Familiarity bias
Familiarity - Home (Local) bias
Availability & attention- grabbing
• The transactions of retail investors are likely to be
concentrated in stocks where information is freely
available.
• “Attention-grabbing” is proxied in three ways:
news reports on a stock, unusually high trading
volume, and extreme returns.
• The latter two factors control for impact since
sometimes news might be neutral. While news can
be of a positive or negative nature, since individual
investors rarely short-sell and normally own only a
small subset of stocks, negative news is likely to be
ignored, while positive news may attract purchases.
• News is likely to lead to net purchases for retail
investors. On the other hand, institutional investors
are much less likely to be so affected
Availability bias - implication
Investors can fall prey to availability bias in several
ways:
• Chasing winners: A catchy story about a recent
stock surge might be readily
available in your mind, leading you to invest without
proper research.
• Herd mentality: Seeing everyone invest in a
particular sector might make it seem like a sure bet.
Availability bias can make these trends more
prominent in your mind, leading you to follow the
crowd.
• Overlooking undervalued assets: Companies
with solid fundamentals but less flashy news
coverage might be ignored because they're not
readily available in
your memory.
Representative bias (stereotype)
a mental shortcut where we judge the likelihood of something
happening based on how similar it appears to a stereotype or
category in our minds, rather than considering actual
probabilities.
• Three main types of representativeness biases:
1. Conjunction fallacy
2. Base-rate neglect
3. Sample-size neglect
Representative bias (Base-rate neglect)
Base-rate neglect, also known as base rate fallacy or base rate bias, is a
cognitive bias where we tend to overlook general statistical information (the
base rate) in favor of specific details (individuating information) when
making judgments.
You hear a compelling story about a little-known company about to take off.
You might get excited and invest based on this specific story while
neglecting the base rate - most "hot tips" turn out to be bad bets, and most
small companies don't become successful.
Representative bias (Sample-size neglect)
Sample-size neglect or gambler’s fallacy states that the sample,
albeit small, should look like the population, in the sense that
essential features should be shared.
This bias can lead investors to make poor choices by:
• Overreacting to news: Investors might make impulsive decisions based
on news articles highlighting a small company's recent success story.
• Misinterpreting past performance:
Looking at a small window of past returns for a stock or fund can be
misleading.
• Placing undue trust in testimonials: A few positive testimonials about a
financial advisor or product don't necessarily translate to widespread
success.
Overconfidence and Missed Opportunities: After a market
crash, investors hit with hindsight bias might believe they "saw
it coming" and regret not selling beforehand. This can lead to
overconfidence in their future predictive abilities, potentially
causing them to miss good opportunities due to excessive
caution.
• Regret and Portfolio Churn: Hindsight bias can also fuel
feelings of regret after losses, making investors dwell on what
they "should have done." This can lead to impulsive decisions
and excessive portfolio churning, which can harm long-term
returns
 1. Answer: A | Re-examining the investment is the right move. However, many investors will instead
1. Investment Scenarios
hold a stock until it reaches a value they have in their head (the price they paid for it, say, or a
1. You buy stock in XYZ Corp. and, after several lackluster earnings reports, find it's
previous high)—a behavioral bias known as anchoring. Getting wed to a number can weigh down
down 25% from what you paid for it. Which is the best course of action?
your judgment, even when the price you're anchored to is irrelevant to the decision at hand. In
A. Reassess the stock as though it were a prospective investment
one seminal study, Kahneman and Tversky spun a wheel containing the numbers 0 through 100
B. Hold on to the stock until it gets back to at least the price you paid
and then asked their research subjects what percentage of the United Nations is made up of
2. A year after buying two particularly promising stocks, one has surged while the
African countries. When the wheel landed on 10, the average estimate was 25%, whereas when
other has slumped. How do you rate your performance?
the number landed on 65, the average estimate was 45%. The numbers on the wheel had
A. You congratulate yourself on your stock-picking acumen
absolutely nothing to do with the question at hand, but they influenced the research subjects'
B. You acknowledge you're only one for two
estimates, nonetheless.
3. Your investment advisor suggests a number of new stocks to replace several long-
2. Answer: B | An honest assessment reveals your track record to be a lackluster 50/50. However,
held, albeit
many investors will instead recall how they knew the surging stock was going to be a winner all
underperforming, investments. How should you react?
along, while conveniently forgetting they were equally hopeful about the second stock—a failure
A. You hold on to the old stocks because they've long been a trusted part of your portfolio
of logic known as hindsight bias. Indeed, people consistently misremember the odds they assigned
B. You listen to your advisor's reasoning and consider the new stocks over the old
to an outcome once that outcome is known. In one landmark study, researchers surveyed groups
4. You inherit $100,000 in cash. What's your next step?
of university students prior to former President Richard Nixon's breakthrough trip to China in 1972
A. You hold the inheritance in cash while you evaluate and reevaluate possible investments
about the probability of certain events taking place, such as a face-to-face meeting with Chairman
B. You invest the money according to the asset allocation in your existing retirement
Mao Zedong. Surveyed again after the trip, the students often misremembered their predictions
plan
in light of what actually transpired—invariably giving themselves higher marks than were
5. After the recent stock market correction, you review your investment plan. Which
warranted.
is the best course of action?
3. Answer: B | In theory, every position must continually earn its place in your portfolio, but in
A. Maintain your current allocation because your long-term goals remain unchanged
practice, we often overvalue things simply because we already own them—a mental miscue
B. Majorly reduce your exposure to equities in an effort to insulate your portfolio against
called the endowment effect. One way to counter the endowment effect is to ask yourself whether the
future
reason you bought a particular investment is still valid. It's possible there's a more appropriate
shocks
investment for you—provided you're willing to let go of what you already own.
6. Your portfolio gains 10% for two consecutive years, before losing half of those
4. Answer: B | Putting your $100,000 windfall to work in the market may be the right choice, since
profits in year three. How do you react to the ups and downs?
cash tends to underperform the stock market over the long haul, even when it's invested at the
A. You don't fret the loss and remind yourself that your portfolio is still up overall
market's peak. However, many investors suffer from analysis paralysis, or choice overload, which
B. You're upset and put your money in cash to help minimize future losses
can cause them to sit on the sidelines rather than get in the game. Indeed a 2000 study found
7. Although U.S. technology stocks have helped your portfolio achieve double-digit
shoppers were 1½ times more likely to visit a display showcasing a large number of jams—but 10
annual growth, your financial advisor now believes the sector to be overvalued. What
times more likely to make a purchase from one with a more-limited selection.
do you do?
5. Answer: A | When it comes to financial decisions, long-term trends are historically more reliable
A. You explore other industries with an eye toward diversification
than near-term events. After all, it took only 19 trading days after the events of September 11 for
B. You downplay your advisor's concerns and redouble your research on technology
the market to return to pre-9/11 levels. Be that as it may, investors often forget this fact because
trends
of recency bias, or our predisposition to give added weight to events that have occurred recently
8. You see a TV interviewer praising a CEO for several new products her company
If a market's been going up, for example, we tend to assume continued gains are therefore more
has developed.
likely, whereas a recent correction can lead us to believe another is right behind it.
Should you buy the stock based on the segment?
6. Answer: A | You should feel as much pain from a 10% loss as you do pleasure from a 10% gain,
A. Yes, because of potentially market-moving news from a trusted source
but researchers have concluded the pain of loss is roughly twice as powerful, psychologically
B. No, because multiple factors determine a stock's performance
speaking, as the pleasure from an equivalent gain—a phenomenon known as loss aversion. As
with many behavioral biases, the roots of such thinking are often attributed to the early days of
2. Multiple choice questions
human existence, when the loss of a day's worth of food could spell disaster, whereas an extra
1. William is described as somebody who likes to go to the opera and play computer
day's worth of food might add little to your odds of survival.
games. You spot William at the restaurant and are asked whether William is a truck driver
7. Answer: A | Our decision-making is subject to confirmation bias—the unconscious tendency to
or a computer programmer. If your reply is that he is a programmer then you are likely
gravitate toward evidence that supports what we already believe. In other words, if you're already
using the:
heavily invested in technology stocks, it may be time to challenge your predisposition, not confirm
A. availability heuristic B. simulation heuristic C. anchoring and adjustment heuristic
it. Confirmation bias is among the more pernicious of our behavioral tics, evident in everything
D. representativeness heuristic
from political polarization to overconcentration in a particular asset class.
2. Suppose that you are told that in 10% of people at a restaurant are computer
8. Answer: B | Company fundamentals are a more reliable barometer of a stock's potential
programmers and the remaining 90% are truck drivers. Buck is described as
performance than the 24/7 news cycle. Unfortunately, humans more often judge probabilities
somebody who likes to go to the movies and play card games. You spot Buck at the
based on how easily corroborating information comes to mind—a tendency known as availability
restaurant and are asked whether he is a truck driver or a computer programmer. If
bias. In this particular case, a compelling TV appearance by a CEO risk crowding out other
your reply is that he is a truck driver then you are likely using the
information that perhaps has a greater bearing on the company's stock. In fact, availability bias is
A. base rate information to make your decision B. representativeness heuristic
one reason people believe they're much more likely to win the lottery than they actually are, as
C. simulation heuristic D. anchoring and adjustment heuristic.
those who hit the jackpot are heavily promoted while the multitudes who come up empty go
3. Suppose that you are considering moving either to Illinois or California. After
unmentioned.
hearing about a recent earthquake in South America you decide not to move to
California. Your decision was likely influenced by Question 3: Prospect Theory
A. availability heuristic B. confirmation bias C. anchoring and adjustment heuristic - Loss Aversion: A core principle of prospect theory is loss aversion. People tend to dislike
D. representativeness heuristic potential losses more than they value potential gains. In the context of iPhones, consumers who
4. Suppose that you recently heard about a woman in your neighborhood winning the own the previous model might feel a sense of loss if Apple continues to sell it alongside the new,
lottery. Even though you have never bought a lottery ticket before, you run to the presumably better model. Due to: (1) Feeling their phone is outdated: This can lead to feelings of
store and buy three tickets for the next drawing. Your decision to buy the tickets now missing out or having a less valuable product. (2) Regret of purchase: If someone recently bought
was likely influenced by the previous model, seeing the new one readily available might make them feel they made the
A. availability heuristic B. representativeness heuristic wrong choice. --> By discontinuing the older model, Apple mitigates these feelings of loss for
C. anchoring and adjustment heuristic D. familiarity heuristic existing customers. They can focus on the perceived value of their current phone and the
5. When a soup company changed the label on their cans of soup from “this product excitement of the new features in the latest model.
contains 5% fat” to “this product is 95% fat free” sales doubled. This is likely to the - Framing: Prospect theory also suggests that framing a situation can influence decisions. By
use of discontinuing the previous model, Apple frames the new iPhone as the only "rational" choice. This
A. availability heuristic B. framing effects creates a sense of scarcity and urgency, potentially pushing consumers towards the new model.
C. anchoring and adjustment heuristic D. representativeness heuristic Question 4: a. Assume you are a new investor, would you invest in this fund based on the
6. Even though the two statements below have the same result, people typically provided performance statistics? Explain your decision. (b). On the other hand, suppose you have
report that the first is a better outcome.(1) 90% of the population will be saved using been an investor in VEOF for over a year. What would you do with your investment now?
this medicine.(2) 10% of the population will die using this medicine.This probably The prospect theory can explain some of your tendencies below:
results due to the use of (1) Selling "Winners" Too Early: Imagine you invested in VEOF more than a year ago, which
A. availability heuristic earned you a return of more than 30%. Following prospect theory, you might feel happy about the
B. framing effects gain (relative to your purchase price, which becomes the reference point). However, due to loss
C. anchoring and adjustment heuristic aversion, you might also fear losing those gains if the price drops. This could lead you to sell the
D. representativeness heuristic stock prematurely, even if it has the potential for further growth.
7. If presented two options that have the same outcome, but one is presented focusing on (2) Hot Tips: Prospect theory highlights how framing can influence decisions. Imagine receiving a
the positive impacts and the other focusing on the negative impact, people generally prefer "hot tip" on a specific stock that supposedly has high growth potential. The excitement and potential
the one that focuses on the positive impact. This is because we often use the ___________ for a big gain (framed as a sure thing) might overshadow the importance of diversification across
when making decisions. different asset classes. This could lead to an overly risky investment portfolio.
A. A.availability heuristic B. B.framing effect heuristic (3) Chasing Past Performance (FOMO): Prospect theory suggests that people tend to overweight
C. C.anchoring and adjustment heuristic D. Familiarity in recent events. Imagine a friend's recent success investing in a specific sector. This "success
story" might make you more likely to invest in that sector, even if past performance doesn't
guarantee future results. You might be focusing on potential gains in that sector (framed by
your friend's success) and neglecting a broader investment strategy.
(4) Ignoring Fees when Chasing Small Gains: Prospect theory suggests a tendency to focus on
gains and potentially underestimate losses. Someone might be attracted to frequent trading with
small potential gains, neglecting the associated fees (considered losses). Over time, these fees can
significantly erode their overall investment returns.