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Behavioural Finance

March 27, 2019

Cognitive Biases:

Conservatism Bias

Conservatism bias is a belief perseverance bias in which peoplescared turtle in shell - Behavioural Financemaintain their prior views or forecasts by inadequately
incorporating new information. This bias has aspects of both
statistical and information-processing errors.

Example: suppose a trader receives some bad news regarding a
company’s earnings and that this news negatively contradicts
another earnings estimate issued the previous month.
Conservatism bias may cause the trader to under-react to the new information, maintaining impressions derived from the
previous estimate rather than acting on the updated information.

Illusion of control

Illusion control bias refers to people’s tendency to
believe that they have control or atleast can influenceIllusion of control - Behavioural Finance
the outcome of uncontrollable events.

Example: studies have demonstrated people think they
have more control over the outcome of a dice game if they
throw the dice themselves than if someone else throws the
dice for them, and they are less apt to sell a lottery ticket
they chose than a ticket chosen by someone else

 

Mental Accounting

Mental Accounting - Behavioural Finance

Mental Accounting refers to the tendency people have to separate their money into different accounts based on miscellaneous subjective criteria, including the source of the money and the intended use for each account.
Example: A beer drinker will probably be willingto pay Rs. 500/- for a beer at an expensive resort. This consumption willbe put in ‘holiday mental account’. At the same time he might refuge paying Rs. 200/- for the same during grocery shopping because this expenditure is in ‘grocery shopping, mental account.

 

Framing Bias

The framing effect is an exampleof cognitive bias, in which people react to a particular choice in different ways depending on how it is presented.
img4 - Behavioural FinanceExample: When given a fifty-fifty odd of either winning 100or 500 and a fifty fifty chance of losing either 100or 500. The people actually felt slightly positive when they lost 100because they avoided losing 500. But when they won 100they reported a feeling of dissatisfaction because they didn’t win 500. They felt good about losing 100because the gamble was framed in terms of losses and they felt bad about winning 100because the gamble was framed in terms of gains

 

Availability Bias

img6 - Behavioural Finance

Availability bias is a cognitive bias that leads to decisions being based on information and events that are more recent, that were observed personally, and are more memorable. It operates on the notion that if something can be recalled, it must be important, or at least more important than alternative solutions which are not as
readily recalled.

Example: Deciding to continue smoking because you know a smoker who lived to be 100 would be a good example of Availability Bias. In this scenario, the story you can recall plays too big a role in your decision to continue smoking.

Emotional Biases:

Loss-Aversion Bias

img8 - Behavioural FinanceLoss-aversion bias is a bias in which people tend to strongly prefer avoiding losses as opposed to achieving gains. Example: example of loss aversion theory can be seen in casinos around the world. There, fun-seekers and hardcore gamblers alike all follow the same pattern: The first round they play–be it
blackjack or slots–is to win. The second round? It’s to recoup losses.

 

Overconfidence Bias

bias - Behavioural FinanceOverconfidence bias is a bias in which people demonstrate unwarranted faith in their own intuitive reasoning, judgments, and/or cognitive abilities. This overconfidence may be the result of overestimating knowledge levels,
abilities, and access to information. Example: A person who thinks he has a photographic memory and a detailed understanding of a subject. The person could show his overconfidence by deciding not to study for a test that he has to take on the subject, thus doing poorly on the test due to lack of preparation.

 

Self-Control Bias

Self Control - Behavioural FinanceBias in which people fail to act in pursuit of their long-term, overarching
goals because of a lack of self-discipline. There is an inherent conflict
between short-term satisfaction and achievement of some long-term
goals. Money is an area in which people are notorious for displaying a
lack of self-control.

Example: In the seminal work on self-control pre-school children were
presented with the simple marshmallow test, in which they could either
eat a small snack right away or wait 15 min and get a larger snack.
Around 67% of the children in the original study failed to resist
temptation and ate the small snack, indicating lower level of self-control

Status Quo Bias

status - Behavioural FinanceStatus Quo bias is an emotional bias in which people do nothing instead of making a change. People are generally more comfortable keeping things the same than with change and thus do not necessarily look for opportunities where change is beneficial. Given no apparent problem requiring a decision, the status quo is maintained.

Example: In Germany, a small town had to be relocated due to a mining project. Citizens were offered many plans for a new town, but citizens voted for a plan which closely resembled the old town with an inefficient serpentine look which had evolved for no rhyme or reason over the years.

Endowment Bias

endowment - Behavioural FinanceEndowment Bias is an emotional bias in which people value an asset more when they hold rights to it than when they do not. Endowment bias is inconsistent with standard economic theory, which asserts that the price a
person is willing to pay for a good should equal the price at which that person would be willing to sell the same good. Example: An individual may have obtained a case of wine that, at the time, was of relatively low cost. If an
offer were made at a later date to acquire that wine for multiples of the original price, the endowment effect might compel the owner to refuse any and all offers, despite the potential monetary gains. There is a sense of personal welfare over actual wealth that is believed to drive such sentiment. So rather than take payment for the wine, the owner may choose to drink it themselves.

 

Vipul Bhatnagar,
MBA-FA(2017-19)

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