Financial Behavior Analyst

i

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

iii

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

v

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

vii

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

vii

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

ix

x

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

xi

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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xv

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

xv

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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

xvi

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 witer@vic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 witer@vic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

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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.

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• 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 in 10 ideniy heir risk olerance as moderae. Alhough hey end o be well educaed, hey have he second lowes ne worh o all millennial personas, jus above he On My Own millennial. Paradoxically, more han hal indicae hey enjoy invesing. Jus over hal (54 percen) have an advisor. Ohers who do no have an advisor believe hey canno afford one or ha hey do no have enough asses o warran using an advisor.

Summary and Conclusions How will he millennials impac he financial services indusry? Given he financially volaile imes in which hey grew up, millennials can be cauious abou is praciioners. ey have winessed he burss o he do-com and housing bubbles, he Enron and Bernie Madoff scandals, and he financial crisis o 2007–2008, is subsequen recession, and is prolonged economic recovery. Non-millionaire and millionaire millennials proess o have a more moderae o aggressive risk olerance han older invesors. e larges percenage o heir invesable asses is in equiies, bu he nex larges percenage is in cash and liquid asses. As or he indusry and is praciioners, millennials canno be aken or graned. e Millennial Disrupion Index (2015), a hree-year survey by Scrach, an in-house uni o Viacom ha idenifies he indusries “mos likely o be ransormed by Millennials,” repors ha banking is a he highes risk o disrupion. Nearly 7 in 10 millennial respondens predic ha in five years he means by which hey access money and pay or hings will be compleely differen. e ile o a ime magazine sory by Kadlec (2014) indicaes he generaion gap in hinking abou financial insiuions. “Why Millennials Would Choose a oo Canal Over Lisening o a Banker” repors he percepion ha banks do no address millennials’ unique financial challenges “in a relevan way… . is generaion is loaded wih suden deb ha’s difficul o refinance; grossly underemployed wihou access o capial o sar a business … and hungry or financial guidance ha isn’ sel-serving. Millennials also wan o conduc heir affairs on a smarphone, no go o a bank branch ever.” According o he Millennial Disrupion Index (2015), nearly hal o millennials are couning on ech sar-ups o overhaul he way banks operae, and nearly hree-ourhs o hem indicae hey would be more excied abou a new financial services offering rom Google, Amazon, Apple, PayPal, or Square han rom heir own banks. Onehird o his group does no hink hey will need a bank. o engage his wary and independen-minded generaion, financial advisors will need o prove heir worh. Advisors mus recognize how millennials differ rom heir older counerpars in regard o financial proessionals. Communicaion is imporan o millennials, wheher hey use radiional channels such as he elephone or he increasingly digial landscape. Financial advisors will need o more widely use social media and he Inerne or communicaing wih invesors. ey have he responsibiliy

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or engaging hese younger cliens wih he communicaion plaorms hey are mos comorable using. Even he less advisor-assised millennials can be encouraged o urn o advisors o answer he quesions hey canno find on Google or via a compuer algorihm. A roboadvisor canno ully projec how financial decisions will affec heir lives. Insead, millennials will urn o advisors who have reached ou o hem and have esablished heir rus. Alhough millennials end o do heir own research on poenial invesmens, hey are seeking advice. According o LinkedIn (2015), abou 34 percen o affluen millennials say ha financial advisors are a “mus-have,” compared o 27 percen o affluen Gen Xers. Financial advisors who look beyond he millennial sereoypes will be beter posiioned o nurure enduring relaionships and help pu millennials in he mos advanageous posiion or he success o which heir popular culure indicaes hey eel eniled.

Discussion Questions 1. 2. 3. 4.

Explain why millennials are disrusul o he financial services indusry. Explain how millennials differ rom baby boomers oher han age. Discuss how financial advisors can engage millennials. Explain how he money habis o millennials disprove he sereoype ha hey are a lazy and an eniled generaion.

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Specrem Group. 2015g. “Millionaire Invesor 2015: Using Social Media and Mobile echnology in Financial Decisions.” Wealh Segmenaion Series. Available ahtp://specrem.com/ Conen_Produc/2015-millionaire-q2.aspx. Specrem Group. 2015h. “Millionaire Invesor 2015: Financial Behaviors and he Invesor’s Mindse.” Wealh Segmenaion Series. Available ahtp://specrem.com/Conen_Produc/ 2015-millionaire-q1.aspx. Specrem Group. 2015i. “e Invesing Habis o Millennials.” Specrem Group Perspecive. Available a htp://specrem.com/Conen_Produc/invesing-habis-millennials.aspx. Specrem Group. 2015j. “UHNW Invesor 2015: Advisor elaionships and Changing Advice equiremens.” Wealh Segmenaion Series. Available ahtp://specrem.com/Conen_ Produc/2015-uhnw-advisor-relaionships-and-advice-requiremens.aspx. Specrem Group. 2015k. “UHNW Invesor 2015: Financial Behaviors and he Invesor’s Mindse.” Wealh Segmenaion Series. Available a htp://specrem.com/Conen_Produc/ 2015-uhnw-q1.aspx. Specrem Group. 2015l. “UHNW Invesor 2015: Using Social Media and Mobile echnology in Financial Decisions.” Wealh Segmenaion Series. Available ahtp://specrem.com/ Conen_Produc/2015-uhnw-q2.aspx. Sein, Joel. 2013. “Millennials: e Me Me Me Generaion.”ime, May 20. Available ahtp://www. prjohnsonenglish.org/uploads/5/3/8/5/5385246/millennials_hemememegeneraion.pd. Severman, Ben. 2015. “Financial Advisers Don’ Care abou Millennials, and he Feeling Is Muual.” BloombergBusiness, May 11. Available a htp://www.bloomberg.com/news/aricles/201505-11/financial-advisers-don--care-abou-millennials-and-he-eeling-is-muual. . owe Price. 2015. “Millennial, Gen X, and Baby Boomer Workers and eirees: eiremen Savings & Spending Sudy.” June 22. Available ahtp://rps.roweprice.com/mc/sies/ eiremenForAll/aricles/MillennialSudyIn-DephFindings.pd. ang,Financial Ning, Andrew Baker,and andBehavior: Paula C. e Peer.ole 2015. he Disconnec beween Knowledge o “Invesigaing Parenal Influence and Psychological Characerisics in esponsible Financial Behaviors among Young Aduls.” Journal o Consumer Affairs 49:2, 376–406. D Amerirade. 2015. “2016 Sel-Employed Survey.” December 9. Available ahtp://s1.q4cdn. com/156458933/files/doc_ downloads/ research/AMD- Sel-Employed- Sudy-esearchepor-November-2015.pd. Wells Fargo. 2014. “2014 Wells Fargo Millennial Sudy.” June. Available a htps://www08.wellsargomedia.com/downloads/pd/press/2q14pr-millennials-save-survey.pd. Yen, Holly. 2012. “1 in 2 New Graduaes Are Jobless or Unemployed.” Associaed Press, April 21. Available a htp://news.yahoo.com/1-2-graduaes-jobless-underemployed-140300522.hml.

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15 Psychological Aspects of Financial Planning DAVE YESKE, CFP® Managing Director, Yeske Buie Distinguished Adjunct Professor, Golden Gate University ELISSA

BUIE, CFP® CEO, Yeske Buie Distinguished Adjunct Professor, Golden Gate University

Introduction Personal financial planning is a process or uncovering clien goals and values, and or

developing inegraed sraegies o bes uilize all a clien’s human and maerial resources in pursui o hose goals in a way ha is consisen wih ha clien’s personal values and preerences. Change is a concepual lens hrough which o view financial planning. Specifically, financial planners help heir cliens adap o environmenal changes, including deah, disabiliy, divorce, and inheriance, or o affec voliional changes, including reiremen and financing children’s educaion. Change can be challenging. According o he World Healh Organizaion (WHO), depression is he leading cause o disabiliy worldwide (Moussav, Chaterji, Verdes, andon, Pael, and Usun 2007). Te WHO also noes ha one o he bigges sources o clinical depression is an inabiliy o adap o unexpeced change, or even, in many cases, “imporan and normal” lie ransiions. Oher sudies show ha he incidences o ulcers, headaches, and depression are hree o five imes higher or hose individuals under financial sress (Choi 2009). o he degree ha i can help aciliae lie ransiions and miigae financial sress, he financial planning process carries he poenial o improve a person’s menal and physical healh. Far ewer people will ace a debiliaing disease or legal crisis han will experience a bad financial oucome during heir lieimes. Tereore, financial planning holds more promise o deliver individual and socieal benefis han many o he radiional proessions, such as medicine and law. Tis chaper describes he naure o he financial planning process, discusses he challenges associaed wih effecing posiive financial change in he lives o individuals and amilies, examines he naure o he underlying relaionship beween planner and clien, and analyzes he behavioral challenges ha financial planners mus overcome when developing financial planning sraegies o help heir cliens achieve heir lie goals. 265

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The History and Development of Personal Financial Planning On December 12, 1969, Loren Duton laid he oundaions upon which financial planning would emerge as a disinc proessional pracice, when he convened a gahering o 13 financial services indusry leaders a a hoel near O’Hare Airpor in Chicago. As a resul o his meeing, he Sociey or Financial Counselling came o serve as he umbrella or a membership organizaion, he Inernaional Associaion or Financial Planning (IAFP), and an educaional arm, he College or Financial Planning (Brandon and Welch 2009). Te firs graduaing class o he college, in urn, ormed he Insiue o Cerified Financial Planners (ICFP) in 1973. Beore hen, personal financial planning had exised largely in universiy home economics deparmens, where he ocus was on eaching individuals how o use and proec heir personal financial resources. Alhough a growing number o individuals engaged in he sale o financial producs had already begun o cross radiional boundaries, cross-licensing in boh insurance and securiies, he IAFP, he ICFP, and College or Financial Planning creaed a ocal poin around which he financial planning proession would begin o coalesce (Brandon and Welch 2009). In 1971, he College or Financial Planning developed a curriculum inended o prepare individuals o give financial advice o he public. I also creaed a credenial, he Cerified Financial Planner (CFP) designaion, which would ideniy hose individuals who had compleed a series o five courses. Te sudy guide or he firs course, “Counseling he Individual Basic Financial Planning,” was divided ino six secions: (1) Fundamenals o Financial Counseling, (2) Money Managemen and Personal Financial epors, (3) eviewing Financial Media, (4) Te Invesmen Model, (5) Consideraions in Effecive Financial Planning, and (6) Counseling and Consumer Behavior. Lesson 2 o his srcinal curriculum enumeraed he services o he financial planner as ollows: collecing and evaluaing financial and personal inormaion, counseling on financial objecives and alernaions, insalling he financial program, coordinaing he elemens o he financial plan ha involve ohers, and keeping he long-range financial plan curren in ligh o inernal and/or exernal changes (Brandon and Welch 2009). Tis oundaion would laer become he six-sep financial planning process. In 1985, he righs o he CFP rademarks became par o he newly ormed nonprofi Inernaional Board or Sandards and Pracices or Cerified Financial Planners (IBCFP), laer renamed CFP Board o Sandards (CFP Board), as par o ransiioning conrol o he CFP rademarks o a new, nonprofi sandards- seting body. Any insiuion o higher learning can now regiser a financial planning educaion program wih CFP Board and qualiy is graduaes o ake he CFP exam. Wha had been a series o six hree- hour exams became a 10- hour exam adminisered over wo days. In 2014, CFP Board moved o a six- hour exam adminisered elecronically via esing ceners and designed o be psychomerically comparable o he ormer 10-hour exam. Te number o colleges and universiies wih educaional programs regisered wih CFP Board grew rom 20 in 1987 o 225 in 2014. Tese regisered insiuions offer cerificae, bachelor’s, maser’s, and docoral degree programs. In

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he meanime, he College or Financial Planning became one o many among he various regisered programs. In 1992, he college creaed he Naional Endowmen or Financial Educaion (NEFE), which evenually became he paren eniy or he college; and in 1997, NEFE sold he College or Financial Planning o he Apollo Group. Tereafer, NEFE became solely devoed o providing financial educaion o consumers. In 1990, Ausralia became he firs member o he Inernaional CFP Council and in 2004, CFP Board ranserred he righs o he Cerified Financial Planner and CFP rademarks ouside he Unied Saes o he Financial Planning Sandards Board (FPSB). As o 2015, he FPSB had 26 nonprofi organizaions as members offering he CFP rademark in heir respecive erriories.

The Financial Planning Process Boh sandard-seting bodies or Cerified Financial Planners CFP Board in he Unied Saes and Financial Planning Sandards Board in all oher counries define he financial planning process as he ollowing six seps (Cerified Financial Planner Board o Sandards 2015): 1. 2. 3. 4. 5. 6.

Esablishing and defining he clien-planner relaionship. Gahering clien daa including goals. Analyzing and evaluaing he clien’s curren financial saus. Developing and presening recommendaions and/or alernaives. Implemening he recommendaions. Monioring he recommendaions.

Financial planners draw rom he ollowing six primary subjec areas or knowledge domains when advising cliens: 1. Financial saemen preparaion and analysis including cash flow analysis/planning and budgeing. 2. isk managemen and insurance planning. 3. Invesmen planning. 4. Income ax planning. 5. eiremen planning. 6. Esae planning. CFP Board and FPSB member organizaions boh employ a cerificaion process or financial plans ha revolves around wha he organizaions reer o as he “Four Es.” Tese consis o he ollowing: • Educaion. A specified course o sudy covering opic areas and compeencies specified by CFP Board and FPSB. Educaional insiuions mus regiser heir programs or hem o saisy his requiremen. Candidaes or cerificaion mus also hold a bachelor’s degree.

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• Examinaion. Candidaes mus pass an exensive cerificaion exam designed o es applied knowledge. • Experience. Candidaes mus have hree years o relevan proessional experience o become cerified. • Ehics. Boh candidaes and CFP proessionals mus agree o abide by an exensive code o ehics and proessional conduc. Failure o do so may resul in public or privae censure, suspension o he righ o use he marks, and permanen revocaion.

The Strategic Dimension of Financial Planning As migh be expeced in a pracice-oriened proession, he financial planning lieraure has generally been dominaed by maerial ha is opical in naure and coningen on he curren sae o applicable laws and regulaions, as well as on prevailing economic condiions. Cerain hemes can be seen o emerge rom he more concepual offerings, especially relaed o he financial planner’s role as sraegis. QUANTITATIVE TECHNIQUES BORROWED FROM FINANCE AND ECONOMICS

Many o he more enduring insighs ha emerged rom he early planning lieraure came rom he applicaion o radiional finance ools in new ways o beter plan or individuals. Warschauer (1981), or example, offers a uniorm risk-liquidiy balance shee approach o accouning or obaining a clien’s rue financial posiion. Tis ramework wen well beyond he radiional balance shee or individuals by reflecing he embedded axes in appreciaed capial asses and he ne presen value (NPV) o employmen-relaed benefis like pensions and Social Securiy. udd and Siegel (2013) laer expanded on his concep wih heir “lieime balance shee.” Tis exension explicily included no jus he presen value o Social Securiy on he asse side o he ledger bu also measures o “human capial,” including he NPV o uure earnings and bonuses. In his ramework, he liabiliy side o he saemen includes he NPV o uure goals including reiremen spending and college unding. Tis process allows calculaing ne resources(i.e., he difference beween oal resources and oal goals), and a margin o saey (i.e., ne resources expressed as a percenage o oal resources). Such an approach also allows or a more complee risk analysis o a amily’s oal porolio o asses and liabiliies. For example, one’s fixed income porolio will consis no jus o bonds, cerificaes o deposi (CDs), and money marke unds (MMFs) bu also morgages, deerred axes, and Social Securiy. Te financial planner can hen analyze he sensiiviy o his raher exoic bu more accurae fixed-income porolio o various risks using radiional analyical ools such as duraion analysis, which is he average lie o a financial insrumen such a bond. As would be expeced, such quaniaive approaches o analyzing clien needs and circumsances have only grown in number and sophisicaion. Tese ools mos ofen represen he applicaion o echniques rom oher fields o he realm o he individual. For example, Hopewell (1997) inroduces sochasic modeling, especially Mone Carlo

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analysis. Hopewell observes ha mos o he analyses perormed by financial planners, rom calculaing lie insurance needs o esimaing he cos o financing reiremen or a child’s educaion, involve uncerainy. Tese uncerainies can include uure raes o reurn, inflaion raes, and he iming and duraion o uure needs, among oher hings. Simple deerminisic approaches can provide a poin esimae or, a bes, a series o poin esimaes allowing one o illusrae bes and wors-case scenarios. However, as Hopewell (1997, p. 85) noes “such analyses show wha is possible, bu no wha is probable.” Te auhor observes ha alhough Bayesian probabiliy analysis, decision rees, and Mone Carlo simulaions have appeared in he business lieraure or 40 years, none o hese echniques had previously made an appearance in he financial planning lieraure. Following Hopewell (1997), sochasic modeling became a regular opic in he lieraure, including urher orays by Kaut and Hopewell (2000) and Kaut and Wieland (2001). Te shorcomings o he echnique also drew scruiny, as when Nawrocki (2001) observed he dangers o assuming ha variables are normally disribued and uncorrelaed when using Mone Carlo analysis. He suggess an alernaive “exploraory simulaion” echnique ha involves ewer assumpions. Meanwhile, Daryanani (2002) offers “sensiiviy simulaions” as a aser alernaive o Mone Carlo, and Brayman (2007) proposes an algorihmic approach o creaing a “reliabiliy orecas.” Besides requiring less ieraion o produce a resul, his later approach is useul in generaing a marix illusraing muliple “success acors” as opposed o he single success acor generaed by he Mone Carlo echnique. Anoher quaniaive echnique ha has emerged and grown in populariy is scenario planning. Ellis, Feinsein, and Searns (2000) inroduced his echnique, srcinally developed by oyal Duch Shell, o inancial planners and i rapidly gained wide accepance. Scenario planning involves ideniying bundles o evens ha are likely o occur ogeher and creaing sylized “scenarios” rom hese bundles. he planner hen analy zes hese scenarios in erms o he appropriae sraegic response ha each would require (S earns 2006). Oher simi lar echniques include sensiiviy simulaions (Daryanani 2002) and discree even simulaion (Houle 2004). Oher ools and perspecives borrowed rom he ields o inance and economics have included lie- cycle inance (Bodie 2002; Basu 2005) and real opions (Kau 2003). DECISION RULES AND POLICYFINANCIAL PLANNING

BASED

Anoher hread running hrough he financial planning lieraure involves processoriened echniques. Tese echniques ofen ake he orm o decision rules (Kaut 2002) ha are mean o provide a ramework or rapid decision making in he ace o changing exernal circumsances. Financial planners have adoped ools and echniques developed in oher fields, including he use o invesmen policies (Boone and Lubiz 2004). An exension o he invesmen policy concep is policy- based financial planning, a concep firs proposed by Hallman and osenbloom (1987) and laer developed by Yeske and Buie (2006, 2014).

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Policy-based financial planning involves he developmen o saemens (policies) ha capure wha cliens inend o do and how hey inend o do i in erms no limied o he presen circumsances. Among he characerisics ha mark a good financial planning policy are ha i mus be boh broad enough o encompass changing exernal circumsances and ime-specific enough o provide a clear answer. Policies are inended o be enduring ouchsones ha keep cliens anchored o an appropriae course o acion, especially when buffeed by urbulen environmens. o be effecive, policies mus reflec o a large degree no only a clien’s explici financial goals and he financial planning principles relaed o hose goals bu also a clien’s belie sysem and preerence srucure. One can hink o he sequence wihin which policies arise as ollows: clien belies or values give rise o goals and objecives, which are hen ormulaed as policies ha embody he relevan financial planning bes pracices, and he policies in urn dicae specific acions in he ace o a paricular se o exernal circumsances. I and when he exernal circumsances change and assuming he clien’s underlying belies and goals have no changed he policies will reurn new answers wihou repeaing he enire analysis. O course, i cliens do no see heir belies and values refleced in heir policies, hey are less willing o be guided by hem. For his reason, he iniial “daa gahering” done by he financial planner mus be expanded ino an exensive “discovery” process. Tis exended discovery process is aimed a uncovering he personal hisory, belies, and values ha ulimaely give rise o a clien’s saed goals. Anoher branch o his process-oriened work has developed around he concep o sae wihdrawal raes. A sae wihdrawal rae reers o he maximum rae a which individuals can spend rom he invesmens earmarked or reiremen o minimize he risk o premaurely consuming he enire principal. Bengen (1994, 1997, 2001) was he firs o address his quesion in a rigorous manner, building upon heoreical oundaions previously developed by pension acuaries. ecen developmens have brough his area more ully ino he policy- driven realm by incorporaing acive decision rules ha can be used o suppor higher iniial wihdrawal raes (Guyon 2004; Guyon and Klinger 2006; Klinger 2007). As wih policy- based financial planning, and unlike circumsances involving saic wihdrawal raes, he decision rules developed by Guyon and Klinger are mos efficacious wih he acive undersanding and paricipaion o cliens. INTERIOR DIMENSION AND FINANCIAL LIFE PLANNING

As previously noed, more financial planning echniques require boh a deeper undersanding o cliens’ underlying moivaions and heir acive engagemen in he process isel. Forunaely, a growing body o work addressing his issue has evolved, almos enirely since 2000. Some reer o his area as inerior finance, financial lie planning, and lie planning, wih he las phrase garnering he greaes number o ciaions. Te beginning o his body o work can be raced o a conerence presenaion given by Dick Wagner and George Kinder a he Insiue o Cerified Financial Planners (ICFP) 1994 erea a Cheyenne Mounain in Colorado. iled “Money and he Meaning o Lie,” Wagner and Kinder’s presenaion offered more quesions han answers. Te sandingroom-only atendance on all hree days ha he session was offered atesed o he ac

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ha he wo preseners were no alone in hinking he ime was righ o address he inerior (i.e., subjecive and humanisic) dimension o money. As a direc consequence o his now-amous gahering, an inormal hink ank called he Nazrudin Projec (named or a Sufi mysic) emerged. Many o he srcinal members o “Naz” wen on o develop echniques and concepual rameworks or dealing wih he inerior dimension o he financial planning process. Tese works include Wagner (2002) in he area o inerior finance, which is a erm he coined, Kinder’s (2000) Te Seven Sages o Money Mauriy, Kinder and Galvan’s (2005) EVOKE sysem, and Kahler’s (2005) financial inegraion ramework. Carol Anderson and Mich Anhony coined he erm “financial lie planning” and much work has been done under ha label (Dilibero and Anhony 2003; Anhony 2006; Dilibero 2006). Wagner’s work was noable or he novel way i used he inegral ramework o Wilbur (2001) o posiion he financial planning process. Wilbur’s inegralism is buil around he concep o he holon, which is inended o represen he individual perspecive o a human being. A holon is a process which is boh a whole and a par. Figure 15.1 shows ha he holon is divided ino quadrans wih he wo on he lef represening he inerior dimension and he wo on he righ represening he exerior dimension. Te wo op quadrans encompass he individual dimension and he wo lower quadrans represen he collecive dimension. When viewing a financial planning clien rom his perspecive, he upper-lef or individual-inerior quadran represens a clien’s values, belies, goals, and objecives, whereas he upper-righ or individualexerior quadran encompasses all hose objecive acs abou a clien, including educaion, occupaion, income, expenses, asses, and liabiliies. Te lower-lef, or collecive-inerior, quadran shows he belies and values ha are collecive, derived rom amily or sociey. Finally, he lower-righ, or collecive-exerior, quadran indicaes all he objecive acs abou he world, including ax raes, inflaion raes, sa o he economy, and he financial markes. For mos o is hisory, financial planning has emphasized he wo exerior quadrans, ocusing primarily on powerul quaniaive ools ofen applied o solve highly sylized goals and wihou much reerence o a clien’s preerence srucure. Te growing awareness ha has led he planning proession o begin exploring he inerior dimension wih

Figure 15.1 Te Holon in Financial Planning. Tis figure indi caes he our lenses hrough which humans view and evaluae he world. Source: Wilbur (2001) and Wagner (2002).

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such vigor is ha simply finding financial soluions ha are echnically easible is insufficien. For maximum success, he planner mus choose rom he many alernaives hose sraegies ha are bes mached o a clien’s personaliy, belie sysem, and personal hisory. Tese sraegies have he highes probabiliy o success, in par because hey enlis a clien’s “bureaucracy o habis” (Heller and Surrenda 1995) in achieving he desired change. Besides offering new perspecives, anoher noable aspec abou he work being done on he inerior dimension is ha i generaes specific ools and echniques or improving he discovery process and oher elemens o he financial planning process (Kinder and Galvan 2005). Alhough financial planners have previously addressed he inerior dimension in heir work wih cliens, wha is undeniably new is he developmen o sysemaic approaches ha can be applied successully by planners o varying abiliies and experience. Kinder’s (2000) Te Seven Sages o Money Mauriyspawned wo-day, week-long, and muli-week workshops ha provide planners wih new ools or exploring inerior issues wih cliens. Besides workshees o various ypes, hese ools include quesions designed o progressively srip away cliens’ preconcepions abou he role o money in heir lives and o allow a deeper undersanding by he planner o he clien’s preerence srucure. Wih his deeper undersanding, planners can do a beter job o developing meaningul alernaives or cliens. Ohers have developed ormal sysems or improved discovery, including Carol Anderson (“Money Quoien”), Mich Anhony (Financial Lie Planning), Lucerne and Colman Knigh (Imaginaion Made eal), Dilibero (Financial Lie Planning), and Klonz and Kahler (Insie). CONNECTING THE INTERIOR AND EXTERIOR

Yeske (2010) suggess ha, when viewed as a whole, he more concepual porion o he financial planning lieraure naurally alls ino he ollowing hree caegories: (1) quaniaive ools, (2) process-orienaion, and (3) inerior dimension. From his observaion, Yeske proposes he Financial Planning Sraegy Modes (FPSM) model as a way o organizing he skills, ools, and echniques used by financial planners around hese hree hemes and in erms o he degree o relaive involvemen by planner and clien in he planning process. I posis five modes o sraegy making along his degree o involvemen specrum, beginning wih he planner-driven mode and progressing hrough daadriven (quaniaive ools), policy-driven (process orienaion), relaionship-driven (inerior dimension), and clien-driven a he oher exreme.wih In empirical Yeske finds ha he policy-driven modemode is mos highly correlaed measuresesing, o clien rus and relaionship commimen, consrucs ha are discussed a greaer lengh in he nex secion.

Client Trust and Commitment Clien rus and commimen have emerged in he financial planning research lieraure as wo imporan predicors o a successul financial planning engagemen. A clien’s rus in he financial planner and commimen o he financial planning relaionship can

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lead direcly o several posiive oucomes, including high acquiescence, a low propensiy o leave, a high degree o cooperaion, and uncional conflic, which is he abiliy o mainain a highly uncional relaionship even when conflics arise (Morgan and Hun 1994). Tese qualiies in urn end o lead o long-lasing relaionships or which financial planners have boh a process moive and a profi moive. Te process moive arises rom he naure o personal financial planning isel, which involves muliple, inegraed seps ha mus unold over ime, ofen requiring a period o years o successully ormulae, communicae, and implemen (Chrisiansen and DeVaney 1998). Higher levels o commimen and rus are associaed wih clien reenion, clien saisacion, increased clien openness in disclosing personal and financial inormaion, and a greaer propensiy o implemen financial planning recommendaions (Anderson and Sharpe 2008). According o Chrisiansen and DeVaney (1998), he profi moive arises rom he ac ha reaining exising cliens coss much less han atracing new ones, which makes longlasing relaionships more profiable han hose o shorer duraion. elaionships exhibiing high rus and commimen are also associaed wih agreaer clien propensiy o make reerrals (Anderson and Sharpe 2008). Tus, financial planners should know wha hey can do o oser clien rus and commimen, and hus reap hese many benefis. Answering his quesion is difficul because financial planning, similar o oher proessional services, has high credence properies, meaning consumers have difficuly judging he qualiy o he service even afer i has been rendered (Sharma and Paterson 1999). One need only consider ha financial planners are rouinely asked o recommend sraegies or ataining goals ha are years or even decades in he uure o see how his concep applies. Nowihsanding he consumer’s difficuly in direcly assessing he value o highcredence services, many anecedens o rus and commimen in he conex o proessional services are available. Tese include swiching coss, relaionship benefis, shared values, communicaion, opporunisic behavior (Morgan and Hun 1994; Chrisiansen and DeVaney 1998), clien percepion o echnical and uncional qualiy (Sharma and Paterson 1999), clien saisacion (Sharma and Paterson 2000), and communicaion asks, ski lls, and opics (Anderson and Sharpe 2008). Tese anecedens are no unique o financial planning, bu are presen in almos any proessional service relaionship. FACT ORS I NFLUENCING THE TRUST AND COMMITMENT RE LA TIONSHIP

Te concep o clien rus and commimen as key mediaing variables firs arose in he relaionship markeing lieraure, noably in he work o Morgan and Hun (1994). In he Morgan and Hun model, illusraed in Figure 15.2, anyhing ha leads o increased clien rus and commimen is associaed wih posiive oucomes such as high acquiescence, low propensiy o leave, high cooperaion, high uncional conflic, and low uncerainy. Among heir proposed anecedens o rus and commimen are relaionship erminaion coss (i.e., swiching coss), relaionship benefis, shared values, communicaion, and opporunisic behavior.

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THE PSYCHOLOGY OF FINANCIAL SERVICES Relationship Switching Relationship Benefits

Commitment

Shared Values Communication Trust Opportunistic Behavior

Figure 15.2 Componens o rus and Commimen. Tis figure shows he major acors ha mos influence clien rus and commimen o he relaionship during he financial planning process. Source: Morgan and Hun (1994).

Relationship Switching Relationship Benefits

Commitment

Shared Values Communication

Trust

Opportunistic Behavior

Figure 15.3 Major Facors or Building he rus and Commimen elaionship. Tis figure shows ha communicaion mos influences clien rus, w hich in urn drives he commimen o he relaionship beween he clien and he financial planner. Source: Chrisiansen and DeVaney (1998).

Morgan and Hun (1994) es his model wih independen ire dealers and heir suppliers and validaed all he proposed linkages excep he hypohesized link beween relaionship benefis and relaionship commimen. Pah analysis shows ha relaionship erminaion coss, relaionship benefis, and shared values ac direcly on relaionship commimen, whereas communicaion and opporunisic behavior ac on rus, which in urn influences relaionship commimen. Morgan and Hun al so esed an alerna ive, non- parsimonious model in w hich no in direc relaionships were allowed and hey ound ar ewer significan relaionships han heir “key mediaing variable” or KMV model. Teir daa demonsrae ha rus and commimen are he key mediaing variables, no jus wo among many independen variables. Chrisiansen and DeVaney (1998) apply his same model o financial planners, drawing daa rom members o hree proessional planning groups in he Unied Saes. Tey employed pah analysis using he CALIS (Covariance Analysis o Linear Srucural equaions) procedures in he SAS saisical sofware. Figure 15.3 shows heir findings ha relaionship erminaion coss, relaionship benefis, and shared values are all anecedens o commimen, whereas shared values, communicaion, and opporunisic

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275

Relationship Communication Functional Quality

Trust

Technical Quality

Figure 15.4 echnical Qualiy, Funcional Qualiy, and Communicaion Effeciveness. Tis figure shows ha communicaion affecs rus and commimen boh

direcly and indirecly hrough is impac on clien percepions o he echnical and uncional qualiy o he financial planner’ s serv ices. Source: Sharma and Paterson (1999).

behavior are all anecedens o rus, which isel is an aneceden o commimen. Tese resuls mach hose o Morgan and Hun (1994). Ineresingly, as an aneceden o commimen, rus has wice he explanaory power o any oher variable. Shared values have a low significance as an aneceden o rus, and opporunisic behavior is no saisically significan. Communicaion has hree imes more explanaory power han shared values as an aneceden o rus and is highly significan. Chrisiansen and DeVaney conclude ha communicaion is he single mos powerul aneceden o rus and commimen, acing direcly on rus and hrough rus on commimen. Sharma and Paterson (1999, 2000) also addressed he quesion o which anecedens mos influences clien rus and commimen. As noed previously, hey observed ha financial planning is a “high credence” service ha unolds over ime, leaving cliens hard pressed o judge he qualiy o he advice in he presen momen. As Sharma and Paterson (1999, p. 151) observed, “Afer all, i cliens have rouble evaluaing oucomes, hen i seems reasonable ha ineracions (“how” he service is delivered) and all orms o communicaions will ake on added significance as cliens seek o minimize dissonance and uncerainy abou he adviser hey have chosen.” Sharma and Paterson (1999, 2000) also explored he links beween percepions o echnical qualiy, uncional qualiy, and communicaion effeciveness, on he one hand, and relaionship commimen, on he oher. Figure 15.4 illusraes heir model. echnical qualiy reers o “wha” is being delivered, and uncional qualiy reers o “how” i is delivered. Sharma and Paterson included rus as an “endogenous mediaing consruc.” Tey repor ha a clien’s percepion o he echnical and uncional qualiy o he planner’s advice is posiively correlaed wih he clien’s level o rus in he planner. Higher levels o rus, in urn, are associaed wih higher levels o commimen o he relaionship. Communicaion effeciveness acs boh direcly on rus and commimen and indirecly hrough is effec on perceived echnical qualiy and uncional qualiy. Alhough communicaion effeciveness has he smalles direc effec on commimen, i has he greaes oal impac when including is indirec effecs. THE ROL E OF SA TISFACTION

Sharma and Paerson (2000) laer reurned o analyzing he anecedens o relaionship commimen, examining he role o rus and a new variable: saisacion.

276

THE PSYCHOLOGY OF FINANCIAL SERVICES Switching Costs, Available Alternatives, and Client’s Prior Experience are LOW

Satisfaction Relationship Commitment Trust Switching Costs, Available Alternatives, and Client’s Prior Experience are HIGH

Satisfaction Relationship Commitment Trust

Figure 15.5 Saisacion and rus as Anecedens o Commimen. Tis figure shows ha saisacion drives clien commimen when sw iching coss are perceived o be low, whereas rus drives commimen when swiching coss are perceived o be high. Source: Sharma and Paterson (2000).

hey esed he impac o rus and saisacion on commimen in ligh o hree coningencies: swiching coss, availabiliy o aracive alernaives, and prior experience. As Figure 15.5 illusraes, rus has he greaes impac on commimen w hen sw iching coss are high, available a lernaives are l ow, and /or prior experience is low. In siuaions where swiching coss are low, available alernaives are high, and/ or he priorac experience is high, saisacion is he rouinely dominanry aneceden o commimen. ha inancial services companies o raise swiching coss by imposing surrender charges and deerred sales charges (backend loads) on many o heir inan cial producs suggess ha cliens undersand he role o his coningency.

THE COMMUNICATION DIMENSION

Anderson and Sharpe (2008) exend he work o Chrisiansen and DeVaney (1998) and Sharma and Paterson (1999, 2000) by ocusing solely on he communicaion dimension. I communicaion is he single mos significan aneceden o rus and commimen, wha paricular ypes o communicaion would have he greaes impac? Tey derived he communicaion elemens o be(1) examined rom he lie planning lieraure and organized hem ino hree dimensions: communicaion asks, (2) communicaion skills, and (3) communicaion opics. According o Anderson and Sharpe, he ollowing asks, skills, and opics are mos highly correlaed wih higher levels o rus and commimen among financial planning cliens: • Communicaion asks. Sysemaic process o clariy goals and values; explaining how advice reflecs goals and values. • Communicaion skills. Eye conac, body language, verbal pacing, and aciliaing difficul conversaions abou money. • Communicaion opics. Clien values and qualiy o lie and iniiaing conversaions abou lie changes.

27

Psychological Aspects of Financial Planning

277

Anderson and Sharpe (2008, p. 77) correlae hese aciviies wih relevan CFP Board pracice sandards relaed o uncovering cliens’ goals and communicaing planning recommendaions, noing ha “our findings give srong suppor or he value o he specific financial planning communicaion asks idenified in hese sandards.” Alhough he srcinal developmen o pracice sandards resuled rom capuring and codiying “esablished norms o pracice,” Anderson and Sharpe provide an empirically derived oundaion or a leas some o hem.

Knowledge and Evidence-Based Financial Planning esearchers have no revalidaed many heoreical and pracical approaches adaped rom oher fields. Moreover, many o he proession’s “bes pracices” resul rom rial and error and acceped norms ha possess inuiive appeal bu lack empirical oundaion. According o Buie and Yeske (2011, p. 39), Financial planning bes pracices also arise rom boh deducive and inducive reasoning. Some have developed rom “sel-eviden” proposiions and heir naural implicaions, while ohers have arisen rom a slow accumulaion o observaions ha ulimaely seem o orm a patern. Ta our bes pracices arise be in aways ha mirror deducive/inducive mehods shouldn’ surprise; humanshehave evolved o hink ha way. o Asscience Alber Einsein pu i, “he whole o science is nohing more han a refinemen o everyday hinking.” O course, ha word “refinemen” is criical. Our rouble as a proession is ha mos o our bes pracices sop a he ormaion o a belie (he case sudy presened below, or example, involves a bes pracice ha exised or decades beore evenually being empirically-esed). And we’re quie comorable sopping here because our personal experience and he experience o colleagues will ofen seem o confirm and reinorce hose belies (he field o behavioral finance calls his “confirmaion bias”). However, such inormal “evidence” is properly ermed anecdoal and canno be he oundaion o a ruly learned proession’s bes pracices. Insead, we mus ake he nex sep: we mus orm our belies ino hypoheses, hen gaher appropriae daa and “bes” ormally es hose Only canevidence: we say wih confidence ha our pracices arehypoheses. ounded upon hehen “bes” A recen developmen in his area is he parnership beween he Financial Planning Associaion (FPA) (US) and he Academy o Financial Services (AFS), he later being a proessional associaion ounded in 1982 o serve he needs o proessional academics eaching and researching in he area o financial planning. Te purpose o he new parnership is o aciliae a deeper connecion beween praciioners and academics. Te pracical maniesaions o his parnership include he ollowing: • A orum Te Teory ino Pracice Knowledge Circle ha serves as a clearinghouse or praciioners o share wih academics opics or quesions or research ha

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would subsanially affec heir work wih cliens and or academics o seek eedback and daa rom praciioners or financial planning research iniiaives. • A join research rack a he FPA’s annual conerence or presening juried research papers by members o AFS, including prizes in he areas o heoreical and applied research. • Join publicaion o FPA’s pracice-oriened Journal o Financial Planning and AFS’s Financial Services Review, wih he later being made available o FPA’s members. In anoher developmen, CFP Board o Sandards, he sandard-seting body or CFPs in he Unied Saes, has launched a series o programs also aimed a deepening he proession’s academic roos. Tese effors include he ollowing iniiaives: • Cener for Financial Planning. CFP Board is exploring he creaion o a cener ha would serve as a credible source o research ha advances he financial planning proessional in hese core areas: • Influencing and supporing academic research ha is dedicaed o helping financial planners beter serve he public; • Supporing diversiy wihin he proession so ha i beter mirrors he American public; and • Building capaciy or he nex generaion o compeen and ehical financial planners o mee public demand. • New Academic Financial Planning Journal. John Wiley & Sons and CFP Board are collaboraing on a peer-reviewed academic journal ocused exclusively on financial planning. Wih his journal, he CFP Board will be creaing an academic home or hose aculy members who are eaching and conducing research in financial planning. Te journal will be available ree o charge o all CFP proessionals (Iacurci 2015).

The Behavioral Dimension of Financial Planning As previously noed, a major role o financial planners is o help cliens adap o change, wheher environmenal (imposed rom wihou) or voliional (moivaed rom wihin). Among he many challenges ha planners ace in his role is he realiy ha financial planning cliens are as subjec o behavioral biases and heurisics as anyone else. Heurisics are menal shorcus or rules o humb individuals uilize o process inormaion. Tese biases and heurisics ofen lead hem o make subopimal choices or o ignore financial planning recommendaions alogeher. In heir work wih cliens, financial planners encouner mos o he menal or cogniive biases idenified by researchers in behavioral finance, such as menal accouning, represenaiveness, anchoring, overconfidence, loss aversion, and availabiliy. MENTAL ACCOUNTING

Menal accouning reers o he endenc y or people o separae heir money ino separae

accouns based on differen subjecive crieria, such as he source o he money and

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279

he inen or each accoun (Kahneman and versky 1979). Menal accouning may cause financial planning cliens o spend differenly, based on he size o he accoun or “bucke” rom which he unds are supplied. For example, cliens migh spend more when using a debi card linked o a large brokerage accoun han when using a debi card linked o a much smaller checking accoun. Financial planners ofen discourage cliens rom choosing brokerage debi cards in lieu o auomaic sysems or moving budgeed unds elecronically rom brokerage o checking, where he smaller balances a any given ime have a higher propensiy o keep spending beter aligned wih budges. REPRESENTA

TIVENESS

HEURISTIC

Te represenaivenessheurisic reers o a propensiy o see paterns, even where hey do no exis (versky and Kahneman 1974). Tis endency can cause financial planning cliens o rade excessively in employer shares because hey believe hey have observed a patern o regular reversal poins in he company’s sock price movemens. As a resul o his bias, individuals ofen ignore imporan inormaion ha should be included in he decision-making process. However, he new daa or inormaion are disregarded. OVERCONFIDENCE, ANCHORING, AND LOSS AVERSION

Overconfidence, anchoring, and loss aversion can combine in ways ha lead o a series o bad decisions (Fischoff, Slovic, and Lichensein 1977; Kahneman and versky 1984). Overconfidence is highly prevalen among invesors, in which individuals overesimae heir own abiliies and predicions or success. For insance, overconfidence can lead employees o hold oo much in employer shares, believing hey have insider insighs ha are superior o marke signals. Anchoring is he process by which individuals hold on o a belie and hen apply his viewpoin o a specific reerence poin in ime or making uure judgmens. Loss aversion is when cliens apply greaer weigh o a loss han o an equivalen gain. Anchoring and loss aversion can cause hese cliens o coninue o hold employer shares even when a reversal in he company’s orunes or hose o is indusry causes is sock price o all (Sherin and Saman 1986). AVAILABILIT

Y HEURISTIC

Availabiliy bias reers o he propensiy o be influenced by inormaion ha is easier

o recall (icciardi 2008), such as highly impacul or more recen memories. A clien’s willingness o buy long- erm care insurance requenly depends on wheher he personally knew someone who had received home healhcare assisance or lodging a a skilled nursing aciliy. Personal experience o long- or shor-lived relaives may influence he willingness o plan or a long reiremen. STRA TEGIES FOR OVERC OMING BI ASES IN FINANCIAL PLANNING

Alhough engaging in he financial planning process and being in a proessional relaionship wih a financial planner can posiively affec clien behaviors, researchers and

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praciioners coninue o develop exensions o he radiional six-sep process in an atemp o beter overcome he orgoing biases and heurisics. Among he suggesed exensions are he EVOKE (Exploraion, Vision, Obsacles, Knowledge, and Execuion) model (Kinder and Galvin 2005). Tis ramework proposes a greaer ocus on uncovering deeper goals, objecives, and values, as well as a more explici examinaion o poenial obsacles o implemenaion. Yeske and Buie (2014) propose using Policy-Based Financial Planning as a orm o “decision archiecure,” along he lines o Taler and Sunsein’s (2008) concep o “choice archiecure.” Financial planning policies represen compac decision rules ha embody boh a disillaion o financial planning bes pracices in a given planning realm and he clien’s goals and values. o he degree ha he planner can craf policies in which he cliens can see heir goals and values clearly refleced, hey are more likely o embrace hose policies as heir own and be guided by hem. Tis is consisen wih he findings o Anderson and Sharpe (2008), who find ha clien rus and relaionship commimen are higher when cliens receive financial planning recommendaions ha are clearly conneced o heir values and goals. Jacobson and Searns (2013) propose appreciaive inquiry as a way o dealing wih behavioral finance issues, including in combinaion wih he ollowing “power ools” or overcoming he well-documened negaiviy bias (Kanouse 1984). Jacobson and Searns (2013, pp. 25–29) provide he ollowing explanaions:

Possibiliy mindse People wih a possibili y mindse believe ha posiive oucomes are achievable, une heir radar o deec and highligh posiive possibiliies, poenials, and opporun iies in new inormaion and circumsances, and mobilize proven srenghs, resources, and successes, as well as he poenial in people and organizaions. Tey don’ dwell on misakes, unskillul acs, and unavorable oucomes. While hey accuraely deec downsides, heir mindse allows hem o lead w ih he posiives o creae upward spirals o effecive hinking, producive conversaion, and collaboraive eamwork.

Realisic opimism A planner pracicing opimism collecs and relevan inormaion, idenifiesrealisic and weighs is implicaions, andassimilaes raher hanall planning or he lowes- risk, mos-likely, or mos avorable oucome, selecs and plans or he bes plausible oucome he oucome ha has boh a significan probabiliy o occurring and a significan payoff.

Posiive conversaional skills Posiive conversaional skills include: • acknowledging ohers’ concerns, ears, and anxieies wihou premaurely ciing acual grounds or opimism.

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• asking posiive quesions and guiding conversaions o ideniy and mobilize posiive orces (such as srenghs, resources, lessons learned, and wisdom gained rom masering previous challenges) o craf workable acion sraegies and plans.

Emoional sel-managemen Emoional sel- managemen (ESM) … has wo principal domains … . ESM relaed o one’s inner experience includes awareness o one’s momeno-momen emoions and he evens ha rigger hem (such as marke g yraions, cliens’ responses o S inormaion, and one’s own houghs); and managing hese emoions appropriaely and effecively, neiher denying hem, suppressing hem, nor giving hem unetered expression … . ESM in he inerpersonal realm includes deecing ohers’ emoions in response o S inormaion and remaining seady in he presence o hese emoions, neiher avoiding nor ignoring hem nor atemping o comba hem wih acs.

Empahy and compassion Empahy enails accuraely perceiving ohers’ emoional reacions, inernally experiencing somehing akin o heir emoions (albei a less inense version), and as appropriae, conveying one’s undersanding, non- verbally and/or verbally. Te financial planner’s ineviable role as a change agen means ha he search or new perspecives, ools, and echniques o help mediae he impac o cliens’ menal biases and heurisics is a never- ending enerprise.

Summary and Conclusions As a proessional pracice, financial planning arose abou 1970 as a process or helping cliens mos efficienly use all o heir human and financial resources in achieving personal goals and objecives. Financial planning is a six-sep process ha draws upon diverse knowledge domains o offer cliens inegraed sraegies accouning or all he inerlocking elemens o heir financial lives. In developing and implemening hese sraegies, financial planners mus work o overcome cliens’ naural biases and heurisics ha can derail or sall effecive acion and posiive change. Because he financial planning process is boh sysemaic and incremenal in naure, i can be effecive in helping cliens undersand he financial orces in heir lives and he pah oward achieving goals. In many cases, however, financial planners mus use addiional echniques as par o he process. Tese echniques could include appreciaive inquiry, coaching, and policy-based financial planning, among ohers. A growing hread in he financial planning lieraure is devoed o helping cliens effec posiive change and how planners migh help o overcome menal and emoional obsacles o ha change. Considering he cenraliy o he financial planner’s role as change agen, his rend is likely o coninue o grow in he uure.

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DISCUSSION QUESTIONS 1. Lis he six seps o he financial planning process as defined by CFP Board o Sandards and Financial Planning Sandards Board. 2. Explain why financial planning cliens end o rely on secondary markers o qualiy when judging he advice hey receive rom heir advisors. 3. Discuss how he availabiliy heurisic can affec a financial planning clien’s percepion o financial planning recommendaions and/or propensiy o ac on hem. 4. Describe hefinancial menal biases o overconfidence, anchoring, and loss aversion can inerac ohow cause planning cliens o make subopimal decisions.

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16 Financial Advisory Services JEROEN NIEBOER Research Fellow in Behavioural Science, London School of Economics and Political Science PA UL DOL AN Professor in Behavioural Science London School of Economics and Political Science IVO VLAEV Professor in Behavioural Science University of Warwick

Introduction Making well-inormed financial decisions is difficul. Consumers ace an overwhelming choice o financial producs, each wih is own benefis,quirks, and condiions offered by a variey o produc providers. On op o ackling he complexiy o he reail financial landscape isel, consumers have o predic heir own wans and needs in he disan uure, make rade-offs over ime, and consider various ypes o uncerainy. Perhaps unsurprisingly, a subsanial marke or financial advice has developed, served in mos counries by a legion o educaed finance proessionals. Te financial advice marke is highly compeiive, ye persuading consumers o par wih heir money in his indusry requires no only knowledge o financial producs bu also a keen undersanding o people’s psychology involving money. Tis chaper presens empirical evidence on he role o financial advisors, no jus as knowledge providers bu also as decision-making expers and persuaders. Te chaper pays special atenion o behavioral science research, which documens how psychological acors influence people’s choices in ways ha may seem irrelevan rom a sricly financial perspecive. Te behavioral sciences are disciplines ha es hypoheses abou human behavior by sysemaically observing people in differen seings, producing evidence ha allows replacing some o he more implausible assumpions in he dominan heories o decision making wih behaviorally inormed ones. Te behavioral science lieraure on giving and receiving advice has expanded considerably in recen years, mos o i in he fields o behavioral finance, economics, and social psychology. Te conribuions surveyed in his chaper range rom conrolled laboraory experimens o field sudies based on surveys or audi exercises, reflecing he richness and diversiy o his inerdisciplinary science.

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Behavioral science research reveals counless ways in which an individual’s financial choices sysemaically diverge rom models o raional decision making. People are grealy influenced by deails in he decision-making conex ha have no impac on he financial oucomes o heir choices. Tey also requenly make decisions hrough heurisics, which are general rules ha are hough o have evolved o allow he human brain o cope wih complex choice environmens (Gigerenzer and odd 1999). Alhough heurisics and oher decision-making shorcus save he brain rom compuaional overload, hey can also lead o predicable misakes, called biases (Kahneman and versky 2000; Kahneman 2003), paricularly in he domain o financial decisions (Kahneman and iepe 1998). Furhermore, consumers are ofen unaware o hese influences. By miigaing he effecs o conex, heurisics, and biases whenever such influences are cosly o consumers, financial advisors can provide a valuable service. Bu advisors have heir own incenives, and as will be discussed laer, he jury is sill ou on wheher financial advisory services ac as bias miigaing. Te presence o behavioral influences on decision making also means ha wellinended producs and policies aiming o improve choices solely by providing exra inormaion o he decision maker ofen ail o deliver (Webb and Sheeran 2006). aher han assuming ha he consumer makes he bes use o he inormaion provided, a more realisic approach o produc and policy design would be o pu his assumpion o he es. Based on exising evidence, people do no always pay sufficien atenion o imporan messages such as he disclosure o conflics o ineres beween he advisor and clien (Inders, Huck, and Chaer 2010). On he posiive side, imely reminder messages careully designed o comba consumer ineria seem o hold promise (Karlan, McConnell, Mullainahan, and Zinman 2010; Financial Conduc Auhoriy 2013). More generally, behaviorally inormed approaches o financial decision making can claim some noable successes. Tese approaches include increasing paricipaion and conribuions in reiremen plans (Madrian and Shea 2001; Taler and Benarzi 2004), reducing he use o expensive credi producs (Berrand, Karlan, Mullaninahan, Shafir, and Zinman 2010; Berrand and Morse 2011), and improving imely paymen o axes (Coleman 1996; Hallsworh, Lis, Mecale, and Vlaev 2014). Similar opporuniies may exis or behaviorally inormed financial advisory services, wih echnology playing a key role. Alhough he ocus o his chaper is on reail advice services, many o he insighs rom he behavioral science lieraure also apply o wholesale financial advice. Te exen o which proessional decision makers are subjec o he same behavioral biases as he general public is sill largely an open, empirical quesion, alhough evidence rom experimenal sudies suggess ha proessionals are cerainly no immune o bias. Tis chaper sars wih a summary o he evidence on he supply o financial advice. Te nex secion discusses he characerisics o financial advice consumers, and is ollowed by a secion on how hese consumers respond o “behavioral” aspecs o he advice process. Ten, an exploraion o how financial advisors may respond o he behavior o heir cliens is presened considering no only he opporuniies or advisors o improve heir cliens’ decisions bu also he incenives creaed by differen ypes o clien behavior. Te concluding secion reflecs on how a beter undersanding o he psychology o money affecs boh he naure o financial advice services and he radiional disincion beween producs and services.

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Financial Advice—The Supply Side Tis secion inroduces he supply side o financial advice: he proessionals who offer hese services, a brie descripion o he services offered, and some perspecives on he purpose served by financial advice in he reail marke. A discussion o evidence on he financial reurn on using financial advice ollows. WHO OFFERS FINANCIAL ADVICE?

Various ypes o proessionals offer financial advice. Firs, here is he financial advisor, who may also use he ile financial planner. However, in mos counries, he later ile is reserved or hose who have earned a cerificaion rom a proessional sandards body affiliaed wih he Financial Planning Sandards Board or a comparable body. Oher cerificaes and iles may be available, depending on he counry. In many counries, hese qualificaions are a legal requiremen or opening a financial advice pracice. Besides being qualified o give financial advice, individuals may also have earned a license o sell or recommend cerain financial producs requiring specialis knowledge, such as insurance producs. Some individuals acing as financial advisors have accorded hemselves iles such as wealh manager or invesmen advisor, bu hese iles are ofen no acknowledged by a proessional body or are even unregulaed. Hisorically, financial advisors have operaed independenly o banks and und providers, is sill largelyhe hefirms case.whose Tis means ha,hey unlike brokers, financial advisors ypically doasno represen producs recommend and sell. Furhermore, and again unlike brokers, mos counries require by law ha financial advisors pu heir cliens’ ineress ahead o heir own, which is reerred o as heir fiduciary duy. Despie his duy, financial advisors may sill receive commissions based on sales o cerain financial producs. Anoher common arrangemen isverical inegraionor a ie-up beween advisors and und providers, which means ha he advisor is resriced o recommending producs rom he provider. Alhough he law sipulaes ha cliens be made aware o such financial arrangemens, his pracice blurs he line beween financial advisors and brokers. o resolve his ambiguiy, he chaper definesbrokers(or salespeople) as hose whose variable earnings are enirely made up o commissions or sales and rades. By conras, financial advisors may also receive income rom charging or advice and conracing services, or receive ees based on asses under managemen or porolio reurns. WHA T IS THE PURPOSE OF FI

NANCIAL ADVICE?

Financial advice given o consumers can cover any aspec o he clien’s finances. Mos advice concerns invesmen, income securiy, and reiremen planning, alhough some advisors also offer ad hoc advice on credi and morgages. A he sar o he advice process, he advisor may help cliens ariculae heir goals by asking a series o quesions abou heir curren finances and heir plans or he uure. As par o his process, he advisor also gauges how comorable he clien is wih differen levels o invesmen risk. Based on he inormaion received rom he clien, he advisor hen gives he clien advice on saving, credi, axaion, he choice o financial producs rom

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differen providers, invesmen opporuniies, and various wealh and income risks. Key consideraions are he suiabiliy and coss o he differen opions. egarding invesmen and savings, he saed objecive is helping cliens consruc a welldiversified porolio ha reflecs heir appeie or risk, in line wih modern porolio heory (Markowiz 1952). So, wha purpose does his process o financial advice serve? Te radiional economic explanaion o markes or experise, such as financial advisors, ocuses on he reurns on he inormaion search (Sigler 1961). Te consumer benefis rom delegaing he search or inormaion o an advisor, who specializes and hus spreads he cos o acquiring such inormaion across all cliens. Because financial advice ofen concerns one-off decisions wih high sakes, clear gains arise rom specializaion. Tis explanaion, in is mos basic orm, assumes ha consumers know how o evaluae he inormaion hey receive rom advisors. Moreover, or he marke o deliver good oucomes o consumers, hose consumers need o undersand he value proposiion o differen advisors. Wheher hese assumpions are warraned depends crucially on he consumer’s sophisicaion, such as he individual’s financial lieracy and awareness o advisor incenives. Advisors may hus no have clear incenives o coninue heir inormaion search unil he clien’s marginal benefi equals marginal cos. In oher words, he advisor may offer a subopimal off-he-shel soluion wihou he clien noicing. Tis siuaion is reminiscen o oher markes or expers, such as docors, lawyers, and car mechanics. A relaed perspecive is ha consumers use financial advisors o proec hemselves agains heir own cogniive biases, as argued by Bluehgen, Ginschel, Hackehal, and Mueller (2008). Financial advisors can ideniy and correc some cogniive biases, hus adding value by reducing cosly misakes. Te auhors cie he disposiion effec (Sherin and Saman 1985), or he endency o sell winning socks oo soon and hold on o losers or oo long, as a prominen example o he ype o bias ha advisors can correc. Conversely, advisors may guard agains myopia by miigaing heir cliens’ endency o wihdraw rom he sock invesmen in a bear marke. Tese examples show how an advisor may no only ac as a purveyor o inormaion bu also provide guidance based on experience and by virue o no being as emoionally involved as he clien. Te advisor can also ac as a eacher, correcing misakes o enable cliens o make beter choices or hemselves. For example, McKenzie and Liersch (2011) show ha he majoriy o paricipans in a laboraory sudy expec savings o grow linearly, raher han exponenially, hrough ineres compounding. Highlighing he exponenial naure o capial growh o hese paricipans increases heir moivaion o save or reiremen. THE ADDED VALUE OF FINANCIAL ADVICE

Compuing he added value o advisory services is challenging. Te essenial quesion is: Knowing he ull, long-erm coss and benefis o financial advice o a paricular invesor, is i in he invesor’s bes ineresed o use an advisor? One approach o answering his quesion is o ocus sricly on he financial benefis and o compare he porolios o advised and non-advised invesors. Chalmers and euer (2012), using daa on U.S. universiy employees, and Hackehal, Haliassos, and Jappelli (2012), using daa on cusomers o a German reail bank, boh ound ha advised reiremen porolios carry more risk han sel-direced porolios and also underperorm sel-direced porolios. By conras, Kramer (2012) and Kramer and Lensink (2012) find ha he advised reiremen

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porolios o Duch enrepreneurs were beter diversified and achieved beter risk-adjused reurns. Tese sudies conrolled or he endogenous choice o using an advisor, hus ruling ou selecion effecs (i.e., cerain ypes o invesors are more likely o receive advice). In an atemp o reconcile hese conradicory resuls, we need o highligh wo differences beween he ormer and he later sudies. Firs, all cliens in he samples used by Kramer and Lensink (2012) had previous exposure o financial advice, poenially making hem more sophisicaed consumers o advice. Second, he financial advisors in he Kramer and Lensink sudy received a fixed wage, whereas hose in he Chalmers and euer (2012) and Hackehal, Haliassos, and Jappelli (2012) sudies received ees and commissions. In an audi sudy, Mullainahan, Noeh, and Schoar (2012) provide conrolled evidence on financial advisors’ acual advice sraegies. Tey randomly assigned proessional audiors o unwiting financial advisors o ask or advice on a pre-designed invesmen porolio. Insead o endowing all he audiors wih well-diversified, lowcos porolios, he auhors purposely designed some o he ficional porolios o heir audiors o mimic common invesmen biases. Tey repor ha he recommendaions o heir sudied financial advisors were in line wih some o he predicions o porolio heory, such as advising married cliens o hold less liquidiy and advising agains holding employer socks. Tey also noe ha he financial advisors were mos supporive o hose cliens wih a low-cos, well-diversified exising porolio. Bu hey also repor ha financial advisors ofen recommended acively managed unds wih higher ees and ha many financial advisors old cliens o make changes even i hey have low-cos, efficien porolios. Te later resul could reflec overzealous advice giving, bu i does sugges ha no all advice is sricly financially beneficial.

The Consumer of Financial Advice Tis secion examines he role o he consumer as he financial advice clien, saring wih an overview o he evidence on he relaionship beween individual characerisics and he demand or financial advice, ollowed by a discussion o he role o rus. WHO LOOKS FOR FINANCIAL ADVICE?

Many sudies find ha women are more likely o seek financial advice han men (Joo and Grable 2001; Loibl and Hira 2011). Tis patern may be due o women’s preerence or personal service raher han anonymous advice. Consisen wih his explanaion, Loibl and Hira repor ha women spend less ime looking or financial inormaion online or hrough oher media. An imporan acor is people’s financial lieracy, which is ypically srongly posiively correlaed wih experience and wealh. Using a large represenaive sample o he U.S. populaion, Lee and Cho (2005) repor ha financial advice cliens are ypically richer, older, beter-educaed, and more experienced invesors. Using a large survey o German reail bank cusomers, Hackehal e al. (2012) also repor ha richer, older invesors are more likely o have a financial advisor. Using survey daa on cusomers rom an Ialian reail bank, Calcagno and Monicone (2015) find ha wealhy and high financially lierae individuals are more likely o consul advisors, whereas low financial

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lieracy individuals are more likely o delegae he managemen o heir porolio or manage heir own porolio wihou advice. Tey also repor ha high financially lierae individuals are more likely o inves in risky asses, such as socks. People’s demand or advice is also affeced by heir psychology and emoional sae. Meier and Sprenger (2013) repor ha individuals assigning greaer value o he uure are more likely o use financial advice. Gino, Brooks, and Schweizer (2012) ound ha people who experience anxiey are more likely o seek ou and rely on advice. Tey also repor ha anxious individuals are less able o discriminae beween good and bad advice, a resul ha underlines he responsibiliy financial advisors have oward anxious cliens. However, some anxiey abou he uure migh be good or people’s financial decisions. For example, Dolan and Mecale (2012) ound ha people wih a negaive atiude are more likely o open a savings accoun. Along similar lines, Hershfield, Goldsein, Sharpe, Fox, Yeykelis, Carsensen, and Bailenson (2011) find ha presening individuals wih a compuer-aged image o heir uure selves increases heir pension conribuions. THE ROLE OF TRUST

Wha role does rus play in he advice process? In a large, pan-European survey, Georgarakos and Inders (2014) included a measure o general rus in judging he advice given by financial insiuions. Tey repor ha rus is posiively relaed wih holdings o risky asses or households wih lower levels o educaion and sel-repored financial lieracy. Ye, or more educaed households, rus in advice is less imporan, especially relaive o heir rus in he counry ’s legal insiuions. Calcagno and Monico ne (2015) used a survey o cusomers o a large Ialian bank. Tey measured he level o rus in he bank’s financial advisor, which yielded boh inuiive and surprising resuls. As migh be expeced, greaer rus in he advisor increases he likelihood o delegaing managemen o one’s porolio and decreases he likelihood o going i alone, bu no significan relaionship exiss beween rus and he likelihood o consuling an advisor. Te survey respondens approache d he bank’s advisor regardless o heir level o rus his siuaion may have been due o he preexising exclusive relaionshi p wih he advisor. When advice was insead offered “ou o he blue,” as in a field sudy on a random sample o cusomers o a German brokerage firm repored by Bhatarchaya, Hackehal, Kaesler, Loos, and Meyer (2012), cus omers will be war y o he qualiy o he adv ice. Only 5 percen o cusomers in he field sudy acceped he offer o advice provided by email and over he elephone. Te level o rus in an advisor also changes during he ineracion beween advisor and prospecive clien. Litle evidence exiss rom he field, bu experimenal research on advisor–advisee ineracion provides some clues. Firs, people are more likely o ollow more experienced advisors (Harvey and Fischer 1997). Second, advisor–advisee similariy maters; Gino, Shang, and Croson (2009) repor ha individuals in a elephone survey experimen were more likely o ollow advice rom advisors ha are similar o hem in erms o gender, educaion, age, region, and poliical affiliaion. Te financial advisor’s ineres may hereore be served by highlighing such similariies beore giving advice. Morris, Nadler, Kurzberg, and Tompson (2002) repor ha business

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ransacions are more likely o succeed when he iniiaing pary highlighs hings ha he wo paries have in common beore any negoiaion occurs. rus is also a uncion o how he advisor communicaes. Joiner and Leveson (2006) find ha cliens give higher raings o financial advisors who use less echnical language and invesmen jargon. Furhermore, more confiden advisors do no always have a bigger impac. Alhough some evidence suggess ha people are more likely o ollow advisors wih exreme and confiden judgmens (Price and Sone 2004; Van Swol and Sniezek 2005), his bias ends o disappear when inormaion on advisors’ accuracy is available (enney, Spellman, and MacCoun 2008). Moreover, Karmarkar and ormala (2010) presen experimenal evidence ha expers are acually perceived as more persuasive i hey admi some uncerainy abou heir recommendaions. Ye, here may be a dark side o rusworhiness. Laboraory experimens on conflico-ineres scenarios sugges ha simply disclosing a conflic o ineres does no make i go away. Paradoxically, advisors who disclose a conflic o ineres o cliens hereby build so much rus ha heir cliens ollow biased advice ha is in heir advisor’s bes ineres bu no heir own (Loewensein, Cain, and Sah 2011). Furher experimens show ha his social conflic is somewha miigaed i he disclosure is done by a hird pary, or when he clien is given ime and privacy o make he advised decision (Sah, Loewensein, and Cain 2013).

Behavioral Aspects of the Advice Process Te preceding secion inroduced some aspecs o consumer psychology ha deermine consumers’ demand and heir percepions o advisor rusworhiness. In his secion, he advice process isel is unpacked, highlighing evidence on conexual acors and deails ha are no considered in ypical models o financial advice, bu which may subsanially aler consumers’ response o advice. CHOOSING THE CHANNEL

Ciccoello and Wood (2001) experimenally simulaed he process o procuring advice on invesmen scenarios hrough differen communicaion channels, in his case using eiher live advisors (suden paricipans) or online sources. Tey repor ha he variance in recommendaions rom boh sources o advice is similar, bu noe ha live advisors are beter a aking he pariculariies o wealhy cliens ino accoun. However, he auhors do no presen any resuls on how cliens perceive he advice. Evidence ha people consider ace-o-ace advice more appropriae comes rom a sudy on healh advice by Labarère, orres, Fourny, Argeno, Gensburger, and Menhonnex (2003). Te auhors repor ha people preer ace-o-ace conac because i allows hem o beer explain he pariculariies o heir siuaion. iegelsberger, Sasse, and McCarhy (2005) presen laboraory paricipans wih financial advice ha was provided hrough differen channels: video, audio, virual cha, ex only, and ex accompanied by a phoo o he advisor. Tey find ha paricipans preer audio and video advice, bu ha heir financial risk-aking is sensiive o any

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orm o advice provided. Obviously, he later resul may no arise in real-world setings where invesors have access o more han one ype o advice and ypically choose heir own preerred channel. Anoher prominen channel is on-line advice. Sillence and Briggs (2007) repor survey evidence ha consumers’ evaluaions o online advice are highly sensiive o indicaors o rusworhiness. Tese indicaors include known financial brands or personal recommendaions, websie design in line wih he res o he financial secor, and parallels wih he off-line advice process (ailored inormaion, personal involvemen in he advice process, and idenifiabiliy o he people behind he websie). Pi, Liao, and Chen (2012) find ha percepions o ransacion securiy, repuaion, design qualiy, and ease o navigaion influence consumers’ level o rus in advice websies. ADVICE PA CKAGING, FRAMING

, AND PRIMING

How financial advisors “package” heir advice is anoher key acor. Tese effecs can be very suble. For example, Brown, Kling, Mullainahan, and Wrobel (2008) show ha he majoriy o individuals preer a savings accoun o a lie annuiy when he choice is ramed as an invesmen decision, bu his patern reverses when he choice is ramed as a uure consumpion decision. Differences in presenaion also affec he willingness o inves in riskier asses, such as socks, ha would give hem greaer reurns on heir invesmen. ecen laboraory and field sudies sugges ha he exen o which his happens depends on how porolio risk is presened. Anagol and Gamble (2013) repor ha people selec riskier porolios when asse porolio daa are presened as aggregaes insead o as a lis o individual asses. Baeman, Ecker, Geweke, Louviere, Sachell, and Torp (2014) repor ha individuals choose riskier porolios when he risk is presened in a graph raher han when expressed as ex percenages. Te auhors also repor ha people wih lower financial lieracy are more suscepible o presenaion effecs. Furhermore, Kaumann, Weber, and Haisley (2013) show ha leting people “experience” risk by having hem draw sample reurns rom a hisorical reurns disribuion leads hem o choose riskier porolios, wihou increasing regre or anxiey aferwards. People’s financial decisions are also grealy sensiive o wha is presened o hem as he deaul opion. According o Madrian and Shea (2001), 71 percen o savers in a U.S. reiremen plan choose he deaul und. Daa rom pension sysem reorms in Sweden presened by Engsröm and Weserberg (2003) ell a similar sory. Despie he presence o many alernaives, aggressive adverising by und providers, and a naionwide inormaion campaign, 33 percen o Swedes sick o he deaul invesmen opion provided by he governmen. Deauls are no jus effecive because hey signal endorsemen; hey also capialize on an individual’s ineria (also known as saus quo bias). An example o using ineria “or good,” in combinaion wih he basic human endency o discoun uure cash flows, is he Save More omorrow program by Taler and Benarzi (2004). In his program, people pre-commi o conribuing higher percenages o uure wages o a pension scheme whenever hey receive a wage increase. Taler and Benarzi repor an increase in he conribuion rae rom 3.5 percen o 11.6 percen over a 28-monh period.

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Anoher suble influence on decisions is wha is ermed peer effecs: people ofen mimic heir peers. Duflo and Saez (2003) show ha individuals are more likely o enroll in a universiy pension plan when heir co-workers atend reiremen benefis inormaion airs. As Burszyn, Ederer, Ferman, and Yuchman (2014) show, invesors are more likely o inves in a new invesmen vehicle offered by heir brokers when ohers have done so or have simply indicaed a desire o do so. However, providing inormaion on peer choices does no always move people oward he planned or socially desirable oucome. Beshears, Choi, Laibson, Madrian, and Milkman (2015) find ha inorming employees o a U.S. manuacuring firm o heir co-workers’ savings raes acually lowers he chance ha hese employees will subsequenly enroll in heir employer’s pension plan. Te auhors atribue his surprising resul o he demoivaing effec o upward social comparisons. PAYING FOR ADVICE

A final aspec o financial advice ha can be presened and packaged in differen ways is is price. Te mos common model o paying or advice is indirec, hrough sales commissions paid by produc providers o advisors. Inders, Huck, and Chaer (2010) provide evidence rom a large pan- European survey ha consumers ofen underesimae he poenial conflics o ineres generaed by a commission- based compensaion model. Owing o policymakers’ concerns abou hese conflics o ineres, some jurisdicions have now moved o a ee- based advice model. According o Hoffman, Franken, and Broekhuizen (2012), his soluion may exclude some individuals rom he benefis o financial advice because people are relucan o pay or advice beore hey see he benefis. Bu over ime, consumers may become accusomed o paying or advice up ron. Evidence rom experimens suggess ha people may even atribue a specific value o paid-or advice: hey are more likely o ollow advice hey paid or han ollow ree advice (Sniezek, Schrah, and Dalal 2004; Pat, Bowles, and Cash 2006). Godek and Murray (2008) repor resuls rom a laboraory experimen showing ha people pay more or advice when hey are primed o hink abou uure invesmen decisions han when hey are primed o hink abou pas decisions. Alhough speculaive, his patern o behavior may exend o he more general quesion o raming cos over ime. Ta is, people are more likely o pay a ee when i is ramed as a cos o expeced benefis han or benefis already realized.

Behaviorally Informed Financial Advice Tis secion reurns o he supply side o he marke. Te approach here can be summed up in he ollowing quesion: Assuming ha advisors are aware o he consumer characerisics and behaviors presened in he preceding wo secions, how migh advisors posiion hemselves in he marke? I will be insighul o compare some o he possible oucomes described here o he curren siuaion in markes, or o he heoreical perspecives on financial advice presened in he firs secion. One oucome ha seems

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consisen wih a leas a casual observaion o markes is he inangible value o advice he idea ha many people value financial advice or more han jus is expeced financial reurn. TOOLS FOR TAKING RISK

Much o he academic lieraure on invesmens highlighs he ac ha socks have hisorically ouperormed oher asse classes. However, prospecive invesors will have o be comorable wih he greaer level o risk associaed wih invesing in socks. One imporan role ha financial advisors can play in his process is making heir cliens eel more comorable wih his risk, hus unlocking higher reurns. Te preceding secion on consumer behavior has highlighed various ools ha he advisor can use or his purpose, such as differen ways o presening invesmen risk and experienial simulaion. Advisors may also eel ha seting deauls and using “social proo” and “peer effec” ype sraegies will help o convince heir cliens o inves in socks. As effecive as hese sraegies may urn ou o be, advisors should coninue o educae heir cliens on he risk associaed wih hese invesmens. Using persuasion sraegies ha promp he clien o engage wih risk is much more (legally) deensible han sraegies ha emp he clien o blindly ollow ohers. SCREENING FO

R UNSOPHISTICA

TES

Much o he survey evidence shows ha he likelihood o having a financial adv isor is posiively relaed o financial lieracy, isel posiively correlaed wih educaion and wealh. Calcagno and Monicone (2015) presen an explanaion or his paern, saring rom he premise ha advisors will find ha providing high- qualiy advice is only worhwhile o well- inormed and wealhy invesors. I consumers anicipae hey will be screened on his basis, advice will only serve a purpose or beter-inormed and relaively wealhy consumers. Consumers wih lower levels o financial sophisicaion and wealh can sill use financial inermedi aries or porolio managemen, bu he relaionship will no be based on he ransmission o inormaion or knowledge. Te evidence reviewed here suggess ha less sophisicaed consumers are more likely o selec heir advisor on rus. In his segmen o he marke, a problem o asymmeric inormaion may occur because he less sophisicaed invesor may be unable o veriy wheher advice is rusworhy. Inders and Otaviani (2012) show ha invesors who lack awareness o advisor commissions ace similar challenges . A relaed issue is ha people value a personalized service, ailored o heir needs and aking he peculiariies o heir siuaion ino accoun. For he wealhier invesor, providing personalized service may be worh he advisor’s ime i he advisor can recoup his or her coss in ees. Bu or invesors wih less wealh, he exra ime spen on personalizaion may have o be recouped some oher way. I he clien is loah o pay ees, hen he only alernaive or he advisor may be o recommend producs wih higher commissions.

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Financial Advisory Services

295

THE INTANGIBLE VALUE OF ADVICE

Evidence shows ha financial advisory services do no only have financial value bu also provide cliens wih some inangible psychological benefis. Del Guercio and euers (2011) pursue his line o argumen in heir discussion o he U.S. muual unds marke. Tey conend ha wo ypes o reail invesors exis: hose who only care or und reurns, and hose who derive inangible benefis o making advised invesmens. Del Guercio and euers presen daa ha suppor he noion ha muual unds arge hese wo consumer segmens separaely. Providing evidence rom marke oucomes, Bergsresser, Chalmers, and uano (2009) repor ha broker-sold unds deliver significanly lower risk-adjused reurns han do direc-sold unds. Te auhors poin ou ha his difference may be due o he inangible benefis o broker services. However, hey do no exclude he possibiliy ha brokers’ sales commissions play a role in generaing he difference. A clever observaion by Canner, Mankiw, and Weil (1997) highlighs anoher way in which advisors’ recommendaions may be ailored o provide inangible benefis. Tey noe ha one o he key implicaions o he influenial capial asse pricing model (CAPM) is ha invesors can diversiy heir porolio or a given risk appeie by changing he allocaion o cash and a “marke porolio” comprising socks and bonds. Bu a survey o advisors’ adverised porolio recommendaions or invesors wih differen risk profiles shows ha he recommended porolio raio o socks o bonds goes up as invesor risk appeie increases. Tese resuls sugges ha financial advisors consider acors oher han he hisorical reurn daa necessary or recommending porolios on he efficien ronier. Tese acors may be inangible and “behavioral” in naure, such as cliens’ need o be convinced ha he suggesed porolio maches heir risk appeie. Furher suppor or his noion comes rom survey research o financial advisors hemselves. A sudy by MacGregor, Slovic, Berry, and Evensky (1999) finds ha he variance in financial advisors’ percepions o he risk o cerain asse classes is 98 percen explained by hree acors: volailiy, knowledge, and worry. Some experimenal evidence indicaes ha he inangible benefis o advice can acually be measured in he brain. Engelmann, Capra, Noussair, and Berns (2009) conduced a neuroscience experimen and find ha financial decisions are less axing or individuals who receive advice. Tese findings raise quesions especially concerning he oucomes o consumers who have a paricularly srong preerence or advised decision making. Cliens who are anxious and/ or value peace o mind paricularly highly, or example, may be less sensiive o he coss o financial advisory services. I so, financial advisors may marke specific producs and services o hese cliens. Porolio churning, or he excessive (and expensive) rebalancing o clien porolios by financial advisors, may be one such “service.” THE PRICE POINT

Alhough his chaper has highlighed various aspecs o pricing financial advice, i is worh considering wo final aspecs o pricing. Firs, some ees may be more visible o

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consumers han ohers. Using he pricing o priners and priner carridges as an example, Gabaix and Laibson (2006) show ha people pay more atenion o visible up-ron coss han hidden expenses ha occur laer. In pricing financial advisory services, advisors may have an incenive o keep he ee o he iniial advice relaively low, insead increasing less prominen ees such as ongoing managemen and adminisraion ees. Anoher ype o ee ha may be lef ou o consumers’ calculaions is he exi charge or cerain invesmen unds. Alhough hese charges ypically decrease over ime, consumers may sill overesimae he ime hey will hold a paricular und. o reduce consumers’ ocus on a single cos or reurn figure, financial advisors may hus wan o operae several differen charges. Noe ha i is no jus a quesion o wheher coss are incurred immediaely or laer, or wheher one-off larger expendiures are more likely o atrac he consumer’s atenion. As he experimenal findings o Godek and Murray (2008) illusrae, an incenive may also exis o rame ongoing charges as relaed o uure invesmen gains insead o o curren planning aciviy. Cliens’ evaluaion o advice ees may be influenced by raming ha suggess he ees belong in a cerain “menal accoun” (Taler 1985).

Summary and Conclusions Advising people on heir financial decisions requires a high level o deailed knowledge and skill. Tis chaper reviewed exensive evidence ha his skill se comprises more han jus financial experise and ha giving advice o cliens goes beyond a review o heir opions, personal siuaion, and saed objecives. Conexual acors, decisionmaking rames, and percepion o risk are jus some o he behavioral aspecs ha eed ino cliens’ overall assessmen o he value o advice. Te financial advisor seeking use he wealh o behavioral insighs will be spoiled or choice. A useul saring poin would be a more specific behavior-change ramework as a checklis o explore he opions available. Examples o such rameworks are Nudge (Taler and Sunsein 2008) and Mindspace (Dolan, Elliot, Mecale, and Vlaev 2012). Te picure ha emerges rom his chaper is ha o a secor o expers who do no serve simply as purveyors o inormaion o hose who need i. Cerainly, a subsanial segmen o sophisicaed consumers are willing o pay or advisory services and appear o benefi financially rom receiving advice. For less sophisicaed advisors, wheher advice always delivers financial benefis is less clear. Especially in markes where commission paymens rom produc providers are relaively large, consumers may be worse off wih an advised porolio. When financial advisors also offer educaion and planning services ha compensae or common invesmen misakes and consumer ineria, he balance may again ip in avor o advised porolios. Evidence suggess ha advisors acively help consumers eliminae common misakes, helping hem o lower expenses and creae more diversified invesmen porolios. Conversely, incenives exis or advisors o leverage some o he rus earned or generaing profis hrough higher ongoing ees and more requen ransacions. An imporan change in he secor is he increase in echnologically driven financial advice. Robo-advisors, or online invesmen plaorms ha provide consumers wih an online equivalen o a financial advice consulaion, is a rapidly growing global

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phenomenon. Tey ofen provide a combinaion o financial advice and producs because many o he unds hey offer o cliens are managed in-house. Because robo-advisors have a low marginal cos per exra clien consuled, heir business model allows hem o reach ou o consumers who migh no have he means o access a radiional financial advisor. Some have raised he concern ha such plaorms will be unable o educae consumers sufficienly in he process. Some o hese plaorms do, however, offer educaional conen o appeal o more financially lierae consumers, or offer privae banking services beyond heir auomaed advice. In ac, some robo-advisors are acively rying o esablish a repuaion or miigaing invesor biases by building in eaures ha proec agains bias-driven behaviors. Tis is an ineresing developmen, where he scale advanages o echnology migh bring behaviorally inormed invesing o consumers in ways ha radiional financial advice would be unable o do. Alhough mos advised cliens will, or he oreseeable uure, preer o have a person in charge o heir finances, dismissing online financial advice as a low-qualiy mass-marke commodiy is premaure. Addiionally, many hybrid orms o echnological and personal advice may develop. A key quesion is wheher robo-advisors will simply shif profis rom he inermediary o he und provider, or wheher hey will deliver suiable advice a a lower cos o consumers. o advance he field, noe hree paricular opics ha would benefi rom more invesigaion. Firs, here is a need or more deailed evidence on how advice reduces common invesors’ biases, no only a he poin o porolio composiion bu also hroughou he advisor–invesor ineracion. Second, consumers’ willingness o pay or advice services is underexplored here is a lack o empirical evidence on how consumers respond o differen pricing models. Tird, many o he opics covered in his chaper migh well have o be reevaluaed in he conex o he growing role o echnology in financial decision making, which is slowly urning financial services ino producs across much o he secor. Undersanding he impac o his process on firms, policymakers, and consumers is perhaps he greaes and mos relevan challenge.

DISCUSSION QUESTIONS 1. 2. 3. 4.

Explain he difference beween financial advisors and brokers. Discuss he purpose o financial advice o consumers. Describe he ypes o consumers who are more likely o look or financial advice. Explain why high- qualiy financial advice may no reach hose who would benefi he mos rom i. 5. Describe characerisics o financial advisors ha affec he degree o which consumers ollow heir advice.

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Labarère, José, Jean-Pierre orres, Parice Francois, Magali Fourny, Philippe Argeno, Xavier Gensburger, and Philippe Menhonnex. 2003. “Paien Compliance wih Medical Advice given by elephone.” American Journal o Emergency Medicine 21:2, 288–292. Lee, Jinkook, and Jinsook Cho. 2005. “Consumers’ Use o Inormaion Inermediaries and he Impac on Teir Inormaion Search Behavior in he Financial Marke.” Journal o Consumer Affairs 39:1, 95–120. Loewensein, George, Daylian M. Cain, and Sunia Sah. 2011. “Te Limis o ransparency: Pialls and Poenial o Disclosing Conflics o Ineres.”American Economic Review 101:3, 423–428. Loibl, Cäzilia, and ahira K. Hira. 2011. “Know Your Subjec: A Gendered Perspecive on Invesor Inormaion Search.”Journal o Behavioral Finance 12:3, 117–130. MacGregor, Donald G., Paul Slovic, Michael Berry, and Harold . Evensky. 1999. “Percepion o Financial isk: A Survey Sudy o Advisors and Planners.” Journal o Financial Planning 12:8, 68–86. Madrian, Brigite C., and Dennis F. Shea. 2001. “Te Power o Suggesion: Ineria in 401 (k) Paricipaion and Savings Behavior.” NBE Working Paper No. 7682. Markowiz, Harry. 1952. “Porolio Selecion.” Journal o Finance 7:1, 77–91. McKenzie, Craig . M., and Michael J. Liersch. 2011. “Misundersanding Savings Growh: Implicaions or eiremen Savings Behavior.” Journal o Markeing Research 48:1, S1–S13. Meier, Sephan, and Charles D. Sprenger. 2013. “Discouning Financial Lieracy: ime Preerences and Paricipaion in Financial Educaion Programs.” Journal o Economic Behavior & Organizaion 95:3, 159–174. Morris, Michael, Janice Nadler, erri Kurzberg, and Leigh Tompson. 2002. “Schmooze or Lose: Social Fricion and Lubricaion in e-mail Negoiaions.” Group Dynamics: Teory, Research, and Pracice 6:2, 89–100. Mullainahan, Markus Noeh, and Annete Schoar. 2012. “Te Marke or Financial Advice: AnSendhil, Audi Sudy. ” NBE Working Paper, w17929. Pat, Anhony G., Hannah . Bowles, and David W. Cash. 2006. “Mechanisms or Enhancing he Credibiliy o an Adviser: Prepaymen and Aligned Incenives.” Journal o Behavioral Decision Making 19:4, 347–359. Pi, Shih-Ming, Hsiu-Li Liao, and Hui-Min Chen. 2012. “Facors Ta Affec Consumers’ rus and Coninuous Adopion o Online Financial Services.” Inernaional Journal o Business and Managemen 7:9, 108–117. Price, Paul C., and Eric . Sone. 2004. “Inuiive Evaluaion o Likelihood Judgmen Producers: Evidence or a Confidence Heurisic.”Journal o Behavioral Decision Making 17:1, 39–57. iegelsberger, Jens, M. Angela Sasse, and John D. McCarhy. 2005. “ich Media, Poor Judgmen? A Sudy o Media Effecs on Users’ rus in Experise.” Proceedings o he HCI-05 Conerence on People and Compuers 19:2, 267–284. Sah, Sunia, George Loewensein, and Daylian M. Cain. 2013. “Te Burden o Disclosure: Increased Journal o Personaliy and Social Psychology

Compliance wih Disrused Advice.” 104:2, 289–301. Sherin, Hersh, and Meir Saman. 1985. “Te Disposiion o Sell Winners oo Early and ide Losers oo Long: Teory and Evidence.”Journal o Finance 40:3, 777–790. Sillence, Elizabeh, and Pam Briggs. 2007. “Please Advise: Using he Inerne or Healh and Financial Advice.”Compuers in Human Behavior23:2, 727–748. Sniezek, Jane A., Gunnar E. Schrah, and eeshad S. Dalal. 2004. “Improving Judgemen wih Prepaid Exper Advice.”Journal o Behavioral Decision Making 17:3, 173–190. Sigler, George J. 1961. “Te Economics o Inormaion.” Journal o Poliical Economy 69:3, 213–225. enney, Elizabeh ., Barbara A. Spellman, and ober J. MacCoun. 2008. “Te Benefis o Knowing Wha You Know (and Wha You Don’): How Calibraion Affecs Credibiliy.” Journal o Experimenal Social Psychology 44:5, 1368–1375. Taler, ichard. 1985. “Menal Accouning and Consumer Choice.”Markeing Science 4:3, 199–214.

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Taler, ichard H., and Shlomo Benarzi. 2004. “Save More omorrow: Using Behavioral Economics o Increase Employee Saving.”Journal o Poliical Economy 112:1, 164–187. Taler, ichard H., and Cass . Sunsein. 2008. Nudge: Improving Decisions abou Healh, Wealh, and Happiness. New Haven, C: Yale Universiy Press. Van Swol, Lyn M., and Jane A. Sniezek. 2005. “Facors Affecing he Accepance o Exper Advice.” Briish Journal o Social Psychology 44:2, 443–461. Webb, Tomas, and Paschal Sheeran. 2006. “Does Changing Behavioral Inenions Engender Behavior Change? A Mea–analysis o he Experimenal Evidence.” Psychological Bullein 132:3, 249–268.

17 Insurance and Risk Management JAMES M. MOTEN JR., CFP®, CHFC®, RICP®, CRPC,

CMFC Assistant Professor of Finance East Central University

C. W. COPELAND, CHFC®, RICP®, CLU Assistant Professor of Insurance The American College of Financial Services

Introduction Economics is predicaed on human decision-making processes. radiional economic heory suggess ha individuals make decisions ha are in heir own bes ineress and are consisen in heir preerences. Ta is, hey do no inenionally make decisions ha would make hem worse off. Individuals ofen seek assisance rom advisors o help hem accumulae asses or building wealh, hereby also improving heir financial decision making. However, par o an advisor’s responsibiliy is helping cliens proec heir accumulaed wealh. Tis goal makes hem beter off financially, bu is seldom communicaed in such a manner. Tis chaper explains how individuals make insurance purchasing decisions using risk managemen echniques wihin he consrucs o behavioral finance. Firs, he chaper describes he ypes o risk, hen surveys he mos common ypes o insurance or individuals. Following is a brie survey o behavioral finance, leading o a discussion o he ineracions o behavioral finance, insurance, and risk managemen. Te chaper concludes wih a summary and conclusions.

Insurance and Risk Tolerance Insurance is a conrac proecing agains risk and conaining our elemens

offer and accepance, consideraion, compeen paries, and a lawul purpose ha provides an individual or eniy proecion agains financial losses caused by perils (Moen 2014). Purchasing insurance is based on he principle o indemnificaion, which involves compensaing a pary or a loss or damaged propery o make he pary whole again. o spread he cos o paying claims, insurance is also based on he law o large numbers. Te law o large numbers is a saisical assessmen saing ha he larger he number o homogeneous exposure unis independenly exposed o loss, he greaer is he 302

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probabiliy ha he acual loss occurred will equal he expeced loss. Te law o large numbers conrass wih he law o small numbers, which is a judgmenal bias based on he belie ha a sample populaion can be accuraely prediced rom a small number o observaions. Insurance is a misundersood commodiy. Laer in his chaper, he opic o raming is discussed. A is core,faming concerns how o communicae wih a clien. Documenaion shows ha he percepion o a problem no only depends on is presenaion bu also on he mindse o he decision maker. Advisors encouner people on an emoional roller-coaser desiring o achieve financial securiy. Insurance is rarely a he op o cliens’ liss, bu when aced wih heir own moraliy or ha o a loved one, here’s a shif in atenion. Alhough insurance is relevan or all cliens, is level o imporance ends o increase wih age. Advisors can guide cliens seeking differen ypes o insurance. Because cliens differ, advisors need o improve heir skills a presening relevan inormaion o differen ypes o cliens. When hey rame insurance properly, is meris become clear o cliens. As an economic ool, consumers can use insurance o build, proec, and pass on wealh. By raming insurance in his manner, consumers may beter undersand is benefis and no view i as a commodiy. THE NATURE OF RISK

isk has differen meanings o differen people and varies wih he individual (Yazdipour and Neace 2013). For example, Markowiz (1952), who developed modern porolio heory (MP), indicaes ha risk-averse invesors atemp o develop a porolio ha maximizes heir reurn or a given level o risk. Ohers view risk as a condiion in which a possibiliy o loss exiss. Insurance serves as a hedge agains pure risk. Pure risk is a risk in which a chance o loss or no loss exiss. No chance o gain exiss, as here is he case o speculaive risk; examples o speculaive risk are playing he lotery and gambling. Te wo primary ypes o risk ha can affec an invesmen are sysemaic risk and unsysemaic risk. Sysemaic risk, also called nondiversifiable risk, is he uncerainy inheren in he enire marke. Unsysemaic risk, also called diversifiable risk, is risk ha is specific o a company. Diversificaion is useul in hedging agains unsysemaic or company-specific risk. For example, i workers o a company wen on srike, he srike would only impac he company or possibly is indusry; his is unsysemaic risk. In conras, a major erroris atack such as he Sepember 11, 2001, atack on win owers in New York Ciy or he Federal eserve Bank’s sudden raising o ineres raes could affec he enire marke, and hence are sysemaic risks (Moen 2014). isk can also be defined as possessing characerisics o objecive risk and subjecive risk. Objecive risk has quaniaive aspecs ha are numerical or saisical componens and hus is well defined and measurable. Subjecive risk has qualiaive acors whereby he assessmen o risk is based on percepion, cogniive issues, and emoions, which are less defined and unmeasurable. Insurance allows consumers o proec hemselves rom large losses or a relaively small premium. Perils are he causes o a possible loss resuling rom such evens as fires, lighning, explosions, aircraf damage, rios, smoke, and errorism. Hazards are condiions ha increase he likelihood ha a loss will occur; he hree primary ypes o hazards are physical, moral, and morale. Physical hazards are environmenal condiions ha affec or enhance he requency and severiy o a loss. Moral hazards involve dishones

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behavior ha causes loss. Morale hazards leads o atiudes o negligence and carelessness ha dominae because o he exisence o insurance. Te our primary responses o risk are risk avoidance, risk reenion, risk reducion, and risk ranser. O course, an individual may avoid he risk o loss by no engaging in an aciviy or owning propery. isk reenion is he mos common mehod o handling risk, however, and should be hose risks ha lead only o small losses. isk reducion may be accomplished hrough loss prevenion and loss conrol. When one pary ransers he chance o loss o anoher pary, ha is a popular orm o risk handling; purchasing insurance is a orm o risk ranser. BEHAVIORAL RESPONSES TO RISK

Insurance provides a ramework or sudying acual invesor behaviors, such as raionaliy, bounded raionaliy, and prospecheory. Raionaliy reers o a decision in which he decision maker inenionally atemps o opimize uiliy. Alernaively,bounded raionaliy reers o limiaions o he decision maker in access o inormaion, cogniive abiliy, and available ime (Copeland 2015).Prospec heory describes how real-world decisions involving risk can deviae rom he raional decisions o expeced uiliy heory. According o Simon (1955), individuals someimes make decisions ha appear o be irraional based on curren inormaion, siuaion,capabiliy, and he environmen in whichhey operae. An individual ypically reains a risk when boh is severiy and requency are low. An example would be paying ou o pocke o replace a Bluray disk; he cos o he disk has dropped subsanially over ime, and i damaged, is minimal o replace i. An individual ypically reducesa risk when boh he severiy and he requency are high. An example would be wearing a seabel while driving; auo accidens requenly happen and heir resuls can be severe. Te opporuniy o avoid a risk is rare. Addiionally, an individual ypically ransers a risk i he severiy ishigh and he requency is low. An example is buying homeowners insurance o proec agains caasrophic incidens; he cos o replacing a home is high, bu he requency o a fire is low, so consumers buy insurance when hey wan o ranser he risk o incurring placemen coss rom hemselves o an insurance company.

Basic Types of Insurance Five main ypes o insurance are available or individuals: • Disabiliy. Tis insurance replaces a porion o he insured’s salary i he individual canno work or a period o ime owing o illness or injury. • Life. Tis insurance proecs a amily or business rom loss o income owing o he breadwinner’s deah. • Propery and casualy. Tis insurance proecs agains propery losses o a business, home, or car and agains he liabiliy ha may resul rom injury or damage o ohers. • Healh. Tis insurance pays or covered medical expenses. • Long-erm care. Tis insurance helps o pay or services such as assised-living aciliies, home healhcare, and/or nursing home says.

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Te commonaliy among all hese ypes o insurance is ha hey are designed o ranser risk and o proec income and/ or asses. DISABILITY INSURANCE

Disabiliy insurance is inended o replace los earnings owing o a disabiliy, as defined

by he policy. Choosing a disabiliy policy requires considering he ollowing parameers: (1) when coverage is riggered, (2) when benefis begin, (3) how much is paid, (4) when coverage ends, (5) wha erms exis or policy renewal, (6) wha is no covered, (7) wha addiional benefis and riders are available, and (8) how disabiliy insurance income is axed. Disabiliy coverage is a suborm o healh insurance and alls ino our caegories: oal disabiliy, parial disabiliy, presumpive disabiliy, and residual disabiliy. oally disabiliy occurs when individuals canno perorm he duies o heir “own occupaion” or a specific period o ime. Anoher version o oal disabiliy is “any occupaion,” and ha is he orm used by he Social Securiy Adminisraion. Parial disabiliy is he inabiliy o perorm one or more imporan duies o an insured’s occupaion. Parial disabiliy benefis are usually 50 percen o he oal monhly benefi. Presumpive disabiliy involves he loss o sigh, hearing, speech, or wo limbs. Te benefis or presumpive losses are usually provided and payable or a lengh o he benefi period or lieime. Residual disabiliy reers o an income replacemen provision due o loss wages ha resul rom a disabiliy. Residual disabiliy benefis provide a reduced monhly benefi in proporion o an insured’s loss o income when he or she has been working again afer a disabiliy, bu a reduced earnings (Moen 2014). LIFE INSURANCE

Lie insurance is a conrac in which he insurer agrees o pay a sipulaed amoun o a

designaed beneficiary upon he occurrence o a coningency defined in he conrac, usually ha o deah o he insured (Moen 2014). Among he various ypes o lie insurance policies are erm, permanen, and endowmens. erm lie insurance is a policy ha provides proecion or a limied number o years or a fixed premium. Whole lie insurance provides permanen proecion or an individual’s lie or a fixed premium. Universal lie insurance, which is a variaion o whole lie insurance, provides permanen proecion wih a flexible premium. Variable lie insurance is a orm o permanen lie insurance conrac whereby he benefis vary wih he invesmen perormance o an underlying porolio o securiies, wih fixed premiums or flexible premiums wih a variable universal lie. A modified endowmen conrac(MEC) is a lie insurance policy whose premiums exceed wha would have been paid o und a similar ype o lie insurance policy wih a given number o annual premium paymens. A radiional reason or purchasing lie insurance is income replacemen; consequenly, i can be sraegically posiioned as a ool or reiremen. A paricular sraegy o ineres is pension maximizaion. Tis sraegy is ypically used o obain more curren pension benefi wihou denying he widow(er) uure benefis. A join and survivor annuiy is an insurance produc ha coninues regular paymens as long as one o he annuians is alive. Married couples who wan o guaranee ha a surviving spouse will

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receive regular income or lie ofen selec his ype o annuiy. Insead o aking he ypical join-and-survivor opion, a couple can also choose o ake he single lie annuiy opion o ge he higher pension benefi and use some o hose gained resources o buy a lie insurance policy o proec he surviving spouse once he oher pary dies. Afer evaluaing he income needs o he surviving spouse and looking a available sources o income, having lie insurance o replace he loss o income may be appropriae. Tis example can be considered a good applicaion or a firs-o-die policy, given ha he need is income replacemen or he remainder o he single spouse’s lie. One o he meris o lie insurance ha is ofen considered in wealhy households, bu bypasses hose wih less money, is guaraneeing a legacy. Some people spend oo much o heir asses, while ohers limi heir spending. A common concern abou over spending is ha doing so may no leave a legacy o amily members. When his is he case, guaraneeing a legacy by buying lie insurance can ree consumers o enhance heir curren liesyle possibly even providing more or heir amilies boh during heir lieimes and afer deah. For reirees wih exra unds ha hey wan o leave o children, grandchildren, or even a chariy, he amoun gifed can be leveraged by purchasing lie insurance. O course, he amoun o he deah benefis depends on he individual’s age and healh. Cash value lie insurance also allows he reiree o reain flexibiliy, so ha unds are sill available o mee reiremen needs, or as discussed previously, even be available or long-erm care. PROPERTY AND CAS

UAL TY INSURANCE

Te mos prominen orms o propery and casualy insurance are homeowners (HO) and auomobile insurance. Homeowners insurance is a ype o insurance ha includes propery and liabiliy coverage. egardless o he HO orm, wo secions o he conrac are secion I (coverages) and secion II (liabiliy). Secion I o homeowners insurance covers he dwelling, oher srucures, personal propery, and loss o use or damages. Secion II o homeowners insurance covers personal liabiliy and medical paymens o ohers. Auomobile insurance is a sae requiremen ha ypically provides a minimum amoun o liabiliy coverage (Moen 2014). Te insurance saisfies a requiremen needed o own and operae a moor vehicle. Insurance is also ied o he abiliy o regiser a vehicle. Facors influencing he cos o auomobile insurance are he operaor’s age, gender, and driving record, as well as he vehicle’s inended use. Auomobile insurance covers six basic areas: (1) bodily injury liabiliy, (2) medical paymens or personal injury proecion, (3) propery damage liabiliy, (4) collision, (5) comprehensive, and (6) uninsured and underinsured mooris coverage. HEALTH INSURANCE AND LONG-

TERM CARE INSURANCE

Healh insurance and long-erm care insurance are designed o provide proecion in he even o a medical loss ha could be shor erm, bu caasrophic in naure or prolonged when a person is older and canno perorm a leas wo aciviies o daily living (ADLs) or is cogniively impaired. Te six mos common ADLs are (1) bahing, (2) dressing, (3) eaing, (4) using he oile, (5) ranserring rom a bed o a chair, and (6) caring or inconinence.

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A Survey of Behavioral Finance According o radiional finance or economics, individuals should behave in a raional manner. Invesors can ypically be placed in one o hree differen ypes o risk atiudes. Mos invesors are risk averse, which means ha when aced wih wo invesmens wih a similar expeced reurn bu differen risks, he invesor preers he one wih he lower risk. Invesors wih low risk aversion ofen preer invesing in money marke muual unds or cerificaes o deposi. Individuals who are risk-seekers are on he opposie end o he isk-seekers selec o invesmens herisk-seekers highes levelsill o risk orina chance a aspecrum. high reurn. Even i a hisory low reurnswih exiss, inves volaile or risky asses. By conras, risk-neural invesors are in he middle, indifferen o he level o risk and concerned only wih heir desired rae o reurn. Tese hree risk atiudes explain he way raional invesors reac o risky siuaions. However, psychology and behavioral finance explain how consumers make purchasing decisions based on perceived risk. Specifically, behavioral finance explains why marke paricipans make irraional sysemaic errors ha are conrary o he way raional markes paricipans should behave. Some expers divide behavioral finance heory ino hree subcaegories: biases, heurisics, and raming (Sherin 2007). BIASES

A bias is a endency oward paricular mehods o hinking ha can lead o bad judgmen and irraional decision making. Te ollowing are biases, wih a general example, a finance example, and an insurance example.

Excessive Opimism Excessive opimism is he inclinaion o downplay he possibiliy o a negaive oucome

or o overemphasize he possibiliy o a posiive oucome. Individuals wih his bias hink hey are less likely han ohers o experience an unavorable even. • General example: “I don’ have o wear a seabel when driving he shor disance o my riend’s house.” • Finance example: “Te governmen bailed ou Bear Searns so we obviously don’ have o ollow Henry Paulson’s advice o find a buyer or our firm.” • Insurance example: “I don’ need lie insurance now because I don’ expec o die any ime soon.”

Overconfidence Overconfidence is he propensiy or individuals o believe heir skills, knowledge, and

abiliies are beter han hey acually are. I also indicaes a resisance o admi misakes. • Simple example: “I am smarer han everybody else so I don’ need o sudy or my final exam.” • Finance example: “I know my calculaions or he value o Apple sock mus be correc, so I’ll inves all my money in ha company raher han diversiy my porolio.”

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• Insurance example: “Insurance is a ‘rip-off.’ I can do beter by saving and invesing my money in he marke insead o giving i o he insurance company.”

Confirmaion Bias Confirmaion bias assers ha individuals look or daa and inormaion o veriy heir

belies. Hence, hey end o ignore conflicing evidence. Tus, hey end o keep inormaion ha helps heir case, bu ignore inormaion when i does no. • Simple example: “Even hough Sam bough me roses and diamond earrings or my birhday, he mus no love me because I didn’ ge he new Mercedes I’ve been waning.” • Finance example: “Despie economic sluggishness in China and Europe, he Federal eserve should raise ineres raes because he unemploymen rae is near 5 percen.” • Insurance example: “I don’ rus lie insurance companies. My dad paid on his lie insurance policy or year and i lapsed beore he go a chance o benefi rom i.”

Illusion o Conrol Illusion o conrol occurs when individuals end o believe ha hey can conrol more

han hey acually can. In oher words, people perceive ha hey have influence over hings hey do no. • Simple example: When rolling dice in craps, which is a dice game in which he players make wagers on he oucome o he roll, or a series o rolls, o a pair o dice, evidence shows ha people end o hrow harder or high numbers and sofer or low numbers. • Finance example: When invesors use sraegies such as limi orders o gain a sense o conrol over invesmens, even hough he overall success o heir porolio is based on acors such as company perormance, which are beyond heir conrol. • Insurance example: “I’ll wai unil I ge closer o needing insurance beore I buy i.”

Saus Quo Bias Saus quo bias occurs when individuals preer o do nohing or mainain decisions hey

have made in he pas. Tey end o preer he curren sae o affairs. • Simple example: “I have always bough iPhones in he pas so I guess I will buy anoher iPhone when i’s ime or my upgrade.” • Finance example: “My aher old me ha muual unds were a sae invesmen so I plan o buy muual unds.” • Insurance example: “I alked o my dad abou his insurance and he el ha a burial policy was all I needed.”

Hindsigh Bias Hindsigh bias occurs when individuals unrealisically believe hey would have prediced

an even ha occurred even hough i would have been nearly impossible o oresee. • Simple example: “I should have expeced rain oday because I washed my car yeserday.”

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• Finance example: “I had a eeling ha he chie execuive officer was embezzling money rom he company.” • Insurance example: “Buying ino he guaraneed insurabiliy opion would have been a wase o money because I’ve had his policy or 40 years and no been sick.”

Recency Bias Recency bias is he illogical endency o make decisions based on wha has happened in

recen memory. Individuals hink ha wha has been happening will coninue. • Simple example: “Te ooball eam has no los a regular season game in more han nine years so I be you $100 hey will bea he nex opponen.” • Finance example: “Because housing prices ypically rise over ime, we don’ have o worry abou buying a house ha is ou o our price range because we can always sell i i we have rouble making he paymens.” • Insurance example: “Because he rae o reurns on permanen insurance policies has been low, I would have been beter off invesing my money elsewhere.”

Conservaism Conservaism occurs when orecasers cling o prior belies in he ace o new inormaion (Byrne and Brooks 2008). • Simple example: “Ta’s he way ha we have always done i.” • Finance example: “Te efficien marke hypohesis explains everyhing ha we need o know abou how he marke works.” • Insurance example: “Single people shouldn’ buy insurance because i is a wase o money.”

Menal Accouning Menal accouning is a mehod by which individuals allocae wealh using separae men-

al accouns while ignoring how hey relae o oher financial decisions. • Simple example: “I have made big plans or my ax reurn!” • Finance example: “I don’ wan my child o have o ake ou suden loans so I am going o ake he money rom my 401(k) plan.” • Insurance example: “Since I have cash value in my lie insurance policy, I will use ha money insead o mainaining a savings accoun.”

Regre Aversion Regre aversion is a mehod in which individuals make decisions or reuse o make deci-

sions so hey can avoid eeling any emoional pain in he uure due o making poor decisions. • Simple example: “Te bes sraegy or me is no o ge involved.” • Finance example: “I los money in he sock marke in he pas, so I’m going o keep my money in he bank.” • Insurance example: “I once had a permanen insurance policy, bu i only earned 3 percen ineres. I could have invesed my money in a beter opporuniy.”

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HEURISTICS

A heurisic is a general rule or menal shorcu ha helps increases he speed o decision making. Tese shorcus presen a problem when hey hinder he abiliy o develop new ideas or when someone aces anomalous circumsances. Te ollowing biases are examples o heurisics, including represenaiveness, availabiliy, and anchoring.

Represenaiveness Represenaiveness is a way o hinking ha places houghs ino caegories. Individuals

make judgmens based on how well somehing fis ino heir preconceived noions based on caegorizaion. Tis syle o hinking closely resembles sereoyping. • Simple example: “David is reserved, wears glasses, enjoys video games, and waches sci-fi movies. I be he is a mah or science major.” • Finance example: An invesor who only owns oil-based socks may believe he enire sock marke is currenly sruggling. However, he realiy is ha his socks are suffering because o alling oil prices. • Insurance example: “Sock marke reurns are so good ha buying erm insurance and invesing he difference has o be a good sraegy.”

Availabiliy Availabiliy is he menal shorcu o relying on wha mos readily comes o mind when

making decisions. Individuals misakenly hink ha i hey can recall somehing easily, i mus be imporan and, hereore, serves as a good basis or decision-making. • Simple example: “John is scared o ask Suzy o he prom because he sill painully remembers how Mary urned him down las year.” • Finance example: “Boh producers and consumers hesiaed o ake advanage o record-low ineres raes as he economy recovered because he memory o he financial crisis was resh in heir minds.” • Insurance example: “When a member o my church died, her amily had o collec money o bury him; hereore, I am going o buy as much lie insurance as I can afford.”

Anchoring Anchoring is he propensiy o rely on he firs number or piece o inormaion (an

anchor). Individuals hen make subsequen judgmens by adjusing he anchor o reflec new inormaion. Tis heurisic can become a problem when hey wrongly inerpre new inormaion hrough he lens o he srcinal anchor. • Simple example: Used car salesmen use anchoring o heir advanage during negoiaions. Once an iniial price is given, any lower price sounds beter o he buyer even i i is sill more han he car is worh. • Finance example: During he ech bubble o he lae 1990s, invesors coninued o speculae and expec echnology-based socks o grow a a rapid rae alhough such growh was unsusainable in he long erm.

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• Insurance example: “My parens bough a permanen lie insurance policy or me when I was young and by he ime I was grown, i had considerable cash value. I am going o buy his ype o policy or my children.”

Affec Heurisic Affec is he menal shorcu when individuals rely on heir emoional response o a siu-

aion o make a decision. I hey have posiive eelings abou he siuaion, hey are more likely o perceive i as less risky. Affec is he “gu eeling” heurisic. • Simple example: People are ypically more araid o airplanes han riding in auomobiles because airplane crashes creae a more emoional response. • Finance example: “I believe ha financial markes are more likely o increase on sunny days han on cloudy days because people generally have a more posiive oulook.” • Insurance example: “My riend jus died and his lack o a lie insurance affeced his amily. I need o buy lie insurance as soon as possible.”

Causaliy Causaliy occurs when individuals wrongly atemp o iner cause rom an effec. For

examples, individuals end o associae correlaion and causaion. • Simple example: “Te amoun o drowning deahs increases when ice cream sales also increase.” I would be wrong o iner ha rising ice cream consumpion causes drowning deahs because he more likely explanaion is ha individuals ea more ice cream and swim more during he summer monhs. • Finance example: “Increased economic growh in he Unied Saes causes more financial developmen.” Tis relaionship could easily be reversed: financial developmen could cause economic growh. Individuals need o be aware o reverse causaliy and hird-par causes. • Insurance example: “My healh insurance was so expensive ha I couldn’ afford i, so I dropped he policy. wo weeks laer, I had o go o he hospial. I be i I had no dropped my healh insurance, I wouldn’ have had o go o he hospial.”

Atribuion Subsiuion Atribuion subsiuion occurs when individuals have o make a decision abou some-

hing more complex and insead make a decision abou a similar, easier subsiue. • Simple example: Someone who has been hinking abou his relaionships and hen is asked abou his happiness migh subsiue how happy he is wih his relaionships, raher han answer he quesion. • Finance example: When domesic socks are down, people ofen move heir money ino cash, as opposed o diversiying wih inernaional socks or bonds or alernaive invesmens. • Insurance example: Anecdoal evidence suggess someone could be offered insurance agains her deah in a erroris atack while on a rip o Europe, while anoher person could be offered insurance ha would cover deah o any kind on he rip. Te firs person is willing o pay more even hough “deah o any kind” includes

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“deah in a erroris atack.” Te person is subsiuing he atribue o ear or he oal risks o ravel. FRAMING EFFECTS

Te faming effec is an example o cogniive bias in which people reac o a paricular choice in differen ways depending on how i is presened, such as a loss or as a gain. Individuals end o avoid risk when presened in a posiive rame bu seek risks when presened in a negaive rame. • Simple example: Te glass is hal-empy versus he glass is hal-ull. • Finance example: Some people would raher risk doubling heir money han losing hal o heir money, alhough he odds migh be he same. • Insurance example: Selling insurance o parens i a child o cover uneral coss is dificul because hey do no wan o hink abou heir child’s moraliy and believe he odds are low or premaure deah. However, selling insurance o parens on heir child is easier i i is o heir child’s uure insurabiliy and build cash value or he uure and has a non-increasing premium.

Loss Aversion Loss aversion occurs when individuals eel losses more srongly han hey do gains. Tis si-

uaion becomes a problem when i causes hem o go o irraional lenghs o avoid aking risks. Anoher problem o loss aversion is ha once people have invesed ime or money, hey become irraionally risk oleran o avoid eeling he loss (aversion o a sure loss). • Simple example: Losing $20 ha a person earned has a greaer impac han losing $20 ha he person ound. • Finance example: isk-averse invesors ofen choose low-risk invesmens despie offering lower expeced reurns han more risky invesmens. • Insurance example: Mos individuals buy he “sae minimums” on auo insurance o save on premiums wihou hinking abou he risk associaed wih being underinsured.

Herd Menaliy Herd menaliy occurs when he behavior o ohers irraionally influences anoher. Tis

bias is similar o “peer pressure.” Individuals do no like o be lef ou, so hey behave in ways conrary heir normal behavior. • Simple example: A non-coffee drinker may pour anoher beverage ino a Sarbucks cup because o he brand’s populariy. • Finance example: Bernie Madoff pulled off he larges Ponzi scheme in U.S. hisory because invesors heard abou his phenomenal reurns rom ohers and eagerly jumped on board. • Insurance example: Insurance companies someimes use celebriies o “sell” insurance in heir commercials because hey believe ha he saus and influence o celebriies convince many consumers o ollow heir example.

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Disposiion Effec Te disposiion effec occurs when invesors are less willing o recognize and acknowledge losses more quickly han gains. Similar o loss aversion, invesors do no like o experience a loss so hey may irraionally reuse o accep i. • Simple example: A ooball player coninues o play on an injured knee and causes permanen damage because he avoided aking adequae care o he injury. • Finance example: Invesors end o sell socks oo early ha increased in value and hold on oexample socks oo longmen ha decreased in value. • Insurance : Some are unwilling o buy insurance because hey do no wan “some oher man living off heir money” as opposed o being responsible and aking care o heir amily.

Money Illusion Money illusion occurs when someone has difficuly acoring he effecs o inflaion ino

purchase decisions. • Simple example: “Bread is now very expensive. I once could buy a loa or a dollar.” • Finance example: “I previously could ge enough ineres rom my money marke accoun o pay my car noe. Now he ineres generaed is oo small o buy lunch.” • Insurance example: “My healh insurance is 20 percen more han i was hree years ago. I don’ undersand why i keeps increasing.”

Behavioral Finance, Insurance, and Risk Management Boh radiional finance and he concep o raionaliy are based on he belie ha when individuals receive new inormaion, hey make choices ha ollow normaive decisionmaking echniques (Barberis and Taler 2003). In radiional finance, hese individuals are considered o be raional maximizers. A raional maximizer is an individual who raionally considers he pros and cons o a given purchase decision. Behavioral finance describes a differen se o rules in which individuals someimes make irraional decisions even when aced wih seemingly raional choices. Tis irraionaliy leads hem o make less han opimal decisions. Behavioral finance helps o explain biases ha are inconsisen wih raional behavior. Behavioral finance heories ofen serve as a ramework or deermining individual behavior in risk managemen decisions. Belbase, Coe, and Wu (2015) sudy which behavioral finance heories explain an employee’s decision o buy lie insurance. Tey examined menal accouning, money illusion, and he role o deauls. Te auhors conduced 24 elephone inerviews wih employees who had o choose he amoun o lie insurance hey waned o buy. Specifically, heir sudy examined employee percepions abou he hrea o premaure deah, financial consequences o heir premaure deah, and how o minimize he cos hrough menal accouning. Belbase e al. asked survey paricipans abou heir choice o buy volunary supplemenal lie insurance benefis available o hem hrough

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heir workplace. Teir objecive was o deermine how hese benefis are presened o employees, wha eaures are atracive, and wha barriers exis or hose who choose no o buy he insurance coverage. Te responses show ha mos respondens undersand he purpose o lie insurance bu admited ha deermining he proper amoun o coverage needed was difficul. Over 40 percen o he respondens repored ha hey spen less han 30 minues o deermine he amoun o insurance needed. Te behavioral finance heory o menal accouning is he mos widely used mehod or deermining he proper amoun. Tis preerence occurs because menal accouning involves he endency or individuals o separae money ino disinc, separae accouns based on subjecive crieria. Te respondens’ budge was he main acor used o find wha amoun o lie insurance would be required o adequaely replace he los wages wihou regard o wha was really necessary o mainain he amily’s curren sandard o living. Te issue o affordabiliy was more o an issue han an analysis o wha hey acually needed. Te resuls ideniy he need o provide complemenary educaion o help in making choices. According o Fisher (1928), individuals someimes hink in erms o nominal raher han real moneary value. A nominal moneary view ignores inflaion, which affecs one’s purchasing power. As Shaer, Diamond, and versky (1997) noe, i his heory holds, hen i conradics he maximizaion paradigm ha is prevalen in economic heory. Tey cie research in cogniive psychology suggesing ha when aced wih he same risky siuaion, muliple responses are available. When individuals only have a chance o gain more o an asse, hey end o choose he mos risky proposiion. However, consisen wih loss aversion, when aced wih he prospec o loss and gain, hey preer he saer be. When individuals hink in erms o moneary value, hey demonsrae conradicory views o menal accouning when valuing heir possessions. Tis narrow view could lead hem o undervalue heir possessions when deermining he amoun o propery and casualy insurance or lie insurance needed o mainain heir curren sandard o living. Liebman and Zeckhauser (2008) sudy he deficiencies in radiional economic models, which are very similar o radiional financial models when individuals ace decisions o buy healh insurance. Te recen prolieraion o healhcare choices has made his decision more difficul. Teir sudy ocused on wo choices involving healh insurance: (1) he ype o insurance o selec, and (2) when o buy insurance. Tey ound ha once cusomers decide o buy insurance, he more risk-averse individuals buy more insurance. Tis choice ollows a raional decision-making model. Addiionally, hose expecing more healh problems based on amily medical hisory also end o buy addiional insurance. However, even when individuals ideniy ha hey need o buy more lie and healh insurance, hey ail o conduc he proper analysis o adequaely address he risk. Te observed behavioral economics heory was “underesimaion.” Consumers who underesimae uure evens do no buy an adequae amoun o healh insurance because hey concenrae on heir presen condiion. Overall, Liebman and Zeckhauser ound ha underinsurance is a acor o ineria because o he complexiy o coverage choices. According o Kunreuher and Pauly (2014), consumers do no ac raionally when making a decision o buy insurance. Tey also poin ou ha individuals wih insurance

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coverage ac irraionally because hey rely on inuiion and emoions, raher han careul hough or proven research. radiional economic heory suggess ha risk-averse consumers should be willing o pay a small premium or a specified level o proecion. However, Kunreuher and Pauly’s empirical evidence suggess ha even when acing low-probabiliy and high-consequences scenarios, inervenion is needed by public and privae insiuions o shape consumer behavior. Te auhors also find ha many individuals selec deaul opions raher han acually assessing heir risk managemen and insurance needs. Many consumers use inuiion in he ace o uncerainy, bu his inuiion is no based on research; raher, i is based on heir narrow experience wih purchasing insurance. When consumers ake an acive role and ruly assess heir needs, he benefis are widespread. Insureds suffer rom underesimaion. Kunreuher and Pauly (2014) discuss an example involving he risk o errorism. Even hough acuaries and underwriers are mahemaical expers, hey underesimae he damage ha could be caused by evens such as he erroris atack on he win owers in New York Ciy on Sepember 11, 2001. Tis example urher illusraes a company’s ailing o adequaely accoun or low-probabiliy and high-consequence evens. wo noable pieces o legislaion ha atemp o address he shorcomings in he decision-making process involve he purchase o insurance. Boh he Bigger- Waers Ac o 2012 and he Affordable Care Ac o 2010 (ACA) atemp o address he issue o insurance shoralls. Te Bigger- Waers Flood Insurance eorm Ac o 2012 exends he Naional Flood Insurance Program (NFIP) or five years, while requiring subsanial program reorm. Te purpose o he Affordable Care Ac (ACA) o 2010 is o make healh insurance more affordable or hose w ih litle or no coverage. Many provisions o he ACA are mean o conrol he coss o insurance premiums and ou-o-pocke coss or healh care and access o insurance. Te inen o boh acs is o encourage or enice organizaions and individuals o implemen risk- reducing measures. Proposals or oher orms o governmenal inervenion may reduce he risk o sociey a large. Huber (2012) conducs a our-par sudy o deermine he effecs o conrac elemens, price presenaion, company raings, and consumer atiudes and percepions on an individual’s decision o buy cerain levels o lie insurance. Te firs par o he sudy ried o ascerain wheher he decision o buy lie insurance is based on guaraneed reurn or subjeciviy willingness o pay, which is a financial pricing approach. Te resuls sugges ha even when aced wih a guaraneed reurn, paricipans sill deviae rom he norm. Te second par o he sudy looked a he perceived value o lie insurance based on differen ways o buy insurance, including bundling, parial bundling, and unbundled. Te resuls o he second par sugges ha consumers do no aler heir purchasing habis based on he bundling o he insurance produc. Huber (2012) urher suggess ha he reason differen individual decisions are no saisically significan is due o he complexiy o he produc and no he percepion o an acual price difference. Te hird par o he sudy examined he raings o he insurance company and is effec on individual purchasing decisions. Huber (2012) sudies wheher individuals make purchasing decisions based on raings and cerificaions o companies perormed

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by hird paries. Te resuls sugges ha company raings and cerificaion have a saisically significan impac on produc evaluaion and on risk percepion. Te ourh par o he sudy ocused on consumer atiudes and percepions, and heir influence on wheher o buy or no o buy insurance. Huber (2012) ess he hypohesis using a uni-linked lie insurance produc wihou any guaraneed componens. Te resuls o sudy sugges ha underlying atiudes significanly affec produc percepions. Huber (p. 169) poins ou ha “risk avoidance presens a raher emoional componen while uncerainy avoidance is raher analyical.”

Summary and Conclusions According o MP, people have complee inormaion abou he likelihood o possible oucomes and can ariculae heir preerences abou hose possible oucomes. Hence, hey should be able o maximize heir expeced uiliy. According o proponens o behavioral finance, individuals do no always operae raionally. egarding insurance, consumers ofen respond differenly rom wha “makes sense.” Salwars o he insurance indusry advocae ha individuals should buy lie insurance i anyone associaed wih hem would suffer financially i he individual were no longer around. Te general hinking is ha he income conribuion being los needs o be replaced and asses ha have been accumulaed need o be preserved. As relaed o insurance, behavioral finance helps explain why consumers’ acions are differen rom wha is expeced, given he issues regarding risk. Behavioral finance sipulaes ha consumers exhibi behaviors ha can be caegorized as biases, heurisics, and raming reerences. Biases are a endency oward paricular mehods o hinking ha can lead o bad judgmen and irraional decision making. Heurisics are general rules or menal shorcus ha help people make decisions aser. Framing effecs are creaed by he way an idea is presened. Each o hese behavioral finance conceps helps provide a beter undersanding o he why, when, and how people buy insurance. Consumers are no moivaed o buy insurance simply or proecion. Teir raionale (he “why”) is largely due o saus quo, he recen occurrence o an even, a desire o avoid a loss, and a lack o undersanding o inflaion or causaliy. Behavioral finance can also help provide undersanding o he “when” in he purchasing decision. Te “when” is ofen premised on he availabiliy o a subsiue opion or how insurance fis ino a predeermined caegory. Te “how” o insurance decision making can be associaed wih confirmaion o previous belies and/ or he effec o emoion. Generally, insurance sales have no decreased since 2009. By conras, propery and casualy insurance sales are up, owing o sae law. Sales o healh insurance have increased as a resul o changes in ederal law. Long-erm care insurance has likely increased owing o more undersanding o he preponderance o Alzheimer’s cases and he raily associaed wih longeviy. Lie insurance sales are acually down, even hough he availabiliy o inormaion has increased several old. Many use insurance as a risk managemen echnique, bu i canno be confirmed ha he reason is ha consumers make smar buying decisions (LIMR 2013).

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DISCUSSION QUESTIONS 1. 2. 3. 4. 5.

Explain he our primary responses o risk. Discuss he hree primary ypes o hazards associaed wih risk managemen. Discuss he hree mos prevalen risk atiudes. Ideniy and discuss he five main ypes o insurance or individuals. Discuss hree subcaegories o behavioral finance heory.

REFERENCES Barberis, Nicholas, and ichard Taler. 2003. “A Survey o Behavioral Finance.” In George M. Consaninides, Milon Harris, and ené M. Sulz, Handbook o he Economics o Finance, Volume 1, 1052–1121. Norh Holland: Elsevier. Belbase, Anek, Normal B. Coe, and April Wu. 2015. “Overcoming Barriers o Lie Insurance Coverage: A Behavioral Approach.” Working Paper, Cener or eiremen esearch, Boson College. Available a htp://crr.bc.edu/wp-conen/uploads/2015/06/wp_2015-5.pd. Byrne, Alisair, and Mike Brooks. 2008. Behavioral Finance: Teories and Evidence. Charlotesville, VA: esearch Foundaion o he CFA Insiue. Copeland, C. W. 2015. Applicaions in Financial Planning II. Bryn Mawr, PA: American College Press. Fisher, Irving. 1928. Te Money Illusion. orono: Longmans. Huber, Carin. 2012. “Behavioral Insurance: Essays on he Influence o aings and Price Presenaion on Consumer Evaluaion, isk Percepion and Financial Decision-Making.” Disseraion, Universiy oAffairs. S. Gallen, School o Managemen, Economics, Law, Social Sciences and Inernaional Available a htp:// www1.unisg.ch/ www/edis.ns/SysLkpByIdenifier/ 3959/$FILE/dis3959.pd. Kunreuher, Howard, and Mark Pauly. 2014. “Behavioral Economics and Insurance: Principles and Soluions.” Working Papers #2014- 01, Wharon School, Universiy o Pennsylvania. Available a htp://cieseerx.is.psu.edu/viewdoc/download?doi=10.1.1.645.8939&rep=rep1&ype= pd. Liebman, Jeffrey, and ichard Zeckhauser. 2008. “Simple Humans, Complex Insurance Suble Subsidies.” NBE Working Paper 14330. Available ahtps://www.hks.harvard.edu/s/rzeckhau/SimpleHumans_websie_version.pd. LIMR. 2013. “U.S. eail Individual Lie Insurance Sales (3Q2013).” Available a htp://www. limra.com/Poss/P/News_eleases/LIMA __Individual_Li e_Insurance_Sales_ Experience_Srong_Fourh_Quarer_Growh.aspx. Markowiz, Harry. 1952. “Porolio Selecion.” Journal o Finance 7:1, 77–91. Moen, James. 2014. Inroducory Financial Managemen: Teory and Applicaion. Second Ediion. edding, Value exbook (BV) Publishing. Shaer, Eldar, CA: PeerBes Diamond, and Amos versky. 1997. “Money Illusion.”Quarerly Journal o Economics, 12:2, 341–374. Sherin, Hersh. 2007. Behavioral Corporae Finance: Decision ha Creae Value. New York. McGraw-Hill Irwin. Simon, Herber A. 1955. “A Behavioral Model o aional Choice.” Quarerly Journal o Economics 69:1, 99–118. Yazdipour, assol, and William P. Neace. 2013. “Operaionalizing a Behavioral Finance isk Model: A Teoreical and Empirical Framework.” Journal o Enrepreneurial Finance 12:2, 1–32.

18 Psychological Factors in Estate Planning JOHN J. GUERIN Owner Delta Psychological Associates, P.C. L. PAUL HOOD JR. Director of Planned Giving The University of Toledo Foundation

Introduction Te dialogue beween an esae planner and a clien, wheher rom he legal or he financial planning proession, has a unique characerisic ha disinguishes i rom all oher financial conversaions. egardless o he deails o he consulaion, here’s a ime when he resuls o he work will be esed. Alas, ha esin g wil l occur when he clien is no longer presen o rework he plan. Ta irrevocabiliy o he esae plan hus creaes a demand ha he proessional consider many possible resuling scenarios as a produc o he planning process. Because all possible scenarios canno be exhausively anicipaed, here’s ofen room or error when developing an esae plan. Along wih he need o draf as comprehensive plan as possible, here is a subsanial barrier also no presen in many oher orms o financial and lie planning. Ta is, he ormulaion o an esae plan implicily involves houghul consideraion o he disribuion o wealh. Along wih his plan can be a saemen o he eelings ha accompany he disribuion, or i can reflec a broad survey o he deceden’s values, lie sories, and worries. Such reflecions are also someime s conained in wil ls or in a separae documen commonly known as an ehical will (eimer and Samper 1991; Baines 2006). Tis chaper explores he complexiy inheren in he esae planning process, including is enaive relaionship wih behavioral finance. Included in his broad view is a discussion o common communicaion problems encounered in esae planning and a look a he effecs in paricular o discussions o moraliy. Tis is ollowed by a review o models rom clinical psychology ha migh be applied o esae planning, as well as some inerview echniques ha could aciliae planner– clien discussions. Finally, he chaper ends wih an overview o curren and poenial collaboraio ns beween he fields o psychology and financial planning.

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Considerations for Estate Planning oday, he process o esae planning has ransmued ino a primary concern abou being axed on wealh or which axes have already been paid. Tereore, he main issue in esae planning is one o ax avoidance, such ha he issue o moraliy acually ofen becomes a secondary consideraion. Adding o his, he esae planner mus acknowledge ha mos people have a low olerance or discussions abou heir own moraliy. Hence, boh clien and planner requenly “dance” around he issue, wih he discussion characerized euphemisms andan wih “gallows humor. ” o esaes. Te common erm A he sameby ime, here has been evoluion in he parlance or arranging one’s posmorem affairs has been called wriing a “Las Will and esamen.” Tis label suggess ha no only does one disribue one’s earhly possessions bu also one provides a raionale or ha disribuion. Ta his ramework may conribue o wealh sraificaion on a social level is usually no a consideraion (Harringon 2012). Te curren ocus o esae planning as ax liabiliy avoidance and asse proecion planning is no surprising, hen, considering ha he esae planning proessional is usually an atorney. However, discussions abou legacy and wealh ranser may also ake placeih w a financial planner. Bu wheher i happens in he office o an atorney or ha o a financial planner, he pracical and numerically definable naure o ax minimizaion makes i an atracive arge or he work o an exper. Tis exper’s inpu can offer a clear “value proposiion,” showing he impac o financial planning by demonsraing perormance wih and wihou such assisance. esae planning an insance, area o direc clien service, i does nohealh fi easily inoAddiionally, a field o scienific research.isFor psychologiss and ye oher menal proessionals may eiher consume or generae research ha can apply o financial planning. Ye, borrowing he principles o human behavior in rendering hese much-needed financial services requires ha he planning proessional selec heories ha seems o apply o direc services. Tis incorporaes concepual models rom psychology ha have varying degrees o credible research o suppor hose ideas. Te meaphor ha aply capures he siuaion is o service proessionals atemping o consruc an auomo bile while driving i. Neverheless, he rising ineres in behavioral finance has made discussion o money and wealh a mainsream concern or psychologiss and oher menal healh proessionals. Alhough behavioral finance has esablished isel as a producive area o research, i is almos exclusively sudied in academic and research setings. o dae, menal healh proessionals are rarely adequaely conversan wih financial and/or legal issues o give anyFor advice direcion ha wouldhere impac financial esae he or service proessional, needs o be and a clear linkacics. beween psychology and finance. However, he naure o ha link or more precisely, he incorporaion o ha link ino he pracices o financial and psychological proessionals remains weak. Atorneys and financial planners know he imporance o uller, deeper, and more meaningul conversaions abou wealh, including an awareness ha wealh is also measured in nonfinancial erms. Should he conversaion ake a urn oward emoional or psychological issues, or oward marial, amily, or relaionship dynamics, however , and he financial proessional is beyond his or her sphere o experise or compeence. Afer all, his scenario risks proessional liabiliy exposure, as well as he loss o a clien i he conversaion deviaes rom a discussion o financial well-being. Indeed, he call o have more exensive discussions wih

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cliens adds a burden o he esae planner atorney, who has a ormidable lis o poenial barriers wih which o conend, including issues o confidenialiy. A crisis may precipiae an individual’s need or esae planning. Family dynamics may inhibi meaningul planning. Facors o jealousy, financial illieracy, addicions, menal healh issues, spending dificulies, and oher barriers can resric decision making and impair he clien’s judgmen and cause discomor or he planner (Foord and Ebersole 2007). Te esae planning atorney mus also acknowledge he evolving naure o amilies (Allianz Insurance 2015). Te radiional amily has given way o blended amilies, single- paren households, same- sex parnerships/ marriages, and older parens. According o Allianz, he number o radiional amilies has dwindled o abou 28 percen o U.S. households. Some sudies have considered he effecs o hese blended or modern amilies (Bernsein and Collins 1985; Hood and Bouchard 2012; Hood and Leimberg 2014). However, he vas majoriy o esae planners are sill operaing wih a radiional model as heir benchmark. Saus quo bias or ineria may resul because using he radiional amily as he emplae or financial planning is simpler, requiring less effor and sophisicaio n. ecognizing such challenges, i is essenial or an esae planner o undersand he relaionship dilemmas ha can arise. Possessing some knowledge o he psychological research ha may have sudied clien behavior is, hereore, imporan in he esae planning process. For example, cliens may need o discuss maters ha bear on moraliy; knowing he exan clinical research on his can be o help. Furhermore, ools ha psychologiss use in oher areas o clinical and consuling work may prove useul in discussions o planning. O course, any research ino behavioral issues in esae planning mus consider he confidenialiy owed o he clien.

The Complexity of the Estate Planning Process Because o he inherenly sensiive naure o esae planning, he heighened emoional pich o his discussion can have major herapeuic or ani-herapeuic effecs. Te esae planner has o be consisenly aware o his possibiliy. Also, he meeings end o be complex, given he many purposes o he process. Hood and Bouchard (2012) provide a lis o some o hese issues: • Te esae planner mus gaher a large amoun o inormaion, which may involve layers o complexiy, such as when an esae involves parial or ull ineress in businesses, or amilies are blended or oherwise nonradiional. Te inormaion gahered mus be boh accurae and complee. • In he service o compleeness, issues ofen arise ha need o be recognized as angenial, so a reocus may need o occur on muliple occasions. • Te esae planner mus engender boh a sense o comor and o compeence or he clien. • Te esae planner mus recognize and address he ac ha esae planning involves a discussion o he clien’s moraliy. • I he clien is more han one person, such as a couple, he esae planner mus balance atenion o boh and atend o relaionship dynamics as hey arise. Te complexiy expands wih he involvemen o oher amily members.

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• Clien moivaions have o be recognized. Boh explici and hidden agendas may be involved in he planning process. • Family hisories may be complex and delicae, paricularly involving a blended amily. • Te esae planner mus gauge he clien’s menal saus or compeence o engage in planning. Ta assessmen o menal saus may include he possibiliy ha anoher pary could be atemping o exer undue influence. Oher consideraions may be presen as well, boh a he ouse and during he remainder o he planning process. Firs, since he planner’s work is ofen billed on an hourly basis, he clien may wish o move as quickly as possible, expressed direcly or eviden in some pressure applied. Te planner someimes sees his pressure as conflicing wih a duy or compleeness and adequae deail, and is obliged o inorm he clien o esimaed coss, even hough complexiies may arise ha affec he ulimae cos o he work. Ta is, checking he accuracy and/or compleeness o he inormaion supplied by he clien someimes calls or due diligence, and hereore affecs he ime esimaes. Second, an implici imbalance exiss in he planner–clien relaionship, given he planner’s knowledge o and experise in he process. Tis dispariy can drive he planner ino beginning o address he “how o” o an esae plan, raher han he “why” o he process. Tird, a poenial or conflics o ineres arises in esae planning. Te wealh holder is he clien who mus be served; however, he success o an esae plan is measured by he views o he beneficiaries. Tus, he esae planner mus predic in he presen how he plan will affec he beneficiaries laer on, and wheher he purposes and ideals o he beneacor will be served. Alhough an esae planner may make a reasonable atemp o orecas he eelings o he clien’s survivors, he manner in which grieving akes place can be unpredicable. Conflics can easily arise among beneficiaries over seemingly small maters, such as posiive or negaive eelings abou he deceased or difficulies conroning heir own moraliy. Alhough hese issues are dauning challenges in he process o esae planning, subsanial evidence exiss ha a well-done esae plan can reinorce amily cohesion and harmony, and ha a well-conduced planning process can have a posiive, growhenhancing oucome or he clien (Shaffer 1970; Glover 2012).

Planner–Client Communications In par, as a resul o he pressure o provide answers, he esae planner may assume he role o “exper,” resuling in aking charge o he process and he conversaion (Hood and Bouchard 2012). Especially among proessionals who have consruced numerous esae plans, a endency exiss o “plug in he ape.” Ta is, a proessional may begin answering a quesion beore he clien has ully ariculaed i, in he belie ha he quesion is already undersood and a ready answer is appropriae. However, a clien may read his behavior as a lack o undersanding or concern. emember, lisening involves no jus reraining rom premaurely issuing advice bu also employing concenraion, inquisiiveness, acknowledgmen, validaion, summarizaion, and empahic concern.

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Added o he complexiy o lisening and responding is he need o address emoional channels o communicaion, wheher hey are verbal, nonverbal, or paralinguisic. Indeed, he more imporan aspecs o communicaion may be nonverbal. Where mixed do messages occur (i.e., where he nonverbal messages are incongruen wih he verbal communicaion), he planner’s atenion o his discrepancy may open he door o deeper ineracion. THE EMOTIONAL CONTRACT

In psychoherapy, he iniial sages may have an emoional conrac ocusing on he herapeuic relaionship. Tis conrac goes beyond elaboraing he services ha will be provided and covering issues such as confidenialiy. However, he relaionship dynamics in esae and financial planning are less likely o occur a he ouse, ye hey are an imporan par o managing he clien’s expecaions ha go beyond provision o he proessional services. According o Hood and Bouchard (2012), some quesions ha are likely o arise or he esae planner are as ollows: • • • •

How available should he planner expec o be or any given clien? Wha are he boundaries o he relaionship? Wha are he clien’s expecaions? Wha are he boundaries ha he clien expecs he planner o honor in erms o

spousal or amily involvemen? • How much atenion or “hand-holding” is he clien going o need? • Will he clien allow work o be handled a a lower level o he organizaion, as in using clerks, paralegals, and junior associaes? • Wha are he specifics o confidenialiy in his case? • How educaed or sophisicaed is he clien, and how will his drive clien involvemen in he process? • Will he clien sugges or demand services ha compromise he planner’s inegriy or proessional ehics? Conversely, he clien may be considering he ollowing aspecs o he emoional conrac: • • • • • • • • • • •

Do I eel comorable in he presence o and speaking wih his planner? Does he planner appear o be compeen o complee he work? Will he planner be loyal o my goals and needs? Will he planner be personally available when needed? Will he planner hear me ou beore advising? Does he planner pick up on nuances and nonverbal channels? Does he planner lisen o me in a discerning manner? Is he relaionship collegial raher han auhoriaive? Will he planner undersand any quesions ha I haven’ phrased in proper legal orm? How long will he process ake? How much will he plan cos?

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As previously saed, he planner needs o lisen on a deep level, and mus be willing o ener ino horough discussions i he ineracion goes in ha direcion. However, inensiying he ineracion can move he planner ino a discussion o maters he or she does no eel prepared or or rained o carry hrough. Addiionally, emoional or psychological dynamics may insinuae hemselves ino he proessional relaionship. Such dynamics can arise on he planner’s end o he relaionship, on he clien’s end, or boh. For example, a conversaion abou moraliy ypically occurs a an inellecual level. However, i he clien’s deep engagemen disarms he planner and disrups ha ormal or sricly inellecual alk o moraliy, he planner’s own eelings on he mater may ener he discussion, wheher consciously or no. Tis phenomenon occurs requenly in he field o psychoherapy and is labeled couner-ranserence, or he disrupion o he herapeuic process based upon eelings oward he clien or issues ha he clien’s inpu or behavior evokes in he proessional. Couner-ranserence is generally viewed as an impedimen o effecive progress in herapy (Cerny 1985), whereas ohers view i as a poenial ool (de Fries 2007). Sill oher researchers have sough o develop conceps o wha qualiies proessionals need o possess or o develop so as o minimize he adverse impac or occurrence o counerranserence. Similarly, wheher seen as a ool or impedimen, hese eelings may arise in boh he clien and he planner regarding moraliy, bu also may be evoked by hose necessary discussions o using medical echnology and lie suppor, pain managemen, powers o atorney, advance direcives, living wills, do no resusciae (DN) orders, and oher relevan acors. Te planner may indeed find aspecs o he clien’s lie ha resonae wih his or her own hisory or relaionships, and will end o view hem rom his or her own perspecive. Te esae planning conex is especially vulnerable o he couner-ranserenial phenomenon, owing o he imbalance in knowledge leading o a quasi-parenal posiioning o he planner. Te proessional mandae or “zealous represenaion” o he clien may also promoe such reacions (Hamel and Davis 2008). esearchers have exensively sudied he phenomenon o couner-ranserence. Various atemps have also been made simply o undersand wha couner-ranserence is, wha causes i, and how o inegrae is various conceps (osenberger and Hayes 2002). Because o his complexiy, he ypical esae planner would probably be unable o remain curren wih he research; however, his should no discourage he esae planner rom resolving o incorporae such basic undersanding ino he planning process (Scot 1973). TRANSFERENCE

Along wih couner-ranserence can come ranserence. ranserence is he projecion ono he proessional o he eelings and atiudes he clien has and had in an earlier relaionship in lie. Tis relaionship is more likely o occur wih a clien whose experiences include having had a primary careaker earlier in lie, an auhoriy figure, or a close sibling relaionship. Some view he occurrence o a ranserenial reacion as an imporan even in psychoherapy, in ha i enhances one’s sel-undersanding. However, such insigh is seldom helpul in he esae planning process. I is, in ac, more likely o be

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a disrupor, disoring he clien’s judgmen. Neverheless, he “exper” posiion o he planner increases he likelihood ha he clien will view him or her, consciously or no, as a parenal or auhoriy figure. Alas, because ew esae planners are amiliar wih he phenomenon o ranserence, hey are unlikely o noice when i occurs; consequenly, a clien’s ranserenial reacion is likely o siderack or runcae he esae planning process, so i is bes o be on guard.

Mortality and Other Client Fears As menioned earlier, he esae planning atorney needs o assess a clien’s compeence o engage in he planning process. And his assessmen may no be exclusive o he clien’s menal capaciies a he ime o developing he plan. Addiionally, he liabiliy o he atorney may exend o he clien’s beneficiaries. Despie he ac ha a planner has a primary responsibiliy o he wealh-holding clien, here is no clear saring line indicaing where consideraion o he ineress o non-cliens begins. Addiionally, consideraion o any ongoing capaciy o he clien o amend or adjus he esae plan over ime should be addressed. Some evidence indicaes ha judgmen and decision-making capaciy may vary in some setings, such as hospice care (Buron, wamley, Lee, Palmer, Jese, Dunn, and Irwin 2012). In hose siuaions, sysemaic measuremen apparenly uncovers various deficis ha are undeecable hrough clinical observaion. Also, as a person ages, here are increasing levels o risk or undue influence (Peisah, Finke, Shulman, Melding, Luxenberg, Henik, and Bennet 2009). Similarly, he esamenary capaciy o a dying person may be subsanially compromised (Peisah, Luxenberg, Lipzin, Wand, Shulman, and Finkel 2014; Schneiderman 1983). Many individuals consider hemselves unique in heir abiliy o be aware o heir moraliy. Ye, individuals have variable olerances or heir abiliies o be aware o ha moraliy, on boh inellecual and emoional levels. When esae planners consider heir general obligaion o assess a clien’s compeence, here is recogniion ha doing purposeul planning wih an engaged awareness o moraliy will aler he qualiy o hinking ha akes place, in erms o boh process and oucome. MORT ALITY SALIEN

CE

Moraliy salience (MS) is he general erm used o describe he presen awareness o

moraliy ha a person has a any given ime. As James (2013) noes, he deense agains eelings o moraliy can resul in he “five D’s”: disracion, differeniaion, denial, delay, and deparure. Disracion occurs when a clien says ha he is “oo busy” o atend o esae planning. Differeniaion akes place when he clien hinks ha conroning issues o moraliy is no required a he ime because she is in good physical healh, has a geneic heriage o longeviy, and sees himsel well beyond he average range o lie expecancy. Denial may ake he orm o believing ha ears o moraliy are overblown. Te delay deense requenly occurs when he clien says ha he is going o end o he planning

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a a laer dae. Finally, some cliens “depar” rom moraliy discussions by simply discouning hem off when hey begin. A body o research has examined he changes ha ake place or an individual as a resul o MS. Chie among he consideraions o MS is he conenion ha awareness o moraliy may be a core moivaor in human behavior (Kesebir and Pyszczynski 2011; Koca-Aabey and Oner-Ozkan 2014). Oher invesigaors see moraliy ears a he core o personaliy (Landau and Sullivan 2014). Te cenraliy o he ear o deah is also posied o lead o behaviors ha reduce risk o he individual as an evoluionary mechanism (Leary and Schreindorer 1997; Lerner 1997). Some invesigaors, such as Bozo, unca, and Yeliz (2009), have examined he link beween deah anxiey and healh-promoing behaviors. Anglin (2014) noes a shif in moivaion o repair roubled relaionships. Appeals or donaions may also be more effecive under condiions o heighened moraliy salience (Cai and Wyer 2015). Dood and Handley (2007) also deec a enaciy in mainaining values. In some cases, emoional awareness and proximiy o deah can resul in mood aleraions ha are reflecive o depression, and goal-direced behavior may hen be reduced (Hayes, Ward, and McGregor 2016). Long-held belies in an aferlie or mind–body dualism may promoe comor raher han depression (Ai, Kasenmüller, ice, Wink, Dillon, and Frey 2014; Heflick, Foldenberg, Har, and Kemp 2015). Lunn, Wrigh, and Limke (2014) discuss he role o atiudinal shifs in how MS affecs percepions o one’s deiy. Sill oher invesigaors have ound a link beween enduring acors, such as selcerainy and uncerainy, in he emoional responses o MS (Hohman and Hogg 2015). Invesigaors also have noed ha he conemplaion o deah enhances posiive word use (Kashdan, DeWall, Schurz, Dechman, Lykins, Evans, McKenzie, Segersrom, Gaillo, and Brown 2014), and ha MS increases personal opimism in people who have high sel-conrol (Kelley and Schmeichel 2015). Ohers have ound changes in social atiudes and percepions (Khoo, See, and Hui 2014), as well as allocaions o ime and money (Lin and Ling 2014). A he mehodology level o many o hese sudies is some ambiguiy abou he effeciveness o measures aken o rea MS in an experimenal seting (Mahoney, Saunders, and Cain 2014). ypically, researchers prime he subjecs by inroducing experiences ha are presumed o raise MS on eiher a supraliminal or subliminal level. Te effeciveness o his echnique on he subliminal level has resised operaional definiion, as well as in oher areas o psychology where subconscious acors are presumed o play a role. As such, jus how effecive hese mehods are or inducing he experimenal condiion is unclear. Given he variabiliy ha MS can inroduce ino a person’s houghs and eelings, hose houghs and eelings can apparenly be a moving arge when MS is inroduced. Tis relaionship may no affec legal definiions o compeence, bu i may influence he qualiy o he plan designed under hose condiions. TERROR MANAGEMENT THEORY

Linked o MS, error managemen heory(M) (Solomon, Greenberg, and Pyszczysnki 2015) posis ha he ear o deah is a he core o one’s personaliy and/or a wide range

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o decisions and behaviors, because he insinc or sel-preservaion is a basic, universal drive in lie (Leary and Schreindorer 1997). Some assume he cenraliy o M o be an evoluionary developmen, bu ohers couner ha his view is inconsisen wih he enes o evoluionary heory (Kirkparick and Navarete 2006). Sill ohers see M in simpler erms ha MS evokes a basic need or conrol o oucomes (Snyder 1997), which exends he explanaory power o M o include volunary suicide in erminal condiions. egardless o wheher M is an evoluionary developmen, is relaionship o atiudes and behaviors has led o sudies o is effec on one’s deenses (KocaAabey and Oner-Ozkan 2014). ADDITIONAL CLIENT FEARS

Addiional sources o resisance and barriers exis ha crop up in he planning process (Hood and Bouchard 2012). Tese issues have no been direcly addressed in he psychological research lieraure, bu hey may make a regular appearance. In general, cliens: • Fear making a misake in he plan. • Experience repidaion abou he uure, wheher in he realm o wealh or healh, and ha may paralyze he planning process. • Worry or exhibi anxiey abou huring he eelings o heir inheriors. • Commi o expenses. he esae irrevocably and hen oulas heir abiliy o live well or pay heir asses medical • Have curren esae plans ha may have been solidified and hen new laws may compromise ha plan. • Have a commimen o one plan ha may engender eelings o a loss o flexibiliy o make uure choices. • ecognize ha commiting an esae plan o writen documens requires disclosing financial and personal maters ha may sacrifice privacy. As a resul o he clien’s heighened anxiey, worry, or ear, he esae planner can expec several emoional reacions. Firs, as discussed, he process o engaging in esae planning brings up he mater o moraliy, which may affec cogniive capaciy and judgmen. Tis ear o deah may be compounded by a concern wih making poor decisions under condiions o emoional arousal (Glover 2012). Te prospec o moraliy may also bring separaion anxiey abou leaving one’s loved ones. Second, he clien may procrasinae in concluding he esae work, as hough finishing i migh hasen his demise. Tis is similar o hinking ha discussing suicide wih a depressed person will precipiae a suicide atemp. A clien may also avoid examining any lie regres by upgrading her view o her lie o an ideal sae. Alernaively, he clien migh move oward grandiosiy in his sel-percepion. Sill oher cliens may use he planning process o bargain wih a higher power in elevenh-hour negoiaions. Tis bargaining phenomenon is consisen wih he sages o coping wih moraliy as described by Kübler-oss (1969).

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Expanded Complexity: Marital and Family Dynamics As hough he clien’s emoional responses o esae planning and moraliy awareness were no enough, he esae planner should acknowledge ha he planning akes place wihin a larger conex ha may include he clien’s spouse, children, close riends, and communiy. Perhaps as a resul o ha complexiy, and he lack o well-developed ools in he proessions, a naural and perhaps unconscious endency exiss o ocus on he single clien. As Kingsbury (2013) noes, when a male clien predeceases his wie, he woman changes financial planners more han 75 percen o he ime. One observaion aken rom his saisic is ha he woman has no el included as a ull parner in he planning process, and perhaps or a subsanial amoun o ime. I one parner acively plans and he oher is eiher silen or absen, he esae planner may draw he erroneous conclusion ha he silence signals aci approval. When he greaer complexiy is acknowledged, orchesraing he inpu o an enire amily in he esae planning process becomes quie difficul. Tere are no working models o accomplish his goal wihin he proessional pracice guidelines o he legal proession. So, adoping some knowledge gained in psychology is a naural move o consider.

Using Tools from Psychology In using he field o psychology o inorm he planning process, he esae planner will immediaely encouner some difficulies, in ha he mos applicable is in clinical psychology. Tere have been subsanial effors o move oward pracice models ha are evidence and research based; sill, many models ocus on heory, assessmen, and reamen in clinical pracice. SOME RECENT CLINICAL MODELS

Use o models became popular pracice because hey were so effecive in clinical pracice. Accepance and commimen herapy (AC) is a orm o cogniive- behavior herapy or o clinical behavior analysis. Te Gotman Mehod (Gotman and Silver 1999) and Imago elaionship Terapy (Hendrix and Hun 1988) are jus wo o many exan models used or couples herapy. Family herapy uses more han a dozen models. I esae planning includes he disposiion o a amily business, some o organizaional psychology’s assessmen and inervenion mehods may be perinen or helpul. For a clinical proessional o be proficien in any given model, le alone a ew dieren models, requires a air amoun o raining and pracice. I is clearly unrealisic o expec an esae planner o learn and become proficien wih any o hese models. Tere is a place or some iner-proessional collaboraion here, hough coordinaing he wo proessionals presens some oher complexiies ha are addressed laer in his chaper.

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TOOLS FOR INDIVIDUAL ASSESSMENT

Alhough praciioners use many insrumens or psychological assessmen, oher ools are available ha ocus on behavioral finance, financial syle, and he fi beween he financial syles o wo or more people. Wih an enhanced awareness o he psychological aspecs o he esae planning process, a financial planner or atorney can responsibly uilize hese various ools o raise he qualiy o service. Tis goal can be accomplished while minimizing he possibiliy o going beyond one’s scope o experise. Mos o hese insrumens have been developed rom he experience o he paricular es developer. As such, hey ofen have a high degree o ace validiy, which means ha he assessmen insrumen seems o be measuring he desired oucome. Despie ace validiy being helpul, i is only one o many psychomeric acors necessary o saisy he psychomeric condiions or a valid research insrumen. Alas, very ew o he available assessmen ools on he marke have been subjeced o sringen examinaion. A he same ime, using hese assessmen insrumens has srong appeal or boh financial and esae planners because hey can give some measure o insigh ino a person’s financial syle. Tis insigh can hen give he planner a basis or decision making, raher han relying on personal percepions o he clien. For insance, using an assessmen insrumen can be a nonjudgmenal means or approaching discussions abou psychological and/or emoional barriers. I can also give he planner somehing o reer o when such encounering barriers, making he discussions nonconronaional. For example, when a disagreemen suraces beween he judgmens o he planner and he clien, he planner may well be able o reer o he resuls o he assessmen insrumen, presening he siuaion as a difference in syle, raher han one pary being correc and he oher incorrec. Assessmen insrumens can also provide an inermediary uncion, so ha he approach o sensiive and emoionally loaded discussions is eased by via he vehicle o es resuls. Discussions ha bear on moraliy, or example, may be iniiaed wih a ocus on a es’s “objecive” resuls. Many valid and reliable insrumens or assessing personaliy and inerpersonal syle are available. However, o apply any assessmen findings o he planning process requires exrapolaion rom he inended purpose o he insrumen, and ha can exrapolaion can lead o difficulies. Conversely, a ew insrumens have been developed specifically or use in fields involving financial syle. Te Financial DNA Assessmen (FDNA) (Massie 2006) and he Fina Merica assessmen have no been reviewed in Carlson, Geisinger, and Janson (2015), bu boh have been developed in a psychomerically sound manner. Boh insrumens assess an individual’s syle, bu hey can also have a second adminisraion o anoher person so as o compare resuls; consisencies beween wo individuals, such as marial parners, can hen be evaluaed. Addiionally, he mach or mismach beween a clien and planner can be gauged. Boh o hese insrumens consider he evolving field o behavioral finance, and his disinguishes hem rom mos o he psychomerically robus insrumens in common use or psychological assessmen. Te FDNA describes rais ha lie along a coninuum running beween wo poles o a characerisic, wih low, medium, and upper ranges. Te insrumen supposedly measures innae rais as opposed o learned behavior. Te esing mehod is a orced-choice

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orma and scores are compued or 12 main characerisics. Te resuls can also be ranslaed ino suggesed porolio srucures ha are consisen wih measures o boh risk olerance and loss avoidance. Conversely, Fina Merica ocuses more closely on issues o risk olerance and loss avoidance, raher han on a wide range o characerisics. Boh insrumens have been widely used in boh he Unied Saes and oher counries, and boh have been subjeced o ess o validiy and reliabiliy o a greaer degree han many similar insrumens. When using hese insrumens wih a larger group, he esae planner should acknowledge he limis o conclusions drawn rom a group scoring, because composie scores are averages o scores across paricipans; his dilues he abiliy o deec ouliers rom he group, which in esae planning migh be crucial knowledge o have. Ta is, knowing who may have endencies ha run conrary o he amily norms may help he planner anicipae laer disurbances in wha is supposed o be a consensually validaed plan. An esae planner can use boh insrumens wihou having o rely on a psychologis o inerpre he daa, so long as he or she has amiliariy wih he insrumen and is inerpreaions. Using he insrumen can open up a discussion o how a clien’s personal syle comes ino play. Tis gives he clien a perspecive ha allows him or her o sep back rom wha is a naural endency or inclinaion and make decisions ha migh be beter inormed. TOOLS FOR FAMILY ASSESSMENT

Psychologiss employ more han a dozen major schools or concepual sysems or amily herapy, wih each based on a differen empirically developed model o amily uncioning. Each school or sysem has is own mehods o assessmen and pracice, as well. When an esae planner is aced wih he ask o dealing wih a amily, here are ew concepual models o be ollowed, beyond one’s own experience and insincs. In his field o amily assessmen, some insrumens are some useul ools, such as he FACES-IV, which akes a sysems perspecive and evaluaes amilies along dimensions o cohesion and flexibiliy (Olson 2011). Tese insrumens can assis a amily wih sel-assessmen in a manner ha is inegraed wih is wealh, esae planning, and philanhropic goals. Te Family oadmap (Fowler 2002) is an invenory or assessing amilies along a number o dimensions bearing on amily culure. Alhough i uncions primarily as an assessmen ool, i can promp amily members o reflec on heir goals and arrive a a sel-ideniy and definiion. Jaffe and Allred (2015) develop a amily assessmen sysem specifically argeing amilies who own businesses. Te ool is specifically argeed oward wealh preservaion across generaions; hence, i offers an approach o maters o succession. Jaffe and Allred’s ool also ocuses on he personal moivaions or wealh ransmission across he generaions, and so i can assis in esablishing a meaningul raionale or he ranser o wealh. Family assessmen ools generally sidesep he issues o moraliy salience and ears o deah by ocusing on coninuiy or he amily and amily business. Wheher he values discussion will also awaken he moraliy salience or he wealh creaor is unclear.

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LIMITA TIONS ON

THE USE OF

PSYCHOLOGICAL TOOLS

One o he difficulies ha esae planners ofen encouner when hey wan o use an assessmen ool is an appearance o criical or negaive judgmens. In a clinical seting, some o he value o psychological esing is in argeing pahology. Unorunaely, his aspec o psychological assessmen someimes makes using such insrumens undesirable in an esae planning conex. Insrumens developed wihin he model o posiive psychology, however, assess individuals rom a srengh-based perspecive. Posiive psychology is he scienific sudy o human flourishing and is an applied approach o opimal uncioning. Tis branch o psychology uses scienific undersanding and effecive inervenion o aid people in achieving a saisacory lie. Unlike some oher rameworks in psychology, posiive psychology ocuses on personal growh, raher han on pahology. As ye, here are no assessmen insrumens or wealh and financial syle wihin he posiive psychology communiy. Seligman (2002) has examined wheher money conribues o happiness, and he ound ha increases in wealh do correlae wih measures o happiness, bu only o he poin where one’s wealh mees and slighly exceeds one’s basic needs. Ta is, addiional wealh does no increase one’s happiness beyond ha poin. Tis finding can be useul in discussions o esae planning, giving perspecive o cliens when assessing he advisabiliy o passing along wealh and making bequess (Bradley 2000).

Interview Methodologies from Psychology Te field o psychology has several mehods o inerviewing ha can be considered by esae planners as ways o enhance discussion and encourage decision making. APPRECIATIVE INQUIRY

Organizaional psychologyis a specialy ha ocuses on he organizaion, group, or com-

pany as he locus or developmen and change. Alhough pahology may be a acor, many aspecs o he pracice are srengh-based, such as appreciaive inquiry (AI). Ta is, AI ollows a orma ha ocuses on srenghs raher han pahology. As an organizaional ool, AI can be used in a group effor o consruc a shared vision. Also, i can be an elemen o discussion or a amily or amily business discussion concerned wih coninuing he inenion and vision o he wealh creaor or presen holder. MOTIV ATIONAL

INTERVIEWIN

G

Te ambivalence oward discussions o moraliy ha has been menioned earlier may open up ineresing lines o inquiry. Good mehods o inerviewing will recognize and validae he inheren conflics involved in he change process. echniques such as moivaional inerviewing (MI) have emerged rom he addicions and chemical dependency specialies o psychology, and has also been medical compliance issues, as well as oher areas ha are ypically addressed in counseling and psychoherapy (Miller and

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ollnick 2013). Given ha he change process ofen involves resisance or ambivalence, MI ariculaes a mehodology ha enhances discussion and decision making in he direcion o change. In clinical psychology, a common belie is ha he decision and iming o change come rom he clien raher han he service provider. Te echnique recognizes ha common conversaions beween an addic and eiher a proessional or amily member ake he orm o rying o convince he addic o change behavior. MI is a mehodology ha is somewha counerinuiive, bu i is boh simple and sensible, guiding he addic o arrive a a decision o change. Tis procedure has proved more effecive han atemps o push a person oward change. As a se o pracical inerviewing ools, MI may provide he esae planner wih a se o echniques or moraliy discussions ha can overcome he ambivalence abou moraliy. DIALECTICAL INTERVIEWING

A reamen modaliy rom clinical psychology ha recognizes he need o balance conflicing emoional orces is dialecical behavioral herapy(DB). DB is a well-srucured approach ha combines cogniive-behavioral herapy wih mindulness pracice. Te reamen arges specific areas o concern, such as sel-harm or relaionship difficulies, and combines individual reamen wih psychoeducaional group work. Alhough DB was developed specifically o address problems encounered by cliens wih borderline personaliy disorder, a main ene o he reamen involves enhancing he individual’s abiliy o hold wo opposing emoional saes or emoions simulaneously (hence, he erm “dialecic”). For he esae planner, he reamen ocuses on mindulness principles, requiring he observaion o inner emoional experience in an observaional manner, wihou judgmen. Te concep o holding wo opposing emoional saes a he same ime may be applied in he financial seting when addressing conflicing desires o boh discuss and avoid issues o moraliy.

Looking Ahead: Collaboration Among the Professions Te curren saus o esae planning generally appears o be biurcaed ino research and pracice. Te research is heoreical, emerging rom psychoanalyic models ha do no easily lend hemselves o operaionalizaion or clear oucome measuremens. Ye, research in behavioral finance by Ariely (2008) and Kahneman (2011) possesses a field research qualiy ha lends isel o boh applied setings and oucome measures. Te complicaions ha emerge in designing useul research in he area o esae planning appear o resul in par rom he sensiiviy ha surrounds he issue o moraliy. Tis disinguishes he esae planning effor rom simple measuremen o human decision making and is oibles. However, specific echniques rom clinical pracice reveal he meris o using differen pracices in he field. Indeed, here is a need o develop more scienific knowledge in he area o esae planning.

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Along wih he need o develop scienific knowledge in he sudy o esae planning, an inherenly inerdisciplinary naure o he pracice presens ongoing challenges o service providers in psychology, law, finance, and business. Te collaboraion o hese disciplines is an underaking ha has been developing only in recen decades, and involves seting guidelines o pracice ha serve he public while reaining he sandards and inegriy o each proession. Given he imporance o money and finance in our lives, and he recogniion ha all o he involved disciplines deserve a voice, such a collaboraive developmen is likely o coninue ino he oreseeable uure. In ac, holisic approaches o financial and esae planning uniormly endorse he collaboraion o differen proessions and are viewed as necessary or rendering a high level o service o cliens. Tis need o cusomize he esae planning service is parly a resul o he prolieraion o increasingly sophisicaed compuer- and Inerne-based invesmen and planning services offered a grealy reduced coss. endering such highly individualized service is one way planners can reduce he impac o his commodiizaion o heir services, where price compeiion has become a driving orce. A relaed issue is ha each financial advisor has a proessional perspecive ha is considered essenial o he esae planning process. An elemen o compeiion can minimize he value o he aoremenioned collaboraion, wheher recognized or no. Each proessional desires o be he “mos rused advisor” o he clien. Neverheless, cross-proessional collaboraion appears o be he wave o he uure, alhough he deails on how his will bes ake place remain unclear. Several inheren conflics render he process o collaboraion difficul. For example, disinc differences in pracice exis beween psychology and financial or esae planning. Proessional sandards differ beween he fields. Addiionally, he proper rendering o services in one proession can be unsetling o he clien relaionship in he oher proession. For example, he discovery process in psychology may cause a suracing o conflics or emoional disrupions. An esae planner can see his developmen as poenially hreaening he clien relaionship. Conversely, he psychologis may recommend, on he basis o psychological observaions, ha issues or iems be included in an esae plan ha are legally complex or even unenable. For example, he psychologis could recommend bequess ha are condiioned upon uure saes, such as sobriey, or based on judgmens o he differing psychological needs o he beneficiaries. Te psychologis may make disincions beween wha is an equal spli o wealh and wha migh be a more equiable spli, based on needs. Te models or his collaboraion ofen appear o be hose ha will evolve over ime among lawyers, financial planners, and menal healh proessionals. A philanhropy proessional could also be in he mix. Already, several financial insiuions and banks have ormalized he organizaion o inerdisciplinary collaboraion wihin heir organizaions, usually o serve ulra-high ne worh cliens and clien amilies. Under he umbrella o he firm, he orchesraion o services could reduce compeiion among proessionals. Addiional models or collaboraion could occur in he amily office enerprises ha provide varying levels o concierge services or financial, esae, philanhropic, and amily dynamics and business issues, ofen oriened oward legacy planning. Te creaion o orums or inerdisciplinary collaboraion among planners, atorneys, and menal healh proessionals has been occurring on a naional and inernaional level. Organizaions such as he Purposeul Planning Insiue, Family Firm Insiue, Naz udin, and he Financial Terapy Associaion ocus on he overlaps among law,

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psychology, and finance while employing a amily dynamics perspecive o research and developmen in wha will be an ever-expanding body o knowledge in he field. No consensually acceped “bes pracices” are available in he field as models evolve over ime.

Summary and Conclusions Tis chaper explored he possibiliy o sronger connecions beween psychology and esae planning, firs by discussing he psychology ha underlies he planner–clien relaionship, and hen by offering models or assessmen and enhancemen o he discussions ha are so perinen o esae planning. Lasly, he chaper opens he door o he uure possibiliy o collaboraion among he proessions, leading o greaer insighs and enlarged service o cliens in need o esae planning.

DISCUSSION QUESTIONS 1. Ideniy he issues ha creae differences beween esae planning and oher areas o financial planning ha can impede or preven progress. 2. Discuss he dimensions ha differeniae esae planning rom oher areas o financial planning and wealh managemen in erms o he emoions accompanying decision making. 3. Explain why esae planning calls or collaboraion beween he planner and clien, as well as beween he clien and inheriors. 4. Discuss how esae planning presens unusual challenges or he legal or planning proessional. 5. Explain how ranserence or couner-ranserence migh play a role in proessional engagemen.

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Seligman, Marin. 2002. Auhenic Happiness: Using he New Posiive Psychology o Realize Your Poenial or Lasing Fulfillmen. New York: Simon and Schuser. Shaffer, Tomas. 1970. Deah, Propery and Lawyers: A Behavioral Approach. Dunellen, NJ: Dunellen. Snyder, Charles. 1997. “Conrol and he Applicaion o Occam’s azor o error Managemen Teory.” Psychological Inquiry 8:1, 48–49. Solomon, Sheldon, Jeff Greenberg, and om Pyszczynski. 2015. Te Worm a he Core: Te Role o Deah in Lie. New York: andom House.

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19 Individual Biases in Retirement Planning and Wealth Management JAMES E. B REWER JR. President, Envision Wealth Planning CHARLES H. SELF III Chief Investment Officer, iSectors

Introduction People ofen live in he momen during mos o heir lives, including in regard o heir Presen bias

money. inenions.is For he endency overvalue immediae rewards he Te expense o long-erm example, aochild may wan he “mus have”aoy. paren may say no, ocusing on paying he privae school educaion, bu he grandparen may choose o buy he oy o experience he immediae joy on ha grandchild’s ace. According o Saman (2011), an individual’s relaionship wih money can ake a uiliarian, emoional, or expressive orm. Hisorically, he sudy o economics and finance has ocused on he uiliarian, which is he abiliy or a service or good o saisy needs and wans. apper Snoop Doggy Dogg (1993) says i his way: “I’ve go my mind on my money and my money on my mind.” An emoional relaionship ocuses on achieving peace o mind, whereas an expressive relaionship concenraes on he role money plays in defining an individual. However, wha abou an individual’s long-erm bes ineress? In a as-paced world, individuals ofen do no have he naural abiliy or he ime o become expers in a opic and o execue he knowledge hey possess. ecall he cardiologis who is overweigh and smokes. Having someone o look ou or he bes ineress o ohers and o provide a litle nudge can promoe beter behavior. Taler and Sunsein (2009) inroduce he concep onudging, also known as paernal liberarianism (Taler and Sunsein 2003). Tis concep describes how corporaions, governmens, or insiuions can develop policies or ools o influence he behavior o individuals by changing heir decisions oward oucomes ha would no occur wihou he nudge. Ta is, he organizaion esablishes he conex in which people make decisions. For insance, financial planning policies based on nudging encourage people o

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save and inves more money. Howard and Yazdipour (2014, p. 195) provide an insance o his: In he example o a worker conribuing o a defined conribuion or 401(k) plan, he employee would be auomaically enrolled o conribue he required amoun o receive he maximum employer mach. Te employee could op ou by selecing an alernaive conribuion or by wihdrawing rom he plan. Anoher example o nudging is he deaul setings or sofware hese choices are made or someone unless he or she selecs a cusomized opion. Nudging does no acually limi choice, bu i suggess ha someone wih exper knowledge has already made he suiable choice. Few people ge a passing grade on he Financial Indusry egulaory Auhoriy’s (FINR) financial lieracy es. Tis finding is no surprising, considering ha personal financial lieracy is no a core curriculum subjec in U.S. schools. Neverheless, individuals benefi rom a nudge oward making beter choices abou heir financial decisions. In a Forbes inerview wih Peer Ubel (2015), ichard Taler saes, “A nudge, as we will use he erm, is any aspec o he choice archiecure ha alers people’s behavior in a predicable way wihou orbidding any opions or significanly changing heir economic incenives. o coun as a mere nudge, he inervenion mus be easy and cheap o avoid.” In he conex o finance, working in someone’s bes ineres akes on a legal saus known as a fiduciary. Employers along wih fiduciary financial planning and invesmen advisors can develop nudges, such as oping people ino he company reiremen plan and selecing proessionally managed model porolios or hem. Kinniry, Jaconeti, DiJoseph, and Zilbering (2014) esimae ha working wih a cerain ype o financial advisor using he Vanguard Advisor’s Alpha Framework can add 3 percenage poins (300 basis poins) a year in ne reurn. Te ramework includes suiable asse allocaion using broadly diversified exchange-raded unds (EFs), coseffecive implemenaion (expense raios), rebalancing, behavioral coaching, asse locaion (ax-efficien invesing), spending sraegy (wihdrawal order), and oal reurn versus income invesing. Vanguard atribues hal o ha reurn o behavioral coaching. Morningsar suggess ha a financial planner can add 1.59 percenage poins (159 basis poins) in reurn rom cerain reiremen planning advice (Blanchet and Kaplan 2013). Tis chaper begins by examining some financial pialls, including people’s all oo common reliance on inuiion, biases, and irraional behavior regarding heir finances. Tese pialls creae he individual’s need or financial planning, which leads o evaluaing wheher o hire a proessional, accep employer nudges, or uilize a combinaion o advice and ®) or CFA proessional. Ten, he chaper nudges rom a Cerified Financial Planner™ (CFP highlighs how nudges can enhance wealh, and concludes wih a chaper summary.

Biases Create the Need for Financial Planning RELIANCE ON INTUITION

According o Nobel Prize recipien Daniel Kahneman, people use wo sysems or hinking (Kahneman 2011): he as sysem, which is inuiive and emoional, and he

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slow one, which is deliberae and logical. Given Kahneman’s view, should people rus heir inuiion? Te inuiion o a child differs rom he inuiion o her parens. Te educaion and greaer lie experience o parens should improve heir inuiion, bu does he inuiion o parens in heir mid-years differ rom he inuiion o seniors? Kahneman offers wo basic condiions or evaluaing he validiy o an inuiive judgmen: (1) here needs o be an environmen sufficienly regular o be predicable, and (2) here needs o be an opporuniy o learn hese regulariies hrough prolonged pracice. When a siuaion mees boh condiions, a person’s acquired skills ofen serve as he basis or his or her inuiion. Ye regardless o age, someone who has earned an academic degree or indusry designaion in invesmens is likely o be more skilled han someone who does no have ha credenial. “UNBIASED” SELF-

ASSESSMENTS

Many people atemp o assess heir own financial needs. Ofen hey simply raionalize he saus quo, ailing o see he biases in heir houghs: • “I don’ need an advisor.” Ofen he bias is ani-accounabiliy. An advisor may wan o change a behavior he clien enjoys. Anoher bias saus quo or ineria is one in which he clien does no wan o change wha is currenly working. Tis bias, also known as he osrich effec, is one in which a clien keeps his head in he sand and acion o any ype. laer. Jus give me wha I wan oday.” Tis saemen rep• avoids “I’ll hink abou reiremen resens presen bias. People who make such asserions hink ha he uure will ake care o isel by meeing heir curren needs. • “I won’ die.” Spending money on lie insurance premiums akes away rom he pleasures o vacaions and hobbies. Alernaively, ocusing on financial obligaions upon deah saddens cliens o hink ha hey will no be young orever. • “I won’ ge disabled.” People do no wan o hink abou becoming impaired and dependen on ohers. Tis saemen also suggess ha a person has conrol over undesirable evens, known as he illusion o conrol. Furher, burying one’s head in he sand (osrich effec) could be harmul o loved ones. • “None omy riends aredoing i.” Alhough heherd mayno be righ, ioffers a pleasan pack o emulae. Cliens someimes eel ha heir siuaion is no complicaed and lends isel sel-drequire iagnosisanwihou specialized Discovering addiional complicaions o migh invesmen o bohknowledge. ime and emoions o address hem. • “I save enough o ge he employer’s mach in my reiremen plan.” People end o ocus on he mach raher han calculaing he needed amoun o reire comorably. Individuals preer o ocus on he mos recognizable eaures: ree money, which is a salience bias. IRRA TIONAL FINA

NCIAL BE HAVI ORS

An individual’s financial behavior ofen does no presen a logical patern o hough o he academic or financial proessional, bu i is perecly coheren o he individual. Tis includes behaviors such as milesones, anchoring on names, money emoions, and

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money languages. Tese behaviors suppor he need or employer and advisor nudges, which are discussed laer in he chaper.

Financial Milesones Many people hink in erms o a milesone-based, linear financial planning process: firs secure a job, hen ge married, buy a house, sar a amily, plan or college educaion expenses or he children, and, finally plan or reiremen. Individuals ofen associae wih a peer group ha holds similar views. When workers have a defined benefi pension plan, he employer conribues he mos money; someimes, he plan requires employee conribuions or permis volunary conribuions. For workers wih hese plans, he pension sysem pays expeced benefis when hey are needed a a laer ime. Conversely, workers wih elecive plans or defined conribuion plans, such as 401(k) plans, make heir own conribuions and invesmen decisions, ollowing heir peer group or hiring someone o help hem. Even when hey are proacive in hese maters, here is grea uncerainy abou he amoun o projeced benefis upon reiremen.

Anchoring on Invesmen Names When venuring ino unamiliar erriory, individuals ofen seek a amiliar label, such as ideniying hemselves as conservaive or aggressive invesors. No surprisingly, muual unds include descripors such as “conservaive” or “aggressive” and some people are atraced o hese unds because o hose descripors. However, he porolio manager’s noion o wha is conservaive may differ rom ha o invesors’. Depending on he risk, reurn, and expenses charged by he und, he und migh look conservaive bu is risk profile is acually aggressive. Tis siuaion can creae anxiey i reurn volailiy is presen. Some see he arge-dae und sraegy as he answer or all paricipans in 401(k) plans. A arge-dae und is a muual und ha auomaically reses he asse mix o socks, bonds, and cash equivalens in is porolio according o a seleced ime horizon ha is appropriae or paricular invesors. Paricipans and someimes he employer’s 401(k) decision makers believe ha arge-dae unds promise a specific accoun balance on he dae o he arge-dae sraegy’s name. Alhough called a arge-dae und, he year does no reer o he adequacy o he accoun balance; i reers only o he ac ha he und becomes more conservaive over ime. Is reurns do no conain a guaranee bu, raher, depend on how he marke perorms. Some arge-dae unds are a he mos conservaive asse allocaion a he arge (saed) year. Ye, ohers could become he mos conservaive 15 or 20 years afer he saed dae, given ha reirees may depend on he und’s balance or decades. Hence, he name “arge-dae und” can be conusing.

Money Emoions People have sel-expressive desires. Boh inexpensive and luxury auomobiles provide a mode o ransporaion, bu he impression hey have on ohers differs. Saving money has litle sel-eseem appeal; ohers may be unaware ha an individual has $5 million in he bank. Many people use consumer deb o obain he appearance ha hey are wealhy; however, given he many sudden bankrupcies o high-profile figures, his image can be jus an illusion. Individuals acing on he need or sel-eseem disproves he noion o raional behavior.

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Docors, lawyers, and oher highly skilled proessionals ofen suffer rom money shame. Brown (2012) discusses he physical and psychological olls ha shame can exac. Tese high-income earners all prey o he same sel-eseem and emoional challenges as experienced by less wealhy individuals. Teir resources allow hem o buy bigger homes in more affluen neighborhoods and o join exclusive clubs; heir need o eed heir sel-eseem and keep up wih heir peers ofen drives heir behavior. As Belsky (2010) noes, i hese individuals find hemselves subsequenly eeering on a financial brink, hey may ask, “How can I be in his siuaion? Wha does his say abou me? I am smar so I can resolve his issue. Who can I rus o no expose my siuaion o my peers?” Alhough logical answers are available o hese quesions, individuals may lack he knowledge o recognize hem or be unable o regulae heir emoions and behavior. One opion is o urn o a financial proessional. According o Saman (2000), he rue value o a financial planner or financial advisor lies in managing he invesor, no he invesmens. Te word smar migh resul in derimenal financial decisions or cliens. Everyone wans o be smar, ye people may label some children “dumb,” a home or a school. Te shame ha hese children eel abou his labeling could las a lieime, and cerainly can affec heir emoions abou money. Away rom hose giving grades or criiques, hey can now assess hemselves as smar. Alhough hey may be skilled in music, ar, or some oher alen or sociey, quaniaive analysis may no be heir area o experise. When a predaory financial “proessional” calls hem “smar,” hese individuals receive affirmaion based on wha hey wan o hear. Tey may perceive ha person as rusworhy and willing o accep heir advice. In ac, some invesmen providers like o incorporae he word smar ino he names o heir unds or analyic descripors. Alhough bea reers o exposure o he broad marke, hese providers use he erm “smar bea” o describe invesing in securiies ha are highly correlaed wih a acor in he marke such as low volailiy or high dividend yield. Tese providers wan invesors o eel inelligen when invesing in heir producs. Who would wan a “dumb bea” when you could have “smar bea?”

Money Languages Gender and marial saus ofen conribue o money language. Money language is applied o how influences such as parenal, ehnic, and religious culures help shape our relaionship wih money. For example: • • • •

“I’m a man; hereore, I’mgood a numbers.” “Women are he caregivers.” “Our people’s wealh comes rom owning propery. Ta’s wha our group does.” Wie: “Wha’s our reiremen plan?” Husband: “Don’ worry, i is under conrol, rus me.”

No surprisingly, men oen exhibi overconidence because hey consider conidence a posiive behavior. hey do no wan o be asked quesions abou he decisions hey make. Some even wan o play “sump he inancial planner.” his show o bravado behavior is an aemp o exhibi heir masculiniy o a spouse or signiican oher.

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Some men say hey are aggressive invesors while acually being jus as concerned abou marke swings as women. Wha hey mean is ha hey wan o earn beter han average marke gains when he marke is up and wan o swich o cash o avoid losses when he marke is down. Tis marke iming behavior is ofen very cosly. Addiionally, men ofen do no wan o hink abou eiher heir moraliy or an evenual decline in heir healh. Teir parners are concerned abou heir moraliy, however, i hey coun on he man’s income or a large porion o household income. Men may rejec purchasing more lie insurance, using excuses such as: he advisor only wans o make money selling insurance, none o his riends carry ha much insurance, or he amily could be using ha money or more producive purposes. Women have he pracical challenge o longer expeced lie spans han men have. Tis greaer longeviy means ha women need o save more han men o he same age and income. In many married households, he husband raher han he wie drives he reiremen planning decision. As hese conversaions are ofen emoionally charged, many couples wan o avoid hem. Women may orgo invesing in heir 401(k) plans so as o inves in heir spouse’s reiremen plan or o help pay or heir children’s educaion. I he couple is conribuing o he spouse’s 401(k) plan, a naural quesion is wheher a differen risk posiion appears in he porolio ha would be wise or he wie. I no, and divorce occurs, hen she migh receive less han wha she oherwise would have received using a more moderae invesing approach. Anchoring and herd behavior influence individuals according o he norms o heir race and culure. Anchoring is a cogniive bias ha describes he endency o rely oo heavily on he firs piece o inormaion offered (he “anchor”) when making decisions. Herd behavior describes how individuals in a group can ac collecively wihou cenralized direcion. Alhough no obviously rue in all cases, Duch Americans have a repuaion or being rugal, whereas Arican Americans ofen receive a label o being spenders. I Arican Americans anchor or believed hese sereoypes, hen hey would spend. A person who does no ollow culural norms can be emoionally uncomorable, eeling himsel o be an oulier. Anoher misconcepion is when Arican Americas choose o save, hey are purposely conservaive invesors (Naella, Meschede, and Sullivan 2014). Prudenial (2015) atribues conservaive behavior o a lack o exposure, educaion, and inormaion, which is availabiliy bias. Availabiliy bias reers o making decisions based on limied inormaion. Tus, he relaive lack o inormaion and exposure o many Arican Americans may predispose hem o more conservaive invesing behavior. According o Prudenial, many financial services firms do no acively seek ou Arican American invesors, which could oherwise improve his group’s risk aking abiliy.

Biases in Deciding Whether to Hire a Professional Te decision o wheher o hire a financial proessional should a leas include evaluaing he areas o someone’s own financial lieracy regarding he ollowing curren siuaion: (1) evaluaing advisor compeency and fiduciary saus; (2) financial saus, including he mix o credi and deb; (3) reiremen planning; (4) college financing

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or children; (5) insurance policies; (6) ax managemen; (7) esae planning; and (8) invesmen sraegy. Alhough mos people elec o coordinae heir own financial plans, research rom he Financial Indusry egulaory Auhoriy (FINR 2013) reveals ha 61 percen o U.S. respondens could no answer more han hree o he ollowing five quesions correcly: 1. Suppose you have $100 in a savings accoun earning 2 percen ineres a year. Afer five years, how much would you have? 2. Imagine ha he ineres rae on your savings accoun is 1 percen a year and inflaion is 2 percen a year. Afer one year, would he money in he accoun buy more han i does oday, he same, or less han oday? 3. I ineres raes rise, wha will ypically happen o bond prices? ise, all, say he same, or is here no relaionship? 4. rue or alse: A 15-year morgage ypically requires higher monhly paymens han a 30-year morgage, bu he oal ineres over he lie o he loan will be less. 5. rue or alse: Buying a single company’s sock usually provides a saer reurn han a sock muual und. Tere is much conusion abou he erm “financial advisor.” No such proessional designaion exiss. People who work wih invesmens and insurance producs migh call hemselves financial advisors because he erm sounds beter han “agen,” “broker” or “financial salesperson.” However, a working definiion or a financial advisor would include hose who provide advice in he bes ineress o he individual, which is legally known as a fiduciary; who holds an indusry designaion ha minimally includes reiremen planning, invesmen planning, and insurance planning; and who mainains an indusry designaion requiring coninuing educaion. A CFP ® proessional fis his definiion, having successully compleed exensive coursework and having pracical experience in financial oundaions, risk and insurance planning, reiremen planning, invesmen planning, ax planning, and esae planning. Te individual has also aken a fiduciary oah. Beyond hese pariculars o raining and knowledge, here are personal characerisics ha people look or when considering a financial advisor. TRUST

rus or some people may reflec a good eeling abou ha person. In her ED alk, Onora O’Neill (2013) saes: “I would aim o have more rus in he rusworhy bu no in he unrusworhy… . Inelligenly placed and inelligenly reused rus is he proper aim.” She provides a srucure or evaluaing rus ha applies o he CFP ® proessional, indicaing ha he judgmen o rus or proessionals requires deermining wheher hey are compeen, hones, and reliable. COMPETENCY

Mos people have had no ormal inroducion o hose involved in he financial planning indusry. Tey ofen ideniy a financial advisor and financial planner as synonymous

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erms. Alhough commonly used, hese may be sel-appoined erms, as indicaed earlier. Ta is why asking abou regisraions, licenses, and proessional designaions is imporan. Some who ideniy hemselves as financial advisors may be morgage agens or proessionals who sell producs, as oppose o offering advice. Many who call hemselves a financial planner do no have he comprehensive planning compeency o a CFP® proessional. Ohers misake a proessional’s oal asses under managemen (AUM) as an indicaor o compeency. Te AUM is he oal marke value o he invesmens managed by a muual und, money managemen firm, hedge und, porolio manager, or oher financial services company. Many firms in he financial services indusry like o ou heir size in erms o heir AUM. Tey wan invesors o believe ha because o he size o he asses hey manage, hey know wha hey are doing. Bu he AUM does no mean heir cliens are on rack o reach heir goals. HONESTY

Mos people preer o hire people who will work in heir bes ineress. Unless he proessional is required o work in he clien’s bes ineress, such as is he case wih a CFP ® proessional, poenial cliens should remain doubul. Te individuals who work in he clien’s ineress can beter rame a clien’s issues rom a holisic financial sandpoin, which includes he “Aspecs o Financial Planning” explained in he nex secion. RELIABILITY

As menioned, he finance indusry ofen ous AUM as an indicaor o reliabiliy and good resuls. However, here are beter mehods or evaluaing he reliabiliy o a financial proession. For example, a poenial clien could survey a ew o he planner’s cliens on how he individual handles various siuaions. Tose siuaions migh be reiremen income planning or educaion planning or blended amilies. Anoher assessmen ool is he FINR BrokerCheck, which provides he regulaory record o advisors.

Aspects of Financial Planning Any caegorizaion o he broad opic o financial planning will differ depending on one’s perspecive. Te ollowing are wo major ones, helping o highligh he services o a CFP® or CFA charerholder. When aken ogeher, hese areas represen his chaper’s definiion o wealh managemen. FINANCIAL

ST ATUS AND

ST ABILITY

Te financial saus o differen individuals can vary dramaically. For example, some people do no have an emergency und; perhaps hey eel ha emergencies will no happen o hem. Ohers have large credi card balances, making heir financial survivabiliy difficul i hey miss several paychecks. Some people’s risk-managemen sraegy is o hope ha calamiies do no happen o hem. Car owners have auo insurance because i

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is legally required o drive an auomobile, no because hey wan o hedge he financial risk o an acciden. Te raionale or hese decisions is born o opimism and he osrich effec. We all end o creae narraives concerning risk ha is based on our inuiion raher han deliberaion. Individuals ake his inuiive ramework wih hem when as employees hey selec opions on heir employer’s healh insurance or disabiliy income proecion. Tey have hem in mind when hey hink abou lie insurance or an elecive employer-sponsored defined conribuion reiremen plan. Alhough mos people eel ha healh care is a necessiy, hey rejec many oher benefis because elecing hem will urher reduce heir ake-home pay, anoher insance o presen bias. Some people elec o coninue wih he healh insurance plan hey had he prior year, raher han invesigae oher opions, revealing a saus quo bias. Many people do no like he high premiums o long-erm care insurance. Tey ypically ocus on he premium, raher han he cos i hey were o pay or nursing care compleely ou o pocke. In ac, mos people do no have he cash or long-erm care, or would raher risk he well-being o heir loved ones o pay hose coss. Some make incorrec, uninormed ye opimisic assumpions abou he role o Medicare and Medicaid in covering long-erm care. In shor, people ofen creae hopeul narraives ha suppor heir overall judgmen, resuling in a denial o he acs in order o avoid negaive emoions. Narrow raming can seriously affec an individual’s financial saus. I especially becomes an issue when someone sees only par o he picure and no he whole. For insance, many people equae having $1 million in income o having $1 million in he bank. However, hey have no calculaed he axes due, as well as oher ees ha may lower ha amoun. Firs-ime recipiens o large sums o money, such as lotery winners and ahlees, ofen spend he money even beore hey receive he unds. RETIREMENT PLANNING

Planning or reiremen can be an emoional challenge. Many associae i wih a loss o vibrancy and even impending deah. Ohers see reiremen as a ime o financial reedom, a ime o do he hings hey have been denying hemselves while hey were working. Tese people ofen have lived rugal lives and hey leave heir jobs a he earlies possible momen so hey can enjoy hemselves in heir reiremen. Presen bias has many people delaying heir reiremen planning unil hey reach heir 50s or 60s. Teir social groups and peers influence heir houghs abou wheher reiremen planning is a prioriy. Addiionally, in heir consideraions, hey ofen discoun he power o small savings and compounding ineres, as research conduced by Ibboson, Xiong, Kreiler, Kreiler, and Chen (2007) shows. Ye knowing he power o small savings could help hem build heir reiremen unds. Le’s look a an example o he savings required or someone o live on 80 percen o a $60,000 gross income during reiremen. Based on he Ibboson e al. research, a 25-year-old would need o save 12 percen o her income unil she reired a age 65. I she wais unil age 50 o save, her savings rae should climb o 50 percen. Tese savings raes assume he invesor will achieve cerain invesmen reurns, which may vary rom hose projeced. Tose reurns may no be wha he reiremen invesor acually

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earns. Obviously, a 25-year-old can more easily save a smaller percenage o income or a longer ime han can a 50-year-old save a larger amoun. Ibboson e al. also show ha as a person’s income goes up, so does he rae o savings required o replace he same 80 percen o gross income. Many individuals wih access o workplace reiremen savings plans do no paricipae in hose plans. Because many o hese plans offer some maching conribuion rom he employer, he workers are “leaving money on he able.” Why would someone no ake “ree money?” esearchers a he Naional Bureau o Economic esearch have concluded ha employees ofen “ollow he pah o leas resisance” (Choi, Laibson, Madrian, and Merick 2015). Some people view heir 401(k) plans as a general savings accoun, raher han a axdeerred, reiremen savings accoun. Tey wihdraw unds or curren needs, wihou much hough abou how ha acion will affec heir reiremen unds. In mos cases, hey would be beter off using a simple savings accoun and reserving heir 401(k) plan, hereby avoiding he early wihdrawal penaly, income ax obligaion, and poenial marke risk. Similarly, many people are anxious o access heir Social Securiy benefis as early as possible. Tey believe ha hey are simply receiving he money owed o hem and some have concerns abou heir longeviy. Unorunaely, maximizing a Social Securiy benefi is no a sraighorward decision; delaying any claim or Social Securiy benefis can add $10,000s, i no $100,000s, over a lieime. Te realiy is ha more people will live longer han expeced, as medicine and medical procedures coninue o improve. Following a deliberae decision-making process or building one’s reiremen savings, raher han an inuiive or wishul one, may help people avoid povery in old age. People are prone o oversimplificaion, which leads o narrow raming or considering oo ew acors in making decisions. Tis bias emerges rom a lack o ime or inormaion, leading o subopimal decisions. Consider, or example, how some large financial insiuions adverise ha hey can help people wih 401(k) plan roll over he unds ino heir individual reiremen accouns (IRs). Tis assumes ha an individual would be beter off rolling over her 401(k) plan unds, raher han leaving hem a her ormer employer. Bu is she moving her unds o a beter invesmen? Wha makes ha rollover beter? And is he rollover consisen wih her overall reiremen plan? Addiionally, is he ease o compleing he paperwork he mos imporan consideraion? A slower, deliberaive decision process migh offer greaer reiremen benefis. Earned income is axable or Social Securiy purposes up o a se amoun. Tose who exceed his income cap ofen view he excess as “ound” money (known as menal accouning), and no as an opporuniy o save or reiremen. Tis scenario is a raming siuaion: many people like he ego boos i provides and le ohers know hey have exceeded he income cap. Ohers enjoy spending he money or un pursuis or luxuries.

Investment Strategies Invesmen planning comprises having an invesmen plan, asse allocaion, value deerminaion, selecion o invesmens, marke iming, regular review o invesmens, and ax planning. Le’s consider he biases and ypical invesor behaviors ha lead o auly financial planning.

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ONE- SIDED INVESTMENT PLANS

Invesmen planning is a muliaceed, ofen emoional pursui. Based on muual und flows, he sraegy ollowed by a majoriy o people is o chase invesmen reurns and pursue marke iming. Some find he pursui o ouperormance o be exhilaraing; however, Pornoy (2014) poins o he uiliy o atemping o pick unds ha consisenly ouperorm ohers. Cenral o undersanding and resolving he invesor’s paradox is recognizing ha invesing is a mater o choice as much as i is a mater o finance and saisics. As menioned earlier, people preer simple soluions. When hey see heir porolio balance go down, reerences o dollar cos averaging and long-erm invesmen sraegies are no wha hey wan o hear. Ye, an evidenced-based, opimal sraegy uses broadly diversified asse allocaion. LIMITED DIVE

RSIFICA TION

A basic enan o Modern Porolio Teory (MP) is ha he mos efficien porolios have he highes expeced reurns or he risks aken. According o Markowiz (1952), by knowing he asses’ expeced reurns, volailiy, and correlaions, a se o porolios will emerge ha represens he mos efficien available, known as he efficien fonier. Markowiz shows ha efficien porolios consis o low-correlaed asses, which resul in diversified porolios. Subsequen erroneous implemenaion o MP led Markowiz (1959, 1991) o sugges enhancemens o MP. Te creaion o Pos-Modern Porolio Teory (PosMP), firs devised by om and Ferguson (1993), addresses some o hese errors by: • Creaing a se o invesmen choices having low correlaions beween hem. • Using 21 s-cenury compuaional resources and saisical processes no dependen on hisorical reurns, sandard deviaions, and correlaions o generae efficien roniers. • Defining risk in more precise erms han volailiy o reflec human behavior. • Considering invesmen vehicles and rading coss when esablishing porolios. Few individual invesors can creae hese ruly diversified porolios on heir own, however. Tey believe ha invesing in muliple muual unds achieves ull diversificaion. On he conrary, financial advisors ofen have access o ools and invesmen vehicles ha can creae such efficien porolios or heir cliens. CONFLICTING SOCIA

L V ALUES

Cliens ofen hold srong social values, ye invesing may ake hem ouside hose values. Do cliens know he naure o heir invesmens? Do hey wan o inves consisenly wihin heir social values o reach heir financial goals? Are issues such as susainabiliy, religion, gender equaliy, or income gap imporan o hem? As boh Kinnel (2015) and obers (2015) show, here is a difference beween he reurns an invesor receives and a comparable index reurn. Furhermore, invesmens in muual unds, on average, ail

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o atain he unds’ expeced reurns. Invesor behavior accouns or much o his resul. Tey ofen rade heir accoun based on emoion. Tis leads o harmul behaviors such as buying high and selling low. However, working wih an advisor ha helps hem inves in a values and goals based way can help calm heir nerves. Invesing in companies ha are aligned wih he invesor’s social and religious values could help hese individuals say wih an invesmen sraegy during volaile imes. FAUL TY INVESTMENT SEL

ECTION

Mos people selec heir invesmens based on desired reurns raher han a desire o avoid risk. No all people who inves may realize ha company cash flows vary over ime, sales flucuae, and demand or producs can change, based on he general economic condiion. Addiionally, invesors ofen lisen o hose who ell hem wha hey wan o hear, raher han hose wih opposing views. Some lisen o con ariss such as Bernie Madoff and have become vicims, ailing o quesion how he could deliver ar higher reurns han he marke was producing. Many invesors wach pundis on elevision and lisen o radio shows in search o orecass and ho ips. Alhough some o he pundis are logical in heir approach, ohers are no much more han enerainmen. In conras, companies such as Morningsar and Lipper use raing sysems o help invesors assess muual unds. Many o hese assessmens employ hisorical daa o base heir raings. emember, hough, ha muual unds carry a warning label saying ha “pas perormance may no be indicaive o uure reurns.” Ye, hisorical perormance is he basis ha many people use when evaluaing invesmen reurns. Who has ime o look a he small prin, anyway? Similarly, when invesing in he company’s reiremen plan, many employees assume ha he employer has careully preseleced he 401(k) menus. Ta is, a single person or invesmen commitee has agreed wih he company’s seleced providers. Ye he invesmen menu may reflec a profi incenive given o he seleced provider and no be in he bes reiremen ineress o he paricipans. Many employees, 401(k) savers, make hasy selecions because he process seem overwhelming. Some eel ashamed ha hey do no undersand he complexiy o he selecion process. Ohers look or paterns o perormance ha ofen do no exis. Tey ocus on he recen winners, ake an equal percenage o each selecion, or accep he deaul choice ha could be a low reurn, cash equivalen und. Ohers are overconfiden in heir abiliy o choose he unds. For many people, und selecion is based on hisorical perormance; hey wan he pas reurns o he und, no necessarily is uure reurns, which are uncerain. STRESS ON MARKET TIMING

Te pursui o increasing reurns via marke iming comes loaded wih an unending number o quesions. Marke imers ocus on deermining he opimal ime o ener or exi he marke, ye his decision hangs on predicing he answers o a variey o quesions. Will he Federal eserve change ineres raes? Will invesors lisen o he pundi wih his opinion on he mater? How will he oreign markes reac? Will wha happens

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in oreign markes ha affec markes in he Unied Saes? Wha should we do and when should we do i? Individuals wan o appear smar, so hey ofen quoe various news sources. Wihou a solid background in economics or finance, hough, hese invesors may no be able o evaluae wha he expers are saying. Tey may discuss he news wih peers who also wan o show heir inelligence and his cycle o grouphink can lead o unnecessary rading. iming he marke correcly can provide huge sel-expressive benefis. Te pundi ges bragging righs o saying “I old you so.” And i can engender eelings o regre i one heard he advice and did no ac on i. Few invesors undersand he negaive impac o managemen ees and rading coss on heir reurns. Ta is, rading coss decrease profis unless one can earn higher reurns o overcome hose coss. Neverheless, requen rading can give an invesor eelings o empowermen, as in conrolling one’s own desiny. Te evidence shows, however, ha over he long- erm, requen raders lose more, on average, han hey win (Barber and Odean 2000). UNBALANC ED INVESTMENT REVIEW

Afer creaing heir porolios, many invesors evaluae heir perormance based on wheher he accoun balance has increased. Te ypical invesmen saemen repors only presen perormance, wihou presening he clien’s risk exposure. Tis ype o presenaion can lead an invesor o rade on emoion. Te mos imporan evaluaion o invesmen perormance is wheher i is consisen wih he required reurns in he financial plan, based on an individual’s savings over a specific ime period. As menioned, many reail invesors use “exper” commenary rom he media in making heir financial decisions. Te rusworhiness o hese “expers” is based on being a media proessional, raher han a credenialed financial proessional. Wha is he real basis or heir experise? Asking ha quesion requires research and deliberaion, while inerruping he pleasure o saisying o one’s emoions. Are hese media “expers” acually invesmen advisors? Tey ofen speak in hyperbole, and hey repor he overall direcion o a marke index, such as he S&P 500. Ye some invesors do no undersand he implicaions o he S&P 500 index; hey do no even know i is only a subse o he oal invesable universe. For example, i hal o an invesor’s porolio consiss o bonds ha rack an inermediae bond und index, hen he S&P 500 index alone is no a good baromeer o perormance. Furher, some experience posiive or negaive emoions based on he perormance heir invesmens compared o he S&P 500 index. Much o his sress would be avoided i hey had knowledge o proper benchmarks or heir holdings. INADEQUA TE TAX PLANNING

ax planning is an ofen-overlooked area o financial planning. Unorunaely, many people menally rame he mater as ax preparaion versus ax planning. Moreover, hey don’ undersand ax brackes in he U.S. ax sysem or capial gains axes vs. income axes. Decreasing he amoun o hose axable dollars can increase one’s wealh.

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Unorunaely, mos people do no hink abou axes unil April 15 is near. Teir opporuniy o save on heir axes mosly ended on December 31 o he prior year. Te urgency o he ax deadline is a huge moivaor, bu procrasinaion is always looming. Few people pursue a knowledgeable ax proessional who can help hem find ways o save on heir axes, such as saring a 401(k) or healh savings accoun. Some individuals preer a sense o conrol or hink hey can easily prepare heir own ax reurns. Many use a sofware program and/or online ax orms, believing hey can do he work o a Cerified Public Accounan (CPA). For ohers, heir ax siuaion is simple and is merely an exercise in ollowing direcions. Ye a CPA can provide boh ax planning and ax reurn preparaion. Mos people preer geting a ax reund raher han finding hey owe he governmen a check. Tis atiude illusraes he concep o loss aversion. Loss aversion sems rom an individual’s srong desire no o ake losses; ypical invesors eel a loss more emoionally han hey do a gain. Some people use heir ax reund as a orced savings program. In many cases, ha reund becomes more o a “slush und,” as i is pu oward vacaions and oher pursuis. Many people overpay heir axes ou o ear ha hey migh owe a he ime o heir filing and no have sufficien unds o make he paymen. Or, hey may no give, insure, save, or inves he bonus, ciing he unavailabiliy o he unds o do so, even wih reund in hand. Tus, an enire indusry o ax preparers exiss ha has atached value o geting individuals a ax reund.

Enhancing Wealth Through Nudges People need help in avoiding he sel-expressive and emoional issues ha can overwhelm heir raional hinking. Qualified financial proessionals can deliver his help. Yeske and Buie (2014, p. 195) poin o he value o nudging as par o he financial planning process, ha i is a mehod o reraming he conversaion and drawing “he clien’s atenion o a differen aspec o he siuaion, one ha ranscends he presen momen, or enliss clien heurisics o nudge hem ino a healhy direcion.” Basically, here are wo major ypes o proessional nudges. EMPLOYER NUDGES

Mos employees have difficuly calculaing heir needed savings raes and reurns, and hen ranslaing his inormaion ino reiremen income. Benarzi (2012) highlighs he imporance o inelligen deauls o help employees wih reiremen planning. Te mos imporan is or employees o enroll auomaically in a plan. Such a conclusion should no come as a surprise, given ha mos ull-ime employees experience auomaic enrollmen in Social Securiy. Anoher is o esablish a deaul conribuion rae, such as 6 percen, and hen coninue o increase i o say, 10 percen in annual incremens. Given ha employees ypically know litle abou proper asse allocaion, having a proessionally managed porolio is criical. An employer can provide he proessional managemen hrough he qualified deaul invesmen alernaive (QDIA) sae harbor.

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According o U.S. Deparmen o Labor regulaions, i employers properly selec and monior heir QDIA choice, hey will receive relie (sae harbor) rom liabiliy or heir employees’ invesmen oucomes. Te operaive word is properly, as some employers have aken his o mean ha all arge-dae unds qualiy. Bu each poenial QDIA und needs o be analyzed separaely o see i he QDIA definiion is me. Using ha same hinking, employers should consider deauling or nudging employees ino he maximum healh, disabiliy, lie, and long-erm care insurance plans, i available. aher han make employees become expers, employers should make he choice easy or hem. New employees are unlikely o view hese acions as reducions rom heir ake-home pay (losses). Ideally, enrollmen or benefis kick-off meeings can help inorm employees abou changes in he benefi selecion and explain he philosophy behind he changes. Tis process can emper he emoions o people who may wan o op ou. A hese meeings, employers can provide heir employees wih a reiremen gap analysis or personalized reiremen plan. Calculaing he required savings raes and considering he inflaion raes, expeced reurns, and ime horizons are complicaed. Besides being a cogniive challenge, his ask can be emoionally draining; ye, people wih a plan are more confiden overall. Implemening such a program can reduce work disrupions, as well. Employees confiden o heir finances will spend less ime hinking abou and working on hem during work hours. Employers can also offer employees he help o a financial proessional hrough a workplace program. FINANCIAL PLANNER NUDGES

Te firs ask a financial planner should underake when meeing wih a prospecive clien is o esablish rus, using O’Neill’s (2013) hree-acor model menioned previously: compeence, honesy, reliabiliy. Te planner should presen how her credenials benefi he prospecive clien. She should educae he individual abou he requiremens o her various licenses, regisraions, and designaions. In he case o he Cerified Financial Board o Sandards, hese requiremens are passing college-level courses in financial undamenals, reiremen, ax, invesmens, and esae planning; passing a wo- day exam; and delivering financial planning o cliens or a leas hree years. Presening a clean regulaory record wih FINR, he Securiies and Exchange Commission (SEC), and he CFP board highlighs a planner’s honesy. Proessionals can bolser heir reliabiliy by providing conacs ha cliens can access o check heir experiences. Financial proessionals should use a meeing process ha allows new cliens o ge o know hem personally. Websie and imagery showing he human side o he service can demonsrae how financial planning can help he clien achieve his or her desired goals. oal wealh opimizaion (wealh managemen) is a mulidisciplinary approach wih prioriies, rade-offs, emoions, and sel-expressions. Is inenion is o balance he many areas ha can affec financial lie. Te financial planner should ask quesions ha address he clien’s enire sel: goals, ineress, values, relaionships, financials resources, and he desired number/ype o planner conacs. Tese answers can uncover he underlying drivers or he clien’s

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expeced oucomes or can esablish needs. Are issues such as susainabiliy, religion, gender equaliy, and income gap imporan o he clien? How migh cliens wan o incorporae heir social values ino invesmens, giving, and acivism? Afer clariying he clien’s goals, he financial planner should assess he clien’s resources and provide a plan based on sandards ha opimize he clien’s oal wealh. Examples o hese sandards could be having a six-monh cash reserve, maximum disabiliy coverage (60 or 70 percen o curren income), lie insurance o cover human economic value, and Social Securiy benefis beginning a age 70, as well as consideraion o he inflaion rae, expeced reurn arges or he ime period, savings consrains, and i applicable, opimizing he use o employer- sponsored reiremen plans. Achieving hese sandards akes ime. Par o he financial planning implemenaion is o help cliens redirec heir spending o areas ha will help hem advance oward heir financial goals. Te planner can rerame a cash-flow plan or budge rom being a consrainer o becoming a ool ha increases oal wealh. For example, some budges only suppor negaive emoions, such as “I no longer can buy whaever I wan.” Insead, cliens may experience posiive emoions by associaing a specific dollar amoun wih a desired clien goal “Save 10 percen o your earnings” does no have he same eel as “Save $600 a monh so ha you can confidenly mainain your liesyle afer aking an early reiremen a age 61.” I is easier o change behavior when presen happiness and uure joy are equal concerns. Mos people seek o avoid immediae pain, such as obaining negaive invesmen reurns. Invesors ofen view hese invesmen reurns in isolaion because hey have no calculaed he reurn needed o reach a specific goal. Tis unnel ocus can be a he expense o oher areas o heir financial plan. However, auomaing he income redirecion helps address he loss o curren discreionary spending and soohes he clien’s emoions accompanying his loss. ypically, employees view payroll deducions as orgone pain (passing up a bigger check) raher han an ourigh loss (paying ino savings “ou o pocke”). Te planner should direc he clien oward he joy o seeing all o his or her financial goals unded. Te financial proessional and he clien can hen celebrae he milesones reached along he way. Tose milesones may include paying off exising deb, enrolling in he company’s reiremen plan, or achieving 20 percen o he clien’s reiremen goal. Tese celebraions boos happy emoions and sel-expression. Planning proessionals migh rerame he reiremen savings around he concep o “lieime income smoohing.” Ta is, would cliens like o have an uninerruped source o income ha susains heir curren liesyle or he res o heir lives? In ac, like mos defined benefi plan paymens, his will be he deaul choice or mos cliens. In making he invesmens, planners should ocus on aking no more risk han is necessary o reach he clien’s goals. Te choice should be minimum risk; heighened risk olerance may no help he clien reach her goals. Deermining he clien’s olerance o risk via a quesionnaire can yield auly resuls, based on her financial knowledge or emoional sae a he ime. Te financial planner needs o explain invesmen risk and expeced invesmen reurn. Te risk expecaions are hen used as guardrails or ongoing clien reviews. And

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he reviews should be clear and useul. For example, i is more imporan or a clien o undersand ha an equiy porolio’s likely annual reurn range has been beween −18 percen and +38 percen or he year han i is o know ha he average rae o reurn has been 10 percen. Using analogies ha resonae can enhance he clien’s undersanding. For insance, people buy on perormance and sell on risk. Tereore, he invesmen reviews should ocus on he planner’s invesmen process. Did he porolio say wihin he clien’s risk expecaions? Similarly, reurns, eiher posiive or negaive, should be he reason a clien considers making a change. As previously menioned, Kinniry e al. (2014) highligh he 150 basis poins o invesor reurn ha can be realized by helping he clien sick wih he plan hrough volaile markes. Ulimaely, clien behavior drives he reurns hey realize when underaking he fiduciary invesmen process.

Summary and Conclusions Emoions ha arise rom uncerainy and he need or immediae sel-expression challenge he financial planning and invesmen process. FINR and oher research organizaions have repored a general lack in people’s financial lieracy. Wihou such a oundaion, people ofen le heir emoions rule heir behavior and find comor in being par o he herd. Tis chaper has reviewed some o he emoion-charged behaviors ha ill-serve invesors. Bu, as suggesed, careully selecing and working wih a qualified financial planner can help avoid such behaviors and ensure a sable financial lie wih a good reiremen uure. Trough nudging, employers can help creae posiive deaul choices or reiremen, healh, disabiliy, lie, and long- erm care. Forward- hinking employers can provide one- on-one financial wellness suppor or heir employees, as well. Similarly, financial advisors are mos effecive using a deaul opion or correcive behavioral acions raher han having people op in o benefis abou which hey know very litle. Behavioral finance in he financial planning process sars when an individual evaluaes wheher o change his or her curren behavior. When he person realizes he need or change, he nex quesion is wheher o make he change personally or o seek proessional help. A CFP ® or, i he need i s invesmen relaed, a Charered Financial Analys (CFA) represens a source o such help. Especially, financial planners can help heir cliens by developing a deaul sysem designed o nudge hem oward opimizing heir oal wealh. By assessing he clien’s knowledge, emoions, sel-expressions, and resources, he financial planner can esablish a deliberae process ha helps hem undersand hemselves and heir financial needs holisically. Financial planning should be an ongoing process ha celebraes milesone achievemens. More research needs o be done o address behavioral aspecs o financial planning beyond invesing. Federal and local policymakers should move oward bolsering high school and college educaion programs o include personal finance. Tis would benefi individuals and he marke, as a whole.

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DISCUSSION QUESTIONS 1. Discuss he biases individuals have when considering heir need or financial planning. 2. Discuss he raionale or hiring and he crieria or selecing a financial proessional. 3. Discuss several biases ha individuals should overcome in he financial planning process. 4. Explain how employers can nudge employees oward financial securiy. 5. Describe how financial planners can nudge cliens oward financial securiy.

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20 Traditional Asset Allocation Securities Stocks, Bonds, Real Estate, and Cash CHRISTOPHER MILLIKEN Vice President, Portfolio Management Hennion & Walsh Asset Management EHSAN NIKBAKHT Professor of Finance Frank G. Zarb School of Business, Hofstra University ANDREW C. SPIELER Professor of Finance Frank G. Zarb School of Business, Hofstra University

Introduction Asse allocaion is an invesmen sraegy ha selecs differen securiies organized ino

muually exclusive groups (i.e., asse classes), which exhibi differen reurns, risks, and pair-wise correlaions (Securiies and Exchange Commission 2009). In general, an asse class will have high inra-asse class correlaion bu low iner-class correlaion. Te objecive o asse allocaion is o achieve a balance beween risk and reurn ha mees an invesor’s goals, abiliy, and willingness o bear risk. Many view Harry Markowiz as he ounder o he modern approach o asse allocaion and he firs o quanifiably measure he benefis o including asse classes ha exhibi differen reurn pahs. He developed modern porolio heory (MP) during he 1950s and incorporaed he relaionships beween expeced risk, reurn, and correlaion among securiies. Markowiz’s (1952) breakhrough led o Sharpe (1964), Linner (1965), and Mossin’s (1966) Capial Asse Pricing Model (CAPM), a linear equaion ha incorporaes sysemaic risk ha coninues o be widely augh and exensively sudied. Furher discussion ollows abou he oundaion o asse allocaion and he pricing models ha arose afer he inroducion o MP. Proessional money managers use counless asse allocaion models oday, bu all incorporae he core enes o risk and reurn. A consisen characerisic o hese models is an atemp o describe he opimal way o allocae asses o achieve he mos desirable reurn disribuion. Tese models vary widely and he principles upon which mos are buil are explored in more deail hroughou he chaper. Te inpus o hese models all include some measure o sandard deviaion (risk), expeced reurn, and he paired 359

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correlaion o he individual securiies. Te less han perec correlaion o a porolio’s underlying holdings is he main acor ha reduces he overall risk o a porolio and he reason ha he sandard deviaion o a muli-asse porolio is no he weighed average o he individual securiies’ sandard deviaions. In simple erms, he firm-specific risk o individual securiies offses each oher leaving only sysemaic (marke) risk in a large porolio. Tis concep is why asse allocaion is said o be “he only ree lunch in finance.” Exensive academic research has examined he imporance o asse allocaion and how much a porolio’s reurn can be atribued o i. Brinson, Hood, and Beebower (1986) atemp o quaniy he porion o reurn or which he asse allocaion decision is responsible and concluded ha he mix o muually exclusive asse groups explains 93.6 percen o a porolio’s reurn. Addiional research has ailed o reach clear consensus on his issue. Despie he coninuing debae, he asse allocaion decision appears a leas parially responsible or he risk and reurn associaed wih a porolio. When building a porolio and considering an asse allocaion sraegy, an invesor mus define he available asse classes and securiies. Te mos common and perhaps undamenal building blocks are socks, bonds, real esae, and cash. Oher securiies such as opions, uures, and srucured producs can add diversificaion benefis and exhibi differen risk and reurn characerisics, bu hese exend beyond he scope o his chaper and hence are no included in he discussion. Te basis o mos decisions in finance ress heavily on balancing risk and reward, and he asse allocaion decision is no differen. An invesor mus decide on boh a reurn objecive and an overall level o risk. As relaed o he objecive o he porolio, he invesor’s arge reurn mainly deermines he porolio’s asse mix. For example, a porolio creaed or he goal o wealh preservaion ypically conains a relaively higher percenage o asses ha exhibi low volailiy, such as fixed income and cash, and a relaively lesser percenage o volaile securiies such as socks. Conversely, a porolio wih he objecive o capial appreciaion uses a higher percenage o equiies compared o relaively less risky fixed income and cash asse classes. eal esae adds diversificaion benefis o boh conservaive and aggressive reurn objecives, and can be a sable allocaion in mos sraegies. Te relaionships among sock, fixed income, and real esae reurns hisorically exhibi low correlaion, and combining all hree, raher han viewing each in isolaion, creaes a more efficien risk and reward rade-off. Besides consideraions o arge reurn, boh he abiliy and he willingness o an individual o assume risk play roles in deermining an asse allocaion sraegy. Te abiliy o olerae risk is a uncion o several acors, including ime horizon, wealh, and liquidiy needs, whereas he willingness o ake risk is a uncion o an invesor’s behavioral characerisics. Curren marke condiions may also deermine he asse allocaion policy developed and mainained or a specific porolio. Tis relaionship resuls rom he availabiliy o cerain asses and he ac ha correlaion, risk, and reurn expecaions are nonsaionary. Ta is, in cerain periods, some asses may become illiquid, creaing challenges or invesmen or divesure objecives. A pruden asse manager considers hese acors and finds asses ha can serve as suiable replacemens. Tis chaper offers a high level overview o asse allocaion including several common asse allocaion models and heir benefis and drawbacks. A discussion o invesor behavior considers he effecs o boh cogniive and emoional biases. Tis opic is an inegral par o he allocaion policy because he models reviewed assume raional

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invesors who can operae wih unbiased processing o inormaion in addiion o oher consrains ha affec he efficiency o he decision-making process. Behavioral biases are boh cogniive and emoional. In heory, cogniive errors are more easily correced han emoional biases, which are ingrained in a person’s emoional psyche. Te research on he cogniive behavioral biases o individuals acknowledges ha menal shorcus such as heurisics, menal accouning, raming, and processing errors drive errors in he decision-making process. Errors are also driven by he invesor’s emoional sae during he decision-making process. Tus, separaing hese wo primary groups ―cogniive and emoional ―is appropriae when discussing he reasons individuals all vicim o hese errors and when reviewing he impac on an invesmen policy and asse allocaion sraegy. Wheher inenional or uninenional, he iniial asse allocaion and srucure o a porolio grealy shapes he uure disribuion o reurns. Alhough asse allocaion is no he sole deerminan o porolio perormance, i cerainly is is larges deerminan. For his reason, he mehodology a porolio manager chooses o use, such as meanvariance opimizaion or he Black-Literman Model, is o umos imporance and drives he uure realized risk and reurn. A large amoun o academic lieraure supporing radiional porolio consrucion mehods assumes a universe o raional, efficien decision makers. An increasing ocus is on human behavior and inheren invesmen biases. Te chaper hus begins by reviewing he building blocks o an asse allocaion sraegy, including socks, bonds, real esae, and cash, and hen examines he asse allocaion models commonly used by porolio managers beore discussing behavioral biases and heir implicaions on asse allocaion. As financial producs coninue o advance and change he medium used o deploy invesmen capial, he ocus remains on models o deermine he allocaion across muually exclusive groups o securiies. Invesmen proessionals can no longer ignore consideraions o human behavior and flaws in decision making when developing a clien’s risk-reurn profile.

Asset Classes In oday’s increasingly complex financial world, he number and variey o available asse classes is coninually growing. In he early 1900s, an asse manager primarily chose among equiies, deb (fixed income), and cash. Tese hree muually exclusive asse classes exhibi unique risk and reurn profiles wih correlaions ha are less han perec (+1), in some insances even less han zero, which provides or diversificaion poenial. oday, however, asse managers have no only he radiional hree asse classes bu also numerous derivaives, such as uures, opions, and swaps, as well as alernaive invesmens ha include real esae, hedge unds, privae equiy, and collecibles. Tis expanded universe o asse classes has grealy increased he abiliy o invesors o find diversificaion opporuniies and o improve a porolio’s riskreward profile. Le’s consider each o hese asse caegories. EQUITIES

When he headline reads “GM Falls 5 Percen” he journalis is reerring o he common equiy issued by General Moors. Equiy reers o an ownership claim in a publicly

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raded firm ha can be bough or sold on a marke wih high liquidiy and anonymiy. Privae equiy involves invesmens in companies ha are no publicly raded, bu such an asse class is no discussed in his chaper. Equiy ownership includes voing righs and eniles he owner o a proporionae share o he profis. Invesors can use blocks o equiy o conrol a company by amassing a majoriy sake in is ousanding shares. For he reail invesor, he benefis o equiy ownership include paricipaing in he profis and growh o he firm (McFarland 2002). For example, ownership o 10 percen o he equiy shares o a company eniles an invesor o boh 10 percen o he company’s voes and is profi or loss. Equiy owners can also receive dividends, paymens o cash, or addiional shares. Equiies are exposed o higher risk han fixed-income securiies, which are primarily concerned wih reurn o principal and ineres. Tus, he perormance o equiy securiies is closely ied o a firm’s profiabiliy and exhibis he mos variabiliy. Addiionally, equiies have he lowes prioriy o receive payback or asses in he even o bankrupcy and come afer crediors, employees, liens, and governmen claims. Ofen he shareholders o a bankrup firm receive nohing. o summarize, he characerisics o he equiy asse class are ha hey: (1) offer relaively higher expeced risk and reurn, (2) provide capial appreciaion and someimes income, and (3) represen ownership in a company. BONDS

Bonds, or fixed-income securiies, are loans o corporaions and oher eniies. When

a corporaion issues a bond, i asks or a loan rom he invesing communiy. Te loan increases boh cash (asses) and deb (liabiliies) on he borrower’s balance shee. Fixed-income securiies provide an invesor wih he opporuniy o earn ineres on he money loaned. Te amoun o capial and he paymen schedule are predeermined, and he ineres rae ha is charged is ypically quoed on an annual basis wih semiannual paymens. A he end o he predeermined period, he invesor receives he iniial invesmen and he final ineres paymen (D Amerirade 2015). Because fixed-income invesors provide companies wih unding, hey are considered crediors and in mos cases have a direc claim agains a company’s asses in he even o a bankrupcy. Fixed-income invesmens radiionally serve as a means o generaing income and preserving principal. Consequenly, invesors view i as a more deensive securiy relaive o socks. For his reason, a heavier allocaion o bonds is common in a porolio wih an objecive o generaing curren income or reducing risk. Fixed-income invesmens have limied upside he bes case is he reurn o principal and ineres on borrowed unds. o summarize, characerisics o fixed-income invesmens include (1) lower expeced risk and reurn han socks; (2) a ocus on income, no capial appreciaion: and (3) lower volailiy han equiies. REAL ESTA TE

Real esae in he ramework o an individual invesor’s porolio mos commonly is he

home in which he individual lives; and owing o he large relaive value o homes or individuals, i ofen makes up he single larges holding in a porolio. Some invesors

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may also own addiional real esae in he orm o land, invesmen properies, vacaion homes, and securiies such as real esae invesmen russ (EIs). o a lesser exen, individuals may have exposure o real esae hrough morgage-backed securiies (MBS) and oher varieies o securiized deb, bu hese alernaive rameworks are more common or insiuional invesors. Te reurn srucure o real esae holdings, wheher physical asses such as homes and land or securiies such as EIs and MBS, has hisorically been a low correlaion wih boh socks and bonds. Tis relaionship is a grea benefi o invesors because i can heoreically lower he overall risk o he porolio wihou sacrificing reurn poenial. However, real esae does pose challenges or individual invesors. Te primary challenge is he lack o acknowledgmen ha he home or oher propery is in ac an invesmen and should be considered par o he overall porolio. Tis menal barrier is less common or holders o EIs and real esae securiies, bu mus be overcome o ully comprehend he asse allocaion in place and he risk–reward profile o he porolio. CASH

Cash reers o deposis ha are considered risk ree in a local currency ha do no fluc-

uae in value. echnically, no asse is ree o risk, bu in he shor erm, inflaion and liquidiy concerns are ignored. Besides he physical noes, examples o cash alernaives include checking or savings accoun deposis, money marke unds, and shor-erm U.S. reasury bills (Morningsar 2015). Holding cash equivalens are mos common or a porolio manager because hey earn a posiive reurn. Cash plays an imporan role in managing a porolio when regular wihdrawals are required. I he invesmen policy saes ha a fixed amoun o unds mus be wihdrawn on a monhly basis, hen holding a cerain percenage o asses in cash offers flexibiliy or porolio managers because hey will no have o liquidae oher invesmens o ulfill he disribuion requiremen. Tis sraegy benefis he invesor by minimizing capial gains axes or posiions ha have appreciaed in value and prevens he unnecessary liquidaion o securiies ha have allen in value in wha poenially may be an inopporune ime o liquidae. Because cash is a “risk ree” asse, i has a zero correlaion wih sock, bond, and real esae holdings in a porolio. Tus, increasing he allocaion o cash serves o reduce a porolio’s risk. During imes o marke sress, cash alernaives are ofen in high demand as raders seek o reduce exposure o risky asses such as socks and low credi- qualiy fixed income. Cerain porolio managemen sraegies also call or cash holdings when securiies rading belo w inrinsic value canno be ound or idenified. W hen opporuniies presen hem selves, cash allows he manager he flexibi liy o purchase securiies wihou he unnecessary liquidaion o oher asses (“ buy on dips”). Alhough cash offers he aoremenioned benefis, he downside o holding his asse is reurn drag. Reurn drag is he opporuniy cos associaed wih he money’s no being invesed in oher securiies or asses during periods o increasing prices, which in urn lowers he porolio’s overall reurn. In summary, cash is a risk- ree asse ha reduces a porolio’s risk and offers flexibiliy, bu has reurn drag reducing a porolio’s reurn.

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THE RISK–

RETURN TRADE-

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ARKETS

OFF

isk and reurn are wo key consideraions in consrucing a porolio and finding he mos efficien balance, is he major objecive o asse allocaion models. An invesmen policy saemen (IPS) ypically conains he risk and reurn parameers or he objecives o he invesed unds oulined by he invesor, as well as he invesor’s abiliy and willingness o ake risk. Assessing he invesor’s risk olerance is imporan because i could be less han he invesor ypically expresses. In a porolio managemen conex, a common measure o risk is a porolio’s sandard deviaion. Tis measure provides insigh ino how much invesed capial could be los relaive o he average reurn o he marke. A more deailed IPS could assign probabiliies o he porolio disribuion. When deermining risk olerance, a financial advisor ypically profiles he clien o gain insigh ino his or her invesing experience, sage o lie, comor wih swings in marke value, and oher imporan consideraions. Invesors who have less experience, are older or reired, or express discomor wih quick changes in marke value ofen have a lower risk olerance. Conversely, experienced, or younger invesors who can accep significan changes in marke value end o have a higher risk olerance. Clariying he disincion beween porolio risk and reurn is o paramoun imporance. Te porolio reurn calculaion is inuiive, i involves aking he weighed average o he individual asse’s reurn, usually on a hisorical basis. Calculaing a porolio’s sandard deviaion is complicaed and mus explicily incorporae paired correlaions beween all asses. eurn objecives wihin a porolio conain wo pars: (1) he requency o cash flow disribuions, and (2) he annualized oal reurn. For example, income invesors require a seady flow o dividends or ineres paymens, which hey can use o cover expenses. By conras, growh invesors ofen have a longer invesmen ime horizon and hey ocus more on he appreciaion o an accoun’s value and less on inermiten cash flows. Growh and income invesing syles are no necessarily muually exclusive. Alhough MP requires an invesmen manager o consider all he invesable asses when designing he asse allocaion sraegy, many individuals exhibi a behavioral bias called menal accouning, which is he menal separaion o asses ino “buckes” o help keep heir finances organized. Phung (2007) defines menal accouning as “he endency or people o separae heir money ino separae accouns based on a variey o subjecive crieria, like he source o he money and inen or each accoun.” In any case, wheher invesing or growh, income, or some combinaion, he earnings o he accoun are measured in percenage unis and hey esimae, on average, he capial growh on an annualized basis. o pu his discussion on risk and reurn ino conex, consider he ollowing example. I a manager invess $1,000 in a porolio ha ollows a normal disribuion wih an expeced rae o reurn o 4 percen, a risk (sandard deviaion) o 6 percen implies ha a he end o he year he manager would expec earnings o all beween abou −2 percen and +10 percen wih a 68 percen probabiliy. Owing o he unique needs, preerences, and circumsances or each invesor, here is no single objecive measure ha defines he appropriae reurn or risk level or all invesors. However, he Sharpe raio is he excess reurn per uni o risk as measured by a porolio’s sandard deviaion. I measures he efficiency o he risk–reward profile. Tis

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raio divides he reurn o he porolio less he reurn o he risk-ree rae (i.e., excess reurn) by he porolio’s sandard deviaion. All else equal, invesors preer a higher Sharpe raio because i poins o a more efficien blend o risk and reurn. Sharpe (1994, p. 56) summarizes his measure: All he same, he raio o expeced added reurn per uni o added risk provides a convenien summary o wo imporan aspecs o any sraegy involving he difference beween he reurn o a und and ha o a relevan benchmark. Te Sharpe aio is designed o provide such a measure. Properly used, i can improve he process o managing invesmens. As his secion shows, risk reers o he sandard deviaion o a porolio’s reurns. Anoher measure o risk is sysemaic risk, or bea. Sysemaic risk is he aggregae risk associaed wih invesing in he sock marke and i canno be diversified away. Te firs model o rame risk in he conex o he overall marke was he CAPM. Based on Markowiz’s (1952) MP, he developers o his model are reynor (1999), Sharpe (1964), Linner (1965), and Mossin (1966). Perold (2004, p. 16) discusses he CAPM: “I is he relaionship beween expeced reurn and risk ha is consisen wih invesors behaving according o he prescripions o porolio heory.” Equaion 22.1 represens he CAPM ormula: R = R +β R F

(

(22.1)

−R

M

F

)

where  F is he risk-ree rae, is a measure o sysemaic risk, and  is he expeced M reurn o he marke. According o he CAPM, invesors are compensaed in wo ways: ime value o money and exposure o marke risk. Te risk-ree rae represens he ime value o money and compensaes invesors or invesing capial over a given ime period. Te risk erm, represened by ( R M − R F ), deermines wha he invesor requires o ake on addiional sysemaic risk inheren in he asse. According o he CAPM, he required reurn o an asse or porolio is equal o he risk-ree rae and a risk premium. I he expeced or orecased reurn is greaer han he required reurn, he invesmen is undervalued and represens a bargain. Te graphic represenaion o he CAPM or differen beas is called he securiy marke line (SML). Te SML permis assessing he risk profile o individual securiies or porolios (osenberg 1981). ALLOCATION MAINTENANCE

An imporan and perhaps underappreciaed aspec o porolio managemen is he procedures or and proocol o mainain and rebalance he invesmens. Sraegic asse allocaion (SAA) reers o he esablishmen o and adherence o a long-erm arge allocaion among equiy, fixed income, and cash. Te allocaion beween sock and bond asse classes is deermined based on a long-erm expeced reurn, risk, and pairwise correlaions. For example, i equiies have hisorically reurned 10 percen a year

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and fixed income has reurned 5 percen a year, a porolio combinaion o 50 percen equiies and 50 percen fixed income would yield an expeced reurn o 7.5 percen a year over a ull marke cycle. Tese reurn, risk, and correlaion esimaes are reerred o as capial marke assumpions(or esimaes) and hey assume he average reurn when considering periods o expansion and conracion in he business, credi, and marke cycle (Benz 2013). acical asse allocaion (AA) represens a more acive approach o weighing differen asse classes. Ta is, AA allows or a more flexible porolio relaive o SAA. Te porolio manager over-weighs or under-weighs he allocaions based on an assessmen o curren and expeced economic condiions. Tis process allows or poenial ouperormance relaive o he benchmark i shor- and inermediae-erm opporuniies arise ha warran an increased exposure o he asse class expeced o ouperorm or a decreased exposure o he asse class expeced o underperorm. AA allows he porolio manager emporarily o unbalance or rebalance a porolio o ake advanage o hese excepional opporuniies. Tis flexibiliy adds a marke-iming componen o he porolio, which permis paricipaion in hose asse classes wih avorable prospecs. Invesmen proessionals consider AA o be a relaively acive sraegy ha requires he willpower, discipline, and confidence o be able o reurn o he pre-se asse mix once he shor-erm opporuniy has passed. REBALANCING STRATEGIES

Several rebalancing sraegies exis ranging rom he very simple buy-and-hold o more sophisicaed ones. Te mos simplisic approach is he buy-and-hold sraegy, which does no rebalance he iniial allocaion. Tis asse allocaion sraegy is se a incepion, bu no adjused. Tus, securiies increasing in value represen a relaively larger porion o he accoun and securiies decreasing in value represen a relaively smaller porion. Implemenaion is easy and increases exposure o invesmens ha have perormed well while reducing exposure o hose ha have no. Ye, a buy-and-hold sraegy no only can aler he accoun’s risk-reurn profile bu also can lead o an evenual allocaion inconsisen wih he srcinal IPS. Calendar rebalancing is anoher rudimenary approach o rebalancing in which he invesor simply ses a dae, or several daes, hroughou he course o he year ha dicae when o place buy and sell orders o reurn he porolio’s allocaion o is arges. One simple suggesion is o rebalance once a year on he invesor’s birhday. Alhough his approach mainains he arge asse allocaion, i may also orce rades a wha may be inopporune imes while ignoring poenially beneficial rades in beween rebalancing daes. A more acive rebalancing approach is he consan mix sraegy. Te consan mix sraegy requires buying securiies ha have decreased in value and selling securiies ha have increased in value. Tis process orces he arge asse allocaion sraegy o remain fixed, bu ofen can incur large ransacion coss and axes i rebalancing is requen. Tis sraegy orms a conrarian sraegy in which invesors or porolio managers buy during alling markes and sell during rising markes. For hese reasons, mos managers se bands around asse class weighs so he rebalancing only needs o occur when allocaions drif ouside he iniial arge allocaion.

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Modern Portfolio Theory As previously discussed, Harry Markowiz (1952) develops a heory o porolio consrucion and evenually received he Nobel Memorial Prize in Economics or his seminal work in 1990. Alhough he basic enes o MP remain, he model has been expanded dramaically over ime and has become more complex. Te pioneering heory describes he seps a “raional invesor” should use o build a porolio ha opimizes reurn based on a saed level o risk. I ocuses on increased risk leading o higher reurn. According o Markowiz, orming reurn an “efficien o opimal porolios was possible ha maximized he expeced or anyronier” level o risk. MP has served as he backbone o academic finance or decades, bu i ress on unrealisic assumpions. Te overarching assumpion is ha invesors ocus on opimizing he risk–reward rade-off or a given porolio. Te ollowing assumpions are necessary or he MP o hold: 1. Invesors are raional, risk- averse, non-emoional beings, who solely ocus on maximizing risk-adjused reurn. MP assumes ha all invesors are idenically programmed compuers ha ollow a pre-se acion–reacion marix. Day-o-day ineracions wih ohers indicae ha his assumpion is alse, bu i is required or he model o be inernally consisen. 2. All invesors have perec and equal access o inormaion and have accuraely calculaed, in advance, an asse’s riskiness, and heir percepion o he reurn disribuion orms a normal disribuion. MP assumes ha asse prices reflec privae and inside inormaion and ha risk can be accuraely deermined ex-ane. Again, alhough his assumpion is alse, i mus be held or inernal consisency. 3. All correlaions beween asse pairs are consan over ime. MP assumes ha evens do no change he relaionships beween asses. Observaions o global markes show his assumpion is also alse because conagion occurs during marke shocks and crises, and correlaions ofen increase dramaically. 4. eurns are normally disribued and ail risk evens occur no more requenly han expeced rom a normal disribuion. In pracice, reurns end o deviae rom assumpions o normaliy based on observaions. ail risk evens, or exremely low probabiliy observaions ha lie in he “ails” o a bell curve, have hisorically occurred more han prediced by normal disribuion. 5. Invesors operae in a world o no ransacion coss and axes, and no minimum lo size exiss or an invesmen. Conrary o hese assumpions, all markes have ransacion coss, including commissions and bid–ask spreads; also, invesors ace capial gains and/or income axes as heir invesmens produce income or appreciae in value. Furhermore, MP assumes he abiliy o buy racional shares, which is no a reasonable assumpion or some invesmens. 6. Invesors are price akers in he classic economic sense. Ta is, hey can buy and sell any amoun o shares wihou affecing he price. However, supply and demand have an effec on asse prices in he marke. 7. Invesors can lend and borrow unlimied amouns a he risk-ree rae. Tis assumpion is no lierally rue, as in comparing he reurn on savings deposis o morgage raes rom he same insiuion. Addiionally, he cos and availabiliy o risk-ree

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asses change during adverse marke condiions or periods when he financial markes are under sress. Clearly, he MP is flawed and no direcly applicable o he behavior and realiies o capial markes. However, owing o a lack o alernaives, i has neverheless ormed he basis or many porolio managemen sraegies ha atemp o correc or offer addiional explanaory power using he same conceps as oulined in MP. Te mos imporan assumpion ha needs o be discussed is ha invesors always behave raionally. Te field o behavioral finance atemps o address his issue, bu i has been unable o develop or adap a universal soluion. MEAN- VARIANCE OPTIMIZATION AND THE BLACK- LITTERMAN MODEL

MP ses orh he conceps ha allow or he modeling o heoreically efficien porolios. Te acual mahemaical ramework or using risk, reurn, and correlaion o creae hese porolios is called mean-variance opimizaion(MVO). Te complicaed and ime-consuming calculaions necessary in MVO require using a compuer o deermine he opimal allocaion. Te inpus include risk and reurn daa ha are user-defined bu ypically ex- pos in naure (i.e., hey use hisorical daa o sugges he uure characerisics o each securiy). A porolio developed using MVO ypically suffers rom an overconcenraion o asses ino a ew securiies or asse classes and is highly inpu sensiive. Small changes in one or more o he risk, reurn, or correlaion parameers can cause dramaic differences in he resuling allocaions. Anoher drawback o his approach is he reliance on hisorical daa. Te hisorical reurns and level o risk associaed wih each o he securiies are unlikely o remain consan over he invesor’s ime horizon. For hese reasons, mos porolio managers use he MVO ramework as a guide and incorporae consrains around asse classes ha orce he oupu o have a minimum or maximum invesmen in a se o asse classes. For example, he user orces he allocaion o exhibi, say, a minimum o 40 percen and a maximum o 70 percen o equiies. Te ulimae allocaion o socks in his example alls inside he range and considers he mos efficien level o equiy exposure given he arge reurn or level o risk. Tis resul is anamoun o deermining he opimal allocaion mix under consrained opimizaion as opposed o unconsrained opimizaion, which is he MVO soluion. Perhaps he mos acceped adjusmen o MVO is he Black-Literman Model (Idzorek 2004). Tis model addresses he inpu sensiiviy assumpion o he MVO model and changes he parameers o give a view ha is no solely based on hisorical daa, bu also on he invesors’ views. Te Black-Literman Model overcomes he problem o high asse class concenraion, inpu sensiiviy, and esimaion error associaed wih he radiional MVO model. By aking he marke weighs on he asse classes ino consideraion and using he CAPM, a reverse opimizaion calculaion is perormed o generae an expeced reurn. Users o his model have he abiliy o express heir views on asse classes by adjusing he reurns calculaed o sugges an over- or underperormance relaive o he calculaion. Te resuling asse allocaion sraegy produced is a

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more diversified porolio relaive o MVO. Alhough he assumpions mus coninue o be held, he sensiiviy o he inpus is grealy reduced, resuling in a more sable porolio.

Behavioral Biases in Asset Allocation Te models and conceps discussed in he previous secion all under he caegory o radiional finance and assume ha invesors are raional. Ta is, invesors make every decision in he conex o heir overall porolios and goal o maximizing sel-ineress. Alhough some invesors migh be able o remove affecive (emoional) biases rom heir decision making, ohers allow eelings, emoions, and moods o influence heir invesmen decisions, ofen subconsciously. When invesors make a decision based on an emoion, hey suffer rom an emoional behavioral bias. Oher acors beyond emoions limi human decision making as well. Limiaions in cogniive abiliies and mechanical errors known as heurisics or menal misakes also creae behavioral biases ha preven invesors rom allocaing asses efficienly. A common example o his flaw o which invesors all vicim is he 1/N heurisic. Tis bias reers o he endency or invesors o allocae asses evenly across he invesmen choices ha are available o hem. o imagine his in pracice, consider employees who have 10 invesmen opions available in heir 401(k) plan. In an atemp o diversiy, hey may place 10 percen o heir unds in each securiy. Alhough Huberman and Jiang (2006) sugges ha his ype o allocaion is no ofen ollowed o he specificaion in his example, he line o hinking is no uncommon. Morrin, Inman, Broniarczyk, Nenkov, and euer (2012) ake his noion a sep urher and deermined ha a connecion exiss beween he number o unds available o 401(k) paricipans and he endency o allocae evenly. When invesors ace a large number o producs rom which o choose, hey become overwhelmed by he decision and are more likely o simpliy he process by allocaing he invesmen dollars in small (ofen no equal) percenages across a large number o unds. Tis oucome is he resul o a cogniive limiaion. Empirical evidence suggess ha cerain behavioral biases have a direc effec on aggregae asse pricing and can lead o excessively over- or undervalued asse classes (Baker and icciardi 2014). In he exreme, his collecive behavior o invesors can cause bubbles. Alhough researchers have idenified many cogniive and emoional biases, his secion o he chaper ocuses on five ha play an imporan role in he asse allocaion decisions o invesors. Familiariy, saus quo, raming, menal accouning, and overconfidence biases all preven invesors rom operaing raionally and orming efficien porolios. FAMILIARITY BIAS

Te amiliariy bias occurs when invesors place greaer value, or expresses a preerence or, holding securiies hey undersand or wih which hey have a connecion (Baker and icciardi 2014). Invesors who hold a large percenage o heir ne worh in heir employer’s sock exhibi his bias because hey are confiden hey know he company

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beter han oher invesors and believe he sock is perpeually undervalued. Benarzi (2001) invesigaes he effecs o pas perormance o company sock and he allocaion o employee discreionary unds o company sock in 401(k) plans. He suggess ha here is a posiive correlaion beween srong recen sock perormance and a greaer allocaion o employee 401(k) asses o company sock. Tis logic is also irraional rom a concenraion perspecive, because an invesor’s oal wealh, which includes labor income and financial wealh, now represens an even larger porion o his or her porolio. Familiariy is also expressed hrough a preerence or owning domesic sock over inernaional sock, which is also called home asse bias (Sammers 2011). Porolios ha are over-allocaed o a single securiy carry unnecessary addiional company-specific or nonsysemaic risk. Enron is a ragic example o his flaw. By one esimae, Enron employees invesed nearly 60 percen o heir 401(k) asses in Enron sock. Enron’s bankrupcy amid a massive accouning scandal subsequenly wiped ou his invesmen (Weinberg 2003). On a wider scale, amiliariy wih domesic securiies prevens an invesor rom reaping he benefis o a porolio wih inernaional diversificaion. As Figure 20.1 shows, inernaional socks are hisorically less han perecly correlaed wih he U.S. sock marke.

120% 100% 80% 60% 40% 20% 0% –20% –40% –60%

0 1 0 2 r e b m e c e D

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1 1 0 2 r e b m e t p e S

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2 1 0 2 r e b m e t p e S

2 1 0 2 r e b m e c e D

3 1 0 2 h rc a M

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3 1 0 2 r e b m e t p e S

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4 1 0 2 r e b m e t p e S

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5 1 0 2 h c r a M

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Morningstar Diversified EM (Price) S&P 500 TR USD (Price) MSCI ACWI Ex USA NR USD (Price)

Figure 20.1 Perormance o U.S., Inernaional, and Emerging Marke Sock Indexes. Tis figure shows he hisorical relaionship o monhly reurns or domesic U.S. socks (S&P 500  USD Price), developed inernaional socks (MSCI ACWI Ex USA N USD Price), and emerging markes (Morningsar Diversified EM Price) rom December 31, 2010 hrough Augus 31, 2015. Source: Bloomberg erminal as o Augus 31, 2015.

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able 20.1 Correlaion Marix ofU.S., Inernaional, andEmerging Marke Sock Indexes

Index

S&P 500 R USD (Price)

S&P500

1.00

MSCIACWIExUS

0.86

Morningsar Diversified EM

0.73

MSCI ACWI Ex USA NR USD (Price)*

Morningsar Diversified EM (Price)

1.00 0.90

1.00

Noe: Tis able shows ha he greaes diversificaion benefis come rom asses exhibiing a negaive correlaion. However, including asses in a porolio whose correlaions are less han perec (+1) also creaes efficiencies in he risk and reward profile. *MSCI ACWI Ex USA N USD (Price) reurn aken rom Bloomberg. Source: Auhors’ calculaions.

Tis ype o relaionship creaes diversificaion opporuniies and can improve a porolio’s Sharpe raio by lowering he porolio’s sandard deviaion. For example, able 20.1 considers he correlaion marix o he MSCI All Counry World Index, he S&P 500 index, and he Morningsar Emerging Markes Index. Familiariy bias is no unique o individual invesors. Using survey daa rom Merrill Lynch, Srong and Xu (2003) sudied und manager senimen in he Unied Saes, coninenal Europe, he Unied Kingdom, and Japan. Tey ound ha relaive o equiy markes, und managers view domesic prospecs more opimisically when compared o inernaional counerpars. However, his resul may no be a cogniive error bu, raher, a conscious business decision. Parwada (2008) poins ou he inormaional advanage und managers have when invesing in domesic socks versus inernaional socks. Choosing o hold a higher percenage o local versus inernaional equiies reduces research expenses. A a high level, amiliariy wih broad asse classes can be an impedimen o orming an efficien porolio. Invesors who have hisorically purchased equiies bu no fixedincome securiies may be hesian o inves in bonds because hey may no undersand how bonds uncion or see he benefis o inroducing a fixed-income securiy o heir sock porolios. Te opposie could also occur or invesors who have only invesed in fixed income and believe ha socks are oo risky. In eiher case, he porolio is unlikely o achieve he invesor’s long-erm goals cerainly no as quickly or as saely as when using a proper asse allocaion sraegy. STA TUS QUO

BIAS

Saus quo bias affecs invesors who canno build up enough momenum o change

heir asse allocaion, even when doing so is in heir bes ineress, because hey exhibi high levels o ineria or procrasinaion. Te reason or heir inabiliy o change may sem rom loss aversion, which is he unwillingness o sell a posiion a a loss. A raional

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invesor judges an invesmen based on is expeced uure perormance, no is recen hisory, and can sell regardless o an invesmen’s cos basis. Invesors ofen commen ha a loss is only a “paper loss” unil a posiion is sold; his view is incorrec because a securiy is only worh is selling price a a given momen plus he opporuniy cos o unding he invesmen. Tus his line o hinking can resul in he poor decision o holding a securiy whose undamenals sugges coninued underperormance relaive o he marke. Te low number o rades in reiremen accouns suggess ha his bias exiss on a broad scale. For example, icciardi (2012) repors ha over a wo-year period, abou 80 percen o paricipans in his sudy made very ew or no rades. Agnew, Balduzzi, and Sunden (2003) invesigaed reiremen accouns over a our- year period rom 1994 o 1998. Tey ound ha alhough rading aciviy varies depending on he characerisics o he paricipans, in aggregae he sudy’s paricipans made ewer han one rade a year. o overcome he saus quo bias, invesors should ask hemselves: “I I held cash insead o he securiy in quesion, would I buy i oday?” Tis orces an analysis o expeced reurn, raher han a view o he decline or appreciaion in value. Anoher way o overcome his bias is o adop a rebalancing approach ha requires making rades eiher annually or afer he porolio has deviaed rom he arge asse allocaion sraegy (Baker and icciardi 2014). Besides here being a lower number o rades aking place wihin reiremen accouns, many savers who are auomaically enrolled in company 401(k) plans make no iniial change away rom he deaul und in which hey were placed a he ouse. Madrian and Shea (2001) explored he saus quo bias in his conex and ound ha he majoriy o 401(k) paricipans, who were enrolled auomaically, mainain he deaul asse allocaion. Considering he deaul und and he asse allocaion are likely inappropriae or every paricipan, his saus quo bias causes an inefficien allocaion o boh preax income and he asses wihin he plan. Bilias, Georgarakos, and Haliassos (2010) find ha in ollowing large marke downurns, paricipans do no reduce heir equiy holdings, suggesing ha acquiring new inormaion is no resuling in asse allocaion adjusmens owing o ineria. FRAMING

Framing biases are common no only in asse allocaion and behavioral finance bu also in oher aspecs o human decision making. Framing is he endency o behave differenly depending on how inormaion is presened (Barclays 2007). For example, consider presening wo porolios, A and B, o an invesor as ollows: porolio A has a 75 percen chance o reurning 10 percen and a 25 percen chance o reurning 0 percen, whereas porolio B is expeced o have a fixed reurn o 8 percen. An invesor who chooses porolio A makes he decision o do so because he perceives he high probabiliy o earning 10 percen as more atracive han he lower 8 percen yield. Mahemaically, porolio B yielding 8 percen is more atracive rom a risk–reward sandpoin. Seul (2006) recognizes his ype o behavior and goes urher o describe how he ype o disribuion and he invesor’s own undersanding o risk influence he raming effec. Te auhor concludes ha he effecs o raming are presen under boh posiively correlaed porolios and ambiguous risk. In oher words, when he

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dispersion o reurns o he individual securiies ha make up a porolio are correlaed, and when risk is ambiguous, raming is presen. Using a conrolled experimen, Diacon and Hasseldine (2007) deermined ha he orma used o presen pas perormance o invesors alers heir view o he invesmen’s poenial risk and reward. Specifically, observers preer viewing he reurn o an equiy und when expressed in an “index o und values” orma raher han a percen reurn orma. Invesors mus no only be aware o he way projeced uure reurns are presened bu also he way pas reurns are expressed. Invesors who wan o buy a sock or bond or heir porolios mus also be aware o he way he relevan inormaion abou he securiy is presened. For example, beore he issuance o an iniial public offering (IPO), invesmen bankers and he company’s managemen eam go on a “road show” designed o generae ineres in he company by brokerage houses. Te invesmen bankers are likely o rame inormaion abou he company in he bes ligh possible. Consequenly, analyss and uure invesors migh wan o consider all available inormaion, including filings o he Securiies and Exchange Commission (SEC), and no simply rely on inormaion presened by he paries wih possible conflics o ineres. Tis bias can aler a porolio’s asse allocaion sraegy by influencing invesors o deviae rom an efficien blend o socks, bonds, real esae, and cash o a mix ha appears atracive based on he presenaion o he inormaion. When invesors receive a call rom a financial advisor who describes a grea sock or bond rade, hey should make he buy decision in he conex o heir exising asse allocaion sraegy and no simply on he meris o he securiy alone. Invesors should be aware o his flaw in decision making and avoid basing heir invesmen decisions on inormaion ha presens securiies in a posiive ligh bu neglecs wha may be heir undamenal weaknesses. MENT AL ACCOUNTI

NG

Menal accouning reers o he cogniive organizaional echnique many invesors

employ by separaing heir invesmens ino differen buckes, wihou considering he overall asse allocaion. More broadly, menal accouning can also be used in he conex o a menal separaion o personal finances and budgeing. For example, evidence shows ha menal accouning plays a role in personal budgeing, no only in a moneary sense bu also in erms o ime and energy. For example, Heah and Soll (1996) discuss how individuals’ labeling o expenses (i.e., or business or a personal hobby) affecs he value hey place on he expendiures, wheher ha value be money, ime, or energy. Menal accouning affecs a person’s view o his or her curren expendiures as i relaes o moneary oulays. For insance, individuals have a endency o separae expenses used or immediae consumpion rom hose o be used laer (Shafir and Taler 2006). Menal accouning in he conex o asse allocaion can poenially have a negaive impac on a porolio. For example, i an invesor experiences an unrealized capial loss, bu places oo much imporance on he dividend received, hen he porolio may be inefficienly allocaed (Baker and icciardi 2015). Similarly, individuals who own real esae display menal accouning by no considering he real esae propery as par o heir overall porolio. For his reason, individuals are more likely o sell propery valued

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above is purchase price and less willing o sell when acing a loss (Seiler, Seiler, and Lane 2012). In he conex o asse allocaion, menal accouning can cause invesors o ocus on he raio o socks o bonds in an accoun- by-accoun basis, wihou considering heir enire exposure in socks versus bonds. For example, an invesor can srucure his reiremen accoun more aggressively wih a 70 percen sock and 30 percen bond allocaion, and a less risky nonqualified accoun wih an asse allocaion o 70 percen bonds and 30 percen socks. Alhough he invesor may eel good abou having he aggressive unds in he reiremen accoun and conservaive unds in he axable accoun, he realiy is ha he porolio would have he same level o risk and reurn poenial i he invesor had boh accouns wih a single 50/50 porolio (assuming equal dollar values o boh accouns and ignoring axes). Choi, Laibson, and Madrian (2009) invesigaed his issue empirically by comparing he asse allocaion sraegies o 401(k) paricipans’ own conribuions and heir employer conribuions. Tey ound ha when employers conrol he invesmen o heir conribuions, paricipans do no adjus heir conribuions (whose asse allocaion is under heir conrol) o reflec he employer’s invesmen choices. Tis suggess ha individuals do no incorporae he allocaion o all heir accouns when selecing invesmens. Simply ocusing on he asse allocaion in each accoun is inappropriae. Invesors can overcome his bias by considering he asse allocaion sraegy associaed wih he overall porolio, and no on an accoun-by-accoun basis.

OVERCONFIDENCE

According o Parker (2013), overconfidence has wo componens: overconfidence in he qualiy o he inormaion received and overconfidence in one’s abiliy o ac on ha inormaion. Te previously discussed asse allocaion models assume ha raional invesors creae heoreically correc porolios. Overconfiden porolio managers and invesors can rely oo heavily on hese models, and his bias can cause overreliance on he oupu he model produces. elying oo heavily on he inpus o hese models is anoher source o overconfidence bias ha negaively weighs on a porolio’s efficiency. Overconfiden invesors can also have inefficien rading paterns, moving in and ou o posiions oo quickly in he belie ha hey can ouperorm he marke. Tis excessive rading incurs heavy ransacion coss and poenial axable evens, and can lower he porolio’s overall reurn (Koeserich 2013). For example, increases in rading aciviy are ypical or individual invesors ollowing bull markes. Te recen posiive pas perormance o equiies during a bull marke cycle brings he individual invesor’s atenion o he perceived opporuniies ha exis and leads o increases in rading aciviy (Chuang and Susmel 2011). Cerified Financial Planners (CFPs) also all vicim o overconfidence. Using survey daa, Cordell, Smih, and erry (2011) compared he confidence levels o financial proessionals who only earned he CFP cerificae wih hose held boh he CFP and Charered Financial Analys (CFA) designaions. Tey ound ha hose only having he CFP designaion are more confiden in heir overall abiliies o give invesmen advice han are hose wih boh designaions. Individuals, arguably less skilled han eiher a

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CFP cerificae holder or a CFA charerholder, should ake special noe o approach invesmen decisions humbly. Invesor confidence mus be balanced wih an undersanding o he limis o a given model or an invesor’s cogniive abiliies. Te later is a much harder menal barrier or invesors o overcome, bu placing oo much weigh on he abiliies o any one decision maker ofen leads o cosly misakes.

Summary and Conclusions o creae a model ha incorporaes he risk and reurn characerisics o securiies, as well as he correlaions beween asse classes, Markowiz (1952) assumed ha all invesors are raional and emoionless. Te pricing and asse allocaion models ha ollowed, including he CAPM and he Black-Literman Model, also generae oupus ha are heoreically sound according o Markowiz’s world. Behavioral finance atemps o incorporae human naure ino capial marke pricing and porolio-level allocaion decisions. Behavioral biases represen he emoional and cogniive errors ha are so common in decision makers. Invesors should ake seps o ideniy and correc hese ofen subconscious biases o avoid misallocaing heir capial. For insance, amiliariy bias can direcly lead o under-diversificaion. Saus quo bias, which is a common problem wih invesors saving or reiremen, can lead o an unusually low urnover in an invesor’s accouns. As a resul, invesors ofen ail o rebalance heir porolios. Framing can generae inefficien allocaion o asses owing o his cogniive consrain. Menal accouning can be beneficial o invesors who use i as a ool o keep unds organized; however, his bias can hur invesors who make asse allocaion decisions on a “bucke-o-bucke” basis and do no consider he asse allocaion o heir enire porolio. Finally, overconfidence has he poenial o impac an invesor’s porolio wih negaive side effecs o placing oo much aih in boh hisorical daa and he abiliy o make sound decisions wih his daa. Overconfiden invesors can rely oo heavily on models ha use radiional finance assumpions and rade oo ofen, believing hey can ouperorm he marke. Te five behavioral biases reviewed in his chaper serve as an example o some o he mos common errors in decision making. Alhough avoiding hese misakes on a subconscious level migh be difficul, invesors should make an effor o ideniy hem and undersand he effecs hey have on heir overall asse allocaion policy or rading behavior.

DISCUSSION QUESTIONS 1. Define acical asse allocaion (AA) and discuss he advanages and disadvanages relaive o sraegic asse allocaion (SAA). 2. Discuss he assumpions used in modern porolio heory (MP) and radiional finance models. 3. Discuss he shoralls o mean- variance opimizaion (MVO) porolios and how he Black-Literman Model atemps o address hese shoralls.

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4. Disinguish beween cogniive and emoional errors, and provide an example o each. 5. Discuss he advanages and disadvanages o menal accouning and how invesors can manage his cogniive error.

REFERENCES Agnew, Julie, Pierlugi 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 Vicor icciardi. 2014. “How Biases Affec Invesor Behaviour.”European Financial Review. February, 2014. Available a htp://www.europeanfinancialreview.com/? p=512. Baker, H. Ken, and Vicor icciardi. 2015. “Undersanding Behavioral Aspecs o Financial Planning and Invesing.”Journal o Financial Planning 28:3, 22–26. Barclays. 2007. “Wha Is Framing?” Available a htps://www.invesmenphilosophy.com/us/ behavioural-finance/decision-making-maters/wha-is-raming. Benarzi, Shlomo. 2001. “Excessive Exrapolaion and he Allocaion o 401(k) Accouns o Company Sock.”Journal o Finance 56:5, 1747–1764. Bilias, Yannis, Dimiris Georgarakos, and Michael Haliassos. 2010. “Porolio Ineria and Sock Marke Flucuaions.”Journal o Money, Credi and Banking 42:4, 715–742. Brinson, Gary, L. andolph Hood, and Gilber Beebower. 1986. “Deerminans o Porolio Perormance.” Financial Analyss Journal42:4, 39–44. Available a htp://www.capubs.org/ doi/pd/10.2469/aj.v42.n4.39. Benz, Chrisine. 2013. “Find he igh Sock/Bond Mix.” Morningsar. Available ahtp://news. morningsar.com/ariclene/aricle.aspx?id=619829. Choi, James J., David Laibson, and Brigite C. Madrian. 2009. “Menal Accouning in Porolio Choice: Evidence rom a Flypaper Effec.” American Economic Review 99:5, 2085–2095. Chuang, Wen-I, and auli Susmel. 2011. “Who Is he More Overconfiden rader? Individual vs Insiuional Invesors.”Journal o Banking and Finance 35:7, 1626–1644. Cordell, David M., achel Smih, and Andy erry. 2011. “Overconfidence in Financial Planners.” Financial Services Review 20:4, 253–263. Diacon, Sephen, and John Hasseldine. 2007. “Framing Effecs and isk Percepion: Te Effec o Prior Perormance Presenaion Forma on Invesmen Fund Choice.”Journal o Economic Psychology 28:1, 31–52. Heah, Chip, and Jack B. Soll. 1996. “Menal Budgeing and Consumer Decisions.”Journal o Consumer Research 23:1, 40–52. Huberman, Gur, and Jiang Wei. 2006. “Offering versus Choice in 401(k) Plans: Equiy Exposure and Number o Funds.”Journal o Finance 61:2, 763–801. Idzorek, Tomas M. 2004. “A SepGuide o he Black-Literman Model.” Working Paper, Zephyr Associaes. Available aby-sep htps://aculy.uqua.duke.edu/~charvey/eaching/BA453_ 2006/Idzorek_onBL.pd. Koeserich, uss. 2013. “Overcoming 3 Bad Invesing Behaviors.” February, 2013. Available a htps://www.blackrockblog.com/2013/02/06/overcoming-3-bad-invesing-behaviors/. Linner, John. 1965. “Te Valuaion o isk Asses and he Selecion o isky Invesmens in Sock Porolios and Capial Budges.”Review o Economics and Saisics 47:1, 13–37. Madrian, Brigite C., and Dennis F. Shea. 2001. “Te Power o Suggesion: Ineria in 401(k) Paricipaion and Savings Behavior.”Quarerly Journal o Economics 116:4, 1149–1187. Markowiz, Harry. 1952. “Porolio Selecion.” Journal o Finance 7:1, 77–91. McFarland, Margare. 2002. “Final ule: Amendmen o Definiion o ‘Equiy Securiy.’” Securiies and Exchange Commission. Available a htps://www.sec.gov/rules/final/33-8091.hm.

37

Traditional Asset Allocation Securities

377

Morningsar. 2015. “Cash Equivalen.” Available ahtp://www.morningsar.com/InvGlossary/ cash_equivalen_definiion_wha_is.aspx. Morrin, Maureen, J. Jeffrey Inman, Susan M. Broniarczyk, Gergana Y. Nenkov, and Jonahan euer. 2012. “Invesing or eiremen: Te Moderaing Effec o Fund Assormen Size on he 1/N Heurisic.” Journal o Markeing Research 49:4, 537–550. Mossin, Jan. 1966. “Equilibrium in a Capial Asse Marke.” Economerica 34:4, 768–783. Parker, im. 2013. “4 Behavioral Biases and How o Avoid Tem.” Invesopedia. Available htp:// a www.invesopedia.com/ aricles/ invesing/ 050813/ 4- behavioral- biases- and- how- avoidhem.asp. Parwada, Jerry . 2008. “Te Genesis o Home Bias? Te Locaion and Porolio Choices o Invesmen Company Sar-Ups.” Journal o Financial and Quaniaive Analysis 43:1, 245–266. Perold, Andre F. 2004. “Te Capial Asse Pricing Model.” Journal o Economic Perspecives 18:3, 3–24. Phung, Alber. 2007. “Behavioral Finance: Key Conceps Menal Accouning | Invesopedia.” Invesopedia. Available a htp://www.invesopedia.com/universiy/behavioral_finance/ behavioral5.asp. icciardi, Vicor. 2012. “Our 3-year Marke Hangover.” MoneySense. Available a htp://www.moneysense.ca/inves/our-3-year-marke-hangover/. osenberg, Barr. 1981. “Te Capial Asse Pricing Model and he Marke Model.” Journal o Porolio Managemen 7:2, 5–16. Securiies and Exchange Commission. 2009. “Beginners’ Guide o Asse Allocaion, Diversificaion, and ebalancing.” Available a htp://www.sec.gov/invesor/pubs/asseallocaion.hm. Seiler, Michael J., Vicky L. Seiler, and Mark A. Lane. 2012. “Menal Accouning and False eerence Poins in eal Esae Invesmen Decision Making.”Journal o Behavioral Finance 13:1, 17–26. Shafir, Eldar, and ichard H. Taler. 2006. “Inves Now, Drink Laer, Spend Never: On he Menal Accouning o Delayed Consumpion.” Journal o Economic Psychology 27:5, 694–712. Sharpe, William F. 1964. “Capial Asse Prices: A Teory o Marke Equilibrium under Condiions o isk.” Journal o Finance 19:3, 425–442. Sharpe, William F. 1994. “Te Sharpe aio.” Journal o Porolio Managemen 21:1, 49–58. Sammers, ober. 2011. “Tree Behavioral Biases Ta Can Affec Your Invesmen Perormance.” Forbes, December 21. Available a htp://www.orbes.com/sies/cainsiue/2011/12/21/ hree-behavioral-biases-ha-can-affec-your-invesmen-perormance/. Seul, Marina. 2006. “Does he Framing o Invesmen Porolios Influence isk-aking Behavior? Some Experimenal esuls.” Journal o Economic Psychology 27:4, 557–570. Srong, Norman, and Zinzhong Xu. 2003. “Undersanding he Equiy Home Bias: Evidence rom Survey Daa.” Review o Economics and Saisics 85:2, 307–312. D Amerirade. 2015. “Add Diversiy and Sabiliy o Your Porolio wih Fixed Income Securiies.” Available a htps://www.damerirade.com/educaion/accoun-ypes-and-invesmenproducs/bonds-and-cds.page. reynor, Jack L. 1999. “oward a Teory o Marke Value o isky Asses.” In ober A. Korajczyk (ed.), Asse Pricing and Porolio Perormance, 15–22. London: isk Books. Forbes

Weinberg, Ari. 2003. “Te Pos-Enron 401(k).” , Ocober 20. Available a htp://www.orbes. com/2003/10/20/cx_aw_1020reiremen.hml.

21 Behavioral Aspects of Portfolio Investments NATHAN MAUCK Assistant Professor University of Missouri – Kansas City

Introduction radiional finance heory suggess ha individuals enrus heir invesmens o financial insiuions in an effor o increase expeced reurns and/or o reduce risk. Alhough many individuals manage all or par o heir wealh independenly, hey mus sill work wih exisingmoney financial producs. Furhermore, individuals use hemanagemen services o proessional managers. Indeed, he sheermany volume o asses under (AUM) by financial insiuions signals heir imporance. According o he Organizaion o Economic Cooperaion and Developmen (OECD 2014), muual unds represen he larges such o his invesmen group as o 2014, wih roughly $30 rillion in AUM. Oher imporan insiuional invesors and money-managemen producs by size include exchange-raded unds (EFs), hedge unds, and pension unds, wih an esimaed $2.3 rillion, $2.5 rillion, and $20 rillion o AUM, respecively. Te relaive imporance o hese insiuions in he marke has increased remendously over ime. Blume and Keim (2012) show ha he proporion o U.S. publicly raded equiy held by insiuions increased rom around 8 percen in 1950 o nearly 67 percen in 2010. On average, hen, insiuional invesors should be more sophisicaed, skilled, and raional han reail invesors. In ac, alhough many reasons exis or he growh in isabsolue size and imporance perceived benefi proessional asserelaive managemen skills.o insiuional invesors, one However, non-wealh-maximizing or irraional insiuional invesor behavior could explain oucomes ha do no mach hese insiuions’ perceived raional superioriy. Te firs such disconnec ha beween he perceived benefis o insiuions and realiy is he underperormance onaverage o hose insiuional invesors. A poenial driving orce behind his underperormance may be behavioral biases o insiuional invesors. In shor, an a priori expecaion is ha insiuional invesors are raional and wealhmaximizing invesors, bu his assumpion may be incorrec. In ruh, proessional money managers demonsrae such biases as overconfidence, opimism, amiliariy, home bias, herding, limied atenion, disposiion effec, and escalaion o commimen, among ohers. 378

379

Behavioral Aspects of Portfolio Investments

379

Te second disconnec ha beween invesor expecaions o insiuions and realiy is relaed o he raionaliy, or lack hereo, o hose individuals who are selecing he insiuions. Specifically, regardless o he raionaliy o insiuional invesors, reail invesors are likely o exhibi he usual biases wheher hey are selecing individual asses or producs rom insiuions such as muual unds and hedge unds. For insance, research has shown ha reail invesors chase he muual unds and hedge unds wih he highes reurns. Ye, doing so appears subopimal, based on he observaion ha und reurns are largely unpredicable. Tis rend-chasing may be atribued o behaviors such as a represenaive bias, which holds ha invesors over-weigh recen experience when orming heir expecaions o uure oucomes, leading hem o chase high reurns by seeking ou recen high perormers. Addiional individual invesor biases are documened in he conex o specific money managers and heir producs, discussed in his chaper. Te raionales or orming muual unds, EFs, hedge unds, and pension unds dier, as do heir respecive levels o regulaory oversigh. Such differences in producs warran a close examinaion o each ype. Tereore, he purpose o his chaper is o explore he financial behavior o each o hese imporan classificaions o invesmens. For each ype o money manager and/or produc, he chaper presens evidence o he raionaliy o boh is invesor group and he reail invesors who demand ha service. Collecively, he evidence suggess ha acual perormance and pracices o hese invesmen insrumens and heir managers do no mach he radiional finance expecaions o wealh maximizaion and raional paricipaion. Te firs secion o his chaper describes muual und size, perormance, and raionaliy, ollowed by a discussion o he emergence o EFs and evidence o heir abiliy o enhance marke efficiency. Ten here is a secion on he perormance and invesor biases or hedge unds, and a subsequen secion on evaluaing pension und perormance and he poenial behavioral biases o pension und managers. Te chaper ends wih a summary and conclusions.

Mutual Funds Te amoun o AUM in muual unds is impressive. According o he Invesmen Company Insiue (ICI 2015), muual unds conrol $16 rillion in U.S. asses alone as o year-end 2014. able 21.1 displays he annual inflow/ouflow o cash or U.S. muual unds beween 2000 and 2014, based on daa rom ICI. Te average annual inflow is $196 billion, even wih he ne ouflow period associaed wih he financial crisis ha persised beween 2009 and 2011. Invesor demand and he desire o invesors o mee financial objecives, including reurn maximizaion and risk managemen, are driving orces underlying he huge size o muual unds. According o ICI, roughly hal o all muual und allocaions are o publicly raded equiy, wih bond unds and money marke unds making up abou 40 percen o allocaions. oughly 89 percen o muual und asses come rom households. Based on he sources o muual und asses and he objecives o invesors in muual unds, he primary quesion o ineres is wheher he expecaions o hese households are being me.

380

BEHAVI ORAL ASPECTS OF IN

VESTMENT PRODUCTS AND M

ARKETS

able 21.1 Annual Cash Flows in U.S. Muual Funds, Based on ICI Daa Year

Ne New Cash Inflow (Ouflow) in $Billions

2000

388

2001

504

2002

75

2003

–48

2004

53

2005

254

2006

472

2007

879

2008

412

2009

–150

2010

–281

2011

–96

2012

198

2013 2014

175 102

Noe: Tis able presens he yearly ne new cash inflow or ouflow o U.S. muual unds beween 2000 and 2014. Source: ICI (2015).

ACTIVE VERSUS PASSIVE

One useul disincion o make in evaluaing muual und perormance is beween acive and passive managemen. Alhough overall AUM remains much larger or acively managed unds, passive unds such as index unds have increased in populariy. In paricular, ICI daa indicae ha index unds accoun or roughly $2.1 rillion o he $16 rillion in U.S. muual und asses. O paricular noe is ha index unds added nearly $150 billion in 2014, compared o an overall inflow o only $100 billion or he indusry overall in 2014. Tus, a ne ouflow o AUM in acively managed unds occurred in 2014, which was offse by an inflow ino passively managed index unds. able 21.2 displays he annual cash inflows ino U.S. index muual unds beween 2000 and 2014. Te relaive increase in imporance o index muual unds is consisen wih invesors’ becoming more ineresed in passively racking he marke versus atemping o pick money managers who bea he marke.

381

Behavioral Aspects of Portfolio Investments

381

able 21.2 Annual Cash Flows in U.S. Index Muual Funds, Based on ICIDaa Year

Ne New Cash Inflow (Ouflow) in $Billions

2000

26

2001

27

2002

25

2003

35

2004

40

2005

28

2006

33

2007

61

2008

35

2009

56

2010

58

2011

55

2012

59

2013 2014

114 148

Noe: Tis able presens he yearly ne new cash inflow or ouflow in U.S. index muual unds beween 2000 and 2014. Source: ICI (2015).

MUTUAL FUND PERFORMANCE

Much research is available on he perormance o acively managed muual unds, and his research ypically documens underperormance. In a seminal sudy, Jensen (1968) examines 115 muual unds and ound ha hey were unable, on average, o ouperorm he marke. In a paricularly sarling resul, Jensen finds ha muual unds canno recover heir expenses. Tus, invesors generally pay ees only o achieve lower perormance han passively holding he marke. More recen research, including Gruber (1996), French (2008), and Fama and French (2010) also documens he negaive afer-ee alphas or acively managed U.S. equiy muual unds. Alpha reers o riskadjus reurns (i.e., reurn no explained by risk). Considerable debae surrounds he raionaliy o reail invesor demand or acively managed muual unds, which ulimaely ail o ouperorm he marke on a risk- and ee-adjused basis. Invesor demand is even more difficul o explain, considering he relaively large compensaion and ees ha accrue o financial inermediaries.

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CHASING RETURNS

Te lieraure is divided on wheher i is raional or invesors o pay muual und managers who ail o generae alpha. Ye, Gruber (1996) finds ha invesors chase perormance, and ha perormance is parially predicable. Tese findings sugges ha invesors may be more raional han he iniial evidence on muual und perormance and reurn-chasing in paricular would indicae. Similarly, Berk and Green (2004) developed a model showing ha he observed characerisics o he muual und indusry are mosly consisen wih a raional and compeiive marke. A key insigh gained rom he model is ha compeiion in he muual und indusry is responsible or he ailure o acive und managers o bea he marke. In shor, heir model suggess ha muual und managers have differen levels o abiliy. Invesors chase perormance, and heir influx o money ensures ha uure reurns o successul managers will be compeiive. Tus, invesors canno predic which managers will have he greaes skill. Fama and French (2010) sugges ha heir empirical evidence conradics he Berk and Green model. Specifically, hey ound ha gross und reurns are zero, and ha negaive alpha is equal o he ees o he und. Tus, invesors do no earn zero alphas by invesing in acively managed unds bu, raher, earn negaive alpha on average. Noneheless, some inerpre Fama and French as supporive o Berk and Green. BEHAVIORAL ISSUES

Some researchers sugges ha he underperormance o muual unds may be due o behavioral biases and irraional invesmen choices on he par o und managers. One o he firs behavioral biases linked o muual und managers is herding (Wermers 1999), which is he endency o ollow ohers when rading. Herding could be raional i ollowing ohers led o generaing alpha, bu he lieraure indicaes ha his is no he case. Anoher behavioral bias relaed o muual und perormance is he amiliariy bias, which also maniess isel in muual unds hrough he home bias, or he endency o inves in asses ha are geographically close o und headquarers (Baker and Nosinger 2002). LIMITED ATTENTION AND DISPOSITION EFFECT

Fang, Peress, and Zheng (2014) examined wo behavioral explanaions or muual und invesmen selecion and perormance, ocusing on he role o media in muual und sock selecion. Teir firs hypohesis relaes o limied atenion. As developed in Kahneman (1973), limied atenion is a bias relaed o he observaion ha individuals’ ime is scarce and ha his lack o unlimied atenion may lead o cerain biases. In he conex o muual und managers, invesors are more likely o noice and poenially selec socks ha receive media coverage, regardless o wheher doing so is wealh maximizing. Media atenion may explain und underperormance, given ha he moivaion or sock selecion is no based on skill or superior inormaion. Similarly, und managers may be less prone o he behavioral bias o limied atenion and may insead exploi his bias among individual invesors. In shor, muual und managers would sill rade in high media-coverage socks, bu heir superior skill and abiliy o ideniy he mispricing caused by biased individual invesors would resul in

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superior perormance. Te resuls o Fang e al. are consisen wih muual und managers’ suffering rom he same limied atenion biases as do individual invesors raher han wih exploiing mispricing owing o reail invesors’ biases. Ohers examine he disposiion effec, which is relaed o prospec heory (Kahneman and versky 1979) in he conex o muual und underperormance. Te disposiion effec is he endency o gamble more wih losses han wih profis. Hence, invesors end o sell winners and hold losers. Lin, Fan, and Chi (2014) sudy he disposiion effec in muual und managers and find ha i negaively affecs he perormance o he unds. Te observed escalaion o commimen is relaed o sel-atribuion, opimism, and cogniive dissonance. Sel-atribuion suggess ha individuals assign success o heir skill and ailure o bad luck. Opimism is relaed o individuals who are biased in heir orecass and overesimae heir poenial oucomes. Cogniive dissonanceis he sae o having inconsisen houghs, belies, or atiudes, especially as relaing o behavioral decisions and atiude changes. Collecively, his bias may lead o an escalaion o commimen whereby a und manager may sick o a losing invesmen sraegy and hus could exacerbae underperormance. Te survey evidence presened in Goezmann and Peles (1997) is consisen wih cogniive dissonance, as he auhors find a posiive bias involving muual und invesors’ memory o pas reurns. BEHAVIORAL BIASES IN SELECTING MUTUAL FUNDS

Muual unds end o underperorm on average, and some porion o he underperormance could resul rom behavioral biases. Tis observaion leads o he second major heme o his chaper, which is he behavioral biases o individuals who selec such unds. In paricular, why i is ha invesors demand cosly financial insrumens ha ail o bea passive sraegies is a puzzle ha has been addressed by he lieraure. Much early work in behavioral finance and individual invesor biases has ocused on sock picking raher muual und selecion; however, wo early resuls rom he behavioral lieraure and muual unds sand ou. Firs, invesors choose unds wih high ees despie exacerbaing underperormance (Gruber 1996; Barber, Odean, and Zheng 2005). Second, invesors chase pas perormance when selecing muual unds (Sirri and uano 1998; Bergsresser and Poerba 2002; Sapp and iwari 2004). As noed previously, Gruber (1996) documens his patern, bu inerpres he relaion as relaively raional, given ha he finds muual und perormance o be parially predicable. Subsequen lieraure, however, does no ypically concur wih he predicabiliy conclusion. Te behavioral lieraure insead suggess ha reurn chasing in his conex is irraional and he resul o agency problems (Chevalier and Ellison 1997). Overall, his finding suggess ha invesors coninue o demand acively managed muual unds parly because hey observe some unds ouperorming passive sraegies and hey believe hey can earn similar superior reurns in he uure by “chasing” hese unds. Bailey, Kumar, and Ng (2011) provide one o he ew behavioral sudies linking individual characerisics o muual und selecion. Tey examined a wide range o he behavioral biases ound in individual sock selecion in he conex o muual und selecion, using housands o brokerage accouns or U.S. reail invesors. In paricular, he auhors ocused on he disposiion effec. Bailey e al. creaed a disposiion effec proxy based on individual invesors’ acual realizaion o gains and losses. Tey also examined

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he role o narrow raming in muual und invesing. Narrow faming is he endency o ocus on individual invesmens wihou considering he porolio more generally. Tis endency is measured by ideniying invesors wih less clusered rades, which are more likely o suffer rom raming. Anoher behavioral bias considered is overconfidence, which maniess isel in his case as he endency o rade oo requenly, bu unsuccessully. Te auhors proxied his bias using porolio urnover and a dummy gender variable. Familiariy was measured by local bias, which was he disance beween he invesor’s home and he und’s headquarers. Te invesor gambling preerence was examined by ideniying lotery socks, which are low-priced socks wih boh high idiosyncraic volailiy and idiosyncraic skewness (based on Kumar 2009). Finally, hey examined invesor inatenion o earnings news and macroeconomic news. Bailey e al. (2011) find ha behavioral acors are relaed o selecing invesmens. In paricular, invesors who exhibi biases end o choose high-ee unds and avoid lowee index unds. Muual und invesors also rade more requenly and are more likely o chase rends. Given ha his invesmen ype exhibis paricularly poor invesmen reurns, he evidence is inconsisen wih ha indicaing invesors chase reurns based on raional crieria. In shor, behavioral biases o he individuals could explain he puzzling demand or underperorming acive muual unds. Anoher possible explanaion or he reurn-chasing observed in he reail invesor selecion o muual unds is he ho-hand allacy (Kahneman and iepe 1998). Gilovich, Vallone, and versky (1985) examine he ho-hand allacy in he conex o baskeball. Tey noe ha boh baskeball ans and players believe ha players have periods in which hey are paricularly “ho,” meaning heir perormance posiively deviaes rom heir long-erm average perormance. Te auhors conclude ha his belie is an illusion, because he number o acual deviaions rom long-erm averages is wihin he bounds o wha should be expeced based purely on chance. In he conex o muual und selecion, hen, he ho-hand allacy reers o invesors’ observing a “ho” sreak by a given und ha has recenly had srong perormance and incorrecly inerring ha he und will coninue o ouperorm in subsequen periods. INDEX MUTUAL FUNDS

Alhough he populariy o acively managed unds despie heir underperormance seems irraional, he index und marke presens anoher puzzle. Despie he ac ha index muual unds or a given asse should all have similar uure reurns (subjec o racking error), he ees o such unds vary widely. racking erroris a measure o how closely a porolio ollows he index o which i is benchmarked. Tis observaion appears o violae he law o one price (LOP), which saes ha idenical goods should have idenical prices. Choi, Laibson, and Madrian (2010) find ha S&P index unds in he CSP muual und daabase have ees ranging rom 0 percen o 5.75 percen. As Elon, Gruber, and Busse (2004) show, high-ee passive unds sill generae large und inflows. Alhough invesors hold large posiions in high-ee unds in general (Gruber 1996; Barber e al. 2005), he resul is paricularly sriking in index unds. Te lieraure has idenified poenial explanaions ha are generally behavioral, including financial lieracy (Elon e al. 2004; Choi e al. 2010), reurn chasing (Sirri and uano 1998;

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Sapp and iwari 2004; Choi e al. 2010; Bailey e al. 2011), search coss (Horacsu and Syverson 2004), and markeing (Khorana and Servaes 2012). Mauck and Salzsieder (2015) provide experimenal evidence suggesing ha he diversificaion bias could be parially responsible or invesor selecion o high-ee index unds. According o he diversificaion bias, which is based on Simonson (1990), people end o diversiy when making simulaneous choices. ead and Loewensein (1995) coined he erm diversificaion bias o describe his behavior, which ohers call he diversificaion heurisic. Taler (1999) conends ha hough diversificaion may be raional, i is no necessarily uiliy maximizing. An experimen conduced by Mauck and Salzsieder (2015) asks subjecs o allocae a hypoheical porolio among our differen S&P 500 index muual unds wih ees and reurns. Te auhors changed he ees and hisorical reurns in various condiions. Te resuls indicae ha invesors chase pas reurns ha differ only due o reporing “since incepion” reurns, which do no correspond o he same ime period or all unds and do no predic uure differences in reurns. However, even when holding hisorical reurns consan or all our unds, invesors do no ocus heir invesmens on he lowes-ee unds and insead diversiy heir holdings, even hough doing so is subopimal. In shor, even in he absence o reurn-chasing, individuals do no minimize ees. A possible explanaion o he demand or money managemen services ha ail o bea a passive sraegy is ha individuals are no solely ineresed in wealh maximizaion. As Gennaioli, Shleier, and Vishny (2015, p. 92) noe, “We … propose an alernaive view o money managemen ha is based on he idea ha invesors do no know much abou finance, are oo nervous or anxious o make risky invesmens on heir own, and hence hire money managers and advisors o help hem inves.” In shor, neiher reail nor insiuional invesors are solely concerned wih reurns when selecing money managers (Lakonishok, Shleier, and Vishny 1992). Gennaioli, Shleier, and Vishny (2015) use he analogy o medical docors: paiens need guidance on heir reamen, and invesors need guidance on heir invesmens. rus is an imporan componen when selecing boh docors and financial advisors. As rus increases, he advisor can charge higher ees. Higher rus is likely required in higher-risk invesmens. According o his model, advisors are incenivized o caer o invesors, leading money managers o adop he biases o heir cliens. For example, und managers had a srong incenive o reallocae o high-echnology socks during he lae 1990s, despie he appearance o overvaluaion resuling rom he reurnschasing biases o heir cusomers. Tus, he emoional and psychological needs and wans o individuals may parly explain he puzzling demand or boh acive and passive muual unds.

Exchange-Traded Funds Many exchange-raded unds (EFs) are similar o index muual unds, in ha hey are designed o rack an underlying index or benchmark, and o provide a relaively low-ee produc or invesors. Mos EFs are similar o open-end unds, and many rack indices such as he S&P 500. However, EFs also allow exposure o commodiies, currencies, and various sraegy-based invesmens. EFs differ rom index unds in ha invesors

386

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VESTMENT PRODUCTS AND M

ARKETS

able 21.3 Annual Cash Flows and Toal Asses of ETFs, Based on ICI Daa Year

Ne New Cash Inflow (Ouflow) in $Billions

oal Asses in $Billions

2003

N/A

151

2004

75

226

2005

70

296

2006 2007

112 172

408 580

2008

–84

496

2009

207

703

2010

188

891

2011

48

939

2012

278

1,217

2013

394

1,611

2014

307

1,918

2000Noe: andTis 2014.able presens he yearly ne new cash inflow or ouflow and oal asses in EFs beween Source: ICI (2015).

can rade hem direcly on an exchange. able 21.3 presens he annual cash flows ino EFs, as well as he overall size o EFs beween 2003 and 2014, based on daa rom he ICI (2015). Te able indicaes an average annual cash inflow o EFs o $161 billion or he period, wih nearly $2 rillion in oal asses by he end o 2014. Te annual average cash flow growh or E Fs compares similarly o muual unds’ average cash flow growh o $164 billion over he same period. Given ha only $17 billion o he nearly $2 rillion in EFs is acively managed, EFs generally ollow passive sraegies, as suggesed by proponens o marke efficiency. o he lieraure, he inroducion EFs is generally efficiency ing.According For example, Kurov and Lasser (2002) haveo documened improved uuresenhancpricing efficiency in erms o boh he size and he requency o violaions in price boundaries. Some view his relaion as resuling rom increased arbirage rading (Hegde and McDermot 2004), and anoher possible explanaion or he improved efficiency is he improved liquidiy o he underlying socks (Madura and ichie 2007). Tese resuls indicae ha EFs may be generally efficiency increasing. Tis conclusion is consisen wih Gleason, Mahur, and Peerson (2004), who do no find evidence o invesor herding in he EF marke. Tis resul sands in conras o he herding behavior ha has been observed among insiuional invesors.

387

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387

INVESTOR SENTIMENT

Alhough evidence shows ha inroducing EFs has improved marke efficiency, he lieraure also documens he presence o behavioral bias in EF markes. In paricular, invesor senimen has received much atenion. Invesor senimen is he endency o invesors o have changes in risk olerance or o become eiher opimisic or pessimisic wih respec o uure projecions. Baker and Wurgler (2006, 2007) find ha invesor senimen is relaed o uure sock reurns. Senimen also appears o affec boh individual and insiuional invesors (Edelen, Marcus, and ehranian 2010). Chau, Deesomsak, and Lau (2011) sudy hree large U.S. EFs: he S&P 500 SPD, he Dow Jones Indusrial Average EF “Diamond,” and he Nasdaq-100 EF “Cubes.” Teir resuls indicae ha invesor senimen has a srong role in eedback rading (i.e., momenum) in EFs. Furhermore, hey ound ha his relaion is sronger during bull markes han during bear markes. OTHER BEHAVIORAL ISSUES

As Madura and ichie (2004) noe, EFs should be efficiency enhancing because hey provide liquidiy and opporuniies o arbirage away any mispricing. However, he radabiliy o EFs may resul in EF price movemens ha are unrelaed o price movemens o he underlying asses. Consisen wih his later observaion, Madura and ichie find ha EF prices overreac, and hus creae inefficiency and opporuniies or eedback raders. Padungsaksawasdi and Daigler (2014) examine he reurn– volailiy relaion in he conex o EFs. Teir sudy highlighs an advanages o EFs namely, direc invesabiliy in boh equiy and commodiy markes. Addiionally, EFs allow or a differen perspecive on exising behavioral heories. Te auhors relae represenaiveness, affec, and he exrapolaion bias o he reurn– volailiy relaion. For insance, i invesors wih a represenaive bias observe a recen downward price movemen, hey may incorrecly believe he marke is ready o decline. Tis conclusion may resul in buying ou- o-he-money pu opions as a hedge agains price drops regardless o he cos o such pus, which would in urn creae a higher VIX value. VIX is he icker symbol or he Chicago Board Opions Exchange (CBOE) Volailiy Index, which shows he marke’s expecaion o 30-day volailiy. I is consruced using he implied volailiies o a wide range o S&P 500 index opions. Similarly, affec creaed by he success or ailure o a pas rade could influence uure invesor decisions. I invesors ear downward movemens in he marke, hey may buy pu opions. A subsequen increase in he VIX, hen, creaes a negaive reurn– volailiy relaion. Finally, exrapolaion bias describes a endency o invesors o rea pas evens as predicors o uure evens. Tus, when prices drop, hese invesors buy pus, which will bid up he price o insuring agains downside risk. Te empirical evidence indicaes ha hese behavioral explanaions bes fi he negaive reurn–volailiy relaion in commodiy EFs.

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OVERALL ETF EFFICIENCY

Collecively, he evidence indicaes ha EFs are generally efficiency enhancing. Te prices o EFs are subjec o he behavioral biases o he invesors selecing he EFs, bu compared o oher invesmen ypes considered in his chaper, EFs appear o be relaively efficien. Coupled wih relaively lower ees and ypically passive sraegies, EFs have increased in populariy. Given he relaively shorer period or he daa, how longer-erm perormance o EFs will manies isel is unclear. Ye, early evidence indicaes ha EFs are likely o coninue o be an imporan invesmen opion.

Hedge Funds Hedge unds share some eaures wih muual unds, in ha hey inves in porolios o asses and have discreion in selecing hose asses. A major difference beween he wo und ypes is ha neiher he Securiies and Exchange Commission (SEC) nor any similar regulaory insiuion generally regulaes hedge unds. As a resul, he range o possible asses and sraegies available o hedge und managers is greaer han ha or muual und managers. Given he unregulaed naure o hedge unds, daa on such invesmens are more difficul o ideniy han or muual unds. However, curren esimaes place he size o global hedge und holdings a around $2.5 rillion (OECD 2014). MISVALUATIONS

Alhough insiuional invesors poenially improve marke efficiency, perhaps no group is more ascribed his abiliy han hedge unds. Given ha hedge unds have a wider range o asses and sraegies a heir disposal, his circumsance should allow hem o ake advanage o any mispricing. As iter (2004) noes, wo general orms o misvaluaion exis. One orm is recurren and can be arbiraged, whereas he oher does no repea and is longer erm in naure. Hedge unds are ofen viewed as arbirageurs. egarding recurren misvaluaions, iter (2004, p. 433) commens ha “Because o his, hedge unds and ohers zero in on hese, and keep hem rom ever geting oo big. Tus, he marke is prety efficien or hese asses, a leas on a relaive basis.” Similarly, Brunnermeir and Nagel (2004, p. 2014) sae ha “Hedge unds are among he mos sophisicaed invesors probably closer o he ideal o ‘raional arbirageurs’ han any oher class o invesors.” Hedge unds can beter exploi poenial marke inefficiencies han muual unds owing o differences in he consrains aced by he unds. According o Fung and Hsieh (1997), muual unds ofen ace consrains on he number o asses, ypes o asse classes, use o leverage, and oher sraegies such as shor selling. Te auhors urher noe ha hedge unds differ rom muual unds wih respec o hese consrains; hedge unds can use more dynamic sraegies wih relaively ewer limiaions. One view o he hedge und’s role in correcing mispricing is ha i rades agains mispricing. Consisen wih his view, Kokkonen and Suominen (2015) find ha hedge und rading a leas parially correcs marke- wide mispricing. Ye, Brunnermeir and Nagel (2004) find ha hedge unds ollowed he echnology bubble raher han raded

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agains i. Furher, hey find ha hedge unds anicipaed he evenual decline in echnology sock prices and sold hem accordingly. Overall, hedge unds were able o deec a bubble, presumably owing o invesor senimen raher han o raional orces, and hey profied rom his knowledge. INVESTMENT PERFORMANCE

Te research has documened ha, similar o muual unds, hedge unds ypically underperorm heir benchmarks, or a leas ail o generae posiive alpha (Malkiel and Saha 2005). Hedge unds ofen ail o bea he marke, bu some evidence indicaes ha hey ouperorm muual unds (Ackermann, McEnally, and avenscraf 1999), alhough he difference may no be saisically significan (Griffin and Xu 2009). In ac, hedge unds ha ouperorm benchmarks canno generally repea he effor (Brown, Goezmann, and Ibboson 1999). Ye, Fung, Hsieh, Naik, and amadorai (2008) find ha hedge unds ha generae alpha are more likely o survive han hose ha do no. Te acual reurns realized by hedge und invesors are lower han hose repored in raw hedge und reurns, owing o ees. Afer considering he ees, Dichev and Yu (2011) find ha acual reurns or hedge und invesors are beween 3 and 7 percen lower han or a simple buy-and-hold benchmark. Early hedge und ees ypically ollowed he “2 and 20” srucure, whereby invesors pay a 2 percen ee or asses managed and a 20 percen ee on reurns. French (2008) find ha annual hedge und ees rom 1996 o 2007 averaged 4.26 percen o asses. Based on his high ee srucure, hedge unds mus generae significan annual abnormal reurns o mach a passively held porolio. Furhermore, Garbaravicius and Dierick (2005) find ha correlaions beween hedge unds and markes have increased, which Sulz (2007) parly relaes o an observaion ha some hedge unds have become de aco muual unds wih higher ees. In shor, as wih muual unds, he coninued and increasing populariy o hedge unds appears o challenge a raional view o invesors who are seeking o maximize heir wealh. Tus, why invesors coninue o inves in hedge unds despie heir high ees and ypical inabiliy o bea he marke is puzzling. According o Agarwal and Naik (2004), hedge unds may provide invesors wih dieren risk exposures han do muual unds, despie heir invesing in similar asses. Te difference in risk is due o hedge unds’ aking boh long and shor posiions and someimes using shorer invesmen horizons. Tus, invesors may demand hedge unds owing o heir individual risk preerences. BEHAVIORAL ISSUES

Besides raional risk-based explanaions, he lieraure conains behavioral explanaions or he invesor demand or hedge unds and heir relaively high ees. As noed in he muual unds secion o his chaper, Gennaioli e al. (2015) develop a heoreical model ha ocused on rus as a deerminan in he financial consumer’s selecion o unds. In paricular, heir sudy showed ha invesors are concerned wih boh wealh maximizaion and he anxiey ha resuls rom making risky decisions abou a opic or which hey lack undersanding. Tus, invesors are willing o pay ees or proessional money managemen even when doing so resuls in underperormance. However, he role o

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rus is even more pronounced in higher-risk invesmens. In hese cases o higher rus, ees are also expeced o be higher, and his seems o explain he perplexing demand or hedge unds. In paricular, hedge unds have boh relaively high ees and high risk, ye hey underperorm passive sraegies, paricularly on an afer-ee basis. Te eaures o a hedge und, paricularly is high risk, mean ha a relaively high degree o rus in he money manager is prerequisie or invesing in ha hedge und. Collecively, he evidence indicaes ha hedge unds may be efficiency enhancing, alhough his uncion does no serve o generae posiive ee-adjused alpha or hedge und invesors. Hedge unds differ rom muual unds mainly in he asses and sraegies available o hem, alhough some hedge unds are becoming de aco muual unds wih hedge und ees.

Pension Funds Employers ypically esablish pension unds or he purpose o invesing employee reiremen unds. Pension unds are he second larges group examined in his chaper, wih curren asses o around $20 rillion. Pension unds share characerisics wih some sovereign wealh unds (SWFs) (Dewener, Han, and Malaesa 2010). SWFs are governmen-owned invesmen vehicles ofen charged wih he preservaion o naional wealh. However, his chaper excludes SWF research, which generally indicaes ha SWFs differ in boh deerminans and perormance relaive o oher insiuions (Koter and Lel 2011; Knill, Lee, and Mauck 2012a, 2012b; Johan, Knill, and Mauck 2013; Boroloti, Foak, and Megginson 2015). Alhough he choice o omission is subjecive, he implicaion is no rivial, because SWFs conrol an esimaed addiional $7 rillion (Boroloti e al.). Pension unds may inves in all he oher invesor groups covered in his chaper namely, muual unds, EFs, and hedge unds. For insance, Agarwal and Naik (2004) noe ha pension unds such as CALPES and Onario eachers have hisorically held boh muual unds and hedge unds in heir porolios. Tis allocaion may be relaed o a desire or exposure o various risk premia. However, CALPES disconinued is hedge und program in 2014 (Aiken 2015). According o CALPES’s inerim chie invesmen officer, hedge unds are no longer a viable opion because o heir complexiy, cos srucure, and inabiliy o scale o size. According o he OECD (2015), pension unds have 51.3 percen, 23.8 percen, and 9.6 percen o heir asses in bills/ bond, equiies, and cash, respecively. Te repor also noes a shif o nonradiional invesmens beginning around 2012 in a search or greaer yield, including hedge unds, privae equiy, and derivaives. WINDOW DRESSING

As Lakonishok, Shleier, Taler, and Vishny (1991) noe, some pension unds manage heir invesmens in-house, bu ohers use ouside money managers. egardless o which mehod is chosen, hey noe ha pension und managers ace imporan annual perormance reporing. Teir evidence indicaes ha pension unds engage in “window dressing” by selling losers beore he end o he year, so hey are no orced o explain

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he inclusion o “loser” socks in he porolio. Tis end-o-he-year selling is no based on raional crieria bu, raher, on he desire o avoid scruiny. Lakonishok e al. (1992) find ha ouside managers who inves pension und asses do no exhibi signs o herding, eedback rading, or passive rading. Tey conclude ha such managers are “neiher he sabilizing nor he desabilizing image” ha is someimes porrayed or such unds. INVESTMENT PERFORMANCE

Andonov, Bauer, and Cremers (2012) sudy overall pension und perormance, including hose wih equiy, fixed income, and alernaives. Imporanly, unlike many prior sudies ha ocus on he perormance o ouside managers, heir sample included boh inernal and exernal managers. Tey noe ha pension unds have differen moives rom muual unds moives ha could affec invesmen behavior. In paricular, he muual und manager’s pay is a uncion o he asses managed, which could in urn be srongly relaed o relaive perormance. In conras, pension unds view acuarial acors as influencing und inflows. Te lack o incenive or shor- erm perormance should lead o an abiliy o pursue less liquid invesmens relaive o muual unds. Ye, Andonov e al. noe ha he a priori relaion beween greaer liquidiy and subsequen reurn is unclear. Overall, hey ound ha pension unds ouperorm he marke, wih posiive abnormal reurns o 89 basis poins a year. Tis resul is parly driven by he relaively greaer exposure o alernaives, which are correspondingly associaed wih higher reurns. FEES AND PERFORMANCE

Bauer, Cremers, and Frehen (2010) documen ha pension unds achieve significanly lower cos levels han muual und ees. In paricular, hey esimae ha pension und ees are around 27 o 51 basis poins a year, whereas muual und ees are roughly around 150 basis poins a year, on average. Furhermore, pension unds ouperorm muual unds despie no generaing a posiive alpha. Teir analysis indicaes ha smaller pension unds, especially hose wih small-cap mandaes, can bea heir benchmarks. RISK EXPOSURE

Andonov, Bauer, and Cremers (2015) compare U.S. public pension unds o privae and public pension unds in he Unied Saes, Canada, and Europe. In paricular, hey noed ha U.S. public pension unds can undersae heir liabiliies by aking on riskier asse allocaions. Teir evidence shows ha unds aking on greaer risk or hese purposes underperorm oher pension unds, which is mosly due o lower reurns on he riskies asses, specifically equiies and alernaives. Te auhors conclude ha he regulaory environmen provides incenives or pension unds o ac couner o he bes pracices recommended by financial heory. PENSION FUND ACTIVISM

Anoher much discussed eaure o pension unds is heir endency o be acivis invesors. Wahal (1996) examines firms argeed by shareholder acivism on he par

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o he ollowing pension unds beween 1987 and 1993: Caliornia Public Employee eiremen Sysem, Caliornia Sae eachers eiremen Sysem, Colorado Public Employee eiremen Sysem, New York Ciy Pension Sysem, Pennsylvania Public School Employee eiremen Sysem, Sae o Wisconsin Invesmen Board, College eiremen Equiies Fund, Florida Sae Board o Adminisraion, and New York Sae Common eiremen Sysem. Te resuls indicae ha hese pension unds are relaively successul a having heir proposals adoped. However, he adopion o pension und proposals is no associaed wih improved firm perormance as measured by eiher he marke response or long-erm perormance. Del Guercio and Hawkins (1999) find no evidence ha pension unds are moivaed by anyhing oher han und value maximizaion. An, Huang, and Zhang (2013) examine corporae sponsors o defined benefi pension plans. Tey noe ha such unds ake on relaively low (or high) risk when hey have low (or high) unding raios and high (or low) deaul risk. BEHAVIORAL BIASES

Overall, he lieraure documens some differences beween pension unds and oher classes o money managers. Collecively, he evidence suggess ha pension unds generally underperorm passive benchmarks, which is consisen wih evidence on muual unds and hedge unds. However, he lieraure also has explored poenial sources o pension und underperormance specific o pension und managers. For example, Gor, Wang, and Siegris (2008) find ha Swiss pension und managers are overconfiden. In paricular, he pension und managers provided oo narrow confidence inervals when asked o do so or pas reurns. However, he pension und managers were less overconfiden han he laypeople conrol group. Addiionally, he auhors find ha younger and beter-educaed und managers are less overconfiden. Overconfidence migh also explain he belie o pension und managers ha hey can eiher inernally generae alpha or selec ouside managers who can do so (Barberis and Taler 2003). Addiionally, markeing effors may influence pension und managers o incorrecly believe hey can pick alpha-generaing ouside money managers (Barber e al. 2005). However, given ha Bauer e al. (2010) find ha some pension unds, specifically smaller unds wih small-cap mandaes, can generae alpha, some classes o pension und managers migh have such skill. Foser and Warren (2015) develop a model ha incorporaes boh raional and behavioral explanaions or money managemen selecion. Tey find ha he opimism bias can lead o subsanial losses when selecing money managers. In summary, he lieraure indicaes ha pension unds can generally ouperorm muual unds and have a much lower ee srucure, bu ha pension unds sill do no generae alpha. Addiionally, pension und managers exhibi similar biases as oher invesors, including overconfidence.

Summary and Conclusions Proessional money managers and producs such as muual unds, EFs, hedge unds, and pension unds conrol a saggering amoun o wealh, a approximaely

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$55 rillion as o he end o 2014. In general, hese invesors and producs canno produce alpha. Addiionally, he ees charged or managing such invesmens range rom modes (EFs ) o high (hedge  unds). Combining he obser ved lack o alpha wih he realiy o invesor ees makes he coninued demand or such asses puzzling. Tis chaper has documened he specific reurn characerisics and observed raionaliy o each invesmen group. Te chaper also examined he raionaliy o hose choosing o inves in such asses. Overall, boh proessional money managers and hose paying or heir services exhibi many behavioral biases ha are seemingly a odds wih a radiional view o wealh-maximizing financial heory. Perhaps in recogniion o his observaion, he observed rends in rising demand or hese various asses seem o indicae a move oward more logical invesor choices. In paricular, he relaive populariy o passive and low-ee asses such as index muual unds and EFs have increased remendously since 2000.

DISCUSSION QUESTIONS 1. Explain he observed reurn perormance o muual unds, hedge unds, and pension unds. 2. Explain he similariies and differences beween muual unds and hedge unds. 3. demonsraedby byhose und managers. 4. Ideniy he behavioral biases demonsraed selecing money managers and relaed producs. 5. Explain he rends in relaive demand or acive and passive sraegies by boh muual unds and EFs.

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22 Current Trends in Successful International M&As NANCY HUBBARD Miriam Katowitz (’73) Endowed Chair in Management and Accounting Goucher College

Introduction Hubbard (2013) surveys financial execuives rom 162 companies who discussed heir laes acquisiions. Te naionaliies o hose companies included he Unied Saes, Unied Kingdom, Neherlands, France, Germany, Ialy, Spain, ussia, Japan, China, India, Canada, andsudied Brazil. period, Each counry in he survey had a leas oneransaccrossborderKorea, ransacion or he or a oal o 54 ransacions. Tese ions ranged in size rom $75 million o $12.36 billion. Te quesionnaire asked he paricipans abou he raionale or he acquisiion, heir synergy assessmens, pricing valuaions, due diligence, planning, any human resources issues ha occurred afer he ransacion, and he overall success o he venure. Te resuls o his survey will be explored in more deph in his chaper. Hubbard (2013) conducs urher in-deph inerviews a 50 inernaional companies, including heir chie execuives, board chairs, and senior direcors, who discussed he issues, challenges, and successes involved in overseas expansion. Te paricipans were rom 16 counries, including he Unied Kingdom, France, Germany, Spain, Swizerland, Israel, Sweden, he Unied Saes, Caribbean, Brazil, Souh Arica, Nigeria, China, Japan, Ausralia, and India. Tey included execuives rom BP, Ford Moor Company, B, Laarge,Bae, Bank o China, JBS, Bayer, Sanander, Cadbury Schweppes, Cargill, AB Group, and SAP, eva.Sony, Tis Hiachi, chaper ABB, provides addiional findings relaed o his research; he daa are bes undersood in he conex o curren rends.

Current Trends: Economic Downturn Meets Global Risk Refocus Four imporan business rends exis ha are increasingly affecing inernaional mergers and acquisiions (M&As): (1) he developing world’s growh aciviy, (2) he 397

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resuling rise o he developing world acquirer, (3) he pursui o lower degrees o inegraion wih arges, and (4) global ocusing. Tis chaper discusses each o hese rends. Te economic umul associaed wih he financial crisis o 2007–2008 brough wih i an unexpeced shif in M&A aciviy. Whereas previous acquisiion aciviy, a leas in large “mega deal” acquisiions o more han $1 billion, ook place primarily in he developed world, he sagnaion o hose economies led organizaions o urn insead o he rapidly developing economies or heir growh opporuniies. Tis siuaion, combined wih inrasrucure privaizaions and a relaxing o overseas invesmen, creaed unprecedened opporuniies in he nonindusrialized world (Chen and Findlay 2003), resuling in a dramaic increase in acquisiion aciviy in hese regions. In ac, by 2012 over one-hird o all mega deals involved a developing world arge, an acquirer, or boh (Hubbard 2013). Even wihin his arena, he demographics are changing. Organizaions previously based in indusrialized economies used o make acquisiions in he developing world. Bu ransacions are increasingly occurring where boh he arge and he acquirer are in he developing world. Te number o developing-world gians now acively acquiring in he indusrialized world is also increasing, ocusing on recognized brands and echnology o supply boh developed and emerging markes. ecen successul examples o his include acquisiions by JBS (Brazil) o Pilgrim’s Pride, Lenovo (China) o IBM Personal Compuers, aa (India) o Jaguar, and Mital (India) o Accelor. Even as economic growh slowly reurns, he scope o aciviy in he developing world in erms o overall growh, consumer demand, and globalizaion means ha his rend will coninue or some ime A by-produc o his aciviy has led o he second rend menioned above: he growh o he developing-world acquirer. In ac, as o 2013 almos 20 percen o he world’s larges companies now hail rom nonindusrialized Europe, Norh America, and Japan, compared o 6 percen only 10 years ago (Hubbard 2013). Developing-world acquirers pose a new and considerable hrea o Wesern indusrialized companies, as hese “new enrepreneurial gians” ofen operae heir muli- billion-dollar behemohs as i hey were a racion o ha size. Tey are amiliar wih he nuances o operaing in he developing world, wih is uncerainy and he flexibiliy ha i enails, and hey are innovaive, able o do more wih ewer resources. Yiu, Lau, and Bruon (2007) find ha developing-world companies are more resourceul and able o srech heir echnology urher han heir indusrialized counerpars. For example, developing-world gians use echnology and shallow organizaional srucures o aciliae as decision making a prerequisie or operaing in he developing world’s immaure markes. Tis change has been borne ou o necessiy; previously, hese companies did no have he resources o build bureaucraic sysems, insead relying on heir lean srucures o reduce coss. Tey are more flexible in heir parnering opions, ofen pursuing “coopeiion” (i.e., working wih a compeior in one marke only o compee in anoher), a concep ofen oreign o indusrialized gians simply because i has never been required (Luo 2004). When hese developing-world globalizers make acquisiions inernaionally, hey are orced o use exising arge managemen, as heir lean and fla organizaional srucures have no had employees o replace hem. Tus, many o hese businesses’ inegraions are highly decenralized, wih a srong “hands off” approach. Tey arge hose ew business areas or collaboraion and invesmen, and leave he res o he operaions alone

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(Luo and ung 2007). Te end resul o his approach, known as parnering, is one in which acquired employees ofen eel hey are in a join venure wih he acquirer, raher han acing as a subsidiary (Kale and Singh 2009). Wih lower degrees o inegraion and less culural overlay beween acquirer and arge, he acquired company’s employees are less affeced by he acquisiion and hus more likely o remain wih he acquiring firm (Hubbard 2013). Previously, some viewed his approach as a weakness. Now, when combined wih sophisicaed communicaion srucures, his leanness promoes agiliy and innovaion (Hubbard 2013). An increasing body o academics finds ha emerging world enrepreneurial gians have used many characerisics o wha had radiionally been a disadvanage liabiliy o newness and ransormed hem ino a compeiive advanage (Auio, Sapienza, and Almeida 2000; Zahra, Sapienza, and Davidsson 2006; Wood, Khavul, Perez-Nordved, Prakhya, Dabrowski, and Zheng 2011). Some developing-world acquirers have begun adoping his approach wih heir increased marke-enry aciviy. Te end resul is a marked shif oward using a “ligher ouch” during acquisiion implemenaion, as opposed o he radiional, immediaely implemened inegraion plan. Tis shif is logical, because less opporuniy exiss or inegraion wih exising operaions when enering a new marke. Some acquirers indicae ha his approach is key o reducing any culural conflic and or enhancing reenion o arge employees, which are he wo primary concerns associaed wih inernaional acquisiions. As will be discussed, he senior execuives inerviewed or his chaper idenified using a ligher ouch as he greaes reason or a successul acquisiion.

THE RISE OF GLOBALFOCUSING

Afer losing heir domesic divisional diversificaion, companies in he developed world began spreading heir risk geographically, buying relaed businesses overseas. Tis rend is called globalocusing (Meyer 2006). Saring in he mid-1980s, hese companies also began a process o de-mergering, or dismanling and selling off heir unrelaed divisions. epeaedly, diversified conglomeraes wih high-perorming divisions were acquired by break-up specialiss, who sold hose divisions o relaed companies rom which he acquirer could secure subsanial operaional synergies. Tese “Noah’s Ark” acquisiions where he combined organizaions have wo o everyhing, including finance deparmens, inormaion echnology (I) sysems, head offices, manuacuring locaions, and branches were ripe or raionalizaion and large cos savings. Te divisional arges were worh more o heir relaed companies because o hese cos savings han heir cash-generaive value was o heir previous paren company conglomeraes. Tis rend coninued hrough he 1990s, ushering in a new millennia o engulfing businesses wih divisional diversificaion. In ac, by 2001, more han one-hird o Briain’s larges 100 companies were de-merging (Hubbard 2001). Tis rend coninued domesically unil only a handul o rue indusrialized conglomeraes remained. Indeed, GE, a basion o conglomerae perormance, has only recenly gone back o is indusrial roos, eschewing much o is previous diversificaion (Krauskop 2015). Globalocusing coninues oday boh in he developed world and increasingly in he emerging economies. Te large-scale de-merging process mean ha highly

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atracive relaed arges were available presigious brands ha simply did no fi ino heir divesor’s indusry. Te Adams conecionary group, including he Chicles gum brand, highlighs his journey. Adams began he 1990s as a division o he pharmaceuical gian Pfizer. Pfizer’s execuives decided o concenrae on is core pharmaceuical business, and as a resul divesed Adams in 2003. In urn, Cadbury Schweppes bough Adams, adding a Lain American ooprin ha complemened Cadbury’s U.K. coverage. Cadbury Schweppes hen decided o ocus on conecionary and de-merged heir Schweppes division in 2008, which hen became he Dr Pepper Snapple Group. Kraf ulimaely acquired Cadbury in a hosile bid in 2010, hus globalocusing hemselves (Cadbury 2015). Globalocusing coninues o offer organizaions compelling opporuniies ha are capable o insananeously enlarging ha organizaion’s geographic profile. Tese opporuniies are called ransormaional acquisiions(Hubbard 2013). Hubbard finds as many as 15 percen o large mulinaional acquisiions are considered geographically ransormaional, propelling hese organizaions ino new regions quickly and wih subsanial scale. While he exen o complemenary geographic fi varies among organizaions as hey are juxaposed, hese ofen become arge opporuniies or more han one acquirer. As such, deensive acquisiion o poenially ransormaional acquisiions or compeiors has also become increasingly prevalen. Ineresingly, globalocusing appears o be a Wesern mulinaional phenomenon, as Asian companies coninue o pursue diversified business group profiles. Chaebols in Souh Korea and keriesus in Japan boh represening he anihesis o globalocusing have exised or decades, and now governmen-sponsored business groups in China are increasingly becoming he norm (Lee and Jin 2009). Tus, no indicaion exiss ha Asian companies will ollow he Wesern patern o globalocusing in he oreseeable uure. Wheher globalocusing is a sage o corporae evoluion or a proacively viable long-erm business sraegy is unknown a his poin. Bu or now, i remains he norm raher han he excepion. Te move oward globalocusing parly explains he shif in wha inernaional acquisiions are seen o achieve. Since he 1990s, inernaional expansion secured a reduced cos base primarily by lowering manuacuring coss or, in a ew cases, creaing economies-oscale consolidaions wih an exising operaion an inernaional version o he Noah’s Ark acquisiion (Koga 1985; KPMG Managemen Consuling 1997). Since he mid2000s, hough, organizaions have begun pursuing overseas acquisiions no or poenial cos savings bu o increase revenue, as hey atemp o reach he developing world’s poenial consumers wih heir rapidly increasing purchasing power. Exending he work o Hubbard (2013), and based on her srcinal survey, his chaper shows ha almos hal (48 percen) o cross-border acquisiions have been compleed or marke enry findings suppored by oher researchers (Pelier 2004; Saples 2008).

The Attractiveness of Foreign Direct Investment Markets Te survey resuls (Hubbard 2013) has revealed wha makes his new poenial marke so atracive. Te responses included boh financ ial and inangible measuremens ,

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which when combined offered an assessmen o a marke’s atraciveness rom which he respondens could rank opporuniies. Some crieria, such as growh o gross domesic produc (GDP) and overall poenial cusomer marke size, are obvious and sel- explanaory. Ohers, such as mauriy o he sock marke and availabiliy o local resources, are less apparen and measurable. able 22.1 provides a comprehensive lis o CEO responses in erms o heir crieria or marke atraciveness and is uniorm across all hose inerviewed unless oherwise noed; as noed earlier , he respondens operae in a global capaciy, alhough heir relaive imporance differs per responden. o begin, several inangible indicaors o marke atraciveness warran urher clarificaion. Execuives idenified sock marke mauriy as imporan or wo reasons: Firs, i provides an exising exi roue via floaaion i hey consider divesmen in he uure. Second, and more imporan, i dicaes he exen o which poenial acquisiion arges are available hrough public offering. In cases o immaure or underdeveloped sock markes, ew i any arges are available excep hrough privae purchase, hus grealy impeding he abiliy o acquire.

able 22.1 Financial and Inangible Facors for Marke Atraciveness, According o Execuives from 50 Inernaional Organizaions

Financial/Economic Facors

Inangible Facors

GDPsize

Exenonaionalism

GrowhoGDP

Differenceinlocalcounryculure o exising operaions

Cos and availabiliy o raw maerials Size o local consumer marke

Necessary produc ailorizaion or local differences Mauriy o banks

Mauriy and exising demand or produc/local markes

Mauriy o sock marke

Exising compeiion

Complexiy o local regulaions, axes and ariffs/bureaucracy o local governmens/

Labor marke cos and availabiliy

Abiliy o acquire human capial (specific o Japanese respondens)

Inrasrucure levels and cos

Supply chain availabiliy Proximiy o oher poenial expor markes Corrupion

Noe: Tis able oulines he responses given by senior execuives o 50 global businesses when asked, in an open-ended quesion: “Wha made a new inernaional marke atracive?” Te answers are grouped ino financially or economically based acors and inangible acors. Financial and economic acors are hose considered o finie and measurable. Inangibles are more subjecive in naure.

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Te execuives also noed he mauriy o he banking indusry as criical or ensuring working capial. Tey also viewed unique local culures as more challenging. In such cases, i he opporuniy is grea enough, execuives ener markes despie local culures, alhough modiying heir mode o enry. In hese cases, join venures and acquisiions are more atracive han greenfield invesmens. Greenfield invesmeninvolves enering a marke organically wih no parners while building new aciliies and/or local relaionships. Naionalism is a acor in cerain jurisdicions and indusries, especially energy, naural resources, and inrasrucure delivery. Almos all Japanese company respondens menioned he abiliy o acquire human capial as a key measure o a marke’s atraciveness. Ineresingly, execuives rom no oher naion menioned his atribue as a acor. Some acors ha do no appear as imporan are somewha surprising. In erms o economic and financial acors, he execuives did no menion exchange raes and exchange resricions as major impedimens o enering a marke. Neiher is ownership resricions seen as reducing marke atraciveness; in ac, execuives rarely ruled ou a marke’s atraciveness because o an inabiliy o own he operaion ourigh. In ac, he opposie occurred: i a marke was deemed atracive, he execuives find a way in which o ener ha marke, wheher or no by acquisiion, join venure, or greenfield invesmen. As or inangible acors, he execuives surveyed considered a corrup governmen a minor barrier o invesmen, wih he vas majoriy o respondens indicaing ha avoiding corrup pracices is jus par o doing business globally. Similarly, respondens spoke o poliical insabiliy in he same manner; wih he increase in economic globalizaion comes he ineviable possibiliy o civil unres i is jus par o doing business in less developed jurisdicions.

The Reasons for Acquisitions For hose companies choosing o expand inernaionally, acquisiion remains he mos preerred mehod over boh join venures and greenfield invesmen when enering a new marke (Hubbard 2013). Conrol was no idenified as he greaes benefi bu, raher, he abiliy o ener a marke quickly wih he requisie size, complee wih inac supply and disribuion chains. Indeed, conrol appeared o be a secondary benefi overall, albei i was o primary concern in cerain indusries such as I (Chen and Findlay 2003; Hubbard 2013). Alhough providing he same level o conrol, greenfield invesmen appears o be oo slow, especially when enering as-paced or changing markes. Similarly, some viewed join venures as slower han acquisiions, wih he added concern o ofen no possessing clear conrol in many cases. Tus, as Chen and Findlay (pp. 25–26) sugges, For a laecomer o a marke or a new field o echnology, cross- border M&As can provide a way o cach up rapidly. Wih he acceleraion o globalizaion, enhanced compeiion and shorer produc lie cycles, here are increasing pressures or firms o respond quickly o opporuniies in he as changing global economic environmen. Cross- border M&As can provide a way o cach up rapidly.

403

Current Trends in Successful International M&As

403

Tus, he raionale or acquisiion alls clearly ino boh meeing financial/sraegic objecives and some irraional consideraions. As discussed in he ollowing secions, he research has shown ha numerous acquisiions occur or irraional reasons. Included in his irraional behavior are aciviies such as overinflaing he purchase prices and underesimaing he poenial synergies. Figure 22.1 illusraes he raionales given by he surveyed execuives or heir las acquisiion. Te respondens offered boh financial and inangible reasons, wih marke enry being he overwhelming one or cross-border acquisiion. Combining marke enry wih ransormaional acquisiions hose ransacions ha insanly ake he organizaion o he nex level, wih a subsanial increase in geography accouns or almos 60 percen o heir raionale or acquisiions. op-line growh, ollowing a clien ino a new geography, akes he oal o “revenue-enhancing acquisiion objecives” o almos 70 percen. Cos-savings acquisiions, eiher hrough cheaper sourcing or economics o scale, accoun or only 8 percen. Alhough all respondens indicaed ha revenue-enhancing acquisiion objecives acored ino heir decision making, only he 45 40 35 30 e g a t n e c r e P

25 20 15 10 5 0

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s x t t t l l try ke on on ing Ta scale on sive lien rce en ona a n a en c o u em  en mar a gra urc c f e t a ot o ifi ef g w es ke ng eren inte r so ies rs D ollo al r ana form et p ar e m Dive F ur s M xis Diff cal eap M o n Ass at r  Ch ra on oe N c e T t E V in

Percentage

Figure 22.1 easons Given or Mos ecen Acquisiion rom Execuives o 50 Inernaional Companies. his igure highlighs he reasons given by 50 senior execuives or heir las inernaional acquisiion. espondens could provide more han one reason or an acquisiion. he resuls demonsrae ha marke enry is he overwhelming reason given or mos inernaional acquisiions. When combined wih oher revenue- producing raionale, such as inroducing a new produc ino an exising marke and ollowing a clien, op- line growh is clearly he oremos acquisiion sraegy a presen.

404

BEHAVI ORAL ASPECTS OF IN

VESTMENT PRODUCTS AND M

ARKETS

Japanese respondens indicaed ha cos savings acored ino heir decision-making process. Te inangible reasons or acquisiion varied, especially among Japanese and developing-world respondens. In ac, every non-European and non-American responden gave a leas one inangible reason or an acquisiion. Tese reasons include gaining access o new echnology, naural resources, and managemen; diversificaion; and deensive acquisiions. Alhough execuives rom all naions indicaed ha acquiring new echnology is an imporan reason or acquisiions, here were key differences menioned in he oher areas o inangibiliy, based on naionaliy. Japanese respondens were he only naionaliy represened o lis acquiring key managemen resources as a major objecive. Tey were also he only ones o indicae ha differeniaion rom key compeiors and diversificaion are key acquisiion objecives. In ac, all he Japanese paricipans indicaed differeniaion acors in heir decision making in some orm, whereas no European or American firms indicaed his acor in heir decision making. Despie is being imporan in undersanding ransormaional acquisiions, only a small number o paricipans menioned deensive acquisiions. As discussed previously, pending acquisiions could be ransormaional or more han one acquiring company. In hese cases, securing he arge or he acquisiion no only serves o ransorm he acquiring business bu also keeps a compeior rom accomplishing he same. IRRATI ONAL REASON

S FOR ACQUISITIONS

Alhough no respondens indicaed irraional reasons or making acquisiions, oher sudies have pained a long and vivid hisory o irraional behavior in jusiying acquisiions. Hun, Lees, Grumbar, and Vivian (1987) find ha irraional or nonsraegic reasons moivaed well over hal o U.K. acquirers, as illusraed in able 22.2. Subsequen research finds ha managers insigaed 26 percen o inernaional acquisiions by U.S. firms or heir own uiliy, as opposed o creaing value or shareholders (Seh, Song, and Peti 2000). Furher research also suppors his finding (Barclay and Holderness 1989; Hieala, Kaplan, and obinson 2003; Gondhalekar, San, and Ferris 2004). Several heories have been atemped o explain he irraional moivaors behind his kind o behavior, including envy heory, ree cash flow heory, deensive behavior, and he hubris hypohesis. • Envy heory. Envy heory suggess ha chie execuives see heir counerpars as conducing large ransacions and geting greaer remuneraion or i. Tey in urn ry o emulae ha behavior (Goel and Tacker 2009), creaing a maniesaion o he principal–agen problem in which execuives maximize heir own uiliy and opporuniy above ha o shareholders (Seh e al. 2000; Zalewski 2001; Kummar 2006). Execuives are rewarded primarily based on he size o heir company, raher han by is profiabiliy, urher encouraging his behavior (Coeurdacier, De Sanis, and Avia 2009; Goel and Tacker 2009). • Free cash flow heory. Tis heory suggess ha execuives may no wan o relinquish unds o shareholders via dividends, insead oping o spend he money even on value-desroying acquisiions (Lang, Sulz, and Walkling 1991; Servaes 1991).

405

Current Trends in Successful International M&As

405

able 22.2 Irraional Reasons Cied for Acquisiions Irraional Reasons or Acquisiion

Dominan or Primary Moivaion (%)

Secondary Moivaion (%)

Sending he righ signals o he financial markes

20

40

Chairperson’sinsisence

8

35

erieve “ace”

5

18

iseinechnologypercepion

0

15

Impress compeiion

3

Buying radiion a Cashcoworoherbids Sorouanoherproblem

8

0 3

8 5

0

3

Noe: Tis able highlighs he findings o Hun e al. (1987) when hey inerviewed execuives rom large U.K. organizaions as o heir reasons or acquiring. In cases o boh domesic and inernaional acquisiions, Hun e al. find ha irraional ha is, nonfinancial or sraegic reasoning was given as a primary reason or almos 40 percen o acquisiions. Secondary moivaions were even more prevalen when respondens were able o give more han one reason or acquiring. Tis evidence suggess ha while financial and sraegic reasoning or acquisiions dominaes moivaion, irraional moivaions sill need o be aken ino accoun.

• Deensive behavior. Some execuives engage in acquisiions o grow he business purely or personal deensive means “ea or be eaen” or a “good deense is a srong offense” as he case may be (Goron, Kahl, and osen 2009). Tus, execuives acquire a arge firm beore i can buy heir firm, which could oherwise resul in execuives subsequenly losing heir jobs. • Hubris hypohesis. A long-esablished and much-esed heory o irraionaliy in acquisiion objecives, his is oherwise known as chie execuive overconfidence. Firs pu orward by oll (1986), he heory holds ha chie execuive officers (CEOs) overesimae heir own abiliies in achieving acquisiion synergies and oher financial objecives, leading hem o complee he ransacions even when presened wih new and less avorable inormaion and especially when i applies o poenial cos savings and synergies (Bogan and Jus 2009). As a resul, he acquirer ofen pays oo much or he arge (oll 1986; Eccles, Lanes, and Wilson 1999; Schmid 1999; Lanes, Sewar, and Francis 2001; Carwrigh and Schoenberg 2006).

Acquisition Success and Failure No mater how he research is analyzed, he unavoidable ruh is ha acquisiions are no guaraneed o creae value or inernaionalizing firms; in ac, i may be quie he conrary. osand (1994) finds ha, a bes, 45 percen ail o deliver heir sraegic

406

BEHAVI ORAL ASPECTS OF IN

VESTMENT PRODUCTS AND M

ARKETS

objecives; a wors, beween 60 and 70 percen do no reach heir inended financial perormance (osand 1994; Laser and Morzaria 2004; Sahl and Voigh 2008). Te majoriy o research agrees wih counless sudies finding he abiliy o generae value is inconsisen, wih a 50/50 chance o being successul in creaing shareholder value (Lubakin, Srinivasan, and Merchan 1997; Brouhers, van Hasenburg, and van den Ven 1998; Agrawal and Jaffe 2000; Conn, Cosh, Gues, and Hughes 2001). Figures 22.2 and 22.3 illusrae ha, in he survey o 162 paricipans, respondens indicaed hey are more successul in acquiring han has been repored in previous surveys o boh domesic and inernaional acquisiions. Alhough sel-repored success runs he risk o being more avorable han oher orms o esing, previous research finds ha sel-repored responses are on a par wih oher orms o empirical esing (Hun e al. 1987; KPMG 1999). Tis finding corresponds wih he execuive inerviews, who also indicaed greaer levels o acquisiion success (Hubbard 2013). Alhough such evidence bodes well or creaing shareholder value via acquisiion, i may be more relaed o how acquisiions are implemened han any deep lessons learned by acquirers. Te shif in he acquisiion landscape oward marke-enry objecives requires a differen skill se or he acquisiion success. In economies-o-scale acquisiions, success requires a sysemaic abiliy o implemen complex operaional inegraions combining sysems and procedures, firing employees, reraining hose who remain, and melding organizaional culures ino a new, cohesive organizaion. Srong human

70 60 50 40 30 20 10 0

Strongly agree

Somewhat agree

Somewhat disagree Domestic

Strongly disagree

Don't know

International

Figure 22.2 Views on Amoun o Shareholder Value Gained rom Mos ecen Acquisiion. he survey asked respondens abou heir mos recen acquisiion and wheher i creaed shareholder value. he 108 domesic acquirers and 52 inernaional acquirers indicae d relaively uniormly ha heir laes acquisiion did creae value. More han 60 percen o boh domesic and inernaional acquirers srongly agreed ha his is he case. he only area no seeing some diereniaion is in he caegory o “somewha disagreeing,” in which inernaional acquisiions were almos wice as likely o answer in his manner.

407

Current Trends in Successful International M&As

407

50 45 40 35 30 25 20 15 10 5 0

Strongly agree

Tend to agree

Tend to disagree Cross border

Strongly disagree

Don't know

Domestic

Figure 22.3 Views on Compeiive Advanage Gained rom Mos ecen Acquisiion Tis figure indicaes he 160 respondens’ answers when asked i heir mos recen acquisiion made he company more compeiive. Boh he 108 domesic respondens and he 52 inernaional respondens srongly agreed wih ha saemen. More inernaional respondens indicae d ha  heir acquisiions made heir company more compeiive compared o domesic acquirers, which had a higher percenage indicaing ha

he acquisiion did no make heir company more compeiive.

resource and I deparmens, bolsered by program managemen experise and ofen suppored by specialis consuling firms who bring wih hem ime-esed processes, are necessary or achieving he requisie organizaional synergies. In he vas majoriy o cases, hese gains simply ail o maerialize as anicipaed. Many examples exis in which he acquisiion process no only ailed o deliver is inended value bu also damaged he acquirer’s underlying business, owing o an overexension o resources. For example, Daimler’s acquisiion o Chrysler, Morrison’s acquisiion o Saeway, and Bank o America’s acquisiion o Counrywide all show how value-creaing, economieso-scale acquisiions desroyed value. As Fizparick (2012) noes, he iniial purchase price o Counrywide was $2.5 billion, bu he esimaed acquisiion cos o Bank o America was more han $40 billion o dae. Acquisiion success relies on a combinaion o financial rigor and human resource experise or implemenaion; he sheer size and complexiy o he process ofen makes success unachievable. In his new world o inernaional acquisiions, success is sill derived rom financial rigor and human resources (H) experise i is he implemenaion o sraegic objecives wih a financial and human perspecive. Te areas being affeced differ, however. Whereas managers achieved previous acquisiion objecives hrough cos cuting, he curren rend is or seeking gains in marke share, no reducions in overlapping operaions. Managers achieve heir objecives hrough revenue growh opporuniies, wih synergies cenered on creaing value hrough inra-firm collaboraion; his can be seen in cross-selling producs in he new geographies and inroducing new producs ino exising markes.

408

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Litle i anyhing exiss o inegrae economies-o-scale objecives, and he complex issues hey bring are simply irrelevan oday. Success relies on reaining exising experise and using i hroughou he organizaion, raher han on reducing coss. In oher words, success depends on collaboraion and reenion, raher han reducion and harmonizaion. Te skills are sill financial in rigor and human resources and in I or delivery, bu hey differ. Success depends on he acquired managemen remaining in place so as o achieve clear and measured organizaional goals. Tese goals are achieved by managing he acquired uni’s employees in a hands-off, almos parnering approach, suppored by effecive horizonal communicaion and decision-making channels. In oher words, he acquiring companies achieve success by using a “ligher ouch” in implemenaion. Te nex secion provides a discussion o hese elemens.

Reasons for Acquisition Success KPMG (1999) serves as an excellen emplae or undersanding he complexiies involved in achieving acquisiion success inernaionally. Te sudy conduced in 1999 asked execuives a 107 large publicly raded companies wha aciviies hey underook beore acquiring inernaionally. Te companies’ perormance was hen racked o ascerain perormance differences versus heir indusrial peers. As he ransacions were large, hey should have affeced perormance. O hose companies underaking six key aciviies, all experienced increased perormance versus heir indusrial peers. Only one o hose ha underook some bu no all o he six aciviies experienced an increase in relaive perormance. Tose six aciviies were a combinaion o financially based and behaviorally oriened reasons. Te hree financially based aciviies were (1) conducing due diligence beyond financial and legal indicaors, (2) having a rigorous pre-acquisiion plan, and (3) underaking horough synergy papers. Te hree behaviorally oriened aciviies were: (1) having a process or dealing wih culural differences beween he arge and acquirer, (2) inroducing srong inernal communicaion process, and (3) deciding he op eam early. Te ypes o acquisiions underaken when his KPMG survey was conduced differ in inen rom he majoriy o acquisiions being underaken oday. KPMG conduced he survey a he heigh o he economies-o-scale acquisiion wave, whereas oday mos acquisiions are argeing op-line growh. Ye aciviies underaken hen are sill relevan oday. Following is an examinaion o hese aciviies, wih daa provided by he Hubbard (2013) sudy o 54 inernaional and 108 domesic survey respondens, as well as her 50 in-deph senior execuive inerviews. FINANCIAL

LY BASED SUCC

ESS FACTORS

Te hree financially based aciviies underaken by acquirers beore he ransacion ha added value are: (1) conducing due diligence beyond financial and legal indicaors, (2) having a rigorous pre-acquisiion plan, and (3) underaking horough synergy papers. Synergy papers are pre-acquisiion synergy analyses required or Briish acquisiions in publicly quoed ransacions as a way o ensuring he cos-saving benefis are considered reasonable. Conducing due diligence beore a ransacion is normal, bu successul acquirers conduced due diligence ha wen beyond purely financial and

409

Current Trends in Successful International M&As

409

legal aspecs. Successul acquirers also underook exensive pre-acquisiion planning ofen based on comprehensive synergy paper analysis. Tis process occurred even i he arge was neiher a publicly raded company nor locaed in a jurisdicion where his was legally required. Each aciviy will be discussed in urn.

Holisic Due Diligence Te KPMG (1999) survey finds a relaionship beween holisic due diligence and inernaional acquisiion success. Logic suggess ha any addiional knowledge gahered on he arge beore an acquisiion would be beneficial in erms o boh valuing he arge and increasing he undersanding o sraegic fi. When asked abou he key reasons or acquisiion success in heir las acquisiion, he senior execuives gave exensive due diligence as he equal highes response (Hubbard 2013). As seen laer in his chaper, his suggess ha hose who pursue addiional inormaion appreciae is value. Surprisingly, companies conduc litle due diligence beore inernaional acquisiions in many cases. able 22.3 displays findings rom he large-scale survey, which asked he 54 cross-border respondens abou he ypes o due diligence underaken beore he able 22.3 Comparison of DueDiligence Underaken byDomesic and Crossborder Acquirers

Domesic Acquisiions

Cross-border Acquisiions (%)

Financial

72

78

Commercial

61

63

Legal

56

57

Operaional

57

52

Sraegic

43

48

Inormaionechnology H

72

33

47

19

echnological

1

4

Environmenal

4

0

ax Oher

0 3

2 7

None

3

4

Noe: Tis able highlighs he findings o a 162-company survey in which execuives o 108 companies discussed heir domesic acquisiions and 54 paricipans discussed heir inernaional acquisiions. Financial due diligence is he mos common due diligence underaken by boh domesic and cross-border acquirers. Commercial, legal, operaional, and sraegic due diligence is also underaken by roughly hal o respondens in boh domesic and inernaional acquisiions. Te bigges differences beween domesic and inernaional acquirers is revealed in heir inormaion echnology and human resource due diligence. In boh cases, domesic acquirers are ar more likely o pursue due diligence when compared o heir inernaional counerpars.

410

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ARKETS

ransacion. espondens repored ha hey compleed 22 percen o overseas acquisiions wihou any financial due diligence, and 43 percen pursued no legal due diligence. espondens repored conducing 7 percen o acquisiions wih no due diligence. Alhough almos all acquisiions should necessiae underaking he financial and legal due diligence, KPMG (1999) finds an associaion beween collecing inormaion in oher business uncions and greaer acquisiion success. Tese areas include commercial due diligence, sraegic due diligence, H due diligence including inormaion on he arge middle and senior managemen, and I due diligence. Wih he majoriy o inernaional acquisiions pursuing op-line growh, he lack o commercial due diligence is surprising, alhough is dearh mirrors domesic due diligence aciviy. Te wo areas where he due diligence underaken in overseas acquisiions differs subsanially rom domesic acquisiions involve H and I. Inernaional ransacions are less han hal as likely o have pursued his inormaion when compared o heir domesic counerpars. Wih “sof issues” being menioned as key or cross-border acquisiion success, he lack o due diligence in his area can be derimenal and hese findings are paradoxical when overseas acquirers repor greaer acquisiion success han beore. As many arges in he developing world are privaely held, one relevan area o due diligence is an undersanding o he expecaions o he arge’s owners. In many cases, he owners are no selling o he highes bidder bu, raher, o he organizaion ha bes mees is business philosophy and fi (Hubbard 2013). egardless, heir suppor is criical o compleing he ransacion; undersanding heir aspiraions, expecaions and concerns is paramoun or ensuring he ransacion is compleed successully.

Pre-acquisiion Planning esearchers repeaedly associae pre-acquisiion planning wih overall acquisiion success (Buono and Bowdich 1989; Hubbard 1999; Laser and Morzaria 2004; Sahl and Voigh 2008). Pre-acquisiion planning was a key o heir success, according o he senior execuives inerviewed (Hubbard 2013). Adequae planning provides he basis or virually all oher aciviies, including he synergisic fi wih he acquirer’s business; wha, i any, o he arge’s asses are o be divesed; key exernal and inernal communicaion messages; op eam selecion; and pricing. I serves as he oundaion or he synergy evaluaions ha ollow. Te large-scale survey (Hubbard 2013) asked boh domesic and inernaional acquirers i hey had a clear pos-deal sraegy beore compleion. As figure 22.4 shows, a combined 72 percen responded ha hey did, wih 20 percen declining o answer he quesion and 8 percen responding ha hey did no. Tere was litle differeniaion beween domesic and inernaional acquirers. When he paricipans were asked when hey began heir planning, inernaional acquirers indicaed heir planning was begun earlier han domesic acquirers, wih 40 percen o he ormer beginning heir planning a leas five monhs beore compleing he ransacion over wice he percenage o domesic acquirers planning a ha sage. In ac, almos 20 percen o inernaional acquirers repored no planning unil afer compleion o he ransacion (a percenage also higher han among he domesic acquirers). Tis resuls is a residual effec delaying he synergy evaluaion, communicaion, and oher H issues, and makes addressing such maters in a imely manner pracically impossible.

41

Current Trends in Successful International M&As

411

35 30 25 20 15

10 5 0

Greater than 6 months

5-6 months

3-4 months Domestic (%)

1-2 months

At completion

After completion

International (%)

Figure 22.4 Advance Planning ime or Domesic and Inernaional Acquisiions. Te figure repors he resuls o a sur vey asking 160 respondens when hey began heir planning beore he acquisiion compleion. Te 108 domesic acquirers and 52 inernaional acquirers had differing approaches. A large percenage (28 percen) o inernaional acquirers began heir planning well in advance o he ransacion’s compleion, compared o only 11 percen o domesic acquirers . In conras, domesic

acquirers werecompleion. more likelyIn oboh begincases,  heiraplanning he our monhs beore he ransacion’s small buinmeaningul number o acquirers did no engage in planning beore he acquisiion .

Synergy Undersanding he financial coss and benefis o be derived by an acquisiion is imporan or ransacions o publicly held companies. Alhough no required or privaely held company ransacions, undersanding he synergisic benefis, according o some researchers, considering he coss and ime rames o a poenial acquisiion is criical or success (Laser and Morzaria 2004; Sahl and Voigh 2008). Wih his in mind, he Hubbard survey asked boh inernaional and domesic respondens how much ime hey devoed o synergisic evaluaions beore compleing he deals. As Figure 22.5 shows, almos hal o all respondens repored invesing litle or no ime in quaniying he synergies beween he wo organizaions. As previously discussed, recen inernaional acquisiions have increasingly argeed op-line revenue opporuniies acquiring new markes and cusomers or exising producs. Te survey asked boh domesic and inernaional acquirers abou wha synergies hey anicipaed in heir mos recen acquisiion. As Figure 22.6 shows, synergies being sough by inernaional businesses ocus on markeing (24 percen compared o none in domesic ransacions), and less so on operaions, back office, procuremen, and propery-cos reducions. Headcoun reducions in which 60 percen o domesic acquirers anicipae synergies accouned or only 2 percen o inernaional ransacions. Tus, cos-reducion synergies across he board are less pursued in inernaional acquisiions. Tis finding has a domino effec or H. As discussed in he ollowing

412

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ARKETS

40 35 30 25 20 15 10 5 0

Agreatdeal

Areasonableamount Domestic

Justalittle

None

International

Figure 22.5 Comparison o ime Spen on Synergisic E valuaions, Domesic and Inernaional Acquirers. Tis figure highlighs he differen approaches aken by hose acquiring domesically and inernaionally. esearchers asked respondens how much ime hey spen underaking sy nergy evaluaions. Te 108 respondens underaking domesic acquisiions were more likely o spend some ime on synergy evaluaion work, wih almos wo-hirds indicaing hey spen eiher a reasonable or jus a litle ime

on aciviy. Te 52indicaing inernaional however, wereormore a boh endsha o he specrum, heyacquirers, eiher spen a grea deal imeskewed or no ime a all on synerg y evaluaions when compared o domesic acquirers.

secion, he H implicaions or op-line revenue synergies differ dramaically rom cos-reducion synergies reenion and collaboraion become paramoun. One opporuniy ha globalocusing has provided inernaionalizing organizaions is he abiliy o acquire sizable blue chip divisions ha simply do no fi he divesor’s new sraegic direcion. In many cases, he divesed divisions were ofen sarved o managemen ime and resources, as hey did no suppor he organizaion’s core business hrus and as a resul suffered rom “orphan syndrome” being unwaned and unappreciaed by heir paren company. I acquired in a ransormaional acquisiion, hese divisions immediaely become inegral o he acquirer’s main business direcion and can experience a radical rejuvenaion. I is a golden opporuniy or boh he arge and he acquirer. BEHAVIORALL

Y BASED

SUCCESS

FACTORS

Te KPMG survey (1999) repors hree qualiaive or behavioral elemens considered criical o acquisiion success: (1) having a process or dealing wih culural differences beween he arge and acquirer, (2) inroducing a srong inernal communicaion process, and (3) ideniying he op eam early. Addiional research suppors hese aciviies as essenial or acquisiion success (Hubbard and Purcell 2001; Schweiger and Goule

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Current Trends in Successful International M&As

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Figure 22.6 Anicipaed Synergies or Domesic and I nernaional Acquisiions. Tis figure highlighs he differences in anicipaed synergies beween domesic and inernaional acquisi ions. Te sur vey asked he 108 domesic acquirers wha sy nergies hey expeced upon compleing heir acquisiion. Tey indicaed hey expeced sy nergies in erms o headcoun, procuremen, and operaions in a leas 60 percen o domesic acquisiions. When asked he same quesion, only 2 percen o  he 52 companies acquiring inernaionally oresaw headc oun reducions, w ih subsanially lower indicaions o oher operaionally based cos savings. Insead, almos one- ourh o hem anicipaed markeing savings, compared o none o he domesic acquirers.

2005; Carwrigh and Schoenberg 2006; Lodoros and Boaeng 2006). Each o hese findings is discussed in he ollowing secions.

Culural Differences Culure can be defined as he sysems and processes ha lead o acceped behavior in

an organizaion. Culural differences exis beween counries, organizaions wihin he same counry, and divisions and uncions wihin one company. Culural differences, or “culure clashes” beween he arge and he acquirer, can be major impedimens o acquisiion success (Schmid 1999; Applebaum and Gandell 2003; Weber and Camerer 2003; Badralei and Baes 2007). Waler (1985) suggess ha culure conflics accoun or as much as a 25 o 30 percen drop in perormance afer acquisiion implemenaion. Oher research finds ha he perormance drop does no resul rom he acual difference in culure, bu rom how he acquirer has addressed he culural differences (Hubbard 1999; Hubbard and Purcell 2001; Applebaum and Gandell 2003; otig 2009). KPMG (1999) suppors his posiion, suggesing ha he culural differences do no cause he problems, bu ha a lack o proacively managing hose differences does. Companies acknowledging he culural differences preempively manage hose dispariies and experience success.

414

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VESTMENT PRODUCTS AND M

ARKETS

ecen research coninues o highligh he perceived imporance o culure, especially in cross-border acquisiions. Te KPMB survey (1999) asked respondens o indicae heir hree bigges H concerns pos-acquisiion. Figure 22.7 shows ha or he Hubbard survey, almos 70 percen o cross-border acquirers repored ha culural differences are among heir hree op concerns, and was noed as he op response by almos woold. Domesic acquirers were hal as likely o indicae hey el culural issues are a poenial problem, suggesing ha he acquisiion’s inernaional aspec is he main cause o culural concern. Alhough culural differences complicae cross-border ransacions, he degree o inegraion can be a miigaing acor. Pu simply, as he degree o inegraion decreases, culural differences affec ewer employees. Conversely, as he degree o inegraion increases, more employees are exposed o he differences. In cases o high culural dissimilariies, some acquirers op or a lower degree o inegraion, hereby reducing he number o employees affeced by he culural difference. In doing so, hey are borrowing he “parnering” approach previously discussed. Te increase in marke-enry acquisiion sraegies reduces he requency o ully inegraed arges, again reducing poenial culural impac. Some organizaions acing unavoidable culural differences use more specialized coping ools, such as inernal culural aciliaors who assis affeced execuives in operaing in boh organizaions’ culures, inroducing widespread culural raining ools, and employing culure audis all designed o assis affeced employees in becoming culurally “bilingual” (Hubbard 1999).

70 60 50 40 30 20 10 0

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Tertiary HR concern

Figure 22.7 op Tree H Concerns afer- Acquisiion by Cross-Border Company. Tis figure highlighs he human resource concerns idenified by inernaional acquire rs. Te survey asked respondens o ideni y heir hree major H concerns during he acquisiion implemena ion. Te op wo responses o culural differences and employee reenion oupaced oher response s, wih he later being he overwhelming primary concern. Te operaing model, communicaion, erms and condiions, and recruimen were also imporan concerns. eenion issues may be exacerbaed, given he ardiness in achieving appoinmens a he deparmen- head level.

415

Current Trends in Successful International M&As

415

Srong Inernal Communicaion Besides KPMG (1999), oher sudies have highlighed he role o inernal communicaion in acquisiions (Piekkari, Vaara, ienari, and Sänti 2005; Lodoros and Boaeng 2006; Sahl and Voigh 2008). Ye, adequae inernal pre-acquisiion communicaion ofen is negleced, or several reasons. Firs, such communicaion relies on senior execuives o craf and deliver he message a a ime when hey are usually involved in he deal negoiaion and execuion. Second, secrecy surrounding hese ransacions means ha he execuives ofen exclude all bu a ew insiders; hus, H personnel are no given adequae ime o prepare communicaions. Finally, and perhaps mos imporan, accurae communicaion depends on pre-acquisiion planning or is conen. As previously menioned, inadequae planning is endemic o various ransacions. Wihou conen, inernal communicaions are ineffecive. Inernaional acquisiions bring wih hem oher communicaion complicaions as well. For example, here is he need o ranslae key documens in a imely manner. Anoher is he poenial o misundersandings beween colleagues when communicaing in a language oher han he naive ongue. Also, hose involved in he acquisiion may be fluen in he language, bu may no undersand he culural ramificaions or linguisic nuances o wha hey are saying, le along how he oher pary inerpres heir communicaions (Piekkari e al. 2005). Finally, communicaion barriers can make cross-organizaional collaboraion more difficul unless organizaions adop a single corporae language (anf and Lord 2002). Afer an acquisiion, good communicaion serves wo disinc purposes. From he acquiring company, effecive communicaion can reduce he anxiey and ambiguiy el by employees o he acquired company, and in doing so, can creae a sense o shared belonging (Buono and Bowdich 1989; Hubbard 1999; anf and Lord 2002; Schweiger and Goule 2005). Tis relaionship can aid in reenion and produciviy during a ime when organizaions are mos vulnerable o heir bes employees leaving hose personnel who have he opporuniies and poenial moivaion o move elsewhere. Second, effecive communicaion can build he bridges ha aciliae inernal knowledge sharing (anf and Lord 2002). Tis inra-firm collaboraion and knowledge sharing is wha many revenue-enhancing acquirers wan o achieve, ye i ofen remains elusive. I inra-firm collaboraion is criical or acquisiion success, “rich communicaion” is undamenal or encouraging he necessary flow o inormaion hroughou he firm (Daf and Lengel 1986). ich communicaion can be achieved by ace-o-ace meeings, cross-company projec specific eams, sie visis o and rom he arge and acquirer, social evens, and culural audis. Iniial ace-o-ace meeings aciliae rus and encourage collaboraors o use urher echnology o coninue he ongoing communicaion. Ye, using echnologically based communicaion wihou he iniial personal ineracions can be ineffecual (anf and Lord 2002). Te geographic and culural divide o inernaional acquisiions can exacerbae a lack o communicaion and collaboraion. anf and Lord (p. 438) sugges ha “rich communicaions were no only helpul or esablishing a avorable climae beween he wo organizaions, bu were essenial or he acual exchange o knowledge across pos-acquisiion inernal organizaional boundaries, paricularly when he acquired firms mainained subsanial auonomy.”

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VESTMENT PRODUCTS AND M

ARKETS

op eam Selecion According o KPMG (1999), he final aciviy ha successul acquirers underake beore he ransacion’s compleion is o selec he arge’s op eam. Having he op eam in place means ha effecive leadership is available o drive he implemenaion orward. Tis process is especially imporan in many developing-world economies, which are experiencing unprecedened growh and, hereore, have very compeiive job markes. In markes where employees can swich jobs easily, securing key employees is even more imporan, as he abiliy o quickly leave a job or anoher is inensified. Securing key As employees doesshows, no seem o behe a prioriy in many border acquisiions, however. Figure 22.8 among Hubbard surveycrossrespondens, more han one-ourh o inernaional acquirers ook hree o six monhs o have a ully working managemen eam in place a he deparmen-head level, meaning ha middle managemen appoinmens below ha level ook even longer o be finalized. Tis degree o managemen ambiguiy can exacerbae employee reenion issues, as affeced managers leave he company in search o more concree employmen opporuniies. Figure 22.7 shows ha he survey evidence bears his ou; reaining key saff is he second mos ofen cied H concern ollowing acquisiion. As previously discussed, he increasing move oward parnering wih he acquisiion arge can also improve reenion raes among acquired employees. Tis parnership is

More than 2 Years 1-2 Years

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Figure 22.8 ime Needed o Appoin Senior Managemen afer Company

Acquisiion. his igure oulines amoun or and acquirers o place senior managemen inohe senior roles,oinime bohneeded domesic inernaional acquisiions. he survey asked respondens he amoun o ime needed o make appoinmens o he level o depar men head. he 103 domesic respondens indicaed making abou wo- hirds o appoinmens o deparmen- head posiions wihin he irs hree monhs, wih almos hal o appoinmens occurring wihin one monh. Alhough he 52 oreign respondens indicaed ha more han hal o heir appoinmens occur red in he irs hree monhs, a lmos 30 percen o appoinmens o deparmen- head level ook beween hree and six monhs. his delay in appoinmens means ha middle managemen appoinmens ake even longer, which may be exacerbaing reenion issues, especially in overheaing inernaional markes.

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criical when he acquirers do no wan o lose ha imbedded knowledge. Tis observaion can be especially imporan when enering a new and subsanially differen marke. o lose hose knowledgeable employees would heighen he acquirer’s “liabiliy o oreignness” in ha marke, hereby increasing is inheren risk (Johanson and Vahlne 2009). OVERALL ACQUISITION SUCCESS FACTORS

Alhough he KPMG sudy was published in 1999, he pre-acquisiion aciviies idenified in ha survey remain relevan oday. When he Hubbard survey asked senior execuives abou he key acors or successul acquisiions, heir responses, as shown in Figure 22.9, included many o he same responses as appeared in he KPMG survey, despie he passage o ime. On he financial side, exensive due diligence, making sraegic sense, clear planning, and a robus process are all imporan. On he behavioral ron, he righ leadership and dealing wih culural issues boh figure prominenly. Hubbard respondens viewed using a ligher ouch in implemenaion as undamenal, which demonsraes he changed naure o cross-border marke enry sraegy and he 16 14 12 10 8 6 4 2 0

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in

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Reasons for acquisition success (%)

Figure 22.9 Saed easons or Acquisiion Success. his igure indic aes he reasons

or success as given by execuives rom 50 global businesses when discussing acquisiion. he survey asked execuives o give hree key acors or successul acquisiions. he respondens menioned successes in boh inancia l (due diligence) and people- based acions (righ leadership), as well as in a srong process. espondens ideniied a ligher ouch on inegraion as being a op- hree response, which conradics previous research in dings. Alhough managemen urged pas acquirers o make changes immediaely, a soer and sl ower inegraion was ound o be more eecive, especially when employee reenion was menioned as criical or uure acquisiion success.

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lower degree o inegraion being underaken. Even hough inernaional ransacions have shifed rom ull inegraion o revenue-enhancing acquisiions, success coninues o rely on a melding o financial and behavioral acors.

Summary and Conclusions Invesors ineresed in growh companies ha are inernaionalizing heir businesses by pursuing acquisiion sraegies should consider several key acors. Firs, ransormaional acquisiions, which represen opporuniies o radically reshape an organizaion’s geographic ooprin, can uniquely and rapidly revoluionize an organizaion. Such acquisiions bode well or invesors, because litle overlap exiss or inegraion issues o arise and subver he organizaion’s atenion and effors as i quickly gains global size. Te opporuniies are inrequen bu atracive when hey arise. Second, some acquirers have buil a rack record in successully acquiring overseas using a mehodology ha clearly works. As long as he ype o acquisiion remains consisen, hose companies wih proven rack records warran atenion. Tus, companies ha have pursued marke-enry sraegies wih success should find ha he process can be replicaed across borders. Finally, hose organizaions ha can ariculae heir sraegic plans and demonsrae ha hey ollow he six key aciviies previously discussed are ar more likely o be successul han hose ha do no. In a changing world, nohing is oolproo. In he case o acquisiions, he merger o financial and behavioral processes grealy enhances he odds o success.

DISCUSSION QUESTIONS 1. 2. 3. 4.

Ideniy several irraional reasons or acquisiions. Discuss how globalocusing can reduce risk he way conglomeraion did previously. Explain how H issues during acquisiion have changed since 2000. Explain he reasons he success rae o inernaional acquisiions has improved.

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23 Art and Collectibles for Wealth Management PETER J. MAY Independent Wealth Advisor

Introduction Tis chaper explores he differen aspecs o buying and selling and collecing fine ar and objecs ha are ermed collecibles, viewed rom a wealh managemen perspecive. Wealh managemen in his conex reers o he ac o combining personal invesmen managemen, financial advisory, and planning disciplines direcly or he benefi o high ne worh (HNW) cliens. Te chaper opens wih a review o he lieraure on behavioral aspecs o collecing fine ar and collecible objecs. Te secion ha ollows idenifies issues and iems ha collecors and wealh managers encouner in such wealh managemen, hen expands o a secion on he passion or acquiring, holding, and disposing o such asses. A discussion on fine ar as an asse class ollows. Te chaper hen moves ino he effec o social media use and online aspecs o wealh managemen and ownership, wih a ocus on educaion abou ar, global acquisiion o ar and collecibles, and give suggesions or how wealh managers can keep pace wih developmens in his rapidly changing arena. Finally, he chaper includes a summary and conclusions.

A Review of the Literature Belk (1995) repors survey resuls based on 200 inerviews wih collecors ha examined he advanages and drawbacks o he collecing process or individuals and households. Te sudy ound ha, in severe cases, collecing iems can be highly addicive and may cause dysuncion or he individual collecor and his or her amily. However, Belk noes ha, overall, collecing is a avorable experience or individual invesors. Baker and Genry (1996) inerview groups o children abou heir collecing habis. Te auhors repor ha children collec iems or he pleasure o experiencing he collecion process, as a way o avoid boredom, o learn abou he collecing field, o saisy an emoional passion or cerain iems, o disinguish hemselves rom oher people, and or connecing emoionally wih amily members and riends. Mos adul invesors develop a bias agains viewing a collecible such as rare samps as par o a diversificaion 422

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sraegy. Insead, hey view such collecing rom a nonfinancial perspecive. However, Grable and Xuan (2015, p. 78) repor ha “in general, collecible samps do a relaively good job hedging inflaion and declines in gold prices … . [Teir] findings also sugges ha hose who inves in samps need a very long ime horizon and avorable marke condiions in order o generae a profi.” AFFECTIVE REACTIONS IN THE COLLECTING PROCESS

Aposolou (2011) examines he role o collecing in eBay-based aucions or sales o ossilized dinosaur eggs, and ound ha collecing is largely based on he desirabiliy o he iem. Te auhor repors ha he desirabiliy o he collecible piece is posiively associaed wih is scarciy, size, and aesheic pleasanness. Dimson and Spaenjers (2014) evaluae he long-erm invesmen reurns or collecibles, including fine ar, samps, and violins, and classified hem as “emoional asses.” Tey repor ha collecibles ouperorm gold, reasury bills, and governmen bonds over he long invesmen horizon. Neverheless, he expense o invesing in rare collecibles is high and invesors incur many poenial risks. Dimson and Spaenjers (p. 20) repor ha “Emoional asses are paricularly atracive o some high-ne-worh invesors. Te need or vigilance makes i hard o jusiy he inclusion o emoional asses in he porolios o mos insiuional invesors.” McAliser and Cornwell (2012) examine he emoional role played by collecible oys, and how offering premiums conneced wih ood purchases influences he ood choices and eaing habis o children. One par o heir sudy examines he influence o oy collecibles offered as premiums wih a ood purchase. Te findings reveal ha hese collecible oy premiums influence a child’s viewpoin abou unhealhy and healhy meal choices. Tey ound ha children preer a healhy meal when i is accompanied by a oy collecible, bu oherwise make an unhealhy ood choice when here is no premium offered. Addiionally, one could reflec on he impac on he purchasing paren. Tey may no care abou he oy, ye he compromise was worh he healhy oucome. Moods also influence he desire or collecing ar. De Silva, Pownall, and Wolk (2012) invesigaed he role o mood changes on subjecive risk and prices a ar aucions in London beween 1990 and 2007. De Silva e al. (p. 167) repor he ollowing resuls: Using a unique daa se ha includes presale esimaes or painings sold hrough Soheby’s and Chri sie’s aucion houses, as well a s weaher daa or London rom he Briish Amospheric Daa Cenre, we find ha he lower par o he price disribuion is populaed wih painings wih a relaive high privae value, whereas in he upper par, prices are driven primarily by he common value characerisics. Indeed, behavioral biases are ofen revealed in he collecion o fine ar. Beggs and Graddy (2009) demonsrae how boh he price o a paining sold during an ar aucion and is pre-sale valuaion by expers are anchored on he sold prices o oher painings wih he same qualiy over he same ime span. Te sudy’s major finding is he anchoring effec or buyers, sellers, and aucioneers. Tis can be based on eiher he “expecing

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anchoring” which is based on he buyer judgmens or revealing anchoring biases in and o hemselves. Te collecion o fine ar can also inroduce agency problems. Mei and Moses (2005, p. 2409) evaluae he connecion beween aucion house esimaes o pre-sale values or ar and he long-erm reurns or hose ar pieces: We find ha he price esimaes or expensive painings have a consisen upward bias over a long per iod o 30 years. High esimaes a he ime o purchase are associaed wih adverse subsequen abnormal reurns. Moreover, he esimaion error or individual painings ends o persis over ime. Tese resuls are consisen wih he v iew ha aucion house price esimaes are affeced by agency problems and ha some invesors are credulous. Nordsleten and Maaix-Cols (2012) examine similar and differen aspecs o hoarding and collecing behavior. By reviewing he lieraure on collecing, hey find ha (p. 165) “or he majoriy o collecors, a diagnosis o Hoarding Disorder is likely o be effecively ruled ou. For a minoriy o ‘exreme’ collecors, a diagnosis may poenially be adequae.” According o McInosh and Schmeichel (2004, p. 86), “collecors are drawn o collecing as a means o bolsering hemselves by seting up goals ha are angible and atainable, and provide he collecor wih concree eedback o progress.” SOME POPULAR TYPES OF COLLECTING

Carey (2008) indicaes ha people have an innae desire o collec iems or boh financial and nonfinancial reasons, so muliple reasons exis or building collecions. Carey develops a model o explain how atemping o complee a se o collecibles influences a person’s behavior; evenually, i brings higher value. For insance, a complee se o a collecible has greaer value in he secondary marke han he oaled value o he individual iems. Ta is, he ac o collecion, when compleed, brings addiional value.

Ar and Wine Collecions Agnello (2002) examines he relaionship beween risk and reurn or a sample o painings by U.S. ariss or sale a aucion beween 1971 and 1996. His findings reveal ha oal reurns or invesmens in painings are low, bu large differences in annual perormance exis. Ta is, painings considered o higher qualiy pos he larges gains, jus behind equiies, and reurns are no compensaed or higher risk. Te auhor suggess ha buying higher-qualiy painings by amous ariss is he bes ype o invesmen approach. Wine may also serve as an opion or reurn enhancemen. Coffman and Nance (2009) noe ha wine as an invesmen has a long hisory in Europe, and is saring o emerge as an imporan asse class in he Unied Saes. o provide proper advice o cliens, financial planners should be able o assess differen ypes o invesmengrade wines, undersand he imporance o he cellar log o make sure he wine has been appropriaely sored and ranspored, ideniy highly regarded vendors o preven counerei purchases, and value he differen markes or collecible wine. Wine qualiy

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judgmens and invesmen decisions are based on numerous acors: he geography where he grapes were grown and he year o harves, he winery doing he aging and botling, he vinage raing assigned by wine expers, and prices o prior vinages. Te auhors sae ha wine is an imporan asse wihin a clien’s porolio or reducing volailiy and a poenial way o earn solid long-erm reurns.

Spors Cards, Especially Baseball Baseball cards have meri in an invesmen porolio. Haley and Van Scyoc (2010) examine he differences beween book values and eBay prices or 30 1960s- era baseball cards ha appeared on more han 870 aucion lisings. A general finding was ha lower-qualiy baseball cards sell above heir book values and higher- qualiy cards sell below heir book values. Anoher finding was ha when buyer insurance is offered by he seller, he number o bids on an iem increases he price on eBay compared o he iem’s book value, and boh he repuaion o he seller and he number o bids increase he chances ha he eBay iem will be sold a a higher price han is book value. egoli, Primm, and Hewit (2007) assess wheher perormance or race deermined he numerical classificaion used by he baseball card manuacurer opps o ideniy he op player baseball cards, also known as “royaly o he diamond,” beween 1956 and 1980. Te auhors conclude ha player perormance was he major deerminan o he opps baseball card numbering sysem. Addiionally, Primm, Piquero, egoli, and Piquero (2010a, p. 865) repor ha “card availabiliy and, o a lesser exen, player perormance is he mos imporan acor affecing he value o a player’s card, while imporanly, a player’s race is no a significan conribuor o card value.” In a relaed sudy, Primm, Piquero, egoli, and Piquero (2010b, p. 129), who examined he role o race or cards o more han 1,200 whie and black ooball players, repor ha “conrolling or oher acors, race has no effec on he value o players’ rookie cards, whereas card vinage exered he mos influence on he value o players’ cards.”

Celebriy Possessions and he Deah Effec Newman, Diesendruck, and Bloom (2011) invesigaed he reasons individuals buy iems ha had previously been owned by celebriies: (1) direc associaion, (2) greaer marke demand, and (3) conagion (i.e., he belie ha hese objecs conain some remnans o heir previous owners). Te iems subsequenly became collecibles. Marke demand has a parial influence on price, bu he conagion acor is he mos imporan, influencing he value o possessions previously owned by celebriies. Deah may play a role in he value o cerain ar and collecibles. Maheson and Baade (2004) sudy how he value o a work o ar or he memorabilia o celebriies increases afer he deah o he aris or celebriy. Tey poin o previous lieraure ideniying he “deah effec.” Te basis or he “deah effec” is he expecaion o collecors ha he supply is now limied, hence grows in desirabiliy. However, his finding is based on he marke or spors memorabilia. As Maheson and Baade (p. 1151) add, “he increase in prices is insead due o a ‘nosalgia effec’ as a resul o he media atenion ha surrounds he deah o a prominen public figure.”

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Seeing the Client’s Passion from a Wealth Management Perspective Passion ofen drives he acquisiion o fine ar and collecibles. Ineres in a paricular paining or admiraion or a collecible baseball card ofen leads o he iniial purchase. Subsequen purchases o similar iems can hen shape an individual ino a collecor. Te compeiion among insiuions o manage he asses o high ne worh (HNW) and ulra-high ne worh (UHNW) cliens is fierce, as firms atemp o expand heir services and evolve heir plaorms. A key quesion hey ace is how o urher hose relaionships wih value-added relaionships and services. Ar and collecibles may be he answer. Inroducing ar and oher collecibleso an invesor may allow a manager o expand ha clien’s invesmen opions beyond he radiional choices. When aking his approach, however, wealh managers need o undersand henaure o he markes involved and he various businesses surrounding hem. I requires undersanding he subjec and he naure o he collecor’s passion: he who, wha, where, why, and when. Wih his knowledge, hough, wealh managers can beter open he doors o an expanding relaionship. Te POV does shif or specific reason: he manager should consider inroducing collecing, because i allows a conversaion o ake place ha ofen does no. Tis conversaion helps he clien o make he bes collecion decisions rom an invesmen viewpoin. Inroducing he idea o collecing as an invesmen opion may ignie a passion or your cliens. Wha are he clien’s invesmen needs? Who are he expers and hirdpary or amily office service providers who can back up your recommendaions? Acquiring his knowledge means working wih he clien in a close relaionship. Online ar markes enable individuals o more easily become acquirers and are prolieraing on a daily basis. Te financial manager should know ha ar acquisiion, or example, and discussed laer herein, is increasingly an imporan par o ha world. Ideally, he wealh manager needs o inegrae he clien’s collecible asses wih his or her invesmens and wealh realiy. Ideniying and navigaing he obsacles ha ge in he way a clien’s passion can someimes be as simple as applying parenal auhoriy in a riendly and suggesive way such ha he clien will come o he wealh advisor more ofen han in he pas when ar and collecing was no par o he conversaion. Wih sufficien knowledge and leadership skills, he wealh manager can guide he clien along he bes pah, helping him or her make he bes collecion decisions rom an invesmen viewpoin.

Collecting for Investment Value How does he wealh manager inegrae a clien’s collecion ino his or her financial balance shee? Te goal o wealh managemen is o keep a clien’s porolio simple and concise. Tis includes creaing a balance shee and filling in he asses and liabiliies. Bu wha sar as simple asses and liabiliies can quickly become difficul o caegorize. Te asse side grows segmened, wih curren, shor- erm, and long- erm asses. Personal angible propery and invesmens are only a ew o he many caegory ypes. Some cliens buy ar because hey like collecing ar. Ohers buy ar because hey consider ar par o heir invesmen porolio. Te difference beween collecing ar

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and invesing in ar is more a journey han an exac differeniaion. For example, more han 30 million collecors worldwide enjoy collecing samps, and hey spend (inves) billions o dollars o assemble heir collecions. Because samps do a relaively good job o hedging inflaion, he evidence suggess ha collecible samps may be a useul alernaive invesmen wihin a porolio (Grable and Chen 2015). I collecors are acquiring ar as a possible invesmen, how do wealh managers make sure hey undersand he clien’s needs? Moivaion is muliaceed, wih collecors moivaed primarily during he acquisiion phase. So, ideniying ha moivaional ocus and he driving reasons or i should be oundaional or wealh managers. Tere are conerences and seminars on his aspec o invesing, as well as eaures o coninuing educaion programs and business developmen courses. A simple Inerne search poins o aricles, lecures, seminars, and evens on he subjec. Addiionally, ar advisors, collecors, and ar consulans ask wealh managers o educae heir cliens on he naure o collecing, and hey offer heir services o incorporae ar ino heir invesmen offering or invesmen plaorm. Family offices are ofen bes posiioned o inegrae ar ino overall clien’s porolio managemen, as i provides a way o preserve a amily’s collecion. Applying he experise o boh inernal and exernal eams o assess he uure atraciveness and invesmen value o collecibles calls or a decision-making ramework o sound governance (Zorloni and Willete 2014). Indeed, he financial indusry as a whole, rom wealh managemen o invesmen brokerage, is assuming a sraegic view o ar as an asse class. In addiion o aiding individual cliens and amilies, here are opporuniies or expanding he indusry conversaion wih addiional mehodologies or inegraing ar as an asse class ino invesmen managemen. Tese areas include ar lending, ar philanhropy, and ar in he conex o esae planning. Especially, he ar lending world coninues o evolve and innovae, people increasingly buy fine ar wih he idea o borrowing money agains is value. ecenly, ar lending has become a “sraegic ocus,” which implies ha wealh managers are being asked o accommodae requess rom imporan cliens. Alhough many insiuions, as par o heir general markeing, indicae hey now have more confidence in ar as collaeral, ofen he realiy is ha hey merely exend clien lines o credi. Neverheless, as radiional lending insiuions provide ewer loans and require addiional collaeral, ar lending has suraced as a financing vehicle wihou creaing covenan-busing realiies. Ar lending is clean, simple, imely, and ocused on providing value-added benefis. Ar philanhropy is anoher aspec calling or wealh managemen. Fine ar may serve as a chariable gif, or example, ha requires clien discussions, including he recipien insiuion so ha an ar preservaion plan can be creaed (Zorloni and Willete 2014). In a word, insead o selling heir ar, some invesors find a chariy, museum, or oundaion o ake i, display or sore i unil a laer ime when he insiuion can sell he ar eiher privaely or a public aucion. Alernaively, a collecor migh consider ranserring eiher par or all o a collecion o a rus or oundaion, which may call or review o sae laws and disclosure requiremens. Lasly, esae planning remains imporan as par o he wealh managemen process. Trough all o hese aspecs o collecing as invesmen, wealh managers mus consider he valuaions, planning, and axaion.

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Cliens have personal, individual needs, and wealh managers mus recognize hese needs and see he means or meeing hem as a business opporuniy. Why should a radiional wealh managemen firm recognize and include ar and collecibles in is porolio managemen process? Because ar represens a large par o he asse pool o some invesors and as such affecs heir asses under managemen. Te more an advisor knows abou a clien’s ineress and financial needs, he less likely he or she will be surprised o receive call rom ha clien or an immediae ranser o unds o cover a recen ar purchase. As previously discussed, McAliser and Cornwell (2012) noe he use o oys and oher collecible objecs as premiums or selling as-ood meals. Te objecs are highly sough afer by children and ofen cause parens o aler or reconsider heir choices or behaviors. I you exrapolae rom ha, you see ha he possibiliies are endless or wealh managemen. All aspecs o ar and collecibles should be inegraed ino clien discussions, les hose conversaions occur in he uure a a compeior’s office. Addiionally, enerainmen and social evens requenly cener on ar and collecibles, adding he emoional ouch. Banks and wealh managemen firms have long suppored he ars and offer evens as par o corporae sponsorship and paronage. Frankly, hese evens boh arge he people wih money o inves and are ways o show muual ineres. Wealh managers can creae goodwill by inviing cliens o evens wih an ar heme. Ar airs and lecures wih ar hisorians or museum recepions wih paricipaing ariss are similar examples o ways o solici new cliens and expand invesmen opions or exising cliens. Expanding he conversaion, creaing educaional opporuniies and innovaive awareness or he clien, and he clien conversaion coninues o creae value, which in he end is he wealh manager goal.

The Care, Management, and Disposition of Art Assets ART LENDING

Lending is a mainsay o he banking side o wealh managemen. Loans and deposis are a naural and basic banking uncion. As a resul, banking services should consider ar lending. However, hese ransacions are complicaed by he abiliy and/or capaciy o he lending insiuion o ake possession o he collaeralized ar. Works o ar need careul ranspor, while he lending insiuion needs o be able o assume possession. Wih ha possession comes responsibiliy or proeced aciliies wih secure access and monioring. Tese deails o ar lending creae addiional risks. An addiional hurdle is ha o he ranser o insurance liabiliy, which can someimes derail an acquisiion. EST ATE PLANNIN

G AND ART

ASSETS

Esae planning ofen overlooks he consequences ha occur when a ax clause is no srucured properly. Indeed, he wealh manager ofen does no pay atenion o or ge paid or anicipaing “wha could go wrong.” Ofen, also, he clien may no reveal his or her complee holdings o he atorney or wealh manager. Wheher by acciden or no,

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angible personal propery such as ar someimes disappears wihou a documened chain o ownership. In ha case, conflic may arise among heirs. Several key areas, including valuaion, axaion, inheriance, and succession planning, need o be incorporaed ino he esae planning when ar or collecibles are involved. For insance, he planning should consider a cos/ benefi analysis o gifing opions versus bequess. Valuaions should be considered or successive generaions when deermining he possession and conrol o he ar alongside he res o he financial wealh. Each o hese areas o experise are well documened wihin he subjec mater o income and esae axes, ye oo ofen wealh managers do no wan o srech he conversaion wih heir cliens o include hese opics. MANAGEMENT AND REPORTING

I he clien is busy collecing ar, hen who akes responsibiliy or he managemen and reporing o hose asses? Te wealh manager could and should assume ha role. Te wealh manager hen inegraes he collecion or collecibles ino a comprehensive asse managemen and reporing srucure. When perormed correcly and in imely manner, he reporing srucure can creae dependency on he wealh manager; indeed, providing periodic and ongoing valuaions should be on every wealh manager’s ask lis. Is he wealh manager in he bes posiion or providing an unbiased service? Or, in he ever evolving and innovaing world o online services, are do.com providers more ap o provide his service? New ools are being creaed and improved or racking invenory, pricing, and insurance. Are wealh managers prepared o evolve wih he indusry ha is currenly ouside heir regulaory bias? Can hey remain curren wihin he ar world ha compliance has ye o recognize? Te core services o an ar advisory migh be bes lef o hose wih subjec mater experise. Tis area is one in which cliens ofen come o he able wih heir own specialis or exper. Ar invesmen unds end o be ouside he radiional realm o wealh managemen, bu hey are an excellen opion or hose who wan o own ar, albei indirecly. Much o he unding or he ars comes rom non-U.S. sources. Many service providers and collecors believe ha wealh managemen firms should be offering hese unds, or a a minimum, be able o commen and advise on heir suiabiliy, as well as heir srenghs and weaknesses. Keeping abreas o developmens wihin he ar world should be a key job o wealh managers, i or no oher reason han or basic business developmen. ART AS AN ASSET CLASS

Should ar be considered a separae asse class? Many say yes, alhough i does no all wihin he guidelines o he Securiies and Exchange Commission (SEC). Some wealh advisors avoid he subjec or ear o no undersanding how o assimilae ar ino a clien’s porolio. Compliance issues such as he lack o regulaory oversigh by he SEC are raised when an ar balance shee iem is lised on he same page and is financially presened by a wealh manager in he conex o a porolio o radiional invesmens. Also, he ar and ar marke coninue o be unregulaed. Te risk o a wealh managemen firm dealing wih a largely unregulaed indusry and producs remains a major concern and seemingly a barrier o enry or purposes o advising cliens.

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However, or hose willing o move ino his field, here are numerous ar indexes providing wihin heir own parameers some esimaes and measuremens o he correlaion o reurns or purposes o financial decision making. Te Mei- Moses index, which is available a www.arasanasse.com , is bu one example. Te quesion or wealh managers is “How does he clien’s ar collecion correlae wih he curren invesmen porolio?” Mos wealh managers have difficuly responding wih a coheren answer. Te ailure o provide a coheren response is no because no answer exiss; raher, i is because inernal compliance resrics heir doing so. Ar as invesmen is complex in naure. By is very naure, wealh managers mus recognize he heerogeneiy o he asse class. Ye, ar can be an imporan consideraion in any porolio diversificaion sraegy. For wealh managers o be able o presen cliens wih a balanced porolio, hey mus explain how ar fis ino ha clien’s porolio and he role i plays in an asse diversificaion sraegy. As he value o fine ar coninues o increase, i has become an increasingly imporan porion o some cliens’ oal ne worh. radiionally, asses are measured or heir oal reurn wihin accepable levels o risk olerance.

The Influence of Social Media on Wealth Management Knowledge ransiioned rom research and ex ohave Inernesearches haownership are availablehas o almos everyone. echnological advances led o abased shif in decision-making processes. Knowledge, rus, and service are sill criical componens or he wealh managemen process, bu hey are being replaced by inormaion on social media oules. Such oules have become a common commodiy ha can be easily acquired or searched. Knowledge, rus, and service have largely been relegaed o anoher easily accessible “commodiy.” Pre-social media, hose who augh, sudied, and learned largely conrolled he knowledge and had he subjec mater experise. Expers wen o class, sudied hard or long hours, earned a degree, and passed examinaions. Tey go paid o share heir knowledge wih he public a large. In a similar ashion, rus was he produc o long relaionships, conacs, affiliaions, and associaions. People earned rus over ime. Cliens appreciaed service, which was unique jus like he delivery channel. Grea service a sar, achanged raing, and Tisearned environmen wiheedback. he enry o social media. During a relaively shor period, ha knowledge or subjec mater experise was ransormed rom a proeced, valued, and precious resource ino a simple, easily obainable commodiy. Te conversaion and relaed research sill akes place online, or may require muliple searches wih coordinaed ollow-up. Tink o he devices and services ha can be done individually or wih a smarphone. Wha sared as a “simple” indusry has exploded wihin he online world. Te echnologies are new and were virually nonexisen five years ago. ransparency has improved and he opporuniy or growh, expansion, and innovaion is now largely limiless.

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Te mos imporan aspecs o his evoluion, innovaion, and revoluion are he abiliy or increased awareness, access, and ineres, as well as he passion or social media. When i comes o a desire o acquire ar, mos desires, addicions, and ar afflicions are only a click away, and all are wihin he convenience o a smarphone, able, or compuer. Cliens oday are finding, learning, and challenging wha was unatainable only a ew years ago. For example, even wihin he confines o social media websies such as LinkedIn, here are numerous discussion groups sharing inormaion, posing aricles, and allowing or member-o-member communicaions ha can only coninue he process o “shrinking he world” as i relaes o online access, communicaion, and daa rerieval. So why do ypical wealh advisors ail o use hese sources o daa o benefi heir cliens? Iniially, he answer involved an issue o compliance and is relaed ormaliies. Compliance officers neiher saw nor had a business-developmen reason o see a causal associaion beween inormaion on ar and a lasing clien relaionship. PREVIOUSL Y LOCAL IS NOW G

LOBAL—

ART WORLDWIDE

Globalizaion is an ofen a misinerpreed and misundersood erm wihin he conex o ar and collecibles. Invesmens in one counry may be unaccepable wihin he confines o anoher sae or jurisdicion. Compleing a ransacion across geographical markes can increase he risk, and hese risks can presen hemselves in orms including legal ile,areand auheniciy, no apply o menion andwealh heir managers enorcemen. Such jurisdicion, associaed risks similar o hose ha o he righs world o and heir relaed invesmen porolio managers. Curren echnology has increased people’s access o ar. Wha was once limied by geography, cos, and access is now pracically atainable by all hrough echnology. A need o see, ouch, and discuss ar in order o undersand i remains, bu he images, evens, and experience can now be shared and used o educae he clien experience. o say ahead o he curve, wealh managers need o be even more knowledgeable or a a minimum, be able o reach ou o cliens insead o waiing o reac and respond o quesions. As he inrasrucure and he ools o he Inerne coninue o increase a an as pace, keeping up wih globalizaion will become more difficul. Alhough he ar marke will always innovae and disrup, i presens even beter opporuniies or wealh managers o show leadership heircreaes clien is relaionships. E-commerce nowwih allows crossing borders wih ease, bu in i also own se o issues ha exised he local ar dealer. Te clien can go rom dealer o dealer “across he globe” wih a poin and click. So how do wealh managers provide leadership or heir cliens? Tey do so by recognizing heir needs and curren realiy as well providing guidance. Consider he issues o differing legal jurisdicions, auheniciy, condiion, deecive ile, righs, and enorcemen. Addiional issues include impor, expor, value added axaion, and he moving he ar, which as menioned earlier involves shipping, packing, and soring, as well as a cos-benefi analysis. Each o hese iems represens an opporuniy o lead and

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guide he conversaion hrough obaining applicable knowledge, which creaes a greaer value added opporuniy o service cliens.

Online Ar Educaion Wih he coninuing advancemen and creaion o online educaion, new and esablished ar and collecible ollowers, jus like hose wihin he wealh managemen arena, can now be educaed wihou limi. Te key o success is he abiliy o be ineracive, wih an emphasis on media. Poin-and-click soluions allow seemingly limiless possibiliies. Tis change is posiive, bu can also be dauning. Te only limi o wha can be offered online is ha which exiss wihin and he consrains o curren business models and regulaors. Given he abiliy, inen, and ineres o universiies, museums, public insiuions, and individuals o educae online, he iniiaive has grea poenial. Te explosion o online ools will coninue o srenghen he inrasrucure used o supply inormaion, including ar inormaion. Tink o he number o ar indexes, news sies, pricing daabases, and analyical ools ha already exis and coninue o be creaed or discovered. Individuals who ravel o a websie ofen observe a separae ab or page dedicaed o “helpul links” or “useul ools” or some oher descripor. Build he connecors/ links an d hey w ill ol low. Wealh managers need o work more closely w ih ouside/ online inormaion, subjec o he requisie compliance limiaions, and educaional and indusry expers so ha heir offering is he mos complee offering. Te only limiaion is he sel- imposed compliance- relaed resricion ha he wealh managemen firm is no in ha business. Wealh managers should no longer see hemselves as produc providers bu as problem solvers, especially when i comes o ar and collecibles.

Online Aucions and Oher Markeplaces As online aucions coninue o receive increased invesmen atenion, wealh managers should consider he hough process as par o heir deliverable or invesmens and conneciviy. I he invesmen world is atenive and he online aucions coninue o grow, hen he wealh clien, especially he HNWs and UHNWs, will wan o know more. Te compeiion o provide daa will increase. New ar markeplaces have been creaed ou o he need or “virual” brick and morar sources. Online consumers need o acquire ar rom online sores. I was only a maer o ime beore he click-and-buy plaorm would be buil in he ar world. Ye, he online markeplace model is simply an inermediary. Go no urher han o recall how Black Friday morphed ino Cyber Monday. IS C2C THE NEW B2B?

Alhough business o business (B2B) was a once a prioriy, consumer o consumer (C2C) has he poenial o disrup curren business models. Enrepreneurs and radiional marke players are now being lef ou o he discussion. C2C is he newes way o eliminae he proverbial middleman who has been he mainsay o how business was conduced previously.

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C2C eliminaes long-esablished relaionships and enables consumers o work direcly wih oher consumers. I basically reduces coss, so ha he service or produc can be exposed and inroduced o he public. A communiy o paricipans hus is creaed ha has been exposed o he opporuniy o have limiless ineracions and communicaions wih he world a large. Tis new he compeiive landscape opens avenues o hose previously a a disadvanage. Te change may be good or bad depending on he side represened. Coupling he C2C and B2B environmens resuls in a mulidimensional hough process ha can expand curren hinking. Meanwhile, he B2B can fix and pach wha he C2C may be unable o iniially ideniy and make proessional adjusmens. For example, he business broker can expand on he ransacion opions where he iniial consumer may no.

E-commerce Te role o e-commerce wihin he ar communiy coninues o evolve and expand similar o oher businesses ha are looking o expand heir clien base beyond he radiional geographic and connec-based models. Te world is geting smaller bu is also exending is reach. Te Inerne and online aciviy have become he general populaion’s answer o “How do I ge here?” Individuals are no longer limied by geography, finance, or even language. Tey can find, obain, and explain almos anyhing wihin a caegory o subjec mater by searching he Inerne.

Beter ools Mean Beter Daa Fee srucure presens challenges or boh wealh firms and innovaive online ideas. For some services, such as consulaion and inormaion services, subscripion ees or differen levels o paricipaion are possible. Wealh relaionships should embrace he opporuniy o know he locaion o such services, how hey exis, and he bes way o include hem wihin heir wealh plaorm offering. I a clien can gain access o beter ools or daa managemen, wealh managers should become aware and begin o inerac accordingly. ONLINE BUSINESSES AND TRANSPARENCY

Te online business world or markes and service providers is ransorming he creaion, delivery, and applicaion o knowledge, as well as some services, ino a commodiybased produc ha coninues o lose is inellecual advanage. Enry o online businesses ino business models ha have been based on high profi margins and lack o ransparency coninues o grow, as evidenced by he innovaive ways ha new producs and services such as invenory racking are creaed and delivered. Te online plaorm has less overhead and reduced ransacion coss. Tis ac should enable his plaorm o compee wih esablished businesses and models. Increased ransparency in he orm o increased educaion and access is here o say. More people are sharing more inormaion abou more ar, especially a he lower and mid-ranges o he ar marke. Tis change does no mean ha all inormaion will become available o everybody all he ime. Te more expensive aucion houses and privae ransacions will no become accessible o he general populaion.

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As more inormaion becomes available online by more people rom more global geographies, addiional inormaion will be shared among people. Tus, wealh managers canno cie lack o ransparency as a limiing acor. Tis change coninues o reinorce he need or wealh managers o grow pas he biases and blockers ha limi heir paricipaion wih cliens o bring ar services and consuling ino heir wealh plaorms. COLLECTION

MANAGEMENT

TOOLS ARE

REALLY

WEALTH TOOLS

Given ha liquidiy is par o many business models, i should also be par o every ar model or collecion. Online services and access o inormaion and daa can only expand he reach o find and acquire new cliens and new ar. New cliens would necessarily mean a growing marke share and growing revenue. Collecion managemen ools such as invenory racking and online educaion should be prioriy iems or very soon o be iems or inegraion ino he wealh advisory service offering. Mos ools are cloud based and are par o a quickly expanding ar service, ar suppor business model ha can be used as a lead o oher ar relaed services or as a proecor or curren clien based businesses. Helping cliens collec and benefi rom he accumulaion and access o all inormaion abou everyhing he owns allows or greaer predicion o he nex seps wih some relaive ease.

Summary and Conclusions o mee fiduciary approaches o he wealh managemen, wealh managers mus deermine how bes o collec and disseminae inormaion abou ar o heir cliens. Some may wan o say ha he fiduciary sandard does no apply unless i alls wihin specific regulaory acs and circumsances. In oday’s world o social media overload and he accompanying abiliy o access almos anyhing a any ime, wealh managers can no longer hide behind he curain o convenien uninelligence when managing wealh, especially when he wealh includes ar.

DISCUSSION QUESTIONS 1. Explain how passion plays in a porolio conaining ar. 2. Elaborae on how a clien migh view adding ar as an asse class o a curren porolio. 3. Discuss he role o risk miigaion or ar invesmens. 4. Discuss he role o social media in inormaion disseminaion as relaed o ar. 5. Jusiy he increasing use o “commodiies” as a erm o describe holdings.

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24 Behavioral Finance Market Hypotheses ALEX PLASTUN Associate Professor Ukrainian Academy of Banking

Introduction No single approach exiss o explain he role o behavior in he financial markes. Te exising conceps are no only conradicory bu also based on differen assumpions. For many years, he dominan economic heory ha atemped o explain he behavior o financial markes was he efficien marke hypohesis (EMH) (Fama 1965; Samuelson 1965). Fama (1965) poins ou ha an efficien marke is one in which he availabiliy inormaion on curren marke prices corresponds wih inrinsicobservalue o he asse.oHowever, he many inconsisencies beween he EMH andhe empirical vaion led o he developmen o he behavioral finance marke hypoheses. Behavioral finance does no assume he raionaliy o he invesors, which is a basic assumpion o he EMH, wih empirical evidence o suppor his sance. De Bond and Taler (1985) show ha invesors overvalue recen inormaion and undervalue pas inormaion, resuling in marke mispricing. Black (1985) inroduces he concep o noise raders irraional invesors whose rades are no based on sound logic. Tese irraional invesors can cause prices o deviae rom heir rue value. Ijiri, Jaedicke, and Knigh (1966) provide anoher reason or he irraionaliy: a habiual response o a amiliar simulus (ermed uncional fixaion). As Mandelbro (1972) shows, prices in he financial markes are no random, and he provides evidence o price persisence. Tis chaper offers a synhesis o research on he behavior o financial markes and discusses heEMH, mos including popular behavioral finance marke hypoheses. Teasfirs explores he is basic assumpions and key provisions, wellsecion as presening a shor lieraure review. Also discussed is he random walk hypohesis, which serves as he basis or he EMH. Te second secion inroduces behavioral financial marke hypoheses and explores Lo’s (2004) adapive marke hypohesis (AMH), wih a view oward is basic assumpions and pracical implicaions. Te hird secion presens he racal marke hypohesis (FMH), which is popular among praciioners. Tis heory denies he randomness o he price dynamics and general raionaliy o he invesors; insead, i claims ha financial markes are persisen and invesors wih differen horizons are presen in he markes. Tis secion also provides comparaive characerisics o he EMH and he FMH. Te ourh and fifh secions hen examine one o he mos popular anomalies o he EMH and heories based on 439

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hem he overreacion and underreacion hypoheses. Tese secions presen a brie descripion, supporive empirical evidence, and some heoreical explanaions o hese overreacion and underreacion effecs. Te sixh secion deals wih he noisy marke hypohesis (NMH), which divides invesors ino raional and irraional invesors, wih noise explaining mos o EMH anomalies. Te final secion explains he uncional fixaion hypohesis, which is based on a habiual response o a amiliar simulus, resuling in irraional acions and decisions.

The Efficient Market Hypothesis Te EMH is an economic heory ha describes he behavior o financial markes. Work by Bachelier (1900) is he basis or his heory, and boh Fama (1965) and Samuelson (1965) independenly ormulaed he EMH hypohesis. Fama (1965) poins ou ha an efficien marke is one in which, owing o he availabiliy o inormaion, curren marke prices correspond o an asse’s inrinsic value. RANDOM WALK HYPOTHESIS

Te random walk hypohesis (WH) led o he emergence o he EMH. According o he WH, an asse’s price a a given momen does no depend on is earlier prices. As a resul, he sudy o pas price changes is no a way o deermine he direcion o uure price movemen. Despie some conroversy abou his hypohesis (i.e., asse prices have a undamenal basis and are a moneary valuaion o hese acors), he WH has ound suppor on boh pracical and heoreical levels. Figure 24.1 models he dynamic process, using randomly generaed prices. Figure 24.2 is a graph o daily gold prices. Te wo graphs are almos idenical, ye such a siuaion is no unique. Similar examples can be ound or oher asses when comparing heir price dynamics wih randomly generaed graphs. Tis indirec evidence offers suppor avoring he WH. Lo and MacKinlay (1987) reexamine he WH, rejecing i or weekly indexes o U.S. sock reurns rom 1962 o 1985. Moreover, Lo and MacKinlay (1999) observe ha afer he publicaion o heir research, several oher sudies also rejeced he WH. EFFICIENT MARKET HYPOTHESIS: BACKGROUND

According o he EMH, all paricipans o financial markes are raional economic individuals who operae under condiions o ree access o inormaion ha allows hem o accuraely predic uure prices. Te prices o asses under hese condiions are ully consisen wih heir inrinsic values, a posiion which prevens abnormal profis in financial markes. Tus, markes in which prices o financial asses are equal o heir inrinsic values are absoluely efficien. As one o he ounders o he EMH, Samuelson (1965) noes ha in an inormaionally efficien marke, price changes canno be orecased, assuming hey ully incorporae he inormaion and expecaions o all marke paricipans. According o Jensen

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Figure 24.1 andomly Generaed Values. Tis figure sh ows he resuls o s ome randomly generaed dynamics wih a probabiliy o 0.5. Te hor izonal axis displays he number o he experimen and he verical a xis shows he cumulaive resul o reurns generaion.

(1978), a marke is efficien i, wih respec o inormaion se N, making economic profis by rading on he basis o inormaion se N is impossible. Tus, greaer marke efficiency implies ha price changes are more randomly generaed by he marke. Indeed, he mos efficien marke is he one in which price changes are compleely random and unpredicable. Tis conclusion is based on he ac ha price is a direc resul o many acions o marke paricipans atemping o profi rom inormaion. Ta is, invesors are consanly rying o use even he smalles inormaional advanages o gain profis. In doing so, hey incorporae inormaion ino hose marke prices and quickly eliminae he profi opporuniies ha moivae heir acions. I his siuaion occurs insananeously, prices should always ully reflec all available inormaion. Tereore, no profis can be obained rom inormaion- based rading, because such profis have already been capured. EFFICIENT MAR KET HYPOTHESIS: ASSU AND PROVISIONS

MPTIONS

Te EMH is based on several key assumpions: • All new marke inormaion is quickly and almos insanly refleced in he securiy prices. • Only raional economic agens are acing in he financial markes. • Financial markes exhibi perec compeiion.

651.060

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632.300

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556.700 2006

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Figure 24.2 Gold Prices or Tree- Monh Period, 2006. Tis figure i s a candlesick char, which shows a porion o daily gold prices (verical during Ocober and Nov ember 2006 (horizonal ax is). Te box is clear i he closing price is higher han he opening price, or is filled i lower han he opening pr ice. Source: Mearader rading Plaorm. Available a htp:// www.meaquoes.ne/en/mearader4.

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• Expecaions o marke paricipans are homogeneous (i.e., all invesors evaluae he likelihood o uure asse reurns in he same way). • Asse prices change according o he “law o a random walk.” Based on hese EMH assumpions, he ollowing key provisions can be ormulaed: (1) marke prices equal he corresponding inrinsic values o asses; and (2) economic decisions ha allow obaining exra profis are impossible. Empirical observaions in he financial markes do no universally suppor he assumpions ha underlie he heory o efficien markes. Te same applies o he main provisions o he EMH. DIFFERENT FORMS OF THE MARKET HYPOTHESIS

EFFICIENT

Te presence o marke anomalies and some pracical inconsisencies in he basic heoreical assumpions o he EMH have led o he emergence o hree orms o marke efficiency weak, semi-srong, and srong based on differen ypes o available inormaion. Te weak orm o efficiency (pas price and volume hisory) is reely available. Te semi-srong orm o efficiency (public inormaion) resuls rom all inormaion ha is publicly available, including pas price and volume hisory o he marke. Te srong orm o efficiency (privae inormaion) reflecs all inormaion rom he previous groups, plus any inside inormaion no available o mos marke paricipans. EFFICIENT MARKET HYPOTHESIS: PROS AND CONS

According o Jensen (1978), no oher proposiion in economics exiss ha has more empirical suppor. Kohari and Warner (2007) sudy scienific publicaions ha suppor he EMH. According o heir analysis, more han 500 publicaions in op economic journals confirm raional invesor behavior and he efficien response o new inormaion. Neverheless, empirical daa rom he financial markes show ha he assumpions underlying he EMH do no always correspond wih pracice. For example, as Ball (2009) noes, he lis o differences beween observaions and he EMH is long and includes boh overreacions and underreacions o cerain inormaion; exreme volailiy and seasonal increases in reurns; and yield dependence on differen variables, including marke capializaion, dividend rae, and marke raes. Alhough he EMH had been he dominan economic heory explaining he behavior o financial markes, many inconsisencies beween he EMH and he empirical evidence led o he developmen o alernaive conceps and heories.

The Adaptive Markets Hypothesis Based on dissimilar precondiions and assumpions, behavioral finance and EMH view he financial markes differenly. Te major variance is he assumpion o raionaliy on he par o marke paricipans. EMH assumes paricipans are raional, whereby heir financial decision is he opimal choice, whereas behavioral finance assumes ha

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paricipans migh exhibi semi-irraional behavior based on he noion o bounded raionaliy. Bounded raionaliy is he premise ha individuals are influenced by heir ases, values, pas judgmens, and limis o heir cogniive process, resuling in a saisacory oucome. Andrew Lo (2004) inroduces a new heory ha atemps o reconcile he EMH wih behavioral finance, called he adapive marke hypohesis (AMH). According o Lo (2004), irraionaliy can be explained by he ac ha individuals adap o changing environmens. Te basic idea o he AMH is he applicaion o evoluionary principles such as compeiion, naural selecion, adapaion, and reproducion o financial markes. Tis idea is consisen wih rading aciviy in he financial markes. No rading sraegy can consanly generae profis in he financial markes because hose financial markes are always changing. For example, innovaions such as Inerne rading have dramaically changed he behavior o financial markes. As a resul, invesors need o consanly be searching or changes and evolve heir sraegies accordingly. Te evoluionary idea o economic behavior is no new, however. For example, Wilson (1975) sysemaically applies he principles o compeiion, reproducion, and naural selecion o human social ineracions. Sociobiology is a field o scienific sudy based on he hypohesis ha social behavior resuls rom evoluion, and i atemps o explain and examine social behavior wihin ha conex. According o Wilson, evoluionary processes, along wih his sociobiology concep, depend on social behaviors such as alruism, aggression, airness, religion, moraliy, and ehics.. Whereas Wilson (1975) uses sociobiology o explain social behaviors, Niederhoffer (1997) applies evoluionary heory o he behavior o financial markes. He considers financial markes as a unique ecosysem, wih herbivores (dealers), carnivores (speculaors), and decomposers (disressed invesors). Similarly, Luo (1998) explores he implicaions o naural selecion or uures markes. He argues ha naural selecion allows or long-erm survival in he uures markes because he irraional raders lose heir money and quickly leave he marke. As a resul, he bes predicors o marke movemens generae beter decisions and he markes gain efficiency. THE SPECIES FOUND IN THE FINANCIAL MARKETS

Lo (2004) expands on he previous research by ormulaing he AMH o show ha prices reflec as much inormaion as are dicaed by he combinaion o environmenal condiions and number and naure o marke paricipans, or species in he economy. Species in his conex are disinc groups o marke paricipans, each behaving in a common manner. For example, marke makers, hedge unds, pension unds, and privae invesors can be hough o as separae species. Tese species are neiher perecly raional nor compleely irraional; raher, hey are bounded in heir degree o raionaliy. Tey make choices based on pas experience and heir percepion o wha migh be opimal in a given siuaion, based on he concep o bounded raionaliy. Lo (2004, p. 22) describes he behavior o marke paricipans: “Individuals make choices based on experience and heir bes guesses as o wha migh be opimal, and hey learn by receiving posiive or negaive reinorcemen rom he oucomes.” Undersanding o he environmen, he naure o heir species, and he prevailing species ypes helps invesors comprehend he marke.

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445

A key insigh provided by he AMH is ha marke equilibrium is neiher guaraneed nor likely o occur a any poin o ime. Tis is because he relaionship beween risk and reward changes over ime. Differen acors can influence his relaionship, including he relaive sizes and preerences o various populaions in he marke, which may include ecology and insiuional aspecs such as he regulaory environmen and ax law. Shifs in hese acors over ime are likely o affec any risk–reward relaionship. For example, during periods o uncerainy and insabiliy, invesors usually reduce he amoun o risky asses in search o “sae havens,” and hey ac raionally. Bu hen here are periods o collecive greed or ear, when bubbles orm and crashes occur and hese are imes when many invesors ac irraionally. THE EVOLUTION OF THE FINANCIAL MARKETS

Neely, Weller, and Ulrich (2009) use he oreign exchange (orex) marke as heir example o demonsrae he evoluionary process o financial markes. Te auhors analyzed excessive reurns in he orex marke, and hey show ha he surplus reurns o he 1970s and 1980s were real, no jus he resul o daa mining. However, hese profi opporuniies disappeared by he early 1990s or models based on filer and movingaverage rules. Te invesmen landscape is also changing. Lo (2012) conends ha he environmen o he las decade is subsanially differen rom ha o he previous seven decades. He says ha oday’s markes are larger, aser, and more diverse han a any oher poin in hisory. Te degree o marke efficiency depends on condiions ha characerize cerain ypes o financial markes. I a large number o species figh or limied resources, he compeiion is high; in his case, markes such as he U.S. sock markes or orex will be efficien or a leas reasonably efficien. Ye, i he number o species is small and he resources are abundan, some markes, such as emerging markes, can be inefficien. Environmenal acors including he number o compeiors in he marke, adapabiliy o marke paricipans, and magniude o available profi opporuniies influence marke efficiency. Anoher imporan aspec o he AMH is he presence o arbirage or profi opporuniies he possibiliy o bea he marke. Profi opporuniies are he resul o marke changes and evoluion; however, hese opporuniies are no consan and hey disappear as raders exploi hem. Te AMH recognizes he exisence o differen orms o marke dynamics: rends, cycles, “flas,” bubbles, and crashes. Each o hese orms requires differen invesmen sraegies. As a resul, invesmen sraegies may perorm well in some environmens and poorly in ohers. ADAPTIVE MARK AND PRACTICAL

ET HYPOTHESIS: ASSUMP IMPLICATI ONS

TIONS

Te assumpions o he AMH are: • Individuals ac in heir own sel-ineres, make misakes, learn and adap. • Compeiion drives adapaion and innovaion and naural selecion shapes marke ecology. • Evoluion deermines marke dynamics.

446

MARKET EFFICIENCY ISSUES

Te main implicaions o he AMH include he ollowing: • A relaionship beween risk and reward exiss, bu i is unlikely o be sable over ime because individual and insiuional risk preerences are unlikely o be sable over ime. • Profi opporuniies do exis occasionally. • Invesmen sraegies (based on echnical or undamenal analysis) can perorm well, bu only in cerain environmens. • Asse allocaion can add value by exploiing he marke’s pah dependence and sysemaic changes in behavior. • Marke efficiency is no an all-or-nohing condiion, bu is a characerisic ha varies coninuously over ime and across markes. • Te primary objecive o any marke paricipan is survival, or which he caalyss are innovaion and he abiliy o adap o marke changes. One o he mos crucial differences beween he EMH and he AMH is reurn predicabiliy. According o he EMH, reurn predicabiliy is impossible, bu he AMH acceps he possibiliy o i, based on empirical observaions. Kim, Shamsuddin, and Lim (2011) find srong evidence ha changing marke condiions drive reurn predicabiliy. Zhou and Lee (2013) cie similar conclusions ha marke condiions influence reurn predicabiliy and ha marke efficiency varies over ime. Charles, Darné, and Kim (2012) provide evidence avoring he AMH: he reurn predicabiliy o oreign exchange raes occurs rom ime o ime, depending on changing marke condiions. odea, Ulici, and Silaghi (2009) analyze he profiabiliy o moving average sraegies and conclude ha heir profiabiliy is no consan in ime; hey also conclude ha he degree o marke efficiency varies hrough ime, and his evidence suppors he AMH. More empirical research is required beore he AMH can serve as a viable alernaive o he EMH. Addiional findings will deermine he evoluionary dynamics o financial markes and invesor behavior across ime and circumsances. Neverheless, he AMH helps o reconcile he EMH and behavioral finance, explaining differen anomalies o he EMH while no denying is enire hypohesis. For example, Urquhar and McGroary (2014) find ha calendar anomalies suppor he AMH and ha he AMH offers a beter explanaion o he calendar anomalies han he EMH.

The Fractal Market Hypothesis A basic assumpion o he EMH is he randomness o pricing processes, based on he WH and he absence o memory in price movemens. However, financial ime-series paterns persis, including hose o a shor- and long-erm naure. Mandelbro (1972) is among he firs o provide evidence o he persisence o long memory in he financial markes. Laer, Greene and Fieliz (1977) find long-erm dependences in sock prices on he New York Sock Exchange (NYSE). Booh, Kaen, and Koveos (1982) also repor ha some financial series have long memories. Helms, Kaen, and osenman (1984) find long memory properies or he price o uures. As a resul, Peers (1991, 1994) proposes an alernaive nonlinear concepion o financial

47

Behavioral Finance Market Hypotheses

447

able 24.1 Comparaive Characerisics ofhe Efficien Marke Hypohesis and he Fracal Marke Hypohesis Crierion

EMH

FMH

Te raionaliy o marke paricipans

Invesors always ac raionally and ry o maximize heir income.

Invesors choose sraegies wihin shor-erm or long-erm horizons ha are subjec o psychological acors, bu invesors do no always

Te degree o compeiion in he marke

None o he marke paricipans can significanly affec prices, which equal he inrinsic value o asses.

Price disribuion

Prices are normally disribued and show Brownian moion.

Markes can demonsrae a posiive price correlaion (indicaive o a rend), a persisen series (more ofen), and a negaive correlaion or ani-persisen series (rarely).

Assumpions

Price is he resul o

Price reflecs he “inrinsic value”

abou pricing

collecive raional assessmens and reflecs he exising undamenal inormaion.

only or he seleced invesmen horizon and can be subjeced o boh undamenal and echnical analysis.

ac raionally. Equilibrium prices are ormed as a resul o a combinaion o shorerm echnical rading and longerm undamenal valuaion.

markes, called he racal marke hypohesis (FMH). Te basic assumpions o he FMH are he concep o racals (presence o paterns in price movemens) and he exisence o differen invesmen horizons, in which some invesors make decisions based on shor-erm horizons while ohers base hem on long-erm horizons.able 24.1 presens he main differences beween he FMH and he EMH.

THE IMPORTANCE OF PERSISTENCE

According o he FMH, a key characerisic o he financial ime series is persisence, which is he characerisic o somehing ha oulives he process ha creaed i or he coninuance o an effec afer is cause is removed. Persisence means ha prices may no be random and ha rends are ypical or a financial ime series. Te EMH excludes he applicaion o echnical analysis, whereas he FMH operaes numerous indicaors ha se he basis o is racal echnical analysis. echnical analysis, according o he FMH, can be an insrumen o predic uure prices. Ta is, i offers arbirage opporuniies or exra profis rom rading in he financial markes. One o he mos applied aspecs o he FMH is he presence o specific indicaors or measuring he level o marke efficiency, such as he racal dimension and he Hurs

448

MARKET EFFICIENCY ISSUES

exponen (Los 2003). I allows ideniying markes wih differen levels o efficiency; an efficien marke is a special case o he FMH. Analyss have examined he persisence o financial daa ime series or differen ypes o financial markes, such as sock markes, orex, and commodiies, wih mixed empirical resuls. For example, Greene and Fieliz (1977), Peers (1991), and Onali and Goddard (2011) ound saisically significan evidence o long-erm memory in he financial markes. However, Lo (1991), Jacobsen (1995), Crao and ay (2000), and Serleis and osenberg (2007) all conclude ha he price flucuaions are random, indicaing he absence o long-erm memory in he financial markes. Differences in mehodology, ime periods, and research objecives can explain hese differen conclusions. wo oher aspecs o hese differences are he insabiliy o boh financial marke behavior and a marke persisence level (Mynhard, Plasun, and Makarenko 2013; Caporale, Gil-Alana, Plasun, and Makarenko 2014b; Oprean, ănăsescu, and Brăian 2014).

The Overreaction Hypothesis Te EMH saes ha prices in he financial markes are generaed randomly. Ye, siuaions in he marke occur ha canno be simulaed by random generaion. For example, figure 24.3 shows ha random generaion ails o display he paterns ha ook place beween 2008 and 2010 in he U.S. sock marke; his illusraes an example o overreacion. Since he 1980s, researchers have paid more atenion o overreacions in he financial markes. Overreacions are generally subsanial deviaions in prices o asses compared o heir average (ypical) values during cerain ime periods. A REVIEW OF THE LITERATURE ON OVERREACTION

As De Bond and Taler (1985) show, invesors overvalue more recen inormaion and undervalue pas inormaion. Tis resuls in an anomaly in which porolios wih he wors (or bes) dynamics during a hree-year period show he bes (or wors) resuls during he subsequen hree years. Tis anomaly led o he ormaion o he overreacion hypohesis. Various sudies have examined he overreacion hypohesis. For example, Brown, Harlow, and inic (1988), who analyze NYSE daa beween 1946 and 1983, reached conclusions similar o De Bond and Taler (1985). Zarowin (1989) finds he presence o shor-erm marke overreacions. Akins and Dyl (1990) repored overreacions in he NYSE afer significan price changes in one rading day, especially in he case o alling prices. Ferri and Min (1996) confirm he presence o overreacions by using S&P 500 Index daa beween 1962 and 1992. Larson and Madura (2003) use NYSE daa beween 1988 and 1998, and also show he presence o overreacions. Overreacions in oher sock markes have been documened inernaionally, including hose in Spain, Canada, Ausralia, Japan, Brazil, China, Greek, urkey, and Ukraine (Mynhard and Plasun 2013). According o Clemens, Drew, eedman, and Veeraraghavan (2009), he overreacion anomaly has no only persised bu also has increased since he 1990s.

Figure 24.3 Movemen o DJIA be ween 2000 and 2013. Tis figure shows he dynamics o he Dow Jones Indu srial Average (DJIA) Index ( axis) beween 2000 and 2013 (horizonal ax is). Daa beween 2008 and 2010 illusrae an ex ample o overreacion ha ook place in he U.S marke. Source: Hisorical Char Gallery: Marke Indexes. Available a htp://sockchars.com/reechars/hisorical/djia2000.hml.

450

MARKET EFFICIENCY ISSUES

REASONS FOR OVERREACTIONS

According o he overreacions heory, he irraional behavior o invesors resuls as overreacions o new inormaion. Tis leads o significan deviaions in asse prices compared o heir undamenal values. able 24.2 shows he reasons or such overreacions, which can be psychological, echnical, or undamenal in naure. I an overreacion resuls rom a combinaion o psychological, echnical, and oher nonraional acors, insead o being achievemen o a new level o air price, should hose overreacion prices achieve equilibrium a he end o he overreacion? Bremer and Sweeney (1991) demonsrae ha afer a very srong negaive price movemen, here is a posiive price movemen, and his movemen exceeds ordinary movemens. Analyses o negaive daily changes exceeding 10 percen have shown ha he nex day hose prices increase by 1.77 percen, on average. Tis phenomenon can be explained by a fixaion on profis (closing he opened posiions generaes profis) and a reassessmen o he inormaion by invesors. Te overreacion hypohesis finds validiy no only on he heoreical and empirical levels bu also in he realm o real rading. Lehmann (1990) and Jegadeesh and iman (1993) find ha a sraegy based on overreacions can generae abnormal prois. However, Caporale, Gil-Alana, and Plasun (2017), who analyzed differen financial markes, find ha a sraegy based on couner-movemens afer overreacions does no generae profis in he orex and he commodiy markes, bu does remain profiable in he large-cap U.S. sock marke. Te auhors ideniy a new anomaly based on he overreacion hypohesis, called he ineria” anomaly, in which on he day afer an overreacion, prices end o move in he same direcion.

The Underreaction Hypothesis As explained previously, he overreacion hypohesis deals wih an unexpecedly srong invesor reacion o cerain evens, wih negaive correlaion in reurns over he long run. Tus, conrarian movemens appear afer overreacions. However, an opposie siuaion could exis in which invesors show litle reacion o an even during is appearance bu reac acively in he nex period. Tis phenomenon is a posiive auocorrelaion, by which a posiive change oday leads o posiive changes omorrow, and vice versa, in shor-erm reurns; his is called he underreacion hypohesis. Culer, Poerba, and Summers (1991) and Bernard and Abarbanell (1992) boh offer empirical evidence supporing underreacion. Tey find ha socks wih announcemens o higher earnings earned higher reurns in he period afer he announcemens, which indicaes ha he marke underreacs o earnings announcemens (inormaion wasn’ incorporaed a once a he day o he announcemen). Shleier (2000, p. 427) saes “he key idea ha generaes underreacions is ha invesors ypically (bu no always) believe ha earnings are more saionary han hey really are.” Jegadeesh and iman’s (1993) sudy o he underreacion hypohesis find ha sock reurns are posiively auocorrelaed over a six-monh horizon. Tey show ha a sraegy o buying a porolio o socks wih he highes posiive reurn in he previous monhs (winners), and selling hose wih he lowes reurns (losers), can generae abnormal reurns during

451

able 24.2 Reasons for Invesor Overreacions Overreacion Cause

Descripion

Psychological reasons

• Invesors ac basedon emoions (Griffin and versky 1992; Madura and ichie 2004). • Purely psychological characerisics o invesor’s behavior are panic and crowd effecs. • Represenaiveness effec: I a paricular marke or marke secor is growing rapidly over ime, i orms a posiive image among invesors. Accordingly, invesors begin o preer asses o his secor. • Overconfidence and biased atiude: Invesors ofen overesimae heir abiliy o analyze he marke siuaion.

echnical reasons

• Execuion o sop-losses (“sops”). Tese are orders o close opened posiions when reaching a cerain level o losses (Duran and Caginalp 2007). Execuing sop-loss orders acs as a movemen caalys or acceleraor and leads o increases in he scale o basic movemen and loss o conrol over is size. Te mos ypical example o overreacion caused by sops execuion is he collapse o he Dow Jones Indusry Average (DJIA) in 1987 (Black Monday), when he DJIA los 22.6 percen o is value. • Margin-call heory: In case o large and unexpeced movemen in he marke, a margin-call mechanism ofen comes ino acion, closing he mos unprofiable posiion o he clien o release he margin (Aiyagari and Gerler 1999). • echnical analysis mehodology is based on he previous price flucuaions in orecass o uure prices. A widely held belie is ha curren movemen in asse prices can generae specific rading signals rom various echnical indicaors ha will lead o massive operaions/rading in he curren movemen direcion and will srenghen i causing overreacion

Fundamenal reasons

• According o he price-raio hypohesis proposed by Dreman (1982), companies wih low price/earnings raios are undervalued. However, ew invesors wan o buy socks o hese companies because invesors sill have srong memories o previous negaive atiudes oward hese companies. Neverheless, when negaive news o such companies ends and posiive news becomes dominan, he demand or shares increases, leading o abnormal movemens. Te opposie siuaion is observed or overvalued shares.

Exisence o noise raders

Irraional invesors are hose who make invesmen decisions on ragmenary inormaion and curren price flucuaions.

Oher reasons

Te lack o liquidiy in he marke can cause siuaions when even a small number and amoun o ransacions can lead o subsanial price flucuaions ( Jegadeesh and iman 1993).

Source: Mynhard and Plasun (2013).

452

MARKET EFFICIENCY ISSUES

he ollowing monhs. Te auhors explain his phenomenon as invesors’ adaping o new inormaion (posiive or negaive) oo slowly; as he resul, here is a momenum effec. Chan, Jegadeesh, and Lakonishok (1996) and ouwenhor (1997) offer urher evidence supporing he underreacion hypohesis. REASONS FOR UNDERREACTION

A possible reason or he underreacion phenomenon is conservaism bias, which describes invesors who are anchored o previous inormaion abou a company or financial asse. When here is new inormaion, hey view i in accordance wih heir prior sance. I his inormaion is inconsisen wih heir earlier views, hey may even ignore i. As a resul, an inappropriae reacion o undamenals occurs. A chance also exiss ha hose invesors migh simply under-weigh ha new inormaion, paricularly a change in dividend policies or surprised earnings. Anoher psychological reason or underreacion is represenaiveness, which describes how invesors can see paterns in random processes. For example, invesors migh believe ha earnings are more saionary han hey really are (Shleier 2000). Tey draw conclusions abou new inormaion such as an earnings announcemens based on heir inerpreaion o realiy, which is no necessarily correlaed wih observaion. A hird possible reason or underreacion involves differen ypes o invesors. Some invesors migh make decisions based on undamenals, whereas oher invesors migh make decisions based on echnical analysis. Some use a shor-erm perspecive, bu ohers use a long-erm perspecive. As a resul, differen invesors make differen invesmen decisions in he same siuaion: some migh buy a cerain asse because in he long run i will rise and undamenal acors provide evidence avoring his acion; ohers migh buy he asse because here are signs o a downrend and he echnical analysis indicaors confirm his acion. Opporuniies resuling rom underreacion could generae profis or arbirage, which is inconsisen wih he EMH. For example, Bernard and Tomas (1989) show ha a rading sraegy based on underreacion generaes posiive reurns. Frazzini (2006) builds an even-driven sraegy based on underreacion. Jegadeesh, Chan, and Lakonishok (1996) provide a comprehensive analysis o invesmen sraegies based on he underreacion and o evidence avoring he underreacion hypohesis.

The Noisy Market Hypothesis A criical eaure o he EMH is he assumpion ha all marke paricipans are raional subjecs. Te FMH idenifies a leas wo ypes o invesors: hose wih a shor-erm orienaion and hose wih a long-erm perspecive. Tese differen invesmen horizons can lead o differen decisions. Black (1985) inroduces he concep o noise rading. In he financial markes, raional invesors rade on inormaion, bu noise raders do no. Shleier and Summers (1990) urher develop he concep. Tey explain ha noise raders are no ully raional and hey base heir decisions on heir own belies or senimens. Tese belies and senimens could be responses o pseudo-signals, such as ollowing marke gurus and

453

Behavioral Finance Market Hypotheses

453

orecasers, using echnical analysis, believing hey can ideniy price paterns, and oher judgmen biases such as exrapolaing rom pas prices. ypical eaures o noise raders are over-opimism and overconfidence. I he belies o differen noise raders correlae during a cerain ime, he aggregae demand or an asse can shif, resuling in a price change. Tese price changes can hen produce deviaions rom air (rue) values. Summarizing he noise concep, Black (1985, p. 534) saes: “Noise creaes he opporuniy o rade profiably, bu a he same ime makes i difficul o rade profiably.” Noise raders are imporan because hey provide liquidiy o he markes. Te effecs o noise rading generally are shor erm and possibly an increase in price volailiy. I he number o noise raders is sufficienly large and he direcion o heir acions is he same, hough, price bubbles may appear; in his case, he effec may become long erm. Siegel (2006) classifies marke paricipans using a differen decision-making basis: speculaors and momenum raders, hedgers and insiders, insiuional invesors and banks, and ohers. Each o hese paricipans has reasons or is decision making, such as diversificaion, asse managemen, ax opimizaion, speculaion, and liquidiy. As a resul, many paricipans wih differen rading raionales can influence prices, which can hen resul in deviaions rom undamenal values during cerain periods. Siegel (2006, p. A14) explains he noisy marke hypohesis (NMH) as ollows: Prices o securiies are subjec o emporary shocks ha I call “noise” ha obscure heir rue value. Tese emporary shocks may las or days or or years, and heir unpredicabiliy makes i difficul o design a rading sraegy ha consisenly produces superior reurns. o disinguish his paradigm rom he reigning efficien marke hypohesis, I call i he “noisy marke hypohesis.” Te NMH can explain some anomalies o he EMH, including he size and value o anomalies, overreacions, and underreacions. One resul o NMH developmen is a undamenal indexing invesmen sraegy in which an invesor orms a por olio using one or more acors such as book value, cash flow, revenue, sales or div idends insead o a sandard capializaion- weighed indexed approach where he weigh o each sock in he index is proporional o he oal marke value o is shares (Arnot, Hsu, and Moore 2005). Te NMH explains why prices canno always be a heir rue value: hey may conain pricing errors, caused by “noise.” A lingering quesion is how o measure boh o hese pricing errors and noise.

The Functional Fixation Hypothesis Behavioral finance mainains ha invesors canno be ully raional. Irraionaliy is caused by many acors, wih some clearly psychological in naure such as ear and greed, overconfidence, and anchoring. Tese acors migh lead o nonraional behavior ha resuls in price bubbles, overreacions, underreacions, and oher anomalies. Habi is cerainly psychological aspec ha can affec invesor behavior. Habis are a resul o an inabiliy o change behavior, even when a siuaion has changed. In he

454

MARKET EFFICIENCY ISSUES

academic lieraure, such a siuaion (ermed a habiual response o a amiliar simulus) is called uncional fixaion, firs documened by Ijiri e al. (1966, p. 194): People inuiively associae a value wih an iem hrough pas experience, and ofen do no recognise ha he value o an iem depends, in ac, upon he paricular momen in ime and may be significanly differen rom wha i was in he pas. Funcional fixaion can occur a all hree sages o he decision-making process: inpu (source and orm o he inormaion available o decision makers), processing (acquiring inormaion, evaluaing he relevance o differen iems o inormaion, and weighing he imporance o specific iems or he decision ask), and oupu (decision sage) (Ghani, Laswad, ooley, and Kamaruzaman 2009). CAUSES OF THE FUNCTIONAL F

IXA TION

Funcional fixaion is a direc resul o he habis ormed by work experience, amiliariy wih he echnologies used in he decision-making process, and personal characerisics such as gender, confidence and cogniive syle (Nouri and Clinon 2006). Decision makers menally acquire knowledge o similar or relaed inormaion or siuaions, and hey hen end o overlook inormaion hose siuaions. Tey also end o assume ha a paricular ineres or pracice is always reaed similarly (Ghani e al. 2009). Funcional fixaion also occurs when someone is unable o hink in a differen or adapive way. Ambiguiy is one o he more imporan cause o uncional fixaion. Ijiri (1967) summarizes he main reasons or uncional fixaion as ollows: • Lack o knowledge abou a change in accouning mehod. • Lack o imely eedback ha would enable individuals o iner ha a change has occurred. • No expecaion o a differen payoff. • esponse in a manner consisen wih induced expecaions o superiors. • Habiual response o inormaion. • Presence o ambiguiy abou he objec.

FUNCTIONAL FIXATION IN THE FINANCIAL MARKETS

Funcional fixaion can be applied o he financial markes as an inabiliy o invesors o change heir decision-making process in response o a change in how he inormaion hey receive has been colleced or presened. Empirical evidence suggess ha financial analyss and invesors ail o adjus ully when here have been changes in accouning mehods ha affec sock prices (Hand 1990; Sloan 1996; Maines and McDaniel 2000). Tis relucance o adjus yields differences in heir evaluaions o he same resuls. Tere has been exensive discussion o he phenomenon o uncional fixaion and is accouning implicaions in regard o invesmen (Hirs and Hopkins 1998; Maines and McDaniel 2000; Luf and Shields 2001; Libby, Bloomfield, and Nelson 2002; Ghani

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e al. 2009). Findings show ha invesors exhibi uncional fixaion when hey compare financial saemens o firms using differen accouning policies. Many years ago, May (1932, p. 337) describes his siuaion as ollows: We accounans know how varied are he mehods commonly and legiimaely employed, how grea he effec o a difference o mehods on he earnings o a paricular period may be … . Invesors give he same weigh o profis o companies in he same business wihou knowing wheher he profis o which heir calculaions are applied have been compued on he same basis or how grea he effec o a difference in mehod migh b e. Hand (1990), who proposes and ess he exended uncional fixaion hypohesis (EFFH), offers anoher view o he concep. For Hand, he EFFH saes ha invesors migh reac o cerain inormaion in a manner consisen wih he EMH (as a raional invesor) or in a manner consisen wih uncional fixaion. POTENTIAL SOLUTIONS

TO FUNCTIONAL FIXATION

Possible soluions o overcome uncional fixaion are as ollows: • Providing insrucional learning (Luf and Shields 2001). • Using an appropriae orma or presening inormaion (Anderson and Kaplan 1992; Ghani e al. 2009). • Using search-aciliaing echnologies (Hodge, Kennedy, and Maines 2004). Funcional fixaion may lead o mispricing in he financial markes. As a resul, invesors who undersand a company’s real siuaion, and are no influenced by uncional fixaion, can rade beter han hose ones who are “uncionally fixaed.” Funcional fixaion migh also lead o anomalies in he financial markes, such as overreacions and underreacions.

Summary and Conclusions Te EMH was a dominan economic heory explaining financial markes or many years. I influenced he developmen o economic heory, such as modern porolio heory, and he ormaion o financial markes, such as exchange-raded unds. Ye, resricive assumpions and empirical inconsisencies have led o alernaive hypoheses, and he mos powerul among hese is behavioral finance. According o he EMH, invesors are ully raional, ye a main posulae o behavioral finance is ha invesors can someimes ac irraionally. Ta irraionaliy leads o marke anomalies and oher siuaions ha are inconsisen wih he EMH. Various explanaions hese anomalies include differing invesmen horizons, presence o shor- and longerm memory in he financial markes, noise raders, adherence o habi, and oher purely psychological effecs. Te presence o anomalies has led o he developmen o differen

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heories, conceps, and hypoheses o explain he markes and heir behavior, including adapive markes hypohesis, racal marke hypohesis, overreacion hypohesis, underreacion hypohesis, noisy marke hypohesis, and uncional fixaion hypohesis. Tese heories ry o explain he empirical findings and canno be viewed as a general heory o he financial markes. euing a heory such as he EMH involves exploring alernaive rameworks. Alhough sill popular, he EMH should be used only wih grea cauion, because is assumpions and resulan anomalies are inconsisen wih realiy. Tus, a need exiss o develop a general economic heory ha explains financial marke behavior.

Discussion Questions 1. 2. 3. 4.

Ideniy he necessary condiions or a marke o be classified as efficien. Discuss why no heory has emerged o ully replace he EFH. Provide several examples o illusrae he evoluion o he financial markes. Discuss wheher efficien markes exhibi reurn persisence and possible measures o marke efficiency. 5. Explain wheher he behavior o financial markes is consisen wih he EMH.

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25 Stock Market Anomalies STEVE Z. FAN Associate Professor of Finance University of Wisconsin Whitewater LINDA YU Professor of Finance University of Wisconsin Whitewater

Introduction Equiy anomalies are empirical relaions beween sock reurns and firm characerisics ha canno be explained by classical asse pricing models such as he capial asse pricing model (CAPM) (Sharpe 1964; Linner 1965) or muli-acor models (Fama and French 1993; Carhar 1997). In oher words, cross-secional sock reurns are predicable by differen company characerisics. eurn predicabiliy has become he hear o he marke efficiency debae and a ocal poin in asse pricing sudies. In he radiional heory o marke efficiency, in which invesors are raional and securiy prices incorporae all relevan inormaion, a securiy’s price equals is undamenal value. Tereore, only “surprises” can move a securiy’s price. Marke efficiency predics a lack o predicabiliy in uure sock reurns, ye he discovery o equiy anomalies direcly conradics he marke efficiency heory. No surprisingly, equiy anomalies have become one o he mos conroversial opics in financial research, wih widespread disagreemen on he underlying reasons or his predicabiliy. ecen lieraure usually atribues he exisence o anomalies eiher o an inadequacy in underlying asse pricing models or o marke inefficiency. Te inadequacy in asse pricing models is usually called he raional explanaion. I builds on he radiional risk–reurn ramework wih assumpions ha invesors are perecly raional and he marke is efficien. Anomalies are he consequences o shorcomings in curren pricing mehods or o missing risk acors. Marke inefficiency, hen, atribues he exisence o anomalies o invesors’ irraional behaviors and is reerred o as he behavioral explanaion. Wihin he ramework o he behavioral explanaion, invesors do no collec and/ or process available inormaion raionally, because hey suffer rom cogniive biases ha resul in mispriced securiies. Te sock reurn predicabiliy hus represens sysemaic mispricing in he equiy marke. Undersanding hese anomalies has become increasingly imporan in asse allocaion, securiy analysis, and oher invesmen applicaions. esearchers have explored 460

461

Stock Market Anomalies

461

anomalies boh in he Unied Saes and inernaionally. Hou, Xue, and Zhang (2015) examined 73 anomalies spread over six caegories momenum, value versus growh, invesmen, profiabiliy, inangibles, and rading ricions and compared heir q-acor model o he Fama and French model. Teir resuls show ha heir q-model ouperorms he five-acor model (Fama and French 2014), especially incapuring price and earnings momenum and profiabiliy anomalies. Fan, Opsal, and Yu (2015), who examined several anomalies in 43 counries, ound ha he anomalies exis in mos equiy markes over a long ime period. able 25.1 summarizes heseanomalies around he world. Because he scope o sudies in anomalies is massive, his chaper ocuses on wo main objecives in making he opic manageable. Firs, he chaper reviews some well-known and widely acceped anomalies ha have been documened in he finance lieraure. Tese anomalies include invesmen-relaed anomalies, value anomalies, momenum and long-erm reversal, size, and accruals. Ten, he chaper presens recen sudies ha atemp o explain he exisence o hese anomalies, including raional and behavioral explanaions or heir exisence. Te chaper ends wih a summary and conclusion.

Equity Anomalies An anomaly is ypically discovered rom empirical ess. Wih he rapid growh in he amoun o daa and compuaional power, here has been an explosion in discoveries o anomalies. Some researchers express concerns abou he “over-discovery” o anomalies and daa snooping (Lo and MacKinlay 1990). Alhough he concerns are legiimae, accumulaed evidence seems o show ha some anomalies are robus across equiy markes and occur during differen ime periods. In a ypical empirical es, a long– shor rading sraegy using porolios ormed on dieren company-level characerisics would generae a posiive abnormal reurn. Tis abnormal reurn could no be explained by curren asse pricing models. Te mos requenly used models or anomaly empirical ess are he radiional asse pricing models such as CAPM (shown in equaion 25.1), muliacor models such as he FamaFrench hree-acor model (shown in equaion 25.2), and ouracor models as shown in equaion 25.3: R i t − R=ft + α i

=+ R it − R ft

R i tf− = R+t

+ i

i

+

+ t RM

0i

+t RM

0i

β+0 iRM t ε it

+SMB t

12i

+ SMB t

1i

+

HML

2 i

HML

i

25.1

t

t

MOM

3 i

25.2

it

ti

t

25.3

For each o hese,R i − R  is he excess reurn rom he long–shor rading sraegy. In a es o anomalies, an abnormal reurn is usually represened by a significan i and M, SMB, HML, and MOM sand or he marke, size, value, and momenum acor, respecively. Given ha summarizing all he discovered anomalies is a dauning ask, he nex secion discusses only some well- known and well-esablished anomalies in he lieraure, including invesmen anomalies, value anomalies, momenum and long-erm reversal, size, and accruals.

able 25.1 Coninued Counry

AG

BM

IA

MOM

NSI

SIZE

H-L 1.231

-value 2.33

H-L 1.474

-value 2.52

H-L 1.224

-value 3.38

H-L 0.482

-value 1.03

H-L 0.242

-value 0.66

H-L 1.319

-value 1.65

Indonesia

–0.655

–0.78

0.998

1.14

0.073

0.14

0.021

0.04

1.061

1.80

0.164

0.23

Malaysia

–0.211

–0.78

1.173

3.37

0.219

0.95

0.463

1.26

–0.018

–0.07

1.045

2.33

Mexico

–0.191

–0.34

1.299

2.23

–0.436 –1.10

0.689

1.46

1.2

2.47

Pakisan

–0.304

–0.54

1.113

1.63

0.742

1.98

0.179

0.42

0.47

0.78

0.136

0.20

Peru

0.252

0.28

3.379

3.17

0.95

1.44

0.897

1.92

–0.277

–0.32

1.209

1.85

Philippines

0.757

1.24

2.193

3.38

1.109

2.23

–0.14

0.36

0.81

2.13

3.06

Poland

1.016

1.33

2.183

1.93

1.365

2.94

1.68

–1.208

–0.60

–0.181 –0.19

0.602

1.93

1.331

India

SouhArica

1.519

4.13

1.636

4.21

0.106

0.32

–0.07 1.523 0.861

3.48

Tailand

0.471

1.30

2.028

4.66

0.197

0.79

0.101

0.29

0.014

0.04

urkey

0.198

0.41

1.491

1.90

0.447

0.97

–0.571

–1.13

–0.199

–0.32

Emerging

0.375

2.45

1.608

8.80

0.316

2.38

0.43

3.34

0.271

1.67

–0.351 –0.80

4.88

1.334

2.99

1.3

2.10

1.051

5.34

Noe: able presens mean values o monhly abnormal reurns and corresponding  values rom he zero-cos sraegy. In June each year, we sored all socks

ing order rom he mos overvalued o he mos undervalued ino quiniles based on rankings o asse growh (AG), book-o-marke (BM), invesmen-oissues (NSI), marke equiy (size), and oal accruals (A) in calendar year −1. We calculaed equal-weighed porolio reurns rom July o year  o June o year Jegadeesh and iman (1993), we used he “6/1/6” mehod o consruc MOM porolios. “H-L” denoes monhly reurns o he zero-invesmen sraegy (he hig porolios i.e., undervalued-minus-overvalued porolios). Te sample period was beween 1989 and 2009.

Source: Adoped rom Fan e al. (2015).

465

Stock Market Anomalies

465

INVESTMENT ANOMALIES

Invesmen anomalies is a erm reerring o he sock reurn predicabiliy rom company characerisics relaed o is invesmen aciviies. Sudies repor ha companies wih high invesmen aciviies earn lower average reurns han hose wih low invesmen aciviies. Te q-heory (Cochrane 1991, 1996) provides a heoreical background o how invesmen can serve as a predicor or uure sock reurns. Many sudies have used ha es and veriy ha company-level measures o invesmen indeed have a power o predic uure sock reurns. Tese invesmen-relaed anomalies include asse growh (Cooper, Gulen, and Schill 2008), invesmen growh (Xing 2008), ne sock issues (Fama and French 2008), invesmen-o-asses (Lyandres, Sun, and Zhang 2008), and abnormal corporae invesmen (iman, Wei, and Xie 2004). Cooper e al. (2008) discover ha companies wih high asse growh earn lower average reurns han hose wih low asse growh. Tey show ha sandard risk–reurn models, including he condiional CAPM, do no explain he effec. Tey also find ha invesors overreac o pas company growh raes and he asse growh effec is weaker in imes o increased corporae oversigh. Figure 25.1 shows he annual reurns rom a buy-andhold rading sraegy or boh equal-weighed (panel A) and value-weighed (panel B) porolios sored by pas asse growh raes. Waanabe, Xu, Yao, and Yu (2013) and Fan e al. (2015) boh repor similar asse growh effec in inernaional equiy markes. In heir influenial sudy, Loughran and iter (1995) documen ha reurns afer sock issues, wheher as an iniial public offering (IPO) or a seasoned equiy offering (SEO), are low. As Figure 25.2 shows, long-run reurns o nonissuers ouperorm he long-run reurns o IPOs and SEOs (Loughran and iter 1995). Poniff and Woodgae (2008) repor ha share issuance exhibis a srong crosssecional abiliy o predic sock reurns, and ha is predicive power is more saisically significan han he predicive power o size, value, and momenum. Fama and French (2008) define ne sock issues as he annual change in he logarihm o he number o shares ousanding. Tey find ha companies issuing new equiy underperorm hose wih similar characerisics; according o Fama and French, ne sock issues are one o he mos pervasive anomalies. Daniel and iman (2006) also show a negaive relaion beween ne sock issues and average reurns. VALUE ANOMAL

IES

Value anomalies reers o findings ha raios o value-relaed accouning measures o marke value can predic uure sock reurns. Te book-o-marke (BM) raio is one o he mos sudied value anomalies. Oher value anomalies include earnings-o-price (E/P), dividends-o-price (D/P), and cash flow-o-price (CF/P) raios. Many sudies show ha high BM socks (or hose using oher measures) earn higher average reurns han low BM socks. Basu (1983) is among he firs researchers o discover a value anomaly. He ound ha companies wih a high E/P raio earn greaer posiive abnormal reurns han companies wih a low E/P raio. More recen sudies o U.S. equiies confirm ha value socks (i.e., socks wih a high BM raio) on average ouperorm growh socks (i.e., socks wih a low BM raio) (osenberg, eid, and Lansein 1985; Fama and French 1992). Oher sudies find similar resuls in inernaional equiy markes (Fama and French 1998; Liew and Vassalou 2000).

MARKET EFFICIENCY ISSUES

466

Panel A: Equal-weighted portfolios 200% 150% 100% 50% 0% –50% –100%

8 6 9 1

0 7 9 1

2 7 9 1

4 7 9 1

6 7 9 1

8 7 9 1

0 8 9 1

2 8 9 1

Decile10(Highgrowth)

4 8 9 1

6 8 9 1

8 8 9 1

0 9 9 1

2 9 9 1

Decile 1 (Low growth)

4 9 9 1

6 9 9 1

8 9 9 1

0 0 0 2

2 0 0 2

8 9 9 1

0 0 0 2

2 0 0 2

Spread(1–10)

Panel B: Value-weighted portfolios 200% 150% 100% 50% 0% –50% –100%

8 6 9 1

0 7 9 1

2 7 9 1

4 7 9 1

6 7 9 1

8 7 9 1

0 8 9 1

Decile10(Highgrowth)

2 8 9 1

4 8 9 1

6 8 9 1

8 8 9 1

0 9 9 1

Decile 1 (Low growth)

2 9 9 1

4 9 9 1

6 9 9 1

Spread(1–10)

Figure 25.1 ime Series o Annual eurn or  wo Asse Growh Porolios. In his figure, panel A plos he annual buy- and-hold reurns or equal- weighed porolios. Panel B plos he annual buy- and-hold reurns or value- weighed porolios. Porolios are sored by pas asse growh rae, wih decile 1 reerring o firms w ih lowes rae and decile 10 reerring o fir ms wih highes rae. Source: Adaped rom Cooper e al. (2008).

Fama and French (1992, 1993) conend ha value (as measured by he value o common sock) and size are wo risk acors missing rom he CAPM. However, Daniel and iman (1997) sugges ha BM and size are no risk acors in an equilibrium pricing model, because hese characerisics dominae he Fama-French size and BM risk acors in explaining he cross-secional patern o average reurns. MOMENTUM AND LONG-

TERM REVERSAL

Momenum anomalies are perhaps he mos amous in he equiy marke. Socks ha perorm well in recen monhs coninue o earn higher average reurns in uure monhs

467

Stock Market Anomalies

467

Annual percentage return 20 15 10 5 Non-issuers IPOs 0

First Year

Second Year

Third Year

Fourth Year

Fifth Year

Annual percentage return 20 15 10 5 Non-issuers SEOs

0 First Year

Second Year

Third Year

Fourth Year

Fifth Year

Figure 25.2 Comparison o IPO/ SEO Annual eurns and Maching Annual eurns o Non-issuing Companies. Tis figure shows he annual reurns o iniial public offerings (IPOs) and heir maching firms (non- issuers) (op) and he average annual reurns o seasoned equiy offerings (SEOs) and heir maching non-issuing firms (botom). Te ime period i s rom 1970 o 1990. Al l reurns are calculaed as he equal- weighed average buy-and-hold reurn during he nex  year.

han socks ha perorm poorly. Jegadeesh and iman (1993) presen a rading sraegy ha simulaneously akes a long posiion in pas winners and a shor posiion in pas losers o generae significan abnormal reurns over holding periods o 3 o 12 monhs. Te abnormal reurn is independen o marke, size, or value acors. able 25.2 shows he reurns o porolios ormed based on pas reurns. As Jegadeesh and iman (2001) show, he momenum effec coninued ino he 1990s afer he anomaly’s discovery. Tis laer evidence suggess ha heir srcinal resuls were no a produc o daa snooping bias. As one o he mos pervasive anomalies, momenum exiss in mos o he equiy markes around he world and has persised during differen ime periods (ouwenhors 1998; Hou, Karolyi, and Kho 2011; Fan e al., 2015). As Carhar (1997) shows, marke, size, and value canno be explained by he momenum acor. Since he Carhar sudy, his our-acor model has become a widely acceped model o es marke efficiency and muual und perormance. able 25.2 demonsraes he momenum effec wih he reurns o he rading sraegy proposed in Jegadeesh and iman (1993). I presens he average monhly reurns o porolios ormed based on previous six-monh reurns

MARKET EFFICIENCY ISSUES

468

able 25.2 Reurns of Porfolios Formed Based on Previous Sock Reurns All

S1

S2

S3

P

0.0079 (1.56)

0.0083 (1.35)

0.0047 (0.99)

0.0082 (2.22)

0.0129 0.0097 (2.92) (2.01)

0.0052 (0.95)

P2

0.0112 (2.78)

0.0117 (2.29)

0.0102 (2.54)

0.0098 (3.08)

0.0140 0.0128 (4.38) (3.37)

0.0086 (1.83)

P3

0.0125 (3.40)

0.0152 (3.23)

0.0125 (3.34)

0.0105 (3.53)

0.0132 (3.77) 0.0133 (4.59)

0.0102 (2.28)

P4

0.0124 (3.59)

0.0163 (3.59)

0.0130 (3.58)

0.0105 (3.66)

0.0134 0.0128 (5.02) (3.82)

0.0110 (2.50)

P5

0.0128 (3.87)

0.0164 (3.74)

0.0134 (3.83)

0.0109 (3.85)

0.0135 0.0135 (5.14) (4.15)

0.0121 (2.86)

P6

0.0134 (4.14)

0.0174 (4.08)

0.0146 (4.22)

0.0102 (3.66)

0.0135 0.0142 (5.23) (4.38)

0.0122 (2.92)

P7

0.0136 (4.19)

0.0175 (4.13)

0.0143 (4.12)

0.0109 (3.90)

0.0136 0.0142 (5.09) (4.43)

0.0126 (3.01)

P8

0.0143

0.0174

0.0148

0.0111

P9

(4.30) 0.0153 (4.36)

(4.11) 0.0183 (4.28)

(4.16) 0.0154 (4.11)

P10

0.0174 (4.33)

0.0182 (3.99)

P10 − P1

0.0095 (3.07)

0.0099 (2.77)

F-saisic

2.83

2.65

4.51

4.38

2.51

1.99

1.69

(0.00)

(0.00)

(0.00)

(0.00)

(0.01)

(0.04)

(0.09)

p-value

Β1

0.0143

Β2

Β3

0.0146

0.0132

(3.86) 0.0126 (4.17)

(5.12) (4.44) 0.0165 0.0156 (5.34) (4.56)

(3.15) 0.0141 (3.28)

0.0173 (4.11)

0.0157 (4.41)

0.0191 0.0176 (5.17) (4.53)

0.0160 (3.50)

0.0126 (4.57)

0.0075 (3.03)

0.0062 0.0079 (2.05) (2.64)

0.0108 (3.35)

Noe: able shows he average monhly reurns o porolios ormed based on previous 6-monh reurns and held or 6 monhs. Porolio P1 reers o an equal- weighed porolio o socks wih he lowes pas reurn decile. Porolio P10 is he equal- weighed porolio o socks wih he highes pas reurn decile. S1, S2, and S3 sand or small, medium, and large firms, respecively. 1, β 2, and 3 sand or firms wih small, medium, and large CAPM beas, respecively. Source: Adaped rom Jegadeesh and iman (1993).

and held or six monhs or differen sample groups. As he able shows, he winning porolios ouperormed he losing porolios across all sample groups. De Bond and Taler (1985, 1987) show ha or porolios o U.S. socks ormed based on reurns or he pas hree o five years, losers ouperorm winners by 25 percen or he nex hree years. Tis phenomenon is called long-erm reversal. Many sudies corroborae he finding, such as Chopra, Lakonishok, and iter (1992).

469

Stock Market Anomalies

469

SIZE

Te size anomaly is among he earlies discovered anomalies. Banz (1981) and einganum (1981) show ha small marke capializaion companies earn higher average reurns han hose w ih large marke capializaion. Fam a and French (1992, 1993) repor ha he size combined wih he BM raio capures he cross- secional reurn variaion. Griffin (2002) find ha he size anomaly also occurs in inernaional equiy markes. Hawawini and Keim (2000) repor ha researchers have observed he size anomaly during many sample periods and in mos equiy markes across counries. ACCRUALS

Te accruals anomaly reers o he negaive relaion beween accouning accruals (he non-cash componen o earnings) and subsequen sock reurns. As Sloan (1996) shows, invesors fixae on corporae earnings when valuing socks. Owing o his bias, companies wih high accruals earn lower average reurns han hose wih low accruals. Figure 25.3 shows he reurns o he accrual sraegy or a sample o 40,679 company-year observaions beween 1970 and 2006, based on Sloan’s (1996) sudy. Pincus, ajgopal, and Venkaachalam (2007) exend Sloan’s sudy o inernaional equiy markes, showing ha he accruals anomaly exiss in hree oher counries in addiion o he Unied Saes (Ausralia, Canada, and he Unied Kingdom). Tey also ound ha he accruals anomaly is likely o occur boh in common law counries and in counries allowing ex ensive use o accrual accouning and having a lower concenraion o equiy ownership. According o Hirshleier, Hou, and eoh (2012), he

40

) 30 % ( rn 20 u t e R o li 10 o ft r o P e g d e H

0

–10

–20

2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 6 6 6 6 6 6 6 6 7 7 7 7 7 7 7 7 7 7 8 8 8 8 8 8 8 8 8 8 9 9 Year

Figure 25.3 eurns o a Long–Shor Porolios Formed on Accruals. Tis figure shows he annual reurns o a porolio ha akes a long posiion in he socks o firms in he lowes decile o accruals and a shor posiion in he socks o firms in he highes decile o accruals. Source: Adaped rom Sloan (1996).

470

MARKET EFFICIENCY ISSUES

accruals anomaly persiss and, even more srikingly, is magniude has no declined over ime.

Why Anomalies Exist Te discovery o anomalies has generaed numerous compeing heories o explain heir exisence. wo main ideas have emerged in he lieraure. Te firs is he raional explanaion, which builds on he oundaion o radiional risk–reurn radeoff heory. Ta is, a raional explanaion explains hese reurn paterns as resuling rom shorcomings in he exising asse pricing models. Tereore, many sudies srive o find beter models or addiional risk acors. Te second heory atribues he reurn paterns o irraional invesor behavior owing o human cogniive biases. Indeed, behavioral finance has become a main sream o hough in modern finance since is inroducion more han 30 years ago. Te remainder o his chaper summarizes he curren research on hese wo ypes o heories. THE RA TIONAL E XPLANATION

Some noable models providing a raional explanaion o he ailure o he CAPM are he ineremporal capial asse pricing model (ICAPM) (Meron 1973); dynamic asse pricing models (Hansen and ichard 1987); consumpion CAPM models (CCAPM) (ubinsein 1976; Lucas 1978; Breeden 1979); and muli-acor models, including he Fama-French hree-acor and our-acor models (Fama and French 1993; Carhar 1997), liquidiy acor model (Pasor and Sambaugh 2003), and invesmen- based model (q-heory model) (Cochrane 1991, 1996; Hou e al. 2015). Te ICAPM (Meron 1973) exends he CAPM by using a differen assumpion abou invesor objecives. In he ICAPM, invesors worry no only abou heir end-operiod payoff bu also abou he opporuniies hey will have o consume or inves he payoff. Maio and Sana-Clara (2012) apply ICAPM crieria o eigh muli-acor models o es size and value effecs. Tey show ha only a small porion o heir ess is consisen wih he ICAPM heory. Financial economiss have criicized he CAPM or is incomplee descripion o asse prices due o is saic naure, and consequenly hey have proposed a dynamic version o he CAPM. For example, Hansen and ichard (1987) show ha a dynamic version o he CAPM could be valid. Gomes, Kogan, and Zhang (2003) develop a general equilibrium model ha can capure he abiliy o he BM o describe he cross-secional sock reurns. Avramov and Chordia (2006) propose a ramework ha allows a sock’s bea o vary wih company-level size and BM, as well as wih some macroeconomic variables. Tey apply he ramework o es wheher some well-known asse pricing models can explain he size, value, and momenum anomalies; heir findings show ha none o he models examined capures any o he marke anomalies wih a consan bea. However, when bea is allowed o vary, hese models ofen explain he size and value effecs, bu no he momenum. Chen, oll, and oss (1986) propose a model o describe he cross-secional sock reurn wih five macroeconomic acors. Since his influenial sudy, many researchers

471

Stock Market Anomalies

471

have developed various muli-acor models. In general, hese acor models can be roughly divided ino models wih macroeconomic acors and models wih acors associaed wih company characerisics. Pasor and Sambaugh (2003) invesigae wheher markewide liquidiy is a sae variable ha is imporan or asse pricing. Tey ound ha expeced sock reurns are relaed o liquidiy afer adjusing or exposures o marke, size, value, and momenum acors. Sadka (2006) demonsraes ha liquidiy risk is imporan or asse pricing anomalies. Te auhor decomposes company-level liquidiy ino variable and fixed price effecs, and find ha unexpeced sysemaic (marke-wide) variaions o he variable componen are priced wihin he conex o momenum and pos-earnings-announcemen drif. Fama and French (1993) sugges ha cross-secional differences in average reurns are deermined by company size and BM, in addiion o marke risk. Fama and French (1996) show ha, excep or he momenum effec, he impac o securiy characerisics on expeced reurns can be explained wihin a risk- based muli-acor model. According o Vassalou and Xing (2004), he size effec is, in ac, a deaul risk, and he BM effec is parially due o deaul risk. However, Daniel and iman (1997) poin ou ha uncerainy sill exiss abou wheher risk acors or non-risk company characerisics explain expeced reurns. Zhang (2005) suggess ha he value anomaly arises naurally in he neoclassical ramework wih raional expecaions. Owing o he reversibiliy and counercyclical price o risk, value asses are riskier han growh opions, especially when he price o risk is high. As Liu and Zhang (2008) show, emporarily higher indusrial producion loadings (a macroeconomic risk acor) on winners more han losers primarily drive he momenum anomaly. Hou e al. (2015) develop an empiricalq-acor model consising o marke, size, invesmen, and profiabiliy acors. Tey ound ha his model largely summarizes he cross-secional sock reurns, showing ha he model can explain abou hal o nearly 80 anomalies; he model ouperorms he Fama and French (1993) hreeacor and he Carhar (1997) our-acor models in explaining anomalies. Using dynamic invesmenbased models, Zhang (2005) capures he reurn paterns associaed wih he value anomaly. Wu, Zhang, and Zhang (2010) show ha capial invesmen helps explain he accrual anomaly. Despie grea effors and recen progress in he research, finding a raional risk-relaed explanaion or anomalies has proved difficul, hence various researchers offer a behavioral explanaion. For more han 30 years, behavioral finance has accumulaed enough evidence o prove ha human behavior is a key componen in deermining sock prices. Te nex secion summarizes recen developmens in developing a behavioral explanaion o anomalies. THE BEH AVIORAL EX

PLANATI ON

Behavioral finance recognizes ha invesors have behavioral biases in collecing and processing financial inormaion, as well as in making invesmen decisions. Tese behavioral biases are pervasive and persisen, and can inroduce sysemaic mispricing in asse valuaion. Because mispricing canno be hedged away owing o he limis o

472

MARKET EFFICIENCY ISSUES

arbirage, various cross-secional reurn paterns (anomalies) exis in he equiy marke. Tis secion reviews he limis o arbirage and hen discusses several imporan behavioral biases and heir impac on sock prices.

Limis o Arbirage and Idiosyncraic Risk Te behavioral explanaion acknowledges ha mispricing is no due o missing risk acors in he CAPM model. Tereore, one would have o ask why hese anomalies are no arbiraged away. Poniff (1996, 2006) and Shleier and Vishny (1997) sugges ha arbirageurs bear boh sysemaic and idiosyncraic risk. Sysemaic risk is he risk atribuable o marke-wide risk sources. Idiosyncraic risk is risk ha is specific o an asse. Because idiosyncraic risk canno be diversified away, i presens a high cos o arbirageurs. According o Shleier and Vishny, raional invesors do no drive away equiy anomalies owing o his cos (i.e., he limis o arbirage). In a review o he limis o arbirage, Gromb and Vayanos (2010) poin ou ha he sudy o limis o arbirage is evolving ino an emphasis on he role o financial insiuions and on agency ricions or asse prices. Teoreically, arbirage is he risk- ree exploiaion o opporuniies when some asses are overvalued relaive o ohers. In a perec marke, hese profi opporuniies atrac raional invesors o correc he marke mispricing, wih no requiremen or capial invesmen and risk. However, in realiy, raional invesors encouner consrains on implemening an arbirage sraegy. Gromb and Vayanos (2002) sudy how leverage consrains prohibi arbirageurs rom eliminaing he mispricings and hey provide liquidiy o ouside invesors. Some consider insiuional money managers as he raional marke correcor, bu because o insiuional consrains, mos proessional invesors canno sell shor. Nagel (2005) invesigaes how his shor-sale consrain on insiuional invesors affecs crosssecional sock reurns, helping o explain cross-secional sock reurn anomalies such as he value anomaly. Oher sudies such as Hirshleier e al. (2011) also explain shorsale consrains. Shleier and Vishny (1997) sugges ha idiosyncraic risk plays an imporan role in limiing arbirage aciviies. Idiosyncraic risk is expeced o be correlaed wih sock reurns; however, considerable conroversy exiss abou he empirical relaion beween idiosyncraic risk and expeced reurn. Some sudies repor ha he marke does no price idiosyncraic risk (Bali, Cakici, Yan, and Zhang 2005; Huang, Liu, hee, and Zhang sudies documen ( Ang, Hodrick, Xing, and Zhang 2006,2010). 2009; Oher Guo and Savickas 2010)boh and negaive posiive relaions (Goyal and Sana-Clara 2003; Malkiel and Xu 2006; Diavaopoulos, Doran, and Peerson 2008; Fu 2009). Some sudies sugges ha idiosyncraic risk should be priced. Because he relaive supply o he socks ha consrained invesors canno hold is high, he price o hose socks mus be relaively low. hereore, an idiosyncraic risk premium can be raionalized or such “unbalance d sup ply.” Addiionally, i consrained invesors canno hold all securiies, he “available marke porolio” or unconsrained invesors will auomaically become less diversiied (Malkiel and Xu 2006). he risk premium o he “available marke porolio” would be higher han he acual

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marke porolio in he radiional CAPM model; hereore, he marke would pr ice idiosyncraic risk.

Behavioral Finance Many excellen survey aricles are available on behavioral finance (abin 1998; Shiller 1999; Hirshleier 2001; Daniel, Hirshleier, and eoh 2002; Barberis and Taler 2003; Campbell 2006; Benarzi and Taler 2007; Subrahmanyam 2008; Kausia 2010). Tis secion is no inended o provide a ull review o behavioral finance; insead, i ocuses on he impac o some well-documened human behavioral biases regarding sock reurns. Tese biases include overconfidence and sel-atribuion, limied atenion, disposiion effec, and invesor senimen.

Overconfidence and Sel-Atribuion People are usually overconfiden abou heir own judgmens, eeling hey are righ subjecively raher han objecively. De Bond and Taler (1995, p. 389) sae ha “perhaps he mos robus finding in he psychology o judgmen is ha people are overconfiden.” Anoher human behavioral rai, sel-atribuion, is closely relaed o overconfidence. Sel-atribuion describes how people end o credi hemselves or pas successes, bu blame oher acors or pas ailures. esearchers ofen use overconfidence and selatribuion o explain various anomalies. As Daniel, Hirshleier, and Subrahmanyam (1998) show, invesors over-weigh heir privae inormaion (overconfidence) and underesimae heir public inormaion, owing o sel-atribuion. As a resul, invesors overreac o privae inormaion and underreac o public inormaion. Tis asymmeric response o overconfiden invesors can explain momenum and long-erm reversal in sock reurns. As Odean (1998) repors, overconfidence influences he financial marke and causes invesors o rade more aggressively. Lakonishok, Shleier, and Vishny (1994) provide evidence ha value anomalies yield higher reurns because conrarian invesors be agains he overpriced “glamour” socks creaed by he subopimal behavior o ypical invesors (excessive exrapolaion o pas perormance owing o overconfidence), and no because hese value socks are undamenally riskier. Daniel, Hirshleier, and Subrahmanyam (2001) offer a model ha includes boh covariance risk and mispercepions o companies’ prospecs. In his model, some invesors overesimae sock inormaion owing o overconfidence; he overconfidence inroduces pricing errors; he mispricing persiss because arbirageurs are risk averse. Te auhors show ha heir model can explain several well-known anomalies, including value and size. As Hribar and Yang (2013) show, chie execuive officer (CEO) overconfidence affecs managemen orecasing, and his could be relaed o he accruals anomaly. Overconfidence ends o be sronger when uncerainy is higher. Tis hen implies ha overconfidence would be sronger in socks having more valuaion uncerainy. Jiang, Lee, and Zhang (2005) show ha companies wih high inormaion uncerainy earn lower uure reurns and he momenum effecs are much sronger or hese companies. Teir findings agree wih heoreical models rom Daniel e al. (1998). Te evidence hus indicaes ha high inormaion uncerainy exacerbaes invesor overconfidence and limis raional arbirage.

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Limied Atenion Limied atenion is he endency o people o neglec salien signals and o overac o relevan or recen news (Camerer, Ho, and Chong 2004). Hirshleier and eoh (2003) ound ha limied invesor atenion leads o marke underreacion. Because atenion is a scarce cogniive resource (Kahneman 1973), invesors have o be selecive in processing inormaion when hey are making invesmen decisions, given he vas amoun o inormaion available and he ineviabiliy o limied atenion. As Peng and Xiong (2006) show, invesors ocus on marke and secor-wide inormaion more han on company-specific inormaion, and his is known as caegory hinking. Te auhors model limied atenion and sudy he impac o his limied atenion on sock reurns. Teir model capures he reurn co-movemen ha is oherwise difficul o explain using sandard raional expecaions models. Hong and Sein (1999) and Hong, Lim, and Sein (2000) show ha limied atenion can explain he momenum anomaly. Tey also find ha momenum is sronger or low-atenion socks such as small socks and socks wih low analys coverage. Limied atenion, such as neglecing he disincion beween accruals and cash flows in earning componens, could help o explain he accruals anomaly (Sloan 1996). As George and Hwang (2004) repor, a 52-week high sock price affecs he behaviors o he company and is invesors, and i explains a large porion o he momenum anomaly. Tis finding is consisen wih aming heory, a human behavior rai showing ha he way a concep is presened in words or numbers affecs he decision-making process o individuals. Hirshleier and eoh (2003) and Hirshleier, eoh, and Yu (2011) sudy he effec o limied atenion on how invesors process accouning inormaion and is impac on sock reurns. Tey conclude ha boh he value anomaly and he accruals anomaly resul rom limied atenion more han rom risks.

Disposiion Effec and Prospec Teory Te disposiion effec is he endency o invesors o sell asses ha have risen in value raher han o sell hose ha have allen (Sherin and Saman 1985). According o Odean (1998), no convenional financial heories can ully explain he disposiion effec. Tus, researchers have urned o prospec heory or an explanaion. Kahneman and versky (1979) iniially proposed prospec heory, and versky and Kahneman (1992) laer exended i. Prospec heory describes invesors’ behaviors in such a way ha hey evaluae oucomes according o heir percepion o gains and losses relaive o a reerence poin, ypically he purchase price. Wihin he ramework o prospec heory, invesors are more sensiive o losses han o gains ( loss aversion), and invesors are risk-averse or gains and risk seeking or losses (diminishing sensiiviy). esearchers use he loss-aversion componen o prospec heory o explain he hisorical high equiy premium (Benarzi and Taler 1995; Barberis and Huang 2001, 2008a). Te disposiion effec can generae price momenum because i creaes a gap beween a sock’s undamenal value and is equilibrium price. Because his effec could lead sock prices o underreac o inormaion (Grinblat and Han 2005; Frazzini 2006; Birru 2015), recen pas sock perormance could coninue in he shor erm. Barberis and Huang (2008b) sudy asse prices in a one-period economy wihin he ramework o prospec heory. Teir model generaed a new predicion ha he marke prices a securiy’s skewness in he disribuion o is reurns. Tey show ha he skewness

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predicion rom prospec heory can shed ligh on some well-known anomalies, such as ne sock issues, described earlier in his chaper.

Senimen According o Baker and Wurgler (2006), invesor senimen is he propensiy o speculae. More specifically, marke-wide senimen is he difference beween he belies o senimen-driven raders and correc objecive belies (Delong, Shleier, Summers, and Waldmann 1990). Baker and Wurgler (2006) find ha he cross-secional o uure sock reurns is condiional on beginning-o-period proxies or senimen. When senimen is low, small socks, unprofiable socks, nondividend-paying socks, highvolailiy socks, exreme growh socks, and disressed socks end o earn relaively high subsequen reurns. Sambaugh, Yu, and Yuan (2012) explore he role o invesor senimen in 11 equiy anomalies in cross-secional sock reurns. Tey find ha each anomaly is sronger (i.e., is long–shor sraegy is more profiable) afer high levels o senimen.

Summary and Conclusions Equiy anomalies have become an increasingly imporan opic in asse pricing. Tis chaper discussed recen developmens in his area and reviewed various invesmenrelaed anomalies, value anomalies, momenum, long-erm reversal, size, and accruals. Te discovery o anomalies has promped he search or boh new asse pricing models and addiional risk acors. Tese effors have dramaically improved our undersanding o marke efficiency and asse pricing. Te discovery o anomalies has also promped sudy o behavioral finance. As he ulimae execuors in securiy rading, he behavioral biases o invesors have a proound impac on securiy valuaion. Te many sudies menioned in his chaper show how invesor behavior plays an imporan role in explaining sock reurn paterns. Te findings sugges ha an approach solely relying on eiher a raional or a behavioral explanaion ails o produce a compleely convincing resul. Combining he approaches may be promising.

DISCUSSION QUESTIONS 1. Explain equiy anomalies. 2. Discuss he major explanaions o why equiy anomalies exis. 3. Ideniy some behavioral biases o invesors ha can be atribued o anomalies. 4. Define an invesmen anomaly and ideniy some documened invesmen anomalies.

REFERENCES Ang, Andrew, ober J. Hodrick, Yuhang Xing, and Xiaoyan Zhang. 2006. “Te Cross-Secion o Volailiy and Expeced eurns.” Journal o Finance 61:1, 259–299.

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26 The Psychology of Speculation in the Financial Markets VICTOR RICCIARDI Assistant Professor in Financial Management Goucher College

Introduction Troughou financial hisory, cogniive and emoional biases have driven invesor behavior and influenced he financial markes in he orm o bubbles. A sock bubble occurs when a subsanial divergence exiss beween a financial asse’s curren marke price and is value.securiy A bubbleorisasse, disinguished exreme increase in heTese price or marke oinrinsic he financial ollowedby byan a seep decline in price. episodes o severe volailiy and exreme risk-aking behavior wihin he financial markes have a derimenal impac on invesmen perormance and economic condiions. According o radiional finance, excessive speculaion in he orm o bubbles should no exis in he markeplace. Speculaive behavior provides suppor agains he efficien marke hypohesis (EMH) espoused by radiional finance heory. Te EMH is based on he premise ha financial markes are efficien in he sense ha invesors in hese markes process inormaion insananeously and ha sock prices compleely reflec all exising inormaion (icciardi 2008a). Behavioral finance provides evidence or why speculaive bubbles occur in he financial markes. Tis chaper discusses major cogniive and affecive issues o behavioral finance ha influence he decision making o individuals and groups during imes o speculaion. Te firsmarkes. secionNex, offershe a brie presenaion o aspecs o speculaive behavior in he financial chaper examines several psychological issues prevalen during bubbles, including overconfidence, herd behavior, group polarizaion, grouphink, represenaiveness bias, amiliariy bias, grandiosiy, exciemen, and overreacion and underreacion o marke prices. Te nex secion ocuses on he afermah o he financial crisis o 2007–2008 and he specific behavioral finance issues ha invesors exhibi or an exended ime period afer he caasrophe even, such as he influence o economic shocks, anchoring, recency bias, worry, loss aversion, saus quo bias, and misrus. Te las secion offers a summary and conclusions.

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A Brief History of Speculation Speculaion, bubbles, manias, and crashes such as he ulip Mania in he 1600s, he Souh Sea Bubble in he 1700s, he Panic o 1907, he sock marke crashes o 1929 and 1987, he Nify-Fify socks o he early 1970s, he Inerne bubble (also called he do. com bubble) o he lae 1990s, and he financial crisis o 2007–2008 occur hroughou financial hisory. For example, in reacion o he sock marke crashes o 1929 and 1987, he Dow Jones Indusrial Average (DJIA) ell almos 12 percen on Ocober 29, 1929, nearlyillusrae 23 percen on Ocobero19,prices 1987and (Schwarz 1995).group Tesebehavior wo sock markeand crashes he inefficiency he irraional o individuals. Bubbles occur in financial markes when here are dramaic and unsusainable price increases as a resul o overly opimisic and irraional exciemen among invesors. Te circumsances surrounding bubbles happen in a similar ashion when markes have excessive price valuaions above hisorical averages, such as he overvalued Inerne socks o he lae 1990s. For he financial crisis o 2007–2008, he DJIA exceeded 14,000 in Ocober 2007 and hen declined o 6,600 in March 2009, represening more han a 50 percen decline in value. Troughou financial hisory, hese speculaive evens ofen resul when here is a new echnology ha people claim will change he world (icciardi 2017). For example, new invenions and innovaions such as airplanes, auomobiles, and radio underlay he sock marke bubble o he 1920s. Anoher example is he Inerne economysocks o 1990s, whichprofis new invesmen approaches emerged oo gran value o Inerne wihduring no earnings or large losses. In he bubble sage he Inerne socks, he invesmen approaches or ools o he pas no longer apply such as earnings perormance or sock valuaion models based on dividends or earnings. As icciardi (2010, pp. 143‒144) poins ou, a major reason or he financial crisis o 2007–2008 was ha radiional finance “embraced he complex innovaions and exoic insrumens o financial risk managemen … which conribued o he Sepember/ Ocober 2008 financial conagion.” Tis hisoric episode demonsraes he imperecions in he assumpions and heories o radiional finance and conribues o he increased accepance o behavioral finance. Te endency in financial markes or bubbles and crashes is evidence ohe value o behavioral finance because hisory ofen repeas isel. Bubbles appear in academic sudies involving laboraory experimens, no jus in he real-world laboraory o financial markes. Laboraory experimens conduced wih sock marke simulaions misjudgmens and irraional behavior o subjecs during bubble anddemonsrae crash cycles,he especially among novice invesors and inexperienced raders (Smih, Suchanek, and Williams 1988). Bubble behavior also occurs among experienced raders and proessional invesors. Ineresingly, here is a learning curve beore subjecs sar o change heir irraional bubble behavior. Caginalp, Porer, and Smih (2000) provide he ollowing imporan finding rom he academic lieraure on sock marke bubble experimens: One o he replicable resuls rom he experimens described earlier is ha once a group experiences a bubble and crash over wo experimens, and hen reurns or a hird experimen, rading depars litle rom undamenal value.

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Wheher in a laboraory environmen or in real-world financial markes, individual biases and crowd psychology are inheren in conribuing o he repeaed and requen bad decision making ha akes place during speculaive imes.

Behavioral Aspects of Speculation Te exisence o speculaive behavior in he orm o bubbles happens based on a wide range o individual and group biases eviden wihin he financial markes. Tis secion ocuses on overconfidence, herd behavior, group polarizaion, grouphink, represenaiveness bias, amiliariy bias, grandiosiy, exciemen, and he overreacion and underreacion o marke prices. OVERCONFIDENCE

Overconfiden behavior is an imporan bias ha occurs during highly speculaive imes in he markes. Invesors reveal overly posiive views o heir abiliy o conrol invesmen gains or orecas he perormance o financial markes. Many invesors believe hey are above average in heir inellec, overall judgmen, and financial experise (icciardi 2008b). According o Sherin (2005, p. 6), “People who are overconfiden abou heir abili ies hink hey are be ter han hey acually are. People who are overconfiden abou heir level o knowledge hink hey know more han hey acually know.” For example, he hisoric bull marke o he 1980s and 1990s creaed a long- erm eeling o overconfidence, opimism, and euphoria in which i was el ha sock prices would coninue o increase orever. Adams and Finn (2006, p. 48) sae: From 1982 o 1999, he U.S. experienced an impressive bull marke. Especially owards he later hal o ha ime period, much o he growh in marke equiy was due o he prolieraion and rapid growh o echnology and inerne firms. As he Dow Jones Indusrial Average increased en- old over 17 years, he NASDAQ composie index, eeming wih ech socks, increased hiry- old. A speculaive caseinvesors sudy o were overconfiden he Inerne bubble o heofferlae 1990s. Firs-ime unaware opsychology he markeisvaluaion o iniial public ings (IPOs) o he Inerne socks and is connecion wih overconfidence, exreme enhusiasm, and he influence o crowd psychology (icciardi 2017). Te major causes or his speculaive bubble were he availabiliy o online rading accouns, excessive margin loans balances, and he ascinaion o he general public and media wih he ad o sock marke invesing (icciardi 2017). Te Inerne bubble burs and produced a severe bear marke in he early 2000s. In Ocober 2002, he value o he NASDAQ Composie ell below 1,200 rom is hisoric high o 5,100 during he bubble only wo and hal years earlier. Tis change was he equivalen o more han a 75 percen downurn in sock prices during his period.

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HERD BEHAVIOR

Anoher ype o speculaive financial behavior, herding or herd behavior explains how individuals in a group seting inerac devoid o a premediaed or an inended oucome. Ta is, people like o join a crowd o invesors who endorse heir purchase and sell judgmens or all ypes o financial asses, based on signals rom he exernal markeplace. Herding occurs when a group o individuals such as novice invesors and invesmen expers all make he same financial decisions based on a specific piece o inormaion, whilesimulaneously ignoring oher imporan daa such as financial news or new earnings releases by corporaions. Siegel (1998, p. 230) describes heherd urging as “i’s beter o fi in wih he crowd―even i he crowd is wrong―han o risk being off on heir own.” People who experience specific behavioral issues such as overconfidence, represenaiveness, excessive risk-aking behavior, anchoring bias, and negaive emoions end also o enhance he herding influence wihin groups (icciardi 2017). Tis herding behavior even amplifies he biases o individual invesors o higher levels o exreme behavior. As Noron (1996, p. 43) saes, “he herd minimizes risks and prevens loneliness… . []he resul o herd behavior on sock prices is ha hey ge bid higher or lower wihou regard o valuaion.” Te size o he herd migh evenually grow ino many housands o people rading he same securiy over a long period. Exernal acors such as news coverage abou a new invesmen philosophy or ad someimes also lead o herd behavior. izzi (2014, p. 444) provides his addiional perspecive on herd behavior:

Herding occurs when a group o individuals mimics he decisions o ohers. Trough herding, individuals avoid alling behind and looking bad i hey pursue an alernaive acion. Herding is based on he social pressure o conorm and reflecs saey by hiding in he crowd. In doing so, someone can blame any ailing on he collecive acion and mainain his repuaion. Herd behavior ofen ranspires over differen ime spans, ranging rom weeks o years. Herding is a major psychological condiion during a bubble, when invesors buy invesmens on sock price momenum while disregarding oher imporan issues such as financial daa, hisorical sock valuaions, and economic saisics. Invesors experiencing herd behavior wihin he group also oversae or ampliy he posiive acors o price perormance and develop incorrec assumpions abou he upside poenial o he markes. When he bubble rupures or sars o deflae, panic ensures and individuals reveal heir herding behavior by exiing and selling all he socks in heir porolio, based on high levels o negaive emoions (icciardi 2017). MacKay (1980, pp. ix– x) provides an example o speculaion and crowd behavior in he hisoric bubble o ulip Mania. ulips, in he ourh decade o he seveneenh cenury in Holland, became he objec o such insane and unreasoning desire ha a single bulb abou he size and shape o an onion could ech a small orune on any o he several exchanges ha  had sprung u p o rade hem. Major rends in he financial markes sar and finish wih exreme periods o volailiy based on emoion and he irraional behavior o invesors. Over he enire marke

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process, his herd behavior occurs on he upside o prices (overbuying o financial securiies during bubbles) and on he downside (overselling o financial securiies during crashes) because crowd psychology moves in he same direcion when large groups o individuals drive invesor senimen. Financial hisory has a predisposiion o repea isel, wih evens o herding occurring during imes o bubbles and crashes (icciardi 2017). GROUP POLA

RIZA TION

In he 1960s, Soner (1961, 1967) firs developed he concep o he risky-shif effec, in which people wihin a group ofen make judgmens afer exensive discussion ha dier rom he final decisions ha someone would ormulae on an individual basis. For example, many research sudies in he social sciences show ha groups in ormal seings make riskier decisions han individuals; his is he risky-shif phenomenon. Soner (1977, p. 333) provides he ollowing perspecive on he risky-shif effec: I is popularly assumed ha groups are more conservaive and cauious han individuals. Considerable evidence shows ha in some siuaions groups make riskier decisions han individuals. In hose siuaions group soluions end o represen “risky shifs” rom soluions ha migh be offered by individual group members. For example, in dealing wih a hypoheical case in which an individual mus decide wheher o say in a secure job or leave or one ha is less secure bu offers a higher salary, groups ha ve been more likely han individuals o recommend he riskier opion. Tis risky-shif effec is associaed wih hisoric evens such as NASA’s decision o launch he space shutle Challenger wihou esing he rubber O-rings, which hen ailed and caused he shutle o explode; or he Sovie Union’s invasion o Aghanisan wihou careul review o Mujahldeen insurgen aciviy. Myers and Lamm (1976) modiy he risky-shif phenomenon ino a more general concep and named i group polarizaion. Te group polarizaion concep is he noion ha group conversaion or debae resuls in shifs in he direcion o more exreme opinions or views abou final decisions among group members. However, research findings someimes repor ha group discussion produces a change or shif in opinions o individual members ha do no always resul in greaer risk-aking behavior. According o Wrighsman and Deaux (1981, p. 466), “I has been shown ha, i he iniial opinions o he group end oward conservaism, hen he shif resuling rom group discussion will be oward a more exreme conservaive opinion.” A premise o he group polarizaion concep is ha groups can move in wo differen direcions: groups may move eiher o exremely risky decisions or behaviors (known as he risky shif) or o very risk-averse decisions or behaviors (known as a cauious shif). Te cauious shif demonsraes ha some group judgmens resul in more conservaive assessmens han hose o individuals. Ye, his finding conradics he iniial premise o Soner’s (1961) risky-shif effec. According o Soner, group polarizaion akes place wihin a ormal organizaional srucure, such as a nonprofi, governmen body, or corporaion. Te members o he group have specific managemen responsibiliies,

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communicae wih each oher direcly, and have a group size ranging rom our o eigh members (icciardi 2017). A noable sudy rom he area o behavioral accouning demonsraes how groups migh shif in differen risk-aking direcions. Carnes, Harwood, and Sawyers (1996) invesigae he influence o group discussion on he probabiliy o ax proessionals’ aking ax reurn posiions preerred by axpayers as “gray areas” o he ax law. In he firs experimen, he auhors offer six ambiguous siuaions o 68 ax proessionals. Te researchers divide he paricipans ino groups and insruc hem o assess each siuaion beore and afer a group conversaion. Generally, heir findings confirm he premise ha group dialogue leads o eiher risky or cauious shifs in ax proessionals’ judgmen. In he firs experimen, conversaions led o a risky “pro-axpayer shif” in all hree high-probabiliy cases and a cauious “pro-IS shif” in wo o hree low-probabiliy siuaions. Overall, hen, group discussion resuls in higher, more risky ax reurn posiions in siuaions defined as high probabiliies o ax reurn posiion requesed by he clien. Te evidence shows a cauious shif or lower, more conservaive ax reurn posiions in siuaions idenified as having low probabiliy. Te noion ha groups someimes make riskier decisions also occurs wihin he financial seting. Slovic (1972) discusses he risky-shif concep as a cenral aspec o group psychology wihin he invesmen managemen domain. Te problem wih a major change in judgmen by group members is ha he risk assessmen ofen resuls in a problemaic and irraional financial decision by he group. For insance, groups someimes selec an oucome ha has a larger payoff bu a lower chance o achievemen. According o Ellis and Fisher (1990, p. 55), “I a group and is individual members were o place bes on a horse, or example, he group would more likely be on 100-o-1 sho han would any o he individuals deciding alone.” Sephens and Silence (1981) examine he risky-shif effec among 35 commercial loan officers a five exas banks. Te auhors provide he subjecs wih an imaginary loan applicaion or an esablished bank cusomer who has a srong credi hisory a a ime o economic uncerainy. Tey designed he loan applicaion o raise “some concerns” bu no so inappropriae as o be rejeced immediaely. Te findings suppor he premise o he risky-shif effec, in ha he loan officers rejeced he loan applicaion individually bu approved i on a group basis or a commitee level. McGuire, Kiesler, and Siegel (1987) assess wheher a difference in he ype o communicaion delivery exiss beween ace-o-ace discussions and compuer-mediaed discussions abou decision making on risky choices, on boh individual and group bases. Te auhors evaluae 48 business managers individually and in hree-member groups in which he subjecs made risk assessmens o invesmen alernaives. Te auhors place he subjecs in boh ace-o-ace discussions and real-ime compuer-oriened dialogues. In each seting, he ask is o make wo group decisions. McGuire e al. (p. 917) find ha afer ace-o-ace discussions, he groups “were risk averse or gains and risk seeking or losses, a endency prediced by prospec heory and consisen wih choice shif.” In conras, he compuer-mediaed group dialogues did no reveal a shif in decisions or he exisence o prospec heory behavior. Inerior group decisions occur in imes o speculaive behavior and bubble siuaions. Buron, Coller, and utle (2006) find ha invesors who subsequenly have he mos excessive price valuaions influence he marke o a greaer exen han do

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487

invesors possessing he mos conservaive belies. As Buron e al. (p. 107) noe, hese resuls also imply “ha paricipaion in a marke will accenuae risk preerences so ha good news produces a cauious shif in prices (i.e., oward lower prices) whereas bad news produces a risky shif (i.e., oward higher prices).” GROUPTHINK BEH

AVI OR

Te grouphink effec is an emerging opic wihin behavioral finance (Haya 2015). In he early 1970s, Irving Janis firs developed he idea o he grouphink effec (Sunsein and Hasie 2015). Grouphink behavior has been conneced o several hisorical evens in which members o a group do no have he desire o upse group consensus or harmony by saing an opposing view (icciardi 2017). Grouphink was firs applied o Presiden Kennedy’s judgmen o use miliary acion by invading Cuba, known as he Bay o Pigs inciden. Alhough Presiden Kennedy’s oreign policy advisors opposed his choice, hey were highly enaive in expressing a conrary viewpoin abou his decision. Janis (1971, p. 44) provides he ollowing perspecive o he grouphink effec: Te sympoms o grouphink arise when he members o decision- making groups become moivaed o avoid being oo harsh in heir judgmens o heir leaders’ or heir colleagues’ ideas. Tey adop a sof line o criicism, even in heir own hinking. A heir meeings, all he members are amiable and seek complee concurrence on every imporan issue, w ih no bickering or conflic o spoil he cozy, “we- eeling” amosphere. A major aspec o grouphink behavior is he noion o conormiy. egarding conormiy in groups, Asch (1952) repors ha differences o opinion cause people o search and find harmony in a final group decision ha enables he individual decision maker o reduce he affecive reacions o anxiey and ear. As Janis (1972, 1982) noes, he high levels o group pressure and eelings o anxiey among individuals o conorm during a grouphink siuaion become overwhelming, resuling in a final group decision o consensus. Each person in he group experiences a personal aversion o depar rom he final group’s consensus opinion or majoriy oucome. Grouphink evens ofen occur wihin a ormal seting among differen ypes o organizaions, such as nonprofis, governmen agencies, and corporaions. In he field o behavioral corporae finance, Sherin (2005) idenifies he grouphink effec as a major cause o he pas accouning scandals and corporae bankrupcies o WorldCom and Enron. egarding he financial crisis o 2007–2008, Sherin (2016) atribues he poor risk managemen pracices and financial problems o AIG, Freddie Mac, and Fannie Mae o grouphink behavior. In paricular, he organizaional srucure o many large organizaions is auly and bureaucraic, which sifles innovaion (Schiller 1992, 2002). Schiller (1992, pp. 74‒75) provides he ollowing perspecive abou insiuional invesors: Group-decision difficulies … miigaed o some exen by he ac ha heir objecive perormance has always been observed on a regular basis … geting eedback on he success o heir invesmen sraegies. Bu, o course

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… he shor- run immediae eedback on heir quarerly invesmen perormance may no awaken a bureaucracy o long-erm sraegic issues; here is room or “grouphink” o arise.

For many organizaions, possible condiions exis or grouphink behavior because misakes during he decision-making process influence all ypes o group behavior, especially financial issues. For example, Cici (2012) idenifies his poenial grouphink effec among invesmen managemen eams, and Puez and uenzi (2011) poin ou he same behavior among muual und managers. For a research sample o 77 sock marke proessionals, Wrigh and Schaal (1988) repor ha hese expers suffer rom grouphink and ha his behavior resuls in poor invesmen reurns. All hese exper groups suffer rom grouphink behavior because he group’s members arrive a absolue agreemen wihou diligenly evaluaing financial recommendaions or invesmen inormaion. Addiionally, a leader wih an ougoing and asserive personaliy influences he group’s overall risk-aking behavior (Sherin 2008). Te final oucome o he group is someimes atribued o he risky-shif phenomenon (icciardi 2017). Wrigh and Schaal (1988, p. 42) explain he associaion beween individual and group decision makers in a finance seting: An invesmen commitee will have a series o norms and atiudes ha may be called “curren policy.” Tis includes views on economic condiions and he course o he markes. Te more imporan he group is o he individual, he greaer he likelihood each proessional believes he policy is correc. He or she is no simply complying … bu has inernalized he commitee policies so hey are now he proessional’s own. For he members o an invesmen commitee,he majoriy posiion migh change an individual’s own opinion. A person migh reveal a endency o adhere o he curren invesmen policy insead o saing any opposiion, resuling in susaining he saus quo judgmen and reinorcing grouphink behavior (icciardi 2017). Moreover, group members ofen respond o he people who challenge heir viewpoins wih disbelie and misgiving. Groups applying grouphink use subsandard financial sraegies when making heir final assessmens and decisions. Groups migh have access o oo much inormaion, inaccurae saisics, or flawed inormaion ha leads o inerior decision-making resuls. Te ypical behavior o a grouphink episode is ha group members do no make a ew minor misakes in judgmen; raher, he group ends o make caasrophic errors and decisions over an exended period. icciardi and Simon (2000) ideniy an example o poenial grouphink in he mismanagemen and bad financial decisions made by rusees a Ecker College. In Augus 2000, a news sory read “Eyes Wide Shu: How Eckerd’s 52 rusees Failed o See wo-Tirds o Is Endowmen Disappear.” Te heme o he news sory concerned how Eckerd College’s endowmen und ell rom $34 million o $13 million, much o he dismay o he suden body, aculy, adminisraion, and rusees. As Pulley (2000, p. A31) noes: A Eckerd College here, hose who have been rying o figure i ou poin o he Board o rusees, whose own leaders concede ha hey didn’ ask

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many quesions, and allowed policies and pracices ha led o he financial fiasco… . Several rusees have likened he fiasco o he complex circumsances behind manmade disasers … . Over he years, Eckerd has suffered rom poorly execued real- esae projecs, quesionable invesmens, an inabiliy o provide he financial daa needed o issue bonds o pay or capial projecs, an undersaffed financial office, aniquaed accouning sysems, and a college presiden who always seemed o have he answers. Te influence o group psychology is apparen in he hisory o finance as seen hrough he lens o speculaive psychology: manias, bubbles, panics, and crashes, as well as herding, group polarizaion, and grouphink. All have some similar characerisics, because each involves an affecive reacion wihin he group and aspecs o crowd or mob psychology (icciardi 2017). Dreman (1977, p. 100) shows he associaion o grouphink o sock marke psychology: Te mindless conormiy and he excessive risk aking ha Janis describes in smaller groups are precisely he major sympoms ha Le Bon pinpoins in larger crowds. Curiously enough, hese sympoms, and he relaxed, chummy amosphere ofen ound in cohesive group decision making were also ound o a significan degree in … speculaive bubbles. Dreman makes he poin ha a hisorical even can demonsrae a grouphink effec among a small group o invesors, and hen over ime i broadens o a much larger group o individuals who sar o ollow a much larger herd (icciardi 2017). For insance, Nosinger (2014, p. 135), who idenifies he real esae bubble o 2001–2006 as a grouphink even, saes: “eal esae became hough o as a speculaive and radable asse or some people, insead o an invesmen.” Te complee accepance o all group members, he exisence o exreme levels o overconfidence, and he presence o overly opimisic invesors may lead o individuals’ rejecing anyhing ha migh be considered evidence or belies conradicory o he final group judgmen. REPRESENTA TIVENESS BIAS, FAMILIARITY GRANDIOSITY, AND EXCITEMENT

BIAS,

An imporan bias ha individuals reveal during he iniial phase o a bubble is represenaiveness bias, which is a endency o have an unrealisic view o a financial circumsance and hen o over-weigh how much his curren siuaion is similar o pas experiences. Wih his decision-making bias, invesors incorrecly conclude ha sock prices will coninue o new highs based on a small sample o socks. For insance, during a bubble, invesors may see prices coninuing o rise ino he uure. epresenaiveness bias acceleraes he herd’s risk-aking behavior o much higher levels, based on group psychology (icciardi 2017). Familiariy bias is eviden when people have a preerence or and inves in amiliar asses based on he name or repuaion o he company. Invesors preer o inves in amiliar local socks (known as local bias) and over-inves in porolios o domesic securiies (known as home bias) (Baker and icciardi 2014a, 2014b, 2015). Invesors

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also end o underesimae and miscalculae he risk o amiliar invesmens. For example, in he early 1970s, a bubble developed in a group o growh socks known as he “Nify-Fify.” Tese socks consised o 50 amiliar large-cap blue chip socks, such as IBM and Disney. Te bubble evenually burs. Invesors ocused on blue chip socks ha received much media atenion, which increased heir amiliariy and raised heir prices. Te invesors incorrecly assessed hese overpriced socks as less risky and wih producing a higher reurn, bu he opposie was rue. Individuals experience high levels o greed when a sock marke bubble is acceleraing and invesors wan o join he crowd (icciardi 2017). Tey also suffer rom exreme grandiosiy. Lifon and Geis (1999, p. 24) describe his grandiosiy as, “when prices coninue o escalae, invesors… eel like Icarus hey eel increasingly excied and capable o flying higher and higher.” Indeed, he eeling o grandiosiy makes invesors eel invincible, coupled wih exreme enhusiasm. As a resul, hey make irraional predicions o sock marke perormance reurns and disregard risk and uncerainy (icciardi 2008a, 2008b). Te eeling o grandiosiy ha characerizes bubbles is conneced wih how exciemen influences he speculaive behavior in financial markes. Andrade, Odean, and Shengle (2016, p. 11) describe he role o exciemen in bubble siuaions: We documen, in an experimenal seting, ha magniude and ampliude o bubbles is greaer when, prior o rading, raders experience he highinensiy, posiive emoion o exciemen … . []he exciemen generaed by rapidly rising prices in real-world markes may rigger emoions ha lead o larger asse pricing bubbles. Individuals ofen disregard raional hinking and replace i wih euphoric expecaion, characerized by overconfidence and opimism abou uure invesmen perormance. Tey ocus on he shor erm and ignore he long-erm invesmen horizon. Te speculaive bubble coninues o expand unil invesors sop buying he socks, in which case he marke can no longer susain he impracicable increase in price valuaions and he bubble implodes. OVERREACTION AND UNDERREACTION

During a bubble or crash,occurs some invesors o movemen new inormaion ohers underreac. Overreacion when heoverreac sock price o he while downside or upside happens oo quickly (De Bond and Taler 1985). By conras, underreacion occurs when he sock price movemens o he downside or upside happen oo slowly (Culer, Poerba, and Summers 1991). Tere is a relaively shor-erm ime horizon during which invesors process new financial daa perhaps several hours, days, weeks, monhs, or even years. All ypes o invesors over- or underreac o good or bad news which he marke may perceive as posiive (valuaions increase) or negaive (valuaions decrease). Invesors ofen experience an exhilaraed degree o overconfidence and opimism during a bubble, when socks pos srong increases in price. According o Dissanaike

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(1997, p. 27), his overreacion occurs when “i sock prices sysemaically overshoo as a consequence o excessive invesor opimism or pessimism, price reversals should be predicable rom pas price perormance.” For example, suppose a secor or indusry repeaedly repors above-average earnings perormance each quarer or an enire year. Invesors overreac o his posiive financial news, eeling excessively confiden and opimisic abou uure earnings expecaions; as a resul, he sock prices are hen mispriced or arificially oversaed (Mynhard and Plasun 2013). Evenually, hose prices see a marke secor correcion and decline when here is news abou indusry groups such as below-average earnings perormance. Negaive senimens ake over. Conversely, when invesors are overly negaive abou a secor or indusry, is sock prices lead o excessive reacions o he downside, as happened wih Inerne socks in he early 2000s and mos all socks during he financial crisis o 2007–2008 (Mynhard, Plasun, and Makarenko 2013). Oher invesors migh underreac o financial news and respond oo slowly (De Bond and Taler 1985). For example, invesor senimen is someimes slow o change afer a bubble burss. Some individuals are slow o reacing o he change or ail o recognize ha he marke has moved rom bull o bear marke cycle. Furher, some invesors preer o avoid he emoional pain o realizing an acual financial loss and suffer he accompanying regre o admiting an invesmen misake.

Behavioral Biases Evident After the Financial Crisis Every generaion o invesors has experienced a sock marke bubble and a major bear marke crash afer he bubble burss. Tis secion examines behavioral finance issues in he afermah o he financial crisis o 2007–2008. Afer a bubble burss, invesors display several biases. In paricular, he collecive memory hypohesis suggess ha recen economic shocks influence an individual’s risk olerance and change invesor behavior (izzi 2014). Especially, he affecive reacions o invesors o recen economic disress have greaer influence on invesor judgmen and decision making han do long-erm hisorical invesmen perormance daa and oher objecive inormaion. Alhough emporary, he change in expeced long-erm influence on risk olerance and risk percepion is likely o be lasing and negaive. Nagel (2012) believes ha younger individuals are more sensiive o recen negaive perormance han older invesors, because he younger generaion has a shorer invesmen hisory. For example, millennial cliens are more prone o behavioral changes based on recen reurns han are older invesors such as baby boomers, who have had decades o experience. Tis was he case ollowing he bear marke o he early 2000s and he financial crisis o 2007–2008. LASTING INFLUENCE OF ECONOMIC SHOCKS

Malmendier and Nagel (2011) examine he role o economic disrupions on individual invesor and risk-aking psychology, using daa rom he Survey o Consumer Finances

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(SCF) beween 1960 and 2007. Tey find ha invesors who have experienced inerior sock marke perormance during heir liespan have a lower financial risk olerance, are less willing o inves in common socks, have a lower percenage o heir overall porolio in socks, and are less opimisic abou uure sock perormance. For saer asses such as bonds, people who experience lower bond reurns are less likely o own bonds. For insance, millennials are a younger generaion ha has suffered a severe economic downurn, making hem more cauious oward risky securiies. However, heir reacion may no be as severe as he cohor group born afer he sock marke crash o 1929 known as he “Depression Babies” generaion. In order o overcome hese economic shocks, invesors should ake a long-erm perspecive o invesing. Over he longerm asse classes perormance are based on he concep known as reversion o he mean. Tis is he premise ha prices and invesmen reurns evenually move back oward heir hisorical averages or each asse class. Bricker, Bucks, Kennickell, Mach, and Moore (2011) examine he impac o he financial crisis o 2007–2008 on amily households, using quesionnaire daa rom he SCF beore and afer he crisis. Based on inerviews done beween mid-2009 and early 2010, he daa reveals a ransormaion oward a more cauious financial psychology o he amily uni afer experiencing he financial shock. Te amilies repor a lower invesmen risk olerance and a higher level o precauionary savings (i.e., a greaer desire or saer cash insrumens while reducing oal household spending). ANCHORING, RECENCY BIAS, AND WORRY

Individuals may suffer several biases afer a bubble burss, including anchoring bias and recency bias, as well as negaive emoions such as worry or depression. Anchoring is he endency o hold ono a belie and hen apply i as a reerence poin or making uure judgmens. People ofen make judgmens based on iniial inormaion and have difficuly alering or changing heir viewpoins when hey receive new inormaion. In his way, many invesors sill employ a negaive anchor afer a financial crisis or sock marke crash. Similarly, invesor experience ha ocuses on recen financial perormance has a srong impac on laer judgmens and decisions. Tis negaive anchor is called recency bias. According o izzi (2014, p. 440), “isk esimaes become anchored on recen evens. Overemphasis on recen evens can also produce disaser myopia … as insrumens are priced as i anoher crisis will occur.” As icciardi (2012) saes, high levels o worry remain or years afer a bubble or a crash. Consequenly, invesors end o under-weigh or avoid socks wihin heir porolios because o exreme risk and loss aversion. Tey have srong negaive emoions, including depression, anxiey, regre, or ear ha affec heir judgmen. Based on an online quesionnaire o more han 1,700 invesors in 2010, icciardi (2011) finds ha a much larger percenage o individuals associae he worry phrase wih socks (70 percen o respondens) han hose who associae worry when compared o bonds (10 percen o respondens). Individuals who have higher levels o anxiey abou invesmens in socks end o raise heir risk percepion and lower heir risk olerance. Tese higher levels o negaive emoions and he anchoring effec caused by he financial crisis o 2007–2008 resuled in many invesors avoiding individual socks or sock muual unds or several years.

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LOSS AVERSION

Invesors end o ocus on downside risk when hey lose money afer a sock marke crash. When hey experience his loss, he oucome no only resuls in an objecive loss in dollar erms bu also a subjecive aspecs as an emoional loss. In paricular, when evaluaing specific invesmen ransacions, individuals allocae more imporance o a loss han o earning an equivalen gain. Tis eeling o losing money can remain or a very long ime. Many invesors who realized severe losses during a financial crisis end o avoid he riskier asse classes such as common socks or an exended period. STA TUS QUO

BIAS

Afer a bubble burss, individuals suffer saus quo bias, in which hey no longer wan o inves in socks or avoid making decisions abou heir invesmen porolios all ogeher. Te eeling o invesmen disress, which is based on oher biases such as anchoring, worry, and loss aversion, urher deepens he saus quo bias by urher delaying curren financial decisions. Invesors no longer wan o manage heir invesmens because hey wan o avoid reliving hese bad experiences. Afer a financial crisis, many o hese invesors have porolios ha under-weigh socks and over-weigh cash and bonds. TRUST AND MISTRUST IN A FINANCIAL SETTING

rus is a key elemen in sociey, needed o develop complicaed social, psychological, and economic relaionships. rus and rusworhiness are uncions o our dependence on or confidence in he ruhulness, accuracy, value, or worh o a person, organizaion, or mater. rus is criical or esablishing personal (e.g., a couple daing or he firs ime) and proessional relaionships (e.g., an individual invesor and a financial advisor). For example, Joiner, Leveson, and Langfield-Smih (2002) evaluae he percepions o rus beween financial planners and heir cliens. Using 186 undergraduae business sudens, Joiner e al. invesigae how rus acored ino decisions o use exper language during he financial planning advisemen process, as well as judgmens on he qualiy o advice received, impressions o he planner’s rusworhiness, knowledge and honesy, and prospecs o consumers o seek such exper advice. Joiner e al. (p. 25) repor he ollowing: Te resuls indicae ha he overuse o echnical language in a lay clien consulaion reduces cliens’ undersanding o he advice offered. Lowered advice undersandabiliy negaively affecs cliens’ percepions o he proessional adviser’s experise and rusworhiness and, subsequenly, clien’s inenion o seek he proessional’s advice. Oher aspecs o rus are essenial o osering confidence in organizaions (e.g., he credibiliy o governmen insiuions) or markes (e.g., confidence in inernaional sock markes). According o Doos and Fishman (2004, p. 623): ecen corporae scandals, raud, and misuse o resources involving op execuives and muli- billion dollar companies such as Sunbeam, yco,

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Medco, Enron, Worldcom, he NYSE and ohers no o menion accouning gian, Arhur Andersen, hreaen he viabiliy and coninued success o he U.S. economy, he global economy, and world-wide poliical sabiliy. Sock markes, employees’ pension unds, naional employmen raes, and he abiliy o ci izens o rus in economic sysems are all adversely affece d. People’s overall rus in he privae and public secors began o decrease (i.e., a rend oward increased misrus) in he lae 1960s (Slovic 1993, 1999), and his exends o financial planning and advice. For example, he higher he level o misrus individual possess in he financial expers, who may be inorming he public abou risky behavior, he more anxiey or worry people eel abou he financial crisis or bursing bubbles. As Opdyke (2007, p. D1) commens, “a growing number o people who have spen years building a relaionship wih a rused financial advisor are having o sar over again wih someone new.” Olsen (2004, p. 190) relaes his misrus o he do.com bubble o he lae 1990s: Firs and oremos, he sabiliy o he marke was being undermined by conflics o ineres in he accouning and financial analysis proessions … . Second, many sock opion plans allowed managers o cash in heir opions afer very shor holding periods (less han a year) … . [S]ome managers’ behavior, while no overly illegal or unehical, resembled gamblers playing wih he “house money.” Ta is, since hey had no paid or heir opions, hey behaved as i hey had litle o lose bu a lo o gain by aking bigger risks wih he fir m’s unds. Finally, rus in he official regulaory process was undermined by revelaions o budge reducions among regulaory agencies and widespread public exposure o a cavalier and “public be damned” atiude on he par o many corporae execuives and proessional money managers. Developing a srong level o rus akes a long ime or invesors. However, rus can quickly urn ino misrus, especially in he afermah o a financial crisis. And once ha misrus akes hold, repairing and resoring rus can be difficul.

Summary and Conclusions Te speculaive behavior associaed wih bubbles, manias, panics, and crashes are occasional, random, and severe evens in financial hisory. Behavioral finance helps o explain ha speculaive behavior, based on cogniive processes and affecive reacions ha influence decision making. Tis chaper discusses various biases ha influence he speculaive psychology o invesors during bubbles. Tese biases include overconfiden behavior, herding, polarizaion, grouphink, represenaiveness bias, amiliariy bias, grandiosiy, exciemen, and overreacion and underreacion o prices in financial markes. Te chaper also presens a deailed overview o wha happens in he afermah o he financial crisis o 2007–2008 and he biases ha influence some invesors or an

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exended period, including he derimenal effec o repeaed economic shocks, anchoring bias, recency effec, worry, loss aversion, saus quo bias, and misrus. Tese are all imporan financial behaviors and characerisics abou which financial proessionals should be aware. By gaining such awareness, hey can beter undersand and manage he behavior o heir cliens, because bad financial misakes have a endency o repea hemselves, especially during bubbles and crashes. In paricular, some cliens may experience negaive long-erm biases afer marke crashes ha influence heir overall judgmen and decision making. Te afermah o he recen financial crisis resuled in many invesors exhibiing lower levels o risk olerance and higher levels o worry and risk percepion, which in urn resuling in underinvesing in socks and overinvesing in bonds and cash.

DISCUSSION QUESTIONS 1. Define he erm sock bubble. 2. Lis and describe our major causes o speculaive behavior. 3. Lis and explain our major biases ha invesors exhibi in he afermah o he financial crisis o 2007–2008. 4. Discuss he influence o invesor psychology in he afermah o a financial crisis or when a bubble burss.

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27 Can Humans Dance with Machines? Institutional Investors, High-Frequency Trading, and Modern Markets Dynamics IRENE ALDRIDGE Managing Director, Able Alpha Trading, Ltd. and Able Markets, Director, Big Data Finance

Introduction In Ocober 2015, he U.S. Securiies and Exchange Commission (SEC) couned 18 naional securiy exchanges regisered wih he SEC under he Securiies Exchange Ac o 1934 (Securiies and Exchange Commission 2015). Te SECregisered exchanges include he NYSE, NYSE Arca, NYSE MK (ormerly NYSE AMEX and he American Sock Exchange), BAS, BAS Y, EDGA, EDGX, BOX Opions, Nasdaq, NASDAQ OMX BX, NASDAQ OMX PHLX, C2 Opions, CBOE, Chicago Sock Exchange, ISE, ISE Gemini, Miami Inernaional SecuriiesExchange, and he Naional Sock Exchange. Te SEC-regisered exchanges are ofen reerred o as “li” exchanges, in comparison wih “dark” rading venues such as dark pools. According o Financial Indusry egulaory Auhoriy (FINR) Alernaive rading Sysem (AS) ransparency Daa, he number o dark pools in he Unied Saes sood a 35 as o Ocober 5, 2015, and included eniies wih names such as Aqua, Bids rading, and Crossfinder. Several dark pools can be recognized as hose operaed by large banks, including Cii Cross, Barclays AS, and JPM-X. Perhaps no surprisingly, many insiuional invesors are concerned abou innovaions in he curren marke srucure o he equiy markes. For insance, D’Anona (2015) repors ha 67 percen o U.S. and European buy-siders wan naural blocks, which are he pools o liquidiy where hedge unds, asse managers, and wealh managers can seamlessly execue large orders wihou reaining personnel or specialy firms o manage heir order execuion, as in he long-gone days when only one exchange exised. Tis chaper discusses developmens in oday’s equiy markes, ouching upon regulaory measures, compeiive dynamics, and new enrans. Mos imporan, he chaper shows ha some o he ears surrounding modern microsrucure may be rue and require addiional invesigaion. In paricular, he chaper documens ha insiuional invesors’ ear o oxic liquidiy may be warraned in oday’s equiy markes. 499

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Modern Market Structure and Liquidity Despie he prolieraion o rading venues, he marke landscape is no necessarily a “Wild Wes,” as here are many similariies among rading venues. wo ypes o orders aciliae he majoriy o rading across all exchanges: marke orders and limi orders. A marke order specifies he quaniy o a given financial insrumen ha he rader desires o buy or sell, bu no he price. Te marke order is hen execued or filled immediaely upon reaching an exchange a he bes available price, provided he bes price saisfies he naional (NBBO) requiremens, is he bes (lowes) available ask pricebes andbid heand besoffer (highes) available bid pricewhich o invesors when hey buy and sell securiies. A limi order is an order conaining he price a which he rader would like o sell or buy a given quaniy o sock. Unlike marke orders, limi orders are execued only when hey become he bes-priced orders on he marke, which happens when oher beter-priced limi orders are execued firs or cancelled. Oher, more complex order ypes end o be aggregaes o limi and marke orders wih various addiional characerisics. Furhermore, all U.S. equiy rading venues deploy he cenralized limi order book o record and mach he orders. Also known as he double- sided coninuous aucion, he limi order book is a reposiory o orders organized by price levels. One limi order book ypically exiss or each financial insrumen raded on a given exchange. Te limi orders sored in he limi order book are “added” by raders much like he manuacurers o ood may orders add heir wares o he o arading groceryday, sore. limi orders, known as day limi , expire a he endshel o he buSome ohers, he good ill cancel orders, may las longer. Similar o a grocery supplier, he limi order rader specifies he size o he limi order and he desired rading price. By seting l imi orders, raders add liquidiy o he exchange. Te resuling liquidiy can be consumed by marke order raders and oher limi order raders who mach he price o resing limi orders. Liquidiy is a complicaed opic. Liquidiy reers o he marke’s readiness o rade. Te deeper he liquidiy, he larger is he order he marke can absorb immediaely wihou noiceable marke movemen. Immediae marke execuion is accomplished using marke orders. In order or a buy or sell marke order o be ulfilled, he marke order needs o be mached wih one or more limi orders o he opposie direcion buy marke orders being mached wih sell limi orders and vice versa. As more limi orders are available or maching arrivingis marke he largerlimi heorders markeha order be. Tus, in echnical erms,heliquidiy he se order, o all available cancan be used or immediae execuion. Demsez (1968) firs defined liquidiy as immediacy o execuion. Figure 27.1 is a snapsho o a limi order book, conaining “displayed” liquidiy: resing buy orders (“bids”) and sell orders (“offers”), aggregaed by price rom lowes o he highes. Besides displaying liquidiy, mos exchanges offer he opporuniy o send in “hidden” limi orders ha, similarly o radiional dark pools, are no revealed unil hey are execued. According o olklore, modern liquidiy has wo subses: “naural” liquidiy and “oxic” liquidiy. Naural liquidiy is hough o consis o dependable limi orders ready o be mached wih he incoming marke orders or liquidiy, or insance, placed by raders

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Can Humans Dance with Machines?

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Last trade price

Price

Bids

Offers(asks)

Figure 27.1 Buy-side Available Liquidiy Exceeding Sell- side Liquidiy. Te figure illusraes ha an incoming marke  buy order aces a sparser limi order book , and hence a less cerain execuion, han an incoming marke sell order.

“Flickering quote”

Last trade

103.25

103.85 Bids

104.20

105.90

106.50

Price

Offers

Figure 27.2 Example o impac o “Flickering Quoes” on Buy Offers Tis figure shows ha a rader using a marke buy order observes he bes quoe a price 105.90, bu is filled a 106.50 because he 105.9 quoe is canceled beore he marke buy order reaches he exchange, resuling in worse execuion.

“who generally plan o hold he posiion or longer han one day” (Pragma 2011, p. 3). oxic liquidiy, also reerred o as opporunisic liquidiy, comprises he limi orders ha are no dependable or sable. Jus as he oxic marke order flow leaves marke makers a a disadvanage in a process reerred o as adverse selecion (Easley, Lopez de Prado, and O’Hara 2012), oxic liquidiy can be disadvanageous o non-marke-making paricipans such as insiuional porolio managers. oxic limi orders are ofen cancelled, only o be promply replenished by anoher se o idenical limi orders. Te goal o such on/off flickering is o be inenionally harmul o he markes along he ollowing dimensions: • Some marke paricipans believe ha flickering quoe behavior is presen o deceive marke paricipans abou he deph o he order book. • Ohers believe ha flickering quoes are used o promp large raders ino revealing heir rue posiion execuion sizes. Such inormaion mining on behal o eniies deploying flickering orders is known as “phishing” or “pinging.” • Overall, flickering or disappearing liquidiy can o be oxic because i can exacerbae he marke impac o incoming orders. Figure 27.2 shows an example o marke oxiciy.

502

MARKET EFFICIENCY ISSUES

Several researchers compare he oxiciy o some exchange characerisics such as ee srucure. Alhough all exchanges are obligaed o observe he SEC egulaion Naional Marke Sysems (eg NMS) ha mandaes all marke orders o be execued only a NBBO pr ices or beter quoes, owing o he compeiive naure o he modern rading landscape, exchanges differeniae hemselves by deploying differen pricing and maching combinaions. As Aldridge (2013a) discusses, some equiy exchanges offer raders moneary incenives o provide liquidiy in an atemp o atrac limi orders, and hus o deepen available liquidiy. Exchanges doing so are known as “normal” and offer “rebaes” or providing liquidiy (posing limi orders), while charging ees or aking liquidiy (placing marke orders). Oher exchanges, known as “invered,” do he opposie. Tey charge or limi orders and pay or marke orders. Te NYSE is an example o a normal exchange and he Boson OMX is an invered exchange. A ew exchange firms have offerings in each caegory. For example, BAS has normal and invered exchanges in he firm’s porolio. According o Sofianos and Yousefi (2010), Aldridge (2013b), and Batalio, Corwin, and Jennings (2015), ees and oher properies o exchanges affec he oxiciy o heir liquidiy. For insance, Batalio e al. ound ha, on average, he ees across all he exchanges are in equilibrium, balancing he explici ees wih implici coss, such as observed spreads. Te lower he ee imposed on “liquidiy makers” providing he limi orders, he higher is he observed spread on a given exchange, poenially implying higher oxiciy levels. Aldridge ound ha order cancellaion raes are lower on exchanges wih lower liquidiy maker ees (higher liquidiy aker ees), also indicaing lower oxiciy levels. Owing o he ofen-inense speed o flickering observed in oxic limi orders, some consider oxic liquidiy o be generaed by machines more so han humans, because o human raders’ physical consrains in observing and clicking he orders. In conras, human marke makers and insiuional marke paricipans generae he mos naural liquidiy. As a direc consequence, he presence o oxic liquidiy has promped debaes abou he useulness o high-requency rading (HF) as marke making (Markes Media 2013). Te nex secion discusses sraegies deployed by high-requency raders and heir aciviies in he markes.

High-Frequency Trading High-equency rading (HF) reers o a caegory o compuer programs designed o process vas arrays o marke inormaion and rade he markes, ypically in an inraday ramework, only occasionally holding posiions overnigh. Aldridge (2013a) provides a deailed classificaion o HF sraegies. Broadly speaking, all HF can be spli ino wo large groups: aggressive HF and passive HF. Te key difference beween he wo caegories is heir buil-in impaience. Aggressive high-requency raders (HFs) end o rade on ime-sensiive inormaion and ypically preer o use marke orders ha deliver immediae execuion a he bes available price. Mos successul aggressive high-requency raders require ulra-as conneciviy and speed o execuion o reach he markes ahead o heir compeiion. In conras, passive high-requency raders

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Can Humans Dance with Machines?

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Aggressive buy order arrives, takes out liquidity

Price

Figure 27.3 Impac o Aggressive HF Orders on Bid– Ask Spreads. Tis figure illusraes ha an arriving aggressive order w ipes ou he bes limi order(s) on he opposing side o he limi order book, w idening spreads and incre asing volailiy hrough larger bid– ask bounce.

able 27.1 Average Aggressive HFT Paricipaion in Equiies onAugus 31, 2015 Lowes Aggressive HF, ou o he S&P 500 Index Percen (%) ZNGA

7.4

VVUS

8.3

RD

9.8

Highes aggressive HF, ou o he S&P 500 Index GOOGL

39.6

AMZN

38.1

GOOG

37.6

Noe: Tis able shows he average proporion o aggressive HF in he order flow o seleced securiies. Source: AbleMarkes (2015).

engage in marke making and oher less ime-sensiive sraegies. As a resul, passive high-requency raders mosly use limi orders. As a naural consequence o aggressive HF marke-aking aciviy, aggressive highrequency raders end o wipe ou limi orders in he direcion ha hey rade, increasing bid–ask spreads and resuling in higher realized volailiy (defined by Andersen, Bollerslev, Diebold, and Labys 2002) rom he bid –ask bounce. Figure 27.3 shows he basic mechanics o how aggressive HF increases bid–ask spreads. Te average proporion o aggressive high-requency raders in socks varies rom sock o sock, bu changes litle over ime. able 27.1 shows he daily average aggressive HF paricipaion in seleced S&P 500 Index socks on Augus 31, 2015. As able 27.1 shows, alhough he mechanics may

504

MARKET EFFICIENCY ISSUES

ollow all marke-aking orders, wo key issues peraining o aggressive HF behavior may paricularly exacerbae available liquidiy: • Aggressive high- requency raders end o execue burss o marke orders a once, poenially deeply affecing he liquidiy on one side o he limi order book. • Aggressive HFs ofen ac in response o major marke announcemens, using heir inrasrucure o reach he markes jus ahead o compeing insiuional raders, subsanially worsening execuion or he later. Several sudies confirm he aggressive HF impac on marke volailiy. For example, Zhang (2010) and Cliff, O’Hara, Hendershot and Zigrand (2011) find ha aggressive HFs are more acive during he periods o high marke volailiy, poenially causing said volailiy. Aldridge and Krawciw (2015) esimae ha socks wih higher aggressive HF display consisenly higher volailiy. Conversely, passive HFs end o reduce volailiy by propping up he limi order book and reducing spreads and he bid–ask bounce o prices. O course, raders deploying passive HFs can cancel heir limi orders, as can everyone else placing limi orders. However, hey canno run away once heir orders have been seleced or maching by he exchange. In oher words, jus by placing a limi order, a passive HF is commiting o honor ha order in he period o ime beore he order may be cancelled. No mater how soon he order cancellaion may be sen, i he limi order is he bes-priced order on he marke, and i a marke order arrives in he ime span beween he placemen o he limi order and is cancellaion, he limi order will be execued. Saed differenly, any limi order always has a posiive probabiliy o execuion. Figure 27.4 summarizes he acions o passive HF’s provision o liquidiy. Brogaard (2010) suppors he passive HF–lower volailiy connecion. Alhough oher researchers find ha HF booss liquidiy (Linon and O’Hara 2011; Moriyasu, Wee, and Yu 2013; Jarnecic and Snape 2014), HFs may be oo quick o wihdraw liquidiy during uncerainy, resuling in exreme liquidiy shorages and inducing crashes (Kirilenko, Kyle, Samadi, and uzun 2011; Linon and O’Hara 2011; Hasbrouck 2013). A paricular concern surrounding passive HF has been a perceived rise in as order cancellaions and he resuling oxiciy o liquidiy in he markes. Hausch and Huang (2011) and Hasbrouck and Saar (2013) documen ha 95 percen o all limi orders

Passive buy order arrives, adds liquidity

Price

Figure 27.4 Placemen o Passive HF Order Placemen. Tis figure shows ha an arriving passive limi order enhances liquidiy, addin g deph o he limi order book.

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Can Humans Dance with Machines?

505

on he NASDAQ are cancelled, mos wihin jus one minue o order placemen. Such unexplained behavior o limi orders has been roubling or raders, exchanges, and oher marke paricipans, resuling in claims ha he observed cancellaions are par o some marke-manipulaion schemes. Exchanges have experienced clogs in heir neworks, in which large porions o nework bandwidhs are aken over by order cancellaions, delaying inormaion ransmital or oher orders, quoes, and rades. Te sheer volume o he cancellaions has baffled regulaors, academics, and broker-dealers. Te remainder o his chaper closely examines he inraday limi order dynamics, including order-by-order analysis o he limi order book evoluion. As he analysis shows, basic order-cancellaion couns ofen erroneously incorporae aciviy by insiuional invesors in heir esimaes o he oxic liquidiy.

A Limit Order Book Under a Microscope A ypical exchange may offer dozens o order ypes o raders o all caegories, including insiuions and HFs. As o Sepember 2015, he NYSE had 25 acive order ypes, including six ypes o immediae or cancel (IOC) orders consiuing variaions o a marke order, five ypes o displayed limi orders, and our ypes o non-displayed or hidden limi orders (Inerconinenal Exchange 2015). Ou o all he order ypes, he NYSE IOC marke-order ypes make up 32.61 percen o all orders in aggregae, displayed limi orders o all sripes accoun or 41.51 percen o all orders, and non-displayed limi orders oal jus 2.46 percen o all orders. By comparison, he ollow is he disribuion o orders on BAS exchanges in Sepember 2015: BAS IOC, including vanilla marke orders, occurred 13.84 percen o he ime, wih displayed limi order variaions submied 48.91 percen o he ime, and non-displayed orders accouning or 37.26 percen o he oal order coun (BAS Global Markes 2015). Te differences in order prevalence by ype may be a uncion o marke srucure divergences among exchanges. However, mos exchange order ypes have a leas one commonaliy: he srucure o order ransmission o and rom he exchanges. Te commonaliies in order ransmission are no o be conused wih he language o ransmission, ormally known as ransmission proocol. As Aldridge (2013a) describes, many exchanges use FIX communicaion proocol o ransmi messages. Ye, some oher exchanges, such as he NASDAQ, have proprieary daa ransmission models ha allow inormaion exchange o be aser and more reliable han FIX. However, mos proocols deploy a message srucure ha includes message addiions, message cancellaions, and message execuions, wih individual messages ofen linked by unique order idenifiers o rack he order arrivals and exising order modificaions. For insance, able 27.2 shows a sylized excerp rom a message log recorded or GOOG on Ocober 8, 2015, by BAS BYX exchange. Te fields included in able 27.2 are Unique Limi Order ID, used o ideniy all limi order addiions and subsequen execuions and revisions; he ime he message was sen ou by he exchange; he ime when he srcinal limi order was added; he size o he srcinal limi order or revision; and he price o he srcinal limi order. able 27.2 shows wo order ypes: “A” or a new limi order addiion and “X” or a limi order cancellaion. Addiional order message

506

MARKET EFFICIENCY ISSUES

able 27.2 Sample from Level III Daa (Processed and Formated) for GOO G on Ocober 8, 2015 Unique Order ID

Message ime (E)

Symbol

Original Order Order Limi Placemen ime Size Price

Order ype

C91K9003DS

9:39:01.688

GOOG

9:39:01.688

100 637.33

A

C91K9003DS

9:39:02.790

GOOG

9:39:01.688

100 637.33

X

C91K9003UU4

9:39:09.213

GOOG

9:39:09.213

100 629.23

A

C91K9003UU4

9:39:10.212

GOOG

9:39:09.213

100 629.23

X

C91K9003W7J

9:39:16.794

GOOG

9:39:15.799

100 648.45

X

C91K9003OB

9:39:19.967

GOOG

9:39:00.270

100 641.00

X

Noe: Tis able presens a snippe o deailed order flow or GOOG recorded on Ocober 8, 2015, by BAS. “A” messages represen limi order addiions and “X” messages are limi order cancellaions.

ypes may include parial or ull execuions o limi orders, marke orders, and hidden order execuions. In he snippe o messages shown in able 27.2, he firs wo messages perain o order ID C91K9003DS. Te firs C91K9003DS message is an addiion o he limi wih price 637.33 recorded a 9:39:01.688 (Te imesamp srcinally order was repored in milliseconds ollowing midnigh, bu E. was convered ino regular ime or reader convenience.) Te second message peraining o he same order ID a cancellaion arrived jus more han one second laer. A similar patern occurs wih he nex order ID, C91K9003UU4. Te message o add he 100-share order, his ime wih a price o 629.23, occurred a 9:39:09:213, while he exchange recorded he message o cancel he same order a 9:39:10:212, jus 999 milliseconds laer. Te las wo messages displayed in able 27.2 are cancellaions o orders placed earlier in he day and no shown in he able. On Ocober 8, 2015, GOOG had 50,274 messages ha were o one o he ollowing ypes: (1) limi order addiions, (2) ull or parial limi order cancellaions, (3) regular limi order execuions, and (4) hidden order execuions. O hose messages, 24,824 (49.3 percen) were limi order addiions, 24,750 (49.2 percen) were limi order cancellaions, 139 (0.3order percen) were limi order percen) records o hidden execuions. able 27.3execuions, summarizesand he561 size(1.1 properies o were each caegory o orders. O all he added limi orders, only 49 were greaer han 100 shares, and he maximum order size was 400 shares. Te posed limi orders exclude hidden or dark orders ha are now available on mos public exchanges (“li” markes). Afer a limi order is added (message ype “A”), i can be cancelled or execued in par or in ull, or i can remain resing in he order book unil is expiry, ypically a he end o he rading day or “unil cancel.” Te rader who places he order compleely deermines he cancellaion. Te execuion is a combinaion o acors: a resing limi order is execued when i becomes he bes available order and a maching marke order arrives, given ha he order is no cancelled beore he marke order’s arrival. A limi order may

507

Can Humans Dance with Machines?

507

able 27.3 Disribuion of Order Sizes in Shares Recorded for GOOG on Ocober 8, 2015 A Average

94.27

E

P

87.37

68.50

X 94.21

Sandarddeviaion

21.40

40.30

102.45

21.38

Maximum

400.00

300.00

2283.00

400.00

99% 95%

100.00 100.00

207.56 100.60

138.79 100.00

100.00 100.00

90%

100.00

100.00

100.00

100.00

75%

100.00

100.00

100.00

100.00

50%

100.00

100.00

86.50

100.00

25%

100.00

74.00

20.00

100.00

10%

80.00

37.30

5.00

80.00

5%

47.00

5.50

2.00

47.00

1%

2.00

3.00

1.00

2.00

1.00 24,824.00

2.00 139.00

1.00 561.00

1.00 24,750.00

2,340,128.00

12,144.00

38,426.00

2,331,811.00

Minimum #Messages oalSize

Noe: Tis able illusraes disribuion o order sizes or orders o differen ypes. Order ypes are: “A” add limi order, “E” resing limi order execued, “P” hidden limi order execued, and “X” limi order cancellaion.

cancelled all a once or in several cancellaion messages, each message chipping away a he limi order’s iniial size. Similarly, a limi order may be execued in ull i he maching marke order size is greaer or equal o ha o he limi order. I he limi order is larger han he maching marke orders, i will be parially execued. able summarizes he disribuional properies o ime he las o record o each order27.4 appeared. For addiions o limi orders, as well as orsince execuions hidden orders, he imes are idenically zero. Limi order cancellaions average 8.3 seconds ollowing he las acion on he order ID: a he order placemen or previous parial cancellaion. Te ime disribuion is highly skewed, wih he median ime beween he las order acion and he ollowing order cancellaion being jus a hal a second. Execuions (order ypes “E”) on average occur 18 seconds since he las order acion, wih he execuions ollowing limi order addiions jus 3 seconds a he median value. O 24,824 limi orders added o GOOG on Ocober 8, 2015, 21,698 (87 percen) were cancelled in ull wih jus one order cancellaion. On average, single cancellaions arrived jus five seconds afer he limi order was added o he limi order book. Te

508

MARKET EFFICIENCY ISSUES

able 27.4 Disribuion of Difference beween SequenialOrder Updaes for All Order Records for GOOG on Ocober 8, 2015

Average Sandarddeviaion

A

E (ms)

0

17,932.87

0

82,984.99

P (ms) 0 0

X (ms) 8,299.75 211,621.90

Maximum

0

687,989.00

0

18,326,189.00

99% 95%

0 0

496,794.70 33,518.00

0 0

29,535.60 11,545.15

90%

0

25,900.00

0

6,599.40

75%

0

10,049.00

0

2,237.00

50%

0

3,010.50

0

567.00

25%

0

626.00

0

68.00

10%

0

29.90

0

4.00

5%

0

0.00

0

1.00

1%

0

0.00

0

0.00

Minimum

0

0.00

0

0.00

Noe: Tis able shows he duraion o ime (in milliseconds) since he las order updae or each given order ID or various order ypes. Order ypes are: “A” add limi order, “E” resing limi order execued, “P” hidden limi order execued, and “X” limi order cancellaion. “A” and “P” ype orders are firs recorded when added and execued, respecively.

median shel lie o a limi order wih a single cancellaion was even shorer: jus more han hal a second. able 27.5 illusraes ha mos o he orders were 100 shares or smaller. As Davis, oseman, Van Ness, and Van Ness (2015) firs poined ou, here is litle evidence o show ha order cancellaions are a resul o single-share liquidiy pinging a “canary in a coal mine” heory ha purpors o describe some o he HF aciviy. As able 27.5 shows, mos o he orders were in 100-share los. Te limi ordersorno cancelled ull wih single order cancellaion can be subsequenly execued cancelled a ainlaer ime.aFigure 27.5 displays a hisogram o he number o order messages or each added limi order when he order messages exceed wo (ypically, addiion and cancellaion, or addiion and execuion). As Figure 27.5 shows, some limi orders end up wih as many as 50 limi order cancellaions. Te mos ineresing par o he limi order dynamics could be in he inraday evoluion o orders. Unil 9:28 E, limi orders arrive and are promply cancelled, wihou any limi orders visibly resing in he limi order book or longer han five minues. Displayed limi orders alernae beween buys and sells and various price levels. Ten, a 9:28:30.231 E, wo orders arrive a buy a 596.57, order ID C91K9000U8; and a sell a 684.27, order ID C91K9000U9. Te buy order is lef unouched unil 11:52:25.912 , a which poin he buy order is modified hrough a simulaneous

509

able 27.5 Size and Shelf Life of Orders Canceled in Full, wih a Single Cancellaion for GOOG on Ocober 8, 2015 Size

ime Unil Cancel (ms)

Average

93.51

5,210.67

Sandarddeviaion

22.56

154,922.70

Maximum

400.00

18,326,189.00

99% 90%

100.00 100.00

27,946.44 6543.00

75%

100.00

2284.00

50%

100.00

630.00

25%

100.00

97.00

10%

80.00

30.00

5%

47.00

1.00

1%

2.00

0.00

Minimum

1.00

0.00

Noe: Tis able shows he summary saisics or limi orders canceled in ull, as opposed o parial order cancellaions.

600

500

400

300

200

100 0 3

5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 4345 4749 51

Figure 27.5 Hisogram o umber o Order Messages per Each Added Limi Order. Tis figure shows he number o order messages or each added limi order excluding order addiions, ollowed by single order cancellaions. Addiion o he limi order (“A” message) is included in he oal order coun, displayed on X ax is. Te Y a xis shows he number o order IDs corresponding o each message coun.

510

MARKET EFFICIENCY ISSUES

cancellaion message and anoher added wih he same order ID and size, a 590.16. A 14:59:30.895, he same order ID is in play again, his ime receiving a simulaneous cancellaion message and an “A” message wih a price o 596.64. A 16:00:00, he limi order is finally cancelled. Te sell order C91K9000U9 is updaed via a simulaneous cancellaion and an order addiion a 9:49:44.619, when he price is rese o 677.88, and hen 11:56:21.674, when he price is rese o 671.49, and hen 14:39:58.082, when he price is changed o 677.95. Tis order, oo, is finally cancelled a 16:00:00.000 by he exchange, probably because i was a day limi order. When a limi order is adjused, i is recorded no as a separae message bu as a sequence o wo messages wih he same order ID: an order cancellaion ollowed by an immediae order addiion wih revised characerisics. In GOOG daa or Ocober 8, 2015, 4,794 messages exised peraining o limi order adjusmens, making up 9.5 percen o he oal message raffic. An average revision occurred 30 seconds afer he las order updae, indicaing likely human direcion. O all he revisions, 99.0 percen occurred wihin 40 seconds o he srcinal order addiion or las revision. able 27.6 summarizes he disribuion o iner- revision imes or limi orders on GOOG on Ocober 8, 2015. O all order revision raffic messages, only 488 (10.2 percen) reerred o singular order updaes; he remaining (89.8 percen) o revised orders incurred several sequenial revisions in a row. For example, he limi sell order C91K9003EDZ was revised five imes wihin six seconds rom 9:38:05.139 o 9:38:11.424, wih he limi sell price dropping wih each consecuive order rom 641.26 o 641.25, o 641.14, o 641.07, o 641.05. For he 3,244 messages peraining o he sell order revisions, he price on 95 percen o he orders was revised downward (i.e., improved wih each revision). Similarly, or he 1,550 buy order revision messages, he price was raised o be closer o he marke in 96 percen o cases. In oher words, he vas majoriy o he 9.5 percen o all limi order raffic comprising limi order revisions was beneficial: he limi order updaes ighened spreads. Unlike order revisions, 6,168 messages, or 12.3 percen o he 50,274 oal order messages or GOOG recorded on Ocober 8, 2015, were shor-lived flashes o liquidiy ha can be considered “flickering liquidiy.” For example, a 100share buy limi order C91K9000W09 is placed a 9:30:02.763 or 632.55, only o be cancelled 678 milliseconds (ms) laer wihou a simulaneous replacemen. A 9:30:09.376, anoher buy limi order C91K9000XZ0 arrives or a higher price o 638.01, and is held or a precise 1,000 ms, a which poin i is also cancelled wihou an immediae replacemen. wo more buy orders urn on and off sequenially, firs or 636.55 a 9:30:11.403 or 1,001 ms, and hen or 629.09 a 9:30:14.422 or 5,352 ms, beore a hidden order execuion rade prin arrives: 23 shares a 642.27 execued a 9:30:47.035. A similar dance o shor-lived quoes ollowed by hidden order execuions coninues hroughou much o he rading day. O he flickering orders, 1,622 message pairs (each flickering order comprises an order addiion and an order cancellaion) perain o sell limi orders, and 1,462 pairs are on he buy side o he limi order book. able 27.7 summarizes he disribuion o he shel lie o orders ha are cancelled wihou immediae replacemen and can, hereore, be considered flickering. Alhough he flickering orders idenified in able 27.7 are likely candidaes or “pings” in he Pragma (2011) sense and “canaries” according o Davis e al. (2015), he

51

Can Humans Dance with Machines?

511

able 27.6 Disribuion of Times beween Subsequen Order Revisions for GOOG on Ocober 8, 2015 Shel Lie o Limi Orders beween Subsequen Revisions (ms) Average Sandarddeviaion Maximum

31,119.40 469,658.70 11,224,983.00

99%

40,072.72

95%

10,763.80

90%

5,458.00

75%

1,201.00

50%

45.00

25%

1.00

10%

0.00

5%

0.00

1%

0.00

Minimum

0.00

Messagecoun

4794.00

%oallmessages

95.36

Noe: Tis able shows he disribuion o ime (in milliseconds) beween subsequen order revisions.

resuls presen a drasically differen picure rom ha o some previous sudies on he dynamics o limi orders, namely Hausch and Huang (2011) and Hasbrouck and Saar (2013), who boh find ha 95.0 percen o limi orders are pings cancelled wihin one minue o heir addiion. A he same ime, neiher makes any menion o order revisions, poenially couning order revisions as simple order cancellaions. O course, possibly, order revisions may be reaed differenly in he daase ha Hausch and Huang and Hasbrouck and Saar sudied NASDAQ oalView. Eiher way, he resuls rom he BAS daa analysis presened in his chaper lead o a drasically differen conclusion: only a small racion (12.3 percen) o all message raffic had characerisics o poenial pings, or oxic order flow a ar cry rom he 95 percen repored in he earlier sudies. O he remaining 78.2 percen o he enire message raffic no accouned or in order revisions and pings, only 700 orders (1.3 percen o he oal daily message rafic) were order execuions. O hose, only 139 orders (0.3 percen) were execuions o limi orders displayed in he limi order book, message ype “E.” Te remaining 561 execuions (1.11 percen o oal message raffic) were ype “P” messages maches o

512

MARKET EFFICIENCY ISSUES

able 27.7 Disribuion of Duraion of Limi Orders Canceled wih an Order Message Immediaely Following he Order Placemen Message Shel Lie o Flickering Limi Orders (ms) Average

1,293.19

Sandarddeviaion

7,682.14

Maximum

268,397.00

99% 95%

11,430.36 4,960.80

90%

2,633.70

75%

1,001.00

50%

196.00

25%

4.00

10%

0.00

5%

0.00

1%

0.00

Minimum Messagecoun

0.00 6,168

%oallmessages

12.27

Noe: Tis able shows he disribuion o visibiliy o flickering limi orders.

marke orders wih hidden limi orders, or special order ypes ha do no appear in he cenralized limi order book. Te finding ha mos order execuions are accomplished wih hidden limi orders is no enirely surprising. Yao (2012) sudies NASDAQ daa in 2010 and 2011, and finds ha hidden orders accouned or 20.4 percen o all execuions. Tis percenage has probably increased, as “li” exchanges are moving oward srucures akin o dark pools.

Order-Based Negotiations According o Yao (2012) and oher recen research, marke paricipans may use “li” limi orders o signal heir willingness o buy and sell a specific prices. Mos o he execuion, however, happens in he ineracion wih hidden or dark liquidiy ha canno be direcly observed in he limi order book. A swif negoiaion may ollow an indicaion o ineres, resuling in a hidden order execuion. An alernaive, less posiive, ye popular hypohesis can be ha he insiuions and oher marke-order and hidden-order

513

Can Humans Dance with Machines?

513

raders are influenced by flickering, subopimal liquidiy provided by high-requency raders. Tis secion presens simple ess o he qualiy o he orders in oday’s markes. o es he ineracion o various order ypes, each order message wihin he daa se is firs separaed and labeled as one o he ollowing caegories: a message revision, a ping, a regular limi order addiion, and a regular limi order cancellaion. Te message revision orders are picked ou by maching he limi order IDs o sequenial orders where he order addiion ollows he order cancellaion wih slighly differen parameers. Pings are idenified as order cancellaions ollowing order addiions wih he same order ID wihou subsequen order addiions. All order ypes are assigned indicaor uncions wih {0, 1} se o oucomes, depending on which subse o order ypes he order messages belong. Finally, 10-message and 300-message moving average series are creaed or each order ype o serve as dependen variables in he analysis o hose order ype impacs on “li” and hidden order execuion. Te observed impac o various order ypes appears o change considerably rom high requency o lower requency. On average hroughou he day, 10 exchange messages were imesamped every five seconds, wih a median ime o wo seconds and he lowes decile o sixy-seven milliseconds. Conversely, 300 messages were processed every 2.5 minues, on average, wih a median processing ime alling o 1.8 minues and 10 percen o all 300-message blocks crowding ino 1 minue. Alhough a human rader can heoreically ollow every 10 rading messages in jus wo seconds, a more likely scenario is ha acions a ha speed are processed by a machine, whereas human raders would more likely observe daa a a minue scale (i.e., 300-message horizon). A 10-message requencies, boh regular marke order execuions and hidden order execuions exhibi dependence on he dynamics o oher order ypes. Using he indicaor uncions o denoe he occurrences o marke order and hidden order execuions, and regressing he obained values on prior 10-order moving average proporions o oher order occurrences, a saisically significan relaion can be deduced o he ollowing naure: 1. A high requencies, flickering orders bear litle impac on he execuion o hidden orders. However, hey have a negaive impac on he execuion o marke orders, poenially deerring marke order raders rom sending in he marke orders. 2. A high requencies, limi order revisions have no impac on marke order execuion, bu have a posiive impac on hidden order execuion. Poenially, limi order revisions serve o ideniy hidden order locaions and approach hidden order locaions aser, resuling in maching. 3. A high requencies, regular limi order placemen and cancellaion has he greaes impac on he execuion o boh marke orders and hidden orders. Surprisingly, in he cases o marke orders and hidden orders, he impac o new limi order arrivals and cancellaions is negaive: he more regularly (non-revision, no-flicker) ha limi order arrivals and cancellaions are observed in he limi order book, he ewer marke orders and hidden orders are execued. Poenially, new limi orders are alernaive acions o marke orders, wih raders choosing limi orders whenever he impending marke movemen is no perceived as urgen. Similarly, addiions and cancellaions o regular limi orders may delay hidden order discovery, reducing he hidden order cancellaion raes.

514

MARKET EFFICIENCY ISSUES

able 27.8 Marke Order Execuions (Message Type “E”) and Oher Order Type Dynamics a 10-Message Frequency Model 1

Model 2

Model 3

Model 4

Inercep

0.0026 (10.279)

0.0033 (10.523)

0.0397 (20.043)

0.0367 (18.650)

Limi order revisions, 10-order MA o indicaor uncion, preceding limi order execuion

0.0021 (0.904)

–

–

–

Flickering orders, 10-order – MA o indicaor uncion

–0.0024 (–1.739)

–

–

egular limi order addiions, 10-order MA o indicaor uncion

–

–

–0.0735 (–18.469)

–

egular limi order cancellaions, 10-order MA o Indicaor uncion

–

–

–

–0.0676 (–17.051)

Adjused 2

−0.0000

0.0000

0.0086

0.0073

Noe: Tis able shows he resuls o regressions examining prevalence o marke order execuions ollowing limi order revisions (Model 1), flickering orders (Model 2), regular limi order addiions (Model 3), and regular limi order cancellaions (Model 4) wihin he ollowing 10 messages (median ime o 2 seconds).

ables 27.8 and 27.9 summarize he saisical resuls o analyses o he impac o order ypes on hidden and “li” order execuions a he 10-order message horizon. As hese ables show, a he 10-message requency boh hidden and “li” order execuion are significanly deermined by acors unrelaed o he order messages immediaely preceding execuion. Tis finding is indicaed by he saisical significance o he inercep in all models shown. Te findings serve o illusrae he relaive imporance ha marke paricipans place on he occurrence o flickering limi orders. hehe 300-message requency, here revisions. is a much sronger dependency o order ionAon preceding pings and order Specifically, ables 27.10 andexecu27.11 show he ollowing: • A lower requencies, flickering orders have a srong impac on marke and hidden order execuion. Specifically, an increase in pings leads o an increase in marke orders and hidden order execuions wih 99.9 percen confidence. Tis finding sarkly conrass wih findings abou he flickering order impacs a higher requencies when he execuion o marke orders declines wih increases in flickering quoaions. • A lower requencies, limi order revisions presen a much sronger influence on increased marke order and hidden order execuion han a higher requencies.

51

Can Humans Dance with Machines?

515

able 27.9 Hidden Limi Order Execuions (MessageType “P”) and Oher Order Type Dynamics a 10-Message Frequency Model 1

Model 2

Model 3

Model 4

Inercep

0.0107 (20.789)

0.0118 (18.399)

0.1219 (30.932)

0.1269 (32.516)

Limi order revisions, 10-order MA o indicaor uncion, preceding limi order execuion

0.0079 (1.708)

–

–

–

Flickering orders, 10-order MA o indicaor uncion

–

0.0035 (1.259)

–

–

egular limi order addiions, 10-order MA o indicaor uncion

–

–

–0.2187 (–27.624)

–

egular limi order cancellaions, 10-order MA o Indicaor uncion

–

–

–

–0.2299 (–29.199)

Adjused 2

0.0000

0.0000

0.0190

0.0212

Noe: Tis able shows he resuls o regressions examining prevalence o hidden order execuions ollowing limi order revisions (Model 1), flickering orders (Model 2), regular limi order addiions (Model 3), and regular limi order cancellaions (Model 4) wihin he ollowing 10 messages (median ime o 2 seconds).

• A lower requencies, he impac o regular order addiion on marke and hidden order execuions is presen, bu i is less saisically significan han ha observed a higher requencies. Te divide in how marke paricipans perceive and inerpre flickering quoes is inormaive on many levels. Firs, i could reveal a weakness in he cenralized quoaion sysem, known as Securiies Inormaion Processor (SIP), adminisered by he SEC. Te rouine SIP offer involves gahering quoes rom rading venues, he bes operaion bid and heobes among he quoes, and henvarious redisribuing he bes finding quoes back o marke paricipans. rading venues migh use SIP o deermine which exchange o orward a marke order in he absence o bes quoes on a given exchange. Te presence o flickering quoes on a paricular exchange could cause SIP o pos he flickering order as he bes naionwide quoe, and cause a spike in marke order rouings o ha exchange. As a resul, he roued marke orders may or may no be filled up a bes prices. Alernaively, human raders waching marke daa on screens could perceive he flickering quoes as he rue available liquidiy and atemp o execue agains he quoes using eiher marke or hidden orders. Finally, flickering orders could be pure pings seeking o ideniy pools o hidden liquidiy wihin he spread in a given limi

516

MARKET EFFICIENCY ISSUES

able 27.10 Marke Order Execuions (Message Type “E”) and Oher Order Type Dynamics a 300-Message Frequency Model 1

Model 2

Model 3

Model 4

Inercep

0.0021 (7.159)

0.1275 (330.659)

0.1511 (8.348)

0.1413 (9.395)

Limi order revisions, 10-order MA o indicaor uncion, preceding limi order execuion

0.0141 (3.644)

–

–

–

–

–

Flickering orders, 10-order MA o indicaor uncion

–

egular limi order addiions, 10-order MA o indicaor uncion

–

–

–0.2997 (–8.157)

–

egular limi order cancellaions, 10-order MA o Indicaor uncion

–

–

–

–0.2809 (–9.165)

Adjused 2

0.0002

0.0429 (40.443)

0.0349

0.0017

0.0021

Noe: Tis able shows he resuls o regressions examining prevalence o marke order execuions ollowing various order ypes a 300-message requency (median ime o nearly 2 minues).

order book. In his case, a small mach o a flickering order wih a hidden order esablishes he locaion o a poenial liquidiy pool in he limi order book. In he conex o signaling, boh hypoheses posulaed a he beginning o his secion appear o hold rue: (1) machine raders ideniy and filer behavior o oher machines, disregarding issues such as flickering quoes or pings; and (2) lower-requency raders appear o inerac wih flickering liquidiy. Alhough he resuls presened here are a case sudy o an individual sock GOOG, on jus one rading day, Ocober 8, 2015 he resuls are easily exended o a larger sock universe where similar conclusions hold.

Summary and Conclusions As his chaper shows, conemporary equiy markes are evolving o bes mee insiuional invesors’ needs. Some issues, however, paricularly hose peraining o he collaboraion o human and machine raders, remain unresolved. Mos regulaed (“li”) exchanges are accommodaing he demand or block rading by converging o a model ha suppors large hidden block orders, producing subsanial liquidiy readily available o execue insiuional invesors’ mandaes. In BAS daa, or insance, he vas majoriy o order execuions are conduced wih hidden limi orders and jus a small racion are carried on wih marke orders.

517

Can Humans Dance with Machines?

517

able 27.11 Hidden Limi Order Execuions (MessageType “P”) and Oher Order Type Dynamics a 300-Message Frequency Model 1

Model 2

Model 3

Model 4

Inercep

0.0076 (13.019)

0.0030 (2.993)

0.6243 (17.651)

0.4465 (15.167)

Limi order revisions, 10-order MA o indicaor uncion, preceding limi order execuion

0.0725 (9.440)

–

–

–

Flickering orders, 10-order MA o indicaor uncion

–

0.0671 (10.204)

–

–

egular limi order addiions, 10-order MA o indicaor uncion

–

–

–1.2402 (–17.271)

–

egular limi order cancellaions, 10-order MA o Indicaor uncion

–

–

–

–0.8824 (–14.710)

Adjused 2

0.0018

0.0023

0.0076

0.0055

Noe: Tis able shows he resuls o regressions examining prevalence o hidden order execuions ollowing various order ypes a 300-message requency (median ime o nearly 2 minues).

Furhermore, he chaper has demysified HF aciviy and shows ha he kind o HF marke-making, ofen considered he wors owing o he “flickering” liquidiy i delivers, comprises only a small racion o available liquidiy. Alhough no as copious as previously hough, flickering liquidiy appears o have a dual impac a disinc requencies. A high requencies, he flickering liquidiy is mosly derimenal o isel, as i is readily observed and avoided by oher high-requency marke paricipans. A lower requencies, however, he flickering liquidiy appears o atrac execuion o boh marke and hidden orders, poenially causing order rouing oward flickering order books by he SEC’s consolidaed ape via SIP and hus disadvanaging human raders. Tis chaper also has presened he firs sudy o he impac o limi order revisions on marke aciviy. Like flickering liquidiy, limi order revisions appear o have a dual impac on order execuions, depending on he requency a which he orders are observed. A high requencies, visible limi order revisions appear o credibly signal a willingness o negoiae and are ollowed by a higher number o hidden order execuions han oher order ypes. A lower requencies, however, limi order revisions appear o sem marke and hidden order execuions. Finally, he chaper has shown ha regular limi order addiions and, separaely, cancellaions appear o deer he execuion o marke and hidden orders. Te observed negaive impac o order addiions and order cancellaions is more saisically significan a higher requencies. raders observing he markes may wan o be aware o he marke’s

518

MARKET EFFICIENCY ISSUES

responses o individual orders and reconsider heir processing o marke daa, as well as heir placemen o orders, wih he marke signaling conex in mind.

DISCUSSION QUESTIONS 1. Discuss he main differences among various equiy exchanges operaing in he Unied Saes. 2. Discuss he key ypes o HF. 3. Explain how exchanges disribue marke inormaion. 4. Describe how exchanges record various order ypes. 5. Ideniy he liquidiy consideraions ha marke paricipans need o consider.

REFERENCES AbleMarkes. 2015. “racking Aggressive HF in Commodiies Helps Invesors Predic Volailiy, Hedge Teir Exposures.” Available ahtp://www.ablemarkes.com/AbleMarkes/load.php?=rackingAggressiveHFinCommodiiesHelpsInvesorsPredicVolailiy20151021.pd. Aldridge, Irene E. 2013a. High-Frequency rading: A Pracical Guide o Algorihmic Sraegies and rading Sysems. Second Ediion. Hoboken, NJ: John Wiley & Sons, Inc. Aldridge, Irene E. 2013b. “Marke Microsrucure and he isks o High-Frequency rading.” Working Paper, Able Alpha rading, LD. Available a htp://ssrn.com/absrac=2294526. Aldridge, Irene E., and Seve F. . Krawciw. 2015. “Socks wih Higher Aggressive HF Are More Volaile.” raders’ Magazine, July, 12. Andersen, orben G., im Bollerslev, Francis X. Diebold, and Paul Labys. 2002. “Modeling and Forecasing ealized Volailiy.”Economerica 71:2, 529–626. BAS Global Markes. 2015. “Order ype Usage Summary.” Available ahtp://www.basrading. com/marke_daa/order_ypes/. Batalio, ober H., Shane A. Corwin, and ober H. Jennings. 2015. “Can Brokers Have I All? On he elaion beween Make-ake Fees and Limi Order Execuion Qualiy.” Working Paper, Universiy o Nore Dame. Available a htp://ssrn.com/absrac=2367462. Brogaard, Jonahan A. 2010. “High-Frequency rading and Is Impac on Marke Qualiy.” Working Paper, Norhwesern Universiy. Cliff, Dave, Maureen O’Hara, errence Hendershot, and JeanPierre Zigrand. 2011. Te Fuure o Compuer rading in he Financial Markes.U.K. Governmen Office or Science. Davis, yan L., Brian S. oseman, Bonnie F. Van Ness, and ober A. Van Ness. 2015. “Canary in a Coal Mine? One-Share Orders and rades.” Working Paper, Universiy o Mississippi. Available a htp://ssrn.com/absrac=2508352. D’Anona, Jr., John. 2015. “67 Percen o U.S. and European Buysiders Wan Naural Blocks, abb epors.”raders Magazine, Ocober 20. Available a htp://www.radersmagazine.com/news/ buyside/67-o-us-and-european-buysiders-wan-naural-blocks-abb-repors-114554-1.hml. Demsez, Harold. 1968. “Te Cos o ransacing.”Quarerly Journal o Economics82:1, 33–53. Easley, David, Marco Lopez de Prado, and Maureen O’Hara. 2012. “Flow oxiciy and Liquidiy in a High-requency World.”Review o Financial Sudies25:5, 1414–1493. Hasbrouck, Joel. 2013. “High-Frequency Quoing: Shor-erm Volailiy in Bids and Offers.” Working Paper, New York Universiy. Hasbrouck, Joel, and Gideon Saar. 2013. “Low-laency rading.” Journal o Financial Markes 16:4, 646–679.

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Hausch, Nicholas, and uihong Huang. 2011. “Te Marke Impac o a Limi Order.” Journal o Economic Dynamics and Conrol 36:4, 501–522. Inerconinenal Exchange. 2015. “NYSE Order ype Usage (Percenage o Mached Volume).” Available a htps://www.nyse.com/publicdocs/nyse/markes/nyse/NYSE-Order-ypeUsage.pd. Jarnecic, Elvis, and Mark Snape. 2014. “Te Provision o Liquidiy by High-Frequency Paricipans.” Financial Review49:2, 371–394. Kirilenko, Andrei A., Alber S. Kyle, Mehrdad Samadi, and ugkan uzun. 2011. “Te Flash Crash: Te Impac o High-Frequency rading on an Elecronic Marke.” Working Paper, Massachusets Insiue o echnology. Linon, Oliver, and Maureen O’Hara. 2011. “Te Impac o Compuer rading on Liquidiy, Price Efficiency/Discovery and ransacion Coss.” U.K. Governmen Foresigh Projec. Markes Media. 2013. “Liquidiy: Te Good, he Bad, and he Ugly.” Available a htp://markesmedia.com/liquidiy-he-good-he-bad-and-he-ugly/. Moriyasu, Hiroshi, Marvin Wee, and Jing Yu. 2013. “Te ole o Algorihmic rading in Sock Liquidiy and Commonaliy in Elecronic Limi Order Markes.” Working Paper, Universiy o Wesern Ausralia. Pragma. 2011. “OnePipe 3.0: Te Nex Generaion Dark Liquidiy Aggregaor.” Available a htp:// www.pragmarading.com/sies/deaul/files/one_pipe_3.0_2011_0.pd. Securiies and Exchange Commission. 2015. “Invesor Inormaion: Exchanges.” Ocober 27. Available a htp://www.sec.gov/divisions/markereg/mrexchanges.shml. Sofianos, George, and Ali Yousefi. 2010. “Smar ouing: Good Fills, Bad Fills and Venue oxiciy.” Goldman Sachs Equiy Execuion Sraegies Sree Smar40: 1–9. Yao, Chen. 2012. “Hidden Agendas: A Sudy o he Impac o Concealed Orders.” Working Paper, Universiy o Illinois a Urbana-Champaign. Zhang, X. Frank. 2010. “High-Frequency rading, a Sock Volailiy and Price Discovery.” Working Paper, Yale School o Managemen. Available htp://ssrn.com/absrac=1691679.

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Part Seven

THE APPLICATION ANDFINANCE FUTURE OF BEHAVIORAL

523

28 Applications of Client Behavior A Practitioner’s Perspective HAROLD EVENSKY, CFP Chairman, Evensky & Katz/Foldes Financial Professor of Practice, Texas Tech University

Introduction Advising cliens abou heir invesmens is a challenging endeavor. Te invesmen universe involves many complexiies and ofen couner-inuiive aspecs. Addiionally praciioners ofen misapplyvarious behavioral finance conceps. Undersanding he behavioral errors o cliens and knowing he echniques ha migh helpmiigae such errors orms a useul knowledge base or he financial advisor. 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 begins wih a discussion o he imporance o clien educaion in esablishing a long-erm relaionship. Nex, he chaper explains he value o raming he planning process, ollowed by a secion on behaviorally based clien managemen. Te final secion offers a summary and conclusions.

Aspects of Client Education Educaing he new clien abou he advisor’s planning and invesmen philosophy is a criical sep in esablishing a sound, long-erm relaionship. Te ollowing secion provides examples ha have proved successul in pracice. FRAMING THE PR OCESS: ANCHORIN ON THE EFFICIENT FRONTIER

G

Many praciioners used o inroduce he planning process by presening he classic Markowiz efficien ronier graphics, accompanied by a high-level discussion o he opimizaion process, including such conceps as sandard deviaions, correlaions, and nonlinear programming. Advisors were so enranced wih heir knowledge ha hey ailed o see heir cliens’ eyes glaze over as hey uned ou o he presenaion. One day, 523

524

THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE

Deena Kaz, a ounder o Evensky & Kaz/Foldes Financial (hereafer called “he firm”), observed ha “when you go o he docor, you don’ expec … a lecure on he developmen o he medicine … prescribed or you.” Given ha insigh, he firm recognized ha i was misraming he discussion. Insead o a ormal and inimidaing echnical presenaion, advisors a he firm now rame he educaional process in an inormal, nonhreaening way using he ollowing approach. Curren pracice is o work in eams, whereby an associae suppors a senior advisor in he clien meeings. Afer compleing he “mee and gree” ceremonies, he senior advisor sars he meeing wih an inroducion such as “Okay, le’s ge sared, I’m going o give you a quick overview on modern porolio heory and explain how we’re going o help you figure ou how you should be invesed o enjoy your reiremen. Tis is going o be un.” Te advisor hen urns o he associae and says “Have you go an exra shee o paper?” A which poin he associae ears a page rom a noepad and gives i o he senior advisor. Te advisor hen draws he simple graph illusraed in Figure 28.1 and explains: “Tis is a picure o possible invesmens showing he balance beween risk and reurn. Down on he lower lef corner is cash or money marke insrumens wih minimal risk and minimal reurn. High up on he righ is an all-sock porolio wih high risk and high poenial reurn, and somewhere in he middle is an all- bond porolio wih moderae risk and moderae reurn.” Even wih jus hree invesmen choices, he advisor can design many porolios. For example, one porolio could consis o 1 percen bonds and 99 percen socks; 99 percen bonds and 1 percen socks; 20 percen cash, 40 percen bonds, and 40 percen socks, and so orh. Figure 28.2 illusraes various combinaions o invesmen choice. Figure 28.2 illusraes he efficien fonier, which is a se o heoreically opimal porolios ha offer he highes expeced reurn or a given level o risk, or he lowes risk or

Return Stock

Bond Cash

Risk

Figure 28.1 Te elaion Beween isk and eurn. Tis figure shows he relaion beween risk and reurn in a way ha invesors can easily undersand.

I want this one Return But the real world is somewhere under this efficient frontier

I

Risk

Figure 28.2 Te Efficien Porolio. Tis figure sho ws a large number o possible porolios w ihin a consrained universe o possibiliies.

52

A p pl i c at i o n s of C l i e n t B e h a v i or

525

a given level o expeced reurn. Invesors desire a porolio ha will give hem a high reurn wih as litle risk as possible, bu he acual projeced perormance resuls all somewhere along and under ha curve. Te imporance o he curve is o show ha no one “bes” porolio exiss or everyone. Te bes porolio depends on he risk–reurn preerence o each invesor. A major responsibiliy o he advisor is o assis in deermining he mos appropriae porolio or an invesor by using wo crieria: (1) he longerm reurn needed o supply he unds necessary o achieve clien goals; and (2) an assessmen o personal risk olerance, which is he degree o variabiliy in invesmen reurns ha an invesor is willing o wihsand. When financial planners menion risk, hey are generally reerring o he poenial loss in an invesmen porolio ha ofen resuls rom a marke downurn. Unorunaely, similar o many erms in he financial world, “risk” has numerous meanings. Risk capaciy describes how much invesmen risk cliens migh ake based on heir financial resources (i.e., how severe a financial loss cliens migh susain and sill have he financial resources o mee heir goals). Many invesors have ample financial resources and can afford o ake considerable marke risk, bu ha does no necessarily mean hey are emoionally prepared o live wih ha risk. Risk requiremen is he level o reurn ha cliens need o mee heir financial goals. Alhough a financial planner considers boh risk capaciy and risk requiremen, risk olerance is also a criical elemen in developing an allocaion recommendaion. As Guillemete, Finke, and Gilliam (2012, p. 42) noe, In such imes as hese [global financial crisis] … he assessmen o how cliens will reac o a severe marke downurn will be criical in deermining wheher hey coninue o ollow his planner’s recommendaions. I a risk olerance quesionnaire ails o accuraely measure a clien’s porolio allocaion preerence, i is more likely ha clien will wan o shif his or her porolio o cash during marke downurns. Unorunaely, no universal agreemen exiss on he definiion o “risk olerance” or is measuremen (oszkowski, Dalaney, and Cordell 2009). Despie considerable discussion and debae abou he differences in risk olerance, risk percepion, risk aversion, and loss aversion, no pracical guidance is available or choosing he appropriae asse allocaion or cliens. From a praciioner’s perspecive, as Guillemete e al. (2012) imply, he only useul definiion o risk olerance is he hreshold or emoional pain ha poin a which a clien calls he advisor during a painul bear marke and says, “I can’ sand i. Sell he securiies in my porolio and place he unds in cash.” Te advisor’s goal is o design a porolio ha will keep he risk below ha hreshold. During he iniial educaional process, he advisor explains he imporance o using a compuer-based analysis know as a capial needs analysiso deermine he unique reurn required o achieve a clien’s goals wih a high probabiliy. Tis analysis akes ino consideraion: (1) he clien’s unique goals, such as caring or aging parens, unding grandchildren’s’ college, and/or paying off a morgage; (2) he iming and coss o reaching hose goals; (3) he imporance and prioriy o each goal; (4) where he money is invesed, such as in personal accouns and ax-deerred accouns; and (5) axes, invesmen expenses, and inflaion. Wih his inormaion, a financial advisor can esimae a required porolio reurn.

526

THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE Return A

B

Risk

Figure 28.3 Anchoring on he Efficien F ronier: isk olerance Exceeds isk Need. Tis figure demonsraes ha when a clien’s risk olerance exceeds his or her risk need, wo possible “ bes” porolios are available. One porolio provides he bes reurn or he clien’s risk olerance and anoher provides he reurn ha he clien needs a he lowes risk.

Wih an esimae o he clien’s reurn requiremen and risk olerance, he advisor can hen deermine he mos appropriae porolios. In describing viable opions, he advisor adds wo lines o he risk-reurn graph. Figure 28.3 shows ha one line reflecs he risk required o achieve a required porolio reurn and he oher reflecs he clien’s risk olerance. Nex, he advisor explains ha, based on his inormaion, wo “righ” answers are available: one reflecs a porolio wih an accepable risk and he oher reflecs a porolio wih he required reurn. A major cogniive bias ha he financial proessional likely employs is called anchoring, which is when an invesor holds on o a belie and hen applies i as a subjecive reerence poin or making uure decisions. Te advisor applies hisPorolio anchoring bias omos ideniy he clien’s risk olerance. B seems appropriae because i provides he highes reurn or is level o risk; however, Porolio A, which is he porolio ha provides he clien wih he reurn needed o achieve his goals, has lower risk. Alhough boh are correc answers, he nex sep is o deermine he more appropriae opion o recommend o he clien. Tis choice depends on he advisor’s proessional experience and philosophy. An advisor who is less confiden in he accuracy o he risk olerance esimae migh op o recommend Porolio A, wih a lower reurn, because he advisor expecs i o mee he clien’s reurn needs and provide some cushion or risk olerance. An advisor who is more confiden in esimaing he clien’s risk olerance migh recommend Porolio B, in he belie ha he higher he reurn, he more financial flexibiliy he clien will have over ime. I an advisor believes ha he clien should be encouraged o consider Porolio A, he advisor may inroduce he concep o Pascal’s wager, a classic philosophical consruc devised he seveneenh-cenury French philosopher, mahemaician, and physicis Blaiseby Pascal. Te ollowing scenario illusraes how an advisor migh presen his concep o cliens. “Suppose you were old ha he probabiliy God exiss is only 20 percen. You could decide ha wih hose odds you would ignore morals and ehics and live a guil-ree immoral lie. O course, despie he low odds ha God exiss, you would ace fire and brimsone i ha were wrong. Conversely, i you choose o live a moral lie and God does no exis, you will have had a nice lie, bu i God does exis, you would have a wonderul aferlie.”

527

A p pl i c at i o n s of C l i e n t B e h a v i or

527

Return A B

I

Risk

Figure 28.4 Anchoring on he Effic ien Fronier: isk Need Exceeds isk olerance. Tis figure demonsraes ha when he clien’s risk need exceeds his or her risk olerance, wo subopimal choices are available. One choice provides he reurn he clien needs a a ri sk exceeding his oleranc e, and anoher offers a reurn below ha needed o mee all he clien’s goals a a risk wihin he level o olerance.

Wha’s he poin? People ofen ocus on probabiliies and orge o look a consequences. Even i a high probabiliy exiss ha he advisor idenifies he correc risk olerance and invess accordingly bu is wrong, he clien migh panic and sell everyhing in a severe bear marke and never recover. Or, i he advisor invess a a lower sock exposure based on meeing he clien’s goals, he clien’s heirs migh receive less money bu he clien will have enjoyed achieving hose personal financial goals. Figure 28.4 shows anoher possible resul: he clien’s reurn objecive requires a sock exposure higher han wha is compaible wih he idenified risk olerance. I his is he case, he clien has wo choices: ea less well or sleep less well. When markes are reasonably sable, cliens can easily hink, “Well, okay, I’ll ake a bi more risk so I can do everyhing I wan.” Unorunaely, i he porolio laer drops precipiously in a bad marke, he clien is likely o orge ha resolve o weaher he sorm and migh sell (Lowensein 2000). Again, he poenial consequences may ar ouweigh he possible benefis. THE BASICS OF CLIENT ED

UCA TION

Given ha he clien has been inroduced o he concep o anchoring on he efficien ronier, he advisor can hen discuss some basic invesmen conceps in a manner ha a nonproessional can undersand so as o build a srong oundaion or proessional invesmen recommendaions.

Modern Porolio Teory According o Markowiz (1952), risk is as imporan as reurn in designing an invesmen porolio. Figure 28.5 shows wo alernaive invesmens. Alhough boh invesmen A and invesmen B are highly volaile, heir reurn paterns are opposies o each oher, hough boh rend upward over ime. In his simple example, allocaing 50 percen o each invesmen resuls in he effecive canceling ou o porolio volailiy. Tis simple char demonsraes why combining wo risky invesmens can resul in a saer porolio, alhough achieving his goal is difficul in pracice.

528

THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE Return 7 6 5 Investment A

4

Investment B 3

50% A and 50% B

2 1 0 1

2

3

4

5

6

7

8

9

10

Time

Figure 28.5 isk educion hrou gh Diversificaion. Tis figure shows wo volaile invesmens, A and B. A lhough hey boh rend up over ime, heir peaks and roughs end o be in opposie direcions. By placing hal o a porolio’s asses in each invesmen, he variaion in he porolio’s value is subsanially reduced because he volailiy o he individual invesmens ends o cancel each oher ou.

Capial Asse Pricing Model

Nex, he advisor migh inroduce he conceps o sysemaic and unsysemaic risk, as well as he capial asse pricing model (CAPM) (Sharpe 1964). Invesing in a single company may resul in a oal loss because o such acors as mismanagemen or he company’s being in he wrong place a he wrong ime. In boh cases, he resul migh be poenial bankrupcy. A useul example is an invesmen in he renal o a single-amily house versus a 10-uni aparmen complex, wih all unis having he same monhly renal. A vacancy in he home means a 100 percen loss o income; he vacancy in an aparmen means a 10 percen loss. Te criical poin is ha an individual invesmen is subjec o unsysemaic risk, also called diversifiable risk, which is risk ha is specific or unique o he company. Unsysemaic risk canno be anicipaed; One example includes he ylenol scare in he early 1980s, when ylenol capsules laced wih poassium cyanide killed seven people in he Chicago area. Tis inciden almos pu Johnson & Johnson, he manuacurer o ylenol, ou o business. Ta ampering inciden hen inspired hundreds o copyca incidens. Anoher example is he Deepwaer Horizon oil spill, which began April 20, 2010, in he Gul o Mexico on he BP-owned ransocean-operaed Macondo Prospec. Afer he explosion and sinking o he Deepwaer Horizon oil rig, a sea-floor oil gusher flowed or 87 days, unil being capped on July 15, 2010. As o February 2013, criminal and civil setlemens, and paymens o a rus und, has cos he company $42.2 billion (Fonevecchia 2013). A discussion o unsysemaic risk leads o a discussion o diversificaion as a risk managemen soluion or reducing unsysemaic risk. Afer he advisor educaes he clien on he imporance o diversificaion o reduce unsysemaic risk, he advisor can hen inroduce he concep o sysemaic risk, also

529

A p pl i c at i o n s of C l i e n t B e h a v i or

529

known as undiversifiable risk, which is he risk endemic o he enire marke or marke segmen. Tese risks include marke risk, ineres rae risk, reinvesmen risk, and inflaion risk. Marke risk is he risk ha he enire marke, or a paricular marke segmen, will experience an economic downurn. For example, a clien migh inves in he S&P 500 Index, which is a U.S. sock marke index o 500 large company socks lised on he NYSE or NASDAQ. Many regard his index as he bes single gauge o perormance or large-cap U.S. equiies. When he marke is down, his means ha an invesmen included in he S&P 500 Index is also down. A ypical response rom sel-syled conservaive invesors is “Ta’s why I avoid socks and inves in bonds.” I so, he advisor can ask wha happens o he “conservaive” porolio o bonds when ineres raes rise. Many invesors realize ha rising ineres raes lead o a decline in he value o heir bond porolios. Te clien has now been inroduced o ineres rae risk, which is he chance ha an increase in ineres raes will negaively affec he value o a fixed-income invesmen such as bonds. Te naïve invesor’s deaul response is o sugges managing ha risk by invesing in shor-erm bonds. In a low-ineres-rae environmen, he clien recognizes ha is a “soluion” wih a low reurn; he risk in a high-ineres-rae environmen is less obvious. In his case, a brie hisory lesson on reinvesmen risk is in order. In 1981, he reurn on U.S. reasury bills was 14.7 percen. One year laer, i decreased 30 percen o 10.5 percen. By 1987, he reurn ell o 5.5 percen. Tose changes mean he income on a $100,000 invesmen dropped rom $14,700 in 1981 o $5,500 in 1987, which is a loss o $9,200 in income. Tis scenario is a classic example o conusing “cerainy” wih “saey.” Ta is, he clien’s corpus was proeced, bu ha did no ensure saey because his sandard o living may have been negaively affeced. As he clien absorbs ha lesson, he advisor can hen inroduce he concep o purchasing power risk, which is he risk ha inflaion will erode he value o he dollar. Even he mos conservaive reiree invesors are aware o his inflaion risk. Te advisor migh conclude he discussion by noing ha no single invesmen will proec he clien rom hese muliple sysemaic risks, and ha he only “sae” sraegy is o diversiy among he asse classes.

Asse Allocaion Te advisor can begin a discussion o porolio selecion by explaining ha he hree mos imporan consideraions in managing an invesmen porolio are asse allocaion, securiy selecion, and marke iming. According o a sudy by Brinson, Hood, and Beebower (1995) and Ibboson (2000), asse allocaion is a criically imporan acor driving porolio perormance. Teir findings help o explain why financial advisors develop an asse allocaion ha is bes suied o he clien’s circumsances and “anchor” he clien on he efficien ronier.

Framing the Planning Process In behavioral finance, he faming effec is an example o cogniive bias, in which people reac o a paricular choice in differen ways depending on how i is presened, such as a loss or a gain. Atenion ocuses, hen, on how o appropriaely anchor risk hrough risk

530

THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE

coaching and on anchoring he reurn hrough a capial needs analysis. However, cliens who engage in improper anchoring become fixaed on pas inormaion, and hey use ha inormaion o make inappropriae invesmen decisions. Insead, heir ideas and opinions should also be based on relevan and correc acs so as o be considered valid. However, his is no always so. Te concep o anchoring draws on he endency o invesors o atach or “anchor” heir houghs o a reerence poin, even hough i may have no logical relevance o he decision a hand. In he financial world, invesors who base heir decisions on irrelevan figures and saisics can experience misakes because o his cogniive bias (Phung 2015). ANCHORING THE RISK: RISK COACHING

As previously noed, he concep o risk olerance is sill being debaed. In ac, some challenge he possibiliy o deermining, in advance, a clien’s risk olerance in a bear marke. Such debaes are irrelevan or he financial advisor. As menioned earlier, he only relevan risk measure is ha hreshold o emoional pain jus beore he clien calls he advisor and says “I can’ sand i anymore. Sell my porolio [and pu me in cash]!” Having he abiliy o predic ha hreshold wih cerainy is unrealisic. Praciioners are aware ha when he markes are rending up, a clien’s risk olerance is higher; and when hey are rending down, he clien’s risk olerance decreases. Unorunaely, advisors canno simply hrow up heir hands and say, “I’s impossible o deermine a clien’s risk olerance.” Planning or a clien’s long-erm financial healh requires making asse allocaion recommendaions. Alhough financial planners migh be unable o predic a clien’s risk olerance wih cerainy, hey mus do he bes hey can. Over he years, using lessons rom behavioral finance, Evensky & Kaz/Foldes Financial developed a risk-coaching quesionnaire o assis he firm’s advisors in esimaing a clien’s risk olerance. Te erm coaching is no used in he sense o guiding cliens’ responses bu, raher, o describe a process ha includes boh educaional and raming conceps ha assis in arriving a a credible resul. Te ollowing discussion offers some examples. Advisors emphasize ha invesing requires a long-erm horizon. Te discussion ocuses on unds ha he clien is unlikely o need or a leas five years. A major aspec o he risk coaching process is o obain clien buy-in by sressing his long-erm concep. Te discussion and quesionnaire sars by clariying wha he clien considers o be a reiremen invesmen nes egg. Specifically, he quesionnaire asks: • Wha is he approximae value o his invesmen porolio? • Wha percenage o your oal invesmens is represened by his porolio? • Is here an immediae or near erm (i.e., wihin five years) need or income rom his porolio? I yes, when will i become needed? • Approximaely how much will be needed in afer-ax dollars annually? • “Do you plan o make subsanial cash wihdrawals over he nex five years? I he clien answers yes o eiher o he las wo yes/ no quesions, he advisor hen adjuss he answer o he approximae value o he invesmen porolio.

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531

For example, suppose he clien srcinally indicaed ha he invesmen porolio was $1 million. I he clien needs $50,000 nex year o relocae a paren o a new house, he advisor hen explains ha he will allocae he $50,000 needed ino a cash flow reserve accoun (o be discussed laer) and adjus he invesmen porolio base rom $1 million o $950,000. I he clien indicaes ha “We also need abou $10,000 in hree years or a special anniversary rip,” he advisor akes $10,000 or he cash flow reserve and adjuss he invesmen porolio base o $940,000. Te nex quesion also emphasizes a long-erm sraegy asking, “Wha is he porolio’s invesmen ime horizon?”Invesmen ime horizon reers o he number o years he clien expecs he porolio o be invesed beore dipping ino he principal. An alernaive quesion is “How long will he goals or his porolio coninue wihou subsanial modificaion?” Te advisor asks he clien o indicae he number o years o he invesmen ime horizon. I he ime horizon is less han 10 years, he advisor hen asks he clien o explain when he unds will be needed. Nex, he advisor presens he clien wih a lis o invesmen atribues, as shown in able 28.1. Tese atribues are no moral issues. Tey are neiher good nor bad, bu simply invesmen atribues. Te poin is o discover how imporan he clien considers each atribue. Te clien can answer wih all 6s (mos imporan), all 1s (leas imporan), or any combinaion o scores. Te advisor insrucs he clien o answer hese quesions assuming ha over he nex 20 o 30 years, he clien achieves hose long-erm invesmen goals. Cliens ypically answer he atribue “capial preservaion” by marking eiher 5 or 6. A ranking o high imporance is expeced. In 30 years o pracice, Evensky & Kaz/ Folds Financial has never had a clien sae a goal o losing he corpus, so his allows he clien o orceully documen long-erm preservaion o capial as a primary concern. egarding “growh,” almos all cliens, including very conservaive invesors, ypically

able 28.1 Atribues of Invesing Atribue

Mos

Capialpreservaion

6

Growh

Aggressive growh

5 6

Lowprincipalvolailiy Inflaionproecion Curren cash flow

Leas

4 5

6 6

4

5 5

6

1

2 2

3 4

1 2

3 3

4 5

2 3

4 4

5 6

3

1 1

2 3

1 2

1

Noe: Tis able assiss in engendering a discussion wih a clien abou he difference in invesmen atribues, such as capial preservaion and principal volailiy, and he conradicory naure o goals, such as he desire or boh capial preservaion and inflaion proecion. For each o he ollowing atribues, circle he number ha mos correcly reflecs your level o concern. Te more imporan, he higher is he number. You may use each number more han once.

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THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE

pick a number beween 4 and 6. Te advisor explains o he clien ha his is a “gocha” quesion. Te clien quickly recognizes ha invesmens in cash, money marke insrumens, or reasury bills, which are he only invesmens ha ensure he preservaion o he corpus, will no resul in long-erm growh. Tis response emphasizes he clien’s conflicing goals. Te response o “low principal volailiy ” helps disinguish be ween loss o corpus and inerim volailiy. I a clien selecs 4, 5, or 6 or his, he advisor coninues he discussion so ha he clien undersands ha such a shor- erm volailiy consrain may have a large negaive im pac on being able o achieve hose long- erm goals. Te “inflaion proecion ” atribue is anoher “gocha” quesion. Again assuming ha he clien neiher adds nor wihdraws rom he porolio, his quesion helps ideniy he imporance ha he value o he invesmens would enable he clien o buy a specific amoun o goods and services in oday’s dollars. Tis quesion ess he clien’s sensiiviy o inflaion. Even he mos conservaive reirees generally selec a 5 or 6 because hey recognize ha “sae” invesmens such as cerificaes o deposi and shor-erm bonds, subjec o inflaion erosion, will be insufficien in he long erm o mee financial goals. For “curren cash flow,” he only correc answer is 1. I he clien selecs any oher number, he advisor asks “Wha did we miss?” esponding o he quizzical look on he clien’s ace afer his response, he advisor reminds he clien ha earlier he had been asked abou his shor-erm need or boh cash flow and lump-sum expenses. Te advisor has moved hese unds ou o he invesmen porolio, allocaing unds o he cash flow reserve porolio. I somehing has been missed, he opporuniy is now available o increase he allocaion o he cash flow reserve and reduce he allocaion o he invesmen porolio. Te clien can hen comorably selec 1 as he answer. Te atribue “aggressive growh” does no mean high growh such as in emerging markes bu, raher, sraegies such as using naked pus and buying on margin. A naked pu, also called an uncovered pu, is a pu opion whereby he opion wrier or seller may no have sufficien liquidiy (cash) o cover he conracs in case o assignmen.Buying on margin reers o using borrowed money o purchase securiies, which increases boh he clien’s leverage and poenial risk and reurn. Mos cliens selec 1, which is fine, because he firm does no recommend such sraegies. Te idea behind he quesion is ha he clien has been able o selec 6 or capial preservaion and 1 or aggressive growh, helping o rame and esablish his comor level wih he overall process. Te quesionnaire also asks several redundan quesions, such as “Wha percen o your invesmens are you likely o need wihin five years?” “Up o wha percenage o his porolio can be pu ino long-erm invesmens?” By his poin, he clien recognizes ha he answers o 0 percen and 100 percen, respecively, anchor heir commimen o long-erm invesing. o rame he clien’s risk and reurn balance, he advisor asks him o selec he porolio ha bes represens his comor level. Te firs column in able 28.2 describes porolio risk. Te firs erm (i.e., low, moderae, and high) describes shor-erm risk o less han five years, and he second describes long-erm risk o over five years. Te second column is he firm’s projeced reurn or he porolio. An inflaion assumpion is included o provide he basis or a discussion abou he difference beween nominal and real reurn.

53

A p pl i c at i o n s of C l i e n t B e h a v i or

533

able 28.2 Projeced Reurn and Risk Exposure under Differen Risk Levels Overall

Projeced

HypoheicalRiskExposure

RiskLevel

oalReurn (Inflaion = 3%)

“Wors Case”* (12 monhs)

Bear Marke** (10/07–2/09)

Low/Low

6.0%

–4.0%

–10.6%

Low/Low

6.8

–7.0

–14.5

Moderae/Low Moderae/Low

7.2 7.4

–9.0 –10.0

–16.2 –20.1

Moderae/Low

7.6

–11.0

–22.9

Moderae/Low

7.8

–13.0

–25.7

High/Moderae

8.0

–14.0

–29.1

High/Moderae

8.3

–16.0

–32.4

High/Moderae

8.6

–20.0

–35.2

High/High

8.8

–22.0

–40.8

High/High

9.0

–24.0

–45.9

High/High

9.4

–-27.0

–50.9

Noe: Tis able allows he clien o selec a porolio ha mees his comor level where he reurn expecaions and porolio risks are relaed and explicily displayed. Several porolio perormance projecions are lised below, including hypoheical poenial losses or hese porolios. In he righ column, check he porolio ha mos nearly reflecs he goal o your porolio. * A wo sandard deviaion esimae. ** Te Grea ecession.

Te hird column is he heoreical “wors case” risk over a 12-monh period. I is acually he loss esimae based on he firm’s wo sandard deviaion esimae. Unorunaely, he experience o he financial crisis o 2007–2008 demonsraes ha realiy may be ar greaer han wo sandard deviaions, which promped adding a column o reflec he acual loss during he bear marke o he financial crisis. Te advisor explains ha he knows he clien would like o selec diagonally or low risk and high reurn, bu realiy requires ha he look horizonally, hus helping rame he relaionship beween risk and reurn. Tis discussion is based on one o he ew quanifiable quesions ha helps esablish an accepable bond-o-sock raio. Te final quesion deals wih he behavioral aspecs o prospec heory and loss aversion (Kahneman and versky 1979; versky and Kahneman 1992), bu he advisor presens i in a less ormal manner. Te advisor gives he clien he ollowing scenario: “You’ve jus sepped hrough he door o a huge gambling casino and a band srikes up a rocking medley. Tousands o people surround you hollering and cheering, and balloons and coneti sream down rom he ceiling. As you sand here bewildered, a

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THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE

genleman in a uxedo walks up o you and says ‘Congraulaions! You’re our 10 millionh cusomer and you win! Now his is Vegas, so you have a choice.’ He poins o his ousreched righ arm holding wha looks like bills going o he ceiling and says, ‘Tis is $800,000. Poin o my righ arm and i’s yours! Bu, because his is Vegas you have a choice. In my lef hand I have a brown bag wih 10 Ping-Pong balls, 8 whie and 2 black. Pu your hand in and pick a whie ball and you win $1 million. Pick a black ball and you win nohing. Wha will i be?’ ” Tis quesion has been used or over a decade, and less han 5 percen o cliens selec aking a chance. Te ollow-up scenario is, “Sorry, I made a misake, you’re no in Vegas, bu you’re in Hell. Te devil walks up o you and says ‘No surprise bu you los; however, I’m a gambling man so you have wo choices.’ He holds ou his righ arm and says ‘See, i’s empy. Poin o ha arm and you owe me $800,000. In my lef hand I have a brown paper bag wih 10 ping-pong balls, 8 whie and 2 black. Pu your hand in and pick a black ball and you owe me nohing, pick a whie ball and you owe me $1 million. Wha will i be?’ ” Te resuls are consisenly jus he opposie, in ha more han 90 percen o cliens say hey will ake a chance. Advisors use hese scenarios o rame he difference beween risk aversion and loss aversion. As an example, he advisor a a brokerage firm migh view a clien’s porolio as oo conservaive and sugges moving hal he unds ino he marke o earn a higher reurn. In ha case, he “conservaive” clien migh leave. Evensky & Kaz/ Foldes Financial migh make he same recommendaion, bu or a differen reason. I an advisor recommends increasing he sock allocaion, he reasons are no o make he clien richer bu, raher, o avoid a clien’s losing his sandard o living in reiremen. A conservaive invesor gains a new perspecive and now undersands and reconsiders revising his invesmens o increase he sock allocaion. ANCHORING THE RE

TURN: CAPITAL NEEDS ANALYSIS

Given ha he firs anchor has been applied o he clien’s risk olerance, he nex anchor is an esimae o he required reurn necessary o accomplish he clien’s goals. Te capial needs analysis considers he our primary elemens o each goal: cos, iming, prioriy, and imporance. For example, i a clien wans o provide or a grandchild’s college educaion, he advisor would need o deermine he year he expendiure would begin, number o years o be unded, annual cos, expeced uiion inflaion, and prioriy o ha goal relaive o all oher clien goals. Alhough hese seem easy quesions o answer, a clien ofen has difficuly providing he necessary inormaion wihou guidance. Te radiional soluion is o provide he clien wih a daa-gahering quesionnaire ha liss various goals. An example is he orm or a college unding goal rom Pie echnologies MoneyGuide Pro (htps://cdn.moneyguidepro.com/Pd/Clienools/College_ Zoomer.pd ). Unorunaely, cliens ofen find a comprehensive daa-gahering package overwhelming and eiher reurn an incomplee package o he advisor or simply decide ha he process is oo inimidaing and erminae heir planning effors a his sage. o deal wih his poenial planning barrier, Bob Curis, principal o PIEech, developed he Goal Card Game. eraming he daa-gahering process as a un card game is a simple bu effecive sraegy.

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535

o rerame he daa-gahering process as a posiive experience, he advisor inroduces he card game wih “Le’s have un and play cards.” Te advisor offers he clien a deck o cards, each wih a picure reflecing a possible goal, such as unding college, ravel, purchasing a second home, providing suppor or a riend or amily member, saring a new business, or replacing a car. Te presenaion coninues wih he advisor saying: “We are going o develop a plan or he res o your lie. Tis is really exciing, bu o ensure he lie you wan o live, we need o deermine when and where you will need o use your financial resources. So wha I wan you o do now is ake his deck o cards and make wo piles. Tose goals ha have nohing o do wih your uure go ino he firs pile. In he second pile, I wan you o pu he cards ha may resonae wih you.” Te process is ineracive, especially when a couple is involved, because envisioning heir uure wih picures o possible goals in ron o hem engenders a lively discussion. For example, one person migh pick up he home remodeling card and aggressively slap i ino he “no ineres pile,” only o have he oher grab he card and move i o he “We need his” pile, commening, “You promised I could remodel he kichen!” Afer soring all he cards, he advisor and clien ocus on he cos, iming, and imporance o he goals seleced. Te advisor hen gives he clien a se o he seleced goal cards along wih he daa-gahering quesionnaire o complee as ime permis. Tis process no only rerames he poenially unpleasan experience o one ha is un bu also resuls in he clien’s emoional ownership o he oucome. When he clien reurns he compleed quesionnaire, he advisor, using capial needs sofware, can inegrae ha inormaion wih his capial marke expecaions and deermine he porolio allocaion necessary or he clien o achieve he unique goals. Te advisor can hen provide a definiive recommendaion or he clien’s invesmen policy saemen (IPS).

Behaviorally Based Client Management Advisors ofen believe ha heir cliens are a risk o making bad decisions. In such cases, echniques and responses based on behavioral heory can be effecive ools in guiding hose cliens o beter decisions. Te ollowing are examples ha can lead o successul conclusions. MARKET TIMING

Te clien may believe ha he or a seleced advisor can accuraely predic when o exi he equiy marke beore a major correcion. Alhough academic research suggess he unlikelihood o his sraegy over an exended period, reerencing ha research ofen ails o persuade an invesor enamored wih his own abiliy (Sharpe 1975; Chang and Lewellen 1984: Jeffrey 1984; Malkiel 2004). Te ollowing raming echnique can be successul in having he clien reconsider his commimen o a marke iming sraegy. Te clien is asked i he can name he op 10 ariss o all ime or he op 10 movies or he op 10 songs, or i a spors an, he op 10 ahlees. A clien ypically responds “O course.” Te advisor ollows up wih he observaion ha alhough some disagreemen

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THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE

migh exis abou who belongs on he lis, coming up wih he 10 names should no be a problem. Te advisor hen asks, “Name he op 10 marke imers o all ime.” Te ypical response is silence. Te ollow-up quesion is, “Well, name he op five.” Again, he clien does no respond. Te advisor concludes wih, “Name one op marke imer.” Wih a final no response, he advisor has clearly made his poin. I successul marke imers were available, people should know heir names. Because he person draws a complee blank, he clien realizes ha he sraegy may no be as obvious a soluion as he individual previously believed. Hence, he person is likely o reconsider wheher o engage in marke iming. WOULD YOU BUY

THA T STOCK TODA

Y?

A clien migh presen a porolio o an advisor ha has a large posiion in a sock wih a subsanial unrealized loss. I he advisor deermines ha he posiion is inappropriae or he clien’s porolio, hen he advisor should recommend selling he sock. Te clien ofen responds ha he plans o sell he sock as soon as he price recovers o he poin ha he individual does no ace a sizable loss. Despie he advisor’s explanaion o why holding he sock is inadvisable, he clien ofen remains unwilling o sell. Te ollowing raming echnique is ofen successul in geting he clien o reconsider. Wih his sraegy, he advisor asks he clien, “Would you buy ha sock oday?” Te response is requenly no. Te advisor hen explains ha i he clien gives his permission o sell, he proceeds o ha sale would be in he clien’s accoun he nex morning. Tereore, by keeping he sock, he clien is acually making a decision o buy he sock a oday’s price. When reramed as a purchasing decision insead o a sale decision, he clien ofen elecs o sell. A HOT INVESTMENT

In his scenario, he clien approaches he advisor anxious o buy an invesmen recommended by his neighbor, a amily member, or riend or based on a sory in he media. I he advisor believes he invesmen is inappropriae, he financial proessional migh provide a houghul and undamenally sound explanaion abou he poenial risk o he invesmen, he inappropriaeness o he invesmen as a par o he oal porolio, and a lack o inormaion he clien has abou he invesmen or oher sound objecions. Unorunaely, he clien is ofen so excied and enamored abou his ho ip ha he disregards he advisor’s wise counsel. In his case, several raming echniques migh prove useul. Te firs echnique recognizes ha he clien may discoun wha he advisor says and hus ransers conrol o he clien. “Ta sounds like a very exciing invesmen, bu I am unamiliar wih ha invesmen. ell me more abou i.” Tis sraegy allows he clien o share his exciemen and o expound on all he possible benefis o he invesmen. Te advisor hen ollows up wih, “As I said, I am unamiliar wih ha invesmen so I was wondering wha migh go wrong?” Tis quesion riggers he clien’s mind o ocus on risk, no jus poenial reurn. Tis novice invesor may say, “Well, governmen approvals are needed ha migh no come hrough and he firm needs o ge is financing in place ha migh also all hrough.” By he ime he clien has reocused his atenion on

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wha migh go wrong insead o solely on he exciemen o everyhing going righ, he may elec o pass on he invesmen or a leas reduce his commimen. Anoher echnique is also based on reraming he clien’s atenion rom he upside o he consequences. “Your idea sounds like a very exciing and poenially rewarding one, so I updaed your financial plan o see wha such an invesmen migh do or you. I ound ha i successul, you can no only ake ha expensive wo-week Caribbean cruise you and your wie have been planning bu also ake he hree-monh world cruise. However, i i ails, I esimae you would have o coninue working wo years pas your curren planned reiremen dae.” Tis sraegy prevens many cliens rom making inappropriae invesmens wih a subsanial porion o heir reiremen savings. Te prior examples are based on reraming a clien’s ocus rom he expeced posiive oucome o he poenial negaive resul. Tis sraegy can be a powerul ool in many circumsances and is based on Pascal’s wager, discussed previously. An advisor migh also use such a sraegy as a raming device or his longeviy assumpion. I can be presened in his manner. “When developing your reiremen plan, a criical acor is esimaing how long you are likely o live. Based on he ac ha you are a nonsmoker, your curren healh and your parens’ and siblings’ healh hisory, I migh recommend planning unil age 93.” I he clien responds, “No, ha’s oo long. I don’ hink I’ll make i pas my mid- 80s,” he advisor hen reminds he clien abou Pascal’s wager as ollows: “Alhough you could die by 85, i you plan o ha age and you live unil 93, he qualiy o your lie or hose las eigh years is likely o be grealy compromised. ” Discussing he concep o Pascal’ s wager wih cliens can be a powerul educaional and raming ool in many aspecs o he clien relaionship, helping he clien o look beyond probabiliies, avoid behavioral errors, and make raional decisions in he reiremen planning process. BEHAVIORAL THEORY IN PRACTICE: AN EXAMPLE

A major risk acing reirees is known as sequence o reurn risk, which is he relaions beween he order in which invesmen reurns occur, he iming o wihdrawal o unds in reiremen, and he impac on porolio value. As Bengen (1994) demonsraes, even i reurns average ou in he long erm, early marke declines combined wih ongoing wihdrawals can resul in a clien’s reiremen spending shorall. For financial advisors, managing his risk has boh pracical and behavioral componens. Te design o an implemenaion plan ha miigaes he sequence o reurn risk is an example o a pracical componen. Te managemen o clien emoions and acions in a volaile marke environmen is an example o a behavioral componen. Tese issues and an invesor’s endency o hink in erms omenal accouns (which reers o he endency or individuals o menally separae heir money ino disinc accouns based on subjecive crieria such as he source or use o unds [Sherin and Taler 1988]) led Evensky o develop he Evensky & Kaz Cash Flow eserve sraegy in he early 1980s (Evensky 1997), which was updaed in 2013 (Peiffer, Saler, and Evensky 2013). oday, his plan would be described as a wo- bucke sraegy. Implemenaion o he sraegy involves biurcaion o he clien’s oal porolio ino a cash flow reserve porolio (he shor-erm porolio) and an invesmen porolio (he long-erm porolio).

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Te cash flow reserve porolio is unded or wo possible shor-erm clien goals. Te firs unding goal is any lump-sum expendiures he clien anicipaes wihin he nex five years. Te basis or he five-year ime rame or lump-sum needs is he hisorical marke record. Te risk o invesmen loss or shor periods is subsanial. For known shor-erm needs, he clien’s goal is o have a specific dollar payou available. Alhough a marke invesmen may resul in a higher reurn, i may also resul in providing inadequae unds when he shor-erm goal requires unding. As an example, his need or unding migh include college unding or a grandchild, a special anniversary rip, or home remodeling. Te second poenial reserve would be one year’s worh o unds required or he clien’s annual living expenses. For example, a clien anicipaing a need or a gross cash flow o $100,000, including axes wih an annual income rom Social Securiy and pension o $70,000, would und he cash flow reserve wih he $30,000 shorall. Tis amoun would no generally exceed 4 percen o he oal porolio. Alhough 4 percen is consisen wih Bengen’s 4 percen rule (Bengen 1994), he firm’s recommended maximum wihdrawal is no based on any arbirary rule; raher, i is limied o an amoun ha a capial needs analysis concludes can be susained over he clien’s lie span. Te balance o he asses would und he long-erm invesmen porolio. Te basis or he one-year cash flow allocaion is boh behavioral and pracical, whereas he five-year lump-sum allocaion is primarily relaed o he pracical managemen o wihdrawal risk. Alhough an obvious opporuniy cos exiss or he unds allocaed o he cash flow reserve porolio, he invesmen porolio’s equiy allocaion may be modesly increased o offse his opporuniy cos. Beore reiremen, mos cliens are used o receiving a consisen salary income, he “paycheck syndrome.” In reiremen, when ha consisen cash flow sream disappears, his ofen resuls in angs on he reiree’s par. o simulae his prior experience, he advisor would arrange wih he porolio cusodian o provide he clien monhly paymens equal o 1/12 o he supplemenal cash flow reserve. Te cusodian makes he paymen o he clien’s personal checking accoun hus replacing he “paycheck.” ypically, cusodians do no charge or he service Having separaed ou shor-erm cash flow needs, he invesmen porolio can be designed and managed as a long-erm, oal reurn porolio. As ime passes and he invesmen porolio requires rebalancing, he advisor akes he opporuniy o refill he cash flow reserve porolio o is srcinal arge amoun. For example, assume he ollowing: Iniial Allocaions

oalporolio Cash flow reserve (supplemenal living expenses) Invesmenpolicy Invesmenporolio Fixedincome Equiy

$1,000,000 $40,000 50percenfixedincome/ 50 percen equiy $960,000 $480,000 $480,000

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539

18 Monhs Laer (Bear Marke)

oalporolio Cash flow reserve (supplemenal living expenses) Invesmenpolicy Invesmenporolio Fixedincome Equiy

$910,000 $30,000 50percenfixed/ 50 percen equiy $880,000 $500,000 $380,000

A his sage, he advisor would rebalance he porolio, selling fixed income and buying equiy. I no cash flow reserve is available, ha would enail selling $60,000 o fixedincome securiies and buying $60,000 o equiy. In his example, in which a need exiss o und he cash flow reserve, he advisor would sell $65,000 o fixed income, buy $55,000 o equiy, and ranser $10,000 o he cash flow reserve porolio. Rebalanced Porolio

oalporolio Cash flow reserve (supplemenal living expenses)

$910,000 $40,000

Invesmen Invesmenporolio policy Fixedincome Equiy

$870,000 50percenfixedincome/ 50 percen equiy $435,000 $435,000

Te resul is a porolio balanced in accordance wih he invesmen policy saemen and a ully unded cash flow reserve accoun, all wihou having o sell equiies a a subsanial loss. According o Evensky (1997), his approach is useul ool. Te pracical benefis o his sraegy are as ollows: • Providing subsanial conrol over he iming o invesmen liquidaions can eliminae mos cash flow relaed volailiy drain. • Making an invesmen porolio or he long erm can improve ax and expense efficiency. • Having a large reserve o liquid unds provides flexibiliy in meeing he unique and changing needs o cliens. Besides hese pracical benefis, he mos imporan benefis are behavioral: • Having a consisen and dependable cash flow, independen o marke volailiy and changing dividend and ineres raes, enables effecively managing he paycheck syndrome by providing comor o he clien during urbulen markes.

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THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE

• Having he source o he clien’s shor-erm cash flow needs visible and reliable in bear markes enables cliens no o panic because hey know ha heir “paycheck” will coninue and hey will no have o sell invesmens a a sizable loss. • Knowing ha he sraegy was in place and has been esed during he Ocober 1987 Black Monday crash, ech bus, and financial crisis o 2007–2008, and has been uniormly successul, enables cliens o remain ully invesed and weaher hese urbulen marke periods. REPORTING One final applicaion o behavioral managemen involves reporing. Alhough advisors generally encourage heir cliens o ocus on long-erm perormance, clien reporing ypically ocuses on perormance and includes perormance merics or he las quarer and year-o-dae, ypically benchmarked o some index such as he S&P 500. As an alernaive, advisors should consider revising heir sandard repors o rame he inormaion provided o cliens in a manner consisen wih long-erm planning. Asse allocaion primarily deermines a clien’s long-erm invesmen success (Brinson e al. 1995). Tus, he firs elemen o he repor should be he policy, no he perormance. Porolio perormance should also ocus he clien on he long erm. Improperly raming perormance by providing shor-erm reurn merics encourages invesors o reac in he shor erm, ulimaely undermining heir long-erm goals. Tereore, he shores ime period refleced in he repor should be one year. Finally, he goal o cliens’ invesmen porolio as refleced in he IPS is o help hem provide he real cash flow necessary o accomplish heir goals, no o bea he marke. As a resul, perormance should be benchmarked o he consumer price index (CPI), no he S&P 500 Index. Individual managers should be benchmarked o an invesable index, such as exchange-raded unds, reflecing he manager’s invesmen syle.

Summary and Conclusions Behavioral finance provides a rich source o insighs ino clien behavior, enabling praciioners o empower heir cliens o make beter decisions. Te use o hese conceps begins wih raming and he new clien’s educaion, plus inroducion o he concep o anchoring on he efficien ronier. Te advisor coninues wih ools such as he MoneyGuidePro Card game o help capure he complexiy o clien goals and evaluae he clien’s risk olerance, such as he Evensky & Kaz isk Coaching process. Beore implemenaion, preparing a houghul IPS helps rame he clien’s expecaions and provides a road map or he acual implemenaion and ongoing managemen. Inroducing cliens o behavioral conceps such as overconfidence and anchoring helps hem manage heir endency o make behavioral errors. evising quarerly repors o properly emphasize he long-erm naure o invesing and appropriae benchmarking keep cliens ocused on he imporan aspecs o heir invesmen reurns. Finally, behavioral based sraegies such as he Cash Flow eserve enable cliens o weaher unpleasan volaile markes.

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DISCUSSION QUESTIONS 1. 2. 3. 4.

Disinguish beween risk capaciy and risk requiremen. Discuss he meaning o risk olerance. Explain how o presen he various elemens o a clien’s quarerly repor. Describe raming and how a financial advisor migh use i.

REFERENCES Bengen, William P. 1994. “Deermining Wihdrawal aes Using Hisorical Daa.”Journal o Financial Planning7:4, 171–180. Brinson, Gary P., L. andolph Hood, and Gilber L. Beebower. 1995. “Deerminans o Porolio Perormance.”Financial Analyss Journal51:1, 133–138. Chang, Eric C., and Wilbur G. Lewellen. 1984. “Marke iming and Muual Fund Invesmen Perormance.”Journal o Business 57:1 Par 1, 57–72. Evensky, Harold. 1997.Wealh Managemen Te Financial Advisor’s Guide o Invesing and Managing Clien Asses. New York: McGraw-Hill. Fonevecchia, Agusino. 2013. “BP Fighing a wo Fron War as Macondo Coninues o Bie and Producion Drops.” Forbes, February 5. Available a www.orbes.com/sies/aonevecchia/ 2013/02/05/bp-fighing-a-wo-ron-war-as-macondo-coninues-o-bie-and-produciondrops/. Guillemete, Michael A., Michael Finke, and John Gilliam. 2012. “isk olerance Quesions o Bes Deermine Porolio Preerences. Journal o Financial Planning 25:5, 36–44. Ibboson, ogerClien G., and Paul D.Allocaion Kaplan. 2000. “Does ”Asse Allocaion Policy Explain 40,90, or 100% o Perormance?” Financial Analyss Journal56:1, 26–33. Jeffrey, ober H. 1984. “Te Folly o Sock Marke iming: No One Can Predic he Markes Ups and Downs over a Long Period, and he isks o rying o Ouweigh he ewards.” Harvard Business Review July-Augus, 102–110. Kahneman, Daniel, and Amos versky. 1979. “Prospec Teory: An Analysis o Decision under isk.” Economerica 47:2, 263–291. Lowensein, George. 2000. “Emoions in Economic Teory and Economic Behavior.” American Economic Review 90:2, 426–432. Malkiel, Buron. 2004. “Models o Sock Marke Predicabiliy.” Journal o Financial Research 27:4, 445–459. Markowiz, Harry. 1952. “Porolio Selecion.” Journal o Finance 7:1, 77–91. Peiffer, Shaun, John Saler, and Harold Evensky. 2013. “Te Benefis o a Cash eserve Sraegy in eiremen Disribuion Planning.” Journal o Financial Planning 26:9, 49–55. Phung, Alber. 2015. “Behavioral Finance: Key Conceps Anchoring.” Invesopedia. Available a htp://www.invesopedia.com/universiy/behavioral_finance/behavioral4.asp?he. oszkowski, Michael J., Michael M. Delaney, and David Cordell. 2009. “Inraperson Consisency in Financial isk olerance Assessmen: emporal Sabiliy, elaionship o oal Score and Effec on Crierion-relaed Validiy.”Journal o Business Psychology 24:4, 455–467. Sharpe, William. 1964. “Capial Asse Prices A Teory o Marke Equilibrium under Condiions o isk.” Journal o Finance 19:3, 425–442. Sharpe, William. 1975. “Likely Gains rom Marke iming.” Financial Analys Journal31:2, 60–69. Sherin, Hersh, and ichard Taler. 1988. “Te Behavioral Lie-Cycle Hypohesis.”Economic Inquiry 26:4, 609–643. versky, Amos, and Daniel Kahneman. 1992. “Advances in Prospec Teory: Cumulaive epresenaion o Uncerainy.”Journal o Risk and Uncerainy 5:4, 297–323.

29 Practical Challenges of Implementing Behavioral Finance Reflections from the Field GRE G B. DAVIES Founding Partner, Centapse, London Associate Fellow, Oxford, Säid Business School PETER BROOKS Behavioral Finance Transformation Director Barclays, London

Introduction aken in isolaion, he ideas and conceps ha make up he field o behavioral finance are o limied pracical use. Indeed, many o he atemps o apply hese ideas amoun o litle more han a rie lis o biases and picures o human brains on PowerPoin slides.  alking a good game in h e arena o behavioral finance is easy, which ofen leads o he mispercepion ha i is superficial. Indeed, making behavioral finance work in pracice is challenging: i requires inegraing hese ideas wih working models, inormaion echnology (I) sysems, business processes, and organizaional culure. Tis chaper reviews some o he common mispercepions o applied behavioral finance and he problems o implemening behavioral ideas, based on experience gained in leading a uncioning corporae behavioral finance eam or nearly a decade. Te chaper is inended o be neiher an academic discussion on mehodological righs and wrongs o human behavior nor an insrucion ki or pracical applicaion he range o environmens and applicaions is oo broad. Insead, he goal is o provide an overview o hemes ha resul in poor implemenaion or oucomes, or in misguided applicaions o commercial problems. Te firs secion addresses some mi sconcepions commonly held by aspiran praciioners, including more han a ew academics rying heir hand a commercial applicaions, abou he naure o behavioral finance. Te second secion looks a some o he common problems or barriers o successul uili zaion o behavioral principles in pracice. Te hird secion offers some consrucive principles on how o approach 542

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543

applicaion. Te final secion concludes w ih some more pracical suggesions on how o bring his rich body o knowledge o lie w ihin an organizaion .

Misconceptions in Commercial Practice About Behavioral Finance Beore discussing he difficulies o pracical implemenaion, i is ofen necessary o persuade praciioners o he need o consider behavioral approaches a all. Tis ask has become much easier since he urn o he cenury, as erms such as behavioral finance, behavioral economics, and decision science are now much more amiliar and less dauning. Tis change has been helped considerably by he explosion o accessible popular science books on various aspecs o he field, as well as by various mainsream journaliss covering he ideas in news sories. Te sharing o he Nobel Memorial Prize in Economic Sciences in 2002 by Daniel Kahneman and Vernon Smih dramaically increased public awareness. Te financial crisis o 2007–2008 urher enhanced he credibiliy o behavioral finance, as i provided a painul reminder ha emoion and psychology are undamenal o how he financial sysem uncions. Tis increased credibiliy was paricularly rue in conras o oher areas oeconomic research behavioral economics was abou he only field o economics ha came ou o he financial crisis wih more credibiliy han i had going in. Te atenion paid o he field o behavioral economics by governmens, paricularly in he Unied Saes and he Unied Kingdom ollowing he publicaion o he book Nudge (Taler and Sunsein 2008), and regulaors, wih he Unied Kingdom’s Financial Conduc Auhoriy (FCA) leading he way, has urher increased is accepance. Te commercial world is now much more open o behavioral hinking. Tis openness can lead o misconcepions and skepicism, someimes o he poin where i risks appearing a managemen ad raher han a serious body o academic knowledge. Mos unorunae among hese misconcepions is he noion ha behavioral finance consiss o nohing more han a lis o psychological biases. Tis percepion is unorunae because he houghul caegorizaion o a complex field ino a number o disinc heurisics and biases, each accompanied by compelling examples, has helped o make he field more undersandable, accessible, and popular. THE “BIAS” BIAS

oday, exremely long liss o biases are available, which do litle o convey he underlying sophisicaion, complexiy, and horoughness o more han hal a cenury o highly robus experimenal and heoreical work. Tese liss provide no real ramework or poenial praciioners o deploy when approaching a angible problem. And many o hese biases appear o overlap or conflic wih each oher, which can make behavioral finance appear eiher very superficial or highly conused. Te easily accessible examples ha academics have used o illusrae hese biases o wide audiences have someimes led o he impression ha behavioral economics is an easy field o maser. Tis misrepresenaion hen leads o ineviable disappoinmen when caegorizing biases proves no o be a panacea. A percepion o he field as “jus

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anecdoes and parlor games” reduces he willingness o he commercial world o pu subsanial invesmens o ime and resource ino building applicaions grounded on he underlying ideas. Building behavioral finance ideas ino commercial applicaions requires boh deph and breadh o undersanding o he heory and, in many cases, large resource commimens. Having broad guiding rameworks, such as he noion o “wo sysems o reasoning” (Sloman 2002) enables users o approach he somewha chaoic muliude o behavioral findings in a pracical way, raher han o have a lenghy lis ha provides no concepual ramework wih which o apprehend he complexiy. BEHAVIORAL IS NO

T IN CONFLICT WITH

TRADITIONAL

A second misconcepion is ha behavioral finance necessarily conflics wih radiional finance (also called classical or sandard finance). Tis concern raises barriers o accepance, paricularly among hose who have buil heir careers on undersanding and deploying he ools, models, and ideas o radiional finance, and has ofen been perpeuaed by behavioral proponens seeking o advance heir ideas by ocusing on areas where radiional finance is deficien. Again, hese “anomalies” have been an effecive way o demonsraing ha any atemp o undersand financial sysems wihou considering behavioral aspecs is incomplee, bu have someimes led o he impression ha behavioral approaches are enirely anagonisic o radiional financial models. Tis combaive approach and academic debae o he wo schools o financial hough is no useul when rying o solve pracical problems: i is off-puting o hose in indusry and risks enire sysems being dismissed based on problems wih specific deails. Implemenaion o behavioral ideas requires building on wha already exiss by undersanding radiional financial heory and rameworks. Couching language in erms ha hose in he indusry can easily undersand and accep is essenial. ecognizing ha behavioral finance is no in opposiion o radiional finance bu, raher, a generalizaion o i, is crucial. Te ools and models o radiional finance in many ways provide he “righ” answer. Te descripive inadequacy o Homo economicus does no mean dismissing all he normaive models o classical finance bu, raher, requires hinking abou how o adap hem or he complex realiy o real people and muliaceed environmens. Behavioral finance should help o make radiional finance more relevan, because i shows how o relax he overly narrow normaive assumpions o adap hese models o he real world, providing beter soluions or real people. THE COST OF “LABELS”

A final source o misconcepion comes largely rom wihin he academic field isel: he endless debaes abou wha i is and wha i is no; coninual atemps o define and label subses o research findings as “behavioral finance” or “behavioral economics”, “social psychology”, or “decision science”; and mehodological debaes abou wha should be excluded. Tis labeling and quarreling may be o academic ineres, bu i leads o considerable conusion among praciioners and makes he field as a whole look disconneced and inernally inconsisen. Tis siuaion, in urn, leads o concerns ha, whaever i is called, behavioral finance is no sufficienly developed and coheren o be pracically useul.

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Practical Challenges of Implementing Behavioral Finance

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Among hese debaes are hose abou wheher deviaions rom he normaive models should be classified as “biases”, or wheher heurisics are reasonable responses o complex choice environmens, including he concern as o wheher hey are “ecologically raional” (odd and Gigerenzer 2012). Te puris inerpreaions ofen lead o sraw-man definiions o wha is “in” and “ou” o he broad field, drawing arificial boundaries and divisions and casing doubs on poenially valuable ools and ideas as being somehow ouside he old. A commonly expressed concern, a leas in he mainsream press, is ha here exiss no grand unified heory o behavioral economics, and ha he field is hus merely a chaoic collecion o unconneced and ofen conradicory findings. For he purpose o pracical implemenaion, he noion ha his is, or needs o be, a clearly defined field should be eliminaed, reducing he desire o erode i wih arbirary labels and definiions. Human behavior operaes a muliple levels, rom he neurological o complex social ineracions. Any ques or a grand unified heory o mirror ha o physical sciences may well be enirely misguided, ogeher wih he noion ha such a heory is necessary or he broad field o be useul. Much more effecive is an approach o reaing he ull range o behavioral findings as a rich oolbox ha can be applied o, and esed on, a range o pracical concerns.

Challenges of Applying Behavioral Finance he use o behavioral inance oen alls prey o supericial approaches or inappropriae applicaions o inancial heory. his secion explores concerns wih he pracical implemenaion o behavioral inance by boh indusry praciioners and academic consulans, who oen resor o a “li and drop” o echniques beween dieren domains o choice wih lile undersanding o he conex o hose choice domains. he secion includes ex amples o recen successes in applying b ehavioral inance. SUPERFICIAL APPROACHES

Te firs major challenge is ha behavioral finance is no paricularly effecive i applied superficially. Ye, superficial atemps are commonplace. Some seek o do litle more han offer a checklis o biases, hoping ha inorming people o poor decision making can solve he problem. Insead, a cenral heme o decision science is he consisen finding ha merely inorming people o heir adverse behavioral procliviies is very seldom effecive in combaing hem. Because behavioral finance is boh opical and ascinaing o many people, i atracs “hobbyiss” who can readily recie a number o biases, bu who have neiher he deph o knowledge o he field overall nor a solid grasp o he heoreical underpinnings o he more echnical aspecs o he field. For example, some reer o he behavioral conceps o loss aversion or prospec heory, wihou ruly undersanding he oundaions and shorcomings. Even Cumulaive Prospec Teory (CP) (versky and Kahneman 1992), a ramework conaining many powerul insighs cenral o behavioral research and arguably he mos acceped alernaive o he radiional Expeced Uiliy Teory, is

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requenly boh misundersood and missaed ouside, and someimes inside, academia. CP is urher discussed in he nex secion. Tis chaper is no an atemp o erec barriers o enry among behavioral praciioners and claim ha only hose wih advanced degrees in he field should be aken seriously. On he conrary, he effec o greaer academic raining can cause is beneficiaries o hold on oo closely o narrow and echnical inerpreaions o he field o make hem effecive praciioners. Indeed, some o he mos effecive praciioners do no have an exensive academic background in he field. However, hey have invesed considerable ime and effor in geting o know and deeply undersand he breadh and deph o he field. Tey undersand how new insighs inersec wih radiional heory and approaches, and reflec on how his body o knowledge applies o a wide range o pracical problems and decision environmens. Limied sudy o behavioral finance hrough reading he popular books on he opic may equip one o sound knowledgeable and appear convincing. However, as his field is a relaively new one, he purchasers o behavioral experise are seldom equipped o know he difference and may be unable o ell a superficially convincing approach rom approaches ha embody rue undersanding. Tis leaves he field open o consulans peddling “behavioral experise” bu having in heir oolki litle more han a lis o biases ha hey apply sequenially and wih litle variaion o each problem encounered. Warning flags should go up whenever he proposal ress heavily on caalogues o behavioral biases or conains a preponderance o picures o brains. Superficial applicaion o behavioral finance leads o a paricular endency o ake a behavioral principle or “ bias” in isolaion and hen implemen somehing based on his process, wihou considering he broader complexiies o he environmen. A specific problem may arise in par rom a paricular idenified bias, bu i does no necessarily ollow ha resolving his bias will eiher resolve he problem or ha he inervenion isel will no cause addiional unoreseen problems o is own. Human behavior is complex and is influenced by a muliude o simulaneous effecs some inernal, some social, and some environmenal. Tese muliple acors all inerac. rying o undersand and change behavior by going hrough a lis o “biases” one by one in isolaion ails o accoun or his complexiy. Many examples exis o nudges ha have effecively addressed a specific problem, ofen by ocusing on a paricular behavioral finding. However, many examples o unsuccessul nudges are also available. Changing behavior in a desired direcion ofen requires a sophisicaed program o experimenaion and esing o see wha works and wha does no. I requires houghul consideraion o all he aspecs o he environmen and behavior ha requires subsanially more deph and breadh han simply icking off a lis o biases. For example, he recenly launched incomeIQ es rom Schroders (2015) assesses respondens’ propensiy o display a number o behavioral biases indicaing areas o improvemen. Alhough cusomers may appreciae he helpul ips, his es may do litle o aler anyone’s behavior. By conras, he Save More omorrow program or increasing pension conribuion raes is an example o a good behavioral design (Taler and Benarzi 2004). Tis behavioral approach has been developed hrough sophisicaed and houghul undersanding o many aspecs o human behavior. I shows a clear undersanding o boh

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he environmen in which he sraegy will be deployed and he objecive he nudge is rying o achieve. An example o a behavioral inervenion, seemingly used wihou ully weighing up he associaed coss, is he design o he deaul pension soluions in he UK’s Naional Employmen Savings rus (NES). o encourage hose new o pension conribuions o paricipae over ime and say invesed, he deaul soluions are invesed a reduced risk levels early on o ensure ha he invesors’ early experiences wih invesing are comorable and hey do no ge pu off by experiencing oo much marke volailiy early in he process. Superficially, his seems like a good idea because emoional comor wih invesing decisions plays a huge role in long-erm invesing success, and bad experiences early on may have long-erm harmul consequences. However, his approach reduces risk a exacly he ime when invesors are mos financially capable o aking risk. Ta is, heir invesmen porolios are small and heir ime horizons are long, which limis he long-erm effecs o early losses. Alhough his sraegy has emoional benefis, i also has considerable financial coss. As a resul, his sraegy should be used only in hose circumsances and or hose invesors or whom he benefis ouweigh he coss. I migh, or example, make sense or nervous invesors wih regard o heir regular invesmens, bu pension invesmens are he one area in which invesors end no o pay much atenion o shor-erm perormance. Tus, he sraegy is very likely o commi invesors o expeced financial coss in a se o circumsances wih ew compensaing emoional benefis. Fideliy recenly announced he launch o a “people like me” approach o invesing, in which invesors can ener personal deails such as heir age and he value o heir holdings as a basis o comparison or invesmen decisions ha have been aken by ohers wih similar characerisics. Tis approach can have powerul effecs on behavior in many domains, leading people o reduce energy usage or exercise more. In he field o invesing, however, i primarily encourages invesors o copy oher people’s poor invesmen decisions. ACADEMIC “LIFT AND DROP”

Te flip side o superficial approaches rom unrained commercial praciioners, which usually occur in he consuling field, is ha o applicaions markeed by highly rained academics who ofen ail o consider he realiies o commercial lie ouside he laboraory. Academics end o build wha hey consider o be real-world applicaions wihin academe and hen seek o “lif and drop” hese ino commercial or policy applicaions. A core concern is ha hose in he commercial world seeking behavioral soluions requenly have litle experise by which o evaluae he proposals and can be easily won over by impressive-sounding academic credenials. Academic findings are no always easily ranserable, a leas no wihou subsanial effor o ailor hem o be effecive in a real-world environmen. Tere are ofen conounding environmenal variables or uninended consequences rom well-inenioned behavioral inervenions. Tree paricular ypes o misguided atemps o implemen academic behavioral ideas are (1) o base an implemenaion on a single behavioral endency ha is valid when observed in conrolled experimenal condiions, bu which has

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poenial coss in a real-world seting; (2) o deliver highly echnical soluions, which are over-engineered and hus no suiable o he pracical problem hey are rying o address; and (3) o offer behavioral alernaives o how hings are already done wihou ruly undersanding he radiional approaches or he language and belies o exising praciioners. Many o he suggesed behavioral approaches o goals-based invesing and atemps o build his ino pracical invesmen ools exempliy he firs ype o a misguided atemp (Das, Markowiz, Scheid, and Saman 2010). Goals-based invesing is requenly jusified using he noion o menal accouning, arguing ha individuals do no ypically see money as compleely ungible, bu insead comparmenalize heir financial siuaion ino menal accouns (Taler 1999). A valid implicaion o his ramework is ha invesors find financial decision making easier and more comorable i hey can conceive o heir wealh in “pos.” Furhermore, invesors end o be more moivaed i hey are pursuing specific goals or which hey are saving. Te recommendaions o his srand o he lieraure generally lead o he suggesion ha invesmens should be managed in a series o “buckes,” each conneced o a specific uure goal and each wih is own ime horizon and risk profile. Menal accouning brings benefis o invesors insoar as i makes decision making easier and more conained. However, his approach also largely ails o consider he concomian coss. Menal accouning reduces financial and psychological flexibiliy, ying invesors o a paricular srucure o goals and preerences ha may be spuriously precise reflecions o heir acual uzzy aspiraions. As a resul, invesors are relaively less able o adap o changing circumsances and preerences over ime. In shor, his sraegy commis he nauralisic allacy o deriving “ough” rom “is.” Much o he academic research in behavioral finance is descripive in ha i describes how people acually behave, no how hey should behave. Tis approach o goals-based invesing delivers boh he benefis and he coss o menal accouning. By conras, a mehod ruly designed o address he problem would seek o build sysems ha incorporae he benefis while minimizing he coss (Davies and Brooks 2014). An example o over-engineered echnical soluions is in he area o porolio opimizaion. Te behavioral lieraure shows ha invesors do no exhibi expeced uiliy heory preerences when making decisions. Insead, heir decision making is more closely approximaed by non-expeced uiliy models such as CP (versky and Kahneman 1992). Opimizing a porolio or CP preerences is no an easy ask because he opimizaion is non-convex. However, He and Zhou (2011) address he issue and find ha compuing a porolio ha would be opimally held by an individual whose preerences are described by CP is possible. Alhough his process is possibly an ineresing mahemaical exercise, why would any invesor ever wan o hold his porolio? Invesing is a long-erm aciviy. Ye, his process incorporaes wihin porolio soluions he very eaures ha arise rom behavioral responses o he immediae conex (e.g., reerence dependence and loss aversion), exrapolaing hem o porolio choices influencing long-erm oucomes o he invesor’s oal porolio. In shor, CP as a pracical implemenaion commis he nauralisic allacy: i conuses descripive preerences or normaive preerences, and hus commis invesors o all sors o choices ha in he long erm hey are likely o wish hey had no made. Observed human choice in small rames is cerainly no always opimal in broader long-erm rames.

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A leas wo oher problems exis wih his approach o porolio opimizaion. Firs, i assumes ha an individual invesor’s preerences can be specified precisely using a sophisicaed model such as CP. Tis model can have up o five parameers o be esimaed one governing loss aversion, wo relaing o he value uncion curvaure in gains and losses, and wo associaed wih some specificaions o he probabiliy disorion uncion. Moreover, he behavioral parameers, calibraed on immediae revealed preerences or hypoheical choices, are assumed o be sable over ime and appropriae o long-erm preerences or oal wealh. Insoar as emoional responses o he curren conex, environmen, emoional sae, and rame induce behavioral procliviies, hey are unlikely o be sable. aher, hey will exhibi large flucuaions in srengh depending on wheher he decision maker is reflecing calmly on broader rames and longer horizons or anxiously ocused on narrow problems. So, even i applying a descripive model o a normaive soluion were appropriae, accuraely fixing his model becomes unlikely. Hence, users migh exhibi spurious confidence and precision in a soluion inappropriae o he problem a hand. Ye, such approaches are increasingly available in commercial applicaions: sysems puting invesors hrough a sequence o quesions ha aim o elici specific individual revealed preerences or risk atiudes, ime preerences, ambiguiy aversion, loss aversion, probabiliy disorion someimes among oher eaures. Advisors hen use hese resuls o calculae recommended individually ailored porolio recommendaions ha somehow “opimize” he porolio or all hese “revealed preerences.” Tis sor o approach is undamenally misguided. I begins wih spuriously precise measuremens o descripive eaures o an invesor’s poin in ime decision patern, which are likely o be highly unsable, or a he leas o evolve over ime. Te approach hen applies hese preerences rom one specific decision rame o anoher one enirely. However, he bigges problem wih his approach is he noion ha hese descripive eaures o someone’s choices are hose ha should be applied o a recommended soluion. Toughul invesors should repudiae many o hese revealed preerences as being inappropriae or heir long-erm wealh oucomes. For example, i is near impossible o raionalize why any invesor would logically choose o use disored probabiliies when selecing an opimal invesing sraegy. Te same goes or any specificaions ha are rame dependen, as are mos o he eaures o CP. A similar difficuly aces hose goals-based porolio consrucion approaches ha use aspiraion-based preerences such as Sherin and Saman (2000). Tese approaches assume ha an invesor’s abiliy o speciy a arge oucome or an individual goal oday should be aken as an accurae expression o long-erm preerences. Such preerences would imply ha he goal is fixed, cerain, and absolue, so ha invesors would give up subsanial upside raher han accep any reducion in he chance o reaching his goal. However, he goal may insead simply be an easy way or an invesor o express somehing ha is in realiy uzzy and uncerain. reaing such preerences as “opimal” or accurae is likely o incur a large poenial cos or litle gain. Te essenial problem wih all hese approaches is ha hey ake a descripive academic model ha explains choice behavior wih reasonable accuracy in specific circumsances, and hen apply i much more broadly han can be reasonably jusified o quie differen real-world siuaions. Normaive models should be used i he goal is o help guide behavior. Te goal o pracical implemenaions o behavioral insigh should be

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o help decision makers miigae deviaions rom hese normaive heories, wihin he consrains imposed by he human need or immediae emoional comor wih siuaions and decisions (Davies and Lim 2014). End users o such ools ofen have litle experience ha would enable hem o evaluae wheher a paricular approach is fi or a specific purpose or over-engineered. Tis problem is exacerbaed in academic “lif and drop” applicaions relaive o he superficial approaches discussed in he previous secion. Ta is, he academic pedigree and apparen sophisicaion and precision can give a srong illusion ha he approach is a he cuting edge o behavioral science, raher han a spurious applicaion o unsable soluions ha could lead o invesors’ locking shor-erm emoional preerences ino imporan long-erm choices. Te ac ha many behavioral praciioners are criical o exising radiional approaches, wihou ruly undersanding hem, makes his concern more problemaic. Tey also ofen arrive wihou undersanding he assumpions, knowledge base, and common language o he commercial world and as such ail o communicae effecively, poenially resuling in considerable misundersanding. Offering he commercial world an alernaive o an esablished approach requires he abiliy o communicae he new ideas in erms ha hose in he indusry clearly undersand. LACK OF TAILORING TO FIT AND ENVIRONMENT

THE PROB LEM

Effecive behavioral implemenaion needs o be highly ailored and atuned o he precise environmen and he pracical realiies o he problem a hand. Tis requires considering boh he increased complexiy and noise o decision making ouside he laboraory, as well as he organizaional realiies o geting he soluions implemened, acceped, and used. ailoring he design and organizaional deploymen are a leas as imporan as he behavioral aspecs i he implemenaion is o be effecive. Te process o achieving hese goals ofen ails on several levels. Firs, he implemenaion is requenly unsuccessul because i is no acceped ino he organizaion a he ouse, leading o skepicism and low usage. Gaining accepance requires senior sponsorship. Accepance also requires exensive effors o ensure ha he proposed approach fis ino he organizaional srucure, exising processes, echnology and sysems, and regulaory requiremens. Addiionally, educaing, preparing, and raining he users are essenial o ensure boh iniial accepance and coninued usage, which in urn requires ongoing suppor. Consideraion o an organizaion’s culure is a vial par o his process. Second, some devoe insufficien hough o user experience (UX) design and ease o use, ofen adding seps or elemens o exising processes. Tese may lead o beter oucomes i used, bu can also make employee or clien asks more ime-consuming or difficul. Poor user experience hampers boh accepance and use o a behavioral ool, and also ofen makes he behavioral insighs hemselves less effecive. A clever behavioral inervenion is o no value i no used. Tis limiaion is paricularly rue or boh echnology and sofware- based implemenaions, bu also o oher behaviorally designed processes such as clien profiling and ac-finding ools, sales processes, and produc-approval processes. An example o such a limiaion is he deploymen o decision journaling sysems o help individuals

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Practical Challenges of Implementing Behavioral Finance

551

documen he raionale behind heir decisions o comba hindsigh and confirmaion biases, and hus o aciliae improved decision making. Tis approach is widely advocaed by he behavioral lieraure and should be a eaure o any good decision suppor ool or sysem. However, unless well designed o fi wih he specific needs o he user, he deails o he decisions hey make, and he organizaional environmen in which hey operae, decision makers will simply ail o use he ool effecively. Tey may also rejec ourigh he broader behavioral sysem o which i is a componen. For many decision makers, he addiional ask o having o documen even a one-senence raionale or requen decisions can be perceived as oo onerous, regardless o how effecive i migh be. Perhaps a beter iniial approach is woold: (1) auomae he capure o as many eaures o he decision as possible, and (2) design a series o quesions ha he individual can quickly answer and which capure some essenial eaures o he decision maker’s emoional sae a he ime, o be used laer o comba hindsigh bias. For example, simple muliple-choice response scales capuring he decision maker’s level o confidence and emoion when making he decision may provide useul daa a very low effor. Te crucial elemen o he process is ha he design is inimaely linked o he needs o he decision maker and his or her willingness o engage. EXECUTIVE RELUCTANCE

A final concern wih pracical implemenaion is ha many execuives are relucan o ully embrace behaviorally grounded approaches, even given considerable evidence supporing heir effeciveness. Forunaely, his discomor wih novely is no longer as prevalen as i was, bu oher sources o relucance persis, orming barriers o adopion. Some o his relucance is relaed o he percepions o superficialiy previously noed. Many sophisicaed execuives have read popular books and aricles in he field. Tey are righly suspicious o ohers overselling simplisic approaches ha offer no deeper insighs han mehods currenly used. Anoher percepion is ha behavioral approaches are useul only or rie or rivial problems. Discussions wih senior execuives should sar by poining ou he many ailings o superficial approaches, and being deliberaely criical is ofen necessary o ge sufficienly over heir skepicism o move orward. A relaed problem is ha many successul execuives assume ha implemening behavioral ideas is simple and does no need o be ackled sysemaically and deeply. Tis atiude is an example o overconfidence ha also leads o percepions ha behavior can be changed simply by reading abou or discussing biases, wihou he need o laboriously build his knowledge ino ools and organizaional design. A paricular relucance in he finance indusry lies in openness o behavioral findings on raming o inormaion and daa design. eraming financial inormaion o align he rame o broader objecives, raher han narrow deails and myopic horizons, can lead o subsanially beter decision making. Lower complexiy is usually beneficial. Benarzi (2015) offers an approachable recen summary o our behavioral knowledge wih regard o digial design. However, he finance indusry is ypically quaniaive in naure. Tis creaes grea relucance o genuinely believe ha shielding ourselves, employees, or cliens rom oo much inormaion and reducing he deail and requency o daa are hings ha should be pursued.

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THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE

A final area o execuive relucance is an ofen surprising unwillingness o engage wih experimenaion, and wih esing behavioral approaches using randomized conrol rial (C) designs, which deploy rigorous applicaion o scienific mehods o ruly esablish wha works and wha does no. Some o his relucance comes again rom overconfidence. In he commercial world, individuals are usually rewarded or having a clear idea, believing in i, and pushing i o implemenaion. Tis mindse is no conducive o admiting a lack o convicion or o design hrough experimenaion. Te corporae world is cerainly becoming more open o C approaches, bu currenly hese are ofen used o es relaively small aspecs o design, such as he placing o design elemens on he screen or he use o differen ons or colors. Such aspecs are worh esing and can someimes make a surprisingly large difference. Ye, even more valuable would be esing larger aspecs o behavioral design ha require execuives o admi hey do no know which pah o ake. Tis admission requires considerable courage, and being able o generae sufficienly ineresing soluions, filer hem, and hen design alernaives or esing requires considerable effor, knowledge, creaiviy, and commimen. I also requires subsanial invesmen in resources o build prooypes and rapidly deploy and es hem. C approaches are more expensive han fiddling wih numerous shades o blue on a web page, bu he poenial upside o ranscending he limis o radiional corporae innovaion is also subsanially greaer. THE GOOD NEWS

Despie drawing atenion o he challenges o implemenaion, over he las decade indusry and policymakers have become more open o behavioral insighs, wih many examples o good implemenaion and good behavioral design. Tese successes include auomaic enrollmen in pensions in various pars o he world, which has led o millions saving or heir reiremen ha would no have oherwise been doing so. Te Unied Kingdom’s Behavioural Insighs eam has, among ohers, used C designs o increase ax compliance and he effeciveness o job ceners. In he Unied Kingdom, he FCA has been pioneering behavioral approaches o financial regulaion o improve oucomes or cusomers, and many companies and sar-ups are using gamificaion echniques o encourage beter healh and financial behaviors. A small number o sophisicaed behavioral consulancies are also helping companies and governmens address commercial and social problems wih subsanial rigor and credibiliy. Barclays has spen nearly a decade building behavioral approaches inooIhelping sysems, sales o process, profiling ools, invesmen soluions, and many oher ways people make beter financial decisions, including a recen launch o a behavioral ramework o encourage impac invesing and philanhropy (Davies 2015). Behavioral findings are more widely known and acceped han hey were previously. Tey are being piloed and explored in an ever- wider range o indusries and applicaions. Furhermore, advances in digial echnology and daa analyics are opening up new visas or applicaion and making personalizaion, esing, and delivery cheaper and easier. Wih ha said, indusry and governmen are sill only in he iniial sages o building he decades o robus academic behavioral research ino pracical applicaions. Much sill needs o be learned and ried.

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553

Applying Behavioral Finance Te previous secion presened illusraions o good and bad applicaions o behavioral finance. Tis secion offers a se o principles ha should be considered when applying behavioral finance. PRINCIPLE 1: BEHAVIORAL FINANCE IS A ALWAYS USELESS IN ISOLATION

LMOST

Consider he mos isolaed applicaion o behavioral finance: simply educaing people abou heir biases. Awareness may lead o a small improvemen in acions and decisions, bu any effec is likely o be shor-lived, as he simuli or he biased acion have no been changed or removed. Successul applicaions o behavioral finance require an approach o people, processes, and echnology. Tey also require an acknowledgmen ha he radiional approach o any scenario may no be wrong. Corporae execuives and ohers should no repudiae radiional hinking bu, raher, embrace and augmen i wih an undersanding o behavior. Te financial crisis o 2007–2008 brough much criicism o radiional porolio managemen pracices. Tis required organizaions o reexamine heir asse allocaion echniques o evaluae possible improvemens. Using volailiy as a porolio risk measure is compuaionally convenien, bu is incongruous wih how individual invesors hink(Egan, abou Davies risk, and i Brooks leads o2011). unreasonable abou he preerences o invesors and Is here conclusions a way o measuring porolio risk ha beter reflecs how individuals hink abou risk ha is, ha is ocused on he downside and allowing or beter han expeced oucomes o reduce porolio risk? Along wih quaniaive financial analyss, Davies and De Servigny (2012) creae a behavioral measure o porolio risk ha can be included in a radiional risk and reurn opimizaion ramework wih he objecive uncion o minimizing behavioral risk subjec o a given level o reurn. Tis Behavioral Modern Porolio Teory recognizes ha behavioral finance is par o he soluion, bu no he whole soluion. In heir model, he deparure rom he radiionally used orm o modern porolio heory (MP) is relaively small. I sill allows invesmen praciioners o alk abou efficien roniers and asse allocaion in a manner ha is consisen wih heir proessional raining, and ye is linked o clien measures o risk olerance (Davies and Brooks 2014) ha are sable and do no suffer precision or over-engineering. Te imporance ingrainedfinance knowledge shouldrom no alse be underesimaed when rying o drive adopion oobehavioral in a large organizaion. Tis belie leads o a second principle. PRINCIPLE 2: BEHAVIORAL FINANC TO TRADITIONAL APPROACHES

E IS A C OMPANION

A recommended mindse is o sar wih he belie ha here are probably good reasons or why hings are as hey are, bu o undersand radiional approaches deeply enough o challenge he saus quo. Te implicaion is ha behavioral finance is only ever par o he soluion and needs o complemen radiional approaches. oday, successul

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THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE

behavioral finance praciioners need o be specialiss in behavioral finance and generaliss in many oher areas. Tey canno operae in isolaion rom oher specialiss wihin an organizaion. PRINCIPLE 3: BEHAVIORAL FINAN NOT JUST NUDGES

CE IS

Alhough all behavioral finance applicaions atemp o change behavior in some way, he wide array o acics end o align o a ew broad opions: educae people abou heir biases; rely on decision ineria wih passive nudges such as changing he deaul opion; and go beyond passive nudges by criically assessing how o presen an acive choice. Simply educaing people abou heir biases is ineffecive. As a resul, here has been an increase in nudge echniques because evidence shows hem o be effecive a changing behavior in many siuaions (Taler and Sunsein 2008). However, a nudge is a blun ool and may no always resul in good individual decisions. Furhermore, alhough nudges may be effecive in addressing specific, isolaed behaviors, hey are no paricularly useul in helping people make confiden, inormed choices in complex decision environmens. eurning o he example o auo- enrollmen in company pension plans, such a program may or may no lead o beter oucomes. By auo- enrolling employees in a pension scheme, he oal amoun o pension savings will increase wihin sociey. Ye, are people saving more appropriaely or heir reiremen? Tis is ar rom cerain. Te nudge akes one decision away rom savers wheher or no o join he company pension plan bu i does so by making one-size-fis-all assumpions on oher decisions. Te blunness o his nudge comes rom he employees’ likely percepion ha all decisions relaed o heir pension savings have been addressed. Te deaul rae o conribuion and he deaul und selecion ac as saey nes or hose who would no make a decision or hemselves. aher han employees’ reviewing heir conribuion rae and invesmen und, which are much more difficul assessmens or novice invesors, mos succumb o ineria and conribue he deaul amoun ino he deaul und wih no assessmen o wheher his is appropriae or heir ype o reiremen. A single deaul, no mater how well chosen o be approximaely righ or mos, is al ways going o be precisely wrong or many . In effec, a valuable nudge on one decision has creaed more quesionable nudges on wo addiional decisions. Alhough people are saving more or reiremen in he Unied Kingdom, i is unlikely ha mos are saving he appropriae amoun or heir reiremen as a resul o auo- enrollmen. Tis assessmen is no a criicism o auo-enrollmen; i is an effecive nudge. Bu more should be done o engage people wih he choices ha hey sill need o make. Alhough debae coninues abou wheher he liberarian paernalisic approach o manipulaing choice hrough nudges is an affron o ree choice, his debae misses a more imporan concep o asymmeric paernalism, which reers o policies designed o help people who can’ or won’ behave so as o advance heir own ineress or example, by consraining opions or nudging oward deaul opions while encouraging more acive engagemen and less etered choice or hose who are willing and able o decide hemselves.

5

Practical Challenges of Implementing Behavioral Finance

555

Under asymmeric paernalism, pracical applicaions o behavioral finance ocus equally on hose who canno or will no make a decision, and hose who could or would engage wih making heir own choices given an accessible opporuniy o do so. Pracical applicaions o nudges have ended o be overly ocused on hose who would no oherwise do somehing ha is in heir beter ineress, ofen o he derimen o hose who are capable o making he decision. Behavioral finance praciioners need o do more o apply heir skills oward engaging decision makers and helping hem make confiden and inormed decisions in complex environmens, as much as o finding deauls ha work well or he passive majoriy. PRINCIPLE 4: ASYMMET A GUIDING PRINCIPLE

RIC PA TERNALISM

SHOULD BE

In pracice, his principle means using a ull oolbox o behavioral approaches. For example, i he goal is confiden and inormed decision making, hen he individual needs hree hings a he poin o decision: (1) he knowledge required o make he decision, (2) engagemen wih he decision, and (3) he emoional comor o enac i. able 29.1 reflecs how effecive various approaches are a achieving hese hree requiremens. Simple inormaion disclosure and radiional educaion accomplish litle wih respec o hese approaches (Fernandes, Lynch, Jr., and Neemeyer 2014). Nudging can change behavior, bu may acually have a harmul effec on knowledge and engagemen because he comor ha knowing someone has hough abou he problem is also an inviaion or people o disengage. Only by bringing he ull behavioral oolki o bear can a ully engaged, inormed, and confiden choice emerge.

able 29.1 Effec of Approaches o Behavioural Change on Knowledge, Engagemen, and Emoional Comfor

Knowledge

Engagemen

None

Emoional Comor

Examples

Disclosure

Litleornone

None

Disclaimers

radiional Educaion

Litle or none

Litle or none

Litle or none

Cavea empor Seminars Classes

Nudges

Noneor negaive

None or negaive

Some

Auo-enrollmen Deauls

Engaged Choice

Yes

Yes

Yes

Jus in ime educaion Gamificaion

Noe: Tis able shows how differen behavioral ools conribue o he orming confiden and engaged decision makers.

556

THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE

PRINCIPLE 5: GOO D APPL ICA TIONS OF BEHAVIORAL FINANCE S HOULD COMBINE AN UNDERSTANDING OF HOW PROCESSES AND PEOPLE INTERACT TO INDUCE BETTER DECISIONS

Many people ail o make decisions because hey eel hey do no undersand he complexiy o wha hey need o consider, or because arriving a and enacing any decision are jus oo difficul. Applicaions o behavioral finance ha ake advanage o hese individuals reflec dishonorably on he discipline. Sadly, he finance indusry has a large number o examples o ailures in his regard. Te use o easer raes on credi cards and savings accoun producs are among he mos pervasive. A common pracice in he Unied Kingdom and he Unied Saes credi card indusry is o offer an exended period o zero percen ineres or individuals who ranser an exising balance rom anoher credi card and pay a small percenage as a ranser ee. Tis opporuniy can be advanageous or hose who are disciplined in heir finances. However, he way ha people and process inerac in his example means ha many are se up o ail. A he end o he ineres-ree period, he ineres rae revers o a level much more ypical o unsecured lending. I he borrower ails o remember ha he ineres-ree period is coming o an end and does no clear he deb, eiher by making regular paymens or by ranserring o a new ineres-ree deal, he rae he borrower ends up paying is ypically puniive compared o he mos compeiive sandard raes. Alhough banks now have a responsibiliy o aler cusomers o he end o easer rae deals, ample opporuniy o profi rom he ineria o ill-disciplined cusomers remains. Te cenral role o behavioral finance should be o reinorce good behaviors and help people make beter financial decisions. I should no be used o profi a he hands o cusomers who do no recognize heir own behavioral biases. Tus, behavioral finance fis well wih he growing emphasis banking regulaors are giving o conduc risk, which can loosely be defined as any commercial conduc ha causes cusomer derimen. Behavioral finance provides he insighs and oolki o ensure ha cusomers are reaed airly, bu his requires undersanding how people inerac wih he processes ha are pu in ron o hem. Te ollowing are some examples o ponder o wheher some specific decision rames are designed o accoun or poenial behavioral bias. • When a user inerace designer recommends shorening he number o available lines on an invesmen und selecion documen so ha i fis on ewer pages, is he designer aware ha he orm is providing a suble nudge o cusomer choices and ha his migh limi porolio diversificaion (Benarzi and Taler 2007)? • Can cusomers be expeced o read and undersand a lenghy exclusions and disclosures documen on a ravel insurance policy wihou any inormaion on he ypical coss o obaining medical reamen abroad o help judge he value o he policy? Te raming o maximum limis on policy payous does no describe he risk he insured cusomer sill carries. Insurance policies ofen suffer inangible inormaion asymmeries ha make judging good value very difficul or consumers. • Wha is he bes way o inorm pension savers wheher hey are on rack or he kind o reiremen hey wan? Can moneary orecass be ranslaed ino liesyle

57

Practical Challenges of Implementing Behavioral Finance

557

desires? Is showing he curren liesyles ha he pensions are orecas o be able o provide a beter way o rame he inormaion, and can i spur workers o raise heir conribuion raes? • Why do online invesmen plaorms ofen show cusomers heir daily reurns and reurns since purchase or each invesmen when displaying he porolio? Daily reurn is no aligned o he ypical cusomer’s ime horizon and increases percepions o risk, and reurn since purchase creaes an irrelevan perormance anchor ha can rigger he disposiion effec. Boh can resul in derimenal cusomer decision making. Is a beter approach o broaden he rame o show porolio-level pas perormance measured over an appropriaely long ime horizon? Behavioral finance praciioners need o accep a role in helping people make beter decisions, and no simply ideniy biases or promulgae hose biases or corporae profi. Tis goal requires he inegraion o behavioral finance wihin organizaions.

How to Make Behavioral Finance Work in an Organization Te pracical applicaion o behavioral finance wihin an organizaion is ricky, paricularly in large organizaions. How can an organizaion sar o ake knowledge ha is concenraed in a ew individuals and make i usable by all? Te FCA’s ocus on using behavioral finance has been beneficial, bu also arguably somewha harmul o he pracical applicaion o behavioral finance in UK financial insiuions. Beneficial, because i highlighs and legiimizes a body o academic knowledge ha has rarely been applied in he real world. However, as a consequence, he firs areas in financial insiuions o become awakened o behavioral finance have ofen been he regulaory conrol uncions, which have ypically scrambled o learn somehing so ha hey are no behind heir regulaor in knowledge. Alhough any applicaion o he field should be encouraged, rying o convince senior decision makers o he value o behavioral finance by ocusing on lowered compliance risk has he effec o limiing he perceived scope o benefis and applicaions. Hiring specialiss is necessary, bu o be ruly effecive in changing he organizaion hey need o be par o business sraegy, cusomer insigh, and proposiion design eams, and no jus wihin conrol uncions. Puting pracical applicaions o behavioral finance in he hands o nonspecialiss requires an assessmen and redesign o ools and processes, and widespread adopion o behavioral finance wihin large organizaions requires houghul design. For example, he Behavioural Insighs eam, which was ormerly par o he UK Cabine Office, published heir EAS (easy, atracive, social, and imely) ramework or using behavioral insighs (Behavioural Insighs eam 2014). Behavioral inervenions should be: • Easy (E): includes harnessing he power o deauls, reducing he “hassle acor” o aking up a service, and simpliying messages. • Atracive (A): includes atracing atenion and designing rewards and sancions or maximum effec.

558

THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE

• Social (S): includes showing ha mos people perorm he desired behavior, using he power o neworks, and encouraging people o make a commimen o ohers. • imely (): includes promping people when hey are mos likely o be recepive, considering he immediae coss and benefis, and helping people plan heir response o evens. Examples ha cohere o his ramework include pension auo-enrollmen, which uses he power o deauls; donaing a se amoun o chariy via a ex message, which provides a deaul donaion and removes he hassle o finding someone’s bank card deails; and providing he deails o average household energy usage wih uiliy bills, which promps people o use less. Te EAS ramework provides a useul guide or nonspecialiss when hinking abou how o harness behavioral finance. However, i should no be consrued as reducing behavioral finance o a checklis o biases and acions ha, i avoided or implemened, mean ha someone has done a good job. Tese ools o he behavioral specialis are no a subsiue or ha specialis’s knowledge. Te Behavioural Insighs eam also recognizes ha “i canno be applied in isolaion rom a good undersanding o he naure and conex o he problem.” A rained behavioral finance specialis should be involved in he “behavioral audi” o exising and new processes o deermine areas o possible improvemen. Tis orms a final principle o consider when applying behavioral finance. PRINCIPLE 6: ATTEMPTS TO MODIF Y BEH AVIOR USING BEHAVIORAL FINANCE TOOLS R EQUIRE A D EEP UNDERSTANDING OF THE OB JECTIVE AN D CONTEXT OF THE DECISION PROBLEM

Digial services are growing in imporance and populariy in various indusries. Tis growh represens he nex ronier or behavioral design and excellence. Benarzi (2015) provides a descripion o he challenges o influencing behavior on small-screen devices. Tese challenges provide no only an opporuniy o make behavioral excellence a prioriy bu also a srong posiion rom which behavioral finance can influence oher offline areas o organizaions. Sriving or behavioral excellence akes ime. While a eam is esablishing isel and is influence in an organizaion, senior managemen mus suppor he iniiaive or i o be effecive. A second elemen o necessary senior managemen suppor is heir accepance ha behavioral finance is as much ar as i is science. Some behavioral inervenions are likely o ail. Tese ailures should no be seen as a weakness o he pracical applicaion o he discipline bu, raher, as an addiional opporuniy o learn in an empirical seting. Markeing sraegies ypically embrace an experimenal approach in which heories are esed and adaped. Behavioral finance needs he same approach. Wellinenioned behavioral inervenions could lead o unexpeced cusomer responses. As conduc risk increases he ocus on cusomer derimen, demonsraing srong behavioral raionale or an inervenion is criical, despie he possibiliy ha i ails o assis disadvanaged cusomers. egulaed organizaions need o be confiden ha hey will

59

Practical Challenges of Implementing Behavioral Finance

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no be sancioned because o ailed experimenaion aimed a helping cusomers make beter decisions.

Summary and Conclusions Grea poenial exiss or behavioral finance approaches o improve he financial decision making o individuals, groups, and organizaions. However, harvesing his poenial mus include an asymmeric paernalisic approach. Mos imporan, his requires more knowledge o he field han can be garnered hrough reading popular science books. Unrained praciioners are driving an overreliance on nudge as a echnique o he derimen o cliens and cusomers. In our example o a behaviorally moivaed alernaive o modern porolio heory, undersanding how cliens behave is deeply embedded in he porolio opimizaion. Tese kinds o implemenaions require specialis knowledge and are he rue vanguards o he discipline. I organizaions are serious abou making he ulles use o behavioral finance, hey need a core eam o specialiss wihin he business ha has enough suppor rom senior managemen o effec improvemens a all levels o organizaional eams and processes. An organizaion can achieve his in many ways, bu many examples are available o boh ailed and successul atemps o embed behavioral finance. Alhough no perec model o applied behavioral finance exiss, he discipline sill has many opporuniies o grow and maure, and here are many commercially valuable unapped insighs in he decades o rigorous academic research ha underpins he field.

DISCUSSION QUESTIONS 1. Explain how nudging alone consiues a narrow use o behavioral finance knowledge. 2. Discuss he eaures o good and bad applicaions o behavioral finance. 3. Discuss an example o behavioral finance supplemening radiional approaches. 4. Explain asymmeric paernalism.

REFERENCES Behavioural Insighs eam. 2014. EAS: Four Simple Ways o Apply Behavioural Insighs. London: Behavioural Insighs eam. Benarzi, Shlomo (wih Jonah Lehrer). 2015. Te Smarer Screen: Wha Your Business Can Learn fom he Way Consumers Tink Online. London: Piakus. Benarzi, Shlomo, and ichard H. Taler. 2007. “Heurisics and Biases in eiremen Savings Behavior.”Journal o Economic Perspecives 21:3, 81–104. Das, Sanjiv, Harry Markowiz, Jonahan Scheid, and Meir Saman. 2010. “Porolio Opimizaion wih Menal Accouns.” Journal o Financial and Quaniaive Analysis 45:2, 311–334. Davies, Greg B. 2015. Te Value o Being Human: A Behavioural Framework or Impac Invesing and Philanhropy. London: Barclays–Wealh and Invesmen Managemen.

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Davies, Greg B., and Anonia Lim. 2014. “Managing Anxiey o Improve Financial Perormance: Don’ Le he Bes Be he Enemy o he Achievable.” In Andrew udd and Sephen Sachell (eds.), Quaniaive Approaches o High Ne Worh Invesmen , 69–98. London: isk Books. Davies, Greg B., and Arnaud De Servigny. 2012. Behavioral Invesmen Managemen: An Efficien Alernaive o Modern Porolio Teory. New York: McGraw-Hill Proessional. Davies, Greg B., and PeerBrooks. 2014. “isk olerance: Essenial, Behavioural and Misundersood.” Journal o Risk Managemen in Financial Insiuions 7:2, 110–113. Egan, Daniel, Greg B. Davies, and Peer Brooks. 2011. “Comparisons o isk Atiudes Across Individuals.” In James J. Cochran, Louis Anhony Cox, Jr., Pinar Keskinocak, Jeffrey P. Kharoueh, and J. Cole Smih (eds.),Wiley Encyclopedia o Operaions Research and Managemen Science, 1–13. Hoboken, NJ: John Wiley & Sons, Inc. Fernandes, Daniel, John G. Lynch Jr., and ichard G. Neemeyer. 2014. “Financial Lieracy, Financial Educaion and Downsream Financial Behaviors.” Managemen Science 60:8, 1861–1883. He, Xue Dong, and Xun Yu Zhou. 2011. “Porolio Choice under Cumulaive Prospec Teory: An Analyical reamen.” Managemen Science 57:2, 315–331. Schroders. 2015. “Schroders incomeIQ.” Available ahtp://incomeiq.schroders.com/en/uk/ invesor/. Sherin, Hersh, and Meir Saman. 2000. “Behavioral Porolio Teory.”Journal o Financial and Quaniaive Analysis 35:2, 127–151. Sloman, Seven A. 2002. “wo Sysems o easoning.” In Tomas Gilovich, Dale Griffin and Daniel Kahneman (eds.), Heurisics and Biases: Te Psychology o Inuiive Judgmen, 379–396. New York: Cambridge Universiy Press. Taler, ichard H. 1999. “Menal Accouning Maters.”Journal o Behavioral Decision Making 12:3, 183–206. Taler, ichard H., and Shlomo Benarzi. 2004. “Save More omorrow: Using Behavioral Economics o ichard IncreaseH., Employee Saving.” Journal 2008. o Poliical Economy 112:1, 164–187. Nudge: Improving Decisions abou Healh, Wealh, Taler, and Cass . Sunsein. and Happiness. New Haven, C: Yale Universiy Press. odd, Peer M., and Gerd Gigerenzer. 2012.Ecological Raionaliy: Inelligence in he World. New York: Oxord Universiy Press. versky, Amos, and Daniel Kahneman. 1992. “Cumulaive Prospec Teory: An Analysis o Decision under Uncerainy.”Journal o Risk and Uncerainy 5:4, 297–323.

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30 The Future of Behavioral Finance MICHAEL DOWLING Associate Professor in Finance ESC Rennes School of Business BRIAN LUCEY Professor of Finance Trinity Business School, Trinity College Dublin

Introduction Te uure o behavioral finance requires undersanding more abou is philosophy, gaining a deeper undersanding o he drivers o financial behavior, and ensuring rigorous research. Tis field o sudy is jus a is beginning sages when icomes o undersanding he influences o human behavior as applied o an individual, firm, groups, or insiuions making financial decisions. Te iniial anomalies in radiional finance ha inspired he birh o behavioral finance in he 1980s have given way o he curren sampling o clearer behavioral biases rom he lieraure on decision making and psychology. Te nex sep o deeper engagemen in more complex behavioral undersanding willbe more difficul, bu he pah is well esablished in many oher business fields. Tis chaper provides a poenial roadmap or his developmen o behavioral corporae finance and invesor psychology. Behavioral corporae finance is perhaps he mos obvious candidae o begin his journey. Te curren ocus in behavioral corporae finance is on chie execuive officer (CEO) rais and someimes chie financial officer (CFO) or board o direcor characerisics as he primary means or inroducing behavioral biases ino he firm’s financial decision making. Tis ocus should be replaced by a more comprehensive undersanding o op managemen eams and he insiuional influences on financial decision making wihin corporaions. New research approaches, such as grounded heory and oher qualiaive ools, are necessary or his developmen o progress. In research on asse pricing invesor psychology, an area o behavioral finance subjec o heavy criicisms o daa mining, a need exiss or much richer models o invesor behavior and he social psychology o groups o invesors. Te curren research on behavioral asse pricing has allowed ha prices can predicably move in pricing paterns owing o widely experienced decision-making biases. However, hese paterns are based on raher simple models o he drivers o behavior and are heavily resriced as o how hese biases mus be proxied, owing o daa resricions. Te uure o behavioral asse pricing needs researchers o be more comorable using he rich new behavioral and 561

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social daases ha online media offer or building a more holisic and argeed undersanding o he drivers o invesmen behavior. Tere is also a need o work closely wih experimenal finance and daa science researchers o design, model, and measure he behavior o groups o invesors so as o orm realisic represenaions o how groups o invesors in a marke make invesmen decisions and how his influences pricing. A paricular “prize” or invesor psychology is in undersanding senimen as an overall measure o psychological influence on asse pricing. Alhough his chaper ocuses on behavioral corporae finance and invesor psychology, i broadens o include he philosophical underpinnings o behavioral finance and he need or ensuring robus invesigaions o behavioral paterns. Te chaper begins wih an evaluaion o he philosophical developmen o behavioral finance and i exrapolaes, based on oher fields, he nex seps in his developmen o an overall philosophical approach o behavioral finance research. Te, he chaper discusses he reliabiliy o behavioral finance research in he conex o research mehods in psychology and economics, reerencing he rigor and replicabiliy o findings in hose areas.

The Philosophy of a Future Behavioral Finance Frankurer (2007) remarks on he general disdain or philosophical discussion in finance. He relays he sory o a ormer suden who atemped, in a PhD seminar, o discuss he philosophical implicaions o he ubiquiy o uiliy heory in finance and was old ha “his is a finance course and no a philosophical course” (p. 49). Such a commen would be anahema o researchers in oher disciplines, even hose closely aligned wih finance such as managemen or mahemaics. Also, a disdain or philosophical discussion does no preclude he influence o philosophical perspecives on he conduc o finance and behavioral finance research. Guba and Lincoln (1994, p. 105) argue or he primacy o philosophical perspecive in conducing research because “quesions o mehod are secondary o quesions o paradigm.” Tis perspecive generally acknowledges ha he research perspecive influences he selecion o mehods and problems. Beore commencing any empirical inquiry, researchers mus address heir onological and episemological assumpions and, indeed, consider how such assumpions align wih heir research quesion and heir mehodological choices. Onology describes realiy, whereas episemology is he relaion beween realiy and he invesigaor, wih he mehodology being he echnique used o discover such relaionship. Tis poin is crucial in beginning any exploraion o he uure o behavioral finance. By undersanding he philosophy o research in behavioral finance, he researcher can learn more abou he developmen o he behavioral finance research paradigm, how heory s hould be bui l, and how research quesions fi ino he paradigm and research program. esearchers can hen exrapolae how he “knowing” in behavioral finance will progress, based on how he research philosophy has developed. Tis secion sars wih a brie summary o he philosophy o science perspecives o Tomas Kuhn and Imre Lakaos, and hen places behavioral finance wihin hese rameworks. Tomas Kuhn popularized he commonly used erms “paradigm,” “paradigm shif,” “normal science,” and “anomalies” in he discussion o how science is conduced and progresses. According o Kuhn, science is conduced wihin paradigms, wih a paradigm

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being a collecion o core rameworks, erminology, and mehodologies ha researchers use o solve problems wihin a paricular area (Kuhn 1970). Bird (2013), in his analysis o Kuhn’s conribuion, gives he uncion o a paradigm as ha o supplying puzzles or scieniss o solve and providing he ools or heir soluion. Working wihin a paradigm, scieniss can engage in normal science, which is he everyday process o solving problems in an area o research. As anomalies, or counerexamples, arise, scieniss atemp o place hese wihin he confines o he paradigm. Someimes he anomalies are jus ignored, as he imporance o normal science is considered paramoun o paradigm rejecion, or scienific revoluion. Only when an anomaly arises ha canno be explained and ha hreaens he core mehods or rejecs he core heories can a paradigm rejecion or paradigm shif occurs. Kuhn (1970, p. 68) erms his a “crisis.” Te anomaly makes normal science impossible, and hus a change mus occur. I researchers do move o a new paradigm, his new paradigm mus no only have he explanaory and problem-solving power o he old paradigm bu mus also offer new and exciing research opporuniies. Lakaos (1978) proffers a similar perspecive o ha o Kuhn, bu ocuses more on how research progresses. His views are insighul or deermining a plausible uure philosophy or behavioral finance. Lakaos preers he erm “research program” o “paradigm.” He views a research programas a collecion o heories used by researchers in a paricular area o sudy. Tese heories are divided ino a “hard core” and “auxiliary hypoheses.” Te hard-core heories are he deeply held belies shared by researchers involved in a paricular research program. Te auxiliary hypoheses emanae rom hardcore heories. Auxiliary hypoheses represen he “work in progress,” he esable hypoheses, and he less firmly held belies o he researchers. Te auxiliary hypoheses also serve as proecion agains atacks on he hard core rom hose ouside he research program. Auxiliary hypoheses can be adjused, or even rejeced, in order o proec he hard core. Lakaos (1978) addresses he issue o heory succession by dividing research programs ino wo caegories: progressive and degeneraive. A progressive research program offers exciing research opporuniies and appears o offer new findings. In conras, a degeneraive research programis one ha researchers consanly have o deend rom atack (perhaps, by adjusing he auxiliary hypoheses) and one ha is unable o generae new and exciing findings. Evenually, researchers in a degeneraive program swich ino more exciing research programs. Tese perspecives on he philosophy o science allow he charing o he developmen o a philosophy or he behavioral finance research program. Te anomalies lieraure o he 1980s represened an iniial criicismo he radiional finance assumpions o raional invesors and efficien markes.  radiional finance responded by making increasing adjusmens o heir heories, as prediced by Kuhn (1970) and Lakaos (1978). For example, he single-acor capial asse pricing model(CAPM) has evolved ino a five-acor model (Fama and French 2015) and a wide range o compeing models, mos o which ail o adhere o he rigorous saisical ess or daa mining (Harvey, Liu, and Zhu2015). Moving beyond he iniial phase o ideniying anomalies in radiional finance, behavioral finance can be described as a research program in is own righ. A key eaure o his new research program is a clear ocus on using he conceps o bounded raionaliy, in which people’s cogniive consrains impose limis on he exen o which hey can be “raional” in heir decision making and he influence o psychology o develop

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able 30.1 Scopus Aricle Counfor “Behavioral Finance” and “Invesor Psychology” Keywords 180 160 140 120

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Noe: Tis able racks he annual number o aricles appearing in Scopus- covered economics and finance journals ha have “behavioral finance” or “invesor psychology” keywords. Source: Te auhor’s work using he Elsevier Scopus daabase.

esable hypoheses o financial decision making. Tere is now a reduced ocus on criicizing radiional finance. esearchers in behavioral finance are increasingly debaing he mos appropriae behavioral heories o explain financial behavior. Ta i is a progressive research program is eviden rom he rise in behavioral finance research being published. able 30.1 provides a ime series o aricles published in Scopus-covered economics and finance journals since 2001 wih he keywords “behavioral finance” and “invesor psychology.” able 30.2 is a coun o working papers appearing in he Social Science esearch Nework (SSN) Behavioral & Experimenal Finance eJournal, also suggesing a vibran research area wih he upward rend indicaing is progressive naure. Given he recen naure o his rise in behavioral finance research, as opposed o research on anomalies in radiional finance, which began in he 1980s, his field seems clearly o be in he early sages o becoming a progressive research program. Te challenge or he uure o behavioral finance is ha work mus coninue o be boh heoreical and empirically progressive. Ta is, researchers in behavioral finance mus advance new heories and be able o empirically invesigae and coninue o develop hese heories. Normal behavioral finance research as i currenly exiss usually invesigaes confirmed heories rom he field o psychology, examining heir applicabiliy o financial behavior. esearchers usually make adjusmens o hese heories o make hem suiable rom a finance perspecive. However, his process is, a bes, jus he beginning o how a core heory o behavioral finance should appear. Te uure will require much richer

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able 30.2 Coun of Aricles in SSRN Behavioral and Ex perimenal Finance eJournal 1200

1000

800

600

400

200

0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Noe: Tis able couns he number o yearly submissions o he SSN Behavioral and Experimenal Finance eJournal, which is he primary deposiory or working papers and acceped paper absracs in his area. Source: Te auhor’s work using SSN Behavioral and Experimenal Finance eJournal daa.

finance-specific behavioral heories. One key issue, however, is how ew oules exis or publishing pure heoreical research on behavioral finance, or even more generally on finance, unlike he economics or business fields. Being a primarily empirical field means here is a limied secion in each research paper devoed o small heoreical developmen. A progressive research program will need more cognizan o he imporance o rewarding purely heoreical research so as o have a solid core o heories upon which o draw. Boh he Journal o Behavioral & Experimenal Finance and he Journal o Behavioral Finance welcome heoreical papers, albei neiher o hese journals is paricularly highly ranked a presen. Higher-ranking finance journals do no normally publish behavioral finance heory papers. Te rare, purely heoreical papers ha have been published, such as Mehra and Sah (2002), need o find a home in economic journals. Empirical work also needs o have he righ ools o appropriaely invesigae heories o behavioral finance. However, he proession is currenly hampered by an almos exclusively posiivis quaniaive approach o research. A move away rom hese purely posiivis quaniaive mehodologies is likely o eaure in he uure o behavioral finance, as i will be necessary o invesigae he validiy o new behavioral heories. wo episemological paradigms ha are he ocus o scieniss’ view o realiy are he posiivis and he inerpreivis perspecives. Te posiivis perspecive is based on a scienific principle consising o an objecive social realiy ha can be idenified. Tus, quaniaive approaches, bu no limied o quaniaive, can effecively enable ideniying paterns o his assumed social realiy. Te inerpreivis perspecive, by conras, assumes

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ha realiy is a social consruc ha canno be sudied ouside o he social acors who creae ha realiy. Tereore, a ocus is on mehodologies ha enable an undersanding o be buil o he social acors’ view, role, and influence in his social world (Livesey 2006). Te mehodologies mos appropriae o his inerpreivis perspecive end o be qualiaive, bu qualiaive mehodologies are largely ignored in finance, including behavioral finance. Inerpreivis mehodologies sar as close as possible o he idea o no heory, and hen use appropriae mehodologies o build heories based on daa. Tis approach is in conras o posiivis research, which largely ocuses on esing heory (Walsham 2006). I behavioral finance is o coninue o develop ino a progressive research program, i needs inerpreivis mehodologies ha allow rich heories o be buil and new esable hypoheses o be developed. Sample inerpreivis mehodologies applied in he analogous field o managemen include ehnographic, acion research, and grounded heory, where he researcher is direcly involved in he group being sudied, and indirec mehods such as building case sudies hrough, or example, inerviews. Tere has been srong philosophical progress in advancing rom anomalies- based atacks on radiional finance o he beginnings o a vibran progressive research program in behavioral finance. Te nex seps call or developing a core o heory raher han borrowing one rom anoher discipline. Inegraing more inerpreivis mehodologies allows hese heories o be developed and appropriaely esed.

The Future of Behavioral Corporate Finance Baker and Wurgler (2012) ouline he wo main curren perspecives o behavioral corporae finance as (1) ocusing on raional managerial acions o accoun or he biases o invesors, and (2) invesigaing wheher behavioral biases influence managerial financial decisions. In he firs perspecive, he firm is a relaive basion o financial raionaliy ha imes financing decisions based on an undersanding o invesor psychology and rames decisions wih his same psychology in mind. Te second perspecive allows managers o run firms wih some o he same behavioral biases as invesors, and hese biases influence an organizaion’s financial decision-making process. Boh approaches have some validiy bu also some problems. A reasonable assumpion is ha managers can raionally use heir superior inormaion and experise o efficienly finance he firm and beter rame financing decisions han a group o invesors wih limied ime or analysis and bounded raionaliy, and when an individual firm is jus one o a porolio o invesmens. Ikenberry, Lakonishok, and Vermaelen (1995) show ha when companies repurchase heir own shares in he marke, hose repurchased shares ouperorm in subsequen periods compared o benchmark indices and o similar firms. Tus, companies presumably can use heir superior inernal inormaion o beter ideniy inrinsic firm value han can invesors and hey use his o make posiive financial decisions ha benefi overall shareholder value. Tis firs raionalis perspecive o behavioral corporae finance is very much wedded o a radiional behavioral finance perspecive o noise raders versus smar money (Black 1986). Managers are posiioned as smar money, whereas invesors are posiioned as noise raders allowing idenifiable mispricing o exis in sock prices. Various

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problems exis wih his perspecive ha suggess i will no play a srong role in he uure o behavioral corporae finance research. One problem is ha his research largely ress on very minimal invesigaion o a company’s moivaions o underake his ype o behavior. Single-quesion anonymous surveys o company execuives, usually he CFO, are he mos common source o claims ha companies reac o heir percepion o marke over- or undervaluaion o heir sock (Graham and Harvey 2001). Ye, litle is known abou how companies ideniy mispricing or wha valuaion models are used and how hese differ rom hose o invesors. Tus, researchers canno know i execuives’ moives are ruly raional. A second, more undamenal issue is he lack o knowledge abou wheher managemen is reacing o invesor behavioral bias–driven irraionaliy or jus invesor mispricing. aional managemen responses o invesors making undamenal errors o valuaion is no “ behavioral” in he sense ha i does no use psychological heories o advance undersanding o financial decision making. Alhough richer inormaion on how firms make hese decisions can overcome he firs problem o a lack o knowledge abou managerial moivaions, he second problem resrics he poenial or behavioral insighs o play a role in he uure o his aspec o modern behavioral corporae finance. Te second perspecive, whereby managers migh be subjec o behavioral biases ha influence heir financial decision making, offers a more producive avenue or he uure developmen o behavioral corporae finance. Te research o dae has largely invesigaed he overconfidence and opimism o CEOs wih various approaches or measuring overconfidence, and links he presence o overconfidence o risk aking in he company’s financial decisions. For example, Malmendier andae (2005) measured overconfidence by he holding o in-he-money, own-company opions by CEOs. Te premise is ha CEOs who hold undiversified porolios hrough large own-company invesmens or unexercised in-he-money opions are overconfiden. ecen research has developed his urher by refining he measuremen o overconfidence. For example, Huang and Kisgen (2013) draw on he greaer likelihood o males being overconfiden o show ha males make more acquisiions. Graham, Harvey, and Puri (2013) used psychomeric esing o deermine he opimism o CEOs, and hey link his o heir atiudes on risk aking. Oher research, beyond he scope and purpose o his chaper, has expanded he range o CEO characerisics invesigaed, such as humiliy (Ou, Waldman, and Peerson 2016) and narcissism (Akas, De Bod, Bollaer, and oll 2012). An issue wih he curren primary ocus on he behavioral influence o he CEO is ha much managemen research conends he CEO plays only a small role in he overall direcion o he firm. Quigley and Hambrick (2015) repor ha CEO influence accouns or abou 20 percen o he variabiliy in perormance o U.S. companies in recen years. Tis variabiliy is measured by variabiliy in profi as a percenage o sales, profi as a percenage o asses, and marke-o-book raios. Tis finding represens an increase rom abou 10 percen influence on variabiliy in perormance rom he 1950s, so CEOs have apparenly become more influenial over ime. Sill, CEOs only explain abou one-fifh o perormance, and a naural quesion arises as o wheher behavioral finance is ocusing oo narrowly by concenraing on a person who explains a relaively small percenage o perormance. In he same analysis, general company characerisics explain abou 30 percen o perormance variabiliy and 50 percen o he explanaion or perormance variabiliy is simply “unknown.”

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A urher issue is ha curren behavioral corporae finance sudies o he CEO seek o ideniy single behavioral aces o hose CEOs, so researchers are no capuring much o hese individuals’ decision-making perspecive. Te influence o he CEO on company direcion in oher counries differs rom ha which happens in he Unied Saes. Crossland and Hambrick (2007) find ha he influence o he CEO is much less in Germany and Japan compared o he Unied Saes, which raises quesions as o he inernaional applicabiliy o he U.S. behavioral corporae finance ocus on he CEO. Coninuing wih Hambrick’s body o research, he seminal paper by Hambrick and Mason (1984) conends ha CEO characerisics mater, bu ha ocusing on he wider op managemen eam (he “upper echelons”) is probably more imporan, and he modern ocus o research on sraegic corporae decision making akes place here. In a laer review o his 1984 aricle, Hambrick (2007, p. 334) summarizes he impac o he paper as creaing a consensus o “atenion o execuive groups, raher han o individuals, ofen yield[ing] beter explanaions o organizaional oucomes.” Papadakis and Barwise (2002) offer an example o his research, having invesigaed wheher CEO characerisics or op managemen eam characerisics mater more in explaining 70 sraegic decisions made by Greek firms across differen sraegic areas. Teir resuls show ha ocusing on he op managemen eam is a much more useul clue in explaining such decisions. Tus, behavioral corporae finance research needs o become more amiliar wih he influence o no jus he CEO and maybe he CFO bu also he res o he op managemen eam i researchers wan o move in line wih acceped managemen wisdom on how companies acually make sraegic decisions. Tis seems paricularly imporan or sraegic corporae finance decisions ha are no purely financial, such as acquisiions, bu probably o less imporance or more core financial decisions on how o finance he company. Ulimaely, he uure o behavioral finance also needs o become more amiliar wih organizaional heory, which is he holisic view o how he company is organized and how his influences is decision making. DiMaggio and Powell (1983) provide he classic reerence on he sociology o he corporaion, arguing ha hree insiuional acors coercive, mimeic, and normaive isomorphism work ogeher o deermine decision making and creae similariy beween companies. Coercive isomorphismreers o exernal culural influences on he company; mimeic isomorphism is he imiaion o oher companies’ pracices in he ace o uncerainy; and normaive isomorphism is based on sandards and norms ha influence company behavior. Imagining how hese acors would influence corporae financial decisions is easy; ye, he acual implemenaion o his heory is ar rom sraighorward. As menioned earlier, implemenaion requires researcher amiliariy wih inerpreivis qualiaive mehodologies, such as acion research and grounded heory. A final large gap in modern behavioral corporae finance research needing o be addressed is a greaer undersanding o how culural differences and behavioral biases inerac o influence corporae financial decisions around he world. Behavioral corporae finance is largely U.S. based a he momen. Unlike research in similar disciplines such as managemen, researchers have no ye made a sufficien effor o ocus on crossculural differences in behavior. Evidence shows here are cross-culural differences in a wide range o corporae finance behaviors, such as dividend pay-ous (Fidrmuc and

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Jacob 2010), corporae governance (Bushman, Pioroski, and Smih 2004), and cash holdings (amirez and adesse 2009). However, he ineracion beween culure and psychological heories is complex. Lucey and Dowling (2014), using emerging markes as an example, examined each o he main psychological heories and how hey differ across culures, and hey ound significan culural influences. A summary o he analysis in ha work suggess ha o he hree main psychology fields applied in finance (cogniive, emoion, and social), social psychology is he mos likely o vary across counries owing o heir srong culural influence. Emoional effecs are largely universal, and cogniive biases need o be individually assessed, because here is an imporan ineracion beween acual cogniive biases and levels o experience ha differs across counries. Tese findings sugges much more work needs o be done o make behavioral corporae finance have inernaional relevance. Inernaional sudies need o deermine appropriae ineracions beween culural effecs and psychological influences on corporae financial decision making.

The Future of Investor Psychology and Asset Pricing Invesor psychology involves he applicaion o cogniive, emoion, and social psychology heories o an undersanding o invesor decision making (Hirshleier 2001). Te field o cogniive psychology provides decision-making biases ha can explain how invesors migh make subopimal invesmen decisions. Emoion psychology explains he role o eelings in invesor decision making, whereas social psychology offers some explanaion or how collecives o invesors migh make joinly influenced and biased invesmen decisions ha are priced in he cross-secion o asse prices. One undamenal issue ha needs o be addressed or he uure o behavioral asse pricing is he eviden ailure o he field o develop producive research. Te limied evidence suggess ha many idenified asse pricing findings are jus no real, using robus saisics. Te influenial Sullivan, immerman, and Whie (1999) sudy, or example, finds ha mos echnical rading rules simply have no saisical suppor afer making appropriae robusness adjusmens. More recenly, Harvey e al. (2015) claim ha mos asse pricing models do no sand up o scruiny afer applying a differen, bu similar, se o robusness checks or daa mining, Te models checked were predominanly based on radiional finance principles raher han on behavioral ones, suggesing a wider problem wih he enire field o asse pricing. Tese findings are likely o be only a small indicaion o a wider problem, as he robusness adjusmen echniques usually ake accoun only o published research. A known bias in publishing exiss oward acceping papers wih saisically significan findings. I he asse pricing researchers coninue o produce large volumes o research ha is, a leas indirecly, a produc o daa mining, hen i will necessarily become a degeneraive research program. Tis siuaion is a challenge or researchers in invesor psychology, bu also an opporuniy because advances are possible in undersanding invesor psychology and is influence on asse pricing. Te remainder o his secion conains poenial ways or he field o reverse is curren downward rajecory.

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THE APPLICATION AND FUTURE OF BEHAVIORAL FINANCE

Te firs, large opporuniy is in senimen modeling. Tere has been a prolieraion o senimen models in recen years as new approaches o, and daa or, measuring invesor senimen have become available. Tese models range rom he undamenal daa approach o Baker and Wurgler (2006) o modern atemps o capure he emoions o groups o invesors hrough social media sources, such as he witer senimen model o Bollen, Mao, and Zeng (2011). Te exponenial growh o compeing models suggess ha undersanding senimen is in is inancy, wih new models appearing on he marke on a daily basis ha are oued as he laes cure-all or undersanding senimen. Ye, senimen modeling does offer he bes poenial or behavioral asse pricing o inegrae boh psychological influences on invesors and he social psychology group effec o many invesors experiencing hose influences. An issue a he momen is he heoreical naure o he curren senimen measures. Even he seminal Baker and Wurgler (2006) model uses six variables wihou srong jusificaion or how he auhors seleced hose six variables ou o an almos infinie universe o possible senimen measures. Te auhors pu hese six variables in a principal componen analysis o exrac acors, hus involving more judgmen as o wha he acors acually represen. Finally, hey made an adjusmen or wha hey consider “raional” senimen and “irraional” senimen. Once again, he auhors do no seriously explore wha raional senimen migh mean or consider wheher raional and irraional senimens can possibly be disenangled rom an invesor perspecive, even i a saisical ool echnically allows he procedure o be done. Such a daa-driven exercise imbued wih judgmen a each sage is unlikely o offer a core heory or senimen models going orward. In he uure, invesor senimen models need o have a core o undamenal heory o guide he building o he model. Oherwise, his area o sudy runs he risk o having a wide range o compeing models ha are simply saisically compared, ofen using very limied daases, raher han undamenally coheren models. wo possible ways or developing his undamenal heory include (1) undersanding he naure o senimen beter hrough experimenal finance, and (2) collaboraing wih compuer science researchers o beter capure he daa needed o measure senimen and advance senimen heories. Senimen is he residual influence o groups o invesors making radin g decisions based on shared opinions. Alhough hose shared opinions are likely o be predominanly raional expecaions abou he prospecs or invesmen, here’ s also a role or eelings such as opimism and pessimism. Overconfidence and oher cogniive biases migh likewise be imporan i decision makers widely experience heir heurisic influence. Experimenal finance probably offers some o he bes poenial o model he real influence and naure o senimen, and i already has a wide range o sudies in his area, such as Smih, Suchanek, and Williams (1988) and Haruvy, Lahav, and Noussair (2007). Ye, a need ex iss or such ex perimenal sudies o creae more realisic marke environmens, perhaps in a field seting , and o ocus more on he naure o senimen. Tis should oser greaer undersandin g o he complexi y o how senimen is seeded and evolves, including he oundaional psychological and financial acors ha inerac o creae and drive senimen. Behavioral finance researchers in he senimen area need o collaborae wih experimenal finance eams o creae such models.

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The Future of Behavioral Finance

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Collaboraion wih daa scieniss rom he compuer sciences is necessary o undersand how o model he daa ha is now available o measure senimen, such as daa rom witer and oher social media sources. esearchers have been largely conen o keep such daa analysis reserved or behavioral finance researchers, despie his no being an area o obvious experise. Sharing he analysis wih researchers who are expers in handling he daa and deermining is meaning is a necessary nex sep. Expecing behavioral finance researchers o be as amiliar wih inerrogaing wha is ofen muliple erabyes o social daa as hey are wih developing behavioral heories is unrealisic. Tis shif means more behavioral finance research will need o find a home in compuer science journals as a way o demonsraing ha he daa approaches are considered valid wihin compuer science. Experimenal finance in general offers srong poenial o inorm heory building in asse pricing. Indeed, i already perorms his role o some exen, such as he aoremenioned senimen models. However, barriers exis beween experimenal finance and behavioral finance ha limi idea sharing. Noussair (2016) speaks o hese issues in his Presidenial Address o he Sociey or Experimenal Finance in 2015, suggesing i is somehing abou which experimenal finance exhibis awareness. Te firs issue ha Noussair raised was ha experimenal finance emerged rom experimenal economics and so i did no explicily originae o work wihin behavioral finance. Tis srcin is no a problem wih experimenal finance bu, raher, speaks o poenially differen moivaions wihin he wo disciplines o experimenal and behavioral finance. Te second issue is ha experimenal finance researchers do no sufficienly collaborae wih researchers in oher finance subdisciplines. A similar commen could easily be made abou he need or behavioral finance researchers o collaborae wih experimenal finance researchers in order o build valid behavioral finance heories. Te ac ha some researchers bypass experimenal finance research and go sraigh o psychological heories ha migh be inapplicable in a finance conex seems perverse. According o Noussair, abou hal he research presened a he 2015 Sociey or Experimenal Finance annual conerence was on asse pricing, and anoher 36 percen o he papers involved invesor characerisics, so he curren lack o deep inegraion beween experimenal finance and behavioral asse pricing is surprising, given he similariy o ineres. Oher approaches o improve robusness involve researching ouside o equiy pricing in he applicaion o behavioral heories. Cummins, Dowling, and Lucey (2015) applied behavioral principles o he pricing o nonerrous meals, represening a firs sudy in hese markes. Te ac ha researchers conduced in 2015 he firs invesor psychology sudy o he huge aluminium, nickel, copper, in, lead, and zinc financial markes suggess he discipline is confined o equiy pricing. o wha oher markes migh ses o behavioral heories apply? Expanding behavioral asse pricing research ouside o equiy pricing is likely o be a eaure in he uure, and is already under way. Te poenial o explore hisoric daases or evidence o behavioral influences on asse pricing figures prominenly in uure research effors. In recen years, researchers have consruced rerospecive sock prices or he eigheenh and nineeenh cenuries ha are broadly uninvesigaed rom an invesor psychology perspecive. For example, he Global Financial Daa daabase provides sock price daa as ar back as 1693 and commodiies pricing daa as ar back as he hireenh cenury. Invesigaing cogniive biases on such hisorical daa is likely o be o limied use, owing o he ac ha modern

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invesors are no cogniively comparable o invesors in hose previous eras. However, such daa offer he poenial or research ino he influence o emoional and social psychology on invesing, given ha emoional and social psychology influences are likely o be innae acors in invesor behavior (Lucey and Dowling 2014). One recen eaure o markes he increase in cross-marke conagions owing o he “financializaion” o markes (Flassbeck, Biccherti, Mayer, and iezler 2011) also offers new poenial or behavioral asse pricing researchers, in a conex similar o ha o exploring new financial markes. Te rise o financializaion should increase he conagion o behavioral principles across markes and hus offers a raionale or exploring new markes wih which behavioral equiy marke researchers currenly lack amiliariy. Anoher issue ha may become more prominen in he uure o invesor psychology research is he need o incorporae culure ino invesor behavior models. Tis issue is similar o he need in behavioral corporae finance. Wih a culural behavioral asse pricing perspecive, invesor psychology research largely dominaed by he sudy o AngloSaxon culure counries is likely o be increasingly viewed as merely regional sudies o phenomena ha probably differ across counries. Asse pricing behavioral paterns such as momenum are culurally deermined. For example, Ji, Zhang, and Guo (2008) find ha Chinese invesors are more likely o predic a reversal rom shor-erm price paterns, whereas Canadian invesors are more likely o predic a momenum patern.

Improving the Reliability of Behavioral Finance Research Much o behavioral finance research relies on survey or experimenal evidence. Many oher papers rely on proprieary or oherwise “secre” daa. In common wih much o finance and economics, concerns abou replicabiliy and reproducibiliy are increasing, albei rom a low base. Cochrane (2015), who is a leading empirical financial economis, has recenly breahed new lie ino his debae. Mapping Cochrane’s argumens o a behavioral and experimenal perspecive appear worhwhile. One iem o noe is he apparen lack o concern wih reliabiliy in curren behavioral finance research. A Scopus search or “replicaion” or “replicabiliy” combined wih “behavioral finance” or “experimenal finance” yields ew resuls. A a high level, ha o publicaion, a dearh o ineres exiss in he issue. Couner his wih psychology, in which here has been a very acive debae on reliabiliy and replicaion or several years. As psychology is a conribuing ounding paradigm o behavioral finance, his gap is all he more worrisome. One wonders wheher behavioral finance researchers are even aware o he replicabiliy o heories seleced rom psychology. Tis secion explores hree issues: (1) he debae sared by Cochrane (2015) rom a behavioral perspecive, (2) he psychology debae, and (3) a proposal drawn rom areas including behavioral science as o how o improve he reliabiliy o behavioral finance research. Cochrane is one o he mos cied and respeced economiss o his generaion. Ye, he clearly has el uneasy or some ime abou he prolieraion o papers ha are, o all inens and purposes, no replicable. He commences wih a discussion o daa errors

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and daa ragiliy, noing, or example, he coding errors in he influenial einhar and ogoff (2010) paper, he highly sensiive naure o many oher papers o daa or coding specificaion, and he challenges o idenificaion. He adds ha he absence o daa and code accompanying published research makes rue replicaion o repored resuls impossible. Paricularly problemaic are secre daa, which are confidenial or proprieary daa. Cochrane advocaes various soluions, bu all disill o he proposiion ha wha is valued maters. Unless and unil finance research values explicily he reproducibiliy and replicabiliy o empirical resuls, via he ediorial, enure, and hiring processes, litle incenive exiss o be open. Wihin economics, a widespread reason exiss o be concerned abou he lack o replicaion and robusness. Ye, a recen se o sudies sugges a widespread lack o ineres in he same. Vlaeminck and Herrmann (2015) find ha even when journals are nominally commited o having a daa-sharing or daa-openness policy, enorcemen is inconsisen and unreliable. Duvendack, Palmer-Jones, and eed (2015), who presened he resuls o a large-scale sudy on he issue, repor ha only 27 o 333 economics journals regularly (i.e., defined as over 50 percen o papers published in a journal) publish daa and mehods files alongside published papers, and only 10 explicily welcome replicaion sudies. Indeed, replicaion is no a consideraion or mos journals, ediors, or auhors. Te Goetingen Universiy replicaion nework (eplicaion Wiki 2016) liss several hundred replicaion sudies, bu ew are pure replicaions in a narrow sense. esearchers have no carried ou similar sudies in finance, suggesing ha he finance field has no even sared o conemplae applying hese issues as a cenral research design approach. esearchers are only beginning o ask wheher economics, and by exension finance, has a replicaion crisis. Based on an examinaion o 13 leading journals and 60 papers, Chang and Li (2015) conclude ha replicaion is generally impossible. Brodeur, Le, Sangnier, and Zylbergerg (2016) raise he issue o “p-hacking” in which researchers use differen models o obain ideal resuls and ail o disclose he ull se o ess. Harvey (2015, p. 37) conends ha “many o he acors discovered in he field o finance are likely alse discoveries.” Te later arises rom poor inerenial saisics in paricular, he ailure o conrol or alse discovery raes and muliple hypoheses. Wha o behavioral finance? Litle sense o urgency exiss in he field, as in much o economics and finance. Clemens (2015) indicaes ha a sandard meric or measuring a paper’s reliabiliy or replicabiliy does no exis. Alhough he oundaions o behavioral finance are siuaed in psychology, he same degree o concern does no ollow. Tis is eviden rom he publicaion o he Open Science Collaboraion sudy (Open Science Collaboraion 2012), which sough o sysemaically replicae all papers published in hree leading psychology journals in 2008. Te sudy shows ha he resuls in erms o replicabiliy are essenially he same as repored in Chang and Li (2015). Te firs secion o his chaper idenified behavioral finance as being a he beginning sages o a progressive research program bu in need o a solid core o heory and appropriae mehodologies in order o coninue o grow. Te reliabiliy o behavioral finance research is, hereore, criical a his sage o is developmen. eliable research requires reliable heories; oherwise an excessive number o heories emerge and valid research has o compee wih research ha canno sand up o rigorous replicaion. Tis siuaion disracs researchers rom pursuing he mos ruiul avenues or uure

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research. Now is he ime o creae a social norm or mehodologies ha incorporae mehod and daa openness so as o encourage replicaion. Nex, here are hree broad soluions or ensuring reliable behavioral finance research. Te firs is insiuional. Cochrane’s (2015) argumens on he need or schools and insiues o ake seriously daa issues in heir hiring and promoion process are worhwhile, bu such a culure change is likely o ake a long ime. Journals also need o make changes. Harvey (2015) offers an ineresing perspecive on he hree main finance journals, in which he describes a rusraed atemp by he ediors o enorce a degree o replicabiliy. Apar rom he argumen on proprieary, or wha Cochrane calls “secre” daa, here is a ear even a he op- ier journals ha his replicaion sandard would damage he comparaive repuaions o he journals, in ha some would no have such a policy, making heir papers less ciable and less “noable.” Firs, in he ineress o research, journals need o insis ha heir auhors make available heir daases and clear mehodology files. esearchers should welcome such ransparency, because i promoes he robusness o he field. I daa canno be made available, hen perhaps ediors can publish papers accompanied by a noe saing ha some resuls involve some degree o “rus.” Ediors could possibly place such papers in a separae secion o heir journals. Calling he secion “Non-eplicable esearch” presumably would rapidly overcome even he mos erven researcher proess. Second, consideraion is needed or pre-experimen research proocols and regisered replicaion repors. Tese sudies would be muli-uni in naure, ollowing he same emplae as o how o proceed, he resuls o which would be published simulaneously, allowing comparison and a sense o he “rue” effec. Tis ramework is currenly being rolled ou in psychology. Tird, here also needs o be consideraion o improving he communicaions inrasrucure o behavioral and experimenal finance. For good or ill, he double-blind peer review or a journal remains he dominan paradigm. Te relaively ew journals ha ocus on behavioral and experimenal areas could consider a degree o hybrid reviewing. In some open-access areas, reviews are done pos-publicaion, as well. Opening up he behavioral finance journals o an explici aim o open-pos replicaion review migh yield benefis. Alhough scieniss are sensiive o replicaion ha ails (Feterman and Sassenberg 2015), i would be a greaer loss no o be open o ideniying poenial ailures. Anoher approach would be o inegrae mea-analysis and srucured lieraure reviews wih replicaion issues. Srucured reviews in medical and cognae disciplines lay he oundaion or urher research; hese are known as Cochrane eviews in he medical sciences. Examples o his approach are increasing in medicine (Pharoah, sai, amus, Phelan, Goode, Lawrenson, and Buckley 2013) and psychology (Nieuwensein, Wiergenda, Wichers, Blom, Wagenmakers, and van ijn 2015), in which he meaanalysis is he firs sage ha inorms he subsequen replicaion. Finally, a newly developed bibliomeric ool, he -Index (Schimmack 2012, 2014), could provide “a doping es or science” (in he words o is creaor) in he orm o a saisical es or bias in a series o sudies. A behavioral finance equivalen o his would allow insigh ino which subareas are mos likely o provide he poenial or ruiul uure research.

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Summary and Conclusions Tis chaper has offered a personal view o he uure concerning many aspecs o modern behavioral finance and has atemped o uniy his perspecive around a common core. Ta is, behavioral finance needs o recognize ha i is jus beginning o be a progressive research program in a philosophical sense. Ta perspecive necessiaes a srong ocus now on developing a robus common core o heory and reaching agreemen on he naure o valid mehodologies. Borrowing heory rom psychology and mehods rom wereignoring a necessary compromise developing behavioral finance as radiional a discipline.finance However, he core pars o a in vibran research program is unaccepable as he field becomes more esablished. Te issues hese compromises raise can be viewed rom he seleced ocus o boh he behavioral corporae finance and invesor psychology secors. Behavioral corporae finance currenly ress on he “raional manager/irraional invesor” perspecive, which is boh poorly specified rom a behavioral heory view and unlikely o offer progressive research. Te oher main ocus CEO characerisics is ou o ouch, in ha managemen research has aken a more holisic view o organizaional decision making. Te influence o invesor psychology on asse pricing is probably he weakes par o modern behavioral finance. Is main poenial conribuion he modeling o senimen is mired in compeing heoreical approaches ha only offer conusion, owing o a prolieraion o measuremens. Tere is a need in invesor psychology research o collaborae wih disciplines hasuch complee he skillses o accomplished appropriaely by invesigae pricing phenomena as senimen; his isneeded primarily working asse wih researchers in he compuer sciences and experimenal finance o build heory and es new complex daases. Alhough his chaper is criical o he curren sae o behavioral finance, behavioral finance has undeniably made asonishing progress rom is sar in he 1980s, when i primarily involved checking or differen reurns a differen imes o he week, monh, and year. Mos behavioral finance research now considers heory as a building block or any qualiy empirical paper. Te problem is o make sure he mos appropriae heories and he mos inormed empirical approaches are used.

DISCUSSION QUESTIONS 1. Discuss he exen o which behavioral finance has progressed philosophically since he 1980s anomalies lieraure, and how i migh develop in he uure. 2. Discuss problems wih he “raional managers/irraional invesors” research sream in behavioral corporae finance. 3. Discuss wheher characerisics o op managemen eams are likely o be eaured in uure research on he drivers o corporae financial behavior. 4. Ideniy and explain key issues ha need o be resolved concerning curren measures o invesor senimen.

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Quigley, imohy J., and Donald C. Hambrick. 2015. “Has he ‘CEO Effec’ Increased in ecen Decades? A New Explanaion or he Grea ise in America’s Atenion o Corporae Leaders.” Sraegic Managemen Journal 36:6, 821–830. amirez, Andres, and Solomon adesse. 2009. “Corporae Cash Holdings, Uncerainy Avoidance, and he Mulinaionaliy o Firms.” Inernaional Business Review 18:4, 387–403. einhar, Carmen M., and Kenneh S. ogoff. 2010. “Growh in a ime o Deb.” American Economic Review 100:2, 573–578. eplicaion Wiki. 2016. Available a htp://replicaion.uni-goetingen.de/wiki/index.php/Main_ Page. Schimmack, Ulrich. 2012. “Te Ironic Effec o Significan esuls on he Credibiliy o MulipleSudy Aricles.”Psychological Mehods 17:4, 551–566. Schimmack, Ulrich. 2014. “Quaniying Saisical esearch Inegriy: Te eplicabiliy-Index.” Available a htp://ww.r-index.org/. Smih, Vernon L., Gerry L. Suchanek, and Arlingon W. Williams. 1988. “Bubbles, Crashes, and Endogenous Expecaions in Experimenal Spo Asse Markes.” Economerica 56:5, 1119–1151. Sullivan, yan, Allan immermann, and Halber W hie. 1999. “Daa‐Snooping, echnical rading ule Perormance, and he Boosrap.”Journal o Finance 54:5, 1647–1691. Vlaeminck, Sven, and Lisa-Krisin Herrmann. 2015. “Daa Policies and Daa Archives: A New Paradigm or Academic Publishing in Economic Sciences?” EconSor Open Access Aricles 145–155. Walsham, Geoff. 2006. “Doing Inerpreive esearch.” European Journal o Inormaion Sysems 15:3, 320–330.

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Chapter 2 The Financial Psychology of Players, Services, and Products 1. Lis and explain some undamenal issues o behavioral finance. Four major enes o behavioral finance are loss aversion, heurisics, overconfidence,

and saus quo bias. Loss aversion is when people evaluae specific financial choices in which hey allocae more imporance o a loss han o earning a gain. Heurisics are menal shorcus people use o process inormaion because o oo much daa, ime limis, or oher pressures. Overconfidence is he inclinaion o overrae one’s level o experise, skills, or abiliies in order o predic invesmen reurns. Saus quo bias is when people suffer rom ineria by deauling o he same decision or acceping he curren circumsance. Adjusing such behavior ofen requires major incenives. 2. Provide an overview o he behavioral finance perspecives o risk. Te behavioral finance viewpoin o risk is based on boh he objecive issues and he subjecive acors in assessing risk or a specific financial service or invesmen produc. A major premise is he noion o loss-averse behavior, in which individuals allocae more weigh o losses han o gains. Consequenly, hey may selec saisacory raher han opimal oucomes. An emerging subjec in behavioral finance concerns an inverse (negaive) relaion beween perceived risk and reurn. 3. Define he heurisic biases o represenaiveness, anchoring, and menal accouning. epresenaiveness is a bias in which individuals have an insincive endency o develop a viewpoin abou a specific experience and over-weigh how much his circumsance reminds hem o oher amiliar decisions. Anchoring is he inclinaion or individuals o lach on o a piece o inormaion or pas experience as a reerence poin or making judgmens and final decisions. Individuals requenly make a financial judgmen on he firs inormaion hey are presened and have problems 579

580

Discussion Questions and Answers (Chapters 2–30)

changing heir assessmen o new daa. Menal accouning is a decision-making approach in which individuals spli heir financial asses ino differen menal caegories or comparmens. 4. Define and describe he process o worrying wihin he finance domain. Te process o worrying is a regular and widespread human experience, especially abou finances. Financial worries induce pas memories and menal picures o uure episodes ha can influence decision making. An individual may have negaive eelings, such as high levels o worry oward risky invesmens, which may resul

in avoiding cerain ypes o financial securiies. Tis behavioral perspecive o financial worry is how an individual migh respond o a specific condiion or judgmen ha resuls in higher levels o depression, dread, regre, or unhappiness abou heir personal finances.

Chapter 3 Individual Investors 1. Discuss he main differences beween he radiional and he modern finance paradigm in undersanding he behavior o individual invesors. Te radiional finance paradigm assumes ha individual invesors make raional decisions and respond only o economic incenives. However, he modern finance paradigm akes a more holisic approach by recognizing he complexiy o indi-

vidual decision making and is collecive influence on financial markes and firm decisions. In he modern paradigm, biological roos, personal lie experiences, psychology, nonsandard preerences, and behavioral conex such as social norms and culure shape individual invesors’ behavior. 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. Sudies show ha invesor behaviors and preerences have biological roos and lie-course deerminans. Alhough many end o describe behavioral biases or nonsandard preerences as subopimal, such behavioral rais and preerences may be he resul o opimal learning in evoluionary ancien imes or in personal lie. Tus, sudies o geneics, neural roos, and lie experiences in finance offer powerul insighs or undersanding he exisence and heerogeneiy o behavioral rais among individual invesors. 3. Discuss he disposiion effec and he proposed explanaions or his effec. Te disposiion effec reers o he endency o invesors o sell winner socks more readily han loser socks. Some expers propose ha he dual-risk atiude embedded in prospec heory generaes risk aversion in he main domain and risk seeking in he loss domain, leading o a greaer endency o realize capial gains. Ohers sugges ha invesors experience realizaion uiliies, which promoe he realizing gains more han he realizing losses. Some show ha cogniive dissonance is parly responsible or he disposiion effec. When invesors can blame heir invesmen managers, hey exhibi no disposiion effec in muual und redempion decisions.

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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. Every individual belongs o social neworks rom which hey acquire inormaion, process inormaion, and reerence heir own behavior. Tus, he group members, group norms, and socieal culures influence invesor decision making. Social ineracion may aciliae wiser invesmen decisions. However, when inormaion sharing among groups is incomplee, biased, or disored, subopimal decisions may prevail. Culure has a disinc, powerul, and long-lasing impac on invesor decision making. Undersanding hese social acors can help provide a beter undersanding o group invesing behavior, socieal rends abou invesing plaorms, and he role o ashion and ads in invesmen ideas.

Chapter 4 Institutional Investors 1. Discuss wheher insiuional invesors are subjec o behavioral biases o he same exen as individual invesors. Empirical evidence suggess ha individual invesors are much more likely o rade based on behavioral biases. Some evidence suggess ha insiuions are subjec o he disposiion effec and overconfidence, bu generalizing his evidence is limied

due o small sample sizes. 2. Explain wheher mood, no direcly relaed o financial undamenals, affecs insiuional invesors. Insiuional invesors seem o be less subjec o mood, unrelaed o marke undamenals, compared o individual raders. However, some mood-based rader behavior seems o exis among insiuions. For example, a sudy o weaher paterns shows ha relaive overpricing o securiies on he Dow Jones Indusrial Average increases on cloudier days a he same ime as does insiuional invesors’ selling propensiies o he securiies. A sock-level mood proxy rom insiuional invesors’ holdings is posiively relaed o a sock’s reurns, especially in more difficul o arbirage securiies. 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. Empirical evidence documens a srong endency o insiuions o herd. Various behavioral reasons could drive such herding. In he case o he insiuional raders, herding appears inormaion based. For cascading, evidence shows ha insiuions ollow each oher’s rades because hey iner inormaion rom each oher. Because insiuions rade on he same inormaion rom he underlying undamenals, herding occurs uninenionally. Boh cascading and invesigaive herding speeds up incorporaing undamenals ino securiy prices and hus increases marke efficiency.

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4. Ideniy how insiuions can exploi behavior biases o individual invesors’ in heir rading choices. Insiuions can exploi individual invesors’ behavioral biases by being on he winning side o he rades. For example, insiuions could ake advanage o marke underreacion o earnings announcemens. Earnings surprises, boh posiive and negaive, are ollowed by a drif because o he marke’s iniial underreacion o he surprise. Insiuional invesors are aware o he drif and profi rom i in heir rades. 5. Discuss how insiuional agens can use behavioral finance o benefi heir cliens. Undersanding basic behavioral characerisics can help financial advisors consruc financial plans and porolio allocaions or heir cliens. For example, financial advisors could adminiser a simple quesionnaire o beter undersand i heir cliens are likely o suffer rom overconfidence or loss aversion. Using he ools rom behavioral finance, advisors can educae heir cliens, consruc and cusomize cliens’ porolios o fi heir invesmen personaliies, and guide cliens during periods o marke urmoil.

Chapter 5 Corporate Executives, Directors, and Boards 1. Ideniy and explain hree psychological acors ha differeniae CEOs in he agency and sewardship rameworks. Tree acors differeniaing CEOs are moivaion, idenificaion, and use o power. Te moivaion o agen CEOs comes rom an economic sel-ineres and leads o behaviors and decisions ha hey perceive as improving heir economic being. Alernaively, seward CEOs are moivaed by inrinsic rewards and acs o enhance heir achievemens and sel-efficacy. Idenificaion reers o aking responsibiliy and blame wihin an organizaion. Agen CEOs exernalize he company’s problems o avoid blame and may exacerbae hem by no aking responsibiliy. Te seward CEO views he problems as an opporuniy o work oward he common goals and earn achievemens. Finally, he use o power in a company in he agency ramework is insiuional in naure o conrol and influence he CEO. In he sewardship ramework, power is on a personal level and derives rom experise, respec, and loyaly. 2. Discuss how CEO opimism migh leado poor capial invesmens. Opimisic managers overesimae an invesmen’s cash flows and underesimae is risk. Tus, some projecs may appear o have a posiive ne presen value when hey really do no. Tis bias leads o invesing in poor projecs. 3. Explain how a CEO migh become overconfiden. Managers end o over-credi heir own role or successes and blame bad luck or poor oucomes. Tis sel-atribuion bias leads o overconfidence hrough experience. Tis overconfidence leads o being more likely o apply or higher-level managemen posions, so overconfiden managers are promoed more ofen.

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Discussion Questions and Answers (Chapters 2–30)

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4. Ideniy and explain group dynamic biases ha migh affec a board o direcors. Groups someimes suffer rom social loafing, poor inormaion sharing, and grouphink. Social loafing, or he ree-rider problem, occurs when board members ail o pu in a high level o effor and sill ge credi or he successes o he group. Tey believe ohers will do heir porion o he work. Poor inormaion sharing occurs when a board member has specialized knowledge bu ails o share i because o he power o knowing somehing ha ohers do no. Also, a board member may ail o share inormaion ha is conradicory o he consensus belie as a confirmaion bias. Grouphink is a ailure o explore alernaive opions by no seriously discussing hem in an effor o achieve consensus.

Chapter 6 Financial Planners and Advisors 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. Financial planners and financial advisors are no regulaed as disinc proessions. Insead, hey are regulaed depending on he uncions hey perorm. Financial advisors who are compensaed or providing invesmen advice are ypically regulaed as Invesmen Advisor epresenaives (IAs) and are affiliaed wih a egisered Invesmen Advisor (IA). IAs are held o a fiduciary sandard o care, where heir recommendaions mus be in he bes ineress o heir cliens. Te Securiies and Exchange Commission (SEC) oversees large IAs and sae securiies regulaors oversee small IAs. Financial advisors who are compensaed or helping individuals buy and sell financial producs are ypically regulaed as a regisered represenaive o a broker-dealer (BD). As such, hey are held o a suiabiliy sandard o care, in which he producs hey sell mus be suiable or heir cusomers. Te Financial Indusry egulaory Auhoriy (FINR) is a sel-regulaory organizaion (SO) ha oversees broker-dealers, and he SEC oversees FINR. Sae insurance commissions regulae financial advisors who sell insurance producs. Financial advisors may be licensed o provide muliple services or cliens. As a resul, hey may all under muliple regulaory regimes. For example, an advisor may be an IA , a regisered represenaive o a BD, and an insurance agen. As such, FINR, he SEC (and/or sae securiies regulaors), and he sae insurance commissions o any sae where he advisor does business would oversee he advisor. 2. Discuss he agency coss involved in receiving proessional financial advice and how o miigae hose coss. Agency coss include monioring coss, bonding coss, and residual losses. Monioring coss involve a principal managing he work perormed by an agen. In financial planning, his arrangemen involves a clien managing he work o his or her financial advisor. Tis monioring can be achieved hrough regulaion by relying on knowledgeable regulaors o oversee he work o financial advisors. Bonding coss ha advisors ypically incur can include he sandard o care o which an advisor is held, such as he fiduciary or suiabiliy sandard. Bonding coss can also include rigorous cerificaions ha can serve as a public signal ha an advisor has acquired

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Discussion Questions and Answers (Chapters 2–30)

adequae financial knowledge o be considered a compeen proessional and is willing o abide by a paricular ehical code o conduc. esidual losses include any addiional losses ha may be incurred, despie he bes effors o he principal. Individuals can miigae agency coss by using an advisor who is willing o incur adequae bonding coss. Tey can also check public records o ensure ha no regulaors or ceriying organizaions have disclosed any disconcering inormaion abou he advisor or he advisor’s firm. 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. Financial advisory firms can be compensaed hrough commissions, a percenage o asses under managemen (AUM), an hourly rae, a reainer ee, projec- based ees, or some combinaion o hese mehods. Commission-based compensaion may enice an advisor o buy and needlessly sell financial producs or o recommend producs wih larger commissions. Advisors wih AUM-based compensaion may seek ways o increase he amoun o managed asses, eiher by incurring more invesmen risk han is opimal or by discouraging wihdrawals rom he porolio o managed asses. Charging an hourly rae may encourage advisors o spend unnecessary ime working on a paricular clien’s siuaion, while reainer ees may encourage he opposie, in which advisors may shirk in heir responsibiliies. Lasly, projec-based compensaion may enice advisors o overesimae he ime and oher resources ha a projec requires or o shor-change he resources acu-

ally used. Alhough conflics o ineres may exis regardless o he compensaion srucure, ehical and compeen financial advisors can operae wihin any orm o compensaion. 4. Discuss he characerisics o individuals who ypically employ he services o financial planners and advisors. Individuals who use a financial advisor end o be wealhier and have more income. Tey also are prone o have beter financial behaviors wih proacive atiudes abou reiremen. Such individuals are more likely o be older and have more educaion han hose who do no use a financial advisor. Women are also more likely han men o repor using a financial advisor. 5. Discuss empirical evidence abou he value o financial advice. Te value o financial advice can include boh quaniaive and qualiaive ac-

ors. egarding quaniaive acors,wih individuals wihclasses. a financial end o have more diversified porolios more asse Tey advisor also end o have higher porolio urnover, incur more ees, and experience lower porolio reurns. Te negaive impacs o using a financial advisor may resul rom misaligned incenives beween he clien and he advisor and may be avoided by miigaing agency coss. Qualiaively, financial advisors may help cliens acquire adequae insurance proecion and avorable ax-shelered accouns. Financial advisors may also help cliens mainain a long-erm ocus, which can be paricularly beneficial during recessions. Some esimae he value o using a financial advisor o be beween 1.5 and 3 percenage poins (150 and 300 basis poins).

58

Discussion Questions and Answers (Chapters 2–30)

585

Chapter 7 Financial Analysts 1. Discuss wheher regulaion solves he problem o bias in analyss’ repors. egulaion solves he problem o bias in analyss’ repors only o he exen ha he regulaions remove bias driven by conflics o ineres. I he bias also resuls rom behavioral acors, such as confirmaion bias or he leniency heurisic, hen regulaion can only reduce bu no eliminae bias. Inormaion uncerainy fills he environmen in which financial analyss orm heir orecass and recommendaions.

As such, he possibiliy o behavioral biases driven by his uncerainy is high. 2. Ideniy wo incenives or environmenal acors ha increase analys bias. Incenives o curry avor wih he firm managers he analyss are ollowing o ge beter inormaion can increase analys bias. Te incenives o please firm managers o increase rading and invesmen banking business or heir brokerage house can also increase bias. Each o hese responses should also lead o increased compensaion or he analys. 3. Ideniy analys characerisics ha reduce analys bias. Some sudies show ha experience in orecasing may reduce analys opimism. Addiional research finds ha analyss who ollow ewer companies and hose who orecas more requenly are less opimisic in heir orecass. 4. Discuss wheher he marke recognizes and adjuss or he bias in analyss’ repors. Much evidence finds ha opimism in analyss’ repors harms smaller and less sophisicaed invesors. Several sudies show ha larger invesors undersand and adjus or he bias in analyss’ repors.

Chapter 8 Portfolio Managers 1. Describe he primary seps o he porolio managemen process. Te firs sep in he porolio managemen process is o esablish he und’s goals along wih is consrains. Nex, he manager develops and implemens he porolio sraegy, which includes deermining an invesmen sraegy o underake and selec he und’s invesmens. Te las sep is o monior and adjus he porolio, which is an ongoing process o ensure ha he und coninues o ollow he esablished objecives. 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. radiional asse managemen firms manage relaively sraighorward, radiional financial producs and are compensaed based on a percenage o heir asses under managemen (AUM). Alernaive asse managers receive boh a ee based on AUM and a perormance ee or reurns above heir high-waer mark. Because hedge und managers receive boh managemen and perormance ees, hey may be incenivized o engage in risk-aking behavior o maximize heir poenial compensaion.

586

Discussion Questions and Answers (Chapters 2–30)

3. Describe he disposiion effec and how i affecs porolios based on an invesor’s uiliy. Te disposiion effec is a phenomenon where invesors eel more srongly abou losses han hey do gains. Ta is, a gain ollowed by an equal-size loss generaes negaive uiliy. Tereore, invesors hold ono losing invesmens because hey do no wan o realize a loss (risk-seeking behavior), bu quickly sell winning invesmens o ensure ha any gains are no eliminaed (risk-avoidance behavior). In a porolio conex, porolio managers end o sell winners oo early and hold losers oo long. 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. Female porolio managers are less likely o display overconfidence bias han are male porolio managers, which has ramificaions on rading aciviy and concenraed posiions. Women also have a greaer abiliy o admi misakes and o sell losing invesmens. Furher, women are less likely o engage in herding behavior and heir porolios have differeniaed reurn paterns as a resul.

Chapter 9 Financial Psychopaths 1. Ideniy he disinguishing characerisics o a radiional psychopah. Te disinguishing characerisics o a radiional psychopah include a pervasive,

lie-long patern o problemaic behavior, 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, lack o moral compass, and absence o remorse. Psychopahs usually presen a charming demeanor. 2. Explain how radiional and financial psychopahs differ. Financial psychopahs are a subse o corporae psychopahs. As such, hey display mos o he rais o radiional psychopahs, bu end o be “passive” in naure. Ta is, financial psychopahs preer o manipulae and exploi ohers hrough acics oher han physical violence. Financial psychopahs have conrol over financial resources raher han managing enire companies. As such, hey use financial insrumens and financial ransacions o inflic damage on ohers in pursui o financial gains or hemselves, experiencing no remorse or he consequences o heir acions. 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. Te bigges acor ha changed he financial environmen is he coninued and rapid advancemen in compuer echnology. Oher key acors include more mahemaicians and compuer- skilled people employed in he financial secor, shifing he personaliy profile o he secor, ransiion o off- exchange rading plaorms, less relaionally based rading venues, financial heories ha emphasize maximizing financial reurns, and loosening o regulaions governing financial markes.

587

Discussion Questions and Answers (Chapters 2–30)

587

4. Explain why correcly ideniying financial psychopahs is imporan. Correcly ideniying financial psychopahs is imporan because hey have he poenial o opple he financial sysem i lef unchecked. Successul financial psychopahs, such as Bernie Madoff and Lee B. Farkus, can operae over long periods wihou deecion. Operaing in his manner enables hem o build up enormous liabiliies rom heir financial schemes, which are usually linked o nonexisen securiies so nohing is backing he liabiliies. A he same ime, he financial psychopah appears o be prospering wih excess money. Te increased linkage o financial sysems globally makes his siuaion even more precarious.

Chapter 10 The Psychology of High Net Worth Individuals 1. Define HNWIs and discuss he demographic rend. HNWIs, or high ne worh individuals, are individuals or households wih more han $1 million in ne worh, which is invesable asses excluding primary residence, collecibles, consumables, and consumer durables. Te global number o HNWIs and heir oal wealh has grown subsanially. Wealh is no only concenraed o he op 1 percen o he world populaion; i also enjoys he highes growh rae a he very op. Asia-Pacific and Norh America drive he majoriy o growh. China and

India are expeced o drive global HNWI growh over he nex ew years. 2. Ideniy he key players in he wealh managemen indusry in heUnied Saes. Te key players in he wealh managemen indusry in he Unied Saes are ullservice broker-dealers (wirehouses), independen broker-dealers (IBDs), independen egisered Invesmen Advisors (IAs), privae banking, and muli-amily offices (MFOs). 3. Discuss he differen assumpions and approaches o behavioral vs. radiional finance. Behavioral finance recognizes real human behaviors and ocuses on cogniive biases and heurisics. Te behavioral finance model combines psychology wih financial heory o undersand he inerplay beween markes and human emoions, personaliy, and reason. Te behavioral approach is evidence based. Te radiional finance

model assumes a “perec” marke or capialo where invesors arewih compleely raional, emoionless, sel-ineresed maximizers expeced uiliy sable preerences. Te radiional approach is normaive. 4. Describe goal-based wealh managemen and holisic invesing. Goal-based wealh managemen considers he shor, inermediae, and long-erm personal heme o HNWIs o help hem prioriize heir goals holisically. Success is measured by how cliens are progressing oward reaching 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. Holisic invesing is characerized by personal relaionships, requen human

588

Discussion Questions and Answers (Chapters 2–30)

ineracions, and cusomized advice. HNWIs are offered inegraed financial planning and wealh managemen advice and soluions encompassing invesmen, credi, ax, esae planning, insurance, philanhropy, and succession planning, boh or businesses and or personal wealh.

Chapter 11 The Psychology of Traders 1. Define overconfidence and give some examples o how overconfidence affecs rading sraegy. Overconfidence is one o he mos severe biases affecing rader behavior. Formally, overconfidence is he endency or someone, such as a rader, o perceive his or her knowledge and skills beter han hey acually are. In pracice, overconfidence induces raders o believe ha hey possess superior inormaion han oher marke paricipans (he beter-han-average effec) or o underesimae he acual riskiness o heir porolios (miscalibraion). Tis mispercepion is popular especially among male raders, leading hem o hold undiversified porolios and o rade more han advisable. Overrading implies a higher amoun o ransacion coss and hus a reducion in he rader’s ne perormance. 2. Describe he main differences beween gregarious and conrarian invesmen sraegies.

A gregarious invesmen sraegy is he endency o raders o ollow ohers’ belies insead o heir own. Tis behavior can be boh raional and irraional. Te ormer siuaion appears when raders preer o ollow he decisions o hose whom hey believe are more inormed or possess superior rading skills. Herding behavior can also be irraional when invesors ollow he group’s belies, even when hey clearly seem erroneous. In his siuaion, he approach is o reduce poenial menal discomor deriving rom wrong individual rading decisions. As several sudies sugges, only a low percenage o raders are profiable. Tus, even hough gregarious behaviors (i.e., momenum-ype sraegies) perorm well when markes are rending, invesors should revise heir sraegies and use an approach ha is he opposie o he majoriy o invesors beore he marke cycle changes. Bu employing a conrarian sraegy does no mean sysemaically moving in he opposie direcion o he rend in all marke condiions. Tus, raders who wan o profiably adop a conrarian sraegy have o ideniy areas where high uncerainy can lead mos invesors o make wrong decisions. Tis usually happens when sock marke prices subsanially differ rom heir undamenal values (e.g., close o marke ops or booms). Ideniying hose areas in pracice can be difficul because emoions play a criical role in influencing rading decisions. Hence, ollowing a profiable conrarian sraegy requires srong menal discipline. 3. Explain he meaning o invesor senimen and provide some examples. Invesor senimen is he atiude o raders oward he marke no jusified by changes in undamenals. Senimen is clear as markes approach ops (or botoms) when mos raders are opimisic (or pessimisic). Ye, he prevalen marke eeling can be difficul o deermine when prices do no show a defined rend.

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Discussion Questions and Answers (Chapters 2–30)

589

wo broad caegories o senimen indicaors are available: he opinionsyle and he acion-syle indicaors. Te ormer group collecs all indexes based on surveys or judgmens o specific caegories o invesors abou uure marke scenarios. An example o an opinion-syle indicaor is he Universiy o Michigan Consumer Senimen Index, which surveys consumers o gaher expecaions abou he overall economy. Acion-syle indicaors include all indicaors describing he acual behaviors pu in pracice by marke paricipans. Examples o acion-syle indicaors are he Commimens o raders (CO), which deails he posiioning o invesors on differen uures markes, and he CBOE Volailiy Index (VIX), which measures he 30-day implied volailiy priced ino S&P 500 index opions. 4. Define possible soluions o miigae opporunisic behavior in rading simulaions. rading simulaions are useul ools o increase experience and improve he knowledge and skills o novice raders. Unorunaely, paricipans can also be induced o adop opporunisic behaviors jus o win he compeiion, such as invesing only in high-volaile asses and concenraing heir porolios. o miigae unrealisic behaviors ha paricipans can exhibi, several opions can make rading challenges more realisic. Tese opions include having paricipans share heir profis and losses wih he subjec promoing he compeiion and no allowing paricipans o direcly observe oher eams. Such acions could improve he qualiy o invesmen simulaions and help overcome cogniive errors affecing novice raders.

Chapter 12 A Closer Look at the Causes and Consequences of Frequent Stock Trading 1. Explain why requen sock rading is bad or invesor reurns. Alhough academic researchers may no all agree on wha drives requen sock rading, hey do agree ha requen rading is derimenal o reurns. Te inerior perormance o requen raders is largely due o heir paying more commissions and generally spending more on ransacion coss. In ac, he more ofen requen raders rade, he more i coss hem. 2. Ideniy he major acors ha migh drive requen rading.

esearch indicaes hahigh various migh drive some people o rade more ofen han ohers, including riskacors seeking, overconfidence, gambling addicion, and emoional issues. O hese acors, risk seeking seems o have he mos evidence as a acor conribuing o requen rading. esearch suggesing ha requen rading may be a orm o compulsive gambling is more recen. 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 leads o he greaes rading requency. ecreaional or leisure moives rea acive invesing as a source o un. Invesors moivaed mainly by his purpose acually enjoy invesing. Te aspiraion or riches moive views invesing similar o a lotery, providing a very small chance or

590

Discussion Questions and Answers (Chapters 2–30)

possibly huge payoffs. Tese invesors may no enjoy invesing, bu hey are very ocused on he poenial oucome. Basically, hey are hoping o become wealhy. Te sensaion-seeking moive ocuses on how he ac o rading, wih all is uncerainies, provides he simulaion and novely some people may eel hey need o keep heir lie exciing. Te hrill o boh he poenial gain and he poenial loss drives invesors moivaed by sensaion seeking. wo o hese groups he recreaional and sensaion-seeking invesors rade or emoional raher han raional reasons. However, only he sensaion-seeking, risk-aking moive acually predics requen rading. In oher words, only invesors who enjoy gambling (he hird group) urn over heir porolios a a much higher rae han oher invesors. 4. Ideniy and explain he gender differences ha exis in invesing and gambling behavior. Males generally rade more requenly han emales, resuling in men having lower reurns han emale invesors. Women are more fiscally conservaive han men and end o inves in less risky asses. Boh risk seeking and overconfidence are more common in men han in women. Overconfidence and risk seeking are also correlaed wih more requen sock rading. O course, differen ypes o risk and overconfidence exis. Compared o women, men seek greaer risk boh financially and oherwise. Men end o be more impulsive. Compared o women, men are more likely o be overconfiden in erms o believing heir skills are beter han average across domains.

In erms o gambling, males are more likely han emales o suffer rom gambling disorder. Males sar gambling a a younger age and end o develop gambling disorder a a younger age 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 disorder, emales seek reamen sooner han men. Tis is also rue o oher psychological disorders. 5. Discuss wheher mobile echnology is likely o affec requen rading. Te rapid increase in mobile device adapaion and usage coninues o affec he global economy. Te global prolieraion o smarphones and oher mobile devices is likely o increase he pervasiveness o requen sock rading. esearchers find ha compulsive gamblers gamble more when new gambling plaorms become available o hem. Tus, he widespread use o he Inerne and mobile devices is likely o also increase he endency o some invesors o indulge in overrading. However, in he conex o invesing in socks, addiional research is needed o undersand he effec o mobile usage on rading requency. 6. Discuss he prevalence o requen sock rading. Frequen rading is a common problem. In ac, some consider invesor overrading as an epidemic. o illusrae, he urnover rae on he New York Sock Exchange (NYSE) reached nearly 100 percen in 2004. Moreover, researchers find ha raional reasons, such as porolio risk-rebalancing needs, do no explain his high rae o urnover. Te problem is paricularly serious or he mos acive raders, who rade much more han he average rader and realize even larger losses or rading oo ofen.

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Discussion Questions and Answers (Chapters 2–30)

591

Chapter 13 The Psychology of Women Investors 1. Explain how men and women view he opic o invesing differenly and why advisors should know his. Hisorically, women have been raised wihou having much knowledge abou money and have deerred o men in he household o make decisions. Some emales may be cauious abou aking conrol o finances; women ofen wan securiy and a sense o belonging. Men view invesing as a compeiive endeavor, in which high risk

o reward is heir accepable. beter serve cliens.Undersanding he moivaions o cliens can help advisors 2. Explain why women ofen lack confidence abou financial maters and how his may affec heir financial decisions. Women are no raised o have high financial confidence, due o socieal pressures ha allow he men in heir lives o conrol he financial decisions. Tis negaively affecs women’s comor and undersanding abou invesing, as well as oher financial maters. Someimes, women’s preerence or low risk or “sae” invesmens can negaively affec heir abiliy o accumulae wealh. 3. Ideniy several imporan financial concerns o women. Women have several imporan financial concerns. For example, many women sruggle o balance heir careers wih heir amily responsibiliies and eel over-

whelmed, andinoverworked. Many concerned abou being able o provide oroverexended, heir loves ones he long erm, evenare afer reiremen. 4. Discuss how he caregiver role affecs invesing. As he radiional caregiver, women look or lower-risk invesmens ha allow longerm reurns wih smaller upron invesmens. Tey spend shor-erm monies as par o heir caregiver roles. Women have o und longer ime rames in reiremen wih a shorer work hisory. Teir shorer work hisory or gaps in employmen ofen resul in smaller defined-pension benefis and smaller reiremen plan balances. 5. Discuss how advisors should rea women. Women need heir advisors o be able o connec wih hem. Women also need o know ha hey are heard and undersood. Women wan someone o workwih hem o undersand he impac ha one decisi on may have on oher areas o heir financial lives.

Chapter 14 The Psychology of Millennials 1. Explain why Millennials are disrusul o he financial services indusry. Millennials came oage in financially unsable imesand many saw heir parens’ financial siuaion compromised. Tey winessed he do-com and housing bubbles burs, he Enron and Bernie Madoff scandals, and he financial crisiso 2007–2008, as well as he subsequen recession and prolonged economic recovery. A 2016 Facebook whie paper repors ha hal o Millennialseel hey have no one hey can rus or financial guidance and ewer han 10 percen rusfinancial insiuions or his guidance.

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Discussion Questions and Answers (Chapters 2–30)

2. Explain how Millennials differ rom Baby Boomers oher han age. One key generaional difference beween millennials and baby boomers is ha Millennials have always had access o he Inerne. Alhough Boomers are “he V generaion,” Millennials are no resriced o jus one screen. Tey are aking he lead in inegraing mobile echnology and he Inerne ino heir lives and hus are changing he way hey consume enerainmen, shop, bank, and inves. Millennials who do no use a financial advisor use hese ools and resources o educae hemselves abou money managemen and financial planning. 3. Discuss how financial advisors can engage Millennials. Millennials are now he larges generaion o dae, surpassing Baby Boomers a 80 million srong. Alhough Boomers currenly hold he greaes amoun o wealh, Millennials are poised o become he wealhies generaion. Financial advisors mus communicae using he language and he ools ha Millennials use, which means having a vial social media presence and a user-riendly websie, blogs, videos, and conen aimed a demysiying wealh managemen and invesing. 4. Explain how money habis o Millennials disprove he sereoype ha hey are a lazy and an eniled generaion. Several sudies indicae ha he unique financial challenges Millennials ace, such as suden deb, have compelled hem o adop responsible money habis. Millennials are oping o save and inves heir money raher han overspend. Millennials are no only conribuing o employer-sponsored reiremen plans bu also using online ools o rack heir expenses, live wihin heir means, and conrol heir wans.

Chapter 15 Psychological Aspects of Financial Planning 1. Lis he six seps o he financial planning process as defined by CFP Board o Sandards and Financial Planning Sandards Board. Te six seps in he financial planning process are: (1) developing and defining he clien-planner relaionship, (2) collecing clien daa including goals, (3) analyzing and evaluaing he clien’s curren financial saus, (4) developing and providing rec-

ommendaions and/or opions, (5) implemening he recommendaions, and (6) monioring he differen recommendaions. 2. Explain why financial planning cliens end o rely on secondary markers o qualiy when judging he advice hey receive rom heir advisors. Financial planning has high credence properies, meaning consumers have difficuly judging he qualiy o he service even afer being rendered. o minimize cogniive dissonance, cliens look o hings hey can direcly observe, such as all orms o communicaion.

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Discussion Questions and Answers (Chapters 2–30)

593

3. Discuss how he availabiliy heurisic can affec a financial planning clien’s percepion o financial planning recommendaions and/or propensiy o ac on hem. Availabiliy reers o he propensiy o be biased by inormaion ha is easier o recall such as highly impacul or more recen memories. For insance, a clien’s willingness o buy long-erm care insurance ofen depends on wheher his individual personally knew someone who had received home healh care assisance or lodging a a skilled nursing aciliy. Personal experience o long- or shor-lived relaives could influence he willingness o plan or a long reiremen. 4. Describe how he menal biases o overconfidence, anchoring, and loss aversion can inerac o cause financial planning cliens o make subopimal decisions. Anchoring bias, overconfidence, and loss aversion can resul in poor decisions and oucomes. Overconfidence ofen resuls in employees holding oo much in employer sock or opions, believing hey have insider insighs ha are superior o marke signals. Loss aversion and he anchoring bias can influence hese employees o coninue o hold employer sock and opions even when a reversal in he company’s orunes or hose o is indusry causes is sock price o decline, confirming he wisdom o broad diversificaion.

Chapter 16 Financial Advisory Services 1. Explain he difference beween financial advisors and brokers. Brokers ofen represen he firms whose producs hey recommend and sell, whereas financial advisors operae independenly o hese firms. Furhermore, unlike salespeople and brokers, financial advisors in mos counries are required by law o pu heir cliens’ ineress ahead o heir own. Alhough financial advisors may receive some commissions based on sales o cerain financial producs, he variable earnings o brokers consis enirely o commissions. 2. Discuss he purpose o financial advice o consumers. Financial advisors help heir cliens ariculae heir financial goals and implemen seps o achieve hese goals by providing advice on saving, credi, axaion, he choice o financial producs rom differen providers, invesmen opporuniies,

and various wealh and income risks. Also, consumers may delegae managemen o heir invesmens and pensions o financial advisors. 3. Describe he ypes o consumers who are more likely o look or financial advice. Women are more likely o seek ou financial advice han men. In laboraory seings, less financially lierae consumers are more likely o look or financial advice, alhough hose acually receiving financial advice ouside o he laboraory are ypically richer, older, beter educaed, and more experienced invesors. People who are more uure oriened and anxious are also more likely o use financial advice.

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Discussion Questions and Answers (Chapters 2–30)

4. Explain why high-qualiy financial advice may no reach hose who would benefi he mos rom i. Financial advisors may find providing high-qualiy advice only o well-inormed and wealhy consumers because hese advisors believe ha (1) less sophisicaed consumers could have a lower willingness o pay or advice because hey are unable o disinguish beween good and bad advice, and (2) poorer consumers are less profiable due o heir smaller porolios and less wealh. When consumers pay or financial advice wih upron ees and no by commissions, hose wih less experience and financial sophisicaion migh be relucan o pay beore hey can see he benefis. 5. Describe characerisics o financial advisors ha affec he degree o which consumers ollow heir advice. Consumers value financial advisors wih more experience, bu hey preer advisors who use less echnical language and invesmen jargon. Alhough confidence is imporan, advisors who admi some uncerainy abou heir recommendaions end o be more persuasive. Consumers ake more advice rom advisors deemed rusworhy, which is also relaed o a degree o ailoring and personal involvemen in he advice process. Consumers are also more likely o be persuaded by advisors similar o hem in erms o gender, educaion, age, region, and poliical affiliaion.

Chapter 17 Insurance and Risk Management 1. Explain he our primary responses o risk. Te our primary responses o risk are risk avoidance, risk reenion, risk reducion, and risk ranser. isk avoidance is a response o risk in which individuals avoid he aciviy alogeher. isk reenion is a orm o sel-insurance in which individuals reain he risk and pay or some o he loss hemselves. isk reducion is a response o risk in which individuals ake precauionary measures o reduce he likelihood or severiy o a loss. isk ranser is a response o risk in which individuals ranser a porion o poenial risk o a hird pary. 2. Discuss he hree primary ypes o hazards associaed wih risk managemen. Te hree primary ypes o hazards are physical, moral, and morale hazards. Physical

hazards arise rom condiionMoral or usehazards o he propery isel. An example physical hazard is ice onhe a sairway. involve dishones behavioroina which he individual causes he loss inenionally. A morale hazard involves atiudes o negligence and carelessness. An example o a morale hazard is when an individual leaves a spare key under he door ma because he knows he has insurance. 3. Discuss he hree mos prevalen risk atiudes. Te hree mos prevalen atiudes oward risk are risk neural, risk adverse, and risk seeking. isk-neural invesors are more concerned abou he expeced reurn rom an invesmen regardless o he risk. isk-adverse invesors require a higher reurn when aking a higher level o risk. isk-seeking invesors accep higher levels o risk even when uncerainy abou he reurn exiss.

59

Discussion Questions and Answers (Chapters 2–30)

595

4. Ideniy and discuss he five main ypes o insurance or individuals. Te five main ypes o insurance or individuals are: • Disabiliy: Some disabiliy policies guaranee income replacemen o 50 o 60 percen o he policyholder’s income. Te cos o disabiliy insurance is based on many acors, including age, occupaion, and healh. • Lie: Tis ype o insurance proecs a amily or business rom loss o income due o deah. • Propery causaliy: Tis ype o insurance proecs agains propery losses o a business, home, or car and agains he liabiliy ha may resul rom injury or damage o ohers. • Healh insurance: Tis ype o insurance pays or covered medical and surgical expenses. Te insured can be reimbursed or expenses or he care provider can be paid direcly o he care aciliy. • Long-erm care: Tese policies reimburse policyholders a daily amoun or services o assis hem wih aciviies o daily living, such as bahing, dressing, coninence, ranserring rom bed o chair, or eaing. Te cos o he policy depends on an individual’s age, benefis chosen, and healh a he ime he policy is issued. 5. Discuss he hree subcaegories o behavioral finance heory. Te hree subcaegories o behavioral finance heory are biases, heurisics, and raming reerences. Bias is a endency oward paricular mehods o hinking ha can lead o bad judgmen and irraional decision making. Common behavioral finance biases

include chasing rends, overconfidence, and a limied atenion span. Heurisics are menal shorcus ha help people make decisions aser. Commonly used heurisics include availabiliy and represenaiveness. Framing is an example o cogniive bias in which people reac o a paricular choice in differen ways depending on how i is presened, such as a loss or a gain. Individuals end o avoid risk when presened wih a posiive rame, bu seek risk when presened in a negaive rame. Some common raming effecs are regre aversion, disposiion effec, and anchoring.

Chapter 18 Psychological Factors in Estate Planning 1. Ideniy he issues ha creae differences beween esae planning and oher areas o financial planning ha can impede or preven progress.

Several differences beween esae planning and oher areas o financial planning can affec progress. For example, esae planning involves a discussion o moraliy, which is an uncomorable discussion or boh planners and cliens. Te effeciveness o an esae plan is ofen measured afer he demise o he clien. 2. Discuss he dimensions ha differeniae esae planning rom oher areas o financial planning and wealh managemen in erms o he emoions accompanying decision making. Several dimensions involving emoions ha accompany decision making differeniae esae planning rom oher areas o financial and wealh managemen. For example, discussions involving moraliy are very difficul or many people. Family and marial dynamics can also influence he planning process. Cliens may have

596

Discussion Questions and Answers (Chapters 2–30)

difficuly relinquishing heir wealh, even afer deah, and may consider plans ha atemp o conrol heir wealh afer deah. 3. Explain why esae planning calls or collaboraion beween he planner and clien, as well as beween he clien and inheriors. Alhough an atorney has an obligaion o represen his clien, esae planning requires considering he impac o he esae on beneficiaries, and he planning process may require involving amily members and ohers who may serve as inheriors. Tis consideraion is necessary o address issues relaed o legal issues and

ax-relaed planning. 4. Discuss how esae planning presens unusual challenges or he legal or planning proessional. Esae planning presens several unusual challenges or he legal or planning proessions. For example, he planner may need o include oher paries in he planning process, which may produce difficulies around issues o confidenialiy and privilege. Including oher paries may also require a level o skill in managing he emoional dynamics o a amily, which may be beyond he planner’s sphere o proessional compeence. 5. Explain how ranserence or couner-ranserence migh play a role in proessional engagemen. ranserence or couner-ranserence could affec he proessional engagemen in

several ways. Wheher or no he proessional has deal wih his own issues o moraliy, any o ha individual’s unresolved conflics may play a role in he ineracion, on eiher a conscious or an unconscious level. Addiionally, discussing an esae plan could mobilize eelings abou he relaionship o he clien o his amily and ouch on eelings he planner has or he people in his lie.

Chapter 19 Individual Biases in Retirement Planning and Wealth Management 1. Discuss he biases individuals have when considering heir need or financial planning. Individuals exhibi many biases when assessing wheher hey need financial planning. For example, hey ofen raionalize heir saus quo and eel ha hey are fine handling heir money. However, his can be a consequence o waning o use money or emoional and sel- expressive pursuis. Even when eeling ha he curren siuaion is no opimal, hey choose o keep heir head in he sand, exhibi ing he osrich effec. Planning involves hinking abou he uure, which conrass wih he presen bias, which ocuses on living or oday. Ofen, people ollow he herd. I heir riends are managing heir finances in a cerain manner, hen hey may conclude ha he herd is righ. Addiionally, people ofen suffer rom he bias o available inormaion when deermining he bes financial course o acion. Discovering more complicaions migh require an invesmen o boh ime and emoion.

597

Discussion Questions and Answers (Chapters 2–30)

597

Many people spend o boos heir sel-eseem. Friends can own heir cars and houses, bu may have low bank balances. Some o he need or greaer sel-eseem may emerge rom one’s culure or race. Sereoypes ofen exis abou gender and marial saus. No ollowing hese expecaions can be emoionally axing. Tus, ollowing he herd is ofen easier han going agains i. 2. Discuss he raionale or hiring and he crieria or selecing a financial proessional. Many people hink in erms o a milesone-marked, linear financial planning pro-

cess: secure a job, ge married, buy a house, sar a amily, plan or children’s college, and finally, plan or reiremen. Individuals ofen associae wih a peer group ha holds he same view. For example, when eachers join a school sysem wih a definedbenefi pension plan, he employer is he predominan conribuor. Someimes, he plan requires employee conribuions or permis volunary conribuions. For hese and many oher public employees, he pension plan is designed o pay expeced benefis when needed. Workers wih elecive plans, such as 401(k) plans, however, mus make heir own conribuion and invesmen decisions, ollow heir peer group’s acion, or hire someone o help hem. Even when hey are proacive in hese maters, hese workers ace grea uncerainy concerning projeced benefis upon reiremen. Te decision wheher o hire a proessional should a leas include evaluaing he ollowing areas o financial lieracy: (1) abiliy o evaluae an advisor, (2) financial saus, including he mix o credi/deb, (3) reiremen planning, (4) college planning, (5) insurance planning, (6) ax planning, (7) esae planning, and (8) invesmen planning. Much conusion exiss over he erm “financial advisor.” Because no proessional financial advisor designaion exiss, a wide range o proessionals who sell invesmen and insurance producs call hemselves financial advisors. Financial advisor sounds beter han agen, financial recommender, or financial salesperson. A proessional financial advisor: • Acs as fiduciary and gives advice in he bes ineress o he individual. • Holds an indusry designaion ha includes reiremen planning, invesmen planning, and insurance planning. • Mainains an indusry designaion requiring coninuing educaion. rusedinormaion advisor is imporan. ofen base hisChoosing choice onalimied or wihouUnorunaely, delving ino heindividuals advisor’s credenials. Some advocae ha rus should be based on credenials, honesy, and reliabiliy. Ohers ocus on a financial proessional’s claim o large asses under managemen and ascribe alen or fiduciary oversigh (working in heir bes ineress) o his claim. Tis leads people o assume, raher han confirm, ha heir financial proessional is working as a fiduciary. 3. Discuss several biases ha individuals should overcome in he financial planning process. Many individuals would raher spend money on un oday han hink abou heir uure. Tis requires hem o change rom a compleely presen bias o one ha

598

Discussion Questions and Answers (Chapters 2–30)

considers heir long-erm financial healh. Money saved or a poenial uure emergency or insurance ha may or may no be used reduces he available cash o spend oday. People ofen underesimae he probabiliies o realized adverse evens and assume negaive incidens will no occur. Proper risk-planning echniques lead cliens o recognize heir moraliy and ha hey do no ully conrol heir lives. In deermining how much o conribue o a reiremen plan, some workers believe ha hey can reire comorably i hey mach he maximum employer conribuion. Many pursue beaing he marke wih heir reiremen money raher han considering he risk reducion o a broad asse allocaion, which is indicaive o an overconfidence bias. Te media gives invesors overconfidence in heir abiliy o ouperorm he marke. 4. Explain how employers can nudge employees oward financial securiy. Employers can use inelligen deauls o aciliae increasing he reiremen savings o heir employees. Mos imporan, all employees should be deauled ino paricipaing in he plan. Ineria will work oward he benefi o having mos employees say in he plan. Employers engaging qualified financial proessionals o provide employees a reiremen gap analysis could also help promoe reiremen. Mos employees do no have he abiliy o calculae he required savings and rae o reurn arges o reire comorably. A financial proessional no only can help hem wih hese calculaions bu can also ac as a coach during he plan’s implemenaion, which may las 20 o 40 years. Employers can also expand guidance on all

employee benefis including healh, disabiliy, lie, and long-erm care insurance. 5. Describe how financial planners can nudge cliens oward financial securiy. Much conusion exiss abou hevarious regisraions and designaions o reail financial proessionals. CFP proessionals represen one o he ew accredied designaions, according o he Financial Indusry egulaory Auhoriy (FINR). Using he FINR websie and oher ools, CFPproessionals can educae cliens abou he kind o financial proessional bes maching he needs o he individual invesor. Similar o an engaged docor, CFP proessionals lisen o sympoms, ask quesions,and perorm diagnosic ess o ge a beter indicaion o an individual’s rue goals and needs. Tis process can be overwhelming o some. Te planner can urn all his inormaion ino clear specific financial goals o atain and creae a muually agreedupon prioriy lis. Many individuals have difficuly changing heir spending habis. A financial planner can horoughly analyze a clien’s spending patern o see ways o reallocae expenses ha may no be apparen o he individual. Te greaes value or many individuals is having an accounabiliy parner who can empahize wih heir siuaion. Many individuals have no ormal knowledge o invesing. Invesmen risk is known o be one o he more emoional issues aced by individuals. A financial proessional using a risk and reward evidence-based mehodology can educae cliens on he available opions or managing invesmen risk. Finally, in knowing ha financial managemen is an emoional process, he advisor helps he clien celebrae ataining cerain milesones, providing posiive reinorcemen.

59

Discussion Questions and Answers (Chapters 2–30)

599

Chapter 20 Traditional Asset Allocation Securities: Stocks, Bonds, Real Estate, and Cash 1. Define acical asse allocaion (TAA) and discuss he advanages and disadvanages relaive o sraegic asse allocaion (SAA). AA allows or greaer flexibiliy in deviaing rom arge weighs over he shor o inermediae erm. Tese deviaions usually resul rom a change in risk and/or reurn assumpions due o he economic or marke environmen. Because o he deviaion rom he arge weighs, a porolio ha uses AA has he poenial o ouperorm he benchmark i he assumpions are correc and he adjusmens are execued properly. I, however, he assumpions are incorrec and/or he execuion is poor, he porolio may underperorm he benchmark. 2. Discuss he assumpions used in modern porolio heory (MPT) and radiional finance models. radiional finance describes a heoreical marke environmen in which he paricipans ac solely or heir own benefi and maximize economic uiliy. Te assumpions ha mus be upheld or MP include he ollowing: (1) all invesors have perec and equal access o inormaion; (2) correlaion s beween asses remain consan over ime; (3) reurns are normally disribued; (4) no ransacion coss or axes are applicable; (5) invesor buying and selling does no

affec price; risk-ree rae.and (6) invesors can borrow and lend unlimied amouns a he 3. Discuss he shoralls o mean-variance opimizaion (MVO) porolios and how he Black-Literman model atemps o address hese shoralls. Te shoralls o he MVO model are is high sensiiviy o inpus and overreliance on hisorical daa. Te resuling asse allocaion sraegies are usually heavily concenraed in only a ew asses or securiies. Te Black-Literman model uses CAPM and a reverse-opimizaion process wih marke weighs o generae orward-looking assumpions, raher han relying on hisorical reurns. Te resul is less reliance on hisorical daa in isolaion and porolios wih more diversified asse allocaion sraegies. 4. Disinguish beween cogniive and emoional errors, and provide an example o each. errors are based on heurisics, which are menal shorcus. hey resul Cogniive rom imperecions in human decision making. For example, he decision o hold an equal weigh o all securiies in a por olio because an invesor assumes his creaes a diversiied porolio is called he 1/ N heurisic. Emoional biases are misakes ha invesors make based on heir eelings oward a decision. An example o an emoional bias i s amiliariy in which invesors place grea er value on or express a preerence or holding securiies hey undersand or have a connecion, such as a common sock inheried rom a amily member.

600

Discussion Questions and Answers (Chapters 2–30)

5. Discuss he advanagesand disadvanages omenal accouning and how invesors can manage his cogniive error. Menal accouning is he ac o allocaing capial o differen buckes based on he end use. For example, an individual may have a savings accoun or a amily vacaion and an invesmen accoun o und reiremen. In he conex o asse allocaion, an invesor may have muliple accouns wih differen allocaions o socks, bonds, and cash. Each accoun appears properly allocaed, bu deviaes rom he overall porolio level. Tis deviaion migh cause an over-concenraion in one or more securiies and an inefficien blend o capial. Menal accouning can help an invesor separae unds or his designaed purposes and increase he invesor’s likelihood o achieving long-erm savings goals. Te key o menal accouning’s successul use is no o ollow his sraegy uninenionally. Alhough an invesor can use muliple accouns, he should pay atenion o he asse allocaion o he overall porolio.

Chapter 21 Behavioral Aspects of Portfolio Investments 1. Explain he observed reurn perormance o muual unds, hedge unds, and pension unds. Evidence shows ha muual unds, hedge unds, and pension unds earn, on average,

non-posiive alphas. Alhough hedge unds and pension unds ouperorm muual unds, hedge und ouperormance is less clear on an afer-ee basis. 2. Explain he similariies and differences beween muual unds and hedge unds. Muual unds and hedge unds are boh porolios o asses designed o provide invesors wih places o deploy heir capial and earn reurns. Muual unds are regulaed, ace relaively sric reporing requiremens, and are limied in erms o asses and sraegies available. Hedge unds are generally unregulaed, ace litle o no reporing requiremens, and have a much broader range o asses and rading sraegies available, including shor sales, leverage, and derivaives. 3. Ideniy he behavioral biases demonsraed by und managers. Fund managers demonsrae herding bias by which hey ollow he rades and rends o ohers in he marke, even when doing so does no generae alpha. Addiionally,

und demonsrae overconfidence anddoopimism how hey believeohey knowmanagers hings wih greaer precision han hey and alsoinexpec oucomes be beter han hey are. Oher biases o und managers include amiliariy, home bias, limied atenion, disposiion effec, and escalaion o commimen. 4. Ideniy he behavioral biases demonsraed by hose selecing money managers and relaed producs. Invesors selecing money managers exhibi he same biases as proessional und managers, including herding, overconfidence, opimism, amiliariy, home bias, limied atenion, disposiion effec, and escalaion o commimen. Herding is he endency o ollow oher invesor acions. Overconfidence describes a bias in decision

601

Discussion Questions and Answers (Chapters 2–30)

601

making in which individuals believe hey know somehing wih greaer cerainy han is acually he case. Opimism relaes o biased in orecass ha overesimae poenial oucomes. Familiariy bias is he endency o inves in companies or unds ha are known o an individual. Home bias is he endency o inves in asses ha are geographically close o und headquarers. Limied atenion is a bias relaed o he observaion ha individuals’ ime is scarce and ha his lack o unlimied atenion may lead o cerain biases. Disposiion effec describes he endency o gamble more wih losses han profis. Escalaion o commimen may resul in a und manager’s remaining in a losing invesmen sraegy, which in urn could exacerbae underperormance. Individuals also exhibi he represenaiveness bias, ho-hand allacy, financial illieracy, search coss, diversificaion bias, affec, and exrapolaion bias. epresenaiveness bias holds ha invesors over-weigh recen experience when orming expecaions o uure oucomes. Te ho-hand allacy is he illusion o shor-erm ouperormance, which in realiy is wihin he bounds o expeced perormance. Financial illieracy describes a lack o undersanding abou personal finance and invesing conceps. Search coss reer o he ime and effor required o ideniy invesmens. Diversificaion bias is he endency o diversiy even when doing so is subopimal. Affec is an emoional associaion wih a decision. Exrapolaion bias is a endency o invesors o rea pas evens as predicors o uure evens. 5. Explain he rends in relaive demand or acive and passive sraegies by boh muual und and ETFs. Beween 2000 and 2014, he demand or passive sraegies increased relaive o ha or acive sraegies. In paricular, demand or index muual unds, which ollow passive sraegies, disproporionaely drives he ne cash inflow ino all muual unds. Te growh o EFs has been impressive, wih average annual cash inflows roughly equal o ha o muual unds beween 2003 and 2014.

Chapter 22 Current Trends in Successful International M&As 1. Ideniy some o he irraional reasons or acquisiions. Four main reasons exis or irraional acquiring: (1) envy heory, (2) ree cash flow heory, (3) deensive behavior, and (4) he hubris hypohesis. Envy heory suggess ha execuives see heir cohors acquiring and geting greaer benefis. Tey hen engage in acquisiions o seek he same benefis. Free cash heory suggess ha execuives spend ne income o acquire companies raher han reurn unds o shareholders. Deensive behavior research suggess execuives acquire oher firms o keep rom being acquired hemselves. Finally, he hubris hypohesis suggess ha execuives perceive ha heir skills are beter han hey really are. Consequenly, hey coninue o make unwise acquisiions believing ha hey can be successul despie a low likelihood o ha occurring.

602

Discussion Questions and Answers (Chapters 2–30)

2. Discuss how globalocusing can reduce risk he way conglomeraion did previously. Organizaions previously reduced risk by pursuing a diversificaion sraegy. Tus, by being in muliple indusries wihin a given geographic area, organizaions reduced he impac o seasonal and indusrial flucuaions. Wih globalocusing, organizaions los ha abiliy by aking on a narrower indusrial ocus. o couner ha and o reduce risk, hese organizaions inernaionalized, hus spreading heir counry exposure and reducing risk. 3. Explain how HR issues during acquisiion have changed since 2000. Previously, he majoriy o acquisiions occurred or economies-o-scale synergies. Te acquisiion process required combining organizaions, reducing saff numbers and harmonizing sysems, managemen syles, and organizaional culures. Carrying ou his process required H deparmens ha were srong in organizaional srucuring, erminaions, raining, and harmonizaion. Acquisiions now ake place or markeing enry where litle inegraion wih curren operaions exiss. Te necessary H skills are reenion and aciliaion o horizonal cross-company communicaion, and inra-company collaboraion. 4. Explain he reasons he success rae o inernaional acquisiions has improved. Acquisiions previously occurred or economies o scale, which creaed considerable organizaional upheaval. Few acquirers could ully capialize on hose cos savings. ecen acquisiions rely more on enhancing revenue hrough geographic expansion. Consequenly, a prolonged and disrupive implemenaion phase has less impac on organizaions. Insead, acquirers use ligher ouch inegraion. Consequenly, employees eel less change wih success coming hrough inra-organizaional cooperaion and increased marke coverage or exising producs.

Chapter 23 Art and Collectibles for Wealth Management 1. Explain how passion plays in a porolio conaining ar. Passion can be a driving orce behind an ar collecion. Undersanding ha he passion can become problemaic is criical or wealh managers. Such knowledge

equips hemmanagers o beter relae o he “I wih gotaheir have cliens i” menaliy ha canbeter grip aleadership collecor. Tis allows o empahize and provide wih heir wealh and collecion. 2. Elaborae on how a clien migh view adding ar as addiional asse class o a curren porolio. Porolio objecives relaed o risk and reurn mus be assessed in conjuncion wih invesor consrains. Nex, asse allocaion choices can consider he role o ar in a poenial porolio. Te clien and he wealh manager mus recognize ha ar should be viewed hrough a differen lens. Like many alernaive asses, an acive secondary marke does no exis or ar, which may presen a challenge or cliens wih higher liquidiy needs. I ar is included in he asse allocaion mix, wealh

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Discussion Questions and Answers (Chapters 2–30)

603

managers need o benchmark ar appropriaely and undersand ha he ar is no a silo on he balance shee. 3. Discuss he role o risk miigaion or ar invesmens. isk miigaion is he abiliy o spo, ideniy, and quaniy any decision ha may affec financial saus. Undersanding and inegraing ar and finances requires a clien o look beyond he obvious and ideniy he collaeral issues ha ohers may miss. Inadequae liabiliy insurance can pu an ar collecion a risk because he invesmen porolio does no consider ar as a separae asse class. 4. Discuss he role o social media in inormaion disseminaion as relaed o ar. Te social media have moved ar and collecible invesing beyond he local level as poenial ar invesors now have access o ouline oules. Despie lacking a ormal secondary marke, a wider exposure o ar creaes a markeplace where ar can be more readily compared and proxies or air marke value can be beter deermined. 5. Jusiy he increasing use o “commodiies” as a erm o describe holdings. Knowledge has become accessible a levels never oreseen. Te days o he knowledge-based classroom and brick and morar are becoming limied. Wealh managers who inves heir ime in lisening and leading are likely o be beter equipped o atrac more cliens, asses, and opporuniies. As ar becomes a more readily acceped asse choice, and as rading oules become more numerous, ar begins o resemble more convenional commodiy asses. Such asses are increas-

ingly being considered par o he porolio holdings o invesors.

Chapter 24: Behavioral Finance Market Hypotheses 1. Ideniy he necessary condiions or a marke o be classified as efficien. A marke would be classified as efficien i i exhibis absolue equaliy o inormaion, including a oal absence o insider inormaion, ull raionaliy o marke paricipans, marke liquidiy, perec compeiion in he financial markes, and he same invesmen horizons and expecaions or all marke paricipans. 2. Discuss why no heory has emerged o ully replace he EMH. Financial markes are oo complicaed o be described wih a single heory conain-

ing highly observaions. resricive assumpions. lead o ainconsisencies wih empirical As a resul,Such he assumpions EMH remains only heoreical model. Addiional heories are needed ha are more consisen wih empirical observaion. 3. Provide several examples o illusrae he evoluion o he financial markes. An example o he evoluion o financial markes is echnological leaps, including advances in compuer capabiliies, Inerne rading, and high- requency rading. Anoher example is he appearance and developmen o he new economic heories such as he EMH. Addiionally, changes in securiies regulaion and changes in economic sysems, such as he evoluion rom an indusrial o a pos- indusrial and inormaion economy, can ac as drivers or he evoluion o he financial markes.

604

Discussion Questions and Answers (Chapters 2–30)

4. Discuss wheher efficien markes exhibi reurn persisence and possible measures o marke efficiency. Efficien markes should no exhibi persisence i evidence suppors ha hey random walk. Persisence implies he presence o price memory, implying ha previous prices influence curren values. I so, rends can exis in he financial markes. Tis possibiliy gives opporuniies or price predicion, which is impossible in efficien markes because prices changes are random and unpredicable. In heory, marke efficiency can be measured using he level o persisence. I no persisence exiss in prices, he marke can be reaed as efficien. Te reasons or persisence ocus on he irraionaliy o he invesors, exisence o noise raders, and echnical and undamenal analysis. 5. Explain wheher he behavior o financial markes is consisen wih he EMH. Te behavior o financial markes is generally consisen wih he EMH. Predicing uure prices and generaing profis rom rading is difficul. Neverheless, siuaions exis ha he EMH canno explain. Empirical observaions, called marke anomalies, provide argumens agains he EMH. Because behavioral finance explains hese anomalies well, providing a synhesis o hese heories is imporan o give a uller explanaion o he financial marke behavior.

Chapter 25 Stock Market Anomalies 1. Explain equiy anomalies. Equiy anomalies are empirical relaions beween uure sock reurn and company characerisics ha canno be explained by classical asse pricing models such as he CAPM or muli-acor models. In oher words, cross-secional sock reurns are predicable by differen company characerisics. 2. Discuss he major explanaions o why equiy anomalies exi. ecen lieraure usually atribues he exisence o anomalies o eiher an inadequacy in underlying asse pricing models or marke inefficiency. Te inadequacy in asse pricing models is usually called he raional explanaion. I builds on he radiional risk–reurn ramework under assumpions ha invesors are perecly raional and he marke is efficien. Anomalies are he consequences o shor-comings o

curren pricing mehods or missing risk acors. Marke inefficiency atribues he exisence o anomalies o he irraional behavior o invesors and is usually called a behavioral explanaion. Under he ramework o he behavioral perspecive, invesors do no collec and/or process available inormaion raionally because hey suer rom cogniive biases, so securiies are mispriced. Te sock reurn predicabiliy represens sysemaic mispricing in he equiy marke. 3. Ideniy some behavioral biases o invesors ha can be atribued o anomalies. Te behavioral biases include overconfidence and sel-atribuion, limied atenion, disposiion effec, and invesor senimen. People are usually overconfiden abou heir own judgmens being righ subjecively raher han objecively. Sel-atribuion reers o when people end o credi hemselves or pas successes, bu blame oher

605

Discussion Questions and Answers (Chapters 2–30)

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acors or ailures. Limied atenion is he endency o people o neglec salien signals and overac o relevan or recen news. Te disposiion effec is he endency o invesors o sell asses ha have risen in value raher han o sell hose ha have allen. Ta is, invesors end o sell winners and hold on o losers. Invesor senimen is he propensiy o speculae. esearchers ofen use hese behavioral biases o explain various anomalies. 4. Define an invesmen anomaly and ideniy some documened invesmen anomalies.

An invesmen anomaly reers o he sock reurn predicabiliy resuling rom company characerisics ha relae o is invesmen aciviies. Sudies repor ha companies wih high invesmen aciviies earn lower average reurns han hose wih low invesmen aciviies. Te q-heory provides a heoreical background o how invesmen can serve as a predicor or uure sock reurns. Te ollowing sudies es and veriy ha company-level measures o invesmen indeed have power o predic uure sock reurns. Tese invesmen-relaed anomalies include asse growh, invesmen growh, ne sock issues, invesmen o asses, and abnormal corporae invesmen.

Chapter 26 The Psychology of Speculation in the Financial Markets 1. Define he erm stock bubble. A sock bubble occurs when marke paricipans drive sock prices considerably above heir inrinsic values. Tus, a bubble is an unexpeced and dramaic increase in he price o he financial asse or invesmen ulimaely resuling in an exreme decline in price. 2. Lis and describe our major causes o speculaive behavior. Four major causes o speculaive behavior are overconfidence, herding, represenaiveness bias, and amiliariy bias. Overconfidence is he endency o an invesor o overesimae his level o skills, experise or accuracy when orecasing uure sock marke perormance. Herding is exhibied when a group o invesors makes he same invesmen judgmens abou a specific piece o inormaion and decides

his inormaion is inclined likely o o lead o increased epresenaiveness bias is when people are develop a beliesock abouprices. a curren experience and overweigh he imporance o his inormaion. During a bubble, invesors conclude ha sock prices are likely o coninue o increase based on a small sample o iniial sock price daa. Familiariy bias is eviden when invesors demonsrae a preerence or and inves in amiliar securiies. During a bubble, invesors perceive amiliar socks as being less risky wih he possibiliy o achieving higher reurns. 3. Lis and explain our major biases ha invesors exhibi in he afermah o he financial crisis o 2007–2008. Four major invesor biases eviden in he afermah o he financial crisis o 2007– 2008 were anchoring, loss aversion, saus quo bias, and misrus. Anchoring is he

606

Discussion Questions and Answers (Chapters 2–30)

inclinaion o hold a viewpoin and hen apply i as a reerence poin or deermining uure decisions. Invesors ofen apply a negaive anchor afer a sock marke bubble burss. Loss aversion is eviden when invesors assign more imporance o a loss han o achieving an equivalen gain when assessing specific financial ransacions. Te experience o invesors’ losing money migh remain or an exended period. Ofen individuals who realize losses during a financial crisis end o avoid invesing in he sock marke. Afer a financial crisis, invesors may suffer rom saus quo bias, no longer waning o inves in common socks or avoid managing heir invesmen porolios. Afer a financial crisis, he public ofen exhibis misrus o financial insiuions and markes. Considerable ime may elapse beore his rus is resored. 4. Discuss he influence o invesor psychology in he afermah o a financial crisis or when a bubble burss. Afer a financial crisis, some invesors may exhibi negaive long-erm biases ha affec heir overall assessmen and decisions abou financial markes. In he afermah o a sock marke bubble, his siuaion resuls in invesors’ experiencing lower levels o risk olerance and higher degrees o negaive emoion and perceived risk. Consequenly, hey end o under-inves in risky asses such as common socks and over-inves in saer asses such as cash and bonds.

Chapter 27 Can Humans Dance with Machines? Institutional Investors, High-Frequency Trading, and Modern Markets Dynamics 1. Discuss he main differences among various equiy exchanges operaing in he Unied Saes. Equiy exchanges in he Unied Saes differeniae hemselves by ee srucure. Some exchanges charge ees or using marke orders o ake away liquidiy. Such exchanges are ofen reerred o as “normal” exchanges and provide rebaes o raders using limi orders o add liquidiy. Te NYSE is an example o a normal exchange. Anoher class o exchanges, known as “invered,” do he opposie by rewarding raders bringing in marke orders wih rebaes and charge raders adding liquid iy. 2. Discuss he key ypes o HFT. All HFs are eiher aggressive or passive. Aggressive HFs end o use marke orders o capure shor-lived arbirage opporuniies. Passive HFs use limi orders o provide liquidiy in marke-making sraegies. 3. Explain how exchanges disribue marke inormaion. Exchanges disribue rading inormaion via messages. Each exchange decides how o communicae wih is marke paricipans. Some exchanges ollow a sandardized FIX rading message proocol, whereas oher exchanges develop heir own proprieary communicaion proocols.

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Discussion Questions and Answers (Chapters 2–30)

607

4. Describe how exchanges record various order ypes. ypically, all exchanges send a leas one message or each o he ollowing marke occurrences: limi order addiion, limi order cancellaion, and order execuion. Te messages ypically conain an order id, imesamp, securiy raded, order size, and order price. 5. Ideniy he liquidiy consideraions ha marke paricipans need o consider. Analysis shows ha raders a various requencies respond differenly o a wide range o marke dynamics, such as flickering limi orders, limi order revisions, and

order addiions and cancellaions. For example, HFs appear o disregard flickering quoes, while lower-requency raders appear drawn in by flickering quoes. Order revisions also appear o polarize raders. For example, HFs seem o view limi order revisions as credible negoiaion signals, while low-requency raders avoid rading when limi order revisions occur in he markes.

Chapter 28: Applications of Client Behavior: A Practitioner’s Perspective 1. Disinguish beween risk capaciy and risk requiremen. Risk capaciy describes how much invesmen risk a clien migh ake based on his financial resources (i.e., how severe a financial loss a clien migh susain and sill have he financial resources o mee his goals).Risk requiremenis he level o reurn a clien needs o mee his financial goals. 2. Discuss he meaning o risk olerance. isk olerance is he amoun o risk ha an invesor is comorable aking, or he degree o uncerainy ha an invesor can handle. isk olerance is ofen relaed o a clien’s demographic characerisics, such as age, gender, employmen, and ne worh. As invesors end o eel opimisic during bull markes and pessimisic during bear markes, some conend ha a clien’s risk olerance varies wih marke perormance. Te risk o basing recommendaions on demographic acors is ha a clien may no be represenaive o a specific demographic profile. Te advisor’s goal is o recommend an allocaion ha a clien will mainain during urbulen imes. A variable measure o risk olerance would be counerproducive because i migh

incorrecly reflec he clien’s risk olerance a wrong a majorime. marke correcion, resuling in he clien’s liquidaing financial asses a he 3. Explain how o presen he various elemens o a clien’s quarerly repor. ypically, a clien’s quarerly repor is solely perormance ocused, including shorerm perormance such as he las quarer and year o dae. Perormance is also ofen measured agains a marke benchmark, such as he S&P 500 Index. Given he imporance o asse allocaion o achieving long-erm reurns, having an allocaion graph or able showing boh policy and curren allocaions would be an imporan elemen in a quarerly repor. o ocus a clien on long-erm vs. shor-erm

608

Discussion Questions and Answers (Chapters 2–30)

perormance, he repor could delee inormaion o less han 12 monhs. Because porolios are rarely 100 percen invesed in equiy, a marke benchmark could provide a misleading guide. Furhermore, a clien’s plan and resulan allocaion recommendaion are based on an esimaed real reurn needed, so benchmarking agains he CPI could be more appropriae han using he S&P 500 Index. 4. Describe raming and how a financial advisor migh use i. Framing is a behavioral heurisic recognizing ha people end o reach conclusions based on how inormaion in he orm o words and numbers are presened. By

reraming issues, an advisor can assis cliens in avoiding behavioral errors and making beter decisions. For example, asking quesions such as “Would you buy ha sock oday?” and “Wha migh go wrong?” are poenial raming quesions ha migh affec clien behavior.

Chapter 29: Practical Challenges of Implementing Behavioral Finance: Reflections from the Field 1. Explain how nudging alone consiues a narrow use o behavioral finance knowledge. Te success o nudging by using smar deauls in pension auo-enrollmen and organ donaion, or hrough social comparisons in energy consumpion, suggess ha nudging can be he panacea or a wide range o decision problems. Tis process excludes more creaive uses o behavioral finance ha res on eaures such as simpliying he decision, encouraging engagemen, reducing he ricions beween deciding and implemening a decision, and pre-commimen o uure acions. Nudging is jus one par o he behavioral finance oolki and should no be he sole, or deaul, ool. Successul applicaions o behavioral finance require a roo and branch approach o undersanding he possible improvemens o how decision makers inerac wih organizaional processes. 2. Discuss he eaures o good and bad applicaions o behavioral finance. A misconcepion exiss ha behavioral finance is nohing more han a lis o biases,

and haseek i is o hereore do.offer As aaresul, many o apply behavioral finance do litle“easy” more o han checklis o atemps biases. Tis process assumes ha problems can be largely solved by inorming people o how hey make poor decisions. Merely inorming people o heir biases is very seldom effecive in combaing hem. Approaches ha are no easily ransporable beween domains can lead o overly engineered soluions. Te bes approaches o behavioral finance demonsrae a highly ailored approach o he problem. Te program Save More omorrow is one such example. Tis program deals wih he ineria or procrasinaion ha sops many people rom joining heir company’s pension plan by keeping iniial conribuion raes low. Save More omorrow also addresses he loss aversion associaed wih raising conribuion

609

Discussion Questions and Answers (Chapters 2–30)

609

raes by geting he paricipan o pre-commi o uure conribuion increases ou o uure pay rises. Alhough mos effecive in a period o rising wages, his process is sill a highly ailored applicaion o behavioral finance ha has led o demonsrable success in raising reiremen saving. 3. Discuss an example o behavioral finance supplemening radiional approaches. A criicism o modern porolio heory or individual invesors is ha opimizing wih volailiy as a risk measure is no behaviorally jusified. Te implicaion ha deviaions away rom he expeced reurn, boh posiive and negaive, add o risk

does no reflec how individuals eiher do, or should, hink abou risk. Invesors rarely sae ha geting more han hey expec eels like a risk. Simply swiching he risk measure o somehing ha can be behaviorally jusified shows how an undersanding o individual behavior can supplemen an ingrained radiional approach o invesing. 4. Explain asymmeric paernalism. Asymmeric paernalism is a dual-ocused approach o help people make beter decisions. Making major financial decisions is difficul or many people. As a consequence, hey ypically make no decision a all. Te applicaion o smar deauls or his group can be helpul. Te deaul may no be a perec soluion, bu i well chosen, i can lead o a beter financial oucome. However, many are capable o making heir own decisions and his should no be orgoten by simplisically applying a deaul or all. Tey need o be acively engaged wih financial decisions and helped o make he bes choice or heir circumsances. Mos individuals require some blend o paernalism and engagemen o sui heir specific capabiliies and circumsances. Asymmeric paernalism involves deaul choices or hose who would no or could no make heir own decisions, bu involves acively engaging hose who would or could make heir own decisions (or, in pracice, some blend o nudges and acive engagemen or each decision- making, according o heir need). Tis asymmeric approach proecs he mos vulnerable financial decision makers while assising he less vulnerable o make he bes decisions possible.

Chapter 30: The Future of Behavioral Finance 1. Discuss he exen o which behavioral finance has progressed philosophically since he 1980s anomalies lieraure, and how i migh develop in he uure. In a Tomas Kuhn philosophy o science perspecive, he iniial anomalies lieraure was firmly wihin he radiional finance paradigm. Deenders o he core paradigm could dismiss he anomalies using he ools and mehodologies o radiional finance. Behavioral finance can now be caegorized as a separae research paradigm ha has is own core heory and some o is own mehodologies. I is also clearly a progressive research program based on he growh in publicaions. Te challenge now is o srenghen he core heory and uilize mehodologies appropriae o hese heories.

610

Discussion Questions and Answers (Chapters 2–30)

2. Discuss problems wih he “raional managers/irraional invesors” research sream in behavioral corporae finance. Te idea ha financial decision making in a company is raional, bu financial decision making ouside a company is no raional seems like an odd compromise. Minimal evidence exiss ha financial decision making wihin organizaions is raional and unbiased. Tis view assumes ha companies undersand when invesors are being irraional, even hough his view has no been developed based on case sudies or oher qualiaive research o he companies making hese decisions. More undamenally, i companies successully engage in marke iming o equiy and deb issues, are hey responding o undamenal mispricing by invesors or o invesor irraionaliy? 3. Discuss wheher characerisics o op managemen eams are likely o be eaured in uure research on he drivers o corporae financial behavior. Te chie execuive officer (CEO) influences perhaps 20 percen o he variabiliy o a company’s perormance. Tus, ignoring he drivers o he oher 80 percen o variabiliy occurring in curren behavioral corporae finance seems perverse. Modern sraegic managemen research preers o ocus on he op managemen eam as drivers o sraegic decisions, and his ocus should include corporae finance decisions. Tus, behavioral corporae finance may sar o emulae his pracice. A move oward inegraing more organizaional heory ino behavioral corporae finance enails greaer emphasis on he wider firm ouside o he CEO, including he op

managemen eam. 4. Ideniy and explain key issues ha need o be resolved concerning curren measures o invesor senimen. Because a muliude o measures exis in invesor senimen, a greaer cross-comparison o hese is needed moving orward o ideniy he mos suiable measures. A dearh o undersanding exiss abou he undamenal drivers o invesor senimen issues such as culural influences and he exen o which senimen influences differen ypes o invesors. New daa opporuniies are on he horizon o develop beter measures o senimen, bu his developmen requires working wih researchers in oher disciplines and no purely keeping he heory building and esing wihin he domain o behavioral finance.

61

Index

(Page numbers in italics reer o ables ( t) and figures (f) wihin he ex.) academic lif and drop. See “lif and drop” applicaion approach, academic accepance and commimen herapy (ACT), 327–328 accredied invesors, defined by SEC, 137 accrual anomaly, 469–470, 469f ACT. See accepance and commimen herapy (ACT) acion syle indicaors, 201–202

agency problems, ar and collecibles, 424 agency heory, 79, 80–81, 91 agency problem, 80 behavior assumpions, 83 compensaion, incenive-based, 80–81, 86 conrol, definiion o, 81 differeniaing acors, agency and sewardship heories, 82–83 opporunisic behavior, 81

acivis high invesors ne worh individuals (HNWIs), 175–176 pension unds, 391–392 adapive markes hypohesis (AMH), 443–446 assumpions and pracical implicaions, 445–446 bounded raionaliy, 444 differences beween EMH and, 446 evoluion o financial markes, 445 species ound in financial markes, 444–445 advice packaging, 292–293 advisers vs. advisors, 108 advisory services. See financial advisory services affec heurisic, 311 disincions beween emoion, mood, and affec, 30 Affec Inusion Model (AIM), 30 Affordable Care Ac o 2010 (ACA), 315 agency coss in financial advice, 102–107 bonding coss, 103–104 compensaion srucures and conflics o ineres, 104–107, 113 asses under managemen (AUM), 105–106 commission-based compensaion, 104–105 hourly compensaion, 106 projec-based ees, 107 reainer ees, 106–107 monioring coss, 103 principal-agen relaionship, 102–103 residual losses, 103–104 suiabiliy sandard, 103 ypes o coss, 103–104

risk-sharing problem, 80–81 specific problems being deal wih, 80–81 sewardship heory, differeniaing acors, 82–83 aggressive high-requency rading, 502–504 algorihmic rading, 193 alernaive asse managemen, invesmen sraegies, 137 alernaive asse managemen firms, 144 ambiguiy aversion uncional fixaion hypohesis, 454 porolio managers, riskaking behavior, 145–146 American dream concep, 242, 243f American Psycho (movie), 153, 162 anchoring bias, 27–28, 310–311 ar and collecibles, 423–424 clien educaion capial needs analysis, anchoring he reurn, 534–535 efficien ronier hypohesis (EFH), anchoring on, 523–527 risk coaching, anchoring he risk, 530–534 financial crisis o 2007–2008 behavioral bias, impac o, 492 invesmen names, anchoring on, 340 irraional financial behaviors creaing need or financial planning, 342 millennials, 27–28 personal financial planning, 279 raders, inormaion processing phase errors, 195, 196

611

612

Index

anomalies. See sock marke anomalies anisocial behavior, 153, 155 anisocial personaliy disorder (APD) classificaion o, 153, 157–158 psychopahic disinguished rom anisocial, 157 APD. See anisocial personaliy disorder (APD) applicaion o behavioral finance. See pracical applicaion o behavioral finance appreciaive inquiry, 330 arbirage and sock marke anomalies, 472–473 idiosyncraic risk, 472–473 sysemaic risk, 472 ar and collecibles, 18, 422–434 ar asses, 428–430 ar lending, 428 as asse class, 429–430 clien’s collecion passion, wealh managemen perspecive o, 426 collecing or invesmen value, 426–428 ar philanhropy, 427 collecing and invesing, differeniaion, 426–427 emoional value, 423, 428 financial and nonfinancial reasons or collecing, 424 as invesmen opion, 426 moivaional ocus, 427

relaionships, business o business (B2B) vs. consumer o consumer (C2C), 432–433 ypes o collecing, 424–425 ar collecions, 424–425 baseball cards, 425 celebriy possessions and he deah effec, 425 reurn enhancemen, wine collecions, 424–425 spors cards, 425 wine collecions, 424–425 ar philanhropy, 427 Asia, privae wealh managemen, 177 aspiraion based preerences approach, 549 asse allocaion, 17, 359–375. See also porolio managers allocaion mainenance, 365–366 sraegic asse allocaion (SAA), 365–366 acical asse allocaion (TAA), 366 anomalies. See sock marke anomalies behavioral biases, 369–375 emoional bias, 369, 375 amiliariy bias, 369–371, 375 raming, 372–373, 375 generally, 369 home asse bias, 370 loss aversion, 371–372 menal accouning, 364, 373–374, 375

porolio managemen reasons or recogniion oprocess, ar and collecibles in, 428 reurn enhancemen, wine collecions, 424–425 sraegic ocus, 427 collecing process, biases, 423– 424 agency problems, 424 anchoring bias, 423–424 emoional bias, 423, 428 hoarding disorder, 424 mood changes, 423 nosalgia effec, 425 esae planning and, 428–429 financial and nonfinancial reasons or collecing, 424 as invesmen opion, 426 lieraure review, 422–425 managemen and reporing, 429 risk miigaion, 429–430 social media’s influence on, 430–434 beter ools, beter daa, 433 collecion managemen ools as wealh ools, 434 e-commerce, role o, 433 globalizaion, 431–432 holdings as commodiies, 430 online ar educaion, 432 online aucions and markeplaces, 432 online businesses and ransparency, 433–434

1/N heurisic bias, 369 overconfidence, 374–375 saus quo bias, 371–372, 375 clien educaion, 529 definiion o, 359 inernaional and emerging marke sock indexes correlaion marix o he Unied Saes, 371, 371t perormance o he Unied Saes, 370, 370f porolio managemen sraegies, 360 Black-Literman model, 368–369 mean-variance opimizaion, 368–369 modern porolio heory (MPT), 359, 367–369, 375 rebalancing sraegies, 366 buy-and-hold sraegy, 366 calendar balancing, 366 consan mix sraegy, 366 reurn objecives, 360, 364–365 risk–reurn rade-off, 364–365 invesmen policy saemen (IPS), 364, 366 measuring risk, 364–365 reurn objecives, 360, 364–365 securiy marke line (SML), 365 sysemaic risk, 365 asse classes, 361–366 ar and collecibles, 429–430 bonds/fixed income securiies, 362 cash, 363 derivaives and alernaive invesmens, 361 equiies, 361–362

613

I n d ex

613

real esae, 360, 362–363 asse managemen firms, alernaive, 144 asse managemen services porolio managemen, 136–137 radiional and alernaive managemen, disinguished, 136–137 asse pricing anomalies and alernaive hypoheses o EMH. See behavioral finance marke hypoheses behavioral research. See asse pricing, uure o invesor psychology research efficien marke hypohesis (EMH), 4, 440–443 asse pricing, uure o invesor psychology research, 561, 569–572, 575 approaches o improve robusness, 570–572 culure, incorporaion in invesor behavior models, 572 emoion psychology, 569 experimenal finance, heory building, 570 financializaion, 572 hisoric daabases, exploraion o, 571–572 producive research, need o develop, 569 publishing bias, ailure o develop producive research and, 569 raional manager/irraional invesor, 570, 575 researching ouside o equiy pricing, 571 senimen, defined, 570

generaional crieria or making invesmen decisions, 251f impeus or seeking advice, 248–249 reliance on, 241 risk olerance and invesmen preerences, 250–251 role o, 254, 255 echnology and financial inormaion, 255 use o, 247–252 financial crisis o 2007–2008, impac o, 244–246, 492 financial lieracy, 242–244, 259 financial crisis o 2007–2008, impac o, 244 knowledge level or invesors by age group and income, 244f reiremen savings, 243–244 financial oulook, shor and long erm, 246–247 invesmen asses, ownership o, 241 personal and naional concerns, 247 reiremen planning, 246–247, 246f reiremen savings, financial lieracy, 243–244 back-end load, 104 baseball card collecions, 425 Baeman, Parick, 153, 154, 162, 166 behavioral finance, 5–9 applicaion o. See pracical applicaion o behavioral finance

senimen modeling, social psychology, 569570–571 asse pricing models.See also sock marke anomalies inadequacies, raional explanaion, 460 asses under managemen (AUM), 105–106 separaely managed accouns, 105 saisics, 378, 392–393 wrap accouns, 105 asymmeric paernalism as guiding principle in applicaion, 555, 555t nudges, 554–555 atribuion subsiuion, 311–312 AUM. See asses under managemen (AUM) auomobile insurance, 306 availabiliy bias, 23, 310 aspecs o, 8 irraional financial behaviors creaing need or financial planning, 342 personal financial planning, 279 raders, errors in inormaion collecion phase, 194 availabiliy cascades, 199

basis 5 srcinsoo,model, 5 premises o, 5, 6 behavioral finance marke hypoheses adapive markes hypohesis (AMH), 443–446 racal marke hypohesis, 446–448, 447t uncional fixaion hypohesis, 453–455 noisy marke hypohesis, 452–453 overreacion hypohesis, 448–450, 449f, 451t underreacion hypohesis, 450–452 Belor, Jordan, 153, 154, 162, 166 Bernie Madoff scandal, impac, 55 beter-han-average effec requen sock rading, 211 raders, inormaion processing phase errors, 198 “bias” bias, 543–544 biases. See also specific bias complexiies o, 546 creaing need or financial planning, 338–342, 353 defined, generally, 97 Bigger-Waers Flood Insurance Reorm Ac o 2012, 315 Black-Literman model, 368–369 boards o direcors. See direcors and boards o direcors bonding coss residual losses, 103–104 suiabiliy sandard, 103 bonds/fixed income securiies, 362

baby boomers American dream concep, 242, 243f compared o millennials, 242–247 financial advisors advisor saisacion, 254 degree o advisor use, by age group and income, 248f

614

Index

book-o-marke equiy, 26 “boomerang children,” 245 bounded raionaliy concep adapive markes hypohesis (AMH), 444 defined, 5, 24 insurance purchasing decisions, risk olerance, 304 managerial rais, 84 research programs, 563–564 break-even effec, 197, 198 broker-dealers, regulaion o, 100 brokers, defined, 287 bubbles. See financial bubbles; speculaion in financial markes business o business (B2B) vs. consumer o consumer (C2C) relaionships, 432–433 capial asse pricing model (CAPM) cerainy vs. saey, 529 clien educaion, 528–529 developmen o, 4 ineres rae risk, 529 marke risk, 529 purchasing power, 529 sysemaic risk (undiversifiable risk), 528–529 capial needs analysis, 534–535

risk-aking and incenive-based compensaion, 86–87 role o curren primary ocus o research, 561, 567–568, 575 generally, 83–84 rais and corporae invesmen decisions, 87–88 cerainy vs. saey, 529 Cerified Financial Planners (CFPs) asse allocaion, overconfidence, 374–375 designaion, 266 personal financial planning, 266 reiremen planning, 338, 343–344, 351, 353 Cerified Financial Planners Board o Sandards (CFP Board o Sandards), 266–267 iniiaives, 278 cerified public accounans (CPAs), 101 CFP. See Cerified Financial Planners (CFPs) charming persona, psychopahs, 156 charered financial analys (CFAs), 374–375 churning, 104 clien educaion, 523–529 asse allocaion, 529 basics, 527–529 capial asse pricing model (CAPM), 528– 529 diversificaion, risk reducion, 527, 528f efficien ronier hypohesis (EFH), anchoring

CAPM. capial asse pricing model (CAPM) Seeresponsibiliies caregiving women invesors, 230, 231, 233, 236, 237 cash as asse class, 363 reurn drag, 363 cash-flow reserve porolio clien managemen, 538–540 casualy insurance, 306 causaliy heurisic, 311 celebriy possessions and he deah effec, collecions o, 425 CEOs behavioral biases, 87–88 culural bias, 74 opimism, 87–88 overconfidence, 87–88 resolueness, 88 risk percepion bias, 87 sel-atribuion bias, 88 CEO urnover, 89–90 corporae akeovers and overconfidence, 87–88 culural similariy o invesors o, 74 mergers and acquisiions (M&As), CEOs’ biases, 87–88, 92 research and researchers CEO’s role as curren primary ocus o, 561, 567–568, 575 recommendaions, 568 risk aversion, 87, 92

523–527 financialon, planning process, raming, 529–535 capial needs analysis, anchoring he reurn, 534–535 daa gahering process, reraming, 534–535 efficien ronier hypohesis (EFH), anchoring on, 523–527 raming effec, 529–530 risk coaching, anchoring he risk, 530–534 modern porolio heory (MPT), 527–528 risk coaching, anchoring he risk, 530–534 atribues o invesing, 531–532, 531t conservaive clien, 534 financial crisis o 2007–2008, impac o, 533 invesmen ime horizon, 531 projeced reurn and risk exposure under differen risk levels, 532, 533t prospec heory and loss aversion, 533–534 risk aversion vs. loss aversion, 534 risk reducion hrough diversificaion, 527, 528f clien inerview mehodologies, esae planning, 330–331 appreciaive inquiry, 330 dialecical inerviewing, 331 moivaional inerviewing, 330–331 clien managemen, applicaion o behaviorally based, 535–540 cash-flow reserve porolio, 538–540 clien emoions, 537 example, reirees, 537–540

615

I n d ex

615

ho invesmens, reraming echniques, 536–537 invesmen policy saemen (IPS), 535, 540 invesmen porolio, 538–540 marke iming, 535–536 menal accouning, 537 paycheck syndrome, 538–540 quarerly reporing, 540 reporing, raming and, 540 reiremen planning, 537 sequence o reurn risk, 537 Would you buy ha sock oday? 536 clien’s compeence, esae planning, 319, 321 clinical depression, sources o, 265 coercive isomorphism, 568 cogniive abiliy and IQ o individual invesors, 46–47 cogniive bias, 5. See also specific bias boards o direcors, 90–91 raders, decision making process, 193–195 cogniive dissonance muual unds, underperormance o, 383 nonsandard invesor preerences, individual invesors, 48 raders, inormaion processing phase errors, 196 collecibles. See ar and collecibles collecive memory hypohesis, 491 commission-based compensaion, 104–105 communicaions

conormiy, 487–488 direcors, 91 individual and group decision makers, associaion beween, 488–489 insiuional invesors, 487– 488 speculaion in financial markes, 487–489 subsandard sraegies, 488–489 moivaed reasoning, 125 raders, inormaion processing phase errors, 196 conflicing ineress compensaion srucures and, 104–107, 113 financial advisors, 112 conormiy effec grouphink behavior, speculaion in financial markes, 487–488 raders, 199 conservaion skills personal financial planning, sraegies or overcoming biases, 280–281 conservaism bias, 309 clien educaion, raming financial planning process, 534 in expecaions, raders’ momenum ype sraegies, 199 managerial rais, 84 underreacion hypohesis, 452 consumer conusion, 107–108

cliens, esae 321–324 clien rus andplanning, commimen, personal financial planning, 276–277 inernal communicaion, inernaional mergers and acquisiions (M&As), 415 compensaion commission-based compensaion, 104–105 compensaion srucures and conflics o ineres, 104–107, 113 hourly compensaion, agency coss in financial advice, 106 incenive-based, agency heory, 80–81, 86 relaion o managerial rais, 86–87 compensaion srucures and conflics o ineres agency coss in financial advice, 104–107, 113 asses under managemen (AUM), 105–106 separaely managed accouns, 105 wrap accouns, 105 compeence clien’s compeence, esae planning, 319, 321 reiremen planning proessional, biases in decision o hire, 343–344 conduc risk, 556 confidence. See overconfidence confirmaion bias, 308 boards o direcors, 91 financial analyss’ repors and orecas opimism bias, 125 grouphink behavior, 487–489 characerisics ha oser, 91

advisers advisors, 108 financial vs. advisors, 108, 113 financial planners, 108, 113 muliple regulaory regimes, 108 consumers o financial advisory services. See financial advisory services conrarian sraegies gregarious and conrarian sraegies, disinguished, 200–201 raders, 200–201 conrol issues bias, 28–29 exernal locus o conrol, 28 ho hand allacy, 29 illusion o conrol, 29 inernal locus o conrol, 28 locus o conrol, 28 sel-conrol bias, 29 corporae and financial psychopahs, disincion, 161 corporae managemen heories, 80–83 agency heory, 79, 80–81, 91 differeniaing acors, agency and sewardship heories, 82–83 sewardship heory, 79, 81–82, 92 corporae raiding, 81 corporae akeovers CEOs, overconfidence, 87–88 direcors, 90 couner-ranserence, 323 CPT. See cumulaive prospec heory (CPT)

616

Index

credi counseling firms, 102 criminal behavior, psychopahs, 157 cross proessional collaboraion modeling esae planning, 332–333 crowd effec, 451t culural bias agency and sewardship heories, differeniaing acors, 83 asse pricing, uure o invesor psychology research, 572 CEOs, culural similariy o invesors o, 74 individual invesors, 55 insiuional invesors, 74 inernaional mergers and acquisiions (M&As), 413–414, 414f invesmen sraegy leading o auly planning, 347–348 language, insiuional invesors, 74 proximiy individual invesors, 55 insiuional invesors, 74 recommendaions or increased amiliariy, 568–569 regional variaions, individual invesors, 55 religion, 84 social values, conflicing, 347–348 cumulaive prospec heory (CPT) academic lif and drop applicaion approach, 548–549 misundersanding o, 545–546 over-engineered echnical soluions, 548–549 daa gahering process, reraming capial needs analysis, anchoring he reurn, 534–535 deense behavior, 405 deerred sales charge (coningen sales charge), 104 defined benefi plans, 340, 352 porolio managemen, 138 psychopahy, emergence in financial environmen, 165–166 defined conribuion plans, 338, 340, 345 porolio managemen, 138 degeneraive research programs, 563 depression, sources o, 265 derivaives and alernaive invesmens, 361 developing world and inernaional mergers and acquisiions (M&As), 397–400 growh aciviy, 397, 398 growh o developing world acquirer, 398 Diagnostic and Statistical Manual of Mental Disorders, 5th ed. (DSM-5) financial psychopahs, crierion, 161–162 gambling disorder, crieria, 215–216 psychopahs, clinical diagnosis, 154–155, 156, 158

dialecical inerviewing, esae planning, 331 digial echnology and daa analyics advancemens, behavioral finance applicaion opporuniies, 552. See also echnology direcors and boards o direcors behavioral biases o boards o direcors, 90–91 ree rider problem (social loafing), 90, 91 groups ampliy cogniive biases o individuals, 90–91 grouphink, 91 poor inormaion sharing, 91 board independence and company perormance, 89 CEO urnover, 89–90 empirical examinaions o boards o direcors, 89–91 inside direcors, 88, 89–91 monioring roles o board and CEO urnover, 89–90 ouside direcors (independen direcors), 88–91 roles o, 88–89 srucures o board o direcors, 88–89 akeover bids, 90 disabiliy insurance, 305 disposiion effec, 7, 23, 313 financial advisory services, consumer bias, 288 individual invesors, nonsandard invesor preerences, 48,phase 49 errors, raders, inormaion processing 196–197 insiuional invesors, 67 heerogeneiy among ypes, 69 muual unds, 67 muual unds insiuional invesors, 67 relaed o underperormance, 383 selecion o, 67, 383–384 underperormance o, 383 sock marke anomalies, 474–475 raders, 196–197, 200 diversificaion bias, 347 index muual unds, 385 insiuional invesors, 65, 72–73, 75 muual unds index muual unds, 385 insiuional invesors, 73 risk reducion, clien educaion, 527, 528f DSM-5. See Diagnostic and Statistical Manual of Mental Disorders, 5th ed. (DSM-5) duraion analysis, 268 earnings orecass, excessive opimism, 120–121 EAST ramework (UK), 557–558 efficien ronier hypohesis (EFH) anchoring on clien educaion, 523–527 capial needs analysis, 525

617

I n d ex

617

efficien porolio, 524, 524f risk capaciy, 525 risk need exceeds risk olerance, 527, 527f risk requiremen, 525, 526 risk-reurn relaionship, 524, 524f risk olerance, 525 efficien marke hypohesis (EMH), 4, 440–443 anomalies and alernaive hypoheses. See behavioral finance marke hypoheses assumpions and provisions, 441, 443 background, 440–441 differen orms o marke efficiency, 443 pros and cons, 443 random walk hypohesis, 440, 441f, 442f raionaliy assumpion, 441 risk aversion, 4 speculaion in financial markes, 481 rader behavior, 192 EFH. See efficien ronier hypohesis (EFH) emerging and inernaional marke sock indexes asse allocaion, amiliariy bias correlaion marix o he Unied Saes, 371, 371t perormance o he Unied Saes, 370, 370f emerging markes culural differences and behavioral biases, 569 EMH. See efficien marke hypohesis (EMH)

Mood Mainenance Hypohesis (MMH), 30 muual unds, 30 negaive emoions, 32–37, 38 exper decision makers, 33–34 individual invesors, 52–53 individual psychology and sressors, 33 money sickness syndrome, 32– 33 neurofinance (also known as neuroeconomics), 34–35 regre aversion heory, 37 reiremen issues, 34 risk percepion and worry, 35–37 worry, 35 overreacion hypohesis, 451t pension conribuions, increasing, 547 posiive emoions, individual invesors, 52–53 risk as eelings effec, 31 seasonal and weaher relaed condiions, 73– 74 sel-affiniy bias, 31 sock invesmen, 31 sraegies or overcoming, 281 rus beween financial proessional and clien, 31 emoional vs. expressive relaionship, 337 endowmen effec, 197 endowmen model (Yale model), 142 endowmens

emoional senimen bias, 5, 30–31. See also invesor

insiuional invesors, 69 porolio managemen, 138 porolio managers, herding behavior, 142 Enron’s bankrupcy, 370 envy heory, 404 episemological paradigms inerpreivis perspecive/mehodologies, 565–566 posiivis perspecive, 565 equiy analyss. See financial analyss equiy exchanges, generally. See also equiy marke developmens disribuion o marke inormaion, 506 FIX communicaion proocol, 506 invered exchanges, 502 “li” exchanges, 499 normal exchanges, 502 recording various order ypes, 505–512 SEC regisered exchanges, saisics, 499 ransmission proocol, 505– 506, 506t equiy home bias, insiuional invesors, 72–73 equiy marke daa. See order-by-order marke daa equiy marke developmens, 19, 499–518 high-requency rading (HFT), 502–505 aggressive HFT, 502–504 defined, 502–503 passive HFT, 502–504 insiuional invesors, 499 oxic liquidiy, 501–502, 504, 505 limi order book, 500, 501f, 505–512

affec heurisic, 30 Affec Inusion Model (AIM), 30 ar and collecibles, 423, 428 asse allocaion, 369, 375 asse pricing, uure o invesor psychology research, 569 clien managemen, 537 communicaions wih cliens, esae planning, 322 emoion, mood, and affec, disincions beween, 30 “emoional inoculaion,” 183–184 financial advisory services, consumer bias, 289–290 financial crisis o 2007–2008, impac o, 31 requen sock rading, 212, 213 hedge unds, insiuional invesors, 75 high ne worh individuals (HNWIs), 183–184 individual invesors, 52–53 insiuional invesors, 73–74, 75 irraional financial behaviors creaing need or financial planning, 340–341 loss aversion, 6–7 money shame, 341 mood changes in, ar and collecibles, 423 emoion, mood, and affec, disincions beween, 30 insiuional invesors, 73–74, 75

618

Index

equiy marke developmens (Cont.) liquidiy, 500–502 buy-side available liquidiy exceeding sell-side liquidiy, 500, 501f defined, 500 ee srucures o exchanges, 502 flickering quoes on buy offers, 501, 501f limi orders, 500–502 modern liquidiy, subses o, 500–501 naural liquidiy, 500–501 normal and invered exchanges, 502 oxic limi orders, 501 oxic liquidiy, 500–501 flickering, 502 insiuional invesors and, 501–502, 504, 505 marke orders, 500 modern marke srucure, 500 naional bes bid offer (NBBO), 500 order-based negoiaions, 512–516 order-by-order marke daa, 505–512 cancellaions, 506–507, 508, 509t, 510, 512t execued orders, 511–512 flickering orders, 510–511, 512t, 514–516 hidden order execuion, 512–515, 515t, 517t inerday evoluion o orders, 508, 510 “li” limi orders, 512, 514

couner-ranserence, 323 emoional conrac, 322 ranserence, 323–324 complexiy o planning process, 318, 320–321 evolving naure o amilies, 320 marial and amily dynamics, 327 consideraions, generally, 319–320 clien’s compeence, 319, 321 evolving naure o amilies, 320 poenial difficulies, 320 value o financial planning, 319 cross proessional collaboraion modeling, 332–333 marial and amily dynamics complexiy o planning process, 327 evolving naure o amilies, 320 ETFs. See exchange-raded unds (ETFs) ehical wills, 318. See also esae planning Europe, privae wealh managemen, 177 excessive opimism, 307 exchange-raded unds (ETFs), 385–388 asses under managemen (AUM), saisics, 378, 386, 386t, 392–393 behavioral issues exrapolaion bias, 387 invesor senimen, 387 reurn-volailiy relaion, 387

marke execuion, 514–515, , 516t numberorder o order messages per each514t added limi order, 508, 509f order sizes, 506–507, 507t order ypes, saisics, 505 revisions/adjusmens o orders, 510, 511t sequenial order updaes, 507, 508t errors. See inormaion collecion phase errors, raders; inormaion processing phase errors, raders esae planning, 16, 318–333 ar and collecibles, 428–429 behavioral herapy ools or esae planners, 327–330 accepance and commimen herapy (ACT), 327–328 amily assessmen ools, 329 individual assessmen ools, 328–329 limiaions on use o, 330 recen clinical models, 327 clien concerns/ears, addressing, 324–326 addiional sources o resisance and barriers, 326 generally, 324 moraliy salience, 324–325 error managemen heory, 325–326 clien inerview mehodologies, 330–331 appreciaive inquiry, 330 dialecical inerviewing, 331 moivaional inerviewing, 330–331 communicaions wih cliens, 321–324

overall efficiency o,expecaion, 388 exciemen/euphoric 490 execuives organizaional applicaion o behavioral finance senior managemen, suppor o, 558– 559 ailoring design and organizaional deploymen, 550–551 execuives/senior managemen. See also CEOs; direcors and boards o direcors execuive relucance, applicaion o behavioral finance, 551–552 atiude owards implemenaion o behavioral ideas, overconfidence, 551 openness on raming/reraming o inormaion and daa design, 551 percepions o superficialiy, 551 unwillingness o engage, 552 expecaion exrapolaion, 199 experimenal finance asse pricing research, heory building, 570 improving reliabiliy, communicaion inrasrucure improvemens, 574 exper decision makers, 33–34 expressive vs. emoional relaionship, 337 exernal locus o conrol, 28 exrapolaion bias, 387 Facebook. See social media amiliariy bias, 29–30

619

I n d ex

asse allocaion, 369–371, 375 home asse bias, 370 inernaional and emerging marke sock indexes, 370–371, 370f, 371t concep explained, 29–30 uncional fixaion hypohesis, 454 insiuional invesors, 68 muual unds, selecion o, 384 speculaion in financial markes, 489–490 home bias, 489 local bias, 489 amiliariy preerence, 49–50 amily dynamics, esae planning. See marial and amily dynamics, esae planning Farkus, Lee B., 162–163, 166 auly invesmen selecion invesmen sraegy leading o auly planning, 348 emale invesors. See women invesors fiduciaries, reiremen planning, 338 financial advisors, 12, 97–113. See also millennials; robo-advisors; women invesors advisor biases, 112 bias, defined, 97 conflicing ineress, 112 agency coss in financial advice, 102–107 compensaion srucures and conflics o ineres, 104–107, 113 102–103 principal-agen relaionship, ypes o coss, 103–104 value o financial advice, 110–112 conflicing ineress, advisor biases, 112 consumer conusion, 107–108 advisers vs. advisors, 108 financial advisors, 108, 113 financial planners, 108, 113 muliple regulaory regimes, 108 incenives, 97 Invesmen Advisers Ac o 1940, 99, 108 meeing wih a financial advisor, 110 regulaion o. See financial advisors, regulaion o reiremen planning proessional, biases in decision o hire, 343 seeking financial advice, 109–110 supply side financial advice, 287 survey quesions abou financial advice, 109 echnology. See robo-advisors use and value o, 108–112 financial anxiey, 110 financial disress, 110 meeing wih a financial advisor, 110 seeking financial advice, 109–110 survey quesions abou financial advice, 109 use o financial advice, 109 value o financial advice, 110–112 financial advisors, regulaion o, 98– 102, 113 broker-dealers, 100

619

cerified public accounans (CPAs), 101 credi counseling firms, 102 financial counseling firms, 102 financial planners, 98 financial herapiss, 102 insurance firms, 101 invesmen adviser represenaives (IARs), 99, 100 muliple regulaory regimes, consumer conusion, 108 personal financial specialiss (PFS) designaion, 101–102 Regisered Invesmen Advisers (RIAs), 98–100 regisered represenaives, 100 financial advisory services, 15, 285–297 consumer biases, 291–293 advice packaging, 292–293 disposiion effec, 288 emoions/anxiey, 290 financial lieracy, 289–290 raming, 292–293 gender bias, 289–290 online advice, 292 paying or advice, 293 peer effec, 293 priming, 292–293 risk-aking, role o rus,292 290–291 consumer biases, sraegies or overcoming, 293–296 financial lieracy, screening or unsophisicaes, 294 inangible value o advice, 295 pricing financial advice, 295–296 risk-aking ools, 294 robo-advisors, 296–297 echnology driven advice, 296–297 consumers o, 289–291 behavioral biases, 291–293 communicaion, 291 downside o rus, 291 role o rus, 290–291 who looks or advice, 289–290 online plaorms, 292, 296–297 supply side financial advice, 287–289 echnology driven advice, 292, 296–297. See also robo-advisors online plaorms, 292, 296–297 value o added value o advice, 288–289 esae planning consideraions, 319 inangible value o advice, 295 pricing financial advice, 295–296 wealh managemen, high ne worh individuals (HNWIs), 176–182, 189

620

Index

financial analyss prospec heory, ambiguous evidence, 125 reporing. See financial analyss’ repors and orecas opimism bias financial analyss’ repors and orecas opimism bias, 12, 118–130 analys characerisics as moderaors o opimism, 127 compeing incenives, 119 earnings orecass, excessive opimism, 120–121 incenives compeing incenives, 119 sock recommendaions, marke regulaion, 121 invesors, impac o analys bias, 128–129, 130 marke reacions, impac o analys bias, 128–129, 130 marke regulaion, increasing objeciviy and reducing bias, 119–123 excessive opimism in earnings orecass, 120–121 pre-and pos-regulaion periods, impac on analys’s bias behavior, 121– 123 Reg FD, 120, 122–123, 125, 130 in sock recommendaions, 121 reducing bias Global Setlemen, 120, 123, 125

financial crashes. See also financial crisis o 2007– 2008, impac o porolio managers, herding behavior, 141 financial crisis o 2007–2008, impac o behavioral biases eviden ollowing, 481, 491–494 anchoring, 492 baby boomers, 492 collecive memory hypohesis, 491 lasing influence o economic shocks/ riskaking and, 491–492 loss aversion, 493 millennials, 492 precauionary savings, 492 recency bias, 492 reversion o he mean, 492 saus quo bias, 493 rus and misrus in a financial seting, 493–494 worry, 492 clien educaion, raming financial planning process, 533 financial emoions ha influence decisions, 31 financial psychopahs, 154–155 individual invesors, 47 inernaional mergers and acquisiions (M&As), 398

marke regulaion, increasing objeciviy, 119–123 moivaional acors, 129 variables, 129 repuaion o analys, impac o, 119, 122, 126, 127, 129 role o financial analyss, 119–120 sock recommendaions, marke regulaion, 121 analys incenives, 121 economic incenives o rade boosing, 121 uncerainy in orecasing and opimism confirmaion bias, 125 herding behavior, 124 heurisics, 124 high inormaion uncerainy, 125–126 leniency heurisic, 124 moivaed reasoning, 125 psychological heories, 123–125 repuaion o analys, impac o, 119, 122, 126, 127, 129 financial anxiey financial advisors, 110 financial behaviors, 88–91, 92 financial bubbles. See also speculaion in financial markes Inerne bubble, overconfidence and, 483 porolio managers, herding behavior, 141 “financial capialism” period, 165–166 financial counseling firms, 102

major reason241–242, or/cause244–246, o, 482 492 millennials, moral hazard concep, 142–143 porolio managers, risk-aking behavior, 142–143 psychopahy, emergence in financial environmen, 163–164 radiional porolio heory, criicism o, 553 women invesors, 232–233, 234 financial disress financial advisors, 110 financial help seeking behavior, 108–112 financial anxiey, 110 financial disress, 110 meeing wih a financial advisor, 110 seeking financial advice, 109–110 survey quesions abou financial advice, 109 use o financial advice, 109 value o financial advice, 110–112 financial indusry careers, gender inequaliy, 235, 237 changing atiudes oward pracical applicaion o behavioral finance, 552 cusomer loyaly, 229–230 dissaisacion wih, 227 financializaion, 572 financial lieracy consumers o financial advisory services, sraegies or overcoming biases, 294 financial advisory services, consumer bias, 289–290

621

I n d ex

millennials, 242–244, 244f, 259 women invesors, 233–234, 237 financial milesones, 340 financial planners consumer conusion, 108, 113 raming effec bias, 27 regulaion o, 98 supply side financial advice, 287 financial planning. See esae planning; personal financial planning; reiremen planning financial planning process clien educaion, raming, 529–535 capial needs analysis, anchoring he reurn, 534–535 daa gahering process, reraming, 534–535 efficien ronier hypohesis (EFH), anchoring on, 523–527 raming effec, 529–530 risk coaching, anchoring he risk, 530–534 financial psychopahs, 13, 153–167 anisocial disinguished rom psychopahic, 157 appropriaion o erm, 154 Baeman, Parick, 153, 154, 162, 166 Belor, Jordan, 153, 154, 162, 166 clinical diagnosis, 154–160 anisocial disinguished rom psychopahic, 157 charming persona, 154, 156 157 clinical guidelines, criminal behavior, 157 diagnosing in business environmen, 158–160 gender bias, 160, 161 geneic componen, 158 Hare Psychopahy Checklis (PCL), 157 passive psychopahs, 159 physiological characerisics, uncional MRIs (MRIs), 157–158 “psychopahic behaviors,” 154 psychopahic disinguished rom anisocial, 157 subsance abuse, role o, 155–156 corporae and financial psychopahs, disincion, 161 definiion o, 161–162 Diagnostic and Statistical Manual of Mental Disorders, 5th Ed. (DSM-5) crierion, financial psychopahs, 161–162 psychopahs, clinical diagnosis, 154–155, 156, 158, 161–162 examples o, 162–163 Farkus, Lee B., 162–163, 166 financial crisis o 2007–2008, 154–155, 163–164 financial environmen, emergence in, 163–166 financial environmen, key changes in, 164–166 “financial capialism” period, 165–166 financial crisis o 2007–2008, 154–155, 163–164

621

“indusrial capialism,” 164–165, 166 pension plans, 165–166 echnology, 164 Grambling, John, Jr., 159 idenificaion o clinical diagnosis, 154–160 generally, 162–163 key changes in financial environmen, 164–166 Madoff, Bernie, 162, 166 financial herapiss, 102 financial herapy, 102 financial wellness, closing gender gap, 236 fine ar. See ar and collecibles FIX communicaion proocol, 506 flickering orders, 510–511, 512t, 514–516 flickering quoes on buy offers, 501, 501f orecas opimism bias. See financial analyss’ repors and orecas opimism bias 401(k) plan, 338, 340, 342, 346, 348 racal marke hypohesis, 446–448 comparaive characerisics o EMH and, 447, 447t persisence, 447–448 raming effec bias, 26–27, 312–313 asse allocaion, 372–373, 375 clien educaion, raming financial planning process, 529–530, 529–535 clien managemen, applicaion o behaviorally based ho invesmens, reraming echniques, 536–537 reporing, raming and, 540 definiion o, 312 disposiion effec, 313 execuive relucance o applicaion o behavioral finance, openness on raming/ reraming, 551 financial advisory services, consumer bias, 292–293 financial planners, 27 herd menaliy, 312 ho invesmens, reraming echniques, 536–537 insurance purchasing decisions based on perceived risk, 303 loss aversion, 312 money illusion, 313 narrow raming muual unds, selecion o, 384 reiremen planning and wealh managemen, 345, 346 wealh managemen, 345, 346 quarerly reporing, clien managemen, 540 success rame and posiive rame, 27 ree cash flow heory, 404 ree rider problem (social loafing), 90, 91

622

Index

requen sock rading, 14, 209–219 as an epidemic, 209 corisol, sress hormone, 217 day raders, behavior o, 213–214 gambling disorder as possible cause o, 215–218, 219 invesor reurns, 209, 212 irraionaliy, 209, 210, 218 mobile echnology, rading implicaions o, 218 negaive emoions, 217–218 possible causes/moives, 209–210 aspiraion or riches moive, 212 beter-han average effec, 211 emoional reasons, 212 emoions or raional hinking, 213 gambling, invesing as subsiue or, 211–212 gambling disorder, 215–218, 219 gender bias, 210, 211, 214 invesing as subsiue or gambling, 211–212 miscalibraion, 210 overconfidence, 210–211 recreaion/leisure moive, 212 risk-as-eelings hypohesis, 213 risk-seeking behavior, 211–212 sensaion seeking moive, 212 esoserone and, 214

financial advisory services, consumer bias, 289–290 requen sock rading, 210, 211, 214 gambling disorder and requen sock rading, 216 human brain, male vs. emale, 231–232 insiuional invesors, 66 irraional financial behaviors creaing need or financial planning, 341–342 managerial rais, 84 porolio managers, 147–148, 149 psychopahs, 160, 161 raders, inormaion processing phase errors, 198 Generaion X (Gen Xers), compared o millennials American dream concep, 242, 243f employmen and unemploymen, 245 financial advisors, role o advisor saisacion, 254 echnology and financial inormaion, 255 financial advisors, use o degree o advisor use, by age group and income, 248f generaional crieria or making invesmen decisions, 251f impeus or seeking advice, 248–249 risk olerance and invesmen preerences,

prevalence 209, 218 ron-end load,o,104 uncional fixaion hypohesis, 453–455 ambiguiy, 454 causes o he uncional fixaion, 454 amiliariy bias, 454 uncional fixaion in he financial markes, 454–455 poenial soluions o uncional fixaion, 455 uncional MRIs (MRIs) psychopahs, physiological characerisics, 157–158

250–251 rus issues or millennials, 250 view o financial advisors, 249 financial crisis o 2007–2008, impac o, 245 financial oulook, shor and long erm, 246–247 reiremen planning, 246–247, 246f healh concerns, poenial impac o, 247 geneic componen individual invesors, 45–46 psychopahs, 158 globalocusing inernaional mergers and acquisiions (M&As), 399–400 Global Setlemen, 120, 123, 125 goal-based invesing aspiraion based preerences approach, 549 single behavior endency, 547 goal-based managemen high ne worh individuals (HNWIs), 180 golden parachue, 81 Grambling, John, Jr., 159 grandiosiy, 490 Grea Depression o he 1930s, 47 greenfield invesmens, 402 group dynamics, 54 group polarizaion (risky-shif effec), 485–487 grouphink behavior, 487–489 characerisics ha oser, 91 conormiy, 487–488 direcors, 91

gambler’s allacy, 196 gambling disorder and requen sock rading, 215–218, 219 clinical crieria, 215–216 corisol, sress hormone, 217 Diagnostic and Statistical Manual of Mental Disorders (DSM-5), crieria, 215–216 gender bias, 216 impulsiviy, 216–217 invesing as subsiue or gambling, 211–212 negaive emoions, 216–217 overconfidence, 215 possible moives or risk-seeking behavior, 211–212 gender bias, 8–9 esae planning, 327

623

I n d ex

individual and group decision makers, associaion beween, 488–489 insiuional invesors, 487– 488 speculaion in financial markes, 487–489 subsandard sraegies, 488–489

623

Hare Psychopahy Checklis (PCL), 157 healh insurance, 306, 316 hedge unds, 388–390 asses under managemen (AUM), saisics, 378, 388, 392–393 behavioral issues, 389–390 insiuional invesors, mood and, 75 invesmen perormance, 389 misvaluaions, orms o, 388–389 porolio managers, 137 rus, 390 herding behavior, 312 cascading/inormaional cascading, 71 financial analyss’ repors and orecas opimism bias, 124 financial bubbles, 141 inormaion based reasons or, 71 insiuional invesors, 65, 71–72 irraional financial behaviors creaing need or financial planning, 342

paricipaion in equiies, 503–504, 503t passive HFT, 502–504 high ne worh (HNW). See ar and collecibles high ne worh individuals (HNWIs), 13–14, 173–189 as acivis invesors, 175–176 behaviors, economic view o, 186–188 human capial heory, 186–188 Te Wealth of Nations,186 definiion o, 173, 176–177 human capial heory, 186–188 inequiy debae, varied responses o, 173–174, 189 invesmen behavioral biases, 174, 175, 182– 186 “emoional inoculaion,” 183–184 emoional invesors, 183–184 human vs. robo-advisors, 184 invesor psychology: nudge or predic, 185–186 irraionaliy, 183 loss aversion, 183 radiional vs. behavioral finance, 182 rus heurisic, 184–185 ulra-high ne worh (UHNW) designaion, 176 wealh accumulaion, 174–175 wealh managemen, 176–182, 189 advice, value o, 180–182

pension 142 140–142, 149 poroliounds, managers, speculaion in financial markes, 484–485 raders, 199 Yale model, 142 heerogeneiy among ypes insiuional invesors, 68–69 heurisics, 7–8, 23, 310–312, 316 affec heurisic, 30, 311 anchoring. See anchoring bias atribuion subsiuion, 311–312 availabiliy. See availabiliy bias causaliy, 311 cogniive bias, 5. See also specific bias financial analyss’ repors and orecas opimism bias, 124 herding. See herding behavior leniency heurisic, 124 1/N heurisic bias, asse allocaion, 369 personal financial planning, 278 represenaiveness. See represenaiveness bias saisficing, 7–8 HFT. See high-requency rading (HFT) hidden order execuion, 512–515 high-requency rading (HFT), 502–505 aggressive HFT, 502–504 defined, 502–503 equiy exchanges, developmens, 502–505 order placemen, 504, 504f orders on bid-ask spreads, 503, 503f

Asia, privae wealhand managemen, changing atiudes invesmen177 behaviors, 180 changing landscape o, 179 changing needs o HNWIs, 179 definiions, 176–177 Europe, privae wealh managemen, 177 global HNWI and wealh rend, 178–179 goal-based managemen, 180 high ne worh (HNW) designaion, 176 holisic invesing, 180 muli-amily office (MFO), privae wealh managemen, 178 philanhropy, 180 players and markes, 177–178 privae wealh managemen, 177–178 social impac effors, 180 ulra-high ne worh (UHNW) designaion, 176 he Unied Saes, privae wealh managemen, 177–178 hindsigh bias, 308–309 HNWIs. See high ne worh individuals (HNWIs) hoarding disorder ar and collecibles, 424 holisic invesing high ne worh individuals (HNWIs), 180 holon in financial planning, 271, 271f home asse bias asse allocaion, 370

624

Index

home bias speculaion in financial markes, 489 home-biased porolios insiuional invesors, 68, 74 homeowners insurance, 306 hormones corisol, sress hormone requen sock rading, 217 marke volailiy and, 232 esoserone levels and risk-seeking behavior requen sock rading, 214 individual invesors, 47 women invesors, 232 ho hand allacy concep explained, 29 muual unds, selecion o, 384 ho invesmens, reraming echniques clien managemen, 536–537 reiremen planning, 537 hourly compensaion agency coss in financial advice, 106 house money effec raders, inormaion processing phase errors, 197 hubris hypohesis. See also overconfidence inernaional mergers and acquisiions, irraional reasons or, 405 human brain

reurn chasing, 385 racking errors, 384 individual invesors, 11, 45–56 biases, 50–53 emoions and mood, 52–53 limied atenion, 51–52 negaive emoions, 52–53 overconfidence, 50–51 posiive emoions, 52–53 senimen/invesor senimen, 52 innae and learned invesor behavior, 45–48 See also financial crisis o 2007–2008, impac o cogniive abiliy and IQ, 46–47 financial crisis o 2007–2008, impac, 47 geneic acors and neural oundaions, 45–46 Grea Depression o he 1930s, 47 lie-course heory, 47 personal lie experiences, 47–48 esoserone and risk-seeking behavior, 47 insiuional invesors, comparisons o. See insiuional invesors muual unds, limied atenion, 51 nonsandard preerences. See individual invesors, nonsandard invesor preerences social conex, 53–56

malecapial differences beween, 231–232 vs. emale, human heory high ne worh individuals (HNWIs), 186–188 sraegic dimension o personal financial planning, 268

Bernie scandal, impac, 55 culure,Madoff 55 group dynamics, 54 online rading, 55–56 peer effec, 53–54 poliically acive individuals, 54 proximiy, 55 regional variaions, 55 social ideniy, 54 social ineracion, 53–54 social norms and values, 54 sock marke aversion, 54 echnology, 55–56 rus in receiving air reurns or economic ransacions, 54–55 social finance, 56 sophisicaion level o, 64 radiional finance vs. modern finance, differences, 45, 56 individual invesors, nonsandard preerences, 48–50 cogniive dissonance, 48 disposiion effec, 48, 49 amiliariy preerence, 49–50 lotery-ype socks and opions, 49 menal accouning, 48 prospec heory, 48 realizaion uiliy o gains and losses, 49 reail invesors, 49 skewness preerence, 49

idiosyncraic risk, 472–473 illusion o conrol, 29, 308 concep explained, 29 financial planning, 339 impulsiviy, 216–217 incenive-based compensaion agency heory, 80–81, 86 managerial rais, 86–87 risk-aking, 86–87 incenives. See also incenive-based compensaion financial advisors, 97 financial analyss’ repors and orecas opimism bias compeing incenives, 119 sock recommendaions, marke regulaion, 121 indemnificaion principle, 302 index muual unds, 384–385 annual cash flows in U.S. index muual unds, based on ICI daa, 381, 381t behavioral bias diversificaion bias, 385 rus, 385

625

I n d ex

625

individual psychology and sressors, 33 “indusrial capialism,” 164–165, 166 inequiy debae, 173–174, 189 ineria. See saus quo bias (ineria) inormaional cascading, 71 inormaion collecion phase errors, raders, 194–198 availabiliy bias, 194 amiliariy bias, 194 heurisics, 194 home bias, 194–195 illusion o conrol, 195 illusion o knowledge, 195 inormaion processing phase errors, raders, 194f, 195–198 anchoring effec, 196 anchoring heurisic, 195 beter-han-average effec, 198 break-even effec, 197, 198 cogniive dissonance, 196 confirmaion bias, 196 disposiion effec, 196–197 endowmen effec, 197 gambler’s allacy, 196 gender bias, 198 house money effec, 197 law o small numbers, 196

porolio under-diversificaion, 73 prospec heory ambiguiy aversion, culure and, 74 repuaion concerns o, 71 sophisicaion level o generally, 64, 65, 75 inormaion advanage and perormance, 69 oxic liquidiy, 501–502, 504, 505 rading behavior, 69–74 culure, 74 equiy home bias, 72–73 herding behavior, 65, 71–72 inormaional cascading, 71 inormaion based reasons or, 71 momenum rading, 70 mood, 73–74, 75 porolio under-diversificaion, 65, 72–73, 75 seasonal and weaher relaed condiions, 73–74 value generaing biases, 65 insurance, generally.See also insurance purchasing decisions definiion o, 302 elemens o, 302 sales, 316 ypes o insurance, 304–306 auomobile insurance, 306

loss 197, 198 meanaversion, reversion, 196 menal accouning, 196 miscalibraion, 198 overconfidence, 198 regre aversion, 196 represenaiveness heurisic, 195 saus quo bias, 198 sop-loss order, 197 inside direcors, 88, 89–91 insiuional invesors, 11–12, 64–75 behavioral biases, 65–68, 75 disposiion effec, 67 amiliariy bias, 68 gender bias, 66 heerogeneiy among ypes, 69 overconfidence, 66 represenaiveness bias, 68 definiion o, 65 endowmens, 69 equiy exchanges developmens, 499 oxic liquidiy, 501–502, 504, 505 grouphink behavior, 487–488 hedge unds, mood, 75 heerogeneiy among ypes, 68–69 home-biased porolios, 68, 74 individual invesors vs., 64–65 muual unds disposiion effec, 67

disabiliy insurance, healh insurance, 306305 homeowners insurance, 306 lie insurance, 305–306 long-erm care insurance, 306 propery and casualy insurance, 306 insurance agens, 101 insurance firms, 101 insurance purchasing decisions, 16, 302–316 bounded raionaliy, 304 perceived risk, decisions based on biases, 307–309, 316 disposiion effec, 313 raming effecs, 303, 312–313, 316 herd menaliy, 312 heurisics, 310–312, 316 loss aversion, 312 money illusion, 313 raional and irraional behavior, 313–316 bounded raionaliy, 304 individuals wih insurance, 314–315 insurance shoralls, 315 lie insurance, decisions o purchase levels o, 315–316 nominal moneary vs. real moneary view, 314 raionaliy, 304 risk atiudes, 307 risk olerance and, 302–304

626

Index

insurance purchasing decisions (Cont.) behavioral responses o risk, 304 bounded raionaliy, 304 indemnificaion principle, 302 law o large numbers, 302–303 law o small numbers, 303 naure o risk, 303–304 prospec heory, 304 raionaliy, 304 responses o risk, 304 radiional economic heory, 302, 315 inegralism, 271 ineres rae risk, 529 inernal locus o conrol, 28 inernaional and emerging marke sock indexes asse allocaion, amiliariy bias correlaion marix o U.S., 371, 371t perormance o he Unied Saes, 370, 370f inernaional mergers and acquisiions, 17, 397–418 behaviorally based success acors, 412–417 culural differences, 413–414, 414f srong inernal communicaion, 415 op eam selecion, 416–417, 416f curren rends, 397–400 developing world acquirer, growh o, 398 developing world’s growh aciviy, 397, 398 financial crisis orise 2007–2008, impac o, 398 globalocusing, o, 399–400 lower degrees o inegraion wih arges, pursui o, 398–399 parnering, 399 ransormaional acquisiions, 400 financially based success acors, 408–412 holisic due diligence, 409–410, 409t pre-acquisiion planning, 410–411, 411f synergy, 411–412, 412f, 413f oreign direc invesmen markes, atraciveness o, 400–402 banking indusry, mauriy o, 402 financial and inangible acors, 401, 401t greenfield invesmens, 402 irraional reasons or acquisiion, 404–405 deense behavior, 405 envy heory, 404 ree cash flow heory, 404 hubris hypohesis, 405 reasons or acquisiions generally, 402–405, 403f irraional reasons, 404–405, 405t success and ailure, generally, 405–408 amoun o shareholder value gained, 406, 406f compeiive advanage gained, 406, 407f successul acquisiions, 408–418 behaviorally based success acors, 412–417 financially based success acors, 408–412 overall success acors, 417– 418, 417f

synergy, 411–412 anicipaed synergies, 411–412, 413f comparison o ime spen on synergisic evaluaions, 411, 412f Inerne bubble, 483 inuiion, evaluaing validiy, 338–339 invered exchanges, 502 invesing atribues, 531–532, 531t invesmen adviser represenaives (IARs), 99, 100. See also Regisered Invesmen Advisers (RIAs), regulaion o Invesmen Advisers Ac o 1940 advisers vs. advisors, 108 Regisered Invesmen Advisers (RIAs), 99 invesmen advisor, 287 invesmen names, anchoring on, 340 invesmen policy saemen (IPS), 535, 540 invesmen ime horizon, 531 invesor senimen acion syle indicaors, 201–202 asse pricing and, 570–571 exchange-raded unds (ETFs), 387 individual invesors, 52 “marke psychology,” 201 opinion-syle indicaors, 201–202 role o media, 201–203 senimen indicaors, 201–203 social media plaorms, sock marke anomalies,202– 475 203 irraional behavior. See raional and irraional behavior isomorphism coercive isomorphism, 568 mimeic isomorphism, 568 knowledge and evidence-based financial planning, 277–278 law o large numbers, 302–303 law o small numbers insurance purchasing decisions, risk olerance, 303 raders, inormaion processing phase errors, 196 leniency heurisic financial analyss’ repors and orecas opimism bias, 124 level load, 104 lie-course heory, 47 lie insurance, 305–306 purchasing decisions and risk managemen, 315–316 sales o, 316 “lif and drop” applicaion approach, academic, 547–550 aspiraion based preerences approach, 549

627

I n d ex

627

goal-based invesing aspiraion based preerences approach, 549 single behavior endency, 547 over-engineered echnical soluions, 548–549 cumulaive prospec heory (CPT), 548–549 porolio opimizaion, 548–549 single behavior endency, 547–548 menal accouning, 548 limied atenion bias muual unds individual invesors, 51 underperormance o, 382–383 sock marke anomalies, 474 limi order book. See order-by-order marke daa LinkedIn. See social media liquidiy. See equiy marke developmens “li” limi orders, 512, 514 local bias, 489 locus o conrol, 28 long-erm care insurance generally, 306 sales o, 316 loss aversion, 6–7, 23, 312 asse allocaion, 371–372 clien educaion, raming financial planning process, 533–534 disposiion effec, 7

managers. See also porolio managers; wealh managemen organizaional applicaion o behavioral finance execuive relucance, 551–552 senior managemen, suppor o, 558–559 ailoring design and organizaional deploymen, 550–551 raionalis perspecive o, 566–567 rais. See managerial rais margin o saey, 268 marial and amily dynamics, esae planning complexiy o planning process, 327 evolving naure o amilies, 320 amily assessmen ools, 329 marke daa. See order-by-order marke daa marke hypohesis. See behavioral finance marke hypoheses “marke psychology,” 201 marke size anomaly, 469 marke iming clien managemen, 535–536 sress on, invesmen sraegy leading o auly planning, 348–349 M&As generally. See mergers and acquisiions (M&As) inernaional M&As. See inernaional mergers and acquisiions

emoional loss, 6–7197 endowmen effec, financial crisis o 2007–2008 behavioral bias, impac o, 493 high ne worh individuals (HNWIs), 183 house money effec, 197 personal financial planning, 279 risk aversion vs. loss aversion, 534 raders, inormaion processing phase errors, 197, 198 lotery-ype socks and opions individual invesors, skewness preerence, 49

mean 196 mean-reversion, variance opimizaion, 368–369 media, role o. See also social media raders, invesor senimen, 201–203 menal accouning bias, 28, 309, 313–314 academic lif and drop applicaion approach, 548 asse allocaion, 364, 373–374, 375 clien managemen, 537 concep explained, 28 individual invesors, 48 personal financial planning, 278–279 raional and irraional behavior, 313–314 reurn objecives, 364 raders, inormaion processing phase errors, 196 mergers and acquisiions (M&As). See also inernaional mergers and acquisiions CEOs’ biases, 87–88, 92 millennials, 14–15, 241–260 American dream concep, 242, 243f anchoring bias and, 27–28 baby boomers and, 242–247. See also baby boomers financial advisors, role o, 252– 259 advisor saisacion, 253–255 engagemen, naional and personal concerns o millennials, 247 echnology and financial inormaion, 255–257 financial advisors, use o, 247–252 deb, 251–252

Madoff, Bernie, 162, 166 managemen heories, 80–83 agency heory, 79, 80–81, 91 differeniaing acors, 82–83 sewardship heory, 79, 81–82, 92 managerial rais, 84–86 bounded raionaliy, 84 compensaion, relaion o, 86–87 conservaism, 84 gender bias, 84 incenive-based compensaion, 86–87 opimism, managerial opimism, 84–85 overconfidence, 84, 85–86 religion, influence o, 84 risk aversion, managerial risk aversion, 86 risk percepion bias, 84

628

Index

millennials (Cont.) degree o advisor use, by age group and income, 248f generaional crieria or making invesmen decisions, 251f household money managemen, 251–252 impeus or seeking advice, 248–249 reerrals, 249 risk olerance and invesmen preerences, 250–251, 251f rus issues or millennials, 250 view o financial advisors, 249 financial advisors and ulra- high ne worh (UHNW) millennials advisor saisacion, 254 reiremen planning, 246 role o, 252–253 use o, 248, 249, 250, 252–253 financial crisis o 2007–2008, impac o, 242, 244–246, 492 “boomerang children,” 245 employmen and unemploymen, 245 financial lieracy, 244 millennial men, 245 millennial women, 245 mindse, 244–246 financial lieracy, 242–244, 259 financial crisis oor 2007–2008, impac o, 244 knowledge level invesors by age group and income, 244f reiremen savings, 243–244 financial oulook, shor and long erm, 246–247 Gen Xers and. See Generaion X (Gen Xers), compared o millennials invesor profiles, 257–259 he climber, 257 amily maters, 258 on my own, 257–258 no worries, 258 he worrier, 259 Millennial Disrupion Index, 259 naional concerns, 247 as percenage o U.S. workers, 241 personal concerns, 247 reiremen planning, 246–247, 246f healh concerns, poenial impac o, 247 robo-advisor, 256–257, 257f, 260 social media, 255–256, 256t sereoype, 241, 244, 260 echnology and financial inormaion, 255–257 likelihood o clien use o financial services via echnology, 257, 258f millennial invesor profiles, 257–259 robo-advisor, 256–257, 257f, 260 “sandwich generaion,” 257 social media used or specified aciviies, 255–256, 256t

mimeic isomorphism recommendaions or increased amiliariy, 568 misrus. See rus modern finance vs. radiional finance, differences, 45, 56 modern liquidiy, subses o, 500–501 modern porolio heory (MPT), 4, 367–369 assumpions under MPT, 367–368, 375 clien educaion, 527–528, 528f developmen o, 359 risk reducion hrough diversificaion, 527, 528f momenum anomalies long-erm reversal, 468–469 reurns o porolios ormed based on previous sock reurns, 467, 468t momenum rading insiuional invesors, 70 momenum ype sraegies, raders, 199–200 conservaism in expecaions, 199 expecaion exrapolaion, 199 money illusion, 313 money languages irraional financial behaviors creaing need or financial planning, 341–342 money shame, 341 money sickness syndrome, 32– 33 monioring coss, 103 Mone Carlo 268–269 mood. See emoional bias alsoanalysis, changes in, ar and collecibles, 423 emoion, mood, and affec, disincions beween, 30 insiuional invesors, 73–74, 75 Mood Mainenance Hypohesis (MMH), 30 moral hazard concep porolio managers, risk-aking behavior, 142–143 moraliy issues irraional financial behaviors creaing need or financial planning, 342 moraliy salience esae planning, 324–325 morgage backed securiies (MBS), 363 moivaional inerviewing clien inerview mehodologies, esae planning, 330–331 MPT. See modern porolio heory (MPT) muli-amily office (MFO), privae wealh managemen, 178 muual unds, 379–385 acive vs. passive managemen, 380–381, 381t asses under managemen (AUM), saisics, 378, 380t, 392–393 disposiion effec insiuional invesors, 67 relaed o underperormance, 383 emoional bias, 30

629

I n d ex

financial emoions ha influence decisions, 30 index muual unds, biases, 381, 381t, 384–385 diversificaion bias, 385 reurn chasing, 385 racking errors, 384 rus, 385 insiuional invesors disposiion effec, 67 porolio under-diversificaion, 73 limied atenion, individual invesors, 51 perormance o acively managed unds, 381, 382 indusry compeiion, impac o, 382 porolio managers, 136 porolio under-diversificaion, insiuional invesors, 73 reurn chasing generally, 382, 384 index muual unds, 385 risk adjused reurns (alpha), 381, 382 selecion o unds, biases, 383–384 disposiion effec, 67, 383–384 amiliariy bias, 384 ho hand allacy, 384 narrow raming, 384 overconfidence, 384 arge dae und sraegy, underperormance, biases340 relaed o, 382 cogniive dissonance, 383 disposiion effec, 383 limied atenion bias, 382–383 opimism, 383 sel-atribuion, 383 narrow raming. See also raming effec bias muual unds, selecion o, 384 reiremen planning and wealh managemen, 345, 346 wealh managemen, 345, 346 naional bes bid offer (NBBO), 500 Nazrudin Projec (“Naz”), 271 negaive emoions, 32–37, 38. See also emoional bias exper decision makers, 33–34 gambling disorder and requen sock rading, 216–217 individual invesors, 52–53 individual psychology and sressors, 33 money sickness syndrome, 32– 33 neurofinance (also known as neuroeconomics), 34–35 regre aversion heory, 37 reiremen issues, 34 risk percepion and, 35–37 worry, 35

629

neoclassical heory o financial decision making, 193 neurofinance (also known as neuroeconomics), 34–35 noisy marke hypohesis, 452–453 opimism, 453 overconfidence, 453 nominal moneary vs. real moneary view, 314 nosalgia effec, 425 novice raders, simulaions and behavior o, 203–205 nudging concep (also known as paernal liberarianism) applicaion o behavioral finance, 554–555 asymmeric paernalism, 554–555 employer nudges, 350–351 examples o successul and unsuccessul nudges, 546–547 financial planner nudges, 351–353 high ne worh individuals (HNWIs), 185–186 pension plans asymmeric paernalism, 554–555 auo-enrollmen, 554, 555t, 558 increasing conribuions, successul and unsuccessul examples, 546–547 reiremen planning, 337–338 employer nudges, 350–351 enhancing wealhnudges, hrough351–353 nudges, 350–353 financial planner wealh managemen, enhancing wealh hrough nudges, 350–353 objecive and subjecive issues influencing decision making, 5 1/N heurisic bias, 369 one-sided invesmen plans, 347 online rading and invesmen plaorms daily reurns, display o, 557 financial advisory services, 292, 296– 297 individual invesors, social conex, 55–56 novice raders, simulaions, 204 speculaion, 483 rader’s overconfidence, impac on, 198 rading requency, 56, 198 opinion-syle indicaors, 201–202 opporunisic behavior, 81 opporunisic liquidiy. See oxic liquidiy (opporunisic liquidiy) opimism bias, 307 CEOs, 87–88 excessive opimism, 307 orecas opimism bias. See financial analyss’ repors and orecas opimism bias managerial opimism, 84–85 mergers and acquisiions, 87–88 muual unds, underperormance o, 383

630

Index

opimism bias (Cont.) noisy marke hypohesis, 453 pension unds, 392 realisic opimism, 280 speculaion in financial markes, 490 order-by-order marke daa, 505–512 cancellaions, 506–507, 508t message immediaely ollowing order placemen, 510, 512t size and shel lie o orders, single cancellaion, 508, 509t execued orders, 511–512 flickering orders, 510–511, 512t, 514–516 hidden order execuion, 512–515, 515t, 517t inerday evoluion o orders, 508, 510 limi order book, 500, 501f, 505–512 “li” limi orders, 512, 514 marke order execuion, 514–515, 514t, 516t number o order messages per each added limi order, 508, 509f order-based negoiaions, 512–516 order sizes, 506–507, 507t order ypes, saisics, 505 revisions/adjusmens o orders, 510, 511t sequenial order updaes, 507, 508t organizaional applicaion o behavioral finance execuive relucance, 551–552

noisy marke hypohesis, 453 online rading, impac on raders, 198 overreacion hypohesis, 451t pension unds, 392 personal financial planning, 279 porolio managers, 139–140, 147–148, 149 resolueness, 88 speculaion in financial markes, 483, 490 sock marke anomalies, 473 raders impac o online rading, 198 inormaion processing phase errors, 198 over-engineered echnical soluions academic lif and drop applicaion approach, 548–549 overreacion and underreacion, 490–491 overreacion hypohesis, 448–450 lieraure review, 448 movemen o DJIA (2000–2013), 449f reasons or invesor overreacions, 450, 451t oversimplificaion reiremen planning and wealh managemen, 346 wealh managemen, 346 overrading. See requen sock rading

senior managemen, suppor o, 558– 559 ailoring design and organizaional deploymen, 550–551 organizaional heory, 568 osrich effec, 339 ouside direcors (independen direcors), 88–91 overconfidence, 8–9, 23, 307–308 asse allocaion, 374–375 CEOs, 87–88 corporae akeovers, 87–88 execuive relucance, applicaion o behavioral finance, 551 requen sock rading, 210–211 gambling disorder and requen sock rading, 215 gender bias insiuional invesors, 66 men vs. women, 8–9 porolio managers, 147–148 hubris hypohesis, inernaional mergers and acquisiions, 405 individual invesors, 50–51 insiuional invesors, 66 Inerne bubble, 483 irraional financial behaviors creaing need or financial planning, 341–342 managerial rais, 84, 85–86 men vs. women, 8–9 mergers and acquisiions, 87–88 muual unds, selecion o, 384

paradigm shifing, 562–563 episemological paradigms, 565–566 inerpreivis perspecive/mehodologies, 565–566 posiivis perspecive, 565 parnering inernaional mergers and acquisiions (M&As), 399 passive high-requency rading, 502–504 passive psychopahs, 159 paernal liberarianism. See nudging concep (also known as paernal liberarianism) Paul v. Virginia (Supreme Cour case), 101 paycheck syndrome, 538–540 peer effec financial advisory services, consumer bias, 293 individual invesors, social conex, 53–54 pension plans, 390–392 acivism/acivis invesors, 391–392 asses under managemen (AUM), saisics, 378, 390, 392–393 asymmeric paernalism, 554–555 auo-enrollmen, nudges, 554, 555t, 558 behavioral biases, 392 conribuions, increasing asymmeric paernalism, 554–555 auo-enrollmen, 554–555 emoions, 547 nudges, examples o successul and unsuccessul, 546–547

panic, 451t

631

I n d ex

631

defined benefi plans, 340, 352 porolio managemen, 138 psychopahy, emergence in financial environmen, 165–166 defined conribuion plans, 338, 340, 345 porolio managemen, 138 ees, 391 401(k) plan, 338, 340, 342, 346, 348 herding behavior, porolio managers, 142 nudges, 554–555, 555t, 558 opimism bias, 392 overconfidence, 392 perormance, 391 porolio managemen, 138 porolio managers, herding behavior, 142 psychopahy, emergence in financial environmen, 165–166 risk exposure, 391 “window dressing”by selling loser socks, 390– 391 perceived risk. See risk percepion bias persisence, 447–448 personal financial planning, 15, 265–281. See also personal financial planning, clien rus and commimen bes pracices, 277–278 biases, sraegies or overcoming, 279–281 emoional sel-managemen, 281

financial lie planning and, 270–272 holon in financial planning, 271, 271f inegralism, 271 Nazrudin Projec (“Naz”), 271 policy-based planning, 269–270 process-oriened echniques, 269–270 quaniaive echniques, 268–269 duraion analysis, 268 human capial, 268 margin o saey, 268 Mone Carlo analysis, 268–269 ne resources, 268 scenario planning, 269 sensiiviy simulaions, 269 sae wihdrawal rae, 270 personal financial planning, clien rus and commimen, 272–277 building rus and commimen relaionship, 274–275, 274f communicaion dimension, 276–277 communicaion effeciveness, 275, 275f componens o rus and commimen, 273–274, 274f acors influencing, 273–275 uncional conflic, 273 uncional qualiy, 275, 275f high credence services, clien difficuly

empahy and compassion, 281280–281 posiive conversaional skills, possibiliy mindse, 280 realisic opimism, 280 biases o cliens, 278–281 anchoring, 279 availabiliy heurisic, 279 heurisics, 278 loss aversion, 279 menal accouning, 278–279 overconfidence, 279 represenaiveness heurisic, 279 Cerified Financial Planner (CFP) designaion, 266 CFP Board o Sandards, 266–267 depression/clinical depression, 265 financial planning process (seps), 267– 268, 281 hisory and developmen o, 266–267, 281 holon in financial planning, 271, 271f inegralism, 271 knowledge and evidence-based financial planning, 277–278 socieal benefis, 265 sandard seting bodies bes pracices, 277–278 generally, 266–267 sraegic dimension, 268–272 decision rules, 269–270 inerior dimension connecing he inerior and exerior, 272

posiive assessing, oucomes,273 273 reerrals, 273 saisacion, role o, 275–276, 276f saisacion and rus as anecedens o commimen, 276, 276f echnical qualiy, 275, 275f personal financial specialiss (PFS) designaion, regulaion o, 101–102 perspecive research and researchers, uure o, 566–569 behavioral bias driven irraionaliy, 567 inerpreivis perspecive/mehodologies, 565–566 paradigm shifing, 562–563 posiivis perspecive, 565 primacy o philosophical perspecive, 562 raionalis perspecive, manager’s, 566–567 philanhropy ar and collecibles, 427 high ne worh individuals (HNWIs), 180 philosophy o uure behavioral finance research, 562–566. See also research and researchers, uure o anomalies, idenificaion o, 563, 566 episemologocial paradigms, 565–566 general disdain or philosophical discussion in finance, 562 inerpreivis perspecive/mehodologies, 565–566

632

Index

philosophy o uure behavioral finance research (Cont.) normal science, 563 paradigm shifing, 562–563 perspecive, primacy o philosophical, 562 posiivis perspecive, 565 publishing behavioral finance research, 564–565, 564t, 565t research programs, 563–566, 575 poliically acive individuals, 54 porolio choice, 4 porolio managemen. See asse allocaion porolio managers, 13, 135–149 behavioral biases, 139–148 gender differences, 147–148, 149 herding behavior, 140–142, 149 endowmens, 142 financial bubbles, 141 pension unds, 142 Yale model, 142 overconfidence, 139–140, 147–148, 149 cerainy overconfidence, 139–140 gender differences, 147–148 predicion overconfidence, 139 prospec heory, 146–147 risk-aking behavior, 142–146, 149 alernaive asse managemen firms, 144

academic lif and drop applicaion approach, 547–550 digial echnology and daa analyics advancemens, 552 execuive relucance/senior managemen, 551–552 good news and changing atiudes, 552 indusry and policymakers, changing atiudes o, 552 superficial approaches/applicaions, 545–547 ailoring design and organizaional deploymen, 550–551 changing atiudes behavioral finance erminology, amiliariy wih, 543 o indusry and policymakers, 552 cumulaive prospec heory (CPT) misundersanding o, 545–546 over-engineered echnical soluions, 548–549 digial echnology and daa analyics advancemens, applicaion opporuniies, 552 EAST ramework (UK), 557–558 execuive relucance/senior managemen, 551–552 good applicaion principles, 553–557 asymmeric paernalism as guiding

ambiguiy aversion, 145–146 moral hazard concep, 142–143 radiional asse managemen firms, 143–144 herding behavior, 140–142, 149 prospec heory, 146–147 real esae invesmen russ (REITs), 147 porolio managers, regulaion o alernaive asse managemen, invesmen sraegies, 137 hedge unds, 137 muual unds, 136 porolio opimizaion over-engineered echnical soluions, 548–549 porolio under-diversificaion. See diversificaion bias posiive conversaional skills, 280–281 posiive rame, 27 posiivis perspecive, 565 possibiliy mindse, 280 pracical applicaion o behavioral finance, 19–20, 542–559 academic lif and drop. See lif and drop applicaion approach, academic asymmeric paernalism, 554–555, 555t bias “bias” bias, source o misconcepion, 543–544 complexiies o, 546 challenges, good and bad applicaions, 545–552

principle, 555 finance almos always isolaion, behavioral useless in, 553 nudges, behavioral finance is no jus, 554–555 senior managemen suppor and organizaional applicaion, 558–559 radiional approaches, behavioral finance as companion o, 553–554 undersanding how processes and people inerac o induce beter decisions, 556–557 indusry and policymakers, changing atiudes o, 552 misconcepions in commercial pracice, 543–545 academic field, cos o “labels,” 544–545 “bias” bias, 543–544 generally, 543 sources o, 543–545 radiional and behavioral finance, 544 misguided atemps o implemen academic behavioral ideas and examples, 547–550 nudges applicaion o behavioral finance, 554–555 asymmeric paernalism, 554–555 examples o successul and unsuccessul nudges, 546–547 organizaional applicaion senior managemen, suppor o, 558– 559

63

I n d ex

633

ailoring design and organizaional deploymen, 550–551 senior managemen execuive relucance, 551–552 suppor and organizaional applicaion, 558–559 superficial approaches/applicaions, 545–547 biases, complexiies o, 546 nudges, examples o successul and unsuccessul, 546–547 ailoring design and organizaional deploymen, 550–551 echnology, digial echnology and daa analyics advancemens and applicaion opporuniies, 552 presen bias financial planning, 339, 345 reiremen planning and wealh managemen, 339, 345 wealh managemen, 339, 345 priming, 292–293 principal-agen relaionship, 102–103 privae wealh managemen. See high ne worh individuals (HNWIs) proessional raders and reail raders, disinguished, 192 progressive research programs, 563, 564, 575

Diagnostic and Statistical Manual of Mental Disorders, 5th Ed. (DSM-5), 154–155, 156, 158, 161–162 financial psychopahs, crierion, 161–162 gender bias, 160 geneic componen, 158 Grambling, John, Jr., 159 Hare Psychopahy Checklis (PCL), 157 passive psychopahs, 159 physiological characerisics, uncional MRIs (MRIs), 157–158 “psychopahic behaviors,” 154 psychopahic disinguished rom anisocial, 157 subsance abuse, role o, 155–156 psychopahy, emergence in financial environmen, 163–166. See also financial psychopahs financial crisis o 2007–2008, 163–164 key changes, idenificaion o, 164–166 “financial capialism” period, 165–166 financial crisis o 2007–2008, 154–155, 163–164 “indusrial capialism,” 164–165, 166 pension plans, 165–166 echnology, 164 pension plans, 165–166 publishing behavioral finance research ailure o develop producive research and

projecees, 107insurance, 306 properybased and casualy prospec heory, 6, 23, 313. See also disposiion effec ambiguous evidence, 125 clien educaion, raming financial planning process, 533–534 cumulaive prospec heory (CPT) academic lif and drop applicaion approach, 548–549 misundersanding o, 545–546 over-engineered echnical soluions, 548–549 insiuional invesors, culure and, 74 insurance purchasing decisions, risk olerance, 304 nonsandard invesor preerences, individual invesors, 48 porolio managers, 146–147 real esae invesmen russ (REITs), 147 role o, 7 sock marke anomalies, 474–475 psychopahs, clinical diagnosis, 154–160. See also financial psychopahs; psychopahy, emergence in financial environmen anisocial disinguished rom psychopahic, 157 charming persona, 156 clinical guidelines, 154, 157 criminal behavior, 157 diagnosing in business environmen, 158–160

publishing bias, 569 o purely limied oules or publishing heoreical research, 565 saisics, 564 coun o aricles in SSRN Behavioral and Experimenal Finance (ejournal), 564, 565t SSRN behavioral and experimenal finance ejournal, aricle coun, 564, 565t purchasing power, 529 randomness o pricing processes racal marke hypohesis and, 446–448, 447t overreaion hypohesis and, 448–450 random walk hypohesis, 440, 441f, 442f random walk hypohesis, 440 gold prices in 3-monh period (2006), 440, 442f randomly generaed values, 440, 441f raional and irraional behavior biases creaing need or financial planning, 339–342 anchoring, 342 anchoring on invesmen names, 340 availabiliy bias, 342 financial milesones, 340 gender bias, 341–342 herding, 342 money emoions, 340–341 money languages, 341–342

634

Index

raional and irraional behavior (Cont.) money shame, 341 moraliy issues, 342 overconfidence, 341–342 arge dae und sraegy, 340 use o he word “smar,” 341 women, longer lie expecancy, 236, 342 bounded raionaliy concep adapive markes hypohesis (AMH), 444 defined, 5, 24 insurance purchasing decisions, risk olerance, 304 managerial rais, 84 research programs, 563–564 requen sock rading, 209, 210, 218 high ne worh individuals (HNWIs), 183 insurance purchasing decisions, 313–316 menal accouning, 313–314 money emoions, 340–341 perspecive behavioral bias driven irraionaliy, 567 manager’s raionalis perspecive, 566–567 raionalis perspecive, manager’s, 566–567 raionaliy/irraionaliy assumpion adapive marke hypohesis and, 443–446 efficien marke hypohesis (EMH), 441

Regisered Invesmen Advisers (RIAs), regulaion o, 98–100 invesmen adviser represenaives (IARs), 99, 100 required filings, 99–100 role o, 99–100 SEC and sae regulaors, 99–100 regisered represenaives, 100 regre aversion, 309 heory, 37 raders, inormaion processing phase errors, 196 REITs. See real esae invesmen russ (REITs) religion, influence, 84 “reniers” (Europe), 182 reporing analyss repors. See financial analyss’ repors and orecas opimism bias ar and collecibles, managemen and reporing, 429 clien managemen, raming and, 540 pre-experimen research proocols and regisered replicaion repors, 574 represenaiveness bias, 25–26, 310 book-o-marke equiy and, 26 concep explained, 25–26 insiuional invesors, 68 overreacion hypohesis, 451t

racal marke hypohesis and, 446–448, uncional fixaion hypohesis, 453–455 447t noisy marke hypohesis, 452–453 raional manager/irraional invesor, asse pricing, 570, 575 raional maximizer, 313 sock marke anomalies, 470–471 raional maximizer insurance purchasing decisions, raional and irraional behavior, 313 real esae asse class, 360, 362–363 morgage backed securiies (MBS), 363 real esae invesmen russ (REITs), 363 real esae invesmen russ (REITs), 363 porolio managers, prospec heory, 147 realisic opimism personal financial planning, sraegies or overcoming biases, 280 realizaion uiliy o gains and losses nonsandard invesor preerences, individual invesors, 49 rebalancing sraegies, asse allocaion, 366 buy-and-hold sraegy, 366 calendar balancing, 366 consan mix sraegy, 366 recency bias, 309 financial crisis o 2007–2008 behavioral bias, impac o, 492 Reg FD financial analyss’ repors and orecas opimism bias, 120, 122–123, 125, 130

personal financial planning, risk-reurn relaionship, 26 279 speculaion in financial markes, 489–490 raders, inormaion processing phase errors, 195 underreacion hypohesis, 452 repuaion concerns financial analyss’ repors and orecas opimism bias, 119, 122, 126, 127, 129 insiuional invesors, 71 research asse pricing. See asse pricing, uure o invesor psychology research uure o. See research and researchers, uure o uure philosophy. See philosophy o uure behavioral finance research generally, 285–286 improving reliabiliy. See research daa and mehodologies, improving reliabiliy programs. See research programs publishing. See publishing behavioral finance research research and researchers, uure o, 20, 561–575 asse pricing research, 561, 569– 572, 575 curren primary ocus o CEO’s role, 561, 567–568, 575 issues wih, 567–568 experimenal finance asse pricing research, heory building, 570 improving reliabiliy, communicaion inrasrucure improvemens, 574 improving reliabiliy, 572–574 perspecive, 566–569

635

I n d ex

635

behavioral bias driven irraionaliy, 567 inerpreivis perspecive/mehodologies, 565–566 paradigm shifing, 562–563 posiivis perspecive, 565 primacy o philosophical perspecive, 562 raionalis perspecive, manager’s, 566–567 philosophy o uure behavioral finance, 562–566 publishing behavioral finance research ailure o develop producive research and publishing bias, 569 publishing o purely heoreical research, limied oules, 565 saisics, 564, 565t recommendaions or increased amiliariy wih CEO, CFO, and managemen eam, 568 coercive isomorphism, 568 culural differences and behavioral biases, 568–569 mimeic isomorphism, 568 organizaional heory, 568 research programs, 563–566, 575 research daa and mehodologies, improving reliabiliy, 572–574 availabiliy o daases and clear mehodology, journal auhors, 574 communicaion inrasrucure

anchoring on invesmen names, 340 availabiliy bias, 342 financial milesones, 340 gender bias, 341–342 herding, 342 money emoions, 340–341 money languages, 341–342 money shame, 341 moraliy issues, 342 overconfidence, 341–342 arge dae und sraegy, 340 use o he word “smar,” 341 women, longer lie expecancy, 236, 342 osrich effec, 339 presen bias, 339, 345 salience bias, 339 saus quo bias, 339 “unbiased” sel-assessmens, 339, 353 Cerified Financial Planners (CFPs), 338, 343–344, 351, 353 emoional vs. expressive relaionship, 337 enhancing wealh hrough nudges, 350–353 employer nudges, 350–351 financial planner nudges, 351–353 fiduciaries, 338 ho invesmens, reraming echniques, 537 invesmen sraegies, biases and behaviors

574 insuringimprovemens, reliable research, soluions, 574 pre-experimen research proocols and regisered replicaion repors, 574 replicaion or reproducibiliy o research, issues concerning, 572–573 secre daa, 572, 574 solid core o heory and improved mehodologies, 573–574 research programs, 563–566, 575 bounded raionaliy concep, 563–564 degeneraive research programs, 563 progressive research programs, 563, 564, 575 publishing o purely heoreical research, limied oules, 565 radiional finance, reduced criicism o, 564, 566 residual losses, 103–104 resolueness, CEOs, 88 reail invesors. See also individual invesors skewness preerence, 49 sophisicaion level o, 64 reainer ees agency coss in financial advice, 106–107 reirees, clien managemen, 537–540 reiremen planning, 16, 337–353. See also pension plans; reiremen planning proessionals biases creaing need or financial planning, 338–342, 353 illusion o conrol, 339 inuiion, evaluaing validiy o, 338–339 irraional financial behaviors, 339–342 anchoring, 342

leading o auly planning, 346–350 conflicing social values, 347–348 auly invesmen selecion, 348 inadequae ax planning, 349–350 limied diversificaion, 347 one-sided invesmen plans, 347 sress on marke iming, 348–349 unbalanced invesmen review, 349 millennials, 243–244, 246–247, 246f negaive emoions wihin financial decision making, 34 nudging concep, 337–338 employer nudges, 350–351 enhancing wealh hrough nudges, 350–353 financial planner nudges, 351–353 saus quo bias, 9, 372 ulra-high ne worh (UHNW) millennials, 246 uiliarian ocus o economics, 337 women invesors, 236 reiremen planning proessionals biases in decision o hire, 342–344, 353 compeency, 343–344 generally, 342–343 honesy, 344 reliabiliy, 344 erm “financial advisor,” 343 raining and knowledge, 342–343 rus, 343 Cerified Financial Planners (CFPs), 338, 343–344, 351, 353 reurn drag, 363

636

Index

reurn objecives asse allocaion, 360, 364–365 menal accouning bias, 364 reurn-volailiy relaion exchange-raded unds (ETFs), 387 reversion o he mean, 492 RIAs. See Regisered Invesmen Advisers (RIAs), regulaion o risk and reurn, inverse relaionship, 24–25, 38 risk-as-eelings hypohesis, 31 requen sock rading, 213 risk aversion, 4 atiudes owards, 304, 307 capial asse pricing model (CAPM), developmen o, 4 CEOs, 87, 92 efficien marke hypohesis (EMH), 4 vs. loss aversion, 534 managerial risk aversion, 86 porolio choice, 4 women invesors, 232–233 risk capaciy efficien ronier hypohesis (EFH), anchoring on clien educaion, 525 risk coaching. See clien educaion risk exposure pension unds, 391 risk managemen. See insurance purchasing decisions risk miigaion ar and collecibles, 429–430 risk percepion bias, 24, 38–39 assessmen o, 24 bounded raionaliy, defined, 24 CEOs, 87 defined, 24 managerial rais, 84 saisficing, 24 worry and, 35–37 risk requiremen efficien ronier hypohesis (EFH), anchoring on clien educaion, 525, 526 risk-reurn radeoff, 26 asse allocaion, 364–365 efficien ronier hypohesis (EFH), anchoring on clien educaion, 524, 524f raional explanaion or sock marke anomalies, 470–471 represenaiveness bias, 26 risk-sharing problem agency heory, 80–81 risk-aking behavior, 24–25. See also risk-reurn radeoff; risk olerance; sysemaic risk (undiversifiable risk) anchoring risk. See clien educaion applicabiliy o, 24 arbirage, sock marke anomalies, 472–473

idiosyncraic risk, 472–473 sysemaic risk, 472 aversion. See risk aversion baby boomers, 492 clien managemen, 537 conduc risk, 556 consumer biases, sraegies or overcoming, 294 financial advisory services, consumer bias, 292 financial crisis o 2007–2008 behavioral bias and, 491–492 requen sock rading, 211–212 gambling disorder and requen sock rading, 211–212, 215–218, 219 hazards, 303 incenive-based compensaion, CEOs, 86–87 millennials, 492 moral hazards, 303–304 naure o risk, 303–304 objecive risk, 303 percepion. See risk percepion bias perils, 303 physical hazards, 303 porolio managers, 142–146, 149 precauionary savings, 492 pure risk, 303 responses o risk aversion. See risk aversion risk neural, 307 risk seekers, 307 risk ranser, 304, 305 reversion o he mean, 492 risk and reurn, inverse relaionship, 24–25, 38 risk need exceeds risk olerance, 527, 527f risk percepion. See risk percepion bias subjecive risk, 303 esoserone levels and requen sock rading, 214 individual invesors, 47 women invesors, 232 and uncerainy disposiion effec, 7 emoional loss, 6–7 loss aversion, 6–7 prospec heory, 6 women invesors, 232 risk-aking ools consumers o financial advisory services, sraegies or overcoming biases, 294 risk-aking ools, sraegies or overcoming biases, 294 risk olerance efficien ronier hypohesis (EFH), anchoring on clien educaion, 525 insurance purchasing decisions, 302–304 invesmen preerences and millennials, 250–251, 251f women invesors, 232–233 risky-shif effec (group polarizaion)

637

I n d ex

speculaion in financial markes, 485–487 robo-advisors clien amiliariy wih erm, 257f consumers o financial advisory services, sraegies or overcoming biases, 296–297 financial advisory services, 296 high ne worh individuals (HNWIs) and, 184 human advisors vs., 184 millennials, 256–257, 260

saey vs. cerainy capial asse pricing model (CAPM), clien educaion, 529 sae wihdrawal rae sraegic dimension o personal financial planning, 270 salience bias financial planning, 339 “sandwich generaion” millennials, 257 women invesors, 237 saisficing, 7–8 risk percepion bias, 24 raders, decision making process, 193 scenario planning sraegic dimension o personal financial planning, seasonal and weaher269 relaed condiions. See also emoional bias insiuional invesors, 73–74 SEC regisered exchanges, saisics, 499 sel-affiniy bias, 31 sel-assessmens, “unbiased,” 339, 353 sel-atribuion bias CEOs, 88 mergers and acquisiions, 88 muual unds, underperormance o, 383 sock marke anomalies, 473 raders, 199 sel-conrol bias, 29 sensiiviy simulaions sraegic dimension o personal financial planning, 269 senimen. See invesor senimen shor-selling, 137 single behavior endency academic lif and drop applicaion approach, 547–548 goal-based invesing, 547 menal accouning, 548 size anomaly (marke size anomaly), 469 skewness preerence individual invesors, 49 lotery-ype socks and opions, 49 reail invesors, 49 “smar” use o he word, financial planning, 341

637

snakebie effec raders, 200 social capial and rus, 54–55 social finance individual invesors, 56 social ideniy o individual invesors, 54 social ineracion individual invesors, social conex, 53–54 social media. See also echnology beter ools, beter daa, 433 e-commerce, role o, 433 globalizaion, 431–432 influence on wealh managemen, 430–434 invesor senimen, 202–203 millennials, 255–256, 256t online businesses and ransparency, 433–434 relaionships, business o business (B2B) vs. consumer o consumer (C2C), 432–433 social psychology asse pricing, uure o invesor psychology research, 569 social values conflicing, invesmen sraegy leading o auly planning, 347–348 individual invesors, 54 socieal benefis o personal financial planning, 265 speculaion in financial markes, 18–19, 481–495 behavioral 483–491 (EMH) and, 481 efficien aspecs, marke hypohesis exciemen/euphoric expecaion, 490 amiliariy bias, 489–490 grandiosiy, 490 group polarizaion (risky-shif effec), 485–487 grouphink behavior, 487–489 herd behavior, 484–485 home bias, 489 local bias, 489 opimism, 490 overconfidence, 483, 490 overreacion and underreacion, 490–491 represenaiveness bias, 489–490 financial crisis o 2007–2008, behavioral biases eviden ollowing, 481, 482, 491–494 anchoring, 492 collecive memory hypohesis, 491 lasing influence o economic shocks, 491–492 loss aversion, 493 recency bias, 492 saus quo bias, 493 rus and misrus in a financial seting, 493–494 worry, 492 hisorical background, 482–483 Inerne bubble, overconfidence and, 483 porolio managers, herding behavior, 141

638

Index

spors card collecions, 425 saus quo bias (ineria), 9, 23, 308 asse allocaion, 371–372, 375 financial crisis o 2007–2008, impac o, 493 financial planning, 339 loss aversion and, 371–372 reiremen accouns, 372 reiremen plans, 9 raders, inormaion processing phase errors, 198 sewardship heory, 79, 81–82, 92 agency heory, differeniaing acors, 82–83 behavior assumpions, 83 sock marke developmens. See equiy marke developmens generally. See equiy exchanges, generally sock marke anomalies, 18, 460–475 accrual anomaly, 469–470, 469f behavioral biases arbirage, limis o, 472–473 disposiion effec, 474–475 idiosyncraic risk, 472–473 limied atenion, 474 overconfidence, 473 prospec heory, 474–475 sel-atribuion, 473 senimen, 475 idenificaion o anomalies, 563, 566

invesmen advisor, 287 purpose o advice, 287–288 verical inegraion or ie-up, 287 wealh managers, 287 who offers advice, 287 sysemaic risk (undiversifiable risk) arbirage, sock marke anomalies, 472 asse allocaion, risk–reurn rade-off, 365 capial asse pricing model (CAPM), clien educaion, 528–529 generally, 303 unsysemaic risk, 303

invesmen 466f, 467f momenumanomalies, anomalies,465, 468–469, 468t size anomaly (marke size anomaly), 469 summary saisics (by counry & anomaly), 460–461, 462t–464t ypes o, 460, 461–470 value anomaly, 465–466, 471 why hey exis, 470–475 behavioral explanaion, 471–475 raional explanaion, 470–471 sock marke aversion individual invesors, social conex, 54 sock marke daa. See order-by-order marke daa sock recommendaions, marke regulaion, 121 sock rading, requen. See requen sock rading sop-loss order, 197 sraegic asse allocaion (SAA), 365–366 subjecive and objecive issues influencing decision making, 5 subsance abuse, role o psychopahs, 155–156 success rame and posiive rame, 27 suiabiliy sandard, 103 supply side financial advice, 287–289 added value o advice, 288–289 brokers, defined, 287 consumer biases, sraegies or overcoming, 293–296 financial advisor, 287 financial planners, 287

robo-advisors. See subheading robo-advisors, below echnology driven advice, 292, 296–297 requen sock rading, 218 individual invesors, social conex, 55–56 millennials and financial inormaion, 255–259 online rading and invesmen plaorms daily reurns, display o, 557 financial advisory services, 292, 296–297 individual invesors, social conex, 55–56 novice raders, simulaions, 204 speculaion, 483 rader’s overconfidence, impac on, 198 rading requency, 56, 198 psychopahy, emergence in financial environmen, 164 error managemen heory, 325–326 esoserone levels and risk-seeking behavior requen sock rading, 214 individual invesors, 47 women invesors, 232 oxic limi orders, 501 oxic liquidiy (opporunisic liquidiy), 500–501 flickering, 502 insiuional invesors and, 501–502, 504, 505 racking errors index muual unds, 384 rade boosing, economic incenives o, 121 raders, 14, 192–205, 194. See also requen sock rading

acical asse allocaion (TAA), 366 akeovers CEOs, overconfidence, 87–88 direcors, 90 arge dae und sraegy, 340 ax planning, inadequae invesmen sraegy leading o auly planning, 349–350 echnology. See also robo-advisors; social media digial echnology and daa analyics advancemens, applicaion opporuniies, 552 financial advisory services

639

I n d ex

biases o availabiliy cascades, 199 cogniive bias, 193–194, 194f conormiy effec, 199 conservaism in expecaions, 199 conrarian sraegies, 200–201 disposiion effec, 200 expecaion exrapolaion, 199 gregarious and conrarian sraegies, disinguished, 200–201 herding, 199 momenum ype sraegies, 199–200 sel-atribuion bias, 199 snakebie effec, 200 social biases, 194, 194f, 199–201 day raders, behavior o, 213–214 decision making process algorihmic rading, 193 biases affecing, 193–201, 194f cogniive bias, 193–195 emoional bias, 194, 195–198 generally, 192–193 neoclassical heory o financial decision making, 193 saisficing, 193 social bias, 194, 199–201 disposiion effec inormaion phase errors, 196–197 social biases,processing 200 efficien marke hypohesis (EMH), 192 emoional bias, 194, 194f inormaion collecion phase, errors in, 194–198 inormaion processing phase errors, 194f, 195–198 invesor senimen acion syle indicaors, 201–202 “marke psychology,” 201 marke senimen, 201 opinion-syle indicaors, 201–202 role o media, 201–203 senimen indicaors, 201–203 social media plaorms, 202–203 momenum ype sraegies, 199–200 conservaism in expecaions, 199 expecaion exrapolaion, 199 novice raders, simulaions and behavior o, 203–205 proessional raders and reail raders, disinguished, 192 radiional asse managemen firms porolio managers, risk-aking behavior, 143–144 radiional economic heory insurance purchasing decisions, 302, 315 radiional finance heory, 3–4 basic premise, 3

639

vs. behavioral finance, high ne worh individuals (HNWIs), 182 capial asse pricing model (CAPM), developmen o, 4 efficien marke hypohesis (EMH), 4 vs. modern finance, differences, 45, 56 porolio choice, 4 reduced criicism o, philosophy o uure behavioral finance, 564, 566 risk aversion, 4 uiliy heory, 3–4 ranserence communicaions wih cliens, esae planning, 323–324 ransormaional acquisiions inernaional mergers and acquisiions (M&As), curren rend, 400 ransmission proocol, 505–506, 506t rus clien rus and commimen, personal financial planning, 272–277 building rus and commimen relaionship, 274–275, 274f communicaion dimension, 276–277 communicaion effeciveness, 275, 275f componens o rus and commimen, 273–274, 274f acors influencing, 273–275 uncional conflic, 273 uncional qualiy, 275, 275f high credence services, clien difficuly assessing, 273 posiive oucomes, 273 reerrals, 273 saisacion, role o, 275–276, 276f saisacion and rus as anecedens o commimen, 276, 276f echnical qualiy, 275, 275f consumers o financial advisory services downside o rus, 291 role o rus, 290–291 beween financial proessional and clien, 31 hedge unds, 390 high ne worh individuals (HNWIs), 184–185 index muual unds, 385 millennials and financial advisors, 250 misrus in a financial seting financial crisis o 2007–2008 behavioral bias, impac o, 493–494 in receiving air reurns or economic ransacions individual invesors, social conex, 55 reiremen planning proessional, biases in decision o hire, 343 role o rus financial advisory services, consumer bias, 290–291

640

Index

12b-1 ees, 104, 105 Twiter. See social media ulra-high ne worh (UHNW). See also ar and collecibles; millennials designaion, 176 unbalanced invesmen review invesmen sraegy leading o auly planning, 349 “unbiased” sel-assessmens, 339, 353 illusion o conrol, 339 osrich effec, 339 presen bias, 339, 345 salience bias, 339 saus quo bias, 339 under-diversificaion. See diversificaion bias underreacion hypohesis, 450–452 conservaism bias, 452 posiive auocorrelaion, 450 reasons or underreacion, 452–453 represenaiveness, 452 undiversifiable risk. See sysemaic risk (undiversifiable risk) Unied Saes, privae wealh managemen, 177–178 United States v. South-Eastern Underwriters (Supreme Cour case), 101 Association uiliarian ocus o economics, 337 uiliy heory, 3–4 value anomaly, 465–466, 471 value generaing biases insiuional invesors, 65 values. See social values verical inegraion or ie-up, 287 wealh accumulaion high ne worh individuals (HNWIs), 174–175 wealh managemen, 344–346. See also high ne worh individuals (HNWIs); reiremen planning aspecs o financial planning, 344–346 financial saus and sabiliy, 344–345 narrow raming, 345, 346 oversimplificaion, 346 presen bias, 339, 345 enhancing wealh hrough nudges, 350–353 employer nudges, 350–351 financial planner nudges, 351–353 financial saus and sabiliy, 344–345 narrow raming, 345, 346 oversimplificaion, 346 presen bias, 339, 345

social media’s influence on, 430–434 beter ools, beter daa, 433 collecion managemen ools as wealh ools, 434 e-commerce, role o, 433 globalizaion, 431–432 holdings as commodiies, 430 online ar educaion, 432 online aucions and markeplaces, 432 online businesses and ransparency, 433–434 relaionships, business o business (B2B) vs. consumer o consumer (C2C), 432–433 wealh managers, 287 Te Wealth of Nations,186 weaher and seasonal relaed condiions. See also emoional bias insiuional invesors, 73–74 wills, 318. See also esae planning wine collecions, 424–425 Te Wolf of Wall Street,153 women invesors, 14, 224–237 emerging influence and affluence o, 224–227 acquisiion o individual wealh, 225 educaional atainmen, 225 emale enrepreneurs, 226–227 leadership o women, 225–226 ranser o wealh, 227 financial advisors’ reamen o,advisors, 231, 238237 communicaion courses or communicaion wih, 228–229 as invisible parner, 230–231 financial concerns or, 235–236 caregiving, 230, 231, 233, 236, 237 hardships, dealing wih, 234 as head o households, 225, 231, 233 lie expecancy, increased, 236, 342 reiremen savings, compared o men, 236 “sandwich generaion,” 237 wage discriminaion, 236 financial crisis o 2007–2008, impac o, 232–233, 234 financial indusry careers, gender inequaliy, 235, 237 cusomer loyaly, 229–230 dissaisacion wih, 227 financial wellness, closing gender gap, 236 invesmen psychology, 227–236 corisol, sress hormone, 232 cusomer loyaly, 229–230 financial concerns, 235–236 financial lieracy, 233–234, 237 generally, 227–229 lack o confidence, 230–231 male vs. emale brain, differences beween, 231–232 marke volailiy, 232 risk aversion, 232–233

641

I n d ex

risk-seeking behavior, 232 risk olerance, 232–233 success and ailure, defining, 234–235 esoserone and risk-seeking behavior, 232 worry, 35

financial crisis o 2007–2008 behavioral bias, impac o, 492 risk percepion and, 35–37 wrap accouns, 105 Yale model (endowmen model), 142

641

643

645

647