Common Behavioral Biases

Mnemonic Devices for Easy Recall

1. Cognitive: Use the following mnemonic device to remind yourself of cognitive biases: Con-Con-Con-Rep-Hind + FAMA (think Fama and French).
2. Emotional: To remember emotional biases, use the following mnemonic device: LESSOR (the owner of an asset lending it to a lessee).

Cognitive

• Conservatism: This is the failure to appropriately update analyses with new information (i.e., skipping the Bayesian framework). Consequence: Investors may underestimate the impact of new information or otherwise fail to act on it, assuming things are as they have always been.

• Confirmation: This refers to the failure to seek contradictory facts or opinions, beginning with the end in mind to justify current beliefs rather than expand thinking. Consequence: Investors may under-diversify their portfolios, assuming their previous choices are still correct. They may hold too much company stock and seek positive information that reinforces previous decisions.

• Control: An illusion of being able to change (mostly) immutable outcomes. Consequence: Investors trade more than is prudent. Control bias may also lead investors to inadequately diversify portfolios. Some investors prefer investing in companies they feel they can influence, such as those they work for. As a result, such investors end up holding concentrated positions in those companies.

• Representativeness: This is a false belief that the past will always repeat itself. Consequence: Representativeness bias often causes investors to invest in the latest “hot investment.” This bias leads to additional costs of moving in and out of funds and a lack of performance persistence.

• Hindsight: This is the bias of thinking that past events were fully detectable when they occurred. In reality, probabilities, Monte Carlo simulation, etc., would have been the closest possibilities to an actual prediction. Consequence: Investors may overestimate their ability to predict an investment outcome. This inspires a false sense of confidence among investors. Hindsight bias can also lead to an unfair assessment of money managers or security performance.

• Framing: This is the tendency to receive and interpret information differently depending on its source and/or presentation rather than the information’s pure value. Consequence: Investors may misjudge their risk tolerance based on how they frame risk tolerance questions. In addition, investors may become more risk-averse when presented with a gain frame of reference. In contrast, when presented with a loss frame of reference, investors may become more risk-seeking. Under such a circumstance, investors may depart from the theoretically perfect portfolio. Lastly, investors may choose suboptimal investments.

• Anchoring: Refers to a case in which an investor pursues target numbers or is fixated on specific outcomes rather than remaining flexible. Consequence: Investors may stick too closely to their original estimates when new information emerges.

• Mental Accounting: This is an improper grouping and/or categorization of wealth that complicates proper economic analysis. An example is the misguided belief that one can afford a lavish vacation because one has saved money in an account titled ‘vacation account’ while simultaneously bearing high-interest consumer loans. Consequence: Investors may disregard opportunities to reduce risk by combining assets with low correlations. Investors may irrationally distinguish between income and capital appreciation returns, i.e., mixing earned income and investment returns.

• Availability: In this case, an investor places more importance on information that they can either easily gather or remember. This bias is anchored upon the logic that more recent and memorable events can impact future probabilities. Consequence: Investors may pick an investment, investment adviser, or mutual fund based on advertising rather than research or thorough options analysis. Consequently, investors may limit their investment opportunity set and fail to diversify or achieve an optimal investment portfolio.

Emotional

• Loss Aversion: This is an appropriate fixation on and avoidance of losses rather than an economically prudent weighting of gains and losses based on their utility. When investors evaluate a potential gain, loss-aversion bias causes risk avoidance. With the possibility of giving back gains already realized, investors lock in profits, limiting the upside.

• Endowment: This refers to the feeling that an asset is worth more because it is already owned. Examples are inherited stock, businesses, or real estate, on which sellers may tag abnormally high prices. Consequence: This bias makes investors not understand appropriate selling points for assets already owned and/or a potential failure to liquidate a holding when cash may truly be needed.

• Self-control: This is a lack of appropriate savings and wealth-building due to overconsumption. Consequence: Excess spending and lack of preparation for the future.
  Note: This emotional bias is different from illusion of control, a cognitive bias. The former is an outward view of having control over external events, while the latter is a failure to control one’s own self appropriately.

• Status Quo: This refers to resistance to change. Consequence: Failure to create proper changes to asset allocation when needed, and not selling investments despite having no justification for holding onto them, etc.

• Overconfidence: This is the belief in one’s superior abilities to collect and process economic information and profit from it. Consequence: Excessive trading, refusal to diversify, and the belief that one is smarter than the market or can control outcomes beyond their reach are common consequences.

• Regret Aversion: This is a case in which an investor seeks to avoid negative outcomes only or inappropriate fixation on undesired results rather than a prudent progress-oriented system. Consequence: Investors choose overly conservative investments and allocations. Further, as a result of risk aversion, investors suffer from a herd mentality, i.e., flowing with the majority. This leads to suboptimal performance. 

Question

When Michael had his first daughter, he decided to save for her future. After calling a local advisor, he set up a UGMA account for college expenses and funded it with life-cycle funds. When it was time for his daughter to go to university, Michael wondered how his plan had worked. He had been afraid to ‘get in over his head’ and had neither contacted his advisor nor made any updates to the savings plan. Which of the following biases is least likely reflected in Michael’s actions?

1. Status-quo bias.
2. Regret aversion bias.
3. Self-control bias.

Solution

The correct answer is C:

We cannot determine if Michael showed signs of self-control bias as the question does not explicitly mention a failure to make regular financial contributions to the plan or improperly fund it.

However, he showed signs of status-quo bias by leaving his plan untouched. Besides, he exhibited regret-aversion, which likely worked in tandem with his status-quo bias and led to the neglect of appropriate monitoring of his plan.

Reading 1: The Behavioral Biases of Individuals.

LOS 1 (b) Discuss commonly recognized behavioral biases and their implications for financial decision making