The Behavioral Biases of Individuals
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Introduction
Research has demonstrated that when people face complex decisions, they often rely on basic judgments and preferences to simplify the situation rather than acting completely rationally. Although such approaches are quick and intuitively appealing, they may lead to suboptimal outcomes. In contrast to this body of research, traditional economic and financial theory generally assumes that individuals act rationally by considering all available information in the decision-making process, leading them to optimal outcomes and supporting the efficiency of markets. Behavioral finance challenges these assumptions by incorporating research on how individuals and markets actually behave. In this reading, we explore a foundational concept of behavioral finance: behavioral biases. Investment professionals may be able to improve economic outcomes by understanding these biases, recognizing them in themselves and others, and learning strategies to mitigate them.
The reading proceeds as follows. Section 2 describes and broadly characterizes behavioral biases. Sections 3 and 4 discuss specific behavioral biases within two broad categories: cognitive errors and emotional biases. The discussion includes a description of each bias, potential consequences, and guidance on detecting and mitigating the effects of the bias. Section 5 discusses market anomalies, which are essentially aggregate expressions of individual biases among financial market participants. A summary and practice problems conclude the reading.
Learning Outcomes
The candidate should be able to:
- compare and contrast cognitive errors and emotional biases
- discuss commonly recognized behavioral biases and their implications for financial decision making
- describe how behavioral biases of investors can lead to market characteristics that may not be explained by traditional finance
Summary
Behavioral biases potentially affect the behaviors and decisions of financial market participants. By understanding these biases, financial market participants may be able to moderate or adapt to them and, as a result, improve upon economic outcomes. Behavioral biases may be categorized as either cognitive errors or emotional biases. The type of bias influences whether its impact may be moderated or adapted to.
Among the points made in this reading are the following:
- Individuals do not necessarily act rationally and consider all available information in the decision-making process because they may be influenced by behavioral biases.
- Biases may lead to suboptimal decisions.
- Behavioral biases may be categorized as either cognitive errors or emotional biases. A single bias may have aspects of both, however, with one type of bias dominating.
- Cognitive errors stem from basic statistical, information-processing, or memory errors; cognitive errors typically result from faulty reasoning.
- Emotional biases stem from impulse or intuition and tend to result from reasoning influenced by feelings.
- Cognitive errors are more easily corrected for because they stem from faulty reasoning rather than an emotional predisposition.
- Emotional biases are harder to correct for because they are based on feelings, which can be difficult to change.
- To adapt to a bias is to recognize and accept the bias and to adjust for the bias rather than to attempt to moderate the bias.
- To moderate a bias is to recognize the bias and to attempt to reduce or even eliminate the bias within the individual.
- Cognitive errors can be further classified into two categories: belief perseverance biases and information-processing biases.
- Belief perseverance errors reflect an inclination to maintain beliefs. The belief is maintained by committing statistical, information-processing, or memory errors. Belief perseverance biases are closely related to the psychological concept of cognitive dissonance.
- Belief perseverance biases include conservatism, confirmation, representativeness, illusion of control, and hindsight.
- Information-processing biases result in information being processed and used illogically or irrationally.
- Information-processing biases include anchoring and adjustment, mental accounting, framing, and availability.
- Emotional biases include loss aversion, overconfidence, self-control, status quo, endowment, and regret aversion.
- Understanding and detecting biases is the first step in overcoming the effect of biases on financial decisions. By understanding behavioral biases, financial market participants may be able to moderate or adapt to the biases and, as a result, improve upon economic outcomes.
- Behavioral finance has the potential to explain some apparent deviations from market efficiency (market anomalies).
1.25 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.