Reading 8

Question 1

Distinguish between cognitive errors and emotional biases

Answer 1

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

Question 2

Identify and evaluate an individual’s behavioural biases

1) Cognitive Errors: Belief Perseverance

Answer 2

Cognitive Errors: Belief Perseverance

• Conservatism
• Confirmation
• Representativeness
• Control
• Hindsight

Question 3

Identify and evaluate an individual’s behavioural biases

2) Cognitive Errors: Information Processing

Answer 3

Cognitive Errors: Information Processing

• Anchoring and adjustment
• Mental accounting bias
• Framing bias
• Availability bias

Question 4

Identify and evaluate an individual’s behavioural biases

3) Emotional Biases

Answer 4

Emotional biases:

• Loss aversion bias
• Overconfidence bias
• Self-control bias
• Status quo bias
• Endowment bias
• Regret-aversion bias

Question 5

Conservatism Bias

Answer 5

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

Question 6

Confirmation Bias

Answer 6

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

Question 7

Representativeness Bias

Answer 7

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

Question 8

Illusion of control bias

Answer 8

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

Question 9

Hindsight Bias

Answer 9

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.

Question 10

Anchoring and Adjustment

Answer 10

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

Question 11

Mental Accounting bias

Answer 11

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

Question 12

Framing bias

Answer 12

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

Question 13

Availability bias

Answer 13

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

Question 14

Loss Aversion Bias

Answer 14

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

Question 15

Overconfidence Bias

Answer 15

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

Question 16

Self-control bias

Answer 16

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

Question 17

Status Quo bias

Answer 17

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

Question 18

Endowment bias

Answer 18

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

Question 19

Regret Aversion bias

Answer 19

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

Question 20

Goals-based investing

Answer 20

• 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

Question 21

Behaviourally Modified Asset Allocation

Answer 21

• 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)

Question 22

Bubbles and crashes

Answer 22

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.