Risk Management and Behavioral Finance

Abstract

Risk management is still dated in concept. It assumes a compliance approach. Current risk management approaches have failed in predicting both macroeconomic and micro-economic setbacks and disasters. This is because financial metrics, the basis for modern risk metrics, are actually a lagging indicator of risk, not a leading indicator. Risk management needs a new paradigm which is based on leading indicators and which can therefore predict such problems. Behavioral finance provides the framework for a new paradigm for risk management. The article sets out such a new paradigm. It is based on a distillation of cognitive biases used in behavioral economics and finance. It shows how these can be used to categorize risky financial behaviors according to differing levels of risk. These various levels of risk can be linked directly to financial and valuation outcomes. This provides us with a new way to measure and predict risk based on a behavioral approach. Since behavior is a leading indicator of risk this provides a new approach which takes into account behaviors which are normally not captured in risk approaches. This opens up a new discipline of behavioral risk management. This is needed to correct for the lack of behavioral data in current approaches.