Section 2: Applied Behavior Finance – Review Slides

What are the Prospect Theory Basics?
-A descriptive theory based on experimental evidence. (Kahneman and Tversky -1979)

-Most individuals are more risk averse vs. pleasure seeking by a ratio of roughly 2:1.

What are the Key Tenants of Prospect Theory?
1) People make decisions based more on probabilities than potential outcomes

2) People make decisions using mental heuristics (e.g., mental shortcuts and biases)

3) Loss aversion: the tendency to feel the impact of losses more than gains

4) This value function can be illustrated graphically using an asymmetrical s-shaped curve

What is the hypothesis of Paradox of Choice?
Giving people more choice does not
increase performance or satisfaction
What are the key findings of the study: “When Choice is Demotivating: Can One Desire Too Much of a Good Things”?
1) People are easily overwhelmed with information

2) Numerous biases come into play

3) People often do nothing if confused

4) Optimal decisions are not made (mistakes are made)

What is the big picture view of Adaptive Market Hypothesis?
Adaptive Market Hypothesis reconciles Efficient Market Hypothesis
(EMH) with research in behavioral economics
What is the thesis of the research: “The Adaptive Markets Hypothesis” by Andrew Lo?
Markets evolve over time as individuals use
numerous evolutionary heuristics and biases to make decisions
What are the conclusions & results of the research: “The Adaptive Markets Hypothesis” by Andrew Lo?
– Opportunities for arbitrage

– Value in quantitative, fundamental, technical strategies

– Survival is primary objective; profit and utility secondary

– Innovation is key to survival and growth

Describe area of discussion on Neuro-economics?
1. Physiological impact on decision making
2. Intuitive vs. deliberative decision making
3. Actions that develop trust
Physiological Impact on Decision Making: The Loewenstein-Lerner Classification

What are the points of the research?

– Future (anticipated) emotions
– Current (immediate) emotions
Physiological Impact on Decision Making: The Loewenstein-Lerner Classification

What is Intertemporal Choice?

-People make choices based on different expected payoffs at different points in time
Physiological Impact on Decision Making: The Loewenstein-Lerner Classification

What are the Determinants of Choice?

– Time
– Probability
– Expected payoffs
Intuitive vs. Deliberative Decision Making: Oveview of Cornelia Betsch’s Preference

What is the intuitive Approach to decision making?

Based upon implicit knowledge. Specifically,
the decision-maker taps knowledge acquired by associative learning and stored in long-term memory to produce a “feeling.” This feeling is used as the
basis for judgments and decisions.
Intuitive vs. Deliberative Decision Making: Oveview of Cornelia Betsch’s Preference

What is the Deliberative Approach to decision making?

An analytic mode that reflectively processes mainly cognitive content such as beliefs, arguments, and reasons. It is the counterpoint to the intuitive approach.
According to Edelman Insights, what are the actions that develop trust?
– Developing empathy
– Shared concerns or goals
– Avoiding conflicts of interest
– Be at risk
– Demonstrate commitment
List the various behavioral biases based on existing beliefs and how they may impact financial decision making and behavior?
1) Cognitive dissonance

2) Conservatism bias

3) Confirmation bias

4) Representative bias

5) Illusion of control bias

6) Hindsight bias

What is Cognitive Dissonance?
In psychology, cognitions represent attitudes, emotions, beliefs, or values. When people attempt to harmonize conflicting cognitions, cognitive dissonance can result. People may rationalize their choices, even when faced with facts that demonstrate that they made poor decisions.

FFs who suffer from this bias can be known to continue to invest in a security or fund they already own after it has gone down (average down) without judging the new investment with objectivity. A common phrase for this concept is “throwing good money after bad.”

What is Conservatism bias?
Conservatism bias occurs when people maintain their prior views or forecasts by inadequately incorporating new information. Investors often under-react to new information and fail to modify their beliefs and actions.

For example, assume an investor purchases a security based on the knowledge about a forthcoming new product announcement. The company then announces that it is experiencing problems bringing the product to market. The investor may cling to the initial, optimistic impression of the new product announcement and may fail to take action on the negative announcement.

What is Confirmation bias?
Confirmation bias occurs when people observe, overvalue, or actively seek out information that confirms their claims, while
ignoring or devaluing evidence that might discount their claims.

Confirmation bias can cause investors to only seek out information that confirms their beliefs about an investment, and 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.

What is Representative bias?
Representativeness bias occurs as a result of a flawed perceptual framework when processing new information using pre-existing ideas. For example, an investor may view a particular stock as a value stock because of similarities to an earlier value stock that was a successful investment, even if the new investment is not actually a value stock.

For instance, a high-flying biotech stock with scant earnings or assets drops 25% after a negative product announcement. Some may take this situation to be representative of a “value” stock because it is cheap; but biotech stocks don’t typically have earnings while traditional value stocks have had earnings in the past but are temporarily underperforming.

What is Illusion of control bias?
The illusion of control bias occurs when people believe that they can control or influence investment outcomes that, in fact, they cannot.

For example, trading-oriented investors, who accept high levels of risk, believe themselves to possess more “control” over the outcomes of their investments than they actually do because they are “pulling the trigger” on each decision.

What is Hindsight bias?
Some investors lack independent thought and are susceptible to hindsight bias, which occurs when investors perceive investment outcomes as if they were predictable – even if they were not. Hindsight bias can give investors a false sense of security when making investment decisions, potentially leading to excessive risk-taking.

An example of hindsight bias is the response by investors to the behavior of the aforementioned tech stock bubble when, initially, many viewed the market’s performance as “normal” (i.e., not symptomatic of a bubble), only to later say, “Wasn’t it obvious?!” when the market melted down.

List the various behavioral biases based on Information Processing and how they may impact financial decision making and behavior?
1) Mental accounting

2) Anchoring and adjustment bias

3) Framing bias

4) Availability bias

5) Self-attribution bias

6) Outcome bias

7) Recency bias

What is Mental Accounting?
Mental accounting occurs when people treat various sums of money differently based on where these sums are mentally categorized. For example, risk averse investors may like to segregate some assets into safe “buckets.”

A classic example of mental accounting is segregating “college money”, ” money for retirement” and “vacation money”. If all of these assets are viewed as “safe money” sub-optimal returns are usually the result.

What is Anchoring and Adjustment bias?
Anchoring bias occurs when investors are influenced by purchase points or arbitrary price levels, and cling to these numbers as they decide whether to buy or sell an
investment.

One of the most common examples of anchoring bias occurs during the implementation of a new asset allocation. For example, suppose a client comes to an advisor with 30% of their portfolio in a single stock and the advisor recommends diversification. Further suppose that the stock is down 25% from its high that it reached 5 months ago ($75/share vs. $100/share). For simplicity, assume that taxes on the sale are not an issue. Frequently, the client will be resistant to
meet the new allocation because they are anchored to the $100 price.

What is Framing bias?
Framing bias describes the tendency of investors to respond to various situations differently based on the context in which a choice is presented (framed). Often, investors focus too much on one or two aspects of a situation, excluding other crucial considerations.

The use of risk tolerance questionnaires provides a good example. Depending upon how questions are asked, framing bias can cause investors to respond to risk tolerance questions in an either unduly conservative or aggressive manner. For example, when questions are worded in the “loss” frame, a risk-averse response is more likely. When questions are worded in the “gain” frame, risk-seeking behavior is the likely response.

What is Availability bias?
Description: Availability bias occurs when people use a rule-of-thumb to estimate the likelihood of an outcome based on how easily the outcome comes to mind.

Easily-recalled outcomes are perceived as being more likely than those that are harder to recall or understand.

As an example, suppose an investor is asked to identify the “best” mutual fund companies. Most investors would perform a “Google” search and, most likely, find funds from firms that engage in heavy advertising –such as Fidelity or Schwab.

Investors subject to availability bias are influenced to pick funds from such companies, despite the fact that some of the best-performing funds advertise very little if at all.

What is Self-attribution Self-Enhancing bias?
Self-attribution bias refers to the tendency of people to ascribe their successes to innate talents, while blaming failures on outside influences.

For example, suppose an II makes an investment that goes up. The reason it went up is not due to random factors such as economic conditions or competitor failures, but rather to the investor’s investment savvy. This is classic self-enhancing bias.

What is Outcome bias?
One will often judge a past decision by its ultimate outcome instead of based on the quality of the decision at the time it was made, given what was known at that time. This is an error because no decision maker ever knows whether or not a calculated risk will turn out for the best. The actual outcome of the decision will often be determined by chance, with some risks working out and others not. Individuals whose judgments are influenced by outcome bias are seemingly holding decision makers responsible for events beyond their control.
What is Recency bias?
Recency bias causes people to more easily recall and emphasize recent events and/or observations, and potentially to extrapolate recent patterns where none exist.

Recency bias ran rampant during the bull market period between 1995 and 1999 when many investors wrongly presumed that the market would continue its enormous gains forever.

List the various behavioral biases based on Emotions and how they may impact financial decision making and behavior?
1) Loss-aversion bias

2) Overconfidence bias

3) Self-control bias

4) Status quo bias

5) Endowment bias

6) Regret-aversion bias

7) Affinity bias

What is Loss-aversion bias?
Research has shown that for many investors, the pain of losses is twice as painful as the pleasure of gains.

Loss aversion prevents people from unloading unprofitable investments, even when they see no prospect of a turnaround. Some industry veterans have labeled this phenomenon “get-even-itis.”

What is Overconfidence bias?
Overconfidence is unwarranted faith in one’s own thoughts and abilities, which contains both cognitive and emotional elements.

For example, a study done by researchers Odean and Barber* showed that after trading costs (but before taxes), the average investor underperformed the market by approximately 2% per year due to unwarranted belief in their ability to assess the correct value of investment securities.

What is Self-control bias?
The illusion of control bias occurs when people believe that they can control or influence investment outcomes that, in fact, they cannot.

For example, trading-oriented investors, who accept high levels of risk, believe themselves to possess more “control” over the outcomes of their investments than they actually do because they are “pulling the trigger” on each decision.

What is Status quo bias?
Status quo bias predisposes people, when facing an array of options, to select the one that keeps conditions the same.

Status quo bias is demonstrated by the investor that has been doing things a certain way for many years, and then hires a new financial advisor. The new advisor may propose practical changes only to find that the investor takes only part of or none of the advice. It’s not that the client doesn’t need good advice – they are simply stuck in the “status quo”.

What is Endowment bias?
Endowment bias occurs when a person assigns greater value to an object he or she possesses and may lose than an object of the same value he or she does not possess and has the potential to gain.

A classic example of endowment bias is a client who holds onto investments that were owned by previous generations, particularly concentrated equity positions or real estate that may have created the family’s wealth to begin with, without justification for why these assets are retained.

What is Regret-aversion bias?
People exhibiting regret aversion bias avoid taking decisive action because they fear that, in hindsight, the course they select will prove less than optimal.

Regret aversion can cause investors to be too conservative in their investment choices. Having suffered losses in the past, some investors have trouble making sensible new investments. This behavior can lead to long term underperformance and can jeopardize investment goals.

What is Affinity bias?
Individual’s tendency to make irrationally uneconomical consumer choice or investment decisions based on how they believe a certain product or service will reflect their values. Example, purchase a Range Rover because they want to be viewed as outdoorsy.
More Behavioral Biases:

You may see other common behavioral terms and biases on your exam.

Sunk-cost fallacy – When one makes a hopeless investment, one sometimes reasons: I can’t stop now, otherwise what I’ve invested so far will be lost. This is true, of course, but irrelevant to whether one should continue to invest in the project.

Get-evenitis – Prioritizing the minimization of a loss. Trap: Refusal to sell a falling stock in the hopes it will turn around.

Gambler’s fallacy – also known as the Monte Carlo fallacy or the fallacy of the maturity of chances, is the mistaken belief that, if something happens more frequently than normal during some period, it will happen less frequently in the future, or that, if something happens less frequently than normal during some period, it will happen more frequently in the future (presumably as a means of balancing nature).

Snake-bit effect – Becoming more risk averse due to past events. Trap: Overreliance on low-risk, low-return options.

House-money effect – The tendency for investors to take more and greater risks when investing with profits. The house money effect gets its name from the casino phrase “playing with the house’s money.”

What are the Investor Personality Types?
– Preservers
– Followers
– Independents
– Accumulators
What is the definition of a Preserver?
Place a great deal of emphasis on financial security and preserving wealth.

Risk tolerance: low

Primary Bias: Emotional
1) Loss Aversion bias
2) Status Quo bias
3) Endowment bias

What is the definition of a Follower?
Investors who do not have their own ideas about investing. Follow the lead of their friends and colleagues in investments.

Risk tolerance: low to medium

Primary Bias: Cognitive
1) Recency bias
2) Hindsight bias
3) Framing bias
4) Cognitive Dissonance bias

What is the definition of an Independent?
These investors have been actively involved in their wealth creation. High risk tolerance because they believe in themselves. Want to maintain some control over their investments.

Risk tolerance: Medium to high

Primary Bias: Cognitive
1) Conservatism bias
2) Availability bias
3) Representativeness bias
4) Self-Attribution bias
5) Confirmation bias

What is the definition of an Accumulator?
Similar to Independent, active higher risk taking investors. Prefer to get very involved in investment decision making and aren’t afraid to roll up their sleeves. Entrepreneurs and first generation wealth.

Risk tolerance: The highest

Primary Bias: Emotional
1) Overconfidence bias
2) Self-control bias