Angelica Montagano

October 1, 2020

Investor Behavior

Episode 118: Victor Ricciardi: The Psychology of Investing — Bounded Rationality

Angelica Montagano

October 1, 2020

Investor Behavior

Victor Ricciardi is currently a Visiting Assistant Professor of Finance at Washington and Lee University. Professor Ricciardi is a leading expert on the academic literature and emerging research issues in behavioral finance. He is the editor of several eJournals distributed by the Social Science Research Network (SSRN) at www.ssrn.com, including behavioral finance, financial history, behavioral economics, and behavioral accounting.

What are the psychological conditions that allow investors to make rational decisions, and how do these processes of decision-making occur? These are the questions that our guest, Victor Ricciardi, is dedicated to answering and what he is here on the show today to talk about! Victor is the Visiting Assistant Professor of Finance at Washington and Lee University as well as the Coordinator of Behavioral and Experimental Research at the Social Science Research Network. He has an MBA in finance and an advanced professional certificate in economics from St. John's University and holds graduate certificates in personal financial planning and financial therapy from Kansas State University. Victor is the co-author of Investor Behavior: The Psychology of Financial Planning and Investing, in which he and H. Kent Baker explore and unpack the exact topics we look at in this episode. In our conversation, we talk about the steps that investors can take in order to make better decisions, and for Victor, this means maintaining a balanced portfolio and recording the circumstances and conditions in which decisions are made. Victor's starting point for better investing is self-knowledge and understanding one's own psychology and risk tolerance. He also underlines becoming familiar with the environments that allow you to make the best decisions and refining this wisdom over time. We also dig into the topics of the subconscious, checking biases, and financial therapy, so make sure to join us to hear it all.

Key Points From This Episode:

The history of academic studies on investor behaviour. [0:02:11.2]
Victor's thoughts on the rational decisions investors should aim for. [0:04:50.5]
The idea of 'bounded rationality'; sufficing and the factors that influence decisions. [0:06:38.9]
Benefits and dangers of group investments — more or less rationality. [0:09:43.2]
Weighing the usefulness of heuristics in the investment process. [0:11:54.1]
The role of the subconscious in human decision-making. [0:13:33.8]
Victor's thoughts on sustained commitment to active investing, despite the evidence. [0:15:45.6]
The framing of information and the impact this has on investor behaviour. [0:19:09.5]
A five-factor model for personality; extroversion, agreeableness, conscientiousness, neuroticism, and openness to intellect. [0:22:33.4]
Unpacking the emerging profession of financial therapy and Victor's thoughts on its benefits. [0:28:36.3]
The relationship between money and happiness; the importance of options. [0:31:42.7]
Methods for checking our biases; education, simplicity, rebalancing, and more! [0:33:44.3]
Prioritizing trust and ways to ensure that received advice is dependable. [0:35:38.2]
The effect of access to free information and weighing the helpfulness of the internet. [0:37:47.2]
The application of behavioural bias models to the real estate market. [0:39:38.6]
Victor's personal definition of success: Impacting students. [0:41:49.4]

Read the Transcript:

How far back to the first documented studies of investor behavior go?

I'm not sure about it, I mean in terms of what you want to classify as investor behavior, but I remember Selden has a book called The Psychology of The Stock Markets, or Stock Market Psychology. That goes back to early 1900s, so there are all types of at least I would say more qualitative, I wouldn't call them studies, but there's a lot of readings that really talk about behavior in the markets. If you're talking about more of an academic, I mean academic or a standard finance with a racial school, didn't even really start until the 1960s. Schools of business or departments of finance in academia really didn't start until the 1970s, so if you're just talking about quality, academic research in finance you're only talking about really 50 years, 60 years of knowledge.

When I was discussing the standard school I'm talking about, things like efficient markets, rational decision making, worn, modern portfolio theory, but many of the earlier work, as I said, it's just very qualitative nature, storytelling, people looking at crashes, looking at some data but really not formalizing until psychology ... Because a lot of what comes from behavioral finance comes from psychological experiments done in the 1970s and 1980s especially by Paul Slovic, Amos Slaversky, and Danny Tonneman.

Standard finance or academic finance really suffers from a status quo bias, meaning they have an inertia of this irrational school, and I am actually a big fan in some ways of rational thinking, rational investment strategies, I just don't agree with necessarily the underlying assumptions.

Do you think that investors should aim to make rational decisions?

Yes, and what I think behavioral finance does is actually understanding what your biases are. Are you over confident? Do you trade too much? Are you a worrier? Do you feel stress? What are your trigger points when you invest money, when you spend money. If you're actually sitting down with a financial advisor or a planner, hopefully they help you develop a non-emotional strategy, things that you're comfortable with and when the market has a massive correction if you're in the proper resper file, if you also have a idea, even within the financial planning context of saying, "I'm 80% towards my goal, the market came back a little bit. Let me keep on that path to reaching my financial goal and my financial plan."

As Mayor Statton says, to give him credit, "If people are normal." We have emotions, we sometimes make bad decision, but not necessarily the worst decisions and this is essentially what's known as bounded rationality. Our past experiences, our emotions, our values, or religious belief, our gender, our family history, and so on, influence decisions we make every day and so even though we're not jumping off of bridges when we make bad decisions we essentially, we're sufficing. If we have a choice of five options, maybe we choose the second one. It wasn't the best one, but maybe we're satisfied with it over time.

Can you go back and maybe just give a little bit more of an explanation of that term, bounded rationality that you used?

Yeah, so it's essentially, it's related to the notion of sufficing, which is as I was eluding to we don't always make the best decision. Well, we can also make satisfactory decisions that we're still happy about, because we are presented with so many different options even just doing an online search on the internet, think about all the different factors that we should be considering. Having a past history in some ways works, but no matter what it's still going to influence our overall decision making.

I mean again even if it's just with an investment portfolio. If the rationale thing would be to optimize a million dollar portfolio, but I wind up having a retirement, $800,000, I still am doing pretty well, so I'm satisfied with the 800,000 and if you drew it as a sample, like as other people who don't have. How much the American public don't have enough saved or around the world people don't have enough for retirement, you're doing better than probably 20% or 10% of the overall population of any particular country.

If we agree that people are irrational, does it follow or does it make sense that a hypothetically rational investor should be able to persistently beat the market by exploiting the irrational investors?

If they're able to consistently act rational. I mean, you may have a time period where you have this rational strategy. You think you're being rational, but you still may be influenced by other biases that you're not even aware of. Again, the human mind is very tricky. You could be described, I guess a way to think about it is you may think you know, so something like over-confidence is maybe measurable. You think you suffer from it and you got over it. Well, maybe there are other biases that you have that you never recognized and that are more subliminal in your mind and those play a factor. For example, the battles of watching financial news can impact your subliminal mind, so if you see a negative story that may put you in a negative mood, you may not recognize it, but maybe you then, maybe you don't make a decision about a stock, maybe you pay too much money for the stock, because the emotion that you're feeling from an outside source may actually effect your propensity to take risks and then it's also going to effect your final decision to buy a security. You ever seen the Seinfeld episode where you have the bubble boy. I guess you've got to live in a bubble sometimes and shut out all the noise.

Do you need other people to check your weaknesses, your biases before decisions are made?

It depends on that group. If the group is just a bunch of people who are informally getting together and they're going to have herd behavior, because they heard about internet stock in the late 1990s, well that's not a critical decision. If it's a formal, more of a formal say a board of trustees, an endowment committee for a university, and everybody has the same thought process. And myself or everybody has a leader that's dominant in the group, then that's going to be a group thing. I think if you're aware of some biases like group, they could potentially come about, whether it's an investment team or research team or a portfolio, I always try to play the role of devil's advocate and I try to play the contrarian. Gets me in trouble sometimes, but actually putting that, some of my consulting work, I try to tell people that you should even maybe develop a little bit of a questionnaire in that format and make sure that people are not suffering from group think, but as well have one or two people on your team who is going to play, "Why are we investing in this mutual fund? Everybody agrees. Well, why not just have one or two people say, "What are the disadvantages of investing in this particular fund or funds category right now?"

Do you think that heuristics (mental models) are net, on average helpful or harmful to investors?

I think many times they're harmful, but they can be helpful to a degree, so heuristics are essentially rules of thumb and they're also a cognitive process, so again I'll give you a couple examples. The behavioral bias known as representativeness is when people draw conclusions about small sample of information. If you invest in an IPO and that first IPO you make a lot of money you then draw a conclusion that all IPOs are good investments going forward versus negative experience like somebody being sold an annuity product and getting a very low return and having high fees they realize later, then they will cancel out and then say, "I never want to invest in an annuity again." Another example is what's known as anchoring and this is detrimental, because people anchor, say on the financial crisis say they anchor on the ... When the pandemic started this year and they lost a lot of money and they pulled out of the market and they never get back in because they're kind of, as I described before they're paralyzed or suffering from stat inertia and they can't change their behavior because of that anchor. What's even worse is even when they're able to lift the anchor, correct their behavior, the anchor has a more likelihood of reappearing.

You eluded to this earlier, but can you elaborate on the role that our subconscious mind plays in making financial decisions?

Yeah, so what I was eluding to was talking about a negative experience. Well, there are psychological experiments that compare a control group that didn't see a story and then another laboratory experiment that shows a negative story and then those people they're not even aware of it and then they are then asked to buy or purchase something and in some cases the people who saw the negative story about the other group that didn't wind up paying two to four times more for say a mug or a cup, so if that's the stock that's the problem, if that's a car, if that's going grocery shopping, so there's a line of thinking related to that is that you know depending on your mood influences your risk taking. So, if subconsciously you become in a negative mood, you may take more risk not realize that above your typical risk fear file and then make riskier decisions that you wouldn't necessarily have made, is another way to frame it around that.

Why do you think that sophisticated and unsophisticated investors continue to invest in high fee, actively managed funds despite all of the evidence showing that they're probably not the best investments?

Well, again, we are attracted by a shiny, red apple. It's like, why did everybody invest in growth stocks? We like the things that feel good. Also, I mean, I think 401k plans where isn't always a flash of rationality. If you want to sometimes kind of a diversified portfolio, say on a 401k plan, even talking about the Morningstar box, sometimes and it may not mean that you want to go completely highly active, but if you want to have a diversified portfolio and I'm not comfortable just putting all of my money in S&P500, so say if I want to go with six Morningstar categories, large cap, mid cap, and small cap and then value and growth, and then a couple of international funds, if you're talking about money in a 401k plan, which typically are very highly regulated and that's really only your choice on your menu, I'm going with the selects, some actually managed funds as a trade-off to maybe wanting some exposure on the value side. That could be my decision of that. Is it rational? Yes. Is that a way of thinking about sufficing about in rationality? I'm making a trade-off on diversification.

The rational part is to be diversified. The sufficing portion is to try to balance between the active, the passive, and the different asset classes and value and growth. That's another way to think about it.

Is there a difference in terms of why investors invest in active funds versus why advisors recommend active funds? Is there a difference between those reasonings?

It also depends on if there's a conflict of interest. How is that advisor compensated? I think also, what it is, the track record of success with the advisor. The bias could be, they could be suffering from representativeness. They have a certain group of active funds that they made a lot of money for their clients, so they're going to draw a conclusion from that example that could be representativeness. Also, there could be integrative over-confidence and they also, advisors could also use heuristics when they're recommending, recommendations. Again, talking about back to risk tolerance. I know it's a little bit off the question, but if you're taking people who are gender bias, so typically men are thought to be more aggressive risk takers than women. Well, for example, if you're a male advisor and you want to automatically put a woman into the less risky category, that's how they may use heuristics. Advisors have to be very careful of these same issues that I'm discussing.

How important is the way that information is framed to the decision making process?

It is extremely important, especially for meeting your financial goals. Positive frames are extremely important, but also typically I think about the annuity puzzle in which people typically don't like annuities, so if you try to sell somebody an annuity and you tell them this investment's going to pay you $2,000 a month in retirement, in income, a 25 year old is going to look at you like you're crazy, so maybe a low percentage of people will take the investment, but if you actually build a relationship and find that at age 65 the person wants to travel around the world, take vacations, play golf, and you frame the discussion around the income's going to be used for your spending activity, they are more likely to accept the investment. And actually doing that's a nice way of reaching your financial goal, but also to step back further we tend to be primed so that a section of our brain, about sex, drugs, and rock n' roll also effects money. We also are inclined, because of the chemicals in our brain, to be spenders. We have impulses to spend money and that's at a trade-off of not reaching our financial goals.

Actually, delaying the consumption in today's dollars and putting the money for retirement, the consumption piece then relates in the future to the spending activity of income and then you have money to spend in the future and you'll have more money from investing as well. You have a higher standard of living because you're saving more money towards the future, but you're spending less money today, but then you could spend more money in the future.

Do you think there's a place where mental accounting can be useful in financial planning?

Yes. Mental accounting and this is coming on the application side, does have that because you can think about mental accounting as creating buckets, so credit card debt is bad. Also, framing it as a mental account, so you want to pay that off. Long-term assets and retirement is for money until at least after age 59 and a half, in an IRA or 401k plan and you don't want to touch that or dip into that, because then also you're going to have the tax consequences for that. For even myself I use it. So 95% of my wealth is in my 401k or my 403b plan, so maybe I actively make adjustments to mutual funds a little bit. Well, like re-balancing, but then I have my IRA account in which I have my play money. If I can't go to the track in the pandemic I, one to 3% of my overall wealth just to get over my gambling urges that I trade a couple stocks here and there, but it will not effect my wealth. That's how to control that gambling instinct in me.

How important is it for investors to understand their own five factor model? Their own factor exposure for their personality? How important is it to understand that in order to be a good investor?

Well, and also it's very important because it also relates to risk decision making. In terms of research, I would say the two most dominant research results are people who are extroverts and people who are neurotic. And so if you tend to be outgoing you may be a little bit more a risk taker, but you balance that off with hopefully you're a little bit rational and you're not taking excessive decisions. I think the problem is when you're very outgoing, extrovert, and you're highly a neurotic, because then you're combining an emotional state, higher emotional state with possibly negative feelings. In the worst case scenario in my second book, there's actually a discussion of financial psychopaths, so about one in 200 people in the population in general have some psychotic or episodes or have some trace in that and I bet Wall Street tends to attract a greater percentage of them, because of the what they like, money and fame and managing money, control, it builds up your ego. That's really on the extreme though. If they try to manage or if you're coming from the idea that you're a financial advisor, being able to deal with different types of personalities, if someone's just outgoing, an extrovert, you may be able to have that conversation, they'll listen to some of your financial advice.

Somebody who is highly neurotic is probably very over-confident and also controlling, and also less trusting. Those people are typically on the extreme are not going to be willing to listen to your financial advice. I think there's also a decision about how much energy are those people? Sometimes you can't save everybody and so you really have to think about how you want to deal with those clients. On the other side, people who are very open and agreeable to new ideas, they accept every idea, you don't want people investing in things they don't understand. Assess the risk. That's kind of where the personality is good in terms of risk taking, people who are willing to invest in certain products, people who are manageable, having a balance of conversations and really getting to know your client and yourself as an investor really does matter on your personality.

Do you think it would be wise for individual investors to do some sort of personality test so they can moderate their biases better?

Yeah, but I would also take it with a grain of salt. It should be also understanding what risk type, type of risk taker you are, and again, if you really get into something like financial therapy or financial coaching it's also maybe keeping a journal. I know that sometimes sound corny, but it doesn't even have to be a journal, but keeping, reflecting on the track record of investments decisions that you've made even for the stock market, and keeping a log, when you make good decisions, how you are feeling, what was your state of mind? Was the room quiet? What environment are you able to make the best decisions as an individual, I think is important to think about too.

And should individuals also look for these traits in their sources of advice? Be it in the media or with their advisor?

I think it's an alternate process, but it shouldn't be the sole trait that you're looking at. I think the gut feeling is that it's so outgoing that their behavior is over the top. I think it's also just who we feel comfortable as well. If you're not comfortable with the financial advice that the advisor's giving you and they keep on pushing it down your throat like you're buying a car, and it feels like an impactful or intimidating sales pitch, whether it's their personality or not, that's when you have the power to get up and leave. The other problem is there's a social component. People sometimes feel obligated to take financial advice just because the advisor sat down with them. Buy a car because they gave their time, especially if you look at the difference between negotiating styles between men and women, I always encourage my female students to realize that they should ask for more. There's nothing wrong with negotiating hard.

There has to be also, there's a gender issue there as well, I try to put myself in sales situations where there's not a high impact thing. If I'm buying a car I try to at least get a quote online before going in, talking to the sales person, because I don't feel comfortable with that type of stuff as well.

Can you describe what financial therapy and how do you think it can benefit investors?

Well, and so I think it's two buckets. The first would be if you're a financial advisor and you're dealing with somebody who suffered from over-confidence and that could be just asking them a question about stock returns and if they always explicitly say they're going to be above average that could be the lead off to the suffering from over-confident behavior and they you're noticing their account that they are trading too much. That's probably an issue of over-confident behavior. If through a conversation of coaching, which would be maybe talking about financial literacy, educating the client and then talking about a financial plan, if they stick with that and they stop trading a lot, it seems like their behavior has subsided, then that's a coaching component. The third [inaudible 00:29:38] component would be somebody who you're doing that same thing with as an advisor, but they constantly don't listen to you or they can't help themselves.

Somebody trading too much might have a history of a family, traumatic experience or think about somebody, and this comes out of the research dealing with hoarders, but also somebody who's a compulsive gambler who is trading in the market too much is probably outside the realm of that financial advisor, so there's a field now that [inaudible 00:30:16] a financial crisis that people who are experts at money behavior who are classically trained as financial therapists. They've actually just rolled out some credentials on it and so it's very interesting in that you could actually become a financial therapist, but I only know of a couple firms that actually will refer a financial therapist, so it is a very unique stages of a beginning field, but it's also a great career opportunity rather than a student just getting an undergraduate degree in psychology if they take some financial planning classes and then they have a degree in psychology they could then become a money therapist.

Rather than charge somebody $200 an hour you can charge someone $1,000 an hour. It's really who you are and who you're clienteled with. That's what financial therapy is. It's really dealing with a much deeper psychological framing and it deals with flash points. In life, early in our relationship those money flash points help us to develop into our childhood money beliefs. Most extreme, those money beliefs become money disorders like hoarding, as I said, compulsive gambling, and there's a list of about six, seven of them that really effect peoples behavior, but that's on the extreme.

There was a section in your book that talked about the relationship between money and happiness. There was a really interesting discussion on whether money results in happiness or happiness results in money. Can you talk a little bit about that?

The point is not to make a certain amount of money, but building wealth gives you options and if you have options that leads to happiness. Making money for the sake of money to me doesn't bring happiness, but even those just anecdotal around $75,000 makes people happy or they have degree of level of satisfaction and happiness. I don't know what the current IRS data is but I think there's always something about 20% of married couples make above $100,000 each. Single people who are, who make about six figures are only about five, 6% of the population. There's this big conglomerate of people making between 30 to what, 75,000 or $80,000 which is most people in most American families. If you live below your means you learn to save money, understand the time value of money, understand what you want out of life, have those discussions of what's important to you, then that leads to happiness.

For me personally, I love being a professor, so I sacrifice other things in my life, because I still had career off as an accountant and I enjoyed the experience for a few years, but going every day and working 60, 70 hours a week doing accounting was not my thing. If I work a lot of hours now during the semester I'm doing it, but I enjoy it. I think the money's an important thing, but one of the things that you enjoy, your family, your career, and money is part of the equation.

Other than them working with a professional what can do-it-yourself investors do to check their own biases?

I would say don't look at your portfolio too much. I mean, it's balancing out between how often you want to check it. Again, you want to educate yourself. I'm not saying not to read about things, but how much of financial news, how much internet action about financial news can you take in a week. Again, even in that regard if you keep a little bit of a journal all you have if you're taking five hours of financial news during the day is that effecting your mood? Versus if it's just an hour or two? It's kind of finding your routine. Additionally, I think stupid and simple is sometimes a better way to do things. Actually, not over-thinking things. I started investing in the market when I was 12 years old. In some ways if I would have just kept the stocks I had and didn't sell stuff, didn't trade stuff and my, during the internet bubble, I would have more money from that than what I'm saving now as a professor. I think sometimes just sticking with the basics, constantly educating yourself, staying away from the new thing of the moments. Highly diversified portfolio, rebalancing.

And I think even just reading some behavioral research, reading some books. Doesn't have to be mine. There are many wonderful books on behavioral finance now. It's just constantly educating yourself to realize how comfortable you are with investing money and not making bad decisions as well, understand. And learning from your past mistakes is very important.

What can a non-expert do to check if they're getting good advice, even if they trust the person that the advice is coming from?

Well, and there tends to be a balance. Part of the equation is trust and control. If you're too trusting in your advisor and you have a lack of control or don't take really any responsibility for your investments, that's when you're going to have Ponzi schemes, you're going to make bad decisions. On the other hand, if you're excessively controlling, neurotic, over-confident about your decisions, and you're too controlling and have a lack of trust in that financial advice and that financial advisor you're not going to have any meaningful relationship with that person. That's really from the advisor and the client. It's really finding that middle ground. And another thing is if people don't typically do this, but there are advisors that specialize, for example, just checking the advice that somebody else gives you. And so if somebody is sitting down with a financial advisor, they're giving you a financial plan, but you don't want to transfer your money, there are personal financial planners. I don't know about Canada, but in the U.S. you can pay them on an hourly basis and you don't have to invest any money with them, but every once in a while, maybe every couple of years have them review the portfolio.

They're an outside source. Make sure they don't know that other person or have any affiliations with them and then you're making sure the advice that you're receiving is adequate. Same way you would go to a doctor and get a second opinion, you're essentially getting a second opinion on your portfolio, and especially as you start to accumulate a good deal of wealth. I think that's very important.

Going back to the biases and I'm thinking about all the information that's basically everywhere on the internet, the free financial advice that we all have access to. Do you think all that access has been helpful or harmful to investors?

And this is where I think you have to be careful, because some free advice is probably fine or free work, but what people don't distinguish from, even like the two books I've done, investor behavior and financial behavior, my colleagues and I in terms of people that wrote them, the people that, the editing that we spent. We're talking about thousands of hours. It's not a rational decision. It's a labor of love. It's creating a quality document. Information that is simply available on, certain like Wikipedia is not necessarily vetted. Other information that's coming from a brokerage house may be free or investment advice may be free, but they may be doing it to get your business. I think it's really thinking about back to the issue of trust. Is that information, whether it's free or not coming from a trusted source? Are there conflicts of interest? I think that's a bigger part of the question, but also the problem is there is so much information and that's when you go back to using heuristics because you're suffering from all the information, the overload. I think it's really, think about creating a top five list of the places that you think are the most helpful and use those as your main source of finding information.

Does the behavioral finance literature suggest that there's a relationship between the behavioral biases we've been talking in application to stock markets, does that also apply to real estate markets?

Yes, so just giving you a couple of examples, especially that I mentioned that anchoring bias. Somebody who paid $200,000 for something previously and then they hear the value, current value of it a year ago was $450,000. However, they go to sell that asset and now they're getting quoted only $400,000. Well, they feel like that $400,000 is a loss, because they sold it a year ago they could have gotten 450. That's an anchoring piece, so that prevents people from actually just selling the asset. Other issues are as you've seen with bubbles in real estate, same things repeat themselves. The heard mentality. I remember seeing those videos, especially during the financial crisis of 2008. Before that they had these videos in which people are jumping up and down, cheering because they're learning to sell and buy real estate at these seminars. Back to that group thing, salesmanship, bad sales practices lead to that and then even certain cultures.

I think the number eight in the Asian culture is a lucky number, so in certain instances people intentionally put the number eight in the price of the real estate, because the cause of people that, well like the address or the price to have an eight in it or the eight floor or something or maybe the 28th floor, that it causes them more likely to buy that real estate. And many of the biases that are related to stocks can also be applied to some of the real estate products as well.

Can you talk about how you define success in your life?

The grain of success in my life, at least on a professional level is when I see students who are learning and get jobs that you never thought they would get. They are successful. For me, educating my students and seeing that over their lifetime that they maybe a little bit of what I taught them makes a difference and impacts them into the future. Realizing if they never had me as a finance professor taking a personal finance class with me they may have never go into finance. To me that's the wonderful of success, knowing that their success is my success and knowing that they're finding happiness because of me actually brings me a great deal of happiness outside of my family, outside of my friends and other relationships that I have. For me that's happiness and being able to teach and talk about money. I discover this wonderful field called behavioral finance and if doing these type of appearances help even people in any way learn about finance in general and it increases financial literacy I've done my job.

When God says to me, "What did you do?" That's going to be my answer. "I taught people to buy low, sell high."