9.5 Behavioral Finance Intro

Question 1

The field of behavioral finance

Answer 1

seeks to understand the behavioral biases that arise when people make investment decisions and design strategies to mitigate them.

Question 2

There are two types of behavioral biases:

Answer 2

Cognitive errors: Due to faulty cognitive reasoning

–> can be corrected through better information and education

Emotional biases: Due to feelings or emotions

–> harder to detect and correct because they normally arise from intuitions on a subconscious level.

Question 3

Cognitive Errors

Answer 3

Belief perseverance biases

Processing errors

Question 4

Belief perseverance biases

Answer 4

Conservatism bias

Confirmation bias

Representativeness bias

Illusion of control bias

Hindsight bias

Question 5

Processing errors

Answer 5

Anchoring and adjustment bias

Mental accounting bias

Framing bias

Availability bias

Question 6

Emotional Biases

Answer 6

Loss-aversion bias

Overconfidence bias

Self-control bias

Status quo bias

Endowment bias

Regret-aversion bias

Question 7

Belief perseverance definition

Answer 7

An individual may cling to their initially held beliefs and refuse to accept new information.

The mental discomfort that arises when new information conflicts with the initial beliefs is known as cognitive dissonance.

Question 8

Processing errors definition

Answer 8

Information may not be processed rationally when making financial decisions.

Question 9

Conservatism bias

Answer 9

occurs when people fail to incorporate new information that conflicts with their prior opinions.

From the Bayesian perspective, these people tend to overweight their prior probability of an event and do not react adequately to the new information.

Question 10

Consequences of Conservatism Bias

Answer 10

Investment view and forecasts are not updated in time.

Complex data is not utilized appropriately to update prior beliefs.

Question 11

Confirmation bias

Answer 11

occurs when people seek “evidence” that confirms their prior beliefs and ignore those that contradict them

An investor who is subject to confirmation bias may insist on holding a certain investment and only use research that supports their decision.

For example, a portfolio manager who has a long position in a stock may seek reassurance by talking to research analysts who have assigned buy ratings on the stock.

Question 12

Consequences of Confirmation Bias

Answer 12

Negative information about an existing investment is ignored.

Screening criteria for potential investments may be invalid.

Portfolios are under-diversified as certain investments are inappropriately overweighted.

Investment in the employing company’s stock is overweighted. It is difficult for employees to acknowledge unfavorable information about their employers.

Question 13

Representativeness bias

Answer 13

occurs when people inappropriately classify new information based on past similar situations.

This will produce a misleading impression about the information especially when each event is inherently unique.

Base-rate neglect

Sample-size neglect

Question 14

Base-rate neglect

Answer 14

refers to the scenario where the base rate (i.e., the rate of incidence in the large population) is neglected when new information arises.

For example, rising jet fuel costs will reduce the profitability of the entire airline industry, especially for companies with limited power to pass on the higher costs to consumers.

An analyst who conducts diligent research on an individual airline stock may overlook this general information.

Question 15

Sample-size neglect

Answer 15

refers to the scenario where a small sample is incorrectly assumed to be representative of the population.

For example, a portfolio manager may achieve 20% annual returns for two consecutive years.

However, it would be dangerous to conclude that the manager is able to consistently generate good returns because the sample size is so small.

Question 16

Consequences of Representativeness Bias

Answer 16

Forecasts are made exclusively based on individual information or a small sample.

Complex data is oversimplified and beliefs are formed using incorrect classifications.

Question 17

Illusion of control bias

Answer 17

occurs when people overestimate their ability to control events and outcomes.

They tend to believe they can predict the outcomes when the results are in fact completely random.

For example, people think their own lottery numbers have the greatest chance of winning although each number has an equal chance of being drawn.

Question 18

Consequences of Illusion of Control Bias

Answer 18

Portfolios are under-diversified as investors hold concentrated positions in companies that they believe they have control over.

Portfolio turnover is unnecessarily high, incurring excessive taxes and transaction costs.

Financial models are overly complex and filled with minor details. Investors are more inclined to believe their model is comprehensive enough to handle every uncertainty.

Question 19

Hindsight bias

Answer 19

occurs when people look back at past events and believe they would have been predictable.

For instance, most investors today think there were many red flags in 2008 that indicated a financial crisis was approaching.

However, history shows that most of the investors, including investment professionals, did not realize the problems until it was too late. Recession always appears more obvious in hindsight.

Question 20

Consequences of Hindsight Bias

Answer 20

The degree of correct predictions is overestimated, resulting in overconfidence.

Manager’s performance may not be fairly assessed. Important information may not have been available when the investment decision was made.

Question 21

Anchoring and adjustment bias

Answer 21

occurs when people rely too much on the initial piece of information (i.e., the “anchor”) in estimating an unknown value. This is closely related to conservatism bias because people tend to adjust their anchors insufficiently when new information emerges.

For example, an analyst may predict a recession and adjust the current stock price of a company by -20%. In this case, the initial price is set as an anchor. A relative estimate that is purely based on this figure may not be comprehensive enough to capture the material changes in market conditions.

Question 22

Consequences of Anchoring and Adjustment Bias

Answer 22

Adjustments made based on new information may not be adequate.

People tend to stick closely to the original value.

Question 23

Mental accounting bias

Answer 23

occurs when people put money in separate mental buckets and treat them differently although money is fungible.

These arbitrary classifications are based on the source or use. For example, people tend to spend their lottery money a lot faster than their monthly salary.

They treat the lottery winnings as “free money” that can be spent on discretionary items, although the money from both sources should be fungible.

Question 24

Consequences of Mental Accounting Bias

Answer 24

Portfolios are constructed with discrete buckets of investments that are correlated, resulting in unnecessary risks.

Investors irrationally distinguish between returns from income and capital appreciation, risking principal in the process.

Investors take excessive risks with investment returns that are not part of the initial investment principal.

Question 25

Framing bias

Answer 25

occurs when people answer the same question differently just based on how the question is framed. This may lead to different decisions.

For example, consider the two statements below:

– 3 of my 4 stock selections result in a profit.
– 1 of my 4 stock selections results in a loss.

Statement 1 is more likely to give a positive outlook than Statement 2 although the statements are essentially the same.

Question 26

Narrow framing

Answer 26

occurs when people lose sight of the big picture and focus on specific points.

For instance, an investor may add a high-yield security into the portfolio and forget to consider the additional risks contributed to the overall portfolio as well as their own risk appetite.

Question 27

Consequences of Framing Bias

Answer 27

Investors become overly risk-averse or risk-seeking depending on how the questions about risk tolerances are framed.

Investors focus on short-term price fluctuations and ignore long-run performances.

Question 28

Availability bias

Answer 28

occurs when people use mental shortcuts when making decisions.

People assume outcomes that are easier to remember are more likely.

Question 29

There are four common availability biases:

Answer 29

Retrievability – An idea will more likely be chosen if it comes to mind more quickly.

Categorization – People may not be familiar with certain topics, so the search set will be smaller.

Narrow range of experience – People often extrapolate from narrow personal experience.

Resonance – People often assume most other people think like they do.

Question 30

Consequences of Availability Bias

Answer 30

Investment opportunity sets are limited.

Investors choose an investment or advisor based on advertising rather than thorough analysis.

Portfolios are likely under-diversified with inappropriate asset allocation.

Question 31

Loss-aversion bias

Answer 31

occurs when people strongly prefer avoiding losses more than achieving gains. This can sometimes cause them to accept more risks to avoid losses than to achieve gains.

This can be depicted in the utility function below. In this graph, the y-axis represents the utility value, which is the psychological satisfaction the investor experiences from an investment gain.

Question 32

disposition effect

Answer 32

the situation of holding investments in a loss position and selling investments in a gain position. Many investors do not want to experience the pain of locking in a loss, and they tend to sell their winners too quickly as they do not want to see their gains “evaporate.”

Question 33

Consequences of Loss Aversion

Answer 33

investors hold investments in a loss position longer than they should.

Investors sell investments in a gain position sooner than they should.

Question 34

Overconfidence bias

Answer 34

occurs when people overestimate their own abilities.

This bias normally arises with self-attribution bias where people consistently attribute success to their own skill and failure to external factors.

Question 35

Prediction overconfidence

Answer 35

results in narrow prediction ranges.

For example, an analyst may estimate the future stock price using a very narrow range of expected returns with a low standard deviation.

Question 36

Certainty overconfidence

Answer 36

results in excessively great probabilities being assigned to uncertain outcomes.

For example, an investor may believe strongly that an investment has no downside risks and refuse to hedge or diversify the risks.

Question 37

Consequences of Overconfidence Bias

Answer 37

Investors underestimate risks and overestimates returns.

Portfolios are under-diversified and exposed to significant risks.

Question 38

Self-control bias

Answer 38

occurs when people fail to make decisions that are best for their long-term goals due to a lack of self-discipline.

Short-term satisfaction often conflicts with long-term goals. People prefer immediate small payoffs to large delayed ones.

Question 39

Consequences of Self-Control Bias

Answer 39

People may not save enough for the future and take on excessive risk in hopes of higher returns.

People borrow too much to finance current spending.

Question 40

Status quo bias

Answer 40

occurs when people are more inclined to do nothing rather than make changes.

Inertia keeps them in the same position. For example, when a client meets the portfolio manager for the first time, an IPS is created to capture the client’s investment goal and risk appetite.

Although the IPS should be reviewed regularly and updated if necessary, most clients tend to stick to the original IPS (i.e., the “default”) even when their circumstances have changed.

The status quo bias is commonly discussed with endowment bias and regret-aversion bias, which will be considered next. These biases will produce the same outcome––they cause people to be reluctant to make changes.

Question 41

Consequences of Status Quo Bias

Answer 41

Investors may maintain inappropriate portfolios.

Investors are less likely to explore other opportunities.

Question 42

Endowment bias

Answer 42

occurs when people value an asset more when they hold the rights to it. According to economic theory, a person should be willing to buy and sell at the same price. However, with this bias, people’s selling price will be greater than the purchase price.

For example, an investor buys shares from a company and believes they are severely undervalued. In the next consecutive weeks, the stock tanks and the investor keeps holding the shares, believing the market is overlooking the company’s fundamentals. However, the investor refuses to buy more shares despite the fact they just claimed the stock was “undervalued.” They have exhibited endowment bias by overestimating the value of the shares already owned in their portfolio.

Question 43

Consequences of Endowment Bias

Answer 43

Investors fail to sell off certain assets when they should.

People hold too many familiar investments.

Asset allocation is inappropriate for the investors’ risk tolerance and long-term objectives.

Question 44

Regret-aversion bias

Answer 44

occurs when people avoid making decisions that could potentially turn out badly.

The regret that arises due to an action that was taken is more painful than the regret that arises due to an action that was not taken. Investors may be reluctant to sell a security now because they fear it might continue to go up in value. Similarly, they might be reluctant to buy because it could drop further.

Question 45

Consequences of Regret-Aversion Bias

Answer 45

Investors become overly conservative because a high-risk investment has more potential to cause regrets.

Investors exhibit herd behavior. Nobody wants to go against the flow and later regret it. It is less emotionally painful when a big crowd fails together.

Question 46

Market anomalies

Answer 46

refer to return distortions that deviate from the efficient market hypothesis.

Investors get persistent positive abnormal returns and the trend is predictable in direction

Question 47

not every deviation is considered an anomaly, and there are a few factors that result in the misclassification of anomalies:

Answer 47

1. Choice of asset pricing model
2. Statistical issues
3. Temporary disequilibria

Question 48

Momentum (a.k.a. trending effects)

Answer 48

causes the stock price to be positively correlated with its recent past.

In other words, outperformers from the last year continue to outperform this year, and underperformers continue to underperform. This positive correlation usually persists for a few years before reverting back to the mean

Question 49

Momentum occurs based on the following biases:

Answer 49

Availability bias

–> This is related to the recency effect, where people assign more weight and credibility to recent events. Retail investors are more likely to extrapolate a recent rise in stock price to the future, which produces buying pressure that increases the stock price even further. Investment professionals are more likely to expect mean reversion instead.

Hindsight bias

–> Investors do not like to face the regret of not owning a stock when it performed well in the previous year. They are likely to feel they could have predicted the significant upward movement of the stock because the signs were “obvious.” To remedy this regret, investors are likely to buy the stock and hope it has not reached its peak yet. This results in overtrading.

Loss aversion bias

Question 50

Halo effect

Answer 50

Investors may assume a favorable characteristic of a company is representative of the entire company. For example, a company that recently has earnings that beat market expectation will see its stock price continue to rise. Investors perceive the overperformance in the current earnings report as a favorable trait that can be extrapolated into future expected stock returns.

Question 51

Home bias

Answer 51

investors prefer to invest in domestic securities rather than global portfolios due to proximity of the former.

Question 52

Under-diversified portfolios are not a potential implication of which of the following behavioral biases?

a) Representativeness

b) Illusion of control

c) Confirmation

Answer 52

a) Representativeness

Under-diversified portfolios are a consequence of both illusion of control and confirmation biases. Researchers have found that some investors prefer to invest in companies that they feel they have control over, such as the companies they work for, leading them to hold concentrated positions. Confirmation bias may lead to FMPs ignoring negative news, paying attention only to information confirming that a company is a good investment, which may result in large positions. Representativeness bias is not typically associated with under-diversified portfolios.

Question 53

Status quo bias is least similar to which of the following behavioral biases?

a) Endowment

b) Regret aversion

c) Confirmation

Answer 53

c) Confirmation

Both endowment bias and regret-aversion bias often result in indecision or inertia—a typical outcome of status quo bias, in which people prefer to not make changes even when changes are warranted.

Question 54

he halo effect, which may be evident in FMP’s assessments of a company with a history of high revenue growth, is a form of which behavioral bias?

a) Endowment

b) Representativeness

c) Regret aversion

Answer 54

b) Representativeness

Representativeness refers to the tendency to adopt a view or forecast based on individual information or a small sample, as well to use simple classifications. The halo effect is an example of representativeness, because FMPs extend an overall favorable evaluation to an investment (e.g., a “good company”) based on one or few characteristics (e.g., a “visionary CEO”).

Question 55

All of the following are reasons that an apparent deviation from the efficient market hypothesis might not be anomalous except:

a) The abnormal returns represent compensation for exposure to risk.

b) Changing the asset pricing model makes the deviation to disappear.

c) The deviation is well known or documented.

Answer 55

c) The deviation is well known or documented.

Bubbles and crashes are well-known and well-documented phenomena yet represent market anomalies.

Question 56

Investment managers incentivized or accountable for short-term performance by current and prospective clients is a potentially rational explanation for which of the following?

a) Home bias

b) Bubbles

c) Value stocks outperforming growth stocks

Answer 56

b) Bubbles

Investment managers’ incentives—or perhaps more accurately, their perception of their incentives—for short-term performance were named as considerations in the technology and real estate bubbles. Not participating in the bubble presented certain FMPs with commercial or career risk.

Question 57

onsider the following question:

“Do you believe that investment outcomes are generally predictable or unpredictable?”

This question is most likely testing for evidence of:

A
hindsight bias.

B
illusion of control bias.

representativeness bias.

Answer 57

A
hindsight bias.

Question 58

Which of the following biases least likely relates to the mental discomfort that occurs when new information conflicts with a set of initial beliefs?

A
Confirmation bias

B
Representativeness bias

C
Anchoring and adjustment bias

Answer 58

C
Anchoring and adjustment bias

Belief perseverance biases relate to cognitive dissonance, the mental discomfort when an investor is given new information that conflicts with prior beliefs. Biases in this category include:

Conservatism bias
Confirmation bias
Representativeness bias
Illusion of control bias
Hindsight bias

Anchoring and adjustment bias is a type of processing error bias.