Behavioral Finance

Question 1

What are cognitive errors and emotional biases?

Answer 1

Cognitive errors: Result from faulty reasoning; heuristics (versus statistical), information processing, or memory errors.

Emotional biases: Result from an impulse or intuition to avoid pain and, to a lesser extent, to seek pleasure.

Cognitive errors are easier to correct than emotional biases.

Question 2

What is conservatism bias and its implications for financial decision making?

Answer 2

Conservatism bias: occurs when individuals fail to adequately update perceptions to reflect new information.
* assign greater weight to previous beliefs about probabilities and outcomes
* smaller weight to new information
* may fail to update a forecast with new information or maintain assumptions

Cognitive errors > Belief perseverance> Conservatism

Question 3

What is confirmation bias and its implications for financial decision making?

Answer 3

Confirmation (selection) bias: people notice what confirms their beliefs and ignore information that contradicts or could change their beliefs.
* consider only positive information about investments they like
* make errors in screening criteria
* hold too much company stock
* fail to diversify

Cognitive errors > Belief perseverance> Confirmation

Question 4

What is representativeness bias and its implications for financial decision making?

Answer 4

Representativeness bias: occurs when people classify new information based on previous experiences.
* people attempt a best fit into an existing classification.
* may use only new information or a small sample to update forecasts.
* avoid mental costs of understanding growth versus change

Cognitive errors > Belief perseverance> Representativeness

Question 5

What is base-rate neglect and sample-size neglect and their implications for financial decision-making?

Answer 5

Base-rate neglect: investors overreact to new information on a company without considering the underlying base probability for an event.

Sample-size neglect: investors draw a conclusion that the entire population resembles a very small sample.

Cognitive errors > Belief perseverance> Representativeness > Base-rate and sample-size neglect

Question 6

What is illusion of control bias and its implications for financial decision making?

Answer 6

Illusion of control bias: occurs when someone mistakenly believe they control outcomes. They may trade more than is prudent or under-diversify portfolios.

This occurs as the result of:
* familiarity
* tasks
* active involvement
* choices
* competition

Cognitive errors > Belief perseverance> Illusion of control bias

Question 7

What is hindsight bias and its implications for financial decision making?

Answer 7

Hindsight bias: individuals believe they could have predicted past events.
* overestimate their ability based on faulty memory of prediction skills.
* may also measure money managers against their memory versus their ex ante forecast

Cognitive errors > Belief perseverance> Hindsight bias

Question 8

What is anchoring and adjustment bias, and its implications for financial decision making?

Answer 8

Anchoring and adjustment bias: describes basing expected future outcomes on an unrealistic starting point.

They may cling to purchase points or GDP growth forecasts even when new information becomes available.

Cognitive errors > Information processing > Anchoring and adjustment bias

Question 9

What is mental accounting bias and its implications for financial decision making?

Answer 9

Mental accounting bias: results when investors assign different levels of importance to different “pots” of money.
* may treat money differently based on its source or the planned use for the money without regard to the overall portfolio
* can lead to high correlation among portfolios and under-diversifying

Cognitive errors > Information processing > Mental accounting

Question 10

What is framing bias and its implications for financial decision-making?

Answer 10

Framing bias: when they answer the same question differently depending on how it is asked.
* may misidentify risk tolerances
* may choose suboptimal investments
* may also trade too much due to short-term price fluctuations

Cognitive errors > Information processing > Framing

Question 11

What is availability bias and its implications for financial decision making?

Answer 11

Availability bias: occurs when people overestimate the probability of an event occurring based on the “availability” of their memory of the event.
* Recent events are much more easily remembered,
* may choose investments or limit an investment opportunity set based on advertising
* may fail to diversify properly
* overinvest in company stock
* invest in their own likes and dislikes

Cognitive errors > Information processing > Availability bias

Question 12

List the 4 types of availability bias.

Answer 12

1. Retrievability
2. Categorization
3. Narrow range of experience
4. Resonance

Question 13

Define emotional biases.

Answer 13

Emotions are mental states that arise whether people want them to or not, and may be very difficult or impossible to control.

Emotional biases, then, may be harder to control because they and may often be a matter of adapting to the effects of emotional biases.

Question 14

What is loss-aversion bias and its implications for financial decision making?

Answer 14

Loss-aversion bias: occurs when investors make decisions designed to avoid losses rather than to seek gains.
* hold losers even if they have no chance of recovering
* sell winners too soon
* may also engage in over-trading to sell winners, which reduces portfolio return
* may hold riskier portfolios due to holding losers

Emotional bias > Loss-aversion bias

Question 15

What is overconfidence bias and its implications for financial decision making?

Answer 15

Overconfidence bias: occurs when people have too much faith in their intuition, reasoning, or judgment because they have overestimated their access to knowledge or take credit for their own successes and assign responsibility for failures.
* may underestimate risk
* overestimate returns
* under-diversify
* trade excessively
* experience lower returns than the market.

Emotional bias > Overconfidence bias

Question 16

What is self-control bias and its implications for financial decision making?

Answer 16

Self-control bias: occurs when FMPs fail to support their long-term goals with short-term behavior.
* under-save for the future
* may accept too much risk in exchange for higher return
* may prefer income-producing investments that often have lower return

Emotional bias > Self-control bias

Question 17

What is status quo bias and its implications for financial decision making?

Answer 17

Status quo bias: Individuals prefer not to change, especially if no problem is apparent, even when they could better meet their goals.
* maintaining suboptimal portfolios
* failure to seize opportunities

Emotional bias > Status quo bias

Question 18

What is endowment bias and its implications for financial decision making?

Answer 18

Endowment bias: confers additional value to something owned or inherited.
* tend to set a sales price for a good higher than the price at which they would purchase it
* can result in suboptimal asset allocation as the endowed asset remains in the portfolio

Emotional bias > Endowment bias

Question 19

What is regret aversion bias and its implications for financial decision-making?

Answer 19

Investors avoid decisions for fear they will turn out poorly; they wish to avoid potential regret associated with their choices.
* too little portfolio risk for fear of negative outcomes.
* may also prefer popular investments (“herding”).

Emotional bias > Regret aversion bias

Question 20

Explain the uses and limitations of classifying investors into personality types.

Answer 20

Classifying investors into personality types may allow advisors to better understand their likely behavioral biases before making investment decisions.

Unfortunately, no exact diagnosis can be made for any investor. Also, investors may display multiple types, and these may change over time.

Question 21

Discuss how behavioral factors affect advisor-client interactions.

Answer 21

Behavioral finance allows advisors to better bond with clients by understanding why they set the goals they do before implementing a plan. Advisors using a behavioral approach better understand what clients expect.

All of this improves the advisor’s professional image and increases trust, possibly helping to retain clients.

Question 22

What is inertia and default biases and thier influence portfolio construction?

Answer 22

Rather than change asset allocations over time, investors instead retain the same allocation regardless of circumstances (inertia) or make no allocation to risk assets (default).

Question 23

How can target funds can be used to counteract inertia and default biases?

Answer 23

To counteract inertia, plans with an “autopilot” strategy, such as target date funds, allow asset selection and allocation to change automatically based upon the time to stated retirement.

Question 24

What is naïve diversification and “investing in the familiar” influence portfolio construction?

Answer 24

Investors use the 1/n allocation, n being the number of available investment options. Other studies indicate a conditional 1/n strategy in which investors select investments and then invest equally.

Question 25

How do behavioral factors regarding company stock influence portfolio construction?

Answer 25

Overallocation results from:
* Familiarity
* Overconfidence
* Representativeness
* Framing
* Status quo effects
* Loyalty to the employer
* Company stock option in retirement plans

Inertia and default may cause participants to retain the holding when they could sell.

Question 26

How do behavioral factors in individual trading influence portfolio construction?

Answer 26

Individual investors may suffer from too much trading:
* Disposition effect: Selling winners too early
* Fear of regret: keeping losers

Excessive trading also generates high trading costs, which further reduces return.

Question 27

How do behavioral factors in international selection influence portfolio construction?

Answer 27

Investors tend to overrepresent domestic issues in their portfolios, which could indicate:
* availability
* confirmation
* illusion of control
* endowment
* status quo biases

Question 28

How can behavioral finance can be applied to the process of portfolio construction using behavioral portfolio theory?

Answer 28

Behavioral portfolio theory describes how investors build portfolios in layered pyramids of investments corresponding to goals, rather than as one portfolio of all their assets.

The investor has different risk and return criteria for each layer but may fail to consider correlations among layers.

Question 29

How does overconfidence affects analyst forecasts?

Answer 29

Analyst forecasts may be stated with false precision due to overconfidence bias.

This can stem from illusion of knowledge and illusion of control, and be reinforced by self-attribution bias and hindsight bias.

Question 30

Recommend remedial actions to counteract overconfidence bias.

Answer 30

Analysts should receive prompt, accurate, and well-structured feedback to counteract overconfidence bias.
* Feedback from systems, colleagues, or superiors provides the best recalibration.
* Incentive structures should reward forecast accuracy.

Question 31

How does framing, and anchoring and adjustment affect analyst forecasts?

Answer 31

Analysts often rely on company management for insight to earnings estimates.

Management may:
* Frame their current outlook in the context of past successes
* Provide overconfident pro forma results that remove nonrecurring costs
* Self-attribution bias may lead to overstate prospects

Question 32

Recommend remedial actions to counteract framing, and anchoring and adjustment biases.

Answer 32

Analysts should:
* Properly frame potential results in the context of underlying base rates.
* Focus on specific, measurable forecast items rather than descriptive, unverifiable items.

Question 33

Discuss how behavioral biases affect how analysts conduct research.

Answer 33

Analysts collecting too much information may engage in illusions of knowledge and control, which can lead to overconfidence and representativeness biases.

Analysts may fail to properly consider or give proper weight to evidence that conflicts with the story (confirmation bias).

Analysts may endow financially strong companies with price growth even though the price is already high.

Question 34

Recommend remedial actions to counteract biases in how analysts conduct research.

Answer 34

Analysts should:
* Research the target using publicly available information and seek contrary facts and opinions.
* Prepare questions to ask management based on this initial research.
* Assign probabilities to scenarios they develop and use a Bayesian approach to eliminate unlikely scenarios and quickly update forecasts.

Question 35

How does behavioral factors affect investment committee decision making, and recommend techniques for mitigating their effects?

Answer 35

Individuals within a group remain subject to their biases but also have the risk of wrongly accepting and following peer judgments (social proof).

Committee members may unthinkingly follow a strong leader’s opinion in the face of contrary information and beat down opposing views.

Question 36

Recommend techniques for mitigating the effect of behavioral factors on investment committee decision making.

Answer 36

Promote opinion diversity by including members with different backgrounds and experiences who are willing to think independently and express their opinions.

The chairperson should create an environment that:
* fosters opinion diversity
* stick to an agenda
* ensure clear decisions after the committee reaches a decision
* may require collection before the meeting

Question 37

Describe how behavioral biases of individuals can create momentum.

Answer 37

Momentum may be caused by anchoring on a purchase price and selling winners before they go down to avoid regret (hindsight bias), especially during volatile markets. Investors also buy investments that outperformed in the previous period, reinforcing the trend.

Bubbles and crashes represent extreme examples of momentum.

Question 38

Describe how behavioral biases of individuals can lead to bubbles and crashes.

Answer 38

Bubbles form slowly, with managers exhibiting illusion of control bias that they can exit at the right time.

Crashes may unwind slowly at first as managers experience cognitive dissonance, fail to update expectations, and then attempt to rationalize poor decisions. Crashes then accelerate quickly as managers try to avoid getting caught out of the herd.

Question 39

Describe how behavioral biases of individuals explain the growth premium.

Answer 39

Although traditional finance theory suggests positive correlation between return and risk, investors act as if the correlation is negative. Growth stocks tend to receive a price premium that may be based on the halo effect (representativeness); that is, managers expect continued good earnings and growth.