Reading 87: The Behavioral Biases of Individuals

Book 4: Portfolio Management

Cognitive Errors

due primarily to faulty reasoning or irrationality

Emotional Biases

not related to conscious thought but stem from feeling, impulses, or intuition

Types of Cognitive Errors (belief perseverance)

Cognitive Dissonance

Conservatism Bias

Confirmation Bias

Representativeness Bias

Base-Rate Neglect Bias

Sample-Size Neglect Bias

Illustration of Control Bias

Hindsight Bias

Cognitive Dissonance

where an individual holds conflicting beliefs or questions a current belief

Conservatism Bias

when market participants rationally form an initial view but then fail to change that view as new information becomes available

Confirmation Bias

when market participants focus on information that supports their beliefs, and avoid the importance of conflicting information

Representativeness Bias

when certain characteristics are used to put an investment in a category and the individual concludes it will have the same characteristics of investments in that category

Base-Rate Neglect

analyzing an individual member of a population without adequately considering the probability of a characteristic in that population

Sample-Size Neglect

making a classification based on a small and potentially unrealistic data sample

Illustration of Control Bias

when market participants believe they can control or affect outcomes when they cannot

Hindsight Bias

a selective memory of past events resulting in an individual’s tendency to see things as more predictable than they really are

How can Cognitive Errors be grouped?

belief perseverance

processing errors

Types of Cognitive Errors (processing errors)

anchoring

mental accounting

framing bias

availability bias

Anchoring

basing expectations on a prior number and overweighting its importance

Mental Accounting

treating different sources of money differently

Framing Bias

decisions are affected by the way in which the data is framed

Availability Bias

putting undue emphasis on information that is readily available

Types of Emotional Biases

Loss-Aversion Bias

Overconfidence Bias

Self-Control Bias

Status Quo Bias

Endowment Bias

Regret-Aversion Bias

Halo Effect

Home Bias

Loss-Aversion Bias

people feel more pain from losses than pleasure from equal gains

Overconfidence Bias

when market participants overestimate their own ability

Self-Control Bias

when individuals lack self-discipline and favor short-term returns over better long-term returns

Hyperbolic Discounting

favor small payoffs as opposed to larger payoffs in the future

Status Quo Bias

comfort with an existing plan causes an individual to be resistant to change

Endowment Bias

when an asset is felt to be special and more valuable because it is already owned

Regret-Aversion Bias

when market participants do nothing out of excessive fear that actions could be hurt them

Halo Effect

a company’s good characteristics are extended into a conclusion that it is a good stock to own leading to overvaluation

Home Bias

investing in domestic issues over international issues