Behavioral Finance

Question 1

What is the adaptive market hypothesis?

Answer 1

Thesis: markets evolve over time as individuals use numerous evolutionary heuristics and biases to make decisions.

Conclusions and results:
Opportunities for arbitrage
Value in quantitative, fundamental & technical strategies
Survival is primary objective; profit and utility is secondary
Innovation is key to survival and growth 

Question 2

What are the six biases based on ‘Existing Beliefs’

Answer 2

RICCCH

Representative bias
Illusion of control bias
Cognitive dissonance
Conservative bias
Confirmation bias
Hindsight bias

Question 3

Which bias is described as: confusion, or frustration that arises when an individual receives new information that does not match up with, or conform to pre-existing beliefs or experiences.

Answer 3

Cognitive dissonance

People may rationalize their choices, even when faced with facts that demonstrate that they made poor decisions.

Cognitive dissonance can cause investors to hold losing Security, positions that they otherwise with sell because they want to avoid the mental pain associated with admitting that they made a bad decision.

Cognitive dissonance can cause investors to get caught up in herds of behavior that is people avoid information that counters in earlier decision

Cognitive dissonance can cause investors to believe it’s different this time.

Question 4

Which bias is describes when people cling to their prior views, or forecast at the expense of acknowledging new information; individuals are inherently slow to change.

Answer 4

Conservatism Bias

Conservativism bias occurs when people maintain their prior views, or forecast by inadequately incorporating new information. Investors often under react to new information and fail to modify their beliefs and actions.

Conservative buyers can cause investors to cling to a view
or forecast, behaving inflexibly when presented with new information.

Conservatism biased, investors often react to new information to slowly

Conservatism can relate to an underlying difficulty in processing new information because people experience mental stress when presented with complex data, and an easy option is to simply stick to a prior belief. 

Question 5

What existing beliefs bias can be described as: when people observe, overvalue, or actively seek out information that confirms what they believe, while ignoring or devaluing information that contradicts their beliefs.

Answer 5

Confirmation bias

Conservatism bias occurs when people maintain their prior views are forecast by inadequately, incorporating new information. Investors often under reacting new information and fail to modify their beliefs and actions.

Confirmation bias can cause investors to:

Continue to hold under diversified portfolio’s. These clients do not want to hear anything negative about favorite investments, but rather see single minutely confirmation that the position will pay off.

Can cause employees to over concentrate and Company stock.

Question 6

What bias is described as: a cognitive bias, where people believe they can control or influence investment outcomes, when in reality they cannot? 

Answer 6

Illusion of Control Bias

Illusion of control bias, contributes in general to investor, overconfidence investors, who have been successful in business or professional pursuits, believe that they should also be successful in the investment realm.

Illusion of control bias can lead investors to:
Trade more than is prudent

Maintain under diversified portfolios

Use limit orders and other techniques in to experience a false sense of control.

Question 7

Which bias can be described as: a cognitive bias, through which individuals process new information, using pre-existing ideas or beliefs; an investor views, a particular situation, or information a certain way, because of similarities to other examples, even if it does not really fit into that category?

Answer 7

Representativeness bias

Occurs as a result of a flawed perceptual framework.

(Ex. Stereotypes of people , placed or things)
The gamblers fallacy is often cited as an example of representativeness bias. This fallacy refers to the commonly held belief that luck, whether in the casino or in the stock market runs in streaks. No scientific proof, however, underlies or enforces this belief.

Question 8

This policy refers to the commonly held belief that luck weather in the casino, or in the stock market runs in streaks.

Answer 8

Gamblers fallacy

Question 9

This cognitive bias is where investors perceive investment outcomes, as if they were predictable, even if they were not.

Answer 9

Hindsight bias

Sometimes gives investors, a false sense of security when making investment decisions, leaving them to excessive force taking

Hindsight bias, investors, rewrite history when they fare poorly and blocked out recollections of prior, incorrect, forecast in order to alleviate embarrassment

Hindsight bias investors can unduly fault their money managers when funds perform poorly.

Hindsight bias can cause investors to unduly praise money managers when funds perform well.

Question 10

What are the seven biases based on information processing?

Answer 10

AM SO FAR

Anchoring
Mental accounting
Self attribution bias
Outcome bias
Framing bias
Availability bias
Recency bias

Question 11

A cognitive bias where investors are influenced by purchase point or arbitrary price levels and cling to these numbers when deciding to buy or sell.

Answer 11

Anchoring bias

Investors tend to make general market forecast that are too close to current levels. Tend to stick too closely to their original estimates.

Question 12

This is a cognitive bias, in which individuals treat various sums of money differently, based on where these monies are mentally categorized.

Answer 12

Mental accounting

Can cause people to imagine that their investments occupy separate buckets or accounts.

Can cause investors to succumb to the “house money“ effect, where risky behavior escalates as wealth grows. Investors with this rationale, failed to treat all money as fungible (replaceable or interchangeable)

Can cause investors to irrationally distinguish between returns, derived from income and those derived from capital appreciation.

Can cause investors to allocate assets differently when employer stock is involved

Can cause investors to hesitate to sell investments that once generated significant gains, but have now fallen in price

Question 13

What is the self attribution bias?

Answer 13

It’s an information, processing bias, where people ascribe success to their talents and blame failures on outside influences.

Self attribution investors can believe that their success is due to their acumen rather than to factors out of their control. This can lead to too much risk, taking as investors become too confident in their own skill.

Often leads investors to trade more than is prudent.

Leads investors to “hear what they want to hear“.

Can cause investors to hold on diversified portfolios, especially when the investor attributes the success of a company’s performance to their own contribution.

Question 14

What is outcome bias?

Answer 14

Where people often make decisions based on the outcome of past events, rather than observing the process through which the outcome occurred. (how the returns were generated, or why they should be investing in that asset class.

Investors may invest in funds that they shouldn’t because their focus on the outcome of a prior action, such as a performance record of a manager, of rather than on the process by which the manager achieved the results. This may cause investors to take on excessive risk if the source of the performance was a risky strategy.

Investors may avoid a manager based on a bad outcome while ignoring the potentially sound process by which the manager made the decision

May lead investors to invest in overvalued asset classes based on recent outcomes.

Question 15

This cognitive bias is where an individual responds to similar situation differently, based on the context in which the choices presented.

Answer 15

Framing bias

The use of risk tolerance questionnaire is provides a good example.

The optimistic or pessimistic manner in which an investment or asset allocation, recommendation is framed, can affect peoples willingness to invest.

Narrow framing can cause even long-term investors to obsess over short term price fluctuations. This can result in excessive trading.

Framing and loss aversion can work together to explain, excessive risk aversion.

Question 16

A cognitive bias, where outcomes are perceived as being more likely than those that are harder to recall or understand.

Answer 16

Availability bias

Occurs when people use a rule of thumb to estimate the likelihood of an outcome based on how easily it comes to mind.

As an example, suppose an investor is asked to identify the best mutual fund companies. Most would perform a Google search and find funds from firms that heavily advertise — such as Fidelity or Schwab.

Retrieve ability – choosing investments, based on information is available to them, and not engaging and discipline, research or due diligence.

Categorization — choosing investments, based on categorical list that they have available in the memory.

Narrow range of experience —investments that fit, narrow ranges of life experience.

Resonance— choosing investments that resonate with personality, or have characteristics that investors can relate to. Ignore potentially good investments because I can’t relate to it.

Question 17

What is recency bias?

Answer 17

An information processing bias, where people more easily recall and emphasize recent events, and often extrapolate patterns and make projections based on this historical data that is too small to ensure accuracy.

Can cause investors to purchase at Price peaks and enter asset classes at the wrong time.

Investors, ignore fundamental value and focus only on recent upper price performance.

Causing investors to think “it’s different this time“.

Ignore proper asset allocation.

Question 18

What are the seven biases based on emotions?

Answer 18

OARLESS

Overconfidence bias
Affinity bias
Regret aversion
Loss aversion
Endowment bias
Self control bias
Status quo bias

Question 19

What is the hypothesis that giving people more choice does not increase performance or satisfaction?

Answer 19

The paradox of choice

Question 20

An emotional bias that displays unwarranted faith in one’s own thoughts and abilities.

Answer 20

Overconfidence bias

Often, overconfident investors don’t even know that they are excepting more than they would, or should normally tolerate

They overstate their ability to evaluate a company as a potential investment, can trade excessively, don’t heed historical investment performance, statistics, can underestimate the downside

ODEAN and barber showed that after trading cost, but before taxes, the average investor under perform the market by 2% per year, due to unwarranted belief in their ability to assess the correct value of investment.

Question 21

What is affinity bias?

Answer 21

When individuals make irrational decisions or choices, based on how they believe a certain product or service will reflect their values.

An emotional bias that can cause investors to invest in products or services or companies that reflect or E.S.G. values without examining the soundness of the investment.

Can cause investors to have home country bias and invest in sophisticated investments as a status symbol.

Question 22

This emotional bias causes people to avoid making decisions, or taking action, because they’re afraid that they’ll make a mistake; or that their decision will prove less than optimal.

Answer 22

Regret aversion bias

Can cause investors to be too conservative. This behavior can lead to long-term under performance and can jeopardize investment goals.

Can lead investors to prefer stocks of subjectively designated, good companies, even when an alternative stock has an equal or higher, expected return.

Regret averse investors may feel that “riskier“ companies require bolder, decision making, so if the investment fails, it will be due to individuals poor judgment.

Regret aversion can cause investors to hold onto winning stocks, too long because they might miss out on further gains.

Can cause investors to hold onto losing positions too long because they don’t like admitting when they’re wrong

Can cause hurting behavior. FOMO.

Question 23

This emotional bias can be described as: pain of loss is roughly twice as painful as the pleasure of gain, a core tenant of prospect theory.

Answer 23

Loss aversion bias

Prevents people from unloading unprofitable investments, even when they see no prospect of a turnaround known as “get even -itis“

“Sunk cost fallacy“

Cause investors to hold onto losing investments, too long and sell winners too early in the fear that their profits will evaporate unless they sell

Can cause investors to unknowingly take on more risk, and to hold on balance portfolios.

Question 24

What is sunk cost fallacy?

Answer 24

When investors continue to hold an investment and even double down because of the time, effort and energy, they have already invested. They are emotionally tied to their initial choice.

This policy is often tied back to loss aversion, anchoring and status quo biases

Question 25

What is get even -itis

Answer 25

A behavioral biases, where investors will often hold losing investments, hoping that the value will rise back to their point their purchase price before selling it. They do so in an effort to prevent realizing a loss.

Question 26

This emotional bias is when people tend to value an object more when they actually hold our own it; discounting the value of objects they do not currently possess.

Answer 26

Endowment bias

When a person assigns greater value to an object that they own and may lose, compared to an object of the same value that they do not own and have the potential to gain.

Influences investors to hold onto securities that they have inherited or purchased regardless of if it’s financially wise.

“Decision paralysis“ – places an irrational premium on the compensation price demanded in exchange for an endowed asset.

Question 27

Emotional bias, where human tendency is to focus on instant gratification, due to a lack of discipline, consequently, failing to act in the best interest of long-term goals.

Answer 27

Self control bias

Can cause investors to lose sight of basic financial principles, such as compounding dollar cost averaging.

And cause investors to spend more today at the expense of saving for tomorrow. Fail to plan for retirement.

No preference for income producing assets due to a “spend today“ mentality can cause asset allocation imbalance problems.

Question 28

And emotional bias, that predisposes people to select the option that keeps conditions the same.

Answer 28

Status quo bias

Demonstrated by investors that have been doing things a certain way for many years. Can cause investors to not hear the advice of new advisers.

Can cause an action, holding inappropriate investments.

Question 29

What are seven additional popular, behavioral biases?

Answer 29

Sunk cost fallacy
Get even-itis
Disposition effect
Snake bit affect
House, money effects
Ambiguity bias
Optimism bias

Question 30

A behavioral bias, in which investors typically hold onto losing investments too long and sale winning investments too early.

Answer 30

Disposition affect

Related to loss, aversion bias, and snake bit effect.

Question 31

Even when investors, feel skillful or knowledgeable, they may not be willing to stake claims on ambiguous investments like stocks, even when they believe they can predict these outcomes based on their own judgment.

Answer 31

Ambiguity bias

Question 32

What are the five Bailard, Biehl and Kaiser model personality types?

Answer 32

Adventurer – people willing to put it all on one bet because they have confidence. Often difficult to advise. Willing to take risk and her by volatile clients from an investment counselor point of you.

Celebrity – FOMO don’t have their own ideas about investments.

Individualist – tend to go there on the way, or typified by small business owners, and professionals, such as lawyers, engineers, or CPAs. Have a careful way of going about things, a degree of confidence, methodical, and analytical. The dream client, a rational investor, with whom the portfolio manager can talk sense.

Guardian – people approaching retirement. They’re careful and worried about their money. They recognize that they have a limited time and want to preserve their assets. Not interested in volatility, lack confidence in their abilities, and look for guidance.

Straight arrow – the average investor displays a little bit of each type of investor. Willing to be exposed to medium amount of risk.

Question 33

What are the four Pompian client, personality types?

Answer 33

Preservers – passive investors, who put a great deal of emphasis on financial security, and preserving wealth. Similar to guardian, personality type.

Followers – follow the crowd. similar to celebrity personality type.

Independence – medium to high risk tolerance, strong, willed, independently, minded, thinker, self-assured, and trust their own instincts. Similar to individualist personality type.

Accumulator – active investor. Actively involved in their wealth creation typically risking their own capital in achieving their wealth objectives. Similar to adventurer personality type