The Psychology of Risk: The Behavioral Finance Perspective by SSRN

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Victor Ricciardi

Goucher College - Department of Business Management

HANDBOOK OF FINANCE: VOLUME 2: INVESTMENT MANAGEMENT AND FINANCIAL MANAGEMENT, Frank J. Fabozzi, ed., John Wiley & Sons, pp. 85-111, 2008

Abstract:

Since the mid-1970s, hundreds of academic studies have been conducted in risk perception-oriented research within the social sciences (e.g., nonfinancial areas) across various branches of learning. The academic foundation pertaining to the "psychological aspects" of risk perception studies in behavioral finance, accounting, and economics developed from the earlier works on risky behaviors and hazardous activities. This research on risky and hazardous situations was based on studies performed at Decision Research (an organization founded in 1976 by Paul Slovic) on risk perception documenting specific behavioral risk characteristics from psychology that can be applied within a financial and investment decision-making context. A notable theme within the risk perception literature is how an investor processes information and the various behavioral finance theories and issues that might influence a person's perception of risk within the judgment process. The different behavioral finance theories and concepts that influence an individual's perception of risk for different types of financial services and investment products are heuristics, overconfidence, prospect theory, loss aversion, representativeness, framing, anchoring, familiarity bias, perceived control, expert knowledge, affect (feelings), and worry.

The Psychology Of Risk: The Behavioral Finance Perspective - Introduction

An emerging subject matter within the behavioral finance literature is the notion of perceived risk pertaining to novice and expert investors. The author provides an overview of the specific concepts of perceived risk and perception for the financial scholar since these two issues are essential for developing a greater understanding and appreciation for the psychology of risk. The next section discusses the notion of classical decision making as the cornerstone of standard finance which is based on the idea of rationality in which investors devise judgments (e.g., the efficient market hypothesis). In contrast, the alternative viewpoint offers behavioral decision theory as the foundation for behavioral finance in which individuals formulate decisions according to the assumptions of bounded rationality (e.g., prospect theory). The reader is presented with a discussion on themajor behavioral finance themes (that is, cognitive and emotional factors) that might influence an investor’s perception of risk for different types of financial products and investment services. Amajor purpose of this chapter was to bring together the main themes within the risk perception literature that should provide other researchers a strong foundation for conducting research in this behavioral finance topic area.

Perceived risk (risk perception) is the subjective decision making process that individuals employ concerning the assessment of risk and the degree of uncertainty. The term is most frequently utilized in regards to risky personal activities and potential dangers such as environmental issues, health concerns or new technologies. The study of perceived risk developed from the discovery that novices and experts repeatedly failed to agree on the meaning of risk and the degree of riskiness for different types of technologies and hazards. Perception is the process by which an individual is in search of preeminent larification of sensory information so that he or she can make a final judgment based on their level of expertise and past experience.

In the 1970s and 1980s, researchers at Decision Research, especially Paul Slovic, Baruch Fischhoff, and Sarah Lichtenstein, developed a survey-oriented research approach for investigating perceived risk that is still prominent today. In particular, the risk perception literature from psychology possesses a strong academic and theoretical foundation for conducting future research endeavors for behavioral finance experts. Within the social sciences, the risk perception literature has demonstrated that a considerable number of cognitive and emotional factors influence a person’s risk perception for non-financial decisions. The behavioral finance literature reveals many of these cognitive (mental) and affective (emotional) characteristics can be applied to the judgment process in relating to how an investor perceives risk for various types of financial services and investment instruments such as heuristics, overconfidence, prospect theory, loss aversion, representativeness, framing, anchoring, familiarity bias, perceived control, expert knowledge, affect (feelings), and worry.

The Psychology Of Risk: The Behavioral Finance Perspective

Behavioral Finance

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