Behavioral Finance Flashcards
Compare and contrast cognitive errors and emotional biases.
Cognitive errors: result from the inability to analyze information or from basing decisions on partial information. Individuals try to process information into rational decisions, but they lack the capacity or sufficient information to do so. Cognitive errors can be divided into belief perseverance errors and processing errors.
Emotional biases: are caused by the way individuals frame the information and the decision rather than the mechanical or physical process used to analyze and interpret it. Emotional bias is more of a spontaneous reaction.
Identify and evaluate an individual’s behavioral biases.
Cognitive Errors: Belief Perseverance
* Conservatism bias.
* Confirmation bias.
* Representativeness bias.
* Control bias.
* Hindsight bias.
Cognitive Errors: Information Processing
* Anchoring and adjustment.
* Mental accounting bias.
* Framing bias.
* Availability bias.
Emotional Biases
* Loss aversion bias.
* Overconfidence bias.
* Self-control bias.
* Status quo bias.
* Endowment bias.
* Regret-aversion bias.
Conservatism Bias
Cognitive
Impact: Slow to react to new information or avoid the difficulties associated with analyzing new information. Can also be explained in terms of Bayesian statistics; placing too much weight on base rates.
Mitigation: Look carefully at the new information itself to determine its value.
Confirmation Bias
Cognitive
Impact: A bias of individuals to focus on information that supports their views, while ignoring or downplaying information that contradicts their beliefs. Can lead to too much confidence in an investment and to overweighting it in a portfolio.
Mitigation: Actively seek out information that seems to contradict your opinions and analyze it carefully. Obtain more information to support your views.
Representativeness Bias
Cognitive
Impact: A belief perseverance bias resulting in people interpreting new information based on past experiences. Placing too much emphasis on a perceived category of new information. Likely to change strategies based on a small sample of information.
Mitigation: Consciously take steps to avoid base rate neglect and sample size neglect. Consider the true probability that information fits a category. Use the Periodic Table of Investment Returns, and hold a well-diversified portfolio.
Illusion of Control Bias
Cognitive
Impact: A belief that individuals can influence outcomes that are outside of their control. The illusion of control over one’s investment outcomes can lead to excessive trading with the accompanying costs. Can also lead to concentrated portfolios.
Mitigation: Seek opinions of others. Maintain a long-term perspective and recognize that many factors are outside of your control. Keep records of trades to see if you are successful at controlling investment outcomes.
Hindsight Bias
Cognitive
Impact: The probabilities of past events that have occurred are seen as more certain than they actually were, with hindsight. Overestimating the accuracy of forecasts and taking too much risk.
Mitigation: Keep detailed record of all forecasts, including the data analyzed and the reasoning behind the forecasts. Recognize your past mistakes honestly and try to learn from them.
Anchoring and Adjustment Bias
Cognitive
Impact: Failure to properly update an initial outcome, estimate, or probability (the anchor) for new information. Tendency to remain focused on and stay close to original forecasts or interpretations.
Mitigation: Give new information thorough consideration to determine its impact on an original forecast or opinion.
Mental Accounting Bias
Cognitive
Impact: Caused by treating equal-sized monetary amounts differently according to the mental account it is assigned to. Portfolios tend to resemble layered pyramids of assets. Subconsciously ignoring the correlations of assets. May consider income and capital gains separately rather than as parts of the same total return.
Mitigation: Look at all investments as if they are part of the same portfolio to analyze their correlations and determine true portfolio allocation. Focus on total return rather than income or price appreciation in isolation.
Framing Bias
Cognitive
Impact: A bias where a person answers a question differently depending on how it is framed (asked). This is particularly evident when questions are framed in terms of gains or losses. A narrow frame of reference; individuals focus on one piece or category of information and lose sight of the overall situation or how the information fits into the overall scheme of things.
Mitigation: Investors should focus on expected returns and risk, rather than on gains or losses. That includes assets or portfolios with existing gains or losses. Investors should focus on whether they are framing decisions as gains or losses and be aware of the impact of loss aversion on their willingness to take risk.
Availability Bias
Cognitive
Impact: An information processing bias where the probability of an outcome is affected by how easily the outcome comes to mind. The four causes are retrievability, categorization, narrow range of experience, and resonance. Selecting investments based on how easily memories are retrieved and categorized. Narrow range of experience can lead to concentrated portfolios.
Mitigation: Develop an investment policy statement (IPS) to promote long-run focus and construct a suitable portfolio through diligent research.
Loss Aversion Bias
Emotional
Definition: A tendency to prefer the avoidance of losses over achieving gains. Results from a bigger decrease in utility caused by a loss relative to an increase in utility caused by a similar-sized gain.
Impact: Focusing on current gains and losses. Continuing to hold losers in hopes of breaking even. Selling winners to capture the gains.
Mitigation: Perform a thorough fundamental analysis. Overcome the mental anguish of recognizing losses.
Overconfidence Bias
Emotional
Impact: Caused by individuals’ unwarranted belief in their own skill and reasoning. Holding under-diversified portfolios; underestimating the downside while overestimating the upside potential. Trading excessively.
Mitigation: Keep detailed records of trades, including the motivation for each trade. Analyze successes and losses relative to the strategy used.
Self-Control Bias
Emotional
Impact: Lacking self-discipline to balance short-term gratification with long-term goals. Tendency to try to make up the shortfall by assuming too much risk.
Mitigation: Maintain complete, clearly defined investment goals and strategies. Budgets help deter the propensity to over-consume. Asset allocation focused on achieving long-term goals and a savings plan should be implemented.
Status Quo Bias
Emotional
Impact: A bias where individuals’ familiarity and comfort in the current status quo result in reluctance to make changes. Risk characteristics of the portfolio change. Investor loses out on potentially profitable assets.
Mitigation: Education about risk and return and proper asset allocation. Difficult to mitigate.