Unit -II

Behavioural Finance
By
Ashima Gaba
Topics Covered
⚫ Cognitive Biases
⚫ Emotional Biases
⚫ Heuristics
⚫ Neuro- Finance
⚫ Mental Accounting
Behavioural Bias
Human minds are prone to observations which are led
by filters of gained experiences. These filters create
biases in judgment and decision making in certain
circumstances. The decisions are backed by some rule of
thumb but not logics which are also known as
‘heuristics’. People isolate with the biases in decision
making.
Thus, investing biases can be categorized into two
categories:-
· Cognitive Bias
· Emotional Bias
Cognitive Bias
⚫ A cognitive bias is a systematic error in thinking that
occurs when people are processing and interpreting
information in the world around them and affects the
decisions and judgments that they make.
⚫ This is the mistake of processing information in one’s
own beliefs, judgments and preferences. The faulty
reasoning, evaluation and remembering by keeping into
fists the existing heuristics regardless of differing
information let the occurrence of cognitive bias.
⚫ The earlier studies evidenced that sometimes cognitive
biases lend hands for processing information in an
effective manner. Thus, the thorough understanding of
this bias is required as it enables quick decisions when
appropriateness is more valuable than accuracy.
Cognitive Vs Emotional Bias
⚫ Cognitive biases are deviations in the process of understanding,
processing, and making decisions on information or facts.
⚫ Emotional biases are deviations in that they emphasize feelings
and spontaneity rather than facts.
⚫ Cognitive biases are generally related to the way a person is
wired to think. These biases are said to arise from statistical,
information procession, or memory errors that cause the decision
to deviate from a rational decision. Because of this, they are also
easy to correct with better information, education, and advice.
⚫ Emotional biases stem from feelings, perceptions, beliefs about
elements. Unfortunately mixing emotions and investing often
leads to bad decisions. Here basically the investor’s brain is
distracted due to his emotions. These biases are generally
tougher to fix in comparison to cognitive biases.
Heuristics
⚫ Heuristics are mental shortcuts that allow people to
solve problems and make judgments quickly and
efficiently.
⚫ These are rule-of-thumb strategies shorten decision-
making time and allow people to function without
constantly stopping to think about their next course
of action.
⚫ Heuristics play important roles in both problem-
solving and decision-making, as we often turn to
these mental shortcuts when we need a quick
solution.
TYPES OF COGNITIVE
&
EMOTIONAL BIASES
Anchoring Bias
⚫ While making a quantitative judgment, people
are subconsciously anchored to some arbitrary
stimulus.
⚫ In the series of assessing the indefinite value or
information the anchoring bias uses the
irrelevant information as reference. The ‘anchor’
acts as the first and foremost piece of
information while making decisions and by the
time subsequent judgment is adjusted.
Anchoring Bias
⚫ A trader buys contracts for difference (CFDs) on the FTSE100
(UK100) Index. A trading session started off with a bullish run.
The trader feels certain that the day would continue in an uptrend,
as they were essentially anchored to the information about the
“bullish run” they received earlier that day. When the market
shows clear signs of exhaustion, they still claim it is bullish.
⚫ A trader buys CFDs on Apple (AAPL) shares at a high price. The
share price begins to drop. The trader becomes anchored to the
original purchase price and continues to hold onto the stock,
hoping that the price will rebound, even as it continues to fall.
⚫ A trader buys CFDs on Tesla (TSLA) shares based on the stock’s
price hike in the past year. The trader becomes anchored to the past
performance and assumes that the stock will continue to rise at the
same rate, without considering other important factors such as
market trends, competition, or the company's financial health.
Anchoring Bias

⚫ An anchoring bias can cause a financial market

participant, such as a financial analyst
or investor, to make an incorrect financial
decision, such as buying an overvalued
investment or selling an undervalued
investment.
⚫ Anchoring is a behavioural finance term to
describe an irrational bias towards an arbitrary
benchmark figure. This benchmark then skews
decision-making regarding a security by market
participants, such as when to sell the investment
Reasons of Anchoring Bias
⚫ Uncertainty relating the true value
⚫ Cognitive laziness
Factors Influencing Anchoring Bias
⚫ Mood
⚫ Experience
⚫ Personality
⚫ Cognitive Ability
Impact of Anchoring Bias on Investors
⚫ Making suboptimal trading decisions based on initial
information or prices
⚫ Creating false expectations about future prices or trends
⚫ Overvaluing or undervaluing assets based on irrelevant
information
⚫ Increasing risk exposure
⚫ Failing to adjust valuations based on new information
⚫ Ignoring important market signals or trends
⚫ Holding onto losing positions for too long
⚫ Failing to buy or sell at optimal prices
⚫ Reducing overall portfolio performance
How to Avoid Anchoring Bias?
⚫ Acknowledge it
⚫ Challenge assumptions and consider alternative
scenarios.
⚫ Seek diverse information
⚫ Implement trading rules
⚫ Diversify portfolio
⚫ Use a systematic approach
Overconfidence Bias
⚫ Most people tend to overestimate their skills, whether
it's changing an electrical outlet or managing their own
finances.
⚫ In investing, overconfidence bias often leads people to
overestimate their understanding of financial markets or
specific investments and disregard data and expert
advice. This often results in ill-advised attempts to time
the market or build concentrations in risky investments
they consider a sure thing.
⚫ Consider that 64% of investors rate their investment
knowledge highly, according to a FINRA study. The
research found that younger investors tend to be more
confident than older investors. Yet investors with more
confidence answered fewer questions correctly on an
investment knowledge quiz.
Overconfidence Bias
⚫ One possible source of overconfidence: the
wealth of accessible online information. Studies
have found that access to voluminous information
can create the illusion of understanding.
⚫ Evidence shows that even financial experts with
powerful tools at their disposal can have
difficulty outpacing the market.
⚫ Case in point: a 2023 Morningstar report found
that only a quarter of all active funds beat their
passively managed peers over the previous 10-
year period.
Overconfidence Bias
The past studies show that investors are
overconfident with respect to their
investing knacks. This tact can be divided
into two parts:
1.Prediction Overconfidence: Investors and traders assign
their range of expectation in a narrow framework.
2.Certainty Overconfidence: Traders become too certain
for their predictions and if they enter in a sure win
sort of situation, they become vague for the outcome
and it certainly dishearten to extreme. It must be kept
in the wall of mind that investing is a crucial exercise
and there is nothing like 100% return aspect always.
Overconfidence & Optimism
⚫ The blend of overconfidence and optimism
cause investor to over estimate their
awareness, underestimate risk and illusion
to control the market events.
⚫ Overdependence of an investor in a specific
industry or stock is also an example of
overconfidence and poor diversification is a
consequence of same.
⚫ Overconfident investors tend to decrease
the expected utility of portfolio.
 Overconfidence and optimism

Overdependence in specific sector

Poor Diversification

Increased portfolio risk

Types of Overconfidence Bias
⚫ Illusion of control
This type of overconfidence bias refers to the belief that someone has
more control over a situation than they actually do. In trading, it could
lead to traders believing they can control the market, when they can’t.
⚫ Over ranking
This refers to the belief that someone is more talented than they actually
are. This is pretty common, largely because no one wants to believe that
they are below average. In trading, this could lead to traders making
trades based on overly optimistic forecasts, culminating in potential
losses.
⚫ Timing optimism
This is when someone incorrectly thinks they could do work far quicker
than they actually are able to. This relates to trading when traders think
that a trade or investment would pay off far quicker than it actually
could.
⚫ Desirability effect
Perhaps better known as wishful thinking, this is when someone thinks
that something is going to happen, purely because they want it to
happen.
Examples

⚫ A trader once made on Amazon shares. They now feel confident the price
will likely continue rising, leading them to hold onto the position for too
long, meaning that when its price trajectory changes there are significant
losses.

⚫ Investors may ignore the risk associated with a particular sector or

industry and trade heavily in it. This could lead to significant losses if the
sector or industry experiences a market correction.

⚫ They may take more risks than they should and trade too frequently,
leading to high transaction costs and lower returns.

⚫ Overconfidence bias may be linked to confirmation bias, where people

seek out information that supports their beliefs while ignoring information
that contradicts them. This could result in traders ignoring or missing
important information and making decisions based on incomplete or
inaccurate information, potentially leading to losses.
What can you do about it?
⚫ Acknowledge it
⚫ Be Realistic
⚫ Research the market
⚫ Keep note of trades
⚫ Be Diligent
⚫ Make room for other’s perspective
⚫ Perform a “pre-mortem”
Representativeness Bias
⚫ Representativeness refers to the tendency to form
judgments based on stereotypes. For example, you may
form an opinion about how a student would perform
academically in college on the basis of how he has
performed academically in school.
⚫ This cognitive bias puts weight on previous experiences
and beliefs which gives the thought to investors for
being in a stereotype framework.
⚫ Representativeness heuristic bias occurs when the
similarity of objects or events confuses people’s
thinking regarding the probability of an outcome.
People frequently make the mistake of believing that
two similar things or events are more closely correlated
than they actually are.
Representativeness Bias
⚫ Representativeness bias refers to the fact
that we mentally take a shortcut by
judging that something is more
representative than it actually is.
⚫ We judge the likelihood of an event
simply based on how closely it represents
other events they are familiar with.
⚫ Representativeness bias can lead investors
astray.
Examples
◦ Investors may be too quick to detect patterns in data that are in
fact random.
◦ Investors may believe that a healthy growth of earnings in the
past may be representative of high growth rate in future. They
may not realise that there is a lot of randomness in earnings
growth rates.
◦ Investors may be drawn to mutual funds with a good track record
because such funds are believed to be representative of well-
performing funds. They may forget that even unskilled managers
can earn high returns by chance.
◦ Investors may become overly optimistic about past winners and
overly pessimistic about past losers.
◦ Investors generally assume that good companies are good stocks,
although the opposite holds true most of the time.
◦ Investors do not invest in new companies due to the unfamiliarity
or newness. This does not fit the mental prototype of “good
investment”
Representativeness & Related Biases
Innumeracy
⚫ Innumeracy refers to a lack of basic mathematical
understanding, which can lead to costly errors and
misunderstandings in everyday life.
⚫ Numeracy skills are essential to make informed
decisions, critically analyze data, and navigate the
increasingly quantitative world we live in.
⚫ Without a solid understanding of concepts such as
compound interest and risk assessment, individuals may
fall prey to get-rich-quick schemes or invest their money
in ventures that have a high likelihood of failure. This
can result in heavy financial losses and a significant
setback in their financial goals.
Innumeracy
⚫ People have difficulty with numbers Trouble with
numbers is reflected in the following.
1. People confuse between “nominal” changes (greater or lesser
numbers of actual rupees) and “real” changes (greater or lesser
purchasing power). Economists call this money illusion.
2. People have difficulty in figuring out the “true” probabilities.
3. People tend to pay more attention to big numbers and give less
weight to small figures.
4. People estimate the likelihood of an event on the basis of how
vivid the past examples are and not on the basis of how
frequently the event has actually occurred.
5. People tend to ignore the ‘base rate’ which represents the
normal experience and go more by the ‘case’ rate, which
reflects the most recent experience.
How innumeracy be mitigated?
⚫ Paulos argues that innumeracy is not a fixed trait but rather a
symptom of a broader problem in our educational system. He
suggests that the focus on rote learning and memorization in
mathematics education overlooks the importance of developing
conceptual understanding and critical thinking skills.
⚫ Paulos advocates for a more holistic approach to mathematics
education that emphasizes problem-solving, logical reasoning, and
the application of mathematical concepts to real-world scenarios.
⚫ He suggests that through self-directed learning and engaging with
mathematics in daily life, individuals can overcome innumeracy's
limitations and make more informed decisions
Probability Matching/Gambler’s
Fallacy
⚫ Gambler’s fallacy is nothing but expecting outcomes in
random sequences to exhibit systematic reversals. When
observing flips of a fair coin, for example, people
believe that a streak of heads makes it more likely that
the next flip will be a tail. The gambler’s fallacy is
commonly interpreted as deriving from a fallacious
belief in the “law of small numbers” or “local
representativeness”: people believe that a small sample
should resemble closely the underlying population, and
hence believe that heads and tails should balance even in
small samples.
⚫ On the other hand, people also sometimes predict that
random sequences will exhibit excessive persistence
rather than reversals.
Gambler’s Fallacy
⚫ For example, some investors may sell a position
after it has increased in value following a long
series of positive trading sessions. They may
believe that the position is more likely to decline
because of the string of gains.
⚫ This line of thinking is wrong as past events do
not change the probability that certain events
will occur in future.
How Gambler’s Fallacy affect stock
traders?
⚫ Overtrading: Traders who believe that they are
"due" to win may overtrade, which can lead to losses.
⚫ Chasing losses: Traders who have lost money on a
trade may be tempted to chase their losses by buying
more of the same stock in an attempt to recoup their
losses. This can lead to even larger losses.
⚫ Making poor investment decisions: Traders who are
influenced by the Gambler's Fallacy may make poor
investment decisions, such as buying stocks that are
overpriced or selling stocks that are undervalued.
How to overcome Gambler’s Fallacy?
⚫ Understand Gambler’s Fallacy
⚫ Rely on data and analysis
⚫ Use risk-management techniques
⚫ Have a long term perspective
⚫ Seek professional help
Conjunction Fallacy
⚫ Conjunction fallacy is rating the conjunction of two
events as being more likely than one of the
constituent events. This, they claim, is a fallacy,
since the conjunction of two events can never be
more probable than either of the component events.
⚫ Conjunction fallacy occurs because we take a mental
shortcuts. We make quick choices based on the
perceived likelihood of a scenario instead of
considering actual probabilities.
⚫ Conjunction fallacy causes us to violate the laws of
probability!
The Linda Problem
⚫ The most famous example of conjunction fallacy was
conducted by Amos Tversky and Daniel Kahneman in 1983.
"The Linda Problem," as it was called, presented the
following scenario to research subjects:
⚫ Linda is 31 years old, single, outspoken, and very bright. She
majored in philosophy. As a student, she was deeply
concerned with issues of discrimination and social justice
and also participated in anti-nuclear demonstrations.
⚫ They then asked the participants to choose which was more
likely to be true —
⮚ Scenario One: Linda is a bank teller.
or
⮚ Scenario Two: Linda is a bank teller and is active in the feminist
movement.
Base-Rate Neglect
⚫ Base rate fallacy refers to the tendency to ignore relevant
statistical information in favor of case-specific information.
Instead of taking into account the base rate or prior probability of
an event, people are often distracted by less relevant information.
⚫ Due to this, people often make inaccurate probability judgments in
medical, business, and everyday decision-making contexts. Base
rate fallacy is also called base rate neglect or base rate bias.
⚫ You are asked to guess whether
⚫ Mark plays soccer or golf based on the following personality
description:
“Mark has a PhD, reads poetry, and loves his cat.”
Your gut feeling tells you that Mark sounds like belonging yo
upper income group, so he must play golf.
However, this is the base rate fallacy at work, since far more
people play soccer than golf.
Example:
⚫ A big tech company releases its quarterly earnings, showing that
the company’s profits took a deep plunge all of a sudden. Seeing
this, an investor who bought the company’s stocks 10 years ago is
considering whether it’s time to sell. On the one hand, this is one
of the most innovative companies, setting retail trends for the past
several years. On the other hand, the investor fears further losses.
⚫ If the investor decides to sell, they have fallen for base rate
fallacy. They will be favouring current information (the quarterly
earnings report), which is just a small set of data, over larger data,
which is the base rate. Instead, the investor should ask “how has
the company performed in the last 10 or 15 years?” It is the
historical data about the company’s performance that sets the
overall context we need to look at to make the right decision.
⚫ A single weak (or strong) earnings report doesn’t give us the full
picture of the company’s track record. Instead, it is most likely a
blip in its overall course
Availability Bias
⚫ In 1974, Tversky and Kanheman beautifully
cited the heuristic of Availability Bias which
tends that people prospects the rate of events in
the way they are effortlessly recalled from the
memory.
⚫ The notion of recalling is utmost important as it
acts as an alarm for the upcoming consequences
which have been perceived.
⚫ The prior experiences build an array of
analogues events which contributes in the
development of biases.
Forms of Availability Bias
⚫ Retrievability:
Investors tend to choose investments based on information that is
available to them (ads, suggestions from friends and advisors, and so
on).
⚫ Categorisation:
Investors tend to choose investments based on categories stored in
their minds. Other types of investments may be ignored by them.
⚫ Narrow range of experience:
Investors tend to choose investments drawn from their narrow range
of life experiences (such as the industry they work in and the region
they live in).
⚫ Resonance:
Investors tend to choose investments that resonate with their own
personality. For example, thrifty people may not invest in stocks with
a high price/ earnings multiple.
Recency Bias & Salience Bias
⚫ Availability is abetted by two other factors:
recency and salience. If something has occurred
recently it is likely to be recalled easily.(This is
referred to as recency bias).
⚫ Likewise, salience contributes to availability. An
event which is reported widely in media is
deemed to occur with a higher probability.(This
is referred to as salience bias).
Ambiguity Aversion Bias
⚫ Ambiguity aversion, or uncertainty aversion, is the
tendency to favour the known over the unknown,
including known risks over unknown risks.
⚫ Frank Knight argued that people dislike uncertainty
(ambiguity) more than they dislike risk.
⚫ For example, it leads people to avoid participating in the
stock market, which has unknown risks (Easley &
O’Hara, 2009), and to avoid certain medical treatments
when the risks are less known (Berger, et al., 2013).
Individual Effect
⚫ The ambiguity effect can prevent us from giving two
viable options equal consideration, resulting in
suboptimal decisions.
⚫ We may automatically decide against something based
solely on the fact that we feel that putting our trust in the
unknown is too risky. Succumbing to this cognitive bias
prevents us from reaping the long-term benefits of
riskier decisions.
⚫ While the ambiguity effect is similar to the concept of
risk aversion, the two biases are distinguished by how
much information the decision-maker has.
Systematic Effect
⚫ The ambiguity effect can influence small choices made
in our day-to-day lives, but it also impacts decision-
making on a much larger scale.
⚫ It can cause institutions, like schools, companies, and
governments, to remain committed to failing systems,
instead of introducing new policies or programs with the
potential for improvement.
⚫ This happens because even though these changes could
better the system, things could still go astray and
ultimately result in us being worse off than when we
started.
Ambiguity Aversion Bias
⚫ Daniel Ellsberg performed an experiment to demonstrate
ambiguity aversion.
⚫ The details of his experiment are given below. Subjects
were presented with two boxes, referred to here as Box 1
and Box 2.
⚫ Subjects were told that;
◦ Box 2 contained a total of 100 balls, 50 white and 50 black.
◦ Likewise, Box 1 contained 100 balls, a mix of white and
black, but in an unknown proportion.
⚫ Subjects were asked to choose one of the following two
options, each of which offered a possible payoff of
$100, depending on the colour of ball drawn at random
from the relevant box.
Ambiguity Aversion Bias
⚫ 1A: Draw a ball from Box 1. The payoff is $100 if the ball is
white and $0 if the ball is black.
⚫ 1B: Draw a ball from Box 2. The payoff is $100 if the ball is
white and $0 if the ball is black.
A follow-up scenario was presented and the subjects were again
asked to choose between two options.
⚫ 2A: Draw a ball from Box 1. The payoff is $0 if the ball is white
and $100 if the ball is black.
⚫ 2B: Draw a ball from Box 2. The payoff is $0 if the ball is white
and $100 if the ball is black
Subjects typically preferred 1B to 1A, and 2B to 2A.
The experiment suggests that people do not like situations
characterised by uncertainty about the probability distribution of
outcomes. Put differently, they have aversion to ambiguity.
Investment Mistakes
⚫ Investors may hold only conservative investments which
may yield meagre post-inflation and post-tax returns.
⚫ Investors may restrict their investments to home country
stocks.
⚫ Investors may invest in stocks of companies in which
they are employed.
⚫ If investors judge themselves to be competent in some
area, they may accept more risks than they should. This
is referred as competence effect and it overrides
ambiguity aversion.
How to avoid ambiguity aversion?
⚫ Self-awareness – an ability to notice a natural
behavioural tendency and override it.
⚫ Make objective assessments.
⚫ The best way to avoid ambiguity aversion is to reframe
alternative choices so that decisions become less binary
when it comes to uncertainty this is known as “ Framing
Effect”.
Cognitive Dissonance
⚫ When newly acquired information is at variance with
pre-existing understanding, people usually experience
mental discomfort which is referred to as cognitive
dissonance.
⚫ In psychology, cognitions represent attitudes,
emotions, beliefs, or values and cognitive dissonance
is the imbalance that arises when contradictory
cognitions interact.
⚫ This concept was introduced by the US Psychologist
Leon Feininger in 1956 which states that the new
fangled piece of information conflicts with existing
notions of experience and thus creates dissonance .
Cognitive Dissonance
⚫ This condition arise due to various reasons like the decision making
is not consistent with the belief, or some new information or
incident goes against their belief, or a situation arises in which the
person will have to decide among two or more alternatives that are
equally good.
⚫ Example: If an investor is keeping in sight the bull view the trend
for trading is on upper side, but immediate bearish sentiment might
lead the trader in a discomfort situation. The decision making will
become very thorny because the disequilibrium situation puts the
investor in dilemma for further actions.
⚫ In order to mitigate cognitive dissonance, it is advisable to
approach investment decisions with objectivity and analytical
thinking rather than being influenced by emotions.
⚫ When faced with cognitive dissonance, individuals often feel
compelled to justify their actions, beliefs, and emotions.
Example
⚫ John is looking to buy a stock of XYZ Ltd. because he
believes that XYZ Ltd. will perform well in the future.
XYZ Ltd. stock is currently trading at $70, and John is
considering buying a stock if it falls a few dollars to $65.
However, in three days, the stock price hit $68, and John
believes the stock price will come to $65 sooner.
However, after three days, the stock price suddenly
increased, reaching $75 because of buying demand from
other investors. At this point, John will probably
experience cognitive dissonance model.
⚫ Now, the question arises, why will John experience
cognitive dissonance and what are the actions that john
might take in this situation.
Aspects of Cognitive Dissonance?
Cognitive dissonance bias manifests itself in the form of two
different aspects. The details of these two aspects have been
mentioned below:
⚫ Selective Perception: Investors who suffer from selective
perception are unable to look at the data available in an unbiased
format. Instead, they tend to look only at data that affirms what
they already believe. The omission of a lot of important data may
happen because of this characteristic. The end result is that there
may be a huge miscalculation from the investor’s point of view.
⚫ Selective Decision Making: Selective decision making is the
tendency of investors to stick to a decision previously made.
Even if contradictory information appears in the market, the
investor seeks to rationalize their behaviour instead of correcting
the course of their action.
Model of Cognitive Dissonance
Types of Cognitive Dissonance
⚫ Choice dissonance – This happens when the person needs to
select one out of many options presented to them and all
such options have benefits and limitation. In such cases the
person has to give up an equally good option in order to get
another.
⚫ Induced compliance – The person is bound to accept a
situation that goes against their own values. In some cases,
people are forced to promote of spread good words about a
product or a service that they believe is not worth it. In such
cases it is induced cognitive dissonance psychology.
⚫ Belief action dissonance – This is a situation in which
people know that their action is not consistent with what
they are doing. They may continue using a product or eat a
type of food that they know, will not add any value for them.
Types of Cognitive Dissonance
⚫ Informational dissonance – Such a case happens when
some new information comes in which goes against the
beliefs. Sometimes we have one type of information
about something and later we come to know more
about that situation that is just opposite to the previous
information. In such cases, the cognitive dissonance is
information related.
⚫ Effort justification dissonance – This kind of situation
takes place when the person give a lot of effort on work
that is not worth it. It will not add much value to the
result compared to the effort that it is taking. Such a
case is an effort justification related dissonance.
Causes of Cognitive Dissonance
⚫ Contradictory belief – It is the major cause of such a
situation where one’s own value does not match with the
behaviour of the person.
⚫ Selective exposure – People sometimes search for
situations that support their existing behavioural traits
but they may find situations that contradict them.
⚫ Decision making – A person may feel the effect of
cognitive dissonance in case they are not able to make
quick decisions. They find it difficult to chose between
options which present them equally valuable opportunity.
⚫ Social pressure – The presence of social pressure can
make a person change their belief to remain a part of a
group.
Effects of Cognitive Dissonance
⚫ Change in belief – People are forced to change their own beliefs or
values in order to remain in the group or sometimes that is what looks
like the best solution to them.
⚫ Rationalization – People wish to be more rational in the ways in
order to reduce stress or risk.
⚫ Self justification – The people may try to justify themselves by
controlling the negative sides of their behaviour and encouraging the
positive sides. This helps the person feel more confident and positive.
⚫ Become more open-minded – People become more open minded
because they understand that they cant continue holding to their own
beliefs that are contradictory to the current situation .
⚫ Discomfort – Even if for a short time, people experience some kind
of discomfort because they need to change their mindset about values
that they have been believing for a long time.
How to reduce Cognitive Dissonance ?
1.Practice mindfulness :One of the best ways to deal with cognitive
dissonance is to practice mindfulness in your daily life. By focusing on
remaining in the moment and being mindful of your own thoughts and
beliefs, you can detect possible inconsistencies early enough to deal with
them before they become real problems.
2. Take a step back and clarify your beliefs and value: When you identify
potential dissonance in your thoughts, beliefs, or actions, it's important to
take time to be as clear as possible about what you believe. What are your
values and how do your current thoughts and actions fit within that
framework? This process can help to create clarity in your cognition. It can
also help when you occasionally challenge your beliefs and values, to ensure
that you're on the right path.
3. Seek out information that could resolve the conflict: If there's a conflict
in your thinking, seek new information to help you to identify any incorrect
areas of belief. There's no shame in admitting that your thought processes
can be improved. In fact, that type of self-awareness can be crucial for
growth and development.
How to reduce Cognitive Dissonance?
4.Create a plan to make real change : If you identify
behaviours or thoughts that need to be changed, create
a strategy to achieve that goal. Remember, the
objective is to make sure that your various beliefs and
actions are all in good alignment and that may require
changes in your thinking, your actions at work, or
your home life - and sometimes all three.
5. Get support if you need it: If you're struggling to resolve
your cognitive dissonance, discuss the conflicting
thoughts with someone you trust. Sometimes, getting
an outside opinion can help you to find the clarity you
need to move forward with change.
Confirmation Bias
⚫ A confirmation bias is cognitive bias that favours
information that confirms your previously existing
beliefs or biases.
⚫ Confirmation biases impact how we gather information
but also influence how we interpret and recall
information.
⚫ In the 1960s, cognitive psychologist Peter Wason
conducted several experiments known as Wason's rule
discovery task. He demonstrated that people tend to seek
information that confirms their existing beliefs
Signs of Confirmation Bias
⚫ Only seeking out information that confirms your beliefs and
ignoring or discredit information that doesn't support them.
⚫ Looking for evidence that confirms what you already think is
true, rather than considering all of the evidence available.
⚫ Relying on stereotypes or personal biases when assessing
information.
⚫ Selectively remembering information that supports your views
while forgetting or discounting information that doesn't.
⚫ Having a strong emotional reaction to information (positive or
negative) that confirms your beliefs, while remaining relatively
unaffected by information that doesn't
⚫ Example: Headlines about inflation or unemployment, for
example, may convince an investor that their views on monetary
policy and Federal Reserve decisions on interest rates are correct.
Types of Confirmation Bias
⚫ Biased attention: This is when we selectively
focus on information that confirms our views
while ignoring or discounting data that doesn't.
⚫ Biased interpretation: This is when we
consciously interpret information in a way that
confirms our beliefs.
⚫ Biased memory: This is when we selectively
remember information that supports our views
while forgetting or discounting information that
doesn't.
Impact on Investment Decision
⚫ Confirmation bias may lead to clients overinvesting in a
particular stock or sector. For example, a client who is
committed to owning shares of a particular company may
ignore unfavourable news about that company.
⚫ Focusing too narrowly on a particular type of investment
makes clients vulnerable to company- or sector-specific
downturns, which in turn can leave their portfolios
misaligned with their long-term goals and risk profiles.
⚫ Confirmation bias can also keep clients from realistically
viewing market conditions. For instance, they may focus
on some expert opinions while ignoring others. This can
potentially lead investors to make decisions based on
incomplete information.
Overcoming Confirmation Bias
⚫ Consider all the evidence available, rather than just the
evidence confirming your views.
⚫ Seek out different perspectives, especially from those
who hold opposing views.
⚫ Be willing to change your mind in light of new
evidence, even if it means updating or even changing
your current beliefs.
⚫ Good communication between advisors and their clients
can help combat confirmation bias.
Overcoming Confirmation Bias
⚫ Create objective trading rules around when clients can
buy, sell, and rebalance their holdings. Such strategies
can help them avoid making sudden investment
decisions driven by their confirmation bias.
⚫ Shifting a client’s focus away from short-term market
moves and toward their long-term goals may help avoid
the fallout from the confirmation bias.
⚫ Long-term strategic asset allocation is a powerful tool in
helping clients avoid confirmation bias. Establishing a
predetermined mix of assets and asset classes with
tolerance ranges can help clients stay disciplined.
Self- Attribution Bias
⚫ Self-attribution bias, also known as self-serving bias, is
a cognitive bias in trading that occurs when a person
attributes positive outcomes to their own skills, but
blames factors outside their control, such as bad luck, for
losses.
⚫ Self-attribution bias means that people tend to ascribe
their success to their skill and their failure to their bad
luck. Harvard psychologist Langer called this
phenomenon as “head I win, tail it’s a chance.”
⚫ Self-attribution bias in trading may lead to
overconfidence and excessive risk taking, as traders may
overestimate their own abilities when on a winning
streak, and vice versa, they may fail to acknowledge their
own mistakes when losing.
Examples:Self- Attribution Bias
⚫ Credit for wins: Traders may attribute gains to their own trading
abilities, even though they were down to external factors.
⚫ Blame external factors for losses: Traders may blame losses on external
factors, such as market volatility, as opposed to their own decision
making.
⚫ Overconfidence: Traders may become overconfident in their trading
abilities, leading them to take more risk than is appropriate.
⚫ Ignore past mistakes: Traders may fail to learn from previous mistakes
and repeat them in the future, if they attribute their past losses to external
factors and not their own actions.
⚫ Risk-taking: Traders may take more risk than they are comfortable with
as they believe their success is down to their own abilities.
⚫ Inaccurate self-assessment: Traders may misjudge their own abilities
and external factors that affect trading results.
⚫ Overemphasis on short-term results: Traders can pay too much
attention to short-term gains and neglect the long-term risks and
consequences of their decisions.
How to Overcome ?
⚫ Trading journal: Keeping a record of all your trades, including
the rationale behind each decision, may help in identifying self-
attribution bias.
⚫ Feedback: Sharing information with other traders may reveal a
different perspective on your behavioural patterns.
⚫ Alternative explanations: When experiencing a loss, you may
consider an alternative reason beyond external factors.
Evaluating your decision-making process may help in assessing
whether your errors may have contributed to the loss.
⚫ Variety of information sources: Looking for diverse data,
including views and perspectives that contradict your own, may
help in identifying self-attribution bias.
⚫ Goal setting: Setting realistic goals may help in staying
grounded about your successes and mistakes.
Conservatism Bias
⚫ Conservatism bias specifically refers to the tendency to
stick with established beliefs and information, and resist
change or new information that challenges those beliefs.
⚫ Conservatism bias is about being resistant to change.
⚫ Conservatism bias can cause investors to cling to a view or
a forecast, behaving too inflexibly when presented with
new information.
⚫ When conservatism-biased investors do react to new
information, they often do so too slowly.
⚫ Conservatism can relate to an underlying difficulty in
processing new information. Because people experience
mental stress when presented with complex data, an easy
option is to simply stick to a prior belief.
Conservatism Bias
⚫ This is the mentality of people to be
conservative or risk-averse and to stick to their
prior views.
⚫ Conservatism bias leads to under-reaction of
investors towards a piece of information.
⚫ For instance in the US, in the 60 days following
an earnings announcement, stocks with the
biggest positive earnings surprise tend to
outperform the market by 2 percent, even after a
4–5 percent outperformance in the 60 days prior
to the announcement.
Conservatism Bias
⚫ For example, assume an investor purchases a security based on
the knowledge that the company is planning a forthcoming
announcement regarding a new product. The company then
announces that it has experienced problems bringing the
product to market. The investor may cling to the initial,
optimistic impression of some imminent, positive development
by the company and may fail to take action on the negative
announcement
⚫ For example, if an earnings announcement depresses a stock
that an investor holds, the conservative investor may be too
slow to sell. The pre-existing view that, for example, the
company has good prospects, may linger too long and exert too
much influence, causing an investor exhibiting conservatism to
unload the stock only after losing more money than necessary.
Conservatism Bias
⚫ For example, if an investor purchases a security on
the belief that the company is poised to grow and
then the company announces that a series of
difficult-to-interpret accounting changes may affect
its growth, the investor might discount the
announcement rather than attempt to decipher it.
More clear-cut and, therefore, easier to maintain is
the prior belief that the company is poised to grow.
⚫ “Conservatism can prevent good decisions from being made,
and investors need to remain mindful of any propensities
they might exhibit that make them cling to old views and
react slowly toward promising, emerging developments.”
Cause of Conservatism Bias
⚫ Fail to revaluate complex data
⚫ Cling to forecast
⚫ Slow to react
How to avoid ?
⚫ Seek Professional Advice: Many investors believe that they have the
necessary financial acumen to make their own financial decisions.
However, they still rely on other professionals to help them with decision
making. They do so not because they don’t trust in their ability to
understand the information. However, they do so because the same
information can be interpreted in different ways, given the frame of mind of
the interpreter. Hence, it is better to engage a professional who tends to
have different views than you. This will help look at facts in a different
light, which will help avoid the conservatism bias.
⚫ Act Resolutely: A lot of investors do understand that they are ignoring
meaningful information. However, they continue to do so because they are
unable to act in a decisive and resolute manner. Whenever new information
comes that contradicts their existing beliefs, they tend to dilly-dally and
waste time. It is important for investors to be slow to make up their minds.
However, once the mind is made up, they should act fast and decisively.
This is because, in investment markets, timing is as important as the
decision itself, if not more.
Hindsight Bias
⚫ The Hindsight Bias is the tendency to look back at an
unpredictable event and think it was easily predictable. It
is also called knew it all along effect.
⚫ Hindsight Bias is the misconception after the fact that one
“always knew” that they were right.
⚫ This leads people to assume that their judgment is better
than it actually is.
⚫ As a result, investors questioning their choices, which
results in bad choices in the future.
⚫ This bias is more pronounced when the focal event has
well defined alternative outcomes (such as the ICC World
Cup) or when the event in question has emotional or moral
overtones.
Example
Take the 2008 financial catastrophe or the late 1990s
dotcom bubble, for example. Many people today would
tell you that all the warning signals were present and
that everyone knew what was about to happen. However,
if you look at the history, you can see that when analysts
or investment experts shouted that there was a problem
at the time, investors largely disregarded their warnings
instead of listening to them.
Example
⚫ Example of this bias took place in the early 1980s, when
energy stocks generated over 20 percent of Standard &
Poor’s (S&P) 500 returns, and lots of investors were
caught up in the boom. By the 1990s, though, the energy
bubble subsided, and many stockholders lost money.
Most now prefer, in hindsight, to not recognize that the
speculative frenzy clouded their judgments.
⚫ Managers of small-cap value funds in the late 1990s, for
example, drew a lot of criticism. However, these people
weren’t poor managers; their style was simply out of
favor at the time.
Levels of Hindsight Bias
⚫ According to psychologists Neal Roese and Kathleen
Vohs, there are three stacking levels of which this can
occur.
✔ The first level is “memory distortion.” This involves
misremembering a past judgment or opinion. We often do
this when claiming we said something when we didn’t.
✔ The second level is centred around our belief that a past
event was inevitable. Roese and Vohs call this degree of the
hindsight bias “inevitability.”
✔ The last level, “foreseeability,” entails believing that we
could have foreseen the event.So, the bias occurs when we
misremember our past thoughts, think a past event was
inevitable, and subsequently, believe the event was
foreseeable.
Causes of Hindsight Bias
⚫ Distorted Memories : Distortion of Memories of past
events can cause people to believe that they correctly
guessed the actual income.
⚫ Reconstruction Bias : It arises when people attempt to
reconstruct a story around the past event that leans toward
the actual outcome.
⚫ Metacognitive: The phenomenon occurs when individuals
think of their past thoughts or events, becoming confused
about their certainty.
⚫ Motivational Bias : Motivational Bias causes people to
misremember their original judgements to look wiser than
they are. People begin to perceive uncertain situations as
predictable as a result of this.
Impact of Hindsight Bias
⚫ Hindsight Bias can become a decision trap
because it leads to a flawed assessment of
the past.
⚫ Hindsight Bias will likely cause us to judge
others unfairly for not having been able to
foresee past events.
⚫ However hindsight bias can also work to
our advantage. Studies have proved it that
hindsight bias can reduce the pain of
negative emotional events.
How to avoid Hindsight Bias?
⚫ Brainstorm alternative outcomes.
⚫ Keep a trading journal and review it.
Belief Perseverance

If you’ve ever gotten into a conversation where you’ve

attempted to change someone’s belief based on your
knowledge of facts, only to have them refuse to consider
the validity of the information you’ve presented, you’ve
encountered belief perseverance in action.
Belief Perseverance
⚫ Belief perseverance is the tendency to cling to one’s beliefs
even when presented with information disproving them.
⚫ People have a natural tendency to cling to their pre-existing
beliefs, even when new information is provided that proves
those beliefs wrong. In other words, beliefs persevere.
⚫ Belief perseverance is often confused with confirmation
bias, but they aren’t the same thing. A confirmation bias is a
bias in which people seek out and recall information that
supports their preconceived beliefs. In contrast, belief
perseverance doesn’t involve using information to confirm
a belief, but the rejection of information that could disprove
it.
Example:
⚫ A 32-year-old Mike financial analyst, is heavily invested
in Company A. Over the past few weeks, sentiment
regarding Company A has been severely bearish due to
major internal accounting fraud. The company’s share
price has plummeted to reflect this new information. In
addition, other financial analysts are negative about the
shares of Company A and assign a low target price. This
financial analyst despite the accounting scandal and
significant negative sentiment regarding Company A,
refuses to change his belief regarding the company and
continues to hold onto his shares in spite of the
declining share price. As Mike is sticking to a
flawed investment strategy
Types of Belief Perseverance
⚫ Self-impressions involve beliefs about the self. These can include
everything from beliefs about one’s looks and body image to one’s
personality and social skills to one's intelligence and abilities. For
example, an individual may be thin and attractive but may believe
that they are overweight and ugly despite ample evidence to the
contrary.
⚫ Social impressions involve beliefs about other specific people. These
people can include those one’s closest to, like a mother or best friend,
as well as people they only know through media, like a famous actor
or singer.
⚫ Social theories involve beliefs about the way the world works. Social
theories can include beliefs about the ways groups of people think,
behave, and interact, and encompasses stereotypes about racial and
ethnic groups, religious groups, gender roles, sexual orientations,
economic classes, and even various professions. This type of belief
perseverance is also responsible for beliefs about political and social
issues, including national security, abortion, and health care.
Causes of Belief Perseverance
⚫ One process that leads to belief perseverance is
the availability heuristic, which people use to
determine how likely an event or behaviour might be
based on how easily they can think of past examples.
⚫ Illusory correlation, in which one believes a
relationship exists between two variables even though it
doesn’t, will also lead to belief perseverance.
⚫ Data distortions happen when one unknowingly creates
opportunities for their beliefs to be confirmed while
ignoring times when their beliefs are disproven.
Endowment Bias
⚫ People who exhibit endowment bias value an asset more
when they hold property rights to it than when they
don’t.
⚫ 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.
Endowment Bias
⚫ “Endowment Effect” is when people often demand
much more to sell an object than they would be willing
to pay to buy it.
⚫ In case of purchased securities decision paralyses is also
attributable to endowment bias.
⚫ Endowment effect is visible in bear markets which is
eventually nullified by sense of regret.
⚫ Endowment bias is one among the “ emotional biases”.
Implications of Endowment Bias
⚫ Endowment bias influences investors to hold onto
securities that they have inherited, regardless of whether
retaining those securities is financially wise. This
behaviour is often the result of the heirs’ fear that selling
will demonstrate disloyalty to prior generations or will
trigger tax consequences.
⚫ Endowment bias causes investors to hold securities they
have purchased (already own). This behaviour 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.
Implications of Endowment Bias
⚫ Endowment bias causes investors to hold securities
that they have either inherited or purchased because
they do not want to incur the transaction costs
associated with selling the securities. These costs,
however, can be a very small price to pay when
evacuating an unwise investment.
⚫ Endowment bias causes investors to hold securities
that they have either inherited or purchased because
they are familiar with the behavioural
characteristics of these endowed investments.
Familiarity, though, does not rationally justify
retaining a poorly performing stock or bond.
Effect on Investors
⚫ Cause investors to hold loss making
securities.
⚫ Leads to “ decision paralysis”.
⚫ Reluctance to incur transaction cost to
offload an unwise investment.
Self- Control Bias
⚫ Self-control bias is a human behavioural 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.
⚫ A taxpayer, estimate that your income this year will cause your income tax
to increase by $3,600, which will be due one year from now. In the interest
of conservatism, you decide to set money aside.
You contemplate two choices:
Would you rather contribute $300 per month over the course of the next 12
months to some savings account earmarked for tax season?
Or
Would you rather increase your federal income tax withholding by $300
each month, sparing you the responsibility of writing out one large check
at the end of the year?
Rational economic thinking suggests that you would prefer the savings
account approach because your money would accrue interest and you
would actually net more than $3,600
Self- Control Bias
⚫ Self-control bias can also be described as a conflict
between people’s overarching desires and their inability,
stemming from a lack of self-discipline, to act
concretely in pursuit of those desires.
⚫ For example,
1. A student desiring an “A” in history class might
theoretically forgo a lively party to study at the library.
2. An overweight person desperate to shed unwanted
pounds might decline a tempting triple fudge sundae.
Reality demonstrates, however, that plenty of people do
sabotage their own long-term objectives for temporary
satisfaction in situations like the ones described
Self- Control Bias
⚫ The technical description of self-control bias is best understood in
the context of the life-cycle hypothesis, which describes a well-
defined link between the savings and consumption tendencies of
individuals and those individuals’ stages of progress from
childhood, through years of work participation, and finally into
retirement.
⚫ Two common tendencies of individuals underlie spending
patterns, according to the life-cycle hypothesis:
1. Most people prefer a higher standard of living to a lower standard of living;
that is, people want to maximize consumption spending in the present.
2. Most people prefer to maintain a relatively constant standard of living
throughout their lives. They dislike volatility and don’t desire abrupt
intervals of feast interspersed with famine.
Basically, the life-cycle hypothesis envisions that people will try to
maintain the highest, smoothest consumption paths possible
Self- Control Bias
⚫ In 1998, Hersh Shefrin and Richard Thaler introduced a
behaviourally explained life-cycle hypothesis which is a
descriptive model of household savings in which self-
control plays a key role. The key assumption of the
behavioural life-cycle theory is that households treat
components of their wealth as “nonfungible” or non-
interchangeable even in the absence of credit rationing.
⚫ Specifically, wealth is assumed to be divided into three
“mental” accounts: (1) current income, (2) current
assets, and (3) future income. The temptation to spend is
assumed to be greatest for current income and least for
future income.
Implications of Self- Control Bias
⚫ Self-control bias can cause investors to spend more today
at the expense of saving for tomorrow. This behaviour can
be hazardous to one’s wealth, because retirement can
arrive too quickly for investors to have saved enough.
Frequently, then, people incur inappropriate degrees of
risk in their portfolios in effort to make up for lost time.
This can, of course, aggravate the problem.
⚫ 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.
Implications of Self- Control Bias
⚫ Self-control bias can cause asset-allocation imbalance
problems. For example, some investors prefer income-
producing assets, due to a “spend today” mentality. This
behaviour can be hazardous to long-term wealth because
too many income producing assets can inhibit a portfolio to
keep up with inflation. Other investors might favour
different asset classes, such as equities over bonds, simply
because they like to take risks and can’t control their
behaviour.
⚫ 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.
Advice for Investors
Spending Control :Self-control bias can cause investors to
spend more today rather than saving for tomorrow. People
have a strong desire to consume freely in the present. This
behavior can be counterproductive to attaining long-term
financial goals because retirement often arrives before
investors have managed to save enough money. This may
spur people into accepting, at the last minute, inordinate
amounts of risk in their portfolios to make up for lost time
—a tendency that actually places one’s retirement
security at increased risk. Advisors should counsel their
clients to pay themselves first, setting aside consistent
quantities of money to ensure their comfort later in life,
especially if retirement is still a long way off. I
Advice for Investors
Lack of Planning: Self-control bias may cause investors to not plan
adequately for retirement. Studies have shown that people who do not
plan for retirement are much less likely not to retire securely than those
who do plan. People who do not plan for retirement are also less likely
to invest in equity securities. Advisors must emphasize that investing
without planning is like building without a blueprint. Planning is the
absolute key to attaining long-term financial goals.
Portfolio Allocation: Self-control bias can cause asset allocation
imbalance problems. Investors subject to this bias may prefer income-
producing assets, due to a “spend today” mentality. This behaviour can
be counterproductive to attaining long-term financial goals because an
excess of income-producing assets can prevent a portfolio from
keeping up with inflation. Self-control bias can also cause people to
unduly favor certain asset classes, such as equities over bonds, due to
an inability to reign in impulses toward risk. Advisors must emphasize
the importance of adhering to a planned asset allocation
Loss Aversion Bias
⚫ Psychologically, the possibility of a loss is on average
twice as powerful a motivator as the possibility of making
a gain of equal magnitude.
⚫ Loss aversion can prevent people from unloading
unprofitable investments, even when they see little to no
prospect of a turnaround.
⚫ Loss aversion bias can make investors dwell excessively
on risk avoidance when evaluating possible gains, since
dodging a loss is a more urgent concern than seeking a
profit.
⚫ Loss aversion causes investors to hold their losing
investments and to sell their winning ones, leading to
suboptimal portfolio returns.
Implications for Investors
1. Loss aversion causes investors to hold losing investments too long. This
behaviour is sometimes described in the context of a debilitating
disease: get-even-itis. This is the affliction in which investors hold
losing investments in the hope that they get back what they lost. This
behaviour has seriously negative consequences by depressing portfolio
returns.
2. Loss aversion can cause investors to sell winners too early, in the fear
that their profit will evaporate unless they sell. This behaviour limits
upside potential of a portfolio, and can lead to too much trading, which
has been shown to lower investment returns.
3. Loss aversion can cause investors to unknowingly take on more risk in
their portfolio than they would if they simply eliminated the investment
and moved into a better one (or stayed in cash).
4. Loss aversion can cause investors to hold unbalanced portfolios. If, for
example, several positions fall in value and the investor is unwilling to
sell due to loss aversion, an imbalance can occur
Regret Aversion Bias
Under conditions of uncertainty, people fear that their decision will turn out
to be wrong in the hindsight. So they display regret aversion and try to
minimise future regret. Here is a conspicuous example of this tendency.
Harry Markowitz, father of Modern Portfolio Theory, said,
“I visualised my grief if the stock market went way up and I wasn’t in it, or
if it went down and I was completely in it. My intention was to minimise
my future regret. So I split my retirement plan contributions fifty-fifty
between bonds and equities.”
Regret-averse people try to avoid the pain arising from two types of
mistakes:
(i) errors of commission (ii) errors of omission.
Errors of commission arise from misguided action, whereas errors of
omission arise from misguided inaction. Regret tends to be more intense
when unfavourable outcomes are due to errors of commission rather than
errors of omission. Further, regret is more palpable when the outcomes of
actions (or inactions) are highly visible or accessible.
Investment Mistakes
⚫ Investors may become too conservative. After a loss, an
investor may shun the market altogether.
⚫ Investors may hold on to a losing position for too long.
People do not like to admit that they’re wrong.
⚫ Investors tend to follow the herd as buying with the herd
assuages potential regret.
⚫ Investors may hold on to a winning stock for too long.
People fear that if they sell they may miss out further
gains.
⚫ Investors tend to prefer ‘good companies’ though they
may not be ‘good investments.’ As J.M. Keynes said, “It is
better to fail conventionally rather than succeed
unconventionally.”
Status Quo
⚫ Status quo bias operates in people who prefer
for things to stay relatively the same. The
scientific principle of inertia bears a lot of
intuitive similarity to status quo bias.
⚫ Inertia means that an individual is relatively
more reluctant to move away from some state
identified as the status quo than from any
alternative state not identified as the status quo.
⚫ Status quo bias implies a more intense
“anchoring effect.”
Status Quo
⚫ A hypothetical grandson who hesitates to sell
the bank stock he’s inherited from his
grandfather. Even though his portfolio is under
diversified and could benefit from such an
adjustment, the grandson favours the status quo
- Risk Aversion
- Personal Attachment
- Aversion to tax consequences
Implications of Status Quo
⚫ Status quo bias can cause investors, by taking no action, to
hold investments inappropriate to their own risk/return
profiles. This can mean that investors take excessive risks
or invest too conservatively.
⚫ Status quo bias can combine with loss aversion bias. In this
scenario, an investor facing an opportunity to reallocate or
alter an investment position may choose, instead, to
maintain the status quo
⚫ Status quo bias causes investors to hold securities with
which they feel familiar or of which they are emotionally
fond. This behavior can compromise financial goals,
however, because a subjective comfort level with a security
may not justify holding onto it despite poor performance
Framing
⚫ Framing bias notes the tendency of decision makers to
respond to various situations differently based on the
context in which a choice is presented (framed).
⚫ Have you ever found an item priced at “3 for $7” also
available at a unit price of $2.33? This isn’t unusual.
Shopping represents a rudimentary rational choice problem.
⚫ A decision frame is the decision maker’s subjective
conception of the acts, outcomes, and contingencies
associated with a particular choice.
⚫ The frame that a decision maker adopts is controlled partly
by the formulation of the problem and partly by the norms,
habits, and personal characteristics of the decision maker.
Framing
⚫ The frame that a decision maker adopts is controlled
partly by the formulation of the problem and partly by
the norms, habits, and personal characteristics of the
decision maker.
⚫ For example, one prospect can be formulated in two
ways: as a gain (“25 percent of patients will be saved if
they are provided with medicine XYZ”) or as a loss (“75
percent of patients will die without medicine XYZ”).
⚫ Framing bias also encompasses a subcategorical
phenomenon known as narrow framing, which occurs
when people focus too restrictively on one or two
aspects of a situation, excluding other crucial aspects and
thus compromising their decision making.
Framing
For example, suppose that Mrs. Smith chooses to invest
in either Portfolio A or Portfolio B. Further suppose that
Portfolios A and B are identical in every respect. Mrs.
Smith learns that Portfolio A will offer her a 70 percent
chance of attaining her financial goals, whereas
Portfolio B offers Mrs. Smith a 30 percent chance of not
attaining her financial goals. If Mrs. Smith is like most
people, she will choose Portfolio A, because its
performance prospects were more attractively framed
Implications of Framing
⚫ When questions are worded in the “gain” frame, a risk-averse
response is more likely. When questions are worded in the “loss”
frame, risk-seeking behavior is the likely response.
⚫ The optimistic or pessimistic manner in which an investment or
asset allocation recommendation is framed can affect people’s
willingness or lack of willingness to invest.
⚫ Narrow framing, a subset of framing bias, can cause even long
term investors to obsess over short-term price fluctuations in a
single industry or stock. This behaviour works in concert with
myopic loss aversion The risk here is that by focusing only on
short-term market fluctuations, excessive trading may be the
result. This trading behaviour has proven to be less than optimal
for investors
⚫ Framing and loss aversion can work together to explain excessive
risk aversion.
Naive Realism
⚫ Naive realism is the tendency to believe our perception
of the world reflects it exactly as it is, unbiased and
unfiltered. We don’t think our emotions, past
experiences, or cultural identity affect the way we
perceive the world and thus believe others see it in the
same way as we do.
⚫ Naive realism is within the egocentric bias category, a
group of biases that indicate we rely too heavily on our
own point of view and fail to understand that it is a
personal point of view.
⚫ These biases make it difficult for us to understand other
people’s perspectives and can lead to arguments and
polarization
Non-consequentialism
⚫ Non-consequentialism is an ethical theory that asserts that the
morality of an action is not solely determined by its
consequences. Instead, it emphasizes other factors such as
intentions, duties, or principles
⚫ It prioritize the inherent rightness or wrongness of actions
themselves, regardless of their consequences.
⚫ Non-consequentialist ethical theories include deontological
ethics, which emphasizes moral rules or duties that must be
followed regardless of the consequences, and virtue ethics,
which emphasizes the development of virtuous character traits.
⚫ These theories often contend that certain actions are inherently
right or wrong, irrespective of their outcomes, based on
principles like human dignity, justice, or rights.
Disjunction Effect

⚫ The disjunction effect is a tendency for people

to want to wait to make decisions until
information is revealed, even if the information
is not really important for the decision, and even
if they would make the same decision regardless
of the information. The disjunction effect is a
contradiction to the "sure-thing principle" of
rational behaviour.
⚫ Experiments showing the disjunction effect were performed by
Tversky and Shafir (1992). They asked their subjects whether they
would take one of the bets that Samuelson's lunch colleague,
discussed above, had refused, a coin toss in which one has equal
chances to win $200 or lose $100. Those who took the one bet were
then asked whether they then wanted to take another such bet. If
they were asked after the outcome of the first bet was known, then
it was found that a majority of respondents took the second bet
whether or not they had won the first. However, a majority would
not take the bet if they had to make the decision before the outcome
of the bet was known. This is a puzzling result: if one's decision is
the same regardless of the outcome of the first bet, then it would
seem that one would make the same decision before knowing the
outcome.
⚫ Tversky and Shafir gave their sense of the possible thought patterns
that accompany such behaviour: if the outcome of the first bet is
known and is good, then subjects think that they have nothing to
lose in taking the second, and if the outcome is bad they want to try
to recoup their losses. But if the outcome is not known, then they
have no clear reason to accept the second bet.
Disjunction Effect
⚫ The disjunction effect might help explain changes in the
volatility of speculative asset prices or changes in the
volume of trade of speculative asset prices at times
when information is revealed.
⚫ For example, the disjunction effect can in principle
explain why there is sometimes low volatility and low
volume of trade just before an important announcement
is made, and higher volatility or volume of trade after
the announcement is made.
⚫ Shafir and Tversky (1992) give the example of
presidential elections, which sometimes induce stock
market volatility when the election outcome is known
even though many sceptics may doubt that the election
outcome has any clear implications for market value.