Behavioral Finance in Theory and Practice

Behavioral Finance in Personal Finance

Instructor: Dr. Fawad Ahmed

Group Members:
Muhammad Abubakar – 21761
Maham Rasheed – 22431
Mahnoor – 22455
Ghazal – 22426
Contents
Behavioral Finance Concepts Applied to Personal Finance....................................................................3
Mental Accounting...............................................................................................................................3
Endowment effect................................................................................................................................3
Disposition effect.................................................................................................................................4
Biases that effect individual’s saving, investing and spending choices...................................................4
Strategies for overcoming these biases....................................................................................................5
Gambler’s Fallacy................................................................................................................................5
Recency Bias........................................................................................................................................6
Loss Aversion.......................................................................................................................................6
Overconfidence....................................................................................................................................7
Confirmation Bias................................................................................................................................7
Anchoring Bias....................................................................................................................................8
References................................................................................................................................................9

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Behavioural Finance Concepts Applied to Personal
Finance
Mental Accounting
Richard H. THALER divides mental accounting into three components: 1. Perception and
evaluation, 2. Assignment of Activities, 3. Frequency of Evaluation. It is a set of operations
individuals use to keep track of their financial activities. Based on subjective criteria,
different values are assigned to the money earned or came from different sources which
impacts the way people spend or save their money. Let’s take an example of tax refund,
whenever we receive a tax refund from the FBR we spend it on some extra things like
discretionary items. (wants, luxuries etc.) Even though this money is not a gift from FBR, it is
the money we have paid them extra, it was our earned money. But the way we treat it is
different.
People save some money from their earnings for some special purposes like children’s
education, purchasing a house, they also earn an interest from that amount by keeping in bank
account but at the same time they are holding the credit card debts, which is charging a very
high amount of interest to them. Here is an example from the paper of Richard on mental
accounting and consumer choice ‘Mr. and Mrs. J have saved $15,000 toward their dream
vacation home. They hope to buy the home in five years. The money earns 10% in a money
market account. They just bought a new car for $1 1,000 which they financed with a three-
year car loan, here is violation of principle of fungibility; The family doesn't treat all their
money the same way. They're careful about paying off their car loan on time but don't plan to
refill their vacation savings once they use it up. But here comes some sentiments, we think
that the money we have saved is for a special purpose and spending that money on our
expenses is not right but due to this we are paying more interest on our debts.
There is a concept of loss aversion. We do not realize our losses because you don’t want to
regret our decisions. Let’s take an example of personal finance, where Mr. A has 2 stocks one
is winning stock, and the other one is losing stock. He must sell one stock right now which
one he is going to choose; he will sell the winning one because that will make him proud that
he has earned the profit. But if he thinks rationally then the losing stock will give him further
losses in future, so it was better to sell it now and close his position but due to his emotions
and sentiments he is not doing that.

Endowment effect
We overvalue the objects that we own as compared to the market, often due to some
emotional connection or significance. There are 2 conditions to this; willingness to pay in
which you are buyers, and you have to quote how much maximum price you are going to pay
for a certain object. Secondly when you are a seller, how much minimum amount you are
willing to accept. It was noticed that selling prices were higher than buying prices. The
endowment effect can be avoided if we control or regulate our emotions and assign the actual
or market values to the objects we own, rather than attaching our emotions with it.

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Disposition effect
Disposition effect is when a stock is performing good the investor will close his position
quickly to realize the gain for the sake of pride. On the contrary, when the same stock
performs bad investor will not close his position quickly and carry the losses for longer time
because he doesn’t want to regret his decision. If an investor can regulate his emotions and
think rationally then he should sell the bad performing stocks early to save himself from
further loses and carry the good performing stocks for a bit long time to make further profits.
This can impact the decision of the individual investor on the personal finance level.

Biases that effect individual’s saving, investing and

spending choices
There are a number of biases that affect how a consumer makes his/her choice whether they
need to spend money or whether they feel the need to invest it. The common and more
prominent biases that play a vital role in these choices are overconfidence, recency bias,
confirmation bias, anchoring bias, gambler’s fallacy and loss aversion. Firstly, a scenario
needs to presented which will explain all of these biases and their implementation by an
investor and saver. Scenario: An investment choice of $500 that has a 60% chance of gaining
$100 and a 40% chance of losing $200.
A person who is circled around gambler’s fallacy, which explains an individual’s behavior of
believing that a random event’s result will be affected by the result of past events. That is to
say that if two events have equal chance of occurring, and event A has occurred the previous
few times, then an individual would think that this time event B has a higher chance of
occurring. This is a fallacy because the event in the past and the current event are independent
of each other and cannot possibly affect each other. That person who faced loss in their
previous investment might want to invest $500, thinking that since he made a loss last time,
he has a higher chance of gaining this time. However, the person who had gained previously
would not be willing to invest, thinking that he will probably make a loss because he won
previously.
Similarly, a similar concept of recency biases touches the same base root of connecting
investments with the recent past. A person who might have lost the recent bet would have the
same thoughts of losing $200 and would prefer no investment.
Then comes the risk appetite of an individual explained through loss aversion concept. A loss
hits more than a gain and if the individual has been making a loss, they would want to cover
up their loss even with the risk of losing $200 more, just so they could gain a part of what
they have been losing and would keep investing. Loss aversion also means that investors
might not invest even if the potential for loss is less than the potential for gain.
Moreover, the overconfidence bias states that people have the tendency of being
overoptimistic about their future and have a tendency to overestimate their knowledge; hence,
they tend to make decisions that might not be always right. Such people have a high-risk
appetite. For instance, they decide to go for a gain of $100 without looking at the risk of $200

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loss that comes with it only because maybe they have a gut feeling or are very confident
about gaining extra money. This puts forward the concept of miscalibration explained within
the terminologies of Overconfidence. On the other hand, overconfidence can be drawn out of
people’s actions through illusion of control where they believe they have control over events
occurring and might makes such moves to gain that extra $100.
Confirmation bias also diverts the money between investment and saving. A confirmation
bias states that new information is favored in such a way that already supports ones exiting
beliefs. So, if the investor strongly thinks that investment in a specific company is bad, he
might not invest in it. He would ignore the information that suggests that this might be a good
investment and actively seek out information that affirms his decision.
Lastly, the anchoring bias states that investors depend on information way too much that they
had obtained in the early stages of a decision that they had to make. They will always anchor
back to their initial decision, even if they obtained more information later on that contradict
their initial decision. The investors would give less weight to later information, and this
would lead to making bad decisions.
All of these biases hinder an individuals' ability to evaluate investment decisions effectively,
often leading to poor choices regarding whether to invest or not.

Strategies for overcoming these biases

There are a number of measures that an individual can take to overcome these biases, or at
least minimize their impact.

Gambler’s Fallacy
There a number of steps that an investor can take to overcome this bias. Firstly, he can try to
understand probability and realize that each event is independent of all other events. For
example, if someone flips a coin with 50% chance of getting head and 50% chance of getting
tail, and he gets head. When he flips the coin again, he must realize that the result of the
previous event can’t affect the probability of this event. The probability of getting head is still
50%. Realizing this can help an investor avoid most of the pitfalls associated with gambler’s
fallacy. Once an investor has realized that the events are independent and can’t affect each
other, he can logically evaluate each decision separately and try to maximize his profits.
Emotions such as frustration, excitement and desperation can encourage investors to take
risks, and this increases the chance of falling prey to gambler’s fallacy. The investor can
minimize the impact of this by setting limits and sticking to them, regardless of the past
results. This can reduce the maximum loss he can make by stopping him from investing
further, even when he thinks he can profit due to the fallacy.

Recency Bias
If an investor has had a bad investment experience last year, and a bad investment experience
20 years ago, it is more likely that he will give more weight to recent bad experience rather
than the one that he had 20 year ago. This is a fallacy because in term of decision making,
both of these experiences should have equal weight. This fallacy can also affect an investor’s
decision making by recent experience influencing his current decision, even if the current

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decision is completely independent from the decision that led to recent bad experience. There
are many steps that an investor can take to overcome this bias. Firstly, the investor should be
aware of recency bias and how it can affect his decisions. Secondly, he should reflect on all
the information available. He should evaluate everything again and check if he is missing any
relevant information. The third step is research, in which the investor should research the
event and base his decision on that research rather than emotions. The investor should
research a longer time horizon when researching historical data as this would help him to
reduce the influence of recent data. Researching also helps because it forces the investor to
evaluate his decisions and not just relay on what he remembers. Trying to make decisions
through purely memory often leads to recency bias as our memories are colored by emotions.
Emotions affect our judgements severely and it is important to avoid them when making
important decisions. The fourth step is to discuss the decisions with others. Other people
would have different experiences and opinions, discussing the decision with them would
reduce the chance of falling prey to recency bias. It is important to take time when making
decisions. Recency bias is more likely to appear when rushing to make decisions.

Loss Aversion
As with all biases, the first step is to be aware of what loss aversion is how it can affect our
decisions. Once the investor is aware of what loss aversion is, he can proceed towards
mitigating its impact and thus maximizing his profitability. There are two methods that can be
used to avoid loss aversion, framing and putting things into perspective. The investor can
frame his decisions positively, that is to say he can frame his decisions in terms of potential
gains rather than potential losses. He can emphasize the possible benefits and opportunities
he can access through an investment, rather than risks and losses it represents. The second
method is putting things into perspective. In this method, the investors questions himself that
what could be the maximum possible loss he can make if he goes through with an investment.
This helps put the potential loss and the associated feeling into perspective and can help get
over the fear of loss. Investors can then use this to determine if it is worth investing or not.
The investors can also reflect on past experiences where loss aversion may have caused them
to lose an opportunity.

Overconfidence:
It is important to be flexible rather than rigid in one's approach. Being flexible enables us
to maintain an open mind toward current circumstances and the various methods that may
be used to address the issue or solve the problem. There could be several ways to
accomplish a single objective in investing. It is necessary to assess each of them.

Another crucial concept that investors need to be aware of is reflection. To prevent

overconfidence bias, it is crucial for investors to have the ability to evaluate situations
objectively and make well-informed decisions.

Information gathering aids in remaining up to date on the essential adjustments occurring

in the field of investments regarding laws and regulations, practices, trends, etc. An
intelligent investor is more likely to be open to learning new things and is therefore less
likely to grow overconfident.

Being skeptical aids in gathering more information to raise awareness as well as in

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 spotting frauds, falsehoods, and loopholes to prevent bias against any given circumstance
or choice. Multiple viewpoints have a significant impact on our decision-making process;
thus, it is crucial to enable our minds to analyze them.

Everyone tackles a problem differently when working and brings diverse viewpoints to
the table. Investing also presents similar scenarios. To prevent unwarranted biases, it is
imperative to consider the thoughts and perspectives of others.

Abstract of the Article by R Arkes, Caryn Christensen, Cheryl Lai, Catherine Blumer on how
to reduce Overconfidence.
Earlier examination has recommended that the vast majority are truly careless in their
responses to general information questions. We endeavored to diminish arrogance in every
one of two separate examinations. In Analysis 1 portion of the subjects addressed five
practice questions which had all the earmarks of being troublesome. The excess subjects
addressed practice issues which seemed, by all accounts, to be simple, however were
similarly basically as troublesome as the other gathering's training questions. Inside every one
of these two gatherings, a big part of the subjects got input on the precision of their responses
to the training questions, while the other half got no criticism. Each of the four gatherings
then, at that point, addressed 30 extra inquiries and demonstrated their trust in these
responses. The gathering, which had gotten five clearly "simple" practice questions and
afterward had been offered criticism on the precision of their responses was underconfident
on the last 30 inquiries. In Examination 2 subjects who expected a gathering conversation of
their solutions to general information questions took more time to respond to the inquiries
and communicated less carelessness in their responses than did a benchmark group.

One more exploration by Hal R. Arkes, Caryn Christensen, Cheryl Lai, and Catherine Blumer
was to decrease carelessness, which is a typical issue overall information question. They
researched systems to lessen carelessness in two examinations. In the main examination,
members addressed practice questions and were given criticism on their exactness. In the
wake of addressing questions that were basic right away, the people who got criticism
showed less presumptuousness in their future reactions. In the subsequent trial, members who
expected bunch conversations addressed questions all the more leisurely and with less
haughtiness. These outcomes infer that giving valuable analysis and advancing cooperative
conversations may successfully decrease dynamic arrogance.

Overcoming Confirmation Bias:

One prevalent psychological characteristic that influences people's decision-making is
confirmation bias. Confirmation bias can result in lost opportunities and less-than-ideal
investing selections when it comes to portfolio management. Confirmation bias is the
tendency for investors to ignore contradicting information in favor of information that
supports their preexisting assumptions. This may result in an inability to diversify their
holdings, overconfidence, and overtrading. Thankfully, investors can employ a number of
techniques to get over confirmation bias and make more logical investment choices.
Seek out different viewpoints: Finding different viewpoints on an investing opportunity is a
useful strategy for overcoming confirmation bias. This can involve participating in internet

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forums, going to conferences, and reading research reports from various analysts. You can
obtain a more thorough grasp of an investing opportunity and lower your chance of making
biased selections by exposing yourself to a variety of points of view.
 Do extensive study: Doing extensive research before to making an investment
decision is another tactic for combating confirmation bias in portfolio management.
This can involve speaking with subject-matter experts, examining market trends, and
evaluating financial statements. Investing can be made more intelligently and with
less impact from human biases if you use a data-driven strategy.
 Question your assumptions: Confirmation bias affects investors, who often cling to
their preexisting opinions despite contradicting information. It's critical to actively
question your presumptions and look for information that defies your ideas in order to
combat this inclination. This can entail debating with other investors, looking for
opposing views, and stress-testing your investment theory.
 Employ decision-making frameworks: Using frameworks for decision-making that are
intended to lessen the impact of individual biases is another successful tactic for
combating confirmation bias. To make sure they take into account all pertinent
elements before making an investment decision, for instance, some investors utilize
checklists. Others assess the possible consequences of many scenarios with the use of
decision trees or other visual aids.

Article by panelChristina Schwind, Jürgen Buder, Ulrike Cress, Friedrich W. Hesse tells us
about avoiding confirmation Bias:

Since the public may access a wide range of viewpoints, the Web presents an ideal
environment for opinion development. However, the variety of perspectives is often
underutilized: The propensity of learners to prioritize information that aligns with their
preferences above that which does not is known as confirmation bias. To investigate whether
technology such as recommender systems could potentially mitigate this bias, two tests were
developed. Researchers were able to better grasp the role of preference-inconsistent
suggestions by comparing their effects to both a condition with recommendations that
matched preferences and a control condition without recommendations. In Study 1,
preference-inconsistent recommendations lessened confirmation bias and encouraged a more
tempered viewpoint on the controversial area of neuro-enhancement. In Study 2, we found
that recommendations that conflicted with preferences led to both balanced and divergent
thinking. These studies all showed that preference-inconsistent recommendations can
minimize confirmation bias and promote a variety of thought processes. Lastly, future
directions and uses for research are highlighted.

Overcoming Anchoring Bias:

These useful suggestions will help us combat the effects of anchoring bias.
Enlarge Your Viewpoint: To promote critical thinking and problem-solving skills, regularly
evaluate opposing views before making important judgments. Your perspective becomes
limited when you anchor bias, resulting in tunnel vision. Instead of basing your beliefs on the
anchor, embrace intellectual variety to broaden your awareness. To get new insights,

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participate in discussions with an open mind and pay attention to opposing viewpoints.
Examining a broad range of options also helps you confront your assumptions with evidence.
The only way to improve social, professional, and personal outcomes is via logical reasoning.

Ask the Anchors Questions

Remain aware of how your perspective is shaped by the facts or points of reference you were
given. Always evaluate their effects and take into account other viewpoints before making
decisions. Take note of the feelings and attitudes they arouse and utilize them as a guide to
access your subconscious.
Analyze anchors' applicability and validity critically. In order to do a critical analysis, you
must look for more data, challenge your presumptions, compare and contrast references,
assess the context, speak with experts, and confirm the correctness of your conclusions.
Perform Your Own Research
Continue to be proactive in gathering data and information from reliable sources to assess the
applicability and reliability of anchoring. Taking into consideration any potential biases or
vested interests, view the anchor in a larger context. Steer clear of arbitrary references.
Seek instead expert comments and a range of viewpoints that can help clarify the situation.
While doing so, keep an eye out for credible data and facts that may contradict or confirm the
original anchor. Verifying the sources' accuracy and reliability is ensured through fact-
checking. You become more well-rounded by using the multifaceted approach, which
reduces the impact of possibly faulty or biased anchors.
Establish Objective Standards
As a framework or guidance for the deliberation process, clearly define the criteria for
making decisions. Never undervalue the influence of an anchoring bias. You must develop
the ability to use reason as second nature.
Establish precise criteria or benchmarks to assess the available solutions. The metrics you
have chosen offer complete anchor analysis and uniformity. Additionally, it encourages
accountability and openness in decision-making. Avoid letting random or unconnected
circumstances affect your decisions; instead, use these criteria as a baseline for comparison.
Allocate Time for Self-reflection
Consider your options carefully while assessing anchoring biases. Snap decisions and rapid
judgments are frequently more problematic since they are rash, shallow, and premature.
Allocate enough time for evaluating anchoring to make fair and accurate decisions.
Take a step back and give yourself some time to consider the circumstances. When doing
your research, be proactive but patient. Time is not enough on its own. A careful and
comprehensive analysis of the data needs to go hand in hand with time. You have time to
think over the larger picture and its consequences before making a final choice.
Overcome Your Anchoring Choices
Every bad and troublesome decision is influenced by anchoring biases, which devalue and
contradict the facts. By setting aside time to examine different viewpoints, challenge the
validity of the anchor, examine professional opinions and data, and create structure during the
reflection process, you can resist the hold of this cognitive inclination. Try it now to prevent
hasty.

As indicated by research by Krishna Savani, Monica Wadhwa, individuals can beat these
anchors by being helped to remember their choices and urged to gauge their choices. This
hypothesis is upheld by seven examinations utilizing US residents, which show that in an
assortment of discussion circumstances, the decision update made members turn away from

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their underlying offers. High mental burden was found to lessen the viability of this
mediation, featuring the meaning of mental assets in direction. By and large, underlining the
possibility of decision can be a strong methodology for decreasing securing predisposition
and empowering more coherent independent direction.

References
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(n.d.). From https://www.jstor.org/stable/40057241?
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%3A738d3a1733b7758cd8a5830c4f6f85b4&seq=1
(n.d.). From https://www.investopedia.com/terms/e/endowment-effect.asp
(n.d.). From https://www.investopedia.com/terms/e/endowment-effect.asp
(n.d.). From https://thedecisionlab.com/biases/loss-aversion
(n.d.). From https://www.investopedia.com/terms/g/gamblersfallacy.asp#:~:text=The%20gambler's
%20fallacy%2C%20also%20known,event%20or%20series%20of%20events.
(n.d.). From https://effectiviology.com/gamblers-fallacy/#:~:text=Overall%2C%20to%20avoid%20the
%20gambler's,cannot%20possibly%20affect%20each%20other.
(n.d.). From https://www.resolve.blog/articles/recency-bias#how-to-overcome-recency-bias
Gal Smitizsky, W. L. (n.d.). The Endowment Effect. : Loss Aversion or a Buy-Sell Discrepancy?
Thaler, R. (1985). Mental Accounting and Consumer Choice. 199_214.
Thaler, R. H. (n.d.). Mental Accounting Matters.

View of the Impact of Anchoring Bias on Financial Decision-Making: Exploring Cognitive Biases in
Decision-Making Processes, www.pioneerpublisher.com/SPS/article/view/412/366. Accessed 4 May
2024.

Author links open overlay panelKrishna Savani a 1, et al. “Choosing Not to Get Anchored: A Choice
Mindset Reduces the Anchoring Bias.” Journal of Experimental Social Psychology, Academic
Press, 12 Jan. 2024, www.sciencedirect.com/science/article/pii/S0022103123001324.

Author links open overlay panelChristina Schwind, et al. “Preference-Inconsistent Recommendations:

An Effective Approach for Reducing Confirmation Bias and Stimulating Divergent Thinking?”
Computers & Education, Pergamon, 13 Oct. 2011,
www.sciencedirect.com/science/article/pii/S0360131511002478.

“Research: When Overconfidence Is an Asset, and When It’s a Liability.” Harvard Business Review,
17 Sept. 2021, hbr.org/2018/12/research-when-overconfidence-is-an-asset-and-when-its-a-
liability.

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Author links open overlay panelHal R Arkes, et al. “Two Methods of Reducing Overconfidence.”
Organizational Behavior and Human Decision Processes, Academic Press, 27 July 2004,
www.sciencedirect.com/science/article/abs/pii/0749597887900495.

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