Behavioral Finance Flashcards
Heuristic
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 (e.g. rules of thumb, educated guess)
Anchoring
Investor sets value at the initial point of information (e.g. buy price)
Prospect Theory
Suffer more from losses than benefit from gains
Recency bias
Makes investor focus more on the most current events, leading to faulty predictions that this is always how it will be
Overconfidence
Leads investors to overestimate their knowledge, underestimate risks and exaggerate ability to control events and predict outcomes.
Factors leading to overconfidence: choice, task familiarity, information, active involvement, past success
Disposition Effect
People seek pride and avoid regret.
Sell winners to quickly and hold losers too long
House Money Effect
Take more risk
Snakebite Effect
Take less risk
Break-evenitis
Take more risk
Mental Accounting
Leads to naive diversification (e.g. the assumption that simply investing in enough unrelated assets will reduce risk sufficiently to make a profit)
Home Bias
Familiarity with something leads to stock concentration (e.g. Blair and Shell holding %)
Herd Mentality
Natural bias to follow the crowd and invest how others are
Optimism
Leads to exuberance, which can lead to market bubbles
Attachment Bias
Holding onto an investment for emotional reason rather than considering more practical applications for the inheritance (eg Anita with parent’s investments)
Cognitive Dissonance
The challenge of reconciling two opposing beliefs
Confirmation Bias
Natural human tendency to accept any information the confirms our preconceived position or opinion and to disregard any information that does not support that preconceived notion.
Diversification Errors
Investors tend to diversify evenly across whatever options are presented to them
Fear of Regret
Tendency to take no action rather than risk making the wrong one
(Mom and Ray with investments)
Gambler’s Fallacy
An individual erroneously believes that the onset of certain random event is likely to happen following an event or a series of events (e.g. after falling on black for 5 turns, believing the ball will land on red)
Hindsight Bias
The 20/20 vision we have when looking at a past event and thinking we understand it, when in reality we may not
Inappropriate Extrapolation
Tendency to look at recent events (or market performance) and assume that those events or conditions will continue indefinitely
Mental Accounting
Entails looking at sums of money differently; depending on their source or intended use
Outcome Bias
Tendency to make a decision based on the desired outcome rather than on the probability of that outcome
Overreaction
Investors emotionally react towards new market information
Self-Affirmation Bias
Belief that when something goes right, it’s because you’re smart and you made the right decision. But if it doesn’t work, it’s because of someone else or bad luck.
Spotting Trends That Are Not There
Investors seek patterns that help support decisions sometimes without adequate confirming research
Status Quo Bias
Tendency of investors to do nothing when action is actually called for.
Economic and Resource Approach
Financial planner is an agent of change. The focus is on obtaining and analyzing quantitative data, such as cash flow, assets, and debt.
Classical Economics Approach
Clients choose among alternatives based on objectively defined cost-benefit and risk-return trade offs. The belief is that increasing financial resources or reducing financial expenditures results in improved financial outcomes.
Strategic Mgmt Approach
A clients goals and value drive the client-planner relationship. Conducting a SWOT analysis is done early in the FP process. The financial planner serves as a consultant.
Cognitive-Behavioral Approach
Clients’ attitudes, beliefs, and values influence their behavior. Planners using this approach attempt to substitute negative beliefs that lead to poor financial decisions with positive attitudes, which should result in better financial results.
Endowment Bias
Valuing an asset more when you own it than when you don’t.
Framing Bias
You answer/solve a question based on how it was presented to you.
Conservatism Bias
Maintaining your previous views by not including new contradicting information.
Illusion Control Bias
Thinking you can control/affect an outcome when you really cannot.
Self-Control Bias
Opting to short-term satisfaction over long-term goals.
Representative Bias
Urge to categorize new information based on previous experiences.
Halo Effect
One’s own impression of a person (e.g. looks, clothes, etc.) impacts judgements, thus align with more visually appealing persons and opinions.
Extension Neglect Bias
Refers to a very small sample sizes that are extended well beyond the reason for interpolation. This bias is often seen in clients with limited experience.
Dunning-Krueger Effect
Overconfidence of a person in their abilities
Baader-Meinhof Phenomenon
Awareness of a particular item or action that makes it seem much more prevalent than it actually is
Backfire Effect
Idea or argument has the opposite impact than intended
Bounded rationality
Making a good but not perfect decision based upon imperfect info, often with a trade off btwn convenience and excellence
Homo Economicus
Theoretical human that rationally and coldly calculates based upon perfect information to make optimal decisions
A rational, perfect allocation between various investments in a portfolio regardless of emotion aligns with what bias?
Homo Economicus
“Econ = rational”
Zero-sum theory
One’s gain or loss is balanced exactly by another’s gain or loss
Game theory
Study of strategy decisions
Baader-Meinhof phenomenon
Aka Frequency Illusion
Where an event that is discussed is noticed more after the discussion thereof, and as such, action to purchase life insurance increases in times of very visible events such as 9/11 and COVID
Why would an investor be slow to sell and underlying stock?
Confirmation bias
