The Behavioral Biases Of Individuals Flashcards
Cognitive Errors vs Emotional Bias
Cognitive Error: bold text
- Based in faulty cognitive reasoning
- Can be easily corrected with better information, knowledge, and advice
Emotional Bias: bold text
- Reasoning is influenced by feelings and emotions
- Best adapted to
Belief Perseverance (x5 )
Cling to prior beliefs Bold Text
A.) Conservatism
B.) Confirmation
C.) Representative
D.) Illusion of Control
E.) Hindsight
Conservatisim
- Maintain prior views by not including new information or conflicting information
- Would overweight prior information, while underweighting new information
Consequence: Maintain on slow to update views and forecasts
Detection/Guidance: Properly analyzing and weighting new information. If information is difficult to interpret, seek expert advice
Confirmation Bias:
- Notice what confirms their beliefs and ignore what does not
Consequences: Consider any positive information about an existing investment and ignore any negative information, this will under diversify the portfolio
Detection/Guidance: Actively seek out information that challenges existing beliefs
Representative Bias
- Classify new information based on past experiences and classifications (stereotyping)
- Base rate: Categorize without considering the probability
- Sample size: Assume small sample size represents the population
Consequence: Will adopt a view based on an individual, specific, information, or small sample
Detection/Guidance: Think about probability before classifying. Be sensitive to sample size
Illusion of Control Bias
- Tend to believe they can control or influence outcomes when in fact they cannot
Consequences: Inadequately diversify portfolio (Concentrated). Trade is more prudent. Complex models/forecast = able to control uncertainty
Detection/Guidance: Understand investing is probabilistic
Hindsight Bias
- Seeing past events as having been predictable
Consequences: Overestimate the degree to which a prediction was accurate = overconfidence
Detection/Guidance: Understand why investments did or did not work vs original thoughts. Keep a log of reasons for that thought
Processing Errors (x4)
- Information being processed and used illogically and irrationally
A.) Anchoring and Adjustment
B.) Mental Accounting
C.) Framing
D.) Availability
Anchoring and Adjustment Bias:
- Some initial default number which they adjust up or down to reflect subsequent information
Consequences: Stick too closely to original estimates. Will hold investments too long or sell too early
Detection/Guidance: Be Aware
Mental Accounting Bias:
- Mentally dividing money into accounts that influence decisions
Consequences: Neglect opportunities to reduce risk by combining assets with low correlations
Detection/Guidance: Be Aware
Framing Bias:
- A person responds differently based on how a problem is framed
Consequence: More risk adverse when presented with gain frame, and more risk seeking when given a loss frame
Detection/Guidance: Reframe the problem. Focus on future expectations not current gains/losses
Availability Bias
- Easily recalled outcomes are perceived as more likely. (Retrievability, Categorization, Narrow Range of Experience, Resonance)
Consequences: Select investment/advisors based on current awareness. Fail to diversify.
Detection/Guidance: Develop appropriate IPS and research investment options
Emotional Bias (x6)
- May only be possible to recognize send adapt to, rather than correct for it
A.) Loss Aversion
B.) Overconfidence
C.) Self Control
D.) Status Quo
E.) Endowment
F.) Regret Aversion
Loss Aversion Bias:
- People tend to strongly prefer avoiding losses as opposed to achieving gains.
- Leads to disposition effect ( Selling winners to soon, and holding losers to long)
Consequences: Will hold riskier portfolios. Will hold losses in hopes of breaking even. Trade excessively. Sell gains early with fear they may drop.
Detection/Guidance: Discipline, Set rules, and follow IPS
Overconfidence Bias:
- Unwarranted faith in their own abilities, reasoning, and judgment ( Self attribution, Prediction Overconfidence, and Certainty overconfidence)
Consequences: Underestimate risks and overestimates expected returns. Hold poorly diversified portfolio
Detection/Guidance: Keep record of all trades. Review past performance, Conduct analysis on BOTH winners and losers
Self Control Bias:
- Fail to act in pursuit of long term goals vs short term satisfaction
- Preferring small payoffs now vs large in future
Consequences: Save insufficiently for future, so will step into more risk to generate returns
Detection/Guidance: Have proper investment plan. Maintain optimized SAA
Status Quo Bias:
- Choose to do nothing instead of making a change even when change is warranted
- Positions are maintained largely due to inertia (default options)
Consequences: Unknowingly maintain portfolios with inappropriate risk characteristics. Fail to explore other options
Detection/Guidance: Education is essential
Endowment Bias:
- Values the asset more when they own it
Consequences: Fails to sell certain assets and replace with others. Hold onto what they are familiar with. Maintain inappropriate asset allocation.
Detection/Guidance: Reframe the problem ( would you be X for that?)
Regret Aversion Bias:
- Tend to avoid making decisions that will result in outcome out of fear
- Error of omission, regret not doing
- Error of commission, regret from doing
Consequences: Engaging in herding behaviour. Conservative investment choices
Detection/Guidance: Losses happen to everyone. Quantify the risk reducing and return enhancing advantages of diversification
Market Anamolies
1.) Momentum - Future price behaviour correlates with that of the past ( Availability and Hindsight Bias)
2.) Bubbles and Crashes ( Overconfidence, Confirmation (Self attribution), Regret aversion, and Anchoring Bias)
3.) Value - Value stocks stent to outperform growth. The halo effect is good growth record means good investment, potentially leading to growth stocks being overvalued)
