Behavioral Finance Flashcards
Prospect Theory Basics
Most individuals are more risk averse vs. pleasure seeking by a ratio of roughly 2:1.
•People make decisions based more on probabilities than potential outcomes
•People make decisions using mental heuristics (e.g., mental shortcuts and biases)
•Loss aversion: the tendency to feel the impact of losses more than gains
•This value function can be illustrated graphically using an asymmetrical s-shaped curve
Paradox of Choice
Hypothesis: giving people more choice does not increase performance OR satisfaction
Adaptive Markets Hypothesis
-Reconciles Efficient Market Hypothesis (EMH) with research in behavioral economics
-Markets evolve over time as individuals use numerous evolutionary heuristics and biases to make decisions
–Opportunities for arbitrage
–Value in quantitative, fundamental, technical strategies
–Survival is primary objective; profit and utility secondary
–Innovation is key to survival and growth
Cognitive Dissonance
Confusion or frustration that arises when an individual receives new information that does not match up with or conform to preexisting beliefs or experiences
Biases based on existing beliefs
a. cognitive dissonance
b. conservatism bias
c. confirmation bias
d. representative bias
e. illusion of control bias
f. hindsight bias
Conservatism Bias
People cling to their prior views or forecasts at the expense of acknowledging new information; individuals are inherently slow to change
Confirmation Bias
People observe, overvalue, or actively seek out information that confirms what they believe while ignoring or devaluing information that contradicts their beliefs
Representativeness Bias
A cognitive bias through which individuals process new information using pre-existing ideas or belief; an investor views a particular situation or information a certain way because of similarities to other examples even if it does not really fit into that category
Illusion of Control Bias
A cognitive bias where people believe they can control or influence investment outcomes when in reality they cannot
Hindsight Bias
Cognitive bias where investors perceive investment outcomes as if they were (had been) predictable, even if they were not; sometimes gives investors a false sense of security when making investment decisions leading them to excessive risk-taking
Biases based on information processing
a. mental accounting
b. anchoring and adjustment bias
c. framing bias
d. availability bias
e. self-attribution bias
f. outcome bias
g. recency bias
Mental Accounting
A cognitive bias in which individuals treat various sums of money differently based on where these monies are mentally categorized
Anchoring and Adjustment Bias
A cognitive bias where investors are influenced by purchase point or arbitrary price levels and cling to these numbers when deciding to buy or sell
Framing Bias
Cognitive bias where an individual responds to similar situations differently based on the context in which the choice is presented
Availability Bias
A cognitive bias where easily recalled outcomes (often from more recent information) are perceived as being more likely than those that are harder to recall or understand
Self-Attribution Bias
A cognitive bias where people ascribe successes to their innate talents and blame failures on outside influences
Outcome Bias
A cognitive bias in which people often make decisions or take action based on the outcome of past events rather than by observing the process by or through which that outcome occurred
Recency Bias
People more easily recall and emphasize recent events/observations and often extrapolate recent patterns where there are none
Biases based on emotions
a. loss-aversion
b. overconfidence bias
c. self-control bias
d. status quo bias
e. endowment bias
f. regret-aversion bias
g. affinity bias
Loss-Aversion Bias
Pain of loss is roughly twice as painful as the pleasure of gains (core tenet of Prospect Theory)
Overconfidence Bias
Unwarranted faith in one’s own thoughts and abilities
Self-Control Bias
Human tendency to focus on instant gratification due to lack of discipline, consequently failing to act in the best interest of long-term goals
Status-Quo Bias
When facing an array of options, status quo bias predisposes people to select the option that keeps conditions the same
Endowment Bias
People tend to value an object more when they actually hold or own it; discounting the value of objects they do not currently possess
Regret Aversion Bias
People often avoid making decisions or taking action because they are afraid that they will make a mistake; or that looking back the decision they make will prove less than optimal
Affinity Bias
Individuals may make irrational decisions or choices based on how they believe a certain product or service will reflect their values
Sunk-Cost Fallacy
- Investors may continue to hold an investment and even invest more (e.g., double down) in large part because of the time, effort and energy they have already invested in the idea behind the investment. Thus, they are emotionally tied to the initial choice.
- The sunk-cost fallacy is often tied back to the following biases: anchoring and status-quo bias.
Get-Even-Itis
Investors will often hold losing investments, hoping that the value will rise back up to the point at which they purchased the asset at which time they would plan to sell. They do so in an effort to prevent realizing a loss and the negative feelings or pain associated with losses.
Disposition Effect
Describes scenarios in which investors typically hold on to losing investments too long but sell winning investments too early.
Snake-Bit Effect
- This occurs when investors experience losses and then become more risk-adverse, even to the extent of not wanting to invest in the same investment or even asset class, based on their painful experience in the past.
- Often associated with a number of biases including anchoring, recency, conservatism, and representativeness.
House Money Effect
Investors often take more chances (take on more risk) once they have gained, won, or experienced profits. It’s as though they feel that they are now playing with someone else’s money and feel more comfortable taking on additional risk.
Ambiguity Bias
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.
Optimism Bias
Many overly optimistic investors believe that bad investments can happen to others but not them. These investors may fail to fully acknowledge the potential for adverse outcomes of their investment decisions.
Personality Traits
Adventurer Celebrity Individualist Guardian Straight Arrow
Adventurer
People who are willing to put it all on one bet and go for it because they have confidence. They are difficult to advice, because they have their own ideas about investing. They are willing to take risks, and they are volatile clients from an investment counsel point of view.
Celebrity
These people like to be where the action is. They are afraid of being left out. They really do not have their own ideas about investments. They may have their own ideas about other things in life, but not investing. As a result, they are the best prey for maximum broker turnover.
Individualist
These people tend to go their own way and are typified by the small business-person or independent professionals such as lawyer, engineer. These are people who are trying to make their own decisions in life, carefully going about things, having a certain degree of confidence about them, but also being careful, methodical and analytical. These are clients whom everyone is looking for-rational investors with whom the portfolio manager can talk sense.”
Guardian
Typically as people get older and begin considering retirement, they approach this personality profile. They are careful and a little bit worried about their money. They recognize that they face a limited earning time span and have to preserve their assets. They are definitely not interested in volatility or excitement. Guardians lack confidence in their ability to forecast the future or to understand where to put money, so they look for guidance.
Straight Arrow
These people are so well balanced; they cannot be placed in any specific quadrant, so they fall near the center. On average this group of clients is the average investor, relatively balanced composite of each of the other four investor types, and by implication a group willing to be exposed to medium amount of risk.
Personality Types
Preservers
Followers
Independents
Accumulators
Preservers
Preservers are, as the name implies, passive investors who place a great deal of emphasis on financial security and preserving wealth rather than taking risks to grow wealth. Subject to: Loss-Aversion Bias Status-Quo Bias Endowment Bias Anchoring Bias Mental Accounting Bias
Followers
Followers are typically passive investors who do not have their own ideas about investing. They often follow the lead of their friends and colleagues in investment decisions, and want to be in the latest, most popular investments without regard to a long-term plan. Subject to: Recency Bias Framing Bias Cognitive Dissonance Bias Regret Aversion Bias
Independents
Independent is an active investor with medium-to high-risk tolerance who is strong-willed and an independently minded thinker. Independents are self-assured and “trust their instincts” when making investment decisions. Subject to: Conservatism Bias Availability Bias Representativeness Bias Self-Attribution Bias Confirmation Bias
Accumulators
With Accumulators, we continue within the realm of the active investor. As we reviewed in earlier articles, active investors have been actively involved in their wealth creation, typically risking their own capital in achieving their wealth objectives. Subject to: Overconfidence Bias Self-Control Bias Affinity Bias Illusion of Control Bias Outcome Bias
