Psychology of Financial Planning Flashcards
What is the difference between Cognitive errors and Emotional Biases?
Cognitive errors—primarily due to faulty reasoning and arising from a lack of understanding of proper statistical analysis techniques, information processing mistakes, or memory errors.
Emotional biases—are not related to conscious thought and stem from feelings, impulses, or intuition. As such, they are more difficult to overcome and may have to be accommodated
Cognitive Errors: Illusion of Control Bias
1.) Illusion of control bias—exists when market participants think they can influ-ence outcomes when they cannot. It is often associated with emotional biases: illusion of knowledge (belief you know things you do not know), self-attribu-tion (belief you personally caused something to happen), and overconfidence biases (an unwarranted belief you are correct).
I can control uncontrollable events
Cognitive Errors: Conservatism bias
2.) Conservatism bias—occurs when clients initially assume a rational view but fail to change that view as new information becomes available. They overweigh the initial probabilities and do not adjust for new information.
emphasis on preexisting data and fail to recognize how new data impacts their original viewpoint. vacation home research.
Cognitive Errors: hindsight bias
3.) Hindsight bias—a selective memory of past events, actions, or what was know-able in the past. Clients tend to remember their correct views and forget the errors. They also overestimate what could have been known.
predicting a sporting event or political action, when in reality they never knew that. I knew it all a long.
Cognitive Errors: Confirmation bias
4.) Confirmation bias—occurs when market participants look for new information to support an existing view. Clients who get involved with the portfolio process by researching holdings may become overly attached to some investments and only bring up information favorable to the holding.
I will only look for information that confirms what I have already concluded.
Cognitive Errors: Representativeness
Representativeness—based on a belief the past will persist and, as a result, new information is classified based on previous experiences. While this may be efficient, the new information can be misunderstood if it is classified based on a superficial resemblance to the past or a classification. Two forms of representa-tiveness follow.
Base rate neglect, where the base rate (probability) of the initial clas-sification is not adequately considered. Essentially the classification is presumed to be 100% correct. A stock could be classified as a value stock, and new information about the stock is analyzed based on that classifica-tion. In reality, the stock may not be a value stock.
Cognitive Errors:Mental accounting
Mental accounting, also known as money jar mentality, involves the tendency of individuals to put their money into separate accounts (or money jars) based on the function of these accounts. For example, amounts of money may be earmarked separately for savings, debt reduction, and a future vacation. In this case, money being set aside for a vacation while carrying a considerable amount of debt is, in general, poor money management.
Cognitive Errors:Self-attribution bias
Self-attribution bias—an ego defense mechanism that occurs to avoid the cog-nitive dissonance associated with having to admit making a mistake
individuals’ tendency to attribute successes to personal skills and failures to factors beyond their control.
Cognitive Errors: Anchoring
Anchoring—irrational decisions based on information that should have no influence on the decisions at hand. Anchoring is especially risky when people know little about the product being purchased, the service being delivered, or the investment being made.
if you first see a T-shirt that costs $1,200 – then see a second one that costs $100 – you’re prone to see the second shirt as cheap.
Cognitive Errors: Adjustment
Adjustment—involves clients clinging on to an initial estimate and not adjusting for new information.
The process of failing to adjust to the new information. You anchor, then you FAIL TO ADJUST.
Cognitive Errors: Outcome bias
Outcome bias—the tendency for individuals to take a course of action based on the outcomes of prior events. An investor may choose a particular stock because that stock had superior performance over the past three years. However, this same investor would be ignoring the current conditions that may be applicable to the stock’s performance in the future.
a cognitive bias that enables us to judge our decision making based on the results of the process rather than the quality of the process itself.
Cognitive Errors: Framing bias
Framing bias—asserts that people are given a frame of reference, a set of beliefs or values, which they use to interpret facts or conditions as they make decisions
is it the positive frame or negative frame? That will dictate my decision.
Cognitive Errors: Recency bias (availability)
Recency bias—recent information is given more importance because it is most vividly remembered. This is also called the availability bias because it is based on data that are readily available, including small data
Recent= Availability Biase. Only what is around me or has happened in the not to distant past is what I care about.
Cognitive Errors: Herding
Herding—when investors trade in the same direction or in the same securities and, possibly, trade contrary to the information they have available.
Emotional Biases: Prospect theory
Prospect theory—clients fear losses much more than valuing gains. Accordingly, they will often choose the smaller of two potential gains if it avoids a sure loss.
You are more afraid of the loss of your choice than the gains you may receive.
Behavioral investors are generally more concerned with avoiding losses, which implies that risk of loss may be the best measure of risk.
Emotional Biases: Loss aversion theory
Loss aversion theory—involves clients valuing gains and losses differently and, as a result, will make decisions based on perceived gains rather than perceived losses. Therefore, if clients were presented with two equal opportunities, one stated in terms of potential gains and the other in terms of potential losses, most would choose the former (gains). Financial planners should be aware of this concept and how it affects both the way recommendations and the suggested implementation of them are communicated to clients.
if given two options (both the same outcome) they will choose the one that is presented as a gain.
Emotional Biases: Overconfidence
Overconfidence—investors exhibiting overconfidence believe that they can control random events merely by acquiring more knowledge and consider their abilities to be much better than they are. They take credit for any financial decisions that have positive results. Any negative outcomes are attributed to external sources.
When retail investors trade their brokerage accounts excessively this is thought to be caused by overconfidence based on a false sense of insight into the investment’s future performance
Takes self-attribution bias one step further.
Emotional Biases: Status quo bias
Status quo bias—occurs when comfort with an existing situation leads to an unwillingness to make changes. If investment choices include the option to maintain existing choices, or if a choice will happen unless the participant opts out, status quo choices become more likely.
Comfort is sought in their choices and therefore that is easier than changing, even if for the better
Emotional Biases: Regret-aversion bias
Regret-aversion bias—occurs when market participants do nothing out of excess fear that actions could be wrong. They attach undue weight to actions of commission (doing something) and do not consider actions of omission (doing anything). Their sense of regret and pain is stronger for acts of commission.
Emotional Biases: Affinity bias
Affinity bias—refers to the tendency to favor things that one can identify with emotionally because they are familiar. This bias can lead to irrational decisions because the investor perceives a product or investment opportunity to be a reflection of their values and associations. Ethnic, religious, or alumni affiliations can be the source of affinity bias.
Nondirective and Directive Communication
NonDirective - Encourage clients to reflect and share their goals, beliefs, traditions, cultural background, feelings, and concerns in a thorough and open manner. They allow the planner to support clients in discussing their
Directive Counseling Skills – financial planner centered or financial planner directed. The planner takes the lead in choosing how the conversation progresses when employing directive communication skills.
