Part 9. The Behaviour Biases of Individuals

Question 1

2 forms of behaviour biases:

Answer 1

1. Cognitive bias - corrected/eliminated through better information, education and advice.
2. Emotional bias - harder to correct as stem from impulses and intuitions.

Question 2

2 categories of cognitive errors:

Answer 2

1. Belief perseverance bias = the tendency to cling to ones previously held beliefs by committing statistical, info-processing or memory errors.
   e. g. conservatism, confirmation, representativeness, illusion of control, hindsight
2. Processing errors = describe how information may be processed and used illogically/irrationally in financial decision making.
   e. g. anchoring and adjustment, mental accounting, framing and availability.

Question 3

Cognitive dissonance

Answer 3

Belief perseverance biases result from mental discomfort that occurs when new information conflicts with previously held beliefs or cognitions.

Question 4

Conservatism bias

Answer 4

A belief perseverance bias in which people maintain their prior views or forecasts by inadequately incorporating new, conflicting information.

• in Bayesian term - tend to overweight their prior probability of event and underweight new information, resulting in revised beliefs about probabilities and outcomes underreact to new information.

Question 5

Consequences of conservatism bias:

Answer 5

• Maintain or be slow to update view or forecast, even when presented with new information.
• Maintain prior belief than deal with mental stress of updating beliefs given complex data – difficultly in processing new info.

Question 6

How to overcome conservatism bias?

Answer 6

• Properly analysing and weighting new information.
• Be aware bias exists, especially for technical, abstract and/or statistical information, as cognitive cost involved in processing info is higher.
• FMPs should conduct careful analysis incorporating new info and respond appropriately.
• Updating prior beliefs in light of new information, in consistency with Bayes Rule.
• If difficult, FMPs should seek guidance in explaining how to interpret the information/explain its implications.

Question 7

Confirmation bias

Answer 7

This refers to tendency to look for and notice what confirms prior beliefs and to ignore or undervalue whatever contradicts them.

This reflects a predisposition to justify ourselves and what we want to believe.

e.g. clients insisting on a particular investment in a portfolio, when adviser recommends otherwise.

Question 8

Consequences of confirmation bias:

Answer 8

• considers only positive information about investment, ignoring any negative information.
• develop screening criteria while ignoring info either refutes the validity of criteria or supports other criteria.
• under-diversify portfolios - FMPs may be convinced of the value of a single company’s stock, building larger position than appropriate.
• Hold disproportionate amount of their investment assets in their employing company’s stock, as believe in their company, and convinced of its favourable prospects.

Question 9

How to overcome confirmation bias?

Answer 9

• By actively seeking out information and challenging existing beliefs.
• To corroborate an investment decision, e.g. if investment selections are based on criteria confirming existing belief, its advisable to confirm decision from another perspective/source.

Question 10

Representative bias

Answer 10

This refers to tendency to classify new information based on past experiences and classifications.

2 types:

Base rate neglect = a phenomenon’s rate of incidence in larger population, its base rate is neglected in favour of specific information.

Sample size neglect = FMPs incorrectly assume that small sample sizes are representative of populations.

Question 11

Consequences of representative bias

Answer 11

• adopt a view/forecast based almost exclusively on individual, specific information or small sample.
• update beliefs using simple classifications than deal with mental stress of updating beliefs given high cognitive costs of complex data.

Question 12

How to overcome representative bias?

Answer 12

• Ask the question “What is the probability that X (the investment under consideration) belongs to Group A (the group it resembles or considered representative of) vs Group B (the group it is statistically more likely to belong to)?
• Questions that help FMPs think whether they are failing to consider base-rate probabilities or neglecting law of small numbers, thus inaccurately assessing particular situation.
• More research to obtain base-rate information.
• More research whether to widen the sample size of observations.

Question 13

Illusion of control bias

Answer 13

When people tend to believe that they can control or influence outcomes when in fact they cannot.

i.e. people perceived themselves as possessing more control than they did, inferred causal connections where none existed, displayed surprisingly great certainty in the predictions for outcomes of chance events.

Question 14

Consequences of illusion of control:

Answer 14

FMPs may do the following:

• Inadequately diversify portfolios - some investors prefer to invest in companies they feel they have control over such as those they work for, leading them to hold concentrated portfolios.
• trade more than is prudent - portfolio turnover is negatively correlated with investment returns.
• construct financial models and forecasts that are overly detailed - belief forecast from models control uncertainty of investment outcomes and inherent risk.

Question 15

How to overcome illusion of control bias?

Answer 15

• The need to recognise that investing is a probabilistic activity, with even the largest IM firms having little control over outcomes of investments they make.
• It is advisable to seek contrary viewpoints; what are the downside risks? What might go wrong?

Question 16

Hindsight bias

Answer 16

This refers to believing past events as having been predictable and reasonable to expect, whereby outcomes that did occur are more readily evident than outcomes that did not.

e. g. people tend to remember their own prediction of future as more accurate than actually were as they are biased by knowledge of what actually occurred.
* poorly reasoned decisions with positive results are remembered as brilliant tactical moves.
* poor results of well-reasoned decisions may be described as avoidable mistakes.

Question 17

Consequences of hindsight bias:

Answer 17

FMPs may do the following:

• Overcome the degree to which they correctly predicted an investment outcome, or predictability of an outcome generally, related to overconfidence bias.
• Unfairly assess money manager or security performance, where performance is compared against what has happened as opposed to expectations at time investment was made.

Question 18

How to overcome hindsight bias?

Answer 18

• FMPs should carefully record their investment decisions, and key reasons for making those decisions in writing at or around time decision is made.
• Consulting written records than memory will often produce a far more accurate examination of past decisions.

Question 19

Processing errors

Answer 19

This refers to information being processed and used illogically or irrationally.

These are less related to errors of memory or in assigning and updating probabilities, rather relates more closely to flaws in how information itself is processed.

Question 20

Anchoring and adjustment bias

Answer 20

This refers to relying on an initial piece of information to make subsequent estimates, judgements and decisions.

Estimating a value with unknown magnitude, people begin with initial default number (anchor) which they adjust up or down.

Regardless of how initial anchor was chosen, people tend to adjust anchors insufficiently, producing end approximations that are consequently biased.

Question 21

Consequences of anchoring and adjustment bias:

Answer 21

• FMPs may stick too closely to their original estimates when learning new information, that potentially has downside and upside risk.

Question 22

How to overcome anchoring and adjustment bias?

Answer 22

• Ask questions “Am I holding onto this stock based on rational analysis, or am I trying to attain a price that I am anchored to such as purchase price or high water mark?
• Awareness that company’s revenues and earnings given period reflect conditions in that period.
• Awareness security prices reflect investors perception of the future at given point in time, a given investor cost basis, past market levels etc.
• FMP should look at basis for any investment recommendation to see whether it is anchored to previous estimates or some default number.

Question 23

Mental accounting bias

Answer 23

This refers to mentally dividing money into “accounts” that influence decisions, even though money is fungible.

Rather that FMPs considering their entire portfolio holistically in risk-return context, investors construct portfolios layered pyramid format, with each layer addressing a specific financial goal.

Question 24

Consequences of mental accounting bias:

Answer 24

FMPs may do the following:

• Neglect opportunities to reduce risk by combining assets with low correlations, as offsetting positions across various portfolio layers/mental accounts can lead to suboptimal aggregate performance.
• Irrationally distinguish between returns derived from income, and those from capital appreciation - focus chasing income streams unwittingly risking principal in process.
• Irrationally bifurcate wealth/portfolio into investment principal and investment returns - belief greater risk can be taken with returns than principal initially contributed.

Question 25

How to overcome mental accounting bias?

Answer 25

• Recognise its drawbacks.
• Primary drawback is correlations between investments are not considered leading to unintentional risk taking - need to combine all assets to see holistic asset allocation.
• Next step would be to create a portfolio strategy taking all assets into consideration.

Question 26

Framing bias

Answer 26

When information processing bias in which a person answers a question differently based on the way in which it is asked or framed.

e. g. a situation presented within a gain context (1 in 4 companies succeed) or within a loss context (3 out of 4 start ups fail).
- 1st frame FMP may adopt a positive outlook, and make venture capital investments.
- 2nd frame the FMP may not.

Question 27

Narrow framing

Answer 27

This is when people evaluate information based on narrow frame of reference, losing sight of big picture in favour of 1 or 2 specific points.

Question 28

Consequences of framing bias

Answer 28

FMPs may do the following:

• Misidentify risk tolerances because of how questions about risk tolerance were framed; more risk averse when presented with gain frame of reference, and vice versa.
• Misidentification can result in suboptimal portfolios.
• Focus on ST price fluctuations, this may result in LR considerations being ignored in decision-making process.

Question 29

How to overcome framing bias?

Answer 29

• Detected when asking such questions as “Is the decision the result of focusing on a net gain or net loss position?”
• FMPs should try to eliminate any reference to gains and losses already incurred, focusing on future prospects of investment, and try to be neutral and open-minded as possible.

Question 30

Availability bias

Answer 30

This is an information-processing bias in which people estimate the probability of an outcome or importance of phenomenon based on how easily information is recalled.

Question 31

4 sources to availability bias applicable to FMPs:

Answer 31

1. Retrievability = if an answer/idea comes to mind more quickly than another answer/idea, the first answer will likely be chosen as correct even if not the reality.
2. Categorisation = when solving problems, people gather info from what they perceive as relevant search sets, with difficultly to characterise search, the estimated probability of event may be biased.
3. Narrow range of experience = when making an estimate, a person may use only a narrow range of experience instead of considering multiple perspectives, e.g. assume success launch of a product in one country is globally successful.
4. Resonance = people are often biased by how closely a situation parallels their own personal situation.

Question 32

Consequences of availability bias:

Answer 32

FMPs may do the following:

• Limit their investment opportunity set, due to using familiar classification schemes, or restrict investments to stocks or bonds, securities of one country etc.
• Choose an investment, investment adviser or mutual fund based on advertising, or quantity if new coverage.
• Fail to diversify - make choices based on a narrow range of experience, e.g. investor who works for company in particular industry may overweigh investments in that industry.

Question 33

How to overcome availability bias?

Answer 33

• The investors need to develop appropriate investment policy strategy, carefully research and analyse investment decisions before making them, focusing on LT historical data.
• Identify issues of categorisation, narrow range of experience and resonance as sources of availability bias.

Question 34

Loss aversion bias

Answer 34

This refers to tendency to strongly prefer avoiding losses to achieving gains.

• Rational FMPs should accept more risk to increase gains not to mitigate losses.

Question 35

Disposition effect

Answer 35

The holding of investments that have experienced losses too long, and the selling of investments that have experienced gains too quickly (i.e. holding on to losers and selling winners).

The resulting portfolio may be riskier than optimal portfolio based on investors risk-return objectives.

Question 36

Consequences of loss aversion:

Answer 36

FMPs may do the following:

• Hold investments in loss position longer than justified by fundamental analysis, in hope they break-even.
• Sell investments in gain position earlier than justified by fundamental analysis, out of fear gains will erode.

Question 37

How to overcome loss aversion?

Answer 37

• A disciplined approach to investment is a good way to alleviate impact of loss-aversion bias.
• By analysing investments and realistically considering probabilities of future losses and gains may help guide FMP rational decision.

Question 38

Overconfidence bias

Answer 38

The bias in which people demonstrate unwarranted faith in their own abilities.

Intensified when combined with self-attribution bias = people take too much credit for successes (self-enhancing), and assign responsibility to others for failures (self-protecting).

Question 39

2 forms of overconfidence bias:

Answer 39

1. Prediction overconfidence = occurs when confidence intervals that FMPs assign to their investment predictions are too narrow/little variation.
2. Certainty overconfidence = this occurs when the probabilities that FMPs assign to outcomes are too high; with certainty being the emotional response.

Question 40

Consequences of overconfidence bias:

Answer 40

FMPs may do the following:

• underestimate risks and overestimate expected returns.
• hold poorly diversified portfolios, which may result in significant downside risk.

Question 41

How to overcome overconfidence bias?

Answer 41

• FMP should review their trading records, identify both winners and losers, and calculate portfolio performance over at least 2 years.
• It is critical investors be objective when making and evaluating investment decisions.
• Advisable to view the reasoning behind, and the results of investments, both winners and losers as objectively as possible.
• When reviewing unprofitable decisions, look for patterns or common mistakes that you were unaware you were making, and try to remain mindful of them “I will do X in the future.”

Question 42

Self-control bias

Answer 42

This is a bias in which people fail to act in pursuit of their long term overarching goals, in favour of ST satisfaction.

e.g. individuals pursuing CFA charter may fail to study sufficiently due to ST competing demands on their time.

Relates to function of hyperbolic discounting, the human tendency to prefer small payoffs now compared with larger payoffs in the future.

Question 43

Consequences of self-control bias

Answer 43

FMPs may do the following:

• Save insufficiently for the future, in turn may result in accepting too much risk in portfolios in attempt to generate higher returns.
• Borrow excessively to finance present consumption.

Question 44

How to overcome self-control bias?

Answer 44

• FMPs should ensure a proper investment plan is in place, and should have a personal budget.
• Plans need to be in writing, so can be reviewed regularly.
• FMPs should look to maintain strategic asset allocation based on thorough evaluation.

Question 45

Status quo bias

Answer 45

An emotional bias in which people choose to do nothing (i.e. maintain status quo) instead of making change, even when change is unwarranted.

Discussed in tandem with endowment and regret-aversion biases, as outcome of biases maintaining existing positions is similar.

Maintained due to inertia than conscious choice.

Question 46

Consequences of status quo bias:

Answer 46

FMPs may do the following:

• Unknowingly maintain portfolios with risk characteristics that are inappropriate for their circumstances.
• Fail to explore other opportunities.

Question 47

How to overcome status quo bias?

Answer 47

• FMPs should quantify the risk-reducing and return-enhancing advantages of diversification and proper asset allocation.
  e. g. with concentrated stock position, showing what can happen to overall wealth level if stock collapses may persuade FMP to diversify.

Question 48

Endowment bias

Answer 48

This is an emotional bias in which people value an asset more when they own it than when they do not.

Inconsistent with standard economic theory, price a person is willing to pay for a good should equal price at which that person would be willing to sell the same good.

Question 49

Consequences of endowment bias:

Answer 49

FMPs do the following:

• Fail to sell certain assets and replace them with other assets.
• Continue to hold classes of assets with which they are familiar, as believe they understand characteristics of investments they already own, reluctant to purchase asset with which they have less experience.
• FMP may maintain an inappropriate asset allocation, with portfolio being inappropriate for investors levels of risk tolerance and financial goals.

Question 50

How to overcome endowment bias?

Answer 50

• Address bias for purchased securities, when estimated ‘sell price’ is far higher than any reasonable FMP’s estimate of ‘buy price’ is to ask, “Would you buy this security today at the current price?”
• A similar question is “Why are you not buying more of this security today?”, these questions can turn the focus away from past to present, toward considering upside from current price.

Question 51

Regret-aversion bias

Answer 51

This is an emotional bias in which people tend to avoid making decisions out of fear the decision will turn out poorly.

2 dimensions:

1. Actions that people take
2. Actions that people could have taken

• Regret is more intense when favourable outcomes are a result of action taken vs result of an action not taken.
• No action becomes the default decision.

Question 52

Consequences of regret-aversion bias:

Answer 52

• Be too conservative in investment choices due to poor outcomes on risky investments in the past, leading to long term underperformance and failure to reach goals.
• Engage in herding behaviour - FMPs feel safer in popular investments to limit potential future regret, leading to preference of stocks of well-known companies even in he face of equal risk and return expectations.

Question 53

How to overcome regret-aversion bias?

Answer 53

• FMPs should quantify risk reducing and return enhancing advantages of diversification and proper asset allocation, as regret aversion can cause some FMPs to invest too conservatively or riskily depending on current trends.
• FMPs must recognise that losses happen to everyone, but keep in mind the LT benefits of including risky assets in portfolios.

Question 54

Anomalies

Answer 54

The apparent deviations from efficient market hypothesis, identified by persistent abnormal returns that differ from zero and predictable in direction.

Question 55

3 sources of anomalies:

Answer 55

1. Choice of asset pricing model - if method of estimating normal returns causes anomaly to disappear, then it is reasonable to suggest anomaly is an illusion.

• low returns following IPO
• positive abnormal returns apparent in 12 months after stock split.
• high returns persist on particular class of securities/relative to specific factor in valuation may simply be compensation for excess risk than anomaly.

2. Statistical issues

• statistical bias in selection or survivorship or data mining overanalyses data patterns and treats spurious correlations as relevant.
• over or underperformance depends critically on choice of benchmark, make it hard to interpret results.

3. Temporary disequilibria
   e. g. small company in Jan effect part of turn of the year effect does not appear persistent once appropriate adjustment for risk is made.

Question 56

Momentum/trending effects

Answer 56

This is when future price behaviour correlates with that of the recent past.

Positive correlation typically lasts up to 2 years before showing reversal/reversion to the mean, evident in 2-5 year return periods.

e.g. short term year on year trending, contribute to overtrading.

Question 57

Explanations of momentum:

Answer 57

• Availability/recency effect - the tendency to recall recent events more vividly, and give them undue weight.
• if price of asset rises for period of time, investors may simply extrapolate this rise to the future.
• Hindsight - feeling regret from an opportunity missed; tendency to see past events as having been predictable.
• Loss aversion biases

Question 58

Behaviours during bubbles:

Answer 58

• Investors exhibit overconfidence, overtrading, underestimation of risk, failure to diversify and rejection of contradictory information.
• Overconfidence and excessive trading linked to confirmation bias and self attribution bias.
• Investors can have faulty learning models that bias their understanding of this profit to take personal credit for success - hindsight bias.
• Regret aversion can encourage investors to participate in bubble, believing they are missing out on profit opportunities as stock appreciate.
• As bubble unwinds, markets may underreact due to anchoring when investors do not sufficiently update their beliefs.
• At early stages of unwinding a bubble can involve investors in cognitive dissonance, who ignore losses and attempt to rationalise flawed decisions.

Question 59

Value stocks

Answer 59

Characterised by low price to earnings ratios, high book to market equity and low price to dividend ratios.

Anomaly disappears in 3 factor asset pricing model, suggesting size and book to market factors are not mispricing, but represent compensation for risk exposures - large potential to suffer distress during economic downturns.

Question 60

Halo effect

Answer 60

• Extends a favourable evaluation of some characteristics to other characteristics.
  e. g. a company with good growth record may be seen as a good investment, with higher expected returns than its risk characteristics merit.

Question 61

Home bias anomaly

Answer 61

This is when portfolios exhibit a strong bias in favour of domestic securities in context of global portfolios.

May reflect a perceived relative informational advantage, greater feeling of comfort with access to company executives that proximity bring or psychological desire to invest in local community.

A more positive emotional rating in company leads investors to perceive company stock as less risky.