Behavioral Finance Flashcards
Mental Accounting
“Money jar mentality”
1. Tendency to put their money into separate accounts based on a function of these accounts.
- Example - Having money separated for savings, debt reduction, and vacation.
- Naïve diversification
Self Attribution Bias
An ego defense mechanism that occurs to avoid the cognitive dissonance associated with having to admit making a mistake
Hard time admitting a mistake
Anchoring
- Irrational decisions based on information that should have no influence on the decisions at hand
- Investor sets a value at the initial point of information (typically their buy price)
Adjustment
Involved clients clinging on to an initial estimate and not adjusting for new information
“clinging”
Avoid adjusting to new info
Outcome Bias
The tendency for individuals to take a course of action based on outcomes from prior events
Investor may purchase a stock because that stock had a superior performance over the past 3 years
However the investor ignores the current conditions that may be applicable to the stocks performance in the future
CPOAX - Outperformed in 2019 so everyone thought it would continue
Double money in an investment without doing research
Framing Bias
Asserts that people are given a frame of reference, set of beliefs or values which they use to interpret facts or conditions as they make decisions
“Frame of beliefs & values used to make decisions”
Recency Bias
Recent information is given more importance because it is most vividly remembered
Also called availability bias because it is based on data that are readily available, including small data samples or data that does not provide the full picture
Herding
When investors trade in the same direction or in the same securities and possibly, trade contrary to the information they have available
Prospect Theory
Suffer more from losses than benefitting from gains
Loss Aversion Theory
Clients valuing gains and losses differently and as a result will make decisions based on perceived gains rather than perceived losses
Client presented two equal opportunities - one stated in terms of potential gains and the other in terms of potential losses: most would choose the former (gains)
Value the upside gains of an opportunity than potential losses.
“What did it gain”
Overconfidence
believe that they can control random events merely by acquiring more knowledge and consider their abilities to be much better than they are
Take credit for positive results
Any negative outcomes are attributed to external sources
Overtrading and high turnover ratio of a fund could be a sign of overconfidence
Self - Control Bias
Lack self discipline
Favor immediate gratification over long-term goals
- take excessive risk in portfolio to compensate for insufficient savings accumulation
Status Quo Bias
When comfort with an existing situation leads to unwillingness to make changes
Investor could potentially benefit their plan from making changes but they do not want to.
Endowment Bias
When an asset is deemed special and more valuable simply because it is already owned
Inherited beach house that is a money pit but special to the family
Put more vale on something because you already own it
Regret Aversion Bias
When market participants do nothing out of excess fear that actions could be wrong
Attach undue weight to actions of commission (doing something)
And not consider actions of omission (doing nothing)
Their sense of regret and pain is stronger for acts of commission
Affinity Bias
The tendency to favor things that one can identify with emotionally because they are FAMILIAR
Can lead to irrational decisions
Ethnic, religious, or alumni affiliations can be a source of affinity bias
“A FAMILIARITY”
Cognitive Errors
Faulty reasoning from
- lack of understanding statistical analysis techniques