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What Is Behavioral Finance?

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 What is Behavioral Finance?
Victor Ricciardi and Helen K. Simon

Abstract
While conventional academic finance emphasizes theories such as modern portfolio theory and the efficient market
hypothesis, the emerging field of behavioral finance investigates the psychological and sociological issues that impact
the decision-making process of individuals, groups, and organizations. This paper will discuss some general prin-
ciples of behavioral finance including the following: overconfidence, financial cognitive dissonance, the theory of
regret, and prospect theory. In conclusion, the paper will provide strategies to assist individuals to resolve these “men-
tal mistakes and errors” by recommending some important investment strategies for those who invest in stocks and
mutual funds.

approach including scholars from the social sciences

Introduction and business schools. From the liberal arts perspec-
During the 1990s, a new field known as behavioral tive, this includes the fields of psychology, sociology,
finance began to emerge in many academic journals, anthropology, economics and behavioral economics.
business publications, and even local newspapers. The On the business administration side, this covers areas
foundations of behavioral finance, however, can be such as management, marketing, finance, technology
traced back over 150 years. Several original books and accounting.
written in the 1800s and early 1900s marked the be- This paper will provide a general overview of the
ginning of the behavioral finance school. Originally area of behavioral finance along with some major
published in 1841, MacKay’s Extraordinary Popular themes and concepts. In addition, this paper will make
Delusions And The Madness Of Crowds presents a chro- a preliminary attempt to assist individuals to answer
nological timeline of the various panics and schemes the following two questions:
throughout history. This work shows how group be- How Can Investors Take Into Account the Biases
havior applies to the financial markets of today. Le Inherent in the Rules of Thumb They Often Find
Bon’s important work, The Crowd: A Study Of The Themselves Using?
Popular Mind, discusses the role of “crowds ” (also How Can Investors “know themselves better” so
known as crowd psychology) and group behavior as They Can Develop Better Rules of Thumb?
they apply to the fields of behavioral finance, social In effect, the main purpose of these two questions
psychology, sociology, and history. Selden’s 1912 book is to provide a starting point to assist investors to de-
Psychology Of The Stock Market was one of the first to velop their “own tools” (trading strategy and invest-
apply the field of psychology directly to the stock ment philosophy) by using the concepts of behavioral
market. This classic discusses the emotional and psy- finance.
chological forces at work on investors and traders
in the financial markets. These three works along with What is Standard Finance?
several others form the foundation of applying psy-
chology and sociology to the field of finance. Today, Current accepted theories in academic finance are
there is an abundant supply of literature including referred to as standard or traditional finance. The
the phrases “psychology of investing” and “psychol- foundation of standard finance is associated with the
ogy of finance” so it is evident that the search contin- modern portfolio theory and the efficient market hy-
ues to find the proper balance of traditional finance, pothesis. In 1952, Harry Markowitz created modern
behavioral finance, behavioral economics, psychology, portfolio theory while a doctoral candidate at the
and sociology. University of Chicago. Modern Portfolio Theory
The uniqueness of behavioral finance is its inte- (MPT) is a stock or portfolio’s expected return, stan-
gration and foundation of many different schools of dard deviation, and its correlation with the other
thought and fields. Scholars, theorists, and practitio- stocks or mutual funds held within the portfolio.
ners of behavioral finance have backgrounds from a With these three concepts, an efficient portfolio can
wide range of disciplines. The foundation of behav- be created for any group of stocks or bonds. An effi-
ioral finance is an area based on an interdisciplinary cient portfolio is a group of stocks that has the maxi-

Business, Education and Technology Journal Fall 2000

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 What is Behavioral Finance?, Victor Ricciardi and Helen K. Simon

mum (highest) expected return given the amount of Defining the Various Disciplines of Behavioral Finance
risk assumed, or, on the contrary, contains the lowest
possible risk for a given expected return.
Another main theme in standard finance is known
as the Efficient Market Hypothesis (EMH). The effi-
cient market hypothesis states the premise that all in-
formation has already been reflected in a security’s
price or market value, and that the current price the
stock or bond is trading for today is its fair value. Since
stocks are considered to be at their fair value, propo-
nents argue that active traders or portfolio managers
cannot produce superior returns over time that beat Figure 2.
the market. Therefore, they believe investors should
just own the “entire market” rather attempting to “out-
perform the market.” This premise is supported by What is Behavioral Finance?
the fact that the S&P 500 stock index beats the overall Behavioral finance attempts to explain and increase
market approximately 60% to 80% of the time. Even understanding of the reasoning patterns of investors,
with the preeminence and success of these theories, including the emotional processes involved and the
behavioral finance has begun to emerge as an alter- degree to which they influence the decision-making
native to the theories of standard finance. process. Essentially, behavioral finance attempts to
explain the what, why, and how of finance and invest-
The Foundations of ing, from a human perspective. For instance, behav-
ioral finance studies financial markets as well as
Behavioral Finance providing explanations to many stock market anoma-
Discussions of behavioral finance appear within the lies (such as the January effect), speculative market
literature in various forms and viewpoints. Many bubbles (the recent retail Internet stock craze of 1999),
scholars and authors have given their own interpre- and crashes (crash of 1929 and 1987). There has been
tation and definition of the field. It is our belief that considerable debate over the real definition and va-
the key to defining behavioral finance is to first es- lidity of behavioral finance since the field itself is still
tablish strong definitions for psychology, sociology developing and refining itself. This evolutionary pro-
and finance (please see the diagram located below). cess continues to occur because many scholars have
such a diverse and wide range of academic and pro-
fessional specialties. Lastly, behavioral finance stud-
ies the psychological and sociological factors that
influence the financial decision making process of
individuals, groups, and entities as illustrated below.
The Behavioral Finance Decision Makers

Figure 1.
Figure 1 demonstrates the important interdiscipli-
Figure 3.
nary relationships that integrate behavioral finance.
When studying concepts of behavioral finance, tradi- In reviewing the literature written on behavioral
tional finance is still the centerpiece; however, the be- finance, our search revealed many different interpre-
havioral aspects of psychology and sociology are tations and meanings of the term. The selection pro-
integral catalysts within this field of study. Therefore, cess for discussing the specific viewpoints and
the person studying behavioral finance must have a definitions of behavioral finance is based on the pro-
basic understanding of the concepts of psychology, fessional background of the scholar. The discussion
sociology, and finance (discussed in Figure 2) to be- within this paper was taken from academic scholars
come acquainted with overall concepts of behavioral from the behavioral finance school as well as from
finance. investment professionals.

Business, Education and Technology Journal Fall 2000

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 What is Behavioral Finance?, Victor Ricciardi and Helen K. Simon

when they invest their money. As a portfolio man-

Behavioral Finance and ager or as an individual investor, recognizing the men-
Academic Scholars tal mistakes of others (a mis-priced security such as a
stock or bond) may present an opportunity to make
Two leading professors from Santa Clara University, a superior investment return (chance to arbitrage).
Meir Statman and Hersh Shefrin, have conducted re- Arnold Wood of Martingale Asset Management
search in the area of behavioral finance. Statman described behavioral finance this way:
(1995) wrote an extensive comparison between the
emerging discipline behavioral finance vs. the old Evidence is prolific that money managers rarely
school thoughts of “standard finance.” According to live up to expectations. In the search for reasons,
Statman, behavior and psychology influence indi- academics and practitioners alike are turning to
vidual investors and portfolio managers regarding the behavioral finance for clues. It is the study of
financial decision making process in terms of risk as- us…. After all, we are human, and we are not
sessment (i.e. the process of establishing information always rational in the way equilibrium models
regarding suitable levels of a risk) and the issues of would like us to be. Rather we play games that
framing (i.e. the way investors process information indulge self-interest…. Financial markets are a
and make decisions depending how its presented). real game. They are the arena of fear and greed.
Shefrin (2000) describes behavioral finance as the Our apprehensions and aspirations are acted out
interaction of psychology with the financial actions every day in the marketplace…. So, perhaps
and performance of “practitioners” (all types/catego- prices are not always rational and efficiency may
ries of investors). He recommends that these inves- be a textbook hoax. (Wood 1995, p. 1)
tors should be aware of their own “investment
mistakes” as well the “errors of judgment” of their
counterparts. Shefrin states, “One investor’s mistakes Now that you have been introduced to the general
can become another investor’s profits” (2000, p. 4). definition and viewpoints of behavioral finance, we
Furthermore, Barber and Odean (1999, p. 41) stated will now discuss four themes of behavioral finance:
that “people systemically depart from optimal judg- overconfidence, financial cognitive dissonance, regret
ment and decision making. Behavioral finance en- theory, and prospect theory.
riches economic understanding by incorporating
these aspects of human nature into financial mod- What is Overconfidence?
els.” Robert Olsen (1998) describes the “new para-
digm” or school of thought known as an attempt to Research scholars from the fields of psychology and
comprehend and forecast systematic behavior in or- behavioral finance have studied the topic of overcon-
der for investors to make more accurate and correct fidence. As human beings, we have a tendency to over-
investment decisions. He further makes the point that estimate our own skills and predictions for success.
no cohesive theory of behavioral finance yet exists, Mahajan (1992, p. 330) defines overconfidence as “an
but he notes that researchers have developed many overestimation of the probabilities for a set of events.
sub-theories and themes of behavioral finance. Operationally, it is reflected by comparing whether
the specific probability assigned is greater than the
portion that is correct for all assessments assigned that
Viewpoints from the given probability.” To illustrate:
Investment Managers
The explosion of the space shuttle Challenger
An interesting phenomenon has begun to occur with should have not surprised anyone familiar with
greater frequency in which professional portfolio the history of booster rockets— 1 failure in every
managers are applying the lessons of behavioral fi- 57 attempts. Yet less than a year before the disas-
nance by developing behaviorally-centered trading ter, NASA set the chances of an accident at 1 in
strategies and mutual funds. For example, the port- 100,000. That optimism is far from unusual: all
folio manager for Undiscovered Managers, Inc., kinds of experts, from nuclear engineers to phy-
Russell Fuller, actually manages three behavioral fi- sicians to be overconfident. (Rubin, 1989, p. 11)
nance mutual funds: Behavioral Growth Fund, Be-
havioral Value Fund, and Behavioral Long/Short
Fund). Fuller (1998) describes his viewpoint of be- Academic research on overconfidence has been a
havioral finance by noting his belief that people sys- recurrent theme in psychology. Take for instance the
tematically make mental errors and misjudgments work in experimental psychology of Fishchhoff,

Business, Education and Technology Journal Fall 2000

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 What is Behavioral Finance?, Victor Ricciardi and Helen K. Simon

Slovic, and Lichtenstein (1977). This piece studied a

group of people by asking them general knowledge
What is “Financial Cognitive
questions. Each of the participants in study had to Dissonance”?
respond to a set of standard questions in which the
answers were definitive. However, the subjects of the The Theory: another important theme from the field
study did not necessarily know the answers to the of behavioral finance is the theory of cognitive dis-
questions. Along with each answer, a person was ex- sonance. Festinger’s theory of cognitive dissonance
pected to assign a score or percentage of confidence (Morton, 1993) states that people feel internal ten-
as to whether or not they thought their answer was sion and anxiety when subjected to conflicting be-
correct. The results of this study demonstrated a wide- liefs. As individuals, we attempt to reduce our inner
spread and consistent tendency of overconfidence. For conflict (decrease our dissonance) in one of two
instance, people who gave incorrect answers to10 per- ways: 1) we change our past values, feelings, or opin-
cent of the questions (thus the individual should have ions, or, 2) we attempt to justify or rationalize our
rated themselves at 90 percent) instead predicted with choice. This theory may apply to investors or trad-
100 percent degree of confidence their answers were ers in the stock market who attempt to rationalize
correct. In addition, for a sample of incorrect answers, contradictory behaviors, so that they seem to follow
the participants rated the likelihood of their responses naturally from personal values or viewpoints.
being incorrect at 1:1000, 1:10,000 and even The work of Goetzmann and Peles (1997) exam-
1:1,000,000. The difference between the reliability of ines the role of cognitive dissonance in mutual fund
the replies and the degree of overconfidence was con- investors. They argue that some individual investors
sistent throughout the study. may experience dissonance during the mutual fund
In both the areas of psychology and behavioral fi- investment process, specifically, the decision to buy,
nance the subject matter of overconfidence contin- sell, or hold. Other research has shown that investor
ues to have a substantial presence. As investors, we dollars are allocated more quickly to leading funds
have an inherent ability of forgetting or failing to learn (mutual funds with strong performance gains) than
from our past errors (known as financial cognitive outflows from lagging funds (mutual funds with
dissonance, which will be discussed in the next sec- poor investment returns). Essentially, the investors
tion), such as a bad investment or financial decision. in the under-performing funds are reluctant to ad-
This failure to learn from our past investment deci- mit they made a “bad investment decision.” The
sions further adds to our overconfidence dilemma. proper course of action would be to sell the under-
In the area of gender bias, the work of Barber and performer more quickly. However, investors choose
Odean (2000) has produced very interesting findings. to hold on to these bad investments. By doing so,
The study of differences in trading habits according they do not have to admit they made a investment
to an investor’s gender covered 35,000 households over mistake.
six years. The study found that men were more over- An Example: In “financial cognitive dissonance,”
confident than women regarding their investing skills we change our investment styles or beliefs to sup-
and that men trade more frequently. As a result, males port our financial decisions. For instance, recent in-
not only sell their investments at the wrong time but vestors who followed a traditional investment style
also experience higher trading costs than their female (fundamental analysts) by evaluating companies
counterparts. Females trade less (buy and hold their using financial criteria such as profitability measures,
securities), at the same time sustaining lower trans- especially P/E ratios, started to change their invest-
action costs. The study found that men trade 45 per- ment beliefs. Many individual investors purchased
cent more than women and, even more astounding, retail Internet companies such as IVillage.com and
single men trade 67 percent more than single women. the Globe.com in which these financial measures
The trading costs reduced men’s net returns by 2.5 could not be applied, since these companies had no
percent per year compared with 1.72 percent for financial track record, very little revenues, and no
women. This difference in portfolio return over time net losses. These traditional investors rationalized
could result in women having greater net wealth be- the change in their investment style (past beliefs) in
cause of the power of compounding interest over a two ways: the first argument by many investors is
10 to 20 year time horizon (known as the time value the belief (argument) that we are now in a “new
of money). economy” in which the traditional financial rules no

Business, Education and Technology Journal Fall 2000

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 What is Behavioral Finance?, Victor Ricciardi and Helen K. Simon

longer apply. This is usually the point in the economic

cycle in which the stock market reaches its peak. The
What is Prospect Theory?
second action that displays cognitive dissonance is Prospect theory deals with the idea that people do not
ignoring traditional forms of investing, and buying always behave rationally. This theory holds that there
these Internet stocks simply based on price momen- are persistent biases motivated by psychological fac-
tum. Purchasing stocks based on price momentum tors that influence people’s choices under conditions
while ignoring basic economic principles of supply of uncertainty. Prospect theory considers preferences
and demand is known in the behavioral finance arena as a function of “decision weights,” and it assumes that
as herd behavior. In essence, these Internet investors these weights do not always match with probabilities.
contributed to the financial speculative bubble that Specifically, prospect theory suggests that decision
burst in March 2000 in Internet stocks, especially the weights tend to overweigh small probabilities and
retail sector, which has declined dramatically from the under-weigh moderate and high probabilities. Hugh
highs of 1999; many of these stocks have decreased Schwartz (1998, p. 82) articulates that “subjects (in-
up to 70% off their all time highs. vestors) tend to evaluate prospects or possible out-
comes in terms of gains and losses relative to some
What is the Theory of Regret? reference point rather than the final states of wealth.”
To illustrate, consider an investment selection be-
Another prevalent theme in behavioral finance is “re- tween
gret theory.” The theory of regret states that an indi-
vidual evaluates his or her expected reactions to a Option 1: A sure profit (gain) of $ 5,000 or
future event or situation (e.g. loss of $1,000 from sell- Option 2: An 80% possibility of gaining $7,000, with
ing the stock of IBM). Bell (1982) described regret as a 20 percent chance of receiving nothing ($ 0).
the emotion caused by comparing a given outcome Question: Which option would give you the best
or state of events with the state of a foregone choice. chance to maximize your profits?
For instance, “when choosing between an unfamiliar
brand and a familiar brand, a consumer might con- Most people (investors) select the first option,
sider the regret of finding that the unfamiliar brand which is essentially is a “sure gain or bet.” Two theo-
performs more poorly than the familiar brand and rists of prospect theory, Daniel Kahneman and Amos
thus be less likely to select the unfamiliar brand” Tversky (1979), found that most people become risk
(Inman and McAlister, 1994, p. 423). averse when confronted with the expectation of a fi-
Regret theory can also be applied to the area of in- nancial gain. Therefore, investors choose Option 1
vestor psychology within the stock market. Whether which is a sure gain of $5,000. Essentially, this appears
an investor has contemplated purchasing a stock or to be the rational choice if you believe there is a high
mutual fund which has declined or not, actually pur- probability of loss. However, this is in fact the less at-
chasing the intended security will cause the investor tractive selection. If investors selected Option 2, their
to experience an emotional reaction. Investors may overall performance on a cumulative basis would be
avoid selling stocks that have declined in value in or- a superior choice because there is a greater payoff of
der to avoid the regret of having made a bad invest- $5,600. On an investment (portfolio) approach, the
ment choice and the discomfort of reporting the loss. result would be calculated by: ($7,000 x 80%) + (0 +
In addition, the investor sometimes finds it easier to 20%) = $5,600.
purchase the “hot or popular stock of the week.” In Prospect theory demonstrates that if investors are
essence the investor is just following “the crowd.” faced with the possibility of losing money, they often
Therefore, the investor can rationalize his or her in- take on riskier decisions aimed at loss aversion
vestment choice more easily if the stock or mutual (though they may sometimes refrain from investing
fund declines substantially in value. The investor can altogether). They tend to reverse or substantially al-
reduce emotional reactions or feelings (lessen regret ter their revealed disposition toward risk. Lastly, this
or anxiety) since a group of individual investors also error in thinking relative to investing ultimately may
lost money on the same bad investment. result in substantial losses within a portfolio of in-
vestments, such as an individual invested in a group
of mutual funds.

Business, Education and Technology Journal Fall 2000

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 What is Behavioral Finance?, Victor Ricciardi and Helen K. Simon

a similar “ checklist” for individual stocks. Tomic and

How Should Investors Take Into Ricciardi (2000) recommend that investors select mu-
Account the Biases Inherent in the tual funds with a simple “4-step process” which in-
Rules of Thumb They Often Find cludes the following criteria:
Invest in only no-load mutual funds with low op-
Themselves Using and How erating expenses;
Should They Develop Better Rules Look for funds with a strong historical track record
over 5 to 10 years;
of Thumb? Invest with tenured portfolio managers with a
As investors, we are obviously influenced by various strong investment philosophy; and
behavioral and psychological factors. Individuals who Understand the specific risk associated with each
invest in stocks and mutual funds should implement mutual fund.
several safeguards that can help control mental errors Essentially, these are good starting point criteria
and psychological roadblocks. A key approach to con- for mutual fund investors. The key to successful in-
trolling these mental roadblocks is for all types of in- vesting is recognizing the type of investor you are
vestors to implement a disciplined trading strategy. along with implementing a solid investment strategy.
In the case of stock investments: the best way for in- Ultimately, for most investors, the best way to maxi-
vestors to control their “mental mistakes” is to focus mize their investment returns is to control their “men-
on a specific investment strategy over the long-term. tal errors” with a long-term mutual fund philosophy.
Investors should keep detailed records outlining such In November 1999, there was a conference entitled
matters as why a specific stock was purchased for their “Recent Advances in Behavioral Finance: A Critical
portfolio. Also, investors should decide upon specific Analysis”(hosted by the Berkeley Program in Finance).
criteria for making an investment decision to buy, sell, The conference featured a debate on the validity of
or hold. For example, an investor should create an behavioral finance between advocates for the “tradi-
investment checklist that discusses questions such as tional finance” and “behavioral finance“ schools of
these: thought. There was no clear winner in this contest;
however, having such an event demonstrates the
Why did an investor purchase the stock? gradual acceptance of behavioral finance. Both schools
What is their investment time horizon? seemed to agree that the best trading strategy is a
What is the expected return from this investment one “long-term buy and hold” investment in a passive
year from now? stock mutual fund such as S&P 500 index. For ex-
What if a year from now the stock has under-per- ample, Terrance Odean, a behavioral finance expert,
formed or over-performed your expectations? Do says in a recent interview that he invests primarily in
you plan on buying, selling, or holding your posi- index funds. As a young man, Odean said, “I traded
tion? too actively, traded too speculatively and clung to my
How risky is this stock within your overall portfolio? losses…. I violated all the advice I now give” (Feldman,
1999, p. 174).
The purpose of developing and maintaining an “in-
vestment record” is that over time it will assist an in- Closing Remarks
vestor in evaluating investment decisions. With this
type of strategy, investors will have an easier time ad- Over the last forty years, standard finance has been
mitting their mental mistakes, and it will support them the dominant theory within the academic commu-
in controlling their “emotional impulses.” Ultimately, nity.
the way to avoid these mental mistakes is to trade less However, scholars and investment professionals
and implement a simple “buy and hold” strategy. A have started to investigate an alternative theory of fi-
long-term buy and hold investment strategy usually nance known as behavioral finance. Behavioral fi-
outperforms a short-term trading strategy with high nance makes an attempt to explain and improve
portfolio turnover. Year after year it has been docu- people’s awareness regarding the emotional factors
mented that a passive investment strategy beats an and psychological processes of individuals and enti-
active investment philosophy approximately 60 to 80 ties that invest in financial markets. Behavioral finance
percent of the time. scholars and investment professionals are developing
In the case of mutual fund investments: in terms of an appreciation for the interdisciplinary research that
mutual funds, it’s recommended that investors apply is the underlying foundation of this evolving disci-
pline. We believe that the behaviors described in this

Business, Education and Technology Journal Fall 2000

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 What is Behavioral Finance?, Victor Ricciardi and Helen K. Simon

paper are exhibited within the stock market by many Heuristics

different types of individual investors, groups of in- Manias
vestors, and entire organizations. Panics
This paper has discussed four themes within the Disposition Effect
arena of behavioral finance, which are overconfidence, Loss Aversion
cognitive dissonance, regret theory, and prospect Prospect Theory
theory. These four topics are an introductory repre- Regret Theory
sentation of the many different themes that have Groupthink Theory
started to occur over the last few years within the field Anomalies
(see checklist of behavioral finance topics after this Market Inefficiency
section). The validity of all of these topics will be tested Behavioral Economics
over time as the behavioral finance scholars eventu- Overreaction
ally research and implement concepts, or as other Under-reaction
practices start to fad or are rejected. Overconfidence
This article has also discussed some trading ap- Mental Accounting
proaches for investors in stocks and bonds to assist Irrational Behavior
them in manifesting and controlling their psychologi- Economic Psychology
cal roadblocks. These “rules of thumb” are a starting Risk Perception
point for investors that encourage them to keep an Gender Bias
investment track record and checklist regarding each Irrational Exuberance
stock or mutual fund within their overall portfolio.
Hopefully, these behavioral finance-driven structured
guidelines for making investment choices will aid in-
Glossary of Key Terms
dividuals by drawing attention to potential mental Academic Finance (Standard or Traditional Finance):
mistakes, hopefully leading to increased investment the current accepted theory of finance at most col-
returns. leges and universities, based on such topics as mod-
In closing, we believe that the real debate between ern portfolio theory and the efficient market
the two schools of finance should address which be- hypothesis.
havioral finance themes are relevant enough today to Anomaly or Anomalies: something that deviates from
be taught in the classroom and published in new edi- the norm or common rule and is usually abnormal,
tions of finance textbooks. A concept such as pros- such as the January Effect.
pect theory deserves mention by finance academics Arbitrage: an attempt to enjoy a risk-less profit by
and practitioners, to offer students, faculty, and in- taking advantage of pricing differences in identical
vestment professionals an alternative viewpoint of fi- securities being traded in different markets or in dif-
nance. ferent forms as a result of mis-pricing of securities.
Behavioral Economics: the foundation of behavioral
The Behavioral Finance Checklist finance, found especially in the groundbreaking work
of Richard Thaler. This field is the alternative to tra-
Anchoring ditional economics since it applies psychology to eco-
Financial Psychology nomics. Other examples of alternative economics are
Cascades economic psychology and socio-economics.
Chaos Theory Behavioral Finance Theory: the belief that psycho-
Cognitive Bias logical considerations are an essential feature of the
Cognitive Dissonance security markets. It is a field that attempts to explain
Cognitive Errors and increase understanding of how the emotions and
Contrarian Investing mental mistakes of investors influence the decision-
Crashes making process.
Fear Bias: an inclination of temperament or outlook; un-
Greed reasoned judgment or prejudice.
Herd Behavior Bubble: the phase before a market crash when con-
Framing cerns are expressed that the stock market is overval-
Hindsight Bias ued or overly inflated from speculative behavior.
Preferences Cognitive Dissonance Theory: states there is a ten-
Fads dency for people to search for regularity among their

Business, Education and Technology Journal Fall 2000

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 What is Behavioral Finance?, Victor Ricciardi and Helen K. Simon

cognitions (i.e., beliefs, viewpoints). When there is a Panics: Sudden, widespread fear of an economic of
discrepancy between feelings or behaviors (disso- market collapse, which usually leads to falling stock
nance), something must transform to eliminate the prices.
dissonance. Prospect Theory: can be defined as how investors as-
Correlation: a concept from probability (statistics). sess and calculate the chance of a profit or loss in com-
It is a measure of the degree to which two random parison to the perceptible risk of the specific stock or
variables track one another, such as stock prices (stock mutual fund.
market) and interest rates (bond market). Psychology: is the scientific study of behavior and
Crash: a steep and abrupt drop in security market mental processes, along with how these processes are
prices. affected by a human being’s physical, mental state, and
Efficient Frontier: the line on a risk-reward graph rep- external environment.
resenting a set of all efficient portfolios that maxi- Regret Theory: The theory of regret states that indi-
mize expected return at each level of risk. viduals evaluate their expected reactions to a future
Efficient Market Hypothesis (EMH): the theory that event or situation
prices of securities fully reflect all available informa- Sociology: is the systematic study of human social
tion and that all market participants receive and act behavior and groups. This field focuses primarily on
on all relevant information as soon as it becomes avail- the influence of social relationships on people’s atti-
able. tudes and behavior.
Efficient Portfolio: a portfolio that provides the great- Standard Deviation: within finance, this statistic is a
est expected return for a given level of risk. very important variable for assessing the risk of stocks,
Expected return: the return expected on a risky asset bonds, and other types of financial securities.
based on a normal probability distribution for all the Time Value of Money: is the process of calculating
possible rates of return. the value of an asset in the past, present or future. It is
Finance: a discipline concerned with determining based on the notion that the original principal will
value and making decisions. The finance function al- increase in value over time by interest. This means
locates capital, including acquiring, investing, and that a dollar invested today is going to be worth more
managing resources. tomorrow.
Herding or Herd Behavior: herding transpires when
a group of investors make investment decisions on a
specific piece of information while ignoring other
Acknowledgements
pertinent information such as news or financial re- The authors would like to thank the following for their
ports. insightful comments and support: Robert Fulkerth,
January Effect: the January effect is generally thought Steve Hawkey, Robert Olsen, Tom Powers, Hank
to be among the most frequent of the stock market’s Pruden, Hugh Schwartz, Igor Tomic, and Mike
anomalies. Investors each January expect above aver- Troutman. An earlier version of this paper was pre-
age gains for the month, which are most likely caused sented by Victor Ricciardi at the “Annual Colloquium
by the result of a flood of new money (supply) from on Research in Economic Psychology” July 2000 in
retirement contributions, combined with optimism Vienna, Austria. The sponsors of this conference were
for the New Year. the International Association for Research in Eco-
Loss Aversion: The idea that investors assign more nomic Psychology (IAREP) and The Society for the
significance to losses than they assign to gains. Loss Advancement of Behavioral Economics (SABE) in
aversion occurs when investors are less inclined to sell affiliation with the University of Vienna.
stocks at a loss than they are to sell stocks that have
gained in value (even if expected returns are the iden-
tical). References
Modern Portfolio Theory: An inclusive investment Barber, B. and Odean, T. (2000). “Boys will be Boys: Gender,
approach that assumes that all investors are risk averse Overconfidence, and Common Stock Investment.” Working
and seeks to create an optimal portfolio in consider- Paper. Available: http://www.undiscoveredmanagers.com/
Boys%20Will%20Be%20Boys.htm.
ation of the relationship between risk and reward as
Barber, B. and Odean, T. (1999). “The Courage of Misguided
measured by alpha, beta and R-squared. Convictions.” Financial Analysts Journal, 55, 41-55.
Overconfidence: The findings that people usually have Bell, D. (1982). “Regret in Decision Making Under Uncertainty.”
too much confidence in the accuracy of their judg- Operations Research, 30,: 961-981.
ments; people’s judgments are usually not as correct Feldman, A. (1999). “A Finance Professor for the People.” Money,
as they think they are. 28: 173-174.

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 What is Behavioral Finance?, Victor Ricciardi and Helen K. Simon

Fishchhoff, B., Slovic, P., and Lichtenstein, S.(1977). “Knowing Thaler, R. Editor. (1993). Advances in Behavioral Finance. New
with Certainty the Appropriateness of Extreme Confidence.” York, NY: Russell Sage Foundation.
Journal of Experimental Psychology: Human Perception and Per- Tomic, I. and Ricciardi, V. (2000). Mutual Fund Investing. Un-
formance, 552-564. published Book.
Fuller, R. J. (1998). “Behavioral Finance and the Sources of Al- Wood, A. (1995). “Behavioral Finance and Decision Theory in
pha.” Journal of Pension Plan Investing, 2 . Available: http:// Investment Management: an overview.” Behavioral Finance and
www.undiscoveredmanagers.com/Sources%20of%20 Decision Theory in Investment Management. Charlottesville, VA:
Alpha.htm. AIMR: 1.
Goetzmann, W. N. and N. Peles (1993). “Cognitive Dissonance
and Mutual Fund Investors.” The Journal of Financial Research,
20,: 145-158.
Inman. J. and McAlister L. (1994). “Do Coupon Expiration Dates
Affect Consumer Behavior?” Journal of Marketing Research, 31,:
About the Authors
423-428. Victor Ricciardi is currently an adjunct faculty mem-
Juglar, C. (1993). Brief History of Panics in the United States, 3rd ber and doctoral student in finance at Golden Gate
edition. Burlington, Vermont: Fraser Publishing Company
University in San Francisco, California. Victor has
Kahneman, D., Slovic, P. and Tversky, A. (eds.). (1982). Judgment
Under Uncertainty: Heuristics and Biases. Cambridge and New
taught classes in finance, economics and behavioral
York: Cambridge University Press. finance. His dissertation and research work is in the
Kahneman, D. and A. Tversky. (1979). “Prospect Theory: An field of behavioral finance. The topic of his thesis is a
Analysis of Decision Under Risk.” Econometrics, 47:263-291. study of how trustees of private universities make in-
Le Bon, G. (1982). The Crowd: a Study of the Popular Mind. vestment decisions regarding endowment funds, from
Marietta, GA: Cherokee Publishing Company. a behavioral finance perspective.
MacKay, C. (1980). Extraordinary Popular Delusions and the Victor received his MBA in Finance and advanced
Madness of Crowds. New York, NY: Crown Publishing Group. masters in Economics from St. John’s University and
Mahajan, J. (1992). “The Overconfidence Effect in Marketing BBAs in Accounting and Management from Hofstra
Management Predictions.” Journal of Marketing Research, 29,:
329-342. University. Victor began his professional career as a
Morton, H. (1993). The Story of Psychology. New York, NY: Ban-
mutual fund accountant for the Dreyfus Corporation
tam Double Dell Publishing Group, Inc. and Alliance Capital Management. In addition, he has
Olsen, R. A. (1998). “Behavioral Finance and its Implication for been employed as an Economic Analyst at the Fed-
Stock-Price Volatility.” Financial Analysts Journal. March/April: eral Deposit Insurance Corporation (FDIC). He also
10-17. has completed a yet unpublished book with Dr. Igor
Peters, E. (1996). Chaos and Order in the Capital Markets, 2 nd Tomic of St. John’s University on the topic of mutual
Edition. New York, NY: John Wiley & Sons, Inc. fund investing.
Pruden, H. (1998). “Behavioral Finance: What is it?.” Market Helen K. Simon, CFP is President of Personal Busi-
Technicans Association Journal. Available: http://
www.crbindex.com/pubs/trader/btv7n6/btv7n6a3.htm ness Management Services, LLC, located in Fort Lau-
Ricciardi, V. (2000). “An Exploratory Study in Behavioral Finance: derdale, Florida. Helen has resided in South Florida
How Board of Trustees Make Behavioral Investment Decisions since 1974 and has nearly 20 years of professional ex-
Pertaining to Endowment Funds at U.S. Private Universities.” perience in the financial services and investment field.
(Preliminary Dissertation Topic). She serves on the adjunct faculty of Florida State Uni-
Rubin, J. (1989). “Trends—the Dangers of Overconfidence.” Tech- versity and Nova Southeastern University where she
nology Review, 92,: 11-12.
teaches classes in financial management, personal fi-
Schwartz, H. (1998). Rationality Gone Awry? Decision Making
Inconsistent with Economic and Financial Theory. Westport,
nance and financial planning. She received a BBA,
Connecticut: Greenwood Publishing Group, Inc. Magna Cum Laude, from Florida Metropolitan Uni-
Selden, G. C. (1996). Psychology of the stock market, Fifth Print- versity, the CFP designation from The College for Fi-
ing. Burlington, Vermont: Fraser Publishing Company. nancial Planning, an MBA from Nova Southeastern
Shefrin, Hersh (2000). Beyond Greed and Fear. Boston, Massa- University and is currently pursuing a Doctorate of
chusetts: Harvard Business School Press. Business Administration (DBA) with a concentration
Statman, M. (1995). “Behavioral Finance vs. Standard Finance.” in Finance. She also serves on the City of Oakland
Behavioral Finance and Decision Theory in Investment Manage- Park, Florida Employee Pension Board.
ment. Charlottesville, VA: AIMR: 14-22.

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