Behavioral Finance Flashcards
Cognitive Errors
- The way the brain functions, processes, and files information, forms memories or makes judgments
- Stem from faulty reasoning.
- Can moderate through education, better information, and advice.
- Can be thought of as blind spots
Emotional Biases
- Related to emotional, motivational, and social influences, or to human needs.
- Arise from impulse, intuition, and spontaneity
- Related to feelings, perceptions, or beliefs
- We must adapt to them.
Belief perseverance biases
Cognitive Errors: Holding on to previous irrational and illogical beliefs
1. Conservatism
2. Confirmation
3. Representativeness
4. Illusion of control
5. Hindsight
Information processing errors
Cognitive Errors: Misusing and the irrational or wrongful processing of information
1. Anchoring and adjustment
2. Mental accounting
3. Framing
4. Availability
Conservatism Bias
- Fails to adequately update perceptions to reflect new information.
- Assign greater weight to previous beliefs and smaller weights to new information.
Recommended solution:
* Be aware that a bias exists.
* React & conduct analysis to new information, avoid retaining old information
Confirmation Bias
People notice what confirms their beliefs and ignore information that contradicts
Recommended solution:
* Common among all participants.
* Seek out information that challenges their beliefs.
* Gather and process both negative and positive information
Illusion of Control Bias
- Believes more control over a situation than they actually have
- Occurs as the result of familiarity, tasks, active involvement, choices, or competition
Recommended solution:
* Acknowledge there is very little control global investing
* Searching for contrary opinions on what might go wrong
Representativeness Bias
- Classify new information based on previous experiences.
- Attempt a best fit into an existing classification
- Base-rate neglect: overreact to new information without considering the probability.
- Sample-size neglect: draw a conclusion that the entire population is similar to a small sample.
Recommended solution:
* Recognize the tendency of relying on patterns rather than determining probabilities.
* Should use an asset allocation strategy and the principles of diversification
Hindsight Bias
- Perceive past events as having been predictable
- Fixate on facts that reinforce their preconceived ideas rather than attempting to learn from what actually happened.
Recommended solution:
* Education is important
* Objectively reflecting on their mistakes and carefully recording their reasons for making investment decisions.
Anchoring and Adjustment Bias
- Base initial forecast on some past experience (anchor) and adjust that estimate with new information
- Expected outcome is disproportionately determined by the starting point (anchor) of the estimate.
Recommended solution:
* Should ask themselves if they are giving irrational weight to a point?
* Historical prices, market performance, and previous reputation have little if no correlation with future investment potential.
Mental Accounting Bias
- Investors assign different levels of importance to different “pots” of money and may treat money differently based on its source
- May fail to optimize their overall portfolio by holding conflicting positions
Recommended solution:
* Can detect by looking at their investments as a single portfolio.
* May identify if cash balances among the layers are higher than necessary
Framing Bias
- Answering the same question differently depending on how it is asked.
- Narrow framing: Occurs when people use some information but not the complete picture
Recommended solution:
* Focus on future investment prospects, than ones that already occurred.
* Keep a neutral outlook in investment selection.
Availability Bias
- Overestimate the probability of an event occurring based on the “availability” of their memory of the event (how easily it comes to mind).
- Recent events are much more easily remembered, as are events in which we personally participate.
Recommended solution:
* Use criteria other than easy recall should be used in selecting an asset allocation approach, choosing investments, and building a portfolio.
* Investment policy statement, carefully research and analyze investments, and focus on long-term results.
4 Types of Availability Bias
- Retrievability: People tend to place more importance on things and events they remember.
- Categorization: Estimates of probability for an event may become biased when an idea cannot be easily categorized into a search set.
- Narrow range of experience: People tend to overestimate the probability of something they experience personally and project that estimate onto the rest of the world.
- Resonance: People often overestimate the number of “like-minds” when it comes to activities they enjoy while underestimate the number when it comes to activities they dislike.
Emotional Biases
- Loss-aversion bias
- Overconfidence bias
- Self-control bias
- Status quo bias
- Endowment bias
- Regret-aversion bias
Loss-Aversion Bias
- Investors make decisions designed to avoid losses rather than to seek gains.
- Disposition Effect: Investors will hold losing positions and cash out of winning positions.
- Myopic loss aversion: Views short-term losses as painful and make adjustments that might be detrimental to their long-term goals.
Recommended solution:
* Consider the probabilities of gains/losses over the time horizon.
* Fundamental analysis can provide a disciplined way
Status Quo Bias
- Change is often uncomfortable and if no problem is apparent they will prefer not to make changes that could optimize outcomes.
- Fail to explore alternatives, rather than make any attempt to further improve their situation.
Recommended solution:
* Education is a key
* Be proactive
* Diversification
* Proper asset allocation
Overconfidence Bias
- Overestimate knowledge, abilities, or access to information and have too much faith in their intuition, reasoning, or judgment.
- Will tend to underestimate risk and overestimate expected returns.
Examples include:
* Illusion of knowledge bias
* Self-attribution bias
Recommended solution:
* Investors will remember the winners and discount the losers.
* Keep proper records of the justification for each investment
Self-Control Bias
- Fail to support their long-term goals with short-term behavior.
- Hyperbolic Discounting: Trade small payoffs in the present against larger payoffs in the future.
- Recommended solution: A carefully written financial plan
Endowment Bias
- Attach more value to the assets they own or inherited than assets they do not own.
- A rational investor would expect to sell something for about the same price they would be willing to purchase it.
- Recommended solution: Assist by showing how an objectively determined asset allocation differs from the current portfolio allocation.
Regret Aversion Bias
- Resist situations that require a decision for fear of a negative outcome.
- Wish to avoid potential regret associated with their choices.
The two dimensions of regret are:
* Errors of commission: Regret from actions taken
* Errors of omission: Regret from actions not taken
Recommended solution:
* Will cause to accept too much or too little risk
* Educate on the proper asset allocation for their determined risk level.
Five-Way Model (BB&K)
- Adventurer: Confident in decisions and willing to take chances, reluctant to accept advice.
- Celebrity: Center of attention who holds some opinions; knows their limitation.
- Individualist: Independent and confident by nature; makes decisions after careful analysis.
- Guardian: Cautious and concerned about the future; May seek professional advice.
- Straight arrow: Sensible and secure, is willing to accept risk commensurate with a normal return.
Behavioral Investment Types (BITs)
- Passive Preservers: Focus on security and wealth preservation.
- Friendly Followers: May have confidence that encourages them to accept greater risk than their regret aversion will allow.
- Independent Individualists: Likely to be contrarian, resist following a plan, and are comfortable taking risks; they will listen to advice if presented in a respectful way.
- Active Accumulators: Likely to have concentrated positions and high portfolio turnover rates. They may attempt to control the investment process based on former successes.
Gambler’s Fallacy
Believing random data patterns will revert to the long-term mean over a specified period.
Hot Hand Fallacy
Believe a continuation of a recent trend
Social Proof Bias
Individuals wrongly accept, favor, and follow the judgment of their peers or group without fully considering the viewpoint.
Momentum
Can be partly explained by short-term under-reaction to relevant information, and longer-term over-reaction
Regret
Is a type of hindsight bias that can result in investors purchasing securities after a significant run-up in price because of a fear of not participating.
This bias could explain momentum.
When Advising Emotionally Biased Investors
- Advisers should focus on explaining how the investment program being created
- How the program affects such issues as financial security, retirement, or future generations
- Do not focus on quantitative details.
When Advising Cognitive Biased Investors
- The interpretation of information is by maintaining a disciplined and systematic research approach.
- Focusing on metrics and comparable data, rather than what is descriptive or unverifiable, can assist forecast accuracy and consistency of approach across research.
Reference Dependence
- The investor using a “reference point” for making buying and selling decisions.
- This could lead to holding on to investments onto loosing or poor performance longer than they should or taking profits too soon if an investment has gained in value.
If Failing to Achieve a Goal
- A behaviorally modified portfolio should be closer to an MVO portfolio.
- If their bias is cognitive; education would be a better tool to successfully mitigate the issues
- Leads to a portfolio that is more in line with a MVO allocation could than a ± difference in their asset class weights.
