Professional Documents
Culture Documents
Attribute substitution:
• Theories suggest people substitute
simpler but related questions in
place of more complex and
difficult questions.
Common Uses
Effort reduction
• : According to this theory, people
utilize heuristics as a type of
cognitive laziness. Heuristics reduce
the mental effort required to make
choices and decisions.
Common Uses
representative
• involves estimating the likelihood
of an event by comparing it to an
existing prototype that already
exists in our minds. This prototype
is what we think is the most
relevant or typical example of a
particular event or object.
Types of Heuristics
• The foundation of this theory is that investors are much more distressed by
prospective losses than they are happy about prospective gains.
Loss aversion theory
• In economics and decision theory, loss aversion refers to people’s tendency
to strongly prefer avoiding losses to acquiring gains.
• Most studies suggest that losses are twice as powerful, psychology, as gains.
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Overconfidence bias
Self Attribution Bias
If it was good, I did it. If it was bad, it was a
fluke.
Hindsight Bias
"I knew it all along"
Confirmation Bias
Finding information that confirms our belief
Narrative Fallacy
When stories compromise objective decision
making
Representativeness Heuristic
When the similarity of objects is confused with
the probability of an outcome
Framing Bias
How the way information is presented can
influence decisions
Anchoring Bias
How the first data point we see impacts our
decisions
Loss Aversion
A preference to avoid losses in investing
Herd Mentality
A form of social bias that impacts investors
The Concept of Behavioral Types
Attempts to explain the differences in
PEOPLE
ASTROLOGY
it was believed that the alignment of the heavens influenced behavior.
there were 12 signs in four groupings symbolized by earth, air, fire, and
water
Attempts to explain the differences in
PEOPLE
• HIPPOCRATES with his concept of the four temperaments( choleric,
phlegmatic, sanguine, and melancholy).
He believed that personality was shaped by blood, phlegm, black bile
and yellow bile
Attempts to explain the differences in
PEOPLE
• DR. CARL JUNG in 1923 wrote the book Psychological Types and
described the
intuitor, thinker, feeler, and sensor. His was the most sophisticated scientific work
done at the time
• Availability bias
• Ostrich bias
• Anchoring
• Placebo effect
• Choice-support bias
• confirmation
Mental Accounting
• Mental accounting theory, framing means that the way a person subjectively
frames a transaction in their mind will determine the utility they receive or
expect.
• It is a tendency of the brain to create short cuts with how it perceived the
information and ending up with outcomes that is difficult to be viewed in
any other way. The results of these mental accounting are that it influence
decisions in unexpected ways
Investors’ Disposition Effect
• Is an anomaly discovered in behavioral finance. It relates to the tendency of
investors to sell shares whose price has increased, while keeping assets that
have dropped in value
Availability bias Bandwagon
Ostrich effect Conservatism bias
Anchoring Blind-spot bias
Placebo effect Outcome bias
Choice-support bias Overconfidence
Confirmation Recency
Survivorship bias Selective perception
Stereotyping Framing
Investors’ Disposition Effect
• Investors are less willing to recognize losses(which they would be forced to
do if they sold assets which had fallen in value), but are more willing to
recognize gains. This is irrational behavior, as the future performance of
equity is unrelated to its purchase price.
Cognitive biases affecting investment decisions
Rational Decisions vs. Emotions
How mood impacts the decisions of individual
investors?
ALTRUISM
Is there goodness in selfishness?
“ There are three factors that influence the market: FEAR, GREED, and
GREED”. --Market folklore
3 Economic Conditions that Warrant Market
Efficiency
• Investor rationality
• Independent deviations from rationality
• Arbitrage the simultaneous buying and selling of securities, currency, or
commodities in different markets or in derivative forms in order to take
advantage of differing prices for the same asset.
"profitable arbitrage opportunities"
Absence of the 3 components lead market to
be inefficient
• It must be that many, many investors make irrational decisions
• The collective irrationality of these investors leads to an overly optimistic or
pessimistic market situation
• this situation cannot be corrected via arbitrage by rational, well-capitalized
investors
Are People Rational
• Cognitive Psychologists found that our actions are influenced by heuristics and
biases.
Frame dependence
Mental accounting
The house money effect
overconfidence
• Prospect theory provides an alternative to classical, rational economic decision-
making : investors are much more distressed by prospective losses than they are
happy about prospective gains
Do managers take advantage of mispricing?