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The material in this blog post is useful to the candidates preparing for: Level III of CFA Exams.

In earlier topics, we discussed the both belief perseverance and information-processing biases which are both related to cognitive errors; what all cognitive errors have in common is that they are related to errors related to the memory. Today, we move on to discuss a different category of behavioral biases which are emotional biases – biases that are related to emotions and feelings.

• Note (1): In this reading, we refer to investors and investment advisors who might be affected by behavioral biases as Financial Market Participants (FMPs)
• Note (2): In the previous posts related to level III, we used to add previous essay exam questions at the end of the related material. This time, we will save all the related questions to behavioral biases to a separate post after covering all the biases.
• Note (3): For each bias covered, we will provide description, discuss its consequences and suggest methods to detect and overcome the bias

Emotional Biases

It is hard to agree about a single definition for emotion; however, for the purpose of our analysis, we can think of emotion as a mental state that arises spontaneously rather than consciously. Emotional biases are related to impulse and intuition and they include:

1. Loss-aversion
2. Overconfidence
3. Self-control
4. Status quo
5. Endowment
6. Regret aversion

Loss-aversion Bias

What is it?

Loss-aversion is an emotional bias where people care more about avoiding losses than they care about making gains. An important related concept here is disposition effect which refers to the keeping losers for too long and selling winners too quickly.

What are the consequences? FMPs may do the following:

1. Hold losers and sell winners in their portfolios for longer than justified resulting in holding a riskier portfolio than the optimal portfolio
2. Lose the upside potential by selling winners too quickly
3. Lower their portfolio returns by incurring commissions as a result of excessive trading (when they sell winners)

Special Application (1): House-Money Effect

When framing and loss-aversion affect behavior simultaneously, the situation gets more dangerous than when each bias affects FMPs separately.  If people frame the new alternatives with respect to what their recent experience was, then those who suffered losses will find risky alternatives as opportunities whereas those who gained will find the same alternatives as threats.  This is related to the “house money effect,” whereby gamblers engage in more risky gambles from their winnings than from their own money. Gamblers view this situation as others’ money rather than their own money.

Special Application (2): Myopic Loss Aversion

Myopic loss aversion occurs when investors don’t only weigh losses more than gains but they also overemphasize short-term results to long-term ones. An investor who is prepared to wait a long time before evaluating investment outcomes will see risky assets as more attractive than another investor (equally loss averse, but more myopic), who expects to evaluate the outcome soon.

How to detect and overcome it?

It is important to focus on fundamental analysis when evaluating investments rather than evaluating them in relative terms.

Overconfidence Bias

Overconfidence is an emotional bias in which people overestimate their abilities to reason and they believe that they are smarter and more informed than they actually are. Overconfidence is intensified when combined with self-attribution bias which is the tendency for people to credit success internally and assign failures to external reasons. Self-attribution is then combined of two biases:

1. Self-enhancing bias: tendency to assign success to personal reasons
2. Self-protecting bias: tendency to assign failures to external reasons

Overconfidence has two types:

1. Prediction overconfidence: occurs when the confidence intervals that FMPs assign to their investment predictions are too narrow (they believe they are certain of outcomes and therefore they decide to narrow down the range of possibilities).
2. Certainty overconfidence: occurs when the probabilities that FMPs assign to outcomes are higher than they are.

What are the consequences?

FMPs may do the following:

1. Underestimate risks
2. Overestimate returns
3. Trade excessively
4. Experience lower returns than those of the market as a result of (1), (2), and (3)

How to detect and overcome it?

Having different opinions will help confirming the level of certainty in the analysts’ views.

Self-Control Bias

Self-control is an emotional bias where people focus on short-term and fail to focus on long-term goals.  A person who is trying to obtain his CFA charterholder should spend more time studying; however, lack of self-discipline results in failing to do so. This could happen because of what is known as ‘hyperbolic discounting ’ which is the human tendency to prefer smaller current payoffs to larger future payoffs.

What are the consequences? FMPs may do the following:

1. Spend more today than needed
2. Save insufficiently for the future
3. Take high risk to generate higher short-term returns
4. Have inappropriate asset allocation because of preference toward income-producing assets

How to detect and overcome it?

They should remember that investing without proper planning is like building without a blueprint.

Status Quo Bias

What is it?

Status quo is an emotional bias where people tend to do nothing instead of taking a change. Even when a change is more beneficial, people are more comfortable keeping things the same than taking the time to look for a beneficial change.

What are the consequences? FMPs may do the following:

1. Hold portfolios with inappropriate risk/return characteristics
2. Fail to seek out new investment opportunities

How to detect and overcome it?

FMPs should look for new opportunities and review the asset allocation frequently to make sure that a proper allocation is maintained.

Endowment Bias

What is it?

Endowment is an emotional bias where people value what they hold more than what they don’t hold.

What are the consequences? FMPs may do the following:

1. State minimum selling prices for a good that exceed maximum purchase prices that they are willing to pay for the same good
2. Hold assets for too long and fail to replace assets with right ones; therefore, they maintain an inappropriate asset allocation.

How to detect and overcome it?

Usually, inherited securities are considered to be a common cause of this bias. FMP should ask questions as as, “If an equivalent sum to the value of the investments inherited had been received in cash, would I have held the same security?”

Regret-Aversion Bias

What is it?

Regret-aversion is an emotional bias where people tend to avoid making decisions because of their fear that the decision outcome might not be favorable. It consists of two types: The fear of taking an action (error of commission ) and the fear from not taking an action (error of omission ). People have more regret when unfavorable outcomes happen because of error of commission (taking an action they shouldn’t have taken) than when unfavorable outcomes happen because of error of omission (not taking an action that they should have taken).

What are the consequences? FMPs may do the following:

1. Be too conservative choosing investments.
2. Engage in herding behavior where they feel safer doing what everyone else in the market is doing – the future regret when outcomes turn unfavorable is reduced.

How to detect and overcome it?

FMPs must recognize that losses happen to everyone and keep in mind the long-term benefits of including risky assets in portfolios.

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