Way back in 2014 I really enjoyed talking to Victor Ricciardi about his book ‘Investor Behavior: The Psychology of Financial Planning and Investing’ which he co-edited with H. Kent Baker.
Jacob Bettany: You and your co-editor H. Kent Baker are very well known to many members of the MoneyScience community through your work in behavioural finance. For the benefit of those who don’t know you, could you begin by introducing yourself and telling us a little bit about Kent as well?
Victor Ricciardi: Kent Baker is one of the most prolific individuals in finance in terms of the academic side of financial history – he has a research track record that dates back about 45 years in the academic literature. He has done it all, across a wide range of every area of finance. Kent has published over 15 books of this type, where the content of the book is a summary of the literature. He has a knack for doing this type of project and he was a great person to work on this type of endeavour. Kent has also embraced the behavioural finance viewpoint.
For myself, I was introduced to behavioural finance by a mentor through my graduate studies about 15 years ago. At the time, there was no book on behavioural finance. The first book on the topic was Hersh Shefrin’s book, Beyond Greed and Fear, and since then, in the last 12-13 years, there have been about 15-20 books in the area. As I was researching several different areas, I started to focus on risk perception (the psychology of risk) and what is nice about this topic is that it’s based on survey research and laboratory experiments. The psychology of risk intertwines with many different themes in behavioural finance and this provided me an excellent insight of all the different aspects of behavioural finance.
JB: So your own personal interest in behavioural finance developed quite early in your academic life. What were you interested in before that?
VR: My career actually started as an accountant in the mutual fund industry. I have a very good understanding of all types of mutual funds, modern portfolio theory, and various financial products; derivatives, bonds, the whole gamut. The first few years of my career I was responsible for the evaluation of portfolios for Wall Street firms from the accounting perspective it gave me an insider view on mutual funds. The behavioural finance subject matter has changed me over the last 15 years. I can’t remember who I was in my 20s! I didn’t know then that I was a behaviourist because all my early course work was in classical or traditional finance such as rationality, modern portfolio theory, and efficient markets. The process of understanding the behavioural finance literature has transformed me – I got religion and I’m now a true believer.
JB: That’s an interesting aspect, the differences between the classical (traditional) and behavioural approaches. You say it’s like getting religion and I’ve heard similar things from other people, I’d be interested if you could unpack that a little bit.
VR: Well you know most of my coursework at the undergraduate and graduate levels in finance, accounting and economics that I was taught were mathematically based and that people were rational and most of the time psychology did not enter into the discussion. I don’t worry much about the academic debate between the different perspectives of finance. My view is that behavioural finance increases people’s opportunity and financial literacy; it gives them additional career prospects when moving over to finance. Financial planners are able to use this field to better advise clients and this enables individuals to have a higher standard of living in retirement. My view point is this improves finance generally when you consider the positives of both schools of thought.
JB: So your view is more nuanced and holistic than simply a debate about the efficient market hypothesis!
VR: Yes, exactly right. Behavioural finance is still progressing rather nicely but the traditional finance school of thought still has a 25 year head start. It will take a while; there are still many avenues to explore in behavioural finance.
JB: How did you get involved in this publication?
VR: I’m a big picture guy. For me the struggle in the beginning of my career with behavioural finance was trying to establish a good foundation. I started off with a checklist that had 10-15 topics – it has now grown to over 125 topics! And, with Kent’s help and also my passion for more of the psychology side of finance we narrowed the topics down to a manageable 30-35 topic areas and we ended up with 30 chapters in the book written by 45 authors. We realised early on in this project that most of the behavioural finance books in the marketplace have a greater emphasis on the macro or the stock market related aspects of behavioural finance and what were missing are the individual or micro aspects of the field. And that’s what I think this book takes into account because you will find that because of the financial crisis, the psychology professors have started new academic organizations such as the Financial Therapy Association.
It’s worth adding that one way I understood what needed to be in this book is through my role with the Social Science Research Network (SSRN) as an Editor for several eJournals, in which I read thousands of working papers and abstracts each year. By reviewing all that research, I intuitively knew what topics should be covered.
JB: I did an interview with Greg Davies who I’m sure you know, he also said there’s a lot of interdisciplinary work to be done. I guess that partly underlines why your book was necessary, but could you expand on that and also talk a little bit about whom it was written for?
For me it helps a wide range of individuals. It’s definitely aimed at the financial planning process and to assist people with the client (investor) and the expert (financial planner) relationship. This is a great book for any level of finance major; students will find it a helpful reference to understand the literature but also it will be of interest to people who want to know more about finance, whether or not they have a college degree in business. Finally, this endeavour is aimed at somebody who may have a psychology background but wants to learn more about finance in the context of financial therapy or Maslow’s Motivation theory.
JB: Part five focuses on trading and investment psychology and strategies, would you say the book could benefit traders also?
VR: Yes, the book does has several chapters on trading related strategies and behaviour, one chapter discusses short term and long term investment strategies in behavioural finance. The other two chapters focus on the individual decision making process of traders. In particular, two of the chapters are written by experts who actually study traders and how they make decisions, or the authors currently provide trading workshops to traders to help them make better judgments and decisions.
JB: There are many chapters of interest in the book; it seems hard to know where to start!
VR: Well the classical decision maker would say “I have to start at the beginning and optimise the process in a chronological manner!” But depending on your background and what your relevant needs are you could just delve into the book. If you’re interested in retirement planning, you could start right in the middle; if you’re interested in risk perception and risk tolerance, you could focus on that chapter; if you’re interested in trading and trader psychology, you can start later on in the book.
JB: What was your approach to compiling this collection of articles? How did you organise them?
VR: Each chapter is an extensive literature review of the current academic studies by experts in each of those fields. Many of the key findings also provide basic key terms; knowledge and introduction to the topic, and several of the chapters provide best practices to hopefully help people improve their overall decision making process. The major premise of the book is not to overwhelm a person with massive amounts of data and quantitative models that general readers are not going to understand or be interested in. Most of the chapters include simple graphs and basic statistics that provide the reader with a very good introduction to hopefully understand the topics.
In terms of the layout of the book; the first few chapters provide an overview of the basic areas and themes in behavioural finance. And then the end of the book goes into three special topics that deal with social investing, mutual funds, and real estate. The middle chapters are more broadly based in psychology and are focussed on individual behaviour while the later chapters move towards topics such as behavioural portfolio theory which has been an emerging topic the last 5 or 10 years. In fact, no one has come up with a perfect Behavioural Capital Asset Pricing Model yet, but hopefully having an introductory chapter of the current findings will inspire a doctoral student or a finance practitioner to advance this particular model. There is a strong balance of academics writing in the book and also investment professionals, as well as some authors who are both financial advisers and academics in their own right – they are aware of both perspectives.
JB: Quite a few areas of finance which we cover at MoneyScience seem to have quite a gulf between the academics and the practitioners, would you say that’s true in this case also?
VR: I think the book itself is integrated well because of the approach that Kent Baker and I took in our roles as editors. For instance, if an author was more of an investment professional and less academic, we tried to emphasise the formal academic aspects in their chapters and vice versa. For the other individuals who are pure academics, the idea in this case was to present the material that it is not simply models and abstract theories. With edits and also additional rewrites of chapters we were able to move the other way that the content is equally relevant for investment professionals, or non-academics or students. We were very, very diligent in this regard and I’m not exaggerating when I say that Kent Baker and I, over the last couple of years, spent over a thousand hours editing these 30 chapters. Each of us edited each chapter a minimum of three times and this resulted in a high quality product.
JB: Is there anything which you would have liked to include in the book but didn’t, or would want to include in a second edition?
VR:It would have been interesting to include chapters on topics such as behavioural accounting, or some of the more interdisciplinary fields. Other emerging topics would be hyperbolic discounting springs to mind – or even things like charitable giving. However, we were constrained to some extent by the book proposal itself which only allowed a maximum of 30 chapters. Sure, we could easily have included another five to ten topic areas that I could think of, but at some point you have to work in the structure provided and we had a proposal and contract with a set number of words, and you have to draw a line. Also, for the newer topics, there are sometimes only three or four experts in the world who could write the chapter, and if they don’t have the time then that has to be a topic for another project.
JB: What were the biggest challenges you faced editing this book, and how did you overcome them?
VR: Well, you constantly have chapters coming in on a regular cycle and you try to say to yourself, does this make sense? Is this going to be interpreted correctly? You have to make sure that definitions are straightforward, double check to make sure that graphs and diagrams are explained correctly. All of the authors are experts and whether they are academics or practitioners, we have a code or language that we take for granted. When editing various chapters I found myself asking whether the language we were using would be understandable to individuals reading the book for the first time. Even in the psychology sections we took pride ensuring that subject matter would make sense to people who were in finance and were not familiar with the terminology. In addition, I would ask the question to myself “Are there additional research studies I could recommend for the author or authors to incorporate in their chapter?”
JB: On the general topic of behavioural finance; could you provide a history of behavioural finance and describe the impact it has had, particularly in practitioner contexts?
VR: Investment professionals and certainly financial planners have recognised for many years that there is a great deal of psychological aspects to the client and expert relationship. I once read an observation by an expert saying that financial planning is 80% behavioural and 20% quantitative. I would imagine the financial planning profession knew very early on that there was a great deal of psychology in dealing with clients. The general field of academic finance known as conventional (traditional) finance started in the 1950s and 1960s that was quantitative. The individuals pursuing careers in the field were from operations management with a very strong statistics background or even the equivalent of engineering background in terms of their math aptitude. In those early years, traditional finance, from the 1980s into the 1990s was a quantitatively oriented discipline based on rationality and classical decision making. In the 1970s, researchers in psychology started to perform more experiments that were money-related – gambling experiments, with probability, and they started to show – the Kahneman and Tversky experiments in particular – that people weren’t rational and they effectively made decisions based on bounded rationality meaning that they would make decisions that were not essentially irrational all the time but they made decisions that were satisfactory to them. This small group of researchers on the psychology side in the 1970s and 1980s started to integrate with a small group of behavioural economists and also finance professors who then in the late 1980s started to take the ideas from psychology experiments and apply them in the frame of context of finance. And in the last 15 years, we have had the internet bubble and the financial crisis and have started to experience a much wider application of behavioural finance among practitioners and academics. In the discipline of psychology, academics started to realise that many of their clients after the financial crisis had money disorders. With all these additional issues and money-related behaviour they’ve taken a much deeper examination and started to develop theories about financial counselling and financial therapy, especially in terms of the financial planning process. There is a well-established literature in financial planning that interfaces with areas such as consumer behaviour, home economics and family studies. These social science disciplines have researchers for many years and now I they’re all starting to create a wonderful body of knowledge that is revealed in several chapters in the book. That’s one of the major themes that separate this project from many other books currently on the market.
JB: What do you think have been the key developments in the field in the last few years, and what impact do you expect them to have in the future?
VR: Well, I think one of the greatest contributions of the last ten years in particular has been the progression of neuroeconomics and neurofinance. The idea is that experts are able to map the parts of the brain that react in a deep emotional way to say sex, eating, our appetites or gambling (or risking) behaviour. These are the parts of the brain that react in the same way to money and finances. There have been many wonderful experiments and much additional research is still being done. The main issue I believe which is discussed in the book in particular is that some of those experiments are what they are, they are experiments. And by taking MRIs and FMRIs of people’s brains, this is expensive, and researchers cannot have very big sample sizes thus this limits the short term validity of this research. As these experiments become cheaper to conduct they will start to have bigger sample sizes and I believe that the findings will have much a wider range of applications.
In the 1960s through the 1980s, most of the psychology academics focused on the cognitive approach of decision making. Or essentially what’s known as making a decision based on heuristics. During the early 1990s, a much bigger emphasis on the emotional aspects of psychology and then in the last 10-12 years there has been a development known as the affect heuristic, meaning we make decisions with a cognitive part of our brain but also our emotional component of the brain. We are very complex creatures because we define our brain as rational, but when we have made a decision to buy, say, a nice reliable and safe car, we go into the car dealership and we are suddenly overwhelmed with emotion and we purchase that nice sports car. A person can’t afford it but is overwhelmed by the emotional aspect of it being a nice red shiny object, and then the emotional mind then takes over the decision in which the person buys the car.
In my view, the next branch of topics that will progress over the coming years will be regarding decision making based on our subconscious mind. I believe that’s the next piece of the puzzle which a substantial amount of the research will examine. For example, a researcher conducts an experiment and that shows an individual a sad movie or a sad commercial and even if that sad visual had nothing to do with this experiment or decision to say to purchase a common stock, the result is people paying more for an object (in this case the common stock) because of viewing the subconsciously depressing movie. And it’s also similar to the experiment in which researchers have a group of subjects (people) write down the last 2 digits of their social security number and those with the highest digits bidding up and then paying the highest price for a financial service or investment product. And that’s the unconscious mind; there are an extensive number of new directions to explore with these types of experiments.
JB: Going back to neurofinance: I’ve been a little perplexed by the use of MRI scans in the field – when you look at a scan and it tells you that certain parts of the brain are activated under certain conditions, what does that tell you? I mean, how can that be put to practical use?
VR: Well the profession cannot yet predict with 100% accuracy the actual behaviour of each individual in which, a person shopping at the store and then monitoring what products activate different parts of your brain to predict a consumer’s final decision! But I believe this shows that there are emotional aspects to the brain and as a minimum this evidence disproves the notion of pure rationality by traditional finance. In the future, what is the willingness of people to agree to shop in a store and to be monitored with medical devices while making purchase decisions about products and services? There is value in even simply understanding when you walk into a store that retailers place specific products to the right because people have the tendency to walk to the right when they first come into the store. Many of these findings are examining human behaviour and store owners have been studying consumer psychology for decades. Richard Peterson the author of the neurofinance chapter in the book provides a wonderful in-depth discussion of this topic area.
JB: To what extent do you feel this new knowledge about human behaviour could be used as a force for evil or unethical behavior?
VR: There are potential problems in which people can be manipulated by the research findings of behavioural finance. I am concerned about the explosion of behavioural finance research and that a small number of experts employed in the financial services industry are focused on making quick money and exploiting people. In addition, there has not been enough of an open honest discussion of the role of developing public policy based on the findings of behavioural economics/behavioural finance. How ethical and to what degree should government officials implement policy based on the research findings of this discipline?
An excellent topic area that serves as an example is the retirement planning chapter and the role of nudging. With nudging, experts attempt to change people’s behaviour through governmental policy to make better decisions, or get them to do what the government or say a financial expert or a company wants them to do. For example, many people do not invest in a company retirement plan because they suffer from status quo bias (or inertia). The nudging research reveals if employees are automatically enrolled in a retirement plan they are far less likely, once they’ve been opted in, to opt out. The main issue I have with nudging, “Is this the correct public policy to have, to automatically place employees into company retirement savings?” What happens if that person has $25,000 in debts? Should different stakeholders be nudging them into saving for retirement?
Here in the United States, there is a conflict of interest among politicians of both parties because they like to publicize that more people are saving for retirement. The financial industry doesn’t mind it because if more people are investing in retirement planning (via mutual funds) that’s going to increase the firm’s management fees. Companies with retirement plans support the idea of automatically placing people into retirement accounts because this ensures the company will earn certain tax breaks for having a retirement plan. Nudging assists the organization in meeting the minimum requirements for having a certain number of employees that are actually contributing money into the retirement plans based on tax regulations. Nudging employees automatically into those accounts takes care of that public policy and I agree with the desire for people to save more for retirement, but I’m not sure some of these nudging policies are always going to be helpful. Individuals developing nudging policies may have the best of intentions but there’s a downside to it. In other words, is a conflict of interest among politicians, the financial services industry, and the company offering the retirement plan? In my assessment, this retirement nudging policy should incorporate investor education and a meeting with a financial planner for each employee. This would provide the employee with a full financial diagnosis, by treating the entire financial patient (in this case the retirement saver) with the proper care thus; resulting in better financial health for the patient (employee) for the long-term.
JB: To what extent has the academic study of behavioural finance now entered the mainstream practitioner environment? How much scepticism is there still among the practitioners?
VR: The professional expert side of things is dependent on what aspect of finance you’re dealing with. Financial planners who are meeting with clients and providing advice to clients, I believe that this expert group very much embraces behavioural finance. On the other hand, experts building financial risk management models, this camp I would say still is very similar to the academic side of finance and the university business schools in the United States that are still engrained in the assumptions of standard or traditional finance. Financial planners and financial analysts have to a substantial degree utilized the principles of behavioural finance. Experts in derivatives securities and financial risk management – for these types of finance careers – I feel have a resistance to behavioural finance.
JB: Do you find any traditional finance professors open to behavioural finance?
VR: Yes, the Sharpe’s, Markowitz’s, and Jensen’s of the world – the fathers of classical (traditional) finance – are open to behavioural finance in some of the conversations that I’ve had with them. However, their protégés who did their PhDs in Finance in the 1980s and 1990s are still the ones who are in the vast majority employed at the university business schools especially in the United States. These traditional finance protégés are the largest group resistant to behavioural finance. Also, traditional finance professors are the major group educating most of the future experts in the financial services industry. Most of the undergraduate and graduate finance students that represent the future of finance are not being taught enough about behavioural finance.
JB: Do you have any views on the way behavioural finance is taught? What could be done better?
VR: Based on the conferences I’ve attended and reviewing the business school curriculum – Europe is substantially ahead than elsewhere in accepting new behavioural topics across the business discipline. Also, there is just a much greater interdisciplinary acceptance of psychology in finance and economics in the general university system in Europe. The schools here in the United States that are focused on national business accreditation – that’s 500 schools approximately, the vast majority – as a rough estimate 80-90% of the faculty are trained in traditional finance. There are a limited number of behavioural finance courses, especially at undergraduate level. There are certainly more behavioural finance courses at the graduate level, however this is still a very small amount. According to colleagues at top universities who teach in graduate level classes, they are not allowed to have a separate behavioural finance course. That’s considered a luxury and these professors cover behavioural finance topics in a couple of chapters in a investments course. Out of the tens of thousands of finance courses there is only a small offering of behavioural finance courses. Within the financial planning curriculum, there is definitely a greater acceptance and coverage of behavioural finance. In my own experience, I having taught at the college level for over 15 years, my best student evaluations are for my behavioural finance and psychology of money courses.
JB: The reason I’m interested in this is that rightly or wrongly people have pointed the finger at business schools as a factor in the financial crisis. Do you feel that a wider knowledge of behavioural finance could have made a difference?
VR: In my opinion, possibly that could have made a difference but there were warnings signs especially among some regulators that noticed the red flags. I believe with any of these crises that it doesn’t matter what party controls the leadership here in the United States, the executive branch or the legislative branch, there’s a lack of communication or acceptance among the senior level people, even in the Federal Reserve. Also, when the party’s going on and you’re in a bubble, nobody wants to take the risk of bursting the bubble. There are definitely people who foretold of the financial crisis in 2008. In my behavioural finance course at Goucher College I showed my students a video on the internet bubble in the late 1990s and, if we were all rational people, we would have learned from our past mistakes! No! Instead the financial crisis of 2008 was not the equivalent of the internet bubble, it was even worse because it wasn’t just the stock market; it was the banking system along with the housing market. I figure in the near term and the immediate future – the next five or ten years in terms of the stock market or the housing market – we have traumatised ourselves with a lifelong lesson, similar to even the Great Depression generation. But what’s going to happen when 25-30 years pass by? People forget, the people who lived through this experience get older and the next generation moves in and these things have a tendency to repeat themselves and they will repeat themselves! Whether it’s 20 years or 50 years from now? We will still be human beings that will create another bubble and a new crisis will happen again at some point in time.