Cognitive Errors

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:

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:

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.

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