CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r06 the behavioral biases of individuals summary

Behavioral Bias Categories Behavioral Biases Cognitive Emotional Belief perseverance biases: hold on to original beliefs; react selectively to new information Information processin

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Level III

The Behavioral Biases of Individuals

Summary

Behavioral Bias Categories

Behavioral

Biases

Cognitive

Emotional

Belief perseverance biases:

hold on to original beliefs; react selectively to new information

Information processing biases:

process information incorrectly;

memory errors; faulty reasoning

Biases influenced by feelings and emotion; avoid pain, produce pleasure

Conservatism Confirmation Hindsight Illusion of Control Representativeness

Framing Anchoring & Adjustment Mental Accounting Availability

Loss-Aversion Overconfidence Self Control Endowment Regret Aversion Status Quo

Cognitive Belief Perseverance Biases

Bias Description Examples/Implications

Conservatism Maintain prior views by

inadequately incorporating new information

• Hold winners or losers too long

• Under-react to new information

Confirmation Look for and notice what

confirms prior beliefs

• Focus on confirmatory/positive information about existing investments

• Over-react to confirmatory/positive information

Hindsight See past events as having been

predictable

• Overestimate the degree to which a prior event was predictable

Illusion of Control False belief that we can

influence or control outcomes

• Feeling of control over company where one works

Representativeness Classify new information based

on past experiences

• Look for patterns in new information

• Over-optimism about a past winner

• Treat small sample as “representative” of entire population

• Invest in companies that remind one of successful clients

C C H I R

Cognitive Information-Processing Biases

Bias Description Examples/Implications

Framing Answer question differently based on

how it is asked/framed

• A and B are similar but A has a 20% chance of loss and B has a 80% chance of not resulting in a loss Client picks B

Anchoring and

Adjustment

Incorrect use of psychological heuristics

• Place high weight on anchor  under-react to new information

• Influenced by purchase price or arbitrary price levels

Mental

Accounting

Treat one sum of money different from other depending on source or use

• Current income, assets and PV of future income treated differently

• Investing some money very conservatively and the rest in speculative stocks

Availability Influenced by how easily outcome

comes to mind

• Place high weight on easily available information  influenced by advertising

• Select alternatives with which one has greater resonance; select alternatives that are easily retrievable

F A M A

Emotional Biases

Bias Description Examples/Implications

Loss Aversion Prefer avoiding losses over

achieving gains

• Hold on to losing stocks too long and sell winning stocks too early (also called “disposition effect”)

Overconfidence Unwarranted faith in ones

abilities (Illusion of knowledge;

self attribution)

• Excessive trading

• Narrow confidence intervals

• Assign high probability of success

Self-Control Fail to act in pursuit of long

term goals

• Focus on short-term satisfaction

• Fail to save enough for the future

Endowment People value asset more when

they hold rights to it

• Shares in father’s company a source of family pride

Regret Aversion Avoid pain of regret associated

with bad decisions

• Prior decision which resulted in a loss, stops client from making the same decision; client will be upset if he sell a share and it goes up

Status Quo Do nothing rather than make a

change

• Hold on to securities even if they are inconsistent with risk/return objectives; trade very infrequently

L O S E R S

The decision to moderate or adapt to a client’s behavioral biases during the asset allocation

process depends on two factors:

1) Client’s level of wealth

• High wealth  low SLR  adapt to biases

• Low wealth  high SLR  try to moderate biases

2) Type of behavioral biases the client exhibits

• Emotional  adapt to biases

• Cognitive  try to moderate biases

Moderate Biases Versus Adapt Portfolio to Biases

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Level III

The Behavioral Biases of Individuals

Appendix

Cognitive Errors

• stem from statistical, information processing or memory errors (e.g inability to do complex

mathematical calculations)

• can arise due to faulty reasoning based on faulty thinking

• can be corrected through better information, education, or expert advice

Emotional Biases

• are influenced by feelings and emotion

• are usually related to human behavior (avoid pain and produce pleasure)

• arise spontaneously as a result of attitudes and feelings

• are less easy to correct relative to cognitive biases

Cognitive Errors

• Conservatism Bias  Maintain prior views by inadequately incorporating new information

• Confirmation Bias  Look for and notice what confirms beliefs

• Representativeness Bias  Classify new information based on past experiences

• Illusion of Control Bias  False belief that we can influence or control outcomes

• Hindsight Bias  See past events as having been predictable

• Anchoring & Adjustment Bias  Incorrect use of psychological heuristics

• Mental Accounting Bias  Treat one sum of money (or source of return) as different from other

• Framing Bias  Answer question differently based on how it is asked

• Availability Bias  Heuristic approach influenced by how easily outcome comes to mind

Belief perseverance biases: being selective in dealing with new information challenging existing beliefs

Information processing biases: processing information in an illogical and irrational way

Conservatism bias refers to maintaining prior beliefs or forecasts by improperly incorporating new information

How to identify? Individuals suffering from this bias tend to

• “under-react” to new information, “react slowly” to new information, underweight the new information

• exhibit discomfort or difficulty in processing new information

Implications: maintain previous view or earnings forecasts, hold winners or losers too long in portfolios

How to overcome: first recognize that bias exists, adequately analyze the impact of new information, seek advice from experts

Confirmation bias (selection bias) refers to seeking information that confirms one’s beliefs

How to identify? Individuals suffering from this bias tend to

• “over-react” to new information

• focus on (ignore) confirmatory/positive (negative) information about existing investment

• include only those investments in portfolio that meet their criteria

Implications: this bias leads individuals to overweight those investments in their portfolios about which they are

optimistic, leading to: under-diversified portfolio, excessive exposure to risk, biased screening criteria

How to overcome? In order to correct or reduce this bias, individuals should

• collect complete information, including contradictory information

• use more than one method of analysis

• get corroborating support for an investment decision

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Representativeness bias refers to classifying new information based on past experiences

How to identify? Individuals suffering from this bias tend to

• look for similar patterns in new information

• be overly optimistic about a past winner

• treat a small sample as “representative” of entire population

Implications: this bias results in long-term underperformance of portfolio due to excessive trading and high

manager turnover (owing to focus on short-term performance)

How to overcome? In order to correct or reduce this bias, individuals should follow an appropriate asset

allocation strategy and avoid chasing returns; use “periodic table of investment returns” whereby asset classes’

returns are ranked over time

Illusion of control bias refers the false belief that one has the ability to exert influence over uncontrollable

events

How to identify? Individuals suffering from this bias tend to invest in companies over which they are perceive to

have some control (e.g employer’s company stock)

Implications: this bias results in:

• long-term underperformance of portfolio due to excessive trading

• under-diversified portfolios due to concentrated position in few companies

How to overcome? In order to correct or reduce this bias, individuals should document rationale underlying each

trade; maintain a long-term perspective rather than chasing returns; seek contradictory viewpoints

Mental accounting bias refers to classifying money based on its source [that is, current income (e.g salary),

currently-owned assets (e.g bonus), and the present value of future income (e.g inheritance)] or planned use (e.g leisure, necessities)

How to identify? Individuals suffering from this bias tend to treat their portfolio as a layered pyramid of assets

representing different investment goals

• ignore correlations among various assets and do not make investment decisions in risk/return context

• treat principal and income as non-fungible account and ignore total return (treating returns derived from

income differently from that of capital appreciation)

Implications: this bias results in suboptimal and poor performing portfolio due to inefficient asset allocation

How to overcome? To correct or reduce this bias, individuals should focus on total return by considering

correlations among various assets

Framing bias refers to tendency of people to respond differently based how questions are asked (framed)

How to identify? Individuals suffering from this bias tend to focus on a narrow frame of reference while ignoring

larger context (referred to as narrow framing)

Implications: this bias results in suboptimal portfolio due to: misidentification of risk tolerances, selection of

suboptimal investments, excessive trading

How to overcome? In order to correct or reduce this bias, individuals should focus on future prospects of

investment (i.e expected risk/return) while making investment decisions rather than referring to gains and losses already incurred; remain neutral & open-minded when interpreting investment-related situations

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Availability bias involves placing higher weight to information which is readily available or easily recalled

There are following four sources of availability biases: retrievability, categorization, narrow range of experience,

resonance (overestimating the probability of an outcome that matches with one’s way of thinking)

How to identify? Individuals suffering from

• “retrievability” tend toselect investment or investment advisor based on advertisements (e.g by industry trade groups and from blogs sponsored by the companies), rather than considering additional independent resources or performing proper due diligence

• “categorization” tend to focus on a limited set of investments E.g restrict investments to stocks and bonds of one country only

• “narrow range of experience” tend to make investment decisions based on their familiarity with the industry or country

• “resonance” tend to invest in companies that match their own personal likes and dislikes

Implications: this bias results in suboptimal and under diversified portfolio due to inappropriate asset allocation

resulting from limited investment opportunity set

How to overcome? In order to correct or reduce this bias, individuals should

• follow an appropriate and disciplined investment policy strategy consistent with risk/return objectives and

constraints

• perform a thorough analysis and research while making investment decisions

• focus on long-term outcomes rather than chasing short-term results

Anchoring & adjustment bias refer to developing estimates based on an “anchor” value (e.g target price) and

adjusting decisions up or down based on that value

How to identify? Individuals suffering from this bias tend to: under-react to new information, place higher weight to the anchor, be influenced by purchase “points,” or arbitrary price levels or price indexes

Implications: due to this bias, individuals remain “anchored to” original estimates (anchor values); investment

decisions become difficult to reverse when the new information indicates that a change is advisable

How to overcome? In order to correct or reduce this bias, individuals should

• avoid making investment decisions based on past /“anchor” value

• examine new information objectively

End of cognitive biases! Moving to emotional biases…

Endowment bias refer to exhibiting an emotional attachment to the asset owned This bias is also related to the

“familiarity bias” in which people tend to prefer assets with which they are familiar and view them as less risky

How to identify? Individuals suffering from this bias tend to hold on to inherited/purchased securities in order to

avoid the feelings of disloyalty associated with selling those securities

Implications: this bias results in inappropriate asset allocation

How to overcome? In order to correct or reduce this bias, individuals should

• treat inherited investments as cash and then invest that cash based on investment goals

• objectively review the historical performance of securities

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Loss-aversion bias is the tendency of people to prefer avoiding losses as opposed to achieving gains Sub-categories of

loss-aversion bias are 1) house money effect: exhibiting risk-seeking attitude in dealing with someone else’s money and

2) myopic loss aversion: exhibiting greater sensitivity to losses than to gains

How to identify? Individuals suffering from this bias tend to

• accept more risk to avoid losses than to achieve gains (myopic loss aversion)

• have risk-seeking (convex) utility function for gains and a risk-averse (concave) utility function for losses

• suffer from the disposition effect, which is the tendency to realize gains early (selling winning stocks too early) and delay recognizing losses (holding losing stocks too long)

• think of outcomes in terms of gains and losses relative to some reference point

• treat profit as if it belongs to someone else and thereby take higher risk when investing it (house-money effect) Implications: this bias results in

• long-term underperformance of portfolio due to focus on short-term results despite having long-term investment goals, leading to excessive trading, high transaction costs and poor investment returns

• riskier portfolio with limited upside potential

• suboptimal portfolio returns as a result of holding losing investments and selling winning ones

How to overcome? In order to correct or reduce this bias, individuals should

• use a disciplined approach based on fundamental analysis

• rationally evaluate probabilities of future losses/gains

Overconfidence bias is the tendency of people to overestimate one’s ability to accurately process, access, and predict

information Overconfidence bias has aspects of both cognitive and emotional errors but emotional aspect dominates

Sub-categories: Illusion of knowledge bias refers to misperceiving an increase in the amount of information available

as having greater knowledge Self-attribution bias refers to taking too much credit for success (self-enhancing) while

denying any personal responsibility or blaming external factors (e.g luck) for failures (self-protecting)

How to identify? Individuals suffering from this bias tend to

• estimate narrow confidence intervals (known as prediction overconfidence)

• assign higher probabilities of success to outcomes (known as certainty overconfidence)

• underreact to new information

Implications: this bias results in:

• excessive trading, leading to higher transaction costs and lower returns

• underestimation of risks and overestimation of expected return, leading to poorly diversified portfolios

How to overcome overconfidence bias? In order to correct or reduce this bias, individuals should:

• critically review trading records

• calculate portfolio performance over 2+ years

• conduct post investment analysis on both successful and unsuccessful investments

• try to gather complete information when making investment decisions