Applied Behavioral Finance Flashcards
Questions to consider in regard to your clients
1) Are you adding value to your clients?
2) Are you effectively communicating your wealth to your clients?
Every behavioral framework can be summarized as:
Correcting or Moderating cognitive errors
Accommodating emotional biases
Types of Cognitive Errors
Belief Perseverance Biases
* Conservatism
* Confirmation
* Representativeness
* Illusion of Control
* Hindsight
Information-Processing Biases
* Anchoring and Adjustment
* Mental Accounting
* Framing
* Availability
Types of Emotional Biases
- Loss Aversion
- Overconfidence
- Self Control
- Status Quo
- Endowment
- Regret Aversion
What to consider when deciding to Moderate or Accommodate a client?
1) Client’s level of wealth (Fundedness)
2) Nature of client’s behavioral biases
Loss Aversion
Feeling twice as bad about a loss as we feel good about an equivalent gain
Preferring to avoid losses over achieving gains
Herding
The tendency to conform to group behavior, following the crowd
Recency Effect
Overemphasizing recent experiences when making a decision
Availability Bias
A cognitive bias where overweighting information that comes most easily to mind or is readily available
Heuristics
Cognitive shortcuts or rules of thumb that simplify decision-making
Overconfidence Bias
An emotional bias where confidence in one’s own judgment is greater than the objective accuracy of that judgment
Recency Bias
A cognitive bias where people are easily influenced by recent news events or experiences
Believe recent events will continue in the future
Confirmation Bias
A cognitive bias where there’s a tendency to seek information that reinforces their perception
Seeking information that confirms preexisting beliefs
Familiarity Home Bias
Make decisions based on own/familiar experiences
Anchoring/Adjustment Bias
A cognitive bias where people have the tendency to focus on specific reference points when making investment decisions
Top Five Client Behavioral Biases
- 35% Recency Bias
- 26% Loss Aversion
- 25% Confirmation Bias
- 23% Familiarity Home Bias
- 22% Anchoring Bias
Cognitive Biases
Biases that involve how people think
Emotional Biases
Biases that involve how people feel
Status Quo Bias
An emotional bias where people like to maintain things the way they are
Things have always been this way, so they feel comfortable keeping them the same
Endowment Bias
An emotional bias where people assign a greater value to an investment they already own
Hindsight Bias
A cognitive bias where people perceive past investment outcomes as if they had been predictable
Framing Bias
A cognitive bias where people respond to situations differently based on the context in which the choice is presented
Cognitive Dissonance Bias
A cognitive bias where multiple beliefs intersect and contradict each other. People try to alleviate this discomfort and find ways to rationalize decisions
Regret Aversion Bias
An emotional bias where people avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove unwise
Conservatism Bias
A cognitive bias where people cling to a prior view or forecast at the expense of acknowledging new information
Availability Bias
A cognitive bias where people estimate the probability of an outcome based on how prevalent that outcome appears to be in their lives
Representativeness Bias
A cognitive bias that occurs because of a flawed perceptual framework when processing new information
Sometimes, they will project outcomes that resonate with their own preexisting ideas
Self-Attribution (Self-Enhancing) Bias
A cognitive bias where people have a tendency to ascribe their successes to their own innate talents and to blame failures on outside influences
Self-Control Bias
An emotional bias which is the tendency to consume today at the expense of saving for tomorrow
Affinity Bias
An emotional bias which refers to people’s tendency to make irrationally uneconomical decisions based on how they believe a certain product or service will reflect their values
Outcome Bias
A cognitive bias that occurs when people focus on the outcome of a process rather than on the process used to attain the outcome
Illusion of Control Bias
A cognitive bias that occurs when people believe that they can control or at least influence investment outcomes when they cannot
Biological Processes Involved in Financial Decision Making
Amygdala - fight or flight; reptilian part; an intuitive part of the brain
Mammalian part of the brain - creating preferences for different decisions that could be made
Prefrontal cortex - where logical decisions are made and tradeoff decisions are made
Exocortex - handing off complex decisions to outside sources, primarily through technology
Intuitive Decision-Making
Thought of as decisions that don’t take much effort to come to a conclusion
Very intuitive, instinctual reaction to a choice
Deliberative Decision-Making
Making a specific choice between options after thought and reason went into it
Expected Value Theory
The comparison of an anticipated average value/return of one scenario with an anticipated average value/return of another scenario
Determining the weighted averages of potential outcomes to see which one is more favorable
Describe Descriptive Utility Function Theory
Whether or not people are willing to put the risk on the table to receive a particular gain, even if there’s an infinite expected value
Making decisions based on whether a person is risk averse or not
Describe Prescriptive Utility Function Theory
A more mathematical model to determine the risk aversion of the average person
Describe Mean Variance Model
Mathematically create an efficient portfolio for a rational person
Being able to create the most optimal portfolio for a person
Describe Prospective Theory
Investors value gains and losses differently, placing more weight on perceived losses versus perceived gains
Describe Adaptive Market Hypothesis
It reconciles Efficient Market Hypothesis (EMH) with research in behavioral economics
Markets evolve over time as individuals different heuristics and biases to make decisions
Preserver Investor Personality Type
An investor who places a great deal of emphasis on financial security and preserving wealth, rather than taking risks to grow wealth
Follower Investor Personality Type
An investor who is passive and often lacks interest in and/or has little aptitude for money or investing
Independent Investor Personality Type
An investor who has original ideas about investing and likes to get involved in the investment process
Accumulator Personality Type
An investor who is interested in accumulating wealth and is confident that he or she can do so
What are the Bailard, Biehl, and Kaiser Investor Models?
- Individualists – They are confident and careful. Generally do not go to a consultant to manage their investments but do it themselves
- Adventurers – Generally go for only big bets. have the resources to do so and willing to take risks. Investments are generally focused and not diversified
- Celebrities – Swayed too much by the trend and do not have any expertise or opinion about investments. Approach investment managers frequently
- Guardians – Both anxious and careful. Lacking confidence, they approach investment counsels. Generally emphasize safety of the capital while making the investments and a significant proportion of their investments is generally devoted to government securities and guaranteed return investments
- Straight arrows – Halfway between complete confidence and anxiety, and extreme carefulness and impetuousness
Mental Accounting
Treating various sums of money differently based on where these monies are mentally categorized
