Behavioural Finance

Biases one over other

2024 After US presidential Elections

Date
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The Importance of Understanding Behavioral Biases
The examination of behavioral biases is a common focus in finance exams, with candidates often required to identify specific biases based on
provided scenarios.
It is crucial for candidates to diagnose these biases accurately to understand their potential impact on client behavior and portfolio management.
A total of 15 biases are discussed, split into nine cognitive errorsand six emotional biases
Cognitive Errors vs. Emotional Biases
Cognitive Errors
Definition: Cognitive errors result from faulty reasoning and information processing.
Characteristics:
Easier to mitigate through education and awareness.
Often subconscious, these errors stem from how individuals have learned to interpret information.
Emotional Biases
Definition: Emotional biases arise from feelings and instinctual responses.
Characteristics:
More challenging to modify because they are ingrained in a person’s personality.
Individuals may recognize their biases but often fail to take responsibility for changing them.
Key Differences
Cognitive errors are linked to thinking processes, while emotional biases are tied to feeling and instinctual reactions.
As a financial professional, recognizing cognitive errors allows for educational interventions, whereas emotional biases require adjustments in
portfolio strategies to accommodate the client’s inherent feelings.
 Categories of Cognitive Errors
The cognitive errors can be categorized into two main groups: belief perseverance biases and information processing issues.
Belief Perseverance Biases
1. Conservatism:

Tendency to underweight new information that contradicts existing beliefs.

Example: An investor holds onto a positive outlook despite deteriorating company fundamentals.
2. Confirmation Bias:

Seeking out information that confirms existing beliefs while ignoring contradictory evidence.
Example: An investor only considers data that supports their view of a stock.
3. Representativeness:

Making judgments based on stereotypes or classifications.

Example: Assuming a growth stock will always deliver higher earnings simply because it is labeled as such.
Information Processing Issues
4. Illusion of Control:

Believing one has more control over outcomes than is realistic.

Example: An investor attributes stock performance to their hard work, despite market forces being the significant factor.
5. Hindsight Bias:

Viewing past events as more predictable than they were.

Example: An investor claiming they “knew” a stock would fall after it has already happened.
6. Anchoring and Adjustment:

Relying too heavily on initial information when making decisions.

Example: Adjusting an earnings forecast slightly downward based on an initial estimate without considering new data.
7. Mental Accounting:

Treating different funds or portions of a portfolio differently based on arbitrary classifications.

Example: Holding cash for emergencies while taking excessive risks with other investments.
8. Framing:

Decisions influenced by how information is presented.

Example: Presenting investment risk in terms of potential gains rather than losses can alter a client’s perception.
9. Availability:

Relying on readily retrievable information to make decisions.

Example: An investor may overestimate the prevalence of growth stocks because they are more familiar with them.
Emotional Biases Overview
Emotional biases, unlike cognitive biases, are harder to educate away. They are often ingrained in human psychology and require a different approach—adapting
asset allocation rather than attempting to remove the biases.
The mnemonic “LOSERS” helps remember the six emotional biases:
Loss aversion: Pain from losing is greater than the joy of winning.
Overconfidence: Overestimation of one’s abilities and predictions.
Self-control: Difficulty in delaying gratification for long-term goals.
Endowment effect: Overvaluation of assets simply because one owns them.
Regret aversion: Avoiding decisions to prevent potential regret.
Status quo: Preference for the current situation due to inertia or laziness.
Loss Aversion
Definition: A psychological trait where individuals experience the pain of loss more intensely than the pleasure of equivalent gains.
Example: Clients often hold onto losing stocks in the hope of breaking even, while they may sell winning stocks prematurely due to fear of losing gains.
Key Concept: The value function from prospect theory illustrates that losses hurt more than gains feel good. The curve’s steepness shows that the pain of
losing is more pronounced.
Overconfidence
Definition: The tendency to overestimate one’s ability to make accurate decisions or predictions.
Characteristics:
Leads to excessive trading, under-diversification, and poor investment results.
Individuals may have overly narrow confidence intervals for their forecasts.
Example: A financial professional, after a brief discussion with company directors, invests all retirement funds into their firm’s stock based on unwarranted
confidence.
Self-Control
Definition: The struggle to prioritize long-term financial goals over immediate gratification.
Consequences: Inefficient saving for retirement as individuals may choose to spend bonuses rather than invest in their future.
Mitigation Strategies: Develop a comprehensive asset allocation-strategy that aligns with both short-term and long-term financial goals.
Status Quo Bias
Definition: A reluctance to change existing behaviors or beliefs due to inertia or laziness.
Implications: Investors may fail to adjust their asset allocation as they age, leading to inappropriate risk exposure.
Example: An individual maintains a young adult asset allocation well into retirement age, ignoring the need for a more conservative approach.
Endowment Effect
Definition: The phenomenon where individuals assign greater value to assets they own compared to those they do not.
Example: A person may refuse to sell a stock inherited from a relative without a significant premium, despite market conditions suggesting otherwise.
Mitigation Strategies: Gradually divest inherited assets to diversify and optimize portfolios.
Regret Aversion
Definition: The tendency to avoid actions to prevent potential future regret.
Consequences: Leads to inaction, where investors avoid buying stocks that could drop or selling stocks that might recover.
Example: An investor fails to rebalance a portfolio due to fear of making a wrong decision.