Best/Worst Trade Fund League Tables Behavioral Finance List of Crises Synopses on Crises

Behavioral Finance

Focusing on an initial point of judgement to make decisions, while ignoring other incoming information. The problem arises when the point becomes irrelevant and causes unfavorable results. This is discerned from conservatism bias as anchoring is clinging to the original forecast, whereas conservatism is clinging to the given information that helped forming the idea. Investors tend to stick to the original investment strategy even when they are informed that the market is shifting.

Case in point: In a survey that asked about the proportion of African countries in the United Nations, the group presented with the question whether it is larger or smaller than 10%, and the other group with 65% had 20% difference in the average of the answers.

Bias in placing more importance on information which is more widespread and recent. One can be easily swayed by the more readily available information or topic that gains more attention, compared to the information one can gather from extensive valuation of each company.

Case in point: Availability bias causes investors to invest in companies that are heavily covered by the media, but a Cornell study found that these companies underperform within 2 years in any given year.

A tendency to achieve consistency in evidence. In a situation where multiple cognitions are psychologically inconsistent, one tends to alter the cognitions to make them more consonant with each other. Because people feel uncomfortable to hold contradictory evidences, the process of achieving compatibility in cognitions can be biased as one strives to reduce the psychological pain. When presented with conflicting information on a company’s financial integrity, investors tend to have a set view for one side when the conclusion should not be made due to differing possibilities.

Case in point: When cult leaders realized that the flood they were expecting did not occur, they immediately reinterpreted the evasion of mass destruction with the success of their prayers.

A cognitive bias whereby one tends to notice and look for information that confirms one’s existing beliefs, whilst ignoring contradictory information. It is a type of selective thinking.

Case in point: Investors would consider analyst reports that agree with their existing views on the market more accurate.

Clinging onto the information that was used to establish one’s opinion even when circumstances change. Conservatism makes it difficult to adjust one’s view during signals of shifting conditions. This is discerned from anchoring as conservatism bias is clinging to the information used in the analysis, whereas anchoring is clinging to the original forecast.

Case in point: A study in 2002 on analysts’ forecasts revealed that they were more representative of the recent past than the future.

A bias caused by the framework within which a situation is described. When an idea is presented with a positive connotation, one tends to perceive the idea in a positive manner; however, when presented in a negative tone, the idea is more likely to be considered with a sub-prime quality.

Case in point: In a psychological study conducted in 1984, a group of people were given two cures to choose from: a cure for a disease that could save 2/3 of the patients, and a cure that would leave 1/3 dead. The participants showed much higher support towards the result that would save 2/3, even though the cures had same outcome.

A tendency to follow the trend. Instead of making rational decisions on individual cases, one makes a biased decision in the midst of information cascade, inundated with the reasoning of others. Investors are swayed by the general trend in movements of the market that convey other investors’ opinions, instead of valuing securities based on reliable information.

Case in point: A study of mass behavior finds that when there are more than three people pointing in the same direction, the rest of the crowd is bound to look in that direction.

A selective adoption of surrounding information. In this process of simplification, investors sometimes use certain rule of their own because it saves time and effort that would have incurred had they digested all the information and handpicked important ones to digest. However, systematically ignoring certain categories of data can cause undervaluation of critical information and prove to be fallacious.

Case in point: The most widely used economic and financial forecast models often comprise of simple metrics. This is because each addition of variables are followed by complication of underlying assumptions and therefore making models inapplicable in varying conditions. In return, simplification of models reduce the accuracy of forecast.

A phenomenon in which an uncertain outcome seems more likely after it has already occurred. Investors are likely to feel that the most efficient execution points from the past were easily identifiable from hindsight, compared to what they had felt when they were actually facing the market volatility.

Case in point: Some people say that they knew that Brazil would lose to Germany by a large margin. However, majority of soccer critics predicted either a tie game in regulation time (first 90 minutes) and Germany to win by a slight margin.

Inconsistency found in the investment behavior, in which one is more fearful of recording losses than sacrificing gains. Because one feels more pain from loss than happiness from gain, one puts more effort into avoiding loss than pursuing gain.

Case in point: According to an empirical study conducted in 1992, the pain of losing $100 was found to be felt more than twice as much as the pleasure of gaining the same amount.

A cognitive bias that leads investors to have an increasing level of confidence as they acquire more information, even though the information does not improve the accuracy of their understanding by a significant amount. Overconfidence is considered to be one of the drivers of high volume of trades in the market. Investors tend to find confirmation of their analysis from new information more influential than they really are.

Case in point: Over 90% of the drivers think they are better than average.

A phenomenon in which one overreacts or underreacts to reliable information because of the noise. This is also called a moderation of confidence. With the given amount of reliable information, one should understand their confidence levels, but this confidence is often moderated by other less-important noise in the market.

Case in point: At the breakout of an economic or financial event, investors tend to over- or under-react to the shift in the landscape instead of accurately calculating the impact of the news.

A tendency to classify information based on the framework established from past experience. The degree to which A is representative of B is presumed by the degree to which A resembles B. Investors may be inclined to classify the impact of an event by analyzing traditional behavior. This reliance on stereotypes disregard the uniqueness of different information.

Case in point: Many investors believe that the growth of Chinese economy drove the recovery of the Amercian economy, but in reality, while the U.S. equity markets improved recently, the Chinese markets have experienced downturn for the past several years.

The practice of attributing positive occurrences to one’s own skill while attributing unfortunate outcome to factors beyond one’s own control. While skills and bad luck may be reasons for successes and failures respectively, self-attribution bias overemphasizes the influence of these factors.

Case in point: Students often associate their success in academic results with their own personal excellence, and dissatisfying results with the fault of circumstances beyond their control.