Applied Behavioral Finance

Question 1

Questions to consider in regard to your clients

Answer 1

1) Are you adding value to your clients?
2) Are you effectively communicating your wealth to your clients?

Question 2

Every behavioral framework can be summarized as:

Answer 2

Correcting or Moderating cognitive errors
Accommodating emotional biases

Question 3

Types of Cognitive Errors

Answer 3

Belief Perseverance Biases
* Conservatism
* Confirmation
* Representativeness
* Illusion of Control
* Hindsight
Information-Processing Biases
* Anchoring and Adjustment
* Mental Accounting
* Framing
* Availability

Question 4

Types of Emotional Biases

Answer 4

• Loss Aversion
• Overconfidence
• Self Control
• Status Quo
• Endowment
• Regret Aversion

Question 5

What to consider when deciding to Moderate or Accommodate a client?

Answer 5

1) Client’s level of wealth (Fundedness)
2) Nature of client’s behavioral biases

Question 6

Loss Aversion

Answer 6

Feeling twice as bad about a loss as we feel good about an equivalent gain
Preferring to avoid losses over achieving gains

Question 7

Herding

Answer 7

The tendency to conform to group behavior, following the crowd

Question 8

Recency Effect

Answer 8

Overemphasizing recent experiences when making a decision

Question 9

Availability Bias

Answer 9

A cognitive bias where overweighting information that comes most easily to mind or is readily available

Question 10

Heuristics

Answer 10

Cognitive shortcuts or rules of thumb that simplify decision-making

Question 11

Overconfidence Bias

Answer 11

An emotional bias where confidence in one’s own judgment is greater than the objective accuracy of that judgment

Question 12

Recency Bias

Answer 12

A cognitive bias where people are easily influenced by recent news events or experiences
Believe recent events will continue in the future

Question 13

Confirmation Bias

Answer 13

A cognitive bias where there’s a tendency to seek information that reinforces their perception
Seeking information that confirms preexisting beliefs

Question 14

Familiarity Home Bias

Answer 14

Make decisions based on own/familiar experiences

Question 15

Anchoring/Adjustment Bias

Answer 15

A cognitive bias where people have the tendency to focus on specific reference points when making investment decisions

Question 16

Top Five Client Behavioral Biases

Answer 16

• 35% Recency Bias
• 26% Loss Aversion
• 25% Confirmation Bias
• 23% Familiarity Home Bias
• 22% Anchoring Bias

Question 17

Cognitive Biases

Answer 17

Biases that involve how people think

Question 18

Emotional Biases

Answer 18

Biases that involve how people feel

Question 19

Status Quo Bias

Answer 19

An emotional bias where people like to maintain things the way they are
Things have always been this way, so they feel comfortable keeping them the same

Question 20

Endowment Bias

Answer 20

An emotional bias where people assign a greater value to an investment they already own

Question 21

Hindsight Bias

Answer 21

A cognitive bias where people perceive past investment outcomes as if they had been predictable

Question 22

Framing Bias

Answer 22

A cognitive bias where people respond to situations differently based on the context in which the choice is presented

Question 23

Cognitive Dissonance Bias

Answer 23

A cognitive bias where multiple beliefs intersect and contradict each other. People try to alleviate this discomfort and find ways to rationalize decisions

Question 24

Regret Aversion Bias

Answer 24

An emotional bias where people avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove unwise

Question 25

Conservatism Bias

Answer 25

A cognitive bias where people cling to a prior view or forecast at the expense of acknowledging new information

Question 26

Availability Bias

Answer 26

A cognitive bias where people estimate the probability of an outcome based on how prevalent that outcome appears to be in their lives

Question 27

Representativeness Bias

Answer 27

A cognitive bias that occurs because of a flawed perceptual framework when processing new information Sometimes, they will project outcomes that resonate with their own preexisting ideas

Question 28

Self-Attribution (Self-Enhancing) Bias

Answer 28

A cognitive bias where people have a tendency to ascribe their successes to their own innate talents and to blame failures on outside influences

Question 29

Self-Control Bias

Answer 29

An emotional bias which is the tendency to consume today at the expense of saving for tomorrow

Question 30

Affinity Bias

Answer 30

An emotional bias which refers to people's tendency to make irrationally uneconomical decisions based on how they believe a certain product or service will reflect their values

Question 31

Outcome Bias

Answer 31

A cognitive bias that occurs when people focus on the outcome of a process rather than on the process used to attain the outcome

Question 32

Illusion of Control Bias

Answer 32

A cognitive bias that occurs when people believe that they can control or at least influence investment outcomes when they cannot

Question 33

Biological Processes Involved in Financial Decision Making

Answer 33

Amygdala - fight or flight; reptilian part; an intuitive part of the brain Mammalian part of the brain - creating preferences for different decisions that could be made Prefrontal cortex - where logical decisions are made and tradeoff decisions are made Exocortex - handing off complex decisions to outside sources, primarily through technology

Question 34

Intuitive Decision-Making

Answer 34

Thought of as decisions that don't take much effort to come to a conclusion Very intuitive, instinctual reaction to a choice

Question 35

Deliberative Decision-Making

Answer 35

Making a specific choice between options after thought and reason went into it

Question 36

Expected Value Theory

Answer 36

The comparison of an anticipated average value/return of one scenario with an anticipated average value/return of another scenario Determining the weighted averages of potential outcomes to see which one is more favorable

Question 37

Describe Descriptive Utility Function Theory

Answer 37

Whether or not people are willing to put the risk on the table to receive a particular gain, even if there's an infinite expected value Making decisions based on whether a person is risk averse or not

Question 38

Describe Prescriptive Utility Function Theory

Answer 38

A more mathematical model to determine the risk aversion of the average person

Question 39

Describe Mean Variance Model

Answer 39

Mathematically create an efficient portfolio for a rational person Being able to create the most optimal portfolio for a person

Question 40

Describe Prospective Theory

Answer 40

Investors value gains and losses differently, placing more weight on perceived losses versus perceived gains

Question 41

Describe Adaptive Market Hypothesis

Answer 41

It reconciles Efficient Market Hypothesis (EMH) with research in behavioral economics Markets evolve over time as individuals different heuristics and biases to make decisions

Question 42

Preserver Investor Personality Type

Answer 42

An investor who places a great deal of emphasis on financial security and preserving wealth, rather than taking risks to grow wealth

Question 43

Follower Investor Personality Type

Answer 43

An investor who is passive and often lacks interest in and/or has little aptitude for money or investing

Question 44

Independent Investor Personality Type

Answer 44

An investor who has original ideas about investing and likes to get involved in the investment process

Question 45

Accumulator Personality Type

Answer 45

An investor who is interested in accumulating wealth and is confident that he or she can do so

Question 46

What are the Bailard, Biehl, and Kaiser Investor Models?

Answer 46

1. Individualists – They are confident and careful. Generally do not go to a consultant to manage their investments but do it themselves 2. Adventurers – Generally go for only big bets. have the resources to do so and willing to take risks. Investments are generally focused and not diversified 3. Celebrities – Swayed too much by the trend and do not have any expertise or opinion about investments. Approach investment managers frequently 4. Guardians – Both anxious and careful. Lacking confidence, they approach investment counsels. Generally emphasize safety of the capital while making the investments and a significant proportion of their investments is generally devoted to government securities and guaranteed return investments 5. Straight arrows – Halfway between complete confidence and anxiety, and extreme carefulness and impetuousness

Question 47

Mental Accounting

Answer 47

Treating various sums of money differently based on where these monies are mentally categorized