Reading 8 Flashcards
The behavioural biases of Individuals
Distinguish between cognitive errors and emotional biases
Cognitive errors:
- inability to analyse information
- basing decisions on partial information
- lack the capacity
- Can be divided into:
1) belief perseverance errors
2) information processing errors
Emotional errors:
- the way individuals frame the information and decision rather than the mechanical or physical process used to analyse and interpret it
- more of a spontaneous reaction
Identify and evaluate an individual’s behavioural biases
1) Cognitive Errors: Belief Perseverance
Cognitive Errors: Belief Perseverance
- Conservatism
- Confirmation
- Representativeness
- Control
- Hindsight
Identify and evaluate an individual’s behavioural biases
2) Cognitive Errors: Information Processing
Cognitive Errors: Information Processing
- Anchoring and adjustment
- Mental accounting bias
- Framing bias
- Availability bias
Identify and evaluate an individual’s behavioural biases
3) Emotional Biases
Emotional biases:
- Loss aversion bias
- Overconfidence bias
- Self-control bias
- Status quo bias
- Endowment bias
- Regret-aversion bias
Conservatism Bias
Cognitive: Belief Perseverance
Impact:
Slow to react to new information or avoid the difficulties associated with analysing new information.
Can also be explained in terms of Bayesian statistics; place too much weight on the base rates
Mitigation:
Look carefully at the new information itself to determine its value
Confirmation Bias
Cognitive: Belief Perseverance
Impact:
Focus on positive information about an investment and ignore or dismiss anything negative.
Can lead to too much confidence in the investment and to overweighting it in the portfolio
Mitigation:
Actively seek out information that seems to contradict your opions and analyse it carefully
Representativeness Bias
Cognitive: Belief Perseverance
Impact:
Place information into categories utilizing an if-then heuristic.
Place too much emphasis on perceived category of new information.
Likely to change strategies based on a small sample of information.
Mitigation
Consciously take steps to avoid base rate neglect and sample size neglect
Consider true probability that information fits a category
Use the periodic table of Investment Returns
Illusion of control bias
Cognitive: Belief Perseverance
Impact
Illusion of control over one’s investment outcomes can lead to excessive trading with the accompanying costs
Can lead to concentrated portfolios
Mitigation
Seek opinions of others
Keep records of trades to see if successful at controlling investment outcomes
Hindsight Bias
Cognitive: Belief Perseverance
Impact
Overestimate accuracy of their forecasts and take too much risk
Mitigation
Keep detailed record of all forecasts, including the data analysed and the reasoning behind the forecast
Hindsight bias is an ego defense mechanism analysts use to protect themselves against being wrong in their forecast. It is used by selectively recalling what actually happened, allowing the analyst to adjust their forecast accordingly and making it look like their forecast was more accurate than it actually was. Hindsight bias is possible when the original forecast is vague and ambiguous, a poor forecasting trait, allowing the forecast to be adjusted.
Anchoring and Adjustment
Cognitive: Information processing
Impact
Tend to remain focused on and stay close to their original forecasts or interpretations
Mitigation
Give new information thorough consideration to determine its impact on the original forecast or opinion
Mental Accounting bias
Cognitive: Information processing
Impact
Portfolios tend to resemble layered pyramids of assets
Subconsciously ignore the correlation of assets
May consider income and capital gains separately rather than as parts of the same total return
Mitigation
Look at all investments as if they are part of the same portfolio to analyse their correlations and determine true portfolio allocation
Framing bias
Cognitive: Information processing
Impact
Narrow a frame of reference; individuals focus on one piece or category of information and lose sight of the overall situation or how the information fits into the overall scheme of things
Mitigation
Investors should focus on expected returns and risk, rather than on gains and losses. That includes assets or portfolios with existing gains or losses
Availability bias
Cognitive: Information processing
Four cases:
1) Retrievability
2) Categorisation
3) Narrow range of experience
4) Resonance
Impact
Select investments based on how easily their memories are retrieved and categorised
Narrow range of experience can lead to concentrated portfolios
Mitigation
Develop an IPS and construct a suitable portfolio through diligent research
Loss Aversion Bias
Emotional bias
Impact
Focus on current gains and losses
Continue to hold losers in hopes of breaking even
Sell winners to capture the gains
Mitigation
Develop an IPS and construct a suitable portfolio through diligent research
Myopic Loss Aversion: combines the effects of time horizon and framing
Overconfidence Bias
Emotional bias
Impact
Hold under-diversified portfolios
Underestimate the downside while overestimating the upside potential
Trade excessively
Mitigation
Keep a detailed record of traces, including the motivation for each trade
Analyse successes and losses relative to the strategy used
Self-control bias
Emotional bias
Impact
Lack discipline to balance short-term gratification with long-term goals
Tend to try to make up the shortfall by assuming too much risk
Mitigation
Maintain complete, clearly defined investment goals and strategies
Budgets help deter the propensity to over-consume
Status Quo bias
Emotional bias
Impact
Risk characteristics of the portfolio change
Investor loses out on potentially profitable assets
Mitigation
Education about risk and return and proper asset
Difficult to mitigate
Endowment bias
Emotional bias
Impact
Value of owned assets higher than same assets if not owned
Stick with assets because of familiarity and comfort of were inherited
Mitigation
Determine whether the asset allocation is appropriate
Regret Aversion bias
Emotional bias
Impact
Stay in low-risk investments
Portfolio with limited upside potential
Stay in familiar investments or ‘follow the herd’
Mitigation
Education is primary mitigation tool
Goals-based investing
- Recognises that individuals are subject to both
1) loss aversion
2) mental accounting - builds a portfolio in layers, each consisting of assets that meet individual goals
Pyramiding:
Bottom layer - comprised of assets designated to meet the investor’s most important goals
Each successive layer consists of increasingly risky assets used to meet less and less import goals
Provides investor with ability to see risk more clearly
Although portfolio probably won’t be efficient, it will tend to to be fairly well diversified
Behaviourally Modified Asset Allocation
- Emotional biases are more often adapted to through deviations from the rational asset portfolio allocation
- Higher wealth relative to lifestyle needs allow for greater deviations from the rational portfolio
- The emotional biases of the lower-wealth individual are treated about the same as the cognitive biases of the wealthier individual
- The amount of deviation is also affected by the number of different asset classes in the portfolio
- The lower the suggested deviation from the rational portfolio asset allocation, the greater the need to moderate the investor’s behavioural biases (Due to significant standard of living risk, for example, the cognitive biases of the low-wealth investor must be moderated)
Bubbles and crashes
Financial bubbles and crashes are periods of unusual positive or negative returns caused by panic buying and selling, neither of which are based on economic fundamentals. In a bubble, the buying is due to investors believing the price of the asset will continue to go up. Another way of defining a bubble or crash is a period of prices for an asset class that is two standard deviations away from the price index’s mean value. A crash can also be characterized as a fall in asset prices of 30% or more over a period of several months.
