Behavioral Finance

Question 1

Prospect Theory Basics

Answer 1

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

Question 2

Paradox of Choice

Answer 2

Hypothesis: giving people more choice does not increase performance OR satisfaction

Question 3

Adaptive Markets Hypothesis

Answer 3

-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

Question 4

Cognitive Dissonance

Answer 4

Confusion or frustration that arises when an individual receives new information that does not match up with or conform to preexisting beliefs or experiences

Question 5

Biases based on existing beliefs

Answer 5

a. cognitive dissonance
b. conservatism bias
c. confirmation bias
d. representative bias
e. illusion of control bias
f. hindsight bias

Question 6

Conservatism Bias

Answer 6

People cling to their prior views or forecasts at the expense of acknowledging new information; individuals are inherently slow to change

Question 7

Confirmation Bias

Answer 7

People observe, overvalue, or actively seek out information that confirms what they believe while ignoring or devaluing information that contradicts their beliefs

Question 8

Representativeness Bias

Answer 8

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

Question 9

Illusion of Control Bias

Answer 9

A cognitive bias where people believe they can control or influence investment outcomes when in reality they cannot

Question 10

Hindsight Bias

Answer 10

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

Question 11

Biases based on information processing

Answer 11

a. mental accounting
b. anchoring and adjustment bias
c. framing bias
d. availability bias
e. self-attribution bias
f. outcome bias
g. recency bias

Question 12

Mental Accounting

Answer 12

A cognitive bias in which individuals treat various sums of money differently based on where these monies are mentally categorized

Question 13

Anchoring and Adjustment Bias

Answer 13

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

Question 14

Framing Bias

Answer 14

Cognitive bias where an individual responds to similar situations differently based on the context in which the choice is presented

Question 15

Availability Bias

Answer 15

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

Question 16

Self-Attribution Bias

Answer 16

A cognitive bias where people ascribe successes to their innate talents and blame failures on outside influences

Question 17

Outcome Bias

Answer 17

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

Question 18

Recency Bias

Answer 18

People more easily recall and emphasize recent events/observations and often extrapolate recent patterns where there are none

Question 19

Biases based on emotions

Answer 19

a. loss-aversion
b. overconfidence bias
c. self-control bias
d. status quo bias
e. endowment bias
f. regret-aversion bias
g. affinity bias

Question 20

Loss-Aversion Bias

Answer 20

Pain of loss is roughly twice as painful as the pleasure of gains (core tenet of Prospect Theory)

Question 21

Overconfidence Bias

Answer 21

Unwarranted faith in one’s own thoughts and abilities

Question 22

Self-Control Bias

Answer 22

Human tendency to focus on instant gratification due to lack of discipline, consequently failing to act in the best interest of long-term goals

Question 23

Status-Quo Bias

Answer 23

When facing an array of options, status quo bias predisposes people to select the option that keeps conditions the same

Question 24

Endowment Bias

Answer 24

People tend to value an object more when they actually hold or own it; discounting the value of objects they do not currently possess

Question 25

Regret Aversion Bias

Answer 25

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

Question 26

Affinity Bias

Answer 26

Individuals may make irrational decisions or choices based on how they believe a certain product or service will reflect their values

Question 27

Sunk-Cost Fallacy

Answer 27

• 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.

Question 28

Get-Even-Itis

Answer 28

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.

Question 29

Disposition Effect

Answer 29

Describes scenarios in which investors typically hold on to losing investments too long but sell winning investments too early.

Question 30

Snake-Bit Effect

Answer 30

• 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.

Question 31

House Money Effect

Answer 31

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.

Question 32

Ambiguity Bias

Answer 32

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.

Question 33

Optimism Bias

Answer 33

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.

Question 34

Personality Traits

Answer 34

Adventurer
Celebrity
Individualist
Guardian
Straight Arrow

Question 35

Adventurer

Answer 35

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.

Question 36

Celebrity

Answer 36

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.

Question 37

Individualist

Answer 37

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.”

Question 38

Guardian

Answer 38

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.

Question 39

Straight Arrow

Answer 39

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.

Question 40

Personality Types

Answer 40

Preservers
Followers
Independents
Accumulators

Question 41

Preservers

Answer 41

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

Question 42

Followers

Answer 42

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

Question 43

Independents

Answer 43

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

Question 44

Accumulators

Answer 44

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