Reading 6 The Behavioral Biases of Individuals

Question 1

cognitive errors definition

Answer 1

1. Cognitive errors - biases based on faulty cognitive reasoning.
2. Cognitive errors stem from basic statistical, information-processing, or memory errors.
3. Cognitive errors are more easily corrected than emotional biases.
4. Individuals are less likely to make cognitive errors if they remain vigilant to the possibility of their occurrence.
5. 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

Question 2

emotional biases definition

Answer 2

1. Emotional biases - biases based on reasoning influenced by feelings or emotions.
2. Emotional biases stem from impulse or intuition.
3. Because emotional biases stem from impulse or intuition—especially personal and sometimes unreasoned judgments—they are less easily corrected.
4. In the case of emotional biases, it may only be possible to recognize the bias and adapt to it rather than correct for it.
5. 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.

Question 3

two categories of cognitive errors

Answer 3

1. Belief perseverance is the tendency to cling to one’s previously held beliefs irrationally or illogically.

The belief perseverance biases discussed are conservatism, confirmation, representativeness, illusion of control, and hindsight (5).

2. Processing errors, describing how information may be processed and used illogically or irrationally in financial decision making.

The processing errors discussed are anchoring and adjustment, mental accounting, framing, and availability (4).

Question 4

cognitive dissonance

Answer 4

Cognitive dissonance is the mental discomfort that occurs when new information conflicts with previously held beliefs or cognitions.

Question 5

1. Conservatism Bias

Answer 5

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

Question 6

2. Confirmation bias

Answer 6

Confirmation bias is a belief perseverance bias in which people tend to look for and notice what confirms their beliefs, and to ignore or undervalue what contradicts their beliefs. This behavior demonstrates a selection bias.

Consequences of Confirmation Bias

In the investment world, confirmation bias is exhibited repeatedly. As a result of confirmation bias, FMPs may do the following:

• Consider only the positive information about an existing investment and ignore any negative information about the investment.
• Develop screening criteria incorrectly to find what they want to see.
• Under-diversify portfolios, leading to excessive exposure to risk.
• Hold a disproportionate amount of their investment assets in their employing company’s stock because they believe in their company and are convinced of its favorable prospects.

Detection of and Guidance for Overcoming Confirmation Bias

• The effect of confirmation bias may be corrected for or reduced by actively seeking out information that challenges your beliefs.
• Another useful step is to get corroborating support for an investment decision
• Do additional research

Question 7

3. Representativeness bias

Answer 7

Representativeness bias is a belief perseverance bias in which people tend to classify new information based on past experiences and classifications (in Bayesian terms investors tend to underweight the base rates&overweight new information). They believe their classifications are appropriate and place undue weight on them.

Base-rate neglect and sample-size neglect are two types of representativeness bias that apply to FMPs.

In base-rate neglect, new information is given too much importance, taken to represent too much, and underlying probabilities are not sufficiently considered (too little weight to the base rate).

In sample-size neglect, FMPs incorrectly assume that small sample sizes are representative of populations (or “real” data).

Consequences of Representativeness Bias

FMPs often overweight new information and small samples because they view the information or sample as representative of the population as a whole. As a result of representativeness bias, FMPs may do the following:

• Adopt a view or a forecast based almost exclusively on new information or a small sample.
• Update beliefs using simple classifications rather than deal with the mental stress of updating beliefs given complex data.

Detection of and Guidance on Overcoming Representativeness Bias

• FMPs need to be aware of statistical mistakes they may be making and constantly ask themselves if they are overlooking the reality of the investment situation being considered.
• In evaluation the performance of a portfolio (or a fund) this would include analyzing: How the performance compares to similiar portfolios? Have there been changes in the managers of the portolio? What is the general reputation of the manager? Has the portfolio or manager changed style or investment approach due to changing conditions?
• When FMPs sense that base-rate or sample-size neglect may be a problem, they should ask the following question: “What is the probability that X (the investment under consideration) belongs to Group A (the group it resembles or is considered representative of) versus Group B (the group it is statistically more likely to belong to)?”

Question 8

4. Illusion of control bias

Answer 8

Illusion of control bias is a bias in which people tend to believe that they can control or influence outcomes when, in fact, they cannot.

Consequences of Illusion of Control

As a result of illusion of control bias, FMPs may do the following:

• Trade more than is prudent.
• Lead investors to inadequately diversify portfolios.

Detection of and Guidelines for Overcoming Illusion of Control Bias

• investors need to recognize that successful investing is a probabilistic activity (even the most powerful investors have little control over the outcomes of the investments they make).
• it is advisable to seek contrary viewpoints
• it is critical to keep records

Question 9

5. Hindsight Bias

Answer 9

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.

Question 10

Information-processing biases

Answer 10

Information-processing biases result in information being processed and used illogically or irrationally.

Question 11

6. Anchoring and adjustment bias

Answer 11

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.

Question 12

7. Mental accounting bias

Answer 12

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):

1. Based on the source of wealth
2. Based on the way people invest

Question 13

8. Framing bias

Answer 13

Framing bias is an information-processing bias in which a person answers a question differently based on the way in which it is asked (framed).

Narrow framing occurs when people lose sight of the big picture and focus on one or two specific points.

Consequences of Framing Bias

FMPs’ willingness to accept risk can be influenced by how situations are presented or framed.

As a result of framing bias, FMPs may do the following:

• Misidentify risk tolerances because of how questions about risk tolerance were framed;
• Choose suboptimal investments, even with properly identified risk tolerances, based on how information about the specific investments is framed.
• Focus on short-term price fluctuations, which may result in excessive trading.

Detection of and Guidelines for Overcoming Framing Bias

• Framing bias is detected by asking such questions as, “Is my decision based on realizing a gain or a loss?”
• Regarding susceptibility to the positive and negative presentation of information, investors should try to be as neutral and open-minded as possible when interpreting investment-related situations.

Question 14

9. Availability bias

Answer 14

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

Question 15

myopic loss aversion

Answer 15

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.

Question 16

10. Overconfidence bias

Answer 16

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.

Question 17

11. Self-control bias

Answer 17

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

Question 18

12. Status quo bias

Answer 18

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.

Question 19

13. Endowment bias

Answer 19

Endowment bias is an emotional bias in which people value an asset more when they hold rights to it than when they do not.

Effectively, ownership “endows” the asset with added value.

Consequences of Endowment Bias

As is the case with status quo bias, endowment bias may lead FMPs to do the following:

• Fail to sell off certain assets and replace them with other assets.
• Maintain an inappropriate asset allocation.
• Continue to hold classes of assets with which they are familiar.

Detection of and Guidelines for Overcoming Endowment Bias

• In the case of inherited investments, an FMP should ask such a question as, “If an equivalent sum to the value of the investments inherited had been received in cash, how would you invest the cash?”
• Research familiar as well as unfamiliar assets the investor may not hold
• Familiar assets can be replaced gradually rather than at once

Question 20

14. Regret-aversion bias

Answer 20

Regret-aversion bias occurs when FMP do nothing out of excess fear that actions could be wrong.

Regret bias can have two dimensions: actions that people take and actions that people could have taken. More formally, regret from an action taken is called an error of commission, whereas regret from an action not taken is called an error of omission.

Regret aversion can initiate herding behavior: it is not just the financial loss they regret; it is also the feeling of responsibility for the decision that gave rise to the loss. In order to avoid the burden of responsibility, regret aversion can encourage FMPs to invest in a similar fashion and in the same stocks as others.

Consequences of Regret-Aversion Bias

As a result of regret-aversion bias, FMPs may do the following:

• Be too conservative in their investment choices as a result of poor outcomes on risky investments in the past.
• This leads to long-term underperformance and a failure to meet goals.
• Engage in herding behavior.

Detection of and Guidelines for Overcoming Regret-Aversion Bias

• In overcoming regret-aversion bias, education is essential. FMPs should quantify the risk-reducing and return-enhancing advantages of diversification and proper asset allocation.
• To prevent investments from being too conservative, FMPs must recognize that losses happen to everyone and keep in mind the long-term benefits of including risky assets in portfolios.
• Efficient frontier research can be quite helpful as an educational tool.

Question 21

15. Loss-aversion bias

Answer 21

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.

Question 22

Behavioral finance and IPS

Answer 22

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?

Question 23

Goals-based investing

Answer 23

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).

Question 24

Behaviorally Modified Asset Allocation

Answer 24

The concept of behaviorally modified asset allocation - approach that begins with the rational portfolio and makes modifications to accommodate behavioral finance considerations.

Question 25

Guidelines for Determining a Behaviorally Modified Asset Allocation

Answer 25

Guideline I

The decision to moderate or adapt to a client’s behavioral biases during the asset allocation process depends fundamentally on the client’s level of wealth. Specifically, the wealthier the client, the more the practitioner should adapt to the client’s behavioral biases. The less wealthy, the more the practitioner should moderate a client’s biases.

Guideline II

The decision to moderate or adapt to a client’s behavioral biases during the asset allocation process depends fundamentally on the type of behavioral bias the client exhibits. Specifically, clients exhibiting cognitive errors should be moderated, and those exhibiting emotional biases should be adapted to.

Designing a standard asset allocation program with a client involves the following steps:

1. Advisers first administer a risk tolerance questionnaire;
2. Advisers discuss the client’s financial goals and constraints;
3. Advisers typically recommend the output of a mean–variance optimization from any number of financial planning software programs.

Question 26

Standard of living risk (SLR)

Answer 26

Standard of living risk (SLR) is the risk that the current or a specified acceptable lifestyle may not be sustainable.

Question 27

How Much to Moderate or Adapt

Answer 27