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1. SECTION IV
Behavioural
Finance

2. CHAPTER 15
Behavioural
Biases

3. Learning Objective Statements
▪ Explain the difference between cognitive errors and
emotional biases
▪ Recognize the main characteristics between cognitive
errors and information processing errors
▪ Identify the implications of each cognitive or emotional bias
listed in this chapter
3

4. Cognitive Biases
4
▪ Cognitive biases and their implications for financial decision making.
Cognitive biases are classified into two categories.
▪ The first category contains ―belief perseverance biases.
▪ Belief perseverance in the context of behavioral biases is the tendency
to cling to one’s previously held or recently established beliefs
irrationally or illogically.
▪ Investors continue to hold and justify the belief because of their bias
toward belief in themselves or their own ideals or abilities.
▪ The second category of cognitive error has to do with how people
process information either illogically or irrationally in financial decision
making.

5. Belief Perseverance Biases
5
CONSERVATISM CONFIRMATION
REPRESENTATIVE
NESS
ILLUSION OF
CONTROL
HINDSIGHT
COGNITIVE
DISSONANCE

6. Conservatism Bias
6
▪ Conservatism bias is a belief perseverance bias in which people maintain their
prior views or forecasts by inadequately incorporating new information that
arises.
▪ People often fail to modify their beliefs and actions to the extent rationally
justified by the new information.
▪ FMPs may under react to or fail to act on new information and continue to
maintain beliefs close to those based on previous estimates and information.
▪ As a result of conservatism bias, FMPs may do the following:
▪ Maintain or be slow to update a view or a forecast about an investment, even
when presented with new information.
▪ Decide to maintain a prior belief rather than deal with the mental stress of
updating beliefs given complex data. This behavior relates to an underlying
difficulty in processing new information.

7. Confirmation Bias
7
▪ Confirmation bias is 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.
▪ All FMPs(financial market Participants)— whether individual investors,
analysts, investment advisors, or fund managers— may, after making
an investment decision, tend to notice and consider information in a
manner that supports their beliefs.
▪ They may notice and consider only confirmatory information and ignore
or modify contradictory information.
▪ Client may insist on continuing to hold the investment, even when the
advisor recommends otherwise, because the clients follow-up research
seeks only information that confirms his belief that the investment is
still a good value.

8. Confirmation Bias
8
▪ confirmation bias is exhibited repeatedly. As a result of confirmation
bias, FMPs may do the following:
▪ Generally consider only positive information about an existing or
proposed investment and ignore or discount negative information
about the investment.
▪ Under diversify portfolios, leading to excessive exposure to risk. FMPs
may become convinced of the value of a single company and its stock.
▪ They ignore negative news about the company and its stock, and they
gather and process only information confirming that the company is a
good investment.
▪ They build a large position and eventually own a poorly diversified
portfolio.

9. Representativeness Bias
9
▪ People tend to classify new information based on past experiences
and classifications. They believe their classifications are appropriate and
place undue weight on them.
▪ This bias occurs because people attempting to derive meaning from
their experiences tend to classify objects and thoughts into
personalized categories.
▪ They rely on a best-fit approximation to determine which category
should provide a frame of reference from which to understand the new
information.
▪ FMPs often overweight new information and small samples because
they view the information or sample as representative of the population
as a whole.

10. Representativeness Bias
10
▪ FMPs may do the following:
▪ Adopt a view or a forecast based almost exclusively on new
information or a small sample. For example, when evaluating
investment managers, FMPs may place undue emphasis on high
returns during a one-, two-, or three-year period, ignoring the base
probability of such a return occurring.
▪ Update beliefs using simple classifications rather than deal with the
mental stress of updating beliefs given complex data. This issue
relates to an underlying difficulty (cognitive cost) in properly processing
new information.

11. Illusion of Control Bias
11
▪ Illusion of control bias is a bias in which people tend to believe that they
can control or influence outcomes when, in fact, they cannot.
▪ Expectancy of a personal success probability inappropriately higher than
the objective probability would warrant.
▪ For example, Langer observed that people permitted to select their own
numbers in a hypothetical lottery game were willing to pay a higher price per
ticket than subjects gambling on randomly assigned numbers.
▪ FMPs may do the following:
▪ Trade more than is prudent. Researchers have found that traders, especially
online traders, believe that they have control over the outcomes of their
investments.
▪ Lead investors to inadequately diversify portfolios. Researchers have
found that some investors prefer to invest in companies that they may feel
they have some control over, like the companies they work for, leading them
to hold concentrated positions.

12. Hindsight Bias
12
▪ Hindsight bias occurs when people see past events as having been
predictable and reasonable to expect. People tend to remember their
own predictions of the future as more accurate than they actually were
because they are biased by the knowledge of what has actually
happened.
▪ FMPs may do the following:
▪ Overestimate the degree to which they predicted an investment
outcome, thus giving them a false sense of confidence. The hindsight
bias may cause FMPs to take on excessive risk, leading to future
investment mistakes.
▪ Cause FMPs to unfairly assess money manager or security
performance. Based on their ability to look back at what has taken place
in securities markets, performance is compared against what has
happened as opposed to what is expected.

13. Cognitive Dissonance Bias
13
▪ When newly acquired information conflicts with 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.
▪ Cognitive dissonance encompasses the responses that arise when
people struggle to harmonize cognitions and thereby relieve their
mental discomfort.

14. Cognitive Dissonance Bias
14
▪ FMPs may do the following:
Cognitive dissonance can cause investors to hold losing securities
positions that they otherwise would sell because they want to avoid the
mental pain associated with admitting that they made a bad decision.
▪ Cognitive dissonance can cause investors to continue to invest in a
security that they already own after it has gone down (average down) to
confirm an earlier decision to invest in that security without judging the
new investment with objectivity and rationality.
▪ A common phrase for this concept is throwing good money after bad.

15. Cognitive Dissonance Bias
15
▪ Cognitive dissonance can cause investors to get caught up in herds of
behavior; that is, people avoid information that counters an earlier
decision (cognitive dissonance).
▪ Cognitive dissonance can cause investors to believe its different this
time.
▪ People who purchased high-flying, hugely overvalued growth stocks in
the late 1990s ignored evidence that there were no excess returns
from purchasing the most expensive stocks available.
▪ In fact, many of the most high-flying companies are now far below their
peaks in price.

16. Information Processing Biases
16
Anchoring and
Adjustment Bias
Mental
Accounting Bias
Framing Bias Availability Bias
Self-Attribution Outcome Bias Outcome Bias
Emotional
Biases
Loss-Aversion
Bias
Overconfidence
Bias
Self-Control
Bias
Status Quo Bias
Endowment
Bias
Regret-Aversion
Bias
Affinity Bias Status Quo Bias

17. Anchoring and Adjustment Bias
17
▪ Anchoring and adjustment bias is an information processing bias in
which the use of psychological heuristics influences the way people
estimate probabilities.
▪ Mental Accounting Bias : Mental accounting bias is an information
processing bias in which people treat one sum of money differently
from another equal-sized sum based on which mental account the
money is assigned to.
▪ Framing Bias : Framing bias is an information processing bias in which
a person answers a question differently based on the way in which it is
asked (framed).
▪ The frame that a decision maker adopts is controlled partly by the
formulation of the problem and partly by the norms, habits, and
personal characteristics of the decision maker.

18. Availability Bias
18
▪ Availability Bias : Availability bias is an information processing bias in which
people take a heuristic (also known as a rule of thumb or a mental shortcut)
approach to estimating the probability of an outcome based on how easily the
outcome comes to mind.
▪ Self-Attribution : Bias 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.
▪ Outcome Bias : Outcome bias refers to the tendency of individuals to decide to do
something— such as make an investment in a mutual fund—based on the
outcome of past events (such as returns of the past five years) rather than by
observing the process by which the outcome came about (the investment
process used by the mutual fund manager over the past five years).
▪ An investor might think: ―This manager had a fantastic five years, I am going
to invest with her, rather than understanding how such great returns were
generated

19. Recency Bias
19
▪ Recency Bias : Recency bias is a cognitive predisposition that causes people to
more prominently recall and emphasize recent events and observations than
those that occurred in the near or distant past.
▪ Emotional Biases : Emotional biases can cause investors to make suboptimal
decisions. Because emotions are rarely identified and recorded in the decision
making process—they have to do with how people feel rather than what and
how they think—fewer emotional biases have been identified.
▪ The seven emotional biases discussed are loss aversion, overconfidence, self-
control, status quo, endowment, regret aversion, and affinity.
▪ Loss-Aversion Bias: loss-aversion occurs when people tend to strongly prefer
avoiding losses as opposed to achieving gains. A number of studies suggest
that, psychologically, losses are significantly more powerful than gains.

20. Emotional Biases
20
▪ Self-Control Bias : Self-control bias is a bias in which people fail to act in
pursuit of their long-term, overarching goals because of a lack of self-
discipline. There is an inherent conflict between short-term satisfaction and
achievement of some long-term goals.
▪ Status Quo Bias : Status quo bias, coined by Samuelson and Zeck hauser, is an
emotional bias in which people do nothing (maintain the status quo) instead
of making a change. People are generally more emotionally comfortable
keeping things the same than they are with change, and thus do not necessarily
look for opportunities where change is beneficial.
▪ Endowment Bias : Endowment bias is an emotional bias in which people value
an asset more when they hold rights to it than when they do not. Endowment
bias is inconsistent with standard economic theory, because the price a person
is willing to pay for a good should equal the price at which that person would be
willing to sell the same good.

21. Emotional Biases
21
▪ Affinity Bias: Affinity bias refers to an individuals tendency to make
irrationally uneconomical consumer choices or investment decisions based on
how they believe a certain product or service will reflect their values.
▪ This idea focuses on the expressive benefits of a product rather than on what
the product or service actually does for someone (the utilitarian benefits).
▪ Overconfidence Bias: Overconfidence bias is a bias in which people
demonstrate unwarranted faith in their own intuitive reasoning, judgments,
and/or cognitive abilities. This overconfidence may be the result of
overestimating knowledge levels, abilities, and access to information.

22. Points to be Remember
Belief Perseverance Biases
CONSERVATISM
People often fail to modify
their beliefs and actions to
the extent rationally
justified by the new
information
CONFIRMATION
People tend to look for and
notice what confirms their
beliefs, and to ignore or
undervalue what
contradicts their beliefs.

23. Points to be Remember
Belief Perseverance Biases
REPRESENTATIVENESS
- Classify new information
based on past experiences
and classifications.
- People attempting to
derive meaning from their
experiences
- often overweight new
information and small
samples
ILLUSION OF CONTROL
- People tend to believe that
they can control or influence
outcomes
- Lead investors to
inadequately diversify
portfolios.

24. Points to be Remember
Belief Perseverance Biases
HINDSIGHT
- People tend to
remember their own
predictions of the future
as more accurate
- Overestimate the
degree to which they
predicted an investment
outcome, thus giving
them a false sense of
confidence.
COGNITIVE DISSONANCE
- People often experience
mental discomfort - a
psychological phenomenon
known as cognitive
dissonance.
- This concept is throwing
good money after bad.
- Cognitive dissonance can
cause investors to believe
its different this time.

25. Points to be Remember
Anchoring and
Adjustment Bias
Mental
Accounting Bias
Framing Bias Availability Bias
Self-Attribution Outcome Bias
Emotional
Biases
Loss-Aversion
Bias
Overconfidence
Bias
Self-Control
Bias
Status Quo Bias
Endowment
Bias
Regret-Aversion
Bias
Affinity Bias Status Quo Bias

26. Points to be Remember
Variance & Co Variance
 Variance refers to the spread of a data set. It’s a
measurement used to identify how far each number in the
data set is from the mean.
 A large variance means that the numbers in a set are far
from the mean and each other.
 A small variance means that the numbers are closer
together in value.
 Covariance is a measure of the relationship between
two random variables. The metric evaluates how much – to
what extent – the variables change together.
 Covariance, we can only gauge the direction of the
relationship (whether the variables tend to move in tandem
or show an inverse relationship).
 Positive covariance: Indicates that two variable tend to
move in the same direction.
 Negative covariance: Reveals that two variables tend to
move in inverse directions.

27. Thanks