Behavioral finance: Cognitive Biases

• Behavioral finance studies how psychology affects financial decisions and markets

Cognitive Biases

• Cognitive biases are systematic errors in thinking that can affect decisions
• These arise from using mental shortcuts or heuristics to simplify complex problems
• These biases can lead to deviations from rational economic behavior
• Confirmation bias is the tendency to seek out information that confirms existing beliefs
• Investors may selectively attend to news that supports their investment decisions
• This leads to overconfidence in their choices
• Availability bias involves overestimating the importance of information readily available
• Recent or vivid events unduly influence decisions
• Representativeness bias leads to judging the probability of an event based on how similar it is to a stereotype
• Investors may believe that a company is a good investment because it resembles successful firms
• This disregards base rates or statistical probabilities
• Anchoring bias is the tendency to rely too heavily on the first piece of information when making decisions
• Initial price points can influence subsequent valuations
• Overconfidence bias is the excessive belief in one's own abilities
• Investors may overestimate their skill in picking stocks, leading to excessive trading
• Hindsight bias is the inclination to see past events as predictable
• After an event occurs, people often believe they knew it all along

Investor Psychology

• Investor psychology looks at emotions and cognitive processes to understand investment decisions
• Fear and greed are powerful emotional drivers that can lead to irrational behavior
• Investors may panic during market downturns, selling low
• They may become overly optimistic during bull markets, buying high
• Prospect theory describes how individuals evaluate gains and losses differently
• People are more sensitive to losses than to equivalent gains
• This can lead to risk-averse behavior when facing potential gains
• It also leads to risk-seeking behavior when trying to avoid losses
• Mental accounting involves categorizing and treating money differently based on its source or intended use
• Investors may be more willing to take risks with money they consider "found money"
• Cognitive dissonance is the discomfort felt when holding conflicting beliefs or values
• Investors may avoid selling losing stocks to avoid admitting they made a mistake
• The herd behavior is the tendency to follow the actions of a larger group
• Investors may buy or sell based on what others are doing, regardless of their analysis

Market Anomalies

• Market anomalies are patterns that deviate from efficient market predictions
• The efficient market hypothesis states that asset prices fully reflect all available information
• Anomalies suggest that markets may not always be efficient
• The January effect is the tendency for stock prices to increase in January more than in other months
• Small-cap stocks often exhibit the January effect more prominently
• The momentum effect is the tendency for stocks that have performed well in the past to continue performing well in the short-term
• Investors may chase recent winners, driving up their prices further
• The value effect is the tendency for value stocks (those with low price-to-book ratios) to outperform growth stocks over long periods
• This suggests that investors may undervalue these firms
• The calendar effects are patterns related to specific times of the year or week
• The weekend effect is the tendency for stock prices to be lower on Mondays than on Fridays
• These anomalies may be caused by behavioral biases
• They are difficult to exploit consistently due to transaction costs and market volatility

Emotional Decision-Making

• Emotional decision-making is when emotions influence choices
• Emotions can override rational analysis in financial settings
• Regret aversion is the desire to avoid the feeling of regret
• This can lead investors to hold onto losing stocks for too long
• They avoid realizing the loss and feeling the regret
• Social proof is the tendency to look to others for cues on how to behave
• Investors may follow the crowd, even if it goes against their better judgment
• Loss aversion can cause investors to make irrational decisions to avoid losses
• They may sell winning stocks too early to lock in gains
• They may hold losing stocks too long in the hope of breaking even

Heuristics in Finance

• Heuristics are mental shortcuts used to simplify decision-making
• They can lead to biases, but also help make quick decisions
• The representativeness heuristic causes people to judge probabilities based on similarity
• Investors may choose investments that resemble past successes, without considering underlying factors
• The availability heuristic relies on easily recalled information
• Recent or vivid events can skew investment decisions
• The anchoring and adjustment heuristic uses an initial piece of information (the anchor) to make subsequent estimates
• Investors may fixate on a previous price and adjust their valuations accordingly
• These heuristics can lead to systematic errors in financial decision-making
• Understanding these can help improve investment outcomes