LO 2.1.1: Predict how psychology in terms of cognitive errors will affect a client’s goals, perspective, understanding, decision making process and actions.

Question 1

Cognitive errors

Answer 1

Cognitive errors are decision-making based on well-known concepts that may or may not be correct.
* based on lack of understanding or faulty reasoning

Question 2

Cognitive errors can be mitigated by

Answer 2

better coaching or information.

Question 3

Illusion of control bias

Answer 3

Believe you can control outcome of an event when you cannot.

• related to overconfidence bias
• e.g. trading more bc can control outcome or are overconfident in analysis

Question 4

Money illusion

Answer 4

Tendency to think one dollar has the same value today, tomorrow, and into the future, without considering inflation.
* e.g. 7% return in 8% inflation vs. 4% return in 2% inflation, money illusion is choosing 7% return / getting more excited about higher returns than lower interest rates.

Question 5

Conservatism bias

Answer 5

Initially form a rational view but fail to change that view as new information becomes available.

• Example on p. 55:
  
  • A client’s stock is a pharmaceutical company switches from five-day to overnight shipping. The stock rose. Later, the same company violated laboratory practices and was fined, which will likely cause the stock to fall. But the client still subconsciously weighed the shipping info as more important, so the client did not sell the stock.

Question 6

Hindsight bias

Answer 6

Selective memory of the past and have a tendency to remember your correct views and forget your errors.
* They also overestimate what could have been known.

Question 7

Confirmation bias

Answer 7

look for ways to justify your current beliefs.

• Example on p. 57:
  
  • Client has been employed at a co. for 25 years, feels he has more info as an employee of co. than those not employed (this is not the case). Client invests more into his employer’s stock—leads to underdiversification and increase of risk of loss that could have been mitigated with diversification.

Question 8

Representativeness

Answer 8

When considering choices in a decision, you tend to recall a past experience similar to the present decision-making situation, and assume this one is like the other.

• Example on p. 57-58:
  
  • A stock could be classified as a value stock, and so new information is analyzed based on that classification even if the stock is not really a value stock.

Question 9

Sample size neglect

Answer 9

Related to representativeness, initial classification based on overly small and potentially unrealistic sample of data.

• Example on p. 58:
  
  • Initial classification of a stock based on dividend yield, without considering any of the other typical characteristics of a value stock

Question 10

Mental Accounting

Answer 10

Mental accounting (AKA money jar mentality) involves the tendency of individuals to mentally put their money into separate accounts (or money jars) based on the purpose of these accounts.

• Example on p. 59:
  
  • Client saved for $15K a Mediterranean cruise in 6 months, but roof began leaking, repairs cost $10K. Client decides to withdrawal from IRA to pay income tax plus 10% penalty instead of spending the money saved for his vacation. Irrational financial decision resulted by mentally putting money into separate accounts based on the function of these accounts.

Question 11

Cognitive Dissonance

Answer 11

Conflicting attitudes, beliefs, or behaviors that cause a feeling of mental discomfort. This leads to changing some of attitudes, beliefs, or behaviors to reduce discomfort and feel more balanced.

Question 12

Selective perception

Answer 12

Related to cognitive dissonance,

• Only register info that appears to affirm with an already chosen decision.
• This ties to rationalization or confirmation bias (p. 57).

Question 13

Selective decision-making

Answer 13

Related to cognitive dissonance, * This occurs when commitment to an original decision course is high.
* Rationalizes actions that enable a person to adhere to the original course.

Question 14

Self-Attribution bias

Answer 14

Ego defense mechanism.

* Individuals take credit for success, and blame others or external factors for failures.

Question 15

Self-enhancing bias

Answer 15

Related to self-attribution bias, tendency to claim an irrational degree of credit for success.

Question 16

Self-protecting bias

Answer 16

Related to self-attribution bias, irrational denial of responsibility for failures.

Question 17

Anchoring

Answer 17

Irrational decisions based on information that should have no influence on the decisions at hand.

• AKA “Anchoring and adjustment bias”
• Example on p. 60:
  
  • Client conduct in late 1990s regarding tech stocks- investors could do no wrong buying tech stocks, no matter what prices were paid, bc they would be higher in the future.
  • However, the prospect of earnings for many of these companies was well into the future, but investors did not react.
  • By the end of 2002, cost of anchoring to these stock prices was resulted in significant losses.

Question 18

Outcome bias

Answer 18

Tendency to take a course of action based on the outcomes of prior events, ignoring current conditions.

• Example on p. 61:
  
  • Client’s friend tells her that last year she received a high return on an investment she made. The client makes the same investment herself, due to major economic downturn before the client made her investment, she lost money. The outcome bias takes place because she the client based her decision to invest on her friend’s outcome rather than on current economic conditions.

Question 19

Framing bias

Answer 19

Tendency to process and respond to information based on the manner in which it is presented.

• Example on p. 61: 1K and 2 options, 2K and 2 options M.2(P.1)
• Framing bias takes place when you choose different options bc of how the question is asked/framed.

Question 20

Recency bias

Answer 20

AKA availability bias, gives recent information more importance because it is most vividly remembered
* Just because something is more recent, or easy to recall — therefore being more vivid — doesn’t mean it’s more important for a decision.

Question 21

Herding

Answer 21

Related to recency bias, investors trade in the same direction or in the same securities, even contrary to information they have available.

• Investors feel more comfortable trading w/consensus of a group
• Recent data or trend becomes investors forecast
• Going by popular opinion, not to blame if others are also wrong

Question 22

How can cognitive errors affect a client’s goals, perspective, understanding, and decision making process and actions

Answer 22

lead to faulty conclusions or a misunderstanding of role in the process.

• As advisers, help clients:
• • understand there is a bias at play here;
• • see it truly is a bias;
• • move that past that to help them make more rational, logical decisions.