Behavioral Finance Flashcards
Heuristics
Mental Decisions that help people make quick decisions.
Ex: Experiences and biases, Trail and Error, Rules of Thumb
Attachment Bias
Holding onto investments for emotional reasons (rather than for practical ones)
Ex: My grandfather left me this stock so I can never sell it.
Anchoring
Become rooted to a specific price as the fair value for a holding
Ex: Bought stock for $100/share. When stock drops to $50, you hang on to it as you believe “real” price is around $100
Endowment Effect/Bias
Because you own an asset, you believe it is more valuable
Ex: You won’t sell family summer home you inherited even though it is a money pit
Cognitive Dissonance
Challenge of reconciling two opposing beliefs
Ex: Remembering the positive parts of an experience and forgetting the negative
Confirmation Bias
Accept information that confirms our preconceived position
Ex: After getting hot stock tip from unverified source, finding information online to prove stock potential
Diversification Errors
Investors diversify evenly across options presented to them
Ex: 401k participants tend to spread money across presented options
Fear of Regret
Take no action rather than risk making the wrong decision
Ex: Holding a losing stock so you don’t feel worse if it were to rebound
Framing Effect
Make decisions based on how things are presented (pos or neg) instead of facts
Gambler’s Fallacy
False belief that a random event is more likely to happen after a series of opposite events
Ex: Roulette table where black comes up five times in a row, people think red is due next
Herd Behavior
Individuals mimic the actions of larger group (FOMO)
Ex: 2000 internet bubble, investing huge money into internet stocks because everyone was doing it
Hindsight Bias
Individuals assume they knew outcome of event after the outcome has happened
Ex: After stock correction, experts share opinion the market was overdue for correction
Inappropriate Extrapolation
Assume recent events (or market performance) will continue indefinitely
Ex: Assume Bond Market will continue to outperform stock market because of continued downturn
Analysis Paralysis
Overthinking a decision to the point where it becomes difficult to act
Ex: To start investing someone is overwhelmed about all the asset-allocation strategies and options so does not invest
Loss Aversion
Investors find losses 2-2.5 times as painful as gains are pleasurable
Ex: Investor sells strong-performing winner to lock in gains without considering if investment remains attractive
Prospect Theory
Explains how people make decisions when faced with risk and uncertainty (relates to loss aversion)
Ex: Utility gained from $50 is greater than getting $100 and losing $50
Mental Accounting
Looking at sums of money differently depending on source or intended use
Ex: Investing in CDs (low interest) when you have credit card debt at 20%
Money Illusion
Economic theory that people view wealth in nominal dollar terms rather than real terms which must consider inflation
Outcome Bias
Make decision based on desired outcome rather than probability
Ex: Investor wants to double money in investment without doing adequate research
Overconfidence
Place too much emphasis on one’s own abilities (works with confirmation bias)
Ex: Fund Manager has early success and steadily increase amount to bet on convictions while decreasing research behind them
Overreaction
Investors emotionally react to new market information
Ex: Good stock news creates larger-than-appropriate price surge
Over-Weighting Recent Past
Using recent past as basis for investment decision without additional research
Ex: Investor study says short-term mutual fund winners tend to persist and invest in top funds
Self-Affirmation Bias
Take credit when something goes right, blame others or bad luck when wrong
Spotting Trends Not There
Investors seek patterns that help support decisions without confirming research
Ex: If NFC wins Superbowl is not basis for investment decision
Status Quo Bias
Tendency of a person to keep things the way they are.
Ex: Non necessary, it is an everyday occurrence
Money Scripts
Subconscious beliefs people have regarding money
-Money Worship
-Money Avoidance
-Money Vigilance
-Money Status
Money Worship
Money itself brings happiness
Ex: Compulsive spending towards never-ending goal of obtaining monetary things to provide happiness
Money Avoidance
Ignore finances to avoid negative emotions/stress
Ex: Money is root of all evil, associating wealth with greed, ignoring bank accounts, debt, ect.
Money Vigilance
Concern and awareness of one’s financial well-being with emphasis placed on saving and being prepared
Ex: Being overly cautious with money to the extent that enjoyable things (vacations, ect.) are sacrificed
Money Status
Person’s self-worth tied to their Net Worth. To be a better person, they need more money
Ex: Overspending, hiding finances from other, and associating shame with a lack of money
CFP Assumptions & Rules:
-Financial Planning Start?
-Investment Advisors Part of First step in Financial Planning Process?
-Scope of Financial Planning?
-Retirement Assumptions?
-Client Knowledge and Experience with Investments?
-“Fee-only”?
-When Fiduciary?
-How to understand client changes?
-When to check for changes?
-Conflicts of Interest?
-Duty of Diligence?
-Duty of Care?
-One-off Advice/Questions?
-Compliance with Client who goes against recommendation?
-Commingling of Assets?
-Frequency and Purpose of Monitoring of Financial Plan?
Financial Planning Start? Formal meeting to discuss client’s financial goals
Investment Advisors Must: Provide a copy of Form ADV (disclosure document that provides information about the investment adviser and their business practices)
Scope of Financial Planning: Covered in written financial planning agreement
Retirement Assumptions: Longevity assumption based on family and personal health history
Client Knowledge and Experience with Investments: Ask about Investment Selections/Experience
“Fee-only”: CFP®, their firm, and related parties receive no sales-related compensation
When Fiduciary: When providing financial advice
How to Understand Client Changes: Schedule periodic meetings with the client.
When to Check for Changes: ALWAYS
Conflicts of Interest: Okay, but must disclose
Duty of Diligence: Respond to reasonable client inquiries in a timely and thorough manner
Duty of Care Act with care, skill, prudence, and diligence from providing financial planning
One-off Advice/Questions: Provide as part of client’s comprehensive plan
Compliance with Client Who Goes against recommendation: Comply with client regardless of recommendation, but document
Commingling of Assets: NEVER
Frequency and Purpose of Monitoring: Done periodically, and plans reevaluated and potentially modified when significant changes occur.
