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8-2 the behavioral biases of individuals (3 cognitive errors (belief…
8-2 the behavioral biases of individuals
1 introduction
2 categorizaitons of behavioral biases
3 cognitive errors
belief perseverance biases:
the tendency to cling to one's previously held beliefs irrationally or illogically
——cognitive dissonance:
the mental discomfort that occurs when new infor conflits with previously held beliefs or cognitions
conservatism biase
maintain prior views or forecast by inadequately incorporating new infor
→overweight initial beliefs about probabilities and outcomes and under-react to new infor
consequences
maintain or be slow to update a view or a forecast even when presented with new infor
opt to maintai a prior belief rather than deal with the mental stress of updating beliefs given complex data
detection and guidance for overcoming
to be aware that a bias exists
cognitve cost
→overreact to infor that is easiliy processed and may even underweight base rates
seek advice from a professional
how to interpret the data
the action implications of the data
confirmation biase
tend to look for and notice what confirms their beliefs and to ignore or undervalue what contradicts theier beliefs
consequences
consider only the positive infor and ignore any negative infor
develop screening criteria and ignore infor that either refutes the validity of the screening criteria or supports other screening criteria
under-diversify portfolios, leading to excessive exposure to risk
hold a disproportionate amount of employing company's stick
detection and guidance for overcoming
actively seeking out infor that challenges your beliefs
to get corroborating support for an investment decision
representativeness bias
tend to classify new infor based on past experiences and classificaions →statistical and infor-processing errors
types
base-rate neglect
the base rate or probability of the categorization is not adequately considered
often follow erroneous path as an easy alternative to the diligent reseach
sample-size neglect
incorrectly assume that small samples sizes are representative of populations
overweight the infor in the small sample
consequences
adopt a view or a forecast based almost exclusively on new infor or small sample
update beliefs using simple calssifications
detection and guidance on overcoming
need to be aware of statistical mistakes
constantly ask themselves if overlooking the reality
excessive trading and inferior performance results
→diversified portfolio to meet financial goals and stick with it
periodic table of investment returns
illusion of control
tend to believe can control or influence outcomes in fact cannot
choices, task familiarity,competition and active involvement
consequences
trade more than is prudent
inadequately diversify portfolios
detection and guidelines for overcoming
recognize that successful investing is a probabilistic activity
to seek contrary viewpoints
critical to keep records
hindsight
with selective perception and retention aspects
may see past events as having been predictable and reasonable to expect
often caused by the reconstructive nature of memory
consequences
overstimate the degree to predicted →a false sense of confidence
to unfairly assess money manager or security performance
detection and guidelines for overcoming
need to be aware of the possibillity of hindsight bias
record and examine decisions
markets move in cycles
expectations must be managed
education is critical
all managers be evaluated relative to appropriate benchmarks and peer groups
information-processing biases:
infor may be processed and used illogically or irrationally
anchoring and adjustment
the use of a psychological hertistic influences the way people estimate probabilities
tend to adjust anchors insufficiently and end approximations biased
consequences
stick too closely to original estimates when new infor is learned
anchored to the economic statees of countries or companies
detection and guidelines for overcoming
consciously ask questions may reveal
remember past prices market levels and reputation provide little infor about future potential
mental accounting
treat one sum of money differently from another equal-sized sum based on which mental accountassigned to
consequences
place into discrete buckets without regard correlations
neglect opportunities to reduce risk by combining low correlations
irrationally distinguish between return from income and capital appreciation
detection and guidelines for overcoming
recognize the drawback - correlations not taken into account
framing
answers a question differently based on the way it is framed
the frame controlled partly by the formulaiton of the problem and partly by the norms habits and personal characteristics of the decision maker
narrow framing occurs when based on a narrow frame of reference
consequences
when investment questions are posed positively or negatively
misidentify risk tolerances
choose suboptimal investments
focus on short-term price fluctuations - excessive trading
detections and guidelines for overcoming
should focus on the future prospects of an investment
try to be as neutral and open-minded
availability bias
take a heuristic approach to estimating the probability of an outcome based on how easily the outcome comes to mind
the basic problem - biases in our memories
sources of availability bias
retrievability
comes to mind more quickly likely be chosen as correct even not reality
categorization
if difficult to come up with a search set, estimated probability may be biased
narrow range of experience
used too narrow a frame of reference
resonance
biased by how closely a situation parallels personal situation
consequences
choose based on advertising rather than on a thorough analysis of the options
limit investment opportunity set
fail to diversify
fail to achieve an appropriate asset allocation
detection and guidelins for overcoming
develop appropriate IPS, carefully research and analyze and focus on long-term results
to realize that humans generally disregard or forget about events happened more than a few years ago
conclusion
remain vigilant to the possibility of their occurrence
4 emotional biases
5 investment policy and asset allocation