When Economies Aren’t Rational: Victor Ricciardi Weighs in On Behavioral Finance

Traditional economists and financial professors like to pretend that we live in a rational world, but a growing body of evidence challenges many of these basic assumptions. Evidence from psychology demonstrates that there are limits to human rationality, and that cognitive and emotional biases are a part of the package. Thankfully, a growing number of economists and financial experts are starting to incorporate some of this knowledge into their theories.

Victor Ricciardi is a Finance Professor at Goucher College in Baltimore, Maryland. He is an expert in behavioral finance and recently, I had the pleasure of reading several book chapters he has written on the psychology of risk. Professor Ricciardi posts behavioral finance news and research on his Twitter account.

My Phone Interview With Victor Ricciardi

I’m glad to get a chance to talk to you.


So I’d like to hear a little about your perspectives on the difference between uncertainty and risk. You’ve spoken about how risk is quantifiable, but uncertainty isn’t. What I’m most interested in is how we do science on something that isn’t quantifiable. How do we differentiate between a high risk decision and an uncertain decision?

I would say that risk is measurable, and it is also calculable. You can assess if a stock went up or down ten percent, and that’s what we call risk, but uncertainty is what will the stock do tomorrow? In many instances you can’t measure uncertainty. That’s the problem with many of the traditional financial models, especially with the financial crises, the derivative models were based on a world of measurable risk within a “standard deviation world.” But those models typically fail when you go out four or five deviations.

But neither risk nor uncertainty is necessarily science?

Right. Something as purely objective as data can provide you with a historical representation, but the academic literature reveals that its highly questionable as a predictor of the future.


Okay so one of the most popular theories in contemporary finance is Modern Portfolio Theory, which makes some of the classical economic assumptions like rational decision making, knowledge of all the available risks, and so on. There were a few interesting points you made. The first was about the use of standard deviation as a measure of risk. You mentioned that standard deviation isn’t necessarily a good measure of risk, because investments don’t always take the shape of a bell curve. Does this mean that Modern Portfolio Theory isn’t a predictive theory?

I wouldn’t think of it as a predictive theory. I think it’s very good for helping establish the way we want to act in a perfect world, but behavioral finance studies how we actually behave. My own personal perspective is that I actually enjoy teaching and I am a proponent of many of the tools of modern portfolio theory, but I think much of it is based on faulty assumptions. Behavioral finance explores how we actually behave, but it is still experimental. If human behavior can be assessed more accurately, an investor can decide on a rational objective strategy based on the tools of standard finance. That’s how I typically use this approach.

You also pointed out that Modern Portfolio Theory predicts that higher risks should coincide with higher rewards, but that this isn’t always the case in the real world. Is behavioral finance offering some insight into why?

I think there are two pieces to this. In times of speculative bubbles, novice investors don’t make a link between risk and return. The positive relationship between risk and return described in traditional finance theory is based on historical data. But the existence of something called the familiarity bias can sometimes lead to an inverse relationship.

Experiments have shown that if somebody is given the financial information of two companies, including risk and return characteristics, this data will often be ignored if they are familiar with one of the companies. For example, if you provide an investor with exact financial information of two companies, Coca Cola compared with a similar company you’ve never heard of, you’re more likely to invest in Coca Cola.

So what you’re saying is when people are given data from two identical companies, they’ll go with the familiar one.

Yes, if they had a positive frame or attitude toward the company they would believe it has a higher return. Apple is a good example right now. The familiar name makes people more likely to continue investing regardless of any financial data. They perceive Apple with an inverse relationship, in which Apple stock is perceived as lower risk with the expectation of a higher return.

Right. Would you say that behavioral finance modifies traditional finance theory, replaces it, or compliments it?

I would say it compliments it, and in many ways it makes a more complete theory of finance. Behavioral finance on its own doesn’t have a model such as the Capital Asset Pricing Model in traditional finance. We don’t currently know how to quantify some of the psychological factors in a way that can be consistently applied. So I would say it compliments it and with my students I teach them both perspectives. I believe they get a more complete picture and can make their own decisions about traditional and behavioral finance.

Alright, I’d like to go ahead and dive into the nuts and bolts of the behavioral finance perspective. Much of it relies on the subject of heuristics. What are they and what can they tell us about the real world behavior of markets?

Heuristics are rules of thumb we use to simplify decision making because of the complexities in our daily lives. A good example is the overwhelming information on the internet. As human beings we can’t look at hundreds of web pages so we go with what we’re familiar with and what we’ve used in the past.

Decision making is very situational. Simple heuristics help us assess positive or bad experiences that influence our decision making. There’s no exact science saying this leads to better decisions or to worse, it depends on the situation. A good example is anchoring. Say somebody bought a car and found out it was a lemon. They’ll anchor on that and they’ll never buy that brand of car again because of the bad consumer purchase experience.

Right. I think we’ve all had experiences like that.

I thought this was interesting. When you offer somebody a sure reward of 75 dollars or an 80 percent chance of 100 dollars, most people pick the first option, even though on average the second option offers an average of 80 dollars to the participants. Why is it that this happens, and is it really an irrational decision?

This is a perfect example of when people “satisfice.” I don’t think of it as being irrational, but I would say that they are following the tenets of bounded rationality. People select that choice because of the certainty. The degree of uncertainty makes them uncomfortable because they don’t like the possibility of receiving nothing.

When you frame it as a choice between risk and certainty, the first choice eliminates all risk. The idea behind the twenty percent chance is it’s a good example of how people don’t like the possibility of getting nothing, and this pushes them to the other decision. People don’t frame the full decision within a portfolio and ask what the optimal decision is. Standard finance assumes people will optimize their decisions quantitatively, but most people don’t.

What we were just talking about is called prospect theory, and it’s similar to this subject of loss aversion, where we take losses to be more significant than gains. The result is that we are too willing to take risks to avoid a loss, but not willing to take enough risks for a gain. Could you offer an example of what this looks like?

The loss on a stock transaction is a great example of what behavioral finance recognizes as an “emotional loss.” When people go from losing value on their stock to making a profit, people get out too early because they see that short term improvement. People hold on to losers too long and sell winners too early. This is based on the notion that they are making money and they don’t want to go back to losing money.

So loss aversion and prospect theory seem very closely related to me.

Yes, loss aversion is an underlying premise of prospect theory. That was the work that earned Daniel Kahneman the Nobel Prize in Economics in 2002, and that would have won Amos Tversky the prize if he hadn’t died in 1996.

The interesting thing about this theory is that it was not created by researchers in economics or finance; it was proposed by academics in psychology. Still today, especially at the university level, the idea of trying to get a teaching position with a background in behavioral finance is very difficult and there’s a lot of resistance to it. Most of the founders of standard finance and their protégés with PhDs in Finance (Economics) were taught and trained during the ’70s, ’80s, and ’90s and are only comfortable with the classical assumptions and theories. They stick with the perspective that they learned, however, at some point in time, many disciplines experience a paradigm shift.

You could argue that there are some cognitive biases there.

Yes. I was classically trained in standard finance. I was introduced to behavioral finance by my mentors Hank Pruden, Bob Olsen, and Hugh Schwartz in the late 1990s as part of my behavioral finance journey when I was working on my dissertation. You might say that doing experimental research as part of my dissertation was probably not a good idea. My basic career objective was to become a finance professor and in my long journey I was fortunate to learn about behavioral finance.

Back in 1999 there was only one book on behavioral finance by Hersh Shefrin. Now there are about 25, which still isn’t very many. But at least now most investment books have a chapter on behavioral finance. I’ve found that most investment professionals such as financial planners embrace behavioral finance, and now the CFA Institute has expanded coursework on the subject matter. But most of the business schools spend one class lecture in an investments course and only a handful offer an entire course in behavioral finance.

A lot of this makes it look like humans, on average, aren’t willing to take enough risks, but you also point out that we have a tendency to be overconfident.

Yes, some people take a lot of risks and that depends on their own risk tolerance and personality traits. The overconfidence issue is especially common in men, who can sometimes be more stubborn with their investments than women. In general, men are more aggressive in their financial decisions and are more likely to trade stocks than take a conservative approach.

The research literature documents that men are more overconfident and that can have a negative impact on returns when compared to women investors. This is all in general of course. I have a working paper out about the literature which documents that women tend to worry more than men about various issues. However, I have been reflecting lately on whether there’s really a major difference between the two genders; perhaps men are simply less likely to admit (less expressive) they experience negative feelings such as worry? (This was pointed out to me in a recent conference sponsored by the Academy of Behavioral Finance & Economics.)

That’s interesting. I’m always interested to hear about some of the research being done about gender differences.

I’ve learned that, as a behavioral finance researcher, it’s important to frame these discussions by reiterating that this is about what is revealed in the academic literature and is based on the findings in a collection of research studies across various disciplines. If I identify 80 studies reporting that more women are experiencing negative emotions about their finances and other related issues than men, I think that’s an interesting avenue for further research.

I’m not in any way implying that women are somehow more weak-minded than men; I’m trying to document the body of knowledge in the academic literature and let people decide how to move forward with this issue. I hope it helps individual investors make better financial decisions and at the same time encourages behavioral finance and financial psychology researchers to explore this issue in the lab and as part of their research agenda.

Yeah I think it’s a mistake to attach too much meaning to these kinds of studies since we can’t be sure what is causing the differences.

Context has a lot to do with our behavior. When we see something that reminds us of a similar situation, we tend to base our behavior off of what happened the last time, even if the analogy isn’t necessarily all that strong. We also make a different decision leading to a different outcome based on the way that a situation is presented to us. Why is it that context is so important?

The big issue is how things are framed. For example, an interesting avenue of research focuses on annuities. Financial planners realize many novices don’t want to invest in annuities. People are resistant to them, especially if you frame it as a long term investment. With an annuity, for example, at retirement you might get $1000 a month for the rest of your life. Only a low percentage of subjects (individuals) choose annuities when they’re framed as a long term investment.

The interesting thing is that when they’re framed in retirement as a way to pay for vacations, spending on enjoyable events, going golfing, and for consumption in general, people become much more likely to invest in annuities. When you frame it so that it is about consumption (spending) instead of a long term investment, people are more likely to take the annuity. This actually closely relates to the concept known as self-control bias. We’d rather consume things today than worry about saving money for tomorrow.

Interesting. You’re saying one reason we like to spend today instead of invest is because we feel like we have more control over the money when we’re spending it.

Yes. People have more fun spending money and going on vacation. This is an example in which, financial planners utilize the behavioral finance research because they can use it in their practice with clients even though there is resistance to it in by standard finance academics.

Was there anything else you wanted to say about anchoring?

I would say that anchors are slow to shift over time and with somebody’s investment personality. For example, if your anchor is set in the financial crisis that can make you more risk averse, or like myself I’ve been anchored on oil prices going up. I’ve been asking myself if I should be investing more in oil-related investments because I’m anchored on those thoughts. Even when a person knows he or she is anchoring it is difficult to pull up the anchor. In addition, the anchoring process can apply across different time periods that happened yesterday to something that happened years ago. This will impact your financial behavior, judgments, and decisions.

Another good example comes from the children of the Great Depression. This whole generation was more likely to horde cash and didn’t want to pay for things on credit. More recently, what the long-term effects of the financial crisis will do to this generation’s spending and investment habits, only time will tell the degree of anchoring that will occur.

We talked a little about control when we talked about annuities. What makes us feel in control, and why do we sometimes feel like we’re in control when we really aren’t?

I always think about an experiment in psychology where you show people playing cards. Say you have 52 cards in a deck and you figure that entire deck is worth 100 dollars. Then you offer somebody a card in the context of it being part of a portfolio. So each card is worth an equivalent amount, so each card should be worth about 2 dollars. But if, in the experiment, you give them the chance to actually touch the card and feel control of it, in many experiments they end up bidding more for the card up to 8 dollars.

This is all because of the perception of control. It’s the same thing with basketball. It’s called the “hot hand fallacy.” If somebody has made four baskets in a row they think they’re more likely to make the fifth basket. In the same way, somebody might feel like they are in control of a stock if its price has been going up for some time especially if they made profits (gains) on their most recent investments.

So just touching something gives people the sense that they have more control?

Yes, and if a baseball player gets 5 hits in a row think they are in a hot streak. The same goes for horse races. If you pick three winning horses in a row you’ll start to think that you’re more likely to pick a winner in the fourth race.

It’s interesting how the mind works that way.

Now you’ve written that it wasn’t until the late 1990s that social scientists started to explore how our mood, or affect, altered our decisions in the face of risk. Why do you think it took so long?

In the context of risk, most experts were approaching it from a cognitive perspective. The original literature in psychology focused on the cognitive decision making process (e.g., heuristics). It wasn’t until the last ten years or so that they started considering emotion more in the literature, from what I have observed in my extensive academic reviews. More recently researchers like Paul Slovic and his colleagues have explored something called the “affect heuristic.”

My viewpoint is that we are using our emotional and our cognitive mind when we make financial decisions. The two systems are intertwined and can work together. For example you might do all the research before buying a car. You want to buy a car at a practical price and spend weeks researching the market, but then at the last minute you see a sports car that gives you an emotional response. Therefore, you purchase the sports car over the practical (reliable) auto in which, the emotional impulse overtook the cognitive decision-making process.

Of course the cognitive and emotional mind can also work together. For example, you might want to buy a car that has the lowest price, but only if it comes in the right color. My mother wants to buy a car for the lowest price with the requirement that it has “heated seats.” The affective mind overtakes the cognitive mind, or sometimes you utilize both to maximize benefits in your own decision-making process.

Is there anything else you wanted to say about how our mood effects our decisions?

I would say be aware of the influence of negative emotions. A recent study explored the relationship between depression and investments. A small portion of the population suffers from seasonal depression. This study found that when people become depressed during the winter months, it means they will become more risk averse, and they’ll be less likely to invest in stocks for example. So this is an exciting new avenue of research where the aggregate market data is being compared with psychological survey data, that ask real people how they feel and how it would affect their decisions. We’re now faced with the possibility that cycles in the market could have something to do with cycles of emotional depression.

This really upsets the traditional (standard) traditional proponents. Some of them are starting to come around and say that a few of these concepts make sense to them. But when you start talking about how a depression disorder could be linked with market behavior this creates a high degree of discomfort among most traditional (standard) finance academics.

So to sum up what we’ve covered so far, traditional finance studies how markets would behave if we were all rational self-interested profit maximizers. Behavioral finance studies how humans really behave in the face of risk. Of course, some people are more rational than others. Does exposure to traditional finance theory cause people to make more rational decisions?

I’m not sure if I have an answer to that. If I had never heard of behavioral finance, I would still perceive myself as being rational. Over time I still think I would be making many of the behavioral mistakes I’m now aware of.

I used to be a big believer in only using the “buy and hold investment strategy.” Today I’m nowhere near that strategy. I still believe in investing for the long term, but I believe people should identify what their risk category is, sit down with a financial planner, and discuss what they perceive their risk category is. My viewpoint now is they should be adjusting their portfolio on a quarterly or yearly basis. I believe this keeps individuals from over-exposure on the upside and the downside.

The problem is that people suffer from inattention (inertia) bias. A study of a million retirement accounts has shown that about 80 percent of people over a two-year period made no trades or very few trades to reallocate their portfolio. Most of general public have gotten the message that they should invest for the long term and diversify portfolios, but they haven’t addressed what their risk tolerance is and they don’t adjust their portfolios to the changes in the performance of different asset classes over time.

For example, if you didn’t adjust your portfolio to the changes in the stock market during the middle 90s, and followed the herd into technology stocks you would have been over exposed to the bear market in the early 2000s, and you would have lost half your money over this ten-year period. My current investment philosophy is to apply a modified “buy and hold” strategy in which, each year, the investor makes “tactical” adjustments to their portfolio based on their risk tolerance category (conservative, average or aggressive) and this is also known as “strategic asset allocation.”

That’s a good point. I’ve wondered, though, if the supposed Homo-economicus were a real investor, would he outperform the market because of his rational thinking process, or would he do poorly because he assumed everybody else was a cold, calculating, self-interested person?

The real issue is that I don’t believe most people behave the way a “rational person” does in the traditional finance academic literature. People aren’t necessarily irrational, but people are normal. A colleague of mine has also pointed out that a person can be rational but may simply have different preferences. Many attempts have been made to try to get people to act the way a rational person should be acting, but most of the time they do not. As a good example they would invest for the long term and diversify, but over time ignore their appropriate risk tolerance category and suffer from inattention bias, because they do not adjust asset allocation strategy on a yearly basis.

My perspective as an academic is that when I talk to entrepreneurs and real investment professionals, they tell me they use gut feelings and emotions. That works for certain people but I try to help people become better decision makers using the behavioral finance theory. At the end of the day, if you can start saving money at age 22, invest several thousand dollars on an annual basis (approximately $4,000 per year) into a retirement account, achieve an 8 to 10 percentage yearly return in your investment portfolio, and retire at age 62 you will become a millionaire. This is the easiest way to become wealthy.

So now it’s time for the elephant in the room, the financial crash of 2008. From the behavioral finance perspective, what caused it?

Many of the standard finance models are based on an aggregate or macro level, and they work a lot of the time during a normal business or investment cycle. The problem is that the traditional risk management models don’t take into account when we don’t live in a normal world. About 90 to 95 percent of the time the behavior of the market falls in the one or two standard deviation world. But these models, even the housing models that derivatives were based on, were created for a world where housing prices never go down. This is my primary issue with the standard model. Many of the “rational” models are actually irrational because they aren’t based on rational assumptions. The idea that housing prices never go down is not rational.

On a micro level, what I think is fascinating is that psychology is moving very slowly toward integrating financial decision making into their field. There is a new sub field based in psychology that offers financial counseling and addresses “money personalities.” There are emerging organizations that focus on financial psychology such as the Financial Therapy Association and Association for Financial Counseling and Planning Education. This increased attention in psychology occurred because people who were being treated by a therapist for psychological issues were often talking about problems attributed to the financial crisis of 2008. Psychologists started to realize that they didn’t know how to treat these clients.

The book Mind over Moneyby Brad & Ted Klontz, is a wonderful book about how clients were suffering from financial psychological trauma. The authors discuss issues such as “financial incest” and hoarding that I found interesting. As a finance professor, I thought some of the material was a little too “touchy-feely” for me, but I think it’s an interesting avenue for research. In addition, in my course “The Psychology of Money” my students shared their personal family experiences about money (both negative and positive) with me because of the personal nature of this book. I encourage students from non-business fields to spend some time in finance and economics because money affects all of us. There are also wonderful employment and career opportunities now that I wouldn’t have even thought of when I was an accounting major at the undergraduate level in the late 1980s.

It’ll be interesting to see where that goes.

Would it be an exaggeration to say that behavioral finance is capable of predicting and preventing these kinds of economic disasters?

I don’t think we could predict an actual event coming, but behavioral finance documents that these behaviors repeat themselves. The housing bubble burst and these bubbles reoccur. They have happened throughout history and will happen again. They can’t necessarily be predicted but they will occur because of failures in the standard model. Behavioral finance reveals that it is a psychological behavior that drives these bubbles.

Another issue that interests me is how we use public policy to address these issues. The book Nudge: Improving Decisions About Health, Wealth, and Happiness, for example, explored how people’s behavior can be influenced by public policy. As an example if you offer people a retirement plan at work, when you give them an option to invest about half of them don’t. The nudging concept would be instead of giving them the option to opt in; you give them the option to opt out.

The only thing that bothers me about that is it doesn’t necessarily make financial sense for people to save for retirement if for example they have high levels of outstanding credit card debt or are nearly bankrupt. Is it good public policy to put somebody into a retirement plan if they haven’t looked at their overall financial situation?

On the other hand, in my opinion, the state laws (to nudge) drivers to buckle up and use their safety belts has saved thousands of lives over the years.

This is a concern. To what degree should public policy be to nudge people in certain directions? It has its benefits and drawbacks.

Do you think that behavioral finance could be used to improve our overall quality of life as a society, or is it better used as a tool for improving individual investment decisions?

I definitely agree that it is good for increasing financial literacy. I’m also a proponent of new avenues for psychology majors, and I argue that maybe they should take a few finance courses for a career in financial psychology. Also, finance majors should enroll in additional psychology courses. On a monthly basis, I have phone conversations and email inquires with financial planners that desire undergraduates with financial knowledge, psychology-based training, and a personal desire to work with clients (e.g., customer service skills).

In terms of public policy adjustments, some ideas have merit, but we should be cautious in how we utilize it. People shouldn’t overreach because this is still experimental and because there are ethical concerns. The “nudging policy” wouldn’t be such an issue in my mind if, say, the default approach required employees in terms of the retirement plan enrollment to meet with a financial planner or counselor. The important thing is that you need to take a look at that person’s financial situation before opting them into something that might not be helpful. I believe that these issues should be taken more on a case-by-case basis whenever possible.

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