Risk Management: Foundations for a Changing Financial World

CHAPTER 44

BEHAVIORAL RISK: ANECDOTES AND DISTURBING EVIDENCE^ar

Arnold S. Wood

Investment managers are expected to act rationally and to incorporate all available information into the decision-making process. Many are often wrong, however, which raises important questions about the risks associated with human judgment. Behavioral flaws such as overconfidence, temptation, self-interest, fear, and greed lead to irrational behavior and impaired judgment. In the investment arena, these flaws are prevalent, dependable, systematic, and exploitable.

Investment managers are accustomed to dealing with financial risks that can be identified, measured, and to some extent, controlled. This presentation addresses another type of risk, one that arises out of the flaws in human perception and preferences.

The basic paradigms underlying utility theory and rational choice are suspect. Money managers are smart, aggressive, and well paid, but are they rational in the textbook sense? The evidence is that money manager performance, on average, is no better than the passive benchmarks they are assigned to beat. In fact, the copious tabs consultants keep on the performance of managers tell a dismal tale. Managers lag their benchmarks for the majority of years.

Forecasting is the lifeblood of security analysts’ careers. Forecasting accurately has all the financial lure (and the trappings) of the lottery. David Dreman and Michael Berry (1995) have compiled extensive evidence, however, that analysts’ ...