offers reflecions on he good, he bad, and he ugly o a pracical applicaion o behavioral finance in a commercial banking seting. I explores he difficulies o

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non-expers who experimen wih behavioral finance, and how effecive applicaions require a unique mix o exper knowledge and an abiliy o effec change. Principles o good applicaions o behavioral finance are presened, along wih inormaion on how o sar using behavioral finance wihin an organizaion. Te chaper also discusses he imporance o senior managemen’s acknowledging ha behavioral finance praciioners do no necessarily know he correc answers and ha hey will need o use randomized conrol rials o help discover hem.

Chaper 30 Te Fuure o Behavioral Finance (Michael Dowling and Brian Lucey) Any posiive uure or behavioral finance necessiaes ha research areas o corporae finance and invesor psychology develop richer models o financial decision-making. Behavioral corporae finance requires expanding he ocus rom chie execuive officer o he enire op managemen eam, and also involves greaer undersanding o organizaional heory. Tere needs o be a clearer ocus on cross-culural acors and how hese acors inerac wih behavioral influences. Invesor psychology requires a more comprehensive heory o he drivers o invesor behavior and beter daa. Invesor senimen research offers poenial or advancing an undersanding o he psychological influences on asse pricing. Tis chaper expands on hese ideas and discuss he conex or uure philosophical developmen o behavioral finance, wih is ineviable push or greaer openness, replicabiliy, and reliabiliy in research.

Summary and Conclusions radiional finance assumes ha invesors make raional decisions. Behavioral finance acknowledges he conribuions o radiional finance, bu also recognizes cogniive and emoional biases ha resul in a decision-making process conradicing he assumpions o sandard finance. Tus, behavioral finance examines he decisionmaking approach o individuals, including cogniive and emoional biases.Financial Behavior: Players, Services, Producs, and Markes seeks o weave he conribuions o boh academics and praciioners ino a single review o imporan buselecive opics relaed o behavioral finance. Behavioral finance affecs he invesmen process on boh micro and macro levels. Te presence o invesors who are influenced by behavioral biases can resul in securiy and marke pricing ha deviaes subsanially rom inrinsic values based on radiional finance. Such decision-making rameworks can also affec financial proessionals and proessional–clien relaionships. By beter undersanding financial behavior, readers can disinguish he conribuions o invesor psychology and he role invesor behavior has on influencing he ypes o producs and services offered, as well as judge he impac such behavior has on marke efficiency.

REFERENCES Acker, Lucy F. 2014. “radiional and Behavioral Finance.” In H. Ken Baker and Vicor Ricciardi (eds.), Invesor Behavior Te Psychology o Financial Planning and Invesing, 25–41. Hoboken, NJ: John Wiley & Sons, Inc.

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Agnew, Julie, Pierluigi Balduzzi, and Annika Sunden. 2003. “Porolio Choice and rading in a Large 401(k) Plan.” American Economic Review 93:1, 193–215. Baker, H. Ken, and John R. Nosinger (eds.). 2010.Behavioral Finance Invesors, Corporaions, and Markes. Hoboken, NJ: John Wiley & Sons, Inc. Baker, H. Ken, and Vicor Ricciardi (eds.). 2014.Invesor Behavior Te Psychology o Financial Planning and Invesing. Hoboken, NJ: John Wiley & Sons, Inc. Barber, Brad M., and errance Odean. 2001. “Boys Will Be Boys: Gender, Overconfidence, and Common Sock Invesmen.” Quarerly Journal o Economics 116:1, 261–292. Benarzi, Shlomo, and Richard H. Taler. 2001. “Naıve Diversificaion Sraegies in Defined Conribuion Savings Plans.”American Economic Review 91:1, 79–98. Benarzi, Shlomo, and Richard H. Taler. 2007. “Heurisics and Biases in Reiremen Savings Behavior.”Journal o Economic Perspecives 21:3, 81–104. Bloomfield, Rober. 2010. “radiional Versus Behavioral Finance.” In H. Ken Baker and John R. Nosinger (eds.), Behavioral Finance Invesors, Corporaions, and Markes , 23–38. Hoboken, NJ: John Wiley & Sons, Inc. Carhar, Mark M. 1997. “On Persisence in Muual Fund Perormance.”Journal o Finance 52:1, 57–82. Fama, Eugene F. 1970. “Efficien Capial Markes: A Review o Teory and Empirical Work.” Journal o Finance 31:1, 383–417. Fama, Eugene F., and Kenneh R. French. 1996. “Muliacor Explanaions o Asse Pricing Anomalies.” Journal o Finance 51:1, 55–84. Gilovich, Tomas, Dale Griffin, and Daniel Kahneman (eds.). 2002. Heurisics and Biases: Te Psychology o Inuiive Judgmen. New York and Cambridge: Cambridge Universiy Press. Kahneman, Daniel, Paul Slovic, and Amos versky (eds.). 1982.Judgmen under Uncerainy: Heurisics and Biases. New York and Cambridge: Cambridge Universiy Press. Kahneman, Daniel, and Amos versky. 1979. “Prospec Teory: An Analysis o Decisions under Risk.” Economerica 47:2, 263–291. Knigh, Frank. 1921. Risk, Uncerainy, and Profi. Chicago: Universiy o Chicago Press. Markowiz, Harry. 1952. “Porolio Selecion.”Journal o Finance 7:1, 77–91. Markowiz. Harry M. 1959. Porolio Selecion: Efficien Diversificaion o Invesmens. New Haven, C: Yale Universiy Press. Oberlechner, Tomas. 2004.Te Psychology o he Foreign Exchange Marke. Chicheser, UK: John Wiley & Sons, Ld. Olsen, Rober A., and George H. roughon. 2000. “Are Risk Premium Anomalies Caused by Ambiguiy?” Financial Analyss Journal56:2, 24–31. Plous, Scot. 1993. Te Psychology o Judgmen and Decision Making. New York: McGraw-Hill. Ricciardi, Vicor. 2006. “A Research Saring Poin or he New Scholar: A Unique Perspecive o Behavioral Finance.” ICFAI Journal o Behavioral Finance 3:3, 6–23. Available ahtp://ssrn. com/absrac=928251. Ricciardi, Vicor. 2008a. “Risk: radiional Finance versus Behavioral Finance.” In Frank J. Fabozzi (ed.), Te Handbook o Finance, Volume3: Valuaion, Financial Modeling, and Quaniaive ools , 11–38. Hoboken, NJ: John Wiley & Sons, Inc. Ricciardi, Vicor. 2008b. “Te Psychology o Risk: Te Behavioral Finance Perspecive.” In Frank J. Fabozzi (ed.), Te Handbook o Finance, Volume 2: Invesmen Managemen and Financial Managemen, 85–111. Hoboken, NJ: John Wiley & Sons, Inc. Ricciardi, Vicor. 2010. “Te Psychology o Risk.” In H. Ken Baker and John R. Nosinger (eds.), Behavioral Finance: Invesors, Corporaions, and Markes, 131–149. Hoboken, NJ: John Wiley & Sons, Inc. Schwarz, Hugh H. 1998. Raionaliy Gone Awry? Decision Making Inconsisen wih Economic and Financial Teory. Wespor, C: Greenwood Publishing Group, Inc. Sharpe, William F. 1964. “Capial Asse Prices: A Teory o Marke Equilibrium under Condiions o Risk.” Journal o Finance 19:3, 425–442. Taler, Richard. 1985. “Menal Accouning and Consumer Choice.”Markeing Science 4:3, 199–214.

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versky, Amos, and Daniel Kahneman. 1973. “Availabiliy: A Heurisic or Judging Frequency and Probabiliy.”Cogniive Psychology 5:2, 207–232. versky, Amos, and Daniel Kahneman. 1974. “Judgmen under Uncerainy: Heurisics and Biases.” Science, 185:4157, 1124–1131. versky, Amos, and Daniel Kahneman. 1981. “Te Framing o Decisions and he Psychology o Choice.” Science 211:4481, 453–458.

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2 The Financial Psychology of Players, Services, and Products VICTOR RICCIARDI Assistant Professor in Financial Management Goucher College

Introduction Behavioral finance explains how cogniive and affecive processes influence he decisions o individuals abou financial issues. When people make financial choices, a collecion o inormaion, including boh objecive and subjec acors, affecs heir final judgmen. Tis chaper brings ogeher hemes wihin behavioral finance ha provide a srong oundaion or undersanding he he issues influencing heirlieraure decisions and clien behavior. Te ollowing areas are undamenal opics and issues in behavioral finance: • Prospect theory: Invesors assess differen opions o losses and gains based on a subjecive reerence poin (or anchor) in dollar erms based on he premise o loss averse behavior. • Loss aversion: When assessing individual financial ransacions, people assign more imporance o a loss han o achieving an equivalen gain. • Disposition effect: Invesors sell securiies wih gains oo quickly and hold invesmens wih losses oo long. • Heuristics: Individuals use undamenal, realisic guidelines o assess inormaion based on menal shorcus because o inormaion overload, ime consrains, or caegories o pressures. • oher Availability heuristic : Individuals have an inclinaion o avor inormaion ha is simple o recall and quickly accessible, a predisposiion o inormaion ha is well known or recen and overemphasize his inormaion. • Overconfidence: Invesors end o overesimae heir experise, alen, and orecass or invesmen perormance. • Status quo bias: Individuals suffer rom ineria by deauling o he same judgmen or oleraing he presen siuaion, and his involves robus reasons or inducemens o modiy hese aciviies. Tis chaper provides a discussion o he emerging cogniive and affecive issues o behavioral finance ha deermine he decision-making process o individuals. Te firs 23

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secion offers an overview o risk percepion advocaed by behavioral finance, including he inverse relaion beween perceived risk and reurn. Nex, he chaper examines imporan biases such as represenaiveness, raming, anchoring bias, menal accouning, conrol issues, amiliariy bias, and rus. Te nex secion ocuses on negaive emoions, such as worry and regre heory, wihin he financial domain. Te las secion offers a summary and conclusions.

The Psychology of Risk Risk is applicable across a wide variey o circumsances, evens, and siuaion. Tis opic has a variey o definiions, dimensions, and descripions by individuals and organizaions. Expers have sudied he risk-aking behavior o individuals and groups in grea deail wihin he social sciences and business domains (Ricciardi 2006, 2008a, 2008b, 2010) and he fields o behavioral accouning, financial psychology, and behavioral economics (Ricciardi 2004). Te academic lieraure shows ha risk has differen meanings, explanaions, and measuremens across many disciplines. Risk percepion is he subjecive aspec o he decision- making process ha individuals apply when evaluaing risk and he amoun o uncerainy. Perceived risk includes boh objecive and subjecive acors ha influence how people make judgmens abou all ypes o financial services and producs. In erms o he objecive aspecs o risk, Ricciardi (2008a) repors more han 150 financial and accouning proxy variables rom he ri sk percepion lieraure as poenial risk acors. Behavioral finance also incorporaes a subjecive aspec o risk and r isk- aking (e.g., cogniive and emoional acors) ha influences individual and group psychology in how people define, assess, and describe ri sk. R icciardi (2004, 2008b ) presens an exensive lis o more han 100 behavioral risk acors rom he behavioral finance lieraur e and more han 10 behavioral ri sk atribues rom he behavioral accounin g lieraure. Te assessmen o perceived risk is based on a descripive model ha explains how invesors make acual choices and decisions. Risk percepion is based on he enes o bounded raionaliy, saisficing, loss aversion, and prospec heory (Ricciardi and Rice 2014). Bounded raionaliy is he idea ha individuals reduce he number o choices o a smaller, abbreviaed se based on pas experiences, values, menal shorcus, and emoions, even hough his approach migh oversimpliy he final decision. Under he condiions o risk and uncerainy, individuals ofen selec a saisacory raher han he opimal choice, which is known as saisficing. INVERSE RELATION BETWEEN RISK AND RETURN

A major ene o radiional finance is he noion o a posiive (linear) relaion beween hisorical risk and reurn. Tis associaion is mainly based on he assumpion o risk aversion in which individuals only inves in higher-risk invesmens such as socks i hey expec o earn a higher reurn. However, his posiive risk–reurn relaion does no always exis. For example, Haugen and Heins (1975, p. 782) reveal “over he long run, sock porolios wih a lesser variance in monhly reurns have experienced greaer average reurns han heir riskier counerpars.” Wihin behavioral finance, an emerging

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research opic is he exploraion o he inverse (negaive) relaion beween perceived risk and reurn (Ricciardi 2008a). Te social sciences academic lieraure documens his inverse associaion in he orm o perceived risk and perceived gain (benefi). Alhough he noion o an inverse associaion has recenly become more common in he behavioral finance academic lieraure, his relaion has been an area o subsanial ineres in sraegic managemen since he early 1980s. Wih accouning daa rom Value Line, Bowman (1980) repors a negaive risk-reurn rade-off or 10 o 11 indusries. Tus, Bowman’s paradox indicaes ha corporae managers underake higher risk despie expecing o earn lower reurns. Bowman (1982) reveals ha financially roubled companies ake more risk during imes o financial difficuly, resuling in higher risk-aking behavior and lower raes o reurn. Te auhor atribues his negaive associaion beween risk and reurn o he principles o prospec heory. Diacon and Ennew (2001) invesigae he risk percepions o U.K. consumers or various personal financial producs. Te auhors adminiser a quesionnaire o 123 respondens o measure heir perceived risk or various financial iems. For each o he 20 financial producs, he quesionnaire asked hem wheher hey currenly owned or previously owned any o he producs o assess he poenial invesmen ownership judgmen. Te 25 risk characerisics in he sudy are mainly behavioral in naure (e.g., issues o losses, knowledge, and ime) wih a ew financial risk indicaors. Diacon and Ennew use acor analysis o classiy he 25 risk atribues ino five main risk dimensions: (1) misrus o he invesmen produc or source (i.e., a salesperson), (2) dislike or adverse oucomes, (3) disase o he volailiy o a financial produc, (4) inadequae knowledge o a financial iem, and (5) he ailure o regulaion. Tese acors accoun or 59.5 percen o an individual’s risk percepion. Diacon and Ennew (2001, p. 405) also explore he noion o an inverse associaion beween perceived risk and reurn and commen as ollows: Alhough invesors need o be compensaed or some aspecs o perceived risk (such as he possibiliy o adverse consequences and poor inormaion) his does no apply o all dimensions o perceived risk. In paricular here is litle evidence ha individual invesors wan compensaion or volailiy o reurns.

Financial Biases Influencing Judgment and Decision Making Individuals suffer rom a wide range o documened biases ha influence heir financial judgmens and decisions. Tis secion ocuses on some imporan psychological issues, including represenaiveness, raming, anchoring bias, menal accouning, conrol issues, and amiliariy bias. Tese biases have a derimenal impac on how individuals perceive and process all ypes o inormaion. REPRESENTATIVENESS

Te represenaiveness biasis a heurisic based on he idea ha people have an auomaic predisposiion o advance a belie abou a specific even and overrae how much his

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siuaion reminds hem o oher amiliar circumsances. Tis bias is based on he noion ha individuals are inclined o have a skewed belie abou a financial even and hen overesimae how much his siuaion is similar o oher ones in he pas. According o Buseniz (1999, p. 330), people are willing “o develop broad, and someimes very deailed generalizaions abou a person or phenomenon based on only a ew atribues o he person or phenomenon.” Represenaiveness resuls in invesors’ classiying a financial invesmen as good or bad based on is recen invesmen reurns. For example, an individual may buy echnology socks afer prices have risen, orecasing ha hese increases will coninue ino he near uure and ignoring blue chip socks when heir prices are lower han heir inrinsic valuaions. As Ricciardi (2008b, p. 100) noes, anoher example o his bias is when “invesors requenly predic he perormance o an iniial public offering by relaing i o he previous invesmen’s success (gain) or ailure (loss).” Sherin (2001) offers an example o represenaiveness bias wihin he conex o an inverse associaion beween risk and reurn. Using a quesionnaire, he conducs several sudies over a five-year period wih he same group o examine he risk–reurn relaion among suden or exper invesmen groups. Sherin assumes ha behavioral finance is based on he belie o a negaive relaion beween expeced reurn and perceived risk (bea). He suggess his noion o an inverse relaion is based on he premise ha invesors depend on he represenaiveness heurisic o explain why individuals relae higher perceived reurns rom sae socks (lower perceived risk or socks). Sherin describes saer socks as good socks/good companies in which individuals view higher-qualiy socks based on such rais as he qualiy o he sock (e.g., financial soundness) and he perceived goodness o he firm (e.g., managemen repuaion). Sherin (2001, pp. 179– 180) provides his perspecive o he sudy: Why do characerisics like book-o-marke equiy provide addiional inormaion over and above he inormaion conveyed by bea? I sugges ha he answer o his quesion involves he represenaiveness- based heurisic “good socks are socks o good companies.” Because good companies are associaed w ih characerisics such as low book-o-marke equiy, represenaiveness will induce invesors o expec higher reurns rom he socks o good companies. In paricular, represenaiveness will lead invesors o associae higher long- run reurns wih low book-o-marke equiy. However, because he sign o he relaionship beween expeced reurns and each characerisic is opposie o ha beween realized reurns and he characerisic, invesors’ percepions are erroneous. FRAMING

An individual exhibis a “raming effec” when an idenical or equivalen descripion o an oucome resuls in a differen final judgmen or answer. As Kahneman and versky (1979) noe, he raming process has wo imporan componens: (1) he seting or ramework o he decision, and (2) he orma in which he quesion is ramed or phrased. For example, Weber (1991) illusraes he role o raming in he conex o a new business venure by asking wheher individuals preer:

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The Financial Psychology of Players, Services, and Products

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Option A: Would you inves all your money in a new business i you had a

50 percen chance o succeeding brillianly? Option B: Would you inves all your money in a new business i you had a

50 percen chance o ailing miserably? As Weber (1991, p. 96) noes, mos individuals selec he “success-rame in A makes i seem more appealing han he ailure-ramed B, alhough he probabiliy o success versus ailure is he same or boh.” Te reason or selecing Opion A is ha he choice is a “posiive rame,” which people find more psychologically comoring and saisying raher han Opion B as he bes opion. Roszkowski and Snelbecker (1990) invesigae he role o raming wihin he conex o gains and losses, using an invesmen case sudy wih 200 financial planners. Alhough financial planners ofen suffer rom similar raming effecs, hey are more conservaive in heir approach o managing heir clien’s money han heir own invesmens. Expers who chose he posiive rame in he orm o a gain demonsrae an inclinaion or risk avoidance, and oher proessionals who avor he negaive rame in he orm o a loss are predisposed o risk-seeking behavior. ANCHORING

Anchoring is he endency o apply a belie as a subjecive reerence poin or making uure judgmens. People ofen base heir financial assessmens on he firs inormaion hey receive (e.g., an srcinal purchase price o a sock) and have difficuly adjusing heir evaluaion o new daa. Te process o anchoring is an example o when a cerain piece o inormaion influences an invesor’s heurisic judgmens and his cogniive decision-making mechanism conrols heir final decision. Even when aware o his anchoring bias, individuals have difficuly overcoming he anchoring effec (Ricciardi 2008b). Piaelli-Palmarini (1994, p. 127) makes he ollowing commens abou he anchoring process: Revising an inuiive, impulsive judgmen will never be sufficien o undo he srcinal judgmen compleely. Consciously or unconsciously, we always remain anchored o our srcinal opinion, and we correc ha view only saring rom he same opinion. Invesors are someimes inclined o ocus on a specific piece o inormaion, which hen serves as a reerence poin ha influences heir decisions. For insance, many invesors view a sock marke decline as a negaive reerence poin or anchor. Tey may remember he value o heir porolios a marke highs, beore he marke declined, and become inen on geting back o he previous highes sock price o he pas. When people anchor on a bad invesmen memory, hey migh suffer higher levels o risk and loss aversion, which resuls in higher levels o worry and leads o under-invesing in socks and over-weighing cash wihin heir porolios. For insance, Kausia, Alho, and Putonen (2008) examine he role o anchoring involving a sample o college sudens and invesmen proessionals by evaluaing socks as an invesmen. Te auhors find a very large anchoring effec or he college sudens in which hey base heir long-erm

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orecass or sock perormance on he srcinal invesmen marke value. Invesmen proessionals also suffer rom he anchoring bias, bu o a smaller degree. MENTAL ACCOUNTING

Menal accouning is a heurisic process in which people spli heir invesmens ino dieren caegories, groupings, or menal comparmens. For insance, i an individual has a negaive oal reurn or he year on a corporae bond, he will use a cogniive judgmen approach ha ocuses on he posiive aspec o he financial securiy, such as a high curren yield or he semi-annual coupon paymen, by separaing i ino a pleasurable menal accoun. Behavioral finance academics view he menal accouning bias as a negaive aspec o he decision-making process because he individual is no assessing heir enire invesmen porolio. Shafir and Taler (2006) evaluae how individuals allocae asses across differen financial menal accouns. Teir evidence reveals ha an advanced purchase such as a botle o wine is idenified as an invesmen ransacion raher han as a spending enry. I he buyer consumes and uses a produc as anicipaed, such as drinking wine a a meal, he buyer considers he iem “on he house” (i.e., ree or complimenary) or in cerain insances labeled as a savings accoun. Shafir and Taler (2006, p. 694) noe: However, when i is no consumed as planned (a botle is dropped and broken), hen he relevan accoun, long dorman, is resusciaed and coss associaed wih he even are perceived as he cos o replacing he good, especially i replacemen is acually likely. In he financial-planning domain, financial praciioners consider menal accouning as having avorable characerisics or managing heir cliens. Yeske and Buie (2014) recommend labeling cerain menal accouns, such as savings or a children’s college educaion, as “buckes.” According o Baker and Ricciardi (2015, p. 24), “I cliens rea hese accouns as long-erm invesmens ha should no be disurbed, hey are more likely o reach heir financial goals.” CONTROL ISSUES

Anoher bias ha influences an individual’s decision-making process is he issue o conrol. One major ype is locus o conrol, which consiss o exernal and inernal conrols (Roter 1971). Locus o conrol describes he degree o which someone perceives he abiliy o exer conrol over his own behavior and personal oucomes o a specific decision. Exernal locus o conrol provides a person wih he idea ha chance or ouside acors affec one’s judgmen or final oucome o a decision even.Inernal locus o conrol is he noion or belie ha an individual conrols his own ae in erms o he oucome o a decision or siuaion. Langer (1983, p. 20) provides his viewpoin on psychology o conrol (perceived conrol) as he “acive belie ha one has a choice among responses ha are differenially effecive in achieving he desired oucome.” Even in circumsances when conrol

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o an oucome is in shor supply, an individual believes ha he has conrol over he oucome o a decision is known as illusion o conrol (Langer 1975). Illusion o conrol is a prevalen bias wihin he behavioral finance academic lieraure. Individuals acknowledge a desire o conrol a specific circumsance, wih he main purpose o influencing he resuls or oucomes in heir avor. Srong (2006, pp. 273– 274) presens his perspecive o illusion o conrol wihin a gambling seting: Casinos are one o he grea laboraories o human behavior. A he craps able, i is observable ha when he dice shooer needs o hrow a high number, he gives hem a good, hard pich o he end o he able… . We like o preend we are influencing he oucome by our mehod o hrowing he dice. I you orce he issue, even a seasoned gambler will probably admi ha he dice oucome is random. Te ho hand allacy is he convicion or belie ha an individual who had achievemen or success wih a chance pas siuaion has a greaer probabiliy o addiional success. For example, a baskeball player believes he is more likely o make a baske based on he success o his previous shos or a ho sreak (Gilovich, Vallone, and versky 1985). Many expers or proessionals believe a “ho hand” influences an individual’s assessmen or percepion o success. raders make a connecion o a “ho hand” based on he previous success o selecing winning socks, and hey develop he belie ha hey are more likely o selec addiional “winners” in he uure. Sel-conrol bias is he propensiy ha causes individuals wih an overwhelming impulse o ocus on he shor erm. According o Sherin (2005, p. 114), many invesors suffer rom “sel-conrol problems ha cause inadequae savings.” In he shor erm, bad behavior, such as overeaing ha resuls in being overweigh, influences individuals. In he invesmen domain, individuals ocus on spending more money oday a he cos o no saving money or he uure. According o Baker and Ricciardi (2015, p. 125), “Te high level o credi card deb and he generally inadequae level o reiremen savings ha many individuals ace provide suppor or his sel-conrol bias.” FAMILIARITY BIAS

Familiariy bias is prevalen when individuals have an overwhelming ondness or wellknown financial securiies regardless o he benefis based on porolio diversificaion. Nosinger (2002, p. 64) conends ha in mos circumsances, “people preer hings ha are amiliar o hem. People roo or he local spors eams. Employees like o own heir company’s sock.” Invesors preer amiliar local invesmens, which resuls in owning subopimal porolios. Invesors perceive hese securiies as having an inverse relaion beween risk and reurn because hey perceive highly amiliar asses as possessing lower risk and higher reurn (Ricciardi 2008a). A he same ime, hey perceive unamiliar asses as producing a higher risk and lower reurn. Wang, Keller, and Siegris (2011) evaluae he risk percepion o more han 1,200 individuals rom a German-language area o Swizerland abou financial producs. Te sudy’s major resul is ha respondens perceive less complicaed (i.e., easier o

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undersand) invesmens as having lower risk, which is consisen wih amiliariy bias. Paricipans also reveal a posiive affecive reacion o amiliar financial securiies. For financial advisors, Wang e al. (2011, p. 18) offer he ollowing observaion: “Te cliens migh overesimae he risk o a cerain invesmen due o heir lack o knowledge or underesimae he risk due o heir overconfidence o he sel-perceived knowledge. o fill he knowledge gap is imporan or effecive risk communicaion.”

Financial Emotions that Influence Decisions Emoional issues can also influence he financial judgmen and decisionmaking process. Finucane, Peers, and Slovic (2003) provide his perspecive abou he differences among emoion, mood, and affec. Anemoion is a sae o consciousness relaed o he arousal o eelings. Amood or eeling is any subjecive reacions, wheher pleasurable or unlikable, ha a person migh experience rom a specific circumsance or even.Affec is he emoional complex (i.e., posiive or negaive eelings) linked wih an idea or hough. However, hese erms are applied inerchangeably wihin his chaper. Sherin (2005, p. 10) provides he ollowing perspecive o affecive (emoional) issues wihin finance: Mos managers base heir decisions on w ha eels righ o hem emoionally. Psychologiss use he echnical erm affec o mean emoional eeling, and hey use he erm affec heurisic o describe behavior ha places heavy reliance on inuiion or “gu eeling.” As wih oher heurisics, affec heurisic involves menal shorcus ha can predispose managers o bias. Grable and Roszkowski (2008) use a mailed quesionnaire o evaluae how an individual’s mood influences financial risk olerance. Teir sudy examined wo differen perspecives: (1) he Mood Mainenance Hypohesis (MMH), which saes i a person is in a posiive (negaive) mood, his deceases (increases) risk olerance; and (2) he Affec Inusion Model (AIM), which is based on he premise ha a posiive (or negaive) mood increases (decreases) an individual’s risk olerance. Based on he AIM premise, he auhors find ha individuals beween 18 and 75 years old who are in a posiive (or happy) mood exhibi a higher level o financial olerance. Rubalelli, Pasini, Rumiai, Olsen, and Slovic (2010) invesigae how individuals’ affecive reacion o differen caegories o muual unds influences heir judgmen o sell his invesmen. Afer examining a socially responsible und and a ypical muual und, paricipans are asked o provide a response o wha price hey would be willing o sell he muual und. Te auhors repor ha selling prices influence how individuals eel abou he unds, which reveals a subjecive aspec o risk. Individuals wih negaive emoional responses abou heir unds (socially and non-socially responsible ypes) have he highes selling prices. Tis oucome demonsraes ha only individuals iniially having negaive expecaions oward a financial securiy are inclined o sysemaically couner he disposiion effec. However, individuals having posiive responses abou he non-socially responsible und anchor on heir firs impressions. Consequenly, hey canno sell he losing invesmen as quickly as individuals wih negaive emoions.

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Using a quesionnaire involving more han 400 individual invesors locaed in norhern Europe, Aspara and ikkanen (2011, p. 78) assess how emoional responses abou a firm migh increase moivaion o inves a company’s sock and find ha mos invesors had affec-based, exra moivaion o inves in socks, over and beyond financial reurn expecaions. Te more posiive an individual’s atiude owards he company was, he sronger was his exra invesmen moivaion. Te auhors assign his srong posiive connecion o he firm’s sock o asel-affiniy bias, which assers ha he sronger a person’s sel-idenificaion wih a produc or a company, he more likely his individual will buy he firm’s produc/service or inves in he company’s sock. Burns, Peers, and Slovic (2012) assess he impac o he financial crisis o 2007– 2008 in order o examine he change in risk percepion during he crisis period. Te sudy uses seven quesionnaires adminisered beween Sepember 2008 and Ocober 2009. More han 600 individuals responded o each survey, and more han 400 paricipans compleed all seven quesionnaires. Te findings reveal ha a person’s percepions o risk declines mainly hroughou he early sages o he crisis and hen sars o become sable. Te mos significan acor atribuing o increases in perceived risk among respondens is negaive affec oward he crisis. Te auhors credi his resul o he risk as eelings effec(i.e., he noion ha people make quick, inuiive judgmens abou risky decisions atribued o heir emoions). TRUST

rus beween a financial proessional and a clien plays an imporan role in he financial-planning process. According o Howard and Yazdipour (2014), rus is a major componen wihin he reiremen-planning process and invesmen managemen. An imporan characerisic o he financial-planning process is developing a balance beween rus and conrol issues wihin his clien–advisor relaionship (Baker and Ricciardi 2014a, 2014b, 2015). Cliens who overly rus financial proessionals or assign oo much conrol abou financial decisions migh endure a bad oucome; Ponzi schemes are a major example o his resul. Conversely, cliens who reveal a lack o rus or who are excessively conrolling may no lisen o a financial planners’ guidance. Expers should ocus on osering a balanced relaionship o rus and conrol wih heir cliens. Wihin he risk domain, Olsen (2012) examines he connecion among rus, individual risk percepion, and cumulaive marke risk premiums. Based on survey responses rom more han 600 members o he American Associaion o Individual Invesors (AAII), he sudy discloses an inverse relaion beween rus and perceived risk in a financial environmen. Olsen (2012, p. 311) also repors ha on an economic counrywide basis, “ex-ane esimaed common sock risk premiums and ex-pos marke ineres raes vary inversely wih naional rus levels. In counries wih greaer inerpersonal rus, risk premiums and ineres raes are lower.”

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Negative Emotions Within Financial Decision Making Negaive eelings and money managemen have a long hisorical radiion and imporance in he area o financial judgmen and decision making. Emoional financial processes influence how people assess and make final decisions. Tis secion provides a discussion o affecive issues rom differen perspecives, such as money sickness, he role o differen groups, he reiremen domain, and neurofinance. Tis secion also presens he negaive emoions o worry, worry and perceived risk, and regre in behavioral finance. MONEY SICKNESS

During he 1950s, William Kauman, a psychosomaicis (i.e., an exper in medical science specializing in he inerrelaions o he mind and he body) coined he erm “money sickness” in reerence o he derimenal associaion beween money and eelings (Anonymous 1954). Kauman (1965) proposes a balanced emoional approach o money, recognizing a difference beween he posiive aspecs described as “money healh” versus he negaive qualiies known as “money sickness.” Kauman (1965, pp. 43−44) offers he ollowing viewpoin: Inappropriae use o money becomes a serious emoional hrea when he person is aced wih he conflic beween his desires and hi s conscience and wih he consequences o his aberran money behavior. Deep unconscious moivaions may preven him rom sponaneously using money in consrucive ways. Such people … ofen develop one o he mos common psychosomaic illnesses o our ime: money-sickness. Even oday many individuals are relucan o admi hey migh have an emoional money disorder, which leads o negaive eelings such as nervousness, worry, or sress. Henderson (2006), an exper in sress managemen and menal healh, concepualizes he disorder known as he money sickness syndrome. For his ype o syndrome, individuals exhibi sympoms o sress occurring rom he worry and anxiey produced by eelings o no having conrol o heir money or limied knowledge o heir financial circumsance. AXA, an invesmen and insurance firm, sponsored Henderson’s research survey o 1,022 U.K. aduls over he age o 16. Te sudy finds ha 43 percen o he respondens exhibi he sympoms associaed wih money sickness syndrome. Tese resuls imply ha he equivalen o 10.75 million o he U.K. populaion experience money worries and reveal he warning signs linked wih his psychological condiion (AXA 2006). For example, physical sympoms o he disorder include headaches, nausea, indigesion, palpiaions, lack o appeie, and poor sleeping habis. Oherwise, he psychological indicaors include mood changes, irriabiliy, general anxiey, negaive eelings, reduced concenraion, poor memory, and inerior judgmens. Tis condiion is a noeworhy example o he emerging imporance o he role o negaive affec (emoion) and financial decision making. Te behavioral finance lieraure reveals he

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evolving role o negaive affec (emoion) wihin he judgmen process in differen areas, such as individual psychology, experise o decision makers, reiremen issues, and neurofinance (neuroeconomics). INDIVIDUAL PSYCHOLOGY

Tis firs grouping o research sudies emphasizes he imporance o negaive eelings (e.g., financial worries) and individual psychology. For insance, Hira and Mugenda (1999, p. 78) invesigae he role o perceived sel-worh and worry, reporing he ollowing resuls: Respondens wih low sel- worh compared wih hose wih high sel- worh exhibied concerns abou heir financial siuaion. A significanly larger proporion o respondens wih low sel- worh (63%) han hose wih high selworh (29%) repored ha hey ofen worried abou heir finances ofen. On he oher hand, hree imes as many respondens wih high sel- worh (23%) han hose wih low sel- worh (7%) repored ha hey never worried abou heir finances. Grable and Joo (2001) examine he financial worries (sressors) o 406 individuals by presening hem wih a collecion o “sressor even iems” such as he poenial decline in income, concern over declaring personal bankrupcy, and influence o experiencing an invesmen/business loss. Te auhors find an associaion beween several acors in which individuals who reveal beter financial behaviors and higher levels o financial confidence are more saisfied wih heir curren financial circumsances. Tose reporing less sressor evens rank higher in erms o heir level o sel-eseem. Öhman, Grunewald, and Waldensröm (2003) evaluae 200 pregnan women’s worries in 16 areas and find ha he major worry caegories are he baby’s healh, birh and miscarriage roubles, and financial issues such as money and employmen problems. In erms o he emoional aspecs o decisions, Leahy (1992) uses a case sudy o describe he role o negaive eelings and he narcissisic endencies o his Wall Sree cliens. EXPERT DECISION MAKERS

Te ollowing collecion o research sudies invesigaes he role o negaive affec and financial judgmens in erms o how hese emoional issues influence he assessmen o exper decision makers. Criddle (1993) suggess ha wihin he financial and invesmen secors, individuals experience a higher degree o sress conneced o compeiive ension, which resuls in episodes o anxiey and worry. Criddle (1993, p. 19) also commens abou he role o a financial exper or invesmen proessional as an “infiniely more dangerous ‘emoional mine field’ han he world o he amaeur invesor!” Garman and Sorhaindo (2005) examine he mos imporan conceps o a “personal financial well-being consruc” in he ramework o a financial disress scale. An exper subjec mater review panel unanimously idenifies he wo op-raed issues as worrying abou he abiliy o mee monhly living coss and surviving on a paycheck-o-paycheck basis. Wihin a capial budgeing ramework, Kida, Moreno, and Smih (2001) demonsrae

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ha managers incorporae boh affecive (emoional) issues and financial saisics when assessing he uiliy o an invesmen opion. Individuals evade financial choices conneced wih negaive inerpersonal responses. Moreno, Kida, and Smih (2002, p. 1331) repor he ollowing findings: Managers were generally risk avoiding or gains in he absence o affecive reacions, as prediced by prospec heory. However, when affec was presen, hey ended o rejec invesmen alernaives ha elicied negaive affec and accep alernaives ha elicied posiive affec, resuling in risk aking in gain conexs. Te resuls also indicae ha affecive reacions can influence managers o choose alernaives wih lower economic value. Sawers (2005) conducs a capial budgeing sudy ha examines he role o negaive affec (emoions) relaed o he invesmen judgmens o 120 execuives. Te sudy repors ha managers presened wih more complex decisions describe eeling more apprehensive, worried, and uncomorable and reveal an increased need o delay making he judgmen han members in he conrol group. RETIREMENT ISSUES

Several sudies examine he influence o worry (anxiey) and financial reiremen issues. For example, Loewensein, Prelec, and Weber (1999, p. 242), who evaluae he money anxiey involved in reiremen issues, noe: Beore reiremen, one has largely adaped o one’s curren income, and hereore is impac on well- being is sligh. Moreover, one is no ye sure wheher savings will be sufficien or reiremen. All o his migh increase overall money anxiey and, simulaneously, disconnec ha anxiey rom objecive financial circumsances. Culer (2001) documens ha individuals wih incomes beween $35,000 and $100,000 and he age caegories o 35–43, 44–53, and 55–64 are more worried abou squandering all heir reiremen wealh on long-erm healh care han abou merely oulasing heir savings and pension unds. Owen and Wu (2007) repor households ha acknowledge unavorable financial pressures, worry more abou he sufficiency (adequacy) o heir financial siuaion in reiremen, even afer accouning or he influence o financial pressures (shocks) on overall wealh. Owen and Wu (2007, p. 515) commen: “we find supporing evidence ha suggess ha a leas par o he increased worry abou reiremen is due o general pessimism raher han changes in an individual’s own circumsances.” NEUROFINANCE

An emerging area o research wihin he behavioral finance lieraure involves negaive affec (emoion) and neurofinance, also known asneuroeconomics (Glimcher 2004; Peerson 2007, 2014; Zweig 2007). Shiv, Loewensein, Bechara, Damasio, and Damasio (2005) assess he financial judgmens made by people who are incapable o eeling

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emoions as a resul o brain lesions. Te sudy reveals ha individuals wih specific ypes o brain damage generae more profis invesing (i.e., produce higher gambling reurns) han he normal and conrol groups. Evidence shows ha because he braininjured subjecs canno experience emoions such as worry, anxiey or ear, hey are more inclined o accep risks wih high rewards and are less likely o exhibi affecive (emoional) reacions o prior gains or losses. Tus, hese individuals are less likely o exhibi loss-averse behavior. WORRY

For many invesors, worrying is a regular occurrence. Worrying makes hem eel as i hey are reliving a pas even or living ou a uure one, and individuals canno sop hese ypes o houghs rom happening (Ricciardi 2008b). Worry causes invesors o reflec upon bad financial memories and produces menal picures o uures ha change shor-erm and long-erm judgmens regarding heir finances. For insance, Ricciardi (2011) discloses ha a large majoriy o invesors ideniy he word worry wih socks (70 percen o he survey sample) compared o bonds (10 percen o he survey sample), based on he response o nearly 1,700 paricipans. A higher level o worry or a financial insrumen such as common socks increases is perceived risk, lowers he level o risk olerance or invesors, and increases he probabiliy o no buying his asse. Snelbecker, Roszkowski, and Culer (1990) examine he acors ha influence an invesor’s risk olerance and reurn expecaions so expers can provide beter invesmen advice and cliens can receive a more accurae risk-olerance profile. Te auhors conend ha financial planners base oo much advice regarding risk olerance and reurn expecaions on he invesmen producs and services, raher han on he clien’s personal characers such as eelings and atiudes abou invesmen decisions. Te auhors conduc wo sudies ha invesigae risk olerance and invesmen reurn prospecs: one sudy involves 49 financial planners and he oher involves 801 poenial invesors. On a group level, he financial planners demonsrae some uniormiy abou inerpreing heoreical cliens’ saemens. Ye, he sudy reveals significan differences in individual respondens’ inerpreaions o he idenical clien saemens. In he second sudy, Snelbecker e al. (1990) conduc a elephone survey or a much larger sample o individual invesors who receive a quesionnaire wih our ses o clien saemens o risk and reurn. Te wo clien saemens wih he highes level o imporance abou he associaion beween risk olerance and reurn involve worry and a desire or an invesmen reurn above inflaion. Te survey measures he worry risk componen using a quesion abou wheher a person is losing sleep worrying abou his invesmens. Te findings demonsrae how prevalen worrying is among individual invesors. Te auhors conclude ha financial proessionals should consider such evidence when communicaing and advising heir cliens. WORRY AND RISK PERCEPTION

Te sudy o worry and risk-aking behavior sared in he social sciences and evenually appeared in he behavioral finance lieraure (Ricciardi 2008b). In he social science domain, he associaion beween worry and perceived risk is an imporan area o

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invesigaion (Ricciardi 2004). Loewensein, Hsee, Weber, and Welsh (2001) propose ha judgmens o risky behaviors and hazardous aciviies incorporae a componen o negaive emoions (eelings) such as dread, concern, worry, anxiey, depression, sadness, or ear. Te oundaion or he behavioral (psychological) acors o riskpercepion sudies in behavioral finance, accouning, and economics sem rom he earlier endeavors on risky behaviors and hazardous aciviies in nonfinancial domains (Ricciardi 2004). Decision Research, an organizaion ounded by Paul Slovic, conduced groundbreaking research on risky and hazardous aciviies. Tis research documens specific behavioral risk acors ha oday are applied wihin a financial and invesmen decisionmaking conex (Ricciardi 2010). Te seminal work by Decision Research uses acor analysis o classiy an exensive collecion o risk indicaors ino wo main risk consrucs (dimensions) or nine sandard behavioral risk characerisics and survey quesions (Fischhoff, Slovic, Lichensein, Read and Comb 1978). Te firs acor is dread risk, measuring various risk-aking behaviors such as possessing caasrophic poenial, severiy o consequences, risk o uure generaions, and conrollabiliy o consequences. As Ricciardi (2008a) noes, his firs acor documens an emoional response o worry or concern oward risk, which evenually became known as dread or dreadness, which affecs an individual’s percepion o risk or a specific risky aciviy or hazardous behavior. In a sudy rom he behavioral accouning lieraure, Hodder, Koonce, and McAnally (2001) propose ha dread risk migh influence an individual’s percepion o risk or complex invesmen producs such as derivaive securiies. Ulimaely, negaive affec (emoion) influences a person’s risk percepion during he financial and invesmen judgmen process. A sudy rom he behavioral finance risk-percepion domain by MacGregor, Slovic, Berry and Evensky (1999) examines he connecion beween he decision-making process and various aspecs o invesmens/asse classes, especially exper’s percepions o reurns, risk, and risk/reurn associaions. Te auhors use compleed surveys rom 265 financial advisors involving heir assessmen o a series o 19 asse classes or 14 specific variables. Some o hese 14 characerisics are behavioral in naure (i.e., atenion, knowledge, and ime horizon) while ohers are judgmen relaed o perceived risk, perceived reurn, and likelihood o invesing. Te main finding reveals hree significan acors worry, volailiy, and knowledge as explaining 98 percen o he exper’s risk percepion. Te sudy demonsraes ha risk is a muli-acor decision-making process across a wide range o invesmen classes. Finucane (2002, p. 238) urher commens on hese findings as ollows: Perceived risk was judged as greaer o he exen ha he advisor would worry abou he invesmens ha he invesmens had greaer variance in marke value over ime, and how knowledgeable he advisor was abou he invesmen opion. Since he 1970s, researchers have conduced hundreds o risk-percepion sudies in nonfinancial areas across a wide specrum o disciplines (Ricciardi 2004, 2010). A noeworhy subjec mater wihin he risk-percepion lieraure concerns worry because his

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emoion migh influence an individual’s percepion o risk. Ulimaely, all ypes o individuals differ in heir percepions o worry and risk-aking behavior wihin he decisionmaking process. Tis perspecive o behavioral finance is based on he assumpion ha he process o worry encompasses boh cogniive and affecive (emoional) issues. Negaive emoions, especially worry, are an imporan risk indicaor and his reaffirms he noion ha risk is a mulidimensional decision-making process across a range o accouning, financial, and invesmen setings (Ricciardi 2004, 2008a, 2008b). REGRET THEORY

Regre aversion explains he emoion o regre encounered afer making a decision ha resuls in eiher an unavorable or a second-rae choice. Individuals who are predisposed by projeced regre are induced o ake less risk because doing so reduces he prospec o bad oucomes. Tis regre bias helps explain why individuals possess a relucance o sell “losing” invesmens because hey do no wan o admi a bad decision. Many individuals avoid selling securiies ha have declined in price o avoid eelings o regre and he disress o disclosing he loss. For example, Srahileviz, Odean, and Barber (2011) examine how individuals’ pas experiences wih a sock influences heir willingness o repurchase ha he same invesmen. Te sudy reveals ha people are hesian o buy back socks previously sold or a realized loss and socks ha have increased in price subsequen o pas sale ransacions. Invesors are dissaisfied when hey sell socks or a loss and experience regre or having purchased hem srcinally. Tis negaive affecive reacion discourages hem rom laer buying back socks hey sell or a loss. Because hey sold such socks, individuals are disenchaned i he socks coninue o increase in price and display regre or having sold hem he firs ime. Tis negaive affec prevens hem rom buying back socks ha increase in value afer being sold. According o Sahileviz e al. (p. S102), “invesors engage in reinorcemen learning by repurchasing socks whose previous purchase resuled in posiive emoions and avoiding socks whose previous purchase resuled in negaive emoions.” As evidence in his secion shows, negaive eelings play an imporan role wihin he realms o financial and invesmen judgmens. In he domain o finance, negaive emoions have real-world imporance or many differen aspecs o invesing. For example, he news media someimes suppor he noion o worrying in he minds o sock marke invesors by ocusing oo much o heir news coverage on marke declines or bad financial news in a shor period o ime. Tis media coverage is communicaed and overwhelms invesors across various orms such as online new sories, prin newspapers, and business segmens o elevision news (Ricciardi, 2008b). Financial worries and negaive eelings influence all ypes o individuals.

Summary and Conclusions Behavioral finance atemps o describe and improve an individual’s knowledge o he cogniive processes and affecive reacions ha shape financial oucomes. Risk percepion involves he objecive and subjecive judgmens ha individuals apply o evaluae

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risk and he degree o uncerainy or all ypes o siuaions. Te noion o an inverse (negaive) connecion beween perceived risk and reurn is o growing imporance. Te chaper discusses a wide collecion o biases ha influence he judgmen and decisionmaking processes o individuals, including represenaiveness bias, raming, anchoring affec, menal accouning, conrol acors, amiliariy bias, rus, worry, and regre heory. Te chaper also presens a deailed overview o he imporan influence o negaive emoional issues wihin he financial judgmens. Money worries and negaive affec have derimenal impacs on he financial decisions o all ypes o people, including amilies, individual invesors, and financial expers. Tese are imporan behavioral finance hemes ha financial proessionals should use o beter advise heir cliens. In effec, financial judgmens are a siuaional, mulidimensional decision-making process ha depends on he specific rais o he financial produc or service.

DISCUSSION QUESTIONS 1. 2. 3. 4.

Lis and explain some undamenal issues o behavioral finance. Provide an overview o he behavioral finance perspecives o risk. Define he heurisic biases o represenaiveness, anchoring, and menal accouning. Define and describe he process o worrying wihin he finance domain.

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Loewensein, George, Drazen Prelec, and Robero Weber. 1999. “Wha Me Worry? A Psychological Perspecive on Economic Aspecs o Reiremen.” In Henry J. Aaron (ed.),Behavioral Dimensions o Reiremen Economics, 215–246. Washingon, DC: Brookings Insiuion Press. MacGregor, Donald G., Paul Slovic, Michael Berry, and Harold R. Evensky. 1999. “Percepion o Financial Risk: A Survey Sudy o Advisors and Planners.” Journal o Financial Planning 12:8, 68–86. Moreno, Kimberly, Tomas Kida, and James F. Smih. 2002. “Te Impac o Affecive Reacions on Risky Decision Making in Accouning Conexs.”Journal o Accouning Research 40:5, 1331–1349. Nosinger, John. R. 2002. Te Psychology o Invesing. Upper Saddle River, NJ: Pearson Educaion, Inc. Öhman, Susanne G., Charlota Grunewald, and Ulla Waldensröm 2003. “Women’s Worries during Pregnancy: esing he Cambridge Worry Scale on 200 Swedish Women.”Scandinavian Journal o Caring Sciences 17:2, 148–152. Olsen, Rober. 2012. “rus: Te Underappreciaed Invesmen Risk Atribue.” Journal o Behavioral Finance 13:4, 308–313. Owen, Ann L., and Sephen Wu. 2007. “Financial Shocks and Worry abou he Fuure.” Empirical Economics 33:3, 515–530. Peerson, Richard. L. 2007. Inside he Invesor’s Brain: Te Power o Mind over Money. Hoboken, NJ: John Wiley & Sons, Inc. Peerson, Richard, L. 2014. “Neurofinance.” In H. Ken Baker and Vicor Ricciardi (eds.), Invesor Behavior Te Psychology o Financial Planning and Invesmen, 381–401. Hoboken, NJ: John Wiley & Sons, Inc. Piaelli-Palmarini, Massimo. 1994. Ineviable Illusions: How Misakes o Reason Rule Our Minds. New York: John Wiley. Ricciardi, Vicor. 2004. “A Risk Percepion Primer: A Narraive Research Review o he Risk Percepion Lieraure in Behavioral Accouning and Behavioral Finance.” Working Paper, Goucher College. Available ahtp://ssrn.com/absrac=566802. Ricciardi, Vicor. 2006. “A Research Saring Poin or he New Scholar: A Unique Perspecive o Behavioral Finance.” ICFAI Journal o Behavioral Finance 3:3, 6–23. Available a htp://ssrn. com/absrac=928251. Ricciardi, Vicor. 2008a. “Risk: radiional Finance versus Behavioral Finance.” In Frank J. Fabozzi (ed.), Te Handbook o Finance, Volume3: Valuaion, Financial Modeling, and Quaniaive ools , 11–38. Hoboken, NJ: John Wiley & Sons, Inc. Ricciardi, Vicor. 2008b. “Te Psychology o Risk: Te Behavioral Finance Perspecive.” In Frank J. Fabozzi (ed.), Te Handbook o Finance, Volume 2: Invesmen Managemen and Financial Managemen, 85–111. Hoboken, NJ: John Wiley & Sons, Inc. Ricciardi, Vicor. 2010. “Te Psychology o Risk.” In H. Ken Baker and John R. Nosinger (eds.), Behavioral Finance: Invesors, Corporaions, and Markes, 131–149. Hoboken, NJ: John Wiley & Sons, Inc. Ricciardi, Vicor. 2011. “Te Financial Judgmen and DecisionMaking Process o Women: Te Role o Negaive Feelings.” Tird Annual Meeing o he Academy o Behavioral Finance and Economics, Sepember. Available ahtps://ssrn.com/absrac=1936669. Ricciardi, Vicor, and Douglas Rice. 2014. “Risk Percepion and Risk olerance.” In H. Ken Baker and Vicor Ricciardi (eds.), Invesor Behavior Te Psychology o Financial Planning and Invesmen, 327–345. Hoboken, NJ: John Wiley & Sons, Inc. Roszkowski, Michael J., and Glenn E. Snelbecker. 1990. “Effecs o Framing on Measures o Risk olerance: Financial Planners Are No Immune.”Journal o Behavioral Economics 19:3, 237–246. Roter, Julian. B. 1971. “Exernal Conrol and Inernal Conrol.”Psychology oday 5:1, 37–42, 58–59. Rubalelli, Enrico, Giacomo Pasini, Rino Rumiai, Rober Olsen, and Paul Slovic. 2010. “Te Influence o Affecive Reacions on Invesmen Decisions.”Journal o Behavioral Finance 11:3, 168–176.

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Part Two

THE FINANCIAL OF MAJORBEHAVIOR PLAYERS

45

3 Individual Investors HENRI

K C RONQV IST Professor of Finance

School of Business Administration, University of Miami DANLING JIANG SunTrust Professor and Associate Professor of Finance College of Business, Florida State University

Introduction Over he pas wo decades, our undersanding o individual invesor behavior has changed dramaically. e radiional paradigm ha ocuses on economic incenives and raionaliy has been replaced by a new, more holisic paradigm ha includes addiional acors influencing invesor behavior. ese addiional acors include invesors’ geneics, lie experiences, nonsandard belies and preerences, socieal norms and culure, and group ideniies. e holisic approach provides a more comprehensive perspecive o wha defines and shapes he decision-making process o individual invesors, and wheher heir behaviors and decisions collecively mater or asse prices and corporae policies. is chaper examines recen advances in finance research along hese dimensions ha define individual invesor behavior and have implicaions or asse pricing and corporae decisions. Owing o limied space, he chaper only reviews some represenaive work in each opic.

Innate and Learned Investor Behavior e radiional paradigm in finance does no atemp o explain he srcins o invesors’ preerences and belies. However, an emerging body o research atemps o do exacly ha by racing he heerogeneiy in invesor behavior back o geneic acors, cogniive abiliy, and various personal experiences. GENETIC FACTORS AND NEURAL

FOUNDA TIONS

e longsanding debae in behavioral geneics and psychology abou wheher “naure” (i.e., geneic acors) or “nurure” (i.e., he environmen) shapes individual rais has recenly made is way ino research on invesor behavior. Barnea, Cronqvis, and Siegel 45

46

THE FINANCIAL

BEHAVI OR OF MAJOR PLAYERS

(2010) and Cesarini, Dawes, Johannesson, Lichensein, Sandewall, and Wallace (2010) combine daa on idenical and raernal wins and daa on porolio allocaions rom ax regisers, enabling hem o decompose he cross-secional variaion in invesor behavior ino geneic and environmenal componens. ey find ha geneic acors explain abou one-hird o he variaion in invesmen decisions. e auhors inerpre hese resuls as evidence o innae differences in acors affecing sock marke paricipaion coss, as well as geneic variaions in risk preerences. Experimenal evidence in economics suppors hese sudies (Cesarini, Dawes, Johannesson, Lichensein, and Wallace 2009; Zyphur, Narayanan, Arvey, and Alexander 2009). Cronqvis and Siegel (2014) exend he noion ha geneic acors may be responsible or heerogeneiy in invesmen behavior by showing ha several well-documened invesmen biases, such as he disposiion effec, perormance-chasing behavior, and a preerence or skewness, are parly geneic. ey inerpre hese resuls as implying behaviors ha may resul in invesmen misakes may have been advanageous in evoluionary ancien imes, in he sense ha hese behaviors resuled in greaer “finess” (i.e., reproducive success) and hereore became more common in he populaion. A relaed sring o research in neuroscience examines he neural oundaions o invesmen behavior (Kuhnen and Knuson 2005). Evidence finds specific genes o be relaed o invesor behavior. For example, he DD4 gene explains financial risk preerences (Dreber, and, Fudenberg, and Nowak 2008), he monoamine oxidase A (MAOA) gene is relaed o risk-aking (Frydman, Camerer, Bossaers, and angel 2011; Zhong, Israel, Xue, Ebsein, and Chew 2009), and wo genes ha regulae dopamine and seroonin neuroransmission (5-HTLP and DD4) deermine risk-aking in he invesmen domain (Kuhnen and Chiao 2009). e same brain areas involved in processing emoional saes also process risk preerences and payoff belies (Kuhnen and Knuson 2011). Candidae gene sudies and genome-wide associaion sudies (GWAS) have boh promises and poenial pialls (Benjamin, Cesarini, Chabris, Glaeser, Laibson, Guonason, Harris, Launer, Purcell, and Smih 2012). COGNITIVE ABILITY AND IQ

Several sudies find ha cogniive abiliy parly explains invesor behavior. Using daa rom 11 European counries, Chriselis, Jappelli, and Padula (2010) find ha differences in individuals’ cogniive abiliy parly explain he propensiy o paricipae in he sock marke. In a series o sudies (2011, 2012, 2016), Grinblat and his coauhors show ha individuals wih higher inelligence quoien (IQ) scores make beter invesmen decisions. Higher IQ invesors are more likely o paricipae in he sock marke, diversiy by holding muual unds or a greaer number o socks, assume less risk, earn higher Sharpe raios, display ewer invesmen biases, exhibi beter iming and sock-picking skills, and avoid high managemen ees when selecing muual unds (Grinblat, Keloharju, and Linnainmaa 2011, 2012; Grinblat, Ikaheimo, Keloharju, and Knuper 2016). ecen relaed research also pays close atenion o he relaions among aging, cogniive abiliy, and invesor behavior, which are increasingly imporan wih an aging populaion responsible or is own invesmens. Aging causes a well-documened decline in people’s cogniive abiliy, bu i also increases invesmen experience. e adverse effec o aging, however, empirically dominaes any experience effec; older invesors exhibi worse invesmen skills even hough hey are more experienced (Korniois and Kumar

47

I n d i v i d u al In v e s to r s

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2011). In ac, financial misakes appear o ollow a U-shaped patern, wih he ewes misakes made around age 53 (Agarwal, Driscoll, Gabaix, and Laibson 2009). Alhough aging decreases cogniion and financial lieracy, i is no associaed wih a drop in confidence in managing one’s own finances (Gamble, Boyle, Yu, and Benet 2015). PERSONAL LIFE EXPERIENCES

Lie-course heory suggess ha boh early and lae personal experiences in lie may explain behavior laer in lie. As a resul, an invesor’s behavior may be pah dependen. In ac, one’s firs lie experiences ake place during he prenaal period, as an unborn eus in he moher’s womb. According o Cronqvis, Previero, Siegel, and Whie, (2016), higher prenaal exposure o esoserone is associaed wih elevaed risk-aking and rading in adulhood. Individuals wih higher birh weigh or a general measure o prenaal lie experience are more likely o paricipae in he sock marke. Addiionally, invesors wih lower birh weigh end o preer porolios wih higher volailiy and skewness. Boh pieces o evidence are consisen wih compensaory behavior. Laer in lie, individuals may be shaped by oher personal lie experiences, including macroeconomic experiences ha influence many individuals simulaneously, such as he Grea Depression o he 1930s or he financial crisis o 2007– 2008. As Malmendier and Nagel (2011) show, individuals’ long-erm experiences wih sock and bond markes deermine heir propensiies o paricipae in hose markes. ey also show ha macro experiences affec belies, raher han risk preerences, because experienced higher sock reurns are associaed wih more opimisic belies abou uure sock reurns. Weber, Weber, and Nosić (2013) and Guiso, Sapienza, and Zingales (2013), however, find ha risk aversion increased subsanially in he immediae afermah o he financial crisis o 2007– 2008, even among invesors who did no suffer any losses. a is, negaive macro experiences resul in increased risk aversion or less opimisic belies abou uure sock reurns. As Knüper, anapuska, and Sarvimäki (2016) repor, workers who experienced adverse labor marke condiions during he Finnish Grea Depression in he early 1990s are less likely o paricipae in he sock marke laer in lie. Cronqvis, Siegel, and Yu (2015) find ha individuals who experienced more adverse macroeconomic condiions are more likely o avor value socks as opposed o growh socks. Individual experiences relaed o he sock marke also explain subsequen invesor behavior. For example, individual invesors who experienced higher reurns rom subscripions o iniial public offerings (IPOs) are more likely o subscribe o uure IPOs in Finland (Kausia and Knüper 2008) and aiwan (Chiang, Hirshleier, Qian, and Sherman 2011). e evidence is consisen wih naïve reinorcemen learning, wherein individuals become overly opimisic afer experiencing good reurns. Consisen wih he noion o “once burned, wice shy,” Srahileviz, Odean, and Barber (2011) find ha invesors are relucan o repurchase socks previously sold or a loss and ha have risen in price subsequen o ha sale. is behavior reflecs invesors’ atemps o di sance hemselves rom negaive emoional ex periences such as disappoinmen and regre. As Greenwood and Shleier (2014) find in muliple surveys o individual invesors, expeced reurns are all highly correlaed wih recen marke reurns, bu are negaively relaed o he implied expeced reurns ha are compued rom aggregaed daa on dividends, consumpion, and marke valuaion measures, as well as uure marke reurns. A conclusion rom hese sudies is ha

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individuals appear o over- weigh heir personal experiences in he sock marke wih insufficien consideraion o all available daa.

Nonstandard Investor Preferences e radiional paradigm summarizes invesor preerences wih respec o risk aversion and wealh. However, recen research inroduces nonsandard preerences relaed o oher acors or example, prospec heory, menal accouning, realizaion uiliy o gains and losses, and preerences or skewness and amiliariy. THE DISPOSITION EFFECT, PROSPECT ACCOUNTING, AND REALIZATION UTILITY

THEORY, MENT

AL

Sherin and Saman (1985) propose he disposiion effec, which reers o he behavior o invesors o sell winner socks more readily han loser socks. ey sugges several explanaions or his effec, including prospec heory (Kahneman and versky 1979) and he relucance o close menal accouns wih a loss (aler 1985). Weber and Camerer (1998) offer evidence o he disposiion effec using an experimenal approach. Odean (1998a) ess he disposiion effec by using brokerage accoun daa and finds ha individual invesors on average realize abou 15 percen o paper gains bu less han 10 percen o paper losses. He ocuses on he prospec heory explanaion, which predics ha prior gains elici risk aversion, whereas prior losses elici risk seeking. In aiwan sock markes where individual invesors dominae, 84 percen o he invesors sell winners aser han losers (Barber, Lee, Liu, and Odean 2007). e srengh o he disposiion effec varies across invesors. More sophisicaed invesors, such as wealhy individuals wih proessional occupaions or more rading experience and who execue more clusered rades, exhibi a weaker disposiion effec (Dhar and Zhu 2006; Feng and Seasholes 2005; Kumar and Lim 2008). However, Barberis and Xiong (2009) show heoreically ha prospec heory canno easily generae he disposiion effec in a dynamic seting. Insead, Barberis and Xiong (2012) and Ingersoll and Jin (2013) sugges ha invesors receive uiliy by realizing paper gains and disuiliy by realizing paper losses consisen wih a menal accouning ha involves a narrow raming o gains and losses. In a recen experimenal sudy, Frydman, Barberis, Camerer, Bossaers, and angel (2014) documen he neural oundaions o such realizaion uiliy. However, when invesors can ranser a menal accoun rom one sock o anoher by selling and buying on he same day, hey exhibi no relucance o sell he iniial losers (Frydman, Harzmark, and Solomon 2016). Addiionally, some propose cogniive dissonance, which is he psychology o eeling discomor when one recognizes one’s own misakes or own incorrec belies as an explanaion or he disposiion effec. For example, individual day raders in Finland are unwilling o close heir losing-day rades, and such uninended posiions hur heir porolio perormance in subsequen monhs (Linnainmaa 2005). Alhough he disposiion effec is presen when rading individual socks, i reverses when rading muual unds or he same invesor and a he same ime, as invesors can blame he managers in regard o he porolio delegaion (Chang, Solomon, and Weserfield 2016).

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Wheher he disposiion effec is he deermining acor in invesors’ selling decisions remains an acive area o research. Evidence by Kausia (2010) shows ha selling propensiy jumps a zero reurns, bu is insensiive o he magniude o gains and losses. As Ben-David and Hirshleier (2012) show, he probabiliy o selling as a uncion o profi is V-shaped (i.e., a shor holding periods, invesors are more likely o sell bigger losers han smaller ones). Similarly, Harzmark (2015) uncovers he rank effec in which invesors are more likely o sell he exreme winning and losing socks in heir own porolio. None o hese findings can be easily reconciled wih he disposiion effec driven by prospec heory or he realizaion uiliy. PREFERENCE FOR SKEWNESS

e idea ha individuals preer o gamble when making invesmen decisions emerged nearly 70 years ago, saring wih Friedman and Savage (1948) and Markowiz (1952). esearchers propose several heoreical reasons or individuals exhibiing a skewness preerence. Sherin and Saman (2000) sugges ha a preerence or loteries or loteryype securiies is a necessary consequence when invesors aspire o move up in social saus. Brunnermeier, Gollier, and Parker (2007) model he preerence or skewness as an oucome o invesors’ being overly opimisic abou he probabiliy o good saes o he world. Miton and Vorkink (2007) model invesors o have heerogeneous preerences or skewness. Barberis and Huang (2008) show ha invesors are willing o pay or skewness as hey over-weigh he probabiliy o exremely rare evens, a eaure o he cumulaive prospec heory (versky and Kahneman 1992). A large body o empirical work suppors conjecures ha invesors have a skewness preerence. As Kumar (2009) shows, he porolios o reail invesors bu no hose o insiuional invesors over-weigh lotery-ype socks, which are characerized by low price, high idiosyncraic volailiy, and high idiosyncraic skewness. e demand or lotery-ype socks increases during economic downurns, and socioeconomic acors ha induce greaer expendiure on loteries are also associaed wihgreaer invesmen in lotery-ype socks. As Doran, Jiang, and Peerson (2012) show, he Las Vegas gaming revenues and inersae lotery sales surge ahe urn o he year, and simulaneously invesors are bullish on lotery-ype socks and opions. Dorn, Dorn, and Sengmueller (2015) and Gao and Lin (2015) provide evidence consisen wih invesors’ alernaing beween playing he lotery and gambling in financial markes. Kumar, Page, and Spal (2011) use he raio o he Caholic o Proesan adherens in a region in he Unied Saes o capure he gambling-oleran culure; hey show ha in regions wih higher Caholic o Proesan raios, local invesors exhibi a sronger propensiy o hold loteryype socks. PREFERENCE FOR

FAMILIARI

TY

e mere-exposure effec in psychology implies ha people have a srong preerenc e or he amiliar, even in he absence o inormaion (Zajonc 1968). Indeed, he invesmen lieraure repeaedly documens a preerence or he amiliar. For example, Huberman (2001) shows ha a regional Bell operaing company’s shareholders end o live in he same region as he company serves. Massa and Simonov (2006) repor ha individual invesors do no hedge bu, raher, inves in socks closely relaed o heir nonfinancial income.

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Individual invesors end o over-weigh local socks in heir porolios, where local socks are o companies whose headquarers are locaed geographically close by. Ivković and Weisbenner (2005) find ha individual invesors earn higher average reurns on local raher han nonlocal holdings, whereas Seasholes and Zhu (2010) find ha local socks purchased by individual invesors generae uure average reurns inerior o local socks sold by hese invesors, suggesing subopimal decisions regarding rading local securiies. Sock in one’s own company and in producers o consumer producs are alernaive sources o amiliariy in he invesmen domain. Individuals have a srong preerence or invesmen in heir own company’s socks, alhough hey do no have any inormaion advanage (Benarzi 2001). Employees in sandalone companies significanly overweigh heir own company’s socks more han employees in conglomerae firms, which is consisen wih loyaly-influencing porolio choice (Cohen 2009). Furhermore, a company’s long-erm cusomers end o be loyal invesors in ha company (Keloharju, Knüper, and Linnainmaa 2012).

Investor Psychology Invesor psychology plays a minimum role in he radiional paradigm ha relies on raional opimizaion o expeced uiliies and Bayesian updaing. However, he new paradigm, especially he developmen o behavioral finance, highlighs he imporance o heurisics and psychological rais in undersanding individual behaviors. Several specific heurisics or rules o humb have spurred considerable finance research. OVERCONFIDENCE

Overconfidence reers o invesors’ endency o overesimae heir own signal precision or heir personal abiliy o do well in rading. I is probably he mos esablished psychological rai in heory and empirical ess o finance research. Earlier models (Daniel, Hirshleier, and Subrahmanyam 1998, 2001; Odean 1998b; Scheinkman and Xiong 2003) esablish he powerul insighs o overconfidence o help undersand excess rading, excess volailiy, over- and underreacions, and even-based reurn predicabiliy. Models o Daniel e al. (1998) and Gervais and Odean (2001) highligh he persisence o overconfidence when invesors exhibi biased sel- atribuion. In a series o empirical sudies using individual rading records rom a large U.S. brokerage house, Barber and Odean, ogeher wih heir coauhors, uncover inriguing evidence ha suppors he heory o overconfiden rading. Socks sold by individual invesors ouperorm socks hey purchase (Odean 1999). Invesors who rade more have worse cos-adjused rading perormances (Barber and Odean 2000a). Males engage in more acive rading han emales, bu suffer rom worse reurns (Barber and Odean 2001). In Finland, more overconfiden invesors, revealed by a sandard psychological assessmen upon inducion ino mandaory miliary service, end o have higher porolio urnover laer in lie (Grinblat and Keloharju 2009).

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In oher words, acive rading is he mos imporan maniesaion o overconfidence. However, i comes wih considerable cos. In aiwan, acive rading by individual invesors resuls in a loss o 3.8 percen in heir aggregae porolio, which is equivalen o 2.8 percen o heir oal personal income and above 2 percen o he counry’s gross domesic produc (GDP) (Barber, Lee, Liu, and Odean 2009). Individual day raders accoun or 17 percen o he rading volume, bu only 20 percen o hem earn posiive ne reurns in a given year and less han 1 percen do so in wo consecuive years (Barber, Lee, Liu, and Odean 2014). French (2008) esimaes ha invesors pay a ne cos o 67 basis poins o he aggregae marke value a year as a resul o atemping o bea he U.S. marke. eories o overconfiden rading and biased sel-atribuion lead o discoveries o marke regulariies. ey include, or example, he posiive correlaion beween urnover and lagged reurns (Saman, orley, and Vorkink 2006), he exisence o sysemaic mispricing ha can be capured by firm exernal financing (Hirshleier and Jiang 2010), he abiliy o he cross-secional dispersion in firm valuaion raios o negaively orecas uure aggregae reurns (Jiang 2013), and he ouperormance o socks wih upward coninuing overreacions relaive o socks wih downward coninuing overreacions (Byun, Lim, and Yun 2016). LIMITED

ATTENTION

Individual invesors have limied atenion and limied processing power; hus, hey can be atraced o, or disraced by he conen, salience, and amoun o news, as well as by aciviies ouside he financial domain. When selecing muual unds, individual invesors pay atenion o he more salien ron-end loads and recen und perormances, as opposed o he less salien operaing expenses (Barber, Odean, and Zheng 2005). In esablishing selecion crieria, individual invesors are ne buyers o socks ha grab heir atenion, such as hose wih high abnormal rading volume or exreme one-day reurns (Barber and Odean 2008). In China, socks ha hi heir upper price limis are associaed wih high invesor atenion as measured by high volumes and more news coverage, bu reurn reversals ollow in he subsequen week (Seasholes and Wu 2007). On he day ollowing a marke-wide atenion even, such as a record level or he Dow Jones Indusrial Average (DJIA), individual invesors sell more equiy holdings (Yuan 2015). is limied atenion by individual invesors leads o predicable reurns and marke reacions o news. eacions o earnings announcemens are weak, bu subsequen drif is srong when earnings are announced on Fridays (DellaVigna and Polle 2009), when many compeing announcemens occur in he same indusry (Hirshleier, Lim, and eoh 2009), and when here is inensive indusry-wide news ( Jacobs and Weber 2016). eurn shocks o large cusomer-produc firms slowly diffuse o he sock prices o heir supplier firms (Cohen and Frazzini 2008). eurn shocks o sraighorward (sand-alone) firms precede he reurn shocks o complicaed (conglomerae) firms (Cohen and Lou 2012). Gradual, small changes in prices are accompanied by srong price momenum, whereas large, sudden changes are no (Da, Gurun, and Warachka 2014). When invesors ocus on earnings as opposed o cash flows, he firms wih high

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ne operaing asses, which measure he cumulaive differences beween earnings and cash flows, on average earn low subsequen reurns (Hirshleier, Hou, eoh, and Zhang 2004). Managers atrac invesor atenion hrough adverisemens o boos shorerm sock prices; he iming o heir adverisemens coincides wih insider rading (Lou 2014). MOOD, EMOTION, AND SENTIMENT

Mood and emoion, which are he saes o eelings a he ime o decision making, may influence invesor behavior (Loewensein, Weber, Hsee, and Welch 2001). Posiive emoions lead o invesor opimism and increased willingness o ake risk (Kuhnen and Knuson 2011). Numerous empirical findings suppor such a hypohesis. For example, Hirshleier and Shumway (2003) repor evidence consisen wih “emoional misatribuion,” in he sense ha weaher condiions such as sunshine and cloud cover affec invesor behavior. Edmans, Garcia, and Norli (2007) sudy changes in invesor mood and behavior during spors evens. Similar sudies show ha negaive mood depresses sock markes, such as hose involving aviaion disasers (Kaplanski and Levy 2010). Invesors do no exer any influence over hese moderaors o heir moods, suggesing a causal inerpreaion. Evidence also shows mood effecs or reoccurring and predicable evens. For example, Kamsra, Kramer, and Levi (2003) repor ha he number o hours o dayligh drives invesor behavior. Frieder and Subrahmanyam (2004); Białkowski, Eebari, and Wisniewski (2012); and Bergsma and Jiang (2016) sudy sock marke behavior during culural and religious holidays, and hey conclude ha esive mood is an explanaion or some marke movemens. Evidence by Karabulu (2013) shows ha he Facebook’s Gross Naional Happiness (GNH) index is a posiive predicor o he nex day’s sock marke reurns. Da, Engelberg, and Gao (2015), who developed he Financial and Economic Atiudes evealed by Search (FEAS) index as a proxy or negaive mood sae, show ha higher reurns oday bu lower reurns he nex day accompany increases in he FEAS index. Some evidence by Kausia and anapuska (2016) shows ha weaher- based mood proxies, such as sunniness, emperaure, and precipiaion, are significanly relaed o he rading behavior o individual invesors, who also exhibi seasonal behavior across days o he year and he week beore holidays. elaed o mood is a large srand o lieraure on invesor senimen, which usually reers o collecive, incorrec belies and preerences, and his can be hough o as a measure o invesor affec sae. Baker and Wurgler (2006) show ha a senimen index consruced rom, or example, he closed-end und discoun, rading volume, iniial public offering (IPO) firs-day reurns, and volume predics he cross-secional reurns on hard-o-arbirage socks in he ollowing year. Hwang (2011) finds ha invesor senimen regarding a cerain counry causes changes in ha counry’s closed-end und discoun. Boh senimen and mood measure he collecive opimism versus he pessimism o invesors oward marke saes and asse values. A possible difference beween he wo is, perhaps, ha mood is ied o emoions ha can vary requenly (daily or even hourly), whereas senimen is ied o atiudes ha are relaively slow moving.

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53

More generally, firms ha elici posiive affec receive a greaer porolio weigh or a pricing premium, including hose wih euphonious (Aler and Oppenheimer 2006; Andersson and akow 2007) or parioic (Morse and Shive 2011; Benos and Jochec 2013) names, and admired companies (Saman, Fisher, and Anginer 2008). In conras, he marke discouns socks ha elici negaive affec, such as hose associaed wih obacco, alcohol, gaming, firearms, miliary sales, and nuclear operaions (Hong and Kacperczyk 2009; Saman and Glushkov 2009). In urn, firms seem o exploi he invesor affec. For example, dual-class companies sraegically label heir inerior voing shares as “Class A” bu heir superior voing shares as “Class B” and hus gain rom IPOs (Ang, Chua, and Jiang 2010). e effec o invesors’ atiudes oward cerain company characerisics can ade or even reverse when he macroeconomic environmen changes. During he do-com boom o he lae 1990s, companies ha changed o do-com ype names experienced posiive marke reacions (Cooper, Dimirov, and au 2001). Ye, when he docom bubble burs in he early 2000s, he companies ha swiched o a convenional name experienced posiive marke reacions (Cooper, Khorana, Osobov, Pael, and au 2005).

Social Context Individuals do no make invesmen decisions in isolaion; raher, hey make heir decisions in he conex o a variey o imporan social acors. Such acors include social ineracion, social ideniy, social norms, and social capial, as well as more general culure effecs. SOCIAL INTERACTION AND PEER EFFECT

Individuals have social neworks ha include amily, riends, co-workers, neighbors, and ohers. People in hese neworks may influence ohers’ invesmen behaviors. e behavior o amily is o he firs order, undersandably. Evidence by Li (2014) indicaes ha an invesor’s likelihood o enering he sock marke wihin he nex five years is 20 o 30 percen higher i he individual’s parens or children have enered he sock marke during he prior five years. Imporanly, social ineracion effecs exend beyond he amily. Evidence shows ha he behavior o peers riends, neighbors, and co-workers parly drives he decision o paricipae in he sock marke (Hong, Kubik, and Sein 2004; Guiso and Jappelli 2005; Brown, Ivković, Smih, and Weisbenner 2008; Hvide and Ösberg 2015). Shive (2010) applies a disease epidemic model and finds ha he ransmission rae o financial rumors hrough social conac predics invesor behavior. However, he orces driving invesor nework effecs such as simple imiaion, herding, or biased inormaion ranser remains unclear (Ozsoylev, Walden, Yavuz, and Bildik 2014). Evidence by Kausia and Knüper (2012) shows ha he invesmen perormance o one’s peers influences an individual’s decision o ener he sock marke. is social learning is runcaed when a peer’s reurns all below zero, which is consisen wih he heoreical predicions by Han and Hirshleier (2015), who model he

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sel-enhancing ransmission bias in social ineracions leading o biased inormaion sharing. Group dynamics is a specific source o social ineracion. Barber and Odean (2000b) find ha invesmen clubs underperorm he marke even more han individuals. Furhermore, boh clubs and individuals are more likely o inves in socks ha are associaed wih a good reason, such as a company on a mos-admired companies lis, bu groups avor such socks more han do individuals, despie he ac ha such reasons do no improve perormance (Barber, Heah, and Odean 2003). SOCIAL IDENTITY AND SOCIAL NORMS

Evidence by Akerlo and Kranon (2000) and Bénabou and irole (2011) shows ha an individual’s social ideniy (i.e., personal sense o sel) affecs his or her invesmen behavior. Specific examples o social ideniy are civic engagemen and poliical orienaion. Poliically acive individuals, irrespecive o heirpoliical affiliaion, spend abou 30 minues more on acquiring news daily and are more likely o paricipae in he sock marke (Bonapare and Kumar 2013). According o Kausia and orsila (2011), moderae lef voers are abou 20 percen less likely o inves in socks compared o moderae righ voers, conrolling or wealh and oher individual characerisics. eir evidence is consisen wih he noion ha personal values affec invesmen decisions, in his case leading o “sock marke aversion.” Individual invesors perceive sock markes as less risky and more undervalued when “heir” pary is in power (Bonapare, Kumar, and Page 2012). Ineresingly, a reverse effec o sock ownership exiss in regard o poliical behavior. Plausibly exogenous demuualizaions in cerain regions inFinland resuled in an increase in he righ-o-cener voe share in hose regions (Kausia, Knüper, and orsila 2015). Social norms and values may also influence invesors. For example, invesors may have social preerences, implying ha hey inernalize he uiliy o ohers in sociey. As Hong and Kosovesky (2012) show, proessional invesors who donae primarily o he Democraic Pary in poliical campaigns over-weigh socks o socially responsible firms, bu avoid socks in indusries such as deense, gun manuacure, and obacco. Some emerging evidence also shows ha individual invesors who exhibi prosocial behavior in experimens are more likely o inves in socially responsible muual unds (iedl and Smees 2014). is research raises he quesion o wheher social ideniy or normconsrained invesors underperorm (i.e., pay a price or heir behavior). Evidence by Hong and Kacperczyk (2009) shows ha “sin” socks earn higher han expeced reurns. Ye, oher evidence suggess ha he more socially responsible or employee-riendly firms deliver higher abnormal reurns (Derwall, Guenser, Bauer, and Koedijk 2005; Edmans 2011). SOCIAL CAPI

TAL AND TRUST

rus reers o he confidence in receiving air reurns rom economic ransacions. As Guiso, Sapienza, and Zingales (2008) show, rusing individuals in he Neherlands are more likely o paricipae in sock markes and inves more in risky asses. Similar resuls are repored or he Unied Saes whereas more rusing individuals and households are beter a managing invesmens (Balloch, Nicolae, and Philip 2015) and debs ( Jiang

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and Lim 2016). rus influences individual invesmen risk percepions and equiy premium (Olsen 2012), and i may also explain he specific securiies ha individuals selec. Kelly (2014) finds ha less rusing individuals have a preerence or dividendpaying as opposed o non-dividend-paying socks. Some recen research shows ha he behaviors o individual invesors reflec changes in rus. As Gianneti and Wang (2016) show, sock marke paricipaion declines in a U.S. sae afer revelaion o a prominen corporae raud case in ha sae. Individuals decreased heir holdings in non-raudulen firms locaed in ha sae, even i hey did no hold socks in he raudulen firms. Similarly, Gurun, Soffman, and Yonker (2015) sudied he effecs o rus on invesor behavior by exploiing he geographic dispersion o vicims in he Bernie Madoff scandal. eir resuls show ha invesors in communiies ha were more exposed o he raud wihdrew heir asses rom heir invesmen advisers and increased heir cash deposis in banks. rus is an imporan componen o social capial. In general, social capial reers o our connecions wih each oher, and i can be measured by he general neworks o hose in a communiy ha promoes social and poliical engagemen (Punam 2000). a is, sociabiliy promoes invesing. Guiso, Sapienza, and Zingales (2004) show ha communiies wih higher social capial have beter financial developmen, including more invesmens in socks and less in cash. Georgarakos and Pasini (2011) and Changwony, Campbell, and abner (2015) also find ha rus, and social engagemen more generally, explains individuals’ paricipaion in sock markes. CULTURE

Culure affecs various economic oucomes (Guiso, Sapienza, and Zingales 2006). Culural norms and proximiy also affec behavior among individual invesors. Evidence by Grinblat and Keloharju (2001) shows ha invesors in Finland are more likely o rade socks in companies ha communicae in he invesor’s naive ongue and ha have a chie execuive o he same culural background. As Kumar, Niessen-uenzi, and Spal (2015) show, financial managers wih oreign-sounding names have 10 percen less annual und flows, and or unds run by hose managers, invesors exhibi greaer sensiiviy o bad perormance. Culural norms reflec values ha change only very slowly over ime, as hey are ransmited rom one generaion o he nex. Findings by D’Acuno, Prokopczuk, and Weber (2015) indicae ha invesors are less likely o paricipae in sock markes in counies o Germany where Jewish persecuion was higher in he Middle Ages and he Nazi period. eir evidence is consisen wih a persisen culural norm o disrus in finance ha varies regionally. TECHNOLOGY

echnology can be considered an environmenal acor ha builds he venues and plaorms or invesing. In recen decades, echnologic innovaions have drasically changed how individual invesors inves. Because echnology has made invesing more accessible and less cosly, i has been beneficial. However, when echnology ineracs wih behavioral biases, i can be derimenal.

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Barber and Odean (2000a) show ha he availabiliy o online rading causes significan increases in rading volume, bu invesors who swich o online rading suffer rom poor rading perormance. Alhough Choi, Laibson, and Merick (2002) find ha web access by invesors doubles he rading requency, hey find no evidence ha online rading leads o higher reurns. Wih such echnological innovaions, inormaion becomes more accessible, which enables measuremen o invesor atenion and inormaion acquisiion more direcly. Using he Google Search Volume Index (SVI) o capure individual invesor atenion, Da, Engelberg, and Gao (2011) show ha his index predics high subsequen reurns wihin he nex wo weeks ha are ollowed by a reversal. Leung, Agarwal, Konana, and Kumar (2016) use he search behaviors o individuals who visi he Yahoo!Finance websie o ideniy reurn co-movemen among socks wihin he search clusers.

Summary and Conclusions Wihin he las wo decades, here has been a ransormaion rom he radiional paradigm o a new approach ha akes a broader view oward undersanding individual invesor behavior and financial decision making. is new paradigm atemps o undersand he behavioral srcin (geneics and neural roos), behavioral ormaion (personal lie experiences), and behavioral moivaion (psychology and preerence), as well as he behavioral conex (sociey, environmen, and culure) o individual invesors. e growh o knowledge in his new paradigm recognizes he complexiy o individual decision making and is collecive influence on financial markes and company decisions. Hirshleier (2015) reers o his new paradigm as “social finance,” a more advanced orm o behavioral finance. Moving orward, finance research is likely o coninue expanding by inegraing knowledge rom oher disciplines ino he undersanding o individual invesors and heir impacs on markes and companies.

DISCUSSION QUESTIONS 1. Discuss he main differences beween he radiional and he modern finance paradigm in undersanding he behavior o individual invesors. 2. Explain he broad implicaions o sudies o geneics, neural roos, and personal lie experiences or undersanding he behavior o individual invesors. 3. Discuss he disposiion effec and he proposed explanaions or his effec. 4. Ideniy he social acors ha influence individual invesor decisions and discuss he imporance o considering he social conex when making invesmen decisions.

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Saman, Meir, Seven orley, and Keih Vorkink. 2006. “Invesor Overconfidence and rading Volume.” eview o Financial Sudies 19:4, 1531–1565. Saman, Meir, Kenneh L. Fisher, and Deniz Anginer. 2008. “Affec in a Behavioral Asse Pricing Model.” Financial Analyss Journal64:2, 20–29. Srahileviz, Michal Ann, errance Odean, and Brad M Barber. 2011. “Once Burned, wice Shy: How Naïve Learning, Couneracuals, and egre Affec he epurchase o Socks Previously Sold.”Journal o Markeing esearch 48:SPL, S102–S120. aler, ichard. 1985. “Menal Accouning and Consumer Choice.”Markeing Science 4:3, 199–214. versky, Amos, and Daniel Kahneman. 1992. “Advances in Prospec eory: Cumulaive epresenaion o Uncerainy.”Journal o isk and Uncerainy 5:4, 297–323. Weber, Marin, and Colin F. Camerer. 1998. “e Disposiion Effec in Securiies rading: An Experimenal Analysis.”Journal o Economic Behavior & Organizaion 33:2, 167–184. Weber, Marin, Elke U. Weber, and Alen Nosić. 2013. “Who akes isks When and Why: Deerminans o Changes in Invesor isk aking.” eview o Finance 17:3, 847–883. Yuan, Yu. 2015. “Marke-Wide Atenion, rading, and Sock eurns.” Journal o Financial Economics 116:3, 548–564. Zajonc, ober B. 1968. “Atiudinal Effecs o Mere Exposure.”Journal o Personaliy and Social Psychology 9:2, p. 2, 1–27. Zhong, Songa, Salomon Israel, Hong Xue, ichard P. Ebsein, and Soo Hong Chew. 2009. “Monoamine Oxidase a Gene (Maoa) Associaed wih Atiude owards Longsho isks.” PLOS ONE 4:12, e8516–e8516. Zyphur, Michael J., Jayanh Narayanan, ichard D Arvey, and Gordon J. Alexander. 2009. “e Geneics o Economic isk Preerences.”Journal o Behavioral Decision Making 22:4, 367–377.

4 Institutional Investors ALEXA NDRE SKIBA Assistant Professor of Economics Department of Economics of Finance, University of Wyoming HILLA SKIBA Assistant Professor of Finance and Real Estate Department of Finance and Real Estate, Colorado State University

Introduction Behavioral biases in he financial markes are well documened. For example, evidence shows ha invesors are overconfiden, prone o he disposiion effec, exhibi loss aversion, demonsrae amiliariy bias, and are driven by mood and senimen. Alhough invesors show endencies oward cogniive and emoional biases, he lieraure also documens ha he exen o he biases differs among invesors. One o he mos imporan differences is invesor sophisicaion, so ha less sophisicaed invesors make poorer choices wih heir invesmen decisions, which also leads o marke underperormance, especially afer considering rading coss. Less sophisicaed invesors are usually considered o be individual or reail invesors, whereas more sophisicaed invesors are proessional money managers and raders. e vas majoriy o behavioral sudies ocus on he behavioral biases o individual invesors. is chaper’s purpose is o review he lieraure on behavioral biases. e chaper specifically examines how behavioral biases may influence more sophisicaed invesors (i.e., insiuional invesors). Aninsiuional invesor reers o a variey o proessional invesors, including banks, insurance companies, pension unds, endowmen unds, muual unds, and hedge unds, as well as invesmen proessionals such as invesmen advisors and wealh managers. is chaper compares behavioral biases beween insiuional and individual invesors. I also invesigaes wheher differences exis among ypes o insiuional invesors, given he dispariy beween he objecives and he skill levels o such invesors. Alhough he lieraure on he behavioral biases o insiuional invesors is limied, i documens ha insiuional invesors engage in rading behaviors ha could be a sympom or a consequence o various behavioral biases. For example, insiuional invesors engage inherding, whereby heir buying and selling behavior is correlaed wih oher insiuional invesors’ rades; hey hold under-diversified, especially home-counry biased, porolios; and hey use a momenum sraegy in which hey appear o buy pas winners. 64

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is chaper invesigaes he lieraure on hese various rading behaviors and wheher he behaviors are value reducing and/or wheher hey desabilize financial markes. e evidence rom he exan lieraure suggess ha he behavior o insiuional invesors is raional compared o ha o individual invesors. Cogniive and emoional misakes ha individuals make are largely absen among insiuional invesors. eY, some conrarian evidence exiss. Mood seems o drive insiuional invesors. Also, culural dierences influence rading and porolio allocaion o insiuions, bu o a lesser exen relaive o he individual invesors. Alhough some behavioral biases are presen among he proessional money managers, overall he insiuional invesors ruly are “smar.” rading behaviors ha could be a sympom o some behavioral bias are acually value generaing or he insiuions. For example, herd behavior seems o be inormaion driven raher han based on ear and greed, or oher behavioral acors. In ac, herding by insiuional invesors appears o be price sabilizing raher han price desabilizing. Similarly, recen empirical lieraure shows ha porolio under-diversificaion among insiuional invesors generaes posiive risk-adjused reurns. e chaper has he ollowing organizaion. e firs secion reviews he lieraure on behavioral biases o insiuional invesors. e nex secion invesigaes differences in behavioral biases across ypes o insiuions, specifically based on he sophisicaion o he insiuional managers. e ollowing secion reviews hree rading behaviors o insiuional invesors ha could be sympoms o behavioral biases: herding, momenum rading, and under-diversificaion. e chaper hen reviews he lieraure on each o he documened rading behaviors, shows how insiuional invesors engage in hese rading behaviors, and explains how he behavior affecs insiuional reurns and marke efficiency. e chaper concludes by invesigaing wheher insiuional invesors ake advanage o individuals prone o behavioral biases. Insiuions are becoming increasingly educaed abou behavioral finance, which is now included in universiy curriculums and exbooks worldwide. Behavioral finance is also a par o proessional educaion, such as he Charered Financial Analys (CFA) curriculum. A growing body o lieraure documens ha insiuions are profiing rom sock marke anomalies and sysemic changes in securiies prices, caused by behavioral biases. For example, insiuions appear o profi rom pos-earnings announcemen drifs. Also, during exreme swings in he marke, such as during marke bubbles and consecuive marke crashes, insiuions, unlike individuals, appear o exi heir posiions rom overvalued securiies beore he marke urns.

Behavioral Biases of Institutional Investors e lieraure documens ha senimen, ads, and emoions drive less experienced individual invesors (Shiller, Fisher, and Friedman 1984; De Long, Shleier, Summers, and Waldmann 1990). Because o poor decision making, individuals underperorm he marke boh beore and afer ees (Barber and Odean 2001). Because proessional invesors are generally on he oher side o hese poor rades, hey appear o rade raionally and profi a he expense o individual invesors. e finance lieraure documens some compelling evidence o suppor his claim. For example, Barber, Lee, Liu, and Odean (2009) find ha in he aiwanese marke,

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individual invesors lose 3.8 percenage poins annually and i is insiuional invesors who mainly harves his loss. e ollowing secions discuss he mos commonly sudied behavioral biases (overconfidence, disposiion effec, and amiliariy bias) and how he empirical evidence or hese biases differs or insiuions and individual invesors. OVERCONFIDENCE

Much o he seminaland workis on overconfidence behavioral finance based on samples o individual invesors ypically proxied byingender (Barber andisOdean 2001; Gervais and Odean 2001). Evidence on he overconfidence o insiuional invesors is less available, perhaps because finding a suiable proxy is more difficul. Chuang and Susmel (2011) invesigaed overconfidence among raders in aiwan, and show ha aiwanese individual invesors are much more prone o overconfiden rading behavior compared o he insiuional invesors. Chou and Wang (2011) also examine overconfidence among differen ypes o invesors in aiwan. ey find ha overconfidence is presen among boh individual and insiuional invesors, bu he level o overconfidence among insiuional invesors is much lower. However, insiuional invesors buy more aggressively afer hey have experienced gains, which is consisen wih overconfidence hypohesis. Chen, Kim, Nosinger, and ui (2007) sudy overconfidence in a sample o Chinese rading accouns, which includes boh individual and insiuional invesors. Afer spliing heir samplehey ino find individual (less sophisicaed) andbias insiuional caed) invesors, ha alhough overconfidence is presen (more in bohsophisigroups, he bias is sronger in he sample o less sophisicaed, individual invesors.

Gender Bias Anoher sream o lieraure compares rading choices beween male and emale proessional money managers. Alhough hese sudies are no always ess o he overconfidence o proessional invesors, he resuls are sill consisen wih he more direc overconfidence sudies previously discussed. Barber and Odean (2001) were he firs o documen ha male invesors make poorer rading choices han emale invesors. ey atribue his o overconfidence. Several oher sudies have invesigaed gender differences among proessional money manager. Akinson, Boyce, Frye, and Frey (2003) sudy how gender affecs muual und managemen, and hey find no real differences beween he genders. ey sugges ha perhaps differences beween he genders, documened among individual invesors, change when acoring in experience and sophisicaion. Similarly, Bliss and Poter (2002) hypohesize ha emale muual und managers are less overconfiden compared wih heir male counerpars; bu conrary o heir predicion, hey find no difference in he urnover raes o emale managers. Beckmann and Menkhoff (2008) also find in heir sample o 649 und managers rom he Unied Saes, Germany, Ialy, and ailand, ha overconfidence among emale and male muual und managers is no saisically significanly dieren. Overall, gender differences in overconfiden endencies do no seem o exis among proessional managers. is evidence may sugges ha experience and invesor sophisicaion eliminae, or a leas lessen, common behavioral biases, a conclusion ha is similar o oher evidence discussed in his secion.

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e disposiion effecis an invesor’s endency o sell winning securiies oo soon and o reain losing securiies oo long. Mos sudies documen he disposiion effec among individual invesors, bu some sudies also use samples o eiher insiuional invesors or boh ypes o invesors. e resuls are similar o hose in he overconfidence lieraure previously reviewed. Chou and Wang (2011) sudy he disposiion effec among boh individual and insiuional rades in  aiwan. eir evid ence shows ha he disposiion effec holds rue only among individual invesors. Similarly, in a sudy o individual and proessionally managed accouns in Israel, Shapira and Venezia (2001) find ha he disposiion effec is presen among boh ypes o invesors, bu is much sronger or individual invesors han or proessionally managed accouns. Feng and Seasholes (2005) sudy invesors’ sophisicaion, rading experience, and he disposiion effec; he auhors repor srong evidence ha invesors’ sophisicaion, combined wih rading experience, eliminaes he relucance o sell losing socks. Experience and sophisicaion also reduce he propensiy o realize gains oo soon. Alhough heir sample consiss only o individuals, his finding sill suppors he idea ha more sophisicaed insiuional invesors wih long rading experience are less likely o suffer rom he disposiion effec. O’Connell and eo (2009) invesigae insiuional invesors’ disposiion effec in U.S. markes and find litle evidence ha insiuions are prone o he disposiion effec. However, he auhors find evidence ha pas perormance affecs invesors so ha hey lower heir risk- aking afer losses and increase heir risk- aking afer gains, which is consisen wih dynamic loss aversion and overconfidence. Saman, orley, and Vorkink (2006) sudy overconfidence and he disposiion effec in U.S. markes and find ev idence or boh. Specifically, heir evidence s hows ha socks wih large hisorical gains experience larger rading volume in subsequen ime periods. Ineresingly, he relaion o pas reurns and volume is sronges in he earlier par o he sample and in smaller securiies. is finding suggess ha socks dominaed by individual raher han insiuional invesors show greaer evidence o boh behavioral biases. Similar o he U.S. resul, Chen e al. (2007) find ha in a Chinese sample o individual and insiuional rading accouns, evidence exiss or similar resuls regarding overc onfidence and he disposiion effec is presen in boh groups o raders. However, he bias is sronger in he sample o less sophisicaed individual invesors. By conras, Frazzini (2006), conducing a sudy o U.S. muual und holdings and he disposiion effec, finds ha U.S. muual und managers exhibi he disposiion effec and ha such behavior also negaively affecs heir reurns. However, he evidence sill aligns wih findings ha more sophisicaed invesors are less subjec o beha vioral biases. Specifically, Frazzini repors ha successul muual und managers are more likely o sell heir losers han are underperorming managers. Coval and Shumway (2005) finds ha U.S. uures rades sufferrom loss aversion, which reers o people’s endency o srongly preer avoidinglosses over acquiring gains. Also, Locke and Mann (2005) sudy proessional U.S. commodiies raders and find ha proessional raders hold ono heir losers or longer han heir winners, bu he behavior does no seem o produce lower han average reurns, conrary o he findings by Coval and Shumway (2005).

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TIVENESS BI

AS

In a large universe o securiies, invesors mus narrow he se o available invesmen opions. One way invesors can o do his is by using menal shorcus and heurisics, which can ulimaely lead o mean-variance inefficien porolios. Familiariy and represenaiveness biases are examples o such heurisics. Familiariy bias is he endency o invesors o inves in wha hey know or wha is amiliar o hem. epresenaiveness bias is ofen linked o invesors’ endency o exrapolae probabiliies or uure evens rom pas or recen oucomes. Similar o overconfidence and he disposiion effec, amiliariy and represenaiveness bias sudies ofen use samples o individual invesors (Huberman 2001), bu litle empirical research is available on insiuional invesors. In a direc comparison sudy o individual versus insiuional invesors, Barber and Odean (2008) find ha individual invesors are much more likely o be drawn o atenion-grabbing socks, such as socks in he news or hose wih large price swings. Individual invesors do no possess he same resources as large insiuions. Because o heir limied atenion, individual invesors need o narrow he se more han do insiuions, and consequenly hey are much more likely o choose atenion-grabbing securiies. Limied atenion and resources are also major reasons or a amiliariy bias- based porolio consrucion. Similar o he evidence or overconfidence and he disposiion effec, Chen e al. (2007) find ha in he Chinese sample o individual and insiuional rading accouns, represenaiveness bias is presen in boh groups o raders. However, he bias is sronger in he sample o less sophisicaed individual invesors. Sudies involving amiliariy bias ofen examine invesors’ porolio composiion, because amiliariy bias can resul in under-diversified porolios; or example, hese are ofen home-biased porolios, in which invesors over-weigh he amiliar home marke. (is chaper discusses equiy home bias and is consequences or insiuional invesors in more deail in a laer secion.) e evidence shows ha insiuional invesors also hold home-biased porolios. Furher, some research links home bias wih amiliariy bias. Ke, Ng, and Wang (2010) sudy invesmens in oreign markes made by muual unds, and find ha managers preer o inves in firms in oreign markes ha have a presence in heir domesic markes. e auhors rule ou an inormaion advanage as a possible explanaion or his finding, concluding ha amiliariy bias is likely o be he driver. Chan, Covrig, and Ng (2005) find ha home bias and oreign marke underweighing by muual unds are associaed wih economic developmen and amiliariy variables. e auhors proxy amiliariy by a common language beween he invesors’ home marke and oreign markes, geographic disance, and bilaeral rade flows.

Heterogeneity Among Types As invesor sophisicaion increases rom individual invesors o insiuional invesors, he exising research shows ha behavioral biases decrease and even disappear. Large heerogeneiy exiss in he sophisicaion level among differen insiuional invesors. For insance, hedge und managers earn he highes compensaion and atrac he op alen, and hus are likely o be he mos sophisicaed invesors, ollowed by managers

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o oher acively managed, well-compensaed insiuions such as muual unds, independen invesmen advisors, pension unds, and endowmens. e less sophisicaed managers are hen in he more passive insiuions, such as insurance companies and banks (Lerner, Schoar, and Wongsungwai 2007; French 2008; Choi, Fedeia, Skiba, and Sokolyk 2016). Based on his finding, sudies ha examine he rading behavior o dieren insiuional ypes are likely o find ewer behavioral biases among hedge und and muual unds managers compared o he passive invesor ypes. e research in his area is limied. Barber, Lee, Liu, and Odean (2007) sudy he disposiion effec in he aiwanese sock marke among differen groups o invesors. eir evidence shows ha he disposiion effec exhibis a srong presence in he marke. Besides individual invesors, corporae invesors (privae and governmen-owned firms) and dealers (financial firms) are subjec o he disposiion effec. By conras, muual unds and oreign invesors (oreign banks, insurance companies, securiies firms, and muual unds) are no subjec o he disposiion effec. Alhough research ha direcly invesigaes behavioral biases among insiuional ypes is limied, several papers have examined how insiuional invesors’ heerogeneiy is refleced in he level o heir sophisicaion and perormance. Lerner e al. (2007) examine differen insiuional ypes including invesmen advisors, banks, pension unds, insurance companies, and endowmens. ey find ha endowmens earn he highes reurns, specifically in heir privae equiy invesmens. Similarly, Bennet, Sias, and Sarks (2003) documen a difference beween raw reurns among differen ypes o insiuional invesors, so ha muual unds and advisors earn larger reurns compared wih managers a banks and in insurance. According o Choi e al. (2016), invesor sophisicaion is relaed o inormaion advanage and subsequen perormance, hus, hedge unds, muual unds, and advisors, ollowed by endowmens and pensions and hen by banks and insurance companies, earn he highes risk-adjused reurns on heir global porolios. e ac ha he level o invesor sophisicaion and reurns is posiively relaed, and ha behavioral biases are more common among less sophisicaed invesors, suggess ha behavioral biases migh a leas parially explain he observed differenial in risk- adjused reurns beween insiuional ypes.

Institutional Trading Behavior As previously discussed, he research on behavioral biases among insiuional invesors is limied bu increasing. However, large sreams o lieraure exis on he rading behaviors o insiuional invesors ha could be sympoms o some underlying behavioral biases. e ollowing secions provide a review o hese well-documened rading behaviors and discuss he consequences o each o marke efficiency and/ or invesors’ risk-adjused perormance. e rading behaviors include he ollowing: (1) momenum rading by insiuions, which could be driven by represenaiveness bias, sel-atribuion, and/or overconfidence, and would have a desabilizing effec on he financial markes; (2) herding, which could be driven by behavioral moivaions, such as ads, ear, or greed, or repuaional concerns, and would have a desabilizing effec on he financial markes; and (3) porolio under-diversificaion, which could be

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a sympom o overconfidence or amiliariy bias, boh which would mos likely resul in lower risk-adjused reurns o he invesor. MOMENTUM TRADING

Since Jegadeesh and iman’s (1993) seminal work, ohers have documened momenum in securiy prices across various asse classes and markes. Momenum in securiy prices is usually linked o marke inefficiency, and he resul is correlaion in securiy reurns rom one period o anoher. Momenum can be presen in wo ways. Prices eiher are pushed away rom heir undamenal values because o ear and greed or are exrapolaed rom pas reurns o predic he uure. Alernaively, markes ail o incorporae inormaion ino he prices efficienly bu, raher, over exended periods o ime. Insiuional invesors end o be momenum raders on a large scale (Grinblat, iman, and Wermers 1995; Nosinger and Sias 1999; Wermers 1999; Badrinah and Wahal 2002). Empirical evidence suppors he ollowing explanaions abou momenum: (1) insiuions chase pas winners and exrapolae pas oucomes ino he uure; or (2) insiuions ake advanage o marke inefficiency upon discovering ha some undamenal inormaion is slow o incorporae, and hence insiuional rading helps push he securiy prices oward heir undamenal values. Evidence has documened momenum rading among all ypes o insiuions. Nosinger and Sias (1999) find ha insiuions are momenum raders when hey examine he inra-period rades o individual securiies. Momenum rading is also presen in muual unds (Grinblat e al. 1995; Wermers 1999). Badrinah and Wahal (2002) invesigae insiuional invesors’ enry and exi decisions ino and ou o securiies. ey find ha insiuions rade on momenum when hey iniiae posiions in securiies. Ye, some variaion in momenum rading exiss across insiuional invesors. Evidence by Badrinah and Wahal shows ha invesmen advisors are more likely o be momenum raders han are pension unds and banks. Lakonishok, Shleier, and Vishny (1992) invesigae pension unds’ momenum rading and find litle supporing evidence. e evidence generally shows ha he price impac o momenum rading by insiuional invesors is overall price sabilizing. is observaion suppors he noion ha insiuional invesors do no rade on momenum because o greed, ear, overconfidence, or represenaiveness bias bu, raher, because o undamenal reasons. For example, in a sample o insiuional invesors, Badrinah and Wahal (2002) find litle evidence or price-desabilizing effecs o insiuional momenum rading. Hvidkjaer (2006) conducs a rade-level sudy ha provides suppor or insiuional invesors sabilizing momenum rading. Based on an analysis o large and small rades, he auhor finds ha small raders’ underreacion may be a reason or he observed momenum effec. In conras, insiuional invesors do no underreac. Choe, Kho, and Sulz (1999) discover similar evidence in he Korean markes, while specifically examining rading behavior by oreigners and Korean insiuional invesors versus Korean individual invesors. e auhors find ha insiuions in Korean markes are largely momenum raders. Again, no evidence indicaes ha he raders would have a price-desabilizing effec on he Korean marke.

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HERDING BEHAVIOR

Much evidence shows ha insiuional invesors end o herd or o ollow each oher’s rades (Lakonishok e al. 1992; Sias 2004). Herding in asse markes occurs wihin individual securiies, wihin indusries, and wihin enire markes. Herding, a leas in he popular media, is ofen associaed wih some irraional behavior, where invesors are chasing ads (Shiller e al. 1984) and are moivaed by ear and greed or oher behavioral reasons. Insiuional invesors may also have repuaional concerns; consequenly, hey would raher be wrong wihin a group han on heir own (Scharsein and Sein 1990; rueman 1994). I he reasons or herding are irraional or behavioral in naure, hen herding should desabilize asse prices and push hem away rom heir undamenal values. However, herding could be raional behavior i i resuls in more efficien markes and/or higher risk-adjused reurns or invesors. e empirical evidence shows a large propensiy by insiuions o herd in and ou o securiies and markes. e vas majoriy o evidence suppors inormaion-based reasons or such herding. ese inormaion-based, raional reasons or herding include cascading and invesigaive herding. In abou hal o he sudies, he documened herding occurs because o inormaional cascades. Inormaional cascades occur when insiuional invesors inenionally ollow each oher rom securiy o securiy, bu only because hey iner inormaion rom each oher’s rades. e oher hal o he sudies find ha herding behavior is invesigaive in naure. is is when insiuional invesors analyze he same underlying undamenal inormaion and draw he same conclusions abou he securiies’ air values, and hey rade similarly; ye, he observed movemen in and ou o securiies is uninenional and based only on underlying inormaion. e consequence o boh inormaion-based herding endencies is ha prices adjus aser o undamenal inormaion. In oher words, herding is inormaion- based and hus increases marke efficiency raher han desabilizes he markes. Evidence documens herding by insiuional invesors across markes, asse classes, and differen ypes o insiuional invesors. Sias (2004) finds ha a he securiy level, insiuional invesors in he Unied Saes ollow each oher rom securiy o securiy, or ha heir rades are correlaed wih heir own and oher insiuions’ lagged rades. He also finds ha insiuions are momenum raders. However, momenum rading only parially explains he herding. According o Sias, he mos likely explanaion or herding is ha insiuions ollow each oher’s rades, bu ha herding is inormaion-based and insiuions iner inormaion rom ohers (cascading) raher han are jus chasing ads. Grinblat e al. (1995) repor widespread herding behavior among managers a U.S.based muual unds. In suppor o a raional explanaion o herding, he auhors find litle evidence or herding ha was inenionally ollowing ohers. Kim and Nosinger (2005) sudy he Japanese marke and herding by is insiuional invesors. e auhors also documened ha insiuions herd in Japan, bu o a lesser exen han hey do in U.S. markes. Herding in Japanese markes is more likely o be invesigaive, and he price impac o herding is generally posiive, so ha invesors’ herding speeds up he price adjusmens, raher han desabilizes hem. Nosinger and Sias (1999) repor a posiive relaion beween changes in insiuional ownership and reurns on securiies. us, momenum in securiy reurns also appears o be relaed o insiuional herding. a is, a posiive relaion exiss beween

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insiuional demand and conemporaneous securiy reurns. e auhors also repor litle evidence o mean reversion in he securiy reurns afer periods o posiive demand and posiive securiy reurns. is finding suggess ha insiuional demand and momenum in securiies incorporaes inormaion aser ino he securiy prices, insead o irraional reurn chasing by insiuions. In oher words, insiuions help o creae aser price adjusmen and greaer marke efficiency. PORTFOLIO UNDER-

DIVERSIFICATION

AND EQUITY HOME BIAS

e finance lieraure documens he phenomenon o porolio under-diversificaion. According o he radiional asse pricing heory semming rom he work o Markowiz (1952), invesors should hold diversified porolios. Evidence exiss, however, ha invesors, including insiuional invesors, do no always do his. For example, sudies documen under-diversificaion wih respec o invesors’ domesic and oreign holdings, so ha invesors have a endency o over-weigh heir home marke relaive o is capializaion weigh (i.e., invesors have a home bias). Equiy home bias is widespread in inernaional porolio invesmen. For example, U.S. insiuional invesors hold abou 86 percen o heir asses in domesic equiies, whereas he U.S. share o he world porolio is only abou 40 percen. is difference means ha U.S. invesors hold a 46 percenage poin overweigh in heir domesic marke. Similar figures occur across he globe (Chen e al. 2007; Anderson, Fedenia, Hirschey, and Skiba 2011; Choi e al. 2016). Also, he small porion o he porolio invesed in oreign counries is usually allocaed o counries ha are he mos similar and he mos correlaed wih he invesor’s home marke (esar and Werner 1995; Chan e al. 2005; Anderson e al. 2011). Evidence documens equiy home bias across all invesor groups. Many reasons led o an equiy home bias in he pas ha are no longer valid. Capial conrols, new invesmen vehicles, and ease o rading over he Inerne now make oreign equiy markes accessible o all invesors. Alhough he persisen equiy bias presens a puzzle, various behavioral reasons provide possible explanaions. In he behavioral finance lieraure, porolio under-diversificaion is ofen a sympom o some behavioral bias. For example, evidence links overconfidence and amiliariy o porolio under-diversificaion. French and Poerba (1991) were he firs o documen equiy home bias. ey offer several explanaions or i, including over-opimism abou he prospecs o he domesic securiies. Based on survey evidence, Srong and Xu (2003) find ha insiuional managers are more opimisic abou domesic equiies. is relaive opimism implies a posiive bias oward domesic equiies and a negaive bias oward oreign equiies. In urn, hese biases would lead o over-weighing domesic equiies and under-weighing oreign equiies. Based on survey evidence rom insiuional managers rom he Unied Saes, Unied Kingdom, Japan, and coninenal Europe, Srong and Xu also find evidence o amiliariy-based asse allocaion by insiuional invesors. o invesigae wheher he observed under-diversificaion is irraional behavior driven by amiliariy bias, over-opimism, overconfidence, or a raional choice, researchers have invesigaed he perormance consequences o underdiversificaion specific o insiuional invesors. Firs, several auhors o heoreical papers conend

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ha under-diversificaion can also be a raional sraegy. e seminal papers in his area include Meron (1987), Gehrig (1993), Levy and Livingson (1995), and more recen work by Van Nieuwerburgh and Veldkamp (2009, 2010). I underdiversificaion is a raional sraegy driven by inormaion advanage, hen i should no deeriorae perormance. Alhough individual invesors wih under-diversified posiion also underperorm he marke even beore accouning or excessive rading and relaed ees, he same is no necessarily rue or insiuional invesors. Choi e al. (2016) find ha underdiversified posiions relaive o he opimal efficien world marke porolio earn higher risk-adjused reurns han do globally diversified porolios. is evidence suggess ha under-diversified porolios can be value enhancing. e auhors also repor ha more skilled invesors are more likely o deviae rom he opimal porolios, providing urher evidence ha under-diversificaion can be opimal behavior i i derives rom a raional, inormaion-based process. Coval and Moskowiz (2001) find similar evidence in he Unied Saes. Sudies have documened local bias in U.S. equiies across invesor classes and ofen have linked i o amiliariy bias in invesmen choices. us, invesors choose o irraionally inves in amiliar securiies (Huberman 2001). Coval and Moskowiz also find ha insiuional invesors, especially muual unds, acually ouperorm when hey hold locally concenraed porolios and ouperorm in nearby securiies. is finding provides urher evidence ha under-diversificaion, i moivaed by some inormaion advanage, can be opimal.

Other Drivers of Institutions’ Trading Behavior is secion reviews wo emerging sreams o lieraure in behavioral finance ha deal wih how mood and naional culure influence invesor behavior. Many o he papers in hese sreams use insiuional invesors as heir subjecs. eir resuls show ha insiuional invesors are ofen moody raders and ha he naional culure o he invesors’ home markes influences heir rading behavior. MOOD

Invesor mood is an imporan deerminan o securiy reurns and i affecs sock markes around he world. For example, Hirschleier and Shumway (2003) show ha he amoun o sunligh, associaed wih he posiive mood o invesors, has a corresponding posiive effec on marke reurns. Kamsra, Kramer, and Levi (2003) find ha seasonal affecive disorder (SAD), which resuls rom people’s experiencing ewer hours o dayligh during cerain imes o he year, is relaed o an increase in invesor risk aversion and securiy reurns. e impac is also sronger in higher laiudes, where he hours o dayligh flucuae more rom season o season. e evidence on behavioral biases consisenly shows ha more sophisicaed invesors are less suscepible o psychological influences. However, he evidence also shows ha mood affecs he rading behavior o insiuional invesors. Goezmann and Zhu (2005) sudy weaher paterns, comparing i o he sock marke rading aciviy o individuals across differen ciies. eir findings show no relaion beween cloud coverage

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and rading aciviy. e auhors sugges ha, insead o raders, perhaps marke makers and oher proessional agens locaed in he ciies o he sock exchanges may be driving he effec. In a more direc sudy o insiuions and mood, Goezmann, Kim, Kumar, and Wang (2015) examine weaher paterns and hey show ha relaive overpricing o securiies o he Dow Jones Indusrial Average (DJIA) increases on cloudier days, as does he securiies-selling propensiies o insiuional invesors. e auhors also consruc a sock-level mood proxy rom he insiuional invesors’ holdings, and find ha his mood proxy is posiively relaed o a sock’s reurns, especially in more difficul-oarbirage securiies. CULTURE

Culure and finance have become a popular opic in recen finance lieraure. Sudies o samples o boh differen invesors and markes show ha culure influences economic exchange, such as saving and invesmen decisions, marke paricipaion raes, and cross-border invesmen and rade (Guiso, Sapienza, and Zingales 2009). In many o hese culure sudies, insiuional invesors are he main subjecs, wih evidence showing ha culure influences insiuional invesors. In a sudy o invesors’ decision making in Finland, Grinblat and Keloharju (2001) find ha he proximiy, language, and culural similariy o invesors and he chie execuive officers (CEOs) o he companies are all significanly relaed o an invesor’s allocaion decision. e auhors’ daase conained boh individual and insiuional invesors. e auhors find ha boh groups behave his way, bu he bias oward culurally similar firms is greaer or individual invesors. Furhermore, Grinblat and Keloharju documen he differences in insiuional invesors, in which he less savvy insiuional invesors, specifically nonprofis and governmenal organizaions, exhibi sronger preerence or culurally similar firms compared o more financially savvy insiuional invesors. Beracha, Fedenia, and Skiba (2014) show ha insiuions’ rading requency declines when shifing rom home markes o culurally similar oreign counries, and on o culurally disan environmens. e auhors also find ha insiuional invesors rom culures marked by lower levels o rus oward ohers, as well as higher levels o ambiguiy aversion, generally rade wih lower requencies, perhaps because o heir lower levels o aih in marke-based finance generally. As previously discussed, insiuions hold home-biased porolios and under-diversiy heir oreign holdings. Alhough many variables can explain hese under-diversificaion paterns, one answer concerns naional culure. For example, porolio allocaion sudies by Anderson e al. (2011) on insiuional invesors and by Beugelsdijk and Frijns (2010) on muual unds across he global markes find ha naional culure is significanly relaed o he heerogeneiy in an insiuion’s level o home bias. More specifically, hese papers invesigaed he effec o Hosede’s (1980, 2001) uncerainy avoidance, masculiniy, and individualism on home bias, and hey find ha uncerainy avoidance is posiively relaed o he level o home bias. Moreover, evidence by Anderson e al. (2011) shows ha a culural similariy o he invesor’s home marke o he asse’s home marke is posiively relaed o he level o asse holdings. Culural disance, as measured along Hosede’s primary dimensions o culure, decreases crossborder porolio allocaion, so ha insiuional invesors preer culurally similar markes.

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Summary and Conclusions is chaper provides a synhesis o he lieraure on insiuional invesors’ rading behavior. e chaper iniially invesigaed wheher common behavioral biases overconfidence, he disposiion effec, amiliariy, and represenaiveness biases are presen in he rades o financial insiuions. As discussed, overall he lieraure provides litle evidence ha insiuions make he same behavioral misakes as do individual invesors in heir rades. e chaper also invesigaed how behavioral biases can explain insiuions’ rading behavior herding, momenum rading, and isunder-diversificaion. As shown, he lieraure finds ha insiuional rading behavior raional and mainly driven by inormaion-based moivaions. Insiuional invesors apparenly benefi rom heir sraegies and make markes more efficien. us, he lieraure suggess ha sophisicaed invesors make raional decisions in heir rading choices and are ree o he common behavioral downalls documened as beallen individual invesors. Insiuional invesors are becoming increasingly educaed abou behavioral finance and he inefficiencies ha behavioral biases can creae in he sock markes. Insiuions are apparenly aware enough o poenial biases as o ake advanage o hem For example, Ke and amalingegodwa (2005) show ha ransien insiuional invesors (i.e., hose invesors wih a shorer-erm view and wih acive engagemen) ake advanage o he pos-earnings announcemen drif in heir rades. Cohen, Gompers, and Vuoleenaho (2002) show ha insiuional invesors are, on average, on he righ side o rades when rading on marke underreacion o cash-flow surprises, Furhermore, insiuions seem o exploi such rading a he expense o individual invesors. e evidence also shows ha insiuional invesors consruc rading sraegies based on mood. For example, Bollen, Mao, and Zeng (2011) find ha mood in social media predics DJIA reurns; several hedge unds developed a sraegy based on his research paper. Also, many hedge unds employ psychologiss on heir managemen eams, because sophisicaed invesors undersand he imporance o mood and senimen o securiy prices. Behavioral biases also affec insiuional invesors hrough he underlying invesor base. A perecly raional insiuional manager wih perec abiliy o analyze securiies’ risk and reurn characerisics sill needs o be aware o underlying invesor endencies or behavioral bias. Indeed, undersanding he underlying invesor base is an especially imporan opic in he field o wealh managemen. Differen models o individual behavior wealh needs. managers he wide rangehas o divided cliens and howino o our bes serve heirhelp individual For undersand example, Pompian (2012) cliens disinc groups: preservers, ollowers, independens, and accumulaors; each group has is unique characerisics, as well as displays he mos likely behavioral biases. Pompian’s work has become a cenerpiece o atenion or he behavioral finance secions o he CFA program, augh o he uure insiuional managers.

DISCUSSION QUESTIONS 1. Discuss wheher insiuional invesors are subjec o behavioral biases o he same exen as individual invesors.

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2. Explain wheher mood, no direcly relaed o financial undamenals, affecs insiuional invesors. 3. Discuss wheher evidence showing ha insiuions herd wih heir rades suppors irraional (marke desabilizing) or raional (marke sabilizing) reasons or insiuional herding. 4. Ideniy how insiuions can exploi behavior biases o individual invesors’ in heir rading choices. 5. Discuss how insiuional agens can us e behavioral finance o benefi  heir cliens.

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5 Corporate Executives, Directors, and Boards JOHN R. NOF SING ER Professor and William H. Seward Endowed Chair in International Finance University of Alaska Anchorage PA TTANAPORN CHA TJUT HAMAR D Associate Professor of Finance Chulalongkorn University

Introduction is chaper examines he financial decision-making behavior o corporae managers and members o boards o direcors. radiionally, academics assumed ha decision makers would be raional when making imporan financial decisions. Over he pas ew decades, scholars have discovered ha decisions can beter be ramed as being normal. Bu wha is normal versus irraional behavior? o some exen, wheher he behavior o corporae leaders differs rom he norm depends on he expecaions o ohers. ereore, his chaper begins by assessing he leadership behavior ha is expeced, based on wo main heories o corporae managemen: agency heory and sewardship heory. Agency heory depics he chie execuive officer (CEO) as a sel-ineresed agen who makes decisions ha are personally beneficial. Sewardship heorydescribes a CEO as a benevolen shepherd seeking higher corporae achievemen. ese wo managemen heories, which are described in more deail in he nex secion, pu his opic ino a ramework ha enables assessing corporae leadership behavior. Besides viewing managerial behavior rom agency and sewardship perspecives, he chaper also examines some psychological biases and rais o CEOs. For insance, managers exhibi opimism bias and overconfidence, and hese biases can impac a manager’s percepion o he company’s growh or a projec’s chances o success. ereore, biased percepions could lead o decisions ha affec invesmen and capial srucure. Similarly, managers can be risk averse, which migh influence he company’s invesmens and capial srucure. In he sewardship ramework, a primary uncion o he board o direcors is o enable he CEO by providing resources, direcion,and advice as needed. However, in he agency ramework, he direcors ac o conrol he CEO.Because he agency CEO acs in a sel-ineresed manner and exhibis boh behavioral biases and oo much risk aversion, 79

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he board mus provide incenives o overcome he agency problem, as well as he biases and risk aversion. e board mus monior he CEO’s decisions and represen he shareholders’ ineress. In many insances, his duy suffers, because boards hemselves exhibi biases and sel-ineresed behavior. Specifically, boards may suffer rom group dynamic problems, such as social loafing, poor inormaion sharing, and grouphink. e firs secion o his chaper describes he agency and sewardship heories, and idenifies he key areas where hey have differen oucomes. en he chaper describes he sel-ineresed behavior, risk aversion, and psychological biases o op managemen. e behavior o he board o direcors is illusraed nex, including some individual and group dynamics. e final secion offers a summary and conclusions.

Theories of Management Many sudies atemp o explain he relaionships beween ownership and managemen o a company. e classic ramework oagency heory by Jensen and Meckling (1976) describes how individual sel-ineres uiliy moivaes he conflic o ineress beween shareholders (principals) and managemen (agens), resuling in he poenial problems o opporunism and he soluions o incenives and monioring. is ramework has been he dominae heory in he finance and economics lieraure. However, an alernaive model o managerial moivaion and behavior has also been popular in he managemen lieraure. I is known assewardship heory (Donaldson and Davis 1991, 1993) and is derived rom psychological and sociological acors. AGENCY THEORY

During he 1960s and 1970s, economiss explored risk-sharing among individuals or groups (Wilson 1968; Arrow 1971). is lieraure described he risk-sharing problem as one ha arises when cooperaing paries have differen atiudes oward risk. Agency heory broadened his risk-sharing lieraure o include wha is now called he agency problem, which occurs when cooperaing paries have differen goals and division o labor (oss 1973; Jensen and Meckling 1976). Specifically, his heory is direced a he pervasive agency relaionship in which one pary delegaes work o anoher agen, who perorms ha work. In describing his relaionship using he meaphor o a conrac, agency heory suggess ha he firm can be viewed as a nexus o conracs (loosely defined) beween he principal and he agen. Agency heory atemps o deal wih wo specific problems: (1) aligning he goals o he agen so ha hey are no in conflic wih he principal (agency problem); and (2) reconciling he principal and agen differences in risk olerances. Furher, i explores he ownership srucure o he corporaion, including how equiy ownership by managers aligns managers’ ineress wih hose o owners. Fama (1980) discusses he role o efficien capial and labor markes as inormaion mechanisms used o conrol he sel-serving behavior o op execuives. From an agency perspecive, Fama and Jensen (1983) describe he role o he board o direcors as an inormaion sysem in which he sockholders in large corporaions could implemen o monior he opporunism o op execuives. When boards provide richer inormaion, op execuives are more likely o engage in behaviors ha are consisen wih sockholders’ ineress. Jensen (1984) and

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Jensen and uback (1983) exend hese ideas o conroversial pracices, such as golden parachues and corporae raiding. Agolden parachue is a large paymen o a CEO as a resul o he firm’s being merged or acquired by anoher firm.Corporae raiding reers o a large block o shares purchased o pressure he firm o enac novel business measures ha conras wih curren managemen pracices. According o agency heory, an imporan componen o he soluion o he agency problem is o arificially bring managemen goals in line wih shareholders goals. is goal is ypically accomplished by srucuring managemen incenives in such ways ha hey align managemen behavior wih shareholder goals. For example, he shareholders could give he CEO shares or opions o sock ha ves over ime, hus inducing longerm behavior and deerring shor-run acions ha harm uure company value. When he ineress o op managemen are brough in line wih hose o shareholders, agency heory argues ha managemen will ulfill is duy o shareholders, no only because o any moral sense o duy o shareholders bu also because o he incenives o maximize heir own uiliy (Donaldson and Davis 1991). Agency heory ofen uses he word conrol, meaning ha he board o direcors (as a proxy represenaion or he shareholders) mus conrol op managemen. A major uncion o he board is o curail such managerial “opporunisic behavior,” including shirking and indulging in excessive perquisies a he expense o shareholder ineress (Williamson 1985; Donaldson and Davis 1991). Alhough incenives are one soluion o he agency problem, anoher soluion is monioring and oversigh. e board conducs his oversigh o managemen o urher couner he agen’s propensiy o engage in opporunisic behavior. Besides providing monioring o CEO acions on he behal o shareholders, he board also offers inpus ino decisions a he op managemen level. us, he behavior and decisions o he board affec he firm hrough he incenives creaed or managemen, he monioring o managemen, and large corporae acions. STEWARDSHIP THEORY

Alhough agency heory is buil rom an economics model, sewardship heory is derived rom a psychology and sociology ramework. Sewardship heory applies when managers choose he ineress o shareholders over heir own personal moivaions or incenives. Generally, sewards are moivaed by a need o achieve and excel in heir work, and can disinguish beween heir work and he compensaion or i. Furher, sewards generally gain inrinsic saisacion hrough successully perorming inherenly challenging asks. Sewards also ofen have a need o exercise responsibiliy and auhoriy o gain recogniion rom peers and board members, or o obain sufficien empowermen o ge he job done properly. ereore, an imporan aspec o sewardship heory occurs in he mind o he manager a belie ha a CEO seward is he owner o he company in proxy and ulfills his responsibiliy even when ha responsibiliy conflics wih his personal ineress. e lieraure on sewardship ocuses on enabling managers, raher han conrolling hem. Managers whose needs are based on achievemen, growh, and sel-acualizaion, and who are inrinsically moivaed, will gain greaer uiliy by accomplishing organizaional raher han personal goals. ereore, wih his heory, he board o direcors is a sounding board and resource or a seward CEO raher han a conrolling body.

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Sewardship heory also involves a high level o principal rus (Davis, Shoorman, and Donaldson 1997). FACTORS DIFF ERENTIATING AGEN AND STEWARDSHIP THEORIES

CY

Davis e al. (1997) explain various dimensions on which agency heory assumpions dier rom hose o sewardship heory. ese dimensions are characerized as eiher he subordinae’s psychological atribues or he organizaion’s siuaional characerisics.

Psychological Facors According o agency heory, op managers are viewed as rooed in economic raionaliy and individualisic sel-serving behaviors. However, sewardship heory is moivaed by he model o a person in op managemen as sel-acualizing and someone who needs o grow beyond his or her curren sae o reach a higher level o achievemen. e ollowing assumpions reflec hese differences. • Motivation. Agency heory ocuses on quanifiable exrinsic rewards or measurable marke moivaion. is reward sysem aims o reduce he agency conflics by aligning ineress. Addiionally, some incenive rewards, such as medical insurance, savings, and reiremen plans, are conrol mechanisms o reduce he likelihood o he CEO’s leaving he firm. Alernaively, sewardship heory ocuses on nonquanifiable inrinsic rewards, such as opporuniies or growh and responsibiliy or doing he work. Achievemen, affiliaion, sel-acualizaion, sel-efficacy, and seldeerminaion are imporan componens. ese inrinsic moivaions relae o he imporance o a shared organizaional vision. • Identification. In agency heory, managers may exernalize organizaional problems o avoid blame. By avoiding incriminaing evidence, hese sel-serving managers may make organizaional problems worse because hey avoid acceping responsibiliy and avoid making decisions o reciy he problems (D’Aveni and MacMillan 1990). In sewardship heory, managers ideniying wih heir organizaion will work oward he organizaion’s goals, solve problems, and overcome barriers in order o help heir organizaions succeed (Mowday, Porer, and Seers 1982; Smih, Organ, and Near 1983; O’eilly and Chaman 1986). ese managers have high idenificaion wih and high value commimen o heir organizaion. • Use of Power. Gibson, Ivancevich, and Donnelly (1994) separae power ino insiuional and personal power. In agency heory, insiuional power includes reward, legiimae, and coercive power (Adams, Almeida, and Ferreira 2005). Appropriae reward sysems and he recogniion o auhoriy in he principal are pooled o creae he required conrol level in he principal–agen relaionship. Coercive power is used as a severe mehod o agen monioring. Alernaively, in sewardship heory, personal power combines boh exper and reeren power. op managemen is more likely o use personal power as a basis or influencing in a principal– seward relaionship.

Siuaional Facors Managing an organizaion includes many ineracions among op leaders, middle managemen, and saff. ese ineracions can be srucured wih differen levels o conrol,

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empowermen, and rus. e siuaional acors are ofen dependen on he prevailing culure. • Management philosophy. Lawler (1986) caegorizes managemen philosophy ino conrol-oriened and involvemen-oriened managemen approaches. Agency heory ends oward a conrol-oriened sysem, which is designed o avoid vulnerabiliy and he need o rus. Managemen implemens greaer conrols o reduce risk or uncerainy. ereore, his sysem works bes in a sable environmen. Unlike agency heory, an involvemen-oriened philosophy allows sewardship heory o build he relaionships ha help managemen deal wih increased uncerainy and risk hrough more raining, empowermen, and rus in workers. • Culture. Culures are ofen measured on an individualism–collecivism scale. Individualism culure emphasizes personal objecives over group goals and is generally common in Wesern culure. Individualism osers agency heory. Collecivism culure defines sel as a par o he group and preers a long-erm relaionship. is culure enables sewardship heory. Anoher common measure o culural dynamics is he disribuion o power wihin a counry or wihin is insiuions and organizaions. e erm power disance describes his disribuion. A high power disance culure indicaes a more narrow disribuion o power and is conducive o he developmen o principal–agen relaionships because i suppors and legiimizes he inheren inequaliy beween shareholders and managemen. Conversely, a lower power disance culure is more conducive o he developmen o principal–seward relaionships because all members emphasize a shared power sysem.

Summarizing he Teories Sundaramurhy and Lewis (2003) show he underlying differences in assumed managerial and board behaviors beween hese wo approaches. Agency heory assumpions include behavior ha sems rom individualism, opporunism, exrinsic moivaion, conflic o ineress, and disrus ha lead o a conrol approach. By conras, sewardship heory assumes behaviors ha come rom collecivism, cooperaion, inrinsic moivaion, goal alignmen, and rus ha lead o a collaboraive approach. According o hese assumpions, each approach suggess cerain board roles and srucures. A conrolling board o direcors acs as an ulimae inernal monior over managemen, whereas a collaboraing board simply acs as an advisor and a supporer o managemen. In summary, alhough agency heory looks a op managemen as individualisic uiliy maximizers, sewardship heory perceives op managemen as collecive sel-acualizers caring abou firm success. e nex secion examines managerial behavior wih hese wo managemen heories in mind.

Corporate Executives and Their Financial Behavior e CEO plays he mos imporan role and bears he mos significan responsibiliy, as well as has he greaes accounabiliy and auhoriy wihin a corporaion. e CEO has he responsibiliy or he overall success o he organizaion and makes he financial decisions, bu sill repors o he corporaion’s board o direcors. Given he leadership posiion o he CEO, much research has been dedicaed o sudying how CEOs make

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heir decisions. ese sudies ideniy rais and psychological biases, and hen have deermined how hose behaviors are relaed o compensaion, financing choices, invesing decisions, and firm perormance. MANAGERIAL TRAITS

Various sudies ideniy specific managerial characerisics and atemp o explain which rais mater. Berrand and Schoar (2003) sudy managers who move rom one firm o anoher firm, and repor evidence consisen wih differen managers having differen syles, behavior, and perormance. Bloom and Van eenen (2007) find ha various managemen pracices are relaed o perormance. Boh Sulz and ohan (2003) and Huang and Darren (2013) show ha gender and religion have a srong influence on managers’ mindses, which is refleced in corporae decisions. ey show ha male managers exhibi overconfidence in imporan corporae decision-making relaive o women. Addiionally, Chajuhamard, Lawaanarakul, Pisalyapu, and Srivibha (2016) find ha culurally based managerial mindses affec firm risk. ey show ha pracices consisen wih he Sufficiency Economy Philosophy in ailand, rooed in Buddhism, are less risky, bu no less profiable. Furhermore, some sudies atemp o ideniy he mos imporan characerisics. Schoar and Zuo (2016) and Graham and Narasimham (2004), or example, find ha CEO acions are relaed o measures o conservaism. According o Malmendier and ae (2005, 2009), Ben-David, Graham, and Harvey (2013), and Graham, Harvey, and Puri (2013), CEO decisions and oucomes are relaed o measures o overconfidence, opimism, risk aversion, and ime preerence. In corporae finance, he sandard assumpion is ha managers are ully raional and make opimal decisions. Alhough behavioral finance assumes managers are normal, ha may no always mean hey are raional. According o behavioral finance, managers make decisions based on he noion o bounded raionaliy. Bounded raionaliy assumes ha individuals are influenced by pas decisions, values, cogniive biases, and emoions ha resul in people’s making only saisacory choices. Behavioral corporae finance criicizes he raionaliy hypohesis o managers and invesors, and explores he effec o such criicisms on a company’s decision making. Psychological biases may drive hose decisions. For example, managers are no ully raional; insead, hey may have oo much confidence in heir abiliy and judgmen, a characerisic called overconfidence. Managers may also be oo opimisic abou uure orecass (Hackbarh 2008). Opimisic managers end o overesimae he growh rae o earnings, a characerisic called growh percepion bias, whereas overconfiden managers end o underesimae he riskiness o earnings, a characerisic known as risk percepion bias.

Opimism Conrary o he radiional corporae finance lieraure, managers do no always ac raionally. ey may presen some opimism or overconfidence biases ha influence company decisions. De Long, Scheier, Summers, and Waldmann (1990) and Goel and akor (2000) describe he difference beween opimism and overconfidence. According o hem, opimism is an overvaluaion o he likelihood o avorable uure evens. Specifically, CEOs may be opimisic abou he success o heir decisions. By conras, overconfidence is an underesimae o he risk o uure evens. Someimes

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overconfidence is also described as a beter-han-average belie. Weinsein (1980) defines managers as opimisic when hey overesimae he probabiliy o good company perormance and underesimae he probabiliy o bad company perormance. Heaon (2002) suggess ha opimisic managers believe he capial marke undervalues risky securiies owned by he firm. Opimisic managers also overvalue heir firm’s invesmen opporuniies, leading o invesmen in negaive ne presen value (NPV) projecs. is process occurs because managers overesimae he projec’s cash flows and underappreciae is risks. Graham e al. (2013) find ha more opimisic managers use more shor-erm deb in heir capial srucure, because heir opimism leads hem o avoiding using more expensive long-erm capial. Managerial opimism can help explain he need or independen direcors and a board chair who does no serve as he CEO or he monioring purposes. According o Kahneman and Lovallo (1993), organizaional opimism is bes alleviaed by inroducing ousiders, because hese ousiders can draw managerial atenion o inormaion ha migh indicae heir percepions are wrong. Addiionally, Parades (2005) mainains ha corporae governance should be reormulaed in order o enlarge is scope o conrol he CEO’s opimism. However, an opimal level o CEO opimism may maximize company value. Campbell, Gallmeyer, Johnson, uherord, and Sanley (2011) show ha low levels o opimism lead o underinvesmen, whereas high levels o opimism lead o overinvesmen.

Overconfidence Sherin (2006, p. 6) describes he beter-han-average aspec o overconfidence as “People make misakes more requenly han hey believe and view hemselves as beter han average.” Bernardo and Welch (2001) incorporae his concep ino managerial heory by building an inormaional cascades model and by suggesing ha overconfiden individuals ac on heir own inormaion while ignoring he acions o ohers in he group. According o psychology and behavioral economics lieraure, a common source o overconfidence is sel-atribuion bias, in which managers over-credi heir role in bringing abou good oucomes and over-credi exernal acors or bad luck or bad oucomes. is leads o managers believing hey are beter han he average manager. Hirshleier (2001) explains ha sel-atribuion causes individuals o learn o be overconfiden raher han converging o an accurae selassessmen. us, overconfidence persiss over ime. Oher finance proessionals also exhibi his bias. For example, Gervais and Odean (2001) sugges ha sel-atribuion causes raders o become overconfiden. Hilary and Menzly (2006) find evidence ha sel-atribuion bias leads analyss wih recen shor-erm success o become overconfiden. How do managers become overconfiden? e source o he overconfidence has implicaions or corporae governance. e base case is ha managers may be born overconfiden. In his explanaion, companies can avoid overconfiden managers by no hiring hem. Alernaively, managers develop overconfidence hrough experience as CEOs. In his explanaion, companies migh adjus heir monioring and incenives o guard agains overconfidence developing (Parades 2005). Lasly, Gervais, Heaon, and Odean (2011) show how managerial overconfidence can resul rom he selecion bias when hiring a manager. ey explain ha someone who is overconfiden is more likely o be seleced as a manager, because people who end o apply or managerial poss are

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more likely o be very confidence abou heir own abiliies. Goel and akor (2008) also find ha overconfiden managers are more likely o ge promoed and ouperorm ohers.

Managerial isk Aversion isk aversion is an imporan managerial rai. isk aversion is he behavior ha characerizes people seeking o reduce risk and uncerainy. isk-averse CEOs are willing o accep he lower reurns ha accompany lower-risk projecs. Many heoreical papers (Friedman and Savage 1948; Prat 1964; Coase 1973; Kahneman and versky 1979; Caballero 1991; Sikin and Pablo 1992; Parrino, Poeshman, and Weisbach 2005) explain he role o managerial risk aversion in corporae decision making. e differen levels o risk aversion among managers can explain he differences in managers’ reacions o decisions involving uncerainy. According o several recen sudies, differences in managerial risk aversion affec corporae decision making and acions in general. For example, Graham e al. (2013) find ha less risk-averse CEOs make more acquisiions. When firms ry o conrol managerial risk-aking in an agency ramework, Chava and Purnanandam (2010) find ha providing risk-aking incenives leads o higher financial leverage and lower cash balances, while avoiding such incenives leads o lower leverage and higher cash balances. In conras, Low (2009) repors ha an increase in managerial risk aversion leads o lower company valuaion, and hus firms may wan o provide risk-aking incenives. op execuives have differen managemen syles wih regard o invesmen, financing, and sraegic decisions. is raises he quesion wheher managerial atiudes and behavior migh explain corporae decision making and acions. Many sudies sugges ha managerial characerisics indeed mater or corporae policies. MANAGERIAL ATTRIBUTES AND

COMPENSATI

ON

In agency heory, he execuive compensaion package is designed o give managers a patern o rewards so as o align heir ineress more closely wih shareholders. is kind o incenive, usually in he orm o sock opions, is imporan o company perormance (Fenn and Liang 2001; Hermalin and Wallace 2001). However, a limiaion on his incenive is ha managers end o receive he incenive pay during a generally rising sock marke (Berrand and Mullainahan 2001). Paredes (2005) confirms his view and also shows ha he incenive governance mechanism can lead o overconfidence bias, because managers ge high rewards rom a rising marke and atribue hose rewards o heir abiliy and perormance. Are managerial rais relaed o compensaion? Graham, Li, and Qiu (2012) find ha more aggressive managers appear o be remuneraed or aking addiional risk. Evidence by Graham e al. (2013) shows ha risk-aking CEOs are paid wih a higher proporion o perormance-based incenives and relaively lower cash salary. ey also find ha CEOs who are more impaien receive proporionaely more in salary. O course, deermining i higher risk-aking managers will ask or more sock opions or i CEOs given more perormance sensiiviy pay are induced o ake more risk is difficul. Indeed, Smih and Sulz (1985) and Guay (1999) conend ha he boards award equiy-based compensaion o managers o overcome managerial risk aversion and o induce opimal

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risk-aking behavior. Low (2009) suppors heir conjecure, and shows ha companies ha experience a decrease in risk are concenraed among firms wih low managerial equiy-based incenives. CEO BEHAVIORAL BIASES AND FIRM CAPITAL STRUCTURE

Hackbarh (2008) suggess ha growh and risk percepion biases are imporan acors or corporae capial srucure decisions. Managers wih a growh percepion bias are considered o be opimisic. Specifically, heir opimism causes hem o overesimae he company’s uure earnings growh rae, which leads hem o perceive a larger cos or issuing equiy han deb. Addiionally, managers wih risk percepion bias are considered o be overconfiden. ey end o underesimae he uure earnings’ risk and also avor issuing deb raher han equiy. ecen aricles suppor his view ha managerial opimism and overconfidence lead o a greaer deb financing. For example, Graham e al. (2013) show ha more opimisic CEOs use more shor-erm deb, whereas Malmendier, ae, and Yan (2011) find ha overconfiden managers view exernal financing o be cosly and preer o use cash. CEO TRAITS AND CORPORATE INVESTMENT DECISIONS

According o Heaon (2002), managerial opimism is evidenly bad, causing eiher over- or under- invesmen. Common disorions in corporae invesmen may be a resul o manager biases. Building on oll (1986) and Heaon (2002), Malmendier and ae (2005) conend ha one imporan link beween invesmen levels and cash flow is he ension beween belies abou he company’s value o he CEO versus he marke. Empirically, Malmendier and ae (2005, 2008) find ha overconfiden CEOs have higher invesmen cash flow sensiiviies and are more likely o engage in value-desroying mergers. Moreover, Goel and akor (2008) show ha a raional and risk-averse CEO under-invess in corporae projecs and his under- invesmen reduces company value. Alernaively, hey also presen a model in which a moderaely overconfiden risk- averse CEO increases compan y value by reducing he underinvesmen problem. e reason or his is ha he overconfiden CEO overesimaes he accuracy o privae inormaion and overreacs o i. Alhough a moderaely overconfiden CEO reduces under-invesmen and increases company value, a highly confiden CEO generaes over-invesmen and reduces company value. Campbell e al. (2011) complemen Goel and akor’s work by showing ha a manager’s opimism can beneficially offse he effec o he individual’s aversion on he invesmen level chosen. oll’s (1986) hubris hypohesis, which now seems o be labeled as overconfidence, suggess ha managers engage in acquisiions wih an overly opimisic opinion o heir abiliy o creae value. He suggess ha overconfidence moivaes many corporae akeovers. Furhermore, Doukas and Pemezas (2007) show ha overconfidence is a undamenal componen o corporae acquisiions. ecen sudies confirm his view; or example, Liu and affler (2008) provide evidence ha overconfiden CEOs are more likely o conduc mergers and acquisiions (M&As) han are raional CEOs. Graham e al. (2013) repor ha more risk-oleran CEOs make more acquisiions.

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Billet and Qian (2008) explore managerial sel-atribuion bias in M&As by looking a he sequence o deals made by individual CEOs. ey sugges ha CEOs wih selatribuion bias become overconfiden. eir evidence shows ha acquirers’ firs deals should have non-negaive wealh effecs. Acquirers who become overconfiden rom successul acquisiion experience are hen more likely o acquire again, and heir uure deals, driven by overconfidence, will resul in poor wealh effecs. Also, experienced acquirers who become overconfiden are more likely o exhibi greaer opimism abou company prospecs and exhibi such opimism when rading heir companies’ socks. e evidence or his behavior is pervasive. For example, Li (2010) shows ha a manager’s sel-atribuion bias affecs corporae policies. Gervais and Odean (2001), Barber and Odean (2002), Doukas and Pemezas (2007), and Billet and Qian (2008) all find ha CEOs end o become overconfiden afer successul acquisiions. As a resul, hese CEOs are more likely o ollow hose successul acquisiions wih oher acquisiions ha negaively impac heir company’s sock price. Bolon, Brunnermeier, and Veldkamp (2013) develop a heory o leadership ha conrass managerial resolueness wih communicaion and lisening skills. esolueness is a orm o overconfidence ha arises when CEOs are unresponsive o ouside inormaion. More resolue and overconfiden CEOs end o perorm beter han CEOs who are beter liseners and communicaors in siuaions requiring greaer coordinaion. is finding suggess a posiive relaion beween resolueness and overconfidence and company perormance.

Directors, Boards, and Their Financial Behaviors Boards o direcors are an inegral par o he governance o large organizaions, including all corporae and many nonprofi organizaions. e firm’s sockholders elec he direcors o govern he organizaion and guard he sockholders’ ineress. e board’s main roles are o hire he CEO and o assess he overall direcion and sraegy o he business. Many finance and economics sudies discuss wheher he board o direcors can help solve he problems associaed wih his separaion o ownership and conrol. ese sudies examine all aspecs o a board o direcors and how is characerisics affec he company. However, his secion ocuses on a subse o his lieraure specifically, how he behavior and characerisics o a board affec CEO behavior. ROLES AND STRUCTURES

Boards o direcors are an imporan opic o research in managemen sudies, economics, finance, business sraegy, and sociology as well as legal areas. Adam Smih (1776) was he firs economis o address boards o direcors in an agency conex. e sudies o Fama (1980) and Fama and Jensen (1983) sugges ha boards o direcors can alleviae he agency conflic o goals and ineress beween he owners and he managers. Generally, boards are composed o boh insiders and ousiders. Inside direcors are employees and hereore hough o be dependen on he CEO, whereasouside direcors (someimes called independen direcors) are no employees and lack any business ies o

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he company. e roles o inside and independen direcors are examined in he conex o monioring managemen. EMPIRICAL EXAMI

NA TIONS OF BOARDS OF DIRE

CTORS

Are boards effecive a monioring heir managers and conrolling heir managers’ behavioral biases? How can his effeciveness be deermined? e primary mechanism or measuring he monioring capabiliy o a board is he proporion o ouside o inside direcors. e more direcors who are independen o he CEO, he more likely hey will be effecive moniors. I hey are successul a creaing he righ incenives and monioring managemen, hen he company should perorm beter. us, sudies ofen examine wheher more independen boards lead o greaer company perormance.

Board Independence and Company Perormance Differen ways are available o measure company perormance. Hermalin and Weisbach (1991), Mehran (1995), Klein (1998), and Bhaga and Black (2002) repor an insigniican associaion beween accouning perormance measures, such as reurn on equiy, and he proporion o ouside direcors on he board. Anoher measure o company perormance is obin’s Q, which is he marke value o a company’s asses (as measured by he marke value o is ousanding sock and deb) divided by he replacemen cos o he company’s asses (book value). Morck, Shleier, and Vishny (1988), Hermalin and Weisbach (1991), andBhaga and Black (2002) all use obin’s Q o reflec he value added by inangible acors, bu hey find no noiceable relaionship beween he proporion o ouside direcors and company perormance. Bhaga and Black also examine he effec o board composiion on long-erm sock and accouning perormance, bu do no find any significan relaion. Does his mean ha boards do no effecively conrol manager behavior? Possibly, bu measuremen errors could exis. Morck (2008) suggess ha many direcors classified as independen are acually associaed wih he firm’s CEO. Specifically, he CEO recruis hem hrough personal conacs or riendships. As more sringen definiions o independence are applied, hough, a clearer relaionship may emerge. Morck also suggess he possibiliy ha behavioral consrains on board independence are high; i so, genuinely independen direcors and board chairs may require insiuional invesors and public shareholders o nominae candidaes or direcorships. Such measures could enail corporae governance risks, in ha hey assume good governance is possible wihin insiuional invesors and shareholder raionaliy.

Boards, Teir Monioring oles, and CEO urnover Oher characerisics may affec a board’s abiliy o conrol manager behavior. For example, do he atribues o he board, such as inside/ouside composiion, size, or compensaion, direcly influence he board’s monioring role? Besides examining board characerisics, various sudies ocus on board responsibiliy in choosing and monioring a company’s CEO. One way o assess a board’s effeciveness is o analyze he qualiy o hose decisions. Numerous sudies illusrae a posiive relaion beween CEO urnover and poor organizaion perormance (Coughlan and Schmid 1985; Warner, Wats,

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and Wruck 1988; Weisbach 1988; Barro and Barro 1990; Jensen and Murphy 1990; Kaplan 1994; Denis and Denis 1995; Huson, Parrino, and Sarks 2001; Eldenburg, Hermalin, Weisbach, and Wosinska 2004). Namely, when company perormance is poor, he board is more likely o find he curren CEO unaccepable and make a change. In paricular, Weisbach (1988) shows ha CEO urnover afer poor perormance is more likely in firms wih more independen direcors. Boards conrolled by ouside direcors do a beter job o monioring he CEO han do boards conrolled by inside direcors. osensein and Wyat (1990) suppor he view ha independen direcors seem o affec a leas some governance effeciveness, and hey show ha sock prices rise on news o ousiders joining boards. Working in groups, such as boards o direcors, can lead o he ree rider problem, also known as social loafing. When more people are in a group, individuals in he group may believe ha ohers will do he work required and hus hey shirk heir responsibiliies. Alhough no sudies o boards direcly examine wheher social loafing occurs, some sudies use he size o he board as a proxy or he possibiliy o shirking. Smaller boards are purpored o have less shirking, and hus be more effecive in monioring managers. Yermack (1996) and Wu (2000) examine CEO urnover and board size as i relaes o firm perormance. Boh sudies find ha companies wih smaller boards have a sronger likelihood o CEO urnover afer poor perormance. is finding is consisen wih he view ha smaller boards are more effecive overseers o heir CEOs han are larger boards. Finally, Perry (2000) examines he relaion beween CEO urnover and company perormance by showing wheher he ouside direcors are paid using incenives. I incenive compensaion is an effecive ool in aligning CEO ineress wih he company’s ineress, hen i migh also work or he direcors. Perry finds ha ouside direcors who receive incenive pay end o have a proessional, raher han a personal, relaionship wih he CEO, and hus hey are relaively more independen.

Boards and he akeover Marke According o Harord (2003), undersanding he reacion o boards o akeover bids requires a recogniion o he incenives governing he direcors. Harord’s evidence shows ha ouside direcors have srong financial incenives o resis a akeover bid. He also finds ha, on average, he gain on he small amoun o equiy hey hold in he company is oo small o compensae hem or heir loss o direcorship income. ereore, a he margin, hese personal financial consideraions lead ouside direcors o resis possible acquisiions, even when hose acquisiions are in he shareholders’ ineres.

Behavioral Biases o Boards o Direcors e board o direcors is, by definiion, a group seting. Scholarly research shows ha groups ofen ampliy he cogniive biases o individuals. o illusrae his poin, consider a sudy conduced wih boh individuals and groups (Whye 1993). When presened wih a bad capial budgeing projec or evaluaion, 71 percen o he individual decision makers correcly erminaed he projec, as did a similar 74 percen o he groups. In he nex round o experimens, Whye adds an addiional piece o inormaion: a nonrecoverable invesmen already spen on he projec. Because people are averse o a sure loss, such as his sunk cos, hey incorrecly include he sunk cos in heir evaluaion.

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us, only 31 percen o he individual decision makers correcly rejec he projec, a resul o loss-aversion bias. Did he groups do beter? No, hey did worse; only 24 percen o he groups correcly rejec he projec. In ac, he groups seem o be even more affeced by he sure loss aversion. Because meeings o he board o direcors are privae, ew scholarly sudies direcly measure heir ineracions and biases (Forbes and Milliken 1999). However, many sudies analyze group behavior in general. Hopeully, wha is known rom group behavior can be exrapolaed o uncover poenial problems in boards o direcors. So, why do group decisions ofen resul in worse perormance han individual decisions? Specifically, why are behavioral biases ofen magnified in groups? ree processes occur in group dynamics ha are no acors or an individual: (1) social loafing, (2) poor inormaion sharing, and (3) grouphink. Social loafing, as menioned earlier, is also known as he fee rider problem (Jensen 1993), in which members o a group migh no pu in a high level o effor because hey assume ohers will do he work. e moivaion or his behavior is a person’s eeling ha he or she will no ge much individual recogniion or he success o he group (Linck, Neter, and Yang 2008). Insead, he social loaer pus more effor ino oher aciviies. Social loafing is more prevalen when responsibiliies wihin he group are vague and diffused, and when he group’s oucome is no linked well wih individual effors. Boards o direcors can be ormed wih members having differen knowledge or skills. e hope is ha each member shares wih he res any specialized knowledge. However, groups ofen display poor inormaion sharing (Boivie 2016). wo acors can influence his inormaion sharing: a eeling o power and an iniial prevailing view. Firs, a eeling o power occurs when one person has inormaion ha ohers do no; sharing ha inormaion reduces ha eeling o power. Second, i some members believe ha oher members avor a specific decision, hey may wihhold inormaion ha conradics ha view; his behavior is he group version o confirmaion bias. Confirmaion biasreers o selecive hinking, whereby one searches or and inerpres inormaion ha confirms prior belies while simulaneously ignoring or discouning relevan inormaion ha conradics hose belies. When a group is ormed o make a decision, i evenually needs o achieve a consensus. e drive o achieve ha consensus can crowd ou serious discussion o alernaives. is siuaion is anoher group orm o confirmaion bias, called grouphink. e group characerisics ha oser grouphink are: (1) a srong or charismaic leader, (2) a riendly amosphere, (3) no clear procedure or making he decision, (4) an over desire or conormiy, and (5) a sressul decision ha has o be made. Boards o direcors are likely o experience a leas some o hese characerisics, and hus be suscepible o grouphink (Zhu 2013).

Summary and Conclusions Agency heory is he prevailing model o CEO behavior in he finance and economics lieraure. is heory describes CEOs as sel-ineresed agens who make decisions based on wha is bes or hem, even i i is no in he bes ineress o he shareholders.

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By conras, sewardship heory describes CEOs as benevolen shepherds o he company, seeking higher achievemen by leading he firm. e expeced behavior o managemen spans he wo heories; hereore, each heory specifies differen roles or he board o direcors. Evidence indicaes ha CEOs end o be opimisic, overconfiden, risk averse, and sel-ineresed. Opimisic and overconfiden CEOs overesimae uure earnings growh and underesimae he earnings’ risk, hereby perceiving a larger cos or issuing equiy han deb. ese biased CEOs are also more likely o engage in wealh-desroying invesmens, paricularly M&As. Lasly, risk-averse CEOs may choose o use oo lile deb financing or under-inves, holding high cash balances. Wih hese behaviors, boards should provide incenives o conrol hese behavioral biases and increase riskaking, as well as align heir CEOs wih shareholder ineress. Besides hese raional roles o boards, direcors have heir own sel-ineress, and so boards can suffer rom group dynamic biases. Specifically, boards may display social loafing, poor inormaion sharing, and grouphink. ese problems may make he boards less effecive in conrolling heir op managemen. However, ar more research is needed in his area; alhough many sudies invesigae hese group biases, ew ocus on he board o direcors.

DISCUSSION QUESTIONS 1. Ideniy and explain hree psychological acors ha differeniae CEOs in he agency and sewardship rameworks. 2. Discuss how CEO opimism migh lead o poor capial invesmens. 3. Explain how a CEO migh become overconfiden. 4. Ideniy and explain group dynamic biases ha migh affec a board o direcors.

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6 Financial Planners and Advisors BENJAMIN F. CUMMINGS Associate Professor of Behavioral Finance The American College of Financial Services.

Introduction A growing number o individuals use financial advisors o provide guidance in navigaing an increasingly complex financial markeplace. Using daa rom he Survey o Consumer Finances, Hanna (2011) repors ha 21 percen o households used a financial planner in 1998, which increased o 25 percen in 2007. More recenly, he Cerified Financial Planner Boards o Sandards, Inc. (CFP Board) (2015) esimaes ha 28 percen o consumers used a financial advisor in 2010, percenand in 2015. e Sociey o Acuaries (SOA) (2013) esimaes haincreasing 55 percenoo40reirees 48 percen o pre-reirees use financial advisors o help hem make financial decisions. e increasing demand or proessional financial advice is accompanied by an increasing demand or alen in financial planning, which can be an atracive career. In 2012, CNN Money (2012) ranked financial advisors as he sixh bes job in America. More recenly,U.S. News and World epors(2016) ranked he job o a financial advisor as he ourh bes business job. e College or Financial Planning (2014) finds ha 90 percen o survey respondens are exremely saisfied wih heir choice o pursue a career in financial advice. Addiionally, he number o financial advisors is projeced o grow or he oreseeable uure. e Bureau o Labor Saisics (BLS) (2015) esimaes ha he number o personal financial advisors will grow by 30 percen over he nex decade, suggesing good prospecs or individuals who are considering he financial advice proession. chaperohers seeks o provide insigh abou he role o financialatenion plannersisand advisorsis in helping manage heir financial resources. Paricular given o he behavior o and incenives or various players wihin he financial advice proession, especially o areas where financial planners and advisors may presen behavioral biases. Bias can be described as a parialiy or or agains someone or somehing, ofen as a resul o varying influences, incenives, or consrains. e incenives or financial planners and advisors ough o be considered when analyzing heir role in a clien–planner relaionship. For example, he incenives ied o compensaion srucures may bias financial proessionals. ese proessionals may also be biased by regulaory consrains or incenives. How incenives may affec he behavior and recommendaions o financial planners and advisors is a primary ocus in his chaper.

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e firs secion o his chaper reviews he regulaion o financial advice and he ypes o firms ha exis, wih paricular atenion given o regisered invesmen advisers, broker-dealers, and insurance firms. e nex secion discusses agency coss as hey relae o financial advice and addresses poenial conflics o ineres ha arise in regard o various compensaion srucures. e hird secion covers a ew issues wihin he financial advice proession ha can conuse consumers. e ourh secion considers he empirical evidence abou he use and value o financial advice. e final secion summarizes he chaper and is main poins beore concluding wih advice or consumers abou selecing a financial proessional.

The Regulation of Financial Advice Differen firm srucures exis wihin he financial advice indusry. ese firms vary considerably in erms o service, business models, regulaory requiremens, and sandards o care. Beore describing he mos common ypes o firms ha provide financial advice, his secion offers a discussion o financial advisors and financial planners so as o provide a conex or examining he various firm srucures. REGULATION OF FINANCIAL PLANNERS

Alhough financial planners are no regulaed as a disinc proession, he Governmen Accounabiliy Office (GAO 2011) suggess ha mos aciviies a financial planner may perorm are regulaed. However, CFP Board has long advocaed regulaing financial planners disinc rom any oher exising regulaory regimes (CFP Board 2016). CFP Board (2016, Why Does egulaion Mater? secion, para. 2) also saes ha ragmened regulaion crea es legal “loopholes” and conflicing sandards o conduc or he differen componens o financial planning, allowing providers o choose he sandard ha is mos financially advanageous o hem, raher han wha is bes or he clien. e Financial Planning Coaliion, consising o CFP Board, he Financial Planning Associaion (FPA), and he Naional Associaion o Personal Financial Advisors (NAPFA), has also expressed concern abou he lack o ederal regulaion o financial planners. In 2014, he Financial Planning Coaliion released a whie paper highlighing evidence ha he lack o ederal regulaion o financial planners harms consumers (Financial Planning Coaliion 2014). For example, many praciioners who ideniy hemselves as a financial planner do no acually provide financial planning services. e Financial Planning Coaliion (2014, p. 17) also cies daa o rom Cerulli Associaes ha “only 38 percen o he sel-idenified financial planners acually had financial planning ocused pracices.” REGISTERED INVESTMENT ADVISERS

egisered Invesmen Advisers (IAs) are firms esablished primarily o provide invesmen advice. Alhough oher financial proessionals may ocus on he ransacion

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o financial producs, IAs concenrae on advice relaed o invesmen decisions. As such, hey are compensaed no or ransacing financial producs bu or providing advice relaed o invesmen sraegies, philosophies, and/or ongoing invesmen managemen. Advisors o IAs are known as Invesmen Adviser epresenaives (IAs). egulaion o IAs daes back o he Invesmen Advisers Ac o 1940. Despie some excepions, an invesmen advisoris defined as ollows: any person who, or compensaion, enga ges in he business o advising ohers, eiher direcly or hrough publicaions or wriings, as o he value o securiies or as o he adv isabiliy o invesing in, purchasing, or sell ing securiies, or who, or compensaion and as par o a regular business, issues or promulgaes analyses or repors concerning securiies. (Invesmen Advisers Ac o 1940, Secion 202(a) (11), p. 3) e Securiies and Exchange Commission (SEC) and sae securiies regulaors oversee invesmen advisers hroughou he counry. Hisorically, he respecive responsibiliies o he SEC and sae securiies regulaors were no compleely clear. Congress clarified hose responsibiliies wih he Invesmen Advisers Supervision Coordinaion Ac, which was par o he Naional Securiies Markes Improvemen Ac o 1996 (Macey 2002). o reduce redundancy in regulaion, his ac prohibied firms rom regisering wih he SEC unless or unil hey had a leas $25 million in asses under managemen (AUM), and firms had o regiser i hey had a leas $30 million o AUM. en he Dodd- Frank Wall Sree eorm and Consumer Proecion Ac o 2010 increased he AUM hreshold so ha, in general, firms wih over $100 million o AUM regiser wih he SEC, and firms mus regiser i hey have a leas $110 million o AUM (Securiies and Exchange Commission 2011c). Addiionally, all invesmen advisers based in Wyoming also regiser wih he SEC, because Wyoming does no regulae invesmen advisers (Macey 2002). e division o he SEC ha is responsible or oversigh o invesmen advisers is he Office o Compliance Inspecions and Examinaions (OCIE). According o he Securiies and Exchange Commission (2014), as o March 2014 he OCIE oversees more han 10,000 firms ha collecively manage over $48 ril lion o AUM. All IAs are required o file a Form ADV as par o heir regisraion wih he SEC or sae securiies regulaor (Securiies and Exchange Commission 2011a). Form ADV consiss o wo pars, boh o which are inended o provide regulaors and consumers wih relevan inormaion abou he firm. Par 1 o Form ADV includes specific inormaion abou he firm, such as is main address, ownership, number o employees and cliens, ypes o cliens he firm serves, and any disciplinary acions. Par 2 provides inormaion relevan o cliens and poenial cliens. I includes a brochure used o communicae he services offered, he ees charged, any conflics o ineres and disciplinary acions, and inormaion abou he managemen and key personnel o he firm (Securiies and Exchange Commission 2011a). Once firms are regisered, hey mus provide heir cliens and regulaors wih an annual updae o any maerial changes in heir Form ADV. Form ADV or any firm is publicly available hrough he Invesmen Adviser Public Disclosure (IAPD) daabase, wheher he firm is regisered wih he SEC or wih one or more sae securiies regulaors (Securiies and Exchange Commission 2016).

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IAs mus submi Form U4 (he Uniorm Applicaion or Securiies Indusry egisraion or ranser) as par o heir regisraion wih he SEC or wih sae securiies regulaors (Financial Indusry egulaory Auhoriy 2009). IAs ypically file hese orms elecronically wih he Invesmen Adviser egisraion Deposiory (IAD) (Securiies and Exchange Commission 2011b). IAs are urged o amend or updae any maerial changes in he inormaion repored on he Form U4 in a imely manner. BROKER- DEALERS

As in oher indusries, brokers serve consumers by connecing buyers and sellers o a paricular produc or producs. In he financial services indusry, brokers ypically provide ransacional suppor or buyers and sellers o financial securiies. e Securiies Exchange Ac o 1934 (1934, Secion 3(a)(4)(A), p. 4) saes ha “e erm ‘broker’ means any person engaged in he business o effecing ransacions in securiies or he accoun o ohers.” In conras, dealers sell producs rom heir invenory. e Securiies Exchange Ac (Secion 3(a)(5)(A), p. 10) saes ha “e erm ‘dealer’ means any person engaged in he business o buying and selling securiies … or such person’s own accoun hrough a broker or oherwise.” Many firms involved in ransacing financial producs provide services as boh broker and dealer, eiher by connecing a buyer wih a poenial seller o a financial securiy or by connecing a buyer wih a financial securiy ha he firm has wihin is own invenory. Because hese firms ofen perorm boh ypes o services, oday hey are commonly known as broker-dealers. Individuals who work or a broker-dealer are commonly known as regisered represenaives o a broker-dealer, or by he nickname, regisered reps, or even more simply, sockbroker or broker. A regisered represenaive may be eiher an employee o he broker-dealer or an independen conra cor. egardless o he employmen arrangemen, broker- dealers are required o supervise he aciviies o heir represenaives (Colby, Schwarz, and Zweihorn 2015). As wih IAs, represenaives o a brokerdealer mus also file Form U4 elecronically excep hey do so hrough he Cenral egisraion Deposiory (CD) as par o heir regisraion process (Financial Indusry egulaory Auhoriy 2009). Inormaion recorded on Form U4 is publicly available online hrough FINR’s BrokerCheck websie (Financial Indusry egulaory Auhori y 2016b). A sel-regulaory organizaion (SO) oversees broker- dealers and heir regisered represen aives. he Maloney Ac o 1938 amended he Securiies Exchange Ac o 1934 o creae he Naional Associaion o Securiies Dealers (NASD) as an SO o provide oversigh o he brokerage indusry. In 2007, he NASD merged wih he regulaory division o he New York Sock Exchange (NYSE) o orm he Financial I ndusry  egulaory Auhoriy (FIN A) (Financial Indusry egulaory Auhoriy 2007). FINA now provides regulaory oversigh o almos 4,000 securiies irms and over 600,000 represenaives (Financial Indusry egulaory Auhoriy 2016a). Alhough FINA operaes as a sel-regulaory organizaion, he SEC oversees FINA wih considerable cos. In a repor released by he Boson Consuling Group (2011), he SEC employs an examiner o oversee abou every 2.2 FINA examiners.

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INSURANCE FIRMS

Insurance producs are ofen a componen o a comprehensive financial plan. In addiion, agens who sell personal lines o insurance requenly provide financial advice. Insurance agens ypically ocus on one or a ew lines o insurance. For example, an insurance agen may ocus on propery and casualy insurance or individuals and amilies. ese propery and casualy insurance agens work o secure or individuals and amilies insurance policies ha will proec hem in case o a financially caasrophic loss, wheher rom loss o propery or rom liabiliy claims or damages or injuries. For mos households, hese insurance producs ypically include auomobile insurance and homeowner’s insurance, and may also include umbrella insurance, which is exra liabiliy insurance designed o help proec individuals rom major claims and lawsuis. Depending on he ype o propery and he risks o which he household is exposed, oher insurance policies may also be purchased, like insurance or waercraf or recreaional vehicles. Insurance agens may ocus on oher risks o which households may be exposed, such as a premaure deah or an unexpeced disabiliy. ese agens, ofen called lie insurance agens, provide advice abou he appropriaeness o lie insurance and disabiliy insurance policies. ey may also offer guidance abou healh insurance, or an agen may ocus specifically on healh insurance, alhough hese agens commonly ocus heir services on employers who provide access o healh insurance or heir employees. Oher insurance agens may ocus on risks specifically dealing wih a paricular proession or proessional role, such as proessional liabiliy insurance, malpracice insurance, errors and omissions (E&O) insurance, and voluneer involvemen, such as direcors and officers (D&O) insurance. Unlike oher sources o financial advice, he regulaion o insurance ress solely a he sae level. Saes have regulaed insurance since he 1850s, emphasized as a sae righ in 1869, in Paul v. Virginia, in which he Supreme Cour ruled ha insurance policies were no ransacions o commerce and, hereore, no under he purview o Congress. In 1944, he Supreme Cour reversed Paul v. Virginia in Unied Saes v. Souh-Easern Underwriers Associaion by declaring ha insurance is considered commerce and is subjec o ederal oversigh. In response, Congress passed he McCarran-Ferguson Ac o 1945 o legislaively allow saes o regulae insurance and esablish licensing requiremens. As such, insurance is regulaed by sae insurance commissions. e need o suppor sae insurance commissioners in ulfilling heir responsibiliies led o he creaion o he Naional Associaion o Insurance Commissioners (NAIC) (2016). Individual insurance agens mus also be licensed in any sae in which hey sell insurance producs, and hese licensing requiremens may vary depending on he sae. OTHER SOURCES OF FINANCIAL ADVICE

Besides he firms and affiliaed individuals previously discussed, oher firms and individuals may provide financial advice. For example, many accounans offer ax preparaion and ax planning, as well as broader financial advice. Cerified Public Accounans (CPAs) can obain he Personal Financial Specialis (PFS) designaion rom he American Insiue o CPAs (AICPA) as a way o disinguish hemselves as an

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accouning proessional who provides financial advice. Atorneys may also offer financial advice, especially relaing o legal maters such as esae planning. Oher proessionals may ocus on oher aspecs o personal and amily finance. Financial counseling and credi counseling firms ofen help individuals seeking o avoid bankrupcy or desiring assisance wih deb and cash-flow managemen concerns. Mos repuable firms ha offer credi counseling services are esablished as nonprofi organizaions and are members o he Naional Foundaion or Credi Counseling (NFCC) and/or he Financial Counseling Associaion o America (FCAA). Oher providers o advice may be housed wihin oher financial insiuions, such as a local bank or credi union. Alhough hese ypes o advisors may be employees or independen conracors working wih or or he banks or credi unions, hey are ofen regisered represenaives o affiliaed broker-dealers or IAs, or boh. ey may also be licensed lie and disabiliy insurance agens affiliaed wih a lie insurance firm. Anoher source o financial advice can come rom a financial herapis, who mos ofen alls under one o he previously menioned providers o financial advice. e Financial erapy Associaion (FA) definesfinancial herapy as he “inegraion o cogniive, emoional, behavioral, relaional, and economic aspecs ha influence financial well-being, and ulimaely, qualiy o lie” (Financial erapy Associaion 2015, para. 1). In essence, financial herapiss exend he perspecive o he clien–planner relaionship beyond he financial decisions involved as hey consider he broader behavior and psychological picure o he individual and amily.

Agency Costs in Financial Advice Because o he naure o he service, consumers may have difficuly deermining he qualiy o he financial advice hey receive rom a financial proessional. Wih search goods, consumers can make comparisons and research he producs o deermine qualiy beore making a purchase (Nelson 1970). Even wih experience goods, such as a haircu or a massage, consumers can a leas deermine he qualiy o he good or service afer hey have experienced i. However, wih credence goods, such as medical procedures or vehicle repairs, consumers ofen have difficuly deermining qualiy even afer receiving he good or service (Darby and Karni 1973). Because credence goods largely rely on he specialized knowledge o an exper, he exper knows more abou he qualiy o he good or service han do he consumers (Dulleck and Kerschbamer 2006). As such, unscrupulous proessionals who provide low-qualiy goods or services can exploi consumers o credence goods. Financial producs and recommendaions could also be considered credence goods because consumers rely on he exper knowledge o a financial proessional. Addiionally, he resuls o financial recommendaions are ofen no realized unil years in he uure. In a principal–agen relaionship, a principal delegaes specific responsibiliies or asks o an agen. Ofen, he delegaed responsibiliies are asks ha he principal eiher does no wan o perorm, does no have ime o perorm, or does no have he knowledges, skills, abiliies, or ools o perorm. In he case o financial planning, he principal is a clien who hires an agen who is a financial advisor o perorm some array o duies relaed o he financial affairs o he principal.

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As in oher agency relaionships, using a financial proessional can creae agency conflics (Jensen and Meckling 1976). In oher words, he ineress o he advisor may no be he same as he ineress o he clien. In such cases, he advisor may ac in selineresed ways o he derimen o he clien. ree ypes o agency coss ha arise in hese ypes o relaionships are monioring coss, bonding coss, and residual losses. Monioring coss reer o he responsibiliy o he principal o monior he effors perormed by he agen. a is, he principal needs o perorm due diligence o ensure ha he hired agen is compeen and ehical. In siuaions in which he agen possesses specialized knowledge ha he principal does no have, adequae monioring can be challenging. is inormaion imbalance ofen provides he jusificaion or governmen regulaion, hereby ousourcing a leas some o he monioring responsibiliies o a governmenal eniy ha can hire a compeen regulaor o perorm some monioring uncions on behal o all principals who employ a paricular agen. e previous secion provided a discussion o governmen regulaors who offer monioring services o financial planners and advisors. Mos noably, he SEC, FINR, sae securiies regulaors, and sae insurance commissions provide oversigh o many proessionals who provide financial advice. Alhough regulaors provide monioring services, agens sill have a responsibiliy o perorm monioring uncions. For example, consumers can check he public records o advisors wih whom hey are considering rusing wih heir financial affairs. ese records are available hrough he SEC’s IAPD, FINR’s BrokerCheck, and ceriying organizaions, such as CFP Board. Bonding coss is anoher orm o agency cos, in which he ineress o he agen are bonded in some way o become more closely aligned wih he ineress o he principal. Unlike monioring coss, which are ypically borne by he principal, he agen generally bears bonding coss, ofen in an effor o demonsrae o consumers ha here is commimen o a higher moral principle. In financial planning, an example o a bonding cos is a cerificaion. For example, financial planners may work o achieve he Cerified Financial Planner (CFP) cerificaion o signal o he public ha hey have acquired considerable knowledge relaed o financial planning, are commited o abiding by CFP Board’s Code o Ehics, and are willing o suffer he consequences i hey violae he code. Anoher example o a bonding cos is he sandard o care o which an advisor is held. For example, IAs are held o a fiduciary sandard o care, in which hey are obligaed o ac in he ineres o heir cliens. Conversely, regisered represenaives o a brokerdealer are merely held o a suiabiliy sandard, which requires ha a financial produc is suiable or a paricular clien. Given ha some financial recommendaions may be suiable or a clien bu no in he ineres o he clien, hese sandards o care may yield differen advice, depending on he regulaory regime o he advisor. Lasly, despie he bes effors o he principal o incur adequae monioring coss and o find an agen who has incurred bonding coss, he principal may sill experience a loss. Jensen and Meckling (1976) call hese losses residual losses. Unorunaely, unscrupulous advisors may exploi invesors while mainaining a clean public record beore someone discovers unehical concerns wih heir pracices; as a resul, consumers may lose considerable sums o money. esidual losses can also represen he losses experienced by consumers who rely on advice rom advisors who have conflics o ineres.

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In 2015, he Whie House (2015) released an analysis by he Council o Economic Advisers (CEA), which esimaes ha confliced advice on reiremen asses coss Americans roughly $17 billion each year. COMPENSATI

ON STRUCTURE

S AND AGENCY COSTS

As wih any proession, providers o financial advice are compensaed or he services hey provide, alhough many advisors also provide pro bono advice or individuals and amilies who canno afford i. However, he orm o compensaion can creae a conflic o ineres in which he ineress o he principal (i.e., clien) and he agen (i.e., advisor) may no be ully aligned. Alhough all orms o compensaion can give rise o conflics o ineres, some orms o compensaion may be more prone o conflics han ohers. a said, hones, rusworhy financial advisors can operae under each o hese compensaion srucures, and no compensaion mehod is compleely ree o conflics o ineres.

Commissions Broadly speaking, a commission is a ee paid o a firm, or an agen or employee o a firm, ofen as a orm o compensaion or providing or assising in he ransacion o a good or service. As relaed o financial decisions, commission-based compensaion ypically ocuses on he ransacions o financial producs, bu i can be arranged in various ways. Commissions in financial services are also known as sales charges or loads. ey are ofen assessed when purchasing invesmens hrough broker-dealers and when purchasing insurance policies hrough insurance agens. An example o one o he mos common commission srucures is a fon-end load on an invesmen produc. When an invesor deermines an amoun o money o inves in a produc ha has a ron-end load, he amoun invesed is reduced by he amoun o he ron-end load. For example, i someone invess $1,000 wih a regisered represenaive o a broker-dealer, and he muual und in which he or she wans o inves has a ronend load o 5 percen, hen he amoun acually invesed is $950. e remaining $50 is a commission ha goes o he brokerage firm, wih a porion o i going o he regisered represenaive as a orm o compensaion. Oher commission srucures exis. Anoher example o a load is a back-end load, also known as a deerred sales chargeor a coningen deerred sales charge. A deerred sales charge occurs when an invesor pays a se percenage when he produc is sold or surrendered. e size o he sales charge may decrease over ime so ha i he invesor owns he produc long enough he or she migh be able o avoid he deerred sales charge. However, waiing unil he sales charge ends does no mean ha he invesor pays no sales charge. ese producs also ypically include a level load, in which hey charge an ongoing ee separae rom he ron-end or back-end load. For example, 12b-1 ees are a level load assessed by muual und companies and are used o compensae advisors or disribuing shares o he muual und. No surprisingly, commission-based compensaion includes conflics o ineres in which he ineress o he clien and he regisered represenaive may no be aligned. Because commissions are based on ransacions, advisors may be incenivized o encourage more ransacions ha may no be opimal or a clien. Excessive rading in an effor o generae commissions is called churning. No only do ron-end loads have

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conflics, oher orms o commission also have conflics. For example, because back-end loads discourage invesors rom selling he invesmen, an advisor may be incenivized o sell an invesmen ha includes boh an ongoing level load (e.g., a 12b1 ee) and a back-end load (i.e., a deerred sales charge). us, invesors are discouraged rom selling he invesmen, even i i may be advanageous o do so, ye he advisor coninues o receive he level load. Commissions on oher financial producs can also generae conflics o ineres. For example, commissions on lie insurance producs may incenivize advisors o encourage individuals o purchase more insurance han is opimal or hem. Similarly, hey may promoe insurance producs ha have higher commissions, even when hose ypes o producs may no be bes or a paricular clien. Commissions can also be quie opaque, which increases he poenial or conflics o ineres. Consumers may no realize he size o he commissions hey pay and may assume ha he services hey receive are ree o charge. Inders and Otaviani (2012) creaed a model suggesing ha when commissions are no disclosed, hey end o be higher han i consumers are old he amoun o he commission. Oher commissions come direcly rom firms, so consumers do no direcly see he coss associaed wih he commissions, and likewise, hey may assume hey are no bearing he cos o compensaing an advisor.

Asses under Managemen Firms managing invesmens or cliens on an ongoing basis may charge a ee based on he size o he managed porolio. ese ees may be srucured as a percenage o AUM, a fla percenage, or iered wih lower raes charged per managed dollar or larger porolios. For example, a consumer wih $2 million o invesable asses who works wih a firm charging a fla 1 percen o AUM annually will pay $20,000 per year or he services perormed by he firm. Alernaively, a firm wih a iered-rae schedule, which charges 1 percen o AUM on he firs million dollars o AUM and 0.75 percen o AUM on he second million dollars, would charge ha same consumer $17,500 per year. Mos firms wih an AUM-based ee bill quarerly, eiher direcly o he clien or by deducing he ees rom he invesmen accoun. Because asse values end o flucuae hroughou he year, individual firms speciy he process o calculaing each quarerly paymen. Alhough AUM-based compensaion is mos common among invesmen advisors, ohers, such as dually regisered advisors, may charge based on AUM as par o a wrap accoun or a separaely managed accoun. Awrap accoun allows invesors o be charged a single ee or heir managed accoun raher han paying commissions on each ransacion. Separaely managed accounsallow or personalized porolio managemen and invesmen decisions ha are separae rom oher invesors. A firs glance, compensaion based on AUM may appear o properly align incenives. A financial advisor is rewarded wih a larger asse base o manage when he clien’s invesmen porolio perorms well, which is ofen a goal or cliens. However, as wih any orm o compensaion in a principal–agen relaionship, conflics o ineres can arise rom a compensaion srucure based on AUM. Because he ee scales wih he size o he porolio, AUM-based advisors are incenivized o mainain and even increase he amoun o invesable asses. Alhough such a goal may seem aligned wih he clien’s ineress, his may no always be he case. For example, a household may be

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averse o holding deb and may wan o pay off a morgage using asses rom heir invesmen porolio, bu an AUM-based advisor migh discourage such a decision. Likewise, an AUM-based advisor migh discourage a clien rom wihdrawing money rom his or her porolio a a rae ha could maximize lieime uiliy or a household. Furher, even when oher financial producs may be opimal o greaer ensure lieime income (e.g., annuiy producs), AUM-based advisors may be discouraged rom recommending such producs unless hose producs could sill be included as par o he managed invesmen porolio. ese advisors are also discouraged rom spending much ime managing a paricular clien’s porolio because heir compensaion is no largely ied o he amoun o ime hey spend managing he asses. As such, hey may be emped o spend minimal ime on a paricular clien’s porolio. AUMbased advisors ofen sugges ha because hey do no charge commissions, hey can provide financial advice ha is ree o conflics o ineres. However, such advisors ofen orge abou he conflics ha exis wihin heir own compensaion srucure.

Hourly Some financial advisors who provide comprehensive financial planning advice view heir value proposiion much more broadly han merely providing invesmen advice and serv ices. As such, hey may be concerned abou ying heir compensaion o only one aspec o heir services (e.g., ransacing financial producs or managing invesmen porolios) when he value hey provide heir cliens includes many oher aspecs o heir cliens’ financial lives. Because o heir concerns wih commission- based and AUM-based compensaion, some financial advisors insead choose o charge hourly. is arrangemen ypically involves assessing an hourly ee or ime spen meeing wih an advisor and ime he advisor spends working on a clien’s financial plan. Many advisors w ho work wih cliens on an hourly basis do no manage asses. Ins ead, hey ofen provide recommendaions ha cliens can implemen on heir own. Alhough many advisors conend ha hourly compensaion is ree o conflics o ineres, his compensaion srucure can also have misaligned incenives. Charging on an hourly basis may moivae an advisor o ake longer on a paricular clien’s case han is acually needed. Charging on an hourly basis also increases he saliency o he cos o advice or cliens. us, cliens may be less inclined o rely on he services o heir financial advisor because o concerns abou he incremenal cos incurred each ime hey conac heir financial advisor. As a resul, cliens may seek less advice han may be appropriae or hem because o heir price sensiiviy o he hourly rae.

eainer Some financial advisors recognize he conflics inheren in commission-based and AUM-based compensaion srucures, so hey may choose insead o charge a monhly, quarerly, or annual reainer. eainer ees are also atracive because hey can provide a seady sream o income or a firm ha depends neiher on he number o ransacions incurred (as is a commission-based compensaion) nor on he perormance o invesmen markes (as is an AUM-based compensaion). As wih oher orms o compensaion, he reainer model may also have conflics o ineres. Because advisors receive he same compensaion regardless o he amoun o ime hey devoe o a paricular clien,

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hey may be emped o shirk heir responsibiliies and spend as litle ime as possible ocusing on each clien.

Projec-Based Fees Wih a desire o align he services ha an advisor provides wih he ees ha cliens pay, some firms charge projec-based ees. ese ees are ofen associaed wih he creaion o a financial plan or an exensive review o a paricular aspec o a clien’s financial siuaion. Because o he emporary naure o his orm o engagemen, advisors may encourage cliens o coninue he engagemen under a differen compensaion srucure. For example, i a clien pursues ongoing invesmen managemen afer compleing he iniial projec, he ee arrangemen could include a discoun. As wih all oher compensaion srucures, charging projec-based ees can also give rise o conflics o ineres. An advisor may be emped o overesimae he amoun o resources a paricular projec will require or, conversely, inenionally complee he projec using ewer resources han iniially oulined, hereby charging he clien more han hey oherwise migh charge. CONFLICTS OF INTEREST IN FINANCIAL PLANNING

All compensaion srucures can creae conflics o ineres; such is he naure o principal–agen relaionships. However, he exisence o a conflic o ineres does no imply ha no advisors will ac in he ineress o heir cliens. Many financial advisors provide air and ehical financial planning services or cliens regardless o he compensaion srucure and despie hese conflics. o deal wih hese inheren conflics, advisors should disclose such conflics o heir cliens. CFP Board (2013) sresses he imporance o disclosing conflics o ineres in wriing and no jus conflics ha arise owing o compensaion srucure. Conflics may also arise owing o he naure o he planner–clien relaionship, and advisors may be swayed or personal ineress and benefis. Conflics may also occur beween a clien and he advisor’s firm, no jus beween a clien and he advisor. o properly miigae any conflics, CFP Board encourages financial planners o disclose any known conflics a he beginning o he clien–planner engagemen and o promply disclose any conflics ha arise during he engagemen.

Consumer Confusion Wih differen regulaory regimes and muliple compensaion srucures, consumers can easily be conused abou he advice hey are receiving. A sudy sponsored by he SEC repors considerable consumer conusion resuling rom he use o generic erms such as financial advisor (Hung, Clancy, Dominiz, alley, Berrebi, and Suvankulov 2008). For example, consumers do no realize ha imporan regulaory disincions in he indusry generae differen sandards o care. is secion highlighs some areas o consumer conusion relaed o using proessional financial advice.

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FINANCIAL PLANNERS AND

FINANCIAL ADVISORS

Many individuals use he financial advisor and financial planner erms synonymously, wihou clearly disinguishing beween hem. Alhough he erms may represen financial proessionals wih slighly differen concenraions, he use o his erminology is no consisen across all individuals. Financial advisordescribes a proessional who provides guidance relaed o financial decisions. Many financial advisors have acquired considerable knowledge relevan o household financial decisions, wih which hey can provide heir cliens wih specialized guidance or heir unique siuaions. Because he erm is unregulaed, some individuals may use he erm wihou having requisie knowledge. a is, hey may use he erm financial advisor as a markeing ool despie lacking any specialized financial knowledge. Financial planner ypically describes a specific subse o financial advisors who give paricular atenion o financial decisions across ime in order o reach uure financial goals. Under his disincion, mos financial planners could also be considered financial advisors, bu some financial advisors may no be financial planners. Furher, some individuals who claim o be financial advisors or financial planners may acually be neiher ype o financial proessional. ADVISERS AND ADVISORS

wo differen spellings oadvisor are commonly used o describe providers o financial advice. Adviser wih an “e” is he spelling used in he Invesmen Advisers Ac o 1940 and is ofen associaed wih IAs. Advisor wih an “o” is ofen he spelling used in he more generic and unregulaed erm, financial advisor. Alhough his spelling disincion is commonly employed, consisency in his spelling disincion is difficul and rare. Even he SEC websie includes boh spellings, which are commonly used inerchangeably. MULTIPLE REGULAT

ORY REGI MES

A conusing aspec o he financial advice indusry is ha a single advisor may operae under muliple auspices. In oher words, a financial advisor may be a regisered represenaive o a broker-dealer and an invesmen adviser represenaive. Advisors who are affiliaed wih a broker-dealer and wih a IA are ofen described as having a dual regisraion or as being dually regisered. o urher complicae maters, he same dually regisered advisor may also be licensed o sell insurance producs. As a resul, consumers may undersandably have difficuly ideniying he regulaory regime o a financial proessional.

The Use and Value of Financial Advice Various sudies examine he use and value o financial advice. Sudies ocusing on he use o financial advice ofen seek o ideniy he characerisics o individuals who employ he services o a financial planner or financial advisor. Oher sudies seek o ideniy acors ha lead someone o begin using he services o a financial proessional. Atemping

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o quaniy he value o financial advice is anoher common research iniiaive, whereas ideniying qualiaive acors ha conribue o he value o financial advice is also beneficial. is secion discusses each o hese aspecs o he use and value o financial advice. SURVEY QUESTIONS ABOUT FINANCIAL ADVICE

Alhough various naionally represenaive daases include quesions abou he use o financial advice, hese quesions differ considerably in wording and purpose. As a resul, he measuremen o who uses o a financial advisor differs depending on he daase. For example, he Naional Longiudinal Survey o Youh (NLSY) includes he ollowing quesion ha ocuses on reiremen preparaion and he use o a financial planner: “People begin learning abou and preparing or reiremen a differen ages and in differen ways. Have you (or your spouse/parner) consuled a financial planner abou how o plan your finances afer reiremen?” e Asse and Healh Dynamics among he Oldes Old (AHEAD) once included a broader quesion in is survey: “Do you have a financial advisor who helps make decisions?” Ye, he AHEAD, now merged wih he Healh and eiremen Sudy (HS), has no asked abou using a financial advisor since he early 1990s. e Survey o Consumer Finances (SCF) asks abou using various financial proessionals in is riennial survey. e SCF asks wo separae quesions abou sources o inormaion in making financial decisions. e firs quesion ocuses on borrowing or credi decisions, and he second quesion deals wih savings and invesmen decisions. e second quesion asks: “I am going o read you a lis. Please ell me which sources o inormaion do you (and your amily) use o make decisions abou saving and invesmens?” A financial planner is he welfh iem on he lis. THE USE OF FINANCIAL ADVICE

Using empirical daa rom he 1998 eiremen Confidence Survey, Joo and Grable (2001) find ha among pre-reirees, women are more likely o seek proessional reiremen planning help han men. e auhors also find ha income, beter financial behaviors, proacive reiremen atiudes, and risk olerance are posiively relaed o seeking proessional reiremen planning help. In 2006, he Invesmen Company Insiue sough o learn more abou he use o invesmen advice among muual und shareholders (Leonard-Chambers and Bogdan 2007). e auhors find ha abou wo-hirds o muual und shareholders engage he ongoing services o a financial advisor. Using daa rom a German bank, Bluehgen, Ginschel, Hackehal, and Müller (2008) find ha users o financial advice end o have more diversified invesmen porolios. Users o proessional financial advice are generally more educaed (Hanna 2011), have higher ne worh (Chang 2005; Bluehgen e al. 2008; Hanna 2011), have higher income ( Joo and Grable 2001), and are older (Bluehgen e al. 2008; Hanna 2011) han hose who do no use proessional financial advice. SEEKING FINANCIAL ADVICE

An analysis o hose who use a financial advisor is somewha differen rom an analysis o hose who are likely o seek financial advice, which can be urher differeniaed by

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analyzing hose who seek proessional financial advice. Using a random sample o clerical workers, Grable and Joo (1999) provide insighs abou financial help-seeking behavior, broadly defined as seeking help rom differen sources such as a financial planner, atorney, credi counselor, riend, relaive, and co-worker. No surprisingly, he auhors find ha recenly experiencing more financial sressors influences seeking financial advice rom ohers. Exhibiing ewer posiive financial behaviors is also relaed o seeking financial advice. Addiionally, younger individuals and reners are more likely o seek advice rom ohers. Women also end o be more likely o seek financial advice han are men (Joo and Grable 2001; Bluehgen e al. 2008). Using daa rom he 1998 Survey o Consumer Finances, Chang (2005, p. 1469) finds ha “social neworks are by ar he mos requenly used source o saving and invesmen inormaion; however hey are used mos ofen by hose wih he leas wealh.” Chang also repors ha wealhier households are more likely o rely on muliple sources or financial guidance, including financial proessionals and media. Hanna (2011) suggess ha he likelihood o using a financial advisor peaks in he mid-ories. is finding suggess ha many individuals may wai unil reiremen decisions appear more pressing beore seeking proessional financial advice. Experiencing major lie changes, including losing a spouse (Leonard-Chambers and Bogdan 2007; Korb 2010; Cummings and James 2014), declining cogniion (Cummings and James 2014), or having a sudden change in income or ne worh (Leonard-Chambers and Bogdan 2007; Cummings and James 2014), can also induce someone o seek financial advice rom a proessional. MEETING WITH A FINANCIAL ADVISOR

A growing area o research includes psychophysiological economics, which can provide insighs abou he psychological and physiological responses during a meeing wih a financial proessional (Grable 2013). In a clinical inervenion pilo sudy o college sudens, Archulea, Burr, Carlson, Ingram, Kruger, Grable, and Ford (2015) find ha meeing wih a financial counselor can no only improve psychological well-being and financial behavior bu also decrease financial disress. Individuals meeing wih a financial advisor also presen considerable discrepancy beween objecive and subjecive measures o financial sress, suggesing ha ew individuals can accuraely assess he impac o heir financial sress during a meeing wih a financial advisor (Grable and Brit 2012). Grable, Heo, and abbani (2014) sudy he ineracion o financial anxiey and physiological arousal; hey find ha individuals wih low financial anxiey bu moderae o high physiological arousal are mos likely o seek proessional financial advice. ose wih high financial anxiey are less likely o seek proessional financial help because he anxiey may cripple heir abiliy o seek help. THE V ALUE OF FINA

NCIAL ADVICE

Analyses o he value o financial advice ofen ocus on he quaniaive, financial benefis o using a proessional financial advisor. However, he value o financial advice ex ends beyond merely financial benefis. Hanna and Lindamood (2010) recognize he difficuly o quaniying many o he financial benefis o using a financial

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planner. e benefis o sound financial advice can also include qualiaive consideraions. For example, consumers ofen seek he services o various proessionals, no in an atemp o save money bu because hey find value in he advice hey receive, which can help hem make decisions wih greaer confidence. e advice o knowledgeable proessionals can also dispel ears and concerns abou an unknown uure. As relaed o financial advice, Leonard- Chambers and Bogdan (2007) repor ha using an advisor provides und owners wih greaer peace o mind, and James (2013) finds evidence ha individuals who rely on a cerified financial proessional are less likely o second guess he experise o heir advisor during periods o marke underperormance. Evidence is mixed when ocusing solely on porolio merics as a benefi o using a financial advisor. In a sudy o German invesors, individuals who use a financial advisor end o have more diversified porolios ha also include more asse classes (Bluehgen e al. 2008) However, hese same individuals end o urn over heir porolios more ofen and subsequenly pay more ransacion ees. An analysis o Duch invesors also suggess greaer diversificaion in porolios o individuals who use financial advisors, bu hese porolios do no have significanly superior risk- adjused perormance (Kramer 2012). However, using he NLSY, Grable and Chaterjee (2014) find ha on average, individuals wih financial planners have superior riskadjused perormance. Oher sudies sugges ha invesors who use financial advisors experience lower porolio reurns (Hackehal, Haliassos, and Jappelli 2012; Karabulu 2013). Differing agency coss inheren in financial planning relaionships may creae varying incenives o ac in he ineres o invesors, hence he mixed resuls abou he value o financial advice in porolio managemen. Using rained audiors who me wih financial advisors, Mullainahan, Noeh, and Schoar (2012) find ha financial advisors end o encourage invesmen behavior and opions ha avor he advisor’s ineress. ese findings sugges he imporance o properly aligned incenives when working wih a financial proessional. Oher sudies ocus on he benefis o financial advice where he value may be more difficul o quaniy. For example, households using a financial planner are more likely o have adequae lie insurance proecion (Finke, Huson, and Waller 2009) and are more likely o use oh Individual eiremen Arrangemens (IRs) (Smih, Finke, and Huson 2012; Cummings, Finke, and James 2013). ese findings sugges ha a financial planner can help households acquire and mainain helpul risk-managemen ools and ax-shelered vehicles, bu quaniying he value o adequae insurance proecion and opimal ax shelering is challenging. Wincheser, Huson, and Finke (2011) show ha invesors who use a financial advisor during a recession are more likely o mainain a long-erm ocus, suggesing ha advisors can help invesors mainain ocus on heir financial goals. Among individuals in heir ories, Finke (2013) repors ha using a financial planner is posiively relaed o ne worh and accumulaed reiremen asses. Alhough he direc effec o his relaion is unclear, he evidence could sugges ha financial planners may play a role in helping invesors deermine and implemen ax advanageous accumulaion sraegies. Several sudies atemp o quaniy he overall value o financial advice. An advisor can provide subsanial value o cliens hrough a combinaion o benefis, such as

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using low-cos invesmens, appropriae asse allocaion and locaion, and porolio rebalancing (Kinniry, Jaconeti, DiJoseph, and Zilbering 2014). is value creaion is capured in wha he auhors erm Vanguard Advisor’s Alpha, which when all componens are implemened, he gain in ne reurns o cliens is esimaed o be abou 3 percenage poins (300 basis poins). Perhaps one o he mos noable conribuions an advisor can make is behavioral coaching, which accouns or he value o an advisor in helping cliens mainain heir long-erm invesmen objecives when markes are volaile. e auhors esimae ha behavioral coaching alone can provide abou 150 basis poins in ne reurn. Blanchet and Kaplan (2013) quaniy he value o inelligen invesmen decisions, which hey erm gamma. Advisors can provide value or heir cliens by helping hem implemen inelligen invesmen decisions, such as opimal asse allocaion, ax-efficiency consideraions, and appropriae porolio wihdrawal sraegies. ese auhors esimae ha gamma can generae a superior reiremen income sraegy, essenially equivalen o increasing he annual reurn by 159 basis poins. is gamma esimae is wihin he same range as he Vanguard Advisor’s Alpha esimae.

Advisor Biases As menioned previously, financial planners and advisors may presen behavioral biases in response o he incenives ha exis or hem. For example, financial advisors may receive kickbacks rom porolio managers, which allows or higher ees and lower ne reurns or invesors (Soughon, Wu, and Zechner 2011). Del Guercio, euer, and kac (2010) find evidence ha suggess muual und amilies arge eiher cliens who value brokerage services or do-i-yoursel invesors, bu rarely do und amilies arge boh ypes o cliens. Muual und invesors o broker-sold unds end o pay higher ees and have lower risk-adjused reurns han invesors who purchase unds direcly wihou a broker (Bergsresser, Chalmers, and uano 2009). Furher, acively managed broker-sold unds end o underperorm index unds (Del Guercio and euer 2014), and cliens wih brokers end o earn lower risk-adjused reurns han similarly mached arge-dae unds (Chalmers and euer 2012). Because o he poenial or conflicing ineress, cliens may be willing o compensae advisors whom hey rus. Because o his rus, ees or financial advice are higher han coss, and managers end o underperorm he marke afer accouning or ees, ye invesors ofen preer o rely on a proessional raher han inves on heir own (Gennaioli, Schleier, and Vishny 2015). Being somewha financially lierae increases rus, bu higher levels o financial lieracy also decrease rus (Lachance and ang 2012). As menioned previously, disclosure is a commonly proposed soluion o comba confliced advice, hereby requiring advisors o disclose poenial conflics, bu evidence suggess ha disclosures do no discourage cliens wih low financial lieracy rom acing on confliced advice (Carmel, Carmel, Leiser, and Spivak 2015). Alhough unbiased advice may be beneficial, ew invesors ake advanage o i when i is offered, and even ewer acually ollow he advice (Bhatacharya, Hackehal, Kaesler, Loos, and Meyer 2012).

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Summary and Conclusions Financial planners and advisors provide financial advice in various business models, regulaory regimes, and compensaion srucures. IAs, broker-dealers, and insurance firms end o be he mos common ypes o firms where households seek financial advice, bu oher providers also exis. Advisors ofen play muliple roles and all under differen regulaory regimes, which can be conusing or consumers. A simplified regulaory srucure ha provides similar proecions or consumers under each regulaory regime is warraned reducemodel, his conusion. egardless o he o business all compensaion srucures conain poenial conflics o ineres, and advisors and consumers ough o be cognizan o hese poenial conflics. Invesors can find ehical advisors wihin each regulaory regime and compensaion srucure. o increase he likelihood o using an ehical advisor, consumers have a responsibiliy o perorm heir own due diligence, raher han relying solely on governmen regulaors. Seeking advisors who have incurred bonding coss can reduce agency conflics. Consumers ough o ask quesions o poenial advisors and check publicly available records abou hem. By working wih a financial planner or advisor wih properly aligned incenives, consumers are likely o benefi boh financially and psychologically.

DISCUSSION QUESTIONS 1. Explain he various regulaory regimes ha encompass financial planners and advisors, and ideniy when a paricular advisor would fi under each regime. 2. Discuss he agency coss involved in receiving proessional financial advice and how o miigae hose coss. 3. Describe he common compensaion srucures used by financial advisory firms, and ideniy poenial conflics o ineres wihin each compensaion srucure. 4. Discuss he characerisics o individuals who ypically employ he services o financial planners and advisors. 5. Discuss empirical evidence abou he value o financial advice.

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7 Financial Analysts SUSAN M. YOUNG Associate Professor of Accounting Gabelli School of Business, Fordham University

Introduction A wealh o academic research examines financial analys behavior during he pas 30 years. ese sudies use many differen approaches o deermine how analyss make decisions. For example, a recen survey invesigaes he “black box” o equiy analyss (Brown, Call, Clemen, and Sharp 2015). Various experimens also examine analys behavior (Young 2009). More commonly, researchers use daa now widely available hrough he omson I/B/E/S daabase o examine analyss’ decision processes (Clemen 1999).euers is daabase allows researchers o measure many individual characerisics o he analyss who are included in he daabase. ese characerisics are associaed wih he accuracy and bias in analyss’ orecass and recommendaions. Examples o hese analys characerisics include pas orecas accuracy and bias, brokerage house size, and orecasing experience. Financial analyss, similar o oher decision makers, are subjec o many o he same biased judgmens. For example, hey are limied in heir capaciy, abiliy, and resources during heir orecasing asks. However, given heir experise in analyzing firms, hey could be less biased or more accurae han he average decision maker. Early sudies in analys experise have esablished ha analyss are more accurae han basic randomwalk models and become more accurae as heir experience in orecasing increases. For example, Brown, Griffin, Hagerman, and Zmijewski (1987) compare he accuracy o analyss’ orecass o o basic ime-series models based onhis hisorical ey find analyss’ orecass be more accurae and atribue findingearnings o bohdaa. he inormaional and he iming advanage o analyss above and beyond a simple mapping o hisorical earnings. Mikhail, Walher, and Willis (1997) find ha analyss become more accurae in heir orecass o earnings per share (EPS) as hey build experience in he orecasing ask. Evidence also shows ha analyss are opimisic in boh heir orecass and heir recommendaions (Francis and Philbrick 1993; Lim 2001). Sudies ypically measure orecas bias as he observed, signed difference beween he analys’s orecas and he observed acual EPS o he firm. Accuracy in orecass is measured as he absolue difference beween an analys’s orecas and he expos realizaion o he firm’s EPS. Biases in recommendaions are measured by orming rading porolios based on analyss’ recommendaions. Ex-pos reurns, boh shor and long 118

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erm, are hen measured o deermine wheher excess posiive or negaive reurns are realized rom relying on analyss’ repors. Ineresingly, one analys can produce boh more accurae and more biased orecass han anoher analys. For example, i Analys A issues wo orecass ha are boh wo cens more han he acual EPS, and Analys B issues one orecas ha is hree cens more and one orecas ha is hree cens less han he acual EPS, Analys A is considered more accurae, bu also more opimisically biased. is chaper ocuses on he bias in analyss’ repors, wih occasional menion o how his relaes o analys accuracy. Prior research provides evidence ha analyss “add value” or are inormaive o he marke as inormaion inermediaries. Sudies find ha analyss’ orecass and recommendaions move sock prices, measured as he sock price reacion and changes in rading volume in response o changes in analys oupus, such as earnings orecass, recommendaions, arge price orecass, and cash-flow orecass. For example, Cheng (2005) finds ha analyss’ orecass explain 22 percen o he variaion in marke-obook raios no capured by oher inormaion variables. However, research also finds ha analyss may produce biased repors in cerain siuaions, which may be predicable, and cerain ypes o analyss may be more likely o be biased in heir repors. Analyss have compeing incenives in heir jobs. ey benefi rom having accurae repors, which can increase heir repuaion and lower job urnover. However, analyss also wan o please managemen wih opimisic long-erm orecass, price arges, and recommendaions. As a resul, hey curry avor wih managers o obain access o beter inormaion and encourage more rading and banking deals, which lead o higher analys compensaion. Given he conex o he analys’s work environmen, disenangling analys bias rom economic incenives (raional or purposeul bias) versus behavioral bias (nonraional or uninenional bias) due o environmenal acors is difficul. esearch on wheher he marke undersands and incorporaes hese biases is mixed. e ollowing secions examine he research relaed o hese opics. e firs secion presens a discussion o he role o equiy analyss in he marke. is secion also reviews some regulaions enaced in he early 2000s relaing o he conflics o ineres among financial analyss, brokerage house srucure, and he managers o publicly raded firms. e second secion discusses he psychological heories ha explain bias in decision making. e hird secion explores he relaion beween inormaion uncerainy in a orecasing ask and analys bias. e ourh secion examines wheher cerain analys characerisics can moderae analys bias. e penulimae secion discusses wheher decision makers can de-bias heir judgmens. e chaper hen concludes wih a summary.

Role of Financial Analysts and Market Regulation As inormaion inermediaries, sell-side financial analyss play a criical role in analyzing, inerpreing, and disribuing inormaion o marke paricipans abou he prospecs o publicly raded firms. e main oupus o heir analyses include quarerly and annual EPS orecass and recommendaions on he firms hey ollow: buy recommendaions or hose firms hey believe are undervalued, hold recommendaions or hose hey believe are appropriaely valued, and sell recommendaions or hose hey believe are overvalued. Analyss also provide a monioring role, which posiively influences

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marke efficiency by reducing agency coss (Chung and Jo 1996). e empirical lieraure provides evidence ha changes in analyss’ rading recommendaions and EPS esimaes affec financial marke valuaions (amnah, ock, and Shane 2008). In response o large marke ailures such as Enron and WorldCom beginning in 2000, marke paricipans, including he U.S. Congress, called or regulaion ha would increase analys objeciviy and reduce bias in analyss’ repors by reducing or eliminaing analys conflics o ineres. In lae 2000, he Securiies and Exchange Commission (SEC) issued egulaion Fair Disclosure (eg FD) o address some o hese concerns. eg FD barred managemen rom selecively disclosing maerial nonpublic inormaion o selec analyss, hereby reducing he incenive or analyss o bias repors in order o gain access o privileged inormaion. Following he release o eg FD, he Naional Associaion o Securiies Dealers (NASD) and he SEC enaced urher rules o miigae wha hey considered a significan opimisic bias in analyss’ repors. During 2002 and 2003, he SEC approved a series o rules o address possible conflics o ineres or equiy analyss. ese rules included a sric separaion o invesmen banking rom equiy research aciviies. e rules also required changes in analyss’ compensaion arrangemens, as well as more inormaive disclosure by analyss who own shares in he companies hey ollow. Also in 2003, he New York Sock Exchange (NYSE), he SEC, NASD, and he atorney general o New York announced ha 10 o he op brokerage houses in he naion had setled an enorcemen acion relaing o conflics o ineres beween research and invesmen banking, reerred o as he Global Setlemen. e brokerage firms paid fines and penalies in excess o $1.3 billion. Alhough he Global Setlemen enorcemen issues only applied o he 10 invesmen firms, i virually esablished new precedens or he limis o conflics beween banking and research in ull-service brokerage firms. e SEC acceped NASD ule 2711, NYSE ule 472, in addiion o he Global Setlemen in lae 2002 and early 2003. ese regulaions urher addressed analyss’ conflics o ineres and limied inormaion ransmission beween analyss and brokerage house invesmen banking branches. In summary, he banks agreed o implemen a series o reorms o address he pervasive concerns relaed o conflics o ineres and opimisic analys research. Subsequenly, in July 2007, Financial Indusry egulaory Auhoriy (FINR) was creaed by consolidaing he NASD and he NYSE. FINR is responsible or rule wriing, firm examinaion, enorcemen, arbiraion, and mediaion uncions, along wih all uncions previously overseen solely by he NASD. OPTIMISM IN EARNINGS FORECASTS

Much o he empirical research finds ha beore hese regulaions, analyss were excessively opimisic in boh heir earnings orecass and heir sock recommendaions. For example, Lim (2001) assers ha managemen preers opimisic orecass because hese orecass increase marke valuaions and hereore managemen compensaion. Lim proposes ha analyss may be willing o bias heir orecass upward in order o receive preerred reamen rom managemen and hereore obain beter nonpublic inormaion abou he firm. Lim’s resuls show ha firms exhibiing higher uncerainy, which is proxied by he sandard deviaion o weekly excess sock reurns, are associaed wih more opimisic analys earnings orecass. Das, Levine, and Sivaramakrishnan

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(1998) sugges ha analyss are more likely o require nonpublic inormaion o develop an accurae orecas o EPS or firms wih low earnings predicabiliy and his higher demand or inormaion causes analyss o be more opimisic o please firm managemen. eir assumpion is ha analys opimism will assis wih access o managemen’s nonpublic inormaion. ereore, analyss should opimally provide opimisic orecass o improve he amoun, iming, and ype o inormaion hey receive rom managemen. e auhors’ resuls show a consisen negaive relaion beween earnings predicabiliy and orecas opimism, which confirms heir managemen relaions hypohesis. OPTIMISM IN S

TOCK RECOMMENDATI

ONS

In addiion o he lieraure ha provides evidence o opimism in analyss’ orecass, he evidence also shows opimism in analyss’ recommendaions. For example, Womack (1996) finds ha analyss are seven imes more likely o issue a new buy recommendaion han a new sell recommendaion. Mikhail, Walher, and Willis (2004) find ha sell recommendaions consiue only 6 percen o heir sample o recommendaions, whereas buy and hold recommendaions make up he remaining 94 percen. Several raional, economic acors may influence analyss’ incenives and cause hem o avoid sell recommendaions. For insance, analyss’ desire o mainain access o imporan managemen-provided inormaion may cause hem o ake acions o curry avor wih managemen, making hem relucan o issue sell recommendaions. Sell recommendaions may also jeopardize he invesmen banking business o he analyss’ employers (Lin and McNichols 1998), or hey may adversely affec commissions generaed rom cusomer rading ransacions (Michaely and Womack 1999). An opimisic bias in recommendaions may also improve an analys’s chances o being promoed by his employer (Hong and Kubik 2003). Francis and Philbrick (1993) find ha analyss’ earnings orecass are more opimisically biased or sell and hold recommendaions han or buy recommendaions. ey conclude ha his patern is consisen wih analys incenives o improve managemen relaions and is inconsisen wih he economic incenives o rade boosing. rade boosing assumes ha equiy analyss are driven by he economic incenive o increase rading in he socks hey cover and hereore o increase heir compensaion. In conras o hese findings, Eames, Glover, and Kennedy (2002) show ha analys earnings orecass are opimisic or buy recommendaions and pessimisic or sell recommendaions. ese resuls suppor he presence o boh a rade boosing incenive and a behavioral explanaion: analyss uninenionally bias heir oupu o orecass sock recommendaions o achieve consisency beween he wo. BEHAVIOR OF ANALYSTS ACROSS T POST- REGULATION PERIODS

HE PRE-

AND

Given ha he goal o he increased regulaion was o reduce analys conflics o ineres, many sudies examine he behavior o analyss across he pre- and pos-regulaion periods in an atemp o deermine wheher he regulaory goals were achieved. o he exen ha opimism in analyss’ repors is due o conflics o ineres ha regulaion

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reduced, he expecaion would be o see analys opimism also reduced or eliminaed. However, i analys opimism is due o behavioral reasons (as discussed in he nex wo secions), he regulaion may no have achieved hese goals. e ollowing is a brie survey o he pos-regulaion research. Ginschel and Markov (2004) sudy wheher eg FD reduced he inormaiveness o analyss’ orecass and recommendaions, which implies ha eg FD was effecive in reducing or curailing selecive disclosure o cerain analyss. eir findings suppor his conjecure. ey find ha in he pos-eg FD period, he absolue price impac o analys inormaion was 28 percen lower han he pre-regulaion level. e auhors also repor ha he drop in price impac varied sysemaically wih brokerage house and sock characerisics. For example, he difference in price impac beween opimisic analyss and non-opimisic analyss in he pos-eg FD period is 50 percen lower compared o is pre-regulaion levels. Erimur, Sunder, and Sunder (2007) also compare analys recommendaions issued beore and afer eg FD and hey find ha he inegriy o “buy” and “hold” recommendaions improved pos-regulaion; he change is more pronounced or analyss hey expeced o be more confliced. e auhors measure he inensiy o conflics o ineres by classiying analyss ino hree groups: (1) firms wih no invesmen banking business (nonconfliced firms), (2) firms wih a relaively low repuaion in he invesmen banking business (medium confliced), and (3) firms wih a high repuaion in he invesmen banking business (highly confliced). ey find ha regulaion increased he relaion beween earnings orecas accuracy and recommendaions o profiabiliy or buy recommendaions wih regard o hose analyss expeced o be he mos confliced. Addiionally, Erimur e al. find ha reaing hold recommendaions as sells resuls in significanly negaive mean abnormal reurns afer regulaion. is finding is in conras o he posiive reurns earned rom such a recommendaion sraegy beore eg FD, indicaing ha pos-regulaion, analyss reduced he opimism in heir recommendaions. Kadan, Madureira, Wang, Zach, and Bahala (2009) find ha conflics o ineres, defined as he pas presence o an underwriing relaionship beween he brokerage house and he firm he analys is ollowing, is a key deerminan o sock recommendaions beore regulaion. Afer regulaion, however, he disribuion o analyss’ repors became more balanced and less opimisic. ey repor ha confliced analyss are no longer more likely o issue opimisic recommendaions han unaffiliaed analyss, bu are sill less likely o issue pessimisic recommendaions. Chih-Ying and Chen (2009) also examined he impac o regulaion on analys behavior. ey find a significanly sronger relaion beween recommendaions and analyss’ earnings orecass relaive o sock prices afer he regulaion came ino effec. eir evidence also shows a weaker relaion beween sock recommendaions and proxies or analys conflics o ineres (ne exernal financing and amoun o underwriing business) afer implemenaion o he regulaion. Furher, hey find ha sock recommendaions issued by analyss wih greaer poenial conflics experience a larger decrease in bias afer his regulaion. Barniv, Hope, Myring, and omas (2009) show ha regulaions have srenghened he relaion beween residual income valuaions o firm equiy and analys recommendaions. ey also find evidence o increased useulness o analyss’ earnings orecass

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or invesors. Addiionally, heir evidence shows ha residual income valuaions have an increasingly posiive associaion wih uure reurns afer he adopion o eg FD and addiional regulaions (NASD ule 2711, NYSE ule 472, and Global Setlemen). Lach, Highfield, and reanor (2012) examine he long-run perormance o analys raings o iniial public offerings (IPOs) ollowing regulaion o assess changes in bias during his period. ey find a reducion in he amoun o posiive bias conained in analyss’ repors afer regulaion. Lee, Srong, and Zhu (2014) also hypohesize ha he series o regulaions occurring beween 2000 and 2003 srenghened he inormaion environmen o U.S. capial markes. eir findings show ha hese regulaions reduced mispricing and increased marke efficiency. ese resuls are more pronounced among higher inormaion uncerainy firms. e auhors use several proxies or firm inormaion uncerainy, including accruals qualiy, firm size, firm age, analys coverage, analys orecas dispersion, and cash flow and sock reurn volailiy. Lee e al. find orecas accuracy also improved in hese firms and conclude ha his is consisen wih an improved inormaion environmen afer he regulaions ook effec. Some research, however, coninues o find evidence o remaining conflics o ineres among analyss. For example, Brown e al. (2015) adminisered a survey and conduced inerviews wih more han 350 analyss. ey noe ha managemen relaionships and he underwriing business coninue o be very imporan o analyss’ compensaion. Brown e al. (p. 4) sae: In spie o regulaors’ effors, 44 percen o our respondens say heir success in generaing underwriing business or rading commissions is very imporan o heir compensaion, suggesing conflics o ineres remain a persisen concern or users o sell- side research. Addiional sudies repor ha a majoriy o recommendaions coninue o be biased upward oward buy recommendaions (Agrawal and Chen 2008) and ha analyss coninue o rarely issue sell recommendaions (Shon and Young 2015). Groysberg, Healy, and Maber (2011) find ha he buy recommendaions o sell-side analyss underperorm he buy recommendaions rom buy-side analyss by 5.8 percen. Buy-side analyss usually work or a pension und or muual und, whereas sell-side analyss ypically work wih a brokerage house. According o Chen and Masumoo (2006), access o manager-provided inormaion is imporan even in he pos-eg-FD era. In summary, much o he empirical research shows ha he regulaions reduced, bu did no eliminae, he amoun o bias in analys recommendaions ollowing regulaion. However, addiional research coninues o find evidence o bias relaed o analyss’ conflics o ineres. e ollowing wo secions discuss he behavioral heories ha hypohesize he explanaion or he observed opimism in analyss’ repors.

Psychological Theories About Analyst Bias e cogniive psychology lieraure suggess ha individuals generally end o be over-opimisic (Armor and aylor 2002). For example, as Helweg-Larsen and

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Shepperd (2001) noe, individuals believe ha hey are less likely o be vicims o auo accidens, crime, and earhquakes and ha hey are less likely han ohers o suer rom il lness, depression, unwaned pregn ancies, or a hos o oher negaive healh evens (Weinsein 1980). e psychology lieraure urher suggess ha uncerainy in a ask affecs he deci sion maker’s level o judgmen and may exacerbae his opimisic bias. HEURISTICS

Based on a series o experimens, versky and Kahneman (1974) repor ha people rely on heurisic principles, or shor- cus, o reduce complex and uncerain asks o predicing values o simpler judgmens. ese heurisics may lead o severe and sysemaic errors. Uncerainy in orecasing may resul rom a low perceived reliabiliy in he ask (i.e., he inormaion provided or he ask is inconsisen) or a low perceived validiy in he ask (i.e., he inormaion may no properly reflec rue values) (Ganzach 1994). Sudies repor ha decision makers become more opimisic as a ask becomes more uncerain, and ha his is robus across a number o asks (Kahneman and versky 1973; Markus and Zajonc 1985; Ganzach and Kranz 1991). Boh financial analysis and orecass o a company’s earnings and uure perormance are complex, unsrucured asks ha vary across indusries and across firms wihin indusries. As such, orecasing asks naurally vary across firms on boh he perceived reliabiliy (e.g., high variance in pas earnings) and he perceived validiy (e.g., presence o earnings managemen) o he inormaion used. For example, consider an evaluaion o wo companies based on wo equally imporan variables, such as las year’s earnings and managemen’s orecas o his year’s earnings. e wo companies have he same mean across he wo variables, bu one has wo moderae numbers whereas he oher has one high number and one low number. e resuls o his research sugges ha he more inconsisen company would receive a higher, or more opimisic, orecas or recommendaion rom a financial analys. One explanaion in he psychology lieraure or his opimism under uncerainy is he leniency heurisic, whereby people have a endency o give he benefi o he doub when predicing perormance (Kahneman and versky 1973). In oher words, when cues are inconsisen, a decision maker will under-weigh negaive inormaion and over-weigh posiive inormaion, hereby leading o an opimisic judgmen. In accordance wih hese cogniive models, Kahneman and versky find he opimism bias is an increasing uncion o ask uncerainy. Durand, Limkriangkrai, and Fung (2014) find relaed resuls when examining he herding behavior o financial analyss. e auhors examined analyss who lag behind heir analys cohor in orecasing or individual firms (laggards). eir evidence shows ha as he orecasing ask becomes more difficul o analyze, he laggards are more likely o move away rom he consensus orecas (ani-herding). Durand e al. also find ha as he laggards become more confiden (measured as he analys’s orecas requency), hey are also less likely o ani-herd. e auhors conclude ha hese resuls indicae ha laggard analyss have lower mea-cogniive skills.

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CONFIRMATION BIAS

A complemenary heory or opimism under uncerainy suggess ha an individual’s preerences can influence he manner in which a person processes inormaion and orms belies (Kahneman and versky 1979). is preerence is known as confirmaion bias, which suggess ha people over-weigh inormaion ha confirms heir prior belies and under-weigh inormaion ha runs couner o heir prior belies. is preerence applies o boh analyss and invesors. A similar heory is moivaed reasoning, which suggess ha invesors are more likely o arrive a conclusions ha hey preer and ha his preerence encourages using sraegies ha are mos likely o yield he desired resuls (Kunda 1990). ess o hese opimism heories include observing analys orecass and recommendaions. Sudies such as Odean (1998) repor ha invesors over- weigh inormaion ha confirms heir prior belies and under- weigh inormaion ha is conrary o heir prior belies. In his survey o invesor psychology as a deerminan o asse pricing lieraure, Hirshleier (2001, p. 1549) saes, “People end o inerpre ambiguous evidence in a ashion consisen wih heir own belies. ey give careul scruiny o inconsisen acs and explain hem as due o luck or auly daa gahering.” Similarly, Hales (2007, p. 613) saes “when people are presened wih inormaion ha is couner o heir direcional preerences, hey are moivaed o inerpre i skepically.” An experimen conduced by Hales shows ha invesor subjecs auomaically agree wih inormaion ha suggess hey will make money and disagree wih inormaion ha suggess hey will lose money, which is consisen wih confirmaion bias. e heory o confirmaion bias is also consisen wih Eames e al. (2002), who find ha analys orecass are signiicanly opimisic or buy recommendaions and pessimisic or sell recommendaions. o summarize, based on hese heories, analyss are likely o exhibi opimisic bias in heir repors even afer eg FD and he Global Setlemen. Given ha research confirms ha hese behavioral biases are inrinsic o he analyss’ asks o orecasing earnings and issuing recommendaions, opimism should be even more likely in siuaions ha are more ambiguous or uncerain.

Information Uncertainty and Analyst Bias Much o he lieraure conduced beore eg FD finds ha as uncerainy in a firm’s inormaion environmen increases, opimism increases in equiy analyss’ earnings orecass. Das e al. (1998) and Groysberg e al. (2011) boh sugges ha he observed opimism in analyss’ repors is primarily due o he economic incenives o he analyss (i.e., analys compensaion is based o a large exen on rading volume and invesmen banking business). e pos-regulaion research provides some evidence ha his opimism is reduced, because some conflics o ineres have been removed rom he analyss’ environmen. As previously discussed, he effeciveness o regulaion in reducing analys bias depends on he srcin o he bias. o he exen ha analyss’ opimism or high uncerainy firms sems rom cogniive biases in heir decision making, he effecs o regulaion such as hose enaced will no compleely eliminae he opimism in analyss’ repors.

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o isolae he cause o he observed bias in analyss’ repors, Young (2009) used an experimenal seting o remove economic incenives rom he analys’s decision process. e resuls o her experimen show ha an increase in he analys’s perceived uncerainy o he orecasing ask resuls in significanly lower relaive opimism in he analys’s earnings orecass. is finding indicaes ha regulaion o remove conflics o ineres may have he abiliy o reduce opimism in analyss’ orecass. Her evidence also shows ha relaive orecas opimism bias is posiively relaed o he level o he analyss’ recommendaions. is finding is consisen wih behavioral heories ha analyss process inormaion in a manner ha suppors heir goals. egulaion would no resolve his behavior. esearch on analys decision making under uncerainy uses many proxies or inormaion uncerainy, including poor credi qualiy, high accouning accruals, and dispersion in analys orecass. Grinblat, Josova, and Philipov (2016) use poor credi qualiy as a proxy or inormaion uncerainy. e auhors acknowledge ha analys recommendaions and orecass move marke prices; hereore, hey examine wheher hese price movemens are jusified by analyss’ superior inormaion (he efficien marke perspecive) or are unmeried and based on invesors’ blindly ollowing exper opinions (he behavioral perspecive). eir resuls show significanly higher opimism in analyss’ earnings orecass or low-credi-qualiy firms and no significan relaion beween analyss’ orecas bias and sock reurns or higher-credi-qualiy firms, supporing he behavioral perspecive. eir evidence also shows ha firms wih more opimisic consensus in analys orecass subsequenly earn lower risk-adjused reurns, also consisen wih he behavioral perspecive. Bradshaw, ichardson, and Sloan (2001) find ha an over-opimisic analys orecas is greaer or firms wih high accruals. e auhors inerpre his finding as analyss’ no ully incorporaing he predicable earnings reversals o he accruals. Zhang (2006) used dispersion in analyss’ orecass as a proxy or inormaion uncerainy. e auhor finds ha greaer inormaion uncerainy leads o more posiive (or negaive) orecas errors and subsequen orecas revisions ollowing good (or bad) news. ese resuls imply ha inormaion uncerainy appears o delay he absorpion o uncerain inormaion ino he analyss’ orecass. Zhang also discovers ha hese effecs are much sronger ollowing bad news han ollowing good news. In general, analyss underreac o new inormaion and underreac more when inormaion uncerainy is greaer. Addiional sudies examine he moives behind analyss’ overly opimisic repors. A sample o hese moives include invesmen banking relaionships (Chan, Karceski, and Lakonishok 2007; Ljungqvis, Marson, Sarks, Wei, and Yan 2007; Agrawal and Chen 2012), career or repuaion concerns (Hong and Kubik 2003; Erimur, Muslu, and Zhang 2011), beter access o managemen’s privae inormaion (Ke and Yu 2006; Wesphal and Clemen 2008), and oher behavioral reasons (Willis 2001; Hales 2007). In general, hese sudies repor higher levels o opimism when hese moives are presen. In summary, he research finds evidence o opimisic bias in analyss’ repors across many siuaions and ha he level o opimism increases in siuaions o high inormaion uncerainy. e nex secion provides a discussion o he research ha examines wheher cerain analys characerisics, such as experience, can reduce opimism.

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Analyst Characteristics as Moderators of Optimism Cogniive psychology research repors ha increased experience and abiliy can lead o decreased opimism in orecass and esimaes. is research suggess ha perormance eedback and experience wih he ask moderae he endency oward opimism. ereore, analyss wih more ex perience are likely o develop superior privae inormaion abou a company’s economics he longer hey ollow he firm. is is suppored by he findings o Mikhail e al. (1997). Erimur e al. (2007) and Bowen, Chen, and Cheng (2008) who alsobyfind abiliy increases wih experience. Furher, evidence presened Ke ha and analyss’ Yu (2006) shows ha analyss improve heir effeciveness in ranslaing earnings orecass ino recommendaions as heir experience increases. Addiional research idenifies analys-specific acors ha have he poenial o reduce he bias in analyss’ repors. Drake and Myers (2011) examine wheher analys characerisics may reduce he relaion beween opimism in analys orecass and firms wih high accouning accruals. eir evidence shows ha analyss wih more general experience and analyss ollowing ewer firms have lower accrual-relaed overopimism. Sickel (1992) finds ha Insiuional Invesor magazine’s all-sar analyss supply orecass more ofen han oher analyss. More requen orecass can be more advanageous or he generaion o recommendaions because hey can incorporae he laes earnings-relevan inormaion and will be less opimisic. esuls obained by Lim (2001) experienced analyss produce more opimisic orecass in order o buildshow accessha o less managemen. Cao and Kohlbeck (2011) examine wheher analys characerisics are associaed wih analyss’ effeciveness in processing public inormaion and in avoiding opimisic bias. e auhors hypohesize ha high qualiy analyss can more easily atrac new banking business owing o heir high repuaions, and hey are hereore more likely o reflec bad news in heir repors on a imely basis, whereas low qualiy analyss have incenives o remain opimisic o please managemen, even in he ace o bad news. Using a sample o large price changes, he auhors find an asymmeric reacion in he analys response o large posiive and large negaive inormaion shocks. Cao and Kohlbeck also find ha heir proxy or analys qualiy is inversely associaed wih he probabiliy o recommendaion downgrades afer large negaive price shocks, indicaing a reducion in asymmery as analys qualiy improves. ey conclude ha heir findings are consisen wihlowerhe asymmery beingSuch associaed wih a superior general inormaion processing bias among qualiy analyss. a bias affecs analyss less ofen, owing a leas in par o heir effeciveness in ranslaing earnings orecass ino recommendaions. ese findings are consisen wih sudies ha find more exper analyss issue more profiable sock recommendaions han do less exper analyss (Sickel 1995; Mikhail e al. 2004). However, a ew early sudies do no find a difference beween experience levels and bias in analys orecass. For example, Mikhail e al. (1997) repor an increase in accuracy bu no change in orecas bias as experience increased. In summary, he majoriy o he lieraure consisenly finds ha some analys characerisics, such as experience, may help reduce analys bias.

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Analyst Bias and the Impact on Market Reactions e lieraure provides mixed resuls on he effec o analys bias on invesors. Alhough some sudies repor ha analys conflics o ineres do no have a sysemaic impac on invesors (Mehran and Sulz 2007; Agrawal and Chen 2008), oher sudies find ha analyss’ biased repors adversely affec invesors. Several sudies esablish bias in analyss’ repors. For example, evidence presened by Barber, Lehavy, and rueman (2007) shows ha buy recommendaions rom independen firmsbanks’ ouperorm hose invesmen banks by roughlyhose 8 percen. However,research invesmen hold and sellrom recommendaions ouperorm rom independen firms by approximaely 4.5 percen. is finding is consisen wih recommendaions rom invesmen banks being posiively biased, resuling in sell recommendaions conaining more inormaion. Addiional sudies differeniae he effecs o his bias on insiuional and reail invesors. ese sudies end o find ha individuals are less aware o bias han are insiuional invesors and hey are more suscepible o i. For example, Michaely and Womack (1999) presen evidence ha he marke does no ully accoun or analys bias. For insance, socks ha underwrier analyss recommend perorm more poorly han buy recommendaions made by unaffiliaed brokers. e auhors esimae he mean excess reurn or IPOs recommended by underwrier analyss is −18 percen afer wo years, compared wih +45 percen or recommendaions made by unaffiliaed brokers. Furher, Malmendier and Shanhikumar (2007) find ha large raders (a proxy or insiuional invesors) adjus heir rading response downward o analyss’ repors, bu small raders (a proxy or reail invesors) do no, suggesing ha individuals may be unaware o analys bias. e auhors show ha an invesmen sraegy o sricly ollowing analys recommendaions produces negaive abnormal reurns or a buy-and-hold sraegy, which may harm small invesors. Baker and Dumon (2014) also analyzed he perormance o buy-and-hold raings and surveyed reail invesors abou heir reliance on analys recommendaions. Alhough he auhors find ha buy raings o firm equiy significanly underperorm hold raings, reail invesors repor ha hey rely on hese recommendaions when making invesmen decisions. Mikhail, Walher, and Willis (2007), who use rade size o disinguish beween large (sophisicaed) and smallconained (unsophisicaed) invesors, find ha large invesors more o he inormaion in recommendaion revisions, whereas small respond invesors respond more o he occurrence o a recommendaion and rade more in response o upgrades and buys. As a resul, he auhors find ha in he five days afer recommendaion revisions, large raders earn an average raw reurn o 5.1 percen, whereas small raders earn −1.8 percen. De Franco, Lu, and Vasvari (2007) examine 50 evens in which analyss issued misleading repors. According o he auhors, small invesors are differenially affeced. Small raders los $2.2 billion wo-and-a-hal imes as much as large raders. Cheng, Liu, and Qian (2006) presen evidence suggesing ha insiuional invesors are more likely o rely on buy-side analyss han on poenially confliced sell-side

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analyss. In summary, subsanial evidence indicaes ha analys bias may harm small and unsophisicaed invesors.

De-Biasing the Bias Can financial analyss improve heir judgmen and decision making by reducing he bias in heir repors? Analyss should be moivaed o reduce heir opimisic bias i his bias reduces heir repuaion and hereore reduces heir compensaion. However, hey would no be moivaed i he opimisic bias helps wih managemen relaions and hereore increases heir compensaion. esearch shows ha analyss have incenives o build and mainain a repuaion or objeciviy hroughou heir career (Ljungqvis, Marson, and Wilhelm 2006; Hugon and Muslu 2010). esearch also provides evidence ha analyss who have been idenified as superior perormers are more likely o experience avorable career oucomes, such as moving up o a high-saus brokerage house (Hong, Kubik, and Solomon 2000; Hong and Kubik 2003). I a reducion in opimism ies ino a higher repuaion, cogniive psychology suggess several remedies. According o cogniive psychology research, repeiion, eedback, and experience end o miigae judgmenal biases (Einhorn and Hogarh 1978; Kagel and Levin 1986; ose and Windschil 2008). For example, Kagel and Levin find ha subjecs who overbid in early rounds o an aucion become less opimisic in heir bids as hey gain experience. Oucomes ha indicae a large discrepancy beween orecased and acual perormance are expeced o moivae he decision maker o increase effor, adjus perormance expecaions, or boh. Ericsson, Krampe, and esch-omer (1993) and adhakrishnan, Arrow, and Sniezak (1996) confirm ha hese correcions should improve he accuracy and reduce he opimism o uure evaluaions. ereore, inroducing new inormaion or knowledge, which is used in uure judgmens and decisions, reduces opimism (Shepperd, Oullete, and Fernandez 1996). is reducion in opimism would occur or analyss as hey receive eedback ha is accurae and imely (i.e., acual quarerly and annual repored EPS), adjus heir perormance, and learn rom general experience wih he ask. Analys sudies find ha several differen variables can miigae opimism, including repuaion concerns (Fang and Yasuda 2009; Bradley, Clarke, and Cooney 2012), compeiion (Hong and Kacperczyk 2010; Sete 2011), he presence o independen analyss (Gu and Xue 2008), or he presence o insiuional invesor-owners (Ljungqvis e al. 2007; Gu, Li, and Yang 2013). Abiliy may also be a miigaing acor. Evidence by Cao and Kohlbeck (2011) shows ha analyss o paricularly high skill and repuaion are less likely o issue overly opimisic recommendaions or o overreac o news. In general, analyss can reduce heir opimisic bias, and hey do so in many siuaions.

Summary and Conclusions e bias in financial analyss’ repors has been a concern o invesors and regulaors or several decades. Some have alleged ha analyss’ repors lack independence and

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objeciviy, due o he conflics o ineres beween he equiy analys uncion in he brokerage house and he banking side. Invesors have complained ha managers o publicly raded firms are providing selec maerial inormaion o a chosen group o analyss, who in urn, disclose his o heir preerred cliens. e resuls o his behavior harmed invesors by excluding hem rom hese inner circles. o address hese conflics, several pieces o regulaion were pu ino place in he early 2000s. e objec o hese regulaions was o eliminae his selecive disclosure o inormaion and hereby level he playing field across invesor caegories. Alhough he marke environmen changed wih eg FD and he addiional regulaions, several sudies find ha a relaion w ih managemen sill appears o be imporan or oday’s analyss. Evidence shows ha he bias in analyss’ repors, despie being somewha reduced, sill remains. Furher, his bias may hur small or unsophisicaed invesors. In ligh o hese findings, regulaors should consider he sources o analys bias when evaluaing wha regulaions would help o eliminae his bias and achieve regulaory goals. Invesors should also consider boh he source o analys bias and he analys characerisics, which may help hem o selec less opimisic analyss’ repors.

DISCUSSION QUESTIONS 1. 2. 3. 4.

Discuss wheher regulaion solves he problem o bias in analyss’ repors. Ideniy wo incenives or environmenal acors ha increase analys bias. Ideniy analys characerisics ha reduce analys bias. Discuss w heher he marke recognizes and adjus s or he bias in analyss ’ repors.

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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 ANDREW C. SPIELER Professor of Finance Frank G. Zarb School of Business, Hofstra University JOSEPH M. TENAGLIA Emerging Markets Portfolio Specialist Emerging Global Advisors

Introduction Porolio managers are proessional invesors who oversee and conrol discreionary pools o capial known as unds, which are available or invesmen o a larger base o invesors. Porolio managers ofen employ a eam o analyss and junior porolio managers who repor o hem. e analyss help provide ideas o managers and perorm research on possible invesmens or he und. Ulimaely, however, he final decisionmaking power ypically lies solely wih porolio managers. A single und could poenially have millions o invesors, wih each o hem couning on he porolio manager o achieve a specific goal, such as income or growh. Wih so many sakeholders involved, he porolio manager needs o develop and adhere o a plan when managing he und. e porolio managemen process may vary depending o he ype o und, bu generally ollows he same basic seps: (1) seting he invesmen objecive, (2) developing and implemening he porolio sraegy, and (3) monioring and adjusing he porolio (Maginn, utle, McLeavey, and Pino 2007). In he firs sep, he porolio manager selecs a benchmark o which he compares he und, boh in composiion and in perormance. I he manager seeks a argeed level o ouperormance relaive o ha benchmark, ha goal is se during his sep. Any consrains o which he und mus comply are also esablished here. e consrains can range rom resricions on he und’s risk, such as ha no allocaion can exceed 5 percen o he und, o is composiion, such as ha only inves in companies wih minoriy chie execuive officers (CEOs). In he second sep, he porolio manager deails a plan as o how he manages he und o achieve he pre-esablished goals. For example, his could be a “op-down” invesmen allocaion, in which he manager idenifies macro rends and broadly allocaes he und among asse classes. is approach conrass wih a “botom up” securiy selecion, in 135

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which he research and picking o individual securiies drive he invesmen process. A his sage, he manager selecs and invess in securiies o creae he desired porolio. Lasly, he manager consanly moniors he und and makes necessary adjusmens. For example, i one o he securiies in he porolio has increased in value o he poin where he manager believes i no longer has sufficien upside poenial, he manager may elec o sell and replace he securiy. is sage o he porolio managemen process is coninuous. a is, he porolio manager mus coninuously monior many acors and analyze he impac on every securiy in he und. e magniude o his dauning ask and he susained success o so ew in being able o do i well help explain why porolio managers can someimes be reerred o as he “rock sars o he financial world” (Myers 2008). is chaper explores he behavioral endencies o porolio managers a asse managemen firms, as well as hose responsible or insiuional porolios. Asse managemen is a service in which an invesmen managemen company uses capial provided rom invesors o implemen an invesmen sraegy, and offers a produc in which he invesors own a paricipaion sake (Concannon 2015). Ofen reerred o as he buy side, asse managers purchase securiies on behal o heir cliens in order o assemble an invesable porolio. e flip side is he sell side, in which firms perorm research on securiies in order o sell heir work o asse managers or use i o generae business or heir brokerage arm (Maginn e al. 2007). e porolio manager o he und ha is creaed by he asse manager hen aps ino he global capial markes and allocaes he invesors’ capial ino securiies ha he manager finds atracive. Asse managers caer o wo invesor ypes: individuals and insiuions. Individual invesors are ofen reerred o as reail invesors, and hey include privae amilies or individuals who are looking o reach heir reiremen and financial goals. Insiuional invesors can represen eniies such as he ongoing suppor und o a universiy or he pool o all reiremen unds o a governmen’s employees. Boh individual and insiuional invesors provide he asse manager wih capial, and in urn, he porolio managers a hese firms seek o generae a reurn on he capial. For his service, asse managers receive a ee or heir effors, wih he implicaion ha he porolio manager is creaing value ha he invesor oherwise canno creae. Wihin asse managemen, firms generally all ino one o wo caegories: radiional and alernaive. Differeniaing beween he wo ypes is imporan because he srucure o each firm plays a large role in he financial behavior o he respecive porolio manager. radiional asse managemen firms offer invesmen producs and earn ees based on a percenage o he oal asses under managemen (AUM). ese firms offer producs such as muual unds or exchange-raded unds (EFs), which ypically ake longonly posiions in convenional securiies such as socks and bonds. A longime saple o reiremen plans and brokerage accouns, muual unds oaled more han $15.8 rillion in asses a he end o 2014 (Invesmen Company Insiue 2015). e appeal o muual unds is ha hey provide exposure o financial markes via a diversified porolio, where he decision o buy and sell securiies is delegaed o a proessional money manager. Addiionally, he pooling o invesors’ capial in muual unds enables he und o achieve economies o scale, helping reduce is oal coss, as opposed o owning each o he individual underlying securiies ourigh (Baker, Filbeck, and Kiymaz 2015). ese producs are regulaed under he Invesmen Company Ac o 1940 and are required o regiser wih he Securiies and Exchange Commission (SEC). e purpose o he regisraion is o minimize conflics o ineres and o disclose inormaion abou he

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und and is objecives o he invesing public. e ac requires he und o provide is financial condiion and invesmen policies o is invesors on a regular basis (Securiies and Exchange Commission 2016a). As a resul o he SEC regulaion, porolio managers o muual unds are relaively resriced in he ypes o securiies in which hey can inves, he size and naure o heir posiions, and how hey adverise o he public. Wih scruiny rom regulaors, coupled wih he overall simpliciy o mos sraegies, radiional asse managemen firms ypically are more ailored o he demands o he reail invesor audience. Alernaive asse managers, similar o radiional asse managers, also earn ees based on a percenage o heir AUM. Many o hese unds include hedge unds and privae equiy unds. One imporan disincion, however, is ha alernaive managers also receive a porion o he profis (i.e., incenive) o he sraegies hey manage (Concannon 2015). Alhough incenive ees have been compressed in recen years, hedge unds have hisorically charged an annual managemen ee o 2 percen o he und’s asses managed, as well as 20 percen o he und’s profis over is high waer mark (HWM), which is a coninuous running ally o he und’s maximum AUM level. e ees levied by hedge unds are subsanially higher han hose charged by mos muual unds, which had an average expense raio o 0.70 percen in 2014 (Invesmen Company Insiue 2015). Perormance incenives provide porolio managers a alernaive firms wih addiional moivaion o generae reurns and ouperorm heir benchmarks; he beter he porolios perorm, he more money he porolio managers make. Besides ees, he porolios managed by alernaive firms sharply differ rom hose by heir radiional counerpars in oher ways. Firs, hedge unds are subjec o considerably less regulaion han muual unds. Hedge unds are no required o regiser wih he SEC, so he financial condiion and invesmen policies ollowed are less ransparen o invesors han hose o muual unds. Nex, perhaps relaed o he lack o regulaion, he invesmen sraegies o alernaive unds end o be more complex in naure han radiional unds. Alhough many differen subsyles o hedge unds are available, mos have he abiliy o inves in publicly and privaely raded securiies in all global financial markes, such as derivaives, as well as engaging in he shor-selling o securiies.Shor-selling is he sale o a securiy ha is no owned by he seller, or ha he seller has borrowed. Shor-selling is moivaed by he belie ha a securiy’s price will decline, enabling he seller o buy i back a a lower price o make a profi. Some hedge unds ake a small number o sizable posiions in heir porolios, which can pay off when he gambles aken by he porolio manager succeed. Lasly, o ensure ha he only invesors in alernaive unds such as hedge unds can bear he economic risk o invesing in unregisered producs, cerain unds are only available o “accredied invesors.” e SEC definesaccredied invesorsas cerain ypes o firms and heir direcors (e.g., banks, savings and loan associaions, invesmen advisers, and insurance companies) and individuals whose ne worh (or combined wih heir spouse) exceeds $1 million (Securiies and Exchange Commission 2016b). Whereas individuals can inves in some muual unds or as litle as $100, hedge unds invesors are required o reach a minimum level o annual income or ne worh in order o inves, limiing heir availabiliy o sophisicaed and wealhy invesors. For purposes o his chaper, however, he major difference beween radiional and alernaive firms relaes o he perormance ee a alernaive firms, as i drives much o he financial behavior o is porolio managers.

138

THE FINANCIAL

BEHAVI OR OF MAJOR PLAYERS

Ouside o asse managemen firms, porolio managers may also direcly oversee pools o money or insiuional eniies, such as pensions. A pension und is a pool o money managed on behal o he employees o a corporaion or governmen ha provides employees wih paymens upon heir reiremen. Also known as defined benefi (DB) plans, pension unds promise o pay a specific dollar amoun o each beneficiary on an ongoing basis afer hey reire.Defined conribuion (DC) plans are also available whereby he beneficiary makes he invesmen decisions and hence bears he risk. is chaper primarily ocuses on DB plans. Employees in civil service posiions, such as firefighers, policemen, and eachers, rely primarily on heir pensions as heir source o reiremen unding. e pension paymen o he beneficiary depends on an acuarial ormula ha includes inpus such as he number o years he beneficiary worked a he employer and salary in he final year o employmen. In anicipaion o he uure paymens ha he und mus disribue, he employer makes regular conribuions o he pension und. e employer needs hese conribuions o sufficienly grow o saisy he und’s uure obligaions, which is why he pension und manager is paramoun in he process. Using assumpions and uure projecions o he ormula’s inpus, he pension und manager esablishes a arge rae o reurn ha i mus achieve. e porolio manager has wo goals: o grow he conribuions so ha all obligaions o curren and uure beneficiaries are saisfied, and o mainain enough liquidiy o make paymens o curren beneficiaries. Alhough he mandaory growh o he conribuions allows he und’s porolio manager o have a long- erm invesmen horizon, he annual disribuion requiremen orces he manager o balance he porolio wih a shor-erm mindse. Many public and privae pension plans have operaed or decades, and beneficially inves billions and someimes rillions o dollars under managemen. As supervisors o he reiremen unds o poenially housands o individuals, pension und porolio managers may find hemselves as some o he mos influenial invesors in he world. Anoher ype o insiuional eniy ha relies on a porolio manager o oversee is invesmens is an endowmen. An endowmen is a gif o money or income-producing propery o a public organizaion such as a hospial or universiy or a specific purpose, such as research or scholarships. e endowed asse is usually kep inac and only he income generaed by i is consumed. Endowmens represen he permanen unds o an organizaion and are responsible or providing money o suppor he operaions o he insiuion in perpeuiy (Swensen 1994). Similar o a pension und manager, he endowmen manager’s goals are woold: preserve he purchasing power o he asses in he endowmen over ime, and provide resources o he insiuion o help und operaions in he presen. Because heir exisence is assumed perpeual, he srucure o an endowmen allows he porolio manager o inves in riskier and less liquid securiies wih higher reurn profiles, mindul ha he endowmen can recoup mos large capial losses over ime. e manager mus also balance he risk- aking porion o he porolio w ih enough shor- erm liquidiy o make paymens o suppor he insiuion. e impac o he perormance o he porolio manager has ramificaions beyond he financial universe. For example, i he endowmen und o a hospial canno make he ull paymens i requires, and he hospial’s operaions are no ully unded as a resul, he consequences could be caasrophic. us, he invesmen manager in charge o an endowmen porolio plays an incredibly pivoal role in he organizaion’s viabiliy.

139

Portfolio Managers

139

Behavioral Biases in Portfolio Management Conrasing he ypes o porolios in he previous secion is necessary because each conains paricular nuances ha ac as caalyss or he financial behavior o he porolio managers. Paricular behavioral biases are inheren in nearly all porolio managers o some degree, bu he naure o he und being managed can also provide a clear delineaion in behavior. Many acors can drive he behavior o a porolio manager ouside hose ypically hough o drive he assumed raional invesmen decision-making process. OVERCONFIDENCE

Overconfidence bias is an unwarraned aih in one’s inuiive reasoning, judgmens, and cogniive abiliies. In shor, overconfidence bias deduces ha invesors hink hey are smarer han hey ruly are and have beter inormaion han hey acually do (Pompian 2006). Psychologically, people in general end o overesimae heir own abiliies. Specific o porolio managers, overconfidence can impac decision making because porolio managers are proessional invesors who are in heir respecive posiions because o heir perceived skills in managing money. In ac, proessionals who are overconfiden in heir own skills are hardly limied o he field o porolio managemen. Psychologiss, docors, engineers, enrepreneurs, lawyers, and oher proessionals have allFor consisenly displayed in heir judgmens andbeabiliies (Odean 1998). any populaion, by overconfidence definiion, hal he consiuens mus below average. No surprising, proessionals are more likely o consider hemselves o be above average a heir job han below average. Ironically, he adep abiliies ha helped proessional porolio managers earn heir posiions could also be he sources o he bias or which hey are much more suscepible han he average invesor. Invesing has wo main ypes o overconfidence: predicion overconfidence and cerainy overconfidence. Predicion overconfidence occurs when an invesor assigns oo narrow a confidence inerval o his invesmen orecass. a is, an invesor believes ha his predicion o he uure value o a securiy mus lie wihin a igh band because he is confiden in he accuracy o his predicion. is phenomenon leads invesors o be surprised when oucomes vary grealy rom predicions. As a resul, hey ofen underesimae he downside risk s. As relaed o porolio mana gers, predicion overconfidence causea securiy’s hem o build poroliosoha are unprepared or large losses. I a managermay expecs perormance all wihin a narrow band and he acual perormance o he securiy alls shor o he manager’s prediced wors-case scenario, he porolio may be subsanially more risky han he manager anicipaed. Cerainy overconfidenceoccurs when invesors assign oo high a probabiliy o heir predicion and have oo much confidence in he accuracy o heir own judgmens. e effecs o cerainy overconfidence can appear in several orms during he porolio managemen process. Odean (1998, p. 1888) conends ha increased rading aciviy is he “mos robus effec o overconfidence.” Invesors who are overconfiden in he precision o heir orecased values o securiies are likely o rade more ofen. Believing hey have beter inormaion han oher invesors, overconfiden invesors place a greaer weigh

140

THE FINANCIAL

BEHAVI OR OF MAJOR PLAYERS

on heir own opinion and hink ha hey can bea he marke by increasing he number o rades ha hey place. Increased rading aciviy drives up ransacion coss, creaes he opporuniy or axable evens, and can reduce he oal reurn o a porolio. Odean ocuses on individual invesors, bu sudies show ha he phenomenon o overconfidence leading o increased rading aciviy and poor perormance also holds rue or proessional porolio managers. For example, Chuang and Susmel (2011) repor ha insiuional raders in aiwan exhibi overconfidence, albei less han individual raders. In he conex o muual unds, Carhar (1997, p. 67), who finds ha a porolio’s urnover is significanly negaively correlaed o is perormance, saes ha “he urnover esimae implies ransacions coss o 95 basis poins per round-rip ransacion.” Furher, Bogle (2006) repors ha muual unds in he op quarile o heir universe in porolio urnover beween 1996 and 2006 underperormed he unds in he botom quarile o urnover by 1.7 percenage poins on an annual basis. Addiionally, he unds in he op quarile o urnover are 27.1 percen more volaile han he botom quarile unds. ese findings are consisen wih he noion ha he porolio managers who are mos confiden in heir abiliies o bea he marke are among he wors a doing so on boh an absolue and a risk-adjused basis. Anoher consequence o overconfidence bias by porolio managers in he porolio consrucion process is concenraion. I porolio managers are very confiden in assessing a securiy’s orecased value, hey may allocae a greaer weigh o ha securiy wihin a porolio. Fund managers who are willing o make large bes on a small number o securiies increase he risk o under-diversiying he porolio. Concenraed posiions in only a ew securiies reduce he diversificaion benefis inheren in he srucure o a porolio and can increase he und’s overall volailiy. I he reason behind a porolio’s concenraion is he porolio manager’s overconfidence, he manager may be associaed wih poorer risk-adjused perormance (Baks, Busse, and Green 2006). However, evidence suggess ha porolios wih a degree o concenraion end o ouperorm heir benchmarks on boh an absolue and a risk-adjused basis (Yeung, Pellizzari, Bird, and Abidin 2012). Sudies also sugges ha managers who manage concenraed porolios display some skill in correcly picking socks (Baks e al. 2006). Alhough mos muual und managers ail o ouperorm heir respecive benchmarks over he long erm (Soe 2015), he confiden ones managing concenraed porolios may sand he bes chance o ouperormance.

HERDING BEH

AVIOR

Herding reers o disregarding one’s opinion or analysis in order o ollow he crowd. Individuals may be unwilling o ake a sance agains a popular opinion or ear o being incorrec and acing repuaional harm as a resul (or worse). As Keynes (1936, p. 158) noes, “Worldly wisdom eaches ha i is beter or repuaion o ail convenionally han o succeed unconvenionally.” Herd behavior is a behavioral phenomenon presen in a many social siuaions, bu is paricularly prevalen in financial markes. Sudies repor ha invesors ypically do no fire he porolio managers o unds who are merely mediocre relaive o heir peers. aher, a manager mus significanly underperorm boh his benchmark and his peers beore he und experiences subsanial ouflows (Sirri and uano 1998). is phenomenon may be a major derivaion o herding

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behavior because i provides he porolio manager wih a srong incenive o ollow he herd or be lef behind and ace he consequences. A key repercussion o herding behavior by porolio managers is he creaion o financial bubbles and crashes. When a new financial innovaion or “disrupion” occurs in an indusry, such as he rise o Inerne companies or he adven o securiizaion, invesors ry o profi rom i. Ofen, he poenial growh o hese asses may no ye be ully undersood by invesors, and hus canno be accuraely measured, providing seemingly unlimied growh poenial. Iniially, he gains in he prices o hese asses can be gradual and he valuaions hey achieve may be jusified. As prices coninue o rise when more invesors atemp o capialize on is momenum, porolio managers may observe heir peers invesing in hese asses and be incenivized o inves in hem as well. ecall ha porolio managers wih average perormance do no end o see redempions rom invesors. However, as invesors coninue o chase rends by purchasing an invesmen, he asse’s marke value can wildly exceed is undamenal value and is lofy valuaions can no longer be suppored. A his poin a bubble has ormed. Invesors ofen ail o realize ha a bubble exiss unil i is oo lae (Brunnermeier and Oehmke 2013). Some ype o even evenually riggers he bursing o he bubble. Whaever he caalys may be, invesors realize ha he asse is overvalued and decide o sell heir sake in i, driving down is price. Seeing he decline in price, porolio managers wan o salvage he maximum value possible or heir ownership and sell he asse as soon as hey can, exacerbaing he all. A crash is now under way. Few invesors may be willing o buy he asse, and he lack o demand urher reduces is marke value. Frequenly, a spillover effec ino oher relaed and even unrelaed asses can occur. is conagion effec may affec a large porion o he overall markeplace. egardless, porolio managers who are lef holding he asse a he end o a crash are likely o suffer severe losses and creae unhappy invesors as a resul. Porolio managers ace a conundrum peraining o herd behavior. I hey do no ollow he herd, hey risk railing behind heir peers. However, i hey ollow he herd, hey may ge caugh on he wrong side o an arificially atracive rade opporuniy. Consider he case o wo hedge und managers during he echnology bubble o he lae 1990s. One manager reused o inves in echnology socks during heir rise, believing hem o be overvalued. Despie a successul rack record or almos wo decades beorehand, he manager had o dissolve he und in 2000 because i did no keep up wih he high reurns rom echnology companies and he compeing unds ha invesed in hem. Conversely, a differen hedge und manager heavily invesed in echnology socks during heir boom. As he do-com bubble popped and echnology socks ell precipiously, he und aced massive losses. Even hough he porolio manager had srong perormance or 12 years beore he crash, he resigned rom he und in 2000 (Pompian, McLean, and Byrne 2011). Porolio managers mus careully weigh heir opions when acing a herd-driven environmen. Aside rom he compeiive pressures, herd behavior can also arise rom emulaion. Many social and financial siuaions may enable and encourage a person o “ollow he leader” when presened wih an opporuniy o do so. In he porolio managemen universe, i a porolio manager sees ha one o his peers is perorming excepionally well, he may be incenivized o copy wha he successul manager is doing. In his ashion, eiher he “copyca” und perorms in line wih he bes unds in he universe, or

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i is no alone should is perormance alers. Indeed, several sudies show ha copyca behavior is pervasive among muual und managers (Phillips, Pukhuanhong, and au 2014; Lesmond and Sein 2015). Ineresingly, he op-perorming muual unds mos requenly mimicked ypically end up underperorming in subsequen periods. Addiionally, porolio managers who run copyca unds also lag he average muual und. Alhough ollowing he leader has no benefied muual und porolio managers, managers o endowmens are currenly experiencing a wave o successul imiaions, albei in a much differen ashion. aher han mimicking sock picks rom he op managers, endowmen managers are elecing o hire away he personnel rom he op unds. David Swensen, Chie Invesmen Officer o he Yale Universiy endowmen, was among he firs endowmen managers o embrace alernaive unds and sray ouside o he securiies ypically associaed wih radiional asse allocaion, such as equiies and fixed income. In wha became known as he “Yale Model,” Swensen used he srucure o an endowmen und o his advanage by invesing in less liquid and insrumens wih lower correlaions, such as privae equiy, real esae, and imberland. e und was he op-perorming endowmen o all colleges and universiies rom 2004 o 2014 (Yale 2014). Given such successul resuls, oher colleges and universiies hired many o he analyss who worked under Swensen o manage heir endowmens. In 2015, Yale’s endowmen, along wih each o he endowmens managed by five o Swensen’s ormer proégés, ouperormed he average universiy endowmen benchmark by a leas 3.0 percenage poins (McDonald and Lorin 2015). Perhaps muual und managers would be more successul i hey were o hire heir peers raher han ry o copy hem. Herd behavior varies by he ype o und managed. In paricular, he previous example o herd behavior by hedge und managers during he echnology bubble had negaive consequences. Wermers (1999) finds ha among muual unds, hose managing growh-ocused sock muual unds are mos likely o engage in herding, paricularly in smaller socks. In ac, Wermers concludes ha muual und porolio managers who herd have a beter chance o being profiable han hose who do no. Conversely, managers o pension unds do no display herding behavior in socks (Lakonishok, Shleier, and Vishny 1992). is lack o herding is perhaps atribued o he srucure o he pension und. Because pension unds have a longer-erm invesmen horizon, managers have more leeway in ha hey are unlikely o ace a backlash or ouflows rom invesors i heir unds underperorm over a shor ime rame. As endowmens only have a singular invesor, hey also do no ace he shor-erm pressures ha normally drive herd behavior. Neverheless, porolio managers o all ypes consanly ace an evolving marke wih opporuniies o seize new rends. How exacly hey manage heir porolios when a herd opporuniy presens isel can dicae a porion o heir overall success. RISK- TAKING BEHAVIOR

e concep o moral hazard is one o requen debae, paricularly in he years ollowing he financial crisis o 2007–2008. Moral hazard sems rom he principal–agen conflic and is a siuaion in which one pary (he agen) is responsible or he ineress o anoher pary (he principal). e ineress o boh paries are unlikely o be compleely aligned, and he agen may be incenivized o place his own ineress beore hose o he

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principal. I he agen knows ha he majoriy o he oal coss lie wih he principal, he agen may be incenivized o ake excessive risks while perorming he ask a hand. Because he agen has limied personal downside risks, his siuaion creaes a convex payoff srucure or he agen and encourages risky behavior. In he end, eiher he agen succeeds and is compensaed or ha accomplishmen, or he agen ails, wih he principal disproporionaely bearing he consequences. is siuaion is summarized wih he euphemisic coin flip: “Heads, I win; ails, you lose” (Dowd 2009). Much recen discussion abou moral hazard is based on he acions o financial insiuions leading up o he financial crisis o 2007–2008. e quesion a hand is wheher op bank execuives knowingly ook excessive risks wih heir capial and lending requiremens. a is, because lenders believed ha i heir loans were o go bad and heir asses los value, he Federal eserve, and ulimaely American axpayers, would bail ou heir banks. Alhough his belie presens a common explanaion, predaory borrowers who secured loans hey were unable or unsure hey could repay also share he blame. Ye, moral hazard clearly exends beyond banking o porolio managers. As previously discussed, radiional asse managemen firms earn ees based on a percenage o AUM. As a resul, hese radiional firms have an incenive o maximize he oal amoun o asses managed. Porolio managers can increase he size o heir porolio eiher by invesing he und’s asses in securiies ha grow or by earning addiional inflows rom invesors ino he und. As discussed shorly, porolio managers who are adep a he ormer ypically benefi rom he later. However, he saed objecive o a muual und may no necessarily be o seek maximum growh. For example, consider a shor-erm governmen bond und whose goal is o oupace inflaion. e und’s porolio manager would likely be violaing he mandae by invesing in he socks o small-cap companies, even i he socks generae higher oal reurns han he shor-erm bonds. Even hough porolio managers wan he highes possible posiive reurn, risk is a crucial componen. Consumers generally inves in a muual und because hey rus he porolio manager’s judgmen in maximizing he und’s risk-adjused reurns, no jus he oal reurns (Chevalier and Ellison 1995). is incongruen objecive beween he porolio manager and invesor creaes a siuaion in which he porolio manager may be incenivized o increase he und’s risk profile beyond is ypical sandards. Ineresingly, siuaions may also arise in which porolio managers are incenivized o reduce he risk levels o heir unds. Chevalier and Ellison (1995) examine he relaion beween muual und perormance and flows by analyzing he behavioral endencies o muual und invesors. e auhors find ha a muual und’s year-end perormance heavily influences invesors, owing o he availabiliy o year-end inormaion and oher acors. A srong relaion exiss beween a und’s excess reurn agains is benchmark in a given year and he und’s flows in he ollowing year. O he unds ha ouperorm heir benchmarks, a sharp increase ends o occur in inflows or hose unds ha have an excess reurn greaer han 15 percen. Alhough unds ha slighly rail heir benchmarks do no see disasrous ouflows, evidence o an acceleraion o ouflows occurs rom he unds ha rail by more han 15 percen. is finding is consisen wih he conclusions rom Sirri and uano (1998). Assume a porolio manager is conscious o how his und compares o is benchmark during a given year, and he is aware ha flows in he ollowing year are relaed o perormance. As he year-end approaches, will he und’s perormance relaive o is

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benchmark affec he way he manager adjuss he porolio beore year-end? According o Chevalier and Ellison (1995), porolio managers o muual unds adjus he riskiness o heir porolios rom Ocober hrough December, depending on heir relaive posiions a he end o Sepember. Managers who subsanially ouperorm heir benchmarks or he year-o-dae period hrough Sepember end o de-risk heir porolios a year-end. is deensive measure will rack he index and “lock in” he und’s excess reurn, which would enable he manager o reap he benefis o srong inflows in he nex year. Conversely, managers whose porolios lag heir benchmarks by a sizable margin hrough Sepember end o increase heir porolio’s sysemaic risk, hoping o close he gap below is benchmark beore he end o he year and avoid poenial ouflows in he upcoming year. As a resul, he end o he year in he muual und indusry ends o have a divide beween porolio managers who avoid risk and hose who acively seek i. According o Baker (1998), he choice o benchmark is no he only acor ha maters in deermining a und manager’s atiudes o risk. A series o inerviews wih und managers shows ha managers also sae ha he iming o perormance evaluaion affecs und managers’ atiudes oward risk and ha quarerly perormance evaluaions lead o a shor-erm atiude and approach o und managemen. Given heir resricions relaive o alernaive asse managemen firms, he ac ha porolio managers a radiional asse managemen firms engage in risk-seeking behavior o raise heir AUM, and subsequenly heir ees, or o atrac inflows rom invesors may surprise some. However, due o he ee srucure a alernaive asse managemen firms such as hedge unds, he possibiliy o he porolio manager’s aking excessive risks should be more obvious. ecall ha he ee srucure a alernaive firms is wopronged: a managemen ee on a und’s AUM and a perormance ee or profis above he und’s HWM. Similar o muual und porolio managers, hedge und managers have an inheren incenive o maximize he amoun o asses managed. e way in which hey atemp o accomplish his goal differs. Hedge und managers are generally no consrained by a mandae in he ypes o securiies in which hey can inves and how hey inves in hem. ereore, he previous example o a porolio manager adjusing a und’s risk profile by adding small-cap socks o a shor-erm governmen bond und may no be inerpreed as irregular. Also, hedge unds may conain a “lockup” provision ha resrics invesors rom wihdrawing heir capial or a specific period o ime. As a resul, he average invesor’s holding period o hedge unds ends o be much longer han ha o he average muual und. is relaion implies ha he flow-seeking behavior displayed by muual und porolio managers a year-end is less prevalen in hedge unds. A srong relaion sill exiss beween pas perormance and flows, bu he flows are more highly correlaed wih perormance persisence over several years raher han he perormance in he mos recen calendar year (Agarwal, Daniel, and Naik 2004). Prior perormance also affecs he choice o risk level. For example, und managers who recenly compleed a successul year or heir porolio end o ake on more risk in he ollowing calendar year. o be specific, hey increase volailiy, bea, and racking error, and hey assign a higher proporion o heir porolio o value socks, small firms, and momenum socks. Poor-perorming und managers swich o passive sraegies (Ammann and Verhoen 2007). However, evidence also suggess ha declining perormance does no necessarily lead he und manager o raise he volailiy o he und’s reurn (Chen and Pennacchi 2009). e researchers repor a endency or muual unds

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o increase he sandard deviaion o racking errors, bu no he sandard deviaion o reurns, as heir perormance declines. ey also find ha his risk-shifing behavior is more common or managers wih longer enure. Ulimaely, he managemen ee aligns he ineress o he manager and he invesors, as he manager is a de aco equiy invesor in he und (Lan, Wang, and Yang 2011). Insead, he mos imporan cause o risk-aking behavior by a hedge und manager comes rom he perormance ee. On is ace, a perormance ee wih a HWM provision appeals o boh he hedge und manager and he invesors. Invesors find comor in he ac ha unless heir invesmen makes a profi, he manager will no receive a bonus (i.e., a perormance ee), and mus ully recover previous losses beore being eligible o receive he bonus (Goezmann, Ingersoll, and oss 1997). For he manager, he atracion is simple: perorm well and be compensaed handsomely. However, he AUM and perormance combined ee srucure essenially acs as a series o call opions or he porolio manager, wih a floor on he downside risk (i.e., he managemen ee), wih unlimied upside poenial (Lan e al. 2011). is asymmerical payoff eaure clearly encourages he hedge und manager o increase porolio risk. Consider a hedge und ha has recorded several consecuive years o negaive reurns. As he und alls urher away rom is HWM, receiving a bonus or perormance becomes less likely or he manager. In his siuaion, litle downside exiss or he manager o engage in risk-seeking behavior. I he und’s added risk pays off and he manager succeeds, he may regain he opporuniy o earn a hefy perormance bonus. I he manager ails, he sill receives an AUM ee. In he wors-case scenario, i he und’s added risk causes i o all urher, and he manager compleely loses hope o reaching he HWM, he can elec o simply close he und and sar a new und wih a more realisic and atainable HWM. In baseball erms, railing he HWM gives he manager a chance o swing or he ences: he manager eiher his a home run or goes down swinging. ereore, he presence o a perormance ee creaes an incenive or an alernaive invesmen porolio manager o increase a porolio’s riskiness paricularly when he und is below is HWM. A similar quesion o wheher porolio managers exhibi specific risk-aking behavior is how porolio managers perceive risk. Wheher his percepion o risk differs rom heoreical models o risk and reurn and/or oher invesors is unclear. A subsanial lieraure invesigaes his issue. In he 1970s, McDonald and Sehle (1975) analyze responses rom financial analyss and porolio managers abou heir risk percepions. Despie anecdoal evidence suggesing he conrary, he sudy finds ha hisorical risk measures, such as hisorical bea and non-marke risk, are highly correlaed o he perceived risk as described by insiuional invesors. In a differen survey o porolio managers, Gooding (1978) repors ha risk expecaions based on company risk, bea, and sandard deviaion o reurns are all imporan componens o analyss’ risk analysis. In a more recen survey o sophisicaed invesors including porolio managers, Olsen (1997) repors ha he principal risk atribues appear o be he poenial or a belowarge reurn, he poenial or a large loss, he invesor’s eeling o conrol, and he level o knowledge abou an invesmen. In a relaed survey, Olsen and roughon (2000) documen ha finance proessionals are ambiguiy averse. is aversion is imporan because radiional asse pricing models, such as he capial asse pricing model (CAPM) do no incorporae his ype o

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ambiguiy. is ailure o incorporae ambiguiy aversion may accoun or he relaively large discouns in iniial public offers (IPOs) and he observaion ha required reurns on large, non-rouine, capial expendiures are se relaively high. Similar in spiri are he findings by Worzala, Sirmans, and Ziez (2000), who repor ha when porolio managers are asked o rank invesmen alernaives by risk and reurn, hese managers end o no rank hese alernaives (e.g., large cap, small cap, and bonds) consisen wih he idea ha risk and reurn are posiively correlaed. e auhors sugges ha his oversigh may explain why acual invesmen porolios are inconsisen wih heoreically suggesed porolios. Finally, Muradoglu (2002) invesigaed porolio managers’ orecass o risk and reurn using business sudens and finance proessionals in an experimenal seing, and ound differences beween finance proessionals and sudens. e later group ends o be more opimisic, bu hedges is opimism beter. A relaed quesion is how finance proessionals orm heir opinions o ex-ane risk. Mear and Firh (1988) find ha accouning repors are an imporan source o inormaion ha proessionals use o iner ex-ane risk. In anoher experimen, Cooley (1977) finds ha porolio managers seem o care abou boh he firs-order momen o reurns and he second-order momen (i.e., concern wih downside risk) involving perceived risk. DISPOSITION EFFECT

On he opposie side o he specrum rom risk-seeking behavior, risk avoidance is when invesors acively seek o remove he poenial or losses in heir porolios. Whereas risk-averse invesors ake addiional risk as long as hey are compensaed wih sufficien reurn, invesors engaging in risk avoidance ry o avoid risk, regardless o he poenial reurns being offered. Occasionally, he divide beween risk-seeking and risk-avoiding behavior can blur. In ac, a porolio manager may exhibi boh o hese behaviors in monioring a single securiy in a porolio. Kahneman and versky (1979) find ha invesors rea he gains and losses in heir porolio differenly. Prospec heory, which is a more popular erm or he disposiion effec, posis ha invesors weigh all gains and losses agains a paricular reerence poin, and heir behavior depends on which side o he poin heir posiion lies. Because invesors eel more srongly abou losses han hey do abou gains, he pain experienced in a losing invesmen ar ousrips he uiliy o an equal-sized profi. us, he invesor’s uiliy uncion akes an asymmerical S-shape, wih gains in a concave shape above he reerence poin and losses orming a seep convex shape below. Given ha invesors do no wan o realize a loss, hey may hold ono an invesmen ha has dropped subsanially in value, hoping o recover heir invesmen. Alernaively, invesors overly ocus on avoiding losses, so hey ofen lock in any gains and sell posiive posiions. e resul is ha he invesor engages in risk-seeking behavior when experiencing losses and risk-avoidance behavior when experiencing gains (Pompian 2006). is is known as he disposiion effec, which is he desire o sell winners oo early and ride losers oo long (Sherin and Saman 1985). Alhough muual und managers are less likely o exhibi disposiion-driven behavior han individual invesors, sudies repor srong evidence or he disposiion effec among such managers (Ammann, Ising, and Kessler 2011). Unlike he oher biases

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discussed in his chaper, he consequences on he porolio managemen process are no necessarily negaive. Muual unds run by managers who have a higher disposiion effec end o have less sysemaic risk han heir peers (Cici 2010). Litle evidence suggess a negaive impac occurs on he und’s perormance (Ammann e al. 2011). Evidence also shows ha hedge und managers show he disposiion effec, paricularly when hey engage in shor-selling (von Beschwiz and Massa 2015) or afer hey personally experience a marriage or divorce (Lu, ay, and eo 2015). Unlike he perormance o muual und managers, he perormance o hedge und managers alers as a resul o his bias. e disposiion effec is no limied o equiy markes. esearchers ideniy he disposiion effec wihin a real esae invesmen rus (EI), which is a proessionally managed secor o he real esae marke. Specifically, a EI is an invesmen vehicle ha aggregaes properies ino an invesable porolio. Similar o a muual und, a EI is a pooled und wih shareholders who paricipae in he und’s gains and losses and a manager who decides which properies o buy and sell. In he case o a EI, he porolio manager is ypically he company’s CEO. Changes in he values o he underlying properies dicae a EI’s value. Crane and Harzell (2010) find evidence o he disposiion effec among EI managers, paricularly hose who manage smaller properies. By holding ono properies ha coninue o lose value and selling winning properies a lower prices han oher relaive properies, he manager’s behavior has negaive implicaions on boh he EI and is invesor base. In summary, alhough each porolio manager ype displays evidence o he disposiion effec, he impac o he perormance differs. GENDER DIFFERENCES

Women now play a larger invesing role in U.S. households. In ac, hey are he primary provider in more han 40 percen o American households, a sarling increase rom 11 percen in 1960 (Wang, Parker, and aylor 2013). Wihin American households, he percenage o couples where women are he primary decision maker o long-erm reiremen plans has more han doubled, rom 9 percen in 2011 o 19 percen in 2013 (Fideliy Invesmens 2013). However, his rend has hi a ceiling and does no appear a he proessional porolio manager role. Among he enire universe o U.S.-lised muual unds, women represen only 9 percen o und porolio managers. Furher, only 2.5 percen o all muual unds exclusively have women porolio managers, and he unds ha hey do manage represen less han 2 percen o all muual und asses (Luton 2015). Based on hese findings, he poenial exiss or more emale managers o ener his marke and capure more AUM. Wihin muual unds, Luton (2015) finds ha unds managed by emale porolio managers perorm in line wih hose managed by men. Ineresingly, unds wih mixedgender eams o porolio managers ared he bes. In he hedge und universe, empirical evidence indicaes ha emale porolio managers perorm beter han average. From 2007 o 2015, he average women-led hedge und generaed a reurn o 59.4 percen, rouncing he indusry average reurn o 36.7 percen (KPMG 2015). Why does his perormance dispariy exis beween male and emale porolio managers? Jones (2015) posis several reasons or emale porolio managers perorming

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beter han males. e recurring heme is ha women are less likely o suffer overconfidence bias han men. By gender, evidence shows ha boh males and emales display overconfidence in heir abiliies (Lundeberg, Fox, and LeCoun 1994). However, alhough boh genders are guily o his bias o a degree, men are consisenly more overconfiden han women in heir predicions, paricularly when relaed o financial decisions (Barber and Odean 2001). Addiionally, in he absence o cerainy, Lenney (1977) finds ha women have lower opinions o heir abiliies han men. Following his logic, Barber and Odean noe ha women display less confidence in heir abiliies in invesing in he marke han men. Earlier, his chaper reviewed he negaive consequences o overconfidence bias in he porolio managemen process. Overconfidence leads o increased rading aciviy, concenraed posiions, and a decreased emphasis on he downside proecion o a porolio. Jones (2015) conends ha male porolio managers paricipae in each o hese aciviies more han emales, poenially explaining why only a ew can mach he perormance o heir emale counerpars. As relaed o overconfidence bias, Lundeberg e al. (1994) find a difference in he confidence o predicions o men and women involving when heir respecive predicions are incorrec. In conras o men, women are more sel-aware o heir poenially incorrec predicions han are men, and are less confiden in heir orecass as a resul. In conras, when heir predicions are incorrec, men show inappropriaely excessive confidence in heir answers. e ramificaions o his behavior on porolio managemen relae o a und’s downside proecion. a is, emale managers are more likely han men o admi misakes. A emale porolio manager is less araid o capping her losses and exiing a posiion rom an invesmen ha did no mee expecaions. is enhances he drawdown proecion in emale-led unds and may help explain why hey ouperorm male-led unds. Besides overconfidence bias, Jones (2015) also suggess ha one possible reason emale-led unds have reurn paterns ha are superior o he general und universe is ha emale managers are less likely o display herd behavior. Because emale managers represen such a minoriy porion o he porolio manager populaion, hey may be less vulnerable o he pialls o grouphink han are heir more homogenized male peers. As he invesing public urher recognizes he superior rack records o emale porolio managers, more opporuniies may maerialize or women in he uure. As he sample size o emale porolio managers expands, he behavioral differences relaive o male managers are likely o manies hemselves more prominenly. A relaed quesion is wheher risk-aking behavior crosses over ino oher aciviies. For example, do porolio managers who like o ake risks in oher aciviies, such as skydiving or flying airplanes, also exhibi more risk in picking porolios? Alhough heoreical argumens exis in eiher direcion, experimenal evidence suggess ha risk aking does no appear o cross aciviies (Belcher 2010).

Summary and Conclusions In he asse managemen world, porolio managers occupy highly imporan and visible posiions. Consequenly, boh invesors and ouside sakeholders can eel shockwaves rom heir work. ey mus consanly keep rack o many moving pars and

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quickly make adjusmens. Failing o properly do so can severely damage heir perormance record, repuaion, and level o compensaion. o ully undersand he acions o porolio managers requires considering he behavioral biases ha provide moives or heir behavior. e overconfidence bias displayed by porolio managers has boh negaive (increased rading aciviy) and posiive (concenraed porolios) effecs. Herd menaliy can race is roos o social behavior and can lead in exreme cases o creaing financial bubbles and crashes. isk-aking behavior is mos prevalen in alernaive asse managers, who are incenivized o seek he highes reurn possible because o perormance ees. e disposiion effec is prevalen among muual und, hedge und, and real esae porolio managers, bu i has differing effecs on heir respecive perormance. Lasly, emale porolio managers are less likely o all vicim o boh overconfidence bias and herd behavior, an asserion suppored by heir superior perormance records. Owing o he srucure o cerain unds, compleely removing paricular biases rom he mindse o a porolio manager is difficul. However, as long as he manager is cognizan o he presence o a specific bias a hand, reducing he impac o he bias on he porolio is possible.

DISCUSSION QUESTIONS 1. Describe he primary seps o he porolio managemen process. 2. Compare he srucure o radiional and alernaive asse managemen firms and ideniy biases ha may arise as a resul o heir differences. 3. Describe he disposiion effec and how i affecs porolios based on an invesor’s uiliy. 4. Conras he differen biases displayed by male and emale porolio managers and he consequences o each on heir respecive porolios.

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9 Financial Psychopaths DEBORAH W. GREGORY Assistant Professor Bentley University

Introduction Menion financial psychopahs and or many people, wo pop-culure characers immoralized by Hollywood spring o mind: Parick Baeman, he iconic Wall Sree invesmen banker who sars in he 1980s novel adapaion, American Psycho (2000); and more recenly Jordan Belor, he so-called and sel-named “Wol o Wall Sree” ’ (Belor 2008), in he film o he same name (Te Wol o Wall Sree2013). Baeman’s characer he1980s, firs film is differs purely rom ficional. He is a man borne o he Wall Sree killculure duringinhe who his colleagues in his procliviy or lierally ing people. e later film, adaped rom Belor’s memoir, depics his liesyle on Wall Sree rom he lae 1980s hrough he mid-2000s. I is replee wih deails o illegal financial deals involving corrupion and raud, drug usage, and his exreme fluency in oul language, sexual promiscuiy, and violence. Belor’s sel-depicion as a sel-aggrandizing person apaheic o he negaive consequences o his acions on ohers is no ficion raher, i is a close rendering o his acual lie and characer. Does eiher or boh o hese characers qualiy asfinancial psychopahs? Boh work on Wall Sree and engage in excessive drinking, drugs, general debauchery, and decepive pracices o achieve financial gain. Moreover, neiher Baeman nor Belor cares abou he effecs o heir acions on he people wih whom hey inerac. a Baeman’s characer addiionally enjoys manslaugher migh mark him as a radiional psychopah, bu ha alone does no answer hereally quesion: Is Baeman beterordescribed as a financial pah? Similarly, is Belor a financial psychopah, is he a psychopah whopsychoworks in he financial secor? Anoher possibiliy migh be ha Belor is no a psychopah a all bu, raher, a clinically diagnosable sociopah. Alhough he shared behavioral characerisics o boh men would sugges hey are likely deserving o a clinical diagnosis o some orm o anisocial personaliy disorder (APD), deermining wheher eihermigh be considered a financial psychopah requires a deeper examinaion owha precisely differeniaes a financial psychopah rom all oher orms o anisocialbehavioral paterns. Away rom he silver screen, oher real-lie ormer financial proessionals, such as Nick Leeson o Barings Bank and urney Duff o Galleon Group, Argus Group, and J. L. Berkowiz, have writen exposés o heir own ime while embedded in he Wall Sree environmen (Leeson 1996; Duff 2013). Belor, Leeson, and Duff all worked 153

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during he las par o he wenieh cenury, wih Duff and Belor’s enures exending ino he beginning o he weny-firs cenury as well, a ime when financiers were he envy o many ouside he proession owing o heir abiliy o generae massive incomes or hemselves, seemingly wih ease. Leeson and Duff’s ales weave ogeher many o he same hreads as Belor’s excessive and regular drug use, promiscuous sex, and raudulen and illici financial dealings. Only Belor has been called o ask publicly or engaging in “psychopahic behaviors” by he adul child o his ormer business associae, om Prousalis (McDowell 2013). e sronges acknowledgmen o Leeson’s raudulen dealings and his hand in he demise o Barings, a veneraed, cenuries-old invesmen bank, has been his placemen on he liss o “op” or “wors” rogue raders by muliple news organizaions such as Te Guardian (Hawkes and Wearden 2011) and CNN (ompson 2011). Duff ’s behavior warrans even less public ineres. His recen online publiciy sresses how he srayed while working under he influence o Wall Sree, reassuring he public ha he is no longer held in is hrall by having reurned o a lie o normalcy (Duff 2015). Placing aside provocaive publiciy purposeully designed o elici greaer book and DVD sales, a commonaliy exiss among all hree men’s experiences working in he modern financial rading/invesmen secor. ese shared qualiies sugges ha he Wall Sree environmen has been acceping o and even condoning behaviors viewed by he general public as psychopahic in naure. Given his, clearly defining wha consiues a financial psychopah becomes necessary o undersand hese men’s behaviors and heir resulan impac on he wider financial indusry and sociey. Once deermined, he possibiliy exiss o invesigae wheher he environmen o finance atracs such individuals and/or i he environmen isel encourages and shapes financially oriened psychopahic behaviors in hose who remain inculcaed.

Defining Financial Psychopaths ose working in he financial secor on Wall Sree and is environs have come under exensive public and governmenal scruiny since he financial crisis o 2007– 2008. a he clinical erm o “psychopah” has been appropriaed o apply o financial proessionals in he afermah o he crisis speaks volumes abou he deph o he global damage on all sraa o socieies caused by hose in he financial indusry. Unil recenly, psychopahs were usually idenified as being like Parick Baeman someone who acs violenly by killing and physically harming vicims wihou any remorse or his or her acions. A no oher ime in hisory including he dramaic sock marke crash o 1929 have financial proessionals been labeled wih such a erm as one usually reserves or he mos violen o criminals wih no moral capaciy. By firs oulining he clinical indicaors or classical psychopahs, i hen becomes possible o esablish a baseline ha leads o an explici definiion o observed behaviors consiuing appropriae labeling o an individual as a financial psychopah. e primary source or guidelines when making a psychiaric diagnosis and developing a reamen plan is he classic Diagnosic and Saisical Manual o Menal Disorders, which is now in is fifh ediion (American Psychiaric Associaion 2013), reerred o as DSM-5. e DSM-5 classifies hundreds o menal disorders in a sysem ha corresponds

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wih ha used by he World Healh Organizaion and insurance companies. By providing behaviors and sympoms associaed wih a paricular disorder, clinicians are guided in ormulaing he mos appropriae diagnosis or an individual. Beore delving ino his diagnosic checklis, noing a descripion o psychopahs writen in plain English is worhwhile because i helps o undersand he core personaliy o people so diagnosed. ober I. Simon, a orensic psychiaris, describes psychopahs as: people who have severe anisocial impulses. ey ac on hem wihou regard or he ineviable and devasaing consequences … . []hey are he predaors among us, chronic parasies and exploiers o he people around hem … . [ey] are unable o pu hemselves in oher people’s shoes, any more han a snake can eel empahy or is prey. (Simon 2008, p. 34) In oher words, psychopahs have oal disregard or oher people and ocus solely on hemselves. Alhough people are naurally concerned abou hemselves, some have personaliy srucures ha require consan eedback rom ohers abou how grea hey are in order o eel good abou hemselves. Psychopahs are narcissisic o such a degree ha hey are harmul o hose wihin heir reach. is pahological excessive emphasis on onesel is also a eaure o narcissisic personaliy disorder, as well as a componen o Asperger’s syndrome (now subsumed under auism in he DSM-5), so care mus be aken o ensure making a correc diagnosis. Wha would consiue a suiable reamen plan or sraegy or managing ineracions wih a person displaying pahological narcissisic sympoms would be vasly differen or psychopahs han or narcissisic personaliies or auisic-inclined individuals, given he wide variances in he expeced oucomes or each diagnosed personaliy ype. ROLE OF SUBSTANCE ABUSE

An imporan exernal acor ha also needs o be considered when making any clinical diagnosis is he use o drugs and alcohol by an individual. e presence o any mind-alering subsance can obuscae an accurae assessmen o a person’s underlying personaliy atribues. Addicion o any kind mus be ruled ou beore making a diagnosis o psychopahy. Smih and Newman’s (1990) sudy o incarceraed men shows 92.9 percen o psychopahs are addiced o alcohol and 73.5 percen are addiced o drugs, which is significanly higher han or he conrol group. A co-morbidiy sudy o psychopahy and addicion by egier, Farmer, ae, Locke, Keih, Judd, and Goodwin (1990) esimaes 75 percen o psychopahs are addiced o alcohol and 50 percen abuse oher drugs. Differen schools o psychological hough atribue his high level o co-morbidiy o differen acors. A he core o he issue is he psychopahic need or consan simulaion, which can be me by sel-medicaing wih alcohol and drugs. Alhough litle academic lieraure exiss abou drug use in he finance indusry, anecdoal evidence suggess ha i is prevalen and has been or decades (Dealbook 2007; Schuser 2009; Inside Job 2011). Belor, Leeson, and Duff became heavily involved wih drugs, paricularly cocaine, while working in he invesmen/rading arena. Boh Leeson and Duff did no inend o sar using drugs, bu ound sopping difficul once

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hey sared paricipaing a paries wih colleagues and cliens. is oleran atiude oward drug use serves o reinorce and could even exacerbae impulsive behavior, one o he hallmarks o psychopahy. In his memoir, Duff (2013) discusses a lengh he impac his drug misuse had on his personal and proessional lie. Some research sudies examine he impac on he brain physiology o boh cocaine and money. Ineresingly, uncional magneic resonance imaging (MI) shows ha cocaine use lighs up he same pleasure ceners o he brain as money (Goldsein and Volkow 2002). Furher sudy reveals ha cocaine addics regiser aciviy in he pleasure ceners o he brain rom smaller amouns o moneary rewards han non- cocaine addics (Goldsein e al. 2003). In oher words, non- cocaine addics do no receive he same ype o pleasurable experience or smaller amouns o moneary rewards as hose who are addiced. e consequence o inensive cocaine abuse, even afer periods o absinence, includes “more marked deficis in … execuive conrol, visuospaial abiliies, psychomoor speed and manual dexeriy” (ogers and obbins 2001, p. 252). For hose working on Wall Sree, hese acions porend a uure wih diminished cogniive capaciy, impairing a person’s abili y o make sound deals. Addiional sudies ha compare he brain physiology o psychopahs o he areas o he brain affeced by drug use show a similar dysuncion occurring in wo idenical regions o he brain. ose wo affeced areas are relaed o he abiliy o be socialized and o “rusraion-based aggression” (Blair 2005, p. 885). is finding again underscores he need o be circumspec when making a psychopahic diagnosis, as he addic may sill have moral and empahic abiliies inac rais ha will be lacking in he psychopahic individual. PSYCHOPATHY

Conrary o wha mos non-clinicians migh expec, he DSM-5 does no include a separae enry or psychopahs. Insead, he diagnosis is grouped under he classificaion o APD, which is a broad caegory ha also encompasses sociopahy and psychopahy. o diagnose APD requires a pervasive lie-long patern o problemaic behaviors srcinaing beore he age o 15 and relaes o he person’s disregard or oher people and oher senien beings. e primary eaures o which only hree mus be me o diagnose include deceiulness, impulsiviy, irriabiliy and aggressiveness, reckless disregard or he saey o sel or ohers, consisen irresponsibiliy, and lack o remorse (American Psychiaric Associaion 2013). An ofen-overlooked eaure o psychopahy is he charming naure o hose wih he diagnosis; such behaviors are known o cach oherwise well-inormed clinical praciioners and ohers off-guard. e response o uncovering a heinous deed perormed by a previously known-o-be charming individual is ofen disbelie: “No way! He [or she] is such a grea person.” e arociy o he deed is subsequenly discouned because o he dissonance beween he ouer behavior o he “charming” person and he observed resul o his or her heinous acion. is discord beween percepion and realiy requenly enables psychopahic individuals o coninue behaving wih impuniy unil hey are lierally caugh in he ac. Even hen, psychopahs migh avoid major repercussions or heir acions owing o he dissonance beween heir charming public persona and he severiy o heir acions.

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ober D. Hare, a Canadian psychologis, developed he Hare Psychopahy Checklis (PCL) in he lae 1970s based on his work wih violen criminals and laer revised i in he 1990s. Boh long and shor versions are available. Proessionals use he PCL o ascerain wheher a person is psychopahic raher han simply anisocial. Hare and Paul Babiak, his co-researcher on corporae psychopahic behavior and a managemenoriened psychologis, esimae ha approximaely 1 percen o he general populaion is psychopahic (Babiak and Hare 2006). is saisic compares wih 3 percen given by he DSM-5 or he incidence o anisocial personaliy disordered individuals occurring in he general populaion. According o Babiak and Hare (p. 19), hose who lie on he sociopahic specrum can be differeniaed rom psychopahs by he sociopahs’ “sense o righ and wrong based on he norms and expecaions o heir subculure or group.” e disincion beween hese wo ypes wihin he APD classificaion emphasizes he awareness o group culural norms by a sociopah, bu no so or psychopahs. ose individuals who are ollowing group norms in he financial secor canno hus be deemed psychopahic purely or adhering o pracices ha heir firm and/or colleagues condone. Because mos financial employees are aware o group culural norms, he possibiliy arises ha some people in he financial secor could be sociopahic, provided hey mee he oher crieria or APD. Cerain behaviors migh no be considered aberran wihin he subculure o finance, whereas hose same behaviors migh be deemed anisocial by sociey a large. Excessive or exreme drug use can serve as an example: Wihin he general sociey, such behaviors would be considered deeply anisocial wih he poenial or grea harm. In he Wall Sree culure o he las wo decades o he wenieh cenury, such behavior migh no have been considered aberran, provided a person’s financial perormance was unaffeced. e DSM-5 emphasizes ha “criminal behavior underaken or gain ha is no accompanied by he personaliy eaures characerisic o his disorder [psychopahy]” (American Psychiaric Associaion 2013, p. 663) does no provide sufficien grounds or making a psychopahic diagnosis. e menal healh proessionals who developed he DSM-5 are aware ha behavior resuling in criminal charges does no necessarily signiy he presence o severe psychopahology. aher, wha he DSM-5 does sress is ha he observed psychopahic personaliy rais be, “inflexible, maladapive, persisen and cause significan uncional impairmen or subjecive disress” (American Psychiaric Associaion 2013, p. 663). For example, when considering wheher a financial proessional could be considered a financial psychopah owing o his manipulaing financial markes in such a way ha i resuls in enormous moneary gains or himsel or his firm, such a behavior alone is an insufficien basis or a psychopahic diagnosis based on DSM-5 crieria. Insead, he underlying personaliy srucure o he individual is he key o he psychopahic porion o he diagnosis, no he financial venue. echnological advances in boh brain imaging and geneics have enabled urher idenificaion o psychopahic individuals based on physiological and DNA characerisics, raher han relying on behavioral characerisics alone. esuls rom sudies using uncional MIs o scan brain physiology indicae he regions o he brain responsible or indicaing he presence or absence o specific behaviors associaed wih psychopahy. For example, he cener in he brain responsible or empahy does no ligh up in he brains o psychopahs (Kiehl, Smih, Hare, Mendrek, Forser, Brink, and Liddle 2001). A more recen sudy by Mozkin, Newman, Kiehl, and Koenigs (2011) confirms

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ha he venromedial preronal corex, which conrols emoions such as empahy and guil, does no communicae properly wih he amygdala, which is responsible or ear and anxiey, in psychopahs. Finally, Glenn, aine, Schug, Young, and Hauser (2009) find ha increased aciviy in he preronal corex, which is he region o he brain ha provides cogniive conrol o offse emoional responses o moral dilemmas, increases in psychopahs when making emoional moral decisions. is aciviy is posiively associaed o he “impulsive liesyle” and “anisocial” acors o psychopahy. Glenn e al. (p. 910) noe a possible implicaion o heir findings is “a ailure o link moral judgmen o behavior wih appropriaely moiving emoions.” e geneic componen or psychopahy is currenly recognized as being somewhere beween a hird and a hal, wih he remaining proporion atribuable o environmenal or oher causes. Epigeneics, he sudy o geneics and environmen, shows ha genes conain coded inormaion and also a swich or “promoer,” cues in he cell isel, as well as he ouer environmen, acivaing he promoer and hence he inormaion in he gene. us, i someone has a high geneic propensiy oward psychopahy, wheher i becomes prominen depends on inernal and exernal environmenal cues (oessler 2012). Because cues are no one-ime swiches, an affeced individual could heoreically become psychopahically “acivaed” when placed in an appropriae environmen ha elicis and rewards psychopahic behavior. ese new ools enable ideniying psychopahs in setings oher han where violen crimes have occurred or in prisons. Physiological ess are confirming earlier behaviorally based asserions ha psychopahs can be more requenly ound among hose who are well educaed and held in high regard by sociey, such as docors, lawyers, and businesspeople (Smih 1978; Hare 1993; Sou 2005; Babiak and Hare 2006). Boddy (2010) ocuses on he incidence o psychopahy among Ausralian managers and discovers more in financial service companies and he civil service. Boh Hare and Simon individually sugges ha Wall Sree is a prime locaion or finding nonradiional psychopahs. Simon (2008, p. 44) saes “i one wans o sudy psychopahs, one should go o Wall Sree. Someimes i is hard o ell he successul person rom he psychopah.” In ac, Hare saes ha he sock exchange isel would be his preerred locaion o sudy psychopahs ouside he prison environmen (Duton 2012, p. 112). DIAGNOSING IN THE BUSINESS ENVIRONMENT

ogeher, Babiak and Hare (2006) developed a more specific diagnosic ool ha ocuses on ideniying noncriminal psychopahs in he general corporae secor. eir Business-Scan 360 (B-scan 360) is no in eiher clinical or commercial use a he ime o his publicaion, bu is being employed in research sudies wih businesses o es is validiy. From heir research, Babiak and Hare idenified hree disinc subses o corporae psychopahs: (1) corporae manipulaors or cons (more passive), (2) bullies (more aggressive), and (3) puppe masers who display boh manipulaive and bullying behaviors. e later caegory is likened o he dangerous violen criminal psychopah known hrough he DSM-5. Manipulaors and bullies boh display he same rais as heir corresponding criminal psychopahic counerpars. Using resuls rom adminisering Hare’s PCL shor version o 200 high-poenial execuives, Babiak and Hare (2006) repor ha seven, or 3.5 percen, o he execuives

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fi he psychopahic profile using he shor version o he PCL. Conrasing his wih he general incidence o psychopahy in he populaion a large o 1 percen, his group o execuives exhibis a higher rae o psychopahy. Babiak and Hare also noe ha only wo o he 200 execuives ell in he bully caegory and none in he puppe maser caegory. is finding suggess ha he proporion o violen, psychopahic individuals who are employed in he corporae secor is on par wih he naional proporion. e majoriy o psychopahic corporae execuives are known as “passive” psychopahs. Earlier research (Cleckley 1988/1941; Babiak and Hare 2006; Simon 2008; Brown 2010) shows ha his ype o psychopah is less likely o be involved in legal conflics resuling rom heir manipulaive behavioral paterns and i hey are prosecued, receive litle or no punishmen or heir offenses. According o Hare (1993), wha renders whie-collar crime so appealing o psychopahic personaliies is he array o high-payoff opporuniies coupled wih hisorically limied punishmens i hey are caugh. Insead o a possible maximum o 20 years or his role in derauding banks o $23.5 million, he auhoriies evenually senenced John Grambling Jr. in 1987 o six monhs o jail ime. Hare (1993, p. 104) idenifies Grambling as a psychopahic individual and commens ha his case: is a model or using educaion and social connecions o separae people and insiuions rom heir money wihou using violence … . []he decei and manipulaion o hese individuals are no confined o simply making money; hese qualiies pervade heir dealing wih everyone … including amily, riends, and he jusice sysem. e financial damage infliced by Grambling was exensive, bu he punishmen meed ou was ligh. No much has changed since Grambling’s ime. As refleced in he cleanup phase o he financial crisis o 2007–2008, he auhoriies senenced very ew financial execuives o ime in prison or heir role in derauding he public. Apuzzo and Proess (2015) repor on a Sepember 9, 2015, memo issued by he Deparmen o Jusice changing heir approach o dealing wih financial maleasance. According o Apuzzo and Proess (p. 1), he new rules confirm wha he public had already observed, namely ha “he Jusice Deparmen ofen arges companies hemselves and urns is eyes oward individuals only afer negoiaing a corporae setlemen. In many cases, ha means he offending employees go unpunished.” A job or occupaion ha provides a high-payoff opporuniy is insufficien or a psychopahic individual o be successul. e posiion also needs o make he bes use o psychopahic behavior rais. For example, a person who likes o bully ohers and kill people may do well in a seting ha includes warare. In such a seting, he person’s behavior would be lauded and no condemned. Hare (1993, p. 109) noes ha occupaions mos likely o atrac psychopahic personaliies are hose in which, “requisie skills are easy o ake, he jargon is easy o learn, and he credenials are unlikely o be horoughly checked”; addiionally, “he proession also places a high premium on he abiliy o persuade or manipulae ohers.” ese crieria fi posiions available on Wall Sree and oher financial secor work environmens. Lewis (1989) describes young male raders working in invesmen banks during he heydays o he lae 1980s in language ha conveys many acceped behavioral characerisics. Lewis (p. 9) firs allows ha hey are “masers o he

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quick killing,” a phrase ha brings psychopahs o mind. Lewis (p. 61) hen atribues he young raders’ abiliy o make grea quaniies o money quickly, despie heir lack o experience, o being “less a mater o skill and more a mater o inangibles flair, persisence, and luck” when alking wih poenial buyers on he elephone. Successul raders possess cerain atribues, many o which mach psychopahic rais. For example, he psychopahic rai o impulsiviy may display in a successul rader as a willingness o ake high degrees o risk in a siuaion when ohers hink i would be oolish, such as when he marke has aken an unexpeced plunge. However, he non-psychopahic rader may in ac be well prepared and waiing or such an opporuniy o presen isel. In acualiy, he is no acing impulsively, bu rom he ouside perspecive i may appear so. Differeniaing beween he wo is no as simple as waching heir ouer behaviors. rading skills evolve over ime and an ouer personaliy develops o presen o he world a large. e purpose o his ouer personaliy or persona is o enable a person o engage in he world, and may or may no accuraely reflec he rader’s rue inner personaliy. e rader in his case may no wan people o know wha he is acually inending and may presen wih charming baner ha is oally unrelaed o he rading opporuniy closes o his hear. us, his ficiious rader displays wo more psychopahic rais: decepion and a charming persona. Based on he guidelines given in he DSM-5 earlier, hese characerisics are all in service o obaining financial gain and are no lie-long, inflexible rais. e rader is no pahologically psychopahic. GENDER BIAS

us ar, he discussion o psychopahy has ocused solely on men. is bias exiss in he lieraure because women are underrepresened in boh he disorder and he financial secor, so very litle has been writen abou hem in his regard. esearchers are finding ha psychopahy displays differenly in women (Kreis and Cooke 2011; Wynn, Høiseh, and Paterson 2012), which may accoun or he lower percenage presen in he general populaion. Kreis and Cooke (p. 644) describe a “prooype” emale psychopah as “manipulaive, deceiul, sel-jusiying, sel-cenered, domineering, deached, uncaring, anagonisic, insincere, and sel-aggrandizing.” Many o heir descripors reflec he radiional psychopah checklis developed wih male subjecs. Like her male counerpar, she also lacks empahy. Ye, as Kreis and Cook (p. 614) noe, he prooype emale psychopah also could be “more manipulaive, emoionally unsable, and have a more unsable sel-concep.” Women, however, show a disinc preerence or using relaionally oriened echniques, such as fliring, o abuse heir vicims (Forouzan and Cooke 2005). Given no obvious physical abuse is generally associaed wih sexual promiscuiy or fliring, pinpoining he more aggressive psychopahic behavioral rai in women is more difficul han or men.

Financial Psychopaths A possible shape and ace can now be ormulaed or a poenial financial psychopah. Alhough many perceive psychopahs as charming individuals, hey display a variey o

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pervasive, lie-long ani-social rais, such as deceiulness, narcissisic orienaion, consisen irresponsibiliy, and a lack o remorse. A subse wihin he general psychopahic designaion is he corporae psychopah. Mos corporae psychopahs are primarily passive ypes who do no display obvious violen behaviors, as would be ound in he general psychopahic populaion. ey end o exploi and manipulae ohers or heir own gain, and in so doing, hey behave in such a way as o avoid becoming enangled wih he legal sysem. Because finance is par o he business environmen, a financial psychopah may be considered a subgroup o corporae psychopahs. Firs, a financial psychopah is ar more likely o be male. is observaion is due parly o he presence o ewer women who are currenly in posiions o conrol finances owing o prevailing socioculural biases, and also owing o he lower incidence o women diagnosed as psychopahs overall. Psychopahic women end o use heir sexualiy o manipulae people. As a resul, hey would be ar less likely o be caugh holding he “smoking gun” o financial manipulaion and insead be censured or heir sexual behaviors. Second, violence is no a normal or primary atribue o he corporae psychopah. However, i canno be ruled ou compleely. Babiak and Hare’s (2006) research indicaes ha a very small minoriy o bully and puppeeer corporae psychopahs use physical violence when manipulaing ohers. Differeniaing beween he corporae and financial psychopah narrows he ocus o he resources over which each has conrol. e primary responsibiliy o corporae execuives is he sraegic managemen o a company, no he handling o money belonging o oher people on a shor- or long-erm basis. e excepion o his is he chie financial officer (CFO), who can be considered eligible or he financial psychopah diagnosis. However, McKinsey & Company noes (Agrawal, Goldie, and Huyet 2013) ha no all CFOs have backgrounds in finance. Accouning and general MBA backgrounds are more prevalen, bu a change has occurred since 2009. Approximaely one-hird o CFOs hired o “grow” a company have had Wall Sree careers in invesmen banking and relaed secors. us, he proporion o CFO financial psychopahs may very well be much smaller han or corporae execuives in general, wih he poenial or an increasing rend in cerain segmens. rus has been placed in financiers o all ypes o honor heir implied or explici fiduciary duy o manage ha money wisely. When ohers perceive financial proessionals as violaing ha rus by no acing prudenly on behal o cliens, and insead aking care o heir own financial needs firs, his should sound an alarm. Furhermore, i invesmen proessionals are unremorseul and callous abou financial oucomes rom heir dealings, paricularly i he oucomes are negaive, hen a key psychopahic eaure has become apparen. us, disinc and separae rom he corporae psychopah, a financial psychopah is a predaor who ruins he lives o ohers hrough aciviies involving financial ransacions; his person is emoionally deached, narcissisic, and shows no remorse, perhaps even aking pleasure in he desrucion o he lives o ohers. His or her ouer demeanor may be charming. o be considered a financial psychopah also requires meeing he basic crierion rom he DSM-5 doing harm o ohers mus be a pervasive, lie-long paern, no isolaed o when adulhood is atained and having access o financial resources. ecognizing ha in early childhood money is no an easily conrollable insrumen or a

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child, inflicion o physical or emoional pain o ohers wihou accompanying remorse would need o be presen. Incorporaing he findings rom epigeneics ha environmenal cues may rigger underlying psychopahic endencies, DNA esing may be necessary or confirmaion i no early patern o inflicing harm o ohers is oherwise eviden. Insead o using guns and oher weapons o desrucion o kill, financial psychopahs use he ools o heir rade compuers and financial ransacions o purposeully harm ohers. Financial psychopahs are no limied by geography because hey do no need o operae locally. In ac, financial psychopahs have he abiliy o inflic more harm o a greaer proporion o he populaion globally, wihou resoring o physical violence, because hey require no personal relaionship wih inended vicims and can carry ou damage anonymously. Moreover, no blood needs o be spilled any damage can be infliced rom arm’s lengh. As wih oher passive ypes o psychopahs, financial psychopahs are less likely o become enangled wih he law and migh escape discovery and punishmen or heir crimes. IDENTIFYI

NG FINANC

IAL PSYCHOPA

THS

Based on he preceding discussion, Baeman’s characer inAmerican Psycho can be classified as a radiional psychopah. Alhough he happens o work in he financial indusry, according o his working definiion he is no a financial psychopah. Belor, by conras, does no presen as a classic psychopah. Wheher his personaliy is bes described as a financial psychopah or as a person who works in he financial secor and displays sociopahic endencies needs urher clarificaion. o find oher financial praciioners who have exhibied behaviors ha migh indicae hey are financial psychopahs requires in-deph invesigaion ino heir lives and acions. e media have highlighed many financial proessionals since 2007 or raud and mismanagemen o money. Few have been prosecued. One highprofile case was Bernie Madoff, accused o running a Ponzi scheme ha derauded invesors o billions o dollars over decades. Diane Henriques spen hours inerviewing Madoff in prison and concluded he was psychopahic. She ound him o be charming and no he leas remorseul or wha he had done. Wihou ormal clinical raining, Henriques (2012) had ollowed he guidelines in he DSM-5 and ormulaed a diagnosis. Madoff’s case illusraes he ease wih which someone in he righ siuaion wih he appropriae connecions and ools can ake money rom ohers. Anoher person inadverenly caugh in he allou rom he morgage securiizaion debacle is Lee B. Farkus, ormer chairman and owner o aylor, Bean & Whiaker Morgage Corporaion (BW), a morgage-processing firm based in Ocala, Florida. Farkus also used financial ransacions and ook advanage o low-grade compuer echnology o make enormous sums o money while derauding banks, governmen agencies, and homeowners. When his firm was shu down in 2009, BW’s books showed a porolio valued by he Federal Home Loan Morgage Corporaion, known as Freddie Mac, a more han $51.2 billion, bu no real asses backed up he paper. e ailure o BW badly damaged he economy o Ocala, Florida, as BW had been a major employer ha paid relaively well. Gregory (2014) deails Farkus’s background and subsequen behaviors using financial insrumens and ransacions o perperae his crimes.

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Farkus’s profile more closely corresponds o he descripion o a financial psychopah oulined in his chaper han does Madoff. However, boh men were culpable o wreaking havoc on he lives o people hey knew as well as counless ohers wih whom hey had no relaionship simply by using financial ransacions, enabled by low-grade compuer echnology.

Emergence of Psychopathy in the Financial Environment In he afermah o he financial crisis o 2007–2008, he general public worldwide became inormed hrough media sories abou he aciviies o financiers in he period leading up o he crisis. Mos people did no undersand he financial insrumens or sraegies ha financial praciioners used o leverage reurns, bu he general public did comprehend ha average people were now suffering. ey atribued he cause o heir pain o he acions aken by hose affiliaed wih Wall Sree and is environs. Forgoten were he immediaely preceding years o record increases in 401(k)s and oher reiremen plans, as well as he meeoric rise in housing prices ha increased household wealh and homeownership raes. Financial praciioners suddenly became pariahs. Across he globe, hey had devoured people’s dreams o sabiliy and uure financial securiy hrough heir greed. Wha caused even more ourage was he percepion by he general public ha financial proessionals did no appear o be suffering o he same exen. In ac, many praciioners seemed o be benefiing rom he crisis and making money and aking care o hemselves, which is a narcissisic qualiy o psychopahs. e majoriy o observers ouside Wall Sree perceived he atiude o hese proessionals oward he damage hey had incurred o be callous and uncaring, which are boh psychopahic qualiies. As Gapper (2012, p. 13) noes, “he culure o he rading floor is remarkably immune o shame.” e response o many in he financial secor o allegaions o impruden behavior was evasive o acceping responsibiliy or causing global harm. Consisen irresponsibiliy is ye anoher psychopahic rai. ese incongruen percepions o he behaviors engaged in by financial proessionals are indicaive o a lack o agreemen over wha consiues accepable and expeced behavior when involved wih proessional money managemen. e general public expecs hose in he financial secor who are asked wih managing money on behal o ohers o do so in a pruden and responsible manner. In shor, hey are expeced o ac as fiduciaries. Many oher individuals engaged in he financial secor do no ac in a fiduciary capaciy, and as such, do no have he same responsibiliy o he average person. From he viewpoin o he general public, all hese financial praciioners all under he same umbrella. Differeniaing one rom he oher is difficul as an ousider. Given he hosiliy and resuling lack o rus ha emanaed rom he allou o he financial crisis, he erm “financial psychopah” was coined in an effor o capure he despicabiliy o he acions o cerain financiers whose acions bore he hallmarks o psychopahy.

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Unil 2008, he media porrayed invesmen praciioners who had been caugh manipulaing financial markes as “rogue raders.” Jérôme Kerviel o BNP Paribas and Nick Leeson o Barings Bank serve as prime examples o his classificaion. From he ouside, heir acions could be consrued as simply no ollowing he writen proocol o heir respecive banks. e resuling financial urmoil rom heir acions was resriced o losses among large and well-unded banks, alhough Kerviel’s acions had he possibiliy o inflicing severe damage o he general financial sysem, given he size o his srcinal posiion (Malack 2008). e average person, however, saw no direc effec on his or her 401k or bank saemen. Conversely, smaller scale financial scams have been in exisence since recorded hisory, wih cauionary ales o warn people o be careul abou where and wih whom hey rus heir lie savings. Con ariss and swindlers are commonly applied erms wihin he financial secors o denoe people who are unrusworhy in handling ohers’ money. No erm so pejoraive or personally pahological as “financial psychopah” exised unil 2008. e expression isel suggess no possible redempion. I iners ha hese paricular financial proessionals should be removed rom sociey or he saey o all, as is he case or radiional psychopahs. Ye, or cenuries, swindlers o all sors have been involved wih financial scams. Wha is differen abou his ime ha provoked he emergence o a new label? Was i he size o he meldown? Was i he atiude o hose who were accused o causing he problem? Was i ear o financial annihilaion and lack o conrol over uure resources on he par o he average ciizen? IDENTIFYI NG KEY CHANGES I THE FINANCIAL ENVIRONMENT

N

Many aces o he financial environmen have changed since he 1980s. Mos o hese changes are no brough o public awareness unless a negaive even occurs ha is broadcas in he general media, such as he Flash Crash o 2010. e flash crash occurred during he afernoon o May 6. U.S. share and uures indices wen ino a seemingly inexplicable ailspin and ell 10 percen in a mater o minues. Sock indexes, such as he S&P 500, Dow Jones Indusrial Average, and Nasdaq 100, collapsed and rebounded very rapidly. e shor-lived plunge raised quesions abou wheher rading rules had ailed o keep up wih markes ha now handle orders in milliseconds. e bigges acors rom he pas 40years ha have influenced he invesmen/rading secors o finance are advances in echnology and compuing abiliy. e ripple effecs o hese rapid advancemens reach ar ino he regulaory arena and how he markes uncion, as well as he ype o person employed in he financial indusry. e impac in each o hese areas has incurred consequences, some o which could no have been easily prediced. aken ogeher, a new financial environmen evolved ha has allowed or a change regarding who is operaing in he secor, resuling in psychopahiclike behaviors being condoned in a desire o maximize reurn on invesmen using aser echnology. Overarching he impac rom echnological advances has been he shif in he approach o he economic environmen wihin which financial praciioners operae. According o Chandler (1994), “indusrial capialism” defines he period rom 1945 o 1980, a ime during which he Norhern Hemisphere was rebuilding rom he ravages o World War II. Financial markes were insrumenal in helping o reallocae capial rom

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invesors o companies ha were esablishing hemselves in peaceime. elaional skills beween financial proessionals and individuals a he helm o corporaions were paramoun o solidiying deals. Physical asses underlay much o he financing required. e financial markes were physical locaions where raders and brokers me ace-o-ace o make deals and discover inormaion again, relaional skills were criical o being successul. Because people me regularly and worked ogeher in close physical proximiy, hose who were psychopahically inclined could no susain a açade ha would enable hem o mainain “normal” everyday ineracions wih he same people. Less opporuniy was hus available or a financial psychopah o be successul over he long erm, as behaviors were more closely moniored by peers. During his ime period, a new, modern heory o finance was also inroduced ha would have resounding implicaions or decades o come. Modern porolio heory (MP) and he efficien markes hypohesis (EMH) boh srcinaed during his era, as did he concep ha he goal o he financial manager is o maximize shareholder wealh by maximizing he value o he firm. Anoher major conribuion o financial heory during his period was he capial asse pricing model (CAPM). One o is basic assumpions, as wih many economic models o he ime, was ha all paricipans ac in an economically raional manner. aken ogeher, hese heories helped o shape no only how people approached markes bu also he ype o person who would succeed financially. Logical, analyical people who could spo inefficiencies and ake advanage o hem beore hey were no longer available did well. e processing speed o compuers was slow enough and markes were no as elecronically conneced. Enough ime was available o discover mispriced asses and make profiable rades beore oher marke paricipans would noice he mispricing and arbirage i away, reurning markes o an efficien sae. By 1980, he pace o he markes had quickened wih he adven o aser echnologies, along wih a loosening o regulaions ha governed he markes. Neal (1993) describes his ime period as he sar o “financial capialism,” which lased unil 2008. Financial firms began o ocus more on how hey could profi rom hese changes raher han on providing capial where i was needed. e mos sough afer employees became hose wih superior mahemaical and compuer skills, who could effecively wrie rading programs o ake advanage o he rapid compuer speeds now available. echnology-driven plaorms provided new venues or rading, circumvening he old, more relaionally based exchanges wih higher ees and slower processing imes. Financial markes o all kinds across he globe became more inerwined in his aspaced elecronic nework. During his phase, U.S. workers became responsible or heir own reiremen accouns wih he inroducion o defined conribuion reiremen plans. Wheher hey manage he money hemselves or rely on a financial proessional, he abiliy or almos all workers o und heir reiremen now depends on heir personal abiliy o inves in he financial markes. Beore his ime period, average individuals did no direcly inerac wih Wall Sree unless hey chose o paricipae in he marke or invesmen or speculaive reasons. Invesmen proessionals managed companysponsored pension plans, known as defined benefi plans. Employees would be old how much hey would be receiving when hey reired. Mos workers did no undersand where or how a financial proessional would inves money earmarked or reiremen unds; hey simply

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knew how much hey could expec o receive when hey reired. Vesing periods became increasingly imporan. A vesing period is he lengh o ime someone has o say wih a company beore being eligible o receive pension benefis. Wih he change o defined conribuion plans, average ciizens became ar more aware o how much heir personal financial lie was inexricably linked wih aciviies on Wall Sree. Laer, hey would undersand ha he financial markes were he provinces o financial proessionals who may or may no be working in he bes ineress o all people. e financial heories ha had been developed during he period o indusrial capialism coninued o be refined during he nex 30 years. For example, Lo (2005, p. 39) urhered he EMH wih his adapive markes hypohesis, based on he assumpion ha “individuals ac in heir own sel-ineres,” as well as raionaliy. Simply because people ac raionally and in heir own bes ineres does no imply hey make decisions ha are no damaging o he greaer sociey. o he conrary, he oucome o Lo’s evoluionarybased model ha he riches survive, lends suppor o he conenion ha individuals in he financial secor who embrace he enes o his model may be narcissisic and predaory in naure. isk managemen became more prominen wih urher developmen o he opion pricing heory (OP) made possible by he advances in compuing echnology. Invesmen and speculaion in derivaive insrumens became widespread, relieving he need or angible, physical asses as proo o ownership. Many financial insrumens became disconneced rom he physical orm hey had assumed or millennia, hus enabling he less scrupulous and more psychopahically inclined individuals o hrive in his new environmen.

Summary and Conclusions is brie synopsis o key changes indicaes ha he proessional financial environmen has been ransormed rom he more relaional, personally conneced milieu ha exised or many cenuries. e enhanced speed wih which inormaion is delivered globally and ingesed ino rading sraegies ha are carried ou in nanoseconds has shifed he ages-old objecive o maximizing reurns ino a pure numbers game. Individuals seeking o maximize reurns or hemselves or heir firm, regardless o wha happens o oher paricipans, can inflic more damage (wheher inenional or no) o a wider swah o global economies, in a shorer ime han previously. is environmen offers abundan opporuniies or financial psychopahs o be successul. Addiionally, he possibiliy exiss o hiding a disrupive inernal psyche srucure behind a açade o polished respecabiliy and social decorum, which makes exposing and prosecuing financial psychopahs more difficul. e power ha accompanies conrol o large sums o money urher exacerbaes his problem. e wo poenial financial psychopahs idenified earlier, Madoff and Farkus, differ grealy rom he Hollywood depicions o Baeman and Belor, boh o whom have been held up as Wall Sree psychopahs. Boh Madoff and Farkus escaped public deecion and prosecuion or years. e impac o heir financial misdoings affeced a much wider range o people in all walks o lie. Only hrough chance coincidences was eiher discovered. Had hey been able o coninue, he damage would have been even greaer.

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Despie now being able o clearly differeniae a financial psychopah, he problem remains ha any ype o passive psychopah uncions in sociey in such a way as o avoid prosecuion. arely are he more insidious psychopahs caugh and prosecued. Insead, less powerul and influenial individuals in he financial secor, many o whom are no psychopahic and are no personally responsible or he mos egregious financial crimes, bear he brun o any invesigaion and ace prosecuion.

DISCUSSION QUESTIONS 1. Ideniy he disinguishing characerisics o a radiional psychopah. 2. Explain how radiional and financial psychopahs differ. 3. Discuss he key changes in he economic and financial environmen ha aciliaed an increase in he psychopahic-like behavior exhibied by financial proessionals. 4. Explain why correcly ideniying financial psychopahs is imporan.

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Simon, ober I. 2008. Bad Men Do Wha Good Men Dream: A Forensic Psychiaris Illuminaes he Darker Side o Human Behavior. Washingon, DC: American Psychiaric Publishing. Smih, ober J. 1978. Te Psychopah in Sociey. New York: Academic Press. Smih, Sevens S., and Joseph P. Newman. 1990. “Alcohol and Drug AbuseDependence Disorders in Psychopahic and Nonpsychopahic Criminal Offenders.”Journal o Abnormal Psychology 99:4, 430–439. Sou, Marha. 2005. Te Sociopah Nex Door.New York: ree ivers Press. ompson, Nick. 2011. “e World’s Bigges ogue raders in ecen Hisory.” CNN, Sepember 15. Available ahtp://ediion.cnn.com/2011/BUSINESS/09/15/unauhorized.rades/. Wol o Wall Sree.2013. Marin Scorsese (Direcor). Paramoun Picures, [DVD]. Wynn, ol, Maria H. Høiseh, and Gunn Paterson. 2012. “Psychopahy in Women: eoreical and Clinical Perspecives.”Inernaional Journal o Women’s Healh 4, 257–263.

17

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FINANCIAL AND INVESTOR PSYCHOLOGY OF SPECIFIC PLAYERS

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10 The Psychology of High Net Worth Individuals REBECCA LI-

HUANG Wealth Advisor

Introduction is chaper explores he economic and psychological aspecs o privae wealh and he pracice o wealh managemen rom a holisic perspecive. I ocuses on he invesor psychology and invesmen behavior o individuals or households wih more han $1 million in invesable asses, commonly known as high ne worh individuals(HNWIs). HNWIs, or simply he wealhy, consiue 0.7 percen o he world’s adul populaion, bu hey own 45.2 percen o global wealh, as o 2015. e wealhy also conrol mos o he world’s power. According o Pikety (2014, p. 277), he op percenile o wealh holders occupies a very prominen place in any sociey and “srucures he economic and poliical landscape.” Deaon (2013, p. 212) observes ha “he rapid growh in op incomes can become sel-reinorcing hrough he poliical process ha money can bring.” Sigliz (2015, p. 91) describes he poliical landscape in he Unied Saes as “wealh beges power, which beges more wealh.” egardless o ideological persuasions and poliical moivaions, observers and sakeholders agree ha he curren economic sysem avors he op income earners and wealh holders. is chaper highlighs he classical economic rameworks o wealh creaion. I also examines recen sudies and empirical findings on wealh accumulaion and disribuion ha have increased he policy debae. e disribuion o income and wealh is widely discussed globally and has increasingly become poliically charged and parisan in policy debae in he Unied Saes, where average wealh has increased bu no equally over he pas 50 years. A saemen such as “he op 1 percen o Americans own 40 percen o he naion’s wealh” is in sark conras o “he botom 80 percen own only 7 percen” and he phrase “he disappearing middle class.” e global rend is similar in ha he share o income and wealh going o hose a he very op has risen sharply over he las generaion, marking a reurn o a patern ha prevailed beore World War I. e world’s op 1 percen o wealh holders now owns hal o all household wealh (Credi Suisse 2015). HNWIs have varied psychological and behavioral responses o he inequiy debae and ani-rich rheoric among populiss. In he Unied Saes, HNWIs increasingly direc heir invesmen according o heir personal belies or amily values, and hey play a 173

174

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NVESTOR PSYCHOLOGY OF SPECIFIC PLA

YERS

large role in public lie hrough philanhropy and poliics. A 1.4 percen o gross domesic produc (GDP), “ax breaks wih a social purpose” are he larges in he Unied Saes where privae spending on social welare is our imes he average in advanced economies (Organizaion or Economic Cooperaion and Developmen 2014). A he pinnacle o he wealh pyramid, billionaires Bill Gaes, Warren Buffet, and Mark Zuckerberg pledge he majoriy o heir wealh o ax-advanaged chariable eniies ounded, unded, and direced by hemselves or heir represenaives. ey urge heir cohors o inves heir wealh in public good in heir own visions, such as “advancing human poenial and promoing equaliy” advocaed by Zuckerberg, no ha o he governmens. A he oher end o ideological specrum, sel-claimed billionaire and poliical ousider Donald rump runs he mos powerul governmen. Ironically, rump’s promise o use his own privae wealh o acquire poliical power has become par o he populis appeal o his economically disadvanaged supporers. Despie he debae ha philanhropy and poliical acivism boh serve o reurn ye more power o he super-wealhy, driving social impac holds broad appeal or a cross-secion o HNWIs globally, who are increasingly ocused on leaving a legacy by giving back o sociey, as well as generaing a financial reurn on invesmen. e holisic reurns on culural, environmenal, social, and poliical causes are gaining imporance in wealh managemen. e rend oward helping HNWIs address heir personal aspiraions and social- impac needs is par o a broader wealh managemen indusry ransiion oward giving holisic wealh advice. HNWIs are prone o behavioral biases and judgmen errors in decision-making processes. eir behaviors and atiudes oward he uure canno be encapsulaed in a single, inexorable psychological parameer. e luck o inheried wealh (or some) aside, HNWIs have no all won he evoluionary lotery in possessing he geneic rais o he perecly raional, uiliy-maximizing, unemoional Homo economicus, which is he economic behavioral role model or Homo sapiens. Even hough case sudies and legends abound or enrepreneurs and invesors who become sel-made millionaires or billionaires by exploiing heir ellow human’s “irraionaliies” and marke inefficiencies, HNWIs are humans wih biases, no a homogenous group o raional agens as prescribed by radiional economic model. esearch in behavioral finance has uncovered a lenghy lis o psychological biases, bu offers ew ools or invesors o correc he persisen errors in heir invesmen decision-making process. An age-old sraegy o overcome cogniive illusions and biases is o avoid he grouphink. Wealh managers add value by bringing objecive bu goal-based inpus o he decision-making process. HNWIs are inundaed wih choices in every decision hey make, rom consumpion and invesmen o privae and public wealh as sakeholders and policy makers, o amily lie and social impac as privae and global ciizens. eir decision choices or any given goal, in he pursui o wealh, healh, and happiness, depend on personal moivaions and saisacions, amily expecaions and limiaions, peer influences, and he social, culural, and insiuional environmen. Financial invesmen is bu one componen in he “well-lived lie” porolios and is imporance varies depending on he lie sages o HNWIs. Invesmen in publicly raded securiies as consumer o financial producs is no he primary conribuor o iniial wealh accumulaion or mos HNWIs. Sanley (2001) reveals ha only abou one in eigh millionaires indicaed ha “invesing in he equiies o public corporaions” was a very imporan acor in explaining heir economic success. Many HNWIs are successul in heir own fields o experise, bu ew

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can disinguish luck rom skills in invesing in public financial markes. Chhabra (2015) finds ha concenraion and leverage are ofen he building blocks o subsanial privae wealh. Neverheless, invesmen in diversified markes and ax-efficien sraegies are essenial or HNWIs o preserve and generae income rom wealh. Since hese invesors experienced he brun o he financial crisis o 2007–2008 and oher marke “ailures,” HNWIs’ needs or a ull specrum o wealh managemen services have grown. Wealh managers increasingly ocus on HNWI behaviors, and hey ranslae he significance o curren evens in erms o cliens’ needs and goals. Wih a behavioral ocus, wealh managemen pracice is ransiioning rom porolios and markes o individuals and objecives, and rom producs and ransacions o advice and relaionships. Wih compeiion rom echnology-based new enrans, no only ransacions bu also basic asse allocaion and invesmen services are becoming increasingly commodiized. Wealh managers adap o he new landscape by ocusing on he human aspec o he advisory relaionship and reoriening heir role oward delivering goals- based financial planning and addressing HNWIs’ holisic invesing needs. Many anecdoes and much lieraure are available wih examples o specacular financial ruin as he resul o poor invesmens or conspicuous consumpions on an individual level. Ye, on a collecive and long-erm basis, HNWIs are he mos successul in boh preserving and growing heir numbers and oal wealh in absolue and relaive erms, especially in he counries and regions wih he highes economic growh in recen decades. As Pikety (2014) shows, he rae o reurn o capial has oupaced he rae o economic growh, and he rae o reurn is persisenly higher or he HNWIs han ha or he less wealhy. He credis he concenraion o wealh and he service o privae wealh managers as he primary sources o he ouperormance or HNWI. Economic policies coninue o shape he global wealh landscape. Asse allocaion and human capial invesmen are he mos imporan long-erm acors deermining overall invesmen reurns and wealh accumulaions. Led by he Unied Saes and now China, global rade and economic growh have been he main orces in creaing, and o some exen reshuffling, he wealhy class in he weny-firs cenury. In he Unied Saes, moneary policy se by he Federal eserve and he ax code by Congress direcly affec financial asse prices and real incomes, especially hose o HNWIs and corporaions, and hey implicily projec he oulook or economic oupu, rae o reurn on invesmen, and income and wealh disribuion. o he exen ha he wealh o HNWIs and corporae profis are inerwined, and he size o wealh correlaes wih he power o influence policy, he collecive invesmen behavior o HNWIs resembles ha o corporaions and insiuional invesors more han ha o reail invesors. As a case in poin, HNWIs wih insiuional-size wealh are “acivis” invesors whose invesmen decisions move he price and affec he reurn o publicly raded securiies (Cohan 2013). e invesor psychology o an acivis invesor who has “skin in he game” and aces known risks is by insiuional design more orward-looking, calculaing, and profi-maximizing han ha o a price-aking individual invesor who aces uncerainies. e beneficial ax reamen and legal srucure o limied liabiliy corporaions urher insulae HNWIs rom individual behavioral biases such as risk aversion. HNWIs someimes exhibi invesmen behavior ha is more raional han ha o corporaions or organizaions managed by agens wih disored incenives. Examples are Warren Buffet’s “voe o confidence” invesmen in Goldman Sachs and HNW privae

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invesors’ cash buying o bank-owned properies amid he widespread oreclosures beween 2008 and 2010. e firs secion o his chaper defines HNWI and inroduces he players and markes o he privae wealh managemen indusry. Drawing on he indusry’s HNWI and wealh manager surveys, as well as empirical research, he nex secion idenifies he rends relaed o HNWI atiudes and invesmen behaviors, shifing demographics o privae wealh, and evolving expecaions and needs o HNWIs. e nex secion hen highlighs relevan behavioral finance research and applicaions o lay a oundaion or he holisic invesing and goal-based wealh managemen pracice rend. Wih he hird secion, he chaper akes an economic view o behavior and wealh by presening he macro acors ha affec HNW invesor behavior on a long-erm and aggregaed basis. e ourh secion presens he heoreical ramework and empirical findings o economic researchers o differen hisorical imes and ideological persuasions, and he final secion summarizes and concludes he chaper.

The World of HNWI and Wealth Management Wealh has varied connoaions and subexs in social, economic, poliical, and hisorical conexs. As a source o finance or uure consumpion, wealh is one o he key componens o he economic sysem. e wealh managemen indusry is primarily concerned wih he financial asses o wealhy individuals and households. WEALTH AND HNWI DEFINED

Alhough wealh has various definiions, one involves ne worh. As defined in he World Wealh epor (Gapgemini Consuling and BC Wealh Managemen 2015), ne worh is synonymous wih invesable asses excluding one’s primary residence, collecibles, consumables, and consumer durables. High ne worh (HNW) reers o an individual or household wih more han $1 million in invesable asses. However, some privae banks use a higher ne worh hreshold o denoe HNWIs. Also, depending on he marke segmenaion o a wealh manager or surveyor, he ulra-high ne worh (UHNW) designaion usually reers o ne worh above $30 million. When accouning or illiquid and nonmarkeable asses such as real esae and land, physical commodiies, ar and collecibles, business ownerships and parnership ineress, a HNWI’s oal wealh is ofen higher han ne worh. On a global basis, having $1 million ne worh pus an individual in he op 1 percen, as HNWIs accoun or 0.7 percen o world’s adul populaion. In he Unied Saes, being in he op 1 percen club akes $380,000 annual income (Dewan and Gebeloff 2012) or $8.4 million ne worh (Gebeloff and Dewan 2012) o qualiy, according o a 2012 demographic profile o he op earners and wealh holders by he New York imes. Income and wealh are differen measures, bu hey ofen go hand in hand. e U.S. ax code is more avorable or invesmen income han or wages, especially or hose already a or near he op a eiher caegory. Alhough he op earners (based on census daa) and op wealh holders (based on Federal eserve daa) are no exacly he same group o people, Dewan and Gebeloff repor ha he

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wo measures overlap by hal, and “mos 1 perceners were born wih socioeconomic advanages.” In conras o he op 1 percen, hose wih a ne worh beween $1 and $5 million are considered enry-level HNWIs in he Unied Saes and are ofen reerred as he “millionaires nex door.” Wih daa spanning 20 years rom he 1970s, Sanley and Danko (1996) conend ha wealh accumulaion is more ofen he resul o a liesyle o planning, perseverance, discipline, and hard work, insead o consumpion, inheriance, advanced degrees, or even high inelligence. Wealh earned hrough enrepreneurship and hard work, no hrough inheriance or arisocracy, is a he core o he American ideal o dynamic capialism. Paradoxically, China’s HNWIs oday, a group almos enirely sel-made, fi he characerisics describing heir American counerpars wo decades earlier. Alhough he commonsensical rule o wealh accumulaion does no change undamenally in he “new economy,” social media algorihms exacerbae human cogniive biases rom he sel-selecion o “likes” and he like-minded o he sysemic overexposure o ouliers. WEALTH MANAGEMENT: PLA

YERS AND M

ARKETS

Wealh managemen is a relaionship beween an advisor and an individual or household. A financial advisor is he general ile or he proession, whereas a wealh manager or privae banker is ofen someone who works exclusively wih HNWIs or UHNWIs. Wealh managers are also broadly defined as financial insiuions serving HNWIs wih banking, invesmen, lending, and oher financial services. In Wesern Europe, wealh managers are commonly known as privae banks and ake he orm o onshore bouiques, onshore universal banks, or offshore banks. Privae banks generally observe muli-jurisdicional fiscal rules. Hisorically dominaed by Swiss banks, offshore banks offer secrecy, low-ax jurisdicion, and proecion agains poliical insabiliies. wo prominen jurisdicions or offshore banking are Swizerland and he Cayman Islands. Saring in 2007, Swizerland los is “ax haven” and secrecy appeal o wealhy U.S. axpayers as a resul o he enorcemen o he Inernal evenue Service (IS) rules or offshore asses o U.S. ciizens held a Swiss banks. Paradoxically, a ew saes in he Unied Saes are becoming offshore jurisdicions or he privae wealh o non-U.S. residens who seek secrecy and poliical sabiliy (Drucker 2016). In Asia, privae wealh managemen is exremely ragmened, combining offshore privae banking hubs in Hong Kong and Singapore wih differen sizes o onshore markes. Asian HNWIs have a relaively srong risk appeie or alernaive and offshore asses, as shown by he surge in cross-border real-esae invesmens made by wealhy Chinese. In response o he upswing in new wealh paricularly rom China and India, he ex-Japan Asia marke is growing rapidly, while he new Chinese onshore marke alone is expeced o accoun or more han hal o all growh in ex-Japan Asia. Wih high saving raes, wealh managemen in China is sill largely a produc-driven marke spurred by he prolieraion o bank wealh managemen producs offered by large saeconrolled banks. Myriad shadow banks are filling he wealh managemen demand gap and becoming a source o privae lending and unregulaed invesmen vehicles in China. In he Unied Saes, wealh managers are well regulaed and have a variey o business models including ull-service broker-dealers (wirehouses), independen broker-dealers

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(IBDs), independen egisered Invesmen Advisers (IAs), privae banking, and muli-amily offices (MFOs). Broker-dealers cover he broades clien base and are regulaed by Financial Indusry egulaory Auhoriy (FINR). e larges naional broker-dealers are inegraed wih an invesmen bank or commercial bank or boh, and offer a large variey o services, such as research, invesmen advice, order execuion, reiremen planning, and lending. Financial advisors employed by or affiliaed wih broker-dealers serve he mass-marke affluen (i.e., hose wih invesable asses beween $250,000 and $1 million) o HNW cliens. ey are compensaed on a ee basis (by a percenage o clien asses under managemen, or AUM) or commission basis (by ransacions). Financial advisors are ofen licensed wih relevan sae regulaors o sell insurance producs such as viable lie and annuiies, and long-erm care insurance. IAs offer invesmen advice on a ee-only basis and are regulaed by he Securiies and Exchange Commission (SEC) or relevan saes. In he IA model, clien asses are “held away” wih a hird-pary cusodian ha ofen offers is own discoun brokerage and invesmen services o do-i-yoursel cliens. Alhough many independen financial advisors ocus on insurance producs wih invesmen componens such as variable lie and annuiies, and provide financial planning o less affluen cliens, some invesmen advisors specialize in managing porolios o securiies or HNWIs and insiuional cliens. Since he financial crisis o 2007–2008, IAs have gained marke share in boh he number o praciioners and clien AUM. Privae banks in he Unied Saes usually operae as he privae wealh managemen subsidiaries o inegraed universal banks, as independen rus companies, or as MFOs. Privae banks ypically offer a ull range o services, including invesmen, amily office, wealh srucuring, and rus and philanhropy services o HNWIs wih invesable asses o more han $5 million. By conras, some bouiques caer exclusively o privae oundaions or UHNWIs wih invesable asses o more han $30 million. e privae bank model emphasizes personalized long-erm relaionships beween he relaionship manager (i.e., he privae banker or clien advisor) and he clien. Clien invesmen porolios are generally managed on a discreionary basis based on clien-specific invesmen policies developed by a eam o specialiss, including porolio managers and rus officers. Privae banking relaionships ofen las or decades and cover several generaions. A muli-amily office (MFO) is a commercial enerprise ha ypically caers o UHNWIs wih a ne worh above $50 million. MFOs provide various amily office services, including invesmen, ax, rus, esae planning, and oundaion managemen. Some MFOs offer liesyle and personal services such as concierge and household saff managemen. In he Unied Saes, MFOs can operae as IAs, rus companies, accouning or law firms, or oher combinaions depending on heir niches. GLOBAL HNWI AND WEALTH TREND

Since 2005, subsanial growh has occurred in he number o HNWIs and oal wealh. Gapgemini Consuling and BC Wealh Managemen (2015) provide he ollowing saisics abou HNWIs and oal wealh. Global HNWI wealh is orecas o cross $70 rillion by 2017, growing a an annualized rae o 7.7 percen rom he end o 2014 hrough 2017. Wealh is concenraed in a similar patern a he op among

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HNWIs: UHNWIs hose wih more han $30 million o invesable asses make up only 1 percen o all HNWIs, bu accoun or roughly 35 percen o HNWI wealh. UHNWIs are also major drivers o global wealh growh, as wealh has been growing a higher raes wih higher concenraion. Geographically, Asia-Pacific and Norh America drive he majoriy o growh. In 2015, Asia-Pacific overook Norh America o become he region wih he larges HNWI populaion a 4.69 million, compared o Norh America’s 4.68 million. e op our HNWI markes he Unied Saes, Japan, Germany, and China accoun or he majoriy (60.3 percen) o global HNWI populaion and also generae he majoriy (67 percen) o growh in 2014, wih he greaes increase occurring in China (17 percen) and he Unied Saes (9 percen). ogeher, he Unied Saes and China drive more han hal he global HNWI populaion growh. e wo mos populous counries wih high economic growh raes, China and India, are expeced o be he bigges engines o drive global HNWI growh during he nex ew years. CHANGING NEEDS OF HNWIs

HNWIs have complex financial needs and hey do no all wan o be involved in he daily managemen o heir invesmens. Insead o an invesmen produc, a new generaion o HNWIs oday wans a higher level o advisory experience and a relaionship wih heir wealh managers ha ocuses on heir concerns, goals, and dreams. e advice required by HNWIs oday is more comprehensive han he ransacional and produccenric relaionship ha was prevalen decades ago, when financial advisors were synonymous wih sock brokers. CHANGING LANDSCAPE OF WEALTH MANAGEMENT

Many orces are changing he wealh managemen landscape. ese include more diverse cliens wih more complex needs, new echnology- based advisory service enrans, increasing regulaions, and evolving global markes; and hese are jus he ip o he iceberg. As basic asse allocaion, invesmen advisory, and risk-profiling services become commodiized, he value proposiion o wealh managers is ransiioning rom securiy selecion and invesmen managemen o goals- based financial planning and a holisic wealh managemen model characerized by personal relaionships and cusomized advice. HNWIs are offered inegraed financial planning and wealh managemen advice and soluions encompassing invesmen, lending, ax and esae planning, insurance, philanhropy, and succession planning, boh or businesses and or personal wealh. Goals-based wealh managemen wih holisic invesing has now become an indusry sandard, paricularly among younger HNWIs. Goals-based wealh managemen differs rom radiional wealh managemen by aking ino accoun he shor, inermediae, and long-erm personal heme o HNWIs and helping hem prioriize heir goals holisically. Success is measured by how cliens are progressing oward heir personalized goals agains he broad range o needs and concerns versus he radiional approach o measuring perormance based on relaive reurns agains benchmark marke indices.

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One imporan heme o holisic invesing is philanhropy. Alhough ax and esae incenives are inegral o philanhropic planning, he majoriy o HNWIs express he desire o drive social impac and give back o sociey as par o a holisic lie goal. According o Gapgemini Consuling and BC Wealh Managemen (2015), 92 percen o HNWIs ideniy some level o imporance o driving social impac, which reers o making a posiive impac on sociey by way o houghul invesmens o ime, money, or experise. HNWIs are looking o heir wealh managers or suppor and advice, such as seting goals and defining heir personal role in heir areas o ineres, ideniying and srucuring invesmens, and measuring he oucomes o heir social impac effors. Wealh managers respond o hese needs by providing access o a eam o expers such as ax and philanhropy specialiss, and educaing heir cliens wih seminars and discussions, which in urn drive markeing and prospecing opporuniies or he sponsoring wealh managers. Cash and credi are wo major hemes relaed o HNWI asse allocaion behavior (Gapgemini Consuling and BC Wealh Managemen 2015). egional and demographic differences in risk atiudes aside, overall HNWIs keep larger amouns o cash in heir invesmen porolios han wha are opimal or heir liesyle needs and risk profiles. Ye, HNWIs are more inclined han he less wealhy invesors o use credi or leverage. Nearly one-fifh o HNWIs globally use leverage, and 60 percen consider i a key crierion in choosing a wealh manager. Younger, wealhier, and emerging markes HNWIs he demographic groups wih he highes growh rae ofen have he greaes ineres in using leverage. VALUE OF WE

ALTH MANAGEMENT ADVICE

An open quesion is wheher and o wha exen financial advisors add value. esearchers have produced mixed findings on he reail side ha cover smaller invesors. A sudy by Foerser, Linnainmaa, Melzer, and Previero (2014) o 800,000 Canadian reail invesors finds ha financial advisors end o encourage reail invesors o accep more risk, which in urn increases invesors’ earning expecaions. Alhough his increase in risk may raise yield, he exra yield ends o be offse by he 2.5 percen in ees ha cliens pay o heir advisors. Beyond risk, he sudy finds ha advisors’ sock picking and marke iming have no impac on reurns. Neverheless, as Foerser e al. (p. 5) noe, “households display a srong revealed preerence or using financial advisors, which suggess ha many expec he benefis o ouweigh he coss.” e auhors posi ha financial advisors add value by miigaing psychological coss, such as reducing anxiey raher han improving invesmen perormance, and cliens benefi rom heir relaionship wih he advisor, specifically hrough financial planning and advice on savings and asse allocaion. On a higher wealh level, he majoriy o HNWIs are saisfied wih heir financial advisors. According o Gapgemini Consuling and BC Wealh Managemen (2015), HNWIs are mosly saisfied wih he service hey receive rom heir wealh managers, giving hem a saisacion raing o 72.5 percen globally. No surprisingly, HNWIs

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who have been wih heir primary wealh managers or he longes ime period (a leas 21 years) are he mos saisfied, regisering a saisacion raing o 84.3 percen. egionally, HNWIs in Norh America are he mos saisfied (82.1 percen), ollowed by hose in Lain America (75.6 percen) and Asia-Pacific excluding Japan (72.7 percen). Among HNWIs who place high imporance on heir wealh needs, he average saisacion level wih he abiliy o wealh managers o ulfill hese needs is 86.4 percen. o earn heir HNW cliens’ saisacion, wealh managers mus undersand HNWI concerns and risk olerance, deliver srong invesmen perormance, and provide ee ransparency. A U.S. survey o HNWIs reveals overall saisacion consisen wih ha ound by Gapgemini Consuling and BC Wealh Managemen (2015). e Specrem Group (2015) repors he level o saisacion varies by occupaion: 86 percen o senior corporae execuives and 74 percen o business owners are saisfied wih heir advisors. egarding ees, 55 percen o HNWIs are comorable wih he ees hey are paying o heir advisors. In ac, 33 percen o HNWIs are unconcerned abou he ees hey are paying as long as heir asses are growing. Why are HNW invesors more saisfied wih heir wealh managers han reail or he less wealhy invesors are wih heir financial advisors? e size o he wealh explains mos, i no all o he difference. Firs, HNWIs pay lower ees as a percenage o AUM because o managemen-ee break poins. Oher han alernaive invesmens such as hedge unds or privae equiy, a $1 million or higher managed accoun is rarely charged a ee o 2.5 percen by regulaed wealh managers in he Unied Saes, hanks o he prevailing compeiion. Excep or he hourly ee–based financial planners, he vas majoriy o wealh managers are no direcly compensaed or hours worked; larger accouns are generally more profiable or he same amoun o rouine work. Second, HNWIs receive higher-qualiy service because ee-based compensaion ies wealh managers’ incenives wih ha o heir cliens o grow asses. Wealh concenraion in ewer accouns creaes economies o scale ha improve he overall produciviy o wealh managers, whose higher service oupu measured qualiaively is refleced in he higher saisacion rae rom heir HNWI cliens. Are wealhy invesors more saisfied because hey ge higher reurns? Surprisingly, invesmen perormance is no he op prioriy, bu is raed hird in HNWI overall saisacion raings (Gapgemini Consuling and BC Wealh Managemen 2015). Does wealh concenraion increase he rae o reurn on wealh? Financial marke paricipans cones any definiive answer o his quesion. Pikety (2014) finds ha wealhier invesors obain higher average reurns on heir capial han less wealhy invesors, despie convenional economic models ha assume he reurn on capial is he same or all owners, regardless o he size o he wealh. Ideological debae nowihsanding, he primary reason behind he long-erm higher reurn is ha he wealhy have greaer means o employ wealh managemen consulans and financial advisors, no because hey ake more risks. Evidence by Pikety shows he firs explanaion “more imporan in pracice” han he second. Wealh managers hardly expec an unsolicied endorsemen rom an economis, much less a proponen o global ax on wealh. Ye, many HNW cliens do expec ax and esae planning advice i Pikety’s findings promp governmen inervenions hrough progressive axaion and oher wealh disribuional measures. As Pikety

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(2014, p. 294) noes, “Europe in 1914–1945 winessed he suicide o renier sociey, bu nohing o he sor occurred in he Unied Saes.” eniers are hose who live off income rom propery raher han labor.ey do no ge good press in coninenal Europe, where he members o a “renier sociey” are regarded disapprovingly as propery owners who “do nohing” o creae value or sociey o earn heir profis ren, in economic erms. In he Unied Saes, however, o live off one’s own saving and wealh regardless o he solvency o a governmen sponsored social saey ne is exacly wha reiremen planning is all abou. No only is privae propery ownership revered bu earnings rom invesmens are generally axeda lower effecive raes han wages. e complexiy o ax code urher advanages hose who employ proessional services o plan and prepare heir ax reurns. Specifically, Scheiber and Cohen (2015) find ha he wealhies Americans “pay millions” or such services o devise sophisicaed ax sraegies o “save billions.” Unless mandaed by cliens, wealh managers do no discriminae agains wealh by ideology. Based on Pikety’s (2014) observaions, wealh managers have done well by heir HNW cliens, especially in he Unied Saes. Benjamin Franklin’s amous wo cerainies in lie deah and axes subsanially affec privae wealh and are proessionally managed or many HNWIs hrough ax and esae planning.

Behavioral Themes Behavioral economics has gained relevance as a field seeking o explain and predic invesmen and consumpion behavior. Behavioral economiss observe ha humans, when lef o heir naural devices, are no good a making opimal decisions as prescribed by radiional economic models. is secion covers represenaive hemes o HNWI invesmen behavior. TRADITIONAL VS. BEHAVIORAL FINANCE

e radiional finance model, drasically simplified, is based on he exisence o a perec marke or capial, in which each owner o capial receives a reurn equal on he highes marginal produciviy available in he economy. On invesor psychology and behavior, he sandard raional-choice model assumes ha invesors are compleely raional, emoionless, sel-ineres maximizers o expeced uiliy wih sable preerences. Furhermore, i assumes ha invesors are a homogenous group wih idenical inormaion ses and expecaions. In conras, behavioral finance recognizes real human behaviors and ocuses on cogniive biases and heurisics. In a behavioral model, real-world invesors make decisions based on a raionaliy bounded by personal values and preerences. ey also selec saisacory opions raher han opimal ones, and hey have emoions. Behavioral finance combines psychology wih financial heory o undersand he inerplay beween markes and human emoions, personaliy and reason. Complee coverage o he cogniive biases and heurisics recognized by behavioral finance requires more han a book. However, his subsecion selecively describes he mos relevan eaures or HNWI invesmen behavior and he wealh managemen advisory relaionship.

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THE EMOTIONAL INVESTORS

Invesors are affeced by psychological biases and are subjec o conscious emoions in heir decision making. Psychologiss observe physiological and psychological sympoms ha poin o varying levels o sress during he decision-making process. Mann, Janis, and Chaplin (1969) observe marked increases in sress, as indicaed by a sharp increase in hear rae when a decision maker is required o choose beween alernaives, boh o which are known o have some unpleasan consequences. Janis and Mann (1977) find ha he inensiy o ha sress depends upon he perceived magniude o loss he decision maker anicipaes. e sress is a pahological acor or a human being’s loss aversion he endency o weigh poenial loss more heavily han poenial gain as diagnosed by behavioral economiss. Financial markes are vasly more complex han a conrolled experimen. Invesors’ decisions under any marke condiions are seldom limied o wo alernaives wih known risks. Invesors ofen deviae rom long-erm objecives and rom making opimal invesmen decisions when hey encouner flucuaions along he invesmen journey, especially during periods o marke exuberance or urmoil. ey leave large porions o wealh in “sae” insrumens such as cash during a bear marke, are overconfiden and overacive during a bull marke, and ineviably capiulae o a srong psychological endency o buy high and sell low. Alhough many invesors can recie he basic rules o invesing, among which “o be earul when ohers are greedy and greedy only when ohers are earul” (Buffet 2005), ew could implemen his advice i lef o heir own devices. Buffet capured he phenomenon amid he marke urmoil in 2008: “So wild hings happen in he markes. And he markes have no goten more raional over he years. ey’ve become more ollowed. Bu when people panic, when ears ake over, or when greed akes over, people reac jus as irraionally as hey have in he pas.” e irraionaliy resuls because human beings, programmed as hey are wih emoions and unconscious moives, as well as limied cogniive abiliies, seldom can approximae a sae o emoional deachmen when making invesmen decisions. Much anxiey arises rom emoional responses independen o risk. Invesmen decision making has emoional coss ha sandard invesmen risk-reurn analysis does no ake ino accoun. e empirical evidence suggess ha invesors’ need or emoional comor coss he average invesor around 3 percenage poin a year in los invesmen reurn (Barclays 2015) and wo-hirds o oal reurn in comparison wih a marke index or he 30-year period beween 1984 and 2013 (Chhabra 2015). e addiional cos o sress is a loss o ime, produciviy, and lie qualiy. ecen research in behavior finance challenges he radiional assumpion ha invesors wan he bes risk-adjused reurns. According o hose findings, wha invesors really wan is he bes reurns hey can achieve or he level o sress hey have o experience. Barclays (2015) finds ha acual invesor reurns are improved by ocusing on achieving he bes anxiey-adjused reurns, which are he bes possible reurns relaive o he anxiey, discomor, and sress hey have o endure during he volaile invesmen journey. Unlike he emoionless Homo economicus, invesors especially HNWIs pracice “emoional inoculaion” by ousourcing he par o he invesmen decisionmaking process ha induces sress. is explains why some successul wealh managemen advisors characerize heir value o heir HNW cliens as modeled afer psychologiss

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and herapiss, and his is also why he low-ee emoionless echnology-driven roboadvisors have no replaced (and unlikely will ully replace) human advisors. HUMAN VS. ROBO-

ADVISORS

Among he major disrupors o he wealh managemen indusry are auomaed advisory services, commonly reerred as virual advisors or robo-advisors, which eschew personalized advice in avor o algorihm-based asse allocaion and basic invesmens in low-ee index and exchange-raded unds (EFs). obo-advisors ap ino he growing prominence o digial and sel-service ools, which are o paricular ineres o younger or less wealhy individuals who are atraced o he convenience and low cos. Human advisors are skepical o heir virual compeiors, noing ha robo-advisors orgo he personal relaionships ha enable wealh managers o build rus and deliver ailored advice and soluions. Alhough he value o robo-advisors has ye o be esed in a ull marke cycle, auomaed advisory services do no appear o be a passing rend and HNWI ineres in hem has been underesimaed. Globally, 48.6 percen o HNWIs say hey would consider using hem, compared o only 20 percen o wealh managers who hink HNWIs would consider using hem. e HNWI propensiy o use an auomaed service is paricularly high in Asia-Pacific (excluding Japan) and Lain America, whereas ineres is lowes in Norh America (Specrem Group 2015). Why does his difference occur? In he Unied Saes, online invesmen services are no ye buil o address he deph and variey o financial planning needs and concerns o invesors who have a air undersanding o he relaive value o human vs. roboadvisors. Among he 6 percen o invesors o he abovemenioned 20 percen who do use robo-advisors, only 47 percen say hey are saisfied overall wih hese virual advisors. In conras, he 90 percen o invesors who use a human advisor repor an 85 percen saisacion rae (Specrem Group 2015). TRUST HEURISTIC

Heurisics are decision-making shorcus ha save ime and money in a world o uncerainy. Invesors employ herus heurisic in heir invesmen decision-making process. For example, hey assume ha porolio managers are relaively beter inormed in a world o complex and ofen misleading inormaion. Emoional and inuiive variables affec he rus heurisic (Alman 2014). According o he Specrem Group (2015) survey o U.S. HNWI and wealh managers, HNWIs pu higher rus han he less wealhy reail invesors in heir financial advisors. Insead o pas invesmen perormance or sandard proessional credenials, honesy and rusworhiness are he primary acors ha HNWIs consider when selecing new financial advisors. is does no sugges ha proessional credenials and compeence do no mater in hese invesors’ minds. In ac, he perormance, capabiliies, and repuaions o he wealh managemen firms and hose o he individual financial advisors are he necessary bu no sufficien parameers in he iniial advisory relaionship selecion process. Consrained by limied ime and resources or due diligence, invesors employ he rus heurisic, assuming ha he caegory leaders are among he fites in a highly regulaed and compeiive marke, and ha he advisors reerred by amily members or riends and acquainances are among

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he bes available o hem. Indeed, reerral is by ar he mos common source o new relaionships in he wealh managemen indusry. Aside rom sandard quaniaive perormance measures, rus is he main qualiaive measure in a wealh managemen relaionship ha can survive he sebacks in invesmen perormance or marke downurns. HNWIs use proxies or rusworhiness, defining rus as a financial advisor’s looking ou or cliens’ bes ineress, being proacive in conacing cliens o inorm imporan developmens, charging reasonable ees ha reflec he value o he services provided, making no misakes in he work hey perorm, and admiting when hey are wrong. e HNWI’s rus in a financial advisor ends o increase wih age. Alhough he size o he wealh is no a major acor in how HNWI invesors define rus as i relaes o working wih a financial advisor, here are marked differences by occupaion. Business owners are he mos likely o define rus as misake-ree work, whereas corporae execuives are mos likely o define i as an advisor’s looking ou or heir bes ineress (Specrem Group 2015). INVESTOR PSYCHOLOGY: NUDGE OR PREDICT?

Invesor psychology is an emerging field ha uses he psychology field o undersand how invesors make decisions. Devoees o he raional ideology o radiional finance criicize invesor psychology or merely exploring abnormaliy and biases, bu ailing o deliver robus ools or “cures” o improve invesmen decision making en masse. Psychologiss find ha he assumpions abou human behavior, including perec raionaliy and homogeneiy, are alse. In essence, he conflic beween behavioral and radiional finance is misplaced. Each has a differen approach and has differen accomplishmens in sudying human behavior: behavioral finance proponens use an evidence-based approach o observe and “nudge,” whereas radiional finance advocaes apply normaive models o predic. ealiy emerges rom he ineracions o many differen agens and orces, including blind luck, ofen producing large and unpredicable oucomes (elock 2006). Like weaher orecass during a Norheas U.S. winer, normaive finance models are no always accurae bu are relied on or guidance; or example, hey help an Uber driver decide wheher o work, or a hardware sore manager how many snow shovels o sock. In conras, he behavioral analysis can help a ski resor price is season ickes regardless o snowall oucome, and i explains why neiher he Uber driver nor he hardware sore should raise prices during a sorm based simply on he undamenal supply-anddemand principle (aler 2015). All invesmen decisions are orward-looking. e idea ha he uure is unpredicable is undermined every day by he ease w ih which he pas is seemingly ex plained. e illusion ha people undersand he pas osers an overconfidenc e in heir abiliy o predic he uure (aleb 2010). As Kahneman (2011, pp. 224−225) concludes, “o maximize predicive accuracy, final deci sions should be lef o ormulas,” because complexiy more ofen han no reduces validiy and “ humans are incorrigibly inconsisen in making summary judgmens o complex inormaion.” e simplified and unrealisic assumpion abou individual raional beha vior has provided he analyical power o enable classical finance o predic aggregaed human invesmen behavior in sysemaic ways. Imperec as he exising models and algorihms are, hey are he

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bes available and are he mos useul or invesmen decision making involving he uure.

The Economic Way of Looking at Behaviors e behavioral basis described here is cenral o modern economics. Economic heories and models explain how he marke works, how wealh is creaed and disribued, and how people allocae resources ha are scarce and have many alernaive uses. According o Sowell (2014, p. 4), “economics sudies he consequence o decisions ha are made abou he use o land, labor, capial, and oher resource.” Economics has evolved as an inellecual genus and is anyhing bu a setled body o hough. In a holisic sense, economics embraces many principles. Ye, an analyical ramework enailing mahemaics is firmly embodied in modern economic analysis. o an economis, mahemaical ools are jus he means o sudy human behavior, which remains oo complex o perecly fi any compuaional models developed by humans. Inuiive assumpions abou behavior are only he saring poin o sysemaic analysis. THE WEALTH OF NA

TIONS IN THE EIGHTEENT

H CENTURY

Many regard Adam Smih as he aher o modern economics. Smih esablished he behavioral basis or economic analysis in Te Wealh o Naions, iniially published in 1776. According o Smih (1976, p. 449), poliical economy is “a branch o he science o a saesman or legislaor.” He posulaed ha he division o labor allows he greaes producion, and ha economic aciviy, income, and wealh are morally beneficial o human. e undamenal explanaion o human behavior, in Smih’s view, is ound in he raional, persisen pursui o sel-ineres. In he preace o he 1976 bicenennial ediion o Te Wealh o Naions, Sigler (1976, p. xi) noes ha modern economiss label he drive o sel-ineres as “uiliy-maximizing behavior.” HUMAN CAPITAL IN THE TWENTIETH CENTURY

Becker (1964) “humanized” economic analysis by challenging he assumpion ha he prospec o selfish and maerial gain was he sole moivaion or individuals. Insead, Becker assers ha a much richer se o values and preerences drives behavior, including alruism, loyaly, and spie. He assumes ha individuals ry as bes hey can o anicipae he uncerain consequences o heir acions. Forward-looking behavior may sill be rooed in he pas, hough, because he pas can exer a long shadow on one’s atiudes and values. Acions are consrained by ime, income, cogniive capaciies, and opporuniy coss deermined by he acions o oher individuals and organizaions. Differen consrains are decisive or differen siuaions, bu he mos undamenal consrain is limied ime. “So while goods and services have expanded enormously in rich counries,” Becker (1996, p. 3) argues ha “he oal ime available o consume has no. us wans remain unsaisfied in rich counries as well as in poor ones.” Becker’s orward-looking saemen has predicive accuracy on consumer behavior oward “unanicipaed” new

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producs, such as he Apple wach ha came o marke afer his ime; ha is, gadgesrich consumers remain unsaisfied. Becker (1964) pioneered human capial analysis on invesmens in educaion, skills, and knowledge. His economic approach inerpres marriage, divorce, eriliy, and relaions hrough he lens o uiliy-maximizing, orward-looking behavior. Human capial analysis sars wih he assumpion ha individuals decide on heir educaion, raining, medical care, and oher invesmens in knowledge and healh by weighing he benefis and coss o each. Benefis include culural and oher nonmoneary gains along wih improvemen in earnings and occupaions, whereas coss depend mainly on he orgone value o he ime spen on hese invesmens. Even hough Becker’s analysis incorporaes he rising value o ime owing o economic growh, uiion and medical care coss were no nearly as imporan acors in he srcinal benefi versus cos analysis. o approach schooling as an invesmen raher han as a culural experience was considered “uneeling and exremely narrow” beore Becker developed he human capial analysis, which was considered conroversial when he presened i in he 1960s. One o he conclusions o he human capial analysis was no inuiive a he ime, bu has become axiomaic: amilies gain rom financing all invesmens in he educaion and skills o children ha will yield a higher rae o reurn in aggregae han he reurn on savings. a is, boh parens and children are beter off when parens make invesmens in heir children, as ha yields a higher reurn han savings invesed or bequess. CAPITAL IN THE TWENTY-

FIRST CENTURY

A hal cenury afer Becker’s inroducion o human capial heory, Murphy, Pikety, and Durlau (2015) explain differen causes and soluions o inequaliy in a panel discussion ha was brough ogeher by he Becker Friedman Insiue and held on he Universiy o Chicago campus. Murphy ocused his analysis on human capial, which “you ake home wih you when you go home a nigh. I affecs your skill a raising children, a mainaining your own healh, a running your financial lie” (Murphy e al. 2015). eurns on human capial go up when demand or skills grows aser han supply. People respond o he incenives when demand ougrows supply, inves more in heir human capial, and are rewarded wih even higher wages. is effec is especially imporan in an inergeneraional conex, where he skills and resources o high-income amilies bege greaer human capial invesmen in heir offspring. For HNW amilies, resources allocaed or human capial invesmens are higher han he less endowed in boh absolue and relaive erms. Besides more financial resources, heir higher invesmen allocaion in human capial includes beter inpu and more involvemen in educaion, access o superior schools, ineracions wih comparably advanaged peers, and oher insiuional advanages, such as he conroversial legacy admissions a elie insiuions ha perpeuae inergeneraional human capial accumulaion. e human capial invesmen premium is empirically eviden in he Unied Saes, where highly skilled individuals enjoy rapid and susained income growh, whereas he unskilled have sagnaed since he mid-1970s. e incenive o advanaged invesors o acquire even more human capial has driven up he price o

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higher educaion sharply. According o Bloomberg (2012), college uiion and ees have surged 1,120 percen since such recordkeeping began in 1978, our imes aser han he increase in he consumer price index (CPI). Evidence by Murphy and opel (2014) shows ha human capial invesmen responds o an increase in he “price” o skills. ey observe ha skill- biased echnical change or oher shifs in economic undamenals, such as a decline in he price o physical capial, drive he seadily rising demand or skills. Greaer incenives o inves in human capial, owing o a higher price o skills, also raise he reurns or using human capial inensively, which in urn increases he reurns on invesmen. a is, he “able” invesors benefi disproporionaely rom an increase in he relaive scarciy o skilled labor because hey are well posiioned o exploi he resuling higher reurns on human capial invesmen and uilizaion. Increased skill uilizaion causes ye a higher rae o reurn or he mos skilled. is human capial concenraion effec is similar o ha o wealh concenraion. Murphy concludes ha marke undamenals avoring more skilled workers are he driving orce behind rising inequaliy, o which he proposes policies ha encourage or enable he acquisiion o skills as a soluion (Murphy e al. 2015). Focusing on physical capial or causes, Pikety’s analysis o inequaliy does no ake ull accoun o human capial. Pikety (2014) posis ha he global rae o reurn on capial depends on many echnological, psychological, social, and culural acors, which resul in a reurn o roughly 4 o 5 percen, which is disincly and persisenly greaer han he economic growh rae o 1 percen. Pikety akes his observaion o be a hisorical ac, no a logical necessiy by exising raional economics models which would predic he increased compeiion on capial accumulaion o cause global reurn on capial o all unil equilibrium emerges. He believes ha he difference beween he rae o reurn on capial and economic growh can explain he logic o wealh accumulaion ha accouns or a very high concenraion o wealh. Pikety, a French economis, conends ha he inequaliy has nohing o do wih marke imperecions, and will no disappear as markes become reer and more compeiive. He concludes ha wealh concenraion, insead o he scarciy o skilled labor, is he cause o inequaliy, and he proposes a global ax on wealh. e difference in he analyses and policy recommendaions beween French economis Pikety and his American counerpars is elling: differen ses o daa and differen ways are available o inerpre he same daa, even among he economiss who use he same se o mahemaical ools and hold he same basic assumpions abou human behavior. Economiss speak differen languages, lierarily and figuraively, o inerpre he pas and atemp o predic he uure. As Yogi Berra is repued o have said, “I’s dificul o make predicions, especially abou he uure.” e mos likely uure will be in he vision o hose who can “predic” he pas convincingly.

Summary and Conclusions HNWI atiudes oward he uure and heir invesmen decisions no only deermine heir individual lie goals on a micro level bu also disproporionally affec he economy and he collecive invesmen reurn on a marke level. Economiss’ pas predicions imbedded in invesmen decisions and heir policy “prescripions,” righ or wrong,

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inended or no, have shaped he presen wealh and power landscape. Sound economic analyses o he pas coninue o influence invesors’ atiudes oward he uure. Wealh concenraions and he scarciy o skilled labor have conribued o he insiuional advanages o HNWIs, including higher reurns on physical and human capial invesmens. Alhough no immune o heurisics and cogniive biases on he individual level, he invesmen behavior o HNWIs resembles ha o corporaions and insiuional invesors more han ha o reail “consumer” invesors. HNWIs are collecively successul in boh growing heir numbers and growing oal wealh. Empirical sudies show ha he rae o reurn on capial has oupaced he rae o economic growh, and he rae o reurn is persisenly higher or HNWIs. Some credi he service o wealh managers or his collecive and long-erm success. Wealh has increased disproporionally a he very op during he pas 50 years. Addiionally, inequaliy has driven global policy debae. HNWIs are increasingly ocused on driving social impac, as well as on generaing a financial reurn on invesmen. e holisic reurns on healh, culure, environmen, as well as heir social and poliical causes, are gaining imporance in wealh managemen. e wealh managemen indusry increasingly ocuses on invesor psychology and behavior o HNWIs. As basic ransacion and asse allocaion has become commodiized, he value proposiion o wealh managers is ransiioning rom producs and markes o goals-based financial planning and a holisic wealh managemen model characerized by personal relaionship, requen human ineracion, and cusomized advice.

DISCUSSION QUESTIONS 1. Define HNWIs and discuss he demographic rend. 2. Ideniy he key players in he wealh managemen indusry in he Unied Saes. 3. Discuss he differen assumpions and approaches o behavioral vs. radiional finance. 4. Describe goal- based wealh managemen and holisic invesing.

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11 The Psychology of Traders DUCCIO MARTELLI Assistant Professor of Finance University of Perugia

Introduction Proessional raders differ rom reail raders. Proessional raders ofen possess privileged inormaion and knowledge, which allows hem o ake advanage o marke imperecions. In conras, reail raders (i.e., individual invesors who buy and sell securiies or heir personal accouns) are usually noise raders who lack he means and skills o exploi marke anomalies. According o he efficien markes hypohesis (EMH), he price o each asse(Fama essenially a random raders paterncan as prices rapidly sraegies incorporae new inormaion 1970).moves us, in proessional use arbirage o realign curren marke prices o he real value o securiies. Such profiable behavior or proessionals is a he expense o reail raders, who evenually leave he marke because o recorded losses or become sophisicaed invesors by learning rom heir pas misakes. Many sudies relaing o behavioral finance show ha markes are no compleely efficien and ha inormaion asymmeries exis. raders, even reail invesors, can generae profis by exploiing an inormaion advanage derived rom such sources as he availabiliy o more accurae inormaion abou he value o he underlying, more reliable models o asse value measuremen and a beter undersanding o he behavior o marke acors. Neverheless, disinguishing beween new marke inormaion and noise is difficul. raders who perorm beter han he marke average over ime can use his abiliy o heir advanage. A rader’s ask given is o make decisions under condiions o inormaion uncerainy. needed, ese ypes o choices arebasic difficul, he complexiy and he amoun o he limied amoun o ime and resources available o make hose choices, and he consequences o he decisions. us, successul raders are generally people who have he necessary inellecual abiliies and personal characerisics o allow hem o survive and be profiable (Fenon-O’Creevy, Nicholson, Soane, and Willman 2007). Ye, cogniive and moivaional acors affec heir operaions. e auomaic naure o heir decisions represens a danger o raders. According o Kahneman (2012), his way o hinking involves wo sysems. e firs sysem is as, auomaic, and always acive, based on unconscious and emoional aspecs, and i requires a limied effor. e second sysem is slow, laborious, and acivaed when

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needed, based on personal experience, and i requires much concenraion. People use he firs sysem when perorming auomaic asks and he second sysem when here is a need o ocus on somehing specific or perorm a challenging ask. Given he general aversion o making decisions, people are inclined o use he firs sysem, even in making complex decisions, because ha sysem requires limied effor and generaes a decision more quickly han does he second. raders need o gain new knowledge and skill s and o develop he analyical capabiliies o undersand marke dynamics. raders mus also be able o handle emoional sress during boh he iniial phase and in managing a new posiion. A porolio’s flucuaing perormance ofen leads o much emoional upheaval. Alhough being a rader may appear o be a soliary career, his is no he case. Peers play a paricularly imporan role by aciliaing an exchange o opinions on he sae o he markes and by confirming a rader’s views. New echnologies have increased he imporance o hese relaionships among raders. raders ace subsanial change because uure marke developmens and shifs in heir peers’ sraegies. ereore, becoming a rader means acquiring new knowledge o apply o he marke and adaping knowledge rom pas evens and personal experience o anicipae likely uure developmens. Algorihmic rading has compleely changed he daily business o raders. Algorihmic rading is he process o using compuers ha have been programmed o ollow a defined se o insrucions or placing a rade so as o generae profis a a speed and requency ha is impossible or a human rader o accomplish. Only hose raders who have managed o adap and be flexible are likely o be profiable. raders who remain firm in heir decisions and who ollow an oudaed line o reasoning are likely o suffer losses and ulimaely o leave he marke.

Biases Affecting aTrader’s Decision-Making Process According o he neoclassical heory o financial decision making, individuals behave raionally o reach he opimal soluion (Von Neumann and Morgensern 1944; Markowiz 1952). However, since he lae 1970s, considerable evidence conradics his heory. For example, individuals end o acquire and process inormaion using approximae rules, resuling in saisficing raher han opimizing behavior. Simon (1956) used he erm saisficing (saisacory/sufficing) o explain he behavior o decision makers under circumsances in which hey lack heknow necessary cogniive resources o reach an opimal decision. Given ha people rarely he exac probabiliy disribuion o evens, hey have difficuly in accuraely evaluaing all possible oucomes. People’s memories are also weak and unreliable. ey end o setle on a suiable soluion, raher han seek he bes alernaive. us, people rely on menal shorcus and use general rules or heurisics o reduce boh he perceived complexiy o a problem and he ime involved in making a decision. As versky and Kahneman (1974) noe, such behavior can resul in errors. In paricular, he misakes ha individuals end o make in heir financial decisions may resul rom inernal condiioning or exernal acors. e ormer are errors associaed wih he psychology o he subjec, consising o cogniive and emoional biases. Cogniive bias

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Behavioral bias External factors

Internal factors Cognitive bias Collection of information

Emotional bias

Social bias

Processing of information

› Availability heuristic › Familiarity bias

› Representativeness bias › Anchoring effect

› Regret aversion › Disposition effect

› Conformity effect › Availability cascade

› Home bias › Illusion of knowledge › Illusion of control

› Gambler’s fallacy › Mean reversion › Mental accounting › Cognitive dissonance › Confirmation bias

› Loss aversion › Break even effect › House money effect › Endowment effect › Status quo bias › Overconfidence › Self-attribution bias

› Herding behaviour

Figure 11.1 Main ypes o Bias Affecing raders’ Invesmen Decisions. e figure shows several ypes o bias affecing raders’ invesmen decisions. Source: Adaped rom Alemanni, Brigheti, and Lucarelli (2012).

resuls rom a limied way o hinking and maniess isel in boh collecing and processing daa. By conras, emoional bias ypically occurs during he processing o he daa colleced. Exernal bias is primarily due o social condiioning, in ha i induces individuals o behave according o he judgmen hey expec o receive rom heir communiy. is condiioning, similar o emoional bias, influences he inormaion-processing phase, hus affecing he individual’s final decision. Figure 11.1 shows he main ypes o bias ha affec raders’ invesmen decisions.

Errors in the Information Collection Phase As menioned, cogniive bias reers o behavioral misakes in he inormaion collecion phase. is ype o error arises rom an individual’s menal srucure aking inellecual or heurisic shorcus o compensae or one’s cogniive limis (Simon 1955; versky and Kahneman 1974; Gabaix and Laibson 2000). In oher words, heurisics are approximae modes o reasoning ha allow he individual o collec and process inormaion in a shor ime and wih limied processing effor. A ypical error ha raders commi in he inormaion gahering phase is he availabiliy heurisic (Kahneman and versky 1973). e ease wih which individuals can recall inormaion rom memory can influence heir behavior. Consequenly, individuals end o consider requen evens ha hey can easily remember. Evens ha individuals remember more easily, as well as hose ha occur more ofen, end o arouse he sronges emoions, as well. In paricular, he amiliariy o invesors wih one or more evens and he belie ha hey have a more horough undersanding o cerain evens are common eaures among raders. Familiariy bias induces invesors o concenrae heir invesmens in companies hey consider less risky. Home bias reers o he endency o concenrae invesmens in specific geographic areas, such as in domesic

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raher han oreign socks (Kilka and Weber 2000; Huberman 2001). Invesors choose nearby invesmens owing o an excessive sense o confidence wih and securiy abou he available inormaion or hese invesmens. ey consider such inormaion as more reliable han or “disan” invesmens in oreign companies (Lewis 1999). Cogniive limis can also lead raders o commi various errors involving il lusions. e illusion o knowledge reers o he amoun o inormaion available. Counerinuiively, collecing a considerable amoun o inormaion does no guaranee eiher he qualiy or he correc use o his inormaion in arriving a an opimal decision. In he presence o oo much inormaion, invesors end o preer and ake accoun o he inormaion hey undersand beter, hus arriving a subopimal decisions (Barber and Odean 2001). Using he Inerne o collec inormaion and having he availabiliy o financial daabase s ampli y he endency o invesors o ocus on readily undersandable inormaion. Unorunaely, recen changes in he financial markes such as algorihmic- rading echniques do no necessarily provide he mos relevan inormaion. Algorihmic means, or algo- rading, encompasses rading sysems ha heavily rely on complex mahemaical ormulas and high- speed compuer programs o deermine rading sraegies. Using easily undersood inormaion can creae he percepion ha individuals can influence evens ha are acually beyond heir conrol (Langer 1975). is illusion confirms, especially among novice and small raders, heir abiliy o deermine heir success in he markes, hus hey neglec he imporance o random acors; his is ermed illusion o conrol.

Errors in the Information Processing Phase Figure 11.1 shows ha raders ofen commi cogniive or emoional errors during he inormaion-processing phase. Cogniive errors are usually he resul o invesors’ making decisions based on sereoypes (ermedrepresenaiveness heurisic) or hey ail o aler heir iniial decisions, even when new inormaion reaches he marke (ermed anchoring heurisic). e represenaiveness heurisic leads invesors o draw conclusions based on limied inormaion. Indeed, his heurisic is he basis o wo common misakes among raders: applying base rae neglec, and ollowing he law o small numbers. Base rae neglec resuls rom he inabiliy o individuals o esimae he probabiliy o an even. When atemping o esimae probabiliy, hey neglec imporan inormaion and depend on belies developed rom personal experience and social sereoypes. versky and Kahneman (1974) presen a sample o individuals in a case orma o illusrae hese poins. For example, Linda, a single woman aged 31 wih a philosophy degree, who as a suden paricipaed in demonsraions agains nuclear power, was deeply concerned wih issues o discriminaion and social jusice. e researchers asked respondens o choose which alernaive is more likely in heir opinion: (1) Linda is a bank eller; and (2) Linda is a bank eller and is acive in he eminis movemen. Alhough he second opion is incompaible wih Bayes’s heorem, which describes how he probabiliy o wo join evens is always less han he probabiliy o he individual evens, he majoriy o respondens chose opion 2. Linda’s behavior a he universiy led he sample o pay limied atenion o he basic inormaion namely, ha Linda working in a bank is presen in boh alernaives.

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Te law o small numbersreers o an inabiliy o ake ino accoun he size o a sample and applying rules o small groups ha are only apparen in much larger sample sizes (abin 2002). One example o his is he gambler’s allacy, in which people believe ha a random even is more likely o occur simply because i has no occurred or a cerain period, such as he evenual selecion o a cerain number in a lotery. Anoher example is mean reversion, which is he endency o individuals o ignore ha exreme evens usually end o reurn o heir average value. Such biases mean ha raders end o overesimae or underesimae he perormance o socks ha have achieved resuls eiher above or below he marke average in he recen pas. However, as De Bond and aler (1985) show, socks ha have perormed beter or worse han he marke during he prior hree years end o record resuls ha are worse or beter, respecively, han he average in he ollowing hree years. Wih he high number o ransacions carried ou over a cerain period by an individual rader, anoher ypical error is heir subdivision ino menal accouns. Menal accouning consiss o classiying operaions separaely according o heir resul (profi or loss) or he desired objecives, such as proecing invesed capial and generaing income (aler 1985). e separae managemen o invesmens in muliple menal accouns ofen creaes he impression ha he rader’s aciviies are profiable mos o he ime, as he profiable rades are over- weighed rom a psychological perspecive. is atiude remains unchanged, even afer several years and especially when unsuccessul raders keep alive heir memories o he ew operaions ha generaed subsanial profis. ey end o orge or undersae he weigh o he many operaions ha closed wih subsanial losses. e anchoring effec reers o he habi o raders o ake pas inormaion, usually he carrying value o securiies in he porolio, as a reerence poin or he uure. Alhough he securiies may have dropped in price, he anchoring effec helps raders mainain heir iniial convicion, despie he availabiliy o new inormaion. e difference beween he rader’s iniial decision and he conrasing marke perormance creaes an unpleasan eeling or he rader when aced wih evidence ha he srcinal belie was wrong. is uneasy eeling is cogniive dissonance, or he discomor ha emerges when belies and acions conflic wih marke behavior. Alhough he more raional way o reduce an uncomorable eeling is o align one’s convicions wih he marke scenario, raders may ac irraionally. For insance, raders may avoid new inormaion ha is inconsisen wih heir srcinal ideas or hey may develop anciul argumens o jusiy heir old opinions. Such behavior is ermed confirmaion bias (McFadden 1999). Besides he errors resuling rom cogniive bias, misakes arising rom emoional bias also play an imporan role in a rader’s decision-making process. Among he many emoions ha a rader eels when buying or selling a financial insrumen, regre is one o he sronges involving invesmen decisions. Alhough regre is a eeling ha occurs afer a decision is made, ear o making he wrong choice, which migh lead o regre, can be srong enough o hal he rader and preven him or her rom making he mos appropriae decision. e aversion o regre is he basis o a classic error known as he disposiion effec, in which raders end o sell winners oo early and hold on o losers oo long (Sherin and Saman 1985). e disposiion effec resuls rom oher biases discussed earlier. For example, assume a rader bough a sock whose price declines immediaely afer

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purchase. In he rader’s mind, he purchase price coninues o represen an anchor o reerence, leading him o ignore inormaion suggesing he immediae sale o he securiy. e rader coninues o hold he sock, hoping is price will reurn o levels close o he purchase price. Ofen, however, he price coninues o drop. In hese siuaions, cogniive dissonance comes ino play, generaed by he incongruiy beween he invesor’s iniial expecaions and he marke’s acual behavior. o ease an uncomorable eeling, he rader sees he drop in sock price as a profi opporuniy o reduce he book value o his porolio. By buying new securiies a lower prices, he rader reduces he average carrying price o he individual asses, bu simulaneously increases he concenraion and hence he porolio’s risk. Such behavior usually recurs whenever he rader can inves new resources in his posiion. is irraional behavior occurs because he heoreical gain achieved by he rader represens an anchor o reerence. Less profi generaes a level o emoional sress much greaer han he regre he rader would eel or having closed a posiion ha migh increase uure perormance (Kahneman, Slovic, and versky 1982). e weighing o coss and benefis o closing he posiion a a profi or leaving he way open or urher gains, bu also possible losses, causes he rader o op or he ormer opion. o limi such irraional behavior as allowing losses o accumulae and closing profiable posiions early, mos exper raders have learned o use soploss orders. A sop-loss order ses a price a which o sell (or buy) a securiy so as o limi any loss should he securiy decline (or increase) in price. e mos advanced raders use sop- loss orders o avoid allowing heir emoion o overcome heir reason. us, a sop- loss order represens a rader’s implici admission o he possibiliy o commiting an error when buying a sock. By insiuing a sop- loss order, he rader is admiting he possibiliy o psychological discomor similar o cogniive dissonance. Deermining which cogniive or emoional biases have he greaes influence on a rader’s decision-making process is difficul. An inappropriae use o sop-loss orders reflecs a paricularly srong emoional bias called loss aversion. Loss aversion is he behavior o avoiding regre; ha is, a loss is experienced as greaer han a gain, hence is bes avoided. A paricularly ineresing aspec o rader behavior occurs when invesors experience negaive perormance. One migh expec ha he degree o risk aversion would rise afer incurring losses. In pracice, however, pas losses, paricularly i subsanial, can encourage urher risk-aking behavior in an atemp o recover he loss and resore he iniial level o wealh. is behavior is ermed he break-even effec (aler and Johnson 1990). wo oher phenomena closely linked o loss aversion are he house-money effec and he endowmen effec. Individuals experiencing he house-money effec are more likely o risk money ha has resuled rom a win or invesmen reurns han money earned hrough work. us, individuals perceive he unds as oher people’s money raher han heir own. e endowmen effecis he endency o individuals o give greaer value o heir own possessions han o hose o ohers. is shows up as a possible delay in liquidaing exising posiions because he curren marke price does no reflec he perceived value o hose asses. e endowmen effec can also influence raders who do no have open posiions in he marke. An open posiion is any rade ha an invesor has enered bu has no ye closed wih an opposing rade. Such raders are inclined o

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wai or a drop in sock prices because hey assign a value ha is usually lower han he marke price, as hey do no own hese socks. Anoher psychological atiude ha characerizes how raders operae is a general relucance o aler posiions aken in he pas. is behavior, known as saus quo bias, is closely relaed o regre ha comes rom realizing ha a prior change in posiion has no generaed he expeced resuls, and ha mainaining he srcinal posiion would have offered beter perormance (Samuelson and Zeckhauser 1988). Overconfidence is he main limiaion ha characerizes mos raders, especially reail raders (Chuang and Susmel 2011). is atiude sems a leas parially rom combining he illusion o knowledge and he illusion o conrol. Overconfidence induces invesors o overesimae heir knowledge and heir capabiliy o influence evens. Overconfiden invesors presume hey have superior skills compared o oher marke paricipans (hebeter-han-average effec) and underesimae boh he risks o he invesmens in heir porolios and he real disribuion o he probabiliy o evens (ermed miscalibraion). One way o demonsrae his later phenomenon is by asking invesors o define a range hey are srongly convinced conains he correc answer o a quesion. In mos cases, he correc answer lies ouside he inerval seleced, because overconfidence makes he invesor oo cerain and hus he or she ops or a oo narrow range. Invesors are mos overconfiden when hey perceive ha hey can influence he oucome o evens. One example is a coin oss. Individuals end o be larger amouns o money i he coin has ye o be ossed. I he coin been already ossed bu he resul remains unknown, hey end o be lower amouns because hey perceive hey can no longer influence he resuls (Langer 1975). In he rading world, he phenomenon o overconfidence is a common eaure among invesors, leading hem o believe ha heir invesmen decisions are correc in mos cases and hus produce a reurn superior o ohers. Barber and Odean (2000) demonsrae how he porolios o overconfiden individuals have a higher level o risk owing o a greaer concenraion o invesmens in a limied number o socks. ese raders srongly believe ha he securiies included in heir porolios will regiser a beter perormance han hose hey chose no o purchase. Hence, hey perceive ha porolio diversificaion is a wase o resources, given ha i encourages some invesmen in underperorming securiies. Barber and Odean also highligh how overconfiden inves ors engage in more rading. Alhough he gross perormance is higher or overconfiden raders, he ne perormance when ransacion coss are considered is generally higher or raders who are no overly sel-confiden. Barber and Odean (2001) find ha men are generally more overconfiden han are women, leading male invesors o rade more requenly. Online rading sysems have amplified he phenomena relaed o overconfidence, including loss aversion and he break-even effec. Such sysems have a greaer speed o execuion and lower ransacion coss. is change has caused a large increase in ransacions carried ou by individual raders and, ulimaely, a reducion in ne perormance (Barber and Odean 2002).

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Herding and Contrarian Behaviors In addiion o inernal biases (cogniive and emoional errors), here aresocial biases, which are orms o condiioning srcinaing in he ear o judgmen by ohers or he desire o obain social approval. e influence o he decisions and opinions o ohers in one’s group affec individual behavior, especially in siuaions marked by a high degree o uncerainy (Ghosh and ay 1997). is is one reason individuals may manies he conormiy effec, which is he endency o all in line wih he “average” judgmens and behaviors o oher individuals s group (Bond 1996). (1999) confirms ha invesors end o in payone’ more atenion o and ideasSmih or acs whenShiller suppored by conversaions, habis, or symbols (known as availabiliy cascades). e main ype o social bias is herding, which reers o behavior ha induces invesors o abandon heir own convicions so as o go along wih hose o a group, even when he group’s belies seem erroneous (Chrisie and Huang 1995; De Bond and Forbes 1999). e phenomenon o herding is due in par o sel-atribuion bias, which is he inclinaion o look or an exernal cause o which o atribue responsibiliy or wrong choices, while profiable decisions remain atribuable solely o he individual rader’s meri. In ac, he endency o go along wih he behavior o he group no only reduces dissaisacion and recriminaions ha migh arise rom having made wrong decisions independenly, bu i also generaes less psychological and repuaional damage han he prejudice caused by he individual’s error. As he saying goes, a rouble shared is a rouble halved (Caparrelli, D’arcangelis, Cassuo 2004). ecenly, hough, scholHerding srcinally described he oolishand behavior o masses. ars have clarified ha herding is no necessarily irraional i individuals preer o ollow he decisions o hose whom hey believe are bes inormed or who are endowed wih superior decisional capaciies (Chang, Cheng, and Khorana 2000; Demirer and Kuan 2006). Jegadeesh and iman (2001) documen how rading rules based on momenumype sraegies (i.e., hose linked o purchasing high-perorming socks and simulaneously selling less sellar ones) show posiive perormance, and hey demonsrae ha he profiabiliy o such rules has persised over ime. From a behavioral poin o view, he profiabiliy o momenum sraegies is linked o expecaion exrapolaion(De Long, Shleier, Summers, and Waldmann 1990) and conservaism in expecaions (Barberis, Shleier, and Vishny 1998). In general, raders who wan o exploi momenum sraegies look or movemens affecing markes (Menkhoff and Schmidhe 2005). As Nosinger andmajor Sias (1999) noe, profiable momenum sraegies challenge efficien marke hypohesis. Undersanding he causes o profiable sraegies by analyzing he various ypes o operaional approaches ha insiuional invesors and reail raders can employ is meaningul. ose ollowing momenum sraegies may be able o ake advanage o emporary srong-rending marke siuaions in which quoaions differ subsanially rom base sock values. However, reail raders end o buy oward marke peaks, owing o opimism and excessive confidence in heir own abiliies. ey also end o close heir posiion during marke botoms wih heavy losses because o behavioral biases, such as

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he disposiion effec. e loss hen makes he rader delay opening buyer posiions in he uure, when he markes are once again posiive. is rame o mind is due o he snakebie effec, a psychological sae srongly condiioned by a prior negaive experience, such as a financial loss. e effec usually has he mos impac on hose who eel regre and have less financial educaion. Such raders end o delay opening long posiions in rising marke siuaions because hey are sill smaring rom losses suffered as a resul o a recen marke collapse. In ac, he disposiion effec hinders reail raders rom closing unprofiable posiions a he opporune momen, leaving hem exposed o even greaer losses. No unil such raders eel a sense o rusraion and a desire o abandon he world o invesing do hey close hose posiions. Ye, socks are mos likely o bounce back a his momen. ecen disgus and rusraion impede he rader rom reacing by opening posiions consisen wih new marke scenarios. Analogous behaviors, bu wih opposie effecs o hose jus described, are seen when raders have long posiions open in markes ha have reached heir peak and are mos likely o correc hemselves in he near uure. In hese siuaions, he disposiion effec, in conjuncion wih an anchoring effec, leads he rader o hold posiions open even when hey are showing negaive perormance, in he rader’s hope hey will achieve he heighs reached in he pas. e consequence o such behaviors is ha only a small percenage o invesors in he marke make money. A ew sudies sugges ha, on average, only beween 15 and 30 percen o invesors make money hrough heir invesmens (Barber, Lee, Liu, and Odean 2009, 2014). is means ha even hough momenum sraegies perorm well under cerain condiions, raders should consider using invesmen sraegies ha run conrary o hose ollowed by he majoriy o invesors who incur losses. a is, invesors should consider conrarian sraegies. Employing a conrarian sraegy does no mean moving in he opposie direcion o he majoriy in all marke condiions. Conrarian sraegieslargely characerize markes; operaing conrarily o he majoriy o invesors would mean sysemaically incurring negaive perormance. raders who wan o use a conrarian sraegy profiably mus be capable o ideniying areas o inversion in which behavioral errors migh lead mos invesors o make he wrong choices. According o Neill (2003), when people hink he same way, hey are likely o be wrong. Adoping a conrarian sraegy requires undersanding human behavior and markes, experience, paience, and he abiliy o manage one’s own emoions. ese later wo characerisics are undamenal, because no marke siuaions are exacly alike, despie hisory and invesor behavior someimes repeaing hemselves. is ac is rue paricularly when srong variaions occur in a sock’s marke price compared o is undamenal value (i.e., speculaive bubbles). Objecively recognizing a difference in value is a relaively simple ask. e problem is ideniying he exac momen when he bubble is abou o burs. Especially in periods o very bullish markes, invesors end o exhibi gregarious behaviors, promped by he financial success o oher members o he group. In hese siuaions, hinking differenly rom he majoriy is difficul. Ye, as Neill suggess, he basis o a conrarian sraegy is menally raining onesel o hink independenly and o move in he opposie direcion rom he group, aking ino due consideraion acors ha may aler he curren rend. Invesors can use his way o hinking in boh bull and bear markes. For example, assume ha all invesors are bullish. e lack o selling invesors serving as counerpars

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o buyers would resul in no new sales. A sock’s price canno coninue o rise and evenually will all. e opposie siuaion occurs during srong downward marke phases. In hose siuaions, once all he sellers have liquidaed heir posiions, he sock marke prices will increase. e difficuly in correcly applying conrarian sraegies is no in undersanding he mehodology bu in managing he emoions a rader eels hroughou he decision process. In ac, raders will find hemselves alone when hey believe a poin o inversion is imminen. In bullish phases, raders will be he only ones hypohesizing bearish scenarios. An analogous case occurs when a conrarian rader expecs an inversion o a bearish rend. As noed earlier, invesors ypically do no like living in soliude; mos people preer o reduce heir psychological risks by imiaing he behavior o ohers. Some conrarian sraegy skepics see he mehod’s populariy as a poenial limi o is profiabiliy. I all invesors adoped a conrarian view, he mehodology would no longer be profiable. Ciing Neill (2003), one o he ounding ahers o his sraegy, Pring (1995, p. 133) saes “he heory o conrary opinion will never become so popular ha i desroys is own useulness. Anyhing ha you have o work hard a and o hink hard abou, o make i workable, is never going o become common pracice.” Ye, conrarian sraegies have become popular owing parly o he developmen o echnology ha allows or keener and imelier analysis o he belies and behaviors o he majoriy o invesors, or wha is ermed marke senimen.

Investor Sentiment and the Role of the Media Many raders believe ha a combinaion o acors leads o marke movemens. Invesors ofen reer o “marke psychology,” confirming he ac ha markes have heir own way o hinking. is psychological sae o he marke or marke senimen allows raders o anicipae is bullish or bearish movemens. Marke senimen is a summary o how invesors perceive he marke. ese eelings are clear as new marke ops or botoms are imminen, and mos invesors are srongly opimisic or pessimism reigns. Invesor senimen is more complex in inermediae siuaions, when markes do no show a defined rend. Senimen indicaors usually all ino wo broad groups: he opinion syle and he acion syle. Opinion-syle indicaors reflec he expression o surveys o opinions o one or more caegories o invesors, such as advisors, consumers, and companies. Acionsyle indicaors summarize he behaviors ha invesors have aken in he markes, such as open ineres and cash flows. Some o hese indicaors represen leading indicaors o marke psychology. Perhaps he bes-known senimen index is he Commimens o raders (CO). e CO repors show he posiioning o raders wih opposie purposes (speculaive or commercial) in differen uures markes. e U.S. Commodiy Fuures rading Commission (CFC) issues weekly repors, and invesors can reely download he documens rom he CFC’s websie. raders use hree iems in he repors o decide heir own rading sraegies: (1) open ineres, (2) ne speculaive posiions and (3) ne commercial posiioning. Open ineres is he oal amoun o all uures conracs ha invesors have enered no offse by a ransacion, delivery, or exercise. Ne speculaive posiions show

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wheher invesors have bullish or bearish expecaions in he markes, depending on he predominance o purchases or shor sales wihin heir porolios. raders analyze poenial differences beween he posiioning o commercial raders such as armers and mulinaional corporaions, he later which use derivaives or hedging purposes, and he posiioning o noncommercial invesors such as large individual raders and hedge unds, who by conras use uures purely or speculaive aims. ese wo basic groups o uures raders usually have opposie invesmen syles, which helps reail raders beter undersand he marke phase in which hey are operaing. Speculaors are more rendollowers, whereas commercial raders appear o adop a conrarian sraegy, holding he larges long or shor posiions in proximiy o marke botom or op urns. Besides he CO, reail raders use several oher indicaors depending on heir invesmen syle. For example, he CBOE Volailiy Index (VIX) measures he 30-day implied volailiy priced ino S&P 500 index opions. Many raders consider he VIX as one o he mos imporan measures o senimen in he sock markes, because i serves as a proxy or invesors’ risk appeie as marke volailiy increases or decreases. Alhough acion-syle indicaors are perhaps he mos used in pracice, raders also adop some opinion-syle measures as inpus o heir rading sraegies. For insance, marke paricipans use indices o consumer or business confidence o esimae marke senimen. For example, he Universiy o Michigan Consumer Senimen Index surveys consumers o gaher heir expecaions abou he overall economy. e Purchasing Managers’ Index (PMI), which is provided by he Insiue or Supply Managemen, resuls rom several hundred inerviews conduced among purchasing managers in major companies operaing a a naional level. Over he years, raders have learned o shif heir ocus rom classic marke daa o he media. Cover sories sill provide one o he bes indicaors o he psychology o he general populaion by ideniying rend reversal poins in he marke. Publicaion on he ron page o a newspaper signals ha he publisher considers ha sory paricularly imporan o invesors and he public. As already discussed, exreme emoions expressed by general public are usually associaed wih marke urns. Newspapers ofen publish srong posiive ron-page news as markes reach heir op. By conras, srong negaive news is usually associaed wih he approach o a marke botom. is principle usually applies regardless o he ype o marke or he insrumen considered by raders, because he invesors’ way o reasoning ollows similar paterns. ereore, raders can exploi differen invesmen sraegies, depending on wheher hey consider he marke o be in an inermediae phase or close o a urn- around. In he firs siuaion, boh good news and bad news are no paricularly meaningul; hey become relevan in he second siuaion, when markes are near making a urn. In his case, financial news sories are more requen and have a more incisive one, wheher posiive or negaive. Considering he influence on prices o news sories in he radiional media only (i.e., elevision, radio, and prin media) would prove o be no only limiing bu also couner-producive. e majoriy o boh reail and insiuional invesors devoe increasing atenion o he analysis o commens and opinions posed on newsgroups or in specialized charooms, as well as on social media plaorms such as witer, Facebook, and LinkedIn. Social media have a double role. On he one hand, by reading messages lef by oher invesors, raders can ge an idea o marke senimen. On he oher hand, as each invesor can pos his own opinions abou uure economic and financial scenarios, raders

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can direcly influence marke psychology. e social media enable invesors o reach a much larger number o peers han do radiional media, wih an inormaion ransmission speed unimaginable only a ew decades ago. ereore, undersanding how o measure he marke senimen in a proper way represens a challenge ha all raders have o ace oday. For his reason, more researchers are ocusing heir sudies on issues closely relaed o marke senimen. eir aim is o ideniy advanced mehodologies or esimaing marke senimen and o veriy wheher he marke psychology, as deermined by analyzing messages posed on differen social media plaorms, direcly influences financial marke perormance. egarding he later aspec, Bollen, Mao, and Zen (2011) ound a high correlaion beween he one o messages lef on witer and shor-erm equiy marke reurns. An increasing number o raders believe ha considering marke senimen as par o heir rading sraegies is an essenial sraegy o remain profiable in he marke. No surprisingly, specialized companies have creaed proprieary mehodologies o esimae and disclose o heir cliens he levels o senimen as hey relae o specific markes, counries, and securiies. One company in his secor is MarkePsych, which launched wih omson euers a series o indices (omson euers MarkePsych Indices) in 2012 based on an analysis o news and social media messages. e purpose was o provide invesors wih inormaion specific o cerain counries, securiies, or economic secors. Zhang (2014) discusses how o use marke senimen in rading sraegies and summarizes some quaniaive mehodologies o correcly measure and profiably apply invesor senimen o rading sraegies. Over ime, more raders will have adoped senimen indicaors, purchased rom exernal providers or creaed inernally, or heir invesmen decisions. e use o echnology aims o increase he capaciy and speed o analysis o relevan high-requency daa and is likely o have a greaer influence on rading profiabiliy. e effecive applicaion in he financial secor o mehodologies relaed o Big Daa, combined wih an increasing use o high-requency invesmen algorihms (high-requency rading), is now he mos imporan challenge ha reail raders ace.

The Role of Simulations and the Behavior of Novice Traders Successul high-earning raders have above-average knowledge, apiude, and skills. Because each rader’s personal hisory and experiences seem o be indispensable elemens or success in he markes, auhors have increasingly sough o veriy wheher simulaed rading aciviies can help invesors in heir proessional careers. A simulaion is a mehod based on probable siuaions. Compared o radiional learning mehodologies, simulaions bridge he gap beween heoreical conceps and real-lie decision making (Kumar and Lighner 2007), and hey help paricipans learn rom he empirical resuls o differen sraegies (iwari, Naees, and Krishman 2014). e use o simulaions in he field o finance is an effecive financial educaion eaching mehod (Alonzi, Lange, and Simkins 2000). Alhough use o simulaions has grown subsanially, he resuls o laboraory experimens remain inconclusive and are ofen

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conradicory. According o Alonzi e al., sudens paricipaing in a simulaion involving he use o derivaives obain benefis in erms o learning. Camerer and Hogarh (1999) couner ha he learning process can only occur in he long erm; urher, such learning is insufficien o eliminae individual behavioral biases. Several sudies coninue o uel he debae. For example, Ascioglu and Kugele (2005) asser ha experience and ime can help invesors o curb nonraional behaviors. Ye, Duggal and Meyer (2008) find no significan empirical relaion beween he use o a rading simulaion based on bond buying and selling and sudens’ level o undersanding, even hough he game helped paricipans o grasp he heoreical conceps sudied in class. Neverheless, experience is a criical acor in successul rading operaions (Gervais and Odean 2001; Nicolosi, Peng, and Zhu 2009). is evidence does no imply ha subjecs behave in a raional manner simply because hey have become more experienced. Indeed, he majoriy sill has some biases ha affec perormance. Marelli (2013) atemps o veriy wheher using simulaion wih sudens could help novice raders overcome or limi he cogniive errors, especially overconfidence, o which hey may have been subjec in he early phases o compeiion. He based his research on analyzing daa rom rading games played wih real money, in which 44 eams rom differen universiies paricipaed during a six-monh period. e behavior o simulaion paricipans shows no signs o reducing overconfidence, which would have led o improvemen in he eams’ perormance during he course o he game. In ac, mos eams seem o demonsrae increasingly speculaive or, raher, opporunisic behaviors as he simulaion drew nearer o conclusion. Marelli assers ha he cause o such opporunisic behaviors is mainly an asymmery in he disribuion o final perormance resuls. Alhough he eams benefied rom any capial gains realized a he end o he simulaion, he process allocaed any capial losses enirely o he iniiaive’s sponsor. is sor o a lack o penaly in he case o negaive resuls direcly influenced he poorly perorming eams, leading hem o increase speculaive/opporunisic behavior. ese conclusions may apply o oher simulaions carried ou in he financial markes, which presen asymmery in he final phase o a remuneraion o he various paricipans. However, his does no mean ha hese ypes o simulaions and rading games are useless or non-educaional because o he paricipans’ opporunisic behaviors. Moffi, Sull, and McKinney (2010) compared paricipans’ scores beore and afer an online rading sock marke simulaion and hey show a significan improvemen in sudens’ learning. e auhors conclude ha sock marke simulaions are an effecive ool or increasing sudens’ financial knowledge, bu he opic requires urher sudy. Alhough some paricipans may ail o show improved perormance during simulaion periods, heir progress is measurable once he game has ended. Such improvemens are due boh o a new awareness gained and o paricipans’ analysis o heir own pas errors. Marelli (2013) suggess several possible soluions ha limi paricipans’ behavioral anomalies. For example, one soluion is he sharing o paricipan profis/losses wih he subjec promoing he rading game. ese proposed remedies seem o show iniial posiive effecs and reduce paricipans’ speculaive behaviors. Dal Sano and Marelli (2015) examine a compeiion in which paricipans could neiher see he oher compeiors’ perormance nor calculae he disance beween hem. e preliminary resuls show ha such a soluion can be more useul

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in educaing ha year’s novice raders han hose paricipaing in pas ediions o he same compeiion in which hese new rules were no presen. e auhors sress ha no all sudens exploi he benefis o a simulaion. A ew paricipans, especially lower- ranked ones, may eel a sense o growing rusraion ha leads o irraional behaviors. A he same ime, such sudens’ moivaion ends o decrease. As Genner, Lowensein, and ompson (2003) demonsrae, individuals, regardless o heir experience, have difficuly exrapolaing and applying learning rom pas conexs o new siuaions. e resuling risk is ha prior inappropriae behaviors may coninue over ime, even among exper raders. is finding confirms ha ex perience alone is insufficien o make individual invesors ino successul raders. o become successul, raders require coninuous learning and he flex ibiliy o handle changing marke siuaions.

Summary and Conclusions e rading proession has dramaically changed during he las decade. For example, echnology has undergone proound innovaions. raders can now analyze huge amouns o daa and clearly ideniy invesor senimen. Only hose raders who can adap heir invesmen sraegies o new marke scenarios will likely be profiable, whereas he ohers will ulimaely leave he marke. Alhough gaining some experience by paricipaing in rading simulaions beore invesing in real markes is useul, invesmen challenges do no usually ake ino accoun possible opporunisic behaviors ha paricipans can use o win he compeiions.

DISCUSSION QUESTIONS 1. Define overconfidence and give some examples o how overconfidence affecs rading sraegy. 2. Describe he main differences beween gregarious and conrarian invesmen sraegies. 3. Explain he meaning o invesor senimen and provide some examples. 4. Define possible soluions o miigae opporunisic behavior in rading simulaions.

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12 A Closer Look at the Causes and Consequences of Frequent Stock Trading MICHAL STRAHILEVITZ Visiting Associate Professor The Center for Advanced Hindsight, Duke University

Introduction A wide body o research clearly indicaes ha requen sock rading negaively affecs invesor reurns. For example, Barber and Odean (2000) invesigae porolios held beween 1991 and 1996 and find ha requen raders pay a huge financial penaly, earning an average o 7.1 percen less han inrequen raders. e auhors atribue his loss o reurn primarily o he high commissions associaed wih inensive rading. More recen research also finds ha individual invesors lose by rading (Barber, Lee, Liu, and Odean 2009). Afer accouning or rading coss, individual aiwanese invesors who rade requenly generally underperorm relevan benchmarks such as he AIEX, a value weighed index o all lised securiies on he aiwan Sock Exchange. Afer conrolling or all oher variables, he more ofen invesors rade, he more money hey lose. Despie he level o knowledge and experience o invesors, litle chance exiss ha requen rading is more profiable han ollowing a buy-and-hold sraegy (Schlomer 1997; alpsepp 2011; Hoffmann, Pos, and Pennings 2013). Meanwhile, invesor overrading is an epidemic. For heir sample o cliens o a discoun brokerage in he Unied Saes, Barber and Odean (2000) repor an average annual urnover o 75 percen. Perhaps even more alarming, he quinile o mos acive raders exhibis an average annual porolio urnover rae o more han 250 percen. More recenly, he urnover on he New York Sock Exchange (NYSE) reached over 150 percen in 2015 (World Bank 2016). esearchers demonsrae ha raional reasons, such as porolio risk-rebalancing needs, ax consideraions, and liquidiy reasons do no explain even hal o he urnover (Barber and Odean 2002; Dorn and Sengmueller 2009). In shor, agreemen exiss among op researchers in finance ha requen rading is boh pervasive and irraional. Such rading is boh bad or individual invesors who engage in i and he sock marke as a whole. Sill, here is litle agreemen on why invesors engage in requen rading. 209

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e purpose o his chaper is o review research ha is relevan o undersanding boh he causes and consequences o requen sock rading. e chaper sars wih reviewing several published aricles ha examine requen rading boh in erms o he financial coss and psychological causes. e nex secion discusses unpublished research ha looks more closely a he emoional side o requen rading, going beyond he financial coss o consider he psychological consequences as well. e chaper ends by suggesing direcions or uure research ha may help ideniy ways requen raders can sop engaging in his irraional and poenially quie harmul patern o invesing.

Does Investor Overconfidence Lead to Frequent Trading? Barber and Odean (2001a) propose ha an irraional sense o overconfidence is he main driver o requen rading. ey conend ha invesors’ belies ha heir abiliies are beter han average make hem hink hey can ouperorm he marke indexes. Overconfidence means ha hese invesors believe heir rades are smarer han he rades o mos oher invesors (De Bond and aler 1995; Odean 1999; Gervais and Odean 2001). Ye, Markiewicz and Weber (2013) mainain ha overconfidence is unlikely o be he main reason some people rade ar more ofen han hey should. ey offer an alernaive explanaion. Specifically, Markiewicz and Weber (2013) noe ha Barber and Odean’s (2001a) explanaion or requen rading is inconsisen wih many empirical findings (Glaser and Weber 2003, 2007; Biais, Hilon, Mazurier, and Pouge 2005). Glaser and Weber (2003) used a quesionnaire o elici nine proxies or overconfidence in a sample o 200 German discoun brokerage cusomers, and hen relaed hose overconfidence proxies o acual porolio urnover. None o he proxies accouned or he average monhly porolio urnover. Addiionally, in rading experimens wih sudens, Biais e al. repor litle or no relaion beween proxies or overconfidence and observed rading aciviy. Markiewicz and Weber sugges ha Barber and Odean (2000) did a relaively poor job o supporing heir argumen ha requen rading is abou overconfidence. ey noe ha Barber and Odean alked abou overconfidence wihou acually measuring overconfidence. Insead, Odean and Barber use wheher he invesor is male or emale as a proxy or overconfidence, conending ha men are more confiden han women when invesing. A problem his viewendencies is ha gender is correlaed wih many variables as well, includingwih risk-seeking (Charness and Gneezy 2010,oher 2012). Sudies by oher researchers ha have ried o direcly assess he degree o invesor overconfidence show an inconsisen relaion beween invesor overconfidence and rading volume. Alhough some sudies have ound an associaion beween overconfidence and high rading requency (Dorn and Huberman 2005; Graham, Harvey, and Huang 2009), ohers ail o find such a relaion (Dorn and Sengmueller 2009). Glaser and Weber (2007) are only able o observe a correlaion beween overconfidence and requen rading i hey exclude he mos acive o he requen raders rom heir analyses. eir evidence suggess ha somehing oher han overconfidence drives he requen raders who rade he mos ofen. One possibiliy is ha he exremely requen

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raders see selling a sock afer buying i as “undoing” a misake. ey are in effec second-guessing hemselves, which is more indicaive o low confidence han o high confidence. Anoher possibiliy is ha because rading requency hurs perormance, hese ulra-requen raders perorm so badly ha i affecs heir confidence in heir abiliy o rade wisely. Anoher challenge wih he overconfidence explanaion is ha muliple mehods are available o measure overconfidence (Moore 2007; Markiewicz and Weber 2013). No all he same mehods o measuring overconfidence yield he same resuls. In oher words, someone could be raed as highly overconfiden using one measure o overconfidence, bu no paricularly confiden using anoher measure. o illusrae, Moore and Healy (2008) find significan gender differences in overconfidence when hey defined overconfidence as a beter-han-average effec, bu no when hey define overconfidence as miscalibraion, which is he inabiliy o assess one’s own perormance accuraely (Grinblat and Keloharju 2009). When overconfidence is defined as miscalibraion, litle suppor exiss or Barber and Odean’s (2001a) proposiion ha overconfidence drives requen rading. As Glaser and Weber (2007) repor, overconfidence using he miscalibraion approach has no influence on invesors’ rading volume or he mos acive invesors in heir sudy. Similarly, Biais e al. (2005) find ha miscalibraion reduces financial perormance, bu does no affec rading volume. Oher sudies also find no relaion beween overconfidence and rading requency (Dorn and Huberman 2002; Oberlechner and Osler 2008). As Markiewicz and Weber (2013) noe, overconfidence may play a role in some excessive rading, bu i is unlikely o be he primary reason so many invesors rade more ofen han hey should.

Are Risk-Seekers More Likely to Be Frequent Traders? Several auhors repor an associaion beween requen rading and higher levels o riskaking. For example, Grinblat and Keloharju (2009) find a correlaion beween he number o recen speeding ickes male Finnish ni vesors received and heir sock rading volume. Speeding involves risk, because i increases boh he chance o receiving a raffic icke and o being in an acciden. is finding hus suggess ha people who are mos comorable danger boh financially andha in erms o saey may be mosorlikely ―researchers ―be o rade morewih ofen. Some sugges subsiues may available saisying he hrill some invesors derive rom requen rading. Specifically, Barber, Lee, Liu, and Odean (2009) sugges ha he inroducion o a naional lotery in aiwan may have conribued o a sizable drop in he urnover volume on he aiwanese Sock Exchange a he same ime. ey propose ha some invesors may view invesing and gambling as subsiues, so he inroducion o he chance o win a lotery may have reduced he desire o rade so ofen. In oher words, similar o speeding or gambling, requen rading may be a way or hose who love o ake risks o saisy heir desires or risk. Similar conclusions can be drawn rom research by Dorn and Sengmueller (2009), which shows ha invesors who enjoy gambling urn over heir porolios

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a wice he rae o heir peers. e auhors sugges a leas hree possible moives or requen rading: (1) he recreaion/leisure moive, which reas acive invesing as a source o un; (2) he aspiraion or riches moive, which reas invesing like a lotery ha provides a very small chance or a possibly huge payoff; and (3) he sensaion-seeking moive, which uses rading wih is uncerainies as providing he simulaion and novely some people may require o eel ha heir lie is no boring. According o Dorn and Sengmueller (2009), wo caegories o invesors hobby invesors and sensaion seekers rade or emoional reasons. is view suggess ha he moives or invesing and rading ofen may vary among invesors, wih some making raional calculaions and ohers rading or emoional reasons. eir work implies ha moives or rading may influence how ofen individual invesors rade. Hence, Dorn and Sengmueller offer ha some invesors may rade simply because hey find i eneraining. Building on Dorn and Sengmueller (2009), Markiewicz and Weber (2013) conend ha risk- seeking behavior drives requen rading. ey build on he noion ha some associaion exi ss beween personaliy and risk- aking (Zaleskiewicz 2001) and sress ha risk- seeking has muliple dimensions. Dorn and Sengmueller (2009) agree wih oher researchers who noe ha risk involves several domains ha should be considered, such as financial, social, and saey (Weber, Blais, and Bez 2002; Figner and Weber 2011). Markiewicz and Weber (2013) also reierae Dorn and Sengmueller’s (2009) emphasis on undersanding differen moives. Specifically , hey mainain ha a sensaion or simulaion- seeking moive exiss whereby he driver o he acion is he hrill o aking a risk. is migh be considered a ho moive wih as hinking (Figner and Weber 2011; Kahneman 2013). Markiewicz and Weber (2013) explain ha he simulaion moive is disinc  rom he insrumenal moive, he later which is considered cold and slow (Figner and Weber 2011; Kahneman 2013). Cogniion and deliberaion drive cold and slow decisions, whereas emoions drive ho and as decisions. Wih he insrumenal moive, he primary driver is he possible achievemen o maerial reurns. Markiewicz and Weber (2013) find ha only emoiondriven risk- aking predics rading requency. In oher words, hose who are aking risks or profi may be wise enough o realize ha heir profis will no improve rom rading more ofen. Markiewicz and Weber’s (2013) research suggess ha invesors who ocus more on exciemen and less on he possible financial rewards may be mos likely o become requen raders, or even day raders. is group pays greaer ransacion ees, spends more ime on invesing, and sill manages o underperorm compared o heir less requen rading counerpars. For his group o raders, gambling risk propensiy (i.e., he ho need or simulaion) is significanly relaed o he exen o heir day-rading aciviy. is finding is in line wih prior work suggesing ha some raders simply find rading o be un (Glaser and Weber 2007; Anderson 2008; Dorn and Sengmueller 2009; Kumar 2009). Alhough day rading may seem a ime-consuming, cosly, and financially risky way o be enerained, recen research suppors he noion ha requen raders find rading o be more exciing han buying and holding (Srahileviz, Harvey, and Ariely 2015).

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Is Frequent Trading Motivated by Emotions or Rational Thinking? According o several researchers who have examined risk-seeking and rading requency, a desire or simulaion may drive requen rading. esearchers in he areas o psychology and decision making have made similar suggesions abou risky behavior (Belsky and Gilovich 2000). In heir acclaimed work on risk as eelings, Loewensein, Weber, Hsee, and Welch (2001) noe ha emoion ofen drives much risk-aking behavior. ey poin ou ha he basis o prior heories used o explain risk-aking was he assumpion ha raional hinking underlies decisions. Loewensein e al., however, mainain ha an expecaion-based calculus is no wha drives all risk-seeking behavior. ey propose a new heoreical ramework, which hey call he risk-as-eelings hypohesis. Drawing on research rom clinical, physiological, and oher subfields o psychology, hey show ha emoional reacions o risky siuaions ofen diverge rom cogniive assessmens o hose risks. When such divergence occurs, emoional reacions ofen drive behavior. ey presen evidence showing ha he risk-as-eelings hypohesis explains a wide range o phenomena ha have resised inerpreaion in cogniive consequenialis erms. Alhough Loewensein e al. (2001) do no discuss sock rading, based on heir heoreical ramework, emoions could logically drive requen rading as much, i no more han, raional calculaions. Addiionally, Loewensein e al. (2001) propose ha he emoions experienced a he momen o decision making have an enormous influence on ha decision. Ohers have noed ha emoions drive much o compulsive behavior (Faber and O’Gunin 1989, 1992; Faber and Vohs 2011). Applying he risk-as-eelings hypoheses o requen rading, he risk o making ye anoher rade may involve some sor o hrill, and or some invesors, ha emoional hrill may influence heir behavior even more han hinking abou expeced oucomes. Srahileviz, Odean, and Barber (2011), who also address heemoion-based argumen or financial decisions, find ha raders generally buy socks on which hey previously made a profi, whereas hey avoid buying sockson which hey previously los money. is behavior is no or raional reasons, because i does no improve reurns. Avoiding pas losers and buying pas winners is really abou avoiding previous bad eelings and repeaing previous good eelings. Srahileviz e al. (2015) conend ha emoional responses, no raional hinking, condiion his patern. Alhough his patern was pervasive, i did no improve he raders’ perormance. is research alsoound ha invesors deliberaely atemp o reduce regre, even when he acions hey ake do no improve heir reurns.

How Do Day Traders Behave? Alhough day raders are an exreme orm o requen raders, ew researchers have examined he drivers o day rading. Day raders pay higher ransacion ees overall, bu did no ge higher profis han ohers in a sudy conduced by Barber e al. (2005). o

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undersand drivers o his behavior, using a suden populaion wih rading simulaions, Markiewicz and Weber (2013) find ha a gambling risk propensiy predics a day-rading propensiy. Markiewicz and Weber (2013) also looked a financial risk-aking propensiy regarding wo moives: gambling and invesing. ey defined hese wo moives as ollows: (1) gambling is a simulaion or sensaion-seeking moive ha has he process o aking a risk as is goal; and (2) invesing is an insrumenal risk-aking moive ha ocuses on he poenial financial oucome o he risky choice (i.e., he achievemen o maerial reurns) as is goal. ey find ha hese wo measures are no significanly correlaed and ha only gambling risk-aking propensiy predics rading volume. In oher words, in heir sample, a desire or simulaion drove he day raders more han a desire o make money. ey conclude ha day raders are hrill-seekers more han profi-seekers. According o Markiewicz and Weber (2013), compared o oher invesors, day raders spend more money, in he orm o ransacion ees, and more ime, in he orm o hours spen rading. Neverheless, as wih previous analyses (Barber e al. 2005), day raders show lower profis or heir effors han do hose who are no day raders. is finding is consisen wih research in general on requen rading. e more requenly invesors rade, he more ime hey spend, he greaer heir ransacion ees, and he lower heir profis. Financially, day rading is clearly a losing proposiion.

Does Frequent Trading Involve Gender Differences? Gender is no a cause o requen rading. However, research suggess ha men and women behave differenly as invesors, including how ofen hey rade. us, a review o lieraure ha looks a gender differences can illuminae he world o requen rading. According o Barber and Odean (2001a), men are more confiden han women especially in he financial domain, and hereore men rade more requenly han heir emale counerpars. e auhors sugges ha more requen rading among males sems rom overconfidence. e problem wih his explanaion is ha overconfidence is no he only relevan gender difference. Specifically, men are more impulsive and have greaer risk-seeking endencies (Charness and Gneezy 2010, 2012). Evidence shows ha all hese acors influence rading requency, and hey are no jus sereoypes. In ac, some research suggess ha hormones could affec invesing behavior. Coaes and Herber (2008) find a posiive relaionship beween he esoserone levels o male sock raders and heir financial reurns. Similarly, Coaes, Gurnell, and usichini (2009) find ha he presence o anoher masculine hormone, prenaal androgen, increases he risk preerences o high-requency sock raders. In shor, alhough women rade less ofen han men, he reasons or his are no oally clear. Wha is clear is ha requen rading is more common among men, bu i is poenially financially harmul o boh genders. us, any insighs o help requen raders o rade less ofen are likely o help boh men and women.

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Frequent Trading and Gambling Given ha Barber e al. (2009) view rading as anoher orm o gambling, examining he naure o he gambling disorder as well as who is mos likely o suffer rom i is worhwhile. Gambling disorder is currenly recognized as a psychiaric condiion and is par o he fifh ediion o he American Psychiaric Associaion’s Diagnosic and Saisical Manual o Menal Disorders, DSM-5 (American Psychiaric Associaion 2013; eilly and Smih 2013). Below are he official diagnosic crieria rom he Diagnosic and Saisical Manual o Menal Disorders (DSM-5): Gambling Disorder: Diagnosic Crieria 312.31 (F63.0) A. Persisen and recurren problemaic gambling behavior leading o clinically significan impairmen or disress, as indicaed by he individual exhibiing our (or more) o he ollowing in a 12-monh period: 1. Needs o gamble wih increasing amouns o money in order o achieve he desired exciemen. 2. Is resless or irriable when atemping o cu down or sop gambling. 3. Has made repeaed unsuccessul effors o conrol, cu back, or sop gambling. 4. Is ofen preoccupied wih gambling (e.g., having persisen houghs o reliving pas gambling experiences, handicapping or planning he nex venure, hinking o ways o ge money wih which o gamble). 5. Ofen gambles when eeling disressed (e.g., helpless, guily, anxious, depressed). 6. Afer losing money gambling, ofen reurns anoher day o ge even (“chasing” one’s losses). 7. Lies o conceal he exen o involvemen wih gambling. 8. Has jeopardized or los a significan relaionship, job, or educaional or career opporuniy because o gambling. 9. elies on ohers o provide money o relieve desperae financial siuaions caused by gambling. B. e gambling behavior is no beter explained by a manic episode. According o he DSM-5 manual, in many culures, individuals gamble on games and evens, and hey do his generally wihou severe negaive consequences. However, some individuals develop subsanial impairmen relaed o heir gambling aciviies. e manual sresses ha he essenial eaure o gambling disorder is persisen and recurren maladapive gambling behavior ha disrups personal, amily, and/or vocaional pursuis (Crierion A). A gambling disorder is defined as a cluser o our or more o he sympoms lised in Crierion A, occurring a any ime in he same 12-monh period. e manual also noes ha alhough some behavioral condiions ha do no involve ingesion o subsances have similariies o subsance-relaed disorders, only one disorder gambling disorder has sufficien daa o be included in he non-subsancerelaed disorders secion o DSM-5. e manual also saes ha overconfidence can be presen in individuals who have a gambling disorder, and ha hose wih a gambling disorder can be impulsive, compeiive, energeic, resless, and easily bored. e manual noes ha hose suffering rom disordered gambling may be overly concerned wih he opinions o ohers. ey

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can also be depressed and lonely, and hey may gamble when eeling helpless, guily, or depressed. is evidence is consisen wih he findings o research on eaing disorders, which shows ha binge eaing ofen occurs when one is depressed (Kemp, Bui, and Grier 2011). Gender differences have also been ound in he conex o disordered gambling. Specifically, in line wih Odean and Barber’s research on gender differences, males are more likely han emales o suffer rom gambling disorder (Marin, Usdan, Cremeens, and Vail-Smih 2014). According o he DSM-5 (American Psychiaric Associaion 2013), males sar gambling a a younger age and end o develop gambling disorder earlier in lie han emales, who are more likely o begin gambling a an older age and o develop gambling disorder in a shorer imerame. Among hose wih gambling disorders, emales seek reamen sooner han men (American Psychiaric Associaion 2013). Alhough muliple researchers have suggesed ha he hrill o gambling moivaes some requen raders (Dorn and Sengmueller 2009; Jadlow and Mowen 2010; Markiewicz and Weber 2013), and ha ohers view requen rading as a subsiue or gambling (Barber e al. 2009), no published work has addressed he possible addicive disordered dimension o requen rading. However, new unpublished research (Srahileviz e al. 2015) has invesigaed wheher requen rading migh also have an addicive componen. Specifically, Srahileviz e al. (2015) have idenified srong connecions beween rading requency and boh emoional vulnerabiliy and a sense o eeling addiced o rading. ey also find ha requen rading is correlaed wih boh considering onesel o be an adrenaline junkie and viewing rading as simulaing and exciing. Furhermore, Srahileviz e al. (2015) also find rading requency o be correlaed wih impulsiviy, risk-seeking in muliple domains and he requency o experiencing a wide range o negaive emoions. ey also find requen raders have a higher levels o confidence in heir skill as invesors. e findings linking adrenaline, simulaion, and exciemen o requen rading reinorce he risk-as-eelings argumen (Loewensein e al. 2001). is suggess ha emoion raher han raional decision making drives many o he risk-seeking behaviors seen across domains. In ongoing research, Srahileviz e al. (2015) are adaping much o he DSM-5’s diagnosic crieria o urher explore he similariies beween requen rading and gambling disorder. THE CONNE

CTION BETWEEN

GAMBLING, IMPU

LSIVITY,

AND NEGA TIVE EMOTIONS

Given ha researchers including Barber e al. (2009) and Markiewicz and Weber (2013) noe ha requen rading is someimes jus anoher orm o gambling, some undersanding o requen rading can be achieved by closely reviewing he lieraure on compulsive gambling. esuls o various sudies on gambling sugges ha impulsiviy, as well as several emoional variables, may play a role in problem gambling (Williams, Grisham, Erskine, and Cassedy 2012; von anson, Wallace, Holub, and Hodgins 2013; Andrade and Pery 2014; Gran and Chamberlain 2014; Canale, Vieno, Griffihs, ubalelli, and Saninello 2015). ese sudies all sress ha impulsiviy is a core issue underlying many addicive behaviors, including problem gambling. In erms o emoions, and

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examining differen populaions, Barraul and Verescon (2013); Holdsworh, Nuske, and Breen (2013); and Marin e al. (2014) find ha problem gambling is linked o depression. Similarly, Dowling e al. (2016) provide a mea-analysis o research showing a connecion beween problem gambling and clinical anger. Seleseem may also be an issue relaed o gambling addicion. According o ockloff, Greer, Fay, and Evans (2011), individuals who hink negaively abou hemselves are more likely o gamble more inensively. Ferenzy, Skinner, and Anze (2006) noe ha sponsorship organizaions such as Gamblers Anonymous give people a sae place o express and handle heir emoions, wihou resoring o compulsive gambling. is suggess ha alhough casual gambling can be un, compulsive gambling is a painul disorder (Blume 1986; achlin 1990). In describing he addicive naure o gambling, anala and Sulkenen (2012, p. 8) explain: “players do ge hooked. e eelings o compeence go away, Lady Luck urns her back, and exciemen and joy disappear.” NEGA TIVE EMOTIONS AND FREQUENT TR

ADING

Alhough research demonsraes ha requen rading is bad or one’s wealh, Srahileviz e al. (2015) sugges ha i may also affec one’s well- being. Besides he sel-idenified addicion and impulsiviy componens ound commonly among requen raders in heir sample, he auhors also see differences in emoions. Specifically, when compared o inrequen raders, requen raders repor ha heir perormance in he sock marke has srong effecs on heir sel-eseem, relaionships wih ohers, and overall happiness. Frequen rading is also posiively correlaed wih negaive emoions including eeling depressed, being sad, eeling supid, experiencing regre, being angry wih onesel, and eeling angrier abou hings in general. Finally, a posiive correlaion also exiss beween requen rading and eelings o social isolaion. Furher evidence connecing rading behavior o emoional disress comes rom Coaes and Herber (2008), who find a posiive correlaion beween levels o he sress hormone corisol in sock raders and heir financial uncerainy, he later measured by he difference beween economic reurn and expeced marke variance. Surprisingly, Kandasamy e al. (2014) find ha when raders experience high levels o corisol, hey become more risk-averse. According o Srahileviz e al. (2015), research on sel-regulaion and sel-conrol (Vohs and Faber 2007; Hedgcock, Vohs, and ao 2012; Homann, Baumeiser, Förser, and Vohs 2012; Homann, Luhmann, Fisher, Vohs, and Baumeiser 2014; Greenaway, Sorrs, Philipp, Louis, Hornsey, and Vohs 2015; Homann e al.2015), and paricularly work on he sel-regulaion o emoion (Koole, van Dillen, and Sheppes 2010; Faber and Vohs 2011), may offer promising suggesions or ways o help requen raders rade less ofen. Vohs, Mead, and Goode (2006); Vohs and Baumeiser (2011); Vohs, Baumeiser, and Schmeichel (2012); and Vohs (2015) also sugges a connecion beween ime spen hinking abou money and boh unhappiness and compeiiveness. Because rading involves hinking abou making and losing money, his may explain why Srahileviz e al. (2015) find requen raders o be less happy and more compeiive han inrequen raders.

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e resuls o Srahileviz e al.’s (2015) work sugges ha solving he problem o requen rading may require more han simply inorming invesors ha requen rading is bad or heir financial well-being. Indeed, i an emoionally charged addicive componen is presen in requen rading, inervenions may need o go beyond merely educaing invesors abou he financial downside o requen rading. Indeed, such inervenions may need o be similar o hose used or reaing compulsive gambling and oher addicions. THE TRADING IMPL

ICA TIONS OF MOBILE TECHNOLOGY

Mobile echnology is rapidly changing he world. Wih global smarphone usage now in he billions, mos invesors are likely o own a smarphone. able usage is also very high. is increase is accompanied by a rise in mobile applicaions ha provide access o marke inormaion, deailed research, and rading plaorms. Despie considerable research on requen sock rading and problem gambling, litle research is available on he effec o new mobile echnologies. Wha has been he emoional and behavioral effec o he huge increase in he use o mobile echnology? La Plane, Nelson, and Gray (2014) and Gainsbury, ussell, Wood, Hing, and Blaszczynsi (2015) find higher raes o disordered gambling among Inerne gamblers han among land-based gamblers. Similarly, Phillips, Ogeil, Chow, and Blaszczynsi (2013) show ha wih he evoluion o he Inerne and mobile devices, problem gamblers have gained access o new orms o gambling. us, he ubiquiy o mobile devices is likely o increase he endency ha some invesors have o indulge in overrading. Basically, he more opporuniies o gamble, he more likely someone is o engage in disordered gambling (Leser 1994; Campbell and Leser 1999; Breen and Zimmerman 2002). Barber and Odean (2001b) noe ha Inerne rading has grealy increased rading volume; however, mobile rading plaorms are even more recen. Alhough some research suggess ha mobile usage can increase rading requency (Srahileviz e al. 2015), and ohers are proposing o do addiional research in his area (Zhang and eo 2014), much remains o be learned abou he effec o mobile devices on rading requency.

Summary and Conclusions esearchers end o agree ha requen rading is financially unwise, given boh he ime and he ransacion coss involved. An implicaion is ha hose engaging in rading socks regularly should modiy heir behavior. e evidence shows ha a ar beter pah or achieving financial success in he sock marke is o buy and hold a highly diversified porolio ha is composed o low-ee index-racking unds. e balance o sock-relaed invesmens o oher asses should reflec an invesor’s financial and emoional risk olerance. Frequen rading is like playing wih fire; i may seem exciing, bu he possibiliy o geting burned is high. Alhough researchers agree ha requen rading is boh irraional and common, hey ail o agree on why so many invesors sill engage in his pracice. One possibiliy is ha invesors may view hemselves as smarer han hey acually are. Oher explanaions

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are ha some invesors hunger or risk, have impulsiviy issues, enjoy gambling, or suer some sor o addicion. egardless o he underlying reason, requen rading is an issue ha is worhy o uure research. esearch examining a poenial addicive componen o he phenomenon o requen rading, which alls in line wih he psychiaric condiion o gambling disorder, may be paricularly promising (Srahileviz e al. 2015). Given he complexiy o he problem o requen rading, uure research should ocus no only on undersanding wha drives requen raders bu also on how researchers in his area can bes help requen raders sop his irraional way o invesing.

DISCUSSION QUESTIONS 1. Explain why requen sock rading is bad or invesor reurns. 2. Ideniy he major acors ha migh drive requen rading. 3. Differeniae among recreaional, aspiraional, and sensaion- seeking moives or invesing, and explain which o hese moives lead o he greaes rading requency. 4. Ideniy and explain he gender differences ha exis in invesing and gambling behavior. 5. Discuss how mobile echnology is likely o affec requen rading. 6. Discuss he prevalence o requen sock rading.

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13 The Psychology of Women Investors MARGAUE

RITA M. CHENG Chief Executive Officer Blue Ocean Global Wealth SAMEER S. SOMAL Chief Financial Officer Blue Ocean Global Wealth

Introduction Women are inegral members o corporae America and he global business landscape. eir emergence as leaders, enrepreneurs, and innovaors has made hem an indispensable par o he economic environmen and he uure o global enerprise. Women are assuming greaer proessional and leadership responsibiliies while sill managing heir personal and amily finances. e increasing availabiliy o educaion o women is no only changing heir lives bu also reshaping public atiudes oward gender differences and equaliy. radiional gender roles no longer reain much currency in conemporary households. e women’s colleges ha opened saring in he lae 1800s rained or careers ha were accepable or women o ener a he ime, such as nursing and eaching. oday hese insiuions and many ohers offer degrees in business, law, medicine, psychology, and oher proessions, once hough o as work or men only. is demographic and socieal evoluion, paricularly rapid in he las several decades, has produced a new se o gender-based compeiive advanages, enabling women o emerge as influenial leaders in fields such as business and finance. Women are now an essenial and inegraed par o he global economy. By leveraging heir srenghs and expounding upon heir skills and experience, women will coninue o realize success and creae value.

The Emerging Influence and Affluence of Women According o a survey o invesors across various earning caegories (Fideliy Invesmens 2015b), he demographics o he emerging affluen look very differen rom hose o previous generaions o upper-middle-income individuals. More han wo-hirds are emale and one-ourh are nonwhie. Women have surpassed men and now conrol more han hal o all wealh in he Unied Saes (Gorman 2015). Women own nearly one-hird o all privae enerprises, employing an esimaed 7.8 million Americans. e influence o women in he business arena is expeced o grow in he uure. 224

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is rise o emale enrepreneurs and execuives coincides wih an increase in he number o women pursuing higher educaion. Presenly, women ounumber men in American colleges and universiies. Differences in educaional atainmen by gender have changed over he preceding decades, wih emale atainmen raes higher han hose o males. e reason or hese differences in educaional atainmen sems rom needs or moivaions (Gage and Brijesh 2012). A moivaional model cies our basic componens: (1) needs (moivaions), (2) behaviors (aciviies), (3) goals (saisacion), and (4) eedback. Moivaions are acors ha rigger a person o carry ou an acion. Money is a major moivaional acor and need in sociey; ew hings occupy as cenral a place in people’s lives as money. Money plays a special role in personal and social lives, exering more power over human lives han any oher commodiy (Oleson 2004). Increasingly, women are moivaed o ener careers requiring higher levels o educaion, such as he medical and business managemen fields. Women srive o earn more money and atain a sense o personal achievemen, jus as heir male counerpars always have. e educaional atainmen o women beween he ages o 25 and 64 in he labor orce has increased subsanially since he 1970s. In 2011, 37 percen o hese women held college degrees, compared wih 11 percen in 1970. Abou 7 percen o women had less han a high school diploma in 2011, down rom 34 percen in 1970 (Bureau o Labor Saisics 2013). Improved educaional opporuniies or young women have conribued o increased influence and affluence. Women are acquiring individual wealh hrough corporae employmen, as well as enrepreneurial pursuis. In erms o earning power, women are now he primary breadwinners in 17.4 million U.S. amilies, more han double he number rom 30 years ago. Families wih wo working parens have become he sandard. In 1979, women working ull ime earned 62 percen o wha men did; oday, women’s earnings are only 22 percen less han ull-ime male employees. e wage gap is smaller or younger workers han or older workers, bu clearly opporuniy or improvemen sill exiss (Bureau o Labor Saisics 2008). According o Wang, Parker, and aylor (2013, p. 1), “Four in 10 American households wih children under age 18 now include a moher who is eiher he sole or primary earner or her amily. is share, he highes on record, has quadrupled since 1960.” wo-hirds (66 percen) o young women beween he ages o 18 and 34 rae proessional success as “very imporan” or “one o he mos imporan hings” in heir lives. Conversely, only 59 percen o heir male counerpars cie proessional success as a lie prioriy. When he Pew esearch Cener issued his survey, more han hal (56percen) o young women cied career success as a op prioriy (Paten and Parker 2012). e ac ha his reorganizaion o lie prioriies has occurred wihin a single generaion is remarkable. THE LEADERSHIP OF WOMEN

e coninued sruggle o women or success in proessional setings is well documened. However, wih oday’s greaer exposure o he workplace and more opporuniies or career advancemen, emale proessionals and enrepreneurs are securing posiions in previously male-dominaed indusries. Women are obaining execuive and board posiions in Forune 500 companies and being appoined o op governmen poss. A record number o women (104) were

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sworn in o he 114h U.S. Congress. Canadian Prime Miniser Jusin rudeau assembled he firs cabine wih an equal number o male and emale represenaives. In he legal and medical proessions, women are achieving pariy wih heir male colleagues. Women now hold 52.2 percen o all managerial and proessional posiions compared wih 30.6 percen in 1968 (Pew esearch Cener 2015). Currenly, women manage $14 rillion in personal wealh, and ha number could reach $22 rillion by he end o he decade. By he year 2030, women are expeced o conrol approximaely wo-hirds o he naional wealh. is projecion is a produc o boh organic growh raes and impending ranser o wealh beween spouses and amily members (BMO Wealh Insiue 2015). WOMEN ENTREPRENEURS

Female enrepreneurs are esablishing new businesses a more han wice he rae o men. e number o women-owned businesses wih more han $10 million in revenue has increased by 40 percen since 1997. Small and mid-size companies led by women employ more workers han all Forune 500 enerprises combined. Women enrepreneurs also have more success in growing heir primary businesses, wih an average $9.1 million in annual sales, compared o $8.4 million or male enrepreneurs (Grace 2014). Women are well posiioned o become he new economic leaders. ey are likely o creae hal o he nearly 10 million small-business jobs by 2018. A brigh spo during he pas several years has been he job growh spurred by women-owned firms, especially in he reail markeplace. Since 2007, privae companies owned by women have added an esimaed 340,000 jobs. Firms owned by women now accoun or nearly one-hird o all enerprises and are only expeced o coninue heir upward ascen (American Express Open 2015). In erms o innovaion or inroducing producs ha are new o some or all consumers, women enrepreneurs ouperorm heir male counerpars. is rend is no limied o he Unied Saes and Europe, because various emerging markes and underdeveloped counries also exhibi his rend (BMO Wealh Insiue 2015). Alhough he Unied Saes is ranked as he mos avorable environmen or emale enrepreneurs, ollowed closely by Canada, Ausralia, and Sweden, he privae secor is sil l a work in progress. e mos common concern or women is securing financing or heir fledgling enerprise. Nearly hree- ourhs o women cie financial capial as a criical challenge o launching heir firms (obb, Coleman, and Sangler 2014). In 2013, a Senae commitee ound ha women lack sufficien access o loans and venure capial (Powell 2014). In ac, male enrepreneurs are more han hree imes as likely o secure equiy financing hrough an angel invesor or venure capialis han women (14.4 percen compared o 3.6 percen). Men also have more success uilizing neworks o close riends and business associaes. For mos emale enrepren eurs (55.4 percen), bank financing is heir sole source o capial. obb and Coleman (2009) find ha men sar w ih almos w ice as much capial as women enrepreneurs. is disadvanage affecs boh he growh rajecory and he employmen poenial o women-owned firms. Presiden Susan Sobbot o American Express Open warned ha enerprises beween one- ourh and hal a million dollars in revenues are a a urning poin in heir developmen (American Express Open 2015). Unil his sizable

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gap in financing is resolved, women enrepreneurs will all shor o maximizing heir ull economic poenial. TRANSFER OF WEALTH

Besides personal income, women o he baby boomer generaion are expeced o inheri wealh rom wo oher sources: heir parens and heir spouses. Baby boomers are poised o inheri as much as $15 rillion over he nex 20 years (Nielsen 2012). O married American women, 7 ou o 10 will evenually become widows and a he relaively early age o 59. ough lie expecancy has risen or boh men and women due o childhood immunizaion, improved healh inrasrucure, beter living condiions, and oher acors, a long-lasing discrepancy in lie expecancy sill exiss beween men and women. Saisically, women oulive men by an average o 5 o 10 years. Among hose age 100 or older, 85 percen are women. In 2010, 40 percen o women over age 65 were widows, compared o jus 13 percen o men. Nearly 50 percen o women age 75 or older lived alone. Wih women surviving heir parners, much o his accrued wealh will all under heir conrol (Blue 2008). According o AAP, individuals over he age o 50 possess 79 percen o all financial asses, 80 percen o money in savings accouns, and 66 percen o all money invesed in he sock marke. e looming ranser o wealh, in size and scope, has no preceden in conemporary American hisory (Brennan 2009). Conrary o wealh ransers in pas generaions, oday’s beneficiaries are unlikely o reside in he same communiy as heir parens and amily members. is is likely o resul in much reshuffling or small and mid- size financial companies, as children can no longer be couned on o remain wih he same advisors and financial insiuions as heir parens. is oucome is especially rue o women, who in surveys have expressed dissaisacion wih he financial indusry as a whole. Despie heir rising affluence, he financial service proessionals, he majoriy o whom are men, ofen overlook women. According o Sae Farm Insurance (2008), only one in hree women russ financial services proessionals, and hree in our women are skepical when iniially meeing wih a financial proessional. A sudy by he Boson Consuling Group (2010) find ha men are 1.7 imes as likely as women o be approached by a financial advisor. Financial proessionals should view he expanding influence o women as a business opporuniy or increasing heir clien base and asses under managemen (AUM).

The Psychology of Women Investors Every invesor has unique wans and needs. esearch shows ha women value personal relaionships and big picure hinking more han men. Sudies also show ha men end o be more compeiive han women in deal making. According o Larimer and Hannagan (2010, p. 43), “Women preer alruisic, reciprocal relaionships and men preer compeiion and sruggle.” Women invesors value financial advisors who recognize heir needs as par o a whole, as opposed o raming discussions in purely moneary erms.

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Women ofen grew up assuming ha men handle financial responsibiliies. As a resul o heir limied opporuniy se, hey did no develop a financial knowledge ramework. a knowledge gap has ended o lessen women’s confidence in money maters. Because o a lack o financial lieracy, women have ofen rerained rom discussing finances and have deerred quesions o he male in he amily (Fideliy Invesmens 2015a). Women hink and behave differenly rom men in erms o he evaluaion and decision-making processes. Compared o men, women consider more acors, raise more quesions, and consul wih more people, such as online groups, riends, and colleagues, beore making an educaed decision. eir mehods diverge when measuring resuls, as well. Men ocus more on symbols o power and success, whereas women need o undersand how power and success affecs he financial posiion o heir amilies and hemselves. Women wan o undersand how heir decisions influence oher areas o heir lives. ey do no ocus on perormance numbers because hey are on heir coninued progress oward achieving heir lie goals. is observaion lends credence o he undamenal divergence beween men and women in erms o heir compeiive naure. Moreover, women communicae differenly rom men. esearchers a he Universiy o exas, Ausin, conclude ha boh genders speak abou he same number o words each day women a 16,215 words and men a 15,669. e research also noes ha women alk more abou oher people, whereas men discuss objecs in heir environmen (Newman, Groom, Handelman, and Pennebaker 2008). Women are ypically drawn o advisors who can hold an engaging conversaion and culivae an environmen ha invies broader discussion o heir work and amily lie. ey need financial proessionals who can empahize wih heir needs and respec heir poins o view. Clear and sraighorward language is preerable o jargon-heavy dialogue. Financial decision making is a muliaceed and emoion-invoking process. People sense he likely ineracions o ohers and ac based on ha assessmen. In ha regard, women ofen prominenly display nonverbal responses. ey are more atuned o eye conac, acial expressions, and hand gesures, using hese cues as a means o decipher boh mood and meaning. For women, lisening skills require consisen eye conac and nonverbal eedback. For example, when a couple is buying a house, i he real esae agen is inatenive and has poor eye conac, hewie may eel uncomorable abou buying rom his person a lack o eye conac and atenion could jeopardize he sale. Conversely, men do no consider eye conac and eedback as measures o effecive lisening. Numbers and acs speak louder han acial expressions. Accordingly, men are more comorable alking side by side, whereas women srongly preer direc, ace-o-ace conac (Newman e al. 2008). Alhough various sereoypes exis abou gender and emoions, many acual dierences exis in he ways males and emales uncion emoionally. ese differences include he exen o which each recognizes emoions in ohers and expresses individual emoions hrough acial and vocal expressions, words, physiological arousal, and behaviors such as aggression. ese gender differences vary according o he paricular siuaion involved and he culural background o he paricipans (Levinson, Ponzeti, and Jorgensen 1999).

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Women have a naural affiniy or deails, and heir “checkliss” ofen resul in a more comprehensive decision-making process. However, hey may place less emphasis on deails such as numbers, acs, and figures, and preer o ocus on ariculaing heir vision or lie afer reiremen and how heir porolio needs o be oriened oward achieve his liesyle. “Women coninue o pursue a diverse range o long-erm financial goals. According o he Pew esearch Cener (2015, p. 1), “hey wan o save enough money o mainain heir liesyle hrough reiremen, cover healh care expenses and avoid becoming a financial burden o loved ones.” For hese women, he imporance o financial independence even afer reiremen is he driving orce. aher han presige, his abiliy o no having o rely on ohers moivaes he invesmen planning. Women wan o undersand how heir decisions influence oher areas o heir lives. Men are used o hinking ha muual unds or socks are eiher green wih lie (when hey are up) or red wih deah (when hey are down). Women ypically are no as ocused on perormance numbers as hey are on heir coninued progress oward heir lie goals. is observaion lends credence o he undamenal divergence beween men and women in erms o heir compeiive naures. Women prioriize long-erm goal achievemen raher han curren perormance numbers. Conversely, women preer consisency and measured progress oward achieving heir financial objecives or goal. Women end o value he progress hey are making oward heir lie goals and he conex o invesmen reurns. CUSTOMER LOYALTY

Cusomer loyaly has been he objec o ineres or businesses, and i is siuaed a he hear o cusomer relaionship managemen (CM). Women exhibi mixed loyaly oward individual service providers and corporaions. e difference in cogniive processes and behavior o male and emale consumers is refleced in he widespread use o gender as a segmenaion variable in markeing pracices. According o Durukan and Bozac (2011), cusomers reflec hree ypes in erms o cusomer loyaly: (1) hose who are no loyal, (2) hose who are orced o be loyal because o some acors such as swiching coss, and (3) hose who are fiercely loyal wih no inenions o changing brands, services, or firms. e hird ype is he ulimae goal or any business, because such cusomers have no negaive eelings and obain inormaion by word o mouh. People are loyal o producs ha offer high saisacion raes, as well as compeiive prices and posiive company image. Cusomers wan o be remembered and have producs ha mee heir needs. However, research reveals ha women are no necessarily more loyal cliens han men. I is imporan o provide some clariy on he conex o loyaly. Alhough women end o be more loyal o individual services providers, hey are less loyal han men o grouplike eniies, such as a paricular company or insiuion (Melnyk, Van Osselaer, and Bijmol 2009). is observaion is encouraging news or financial advisors who work closely wih women cliens on a one-on-one basis. Acually, women end o reer an advisor more ofen o heir amilies and riends, especially i hey eel genuinely engaged and conneced o he advisor’s communicaion syle and perormance.

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Women share heir experiences wih ohers, meaning ha hey ell many amily, riends, colleagues, and even srangers abou heir financial advisor experience. e word-o-mouh markeing or reerral markeing benefis financial advisors by improving clien saisacion and reenion. is firs- hand esimony creaes loyaly o a brand by sharing hese personal, relaable experiences. e concep o loyaly presens a compelling opporuniy or financial proessionals o make heir emale clien engagemens memorable, because hese cliens will hen communicae heir exciemen wih ease. I done houghully, reerrals can come wih enhanced velociy and purpose. According o Blaney (2010, p. 18), “Women rarely ry o compee wih he advisor, or hink hey know beter. A women r uss her advi sor, she can be a powerul source o reerrals. Men by conras, ofen like o keep a grea advisor or hemselves.” is saemen shows he undamenal difference in he hough processes o women and men. Women wan o share heir success, whereas men end o ear ha sharing he inormaion will cos hem in some way. Women’s lower risk preerence makes hem a naural fi o ocus on managing risk and capial preservaion as par o heir writen financial plan. By exension, a lower risk olerance leads o a more diversified porolio preerence o miigae loss poenial or women, raher han he more risky preerence or men in general. Women are generally relaionship driven, whereas men are ypically resuls driven. Consequenly, women prioriize he clien experience over pure resuls. ey value he experience o being heard, respeced, and valued. A survey by Prudenial Financial (2015) concluded ha women ace challenges in rying o mee heir long-erm financial goals. e research shows ha women are confiden in heir knowledge o dayo-day financial maters. In ac, he sudy repors ha 33 percen o women evaluae hemselves highes on heir knowledge o managing deb and 7 percen rank hemselves lowes on heir knowledge o invesing. In erms o knowledge o managing money or deb, women grade hemselves as a B or B minus. e survey also ound ha 27 percen o married women are relaively confiden in heir knowledge o key financial decisions, such as securing financing or a home and purchasing lie insurance. Alhough he sudy indicaed ha women eel confiden o handle financial planning and decision making on heir own and eeling more financially secure, only 31 percen are now using a financial proessional. e sudy suggess ha companies can mee heir needs by fine-uning, raher han reinvening, heir approach o serving women cliens. THE INVISIBLE PARTNER

A lack o confidence abou heir personal finance decisions has long been a source o rusraion or women, hindering heir abiliy o ake greaer conrol o amily finances. As young women and girls, hey ofen hear he message ha money is a man’s responsibiliy. a idea paved he way or women no o worry as much abou wha would happen i hey needed o ake on muliple caregiver roles and/or be financially independen. Women are becoming financially and psychologically independen rom heir husbands a an increasing rae, while also gaining greaer confidence in personal finance and wealh managemen. Ye, in many cases, women are negleced in heir conversaions

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wih an advisor when heir husbands are presen. Because o his disadvanaged posiion, women generally need more ime o gaher inormaion, especially rom op influencers such as heir husbands, parens, and close riends. In oday’s digial age, women are using he Inerne o amiliarize hemselves wih financial erminology and producs. According o a sudy by Prudenial Financial (2015, p. 10), “a hird o women coun financial company websies (31 percen) and financial news websies (29 percen) as ools or researching and learning abou financial producs.” In erms o social media, women consumers use Facebook over oher social media plaorms. A houghul financial proessional needs o respec a woman’s ime and give her he space o make an inormed decision. Advisors should clearly ariculae heir messages and no offer soluions unil heir cliens ully undersand heir opions. Offering more inormaion o a emale clien han jus acs and figures will give hem a greaer comor and confidence in heir decision-making abiliies and heir abiliy o plan. A posiive rai o women cliens is ha hey end o have a beter and more comprehensive picure o heir amily’s financial posiion han do men because women ofen assume he dual roles o caregiver o amily members and manager o household expenses. us, consuling he emale head o household beore beginning a financial planning engagemen makes sense. For his reason, an advisor should no dismiss or ignore he needs and opinions o he wie, even when he husband is presen. DIFFERENCES BETWEEN THE MALE AND FEMALE BRAIN

Women process and receive inormaion differenly rom men. rough advances in neuroscience, researchers now undersand ha women depend more heavily on cerain regions o he brain. Female brains are generally conneced across he righ and lef hemispheres, whereas male brains orge a sronger connecion beween he ron and back lobes. Women end o use boh sides o he brain, whereas men primarily employ he lef side he lobe ha conrols logic and reason when making decisions or perorming asks (Ingalhalikar e al. 2014). e mos sriking difference beween he male and emale brain is he corpus callosum, a srech o issue connecing he righ and lef hemispheres o he brain. e righ hemisphere is he nexus o emoion and creaiviy. e lef hemisphere processes daa in a more linear and mahemaical ashion (Ingalhalikar e al. 2014). Alhough boh men and women possess righ and lef hemispheres, women can shutle inormaion beween he wo sides more effecively han can men, as a resul o being graced wih a larger corpus callosum. For his reason, women can draw connecions beween words and emoions more easily and inuiively han men (Niu 2014). Addiionally, women end o be more comorable muliasking han men. Women are more sensiive o sound and language and have an easier ime expressing heir emoions verbally. Alhough a larger inerior-parieal lobule helps men excel in mahemaics, women have a more complex limbic sysem, making hem beter atuned o heir own eelings and he emoions o hose around hem. Because o his difference, women adop a more holisic and inclusive approach o decision making. Men sruggle o undersand emoions when no clearly saed; heir decision-making process is narrower, ocusing on precise issues and dismissing inormaion hey deem superfluous o he mater a hand.

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Finally, men are more amenable o risk han are women. eir brains receive a greaer rush o endorphins when presened wih a risk or challenge. is knowledge is absoluely criical o undersanding he psychology o women invesors and will be discussed urher in he nex secion. RISK TOLERANCE

Wealh holds a differen meaning or men and women. A sudy by Fideliy Invesmens (2015b) finds ha he majoriy o women (54 percen) connec wealh wih securiy. Conversely, men generally associae he erm wih saus or power. is disincion shapes he way men and women approach and hink abou invesing. Men ofen have a shor-erm perspecive, whereas women value relaionships and long-erm goal seting. However, he noion ha women are more risk-averse han men has been somewha oversaed. For example, Nelson (2012) perorms a saisical review o exising sudies on gender and risk olerance. He finds ha he difference in risk-aversion is considerably weaker han previously hough. In ac, Nelson repors ha some sudies show no difference. aher han consider women as risk-averse, financial proessionals would be beter served o hink o hem as “risk-aware.” Women need a firm undersanding o he risk beore proceeding. When making a major invesmen decision, hey desire some clariy on he poenial rade-offs. Addiionally, women require more ime when making an invesmen decision. ey are collaboraive decision makers and preer o consul close riends, wealh expers, and oher financial resources. Perhaps a more accurae erm o describe men is “risk-enhusiass.” In a survey conduced by Prudenial Financial (2012), 70 percen o men expressed a willingness o assume some risk in exchange or greaer financial reward. Also, 40 percen o men said ha hey enjoy he “spor o invesing,” compared o jus 22 percen o women. Hormones, specifically esoserone, may play a role in he willingness o men o assume addiional risk. Neuroscienis John Coaes conduced an experimen wih 17 high-volume raders rom he London financial disric. wice a day, hey repored heir gains and losses and provided Coaes wih a sample o saliva. His resuls show ha above-average gains correlae wih higher esoserone levels, whereas marke volailiy affecs corisol levels. As Coaes and Herber (2007, pp. 4−5) noe, Corisol is likely, hereore, o rise in a marke crash and, by increasing risk aversion, o exaggerae he marke’s downward movemen. esoserone, on he oher hand, is likely o rise in a bubble and, by increasing risk- aking, o exaggerae he marke’s upward movemen. ese seroid eedback loops may help o explain w hy people caugh up in bubbles and crashes ofen find i difficul o make raional choices. e ac ha women have subsanially less esoserone han men may explain heir diligen and measured approach o risk-aking. aional hough influences heir invesmen decisions more han chemical processes. Women are, hereore, less likely o succumb o marke panic or “irraional exuberance.” is difference may be one reason a lower percenage o women dumped equiies during he Grea ecession, which

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officially lased rom December 2007 o June 2009. is “look beore you leap” approach o invesing can be boh a blessing and a curse or he emale invesor. Alhough women may ake more ime o review he inormaion beore making a decision, heir decisions are less hase and more long erm. Once hey decide on a course o acion, hey preer o see i hrough. WOMEN AND

FINANCIAL LITERACY

Basic financial knowledge helps women make financial decisions wih greaer confidence. Wheher men acually have a more complee undersanding o financial produc or women suffer he effecs o low sel-eseem rom generaions o social condiioning is unclear. In eiher case, wih he increasing number o single-moher households, women mus eel confiden in heir financial lieracy. is developmen has boh a shor- and long-erm effec on heir lives and households. By increasing women’s financial lieracy, he change can become permanen and also can be passed on o uure generaions. is change o social condiioning is likely o occur over ime. However, oday’s financial advisors can drive such change by providing guidance oward supporing he undersanding o finance. Guidance includes encouraging cliens o read books abou people who have overcome financial obsacles. Also, offering several workshops or various financial lieracy levels beginners, inermediae, and exper can help. Financial lieracyis he abiliy o comprehend basic eaures o personal finance, such as credi, deb, and consumer proecions. is includes he capaciy o make inormed decisions abou saving, budgeing, invesing, and managing money. Evidence shows ha a large porion o he populaion possesses low financial lieracy skills, which makes building and proecing personal wealh challenging. Despie he prevalence o financial educaion classes, he average American is sill criically deficien in his or her basic financial knowledge. According o a Harris Poll (2014), only 39 percen o U.S. aduls keep close rack o heir spending and 32 percen do no place any porion o heir income ino a reiremen savings accoun. Poor financial lieracy can be especially cosly or women, who endure more pronounced economic challenges han men, such as greaer longeviy and is atendan healhcare coss. Caregiving and amilial responsibiliies can also impede heir abiliy o conserve and grow heir wealh. Because o childbirh and responsibiliies associaed wih parening, women are more likely han men o have ransiioned ou o he workorce a some poin in heir lives. By he age o 62, 90 percen o men have a leas 35 years o earning hisory versus 30 percen o women a ha age. For his reason, women mus make a concered effor o remain financially “fi.” o achieve his, women mus undersand heir financial posiion, invesmen opporuniies and risks, and how much hey need o save o ensure a comorable reiremen. For some women, money remains an uncomorable opic o conversaion. According o Fideliy Invesmens (2015b), 80 percen o women repor reraining rom discussing finances wih hose close o hem. Less han hal o he women surveyed indicae hey would eel confiden discussing money wih a qualified proessional. Ye, 77 percen indicae hey would eel confiden discussing medical issues wih a docor. In cerain cases, heir relucance o discuss money wih close riends and financial proessionals

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prevens hem rom gahering imporan financial inormaion. is underscores he need or increased financial lieracy or women. Alhough heir lack o comor alking o financial proessionals may be a resul o social condiioning, i can be overcome hrough increased undersanding o he goals and decision-making process or women. Women under he age o 35 are dealing wih unexpeced hardships. e Grea ecession and he rising cos o educaion have made advancemen especially difficul or hem. ey have he highes unemploymen rae o any age group and he lowes rae o financial produc ownership. According o Prudenial Financial (2012), 22 percen o women under 35 lack a checking or savings accoun. Addiionally, 67 percen o hose surveyed depend on amily or riends or financial suppor. Alhough his demographic is also he mos eager or financial inormaion, financial proessionals mus o a beter job educaing younger women in order o preven hem rom accruing deb and ruining heir credi. is group o women more han heir predecessors sees he value and need or financial lieracy and sabiliy. However, reaching hem mus be done on heir erms. As previously saed, his demographic relies heavily on he word o riends, amily, and social media sources such as Facebook. e abiliy o gaher inormaion rom hese sources is paramoun o hem. DEFINING SUCCESS AND FAILURE

As men and women define success differenly, hey also have conrasing views o ailure. Alhough boh male and emale business owners sae ha hard work is he key acor in recovering rom a business ailure, men are much more likely han women o ascribe he recovery o sel-confidence (33.3 percen versus 17.5 percen) (obb e al. 2014). When a man ails, he poins o acors like “didn’ sudy enough” or “no ineresed in he subjec mater.” When a woman ails, she is more likely o believe ha ailure resuls rom an inheren lack o abiliy. In siuaions in which a man and a woman each receive negaive eedback, he women’s sel-confidence and sel-eseem drop by a much greaer degree. e inernalizaion o ailure and he insecuriy i breeds hur uure perormance, so his patern has serious long-erm consequences (Sandberg 2013). is difference means ha men recover rom ailure and are quickly ready o move orward and even ake risks again. Ye, women end o eel he ailure and need a longer period o ime beore moving orward. is characerisic can also resul in decreased risk olerance or women. During his pos-ailure period i is imperaive or women o have more suppor o overcome hese effecs on heir sel-eseem and sel-confidence. Men possess a more posiive opinion o heir capabiliies as enrepreneurs. Despie similar levels o educaion and ex perience, less han hal o women (47.7 percen) express confidence in heir abiliy o sar a business, compared wih nearly wo-hirds (62.1 percen) o men. In Japan, where women assume a secondary role o men, only 5 percen o women surveyed believe hey have he requisie skills o launch a business (Clifford 2013). However, his social engineering and condiioning can be overcome. Supporing women enrepreneurs during he early sages o a business venure is criical o heir success. alened women should be encouraged o reurn o enrepreneurship-relaed aciviies afer iniial sebacks and develop new opporuniies or uure success. Helping women undersand he cause o he seback by providing pracical educaion can help hem reurn o enrepreneurship. is period o growh can

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also be a caalys or heir uure achievemen, because hey will carry his inormaion orward and help inorm uure decisions. GENDER INEQUALITY IN FINANCE

In he financial indusry, women coninue o be severely underrepresened. Alhough finance organizaions now recognize he need or greaer diversiy in he workplace, progress has moved a a very slow pace. As Chandler (2015) repors, women consiue jus 9 percen and 6 percen o senior managemen in venure capial and privae equiy firms, respecively. Women occupy jus 3 percen o senior posiions in hedge unds. Alhough he figures have improved rom a decade ago, hey have no kep pace wih oher indusries. o reciy his imbalance, financial companies mus ideniy alen early and implemen plans o prepare emale proessionals or uure leadership posiions. A sudy by Bardon, Devillard, and Hazelwood (2015) reveals ha gender diversiy was a op 10 sraegic prioriy or jus 28 percen o companies. Onehird o companies surveyed had no plans or improving gender diversiy wihin heir srucures or culure. According o he Bureau o Labor Saisics (2015), financial planning is expeced o be one o he ases-growing fields in he Unied Saes, ye he number o women joining pracices has sagnaed. Only 23 percen o Cerified Financial Planners (CFPs) are women, even as he number o CFPs has increased (Cerified Financial Planner Board o Sandards, Inc. 2015). A repor by he Cerified Financial Planner Board o Sandards, Inc. (2014) shows ha 42 percen o CFP® proessionals believe ha more women would be drawn o he proession i firms used a salary-based pay model insead o commissions or pay based on AUM. According o Kingsbury (2015, p. 4), I is a myh ha women are no ineresed in heir financial lives. ey’re ineresed, bu hey wan a emale- riendly advisor who will coach and educae hem abou how o bes navigae he wiss and urns o heir financial lives. No one ha jus sells producs. Women are especially well suied or careers in financial planning. ey end o be good liseners, orward looking, and holisic in heir approach o planning. Alhough married and single women rarely express a gender preerence, one in our women who are widowed or divorced srongly preer a emale advisor (Etinger and O’Connor 2011). For his demographic, he driving orces in he decision on choosing an advisor are comor and relaabiliy. o remain compeiive, senior parners mus do a beter job advocaing or gender balance in he workplace. Gender equaliy in finance will be realized only when public and privae insiuions make a commimen o oser a more inclusive corporae culure. Even afer decades o progress, many companies sill lack gender diversiy. Consequenly, balancing he scales involving gender diversiy and equaliy is likely o ake ime. FINANCIAL CONCERNS FOR WOMEN

e hough o running ou o money in heir laer years is a concern shared by many successul women. Even hose wih considerable financial knowledge ofen ear hey may no have enough money se aside o suppor heir amilies afer reiremen.

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e pressures o caregiving can compound hese worries. Many women assume ull responsibiliy or careaking needs, which akes boh an emoional and a financial oll. Aduls over he age o 50 who look afer heir parens lose roughly $3 rillion in wages, Social Securiy, and pensions. e financial cos is higher or women, who exhaus an esimaed $324,044 as a resul o caregiving $40,328 more han men in caregiving roles. ising healhcare coss hreaen o only exacerbae he problem. Addiionally, women are more likely han men o sacrifice career ambiions o care or ohers: 16 percen o women ake less demanding jobs (compared o 6 percen o men) and 12 percen give up work enirely (3 percen o men). A oal o 70 percen o working caregivers repor difficulies a work because o heir responsibiliies a home (Family Caregiver Alliance 2012). Beween caregiving and increased lie expecancies, he financial concerns o women are jusified. ese uncerainies orce women o be more cauious and pragmaic when planning or reiremen. Men approaching reiremen age end o ocus narrowly on he needs o heir parners, whereas women consider all members o heir exended amily: grown children, grandchildren, parens, siblings, and oher relaives. Alhough women sill save less or reiremen han heir male counerpars, heir atiudes oward saving and planning are changing. In a survey by Fideliy Invesmens (2015b), 74 percen o emale respondens said ha hey are proacive abou saving or he uure. Addiionally, 81percen said ha hey have become more involved in heir long-erm financial planning over he pas five years, and 83 percen wan o become more involved wihin he coming year.

Closing the Gender Gap in Financial Wellness Sudies on financial wellness demonsrae angible resuls. For example, an annual survey by Financial Finesse (2015) repors a 4.2 percen increase beween 2012 and 2014 in he number o women who consider hemselves on rack or reiremen. For men, his figure dropped 1.5 percen over he same ime span (Hannon 2015), Women proessionals are aking greaer conrol o heir personal finances and reaping he rewards. e number o women who have placed money in an emergency und has also increased. ough are in doing a beter job preparing he uure,pracices. hey sillMen rail behind heir male women colleagues money managemen and or invesmen end o be more confiden in heir invesmen sraegy. Only 34 percen o women eel confiden ha heir invesmens are properly allocaed compared o 48 percen o men. Similarly, 55 percen o men say hey have aken a risk-olerance assessmen; jus 40 percen o women offer he same response (Financial Finesse 2015). According o he U.S. Census Bureau (2015), women are losing an average o $10,672 in annual income due o gender-based wage discriminaion. A more aggressive and diversified invesmen sraegy could help counerbalance his income dispariy. Ye, he cauiousness o women invesors ofen keeps hem rom commiting o more proacive invesmen plans.

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Summary and Conclusions Women ofen uninenionally neglec heir personal finances because o oher responsibiliies. An increasing number o women find hemselves in he “sandwich generaion,” simulaneously responsible or raising heir own children and caring or heir elderly parens. In many cases, women have o coordinae care or he whole amily, such as or boh an 8-year-old daugher and an 80-year-old aher. Some women are sruggling o balance heir careers wih heir amily responsibiliies. As a resul o eeling overwhelmed, overexended, andwomen overworked, women atenion o financial planning. Ofen his causes o se many aside heir jobspay oless ulfill hese responsibiliies. Consequenly, his leads o a loss in uure financial planning opporuniies. A pressing need exiss o educae financial proessionals on he psychology o women invesors. Firms should insruc proessionals on how o ask beter quesions, lisen more atenively, and read verbal cues and body language. Proessional communicaion courses should become a prerequisie or advisors. is will ensure a level o service ha opens he door o long-erm relaionships and enhanced clien saisacion. Moreover, he precise skills ha srenghen relaionships wih emale invesors such as paience and empaheic lisening will aciliae improved communicaion and undersanding. Financial proessionals who coninue o ignore he individual values, moivaions, and needs o women invesors can expec o see heir businesses gradually decline. Insead, increasing he number o women cliens should be considered a business opporuniy o expand base economy, and Assesfirms Under Managemen (AUM).heir As women assume a larger rolehe in clien he global should consider adaping clien service and/or business model. e one-size-fis-all approach is no longer an appropriae soluion. Women expec cusomized service and clear communicaion rom financialexpers. Women who have experienced major lie evens, such as divorce or deah o a spouse, will undoubedly have unique needs and preerences. Firms commited o building srong, personal ies wih heir emale cliens will enjoy improved clien reenion and acquisiion. raining and menoring alened women should be a prioriy or every financial insiuion. A diverse workplace is a more adapable, markeable, and profiable one. Women add value o companies hrough heir inuiive and collaboraive approach o clien relaionships. Wih women inheriing a greaer share o wealh, he demand or emale financial advisors and wealh proessionals will only grow. o bridge he confidence gap, financial proessionals mus improve how hey engage women wih money low financial lieracy beore hem wih hewomen necessary ools o manage heir wih greaer ease. eyproviding need o remember ha cliens ofen wan more ime o consider heir decision. By making a commimen o beter serve women cliens, financial proessionals will help heir cliens saeguard heir money and gain confidence a any sage o heir lives.

DISCUSSION QUESTIONS 1. Explain how men and women view invesing differenly and why advisors should know his.

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2. Explain why women ofen lack confidence abou financial maters and how his may affec heir financial decisions. 3. Ideniy several imporan financial concerns o women. 4. Discuss how he caregiver role affecs invesing. 5. Discuss how advisors should rea women.

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14 The Psychology of Millennials APR IL R UDI N Founder and President Rubin Group CA THERINE M CBREEN Managing Director Spectrem Group

Introduction e premiere episode o he 41s season o Saurday Nigh Live in Ocober 2015 eaured a parody o a commercial or a new V workplace drama called “e Millennials.” Crammed ino his shor skech was perhaps every sereoype atached o a generaion deemed o be sel-absorbed, eniled, and irriaing. For insance, one characer demands a promoion afer having worked a he company or hree days. Ohers engage in obsessively exing on heir phones, oblivious o all around hem. A hird characer needs “perspecive” and ells her boss she will no longer come o work, bu ha she is no quiting. e boss, who has spen 25 years working and sacrificing o “claw his way o he op” o his company, sums up his disdain or his new generaion o workers: “I hae hese kids.” e show has never done similar generaional parodies abou baby boomers or Gen Xers. Bu millennials seem o be a major arge, especially by heir elders. In his ime magazine sory profiling he demographic o young aduls born beween 1980 and 2000, Sein (2013) reflecs on wha he calls he “Me Me Me Generaion.” is barbed porrai cass millennials in he wors ligh as coddled, lazy, and above all, narcissisic. Ye, regarding how millennials will shape he financial services indusry and he uure o advisor–clien relaionships, maybe he atenion is all abou hem i no oday, hen cerainly omorrow and or decades o come. o paraphrase Bob Dylan, he imes are changing once again. Currenly, baby boomers dominae he ownership o invesmen asses. ey also represen he larges percenage o invesors o currenly reply on financial advisors. Millennials, a 80 million srong, have surpassed baby boomers as he larges generaion. In 2015, millennials represened more han one-ourh o he U.S. populaion (Census Bureau 2015) and represened more han one in hree American workers (Fry 2015a). By 2020, millennials will consiue abou 46 percen o all U.S. workers (Brack and Kelly 2012). is group also has he poenial o become he wealhies generaion so ar. 241

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is chaper discusses qualiaive and quaniaive age and wealh-segmen research o millennials by he Specrem Group and he invesmen atiudes and behaviors o millennials by he udin Group. I specifically examines how he financial crisis o 2007–2008 helped shape heir atiudes oward personal financial siuaions, he overall financial services indusry, and financial advisors. is research indicaes ha millennials, as were he boomers beore hem, are poised o leave heir imprin on he financial services indusry, changing business as usual in he way hey inerac wih advisors, wheher human or robo, and wheher hey use weny-firs-cenury ools and resources o shape heir financial uures.

Millennials and Boomers—Two Different Worlds e rules o engagemen by which financial advisors conduc business wih heir baby boomer cliens is unlikely o be as effecive wih he millennials, who grew up during financially unsable imes. According o Facebook IQ (2016), a litle over hal, or 53 percen o millennials eel hey have no one hey can rus or financial guidance, and in ac only 8 percen rus financial insiuions or such advice. e Facebook sudy repors ha millennials drive 40 percen o he financial conversaions on he social nework, generaing 6.5 million poss, commens, likes, and shares. Baby boomers are he V generaion, bu millennials are no bound by one screen; hey are “cuting he cord” and viewing he media on heir own erms and schedules. More ech-savvy han baby boomers, millennials are also more responsive o he laes gadges and are quicker o inegrae hem ino heir daily lives. Similarly, hey are no uilizing he radiional communicaion plaorms; or example, wo-hirds o millennials do no have landlines. Bu millennials do share heir elders’ concep o he American dream as envisioned by Pulizer Prize- winner James ruslow Adams, who coined he erm in 1931. He saw America as a land o equal opporuniy ha would allow people o atain o he ulles saure o which hey are innaely capable, regardless o he circumsances o birh or posiion (Adams 1931). Similarly, 6 in 10 millennials define he America dream as “equal opporuniy or all people.” e second highes percenage o millennials (56 percen) believe ha he American dream ranslaes o educaional opporuniies, whereas 44 percen see i as owning one’s own home (Specrem Group 2015a). For many financially beleaguered millennials, however, his goal is a dream deerred. Among non-millionaire millennials, ownership o a principal residence is down considerably rom 2014 rom 62 percen o 50 percen. Nearly hal (46 percen) see he American dream as having sufficien reiremen asses. is finding indicaes ha despie financial challenges, millennials view he American dream as aspiraional. Figure 14.1 shows he generaional divide on how millennials view he American dream as compared o heir older counerpars. MILLENNIALS AND FINANCIAL LITERACY

Several sudies provide inormaion abou he financial lieracy o American millennials. For example, ang, Baker, and Peer (2015) find ha when presened wih hree basic quesions abou socks, ineres raes, and inflaion, only oneourh o respondens could answer all hree correcly. Furhermore, only 2 percen o respondens show consisenly

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By Age

57%

An equal opportunity for all people

63% 71%

79%

44% 42% 43% 47%

Owning a home

46% 51% 55% 58%

Having sufficient retirement assets

41% 43% 47% 45%

Job security

56% 49% 55% 61%

Educational opportunities

46% 53% 55% 55%

Future generations will do better than the current generation 32% 30% 37% 36%

Being able to retire when i want

2%

None of the above

Under 40

41–50

8% 5% 2%

51–60

61 and over

Figure 14.1 Views o he American Dream, by Age Group. is figure shows surveybased daa on wha he American Dream means o millennials compared o previous generaions. Source: Specrem Group (2015a). responsible money managemen behavior in hree caegories: paying off debs in a im ely manner, seting and sicking o a budge, and saving oward reiremen; he average survey responden exhibied responsible behavior in only one o hese caegories. e sudy also showed a disconnec beween financial knowledge and money managemen behavior, in ha millennials make poor financial choices even hough hey may know beter. A sudy by . owe Price (2015) finds a generaion ha is pracicing good financial habis, especially compared wih baby boomers. e sudy also repors ha millennials are saving nearly as much or reiremen as did baby boomers, bu ha more millennials have increased heir 401(k) savings. e sudy also ound ha 75 percen o millennials careully rack heir expenses, compared wih 64 percen o baby boomers. According o he sudy, nearly 9 in 10 millennials indicae hey are “prety good” a living wihin heir means, while roughly hree-ourhs proess being more comorable saving and invesing heir exra money han spending i. According o a Wells Fargo

244

FINANCIAL AND I

NVESTOR PSYCHOLOGY OF SPECIFIC PLA I am very knowledgeable about financial products and investments

17% 25%

I am fairly knowledgeable, but still have a great deal to learn I am not very knowledgeable about financial products and investments, but i do understand... I am not at all knowledgeable about financial products and investments

YERS

41% 54%

39% 21%

3% 0%

Millennials with less than $1MM net worth Millennials with more than $1MM net worth

Figure 14.2 Knowledge Level or Invesors, by Age Group and Income. is figure shows survey- based daa on how non-millionaire and millionaire mil lennials perceive heir financial lieracy regarding financial producs and invesmens. Source: Specrem Group (2015i).

(2014) sudy, 8 ou o 10 millennials repor ha he Grea ecession augh hem o save “now” o prepare in case o uure economic problems. According o a sudy by Bank o America/USA ODAY (2015), nearly 7 in 10 millennials (68 percen) learned abou money rom heir parens. Alhough 60 percen eel heir parens did a good job eaching hem abou finances, almos hal (47 percen) wish hey had sared alking o hem abou money sooner. Conrary o he common sereoype, millennials have ew illusions abou heir financial lieracy. Among non-millionaire and millionaire millennials, he highes percenages consider hemselves only airly knowledgeable, wih sill much o learn abou financial producs and invesmens (Specrem Group 2015i), bu millionaires are more likely han non-millionaires o describe heir financial knowledge his way han nonmillionaires (54 percen vs. 41 percen). Figure 14.2 shows he confidence levels o nonmillionaire and millionaire millennials regarding heir financial knowledge. THE MILLENNIAL MINDSET

Millennials came o age during he financial crisis o 2007–2008, he wors economic crisis since he Grea Depression. During his period, many o he larges and mos

245

The Psychology of Millennials

245

recognized financial insiuions olded, including Lehman Brohers, Bear Searns, and Counrywide. Younger millennials winessed he devasaion ha he financial crisis infliced on heir parens’ financial siuaions, while older millennials enering he workorce ound he job marke rie wih layoffs and unemploymen. e financial crisis was a proound realiy check or millennials. Seven in 10 Americans believe ha a college educaion is very imporan (Newpor and Buseed 2013); ineresingly, in 1978, when Gallup firs asked his quesion in a survey, only 36 percen considered a college educaion o be very imporan. According o he Council o Economic Advisors (2014), hough, millennials are he mos educaed generaion, wih almos hal (47 percen) having earned some possecondary degree, compared o nearly onehird o baby boomers who reached ha same milesone. Millennials wih a ne worh o a leas $1 million are more ap o credi heir educaion, raher han hard work, as heir primary wealh-creaion acor, compared o Gen Xers, baby boomers, and seniors, who rank heir educaion as second behind hard work (Specrem Group 2013). According o an analysis o governmen daa, hal o oday’s college graduaes are eiher unemployed or underemployed in jobs or which hey are eiher overqualified or no in heir field o sudy (Yen 2012). e naional unemploymen rae or young aduls ages 18 o 34 years old reached a recession heigh o 12.4 percen in 2010, bu by he firs hal o 2015 his rae had dropped o 7.7 percen, ye i was sill well above he naional average o roughly 5.5 percen or he same period (Fry 2015b). According o Paten and Fry (2015), millennial men are no only less likely han heir Gen X counerpars o be employed bu also less likely o be employed compared wih baby boomers and seniors when hey were he same age (primarily in he 1970s and 1980s). Millennial women are also less likely o be employed compared wih Gen Xers, bu hey are in a beter posiion employmen-wise han heir baby boomer and so-called silen generaion orebears (women o previous generaions who more commonly sayed home and raised a amily). Many millennials are compelled o delay imporan long-erm lie decisions, such as saring a amily and buying a house, because o he financial challenge o unprecedened suden deb, which is repored a more han $1 rillion (Kanrowiz 2016). is patern has earned millennials he sobrique o “boomerang children” young aduls waiing ou a consrained job marke or oherwise unable o afford a place o heir own, and having reurned home o live wih heir parens. In 2015, 15.1 percen o 25- o 34-year-olds were living a home (Mathews 2015), which is he ourh sraigh annual increase or his group. In ac, U.S. Census Bureau daa show ha 36.4 percen o millennial women ages 18 o 34 lived wih heir amilies in 2014, he highes percenage since 1940. ese young women are more likely o be college educaed and unmarried han earlier generaions o American women in his age group, as hey sruggle wih economic issues such as suden deb, high cos o living, prolonged economic downurn, and a challenging job marke. As or millennial men, he daa show ha 42.8 percen lived wih heir parens or relaives in 2014, bu his was below he 47.5 percen recorded or men in 1940 (Fry 2015c). Besides geting room and board, 35 percen o millennials repor receiving parenal financial assisance (Bank o America/USA ODAY 2015). A leas 20 percen ge financial help o pay heir cellphone bills, groceries, and unexpeced expenses. Furher,

246

FINANCIAL AND I

NVESTOR PSYCHOLOGY OF SPECIFIC PLA

YERS

80 percen o hose who receive help rom he “bank o mom and dad” repor ha hey know many riends heir age receiving similar assisance. A ROSIER LONG VIEW

Despie heir difficul circumsances, millennials are relaively opimisic abou heir shor- and long-erm financial uures. aher han living only or oday, as exemplified in some o he harsher media porrayals, many are proacively planning or heir reiremen. A generaion ha has never known a day wihou he Inerne is using mobile devices o manage heir finances, as well as o increase heir financial lieracy. ree-ourhs o non-millionaire millennials wih a ne worh o a leas $100,000, excluding a primary residence, repor ha heir financial siuaion is currenly beter han i was one year ago (Specrem Group 2015c). is observaion is on a par wih Gen Xers and well above he 60 percen o hose surveyed who ages 45 and up. Eigh in 10 o non-millionaire millennials and heir Gen X cohors are equally confiden ha heir financial siuaion will be sronger one year rom now han a presen. Millionaire millennials wih a ne worh beween $1 million and $5 million, excluding a primary residence, offer a more cauious view o heir presen and uure financial siuaions, wih 6 in 10 indicaing ha hey are beter off now han one year ago, and hreeourhs expecing o be in a sronger posiion financially one year rom now (Specrem Group 2015h). is same rend exiss or heir ulra-high ne worh (UHNW) counerpars, or hose wih a ne worh beween $5 million and $25 million. Six in 10 o hem repor hey were beter off financially in 2015 han in he previous year, whereas abou 7 in 10 expec o be beter off in he nex 12 monhs (Specrem Group 2015k). O he non-millionaire millennials, 71 percen indicae ha hey ully expec o have sufficien income o live comorably during reiremen. ey are no alone in heir guardedly opimisic orecass. O non-millionaire Gen Xers, 64 percen eel similarly, along wih 62 percen o baby boomers and a more confiden 78 percen o he seniors. Millionaire millennials are less confiden han previous generaions ha hey will have sufficien income o live comorably during reiremen (Specrem Group 2015i). Figure 14.3 shows how non-millionaire and millionaire millennials gauge heir reiremen securiy. 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%

Millennials

Gen X

93% Baby Boomers

WWII

Figure 14.3 Survey esponses o Q uesion abou eir emen Planning. is figure shows survey- based daa abou how millennials view heir reiremen securiy compared o previous generaions. Source: Specrem Group (2015i).

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The Psychology of Millennials

247

A majoriy o young aduls are confiden hey will be able o live comorably in reiremen on heir income. is siuaion represens an opporuniy or financial advisors o engage hem on financial planning. As millennials embark on heir careers, a primary concern is seeking adequae help ha will allow hem o reach heir financial goals. NA TIONAL AND PERSONAL CON

CERNS

Financial advisors seeking o engage millennials should know wha naional and personal issues weigh mos on heir minds. On he naional ron, young aduls wih a ne worh o less han $1 million are mos concerned abou ax increases, ollowed closely by he racious poliical environmen. A leas wo-hirds rank he ederal defici as he naional issue mos on heir minds. Addiionally, 6 in 10 ideniy low ineres raes on savings, inflaion, and sock marke perormance as concerns. On he personal ron, non-millionaire millennials are mos concerned abou wo o he mos pressing financial maters hey will ace in heir lieimes: financing heir children’s educaion, and being able o reire when hey wan o. ese concerns even ake precedence over mainaining heir curren financial siuaion (Specrem Group 2015i). Millennials recognize ha healh concerns could have a direc impac on heir reiremen savings. A majoriy o hem express concern abou aking responsibiliy or heir aging parens, a percenage on a par wih he Gen Xers and baby boomers. oughly 4 in 10 non-millionaire millennials cie heir own healh, he healh o heir spouse, a amily healh caasrophe, and spending heir final years in a healhcare aciliy as heir primary personal concerns (Specrem Group 2015c). On wo financial issues, non-millionaire millennials express even greaer concern han heir older counerpars. e firs involves using heir wealh o help ohers, while he second is abou business revenues or an eniy hey own. e later speaks o anoher generaional difference. Unlike previous generaions, whose careers ollowed he radiional 9-o-5 roue a a company, millennials wan o sar heir own businesses. Nearly one-hird (32 percen) o millennials who are sel-employed are running heir own sar-ups, compared o jus 9 percen o heir baby boomer cohors (D Amerirade 2015).

Millennials and the Use of Financial Advisors Millennials represen a srong growh opporuniy or financial advisors. As Figure 14.4 shows, young aduls wih a ne worh o less han $1 million are more likely han older invesors o ideniy hemselves as sel-direced, meaning hey make all heir financial and invesmen decisions wihou he guidance o a proessional advisor. Increasing age is generally associaed wih greaer wealh and more insances in which invesors seek a financial advisor. Figure 14.4 shows how millennials engage financial advisors compared o older households. Figure 14.4 shows ha millennials eschew using a financial advisor primarily as a mater o rugaliy and a percepion ha financial advisors would no deem hem worhwhile cliens. Almos hal (46 percen) o non-millionaire millennial households believe hey canno afford a financial advisor, and a he same ime hey consider heir asses

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M M 1 $ n a h t s s e L

th r o W t Baby e N

n a h t r te a e r G

h Millennials rt o W Gen X t e N Baby Boomers M M WWII 1 $

Self-Directed Investors make their own investment decisions without the assistance of an investment advisor

Millennials

51%

Gen X Boomers WWII

YERS 38 %

47% 37%

32%

34%

43%

28%

32%

Advisor-Assisted Investors regularly consult with an investment advisor regarding most investment needs, but make most of the final decisions

11%

1 0%

3 5% 31%

4%

13%

26%

38%

28%

Event-Driven

1 3% 1 8%

29%

38%

Investors make most of their own decisions but use an investment advisor for specialized needs such as retirement planning, asset allocation advice or selecting alternative investments

1 1%

3 7%

14%

1 6% 27% 25%

6% 14% 15%

Advisor-Dependent Investors rely on an investment professional or advisor to make most or all investment decisions

Figure 14.4 Degree o Advisor Use, by Age Group and Income. is figure shows how Millennials engage financial advisors compared wih older households. Source: Specrem Group (2015i).

insufficien o jusiy using one. ellingly, heir wealhier counerpars in millionaire and UHNW households indicae hey do no use financial advisors primarily because hey eel hey can do a beter job (Specrem Group 2015b, 2015, 2015j). According o Bond (2015), millennials do no rus financial planners, or several reasons. One is he negaive repuaion o he financial indusry as a resul o he financial crisis o 2008. Addiionally, reasons include he income inequaliy debae, conusing jargon, high ees, culural differences, and Inerne or media access o ree financial planning inormaion such as on Yahoo! Finance,CNN Money, and MSN Money. And i many millennials are no seeking he advice o a financial advisor, he eeling seems o be muual. Only 30 percen o financial advisors are acively looking or cliens in his age demographic. e belie is ha younger individuals have lower income and less wealh. And generally speaking, older households have more asses and mos advisors ge paid on a percenage o hose asses. Older baby boomers own 22 imes more in asses han households under age 35, so financial advisors undersandably wan o ocus heir atenion on his older demographic (Severman 2015). However, according o Andree (2015), millennials possess some valuable qualiies. For example, hey have an enrepreneurial spiri and wan o leave heir mark on he world. Addiionally, millennials are well inormed and ech-savvy. ey also wan o build communiy and ofen seek inormaion, especially online. THE IMPETUS FOR SEEKING FINANCIAL ADVICE

Wha would compel millennials o consider using an advisor? egardless o heir wealh level, a majoriy cie hree scenarios: (1) receiving a windall o money wih which hey would need help invesing; (2) a specific financial siuaion or which hey would

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seek proessional advice, such as creaing a financial plan; and (3) a siuaion in which hey could receive a financial advisor’s services or wha hey perceive o be a air price (Specrem Group 2015b, 2015, 2015j). Non-millionaire millennials are much more likely han heir older counerpars o consul a financial advisor in hese siuaions. Nearly 4 in 10 (38 percen) would consider using an advisor ollowing a change in heir household saus, such as marriage or a new baby, compared wih 8 percen o Gen Xers, 16 percen o hose ages 45 o 54, and 9 percen o baby boomers. ey are also a leas wice as likely as older households o consider using an advisor should hey ire o managing heir invesmens (Specrem Group 2015b). Under hese circumsances, millionaire millennials would be more likely han heir older cohors o consider engaging a financial advisor. As heir wealh increases, he percenage o millennials who migh consider using a financial advisor also increases i hey no longer wan o manage heir invesmens. HOW MILLENNIALS VIEW A FINANCIAL ADVISOR

Despie he populariy o echnology, his age demographic finds advisors hrough reerrals, which older generaions also use. According o Johnson and Larson (2009, p. 66), consumers generally “use word-o-mouh reerrals [because] hey rus he people hey are asking o give hem a good recommendaion, and consumers rus riends, relaives, and expers hey know in a relaed field.” egardless o heir wealh level, millennials are mos likely o be reerred o an advisor by a amily member or riend (Specrem Group 2015b, 2015, 2015j). Millennials seek specific characerisics rom heir advisors and place he highes premium on perceived honesy and rusworhiness. is firs generaion o digial naives, whose homes likely conain a leas one compuer and who pos and wee abou heir personal lives on Facebook, witer, and oher social media, lives by ransparency and expecs similar openness rom a financial advisor. Indeed, millennials place less emphasis on ees or commissions charged, or wheher he advisor’s firm is well known, han on he advisor’s invesmen rack record or he qualiy o reerrals. When hey use hem, millennials ener ino a working relaionship wih a financial advisor armed wih preerences and prejudices. Firs and oremos, hey expec heir advisors o respond promply o inquiries and quesions. ey also preer o work wih one advisor who handles all aces o heir wealh. a heir advisor has proessional regisraions and licenses is less imporan han i is or older households, bu millennials place more imporance on heir advisor’s regularly ouperorming he marke. Nearly 6 in 10 non-millionaire millennials rae heir advisors on wheher hey regularly ouperorms he marke, compared wih 53 percen o millionaires and 42 percen o UHNW households (Specrem Group 2015b, 2015, 2015j). Are financial advisors biased oward cerain invesmen groups or producs? A majoriy o millennials hink so. o a lesser exen, hey also eel ha advisors are more concerned wih selling producs han wih helping heir cliens. According o a sudy by he Pew esearch Cener (2014), his skepicism is perhaps endemic o millennials. e sudy repors ha only 19 percen o millennials believe ha mos people can be rused, compared wih 31 percen o Gen Xers, 37 percen o seniors, and 40 percen o baby boomers.

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Among affluen invesors, rus in one’s financial advisor increases wih age. is is no surprising. On a scale o rom 0 o 100, wih 100 equaling “grea rus,” non-millionaire millennials rae heir rus o financial advisors a only 69, compared o 75 or Gen Xers, 79 or hose ages 45 o 54, 82 or baby boomers, and 83 or seniors. Alhough he scores are relaively higher or millionaire and UHNW millennials, hey noneheless express less rus in financial advisors han do heir older counerpars (Specrem Group 2015b). How do millennials define rus as i perains o a financial advisor? e highes percenage consider rus o mean ha he financial advisor is looking ou or he clien’s bes ineress, ollowed by an advisor’s admission i he is wrong. Also, millennials are much more likely o express hese views han would heir older cohors. ey are also mos likely o see he advisor–clien relaionship as one in which he advisor can be couned on o make no misakes (Specrem Group 2015b, 2015, 2015j). Millennials are less likely han older invesors o insis ha he advisor conac hem regularly. ey are also generally less likely o expec he advisor o relay imporan inormaion peraining o heir invesmens. a is, financial advisors find ha millennials are engaged invesors who may be less inclined o be acively involved in he day-o-day managemen o heir invesmens, bu who enjoy invesing and would no wan o give i up. Non-millionaire and millionaire millennials preer advisors o conac hem on a quarerly or a leas a semi-annually basis (Specrem Group 2015b, 2015). RISK TOLERANCE AND INVESTMENT PREFERENCES

As migh be expeced, millennial invesors have a higher olerance or risk han do older invesors. Somewha more han hal (54 percen) o non-millionaire millennials indicae ha hey are willing o ake subsanial invesmen risk on a porion o heir invesmens so as o earn a high reurn, compared wih 44 percen o invesors ages 45 o 54, 37 percen o baby boomers, and 27 percen o seniors ages 65 and up (Specrem Group 2015c). is evidence does no sugges ha millennials inves wihou regard o risk, however. egardless o heir wealh level, millennials consider he risk associaed wih an invesmen as he mos imporan acor in invesmen selecion, ollowed by an invesmen’s ax implicaions and he diversiy o he invesmen (Specrem Group 2015b, 2015, 2015j). According a separae sudy, non-millionaire millennials are more likely o consider an invesmen’s rack record as an invesmen selecion acor (79 percen) han are heir millionaire (53 percen) and UHNW (54 percen) counerpars. ey are also more impressed by he repuaion o he firm making heir invesmens. ree-ourhs o non-millionaire millennials consider he firm’s repuaion when selecing an invesmen, compared wih 62 percen o millionaire and 65 percen o UHNW millennials invesors (Specrem Group 2015c, 2015h, 2015k). As Figure 14.5 shows, he social responsibiliy o an invesmen ends o have a higher prioriy among younger invesors han among older households. More so han oher generaions, millennials are inclined o choose companies ha are no only “perorming well” bu ha also are “doing good.” Bu across all wealh segmens and all age

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The Psychology of Millennials 77% 67% 74% 69%

Tax implications of investments

81% 84% 90% 85%

Level of risk associated with investments

72% 84% 85% 85%

Diversity of investments

Social responsibility of investments

40% 35% 36% 31% 79% 72% 77% 78%

Past track record of investments

75% 79% 81% 82%

Reputation of companies where investments are made

Millennials

Gen X

251

Baby Boomers

WWII

Figure 14.5 Generaional Cri eria or Making Invesmen Decisions. is figure shows survey- based daa indicaing he acors millennials consider o be he mos imporan in selecing an invesmen, compared wih previous generaions. Source: Specrem Group (2015i).

groups, less han 50 percen cie social responsibiliy as a primary invesmen selecion acor. Millennials are no differen han older generaions; he highes percenage o hem consider heir invesmen objecives o be purely financial. HOUSEHOLD MONEY MANAGEMENT

In erms o financial planning, here are several ways or financial advisors o engage millennials. One major caegory o millennials’ concern is deb. Across all wealh segmens, millennials make up he highes percenage o respondens who indicaed concern abou he amoun o deb heir households currenly carry. Deb is a real and growing concern. Wheher he deb involves suden loans, home morgages, or car paymens, wo-hirds o millennials o ages 23 o 35 in 2012 repored having a leas one source o ousanding long-erm deb. iry percen indicaed more han one loan, and 81 percen o college graduaes menioned having a leas one source o long-erm deb. One-hird o millennials wih annual household income above $75,000 doub hey will be able o repay heir suden loans. And besides suden loans, or long-erm deb, millennials carry shor-erm deb, mosly credi card balances. More

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han hal o millennials who used credi cards in 2015 repored carrying a balance in he previous 12 monhs a balance or which hey were charged ineres (Scheresberg and Lusardi 2015). How are millennials handling heir household finances? As have heir elders, millennials are mos likely o pool finances as a household (Specrem Group 2015c, 2015h, 2015k). However, he number o millennial households ha make heir financial decisions joinly decreases wih an increase in wealh. Seven in 10 non-millionaire millennial households make heir decisions joinly, compared wih 61 percen o millionaire households and jus 35 percen o UHNW households. a is, he number o millennial households in which he husband makes mos o he financial decisions increases wih wealh, rom jus 15 percen o non-millionaires o 35 percen o millionaire and 59 percen o UHNW millennials. Accordingly, he rae o spousal agreemen abou finances is higher among non-millionaire millennials han i is or heir wealhier counerpars. Bu beween spouses and financial advisors, he later are credied wih being more helpul in making financial decisions as a household’s ne worh increases. Non-millionaire millennials scored financial advisors a 61 on a scale o 0 o 100, on which 100 equaled “very helpul.” In comparison, hey scored heir spouses a 69. Millionaires gave heir financial advisors a score o 60 and heir spouses a 56 on he helpulness scale, whereas UHNW millennials gave heir financial advisors a 61 versus a 60 or heir spouses. e degree o wealh is a acor in how millennials engage financial advisors. Nonmillionaire millennials repor ha hey conrol 73 percen o heir asses wihou any proessional help, compared wih millionaires, who conrol 53 percen o heir asses and UHNW Millennials, who repor conrolling 52 percen. Across all wealh segmens, older invesors end o cede more conrol o heir asses o an advisor. Millionaire millennials have financial advisors conrolling over he highes percenage o heir asses 20 percen versus 9 percen among non-millionaires and 13 percen among UHNWs. e later consul wih a financial advisor, bu make he final invesmen decisions hemselves or over 35 percen o heir asses, compared wih 27 percen or millionaires and 18 percen or non-millionaires. Non-millionaire millennials are mos likely o urn o a discoun broker or independen financial planner, whereas heir wealhier counerpars are more likely o engage he services o a ull-service broker (Specrem Group 2015b, 2015, 2015j).

The Role for a Financial Advisor Wha advice does an financial advisor mos likely provide o millennials? Among nonmillionaires, he likelihood o receiving advice abou creaing a financial plan increases wih age. Millennials are wice as likely as earlier generaions o receive his advice rom someone oher han a primary financial advisor. is means hey are urning o lawyers, accounans, or even he Inerne or his ype o advice. Millionaire and UHNW millennials are also more likely han older generaions o have received his advice rom someone oher han heir primary advisor (Specrem Group 2015b, 2015, 2015j). Wha do hese affluen young aduls hink is mos imporan o include in heir financial plan? For non-millionaire and millionaire millennials, he mos imporan iems are he invesmen rae o reurn needed o mee heir financial goals, as well as

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how o calculae heir presen ne worh. Besides hese acors, UHNW millennials hink heir financial plan should include ax-planning advice and guidelines (Specrem Group 2015b, 2015, 2015j). Addiionally, non-millionaires and millionaires in his age group are more likely han heir older counerpars o indicae a willingness o seek advice in he uure abou a wider range o issues. ese issues include diversiying heir asses; selecing individual socks, bonds, and muual unds; implemening ax-advanage financial sraegies; seeking alernaive invesmens such as hedge unds; using credi effecively; and esablishing reiremen income sreams. Currenly, hese millennials are he mos likely o indicae hey are already receiving advice abou hese issues rom someone oher han a primary advisor. Generally his means hey are urning o amily members or riends or advice, as well as researching opics on heir own on he Inerne (Specrem Group 2015b, 2015, 2015j). As non-millionaire millennials are more likely han wealhier households o ideniy hemselves as sel-direced invesors, hey make up he highes percenage o millennials who would be “likely” (54 percen) o use an advisor in he uure. In comparison, 25 percen o millionaire and UHNW millennials indicae hey would “likely” use an advisor in he uure (Specrem Group 2015b, 2015, 2015j). ADVISOR

SA TISFACTION

Are millennials harder o please han older invesors? egardless o heir wealh level, roughly hal o all millennials repor ha overall hey are saisfied wih heir advisors. e percenages increase wih age. Specifically, among surveyed non-millionaires, millennials are less li kely han heir older counerpars o express saisacion wih heir advisor’s knowledge and experise (57 percen), responsiveness o requess (54 percen), and per ormance (45 percen). Millionaire and UHNW millennials are he leas saisfied wih heir advisor’s perormance in comparison o older households (Specrem Group 2015b, 2015, 2015j). e greaes concern o he millennial invesors who work wih a financial advisor is a ailure o communicae. Ye, his is jus one o he reasons millennials would swich advisors, in conras wih older generaions. Among non-millionaire millennial invesors who do use an advisor, nearly 7 in 10 indicae hey would fire heir advisor i heir phone calls were no reurned in a imely manner (e.g., by a leas he nex day). Only 50 percen o non-millionaires ages 36 o 44 eel likewise, as do 54 percen o hose ages 45 o 54, wih roughly wo-hirds o baby boomers and seniors agreeing wih ha senimen. Similarly, non-millionaire millennials are slighly more likely han older generaions o indicae hey would swich i heir advisors did no reurn e-mails in a imely manner (Specrem Group 2015b). Non-millionaire millennials would also be more likely han older generaions o change heir financial advisors afer losses accrued over he span o one, wo, or five years, and i he advisor is underperorming compared o he overall sock marke. Older invesors express a will ingness o change advisors because o a lack o proacive conac, as well as i heir advi sors alked o hem only abou invesmens and seemed no concerned abou heir overall financial siuaion.

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egarding ees, non-millionaire and millionaire millennials are more likely han older generaions o consider he services o a proessional advisor o be expensive; UHNW millennials eel less so in his regard. Especially, non-millionaire millennials do no adop he mindse o being unconcerned abou he ees hey pay as long as heir asses are growing. In ac, roughly one-ourh express being unconcerned abou he ees hey pay as long as heir asses are growing, compared wih 32 percen o Gen Xers, roughly 30 percen o baby boomers, and one-hird o seniors. Among all surveyed nonmillionaire and millionaire invesors, millennials consiue he highes number who preer o pay fixed ees or financial and invesmen advice (Specrem Group, 2015b, 2015, 2015j). In ac, millennials consider ee-only planners more likely o possess he rusworhiness, honesy, and horoughness hey seek in an advisor (Johnson and Larson, 2009). e highes percenage o UHNW millennials preer ha he cos o financial advice be ied o produc perormance. Ye across all wealh segmens, millennials’ comor level wih he ees hey pay is on a par wih heir older counerpars. e acions ha financial advisors ake wih heir millionaire millennial cliens seem o be working, because 42 percen o hose millennials sae hey are more saisfied wih heir advisor oday han hey have been in he pas, compared wih 29 percen o Gen Xers, 31 percen o hose ages 36 o 44, 37 percen o baby boomers, and 36 percen o seniors ages 65 and up. Non-millionaires and UHNW millennials are he leas likely across all age groups o repor hey are currenly more saisfied oday han in he pas wih heir advisor. Addiionally, millionaire millennials are more likely han heir older counerpars o believe heir financial advisors are very proessional or knowledgeable; UHNW millennials are he leas likely o express his opinion (Specrem Group 2015b, 2015, 2015j). Wha do millennials expec rom heir financial advisors? egardless o wealh level, millennials pu he highes premium on an advisor who offers producs rom differen companies, has proessional regisraions and licenses, and responds promply o heir inquiries and quesions. Alhough having heir advisor call hem regularly is less a prioriy across all wealh segmens, his service is more imporan o millionaire millennials (42 percen) han i is or heir non-millionaire (24 percen) and UHNW counerpars (33 percen) (Specrem Group 2015b, 2015, 2015j). Millionaire millennials indicae hey are mos in agreemen wih heir advisors. For example, 84 percen eel heir advisor undersands heir appeie or risk, compared wih 68 percen o non-millionaires and 71 percen o UHNW households. How does his ranslae o a reerral? On a scale o 0 o 10, wih 10 equaling “highly likely,” he highes percenage o millennials who scored beween 0 and 6 on wheher hey would recommend heir primary advisor o a riend or colleague were non-millionaire and UHNW households. Millionaire millennials are more likely han older invesors o score beween 7 and 8 (Specrem Group 2015). No surprisingly, millionaire millennials express more loyaly o heir financial advisors han do non-millionaires or UHNW households. When asked wha hey would do i heir advisor lef he firm or anoher, 58 percen o millionaires said hey would move wih heir advisor. In comparison, 41 percen o non-millionaires and 46 percen o UHNW responded similarly. Wih he excepion o Gen X millionaires, non-millionaire and UHNW millennials indicae hey would be mos likely across he generaions o

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say wih he firm, indicaing ha changing would be oo much o a hassle (Specrem Group 2015). TECHNOLOGY AND FINANCIAL INFORMATION

Complicaing he financial advisor–clien dynamic, bu represening ye anoher opporuniy o engage young aduls, is he Inerne and mobile echnology ha pu sorehouses o news and inormaion jus a click away. According o he Council o Economic Advisers (2014), millennials are more conneced o echnology han older generaions, and one-ourh o millennials believe ha relaionship o echnology is wha makes heir generaion unique. According o he Council o Economic Advisers (p. 7), “W hile all generaions have experienced echnological advances, he sheer amoun o compuaional power and access o inormaion ha Millennials have had a heir fingerips since grade-school is unparalleled.” No surprisingly, millennials more han older age segmens consider radiional news channels and plaorms such as he elephone, newspapers, and elevision o be oudaed, and are more ap o rely on social media o communicae and o obain heir inormaion. Millennials, more han previous generaions, indicae a greaer likelihood o using heir smarphones or aciviies such as corresponding wih heir financial advisors and obaining marke updaes (Specrem Group 2015d, 2015g, 2015l). Bu he pervasiveness o social media and mobile echnology has no ye ranslaed ino widespread use o echnology or financial aciviies beyond checking accoun balances, making purchases, and paying bills. able 14.1 provides a sampling o curren social media usage conduced by non-millionaire households or a variey o financial aciviies. Young aduls express he mos ineres in he prospec o reading financial blogs posed by financial or invesmen firms, preerably on he websies o major financial media oules. ey are also ineresed in reading blogs ha perain o financial opics (Specrem Group 2015d, 2015g, 2015l). ech-savvy young aduls would be considerably more ineresed han older affluen households i heir financial service firms provided inormaion via social media and hrough apps. ey would also be more inclined o use a financial produc or service hey saw adverised or discussed on a social media plaorm. ech-savvy young aduls are more han wice as likely as older households o consider choosing a new financial advisor or provider based in par on how much ha advisor communicaes using social media (Specrem Group 2015d, 2015g, 2015l). Jus as millennials have come o age accusomed o waching wha hey wan, when hey wan, and on he porable screen hey wan, hey are mos open o waching videos on financial websies. Four in 10 non-millionaire millenials repor having done so, compared wih 35 percen o Gen Xers and ewer han 3 in 10 o baby boomers and seniors. e mos commonly wached videos on he financial websies are financial inormaion videos, ollowed by videos on curren financial evens and sock ips, as well as videos eauring financial commenaors (Specrem Group 2015d). In gahering financial inormaion, millennials share some o heir older counerpars’ old-school preerences or alking o someone in person and in reading an aricle. Ye, peraining o communicaion wih a financial advisor, millennials are he mos likely age demographic o preer email over he elephone or in person conac. Again,

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able 14.1 Social Media Most Likely to Be Used for Specified Activities Facebook %

LinkedIn %

witer %

Youube %

None or No Applicable %

esearching invesmen inormaion

1

3

1

4

91

Finding a financial or

2

7

0

1

90

invesmen advisor Obaining marke updaes

3

2

2

2

91

eading aricles abou financial opics

8

7

1

2

81

Waching videos abou financial opics

7

3

1

21

67

Noe: is able shows survey-based daa on he overall usage o social neworks by non-millionaire invesors or conducing heir financial aciviies. Source: Specrem Group (2015d).

he percenages are small (less han one-ourh), bu millennials have aken he lead in communicaing wih heir financial advisors via Facebook, LinkedIn, witer, and Snapcha. Among all age segmens, millennials are mos likely o consider using a smarphone or e-reader o have a video cha wih or meeing wih a financial advisor. Nearly all millennials surveyed repor having a smarphone, and almos hree-ourhs use a able (Specrem Group 2015d, 2015g, 2015l). Alhough older individuals are more likely o ollow he news via heir devices, millennials are he mos likely o indicae hey use such devices o research inormaion on financial producs and services (Specrem Group 2015d, 2015g, 2015l). e highes percenages o millennial witer users ollow amily or riends, ollowed by movie sars, bu hey are more likely also o ollow financial and/or invesmen commenaors on witer han are older generaions. Addiionally, hey are more requen daily and weekly online buyers and sellers o socks. Wih his echnology a heir disposal, how emped will millennials be o bypass human advisors and op or a virual or robo-advisor? Specrem Group (2015b, 2015, 2015j) indicaes ha, or now, human advisors can res easy. For a wide range o services, including esablishing a financial plan, obaining insurance o mee personal needs, adjusing invesmens in conjuncion wih saus changes, selecing invesmens or a reiremen plan, and picking socks ha align wih heir risk olerance, he highes percenage o invesors regardless o age hink a personal advisor would do a beter job. Financial advisors should consider ha among he comparaively ewer who hink a robo-advisor would do a beter job, he highes percenage are millennials. According

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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 Clien Familiariy wih Invesmen erms. is figure shows survey- based daa abou he amiliariy o affluen millennial invesors wih he erm “robo-advisor.” Source: Specrem Group (2015i). o Observer (2015), robo-advisors are a possible “gaeway o millennials.” eJournal o Financial Planning aricle quoes a CNBC piece in which Adam Nash, ounder o Wealhron, a robo-advisor wealh managemen firm, observes ha he financial advice indusry has large ignored young people because servicing hem is no economical. echnology changes ha debae because helping young people wih heir money can now be economical. Figure 14.6 shows ha amiliariy wih he erm “robo-adviser” is low overall bu highes among millennials. Millennials embarking on ha long road o a secure financial uure are more inclined o seek advice and counsel rom a proessional in he uure. Ye, he hurdles hey ace now deb, a volaile marke, an uncerain economy and job marke, and “sandwich generaion” responsibiliies caring or heir fledgling households and heir aging parens represen srong argumens or employing a financial advisor, wheher human or echnology-based. Figure 14.7 illusraes ha millennials are more likely han previous generaions o consider using a service ha is eiher 100 percen echnologybased or uses plaorms such as Skype or Faceime. MILLENNIAL INVESTOR PROFILES

As wih any generaion, advisors should avoid paining millennials wih one broad brushsroke. No “ypical” millennial household exiss; one-size-fis-all financial planning models are oumoded or his age segmen. Neverheless, some generalizaions can be made. Based on inerviews and surveys, Specrem Group (2015e) has idenified five millennial invesor profiles ha vary on demographics, wealh saus, and invesmen mindse: e Climber, On My Own, No Worries, Family Maters, and he Worrier. • Te Climber is he mos aggressive invesor among his peers. Climbers end o hold high-profile, high-income jobs such as atorneys, consulans, or inormaion echnology proessionals and are he mos advisor engaged. • On My Own is he leas wealhy millennial invesor, bu his ype has a srong work ehic and conscieniously saves is money. wo-hirds are women. ey are he mos likely o prioriize geting advice o reach heir financial goals. Nearly 7 in 10 o hese

258

FINANCIAL AND I

NVESTOR PSYCHOLOGY OF SPECIFIC PLA

YERS

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 recommends a portfolio for me to invest in.

31.56 24.27 16.73

40.69 32.55

A service where I communicate with my advisor through Skype/FaceTime video or on-line chat communication and do not meet in person with the advisor.

27.09 20.68 16.73

≤35

36–44

45–54

55–64

≥65

Figure 14.7 Likelihood o Clien Use o Financial Services via echnology. is figure shows survey- based daa involving a generaion gap in ineres abou using a virual advisor or communicaing wih an advi sor via echnology. Source: Specrem Group (2015i).

invesors consider hemselves airly or very knowledgeable abou financial producs and invesmens, and so hey ideniy hemselves as moderae o aggressive invesors. • No Worries are he wealhies o he millennial invesor personas wih hal crediing heir wealh o receiving an inheriance and 67 percen o being in he righ place a he righ ime. is group ends o be ehnically diverse and has he highes percenage o wo-income households. ey preer regular financial advisor conac and are big users o echnology in heir dealings wih hem. In erms o invesing, hey are more likely han heir peers o inves in pharmaceuicals and consrucion, and have he larges porion o heir invesible asses in equiies. • Family Matersare older millennials who have a “married wih kids” mindse ha influences heir financial decisions. Concerns abou reiremen and healh issues makeru galiy an imporan heme. Wih a moderae o aggressive riskolerance, 21 percen o heir invesible asses are in fixed income and almos hal (48 percen) are in equiies. Less han hal (44 percen) have an advisor. e primary reasons hey give or no using an advisor are ha hey do no know whom o use, hey ge help rom riends or amily, and concerns ha an advisor will no look ou or heir bes ineress.

259

The Psychology of Millennials

259

• Te Worrier,no surprisingly, is more likely han his or her peers o sel-repor being eiher “airly” or “no very” knowledgeable abou financial producs and invesmens. Eigh