Behavioral Finance- Class 3 (Cognitive biases: Information processing)

Information Processing Biases, Cognitive biases where information is processed and used illogically or irrationally, causing faulty reasoning in decision-making.

Anchoring and Adjustment Bias (Definition), When estimating an unknown value, people start from an initial default number (the anchor) and adjust insufficiently, resulting in biased final estimates that place too much weight on the anchor.

Anchoring and Adjustment Bias (Explanation), People use anchors because they are better at estimating relative comparisons than absolute figures. Underlying difficulty in processing new information also contributes.

Anchoring and Adjustment Bias (Consequences), Investors cling to arbitrary price levels such as purchase points, highs, and lows, and perceive new information through a distorted lens biased by those anchors.

Anchoring and Adjustment Bias (Investor Implications), (1) Market forecasts stay too close to current levels; (2) Analysts stick too closely to original estimates when new info emerges; (3) Forecasts for asset class returns are anchored to current return levels.

Anchoring and Adjustment Bias (Mitigation), Treat new information objectively. Build awareness of the bias. Account for analyst anchoring when reviewing earnings estimates. Use radically strict initial positions in negotiations.

Anchoring vs. Conservatism Bias, Conservatism bias = reluctance to update beliefs due to new information (status quo). Anchoring bias = insufficient adjustment away from an initial number, regardless of its relevance to the decision.

52-Week High/Low Proxy (Anchoring), Current price / 52-week high: stocks near highs keep being bought (momentum). Current price / 52-week low: investors buy just because a stock looks cheap relative to its past price.

Mental Accounting (Definition), The tendency to categorize and treat money differently based on its source, purpose, or intended use, leading to inconsistent financial decisions.

Mental Accounting (Three Parts), (1) Coding: labelling money by source or purpose; (2) Categorization: sorting money into separate buckets; (3) Evaluation: judging decisions within each bucket, often inconsistently.

Mental Accounting (Explanation), People create mental accounts to justify actions that seem enticing but are unwise (e.g. treating a tax refund as found money to spend on luxuries). Each mental account is treated separately rather than as part of the overall financial picture.

Mental Accounting (Three Wealth Classifications), People mentally allocate wealth over: (1) current income, (2) current assets, (3) future income.

Mental Accounting (Investment Buckets), Investors mentally allocate savings into: a safety bucket (bonds to beat inflation), a growth bucket (equities), and an aspirational bucket (alternative investments, very high risk).

Mental Accounting (Investor Implications), (1) Imagining separate investment buckets per financial goal; (2) Irrationally distinguishing between dividend income and capital appreciation returns; (3) Over-allocating to employer stock in retirement plans, causing under-diversification.

Mental Accounting (Mitigation), Consider correlations between buckets using a holistic portfolio view. Focus on total portfolio returns rather than individual asset returns. Avoid company stock bias and the resulting under-diversification.

Framing Bias (Definition), The tendency for decision-makers to respond differently to the same situation based on how the choice is presented. Perception and probabilistic evaluation change depending on the connotations of the options.

Narrow Framing, A subset of framing bias where people focus too restrictively on one or two aspects of a situation, excluding other crucial aspects and compromising decision-making.

Framing Bias (Explanation), The frame adopted is controlled by: (1) the formulation of the problem, and (2) the norms, habits, and personal characteristics of the decision-maker.

Framing Bias (Consequences), Investors make decisions based on how information is presented to them, leading to biased conclusions. Narrow framing causes investors to over-focus on one part of a decision when broader analysis is needed.

Framing Bias (Investor Implications), (1) Risk tolerance responses skewed too conservative (gain frame) or too aggressive (loss frame); (2) Optimistically framed recommendations increase willingness to invest; (3) Narrow framing causes long-term investors to obsess over short-term price fluctuations.

Gain vs. Loss Frame (Framing Bias), When a question is worded in a gain frame, risk-averse responses are more likely. When worded in a loss frame, risk-seeking behavior is the likely response.

Framing Bias (Mitigation), Keep the big picture in mind (overall wealth and long-term goals). Isolate decisions from prior gains/losses. Present facts and choices as neutrally and uniformly as possible. Use unbiased risk tolerance questionnaires.

Availability Bias (Definition), A mental shortcut where people estimate the probability of an outcome based on how easily it comes to mind. Recent, vivid, or memorable information has a disproportionate impact on decision-making.

Three Categories of Availability Bias, (1) Accessibility: most easily recalled ideas seem most credible; (2) Categorization: people summon information matching a certain reference category; (3) Resonance: personal situations influence judgment about investments.

Availability Bias (Explanation), Humans have selective memory, making it easier to recall recent and positive events. It is easier to process new information through the lens of previously formed mental associations.

Availability Bias (Consequences), People treat easily recalled possibilities as more likely. Investors overreact to present-day market conditions, whether positive or negative.

Availability Bias - Accessibility Example, Investors are more likely to pick a mutual fund company that advertises heavily because it is top of mind, not because it is objectively best.

Availability Bias - Categorization Example, Many US investors would name the US as the best country to invest in because it is their default mental reference point, not based on systematic global comparison.

Availability Bias - Resonance Example, Investors favor ESG investments because they match their personal values and identity, rather than purely on risk-return grounds.

Availability Bias (Investor Implications), (1) Stock/sector selection driven by media frequency; (2) Investments chosen based on a mental list of safe stocks like Apple or Google; (3) Investments chosen because they match the investor's personality such as ESG.

Availability Bias (Mitigation), Research investments carefully before acting. Focus on long-term results and resist trend-chasing. Acknowledge the human tendency to overweight recent events. Maintain a comprehensive, balanced information set without excessive focus on recent data.

Availability Bias Proxy, Track companies with high investor traction (social media sentiment, news mentions, brokerage rankings) and test whether they outperform around awareness peaks — e.g. meme stocks like GameStop and AMC.

Meme Stocks as Availability Bias Example, GameStop and AMC surged when retail investors, driven by social media buzz, perceived them as likely winners due to their high availability in memory, not fundamentals.

ChatGPT / AI Stocks as Availability Bias Example, When ChatGPT became a hot topic, investors were inclined to invest in AI-related stocks because AI was highly available in memory, potentially overvaluing leaders and penalizing laggards unfairly.

Crypto as Mental Accounting Example, Cryptocurrencies are often placed in the aspirational bucket — seen as a vehicle to achieve high wealth goals like buying a house, making investors accept very high risk for that specific allocation.

Solar Energy as Framing Bias Example, When investors are constantly exposed to positive news about solar energy, they may perceive it as safer and more profitable than fundamentals justify — their decision is framed by that positive information flow.

S&P500 2020 Return and Framing, The S&P500 gained 8.6% in 2020. Framed against the 6% historical equity risk premium it seems good. Framed against Asian and Emerging Market stocks it was a relative underperformer. The same return looks different depending on the reference point.

Muller-Lyer Illusion (Class Experiment), Two lines of equal length appear different due to the direction of arrowheads at their ends. Illustrates how context and visual framing distort perception, analogous to how framing distorts financial judgment.

Salary vs. Bonus Experiment (Mental Accounting), People tend to spend a 4000 euro salary on essential expenses but a 4000 euro bonus on luxuries. Identical amounts are treated differently based on how they are labelled — regular income vs. windfall.

Real Estate Negotiation (Anchoring Experiment), The seller sets a high initial price to maximize commission, anchoring the buyer. The buyer starts with a low offer, anchoring the seller. Both parties adjust insufficiently from their respective anchors.