101-2 Behavioral Finance Flashcards
Behavioral Finance
A field of study which relates behavioral and cognitive psychology to financial planning and economics in an a attempt to understand why people act irrationally during the financial decision making process
Cognitive errors
Due to faulty reasoning and could arise from a lack of understanding of proper statistical analysis techniques, information processing mistakes, faulty reasoning, or memory errors
Illusion of control bias
Exists when market participants think they can control or affect outcomes when they cannot
Conservatism bias
Occurs when market participants initially form a rational view but fail to change that view as new info becomes available
They overweight the initial probabilities and do not adjust for new information
Hindsight bias
A selective memory of past events, actions, or what was knowable in the past
Confirmation bias
Occurs when market participants look for new information or distort new information to support an existing view
Representativeness
Based on a belief that the past will persist and new information is classified based on past experience or classification
Mental accounting
Aka money jar mentality
Involves the tendency of individuals to put their money into separate accounts based on the function of these accounts
For example: savings, debt reduction, and a future vacation
Money set aside for a vacation while carrying a considerable amount of debt is poor money management
Self-attribution bias
An ego defense mechanism
Analysts take credit for their successes and either blame others or external factors for failures
Anchoring
Involves individuals making irrational decisions based on information that should have no influence on the decisions at hand
Adjustment
May include market participants who stay anchored to an initial estimate and do not adjust for new information
Outcome bias
The tendency for individuals to take a course of action based on the outcomes of prior events
Framing bias
Asserts that people are given a frame of reference, a set of beliefs or values that they use to interpret facts or conditions as they make decisions
Recency bias
Aka availability bias
Recent info is given more importance because it is most vividly remembered
Herding
When investors trade in the same direction or in the same securities, and possibly even trade contrary to the information they have available
Emotional biases
Not related to conscious thought and stem from feelings, impulses, or intuition
Prospect theory
Results in making choices that favor certain outcomes versus probable outcomes
Loss aversion theory
Involves clients valuing gains and losses differently and, as a result, making decisions based on perceived gains rather than perceived losses
Self-control bias
Occurs when individuals lack self-discipline and favor immediate gratification over long-term goals
Status quo bias
Occurs when comfort with an existing situation leads to an unwillingness to make changes
Endowment bias
Occurs when an asset is felt to be special and more valuable simply because it is already owned
Regret-aversion bias
Occurs when market participants do nothing out of excess fear that actions could be wrong
Affinity bias
Refers to the tendency to favor things that can be identified with emotionally because they are similar to us
Attitudes
Reflect a person’s opinions, values, and wants
Beliefs
A type of attitude because they reveal the understanding of some aspect of a person’s life
Values
Attitudes and beliefs for which a person feels strongly and considered values and represent what he believes to be right
Myers-Briggs assessment
Evaluates personalities based whether the individual is:
- introverted or extroverted
- driven by senses or intuition
- influenced by thinking or feeling
- apt to perceive or judge
Perception
An individual’s personal awareness of things, people, events, or ideas
Judgment
Involves making conclusions about what has been perceived
3 types of learning styles
Visual
Auditory
Kinesthetic
Financial counseling
A process that helps clients change poor financial behavior through education and guidance
Financial counseling approach A:
Economic and resource approach
Clients are assumed to be rational and will change to the most favorable behavior if given the appropriate counseling
The focus is on obtaining and analyzing quantitative data, such as cash flow, assets, and debt
Financial counseling approach B:
Classical economics approach
Clients choose among alternatives based on objectively defined cost-benefit and risk-return tradeoffs
The belief in this approach is that increasing financial resources or reducing financial expenditures results in improved financial outcomes.
Financial counseling approach C:
Strategic management approach
A client’s goals and values drive the client-planner relationship
SWOT analysis (identifying Strengths, Weaknesses, Opportunities, Threats)
Financial counseling approach D:
Cognitive-behavioral approach
Clients’ attitudes, beliefs, and values influence their behavior
Financial counseling approach E:
Psychoanalytic approach
Rarely used, based on psychoanalytic theory
Kinesthetic learning style
Understands concepts better using a hands-on approach
Writing down goals and objectives with bullet points as they are formulated engages clients with this learning style
Risk capacity
The degree to which a client’s financial resources can cushion risk
Risk perception
The client’s assessment of the magnitude of the risks being traded-off
Risk tolerance
The tradeoffs that clients are willing to make between potential risks and rewards
Risk capacity
The degree to which a client’s financial resources can cushion risks
