Refresher Reading
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2021 Curriculum CFA Program Level III Portfolio Management and Wealth Planning
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Much of traditional economic and financial theory is based on the assumptions thatindividuals act rationally and consider all available information in the decision-makingprocess and that markets are efficient. Behavioral finance challenges these assumptionsand explores how individuals and markets actually behave. To differentiate the studyof individual investor behavior from the study of collective market behavior, thesubject of behavioral finance can be classified as Behavioral Finance Micro (BFMI) and Behavioral Finance Macro (BFMA).
BFMI examines the behavioral biases that distinguish individual investors from therational decision makers of traditional finance. BFMA detects and describes marketanomalies that distinguish markets from the efficient markets of traditional finance.In this reading, we focus on BFMI and the behavioral biases that individuals may exhibitwhen making financial decisions. BFMI attempts to observe and explain how individualsmake financial decisions. This approach is in contrast to traditional theories offinancial decision making that describe how people should make decisions under uncertainty.
Many prominent researchers have demonstrated that when people are faced with complexdecision-making situations that demand substantial time and effort, they have difficultydevising completely rational approaches to developing and analyzing various coursesof action. Facing uncertainty and an abundance of information to process, individualsmay not systematically describe problems, record necessary data, or synthesize informationto create rules for making decisions. Instead, individuals may follow a more subjective,suboptimal path of reasoning to determine a course of action consistent with theirbasic judgments and preferences.
A decision maker may have neither the time nor the ability to arrive at a perfectlyoptimal decision. Individuals strive to make good decisions by simplifying the choicesavailable, using a subset of the information available, and discarding some possiblealternatives to choose among a smaller number. They are content to accept a solutionthat is “good enough” rather than attempting to find the optimal answer. In doingso, they may unintentionally bias the decision-making process. These biases may leadto irrational behaviors and decisions.
By understanding behavioral biases, investment professionals may be able to improveeconomic outcomes. This may entail identifying behavioral biases they themselves exhibitor behavioral biases of others, including clients. Once a behavioral bias has beenidentified, it may be possible to either moderate the bias or adapt to the bias sothat the resulting financial decisions more closely match the rational financial decisionsassumed by traditional finance. Knowledge of and integration of behavioral and traditionalfinance may lead to superior results.
Section 2 describes and broadly characterizes behavioral biases. Sections 3 and 4discuss specific behavioral biases within two broad categories: cognitive errors andemotional biases. The discussion will include a description of the bias, potentialconsequences of the bias, detection of the bias, and guidance on moderating the effectsof the bias. A summary and practice problems conclude the reading.
Learning Outcomes
The member should be able to:
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distinguish between cognitive errors and emotional biases;
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discuss commonly recognized behavioral biases and their implications for financial decision making;
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identify and evaluate an individual’s behavioral biases;
Summary
Behavioral biases potentially affect the behaviors and decisions of financial market participants. By understanding behavioral biases, financial market participants may be able to moderate or adapt to the biases and as a result improve upon economic outcomes. These biases may be categorized as either cognitive errors or emotional biases. The type of bias influences whether the impact of the bias is moderated or adapted to.
Among the points made in this reading are the following:
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Individuals do not necessarily act rationally and consider all available information in the decision-making process because they may be influenced by behavioral biases.
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Biases may lead to sub-optimal decisions.
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Behavioral biases may be categorized as either cognitive errors or emotional biases. A single bias may, however, have aspects of both with one type of bias dominating.
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Cognitive errors stem from basic statistical, information-processing, or memory errors; cognitive errors typically result from faulty reasoning.
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Emotional biases stem from impulse or intuition; emotional biases tend to result from reasoning influenced by feelings.
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Cognitive errors are more easily corrected for because they stem from faulty reasoning rather than an emotional predisposition.
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Emotional biases are harder to correct for because they are based on feelings, which can be difficult to change.
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To adapt to a bias is to recognize and accept the bias and to adjust for the bias rather than to attempt to moderate the bias.
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To moderate a bias is to recognize the bias and to attempt to reduce or even eliminate the bias within the individual.
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Cognitive errors can be further classified into two categories: belief perseverance biases and information-processing biases.
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Belief perseverance errors reflect an inclination to maintain beliefs. The belief is maintained by committing statistical, information-processing, or memory errors. Belief perseverance biases are closely related to the psychological concept of cognitive dissonance.
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Belief perseverance biases include conservatism, confirmation, representativeness, illusion of control, and hindsight.
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Information-processing biases result in information being processed and used illogically or irrationally.
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Information-processing biases include anchoring and adjustment, mental accounting, framing, and availability.
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Emotional biases include loss aversion, overconfidence, self-control, status quo, endowment, and regret aversion.
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Understanding and detecting biases is the first step in overcoming the effect of biases on financial decisions. By understanding behavioral biases, financial market participants may be able to moderate or adapt to the biases and as a result improve upon economic outcomes.
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