Behavioural Finance Flashcards
Cognitive Errors
Emotional Biases
9x Cognitive Errors - Easier to remove as they arise from faulty reasoning or memory errors. 9x
Conservatism
Confirmation
Representativeness
Illusion of control
Hindsight
Anchoring & Adjustment
Mental Accounting
Framing
Availability
6x Emotional Biases LOSSER - Not related to conscious thought. Stem from feelings or impulses. Difficult to overcome.
Loss Aversion bias
Overconfidence bias
Self control bias
Status Quo bias
Endowment bias
Regret aversion bias
Cognitive Errors (Consequence, Mitigation)
Conservatism
Confirmation
Representativeness (2 types)
Conservatism - Maintaining a prior forecast by inadequately incorporating IMPORTANT INFORMATION. market participants rationally form an initial view but then fail to change that view as new information becomes available. FAIL TO INCORPORATE NEW INFORMATION
Consequence - Unwilling or slow to update a view or forecast for new information, and therefore hold an investment too long.
Detection - Cognitive cost. The higher the cognitive cost the less likely new informaiton will be processed. It can be corrected by properly analyzing and weighting new information.
Confirmation - actively looking for new information or distort new information to support an existing view.
consequence - Consider positive but ignore negative information and therefore hold investments too long.
Set up the decision process or data screens incorrectly to find what they want to see.
Detection - Corrected by actively seeking information which changes your belief.
Representativeness - ‘Representativeness is classifying new information based on past experience’. It involves adopting a forecast based on LIMITED INFORMATION. However people will often place TOO MUCH EMPHASIS ON NEW INFORMATION. Such that recent bankruptcies in the sector will cause a focus company also to become bankrupt. Too much emphasis based on new information.*
Base rate neglect - Ignoring long term base rate probability data. (Ie a company survived the last cycles so why not this one?) saying 100% that a stock is a value stock when news suggests otherwise.
Sample size neglect - using a too small a sample to make classifications of a larger population. eg short time horizon to show talent.
Detection: ‘Use a periodic table of investment returns’ to identify previous periods have also had varying returns.
Cognitive Errors (Consequence, Mitigation)
Illusion of control
Hindsight
Anchoring & Adjustment
Illusion of control - market participants think they can control or affect outcomes when they cannot. Unwilling to listen to others.
Trade more than is appropriate as they mistakenly believe they can control the outcome of a trade or are overconfident in their analysis.
Fail to adequately diversify.
Overtrading.
Detection: Investors should recognize that investing is a probabilistic activity. Acknowledging that short-term beliefs empirically have little impact on long-term performance.
Hindsight - selective memory of past events, actions, or what was knowable in the past, resulting in an individual’s tendency to see things as more predictable than they really are. Individuals assume they could have foreseen uncertain events.
Overestimate the rate at which they correctly predicted events which could reinforce an emotional overconfidence bias.
Detection: Ask yourself ‘Am I re-writing history or being honest about the mistakes I made?’
Anchoring & Adjustment - ‘Individuals begin with an initial default number (anchor) which is adjusted insufficiently with additional IMPORTANT INFORMATION. “Estimating a number with unknown magnitude such as price target being somwhere around a 52 week high”. When individuals are forced to estimate an unknown, they often select an arbitrary initial value (the anchor) and then try to adjust it up or down as they process information.
Consequence - sticking too closely to original estimates when new info is learned.
Detection - Ask yourself ‘Am I holding this stock based on rational analysis or am I anchored to a purchase price or high water mark?’
Cognitive Errors (Consequence, Mitigation)
Mental Accounting
Framing
Availability
Mental Accounting - money is treated differently depending on how it is categorized. For example a client might mentally treat wages differently from a bonus when determining saving and investment goals.
Segregating return into arbitrary categories of income, realized gains and losses.
Consequence - Placement of investments into buckets without regard to correlations of each bucket., Underdiversification.
Detection - Look to recognise the drawbacks of not considering correlation in the portfolio construction process.
Framing - when decisions are affected by the way in which the question or data is “framed.
Consequence - Picking portfolios based on how IPS are worded. ie 70% chance you will reach a target sounds better than 30% chance you wont reach a target. Choose suboptimal risk for their portfolio or assets based on the way a presentation is made.
Detection - Ask questions such as ‘is the decision a result of focusing on a net gain or net loss position?’
Availability - ‘Estimate the probability of outcome based on how easily it comes to mind.
LIMITED INFORMATION.
Consequence - Choose a manager or investment based on advertising or recalling they have heard the name. Limited opportunity set.
Detection - Availability could be overcome by maintaining a carefully researched and constructed Investment Policy Statement (IPS); through appropriate research and analysis of all decisions; and a long term focus
Emotional Biases
LOSSER
c - consequence
m -
L
O
S
Loss Aversion bias - feeling more pain from a loss than pleasure from an equal gain. The conclusion is that individuals display asymmetrical responses to gains and losses.
consequence - Running losers and selling winners. Lower trading volumes due to holding losers and concentration in subsectors (unless it’s an EMN strategy)
detection - Loss aversion could be overcome by maintaining views based on FUNDAMENTAL analysis not perceived gain or loss.
Overconfidence bias - ‘when market participants overestimate their own intuitive ability’ or reasoning. It can show up as illusion of knowledge where they think they do a better job of predicting than they actually do.
consequence - Underestimate risk and overestimate return. Lack of diversification.
detection - Trading records should be reviewed identifying both winners and losers over a minimum TWO-YEAR time horizon.
Self control bias - when individuals lack self-discipline and favor immediate gratification over long-term goals. This creates deviation from the IPS and long term goals and results in asset allocation imbalance and risk profile change.
consequence - insufficient savings accumulation to fund retirement as you think you’ll do better than realistic.
Detection - Self-control bias might be overcome by establishing an appropriate INVESTMENT PLAN (asset allocation) and a budget to achieve sufficient savings.
Emotional Biases
LOSSER
c - consequence
m - mitigation
S
E
R
Status Quo bias - when comfort with the existing situation leads to an unwillingness to make changes. Such as staying in your original risk profile.
Consequence - Holding portfolios with inappropriate risk.
Detection - Exceptionally hard to overcome so EDUCATION on risk/return is key.
Endowment bias - occurs when an asset is felt to be special and more valuable simply because it is already owned. For example, when one spouse holds on to the securities their deceased spouse purchased for some reason like sentiment that is unrelated to the current merits of the securities.
Consequence - Fail to sell assets and replace them with others. Innappropriate asset allocation.
Detection - Endowment is common with inherited assets and might be detected or mitigated by asking a question such as “Would you make this same investment with new money today?
Regret aversion bias - when market participants do nothing out of excess fear that their actions could be wrong. Their sense of regret and pain is stronger for acts of commission, often resulting in inaction.
Consequence - Excess CONSERVATISM in the portfolio because of bad experience in the past. HERDING behaviour feeling safer in a crowd..
Detection - EDUCATION is essential, regret-aversion might be mitigated through effective communication on the BENEFITS OF DIVERSIFICATION.
status quo bias
naive diversification
excessive trading
home bias
status quo bias - staying in your original risk bucket and not moving as you get older. Failure to explore other options.
naive diversification - splitting cash 1/n equally among suggested funds even though they might me 4 out of 5 of them bond funds.
excessive trading - disposition effect selling winners and running losers.
home bias - buying the home market only due to ‘availability’ ‘endownment’ or ‘illusion of control’ bias.
Behavioral Portfolio Theory
Behavioral Portfolio Theory - Creating 5 Layers
Goals
Asset Allocation
Diversification
Market asymetry/concentrated holdings
cash allocation
Layering like this creates ‘mental account’ behavioural bias.
Goal Based Investing GBI behavioural portfolio theory
Mean variance portfolio
Setting Layers similarly to BPT with high priority goals at the bottom and lower risk assets used to meet that need and low priority aspirational goals at the top with riskier assets used to reach those aspiration.
Mean variance portfolio places does not create mental accounts and looks at looks at expected return and variance of the portfolio as a whole.
Consistent with Loss aversion in prospect theory.
Gamblers Fallacy
Hot hand fallacy
Gamblers Fallacy - Thinking a mean reversion or reverse in trend is more likely than probable. Ie three reds in a row must make a black more likely next time when it’s still 50:50.
Hot hand fallacy where you extrapolate data into the future without new basis. Ie a stock is a growth stock so will continue to be so. Uses reprasentative bias.
Social Proof Bias
Self attribution
Social proof bias = When a person follows the belief of a group. Seeking endorsement or favourable judgement as you wish to appease your group. Remedied by having a diverse group of backgrounds on the board.
Self attribution = Taking credit when things go right and blaming others when things go wrong.
Momentum Effect
Herding
Investors joining into a trend which can last up to two years. Following the lead of others which at first is not considered irrational.
Herding -
Classifying investors models
Barnewall two-way behavioural model -
You have two behaviour types Active & Passive
Active: Usually a self made individual with higher risk tolerance. Likes to take an active role and feel informed/in control.
Passive: More concerned about losing money and risk averse. Makes earnings passively from employment. Needs greater security due to less economic resources.
Classifying investors models
BB&K Model - Bailard, Biehl and Kaiser 5-way model
Bailard, Biehl and Kaiser 5-way model
See image: Y axis Confident in decision making through to anxious, X axis Careful through to Impetuous
Individualist (Top left) Good to work with and rational
Adventurer (Top right) Takes chances, difficult to work with
Straight arrow (center) Sensible and secure
Guardian (bottom left) Seeks advice
Celebrity (bottom right) Center of attention, seeks advice
I - A
- S -
G - C
The Pompian Behavioural Model
4 behavioural types
Passive Preserver (Passive, Lowest Risk Tolerance, Conservative style, Emotional decision making)
Friendly Follower (Passive, Cognotive decision making)
Independant Individualist (Active, Cognitive)
Active Accumulator (Active, Highest Risk Tolerance, Most Aggressive style, Emotional decision making)
See table in notebook and create physical flash card**
