General Principles Ch1 Flashcards
Experiences and biases that can facilitate problem solving and probability judgement. Generalizations, “rules-of-thumb”. Often result in irrational or inaccurate conclusions.
Heuristics
Examples include:
trial and error
rule of thumb
educated guess
Heuristics
Study of how psychology affects finance
Behavioral Finance
Happens 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.
Financial infidelity
Signs include unexplained withdrawals from accounts, expensive purchases, unfamiliar credit card or bank statements
Financial infidelity
Tendency of investors to become attached to a specific price as the fair value of a holding.
Anchoring
Holding onto an investment for emotional reasons rather than considering more practical applications.
Example: My grandfather left me this stock so I can never sell it.
Attachment Bias
An emotional bias that causes individuals to value an owned object higher, often irrationally, than its real-world market value.
Endowment Bias
Happens when the finances of parents and children are inappropriately commingled; may lead to children having a lack of financial motivation and even to lowered confidence and self-esteem.
Financial Enmeshment Bias
The challenge of reconciling two opposing beliefs.
Occurs when a person believes in two contradictory things at the same time.
Cognitive Dissonance
Investors tend to diversify evenly across what ever options are presented to them.
Example: 401k participants tend to spread their money across whatever options they have.
Diversification Errors
Tendency to take no action rather than risk making the wrong one.
Investor holds onto stock that’s losing value because if they sold and it rebounded, they would feel even worse.
Fear of Regret
Individual erroneously believes the onset of a certain random even is likely to happen following an event or series of events.
Example: Investor might hold onto a stock that has fallen in multiple sessions because they view further declines as improbable.
Gambler’s Fallacy
Tendency for individuals to mimic the actions of a larger group.
Herd Behavior or Fear of Missing Out (FOMO)
The 20/20 vision we have when looking at a past even and thinking we understand it, when in reality, we may not.
Example: After a prolonged period of solid returns, stock market drops 15%. Immediately, all kinds of experts appear on television saying we were due for a correction, as if the decline was obvious and inevitable.
Hindsight Bias
Tendency to look at recent events or market performance and assume that those events or conditions will continue indefinitely.
Inappropriate Extrapolation
Describes an individual/ a couple overanalyzing a situation and can cause decision making to become “paralyzed”, meaning no solution or course of action is decided upon.
When the fear of either making an error outweighs the potential value of success in a decision made in a timely manner. Results in suppressed decision making in an unconscious effort to preserve existing options.
Analysis paralysis
While investors are risk ________ when it comes to gains (they do not want to give them up), they are risk ________ when it comes to losses (they will take big risks to avoid realizing them).
averse / seekers
Describes different ways people evaluate losses and gains. Losses have a much greater negative impact than a commensurate gain will have positive impact.
Prospect Theory
Entails looking at sums of money differently, depending on their source or the intended use.
Example: investing in low interest CDs when you still have mortgage debt at 5% or carry a balance on your credit cards.
Mental accounting
The tendency to make a decision based on the desired outcome rather than on the probability of that outcome.
Example: investor wants to double his money in an investment without doing adequate research
Outcome bias
Tendency to place too much bias on one’s own abilities. Often works hand in hand with confirmation bias
Overconfidence
Investors emotionally react towards new market information
Overreaction
Investors like patterns, and recent past represents a nice, easy-to-find pattern that can become the basis for an investment decision.
Over-weighting the Recent past
The 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.
Self-Affirmation Bias
Tendency of investors to do nothing when action is actually called for.
Status Quo Bias
Investors seek patterns that help support decisions sometimes without adequate confirming research
Spotting Trends that Are Not There
Subconscious beliefs people have regarding money, many of which were developed in childhood.
Money Scripts
Negative ideas about wealth; having less is more morally sound; $ = evil
Money avoidance
Spend too much; overestimate sense of satisfaction from buying things
Money worship
Wealthy but still have higher-than-average financial anxiety
Money vigilance
Conflate net worth and self-worth
Money Status
A person makes a decision based on whether the various options are presented in a positive or negative way, meaning individuals tend to overlook factual data.
Examples:
If you buy Security 1, you could make a 50% profit.
If you buy Security 1, you could lose everything if anything goes wrong and also miss out on a 50% profit.
Choosing a soap that kills 98% of germs rather than one that allows only 2% of germs to survive.
Framing Effect
People have a tendency to view their wealth in nominal dollar terms rather than real terms, which must take inflation into consideration.
Example: A 2% reduction in pay with 0% inflation is deemed worse than a 2% pay increase with 4% inflation. Identical net effect to worker.
Money Illusion
FINANCIAL PLANNING PROCESS
Umbrellas
In
A
Downpour
Prevent
Immense
Mess
- Understanding Client’s Personal & Financial Circumstances
- Identifying and selecting goals
- Analyzing current and potential courses of action
- Developing recommenations
- Presenting recommendations
- Implementing recommendations
- Monitoring progress and updating.
