General Principles Chapter 1: Behavioral Finance

Question 1

Heuristics

Answer 1

Experiences and biases that can facilitate problem-solving and probability of judgement. These strategies are generalization, or rules-of-thumb, reduce cognitive load.
Examples: using trial and error, a rule of thumb, or an educated guess

Question 2

Financial Infidelity

Answer 2

happens when one partner, typically a spouse, lies to the other about debts, credit cards, keeps money in a secret account, hides purchases and otherwise hides or lies about money. There can still be a sharing of money, assets, and financial decisions within the relationship.

Question 3

Anchoring

Answer 3

the tendency of investors to become attache to specific price as the fair value of a holding

Question 4

Attachement Bias

Answer 4

holding onto an investment for emotional reasons rather than considering more practical applications
example: my grandfather left my this stock so I can never sell it

Question 5

Endowment Bias

Answer 5

The endowment effect describes an emotional bias that causes individuals to value an owned object higher, often irrationally, that its real-world market value. In reality, you might not even purchase the asset if you didn’t already own it.

Question 6

Financial Enmeshment Bias

Answer 6

happens when the finances of parents and children are inappropriately commingled. There are position papers that argue that situations like pursuing college education, tight job markets and expensive housing costs may lead to financial enmeshment. Excessive financial enmeshment may lead to children having a lack of financial motivation and even to lowered confidence and self-esteem.

Question 7

Cognitive Dissonance

Answer 7

the challenge of reconciling two opposing beliefs

Question 8

Confirmation Bias

Answer 8

The natural human tendency accept any information that confirms our preconceived position or opinion and to disregard any information that does not support that preconceived notion

Question 9

Diversification Errors

Answer 9

investors tend to diversify evenly across whatever options are presented to them

Question 10

Fear of Regret

Answer 10

the tendency to take no action rather than risk making the wrong
example: an investor who holds onto a stock that’s losing value, because if they sold it and it rebounded they would feel even worse

Question 11

Gambler’s Fallacy

Answer 11

an individual erroneously believes that the onset of a certain random event is likely to happen following an event or series of events

Question 12

Herd Behavior

Answer 12

the tendency for individuals to mimic the actions of a larger group. Can also be described as Fear of Missing Out (FOMO)

Question 13

Hindsight Bias

Answer 13

the 20/20 vision we have when looking at a past event and thinking we understand it, when in reality we may not

Question 14

Inappropriate Extrapolation

Answer 14

the tendency to look at recent events (or market performance) and assume that those events or conditions will continue indefinitely
example: the bond market has outperformed the stock market for the past year and will continue to do so for the future because of the continued economic downturn

Question 15

Analysis Paralysis

Answer 15

Describes an individual/couple overanalyzing a situation and can cause decision making to become ‘paralyzed’, meaning that no solution or course of action is decided upon.
When the fear of either making an error outweighs the potential value of success in a decision made in a timely manner

Question 16

Loss Aversion and Risk Taking

Answer 16

while investors are risk averse when it comes to gains (they do not want to give them up), they are risk seeker when it comes to losses (they will take big risks to avoid realizing them). Emotion has clouded the decision. Compounding the problem is that investor’s view errors of omission as worse than errors of making a bad decision

Question 17

Prospect Theory

Answer 17

describes the different ways people evaluate losses and gains. researchers found that losses have much greater negative impact than a commensurate gain will have positive

Question 18

Mental Accounting

Answer 18

entails looking at sums of money differently, depending on their source or the intended use

Question 19

Outcome Bias

Answer 19

tendency to make a decision based on the desired outcome rather than on the probability of that outcome

Question 19

Overconfidence

Answer 19

tendency to place too much emphasis on one’s own abilities, often works hand in hand with confirmation bias

Question 19

Overreaction

Answer 19

investors emotionally react towards new market information

Question 20

Over-Weighting the Recent Past

Answer 20

investors like patterns, and recent past represents a nice, easy-to-find pattern that can become the basis for an investment decision

Question 20

Self-Affirmation Bias

Answer 20

belief that when something goes right, it is because you were smart and made the right decision. If it does not work out, it someone else’s fault or simply bad luck

Question 21

Spotting Treat That Are Not There

Answer 21

investors seek patterns that help support decision sometimes without adequate confirming research

Question 22

Status Quo

Answer 22

tendency of investors to do nothing when action is actually called for

Question 23

Money Avoidance

Answer 23

Feeling that money has a negative connotation and ignore personal finances to avoid emotional distress Example: "money is the root of all evil" Ways to deal with: disassociating the idea of good and evil from money, as well as regularly scheduling time to review and check on your finances

Question 24

Money Worship

Answer 24

belief that happiness externally comes from, and directly related to, having more wealth. Example: could be compulsive spending towards a never-ending goal of obtaining monetary things to provide happiness Ways to deal with: shifting the emphasis towards non-monetary things in your life that bring you joy including meditation, exercise, relationships, pets, hobbies, etc.

Question 25

Money Vigilance

Answer 25

being concerned and aware of one's financial wellbeing; with important and emphasis being placed on savings and being prepared Example: being overly cautious with money to the extent that enjoyable things (vacations) are sacrificed Ways to deal with: include achieving a balance of feeling secure with savings, while still spending money on things that make you happy

Question 26

Money Status

Answer 26

belief that one's internal value and self-worth is directly correlated to their financial worth, and that to be a better person, they need more. Example: include overspending, hiding finances from others and associating shame with lack of money Ways to deal with: could include uncovering and resolving the root cause of this mindset, often instilled during childhood and separating your worth from your amount of wealth. Similar to money worship but worship tends to have involve more excessive spending

Question 27

Framing Effect

Answer 27

Cognitive bias, in which a person makes decision based on whether the various options are presented oin a positive or negative way, meaning individuals can tend to overlook factual data. This person is affected by how the information worded rather than the actual information

Question 28

Money Illusion

Answer 28

an economic theory positioning that people have a tendency to view their wealth in nominal dollar terms rather than real terms which must take inflation into into consideration. Also called "price illusion"