CFA 2018 level 3 gostudy behavioral biases of individuals (r6)

www.gostudy.io Go Study’s CFA Exam Level ® Behavioral Biases of Individuals by GoStudy™ www.gostudy.io Everything you need to pass & nothing you don’t www.gostudy.io Guided Notes for CFA® Level – 2016 Copyright © 2016 by Go Study LLC.® All Rights Reserved Published in 2016 The “CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute CFA Institute does not endorse, promote, review, or warrant the accuracy of the products or services offered by www.cfaexamlevel3.com Certain materials contained with this text are the copyrighted property of the CFA Institute The following is the copyright disclosure for those materials: “Copyright, 2016, CFA Institute Reproduced and republished from 2016 Learning Outcome Statements, Level III CFA® Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institute’s Global Investment Performance Standards with permission from CFA Institute All rights reserved.” Disclaimer: These guided notes condense the original CFA Institute study material into 300 pages It is not designed to replace those notes, but to be used in conjunction with them While we believe we cover all of the core concepts accurately we cannot guarantee nor warrant that this is true Use of these notes is not a guarantee of exam success (although we think it will help a lot) and we cannot be held liable for your ultimate exam performance About gostudy.io Along with these Guided Notes, GoStudy offers a suite of products for in-depth exam strategies and comprehensive subject review to help candidates pass the final CFA exam We have hundreds of notecards and practice problems built into a mobile app for on-the-go review, with detailed analytics (coming), and last-minute cram material such as equation lists and “week before” summary sheets We also highly recommend candidates subscribe to our free newsletter for exclusive offers, access to study tips, tricks, and in-depth discussions of the exam We also periodically provide bonus resources such as mock exams, practice problems, and more to our subscribers If you have any questions regarding this product, the exam, or how we can help please contact us via the website We strive to answer every question a candidate has and are always incorporating Candidate feedback into what we build next www.gostudy.io Contents Behavioral Biases of Individuals (Reading 6) Cognitive Errors Emotional Errors Investment Errors –Analysts and Pension Plan Participants (R7) 11 Investment Errors of Retail Clients/Investors 12 www.gostudy.io Behavioral Biases of Individuals (Reading 6) This is a critical section You will need to have a firm grasp of each bias and be able to (1) identify these behaviors, (2) differentiate between them when reading passages in the exam, and (3) talk about the implications of these biases for decision making as an investment advisor These concepts often show up on the exam as part of the IPS section in the morning, but it could very easily show up again in the afternoon There is also a section dedicated to common errors for financial analysts The good news is that this stuff isn’t overly complex It just takes time and repetition to memorize…along with doing enough practice problems to get a feel for correctly identifying them and then justifying that choice based on evidence in a passage In other words, this is a section of lists Take the time to memorize these lists by grouping types of errors and thinking through the relationships between them and this should give you an opportunity to earn points and save time on exam day Guidance for answering these questions The behavioral biases of individuals are divided into emotional biases and cognitive biases Yet there are definitely biases that share both emotional and cognitive elements While it is possible the test makers try to trick you between two similar emotional or cognitive biases,1 they are more likely to ask a question in the morning section where you might have to read a passage and ID/list two cognitive errors and two emotional errors and describe why they are occurring For our purposes a bias is anything that results in irrational financial decisions There are two broad sources for this irrationality—either faulty cognitive reasoning or the influence of feelings Emotional vs Cognitive Biases If the context emphasizes unconscious emotion or an investor that is unwilling or unable to change their view than we are probably dealing with an emotional bias If the issue can be overcome easily or changed via education then it is probably a cognitive bias If we think of decision-making as lying on a spectrum from totally rational, traditional finance one side and completely irrational, decision-making on the other, than cognitive errors are closer to traditional finance than emotional errors They are thus also easier to correct Or differentiate between information processing and belief preservation errors www.gostudy.io Distinguishing between Cognitive and Emotional Biases Cognitive Errors Cognitive errors result from one of two things: (1) either an inability to analyze information properly or (2) from having incomplete information in the first place Generally, if you point out cognitive errors to an individual they are likely to be receptive to changing their behavior In the curriculum the nine major cognitive errors are divided into two categories: belief perseverance errors and information processing errors Belief Perseverance Errors [Con Con Con Rep Hind] Belief perseverance errors refer to holding onto past views and failing to consider new information This is closely associated with cognitive dissonance which is the mental discomfort that arises when new information conflicts with previously held beliefs To resolve or avoid this dissonance people may: Only notice information of interest (selective exposure) Ignore or modify information that conflicts with existing thinking (selective perception) Only remember or consider information that confirms existing thinking (selective retention) For the exam there are five belief perseverance biases (with a tagline to help remember them): CON CON CON REP HIND      Conservatism bias Confirmation bias Illusion of control Representativeness Hindsight bias www.gostudy.io Conservatism Bias What: Individuals hold onto previous views/forecasts by inadequately incorporating new info Put differently, they overweight their initial beliefs and are slow to react to new info You can think of this in a Bayesian framework You’ll see this come up more often with analysts Closely related to the info processing error, anchoring and adjustment bias Consequences: Unwilling or slow to update beliefs Hold onto investments too long Mitigate: Actively ask: How does this new information change my forecast? Confirmation Bias What: Investors only notice or overweight information that agrees with previously held beliefs and ignore contradictory info They may even actively look for confirming evidence of their thesis This is related to selection bias Consequences: Hold investments too long because only focus on positive info, e.g are overconfident, set-up decision processes or investment screens improperly, under-diversify portfolio (hold too much employer stock) Mitigate: Actively seek and carefully consider info that contradicts your opinion Use multiple methods of analysis (e.g both fundamental and technical analysis) Illusion of Control What: Overconfidence due to illusion of knowledge and self-attribution or belief in one’s ability to influence outcomes (e.g pick your own lottery numbers) Closely associated with emotional biases Consequences: Excessive trading, inadequate diversification (own company stock) Mitigate: Understand that investing is probabilistic, seek contrary opinions, record trades and rationale for them Representativeness Bias What: Using overly simple if-then or rule-of-thumb decisions instead of thorough analysis Individuals use heuristics (experience) to classify information: “IF it looks a certain way THEN it must be in a certain category.” There are two forms representativeness bias can take: Base-rate neglect is where new info is given too much weight relative to the old information whereas sample-size neglect refers to the assumption that small samples represent the entire population Consequences: New info is given too much weight, often using simple classifications or stereotypes rather than engaging in the mental effort of updating beliefs (e.g buying a stock simply because it is in country X or investing with a manager based on short-term results), base decisions on small sample sizes Mitigate: Consider actual probabilities, focus on historical returns (periodic table of investment returns) Hindsight Bias What: A selective memory bias where we tend to remember correct views and forget mistakes Recollections of past are updated with preferred beliefs not what you were actually thinking at the time www.gostudy.io Consequences: Believe predictions were more accurate than they actually were or believe you were right more often that you were This can lead to excessive risk taking/overconfidence or over-criticizing the performance of others Mitigate: Record rationale for trades, consistently remind oneself of the cyclical nature of markets, evaluate managers according to consistent benchmarks Information Processing Errors [FAMA] Information processing errors are less related errors of memory or assigning and updating probabilities and more related to how information is processed No surprise there People have biases in the way the process things based on different factors such as the order information is received or whether it fits into their previous way of thinking FAMA  Framing Bias  Anchoring & Adjustment  Mental Accounting  Availability Bias Framing Bias What: View information or answer a question differently depending on the context or way the question was asked (framed) Consequences: Fail to properly assess risk, focus on short-term price fluctuations which leads to trading too often Can be related to loss aversion / risk aversion depending on how information is presented Also common with analysts evaluating company management presentations Mitigate: Consider source of information Anchoring and Adjustment What: Remain anchored to an initial value (expected price, forecast) and ± from that anchor It’s similar to conservatism bias, so remember on the exam that anchoring & adjustment is ALWAYS related to a SPECIFIC NUMBER.2 Consequences: Failing to adjust forecasts enough due to interpreting new information around the anchor Mitigate: Focus on fact that past prices/info provide little guidance on future potential Mental Accounting Bias What: Individuals place wealth into different buckets to meet different goals/treat different sources of money differently depending on which bucket they are in Ignores the fungible nature of wealth Related to Goal Based Investing Consequences: Layering, Failing to consider the risk and correlation on a portfolio basis and thus under-diversifying between buckets, over-emphasizing income over total return (chasing yield) Mitigate: Educate about portfolio theory, correlation, and benefits of diversification In a non-investment context this often occurs around negotiating For example the first price thrown out in a negotiation often anchors the negotiation around that price www.gostudy.io Availability Bias What: Focus on info that is easy to find, or focus on easily remembered past experiences, possibly depending on heuristics or rules of thumb Caused by:    Retrievability: How easily/quickly something is recalled Categorization: Using familiar classifications (even if not relevant) Range of Experience: Narrow experience can cause estimation bias & narrow frame of reference  Resonance: People evaluate situations relative to their own likes/dislikes/circumstances and use those to judge or compare Consequences: Easily recalled & understood events perceived as being more likely Select investments base on advertising, may lack diversification because they limit their opportunity set or over-invest in firms and industries that resonate with them Common issue with analysts Mitigate: Use an investment policy statement, thorough research, focus on long term results Summarizing the Cognitive Errors Cognitive Errors Belief Preservation (Con Con Con Rep Hind) Information Processing Errors (FAMA) Conservatism Bias Hold onto previous views/forecasts by inadequately incorporating new info Framing Bias Confirmation Bias Only notice or overweight information that agrees with previously held beliefs and ignore contradictory info Anchoring & Adjustment Bias Illusion of Control Overconfidence due to illusion of knowledge and selfattribution or belief in one’s ability to influence outcomes Mental Accounting Bias Representativeness Bias Hindsight Bias Using overly simple if-then or rule-of-thumb decisions instead of thorough analysis (IF/THEN) A selective memory bias where we tend to remember correct views/calls in the past and forget mistakes Availability Bias View information or answer a question differently depending on the context or way the question was asked (framed) Remain anchored to an initial value (expected price, forecast) and ± from that anchor It’s similar to conservatism bias, so remember on the exam that anchoring & adjustment is ALWAYS related to a SPECIFIC NUMBER Individuals place wealth into different buckets to meet different goals/treat different sources of money differently depending on which bucket they are in Ignores the fungible nature of wealth Focus on info that is easy to find, or focus on easily remembered past experiences, possibly depending on heuristics www.gostudy.io Emotional Errors Emotional biases arise from impulse, intuition, and feelings that result in personal and unreasoned decisions They come from how we feel and how we react Because the emotional decisions we make are more impulsive reactions they are harder to mitigate than cognitive ones That means that unlike cognitive errors where we can educate and overcome, emotional errors must often be accommodated or mitigated if the client’s financial situation permits that flexibility Let’s look at each of these LOSERS in turn LOSERS  Loss Aversion  Overconfidence  Self-control bias  Endowment bias  Regret Aversion  Status quo bias Loss Aversion What: Feeling greater pain for a loss than pleasure for a gain of equal value Put differently, people will strongly prefer avoiding losses as opposed to achieving gains See loss aversion under prospect theory Consequences: Hold losing stocks too long and sell winners too early Trade too often which increases transaction costs Often have excessive risk taking after an initial loss to “make up” for it Myopic loss aversion3 Also related to the house money effect (where when you win at a casino you start playing fast and loose with house money), avoid assets that have seen short-term volatility Mitigate: Fundamental analysis, trying to overcome anguish of losses through the use of a rational lens Overconfidence What: Thinking you know more than you or having unwarranted faith in your abilities Can be separated into prediction overconfidence (narrow confidence intervals/range of estimates) and certainty overconfidence (assigning too high a probability to an outcome) Overconfidence can be worsened if combined with self-attribution bias where you take credit for the good and pass the blame when bad The cognitive bias, illusion of control, can also be a contributing factor Consequences: Overconfident in predictions, underestimate risk and overestimate returns Under-diversify positions Can also lead to excessive turnover and trading costs and thus lower returns Myopic loss aversion happens when an investor temporarily lose sight of the bigger picture and focuses too much on short term declines This could be thinking about markets in terms of annual returns vs 30 year time horizons, and therefore allocating less to equities than they might otherwise It also can mean panic selling during sharp market declines See http://www.zeninvestor.org/behavioral-finance-2/myopic-loss-aversion-what-it-is-and-how-toavoid-it/ www.gostudy.io Mitigate: Keep detailed trade records including motivation for making a trade, develop track records to mitigate the tendency to remember the winners/forget the losers Self-Control Bias What: Inability to pursue long-term goals due to self-control issues Frequently manifests as insufficient saving due to tendency for overconsumption (short-run gratification) and overemphasis on income versus total return Consequences: Fail to act in pursuit of long term goals Excessive risk taking to overcome lack of saving, asset allocation issues (due to overemphasizing shorter-term income) Mitigate: Budgeting, clearly defined written investment and financial planning goals Endowment Bias What: When you see assets you own as worth more than you’d actually be willing to pay to acquire them, likely to be tested in the context of inherited assets Consequences: Hold onto investments too long or fail to sell off and replace assets, sometimes leading to an inappropriate asset allocation Ask for too high a price Often stick with inherited assets or assets you’ve owned for a long time because they are comfortable and familiar Mitigate: Research the historical risk-return of assets, develop a plan to replace gradually Regret-aversion What: Tendency to nothing due to a fear of making the wrong decision Basically making errors of omission instead of errors of commission in order to avoid pain of regret.4 Consequences: Herding behavior (doing what others to avoid the responsibility for the decision), somewhat similar to status quo bias, can cause investors to over-concentrate in low risk investments or well-known companies, can also cause investors to stay out of a market that recently fell sharply even if that presents great buying opportunities Mitigation: Educate on risk/return, asset allocation, use the concept of efficient frontier Status Quo Bias What: A tendency to stay with current investments due to apathy In other words it’s an emotional desire to nothing or to stay with the default option rather than opting to make a new, possibly better choice Somewhat related to endowment bias & regret-aversion Consequences: Hold inappropriate portfolios or not adjust to new circumstances, fail to consider other better options Common w/ 401(k)s We also see low opt-in rates vs opt-out rates on defined contribution plans Mitigate: Status quo bias can be very hard to mitigate Education about asset allocation is essential Also led to rise of Target Date Funds Omission: not taking action/ commission: taking action 10 www.gostudy.io Summarizing the Emotional Errors Emotional Errors (LOSERS) Bias What Loss Aversion Feeling greater pain for a loss than pleasure for a gain of equal value Overconfidence Thinking you know more than you or having unwarranted faith in your abilities Self-Control Bias Inability to pursue long-term goals due to self-control issues Frequently manifests as insufficient saving Endowment Bias See assets you own as worth more than you’d actually be willing to pay to acquire them Regret-aversion Status Quo Bias Tendency to nothing due to a fear of making the wrong decision Basically making errors of omission instead of errors of commission in order to avoid pain of regret A tendency to stay with current investments due to apathy Consequences Hold losing stocks too long and sell winners too early Trade too often (↑ transaction costs) Often have excessive risk taking after an initial loss to “make up” for it Myopic loss aversion Also related to the house money effect Overconfident in predictions, underestimate risk and overestimate returns Under-diversify positions Can also lead to excessive turnover and trading costs and thus lower returns Fail to act in pursuit of long term goals Excessive risk taking to overcome lack of saving, asset allocation issues (due to overemphasizing shorter-term income) Hold onto investments too long or fail to sell off and replace assets, sometimes leading to an inappropriate asset allocation Ask for too high a price Often stick with inherited assets or assets you’ve owned for a long time because they are comfortable and familiar Herding behavior (doing what others to avoid the responsibility for the decision), somewhat similar to status quo bias, can cause investors to over-concentrate in low risk investments or well-known companies, can also cause investors to stay out of a market that recently fell sharply even if that presents great buying opportunities Hold inappropriate portfolios or not adjust to new circumstances, fail to consider other better options Common w/ 401(k)s Investment Errors –Analysts and Pension Plan Participants (R7) The CFAI curriculum places this material within Reading at the very end of Study Session 3, right after discussing the three behavioral models for classifying individuals and before jumping into how to construct an IPS We think it makes much more sense to think about it here, while you’re still focused on the individual biases displayed by investors In any case, it will stand you in good stead to be familiar with the types of errors more common to retail investors, those saving for retirement as well as financial analysts themselves These have often been tested in the past Investment Errors of Defined Contribution Investors DC plan participants tend to suffer from status quo bias They save money, choose a few options for where that money gets invested, and then forget about their allocations DC participants also often tend to suffer from naïve diversification, which involves dividing contributions equally amongst the investment options irrespective of the underlying composition of those options In 11 www.gostudy.io other words it means following a 1/n strategy, or putting an equal amount of money into each available option.5 The most commonly tested issue that comes up here, however, is why employees may tend to have too much invested in their company’s stock The main issue with this strategy is that they are tying both their financial and human capital to the same company Clearly this is very risky Note, this comes up again in Human Capital and Retirement Planning and also under ways to diversify a concentrated asset position Key behavioral reasons for concentration in employee stock:  Familiarity and overconfidence  Framing - Stock compensation is seen as recommendation of the quality of the stock  Representativeness - Past performance as an indicator of future performance)  Loyalty  Financial or tax incentives Investment Errors of Retail Clients/Investors In contrast to DC plan participants, retail clients are often guilty of over-trading their accounts This can be due to overconfidence The result is usually lower overall returns because of transaction costs and the disposition effect, which is the act of selling winners too soon and holding losers too long These clients can also suffer from home bias which results in holding too high a percentage of their assets in their own country Analyst Errors Many of these overlap with individual biases The difference here is that the curriculum presents more detailed strategies to mitigate three specific biases that result from (1) overconfidence, (2) the way management presents information (framing/availability), and (3) biased research It’s almost like the CFA Institute is telling the reader to be especially careful of personally falling into these traps as an investment professional Social Proof Bias (Groupthink) Before individual analyst biases, however, we should also talk about the danger of groups Social proof bias, or groupthink, happens when investment committees share the same opinions or think in the same way Groupthink has traditionally led to poor decisions by investment committees because feedback is inaccurate and slow and systematic biases are left unidentified To counteract social proof bias:     Create a committee of individuals with a diverse background Ensure mutual respect among members Ensure members are not afraid to express their opinion (have committee chair ensure this) Actively solicit opinions from each member Think of naïve diversification as the rough, almost instinctive division of a portfolio without resorting to sophisticated mathematical models 12 www.gostudy.io Overconfidence Overconfidence is having too much faith in your own ability to forecast markets, i.e thinking you are smarter than you are This is often caused by collecting and analyzing a lot of data Ultimately overconfidence leads to underestimating risk and creating confidence intervals that are too narrow around your predictions A prime example of this would be an analyst forecasting an earnings range of just a few pennies because they built such an elaborate model Factors leading to overconfidence:  Representativeness  Illusion of knowledge or control  Availability bias: management often readily available so tendency to trust their numbers and guidance  Ego-defense mechanisms o Hindsight bias o Self-attribution bias: Take credit for success, blame external factors or others for failures Presentation of Information by Company Management The information a company shares and the way a company frames that information can influence how analysts remember and use it This issue usually stems from cognitive issues that management itself has including self-attribution bias, where they over-emphasize all the positives where they feel they personally contributed Of course it also doesn’t help that management compensation is tied to the operating results they are reporting on To overcome this an analyst should try to rely strictly on quantitative data in their reporting Other biases displayed or triggered by management are classic information processing errors:    Framing: Management usually reports the good info first and saves the bad news for later Availability: Management is enthusiastic in reporting certain numbers, making it easier for an analyst to recall the information Anchoring & Adjustment: If an analyst has been covering a stock for a while, they may be anchored to their previous forecast and fail to adequately adjust Research Biases  Overconfidence (see previous section)  Representative bias: Thinking the past is representative of the future I.E calling a stock a growth company because of its past history of high growth  Confirmation Bias  Gambler’s fallacy: This is an interesting one and has been tested on past exams Basically it is thinking that there will be a reversal to the long-term average more often than is actually true The classic example of this is increasing the mental odds of a coin toss coming up tails if the last 10 were heads 13 www.gostudy.io Mitigating Analyst Errors  Use a Bayesian probability framework or very structured process of incorporating new information  Get prompt feedback, create structures that reward accuracy  Strive for self-calibration and constantly re-evaluate opinions  Actively look for counterarguments to your view & document the entire process Want more notes? Get them plus a study app + cram guides + equation sheets + mock exams and more www.gostudy.io Questions? Email vsowers@gostudy.io 14 ... Investment Errors of Retail Clients/Investors 12 www .gostudy. io Behavioral Biases of Individuals (Reading 6) This is a critical section You will need to have a firm grasp of each bias and... Guidance for answering these questions The behavioral biases of individuals are divided into emotional biases and cognitive biases Yet there are definitely biases that share both emotional and cognitive... trademarks owned by CFA Institute CFA Institute does not endorse, promote, review, or warrant the accuracy of the products or services offered by www.cfaexamlevel3.com Certain materials contained