Behavioural Finance Flashcards
What are heuristics?
Heuristics are rules of thumb, mental shortcuts, guidelines or strategies people use to solve problems or make decisions.
What are the three key elements of heuristics? Define them.
Availability heuristic - Tendency for people to base their answer on recently acquired information
Eg a company announcing good first quarter results and the stock price rising temporarily.
Representativeness heuristic - when being asked to predict likelihood of A belonging to B we will often think of a similarity between them and base a response on that.
Eg people thinking because a company is in the same industry as another underperforming company, then that company is a poor investment.
Anchoring and adjustment heuristic - the tendency to focus heavily on or anchor to one specific piece of info or reference point and adjust expectations from there
Eg an investor not reacting appropriately to positive earnings from a company that in the past did not perform very well.
What is conservatism bias?
Conservatism bias is when one doesn’t revise beliefs after being presented with new evidence
What is confirmation bias?
Confirmation bias is when one interprets info that confirms one’s preconceptions
What is cognitive dissonance?
Cognitive dissonance was the discomfort when dealing with two contradictory ideas.
What is hindsight bias?
Hindsight bias is when past events were predictable at the time they occurred.
What is the illusion of control?
The illusion of control is the overestimation of one’s control over external events.
What is affinity?
Affinity is the tendency to be drawn to those people/things that one’s views are similar to themselves.
What is disposition?
Disposition is the tendency to sell an asset that has accumulated in value and resist selling one that has declined in value.
What is endowment or divestiture aversion?
Endowment or divestiture aversion is the tendency to overvalue an object because you possess it.
Eg a homeowner may expect to seek his home for a higher price than comparable homes because he thinks it’s worth more
What is loss aversion?
Loss aversion is the tendency to think that losses are more painful than gains
What is overconfidence?
Overconfidence is the tendency to be overly sure of oneself and ones ideas.
It can cause investors to under-react to new information.
A way to eliminate this bias is to have an investor purchase the entire market through an index fund than selecting individual securities.
What is regret aversion?
Regret aversion is the tendency to avoid making decisions for fear of experiencing regret.
What is prospect theory?
Prospect theory attempts to explain how people make choices when they are confronted with risk or the outcome is unknown.
What is status quo bias?
Status quo bias is a tendency to stick with the status quo even though it is not more attractive than the other options available.
Eg an eg employees deciding to stick with a fund in a DCPP because employers automatically deposit contributions in that fund.
