Reading 6 The Behavioral Biases of Individuals Flashcards
cognitive errors definition
- Cognitive errors - biases based on faulty cognitive reasoning.
- Cognitive errors stem from basic statistical, information-processing, or memory errors.
- Cognitive errors are more easily corrected than emotional biases.
- Individuals are less likely to make cognitive errors if they remain vigilant to the possibility of their occurrence.
- Ways to reduce the cognitive errors:
- gather, record, and synthesize information
- document decisions and the reasoning behind them
- compare the actual outcomes with expected results
- systematic process to describe problems and objectives
- Status quo bias
Status quo bias, is an emotional bias in which people do nothing (i.e., maintain the “status quo”) instead of making a change.
Status quo bias is often discussed in tandem with endowment and regret-aversion biases (described later) because the outcome of the biases, maintaining existing positions, may be similar. However, the reasons for maintaining the existing positions differ among the biases. In the status quo bias, the positions are maintained largely because of inertia rather than conscious choice. In the endowment and regret-aversion biases, the positions are maintained because of conscious, but possibly incorrect, choices.
When status quo, endowment, and regret-aversion biases are combined, people will tend to strongly prefer that things stay as they are, even at some personal cost.
Consequences of Status Quo Bias
As a result of status quo bias, FMPs may do the following:
- Unknowingly maintain portfolios with risk characteristics that are inappropriate for their circumstances.
- Fail to explore other opportunities.
Detection of and Guidelines for Overcoming Status Quo Bias
Status quo bias may be exceptionally strong and difficult to overcome. Education is essential. FMPs should quantify the risk-reducing and return-enhancing advantages of diversification and proper asset allocation.
- Anchoring and adjustment bias
Anchoring and adjustment bias is an information-processing bias in which the use of a psychological heuristic influences the way people estimate probabilities.
This bias is closely related to the conservatism bias.
Consequences of Anchoring and Adjustment Bias
As a result of anchoring and adjustment bias, FMPs may stick too closely to their original estimates when new information is learned.
Detection of and Guidelines for Overcoming Anchoring and Adjustment Bias
- The primary action FMPs can take is to consciously ask questions that may reveal an anchoring and adjustment bias.
- It is important to remember that past prices, market levels, and reputation provide little information about an investment’s future potential and thus should not influence buy-and-sell decisions to any great extent.
- Conservatism Bias
Conservatism bias is a belief perseverance bias in which people maintain their prior views or forecasts by inadequately incorporating new information (in Bayesian term people overweight the base rates& underreact to new information).
This bias has aspects of both statistical and information-processing errors.
Consequences of Conservatism Bias:
As a result of conservatism bias, FMPs may do the following:
- Maintain or be slow to update a view or a forecast, even when presented with new information
- Opt to maintain a prior belief rather than deal with the mental stress of updating beliefs given complex data
Detection of and Guidance for Overcoming Conservatism Bias
- The effect of conservatism bias may be corrected for or reduced by properly analyzing and weighting new information.
- seek professional advise
- Loss-aversion bias
In prospect theory, loss-aversion bias is a bias in which people tend to strongly prefer avoiding losses as opposed to achieving gains.
Rational FMPs should accept more risk to increase gains, not to mitigate losses. However, paradoxically, FMPs tend to accept more risk to avoid losses than to achieve gains.
Disposition effect: the holding (not selling) of investments that have experienced losses (losers) too long, and the selling (not holding) of investments that have experienced gains (winners) too quickly.
Consequences of Loss Aversion
As a result of loss-aversion bias, FMPs may do the following:
- Hold investments in a loss position longer than justified by fundamental analysis.
- Sell investments in a gain position earlier than justified by fundamental analysis.
- Limit the upside potential of a portfolio by selling winners and holding losers.
- Trade excessively as a result of selling winners.
- Hold riskier portfolios than is acceptable based on the risk/return objectives of the FMP.
Further, framing and loss-aversion biases may affect the FMP simultaneously, and is a potentially dangerous combination.
Detection of and Guidelines for Overcoming Loss Aversion
A disciplined approach to investment based on fundamental analysis is a good way to alleviate the impact of the loss-aversion bias.
- Availability bias
Availability bias starts with putting undue empasis on the information that is readily availiable.
There are various (4) sources of availability bias:
- Retrievability. If an answer or idea comes to mind more quickly than another answer or idea, the first answer or idea will likely be chosen as correct even if it is not the reality.
- Categorization. When solving problems, people gather information from what they perceive as relevant search sets.
- Narrow Range of Experience. This bias occurs when a person with a narrow range of experience uses too narrow a frame of reference based upon that experience when making an estimate.
- Resonance. People are often biased by how closely a situation parallels their own personal situation.
Consequences of Availability Bias
As a result of availability bias, FMPs may do the following:
- Choose an investment, investment adviser, or mutual fund based on advertising rather than on a thorough analysis of the options.
- Limit their investment opportunity set.
- Fail to diversify.
- Fail to achieve an appropriate asset allocation.
- Availability bias causes investors to overreact to market conditions, whether positive or negative
Detection of and Guidelines for Overcoming Availability Bias
- To overcome availability bias, investors need to develop an appropriate IPS, carefully research and analyze investment decisions before making them, and focus on long-term results.
- Questions such as “where did I hear of this idea?” could help to detect availiability bias
- Overconfidence bias
Overconfidence bias is a bias in which people demonstrate unwarranted faith in their own intuitive reasoning, judgments, and/or cognitive abilities.
Overconfidence bias has aspects of both cognitive and emotional errors but is classified as emotional because the bias is primarily the result of emotion.
Self-attribution bias is a bias in which people take credit for successes and assign responsibility for failures. It can be broken down into two subsidiary biases: self-enhancing and self-protecting.
People generally do a poor job of estimating probabilities; still, they believe they do it well because they believe that they are smarter and more informed than they actually are. This view is sometimes referred to as the Illusion of knowledge bias.
There are two basic types of overconfidence bias rooted in the illusion of knowledge: prediction overconfidence and certainty overconfidence. Both types have cognitive and emotional aspects
- Prediction overconfidence occurs when the confidence intervals that FMPs assign to their investment predictions are too narrow.
- Certainty overconfidence occurs when the probabilities that FMPs assign to outcomes are too high. People susceptible to certainty overconfidence often trade too frequently.
Consequences of Overconfidence Bias
As a result of overconfidence bias, FMPs may do the following:
- Underestimate risks and overestimate expected returns.
- Hold poorly diversified portfolios.
- Trade excessively.
- Experience lower returns than those of the market.
Detection of and Guidelines for Overcoming Overconfidence Bias
- FMPs should review their trading records, identify the winners and losers, and calculate portfolio performance over at least two years.
- It is critical that investors be objective when making and evaluating investment decisions.
- To stay objective, it is a good idea to perform post-investment analysis on both successful and unsuccessful investments.
- Mental accounting bias
Mental accounting bias is an information-processing bias in which people treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to.
Consequences of Mental Accounting Bias
A potentially serious problem that mental accounting creates is the placement of investments into discrete “buckets” without regard for the correlations among these assets.
As a result of mental accounting bias, FMPs may do the following:
- Neglect opportunities to reduce risk by combining assets with low correlations.
- Irrationally distinguish between returns derived from income and those derived from capital appreciation.
Detection of and Guidelines for Overcoming Mental Accounting Bias
- An effective way to detect and overcome mental accounting behavior is to recognize the drawbacks of engaging in this behavior. The primary drawback is that correlations between investments are not taken into account when creating an overall portfolio.
- With regard to the income versus total return issue, an effective way to manage the tendency of some FMPs to treat investment income and capital appreciation differently is to focus on total return.
Mental accounting bias can have either of the following forms (or both):
- Based on the source of wealth
- Based on the way people invest
- Self-control bias
Self-control bias is a bias in which people fail to act in pursuit of their long-term goals because of a lack of self-discipline.
The apparent lack of self-control may also be a function of hyperbolic discounting. Hyperbolic discounting is the human tendency to prefer small payoffs now compared to larger payoffs in the future.
Consequences of Self-Control Bias
As a result of self-control bias, FMPs may do the following:
- Save insufficiently for the future.
Upon realizing that their savings are insufficient, FMPs may do the following:
- Accept too much risk in their portfolios in an attempt to generate higher returns.
- Cause asset allocation imbalance problems.
Detection of and Guidelines for Overcoming Self-Control Bias
FMPs should ensure that a proper investment plan is in place and should have a personal budget
Information-processing biases
Information-processing biases result in information being processed and used illogically or irrationally.
Behaviorally Modified Asset Allocation
The concept of behaviorally modified asset allocation - approach that begins with the rational portfolio and makes modifications to accommodate behavioral finance considerations.
Behavioral finance and IPS
Behavioral finance considerations may have their own place in the constraints section of the investment policy statement along with liquidity, time horizon, taxes, legal and regulatory environment, and unique circumstances. Responses to such questions as the following may help develop the behavioral finance considerations that have an impact on investment decisions and the resulting portfolio:
- What are the biases of the client?
- Are they primarily emotional or cognitive?
- How do they affect portfolio asset allocation?
- Should the biases be moderated or adapted to?
- Is the behaviorally modified asset allocation warrantted?
- What are the appropriate quantifible modification?
- Hindsight Bias
Hindsight Bias is a bias when people may see past events as having been predictable and reasonable to expect.
Consequences of Hindsight Bias
As a result of hindsight bias, FMPs may do the following:
- Overestimate the degree to which they predicted an investment outcome, thus giving them a false sense of confidence.
- Cause FMPs to unfairly assess money manager or security performance.
Detection of and Guidelines for Overcoming Hindsight Bias
- Once understood, hindsight bias should be recognizable. FMPs need to be aware of the possibility of hindsight bias and ask such questions as, “Am I re-writing history or being honest with myself about the mistakes I made?”
- To guard against hindsight bias, FMPs need to carefully record and examine their investment decisions, both good and bad, to avoid repeating past investment mistakes.
emotional biases definition
- Emotional biases - biases based on reasoning influenced by feelings or emotions.
- Emotional biases stem from impulse or intuition.
- Because emotional biases stem from impulse or intuition—especially personal and sometimes unreasoned judgments—they are less easily corrected.
- In the case of emotional biases, it may only be possible to recognize the bias and adapt to it rather than correct for it.
- Ways to work with emotional biases:
- When possible, focusing on cognitive aspects of the biases may be more effective than trying to alter an emotional response.
- Also, educating about the investment decision-making process and portfolio theory can be helpful in moving the decision making from an emotional basis to a cognitive basis.
- When biases are emotional in nature, drawing these to the attention of an individual making the decision is unlikely to lead to positive outcomes; the individual is likely to become defensive rather than receptive to considering alternatives. Thinking of the appropriate questions to ask to potentially alter the decision-making process is likely to be most effective.
myopic loss aversion
Myopic loss aversion refers to a situation where FMPs overemphasize the short term potential losses that can occur on stocks and underemphasize the long term return.
This results in a risk premium on stocks that is too high given their long term characteristics and an under-weighting in stocks.
Goals-based investing
Goals-based investing involves identifying an investor’s specific goals and the risk tolerance associated with each goal. Investments are chosen considering each goal individually. Thus, a portfolio is constructed in layers rather than using the holistic approach to portfolio construction of modern portfolio theory (MPT).
How Much to Moderate or Adapt
