Behavioral Finance Theory Flashcards
Prospect Theory
Most individuals are more risk averse vs. pleasure seeking by a ratio of roughly 2:1.
• People make decisions based more on probabilities than potential outcomes
• People make decisions using mental heuristics (e.g., mental shortcuts and biases)
• Loss aversion: the tendency to feel the impact of losses more than gains
• This value function can be illustrated graphically using an asymmetrical s shaped curve
Examples of Cognitive Dissonance
Cognitive dissonance can cause investors to hold losing securities positions that they otherwise would sell because they want to avoid the mental pain associated with admitting that they made a bad decision.
Cognitive dissonance can cause investors to continue to invest in a security that they already own after it has gone down (average down) to confirm an earlier decision to invest in that security without judging the new investment with objectivity and rationality. A common phrase for this concept is “throwing good money after bad.”
Cognitive dissonance can cause investors to get caught up in herds of behavior; that is, people avoid information that counters an earlier decision (cognitive dissonance) until so much counter information is released that investors herd together and cause a deluge of behavior that is counter to that decision.
Conservatism
• bias where people cling to their prior views or forecasts at the expense of acknowledging new information
• individuals are inherently slow to change
When conservatism biased investors do react to new information, they often do so too slowly.
Conservatism can relate to an underlying difficulty in processing new information.
Cognitive Dissonance
confusion or frustration that arises when an individual receives new information that does not match up with or conform to preexisting beliefs or experiences
Representativeness
- a cognitive bias through which individuals process new information using pre existing ideas or beliefs
- an investor 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
Examples of Illusion of Control
Illusion of control bias can lead investors to trade more than is prudent.
Illusions of control can lead investors to maintain under diversified portfolios.
Hindsight Bias
cognitive bias where investors perceive investment outcomes as if they were predictable, even if they were not
Hindsight biased investors can unduly fault or praise their money managers when funds perform poorly/well
When an investment appreciates, hindsight biased investors tend to rewrite their own memories to portray the positive developments as if they were predictable.
Mental Accounting
a cognitive bias in which individuals treat various sums of money differently based on where these monies are mentally categorized (e.g., retirement, college, etc.)
Mental accounting bias can cause investors to irrationally distinguish between returns derived from income and those derived from capital appreciation.
Mental accounting bias can cause investors to allocate assets differently when employer stock is involved.
In the same vein as anchoring bias, mental accounting bias can cause investors to succumb to the “house money” effect, wherein risk taking behavior escalates as wealth grows.
Anchoring
Forecasts are too…
• a cognitive bias where investors are influenced by purchase point or arbitrary price levels and cling to these numbers when deciding to buy or sell and investments
• individuals often rely too heavily on certain information (often the first data points received) when making decisions
Investors tend to make general market forecasts that are too close to current levels.
Investors (and securities analysts) tend to stick too closely to their original estimates when new information is learned about a company.
Framing
cognitive bias where an individual responds to similar situations differently based on the context in which the choice is presented
Narrow framing, Narrow framing, a subset of framing bias, can cause even long long-term investors to obsess over short short-term price fluctuations in a single industry or stock.
Framing and loss aversion can work together 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 predisposed toward less risky alternatives.
Availability
a cognitive bias where easily recalled outcomes (often from more recent information) are perceived as being more likely that those that are harder to recall or understand
Narrow range of experience. Investors will choose investments that fit their narrow range of life experiences, such as the industry they
Resonance. Investors will choose investments that resonate with their own personality or that have characteristics that investors can
Self Attribution
a cognitive bias where people ascribe successes to their innate talents and blame failures on outside influences
Self attribution bias often leads investors to trade more than is prudent or take on too much risk.
Self attribution bias leads investors to “hear what they want to hear.” That is, when investors are presented with information that confirms a decision that they made to make an investment, they will ascribe “brilliance” to themselves.
Self attribution bias can cause investors to hold under diversified portfolios
Outcome Bias
a cognitive bias in which people often make decisions or take action based on the outcome of past events rather than by observing the process by which that outcome occurred
Recency Bias
Can make investor ignore…(2)
• investors tend to believe that patterns, trends and movements in the recent past are likely to repeat themselves
• individuals put too much weight on and make decisions based on inputs and feedback they have recently received
Recency bias can cause investors to extrapolate patterns and make projections based on historical data samples that are too small to ensure accuracy. Investors who forecast future returns based too extensively on only a recent sample of prior returns are vulnerable to purchasing at price peaks.
Recency bias can cause investors to ignore fundamental value and to focus only on recent upward price performance.
Recency bias can cause investors to ignore proper asset allocation. Professional investors know the value of proper asset allocation, and they rebalance when necessary, in order to maintain proper allocations.
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 causes investors to hold losing investments too long. This hold losing investments too long.
Loss aversion can cause investors to sell winners too early, in the fear that investors to sell winners too early
Loss aversion can cause investors to unknowingly take on more risk in their portfolio than they would if they simply eliminated the investment and moved into a better one (or stayed in cash).
