Behavioral Finance Flashcards
Prospect Theory
more risk averse vs pleasure seeking by ratio of 2:1
• make decisions based on probabilities than potential outcomes
• loss aversion ties into this theory; attendance to feel impact of losses more than the pleasure of gains (asymmetrical S-shape)
• people make financial and investment decisions using mental shortcuts and biases (called heuristics)
Paradox of Choice
giving people more choice does not increase performance/satisfaction
• people easily overwhelmed with information
• often do nothing when conflicted
• optimal decisions are note made
Adaptive Market Hypothesis (AMH)
reconciles EMH with behavioral economics
• markets evolve over time as individuals use numerous heuristics/biases to make decisions
• opportunities for arbitrage; value in fundamental/technical/quantitative strategies
• survival is primary objective, profit and utility are secondary; innovation is key to survival and growth
Cognitive Dissonance
confusion/frustration when new info does not conform beliefs; hold losers, herd behavior, “different this time”
Conservatism Bias
cling to prior views at expense of new info, slow to change, under-react, ignore complex/conflicting information
Confirmation Bias
actively seek out information that confirms prior views, ignore conflicting info, under-diversified, pre-determined screen
Representative Bias
process new info using pre-existing beliefs, similarities to past events, flawed perception; gambler’s fallacy
Illusion of Control
think you can control investment outcomes, leads to overconfidence, excess trading, under diversification, limit orders
Hindsight Bias
perceive outcomes as if predictable, criticizing managers in out of favor asset classes
Mental Accounting
treat various sums of money differently, mental categorize, house money effect, sell at gain after draw down
Anchoring/Adjustment Bias
influenced by purchase price, cling to numbers when forecasting estimated returns
Framing Bias
respond to similar situations differently based on context which presented, risk tolerance questions, excessive risk aversion
Availability Bias
easily recalled/recent outcomes perceived as more likely to occur; retrievability, resonance, categorization, narrow range of experience
Self-Attribution Bias
ascribe successes to talent/failures to outside influences; under diversification, excessive risk-taking
Outcome Bias
make decisions based on past outcomes rather than process through which outcome occurred, focus solely on track record
Recency Bias
more easily recall recent events, extrapolate recent patterns that don’t exist, enter asset classes at wrong time, “different this time”
Loss Aversion
pain of loss 2x worse than pleasure of gain, keep losers, sell winners too quickly, stay in cash too long, unbalanced portfolio
Overconfidence Bias
unwarranted faith in one’s own abilities, under diversified, excessive risk, excess trading
Self-Control Bias
focus on instant gratification, failing to act in best interest of LT goals, spend more today at expense of tomorrow
Status Quo Bias
when forced with array of options, pick choice to keep same; emotionally attracted to stocks
Endowment Bias
place more value on object when you won it, less when you don’t own it, decision paralysis, hold to avoid taxes
Regret-Aversion Bias
avoid making decisions/taking action to avoid chance of making a mistake, too conservative, may lead to herd behavior
Affinity Bias
irrational choice from new company/product that reflects value of investor, ESG only focus w/o regards for fundamentals
Disposition Effect
hold losers too long, sell winners to quickly
Ambiguity Bias
investors may not want to stake claims on ambiguous investments; want to take the less favorable choice if outcome is known
Preservers
passive
low risk-tolerance
emotional
looking for financial security/preservation of wealth.
Need “big-picture” advice, don’t need to get lost in the details but need to be shown how their portfolio will deliver desired results for future generations and meet their LT goals.
- loss aversion
- status-quo bias
- endowment bias
- anchoring bias
- mental accounting
Followers
passive low/medium risk-tolerance cognitive no own ideas follow crowds most popular investments no regard for LT goals.
Handle with care – they often say yes to anything. Should challenge them to back up their own recommendations with data-backed substantiation.
- recency bias
- framing bias
- cognitive dissonance
- regret aversion bias
Independents
active medium/high risk-tolerance cognitive strong willed independent thinker self-assured trust instincts
Difficult clients to advise, need to educate to change behavior, have regular unambiguous educational discussions, stress diversification and a long-term plan.
- conservatism bias
- availability bias
- representativeness
- self-attribution bias
- confirmation bias
Accumulators
active high risk-tolerance emotional actively involved with wealth creation risked own capital
Take control of situation, demonstrate the impact of financial decisions.
- overconfidence bias
- self-control bias
- affinity bias
- illusions of control
- outcome bias
