Due to the different nature of the two categories of biases, cognitive errors can be
“___1___” – typically through education. By contrast, it may only be possible for an advisor to “___2__” to a client’s emotional biases, which are less easily “corrected”.
1 = Moderate (educate) 2 = Adapt
What are the 2 different types of Cognitive error biases?
Belief Perseverance and Information Processing
What are the 5 belief perseverance biases?
- Conservatism
- Confirmation
- Representativeness
- Illusion of control
- Hindisght Bias
“Conservatives continue to confirm my party and represent my ideals. In hindsight though no party has complete control.”
What are the consequences of conservatism and how do you overcome it?
Maintain prior views or forecasts by inadequately incorporating new information
Has aspects of statistical and information processing errors
Causes individuals to overweight initial beliefs about probabilities and outcomes
Under-react to new information
Overcoming Conservatism Bias:
- Recognize that bias exists
- Ask questions: How does this information change my forecasts? Impact?
- Updating beliefs is inversely correlated with effort involved
- Seek advice from experts
What are the symptoms of confirmation bias and how do you overcome confirmation bias?
Symptoms:
- Consider only information that supports belief
- Develop screening criteria and ignore info that would refute that screening criteria
- Under-diversify - excessive exposure to risk
- Hold excessive amount of stock in employing companies stock
Overcome:
- Seek information that challenges belief
- Get corroborating support from other sources
What are the symptoms of representativeness bias, what are the 2 subsets of representativeness bias, and how do you overcome representativeness bias?
Symptom: classifying new information based on past experiences and categories.
Subsets: Base Rate Neglect and Sample Size Neglect
Overcome:
- Be aware of the statistical errors you may be committing
- Are you overlooking reality of an investment situation?
What is Base Rate Neglect?
base rate or probability of categorization is not adequately considered
Categorize Company ABC as growth stock without appropriate due diligence
Rely on stereotypes without adequately incorporating base probability of stereotype occurring
What is sample size neglect?
FMPs incorrectly assume that small samples are representative of populations
What are the symptoms of Illusion of Control bias and how do you overcome this bias?
Symptoms:
- Trade more than is prudent
- Inadequate Diversification
Overcome:
- Recognize that investing is a probabilistic activity
- Global capitalism is complex - Even powerful investors have little control over outcomes
- Seek contrary viewpoints
- Keep records
What are the symptoms of hindsight bias and how do you overcome this bias?
Consequences:
- FMPs overestimate degree to which they predicted past investment outcomes à false confidence
- Unfairly assess money manager or security performance
Overcome:
- Recognize the bias
- Am I re-writing history or being honest about mistakes I made?
- Carefully record and examine investment decisions – both good and bad
What are the 4 information- processing biases?
- Anchoring and Adjustment Bias
- Mental Accounting Bias
- Framing Bias
- Availability Bias
What are the symptoms of anchoring and adjustment bias and how do you overcome this bias?
Symptoms:
1. FMPs may stick too closely to original estimates when new information is learned
Overcome:
- Consciously ask questions that may reveal an anchoring and adjustment bias
- Recognize that past prices and market levels are not an indication of what will happen in the future
What are the symptoms of mental accounting bias and how do you overcome this bias?
Symptoms:
- Money placed in ‘buckets’ or ‘layers’
- Neglect opportunity to reduce risk by combining assets with low correlations
- Irrationally distinguish between returns derived from income vs. capital appreciation
Overcome:
- Recognize drawbacks of putting money in different buckets
- Combine all assets on one spreadsheet
- Focus on total return
What are the symptoms of framing bias and how do you overcome this bias?
Symptoms:
- Willingness to accept risk is influenced by how situations are framed - Misidentify risk tolerances
- Choose sub-optimal investments based on how information about specific investment is framed
- Narrow frame - Focus on short-term price fluctuations
What are the symptoms of availability bias and how do you overcome this bias?
Take a heuristic approach to estimating the probability of an
outcome based on how easily the outcome comes to mind
symptoms:
1. Choose investment, investment advisor or mutual fund based on advertising
2. Limit investment opportunity set
3. Fail to diversity
4. Fail to achieve appropriate asset allocation
Overcome:
- Recognize the bias
- Disciplined approach to investing
- Ask good questions: Did I consider all options?
- Recognize that we forget events that happened a few years ago
What are the 6 emotional biases?
- Loss Aversion
- Overconfidence
- Self - Control
- Status-Quo
- Endowment
- Regret Aversion
What are the consequences of loss aversion bias and how do you overcome this bias?
Consequences:
1. Hold investments in loss position longer than justified - Hold riskier portfolios than is justified
2. Sell investments in gain position earlier than justified - Trade excessively as a result of selling winners
Myopic loss aversion: even long term investors are influenced by annual returns
Overcoming loss aversion bias:
use a disciplined approach based on fundamental analysis
What are the consequences of loss aversion bias and how do you overcome this bias?
definition: People demonstrate unwarranted faith in their own intuitive reasoning, judgments and/or cognitive abilities
