Behavioral Finance Biases

Question 1

Affluenza

Answer 1

Affluenza is a phenomenon that affects young people from affluent (i.e., high net worth) households. Outcomes associated with affluenza include guilt, low motivation, a sense of entitlement, and isolation.

Question 2

Allais Paradox

Answer 2

Based on a unique experiment, Allais showed that decision-makers do not always follow normative expected utility theory predictions; this paradox established many of the foundational arguments associated with behavioral finance.

Question 3

Ambiguous loss

Answer 3

Ambiguous loss refers to situations in which a client is physically present but psychologically or cognitively absent. Ambiguous loss is most closely aligned with Alzheimer’s disease and cognitive decline.

Question 4

Anchoring

Answer 4

Anchoring involves the use of information, such as the purchase price of a security, as a reference for evaluating or estimating an unknown value of a financial outcome.

Question 5

Asset bias

Answer 5

An asset bias is a tendency exhibited by some clients to hold pre-determined attitudes and opinions about the favorability of a particular investment asset. An asset bias is typically shaped by previous experience and information transmitted from trusted sources.

Question 6

Attachment bias

Answer 6

This bias occurs when a decision-maker becomes psychologically attached to an asset; this is similar to viewing asset holdings through “rose-colored glasses.”

Question 7

Availability bias

Answer 7

An availability bias is a mental shortcut that relies on immediate examples that come to mind when evaluating a specific topic, concept, method, or decision. The availability bias operates on the notion that if something can be recalled, it must be important, or at least more important than alternative solutions that are not as readily recalled.

Question 8

Aversion to debt bias

Answer 8

This phenomenon occurs when a financial decision-maker expresses an aversion to debt even when the use of debt is appropriate and results in positive outcomes.

Question 9

Break-even effect

Answer 9

This describes a situation in which some financial decision-makers take additional risks in the hopes of either avoiding losses or recouping realized losses; having lost some money, many financial decision-makers are willing to take a double-or-nothing gamble.

Question 10

Bubble

Answer 10

A bubble represents a rapid rise in the price of an asset or investment market based on collective thought and enthusiasm, often leading to exuberance and a sharp contraction in prices. See also momentum investing and noise trading.

Question 11

Choice architecture

Answer 11

Choice architecture is a decision-making design approach used to differentiate the ways in which choices can be presented to consumers. Choice architecture includes an analysis of the impact of a presentation on consumer decision-making. For example, the number of choices presented, the manner in which attributes are described, and the presence of a “default” are known to influence consumer choices.

Question 12

Cognitive ability

Answer 12

Cognitive ability refers to a person’s ability to reason, analyze, learn, apply knowledge, and process information.

Question 13

Cognitive dissonance

Answer 13

Cognitive dissonance occurs when decision-makers are motivated to reduce or avoid psychological inconsistencies; this results in holding two psychologically inconsistent thoughts.

Question 14

Cognitive load

Answer 14

Cognitive load, as defined in cognitive load theory, refers to the amount of working memory and mental effort needed to solve a problem. Cognitive load is typically categorized into three types: intrinsic, extraneous, and germane. Intrinsic cognitive load is the effort associated with achieving a specific outcome. Extraneous cognitive load refers to the way information or tasks are presented to a learner, whereas germane cognitive load refers to the work put into creating a permanent store of knowledge, or a schema.

Question 15

Confirmation bias

Answer 15

Confirmation bias suggests that investors seek out information that confirms pre-existing opinions while ignoring contrary information that refutes pre-established ideas. This psychological phenomenon occurs when investors filter out potentially useful facts and opinions that don’t coincide with preconceived notions.

Question 16

Conservatism

Answer 16

This concept represents the notion that once established, decision-makers are reluctant to change their probability estimates when presented with new information; this is similar to anchoring; conservatism conflicts with the representative bias.

Question 17

Contrast effect

Answer 17

This refers to situations in which judgments depend on the context of the situation.

Question 18

Control uncertainty

Answer 18

Control uncertainty refers to the notion that some clients desire to control their future. Those who exhibit control uncertainty often have a difficult time accepting the fact that some elements of life cannot be controlled with certainty.

Question 19

Denial

Answer 19

Denial refers to the tendency of some decision-makers to fail to imagine the probability of an event if the outcome is extremely negative; denial can also arise in relation to a confirmation bias.

Question 20

Diminished capacity

Answer 20

Capacity refers to the ability of someone to make a decision or engage in a predetermined behavior. Typically, diminished capacity refers to a mental impairment that limits cognitive abilities.

Question 21

Dishonesty, Dysfunction, and Lack of Disclosure

Answer 21

Dishonesty, dysfunction, and lack of disclosure refer to the tendency among some decision-makers to disguise information or withhold information through secrecy when seeking the advice of others before making a financial decision.

Question 22

Disposition effect

Answer 22

The disposition effect relates to the tendency of investors to sell shares when the price has increased, while holding assets that have dropped in value.

Question 23

Dunning-Kruger effect

Answer 23

A cognitive bias whereby people with limited knowledge or competence in a given intellectual or social domain greatly overestimate their own knowledge or competence in that domain relative to objective criteria or to the performance of their peers or of people in general.

Question 24

Ellsberg’s Paradox

Answer 24

Similar to the Allais Paradox, this represents a situation in which a decision-maker’s choices conflict with predictions made using expected utility theory; this occurs because some decision-makers want to reduce uncertainty.

Question 25

Emotional intelligence/competence

Answer 25

Emotional intelligence, sometimes referred to as EI or emotional quotient, refers to the ability of one person to infer and recognize another person’s mental state using verbal and non-verbal cues. Emotional intelligence is associated with being able to differentiate between feelings and use signals and cues from another person to guide interpersonal actions.

Question 26

Enabling behavior

Answer 26

Enabling is a behavior in which one person shields another person or persons from experiencing the impact of behavioral outcomes.

Question 27

Endowment effect

Answer 27

The endowment effect, in behavioral finance, describes a circumstance in which individuals value something that they already own more than something that they do not yet own. Sometimes referred to as divestiture aversion, the perceived greater value occurs merely because the individual possesses the object in question. Investors, therefore, tend to hold certain assets because of familiarity and comfort, even if the assets are inappropriate or become unprofitable. The endowment effect is an example of an emotional bias.

Question 28

Expected utility theory

Answer 28

Expected utility is an economic concept used to describe the satisfaction that a person, entity, or aggregate economy is expected to reach under any number of circumstances. Expected utility is calculated by taking the weighted average of all possible outcomes under certain circumstances, with the weights being assigned by the likelihood, or probability, that any particular event will occur.

Question 29

Familiarity bias

Answer 29

A familiarity bias is present when a decision-maker exhibits a preference for the familiar over novel places, people, or things.

Question 30

Fear

Answer 30

Fear is an intense sense of terror, trepidation, alarm, or anxiety associated with the real or potential engagement in an action. Fear can create a physiological stress response, including the fight or flight response, that can act as an obstacle to plan implementation.

Question 31

Fee saliency

Answer 31

Fee saliency refers to the awareness among financial services clients of the cost of services when services are paid directly rather than through automatic account deductions.

Question 32

Flat rate bias

Answer 32

The flat-rate bias describes situations in which consumers favor flat-rate tariffs, although a pay-per-use tariff would be cheaper with regard to their actual usage volume.

Question 33

Framing bias

Answer 33

Framing bias is the human tendency to view a scenario differently depending on how the situation is presented or framed. Typically, decision-makers exhibit risk aversion when a decision frame is presented in the gain domain. The same decision-maker will often shift to a risk-taking stance when the same situation is presented in the loss domain.

Question 34

Gambler’s fallacy

Answer 34

This bias exists when a decision-maker believes that good luck or fortune will always follow a streak of bad luck or negative outcomes.

Question 35

Greater fool theory

Answer 35

The greater fool theory states that as prices rise more money is drawn into the market, pushing prices even higher; soon the bid/ask spread finds fewer and fewer buyers and higher and higher prices; although prices appear to remain high, these prices are maintained with little volume.

Question 36

Group think effect

Answer 36

This effect describes the phenomenon that groups share an illusion of invulnerability, and as such, group decisions tend to take on more risk than the same decisions made by individuals.

Question 37

Halo effect

Answer 37

The halo effect is a cognitive impression someone makes of another person based on physical and emotional characteristics that then influence future interactions with the person.

Question 38

Herding instinct

Answer 38

The herding instinct is a mentality that is distinguished by a lack of individual decision-making or introspection, causing people to think and behave similarly to those around them. In finance, the herding instinct relates to instances in which investors gravitate toward the same or similar investments based almost solely on the fact that many others are buying the securities. The fear of missing out on a profitable investment idea is often the driving force behind the herding instinct.

Question 39

Heuristic

Answer 39

A heuristic is an innate decision-making strategy that relies on mental models, previous experience, and standardized rules to simplify the decision-making process.

Question 40

Hindsight bias

Answer 40

Hindsight bias refers to a person’s belief that past events, behaviors, and attitudes were predictable when, in reality, the events, behaviors, and attitudes in question were not obvious at the time or predictable beforehand.

Question 41

House money effect

Answer 41

This effect is present after decision-makers have experienced a gain; at that point, they often are willing to take more risk because they fail to fully consider the new money as real or their own; this concept is related to mental accounting.

Question 42

Illusion of control

Answer 42

The illusion of control exists when decision-makers exhibit overconfidence when they feel like they have control of an outcome, even when this is not the case.

Question 43

Illusion of security

Answer 43

An illusion of security is based on the notion that a person can control their environment and minimize the risks associated with daily life.

Question 44

Illusion of truth bias

Answer 44

This bias occurs when financial decision-makers assume that what they understand must be the truth, even if data does not support the conclusion.

Question 45

Intransitivity

Answer 45

Intransitivity refers to a situation that occurs when two alternatives have a very similar probability of success and decision-makers chose the one with the higher payoff; however, when the difference in probabilities is extreme, the same person then chooses the alternative with the higher probability of winning.

Question 46

Emotion(s)

Answer 46

Emotions refer to a person’s level of mental activity and the degree of pleasure or displeasure someone receives from a behavior or experience. Stress relates to psychological perceptions of pressure, either positive or negative.

Question 47

Lack of patience bias

Answer 47

The lack of patience bias—or lack of impulse control—is the absence of capacity to tolerate or accept delays or setbacks without exhibiting annoyance or anger.

Question 48

Law of Small Numbers

Answer 48

This describes the tendency of decision-makers to believe that small samples actually represent population data.

Question 49

Loss aversion

Answer 49

In client psychology, economics, decision theory, and behavioral finance, loss aversion refers to the tendency of a financial decision-maker to strongly prefer avoiding losses to acquiring gains. Most studies suggest that losses are twice as painful, psychologically, as gains are pleasurable.

Question 50

Maslow’s Hierarchy of Needs

Answer 50

A model of behavior often used to describe and explain human decision-making, where people progress towards self-actualization only after meeting certain needs, including physiological, safety, social, and esteem needs.

Question 51

Mental accounting

Answer 51

Mental accounting is an economic concept which contends that individuals classify personal funds differently and therefore are prone to irrational decision-making when engaging in spending and investment behavior.

Question 52

Mindfulness

Answer 52

A mental and physiological state in which someone's thinking and attention (mind) are fully attending to what is occurring at that moment. Being mindful is one way to counteract common behavioral finance biases.

Question 53

Momentum investing

Answer 53

An investment strategy that seeks to capitalize on the continuation of an existing price trend; the strategy assumes that past returns predict future returns.

Question 54

Money disorders and other problematic financial behaviors

Answer 54

Money disorders are the maladaptive patterns of financial beliefs and behaviors that lead to clinically significant distress - or impairment in social or occupational functioning, due to financial strain or an inability to appropriately enjoy one’s financial resources.

Question 55

Money scripts

Answer 55

A money script is a story someone tells himself or herself about what is normal, expected, or desired in the context of money and personal finances. Money scripts can result in biased information processing.

Question 56

Naïve diversification

Answer 56

This is a phenomenon in which an investor believes their portfolio is more diversified than is the case. Naïve diversification occurs when an investor focuses too intently on the number of investments or assets held versus asset location.

Question 57

Narrative fallacy

Answer 57

The narrative fallacy is used to explain the tendency of decision-makers to build explanations into and around events and facts without sufficient information or background data.

Question 58

Need for acceptance

Answer 58

The need for acceptance refers to a persistent need to be liked and included by peers, colleagues, and people who have perceived power. The need for acceptance is related to lower levels of self-esteem, low self-confidence, and reduced well-being.

Question 59

Need for validation

Answer 59

A need for validation is a phenomenon exhibited by decision-makers who search for an outside source or expert to prove the authenticity of an opinion, attitude, or behavior.

Question 60

Noise trading

Answer 60

Noise trading occurs when an investor decides to buy or sell an investment or asset without the use of fundamental data; noise trading is biased in that the strategy is essentially based on herding behavior and trend following.

Question 61

Overconfidence bias

Answer 61

The overconfidence bias (effect) is a well-established predisposition in which a person's subjective confidence in their judgments is reliably greater than the objective accuracy of those judgments, especially when confidence is relatively high. For example, in some quizzes, people rate their answers as "99% certain" but are wrong 40% of the time.

Question 62

Perceptions

Answer 62

Perceptions refer to cognition associated with the process of becoming aware of interpreting something that impacts the client-planner relationship, financial decision-making, or any element associated with financial well-being.

Question 63

Personality

Answer 63

Personality refers to the combination of characteristics or qualities that form an individual's distinctive character. The Big Five are often used to describe a person’s personality (i.e., openness, conscientiousness, extraversion, agreeableness, and neuroticism).

Question 64

Political bias

Answer 64

Political bias refers to a client’s tendency to react to political and regulatory events based on deeply held convictions rather than through a value-free analysis of the political or tax environment.

Question 65

Possibility effect

Answer 65

A possibility effect exists whenever a financial decision-maker exaggerates the probabilities associated with highly unlikely events or outcomes.

Question 66

Preference reversal

Answer 66

This describes a situation in which a decision-maker is asked to set a price for a fair bet based on how large the potential payoff will be, but when asked to choose between two bets, the decision-maker over-weights the probability of winning, thus reversing the original preference.

Question 67

Primacy effect

Answer 67

This effect represents a decision-maker’s tendency to overweight data and information that is obtained early in the decision-making process while discounting later obtained data and information.

Question 68

Projection bias

Answer 68

Projection bias is an assumption that current preferences or states of being or action will continue into the future (i.e., what is true today will be true tomorrow).

Question 69

Prospect theory

Answer 69

Prospect theory assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. Also known as loss-aversion theory, the general concept is that if two choices are put before an individual, both equal, with one presented in terms of potential gains and the other in terms of possible losses, the former option will be chosen [see framing].

Question 70

Recency bias

Answer 70

The tendency for investors to remember recent events compared to recalling historical norms. A common manifestation occurs when investors allow financial news to shape feelings about the market and portfolio negatively.

Question 71

Regression to the mean bias

Answer 71

This concept suggests that decision-makers fail to account for the statistical tendency of future outcomes to eventually revert back to a mean level; momentum traders, for example, instead believe that the future will resemble the present situation rather than accounting for the average expected outcome.

Question 72

Regret aversion

Answer 72

Regret aversion refers to a preference to avoid engaging in behaviors in which the outcome can be negative. This avoidance behavior serves to reduce grief and distress associated with making a bad decision. Regret aversion is sometimes referred to as loss aversion.

Question 73

Regret theory

Answer 73

Regret theory suggests that decision-makers anticipate future regret and as such, structure current decisions to minimize or avoid anticipated regret.

Question 74

Renter rather than owner mentality

Answer 74

The renter rather than owner mentality hypothesizes that a client will be less likely to engage in problematic financial behavior (e.g., selling investments at a market bottom) if the client views the investment as something owned (like a business) rather than something transitory.

Question 75

Representative bias

Answer 75

A representative bias describes a type of heuristic decision-makers use when making judgments about the probability of an event under uncertainty. When used, a decision-maker evaluates the odds of success or failure associated with a decision by comparing the potential consequences to outcomes associated with previous, but similar, decisions.

Question 76

Risk-aversion effect

Answer 76

Risk aversion—the tendency to avoid financial risks—increases after a decision-maker experiences a financial loss.

Question 77

Risk literacy

Answer 77

Risk literacy is understood as the ability to perceive the risk individuals, communities, and the environment is exposed to. This information is then used to derive appropriate decisions from awareness about the risk.

Question 78

Risk shift

Answer 78

Risk shift occurs when decision-makers alter their original perception of the riskiness of a situation—they are more willing to advocate risky actions—after they have participated in a group discussion.

Question 79

Seeking pride bias

Answer 79

This cognitive bias occurs when decision-makers want to be recognized for their good work but feel underappreciated; someone exhibiting a seeking pride bias wants others to acknowledge their skills and abilities.

Question 80

Self-actualization

Answer 80

Self-actualization is an element within Maslow’s Hierarchy of Needs. Self-actualization refers to the fulfillment of one’s desires, potentialities, and talents.

Question 81

Self-attribution bias

Answer 81

Self-attribution bias refers to the tendency to attribute personal, professional, and investment success to one’s own efforts and negative personal, professional, and investment outcomes to external forces and powerful outside influences.

Question 82

Self-determination

Answer 82

Self-determination is defined as self-determination theory (SDT). SDT is a macro theory of human motivation and personality that concerns people's inherent growth tendencies and innate psychological needs. SDT is concerned with the motivation behind choices decision-makers make without external influence and interference. SDT focuses on the degree to which an individual's behavior is self-motivated and self-determined.

Question 83

Self-efficacy

Answer 83

Self-efficacy is an individual's belief in their innate ability to achieve goals. Expectations of self-efficacy determine whether an individual will be able to exhibit coping behavior and how long effort will be sustained in the face of obstacles.

Question 84

Self-fulfilling prophecy

Answer 84

This is a situation in which misconceptions can ultimately prove true when decision-makers create false expectations, which then leads to confirmation behaviors.

Question 85

Situational awareness

Answer 85

Situational awareness or situation awareness (SA) is the perception of environmental elements with respect to time or space, the comprehension of their meaning, and the projection of their status after some variable has changed, such as time, or some other variable, such as a predetermined event.

Question 86

Social desirability

Answer 86

Social desirability refers to a way of acting that disguises true beliefs, preferences, and attitudes by exhibiting behaviors that are thought to be socially acceptable or desirable.

Question 87

Social environment

Answer 87

The social environment refers to the setting in which someone lives and makes decisions. The social environment includes social media, the physical environment, and the social setting. The social environment can inform the decision-making process and, in some cases, be a cause of media-induced fear.

Question 88

Solution-focused counseling

Answer 88

A mental health and therapeutic treatment approach that helps a client uncover solutions to their own problems by examining how the person has achieved positive and successful outcomes in the past. Solution-focused therapy is future-oriented rather than past-focused and can be used to improve cognitive processing and decision-making.

Question 89

Stages of grief

Answer 89

Stages of grief refers to a person’s typical reaction to loss. The five stages of grief include 1) denial, 2) anger, 3) bargaining, 4) depression, and 5) acceptance. In addition to understanding the stages of grief in relation to death, the stages of loss may apply to broader financial planning situations, including the sale or loss of a business.

Question 90

Status quo bias

Answer 90

The status quo bias is an emotional predisposition; the status quo bias is a preference for the current state of affairs. The current baseline (or status quo) is taken as a reference point, and any negative change from that baseline is perceived as a loss.

Question 91

Stereotyping

Answer 91

Stereotyping refers to generalizing about cause and effect from a limited set of facts.

Question 92

Sunk cost fallacy

Answer 92

The sunk cost fallacy refers to a tendency for decision-makers to irrationally follow through on an activity that is not meeting their expectations. This is because of the time or money they have already invested. The sunk cost fallacy explains why people finish movies they are not enjoying, finish meals that taste bad, keep clothes in their closet that they've never worn, and hold on to underperforming investments.

Question 93

Survivorship bias

Answer 93

This represents the tendency to overestimate historical performance without accounting for lost data from firms, assets, and investments that are no longer included in the market.

Question 94

Testimonial bias

Answer 94

This bias describes the potential for a handful of heartfelt testimonials to outweigh statistics and other empirical data.

Question 95

Vividness bias

Answer 95

This bias describes the tendency of decision-makers to be more affected by vivid information than abstract information or past data.

Question 96

Writing a check effect (also known as the bottom dollar effect)

Answer 96

The writing a check effect describes the phenomenon that clients find paying management fees from assets or automatic withdrawals more appealing compared to writing a check for services.

Question 97

How do you pass the CFP Exam?

Answer 97

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