BEHAVIORAL FINANCE Behavioral finance, commonly defined as the application of psychology to finance, has become a very hot topic, generating new credence with the rupture of the tech-stock bubble in March of 2000. While the term behavioral finance is bandied about in books, magazine articles, and investment papers, many people lack a firm understanding of the concepts behind behavioral finance. Additional confusion may arise from a proliferation of topics resembling behavioral finance, at least in name, including behavioral science, investor psychology, cognitive psychology, behavioral economics, experimental economics, and cognitive science This section will try to communicate a more detailed understanding of behavioral finance. First, we will discuss some of the popular authors in the field and review the outstanding work they have done (not an exhaustive list), which will provide a broad overview of the subject. We will then examine the two primary subtopics in behavioral finance: Behavioral Finance Micro and Behavioral Finance Macro
Key Figures in the Field In the past 10 years, some very thoughtful people have contributed exceptionally brilliant work to the field of behavioral finance. Some readers may be familiar with the work Irrational Exuberance Professor Robert Shiller Ph.D. Certainly, the title resonates; it is a reference to a now-famous admonition by Federal Reserve chairman Alan Greenspan during his remarks at the Annual Dinner and Francis Boyer Lecture of the American Enterprise Institute for Public Policy Research in Washington, D.C., on December 5, 1996. In his speech, Greenspan acknowledged that the ongoing economic growth spurt had been accompanied by low inflation 1 In Shillers Irratonal Exuberance, which hit bookstores only days before the 1990s market peaked, Professor Shiller warned investors that stock prices, by
various historical measures, had climbed too high. He cautioned that the public may be very disappointed with the performance of the stock market in coming years.2 It was reported that Shillers editor at Princeton University Press rushed the book to print, perhaps fearing a market crash and wanting to warn investors. Sadly, however, few heeded the alarm. Professor Richard Thaler , Ph.D., of the University of Chicago Graduate School of Business, penned a classic commentary with Owen Lamont entitled Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs,3 also on the general topic of irrational investor behavior set amid the tech bubble. The work related to 3Com Corporations 1999 spin-off of Palm, Inc. It argued that if investor behavior was indeed rational, then 3Com would have sustained a positive market value for a few months after the Palm spin-off. In actuality, after 3Com distributed shares of Palm to shareholders in March 2000, Palm traded at
levels exceeding the inherent value of the shares of the original company. This would not happen in a rational world, Thaler noted. (Professor Thaler is the editor of Advances in Behavioral Finance, which was published in 1993.) Professor Kahneman found that under conditions of uncertainty, human decisions systematically depart from those predicted by standard economic theory. Kahneman, together with Amos Tversky (deceased in 1996), formulated prospect theory. An alternative to standard models, prospect theory provides a better account for observed behavior and is discussed Smith also performed wind-tunnel tests to estimate the implications of alternative market configurations before such conditions are
implemented in practice. The deregulation of electricity markets, for example, was one scenario that Smith was able to model in advance. Smiths work has been instrumental in establishing experiments as an essential tool in empirical economic analysis at length in later chapters. Kahneman also discovered that human judgment may take heuristic shortcuts that systematically diverge from basic principles of probability Behavioral Finance Micro versus Behavioral Finance Macro As we have observed, behavioral finance models and interprets phenomena ranging from individual investor conduct to market-level outcomes. Therefore, it is a difficult subject to define.
we break our topic down into two subtopics: Behavioral Finance Micro and Behavioral Finance Macro. 1. Behavioral Finance Micro (BFMI) examines behaviors or biases of individual investors that distinguish them from the rational actors envisioned in classical economic theory. 2. Behavioral Finance Macro (BFMA) detects and describe anomalies in the efficient market hypothesis 3. wealth management practitioners and investors, our primary focus will be BFMI, the study of individual investor behavior. Specifically, we want to identify relevant psychological biases and investigate their influence on asset allocation decisions so that we can manage the effects of those biases on the investment processesis
THE TWO GREAT DEBATES OF STANDARD FINANCE VERSUS FINANCE ThisBEHAVIORAL section reviews the two basic concepts in standard finance that behavioral finance disputes: rational markets and rational economic man. It also covers the basis on which behavioral finance proponents challenge each tenet and discusses some evidence that has emerged in favor of the behavioral approach. Standard finance theory is designed to provide mathematically elegant explanations for financial questions that, when posed in real life, are often complicated by imprecise, inelegant conditions. The standard finance
approach relies on a set of assumptions that oversimplify reality. For example, embedded within standard finance is the notion of Homo Economicus, or rational economic man. It prescribes that humans make perfectly rational economic decisions at all times. Standard finance, basically, is built on rules about how investors should behave, rather than on principles describing how they actually behave. Behavioral finance attempts to identify and learn from the human psychological phenomena at work in financial markets and within individual investors. Behavioral finance, like standard finance Efficient Markets versus Irrational Markets During the 1970s, the standard finance theory of market efficiency became the model of market behavior accepted by the majority of academics and a good number of professionals. The Efficient Market Hypothesis had matured in the previous decade, stemming from the doctoral dissertation of Eugene Fama. Fama persuasively demonstrated
that in a securities market populated by many well-informed investors, investments will be appropriately priced and will reflect all available information. There are three forms of the efficient market hypothesis 1. The Weak form contends that all past market prices and data are fully reflected in securities prices; that is, technical analysis is of little or no value. 2. The Semistrong form contends that all publicly available information is fully reflected in securities prices; that is, fundamental analysis is of no value. 3. The Strong form contends that all information is fully reflected in securities prices; that is, insider information is of no value. Historical Roots Investor irrationality has existed as long as the markets themselves have. Perhaps the best-known historical example of irrational investor behavior dates back to the early modern or mercantilist period during the sixteenth century. A
man named Conrad Guestner transported tulip bulbs from Constantinople, introducing them to Holland. Beautiful and difficult to obtain, tulips were a consumer sensation and an instant status symbol for the Dutch elite. Although most early buyers sought the flowers simply because they adored them, speculators soon joined the fray to make a profit. Trading activity escalated, and eventually, tulip bulbs were placed onto the local market exchanges. It wasnt until the mid-eighteenth-century onset of the classical period in economics, however, that people began to study the human side of economic decision making, which subsequently laid the groundwork for behavioral finance micro. At this time, the concept of utility was introduced to measure the satisfaction associated with consuming a good or a service. Scholars linked economic utility with human psychology and even morality, giving it a much broader meaning than it would take on later, during neoclassicism, when it survived chiefly as a principle underlying laws of supply and demand
Many people think that the legendary Wealth of Nations (1776) was what made Adam Smith (Figure 2.1) famous; in fact, Smiths crowning composition focused far more on individual psychology than on production of wealth in markets. Published in 1759, The Theory of Moral Sentiments described the mental and emotional underpinnings of human interaction, including economic interaction. In Smiths time, some believed that peoples behavior could be modeled in completely rational, almost mathematical terms. Others, like Smith, felt that each human was born possessing an intrinsic moral compass, a source of influence superseding externalities like logic or law. Smith argued that this invisible hand guided both social and economic Rational Economic Man Rational economic man (REM) describes a simple model of human behavior. REM strives to maximize his economic well-being, selecting
strategies that are contingent on predetermined, utility-optimizing goals, on the information that REM possesses, and on any other postulated constraints. The amount of utility that REM associates with any given outcome is represented by the output of his algebraic utility function. Basically, REM is an individual who tries to achieve discretely specified goals to the most comprehensive, consistent extent possible while minimizing economic costs. REMs choices are dictated by his utility function. Often, predicting how REM will negotiate complex trade-offs, such as the pursuit of wages versus leisure, simply entails computing a derivative. REM ignores social values, unless adhering to them gives him pleasure Cognitive Psychology Many scholars of contemporary behavioral finance feel that the fields most direct roots are in cognitive psychology. Cognitive psychology is the scientific study of cognition, or the mental processes that are believed to drive human behavior. Research in cognitive psychology investigates a variety of topics, including memory, attention, perception,
knowledge representation, reasoning, creativity, and problem solving Decision Making under Uncertainty Each day, people have little difficulty making hundreds of decisions. This is because the best course of action is often obvious and because many decisions do not determine outcomes significant enough to merit a great deal of attention. On occasion, however, many potential decision paths emanate, and the correct course is unclear. Sometimes, our decisions have significant consequences. These situations demand substantial time and effort to try to devise a systematic approach to analyzing various courses of action 1. Take an inventory of all viable options available for obtaining information, for experimentation, and for action.
2. List the events that may occur. 3. Arrange pertinent information and choices/assumptions. 4. Rank the consequences resulting from the various courses of action. 5. Determine the probability of an uncertain event occurring. Barnewall Two-Way Model
Passive investors Are defined as those investors who have become wealthy passivelyfor example, by inheritance or by risking the capital of others rather than risking their own capital. Passive investors have a greater need for security than they have tolerance for risk. Active investors are defined as those individuals who have earned their own wealth in their lifetimes. They have been actively involved in the wealth creation, and they have risked their own capital in achieving their wealth objectives. Active investors have a higher tolerance for risk than they have need for security Bailard, Biehl, and Kaiser Five-Way
Model The Bailard, Biehl, and Kaiser (BB&K) model features some principles of the Barnewall model; but by classifying investor personalities along two axeslevel of confidence and method of actionit introduces an additional dimension of analysis. The Adventurer People who are willing to put it all on one bet and go for it because they have confidence. They are difficult to advise, because they have their own ideas about investing. They are willing to take risks, and they are volatile clients from an investment counsel point of view.
The Celebrity These people like to be where the action is. They are afraid of being left out. They really do not have their own ideas about investments. They may have their own ideas about other things in life, but not investing. As a result they are the best prey for maximum broker turnover. The Individualist These people tend to go their own way and are typified by the small business person or an independent professional, such as a lawyer, CPA, or engineer. These are people who are trying to make their own decisions in life, carefully going about things, having a certain degree of confidence about
them, but also being careful The Guardian Typically as people get older and begin considering retirement, they approach this personality profile. They are careful and a little bit worried about their money. They recognize that they face a limited earning time span and have to preserve their assets. They are definitely not interested in volatility or excitement. Guardians lack confidence in their ability to forecast the future or to understand where to put money, so they look for guidance. The Straight Arrow These people are so well balanced, they cannot be placed in any specific quadrant, so they fall near the center. On average this group of clients is the average investor, a relatively balanced composite of each of the other four investor types, and by implication a group willing to be exposed to medium amounts of risk
BEST PRACTICAL ALLOCATION Practitioners are often vexed by their clients decision-making processes when it comes to structuring investment portfolios. Why? As noted in the previous section, many advisors, when designing a standard asset allocation program with a client, first administer a risk tolerance questionnaire, then discuss the clients financial goals and constraints, and finally recommend the output of a mean-variance optimization. A clients best practical allocation may be a slightly underperforming long-term investment program to which the client can comfortably adhere, warding off an impulse to change horses in the middle of the race. In other cases, the best practical allocation might contradict
clients natural psychological tendencies, and these clients may be well served to accept risks in excess of their individual comfort levels in order to maximize expected returns. HOW TO APPLY BIAS DIAGNOSES WHEN STRUCTURING ASSET ALLOCATIONS Incorporating Behavioral Finance into Your Practice which I with my colleague John Longo originally published in the March 2005 Journal of Financial Planning. It sets forth two principles for constructing a best practical allocation in light of client behavioral biases. These principles are not intended as prescriptive absolutes Principle I Moderate Biases in Less-Wealthy Clients Adapt to Biases in Wealthier Clients
A client outliving his or her assets constitutes a far graver investment failure than a clients inability to amass the greatest possible fortune. If an allocation performs poorly because it conforms or adapts, too willingly to a clients biases, then a less-wealthy investors standard of living could be seriously jeopardized. The most financially secure clients, however, would likely continue to reside in the 99.9th socioeconomic percentile. In other words if a biased allocation could put a clients way of life at risk, moderating the bias is the best response. If only a highly unlikely event such as a market crash could threaten the clients day-to-day security, then overcoming the potentially suboptimal impact of behavioral bias on portfolio returns becomes a lesser consideration. Adapting is then, the appropriate course of action. Principle II Moderate Cognitive Biases; Adapt to
Emotional Biases Behavioral biases fall into two broad categories cognitive and emotional, with both varieties yielding irrational judgments.Because cognitive biases stem from faulty reasoning, better information and advice can often correct them.Conversely because emotional biases originate from impulse or intuition rather than conscious calculations, they are difficult to rectify Cognitive biases include heuristics such as anchoring and adjustment availability and representativeness biases Overconfidence General Description Overconfidence can be summarized as unwarranted faith in ones
intuitive reasoning, judgments and cognitive abilities. The concept of overconfidence derives from a large body of cognitive psychological experiments and surveys in which subjects overestimate both their own predictive abilities and the precision of the information theyve been given. People are poorly calibrated in estimating probabilitiesevents they think are certain to happen are often far less than 100 percent certain to occur. In short people think they are smarter and have better information than they actually do Technical Description Numerous studies have shown that investors are overconfident in their investing abilities. Specifically, the confidence intervals that investors assign to their investment predictions are too
narrow. This type of overconfidence can be called prediction overconfidence. For example, when estimating the future value of a stock, overconfident investors will incorporate far too little leeway into the range of expected payoffs, Investors are often also too certain of their judgments. We will refer to this type of overconfidence as certainty overconfidence . For example, having resolved that a company is a good investment, people often become blind to the prospect of a loss and then feel
surprised or disappointed if the investment performs This behavior results in the tendency of investors to fall prey to a misguided quest to identify the next hot stock. Thus, people susceptible to certainty overconfidence often trade too much in their accounts and may hold portfolios that are not diversified enough. PRACTICAL APPLICATION Prediction Overconfidence.s Roger Clarke and Meir Stat man demonstrated a classic example of prediction overconfidence in 2000 when they surveyed investors on the following question: In 1896, the Dow Jones Average, which is a price index that does not include dividend reinvestment, was at 40. In 1998, it crossed 9,000. If dividends had been reinvested, what do you
think the value of the DJIA would be in 1998? In addition to that guess, also predict a high and low range so that you feel 90 percent confident that your answer is between your high and low guesses.1 In the survey, few responses reasonably approximated the potential 1998 value of the Dow, and no one estimated a correct confidence interval. A classic example of investor prediction overconfidence is the case of the former executive or family legacy stockholder of a publicly traded company such as Johnson & Johnson, ExxonMobile, or DuPont. ADVICE Overconfidence is one of the most detrimental biases that an investor can exhibit. This is because underestimating downside risk, trading too frequently and/or trading in pursuit of the next hot stock, and holding an under diversified portfolio all pose serious hazards to your wealth
(to borrow from Barber and Odeans phrasing). Prediction and certainty overconfidence have been discussed and diagnosed separately, but the advice presented here deals with overconfidence This advice is organized according to the specific behavior it addresses. All four behaviors are wealth hazards resulting frequently from overconfidence in an across-the-board, undifferentiated manner 1.Unfounded belief in own ability to identify companies as potential investments
Many overconfident investors claim above-average aptitudes for selecting stocks, but little evidence supports this belief. The Odean study showed that after trading costs (but before taxes), the average investor underperformed the market by approximately 2 percent per year.5 Many overconfident investors also believe they can pick mutual funds that will deliver superior future performance, yet many tend to trade in and out of mutual funds at the worst possible times because they chase unrealistic expectation An advisor whose client claims an affinity for predicting hot stocks should consider asking the investor to review trading records of the past two years and then calculate the performance of the clients trades. 2.Excessive trading When a clients account shows too much trading activity, the best advice is to ask the investor to keep track of each and every investment trade and then to calculate returns. This exercise will demonstrate the
detrimental effects of excessive trading. Since overconfidence is a cognitive bias, updated information can often help investors to understand the error of their ways. 3.Underestimating downside risks Overconfident investors, especially those who are prone to prediction overconfidence, tend to underestimate downside risks. They are so confident in their predictions that they do not fully consider the likelihood of incurring losses in their portfolios. For an advisor whose client exhibits this behavior. Second, point to academic and practitioner studies that show how volatile the markets are. The investor often will get the picture at this point, acquiring more cautious respect for the vagaries of the
markets. 4.Portfolio under diversification As in the case of the retired executive who cant relinquish a former companys stock, many overconfident investors retain under diversified portfolios because they do not believe that the securities they traditionally favored will ever perform poorly. The reminder that numerous, once-great companies have fallen is, oftentimes, not enough of a reality check. In this situation, the advisor can recommend various hedging strategies, such as costless collars, puts, and so on If you didnt own any XYZ stock today, would you buy as much as you own today? When the answer is no, room for maneuvering
emerges. Tax considerations, such as low cost basis, sometimes factor in; but certain strategies can be employed to manage this cost. Representativeness General Description . In order to derive meaning from life experiences, people have developed an innate propensity for classifying objects and thoughts. When they confront a new phenomenon that is inconsistent with any of their pre constructed classifications, they subject it to those classifications anyway, relying on a rough best-fit approximation to determine which category should house and, thereafter, form the basis for their understanding of the new element. This perceptual framework provides an expedient tool for processing new information by simultaneously incorporating insights
gained from (usually) relevant/analogous past experiences. Technical Description 1. Two primary interpretations of representativeness bias apply to individual investors Base-Rate Neglect In base-rate neglect, investors attempt to determine the potential success of say, an investment in Company A by contextualizing the
venture in a familiar easy-to-understand classification scheme. Such an investor might categorize Company A as a value stock and draw conclusions about the risks and rewards that follow from that categorization. This reasoning, however ignores other unrelated variables that could substantially impact the success of the investment. Investors often embark on this erroneous path because it looks like an alternative to the diligent research actually required when evaluating an investment Sample-Size Neglect In sample-size neglect, investors, when judging the likelihood of a particular investment outcome, often fail to accurately consider the sample size of the data on which they base their judgments. They incorrectly assume that small sample sizes are representative of
populations (or real data). Some researchers call this phenomenon the law of small numbers. When people do not initially comprehend a phenomenon reflected in a series of data, they will quickly concoct assumptions about that phenomenon relying on only a few of the available data points. Individuals prone to sample-size neglect are quick to treat properties reflected in such small samples as properties that accurately describe universal pools of data. The small sample that the individual has examined, however, may not be representative whatsoever of the data at large. PRACTICAL APPLICATION This section presents and analyzes two miniature case studies that demonstrate potential investor susceptibility to each variety of representativeness bias and then conducts a practical application research review Miniature Case Study Number 1: Base-Rate Neglect Case Presentation. Suppose George, an investor, is
looking to add to his portfolio and hears about a potential investment through a friend, Harry, at a local coffee shop. The conversation goes something like this: GEORGE: Hi, Harry. My portfolio is really suffering right now. I could use a good long-term investment. Any ideas? HARRY: Well, George, did you hear about the new IPO [initial public offering] pharmaceutical company called Pharma Growth (PG) that came out last week? PG is a hot new company that should be a great investment. Its president and CEO was a mover and shaker at an Internet company that did great during the tech boom, and she has Pharma Growth growing by leaps and bounds. GEORGE: No, I didnt hear about it. Tell me more. HARRY: Well, the company markets a generic drug sold over the Internet for people with a stomach condition that millions of people have. PG
offers online advice on digestion and stomach health, and several Wall Street firms have issued buy ratings on the stock. GEORGE: Wow, sounds like a great investment! HARRY: Well, I bought some. I think it could do great. GEORGE: Ill buy some, too. George proceeds to pull out his cell phone, call his broker, and place an order for 100 shares of PG. Miniature Case Study Number 2: Sample-Size Neglect Presentation. Suppose George revisits his favorite coffee shop the following week and this time encounters bowling buddy Jim. Jim raves about his stockbroker, whose firm employs an analyst who appears to have made many recent successful stock picks. The conversation goes something like this
GEORGE: Hi, Jim, how are you? JIM: Hi, George. Im doing great! Ive been doing superbly in the market recently. GEORGE: Really? Whats your secret JIM: Well, my broker has passed along some great picks made by an analyst at her firm.
GEORGE: Wow, how many of these tips have you gotten? JIM: My broker gave me three great stock picks over the past month or so. Each stock is up now, by over 10 percent. GEORGE: Thats a great record. My broker seems to give me one bad pick for every good one. It sounds like I need to talk to your broker; she has a much better record! Anchoring and Adjustment Bias General Description. When required to estimate a value with unknown magnitude, people generally begin by envisioning some initial, default number an anchor
which they then adjust up or down to reflect subsequent information and analysis. The anchor, once fine-tuned and reassessed, matures into a final estimate. Numerous studies demonstrate that regardless of how the initial anchors were chosen, people tend to adjust their anchors insufficiently and produce end approximations that are, consequently, biased. Suppose you are asked whether the population of Canada is greater than or less than 20 million. Obviously, you will answer either above 20 million or below 20 million. If you were then asked to guess an absolute population value, your estimate would probably fall somewhere
Technical Description Anchoring and adjustment is a psychological heuristic that influences the way people intuit probabilities. Investors exhibiting this bias are often influenced by purchase pointsor arbitrary price levels or price indexesand tend to cling to these numbers when facing questions like Should I buy or sell this security. Anchoring and adjustment bias, however, implies that investors perceive new information through an essentially warped lens. They place undue emphasis on statistically arbitrary, psychologically determined anchor points. Decision making therefore deviates from neo classically prescribed rational norms. PRACTICAL APPLICATION This chapter reviews one miniature case study and provides an accompanying analysis and interpretation that will demonstrate investor potential for anchoring and adjustment bias. Miniature Case Study: Anchoring
and Adjustment Bias Case Presentation. Suppose Alice owns stock in Corporation ABC. She is a fairly astute investor and has recently discovered some new information about ABC. Her task is to evaluate this information for the purpose of deciding whether she should increase, decrease, or simply maintain her holdings in ABC. Alice bought ABC two years ago at $12, and the stock is now at $15. Several months ago, ABC reached $20 after a surprise announcement of higher-than-expected earnings, at which time Alice contemplated selling the stock but did not. Unfortunately, ABC then dropped to $15 after executives were accused of faulty accounting practices. Today, Alice feels as though she has lost 25 percent of the stocks value, and she would prefer to wait and sell her shares in ABC once it returns to its recent $20 high ADVICE
From the investment perspective, awareness is the best countermeasure to anchoring and adjustment bias. When you are advising clients on the sale of a security, encourage clients to ask themselves: Am I analyzing the situation rationally, or am I holding out to attain an anchored price? When making forecasts about the direction or magnitude of markets or individual securities, ask yourself: Is my estimate rational, or am I anchored to last years performance figures? Taking these sorts of actions will undoubtedly root out any anchoring and adjustment bias that might take hold during asset sales or asset reallocation Cognitive Dissonance Bias General Description. When newly acquired information conflicts wit preexisting understandings, people often experience mental discomfort a psychological phenomenon known as cognitive dissonance. Cognitions, in psychology, represent attitudes, emotions, beliefs, or values; and cognitive dissonance is a state of imbalance that occurs when contradictory cognitions intersect.
The term cognitive dissonance encompasses the response that arises as people struggle to harmonize cognitions and thereby relieve their mental discomfort. For example, a consumer might purchase a certain brand of lawn mower, initially believing that it is the best lawn mower available Technical Description Psychologists conclude that people often perform far-reaching rationalizations in order to synchronize their cognitions and maintain psychological stability. When people modify their behaviors or cognitions to achieve cognitive harmony, however, the modifications that they make are not always rationally in their self-interest Any time someone feels compelled to choose between alternatives, some sense of conflict is sure to follow the decision. This is because the selected alternative often poses downsides, while the
rejected alternative has redeeming characteristic. 1. Selective perception Subjects suffering from selective perception only register information that appears to affirm a chosen course, thus producing a view of reality that is incomplete and, hence, inaccurate. Unable to objectively understand available evidence, people become increasingly prone to subsequent miscalculations.
2. Selective decision making. Selective decision making usually occurs when commitment to an original decision course is high. Selective decision making rationalizes actions that enable a person to adhere to that course, even if at an exorbitant economic cost. Selective decision makers might, for example, continue to invest in a project whose prospects have soured in order to avoid wasting the balance of previously sunk funds. ADVICE Cognitive dissonance does not in and of itself preordain biased decision
making. The driving force behind most of the irrational behavior discussed is the tendency of individuals to adopt certain detrimental responses to cognitive dissonance in an effort to alleviate their mental discomfort. Therefore, the first step in overcoming the negative effects of cognitive dissonance is to recognize and to attempt to abandon such counterproductive coping techniques. People who can recognize this behavior become much better investors 1. Modifying beliefs. 2.
Modifying actions. 3. Modifying perceptions of relevant action 1. Modifying beliefs. Perhaps the easiest way to resolve dissonance between actions and beliefs is simply to alter the relevant beliefs. In the aforementioned incident, for example, you could just recategorize hitting ones dog as a perfectly acceptable behavior. This would take care of any dissonance. When the principle in question is important to you, however, such a course of action becomes unlikely. Peoples most basic beliefs tend to remain stable; they
dont just go around modifying their fundamental moral matrices on a day-to- day basis. 2. Modifying actions. On realizing that you have engaged in behavior contradictory to some preexisting belief, you might attempt to instill fear and anxiety into your decision in order to averse-condition yourself against committing the same act in the future. Appalled at what you have done, you may emphasize to yourself that you will never hit your dog again, and this may aid in resolving cognitive dissonance. However, averse conditioning is often a poor mechanism for learning, especially if you can train yourself, over time, to simply tolerate the distressful consequences associated with a forbidden behavior.
3. Modifying perceptions of relevant action A more difficult approach to reconciling cognitive dissonance is to rationalize whatever action has brought you into conflict with your beliefs. For example, you may decide that while hitting a dog . is generally a bad idea, the dog whom you hit was not behaving well; therefore, you havent done anything wrong. People relying on this technique try to recontextualize whatever action has generated the current state of mental discomfort so that the action no longer appears to be inconsistent with any particular belief. Availability Bias General Description.
The availability bias is a rule of thumb, or mental shortcut, that allows people to estimate the probability of an outcome based on how prevalent or familiar that outcome appears in their lives. People exhibiting this bias perceive easily recalled possibilities as being more likely than those prospects that are harder to imagine or difficult to comprehend. One classic example cites the tendency of most people to guess that shark attacks more frequently cause fatalities than airplane parts falling from the sky do. However, as difficult as it may be to comprehend, the latter is actually 30 times more likely to occur. Shark attacks are probably assumed to be more prevalent because sharks invoke greater fear or because shark attacks receive a disproportionate degree of media attention
Technical Description People often inadvertently assume that readily available thoughts, ideas, or images represent unbiased indicators of statistical probabilities. People estimate the likelihoods of certain events according to the degree of ease with which recollections or examples of analogous events can be accessed from memory. Impressions drawn from imagination and past experience combine to construct an array of conceivable outcomes, whose real statistical probabilities are, in essence, arbitrary. 1. Retrievability 2. Categorization 3. Narrow range of experience.
1. Retrievability. Ideas that are retrieved most easily also seem to be the most credible, though this is not necessarily the case. For example, David Kahneman, Paul Slovic, and Amos Tversky performed an experiment in which subjects were read a list of names and then were asked whether more male or female names had been read.1 In reality, the majority of names recited were unambiguously female; however, the subset of male names contained a much higher frequency 2. Categorization. Representativeness Bias we discussed how peoples minds comprehend and archive perceptions according to certain classification schemes. Here, we will discuss how people attempt to categorize or summon information that matches a certain reference. The first thing that their brains do is generate a set of search terms, specific to the task at hand, that will allow them to efficiently navigate their brains classification structure and locate the data they need
3. Narrow range of experience. When a person possesses a toorestrictive frame of reference from which to formulate an objective estimate, then narrow range of experience bias often results. For example, assume that a very successful college basketball player is drafted by a National Basketball Association (NBA) team, where he proceeds to enjoy several successful seasons. Because this person encounters numerous other successful former college basketball players on a daily basis in the NBA, he is likely to overestimate the relative proportion of successful college basketball players that go on to play professionally. PRACTICAL APPLICATION Each variation of the availability bias just outlined has unique implications in personal finance, both for advisory practitioners and for clients. Lets explore these now.
1. Retrievability 2. Categorization 3.Narrow range of experience 4.Resonance. 1. Retrievability. Most investors, if asked to identify the best mutual fund company, are likely to select a firm that engages in heavy advertising, such as Fidelity or Schwab. In addition to maintaining a high public relations profile, these firms also cherry pick the funds with the best results in their fund lineups, which makes this belief more available to be recalled. In reality, the companies that manage some of todays highest-performing mutual funds undertake little to no advertising. 2.Categorization Most Americans, if asked to pinpoint one country,
worldwide, that offers the best investment prospects, would designate their own: the United States. Why? When conducting an inventory of memories and stored knowledge regarding good investment opportunities in general, the country category that most Americans most easily recall is the United States. However, to dismiss the wealth of investment prospects abroad as a result of this phenomenon is irrational. 3.Narrow range of experience. Assume that an employee of a fast growing, high-tech company is asked: Which industry generates the most successful investments? Such an individual, who probably comes into contact with other triumphant tech profiteers each and every day, will likely overestimate the relative proportion of corporate successes stemming from technologically intensive industries. Like the NBA star who got his start in college and, therefore, too optimistically estimates the professional athletic prospects of college basketball players, this hypothetical high-tech employee demonstrates narrow range of
experience availability bias 4. Resonance. People often favor investments that they feel match their personalities. A thrifty individual who discount shops, clips coupons, and otherwise seeks out bargains may demonstrate a natural inclination toward value investing. At the same time, such an investor might not heed the wisdom of balancing value assets with more growthoriented ventures, owing to a reluctance to front the money and acquire a quality growth stock. The concept of value is easily available in such an investors mind, but the notion of growth is less so. This persons portfolio could perform sub optimally as a result of resonance availability bias. ADVICE Generally speaking, in order to overcome availability bias, investors need to carefully research and contemplate investment decisions before executing them. Focusing on long-term results, while resisting chasing trends, are the best objectives on which to focus if availability bias appears to be an issue. Be aware that everyone possesses a human tendency to mentally overemphasize recent, newsworthy events; refuse
to let this tendency compromise you. The old axiom that nothing is as good or as bad as it seems offers a safe, reasonable recourse against the impulses associated with availability bias Self-Attribution Bias General Description. Self-attribution bias (or self-serving attribution bias) refers to the tendency of individuals to ascribe their successes to innate aspects, such as talent or foresight, while more often blaming failures on outside influences, such as bad luck. Students faring well on an exam, for example, might credit their own intelligence or work ethic, while those failing might cite unfair grading. Similarly, athletes often reason that they have simply performed to reflect their own superior athletic skills if they win a game, but they might allege
unfair calls by a referee when they lose a game Technical Description. Self-attribution is a cognitive phenomenon by which people attribute failures to situational factors and successes to dispositional factors. Self-serving bias can actually be broken down into two constituent tendencies or subsidiary biases. 1. Self-enhancing bias represents peoples propensity irrational degree of credit for their successes. to claim an
2. Self-protecting bias represents the corollary effectthe irrational denial of responsibility for failure ADVICE Recall again the old Wall Street adage that perhaps provides the best warning against the pitfalls of self-attribution bias: Dont confuse brains with a bull market. One of the best things investors can do is view both winning and losing investments as objectively as possible. However, most people dont take the time to analyze the complex confluence of factors that helped them realize profit or to confront the potential mistakes that aggravated a loss. Post analysis is one of the best learning tools at any investors disposal. Its understandable but, ultimately, irrational
to fear an examination of ones past mistakes. The only real, grievous error is to continue to succumb to overconfidence and, as a result, to repeat the same mistakes Illusion of Control Bias General Description. The illusion of control bias describes the tendency of human beings to believe that they can control or at least influence outcomes when, in fact, they cannot. This bias can be observed in Las Vegas where casinos play host to many forms of this psychological fallacyproduct of a pair of tossed dice. In the casino game craps, for example, various research has demonstrated that people actually cast the dice more vigorously when they are trying to attain a higher number. Some people, when successful at trying to predict the outcome of a series of coin tosses, actually believe that they are better guessers, and some claim that distractions might
diminish their performance at this statistically arbitrary task. Technical Description Ellen Langer, Ph.D., of Harvard Universitys psychology department, defines the illusion of control bias as the expectancy of a personal success probability inappropriately higher than the objective probability would warrant.1 Langer found that choice, task familiarity, competition, and active involvement can all inflate confidence and generate such illusions. For example, Langer observed that people who were permitted to select their own numbers in a hypothetical lottery game were also willing to pay a higher price per ticket than subjects gambling on randomly assigned numbers. Since this initial study, many other researchers uncovered
similar situations where people perceived themselves to possess more control than they did, inferred causal connections where none existed, or displayed surprisingly great certainty in their predictions for the outcomes of chance events. ADVICE What follows are four advisories that investors can implement to stem the detrimental financial effects of illusions of control 1. Recognize that successful probabilistic activity. The first step
investing is a on the road to recovery from illusion of control bias is to take a step back and realize how complex U.S. and global capitalism actually is. Even the wisest investors have absolutely no control over the outcomes of the investments that they make Recognize and avoid circumstances that trigger susceptibility illusions of control. A villager blows his 2.
trumpet every day at 6 P.M., and no stampede of elephants ensues. Does the trumpet really keep the elephants away? Applying the same concept to investing, just because you have deliberately determined to purchase a stock, do you really control the fate of that stock or the outcome of that purchase? Rationally, it becomes clear that some correlations are arbitrary rather than causal. Dont permit yourself to make financial decisions on what you can logically discern is an arbitrary basis. 3. Seek contrary viewpoints. As you contemplate a new investment, take a moment to ponder whatever considerations might weigh against the trade. Ask yourself: Why am I making this investment? What are the downside risks? When will I sell? What might go wrong? These important questions can help you to screen the logic behind a decision before implementing that decision.
4. Once you have decided to move forward with an investment, one of the best ways to keep illusions of control at bay is to maintain records of your transactions, including reminders spelling out the rationale that underlie each trade. Write down some of the important features of each investment that you make, and emphasize those attributes that you have determined to be in favor of the investments success