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
Conservatism Bias
- Initially assume rational view
- Fail to change view as new info comes available
- Does not adjust to new info
TSLA investor refuses to change view after negative analysis comes out. Does not adjust to any of the new info.
Illusion Control Bias
- Market participants think they can influence outcomes when they cannot
- Belief you know things you do not
- Over confidence
- Belief you are correct
Hindsight Bias
- Selective memory of past events, actions or what was knowable in the past
- Remember correct views but forget errors
- Overestimate what could have been known
- Thinking we understand the past when in reality we may not
Confirmation Bias
Investor looks for new info to support existing view
“Only bring up favorable research on a holding”
“Confirm my onion”
Representativeness
Belief that the past will persist & new information is classified based on previous experiences
- new info is misunderstood because it is classified incorrectly originally
- Base Rate Neglect: Initial classification is not adequately considered
- the classification is assumed to be 100% correct
- a stock is classified as a value stock and new info about the stock is analyzed bases on the classification of it being a value stock when in reality it is not - Sample Size Neglect: Initial classification is based on an overly small and potentially unrealistic sample of data
Leading Responses
Guide the client to give more detailed responses, making a “meeting of the minds” more likely
Mirroring
Physical mirroring - financial planner uses the client’s body language
Verbal mirroring - financial planner imitates the clients word use, tone of voice and communication method
Learning Styles
Visual - clients with visual learning styles tend to respond to graphs, charts, pictures
Auditory - Retain information by hearing or speaking
Kinesthetic - Understand concepts better using hands on approach (writing goals and objectives with bullet points as they are formulated engages clients)
Economic and Resource Approach
Counseling to change to favorable behavior if given the appropriate counseling
Planner focuses on obtaining and analyzing QUANTITATIVE data such as cash flow, assets and debts
Classical Economics Approach
Cost benefit and risk-return trade offs
Strategic Management Approach
SWOT Analysis is completed early on in the planning process
Cognitive Behavior Approach
Planner tries to substitute negative beliefs that lead to poor financial planning decisions with positive attitudes which lead to better financial results
Cognitive Errors
Faulty reasoning and arising from a lack of understanding of proper statistical analysis techniques, information processing mistakes and memory errors.
These errors can be corrected or mitigated with better training or information
Emotional Biases
Not related to conscious thought and stem from feelings, impulses, or intuition
More difficult to overcome
Disposition Effect
Sell winners too quickly (confirms current choice)
Hold losers too long (avoids confirming incorrect choice)
Donny Disposition
When investors consider the past, they tend to suffer from?
House money effect (take more risk)
Snakebite effect (take less risk)
Break-evenitis (take more risk)
Home Bias
Familiarity, single stock concentration
Cognitive Dissonance
Reconciling two opposing beliefs
Remembering the positive part of an experience but forgetting the negative
“Coggy remebers the positives forgets the negative”
Gambler’s Fallacy
Belief that a stock with a random event is less likely to happen following an event or a series of events.
Sell a stock that has gone up a few days in a row because they believe it wont continue.
Hold a stock that has fallen multiple days because they view further declines as improbable
Norman Batansky
Inappropriate Extrapolation
Belief recent events will continue indefinitely
“The market will keep going up”
“This bear market will continue on”
“Inappropriate to think this will not continue”
Which of the following BEST describes a story someone tells himself or herself about what is normal, expected, or desired in the context of money and personal finances?
Money Scripts
Money scripts are learned behaviors and preferences that move you through the world, and they greatly impact your financial decisions. A person’s views, attitudes, and belief system about money shape the way they approach, discuss, and further their financial vision.
Which of the following best describes a cognitive bias whereby people with limited knowledge or competence in an intellectual or social domain greatly overestimate their own knowledge or competence relative to objective criteria?
Dunning-Kruger Effect
A cognitive impression someone makes of another person based on physical and emotional characteristics that then influence future interactions with the person is known as which of the following?
Halo Effect
The halo effect refers to the tendency to use your first or overall impression of a person to evaluate specific traits that you haven’t actually observed.
Loss Aversion Example
Losses more painful than gains
Heuristic
is any approach to problem-solving that employs a more practical method that is not guaranteed to be optimal or rational, but is sufficient for reaching a short-term goal or approximation.
Examples: Rules of thumb, educated guesses, and trial & error.
Heuristics reduce the cognitive load of decision making.
This ease allows biases to cloud objectivity.
Affluenza
Affluenza is a phenomenon that affects young people from affluent (i.e., high net worth) households. Outcomes associated with affluenza include a sense of entitlement..
