Behavioral Finance Biases Flashcards
Affluenza
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.
Allais Paradox
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.
Ambiguous loss
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.
Anchoring
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.
Asset bias
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.
Attachment bias
This bias occurs when a decision-maker becomes psychologically attached to an asset; this is similar to viewing asset holdings through “rose-colored glasses.”
Availability bias
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.
Aversion to debt bias
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.
Break-even effect
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.
Bubble
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.
Choice architecture
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.
Cognitive ability
Cognitive ability refers to a person’s ability to reason, analyze, learn, apply knowledge, and process information.
Cognitive dissonance
Cognitive dissonance occurs when decision-makers are motivated to reduce or avoid psychological inconsistencies; this results in holding two psychologically inconsistent thoughts.
Cognitive load
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.
Confirmation bias
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.
Conservatism
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.
Contrast effect
This refers to situations in which judgments depend on the context of the situation.
Control uncertainty
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.
Denial
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.
Diminished capacity
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.
Dishonesty, Dysfunction, and Lack of Disclosure
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.
Disposition effect
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.
Dunning-Kruger effect
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.
Ellsberg’s Paradox
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.
Emotional intelligence/competence
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.
Enabling behavior
Enabling is a behavior in which one person shields another person or persons from experiencing the impact of behavioral outcomes.
Endowment effect
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.
Expected utility theory
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.
Familiarity bias
A familiarity bias is present when a decision-maker exhibits a preference for the familiar over novel places, people, or things.
Fear
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.
Fee saliency
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.
Flat rate bias
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.
Framing bias
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.
Gambler’s fallacy
This bias exists when a decision-maker believes that good luck or fortune will always follow a streak of bad luck or negative outcomes.
Greater fool theory
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.
Group think effect
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.
Halo effect
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.
Herding instinct
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.
