Behavioral Biases of Individuals Flashcards
a distinguish between cognitive errors and emotional biases; b discuss commonly recognized behavioral biases and their implications for financial decision making; c analyze an individual’s behavior for behavioral biases; d evaluate the impact of biases on investment policy and asset allocation and discuss approaches to mitigate their effect."
Cognitive Biases
- Statistical, information processing or memory errors that cause decision to deviate from rational decisions
- Can be moderated (recognise it and attempt to reduce it or completely remove it)
- How? Better information and education
Emotional Biases
Result of attitudes and feelings
- Recognise it and adapt to it (no reducing or eliminating the bias)
Types of Cognitive Errors
- Belief Perseverance Biases
a. Conservatism Bias
b. Confirmation Bias
c. Representativeness Bias
d. Illusion of control Bias
e. Hindsight Bias - Information Processing Bias
a. Anchoring and Adjustment Bias
b. Mental Accounting Bias
c. Framing Bias
d. Availability Bias
Belief Perseverance Bias
- Cling to one’s belief
- Cognitive Dissonance : New info conflicts with existing cognitions
Conservatism Bias - Def, Consequences, Detection and Guidance
Def:
- People overweight initial probabilities and outcomes and underreacting to new information
Consequences:
- Maintain or slow update to the new information in comparison to a rational investor
-Opt to believe the prior info than go through the mental stress of making changes given the complexity of data
Detection:
-Not accepting the new information or ignoring it on the basis of irrelevance, difficult to understand and would not chnage the current belief
Cognitive costs are studied. Cognitive costs higher, the lower the weight to new information
GUIDANCE:
Ask the question “how does new info change the forecasts?”
- Conduct analysis incorporating new info and then respond appropriately.
-Investors seek advice of professionals in case of info is difficult to understand
Confirmation Bias Def, Consequences, Detection and Guidance
Definition
- One sees only that information that confirm with beliefs and ignores or undervalues that which is against it
Consequences
-Only +ve information
- Develop screening criteria
- Under-diversify a portfolio and increase risks
- Holding disproportionate assets in employing company’s stock
Guidance:
-Actively seeking out new info whether positive or negative
-Corroborating support
Representative Bias: Def, Consequences, Detection and Guidance
- Tend to classify new information based on past experiences
Two types:
1. Base Rate neglect
2. Small Size Neglect
Consequences:
- Adopt view or forecast based solely on new information or small sample.
- Update beliefs using simple classification rather than mental stress to update with complex data.
Guidance:
-Should conduct more research to analyse whether a particular decision is right and are the FMPS falling under the base rate or small size neglects.
Illusion of Control Bias:
- People tend to believe that they control or influence outcomes
Consequences: - Trade More
- Inappropriately diversify the portfolio
Detection & Guidance - Successful investing is a probalisitic activity
- Contrary viewpoints
- Keep records
Hindsight Bias
- Selective perception and retention aspects
- Past experiences influences future
Consequences: - Overestimate the degree to which they predict investment outcome
- Asses money managers and security performance
Detection & Guidance:
“Re-writing history?
Guidance: - Record and examine investment decisions both good and bad.
- Understand that market moves in cycles and managers stick to their strategies both good and bad times
- Education
- Evaluation
Anchoring and Adjustment Bias
- Information processing bias in which individuals use psychological heuristics influences the way people estimate probabilities.
- Envision some default number as “anchor”
ConsequenceS: - Stick too closely to initial estimates when new information is provided
Detection and Guidance:
- ““Am I holding onto this stock based on rational analysis, or am I trying to attain a price that I am anchored to, such as the purchase price or a high water mark?” and “Am I making this market or security forecast based on rational analysis, or am I anchored to last year’s market levels or ending securities prices?””
- View basis and see if they are anchored to some value and make changes with company changes.
Mental Accounting Bias:
- Treat one sum of money differently from an equal sized sum of money based on which mental accounts money is assigned to.
Consequences: - Placing money into discrete accounts without understanding the correlation between the asset accounts.
- Neglect opportunities to reduce risk by combining low correlation assets
- Irrational distinguishing between income and capital appreciation
Detection and Guidance: - Correlation is not taken into consideration during mental accounting, hence creating a summary of the mental accounting assets would provide a holisitic picture and help create a optimal portfolio.
- Place importance to total returns and not specifically to capital appreciation or income and place money in low investment income products and let capital grow even after inflation.
Framing Bias
-Results as FMPs answers questions depending how the question is asked.
- Narrow framing results in people losing the big picture.
Consequences:
- Depends if the investment question is posed positively or -vly
- Misidentify risk tolerance based on how questions are framed.
- Suboptimal portfolios depending on how investment info is framed
- Focus on short term fluctuations and result in excessive trading
(Positive Framing - Risk averse decisions, Negative framing - Risk seeking decisions)
Detection and Guidance:
- Is the decision based on net gain or net loss position?
- Focus on future prospectus rather than net gain or loss
- Be neutral and open minded
Availability Bias
- Heuristic approach in determining the probabilities of outcomes depending how easily the outcome comes to mind.
4 sources of the bias:
Retrievability: If one answer comes more quickly than others, the first answer is chosen.
Categorisation: People gather info from what they perceive as relevant search set
Narrow Range Experience
Resonance: How situations parallels their own personal situation.
Consequences: - Making a choice based on advertisement than analysis
- Limiting investment opportunity set
- Fail to diversify
- Fail to achieve appropriate asset allocation
Detection and Guidance: - Develop appropriate startegy, do more analysis and focus on long term results.
- Disregard incidents that happened recently.
Emotional Bias & Types
- Impulse and intuition
- How people feel
Types:
a. Loss Aversion
b. Self control
c. Status quo
d. Endowment
e. Overconfidence
f. Regret aversion
Loss Aversion Bias
- People tend to avoid losses strongly than prefer gains
- FMPS accept more risk to avert loss than to achieve gains
Consequences: - hold investments in a loss position longer than justified
- sell investment in a gain position quickly than justified
- Limit the upside potential
- Trade excessively as a result of selling winners
- Hold riskier profiles
Detection and Guidance: - Disciplined approach to investment based on fundamental analysis is good
