Behavioral Finance Theories Flashcards
Prospect Theory state that people make decisions based on
probabilities more than potential outcomes
Prospect Theory state that people make decisions using
mental heuristics (mental shortcuts and biases)
Loss Aversion
the tendency to feel the impact of losses more than gains
Prospect Theory can be illustrated graphically using an
asymmetrical s shapred curve
Cognitive dissonance
confusion or frustration that arises when an individual receives new information that does not match up with or confirm to preexisting beliefs or experiences
Cognitive dissonance causes invstors to
hold losing securities that they otherwise would sell because they want to avoid the mental pain associated with admitting that they made a bad decision
average down investing
Average down investing
throwing good money after bad
Cognitive dissonance can cause investors to get caught up in
herds of behavior - people avoid information that counters an earlier decision
Conservatism
bias where people cling to their prior views or forecasts at the expense of acknowledging new information
Slow to change
Difficulty in processing new information
Confirmation
Where people observe, overvalue, or actively seek out information that confirms what they believe while ignoring or devaluing information that contradicts their beliefs
Believe strongly in predetermined screens.
Cause employees to over concentrate in company stock
Representativeness
Bias through which individuals process new information using preexisting ideas or beliefs
views a particular situation or information a certain way because of similarities to other examples even if it does not really fit into that category
Illusion of control bias investors tend to
trade more than is prudent
maintain underdiversified portfolios
use limit orders
overconfidence
Anchoring bias investors tend to succumb to
house money effect - where risk-taking behavior escalates as wealth grows
Anchoring and adjustment
Cognitive bias where investors are influenced by purchase price points or arbitrary price levels and cling to these numbers when deciding to buy or sell
often rely too heavily on certain information when making decisions
Framing
cognitive bias, where an individual responds to similar situations differently based on the context in which the choice is presented
Framing and loss aversion can work together by
To explain excessive risk aversion. An investor who has incurred a net loss becomes likelier to select a riskier investment, whereas a net gainer feels redisposed toward less risky alternatives.
Availability
cognitive bias where easily recalled outcomes are perceived as being more likely that those that are harder to recall or understand
Examples of availability
choose investments based on information that is available to them by advertising, suggestions from advisors, friends, etc…
Choose investments that resonate with them
Loss aversion
emotional bias where an investor finds the idea of losses twice as painful as the pleasure of gains
core tenet of prospect theory
Loss aversion investors tend to
hold losing investments too long
get-even-itis - hold losing investments in the hope that they get back what they lost
unknowingly take on more risk in their portfolio
Examples of self control bias
cause investors to spend more today at the expense of saving for tomorrow
fail to plain for retirement
Status quo bias
emotional bias where when faced with an array of options, an investor is predisposed to select the option that keeps conditions the same
Examples of status quo
Cause investors to take no action to hold investments inappropriate to their own risk. This can mean that investors take an excessive risk or invest too conservatively.
Can be combined with loss aversion bias
Endowment effect
an emotional bias where an individual assigns a greater value to an object already held or owned
Investors may assign additional value to stocks they have inherited or purchased because they do not want to incur the transaction costs associated with selling the securities.
Regret aversion
An emotional bias where investors avoid taking decisive action because they are afraid that when looking back at the course they select it will prove less than optimal
Examples of regret aversion
Having suffered losses in the past, investors tend to be too conservative in their investment choices.
Hold onto losing positions for too long
Herding behavior
Hold onto winning stocks for too long
Affinity
emotional bias where investors make decisions based on how they believe a product or service reflects their values
Examples of affinity
are prone to purchase stocks that reflect their self image
Sunk cost fallacy
investors may continue to hold an investment and even invest more (double down) in large part because of the time, effort and energy they have already invested
Often tied back to anchoring and status quo bias
Get Even Itis
investors will often hold losing investments, hoping that the value will rise back up to the point at which they purchased the asset, at which time they would plan to sell.
Disposition Effect
investors typically hold on to losing investments too long but sell winning investments too early
succumb to the so called “snake bit effect” where investors are seeking to avoid lossses
Snake Bit Effect
investors experience losses and then become more risk averse even to the entent of now wanting to invest in the same investment or even asset class, based on their painful experience in the past
Snake bit effect is often associated with other biases including
anchoring, recency, conservatism and representativeness
Preservers as typically what type of investors
passive; who place emphasis on security and preserving wealth rather than taking risks to grow wealth
Preservers are often subject to what type of biases
endowment, loss aversion, status quo, anchoring and mental accounting
Followers as typically what type of investor
passive investors; dont have their own ideas about investing so they follow the lead of friends and colleagues
Prone to follow the herd and look for the most popular investments
Followers are often subject to what type of biases
recency, hindsight, framing, regret , cognitive dissonance and outcome
Independents are what type of investors
active; higher tolerance of risk than they have need for security
tend to get involved with investment decisions and maintain some amount of control of their own investments
Independents are often subject to what type of biases
conservatism, availability, confirmation, representativeness and self attribution
Accumulators are what type of investor
active; often entrepreneurial and the first generation to create wealth
strong willed and confident
often have a higher tolerance for risk
Accumulators are often subject to what type of biases
overconfidence, affinity and illusion of control
Behavioral portfolio theory assumes what
investors construct portfolios to satisfy goals
Tendency of followers to respond to situations differently based on the context in which a choice is presented
Framing bias
If presented with too many hot investment ideas, a typical follower will do what
take them all
In the barnewell two way model, passive investors have a significant need for what
Security
Passive investors have a greater need for what
security more so than risk
Accumulators typically do not have believe in what
diversification
Can cause investors to fell uncomfortable with a security they own
Cognitive dissonance
Type of investor most likely not to follow a financial plan
Independents
Type of investor most likely to hold concentrated portfolios
Indpendents
Can lead to higher risk by limiting investments in a portfolio by concentrating on domestic securities and reducing currency exposure
Home country bias
Extrapolating patterns based on small historical data is exhibiting which type of bias
Recency
Investor focused on short term technical trading based on information gathered on a short term bias, may be suffering from what
Recency bias
Can cause investors to ignore fundamental value and to focus only on recent upward price performances
Recency bias
Under the Bailard, Biehl and Kaiser five way model, a sensible investor who takes on risk is called a
Straight arrow
Investors that are sensible who take risk at appropriate times
Straight arrow
Investor making investment choices based on knowledge of how similar investments have performed in the past may have what kind of bias
Representativeness
Occurs when we take mental shortcuts and jump to conclusions about one investment based on perceived similarities to other investments
representativeness
Investor who gathers all investment recommendations from golfing friends
Representativeness
House money effect
Mental accounting
Can cause investors to be too conservative in their choices, especially if they have suffered losses in the past
regret aversion
Emotional investors who place a great deal of emphasis on security
Preservers
Investors have more equity choices in a 401K than fixed income choices. Although risk averse, this investor picks more equity funds to invest in
Framing bias
Investors pick investments based products or services that will reflect their values
Affinity bias
Can lead to an investor to hold on to a security too long for fear of missing out on gains
regret aversion
Hold and no nothing on investments that they own
likely cognitive dissonance
An investor chooses to review only investment info that reaffirms the decisions already made
Selective perception
Individual to miscalculate based on utilization of info that reaffirms a chosen path
Selective perception
Overconfident investors may have what, than they know
downside risk
A patriotic investor displaying home bias without any reasearch
affinity bias
To assist an investor with representative bias, good advice would by
past models and experiences may not always apply to a current investment
Do not have their own ideas about investing
followers
