Behavioral Finance

Question 1

What is Prospect Theory?

Answer 1

investors value gains and losses differently, placing more weight on perceived gains versus perceived losses.

Loss Aversion

suggests investors chose perceived gains because losses cause a greater emotional impact.

Question 2

What is the Adaptive Markets Hypothesis?

Answer 2

It reconciles Efficient Market Hypothesis (EMH) with research in behavioral economic.
Markets evolve over time as individuals different heuristics and biases to make decisions
Conclusions & Results:
– Opportunities for arbitrage
– Value in quantitative, fundamental, technical strategies
– Survival is primary objective; profit and utility secondary
– Innovation is key to survival and growth

Question 3

What are the 6 existing belief biases?

Answer 3

a. cognitive dissonance
b. conservatism bias
c. confirmation bias
d. representative bias
e. illusion of control bias
f. hindsight bias

Question 4

What is Cognitive Dissonance

Answer 4

It is confusion or frustration that arises when an individual receives new information that does not match up with or conform to preexisting beliefs or experiences

Bias Type: Existing Beliefs

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

Question 5

What is an example of Cognitive Dissonance?

Answer 5

Holding on to a losing positions that they otherwise would sell because they want to avoid the mental pain associated with admitting that they made a bad decision.

Question 6

What is Conservatism Bias?

Answer 6

Cling to prior views or forecasts at the expense of acknowledging new information; being slow to change

Bias Type: Existing Beliefs

It occurs when people maintain prior views or forecasts by inadequately incorporating new information.
Investors often under-react to new information and fail to modify their beliefs and actions

Question 7

What are examples of Conservatism Bias

Answer 7

clinging to a view or a forecast, behaving too inflexible when presented with new information.

Assume an investor purchases a security based on the knowledge that the company is planning a forthcoming announcement regarding a new product. The company then announces that it has experienced problems bringing the product to market. The investor may cling to the initial, optimistic impression of some imminent, positive development by the company and may fail to take action on the negative announcement.

Question 8

What is Confirmation Bias?

Answer 8

people observe, overvalue, or actively seek out information that confirms what they believe while ignoring or devaluing information that contradicts their beliefs

Bias Type: Existing Beliefs

Occurs when people maintain their prior views or forecasts by inadequately incorporating new information. Investors often under-react to new information and fail to modify their beliefs and actions.

Question 9

What is Representativeness Bias?

Answer 9

processing new information using pre-existing ideas or belief; 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

Bias Type: Existing Beliefs

It occurs as a result of a flawed perceptual framework when processing new information using pre-existing ideas.
an investor may view a particular stock as a value stock because of similarities to an earlier value stock that was a successful investment, even if the new investment is not actually a value stock.

Question 10

What is gambler’s fallacy?

Answer 10

An example of representativeness bias.

The belief that luck, whether in the casino or in the stock market, runs in streaks.

Gamblers and investors will apply their own theories and misconceptions to events and bet or invest according to their own beliefs while ignoring or discounting meaningful data.

Question 11

What is Illusion of Control Bias?

Answer 11

people believe they can control or influence investment outcomes when in reality they cannot

Bias Type: Existing Beliefs

contributes to investor overconfidence.
Investors who have been successful in business or other professional pursuits believe that they should also be successful in the investment realm.
What they find is that they may have had the ability to shape outcomes in their vocation, but investments are a different matter altogether.

Question 12

What is Hindsight Bias?

Answer 12

Investors perceive investment outcomes as if they were (had been) predictable, even if they were not; can give investors a false sense of security when making investment decisions leading them to excessive risk-taking

Bias Type: Existing Beliefs

When an investment appreciates, hindsight-biased investors tend to rewrite their own memories to portray the positive developments as if they were predictable.
The rationale can inspire excessive risk taking because hindsight-biased investors begin to believe that they have superior predictive powers, when, in fact, they do not. The bursting of the technology bubble is an example of this bias in action.

Question 13

What 7 biases are based on information processing

Answer 13

a. mental accounting
b. anchoring and adjustment bias
c. framing bias
d. availability bias
e. self-attribution bias
f. outcome bias
g. recency bias

Question 14

What is Mental Accounting?

Answer 14

Treating various sums of money differently based on where these monies are mentally categorized.

Bias Type: Information Processing

It can cause people to imagine that their investments occupy separate “buckets,” or accounts. Envisioning distinct accounts to correspond with financial goals however, can cause investors to neglect positions that offset or correlate across accounts. This can lead to suboptimal aggregate portfolio performance.
In the same vein as anchoring bias, mental accounting bias can cause investors to succumb to the “house money” effect, wherein risk-taking behavior escalates as wealth grows. Investors exhibiting this rationale behave irrationally because they fail to treat all money as fungible. Biased financial decision making can, of course, endanger a portfolio.

Question 15

What are Anchoring and Adjustment Bias

Answer 15

Being influenced by purchase point or arbitrary price levels and cling to these numbers when deciding to buy or sell

Bias Type: Information Processing

Relying too heavily on certain information (often the first data points received) when making decisions

Question 16

What is Framing Bias?

Answer 16

Responding to similar situations differently based on the context in which the choice is presented

Bias Type: Information Processing

It is the tendency to respond to various situations differently based on the context in which a choice is presented (framed).

The use of risk tolerance questionnaires provides a good example. Depending upon how questions are asked, framing bias can cause investors to respond to risk tolerance questions in an either unduly conservative or aggressive manner.

Question 17

What is Availability Bias?

Answer 17

Easily recalled outcomes (often from more recent information) are perceived as being more likely that those that are harder to recall or understand

Bias Type: Information Processing

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

Question 18

What is Self-Attribution Bias?

Answer 18

Ascribing successes to innate talents and blaming failures on outside influences

Bias Type: Information Processing

Instead of realizing the reason an investment choice went up due to random factors (e.g., economic conditions or competitor failures), attributing the success to the investor’s investment savvy.
If the investment choice loses money, investors may believe that it was random factors (e.g., economic conditions or competitor failures).

Question 19

What is Outcome Bias?

Answer 19

making decisions or take action based on the outcome of past events rather than by observing the process by or through which that outcome occurred

Bias Type: Information Processing

Investors who are susceptible to outcome bias may make mutual fund investments based on their focus on the outcome of a past investment experience related to this decision—such as their manager’s track record or the asset class performance of that particular investment— and are not focused on how the returns were generated or why they should be investing in that asset class.

Question 20

What is Recency Bias?

Answer 20

Easily recall and emphasize recent events/observations and often extrapolate recent patterns where there are none

Bias Type: Information Processing

Recency bias can cause investors to extrapolate patterns and make projections based on historical data samples that are too small to ensure accuracy.
Investors who forecast future returns based too extensively on only a recent sample of prior returns are vulnerable to purchasing at price peaks. These investors tend to enter asset classes at the wrong times and end up experiencing losses.

Question 21

What are biases based on emotions?

Answer 21

a. loss-aversion
b. overconfidence bias
c. self-control bias
d. status quo bias
e. endowment bias
f. regret-aversion bias
g. affinity bias

Question 22

What is Loss-Aversion Bias?

Answer 22

The pain of loss is roughly twice as painful as the pleasure of gains (core tenet of Prospect Theory)

Bias Type: Emotional

Loss aversion prevents people from unloading unprofitable investments, even when they see no prospect of a turnaround.

Some industry veterans have labeled this phenomenon “get-even-itis.”

This bias also drives poor decisions based on the so-called “sunk-cost fallacy”.

Question 23

What is Overconfidence Bias?

Answer 23

Unwarranted faith in one’s own thoughts and abilities

Bias Type: Emotional (some also consider this cognitive)

Overconfident investors often hold under-diversified portfolios, thereby taking on more risk without a commensurate change in risk tolerance.

Question 24

What is Self-Control Bias?

Answer 24

Human tendency to focus on instant gratification due to lack of discipline, consequently failing to act in the best interest of long-term goals

Bias Type: Emotional

It can cause investors to lose sight of basic financial principles, such as compounding of interest, dollar cost averaging, and similar discipline behaviors that, if adhered to, can help create significant long-term wealth.

Question 25

What is Status-Quo Bias?

Answer 25

When facing an array of options, people tend to select the option that keeps conditions the same

Bias Type: Emotional

The investor that has been doing things a certain way for many years, and then hires a new financial advisor. The new advisor may propose practical changes only to find that the investor takes only part of or none of the advice. It’s not that the client doesn’t need good advice – they are simply stuck in the “status quo”.

Question 26

What is Endowment Bias?

Answer 26

Valuing an object more when you hold or own it; discounting the value of objects you do not currently possess

Bias Type: Emotional

Endowment bias occurs when a person assigns greater value to an object he or she possesses and may lose compared to an object of the same value he or she does not possess and has the potential to gain.

Question 27

What is Regret Aversion Bias?

Answer 27

avoiding making decisions or taking action because of fear of making a mistake; or that looking back a decision will prove less than optimal

Bias Type: Emotional

It can cause investors to be too conservative in their investment choices. Having suffered losses in the past, some investors have trouble making sensible new investments. This behavior can lead to long term underperformance and can jeopardize investment goals.

Question 28

What is Affinity Bias?

Answer 28

Making an irrational decision or choice based on how a person believes a certain product or service will reflect their values

Bias Type: Emotional

Investors subject to affinity bias may make investments in companies that make products or deliver services that they like but don’t examine carefully enough the soundness of the investment characteristics of those companies.

Question 29

What is Sunk-Cost Fallacy

Answer 29

Investors may continue to hold an investment and
even invest more (e.g., double down) in large part
because of the time, effort and energy they have
already invested in the idea behind the investment.

They are emotionally tied to the initial choice.
The sunk-cost fallacy is often tied to anchoring and status-quo bias.

Question 30

What is Get-Even-Itis

Answer 30

Holding on to losing investments, hoping that the value will rise back up to the point at which they purchased the asset at which time they would plan to sell.

They do so in an effort to prevent realizing a loss and the negative feelings or pain associated with losses.

Question 31

What is the Snake-Bit Effect?

Answer 31

This occurs when investors experience losses and then become more risk-adverse, even to the extent of not wanting to invest in the same investment or even asset class, based on their painful experience in the past.

The snake-bit effect associated with a number of biases including anchoring, recency, conservatism, and representativeness.

Question 32

What is the House Money Effect?

Answer 32

Investors often take more chances (take on more risk) once they have gained, won, or experienced profits.

It’s the feeling that they are playing with someone else’s money and feel more comfortable taking on additional risk.

Question 33

What is Optimism Bias?

Answer 33

Bias Type: Emotional

Many overly optimistic investors believe that bad investments can happen to others but not them.

Question 34

Who are Kahneman and Tversky?

Answer 34

Creators of prospect theory

Question 35

What is the Disposition Effect

Answer 35

holding on to losing investments too long but sell winning investments too early.

Holding losing positions an be tied back to the “snake-bit effect” where investors are seeking to avoid losses.

Selling winners too early may be traced to an investor seeking to lock in a gain and in doing so either avoid the risk of losing said gain, and/or to experience the immediate gratification that comes from the realized gain.

Question 36

What are the Bailard, Biehl, and Kaiser Investor Models?

Answer 36

1. Individualists – They are confident and careful. Generally do not go to a consultant to manage their investments but do it themselves.
2. Adventurers – Generally go for only big bets. have the resources to do so and willing to take risks. investment ms are generally focused and not diversified.
3. Celebrities – Swayed too much by the trend and do not have any expertise or opinion about investments. approach investment managers frequently.
4. Guardians – Both anxious and careful. Lacking confidence, they approach investment counsels. Generally emphasize safety of the capital while making the investments and a significant proportion of their investments is generally devoted to government securities and guaranteed return investments.
5. Straight arrows – Halfway between complete confidence and anxiety, and extreme carefulness and impetuousness.

Question 37

Profile a Preserver personality type.

Answer 37

Basic type: Passive
Risk tolerance level: Low
Primary bias: Emotional

Passive investors who place emphasis on financial security and preserving wealth rather than taking risks to grow wealth.

Subject to:
  Loss-Aversion Bias
  Status-Quo Bias
  Endowment Bias
  Anchoring Bias
  Mental Accounting Bias

Question 38

Profile a Follower personality type

Answer 38

Basic type: Passive
Risk tolerance level: Low to medium
Primary bias: Cognitive

Passive investors who do not have their own ideas about investing. They follow the lead of their friends and colleagues in investment decisions, and want to be in the latest, most popular investments without regard to a long-term plan.

Subject to:
   Recency Bias
   Framing Bias
   Cognitive Dissonance Bias
   Regret Aversion Bias

Question 39

What is an independent personality type

Answer 39

Basic type: Active
Risk tolerance level: Medium to high
Primary bias: Cognitive

active investor with medium- to high-risk tolerance who is strong-willed and an independently minded thinker. Independents are self-assured and “trust their instincts” when making investment decisions.

Subject to:
   Conservatism Bias
   Availability Bias
   Representativeness Bias
   Self-Attribution Bias
   Confirmation Bias

Question 40

What are Accumulators

Answer 40

Basic type: Active
Risk tolerance level: High
Primary bias: Emotional

Active investor who have been actively involved in their wealth creation, typically risking their own capital in achieving their wealth objectives.

Subject to:
  Overconfidence Bias
  Self-Control Bias
  Affinity Bias
  Illusion of Control Bias
  Outcome Bias