Risk: Traditional Finance Versus Behavioral Finance

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). Ultimately, financial and investment risk is a situational, multidimensional judgment process that is dependent on the specific characteristics of the investment product or financial service.

Keywords: risk, uncertainty, objective risk, subjective risk, risk perception, perceived risk, risk-taking behavior, standard finance, behavioral finance, behavioral economics, financial psychology, modern portfolio theory, standard deviation, variance, semivariance, beta, capital asset pricing model

JEL Classification: A12, D81, G00, G30, G10, M00, M10, M41