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The Behavioral Biases of Individuals

LOS a Distinguish b/w Cognitive errors & Emotional biases
This distinction is not only simple & easily understood, but it also provides a useful framework for
understanding how effectively biases can be corrected for.

Cognitive Errors Emotional Biases

Basic statistical, information-processing, or Arise spontaneously as a result of attitudes &

memory errors that cause the decision to feelings that can cause the decision to deviate
deviate from the rational decisions of from the rational decisions of traditional
traditional finance. finance.

More Easily Corrected. Individuals are better Emotions may be undesired to the individual
able to adapt their behaviors or modify their feeling them; he or she may wish to control
processes if the source of the bias is logically them but often cannot
identifiable, even if not completely understood

Because cognitive errors stem from faulty
reasoning, better info, education, and advice
can often correct them. Thus, most cognitive
biases can be “moderated”—to moderate the
impact of a bias is to recognize it & attempt to
reduce or even eliminate it
It may only be possible to recognize an
emotional bias & “adapt” to it. When a bias is
adapted to, it is accepted & decisions are made
that recognize & adjust for it (rather than
making an attempt to reduce or eliminate it).

LOS b,c & d Summary of Behavorial Biases

Cognitive Biases Emotional Biases

Self-Perseverance Bias Information Processing Bias ª Loss Aversion Bias

ª Confirmation Bias ª Anchoring & Adjustment ª Regret Aversion Bias

Bias
ª Conservatism Bias ª Mental Accounting Bias ª Overconfidence Bias

ª Illusion of Control Bias ª Framing Bias ª Self Control Bias

ª Representativeness Bias ª Availability Bias ª Status Quo Bias

ª Hindsight Bias ª Endowment Bias

ª repetition Bias

ª Hindsight Bias
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Belief Perseverance Description Consequences Detection of & Guidance

Biases for Overcoming

ª Maintain - prior views ª Hold the security Step 1

or forecasts by longer than a rational Be aware that a bias
inadequately investor would exists
incorporating new
info. Step 2
Reasons Properly analyzing &
ª Underreact to or fail weighting new info.
Conservatism Bias to act on new info. & Ü Maintain or be
continue to maintain slow to update a Conduct careful analysis
beliefs close to those view or forecast. incorporating the new
maintained Ü Do not prefer to info & then respond
previously. deal with the appropriately.
mental stress of
updating beliefs Step 3
given complex Info - difficult to
data. interpret or understand.
Seek advice from a
professional.

Understand - how to
interpret info or action
implications of complex
info.

ª Look for & notice ª Develops Faulty Step 1

what confirms their Screening Criteria ª Actively seek out info.
beliefs & to ignore or a. Good investments That challenges your
undervalue what that do not meet the beliefs. Leads to better
contradicts their screening criteria - decision making
beliefs. ignored
b. Bad investments Step 2
ª Consider only the that do meet the ª Obtain corroborating
positive info. Ignore screening criteria - support for an
any negative info. selected investment. E.g., 52-
Confirmation Bias week high + good
üHold a fundamentals
disproportionate
amount of investment
assets in employers
company's stock
a. Convinced of
favorable prospects &
Unfavorable info is
ignored.
b.If, acknowledge -ve
info- mental
discomfort to continue
working (for same
employer) is very high.
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Belief Perseverance Description Consequences Detection of & Guidance

Biases for Overcoming

Classify new info based Adopt a view or Be aware of the

on past experiences & forecast based almost statistical mistakes
classifications. exclusively on new info being committed.
or small sample. Constantly ask - if they
are overlooking the
Base-Rate Neglect
a. Hire investment reality of the investment
The base rate or mangers with high situation being
probability of the returns. (High returns considered.
categorization is not being 1 yr, 2 yr or 3 yr
adequately considered. i.e., not proven in the
It is an easy alternative long run)
Representativeness to the diligent research
Bias actually required when b. High investment
evaluating manager turnover, as
investments. hiring took place
based on short-term
results.

Sample-Size Neglect Simply reclassify the

stock rather than
Incorrectly assume attempt to decipher the
that small sample sizes fundamental impact of
are representative of info. Results in trading
populations (or "real" contrary to 'what-
data). "The law of fundamentals-would-
small numbers." suggest’

Quick to treat properties Growth stock,

reflected in small restatement of
Representativeness samples as properties earnings, difficult to
Bias (Contd.) that accurately describe interpret accounting
large pools of data. changes. Sell the stock,
even if, fundamentals
Sample Size Neglect suggest otherwise.
(Contd.)

People tend to believe - ª Trade more than is Step 1

control or influence
outcomes when, in fact,
they cannot.
ª Leads investors to
Illusion of Control
Bias
prudent. Belief - they Recognize that
have "control" over successful investing is
the outcomes of their a probabilistic activity.
investments.
Step 2
Logically evaluate an
inadequately investment decision
diversify portfolios. before implementation.
Prefer investing -
sense of "control" Step 3
over the company Critical to keep records.
e.g., employer stock. E.g. Reminders
In adverse economic outlining the rationale
sceanrio, may lead to behind each trade, imp.
dual loss = Loss of Features of
employment + Loss investments made.
of investment value.
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Belief Perseverance Description Consequences Detection of & Guidance

Biases for Overcoming

ª A bias with selective ª Overestimate the Step 1

perception & retention
aspects.
ª To alleviate discomfort
associated with the
unexpected, people
tend to view things that ª Cause FMPs to take
have already happened
as being relatively
inevitable &
Hindsight Bias predictable.
ª Unfairly assess
degree to which they Understanding how
predicted an markets work, & why
investment outcome - investments go wrong is
a false sense of critical to achieving
confidence. investment success.
Step 2
on excessive risk, FMPs need to carefully
leading to future record & examine their
investment mistakes. investment decisions
both good & bad to avoid
repeating past mistakes.
money manager or
security performance Step 3
FMPs should constantly
remind themselves that
markets move in cycles
& that good managers
stay true to their
strategies through good
times & bad.

Information Description Consequences Detection of & Guidance

Processing Biases for Overcoming

ª When required to ª May stick too closely Step 1

estimate a value with
unknown magnitude,
people generally begin
by envisioning some
initial default number - ª E.g., FMP originally
an "anchor" - which
they then adjust up or
down to reflect info &
analysis.
Anchoring & ª This bias is closely
Adjustment Bias related to the
conservatism bias.
ª This mindset is not
ª Investors with an
anchoring &
adjustment bias - place
undue emphasis on
statistically arbitrary,
psychologically
determined anchor
points.
to their original Remember that past
estimates when new prices, market levels &
info is learned. reputation provide little
info about an
investment's future
estimates the next potential.
year's EPS $2, the
company experiences Step 2
difficulty during the Look at the basis for any
year, FMP may not recommendations to see
adequately adjust the whether they are
$2 estimate. anchored to previous
estimates or based on an
objective, rational view
limited to downside of changes in company
adjustments; the same fundamentals.
phenomenon occurs
when companies have
upside surprises.
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Information Description Consequences Detection of & Guidance

Processing Biases for Overcoming

ª People treat one sum of ª Placement of Step 1

money differently from investments into Recognize the
another equal sized discrete 'buckets' drawbacks of engaging
sum based on which without regard for the in this behavior. The
mental account the correlations among primary drawback is that
money is assigned to. these assets. correlations b/w
investments are not
ª Mental accounts are ª Neglect opportunities taken into account when
based on such arbitrary to reduce risk by creating an overall
classifications as the combining assets with portfolio.
source of the money low correlation.
(e.g., salary, bonus, Step 2
Mental Accounting inheritance, gambling) ª Irrationally distinguish Go through the exercise
Bias or the planned use of b/w returns derived of combining all of their
money (e.g., leisure, from income & capital assets onto one
necessities etc.) appreciation. spreadsheet or other
Although, many people summary document.
ª Each Layer of the feel the need to Shows the suboptimal
portfolio addresses a preserve capital nature of the portfolio
particular investment appreciation constructed using
goal (e.g., retirement (principal), they focus mental accounting.
funds) that is on the idea of
independent of other spending income that Step 3
investment goals. the principal Focus on total return
generates. As a result, aspect - to solve income
many FMPs chase v/s capital appreciation
income streams, conflict.
unwittingly eroding
principal in the
process. E.g., buying a
high-yield or junk
bond.
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Information Description Consequences Detection of & Guidance

Processing Biases for Overcoming

A person answers a ª Misidentify risk Step 1

question differently based tolerances because of Try to eliminate any
on the way in which it is how questions about reference to gains &
asked (framed). How info risk tolerance were losses already incurred;
is processed is dependent framed; instead they should
upon how the question is focus on the future
framed. ª Choose suboptimal prospects of an
investments, even investment.
with properly
identified risk Step 2
tolerances, based on Try & be as neutral &
Framing Bias how info. about the open-minded as possible
specific investment is when interpreting
framed. investment-related
situations. Eliminate
ª Focus on short-term biased responses, create
price fluctuations, better portfolios + a
which may result in better chance of meeting
excessive trading. long-term financial
objectives.

ª People decide the ª Choose an Step 1

probability of an event investment, Develop an appropriate
by how easily they can investment adviser, investment policy
recall a memory of the or mutual fund based strategy, carefully
event. Easily recalled on advertising rather research & analyze
outcomes are often than on a thorough investment decisions
perceived as being more analysis of the before making them, &
likely v/s harder to options. focus on long-term
recall or understand. results.
ª Limit their investment
Retrievability aspect opportunity set. Step 2
Availability Bias Restrict themselves Avoid overreacting to
If an answer or idea to stocks & bonds of market conditions
comes to mind more one country or may whether positive or
quickly than another fail to consider AI negative.
answer or idea, the when appropriate.
first answer or idea Step 3
will likely be chosen as ª Fail to diversify. E.g., Acknowledge the fact
correct even if it is not overweighting stocks that they lack the
the reality of their employment training, experience, &
industry. objectivity to interpret
the massive amount of
Resonance aspect. investment info
available.
People are often biased
by how closely a
situation parralels their
own personal situation.

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Information Description Consequences Detection of & Guidance
Processing Biases for Overcoming

Categorization Aspect ª Fail to achieve an

appropriate asset
e.g., If an American is allocation. Invest in
asked to come up with companies that match
a list of famous their own likes &
basketball players v/s dislikes without
famous soccer players, properly taking into
Availability Bias the list of soccer account risk & return.
players - quite short.
Assignment might
lead the Americans to
erroneously conclude
that there a fewer
famous soccer players
v/s famous basketball
players.

Narrow range of
experience

Occurs when a person

with a narrow range of
experience uses too
narrow a frame of
reference based upon
that experience when
making an estimate.

Emotional Biases Description Consequences Detection of & Guidance

for Overcoming
ªStrongly prefer avoiding ªHold investments in a Step 1
losses as opposed to loss position longer Analyzing investments &
achieving gains. than justified by realistically considering
fundamental analysis. the probabilities of
ªUtility derived from a ªSell investments future losses may help
gain < Utility given up earlier than justified guide the FMP to a
with an equivalent loss. by fundamental rational decision.
analysis.
ªThe disposition effect. ªLimit the upside Step 2
Loss Aversion Bias The holding (i.e.,not potential - selling A disciplined approach to
selling) of investments winners & holding investment based on
that have experienced losers. fundamental analysis.
losses (losers) too long, ªTrade excessively a
& the selling (i.e., not result of selling
holding) of investments winners.
that have experienced ªHold riskier portfolios
gains (winners) too than is acceptable
quickly. based on risk/return
objectives. Caused by
the sale of
investments (i.e.,
winners) & the
retention of
investments (i.e.,
losers). 5
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Emotional Biases Description Consequences Detection of & Guidance

for Overcoming

ªOverestimating ªUnderestimate risks & Step 1

knowledge levels, overestimate Review the winners,
abilities & access to expected returns. losers, & calculate
info. portfolio performance
ªHold poorly diversified over at least 2 years.
portfolios.
Prediction Step 2
overconfidence ªTrade excessively When FMPs engage in
too much trading, they
Overconfidence Underestimate risks, ªExperience lower should be advised to
Bias particularly downside returns than those of keep track of every
risks. Leads to holding the market. investment trade & then
poorly diversified calculate returns.
portfolios ( excessive
belief in positive future Step 3
value of a stock). More complete info - help
FMPs understand the
error of their ways (due
Certainity to overconfidence bias
overconfidence being partially cognitive
in nature).
Probabilities that
FMPs assign to Step 4
outcomes are too high Investors be objective
because they are too when making &
certain of their evaluating investment
judgments. Results in decisions. Advisable to
excessive trading view the reasoning
(moving from one high behind & the resultls of
return investment to the investments, winning
the other). & losing, as objectively
as possible.

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Emotional Biases Description Consequences Detection of & Guidance

for Overcoming

ªSelf-enhancing bias -
people's propensity to
claim too much credit
Overconfidence for their successes.
Bias
ªSelf-protecting bias -
denial of personal
responsibility for
failures.

ªA bias in which people ªSave insufficiently for Step 1

fail to act in pursuit of the future Ensure that a proper
their long-term, investment plan is in
overarching goals ªUpon realizing that place & should have a
because of a lack of their savings are personal budget.
self-discipline. There is insufficient :
an inherent conflict Step 2
b/w short-term a. Accept too much risk Adhering to a saving plan
satisfaction & in their portfolio in an & an appropriate asset
achievement of some attempt to generate allocation strategy are
long-term goals. higher returns. The critical to long-term
capital base is put at financial success.
ªSacrificing in the risk.
present require much
Self-control Bias greater payoffs in the b. Cause asset allocation
future; otherwise imbalance problems.
people will not be For e.g., prefer
willing to make current income-producing
sacrifices. People tend assets - offer lower
to have temporal short- return potential -
sightedness or inhibit a portfolio's
temporal myopia, ability to maintain
focusing on the present spending power after
& discounting the inflation.
future. They spend
today rather than save
for tomorrow. This
behavior can lead to
high short-term utility
& disastrous long-term
utility.

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Emotional Biases Description Consequences Detection of & Guidance

for Overcoming

ªAn emotional bias in ªUnkowingly maintain Step 1

which people do nothing
(i.e. maintain the
"status quo") instead of
making a change.
ªFurther, if given a ªFail to explore other
situation where one
Status Quo Bias choice is the default
choice, people will
frequently let that
choice stand rather than
opting out of it &
making another choice.
portfolios with risk Quantify the risk-
characteristics that reducing & return
are inappropriate for enhancing advantages of
their circumstances. diversification & proper
asset allocation.
opportunities. For e.g., with a
concentrated stock
position, showing what
can happen to overall
wealth levels if the stock
collapses.

ªE.g., Companies that

enroll employees in DC
pension plans but give
the employees the
ability to opt out of the
plan have a much higher
participation rate v/s
companies where
employees have to opt
in the plan.

ªPeople value an asset ªFail to sell off certain Step 1

more when they hold assets & replace them Ask questions like :-
rights to it v/s when with other assets.
they do not. "If an equivalent sum to
ªMaintain an the value of the
ªCan affect attitudes inappropriate asset investments inherited
towards items owned allocation. had been received in
for long periods of time Inappropriate for cash, how would you
or can occur investors' level of risk invest the cash ?"
immediately when an tolerance & financial
item is acquired. goals. "Was the primary intent
to leave the specific
Endowment Bias ªMay apply to inherited ªContinue to hold investment portfolio
or purchased securities. classes of assets with because it was perceived
which they are to be a suitable
ªThese investors are familiar. Familiarity investment based on
often resistant to selling adds to owner's fundamental analysis, or
even in the face of poor perceived value of a was it to leave financial
prospects. security. resources to benefit the
heirs?"
ªOften in these
situations, investors cite
feelings of disloyalty
associated with the Step 2
prospect of selling Rather than replacing all familiar holdings with
inherited securities, new, intimidating ones, start with a small purchase
generally uncertainity in of the unfamiliar investments until a comfort level
determining the right with them is achieved.
choice, & concerns with
tax issues.
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Emotional Biases Description
ªAn emotional bias in ªBe too conservative in
which people tend to
avoid making decisions
that will result in action
out of fear that the
decision will turn out
poorly. Simply put,
people try to avoid pain
Regret Aversion of regret associated
Bias with bad decisions.
ªRegret from an action
taken is called error of ªEngage in herding
commission.
ªRegret from an action
not taken is called error
of omission.
ªRegret is more intense
when the unfavorable
outcomes are the result
of an error of
commission v/s an error
of omission.
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Consequences Detection of & Guidance
for Overcoming
Step 1
their investment Quantify the risk-
choices as a result of reducing & return
poor outcomes on enhancing advantages of
risky investments in diversification & proper
the past. Lead to long- asset allocation.
term
underperformance & Step 2
potential failure to With proper
reach investment diversification, FMPs will
goals. accept the appropriate
level of risk in their
portfolios ,of course, on
behavior. Lead to return objectives.
preference for stocks
of well-known Step 3
companies even in the To prevent investments
face of equal risk & from being too
return expectations. conservative, recognize
Choosing the stocks of that losses happen to
less familiar everyone & keep in mind
companies is the long-term benefits of
perceived as riskier & incl. risky assets in
involves more portfolios.
personal responsibility
& greater potential for Step 4
regret. Efficient frontier
research can be quite
helpful as an educational
tool.