Behavioural Finance

Heuristics and Biases

Irrational Behavioural (Fernandes, Pena
and Benjamin, 2009)
Irrationality

Heuristics Biases

-Representativeness Emotional Cognitive

-Availability
-Anchoring
Endowment Effect
Confirmation
Disposition Effect
Loss Aversion Overconfidence
Regret Aversion Gamblers fallacy
Framing
Self Control
Mental Accounting
 According to this classification, biases are grouped in two
– cognitive and emotional.

 Cognitive are caused by wrong reasoning.

 Emotional are caused by sudden emotions and insights.

 Cognitive are overcome to a certain extent through

availability of more information.

 Emotional on the other hand are difficult to overcome.

Heuristics
Heuristics
 Heuristics are simple, efficient rules people use to form
judgments and make decisions.

 People make use of a lot of shortcuts that help in

reducing complex problems.

 Heuristics usually work well, but can lead to

systematically irrational outcomes. These errors are called
biases
What to understand about each
Bias/heuristic
 General Description

 Technical Description

 Implication on Investors

 Diagnostic Testing of Bias/heuristic

 Three major heuristics to know
 Representativeness - Overweights the probability of events
that match our expectations

 Availability - Overweights the probability of events that are

recent, vivid, or dramatic

 Anchoring - Overweights the importance of the first piece of

information we receive
Representativeness
Representativeness: General Description
 This was traced back in 1974 by Kahneman and Tversky.

 They established that while making judgments, people

often tend to categories an events as representative of a
certain well-known class.

 People predict future by attaching it to past patterns or

recently observed things.

 Also, known as similarity heuristics.

 It is based on stereotyping.
Representativeness
 Psychologists have proved our mind assumes and groups
things that have similar qualities.

 Judgments based on such stereotypes is known as

representativeness.

 This leads to assigning higher degree of probability to

certain events, developments, reports or information than
they deserve.

 E.g.: investment decisions based on certain declarations

made by political or corporate leaders.
Representativeness
 Representativeness can also arise as a result of ‘law of
small numbers-small numbers are capable of representing
whole population’

 Here investors use small samples to represent the whole

population.

 Thus, this heuristic makes people buy stocks that

represent certain desirable qualities.

 It makes people optimistic about past winner and

pessimistic about past losers.
Representativeness
 This heuristic can lead to overpricing of stocks.

 As investors prefer to buy stocks with consistent returns,

without analysing if the consistency in growth would
continue.

 Thus by making the stock popular, they buy it and make it

over priced.

 When investors become aware that they were too

optimistic about the stock, the prices fall.
Representativeness – Psychological
background
• Determining class inclusion or likelihood by similarity:
– A member ought to resemble the overall category
– An effect ought to resemble or be similar to the cause
– An outcome ought to resemble the process that produced it
• Like goes with like
• Often easier to assess similarity than probability
– Does he look like an engineer?
– Does it look like it could cause a clogged artery?
– Does it look like a random sequence?
Representativeness – Psychological
background
• Linda is 31 years old, single, outspoken, and very bright.
She majored in philosophy. As a student, she was deeply
concerned with issues of discrimination and criminal
justice, and also participated in anti-nuclear
demonstrations.

• Rank likelihood that Linda is:

1. A bank teller
2. Active in feminist movement and a bank teller
Representativeness – Psychological
background
 It is more likely that Linda works in a bank.

 To argue that 2 is more likely is to commit a conjunction

fallacy.

 To this answer 85% of professional fund managers chose

(1). (Kahneman and Tversky, 1983)
Representativeness – Psychological
background
 Judging the conjunction of two events to be more
probable than one of the constituent

Bank teller

Feminists

P(A & B) > P(A) or P(B)

Representativeness – Psychological
background
 Representativeness heuristic
What does random look like?

HHHHHTTTTH
HTHHHTHTHT

 Gambler’s fallacy: the belief that small samples will

reflect the populations they’re drawn from
Representativeness: Technical Description

 Base-Rate Neglect.
 In base-rate neglect, investors attempt to determine the potential
success of, say, an investment in Company A by contextualizing the
venture in a familiar, easy-to-understand way.
 To summarize this characterization, some investors tend to rely on
stereotypes when making investment decisions.

 Sample-Size Neglect.
 In sample-size neglect, investors, when judging the likelihood of a
particular investment outcome, often fail to accurately consider the
sample size of the data on which they base their judgments.
Case – Application of Representativeness
GEORGE: Hi, Harry. My portfolio is really suffering right now. I could use a good
long-term investment. Any ideas?
HARRY: Well, George, did you hear about the new IPO [initial public offering]
pharmaceutical company called PharmaGrowth (PG) that came out last week? PG
is a hot new company that should be a great investment. Its president and CEO was
a mover and shaker at an Internet company that did great during the tech boom, and
she has PharmaGrowth growing by leaps and bounds.
GEORGE: No, I didn’t hear about it. Tell me more.
HARRY: Well, the company markets a generic drug sold over the Internet for
people with a stomach condition that millions of people have. PG offers online
advice on digestion and stomach health, and several Wall Street firms have issued
“buy” ratings on the stock.
GEORGE: Wow, sounds like a great investment!
HARRY: Well, I bought some. I think it could do great.
GEORGE: I’ll buy some, too. George proceeds to pull out his cell phone, call his
broker, and place an order for 100 shares of PG
 George displays base-rate neglect representativeness bias by
considering this hot IPO is, necessarily, representative of a good
long-term investment.
 Many investors like George believe that IPOs make good long-
term investments due to all the up-front hype that surrounds
them.

 In fact, numerous studies have shown that a very low

percentage of IPOs actually turn out to be good long-term
investments.
 This common investor misperception is likely due to the fact
that investors in hot IPOs usually make money in the first few
days after the offering.
 Over time, however, these stocks tend to trail their IPO prices,
often never returning to their original levels.
Representativeness: Implication on
investors
 Base rate neglect –
 What is the probability that Company A
(ABC, a 75-year-old steel manufacturer that
is having some business difficulties) belongs
to group B (value stocks that will likely
recover) rather than to Group C (companies
that will go out of business)?
Representativeness: Implication on
investors
 In answering this question, most investors will try to
judge the degree to which A is representative of B or C.

 In this case, some headlines featuring recent bankruptcies

by steel companies make ABC Steel appear more
representative of the latter categorization i.e. Group C
(companies that will go out of business)

 They are ignoring, however, the base-rate reality that far

more steel companies survive or get acquired than go out
of business
Representativeness: Implication on
investors
 Sample size neglect - Investors also make similar
mistakes when investigating track records of stock
analysts.

 For example, they look at the success of an analyst’s past

few recommendations, erroneously assessing the analyst’s
aptitude based on this limited data sample.
Availability
Availability: General Description
 Availability refers to how easily an event comes to mind.

 Tversky and Kahneman (1973) opine that people rely on

availability while judging frequency of events.

 We give higher weightage to events that come to mind

more easily.

 In other words, more recent, salient and familiar events

weighs more heavily and distorts the thought process.
 It is a judgmental heuristic where people evaluate probability
of event by the ease with which relevant instances come to
mind.

 Experiment 8: by Tversky and Kahneman (1973)

 Thus, people tend to be influenced by attention grabbing

information and information that is recent.

 They may avoid doing detailed analyses of past events and may
be biased to recent news only.

 Thus aspects that may not be immediately available would be

conveniently ignored.
 People base judgments on what can be easily recalled and not
on all relevant information.

 And Familiar, salient and recent information is easy to recall.

 Thus, while choosing stocks, investors tend to consider only

those stocks that have caught their attention.

 E.g.: Stocks with positive/negative news, high trading volumes,

jump in price etc. catch greater attention.

 Stock with higher media coverage underperformed in

subsequent two years (Choido et al, 2003).
Availability: Technical Description
 There are several categories of availability bias, of which
the four that apply most to investors are:
 (1) retrievability,
 (2) categorization,
 (3) narrow range of experience, and
 (4) resonance.
 Retrievability: Most investors, if asked to identify the “best”
mutual fund company, are likely to select a firm that engages in
heavy advertising.

 Categorization: People who are unduly “patriotic” when looking

for somewhere to invest often suffer from availability bias and
shall often believe their country as the best place to invest in.

 Narrow range of experience: Assume that an employee of a fast-

growing, high-tech company is asked. “Which industry generates
the most successful investments?” --- ANS??

 Resonance. People often favor investments that they feel match

their personalities. The concept of value is easily available in an
investor’s mind who resonates with value as an individual but the
notion of growth is less so.
Availability: Implication on investors
 Retrievability.
 Investors will choose investments based on information that is
available to them (advertising, suggestions from advisors, friends,
etc.)
 Will not engage in disciplined research or due diligence to verify
that the investment selected is a good one.

 Categorization.
 Investors will choose investments based on categorical lists that
they have available in their memory.
 For example, U.S. investors may ignore countries where
potentially rewarding investment opportunities may exist
because these countries may not be an easily recalled category in
their memory.
 Narrow range of experience.
 Investors will choose investments that fit their narrow range of
life experiences, such as the industry they work in, the region
they live in, and the people they associate with.
 For example, investors who work in the technology industry
may believe that only technology investments will be profitable.

 Resonance.
 Investors will choose investments that resonate with their own
personality or that have characteristics that investors can
relate to their own behavior.
 This will lead to sub-optimal portfolios.
Availability Bias - Diagnostic Test
 Question 1: Suppose you have some money to invest and
you hear about a great stock tip from your neighbor who is
known to have a good stock market sense. He
recommends you purchase shares in Mycrolite, a company
that makes a new kind of lighter fluid for charcoal grills.
What is your response to this situation?
 a. I will likely buy some shares because my neighbor is usually
right about these things.
 b. I will likely take it under advisement and go back to my house
and do further research before making a decision.
 Question 2: Suppose that you are planning to buy stock in a
generic drug maker called “Generics Plus.” Your friend Marian
sent you a report on the company and you like the story, so
you plan to purchase 100 shares. Right before you do, you hear
on a popular financial news show that “GN Pharmaceuticals,”
another generic drug maker, just reported great earnings and
the stock is up 10 percent on the news. What is your response
to this situation?
a. I will likely take this information as confirmation that generics are a
good area to be in and proceed with my purchase of Generics Plus.
b. I will pause before buying Generics Plus and request research on
GN prior to proceeding with the purchase of Generics Plus.
c. I will purchase GN rather than Generics Plus because GN appears to
be a hot stock and I want to get in on a good thing.
Anchoring
Anchoring: General Description
 Psychologists have proved that humans have an innate
tendency to attach thoughts to certain reference points.

 These reference points are termed as anchors.

 This is a mental error and is often done without any logic,

association or reason.

 Anchoring is resorted to by investors when they base

their decisions on irrelevant figures and statistics.
 Some investor might take a decision to invest in a stock
that has fallen recently as the same stock had given high
returns in the past.

 The investor feels this fall in price is due some short term
market corrections.

 In reality, the stock prices might have fallen due to some

serious fundamental changes.

 Thus anchoring heuristic is a decision based on irrelevant

logic.
Anchoring: Technical Description
 Points of Anchoring:
 Anchoring on Purchase Price

 Anchoring on Historical Price

 Anchoring on Historical Perceptions

Case- Anchoring
 Suppose Alice owns stock in Corporation ABC. She is a fairly astute
investor and has recently discovered some new information about
ABC. Her task is to evaluate this information for the purpose of
deciding whether she should increase, decrease, or simply maintain
her holdings in ABC.

 Alice bought ABC two years ago at $12, and the stock is now at
$15. Several months ago, ABC reached $20 after a surprise
announcement of higher-than-expected earnings, at which time Alice
contemplated selling the stock but did not.

 Unfortunately, ABC then dropped to $15 after executives were

accused of faulty accounting practices. Today, Alice feels as though
she has “lost” 25 percent of the stock’s value, and she would prefer
to wait and sell her shares in ABC once it returns to its recent $20
high.
 Alice has a background in accounting, and she does some
research that leads her to conclude that ABC’s methods are
indeed faulty, but not extremely so.

 However, Alice cannot entirely gauge the depth of the problem

and realizes that holding ABC contains risk, but ABC is also a
viable corporate entity with good prospects. Alice must make a
decision.

 On one hand, she has confirmed that ABC does have an

accounting problem, and she is unsure of how severe the
problem might become. On the other hand, the company has a
solid business, and Alice wants to recoup the 25 percent that
she feels she lost.

 What should Alice do?

Anchoring: Implications on investors
 Investors tend to make general market forecasts that are too
close to current levels.
 Investors (and securities analysts) tend to stick too closely to
their original estimates when new information is learned about
a company.
 Investors tend to make a forecast of the percentage that a
particular asset class might rise or fall based on the current
level of returns.
 For example, if the DJIA returned 10 percent last year,
investors will be anchored on this number when making a
forecast about next year.
 Investors can become anchored on the economic states of
certain countries or companies.
 For example, in the 1980s, Japan was an economic
powerhouse, and many investors believed that they would
remain so for decades.
Deficient Market Hypothesis
 Heuristics can lead to deficient market hypothesis.

 Deficient market hypothesis proposes that market is

populated by investors who often make systematic errors
in their assessment.

 This affects market prices.

 Since irrational choices are pervasive in any market,

fundamentals are not reflected in security prices.
 This leads to misallocation of capital and improper
functioning of markets.

 This proposition is contra to EMH.

 Most investors treat the information they possess as

more correct than it actually is.

 They overestimate the value of private information and

their abilities to beat the market.
 Rational investors look at overall portfolios and ignores
minor deviations in profit/loss of a few securities.

 In reality, however, investors are super sensitive to such

deviations.
Biases
Biases
 In an attempt to make quick and easy decisions,
individuals tend to deviate from rationality.

 These decisions are termed biases.

 Biases are systematic errors occurred due to the level of

time, resources, cost or capacity they use to process the
available information before them.

 Some biases tend to lead to some other biases as well.

Emotional Biases
 Endowment Effect

 Loss Aversion

 Regret Aversion

 Self Control

 Disposition Effect
Endowment Effect
Endowment Effect: General Description
 Owner considers mere possession of an object to increase its
value.

 This cognitive dissonance contributes towards endowment

effect.

 This effect makes investors hold on to losing investments for

too long, even if there are remote chances of revival.

 Many time they don’t sell it, as they hate to acknowledge a bad
choice.

 In this context, they wait till they are practically proven wrong.
Endowment Bias
 Endowment bias is described as a mental process in
which a differential weight is placed on the value of an
object.

 That value depends on whether one possesses the object

and is faced with its loss or whether one does not
possess the object and has the potential to gain it.

 If one loses an object that is part of one’s endowment,

then the magnitude of this loss is perceived to be greater
than the magnitude of the corresponding gain if the
object is newly added to one’s endowment.
Endowment Effect: Technical Description
• The endowment effect describes a circumstance in which an individual
places a higher value on an object that they already own than the value
they would place on that same object if they did not own it.
• Endowment effect can be clearly seen with items that have an emotional
or symbolic significance to the individual.

1. Loss aversion: shoppers are far more sensitive to price increases

than they are to price decreases, leading to shoppers to prefer
avoiding losses to acquiring equivalent gains - the endowment effect
may cause a person to overvalue an item because they want to avoid
a loss.

1. Ownership: people value items they already own more than a similar
item they do not own. It does not matter if the object in question was
purchased or received as a gift; the effect still holds.
Implication for investors
 Endowment bias influences investors to hold onto securities
that they have inherited, regardless of whether retaining those
securities is financially wise.

 Endowment bias causes investors to hold securities they have

purchased (already own). This behavior is often the result of
decision paralysis

 Endowment bias causes investors to hold securities that they

have either inherited or purchased because they are familiar
with the behavioral characteristics of these endowed
investments.
 Familiarity, though, does not rationally justify retaining a poorly
performing stock or bond.
Diagnostic check
 Question 1: Assume that your dearly departed Aunt Sally
has bequeathed to you 100 shares of IBM. Your financial
advisor tells you that you are too “tech-heavy” and
recommends that you sell Aunt Sally’s shares. What is
your most likely course of action?

 a. I will likely hold the IBM shares because Aunt Sally

bequeathed them to me.
 b. I will likely listen to my financial advisor and sell the
shares
Loss Aversion
Loss Aversion: General Description
 People take higher risks to avoid losses than to realize gains.

 Loss aversion is fundamental to any human being.

 The pain associated with loss is greater than the pleasure

derived from equivalent gain.

 Loss aversion avoids people to take decisions that may result

in changes.

 This includes financial decision making as well.

 It may lead to psychological factor called investor paralysis.

 They are even more averse to prospect of future losses

when they have experienced loss in the recent past.

 This kind of investor paralysis was apparent in 2008

financial crisis.
Loss Aversion: Technical Description
Implications on investors
 Loss aversion is a bias that simply cannot be tolerated in
financial decision making. It instigates the exact opposite
of what investors want: increased risk, with lower returns.
 Investors should take risk to increase gains, not to mitigate
losses.

 Holding losers and selling winners will wreak havoc on a

portfolio.
Implications on investors
 Loss aversion causes investors to hold losing investments
too long.

 Loss aversion can cause investors to sell winners too

early, in the fear that their profit will evaporate unless
they sell.

 Loss aversion can cause investors to hold unbalanced

portfolios. If, for example, several positions fall in value
and the investor is unwilling to sell due to loss aversion,
an imbalance can occur.
Diagnostic Check
 Suppose you make a plan to invest $50,000.You are
presented with two alternatives. Which scenario would
you rather have?

 a. Be assured that I’ll get back my $50,000, at the very

least—even if I don’t make any more money.

 b. Have a 50 percent chance of getting $70,000 and a 50

percent chance of getting $35,000.
Regret Aversion
Regret Aversion: General Description
 People exhibiting regret aversion avoid taking decisive actions because they
fear that, in hindsight, whatever course they select will prove less than
optimal.

 It is a phenomenon that often arises in investors, causing them to hold onto

losing positions too long in order to avoid admitting errors and realizing
losses.

 Regret aversion also makes people unduly apprehensive about breaking into
financial markets that have recently generated losses.

 An investor is said to be suffering from regret aversion bias when he/she

refuses to make any decision because of the fear that the decision will turn
out to be wrong and then may later lead to feelings of regret.

 The emotional process behind this is pretty simple. Regret causes emotional
pain. Hence, the brain tries to avoid making decisions that cause regret.
Regret Aversion: Technical Description
 People exhibiting regret aversion can be reluctant, for
example, to sell a stock whose value has climbed
recently—even if objective indicators attest that it’s time
to pull out.

 People who are regret averse try to avoid distress arising

from two types of mistakes:
 (1) errors of commission and
 (2) errors of omission.
 Errors of commission occur when we take misguided
actions.

 Errors of omission arise from misguided inaction, that is,

opportunities overlooked or foregone.

 Regret aversion need not always be negative. In

some cases, these biases may help investors from
making wrong decisions.
 For example, if a buyer has already lost money by
investing in an overheated market, the regret aversion
will prevent them from investing in peaking markets
the next time. This might actually help them avoid
some losses.
Difference between loss and regret aversion
 Investors who are loss averse do not have
problems making decisions. They just tend to
make the wrong decisions because of emotional
factors.

 On the other hand, regret aversion is a paralyzing

fear because of which the investor is not able to
make any decision.
 Case
 Suppose that Jim has a chance to invest in Schmoogle, Inc., an initial
public offering (IPO) that has generated a great buzz following its
recent market debut. Jim thinks that Schmoogle has high potential and
contemplates buying in because Schmoogle’s price has recently
declined by 10 percent due to some recent market weakness.
 If Jim invests in Schmoogle, one of two things will happen:
 (1) Schmoogle will drop further (Jim made the wrong decision), or
 (2) Schmoogle will rebound (Jim made the right decision).

 If Jim doesn’t invest, one of two things will happen:

 (1) Schmoogle will rebound (Jim made the wrong decision), or
 (2) Schmoogle will drop further (Jim made the right decision).
 Suppose that Jim does invest and Schmoogle goes down. Jim will have
committed an error of commission because he actually committed
the act of investing and will likely feel regret strongly because he
actually lost money. Now suppose that Jim does not invest and
Schmoogle goes up. Jim will have committed an error of omission
because he omitted the purchase of Schmoogle and lost out
Implications on investors
§ Herding Effect: People who experience a lot of regrets are often
not sure of their own decisions. This is the reason that they try to
find validation in the decisions made by others. When their
decision matches with the crowd, they feel that the potential for
future regret has been minimized.

§ Preference for Blue Chip Stocks: Regret aversion causes people

to choose famous stocks like blue-chip stocks. Investors
experiencing regret aversion are afraid of taking personal
responsibility by investing in stocks that are not well known to the
general public. These investors will never be able to pick up a
stock early and gain from its upside because of their regret
aversion.

§ Conservatism: Many investors who experience regret aversion

want to simply avoid risky investments. Instead, they are happy
choosing investments that provide lesser returns because of the
safety involved. In the long run, this could lead to
underperformance and sub-optimal outcomes for the investor.
Self Control
Self control bias
 Self-control bias is a human behavioral tendency that causes
people to consume today at the expense of saving for
tomorrow.

 Investors act as if they are maintaining separate funds within

their individual accounts, separating income into current
income and wealth.
 The Marginal Propensity to consume varies according to source of
income; people are likely to build assets with money or savings which
they view as wealth whereas they are less likely to save what they
consider as current income.

 Self control bias can cause investors to lose sight of basic

financial principles like magic of compounding, rupee averaging
and such discipline behaviors which if adhered to can help to
create significant long term wealth.
Self control bias: Technical Description
 Behavioral life-cycle theory divides income into slots.
 be divided into three “mental” accounts:
(1) current income,
(2) current assets, and
(3) future income.

 The temptation to spend is assumed to be greatest for

current income and least for future income.
 Implications for investors
 Self-control bias can cause investors to spend more today at the
expense of saving for tomorrow.
 This behavior can be hazardous to one’s wealth, because retirement can
arrive too quickly for investors to have saved enough.
 Fail to plan for retirement
 Not making enough savings or investments during earning days
 Self-control bias can cause asset-allocation imbalance problems.
 For example, some investors prefer income-producing assets, due to a
“spend today” mentality.
 Self-control bias can cause investors to lose sight of basic financial
principles.
 such as compounding of interest, dollar cost averaging, and similar
discipline behaviors that, if adhered to, can help create significant long-
term wealth.
Diagnostic Check
 How well would you rate your own self-discipline?
 a. I always achieve a goal if it is important to me. If I want
to lose 10 pounds, for example, I will diet and exercise
relentlessly until I am satisfied.
 b. I can often attain my goals, but sometimes I have
trouble sticking to certain difficult things that I have
resolved to accomplish.
 c. I have a tremendous amount of difficulty keeping
promises to myself. I have little or no self-discipline, and I
often find myself reaching out to others for help in
attaining key goals.
 Suppose that you are in need of a new automobile. You have been
driving your current car for seven years, and it’s time for a change.
Assume that you do face some constraints in your purchase as
“money does not grow on trees.” Which of the following
approaches are you most likely to take?
 a. I would typically underspend on a car because I view a car as
transportation, and I don’t need anything fancy. Besides, I can save
the extra money I might have spent on a fancy car and put it away in
my savings accounts.
 b. I would typically purchase a medium-priced model, with some
fancy options, simply because I enjoy a nice car. I may forgo other
purchases in order to afford a nice car. I don’t imagine that I’d go
crazy and purchase anything extravagant, but a nice car is something
that I value to an extent and am willing to spend money to obtain
this.
 c. When it comes to cars, I like to indulge myself. I’d probably splurge
on a top-of-the-line model and select most or all available luxury
options. Even if I must purchase this car at the expense of saving
money for the long term, I believe that it’s vital to live in the
moment.This car is simply my way of living in the moment.
Disposition Effect
 The tendency to sell winning stocks too early and holding
on to losing stocks far too long is disposition effect.

 First identified by Shefrin and Statman in 1995.

 Disposition effect occurs due the notion that realizing

profits allows one to maintain self esteem but realizing
losses causes one to implicitly admit a wrong decision and
hence it is avoided (Odean, 1998)

 Past researches have confirmed disposition effect among

trading activity of investors.
Statistical Bias
 In any market prices are not determined by random numbers
but from real trades.

 Market information is often complicated by so called experts

through use of statistical modelling.

 This results in viewing occasional success as “hot hands”

 It is extremely difficult to distinguish between victories based

on luck and skill.

 This leads to rewarding of a lucky fool.

 Statistics based risk management practices have their own
inherent limitations.

 There is possibility of unexpected changes in market

conditions that may render the data on which modelling is
done, obsolete.

 During boom periods, assuming that the trend will continue

leads to another error known as “extrapolation bias”.

 Here we fail to note aspects like historical experience, sample

size, etc.
 Another bias with potential danger is “disaster myopia”

 This bias occurs to due to underestimation of low frequency-

but high impact events.

 Since events like market collapse are less in frequency, they are
assumed to not to occur.

 However, unlikely events are neither impossible nor remote

and are most likely to occur.

 E.g.: Housing bubble in the US when investors expected that

the prices of houses would never decline.
Cognitive Bias
 Confirmation Bias

 Familiarity Bias

 Overconfidence

 Self Attribution

 Hindsight Bias

 Reference Point Effect

Confirmation Bias
Confirmation Bias: General Description
 It is the tendency to interpret available information in a
way that confirms their own views.

 They would give more importance to evidence in favour

of their view.

 And give less importance to evidence against it.

 Under this bias, people tend to seek information that

supports their hypothesis and even interpret it in a way
to support it.
 They tend to stick to their belief even though newly
available data may invalid their earlier hypothesis.

 Thus, confirmatory information is provided more

importance than it deserves.

 In terms of investments, people tend to invests in stocks

for whom they some preconceived notion.

 In reality, that decision could be far from rationality.

 While we think that our beliefs are the result of years of
experience and objective analysis, the reality is that all of us
are susceptible to confirmation bias.

 Investors are not prepared to acknowledge anything negative

about their immediate investments even in the presence of
evidence to the contrary.
 As a result, they may be in the dark about the imminent decline of a
stock.
 Since confirmation bias constantly screens out non-confirming
evidence, it increases investor over-confidence ;
 it also leads to higher perceived competence because of which
investors trade too frequently
Technical Description
 Example of Card - Vowel and even number

 Imagine that a person believes left-handed

people are more creative than right-handed
people.
 Whenever this person encounters a person who is both
left-handed and creative, they place greater importance
on this "evidence" that supports what they already
believe.
 However, he may have conveniently ignored creative
right-handed people.
 The “most likely reason for the excessive influence of
confirmatory information is that it is easier to deal with
cognitively”.

 Most people find it easier to discern how a piece of data might

support rather than challenge a given position.

 Researchers are sometimes guilty of confirmation bias, as they

occasionally design experiments or frame data in ways likely to
confirm their hypotheses.

 To compound the problem, some scholars also avoid dealing

with data that would contradict their hypotheses.
Case - IBM
 In the early 1990s, many IBM employees were convinced that their company’s
OS/2 operating system would achieve industry standard status. They frequently
ignored unfavorable signs, including evidence of competition from Microsoft
Windows.

 These employees loaded up on IBM stock, anticipating that OS/2’s performance

would drive the company forward. In 1991, IBM stock reached a split-adjusted
peak of $35 per share. Over the course of the next two years, however, IBM
slid to a low of $10. It would not reach $35 again until the end of 1996.

 During this five-year slump, IBM employees rallied around seemingly positive
developments that “confirmed” that IBM was making a comeback. Some even
delayed retirement. Unfortunately, in an effort to engineer a turnaround, IBM
laid off a number of its employees.

 In the end, OS/2 caused Confirmation Bias and led many people to become less
wealthy. For some, the failed operating system even led to unemployment. This
is a classic case of confirmation bias in action
 In this case, confirmation bias played a significant role in
the behavior of the IBM employees. It led them to accept
information that supported their rosy predictions
regarding IBM while discounting evidence of increased
competition from Microsoft.
Implications on investors
 Confirmation bias can cause investors to seek out only
information that confirms their beliefs about an investment that
they have made and to not seek out information that may
contradict their beliefs.
 This behavior can leave investors in the dark regarding, for example,
the imminent decline of a stock.

 Confirmation bias can cause employees to overconcentrate in

company stock.

 Wrongly believing in predetermined screens

 Their favourite stock crossing 52-week high

 Confirmation bias can cause investors to continue to hold

under diversified portfolios.
Diagnostic check
 Suppose you have invested in a security after some careful
research. The investment appreciates in value but not for the
reason you predicted (e.g., you were enticed by some buzz
surrounding a new product, but resurgence by an older
product line ultimately buoyed the stock). What is your natural
course of action?

 a. Since the company did well, I am not concerned. The shares

I’ve selected have generated a profit. This confirms that the
stock was a good investment.

 b. Although I am pleased, I am concerned about the

investment. I will do further research to confirm the logic
behind my position
Familiarity Bias
Familiarity Bias: General Description
 People in general prefer aspects familiar to them.

 Investors have the habit of having faith in familiar stocks.

 Such stocks are even considered safe over a diversified

portfolio.

 This is termed as familiarity bias.

Familiarity Bias: Technical Description
 Under this bias, people gravitate towards investments that
have proximity to aspects like location, occupation,
language, etc.

 E.g.: Several studies in the past have found familiarity bias

in people’s investments:
 Investors working a company were found to hold
inappropriately high per cent of wealth in their company
 Investors invest more in the companies located in their home
town as more information is available about such firms.
 People tend to hold highly concentrated portfolios consisting
of recognised stocks
  Home bias was found also found as many fund managers tend
to invest in stocks that have a presence in home country.

 Such a bias compromises decision-making process of

investors.

 Such decisions can make portfolios more concentrated

rather than diversified.
Implication on Investors
 Such a bias compromises the decision-making process of
investors.

 It results in committing too much of funds in too few

assets/securities.

 Such decisions can make portfolios more concentrated

rather than diversified.
Overconfidence Bias
Overconfidence: General Description
 Most consistent, powerful and widespread psychological
bias.

 In psychology, there are volumes of literature that people

are over confident.

 Overconfidence is an error of judgement that can lead to

risks.

 Overconfidence can be about overestimating one’s

capabilities of doing tasks, underestimating an opponent
or possible risks.
 Highly overconfident people have great beliefs in their
abilities.

 They believe they more skilful and knowledgeable than

others.

 But, it is a judgemental error where people tend to give

over importance to their ability of processing information,
of their knowledge and to perform assigned task.

 This may lead investors to overweight their confidence

and underweight the publicly available information.
 Overconfidence is set to arise from two other biases:
 Self Attribution Bias:
 Tendency of ascribing success to their own talents and blaming bad
luck for their failures and on their own incompetence.
 Repeated self attribution may lead to a pleasing conclusion that they
are talented.
 Through several quarters of investment success, investors become
overconfident.
 Hindsight Bias:
 Tendency of people to believe that they predicted event before it
occurred, after it has actually occurred.
 They remain in this belief that they can predict future.
 E.g.: in the 1980s Japanese bull run, 14% per cent investors expected a
crash. However after the crash, 32% people opined that they expected
a crash.
Overconfidence Bias: Technical Description
 Three aspects overconfidence:
 Miscalibration
 Better than average effect
 Illusion of control

 Other factors that contribute to overconfidence:

 Illusion of knowledge
 Illusion of control
Implication on Investors
 Adverse results of overconfidence:
 Mistaking luck for skill
 Too much risk
 Excessive trading
 Underestimate the downside risks to their portfolios
 Overlook any information which contradicts their decision.
Self Attribution Bias
Self attribution bias: General Description
 Self-attribution bias (or self-serving attributional bias)
refers to the tendency of individuals to ascribe their
successes to innate aspects, such as talent or foresight,
while more often blaming failures on outside influences,
such as bad luck.

 Self-attribution is a cognitive phenomenon by which

people attribute failures to situational factors and
successes to dispositional factors.

 Self-serving bias can actually be broken down into two

constituent tendencies or subsidiary biases.
 Self-enhancing bias represents people’s propensity to claim an
irrational degree of credit for their successes.

 Self-protecting bias represents the corollary effect—the

irrational denial of responsibility for failure.

 When an investor who is susceptible to self-attribution bias

purchases an investment and it goes up, then it was due,
naturally, to their business and investment savvy.

 In contrast, when an investor who is susceptible to self-

attribution bias purchases an investment and it goes down,
then it was due, naturally, to bad luck or some other factor
that was not the fault of the investor
Self attribution bias: Technical Description
 Self-attribution bias (or self-serving attributional bias)
refers to the tendency of individuals to ascribe their
successes to innate aspects, such as talent or foresight,
while more often blaming failures on outside influences,
such as bad luck.

 Self-attribution is a cognitive phenomenon by which

people attribute failures to situational factors and
successes to dispositional factors.

 Self-serving bias can actually be broken down into two

constituent tendencies or subsidiary biases.
Implications on investors
 Self-attribution bias often leads investors to trade too
much than is prudent.

 As investors believe that successful investing (trading) is

attributed to skill versus luck, they begin to trade too
much, which has been shown to be “hazardous to your
wealth.”

 Self-attribution bias can cause investors to hold

underdiversified portfolios
Hindsight Bias
Hindsight Bias
 Described in simple terms, hindsight bias is the impulse that
insists:“I knew it all along!”

 Hindsight bias is the tendency of people, with the benefit of

hindsight following an event, to falsely believe that they
predicted the outcome of that event in the beginning.

 A person subject to hindsight bias assumes that the outcome

he or she ultimately observes is, in fact, the only outcome that
was ever possible.

 Thus, he or she underestimates the uncertainty preceding the

event in question and underrates the outcomes that could
have materialized but did not
• Hindsight bias is a psychological phenomenon in which
one becomes convinced they accurately predicted an
event before it occurred.

• It causes overconfidence in one's ability to predict other

future events and may lead to unnecessary risks.

• In investing, hindsight bias may manifest as a sense of

frustration or regret at not having acted in advance of an
event that moves the market.

• One key for managing hindsight bias involves

documenting the decision-making process via a journal
(e.g. an investment diary).
Implications on investors
• Investors who are prone to this bias might have an
overestimation of their intelligence or false overconfidence
effectiveness of their thoughts or decisions.

• This can lead the investors to make riskier decisions, which

may harm their financial well-being.

 This bias might also encourage investors to blame others. The

investors can often blame their advisers or portfolio managers
for their investments' poor performance and entitle them with
praise when their investments earn profits.
Reference Price Effect
 It is similar to disposition effect.

 Under this effect, individuals are likely to sell a stock only

if it attains a previous high.

 E.g.: if an investor buys a stock for Rs. 150 which

subsequently falls to Rs. 110 and later rises o Rs. 140, the
investor would not sell sell it unless it moves above the
purchase price.

 Similarly, volume of trading is low, if the stock price is

below the offer price and vice versa.
Framing Bias
Framing Bias: General Description
 Framing bias notes the tendency of decision makers to
respond to various situations differently based on the context
in which a choice is presented (framed)

 The frame that a decision maker adopts is controlled partly by

the formulation of the problem and partly by the decision
maker's norms, habits, and personal characteristics.

 Framing bias also encompasses a subcategorical phenomenon

known as narrow framing, which occurs when people focus
too restrictively on one or two aspects of a situation,
excluding other crucial aspects and thus compromising their
decision-making.
Framing: Technical Description
 Framing effects occur when preferences change as a
function of some variation in framing.
 For example, one prospect can be formulated in two ways:
 “25 percent of patients will be saved if they are provided
with medicine XYZ”
 “75 percent of patients will die without medicine XYZ”
 Most people in the first case will adopt a gain frame, which
generally leads to risk-averse behavior.
 In the second case—75 percent of patients will die—most
people will adopt a loss frame and thereby become more
likely to engage in risk-seeking behavior.
 E.g.:
 Option 1: “In Q3, our Earnings per Share (EPS) were $1.25,
compared to expectations of $1.27.”
vs.
 Option 2: “In Q3, our Earnings per Share (EPS) were $1.25,
compared to Q2, where they were $1.21.”

 Clearly, option 2 does a better job of framing the earnings

report. The way it is presented – as an improvement over the
previous quarter – puts a more positive spin on the EPS
number.
 E.g.:
 One advisor presents the fund to the investor, highlighting that
it has an average return of 12% over the past three years.

 The other advisor tells the investor that the fund has had
above-average returns in the past 10 years, but in recent years
it has been declining.

 Though the investor was presented with the exact same

mutual fund, he is likely to buy the fund from the first advisor,
who expressed the fund’s rate of return as an overall gain
instead of the advisor presenting the fund as having high
returns and losses.
Implications on investors
 The optimistic or pessimistic manner in which an
investment or asset allocation recommendation is framed
can affect people’s willingness or lack of willingness to
invest.

 Narrow framing, a subset of framing bias, can cause even

longterm investors to obsess over short-term price
fluctuations in a single industry or stock.
Other Non Rational Investment
Behaviours
Groupthink Bias
 Usually corporates suffer from group think bias.

 This bias discounts contrary views and opinions.

 Such decisions give a feel good factor, but they may not be
realistic.

 Further, if CEO and Chairman of a board are same, this could

have explosive effects.

 When members owe their membership to the CEO, they

would prefer to be polite and courteous instead of being
truthful, frank and upright.
 This bias interplay with confirmation bias and selective
perception bias.

 During audits, the human tendency of auditors could bias

their judgements.

 They would believe that since the firm has undergone

audit, everything must be okay.

 Also, even if any misgivings are identified, during the audit,

they would have a selective bias and attribute it to other
excuses.
 Thus, it will limit the auditor to exercise an appropriate
level of professional scepticism which they ought to
exercise.
House money effect
 Taking higher risk under influence of recent gains.

 People are risk averse in gains and risk seeking in losses.

 It may involve strong emotions like greed, fear, regret, etc.

Herd behaviour
 Patterns of behaviour that are correlated with others and
it increases when there are more previous adopters.

 As humans are social being, they inherently, have a strong

belief in group behaviour.

 In herd behaviour, they tend to rationally or irrationally

mimic actions of a larger group.

 They would do things which they individually desist form

doing.
 So they trust the groups' knowledge more than their own.

 Many times, investors believe more in tips given by analysts

than any thing else.

 E.g. of herd behaviour is the dotcom bubble.

 Main reasons:
 Pressure from society for conformity
 Common rational that large group cannot be wrong
 Other Biases:
 Overreaction
 Hot-hand bias
 Procrastination
 Conservatism
 Superstition
Interaction Between Biases
Interaction Between Biases
 Biases can never be viewed in isolation

 While making decisions various biases interact with each

other.

 Each decision may be the result of interaction and interplay of

multitude of biases.

 More than one or even several biases may also operate

simultaneously.

 And can lead to self reinforcement of biases.

 Some biases can be complementary and some can be
opposites as well.

 There is a complementary relationship between status quo

and familiarity biases.

 Over optimism and overconfidence again are complementary

from one end.

 An overconfident investor might be over optimistic about the

information and knowledge he has.

 However, an optimistic investor might not be so confident

about hid skills or knowledge.
Outcomes of Biases
 Intermediate
 Final

 Intermediate:
 Illusions that may impact the speed with decisions are made
 Overconfidence and over optimistic biases can lead to quick and
aggressive decision making behaviour.

 Representative lead to an illusion that the decision made is right

 Delayed reaction (procrastination, disposition effect, loss aversion,

familiarity bias)
 Final Outcomes
 Decision making that is irrational or suboptimal

 Market prices might not reflect actual value of assets

 This leads to inappropriate returns predictions

 Fear of loss of reputation as a result of loss making decisions

 This fear leads to further irrational decisions

Dealing with Biases
 All most all investment decisions tend to ignore available
information and exposures and base them on previous
experiences.

 This could lead to a false sense of security, reduced

vigilance and resultant surprise losses.

 They are unable to distinguish between noise and true

information.

 Even the most experienced investors may tend to make

grave blunders.
 Three parameters bound with an investment (Azzopardi,
2012):
 Opportunity Cost of Money
 Time
 Probability

 Studying BF might help in unearthing the effective high

probability winning trades when merged with technical
finance.
Overcoming Biases
Overcoming Biases
 Presenting remedies to biases sounds like disclosing
things that everybody knows.

 Can biases be eliminated is difficult to answer.

 Individuals who are aware of these biases, still continue to

make decisions under their influence.

 Other thought is that biases generating from lack of

knowledge can be reduced through financial training.
Overconfidence
 Awareness on uncertainty

 Avoid hasty decisions

 Regular evaluation of portfolio

 Avoid geographic proximity/ patriotism

Optimism
 Objective evaluation

 Awareness that everybody can go wrong

 Convert previous failures into learning lessons

 Diversified portfolio

 Long term investment plan

Conservatism
 Objective verification

 Sound investment strategy

 Going for sound and capable financial advisors

Hindsight Bias
 Check if analysts are forward looking

 Cross check client’s portfolio periodically

 Appropriately reward/ punish financial advisors

Anchoring
 Awareness about anchoring

 Confirm that advisors have not deviated from rationality

 Proper verification of data used by advisors in taking

decisions
Availability Bias
 Formulate investment strategy in advance.

 Cross check source and relevance of information before

believing in it.

 Resist herd instinct

Representativeness Bias
 Check behaviour of comparable investment funds as
against the investment made.

 Check the rules for employing fund managers.

 What are the success backgrounds of managers?

 Has average return of fund as compared to the index (3,5

& 10 years)
Some other remedies (Rizzi, 2003)
 Limits to new products and markets

 Second opinion

 List as many as possible scenarios

 Not to blindly follow experts

 Avoid herding

 Postmortem analysis

 Conduct independent investigation

Remedies for organisation
 Heterogeneous risk team

 Lengthening risk horizon

 Delphi technique

 Portfolio control

 Exit strategy
Debiasing
 Debiasing is learning from the past, watching the present
and creating the future.

 It is the procedure of reducing or eliminating biased

decision making.

 It is done through 3 steps:

1. Identification of the existence and nature of potential bias.
 Retrospective, Introspective and Prospective
2. Consideration of ways and techniques to lower impact of the
bias.
3. Evaluation of effectiveness of the selected technique.