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Representativeness Bias

A belief perseverance bias in which people tend to classify new information based on past experiences and classifications. They believe their classifications are appropriate and place undue weight on them.

Base-rate neglect and sample-size neglect are two types of representativeness bias that apply to financial management professionals.

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Confirmation Bias

A belief perseverance bias in which people tend to look for and notice what confirms their beliefs and to ignore or undervalue what contradicts their beliefs.

Conservatism Bias

A belief perseverance bias in which people maintain their prior views or forecasts by inadequately incorporating new information.

This bias has aspects of both statistical and information-processing errors.

The two types of Cognitive Errors are:

Belief Perseverance & Processing Errors

Belief Perseverance is the tendency to cling to one’s previously held beliefs irrationally or illogically. The belief continues to be held and justified by committing statistical, information-processing, or memory errors.

Processing Errors describe how information may be processed and used illogically or irrationally in financial decision making.

Differences Between Cognitive Errors and Emotional Biases

Cognitive Errors are basic statistical, information-processing, or memory errors that cause the decision to deviate from the rational decisions of traditional finance.

Emotional Biases arise spontaneously as a result of attitudes and feelings that can cause the decision to deviate from the rational decisions of traditional finance.

Cognitive errors are more easily corrected than emotional biases.

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Visual Guideline for Determining a Behaviourally Modified Asset Allocation

behaviorallyModifiedAssetAllocation

This image was taken from the official Level 3 textbook published by the CFA Institute.

Risk Aversion VS Loss Aversion

Risk Aversion: Investor values gains and losses equally. Will choose certain gains over uncertainty. For equal expected returns will choose less risky option.

Loss Aversion: The investor values losses higher than gains. In the event of a loss an investor may take on additional risk to reverse the loss, doubling down. Wealth level matter more than investment valuation and biased expectations possible.

Under behavioural portfolio theory an investor is ____ so may continue to hold some securities…

Because of a reluctance to realize loses an investor will hold some securities not because of their potential but strictly due to loss aversion.

Mental accounting is…

…the phenomenon whereby people treat one sum of money differently from another sum even though money is interchangeable aka fungible.

Under Expected Utility Theory Individuals…

  • exhibit self control
  • follow a budget
  • are able to defer consumption
  • attempt to maximize present value of utility