Reading 8: The Behavioural Biases of Individuals

Question 1

Cognitive Errors

Answer 1

Can be mitigated with better training or information and are due to faulty reasoning, information processing mistakes or memory errors. Five ‘belief perspectives’ to stick with prior decision and four ‘processing errors’ where information analysis is flawed.

Question 2

Cognitive Errors: Belief Perspectives (keep prior decision)

Answer 2

Conservative bias: failing to change initial view as new info becomes available (overweight initial probabilities). Results in investments held too long.
Confirmation Bias: look for info to support a view or ignores negative info. Results in over concentration, under diversification, holding for too long.
Representative bias: new info is classified based on past experience easily remembered that may not be correlated. Base rate neglect is when the original experience is taken as 100% correct; Sample size neglect is based on small sample. Results in too much importance on new info, excessive transactions.

Question 3

Part 2: Cognitive Errors: Belief Perspectives (keep prior decision)

Answer 3

Illusion of control bias: participants think they can control outcomes; includes illusion of knowledge, self-attribution (you caused an event to occur), and overconfidence bias (you are correct). Results in over trading and less diversification (narrow range of investments).
Hindsight bias: seeing things as more predictable than they really are based on history.

Question 4

Cognitive Errors: Information Processing

Answer 4

Anchoring & adjustment bias: estimating an arbitrary initial value then working off it when new info comes out, relying too heavily on the anchor.
Mental Accounting Bias: money is treated differently depending on how it is categorised. Results in layered portfolios to meet objectives but with higher correlation than optimal between layers.
Framing Bias: depends on how question is framed (overly risk averse/seeking)
Availability bias: undue emphasis on info that is readily available (most recent events which are easier to recall). Broken down into retrievability, categorisation, narrow experiences, resonance.

Question 5

Emotion Biases: Six in Total

Answer 5

Loss aversion bias holds onto losses for longer, increases trading to realise small gains.
Overconfidence bias: illusion of knowledge, self-attribution bias, self-enhancing (blame others). Can be both cognitive and emotional but usually emotional.
Self-control bias: lacking self discipline and favouring immediate gratification, can result in excessive risk to try compensate for insufficient savings.
Status quo bias: comfort with existing choices lead to no change.
Endowment bias: holding securities only for sentimental reasons.
Regret aversion: do nothing out of fear of being wrong.

Question 6

Goals-Based Investing

Answer 6

Starts with objective but still uses layer like BPT. Starts with essential needs and invests a layer to satisfy that with low risk securities, going up the pyramid with higher risk lower needs based layers. Consistent with loss aversion.

Question 7

Behaviourally Modified Asset Allocation

Answer 7

High real wealth equals low standard of living risk (SLR). If client has low SLR you can adapt to emotion errors and adapt and moderate to cognitive errors. Essentially the wealthy can be more eccentric. High SLR you would moderate (change) cognitive errors with justification and adapt and moderate emotional errors (harder to moderate).