General Principles Chapter 1: Behavioral Finance Flashcards
Heuristics
Experiences and biases that can facilitate problem-solving and probability of judgement. These strategies are generalization, or rules-of-thumb, reduce cognitive load.
Examples: using trial and error, a rule of thumb, or an educated guess
Financial Infidelity
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. There can still be a sharing of money, assets, and financial decisions within the relationship.
Anchoring
the tendency of investors to become attache to specific price as the fair value of a holding
Attachement Bias
holding onto an investment for emotional reasons rather than considering more practical applications
example: my grandfather left my this stock so I can never sell it
Endowment Bias
The endowment effect describes an emotional bias that causes individuals to value an owned object higher, often irrationally, that its real-world market value. In reality, you might not even purchase the asset if you didn’t already own it.
Financial Enmeshment Bias
happens when the finances of parents and children are inappropriately commingled. There are position papers that argue that situations like pursuing college education, tight job markets and expensive housing costs may lead to financial enmeshment. Excessive financial enmeshment may lead to children having a lack of financial motivation and even to lowered confidence and self-esteem.
Cognitive Dissonance
the challenge of reconciling two opposing beliefs
Confirmation Bias
The natural human tendency accept any information that confirms our preconceived position or opinion and to disregard any information that does not support that preconceived notion
Diversification Errors
investors tend to diversify evenly across whatever options are presented to them
Fear of Regret
the tendency to take no action rather than risk making the wrong
example: an investor who holds onto a stock that’s losing value, because if they sold it and it rebounded they would feel even worse
Gambler’s Fallacy
an individual erroneously believes that the onset of a certain random event is likely to happen following an event or series of events
Herd Behavior
the tendency for individuals to mimic the actions of a larger group. Can also be described as Fear of Missing Out (FOMO)
Hindsight Bias
the 20/20 vision we have when looking at a past event and thinking we understand it, when in reality we may not
Inappropriate Extrapolation
the tendency to look at recent events (or market performance) and assume that those events or conditions will continue indefinitely
example: the bond market has outperformed the stock market for the past year and will continue to do so for the future because of the continued economic downturn
Analysis Paralysis
Describes 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.
When the fear of either making an error outweighs the potential value of success in a decision made in a timely manner
Loss Aversion and Risk Taking
while investors are risk averse when it comes to gains (they do not want to give them up), they are risk seeker when it comes to losses (they will take big risks to avoid realizing them). Emotion has clouded the decision. Compounding the problem is that investor’s view errors of omission as worse than errors of making a bad decision
Prospect Theory
describes the different ways people evaluate losses and gains. researchers found that losses have much greater negative impact than a commensurate gain will have positive
Mental Accounting
entails looking at sums of money differently, depending on their source or the intended use
Outcome Bias
tendency to make a decision based on the desired outcome rather than on the probability of that outcome
Overconfidence
tendency to place too much emphasis on one’s own abilities, often works hand in hand with confirmation bias
Overreaction
investors emotionally react towards new market information
Over-Weighting the Recent Past
investors like patterns, and recent past represents a nice, easy-to-find pattern that can become the basis for an investment decision
Self-Affirmation Bias
belief that when something goes right, it is because you were smart and made the right decision. If it does not work out, it someone else’s fault or simply bad luck
Spotting Treat That Are Not There
investors seek patterns that help support decision sometimes without adequate confirming research
Status Quo
tendency of investors to do nothing when action is actually called for
Money Avoidance
Feeling that money has a negative connotation and ignore personal finances to avoid emotional distress
Example: “money is the root of all evil”
Ways to deal with: disassociating the idea of good and evil from money, as well as regularly scheduling time to review and check on your finances
Money Worship
belief that happiness externally comes from, and directly related to, having more wealth.
Example: could be compulsive spending towards a never-ending goal of obtaining monetary things to provide happiness
Ways to deal with: shifting the emphasis towards non-monetary things in your life that bring you joy including meditation, exercise, relationships, pets, hobbies, etc.
Money Vigilance
being concerned and aware of one’s financial wellbeing; with important and emphasis being placed on savings and being prepared
Example: being overly cautious with money to the extent that enjoyable things (vacations) are sacrificed
Ways to deal with: include achieving a balance of feeling secure with savings, while still spending money on things that make you happy
Money Status
belief that one’s internal value and self-worth is directly correlated to their financial worth, and that to be a better person, they need more.
Example: include overspending, hiding finances from others and associating shame with lack of money
Ways to deal with: could include uncovering and resolving the root cause of this mindset, often instilled during childhood and separating your worth from your amount of wealth. Similar to money worship but worship tends to have involve more excessive spending
Framing Effect
Cognitive bias, in which a person makes decision based on whether the various options are presented oin a positive or negative way, meaning individuals can tend to overlook factual data. This person is affected by how the information worded rather than the actual information
Money Illusion
an economic theory positioning that people have a tendency to view their wealth in nominal dollar terms rather than real terms which must take inflation into into consideration. Also called “price illusion”
