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Sources of cognitive biases

Errors :

Statistical
Information processing
Memory

Or result from reasoning based on faulty thinking.

1

Emotional biases caused by

Impulse
Intuition

Or result from reasoning influenced by feelings

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Adjectives describing traditional vs behavioral finance

Traditional finance - prescriptive
Behavioral finance - descriptive

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Utility theory

People maximize PV of Utility considering PV of budgetary contraints.

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4 axioms of utility

Completeness - people choose A or B or are indiferent
Tranzitivity - if A is better than B and B is better then C then A is better then C
Continuity - inlimited amount of optins to combine A with B to get a constant (indiferent) level of utility
Independence - if A is better than B then A+xC is better than B+xC

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Bayes formula

P(A/B) = P(B/A) * P(A) / P(B)

Probability A happening given B already happenend =...

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Utility wealth function for risk NEUTRAL individual is

A straight line with positive slope.

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Utility ealth function for risk AVERSE individuals is

Concave curve.

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Utility wealth function of risk SEEKING individuals is

Convex curve.

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Bounded rationality assumes...

assumes knowledge capacity LIMITS and
removes the ASSUMPTIONS of
...perfect information,
...fully rational decision making, and
...consistent utility maximization.

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Satisficing is when individuals

Find acceptable/satisfactory solution as opposed to optimal.

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7 steps of Editing/framing part of decision process


... Codification
... Combination
... Segregation
... Cancelation
... Simplification
... Dominance detection

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Behavioral approach to asset pricing

Discount rate used in asset valuation should include a SEMNTIMENT premium (which accou ts for dispersion of analyst estimates)

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Behavioral portfolio theory - portfolio are constructed...

in layers to satisfy goals rather than to be mean variance efficient.

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Benavioral life cycle hypothesis - Suggests people classify their...

... assets into nonfungible mentals accounts when planning savings/consumption and as a result achieve a non optimal balance between short term gratification and LT goal achievement.

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Cognitive errors - 2 categories

Belief perseverance biases
Information processing biases

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5 Cognitive errors... Belief perseverance biases

CRICH

Are related to cognitive dissonance - mental discomfort when new infomration contradicts with oreviously held beliefs

CONSERVATISM. Slow or unwilling to react to new information
Mitigation: Look carefully at the new information itself to determine its value.

CONFIRMATION. Focus just on positive information about an investment . Leads to overconfidence and overweighiting.
Mitigation: seek contradiction and analyze it carefully.

REPRESENTATIVENESS. Place too much emphasis on perceived category of new information. Likely to change strategies based on a small sample of information.
Mitigation: Consciously take steps to avoid base rate neglect and sample size neglect.

ILLUSION OF CONTROL over investment outcomes. Can lead to excessive trading or concentrated portfolios.
Mitigation: Seek opinions of others. Keep records of trades to see if successful at controlling investment outcomes.

HINDSIGHT. Overestimate accuracy of their forecasts and take too much risk.
Mitigation: Keep detailed record of all forecasts, including the data analyzed reasoning behind the forecast.

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4 Cognitive errors... Informations processing.

FAMA

ANCHORING AND ADJUSTMENT.. Stay close to their original forecasts or interpretations.
Mitigation: Give new information thorough consideration to determine its impact on the original forecast or opinion.

MENTAL ACCOUNTING: Portfolios in layered pyramids of assets. ignore correlations. May consider income and capital gains separately.
Mitigation: Look at all investments as a single portfolio.

FRAMING: individuals focus on one piece of information and lose sight of the overall situation or how the information.
Mitigation: Investors should focus on expected returns and risk, rather than on gains or losses.

AVAILABILITY: Four causes are retrievability, categorization, narrow range of experience, and resonance.
Impact: Select investments based on how easily their memories are retrieved and categorized. Narrow range of experience can lead to concentrated portfolios.
Mitigation: Develop an IPS and construct a suitable portfolio through diligent research.

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Conservatism
vs anchoring
vs status quo

Conservatism. Belief perserverance. Avoiding new info.

Anchoring. Information processing problem.

Status quo. Holding constant portfolio.

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6 Emotional biases

LOSSER

Loss AVERSION Bias - Myopic loss aversion combines the effects of time horizon and framing.
Impact: Focus on current gains and losses. Continue to hold losers in hopes of breaking even. Sell winners to capture the gains.
Mitigation- Perform a thorough fundamental analysis. Overcome mental anguish of recognizing losses.

OVERCONFIDENCE Bias Impact: Hold under-diversified portfolios; underestimate the downside while overestimating the upside potential. Trade excessively.
Mitigation: Keep detailed records of trades, including the motivation for each trade. Analyze successes and losses relative to the strategy used.

SELF-CONTROL Bias Impact: Lack discipline to balance short-term gratification with long-term goals. Tend to try to make up the shortfall by assuming too much risk.
Mitigation: Maintain complete, clearly defined investment goals and strategies. Budgets help deter the propensity to over-consume.

STATUS QUO Bias Impact: Risk characteristics profitable assets.
Mitigation: Education about risk and return and proper asset. Difficult to mitigate.

ENDOWMENT Bias Impact: Value of owned assets of the portfolio change. Investor loses out on potentially higher than same assets if not owned. Stick with assets because of familiarity and comfort or were inherited.
Mitigation: Determine whether the asset allocation is appropriate.

REGRET AVERSION Bias Impact: Stay in low-risk investments. Portfolio with limited upside potential. Stay in familiar investments or "follow the herd." Mitigation: Education is primary mitigation tool.

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Goals-based investing - recognizes/builds

recognizes that individuals are subject to loss aversion and mental accounting. Builds a portfolio in layers, each consisting of assets used to meet individual goals.

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Behaviorally Modified Asset Allocation - how to deal with biases

Emotional biases can be accomodated, especially for higher wealth relative to lifestyle need.

Congnitive biases must be mitigated/educated, especially for lower wealth vs lifestyle needs more often accommodated through deviations from the rational asset portfolio allocation.

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BBK 5 FACTOR MODEL
Adventurer...

Confident + Impetuous

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Bbk 5 factor model
Celebrity...

Impetuous and anxious

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Bbk 5 factor model
Individualist

Confident and careful

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Bbk 5 factor model
Guardian

Anxious and careful

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Bbk 5 factor model
Staight arror

Neither anxiuous nor confident
Neither careful nor impetuous

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Bbk five factor model

Adventurer
Guardian
Celebrity
Individualist
Straight arrow - avg investor

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Pompian model 4 types
Passive preserver

Emotional + conservative
Biases emotional - Passive Preserver: Endowment, loss aversion, status quo, regret aversion.
Biases cognitive - Passive Preserver: Mental accounting, anchoring and adjustment.

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Pompian 4 type
Friendly Follower

Conservative + conitive
Biases emotional: Regret aversion.
Biases cognitive: Availability, hindsight, framing.

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Pompian 4 types
Independent / individualist

Cognitive + aggresive
Emotional biases - Overconfidence, self-attribution.
Cognitive biases - Conservatism, availability, confirmation, rep resentariveness.

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Pompian 4 types
Active accumulator

Aggresive + emotional
Emotional biases - Overconfidence, self-control.
Cognitive biases - Illusion of control.

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Succes of investor advisor relationship

The adviser UNDERSTANDS the long-term financial GOALS ofthe client.

The adviser maintains a CONSISTENT APPROACH with the client.

The adviser ACTS as the client EXPECTS.

BOTH client and adviser BENEFIT from the relationship.

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Gamblers phalacy

is thinking that there will be a reversal to the long-term mean more frequently than actually happens

34

Social proof bias is

is when a person follows the beliefs of a group

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halo effect is

perception of positive qualities in one thing or part GIVES RISE to the perception of SIMILAR qualities in related things or in the whole.

Being positive about one thing or the whole, based on positive perceptions about related things or parts.

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Incorporating behavioral biases into the client's IPS - benefits

Portfolios that are CLOSER to the EFFICIENT frontier.

More SATISFIED clients.

Clients who are better able to SATY ON TRACK with their long-term strategic plans.

BETTER working RELATIONSHIPS between the client and adviser.

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Analyst can minimize overconfidence by

Get FEEDBACK through self evaluations, colleagues, and superiors, combined with a structure that rewards accuracy, leading to better self-calibration.

Develop FORECASTS that are unambiguous and DETAILED, which help to reduce hindsight bias.

Provide one CONTRARGUMENT supported by evidence for why their forecast may not be accurate.

Consider SAMPLE SIZE and model complexity.

Use BAYES' formula.

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Company mgmt biases

Framing.
Anchoring and adjustment.
Availability.

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Disposition effect

Selling winners, holding losers

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Risk tolerance questionares are more efficient with

Cognitive-biased individuals

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Self attribution

Blaming others for one's own wrong forecast.

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Limitations of classifying investors into behavioral types include the following:


.Individuals can display BOTH EMOTIONAL and COGNITIVE errors at the same time.
.The same individual may DISPLAY TRAITS OF 2+ behavioral investor type.
.As investors AGE, they become more risk averse and emotional toward investing.
.Individuals of same behavioral type SHOULD.T necessarily be TREATED the same.
.Unpredictably, individuals tend to ACT IRRATATIONALLY AT DIFFERENT TIMES

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4 BENEFITS for client/adviser relationship from INCORPORATING BEHAVIORAL FINANCE into the relationship:

1 . Behavioral finance helps the adviser UNDERSTAND the reasons for the client's goals.
2. Behavioral finance ADDS STRUCTURE AND PROFESSIONALISM to the relationship.
3. The adviser is BETTER EQUIPED TO MEET the client's expectations.
4. A CLOSER BOND between them results in happier clients and an enhanced practice for the adviser

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Biases of defined contribution plan beneficiaries

Status quo bias: Investors make no changes to their initial asset allocation.

Nai"ve diversification (lin nai've diversification): Employees allocate an equal proportion of their retirements funds to each mutual fund in the plan.

45

Why holding stocks issued by employer

FFF L Ex

Familiarity: They underestimate its risk; they become overconfident in their estimate of the company's performance.

Nai"ve extrapolation: The company's recent good performance is extrapolated into expected future performance.

Framing: If the employer's contribution is in company stock, employees tend to keep it rather than sell it and reallocate.

Loyalty: Employees hold company stock in an effort to help the company (e.g., to prevent a takeover by another firm).

Financial incentive: Tax incentives or the ability to purchase the stock at a discount lead to holding too much company stock.

46

Using behavioral finace in portfolio construction to handle status quo and high turnover issues...

TARGET FUNDS to overcome STATUS QUO bias.

LAYERED PORTFOLIOS to ACCOMODATE PERCEPTIONS of risk and importance of goals to build portfolios the client will STAY WITH.

47

Analysts should be aware of the following when a management report is presented:

Results and accomplishments are usually presented first, giving more importance to that information.

Self-attribution bias in the reports.

Excessive optimism.

Recalculated earnings.

47

biases leading to overconfidence

SHI AIR

The illusion of knowledge bias.
The self-attribution bias.
Representativeness.
The availability bias.
The illusion of control bias.
Hindsight bias.

48

Actions the analyst can take to prevent undue influence in management reports:

Focus on verifiable quantitative data.

Be certain the information is framed properly.

Recognize appropriate base rates so the data is properly calibrated.

49

Analyst biases in research

Usually related to collecting too much information.

Leads to illusions of knowledge and control as well as representativeness. Overconfidence.

interpreting management reports

Inaccurately extrapolate past data into the future.

Can suffer from confirmation bias and gambler's fallacy. • • • •

50

Committe biases and solutions

BIASES
Committees are typically comprised of people with similar backgrounds; they tend to approach problems in the same manner.
Individuals may feel uncomfortable expressing their opinions.

SOLUTIONS
To overcome these problems,
- construct committees with individuals who have diverse backgrounds, are not afraid to express their opinions, and
- have respect for the other members of the group.

51

Financial bubbles and crashes

Periods of unusual positive or negative returns caused by panic buying or selling. They can be defined as a period of prices two standard deviations from their historical mean.

A crash can also be characterized as a fall in asset prices of 30% or more over a period of several months; bubbles usually take much longer to form.

Behavioral biases exhibited during bubbles are overconfidence, confirmation bias, self-attribution bias, hindsight bias, regret aversion, and the disposition effect.

52

Momentum effect

Patterns in returns that are caused by investors following the lead of others; they tend to trade in the same direction, which is referred to as herding.

53

Bbk 5 vs pompian 4

Bbk - careful/impulsive, anxious/confident
Pompian - cognitive/emotional, conservative/aggressive

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Target fund

A target-date fund – also known as a lifecycle, dynamic-risk or age-based fund – a portfolio whose asset allocation mix becomes more conservative as the target date (usually retirement) approaches