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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 markethypothesis, 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.

Introduction

During the 1990s, a new field known as behavioralfinance began to emerge in many academic journals,

business publications, and even local newspapers. Thefoundations of behavioral finance, however, can betraced back over 150 years. Several original bookswritten in the 1800s and early 1900s marked the be-ginning of the behavioral finance school. Originallypublished in 1841, MacKays Extraordinary PopularDelusions And The Madness Of Crowdspresents a chro-nological timeline of the various panics and schemesthroughout history. This work shows how group be-havior applies to the financial markets of today. LeBons important work, The Crowd: A Study Of ThePopular Mind, discusses the role of crowds (alsoknown as crowd psychology) and group behavior asthey apply to the fields of behavioral finance, socialpsychology, sociology, and history. Seldens 1912 bookPsychology Of The Stock Marketwas one of the first toapply the field of psychology directly to the stockmarket. This classic discusses the emotional and psy-chological forces at work on investors and tradersin the financial markets. These three works along withseveral others form the foundation of applying psy-chology and sociology to the field of finance. Today,there is an abundant supply of literature includingthe phrases psychology of investing and psychol-ogy of finance so it is evident that the search contin-

ues to find the proper balance of traditional finance,behavioral finance, behavioral economics, psychology,and sociology.

The uniqueness of behavioral finance is its inte-gration and foundation of many different schools ofthought and fields. Scholars, theorists, and practitio-ners of behavioral finance have backgrounds from awide range of disciplines. The foundation of behav-ioral finance is an area based on an interdisciplinary

approach including scholars from the social sciencesand business schools. From the liberal arts perspec-tive, this includes the fields of psychology, sociology,anthropology, economics and behavioral economics.On the business administration side, this covers areassuch as management, marketing, finance, technologyand accounting.

This paper will provide a general overview of thearea of behavioral finance along with some majorthemes and concepts. In addition, this paper will makea preliminary attempt to assist individuals to answerthe following two questions:

How Can Investors Take Into Account the BiasesInherent in the Rules of Thumb They Often FindThemselves Using?

How Can Investors know themselves better soThey Can Develop Better Rules of Thumb?

In effect, the main purpose of these two questionsis to provide a starting point to assist investors to de-velop their own tools (trading strategy and invest-ment philosophy) by using the concepts of behavioralfinance.

What is Standard Finance?

Current accepted theories in academic finance arereferred to as standard or traditional finance. Thefoundation of standard finance is associated with themodern port folio theory and the efficient market hy-

pothesis. In 1952, Harry Markowitz created modernportfolio theory while a doctoral candidate at theUniversity of Chicago. Modern Portfolio Theory(MPT) is a stock or portfolios expected return, stan-dard deviation, and its correlation with the otherstocks or mutual funds held within the portfolio.

With these three concepts, an efficient por tfolio canbe created for any group of stocks or bonds. An effi-cient portfolio is a group of stocks that has the maxi-

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mum (highest) expected return given the amount ofrisk assumed, or, on the contrary, contains the lowestpossible risk for a given expected return.

Another main theme in standard finance is knownas the Efficient Market Hypothesis (EMH). The effi-cient market hypothesis states the premise that all in-formation has already been reflected in a securitysprice or market value, and that the current price thestock or bond is trading for today is its fair value. Sincestocks are considered to be at their fair value, propo-nents argue that active traders or portfolio managerscannot produce superior returns over time that beatthe market. Therefore, they believe investors shouldjust own the entire market rather attempting to out-perform the market. This premise is supported bythe fact that the S&P 500 stock index beats the overallmarket approximately 60% to 80% of the t ime. Evenwith the preeminence and success of these theories,behavioral finance has begun to emerge as an alter-native to the theories of standard finance.

The Foundations of

Behavioral Finance

Discussions of behavioral finance appear within theliterature in various forms and viewpoints. Manyscholars and authors have given their own interpre-tation and definition of the field. It is our belief thatthe key to defining behavioral finance is to first es-tablish strong definitions for psychology, sociologyand finance (please see the diagram located below).

Figure 1 demonstrates the important interdiscipli-

nary relationships that integrate behavioral finance.When studying concepts of behavioral finance, tradi-tional finance is still the centerpiece; however, the be-havioral aspects of psychology and sociology areintegral catalysts within this field of study. Therefore,the person studying behavioral finance must have abasic understanding of the concepts of psychology,sociology, and finance (discussed in Figure 2) to be-come acquainted with overall concepts of behavioralfinance.

What is Behavioral Finance?

Behavioral finance attempts to explain and increaseunderstanding of the reasoning patterns of investors,including the emotional processes involved and thedegree to which they influence the decision-making

process. Essentially, behavioral finance attempts toexplain the what, why, and how of finance and invest-ing, from a human perspective. For instance, behav-ioral finance studies financial markets as well asproviding explanations to many stock market anoma-lies (such as the January effect), speculative marketbubbles (the recent retail Internet stock craze of 1999),and crashes (crash of 1929 and 1987). There has beenconsiderable debate over the real definition and va-lidity of behavioral finance since the field itself is stilldeveloping and refining itself. This evolutionary pro-cess continues to occur because many scholars havesuch a diverse and wide range of academic and pro-fessional specialties. Lastly, behavioral finance stud-ies the psychological and sociological factors thatinfluence the financial decision making process ofindividuals, groups, and entities as illustrated below.

In reviewing the literature written on behavioralfinance, our search revealed many different interpre-tations and meanings of the term. The selection pro-cess for discussing the specific viewpoints anddefinitions of behavioral finance is based on the pro-fessional background of the scholar. The discussionwithin this paper was taken from academic scholarsfrom the behavioral finance school as well as frominvestment professionals.

W hat is Behavioral Finance?, Victor Ricciardi and H elen K. S imon

Defining the Various Disciplines of Behavioral Finance

The Behavioral Finance Decision Makers

Figure 1.

Figure 2.

Figure 3.

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Behavioral Finance and

Academic Scholars

Two leading professors from Santa Clara University,Meir Statman and Hersh Shefrin, have conducted re-search in the area of behavioral finance. Statman(1995) wrote an extensive comparison between the

emerging discipline behavioral finance vs. the oldschool thoughts of standard finance. According toStatman, behavior and psychology influence indi-vidual investors and portfolio managers regarding thefinancial decision making process in terms of r isk as-sessment (i.e. the process of establishing informationregarding suitable levels of a risk) and the issues offraming (i.e. the way investors process informationand make decisions depending how its presented).

Shefrin (2000) describes behavioral finance as theinteraction of psychology with the financial actionsand performance of practitioners (all types/catego-

ries of investors). He recommends that these inves-tors should be aware of their own investmentmistakes as well the errors of judgment of theircounterparts. Shefrin states, One investors mistakescan become another investors profits (2000, p. 4).Furthermore, Barber and Odean (1999, p. 41) statedthat people systemically depart from optimal judg-ment and decision making. Behavioral finance en-riches economic understanding by incorporatingthese aspects of human nature into financial mod-els. Robert Olsen (1998) describes the new para-digm or school of thought known as an attempt to

comprehend and forecast systematic behavior in or-der for investors to make more accurate and correctinvestment decisions. He further makes the point thatno cohesive theory of behavioral finance yet exists,but he notes that researchers have developed manysub-theories and themes of behavioral finance.

Viewpoints from the

Investment Managers

An interesting phenomenon has begun to occur withgreater frequency in which professional portfolio

managers are applying the lessons of behavioral fi-nance by developing behaviorally-centered tradingstrategies and mutual funds. For example, the port-folio manager for Undiscovered Managers, Inc.,Russell Fuller, actually manages three behavioral fi-nance mutual funds: Behavioral Growth Fund, Be-havioral Value Fund, and Behavioral Long/ShortFund). Fuller (1998) describes his viewpoint of be-havioral finance by noting his belief that people sys-tematically make mental errors and misjudgments

when they invest their money. As a portfolio man-ager or as an individual investor, recognizing the men-tal mistakes of others (a mis-priced security such as astock or bond) may present an opportunity to makea superior investment return (chance to arbitrage).

Arnold Wood of Martingale Asset Managementdescribed behavioral finance this way:

Evidence is prolific that money managers rarelylive up to expectations. In the search for reasons,academics and practitioners alike are turning tobehavioral finance for clues. It is the study ofus. After all, we are human, and we are notalways rational in the way equilibrium modelswould like us to be. Rather we play games thatindulge self-interest. Financial markets are areal game. They are the arena of fear and greed.Our apprehensions and aspirations are acted outevery day in the marketplace. So, perhapsprices are not always rational and efficiency may

be a textbook hoax. (Wood 1995, p. 1)

Now that you have been introduced to the generaldefinition and viewpoints of behavioral finance, wewill now discuss four themes of behavioral finance:overconfidence, financial cognitive dissonance, regrettheory, and prospect theory.

What is Overconfidence?

Research scholars from the fields of psychology andbehavioral finance have studied the topic of overcon-fidence. As human beings, we have a tendency to over-estimate our own skills and predictions for success.Mahajan (1992, p. 330) defines overconfidence as anoverestimation of the probabilities for a set of events.Operationally, it is reflected by comparing whetherthe specific probability assigned is greater than theportion that is correct for all assessments assigned thatgiven probability. To illustrate:

The explosion of the space shuttle Challengershould have not surprised anyone familiar withthe history of booster rockets 1 failure in every

57 attempts. Yet less than a year before the disas-ter, NASA set the chances of an accident at 1 in100,000. That optimism is far from unusual: allkinds of experts, from nuclear engineers to phy-sicians to be overconfident. (Rubin, 1989, p. 11)

Academic research on overconfidence has been arecurrent theme in psychology. Take for instance thework in experimental psychology of Fishchhoff,

W hat is Behavioral Finan ce?, Victor Ricciardi and H elen K. S imon

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Slovic, and Lichtenstein (1977). This piece studied agroup of people by asking them general knowledgequestions. Each of the participants in study had torespond to a set of standard questions in which theanswers were definitive. However, the subjects of thestudy did not necessarily know the answers to thequestions. Along with each answer, a person was ex-pected to assign a score or percentage of confidenceas to whether or not they thought their answer wascorrect. The results of this study demonstrated a wide-spread and consistent tendency of overconfidence. Forinstance, people who gave incorrect answers to10 per-cent of the questions (thus the individual should haverated themselves at 90 percent) instead predicted with100 percent degree of confidence their answers werecorrect. In addition, for a sample of incorrect answers,the participants rated the likelihood of their responsesbeing incorrect at 1:1000, 1:10,000 and even1:1,000,000. The difference between the reliability ofthe replies and the degree of overconfidence was con-

sistent throughout the study.In both the areas of psychology and behavioral fi-

nance the subject matter of overconfidence contin-ues to have a substantial presence. As investors, wehave an inherent ability of forgetting or failing to learnfrom our past errors (known as financial cognitivedissonance, which will be discussed in the next sec-tion), such as a bad investment or financial decision.This failure to learn from our past investment deci-sions further adds to our overconfidence dilemma.

In the area of gender bias, the work of Barber andOdean (2000) has produced very interesting findings.

The study of differences in trading habits accordingto an investors gender covered 35,000 households oversix years. The study found that men were more over-confident than women regarding their investing skillsand that men trade more frequently. As a result, malesnot only sell their investments at the wrong time butalso experience higher trading costs than their femalecounterparts. Females trade less (buy and hold theirsecurities), at the same time sustaining lower trans-action costs. The study found that men trade 45 per-cent more than women and, even more astounding,single men trade 67 percent more than single women.

The trading costs reduced mens net returns by 2.5percent per year compared with 1.72 percent forwomen. This difference in portfolio return over timecould result in women having greater net wealth be-cause of the power of compounding interest over a10 to 20 year time horizon (known as the time valueof money).

What is Financial Cognitive

Dissonance?

The Theory: another important theme from the fieldof behavioral finance is the theory of cognitive dis-sonance. Festingers theory of cognitive dissonance(Morton, 1993) states that people feel internal ten-

sion and anxiety when subjected to conflicting be-liefs. As individuals, we attempt to reduce our innerconflict (decrease our dissonance) in one of twoways: 1) we change our past values, feelings, or opin-ions, or, 2) we attempt to justify or rationalize ourchoice. This theory may apply to investors or trad-ers in the stock market who attempt to rationalizecontradictory behaviors, so that they seem to follownaturally from personal values or viewpoints.

The work of Goetzmann and Peles (1997) exam-ines the role of cognitive dissonance in mutual fundinvestors. They argue that some individual investors

may experience dissonance during the mutual fundinvestment process, specifically, the decision to buy,sell, or hold. Other research has shown that investordollars are allocated more quickly to leading funds(mutual funds with strong performance gains) thanoutflows from lagging funds (mutual funds withpoor investment returns). Essentially, the investorsin the under-performing funds are reluctant to ad-mit they made a bad investment decision. Theproper course of action would be to sell the under-performer more quickly. However, investors chooseto hold on to these bad investments. By doing so,

they do not have to admit they made a investmentmistake.An Example: In financial cognitive dissonance,

we change our investment styles or beliefs to sup-port our financial decisions. For instance, recent in-vestors who followed a traditional investment style(fundamental analysts) by evaluating companiesusing financial criteria such as profitability measures,especially P/E ratios, started to change their invest-ment beliefs. Many individual investors purchasedretail Internet companies such as IVillage.com andthe Globe.com in which these financial measurescould not be applied, since these companies had nofinancial track record, very little revenues, and nonet losses. These traditional investors rationalizedthe change in their investment style (past beliefs) intwo ways: the first argument by many investors isthe belief (argument) that we are now in a neweconomy in which the traditional financial rules no


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longer apply. This is usually the point in the economiccycle in which the stock market reaches its peak. Thesecond action that displays cognitive dissonance isignoring traditional forms of investing, and buyingthese Internet stocks simply based on price momen-tum. Purchasing stocks based on price momentumwhile ignoring basic economic principles of supplyand demand is known in the behavioral finance arenaas herd behavior. In essence, these Internet investorscontributed to the financial speculative bubble thatburst in March 2000 in Internet stocks, especially theretail sector, which has declined dramatically from thehighs of 1999; many of these stocks have decreasedup to 70% off their all time highs.

What is the Theory of Regret?

Another prevalent theme in behavioral finance is re-gret theory. The theory of regret states that an indi-vidual evaluates his or her expected reactions to afuture event or situation (e.g. loss of $1,000 from sell-ing the stock of IBM). Bell (1982) described regret asthe emotion caused by comparing a given outcomeor state of events with the state of a foregone choice.For instance, when choosing between an unfamiliarbrand and a familiar brand, a consumer might con-sider the regret of finding that the unfamiliar brandperforms more poorly than the familiar brand andthus be less likely to select the unfamiliar brand(Inman and McAlister, 1994, p. 423).

Regret theory can also be applied to the area of in-vestor psychology within the stock market. Whether

an investor has contemplated purchasing a stock ormutual fund which has declined or not, actually pur-chasing the intended security will cause the investorto experience an emotional reaction. Investors mayavoid selling stocks that have declined in value in or-der to avoid the regret of having made a bad invest-ment choice and the discomfort of repor ting the loss.In addition, the investor sometimes finds it easier topurchase the hot or popular stock of the week. Inessence the investor is just following the crowd.Therefore, the investor can rationalize his or her in-vestment choice more easily if the stock or mutual

fund declines substantially in value. The investor canreduce emotional reactions or feelings (lessen regretor anxiety) since a group of individual investors alsolost money on the same bad investment.

What is Prospect Theory?

Prospect theory deals with the idea that people do notalways behave rationally. This theory holds that thereare persistent biases motivated by psychological fac-tors that influence peoples choices under conditionsof uncertainty. Prospect theory considers preferences

as a function of decision weights, and it assumes thatthese weights do not always match with probabilities.Specifically, prospect theory suggests that decisionweights tend to overweigh small probabilities andunder-weigh moderate and high probabilities. HughSchwartz (1998, p. 82) art iculates that subjects (in-vestors) tend to evaluate prospects or possible out-comes in terms of gains and losses relative to somereference point rather than the final states of wealth.

To illustrate, consider an investment selection be-tween

Option 1:A sure profit (gain) of $ 5,000 orOption 2:An 80% possibility of gaining $7,000, with

a 20 percent chance of receiving nothing ($ 0).Question: Which option would give you the best

chance to maximize your profits?

Most people (investors) select the first option,which is essentially is a sure gain or bet. Two theo-rists of prospect theory, Daniel Kahneman and AmosTversky (1979), found that most people become riskaverse when confronted with the expectation of a fi-nancial gain. Therefore, investors choose Option 1which is a sure gain of $5,000. Essentially, this appears

to be the rational choice if you believe there is a highprobability of loss. However, this is in fact the less at-tractive selection. If investors selected Option 2, theiroverall performance on a cumulative basis would bea superior choice because there is a greater payoff of$5,600. On an investment (portfolio) approach, theresult would be calculated by: ($7,000 x 80%) + (0 +20%) = $5,600.

Prospect theory demonstrates that if investors arefaced with the possibility of losing money, they oftentake on riskier decisions aimed at loss aversion(though they may sometimes refrain from investing

altogether). They tend to reverse or substantially al-ter their revealed disposition toward r isk. Lastly, thiserror in thinking relative to investing ultimately mayresult in substantial losses within a portfolio of in-vestments, such as an individual invested in a groupof mutual funds.


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How Should Investors Take Into

Account the Biases Inherent in the

Rules of Thumb They Often Find

Themselves Using and How

Should They Develop Better Rules

of Thumb?As investors, we are obviously influenced by variousbehavioral and psychological factors. Individuals whoinvest in stocks and mutual funds should implementseveral safeguards that can help control mental errorsand psychological roadblocks. A key approach to con-trolling these mental roadblocks is for all types of in-vestors to implement a disciplined trading strategy.

In the case of stock investments: the best way for in-vestors to control their mental mistakes is to focuson a specific investment strategy over the long-term.

Investors should keep detailed records outlining suchmatters as why a specific stock was purchased for theirportfolio. Also, investors should decide upon specificcriter ia for making an investment decision to buy, sell,or hold. For example, an investor should create aninvestment checklist that discusses questions such asthese:

Why did an investor purchase the stock?What is their investment t ime horizon?What is the expected return from this investment one

year from now?What if a year from now the stock has under-per-

formed or over-performed your expectations? Doyou plan on buying, selling, or holding your posi-tion?

How risky is this stock within your overall por tfolio?

The purpose of developing and maintaining an in-vestment record is that over time it will assist an in-vestor in evaluating investment decisions. With thistype of strategy, investors will have an easier time ad-mitting their mental mistakes, and it will support themin controlling their emotional impulses. Ultimately,the way to avoid these mental mistakes is to trade less

and implement a simple buy and hold strategy. Along-term buy and hold investment strategy usuallyoutperforms a short-term trading strategy with highportfolio turnover. Year after year it has been docu-mented that a passive investment strategy beats anactive investment philosophy approximately 60 to 80percent of the time.

In the case of mutual fund investments: in terms ofmutual funds, its recommended that investors apply

a similar checklist for individual stocks. Tomic andRicciardi (2000) recommend that investors select mu-tual funds with a simple 4-step process which in-cludes the following criteria:

Invest in only no-load mutual funds with low op-erating expenses;

Look for funds with a strong historical track recordover 5 to 10 years;

Invest with tenured portfolio managers with astrong investment philosophy; and

Understand the specific risk associated with eachmutual fund.

Essentially, these are good starting point criteriafor mutual fund investors. The key to successful in-vesting is recognizing the type of investor you arealong with implementing a solid investment strategy.Ultimately, for most investors, the best way to maxi-mize their investment returns is to control their men-tal errors with a long-term mutual fund philosophy.

In November 1999, there was a conference entitled

Recent Advances in Behavioral Finance: A CriticalAnalysis(hosted by the Berkeley Program in Finance).The conference featured a debate on the validity ofbehavioral finance between advocates for the tradi-tional finance and behavioral finance schools ofthought. There was no clear winner in this contest;however, having such an event demonstrates thegradual acceptance of behavioral finance. Both schoolsseemed to agree that the best trading strategy is along-term buy and hold investment in a passivestock mutual fund such as S&P 500 index. For ex-ample, Terrance Odean, a behavioral finance expert ,

says in a recent interview that he invests primarily inindex funds. As a young man, Odean said, I tradedtoo actively, traded too speculatively and clung to mylosses. I violated all the advice I now give (Feldman,1999, p. 174).

Closing Remarks

Over the last forty years, standard finance has beenthe dominant theory within the academic commu-nity.

However, scholars and investment professionals

have started to investigate an alternative theory of fi-nance known as behavioral finance. Behavioral fi-nance makes an attempt to explain and improvepeoples awareness regarding the emotional factorsand psychological processes of individuals and enti-ties that invest in financial markets. Behavioral financescholars and investment professionals are developingan appreciation for the interdisciplinary research thatis the underlying foundation of this evolving disci-pline. We believe that the behaviors described in this


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paper are exhibited within the stock market by manydifferent types of individual investors, groups of in-vestors, and entire organizations.

This paper has discussed four themes within thearena of behavioral finance, which are overconfidence,cognitive dissonance, regret theory, and prospecttheory. These four topics are an introductory repre-sentation of the many different themes that havestarted to occur over the last few years within the field(see checklist of behavioral finance topics after thissection). The validity of all of these topics will be testedover time as the behavioral finance scholars eventu-ally research and implement concepts, or as otherpractices start to fad or are rejected.

This article has also discussed some trading ap-proaches for investors in stocks and bonds to assistthem in manifesting and controlling their psychologi-cal roadblocks. These rules of thumb are a startingpoint for investors that encourage them to keep aninvestment track record and checklist regarding each

stock or mutual fund within their overall portfolio.Hopefully, these behavioral finance-driven structuredguidelines for making investment choices will aid in-dividuals by drawing attention to potential mentalmistakes, hopefully leading to increased investmentreturns.

In closing, we believe that the real debate betweenthe two schools of finance should address which be-havioral finance themes are relevant enough today tobe taught in the classroom and published in new edi-tions of finance textbooks. A concept such as pros-pect theory deserves mention by finance academics

and practitioners, to offer students, faculty, and in-vestment professionals an alternative viewpoint of fi-nance.

The Behavioral Finance Checklist

AnchoringFinancial PsychologyCascadesChaos TheoryCognitive BiasCognitive Dissonance

Cognitive ErrorsContrarian InvestingCrashesFearGreedHerd BehaviorFramingHindsight BiasPreferencesFads

HeuristicsManiasPanicsDisposition EffectLoss AversionProspect TheoryRegret TheoryGroupthink TheoryAnomaliesMarket InefficiencyBehavioral EconomicsOverreactionUnder-reactionOverconfidenceMental AccountingIrrational BehaviorEconomic PsychologyRisk PerceptionGender BiasIrrational Exuberance

Glossary of Key Terms

Academic Finance (Standard or Traditional Finance):

the current accepted theory of finance at most col-leges and universities, based on such topics as mod-ern portfolio theory and the efficient markethypothesis.Anomaly or Anomalies:something that deviates fromthe norm or common rule and is usually abnormal,such as the January Effect.Arbitrage: an attempt to enjoy a risk-less profit by

taking advantage of pricing differences in identicalsecurities being traded in different markets or in dif-ferent forms as a result of mis-pricing of securities.Behavioral Economics: the foundation of behavioralfinance, found especially in the groundbreaking workof Richard Thaler. This field is the alternative to tra-ditional economics since it applies psychology to eco-nomics. Other examples of alternat ive economics areeconomic psychology and socio-economics.Behavioral Finance Theory: the belief that psycho-logical considerations are an essential feature of thesecurity markets. It is a field that attempts to explain

and increase understanding of how the emotions andmental mistakes of investors influence the decision-making process.Bias: an inclination of temperament or outlook; un-reasoned judgment or prejudice.Bubble: the phase before a market crash when con-cerns are expressed that the stock market is overval-ued or overly inflated from speculative behavior.Cognitive Dissonance Theory: states there is a ten-dency for people to search for regularity among their


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cognitions (i.e., beliefs, viewpoints). When there is adiscrepancy between feelings or behaviors (disso-nance), something must transform to eliminate thedissonance.Correlation: a concept from probability (statistics).It is a measure of the degree to which two randomvariables track one another, such as stock prices (stockmarket) and interest rates (bond market).Crash: a steep and abrupt drop in security marketprices.Efficient Frontier:the line on a risk-reward graph rep-resenting a set of all efficient portfolios that maxi-mize expected return at each level of risk.Efficient Market Hypothesis (EMH): the theory thatprices of securities fully reflect all available informa-tion and that all market participants receive and acton all relevant information as soon as it becomes avail-able.Efficient Portfolio:a portfolio that provides the great-est expected return for a given level of risk.

Expected return: the return expected on a r isky assetbased on a normal probability distribution for all thepossible rates of return.Finance: a discipline concerned with determiningvalue and making decisions. The finance function al-locates capital, including acquiring, investing, andmanaging resources.Herding or Herd Behavior: herding transpires whena group of investors make investment decisions on aspecific piece of information while ignoring otherpertinent information such as news or financial re-ports.

January Effect:the January effect is generally thoughtto be among the most frequent of the stock marketsanomalies. Investors each January expect above aver-age gains for the month, which are most likely causedby the result of a flood of new money (supply) fromretirement contributions, combined with optimismfor the New Year.Loss Aversion: The idea that investors assign moresignificance to losses than they assign to gains. Lossaversion occurs when investors are less inclined to sellstocks at a loss than they are to sell stocks that havegained in value (even if expected returns are the iden-

tical).Modern Portfolio Theory: An inclusive investmentapproach that assumes that all investors are risk averseand seeks to create an optimal portfolio in consider-ation of the relationship between risk and reward asmeasured by alpha, beta and R-squared.Overconfidence: The findings that people usually havetoo much confidence in the accuracy of their judg-ments; peoples judgments are usually not as correctas they think they are.

Panics: Sudden, widespread fear of an economic ofmarket collapse, which usually leads to falling stockprices.Prospect Theory:can be defined as how investors as-sess and calculate the chance of a profit or loss in com-parison to the perceptible risk of the specific stock ormutual fund.Psychology: is the scientific study of behavior andmental processes, along with how these processes areaffected by a human beings physical, mental state, andexternal environment.Regret Theory: The theory of regret states that indi-viduals evaluate their expected reactions to a futureevent or situationSociology: is the systematic study of human socialbehavior and groups. This field focuses primarily onthe influence of social relationships on peoples atti-tudes and behavior.Standard Deviation: within finance, this statistic is avery important variable for assessing the risk of stocks,

bonds, and other types of financial securities.Time Value of Money: is the process of calculatingthe value of an asset in the past, present or future. It isbased on the notion that the original principal willincrease in value over time by interest. This meansthat a dollar invested today is going to be worth moretomorrow.

Acknowledgements

The authors would like to thank the following for theirinsightful comments and support: Robert Fulkerth,

Steve Hawkey, Robert Olsen, Tom Powers, HankPruden, Hugh Schwartz, Igor Tomic, and MikeTroutman. An earlier version of this paper was pre-sented by Victor Ricciardi at the Annual Colloquiumon Research in Economic Psychology July 2000 inVienna, Austria. The sponsors of this conference werethe International Association for Research in Eco-nomic Psychology (IAREP) and The Society for theAdvancement of Behavioral Economics (SABE) inaffiliation with the University of Vienna.

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About the Authors

Victor Ricciardi is currently an adjunct faculty mem-ber and doctoral student in finance at Golden GateUniversity in San Francisco, California. Victor hastaught classes in finance, economics and behavioralfinance. His dissertation and research work is in thefield of behavioral finance. The topic of his thesis is astudy of how trustees of private universities make in-vestment decisions regarding endowment funds, from

a behavioral finance perspective.Victor received his MBA in Finance and advancedmasters in Economics from St. Johns University andBBAs in Accounting and Management from HofstraUniversity. Victor began his professional career as amutual fund accountant for the Dreyfus Corporationand Alliance Capital Management. In addition, he hasbeen employed as an Economic Analyst at the Fed-eral Deposit Insurance Corporation (FDIC). He alsohas completed a yet unpublished book with Dr. IgorTomic of St. Johns University on the topic of mutualfund investing.

Helen K. Simon, CFP is President of Personal Busi-

ness Management Services, LLC, located in Fort Lau-derdale, Florida. Helen has resided in South Floridasince 1974 and has nearly 20 years of professional ex-perience in the financial services and investment field.She serves on the adjunct faculty of Florida State Uni-versity and Nova Southeastern University where sheteaches classes in financial management, personal fi-nance and financial planning. She received a BBA,Magna Cum Laude, from Florida Metropolitan Uni-versity, the CFP designation from The College for Fi-nancial Planning, an MBA from Nova SoutheasternUniversity and is currently pursuing a Doctorate of

Business Administration (DBA) with a concentrationin Finance. She also serves on the City of OaklandPark, Florida Employee Pension Board.


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