Topic 9 - Behavioural Biases and Decision Making

Question 1

behavioural biases

Answer 1

are systematic errors in our judgement and decision making processes.

Question 2

Cognitive biases

Answer 2

are those biases based on faulty cognitive reasoning or cognitive errors.

Information Processing
Belief Perseverance

Question 3

Information Processing

Answer 3

cognitive errors in processing information

Question 4

Belief Perseverance

Answer 4

the tendency to cling to one’s previously held or recently established beliefs irrationally or illogically

Question 5

Emotional biases

Answer 5

stem from our impulses or intuitions, and may be considered to result from reasoning influenced by feelings or emotions, rather than facts

Question 6

Mental accounting

Answer 6

is a cognitive process in which individuals separate their financial assets and liabilities into different groupings or mental accounts

Rather than focus on their overall state of wealth, they instead focus independently on their different mental accounts

Question 7

Framing

Answer 7

The response to a question should not depend on how the question is phrased.

if a scenario is presented in two different (but really equivalent) ways, individuals often make inconsistent choices.

Question 8

Self-Attribution

Answer 8

have the tendency to ascribe their successes to innate aspects, such as talent or foresight, while more often blaming failures on outside influences, such as bad luck.

Question 9

When an investor who is susceptible to self-attribution bias purchases an investment:

Answer 9

if it goes up, then it was due, naturally, to their business and investment savvy

if it goes down, then it was due, naturally, to bad luck or some other factor that was not the fault of the investor

Question 10

Recency Bias

Answer 10

causes people to more prominently recall and emphasise recent events and observations than those that occurred in the near or distant past.

Question 11

6 types of Belief Perseverance biases

Answer 11

Confirmation Bias
Conservatism
Illusion of Control
Familiarity
Hindsight Bias
Cognitive Dissonance

Question 12

Confirmation Bias

Answer 12

tendency to look for and notice information that supports or confirms our existing beliefs, while devaluing or ignoring information which contradicts our beliefs

Question 13

Conservatism

Answer 13

mental process in which people cling to their prior views or forecasts at the expense of acknowledging new information

may cause the investor to underreact to the new information, maintaining impressions derived from the previous estimate rather than acting on the updated information

Question 14

Illusion of Control

Answer 14

Human beings have the tendency to believe that they can control or at least influence outcomes when, in fact, they cannot.

contributes to investor overconfidence, which can lead investors to trade more than is prudent, maintain under-diversified portfolios, and exhibit a false sense of control over their investments.

Question 15

Familiarity Bias

Answer 15

Occurs when investors have a preference for familiar investments despite the seemingly obvious gains from diversification
Investors also perceive these familiar assets as less risky and generating a higher return.

Question 16

Hindsight Bias

Answer 16

occurs when people see past events as having been predictable or reasonable to expect.

often caused by the reconstructive nature of memory: when people look back, they often do not have perfect memory and tend to “fill in the gaps” with what they prefer to believe

Question 17

Cognitive Dissonance

Answer 17

When newly acquired information conflicts with pre-existing understandings, people often experience mental discomfort

Commitment, which indicates an emotional attachment by an individual to a decision, always precedes the surfacing of cognitive dissonance

• If facts challenge the course to which a subject is emotionally attached, then those facts pose emotional threats
• Most people try to avoid dissonant situations and will even ignore potentially relevant information to avoid psychological conflict

Question 18

The term cognitive dissonance encompasses the response

Answer 18

that arises as people struggle to harmonise cognitions and thereby relieve their mental discomfort

Question 19

Loss Aversion (Prospect Theory)

Answer 19

looses loom larger than gains

That is, people generally feel a stronger impulse to avoid losses than to acquire equivalent gains

Question 20

Disposition Effect

Answer 20

The disposition effect refers to people’s tendency to:

• Hang on to losers too long (risk-seeking behavior)-
• Sell the winners too soon (risk-avoidance behavior)

Question 21

Overconfidence

Answer 21

unwarranted faith in one’s intuitive reasoning, judgments, and cognitive abilities.

Question 22

Status Quo

Answer 22

tend to default to the same judgment or accept the current situation.

Status quo bias occurs when investors fail to update their investments despite potential gains from doing so.

Question 23

regret aversion

Answer 23

People exhibiting regret aversion avoid taking decisive actions because they fear that, in hindsight, whatever option they select will prove less than optimal.

Question 24

Regret aversion can also lead to herding behaviour

Answer 24

as ,for some individuals, buying into an apparent mass consensus can limit future regret.

Question 25

Herding / Trend-chasing

Answer 25

Investors often chase past performance in the mistaken belief that historical returns predict future investment performance.

Although investors may feel better when investing with the crowd, such an investment strategy is unlikely to lead to superior long-term performance.

Question 26

Endowment Effect

Answer 26

value an asset more when they possess the asset than when they don’t

i.e., the minimum selling price people tend to state exceeds the maximum purchase price they are willing to pay for the same asset.

Question 27

Self-Control

Answer 27

behavioural tendency which causes people to consume (spend) money today at the expense of saving more for tomorrow.

Question 28

Hyperbolic Discounting (Present Bias)

Answer 28

Human motivation is highly influenced by how imminent the reward is perceived to be — meaning, the further away the reward is, the more you discount its value.

Hyperbolic discounting refers to the tendency for people to choose smaller, immediate rewards rather than larger, later rewards.

Question 29

3 information processing biases

Answer 29

Mental Accounting
Framing
Self-Attribution

Question 30

List of Emotional Biases

Answer 30

Loss Aversion
Disposition Effect
Overconfidence
Status Quo
Regret Aversion
Herding / Trend-chasing
Endowment Effect
Self-Control
Hyperbolic Discounting (Present Bias)

Question 31

What is mental accounting? and

Answer 31

Mental accounting is a cognitive process in which individuals separate their financial assets and liabilities into different groupings or mental accounts, rather than focus on their overall state of wealth.

Question 32

Give one example of mental accounting

Answer 32

For example:
• We are more likely to spend an unexpected bonus or windfall gain than we would our regular income
• gamblers have a tendency to take higher risks with their winnings than they would with their own stake (the house money effect)
• if you have savings in the bank, but your credit cards aren’t always paid off, it is likely that you are paying more interest than you are earning.

Question 33

explain why mental accounting is not rational behaviour

Answer 33

Mental accounting is generally regarded as irrational behaviour as it implicitly treats money as being nonfungible (non-interchangable), whereas in reality that is not the case.

Question 34

What is ‘framing’?

Answer 34

Framing bias notes the tendency of decision makers to respond to various situations differently, based on the context in which a choice is presented (framed).

Question 35

How can ‘framing’ be used to increase client engagement with financial planning outcomes.

Answer 35

Positively worded options are more likely to garner affirmative responses, and positively worded answer choices are more likely to be selected than negatively phrased alternatives.
For example, retirement savings projections framed as a gain, or positive outcome, are more likely to evoke an affirmative response from clients than when framed as a loss, or negative outcome:
Gain: “We project you will retire with 60% of your current income.”
Loss: “We project you will retire with 40% less than your current income.”

Question 36

Suggest how an individual might seek to overcome potential confirmation bias

Answer 36

The first step toward overcoming confirmation bias is to recognise that the bias exists. Then people can mindfully compensate by making sure to seek out information that could contradict—not just confirm—their decisions.

Question 37

Describe how ‘familiarity’ bias may influence an investor’s evaluation of potential investment alternatives.

Answer 37

Investors display a preference for local assets with which they are more familiar (local bias) as well portfolios tilted toward domestic securities (home bias). An example of familiarity bias is the preference of many first-time investors to invest in residential property, despite already having a significant proportion of their overall wealth invested in the family home
Investors also perceive these familiar assets as less risky and generating a higher return.

Question 38

Briefly explain how prospect theory differs from expected utility theory.

Answer 38

Prospect theory starts with the concept of loss aversion

Question 39

What are the implications of prospect theory with respect to how people decide between alternatives that involve risk and uncertainty?

Answer 39

people make decisions based on the potential gain or losses relative to relative to a reference point (e.g. current wealth) rather than in absolute terms.

Question 40

What is the theorised relation between Loss Aversion and the Endowment Effect?

Answer 40

. If one loses an item that was part of their ‘endowment’, then the magnitude of this loss is perceived to be greater than the magnitude of the corresponding gain.

Question 41

Contrast ‘overconfidence’ and ‘status quo’ bias, and describe their respective potential influence on investor behaviour.

Answer 41

Research documents that overconfident behaviour is connected to excessive trading and results in poor investment returns.

By contrast, some investors suffer from status quo bias or inertia and under-manage their accounts. Status