Behavioral Finance Flashcards
Anchoring
Focused on the price you bought something that’s thinking that’s the real value.
Attachment Bias
Holding onto an investment for emotional reasons (grandpa bought it for me, can never sell it)
Herd Behavior
Following the crowd, FOMO, everyone else is doing it, chasing growth stocks.
Gambler’s Fallacy
Believe a series of events should result in a high probability event, even if its random. Stock went up for 10 days, it has to come down, right?
Endowment Bias
- My house is awesome so it’s worth more than it really is.
- Won’t sell a money pit vacation house you own
Heuristics
Experiences, biases, trial and error, rules of thumb, generalizations result in inaccurate decision making.
Cognitive Dissonance
Challenging opposing beliefs
Inappropriate Extrapolation
- Performance has been strong, it should persist
- Economy is doing well, it should keep doing well
- Investment/economy is doing poorly, it will never rebound
- growth stocks have outperformed for 10 years, they should continue
Analysis Paralysis
- Too much information, too complex so don’t make a decision
- Waiting for the perfect information to make the perfect decision, so never make a decision
- Afraid to make a bad decision so keep doing analysis
- Fear of making a bad decision outweighs just making a timely decision
Framing Effect
- Using a narrative to make a decision
- Using positive/negative emotions to make a decision rather than factual data
- A cognitive bias
Confirmation Bais
- Seek out information that confirms one’s belief and ignoring information that doesn’t
- Example: investing in a hot stock that has done well and finding good news for it, but ignore bad facts about it
Diversification Errors
Overly diversifying based on lack of knowledge. Equal weight investments by # of investments in 401k plan, style boxes, etc.
Fear of Regret
Not making a decision because the decision might be wrong. Don’t sell a position because it might go back up and you’d feel worse.
Hindsight Bias
- Hindsight is 20/20. Looking back and figuring out the reason an investment did something and believing you know why.
- Experts come on TV telling why something happened in the past rather than making an investment decision before it happens.
Loss Aversion and Risk Taking
- Would rather lock in a gain even if fundamentals are still solid.
- Don’t want to sell a losing position to “lock in” a loss. A loss isn’t real until it’s sold.
- The error of judgement feels worse than the actual loss, so avoid the error of judgment.
- Often results in inaction (doing nothing), don’t want to lock in a loss.
- Don’t do anything so miss potential opportunities.
Prospect Theory
- People value gains and losses differently.
- Losses are more negative than gains are positive.
- Example: getting $100 then losing $50 to net $50 is worse than just getting $50
- Example: better to get $50 than to potentially get $100 then possibly lose $50
Mental Accounting
- Bucketing investments for different reasons: safe bucket, speculative bucket
- Debt interest rate vs. investment interest rate are different buckets. Better to pay off high interest rate debt than invest.
Money Illusion
Think money in nominal terns, not real returns and the impact of inflation on money.
Outcome Bias
- Focus on the outcome rather than the probability of achieving the outcome.
- Example: trying to double your investment without understanding the probability of doing so (i.e. a speculative stock)
Overconfidence
- You think you are better than you are.
- You had some success (probably due to luck) and think the success will continue so you make more aggressive positions and it can backfire.
Overreaction
- Overreaction to new information.
- Example: stock price spikes based on recent strong earnings, then comes back down to normal.
Overweight the Recent Past
Make decisions based on the simple belief recent trends and patterns persist rather than based on research.
Self-Affirmation Bais
Belief your recent good result is because you were smart and in control. If it was a bad result it’s because of bad luck and elements out of your control.
Spotting Trends that are Not There
Belief in random correlating events are causing each other (i.e. full moon means higher stock market).
Status Quo Bais
Belief that everything is fine, don’t need to do anything when something should be done.
Money Scripts
Emotional attachment to money based on childhood (avoidance, worship, vigilance, status).
