BEHAVIORAL FINANCE

BIASES P3

Christian Neil A. Ramos, MBA, CIA

Faculty, BSBA – Financial Management
OUTLINE

AMBIGUITY AVERSION BIAS

ENDOWMENT BIAS
SELF-CONTROL BIAS
OPTIMISM BIAS
Ambiguity Aversion Bias

◦ Ambiguity aversion refers to the bias when people tend to lean towards known outcomes over unknown
ones. They want to avoid uncertainty and choose what they are confident of. It is applicable when a
choice has to be made between risky or ambiguous alternatives.

◦ In the context of investments and investors, ambiguity aversion bias leads investors to hesitate in
situations that are ambiguous. When there is a change in the usual rate of interest (for example) on a
financial product, decisions taken by the investor would depend on his subjective competence level
Ambiguity Aversion Bias

Key takeaways

1. Ambiguity aversion may cause investors to demand higher compensation for the perceived risks of
investing in certain assets. Thus, the investors may hold only conservative investments, which can
cause the potential to outlive an asset base, purchasing power erosion, and other consequences.
2. Ambiguity aversion may restrict investors to their own national indexes (e.g., Standard & Poor’s 500)
because these indexes are more familiar than foreign ones. This is particularly important in light of the
boom in exchange traded funds (ETFs), which offer Americans the ability to invest in often unfamiliar
locales, such as China and South America
Ambiguity Aversion Bias

Key takeaways

3. Ambiguity aversion can cause investors to believe that their employers’ stocks are safer investments than
other companies’ stocks because investments in other companies are ambiguous.
4. A unique aspect of ambiguity aversion is the competence effect. Here, investors presented with an
uncertain probability distribution might be expected to display caution due to ambiguity aversion
Endowment Bias

Endowment bias is described as a mental process in which a differential weight is placed on the value of an
object. That value depends on whether one possesses the object and is faced with its loss or whether one
does not possess the object and has the potential to gain it. If one loses an object that is part of one’s
endowment, then the magnitude of this loss is perceived to be greater than the magnitude of the
corresponding gain if the object is newly added to one’s endowment.

Refers to an emotional bias that causes individuals to value an owned object higher, often irrationally, than
its market value.
Endowment Bias

Key takeaways

1. Endowment bias influences investors to hold onto securities that they have inherited, regardless of
whether retaining those securities is financially wise.
2. Endowment bias causes investors to hold securities they have purchased (already own). This behavior
is often the result of decision paralysis, which places an irrational premium on the compensation price
demanded in exchange for the disposal of an endowed asset.
Endowment Bias

Key takeaways

3. Endowment bias causes investors to hold securities they have either inherited or purchased because they
do not want to incur the transaction costs of selling the securities. However, these costs can be a very small
price when evacuating an unwise investment.
4. Endowment bias causes investors to hold securities that they have either inherited or purchased because
they are familiar with the behavioral characteristics of these endowed investments. Familiarity, though,
does not rationally justify retaining a poorly performing stock or bond.
Self-control Bias

Simply put, self-control bias is a human behavioral tendency that causes people to consume today at the
expense of saving for tomorrow. Money is an area in which people are notorious for displaying a lack of
self-control.

The human behavioral tendency that causes people to fail to act in pursuit of their long-term, overarching
goals because of a lack of self-discipline
Self-control Bias

Key takeaways

1. Self-control bias can cause investors to spend more today at the expense of saving for tomorrow. This
behavior can be hazardous to one’s wealth because retirement can arrive too quickly for investors to
have saved enough.
2. Self-control bias may cause investors to fail to plan for retirement. Studies have shown that people who
do not plan for retirement are far less likely to retire securely than those who do plan. Studies have
shown that people who do not plan for retirement are also less likely to invest in equity securities.
Self-control Bias

Key takeaways

3. Self-control bias can cause asset-allocation imbalance problems. For example, some investors prefer
income-producing assets, due to a “spend today” mentality. This behavior can be hazardous to long-term
wealth because too many income-producing assets can inhibit a portfolio to keep up with inflation.
4. Self-control bias can cause investors to lose sight of basic financial principles, such as compounding of
interest, dollar cost averaging, and similar discipline behaviors that, if adhered to, can help create
significant long-term wealth.
Optimism Bias

◦ Investors, too, tend to be overly optimistic about the markets, the economy, and the potential for positive
performance of the investments they make. Many overly optimistic investors believe that bad
investments will not happen to them—they will only afflict “others.” Such oversights can damage
portfolios because people fail to mindfully acknowledge the potential for adverse consequences in the
investment decisions they make.
Optimism Bias

Key takeaways

1. Optimism bias can cause investors to potentially overload themselves with company stock because
optimism biases can make them think that other companies are more likely to experience downturns than
their own. Also, employees feel greater comfort and optimism with the stock of their employer, feeling that
an investment there is less risky than an investment elsewhere.
2. Optimism bias can cause investors to believe they are getting marketlike returns, when in fact they need
to be wary of things like inflation, fees, and taxes that eat away at these returns and eliminate the long-term
benefits of compounding returns.
Optimism Bias

Key takeaways

3. Optimism bias can cause investors to read too much into “rosy” forecasts such as earnings estimates of
analysts or their own research done by reading company reports that show rosy outlooks. Additionally,
investors prefer to get good news about the markets or their investments and so may be predisposed to
optimism versus pessimism.
4. Optimism bias can cause investors to think they are above-average investors, simply because they are
optimistic people in general, or to believe that they are above average in other areas of their life, such as
driving ability or social skills.
Optimism Bias

Key takeaways

5. Optimism bias can cause investors to invest near their geographic region (home bias) because they may
be unduly optimistic about the prospect of their local geographic area.
THANK YOU!!!