Understanding Behavioural Biases: Cognitive Errors | CFA Level I Portfolio Management
In this lesson, we explore the fascinating world of behavioural finance and cognitive errors that can influence the decisions of market participants.
Introduction to Behavioural Finance
Traditional finance theories, like the efficient market hypothesis, assume that individuals act rationally and consider all relevant information to make optimal decisions in the markets. However, research has shown that people often rely on basic judgments and preferences to simplify complex decisions. This gives rise to the field of behavioural finance, which studies the biases of market participants to better explain market anomalies.
Categories of Biases
Biases can be broadly categorized as cognitive errors or emotional biases:
- Cognitive errors stem from irrationality (belief perseverance biases) or faulty reasoning (processing errors).
- Emotional biases arise from feelings, impulses, or intuition and are difficult to overcome.
First, let’s explore cognitive errors, specifically belief perseverance biases.
Belief Perseverance Biases
Belief perseverance biases reflect an irrational reluctance to change prior beliefs and decisions. They include:
1. Conservatism Bias
Conservatism bias occurs when individuals fail to update their views as new information becomes available. This may result in holding investments for too long or avoiding the mental effort of updating prior beliefs.
EXAMPLE
An investor may persist in allocating 80% of their portfolio to equities, despite reports that equities are overvalued and the odds of a recession are higher.
2. Confirmation Bias
Confirmation bias happens when people seek out information that supports their prior beliefs and avoid or dismiss conflicting information. This can lead to overconfidence.
EXAMPLE
An investor heavily invested in energy stocks may only read bullish articles on the sector, ignoring bearish viewpoints.
3. Representativeness Bias
Representativeness bias involves making premature conclusions based on flawed assumptions. It can manifest as:
- Base-rate neglect – Ignoring broader population statistics in favor of specific information.
- Sample-size neglect – Drawing conclusions from small, unrealistic data samples.
EXAMPLE
Investors may assume a fund manager with strong performance over three years has superior skill, ignoring longer sample periods that show a lack of persistence.
4. Illusion of Control Bias
Individuals with an illusion of control bias believe they can influence outcomes when they cannot. This can lead to inadequately diversified portfolios or overconfidence.
5.Hindsight Bias
Hindsight bias is the tendency to believe that past events were predictable. This can lead to overconfidence and unfair assessments of investment managers.
EXAMPLE
Investors may blame a manager for not predicting certain outcomes, even though those outcomes were difficult to foresee at the time.
Information Processing Biases
Next, we will explore the second type of cognitive error: information processing biases. These biases stem from illogical or irrational processing of information rather than the decision-making process.
1. Anchoring and Adjustment Bias
Anchoring and adjustment bias involves basing expectations on a previous number and overweighting its importance, making adjustments in relation to that number as new information arrives.
EXAMPLE
An investor decides to buy a stock trading at $100 but delays the purchase. The next day, the company announces a major contract win, and the stock price jumps to $120. The investor doesn’t buy because they could have gotten it for $100 the day before. This example shows how the investor’s anchor ($100) led them to ignore or underestimate the new information about the contract win on the stock price.
2. Mental Accounting Bias
Mental accounting bias occurs when investors view money in different accounts or from different sources differently when making investment decisions.
EXAMPLE 1
A lottery winner invests all winnings in highly risky cryptocurrency investments, considering the winnings as “extra money.” The investor should have considered the winnings as part of their overall portfolio and allocated a portion to cryptocurrencies based on their risk tolerance.
EXAMPLE 2
An investor holds onto a stock just because the price is lower than what they paid for it. This is mental accounting bias, as decisions should be made from a portfolio perspective, selling the stock if it no longer has a place in the portfolio, regardless of profit or loss.
3. Framing Bias
Framing bias is when a person answers a question differently based on how it is asked or framed.
EXAMPLE
A prospective investor of a PE fund may reject a proposal if success rates are framed in terms of losses, but accept it if framed in terms of gains. Investment managers must avoid framing bias when assessing an investor’s risk tolerance.
Narrow framing happens when people evaluate information based on a narrow frame of reference, losing sight of the big picture in favor of one or two specific points.
EXAMPLE
An investor might focus solely on short-term fluctuations in a firm’s stock price, overlooking or dismissing other important factors such as its business model, fundamental performance, and valuation.
Availability Bias
Availability bias refers to putting undue emphasis on information that is readily available, easy to recall, or based narrowly on personal experience or knowledge.
EXAMPLE 1
Investors may choose investments based on familiar broad classifications of stocks and bonds or stick with big names, limiting their investment universe.
EXAMPLE 2
Some investors may choose funds or investment advisors based on advertisements rather than selecting one that fits their objectives and risk profile.
Now that we’ve covered various cognitive errors and biases, our next lesson will focus on emotional biases.
✨ Visual Learning Unleashed! ✨ [Premium]
Elevate your learning with our captivating animation video—exclusive to Premium members! Watch this lesson in much more detail with vivid visuals that enhance understanding and make lessons truly come alive. 🎬
Unlock the power of visual learning—upgrade to Premium and click the link NOW! 🌟
