Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 2. Risk: Traditional Finance versus Behavioral Finance

VICTOR RICCIARDI

Assistant Professor of Finance, Kentucky State University, and Editor, Social Science Research Network Behavioral & Experimental Finance eJournal

Abstract: The notion of risk encompasses a wide range of meanings across different disciplines, notably the social sciences and business administration fields. Within academic finance, the focal point of traditional (or standard) finance researchers involves the objective nature of risk. This traditional finance viewpoint encompasses a quantitative measure of risk (e.g., beta, standard deviation) which is based on a macro-level assessment of risk incorporating all the participants in the financial markets. A fundamental assumption in traditional finance is the linear (positive) relationship between risk and return. In contrast, behavioral finance academics provide an extensive examination in which risk is based on a combination of both subjective and objective factors. The behavioral finance perspective incorporates a qualitative aspect of risk (e.g., the influence of cognitive issues and emotional factors) that is highly significant if on a micro level it is acknowledged that the decision maker is an essential aspect of defining and understanding risk. An emerging topic of interest and exploration by researchers in the behavioral finance camp has been the assessment of an inverse (negative) relationship between perceived risk and expected return (perceived gain). ...