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2020 Curriculum CFA Program Level III Portfolio Management and Wealth Planning

The Behavioral Biases of Individuals

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Introduction

Much of traditional economic and financial theory is based on the assumptions that individuals act rationally and consider all available information in the decision-making process and that markets are efficient. Behavioral finance challenges these assumptions and explores how individuals and markets actually behave. To differentiate the study of individual investor behavior from the study of collective market behavior, the subject 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 the rational decision makers of traditional finance. BFMA detects and describes market anomalies that distinguish markets from the efficient markets of traditional finance. In this reading, we focus on BFMI and the behavioral biases that individuals may exhibit when making financial decisions. BFMI attempts to observe and explain how individuals make financial decisions. This approach is in contrast to traditional theories of financial decision making that describe how people should make decisions under uncertainty.

Many prominent researchers have demonstrated that when people are faced with complex decision-making situations that demand substantial time and effort, they have difficulty devising completely rational approaches to developing and analyzing various courses of action. Facing uncertainty and an abundance of information to process, individuals may not systematically describe problems, record necessary data, or synthesize information to create rules for making decisions. Instead, individuals may follow a more subjective, suboptimal path of reasoning to determine a course of action consistent with their basic judgments and preferences.

A decision maker may have neither the time nor the ability to arrive at a perfectly optimal decision. Individuals strive to make good decisions by simplifying the choices available, using a subset of the information available, and discarding some possible alternatives to choose among a smaller number. They are content to accept a solution that is “good enough” rather than attempting to find the optimal answer. In doing so, they may unintentionally bias the decision-making process. These biases may lead to irrational behaviors and decisions.

By understanding behavioral biases, investment professionals may be able to improve economic outcomes. This may entail identifying behavioral biases they themselves exhibit or behavioral biases of others, including clients. Once a behavioral bias has been identified, it may be possible to either moderate the bias or adapt to the bias so that the resulting financial decisions more closely match the rational financial decisions assumed by traditional finance. Knowledge of and integration of behavioral and traditional finance may lead to superior results.

Section 2 describes and broadly characterizes behavioral biases. Sections 3 and 4 discuss specific behavioral biases within two broad categories: cognitive errors and emo

Learning Outcomes

The member should be able to:

  • distinguish between cognitive errors and emotional biases;
  • discuss commonly recognized behavioral biases and their implications for financial decision making;

  • identify and evaluate an individual’s behavioral biases;

  • evaluate how behavioral biases affect investment policy and asset allocation decisions and recommend approaches to mitigate their effects. 

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:

  • Individuals do not necessarily act rationally and consider all available information in the decision-making process because they may be influenced by behavioral biases.

  • Biases may lead to sub-optimal decisions.

  • 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.

  • Cognitive errors stem from basic statistical, information-processing, or memory errors; cognitive errors typically result from faulty reasoning.

  • Emotional biases stem from impulse or intuition; emotional biases tend to result from reasoning influenced by feelings.

  • Cognitive errors are more easily corrected for because they stem from faulty reasoning rather than an emotional predisposition.

  • Emotional biases are harder to correct for because they are based on feelings, which can be difficult to change.

  • 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.

  • To moderate a bias is to recognize the bias and to attempt to reduce or even eliminate the bias within the individual.

  • Cognitive errors can be further classified into two categories: belief perseverance biases and information-processing biases.

  • 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.

  • Belief perseverance biases include conservatism, confirmation, representativeness, illusion of control, and hindsight.

  • Information-processing biases result in information being processed and used illogically or irrationally.

  • Information-processing biases include anchoring and adjustment, mental accounting, framing, and availability. 

  • Emotional biases include loss aversion, overconfidence, self-control, status quo, endowment, and regret aversion.

  • 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.