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IFT Notes for Level I CFA® Program

LM05 The Behavioral Biases of Individuals

Part 2

4. Emotional Biases

Instructor’s Note: A summary of the six types of emotional biases is presented below. They are covered in detail in the subsequent sections. Memorize this summary. Use the acronym ‘LOSSER’ to remember this list.

  • Loss-aversion bias: Prefer avoiding losses over achieving gains.
  • Overconfidence bias: Unwarranted faith in one’s abilities.
  • Self-control bias: Fail to act in pursuit of long-term goals.
  • Status quo bias: Do nothing rather than make a change.
  • Endowment bias: People value asset more when they hold rights to it.
  • Regret-aversion bias: Avoid pain of regret associated with bad decisions.

4.1 Loss-Aversion Bias

Loss-aversion bias is a bias in which people prefer avoiding losses over achieving gains. When comparing absolute values, the utility derived from a gain is much lower than the utility given up with an equivalent loss. Stated simply, people hurt more when there is a loss and are less happy when they gain the same value.

Loss-averse behavior is explained as the evaluation of gains and losses based on a reference point. A value function that passes through this reference point is seen in Exhibit 1 below. The x-axis has gains/losses, and the y-axis has value. Say we have a 5% gain, the positive value is 5 units, but for the same amount of loss, 5%, notice from the exhibit that the value is much higher, say -15 units. So, the value of gain is not symmetric to the value of the loss.

The value function is s-shaped and asymmetric; it has a greater impact of losses than gains for the same variation in absolute value. This utility function implies risk-seeking behavior in the domain of losses (below the horizontal axis) and risk avoidance in the domain of gains (above the horizontal axis).

An important concept based on this utility function is disposition effect: the holding of investments that have experienced losses too long, and the selling of investments that have experienced gains too quickly. Hence the resulting portfolio may be riskier than the one based on the investor’s risk/return objectives.

Consequences of loss aversion:

  • Hold investments in a loss position for a longer period of time than is justified by fundamentals in the hope that they will return to breakeven.

For example, you bought a stock for 20, and after a while, its price declined to 15. This was a reasonable price to sell, given the fundamental value of the stock. But you held on to the stock in the hope of regaining value rather than recognizing a loss. Such behavior leads to a riskier portfolio than one that was based on risk/return objectives and fundamental analysis.

  • Sell investments in a gain position earlier than justified by fundamentals. Trade excessively as a result of selling winners.

Here, say you bought a stock that increased by 10%, and you sold it because you were afraid that price would decrease if you held on. As a result, you would trade excessively. Fundamentals should justify your selling decisions.

  • Limit the upside potential of a portfolio by selling winners and holding losers.

Detecting and overcoming loss aversion:

  • Use a disciplined approach to investment based on fundamental analysis.

4.2 Overconfidence Bias

Investors demonstrate unwarranted faith in their own intuitive reasoning, judgments, and/or cognitive abilities. For example, people generally think they do a better job of estimating probabilities than they actually do.  This is known as illusion of knowledge bias.

The two basic types of overconfidence bias within the illusion of knowledge bias are prediction overconfidence and certainty overconfidence.

  • Prediction overconfidence happens when the confidence intervals assigned (for investment predictions) are too narrow. For example, when estimating a stock’s value, you are overconfident that there will be too little variation—use a narrower expected payoffs’ range and a lower standard deviation of returns than justified by the fundamental value.
  • Certainty overconfidence occurs when the probabilities for outcomes are too high because FMPs are too certain of their judgments. For example, if you are certain that the investment will increase in value, the probability that you will assign to this scenario will be too high. Thus, you do not consider the prospect of a loss and predict high returns with virtual certainty.

Self-attribution bias is a bias in which people take credit for successes and blame exogenous factors (such as bad luck) for failures. This bias can be divided into two subsidiary biases: self-enhancing and self-protecting. Self-enhancing bias describes people’s propensity to claim too much credit for their successes. Self-protecting bias describes the denial of responsibility for failures.

Consequences of overconfidence bias:

  • Underestimate risks and overestimate expected returns.
  • Hold poorly diversified portfolios.

Detecting and overcoming overconfidence bias:

  • Review trading records, identify the winners and losers. Look at your data, the stocks you bought, how they performed, and if it was in line with your expectations. Keeping a track of your performance history can adjust the overconfidence bias.
  • Calculate portfolio performance over at least two years.
  • There is an old Wall Street adage, “Don’t confuse brains with a bull market.” In a bull market, an average person will select stocks that will do well. Because in a bull run of the market, all stocks will be going up, and it does not take a genius to pick winning stocks.
  • Conduct a post-investment analysis of both successful and unsuccessful investments.

4.3 Self-Control Bias

Self-control bias is a bias in which people fail to act in their long-term best interest because of a lack of self-discipline. Individuals are impulsive, and there is an inner conflict between short-term satisfaction and achievement of some long-term goals. For example, “People pursuing the CFA charter may fail to study sufficiently because of short-term competing demands on their time.”

Consequences of self-control bias:

  • Save insufficiently for the future. If an individual does not have self-control, he may spend on, say, a new car or a vacation, instead of saving for retirement.
  • Upon realizing that the savings are insufficient, FMPs may accept excessive risk in their portfolios to generate higher returns. This is done to compensate for inadequate savings, which puts the capital base at risk.
  • Borrow excessively to finance current consumption.

Detecting and overcoming self-control bias:

  • Create a proper investment plan.
  • Execute the plan. Adhere to a saving plan and an appropriate asset allocation strategy.

4.4 Status Quo Bias

Status quo is an emotional bias in which people do nothing (i.e., maintain the “status quo”) instead of making a change. People are generally lazy and keep things the same. They do not necessarily look for opportunities where a change is beneficial. A phrase commonly used can be understood in the context of status quo, “if it ain’t broke, don’t fix it.” This saying means leave something, avoid correcting or improving it.

Status quo bias is often discussed in tandem with endowment and regret-aversion biases (described later) because the outcome of the biases may be similar. However, the reasons differ among the biases. In the status quo bias, positions are maintained primarily due to inertia rather than conscious choice. In the endowment and regret-aversion biases, the positions are maintained because of conscious, but incorrect choices.

Consequences of status quo bias:

  • FMPs unknowingly maintain portfolios with risk characteristics that are inappropriate for their circumstances.
  • They fail to explore other opportunities.

Detecting and overcoming status quo bias:

  • Education is crucial.
  • Quantify the risk-reducing and return-enhancing advantages of diversification and proper asset allocation.

4.5 Endowment Bias

Endowment bias is an emotional bias in which people value an asset more when they
hold rights to it than when they do not. For example, a person owns his house, and it has a specific value to him. After some time, he decides to buy another house next door, very similar to his house. But he feels the price quoted for it is too high. However, if he were to sell his own house, he would perhaps ask for a higher price. Standard economic theory states that similar assets should be bought/sold at the same price. Because he has lived and owned this house for the past 30 years, endowment bias has affected his attitudes toward it. Effectively, ownership “endows” the asset with added value.

Endowment bias may also occur when someone inherits or purchases securities. The value in their minds is more than what it should be. Consequently, FMPs may irrationally hold on to securities or assets they already own even though it violates the law of one price.

Endowment bias can be combined with the status quo bias. Clients are reluctant to sell securities bequeathed by previous generations.

Consequences of endowment bias:

  • Fail to sell off certain assets and replace them with other assets.
  • Maintain an inappropriate asset allocation.
  • Continue to hold assets with which they are familiar.

Detecting and overcoming endowment bias:

  • In the case of inherited investments, ask such a question, “If I were given an equivalent amount in cash, how would I invest it now?”
  • Address emotional attachment.

4.6 Regret-Aversion Bias

Regret-aversion bias is a bias in which people tend to avoid making decisions out of fear that the decision will turn out poorly. For example, many years ago, there was a saying that no one gets fired for selecting IBM. Because IBM was a big company, and it was considered safe to buy merchandise from it. Even if your decision went wrong, you could save face by saying, “I bought from the biggest company,” which is commonly accepted as the appropriate thing to do. Generally, people try to avoid the pain of regret associated with bad decisions. Thus, no action becomes the default decision.

Consequences of regret-aversion bias:

  • Be too conservative in their investment choices because of poor outcomes
    on risky investments in the past. To avoid the regret of coping with another bad decision, FMPs will invest in low-risk assets failing to reach investment goals in the long-term.
  • Engage in herding behavior. FMPs may feel safer investing in popular investments. It seems safe to be with the crowd; if the investment turns out to be unsuccessful, everyone faces the loss, reducing emotional pain.

Detecting and overcoming regret-aversion bias:

  • Education is crucial.
  • Quantify the risk-reducing and return-enhancing advantages of diversification and proper asset allocation.
  • Recognize that losses happen to everyone; keep in mind long-term objectives.

5. Behavioral Finance and Market Behavior

Traditional finance assumes that markets are efficient, that they instantly and fully incorporate all information into asset prices. However some persistent market patterns such as momentum, value, bubbles, and crashes challenge this assumption. In this section we will use behavioral finance to understand why these patterns occur.

5.1 Defining Market Anomalies

Market anomalies are persistent deviations from the efficient market hypothesis (EMH). Anomalies are identified by persistent abnormal returns that differ from zero and are predictable in direction. Possible explanations of anomalies are:

  • Shortcomings in the underlying asset pricing model – For example, the CAPM model uses return relative to risk (beta) incurred. If the mispricing of security is due to other types of risks not considered in the model, then the market is not anomalous; the model is limited. Examples are low returns following initial public offerings (called the “IPO puzzle”) and the positive abnormal returns in the 12 months after a stock split.
  • Small sample involved.
  • Statistical bias in selection or survivorship, or data mining that overanalyzes data for patterns and treats spurious correlations as relevant.
  • Temporary disequilibrium behavior – unusual features that may survive for years but ultimately disappear.

Despite the challenges, behavioral finance has identified several market anomalies and offered explanations based on individual investors’ behavioral biases. Three such anomalies are momentum, bubbles, and crashes, and value stocks vs. growth stocks.

5.2 Momentum

Momentum (or trending) occurs when future price movements are correlated with recent past prices. Correlation is positive in the short term, up to two years, but for longer periods of two to five years, correlation is negative, and returns revert to the mean.

Why does this phenomenon occur?

Momentum can be partly explained by availability and hindsight biases.

Several studies have found that traders have faulty learning models in which their reasoning is based on their most recent experience. This is also referred to as availability bias. The recency effect is the tendency to recall recent events more vividly and give them undue weight. If the price of a security rises for a period, investors extrapolate this rise to the future. Recency bias causes investors to place too much emphasis on small samples because of the readily available information.

Regret is the feeling that an opportunity has been missed and is related to hindsight bias. Hindsight bias is the tendency to see past events as having been predictable. Suppose a mutual fund or stock did well a year ago; the regret of not owning this well performing asset can drive investors to remedy it by purchasing the asset. These behavioral factors can explain short-term year-on-year trending and overtrading creating a trend-chasing effect. Investors have a bias to buy investments they wish they had owned the previous year.

5.3 Bubbles and Crashes

Bubbles and crashes are defined as periods of unusual positive or negative asset returns.  Bubbles and crashes appear to be panics of buying and selling. A continuous increase in asset price is fueled by further expectations of increase; asset prices become decoupled from economic fundamentals. Bubbles typically develop more slowly relative to crashes, which can be rapid. This asymmetry is because of the behavioral factors involved. A crash is a fall of 30% or more in asset prices over several months. Recent examples are the technology bubble of 1999–2000 and the residential property boom of 2005–2007.

Rational and behavioral finance explanations for asset bubbles is given in Example 16. Both managers did not understand the risks involved in the technology stock bubble and exhibited the illusion of control bias.

Example: Investor Behaviour in Bubbles

(This is Example 16 in the curriculum.)

Consider the differing behavior of two managers of major hedge funds during the technology stock bubble of 1998–2000:

The manager of Hedge Fund A was asked why he did not get out of internet stocks earlier even though he knew by December 1999 that technology stocks were overvalued. He replied, “We thought it was the eighth inning, and it was the ninth. I did not think the NASDAQ composite would go down 33% in 15 days.” Faced with losses, and despite his previous strong 12-year record, he resigned as Hedge Fund A’s manager in April 2000.

The manager of Hedge Fund B refused to invest in technology stocks in 1998 and 1999 because he thought they were overvalued. After strong performance over 17 years, Hedge Fund B was dissolved in 2000 because its returns could not keep up with the returns generated by technology stocks.

The behavioral biases associated with bubbles and crashes are

  • Overconfidence is, almost by definition, abundant during bubbles (but not necessarily in crashes). This bias causes investors to overestimate expected returns, underestimate risk, trade excessively, and hold undiversified portfolios. The overconfidence and excessive trading are linked to confirmation bias and self-attribution bias. Confirmation bias exists because investors can select news that supports an existing decision or investment.
  • Even if winners are being sold too soon in a bubble, sales will be profitable because of a rising market. Investors can demonstrate hindsight, in which individuals can reconstruct prior beliefs and deceive themselves that they are correct more often than they truly are.
  • Regret aversion is also present in a bubble, as investors may think they are “missing out” on profit opportunities.
  • As a bubble unwinds, there can be underreaction that can be caused by anchoring

when investors do not update their beliefs sufficiently.

  • There can be cognitive dissonance, ignoring losses, and attempting to

rationalize flawed decisions as a bubble unwinds. Investors may initially be unwilling to accept losses.

  • In crashes, the disposition effect leads investors to hold on to losers and postpone regret. This leads to an initial underreaction to bad news but later causes capitulation and acceleration of share price decline, which results in a crash.

5.4 Value

Studies show that value stocks outperform growth stocks over long periods. Value stocks are typically characterized by low price-to-earnings ratios, high book-to-market equity, and low price-to-dividend ratios. A growth stock has the opposite characteristics of a value stock. For example, growth stocks are characterized by low book-to-market equity, high price-to-earnings ratios, and high price-to-dividend ratios.

The Fama and French three-factor model incorporates additional factors, size, and value, alongside market beta in their asset pricing model to explain this anomaly and other apparent anomalies. Fama and French claim the value stock anomaly disappears in their three-factor model. They believe that the factors are associated with risk exposures that show the greater potential to suffer distress during economic downturns. In other words, it is not the mispricing of value and growth stocks that lead to the difference in their performance but the difference in risk between the two classes of stocks.

Some studies present anomalies as mispricing rather than risk. These studies identify the emotional factors involved in valuing stocks. The halo effect, for example, is based on a favorable evaluation of some characteristics relative to others. This view is related to representativeness that can lead investors to extrapolate recent past performance into
future returns. A company with a sound growth track and share price performance might be seen as a good investment with higher returns than its risk would merit. This means that the risk of growth stocks is underestimated.

Emotions play a role in estimating risk and expected return of stocks. An emotional rating in a company leads investors to perceive the company’s stock as less risky. Although the capital asset pricing model assumes risk and expected return are positively correlated, many investors behave as if the correlation is negative, expecting higher returns with lower risk.

The emotional attraction of a stock can be enhanced by personal experience of products, the brand’s value, and the proximity of its head offices to the analyst or investor. This last issue is known as the home bias anomaly, whereby domestic securities are favored over international securities in global portfolios.

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