General Principles: Behavioral Finance

Question 1

What is Heuristics?

Answer 1

Experiences and biases that can facilitate problem-solving and probability judgements. These strategies are generalizations or rules of thumb, but they often result in irrational or inaccurate conclusions

Question 2

What is financial infidelity?

Answer 2

When one partner, typically a spouse, lies to the other about debts, credit cards, keeps money in a secret account, hides purchases and otherwise hides or lies about money.

Question 3

What is anchoring?

Answer 3

Tendency of investors to become attached to a specific price as the fair value of a holding

Question 4

What is attachment bias?

Answer 4

Holding onto an investment for emotional reasons rather than considering more practical applications for inheritance

Question 5

What is endowment bias?

Answer 5

An emotional bias that causes individuals to value an owned object higher, often irrationally, that its real market value.

Question 6

What is financial enmeshment bias?

Answer 6

When the finances of parents and children are inappropriately commingled or when parents involve their children in adult financial matters before the children are cognitively and emotionally ready to cope with the information.

Question 7

What is cognitive dissonance?

Answer 7

The challenge of reconciling two opposing beliefs

Question 8

What is confirmation bias?

Answer 8

The natural human tendency to accept any information that confirms our preconceived position or opinion and to disregard any information that does not support that notion

Question 9

What are diversification errors?

Answer 9

Investors tend to diversify evenly across whatever options are presented to them

Question 10

What is fear of regret?

Answer 10

The tendency to take no action rather than risk making the wrong one

Question 11

What is gambler’s fallacy?

Answer 11

An individual erroneously believes that the onset of a certain random event is likely to happen following an event or a series of events

Question 12

What is herd behavior?

Answer 12

The tendency for individuals to mimic the actions of a larger group

Question 13

What is hindsight bias?

Answer 13

20/20 vision when we look at a past event and think we understand it, when in reality we probably do not and causes overconfidence

Question 14

What is inappropriate extrapolation?

Answer 14

The tendency to look at recent events (or market performance) and assume that those events or conditions will continue indefinitely

Question 15

What is analysis paralysis?

Answer 15

An individual/couple overanalyzing a situation and can cause decision making to become paralyzed, meaning that no solution or course of action is decided upon. The situation may be deemed as too complicated and a decision is never made due to the fear that a potentially larger problem may arise.

Question 16

What does it mean when someone has loss aversion or risk taking?

Answer 16

Investors are risk averse when it comes to gains (they dont want to give them up) and they are risk seekers when it comes to losses ( they will take big risks to avoid realizing them). Investors will hang onto losers to avoid the emotional pain of a loss.

Question 17

What is the prospect theory?

Answer 17

Researchers Kahnerman and Tversky found that losses have a much greater negative impact than a commensurate gain will have positive

Question 18

What is mental accounting?

Answer 18

Entails looking at sums of money differently, depending on their source or intended use

Question 19

What is outcome bias?

Answer 19

Tendency to make a decision based on the desired outcome rather than on the probability of that outcome

Question 20

What is overconfidence?

Answer 20

Tendency to place too much emphasis on one’s own abilities, often works hand in hand with confirmation bias

Question 21

What is overreaction?

Answer 21

Investors emotionally react towards new market information

Question 22

What is over-weighting the recent past?

Answer 22

Investors like patterns, and recent past represents a nice, easy-to-find pattern that can become the basis for an investment decision.

Question 23

What is self-affirmation bias?

Answer 23

Belief that when something goes right, it is because you were smart and made the right decision. If it does not work out, it is someone else’s fault or simply bad luck

Question 24

What is spotting trends that are not there?

Answer 24

Investors seek patterns that help support decisions sometimes without adequate confirming research

Question 25

What is status quo bias?

Answer 25

Tendency of investors to do nothing when action is actually called for

Question 26

What questions should a financial planner ask regarding biases or emotions to avoid these decision errors?

Answer 26

1. If you had to sell the investment and things turned around would you buy it back
2. Is feeling that you may be wrong affecting your decision
3. What is the client’s risk tolerance