Behavioral Finance

Question 1

Behavioral Finance

Answer 1

Relates behavioral and cognitive psychology to financial planning and economics in an attempt to understand why people make certain choices during the financial decision making process. Client actions are organized into two groups - cognitive errors and emotional biases.

Question 2

Cognitive Errors

Answer 2

Primarily due to faulty reasoning and arising from lack of understanding of proper statistical analysis techniques, information processing mistakes, or memory errors. These errors can be connected or mitigated with better training or information.

Question 3

Illusion of Control Bias

Answer 3

Exists when market participants think they can influence outcomes when they cannot. It is often associated with emotional biases: Illusion of Knowledge, self-attribution, and overconfidence biases.

Question 4

Hindsight Bias

Answer 4

Selective memory of past events, actions, or what was knowable in the past. Clients tend to remember their correct views and forget the errors. They also overestimate what could have been known.

Question 5

Confirmation Bias

Answer 5

Occurs when market participants look for new information to support an existing view. Clients who get involved with the portfolio process by researching holdings may become overly attached to some investments and only bring up information favorable to the holding.

Question 6

Representativeness

Answer 6

Based on belief the past will persist and, as a result, new information is classified based on previous experiences. While this may be efficient, the new information can be misunderstood if it is classified base on superficial resemblance to the past or a classification.

Question 7

Base Rate Neglect (Representativeness)

Answer 7

Where the base rate (probability) of the initial classification is not adequately considered.

Question 8

Sample Size Neglect (Representativeness)

Answer 8

Makes the initial classification based on an overly small and potentially unrealistic sample of data.

Question 9

Mental Accounting

Answer 9

“Money jar mentality”. Involves the tendency of individuals to put their money into separate accounts based on the function of these accounts.

Question 10

Self-Attribution Bias (Ego)

Answer 10

An ego defense mechanism that occurs to avoid the cognitive dissonance associated with having to admit making a mistake.

Question 11

Self-Attribution Bias

Answer 11

An ego defense mechanism that occurs to avoid the cognitive dissonance associated with having to admit making a mistake.

Question 12

Anchoring

Answer 12

Irrational decisions based on information that should have no influence on the decisions at hand. Especially risky when people know little about the product being purchased, the service being delivered, or the investment being made.

Question 13

Adjustment

Answer 13

Involves clients clinging to on clinging on to an initial estimate and not adjusting for new information.

Question 14

Outcome Bias

Answer 14

The tendency for individuals to take a course of action based on the outcomes of prior events.

Question 15

Framing Bias

Answer 15

Asserts that people are giving a frame of reference, a set of beliefs or values, which they use to interpret facts or conditions as they make decisions.

Question 16

Recency Bias

Answer 16

Recent information is given more importance because it is most vividly remembered. Also called Availability Bias.

Question 17

Herding

Answer 17

When investors trade in the same direction or in the same securities and, possibly, trade contrary to the information they have available.

Question 18

Emotional Bias

Answer 18

Not related to conscious thought and stem from feelings, impulses, or intuition. More difficult to overcome.

Question 19

Prospect Theory

Answer 19

Client fearing losses much more than valuing gains. Will choose smaller gain if it avoids a loss.

Question 20

Loss Aversion Theory

Answer 20

Involves clients valuing gains and losses differently, and as result, will make decisions based on perceived gains than perceived losses.

Question 21

Loss Aversion Theory

Answer 21

Involves clients valuing gains and losses differently, and as result, will make decisions based on perceived gains than perceived losses.

Question 22

Overconfidence

Answer 22

Investors exhibiting overconfidence believe that they can control random events merely by acquiring more knowledge and consider their abilities to be much more than they are. Take credit for for any financial decisions that have positive results. Any negative outcomes attributed to external sources.

Question 23

Self-Control Bias

Answer 23

Occurs when individuals lack self discipline and favor immediate gratification over long-term goals.

Question 24

Status Quo Bias

Answer 24

Occurs when comfort with an existing situation leads to an unwillingness to make changes. If an investment choices include the option to maintain existing choices, or if a choice will happen unless the participant opts out, status quo choices become more likely.

Question 25

Endowment Bias

Answer 25

Occurs when an asset is deemed special and more valuable since it is already owned.

Question 26

Regret Aversion Bias

Answer 26

Occurs when market participants do nothing out of excess fear that actions could be wrong. They attach undue weight to actions of commission (do something) and do not consider actions of omission (doing nothing). Their sense of regret and pain is stronger for acts of commission.

Question 27

Affinity Bias

Answer 27

Refers to tendency to favor things that one can identify with emotionally because they are familiar. This bias can lead to irrational decisions because the investor perceives a product or investment opportunity to be a reflection of their values and associations.