Common Behavioral Biases

Mnemonic Devices for Easy Recall

1. Cognitive: The cognitive biases can be remembered with the following mnemonic device: Con-Con-Con-Rep-Hind + FAMA (think Fama and French).
2. Emotional: The emotional biases can be remembered with the following mnemonic device: LESSOR (the owner of an asset lending it for use to the lessee).

Cognitive:

Conservatism – The failure to appropriately update analyses with new information as it becomes available (i.e. skipping the Bayesian framework). Consequence: Investors may underestimate the impact of new information, or otherwise fail to act on it, and continue to believe things as they have in the past.

Confirmation – The failure to seek out 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 believing that their previous choices are still correct, they may hold too much company stock, and may also seek out positive information that reinforces previous decisions.

Control – An illusion of being able to change often (mostly) immutable outcomes. Consequence: Trade more than is prudent. Control bias may also lead investors to inadequately diversify portfolios. Some investors prefer investing in companies that they feel they can influence, such as the companies they work for, leading them to hold concentrated positions.

Representativeness – 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 lack of performance persistence.

Hindsight – The bias of thinking that past events were fully knowable at the time 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, which gives them a false sense of confidence. Hindsight bias can also lead to an unfair assessment of money managers or security performance.

Framing – A tendency to receive and interpret information differently depending on its source and/or presentation, rather than on the pure value of the information itself. Consequence: Investors may misjudge their risk tolerance based on the way questions about risk tolerance were framed. When presented with a gain frame of reference, investors may become more risk-averse, while when presented with a loss frame of reference, they may become more risk-seeking, which may cause them to depart from the theoretically perfect portfolio. Lastly, investors may choose suboptimal investments.

Anchoring – Pursuing target numbers or fixating on specific outcomes rather than remaining flexible. Consequence: Investors may stick too closely to their original estimates when new information comes to light.

Mental Accounting – An improper grouping and/or categorization of wealth which complicates proper economic analysis. For example, potentially believing that a lavish vacation can be afforded because one has saved money in an account titled ‘vacation account’, while simultaneously carrying high-interest consumer loans. Consequence: Investors may disregard opportunities to reduce risk by combining assets with low correlations. Investors may irrationally distinguish between returns derived from income and those derived from capital appreciation, i.e. mixing earned income and investment returns.

Availability – Placing more importance on information that is more easily gathered or remembered. Future probabilities can be impacted by more recent and memorable events. Consequence: Investors may pick an investment, investment adviser, or mutual fund based on advertising rather than research or thorough analysis of the options. Investors may limit their investment opportunity set, fail to diversify or achieve an optimal investment portfolio.

Emotional:

Loss Aversion – An appropriate fixation on and avoidance of losses, rather than an economically prudent weighting of gains and losses based on their utility. Due to loss aversion, people tend to hold their losers even when they have little or no chance of returning. When people evaluate a potential gain, loss-aversion bias causes risk avoidance. With the possibility of giving back gains already realized, investors lock in profits, limiting upside.

Endowment – The feeling that an asset is worth more because it is already owned. Examples are often inherited stock, businesses, or real estate which sellers may place too high of a price on. Consequence: This bias causes investors not to 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 – A lack of appropriate savings and wealth building due to overconsumption. Consequence: excess spending, lack of preparation for the future.

Note: This emotional bias varies from the cognitive bias Illusion of Control in that the former is an outward view of having control over external events, while the latter is a failure to appropriately control one’s own self.

Status Quo – A resistance to change. Consequence: Not creating the proper changes to asset allocation when they are needed, not selling investments despite their having no justification for holding into the future, etc.

Overconfidence – A belief in one’s own superior abilities to collect and process economic information and profit from it. Consequence: excessive trading is a common consequence, or the refusal to diversify, believing that one is smarter than the market, or can control outcomes beyond their reach.

Regret Aversion – Seeking to avoid negative outcomes only, or inappropriate fixation on undesired results, rather than a prudent progress-oriented system. Consequence: Choosing overly conservative investments and allocations. Also following the herd is another choice which makes those suffering from regret aversion bias feel safer, this leads to suboptimal performance. 

Question

When Michael had his first daughter, he knew he wanted to save for her future. After calling up a local advisor, Michael set up a UGMA account for college expenses and funded it with life-cycle funds. As the years passed, Michael realized his daughter would be going to university in a few months and wondered how his plan had worked. Michael 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 are unable to determine if Michael showed signs of self-control bias as the question does not specifically mention a failure to make regular financial contributions to the plan, or to improperly fund it.

Reading 1: The Behavioral Biases of Individuals

LOS 1 (c) Identify and evaluate an individual’s behavioral biases