Behavioral Finance

Cognitive Biases
Information Processing

Gonçalo Sommer Ribeiro

Behavioral Finance Information Processing

Behavioral Finance
Cognitive Biases
Information Processing Biases

• Information processing biases result in information being processed and used

illogically or irrationally

• Usually people collect information, process it, and make a decision. Our
cognitive system is permanently influenced by the way we process that
information causing faulty reasoning

• What we pay attention to is influenced by our prior experiences, including

reward history and past successes and failures, even when we are not aware of
this history

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Behavioral Finance
Information Processing Biases
Anchoring and Adjustment Bias
Definition
• Anchoring and Adjustment Bias is a bias in which the use of a psychological
heuristic influences the way people estimate probabilities

• When required to estimate a value with unknown magnitude, people generally

begin by envisioning some initial default number which they then adjust up or
down to reflect subsequent information and analysis

• People tend to adjust their anchors insufficiently and produce end

approximations that are, consequently, biased

• In anchoring and adjustment, people place undue weight on the anchor.

Related to the conservatism bias

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Behavioral Finance
Information Processing Biases
Anchoring and Adjustment Bias
Explanations
• People anchor and adjust because they are generally better at estimating relative
comparisons than absolute figures

• Some of the conservatism might be due, as well, to an underlying difficulty in

processing new information

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Behavioral Finance
Information Processing Biases
Anchoring and Adjustment Bias
Consequences
• Investors exhibiting this bias are often influenced by purchase “points”, or
arbitrary price levels or price indexes, and tend to cling to these numbers
(entrance level, highs, lows)

• Investors with an anchoring and adjustment bias perceive new information

through a warped lens. They place undue emphasis on statistically arbitrary,
psychologically determined anchor points

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Behavioral Finance
Information Processing Biases
Anchoring and Adjustment Bias
Implications for investors

1. Investors tend to make general market forecasts that are too close to current
levels
▪ Example: using current index price and use historical returns and standard deviations

2. Investors (and securities analysts) tend to stick too closely to their original
estimates when new information is learned about a company

3. 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

4. Investors can become anchored on the economic states of certain countries or

companies
▪ Example: Japan in 1980’s vs now

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Behavioral Finance
Information Processing Biases
Anchoring and Adjustment Bias
Mitigation

• Rational investors should treat new pieces of information objectively

• For investors awareness is the best countermeasure to anchoring and

adjustment bias

• Analysts tend to suffer anchoring and adjustment bias when calling on

earnings, so investors can take this into account when looking at estimates

• Many negotiation experts suggest that the participants communicate radically

strict initial positions, arguing that an opponent subject to anchoring can be
influenced even when the anchor values are extreme

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Behavioral Finance
Information Processing Biases
Anchoring and Adjustment Bias
Literature

• George, T. J. and Hwang, C. 2004. “The 52-Week High and Momentum

Investing.”

• Shefrin, H. 2010. “Behavioralizing Finance.”

• Samson, A. (Ed.). 2020. The Behavioural Economics Guide 2020

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Behavioral Finance
Information Processing Biases
Anchoring and Adjustment Bias
Proxys
Examples of possible bias proxy’s:

• Relationship with 52–Week high: Current price /52–Week high

• Relationship with 52–Week low: Current price /52–Week low

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Behavioral Finance
Information Processing Biases
Anchoring and Adjustment Bias
Markets Example
• Comparing current price to 52-week high and low

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Behavioral Finance
Information Processing Biases
Mental Accounting
Definition
• Mental Accounting bias is people’s tendency to code, categorize, and evaluate
economic outcomes by grouping their assets into any number of nonfungible
(noninterchangeable) mental accounts

• Mental accounting is about coding, categorization, and evaluation of financial

decisions

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Behavioral Finance
Information Processing Biases
Mental Accounting
Explanations
• People create mental accounts in order to justify actions that seem enticing but
that are, in fact, unwise

• Investors simplify their outcomes evaluation according to each financial

objective

• Limited memory causes investors to focus on specific components of the

portfolio

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Behavioral Finance
Information Processing Biases
Mental Accounting
Consequences
• People mentally allocate wealth over three classifications:
▪ (1) current income
▪ (2) current assets
▪ (3) future income

• People mentally invest with different goals, not holistically, by allocating part
of their savings:
▪ In a bucket to beat inflation (safety net – bonds)
▪ In a bucket to grow (risky layer – equities)
▪ In a bucket to achieve our most aspiring needs (very risky assets –
alternative investments)

• Distinct financial decisions may be evaluated jointly or separately depending

on the way they are perceived before the decision-making process

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Behavioral Finance
Information Processing Biases
Mental Accounting
Implications for investors

1. Can cause people to imagine that their investments occupy separate “buckets”,
or accounts, envisioning distinct accounts to correspond with financial goals

2. Can cause investors to irrationally distinguish between returns derived from

income and those derived from capital appreciation

3. Can cause investors to allocate assets in retirement plans differently when

employer stock is involved because they separate the employers' stocks from
retirement, causing overweight in equities and under diversification

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Behavioral Finance
Information Processing Biases
Mental Accounting
Mitigation

• Consider the correlations between investment “buckets”, viewing the portfolio

in an holistic approach

• Focus on total returns from a portfolio instead of individual assets/strategies

returns or if return is coming from capital appreciation on yield returns

• Avoid company stock bias and consequent under diversification

• Have bad investment experiences in the back of your mind so you remember to
evaluate each investment position individually and rationally

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Behavioral Finance
Information Processing Biases
Mental Accounting
Literature

• Thaler, R., 1985. “Mental Accounting and Consumer Choice.”

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Behavioral Finance
Information Processing Biases
Mental Accounting
Proxys
Examples of possible bias proxy’s:

• Asset allocation that is not consistent with recommended allocation for a

investor’s life stage

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Behavioral Finance
Information Processing Biases
Mental Accounting
Markets Example
• Crypto currencies are often perceived as a way to achieve high levels of wealth
to fulfill the most aspirational desires (buy a house or a boat)

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Behavioral Finance
Information Processing Biases
Framing Bias
Definition
• Framing implies that the perception of a problem and the probabilistic
evaluation process can be altered depending on the connotations with which
the options are presented

• 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)

• Framing bias also encompasses a sub categorical 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

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Behavioral Finance
Information Processing Biases
Framing Bias
Explanations
• The frame that a decision maker adopts is controlled partly by the formulation
of the problem and partly by the norms, habits, and personal characteristics of
the decision maker

• Framing bias might guide us to a specific answer based on our personality and
biases
▪ Example: Investor risk tolerance questionnaire

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Behavioral Finance
Information Processing Biases
Framing Bias
Consequences
• Investors take decisions based on the information that are presented to them,
which might be framed to a certain extent. This will cause a biased decision
making

• Narrow framing to a certain aspect of a decision when it warranted a much

more complex and detailed analysis

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Behavioral Finance
Information Processing Biases
Framing Bias
Implications for investors
1. Can cause investors to communicate responses to questions about risk
tolerance that are either unduly conservative or unduly aggressive
▪ Example: questions are worded in the “gain” frame, a risk-averse response is more likely.
When questions are worded in the “loss” frame, risk-seeking behavior is the likely response

2. 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
▪ Example: Optimistically worded questions are more likely to garner affirmative responses

3. Narrow framing, a subset of framing bias, can cause even long-term investors
to obsess over short-term price fluctuations in a single industry or stock

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Behavioral Finance
Information Processing Biases
Framing Bias
Mitigation
• About narrow framing, investors should keep the big picture in mind: overall
wealth accumulation and long-term financial goals

• Isolate from their ongoing decision making any references to gains or losses
incurred in a prior period

• Emphasis on education, diversification, and proper portfolio management can

help to neutralize these biases

• Risk tolerance questionnaires are critical in assessing client goals and selecting
appropriate investments, so they need to be nonbiased

• When it takes to decision making, present facts and choices as neutrally and
uniformly as possible

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Behavioral Finance
Information Processing Biases
Framing Bias
Proxys
Examples of possible bias proxy’s:

• Compare questionnaires risk tolerance vs real investment behavior

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Behavioral Finance
Information Processing Biases
Framing Bias
Markets Example
• S&P500 in fact increased in the quarter, that is consistent with historical
statistical returns and caused by well know factors that explain its performance

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Behavioral Finance
Information Processing Biases
Availability Bias
Definition
• Availability bias is a rule of thumb, or mental shortcut, that allows people to
estimate the probability of an outcome based on how prevalent or familiar that
outcome appears in their lives
• People often inadvertently assume that readily available thoughts, ideas, or
images represent unbiased indicators of statistical probabilities
• People estimate the likelihoods of certain events according to the degree of ease
with which recollections or examples of analogous events can be accessed from
memory
• There are several categories of availability bias, of which the four that apply
most to investors are:
▪ (1) retrievability - ideas that are retrieved most easily also seem to be the most credible
▪ (2) categorization - people attempt to categorize or summon information that matches a certain
reference
▪ (3) narrow range of experience – too restrictive frame of reference from which to formulate an
objective estimate
▪ (4) resonance - The extent to which certain own, personal situations can also influence judgment

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Behavioral Finance
Information Processing Biases
Availability Bias
Explanations

• Humans have selective memory, so its easier to recall recent, good events

• Its easier to process information at the light of our previously conceived

relationships

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Behavioral Finance
Information Processing Biases
Availability Bias
Consequences
• Perceive easily recalled possibilities as being more likely than those prospects
that are harder to imagine or difficult to comprehend
▪ Example: shark attacks are more probable than airplane crashes, but people are more afraid
of the former

• It might cause investors to overreact to present-day market conditions, whether

they are positive or negative
▪ (1) retrievability - Most investors, if asked to identify the “best” mutual fund company, are likely
to select a firm that engages in heavy advertising
▪ (2) categorization - Most Americans, if asked to pinpoint one country, worldwide, that offers the
best investment prospects, would designate their own: the United States
▪ (3) narrow range of experience – if an employee of a fast growing, high-tech company is asked:
“Which industry generates the most successful investments?”, he probably answers tech
▪ (4) resonance - People often favor investments that they feel match their personalities - ESG

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Behavioral Finance
Information Processing Biases
Availability Bias
Implications for investors

• (1) retrievability - Investors will choose investments based on information that

is available to them

• (2) categorization - Investors will choose investments based on categorical lists

that they have available in their memory

• (3) narrow range of experience – Investors will choose investments that fit their
narrow range of life experiences

• (4) resonance - investors will choose investments that resonate with their own
personality or that have characteristics that investors can relate to their own
behavior

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Behavioral Finance
Information Processing Biases
Availability Bias
Mitigation
• Investors need to carefully research and contemplate investment decisions
before executing them

• Focusing on long-term results, while resisting chasing trends, are the best
objectives on which to focus if availability bias appears to be an issue

• Be aware that everyone possesses a human tendency to mentally

overemphasize recent, newsworthy events

• Keep an updated information set without focus on recent data

• Consider how you decide which investments to research before making an

investment

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Behavioral Finance
Information Processing Biases
Availability Bias
Literature

• Shefrin, H. 2010. “Behavioralizing Finance.”

• Samson, A. (Ed.). 2020. The Behavioural Economics Guide 2020

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Behavioral Finance
Information Processing Biases
Availability Bias
Proxys
Examples of possible bias proxy’s:

• Check which companies have more traction by investors (Twitter sentiment,

other metrics such as brokerage house buying rankings) and see if they
outperform around peaks of awareness (Christopher Gadarowski, 2001)

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Behavioral Finance
Information Processing Biases
Availability
Markets Example
• Chat GPT investments – investors recall the hot topic and might feel inclined to
invest in this technology while penalizing those lagging behind the technology

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Behavioral Finance
Cognitive Biases
Information Processing Biases
List of Biases
• Anchoring and Adjustment Bias

• Mental Accounting

• Framing Bias

• Availability Bias

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