Behavioral Finance

Question 1

Belief Perseverance Biases

Answer 1

RICCH (Moderate - Cognitive)

1. Representativeness - tendency to overweight the importance of the most recent observations and information relative to a longer-dated, or more comprehensive set of long-term observations & information (base rate neglect)
2. Illusion of Control - choice, familiarity, competition, and active involvement can inflate confidence
3. Conservatism - people maintain their prior views or forecasts by inadequately incorporating new information
4. Confirmation bias - look for confirming evidence
5. Hindsight bias - see past events as being predictable

Question 2

Information Processing Biases

Answer 2

FAMA (Moderate - Cognitive)

1. Framing - information is processed differently based on how it is framed
2. Availability - estimate the outcome based on how easily the information comes to mind (retrievability, categorization, narrow range of experience, resonance, personal experience)
3. Mental Accounting - investors treat buckets of money differently
4. Anchoring and Adjustment - begin with an anchored, default value and adjust based on new information

Question 3

Emotional Biases

Answer 3

LOSERS are EMOTIONAL! (ADAPT - Behavioral)

1. Loss aversion - investors strongly prefer avoiding losses vs. earning positive returns
   a. Disposition effect - holding losers too long and not selling quick winners (Bbox 4)
   b. House money effect - increase risk tolerance or gamble more based on recent winners/gains
   c. Myopic loss aversion - combines time horizon, mental accounting and loss aversion to have more concern for potential short-term losses than long term diversification
2. Overconfidence - unjustified faith in your own judgement and intuitive reasoning abilities
   a. Prediction overconfidence - narrow range of potential outcomes, too narrow confidence intervals
   b. Certainty overconfidence - assign probabilities of an outcome too high
   c. Self-attribution bias - take personal credit for success and blame failure on bad luck
3. Self-control - investors fail to act in their long-term best interest, lack self-discipline
   a. Hyperbolic discounting: prefer small payoff now vs. larger payoffs in the futures
4. Endowment - believe an asset held more valuable than if they didn’t own it and were to price the endowment
5. Regret-aversion - avoid making decisions for fear of making the wrong decision or the decision working out poorly
6. Status-quo - investors prefer to do nothing, maintain status quo, keep things the same, related to endowment and regret aversion biases

Question 4

Pompian Model

Answer 4

PFIA
Barnewall: Passive -> Active
Risk Tolerance: Low -> High
Investment Style: Conservative/Moderate/Growth/Aggressive
Test for Behavioral Biases: Emotional/cognitive/cognitive/emotional
Emotional bases:
P: Endowment, loss aversion, status quo, regret aversion

Question 5

Pompian Model

Answer 5

PFIA
Barnewall: Passive -> Active
Risk Tolerance: Low -> High
Investment Style: Conservative/Moderate/Growth/Aggressive
Test for Behavioral Biases: Emotional/cognitive/cognitive/emotional
Emotional bases:
P: Endowment, loss aversion, status quo, regret aversion
F: Regret aversion
I: Overconfidence, Self-Attribution
A: Overconfidence, Self-control
Cognitive Biases:
P: Mental accounting, Anchoring & adjustment
F: Availability, Hindsight, Framing
I: Conservatism, Availability, Confirmation, Represntativeness
A: Illusion of Control

Question 6

Analyst Biases Conducting Research

Answer 6

1. Confirmation Bias
2. Gambler’s fallacy (wrongly predict reversion to mean)
3. Representativeness (good = safe)