As companies and governments move away from traditional defined benefit pension plans toward defined contribution plans, the role of the financial adviser has gained greater importance. The work of Harry Markowitz and the birth of modern portfolio theory have given finance professionals a framework for creating the optimal portfolio. Even though numerous models exist for constructing portfolios, it can be difficult to persuade lay investors to make rational choices. Their seemingly irrational decisions can arise from a lack of knowledge or from psychological barriers that prevent them from behaving rationally.
In Investor Behavior: The Psychology of Financial Planning and Investing, H. Kent Baker of American University’s Kogod School of Business and Victor Ricciardi of Goucher College have assembled a collection of 30 articles written by more than three dozen scholars in the field of behavioral finance. The articles encompass a wide range of topics in the psychology of investing, focusing on academic work on financial planning. Even readers who are somewhat familiar with the literature on behavioral finance will benefit because the book addresses a number of topics not usually covered in the mainstream behavioral finance literature.
The first section, “Foundations of Investor Behavior,” begins with two excellent overviews of investor behavior. The first, by Baker and Ricciardi, recounts the origins of the psychology of investing. For many students of investments, the study of investor behavior begins with Amos Tversky and Daniel Kahneman’s path-breaking work on prospect theory from the late 1970s. Baker and Ricciardi trace the roots much further back, however, beginning with Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds, originally published in 1841. Their review includes not only many mainstream books on the role of psychology in the investment process but also some that may be less familiar to the reader. In the second chapter, Lucy F. Ackert compares traditional finance with behavioral finance. Newcomers to behavioral finance will benefit from this excellent overview of the two competing points of view. The final chapter in this section, by Morris Altman, continues Ackert’s discussion by delving deeper into the decision-making process, examining such issues as animal spirits, herding, ambiguity aversion, and the winner’s curse.
The second section, “Personal Finance Issues,” reveals that this book differs from academic treatments by focusing on topics of interest to practicing financial professionals. Among the articles in this section are “Financial Literacy and Education,” by Michael S. Finke and Sandra J. Huston; “Personality Traits,” by Lucia Fung and Robert B. Durand; and “The Effect of Religion on Financial and Investing Decisions,” by Walid Mansour and Mouna Jlassi. Although outside the mainstream of higher-education finance courses, these subjects can be vital in enabling a financial professional to deal with client issues that transcend the biases customarily discussed in the behavioral finance literature.
Part Three, “Financial Planning Concepts,” explores evolving topics and areas of investor behavior far from the beaten path. Renee M. Snow’s “Transpersonal Economics” feels more like an article on Far Eastern religion than one dealing with investor behavior. “Policy-Based Financial Planning: Decision Rules for a Changing World,” by Dave Yeske and Elissa Buie, and “Advising the Behavioral Investor: Lessons from the Real World,” by Gregg S. Fisher, cover more mainstream financial planning topics and provide excellent overviews of academic research, along with practical advice to financial planners on implementing the concepts to help investors.
Part Four looks more deeply into investor psychology. Richard L. Peterson’s “Neurofinance” takes the reader through the science of the brain and its impact on financial decision making. Peterson discusses the impact of medications and drug abuse on financial risk taking, something that can be crucial to helping clients through the investment process but that is rarely discussed. Included in this part of the book is “Behavioral Portfolio Theory and Investment Management,” by Erick W. Rengifo, Rossen Trendafilov, and Emanuela Trifan. It provides a more traditional mathematical view of behavioral investing topics, such as prospect theory, behavioral portfolio theory, and behavioral asset pricing.
In Part Five, “Trading and Investing Psychology and Strategies,” Julia Pitters and Thomas Oberlechner’s “The Psychology of Trading and Investing” examines the impact of personality traits. Although they address some mainstream behavioral finance topics, they also venture into such less familiar areas as terror management, empathy and altruism, and ethics. “The Surprising Real World of Traders’ Psychology” — by Denise K. Shull, a principal at the ReThink Group, and trading psychologists Ken Celiano and Andrew Menaker — covers not only the psychology of trading but also the physiology.
The book’s final section, “Special Investment Topics,” is something of a hodgepodge. Julia M. Puaschunder’s “Ethical and Socially Responsible Investing” discusses the motives for engaging in socially responsible and ethical investing. “Mutual Funds and Individual Investors: Advertising and Behavioral Issues,” by John A. Haslem, addresses why investors choose actively managed funds even though they have historically underperformed low-cost index funds. Finally, “Real Estate Investment Decision-Making in Behavioral Finance,” by Eli Beracha and Hilla Skiba, shows that many of the same biases that investors display in the stock market are evident in the real estate market.
Baker and Ricciardi have done an excellent job of soliciting articles that blend academic research with real-world applications that can be used by financial planners. Providing a sound financial plan for an individual requires going beyond using mathematical techniques to optimize a portfolio; it should also include understanding the client’s psychological biases. Investor Behavior is an excellent book for anyone who wishes to detour from the beaten path of behavioral finance and to implement what has been learned about investor psychology to better understand traders and assist clients.
© 2015 CFA Institute. First appeared in Inside Investing http://blogs.cfainstitute.org/insideinvesting/