Behavioral Biases

Table of Contents

BF1:  Behavioral Finance

BF2:  Overconfidence Bias

BF3:  Representative Bias

BF4: Anchoring and Adjustment Bias

BF5:  Cognitive Dissonance

BF6:  Availability Bias

BF7:  Self Attribution Bias

BF8:  Illusory Control Bias

BF9:  Conservatism Bias

BF10:  Ambiguity Bias

BF11:  Endowment Bias

BF12:  Self Control Bias

BF13:  Optimism Bias

BF14:  Mental Accounting Bias

BF15:  Confirmation Bias

BF16:  Hindsight Bias

BF17:  Loss Aversion Bias

BF18:  Recency Bias

BF19:  Regret Aversion Bias

BF20:  Framing Bias

BF21:  Status Quo Bias

Behavioral Finance

1.      Normative Analysis:  Concerned with the rational solution to the problem at hand.

2.     Descriptive Analysis:  Concerned with the manner in which real people actually make decisions.

3.     Prescriptive Analysis:  Concerned with practical advice and tools that help people achieve results more closely approximating those of normative analysis.

Generally accepted guidelines that a decision maker should follow:

1.     Take inventory of all viable options available for obtaining information, for experimental and for action.

2.     List the events that may occur.

3.     Arrange pertinent information and choices/assumptions.

4.     Rank consequences resulting from the various courses of action.

5.     Determine the probability of an uncertain event occurring.

Tversky & Kahnmen Paper:  Prospect theory and analysis of decisions under risk.

·      Risky prospects exhibit effects inconsistent with utility theory.  People underweight outcomes that are merely probable compared to outcomes obtained with certainty.

·      This called the certainty effect.

·      Contributes to risk aversion in choices in seeking gains and to risk seeking in sure losses.

·      Called the isolation effect which leads to inconsistent preferences when the same choice is presented in different forms.

·      Extreme ends of information is processed and people tend to discard components that are shared by all prospects under consideration.

Key Insight:  The isolation effect suggests people may chose options differently, although the probability of the outcomes is the same.  Why?  It’s in how the questions is answered.  When evaluating, ask gain loss questions to self in different formats to obtain clearer understandings and to perceive reality better. Will help the thought process ‘edit’ information in different lights and help ‘evaluate’ probable outcomes in a different light.  Example:  Pros and Cons sheet.

Key Point:  People are more affected by loosing money than gains, almost 2 to 1.  Emotionally, trader styles include getting out at low percentage loss and ‘letting it ride’ for trends up.

•  Loosing money is more of a factor in markets than gaining money.  But that is not how its sold and that’s not what we tell ourselves.

Daniel Kahnmen:  Aspects of investor psychology: Beliefs, preferences and Biases

Biases of Judgment:

•  Overconfidence

•  Optimism

•  Hind  Sight

•  Over Reaction to Chance Events

Errors of Preferences:

•  Nonlinear Weighting of Probabilities.

•  Tendency to value change, not states.

•  Shape and attractiveness of gambles.

•  Use of purchase prices as main reference point.

•  Narrow Framing.

•  Tendencies related to repeated gambles and risk policies.

•  Adoption of short versus long views.

Living With Consequences of Decisions:

•  Gives rise to regrets of omission and commission.

•  Relationship between regret and risk taking.

Biases fall into two broad categories;

1.      Cognitive:  Faulty logic, remedied by more information.

2.     Emotional:  Derived from impulses or intuition.  Much harder to rectify.

BF2:  Overconfidence Bias

Too many people overvalue what they are not and undervalue what they are.

Bias Type:  Cognitive

Description:  Unwarranted faith in one’s intuitive reasoning, judgments and cognitive abilities.  People overestimate their own predictive abilities and the precision of the information given.  People think they are smarter and have better information than they do.   They are willing to take action on a perceived knowledge advantage.

Studies indicate investors are overconfident in their investing abilities and their estimates are too narrow.  Implies investors underestimate down side risks.

Common mistakes due to overconfidence:

1.      Over estimate their ability to evaluate a company.  Can become blind to negative information.

2.     Leads to excessive trading.  More trading usually leads to poorer performance.

3.     Underestimate down side risks.

4.     Tend to hold less diversified portfolio which leads to increased risk.

Overconfident investors may not be prepared for investors.

BF3:  Representative  Bias:

Fit no stereotypes, don’t chase the latest fad, the situation will dictate the best course of action.

Bias Type:  Cognitive

Description:  People have an innate propensity to classify objects and thoughts.  When new objects or thoughts come into view, we tend to analyze them based on post experiences.  This perceptual process allows us to process and quickly respond to events.

The new stimuli resembles (represents) familiar elements that have been already classified.  In reality, these are drastically different analogies.  This leads to a new classification that is deceptive and produces an incorrect understanding.  Often persists and biases all our future interactions with that element.

Two interpretations related to investors:

1.      Base Rate:  Investor classifies potential stock in an established group (value, growth).  It ignores aspects of a company after the initial classification is determined.

2.     Sample Size Neglect:  Failure to collect enough data.  The evaluation of prospects are made on a small sample and the range of the collected data does not represent the entire population.

Time Diversification:  Spreading investments over different market cycles.  Can include different sectors or market types.

BF4:  Anchoring and Adjustment Bias

Bias Type:  Cognitive

Description:  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.  Studies demonstrate that whatever the initial anchor is, people adjust insufficiently up or down and are consequently, biased.

Anchoring and adjustments are psychological heuristics that influences the way people intuit probabilities.  New news tends to be interpreted through a warped lens based on the anchors of purchase and/or target prices.

New news should be evaluated without anchors.  Should look at new news as increasing or decreasing the probability of the stock price.

People tend to anchor on the purchase price for determining future value.  The anchor increase with the rise in price.  If a rise occurs, then falls, investors tend to anchor on higher prices and information is biased toward the desired higher anchor.

Awareness of bias is best recourse for dealing with it.

Thoughts: 

•  When trends break, then climb back to the trend line, is this a reflection of the anchoring bias.

•  Write out biases for self reflection.

•  Write out biases to recognize that others posses them.

•  Write out biases in the context of how to exploit them from other investors.

•  Look for biases in the context of Technical Analysis.

Can be exploited.  Analysts tend to anchor estimates.  If an upgrade and earnings are increasing, then it may be a positive sign as estimates are anchored and are probably narrowly underestimated.  The reverse can be used for down trends.

BF5:  Cognitive Dissonance Bias

Bias Type:  Cognitive

Description:  When newly acquired information conflicts with preexisting understandings, people often feel discomfort.  Cognitions, in psychology, represents attitudes, emotions, beliefs, or values.  Cognitive dissonance is a state of imbalance that occurs when contradictory cognitions intersect   It encompasses the response that of people trying to harmonize cognitions to relieve their mental discomfort.

People tend to perform far reaching rationalizations to maintain psychological balance.  When people modify their actions or beliefs to achieve cognitive harmony, they are not always in their best interest.

Falls in line with the theory of belief conservatism.  New information not in line with beliefs and commitments are considered emotional threats.  New thoughts or decisions carry potential downsides, while the rejected alternatives have redeeming values.  Most people try to avoid dissonant situations and may ignore relevant information to avoid psychological conflict.

Selective Perception:  Only registers or perceives information that appears to affirm a chosen course.  As a result, the understood reality is incomplete, thus inaccurate.  People will then become increasingly prone to subsequent miscalculations.

Selective Decision Making:  Occurs when a commitment to a selected course is high.  Enables someone to rationalize actions that maintain the course, even at significant economic cost.

The higher the dissonance between new information and existing beliefs (or fear of looking stupid) the farther the rationalization or change in behavior will occur.

Impacts:

1.      Investors may hold onto losing investments, or hang on to them to avoid the mental pain of making a wrong decision.

2.     May cause the ‘throwing good money after bad’ effect.

3.     Cause investors to get caught up in herd behavior.

4.     Can cause the ‘It’s different this time’ phenomenon.

The most significant cognitive dissonance in stocks is the difference between purchase price and current price.  Especially if money is lost, the greater the dissonance, the greater the rationalization to stay the course.  Losing money is twice as painful.

The driving force behind most irrational behavior is the tendency to adopt detrimental responses to cognitive dissonance in order to alleviate mental discomfort.

Reconciliation of internal Conflict is usually done in one three ways:

1.      Modifying beliefs:  Can change an attitude or belief due to an event.  However, theory of belief conservatism comes into play and is difficult to change significant beliefs.

2.     Modifying Actions:  Saying you won’t do it again.  Though not generally thought of as a reliable change.

3.     Modify the perceptions that led to action.  ‘They deserved it’ attitude.

Reconciliation doesn’t mean a positive solution is in place.  It just outlines how people respond.  In knowing how one responds, someone can recognize their behavior and view of the event.

BF6:  Availability Bias

Bias Type:  Cognitive

Description:  A rule of thumb, or mental shortcut, that allows one to estimate the probability of an outcome based on how prevalent or familiar that outcome appears in their lives.  We often assume that readily available thoughts, ideas, or images represent unbiased indicators of statistical probabilities.  Impressions drawn from memory and imagination combine to construct an array of conceivable outcomes, whose real statistical probabilities are in reality, arbitrary.

Top Four Availability Biases (categories) Include:

1.      Retreivability:  ideas retrieved most easily are most credible.

2.     Categorization:  Items or sets that we can find easier are more credible.  We tend to look for the familiar.  Difference between finding something easy versus hard can be biased just due to the differences in retrieval of information.

3.     Narrow Range of Experience:  A bias generated from a narrow framework or sample set.

4.     Resonance:  To the extent something resonates with the individual.  Someone who listens to classical music may overestimate the overall number of people who listen to classical music.

Applications:

1.      Retreivability:  Investors may choose stocks based on advertising, friends or advisors without any real research.

2.     Categorization:  investors may choose stocks readily in their mind.   Examples include investors buying on U.S. stocks while missing returns from other countries.

3.     Narrow Range:  investors pick stocks based on limited life experiences, maybe specific industries or regions.

4.     Resonate:  investors ignore potentially good stocks as they do not resonate with the investor.

Note:  Attention grabbing stocks do not normally outperform the market.

BF7:  Self Attribution Bias

Bias Type: Cognitive

Description:  Refers to the tendency of individuals to ascribe their success to innate attributes, such as talent or foresight, while blaming failures to outside influences, such as bad luck.  People attributing failures to situational factors and success to dispositional factors.

Two Main Tendencies:

1.      Self enhancing Bias:  propensity to claim an irrational degree of credit to their success.

2.     Self protecting Bias (corollary effect):  the irrational denial of responsibility of failure.

Self enhancing bias can be explained by people naturally acting more credit for success than failure, a they intend to succeed.

Self protecting bias comes from an emotional level in which people tend to protect their self esteem and psychological balance.

Strengths and weaknesses are in line with self enhancing bias and self protecting bias.  People tend to associate strengths to self enhancing bias, and associate weaknesses with the self protecting bias.  People tend to ignore their weaknesses which hampers their ability to enhance their strengths.

Impact to Investors:

1.      If failures are attributed to outside factors, then mistakes will be dismissed and the opportunity to learn is lost.

2.     In case of wining streaks, investors can become overconfident.

  

BF8:  Illusion of Control Bias

Bias Type:  Cognitive

Tendency for people to believe they can control or influence outcomes, when in fact, they cannot.  Expectancy of a personal success probability becomes inappropriately higher than the objective probability would warrant.  Choice, task familiarity, competition and active involvement can inflate confidence and generate the illusion of control.

Two components include the desire for control and belief in good luck.

Can lead to:

1.      More trading

2.     Undiversified portfolios.

3.     Use of limit orders and other techniques.  Idea is that limit orders give a false sense of control and the reality that an eighth or quarter percent really has no impact on the total returns.

4.     Contributes to overconfidence.

Advice:

 Recognize that successful investing is a probabilistic activity.

1.     Recognize and avoid circumstances that trigger susceptibility illusion of control.

2.     Seek contrary advice.

3.     Write down decisions for trades.

BF9:  Conservatism Bias

Bias Type:  Cognitive

A mental process in which people cling to their prior views or forecasts at the expense of acknowledging new information.  Can cause people to under react to new information.  Tends to over rate base rates and under react to sample evidence.  As a result, they fail to accept changes and their view of reality is distorted.

People tend to underweight abstract information, such as statistics, and overweight information that is easily processed.  This tendency is attributed to the cognitive cost to processing larger amounts or more difficult information.

Forecasts tend to follow real indices, not vice versa, as one would expect.

Implications:

1.      Conservatism can cause investors to cling to a view and become inflexible.

2.     Tend to react too slowly.

3.     May cause investors to discount new information if it is difficult to process.

Over reaction:  If a stock is crushed due to news, it might be a good time to buy if fundamentals are sound.  People tend to overreact to news that can be easily processed.

Under Reaction:  If a stock rises on good earnings news, it might be a good time to purchase.  Earnings is considered abstract or statistical and people tend to under react to the news.

Advice:

1.      Do not cling to forecasts.  In fact, be prepared for either possibilities.  Note also the preparation for wider ranges of possibilities.

2.     Evaluate new information rationally.  Pro/con sheet that can be added to.

BF10:  Ambiguity Aversion Bias

Bias Type:  Cognitive

People tend to hesitate when the odds are unknown.  Risk is a gamble with certainty.  Uncertainty arises when the distribution of possible outcomes is unknown.

Note:  Crossing biases one might say risk is a gamble with ‘perceived certainty’.

An individual expectation of utility is weighted by the individuals subjective probability assessment.  When someone feels more skillful, the more certain they feel about making judgment calls.  Whether the call are predictable, or, just imaginative.  Falls in line with the illusion of control bias.

Can cause:

1.      Investors to expect higher returns.

2.     May restrict investors to their own national index.

3.     A belief that their own employers stocks are safer.

4.     May affect investors by believing they have the ability to predict events that are truly ambiguous in which distributions are unknown.

BF11:  Endowment Bias

Bias Type:  Emotional

When someone values an asset more when they hold the property rights to it more than when they don’t.  Economic theory states a person’s willingness to pay for a good or object should always equal the person’s willingness to accept dispossession of the good or object.  People tend to state minimum prices to sell an item higher than the maximum they are willing to pay for it.  Ownership endows the asset with added value.

A mental process of which a differential weight is placed on the value of an object.  Value depends on someone in possession of an object to sell, or someone not in possession and willing to buy. 

Investors prove resistant to change once they become endowed with the ownership of the security.

1.      Influences investors to hold onto securities that they inherited.  Regardless of financial risk.

2.     Causes investors to hold onto stocks they already own.

3.     Can cite or be influenced by tax or transaction costs as a reason not to sell.

4.     May bias toward a hold due to familiarity.

BF12:  Self Control Bias

Bias Type:  Emotional

A tendency for people to consume today at the expense of saving for tomorrow.  Money is an area that people notoriously display a lack of self control.  People tend to sabotage their long term goals for temporary satisfaction.

Most of the chapter was aimed at saving decisions for retirement, rather than behaviors in the market.  However, there is a link between how someone spends (purchases) stocks and self control.

BF13:  Optimism Bias

Bias Type:  Emotional

Most people with respect to a personal trait, sense of humor, looks, aptitude, tend to rate themselves higher than the populations.  Investors also rate themselves higher in the context of positive performance, the markets , and the economy as they tend to be optimistic.

Investors tend to take an inside view rather than an outside view.  Inside view meaning reviewing the current situation with personal involvement (illusory control bias).

Outside view is a dispassionate assessment of the current situation in light of results gained from the past and/or related situations.

The inside view generally consists of data from the specific object being evaluated (stock).  The outside view would consist of data from a set of objects (sector).  Investors may focus on the individual stock rather than a sector or even the macro economic environment.

Undue optimism can be financially harmful because it creates the illusion of some unique insight or upper hand.

The optimism bias can:

1.      Encourage investors to load up on one stock.

2.     Believe they are getting market like returns.

3.     Read too much into rosy forecasts.

BF14:  Mental Accounting Bias

Bias Type:  Cognitive

People’s tendency to categorize and evaluate economic outcomes by grouping their assets into non interchangeable accounts.  In other words, treating money differently due to its source (inheritance, work, gambling winnings, etc…).  A form of mental framing.

People mentally allocate wealth over three allocations:

1.      Current income.

2.     Current Assets.

3.     Future Income

The propensity to consume is greatest from the current income account, and is more conservative from the future income account.

People tend to separate money from different accounts.  Money (cash) is treated differently than credit cards.

Mental accounting can cause:

1.      People to differentiate between capital gains and interest.  People tend to preserve capital gains and spend interest.

2.     Can cause the ‘house money’ mentality which lends to escalated risk when wealth grows.

3.     Investors to hang onto stocks that once generated gains, but now do not.

Advice.

1.      Understand and develop correlations between investment classes.  In other words, distinguish how they are the same rather than how they are different.

2.     Make total returns the priority.

3.     Understand house money effect.  The gains do not change value, nor should they be mentally changed.

4.     Understand the concept of clinging to securities.

BF15:  Confirmation Bias

Bias Type:  Cognitive

It is the peculiar and perceptual error of the human understanding to be more moved and excited by affirmatives than by negatives.

Refers to a type of selective perception that emphasizes ideas that confirm our beliefs, while devaluing whatever contradicts them.  We attach undue emphasis on what we want to see and down play contrary evidence.

This bias encourages people to look for and affirm their belief, rather than to look for contrary evidence to the belief.  People excessively value confirmatory  evidence that affirms their belief, rather than looking for contrary evidence to the belief.  People excessively value confirmatory information.  People find it cognitively easier to find information that supports a position rather than to challenge the position.

Tends to lead investors into non diversified portfolios and larger positions.  Focusing on a payoff of the present may hurt you if you haven’t considered the downside risk of a significant change.

Advice:  Develop multiple indicators and quantitatively evaluate them.

Awareness to the confirmation bias is the best way to deal with it.  As well as focusing on seeking contrary positions or different angles to view potential outcomes.

BF16:  Hindsight Bias

Bias Type:  Cognitive

Is the impulse that insists: ‘I knew it all along.’  People tend to perceive that the event was predictable, even if it wasn’t.  It is precipitated because actual outcomes are more readably grasped than the infinite array of outcomes that could have but didn’t materialize.

Unpredictable events bother people, since its embarrassing to be caught off guard.  Hindsight bias alleviates embarrassment under these circumstances.  It blunts surprises and populates our horizons with inevitabilities.

A person subject to the hindsight bias assumes the outcome they observed is the only outcome that was ever possible.  Thus, underestimating the uncertainty preceding the event and underrates the outcomes that could have materialized.

Susceptibility to the hindsight bias hinders learning and invokes other biases, such as anchoring and illusory control bias.  Can also give investors a false sense of security.

In short, the hindsight bias allows investors to rewrite history in their favor. However, a rewrite after doing well supplies investors with a false sense of security.  Re-writing negatively eliminates that ability to identify signals or mistakes.  Either one clouds reality.

Hindsight bias can come into play when reviewing historical data.  As new indexes, trading mechanisms, and reporting changes are implemented, one may find themselves comparing apples to oranges with data stretched over long periods of time.

BF17:  Loss Aversion Bias

Bias Type:  Emotional

People generally feel a stronger impulse to avoid losses than to acquiring gains.  A loss generally considered to have twice the motivating power as making gains.

Can prevent people from unloading profitable investments.  Getting back to even (purchase price anchor) can block what might be a better response of selling hurt securities and redeploying the assets.

Disposition Effect:  is the desire to hold losing investments to long (risk seeking) and to sell winning investments too quickly (risk avoidance).

Loss aversion instigates increased risk, with lower returns.  Investors should take risks to increase gains, not mitigate losses.

BF18:  Recency Bias

Bias Type:  Cognitive

A predisposition of people to more prominently recall and emphasize recent events and observations than those that occurred in the near or distant past.  When attempting to recall items from a list, people tend to remember the first items given (primacy effect) and the later items (recency effect0.

The recency bias privileges information recently retained and neglects observations not as fresh in the mind.

Investors tend to:

1.      Chase returns rather than understanding the business cycle.

2.     To extrapolate patterns from narrow samples of historical data.

3.     Susceptible to overconfidence.

4.     Can cause the ‘its different this time’ effect.

5.     To shift focus from underlying value to current price.

6.     Causes imbalanced portfolios.

The recency bias also tends to invoke the anchoring bias.

Advice:

1.      Make sure you have large enough sample sizes.

2.     Keep value at forefront of your mind, rather than the price.

3.     Remember to be properly diversified.

BF19:  Regret Aversion Bias

Bias Type:  Emotional

People that avoid taking decisive actions because they fear that, in hindsight, whatever course they choose will be less optimal.  It forestalls the pain and regret associated with poor decision making.

When are experiences negative investment outcomes they are intrinsically driven to retreat, conserve, and to heal.  Its at these times that depressed prices occur and present the best buying opportunities.

Can also occur when gains start to accrue.  Individuals may hold onto securities in fear the price may continue to rise and they lose out on profits.

Error of Commission:  Erred by committing to the action.

Error of Omission:  Erred by not committing to an action.

Regret aversion can trigger risk avoidance and make investors timid.  Can be elevated and investors may feel a dread of feeling responsible for their own misfortunes.

Can cause investors to:

1.      Act too conservitaley.

2.     Shy a way from depressed markets.

3.     Held onto losing positions.

4.     Herding Behavior.

5.     Prefer stocks of ‘good companies’ that are ‘reliable’ or ‘safe’.  These companies lend to have lower returns.

6.     Hold onto winning stocks too long.

Advice:

1.      Some risk is healthy and should be part of a portfolio.

2.     Best advice is to buy low and sell high.  However, our nature contradicts this philosophy.

3.     First loss is the best loss.

4.     Questioning motivations can counter herd mentality.

5.     On selling, if you have objective reasons for selling, but your only reason for not is fear of losing gains, its probably a good time to sell.

BF20:  Framing Bias

Bias Type:  Cognitive

Tendency of decision makers to respond differently to situations based on the context in which the choice is framed (presented).  A decision maker’s subjective conception of the acts, outcomes and contingencies associated with a particular choice.

Narrow Framing:  Occurs when people focus on only one or two aspects of  a situation, excluding other crucial aspects, thus compromising their view of reality.

Example:  Two portfolios of equal weights and descriptions.  When presented to a client, it can be framed in two ways.

a.      It has a 70% chance reaching the client’s financial goals.

b.     There is a 30% chance it will not reach the client’s financial goals.

Portfolio A is framed more attractively as it describes what will be gained.  Portfolio B is negatively framed as it emphasizes the loss.

Framing and loss aversion biases can work together.

1.      If an investor just suffered losses, they may be more tolerant to risk.

2.     Those that have made gains may become risk adverse and go for the sure thing.

Framing can affect decision making not only in terms of how one presents questions to themselves, but also in how the raw data was collected and evaluated.

If a questioned is framed to elicit a loss, the recipient may be inclined to enter risk seeking behavior.

 If a question is framed to elicit a gain, the recipient may be inclined to adopt risk adverse behavior.

Investors who’ve been faring poorly will seek out risk while those pleased with returns will play it safe.

Be aware of Bias when evaluating personal risk tolerance.  How you ask questions can warp your evaluation and subsequent decision.  Find ways to ask your self neutral questions.

FB21:  Status Quo Bias

Bias Type:  Emotional

A bias that predisposes people, who are presented with multiple choices, to choose the one that extends current conditions in lieu of other options that my bring about change.

A finding that an option is more desirable if it is designated as the ‘status quo’ than when it is not.  Status quo implies an anchoring bias.

Things do not change, we do.