Behavioral Finance

Question 1

Heuristics

Answer 1

Experiences and biases that can facilitate problem-solving and probability judgements.

Examples in daily life are “trial and error” and “rules of thumb”

These strategies are generalizations that result in inaccurate or irrational conclusions.

Question 2

Behavioral Finance

Answer 2

The study of how psychology affects finance.

Question 3

Anchoring

Answer 3

The tendency of investors to become attached to a specific price as the fair value of a holding.

Question 4

Anchoring Example

Answer 4

You bought a stock at $100 a share. It drops to $50. You believe that the stock’s “real” value is around $100 and based on this expectation you are inclined to hang on since it “should” come back.

Question 5

Attachment Bias

Answer 5

Holding onto an investment for emotional reasons rather than considering more practical applications for the inheritance.

Question 6

Attachment Bias Example

Answer 6

My grandfather left me this stock so I can never sell it.

Question 7

Endowment Bias

Answer 7

The feeling that because you own an asset, it is more valuable and special since it is yours. In reality, you might not even purchase the asset if you didn’t already own it.

Question 8

Endowment Bias Example

Answer 8

You inherited the family summer home and wouldn’t ever sell it even though it has become a money pit.

Question 9

Cognitive Dissonance

Answer 9

The challenge of reconciling two opposing beliefs

Question 10

Cognitive Dissonance Example

Answer 10

Remembering the positive part of an experience but forgetting the negative.

Question 11

Confirmation Bias

Answer 11

The natural human tendency to accept any information that confirms our preconceived position or opinion and to disregard any information that does not support that preconceived notion.

Question 12

Confirmation Bias Example

Answer 12

An investor hears about a hot stock from an unverified source and is intrigued by the potential returns that investor might choose to research the stock in order to prove its touted potential is real.

Question 13

Diversification Errors

Answer 13

Investors tend to diversify evenly across whatever options are
presented to them.

Question 14

Diversification Errors Example

Answer 14

Consider the style-box mania where investors feel compelled to own a piece of each box in order to be diversified. 401K participants tend to spread their money across whatever options they have.

Question 15

Fear of Regret

Answer 15

The tendency to take no action rather than risk making the wrong one.

Question 16

Fear of Regret Example

Answer 16

An investor holds onto a stock that’s losing value, because if they sold and it rebounded, they would feel even worse.

Question 17

Gambler’s Fallacy

Answer 17

An individual erroneously believes that the onset of a certain random event is likely to happen following an event or a series of events.

Question 18

Gambler’s Fallacy Example

Answer 18

Some investors believe that they should liquidate a position after it has gone up in a series of subsequent trading sessions because they do not believe that the position is likely to continue going up. Conversely, other investors might hold on to a stock that has fallen in multiple sessions because they view further declines as improbable. The solution is investors should base their decisions on analysis.

Question 19

Herd Behavior

Answer 19

The tendency for individuals to mimic the actions of a larger group. Can also be described as Fear of Missing Out (FOMO).

Question 20

Herd Behavior Example

Answer 20

This was exhibited in the late 1990’s as venture capitalists and private investors were frantically investing huge amounts of money into internet-related companies. Avoiding is steering clear of a bandwagon. Those overvalued investments took a big hit that many still have not recovered from.

Question 21

Hindsight Bias

Answer 21

The 20/20 vision we have when looking at a past event and thinking we understand it, when in reality we may not.

Question 22

Hindsight Bias Examples

Answer 22

Example 1: Many people now claim that they saw signs of the tech bubble of the 1990’s. The problem this causes is overconfidence.

Example 2: After a prolonged period of solid returns, the stock market declines by 15%. Immediately thereafter, all kinds of “experts” appear on television and in the mass media, proclaiming that we were long overdue for a correction, as if the decline were obvious and inevitable. But where were these experts before the event? If it was so obvious, why weren’t they speaking up before the market took a dive? If it was so obvious, why didn’t investors start cashing out just prior to the sell-off? Hindsight biases also regularly manifest themselves between investment advisors and their clients. Once the reasons why an investment performed poorly are understood, it becomes difficult to understand why it wasn’t avoided.

Question 23

Inappropriate Extrapolation

Answer 23

The tendency to look at recent events (or market performance) and assume that those events or conditions will continue indefinitely.

Question 24

Inappropriate Extrapolation Example

Answer 24

The bond market has outperformed the stock market for the past year and will continue to do so for the future because of the continued economic downturn.

Question 25

Analysis Paralysis (or Paralysis by Analysis)

Answer 25

This describes an individual/couple overanalyzing a situation and can cause decision making to become ‘paralyzed’, meaning that no solution or course of action is decided upon. A situation may be deemed as too complicated and a decision is never made, due to the fear that a potentially larger problem may arise. A person may desire a perfect solution but may fear making a decision that could result in error, while on the way to a better solution. Equally, a person may hold that a superior solution is a short step away, and stall in its endless pursuit, with no concept of diminishing returns.

Analysis paralysis is when the fear of either making an error outweighs the potential value of success in a decision made in a timely manner. This imbalance results in suppressed decision making in an unconscious effort to preserve existing options. An overload of options can overwhelm the situation and cause the “paralysis”, rendering one unable to come to a conclusion.

Question 26

Analysis Paralysis (or Paralysis by Analysis) Example

Answer 26

Investing is too complex so I will analyze all the various asset allocation strategies and create a plan. In the end, the investment plan is never created, and the money is still in cash.

Question 27

Loss Aversion and Risk Taking

Answer 27

While investors are risk averse when it comes to gains (they do not want to give them up), they are risk seekers when it comes to losses (they will take big risks to avoid realizing them). Given a choice between a sure gain and a chance to win more, people usually opt for the sure gain. Investors find losses roughly twice to two-and-a-half times as painful as gains are pleasurable. To avoid the emotional pain of loss, investors have a strong tendency to hang on to losers (they treat a loss as not real until it is realized). In some cases that may turn out to be a good decision and, in some cases, it may turn out to be bad. The problem is that the investor, faced with a loss, is largely leaving it now to “chance” and hope rather than to a sound and rationally informed decision based on a reassessment of the fundamentals.

Emotion has clouded the decision. Compounding the problem is that investor’s view errors of omission as worse than errors of making a bad decision. As a result, investors are biased toward inaction, and seriously underweight the cost of missed opportunities (opportunity cost).

Question 28

Loss Aversion and Risk Taking Example

Answer 28

An investor sells a strong-performing winner to lock in gains, without considering whether the investment remains attractive or whether a more attractive investment option exists. It turns out that the company is well managed with strong fundamentals, and even after the sale it continues to perform well. Meanwhile, the investor has held on to another loser, and used some of the proceeds from the sale of his winner to add to his holding in the loser in the hopes that even a partial rebound will cover the loss.

Question 29

Prospect Theory (similar to Loss Aversion/Risk Taking)

Answer 29

Describes the different ways people evaluate losses and gains. The researchers Kahnerman and Tversky found that losses have a much greater negative impact than a commensurate gain will have positive.

Question 30

Prospect Theory (similar to Loss Aversion/Risk Taking) Example

Answer 30

In a traditional way of thinking, the amount of utility gained from receiving $50 should be equal to a situation in which you gained $100 and then lost $50. The end result is the same which is most people view a single gain of $50 more favorably.

Question 31

Mental Accounting

Answer 31

This entails looking at sums of money differently, depending on their source or the intended use.

Question 32

Mental Accounting Example

Answer 32

Example 1: Some investors divide their investments between a safe investment portfolio and a speculative portfolio in order to prevent the negative returns that speculative investments may have from affecting the entire portfolio. All money is the same.

You invest in CDs (low interest) but you still have outstanding debt in your house at 5% (worse yet credit cards). The interest on your debt will erode any interest you can earn. While saving is important, sometimes it makes more sense to forego your savings in order to pay off debt.

Example 2: An unsophisticated 401(k) participant invests his own contributions in safe investments, while earmarking his employer contributions to risky investments. His thinking is that he had worked hard to earn the money he was contributing and did not want to risk it, while the money the company contributed was “free” money and could be gambled. Since the majority of money contributed was from the employer, the participant was investing too high a proportion of his assets in highly aggressive investments. Another example is people who borrow money for a car or keep a balance on their credit card, even though the interest rate on these loans is higher than the interest they earn on the money in their savings accounts or returns on their other investments.

Question 33

Outcome Bias

Answer 33

The tendency to make a decision based on the desired outcome rather than on the probability of that outcome.

Question 34

Outcome Bias Example

Answer 34

The investor wants to double his money in an investment without doing adequate research.

Question 35

Overconfidence

Answer 35

This is the tendency to place too much emphasis on one’s own abilities. It often works hand in hand with confirmation bias.

Question 36

Overconfidence Examples

Answer 36

Example 1: Overconfident investors tend to believe they are better than others at choosing the best stocks and the best times to enter or exit a position.

NOTE: Even professional fund managers with investment industry reports often struggle

Example 2: A young fund manager has so much success that he begins to believe that the reason is his own exceptional talent and that investing just happens to come easy for him. He steadily increases the amount he is willing to bet on his convictions, while at the same time decreasing the amount of research that is behind them. Eventually the manager is wrong, and with this heavy over-weighting, disaster strikes.

Question 37

Overreaction

Answer 37

Investors emotionally react towards new market information.

Question 38

Overreaction Example

Answer 38

Good news comes out on a stock that should raise the price accordingly. However, participants overreact to the new information creating a larger-than-appropriate effect on the security. But the truth is new information should more or less be reflected instantly in the security’s price. Although the change is usually sudden and sizable, the surge erodes over time.

Question 39

Over-Weighting the Recent Past

Answer 39

Investors like patterns, and recent past represents a nice, easy-to-find pattern that can become the basis for an investment decision. A fund that just had a great year, or a stock that has had a great recent run, can influence investors to pull the trigger based on the assumption that the recent past will repeat itself in the future, but they make this decision with little real research. The same holds true for broader trends. The problem is that while some tend to persist, others tend to revert to the mean, and there is no way to gauge which is more likely without doing research.

Question 40

Over-Weighting the Recent Past Example

Answer 40

An investor reads a study that says short-term mutual fund winners tend to persist. On that basis he decides to invest in several top funds from the prior year, and to revisit his holdings the following year. A few funds do well, but one collapses as its highly specific investment and aggressive style falls out of favor, leading to poor overall results.

Question 41

Self-Affirmation Bias

Answer 41

The belief that when something goes right, it is because you were smart and made the right decision. If it does not work out, it is someone else’s fault or simply bad luck.

Question 42

Spotting Trends That Are Not There

Answer 42

Investors seek patterns that help support decisions sometimes without adequate confirming research.

Question 43

Spotting Trends That Are Not There Example

Answer 43

When the NFC wins the Super Bowl is not a basis for an investment decision.

Question 44

Status Quo Bias

Answer 44

The tendency of investors to do nothing when action is actually called for.

Question 45

Status Quo Bias Example

Answer 45

None necessary, it is an everyday occurrence.