IFT Notes for Level I CFA® Program
LM05 The Behavioral Biases of Individuals
Traditional finance assumes that individuals act rationally by considering all available information in their decision-making process. This leads to optimal outcomes and efficient markets.
Behavioral finance challenges these assumptions by incorporating research on how individuals and markets actually behave. It assumes that people act “normal” rather than rational. It recognizes that people have behavioral biases that impact financial decision making. Behavioral biases can cause decisions to differ from the “rational” decisions of traditional finance.
This reading is organized as follows:
- Section 2 broadly characterizes behavioral biases into cognitive errors and emotional biases.
- Section 3 explains cognitive errors, the consequences of each bias, detection of the bias, and guidance for overcoming these biases.
- Section 4 describes emotional biases, the consequences of each bias, detection of the bias, and guidance for overcoming these biases.
- Section 5 discusess how behavioral finance influences market behaviour and the occurance of market anomalies
2. Behavioral Biases Categories
Behavioral biases can be either cognitive errors or emotional biases.
- Stem from statistical, information-processing, or memory errors.
- Can occur as a result of faulty reasoning.
- Are more easily corrected than emotional biases.
- Can be corrected through better information, education, and advice.
- Stem from impulse or intuition.
- Are influenced by feelings and emotion.
- Are spontaneous.
- Are less easy to correct as compared to cognitive errors.
- Can be recognized and “adapted” to.
3. Cognitive Errors
There are two categories of cognitive biases: 1) belief perseverance biases and 2) information-processing biases.
Instructor’s Note: A summary of the nine cognitive errors is provided below. They are covered in detail in the subsequent sections. Memorize this summary.
Belief perseverance biases
- Conservatism bias: Maintain prior views by inadequately incorporating new information.
- Confirmation bias: Look for and notice what confirms their beliefs.
- Representativeness bias: Classify new information based on past experiences.
- Illusion of control bias: False belief that we can influence or control outcomes.
- Hindsight bias: See past events as having been predictable.
- Anchoring & adjustment bias: Incorrect use of psychological heuristics.
- Mental accounting bias: Treat one sum of money different from other.
- Framing bias: Answer question differently based on how it is asked.
- Availability bias: Heuristic approach influenced by how easily outcome comes to mind.
3.1 Belief Perseverance Biases
Belief perseverance is the tendency to cling to one’s previously held beliefs irrationally
or illogically. Belief perseverance biases are closely related to cognitive dissonance. Cognitive dissonance is the mental discomfort that occurs when new information conflicts with old beliefs or cognitions.
The belief perseverance biases discussed in this reading are: conservatism, confirmation, representativeness, illusion of control, and hindsight.
Individuals maintain prior views by inadequately incorporating new information. From the traditional finance perspective, this can be described as the failure to update probabilities using Bayes’ formula.
This bias has aspects of both statistical and information-processing errors. It causes individuals to overweight initial beliefs about probabilities and outcomes; and under-react to new information.
Consequences of conservatism bias:
- Maintain or be slow to update a view or a forecast, even when new information is available.
- Opt to maintain a prior belief rather than deal with the mental stress of updating beliefs given complex data. This relates to an underlying difficulty in processing new information.
- As a consequence of conservatism, an investor may hold a security longer than a rational decision maker.
Detecting and overcoming conservatism bias:
- Recognize that bias exists.
- Ask questions when presented with new information: “How does this information change my forecast?” “What is the impact of this information?”
- Updating of beliefs is inversely correlated with the effort involved. The more effort it takes to change a prior view, or the more effort it takes to process new information, the more likely the individual will ignore it.
- Should conduct careful analysis incorporating the new information.
- When it is difficult to interpret new information, seek advice from experts.
Confirmation bias occurs when individuals look for and notice what confirms their beliefs and ignore what contradicts their beliefs.
A client insists on continuing to hold stock, even when the adviser recommends otherwise because the client’s follow-up research seeks only information that confirms his belief that the investment is still a good value.
Consequences of confirmation bias:
- Consider only positive information about an existing investment and ignore negative information.
- Develop screening criteria and ignore information that refutes the screening criteria’ validity or supports other screening criteria.
- Under-diversify portfolios, leading to excessive exposure to risk.
- Hold a disproportionate amount of their investment assets in their employing company’s stock. Because of the confirmation bias, the FMP(Financial market participant) is convinced of the company’s favorable prospects and ignores unfavorable information.
Detecting and overcoming confirmation bias:
- Seek information that challenges your (FMPs) beliefs.
- Get corroborating support on an investment decision. If you are a technical analyst and you believe that the stock will go up. Before giving investment advice, it is advisable to get supporting information from (say) your colleague, a fundamental analyst. Because your colleague may have a completely different valuation of the stock. It is essential to make the extra effort to gather complete information, positive and negative, for better decisions.
Representativeness bias is when people classify new information based on past experiences and classifications. The two types of representativeness bias are ‘base-rate neglect’ and ‘sample-size neglect’.
In base-rate neglect the base rate, or probability of the categorization is not adequately considered. For example, categorizing Company ABC as a “growth stock” without appropriate due diligence. FMPs rely on stereotypes when making investment decisions without adequately incorporating the base probability of the stereotype occurring. So, the classification of ABC is based on FMPs stereotypes about growth companies, but it ignores the base probability that the company may not be a growth company.
In sample-size neglect FMPs incorrectly assume that small sample sizes are representative of populations (or “real” data). In the investment context, sample size neglect can be seen when a few data points are naïvely extrapolated as being representative of a long-term trend. For example, an investor who puts too much emphasis on short-term results when considering a potential investment.
Consequences of representativeness bias:
- Adopt a view or a forecast based almost exclusively on new information or a small sample.
- Update beliefs using simple classifications rather than deal with the mental stress of updating beliefs given complex data.
Detecting and overcoming representativeness bias:
- Be aware of statistical mistakes you may be committing.
- Continually ask yourselves, “Are you overlooking the reality of the investment situation?”
Illusion of Control Bias
Illusion of control bias occurs when individuals incorrectly believe that they can control or influence outcomes when they cannot.
Consequences of illusion of control:
- Trade more than is prudent. For example, day traders believe that they have “control” over their investments’ returns. This view leads to excessive trading, which may lead to lower realized returns.
- Inadequate diversification. An investor prefers to invest in a company where he works because he feels he controls its future. This leads to concentrated positions.
Detecting and overcoming illusion of control bias:
- Recognize that investing is a probabilistic activity.
- Global capitalism is complex; even the most powerful investors have little control over the outcomes of their investments. For example, AIG did not have control over what happened in 2008-2009.
- Seek contrary viewpoints.
- Maintain records of your transactions, the rationale behind each trade, the attributes that you have determined to be in favor of the investment’s success. This will make you realize that you do not control the outcome of the investment.
Hindsight bias is a bias where people may see past events as having been predictable and reasonable to expect. In hindsight, poorly reasoned decisions with positive results may
be described as brilliant tactical moves, and poor results of well-reasoned decisions
may be described as avoidable mistakes. Also, people will remember their own predictions
of the future as more accurate than they actually were because they are biased by the knowledge of what has actually happened.
Consequences of hindsight bias:
- Overestimate the degree to which they predicted an investment outcome, which can
lead to a false sense of confidence.
- Unfairly assess a money manager’s or security’s performance. For example, a money manager might have performed well in the past, given his value-investing strategy. But in the present year, growth stocks gave better returns. As a result, investors with the hindsight bias will believe that growth managers show superior performance to value managers because of what has taken place in securities markets. Performance is compared against what has happened as opposed to expectations.
Detecting and overcoming the bias:
- Recognize the bias.
- Ask such questions as, “Am I re-writing history or being honest with myself about the mistakes I made?”
- Carefully record and examine investment decisions, both good and bad.
3.2 Processing Errors
The second category of cognitive error is information-processing biases. These biases result in information being processed and used illogically or irrationally. In contrast to belief perseverance biases, these are less related to errors of memory and more to do with
how information is processed. The processing errors discussed in this reading are anchoring and adjustment, mental accounting, framing, and availability.
Anchoring and Adjustment Bias
Anchoring and adjustment bias is an information-processing bias in which the use
of a psychological heuristic influences the way people estimate probabilities. People set an anchor that influences their decisions; they adjust the anchor up or down to reflect subsequent information. Irrespective of how the initial anchor was chosen, people often fail to adjust their anchors properly, and as a result produce biased approximations.
This bias is closely related to the conservatism bias. In the conservatism bias, people place undue weight on past information compared to new information. In anchoring and adjustment, people place undue weight on an “anchored” value.
Consequences of anchoring and adjustment bias:
- FMPs may stick too closely to their original estimates when new information is learned. For example, an FMP originally bought a technology stock for $25, and the stock kept doing well until the company started experiencing difficulties during the year. As the stock price dived, the FMP did not adequately adjust the $25 given the difficulties. He remained “anchored” to the $25 he had paid and refused to sell the stock. This mindset is not limited to downside adjustments; the same can happen when companies have upside surprises.
Detecting and overcoming anchoring and adjustment bias:
- Consciously ask questions that may reveal an anchoring and adjustment bias. For example, “Am I holding onto this stock based on rational analysis, or am I trying to attain a price that I am anchored to, such as the purchase price or a high-water mark?”
- Recognize that past prices and market levels are not an indication of what will happen in the future. They should not significantly influence buy and sell decisions.
Mental Accounting Bias
Mental accounting bias is a bias in which people treat one sum of money differently from another sum based on which mental account (layer) the money is assigned to.
An investor may create three layers of money – the first layer includes conservative investments, the second layer has moderate risk investments, and the third layer has high-risk assets. Investors assign investments into discrete “buckets,” i.e., several non-fungible mental accounts. This method is problematic and contradicts rational economic thought because money is inherently fungible (interchangeable).
Consequences of mental accounting bias:
- Money is placed in “buckets” or “layers” without considering correlations among assets. FMPs neglect opportunities to reduce risk by combining assets with low correlations.
- Irrationally distinguish between returns derived from income and from capital appreciation. Some FMPs are more comfortable spending the income generated but try to preserve the principal. As a result, they may overweight income generating assets, which may result in a lower total return.
- Irrationaly distinguish between investment principal and investment returns. Some FMPs invest the original principal rationally but are willing to take a very high risk with the investment returns. In the casino sector, “playing with house money” is a typical term used for this situation.
Detecting and overcoming mental accounting bias:
- Recognize the drawbacks of putting money in different buckets.
- Combine all assets onto one spreadsheet to see the true asset allocation of various mental account layers.
- Focus on total return instead of dividing return into income and capital appreciation components. Say you buy a stock that is increasing in value but does not pay dividends. You can always sell a part of your stock and create an income stream.
Framing bias occurs when an individual answers a question differently, depending on how it is asked (framed).
A situation may be presented within a gain context (one in four start-up companies succeed) or within a loss context (three out of four start-ups fail).
Given the first frame, an FMP may adopt a positive outlook and make venture capital investments. Given the second frame, the FMP may avoid making the investment.
Consequences of framing bias:
- FMPs’ willingness to accept risk can be influenced by how situations are presented or framed. This can result in misidentifying risk tolerances. Because of how questions are framed, FMPs may become more risk-averse when presented with a gain frame of reference and more risk-seeking when presented with a loss frame of reference.
- Choose suboptimal investments based on how information about the specific investments is framed.
- Have a narrow frame when evaluating an investment. Focus on short-term price fluctuations may result in excessive trading.
Detecting and overcoming framing bias:
- Ask such questions as, “Is the decision the result of focusing on a net gain or net loss position?”
- Try to be neutral and open-minded when evaluating investments.
Availability bias is when people take a heuristic (sometimes called a rule of thumb or a mental shortcut) approach to estimating the probability of an outcome based on how easily the outcome comes to mind. Easily recalled and understandable outcomes are perceived as more likely than harder to recall ones.
The four sources of the bias most applicable to FMPs are retrievability, categorization, narrow range of experience, and resonance.
Retrievability: If an answer or idea comes to mind more quickly than others, it will likely be chosen as correct even if it is not. For example, a study was done in which
subjects listened to a list of 50 names and were then asked to judge if the list contained
more men or women. The list contained 30 generic women names, but the 20 men were all famous. As availability theory would predict, most of the subjects concluded that the list contained more men than women because they immediately recalled the famous men’s names.
Categorization: When solving problems, people gather information from what they
recognize as relevant search sets. If it is difficult to come up with a search set, the estimated probability may be biased. For example, in the US, baseball is a popular sport, but soccer is not. If an American is asked to list famous baseball players and famous soccer players, the list of soccer players will be relatively short. An American may incorrectly conclude that there are more famous baseball players than soccer players. Because in their categorization, there are more baseball players than soccer players.
Narrow Range of Experience: This bias occurs when a person with a narrow range
of experience uses too narrow a frame of reference based upon that experience when
he makes an estimate. For example, assume that an investor advisor has only been in the market for three years. When he makes conclusions or decisions, his availability bias will be based on three years of experience. He would not have seen the great stock market crashes, the booms/bursts of the past.
Resonance: The conclusions or decisions people take are often biased by how closely a situation resonates with their personal experience. For example, jazz music lovers are likely to overestimate how many people listen to jazz music. On the other hand, people who dislike jazz music are likely to overestimate the number of people who dislike jazz music.
Consequences of availability bias:
- Choosing an investment, investment adviser, or mutual fund based on advertising rather than appropriate analysis. For instance, when choosing a mutual fund to invest with, many people will choose the fund that does extensive advertising because its name will easily come to mind. Choices based on advertising are consistent with retrievability as a source of availability bias.
- FMPs limit their investment opportunity set.
- Fail to diversify.
- Fail to achieve an appropriate asset allocation.
Detecting and overcoming availability bias:
- Recognize the bias. It is a human tendency to overemphasize the most recent financial events because of easy recall.
- Follow a disciplined approach to investing. To develop an appropriate investment policy strategy, carefully research, and analyze investment decisions and focus on the long-term.
- Ask such questions: “How did I hear about the stocks?” Was it on Bloomberg, or saw them on CNBC, or read a research report?” and “Am I buying or selling investments because of a recent market event without doing a thorough analysis?”
- Recognize that we forget events that happened a few years ago.