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
