Behavior Finance Biases Flashcards
Loss Aversion Bias
Bias Type: Emotional
Research has shown that for many investors, the pain of losses is twice as painful as the pleasure of gains.
Loss aversion prevents people from unloading unprofitable investments, even when they see no prospect of a turnaround. Some industry veterans have labeled this phenomenon “get-even-itis.”
Endowment Bias
Bias Type: Emotional
Endowment bias occurs when a person assigns greater value to an object he or she possesses and may lose than an object of the same value he or she does not possess and has the potential to gain.
A classic example of endowment bias is a client who holds onto investments that were owned by previous generations, particularly concentrated equity positions or real estate that may have created the family’s wealth to begin with, without justification for why these assets are retained.
Status Quo Bias
Bias Type: Emotional
Status quo bias predisposes people, when facing an array of options, to select the one that keeps conditions the same.
Status quo bias is demonstrated by the investor that has been doing things a certain way for many years, and then hires a new financial advisor. The new advisor may propose practical changes only to find that the investor takes only part of or none of the advice. It’s not that the client doesn’t’t need good advice – they are simply stuck in the “status quo”.
Regret Aversion Bias
Bias Type: Emotional
People exhibiting regret aversion bias avoid taking decisive action because they fear that, in hindsight, the course they select will prove less than optimal.
Regret aversion can cause investors to be too conservative in their investment choices. Having suffered losses in the past, some investors have trouble making sensible new investments. This behavior can lead to long term underperformance and can jeopardize investment goals.
Anchoring Bias
Bias Type: Cognitive
Anchoring bias occurs when investors are influenced by purchase points or arbitrary price levels, and cling to these numbers as they decide whether to buy or sell an investment.
One of the most common examples of anchoring bias occurs during the implementation of a new asset allocation. For example, suppose a client comes to an advisor with 30% of their portfolio in a single stock and the advisor recommends diversification. Further suppose that the stock is down 25% from its high that it reached 5 months ago ($75/share vs. $100/share). For simplicity, assume that taxes on the sale are not an issue. Frequently, the client will be resistant to meet the new allocation because they are anchored to the $100 price.
Mental Accounting Bias
Bias Type: Cognitive
Mental accounting occurs when people treat various sums of money differently based on where these sums are mentally categorized. For example, risk averse investors may like to segregate some assets into safe “buckets.”
A classic example of mental accounting is segregating “college money”, “money for retirement” and “vacation money”. If all of these assets are viewed as “safe money” sub-optimal returns are usually the result.
Recency Bias
Bias Type: Cognitive
Recency bias causes people to more easily recall and emphasize recent events and/or observations, and potentially to extrapolate recent patterns where none exist.
Recency bias ran rampant during the bull market period between 1995 and 1999 when many investors wrongly presumed that the market would continue its enormous gains forever.
Hindsight Bias
Bias Type: Cognitive
Some investors lack independent thought and are susceptible to hindsight bias, which occurs when investors perceive investment outcomes as if they were predictable – even if they were not. Hindsight bias can give investors a false sense of security when making investment decisions, potentially leading to excessive risk-taking.
An example of hindsight bias is the response by investors to the behavior of the aforementioned tech stock bubble when, initially, many viewed the market’s performance as “normal” (i.e., not symptomatic of a bubble), only to later say, “Wasn’t it obvious?!” when the market melted down.
Framing Bias
Bias Type: Cognitive
Framing bias describes the tendency of investors to respond to various situations differently based on the context in which a choice is presented (framed). Often, investors focus too much on one or two aspects of a situation, excluding other crucial considerations.
The use of risk tolerance questionnaires provides a good example. Depending upon how questions are asked, framing bias can cause investors to respond to risk tolerance questions in an either unduly conservative or aggressive manner. For example, when questions are worded in the “gain” frame, then a risk-taking response is more likely. When questions are worded in the “loss” frame, then risk-averse behavior is the likely response.
Cognitive Dissonance Bias
Bias Type: Cognitive
In psychology, cognitions represent attitudes, emotions, beliefs, or values. When people attempt to harmonize conflicting cognitions, cognitive dissonance can result. People may rationalize their choices, even when faced with facts that demonstrate that they made poor decisions.
Individuals who suffer from this bias can be known to continue to invest in a security or fund they already own after it has gone down (average down) without judging the new investment with objectivity. A common phrase for this concept is “throwing good money after bad.”
Ambiguity Aversion Bias
Bias Type: Cognitive
Ambiguity aversion may be best explained using an example. Suppose a researcher asks Mr. Jones to predict whether a certain sports team will win its upcoming game, and he gives the team a 60% chance of winning. Further suppose that the researcher presents Mr. Jones with a 50%/50% slot machine (no ambiguity) and asks which bet is preferable. If Mr. Jones is ambiguity-averse, he may choose the slot machine even if he feels confident about the team winning.
Translating this idea to the investment world, even when investors feel skillful or knowledgeable, they may not be willing to stake claims on “ambiguous” investments like stocks, even when they believe they can predict these outcomes based on their own judgment.
Conservatism Bias
Bias Type: Cognitive
Conservatism bias occurs when people maintain their prior views or forecasts by inadequately incorporating new information.
Investors often under-react to new information and fail to modify their beliefs and actions.
For example, assume an investor purchases a security based on the knowledge about a forthcoming new product announcement. The company then announces that it is experiencing problems bringing the product to market. The investor may cling to the initial, optimistic impression of the new product announcement and may fail to take action on the negative announcement.
Availability Bias
Bias Type: Cognitive
Description: Availability bias occurs when people use a rule-of-thumb to estimate the likelihood of an outcome based on how easily the outcome comes to mind.
Easily-recalled outcomes are perceived as being more likely than those that are harder to recall or understand.
As an example, suppose an investor is asked to identify the “best” mutual fund companies. Most investors would perform a “Google” search and, most likely, find funds from firms that engage in heavy advertising – such as Fidelity or Schwab. Investors subject to availability bias are influenced to pick funds from such companies, despite the fact that some of the best-performing funds advertise very little if at all.
Representativeness Bias
Bias Type: Cognitive
Representativeness bias occurs as a result of a flawed perceptual framework when processing new information using pre-existing ideas. For example, an investor may view a particular stock as a value stock because of similarities to an earlier value stock that was a successful investment, even if the new investment is not actually a value stock.
For instance, a high-flying biotech stock with scant earnings or assets drops 25% after a negative product announcement. Some may take this situation to be representative of a “value” stock because it is cheap; but biotech stocks don’t typically have earnings while traditional value stocks have had earnings in the past but are temporarily underperforming.
Self-Attribution Self-Enhancing Bias
Bias Type: Cognitive
Self-attribution bias refers to the tendency of people to ascribe their successes to innate talents, while blaming failures on outside influences.
For example, suppose an Independent Investor makes an investment that goes up. The reason it went up is not due to random factors such as economic conditions or competitor failures, but rather to the investor’s investment savvy. This is classic self-enhancing bias.
