LM 5: The Behavioral Biases of Individuals

Question 1

What is the difference between cognitive errors and emotional biases?

Answer 1

emotional biases: decisions made on feelings or emotions

cognitive errors: due to faulty cognitive reasoning

Question 2

What are two ways to classify cognitive errors?

Answer 2

belief perseverance biases & information processing errors

Question 3

What are the 5 different belief perseverance biases? CCRIH

Answer 3

-conservatism
-confirmation
-representativeness
-illusion of control
-hindsight

Question 4

Describe conservatism bias, confirmation bias, and representativeness biases.

Answer 4

• conservatism bias: Failing to incorporate new information in a timely manner or holding onto prior views
• confirmation bias: tendency to look for & notice what confirms prior beliefs and ignore or undervalue whatever contradicts them.
• representativeness bias: assessing likelihood of event based on past event

Question 5

Describe illusion of control bias and hindsight bias.

Answer 5

• illusion of control bias: people tend to believe that they can control or influence outcomes when in fact they cannot
• hindsight bias: believing past events as having been predictable and reasonable to expect

Question 6

What are the 6 types of emotional biases? LOSSER

Answer 6

-loss-aversion bias
-overconfidence bias
-self-control bias
-status quo bias
-endowment bias
-regret-aversion bias

Question 7

What is loss aversion or disposition effect?

Answer 7

• loss aversion bias refers to strongly prefer avoiding losses to achieving gains (disposition effect)

Question 8

What is overconfidence bias?

Answer 8

• overconfidence bias: bias in which people demonstrate unwarranted faith in their own abilities

Question 9

What is self-control bias?

Answer 9

• which people fail to act in pursuit of their long-term goals for their short-term satisfactory goals.

Question 10

What is status quo bias?

Answer 10

• status quo bias: where people choose to do nothing instead of making a change, even when change is warranted

Question 11

What is endowment bias?

Answer 11

• endowment bias: people value an asset more when they own it than when they don’t

Question 12

What is regret aversion bias?

Answer 12

regret-aversion bias: people tend to avoid making decisions out of fear decision will turn out poorly

Question 13

What are the 4 information processing biases?

Answer 13

-anchoring & adjustment bias
-mental accounting bias
-framing bias
-availability bias

Question 14

What is anchoring & adjustment bias?

Answer 14

• anchoring & adjustment bias: people rely too much on the initial piece of information (i.e., the “anchor”) in estimating an unknown value

Question 15

What is mental accounting bias?

Answer 15

mental accounting bias: mentally dividing money into accounts that influence decisions

Question 16

What is framing bias?

Answer 16

• framing questions: person answer differently based on how question is asked or framed

Question 17

What is availability bias?

Answer 17

• availability bias: rely on information that comes readily to mind when evaluating situations or making decisions

Question 18

What are market anomalies?

Answer 18

change in a security’s price that cannot be attributed to new information.

Question 19

What are 3 types of market anomalies?

Answer 19

• momentum
• bubbles & crashes
• value

Question 20

What is momentum anomaly?

Answer 20

buying stocks that have momentum or have been doing well

Question 21

Which 3 biases cause momentum anomaly? AHL

Answer 21

• availability bias
• hindsight bias
• loss aversion bias

Question 22

What is bubble or crash market anomaly?

Answer 22

rapid escalation or deescalation of market value or price of assets

Question 23

What are 3 biases that cause bubbles & crashes in market anomaly? OCS

Answer 23

-overconfidence bias
-confirmation bias
-self-attribution bias

Question 24

What is value anomaly in market anomaly?

Answer 24

higher average returns on value as opposed to growth stocks

Question 25

What is the behavioral explanation for value market anomaly?

Answer 25

mispricing rather than compensation for increased risk

Question 26

What is the halo effect?

Answer 26

evaluation of one characteristics making assumptions for other characteristics that are unrelated

Question 27

What is home bias?

Answer 27

portfolios exhibit strong bias in favor of domestic securities instead of global securities

Question 28

What is the difference between belief perseverance biases & processing errors?

Answer 28

• belief perseverance: cling to previously held beliefs and refuse to accept new information
• processing errors: information processed and used illogically or irrationally in financial decision making

Question 29

What is cognitive dissonance?

Answer 29

mental discomfort that arises when new information conflicts with initial beliefs

Question 30

What are the 2 types of representativeness bias?

Answer 30

1. base rate neglect
2. sample size neglect

Question 31

Whats the difference between base rate neglect vs sample size neglect?

Answer 31

base rate neglect: neglect existing knowledge when evaluating new information.

Sample-size neglect: scenario where a small sample is incorrectly assumed to be representative of the population

Question 32

What is narrow framing?

Answer 32

focusing too much on the details and losing sight of the big picture

Question 33

What is self-attribution bias?

Answer 33

where people consistently attribute success to their own skill and failure to external factors.

Question 34

What are 3 factors that result in misclassification of anomalies?

Answer 34

1. Choice of asset pricing model
2. Statistical issues
3. Temporary disequilibria (January effect)

Question 35

What is the recency effect?

Answer 35

where people assign more weight and credibility to recent events.

Question 36

What are 2 behavioral causes of value anomalies?

Answer 36

1. halo effect
2. home bias