MASTER OF BUSINESS

ADMINISTRATION
(FINANCIAL MANAGEMENT)
SEMESTER II

BEHAVIORAL FINANCE
MBAEF 204
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 CONTENT

Unit - 1: Introduction To Behavioural Finance.......................................................................... 4

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UNIT - 1: INTRODUCTION TO BEHAVIOURAL
FINANCE

STRUCTURE

1.0 Learning Objectives

1.1 Introduction

1.2 Definition of Behavioural Finance

1.2.1 The Big Picture

1.2.2 Standard Finance

1.2.3 Difference between Standard Finance and Behavioural Finance

1.2.4 The Role of Behavioural Finance in Creating a Successful Advisory

Relationship

1.3 History of Behavioural Finance

1.3.1 Historical Perspective on the link between Psychology and Economics

1.3.2 Modern Behavioural Finance

1.3.3 Psychographic Models used in Behavioural Finance

1.4 Introduction to Behavioural Biases

1.4.1 Definition

1.4.2 Categorization

1.4.3 Differences between Cognitive and Emotional Biases

1.5 Applications of Behavioural Finance

1.6 Foundations of Behavioural Finance

1.7 Summary

1.8 Keywords

1.9 Learning Activity

1.10 Unit End Questions

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 1.11 References

1.0 LEARNING OBJECTIVES

After studying this unit, you will be able to

 Illustrate the history of behavioural finance.

 Explain the historical perspective on the link between psychology and economics.

 Illustrate the psychographic models used in behavioural finance.

1.1 INTRODUCTION

The neoclassical models in economics and finance assume that the typical decision maker has
all the information and unlimited cerebral capacity. He considers all the relevant information
and comes up with an optimal choice under the given circumstances using a process called
―constrained optimisation‖. To illustrate this, let us consider portfolio theory developed by
Harry Markowitz for which he was awarded the 1990 Nobel prize in economics. This theory
assumes that investors can analyse the universe of securities, estimate expected returns and
variances for all securities as well as co-variances among all securities, define their utility
indifference curves for risk and return and choose the optimal portfolios that maximise their
utility. In the real world, people make decisions with inadequate and imperfect information
and have limited cognitive capacity. They rely on heuristics which can lead to biases. A
heuristic is a crude rule of thumb for making judgments about probabilities, future outcomes,
and so on. A bias is a tendency towards making judgmental errors. The heuristic and biases
approach studies the heuristics people employ to form judgements and the associated biases
in those judgments. Some biases stem from specific heuristics. Availability (the tendency to
form judgments based on information which is readily available) and representativeness (the
tendency to rely on stereotypes) are examples of such biases. Although some biases are
associated with specific heuristics, other biases stem from a variety of factors such as
overconfidence, unrealistic optimism and the illusion of control.

It‘s been a long time since I studied for my economics degree, twenty years in fact and a lot
has happened since then. Starting off as a trainee financial planner back then, I didn‘t give the
obscure behavioural finance module much more thought. Roll forward twenty years, and I
find myself fretting over a big financial decision; to sell our house and move out of London.
My partner Petra was recovering from breast cancer, and we now had a beautiful two-year-

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old daughter, Lux. With everything we had been through, we agreed that moving back to
Dorset was the right thing for our family. But something was holding me back. Perhaps
unsurprisingly, given my career, I was obsessed with the financial implications of the move.
What if house prices continued to rise faster in London than in Dorset? Was now a good time
to move given the recent EU Referendum result? House prices always rose in London, surely
this would continue? Our house price was higher in the summer before, and I was struggling
to accept that we would receive a lower figure now. We finally managed to move in March
2017. On reflection, I realised that a combination of behavioural biases where preventing me
from making this big decision. If this was affecting me in this way, surely our clients could
be effected in the same way? As a financial planning firm, we therefore had a duty to help
educate our clients about the many biases that could prevent them from reaching their
ultimate goals in life. I dusted down my old Economics textbooks, and called my client
Professor Brett Kahr with my idea to put together a book on behavioural finance. Our aim, to
combine the textbook theory with real life examples of how the biases manifest in day to day
decision making. I hope you enjoy reading our book as much as we enjoyed writing it.

Behavioural finance (part of the broader field of behavioural economics), is the field of study
that seeks to explain situations like the above. The situations where real people make real
financial decisions that might not be easily explained or predicted by traditional economic
theories. Over the following pages, we‘ll be looking at a different aspect of behavioural
economics as a way of examining just how much our decisions can be influenced by factors
other than the cold, hard calculations we might think we‘re making as informed investors. We
are all prone to biases and emotional thinking. It‘s part of being human. These are not
‗problems‘ we can ‗solve‘ as such – behavioural economics rests on the recognition that
we‘re all only human after all – but having an awareness of them can certainly help us in our
approach to investing (and life in general). In order to give some of the key concept‘s
substance, and in an attempt to bring the theory to life, we‘ve considered areas where the
biases manifest themselves in real-life decision making. I recently wrote about myself and my
family moving to Dorset and the various questions we contemplated beforehand. Looking
back, our decision-making process was affected by my loss-aversion, anchoring, status-quo
bias and under-confidence – all of which we‘ll cover in this series. It‘s no wonder it took us
so long to move house.

Behavioural finance is the paradigm where financial markets are studied using models that
are less narrow than those based on Von Neumann-Morgenstern expected utility theory and

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arbitrage assumptions. Specifically, behavioural finance has two building blocks: cognitive
psychology and the limits to arbitrage. Cognitive refers to how people think. There is a huge
psychology literature documenting that people make systematic errors in the way that they
think: they are overconfident, they put too much weight on recent experience, etc. Their
preferences may also create distortions. Behavioural finance uses this body of knowledge,
rather than taking the arrogant approach that it should be ignored. Limits to arbitrage refers to
predicting in what circumstances arbitrage forces will be effective, and when they won't be.
Behavioural finance uses models in which some agents are not fully rational, either because
of preferences or because of mistaken beliefs. An example of an assumption about
preferences is that people are loss averse - a $2 gain might make people feel better by as
much as a $1 loss makes them feel worse. Mistaken beliefs arise because people are bad
Bayesians. Modern finance has as a building block the Efficient Markets Hypothesis (EMH).
The EMH argues that competition between investors seeking abnormal profits drives prices
to their ―correct‖ value. The EMH does not assume that all investors are rational, but it does
assume that markets are rational. The EMH does not assume that markets can foresee the
future, but it does assume that markets make unbiased forecasts of the future. In contrast,
behavioural finance assumes that, in some circumstances, financial markets are information
ally inefficient. Not all misevaluations are caused by psychological biases, however. Some
are just due to temporary supply and demand imbalances. For example, the tyranny of
indexing can lead to demand shifts that are unrelated to the future cash flows of the firm.
When Yahoo was added to the S&P 500 in December 1999, index fund managers had to buy
the stock even though it had a limited public float. This extra demand drove up the price by
over 50% in a week and over 100% in a month. Eighteen months later, the stock price was
down by over 90% from where it was shortly after being added to the S&P. If it is easy to
take positions (shorting overvalued stocks or buying undervalued stocks) and these
misevaluations are certain to be corrected over a short period, then ―arbitrageurs‖ will take
positions and eliminate these mispricing‘s before they become large. But if it is difficult to
take these positions, due to short sales constraints, for instance, or if there is no guarantee that
the mispricing will be corrected within a reasonable timeframe, then arbitrage will fail to
correct the mispricing. Indeed, arbitrageurs may even choose to avoid the markets where the
mispricing is most severe, because the risks are too great. This is especially true when one is
dealing with a large market, such as the Japanese stock market in the late 1980s or the U.S.
market for technology stocks in the late 1990s. Arbitrageurs that attempted to short Japanese
stocks in mid1987 and hedge by going long in U.S. stocks were right in the long run, but they

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lost huge amounts of money in October 1987 when the U.S. market crashed by more than the
Japanese market (because of Japanese government intervention). If the arbitrageurs have
limited funds, they would be forced to cover their positions just when the relative
misevaluations were greatest, resulting in additional buying pressure for Japanese stocks just
when they were most overvalued.

1.2 DEFINITION OF BEHAVIOURAL FINANCE

Behavioural finance, a subfield of behavioural economics, proposes that psychological

influences and biases affect the financial behaviours of investors and financial practitioners.
Moreover, influences and biases can be the source for explanation of all types of market
anomalies and specifically market anomalies in the stock market, such as severe rises or falls
in stock price. Behavioural finance is an area of study focused on how psychological
influences can affect market outcomes.

 Behavioural finance can be analysed to understand different outcomes across a variety

of sectors and industries.

 One of the key aspects of behavioural finance studies is the influence of psychological
biases.

Behavioural finance can be analysed from a variety of perspectives. Stock market returns are
one area of finance where psychological behaviours are often assumed to influence market
outcomes and returns but there are also many different angles for observation. The purpose of
the classification of behavioural finance is to help understand why people make certain
financial choices and how those choices can affect markets. Within behavioural finance, it is
assumed that financial participants are not perfectly rational and self-controlled but rather
psychologically influential with somewhat normal and self-controlling tendencies.

One of the key aspects of behavioural finance studies is the influence of biases. Biases can
occur for a variety of reasons. Biases can usually be classified into one of five key concepts.
Understanding and classifying different types of behavioural finance biases can be very
important when narrowing in on the study or analysis of industry or sector outcomes and
results.

Behavioural Finance Concepts

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  Mental accounting: Mental accounting refers to the propensity for people to allocate
money for specific purposes.

 Herd behaviour - Herd behaviour states that people tend to mimic the financial
behaviours of the majority of the herd. Herding is notorious in the stock market as the
cause behind dramatic rallies and sell-offs.

 Emotional gap: The emotional gap refers to decision-making based on extreme

emotions or emotional strains such as anxiety, anger, fear, or excitement. Oftentimes,
emotions are a key reason why people do not make rational choices.

 Anchoring: Anchoring refers to attaching a spending level to a certain reference.

Examples may include spending consistently based on a budget level or rationalizing
spending based on different satisfaction utilities.

 Self-attribution: Self-attribution refers to a tendency to make choices based on

overconfidence in one's own knowledge or skill. Self-attribution usually stems from
an intrinsic knack in a particular area. Within this category, individuals tend to rank
their knowledge higher than others, even when it objectively falls short.

1.2.1 The Big Picture

Economists also look at two realms. There is big-picture macroeconomics, which is

concerned with how the overall economy works. It studies such things as employment, gross
domestic product, and inflation-the stuff of news stories and government policy debates.
Little-picture microeconomics is concerned with how supply and demand interact in
individual markets for goods and services. In macroeconomics, the subject is typically a
nation-how all markets interact to generate big phenomena that economists call aggregate
variables. In the realm of microeconomics, the object of analysis is a single market-for
example, whether price rises in the automobile or oil industries are driven by supply or
demand changes. The government is a major object of analysis in macroeconomics-for
example, studying the role it plays in contributing to overall economic growth or fighting
inflation. Macroeconomics often extends to the international sphere because domestic
markets are linked to foreign markets through trade, investment, and capital flows. But
microeconomics can have an international component as well. Single markets often are not
confined to single countries; the global market for petroleum is an obvious example. In
macroeconomics, the subject is typically a nation-how all markets interact to generate big
phenomena that economists call aggregate variables. In the realm of microeconomics, the

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object of analysis is a single market-for example, whether price rises in the automobile or oil
industries are driven by supply or demand changes. The government is a major object of
analysis in macroeconomics-for example, studying the role it plays in contributing to overall
economic growth or fighting inflation. Macroeconomics often extends to the international
sphere because domestic markets are linked to foreign markets through trade, investment, and
capital flows. But microeconomics can have an international component as well. Single
markets often are not confined to single countries; the global market for petroleum is an
obvious example. The macro/micro split is institutionalized in economics, from beginning
courses in "principles of economics" through to postgraduate studies. Economists commonly
consider themselves macroeconomists or macroeconomists. The American Economic
Association recently introduced several new academic journals. One is called
Microeconomics. Another, appropriately, is titled Macroeconomics.

1.2.2 Standard Finance

Current accepted theories in academic finance are referred to as standard or traditional

finance. The foundation of standard finance is associated with the modern portfolio theory
and the efficient market hypothesis. In 1952, Harry Markowitz created modern portfolio
theory while a doctoral candidate at the University of Chicago. Modern Portfolio Theory
(MPT) is a stock or portfolio‘s expected return, standard deviation, and its correlation with
the other stocks or mutual funds held within the portfolio. With these three concepts, an
efficient portfolio can be created for any group of stocks or bonds. An efficient portfolio is a
group of stocks that has the maxi mum (highest) expected return given the amount of risk
assumed, or, on the contrary, contains the lowest possible risk for a given expected return.

Another main theme in standard finance is known as the Efficient Market Hypothesis (EMH).
The efficient market hypothesis states the premise that all information has already been
reflected in a security‘s price or market value, and that the current price the stock or bond is
trading for today is its fair value. Since stocks are considered to be at their fair value,
proponents argue that active traders or portfolio managers cannot produce superior returns
over time that beat the market. Therefore, they believe investors should just own the ―entire
market‖ rather attempting to ―outperform the market.‖ This premise is supported by the fact
that the S&P 500 stock index beats the overall market approximately 60% to 80% of the time.
Even with the pre-eminence and success of these theories, behavioural finance has begun to
emerge as an alternative to the theories of standard finance.

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The range of questions is wide. It includes investor behaviour; the interaction of investors in
markets, which determine security prices; and the interaction of citizens in public policy
arenas, which determines financial regulations. Standard finance-the body of knowledge that
is built on such pillars as the arbitrage principles of Merton Miller and Franco Modigliani, the
portfolio construction principles of Harry Markowitz, the capital asset pricing theory of John
Lintner and William Sharpe, and the option-pricing theory of Fischer Black, Myron Scholes,
and Robert Merton-is so compelling because it uses only a few basic components to build a
unified theory, a theory that should provide answers to all the questions of finance.

Few theories, however, are fully consistent with all the available empirical evidence, and
standard finance is no exception. For example, Miller readily acknowledges that the observed
preference for cash dividends is one of the "soft spots in the current body of theory" Miller
goes on to argue, however:

that the rationality-based market equilibrium models in finance in general and of dividends in
particular are alive and well-or at least in no worse shape than other comparable models in
economics at their level of aggregation. The framework is not so weighed down with
anomalies that a complete reconstruction (on behavioural cognitive or other lines) is either
needed or likely to occur in the near future.

1.2.3 Difference between Standard Finance and Behavioural Finance

Investing in anything from properties, gold, stocks or an essay writing website is a bold and
risky move. But what most people don't know is that the decision to invest in those stocks is
influenced by traditional and behavioural finance.

In traditional finance, there is the assumption that the investor and the market are rational.
They gather or receive all the information they need and their decisions are based on that
data. Therefore traditional finance simply states that investors don't make financial decisions
on emotions.

In behavioural finance, psychology has a role in how people make financial decisions or
investments. Behavioural finance explains that people are irrational and our own emotions
and bias have a role to play when making investment decisions. For example, a student will
order an essay online from a single organization. This is because of his past experiences
therefore bias affects the decision to invest more in that organization.

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This is what usually happens to investors when making a decision on what to buy and sell.
This happens because investors might base their decisions on fear, overconfidence, gut
feeling, what others are doing thereby following the crowd and past experiences.

With both traditional and behavioural finance having contrasting views of the financial and
investing world. Here are the three main differences.

 Traditional finance assumes that an investor is a rational person who can process all
information unbiased. While behavioural finance draws from real-world experience
stating that an investor has biases, it is irrational, and his emotions do play a role in
the kind of investments undertaken. Take a student who needs academic writing help,
for example. The student seeks writing help from an online firm or company and there
are two companies to choose from. One is local while the other is foreign; the student
will most likely choose the local company.

 Why this is so is because just like an investor, the student own biases played a role in
the decision. His bias of overconfidence and familiarity in the local firm made the
student invest in it. Although the foreign company has a good track record and
performance, the student will invest in the local company because of these biases.

 According to traditional finances, investors receive unlimited knowledge, data, and

information that are perfect. The investor carefully processes this information,
therefore there's complete rationality. But in behavioural finance, investors have
bounded rationality so the investor doesn't process all information. Regardless of how
accurate the information is, investors are still bound to make an error in judgment.

 Traditional finance states that the market is efficient and is a representation of the
financial market's true value. This argument is based on the fact that traditional
finance believes that investors have self-control. But behavioural finance believes that
the market is volatile and that's why there are market anomalies. Here investors don't
have perfect self-control, so limitations exist. The volatility of the market leads to the
rising and falling of stock prices, so an inconsistent market.

Investors have to realize that a rational financial decision can be made, but they shouldn't fall
into the trap of using emotions or urges to make an investment.

For instance, a student offers to do my homework for me and does it perfectly. If tomorrow
that same student decides to run for student president. The decision to support him will be

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biased. This means that an investor can receive gifts or favours from a certain organization
which will unconsciously influence his decision of either buying or selling stocks of the
organization.

Cash, assets, properties, liabilities, budgeting, and other aspects of finance are all part of daily
life. Finance documents are important to any entrepreneur because they provide a clear
strategy and path for where to take or start their company. At [Link] they offer ready-
made finance templates to help you make sound financial decisions and present those ideas
convincingly to a board of investors or stakeholders.

Table 1.1: Difference between Standard Finance and Behavioural Finance

1.2.4 The Role of Behavioural Finance in Creating a Successful Advisory Relationship

In recent times, capital markets are attracting the attention of retail investors across the globe
and this number is increasing due to diversified reasons like declining interest rates,
insecurity and volatility amongst fixed income securities, increasing awareness about
investment options, trading through the proper means, increasing role of technology in capital
markets and their tech savvy investors etc. However, to understand this whole process,
behavioural finance acts as a catalyst and helps us as a medium both for reasons and causes
for those reasons. Behavioural finance refers to the psychology of finance and people dealing

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in finance. This subject contributes and affects finance in multiple ways as it evaluates human
desire and the motivating factors of desire in making investment, there by contributing to
value maximization of investments made. It is an interdisciplinary subject with flavours of
psychology, economics and sociology.

Advances in psychology and economics as contributors to one another are coined by

researcher‘s decades ago. Economics does follow psychology theories and sometimes it so
appears that economists as psychologists in their thinking. Behavioural approach in capital
markets has emerged in 1980s. Investor‘s behavioural analysis started in early 20th century in
the book titled ―The story of Behavioural Finance‖ by Adams and Finn. Importance to
psychology in economics started with the observation of anomalies and puzzles faced by
theorists in their research where the main stream theories couldn‘t provide a solution.
Efficient market hypothesis (EMH) is an example to this in 1960s. Due to the adoption of
EMH theory, earlier theories such as CAPM started showing inconsistent results and neo
classical researchers like Ball were concerned about these anomalies and their influence in
economics studies and started looking for a solution that led them to understanding
behavioural finance as one of the solutions. Anomalies‘ influence can be minimized with the
application of sophisticated statistical tests and this has challenged neo classical finance
researchers preferring behavioural theories application in economics and finance.

Prospect theory is an example for understanding the importance of Behavioural Finance. It is

a descriptive theory of choice under uncertainty based on the outcome of numerous
experimental psychological studies. In the Annual General Meeting of 1984, Fisher Black,
the then President of American Finance Association, has supported the concept of
behavioural finance and after one year, Journal of Finance has published two papers based on
prospect theory to market pricing. This theory has become the foundation for behavioural
approach in economics after integrating several psychological biases such as loss aversion,
conservatism, anchoring, and frame dependence and disposition effect. Later in 1980s,
behavioural finance concept has come into existence along with financial economics. Later
on, many books and papers have been published on behavioural finance that leads to the
development and progress of this concept.

1.3 HISTORY OF BEHAVIOURAL FINANCE

Behavioural Finance emergence is based on three aspects namely psychological origin,

economic origin and financial origin. The psychological origin seems to be clear in the minds

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of theoreticians Thaler and Mullainathan who explain clearly that behavioural finance; comes
from an interdisciplinary field of finance where cognitive psychology and economics,
together yield effective results. The main paradigm of psychology is cognitive psychology,
social psychology, behavioural aspects, Freudian psychology and socio linguistics. Cognitive
psychology studies about internal mental process such as problem solving, language and
memory. It includes various aspects such as perception psychology or memory learning
study. This concept was used in Gestalt psychology in 20th century by Max Wertheimer and
Wolfgang Kohler. Through this concept, people can understand the objects and scenes in the
simplest manner. It is also referred to as ―Law of Simplicity‖. Authors from behavioural
finance clearly mentioned that this field of research comes from cognitive psychology.
Behavioural finance should be considered to be similar to the paradigm of behaviour, which
means a collection of assumptions based on comprehending the process of learning in terms
of behavioural principles and these two are based upon experimental approach that will not
exhibit the results in the same way.

Behavioural paradigm arrives from the internal human mind, without recourse of internal
introspection. Psychology refers to thought of, something esoteric in its methods. ―If anyone
fails to reproduce other‘s thoughts or findings, it is not due to fault in their approach or the
research procedure followed or their equipment or in control of the stimulus; rather, it is due
to the fact that introspection of the researcher is untrained‖. Neglecting the subjective
dimensions of human behaviour and by focusing only on the results of behaviour, the
behaviourist approach would probably be closer to neoclassical finance. The economic origin
of behavioural finance deemed to happen in 1950s and slowly developed as a discipline by
[Link] approach claims to be more descriptive than neo classical approach while
prospect theory which can be seen as the first theoretical foundation of behavioural finance.
Perseverance of psychological approach by economists started after 1920s only; however,
psychology concepts have not developed enough clarifications through its theories to fulfil all
the questions that arouse due to the emergence of a cognitive approach in economics.
Behavioural economics concerns with how feelings and human attitude structure affect the
decision-making process.

Some economists denied that psychology could be relevant to economic theory which had a
notion to focus on value and not on the motivation of people. Some other researchers felt that
most anomalies of neoclassical finance have been enhanced due to advances in cognitive
psychology and experimental economics. After understanding about economic emergence

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and psychological aspects of behavioural finance, it is about finance origins of behavioural
finance that needs to be understood. In 1950‘sbehavioural finance was not an identified field;
rather, it was a kind of protoscience. However, it is found that by using Gaussian framework,
the founder of cognitive and experimental psychology, researchers tried to find statistical
correlations between mass psychology and financial quotations and also the psychological
dimensions of financial markets. There are researchers, who considered the complexity of
human behaviour in financial theory and financial originators in understanding behavioural
finance.

The advancement of behavioural finance can be found in Grahams works. He wrote two
books which focus particularly on investments: Security Analysis: Principles and Technique
and The Intelligent Investor. The investors‘ decision depends on their intelligence and he
reminded the word ―Intelligent‖ used in his second book which explains the capacity of
knowledge and understanding. The notion Graham used Intelligence refers to personality and
psychology of investors. Several psychological biases or anomalies used in behavioural
finance can be found in the words of Graham. He wrote ―The Speculative public is
incorrigible‖. Graham was a historian and a great psychological thinker who did not consider
the financial reality as fixed and a historic but rather as an evolving and historic system.
Moreover, by focusing on what investors can do and not on what they ought to do, he
provided descriptive approach of behavioural finance. Graham used several themes which
focus about the investors‘ activity in behavioural finance.

1.3.1 Historical Perspective on the link between Psychology and Economics

The theme of the relationship between economics and psychology has a long and rather
complicated history. Psychology is considered as probably the closest neighbouring field to
economics. Psychological ideas had always played a role on the formation of economic
thought even before the classical school of economics. The presence of psychological
elements and observations became even more obvious in the works of major classical
economists. The same trend can be observed with the emergence of the marginalist school
and the shift towards the study of individual economic behaviour. The marginalists were
paying more attention to psychological ideas and especially to the particular theory of
psychological hedonism. Up to the beginning of the 20th century, there was almost no
methodological objection regarding the incorporation of ideas from psychology into
economic theories. After this period, a fundamental shift in economics took place which is
also known as the Paretian turn. This conceptual change, initiated mainly by Vilfredo Pareto

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and completed in the first decades of the 20th century by John Hicks, Roy Allen and Paul
Samuelson, attempted to expel all psychological notions from economic theory. The main
consequence of the establishment of axiomatic rational choice theory by the above authors,
was that economics explicitly severed its ties from psychological research. The same trend
continued in the following decades with the formation of the micro-foundations and the
‗rational expectations‘ literature which extended rational choice theory to macroeconomics.
The subsequent application of rational choice theory to most areas of economics such as
public choice theory and labour economics, completed the Paretian turn of mainstream
economics.

Although there has been continuous criticism of the isolation of economics from other social
sciences and especially from psychology, the dominance of orthodox economics ensured the
methodological justification and reign of the Paretian turn. However, in the last three
decades, the increasing appeal of subjective well-being research and especially of the new
behavioural economics brought the issue onto the surface. The relationship between
economics and psychology and its ensuing methodological dimension is currently attracting
increasing attention. In particular, one of the main characteristics of the new behavioural
economics is 3 the criticism of mainstream economic rationality in terms of research findings
from psychology. A very important consequence of these developments was that it re-opened
the methodological issue of the role and the place of psychological assumptions in
economics.

The issue of the relationship between economics and psychology effectively contains two
central points which are the following.

1. To what extent do economic assumptions need to be based on sound psychology and

2. The possibility of independence of economics from psychology

It is clear that these two points also exhibit a strong historical and methodological bend. Thus
and in order to get further insights to the above, a substantial part of the relevant literature is
focused on the history of the relationship between economics and psychology. The bulk of
this literature deals with the relation between economics and psychology after the marginalist
revolution. In particular, the strive of late marginalist / neoclassical economics to expel
psychology from economic theory is a well-researched topic. Given the recent discussion of
re-introducing psychological elements in economics mainly in the context of behavioural
economics other papers focus on the history of behavioural economics since WWII. In

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general, most of the research concentrates to the period that followed the marginalist
revolution and only mentions briefly the historical developments before that period. Thus,
there is a considerable gap which lies on the earlier ideas on the role of psychology in
economics. In fact, for many pre-marginalist major authors, the issue of incorporating
psychological elements in economic discourse was also an important theme. There are many
such examples in the works of Whitely, Banfield, Lloyd and Gossen. More detailed
discussion and arguments can also be found in the economic thought of Senior and Jennings.

In order to contribute to the recent discussion concerning the relationship between the two
disciplines, the focus of this paper is on the works of early authors on this subject. An
investigation of the views regarding psychological ideas and their methodological
justification might assist to the further understanding of the complicated issue of the
interaction between economics and psychology. In particular, the paper will start with a brief
sketch of the history of the relationship between economics and psychology, focusing also to
the recent literature which points to a reconsideration. In the next section there will be an
examination of psychological ideas found in influential pre-marginalist writers.
Consequently, the paper will discuss the arguments supporting the case for the interaction
between the two fields. Emphasis will be placed on the methodological justification found in
the works of Senior and Jennings. A concluding section will close the paper.

Economics and Psychology: A Brief Sketch

The discussion of the formation of human nature and how it affects human behaviour is very
old. In the writings of Aristotle, we may find the roots of both Associationism and Hedonism,
two intellectual movements which influenced early economists‘ thought during the 18th and
19th centuries. Questions of human nature are significant for economics since they help us
examine motives and behaviour in economic matters. Although the fundamental assumption
of rationality in mainstream economic theory ―avoids the necessity of studying human
thought processes the psychological approach is relevant to economics in that it provides a
more realistic basis to explain behaviour and behavioural change‖.

The interaction between economics and psychology has many episodes in the history of both
fields. Since the 18th century, economists have usually founded their own economic theories
on some principles and ideas about human nature; accordingly, economics was not
independent from psychological foundations. As Peter Earl points out, ―if we probe more
deeply into a person‘s reasoning, sooner or later their emotional core will be reached, and the

18
person will be unable articulate a basis for why a particular issue matters to them: it just
‗does‘. This aspect of psychological economics is very much in line with the intuition of
Adam Smith and David Hume and it naturally takes us into the origins of aesthetics (i.e.,
principles of good taste), and other customs that underpin many choices‖.

Before the marginalist revolution, there were major writers who attempted to infuse
psychological ideas and concepts into economics. Influenced mainly by psychological
hedonism, these classical writers accepted a subjective theory of value and explicitly argued
for the necessity of psychological reasoning. As will be seen in more detailed manner in
Section III, these authors adopted many significant behavioural and psychological
assumptions with respect to economic activities, opening the ground for future developments
such as the emergence of psychological economics. It seems that the work of Richard
Jennings can be regarded as the height of this early interaction between economics and ideas
from psychology.

Economics and Psychology: The Revival

In the late 1970s, the theoretical and empirical validity of expected utility theory started to be
questioned by psychologists Daniel Kahneman, Amos Tversky, and Paul Slovic. These works
marked the revival of psychological ideas in economic analysis. Even the mainstream
response to this criticism was the attempt to alter the expected utility models by including
explicit psychological variables such as regret and disappointment. Moreover, Kahneman and
Tversky‘s work is considered to have given the stimulus for the emergence of new
behavioural economics. Kahneman and Tversky‘s approach had a strong orientation towards
psychology and many key ideas found in new behavioural economics were stimulated by
psychological literature. Notions such as reference dependence, loss aversion, adaptation,
endowment effects, and framing effects are commonplace in modern behavioural economics.
For instance, Ernst Fehr and Klaus Schmidt acknowledge that their work concerning fairness
is connected to the relevant psychological theories: ―Our theory is motivated by the
psychological evidence on social comparison and loss aversion‖. Furthermore, some of the
more recent models originating from the new behavioural economics draw on explicitly from
findings from neuroscience and cognitive psychology. Their aim is to offer an improved
understanding of how cognition and emotion might interact to bring phenomena of economic
relevance, such as cooperation, intertemporal choice and risky decision.

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Another source of renewed interest to psychological findings relates to the rise of research on
subjective well-being (or happiness economics). This relatively new field has an explicit link
to psychology and especially to positive psychology. Key concepts of the field such as life
satisfaction, positive and negative affect, quality of life, as well as the cardinal approach to
utility measurement indicate the strong interaction with psychology. The increasing appeal of
happiness research with its extensive use of psychological notions represents a challenging
tendency to the mainstream resistance to explicitly interact with psychology. In short, new
behavioural economics and happiness economics represent the main manifestations of the
current revival of the interaction between economics and psychology.

1.3.2 Modern Behavioural Finance

Consumers, investors, business, and government are assumed to be rational in decision

making. The concept of the rational man has dominated economic and finance theories for
more than 50 years. The rational man is assumed to be economical, rational, knowledgeable,
and skilful in calculating the probabilities of each alternative, and then to choose the best
alternative that maximizes his utility for the lowest cost. However, tremendous empirical
evidence raises the question of the rationality of investors. Modern finance taught in finance
courses built its foundation on the notion of rationality. It assumes that investors are rational
and thus should make decisions that maximize their return for the lowest level of risk.
Efficient market theory (EMT) is one of the most fundamental theories of modern finance
that assumes rationality of investors.

Efficient market theory, introduced by Fama states that stock prices reflect all relevant
information. Thus, if stock markets are said to be efficient, then active investors cannot beat
the market return on a continuous basis. On the other hand, passive investors can profit on
average as active investors do. Rational investors (e.g. buying undervalued stock) should
correct any deviation in prices. As a result, stock prices always reflect their true value.
According to EMT, market efficiency is divided into three hypotheses, which differ based on
the type of information involved. The hypotheses are:

The weak-form efficient market hypothesis, where stock prices reflect all historical
information (e.g. rate of return, trading volume, and prices) implies that investors who use
historical data (e.g. technical analysis) cannot simply beat or predict the market.

The semi strong efficient market hypothesis assumes that stock prices reflect historical and
public information. This implies that an investor who makes the decision to invest based on

20
historical (technical analysis) and publicly released information (e.g. annual report) cannot
achieve superior return.

The strong form efficient market hypothesis assumes that stock prices reflect past public and
private information. This implies that investors who trade based on past, public, and insider
information will not be able to achieve above-average risk-adjusted return.

However, empirical evidence has been accumulating since 1970 that tends to contradict
EMT. There are a number of observed deviations in stock prices that appear not to be related
to any information. The unjustified deviations in stock prices are known as stock price
anomalies.

1.3.3 Psychographic Models used in Behavioural Finance

Psychographic models are designed to classify individuals according to certain

characteristics, tendencies, or behaviours. Psychographic classifications are particularly
relevant with regard to individual strategy and risk tolerance. An investor‘s background and
past experiences can play a significant role in decisions made during the asset allocation
process. If investors fitting specific psychographic profiles are more likely to exhibit specific
investor biases, then practitioners can attempt to recognize the relevant tell-tale behavioural
tendencies before investment decisions are made. Hopefully, resulting considerations would
yield better investment outcomes. Two studies – Barnewall and Bailard, Biehl, and Kaiser
apply useful models of investor psychographics.

Barnewall Two-Way Model

One of the oldest and most prevalent psychographic investor models, based on the work of
Marilyn MacGruder Barnewall, was intended to help investment advisors interface with
clients. Barnewall distinguished between two relatively simple investor types: passive
investors and active investors. Barnewall noted

―Passive investors‖ are defined as those investors who have become wealthy passively—for
example, by inheritance or by risking the capital of others rather than risking their own
capital. Passive investors have a greater need for security than they have tolerance for risk.
Occupational groups that tend to have passive investors include corporate executives, lawyers
with large regional firms, certified public accountants with large CPA firms, medical and
dental non-surgeons, individuals with inherited wealth, small business owners who inherited
the business, politicians, bankers, and journalists. The smaller the economic resources an
investor has, the more likely the person is to be a passive investor. The lack of resources

21
gives individuals a higher security need and a lower tolerance for risk. Thus, a large
percentage of the middle and lower socioeconomic classes are passive investors as well.

―Active investors‖ are defined as those individuals who have earned their own wealth in their
lifetimes. They have been actively involved in the wealth creation, and they have risked their
own capital in achieving their wealth objectives. Active investors have a higher tolerance for
risk than they have need for security. Related to their high risk tolerance is the fact that active
investors prefer to maintain control of their own investments. If they become involved in an
aggressive investment of which they are not in control, their risk tolerance drops quickly.
Their tolerance for risk is high because they believe in themselves. They get very involved in
their own investments to the point that they gather tremendous amounts of information about
the investments and tend to drive their investment managers crazy. By their involvement and
control, they feel that they reduce risk to an acceptable level.

Barnewall‘s work suggests that a simple, non-invasive overview of an investor‘s personal

history and career record could signal potential pitfalls to guard against in establishing an
advisory relationship. Her analysis also indicates that a quick, biographic glance at a client
could provide an important context for portfolio design.

Bailard, Biehl and Kaiser Five-Way Model

The Bailard, Biehl, and Kaiser (BB&K) model features some principles of the Barnewall
model; but by classifying investor personalities along two axes—level of confidence and
method of action—it introduces an additional dimension of analysis. Thomas Bailard, David
Biehl, and Ronald Kaiser provided a graphic representation of their model (figure 1.1) and
explain.

22
 Figure 1.1: Overview of Straight Arrow

The first aspect of personality deals with how confidently the investor approaches life,
regardless of whether it is his approach to his career his health, his money. These are
important emotional choices, and they are dictated by how confident the investor is about
some things or how much he tends to worry about them. The second element deals with
whether the investor is methodical, careful, and analytical in his approach to life or whether
he is emotional, intuitive, and impetuous. These two elements can be thought of as two
―axes‖ of individual psychology; one axis is called ―confident-anxious‖ and the other is
called the ―careful impetuous‖ axis.

1.4 INTRODUCTION TO BEHAVIOURAL BIASES

The efficient markets hypothesis suggests that information is swiftly integrated into stock
prices. Models of the 1970s linked economic fundamentals with speculative asset prices
through rational expectations. However, during the 1980s behavioural finance theorists
argued that behavioural / psychological factors play a major role in explaining investor
decisions and asset prices. Grossman & Stiglitz made a significant contribution on price
patterns by examining the over-reaction of prices to new information. The proponents of
rational expectations theory and efficient markets hypothesis have argued that there is no
concrete statistical evidence regarding the over-reaction and under-reaction of stock prices.
They also suggest that well-functioning markets are generally efficient. Prior research has
found that investors are not able to make consistently high (abnormal) returns from trading in
developed financial markets.

The stock market and the economy of a country are closely related. A booming stock market
positively affects the growth and development of a country. Thus, investment decisions in the
stock market play a vital role in the economy. This research examines the impact of
behavioural biases on investor decisions at the Pakistan Stock Exchange (PSX). Behavioural
biases include both cognitive biases (such as anchoring, representativeness, mental
accounting and availability) and emotional biases (such as risk aversion, overconfidence and
regret aversion). Despite decades of research in finance, behavioural finance research has
remained scarce in developing countries. The study provides a basis for exploring the role of
behavioural / psychological factors on investor decisions in the context of Pakistan. The
remainder of the study is organized as follows. The next section presents the literature review

23
and the conceptual framework. This is followed by the methodology, results and discussion.
Finally, the conclusion and suggestions for future research are mentioned.

1.4.1 Definition

Behavioural biases are irrational beliefs or behaviours that can unconsciously influence our
decision-making process. They are generally considered to be split into two subtypes –
emotional biases and cognitive biases.

Emotional biases involve taking action based on our feelings rather than concrete facts, or
letting our emotions affect our judgment. Cognitive biases are errors in our thinking that arise
while processing or interpreting the information that is available to us.

1.4.2 Categorization

One of the most fundamental aspects of thinking is the ability to perceive similarities and
differences among the events that we expedience. Events rarely repeat themselves in exactly
the same way. And even if they did, it is still questionable whether Dur interpretation would
be quite the same as before. In this respect, impressions are always new to us. It is Dur
conceptual system, however, that allows us to perceive similarities between new and old
expedience‘s. We are inclined to relate incoming information to things that we know. One
mental operation by which this can be accomplished is categorisation. By categorising, the
continuous variation in environmental information is reduced to manageable and knowable
proportions. Categorisation provides a means of attaining cognitive economy. In this way,
adequate reactions are possible.

Mental categories generally are formed by experience. Expedience, however, usually

encompasses only a reduced sample of the total set of exemplars of a category, and this raises
a number of important questions. The main issue, of course, is the question of what these
mental categories are like. What is the nature of the process of categorisation? Are there
general constraints regarding this process? How can limited expedience lead to knowledge of
the whole category? What are the constraints on this knowledge? And how, for instance, do
we determine the boundaries of a category? How is experience related to category width? A
variety of answers have been given to these and related questions on how we farm a mental
representation of a category on the basis of Dur experience. A short description of the
historical development of views on categorization and the main current theoretical positions
Will be dealt With first. From that, it follows the categorization is biased in a number of
different ways. We shall go into ibis matter subsequently. With respect to biases, in

24
succession, the role of prototypes, basic level categories, existing schemata, the formation of
category boundaries and the influence of context, the representation of feature frequency and
correlation among features Will be discussed, as well as the issues of selective attention,
hypothesis testing and task demands.

1.4.3 Differences between Cognitive and Emotional Biases

Cognitive Biases

Pompian describes the first types of prejudice, which are seen as the most important.

Over-Confidence Bias

This is one of the cognitive prejudices possessed by people, and is believed to be one of
the most prominent features of success and excellence in many decision-making areas. It
also refers to confidence, and confidence in language means a person‘s sense of
certainty. It may also indicate the accuracy in the expression and persuasion of
something. The person who possesses this bias tends to exaggerate their cognitive
abilities and skills in the investment field because they believe they possess more
knowledge and insight than others when making a decision. The first to describe
excessive confidence in the field of psychology was Oskamp. Psychologists believe that
a person with excessive confidence over-estimates events and how to control them, and
reduces the time required to assess risk; this also means over-estimating a person‘s own
ability to perform certain tasks and showing more confidence in making decisions. When
making a decision to buy and sell securities, the presence of an over-confidence bias
leads to heterogeneity in the decisions of the dealers in securities. When investors in the
markets and decision-makers are characterised by excessive confidence, it leads to
excessive trading. People who experience this bias fail to understand information or
make an effort to obtain it. Securities are generally bought at a high price and sold at a
low price due to excessive confidence. This cycle leads to losses for the investor and
bubbles in the financial markets.

Excessive confidence explains anomalies in stock markets through financial psychology

which may be the most important behavioural element when trying to understand
anomalies in stock markets because it increases people‘s confidence in their judgements
compared with reality. To over-estimate their predictions researchers have divided the
over judgement of people for this bias into two areas: over-estimation of subjective
potential and over-estimation of the accuracy of one‘s knowledge and information.

25
Representativeness Bias

This cognitive bias means people try to fit a new and unknown event into a current event.
The nature of people is to judge something according to their ideas and what their
memory retains. Kahneman and Tversky were the first scholars to describe this bias,
which manifests when people prefer to generalise a phenomenon based on previous
experience. This means that they depend on the similarity between the event and a
similar previous event, and on the mental image generated, by allocating more weight to
the latter phenomenon without taking an average of the phenomenon in the long term.
Thus, they ignore the random nature of events by linking current analysis periods with
previous periods. This in turn leads to inaccuracies in investment decision-making
because of the inaccuracy of the decision-maker in selecting the sample.

Availability Bias

Another important cognitive bias that appears when decisions are made on the basis of
memory is estimating the probability of the latest event by adopting a mental event
retrieval formula to increase the probability of event retrieval. This provides a rapid
estimation and evaluation of the event for easy retrieval of examples, leading to speed
decision-making.

Illusion of Control Bias

This bias means a person thinks they are capable of controlling the consequences of
events, whereas they don‘t possess that ability. It reflects negatively on their future
decisions. Such bias affects the relative importance of skill, the role of luck and the
incentives a person has to control the investment environment of the financial market.

Confirmation Bias

Trading requires the availability and collection of information about the current assets
and their basic characteristics, and anticipation of what other investors in the market will
do in order to make a correct estimate of assets in the future. This bias leads to a
tendency for investors to focus on information that agrees with their views, preventing
them from responding to any other information; this can lead to the creation of bubbles
in financial markets.

Hindsight Bias

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 Hindsight bias is a cognitive bias that makes a person convinced that the circumstances
of an event after the occurrence of the event were expected based on historical data.
There is a belief in predictability, which is seen as an ability to make investment
decisions.

Emotional Biases

It is human nature to want to avoid loss, and this can play a big role when making an
investment decision. Yet this bias can lead to irrational behaviour. This will affect the
investment decision because investors retain investments to avoid loss when they should
exit the market. Numerous psychological studies have shown that individuals do not
view the results as the ultimate state of wealth or wellbeing, as but rather as gains and
losses relative to a particular reference point, usually the status quo.

Endowment Bias

The cost of giving away anything from a person‘s property is seen as a loss and the
opportunity cost (not buying a commodity or financial asset) is seen as a prior profit. The
first should be given greater weight, as investors resist change when they own a security.
Pompian states that this bias.

 Affects investors in holding onto the securities they have inherited, regardless of
whether it is financially wise to do so.

 Results in investors holding the securities they have purchased, which is often the
result of a decision deficit.

 Results in investors retaining the securities they have inherited or bought because they
do not want to bear the transaction costs associated with selling securities.

 Leads to investors retaining the securities they have inherited or purchased because
they are aware of the behavioural characteristics of these investments.

Self-Control Bias

Restraint bias can lead to many mistakes for investment and thus affect investor
decisions and profits, and create bubbles in the market; this bias leads to investors
spending more today rather than saving for tomorrow. Retirement can arrive so quickly
that investors cannot provide enough; often, people assume an inappropriate degree of
risk in their portfolios in an effort to make up for lost time. People who do not plan to

27
 retire are less likely to invest in securities. Restraint bias can lead investors to overlook
basic financial principles.

Regret Aversion Bias

Emotional biases describe people feeling sad about doing something. Grief may result
from comparing the actual result with an alternative result and feeling responsible or
blaming oneself for the negative outcome of a decision. Avoiding remorse is a
psychological theory that shows regret when people see that their decisions are wrong,
even if they seemed correct originally. Regret is associated with a sense of responsibility
for the option, so it differs from the frustration of placing responsibility on external
elements for bad outcomes.

Status Quo Bias

Individuals who face a range of options tend to elect any option that maintains the status
quo, rather than alternative options that might bring about change. That is, they make the
decision only because it maintains the current situation. This bias means that people have
a tendency to stay where they are, even if they have better alternatives. This bias may
result from the search for comfort, because people resist change and fear the remorse of
change if they take effective steps to change the status quo. This means people tend to
retain their existing alternative rather than changing, which is linked to the researchers‘
view of ownership bias, but there is a difference between the two biases.

Analysis and Interpretation of Tests for the Availability of Behavioural Biases

In this article, a statistical analysis was conducted to measure the results of investors‘
answers about the nature of the biases studied, particularly regarding whether they are
available in the Iraqi Stock Exchange. All biases and the tests used to detect them have
been treated by calculating the statistical parameters of the weighted average, the
intensity of the response, the standard deviation, the coefficient of variation, the variation
Yeh and t-test relative to the spirits and the specimen. Following is a detailed explanation
the results relating to each bias.

1.5 APPLICATIONS OF BEHAVIOURAL FINANCE

The understanding of heuristics and bias in economic actors and incorporating these variables
in investment decisions have benefitted traditional finance and transformed it into
behavioural finance. From capital budgeting, initial public offering, mergers and acquisitions,

28
dividend policy decisions to leadership, organisational culture and corporate governance
standards have all been influenced by the advent of the behavioural variable. This section of
the essay briefly discusses three instances where behavioural applications have modified
traditional finance and one instance (pension participation) beyond finance.

Capital Budgeting and Investment Decisions

Corporate budgeting is a method by which corporations invest their capital. This is done by
computing actual financial cost based on net present value. Net present value and internal rate
of return are the two concepts used widely in traditional finance. However, behavioural
finance looks beyond cost-related factors into the manager making these decisions (biases
and heuristics). In reality, a manager‘s traits like optimism and overconfidence lead to
erroneous evaluations of costs and returns. Behavioural fallacies lead managers to
overestimate precision of information and their ability to control risks.

Dividend Policy Decisions

Dividend policy decisions are important in a firm‘s stock values even if dividend as a form of
payment to shareholders is not as gainful as capital stocks. Yet, dividend policy has continued
for the last four hundred years as the primary method of payment in what is known as the
‗dividend puzzle‘. It is found that dividend payment is the preferred method of payment by
large established firms with low risk. Dividend volatility is generally less than stock price
volatility. Dividend is also an inefficient way to distribute cash to shareholders because of the
presence of double taxation. Yet, stock price reaction to dividend announcement tends to be
positive. Behavioural explanations for this paradox include inertia based explanations, mental
accounting of shareholders and problems with self-control. Dividend payment (a series of
small gains) is preferred over one big gain through capital stocks.

Asset Allocation and Trading

Another area where behavioural explanations are required to account for less-than rational
decisions of the investment managers is the allocation of portfolio. Individual investors do
not have time-consistent preferences and the presence of default bias and extrapolation bias is
strong. Even in trading portfolio, the main objective is how to rebalance the portfolio over
time. Inertia operates in this situation, often preventing investors in making well-defined
rational investment decisions.

Pension Participation

29
Outside the field of behavioural finance, there are numerous applications of the behavioural
variable in public policy. Pension participation is an example. Many countries with developed
markets have attempted social security and well-defined benefit plans and contribution plans
in the realm of pensions. There are a number of decisions awaiting the participant of a
pension programme. This includes decisions like whether to participate, how much to
contribute, where to allocate assets, how to rebalance allocation and how to handle the sum
post retirement. Default option has a major impact in the way the programme design in
perceived among participants. For instance, it has been found that default setting like
‗voluntary opt-in‘ has a more positive impact on enrolment than an ‗opt-out‘ arrangement on
participation level. At the stage of enrolment, status-quo bias, peer effect and choice overload
operate making ‗opt-in‘ default setting to ensure better participation. At the next stage of
deciding contribution level, strong default bias and reinforcement learning heuristic operates
through which individuals increase weights on strategies where they had previously
experienced success.

1.6 FOUNDATIONS OF BEHAVIOURAL FINANCE

Just like economics consists of microeconomics and macroeconomics, both finance and
behavioural finance can be similarly divided into two somewhat separate parts. Miller
suggests that research in finance falls into two streams: micro-normative and macro-
normative. The first vein is concerned with individual decision-making and is historically
associated with the approach taken by Business Schools aiming to teach students to make
high-quality financial decisions. The second approach is historically associated with the
research done in Economic Departments with the main goal to derive the dynamic of asset
prices from the behaviour of individuals.

In the same style, Pompian proposes a similar approach to describe a variety of topics in
behavioural finance. Micro behavioural finance documents behavioural biases of individual
investors and its implications for decision-makers. It also tries to uncover the roots of
behavioural biases and mechanisms by which they operate. Similarly to the macro-normative
stream of research in finance, macro behavioural finance is interested in how the behaviour of
individual decision-makers determines and influences asset prices. However, unlike the
former, macro behavioural finance does not assume that individuals behave like Icons, rather,
it is based on the behaviour of real humans described by micro behavioural finance.

30
Inspired by this distinction, this section starts with an account of the theoretical
underpinnings of micro behavioural finance by examining the difference between Humans
and Icons. Then, the section turns to the most important findings in the realm of macro
behavioural finance, which are mostly related to the so-called financial market "anomalies"
and the question of financial market efficiency.

Micro Behavioural Finance

Homo Economicus is a highly-specified model and this fact makes it easy to make a
distinction between Econs (suggesting how economic agents behave) and Humans (empirical
evidence on how real humans actually behave). In short, Econs should have the following
three qualities. First, Econs should process information efficiently and effortlessly translate it
into actions, i.e., correctly retrieve information from their memory; correctly access the
accuracy of the knowledge and skills they have; correctly infer new information from
observations of their environment; be indifferent to the way information is presented; ignore
non-relevant information; make correct probabilistic judgments; and possess the required
self-control to execute the needed actions.

Secondly, Econs should have so-called standard preferences that are known to an individual,
are stable in time, and do not change under the influence of irrelevant information.
Interestingly, the examples of prosocial and other types of behaviour contradicting the notion
of unbounded self-interest do not constitute a threat to Homo Economicus, at least on the
micro level. The theory of rational choice states that economic agents act rationally given
their preferences. It means that if an individual investor trades securities on a stock exchange
to satisfy his/her sensation seeking, he / she does not act irrationally since he/ she satisfies
his/her preferences, whatever they might be (sensation seekers are looking for intense and
novel experiences associated with risky behaviour; Grinblatt and Keloharju, 2009 found that
sensation seeking is associated with higher trading activity). The failure to account for the
limits of self-interest (in the strict sense of pursuing only one‘s own monetary gain) may
result in incorrect estimation of response to government or business actions. However, this
problem has a rather technical nature and potentially can be dealt with through more or better
data (the problem is rather how to measure prosocial preferences).

Finally, the model of Homo Economicus implies that people can and will learn from their
mistakes and that the process of learning can be described by the so-called Bayesian
updating. The latter means that humans have a prior probability estimate (probabilistic

31
estimate given all available information) of the occurrence of some event and when the new
relevant information becomes available, we produce a posterior probability estimate (new
estimate) by applying the Bayesian rule of updating probabilities. In other words, people
apply probabilistic thinking to most real-world situations, efficiently process information, and
change their minds based on rules of probabilities estimation. Behavioural studies have
shown that all these propositions are far from the universal truth.

First, Humans make decisions based on the so-called dual process theory of decision-making
and over-rely on quick intuitive shortcuts (heuristics) rather than on deliberate thinking,
which in the end leads to a variety of behavioural biases. Secondly, real human preferences
are better described by the prospect theory, rather than by EUT. Likewise, Humans are not
necessarily aware of their preferences, and the preferences themselves may be unstable over
time and depend on the way the choice is framed (depend on the way the situation is
presented). Finally, there are a number of behavioural phenomena preventing Humans from
learning from their own mistakes, and the process of learning is better described by the model
of Reinforcement Learning rather than by Bayesian updating. Moreover, Human‘s experience
emotions and those emotions can influence all three ingredients constituting Homo
Economicus: processing of information, preferences, and learning. Behavioural research was
also successful in addressing the most often used objection to its findings, namely, the high-
stakes argument (when the stakes are high enough, people will make decisions just like
Econs). Reviewing the relevant literature, Camerer and Hogarth concluded that there is
simply not enough evidence that Humans act more like Econs during high stakes situations
rather than at low stakes. In addition, a recent study documented peoples‘ behaviour during
particular game shows where participants were making decisions with very substantial sums
of money at stake and found no support for the argument that high stakes force Humans to act
in accordance with the model of Homo Economicus.

The rest of the sub-section examines these three sources of differences between Econs and
Humans in more detail (biases that arise due to the dual process theory of decision-making,
the difference in preferences, and limits to learn from own mistakes) and concludes with a
discussion of the heterogeneity of behavioural biases, as well as the main factors behind it.

Dual Process Theory of Decision-Making

The Dual process theory of cognition proposes that we use two parallel systems of decision-
making. The first system is automatic, effortless, heavily influenced by associations, intuitive,

32
quickly jumps to conclusions, largely unconscious, and mostly based on heuristics (shortcuts
or rules of thumb which "represent an adaptive mechanism that saves us time and effort while
making daily decisions". The second system is deliberate, conscious, effortful, logical and
slow. Most researchers refer to those two systems as system 1 and system 2 however,
following Haidt and Kesebir and Hirshleifer, I will refer to them as intuitive and reasoning
systems.

To illustrate the difference between the two systems, consider an example. Answer the
question: how many people are living in the New York City? Notice that, no matter if you
know the right answer of not, you still have an intuitive answer. It probably came to you at
once and was based on simple heuristics. I know that a big city has several millions
inhabitants, New York is among the biggest cities in the world, so it may have something
close to 10 million people (the right answer is 8.5 million). This was an intuitive system at
work. It is also reasonable to assume that your answer at least partially depended on the size
of the city you live in, because the size of it, no matter how irrelevant it is, still may have
influenced the guess of the intuitive system (this is an example of the "anchoring effect",
which is discussed later in this section). Now consider a different question: what is the
product of 57 and 28? Notice that your intuitive system was most likely silent this time. This
was a question designed to be addressed by the reasoning system, while your intuition was
not able to provide an easy guess. The work of these two systems is not entirely separate,
rather they may work in parallel, where the intuitive system generates impressions, guesses,
and tentative judgments, which might be accepted, blocked, or corrected by the reasoning
system. One of the most colourful and useful metaphors depicting this interaction was
popularized by Haidt. "Like a rider on the back of an elephant, the conscious, reasoning part
of the mind has only limited control of what the elephant does". There are two important
details about this interaction between the intuitive and reasoning systems.

Firstly, the reasoning system requires a lot of cognitive resources and, thus, most of our
decisions are made on autopilot. Lakoff and Johnson estimated that people spend about 95%
of their time under the control of the intuitive system. It also means that most of the decisions
produced by the intuitive system go unchecked by the reasoning system. The intuitive system
is always involved in decision-making, i.e., the limbic system is consistently interfering with
cognitive processes and medical conditions preventing the experience of emotions results in a
worse quality of decision-making. Secondly, the intuitive system was well suited to the
human ancestral environment, however, it provides poor guidance for decision-making in a

33
modern complex world. Consequently, since the problems that our mind evolved to deal with
are different from today's, heuristics developed by our ancestors are likely to generate
systematic and predictable errors in decision-making (behavioural biases). Despite the idea
that our brain is not very well suited to a modern environment may seem highly speculative,
there is growing evidence that behavioural biases indeed have evolutionary roots. For
instance, Santos and Rosati review literature on the origins of decision-making and conclude
that comparative studies of humans and nonhuman primates‘ decision-making support the
notion of evolutionary roots of behavioural biases. Other studies reached the same conclusion
by analysing isolated behavioural phenomena. For example, Apicella provide an evolutionary
explanation for an endowment effect, while Moshe and Levy and Zhang showed the
evolutionary origins of risk aversion.

The important conclusion is that the intuitive system has a predominant influence on our
decision-making and its reliance on heuristics may lead to predictable and systematic
mistakes in specific circumstances. Literature usually highlights the four most important
heuristics: availability, representativeness, anchoring and adjustment, and affect. The first
three were introduced by Daniel Kahneman and Amos Tversky in the early 1970s and
eventually helped them to formulate prospect theory which to this day remains the most
successful alternative to the EUT. The availability heuristic is the tendency to estimate the
probability of an event based on how prevalent or familiar it appears in our lives. While this
is a sensible mental shortcut on its surface, it can result in mistaken estimates because not all
past instances of this event are equally retrievable from memory. Thus, people tend to make
judgments based on a limited sample of past occurrences, overweighting more recent or more
vivid memories. For example, after witnessing a car accident, people will likely drive more
carefully for some time afterwards despite the fact that traffic does not become riskier.
Likewise, when investors overweight the last available and more vivid information, they tend
to overreact to news which, in turn, helps to explain the positive autocorrelation of returns
and momentum. The extrapolation from past returns is also partially explained by the
representativeness heuristic, which states that people judge the probability that an object A
belongs to a class B by considering how much A is similar to B, i.e., by relying on formed
stereotypes. This leads to all sorts of probabilistic mistakes from sample size neglect
(alternatively the law of small numbers) – the tendency to make inferences from too small
samples to a conjunction fallacy – the mistaken belief that the conjoint occurrence of two
independent events are more probable than the probability of either one occurring alone.

34
These heuristics, together with self-attribution and hindsight bias (discussed later in this
section), result in overconfidence and its correlates (overoptimism and wishful thinking). As
a result, Humans display unrealistically positive views of their abilities and prospects and rely
on too narrow a confidence interval when estimating probabilities. The anchoring and
adjustment heuristic represents a tendency to place too much weight on the first piece of
information available or offered (anchor) when making an estimate. People start with the
anchor (no matter how irrelevant it may be) and make adjustments based on the newly
received information. The heuristic may cause two sorts of problems. First, Humans are
influenced by non-relevant information. For example, Ariely presented experimental
evidence that the last digits of a tax identification number (irrelevant anchor) may influence
the willingness to pay for several consumer items (including wine, books, and computer
accessories). Secondly, problems arise because the adjustments are usually insufficient and
the final estimate remains too close to the initial starting point. For example, Cen
demonstrated that analysts make insufficient adjustments to their earnings forecasts even if
such adjustments are well supported by new information. Finally, Slovic reformulated and
popularized the affect heuristic which states that emotions provide guidance in the process of
decision-making. Emotions and feelings help to weight possible outcomes, which simplifies
the process of comparison and motivates decisions and actions. The affect heuristic helps to
explain well-documented findings that sentiment (time-varying mood swings) can influence
asset prices and macroeconomic outcomes. For instance, recent studies found that sentiment
affects investor‘s preferences for risk-taking as well as confidence in their own skills and
abilities, thus emotions affect both preferences and beliefs.

Preferences: Humans vs. Econs

If humans behave like econs, then preferences are known and independent from the way the
situation is presented. However, empirical evidence rejects both of these assumptions. In a
creative paper titled Tom Sawyer and the construction of value, Ariely provide evidence that
in some situations people do not have a pre-existing sense regarding a particular experience.
Subjects in this study were shown to be easily manipulated by non-normative cues to change
their perception from good to bad even if they have tried a similar experience before.
Humans‘ preferences also depend on the way the situation is described (framing effect), i.e.,
people make different choices depending on how the choices are presented to them (for
example, the "Asian disease problem", described in the introduction). The way we react to a
difference in the representation of the problem is called mental accounting. For example,

35
people treat gains and losses of the same magnitude differently and sometimes make a
distinction between financial assets depending on how they frame them, as belonging to
current wealth, current income, or future income. The last example means that Humans treat
one dollar in their left pocket differently from one dollar in their right pocket. Preferences are
also shown to be time-inconsistent. Unlike Econs, who applied a stable discount factor to
value future payoff, Human‘s discount near term payoffs much more rapidly than payoffs
they expect to receive in the distant future meaning that the value of the discount factor
depends on the characteristics of the situation. Such a difference in approach to near term
versus distant rewards is an example of failing to resist a temptation and related to a problem
of limited self-control. Interestingly, as early as in the late 1970s and early 1980s, Thaler and
Shefrin illustrated that people are generally aware of this problem and impose personal rules
with the goal of increasing their savings. For example, authors describe a case of Christmas
clubs, savings programs which were popular in the first half of the XX century in the United
States. The design of the scheme was that customers deposit money during the year into a
special account, and receive them back before Christmas. Even though such accounts paid no
interest, they were nonetheless popular as a part of a commitment strategy helping to address
the problem of insufficient self-control.

The next big thing which distinguishes humans and econs is that Humans are loss averse, i.e.,
they prefer to avoid a loss to acquiring a gain of equal magnitude. In practice, it means that
people will unlikely participate in a gamble with an expected value of zero because the
negative emotions from the loss of 100 dollars are much more powerful than the positive
emotions from winning 100 dollars. In general, the magnitude of loss aversion is domain and
situation specific, but most estimates put the loss aversion coefficient into the range from 1.4
to 4.8, meaning that loses on average are more than twice as powerful as gains. Although it is
rather unclear how we should perceive loss aversion, as a preference, a behavioural bias or as
an emotional reaction driven by fear, empirical studies have shown that loss aversion is a
universal and important aspect of human behaviour. Loss aversion can help explain many
behavioural phenomena, from the famous St. Petersburg paradox to the status quo bias, a
tendency to take no actions and follow the chosen decision path. It also explains the
endowment effect, a tendency to value things people own relatively more only because of the
fact of ownership. Loss aversion seems to be a very basic trait and may have evolutionary
origins as it was found present in the behaviour of capuchin monkeys.

36
The combination of loss aversion and short evaluation horizons produce myopic loss
aversion. The latter helps understand relatively high stock market returns (compared to such
safe assets as government bonds) over the last century that cannot be explained by the
relative riskiness of securities alone (equity premium puzzle). Instead of focusing their
attention on stock market returns over the long run, investors focus on short-time price
fluctuations. As a result, such investors observe more frequent "paper" losses (negative price
changes) and since they are loss averse, investors demand relatively higher compensation (a
higher equity premium). Loss aversion also constitutes one of the main building blocks in the
prospect theory of choice under risk and uncertainty which to this day remains the sole
alternative to the standard framework of the EUT. Prospect theory states that individuals
value outcomes of choices they consider to make in relative terms, comparing them to a
reference point. Rather than consider the expected value of some risky option, individuals
instead will make a decision based on the potential value of gains and losses resulting from
such a risky option. First of all, since Humans are loss-averse, they unlikely take a risk if the
pleasure they expect to receive from a gain will be lower than the pain they will experience in
the case of loss. Secondly, people will exhibit more risk aversion (less tendency to take on
risks) if there is a high chance of gain, while they will act in a more risk seeking manner
facing the greater probability of loss. It is usually said that Humans are risk-averse in gains,
but risk-seeking in losses. Finally, prospect theory considers mistakes people make when they
perceive probabilities, namely, it accounts for a tendency to overweight small probabilities
and underweight the large ones. In a seminal review, Barberies documents a wide list of
applications of the prospect theory for the analysis of real-world problems, especially in
finance and insurance since prospect theory models decision-making under risk and
uncertainty. For example, prospect theory helps explain a robust and widespread finding – the
disposition effect, a tendency of individual investors to realize their profits quickly (sell
securities which went up in price after they were bought), but hold losing positions for too
long. Prospect theory was also successfully used to enrich standard models of consumer
choice understand business strategy for price setting and explain the intriguing finding of
Camerer that the daily labour supply of New York City cab drivers negatively correlates with
the average hourly wage on that day.

The next important distinction between Humans and Econs in terms of their preferences
concerns their motives for making financial decisions. While Econs make investments with
the goal to receive utilitarian benefits (increase in wealth), Humans also focus on expressive

37
and emotional benefits of their financial decisions. Expressive benefits communicate to
others our values, tastes, and status, while emotional benefits represent how our decisions
make us feel. For example, by analysing data from retail brokerage accounts in China, Hong
showed that status concerns may explain a number of stylized facts that characterize the
behaviour of retail stock market investors, including excessive trading and preferences for
stocks with small market capitalization. If Humans are concerned only with utilitarian
benefits, there are still some important differences from the behaviour predicted by the model
of Homo Economicus. In theory, investors desire high returns with low risk, while the
standard deviation of returns constitutes a good proxy for risk. However, the development of
psychological risk-return models following Weber and Milliman and corresponding empirical
evidence suggest that Humans perceive risk in a subjective manner, i.e., the same level of
objective risk (captured by the standard deviation of returns) may be perceived differently by
different people. At the same time, recent studies challenge an even more fundamental
assumption that the returns themselves are the most important parameter that matters to
investors. Grosshans and Zeisberger demonstrate that investor satisfaction with an investment
depends heavily on the price trajectory by which the final return is achieved. For instance,
investors in this study were mostly satisfied when the price path of an investment was first
negative before starting to yield positive results. Finally, except aversion to risk and losses,
Humans also tend to avoid ambiguity (ambiguity aversion) and prefer the familiar (preference
for the familiar). These effects help to explain limited stock market participation, under-
diversification, home bias (failure to diversify stock market portfolio with foreign stocks),
and excessive holdings of stock in their own company.

1.7 SUMMARY

 Standard finance is well built on the arbitrage principles of Miller and Modigliani, the
portfolio construction principles of Markowitz, and the CAPM of Lintner and Sharpe.
Standard finance does not do well, however, as a descriptive theory of finance.
Investors regularly overlook arbitrage opportunities, fail to use Markowitz's principles
in constructing their portfolios, and fail to drive stock returns to levels commensurate
with the CAPM.

 People in standard finance are rational. They are not confused by frames, they are not
affected by cognitive errors, they do not know the pain of regret, and they have no
lapses of self-control. People in behavioural finance may not always be rational, but

38
 they are always normal. Normal people are often confused by frames, affected by
cognitive errors, and know the pain of regret and the difficulty of self-control. I argue
that behavioural finance is built on a better model of human behaviour than standard
finance and the better model allows it to deal effectively with many puzzles that
plague standard finance, among them, the puzzles discussed here-investor preference
for cash dividends, investor reluctance to realize losses, the determination of expected
returns, the design of securities, and the nature of financial regulations.

 Finance offers many other puzzles. Some are small-for example, why the practice of
dollar-cost averaging persists despite its inconsistency with standard finance. Some
are large for example, why investors ignore Markowitz's rules of portfolio
construction. These puzzles might be solved within behavioural finance.

 Financial professionals who understand behavioural finance will understand their own
behaviour and improve their decisions. Institutional investors who understand
behavioural finance will understand the beliefs and motives of their clients and will be
better at serving and educating them.

 With the advancement of cognitive psychology, combined with the development of

critic perspective in economics led to the emergence of a new field of research
flourish both in academics and practice i.e. Behavioural Finance. This study shows
the starting point for the emergence of Behavioural Finance with the help of
Behavioural portfolio theory, which was contributed by various psychologists and
economic thinkers. In this study the authors identified, in the first part of 20th century
the historical roots and evolution of behavioural finance which focused mainly on
Behavioural Portfolio Theory that helps to make better investment and financial
decisions. Current study contributes some historical roots to behavioural finance and
proposes a kind of archaeology to this field which makes to remind the advent of new
theoretical field of behavioural finance which is very complex even though after its
emergence conditions and helps to understand the cognitive emotions of the investors
that helps to choose a wise portfolio selection and better investment decision making
studies in future time periods.

 Individuals‟ decision-making is influenced by cognitive psychology and heuristics.

Biased decisions create anomalies and unjustified mispricing in stocks, reduce market
efficiency, create higher risk with opportunities, and create market bubbles and panic

39
 that affects the majority of individuals. Many studies on individuals‟ decisions and
their impact on price and market have been conducted in markets where individuals
are the minority but not in markets that are dominated by individual investors like the
SSE. For a future study, there is a need to investigate individuals‟ buying decisions in
the SSE from a behavioural finance approach. Future studies should start with Micro
Behavioural Finance (MIBF) before moving to Macro Behavioural Finance (MABF)
studies in the SSE. Understanding the impact of individuals‟ decisions on their
portfolio, stock prices, and the SSE will be a great contribution to the field of
behavioural finance. Findings will allow researchers to gain a deeper understanding of
the extreme impact of individuals‟ decisions on stock prices and the market when
individuals are the majority.

 This review of the history of behavioural finance and its foundations is intended to
serve as an extensive introduction to the field for novice readers, as well as to affirm
several broad ideas.

 A closer look at the history of the field reveals that the psychology-free economics of
the 1950s–1970s appears to be an interlude in the long lasting and complex
relationship between psychology and other social sciences on one hand, and
economics and finance on the other. It also seems that neither economics nor finance
were ever truly psychology-free and, instead of rejecting psychology, economics was
rather defined by it. Homo Economicus also appears to be a product of the intellectual
environment of late the XIX to early XX centuries with characteristic dominance of
mechanistic and deterministic views of the world. However, as Dow (2003) points
out, many sources of this inspiration are long gone, as many predominant views in the
fields of theoretical physics, psychology, and even mathematics all underwent
substantial changes.

 Another lesson of history indicates that the development of behavioural economics

and behavioural finance was defined by their striving to prove themselves worthy of
inclusion into the mainstream. This need to wage a constant war against the
predominant and even orthodox approach has left its mark on both behavioural
approaches as it developed as a "negative science", with the main goal of rejecting
explicit and implicit hypothesis proposed by neoclassical economics and standard
finance.

40
  Finally, the overwhelming evidence against Homo Economicus as a realistic
description of real humans as well as a compelling case against the efficient market
hypothesis does not mean that behavioural finance holds the keys to all important
answers. For instance, as the discussion of the variety of behavioural biases and their
causes illustrates, we still do not know how exactly such a basic trait as age affects
our propensity to make systemic and predictable mistakes.

 Likewise, as a part of the mainstream, behavioural economics and finance (at least at
this stage) leave out many important issues such as methodological individualism or
complexity. By including Humans in its models, behavioural finance certainly
improves our understanding of the real world. However neither behavioural
economics nor behavioural finance can be used as a substitute for an inclusive
interdisciplinary approach to important real-world problems.

1.8 KEYWORDS

 Arbitrage: An attempt to enjoy a risk-less profit by taking advantage of pricing

differences in identical securities being traded in different markets or in different
forms as a result of mis-pricing of securities.

 Behavioural Economics: The foundation of behavioural finance, found especially in

the ground-breaking work of Richard Thaler. This field is the alternative to traditional
economics since it applies psychology to economics. Other examples of alternative
economics are economic psychology and socio-economics.

 Bias: An inclination of temperament or outlook; unreasoned judgment or prejudice.

 Correlation: A concept from probability (statistics). It is a measure of the degree to

which two random variables track one another, such as stock prices (stock market)
and interest rates (bond market).

 Finance: A discipline concerned with determining value and making decisions. The
finance function allocates capital, including acquiring, investing, and managing
resources.

1.9 LEARNING ACTIVITY

1. Conduct a session on history of behavioural finance.

41
___________________________________________________________________________
___________________________________________________________________________

2. Illustrate the term behavioural bias in brief.

___________________________________________________________________________
___________________________________________________________________________

1.10 UNIT END QUESTIONS

A. Descriptive Questions

Short Questions

1. What is standard finance?

2. Describe history of behavioural finance?

3. Define behavioural biases?

4. Define behavioural finance?

5. Mention the different types of behavioural biases.

Long Questions

1. Difference between standard finance and behavioural finance?

2. Discuss in brief the modern behavioural finance.

3. Illustrate psychographic models used in behavioural finance.

4. Explain the differences between cognitive and emotional biases.

5. Explain applications of behavioural finance.

B. Multiple Choice Questions

1. Which among the following VCE should be used for faithful amplification?

a. Be zero
b. Be 0.2 V
c. Not fall below 0.7 V
d. None of these

42
 2. What occurs in a base resistor method, if the value of β changes by 50, then collector
current will change by a factor?

a. 25
b. 50
c. 100
d. 200

3. What is the stability factor of a collector feedback bias circuit, if that of base resistor
bias?

a. The same as
b. More than
c. Less than
d. None of these

4. Which among the following design of a biasing circuit, the value of collector load RC
is determined?

a. VCE consideration
b. VBE consideration
c. IB consideration
d. None of these

5. What happens to the value of VCE if the value of collector current IC increases?

a. Remains the same

b. Decreases
c. Increases
d. None of these

Answers
1-c, 2-b, 3-c, 4-, 5-b

43
1.11 REFERENCES

Reference

 Adams, B & Finn, B. (2006). ―The story of Behavioural Finance‖, Lincoln Universe.

 Ahmad, Z. Ibrahim, H.& Tuyon, J. (2017). Institutional investor behavioural biases:

Syntheses and theory and evidence. Management Research Review.

 Adam, Smith. (1790). ―The Theory of Moral Sentiments‖, Sixth edition, Metalibri,
Sao Paulo, Brazil.

Textbooks

 FamaE. (1998). ―Market Efficiency, Long-Term Return and Behavioural Finance‖.

Journal of Financial Economics.

 Festinger, L. (1962). A theory of cognitive dissonance. Stanford university press.

 Graham, B. (1949). The Intelligent Investor. HarperCollins. New York.

Website

 [Link]

 [Link]

 [Link]
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44
MASTER OF BUSINESS
ADMINISTRATION
(FINANCIAL MANAGEMENT)
SEMESTER II

BEHAVIORAL FINANCE
MBAEF 204
All rights reserved. No Part of this book may be reproduced or transmitted, in any form or by any means,
without permission in writing from Mizoram University. Any person who does any unauthorized act in
relation to this book may be liable to criminal prosecution and civil claims for damages. This book is
meant for educational and learning purposes. The authors of the book has/have taken all reasonable
care to ensure that the contents of the book do not violate any existing copyright or other intellectual
property rights of any person in any manner whatsoever. In the even the Authors has/ have been unable
to track any source and if any copyright has been inadvertently infringed, please notify the publisher in
writing for corrective action.
 CONTENT

Unit - 2: Belief Perseverance Biases .......................................................................................... 4

UNIT - 2: BELIEF PERSEVERANCE BIASES

STRUCTURE

2.0 Learning Objectives

2.1 Introduction

2.2 Cognitive Dissonance Bias

2.3 Conservatism Bias

2.4 Confirmation Bias

2.5 Representativeness Bias

2.6 Illusion of Control Bias

2.7 Hindsight Bias

2.7.1 Description

2.7.2 Practical Application

2.7.3 Research Review

2.7.4 Diagnostic Testing

2.7.5 Advice

2.8 Summary

2.9 Keywords

2.10 Learning Activity

2.11 Unit End Questions

2.12 References

2.0 LEARNING OBJECTIVES

After studying this unit, you will be able to

 Illustrate the concept of cognitive dissonance bias.

  Explain confirmation bias.

 Examine representativeness bias.

2.1 INTRODUCTION

Growing up one is raised a certain way by the people and surroundings around. You are told
what is right or wrong, what things are called and what you should believe in. We are told the
sky is blue, that the grass is green and that those are the correct ideologies. We are given an
initial thought on life by our parents, teachers, and others around us. The concept of all this
information grows up with us, and eventually, dictates what we will believe and agree on in the
future. One must question one‘s own beliefs when being placed in a situation that contradicts
what they believe in, with facts that have been proven to be right. This notion focuses on belief
perseverance and how it challenges your approved initial beliefs by presenting you new and
different information that may contradict your initial beliefs. This can hold back one‘s self-
enhancement and self-growth by keeping one closed minded in a world that is improving with
more accurate beliefs that are supported by considerable research to be proven true. Emotions
can also tie your past experiences to your original ―true beliefs‖, which can, in fact, hinder one to
make correct decisions about new ideas in everyday situations. Can one‘s initial ideologies or
beliefs stand up to and go against our confirmation bias being challenged daily? Will having
these new and challenging ideas create a personal conflict?

Researchers believe that perseverance comes from stories one creates to defend their original
beliefs and to explain their ideologies. ―What do we do when the facts contradict our theoretical
premises or beliefs? Do we modify those beliefs?‖. When being put in a situation where you are
being observed you begin to think/act differently to correspond with the situation. Multiple
researchers have proposed the idea that most people try to maintain the most promising self-
image that produces positive feedback that affects their self-concepts.

Trying to maintain this self-image of compliance can have an impact on your belief perseverance
and can even change one‘s ideologies. One way that this links to maintaining a conforming self-
image are by the process of debriefing. When one is told to not do something during a certain
situation due to it being the wrong action, this can influence the decision to continue to not do it.
It changes one‘s beliefs of thinking what was a correct action, then later being informed it was
wrong, can change one‘s initial thoughts of one‘s beliefs being right Belief perseverance is
examined a lot through briefing procedures and how informing participants before receiving any
feedback that their initial information was incorrect (Bui, 2014). Receiving feedback can
influence one‘s original thoughts by helping one push through their contradicting thoughts and
eventually accepting new ideas and beliefs.

When being told you‘re wrong we tend to get defensive and even emotional about being
contradicted. Emotions have a large play in anyone‘s day to day life, even changing our opinions
on certain things. ―Emotional belief is a belief that is made up of and strengthened by emotions.
Emotional beliefs are based on an individual‘s internal inferences, not on objective comparisons.
Thus, having an emotional belief can mean that the belief could be wrong‖. Our initial beliefs are
occasionally linked to emotional memories of our childhood and the people in those moments
who taught us what is true. One may have belief perseverance due to the emotionally strong
connection to our past and its experiences. This can lead us to use our conformational bias to
ignore the facts presented and stick to what we have experienced to be true. However, it is not
scientifically proven that one may conform to their schemas, which are structures and guides of
our memories. Instead, they may be used to support our ideologies and lead to the use of this
perseverance phenomenon.

2.2 COGNITIVE DISSONANCE BIAS

Cognitive dissonance is the unpleasant emotion that results from believing two contradictory
things at the same time. The study of cognitive dissonance is one of the most widely followed
fields in social psychology. Cognitive dissonance can lead to irrational decision making as a
person tries to reconcile their conflicting beliefs.

 Cognitive dissonance occurs when a person believes in two contradictory things at the
same time.

 Within investing, it can lead to irrational decision-making.

 Typically the person experiencing cognitive dissonance attempts to resolve the

conflicting beliefs so that their thoughts once again become linear and rational.
Conflicting beliefs can be held at the same time, often without a person realizing it. This is
particularly true when conflicting beliefs deal with different areas of life or are applied to
separate situations. When a situation causes the person to become conscious of their conflicting
beliefs, cognitive dissonance occurs and creates an uneasy feeling. The person experiencing the
dissonance will work to resolve one of the conflicting beliefs so their thoughts are once again
linear and rational.

According to previous research, sunk costs can lead to and reaffirm cognitive dissonance. This is
because an individual or trader's future decision making may be influenced by his previous
investment decisions. As such, his future decisions, which may be contrary to his investing
beliefs, are taken to reaffirm the amount of time and money he has invested in his previous ones.

For example, an investor believes heavily in the "sell in May and go away" market anomaly. The
investor thinks that people sell stocks in May and it causes prices to be artificially depressed.
Therefore, you shouldn't ever sell stocks in May because the selling bids down prices and you
can't ever get the best price.

Separate from this thought, the investor receives a call from his broker about a stock he owns.
Apparently, the company is going through a hostile takeover and the stock price has started to
fall. The broker thinks this is only the tip of the iceberg and that the investor should immediately
sell the stock. The investor is on board until they look up at their calendar and see it is May 1.
The investor immediately thinks of the "no selling in May" guideline and starts to experience
anxiety related to cognitive dissonance. The investor will have to find a way to reconcile their
desire to sell the stock with the belief that selling stocks in May is a bad idea to be at peace with
whatever decision they reach.

Cognitive dissonance describes when we avoid having conflicting beliefs and attitudes because it
makes us feel uncomfortable. The clash is usually dealt with by rejecting, debunking, or avoiding
new information.

Where this bias occurs

Everything you need to know about behavioural science, and how to apply it to your work. In
one place.

Access our knowledge centre to see our resources for practitioners.

Consider the following hypothetical situation: John is an avid environmentalist. He is president
of the environmental club at school, goes to climate change marches, and John‘s family owns an
electric car.

One day, he decides to attend a lecture on the negative environmental effects of certain animal
products which apparently contribute significantly to climate change. To his dismay, John
realizes that he uses many of those products on a regular basis. His stomach drops:

That means that he is part of the problem he is trying to resolve.

This cannot be! John is a champion of the environment. But, John doesn‘t think he is willing to
stop eating meat and he knows his family won‘t be.

To get rid of the pit in his stomach and resolve the identity crisis he is having, John quickly
concludes that the speaker must not know what they are talking about. Also, he thinks, even if
animal products aren‘t great for the environment, he has done so many other things that are good
for the environment, that it must even out (at least). John‘s mind is put at ease.

Cognitive dissonance is most likely at work here. To resolve the inconsistency revealed by this
new information on certain animal products, John rejects and rationalizes the speech so that his
identity as an environmentalist isn‘t painfully compromised.

Individual Effects

Rejecting, rationalizing, or avoiding information that conflicts with our beliefs can lead us to
make poor decisions. This is because the information is not rejected because it is false but
because it makes us uncomfortable. Information that is both true and useful can often have this
effect. Decisions made in the absence of true and useful information can have harmful
consequences. Smoking, for example, has been shown to cause cancer and contribute to various
other chronic health conditions. Smokers often rationalize their detrimental decision to continue
smoking by either denying evidence that supports its health risks or by considering themselves to
be the lucky exception.

Systemic Effects

Looking further into the effects of cognitive dissonance leads to troubling conclusions across
academia and political society. If researchers tend to analyse information in a way that supports
conclusions that are consistent with their own beliefs, then cognitive dissonance may threaten the
objective methodology that underpins much of academia today.

The effectiveness of social causes is also threatened by cognitive dissonance. The change they
often call for requires many people to change their existing beliefs and behaviour. This is not
possible if a significant portion of us do not consider evidence that conflicts with the beliefs or
behaviours these causes seek to alter. Environmentalism and its associated climate change action
movements are a good example. Most of us care for nature and want to preserve it. But the
evidence championed by these movements often indicates that we aren‘t doing enough as
individuals. Many of us are part of the problem. Such evidence shows us that our behaviours are
often at odds with our beliefs.

Seeing this contradiction, many of us respond by either rationalizing our behaviours, rejecting
environmentalism and the evidence it relies on, or adopting the belief that our individual actions
have a negligible effect on the environment. This prevents the widespread behavioural change
many environmental causes call for.

Cognitive dissonance may also facilitate a political divide. When we believe strongly in a
political leader or ideology, we are more likely to dismiss information that does not support their
message. In other words, we often ignore or distort evidence that challenges our political beliefs.
This is part of the reason why it is so difficult to change someone‘s mind on political issues.
Voters are likely to remain loyal to their chosen candidates and party even when evidence that
should challenge those loyalties is presented.

Example

Picking up after your dog

Let‘s say you have a dog that you take for daily walks around your neighbourhood. Like any
responsible dog owner, you carry plastic bags and always clean up after your dog.

One day, you realize you forgot the bags while halfway through the walk. And your dog chooses
that moment to do his business.

You take a quick look along the street. No one‘s around, so you call your dog and hustle away.
Once home, you begin to feel guilty. You know it‘s not right to leave your dog‘s mess. What if
someone steps in it or it ruins your neighbour‘s lovely garden?
―But it‘s just the one time,‖ you tell yourself. You ran out of bags. You‘ll replace them and
always pick up after your dog in the future.

Besides, it‘s not like you‘re the only one who does it. You‘ve seen other dog‘s messes in the
neighbourhood. If other people don‘t pick up after their dogs, why should you have to?

2.3 CONSERVATISM BIAS

Environmental concerns in general, and issues regarding climate change in particular, are
moving from the realm of corporate Environment, Health, and Safety (EH&S) personnel, into
that of corporate financial strategy, which involves top management and government as well.
The pace of this transformation has left few unaffected, from companies and cities managing
their greenhouse gas emissions to equity and debt analysts paying close attention to climate
liabilities along with physical concerns regarding the potential impacts of climate change
patterns. Carbon finance explores the financial implications of living in a carbon constrained
world a world in which emissions of carbon dioxide and other greenhouse gases carry a price.
Thus, carbon finance represents the environmental finance, to explore financial risks &
opportunities and helps to transferring environmental risk and achieving environmental
objectives as well. This conveys a more inclusive meaning than the one adopted by the World
Bank as ―Carbon finance is the term applied to the resources provided to a project to purchase
greenhouse gas emissions reductions‖. A variety of drivers influence the discipline of carbon
finance, which in turn takes many forms. It is shaped by national and international regulations,
which require producers and consumers to emit fewer greenhouse gases (GHGs), or to pay the
price. Some of these regulations had their origin in an earlier piece of legislation designed to
curb air pollution, conserve energy, and promote renewable energy. Others have been created by
international agreements such as the Kyoto Protocol and the European Union Emission Trading
Scheme. So, putting a price on greenhouse gas emissions will have a significant effect on
country and company bottom lines. At the same time, government climate policies can do much
to change behaviour patterns and encourage markets to mitigate these issues. Corporations must
be considered in analysts‘ assessments of their effects on companies‘ earnings, profitability, or
return on capital invested.

For any company, its carbon exposure can be found in three levels of the value chain.
  Emissions from the company‘s own operations.

 Indirect emissions from the company‘s supply chain, especially energy.

 Emissions linked to the use of a company‘s goods and services.

Climate change has become a salient issue, seen constantly in the headlines and discussed at the
highest political level as evidenced by the 2005 G8 summit. It poses a major risk to the global
economy, affecting the wealth of societies, the availability of resources, the price of energy, and
the value of companies. Carbon risk management is expected to increasingly affect shareholder
value, due to higher energy prices, restrictive GHG targets, and increased losses due to severe
and adverse weather events. In this way, global warming has become the environmental issue
that has the most potential to effect the profitability and in extreme cases the actual existence of a
number of companies. Present Status and Future Prospects,‘‘ outlines concerns regarding
increased levels of climate change, the opportunities for players and products to alleviate some
of the potential impacts, and the role that carbon finance plays in this global phenomenon.
Mostly people do not want to change or establish a change in very slow process because human
mind is basically conservative. It cannot change quickly as it resists the change. For example if
in past years outcome is sufficient no one will not be incorporate new terminology or innovation
in particular segment. Similarly, carbon financing is suffering due to conservatism bias as the
investors and entrepreneurs are hunted therefore, industrial sector of Pakistan which has huge
potential for carbon finance losing billions of dollars.

In accounting, conservatism means that if two values of an asset are present, the accountant
recognizes the lower value. Hence, the principle of conservatism is based on how an investor is
supposed to react when they receive multiple and often contradictory reports about the same
asset.

This is the case in behavioural finance as well. However, it has been observed that investors
often form a deeply emotional view about an investment. This view may be positive or negative.
However, it is developed earlier. Then, when the same investor is presented with information
that is contradictory to their view formed earlier, they simply discount the new information and
hang on to their original opinion. Sometimes, investors may not react to new information, and
other times, they may react very slowly.
For example, investors may have a belief that a company like Enron is a good investment.
Hence, when early information about the possibility of a scam in Enron came to light, a lot of
these investors stuck to their previous views and were slow to react. In the process, the details of
the scam became public, and some investors lost a huge portion of their investment.

The Root Cause of Conservatism Bias

As investors, we are aware that conservatism bias does actually exist in the marketplace. We
have experienced it ourselves, or we may have come across others who have experienced it over
time. However, we don‘t much about the root causes because of which conservatism bias
continues to exist.

 Failure to revaluate complex data: The first and foremost reason is that formulating an
opinion on the financial position of a company is a complex task. The investor has to go
through a wide range of financial information and critically analyse the same before they
can make any decisions. This process is both arduous as well as time-consuming. The
problem is that whenever new information about the company comes out, the investor is
supposed to perform the entire analysis again. This can be physically as well as
emotionally stressful for the investor. Hence, instead of forming new opinions, the buyers
simply hold on to pre-existing beliefs about the firm.

 Cling to forecasts: Investors have an innate need to feel validated. When investors go
through results, very few of them are objectively viewing the results. Instead, they are
validating their own beliefs. Hence, if an earlier forecast provided by the company or
critics matches with their beliefs, they tend to hang on to that belief instead of
reformulating their beliefs. If an investor reads a hundred-page report, they are more
likely to remember the four or five pages that validate their belief.

 Slow to react: The initial belief of the investor is firmly entrenched in their mind. Hence,
they do not change that belief unless there is overwhelming evidence that their initial
belief is wrong. They often take a long time processing the information in their heads. As
a result, they are often slow to react. This may cause them to hold on to stocks longer
than they should cause erosion in their wealth.

Avoid Conservatism Bias

Just like with all other biases, the key to avoiding conservatism bias is by believing the
assumption that we could be wrong and our decisions could be incorrect. Biases tend to hide in
our mental blind spots. Hence, if we acknowledge them, the problem is half solved anyway.

 Seek professional advice: Many investors believe that they have the necessary financial
acumen to make their own financial decisions. However, they still rely on other
professionals to help them with decision making. They do so not because they don‘t trust
in their ability to understand the information. However, they do so because the same
information can be interpreted in different ways, given the frame of mind of the
interpreter. Hence, it is better to engage a professional who tends to have different views
than you. This will help look at facts in a different light, which will help avoid the
conservatism bias.

 Act resolutely: A lot of investors do understand that they are ignoring meaningful
information. However, they continue to do so because they are unable to act in a decisive
and resolute manner. Whenever new information comes that contradicts their existing
beliefs, they tend to dilly-dally and waste time. It is important for investors to be slow to
make up their minds. However, once the mind is made up, they should act fast and
decisively. This is because, in investment markets, timing is as important as the decision
itself, if not more.

The bottom line is that conservatism bias provides another formidable mental challenge for
an investor. An investor is required to overcome this challenge so that their wealth keeps on
growing, and they don‘t end up in the self-destructive mode.

Example

Investors may have a belief that a company like Enron is a good investment. Hence, when early
information about the possibility of a scam in Enron came to light, a lot of these investors stuck
to their previous views and were slow to react.

2.4 CONFIRMATION BIAS

Let us start by understanding what confirmation bias really is. Confirmation bias is the tendency
of human beings to actively search for information that matches with the preconceived notion
that they have. Individuals tend to pay an excessively large amount of attention to the
information which confirms their beliefs. At the same time, they tend to discredit any
information that does not conform to their belief.

It needs to be understood that the investor is not doing any of this consciously. Instead, the entire
process takes place subconsciously. Investors tend to hold a belief which is often not the result of
due diligence. The mind of the investor automatically seeks out information that helps confirm
the belief while shunning away information that contradicts it. The problem with confirmation
bias is that the investor feels as though they have done the required due diligence even though
they really haven‘t.

Human Beings have Confirmation Bias

Human beings are always searching for inner harmony. This means that they want their beliefs to
be harmonious. Hence, if any person is holding conflicting beliefs at any given point in time, it
becomes their innate nature to choose one belief. Then they start choosing facts that support their
beliefs. This is done by them subconsciously in order to avoid cognitive dissonance.
Confirmation bias is a deep-rooted evolutionary behaviour that allows human beings to maintain
their sanity.

Confirmation Bias Affects Investment Behaviour

Confirmation bias affects decisions in all walks of life. However, it has a profound effect when it
comes to financial behaviour. Some of the main distortions caused by confirmation bias have
been listed below.

 Missed opportunities: Confirmation bias is responsible for a large amount of missed

opportunities. This is because investors are only able to identify an opportunity and invest
in it if they are able to get a fair and unbiased view. However, investors who have a
confirmation bias are actually preoccupied with their own thought processes. They do not
tend to pay attention to the opportunities presented to them. This is because they are
preoccupied with their own notions.

 Concentrated portfolios: Probably, the worst outcome of confirmation bias is a

concentrated portfolio. It is a known fact that over the course of time, diversification
provides a shield to investors. Investors who have a diversified portfolio earn a better
 risk-adjusted return as compared to their peers. Confirmation bias causes the thinking of
the investors to become distorted. They become obsessed with a few companies or a few
investment classes. This causes them to ignore diversification and concentrate their
holdings in a single company or investment class. This may benefit them in the short run.
However, empirical evidence states that in the long run, diversified portfolios do much
better than concentrated portfolios.

 Prone to bubbles: Another problem with confirmation bias is that this thinking is prone to
get the investors into asset bubbles. This is because, in the case of asset bubbles, the price
of the asset keeps on going higher until one fine day, it doesn‘t anymore. This means that
people with confirmation bias are likely to invest more and more in asset bubbles as
compared to other investors.

Avoid Confirmation Bias

Avoiding confirmation bias can be tricky. However, it is possible. The trick once again is to first
realize that there is the possibility that one‘s thinking may be biased. Half the battle is one when
an investor starts to doubt their thinking and acknowledges the possibility that he / she may be
flawed. Some other steps that can be taken are as follows:

 Actively seek contradictory evidence: In case of confirmation bias, the mind is working
automatically to seek evidence in favour of a belief. Hence, if there is no external
interference, the belief may get reinforced over time. The role of an investor is to play the
devil‘s advocate. They must always seek evidence to disprove the belief that they are
holding. It could also be to prove an opposing belief. However, the idea is to hear both
sides of the argument. If there is merit in the other argument, the investor will be forced
to modify their behaviour, and the bias will be avoided.

 Consider the other person‘s point of view: In some cases, the investor‘s belief might be
too entrenched. As a result, they may not be able to consider the other points. Hence, it
would be better for them to ask another person to debate and provide an opposing view.
There is always an opposing view because if there is a buyer, then there is also a seller.
The existence of a seller proves that there is someone who has a difference of opinion.
Understanding their stance can prove to be worthwhile.
The bottom line is that the confirmation bias can cause significant distortions in the thinking of
the investor. These distortions can then also lead to serious financial consequences.

Example

People who support or oppose a particular issue will not only seek information to support it, they
will also interpret news stories in a way that upholds their existing ideas.

2.5 REPRESENTATIVENESS BIAS

Representativeness heuristic bias occurs when the similarity of objects or events confuses
people's thinking regarding the probability of an outcome. People frequently make the mistake of
believing that two similar things or events are more closely correlated than they actually are.
This representativeness heuristic is a common information processing error in behavioural
finance theory. Representativeness Heuristic Example Representativeness Heuristic Example
Let's look at an example of information processing errors, commonly referred to as heuristic
simplification. Let's imagine the following scenario. Consider Laura Smith. She is 31, single,
outspoken and very bright. She majored in economics at university and, as a student, she was
passionate about the issues of equality and discrimination. Is it more likely that Laura works at a
bank? Or, is it more likely that she works at a bank AND is active in the feminist movement?
Many people when asked this question go for option that Laura works in a bank but is also active
in the feminist movement. But that is incorrect. In fact, in giving that answer, they've actually
been influenced by representativeness heuristic bias. One of the things you want to think about is
that you want to judge things strictly as they are statistically or logically, rather than as they
merely appear. The second option, "Laura works in a bank and is active in the feminist
movement" is a subset of the first option, "Laura works in a bank." Because of that fact, the
second option can't be more probable than the first. (The odds of Laura's behaviour(s) falling into
a narrower subset must be statistically lower than the odds of her falling into the larger group of
"bank employees".) This example is an excerpt from CFI's behavioural finance course.
Protecting against the Representativeness Heuristic Let's look at strategies to protect against this
heuristic as an investor. You may want to consider keeping an investment diary. Write down
your reasoning and then match it to the outcomes, whether good or bad. In financial markets, one
example of this representative bias is when investors automatically assume that good companies
make good investments. However, that is not necessarily the case. A company may be excellent
at their own business, but a poor judge of other businesses. Another example is that of analysts
forecasting future results based on historical performance. Just because a company has seen high
growth for the past five years doesn't necessarily mean that trend will continue indefinitely into
the future.

Additional Resources

Thank you for reading this CFI guide to the representativeness heuristic and its place in financial
decision making. To learn more, check out CFI‘s behavioural finance course.

Additional Helpful Resources Include

 Behavioural interview questions

 Hindsight bias

 Anchoring bias

 Loss aversion bias

Example

Let‘s look at strategies to protect against this heuristic as an investor. You may want to consider
keeping an investment diary. Write down your reasoning and then match it to the outcomes,
whether good or bad.

In financial markets, one example of this representative bias is when investors automatically
assume that good companies make good investments. However, that is not necessarily the case.
A company may be excellent at their own business, but a poor judge of other businesses.

Another example is that of analysts forecasting future results based on historical performance.
Just because a company has seen high growth for the past five years doesn‘t necessarily mean
that trend will continue indefinitely into the future.

2.6 ILLUSION OF CONTROL BIAS

Any stock market around the world is huge in size. It is made up of many participants who
regularly buy and sell assets. Since there are so many buyers and sellers, and the money is spread
out amongst them, none of them has complete control over the events that take place in the
market. The fact of the matter is that investment markets are based on probabilities. Anyone who
claims that they can predict the outcome of stock markets with complete accuracy is most
certainly suffering from a mental bias. This bias is called an illusion of control bias. In this
article, we will understand what this bias is and how it affects the decision making of a normal
investor.

Illusion of Control Bias

Illusion of control bias is the tendency of investors to believe that they have a certain degree of
control over the outcomes of investment markets! Not all investors believe that they have
complete control. However, a lot of them do believe that they have some influence over the
market. In most cases, this is not true because investment markets are huge markets where
trillions of dollars change hands every week. Hence, if an individual investor or even a small to
mid-size institution believes that they are in control of the market, they may be wrong.

It is true that some of the investor‘s predictions might come true in the short run. However, it
may be a mere co-incidence and may not prove anything in the long run. A lot of times, investors
feel in control of their portfolios because they use techniques such as limit orders, etc., to buy
and sell shares. However, in many cases, it just leads to unnecessary buying and selling as prices
fluctuate within a given range. The illusion of control bias is also closely linked to the feeling of
overconfidence, which has been discussed in another article.

Illusion of Control Harm Investors

A false illusion of control can cause some serious harm to the investors‘ portfolio. Some
examples have been provided below.

Illusion of control causes investors to take positions in penny stocks. This is because they believe
that since the company is small, they can use their capital to gain a significant stake in the
company and then control the outcome. However, a lot of these penny stocks are inherently risky
because of the nature of the business that they are in. This illusion of control only causes
investors to lose more money.

Investors with an illusion of control often tend to believe that they are experts in certain sectors.
Hence, they concentrate most of their portfolio in one single sector or industry. This is where the
problem starts since the portfolio is undiversified. An undiversified portfolio is likely to see
severe fluctuations in value if an adverse event takes place.

Illusion of control causes investors to not pay attention to an opportunity when it arises. They
may miss good entry and exit points in a particular stock because they had a false illusion of
control.

Avoid This Illusion

Now, since we have determined that such an illusion is bad for the investors, it is now time to
understand how we can recognize and remove this illusion from our thought process so that we
can make effective decisions.

The first and foremost step is to realize that when it comes to investing, there is no certainty. The
profit which is earned from investing is a reward for risk-bearing. Hence, if there is no risk,
ideally, there would be no need for a reward either! Investors need to understand that all
investing involves the use of probability, and hence there are several outcomes possible,
controlling all of which are impossible. In order to really drill this point, investors must try and
make a list of the number of factors that could influence the price of a stock. They would find
that there are factors at the government level, the competitor level, the macro-economy level, the
market level, and so on. Since there are so many diverse factors involved in this complex system,
controlling it is almost impossible.

Investors must avoid investing in stocks or other financial instruments, which give them a false
illusion of control. This is particularly the case when investors start investing in penny stocks or
other asset classes where there are wild fluctuations in the valuation. Investors must actively try
to look at the risks involved in their investments. They should realize that since they do not
control the outcome of the investment, there are many possible outcomes. Do they have the
wherewithal to survive each of these outcomes is the question that needs to be asked by the
investor? It would be prudent for the investor to be absolutely clear upon their investment time
frame as well as the possibility that some things can go wrong during that time frame.

The fact of the matter is that if any broker or any investor tells you that they are in complete
control of their investments, they are most likely not telling the truth. It is impossible for retail
investors and even smaller institutions to make any dent in the functioning of the stock markets.
Example

One research study found people are willing to pay more money for a lottery ticket if they get to
choose the numbers themselves than if the numbers are chosen by a computer at random.

2.7 HINDSIGHT BIAS

Hindsight bias is a psychological phenomenon that allows people to convince themselves after
an event that they had accurately predicted it before it happened. This can lead people to
conclude that they can accurately predict other events. Hindsight bias is studied in behavioural
economics because it is a common failing of individual investors.

Example

After attending a baseball game, you might insist that you knew that the winning team was going
to win beforehand. High school and college students often experience hindsight bias during the
course of their studies. As they read their course texts, the information may seem easy.

2.7.1 Description

 Hindsight bias is a psychological phenomenon in which one becomes convinced that one
accurately predicted an event before it occurred.

 It causes overconfidence in one's ability to predict other future events.

 In investing, hindsight bias may manifest as a sense of frustration or regret at not having
acted in advance of an event that moves the market.

 Financial bubbles are always subject to substantial hindsight bias after they burst.
Following the dotcom bubble in the late 1990s and the Great Recession of 2008, many
pundits and analysts demonstrated clearly how events that seemed trivial at the time were
actually harbingers of future financial trouble. They were right, but other concurrent
events reinforced the assumption that the boom times would never end.

 In fact, if a financial bubble was easy to spot as it occurred, it would likely have been
avoided altogether.

Bright Ideas
  The usual subjects of hindsight bias are not on that scale. Any number of investors who
had the passing thought, sometime in the 1980s, that Bill Gates was a bright guy or that a
Macintosh was a neat product may deeply regret not buying stock in Microsoft or Apple
way back then when they "saw it coming." Actually, they may suffer from hindsight bias.

 Investors should be careful when evaluating their own ability to predict how current
events will impact the future performance of securities. Believing that one is able to
predict future results can lead to overconfidence, and overconfidence can lead to
choosing stocks not for their financial performance but on a hunch.

 Hindsight bias and intrinsic valuation

 Hindsight bias can distract investors from an objective analysis of a company. Sticking
to methods helps they make decisions on data-driven factors and not personal ones.

 Intrinsic value refers to the perception of a stock‘s true value, based on all aspects of the
business and may or may not coincide with the current market value.

Quantitative and Qualitative Analysis

 An intrinsic valuation will typically take into account qualitative factors such as a
company‘s business model, corporate governance, and target market. Quantitative factors
such as financial statement analyses offer insights into whether the current market price is
accurate or if the company is overvalued or undervalued.

 Analysts generally use the discounted cash flow model (DCF) to determine a company's
intrinsic value. The DCF will take into account a company's free cash flow and weighted
average cost of capital (WACC).

2.7.2 Practical Application

The current trend in hindsight research seems to be examining those situations in which the bias
does not occur. For example, I proposed a model in which hindsight bias only occurs if the sense
making process is activated and successful. We observe little hindsight bias for expected
outcomes, because there is no need to make sense of them. They will seem obvious not because
of any biased processing, but because they actually are obvious! Further, we do not observe
hindsight bias for unexpected outcomes that are difficult to make sense of. If there are no clear
causal antecedents (e.g. A war is won because a freak tornado kills most of the enemy troops)
then we don‘t show the bias. How do we know when an outcome makes sense? One possibility is
that the ease with which we generate reasons for the outcome cues us. Sanna, Schwarz, and
Small asked participants to generate either 10 or 2 reasons for an outcome. The 10-reasons group
had some trouble with this, and only listed about eight, but surely listing eight reasons should
produce more hindsight bias than only two, right? In fact, the 10-reasons group actually showed
a reverse bias! Apparently, when it‘s difficult to generate a lot of reasons, we conclude that we
really didn‘t know it would happen. Harley et al. used a different technique to show that ease of
thoughts (which they called ‗processing fluency‘) affects hindsight bias. They asked subjects to
indicate when they recognized each of a series of celebrity‘s photographs that became less blurry
over time. Later they were asked to recall how blurry the picture was when they first recognized
the target‘s identity. Participants believed they had identified the celebrities sooner (when the
pictures were blurrier) than they really did. Presumably this is because it was easier to make
sense of the blurry picture once they knew the identity.

Even facial muscle movements can provide clues as to how easy something is to make sense of.
Sanna, Schwarz, and Small asked participants to furrow their brow or not while considering
factors leading the actual outcome or an alternative outcome. Participants who furrowed their
brow showed less bias! Future research might examine whether people who receive negative and
self-relevant outcomes show less hindsight bias because their troubled facial expressions provide
a cue that the outcome doesn‘t make sense, or because the emotion itself simply inhibits
cognitive processing necessary to make sense of it. Indeed, any extremely emotional outcome –
whether negative or positive – might produce less hindsight bias, at least initially . I know of no
research that has examined this directly..

2.7.3 Research Review

In 1975, Fisch off first demonstrated the hindsight bias, the tendency to overestimate how much
we believed we would have or did know about something had we been asked before the truth
were revealed to us. His study was simple enough. People in a foresight condition were given a
scenario (e.g. an unfamiliar 19th century war, or a clinical case study) with a list of possible
outcomes, and asked to rate the likelihood of each outcome. People in a hindsight condition were
told the ‗correct‘ outcome, but asked to ignore it when they made their estimates – that is, to
respond hypothetically, as if they didn‘t know the outcome. They couldn‘t, and gave higher
likelihood estimates for whatever outcome they believed occurred.

Trying a different approach, Fisch off and Beth asked students to predict the likelihood of
different possible events that might occur during President Nixon‘s upcoming trip to China and
the USSR. Two weeks to 6 months later, they asked the students to recall their predictions and to
indicate which events actually occurred. Student remembered giving higher probabilities to
events that they believed had occurred, and lower probabilities to events that they didn‘t think
had occurred. In both studies the responses seemed to imply that they ‗knew all along‘ – or rather
believed that they knew – what would happen. Fisch off quickly became a citation classic, and
has been cited over 700 times according to ISI Web of Knowledge. Fischoff only published a
few additional studies on the bias himself but each year an increasing number of articles appear
addressing the topic An excellent review of the first 15 years of research can be found in
Hawkins and Hastie , and two special issues of new theoretical and empirical work were
published in the past 10 years.

Although hindsight bias research asks participants to look backwards, it can be considered part
of a larger family of biases related to forecasting that include overconfidence.

Figure 2.1: Number of publications citing Fischhoff (1975) to 2010.

Web of Knowledge search conducted December 19, 2010. The astute reader may notice a
similarity to Christensen-Szalanski and Beach (figure2.1) who demonstrated a ‗citation bias‘ in
which the average number of citations per article per year increases over time for articles about
poor reasoning, whereas those concerning accurate reasoning do not. Human flaws make for
interesting reading. The planning fallacy has affective forecasting and foresight bias. All involve
an undue focus on confirmatory factors (e.g. factors leading to the known outcome, to why my
answer is correct, etc.) and neglect for alternatives (e.g. the opposite outcome, being wrong, etc.).
In the sections that follow, I outline the major things we‘ve learned from this research with an
eye toward the researcher interested in motivational factors. Along the way, I‘ll offer some
observations and a few criticisms too.

2.7.4 Diagnostic Testing

The hindsight bias manifests in the tendency to exaggerate the extent to which a past event could
have been predicted beforehand. First systematically investigated by Fischhoff , the bias is
sometimes called ―Monday morning quarterbacking‖ or the ―I knew-it-all-along effect‖ The
hindsight bias has particularly detrimental effects in the domain of medical decision making. I
begin with the classic study demonstrating how the bias diminishes the salutary impact of a
medical education exercise.

The Hindsight Bias as an Impediment to Learning A clinicopathologic conference (CPC) is a

dramatic event at a hospital. A young physician, such as a resident, is given all of the
documentation except the autopsy report that pertains to a deceased patient. After studying the
material for a week or so, the physician presents the case to the assembled medical staff, going
over the case and listing the differential diagnosis, which consists of the several possible
diagnoses for this patient. Finally, the presenting physician announces the diagnosis that he or
she thinks is the correct one. The presenter then sits down, sweating profusely, as the pathologist
who did the autopsy takes the podium and announces the correct diagnosis. The cases are chosen
because they are difficult, so the presenting physician‘s hypothesis often is incorrect.

The CPC is supposed to be an educational experience. Its goal is to enlighten the audience
members about diagnosing a particularly challenging case. However, after hearing the
pathologist‘s report, which contradicts the diagnosis made by the presenting physician, many
audience members think, ―Why aren‘t we hiring residents as astute as my cohort of residents?
This diagnosis was easy.‖ The audience members do not learn from the instructive case
presented at the CPC. Instead, they criticize the presenter, because in hindsight, they think the
case was relatively obvious.

A CPC is fertile ground for the manifestation of the hindsight bias; after the correct diagnosis is
disclosed, it seems as if it could easily have been discerned beforehand. Dawson et al. interrupted
eight CPCs at two critical junctures. At each CPC, after the presenter listed the five possible
diagnoses, the researchers asked half of the audience to assign a probability to each diagnosis
(i.e., the likelihood that it was correct). These participants were in the foresight group, because
they were asked to provide data before the correct diagnosis was revealed. These data were
collected, the pathologist then revealed the true diagnosis, and the CPC was paused a second
time for the other half of the audience to provide data.

The researchers asked them to assign a probability to each of the five possibilities as if they had
not just been informed of the right answer. These participants were in the hindsight group,
because they were asked to provide data after the correct diagnosis was revealed. For each case,
Dawson et al. asked two experts who had attended their domain-appropriate CPC to indicate, on
a 10-cm line, what proportion of good clinicians would choose the correct diagnosis. The
average of the two experts‘ ratings was used to divide the eight CPCs into two quartets—one
being the four more difficult cases and the other being the four less difficult ones. Dawson et al.
divided the attendees into groups of less experienced and more experienced physicians on the
basis of their training and seniority. As figure 2.1 shows, in three of the four experience–
diagnostic-difficulty groups, the hindsight participants estimated the correct answer to be more
likely than the foresight group did. The difference averaged approximately 12 percentage points.
Hindsight physicians mistakenly think that the case was easier than it really was (as evidenced
by the predictions of the foresight subjects). The educational benefit of the CPC is consequently
diminished, because the audience members think there is little or nothing to be learned, given
that they retrospectively judge their diagnoses to have been relatively accurate.

2.7.5 Advice

So what exactly causes this bias to happen? Researchers suggest that three key variables interact
to contribute to this tendency to see things as more predictable than they really are
  Cognitive: People tend to distort or even misremember their earlier predictions about an
event. It may be easier to recall information that is consistent with their current
knowledge.

 Metacognitive: When we can easily understand how or why an event happened, that
event can seem like it was easily foreseeable.

 Motivational: People like to think of the world as a predictable place. Believing an

outcome was "inevitable" can be comforting for some people.

When all three of these factors occur readily in a situation, the hindsight bias is more likely to
occur.

When a movie reaches its end and we discover who the killer really was, we might look back on
our memory of the film and misremember our initial impressions of the guilty character. We
might also look at all the situations and secondary characters and believe that given these
variables, it was clear what was going to happen. You might walk away from the film thinking
that you knew it all along, but the reality is that you probably didn't.

One potential problem with this way of thinking is that it can lead to overconfidence. If we
mistakenly believe that we have exceptional foresight or intuition, we might become too
confident and more likely to take unnecessary risks.

Such risks might be financial, such as placing too much of your nest egg in a risky stock
portfolio. They might also be emotional, such as investing too much of yourself in a bad
relationship.

So, is there anything that you can do to counteract the hindsight bias? Researchers Roese and
Vohs suggest that one way to counteract this bias is to consider things that might have happened
but didn't. By mentally reviewing potential outcomes, people might gain a more balanced view
of an outcome's apparent inevitability.

2.8 SUMMARY

 Source credibility takes play in one‘s experiences with persuasion and even with belief
perseverance. Low or high levels of credibility affects an individual and how they
perceive the information at hand. Multiple variables given in any situation affects how
 source credibility can affect the decision and the compliance of taking in new
information.

 The previous study had two independent variables with four different conditions (more
vs. less preferable) and (high vs. low credibility). A participant would prefer a study
conducted with a higher credible source more than when conducted with a low credible
source.

 We hypothesized that the participants would believe that child preferred the toy when the
study was conducted in a higher credible source such as an IV League University over a
low credible source such as a community college and be persuaded due to the level of
credibility.

 We also predicted that once the participant is told the study was fictitious they would
continue to believe the results are correct only if the study was conducted at a high
credible source instead of a low credible source. The dependent variable in the previous
study is the participant‘s responses to the questions asked in the survey relating towards
what they had read from the study.

 The dependent variable questioned how preferable will real children rank the forbidden
toy in the threat vs. not threat condition, and analysed the results. The tests conducted
resulted with a significant difference between high and low credibility sources and its
effect on one‘s believe initial results on previous studies.

 In this paper attempted to summarize many (though certainly not all) of the key findings
from large literature on hindsight bias. My primary focus was motivational mechanisms
that have been hypothesized to reduce the bias. Although hindsight bias is studied across
a variety of academic domains (e.g., psychology, business, medicine, and law) it does
suffer a bit from insularity. Ironically, the field is so large that it is relatively easy to cite
only papers directly examining hindsight bias, neglecting the many related fields that
could inform our research. For this reason, I introduced a number of studies from areas
not traditionally considered to fall under the hindsight bias umbrella. I hope that this will
inspire researchers to pursue creative ways to study this important phenomenon.
  Early belief perseverance studies tested whether people sometimes truly cling to
unfounded beliefs more so than is logically defensible. But, it is difficult to specify just
how much a given belief ―should‖ change in response to new evidence. One ―C‖ on a
math test should not totally overwhelm several years of ―A‖s in other math classes, but
how much change (if any) is warranted?

 There is one clear case in which researchers can specify how much belief change should
occur. That case is when the basis of a specific belief is totally discredited. For example,
assume that Mary tells Jose that the new student Sam is not very smart. Jose may even
meet and interact with Sam for several days before learning that Mary was actually
talking about a different new student. Because Jose knows that his initial belief about
Sam‘s intelligence was based on totally irrelevant information, Jose‘s social impression
about Sam should now be totally uninfluenced by Mary‘s initial statement. This
essentially describes the debriefing paradigm, the primary method used to study
unwarranted belief perseverance.

 In the first belief perseverance study using this method, half of the research participants
were led to believe that they had performed well on a social perceptiveness task; the other
half were led to believe that they had performed poorly. Later, all were told that their
performance had been manipulated by the researcher to see how participants responded to
success or failure.

2.9 KEYWORDS

 Self-Enhancement: Self-enhancement theory is based on various personality theories

and suggests that people have a basic drive to perceive the self positively and receive
positive evaluations from others. One's desire for positive feedback increases if positive
evaluations are not received.

 Self-Growth: It can help you in all areas of your life. It can help you at work. It can
change your attitude toward work, and therefore, open new opportunities for
advancement. Personal growth can help in growing emotionally and mentally and
becoming a more considerate, loving and positive person.
  Emotions: A strong feeling deriving from one's circumstances, mood, or relationships
with others.

 Cognitive Dissonance: Cognitive dissonance is the unpleasant emotion that results from
believing two contradictory things at the same time. The study of cognitive dissonance is
one of the most widely followed fields in social psychology.

 Perseverance: Perseverance is the ability to keep doing something in spite of obstacles.

People who persevere show steadfastness in doing something despite how hard it is or
how long it takes to reach the goal.

2.10 LEARNING ACTIVITY

1. Conduct a survey about belief perseverance bias.

_____________________________________________________________________________________
_________________________________________________________________

2. Conduct a session on cognitive dissonance bias with your friends.

_____________________________________________________________________________________
_________________________________________________________________

2.11 UNIT END QUESTIONS

A. Descriptive Questions

Short Questions

1. What is cognitive dissonance bias?

2. Describe conservatism bias?

3. What is confirmation bias?

4. Define representativeness bias

5. Explain illusion of control bias.

Long Questions

1. Explain hindsight bias.

 2. Discuss in brief the practical application of hindsight bias.

3. Illustrate belief perseverance bias.

4. Explain the diagnostic testing in hindsight bias.

5. Describe research review in hindsight bias.

B. Multiple Choice Questions

1. Identify the disadvantage of voltage divider bias if it has ?

a. High stability factor

b. Low base current
c. Many resistors
d. None of these

2. When does Thermal runaway occurs?

a. Collector is reverse biased

b. Transistor is not biased
c. Emitter is forward biased
d. Junction capacitance is high

3. What is the purpose of resistance in the emitter circuit of a transistor amplifier is to?

a. Limit the maximum emitter current

b. Provide base-emitter bias
c. Limit the change in emitter current
d. None of these

4. Which among the following satisfies the formula in the statement: In a transistor
amplifier circuit VCE = VCB +?

a. VBE
b. 2VBE
 c. 5 VBE
d. None of these

5. What method is generally used in the base resistor?

a. Amplifier circuits
b. Switching circuits
c. Rectifier circuits
d. None of these

Answers

1-c, 2-b, 3-c, 4-a, 5-b

2.12 REFERENCES

References

 Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work*.
The journal of Finance.

 Fama, E. F & French, K. R. (1992). The cross section of expected stock returns. the
Journal of Finance.

 Fischoff, B. (1982). For those condemned to study the past: Heuristics and biases in
hindsight. Judgement under uncertainty: Heuristics and biases.

Textbook

 Johnson, D. D. (2009). Overconfidence and war. Harvard University Press.

 Kahneman, D & Tversky, A. (1973). On the psychology of prediction. Psychological

review.

 Kahneman, D & Tversky, A. (1979). Prospect theory: An analysis of decision under risk.
Econometrical: Journal of the Econometric Society, 263-291.

Website
 [Link]

 [Link]

 [Link]
MASTER OF BUSINESS
ADMINISTRATION
(FINANCIAL MANAGEMENT)
SEMESTER II

BEHAVIORAL FINANCE
MBAEF 204
All rights reserved. No Part of this book may be reproduced or transmitted, in any form or by any means,
without permission in writing from Mizoram University. Any person who does any unauthorized act in
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 CONTENT

Unit - 3: Information Processing Biases .................................................................................... 4

UNIT - 3: INFORMATION PROCESSING BIASES

STRUCTURE

3.0 Learning Objectives

3.1 Introduction

3.2 Mental Accounting Bias

3.3 Anchoring and Adjustment Bias

3.4 Framing Bias

3.5 Availability Bias

3.6 Self-Attribution Bias

3.7 Outcome Bias

3.8 Recency Bias

3.8.1 Description

3.8.2 Practical Application

3.8.3 Research Review

3.8.4 Diagnostic Testing

3.8.5 Advice

3.9 Summary

3.10 Keywords

3.11 Learning Activity

3.12 Unit End Questions

3.13 References

3.0 LEARNING OBJECTIVES

After studying this unit, you will be able to

  Illustrate the concept of the mental accounting bias.

 Explain framing bias.

 Examine the availability bias.

3.1 INTRODUCTION

Psychologists have observed many systematic biases in the way that individuals update their
beliefs as new information is received. Many studies have suggested a first impressions matter
bias: exchangeable signals are processed in a way which puts too much weight on the initial
signals. In particular, people tend to pay too much attention to information which supports their
initial hypotheses, while largely disregarding (or even misinterpreting) information which
opposes these hypotheses. As they become more convinced that their beliefs are correct, the
problem becomes even more severe: many individuals seem to simply ignore all information
once they reach a ―confidence threshold‖.

A related phenomenon is belief polarization. Several experiments have taken two individuals
with opposing initial beliefs, then given them exactly the same sequence of information. In many
cases, both individuals became even more convinced of their initial position. Obviously this is in
contrast to Bayes‘ rule, which says that the prior should not affect the way in which the new
information is interpreted.

A third bias is overconfidence/under confidence: belief adjustments tend to be more extreme

than those of a Bayesian after a sequence of relatively uninformative signals (overconfidence),
but too conservative after a highly informative sequence of information.

Several recent papers in behavioural economics have focused on identifying some of these
biases, and exploring their implications for the standard economic models; see Rabin (1998) for
a comprehensive survey. Mullainathan made the potential connection between memory and
biased information processing, in a model which makes several explicit (psychology-based)
assumptions on the memory process. In particular, he assumes that the agent‘s ability to recall a
past event depends on how similar it is to the current environment, how similar it is to a
randomly drawn event, and how often he has recalled the event in the past. The goal of this paper
is to develop a more primitive model of limited memory, and to demonstrate how these biases
can arise from optimal behaviour.

The paper considers an infinitely lived decision maker, who receives a sequence of signals. Each
signal provides partial information about the ―state of the world‖, which may be either H or L. At
the start of each period, there is a probability η that this process will terminate, in which case the
decision-maker must take an action; the correct action depends on the true state of the world. The
paper will focus on the case where η is close to zero; this approximates a situation in which the
agent expects to receive a long sequence of signals, but is not exactly sure when the process will
end (and assigns an almost equal probability to all possibilities). A standard Bayesian decision-
maker would be able to base his decision on the entire sequence of signals. In contrast, we study
a decision-maker with a bounded memory: he is restricted to a finite set N = {1, .., N} of
available memory states. A memory process on N consists of an initial distribution g0 (which
tells the agent where to start), a transition rule σ (which tells him which state to go to when he
receives new information, as a function of the current state), and an action rule a (which tells him
what to do in the terminal period, as a function of the current state). This model of memory bears
some resemblance to several others proposed in the literature. Dow studies an agent who
searches sequentially for the lowest price, but can only remember each price as being in one of a
finite number of categories. Lipman and Rubinstein also discuss related models.

The basic idea of the model is that the decision-maker cannot recall all of the information that he
receives, and he cannot perform and recall an exact Bayesian update after each new signal. The
finite-state memory system just describes the heuristic that he uses to process and store
information. For example, suppose that there are two possible signals in the world: a low signal,
and a high signal. Then each state might correspond to a set of signals that the decision-maker
can recall (e.g., i high signals, N − i low signals in state i). The N memory states might also
correspond to a set of N different beliefs that the decision-maker can have; in this sense, the
transition rule σ describes his version of Bayesian updating. Since the decision-maker must
behave the same way every time he reaches a particular memory state, the memory rule which is
optimal in the long run may perform poorly in the short run. This accounts for many of the
―biases‖ described above, which may simply result from the optimal long-run behaviour when
memory is bounded.
The paper characterizes optimal behaviour for agents with bounded memory. As Rubinstein and
Piccione point out, the correct notion of optimality is not necessarily unambiguous in decision
problems with imperfect recall. In particular, there may be an incentive to deviate from the rule
which would be optimal under full commitment. Rubinstein and Piccione propose an alternative
solution concept - modified multi-self-consistency - which says that the agent cannot have any
incentive for single deviations from his strategy, assuming that he follows the strategy at all other
information sets. For the problem considered in this paper, there is no conflict between the two
solution concepts: every ex-ante optimal strategy is modified multi-self-consistent, so the agent
has no incentive to deviate.

3.2 MENTAL ACCOUNTING BIAS

The preceding anecdotes all illustrate the cognitive processes called mental accounting. What is
mental accounting? Perhaps the easiest way to define it is to compare it with financial and
managerial accounting as practised by organizations. According to my dictionary accounting is
'the system of recording and summarizing business and financial transactions in books, and
analysing, verifying, and reporting the results'. Of course, individuals and households also need
to record, summarize, analyse, and report the results of transactions and other financial events.
They do so for reasons similar to those which motivate organizations to use managerial
accounting: to keep track of where their money is going, and to keep spending under control.
Mental accounting is a description of the ways they do these things. How do people perform
mental accounting operations? Regular accounting consists of numerous rules and conventions
that have been codified over the years. You can look them up in a textbook. Unfortunately, there
is no equivalent source for the conventions of mental accounting; we can learn about them only
by observing behaviour and inferring the rules. Three components of mental accounting receive
the most attention here. The first captures how outcomes are perceived and experienced, and how
decisions are made and subsequently evaluated. The accounting system provides the inputs to do
both ex ante and ex post cost-benefit analyses. This component is illustrated by the anecdote
above involving the purchase of the quilt. The consumer's choice can be understood by
incorporating the value of the 'deal' (termed transaction utility) into the purchase decision
calculus. A second component of mental accounting involves the assignment of activities to
specific accounts. Both the sources and uses of funds are labelled in real as well as in mental
accounting systems. Expenditures are grouped into categories (housing, food, etc.) and spending
is sometimes constrained by implicit or explicit budgets. Funds to spend are also labelled, both
as flows (regular income versus windfalls) and as stocks (cash on hand, home equity, pension
wealth, etc.). The first two anecdotes illustrate aspects of this categorization process. The
vacation in Switzerland was made less painful because of the possibility of setting up a Swiss
lecture mental account, from which the expenditures could be deducted. Similarly, the notional
United Way mental account is a flexible way of making losses less painful. The third component
of mental accounting concerns the frequency with which accounts are evaluated and what Read,
Loewenstein and Rabin have labelled 'choice bracketing'. Accounts can be balanced daily,
weekly, yearly, and so on, and can be defined narrowly or broadly. A well-known song implores
poker players to 'never count your money while you're sitting at the table'. An analysis of
dynamic mental accounting shows why this is excellent advice, in poker as well as in other
situations involving decision making under uncertainty (such as investing). The primary reason
for studying mental accounting is to enhance our understanding of the psychology of choice. In
general, understanding mental accounting processes helps us understand choice because mental
accounting rules are not neutral. That is, accounting decisions such as to which category to
assign a purchase, whether to combine an outcome with others in that category, and how often to
balance the 'books' can affect the perceived attractiveness of choices. They do so because mental
accounting violates the economic notion of fungibility. Money in one mental account is not a
perfect substitute for money in another account. Because of violations of fungibility, mental
accounting matters. The goal of this paper is to illustrate how mental accounting matters. To this
end I draw upon research conducted over the past two decades. This describes where 1 think the
field is now, having been informed by the research of many others, especially over the past few
years.

The Value Function

We wish to understand the decision-making process of an individual or a household interacting

in an economic environment. How does a person make economic decisions, such as what to buy,
how much to save, and whether to buy or lease an item? And how are the outcomes of these
financial transactions evaluated and experienced? Following my earlier treatment of these
questions I assume that people perceive outcomes in terms of the value function of Kahneman
and Tversky's prospect theory. The value function can be thought of as a representation of some
central components of the human perceived pleasure machine. It has three important features,
each of which captures an essential element of mental accounting.

 The value function is defined over gains and losses relative to some reference point. The
focus on changes, rather than wealth levels as in expected utility theory, reflects the
piecemeal nature of mental accounting. Transactions are often evaluated one at a time,
rather than in conjunction with everything else.

 Both the gain and loss functions display diminishing sensitivity. That is, the gain function
is concave and the loss function is convex. This feature reflects the basic psychophysical
principle (the Weber Fechner law) that the difference between $10 and $20 seems bigger
than the difference between $1000 and $1010, irrespective of the sign.

 Loss aversion. Losing $100 hurts more than gaining $100 yields pleasure: v {x) < — v
(—x). The influence of loss aversion on mental accounting is enormous, as will become
evident very quickly.

Decision Frames

The role of the value function in mental accounting is to describe how events are perceived and
coded in making decisions. To introduce this topic, it is useful to define some terms. Tversky and
Kahneman define a mental account J quite narrowly as 'an outcome frame which specifies

i. The set of elementary outcomes that are evaluated jointly and the manner in which
they are combined and

ii. A reference outcome that is considered neutral or normal'.

(Typically, the reference point is the status quo.) According to this definition, a mental account is
a frame for evaluation. I wish to use the term 'mental accounting' to describe the entire process of
coding, categorizing, and evaluating events, so this narrow definition of a mental account is a bit
confining. Accordingly, I will refer to simply outcome frames as 'entries'. In a later paper,
Kahneman and Tversky, propose three ways that outcomes might be framed: in terms of a
minimal account, a topical account, or a comprehensive account. Comparing two options using
the minimal account entails examining only the differences between the two options,
disregarding all their common features. A topical account relates the consequences of possible
choices to a reference level that is determined by the context within which the decision arises. A
comprehensive account incorporates all other factors including current wealth, future earnings,
possible outcomes of other probabilistic holdings, and so on. (Economic theory generally
assumes that people make decisions using the comprehensive account.) The following example*
illustrates that mental accounting is topical.

Imagine that you are about to purchase a jacket for ($125) and a calculator for (S15). The
calculator salesman informs you that the calculator you wish to buy is on sale for ($10) at the
other branch of the store, located 20 minutes‘ drive away. Would you make the trip to the other
store? When two versions of this problem are given (one with the figures in parentheses, the
other with the figures in brackets), most people say that they will travel to save the $5 when the
item costs $15 but not when it costs $125. If people were using a minimal account frame they
would be just asking themselves whether they are willing to drive 20 minutes to save $5, and
would give the same answer in either version. Interestingly, a similar analysis applies in the
comprehensive account frame. Let existing wealth be W and W be existing wealth plus the jacket
and calculator minus $140. Then the choice comes down to the utility of W plus $5 versus the
utility of W plus 20 minutes. This example illustrates an important general point — the way a
decision is framed will not alter choices if the decision maker is using a comprehensive, wealth-
based analysis. Framing does alter choices in the real world because people make decisions
piecemeal, influenced by the context of the choice.

Hedonic Framing

The jacket and calculator problem does demonstrate that mental accounting is piecemeal and
topical, but there is more to learn from this example. Why are we more willing to drive across
town to save money on a small purchase than a large one? Clearly there is some psychophysics
at work here. Five dollars seems like a significant saving on a $15 purchase, but not so on a $125
purchase. But this disparity implies that the utility of the saving must be associated with the
differences in values rather than the value of the difference. That is, the utility of saving $5 on
the purchase of the expensive item must be (v(-$125) - v(-$120) (or perhaps the ratio of these
values) rather than v($5), otherwise there would be no difference between the two versions of the
problem. What else do we know about mental accounting arithmetic? Specifically, how are two
or more financial outcomes (within a single account) combined? This is an important question
because we would like to be able to construct a model of how consumers evaluate events such as
purchases that typically involve combinations of outcomes, good or bad.

One possible place to start in building a model of how people code combinations of events is to
assume they do so to make themselves as happy as possible. To characterize this process we
need to know how someone with a prospect theory value function could wish to have the receipt
of multiple outcomes framed. That it, for two outcomes x and y, when will v(x + y) be greater
than v{x) + v(j)? I have previously considered this question (Thaler, 1985). Given the shape of
the value function, it is easy to derive the following principles of hedonic framing, that is, the
way of evaluating joint outcomes to maximize utility.

 Segregate gains (because the gain function is concave).

 Integrate losses (because the loss function is convex).

 Integrate smaller losses with larger gains (to offset loss aversion).

 Segregate small gains (silver linings) from larger losses (because the gain function is
steepest at the origin, the utility of a small gain can exceed the utility of slightly reducing
a large loss).

As I showed, most people share the intuition that leads to these principles. That is, if you ask
subjects 'Who is happier, someone who wins two lotteries that pay $50 and $25 respectively, or
someone who wins a single lottery paying $75?' 64% say the two-time winner is happier. A
similar majority shared the intuition of the other three principles. These principles are quite
useful in thinking about marketing issues. In other words, if one wants to describe the advantages
and disadvantages of a particular product in a way that will maximize the perceived
attractiveness of the product to consumers, the principles of hedonic framing are a helpful guide.
For example, framing a sale as a 'rebate' rather than a temporary price reduction might facilitate
the segregation of the gain in line with principle.

The failure of the hedonic editing hypothesis

It would be convenient if these same principles could also serve as a good descriptive model of
mental accounting. Can people be said to edit or parse the multiple outcomes they consider or
experience in a way that could be considered optimal, that is, hedonic editing.* More formally, if
the symbol '&' is used to denote the cognitive combination of two outcomes, then hedonic
editing is the application of the following rule

v{x&.y) = Max[v(x + y), v{x) + v(y)\

The hypothesis that people engage in hedonic editing has obvious theoretical appeal,! but some
thought reveals that it cannot be descriptively correct. Consider the jacket and calculator problem
again. If the $5 saving were coded in a utility-maximizing way it would be segregated in either
case, inconsistent with the data. Furthermore, there must be some limits to our abilities to engage
in self-deception. Why stop at segregating the $5 gain? Why not code it as five gains of $1?
Nevertheless, hedonic editing represents a nice starting point for the investigation of how people
do code multiple events. Eric Johnson and I have investigated the limits of the hedonic editing
hypothesis. Our ultimate goal was to explore the influence of prior outcomes on risky choices
(see below), but we began with the more basic question of how people choose to code multiple
events such as a gain of $30 followed by a loss of $9. One approach we used was to ask people
their preferences about temporal spacing. For two specified financial outcomes, we asked
subjects who would be happier, someone who had these two events occur on the same day, or a
week or two apart? The reasoning for this line of inquiry was that temporal separation would
facilitate cognitive segregation. So if a subject wanted to segregate the outcomes x and y, he
would prefer to have them occur on different days, whereas if he wanted to integrate them, he
would prefer to have them occur together. The hedonic editing hypothesis would be supported if
subjects preferred temporal separation for cases where the hypothesis called for segregation, and
temporal proximity when integration was preferred. For gains, the hedonic editing hypothesis
was supported. A large majority of subjects thought temporal separation of gains produced more
happiness. But, in contrast to the hedonic editing hypothesis, subjects thought separating losses
was also a good idea. Why? The intuition for the hypothesis that people would want to combine
losses comes from the fact that the loss function displays diminishing sensitivity. Adding one
loss to another should diminish its marginal impact. By wishing to spread out losses, subjects
seem to be suggesting that they think that a prior loss makes them more sensitive towards
subsequent losses, rather than the other way around. In other words, subjects are telling us that
they are unable to simply add one loss to another (inside the value function parentheses). Instead,
they feel that losses must be felt one by one, and that bearing one loss makes one more sensitive
to the next. To summarize, the evidence suggests that the rules of hedonic framing are good
descriptions of the way people would like to have the world organized (many small gains
including silver linings; losses avoided if possible but otherwise combined). People will also
actively parse outcomes consistent with these rules, with the exception of multiple losses. There
are two important implications of these results for mental accounting. First, we would expect
mental accounting to be as hedonically efficient as possible. For example, we should expect that
opportunities to combine losses with larger gains will be exploited wherever feasible. Second,
loss aversion is even more important than the prospect theory value function would suggest, as it
is difficult to combine losses to diminish their impact. This result suggests that we should expect
to see that some of the discretion inherent in any accounting system will be used to avoid having
to experience losses.

Mental Accounting Decision Making

What happens when a consumer decides to buy something, trading money for some object? One
possibility would be to code the acquisition of the product as a gain and the forgone money as a
loss. But loss aversion makes this frame hedonically inefficient. Consider a thirsty consumer
who would rather have a can of soda than one dollar and is standing in front of a vending
machine that sells soda for 75 cents. Clearly the purchase makes her better off, but it might be
rejected if the payment were cognitively multiplied by 2.25 (an estimate of the coefficient of loss
aversion). This thinking has led both Kahneman and Tversky and me to reject the idea that costs
are generally viewed as losses. Instead, I proposed that consumers get two kinds of utility from a
purchase: acquisition utility and transaction utility. Acquisition utility is a measure of the value
of the good obtained relative to its price, similar to the economic concept of consumer surplus.
Conceptually, acquisition utility is the value the consumer would place on receiving the good as
a gift, minus the price paid. Transaction utility measures the perceived value of the 'deal'. It is
defined as the difference between the amount paid and the 'reference price' for the good, that is,
the regular price that the consumer expects to pay for this product. The following example
illustrates the role of transaction utility. You are lying on the beach on a hot day. All you have to
drink is ice water. For the last hour you have been thinking about how much you would enjoy a
nice cold bottle of your favourite brand of beer. A companion gets up to go make a phone call
and offers to bring back a beer from the only nearby place where beer is sold (a fancy resort
hotel). He says that the beer might be expensive and so asks how much you are willing to pay for
the beer. He says that he will buy the beer if it costs as much or less than the price you state. But
if it costs more than the price you state he will not buy it. You trust your friend, and there is no
possibility of bargaining with the (bartender). What price do you tell him? Two versions of the
question were administered, one using the phrases in parentheses, the other the phrases in
brackets. The median responses for the two versions were $2.65 (resort) and $1.50 in 1984
dollars. People are willing to pay more for the beer from the resort because the reference price in
that context is higher. Note that this effect cannot be accommodated in a standard economic
model because the consumption experience is the same in either case; the place of purchase
should be irrelevant. The addition of transaction utility to the purchase calculus leads to two
kinds of effects in the marketplace. First, some goods are purchased primarily because they are
especially good deals. Most of us have some rarely worn items in our closets that are testimony
to this phenomenon. Sellers make use of this penchant by emphasizing the savings relative to the
regular retail price (which serves as the suggested reference price). In contrast, some purchases
that would seemingly make the consumer better off may be avoided because of substantial
negative transaction utility. The thirsty beer drinker who would pay $4 for a beer from a resort
but only $2 from a grocery store will miss out on some pleasant drinking when faced with a
grocery store charging $2.50.

Opening and Closing Accounts

One of the discretionary components of an accounting system is the decision of when to leave
accounts 'open' and when to 'close' them. Consider the example of someone who buys 100 shares
of stock at $10 a share. This investment is initially worth $1000, but the value will go up or
down with the price of the stock. If the price changes, the investor has a 'paper' gain or loss until
the stock is sold, at which point the paper gain or loss becomes a 'realized' gain or loss. The
mental accounting of paper gains and losses is tricky (and depends on timing — see below), but
one clear intuition is that a realized loss is more painful than a paper loss. When a stock is sold,
the gain or loss has to be 'declared' both to the tax authorities and to the investor (and spouse).
Because closing an account at a loss is painful, a prediction of mental accounting is that people
will be reluctant to sell securities that have declined in value. In particular, suppose an investor
needs to raise some cash and must choose between two stocks to sell, one of which has increased
in value and one of which has decreased. Mental accounting favours selling the winner whereas a
rational analysis favours selling the loser. Odeon finds strong support for the mental accounting
prediction. Using a data set that tracked the trades of investors using a large discount brokerage
firm, Odeon finds that investors were more likely to sell one of their stocks that had increased in
value than one of their stocks that had decreased Other evidence of a reluctance to close an
account in the 'red' comes from the world of real accounting. Most public corporations make
official earnings announcements every quarter. Although earnings are audited, firms retain some
discretion in how quickly to count various components of revenues and expenses, leaving them
with some control over the actual number they report. Several recent papers show that firms use
this discretionary power to avoid announcing earnings decreases and losses. Specifically, a plot
of earnings per share (in cents per share) or change in earnings per share (this quarter versus
same quarter last year) shows a sharp discontinuity at zero. Firms are much more likely to make
a penny a share than to lose a penny a share, and are much more likely to exceed last year's
earnings by a penny than to miss by a penny. So small losses are converted into small gains. In
contrast, large gains seem to be trimmed down (to increase the chance of an increase again next
year) whereas moderate losses are somewhat inflated (a procedure known in accounting circles
as 'taking the big bath'). Apparently, firms believe that shareholders (or potential shareholders)
react to earnings announcements in a manner consistent with prospect theory.

Example

Jim rented a car from Carrentals Limited. The rented car got a little dint when Jim was driving it
and the company charged him $800 for that dint. Jim applied to his third party insurer for
claiming back $800. Jim thought that upon receiving the claim he will contribute this amount for
a charitable cause and if he doesn‘t get that back he will not be able to do so at all.

This means Jim is not willing to absorb this loss and dip onto his main savings account. As per
mental accounting theory, Jim must treat all the amount of money as fungible. However, in
reality, it is very difficult to differentiate savings and unexpected gains/losses.

3.3 ANCHORING AND ADJUSTMENT BIAS

Over the next decade, advances in genomics will make it increasingly possible to provide
patients with personalized, genetic-based risks of common diseases, allowing them the
opportunity to take with personalized, genetic-based risks of common diseases, allowing them
the opportunity to take preventive steps through behavioural changes. However, previous
research indicates that people may insufficiently adjust their subjective risk to the objective risk
value communicated to them by a healthcare provider, a phenomenon called anchoring-and-
adjustment bias. In this narrative review, we analyse existing research on how patients process
disease-risk information, and the processing biases that may occur, to show that the bias
observed in disease-risk communication is potentially malleable to change. We recommend that,
to reduce this bias and change patients‘ misperceptions of disease risk in clinical settings, future
studies investigate the effects of forewarning patients about the bias, tailoring risk information to
their numeracy level, emphasizing social roles, increasing motivation to form accurate risk
perception, and reducing social stigmatization, disease worry and information overload.

Over the next decade, communication to patients about their disease risk based on genetic
susceptibility is likely to become increasingly important in the clinical context. Rapid advances
susceptibility is likely to become increasingly important in the clinical context. Rapid advances
in genomics will make it increasingly possible to provide patients with personalized, genetic
based risks of common diseases, allowing them the opportunity to take preventive steps through
behavioural changes. It is also possible to estimate disease risk based on patients‘ family and
medical history and nutritional life-styles, and communication of this type of risk information is
becoming more and more common. Therefore, communication of disease risk to patients is
relevant to both present and future healthcare contexts, highlighting the importance of ensuring
people‘s accurate understanding of their disease risk. Existing research on how patients process
disease-risk information, and the processing biases that may occur, may help to illuminate how
best to provide this risk information to patients. The present paper explores one such bias,
anchoring-and-adjustment, which is the insufficient adjustment of one‘s subjective risk to an
objective risk communicated by a healthcare provider, and investigates whether and/or how this
bias can be diminished. As will be discussed below in more detail, the investigation of this bias
in other experimental contexts has shown that a certain type of this bias can be diminished. The
literature reviewed in this paper suggests that certain type of this bias can be diminished. The
literature reviewed in this paper suggests that the bias, as it exists in disease-risk communication,
resembles the type that was shown to be malleable to change. Therefore, it becomes possible to
make research recommendations to examine how this bias might be reduced in disease-risk
communications. Below we discuss the importance of this bias for health outcomes (Effects of
insufficient adjustment of disease risk on patient outcomes section), its definition and prevalence
in disease-risk communication (definition and prevalence of anchoring and adjustment bias
section), factors reported to be affecting this bias in controlled experimental settings (Factors
affecting anchoring-and adjustment bias section), factors that may affect the bias in provider-
patient communications of disease risk (Factors affecting adjustment of disease-risk perception
section), and recommend future research towards diminishing this bias in provider-patient
communication (Recommendations for future research and conclusion sections).

Effects of Insufficient Adjustment of Disease-Risk on Patient Outcomes

Previous research suggests that eliminating patients‘ biases in disease-risk perception may
decrease disease worry and lead to better informed decisions about health-protective behaviour
decrease disease worry and lead to better informed decisions about health-protective behaviour
change. It also suggests that changing risk perception towards a more accurate risk value is
positively associated with either actual or intended health-protective behaviour change or a
decrease in disease worry. Bowen and her colleagues‘ randomized trial in 211 women
demonstrated that when women‘s risk perception became more accurate in a genetic counselling
session due to a decrease in their overestimated perception of breast cancer risk, their interest in
having genetic testing for breast cancer decreased accordingly. Similarly, in a controlled trial that
compared the effectiveness of genetic counselling of individuals versus groups on breast cancer
risk, women‘s overestimated risk perceptions decreased together with their interest in genetic
testing for breast cancer for both types of counselling. These findings suggest that more accurate
risk perceptions lead people to make more informed decisions. In addition, where perceived risk
increases toward a higher objective risk, people engage in more health protective behaviour. The
Health Belief Model, Protection Motivation Theory, and Extended Parallel Process Model
identify perceived risk as an important predictor of change in health behaviours. In trials of
interventions based on these theories, changes in risk perception have been associated with actual
or intended health-protective behaviour change or a decrease in disease worry. The Health Belief
model highlights the importance of perceived risk as a predictor of health behaviour change. It
predicts that people will engage in a health-protective behaviour (e.g., quitting smoking) to avoid
a disease (e.g., lung cancer) if they perceive their risk for that disease to be high (Perceived
Susceptibility); the consequences of contracting the disease as severe (Perceived Severity); the
health-protective behaviour to be effective in decreasing the susceptibility for and severity of the
disease (Perceived Benefits), and the barriers to engage in health-protective behaviour to be low
(Perceived Barriers). For example, in a controlled trial of 295 women an intervention designed to
increase mammography use increased perceived susceptibility (i.e., perceived risk). Participants
were interviewed at 3-month follow-up and those who had not obtained a mammogram by then
were interviewed again at 6-month follow-up. It was observed that the rate of obtaining a
mammogram increased at both of these time points compared to the baseline. The effect of the
increase in risk perception on obtaining a mammogram was modified by how much participants
believed in the benefits of a mammogram and the perceived severity of breast cancer. These
findings indicate that other factors should be considered as mediating or moderating the effect of
risk perception on health-protective behaviours.

More recent health behaviour change models such as Protection Motivation Theory (PMT) and
Extended Parallel Process Model (EPPM) also predict that people will engage in a health and
Extended Parallel Process Model (EPPM) also predict that people will engage in a health
protective behaviour to a greater extent if they perceive their risk for the disease to be high;
consequences of contracting the disease to be severe; and the health-protective behaviour as
effective. In addition, PMT and EPPM predict that the more confidence people have to engage in
a health-protective behaviour (self-efficacy), the more they will actually engage in this
behaviour. EPPM also predicts that high perceived risk might sometimes lead to avoidance of
health protective behaviour, especially when people have low self-efficacy. In a recent study
based on these two models, smokers were asked to report their intention to quit smoking if they
were hypothetically found to have a risk-increasing gene for heart disease. Increased risk
perceptions as a result of having this gene led to an increase in intentions to quit smoking.
Although this effect was not moderated by smokers‘ self-efficacy, as EPPM would predict, self-
efficacy had an independent effect on intentions to quit. Changed risk perception is not only
associated with a change in health-protective behaviours but also in disease worry. In four
studies of breast cancer counselling outcomes, the decrease in women‘s overestimation of breast
cancer risk towards a more accurate risk value as a result of counselling was associated with a
decrease in their cancer worry. It also has to be noted here that the relationship between risk
perception and patient outcomes discussed above in this section usually concerns relatively low
levels of risks (i.e., 15%–35% absolute life time risks). However, according to prospect theory
when people face relatively higher levels of risk they become less likely to carefully weigh the
risk information and more likely to think in terms of certainties (e.g., I will / will not get the
disease). Therefore, when disease-risk information concerns high risk values, it is possible that
changing risk perception will have a relatively lesser impact on subsequent health-protective
behaviour and disease-worry than in the context of lower risk values. As will be discussed below
in more detail, participants in genetic counselling sessions tend to insufficiently adjust their
perceived disease risk to the objective risk. It is therefore very likely that in such contexts the
related changes in disease worry and health protective behaviours would be less than the possible
magnitude of change if individuals adjusted their perceived risk more sufficiently. Therefore,
identifying factors that lead to greater adjustments becomes an important step towards achieving
better informed decisions about health protective behaviours.

Definition and Prevalence of Anchoring and Adjustment Bias

A number of heuristics are important in healthcare contexts. One heuristic that seems to be
particularly important in the context of provider-patient communication is the anchoring and- to
be particularly important in the context of provider-patient communication is the anchoring and-
adjustment heuristic. This heuristic is utilized when patients receiving information about their
objective risk of disease anchor their risk perception on their subjective risk, and, therefore, do
not sufficiently move toward the objective risk. As a result, their final perceived risk falls
somewhere in-between the initial subjective estimate and the objective risk, leading them to
continue under- or over-estimating their disease risk. This bias is common in communication in
general and in health-care contexts in particular. Since it can be a demanding process to guess
what is in the mind of one‘s communication partner, individuals take short-cuts to guess what
their partner means by an ambiguous utterance. They initially interpret a message from their own
perspective, and then try to adjust to their communication partner‘s perspective, showing an
anchoring-and-adjustment bias. In healthcare settings, too, findings from a number of research
studies can be interpreted as indicating that the anchoring-and-adjustment heuristic operates in
such settings. Healthcare providers, for example, insufficiently adjust what they know about
medical issues to the level of knowledge among patients, thus overestimating patients‘ ability to
understand medical concepts and terminology medical concepts and terminology. In addition,
prior research has shown that patients insufficiently adjust their perception of numeric risk when
they are provided with their objective risk for breast cancer. Such studies use the breast cancer
risk models of Gail or Claus to calculate participants‘ objective cancer risk based on participants‘
self-reported risk factors (e.g., family history). Participants are also asked in those studies to
report their subjective risk estimates for breast cancer before being given the objective risk
estimates in a genetic counselling session. Thus, it becomes possible to see how people adjust
their subjective risk estimates to the objective risk. In a study conducted with 450 of women who
had a family history of breast cancer and were referred to breast cancer counselling, women who
overestimated their numeric breast cancer risk prior to genetic counselling did not sufficiently
decrease their risk estimate in the direction of the objective risk. Therefore, they still
overestimated it after counselling. The same study also reported that those women who
underestimated their numeric risk prior to counselling did not increase it enough to match the
counselled risk figure. A similar study of 108 women visiting a cancer clinic to receive
counselling on breast cancer risk showed an insufficient adjustment of their perceived risk for
breast cancer. Although genetic counselling led these patients to decrease their subjective
estimate from 61% to 44% on average in the direction of the objective risk provided to them (i.e.,
22.4% on average), post-counselling risk estimates were still significantly higher than the
objective risk. These women also incorrectly recalled the objective risk values they were given,
and the incorrect values were biased toward their initial estimates. Other studies‘ findings can
also be interpreted as suggesting an insufficient adjustment of perceived disease-risk, although
these studies did not report whether the post-counselling risk estimates were significantly
different from the objective risk value. In a study of 193 women visiting 10 familial cancer
clinics to receive genetic counselling for breast cancer, more than two-thirds of the women who
underestimated their risk prior to counselling continued to underestimate it after the counselling.
About half of the women who overestimated their risk prior to counselling continued to
overestimate it after counselling. In another controlled trial of 732 men and women, participants
were given their risk for heart attack based on objective risk factors, such as cholesterol level,
blood pressure, weight and smoking behaviour. More than two-thirds of the participants did not
change their perceived risk for heart attack. A randomized trial of 340 patients comparing the
effectiveness of telephone versus in-person genetic counselling for breast cancer reported a
decrease in average risk perception from 30% prior to counselling to 20% after counselling for
in-person counselling and a decrease from 30% to 21 % for telephone-counselling.6 However,
the post-counselling risk estimates were still more than twice as high as the objective risk
provided during the counselling (i.e., 9.9 % for in-person counselling and 9.5% for group
counselling, on average). One may propose that disbelief in an objective risk estimate due to
various reasons, such as self-serving biases that lead people to discard communicated risk
information, might be responsible for such insufficient adjustment. However, evidence suggests
that this is not the case. In a controlled trial, 121 women recruited from newspaper
advertisements were provided with their breast cancer risk. It was found that they insufficiently
adjusted their perceived risk for breast cancer after breast-cancer risk counselling. It was also
found that the degree to which the objective risk estimate was perceived as credible, trustworthy
and accurate was not related to the amount of adjustment. In another study of 108 female patients
visiting a cancer clinic to receive breast-cancer counselling, the patients incorrectly recalled their
objective breast-cancer risk given to them by providers. Most importantly, their incorrectly
recalled risk values were biased toward their initial subjective estimates independent of their
disbelief in the recalled risk value. This finding shows that the bias relates to processing of the
risk information. Therefore, in line with research on how people make sense of messages in
communication it is reasonable to conclude that the insufficient adjustment of communication it
is reasonable to conclude that the insufficient adjustment of risk perception observed in disease-
risk communication is, at least partly, a result of the anchoring-and-adjustment heuristic. In sum,
the anchoring-and-adjustment bias seems to be present in a number of healthcare contexts, and
particularly, in the communication of disease risk information in genetic counselling. Thus, the
question becomes, how can this bias be reduced and what are the effects of reducing it?

Factors Affecting Anchoring-and-Adjustment Bias

Until recently, investigation of the anchoring-and-adjustment heuristic in decision making

research had shown that the bias is very robust and almost impossible to diminish research had
shown that the bias is very robust and almost impossible to diminish. However, recent studies
have distinguished adjustment from self-generated versus externally provided anchors, and have
found that the former type is malleable to change. Thus, if the adjustment of disease risk
perception is similar to the adjustment from self-generated anchors, it might be possible to
mitigate this bias in disease-risk communication. The classical investigation of anchoring-and-
adjustment bias tested adjustments from externally provided anchors. People were first given an
anchor by the experimenter, and then asked to make their decisions. For example, people were
asked to estimate the average number of babies born in the U.S. per day either after they
considered whether it was higher or lower than 100 or after they considered whether it was
higher or lower than 50,000. The median responses were estimates of 1,000 in the former case
and 40,000 in the latter case, clearly showing that the provided anchor puts a drag on the final
estimate. The results did not change after explaining to participants that the anchor values were
randomly chosen and had nothing to do with the correct answer. Forewarning participants about
the bias, giving them incentives for accuracy, and extremity of the anchor also did not lead to
any difference in the biased responses. However, more recently, Epley and Gilovich noted that
anchors can be self-generated, rather than being externally provided. For example, without being
prompted, people use Earth‘s orbiting time as an anchor in guessing Mars‘s orbiting time around
the sun. Externally provided anchors seem to prime automatically and make accessible values
near the anchor thereby not allowing for effortful adjustment, whereas self-generated anchors do
not involve such processes above. Recent experiments have shown that when people were given
financial incentives for accuracy or were forewarned that their estimates might be biased, they
were more likely to show improved adjustment with self-generated, but not externally provided,
anchors. Motivation to engage in effortful thinking has also been related to increased adjustment.
Thus, effortful thinking and motivation to be accurate seems to be able to diminish the
anchoring-and-adjustment bias for self-generated anchors. In disease-risk communication
contexts, it is possible that people do not self-generate their initial disease-risk estimates (i.e.,
anchor values), but instead, rely on estimates provided in media or by other people around them.
However, in the next section, we demonstrate that people‘s subjective estimates of disease risk
resemble self-generated rather than externally provided anchors.

Factors Affecting Adjustment of Disease-Risk Perception

Prior research has shown that externally provided risk values have an effect on people‘s
estimation of risk for a health condition. On the other hand, the factors affecting adjustment of
risk perception in the context of disease-risk communication show that the adjustment can be
modified. This suggests that such adjustments are from self-generated, rather than externally
provided, anchors. Although we do not yet know exactly what factors modify the adjustment
provided, anchors. Although we do not yet know exactly what factors modify the adjustment of
perceived disease-risk, the existing literature suggests that effortful thinking and motivation to
adjust underlie the amount of adjustment. Effortful thinking refers to the level of attention that is
devoted to a task. For example, people who have sufficient time to complete a task or who are
not under the influence of alcohol are more likely to engage in effortful thinking. The
involvement of effortful thinking in adjustment of disease-risk perception can be seen in studies
reporting an effect of disease worry on how much people change their disease-risk perception.
Previous experimental studies have found that strong negative affect leads to decreased
systematic processing or effortful thinking suggesting that increased worry may decrease
systematic processing, and hence, adjustment. In a randomized trial of 400 women that compared
general health counselling with individualized breast-cancer risk counselling, women who were
more worried about breast cancer prior to a genetic counselling session were less likely to
change their perceived risk for breast cancer after the counselling. This result seems to be
consistent with the effect of effortful thinking on adjustments from self-generated anchors.
Disease worry also seems to mediate the insufficient adjustment of risk perception among
individuals at high risk for breast cancer. There is evidence to suggest that women who are at a
higher risk for breast cancer due to their family history worry about breast cancer to a greater
extent.42 There is also evidence showing that high-risk women with an individual or family
history of breast cancer are also less likely to change their perceived risk for breast cancer after
receiving counselling compared to those at lower risk. Thus, it is possible that high risk
individuals worry about breast cancer more. As a result, this worry might lead them to adjust
their perceived risk for breast cancer to a lesser extent. The effects of worry and level of risk as
moderators of another factor, time, on disease-risk adjustment also indicate a role for effortful
thinking. In a study of 283 women with a family history of breast cancer, their perceived risk
was more accurate, and over-estimations were more reduced, right after the counselling than at
the twelve-month follow-up suggesting the role of time. Another study with 203 women who had
a family history of breast cancer found that time effects were greater for those at high risk or for
affected patients than for those at moderate or low risk. This study also found that high-risk and
affected people worried about cancer more than the other groups. Thus, it might be the case that
individuals with higher risk perceptions and higher worry engaged in less systematic processing,
which, together with time, prevented them from adjusting to the objective risk. Another factor
affecting people‘s engagement in effortful thinking might be numeracy, which is the ability to
process basic probability and numerical concepts. There is evidence to suggest that people low in
numeracy, compared to those high in numeracy, are less likely to attend to the numeric risk
information and more likely to be affected by how the numeric risk information is framed. For
example, people in general think that a patient poses a greater threat to others when they are told
that 20 out of 100 similar patients commit an act of violence compared to when they are told that
the patient has 20% risk of committing a violent act. It was shown that low numeracy people are
more likely to be affected by such framing effects. They were also found to adjust their risk
perception consistent with provided numeric risk information to a lesser extent compared to
those with high numeracy skills. A sample of 500 women randomly drawn from a registry of
female veterans was given numeric risk information about how much mammography screening
decreased their chances of death from breast cancer. After receiving this information, women
tended to overestimate how much mammography screening can reduce their risk. However,
those with higher numeracy skills were less likely to overestimate and more likely to adjust their
risk perception toward objective risk. In this study, processing the numeric risk information more
attentively (i.e., more effortful processing) may have led those high in numeracy to adjust their
risk perception toward the communicated risk those high in numeracy to adjust their risk
perception toward the communicated risk information to a greater extent. It is also possible that
numeracy led to a better understanding of numeric risk values. Further research is needed to
uncover the mediating mechanism between numeracy and adjustment of perceived risk. The
second set of studies that will be reviewed in this section seems to indicate a role for motivation
in the adjustment of disease-risk perception. For example, change in risk perception has been
reported to be moderated by whether or not the risk counselling was personalized. In Green and
his colleagues randomized controlled trial, 211 women with individual or family history of breast
cancer were either given individualized estimates in a standard genetic counselling session or
were given general information about the risk of breast cancer for different populations in a
computer-based intervention. The overestimation of risk was much more reduced in the former
compared to the latter condition. It is possible that, in this study, the personalized risk
counselling might have motivated participants more to engage in adjustment. However, other
factors such as lack of face-to-face communication in computer based counselling might have
also played a role in the adjustment. In another controlled trial, 30 732 men and women were
classified as to whether they were below average, average or above average risk for heart-disease
based on their risk factors, such as cholesterol level, blood pressure, weight and smoking
behaviour. Four different risk appraisal instruments were used in that study; and, feedback from
one instrument, compared to the other three, was better in changing people‘s perceived risk of
heart attack toward a more objective risk value. The authors commented that this might have
been due to the fact that the most effective feedback told the participants which risk group they
were in more clearly and directly. The effect of social characteristics on disease-risk adjustments
might also be mediated by motivation to adjust. There is some evidence that having strong
identification with one‘s social or racial group is associated with greater and more accurate
changes in risk perception as a result of genetic counselling in breast cancer patients.13,46 The
psychological processes that underlie these effects need further study. The findings may,
however, be related to individuals‘ motivation to make adjustments from their anchor. For
example, one possibility is that patients‘ level of identification with their social group might be
related to their motivation to view themselves from a societal perspective, and by extension, their
motivation to evaluate their risks from the perspective of society‘s experts, leading to increased
change in their risk perception. However, the link between social identity and adjustment of risk
perception is not yet clear. In a randomized trial with 211 Ashkenazi Jewish women, those who
more strongly identified with their ethnic group showed a lesser change in their perceived risk
for breast cancer as a result of counselling. In this study, women‘s feeling of stigmatization also
increased as a result of the genetic counselling intervention. As noted by the authors, women
might have felt stigmatized due to their ethnic identity as a result of learning the connection
between their ethnic group and breast cancer risk during counselling. This might have reduced
their motivation to be accurate, which, in turn, might have led to insufficient adjustment. Thus,
social identity‘s effect on the anchoring-and-adjustment bias seems to be mediated by motivation
to adjust to the expert‘s perspective. However, empiric research about ethnic identity,
motivation, and adjustment of risk perception is needed in order to draw conclusions about these
relationships. A future study explicitly showing the mediating role of motivation for the effect of
social identification would also directly show the disease-risk adjustments to be adjustments
from self-generated anchors. One might think that all the factors enumerated above are affecting
disbelief in the communicated risk information, which, in turn, leads people to adjust differently.
However, disbelief in communicated risk information does not seem to affect the degree to
which people change their risk perception as a result of risk counselling. Therefore based on
available change their risk perception as a result of risk counselling. Therefore, based on
available evidence, it is reasonable to posit that the factors that impact change in risk perception
are not affecting disbelief in the objective risk information, but rather, the anchoring-and-
adjustment process that underlies how people interpret messages in communication. In summary,
even though the exact psychological processes involved are not clear, past research has shown
that the adjustment of disease-risk perception can be modified. This suggests that the anchoring-
and- adjustment bias in disease-risk perception is similar to the anchoring-and-adjustment bias
with self-generated anchors, which is malleable to change. The factors affecting the adjustment
of disease-risk perception in genetic counselling settings (i.e., worry, numeracy, individualized
counselling, social identification, stigma) are consistent with how the anchoring-and-adjustment
heuristic is affected by effortful thinking and motivation in the context of self-generated anchors.

Recommendations for Future Research

The findings presented here, and the similarity of anchoring and adjustment in disease-risk
communication to adjustment observed from self-generated anchors, make it possible to
communication to adjustment observed from self-generated anchors, make it possible to suggest
some ways in which the anchoring-and-adjustment bias might be mitigated. Here we identify
possible future areas for research in the communication of disease risk information:

 Does forewarning patients about the bias of insufficient adjustment help ensure better
adjustment to counselled risk estimates?

 What is the role of effortful thinking in this process? Does giving patients more time
during counselling to process risk information lead to better adjustment? What is the
optimal amount of information provided in order not to overwhelm patients? Does
parsing up the information to several counselling sessions and reminding people of their
objective risk in each session reduce the cognitive load and the negative effect of time?

 How does motivation work in reducing bias? Does increasing patients‘ motivation help
improve adjustment? For example, does explaining the benefits of forming an accurate
understanding of their disease risk for better informed decisions motivate patients to
spend more effort in processing risk information and, perhaps, lead to more accurate risk
perceptions?

 Does tailoring risk information to people‘s numeracy levels lead to better adjustment?

 How does level of worry affect risk adjustment? Does a high level of worry lead to
insufficient adjustment of perceived risk? Do lower levels of worry help patients better
adjust, given that mild negative affect has been linked with increased systematic
processing?
  Does emphasizing patients‘ social roles as family or community members during
counselling motivate them to move away from their own risk anchor in the direction of
the counselled risk?

 Is feeling stigmatized as a result of belonging to a certain racial or ethnic group related to

being less motivated and, hence, to more insufficient adjustment?

In addition to these questions, it is also important to broaden the evidence base to conditions
other than breast cancer and to investigate factors that mediate or moderate the predicted effects
outlined here. For example, as discussed earlier, people‘s beliefs about the disease and about
protective behaviours might also affect how much people adjust their risk perceptions. It is also
important to investigate how the anchoring and adjustment bias might interact with other biases
of disease-risk perception such as heuristics of availability, affect and framing. Of disease-risk
perception such as heuristics of availability, affect and framing. Furthermore, more research is
needed to determine how these processes might operate in the context of risk information
calculated based on genetic susceptibility. The breast cancer counselling research described
above was based on communication of disease risk calculated from patients‘ family and medical
history. One randomized trial with 162 adult children of Alzheimer‘s disease patients directly
compared the provision of disease-risk information based on family history with information
based on genetic testing. It was found that the genetic test information changed people‘s
perceived risk for Alzheimer‘s disease to a greater extent. This study raises the possibility that
the anchoring-and-adjustment bias might work differently in the context of genetic risk
perception.

Example

A used car salesman (or any salesman) can offer a very high price to start negotiations that are
arguably well above the fair value. Because the high price is an anchor, the final price will tend
to be higher than if the car salesman had offered a fair or low price to start.

3.4 FRAMING BIAS

Framing bias is an individual decision-making misconception caused by the fact that a person
interprets the surrounding world according to a decision frame chosen by her or his subjective
opinion. This article aims to review various kinds of factors that cause and affect framing or lead
to debiasing, i.e. a decrease in the resulting framing bias. The objective of the study is carried out
using a literature review that analyses recent empirical studies. As a result, numerous factors are
identified that according to the studies have an impact on framing. It transpires that four broader
groups of these factors can be established – decision situation setup (amount of information,
additional presentation of options), experience (knowledge, engagement), effort (attention,
complexity, the amount of information to process) and demographics (gender, nationality).

The literature building upon neoclassical economic theory (i.e. authors like Friedman, von
Neumann, or Morgenstern) considers man to be a rational being, which allows neat mathematical
analysis of human decision-making. However, such a full rationality put huge demands on
decision-making. Among them, that [Link] choices should also be consistent
regardless of the way individual options are formulated. However, in reality, people make
decisions that deviate due to number of factors from a rational choice. One factor plays a role in
this is framing which is the subject of this article. Goffman argues that people interpret the
surrounding world according to the primary frame they choose based on their subjective
opinions. The primary frame is one that is considered to render what would otherwise be an
insignificant aspect of the scene into something that is meaningful. Russo and Shoemaker also
point out that framing is about the mental structure which people create to organize and simplify
the world. Plous describes the framing effect by suggesting that people respond differently to the
choices offered to them depending on the form the speaker uses to give her or his speech and the
way of presentation of individual options. The key element of framing is the reference point
which is used for evaluating events that may result from a decision - a typical reference point
may be current profit level or target income. Changes to this reference point can have a major
impact on the way a judgment is assessed, and thus on a chosen procedure Goffman argues that
people interpret the surrounding world according to the primary frame they choose based on their
subjective opinions. The primary frame is one that is considered to render what would otherwise
be an insignificant aspect of the scene into something that is meaningful. Russo and Schoemaker
also point out that framing is about the mental structure which people create to organize and
simplify the world. Plous describes the framing effect by suggesting that people respond
differently to the choices offered to them depending on the form the speaker uses to give her or
his speech and the way of presentation of individual options. The key element of framing is the
reference point which is used for evaluating events that may result from a decision - a typical
reference point may be current profit level or target income. Changes to this reference point can
have a major impact on the way a judgment is assessed, and thus on a chosen procedure. .In the
experimental situation known as the Asian disease problem, Tversky and Kahneman examine
framing and the resulting framing bias of a decision. Maker. They conclude, based on results of
their experiment, that if people have an option that is interpreted positively, from the side of
gains, they tend to choose a variant that is less risky than when individual options are formulated
negatively as potential losses. In addition to framing in the Asian disease problem, Levin
mention two other types of frame manipulation

i. Framing of an attribute, i.e. a description of characteristics of one thing in a positive

or negative light and

ii. Framing a goal and highlighting an achievement as gains or losses caused by a certain
behaviour.

The framing of options and situations is a subject of further research in which the term negativity
bias is introduced. Negativity bias stems from conclusions that bad has a stronger effect than
good in various situations, whether in creating impressions, perceptions, memories, or decision-
making. In general, Janiszewski argue that since framing in decision-making often involves
information from human unconscious memory, it is very difficult to prevent its influence on
decision making.

Methodology

We search for literature using systematic review approach in order to offer a systematic,
transparent and reproducible process. This process minimizes distortions through a detailed
literature search of published and unpublished studies, which is accompanied with a listing of
decisions, procedures and results. This article aims to find and analyse recent empirical
experimental research on framing bias. The search uses the criteria described below. After the
search, individual factors affecting framing are compiled in an overview using more traditional
narrative process. The research question is: ―Which recently studied factors in experiments
influence (both by creating or reducing) framing of decisions and the resulting framing bias?‖
The EBSCOhost database is chosen as the source of the search for publications. The key words
used in the search query are framing, bias and experiment. Additionally, the search is aimed at
articles written in English and, in order to review the most recent literature on the topic,
published from 2005 until May 2017. The resulting number of identified resources is 123. From
the resources found by the criteria mentioned above, we first remove duplicates and have 75
articles. Another round of screening focuses on an assessment of whether the research is directly
focused on framing bias testing, or uses the framework as just a part of methodology for
conducting an experiment about a different topic. We make this decision based on examination
of abstracts, discussions and conclusions of the articles. The number of relevant articles fulfilling
our criteria is 34. Finally, after analysing whole articles, we make the final list of 21 articles that
not only address framing, but also analyse factors influencing its resulting magnitude. From the
resources found by the criteria mentioned above, we first remove duplicates and have 75 articles.
Another round of screening focuses on an assessment of whether the research is directly focused
on framing bias testing, or uses the framework as just a part of methodology for conducting an
experiment about a different topic. We make this decision based on examination of abstracts,
discussions and conclusions of the articles. The number of relevant articles fulfilling our criteria
is 34. Finally, after analysing whole articles, we make the final list of 21 articles that not only
address framing, but also analyse factors influencing its resulting magnitude.

Literature Review

Based on review of identified articles we formulate four groups of factors involved in framing
decision situation setup, experience, effort and demographics. The first group of factors, decision
situation setup (apart from general positive or negative framing of options) plays an important
role. As mentioned in the introduction, framing is related to a decision maker conception of risk.
A weak framing effect is observed in cases where the risky option is relatively unattractive.
Higher attractiveness increases framing bias when both options are equally attractive in relative
terms. Increasing rewards also raises the framing bias. People make higher-risk decisions if they
can get more - even if it is the same amount, i.e. only calculated in a different currency. In Ert
and Erevfs experiment, people can get 10 shequels or 1000 agoras (with 1 shequel = 100 agoras),
and yet the framing bias for agoras is higher. Hilbig found that there is also an influence
depending on whether a reward is paid or whether it is stated as a number or percentage. The link
between reward and the attractiveness of a high-risk option is confirmed by Kuhberger and
Wiener. They claim that people are affected by the bias regarding how much money they want to
save. If their minimum amount can only be reached by choosing a high-risk option, then they
choose this option regardless of how the assignment is framed because it is considerably more
attractive for them. Other example of factor in situation setup is so-called two-side framing in
which, for example, some negative information is contained in a positive message. Two sides
framing reduces the resulting framing bias as it gives people the feeling that they have more
information about the subject. Experiments of Eisend support this claim as two-side framing
increases the perceived credibility of a source. Similarly, Arbuthnott and Scerbe note that
mentioning the negative aspects of solutions increases a feeling of transparency. In addition,
Olsen finds that framing bias is also influenced by order of the information presented, where the
initial exposure to positive information weakens the susceptibility to negative framing, but not
vice-versa. Van Buiten and Keren also support the diminishing effect of framing based on the
order of information when they try to discover which assignments (positively or negatively
framed) speakers choose when trying to convince listeners about their statements. When these
assignments are presented to the speaker one after the other, and not at the same time, the
speakers presenting higher-risk solutions assume that their listeners would be more easily
convinced when their speech is negatively framed. In these experiments, the impact of the
number of options is also highlighted. As opposed to speakers, listeners are largely affected by
the framing because they receive only one option for solving a problem, i.e. they receive less
information. From these studies, one can infer that additional information about an area, or at
least the feeling that the decision maker has more information leads to a reduction in the framing
effect. Other example of factor in situation setup is so-called two-side framing in which, for
example, some negative information is contained in a positive message. Two side framing
reduces the resulting framing bias as it gives people the feeling that they have more information
about the subject. Experiments of Eisend support this claim as two-side framing increases the
perceived credibility of a source. Similarly, Arbuthnott and Scerbe note that mentioning the
negative aspects of solutions increases a feeling of transparency. In addition, Olsen finds that
framing bias is also influenced by order of the information presented, where the initial exposure
to positive information weakens the susceptibility to negative framing, but not vice-versa. Van
Buiten and Keren also support the diminishing effect of framing based on the order of
information when they try to discover which assignments (positively or negatively framed)
speakers choose when trying to convince listeners about their statements. When these
assignments are presented to the speaker one after the other, and not at the same time, the
speakers presenting higher-risk solutions assume that their listeners would be more easily
convinced when their speech is negatively framed. In these experiments, the impact of the
number of options is also highlighted. As opposed to speakers, listeners are largely affected by
the framing because they receive only one option for solving a problem, i.e. they receive less
information. From these studies, one can infer that additional information about an area, or at
least the feeling that the decision maker has more information leads to a reduction in the framing
effect. In real life, more information on the subject is rather the result of experience, past
knowledge or engagement in the area of decision making. Indeed, numerous authors show that
this group of factors considerably affects the decision in term of the framing effect. Kang and
Lin for example, test the impact of a positive/negative framing in a message that mentions the
harmful impacts of smoking on health. They find that framing has no effect on reactions of
people who are smoking. Similarly, an experiment by Cheng and Wu shows that people with
high engagement in a subject matter are less sensitive to the impact of information framing, as
they tend to look at the information more thoroughly. Likewise, Olsen who studies citizens
opinions on hospital facilities, concludes that people who had worked in hospitals in the past or
had other personal experience with them are not influenced by a negative framing. In fact, they
judge hospitals just like those who never had any experience with hospitals and are presented
with a positive framing. Similarly, a general awareness of politics is considered to be one of the
reasons why certain respondents are not influenced by framing in Schuck and De Vreesefs EU-
risk experiment. In the research by Jefferies-Sewell on the basis of negatively framed
information less experienced psychiatrists choose to accept a psychiatric patient for treatment
more often than experienced ones. Based on a number of the studies, it clearly seems that
experience and personal engagement diminish the effect of framing on decision making. On the
other hand, it is important to note contrasting findings by Schwitzgebel and Cushman who test
the impact of framing bias in an Asian disease problem-like experiment. In the experiment, they
compare the answers of philosophers with years of experience in the field with non-professionals
(people with a similar level of education but from other fields) and prove a presence of framing
bias and risk aversion among participants from the philosophers group. However, even the
authors agree with the statement that experience and knowledge of a subject under consideration
reduce the impact of framing and framing bias. Nevertheless, reaching a decision that is
subsequently minimally affected by framing bias, can be accomplished even if there is
insufficient information about a problem simply by putting more effort into decision making.
Meissner and Wulf investigate the impact of complexity and planning in decision-making.
According to them, the preparation of variants of a future situation reduces the impact of framing
bias by broadening the decision makers overview of it. Cheng support them by acknowledging a
debiasing effect of information processing or the consideration of circumstances which force
participants to better process and rationally review their decisions while considering other
alternatives. Park and Rothrock also find out that the impact of framing bias is reduced by the
complexity of a decision together with time pressure. At the same time, the visualization of the
impact of a decision (i.e. getting feedback) has also shown to have a debiasing effect. Unlike this
finding, the visualization of the assignment does not affect the framing bias. On the other hand,
Park and Rothrock‘s visualisation effect contradicts the results of Kang and Linfs experiments
with smokers. These authors find that images of healthy and cancer-affected lungs do not have
an impact on smokers because the high-risk option (to keep smoking) is too important to them.
Nevertheless, reaching a decision that is subsequently minimally affected by framing bias, can be
accomplished even if there is insufficient information about a problem simply by putting more
effort into decision making. Meissner and Wulf investigate the impact of complexity and
planning in decision-making. According to them, the preparation of variants of a future situation
reduces the impact of framing bias by broadening the decision makers overview of it. Cheng
support them by acknowledging a debiasing effect of information processing or the consideration
of circumstances which force participants to better process and rationally review their decisions
while considering other alternatives. Park and Rothrock also find out that the impact of framing
bias is reduced by the complexity of a decision together with time pressure. At the same time, the
visualization of the impact of a decision (i.e. getting feedback) has also shown to have a
debiasing effect. Unlike this finding, the visualization of the assignment does not affect the
framing bias. On the other hand, Park and Rothrock‘s visualisation effect contradicts the results
of Kang and Linfs experiments with smokers. These authors find that images of healthy and
cancer-affected lungs do not have an impact on smokers because the high-risk option (to keep
smoking) is too important to them. Generally, the attractiveness of options can also be affected
by demographic factors such as our cultural habits, group affiliation or gender. Kencono Putri
find that due to some cultural habits people are not subject to framing bias at all. Participants in
their study choose a non-risk option for positively framed information (this is in line with the
framing theory), but in the case of negatively framed information, they choose the lowest risk
option (that contradicts the theory which assumes that in such a situation they would choose a
high risk one). The authors explanation lies in the cultural traditions (the sample consists of
Indonesian respondents) and risk aversion in the given security market. This is further supported
by Huerta who states that the nationality of respondents and the associated habits in a given
country have a significant impact on the resulting framing bias. Oganian identify a debiasing
effect of formulating instructions in a different language than options as solving a situation cause
transitional changes in cognitive control.

Similarly to the nationality, affiliation to a particular social groups has a certain, although not
clear, impact on framing bias. The influence of positive framing differs depending on social
distance (affiliation to a group), but the effect does not change proportionally to it. The framing
effect is not weaker when people judge someone from a more distant social group, but differs
between the particular levels of distance. In Nanfs experiments, message framing has a stronger
impact when it relates to a best friend than a colleague, but on the other hand, it is stronger when
it relates to a colleague than a decision maker. Similarly, as Gamliel describes, even if a member
of a certain group is preferred to a certain position, it does not matter whether this decision is
made by members of a given group or members of another group the framing of an assignment
has the same impact on both. Numerous experiments demonstrate that gender plays a role in
reactions to framing. Agnew research on investment shows that both sexes tend to opt to invest if
they receive negatively framed information about retirement savings, while only men choose to
save if they receive negatively framed investment information. According to the authors, one
possible explanation is the fact that women are more risk-averse than men, so they prefer to
choose a safer option, which is saving for a pension in this case. However, if they have more
information about the investment, they choose to invest directly and they are no longer affected
by framing bias.

In the review, individual debiasing factors affecting framing are grouped into several categories,
with previous experience and knowledge in an area having the most frequent effect on reducing
framing bias. According to numerous authors, most of the biases created during the first contact
with a description of a situation are weakened or completely disappear if the selection is based
on experience. Huerta describe this phenomenon as preferences developing by experience.
Nevertheless, even expertise in the field does not automatically guarantee a reduction in the
framing bias, as it is shown by Schwitzgebel and Cushman whose findings mostly contradict the
ones above. They mention Mandel‘s argument that participants in the Asian disease experiment
can read the option ―200 people to be saved‖ as ―at least 200 people will be saved‖ (perhaps
more) and comparable ―400 people die‖ as ―at least 400 people die‖, leading to the choices of
participants that are different than expected. Another problem may be the fact that for problems
like the Asian-disease experiment, it is not possible to test how correct an answer is. It is, after
all, only a moral choice. All these arguments leads to questioning of validity of experimental
findings (note number of factors affecting framing on decision situation setup). Possibly even
more important is the discussion on whether framing is biased or not. In this text, we distinguish
between framing and framing bias. Framing generally refers to a process of decision-making,
namely the ―decision-maker‘s conception of the acts, outcomes, and contingencies associated
with a particular choice‖ involved in this process. Framing bias, on the other hand, refers to the
possible variation in the outcomes of decision-making, resulting in a deviation from a rational
choice. Both terms are linked to each other, i.e. the process leads to bias, yet it is important to
distinguish between them. Possibly even more important is the discussion on whether framing is
biased or not. In this text, we distinguish between framing and framing bias. Framing generally
refers to a process of decision-making, namely the ―decision-maker‘s conception of the acts,
outcomes, and contingencies associated with a particular choice‖ involved in this process.
Framing bias, on the other hand, refers to the possible variation in the outcomes of decision-
making, resulting in a deviation from a rational choice. Both terms are linked to each other, i.e.
the process leads to bias, yet it is important to distinguish between them. There is a logical
argumentation that framing does not always have to result in an irrational and therefore biased
behaviour, as the two statements/options can logically be equivalent, but not necessarily
informatively equivalent. A person, for example, can gain or lose points in an exam. However,
should the opposite of ―gaining‖ be ―not gaining‖? Alternatively, is the opposite of ―losing‖ ―not
losing‖? All this should be again acknowledged in the methodology of empirical framing
research and especially in the interpretation of findings. As a topic for further research, we
suggest a focus on the role of attention, similarly to, e.g. attention-based view in strategic
management. The complexity of choices, a different perspective and changing the language in an
assignment and options, can be linked to the need to put more effort (and therefore attention) into
a decision-making process. There may be other possible explanations, and further research may
shed more light on this issue. Beside this, studying the influence of nationality on framing in
decision-making may also be beneficial. Such a cross-cultural study involves a larger number of
different nationalities to ensure generalizable findings. The limitations of this article stem mainly
from using one database for the search, leading to the possible omission of some articles. On the
other hand, we believe that risk of this omission is limited by the general nature of the database
selected. The time frame for the systematic review and the exclusive use of the English language
also may have restricted us from a more complex study of framing and framing bias. However,
our foremost goal is to review recent research on this widespread topic in decision-making and
therefore we do not strive to review all the countless studies on framing.

Example

How can you guard against framing bias? One of the things you can do as an investor is to
always challenge the framing. Consider rephrasing the information you‘re reading and see what
impact, if any, that has on your conclusion. The key thing is trying to kick in the logical,
reflective approach to decision making and avoid impulsive, reflexive decisions.

For example, an equity research report may come with a lot of opinion and bias included in the
research. Try to remove any editorial/judgmental comments and look at only the key numbers
and underlying assumptions driving the valuation. Then arrive at your own conclusions, rather
than being swayed by how the information is presented to you.

3.5 AVAILABILITY BIAS

The availability heuristic is a strategy that people use to make quick decisions but often lead to
systematic errors. We propose quick decisions but often lead to systematic errors. We propose
three ways that visualization could facilitate unbiased decision making. First, visualizations can
alter the way our memory stores the events for later recall, so as to improve users' long-term
intuitions. Second, the known biases could lead to new visualization guidelines. Third, we
suggest the design of decision-making tools that are inspired by heuristics, e.g. suggesting
intuitive approximations, rather than target to present exhaustive comparisons of all possible
outcomes, or automated solutions for choosing decisions.

We all want to make good decisions. However, decision making judgments often involve
approximate estimations of judgments often involve approximate estimations of probabilities and
frequencies. In order to reduce the complexity of estimation people rely on a limited number of
strategies. One of these strategies is called Availability Heuristic. The availability heuristic is a
rule of thumb in which decision makers ―estimate the frequency or probability by the ease with
which instances or associations could be brought to mind‖. For example, news about a terrible
plane crash may temporarily alter our feelings on flight safety. This heuristic simplifies some
otherwise very difficult judgments, and it is usually effective since in principle it is easier to
recall or imagine common events than uncommon ones. However, apart from the actual
frequency or probability, other factors affect the ease of recalling instances, and thus estimating
frequencies for making decisions. Some of these factors affecting recall, illustrated by Tversky
and Kahneman often lead to systematic errors: Bias due to retrievability of instances: People
evaluate the probability of an event as higher, when they retrieve its instances effortlessly.
Schwarz asked one group of participants to recall 12 examples of their past assertive behaviour,
and another group to recall only 6. After that, they rated their assertiveness. The 12 examples
were harder to be recalled than the 6, so the first group rated themselves as less assertive than the
second group. Retrievability is often related to

i. Familiarity or what Whittlesea refers to as the "illusion of pastness".

ii. Saliency where one instance elicits more attention than another.

iii. Recency where for example the serial presentation of information may affect
memorization.

Bias due to the effectiveness of the search set: the generation of a search set depends also on the
performed search task. When we ask to compare the instances of the word ‗love' with the word
‗door‘ the first seems more frequent. A main reason for this is that besides the comparison of
words, there is a hidden task of recalling contexts in which these words appear. It is generally
easier to recall abstract contexts than concrete ones. Bias of imaginability: When the frequency
of an instance is not stored in memory, we sometimes generate this frequency according to some
rule. For example when we want to estimate which is more frequent, the existence of committees
of 8 members or of 2, we will mentally construct committees and rate them by the ease of this
construction. The mental construction of 2 member committees is easier, and thus may be
considered as most frequent. In real life imaginability biases can lead us to overestimate some
risks with vivid scenarios and underestimate dangerous risks that are hard to conceive. Bias due
to illusory correlation: When two events co-occur people tend to overestimate the frequency of
natural association. For example it is common to patients with paranoia to have peculiar eyes.
This association misled undergraduate clinicians to diagnose as paranoid patients with no other
symptoms related to paranoia in their medical data, simply because they were guided by a given
picture of the patient with peculiar eyes. Availability bias affects the decision-making ability in
an unconscious way, and can lead people to irrational decisions. We believe we can better
support decision-making, through the design of visualizations that take into account these factors
that influence decision-making. We illustrate this in a voting scenario that we imagine takes
place with and without hypothetical visualizations designed to account for biases.

Imagine that one needs to decide which political candidate to vote for. There are three steps. As a
first step, she shapes an opinion on which are the important personal and society issues based on
her past exposure to information (media, social environment, personal experiences etc.). Second,
she investigates environment, personal experiences etc.). Second, she investigates the candidates‘
former actions, background and current positions, and estimates their ability and willingness to
solve the important society issues. Finally, she compares all the alternatives and decides on a
candidate. In an ideal world, voters are aware of their position in the complex political landscape,
understand statistical analysis data and micro-macroeconomics, and have endless memory
capacity and time to process all the relative candidates‘ history. In reality, voters usually simplify
this decision using heuristics. However, as we discussed, the common heuristics like availability
may lead one to pick a candidate according to, for example: meaningless actions that media over-
cover, without important impact in the society the sequence of their presentation in the public
debate the vividness of the way they talk or even whether their victory is an event easy to
envision.

The actual challenge on the three decision-making steps in the voting problem is how to filter,
understand, recall and the voting problem is how to filter, understand, recall and compare
information. In principle, this challenge is related to the objectives. But how could visualizations
actually assist a voter to reduce availability biases? Visualizations to aid recall: Let‘s think of a
scenario with simple hypothetical visualizations involved in the voting problem. Consider also
two alternative policies: a consolidation of the national health system focusing on cancer cure,
and a high-cost terrorism counteraction. People tend to make wrong estimations on most
probable causes of death in their country misled by media. In contrast, imagine the voter had
access to a map with stacked (men / women) bar charts of death causes (society issues
awareness) that she can filter. For the simplicity of the argument here we assume a voter who
wants to maximize her own self-interest. Thus, the displayed causes can be filtered according to
her family‘s medical records and other individual characteristics (personal issues awareness).
The user interacts with the visualization, composing a view that is focused on her interests. From
the amount of information that she was able to process, she captures a snapshot of her self-
constructed view of the visualization to save among her personal notes. In the last step of the
decision-making, she evaluates the policies of each candidate. Based on her memorable
interaction experience with the visualization, she intuitively evaluates which election promise
has greater impact in her life. Visualizations could thus educate decision makers to develop
unbiased intuitions of their surroundings. However, as we saw in the previous example, this does
not only imply visual comparisons of choices and consequences. The availability heuristic
succeeds when memory stores the frequent events in an easy-to-recall way. In our example, the
visualization facilitates the user‘s memory by capturing her self-constructed summary. Thus,
visualizations could go beyond simply showing all possible alternatives. Visualizations should
also help decision makers easily recall the important take-away information. Visualizations to
remove biases: So visualizations can help deal with biases. But visualization designers can also
reuse the knowledge of robust biases already studied in psychology literature to make better
visualizations. Studies on how the candidates‘ order in the set of ballot papers affects the vote
rank, confirm that ―recency effect‖ occurs also in visualizations. Thus visualizations can
reinforce the importance of some information due to some known biases (e.g., presenting them
last). Moreover, if the magnitude of a visual variable does not reflect its real impact, we may
reinforce not only visual perception bias (bigger is more important), but also retrievability biases
(bigger may be easier to remember). For example, consider the two political candidates suggest
either the increase of unemployment allowance, or the tax exemption of families with a lot of
children. Both are fair measures, but unemployment applies to a larger part of the population.
However, families with many children may not be able to survive with the current tax policy. A
visualization where the visual variable depends exclusively on the population size is legible, but
may lead voters to evaluate the policies only according to the population criterion, even for
voters who have 10 children themselves. Visualizations, in addition to what the media can offer,
should be able to also display a customized perspective and alternative views of the data. These
customized views of the data will be the ones most likely retrieved from their memory during the
decision process. The visualization design should also take into account the biases due to
imaginability. When it comes to radical ideas, the mind‘s inability to construct the outcome of
this idea can lead a person to consider it as impossible to happen. In the voting problem, if a
candidate proposes ―decentralization of state power to local communities‖, the voters may reject
it not only because they disagree, but also because the outcome is an event hard to envision. A
conceptualized, but vivid, map representation of the idea of decentralization could alter the
voter‘s willingness to accept a change. Visualizations inspired by heuristics: We mostly
discussed so far how to present the information to lead to effective and unbiased decisions.
However, the decision-making process itself can be hard even when all the information we need
is available. Automated decision-making tools that give explicit answers according to probability
computations, may not always feel intuitive and understandable even by experts. They often
restrict users by expecting a very particular input, or ignoring other context-relevant information
that the users may have. On the other hand common visualization tools often hide uncertainty in
the data and do not actually shield decision makers against perceptual and cognitive biases.
Visualization tools are currently designed and evaluated based on data retrieval and insight tasks,
rather than on the ultimate and crucial task of decision-making. Thus we could drive some
inspiration of how heuristic strategies like availability, simplify decision tasks, find the effective
trade off among simplicity and accuracy, and apply this analogy on new visualization tools. That
is, decision tools may need to allow some imperfection for the sake of understand ability.

Availability bias describes the way in which human beings are biased toward judging events‘
likelihood/frequency based on how easily their minds can conjure up examples of the event
occurring in the past.

For this reason, if we‘re trying to judge whether something is likely to happen (to make a risk
assessment) if a similar event has occurred recently and/or past instances induced strong
emotions that made their occurrence more memorable, we‘re much more likely to predict that the
event is likely to occur. This is a bias because the accuracy of our judgment is clouded by the
fact that the event was recent or carried strong emotional weight and thus came to mind quickly.

The result of availability bias is that consumers tend not to be very good at risk assessment. We
might under- or overestimate a risk, choosing to focus on the wrong risks. The way that these
biases manifest is likely to be heavily influenced by media representations of risks.
Example

 Fear of Flying

Excessive coverage on the news or social media about plane crashes uses vivid images and
stories to elicit an emotional response. That‘s why many people develop a fear of flying -
they remember those images the next time they fly.

Yet, this fear is entirely in opposition to the statistical danger of flying. The chances of
experiencing a plane crash on a commercial airline are incredibly low.

But, data doesn‘t usually speak to us emotionally. It‘s much easier to remember the vivid
images of destruction.

Availability bias makes those images easily accessible, causing an irrational fear of flying.

 Memories of Past Success

People try to repeat what has worked for them in the past. This is so even if the variables
have changed significantly since that past success happened.

This occurs in professional sports all the time. General Managers who have won
championships in the past bring with them vivid memories not just of the win, but of how
they won.

So, naturally, they try to duplicate their prior process and success with their new team.

The problem is that the game may have changed in the interim. Availability bias doesn‘t
allow them to acknowledge that ―this time is different.‖

Don‘t let vivid stories and experiences of past success stop you from seeing that things have
changed. What worked before may well not work now.

3.6 SELF-ATTRIBUTION BIAS

Financial theories are mostly subjective and often based on ideas for the explanation of how the
market works rather on ideas for the explanation of how the market works rather than any proven
laws in finance. Such is the case with the EMH (Efficient Market Hypothesis). According to
EMH, stock prices reflect fundamental values as the market possess all the available information.
Further on, investors perceive all the information exactly the same manner, and so no individual
investor is able to earn greater returns than other individuals in the same market. In light of the
EMH, the best investment strategy would be to invest in an index fund, whose performance will
increase or decrease according to the overall level of corporate profitability or losses. However,
the history of stock market shows a different scenario. Evidence is available for a wide range of
returns among investors. In the mutual fund industry, returns range from significant losses to
50% profits or above. Warren Buffett, who is known as the legendary investor can be seen as an
example, who managed funds and beat the market for a number of years. The irregularities
discussed above could be due to the basic assumption of standard finance that is ―all investors
are rational‖. This assumption of rational economic man faces a lot of criticism. As Kahneman
and Tversky showed that people have preferences that are in many aspects different from rational
individuals. Psychological biases are considered to generate asset pricing anomalies such as
momentum, post announcement drifts, reversals and closed-end fund discounts etc. which causes
market inefficiency. In order to explain these anomalies that are inconsistent with the rational
efficient market, behavioural finance emerged. Behavioural finance models unlike the standard
finance models, take into consideration the irrational characteristics associated with individuals
which may influence their decision making. These include psychological biases, both emotional
and cognitive. A new developing string of finance literature is based on the two most important
behavioural biases namely self-attribution bias and overconfidence bias as evident from the
studies by Benos, Daniel, Hirshleifer, and Subrahmanyam, Odean and Gervais and Odean. Self-
attribution bias refers to the tendency of individuals to credit success to their skills and talents
and blame the external factors for the failure. In this study‘s context, the self-attribution theory
suggests that individuals who invest in stocks, credit their success more to their own abilities and
skills and less to luck and chance, while blame external factors like luck and chance for their
failure. This often leads individual to be overconfident. Overconfidence is viewed by
behaviourists as a factor playing an important role in financial markets because many
experimental psychologists found it existing in many aspects of human behaviour. According to
De Bondt and Thaler, ―perhaps the most robust finding in the psychology of judgment is that
people are overconfident‖. Huge amount of literature on overconfidence bias has been provided
by Odean and Daniel which suggest that in the presence of overconfident investors in the market
place there will be excessive trading and high price volatility. Most of the previous studies
analysed overconfidence and self-attribution from the perspective of managers and executives,
and have used one as a proxy for the other. In this study we use the individual investor as the
basic unit of analysis. Self-attribution may be relevant to market efficiency because it can lead
individuals to be overconfident, which influence the market efficiency as evidenced from the
literature. We investigate the impact of self-attribution bias as well as overconfidence bias on
perceived market efficiency.

Self- attribution leads to overconfidence so we further check for the mediating role of
overconfidence bias in the relationship between self-attribution bias and perceived market
efficiency. As the variables are measured through primary data collected through questionnaires,
so instead of market efficiency the term perceived market efficiency is used. As stated earlier,
behavioural biases make the market less efficient by generating mispricing unless rational
arbitrageurs bring prices to the true fundamental values. However, overconfident investors have
strong confidence in themselves and therefore believe that they can earn extraordinary returns
and so are engaged in investing resources to acquire more and more information. More
specifically, overconfident investors expect to earn extraordinary returns because they invest too
many resources in information acquisition. And hence by providing such information into the
market the overconfident investors can bring security‘s prices to their true value. As, Rubinstein
stated that, overconfidence causes investors to overspend on research and perhaps this
overspending may not be in one‘s self-interest but it does help passive investors who can find
now that prices incorporate more information and market is efficient. This study is also an
attempt to investigate if these biases have any positive influence on perceived market efficiency.
The mediation regression analysis evidence a significant positive relationship between the self –
attribution bias and perceived market efficiency and also a significant positive relationship
between overconfidence bias and perceived market efficiency. The results further show that,
overconfidence bias partially mediates the relationship between self-attribution bias and
perceived market efficiency. The results of this study have some novel implications regarding
investing behaviour of individuals. Practitioners can use it while dealing with various types of
investors. An important debate among stock market participants is about stock market efficiency.
Efficient market hypothesis is a statement that securities prices fully reflect all available
information. A precondition for this strong version of the hypothesis is that information and
trading costs, the costs of getting prices to reflect information are always zero. Further they
observed that in a world with costly information, it is impossible for markets to be
informationally efficient. The concept of market efficiency stems from the work of Lovis
Bachelier, who argued in his Ph.D. thesis dissertation in 1900, that motion of stock prices is
identical to random walks. Then Paul samuelson Nobel prize winner proved that prices fluctuate
randomly, and are not predictable. Fama concluded the theory of market efficiency and identified
three types of market efficiencies namely weak form, semi strong form, and strong form
efficiencies. Just like most of the theories of standard finance, EMH is also based on some
assumptions, like all investors are rational, all investor perceive all available information in
precisely the same way, and one can get no extraordinary positive information using his skills
and so price is closed to fundamental values. This is consistent with the view of Shiller who
stated that individual‘s decisions reflect all available information and thus prices can be guessed
as a correct representative of fundamental values. Looking at these assumptions of market
efficiency, it can be admitted that no investor would ever be able to beat the market. However in
reality this is not so and there can be found many examples where investors have consistently
beaten the market. Warren Buffett is one of those who managed to beat the market year after
year. There can be various factors responsible for such irregularities and inefficiencies. One of
the main factors could be human behaviour. Individuals‘ decisions are influenced by their
behaviours. As individuals have different behaviours so each individual‘s decision is in a
different way affected by his behaviour. Kahneman and Tversky showed that people have
preferences that are in many aspects different from rational individuals. Also in a specific period
of time human thinking power is limited and is not able to optimally process the information in a
problematic situation. Further on, people have sense of social responsibility as well as some
religious constraints, for example having a sense of social responsibility many people might not
invest in tobacco companies. So here it will make sense to say that most investors do not behave
rationally all the time and in all situations. They have emotions which do influence their
decisions. And these factors are not accounted for in the standard finance models. On the other
hand, behavioural finance struggles to account for these factors. Kuhn in his study concluded that
the concept of efficient market is disintegrating and that of behavioural finance is going to
emerge. In the past few decades most of the theories of standard finance have been criticized by
many researchers. For instance, we can look at the CAPM (Capital Asset Pricing Model). APT
(Arbitrage Pricing Theory) by Ross (1976) can be considered as a criticism on CAPM. Many
anomalies which are in simple words deviations from expectations were introduced. For
example, in 1977 P/E anomaly by Sunjay Basu, in 1981 size anomaly by Banz, in 1993
momentum anomaly by Jagdeesh & Titman, in 1997 liquidity anomaly by Amihud, in 1985
leverage anomaly by Staltman, and some other like Dividend Yield anomaly, were introduced.
Chen, Roll and Ross identified more factors which they called macroeconomic factors. And
more interestingly Fama and French withdraw his support from CAPM and introduced the three
factor model. Similarly in 1997 carhart 4-factor model was introduced by adding another factor
i.e. the momentum premium to the 3-factor model of Fama and French. These anomalies raised
some important questions to which standard finance was unable to address, and which show that
standard finance is not adequate alone. In 1990s another phase started with the entry of
behavioural finance, which was to incorporate human factor in decision making. In the past three
decades significant theoretical work has been done in which instead of fully rational agents,
financial markets were modelled with less than fully rational agents. Investors may be
susceptible to a variety of cognitive and emotional biases collectively called behavioural biases,
which influence their decisions. For example, in recent years, De long, Odean and Daniel,
Hirshleifer and Subrahmanyam used models with overconfident individuals to explain empirical
patterns in stock returns and individuals to explain empirical patterns in stock returns and found
them incompatible with standard finance theories based on unbiased individuals. In this study we
consider two well-known behavioural biases namely self-attribution bias and overconfidence
bias, the second stemming from the first. We study these biases with regard to their impact on
individual decisions and how these in turn impact the stock market behaviour. We start with the
view that individuals make self-serving attribution to explain their performance which increases
overconfidence. Self-attribution bias refers to people tendency of crediting success to their own
skills and talents, while blaming external factors such as bad luck for their failure. This often
lead individual to a pleasant but erroneous belief, that they are very talented. According to Bem
attribution theory, individuals too strongly attribute events that confirm the validity of their
actions to high ability, and events that disconfirm the action to external noise or sabotage. The
psychological literature evidence that, individuals tend to credit themselves for success while
blame the external factors for failure stated ―heads I win, tails its‘ a chance‖. Self-attribution bias
has been discussed in economics and finance literature. Daniel, Hirshleifer and Subrahmanyam
theorize that both overconfidence and self-attribution cause more volatility compared to models
with rational individuals, in securities markets. Traders susceptible to self-attribution, overtime
become more overconfident. In their study, Choi and Lou documented that mutual funds
managers‘ decision are greatly affected by self-attribution and hence leads to poor performance.
Further they stated that younger managers are more susceptible to self-attribution bias relative to
experienced ones. Overconfidence bias is a main finding in research that influences the
individual decision making process. De bondt and thaler state that perhaps the strongest finding
in the psychology of judgment is that people are overconfident. Studies show overconfidence as
a cause of various outcomes. For example, overconfidence is one obvious factor that leads to
high rates of entrepreneurial entry, and such entrepreneurs failed most frequently. Malmendier
and Tate conducted a study and concluded that overconfidence leads to high rates of mergers and
acquisitions while such decisions often fail. Also Roll, showed that just as overconfidence
among individual investors may lead to excessive trading so overconfidence among managers
may lead to excessive takeover activity. Howard and Johnson identified overconfidence among
one of the factors that may cause a war. At last, Plous said that in judgment and decision making
overconfidence is more prevalent and more terrible. Schrand and Zechman clearly stated that
overconfident managers have high expectations and when these expectations no longer meet they
are more likely to engage in fraud. Overconfidence bias can be measured in three ways or we can
say that it has three facets. The first one is overestimation defined as overstating one‘s own
ability. The second is over placement identified by Larrick, Burson, and Soll. It is when people
think of themselves as better than others. The third one is over precision, which is excessive
certainty regarding the accuracy of one‘s beliefs. Scores of studies have been conducted on the
impact of overconfidence bias and market efficiency. Overconfident investors are deemed to
cause excessive trading in the market, and also expose themselves to high risk. Studies show that
excessive trading and exposure to high risk can be used as proxies for overconfidence. Also
Debondt and thaler and Statman, Thorley &Vorkink considered the proposition that
overconfident investors in the market are engage in excessive trading and thus disturbing market
efficiency. Odean examined overconfidence and its reaction to private signals and concluded that
as a consequence there created excess volatility and negative return autocorrelation. As in the
above literature contrasting views can be found about overconfidence and its impact on
perceived market efficiency. Most of these studies show a negative impact of overconfidence on
market efficiency. However it can also be found that when people claim that they are above
average, it may be true in certain cases. As Griffin and Tversky argued that experts tend to be
more overconfident than relatively inexperienced ones. This study is an effort to find out if there
are any positive or favourable impacts of overconfidence bias stemming from self-attribution
bias on perceived market efficiency.

Data were collected through questionnaires from Islamabad Stock Exchange investors. The
population for this study was Stock Exchange investors. The population for this study was all the
investors of Islamabad Stock Exchange. Total of 500 questionnaires were distributed among the
investors but only 330 were returned showing a response rate of 75 percent. Data for this study
was collected through questionnaire. All the variables were operationalized into different
dimensions and elements. The independent variable i.e. self-attribution bias was divided into two
facets namely self-enhancing bias and self-protecting bias. Four questions were put regarding
each of the two facets. The mediating variable i.e. Overconfidence bias was divided into its three
facets namely over precision, over placement and over estimation as identified by Larrick,
Burson, and Soll and Barber and Odean. Five questions were put regarding each of the three
facets. Similarly, the dependent variable i.e. perceived market efficiency was measured by
putting questions regarding fundamental analysis and technical analysis.

Data collected through questionnaire were analysed using SPSS version 17. Statistical tools like
descriptive analysis, correlation analysis and regression analysis were used. The results from this
analysis are interpreted one by one as follow

The first condition (i.e. the significant relationship between self-attribution and perceived market
efficiency) is satisfied as self-attribution and perceived market efficiency) is satisfied as shown
in analysis one, thus leading to the acceptance of our first hypothesis. The second condition (i.e.
the significant relationship between self-attribution and overconfidence) is also satisfied as
shown in analysis two. Similarly the third condition (i.e. the significant relationship between
overconfidence and perceived market efficiency) is also met as show in the step 1 of the analysis
three, thus leading to the acceptance of our second hypothesis. In step 2 of analysis three,
controlling for the effects of the mediating variable (i.e. overconfidence bias), the beta for self-
attribution bias reduced by some amount (from .333 to .217) and also a little bit decrease in the
p-value (from .000 to .007) occurred thus showing the existence of a partial mediation. Hence the
hypothesis that overconfidence bias mediates the relationship between self-attribution bias and
perceived market efficiency is partially accepted. The results from the analysis, leads to partially
accepting the hypothesis that overconfidence bias mediates the relationship between self-
attribution bias and perceived market efficiency. Thus evidencing the establishment of a partial
mediation, which implies that there exist not only a significant relationship between
overconfidence bias and perceived market efficiency, but also some direct relationship between
self-attribution bias and perceived market efficiency. Also the hypothesis that self-attribution
bias has a relationship with perceived market efficiency is accepted, and this is a direct positive
relationship. Furthermore the hypothesis that overconfidence bias has a relationship with
perceived market efficiency is also accepted. This again is a direct positive relationship. The
reason behind this again is a direct positive relationship. The reasons behind these results are that
investors susceptible to such biases devote most of their time and money in collecting a wide
range of information. Also such investors are found to be more active as compared to others.
More specifically, overconfident investors expect to earn extraordinary returns because they
invest too many resources in information acquisition. And hence by providing such information
into the market the overconfident investors can bring security‘s prices to their true value. As,
Rubinstein stated that, overconfidence causes investors to overspend on research and perhaps
this overspending may not be in one‘s self-interest but it does help passive investors who can
find now that prices incorporate more information and market is efficient. These and other such
tendencies of these investors sometimes generate the arbitrage processes and provide liquidity to
the market. Hence an optimal amount of these biases contribute positively to market efficiency.

The main objective of this study was to establish the effect of self-attribution bias on investment
in the Rwanda Stock Exchange. The study used cross-sectional descriptive survey research
design to ascertain and establish the effect of behavioural biases on investment in the Rwanda
stock exchange. The target population comprised of 13,543 individual, group investors at the
Rwanda Stock Exchange. Random sampling was used where the targeted population was
individual investors to finally yield a sample size of 374 respondents. A questionnaire was used
to collect the primary data. A pilot test was undertaken by carrying out a small scale trial run of
the research instrument. Data analysis involved the use of descriptive and inferential statistics. A
Linear regression model was used to predict the probability of different possibility outcomes of
dependent variables, helping to predict the probability of an investor to invest in RSE. The
results confirmed that there was a significant positive linear relationship between self-attribution
bias and Investment in Rwanda stock market. The study also concluded that most investors
suffered from self-attribution bias in investment in stock markets. The study recommends that
investors should be keen to identify such bias to increase their rationality in stock trading.

Behavioural finance is the new field that seeks to combine behavioural (aspirations, cognition,
emotions) and cognitive psychological theory. It explains why investors makes a rational
financial decisions on the stock market. It describes the outcomes of interactions between
investors and managers in financial and capital markets; and it prescribes more effective
behaviour for investors and managers. The investment is mostly influenced in a large proportion
by psychological and emotional factors. Behavioural finance attempt to better understand and
explain how emotional and cognitive errors influence investment on the stock markets. The stock
markets are able to positively influence the economic growth through encouraging savings
amongst individuals and providing avenues for firm financing. Liquid stock markets may.

improve the allocation of capital and enhance prospects for long-term growth. Investment is not
an easy process, since the assumption is that investors always expect to maximize the returns
although not all investors are so rational. Traditional financial theories assume that investors are
rational and risk averse, and hold diversified, optimal portfolios. However, this doesn‘t work in
reality since investors must consider the behavioural biases in investing as this can help the
investors to avoid some unnecessary mistake made in investment in order to maximize the return
and minimize the risk. According to Shefrin bias is nothing else yet the inclination towards
failure. Bias is tendency to make decisions while the decision maker is already being subjected to
an underlying credence or belief. There are so many biases in human psychology. These biases
lay impact on individuals in such a way that they frequently deed on an obviously silly way,
routinely disregard conventional ideas of risk aversion, and make foreseeable lapses in their
conjectures and judgments. These biases play their part in shaping individual‘s choices, financial
decisions in corporations and financial markets. Unreasonable choices hamper the investor's
wealth and the execution of companies and additionally the productivity of business sector.
Scholars have identified so many biases Kahnemann and Tversky wrote a paper in which they
stated different states of mental biases that may impact the investment process; they are risk
aversion, regret aversion and self-attribution and the locus of control. According to Lam the
investors‘ predictions of the market fluctuations with certain methods, may be technical or
fundamental analysis used to predict money market. Technical analysis is used in forecasting
stock price fluctuations while fundamental analysis attempts at differentiating the investment
approach. African stock markets have historically offered a limited, narrow range of products
with the principle role of financial sector being the provision of the source of domestic funding
to offset government budgetary deficits. Common factors still inhibiting stock market
development include the lack of legal protection for investors and creditors. Other constraints are
that most African Stock Exchanges have limited trading hours and are closely synchronized with
other regional markets. Trading in the majority of markets is overwhelmingly dominated by a
handful of stocks, even if more securities are actually listed and bulk trading of a limited number
of stocks in the smaller exchanges hinders activity on the domestic markets. The first stock
exchange in sub Saharan Africa was Zimbabwe Stock Exchange (ZSE), the official stock
exchange of Zimbabwe which started in 1948. It has 64 listed companies and opened to foreign
investment since 1993. Zimbabwe Stock Exchange was established after Egyptian Exchange
stock (EGX) which started in 1883. The EGX is the largest in Africa with 833 listed companies
followed by Johannesburg Security Exchange or JSE that started in 1887 and in 2003 had an
estimate of 472 listed companies. The Nigeria Stock Exchange (NSE) stated in 1960 and it has a
population of 223 listed companies. Prices in the African stock markets tend to be highly volatile
and enable profits within short periods. Critics point out that the actual operation of the pricing
and takeover mechanism in well-functioning stock markets lead to short term and lower rates of
long term investment. This is because prices react very quickly to a variety of information
influencing expectations on financial markets. These problems are further magnified in
developing countries especially sub-Saharan African economies like Rwanda, with their weaker
regulatory institutions and greater macroeconomic volatility. The higher degree of price volatility
on stock markets in developing countries reduces the efficiency of the price signals in allocating
investment resources. These serious limitations of the stock market have led many analysts to
question the importance of the system in promoting economic growth in African countries. Some
of the common mistakes made by investors in designing their investment are identified as
follows: investors fail to design their investment avenues systematically; investors fail to
diversify their investment choice investors generally overestimate their skills, attributing success
to ability they don‘t possess and seeing order in information or data where it doesn‘t exist i.e.,
investors are overconfident while making investment; investors blindly follow the crowd (herd
mentality) while making investment which leads to wrong investment; investors anchor on
historical information; investors think that good times are permanent. They feel that ones they
earn a good profit from their investment avenue ,the investment would give them good returns
permanently; investors are greed and they want to earn money quickly (instant gratification)
which also leads to wrong investment. Finally, investor‘s generally make short term investments
rather than long term investments Rwanda is one of the youngest stock market in East Africa
with a small number of listed companies and low market capitalization, an indicator of low Stock
Market development. The Rwanda Stock Exchange Limited (RSE) was incorporated in 2005 and
launched officially in 2008. It is the principal stock exchange operating under the jurisdiction of
Rwanda's Capital Market Authority (CMA), previously known as Capital Markets Advisory
Council (CMAC), which in turn reports to the (MINECOFIN) Ministry of Finance and
Economic Planning. Rwanda‘s Stocks Exchange is young compared to the other markets in
EAC, like Nairobi Security Exchange (NSE) which was established in 1954, Dares Salaam
Security Exchange in 1996 and Uganda Stock Exchange in 1997. Currently RSE has only three
Initial Public Offering (IPO), Bralirwa, Bank of Kigali and Crystal Ventures as primarily listed
in Rwanda and four IPO as secondarily listed in Rwanda includes: Kenya Commercial Bank
Group and Nation Media Group, which are primarily listed in Nairobi Stock Exchange and cross
listed on the Rwanda Stock Exchange. The government has ensured that investors in the Rwanda
Stocks Exchange are protected, by advising and guiding companies seeking investment through
provision of important infrastructures and conducive environment for business development.
Despite these efforts, investment in the Rwanda stock exchange is low and the Rwanda Stocks
Exchange is not growing at the pace expected. Currently there are approximately 13,543
registered investors, all these investors are composed by the individual investors, group investors
and institutional investors. The market capitalization of Rwanda Stocks Exchange is USD 3.7
billon with 7 listed companies (RSE, 2015). In comparison with Nairobi Securities Exchange,
there are approximately 66 listed companies with a total market capitalization of approximately
USD 23 billion (Mwangi, 2016).

There are a number of theories that explain the relationship between behavioural biases and
investment decision. These include herding behaviour theory, prospect theory and heuristics
theory. In addition, Marchand states that heuristics stands for the tendency that individuals make
judgments quickly. Heuristics are strategies used to access complex problems and limit the
explaining information. Investors tend to make rules of thumb in order to process the information
so that they can make investment.
Those that herding can drive property trading and create the momentum for trading. In the case
of Rwanda Stock Exchange, the impact of herding behaviour may break down when it reaches a
certain level because the cost to follow the herd may increase to get the increasing abnormal
returns. Choices are made when people tend to give losses more weight than gain, where they
focus on how much they gained or lost instead of how much they gained. Choices are also made
where people are interested in their gains and losses as opposed to their final income and wealth.
In the case of investment choice in the Rwandese Stock Exchange, investors may attribute choice
of investments to own initiatives leading to self-attribution bias. In general, heuristics are quite
useful, particularly when time is limited but sometimes they lead to biases. In addition,
Marchand states that heuristics stands for the tendency that individuals make judgments quickly.
Heuristics are strategies used to access complex problems and limit the explaining information.
Investors tend to make rules of thumb in order to process the information so that they can make
investment. b) Empirical Literature Review Though the literatures of behavioural finance are
very large, some of the empirical cases of behavioural finance, which are based on the
psychology, attempt to understand how behavioural biases and cognitive errors influence
individual investors‘ behaviours. Hoffmann and Post conducted a study on self-attribution bias in
consumer financial decision making and how investment returns affect individuals‘ belief in skill
in Netherlands firms. The study found that the higher the returns in a previous period are, the
more investors agree with a statement claiming that their recent performance accurately reflected
their investment skills and vice versa. The study further established that while individual returns
relate to more agreement, market returns have no such effect. Tine study focused on attribution
bias and overconfidence in escalation of commitment the role of desire to rectify past outcomes.
This research investigated two cognitive biases that we posit lead to IT escalation of
commitment, namely, attribution bias and overconfidence in an escalation decision, as well as
desire to rectify past outcomes (DRPO) for its potential role as a mediator. To test our research
model, 160 IT managers participated in a web-based role-playing experiment. Attribution was
manipulated at two levels (internal and external), creating two treatment conditions. We posited
that the participants assigned to the internal attribution condition would escalate their
commitment to the failing IT project to a greater extent than participants assigned to the external
attribution condition; that individuals that have a high, versus low, level of overconfidence
would have a greater tendency to escalate; and that DRPO would mediate the effects of
attribution and overconfidence on escalation of commitment. Attribution bias was significant at
the level, but in the opposite direction of what was hypothesized; overconfidence showed a
significant main effect on escalation. The effect of attribution bias on escalation was significantly
mediated by DRPO, but the effect of overconfidence on escalation was not mediated by DRPO.
Implications of these findings for both research and practice are discussed. Malmendier and Tate
in a study on CEO over-confidence and the market reaction found that the motivational process
e.g. self-enhancement and self-preservation combines with cognitive factors e.g. self-esteem and
locus of control creates self-attribution bias. In addition, chief operation officers (CEOs)
suffering self-attribution bias credit the success of company because of their abilities, while
failures are attributed to economic situation, CEOs suffering from self-attribution bias tend to
overestimate their capabilities and therefore invest in such projects which are risky. Schneider
found that self-attribution bias also builds up an individual‘s overconfidence Individual exposed
to self-attribution bias think that they have more abilities than average, known as ―Batter then
average effect‖. As self-attribution enhances overconfidence, so the subjects who suffer from this
bias will be overconfident in their decisions and judgments. Self-attribution bias affects the
ability of a person to estimate his/her abilities and also affects the learning from past
performances of that person to estimate his/her abilities and also affects the learning from past
performances of that person. Gervais and Odean in a study on the effects of previous
performances of the investors on their behaviour, and found that success strengthens the
overconfidence. Further, when an investor is successful, they credit this success with their own
capabilities and skills and firm their beliefs regarding their ability too much, as a result they
become overconfident. Finally, it was found that people suffering from self-attribution bias
become more overconfident after a success and it affects the conception about own capabilities
as it hinders the evaluation of past performance, this leads to overconfidence. Yosef and Kumar
found that investment agents (brokers) biased self-attribution bring excessive optimism. When
confronted with uncertainty investors tend to be increasing biased self-attributing, which
ultimately induce overconfidence in them. The study also found that individuals become more
overconfident instead of going for self-assessment when affected by self-attribution bias.
Investors are overconfident about the events which they hope will generate positive outcomes
and will personify them. So self-enhancement triggers overconfidence in investors. Choi and Lou
found in their study of self-attribution bias, that self-attribution bias affects the impression of
people regarding their abilities and diverts them from learning from past successes. Self-
attribution biases is a significant channel that hinder people to link their successes with their
internal forces e.g. personal capabilities, and their non-successes with external forces.
Furthermore the evidence shows that the investors who are not exposed or aware of the biases
make rational decisions and thus they enjoy more favourable outcome. While on the other hand
the rational investors will make optimal decisions and generate the desired results. So it is
established that self-attribution motivates overconfidence hindering the investor from rational.

The underlying epistemology of this research was positivist; focusing on examining earlier
established theories under the assumption that reality is objectively given and can be described
by measurable properties independent of the observer and the instruments. The study used cross-
sectional descriptive survey research design to assess and establish the effect of behavioural
biases on investment at the Rwanda stock exchange. The design was suitable for the proposed
study because it attempted to determine current status of the phenomenon. The cross-sectional
descriptive survey method was suitable for this study since data was collected at one particular
time across the respondents in the Rwanda Stock Exchange. The target population of this study
comprised of individual, group and institutional investors at the Rwanda Stock Exchange which
are approximately 13,543 RSE, 2015. There are approximately 10,662 local investors, 2,474
from EAC and 407 registered as foreigner investors, all these investors are composed by the
individual investors, group investors and institutional investors (Directory, Rwanda Stocks
Exchange, 2015). Stratified random sampling was used and it involved dividing the population
into homogeneous subgroups followed by a simple random sample. To determine the sample size
for small populations, we use the normal approximation to the hyper-geometric distribution,
similar studies (Morris, 2014) have adopted the hyper-geometric distribution due to its ability to
estimate sample sizes from small populations accurately.

The study sought to find out whether investors considered their investment performance to be
always well thought out, the results showed that 25.4% of the respondents agreed, 18.3%
strongly agreed while 18.6% and 17.7% strongly disagreed and disagreed respectively. The
finding further revealed that 27.4% and 24.9% disagreed and strongly disagreed that loss making
is a result of investment advice taking from other people. Those who agreed and strongly agreed
were 11.1% and 15.4% respectively. On whether investors at Rwanda stock exchange considered
losing stock as a result of poor advice from others, 30.0% and 22.0% of the respondents
disagreed and strongly disagreed respectively. The findings further showed that 16.9% and
10.6% agreed and strongly agreed respectively. The mean of 2.64 confirmed that majority of the
respondents disagreed with the statements. The study further sought to establish whether
respondents viewed buying ‗hot‘ stock as result of their proactive knowledge of the stock
market, the findings showed that 20.6% disagreed, 20.3% strongly disagreed, 20.9% were not
sure, 22.3% agreed while 16.0% strongly agreed. The results further revealed that 21.1%
strongly disagreed, 16.6% disagreed, 24.6% not sure 19.1% agreed and 18.6% strongly agreed
that they knew when to trade and how much to invest in the stock market without making loss.
Similarly, the findings of this study established that respondents were divided on whether they
considered their investment performance to be always well thought out as shown by the mean
response of 3 and standard deviation of 1.30. The study sought to find out from the respondents
whether their skills and knowledge of stock market always helped them to outperform the
market, the findings showed that 26.6% and 12.9% agreed and strongly agreed while 24.0%
strongly disagreed and 13.1% disagreed. The results further revealed that majority of the
respondents disagreed they always relied on my predictive skills to time and outperform the
stock market as shown by the mean of 2.99. This study further sought to establish whether,
investors at Rwanda stock market ensured their reaction was as quickly as possible to the
changes of the market and followed the reactions to the stock market; the findings showed that
20.9% and 21.1% of the respondents disagreed while 26.0% agreed and 14.3% strongly agreed.
Finally, the study sought to establish whether investors considered the information from close
friends and relatives as the reliable reference for investment in the stock market. The findings
showed that 23.4% strongly disagreed, another 23.4% disagreed, 19.7% agreed and 10.0%
strongly agreed. The statement had a mean of 2.69 which further confirmed that majority of the
respondents disagreed while the standard deviation of 1.30 indicated wide varying from the mean
in the responses received.

These findings implied that investors at Rwanda stock market lacked self-attribution bias and
this could explain why they don‘t invest heavily in securities. Schneider found that self-
attribution bias builds up an individual‘s overconfidence Individual exposed to self-attribution
bias think that they have more abilities than average, known as ―Batter then average effect. Self-
attribution enhances overconfidence, so the subjects who suffer from this bias will be
overconfident in their decisions and judgments. Self-attribution bias affects the ability of a
person to estimate his/her abilities and also affects the learning from past performances of that
person to estimate his/her abilities and also affects the learning from past performances of that
person. Gervais and Odean also found that people suffering from self-attribution bias become
more overconfident after a success and it affects the conception about own capabilities as it
hinders the evaluation of past performance, this leads to overconfidence and investors place too
much weight on information they collect themselves due to excessive optimism.

The findings also established that the correlation between Investment in Rwanda Stock Market
by individual investors at the Rwanda stock market and Self-Attribution Bias was 0.550 with a
corresponding p value of 0.000. These findings implied that there existed a positive and
significant association between Self Attribution Bias and Investment in Rwanda Stock Market by
individual investors at the Rwanda stock market. The findings further implied that if Self-
Attribution Bias increases individuals Investment in Rwanda Stock Market also increases.
Schneider found that self-attribution bias builds up an individual‘s overconfidence Individual
exposed to self-attribution bias think that they have more abilities than average, known as
―Batter then average effect. Self-attribution enhances overconfidence, so the subjects who suffer
from this bias will be overconfident in their decisions and judgments. Gervais & Odean also
found that people suffering from self-attribution bias become more overconfident after a success
and it affects the conception about own capabilities as it hinders the evaluation of past
performance, this leads to overconfidence.

Example

A student gets a good grade on a test and tells herself that she studied hard or is good at the
material. She gets a bad grade on another test and says the teacher doesn't like her or the test was
unfair. Athletes win a game and attribute their win to hard work and practice.

3.7 OUTCOME BIAS

A fault condemned but seldom avoided is the evaluation of the intention of an act in terms of the
act's outcome. An agent who acted as wisely as the foreseeable circumstances permitted is
censured for the ill-effects which come to pass through chance or through malicious opposition
or through unforeseeable circumstances. Men desire to be fortunate as much as they desire to be
wise, but yet they fail to discriminate between fortune and wisdom or between misfortune and
guilt. We are ingenious in 'discovering' the defect of character we believe would account for a
person's misfortune. Since good decisions can lead to bad outcomes (and vice versa) decision
makers cannot infallibly be graded by their results. A good decision cannot guarantee a good
outcome. All real decisions are made under uncertainty. A decision is therefore a bet, and
evaluating it as good or not must depend on the stakes and the odds, not on the outcome.
Evaluations of decisions are made in our personal lives, in organizations, in judging the
performance of elected officials, and in certain legal disputes such as malpractice suits, liability
cases, and regulatory decisions. Because evaluations are made after the fact, there is often
information available to the judge that was not available to the decision maker, including
information about the outcome of the decision. It has often been suggested that such information
is used unfairly, that reasonable decisions are criticized by Monday-morning quarterbacks who
think they might have decided otherwise, and that decision makers end up being punished for
their bad luck. The distinction between a good decision and a good outcome is a basic one to all
decision analysts. The quotation from Edwards cited earlier is labelled by the author as "a very
familiar elementary point". In this paper, we explore how well the distinction between decisions
and outcomes is recognized outside the decision-analysis profession. Information that is
available only after a decision is made is irrelevant to the quality of the decision. Such
information plays no direct role in the advice we may give decision makers ex ante or in the
lessons they may learn. The outcome of a decision, by itself, cannot be used to improve a
decision unless the decision maker is clairvoyant. Information about possible outcomes and their
probabilities falls into three relevant classes: actor information, known only to the decision
maker at the time the decision is made; judge information, known only to the judge at the time
the decision is evaluated; and joint information, known both to the decision maker at the time of
decision and to the judge at the time of evaluation. (In some cases, the decision maker and the
judge will be the same person, at different times.) In the cases we consider, the judge has the
outcome information and the actor does not. Although outcome information plays no direct role
in the evaluation of decisions, it may play an appropriate indirect role. In particular, it may affect
a judge's beliefs about actor information. A judge who does not know the decision maker's
probabilities may assume that the probability was higher for an outcome that occurred than for
the same outcome had it not occurred. (Note, however, that outcome information tells us nothing
about the utilities of a decision maker, even if we have no other information about them.) In the
extreme, if we have no information except outcome, it is a reasonable prima facie hypothesis that
bad outcomes (e.g., space-shuttle accidents) result from badly made decisions. We do not usually
set up commissions of inquiry to delve into policy decisions that turn out well.

Another appropriate indirect role of outcome information is that it allows decision makers to
modify beliefs about probabilities in similar situations. If they know nothing about the proportion
of red cards in a deck, they can learn something about that proportion by drawing cards from the
deck. (However, if they know that the deck is an ordinary one, sampled with replacement, they
learn nothing by drawing cards.) This effect of outcome information can operate only within a
sequence of similar decisions, not in a single decision. At issue here is whether there is an
outcome bias, in which people take outcomes into account in a way that is irrelevant to the true
quality of the decision. This sort of bias is not established by showing that people take outcomes
into account. As we argued earlier, outcomes are relevant when they can inform us about actor
information. One way to show an outcome bias is to give the judge all relevant information about
outcome probabilities known to the decision maker, plus the outcome. That is, there is only joint
information and judge information (the outcome), no actor information. Information (relevant or
irrelevant) may have two effects on evaluations.

i. An effect on the judged probability of outcomes, which, in turn, affects evaluation

and

ii. A direct effect on the judged quality of the decision, as shown below

For example, we may think a decision is bad if we believe that bad outcomes were highly
probable, but outcome information may also affect our evaluation even if the probability of an
outcome is known. Fischhoff demonstrated the existence of a hindsight bias, an effect of
outcome information on the judged probability of an outcome. Subjects were given scenarios and
asked to provide probabilities for different outcomes. When subjects were told the outcome and
asked what probability other subjects who did not know the outcome (or they themselves if they
did not know it) would give, they gave higher probabilities than those given by actual other
subjects not told the outcome (or told that some other outcome had occurred). Note that these
demonstrations filled our condition of eliminating actor information (where the actors were the
other subjects). Subjects were asked to judge the probability for someone who had exactly the
same information they had (except for outcome), no more. Although it seems likely that the
hindsight bias would lead to biased evaluations of decision quality, this has not been shown, nor
is it what we seek to show here. Rather, we seek a direct effect of outcome on evaluation of
decisions, an effect that does not operate through an effect of outcome knowledge on a judge's
assessed probabilities of outcomes. To this end, we held probability information constant by
telling subjects that probabilities were known, or by otherwise limiting probability information.
Of course, in real life, the outcome bias we seek could work together with the hindsight bias to
distort evaluations of decisions even more than either bias alone. Zakay showed that managers
counted good outcomes as one of the criteria for evaluating decisions made by other managers.
However, as we have argued, it is perfectly reasonable to do this when there are facts known
only to the decision maker (actor information). At issue in this article is not whether people use
outcome information but whether there are conditions under which they overuse it. Thus, we
look for an effect of outcome information when the subject is told everything that is relevant. In
this case, outcome should play no role in our evaluations of decisions, although we hypothesize
that it will. The outcome bias we seek may be related to Walster's finding that subjects judged a
driver as more "responsible" for an accident when the damage was more severe. However,
questions about responsibility might be understood as concerning the appropriate degree of
punishment or blame rather than rationality or quality of decision making. As a general rule, it
makes sense to punish actors more severely for more severe consequences; it is usually difficult
to know what the actor knew, and severity of consequences is a clue as to the degree of
negligence. Even when we know what the actor knew, use of this general rule may set clearer
precedents for others (as in the utilitarian rationale for "punishing the innocent"). Walster
apparently intended the question about responsibility to tap subjects' beliefs about the extent to
which the driver could have prevented the accident by acting differently. Walster suggested that
her results were due to subjects' desire to believe that events were controllable: If bad outcomes
are caused by poor decisions or bad people, we can prevent them by correcting the decision
making or by punishing the people. If subjects interpreted the question this way, they would be
making an error, but not the same error we seek in this study. Similarly, studies of the effect of
outcomes on children's moral judgments have used judgments of responsibility, deservingness of
punishment, and badness, each of which could be appropriately affected by outcome. Also, in
most cases no effort was made to provide the judge with all relevant information available to the
actor. Mitchell and Kalb also showed effects of outcome knowledge on judgments of both
responsibility for outcomes and outcome probability. Subjects (nurses) read descriptions of poor
performance by nurses (e.g., leaving a bed railing down) that either resulted in poor outcomes
(e.g., the patient fell out of bed) or benign outcomes. In fact, outcome knowledge affected both
probability judgments and responsibility judgments. Although the former effect might have been
a hindsight bias, it might also have been an appropriate inference about actor information:
Outcome information might have provided information about factors that affected outcome
probability from the decision maker's viewpoint (e.g., whether the patient was alert and, if not,
whether she slept fitfully). Mitchell and Kalb argued that the effect of outcome on probability did
not explain the effect on responsibility judgment: The correlation between judged probability and
judged responsibility, with outcome held constant, was nonsignificant across subjects. Of course,
the problem still remains that the term responsibility need not refer only to quality of the
decision. In our experiments, instead of examining the correlation between outcome judgments
and probability judgments, we fixed the outcome probabilities by telling the subjects what they
were from the decision maker's viewpoint. We also explicitly asked about the "quality of
thinking." All decisions were expressed in the form of gambles. For example, an operation may
lead to a cure or to death, with given probabilities. We gave the subjects probabilities of all
possible outcomes and brief descriptions of each outcome. It is reasonable to assume that the
quality of the decision would depend on the probabilities of the outcomes— which summarize all
the information we have about uncertain states of the world that could affect the outcome—and
the desirability or utilities of the outcomes. Although we did not provide all necessary
information about desirability‘s, the outcome provided no additional information on this score. In
our studies an outcome bias existed when the evaluation of the decisions depended on their
outcomes. We expected to find an outcome bias because the generally useful heuristic of
evaluating decisions according to their outcomes may be overgeneralized to situations in which it
is inappropriate. It may be learned as a rigid rule, perhaps from seeing punishment meted out for
bad outcomes resulting from reasonable decisions. Of course, it can often be appropriate to use
outcome information to evaluate decision quality, especially when actor information is
substantial relative to judge information or joint information and when it is necessary to judge
decisions by their outcomes (as fallible as this may be) simply because there is little other useful
information. This is especially true when decision makers are motivated to deceive their
evaluators about the nature of their own information. Ordinarily, it is relatively harmless to
overgeneralize the heuristic of evaluating decisions according to their outcomes. However, when
severe punishments (as in malpractice suits) or consequential decisions (as in elections) are
contingent on a judgment of poor decision making, insight into the possibility of
overgeneralization may be warranted. A second reason for outcome bias is that the outcome calls
attention to those arguments that would make the decision good or bad. For example, when a
patient dies on the operating table, this calls attention to the risk of death as an argument against
the decision to perform surgery. When subjects attempt to re-examine the arguments to consider
what they would have thought if they had not been told the outcome, the critical information
remains salient. Fischhoff found an analogous mechanism to be operating in hindsight bias.
When subjects were asked to rate the relevance to their judgment of each item in the scenario,
the relevance of the items depended on the outcome subjects were given. Note that the salience
of an argument based on risk or possible benefit may not be fully captured by a description of the
subjective probability and utility of the outcome in question. One type of argument for or against
a decision concerns the difference between outcomes resulting from different decisions in
otherwise identical states of the world. For example, a decision to buy a stock or not may
compare one's feelings about buying or not buying if the stock goes up (rejoicing vs. regret), or if
the stock goes down. Regret theory explicitly takes such differences into account in explaining
choice. Once the true state is revealed (e.g., the stock goes down), the judge may overweigh the
regret associated with this state (the difference between buying and not buying in this case) when
judging decision quality. Another type of argument is that a bad outcome may be avoided by
considering choices other than those considered so far, or by gathering more information about
probabilities. Such arguments are equally true regardless of whether the outcome is good or bad
but a bad outcome may make them more salient. In many of our examples, there is no possibility
of additional choices or information. A third reason for outcome bias is that people may regard
luck as a property of individuals. That is, people may act as if they believe that some people's
decisions are influenced by unforeseeable outcomes. Such a belief might have been operating in
the experiments of Langer who found that people were less willing to sell their lottery tickets
when they had chosen the ticket number themselves than when the numbers had been chosen for
them. Langer interpreted this finding (and others like it) in terms of a confusion between chance
and skill, but the skill involved might have been the sort of clairvoyance described earlier. Our
experiments did not test this explanation directly, but we mention it here for completeness.

Example

A doctor decides to give a critically ill child a new, experimental medication that has a 50%
chance of curing the child's condition.

3.8 RECENCY BIAS

Recency bias is a cognitive bias that favours recent events over historic ones. A memory bias,
recency bias gives "greater importance to the most recent event" such as the final lawyer's
closing argument a jury hears before being dismissed to deliberate.

Recency bias should not be confused with anchoring or confirmation bias. It commonly appears
in employee evaluations, as a distortion in favour of recently completed activities or
recollections, and can be reinforced or offset by the Halo effect.

Recency bias can skew investors into not accurately evaluating economic cycles, causing them to
continue to remain invested in a bull market even when they should grow cautious of its potential
continuation, and refrain from buying assets in a bear market because they remain pessimistic
about its prospects of recovery.

When it comes to investing, recency bias often manifests in terms of direction or momentum. It
convinces us that a rising market or individual stock will continue to appreciate, or that a
declining market or stock is likely to keep falling. This bias often leads us to make emotionally
charged choices—decisions that could erode our earning potential by tempting us to hold a stock
for too long or pull out too soon.

Lists of superlatives such as "Top 10 Superbowls", Greatest of All Time (G.O.A.T.), and sports
awards (such as MVP trophies, Rookie of the Year, etc.) all are prone to distortion due to
recency bias. Sports betting is also impacted by recency bias.

Recency bias is related to the serial-position effect known as the recency effect. It is not to be
confused with recency illusion, the belief or impression that a word or language usage is of
recent origin when in reality it is long-established.
The amount of information available to the mathematics teacher is so enormous that the selection
of desirable content is gradually becoming a huge task in itself. With respect to the inclusion of
elements of desirable content is gradually becoming a huge task in itself. With respect to the
inclusion of elements of history of mathematics in mathematics instruction, the era of Big Data
introduces a high likelihood of Recency Bias, a hitherto unconnected challenge for stakeholders
in mathematics education. This tendency to choose recent information at the expense of relevant
older, composite, historical facts stands to defeat the aims and objectives of the epistemological
and cultural approach to mathematics instructional delivery. This study is a didactic discourse
with focus on this threat to the history and pedagogy of mathematics, particularly as it affects
mathematics education in Nigeria. The implications for mathematics curriculum developers,
teacher-training programmes, teacher lesson preparation, and publication of mathematics
instructional materials were also deeply considered.

Mathematics is an embodiment of tradition. As a field of study, mathematics is the

conglomeration of centuries of efforts structurally pieced together from diverse facet of human
endeavour and from across centuries of efforts structurally pieced together from diverse facet of
human endeavour and from across different cultures around the globe. This structure of
knowledge is communicated over the ages to students in schools as a composite subject, with its
practice and evolution deeply embedded in all successful (and sometimes unsuccessful) human
advancement. The fact of the relevance of mathematics to life elevates the status of the
mathematics educator to paramount. In expressing this truth, Pepin rightly asserts that
mathematics educators are charged with explaining the processes of growth of mathematical
knowledge, monitoring the processes of mathematical discovery in the making of the
mathematician, and provoking such processes in teaching. Mathematics teachers are therefore
expected to be the custodians of the rich history and traditions of the discipline. Mathematical
creativity ensures the growth of the field of mathematics as a whole. The ingenuity of
mathematician‘s past are today manifesting in the indispensability of modern science and
technology. Their painstaking strides have woven a rich mosaic of conceptions of the nature of
mathematics, ranging axiomatic structures to generalized heuristics for solving problems. In its
earliest days (spanning the era of the Egyptian and Greek thinkers) mathematics was often bound
up with practical inquiry. However, as time progresses, it became more balanced and more
realistic to consider that mathematics exists as a body of truths about relationships between
abstract entities and structures.

These abstract relationships are reflected or instantiated, in various forms and at different levels,
in the concrete structure of the physical world. Even in its most advanced form, the subject is
rooted in reality concrete structure of the physical world. Even in its most advanced form, the
subject is rooted in reality with applications in everyday life. Mathematics is vital to business,
agriculture, medicine, psychology and several fields of human endeavour. The permeability of
mathematics made emphasis on the pedagogy of the subject a central concern to educators. The
burden of the sustainability of mathematical knowledge rests squarely on the shoulders of
mathematics teachers, whose methodology of communicating facts determine both immediate
and future outcomes for students. It is obvious that mathematics in some sense has a common
language: a language of symbols, technical definitions, computations, and logic. The rectitude of
mathematics requires students to articulate sound mathematical explanations and always justify
their solutions. Currently, focus is shifting from teacher-centred instructional strategies that stunt
the growth of mathematical mastery to student-driven mathematical intuition, mathematical
thinking and real-world problem solving. Linking the teaching of mathematical concepts to the
histories behind them has been associated with setting students on the path of mathematical
discovery, irrespective of the method of instruction. Over recent decades, advances in digital
technology have provided several forms of augmentation to the traditional mathematics
classroom. Today, powerful information and communications technology (ICT) tools and
platforms at the disposal of the mathematics teacher are helping transform education in terms of
its contents, methods and outcomes. Both teachers and students of mathematics now have access
to vast amount of resources at their fingertips wherever they are. Indeed there have been a
massive revolution in the way mathematics learners‘ study and do research. This digital
revolution is being fuelled by the increasing broadband penetration and ubiquity of smartphones
among the new genre of learners who are successively imbibing a trendy culture of leisure and
school work. Tons of digital content are being churned out by different outlets daily over the
internet, with the Computer Science Corp forecasting an annual increase of 4300% by the year
2020 when the information super-highway will be holding an estimated milestone traffic of 35
Zettabyte of data. This phenomenon of data explosion playing out in the current era is termed
―Big Data‖. Big data has been described as the incomprehensibly large worlds of information
which have been on the rise due to explosion in mobile networks, cloud computing and new
technologies. According to Boyd and Crawford Big Data is less about data that is big than it is
about a capacity to search, aggregate, and cross-reference large data sets. The interconnection of
databases and development of powerful new software tools for inference making are resulting in
a new kind of knowledge infrastructure freely available for patronage by every inquisitive mind.
Educational establishments are active players in this knowledge economy. But like the Aspen
Institutes Executive Director Charles M. Firestone asked in his forward to the Bollier report,
―does the ability to analyse massive amounts of data change the nature of scientific
methodology? Does Big Data represent an evolution of knowledge, or is more actually less when
it comes to information on such scales?‖ The answers to these questions are fast constituting a
heated debate among scholars, and obviously the promises outweighing the perils. When
eyeballed in the context of mathematics education, the existence of Big Data is immensely
widening the scope of coverage for both teachers and students. It can be argued that
mathematicians have more access to inexhaustible resources now than ever before. The
attainable horizon of research in the discipline is now unendingly scalable. However, with
respect to the study of history of mathematics, the issues become more confounding and complex
than outright. With more new information being added daily to educational resources, focus on
integrating elements of history into normal mathematics classroom activities may suffer some
setbacks, not excluding the tendency to resort to more recent history. If this bias becomes
pervasive in mathematics education practice, the very objectives of the inclusion of elements of
history will be gravely endangered.

The psychological tendency to reference more recent information at the expense of older,
detailed and more relevant data, rightly termed ―Recency Bias‖, may be gradually eroding the
foundations of more relevant data, rightly termed ―Recency Bias‖, may be gradually eroding the
foundations of mathematical knowledge. The chain of events weaved up in the history of basic
mathematical concepts are fundamental to enriching students understanding of school
mathematics. It is against this backdrop that this work seeks to lay out the issues contending with
the handling of history of mathematics, particularly in Nigeria. The study intends to establish the
current status of history of mathematics in Nigeria and the need for various stakeholders in
mathematics education to rise to the challenge of saving this aesthetic component of mathematics
from an impending demise.
Mathematics is proud of its history, confident in its traditions and certain that the truth it
pronounced are real truths applying to the real world. There is nothing as dreamy and poetic,
nothing as real truths applying to the real world. There is nothing as dreamy and poetic, nothing
as radical, subversive, and psychedelic, as mathematics, since it is the purest of the arts, as well
as the most misunderstood. Mathematics, as taught in school has reduced the rich and fascinating
adventure of the imagination to a sterile set of facts to be memorized and procedures to be
followed. History of mathematics adds aesthetic value to the teaching and learning of
mathematics. Teaching mathematics without adequately incorporating the elements of its history
leads to removing the creative process and leaving only the results of that process. This will
automatically lessen the chance of any real engagement with the subject. History of mathematics
places mathematics in real time and location, and blending it into classroom instruction,
according to Lockhart enables students to pose their own problem, make their own conjectures
and discoveries, to be wrong, to be creatively frustrated, to have an inspiration and to cobble
together their own explanations and proofs. These rich experiences are what makes
mathematicians, both ancient and modern, admirable characters in the society. Denying students
the opportunity to engage in these activities implies denying them mathematics altogether.
Mathematics should be thought of as a living organism with its peculiar long history and a vivid
present. Considering this, mathematics is expected to be taught with reference to a historical,
epistemological and cultural approach. Vallhonesta, Esteve, Casanova, Puig-Pla and Roca-Rosell
stated that history of mathematics can be used implicitly and explicitly to enrich mathematics
education. On the one hand, the history of mathematics can be used as an implicit resource in the
design of activities to adapt some standard concepts, and to prepare problems and auxiliary
sources. On the other hand the history of mathematics can be used in an explicit way to direct
and propose research works using historical materials to aid students‘ understanding of
mathematical concepts. History of mathematics helps to develop the analytic and synthetic
thought process of students. The ideas generated from historical attachments to mathematical
concepts can truly create conflictive situation in which students are encouraged to reflect upon
the rules that define their actions when dealing with the concepts. This approach, results in both
sensitive and historical thinking, mediated by bodies, signs, artefacts and cultural meanings. The
approach gives rise to a non-mentalist conception of thought. Generally, students‘ reflections
about the nature of mathematics through history evidently results in enhanced mathematical
literacy, increased psychological motivation, and linguistic and transverse competencies. The
usage of original sources has been shown to be effective in the teaching and learning
mathematics. In view of the usefulness of history of mathematics, content selection must be a
careful effort on the part of the teacher in order to achieve an unbroken connection of related
facts.

Recency, basically, is a cognitive bias that convinces one that new information, which is more
recent, is more valuable and important than older information. According to Townsend this may
be true, but more valuable and important than older information. According to Townsend, this
may be true, but it is not necessarily true. Kanasky attributes recency effect to a simple
enhancement of short-term memory due to recent exposure to information. Sousa related that
Ebbinghaus published the first studies on this phenomenon in the 1880s, and as such, recency
bias itself is not a new discovery. Cases of recency bias are well established in the fields of
Educational Psychology, Law, and Behavioural Finance. Jones and Sieck having considered
advantageous and disadvantageous scenarios of recency effect, suggested that regardless of the
mechanisms responsible, it is instructive to consider their role in relationship to normative and
descriptive behaviour. Barbosa, de Lima-Neto, Evsukoff and Menezes found that when it comes
to visitation patterns, humans are extremely regular and predictable, where recurrent travels
responsible for most of the movements. Teachers usually circumvent the recency effect in the
classroom often by applying review, warm-ups, recap of previous knowledge, practice, and
summary. Lawyers, for instance, call their strongest witness last to make a lasting impression.
Advertisers also apply the recency factor by ensuring the last portion of their promotion creates
the desire to purchase their product. Recency bias is often classified as one of many different
decision-making errors and closely related to the human tendency towards cognitive ease as
against the hard work of thinking, analysing and deciding. It is the habitual laziness factor in
recency bias that distinguishes it from the seemingly similar recency effect which is dictated by
limitation. This fact links recency bias to choice, which is in turn heavily dependent on the
amount of available possibilities. Considering how limited abilities to process information affect
choice behaviour the current era of Big Data certainly stretches the range of available
possibilities to an unimaginable extent. While it is advisable to weigh as much facts and
contextual information as possible before making decisions, is not always practicable in the
decision making process of lesson preparation and individual study. Those in charge of selecting
instructional aid on both online and offline media are subject to recency bias and history of
mathematics as an element of mathematics instruction tends to be adversely affected considering
the ease of neglecting pre-modal historical data by the non-professional eye on the grounds of
perceived irrelevance or age. Processes of globalization resulting in Big Data have produced a
strong cross-cultural perspective on how people recall and historical narratives. The chain of
events which constitute the body of communicated history is required to be transmitted
systematically. However, in the case of history of mathematics, teachers‘ departure from relating
specific origins of concepts and attempts by ancient mathematicians in providing solutions to
mathematical problems is contributing to the mystification of the subject. Students are
erroneously led to believe that mathematics is highly abstract because concepts treated in the
classroom are left hanging without meaningful beginning and representation in real life. An
illustration can be cited of the case of analytic geometry in which most instructional contents
dwell only on deriving and resolving equations without at least going backward to the significant
contributions of Rene Descartes, or even backtracking further to early attempts by ancient
Egyptian and Greek mathematicians. Recency bias in the development of mathematical contents
occasioned by the multiplicity of sources in this era of Big Data is making mathematics more
mechanic than realistic. Mathematics is mechanical if it is devoid of history and applications.
Teachers of mathematics, being aware of this fact, are expected to be seasoned editors of
materials with interest in promoting the aesthetic value of the subject by transcending cultures
and ages to connect the contents they are required to deliver.

The joy in mathematics can be felt in discovering new mathematics, rediscovering old
mathematics, learning a way of thinking from a person or text, and finding a new way to view an
old mathematical learning a way of thinking from a person or text, and finding a new way to
view an old mathematical structure. The teacher of mathematics, irrespective of the level of
education, is at the centre of communicating a sound mathematical experience to students. It is
the duty of such teacher to design mathematics instruction that will dynamically utilize aspects of
concept history to enrich the learning experience. Although, Nigeria is on the African continent
known for its rich heritage of mathematics culture, indigenous studies into the history of its
mathematics are scanty and still hard to come by. However, pockets of studies into the
integration of cultural art-facts in the study of mathematics affirm the relevance of history of
mathematics in the communication of mathematics in Nigeria. Full empirical deployment of
history of mathematics in the classroom is still unavailable from Nigeria. There is the indication
that little elements of history are being embedded in classroom instruction in mathematics
considering how General History fared in the development of curriculum in Nigeria. A glimpse
through the literature available for the teaching and learning of mathematics attest to the poor
handling of history of mathematics in Nigeria. Techers who did not wake up to the discovery of
the relevance of history of mathematics are left groping with the teaching of the subject only as
they, in turn, were taught. In the absence of innovation, students are mechanically put through
the age-long myth of difficulty of mathematics by grinding through sets of solutions without any
explanation of the mechanisms involved. Heightened mathematics phobia arising out of this
status quo drove away a good number of students from pursuing mathematics related careers.
The few who could attain mathematical proficiency out of personal effort are viewed as
privileged and gifted, making it appear like it is unnatural to understand mathematics. There is
obviously a serious need for mathematics educators to begin at the beginning. Teachers should
bring in historical connections that give students the opportunity to model mathematical problem
in its existential context, to carry out analysis of the learning materials and discover
mathematical properties that are completely new. One of the means of demystifying mathematics
is for teachers to introduce original sources to their classroom discussion. The archetypal texts of
early attempts of ancient mathematicians can be used as starting points for classroom discussion.
A prominent example of original source instructional materials is the Chinese text: The Nine
Chapters in Mathematical Arts, which has ties to most mathematical procedures of the current
era. Systems of linear equations, trigonometry and geometry are aspects of school mathematics
that could be spiced up by referencing this ancient text as a starting point. As soon as students
attain the formal operational stage (11-16 years), they are ready to be confronted with historical
materials that foster hypothetical deductive reasoning. The support of carefully articulated
elements of history can spark up reflective thought process from concrete considerations,
building up to more abstract reasoning. Such articulation of materials must be free of prejudices
arising from Big Data.

There is accumulating evidence that recent prior knowledge about expectations plays an
important role in perception. Internet continues to be intertwined with perception. As the Internet
continues to be intertwined with peoples‘ daily lifestyle, it is negatively shaping the way
information is being processed and interpreted. Weyers observed that the way teachers and
students are currently using the Internet is reducing the desire to be inquisitive, think,
comprehend, and ultimately retain information. Specifically, the era of Big Data is increasingly
contributing to the display of recency bias with respect to the handling of history of mathematics.
The implications of this didactic discourse are considered here from some key perspectives.
These are as it relate to curricular emphasis, teacher preparation, reformation of publications of
basic mathematics literature, and teacher training programmes. Literature suggests that most
creative individuals tend to be attracted to complexity often arising out of past problems, an
existence of which most school curricula has very little to offer.

Mathematics curricular efforts rarely throw open problems with the sort of underlying
mathematical structure that would warrant students having a prolonged period of engagement
and the independence to structure that would warrant students having a prolonged period of
engagement and the independence to formulate solutions. Mathematics curricular efforts in
Nigeria should seek to attain the higher aim of mathematics education, which is to establish in
students‘ clarity of thought and the ability to pursue assumptions to logical conclusions. Re-
integrating elements of mathematical history to the background of instructional content could be
a safe starting point for both developers and implementers of the curriculum. The Nigerian
Education Research and Development Council (NERDC) which is charged with this onerous
regulatory function must be repositioned to effect sound instructional delivery in mathematics
across the country. Developers must stand up against the idea of recycling mathematics
curriculum with no historical perspective and should put in place mechanisms for restoring
discovery and exploration, natural and meaningful problem solving, and factual simplicity.
Practical cognitive artefacts like early classical texts and historical approaches to solving
mathematical problems can be recommended by the curriculum. If these are passed down with
the publication of textbooks and other instructional materials, curious students can lay hold on
their benefits to drive more personalized learning. Mathematics is a slow, contemplative process
which takes time to produce and a skilled teacher to even recognize one. Lockhart posit that it is
unacceptable to have mathematics teachers who know nothing of the history and philosophy of
the subject, nothing about past and recent developments, nothing in fact beyond what they are
expected to present to their unfortunate students. Only a high level of coordination on the part of
the mathematics teacher can prevent mathematics instruction from being reduced to mere data
transmission, a process in which there is no sharing of excitement and wonder. The teacher of
mathematics is expected to first develop himself at the personal level in the art of building
openness and honest intellectual relationship with students by leveraging on the connecting
power of rudimentary mathematical history in instruction delivery. Every mathematics class
should be loaded with rich learning experiences based on the teachers‘ ability to connect the past
to the present and recognize information without prejudice to distance from the current era. In
handling the distractions of Big Data, the mathematics teacher, like a professional driver, must
avoid the temptation of being overwhelmed by the speed of visual data hitting him, by adopting
expert vigilance and focusing on a far-away point which is the goal of his duty. Without
confident, knowledgeable teachers in the classroom, improvement in mathematics education is
certainly impossible. The foregoing implication partially re-directs responsibility to teacher-
training programmes in Nigeria. Universities and colleges of Education mounting programmes in
mathematics education must emphasize the relevance of history of mathematics in the pedagogy
of mathematics. Professionals at this level should inculcate in both in-service and pre-service
teachers the notion that elements of history of mathematics constitute effective tools to help in
the understanding of mathematics as useful, dynamic, humane, interdisciplinary and heuristic
science. Apart from the teaching of the usual mandatory two-credit-units course – History of
Mathematics, mathematics educators should practically engraft history into their own classroom
discussions, thereby setting a good example for the teachers-in-training to follow. Nigerian
mathematics education practitioners should set the pace in developing instructional strategies
that make use of original sources from across the globe. In already developed forms, these tools
can easily be picked up by mathematics teachers at the secondary and primary education levels
for onward blended utilization. The widespread dissemination of mathematical knowledge is
expected to present a more humanistic idea of what mathematics is by reporting mathematical
history without breaking its genealogy. Basic mathematics literature available for use at lower
educational levels in Nigeria is expected to position mathematics in time by adequately linking
concepts to their origins. Publishers of textbooks, the National Mathematical Centre (NMC),
Abuja, and the Mathematical Association of Nigeria must break away from the practice of
producing literature that enforces a rigid view of mathematics. Online publications intended for
classroom consumption should also cover essential aspects of historical linkages to key
mathematical concepts. Materials in study books should be presented first from the concrete
level, before gradually increasing in abstraction.
Example

If you are asked to name 30 movies that you have seen there is likely to be a tendency of
recalling movies you have seen in the recent 1 or 2 years more than movies you saw 10 – 15
years back. Recency bias is seen in many aspects of our lives.

3.8.1 Description

Performance reviews are such an integral part of the whole performance management system,
but they are often met with hesitation because many people believe that they are laced with
biases. There are several different types of biases that adversely impact the performance review
process, one of which is called recency bias.

As the name suggests, this type of bias focuses on an employee‘s performance in a recent time
period instead of considering the total time period.

When managers or supervisors evaluate and review employee performance and progress, they
often end up focusing on all that has happened lately, or in other words, the recent events. A
major reason behind that is it‘s quite easier and more convenient to remember and recall events
that have occurred recently.

As human beings, a lot of the time, our views and opinions of others are coloured something that
they have done recently. So, for instance, if an employee completely messed up their last
presentation or alternatively, if an employee secured a great deal with a customer, the recent act
or performance is likely to be at the top of the list in their manager‘s or supervisor‘s mind.
Naturally, this ends up creating a serious bias in that employee‘s performance review, which also
further leads to contradictions.

The core foundation of any performance review or appraisal system is objectivity, where
managers and supervisors are required to be as objective as possible.

Recency bias also alters the results because the bigger picture is ignored here, creating a biased,
untrue representation of an employee‘s work and performance. It can make or break the entire
performance review process. An issue with recency bias is that it brings in unconscious bias
since it can actually be hard to recollect information from the past, and the unfairness can be
attributed to a person‘s memory as well.

3.8.2 Practical Application

Being easily influenced by recent news is one of the most common behavioural biases that
impact investing decisions, but helping clients overcome such bias remains an ongoing
challenge.

That‘s one finding from the BeFi Barometer 2019 survey of 301 financial advisors. The survey
sponsored by Charles Schwab Investment Management (CSIM) and conducted in collaboration
with the Investments & Wealth Institute and Cerulli Associates set out to learn how advisors
view and use behavioural finance when working with clients.

In the resulting white paper, ―The Role of Behavioural Finance in Advising Clients,‖ the firms
advise that understanding the various ways behavioural tendencies can impact investors is
fundamental to building a successful wealth management practice.

―With the prospect of increased volatility and lower returns on the horizon, advisors who
understand the psychological or emotional factors that predispose investors to behavioural biases
can differentiate their services in what is becoming an increasingly competitive environment,‖
explains Omar Aguilar, PhD, Chief Investment Officer of Equities and Multi-Asset Strategies at
CSIM.

In asking advisors what the most effective methods are to help clients avoid the impact of
behavioural biases, nearly two-thirds (62%) cite helping clients take a long-term view as a ―very
effective‖ strategy. This is true particularly in periods of volatility, reminding clients of their
investment goals and ensuring they adhere to a sensible financial plan can help them reduce
emotional reactions and avoid making poor investment decisions, according to the study.

Advisors also cite implementing a systematic process (e.g., automatic rebalancing) and a goals-
based planning approach as effective strategies to help take the emotional decision making out of
the process and reduce the likelihood they will overreact to a drastic market move.

The research also highlights that it is important for advisors to not only understand client biases,
but also be cognizant of their own. Advisors ranked loss aversion (29%), overconfidence (17%)
and confirmation (9%) as the top three biases that impact their own perspectives and decision
making.

3.8.3 Research Review

The recency effect is a cognitive bias in which those items, ideas, or arguments that came last are
remembered more clearly than those that came first. The more recently heard, the clearer
something may exist in a juror's memory. This is common when information is given in lists –
the last thing heard is recalled, while those at the beginning and in the middle may be forgotten.
As a result, the party delivering the final closing argument – the defence – has an advantage.

The recency effect is increased when too much information is presented too quickly, and it is
reduced when coupled with other tasks. With respect to jury memory, allowing note taking could
also reduce both primacy and recency effects.

3.8.4 Diagnostic Testing

In this two-part series on sources of bias in studies of diagnostic test performance, we outline
common errors and optimal conditions during three study phases: patient selection, interpretation
of the index test and disease verification by a gold standard. Here biases associated with
suboptimal participant selection are discussed through the lens of partial verification bias and
spectrum bias, both of which increase the proportion of participants who are the 'sickest of the
sick' or the 'wellest of the well.' Especially through retrospective methodology, partial
verification introduces bias by including patients who are test positive by a gold standard, since
patients with a positive index test are more likely to go on to further gold standard testing.
Spectrum bias is frequently introduced through case-control design, dropping of indeterminate
results or convenience sampling. After reading part 1, the informed clinician should be better
able to judge the quality of a diagnostic test study, its inherent limitations and whether its results
could be generalisable to their practice. Part 2 will describe how interpretation of the index test
and disease verification by a gold standard can contribute to diagnostic test bias.

3.8.5 Advice

Recency bias is the tendency to place too much emphasis on experiences that are freshest in your
memory—even if they‘re not the most relevant or reliable. Would you want to go for a long
ocean swim after watching Jaws? Probably not, even though the actual risk of being attacked by
a shark is infinitesimally small.

In the investing world, recency bias can be hard to avoid. Clients display recency bias when they
make decisions based on recent events, expecting that those events will continue into the future.
It can lead them to make irrational decisions, such as following a hot investment trend or selling
securities during a market downturn.

In fact, the BeFi Barometer 2020 study, conducted by Cerulli Associates and sponsored by
Charles Schwab Investment Management in collaboration with the Investments & Wealth
Institute, found that recency bias is the most common behaviour bias that advisors believe is
affecting clients‘ investment decisions.

3.9 SUMMARY

 Ensuring that people understand the risk of a disease is likely to lead to better decisions
about health-protective behaviours and lower levels of worry. Thus, research on
understanding this health-protective behaviours and lower levels of worry. Thus, research
on understanding this type of risk communication is critical in order to be able to provide
comprehensible disease risk messages to patients.

 In this paper, we explored one important communication bias, anchoring and adjustment,
as a useful tool for understanding the persistence of over- and underestimation of disease
risk after provision of risk information in provider-patient interactions, such as genetic
counselling, and the factors affecting this process. In addition to the recommendations
above, new findings as to how the anchoring-and-adjustment heuristic works in other
decision making and interpersonal communication contexts might further help illuminate
how this bias works in disease-risk communication.

 Received from the Social and Behavioural Research Branch, National Human Genome
Research Institute, National Institutes of Health, Bethesda, Maryland (IS, KAK). This
research was supported by the Intramural Research Program Institutes of Health,
Bethesda, Maryland (IS, KAK). This research was supported by the Intramural Research
Program of the National Human Genome Research Institute, National Institutes of
Health.

 We thank Colleen McBride, Ph.D. and Laura Koehly, Ph.D. from the Social and
Behavioural Research Branch at the National Human Genome Research Institute and
Rick Hoyle, Ph.D. from the Department of Psychology and Neuroscience at Duke
 University for their thoughtful review of previous drafts of this manuscript. Authors
declare no conflict of interest for this manuscript.

 The goal of this review is to find the factors that influence effects of framing in
experiments. Probably the most significant factors are previous experience or knowledge
that together with an individual‘s engagement in a topic significantly reduce framing
bias. The participants resilience to this effect is also influenced by additional information
given to them that, combined with the complexity of the data and planning, broaden their
perspectives and enables them to have a more objective view of the issue and lead them
to put more effort into decision-making. On the other hand, there is no clear debiasing
effect on decision. Makers of the visualization of the options.

 Whether a participant is influenced by framing also depends on the rewards got for
different options. The consequences of rewards do not only depend on the value, but also
on the way in which the rewards are described. Finally, demographic factors distinguish
decisionmakers predispositions for framing bias. Nationality and certain national customs
have a debiasing effect.

 According to the findings, women are naturally more risk-averse and, therefore, subject
to framing. Besides that, affiliation to certain groups does not change framing bias. In
sum, it seems that at least four broad groups of factors influence framing . decision
situation setup (amount of information, additional presentation of options), experience
(knowledge, engagement), effort (attention, complexity, the amount of information to
process) and demographics (gender, nationality).

 We discussed so far how information visualization could eliminate biases due to

availability, when we visualize the actual eliminate biases due to availability, when we
visualize the actual probabilities, rearrange the sequence of information, increase their
saliency or filter a subset of them for later recall. While designing such systems, our goal
should not be to eliminate the use of heuristics that can cause these biases altogether, but
rather to exploit them helping users make better decisions.

 To sum up, we suggest that information visualization can reduce availability biases and
assist decision-making in three ways. First, we can take advantage of the good use of
 availability heuristics and improve users' long-term intuitions. Second, visualizations
could provide design techniques that eliminate the known availability biases. Third, we
can investigate new decision-making tools that target to inspired by rather than replace
the way that availability heuristics work.

 Psychological biases are considered as causing irregularities in the market. Researchers in

behavioural finance have in the market. Researchers in behavioural finance have
provided evidences that psychological biases are disturbing the market efficiency.

 Psychological biases are considered to generate asset pricing anomalies such as

momentum, post announcement drifts, reversals and closed-end fund discounts etc. which
causes market inefficiency. However certain studies exist that favour the positive role of
several psychological biases.

 This paper is also an attempt to find out if there are any positive impacts of behavioural
biases such as self-attribution bias and overconfidence bias on perceived market
efficiency. This study concludes that self-attribution bias and overconfidence bias are
both positively associated with perceived market efficiency, and furthermore
overconfidence bias partially mediates the relationship between self-attribution bias and
perceived market efficiency. In other words, overconfidence bias stems from self-
attribution bias and positively impact perceived market efficiency.

 This study has some novel implications regarding investing behaviour of individuals. The
results provide an insight on the existence of investors susceptible to behavioural biases.
Practitioners can get an insight in dealing with various types of investors in the market
place. This study may suffer from a limitation that the sample size it considered is small
which may affect the reliability of its results.

 For future researchers it is suggested to use a large sample size in order to get
generalization for the results, and also to consider other relevant biases along with these
two in order to present a full picture of human psychology in financial decision making.

 This discourse has attempted to stress the danger Big Data poses to the inclusion of
wholesome elements of history in mathematics instructional delivery. In the presence of
so much information, even elements of history in mathematics instructional delivery. In
 the presence of so much information, even mathematics teachers as guides in the teaching
and learning process can succumb to the tendency to consider more recent history at the
expense of a complete picture of origin of concepts. The need to reposition history of
mathematics as an indispensable component of mathematics instruction was also
highlighted.

 The Nigerian situation was given peculiar attention to emphasize the role history of
mathematics can play in restoring the aesthetic value of mathematics among all levels of
students in the country. The implications of the realities unravelled by this study were
pointedly considered along its significance to Nigerian teacher-training institutions,
mathematics teachers and students, curriculum developers and content publishing outlets.
Like other herald of this timely tintinnabulation, this study has brought to light the need
to preserve academic creativity and critical thinking. Indeed there is the need for selective
modesty irrespective of the amount and speed of processing of available information. All
stakeholders in mathematics education must pay wide attention to the chance of losing
originality to recency bias as a result of Big Data.

3.10 KEYWORDS

 Ethnicity: The culture of people in a given geographic region, including their language,
heritage, religion and customs.

 First Nations People: individuals who identify as those who were the first people to live
on the Western Hemisphere continent; people also identified as Native Americans.

 Gender: Social, cultural and psychological traits linked to males and females that define
them as masculine or feminine.

 Gender Identity: Refers to a person‘s internal, deeply felt sense of being a man or
woman, or something other or in between, which may or may not correspond with the sex
assigned at birth; because gender identity is internal and personally defined, it is not
visible to others.
  Intersex: A general term used for a variety of conditions in which a person is born with
reproductive organs, sexual anatomy or chromosomes that are not considered ―standard‖
for either male or female.

3.11 LEARNING ACTIVITY

1. Create a session on the concept of mental accounting bias.

_____________________________________________________________________________________
_________________________________________________________________

2. Create a survey on the concept of anchoring and adjustment bias.

_____________________________________________________________________________________
_________________________________________________________________

3.12 UNIT END QUESTIONS

A. Descriptive Questions

Short Questions

1. What is mental accounting bias?

2. Define anchoring?

3. Define adjustment bias?

4. What is framing bias?

5. Write the main aim of availability bias?

Long Questions

1. Explain the concept of mental accounting bias.

2. Explain the concept of anchoring and adjustment bias.

3. Illustrate the concept of framing bias.

4. Illustrate the concept of availability bias.

5. Examine the concept of self-attribution bias.

B. Multiple Choice Questions

1. What is the transistor biasing representing conditions?.

a. A.C
b. D.C
c. B C
d. None of these

2. What is done to keep transistor biasing in the circuit?

a. Proper direct current

b. Proper alternating current
c. The base current small
d. Collector current small

3. What does Operating point represent?

a. Values of IC and VCE when signal is applied

b. The magnitude of signal
c. Zero signal values of IC and VCE
d. None of these

4. What does results in if biasing is not done in an amplifier circuit?

a. Decrease in the base current

b. Unfaithful amplification
c. Excessive collector bias
d. None of these

5. What is the transistor biasing is generally provided by a?

a. Biasing circuit
b. Bias battery
c. Diode
 d. None of these

Answers

1-b, 2-a, 3-c, 4-b, 5-a

3.13 REFERENCES

References

 Amar, R. A. Stasko, J. T. (2005). Knowledge Precepts for Design and Evaluation of

Information Visualization, IEEE Transactions on Visualization and Computer Graphics –
TVCG.

 Borgida, E. & Nisbett, R, E. (1977). The differential impact of abstract vs. concrete
information on decisions. Journal of Applied Social Psychology.

 Carroll, J.S. (1978). The effect of imagining an event on expectations for the event: An
interpretation in terms of availability heuristic. Journal of Experimental Psychology.

Textbook

 Chapman, L. J. & Chapman, J. P. (1967). Genesis of popular but erroneous

psychodiagnostic observations. Journal of Abnormal Psychology.

 Chapman, L. J. & Chapman, J. P. (1969). Illusory Correlation as an Obstacle to the Use

of Valid Psychodiagnostic Signs. Journal of Abnormal Psychology.

 Combs, B. & Slovic, P. (1979). Newspaper coverage of causes of death. Journalism

Quarterly.

Website

 [Link]
ype%20of%20cognitive,the%20ones%20that%20have%20happened%20a%20long%20w
hile.

 [Link]
 [Link]
MASTER OF BUSINESS
ADMINISTRATION
(FINANCIAL MANAGEMENT)
SEMESTER II

BEHAVIORAL FINANCE
MBAEF 204
All rights reserved. No Part of this book may be reproduced or transmitted, in any form or by any means,
without permission in writing from Mizoram University. Any person who does any unauthorized act in
relation to this book may be liable to criminal prosecution and civil claims for damages. This book is
meant for educational and learning purposes. The authors of the book has/have taken all reasonable
care to ensure that the contents of the book do not violate any existing copyright or other intellectual
property rights of any person in any manner whatsoever. In the even the Authors has/ have been unable
to track any source and if any copyright has been inadvertently infringed, please notify the publisher in
writing for corrective action.
 CONTENT

Unit- 4: Emotional Biases .......................................................................................................... 4

UNIT- 4: EMOTIONAL BIASES

STRUCTURE

4.0 Learning Objectives

4.1 Introduction

4.2 Loss Aversion Bias

4.3 Overconfidence Bias

4.4 Self-Control Bias

4.5 Status Quo Bias

4.6 Endowment Bias

4.7 Regret Aversion Bias

4.8 Affinity Bias

4.8.1 Description

4.8.2 Practical Application

4.8.3 Research Review

4.8.4 Diagnostic Testing

4.8.5 Advice

4.9 Summary

4.10 Keywords

4.11 Learning Activity

4.12 Unit End Questions

4.13 References

4.0 LEARNING OBJECTIVES

After studying this unit, you will be able to

  Examine the concept of emotional biases.

 Illustrate the concept of loss aversion bias.

 Explain the concept of overconfidence bias.

4.1 INTRODUCTION

Emotions are biologically-based psychological states brought on by neurophysiological changes,

variously associated with thoughts, feelings, behavioural responses, and a degree of pleasure or
displeasure. Research on emotion has increased over the past two decades with many fields
contributing including psychology, medicine, history, sociology of emotions, and computer
science. The numerous theories that attempt to explain the origin, function and other aspects of
emotions have fostered more intense research on this topic. Current areas of research in the
concept of emotion include the development of materials that stimulate and elicit emotion. In
addition, PET scans and MRI scans help study the affective picture processes in the brain.

From a mechanistic perspective, emotions can be defined as "a positive or negative experience
that is associated with a particular pattern of physiological activity." Emotions produce different
physiological, behavioural and cognitive changes. The original role of emotions was to motivate
adaptive behaviours that in the past would have contributed to the passing on of genes through
survival, reproduction, and kin selection.

In some theories, cognition is an important aspect of emotion. Other theories, however, claim
that emotion is separate from and can precede cognition. Consciously experiencing an emotion is
exhibiting a mental representation of that emotion from a past or hypothetical experience, which
is linked back to a content state of pleasure or displeasure. The content states are established by
verbal explanations of experiences, describing an internal state.

Emotions are complex. There are various theories on the question of whether or not emotions
cause changes in our behaviour. On the one hand, the physiology of emotion is closely linked
to arousal of the nervous system. Emotion is also linked to behavioural tendency. Extroverted
people are more likely to be social and express their emotions, while introverted people are more
likely to be more socially withdrawn and conceal their emotions. Emotion is often the driving
force behind motivation. On the other hand, emotions are not causal forces but simply syndromes
of components, which might include motivation, feeling, behaviour, and physiological changes,
but none of these components is the emotion. Nor is the emotion an entity that causes these
components.

Emotions involve different components, such as subjective experience, cognitive processes,

expressive behaviour, psychophysiological changes, and instrumental behaviour. At one time,
academics attempted to identify the emotion with one of the components: William James with a
subjective experience, behaviourists with instrumental behaviour, psychophysiologists with
physiological changes, and so on. More recently, emotion is said to consist of all the
components. The different components of emotion are categorized somewhat differently
depending on the academic discipline. A similar multi-componential description of emotion is
found in sociology. For example, Peggy Thoits described emotions as involving physiological
components, cultural or emotional labels (anger, surprise, etc.), expressive body actions, and the
appraisal of situations and contexts.

The word "emotion" dates back to 1579, when it was adapted from the French word émouvoir,
which means "to stir up". The term emotion was introduced into academic discussion as a catch-
all term to passions, sentiments and affections. The word "emotion" was coined in the early
1800s by Thomas Brown and it is around the 1830s that the modern concept of emotion first
emerged for the English language. "No one felt emotions before about 1830. Instead they felt
other things – "passions", "accidents of the soul", "moral sentiments" – and explained them very
differently from how we understand emotions today. "Some cross-cultural studies indicate that
the categorization of "emotion" and classification of basic emotions such as "anger" and
"sadness" are not universal and that the boundaries and domains of these concepts are
categorized differently by all cultures. However, others argue that there are some universal bases
of emotions. In psychiatry and psychology, an inability to express or perceive emotion is
sometimes referred to as alexithymia.

Human nature and the following bodily sensations have been always part of the interest of
thinkers and philosophers. For most extensively, this interest has been of great interest by both
Western and Eastern societies. Emotional states have been associated with the divine and the
enlightenment of the human mind and body. The ever-changing actions of individuals and its
mood variations have been of great importance by most of the Western philosophers (Aristotle,
Plato, Descartes, Aquinas, Hobbes) that lead them to propose vast theories; often competing
theories, that sought to explain the emotion and the following motivators of human action and its
consequences.

In the Age of Enlightenment Scottish thinker David Hume proposed a revolutionary argument
that sought to explain the main motivators of human action and conduct. He proposed that
actions are motivated by "fears, desires, and passions". As he wrote in his book Treatise of
Human Nature: "Reason alone can never be a motive to any action of the will… it can never
oppose passion in the direction of the will. The reason is, and ought to be the slave of the
passions, and can never pretend to any other office than to serve and obey them". With these
lines Hume pretended to explain that reason and further action will be subjected to the desires
and experience of the self. Later thinkers would propose that actions and emotions are deeply
interrelated to social, political, historical, and cultural aspects of reality that would be also
associated with sophisticated neurological and physiological research on the brain and other parts
of the physical body & its nature.

4.2 LOSS AVERSION BIAS

For more than 40 years, Paul Ekman has supported the view that emotions are discrete,
measurable, and physiologically distinct. Ekman's most influential work revolved around the
finding that certain emotions appeared to be universally recognized, even in cultures that were
preliterate and could not have learned associations for facial expressions through media. Another
classic study found that when participants contorted their facial muscles into distinct facial
expressions (for example, disgust), they reported subjective and physiological experiences that
matched the distinct facial expressions. Ekman's facial-expression research examined six basic
emotions: anger, disgust, fear, happiness, sadness and surprise.

Later in his career Ekman theorized that other universal emotions may exist beyond these six. In
light of this, recent cross-cultural studies led by Daniel Cordaro and Dacher Keltner, both former
students of Ekman, extended the list of universal emotions. They also found evidence for
boredom, confusion, interest, pride, and shame facial expressions, as well as contempt, relief,
and triumph vocal expressions.
Robert Plutchik agreed with Ekman's biologically driven perspective but developed the "wheel
of emotions", suggesting eight primary emotions grouped on a positive or negative basis: joy
versus sadness; anger versus fear; trust versus disgust; and surprise versus anticipation. Some
basic emotions can be modified to form complex emotions. The complex emotions could arise
from cultural conditioning or association combined with the basic emotions. Alternatively,
similar to the way primary colours combine, primary emotions could blend to form the full
spectrum of human emotional experience. For example, interpersonal anger and disgust could
blend to form contempt. Relationships exist between basic emotions, resulting in positive or
negative influences.

Psychologists have used methods such as factor analysis to attempt to map emotion-related
responses onto a more limited number of dimensions. Such methods attempt to boil emotions
down to underlying dimensions that capture the similarities and differences between experiences.
Often, the first two dimensions uncovered by factor analysis are valence (how negative or
positive the experience feels) and arousal (how energized or enervated the experience feels).
These two dimensions can be depicted on a 2D coordinate map. This two-dimensional map has
been theorized to capture one important component of emotion called core affect. Core affect is
not theorized to be the only component to emotion, but to give the emotion its hedonic and felt
energy.

Using statistical methods to analyse emotional states elicited by short videos, Cowen and Keltner
identified 27 varieties of emotional experience: admiration, adoration, aesthetic appreciation,
amusement, anger, anxiety, awe, awkwardness, boredom, calmness, confusion, craving, disgust,
empathic pain, entrancement, excitement, fear, horror, interest, joy, nostalgia, relief, romance,
sadness, satisfaction, sexual desire and surprise.

In Buddhism, emotions occur when an object is considered as attractive or repulsive. There is a

felt tendency impelling people towards attractive objects and impelling them to move away from
repulsive or harmful objects; a disposition to possess the object (greed), to destroy it (hatred), to
flee from it (fear), to get obsessed or worried over it (anxiety), and so on.

In Stoic theories, normal emotions (like delight and fear) are described as irrational impulses
which come from incorrect appraisals of what is 'good' or 'bad'. Alternatively, there are 'good
emotions' (like joy and caution) experienced by those that are wise, which come from correct
appraisals of what is 'good' and 'bad'.

Aristotle believed that emotions were an essential component of virtue. In the Aristotelian view
all emotions (called passions) corresponded to appetites or capacities. During the Middle Ages,
the Aristotelian view was adopted and further developed by scholasticism and Thomas Aquinas
in particular.

In Chinese antiquity, excessive emotion was believed to cause damage to qi, which in turn,
damages the vital organs. The four humours theory made popular by Hippocrates contributed to
the study of emotion in the same way that it did for medicine.

In the early 11th century, Avicenna theorized about the influence of emotions on health and
behaviours, suggesting the need to manage emotions.

Early modern views on emotion are developed in the works of philosophers such as René
Descartes, Niccolò Machiavelli, Baruch Spinoza, Thomas Hobbes and David Hume. In the 19th
century emotions were considered adaptive and were studied more frequently from
an empiricist psychiatric perspective.

Loss aversion bias was developed by Daniel Kahneman and Amos Tversky in 1979 as part of the
original prospect theory specifically, in response to prospect theory‘s observation that people
generally feel a stronger impulse to avoid losses than to acquire gains. A number of studies on
loss aversion have given birth to a common rule of thumb: Psychologically, the possibility of a
loss is on average twice as powerful a motivator as the possibility of making a gain of equal
magnitude; that is, a loss-averse person might demand, at minimum, a two-dollar gain for every
one dollar placed at risk. In this scenario, risks that don‘t ―pay double‖ are unacceptable. Loss
aversion can prevent people from unloading unprofitable investments, even when they see little
to no prospect of a turnaround. Some industry veterans have coined a diagnosis of ―get-even-itis‖
to describe this widespread affliction, whereby a person waits too long for an investment to
rebound following a loss. Get-even-itis can be dangerous because often, the best response to a
loss is to sell the offending security and to redeploy those assets. Similarly, loss aversion bias can
make investors dwell excessively on risk avoidance when evaluating possible gains, since
dodging a loss is a more urgent concern than seeking a profit. When their investments do begin
to succeed, loss-averse individuals hasten to lock in profits, fearing that, otherwise, the market
might reverse itself and rescind their returns. The problem here is that divesting prematurely to
protect gains limits upside potential. In sum, loss aversion causes investors to hold their losing
investments and to sell their winning ones, leading to suboptimal portfolio returns

The technical definition of loss aversion comes from prospect theory, wherein Kahneman and
Tversky don‘t explicitly mention concrete, relative preferences (e.g., ―I prefer avoiding a loss to
realizing a gain‖). Rather, they discuss loss aversion in the context of the S-shaped, utility
representative value function that models the entire evaluation stage in prospect theory.
According to Kahneman and Tversky, people weigh all potential gains and losses in relation to
some benchmark reference point (the point of origin on the graph. The value function that passes
through this point is asymmetric; and its profile implies, given the same variation in absolute
value, a bigger impact of losses than of gains. The result is that risk-seeking behaviour prevails
in the domain of losses (below the x axis), while risk-averse behaviour prevails in the domain of
gains (above the x axis). An important concept embedded in this utility representation is Hersh
Shefrin and Meir Statman‘s disposition effect. The disposition effect is the desire to hold losing
investments too long (risk-seeking behaviour) and to sell winning investments too quickly (risk-
avoidance behaviour).

Loss aversion bias, observed in practice as the disposition effect, is seen often by wealth
management practitioners. Investors open up the monthly statements prepared by their advisors,
skim columns of numbers, and usually notice both winners and losers. In classic cases of loss
aversion, clients dread selling the securities that haven‘t performed well. Get-even-itis takes
hold, and the instinct is to hold onto a losing investment until, at the very least, it rebounds
enough for the client to break even. Often, however, research into a losing investment would
reveal a company whose prospects don‘t forecast a rebound. Continuing to hold stock in that
company actually adds risk to an investor‘s portfolio (hence, the client‘s behaviour is risk
seeking, which accords with the path of the value function. Conversely, when the monthly
statement indicates that profits are being made, the loss-averse client is gripped by a powerful
urge to ―take the money and run,‖ rather than to assume continued risk. Of course, frequently,
holding onto a winning stock isn‘t a risky proposition, if the company is performing well; that is,
profitable investments that the loss-averse investor wants to sell might actually be improving the
portfolio‘s risk/return profile. Therefore, selling deteriorates that risk/return profile and
eliminates the potential for further gains. When the increased risks associated with holding onto
losing investments are considered in combination with the prospect of losing future gains that
occur when selling winners, the degree of overall harm that a loss-averse investor can suffer
begins to become clear. A final thought on taking losses: Some investors, remarking on losing
investments that haven‘t yet been sold, rationalize that ―it‘s only a paper loss.‖ In one sense, yes,
this is true. Inasmuch as the investment is still held, a loss has technically not been triggered for
tax purposes. In reality, though, this kind of rationale covers up the fact that a loss has taken
place. If you went to the market to sell, having just incurred a ―paper loss,‖ the price you would
obtain for your investment would be lower than the price you paid—effecting a very ―real‖ loss
indeed. Thus, if holding onto a losing investment does not objectively enhance the likelihood of
recouping a loss, then it is better to simply realize the loss, which won‘t remain on paper forever

Loss aversion is a bias that simply cannot be tolerated in financial decision making. It instigates
the exact opposite of what investors want: increased risk, with lower returns. Investors should
take risk to increase gains, not to mitigate losses. Holding losers and selling winners will wreak
havoc on a portfolio. Summarizes some common investment mistakes linked to loss aversion
bias.

Example

Below is a list of loss aversion examples that investors often fall into:

 Investing in low-return, guaranteed investments over more promising investments that

carry higher risk

 Not selling a stock that you hold when your current rational analysis of the stock clearly
indicates that it should be abandoned as an investment

 Selling a stock that has gone up slightly in price just to realize a gain of any amount,
when your analysis indicates that the stock should be held longer for a much larger profit

 Telling oneself that an investment is not a loss until it‘s realized (i.e., when the
investment is sold)

4.3 OVERCONFIDENCE BIAS

In its most basic form, overconfidence can be summarized as unwarranted faith in one‘s intuitive
reasoning, judgments, and cognitive abilities. The concept of overconfidence derives from a
large body of cognitive psychological experiments and surveys in which subjects‘ overestimate
both their own predictive abilities and the precision of the information they‘ve been given.
People are poorly calibrated in estimating probabilities—events they think are certain to happen
are often far less than 100 percent certain to occur. In short, people think they are smarter and
have better information than they actually do. For example, they may get a tip from a financial
advisor or read something on the Internet, and then they‘re ready to take action, such as making
an investment decision, based on their perceived knowledge advantage.

Numerous studies have shown that investors are overconfident in their investing abilities.
Specifically, the confidence intervals that investors assign to their investment predictions are too
narrow. This type of overconfidence can be called prediction overconfidence. For example, when
estimating the future value of a stock, overconfident investors will incorporate far too little
leeway into the range of expected payoffs, predicting something between a 10 percent gain and
decline, while history demonstrates much more drastic standard deviations. The implication of
this behaviour is that investors may underestimate the downside risks to their portfolios (being,
naturally, unconcerned with ―upside risks‖). Investors are often also too certain of their
judgments. We will refer to this type of overconfidence as certainty overconfidence. For
example, having resolved that a company is a good investment, people often become blind to the
prospect of a loss and then feel surprised or disappointed if the investment performs poorly. This
behaviour results in the tendency of investors to fall prey to a misguided quest to identify the
―next hot stock.‖ Thus, people susceptible to certainty overconfidence often trade too much in
their accounts and may hold portfolios that are not diversified enough.

Roger Clarke and Meir Statman demonstrated a classic example of prediction overconfidence in
2000 when they surveyed investors on the following question: ―In 1896, the Dow Jones Average,
which is a price index that does not include dividend reinvestment, was at 40. In 1998, it crossed
9,000. If dividends had been reinvested, what do you think the value of the DJIA would be in
1998? In addition to that guess, also predict a high and low range so that you feel 90 percent
confident that your answer is between your high and low guesses. ‖In the survey, few responses
reasonably approximated the potential 1998 value of the Dow, and no one estimated a correct
confidence interval. (If you are curious, the 1998 value of the Dow Jones Industrial Average
under the conditions postulated in the survey would have been 652,230) A classic example of
investor prediction overconfidence is the case of the former executive or family legacy
stockholder of a publicly traded company such as Johnson & Johnson, ExxonMobil, or DuPont.
These investors often refuse to diversify their holdings because they claim ―insider knowledge‖
of, or emotional attachment to, the company. They cannot contextualize these stalwart stocks as
risky investments. However, dozens of once-iconic names in U.S. business—AT&T, for
example—have declined or vanished.

People display certainty overconfidence in everyday life situations, and that overconfidence
carries over into the investment arena. People tend to have too much confidence in the accuracy
of their own judgments. As people find out more about a situation, the accuracy of their
judgments is not likely to increase, but their confidence does increase, as they fallaciously equate
the quantity of information with its quality. In a pertinent study, Baruch Fischoff, Paul Slovic,
and Sarah Lichtenstein gave subjects a general knowledge test and then asked them how sure
they were of their answer. Subjects reported being 100 percent sure when they were actually only
70 percent to 80 percent correct. A classic example of certainty overconfidence occurred during
the technology boom of the late 1990s. Many investors simply loaded up on technology stocks,
holding highly concentrated positions, only to see these gains vanish during the meltdown.

Numerous studies analyse the detrimental effects of overconfidence by investors, but the focus
here is on one landmark work that covers elements of both prediction and certainty
overconfidence. Professors Brad Barber and Terrance Odean, when at the University of
California at Davis, studied the 1991–1997 investment transactions of 35,000 households, all
holding accounts at a large discount brokerage firm, and they published their results in a 2001
paper, ―Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment. ―Barber
and Odean were primarily interested in the relationship between overconfidence as displayed by
both men and women and the impact of overconfidence on portfolio performance. Overconfident
investors overestimate the probability that their personal assessments of a security‘s value are
more accurate than the assessments offered by others. Disproportionate confidence in one‘s own
valuations leads to differences of opinion, which influences trading. Rational investors only trade
and purchase information when doing so increases their expected utility. Overconfident investors
decrease their expected utilities by trading too much; they hold unrealistic beliefs about how high
their returns will be and how precisely these returns can be estimated; and, they expend too many
resources obtaining investment information. Odean and Barber noted that overconfident
investors overestimate the precision of their information and thereby the expected gains of
trading.

They may even trade when the true expected net gains are negative. Models of investor
overconfidence predict that because men are more overconfident than women, men will trade
more and perform worse than women. Both men and women in Barber and Odeon‘s study would
have done better, on average, if they had maintained their start-of-the-year portfolios for the
entire year. In general, the stocks that individual investors sell go on to earn greater returns than
the stocks with which investors replace them. The stocks men chose to purchase underperformed
those they chose to sell by 20 basis points per month. For women, the figure was 17 basis points
per month. In the end, Barber and Odean summarized overconfidence as a factor that is
―hazardous to your wealth.‖ They concluded that ―individuals turn over their common stock
investments about 70 percent annually.‖ Mutual funds have similar turnover rates. Yet, those
individuals and mutual funds that trade most earn lowest returns. They believe that there is a
simple and powerful explanation for the high levels of counterproductive trading in financial
markets: overconfidence.

This is a diagnostic test for both prediction overconfidence and certainty overconfidence. If you
are an investor, take the test and then interpret the results. If you are an advisor, ask your client to
take these tests and then discuss the results with you. After analysing the test results in the next
section, we will offer advice on how to overcome the detrimental effects of overconfidence.

Example

An example of this is where people overestimate how quickly they can do work and
underestimate how long it takes them to get things done. Especially for complicated tasks,
business people constantly underestimate how long a project will take to complete.

4.4 SELF-CONTROL BIAS

Simply put, self-control bias is a human behavioural tendency that causes people to consume
today at the expense of saving for tomorrow. Money is an area in which people are notorious for
displaying a lack of self-control. Attitudes toward paying taxes provide a common example.
Imagine that you, a taxpayer, estimate that your income this year will cause your income tax to
increase by $3,600, which will be due one year from now. In the interest of conservatism, you
decide to set money aside. You contemplate two choices: Would you rather contribute $300 per
month over the course of the next 12 months to some savings account earmarked for tax season?
Or would you rather increase your federal income tax withholding by $300 each month, sparing
you the responsibility of writing out one large check at the end of the year? Rational economic
thinking suggests that you would prefer the savings account approach because your money
would accrue interest and you would actually net more than $3,600. However, many taxpayers
choose the withholding option because they realize that the savings account plan would be
complicated in practice by a lack of self-control. Self-control bias can also be described as a
conflict between people‘s overarching desires and their inability, stemming from a lack of self-
discipline, to act concretely in pursuit of those desires. For example, a student desiring an ―A‖ in
history class might theoretically forgo a lively party to study at the library. An overweight person
desperate to shed unwanted pounds might decline a tempting triple fudge sundae. Reality
demonstrates, however, that plenty of people do sabotage their own long-term objectives for
temporary satisfaction in situations like the ones described. Investing is no different. The primary
challenge in investing is saving enough money for retirement. Most of this chapter will focus on
the savings behaviours of investors and how best to promote self-control in this often-
problematic realm. Perhaps the best framework for understanding how to advise clients on self-
control bias is done in the context of lifecycle hypothesis, a rational theory of savings behaviour.
This is a standard finance concept that we will examine and then entertain from a behavioural
perspective.

The technical description of self-control bias is best understood in the context of the life-cycle
hypothesis, which describes a well-defined link between the savings and consumption tendencies
of individuals and those individuals‘ stages of progress from childhood, through years of work
participation, and finally into retirement. The foundation of the model is the saving decision,
which directs the division of income between consumption and saving. The saving decision
reflects an individual‘s relative preferences over present versus future consumption. Because the
life-cycle hypothesis is firmly grounded in expected utility theory and assumes rational
behaviour, an entire lifetime‘s succession of optimal saving decisions can be computed given
only an individual‘s projected household income stream vis-à-vis the utility function. The
income profile over the life cycle starts with low income during the early working years,
followed by increasing income that reaches a peak prior to retirement. Income during retirement,
based on assumptions regarding pensions, is then substantially lower. To make up for the lower
income during retirement and to avoid a sharp drop in utility at the point of retirement,
individuals will save some fraction of their income when they‘re still working, spending it later
during retirement. The main prediction, then, of the life-cycle hypothesis is a lifetime savings
profile characterized by a ―hump‖-shaped curve, with savings building gradually, maxing out,
and finally declining again as a function of time. Two common tendencies of individuals
underlie spending patterns, according to the life-cycle hypothesis.

1. Most people prefer a higher standard of living to a lower standard of living; that is,
people want to maximize consumption spending in the present.

2. Most people prefer to maintain a relatively constant standard of living throughout their
lives.

They dislike volatility and don‘t desire abrupt intervals of feast interspersed with famine.
Basically, the life-cycle hypothesis envisions that people will try to maintain the highest,
smoothest consumption paths possible. Now that we have an understanding of the life cycle
hypothesis, we can integrate behavioural concepts that account for real-world savings behaviour.
In 1998, Hersh Shefrin and Richard Thaler introduced a behaviourally explained life-cycle
hypothesis which is a descriptive model of household savings in which self-control plays a key
role. The key assumption of the behavioural life-cycle theory is that households treat components
of their wealth as ―nonfungible‖ or noninterchangeable even in the absence of credit rationing.
Specifically, wealth is assumed to be divided into three ―mental‖ accounts:

1. Current income

2. Current assets and

3. Future income

The temptation to spend is assumed to be greatest for current income and least for future income.
Considerable empirical evidence supporting the behavioural life-cycle theory exists. In a survey
of students´ expectations of future consumption, Shefrin and Thaler obtained direct support for
the tenets of behavioural life-cycle theory. Specifically, they found that subjects envisioning
themselves to be the beneficiaries of some financial windfall predicted that they would consume,
immediately, a greater portion of that windfall during the same year if the money was coded as
current income rather than current assets. Subjects said that they would consume the smallest
portions of income coded as future income. For most people, consumption and income (i.e.,
saving) are mediated by institutions, not individual decisions. Examples include home mortgage
repayment schedules, 401(k) plans, and individual retirement accounts (IRAs); often, these in
students represent an individual‘s only real savings, with no additional funds being set aside.
Self-control has a cost, and people are willing to pay a price to avoid reigning in their natural
impulses. Consumers act as if they are maintaining separate funds within their individual
accounting systems, separating income into current income and wealth. The marginal propensity
to consume varies according to the source of income (e.g., salary versus bonus), even if the
measure taken to activate or to sustain the source of income (e.g., work) is the same. People are
more likely to build assets or savings with money they view, or ―frame,‖ as wealth, whereas they
are less likely to build savings using what they consider to be current income. Many researchers
have continued to elaborate on the behavioural life-cycle model, particularly as it relates to
retirement savings.

Encouraging people to save more is a task that constantly challenges financial advisors. The
―Save More Tomorrow Program,‖ developed by Professors Richard H. Thaler, of the University
of Chicago, and Shlomo Benartzi, of the Anderson School of Business at UCLA, aims to help
corporate employees who would like to save more but lack the willpower to act on this desire.
The program offers many useful insights into saving behaviour, and examining it will serve as
our practical application discussion in this chapter.

Let‘s examine the results of a trial of the Save More Tomorrow Program (SMTP) by a midsize
manufacturing company in 1988. Prior to the adoption of the SMTP, the company suffered from
a low participation rate as well as low saving rates. In an effort to increase the saving rates of the
employees, the company hired an investment consultant and offered this service to every
employee eligible for its retirement savings plan. Of the 315 eligible participants, all but 29
agreed to meet with the consultant and get his advice. Based on information that the employee
provided, the consultant used commercial software to compute a desired saving rate. The
consultant also discussed with each employee how much of an increase in saving would be
considered economically feasible. If the employee seemed very reluctant to increase his or her
saving rate substantially, the consultant would constrain the program to increase the saving
contribution by no more than 5 percent. Of the 286 employees who talked to the investment
consultant, only 79 (28 percent) were willing to accept the consultant‘s advice, even with the
adjustment to constrain some of the saving rate increases to 5 percent. For the rest of the
participants, the planner offered a version of the SMTP, proposing that they increase their saving
rates by 3 percentage points a year, starting with the next pay increase. Even with the aggressive
strategy of increasing saving rates, the SMTP proved to be extremely popular with the
participants. Of the 207 participants who were unwilling to accept the saving rate proposed by
the investment consultant, 162 (78 percent) agreed to join the SMTP. The majority of these
participants did not change their minds once the saving increases took place. Only 4 participants
(2 percent) dropped out of the plan prior to the second pay raise, with 29 more (18 percent)
dropping out between the second and third pay raises. Hence, the vast majority of the
participants (80 percent) remained in the plan through three pay raises. Furthermore, even those
who withdrew from the plan did not reduce their contribution rates to the original levels; they
merely stopped the future increases from taking place. So, even these workers are saving
significantly more than they were before joining the plan. The key lesson here is that people are
generally poor at planning and saving for retirement. They need to have self-discipline imposed
on them consistently in order to achieve savings.

Lusardi‘s empirical analysis showed that householders not planning for retirement tend to have
much lower savings than householders who have given thought to retirement. The study
controlled for numerous additional variables that might arguably impact savings and also tried
substituting various measures of asset accumulation (e.g., financial or total net worth) as proxy
variables to provide alternative planning measures. Still, the result remains conclusive: Savings
levels depend significantly on whether a householder has planned for retirement. Additionally,
planning may have an effect not only on wealth but also on portfolio choice. If obtaining
information about complex investment assets, such as stocks, required too much effort, families
facing retirement will be less likely to invest in those assets. Thus, the question of whether
planning affects stock ownership is also important and can be examined using regression
analysis. Again, Lusardi incorporated a wide array of proxy variables to control for resource and
preference attributes of households that, though not explicitly measurable, could be expected to
bias results. Rather than considering total pension wealth, for example, the analysis distinguished
between households whose heads maintain defined contribution, defined benefit, or other types
of pensions. The underlying logic here is that plan structure might impact the degree of
discretion employees exercise over the allocation of pension assets and that this, in turn, might
impact allocation of non-pension assets. The results of this analysis showed that lack of planning
is also a strong determinant of portfolio choice. Households that do not plan are less likely to
invest in stocks; this result is consistent even after a variety of factors have been accounted for.
In the HRS, respondents were asked to rate their retirement experiences, and to state how they
felt retirement compared to their working years. More than 54 percent of those respondents who
had not thought about retirement rated their retirement experiences poor with respect to their
preretirement years.

Self-control bias can cause investors to spend more today rather than saving for tomorrow.
People have a strong desire to consume freely in the present. This behaviour can be
counterproductive to attaining long-term financial goals because retirement often arrives before
investors have managed to save enough money. This may spur people into accepting, at the last
minute, inordinate amounts of risk in their portfolios to make up for lost time—a tendency that
actually places one‘s retirement security at increased risk. Advisors should counsel their clients
to pay themselves first, setting aside consistent quantities of money to ensure their comfort later
in life, especially if retirement is still a long way off. If an advisor encounters investors who are
past age 60 and have not saved enough for retirement, then a more difficult situation emerges. A
careful balance must be struck between saving, investing, and risk taking in order to increase the
pot of money for retirement. Often, these clients might benefit from examining additional
options, such as part-time work (cycling in and out of retirement) or cutting back on
consumption. In either case, emphasizing paying oneself first—assigning a sufficient level of
priority to future rather than present-day consumption—is critical.

Self-control bias may cause investors to not plan adequately for retirement. Studies have shown
that people who do not plan for retirement are much less likely not to retire securely than those
who do plan. People who do not plan for retirement are also less likely to invest in equity
securities. Advisors must emphasize that investing without planning is like building without a
blueprint. Planning is the absolute key to attaining long-term financial goals. Furthermore plans
need to be written down so that they can be reviewed on a regular basis. Without planning,
investors may not be apt to invest in equities, potentially causing a problem with keeping up with
inflation. In sum, people don‘t plan to fail—they simply fail to plan.
Self-control bias can cause asset allocation imbalance problems. Investors subject to this bias
may prefer income-producing assets, due to a ―spend today‖ mentality. This behaviour can be
counter-productive to attaining long-term financial goals because an excess of income-producing
assets can prevent a portfolio from keeping up with inflation. Self-control bias can also cause
people to unduly favour certain asset classes, such as equities over bonds, due to an inability to
reign in impulses toward risk. Advisors must emphasize the importance of adhering to a planned
asset allocation. There is a litany of information on the benefits of asset allocation, which can be
persuasively cited for a client‘s benefit. Whether they prefer bonds or equities, clients exhibiting
a lack of self-control need to be counselled on maintaining properly balanced portfolios so that
they can attain their long-term financial goals.

Example

Attitudes toward eating and dieting provide a simple example of self-control. We know, for
example, that eating lots of carbohydrates is not a good tactic for weight loss.

4.5 STATUS QUO BIAS

Status quo bias, a term coined by William Samuelson and Richard Zeckhauser in 1988 is an
emotional bias that predisposes people facing an array of choice options to elect whatever option
ratifies or extends the existing condition (i.e., the ―status quo‖) in lieu of alternative options that
might bring about change. In other words, status quo bias operates in people who prefer for
things to stay relatively the same. The scientific principle of inertia bears a lot of intuitive
similarity to status quo bias; it states that a body at rest shall remain at rest unless acted on by an
outside force. A simple real-world example illustrates. In the early 1990s, the states of New
Jersey and Pennsylvania reformed their insurance laws and offered new programs. Residents had
the opportunity to select one of two automotive insurance packages.

1. A slightly more expensive option that granted policyholders extensive rights to sue one
another following an accident and

2. A less expensive option with more restricted litigation rights. Each insurance plan had a
roughly equivalent expected monetary value.
In New Jersey, however, the more expensive plan was instituted as the default, and 70 percent of
citizens ―selected‖ it. In Pennsylvania, the opposite was true—residents would have to opt out of
the default, less-expensive option in order to opt into the more expensive option. In the end, 80
percent of the residents ―chose‖ to pay less.

Status quo bias refers to the finding that an option is more desirable if it is designated as the
―status quo‖ than when it is not. Status quo bias can contribute to the aforementioned inertia
principle, but inertia is not as strong as status quo bias. Inertia means that an individual is
relatively more reluctant to move away from some state identified as the status quo than from
any alternative state not identified as the status quo. People less readily abandon a condition
when they‘re told, ―Things have always been this way.‖ Status quo bias implies a more intense
―anchoring effect.‖ Status quo bias is often discussed in tandem with other biases, namely
endowment bias and loss aversion bias. Status quo bias differs from these two in that it does not
depend on framing changes in terms of losses and potential gains. When loss aversion bias and
status quo bias cross paths, it is probable that an investor, choosing between two investment
alternatives, will stick to the status quo if it seems less likely to trigger a loss—even if the status
quo also guarantees a lower return in the long run. Endowment bias implies that ownership of a
piece of property imbues that property with some perceived, intangible added value—even if the
property doesn‘t really increase the utility or wealth of the owner. By definition, endowment bias
favours the status quo—people don‘t want to give up their endowments. Loss aversion bias,
endowment bias, and status quo bias often combine; and the result is an overall tendency to
prefer things to stay as they are, even if the calm comes at a cost.

Investors with inherited, concentrated stock positions often exhibit classic status quo bias. Take
the case of a hypothetical grandson who hesitates to sell the bank stock he‘s inherited from his
grandfather. Even though his portfolio is under diversified and could benefit from such an
adjustment, the grandson favours the status quo. A number of motives could be at work here.
First, the investor may be unaware of the risk associated with holding an excessively
concentrated equity position. He may not foresee that if the stock tumbles, he will suffer a
significant decrease in wealth. Second, the grandson may experience a personal attachment to the
stock, which carries an emotional connection to a previous generation. Third, he may hesitate to
sell because of his aversion to the tax consequences, fees/commissions, or other transaction costs
associated with unloading the stock. The advice section of this chapter reviews some strategies
for dealing with each of these potential objections—all of which could contribute to status-quo-
biased behaviour.

Samuelson and Zeckhauser‘s paper, ―Status Quo Bias in Decision Making,‖ provides an
excellent practical application of status quo bias. It examined a study in which subjects were told
that they had each just inherited a large sum of money from an uncle and could choose to invest
the money in any one of four possible portfolios. Each portfolio offered a different level of risk
and a different rate of return. The scenario was repeated twice; in the first trial, subjects were
given only the aforementioned information, with no indication of how the conferring uncle might
have invested the money himself. In the second trial, the subjects were informed that the uncle,
prior to his death, had invested the sum in a moderate-risk portfolio—one of the four options
available to the subjects at present. As you might expect, the moderate-risk portfolio proved far
more popular in the second trial, when it was designated as the status quo, than in the first trial,
when all options were equally ―new.‖ This study reinforced the idea that investors tend to prefer
upholding the present status. Advisors need to recognize this phenomenon and target their advice
accordingly. Status quo bias is strong and, since it is an emotional bias, a lot of skill must be
exercised in order to guide clients away from it.

These questions are designed to detect signs of cognitive errors stemming from status quo bias.
To complete the test, select the answer choice that best characterizes your response to each item.

Doing nothing is much easier than making a decision. This is especially true when a decision
might bring about emotional pain, for example, the decision to sell a losing investment may
register the impact of a loss. Sometimes, however, inaction can compromise long-run returns.
When clients hesitate to implement changes, advisors should carefully analyse whether adhering
to the status quo will affect attainment of financial goals. If you discover that your client‘s biased
behaviour will indeed impact his or her wealth down the road, then education is critical. Explain
to clients the common cognitive and emotional oversights they may be committing and
demonstrate the benefits of decisive action.

Emotions are perhaps the least legitimate concerns in asset management. When financial goals
are in jeopardy, it can be too risky to sit back and adhere to an affective whim. Advisors need to
demonstrate how emotions need to be managed. ―Emotional intelligence,‖ a well-publicized
topic in popular psychology, offers many insights to this end. Do a little reading, and you may
find yourself better equipped to help your clients work through their emotional attachments.

Emotions are perhaps the least legitimate concerns in asset management. When financial goals
are in jeopardy, it can be too risky to sit back and adhere to an affective whim. Advisors need to
demonstrate how emotions need to be managed. ―Emotional intelligence,‖ a well-publicized
topic in popular psychology, offers many insights to this end. Do a little reading, and you may
find yourself better equipped to help your clients work through their emotional attachments.

Example

Sticking with your current cable/satellite provider is another example of how the status quo bias
may influence everyday decisions. Even though another provider might offer more channels at a
cheaper price, you are already familiar with the rates, choices, and customer service offered by
your current provider.

4.6 ENDOWMENT BIAS

People who exhibit endowment bias value an asset more when they hold property rights to it than
when they don‘t. Endowment bias is inconsistent with standard economic theory, which asserts
that a person‘s willingness to pay for a good or an object should always equal the person‘s
willingness to accept dispossession of the good or the object, when the dispossession is
quantified in the form of compensation. Psychologists have found, however, that the minimum
selling prices that people state tend to exceed the maximum purchase prices that they are willing
to pay for the same good. Effectively, then, ownership of an asset instantaneously ―endows‖ the
asset with some added value. Endowment bias can affect attitudes toward items owned over long
periods of time or can crop up immediately as the item is acquired.

Endowment bias is described as a mental process in which a differential weight is placed on the
value of an object. That value depends on whether one possesses the object and is faced with its
loss or whether one does not possess the object and has the potential to gain it. If one loses an
object that is part of one‘s endowment, then the magnitude of this loss is perceived to be greater
than the magnitude of the corresponding gain if the object is newly added to one‘s endowment.
Professor Richard Thaler, of the University of Chicago, defines the endowment bias.
If out-of-pocket costs are viewed as losses and opportunity costs are viewed as foregone gains,
the former will be more heavily weighted. Furthermore, a certain degree of inertia is introduced
into the consumer choice process since goods that are included in the individual‘s endowment
will be more highly valued than those not held in the endowment, ceteris paribus. This follows
because removing a good from the endowment creates a loss while adding the same good (to an
endowment without it) generates a gain. Henceforth, I will refer to the underweighting of
opportunity costs as the endowment effect.

In 1989, a researcher named J. L. Knetsch reported results from experiments designed to

examine the endowment bias. Knetsch‘s results provided an excellent practical application of
endowment bias and concerned an experiment involving two groups of subjects. The 76 subjects
in the first group were each given a coffee mug. They were then asked to complete a
questionnaire, after which they were shown some candy bars. It had been determined earlier that
the 76 subjects were about evenly divided over whether they generally preferred candy bars or
coffee mugs if given a choice. But when told that they could substitute a candy bar for the coffee
mug they had been given, 89 percent chose to keep the coffee mug. The second group consisted
of 87 subjects. Again, about 50 percent preferred candy bars, and 50 percent preferred coffee
mugs. The second group participated in the same exercise as the first group, except this time, the
candy bars were the endowment good and the coffee mugs were offered subsequently as
substitutes. In the second group, 90 percent declined to trade their endowed candy bars. Knetsch
concluded that this dramatic asymmetry resulted because ―subjects weigh the loss of giving up
their initial reference entitlement far more heavily than the foregone gains of not obtaining the
alternative entitlement.‖ Neither coffee mugs nor candy bars seemed, in this experiment, innately
more desirable by any significant margin; rather, subjects‘ preferences depended on their
respective endowments.

Investors prove resistant to change once they become endowed with (take ownership of)
securities. We will examine endowment bias as it relates both to inherited securities and
purchased securities. Then, we‘ll look at two common causes of endowment bias.

William Samuelson and Richard Zeckhauser4 performed an enlightening study on endowment

bias that aptly illustrates investor susceptibility to this bias. Samuelson and Zeckhauser
conducted an experiment in which investors were told to imagine that they had to newly acquire
one of four investment options:

Another group of investors was given the same list of options. However, they were instructed to
imagine that they had already inherited one specified item on the list. If desired, the investors
were told, they could cede their hypothetical inheritance in favour of a different option and could
do so without penalty. In every case, however, the investors in the second group showed a
tendency to retain whatever was ―inherited.‖ This is a classic case of endowment bias. Most
wealth management practitioners have encountered clients who are reluctant to sell securities
bequeathed by previous generations. Often, in these situations, investors cite feelings of
disloyalty associated with the prospect of selling inherited securities, general uncertainty in
determining ―the right thing to do,‖ and tax issues.

Endowment bias also often influences the value that an investor assigns to a recently purchased
security. Here is an example to illustrate this point: Assume that you have a great need for
income. How much would you pay for a municipal bond that pays you triple your pre-tax
income? Further assume that you have purchased this bond and that it is performing as expected.
Interest rates have not changed, the market for securities is highly liquid, and you have the type
of account that offers unlimited transactions for one fee. How much would you demand in
exchange for the bond if someone wanted to buy it from you? Rational economic theories predict
that your willingness to pay (WTP) for the bond would equal your willingness to accept (WTA)
compensation for it. However, this is unlikely to be the case. Once you are endowed with the
bond, you are probably inclined to demand a selling price that exceeds your original purchase
price. Many wealth managers have observed that investor decision making regarding both
inherited and purchased securities can exhibit endowment bias and that ―decision paralysis‖
often results: Many clients have trouble making decisions regarding the sale of securities that
they either inherited or purchased themselves, and their predicament is attributable to
endowment bias.

There are some practical explanations as to why investors are susceptible to endowment bias.
Understanding the origins of endowment bias can help to provide intuition that guards against
the mistakes that the bias can cause. First, investors may hold onto securities that they already
own in order to avoid the transaction costs associated with unloading those securities. This is
particularly true regarding bonds. Such a rationale can be hazardous to one‘s wealth, because
failure to take action and sell off certain assets can sometimes invite otherwise avoidable losses,
while forcing investors to forgo the purchase of potentially more profitable, alternative assets.
Second, investors hold onto securities because of familiarity. If investors know from experience
the characteristics of the instruments that they already own (the behaviour of particular
government bonds, for example), then they may feel reluctant to transition into instruments that
seem relatively unknown. Familiarity, effectively, has value. This value adds to the actual,
market value of a security that an investor possesses, causing WTA to exceed WTP.

Professor John A. List, of the University of Maryland, authored a unique and highly relevant
paper entitled ―Does Market Experience Eliminate Market Anomalies?‖ which reviewed some
key aspects of endowment bias, the lessons of which can be relevant to investors. In the paper,
Professor List tried to ascertain the effect of trading expertise on an individual‘s susceptibility to
endowment bias. List‘s sample population traded sports cards and other sports memorabilia, and
the key result of List‘s empirical analysis was that traders with more real-world experience were
less susceptible to endowment bias. Most professional sports memorabilia dealers, for example,
showed little biased behaviour. List also demonstrated that people who are net sellers learn how
to trade better and more quickly, with less biased behaviour, than people who are net buyers.
These lessons have direct implications for securities markets, and readers should take note.

Neoclassical models include several fundamental assumptions. While most of the main tenets
appear to be reasonably met, the basic independence assumption, which is used in most
theoretical and applied economic models to assess the operation of markets, has been directly
refuted in several experimental settings. These experimental findings have been robust across
unfamiliar goods, such as irradiated sandwiches, and common goods, such as chocolate bars,
with most authors noting behaviour consistent with an endowment effect. Such findings have
induced even the most ardent supporters of neoclassical theory to doubt the validity of certain
neoclassical modelling assumptions. Given the notable significance of the anomaly, it is
important to understand whether the value disparity represents a stable preference structure or if
consumers‘ behaviour approaches neoclassical predictions as market experience intensifies. In
this study, I gather primary field data from two distinct markets to test whether individual
behaviour converges to the neoclassical prediction as market experience intensifies. My data
gathering approach is unique in that I examine
 i. Trading patterns of sports memorabilia at a sports card show in Orlando, FL, and

ii. Trading patterns of collector pins in a market constructed by Walt Disney World at
the Epcot Centre in Orlando, FL.

In addition, as an institutional robustness check, I examine explicit statements of value in actual

auctions on the floor of a sports card show in Tucson, AZ. All of these markets are natural
settings for an experiment on the relationship between market experience and the endowment
effect, as they provide natural variation across individual levels of expertise. In the sports card
show field experiments, I conduct some of the treatments with professional dealers and others
with ordinary consumers. The design was used to capture the distinction between consumers who
have intense trading experience (dealers) and those who have less trading experience (non-
dealers). A major advantage of this particular field experimental design is that my laboratory is
the marketplace: subjects would be engaging in similar activities whether I attended the event or
went to the opera.

Example

So, rather than take payment for the wine, the owner may choose to wait for an offer that meets
their expectation or drink it themselves. The actual ownership has resulted in the individual
overvaluing the wine.

4.7 REGRET AVERSION BIAS

People exhibiting regret aversion avoid taking decisive actions because they fear that, in
hindsight, whatever course they select will prove less than optimal. Basically, this bias seeks to
forestall the pain of regret associated with poor decision making. It is a cognitive phenomenon
that often arises in investors, causing them to hold onto losing positions too long in order to
avoid admitting errors and realizing losses. Regret aversion also makes people unduly
apprehensive about breaking into financial markets that have recently generated losses. When
they experience negative investment outcomes, they feel instinctually driven to conserve, to
retreat, and to lick their wounds—not to press on and snap up potentially undervalued stocks.
However, periods of depressed prices often present the greatest buying opportunities. People
exhibiting regret aversion avoid taking decisive actions because they fear that, in hindsight,
whatever course they select will prove less than optimal. Basically, this bias seeks to forestall the
pain of regret associated with poor decision making. It is a cognitive phenomenon that often
arises in investors, causing them to hold onto losing positions too long in order to avoid
admitting errors and realizing losses. Regret aversion also makes people unduly apprehensive
about breaking into financial markets that have recently generated losses. When they experience
negative investment outcomes, they feel instinctually driven to conserve, to retreat, and to lick
their wounds—not to press on and snap up potentially undervalued stocks. However, periods of
depressed prices often present the greatest buying opportunities.

An extensive body of literature in experimental psychology suggests that regret does influence
decision making under conditions of uncertainty. Regret causes people to challenge past
decisions and to question their beliefs. People who are regret averse try to avoid distress arising
from two types of mistakes.

1. Errors of commission and

2. Errors of omission.

Errors of commission occur when we take misguided actions. Errors of omission arise from
misguided inaction, that is, opportunities overlooked or foregone. Regret is different from
disappointment, because the former implies that the sufferer had some sense of agency in
achieving the negative outcome. Also, feelings of regret are more intense when unfavourable
outcomes emerge from errors of commission rather than errors of omission. The ―Implications
for Investors‖ section uses an example to examine more concretely the distinction between errors
of commission and errors of omission in the context of regret aversion bias. Regret is most
palpable and takes the greatest toll on decision making when the outcomes of foregone
alternatives are highly ―visible‖ or ―accessible.‖ By the same token, regret becomes a less
influential factor when consequences of mistakes are less discernible. Some researchers have
proposed theories of choice under uncertainty that incorporate regret bias as a partial explanation
for observed violations of traditional expected utility theory. Regret theory assumes that agents
are rational but base their decisions not only on expected payoffs but also on expected regret.
The Allais paradox along with other human tendencies that seem to interfere with utility
optimization, make sense from the perspective of regret theory. Regret theory bears some
similarities to prospect theory (discussed earlier), and many of its predictions are consistent with
the empirical observations of human behaviour that constitute the building blocks of prospect
theory.

A hypothetical case illustrates both aspects of regret bias: error of commission and error of
omission. The case shows a regret-averse investor under two sets of circumstances.

1. An investor experienced a loss and regrets his decision to invest.

2. An investor missed an opportunity to invest in something that later appreciated in value

and regrets his failure to reap profits.

Suppose that Jim has a chance to invest in Schmoogle, Inc., an initial public offering (IPO) that
has generated a great buzz following its recent market debut. Jim thinks that Schmoogle has high
potential and contemplates buying in because Schmoogle‘s price has recently declined by 10
percent due to some recent market weakness. If Jim invests in Schmoogle, one of two things will
happen.

1. Schmoogle will drop further (Jim made the wrong decision) or

2. Schmoogle will rebound (Jim made the right decision).

Suppose that Jim does invest and Schmoogle goes down. Jim will have committed an error of
commission because he actually committed the act of investing and will likely feel regret
strongly because he actually lost money. Now suppose that Jim does not invest and Schmoogle
goes up. Jim will have committed an error of omission because he omitted the purchase of
Schmoogle and lost out. This regret may not be as strong as the regret associated with the error
of commission. Why? First, as we learned, investors dislike losing money more than they do
gaining money. Second, in the first possibility, the investor actually committed the act of
investing and lost money; in the second possibility, the investor merely did not act and only lost
out on the opportunity to gain.

Regret aversion causes investors to anticipate and fear the pain of regret that comes with
incurring a loss or forfeiting a profit. The potential for financial injury isn‘t the only disincentive
that these investors face; they also dread feeling responsible for their own misfortunes (because
regret implies culpability, whereas simple disappointment does not). The anxiety surrounding the
prospect of an error of commission, or a ―wrong move,‖ can make investors timid and can cause
them to subjectively and perhaps irrationally favour investments that seem trustworthy (e.g.,
―good companies‖). Suppose that regret-averse Jim is now considering two investments, both
with equal projected risk and return. One stock belongs to Large Company, Inc., while the other
confers a share in Medium-Size Company, Inc. Even though, mathematically, the expected
payoffs of investing in these two companies are identical, Jim will probably feel more
comfortable with Large Company. If an investment in Large Company, Inc., fails to pay off, Jim
can rationalize that his decision making could not have been too egregiously flawed, because
Large Company, Inc., must have had lots of savvy investors. Jim doesn‘t feel uniquely foolish,
and so the culpability component of Jim‘s regret is reduced. Jim can‘t rely on the same excuse,
however, if an investment in Medium-Size Company fails. Instead of exonerating himself (―Lots
of high-profile people made the same mistake that I did—perhaps some market anomaly is at
fault?‖), Jim may condemn himself (―Why did I do that? I shouldn‘t have invested in Medium-
Size. Only small-time players invested in Medium-Size, Inc. I feel stupid!‖), adding to his
feelings of regret. It‘s important to recall here that Large Company and Medium-Size Company
stocks were, objectively, equally risky. This underscores the fact that aversion to regret is
different from aversion to risk. Reviews six investor mistakes that can stem from regret aversion
bias. Remedies for these biases will be reviewed in the Advice section.

Regret aversion can cause investors to be too conservative in their investment choices. Having
suffered losses in the past (i.e., having felt pain of a poor decision regarding a risky investment),
many people shy away from making new bold investment decisions and accept only low-risk
positions. This behaviour can lead to long-term underperformance, and can jeopardize
investment goals.

Regret aversion can cause investors to shy away, unduly, from markets that have recently gone
down. Regret-averse individuals fear that if they invest, such a market might subsequently
continue its downward trend, prompting them to regret the decision to buy in. Often, however,
depressed markets offer bargains, and people can benefit from seizing, decisively, these
undervalued investments.

Regret aversion can cause investors to hold onto losing positions too long. People don‘t like to
admit when they‘re wrong, and they will go to great lengths to avoid selling (i.e., confronting the
reality of) a losing investment. This behaviour, similar to loss aversion, is hazardous to one‘s
wealth.
Regret Aversion Bias: Behaviours That Can Cause Investment Mistakes that investors prefer
stocks that pay dividends. They argued that this is true because by paying dividends, investors
can avoid, in some measure, the frustration that is felt when taking an action that leads to a less
than desirable outcome. As previously noted, regret is stronger for errors of commission (cases
where people suffer because of an action they took) than for errors of omission (cases where
people suffer because of an action they failed to take). Suppose that an investor buys stock in
Company A, which does not pay a dividend. In order to extract cash flow from this investment
consumption, an investor would have to sell some stock. If the stock subsequently goes up in
value, the investor feels substantial regret because the error is one of commission; he can readily
imagine how not selling the stock would have left him better off. Conversely, suppose the
investor invests in Company D, which does pay a dividend. With Company D, the investor
would be able to extract cash flow from dividends, and, thus, a rise in the stock price would not
have caused so much regret. This time, the error would have been one of omission: To be better
off, the investor would have had to reinvest the dividend.

No matter how many times an investor has been ―burned‖ by an ultimately unprofitable
investment, risk (in the context of proper diversification) is still a healthy ingredient in any
portfolio. Demonstrating to clients the long-term benefits of adding risky assets to a portfolio is
essential. Efficient frontier research can be very helpful here. Investing too conservatively
doesn‘t place an investor‘s assets in any acute danger—by definition, an excess of conservatism
denotes a relative absence of risk. However, refusing to assume a risk often means forgoing a
potential reward. Investors who swear off risky assets due to regret aversion may see less growth
in their portfolios than they could otherwise achieve, and they might not reach their investment
goals. Staying Out of the Market after a Loss. There is no principle more fundamental in
securities trading than ―buy low, sell high.‖ Nonetheless, many investors‘ behaviour completely
ignores this directive. Again, human nature is to chase returns, following ―hot‖ money. Of
course, it is possible to profit from following market trends the problem is, you never know when
the balloon is going to pop and cause, for example, yesterday‘s coveted security to plummet 40
percent in an afternoon. Disciplined portfolio management is crucial to long-term success. This
means buying at times when the market is low and selling at the times when the market is up.
Holding Losing Positions Too Long. An adage on Wall Street is, ―The first loss is the best loss.‖
While realizing losses is never enjoyable, the wisdom here is that following an unprofitable
decision, it is best to cut those losses and move on.

Example

If a buyer has already lost money by investing in an overheated market, the regret aversion will
prevent them from investing in peaking markets the next time. This might actually help them
avoid some losses.

4.8 AFFINITY BIAS

Humans subconsciously judge others as being either similar or dissimilar to themselves,

manifesting as an unconscious preference, or affinity bias, for those who are perceived to be
similar. In human-to-human interaction, affinity bias can significantly influence trust formation
and lead to discrimination, for example, in decisions related to recruitment and team selection.
We investigate whether affinity bias is observed in human-robot interaction during team
formation with social agents that differ in gender and skin tone. In this study, we asked 61
participants to order the resumés of 24 different avatars that varied in gender, skin tone, and
competency under the pretext of choosing the ―best‖ avatars to be the participant‘s teammate.
Then, using a wizard-of-oz style experiment, participants performed a task with two avatar
teammates (one most preferred and one least preferred) to measure trust. Results showed that
while avatars were predominantly chosen based upon competency, avatar appearance generated
an affinity bias in resumé sorting, and participants were more likely to trust their preferred
teammate.

Subconsciously, humans are happiest and most content when surrounded by familiar things, or
by similar people. This affinity bias can unconsciously affect how we make decisions such as
during recruitment and team selection and during human-to-human interaction (HHI) when
forming and developing trust in a relationship so that we can perpetuate the familiar and the
comfortable. Affinity bias relies upon our ability as humans to make psycho-social judgements
about others, which in many cases are affect-based. These judgements can be race and gender
based and just as affinity bias produces positive discrimination for the familiar/similar,
unfamiliarity and difference can equally lead to unconscious negative bias and discrimination.
The main aim of this study is to investigate whether affinity bias common in HHI is observed in
human-to-robot interaction (HRI), specifically whether human decision making during the
recruitment process is affected by affinity bias, and whether improvements in trust formation and
development occur when humans show affinity bias towards robots. Understanding whether
affinity bias impacts HRI has utility in everyday tasks in education healthcare and commerce not
least by making the robot appear more familiar/similar to users to improve trust, likeability, robot
acceptance, HRI, and ultimately, the user experience. In this study we presented 61 participants
with one-page resumés of 24 avatars comprising avatar photos with different skin tones and
genders, and text highlighting avatar competency (high, medium or low). Resumés were then
sorted into their most preferred (the ―top 8‖) and least preferred candidates (the ―bottom 8‖),
with a third pile for those they were unsure of (the ―middle 8‖). We assessed participants
methods for resumé selection (e.g. the influence of text describing the avatar‘s competence or the
avatar‘s appearance). Participants were then assigned two avatar teammates for a cooperative
visual-tracking task designed to measure trust, with one avatar being their handpicked favourite,
and the other being a randomly assigned avatar from the ―bottom 8‖. The AI algorithm remained
unchanged for each avatar (i.e., all avatars were of equal competence), and participants rated the
avatars on a range of characteristics.

Example

Attending the same college, growing up in the same town, or reminding us of ourselves or
someone we know and like.

4.8.1 Description

In social categorization, individuals classify themselves and others, based on their characteristics,
into different social groups: in-groups (to which they belong), and out-groups (individuals not in
their in-group). These psycho-social classifications introduce bias in human-to-human interaction
(HHI), where out-group members are perceived as being more different and viewed less
favourably than in-group members. These biases occur with humans, robots, and avatars, where
individuals act pro-socially towards in-group robots, treating them more favourably than out-
group robots. Previous studies have shown that people with strong racial biases prefer robots to
dark-skinned people and that attitudes to out-group robots are similar to human minority out-
groups. These biases occur in resumé screening where recruiters select applicant resumés with
the same gender or ethnicity. In the current study, we expect avatar resumé selections to have
similar characteristics to participants, irrespective of competence (H1). When a robot is ‗in-
group‘ (e.g. the robot shares common characteristics), it tends to be anthropomorphised and
ascribed human characteristics (e.g. ambition, emotions) compared to out-group robots. This is a
direct result of social attitudes and racial bias which has also been shown to be positively
changed through human robot embodiment. In the absence of embodiment, we expect these
unconscious biases to be present in avatar interaction. Thus, we expect images to play a greater
role in avatar selection for a given task (H1), and that participants prefer working with visually
self-similar avatars (H2).

Positive and negative discrimination is reinforced by stereotyping and can be implicit

(subconscious). Implicit biases, create and perpetuate human attitudes that negatively impact
interpersonal relationships. For example, teams comprising in-group members have stronger
relationships of mutual trust and respect, whereas out-group members are viewed as incompetent
and untrustworthy. We expect to see a similar effect in this study, where participants have less
trust in randomly assigned avatars, than avatars they have previously self-selected, as assessed
by the participant reactions to the avatar‘s opinion/recommendation during the task (H3). We
also expect participants chosen avatars to be rated as more competent, likeable, and having better
teamwork ability than assigned avatars (H4). Gender biases are also present in HRI and robots
have been ascribed stereotyped roles based on perceived gender (e.g. feminine robots to
domestic labour). Robots ascribed human characteristics on cross-gender bases (e.g. based on
body proportions; female-to-male and vice versa) are viewed as more trustworthy and credible
but can bias a robot‘s perceived ability and acceptability. Feminine robots are judged as warmer
and more engaging than masculine robots, which can affect the robot‘s perceived strengths,
flaws and suitability. In team formation, more competent individuals are chosen first, yet in the
absence of perceived competency, team members were chosen based on their similarity to the
chooser. Thus, we anticipate affect-based (gender and race) differences to be evident in avatar
selection (H1), in ratings of trust (H3) and in perceived competency (H4), which has ethical
implications for visual diversity: a theme vital in HRI.

4.8.2 Practical Application

Sixty-one Western Sydney University (WSU) first-year psychology students (51 females, 83.1%;
10 males, 16.9%; mean age = 21.6 years old; age range 17-43 years) were recruited via WSU‘s
online participation system and received course credit for participation. The study was approved
by the Human Research Ethics Committee.

Participants were told a cover story that experimenters were testing 24 avatars each with a
unique computer vision algorithm, that they would play a graphical version of the ―shell‖ (or
―cup‖) game with an avatar as a teammate, and that they would evaluate each avatars‘
performance as compared to human-level performance. Participants were told avatars would
track objects using a Microsoft Kinect, directed towards a monitor where task stimuli appeared
(the avatar was really a confederate operated by Wizard-of Oz). Participants were informed
avatar task performance was ―good, but not perfect‖, and could make mistakes. Participants were
also told that each avatar were distinct in appearance and personality and had been benchmarked
on other computer vision tasks. This formed the basis of each avatar‘s resume.

The shell (or cup) game involves hiding an object under one of three cups, and then shuffling the
cups to create uncertainty as to the object‘s true location. Participants played this computerized
shell game task; cups were displayed and shuffled on a monitor, with participants (falsely)
believing their avatar partner was tracking the objects using the Kinect. The task had 48 trials,
with each trial taking 15s in total. After the shell shuffling on each trial, the avatar voice asked,
―what is your answer?‖. Participants were required to face the avatar and nominate a shell choice
of either ‗left‘, ‗middle‘ or ‗right‘: failure to look at the avatar prompted it to say: ―please look at
me when I‘m talking to you‖. The game had three difficulty levels, which were determined by
cup speed and the number of times the cups shuffled. Four trials were ―easy‖, 24 were ―medium‖
difficulty, and 20 ―hard‖. In the easy level, the avatars disagreed with the participant if the
participant answered incorrectly, offering a correct answer (to ensure avatar credibility). In the
medium and hard levels, each avatar disagreed with the participant five times, and offered a
different answer (regardless of correctness), for example ―I disagree, I think it is on the left.
What is your final answer?‖. We measured trust by assessing the number of times a participant
changed their initial answer to a disagreeing avatar‘s suggested answer. The experimental setup
used two monitors, one for the game, the other for the avatar (facing the participant), and a
Kinect directed towards the monitor displaying the shell game.

Each avatar had a resumé which featured their picture, and text describing the avatar‘s
competence. All of the avatars were equally competent at playing the game, but the resumés
described eight with low competence, eight with medium competence, and eight with high
competence, with competence categories (similar task score, perception and processing ability)
evenly distributed among gender and skin tone. Avatars were created using the web-based
program Avatar maker comprising equal numbers of four skin tones: white, brown, black, and
yellow, for both male and female, and all had similar facial features. Avatars had either a male or
female voice with Australian accents depending on their gender, created using TTSMP3.

4.8.3 Research Review

Is it realistic to believe that we can keep it from happening or manage our way out of it? Or is
affinity bias such an entrenched part of human behaviour that we cannot hope to change it?

If I were to make a hierarchical list of unconscious biases and their impact on retention and the
talent pipeline, ―Affinity Bias‖ would surely be a top contender. It is true that affinity bias is
most often defined in the context of the hiring process—when interviewers show a preference for
candidates who are similar to themselves—but I would argue that it has much more wide-ranging
ramifications.

Understandably, corporate hiring practices are set up to find people who are a ―good fit‖ for the
organization, people who will bring value to the team. These requirements cause us to look for
candidates who are not only professionally skilled, but are also people we can relate to.
However, as corporations seek to recruit and retain diverse candidates, they are turning the
spotlight more and more on our natural human tendency towards affinity bias—towards hiring
(and promoting) in our own image. To mitigate affinity bias in the hiring process, many
corporations have engaged diverse recruitment panels to add different perspectives to the hiring
discussion. Some of my clients are removing names from resumes during the first round of the
recruitment process to limit initial bias. So why is it that, simultaneously, hallway discussions
about reverse discrimination, political correctness, and whether or not we have gone too far with
the D & I agenda, continue?

In truth, we all have a natural propensity to want to be around people we can relate to and, if we
are honest, have a really hard time contemplating the contrary. If affinity bias means being
biased towards ―people who make me comfortable‖ or ―people who are like me,‖ then, surely,
somewhere tucked in the recesses of our minds are the shadows of these thoughts—―people who
make me uncomfortable‖ and ―people who are not like me.‖ And, let‘s be honest, who in their
right mind wants to surround themselves with people who make them uncomfortable?

When we talk about affinity bias in the context of the workplace, the subtext of that conversation
implies that we are asking the dominant culture—namely white men—to recognize that we need
more diversity. That may be accurate, but it is only one piece of the story. We all have a
predisposition towards affinity bias, regardless of our race, culture, gender, or other diversity
group membership(s). Affinity bias is not the exclusive right of the dominant culture, and yet
there exists an interesting and paradoxical phenomenon in that it is still much more difficult for
people from subcultures to hire or promote people in their own image (a subject we will return to
in the next article.

4.8.4 Diagnostic Testing

In this two-part series on sources of bias in studies of diagnostic test performance, we outline
common errors and optimal conditions during three study phases: patient selection, interpretation
of the index test and disease verification by a gold standard. Here in part 1, biases associated
with suboptimal participant selection are discussed through the lens of partial verification bias
and spectrum bias, both of which increase the proportion of participants who are the 'sickest of
the sick' or the 'wellest of the well.' Especially through retrospective methodology, partial
verification introduces bias by including patients who are test positive by a gold standard, since
patients with a positive index test are more likely to go on to further gold standard testing.
Spectrum bias is frequently introduced through case-control design, dropping of indeterminate
results or convenience sampling. After reading part 1, the informed clinician should be better
able to judge the quality of a diagnostic test study, its inherent limitations and whether its results
could be generalisable to their practice. Part 2 will describe how interpretation of the index test
and disease verification by a gold standard can contribute to diagnostic test bias.

4.8.5 Advice

Affinity Bias is defined as the state of being biased toward a group of people in the workplace
who aren‘t like-minded or are from varied backgrounds, castes, and religions. This is an
unconscious practice that people tend to follow in workplaces.
However, people are psychologically inclined to mix along with like-minded people. Sitting in a
workplace, we know that you would not only meet people who match your mentality. This may
lead to the neglect of people from a minority in the workplace.

This may make them feel unwelcome. It may tamper with their mental well-being. To avoid such
circumstances, efforts are needed from both ends to mend such relationships.

Have you ever met a job applicant who wasn‘t a good fit? This may be related to your own
affinity bias.

It‘s believed that opposites attract each other in the dating scene; however, this infrequently
applies to the work environment. Neuropsychology studies show that we subliminally float
towards individuals who share our inclinations, convictions, and foundation. This is called
proclivity predisposition and can cause various issues in the working environment.

Our cerebrums can catch 11 million pieces of data in one single second. However, we really can
deal with 40 all at once. Consequently, we regularly pursue oblivious faster routes to arrive at a
speedier resolution.

When meeting new individuals, these fast-fire decisions occur before we‘re ever mindful of it,
evaluating them on elements like sex, identity, sexuality, and class. This is alluded to as
oblivious predisposition, with fondness inclination being one of the typical kinds of
predisposition.

What someone looks like, talks, and presents themselves will make us make a snap judgment
concerning the individual we accept they are. In the work environment, these predispositions will
make us make suppositions about an individual‘s abilities, capacities, and by and large direct. So
what are some particular manners by which proclivity predisposition can show itself in the
working environment?

When you fail to recruit talented people regarding their ability, you will likely miss a better fit
for the work. While numerous administrators know about the results of terrible recruiting choices
(for example, diminished usefulness and high turnover), they may not have the foggiest idea
about the actual expense of inclination.

When pioneers enlist some unacceptable individuals, they cause a scope of immediate and
aberrant expenses. Liking inclination can likewise prompt individuals to consistently be
disregarded for advancement. When pioneers see themselves in their representatives, they
frequently need to sustain their latent capacity. While this in itself is positive, it may very well be
to the impairment of different individuals from a group who are similarly gifted.

As per a 2019 investigation of ―Ladies in the Workplace,‖ for every 100 men elevated to an
administrative position, just 72 ladies were offered an equal chance to progress. This is likely
because of men being the ones principally settling on these choices. If men continue to make the
same choices based on their similar examples of disparity don‘t handle liking predisposition, it
could keep on holding ladies back from progressing.

Chiefs need to believe their group to assist them with choosing a specific game-plan. In any case,
everybody‘s assessment should be held in similarly high regard. Pioneers may depend on the
commonality of the individuals who hold comparative perspectives and thoughts to them.

Fondness predisposition could make administrators verifiably esteem the assessment of certain
colleagues over those they believe they can‘t identify with by and by. This will deny them new
learning openings and new viewpoints. Organizations will think that it‘s a lot simpler to concoct
creative novel thoughts when everybody can offer their own remarkable experiences.

95% of representatives say that hands-on acknowledgment assists with making a positive
organizational culture. Notwithstanding, if pioneers acclaim the individuals who display
attributes that they appreciate in themselves, different representatives who don‘t fit a similar
shape could indeed be neglected.

An investigation from Stanford University centres around what they call a ‗gendered acclaim
partition.‘ Researchers found that while ladies are bound to get more conventional and tepid
commendations, for example, ―you‘ve had an extraordinary year,‖ men will be classified as
―creative‖ or ―visionary.‖ As well as this, men are all the more habitually praised for explicit
accomplishments. This implies that while ladies will be classified as ―a genuine resource for the
group,‖ men will be commended for surpassing a business amount by a specific rate.

When specific individuals from the group are held in high regard (maybe outlandishly) for
explicit achievements, while others get similar cut-out praises, this can cause rubbing among
representatives and have a drawn-out adverse consequence on spirit and work environment
culture.
At Applied, we will likely plan oblivious predisposition out of the recruiting interaction. Perhaps
than succumbing to fondness inclination, pioneers can utilize daze enrolment programming to
guarantee that recruiting choices depend simply on abilities and legitimacy. Solicitation a demo
today to perceive how the Applied stage can assist you with getting employing choices right –
the first time.

Fundamental Anomalies

Irregularities that emerge when a stock‘s performance is considered in light of a fundamental

assessment of the stock‘s value are known as fundamental anomalies. Many people, for example,
are unaware that value investing—one of the most popular and effective investment methods—is
based on fundamental anomalies in the efficient market hypothesis. There is a large body of
evidence documenting that investors consistently overestimate the prospects of growth
companies and underestimate the value of out-of-favour companies. One example concerns
stocks with low price-to-book-value (P/B) ratios. Eugene Fama and Kenneth French performed a
study of low price-to book-value ratios that covered the period between 1963 and 1990.9 the
study considered all equities listed on the New York Stock Exchange (NYSE), the American
Stock Exchange (AMEX), and the Nasdaq. The stocks were divided into 10 groups by
book/market and were reranked annually. The lowest book/market stocks outperformed the
highest book/ market stocks 21.4 percent to 8 percent, with each decile performing more poorly
than the previously ranked, higher-ratio decile. Fama and French also ranked the deciles by beta
and found that the value stocks posted lower risk and that the growth stocks had the highest risk.
Another famous value investor, David Dreman, found that for the 25-year period ending in 1994,
the lowest 20 percent P/B stocks (quarterly adjustments) significantly outperformed the market;
the market, in turn, outperformed the 20 percent highest P/B of the largest 1,500 stocks on
Compustat. Securities with low price-to-sales ratios also often exhibit performance that is
fundamentally anomalous. Numerous studies have shown that low P/B is a consistent predictor
of future value. In What Works on Wall Street, however, James P. O‘Shaughnessy demonstrated
that stocks with low price-to-sales ratios outperform markets in general and also outperform
stocks with high price-to-sales ratios. He believes that the price/sales ratio is the strongest single
determinant of excess return. Low price-to-earnings (P/E) ratio is another attribute that tends to
anomalously correlate with outperformance. Numerous studies, including David Dreman‘s work,
have shown that low P/E stocks tend to outperform both high P/E stocks and the market in
general. Ample evidence also indicates that stocks with high dividend yields tend to outperform
others. The Dow Dividend Strategy, which has received a great deal of attention recently,
counsels purchasing the 10 highest yielding Dow stocks.

Another major debate in the investing world revolves around whether past securities prices can
be used to predict future securities prices. ―Technical analysis‖ encompasses a number of
techniques that attempt to forecast securities prices by studying past prices. Sometimes, technical
analysis reveals inconsistencies with respect to the efficient market hypothesis; these are
technical anomalies. Common technical analysis strategies are based on relative strength and
moving averages, as well as on support and resistance. While a full discussion of these strategies
would prove too intricate for our purposes, there are many excellent books on the subject of
technical analysis. In general, the majority of research-focused technical analysis trading
methods (and, therefore, by extension, the weak-form efficient market hypothesis) finds that
prices adjust rapidly in response to new stock market information and that technical analysis
techniques are not likely to provide any advantage to investors who use them. However,
proponents continue to argue the validity of certain technical strategies.

Calendar Anomalies

One calendar anomaly is known as ―The January Effect.‖ Historically, stocks in general and
small stocks in particular have delivered abnormally high returns during the month of January.
Robert Haugen and Philippe Jorion, two researchers on the subject, note that ―the January Effect
is, perhaps, the best-known example of anomalous behaviour in security markets throughout the
world.‖ The January Effect is particularly illuminating because it hasn‘t disappeared, despite
being well known for 25 years (according to arbitrage theory, anomalies should disappear as
traders attempt to exploit them in advance). The January Effect is attributed to stocks rebounding
following yearend tax selling. Individual stocks depressed near year-end are more likely to be
sold for tax-loss harvesting. Some researchers have also begun to identify a ―December Effect,‖
which stems both from the requirement that many mutual funds report holdings as well as from
investors buying in advance of potential January increases. Additionally, there is a Turn-of-the-
Month Effect. Studies have shown that stocks show higher returns on the last and on the first
four days of each month relative to the other days. Frank Russell Company examined returns of
the Standard & Poor‘s (S&P) 500 over a 65-year period and found that U.S. large-cap stocks
consistently generate higher returns at the turn of the month. Some believe that this effect is due
to end-of-month cash flows (salaries, mortgages, credit cards, etc.). Chris Hensel and William
Ziemba found that returns for the turn of the month consistently and significantly exceeded
averages during the interval from 1928 through 1993 and ―that the total return from the S&P 500
over this sixty-five-year period was received mostly during the turn of the month.‖ The study
implies that investors making regular purchases may benefit by scheduling those purchases prior
to the turn of the month. Finally, as of this writing, during the course of its existence, the Dow
Jones Industrial Average (DJIA) has never posted a net decline over any year ending in a ―five.‖
Of course, this may be purely coincidental. Validity exists in both the efficient market and the
anomalous market theories. In reality, markets are neither perfectly efficient nor completely
anomalous. Market efficiency is not black or white but rather, varies by degrees of grey,
depending on the market in question. In markets exhibiting substantial inefficiency, savvy
investors can strive to outperform fewer savvy investors. Many believe that large-capitalization
stocks, such as GE and Microsoft, tend to be very informative and efficient stocks but that small-
capitalization stocks and international stocks are less efficient, creating opportunities for
outperformance. Real estate, while traditionally an inefficient market, has become more
transparent and, during the time of this writing, could be entering a bubble phase. Finally, the
venture capital market, lacking fluid and continuous prices, is considered to be less efficient due
to information asymmetries between players.

Rational Economic Man versus Behaviourally Biased Man

Stemming from neoclassical economics, Homo economicus is a simple model of human

economic behaviour, which assumes that principles of perfect self-interest, perfect rationality,
and perfect information govern economic decisions by individuals. Like the efficient market
hypothesis, Homo economicus is a tenet that economists uphold with varying degrees of
stringency. Some have adopted it in a semi-strong form; this version does not see rational
economic behaviour as perfectly predominant but still assumes an abnormally high occurrence of
rational economic traits. Other economists support a weak form of Homo economicus, in which
the corresponding traits exist but are not strong. All of these versions share the core assumption
that humans are ―rational maximisers‖ who are purely self-interested and make perfectly rational
economic decisions. Economists like to use the concept of rational economic man for two
primary reasons.
 1. Homo economicus makes economic analysis relatively simple. Naturally, one might
question how useful such a simple model can be.

2. Homo economicus allows economists to quantify their findings, making their work more
elegant and easier to digest.

If humans are perfectly rational, possessing perfect information and perfect self-interest, then
perhaps their behaviour can be quantified. Most criticisms of Homo economicus proceed by
challenging the bases for these three underlying assumptions—perfect rationality, perfect self-
interest, and perfect information.

Private clients can greatly benefit from the application of behavioural finance to their unique
situations. Because behavioural finance is a relatively new concept in application to individual
investors, investment advisors may feel reluctant to accept its validity. Moreover, advisors may
not feel comfortable asking their clients psychological or behavioural questions to ascertain
biases, especially at the beginning of the advisory relationship. One of the objectives of this book
is to position behavioural finance as a more mainstream aspect of the wealth management
relationship, for both advisors and clients.

As behavioural finance is increasingly adopted by practitioners, clients will begin to see the
benefits. There is no doubt that an understanding of how investor psychology impacts investment
outcomes will generate insights that benefit the advisory relationship. The key result of a
behavioural finance–enhanced relationship will be a portfolio to which the advisor can
comfortably adhere while fulfilling the client‘s long-term goals. This result has obvious
advantages—advantages that suggest that behavioural finance will continue to play an increasing
role in portfolio structure.

4.9 SUMMARY

 At the conclusion of the first period, the second period commences and four shares of an
identical single-period stock are auctioned off in the exact same fashion. A trader‘s cash
balance is carried forward across periods within a market. As before, subsequent to
allocation with a Vickery auction, a die roll determines pay-out. A third period follows
with identical procedures.
 The advantage of this approach is that it is possible to generate a reasonable number of
identical dividend evolutions. Six or eight markets are conducted in a similar manner
bringing the session to a close. The traders‘ endowments are reinitialized at the beginning
of each market. Subjects are told at the outset that they will be paid based on the results
of only one of the markets, and this market is chosen by a die roll (or, in the case of
sessions 6–9, by a card draw).

 Since ex ante the students have no way of knowing the identity of the pay-out market it is
in their interest to treat all markets equally seriously. Participants‘ experimental earnings
include their cash endowment, less payments to acquire stock, plus dividends earned on
stock held in the one randomly selected market. In addition, the participant with the
lowest absolute prediction error in the randomly selected market receives a bonus of $20.
At the beginning of each period, participants are informed that the participant with the
lowest sum of the three absolute prediction errors in the selected market will receive the
bonus.

 As many wealth managers know, recency bias ran rampant during the bull market period
between 1995 and 1999. Many investors implicitly presumed, as they have during other
cyclical peaks, that the market would continue its enormous gains forever. They all but
forgot the fact that bear markets can and do occur. Investors, who based decisions on
their own subjective short-term memories, hoped that near-term history would continue
to repeat itself. Intuitively, they insisted that evidence gathered from recent experience
narrowed the range of potential outcomes and thus enabled them to project future returns.

 All too often, this behaviour creates misguided confidence and becomes a catalyst for
error. When studying the market, good investors analyse large data samples to determine
probabilities. By doing so, solid conclusions can be scientifically obtained. Recency bias
causes investors to place too much emphasis on data recently gathered, rather than
examining entire, relevant bodies of information, which often span much more extensive
intervals of time.

 Investors need to be advised to look at underlying value and not just recent performance.
If prices have just risen strongly, for example, then assets may be approaching or may
have exceeded their fair value. This should imply that there are, perhaps, better
 investment opportunities elsewhere. Summarizes investment mistakes that can stem from
recency bias.

 Although some researchers felt that Thurston‘s experiment was too hypothetical, it was
still considered important. In the 1940s, two researchers named Stephen W. Rousseas and
Albert G. Hart performed some experiments on indifference curves designed to follow up
on Thurstone‘s experiment and to respond to some of the experiment‘s critics.

 They constructed what they viewed as a more concrete and realistic choice situation by
having subjects select among possible breakfast menus, with each potential breakfast
consisting of a specified number of eggs and a specified quantity of bacon strips.

 They required that ―each individual was obliged to eat all of what he chose; i.e., he could
not save any part of the offerings for a future time. ―In this experiment, individual
subjects made only a single choice (repeated subsequently a month later); and, in addition
to selecting among available combinations, each was asked to state an ideal combination
of bacon and eggs.

 While this experiment did not ask its subjects to make too many choices of the same type
(i.e., different combinations of two goods), thereby averting a common criticism of
Thurstone, it left Rousseas and Hart with the problem of trying to aggregate individual
choice data collected from multiple individuals.

 They attempted to ascertain whether choices made by separate individuals stating similar
―ideal‖ breakfast combinations could be pieced together to form consistent indifference
curves. This last step presented complications, but overall the project was considered a
success and led to further experiments in the same vein.

 Also inspired by Thurstone, Frederick Mosteller and Phillip Nogee sought in 1951 to test
expected utility theory by experimentally constructing utility curves. Mosteller and
Nogee tested subjects‘ willingness to accept lotteries with given stakes at varying payoff
probabilities.

 They concluded, in general, that it was possible to construct subjects‘ utility functions
experimentally and that the predictions derived from these utility functions were ―not so
good as might be hoped, but their general direction [was] correct.‖ This is a conclusion
 that many experimental economists would still affirm, with differing degrees of
emphasis.

 When businesses hire for ‗cultural fit,‘ they are most frequently falling to a liking
tendency. When hiring groups find someone they really like who knows will coexist with
the team, it‘s a general principle, so this individual gives comparable interests,
experiences, and roots, that‘s not aiding your team with evolving and differing. When
companies employ for ‗cultural fit,‘ they typically fall prey to the like propensity.

 When her groups discover someone they truly like and know will get along with the
company, it‘s a common rule that this individual has similar interests, experiences, and
roots, which isn‘t helping your team evolve and diverge.

 Be prepared to question individuals about what you are seeing or hear if you notice your
organization displaying affinity bias. Inquire with management on how the company may
reduce bias and enhance diversity. You can assist your company to gain a competitive
edge by hiring, embracing, promoting, and allowing a diverse workforce. Be a positive
impact.

 Affinity bias is our propensity to gravitate toward — and connect with — those who
reflect us. Affinity bias maintains uniformity, whether coming from the same city, having
similar political ideas, or being of the same ethnicity. Understand that in the lack of
straightforward advice that fosters diversity, people in your workplace will prefer to
gravitate toward individuals who are similar to themselves. Everyone is included in this.

 A few weeks ago I had occasion to call a customer service number for assistance with
one of my recent purchases. The young woman who answered the phone had a shrill,
high-pitched voice, and spoke quickly and incessantly in a monotonous tone, suggesting
to me that she was reading from a script. No matter what question I asked her, she
repeated the same scripted response. My blood pressure was rising and my patience was
wearing thin. No matter what I said, I could not get her to understand what I needed. I
finally asked her where she was located, and she said, ―The Philippines, but I am very
well trained.‖
  I detected some, perhaps understandable, defensiveness in that answer; however, I
hesitated to tell her my inner thoughts at that time (being that she was indeed very well
trained to read the script, but only the script). Instead I asked to be put through to a
supervisor. A few minutes later I heard an American voice: ―Hello, this is Mary. How can
I help you?‖ I asked her where she was located, and she said she was in Indiana. My
breathing began to normalize, I started to feel more relaxed, and I began my story
again—feeling more confident that I was ―in good hands‖ and, this time, would reach a
satisfactory resolution.

 There are many ways we could unpack this story. We could focus on customer service
and discuss the vagaries, and rights and wrongs, of off-shoring; or whether the customer
feels heard and the impact of language, accent, tone of voice, and pace of speech on our
ability to listen. However, as my main point of focus is on affinity bias, I found myself
wondering how often I notice that I am breathing easier around people who are like me.
Conversely, I wondered how aware I am of the physiological changes that occur inside
me, when I am around people who are different from me, without even realizing they are
happening. I venture to suggest that this almost unconscious physiological reaction is
impacting trust, inevitably affecting the quality of my relationships, and, perhaps, even
having a detrimental effect on the decisions I might make about projects and assignments.

4.10 KEYWORDS

 Multiracial: A person who identifies as coming from two or more races; a person whose
biological parents are of two or more different races.

 Multi-ethnic: A person who identifies as coming from two or more ethnicities; a person
whose biological parents are of two or more ethnicities.

 Pansexual - Referring to the potential for sexual attractions or romantic love toward
people of all gender identities and biological sexes; the concept of pansexuality
deliberately rejects the gender binary.
  People of Colour: Used primarily in the United States to describe any person who is not
white; the term is meant to be inclusive among non-white groups, emphasizing common
experiences of racism.

 Queer: An umbrella term that can refer to anyone who transgresses society‘s view of
gender, sexual orientation or sexuality.

4.11 LEARNING ACTIVITY

1. Create a session on concept of loss aversion bias.

_____________________________________________________________________________________
_________________________________________________________________

2. Create a survey on concept of overconfidence bias.

_____________________________________________________________________________________
_________________________________________________________________

4.12 UNIT END QUESTIONS

A. Descriptive Questions

Short Questions

1. What is loss aversion bias?

2. Define overconfidence bias?

3. Define self-control bias?

4. What is endowment bias?

5. Write the meaning of diagnostic testing?

Long Questions

1. Explain the concept of loss aversion bias.

2. Explain the concept of overconfidence bias.

3. Illustrate the concept of status quo bias.

4. Illustrate the concept of endowment bias.

 5. Examine the concept of regret aversion bias.

B. Multiple Choice Questions

1. What should be the value of VBE should for a silicon transistor for faithful amplification
by a transistor circuit?

a. Be zero
b. Be 0.01 V
c. Not fall below 0.7 V
d. Be between 0 V and 0.1 V

2. Which among the following the collector should have for proper operation of the
transistor?

a. Proper forward bias

b. Proper reverse bias
c. Very small size
d. None of these

3. What should be the value of VCE should for silicon transistor for faithful amplification
by a transistor circuit?

a. Not fall below 1 V

b. Be zero
c. Be 0.2 V
d. None of these

4. What is the best stabilization of operating point the circuit provides?

a. Base resistor bias

b. Collector feedback bias
c. Potential divider bias
d. None of these
 5. What does the point of intersection of d.c. and a.c. load lines represent?

a. Operating point
b. Current gain
c. Voltage gain
d. None of these

Answers

1-c, 2-b, 3-a, 4-c, 5-a

4.13 REFERENCES

References

 Galbraith, R. C. & Underwood, B.J. (1973). Perceived Frequency of Concrete and

Abstract Words. Memory and Cognition.

 Gersh, J. R. McKneely, J. A. & Remington, R. W. (2005). Cognitive Engineering:

Understanding Human Interaction with Complex Systems. Johns Hopkins APL Technical
Digest.

 Hullman, J. Diakopoulos, N. (2011). Visualization Rhetoric: Framing Effects in Narrative

Visualization, IEEE Transactions on Visualization and Computer Graphics –TVCG.

Textbook

 Bachellier, L. (1900). Theory of speculation. The random character of stock market

prices.

 Banz, R. W. (1981). The relationship between return and market value of common
stocks. Journal of financial economics.

 Barber, B. & Odean, T. (1999). Do investors trade too much?. American Economic
Review.

Website
 [Link]

 [Link]

 [Link]
EcG9zAzMEdnRpZANEMTA0NV8xBHNlY
MASTER OF BUSINESS
ADMINISTRATION
(FINANCIAL MANAGEMENT)
SEMESTER II

BEHAVIORAL FINANCE
MBAEF 204
All rights reserved. No Part of this book may be reproduced or transmitted, in any form or by any means,
without permission in writing from Mizoram University. Any person who does any unauthorized act in
relation to this book may be liable to criminal prosecution and civil claims for damages. This book is
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writing for corrective action.
 CONTENT

Unit- 5: Application Of Behavioural Finance To Asset Allocation And Case Studies ............. 4
UNIT- 5: APPLICATION OF BEHAVIOURAL FINANCE
TO ASSET ALLOCATION AND CASE STUDIES

STRUCTURE

5.0 Learning Objectives

5.1 Introduction

5.2 Application of Behavioural Finance to Asset Allocation

5.3 Practical Allocation

5.4 Guidelines for Determining Asset Allocation

5.5 Investment Policy

5.6 Asset Allocation

5.7 Summary

5.8 Keywords

5.9 Learning Activity

5.10 Unit End Questions

5.11 References

5.0 LEARNING OBJECTIVES

After studying this unit, you will be able to

 Examine the concept of application of behavioural finance to asset allocation.

 Illustrate the guidelines for determining asset allocation.

 Explain the concept of investment policy.

5.1 INTRODUCTION

In financial accounting, an asset is any resource owned or controlled by a business or an

economic entity. It is anything (tangible or intangible) that can be used to produce positive
economic value. Assets represent value of ownership that can be converted into cash (although
cash itself is also considered an asset). The balance sheet of a firm records the monetary value of
the assets owned by that firm. It covers money and other valuables belonging to an individual or
to a business.

IFRS (International Financial Reporting Standards), the most widely used financial reporting
system, defines: "An asset is a present economic resource controlled by the entity as a result of
past events. An economic resource is a right that has the potential to produce economic benefits."

The definition under US GAAP (Generally Accepted Accounting Principles used in the United
States of America): "Assets are probable future economic benefits obtained or controlled by a
particular entity as a result of past transactions or events invests to allocate money with the
expectation of a positive benefit/return in the future. In other words, to invest means owning an
asset or an item with the goal of generating income from the investment or the appreciation of
your investment which is an increase in the value of the asset over a period of time. When a
person invests, it always requires a sacrifice of some present asset that they own, such as time,
money, or effort.

In finance, the benefit from investing is when you receive a return on your investment. The
return may consist of a gain or a loss realized from the sale of a property or an investment,
unrealized capital appreciation (or depreciation) or investment income such as dividends,
interest, rental income etc., or a combination of capital gain and income. The return may also
include currency gains or losses due to changes in the foreign currency exchange rates.

Investors generally expect higher returns from riskier investments. When a low-risk investment
is made, the return is also generally low. Similarly, high risk comes with high returns.

Investors particularly novices, are often advised to adopt a particular investment strategy and
diversify their portfolio. Diversification has the statistical effect of reducing overall risk.

An investor may bear a risk of loss of some or all of their capital invested. Investment differs
from arbitrage, in which profit is generated without investing capital or bearing risk.
Savings bear the (normally remote) risk that the financial provider may default. Foreign
currency savings also bear foreign exchange risk: if the currency of a savings account differs
from the account holder's home currency, then there is the risk that the exchange rate between
the two currencies will move unfavourably so that the value of the savings account decreases,
measured in the account holder's home currency.

Even investing in tangible assets are like property has its risk. And just like with most risk,
property buyers can seek to mitigate any potential risk by taking out mortgage insurance and by
borrowing at a lower loan to security ratio.

In contrast with savings, investments tend to carry more risk, in the form of both a wider variety
of risk factors and a greater level of uncertainty.

Industry to industry volatility is more or less of a risk depending. In biotechnology for example,
investors look for big profits on companies that have small market capitalizations but can be
worth hundreds of millions quite quickly. The risk is approximately 90% of the products
researched do not make it to market due to regulations and the complex demands within
pharmacology as the average prescription drug takes 10 years and $2.5 billion USD worth of
capital.

The Code of Hammurabi (around 1700 BC) provided a legal framework for investment,
establishing a means for the pledge of collateral by codifying debtor and creditor rights in regard
to pledged land. Punishments for breaking financial obligations were not as severe as those for
crimes involving injury or death.

In the medieval Islamic world, the qirad was a major financial instrument. This was an
arrangement between one or more investors and an agent where the investors entrusted capital to
an agent who then traded with it in hopes of making a profit. Both parties then received a
previously settled portion of the profit, though the agent was not liable for any losses. Many will
notice that the qirad is similar to the institution of the commenda later used in western Europe,
though whether the qirad transformed into the commenda or the two institutions evolved
independently cannot be stated with certainty.

Amsterdam Stock Exchange is considered to be the world's oldest stock exchange. Established in
1602 by Dutch East India Company, the company issued the first shares on the Amsterdam Stock
Exchange. In the early 1900s, purchasers of stocks, bonds, and other securities were described in
media, academia, and commerce as speculators. Since the Wall Street crash of 1929, and
particularly by the 1950s, the term investment had come to denote the more conservative end of
the securities spectrum, while speculation was applied by financial brokers and their advertising
agencies to higher risk securities much in vogue at that time. Since the last half of the 20th
century, the terms speculation and speculator have specifically referred to higher risk ventures.

A value investor buys assets that they believe to be undervalued (and sells overvalued ones). To
identify undervalued securities, a value investor uses analysis of the financial reports of the
issuer to evaluate the security. Value investors employ accounting ratios, such as earnings per
share and sales growth, to identify securities trading at prices below their worth.

Warren Buffett and Benjamin Graham are notable examples of value investors. Graham
and Dodd's seminal work, Security Analysis, was written in the wake of the Wall Street Crash of
1929.

The price to earnings ratio (P/E), or earnings multiple, is a particularly significant and recognized
fundamental ratio, with a function of dividing the share price of the stock, by its earnings per
share. This will provide the value representing the sum investors are prepared to expend for each
dollar of company earnings. This ratio is an important aspect, due to its capacity as measurement
for the comparison of valuations of various companies. A stock with a lower P/E ratio will cost
less per share than one with a higher P/E, taking into account the same level
of financial performance; therefore, it essentially means a low P/E is the preferred option.

An instance in which the price to earnings ratio has a lesser significance is when companies in
different industries are compared. For example, although it is reasonable for a
telecommunications stock to show a P/E in the low teens, in the case of hi-tech stock, a P/E in
the 40s range is not unusual. When making comparisons, the P/E ratio can give you a refined
view of a particular stock valuation.

For investors paying for each dollar of a company's earnings, the P/E ratio is a significant
indicator, but the price-to-book ratio (P/B) is also a reliable indication of how much investors are
willing to spend on each dollar of company assets. In the process of the P/B ratio, the share price
of a stock is divided by its net assets; any intangibles, such as goodwill, are not taken into
account. It is a crucial factor of the price-to-book ratio, due to it indicating the actual payment for
tangible assets and not the more difficult valuation of intangibles. Accordingly, the P/B could be
considered a comparatively conservative metric.

5.2 APPLICATION OF BEHAVIOURAL FINANCE TO ASSET

ALLOCATION

An emotional investor is very likely to make poor decisions over his or her financial
life. Various experts (DALBAR, American College, etc.) have done in-depth studies to measure
exactly how investor returns have lagged overall market performance. Measuring this
behaviour over an extended period for an ―average investor‖ has proven difficult. The exact
difference, in our opinion, is not as important as the undeniable trends in activity that occurs
throughout full market cycles. The data tells us investors can be their own worst enemies.

The chart measures mutual fund flows over what we would classify (at least) a full market cycle
(2000 through 2010). Notice how buying and selling activity follows market momentum. The
highest inflows (buys) came near the top of the Tech Bubble in 2000 and, conversely, the highest
outflows (sales) happened at bottom of the market during the Financial Crisis in 2009. If we
think about the most opportune time to invest in the last twenty years, you would be hard pressed
to find a better time in March 2009.

The chart below is one we reference from time to time both for our own consideration of a
market lifecycle as well as with our clients when discussing behavioural finance. Think of the
different emotions you have had as an investor at varying points along the cycle. Markets will
push our emotions to motivate us to make the worst decisions at the worst times. It is fascinating
how the two charts mimic each other in shape but more importantly the emotions experienced
and purchase or sale activity motivated by said emotions.
 Figure 5.1: Cycle of Investor Emotions

We believe the most effective approach to combat investor emotions is an asset allocation
approach that avoids emotional decision making. According to Vanguard if we look at the return
of a 60% Stock and 40% Bond portfolio, over the previous 90 years ending in 2017, an investor
would have realized an annualized return of 8.8%. Not bad performance for not changing your
allocation for over 90 years.

Practically speaking, sound asset allocation planning will have a positive impact on other aspects
of your financial picture, a few of which I have listed below.

There is a Benefit to Low Risk Assets for Liquidity (and therefore Decision Making)

This is often the most overlooked benefit of a fixed income or bond allocation. When talking
with clients about dealing with market volatility, we point to the idea that we can pull a
distribution from any asset at any time. By taking from fixed income in a bear market, we can
avoid having to sell the equity portion, giving your stocks additional time to recover. By
educating our clients to this approach, we believe we are empowering them to be patient in
volatile market periods.

Rebalancing when Appropriate doesn’t Require you to be Right Two Times

I am always amused when someone tells me, with pride, that he sold during the financial crisis.
What I rarely hear is when they sold and, more importantly, when they bought back in. Data tells
us that the largest number of sales came during March 2009, the very bottom of the market
during that period. The reality is, a ―timing investor‖ has to know when to sell and when to buy
back in. It is highly likely that those that sold in the trough of 2009 bought back in much higher,
if at all. A rebalancing approach is a less risky way of attempting to time the markets by taking
on incrementally higher positions in asset classes that have not performed as well. We look to
rebalance portfolios to trim areas that have outperformed others but not as an attempt to time a
short-term market period.

A High-Risk Portfolio often doesn’t Bring Commensurately High Returns

Historically, more risk in a portfolio leads to higher investment returns over a long period of time
versus a less risky portfolio. The problem is the increase in risk, usually defined by volatility or
standard deviation, is not typically associated with an EQUAL increase in performance. At some
point, you could be increasing risk and downside potential while only incrementally increasing
your opportunity to the upside. We strive to find an allocation that we believe manages the client
objective, balancing risk and return expectations. This is addressed in our last Atheneum on
Asset Allocation, but the most important aspect of proper allocation selection is positioning
yourself specific to your own risk tolerance and liquidity needs.

You can Avoid the (Imaginary) Race

As our clients get older and closer to needing income, it is critical that their asset allocation is
appropriate for them and their needs. When markets have prolonged bull market stretches, we get
a sense that many investors‘ expectations rise accordingly. Conversely, people tend to expect
less aftermarket pullbacks. This ebb and flow of expectations can wreak havoc on a financial
plan. If you are an investor taking income or planning to over the next several years,
benchmarking yourself solely against the overall stock market is a futile practice. Why would
you compare yourself to the stock market if you are only partially invested in the stock market?
We create blended indexes to more properly measure portfolio performance against a portfolio of
similar holdings. Most sophisticated, institutional investors do the same.

In conclusion, it is important that investors recognize the emotional pull that can come at various
points in a market cycle. In our experience, the patient investor tends to perform best and only
decides to make changes to his or her allocation when their own situation changes i.e. early
retirement, inheritance, or business sale. Drastically modifying one‘s allocation in reaction to
market swings may feel natural but realize you may only be taking from your future self.

5.3 PRACTICAL ALLOCATION

From the Dot-Com bubble onward, traditional investment models have repeatedly disappointed
those who relied on them. When compared to mathematically based models, behavioural finance
provides a superior foundation. Here is an alternative investment paradigm, grounded in
behavioural finance that is practical and effective over time periods that are relevant for a
significant portion of investors.

The list of investment models that have failed professional investors include the following.

 Markowitz Portfolio Theory

 Capital Asset Pricing Model (CAPM)

 Efficient Market Hypothesis (EMH) (along with the unhedged-index strategies flowing
from it)

 Traditional Hedge Fund Model

 Endowment Model

These models may work in specific circumstances. They may even work over the long run. But
as John Maynard Keynes noted in the long run, we are all dead.‖

Professional investors and their constituencies have more practical time horizons. The long-term
models cited above require one to remain fully invested and endure losses for extended periods
of time to avoid the inevitable pitfalls of market timing. Telling institutional or individual
investors they may have to suffer large losses is neither practical nor satisfactory. This is
particularly true for those who need to meet short- to intermediate-term obligations or for whom
nearer-term results take on greater importance, for economic or emotional reasons. Our thesis,
which borrows heavily from the field of behavioural finance, makes an important contribution to
the field. This article reintroduces and explains an alternative investment paradigm that has been
in use since 2009. Our aim is to deliver consistent and predictable returns for specific market
outlooks.

Behavioural finance focuses on human biases that lead to illogical and irrational investment
decisions. A basic tenet is that the human mind is essentially programmed to seek familiar
patterns in observed events and place those patterns within a context based on past experience.
We are creatures of habit and emotion, and this process leads us to act in predictable ways, often
to our own detriment.

For example, psychologists believe that fear and greed, as inextricable parts of human nature,
cause investors to chase performance. We greedily buy at market tops and fearfully sell at market
bottoms. Figure 1illustrates the astonishingly subpar results that the average investor achieved
from 1992 to 2011. By comparing returns for investors in various mutual funds to those in the
underlying asset classes figure 5.2 documents underperformance in nearly every major asset
class. Any investment strategy that is to be of lasting value must include a methodology for
taming and reducing behavioural biases.

Two of the most interesting – and, for this discussion, most relevant – perspectives on investor
behaviour to come out of behavioural finance research are the cycle of market emotions and
prospect theory. The former was developed by an investment firm based on anecdotal
observations of investor behaviour, and the latter represents a traditional academic undertaking.
Both perspectives agree that human emotions drive bad investment decision-making.
 Figure 5.2: Subpar Investor Results

Behavioural finance is not a new field of study. But the field did not receive an official
endorsement from the economics and investment communities until 2002, when Daniel
Kahneman and Vernon Smith won the Nobel Prize in economic sciences for their work in
behavioural economics.

Today, the key question regarding behavioural finance is not, ―Is it relevant to investors?‖ but
rather, ―How can its applications be of lasting practical value to investors?‖

The cycle of market emotions provides an excellent overview of the stages an investor passes
through during market gains and losses. Prospect theory examines why investors chase
performance, why changes in wealth matter as much as wealth accumulation and why losses hurt
twice as much as gains. Both theories help explain why the average investor experienced the
subpar performance shown in figure 5.2.

The Cycle of Market Emotions

The cycle of market emotions, generally attributed to West core Funds, is well known in the
financial services industry. As market prices rise, the typical investor feels a sense of optimism.
If prices continue to rise, the feeling of optimism progresses to excitement and ultimately
euphoria. In hindsight, the euphoria stage is the point of maximum risk. The euphoria turns to
anxiety if prices decline from their peak. According to the theory, the investor‘s emotional state
worsens as anxiety devolves into fear, panic and capitulation. Once again, in hindsight, the
capitulation point in the cycle is the point of maximum financial opportunity. Then the cycle
begins anew, as depression morphs into hope, relief and back to optimism.

Prospect Theory: Performance Chasing and the Disposition Effect

Nobel Laureate Daniel Kahneman, along with his late colleague Amos Tversky, developed the
prospect theory. It argues that utility, or satisfaction, is not simply a function of risk and return,
but that it also focuses on purchase price as a reference point. For example, investors feel regret
when they are losing money on an investment and feel joy when they are making money relative
to their initial investment. This leads to a ―disposition effect,‖ where the typical investor holds
onto losing investments too long and sells winning investments too soon.
For example, an investor might purchase a stock near market top because he or she regrets
missing a major market move, as many did near the peak of the Dot-Com bubble. A subset of
those investors continues to hold the stock through the ensuing decline in the hope that the stock
will recover. This behaviour is a function of investors not viewing a paper loss the same as a
realized loss.

The converse example illustrates the disposition effect – an investor who bought Apple five
years before its peak, but sold the stock to book a profit after a year. While locking in a gain can
provide an important measure of satisfaction, this investor did not receive the vast proportion of
the stock‘s ultimate gain.

According to prospect theory, losses for the typical investor hurt roughly twice as much as gains
feel good. In a similar vein, it was found that, for individual investors, the percentage change in
wealth matters more than the magnitude of their wealth.

For investment professionals, the practical implications of prospect theory are profound. Their
clients not only care about the total amount of their wealth but also about the path to amassing it.
Investment professionals have their own set of biases that can cause them to follow the crowd.
From a business perspective, their worst fear is to be both wrong – and alone. This leads to a
pronounced tendency to err towards ―benchmark hugging,‖ or recommending investments that
are popular or have worked well in the recent past.

A Practical and Actionable Behavioural Finance Investment Paradigm

During the depths of the credit crisis, we developed a new set of risk-controlled investment
strategies that are practical and actionable. The process and its risk management are built around
two tenets:

 Investments are made in a systematic manner to take advantage of changes in market

volatility by diversifying entry and exit points.

 Each individual investment delivers predictable, mathematically formulaic returns.

These strategies seek to tame the effects of the cycle of market emotions by incorporating the
best features of exchange-traded funds (ETFs) and hedge funds while avoiding the unfavourable
characteristics of both.
The strategies can serve as core or satellite investments. They are structured to eliminate
counterparty risk and offer a liquid and transparent risk-contained solution at lower fees than the
typical hedge fund. The disciplined investment process at the core of these investments creates
multiple entry and exit points throughout the year, enabling an investor to take advantage of –
rather than be intimidated by – intra-year market volatility. Depending upon the particular
strategy chosen, the investment process offers investors needed protection when complacency is
high and allows investors to enhance returns at the opposite point in the cycle.

Bottom of Form

We use the S&P 500 because it is easily understood, provides exceptional liquidity and serves as
the benchmark for a core U.S. investment portfolio. It broadly represents the U.S. equities
market and also offers meaningful international exposure, since roughly 50% of the index‘s
earnings come from foreign sources.

The strategies are implemented using a series of 12, rolling one-year ―tranches‖ constructed with
S&P 500 ETFs, which are purchased together with coordinated sales and purchases of traded
options to deliver a predetermined, formulaic risk/return pattern. As tranches mature, their
proceeds fund the purchase of the next tranche. Performance at the portfolio level will equal the
time- and value-weighted average of the tranches held in the portfolio over the course of the
period. In other words, portfolio performance in a given year will be determined by the average
of the returns on the remaining life of each of the 12 tranches owned at the start of the period,
plus the partial period returns for the tranches that are purchased each month to replace the
matured tranches. Therefore, no single investment is likely to skew the pattern of returns over the
course of any time period. In addition, enhanced gains or prevented losses are locked in, because
the risk/return pattern is re-established going forward for the replacement tranche. Likewise, new
loss protection is locked in when relevant from new market levels.

An individual tranche in this strategy might be constructed through the purchase of the SPY ETF
at a price of $100 to gain broad market exposure. At the same time, an at-the-money put on the
SPY would be purchased and another put sold at a strike price of $88, effectively eliminating the
first 12% of the downside relative to the price of the ETF. An at-the-money call would be
purchased on the SPY to double the market exposure and two out-of-the-money calls sold. The
level at which the calls are sold would be determined by market pricing and would establish a
maximum return on that tranche. Participation above the maximum is effectively sold off to pay
for the downside protection and return enhancement. Maximum returns on an individual tranche
in this version of the strategy could range from 8% to 12% in periods of normal volatility.

What the Strategies Deliver

We propose three strategies. The first is designed to consistently outperform the S&P 500 on a
risk-adjusted basis in both rising and declining markets, delivering returns in the high single-digit
to low double-digits in rising markets while reducing losses in declining markets. This is an
attractive strategy for investors seeking to mitigate market volatility and buffer losses while
increasing the probability of earning attractive returns.

The second is designed to consistently outperform the S&P 500 in most rising markets,
delivering returns in the mid-teen to mid-twenties percent range in rising markets, while posting
returns equal to the S&P 500 price decline in falling markets. This is attractive for investors
seeking to enhance returns without increasing downside risk.

The third is designed for a ―black swan‖ market environment. It is structured to allow market
participation into the low- to high-teens range in rising markets, with less volatility, while
substantially reducing losses in markets that suffer abnormally steep declines. This is an
attractive strategy for investors seeking to mitigate normal market volatility and reduce losses
during severe market breaks while enjoying linear, market-like price appreciation.

Complete descriptions of these strategies, including performance, may be found

at [Link].

The Peace of Mind Factor

Perhaps most important in the context of behavioural finance, these strategies offer peace of
mind. The strategies eliminate the temptation to make emotionally flawed investment choices
like buying at market tops and selling at market lows. Investors derive comfort from knowing
that – without trying to engage in market timing – they can remain engaged and invested in any
the market trend. Material losses can be avoided or substantially mitigated, and a pattern of
returns can be achieved with fewer peaks and valleys. Market bottoms are the times when
investors must remain engaged, since the maximum return levels on reinvested proceeds from
maturing tranches may be highest.
5.4 GUIDELINES FOR DETERMINING ASSET ALLOCATION

While an asset allocation plan can be a valuable tool to help reduce overall volatility,
diversification does not guarantee a profit or protect against a loss. All investments involve risks,
including possible loss of principal. Typically, the greater the potential return, the more risk
involved. Generally, investors should be comfortable with some fluctuation in the value of their
investments, especially over the short term. Stock prices fluctuate, sometimes rapidly and
dramatically, due to factors affecting individual companies, particular industries or sectors, or
general market conditions. Small-capitalization stocks can be more volatile than large-
capitalization stocks. Bond prices generally move in the opposite direction of interest rates. Thus,
as the prices of bonds in a fund adjust to a rise in interest rates, that fund‘s share price may
decline. Foreign investing carries additional risks such as currency and market volatility and
political or social instability; risks which are heightened in emerging markets. Hedge strategies
may employ a wide range of investment techniques, including the use of derivatives, leverage,
currency management strategies, short sales, and merger arbitrage, which may result in
significant volatility and loss of principal. These risks are described in a fund‘s prospectus. The
content of this brochure is general in nature and intended for educational purposes only; it should
not be considered tax, legal or investment advice, or an investment recommendation. Consult
your financial professional for personalized advice that is tailored to your specific goals,
individual situation, and risk tolerance

While some believe they can achieve investment success by buying and selling hot stocks at
exactly the right time, for many investors, the biggest factor in determining long-term investment
success has been asset allocation. Simply stated, asset allocation is investing your money in
different categories of assets— typically stocks, bonds and cash equivalents such as money
market funds—so your investments are well diversified. Ultimately, the objective of a good asset
allocation plan is to develop an investment portfolio that will help you reach your financial
objectives with the degree of risk you find comfortable. A well-diversified plan will not
outperform the top asset class in any given year, but over time it may be one of the most
effective ways to realize your long-term goals.

Reduce risk. Portfolio diversification may reduce the amount of volatility you experience by
simultaneously spreading market risk across many different asset classes. Improve your
opportunity to earn more consistent returns over time. By investing in several asset classes, you
may improve your chances of participating in market gains and lessen the impact of poor‐
performing asset categories on your overall portfolio returns. Stay focused on your goals. A well-
allocated portfolio alleviates the need to constantly adjust investment positions to chase market
trends, and can help reduce the urge to buy or sell in response to the market‘s short-term ups and
downs.

Within each of the two broad asset classes of stocks and bonds are several asset categories
defined by certain characteristics that affect their performance. Because these types of
investments may perform differently in various types of markets, each can provide an additional
layer of diversification.

Market capitalization—Stocks are often categorized by the company‘s size, as measured by

market capitalization. Larger companies tend to be more mature and established, while smaller
companies usually have better growth potential, but may be more volatile.

Value stocks are usually those of well-established businesses that may be temporarily out of
favour with investors, and often exhibit low price/earnings (P/E) ratios. They often pay more
substantial dividends and tend to outperform during sluggish markets or periods of market
volatility.

Growth stocks generally have exhibited faster than average growth in earnings or revenues and
are expected to continue to grow faster than the economy. Growth stocks tend to have higher P/E
ratios and often make little to no dividend payments to shareholders. These stocks frequently
outperform in a strong economy.

Yes. In addition to helping reduce overall volatility and improving your chances to earn more
consistent returns over time, keeping assets properly allocated helps you avoid the temptation to
try to time the market. Consider the three scenarios below, illustrating different strategies used
by investors. In each situation, $10,000 was invested annually each January 1, over 20 years for a
total investment of $200,000.3 The first scenario shows the results of a momentum strategy
chasing the winners (investing equally in the previous year‘s best performing asset class), while
the second illustrates the returns generated by a bottom fishing strategy (investing equally in the
previous year‘s worst-performing asset class). The third scenario shows the results of an asset
allocation plan that consistently invested across nine asset classes in equal proportion each year.
While these returns can‘t guarantee future results, as you can see during the past 20 years, asset
allocation was the most successful strategy

Asset allocation helps you stay in control of your financial plan, tailoring your investments to fit
your goals and tolerance for risk. Think of it this way: While you might like to earn 30%
annually on your investments, could you weather a 30% loss? Could you ride out a bear market
that lasted a year or longer, or would you need to tap your investments for near-term expenses?
Creating an asset allocation plan designed with your unique needs in mind can help you face any
type of market with greater confidence. The graph below shows the historical returns and
volatility of nine asset classes individually, compared to an asset allocation spread evenly across
those asset classes. As you can see, although a few asset classes had slightly higher returns, they
also exposed the investor to more risk than the asset allocation portfolio. While past results can‘t
guarantee future returns, you can see that a little diversification can go a long way.

The first step in developing your asset allocation plan should be a discussion with your financial
professional. Here are some questions you may want to consider: Have I prioritized my primary
financial goals? What‘s my investment time frame? How much fluctuation in the value of my
investments can I handle? The samples below offer a general idea of what various asset
allocation plans look like and how they have performed over time. Please remember, past
performance does not guarantee future results.

The first step in developing your asset allocation plan should be a discussion with your financial
professional. Here are some questions you may want to consider: Have I prioritized my primary
financial goals? What‘s my investment time frame? How much fluctuation in the value of my
investments can I handle? The samples below offer a general idea of what various asset
allocation plans look like and how they have performed over time. Please remember, past
performance does not guarantee future results.

All investments involve risks, including possible loss of principal. Typically, the greater the
potential return, the more risk involved. Generally, investors should be comfortable with some
fluctuation in the value of their investments, especially over the short term. Stock prices
fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies,
particular industries or sectors, or general market conditions. Small-capitalization stocks can be
more volatile than large capitalization stocks. Bond prices generally move in the opposite
direction of interest rates. Thus, as the prices of bonds in a fund adjust to a rise in interest rates,
that fund‘s share price may decline. Foreign investing carries additional risks such as currency
and market volatility and political or social instability; risks which are heightened in emerging
markets. Hedge strategies may employ a wide range of investment techniques, including the use
of derivatives, leverage, currency management strategies, short sales, and merger arbitrage,
which may result in significant volatility and loss of principal.

Focused And Alternative Opportunities

Investors looking for a targeted investment opportunity, but who want professional management and
greater diversification than owning a few individual stocks or bonds can offer, may want to consider
sector or regional funds. Because these funds employ concentrated, narrowly focused investment
strategies, they may offer greater potential returns than more broadly invested portfolios. Please
remember that the opportunity for increased reward also brings greater risk. Conversely, investors
seeking funds that invest outside the realm of traditional stocks and bonds may want to consider the
alternatives. These funds invest in areas that have historically generated returns that were uncorrelated
with more traditional investments.

Franklin Templeton offers many multi asset funds that can help simplify asset allocation. These include
three actively managed target risk funds with objectives ranging from conservative to growth oriented,
and retirement target date funds offering active management and asset allocation that becomes more
conservative as the retirement target date nears.13 Finally, Franklin Templeton offers two portfolios
that invest in set allocations of some of our flagship funds and have an automatic rebalancing feature

Determining the appropriate asset allocation model for a financial goal is a complicated task.
Basically, you‘re trying to pick a mix of assets that has the highest probability of meeting your
goal at a level of risk you can live with. As you get closer to meeting your goal, you‘ll need to be
able to adjust the mix of assets.

If you understand your time horizon and risk tolerance - and have some investing experience -
you may feel comfortable creating your own asset allocation model. ―How to‖ books on
investing often discuss general ―rules of thumb,‖ and various online resources can help you with
your decision. For example, although the SEC cannot endorse any particular formula or
methodology, the Iowa Public Employees Retirement System ([Link]) offers an online
asset allocation calculator. In the end, you‘ll be making a very personal choice. There is no
single asset allocation model that is right for every financial goal. You‘ll need to use the one that
is right for you.
Some financial experts believe that determining your asset allocation is the most important
decision that you‘ll make with respect to your investments - that it‘s even more important than
the individual investments you buy. With that in mind, you may want to consider asking a
financial professional to help you determine your initial asset allocation and suggest adjustments
for the future. But before you hire anyone to help you with these enormously important
decisions, be sure to do a thorough check of his or her credentials and disciplinary history.

Diversification is a strategy that can be neatly summed up by the timeless adage, ―don‘t put all
your eggs in one basket.‖ The strategy involves spreading your money among various
investments in the hope that if one investment loses money, the other investments will more than
make up for those losses.

Many investors use asset allocation as a way to diversify their investments among asset
categories. But other investors deliberately do not. For example, investing entirely in stock, in
the case of a twenty-five year-old investing for retirement, or investing entirely in cash
equivalents, in the case of a family saving for the down payment on a house, might be reasonable
asset allocation strategies under certain circumstances. But neither strategy attempts to reduce
risk by holding different types of asset categories. So choosing an asset allocation model won‘t
necessarily diversify your portfolio. Whether your portfolio is diversified will depend on how
you spread the money in your portfolio among different types of investments.

A diversified portfolio should be diversified at two levels: between asset categories and within
asset categories. So in addition to allocating your investments among stocks, bonds, cash
equivalents, and possibly other asset categories, you‘ll also need to spread out your investments
within each asset category. The key is to identify investments in segments of each asset category
that may perform differently under different market conditions.

One way of diversifying your investments within an asset category is to identify and invest in a
wide range of companies and industry sectors. But the stock portion of your investment portfolio
won‘t be diversified, for example, if you only invest in only four or five individual stocks. You‘ll
need at least a dozen carefully selected individual stocks to be truly diversified.

Because achieving diversification can be so challenging, some investors may find it easier to
diversify within each asset category through the ownership of mutual funds rather than through
individual investments from each asset category. A mutual fund is a company that pools money
from many investors and invests the money in stocks, bonds, and other financial instruments.
Mutual funds make it easy for investors to own a small portion of many investments. A total
stock market index fund, for example, owns stock in thousands of companies. That‘s a lot of
diversification for one investment!

Be aware, however, that a mutual fund investment doesn‘t necessarily provide instant
diversification, especially if the fund focuses on only one particular industry sector. If you invest
in narrowly focused mutual funds, you may need to invest in more than one mutual fund to get
the diversification you seek. Within asset categories, that may mean considering, for instance,
large company stock funds as well as some small company and international stock funds.
Between asset categories, that may mean considering stock funds, bond funds, and money
market funds. Of course, as you add more investments to your portfolio, you‘ll likely pay
additional fees and expenses, which will, in turn, lower your investment returns. So you‘ll need
to consider these costs when deciding the best way to diversify your portfolio.

5.5 INVESTMENT POLICY

By formalising an investment process in a policy, asset owners differentiate emotions from facts when
making investment decisions, keeping a relentless focus on performing in line with their investment
strategy in an evidence-based manner. This guide helps asset owners to revise and develop their
investment policy and incorporate all long-term factors, including ESG considerations, into their
investment decisions, no matter whether these decisions are made directly or indirectly. It has been
written for asset owners – public and corporate pension funds, superannuation funds, insurance
companies, endowments, foundations, family wealth offices (etc.) – and specifically the individuals in
those organisations responsible for investment policy development, whether decision makers or project
members. Organisations that support the formulation of investment policies (investment consultants or
asset managers that work directly with asset owners throughout the investment process) will also
benefit from the guidance provided. Advocating the highest standard of ESG incorporation, the guide
provides asset owners globally with future-proof best practice. Investment policy that codifies strategic
considerations into mainstream investment practices and organisational processes paves the way for a
future where asset owner strategy and policy are formally intertwined – enabling a day-to-day, razor-
sharp focus on achieving an organisational mission – and where all material factors are incorporated
into investment decision-making, in the name of optimum performance and long-term value creation.

In 2012, the PRI published Writing a responsible investment policy, outlining how an organisation can
develop a specific responsible investment policy to complement its main institutional investment policy.
Since then, the investment market has matured due to growing evidence of ESG factors influencing long-
term performance – the materiality of climate change, for example, is now clear as day. A number of
leading asset owners have led the trend of ESG integration, to ensure their investment processes are
understood and practiced by all stakeholders in a coherent and holistic manner.

The ideal form and substance of an investment policy relies on many internal and external factors. With
regards to ESG issues, some are global – climate change, demographic shifts, and resource scarcity affect
all asset owners across the board, influencing activity and price discovery in most financial markets. The
best way to account for these issues during policy development, however, differs from asset owner to
asset owner. A tailored approach led by a robust investment strategy will produce the best outcome.
Regional requirements will further differentiate best practice asset owner policies. For example, in
France, the French Energy Transition Law requires institutional investors to disclose how ESG criteria is
considered in their investments decisions, which will shape investment policy for asset owners in that
region.

It provides a process overview of steps to be considered during your investment policy revision
and development process. It assumes that your organisation has already reviewed its investment
strategy and all material long-term factors (including ESG) within it. Investment strategy will
form the highest order guidance for the revision of your policy and therefore the construction of
your investment portfolios. However, if your organisation has yet to consider and incorporate
ESG factors at the strategic level, an increased awareness of critical factors in your current policy
can be a sufficient temporary solution.

To start, engage executives so there is sufficient support in the organisation (including the board)
to execute the policy revision process. Involvement, or at least support, of the organisation‘s
highest governing bodies is critical for your policy to be effectively developed, applied and
implemented. The policy‘s cultural fit to your organisation and formal governance structure
‗buy-in‘ is also a crucial ingredient for an effective policy. Before any revision occurs, your
institution must be clear on who holds ownership of the policy and who will administer it. With
these cornerstones in place, writing is made easy and collaborative, with input from mainstream
investment and responsible investment/ESG experts, as well as management, board members,
and potentially other stakeholders.

Although the present functions without the past, we can understand it better if we look at its
historical developments step by step. The same is true for financial market research. This
research currently consists of fairly complicated mathematical and psychological models that, at
first glance, can be confusing. The figure below highlights the history of portfolio theory, one of
the primary areas of financial market research.
For the first coin toss, the expected value is 4; for the second coin toss, it is 5. Therefore, in
Pascal‘s view, one should choose the second coin toss. Daniel Bernoulli, a mathematician from
Basel, had the same idea when his brother Nikolaus told him about the St. Petersburg game more
than one hundred years later. Under Blaise Pascal‘s theory, the citizens of St. Petersburg should
wager every cent they had to play on the St. Petersburg game, because it had an infinite expected
value. This contradicted the observations of Nikolaus Bernoulli, which revealed an average pay
out of 2 ducats. The average pay out of 2 ducats may seem like a paradox at first, but is
explained by Daniel Bernoulli‘s generalization of the theory on calculating the expected pay out.
Bernoulli‘s function, as applied to Pascal‘s theory, is now known as the utility function. The
utility function refers to a fundamental psychological law, the diminishing marginal utility of
money. Or, as Daniel Bernoulli said, ―There is no doubt that a gain of 1,000 ducats is more
significant to the pauper than to a rich man, though both gain the same amount.‖ It is important
to note that the diminishing marginal utility of money embodies the risk aversion of the person
making the decision. A decision maker is averse to risk if, instead of a random pay out, he
prefers the certainty of the expected fixed pay out from a game. The St. Petersburg game shows
that the people of St. Petersburg were averse to risk. Suppose someone made the decision to
receive the expected pay out. If he chose to gamble instead, in some cases he would win more,
and in other cases he would win less. Due to the money‘s diminishing marginal utility, the utility
of the higher pay out would be lower than for a reduced pay out. This is why it is more rational
to take the average pay out with certainty.

This does not mean that everything had been figured out by the middle of the twentieth century.
The expected out by the middle of the twentieth century. The expected utility hypothesis was
flexible enough to illustrate different Behaviours in uncertain situations and was the only
sensible way to proceed in such situations. Unfortunately, there was a significant weak spot in
this hypothesis: Where besides a coin toss could one find realistic probabilities for calculating
the expected utility? For instance, how can we define the probabilities of returns on asset classes
such as bonds, equities, or alternative investments, or even single securities within a class? These
returns depend, among other things, on economic factors such as the economy itself, monetary
policy, innovation, and growth alongside the behaviour of other stakeholders. The sum of these
factors results in an almost impossibly tangled mass of interactions. To unravel this Gordian
Knot, Eugene Fama developed his efficient market hypothesis in the 1970s, which had its
predecessors in the 1950s. If all market participants thought constantly about the factors behind
the returns on securities and developed trading strategies based on these factors, their buying and
selling decisions would ensure that all profitable information about these factors was priced into
the securities. The market anticipates every predictability in prices. The remaining price
developments result from previously unanticipated changes – in other words, surprise
information. Because surprises are impossible to predict, the prices of securities develop by pure
chance, statistically independent of one another. We know from statistics that the sum of random
variables can be defined by normal distribution (bell curve). The distribution is well-defined by
its mean and its standard deviation. The efficient market hypothesis is a brilliant simplification of
decision-making in uncertain situations because these decisions depend only on the mean and the
standard deviation.

When the average return (mean) increases, the expected risk (standard deviation) of an
investment also increases. For each return level indicated, an investor can minimize his risk by
diversification. This sequence of minimization results in the efficient frontier, which denotes the
minimum risk for a given return level. Depending on the individual risk tolerance of an investor,
the best portfolio can be selected on the efficient frontier. Behavioural finance is the newest
chapter in the history of portfolio theory. Why do we yet need another theory? Behavioural
finance explains the typical mistakes (behavioural biases) made by investors. It also provides a
detailed picture of investors‘ risk preferences. This second aspect is covered by Daniel
Kahneman and Amos Tversky‘s prospect theory. Unlike the Markowitz analysis, the prospect
theory focuses on the significance of investment losses. In their studies, Kahneman and Tversky
found that most investors are averse to loss. This means that investment losses must be
compensated through the opportunity for higher returns. For most investors, these returns must
be at least twice as high as the potential loss.

The utility function of the prospect theory is shown. A maximize of prospect utility evaluates the
result of his investments using a reference point. For example, this can be the purchase price of a
security. Loss aversion is reflected in the fact that the utility function initially has a much steeper
curve than the profit area. The prospect utility theory draws from the expected utility theory the
characteristic of declining marginal utility of the gains.
The loss area reflects the declining marginal damage of the losses. This is demonstrated by the
fact that prospect utility maximisers would risk their investment for a break-even opportunity
rather than face a definite loss. Thus, they prefer a random pay out to the expected utility if it is
negative.

If markets were efficient as per Fama‘s theory, all investment returns would have normal
distribution and the application of the mean-mean standard deviation criterion would still be
justified for prospect theory investors. In reality, the efficient market hypothesis is not valid, so
very few investments have returns with normal distribution. For this reason, the loss aversion
under the prospect theory is key to an optimal portfolio. We must replace the efficient market
line in the mean-standard deviation model with a behavioural efficient frontier based on the
prospect theory. The behavioural efficient frontier was first developed in a paper by Enrico De
Giorgi, Thorsten Hens, and Janos Mayer. It depicts the prospect theory using a risk-return
diagram. Investment results are broken down into cases in which a profit is made and those in
which a loss is sustained. The degree of loss aversion determines the selection of an optimal
portfolio on the behavioural efficient frontier. If we compare the prospect theory portfolios with
the Markowitz portfolios, we see that these have a lower portion of equities and hedge funds
while weighting capital protection products more heavily. Equities and hedge funds are not
largely represented in the prospect portfolios, because of their potential high losses. On the other
hand, capital protection products are not very common in the Markowitz portfolios. Although
they do not show a loss as long as the counterparty does not default, they have varying levels of
high returns and thus a standard deviation. Practice has shown that clients whose portfolios are
based on the Markowitz theory do not adhere to their investment strategy when the markets
decline. As a result, they usually miss the rebound and performance is lower than if they had
maintained their strategy. Thus, it is worth choosing a prospect theory so that investors can stick
to the strategy both financially and emotionally.

The cyclical investment process – including information procurement; stock picking; and
making, holding, and selling investments, followed by making a new selection – is full of
pitfalls. These can come at a high price to investors. As Benjamin Graham liked to say, ―The
worst enemy of the investor is most likely himself.‖ Purchasing investments is a rapid-fire
process, and the value of these investments can decline just as rapidly – even to zero, making
them a waste of money.
In this section, we will illustrate each step of the process and explain the potential pitfalls. In the
next section, we will show how you can avoid these pitfalls with the help of Credit Suisse‘s
wealth management approach. Let us start from the beginning: the investment roller coaster.

The markets are on the rise, the stock exchanges register record highs, and the media waters
down this news. Business journalists report on innovative, creative companies that are all making
a profit in these markets. However, they fail to see that not all companies are successful using
those same criteria. Thus, they do not falsify the theory of success, a mistake known as the
confirmation bias. We cannot avoid reading the headlines about price gains and booming
markets or the multitude of success stories. Unfortunately, these stories attract the interest of
many amateur investors. Readers follow developments in the bull market with baited breath;
with some hesitation and a safe distance, they make note of certain stocks and shares. If the
media spotlights a particular stock, it is more likely to attract investor attention. After a certain
amount of watching from the wings, some investors will decide to participate in the uptrend
before it is too late. With the wind of so many success stories beneath their sails, investors
erroneously believe they have almost no chance of failing. So the survival error takes hold. The
media and its readers love success stories; looking at the gossip magazines while at the
hairdresser, for instance, all we see are glitz and glam. However, these publications only feature
the rich and famous – wealthy entrepreneurs, writers, celebrities, singers, and other people who
have made it. Readers follow developments in the bull market with baited breath; with some
hesitation and a safe distance, they make note of certain stocks and shares. If the media spotlights
a particular stock, it is more likely to attract investor attention. After a certain amount of
watching from the wings, some investors will decide to participate in the uptrend before it is too
late. With the wind of so many success stories beneath their sails, investors erroneously believe
they have almost no chance of failing. So the survival error takes hold. The media and its readers
love success stories; looking at the gossip magazines while at the hairdresser, for instance, all we
see are glitz and glam. However, these publications only feature the rich and famous – wealthy
entrepreneurs, writers, celebrities, singers, and other people who have made it. Of course, there is
never any mention of the hundreds of thousands, even millions, of people who have not
succeeded. As a result, we grossly overestimate the stellar achievements of the success stories,
which are as unlikely as a winning lottery ticket. Investors also fall victim to induction. They see
a security rise and rise, until they are certain that it can only get better. Often they invest a large
portion of their assets in this security – resulting in a serious cluster risk – and are likely to lose it
all. Because investors do not know they have fallen into the trap, they look for familiar company
names when trying to find a good investment. In situations like these, it is very hard to avoid the
availability/attention bias. Events that come up more frequently (often with additional media
coverage) remain in our minds more than events we hear about less frequently. We forget that
there are other scenarios. On the other hand, rare, dramatic events that attract heavy media
attention are overestimated. For example, if we ask a random person what the most common
cause of death is, he or she might say a car accident or plane crash. This is because the media
pounces on these sensational causes of death, which then stay in our minds whether we want
them to or not. What is more, illustrated, easy-to-digest information is easier to remember than
statistical figures. This distorts our perception between the frequency distribution and statistical
reality. As a result, investors never choose information from the other side of the fence. Instead,
they choose information based on their experiences and preferences. This means that we are
more likely to recall the front page of a newspaper showing a CEO racing down the French
Riviera in his convertible. We are less likely to remember that his company‘s net profit margin
dropped by 30% and its earnings by 18%. Investors make positive associations with the company
because they liked the car or the CEO had a nice smile in the photo. They may also remember
the CEO‘s attractive companion with bright red lipstick. The image in their head is a good one,
and so is their impression of the company. Typical investors evaluate information according to
how quickly it can be recalled. This means that in most cases, we do not continue to think of
alternatives because we are satisfied with our initial thought. Investors who remember the CEO
in his convertible associate the company with success and think it would be a good investment.
As soon as we remember a promising company, we begin to support our opinions about it with
other publicly accessible information. This is not very rational, as the process does not permit a
differentiated view. Once an investment has won the investor over, he often makes the mistake
of looking for only positive information. We made reference to this at the beginning of this
section when we mentioned business journalists. Confirmation bias is the phenomenon of
supporting our own opinions with selective information. Investors seek confirmation for their
assumptions. They avoid critical opinions and reports, reading only those articles that put the
product in a positive light.
Suppose our investor‘s boss is also interested in market developments and likes to talk about the
bull market during developments and likes to talk about the bull market during his coffee breaks.
And suppose this boss recommends investing in the pharmaceuticals industry. Because the
investor is afraid to contradict his boss or would not even consider doing so, he begins to do
some research into these investments. The coffee break scenario is a good example of the
authority pitfall that our investor falls prey to. He considers his boss an investment authority and,
right or wrong, takes his recommendations to heart. However, the boss is no more or less correct
than his employee. Because our investor does not know about this bias (or that he has succumbed
to it), he begins to research the earnings made by three US pharmaceutical companies over the
last few years. The investor also reviews the returns on the companies‘ stock. Unfortunately, he
looks only at the last three years. In addition, he cannot find the profits for one of the three
companies. However, he sees that corporate revenues have grown steadily over the last three
years. Thus, he incorrectly concludes that profits will continue to grow in the future and that the
company must be successful. Investors do not tend to use representative data. This means that
the time period they examine is too short to determine the statistical population. Thus, it is not
possible to draw conclusions about the statistical population. In the above scenario, it would be
wrong to draw conclusions about the entire industry based on an analysis of three companies.
Moreover, one to three years is too short a time period to draw a valid conclusion. We refer to
this as the law of small numbers. You may remember learning about the law of large numbers in
school. If you toss a coin enough times, the number of times you get heads will be essentially
equal to the number of times you get tails. Unfortunately, we often believe that this equality
applies to smaller random samples. As a result, we look forward to very high returns based on
very little information.

Suppose that while researching the profits of the pharmaceutical company, our investor finds an
interesting article in a reputable business journal. It reports on a US company with a 40% chance
of generating a 5% excess return over the S&P 500. Our investor is so excited that he decides to
invest in this company. He probably would not have done so if he had read that there was a 60%
chance of the company generating a less than 5% excess return over the S&P 500. Our investor
has just fallen for the framing effect. In other words, the way information is presented will
influence our decisions. the S&P 500. Our investor has just fallen for the framing effect. In other
words, the way information is presented will influence our decisions. For instance, there is a
huge difference in whether a sum is presented as a loss or a missed profit, even if these terms
mean the same thing. Therefore, our decisions are based largely on how the data is depicted. The
choice of scale on a chart is seldom random. It is chosen intentionally to influence the desired
result as much as possible. Such framing effects apply to everything in life. Imagine our investor
is having dinner at a friend‘s house and she tells him that she made the sauce with 80% fat-free
cream. Do you think she would have bought the cream if the package labelled it 20% fat? Now
consider the package that says 98% fat-free as opposed to 2% fat. Most people would choose the
98% fat-free product even though factually, it has more fat than the product with 2% fat. Since
he saved so many calories with the meal, our investor should treat himself to another beer.
Imagine the beer bottle says 3.9% alcohol – how do you think consumers would feel about a beer
label that boasts 96.1% water? A company‘s presentation of a product is never random. It is
usually intended to serve the seller‘s purpose, which does not always conform to the buyer‘s
purpose. Because our investor does not really care about cream sauce, he changes the subject and
boasts about the investments he made in the stock market. He tells his friend that he invested in
high-growth, successful companies, namely equities from Apple, Google, Facebook, and Credit
Suisse. As he moves down the list, he does not realize most of these shares are country specific
or target-customer specific. The home bias is to blame. According to this bias, most investors
choose the majority of their equities from their home country. These stocks seem more
trustworthy, as we grew up with these company names. They are also mentioned more frequently
in the local media. This is one reason investors do not diversify enough, but it is far from the
only reason. Once we invest in a stock, we hope the price will go up but worry it will go down.
Of course, price developments depend on chance. Psychologically speaking, what counts is how
we handle these fluctuations. When the price goes up, the optimists feel satisfied with their
decision. They think, ―Thank goodness I didn‘t wait any longer.‖ However, our investor is not
the only one; everyone wants to be part of the boom (herd instinct). This includes the pessimists,
who feel lucky each time the price increases. This herd instinct is rooted within us and, once
upon a time, was necessary for our survival. After an uptrend phase – a phase of hoping for big
profits, for instance – the price begins to drop. The optimists will say that these dips in price are
bad luck, or a necessary correction. The pessimists will be furious if they suffered a loss.
Pessimists do not remain invested for long – unless they are masochists. This is why the stock
market tends to attract more optimists, who frequently invest out of hope. Thus, they invest in
innovative technologies that have a low probability of generating enormous returns. We call this
the favourite long-shot bias. People who fall into this psychological trap always bet on the long
shot because it promises very high returns. Unfortunately, they forget that the likelihood of the
long shot winning cancels the profit. Of particular interest is the typical investor behaviour
during long-term loss, when the downward spiral persists and the prices plummet – a bear
market. On the one hand, investors will initially ignore all information indicating a downward
trend because such information does not support their preconceived notion that the investment is
good and that there is an uptrend. Another common, irrational response is to buy more stock
(―I‘m taking advantage of the correction and reinforcing my position,‖ or, ―Great, I‘ll double my
position at this price‖). This behaviour is caused by contrast and anchoring.

Example

Take a look at the following fictitious example of an Investment Policy Statement.

Investor First Advisory, LLC Investment Policy Statement for Juan Martinez

Executive Summary:

Juan Martinez, Individual Investor, age 55

Portfolio: Individual, Taxable

State: California

Tax ID: xxx-xx-xxxx

Current Assets: $500,000

5.6 ASSET ALLOCATION

This review of behavioural finance aims to focus on articles with direct relevance to practitioners
of investment management, corporate finance, or personal financial planning. Given the size of
the growing field of behavioural management, corporate finance, or personal financial planning.
Given the size of the growing field of behavioural finance, the review is necessarily selective. As
Shefrin points out, practitioners studying behavioural finance should learn to recognize their own
mistakes and those of others, understand those mistakes, and take steps to avoid making them.
The articles discussed in this review should allow the practitioner to begin this journey.
Traditional finance uses models in which the economic agents are assumed to be rational, which
means they are efficient and unbiased processors of relevant information and that their decisions
are consistent with utility maximization. Barberis and Thaler note that the benefit of this
framework is that it is ―appealingly simple.‖ They also note that ―unfortunately, after years of
effort, it has become clear that basic facts about the aggregate stock market, the cross-section of
average returns, and individual trading behaviour are not easily understood in this framework.‖
Behavioural finance is based on the alternative notion that investors, or at least a significant
minority of them, are subject to behavioural biases that mean their financial decisions can be less
than fully rational. Evidence of these biases has typically come from cognitive psychology
literature and has then been applied in a financial context.

Behavioural finance also challenges the use of conventional utility functions based on the idea of
risk aversion. For example, Kahneman and Tversky propose prospect theory as a descriptive
theory of decision making For example, Kahneman and Tversky propose prospect theory as a
descriptive theory of decision making in risky situations. Outcomes are evaluated against a
subjective reference point (e.g., the purchase price of a stock) and investors are loss averse,
exhibiting risk-seeking behaviour in the face of losses and risk-averse behaviour in the face of
gains.

One aspect of the discussion about rational and irrational investors that is important to consider
is the extent to which professional traders and money managers are subject to the same
behavioural biases that are more to which professional traders and money managers are subject
to the same behavioural biases that are more commonly discussed in the context of individual
(typically assumed uninformed) investors. A number of articles— discussed here—consider this
issue directly and find that professionals are far from immune to the biases. A full description of
these biases and the evidence for them is beyond the scope of this review. Readers who would
like a more detailed discussion should refer to Barberis and Thaler and Shefrin. Although the
existence of behavioural biases among some investors is an essential component of behavioural
finance, a second essential strand relates to the limits to arbitrage. Traditional finance holds that
if some (irrational) investors misprice assets, the mispricing will be corrected by the trading
actions of rational investors (arbitrageurs) who spot the resulting profit opportunity, buy cheap
assets, and sell expensive ones. Behavioural finance theory counters that mispricing may persist
because arbitrage is risky and costly, which has the result of limiting the arbitrageurs‘ demand
for the fair-value restoring trades. The existing academic literature has tended to develop
behavioural finance against the ―foil‖ of traditional rational finance. But a number of authors
make the case for the ―end of behavioural finance,‖ arguing that because all financial theory
requires some assumptions about investor behaviour, researchers should strive to make the best
assumptions about behaviour in all models rather than invent a subclass of models featuring
empirically observed behaviour. Despite great strides in recent years, behavioural finance does
not appear to have reached the point of being considered in all models. Investors seeking a more
comprehensive introduction to the field are directed to the review articles by Hirshleifer and
Barberis and Thaler as well as to the relevant articles in the November / December 1999 issue of
the Financial Analysts Journal. Shefrin‘s book Beyond Greed and Fear is also recommended. In
the following sections, we discuss key areas in the application of behavioural finance. We
discuss the limits to arbitrage and then proceed to discuss behavioural asset pricing theory,
behavioural corporate finance, and evidence of individual investor behaviour and behavioural
portfolio theory. We also discuss briefly the psychology of risk, ethics, and the emerging field of
neuroeconomics. The final section of this review provides a bibliography with a brief summary
of each reference. The Limits to Arbitrage A key argument in behavioural finance is that the
existence of behavioural biases among investors (noise traders) will affect asset prices and
returns on a sustained basis only if limits to arbitrage also exist that prevent rational investors
from exploiting short-term miss pricings and, by doing so, returning prices to equilibrium values.
Evidence suggests that limits to arbitrage exist, for example, in the failure to eliminate obvious
and straightforward mispricing situations. Mitchell, Pulvino, and Stafford are able to document
82 cases in which the market value of a company is less than the market value of the company‘s
stake in its subsidiary. These situations imply arbitrage opportunities leading to swift correction
of the pricing anomaly, but the authors find a degree of persistence that indicates barriers to
arbitrage. Barberis and Thaler outline the various issues that create limits to arbitrage. When the
mispriced asset lacks a fairly priced close substitute, arbitrageurs are faced with fundamental risk
in that they are unable to effectively hedge their position in the mispriced asset from adverse
changes in fundamentals. Even if a close substitute is available, arbitrageurs face noise trader
risk. Because trading by uninformed investors may cause the mispricing to increase before it
corrects, the arbitrageur may be unable to maintain the position in the face of margin calls,
especially when trading with other people‘s capital, as in institutional investment management.
Finally, other issues include high implementation costs for any arbitrage trade. At the extreme,
taking a short position in an overpriced security may be impossible if, for example, stock lending
is prohibited or no shares are available to borrow. On the latter point, Lamont and Thaler review
examples in which the market value of spun-out subsidiaries of tech companies exceeded that of
the parent company that retained a majority stake in the spinout. In these cases, short-selling of
the spinout was difficult, expensive, or impossible, reducing or eliminating the arbitrage
opportunity.

Whereas academics talk about asset pricing and about explaining the cross-section of stock
returns, for practitioners, the same issues fall under the simpler heading of ―stock picking.‖ If
behavioural biases among investors practitioners, the same issues fall under the simpler heading
of ―stock picking.‖ If behavioural biases among investors cause mispricing of stocks in a
predictable fashion, then active managers may have the scope to beat the market by using
strategies based on these sources of mispricing.

One important issue is whether investor sentiment has the potential to affect stock returns, which
is considered self-evident by most practitioners. But traditional finance theory has little role for
returns, which is considered self-evident by most practitioners. But traditional finance theory has
little role for sentiment in asset pricing. Recent behavioural literature suggests evidence of
investor sentiment affecting stock returns. The effect is most pronounced for stocks that are
difficult to value and/or hard to arbitrage. This category includes small stocks, young stocks,
unprofitable stocks, and extreme growth stocks. When investor sentiment is high, subsequent
returns for these types of stocks tend to be relatively low, and vice versa. Causes of swings in
investor sentiment vary and, in some cases, can be quite trivial. Hirshleifer and Shumway present
evidence that daily returns across the world‘s markets are affected by the weather in the city of
the country‘s leading stock exchange. Unfortunately, a strategy to exploit this predictability in
returns involves quite frequent trading, and trading costs may well eliminate any available gains
for most investors. Kamstra, Kramer, and Levi provide similar evidence, showing that returns in
various countries through the year are related to hours of daylight—a result possibly driven by
the occurrence of seasonal affective disorder. The effect of sentiment is evident in various
arenas. For example, Gemmill and Thomas show that noise trader sentiment, as proxied by retail
investor fund flows, leads to fluctuations in the discount of closed-end funds. Of note, one
measure of sentiment that does not predict returns is the current sentiment—bullish or bearish—
of investment newsletter writers. Rather, recent past returns predict the sentiment of the writers,
which, in turn, has no correlation with future returns.

Another key area of behavioural research relates to the extent to which investors under- or
overreact to information in pricing securities. The available empirical evidence appears to
investors under- or overreact to information in pricing securities. The available empirical
evidence appears to suggest short-term (up to 12 months) return continuations, or momentum but
longer term (three- to five-year) reversals. This evidence poses something of a challenge for
behavioural researchers to come up with a theory that explains initial underreaction but longer
term overreaction and rebuts Fama‘s contention that a market that overreacts about as much as it
underreacts can be regarded as broadly efficient. Various behavioural models have been
developed to explain the empirical findings. In Barberis, Shleifer, and Vishnu, investors suffer
conservatism bias and use the representativeness heuristic. Conservatism means that individuals
are slow to change their beliefs in the face of new evidence and can explain why investors would
fail to take full account of the implications of an earnings surprise. The representativeness
heuristic means that individuals assess the probability of an event or situation based on
superficial characteristics and similar experiences they have had rather than on the underlying
probabilities. This approach can mean that investors, seeing patterns in random data, could
extrapolate a company‘s recent positive earnings announcements further into the future than is
warranted, creating overreaction. Daniel, Hirshleifer, and Subrahmanyam present a related model
based on overconfidence and biased self-attribution. Overconfidence leads investors to
overweight their private information in assessing the value of securities, causing the stock price
to overreact. When public information arrives, mispricing is only partially corrected, giving rise
to underreaction. Furthermore, biased self-attribution means that when public information
confirms the initial private signal, investor confidence in the private signal rises, leading to the
potential for overreaction.

Finally, Hong and Stein present a model populated by ―news watchers,‖ those who base their
trades on private information but not past prices, and ―momentum traders,‖ those who base their
trades on past price on private information but not past prices, and ―momentum traders,‖ those
who base their trades on past price trends. News spreads slowly among the news watchers,
causing initial under reaction, but it is followed by momentum buying that can create an eventual
overreaction. Related empirical work includes Dreman and Berry‘s study that finds an
asymmetry of response to earnings surprise between low and high P/E stocks. Low P/E (i.e.,
value) stocks respond most favourably to a positive earnings surprise, suggesting the low P/E
status may be the result of prior overreaction to negative news. Lee and Swaminathan show that
turnover levels provide a link between value and momentum effects. Winners have high past
volume experience reversals at five-year horizons, consistent with initial under reaction and
eventual overreaction. They argue also that as stocks decline in popularity, trading volume drops
off and the stocks become neglected value stocks. Taffler, Lu, and Kausar document market
under reaction to the bad news contained in going-concern-modified audit reports. The under
reaction may be the result of the limits to arbitrage in the sample companies, predominantly
small loser stocks, but the authors cannot rule out the behavioural explanation of investors
(professional and individual) being in denial of the implications of the going-concern opinion.
Other articles attempt to explain short-term momentum in returns, arguably the most difficult
empirical finding to reconcile with traditional rational finance theory. Grinblatt and Han argue
that prospect theory, and the resulting tendency of investors to hold losing positions and sell
winners, explains the momentum effect. This trading behaviour of investors means prices
underreact to news and momentum occurs as the mispricing slowly corrects. For example, when
good news emerges about a stock, selling by investors who, subject to the disposition effect, are
inclined to sell winners will slow the pace at which the good news can be reflected in a higher
stock price. The authors find that a proxy for unrealized gains, which will determine investors‘
disposition to sell or hold, can explain the level of momentum profits.

Rational Managers and Irrational Investors

The rational managers/irrational investors school of thought has its main implications in terms of
corporate financial structure and the timing of securities issues. of thought has its main
implications in terms of corporate financial structure and the timing of securities issues. For
example, Baker and Wurgler find that the share of equity issues relative to total equity and debt
issues is high before periods of low equity market returns, suggesting that companies time their
equity issues to take advantage of positive investor sentiment and market mispricing. These
results suggest also that corporate capital structure often reflects the cumulative outcome of past
attempts to time the equity market rather than some target capital structure. Baker and Wurgler
argue that dividend policy may be influenced by managers ―catering‖ to the demands of
investors. According to the authors, managers rationally cater to investor demand by paying
dividends when investors put higher prices on payers and not paying when investors prefer
nonpayers. The authors show that the lagged dividend premium—the difference between the
average market-to-book ratio for dividend payers relative to the average for nonpayers—is
positively related to dividend initiations. The authors argue also that investors‘ time-varying
demand for dividends is related to sentiment. When the dividend premium is high, investors are
seeking companies that exhibit characteristics of safety, and when it is low, investors are seeking
maximum capital growth. Shleifer and Vishnu present a model that seeks to explain merger and
acquisition (M&A) deals in behavioural terms. In the model, stocks are mispriced and
management perceives and responds to the mispricing. The authors argue that M&A decisions
and decisions about methods of financing deals are driven by mis valuations of the participating
companies; for example, acquisitions will involve payment in stock when valuations are high.
The model suggests that acquisitions for stock are made by overvalued companies and target
companies tend to be less overvalued. The model is able to explain many of the observed
characteristics of the M&A market. Behavioural finance also has implications for the market for
IPOs. These offerings are widely documented as showing high first-day returns, usually taken to
imply that the issues are under priced at the offering price. One puzzle is why issuers and pre-
IPO shareholders are prepared to tolerate this ―money left on the table‖ phenomenon. Loughran
and Ritter propose a model based on prospect theory in which issuers are likely to net the amount
of money left on the table by an under-priced offering together with the ―gain‖ in their wealth
that comes from the rise in the price of the shares that they retain in the company. The net
amount will often be a positive sum with the increase in value of the retained holdings exceeding
the difference between the offer price and the market price for the shares sold in the offering.
Furthermore, the most under-priced offerings tend to be those in which price for the shares sold
in the offering. Furthermore, the most under-priced offerings tend to be those in which the offer
price has been revised up in the face of strong demand from the price set out in the prospectus.
Therefore, the original pre-IPO shareholders can offset the loss of the under-pricing with the
good news that their total wealth is higher than was previously expected. Ljungqvist and
Wilhelm provide some support for this hypothesis in that issuers of under-priced offerings often
use the IPO underwriter for subsequent equity issues, suggesting they are not unhappy with the
service received.

Irrational Managers
Despite the suggestion by Baker and Wurgler that the irrational managers school of behavioural
corporate finance is currently underdeveloped, the theory can be regarded as having a relatively
school of behavioural corporate finance is currently underdeveloped, the theory can be regarded
as having a relatively long history. For example, Roll‘s ―hubris hypothesis‖ of takeovers is based
on the idea of overconfidence among managers, which leads them to overestimate the gains to be
made from corporate activity. More recently, Doukas and Petmezas calculate a measure of
management overconfidence and find overconfident managers‘ companies earn lower merger
announcement returns and have poorer long-term share price performance. Self-attribution bias
also appears to be at play, in that returns are lower for serial acquirers (five or more deals in three
years) than for first-time deals. Another example of the managerial overconfidence idea relates to
project appraisal and internal investment decisions. Malmendier and Tate argue that
overconfident management overestimates the returns on investment projects and views external
funds as too costly. They tend to overinvest when internal funds are abundant but refrain from
investing when external funds are required. The authors use management‘s personal financial
exposure to company-specific risk as a proxy for overconfidence and find that investment by
overconfident CEOs is closely related to cash flow.

Categorizing market participants as informed and uninformed traders, or noise traders and
arbitrageurs, encourages the perspective of professional investors as the rational, informed
arbitrageurs. traders and arbitrageurs, encourages the perspective of professional investors as the
rational, informed arbitrageurs. But plenty of evidence is available of behavioural biases being
displayed by professional investors, even in ―real money‖ situations. Hong, Kubik, and Stein
find that mutual fund managers herd in terms of the stocks that they buy or sell during a
particular quarter. Coval and Shumway show that traders at the Chicago Board of Trade (CBOT)
are loss averse and inclined to take more risk in the afternoon if they have had losses in the
morning. Their action has at least a short-term effect on prices. In an experimental setting, Haigh
and List show that CBOT traders display myopic loss aversion to a greater degree than do
students. Garvey and Murphy find evidence of the disposition effect—the tendency to sell
winners and hold losers—among a group of profitable proprietary traders. The tendency to sell
winners and hold losers lowers the returns the traders earn.

Individual Investors
In this section, we look at the trading behaviour and portfolio choices of individual (or retail)
investors. Some of the behaviour relates to pension fund portfolios—for example, 401(k) plans—
whereas (or retail) investors. Some of the behaviour relates to pension fund portfolios—for
example, 401(k) plans—whereas some relates to trading in brokerage accounts or mutual fund
selection. Behavioural findings relating to personal financial issues have a number of practical
implications. Professional investors could use knowledge of the biases and mistakes of
individual investors in attempts to ―get on the other side of the trade‖ and make profits at the
expense of the individual investors. Alternatively, financial services firms could use knowledge
of such biases to inform their product development and marketing departments. Finally,
regulators could apply the knowledge to informing regulation and education that can be used to
mitigate the biases and improve the welfare of individual investors. Evidence suggests that
individual investors fail to behave rationally in even quite simple situations. Elton, Gruber, and
Busse examine investors‘ choices of index funds. Fees vary across funds, and given nearly
identical investment strategies, the variations drive predictable differences in performance.
Despite this predictability, many investors invest in high-fee funds with (predictable) inferior
performance. Evidence also indicates that many investors have fairly weak portfolio preferences.
For example, Benartzi and Thaler examine investors‘ portfolio choice decisions in the context of
401(k) plans. A majority of survey participants prefer the distribution of outcomes of the median
investor‘s portfolio to the one they have chosen, leading the authors to conclude that investor
autonomy is ―not worth much.‖ The idea that investors struggle to deal with investment choices
is also consistent with the evidence of Sethi- Iyengar, Jiang, and Huberman who document a
negative relationship between the number of fund choices in a 401(k) plan and the participation
rate. They find the average participation rate in plans with 2 fund choices is 75 percent, whereas
in plans with 20 fund choices, it is 70 percent, and in plans with 40 fund choices, 65 percent. The
results suggest that fund choices create complexity for members, which discourages them from
joining the plan.

Investors with weak preferences or limited knowledge may use simple rules of thumb to deal
with investment choice. Benartzi and Thaler document experiments of investors using a naïve
1/n diversification strategy choice. Benartzi and Thaler document experiments of investors using
a naïve 1/n diversification strategy in which they allocate contributions equally among the funds
offered in their 401(k) pension plans. This type of strategy means the fund range has a strong
influence on the investors‘ chosen asset allocation. Huberman and Jiang using a larger and more
appropriate dataset, find evidence instead for a conditional 1/n approach in which investors
choose three or four funds from the range offered and then allocate equally among them. In this
case, fund range has less influence on asset allocation. One particularly puzzling example of
investor behaviour observed in 401(k) plans is the enthusiasm of many participants for investing
their contributions in the stock of their employer. Although some of the account balances
invested in employer stock are explained by the fact that employer matching contributions are
often made in the form of stock, with restrictions on sale, studies find participants voluntarily
allocating their own contributions to employer stock. Obviously, not only does this strategy
represent an under diversified portfolio, but the investment also has a strong correlation with
employees‘ labour income. Participants should, ideally, look to hedge the labour income risk
they face rather than ―double up‖ with portfolio investments. Explanations for this strange
investment approach include naïve extrapolation of the strong past performance of the
company‘s shares (Benartzi 2001) and employees underestimating the risk of the employer‘s
share, possibly because of their familiarity with the company. Employees may also perceive
implicit advice (or an endorsement) in the fact that employer matching contributions are made in
stock. In addition to evidence of 401(k) investors following dubious investment strategies,
substantial evidence shows inertia that leads participants to stick with default options in terms of
savings rates and investment funds. In many cases, the default funds will be cash or money
market funds, which are arguably too conservative for long-term saving.

The Psychology of Risk

Risk management is an important aspect of investment, and perceptions of risk are likely to be
influenced by psychology. Shiller looks explicitly at applications of psychology in risk
management. Perhaps the psychology. Shiller looks explicitly at applications of psychology in
risk management. Perhaps the most obvious implication of the behavioural biases that underpin
behavioural finance is that overconfidence and over optimism can lead individuals to
underestimate risk. The complexity of risk may also create problems in risk perception. Framing
is relevant in that perceptions of risk may be affected by aspects of the presentation of the
situation. Shiller notes that risk management may be regarded as more attractive when described
as ―insurance.‖ Framing outcomes in terms of gains and losses may also affect risk-taking
behaviour, with evidence that individuals become risk seeking in the domain of losses (as in
prospect theory). Shiller also discusses the notion of ―risk as feelings.‖ He notes that intellectual
recognition of a risk may not be enough to provoke action without an emotional (or affective)
response to the risk. Conversely, some risks that are quite trivial when considered on an
intellectual level may provoke action if they somehow manage to create an effective response.
An example might be extremely low probability events that have a ―dread‖ element to them,
such as a disaster at a nuclear power station. In terms of levels of risk, changes in investor beliefs
can be a source of risk. Kurz introduces the concept of endogenous uncertainty. Exogenous
uncertainty relates to changes in asset prices caused by changes in fundamentals, but asset prices
also fluctuate because of changes in investors‘ beliefs, or endogenous uncertainty. Kurz assumes
that economic agents cannot know the true value of an asset and have scope to disagree over the
implications of news for future market performance.

Example

BMAA begins with that optimal portfolio construction but then allows deviation from that
allocation to reduce the chance of behavioural biases impacting decisions (making them sell at
the worst possible time). BMAA assess investors and determines whether to adapt to or moderate
their behavioural biases. It then considers how much to deviate from the optimal portfolio to
reduce biased decisions, building a portfolio the client can stick with.

5.7 SUMMARY

 Standards of ethics and ethical decision making are important for the functioning of the
investment industry and the wider financial system. Decisions on ethical issues, like
decisions of any kind, are driven by the psychology of the wider financial system.
Decisions on ethical issues, like decisions of any kind, are driven by the psychology of
the decision maker. Oberlechner (2007) provides an extensive review of psychology
research relevant to ethical decision making in the finance and investment industries. He
notes that ethics goes beyond restraining from unethical behaviour because of the
potential costs of exposure.

 Some psychology research suggests people want to be ethical, an intrinsic interest that
does not rely on a desire to avoid punishment. Psychological concepts used in
 behavioural finance, heuristic biases or cognitive dissonance, for example, can also affect
ethical decision making.

 The review presents arguments that situational and social forces can result in otherwise
ethical individuals committing unethical acts. Notably, in the financial sector the
temptation to act unethically can be high because of the large sums of money involved.
Prentice (2007) provides another broad review of ethical decision making in a financial
context. He argues that well-intentioned people can have ethical lapses if they find
themselves in particular circumstances and do not take account of the errors in judgment
that humans are behaviourally inclined to make.

 In short, ―bad acts‖ are not committed only by ―bad people.‖ Sometimes ―good people‖
act in an unethical manner, out of a desire to conform with others around them or because
they are overconfident, for example.

 Standards of ethics and ethical decision making are important for the functioning of the
investment industry and the wider financial system. Decisions on ethical issues, like
decisions of any kind, are driven by the psychology of the wider financial system.
Decisions on ethical issues, like decisions of any kind, are driven by the psychology of
the decision maker. Oberlechner (2007) provides an extensive review of psychology
research relevant to ethical decision making in the finance and investment industries. He
notes that ethics goes beyond restraining from unethical behaviour because of the
potential costs of exposure.

 Some psychology research suggests people want to be ethical, an intrinsic interest that
does not rely on a desire to avoid punishment. Psychological concepts used in
behavioural finance, heuristic biases or cognitive dissonance, for example, can also affect
ethical decision making. The review presents arguments that situational and social forces
can result in otherwise ethical individuals committing unethical acts.

 Notably, in the financial sector the temptation to act unethically can be high because of
the large sums of money involved. Prentice (2007) provides another broad review of
ethical decision making in a financial context. He argues that well-intentioned people can
have ethical lapses if they find themselves in particular circumstances and do not take
 account of the errors in judgment that humans are behaviourally inclined to make. In
short, ―bad acts‖ are not committed only by ―bad people.‖ Sometimes ―good people‖ act
in an unethical manner, out of a desire to conform with others around them or because
they are overconfident, for example.

 The field of modern financial economics assumes that people behave with extreme
rationality, but they do not. Furthermore, people‘s deviations from rationality are often
systematic. Behavioural finance they do not. Furthermore, people‘s deviations from
rationality are often systematic. Behavioural finance relaxes the traditional assumptions
of financial economics by incorporating these observable, systematic, and very human
departures from rationality into standard models of financial markets.

5.8 KEYWORDS

 Social Identity: Involves the ways in which one characterizes oneself, the affinities one
has with other people, the ways one has learned to behave in stereotyped social settings,
the things one values in oneself and in the world, and the norms that one recognizes or
accepts governing everyday behaviour.

 Annual Report - The yearly audited record of a corporation or a mutual fund's condition
and performance that is distributed to shareholders.

 Balanced Fund - Mutual funds that seek both growth and income in a portfolio with a
mix of common stock, preferred stock or bonds. The companies selected typically are in
different industries and different geographic regions.

 Capital Gain - The difference between a security's purchase price and its selling price,
when the difference is positive.

 Capitalization - The market value of a company, calculated by multiplying the number

of shares outstanding by the price per share.

5.9 LEARNING ACTIVITY

1. Create a session on application of behavioural finance to asset allocation.

_____________________________________________________________________________________
_________________________________________________________________

2. Create a survey on guidelines for determining asset allocation.

_____________________________________________________________________________________
_________________________________________________________________

5.10 UNIT END QUESTIONS

A. Descriptive Questions

Short Questions

1. What is asset?

2. Define asset allocation?

3. Define investment policy?

4. What is behavioural finance?

5. How to determine the guidelines of asset allocation?

Long Questions

1. Explain the application of behavioural finance to asset allocation.

2. Explain the concept of practical allocation.

3. Illustrate the guidelines for determining asset allocation.

4. Illustrate the concept of investment policy.

5. Examine the concept of asset allocation.

B. Multiple Choice Questions

1. What is an ideal value of stability factor is?

a. 100
b. 200
c. More than 200
d. 1
2. Which among the following does the zero signal IC is generally mA in the initial stages
of a transistor amplifier?

a. 4
b. 1
c. 3
d. More than 10

3. What should be the zero signal collector current should be at least equal to if the
maximum collector current due to signal alone is 3 mA?

a. 6 mA
b. mA
c. 3 mA
d. 1 mA

4. What is the disadvantage of base resistor method of transistor biasing?

a. Is complicated
b. Is sensitive to changes in ß
c. Provides high stability
d. None of these

5. What if the biasing circuit has a stability factor of [Link] to temperature change, ICBO
changes by 1 µA, then IC will change by?

a. 100 µA
b. 25 µA
c. 20 µA
d. 50 µA
Answers

1-a, 2-b, 3-c, 4-b, 5-d

5.11 REFERENCES

References

 Nisbett, R. R. & Ross, L. (1980). Human inference: Strategies and shortcomings of social
judgment. Englewood Cliffs, NJ: Prentice-Hall.

 Plous, S. (1993). The psychology of judgment and decision-making. McGraw-Hill Book

Company.

 Reyes, R. M. Thompson, W. C. & Bower, G. H. (1980). Judgmental biases resulting from

differing availabilities of arguments. Journal of Personality and Social Psychology.

Textbook

 Tversky, A. & Kahneman, D. (1973). Availability: A heuristic for judging frequency and
probability. Cognitive Psychology.

 Tversky, A. & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases.
Science.

 Ward, W. C. & Jenkins, H. M. (1965). The display of information and the judgment of
contingency. Canadian Journal of Psychology.

Website

 [Link]

 [Link]
EcG9zAzEEdnRpZANEMTA0NV8xBHNlYwNzcg/RV=2/RE=1628101112/RO=10/RU
=http%3a%2f%[Link]%2fpub%2fgh%2fSample_Investment_Policy_2.p
df/RK=2/RS=r6QGYyhfafyHq50rVkQKFIcOVuo-

 [Link]
EcG9zAzQEdnRpZANEMTA0NV8xBHNlYwNzcg/RV=2/RE=1628101112/RO=10/RU
=https%3a%2f%[Link]%2fwp-content%2fthemes%2fcffgr-
2015%2ffiles%[Link]/RK=2/RS=4CuQ8FpQoHBnVpnuCNOkU0SapS
U-
MASTER OF BUSINESS
ADMINISTRATION
(FINANCIAL MANAGEMENT)
SEMESTER II

BEHAVIORAL FINANCE
MBAEF 204
All rights reserved. No Part of this book may be reproduced or transmitted, in any form or by any means,
without permission in writing from Mizoram University. Any person who does any unauthorized act in
relation to this book may be liable to criminal prosecution and civil claims for damages. This book is
meant for educational and learning purposes. The authors of the book has/have taken all reasonable
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writing for corrective action.
 CONTENT

Unit- 6: Behavioural Investor Types.......................................................................................... 4

UNIT- 6: BEHAVIOURAL INVESTOR TYPES

STRUCTURE

6.0 Learning Objectives

6.1 Introduction

6.2 Behavioural Investor Type Diagnostic Process

6.3 Background of the Development of Behavioural Investor Types

6.4 Psychographic Models of Investor Behaviour

6.5 Early Psychographic Models

6.6 The Behavioural Alpha Process

6.7 Top-Down Approach

6.8 Behavioural Investor Types

6.8.1 Preserver

6.8.2 Follower

6.8.3 Independent

6.8.4 Accumulator

6.9 Summary

6.10 Keywords

6.11 Learning Activity

6.12 Unit End Questions

6.13 References

6.0 LEARNING OBJECTIVES

After studying this unit, you will be able to

 Examine the concept of behavioural investor.

  Illustrate the background of the development of behavioural investor types.

 Explain the psychographic models of investor behaviour.

6.1 INTRODUCTION

The success of the simple 60/40 portfolio has been one of the defining features of the investment
landscape over the past decade. A combination of persistently declining bond yields and
exceptional performance from US equities has meant that it has trounced most alternative
allocation approaches. Doing anything but hold a 60/40 portfolio (or a derivation of it) has
almost inevitably come at a cost. It is now considered to be the natural, default option by many
investors. It is not clear, however, whether this status is because of something innate in the 60/40
structure that makes it the neutral choice, or whether investor opinions would change if it
endured a prolonged spell of disappointing returns.

This piece is not another critique of the 60/40 approach (most of which are attempting to sell
another product), nor an assertion that investors must do something else (aside from lower their
expectations for future returns). It is about how investors treat evidence. What evidence we
choose to use, what we choose to discard and the importance we place on certain elements.

A ‗passive‘ allocation to a 60/40-type portfolio is often framed as the obvious, evidence-based

investment decision, and there is certainly compelling support for it. The returns have been
stellar, particularly since the secular decline in yields began, and it has inevitably been boosted
by the low costs typically attached to this approach to investment. Yet in assuming this is now
the only approach to adopt in the future, we are inescapably ignoring other pieces of evidence.
Investors in 60/40 portfolios hold significant allocations to the US equity market (which has been
a particular boon for non-US investors) and long duration sovereign / quasi-sovereign bonds.
Holding a US equity focus in a portfolio now is to choose to ignore the evidence that over the
long-run expensive markets tend to produce lower returns than those which are more attractively
valued. Furthermore, owning long duration, low yield assets is a recipe for higher volatility and
under whelming returns.

If we suspend our disbelief and imagine that over the next ten years US equities have been
trounced by other developed and emerging markets, what would our reaction be? Would the
60/40 still be the in-vogue, evidence-based default, or would something else now be in its place?
Given how sensitive our investment perspectives and purported beliefs are to historic
performance, it is almost certain that investment industry would be awash with obituaries for a
60/40 approach, probably at the precise time it becomes a more compelling option. When an
investment strategy has been successful, particularly for a sustained period, it is incredibly
difficult to envisage this changing. Yet we only have to look at the performance of the value
factor over the last ten-years (plus) to understand how this can occur. Having exposure to value
is well-supported by the evidence but has failed to deliver meaningfully for a sustained period.
Even investment approaches that work will go through arduous period when they don‘t. No
strategy is immune to this.

In the scenario where a 60/40 portfolio has struggled relative to other options, investors have
endured a cost because they have focused on a certain piece of evidence (the long run success of
this approach) and ignored other relevant information (the long run poor results of expensive
assets). This is perfectly reasonable. All investors are faced with a plethora of evidence, and it is
upon us to filter this and focus on that which we believe to be most robust and material.

The danger is to assume that any view we take is neutral. It is not. We are always making
judgements and trade-offs. It is easy now to state that a 60/40 approach is simply following the
evidence because it has performed so well, for so long. Yet we frame and weigh evidence
through the window of recency. If something is working now, then the evidence we have
supporting it seems more important and more obvious. It is easy to disregard or underweight
evidence to the contrary. We can see how past performance informs our use of evidence by
looking at the typical home equity bias held by investors. From an investment philosophy
standpoint there is limited compelling evidence for holding a heavy bias towards our domestic
market, but how any given investor perceives the home bias is likely to be dictated by where they
are located. In the UK, there is an ongoing clamour to remove this home skew. Not because
everyone has suddenly alighted upon the evidence, but because returns from the UK equity
market have been wretched (on a relative basis) for years. By contrast, is it unlikely that US
investors are desperate to increase their exposure to underperforming international markets? If
anything, in this scenario, it is UK investors that should be more circumspect about the speed of
such a shift in allocation given the evidence of strong long-run performance from undervalued
markets, but this is far from the case. Recent performance is not only used as the most important
piece of evidence, but it also frames how we perceive all other information. Our time horizons
are also a major defining factor in the evidence we choose to follow and that which we choose to
ignore. Investment approaches supported by the most robust evidence only play out over of the
long-run (if at all) and patience is required to see it come to fruition. One thing the investment
industry has little of is patience. That is why the evidence of what is performing well right now is
so compelling. We are not asking people to wait, to believe something different to what they are
currently witnessing or bear uncomfortable risks. Even if we consider something to be the
neutral investment option it is imperative to consider the evidence we are using to support that
view and also justify why we have chosen to ignore other pieces of evidence. We also need to
envisage a future where the default disappoints and understand how we would react in such a
scenario. The 60/40 has been a great option for many investors, but we cannot forget that it is an
investment view and should treat it as such.

The argument against the use of active management is often focused on the difficulty of
identifying a fund manager with the requisite skill to outperform the market. This perspective,
however, ignores a critical element of employing active fund managers. It is not simply about
finding the right ones, it is about being able to stick with them over the long-term. An elegant
study recently released by Vanguard put this into sharp contrast. It showed that even successful
active funds endured protracted, multi-year spells of underperformance. The message is simple:
if we are not able to withstand years of under-par returns, we should not be using active
managers at all. The Vanguard study, which looks at the performance of open-ended actively
managed equity funds with US domicile, covers over 2,500 funds across a 25-year period. The
entire piece is worth reading but there are some critical observations. ―Close to 100% of
outperforming funds have experienced a drawdown relative to their style and median peer
benchmarks over one, three and five year evaluation periods‖. ―Eight out of ten outperforming
funds had at least one five year period when they were in the bottom quartile relative to their
peers‖. Underperformance is an inevitable and expected part of the return profile of all active
managers, even those with skill who manage outperform over the long-term. Hopefully, the
study lays to rest the spurious but pervasive notion that years of consistent outperformance is
either a reasonable expectation or anything more than random patterns being weaved.
Identifying a skilful active manager is incredibly difficult; but even if we can do it, it will not
matter if we are unable to cope with the barren periods. The first question we ask before
considering investing in an active manager should not be – do we have the ability to find one?
Rather, are we in a position where we could hold them for the uncomfortable and volatile long-
term? If the answer is no, we should not even begin the search. It is easy looking at historic
underperformance on a screen before we invest; living through it is an entirely different
proposition. The doubts about the quality of an underperforming manager or their suitability for
the prevailing market environment are relentless.

6.2 BEHAVIOURAL INVESTOR TYPE DIAGNOSTIC PROCESS

Figure 6.1: Behavioral Investor Types

Behavioural finance, which identifies and learns from the human psychological and learns from
the human psychological phenomena at work in financial markets and within individual
investors, has taken a more prominent place in the financial advisory world since the bursting of
the technology stock bubble in March 2000. Evidence of this fact is documented in my August
2007 research study titled ―The Ultimate Know-Your-Customer Approach: Using Behavioural
Finance to Retain and Acquire Wealth Clients.‖ In that study, I surveyed 290 sophisticated
financial advisors (identified as such by having at least one advanced designation, such as CFP®,
CFA, or CPA) in 30 countries about their interest in and use of behavioural finance with their
clients. The results were astounding: 93 percent of advisors believed that individual investors
make irrational investment decisions, and 96 percent were successfully using behavioural finance
to improve relationships with their clients. Why is behavioural finance catching on? These
advisors have figured out that acquiring clients is difficult and expensive, and losing them is
easy—and contrary to popular belief, the primary reason financial advisors lose clients is not
because of subpar investment results. Advisors acknowledge that the most common reason they
lose clients is that they are unable to get inside the heads of their clients enough to build solid
personal and financial relationships. Understanding how clients actually think and behave is a
key ingredient in the recipe for success in acquiring and retaining clients. As such, behavioural
finance is becoming a powerful force in the financial advisory field. But some financial advisors
are needlessly struggling with behavioural finance because they lack a systematic way to apply it
to their client relationships. This paper intends to make the application of behavioural finance
easier by building on key concepts outlined in my earlier March 2005 Journal of Financial
Planning article, ―Incorporating Behavioural Finance into Your Practice,‖ and my 2006 book,
Behavioural Finance and Wealth Management. In those two works, I outline a method of
applying behavioural finance to private clients in a way that I now refer to as ―bottom-up.‖ This
means that for an advisor to diagnose This means that for an advisor to diagnose and treat
behavioural biases, he or she must first test for all behavioural biases in the client, and then
determine which ones a client has before being able to use bias information to create a
customized investment plan. For example, in my book I describe 20 of the most common
behavioural biases an advisor is likely to encounter, explain how to diagnose these biases, show
how to identify behavioural investor types, and finally show how to plot this information on a
chart to create the ―best practical allocation‖ for the client. But some advisors may find this
bottom-up approach too time-consuming or complex. So in this paper, I present a simpler, more
efficient approach to bias identification that is ―top-down‖—a shortcut, if you will—that can
make bias identification much easier. I call it Behavioural Alpha. The Behavioural Alpha
approach is a multi-step diagnostic process that classifies clients into four behavioural investor
types (BITs). Bias identification, which is done near the end of the process, is narrowed down for
the advisor by giving the advisor clues as to which biases a client is likely to have based on the
client‘s BIT. The word ―alpha‖ is used for two reasons. For one thing, it means ―first‖ or ―the
beginning.‖ Before an investment program is created for a client, financial advisors need to take
inventory of a client‘s behaviour first—hence Behavioural Alpha. Second, the word has become
synonymous with describing performance beyond expectations. By taking inventory of a client‘s
investing behaviour before creating an investment plan, the result will likely be performance that
exceeds both the expectations of the client and the advisor. The paper begins with an
introduction to the four behavioural investor types.

i. Passive preservers

ii. Friendly followers

iii. Independent individualists

iv. Active accumulators

Next, a detailed description of each BIT is provided, including a simple diagnostic for some of
the behavioural biases and advice for dealing with each BIT. The paper concludes with a review
of the Behavioural Alpha approach to identifying BITs, which starts by identifying active and
passive investor traits and then uses traditional risk tolerance questionnaires to initially classify
the client before identifying the client‘s irrational biases to determine the client‘s BIT.

Behavioural investor types were designed to help advisors make rapid yet insightful help
advisors make rapid yet insightful assessments of what type of investor they are dealing with
before recommending an investment plan. The benefit of defining what type of investor an
advisor is dealing with up front is that this will mitigate unwelcome surprises from the client
wishing to change the portfolio allocation due to market turmoil. If an advisor can reduce
traumatic episodes throughout the advisory process by delivering smoother, anticipated
investment results due to an investment plan that is customized to the client‘s behavioural make-
up, the client relationship will be stronger. BITs, are not intended to be absolutes, but rather
guideposts to use when making the journey with a client; dealing with irrational investor
behaviour is not an exact science. For example, an advisor may find that he or she has correctly
classified a client as a certain BIT, but finds that the client also has traits (biases) of another.
Each BIT is characterized by a certain risk tolerance level and a primary type of bias—either
cognitive (driven by faulty reasoning) or emotional (driven by impulses or feelings). One of the
most important concepts advisors should keep in mind as they go through this section is that the
least risk-tolerant BIT and the most risk tolerant BIT are driven by emotional biases, while the
two types in between these two extremes are mainly affected by cognitive biases. Emotional
clients tend to be more difficult clients to work with. Advisors who can recognize the type of
client before making investment recommendations will be much better prepared to deal with
irrational behaviour when it arises.

Passive Preservers are, as the name implies, investors who place a great deal of implies, investors
who place a great deal of emphasis on financial security and preserving wealth rather than taking
risks to grow wealth. Many have gained wealth through inheritance or conservatively by working
in a large company. Because they have gained wealth by not risking their own capital, Passive
Preservers may not be financially sophisticated. Some Passive Preservers are ―worriers‖ in that
they obsess over short-term performance and are slow to make investment decisions because
they dislike change. This is consistent with the way they have approached their professional
lives, being careful not to take excessive risks. Some Passive Preservers who inherit wealth may
have intense feelings of guilt or low self-esteem because they didn‘t earn their money, and may
have a fear of failure or lack of motivation. Most Passive Preservers are focused on taking care
of their family members and future generations, especially funding life enhancing experiences
such as education and home buying. Because the focus is on family and security, Passive
Preserver biases tend to be emotional rather than cognitive. As age and wealth level increase, this
BIT becomes more common. Although not always the case, many Passive Preservers enjoy the
wealth management process—they like the idea of being catered to because of their financial
status—and thus are generally good clients. Behavioural biases of Passive Preservers tend to be
emotional, security-oriented biases such as endowment bias, loss aversion, status quo, and regret.
They also exhibit cognitive biases such as anchoring and mental accounting.

This emotional bias occurs when a person assigns greater value to an object when he or she
possesses it to an object when he or she possesses it and is faced with its loss, than when he or
she doesn‘t possess the object and has the potential to gain it. A classic example of endowment
bias is a client who holds onto investments that were owned by previous generations, particularly
concentrated equity positions or real estate that may have created the family‘s wealth to begin
with, without justification for why these assets are retained. Ask your client if they keep objects
or investments because they already own them (through inheritance, for example), but wouldn‘t
be interested in buying these objects or investments themselves. If so, they are likely to have
endowment bias. Loss aversion bias. Most Passive Preservers feel the pain of losses more than
the pleasure of gains—the essence of loss aversion. This emotional bias prevents people from
unloading unprofitable investments, even when they see no prospect of a turnaround. Some
industry veterans have coined this ―get-even-itis.‖ Holding losing investments in the hope that
they get back to break-even has seriously negative consequences on portfolio returns when these
investments stay in losing territory for extended periods. A simple diagnostic for loss aversion
bias: Provide your client a scenario in which they buy a security and it drops 25 percent with no
foreseeable rebound. Ask if they are likely to hold it until it gets back to even or sell it and buy
something with better prospects. If they hold on to the investment, they are likely to have loss
aversion bias. Status quo bias. This emotional bias predisposes people, when facing an array of
choices, to elect whatever option keeps conditions the same. Passive Preservers often tell
themselves ―things have always been this way‖ and are more comfortable keeping things the
same. Status quo bias is demonstrated by the investor who has been doing things a certain way
for many years, and then hires a new financial advisor. The new advisor may propose practical
changes, only to find that the investor takes part of or none of the advice. It‘s not that the client
doesn‘t need good advice— they are simply stuck in the status quo. Regret aversion bias. People
exhibiting this emotional bias avoid taking decisive actions because they fear that, in hindsight,
whatever course they select will prove less than optimal. Regret aversion can cause investors to
be too conservative in their investment choices. Having suffered losses in the past, they may shy
away from making sensible new investments. This behaviour can lead to long-term
underperformance and can jeopardize investment goals. Ask your client if they have made
investments in the past that they regret—and if that regret affects current or future investment
decisions. Anchoring bias. This cognitive bias occurs when investors are influenced by purchase
points or arbitrary price levels, and tend to cling to these numbers when facing questions like
―should I buy or sell this investment?‖ One of the most common examples of anchoring bias
occurs during the implementation of a new asset allocation. For example, suppose a client comes
to an advisor with 30 percent of their portfolio in a single stock and the advisor recommends
diversification. Further suppose that the stock is down 25 percent from the high it reached five
months ago ($75 a share versus $100 a share). For simplicity, assume that taxes on the sale are
not an issue. Frequently, the client will resist the new allocation because they feel they must only
sell the stock when its price rebounds to the $100 a share it achieved five months ago. This is
anchoring bias. Mental accounting bias. The last Passive Preserver bias is mental accounting, a
cognitive bias that occurs when people treat various sums of money differently based on where
these sums are mentally categorized. Passive Preservers are risk averse and like to segregate their
assets into safe ―buckets.‖ A classic example of mental accounting is segregating college money,
money for retirement, and vacation money. If all of these assets are viewed as ―safe money‖ sub-
optimal returns are usually the result. Advising passive preservers. After reviewing this section,
readers might correctly conclude that Passive Preservers are difficult to advise because they are
driven mainly by emotion. This is true; however, they are also greatly in need of good financial
advice. Advisors should take the time to interpret behavioural signs provided to them by Passive
Preserver clients. Passive Preservers need ―big picture‖ advice and advisors shouldn‘t dwell on
details like standard deviations and Sharpe ratios, or else they will lose the client‘s attention.
Passive Preservers need to buy into their advisor‘s general philosophy first and then, once trust is
gained, they will take action. After a period of time, Passive Preservers are likely to become an
advisor‘s best clients because they value greatly the advisor‘s professional expertise and
objectivity in helping make the right investment decisions.

Friendly Followers are passive investors who usually do not have their own ideas who usually do
not have their own ideas about investing. They often follow the lead of their friends and
colleagues in investment decisions, and want to be in the latest, most popular investments
without regard to a long-term plan. One of the key challenges of working with Friendly
Followers is that they often overestimate their risk tolerance. Advisors need to be careful not to
suggest too many ―hot‖ investment ideas—Friendly followers will likely want to do all of them.
Some don‘t like, or even fear, the task of investing, and many put off making investment
decisions without professional advice; the result is that they maintain, often by default, high cash
balances. Friendly followers generally comply with professional advice when they get it, and
they educate themselves financially, but can at times be difficult because they but can at times be
difficult because they don‘t enjoy or have an aptitude for the investment process. Biases of
Friendly followers are cognitive recency, hindsight, framing, cognitive dissonance, and
ambiguity aversion. Recency bias. This is a predisposition for people to more prominently recall
and emphasize recent events or observations, and potentially extrapolate patterns where none
exist. Recency bias ran rampant during the bull market period between 1995 and 1999 when
many investors wrongly presumed that the market would continue its enormous gains forever.
Friendly Followers often enter an asset class when prices are peaking, which can end badly with
sharp price declines. Hindsight bias. Friendly Followers, who often lack independent thought on
investments, are susceptible to hindsight bias, which occurs when an investor perceives
investment outcomes as if they were predictable— even if they weren‘t. An example of hindsight
bias is the response by investors to the tech stock bubble when, initially, many viewed the
market‘s performance as normal (not symptomatic of a bubble), only to later say, ―Wasn‘t it
obvious?‖ when the market melted. (Ask your client if they thought the bursting of the 2000
technology stock bubble was predictable.) The result of hindsight bias is that it gives investors a
false sense of security when making investment decisions, and thus excessive risk is taken.
Framing bias. This is the tendency of Friendly Followers to respond differently to various
situations based on the context in which a choice is presented (framed). Investors often focus too
restrictively on one or two aspects of a situation, excluding other considerations. The use of risk
tolerance questionnaires provides a good example. Depending on how questions are asked,
framing bias can cause investors to respond to risk tolerance questions in either an unduly
conservative or risk taking manner. For example, when questions are worded in the gain
―frame,‖ then a risk-taking response is more likely. When questions are worded in the loss
―frame,‖ then risk-averse behaviour is the likely response. A simple diagnostic for framing bias
is to pick one question from a typical risk tolerance questionnaire and re-phrase it to test if a
client would answer the same question differently based on how it is asked. If they answer the
question differently, they are likely subject to framing bias. Cognitive dissonance bias. In
psychology, cognitions represent attitudes, emotions, beliefs, or values. When multiple
cognitions intersect—for example, a situation arises in which a person believes in something
only to find out it is not true— they try to alleviate their discomfort by ignoring the truth and
rationalizing their decision to ignore the truth. Friendly Followers who suffer from this bias may
continue to invest in a security or fund they already own after it has gone down (average down),
even when they know they should be judging the new investment with objectivity. A common
phrase for this concept is ―throwing good money after bad.‖ Ambiguity aversion bias. This is a
difficult bias to explain; therefore, an example works best. Suppose a researcher asks Mr. Jones
(or you ask your client) his prediction of the outcome of an ambiguous situation: whether a
certain sports team will win its upcoming game. Suppose he estimates a 60 percent chance the
team wins. Further suppose the researcher presents Mr. Jones with a 50 percent / 50 percent slot
machine, which offers no ambiguity, and then asks which bet is preferable. If Mr. Jones is
ambiguity-averse, he will likely choose the slot machine, even if he feels confident about the
team winning. Translating this idea to the investment world, even when investors feel skilful or
knowledgeable, they may not be willing to stake claims on ―ambiguous‖ investments like stocks,
even when they believe they can predict these outcomes based on their own judgment. Advising
Friendly Followers. Advisors to Friendly Follower clients know that Friendly Followers often
overestimate their risk tolerance. Risky trend-following behaviour occurs in part because
Friendly Followers don‘t like situations of ambiguity. They also may convince themselves that
they ―knew it all along,‖ which also increases risk-taking behaviour. Advisors need to handle
Friendly Followers with care because they are likely to say yes to advice that makes sense to
them. Advisors need to guide them to take a hard look at behavioural tendencies to overestimate
their risk tolerance. Because Friendly Follower biases are mainly cognitive, education on the
benefits of portfolio diversification is usually the best course of action. Advisors should
challenge Friendly Follower clients to be introspective and provide data-backed substantiation
for recommendations. Offer education in clear, unambiguous ways so they have the chance to get
it. If advisors take the time, this steady, educational approach will generate greater client loyalty
and adherence to long-term investment plans.

6.3 BACKGROUND OF THE DEVELOPMENT OF BEHAVIOURAL

INVESTOR TYPES

Some advisors do a less than optimal job in their advisory roles, not because they lack technical
knowledge of the markets or because they lack and understanding the strategies of investment
managers or because they lack the systems that can deliver the best methods of portfolio
construction. Rather, these advisors lack an understanding of what is truly important to their
clients and don't know how to communicate and interact in a way that is meaningful and
effective.

This is the first in a series focusing on behavioural investor types. This series is intended to help
advisors strengthen their relationships with their clients by helping them better understanding
clients' financial personalities. Once advisors understand the various investor types at play, they
can adjust their advisory approach for each type.
The first step provides background on how I developed behavioural investor types. To gain an
appreciation for the foundation of the concept of a behavioural investor type, it is essential that
we explore how personality types were developed.

Personality Type Theories

While there are many different theories of personality, what is meant by the term "personality?"
Personality is made up of the characteristic patterns of thoughts, feelings, and Behaviours that
make a person unique. It arises from within the individual and remains fairly consistent
throughout life.

Behavioural investor types are most strongly influenced by the Type Theories; they're a
classification scheme similar to Hippocrates' four original types, the Kiersey types, and the
Myers-Briggs types.

Type theories take us all the way back to ancient Greece, around 400 B.C., to the work of
Hippocrates. The great physician believed that people could be "typed" into four distinct
categories: Melancholic, Sanguine, Choleric, and Phlegmatic after the bodily fluids that were
then thought to influence personality. Each category was also linked to one of the four elements--
fire, air, water, and earth--collectively referred to as the "humours."

Today, Hippocrates' personality types are called Guardians (fact-oriented), Artisans (action-
oriented), Idealists (ideal-oriented), and Rationalists (theory-oriented).

These humours encompass the most basic, underlying characteristics of what we today refer to as
"personality." No one's actions are entirely "rational" or "theory-based," and no one is solely
"action-oriented." Rather, most people are a combination of many of these humours, but in
varying proportions. For example, your spouse may be a rationalist and you may be more action-
oriented, but obviously neither of these characteristics comprises your entire personalities.

This is true of financial personality, as well. Personality type schemes tend to overgeneralize
about personality traits (since people are rarely only one type of person), but they are a useful
tool for organizing one's thoughts about how to compare one type of person versus another.

The Behavioural Investor Type Framework and Behavioural Alpha Similar to the psychological
typing theories that we just read about; behavioural investor types are models for various types
of investors. This framework has four behavioural investor types: the Preserver, the Follower, the
Independent, and the Accumulator. Each of these types will be reviewed in detail in the next
article.

Behavioural investor types are assigned through a process called Behavioural Alpha, which is
covered more deeply in my book, Behavioural Finance and Investor Types.

The process is as follows:

Identify a Client's Active or Passive Traits

Most advisors begin the planning process with a client interview, which consists mainly of a
question and answer session intended to gain an understanding of the objectives, constraints, and
past investing practices of a client. As part of this step, advisors should determine whether a
client is an active or passive investor. In a nutshell, try to figure out if the client has in the past
(or currently) put his or her capital at risk to build wealth.

Administer Risk Tolerance Questionnaire

The next step is to administer a traditional risk tolerance questionnaire to identify which one of
the four behavioural investor type categories the client falls into. The advisor's task at this point
is to determine where the client falls on the risk scale in relation to where the client falls on the
active / passive scale.

Test for Behavioural Biases

The third step in the process is to confirm the expectation that certain behavioural biases will be
associated with unique behavioural investor types. For example, if an investor is passive, and the
risk tolerance questionnaire reveals a very low risk tolerance, the investor is likely to be a
Preserver, and the advisor can test for behavioural biases likely to be associated with Preserver
behavioural investor types. Once these three steps are completed, the identification is made.

6.4 PSYCHOGRAPHIC MODELS OF INVESTOR BEHAVIOUR

Research in behavioural finance is relatively new. Within behavioural finance it is assumed that
information structure and the characteristics of market participants systematically influence
individuals' investment decisions as well as market outcomes. According to behavioural finance,
investor market behaviour derives from psychological principles of decision making to explain
why people buy or sell stocks. The research we have done was on the topic? Factors Influencing
the Individual Investor Behaviour? The behavioural finance revolution in academic finance in
the last several decades is best described as a return to a more eclectic approach to financial
modelling. The earlier neoclassical finance revolution that had swept the finance profession in
the 1960s and 1970s represented the overly-enthusiastic pursuit of only one model. Freed from
the tyranny of just one model, financial research is now making faster progress, and that progress
can be expected to show material benefits. An example of the application of both behavioural
finance and neoclassical finance is discussed: the reform of Social Security and the introduction
of personal accounts. The current state of research from the efficient market and behavioural
perspectives therefore suggests that an inclusive and diverse approach in the choice of theoretical
explanations of the behaviour of financial markets will be the pragmatic response to the
inconclusive results on either side of the debate. While, on the one hand, investors are not
making large sums of money from market anomalies, not many people will disagree that the
stock market bubble burst of 2000 or in 2008 is better explained by hubris and irrational
exuberance grounded in behavioural finance than by the efficient market‘s theory. Behavioural
finance is the paradigm where financial markets are studied using models that are less narrow
than those based on Von Neumann-Morgenstern expected utility theory and arbitrage
assumptions. Specifically, behavioural finance has two building blocks: cognitive psychology
and the limits to arbitrage. Cognitive refers to how people think. There is a huge psychology
literature documenting that people make systematic errors in the way that they think: They are
overconfident, they put too much weight on recent experience, etc. Their preferences may also
create distortions. Behavioural finance uses this body of knowledge rather than taking the
arrogant approach that it should be ignored. Limits to arbitrage refers to predicting in what
circumstances arbitrage forces will be effective, and when they will not be. According to
economic theorists', investors think and behave? rationally? when buying and selling Stocks.
Specifically investors are presumed to use all available information to form rational Economy
Expectations? about the future in determining the value of companies and the general health of
the Economy. Consequently, stock prices should be accurately reflecting fundamental values and
will only move up and down when there is unexpected positive or negative news, respectively.
Thus Economists have concluded that financial markets are stable and efficient, stock prices
follow a "Random walks and the overall economy tends toward general equilibrium? In reality
however, according to Shiller investors do not think and behave rationally. To The contrary,
driven by greed and fear, investors speculate stocks between unrealistic highs and Lows. In other
words, investors mislead be extremes of emotion, subjective thinking and the Whims of the
crowd, consistently form irrational expectation for the future performance of Companies and the
overall economy such that stock prices swing above and below fundamental Values and follow a
somewhat predictable, wave-like path. Behavior of investors is a part of academic discipline
known as "financial-behavioural" which states how feeling and cognitive errors influence
investors and their decision-making. It is long time that the behaviour of individual investors is
interested academias and managers of securities, but not investors because sometimes mentality
of public dominates rationality. Behaviour of people is caused by the involuntary intellectual
interaction in individuals who react to others' behaviour signals.

Behavioural finance attempts to explain and increase understanding of the reasoning patterns of
investors, including the emotional processes involved and the degree to which they influence the
decision-making process. Essentially, behavioural finance attempts to explain the what, why, and
how of finance and investing, from a human perspective. For instance, behavioural finance
studies financial markets as well as providing explanations to many stock market anomalies
(such as the January effect), speculative market bubbles (the recent retail Internet stock craze of
1999), and crashes. There has been considerable debate over the real definition and validity of
behavioural finance since the field itself is still developing and refining itself. This evolutionary
process continues to occur because many scholars have such a diverse and wide range of
academic and professional specialties. In reviewing the literature written on behavioural finance,
our search revealed many different interpretations and meanings of the term. The selection
process for discussing the specific viewpoints and definitions of behavioural finance is based on
the professional background of the scholar. The discussion within this paper was taken from
academic scholars from the behavioural finance school as well as from investment professionals.
In reviewing the literature written on behavioural finance, our search revealed many different
interpretations and meanings of the term. The selection process for discussing the specific
viewpoints and definitions of behavioural finance is based on the professional background of the
scholar. The discussion within this paper was taken from academic scholars from the behavioural
finance school as well as from investment professionals.

Current accepted theories in academic finance are referred to as standard or traditional finance.
The foundation of standard finance is associated with the modern portfolio theory and the
efficient market hypothesis. In 1952, Harry Markowitz created modern portfolio theory while a
doctoral candidate at the University of Chicago. Modern Portfolio Theory (MPT) is a stock or
portfolios expected return, standard deviation, and its correlation with the other stocks or mutual
funds held within the portfolio. With these three concepts, an efficient portfolio can be created
for any group of stocks or bonds. An efficient portfolio is a group of stocks that has the maxi
mum (highest) expected return given the amount of risk assumed, or, on the contrary, contains
the lowest possible risk for a given expected return. Another main theme in standard finance is
known as the Efficient Market Hypothesis (EMH). The efficient market hypothesis states the
premise that all information has already been reflected in a security price or market value, and
that the current price the stock or bond is trading for today is its fair value. Since stocks are
considered to be at their fair value, proponents argue that active traders or portfolio managers
cannot produce superior returns over time that beat the market. Therefore, they believe investors
should just own the \entire market. rather attempting to outperform the market. This premise is
supported by the fact that the S&P 500 stock index beats the overall market approximately 60%
to 80% of the time. Even with the pre-eminence and success of these theories, behavioural
finance has begun to emerge as an alternative to the theories of standard finance Another main
theme in standard finance is known as the Efficient Market Hypothesis (EMH). The efficient
market hypothesis states the premise that all information has already been reflected in a security
price or market value, and that the current price the stock or bond is trading for today is its fair
value. Since stocks are considered to be at their fair value, proponents argue that active traders or
portfolio managers cannot produce superior returns over time that beat the market. Therefore,
they believe investors should just own the \entire market rather attempting to \outperform the
market.. This premise is supported by the fact that the S&P 500 stock index beats the overall
market approximately 60% to 80% of the time. Even with the pre-eminence and success of these
theories, behavioural finance has begun to emerge as an alternative to the theories of standard
finance.

In research published through the late 1990s, the study of investor performance had focused
almost exclusively on the performance of institutional investors, in general, and, more
specifically, equity mutual funds. This was partially a result of data availability (there was
relatively abundant data on mutual fund returns and no data on individual investors). In addition,
researchers were searching for evidence superior investors to test the central prediction of the
efficient market‘s hypothesis: investors are unable to earn superior returns (at least after a
reasonable accounting for opportunity and transaction costs). While the study of institutional
investor performance remains an active research area, several studies provide intriguing evidence
that some institutions are able to earn superior returns. Grinblatt and Titman (1989) and Daniel,
Grinblatt, Titman, and While the study of institutional investor performance remains an active
research area, several studies provide intriguing evidence that some institutions are able to earn
superior returns. Grinblatt and Titman and Daniel, Grinblatt, Titman, and Wermers study the
quarterly holdings of mutual funds. Grinblatt and Titman concludes superior performance may in
fact exist. for some mutual funds. DGTW, use a much larger sample and time period and
document as a group, the funds showed some selection ability. In these studies, the stock
selection ability of fund managers generates strong before-fee returns, but is insufficient to cover
the fees funds charge. In financial markets, there is an adding up constraint. For every buy, there
is a sell.

If one investor beats the market, someone else must underperform. Collectively, we must earn
the market return before costs. The presence of exceptional investors dictates the need for subpar
investors. With some notable exceptions, which we describe at the end of this section, the
evidence indicates that individual investors are subpar investors. To preview our conclusions, the
aggregate (or average) performance of individual investors is poor. A big part of the performance
penalty borne by individual investors can be traced to transaction costs (e.g., commissions and
bid-ask spread). However, Transaction costs are not the whole story. Individual investors also
seem to lose money on their trades before costs. To preview our conclusions, the aggregate (or
average) performance of individual investors is poor. A big part of the performance penalty
borne by individual investors can be traced to transaction costs (e.g., commissions and bid-ask
spread). However, Transaction costs are not the whole story. Individual investors also seem to
lose money on their trades before costs. The one caveat to this general finding is the intriguing
evidence that stocks heavily bought by individuals over short horizons in the U.S. (e.g., a day or
week) go on to earn strong returns in the subsequent week, while stocks heavily sold earn poor
returns. It should be noted that the short-run return predictability and the poor performance of
individual investors are easily reconciled, as the average holding period for individual investors
is much longer than a few weeks. For example, Barber and Odean document that the annual
turnover rate at a U.S. discount brokerage is about 75% annually, which translates into an
average holding period of 16 months. (The average holding period for the stocks in a portfolio is
equal to the reciprocal of the portfolios' turnover rate.) Thus, short-term gains easily could be
offset by long-term losses, which are consistent with much of the evidence we summarize in this
section. It should be noted that all of the evidence we discuss in this section focuses on pre-tax
returns. To our knowledge, there is no detailed evidence on the after-tax returns earned by
individual investors because no existing dataset contains the account-level tax liabilities incurred
on dividends and realized capital gains. Nonetheless, we observe that trading generally hurts
performance. With some exceptions (e.g., trading to harvest capital losses), it is safe to assume
that ceteris paribus investors who trade actively in taxable accounts will earn lower after-tax
returns than buy-and-hold investors. Thus, when trading shortfalls can be traced to high turnover
rates, it is likely that taxes will only exacerbate the performance penalty from trading.

Most financial theory is based on the idea that everyone takes careful account of all available
information before making investment decisions. But there is much evidence that is not the case.
Behavioural finance, a study of the markets that draws on psychology, is throwing more light on
why people buy or sell the stocks they do - and even why they do not buy stocks at all. This
research on investor behaviour helps to explain the various 'market anomalies' that challenge
standard theory. It is emerging from the academic world and beginning to be used in money
management. There are some factors for influencing investor behaviour. Private clients can
greatly benefit from the application of behavioural finance to their unique situations. Because
behavioural finance is a relatively new concept in application to individual investors, investment
advisors may feel reluctant to accept its validity. Moreover, advisors may not feel comfortable
asking their clients psychological or behavioural questions to ascertain biases, especially at the
beginning of the advisory relationship. One of the objectives of this book is to position
behavioural finance as a more mainstream aspect of the wealth management relationship, for
both advisors and clients. As behavioural finance is increasingly adopted by practitioners, clients
will begin to see the benefits. There is no doubt that an understanding of how investor
psychology impacts investment outcomes will generate in- sights that benefit the advisory
relationship.

By the early twentieth century, neoclassical economics had largely displaced psychology as an
influence in economic discourse. In the 1930s and 1950s, however, a number of important events
laid the groundwork for the renaissance of behavioural economics. First, the growing field of
experimental economics examined theories of individual choice, questioning the theoretical
underpinnings of Homo economicus. Some very useful early experiments generated insights that
would later inspire key elements of contemporary behavioural finance. Real investors are
influenced by where they live and work. They tend to hold stocks of companies close to where
they live and invest heavily in the stock of their employer. These Behaviours lead to an
investment portfolio far from the market portfolio proscribed by the CAPM and arguably expose
investors to unnecessarily high levels of idiosyncratic risk. Psychographic Models Used in
Behavioural Finance Psychographic Models Used in Behavioural Finance Psychographic models
are designed to classify individuals according to certain characteristics, tendencies, or
Behaviours. Psychographic classifications are particularly relevant with regard to individual
strategy and risk tolerance. An investor‘s background and past experiences can play a significant
role in decisions made during the asset allocation process. If investors fitting specific
psychographic profiles are more likely to exhibit specific investor biases, then practitioners can
attempt to recognize the relevant tell-tale behavioural tendencies before investment decisions are
made. Hopefully, resulting considerations would yield better investment outcomes. Practical
Application of Behavioural Finance Almost anyone who knows from experience the challenge of
wealth management also knows the potential for less-than-rational decision making in finance.
Therefore, many private-client advisors, as well as sophisticated investors, have an incentive to
learn coping mechanisms that might curb such systematic miscalculations. The overview of
behavioural finance research suggests that this growing field is ideally positioned to assist these
real-world economic actors. However, only a few of the biases identified in behavioural finance
research today are common considerations impacting asset allocation. Why does behavioural
finance remain underutilized in the mainstream of wealth management? First, because no one has
ever contextualized it in an appropriately user-friendly manner. Researchers have worked hard to
reveal behavioural biases, which are certainly usable; but practitioners would benefit not merely
from an academic discourse on discovered biases, but also from lessons on how to go about
detecting biases themselves and advising their clients on how best to deal with these biases.
Second, once an investor‘s behavioural biases have been identified, advisors lack pragmatic
guidelines for tailoring the asset allocation process to reflect the specific bias. This book intends
not only to familiarize financial advisors and investors with 20 of the major biases unearthed in
behavioural finance research, but to do so in a lexicon and format that is applicable to asset
allocation. This chapter establishes a knowledge base that serves in the following chapters,
wherein each of 20 specific biases is reviewed in detail. The central question for advisors when
applying behavioural finance biases to the asset allocation decision is: When should advisors
attempt to moderate, or counteract, biased client reasoning to accommodate a predetermined
asset allocation? Conversely, when should advisors adapt asset allocation recommendations to
help biased clients feel more comfortable with their portfolios? Furthermore, how extensively
should the moderate-or-adapt objective factor into portfolio design? Financial-behavioural
theories There is huge psychology literature which proves with evidences that people commit
systematic errors in their thought. They always decide easily, have high confidence and value
current experience (agency), separate decision making which must be merged (intellectual
accounting), mistake in individual problems (frame), tendency for slow changes (conservatism)
and their regulations prevent losses and meet achievements. Financial behavioural uses models
that in them some next factors are rational because of regulations or wrong beliefs. In the case of
regulations, it is assumed that people oppose losses, because they are bas Bayesians (statistical
methods, probability, guess), there are wrong beliefs. Most of the basic financial-behavioural
theories are concerned with a series of new concepts called "limited rationality", a term which is
associated with Herbkst Simon. This term relates to cognitive limitations in decision making. As
a result, behaviour of human is built based on simplified methods and innovations.

Slavy on risk taking behaviour of investor. He found that human had limitations as a processor of
information and showed some judgment prejudices which guide people in the direction of extra
information. Individuals are inclined to show extreme reaction to information. Shiller presented
some key ideas in financial-behavioural including landscape theory, regret theory, stabilization,
extreme and less sensitivity. Landscape theory by Comnan and Torsky showed that people give
different answers to same situation depending loss theory. Generally, investors in loss landscape
are anxious and are consent with likely achievements. Sometimes they face certain profit. Most
of the investors escape from risk but in encountering certain loss they become risk takers.
According to Conmon theory, investors hate losses. This hatred of losses means that they take
more risks to avoid losses and increase gains. Hatred of losses explains this essential notion that
although investors are optimists about predictions (this stock is certain), but they are inclined to
lose less money than earn. Shiller presented some key ideas in financial-behavioural including
landscape theory, regret theory, stabilization, extreme and less sensitivity. Landscape theory by
Comnan and Torsky showed that people give different answers to same situation depending loss
theory. Generally, investors in loss landscape are anxious and are consent with likely
achievements. Sometimes they face certain profit. Most of the investors escape from risk but in
encountering certain loss they become risk takers. According to Conmon theory, investors hate
losses. This hatred of losses means that they take more risks to avoid losses and increase gains.
Hatred of losses explains this essential notion that although investors are optimists about
predictions (this stock is certain), but they are inclined to lose less money than earn. Regret
theory is another theory which deals with feelings and reacts to judgment error. For example,
investors avoid selling valueless stocks to prevent regret from bad investment and regret from
loss. Shame may help the tendency of not selling investment that some researchers put forward
this theory investors follow common wisdom to avoid regret when it was proved that they follow
wrong decisions. Most investors find that buying public shares and rationalizing it for coming
down is easy because others have that share and think of it. Buying share with a bad imagination
is more difficult than rationalizing it.

6.5 EARLY PSYCHOGRAPHIC MODELS

Plog‘s model was published in 1974 as an article titled, ―Why Destination Areas Rise and Fall in
Popularity,‖ in the Cornell Hotel and Restaurant Administration Quarterly. The journal article
was a version of a 1972 conference presentation at the Southern California Chapter of the Travel
Research Association (now the Travel and Tourism Research Association). However, the core
concepts in the model originated in 1967 as part of a consulting project assigned to Plog‘s
market-research company, Behaviour Science Corporations (also known as BASICO). Sixteen
domestic and foreign airlines, airframe manufacturers, and various magazines sponsored Plog‘s
research in order to understand the psychology of certain segments of travellers. With the
introduction of commercial jet airplanes, it was estimated that new capacity for the airlines was
about to develop much more quickly than the previously expected growth in air travel.
Therefore, the purpose of the project was to visualize what companies could do to broaden the
base of the travel market in order to turn more non-flyers into flyers. The proprietary study
consisted of a qualitative phase based on face-to-face, 2-hour personal interviews with flyers and
non-flyers, followed by a quantitative test using a national sample of 1,600 in-home surveys. The
result from that research, as well as other related projects Plog conducted, was the delineation of
a personality-based, psychographic typology of travellers. In Plog‘s psychographic typology,
tourists are classified based on personality traits along a continuum, with allocentric on one end
of the spectrum and psychocentric on the other. Allocentric, who Plog also called venturers, are
individuals who feel that what happens to them is largely under their own control. They are thus
comfortable making choices that involve some degree of variation, adventure, or risk. The term
allocentric comes from the root words allow (varied in form) and centric, meaning these
individuals focus their interest patterns on varied activities. Conversely, psychocentric (or
dependable) believe that what happens to them is largely beyond their control. They thus try to
make safe, consistent choices by preferring popular things. The term psychocentric comes from
the root psyche (self) and centric, meaning these individuals centre their thoughts or concerns on
the small problems of daily life. In the middle of the continuum, mid-centric are those travellers
that have a balanced combination of both psychographic traits. In addition, tourists might lean to
one direction or the other on the continuum, either as near-allocentric or near-psychocentric, but
without falling completely into the extreme types. According to Plog‘s model, destinations
typically move through the allocentric-psychocentric continuum, appealing to the various tourist
types. The first tourists to ―discover‖ a new place are allocentric. These allocentric enjoy visiting
unusual destinations, so they prefer no touristy, novel locations that are unfamiliar to most
people. Allocentric start talking to other people about the vacations they had, marketing by word-
of-mouth, and recommending the exotic place they visited. This leads to a larger number of
people traveling to the still underdeveloped tourism area, which is then being visited by near-
allocentric. After some time, as the destination becomes more popular among travellers, more
tourist infrastructure is provided and marketing and promotion activities increase. Mid-centric
begin visiting the destination, and the continuing increase of tourist arrivals stimulates further
development of hotels, restaurants, shops, scheduled tours, and other tourist-oriented business
that charge higher prices. Eventually, allocentric are turned off by the destination because it has
lost its sense of novelty and unique atmosphere, though some near-allocentric keep visiting the
area. The destination reaches a point in which it is widely popular with a well-established image
that attracts mass tourism. In Plog‘s model, as the area becomes touristy and commercialized, the
number of near-allocentric visiting decreases, but the destination begins to appeal to more near-
psychocentric. The area eventually loses positioning in the tourism market, the total tourist
arrivals decrease gradually over the years, and the destination moves toward the psychocentric
end of the continuum. Psychocentric then become the main type of visitors, since they prefer
destinations that are well known with plenty of the services, facilities, and activities that they are
familiar with at their places of residence. However, because psychocentric constitute a small
proportion of the overall tourism market, the destination has fewer visitors than before, losing the
popularity it once enjoyed. According to Plog, a consequence of this is a price reduction to
remain competitive against competitors, contributing to the decline and demise of the
destination.

For years, tourism and marketing scholars have empirically studied the validity of Plog‘s
concepts. Segmentation studies have assessed the psychological dimensions of the typology,
corroborating the identification of groups with characteristics corresponding to Plog´s
psychographic continuum. Other studies have instead focused on testing the model‘s ability to
predict tourists‘ destination choice as suggested by Plog. These investigations have provided
varying degrees of support, yielding inconclusive results. According to some studies reported in
various academic publications, allocentric are more prone to choose destinations classified as
novel or non-touristy, mid-centric tend to prefer destinations in a moderate level of tourism
development, and psychocentric are more likely to choose destinations that are well positioned
and heavily commercialized. For example, one study showed that allocentric tourists have a
higher preference for destinations such as a primitive South Pacific island, and psychocentric
tourists have a higher preference for places such as major amusement parks. However, other
research failed to corroborate Plog‘s psychographic traits as predictors of destination choice.
These findings showed no correlation between allocentric psychocentric and the type of
destinations preferred by participants. In a number of rejoinders and commentary articles, Plog
argued that the reason for conflicting results was that studies in which no support was found
failed to employ the original scale he developed to measure allocentric psychocentric. He also
noted issues in the methodological designs of those studies.

Plog‘s model is considered seminal and has been widely cited in the tourism literature. Because
of its intuitive appeal and simplicity, the model is found in most tourism and hospitality
textbooks worldwide. Even though the concept of allocentric psychocentric is not exempt from
criticism by scholars in the discipline, Plog‘s model is still being used as conceptual framework
and is still subject to academic scrutiny, as attested in recent journal publications. After more
than 40 years, the fundamental implications of Plog‘s model seem to remain valid. As Plog
notes, destinations that become successful in the tourism market also carry with them the seed of
their own potential destruction, because such places tend to become more commercialized,
overdeveloped, and eventually lose the qualities that originally attracted tourists. Thus,
destinations‘ managers must not let unfocused development trample the beautiful areas that
appealed to tourists originally.

6.6 THE BEHAVIOURAL ALPHA PROCESS

Figure 6.2: Behavioural Alpha

Behavioural finance is a relatively new field in economics that has become a ―hot topic‖ for
investment professionals. For example, a large number of conferences oriented topic‖ for
investment professionals. For example, a large number of conferences oriented toward investors
have recently featured sessions on behavioural finance. However, because the field is so new,
most professionals responsible for large portfolios were not exposed to the principles of
behavioural finance in their college curricula and these principles have significant practical
implications for investment management. Consequently, this article provides an overview of
behavioural finance. The conclusion presents some insights from behavioural finance that
specifically apply to the problem plan sponsors face when evaluating and selecting active equity
managers not only how many people want their product, but also how many would actually be
willing and able to buy it.
Behavioural finance has recently become a subject of significant interest to investors. Because it
is a relatively new and evolving field in economics and consequently not well Because it is a
relatively new and evolving field in economics and consequently not well defined, a legitimate
question is: ―What exactly is behavioural finance?‖ I personally describe behavioural finance in
the following ways.

All economic models make simplifying assumptions about both market conditions and the
behaviour of market participants. Sometimes the simplifying assumptions and the behaviour of
market participants. Sometimes the simplifying assumptions underlying the model are explicitly
stated and sometimes the assumptions are implicit – the latter is often the case regarding the
behavioural assumptions underlying the model. To illustrate, consider the efficient market
hypothesis (EMH), an economic model of considerable importance to investors.

The first behavioural assumption is frequently stated as investors are ―rational expectations
wealth maximisers‖ – this means that investors form unbiased expectations of the future wealth
maximisers‖ – this means that investors form unbiased expectations of the future and given these
expectations, they buy and sell in the securities markets at prices which they believe will
maximize the future value of their portfolios. Behavioural finance questions whether the
behavioural assumptions underlying the EMH are true. For example, consider the assumption
that individuals always act in their economic self-interest. Suppose you are having dinner at an
out-of-town restaurant and it is extremely unlikely that you will ever return to this restaurant. Do
you leave a tip? 3 Most people do, but in this case leaving a tip decreases, rather than increases
one‘s wealth, and because you won‘t be returning to this restaurant there are (presumably) no
―costs‖ associated with not leaving a tip. In this case leaving a tip violates the rational
expectations and self-interest assumptions. More germane to the EMH, consider ―social
investing‖ such as arbitrarily deciding not to invest in tobacco stocks or deciding to overweight
environmentally clean industries, etc. Such behaviour is not consistent with pure wealth
maximization, if for no other reason than opportunities for forming better-diversified portfolios
are foregone. Why investors might engage in non-wealth maximizing behaviour, and what are
the implications of such behaviour for security pricing, are areas of inquiry in behavioural
finance. Another aspect of behavioural finance concerns how investors form expectations
regarding the future and how these expectations are transformed into security prices. Researchers
in cognitive psychology and the decision sciences have documented that, under certain
conditions, people systematically make errors in judgement or mental mistakes. These mental
mistakes can cause investors to form biased expectations regarding the future that, in turn, can
cause securities to be mispriced. By considering that investors may not always act in a wealth
maximizing manner and that investors may have biased expectations, behavioural finance may
be able to explain some of the anomalies to the EMH that have been reported in the finance
literature. Anomalous returns such as those associated with ―value‖ stocks, earnings surprises,
short-term momentum and long-term price reversals are fertile ground for researchers in
behavioural finance.

Alpha can be defined as the difference between a portfolio‘s risk-adjusted return and the return
for an appropriate benchmark portfolio. Most active investors are trying to the return for an
appropriate benchmark portfolio. Most active investors are trying to maximize alpha. In contrast,
passive investors generally accept the EMH and merely try to match the benchmark return. In the
process of forming portfolios, active investors buy and sell securities based on their expectations
about the future – typically expectations regarding the future profitability and risk characteristics
of the firm issuing the securities. For example, a company‘s stock price may be largely
determined by the consensus expectation (the market‘s expectation) regarding the company‘s
future earnings. (From this point forward I will refer to the consensus of investors, as reflected in
current prices, as the ―market.‖) If today‘s stock price is based on the market‘s expectation
regarding the future, then in order to predict tomorrow‘s stock price change, one must have
better expectations about the future than the market. In this sense, the mother of all alphas is the
ability to form expectations that are better than the market‘s expectations. Consequently, for an
active investment manager to claim that he can generate above normal returns (a positive alpha)
in the future, he must argue that, in some manner, his expectations regarding the future are better
than the market‘s expectations.

It is important to note that if a particular investor has superior information, this does not
necessarily imply that the market‘s expectations are biased – the market cannot not necessarily
imply that the market‘s expectations are biased – the market cannot incorporate information it
does not have into its expectations in either a biased or unbiased fashion. Rather, in this case, the
market‘s expectations are simply not as good Titman with respect to long-term price reversals,
see DeBondt and Thaler as they would be if the market had the private information. The key
question to consider, however, is: What are the probabilities of any individual investor or
investment manager consistently gathering superior, private information when so many other
investors are trying to do the same thing? A similar point can be made with respect to processing
information. If the market does not know the best way to process information, it may still form
unbiased expectations that are simply not as good as they might be if the market knew the better
method for processing information. To illustrate, suppose a three-factor model generates returns,
but the market uses a two-factor model in processing information. In this case the market‘s
expectations might be unbiased, but not as good as the expectations of an individual investor
using the correct three-factor model. Again, the key question to ask is: What are the probabilities
of any single investor or investment manager discovering the true factor model when so many
other investors are trying to do the same thing? There is a third possible source of alpha.
Behavioural Biases: Scholars in psychology and the decision making sciences have documented
that in some circumstances investors do not try to maximize wealth and in other circumstances
investors make systematic mental mistakes. Both of these cases can result in mispriced securities
and both are the result of behavioural biases. The conditions under which behavioural biases
occur and how they might affect security pricing are discussed in the next section. For now,
simply note that there are three possible sources of alpha: Superior (private) information, better
methods for processing information and behavioural biases.

As mentioned earlier I generally think of investors who try to generate superior information as
fundamental or traditional managers, and the majority of active investors information as
fundamental or traditional managers, and the majority of active investors are in this group. For
example, almost all of Wall Street‘s research represents an attempt to generate superior
information. I also tend to think of investors who try to develop better procedures (better models)
for processing information as quantitative managers. Behavioural managers try to exploit
situations where securities are mispriced by the market because of behavioural factors. Of course
there is overlap between all three types of managers.

There are many examples of non-wealth-maximizing behaviour. Agency problems represent one
broad class of this type of behaviour. "Window dressing" at the end of a represent one broad
class of this type of behaviour. "Window dressing" at the end of a quarter or year is an example.
Selling stocks just before the end of a quarter which have been big losers and buying stocks that
have been big winners will not raise the portfolio's return and the associated transaction costs of
trading may actually lower the return. However, the portfolio manager may have an easier time
at the quarterly client meeting if highly visible "losers" are not in the portfolio at the end of the
quarter. The concept of regret can cause another class of problems that result in non-wealth
maximizing behaviour. Kahnamen and Tversky's prospect theory formally addresses the fact that
for most investors the pain associated with losses exceeds the pleasure of gains. One
manifestation of this is the fact that investors tend to hold onto their loser too long and tend to
sell their winners too soon. People also suffer from a lack of self-control, which can lead to non-
wealth maximizing behaviour. Statman shows that dollar cost averaging is sub-optimal with
respect to maximizing wealth. Nevertheless, dollar cost averaging is used by many investors who
apparently lack the discipline (and fortitude) to invest all of their wealth in risky assets at one
point in time. However, for non-wealth maximizing behaviour to result in mispriced securities,
the market as a whole must engage in this type of behaviour, as opposed to isolated investors.
Further, for an investment strategy to be able to exploit such miss pricings, the market must
engage in non-wealth maximizing behaviour in a systematic fashion. These two conditions are
not likely to be met. On the other hand, heuristic biases can cause the majority of investors to
make systematic mental errors. These mental mistakes, in turn, cause the market to have biased
expectations and, as a result, misprice securities. Thus, heuristic biases are potentially
exploitable. Heuristics, Heuristic Biases and Optical Illusions Heuristics are rules of thumb, or
mental shortcuts, the human brain uses to quickly solve complex problems. For example, a
billiard player does not solve the trigonometric and differential equations needed to determine at
what angle and speed to hit the cue ball in order to put another ball in the correct pocket. Rather,
a billiard player uses rules of thumb and mental shortcuts that allow him to play the game, even
though he may not understand the mathematics. Thus, heuristics are very useful, powerful
problem solving tools. However, when used in the wrong situation, heuristics can cause people
to make systematic mental mistakes. Optical illusions are a simple way of illustrating heuristic
biases. Vision is a very complex problem for the brain to solve. The eye generates a tremendous
amount of information which must be quickly analysed and interpreted by the brain to form the
images which we "see." Over many thousands of years the human brain has developed mental
shortcuts for interpreting vision data and these vision heuristics typically work quite well.
However, when these mental shortcuts for solving vision problems are used in the wrong
context, a heuristic bias results in an optical illusion.
The answer to this question (assuming the respondent is human and not cheating) is the vertical
straight line on the left "looks" longer. In fact, the two lines are drawn to be the vertical straight
line on the left "looks" longer. In fact, the two lines are drawn to be exactly the same length. The
optical illusion results from the brain using heuristics for solving three-dimensional vision
problems when the lines are drawn on a two dimensional surface. What "tricks" the brain into
thinking it is receiving three dimensional data from the eye are the arrowheads drawn on the end
of each vertical line segment. The reverse arrowheads drawn on the left line segment give the
illusion of depth and the line appears to be farther away from the eye than it really is. The regular
arrowheads on the right line also give the illusion of depth, but in this case the brain is tricked
into thinking the line is closer to the eye that it actually is. The brain uses the following heuristic
for converting three-dimensional vision information: Objects that are farther away are bigger
than they appear and objects that are close are smaller than they appear. (For example, a house
observed from a long distance creates a very small image on your eye's retina, but you still know
the house is a large object.) Thus, while both vertical line segments create the same image on
your eye's retina, your brain converts this information so that the vertical line on the left, which
appears to be farther away, is longer than the vertical line on the right, which appears to be
closer. An interesting, and important, aspect of heuristic biases is that they are very difficult to
overcome. For example, now that you understand what causes the optical illusion, look again at
the two vertical line segments. Which vertical line appears longer? If you are typical, the line on
the left still appears longer, even though you know the two line segments are the same length and
you understand what causes the optical illusion. Heuristics, which have evolved over thousands
of years, can be thought of as being part of the brain's hardware. Unlike software, these mental
shortcuts are such useful and powerful problem solving tools they simply cannot be
reprogrammed. However, when a heuristic is used in the wrong situation (when the wrong rule-
of-thumb is used to solve a problem), a heuristic bias causes the person to make a mental
mistake.

6.7 TOP-DOWN APPROACH

Fishermen often use the expression ―to set the hook‖ and that is what I hope to do for
Behavioural Finance and Investor Types. Michael Pompian hope to do for Behavioural Finance
and Investor Types. Michael Pompian graciously asked me if I would write this Foreword and, in
a blink, I agreed. Why? Because the investing pond is full of investors who need to take the hook
Michael is presenting here. You are about to read and solve a mystery of sorts. It lifts the curtain
on what lurks behind investment choices—improperly formulated choices that so often derail
expectations. This book takes the often tedious and proverbial ―scraping and sanding before
painting‖ and makes it the intriguing cornerstone of investing. Ben Franklin, always insightful
about visionaries, wrote in the 1769 Farmers‘ Almanac, ―There are three things extremely hard:
steel, a diamond, and to know one‘s self.‖ To make sound choices, you must know yourself in
order to know what decisions your personality can withstand when building and implementing
an investment policy and process. You must know yourself, or the organization for which you
serve, well enough to convey the beliefs, preferences, and biases about those whom you have
chosen to advise you on investment decisions. This includes brokers, consultants, investment
advisors, and so on. To be unable to do so is a prescription for inappropriate asset selection and
portfolio composition—a far too common outcome. This is true from both an expected return
and an expected risk perspective. It is hard to imagine how much effort and knowledge was
required to create this book. To focus effectively on what drives different types of personalities
and match those personalities with an appropriate, fitted investing solution requires a long and
patient observer and practitioner, like Michael Pompian. After many years in the consulting
business, Michael has honed a deep psychological understanding of investor personalities, and
accurately characterizes and classifies them into types. He is a rare breed with his deep
knowledge of what drives investors and what drives portfolios—an elementary alignment that is
the missing ingredient for the vast majority of investors—both individuals and institutions.
Behavioural Finance is about the psychology that drives financial or investment choices in an
uncertain future environment. Behavioural finance has been mostly under the wing of the
academic community whose research has become prolific enough to offer a source of meaning
and direction for has become prolific enough to offer a source of meaning and direction for
investors. Twenty years ago behavioural finance was mostly a nebulous, certainly unrequited,
and scattered collection of research by those who dared to tamper with classical views of finance.
Recognizing the overwhelming role of psychology in decision making has forever changed the
role of individuals and groups in making investment choices! Way back in the 1930s, John
Maynard Keynes wrote of ―animal spirits,‖ a now bantered catch-all for our behaviour as
investors. Then, in 2002, Daniel Kahneman put behavioural finance front and centre by winning
the Nobel Prize in Economics. Kahneman is a psychologist and points out that he has never
taken a course in economics. Since that event, interest in behavioural finance has catapulted to
become a source of rationale for investors‘ decisions. Michael has done yeoman‘s service in
taking years of academic research and his own practitioner insights to illuminate the mandatory
need to understand the virtues of the physiological implications of choice. He is bringing these
essential findings to the forefront of untangling everyday investment thinking with the clear
mandate of implementing sound investment decisions. His combined knowledge of the inherent
drivers of investor behaviour, and years of careful observation, clearly illuminates that shoe
sizes, so to speak, vary a great deal. He has effectively ―typed‖ investors—be they individuals or
institutions—as a way to narrow and clarify what choices would be best for them. This ―sanding
and scraping‖ provides compatibility between investor expectations and ultimate results. So, who
should read this book? If we start with every investor and every consultant or broker, the answer
is all of them. The psychological insights into personality types developed from the building
blocks of beliefs, preferences, and behavioural biases are now essential for developing
appropriate recommendations. All the agents involved in this process now realize what Ben
Franklin described as one of the hardest things in life—to know one‘s self. Portfolios must
reflect both the personality of their clients and their needs in order to create a thoughtful, sound
investment program. Otherwise, investors and their advisors will join the majority of those who
do not have the benefit of the practical blueprint that Behavioural Finance and Investment Types
so effectively provides.

Although it might seem to be an impossible task to try to categorize people by their Behaviours,
many thoughtful people have tried to do so. Many of by their Behaviours, many thoughtful
people have tried to do so. Many of the people who have tried to do this are quite well known—
Freud, for example—while others are quite unknown. Several chapters of this book are devoted
to an historical view of personality theory and the research that has gone into this subject. After
reading this work, what one quickly realizes is that the study of personality is an imperfect
science. Unlike hard sciences like physics and chemistry, which have elegant mathematical
formulas for explaining naturally occurring phenomena, social science is less precise. This book
is certainly closer to being imprecise than it is to being precise based on this fundamental idea.
The ideas in the book are an attempt to categorize investors by their behaviour.
If we were to implement this algorithm in a programming language and run it on a variety of
examples, we would discover that for sufficiently large inputs — typically a few thousand
elements — the program will terminate due to a stack overflow. This problem is not, strictly
speaking, an error in the algorithm, but instead is a reflection of the fact that it uses the
machine‘s runtime stack inefficiently. Using the analysis tools, it is possible to show that this
algorithm‘s stack usage is linear in the size of the array. Because the runtime stack is usually
much smaller than the total memory available, we usually would like the stack usage to be
bounded by a slow-growing function of the size of the input — a logarithmic function, for
example. Thus, if we were to do the analysis prior to implementing the algorithm, we could
uncover the inefficiency earlier in the process. Having uncovered an inefficiency, we would like
to eliminate it. The runtime stack is used when performing function calls. Specifically, each time
a function call is made, information is placed onto the stack. When the function returns, this
information is removed. As a result, when an algorithm uses the runtime stack inefficiently, the
culprit is almost always recursion. This in not to say that recursion always uses the stack
inefficiently — indeed, we will see many efficient recursive algorithms in this book. The
analysis tools will help us to determine when recursion is or is not used efficiently. For now,
however, we will focus on removing the recursion. It turns out that while recursion is the most
obvious way to implement an algorithm designed using the top-down approach, it is by no means
the only way. One alternative is to implement the top-down solution in a bottom-up way. The
top-down solution for Insert Sort is to reduce a large instance to a smaller instance and an
instance of Insert by first sorting the smaller instance, then applying Insert. We can apply this
same idea in a bottom-up fashion by observing that the first element of any nonempty array is
necessarily sorted, then extending the sorted portion of the array by applying Insert. In other
words, we repeatedly apply Insert to A[1..2], A[1..3], . . ., A[1..n]. This can be done using a loop.
The bottom-up implementation works well for Insert Sort because the recursive call is essentially
the first step of the computation. However, the recursive call in Recursive Insert is necessarily
the last step. Fortunately, there is a fairly straightforward way of removing the recursion from
this type of algorithm, as well. When a reduction has the form that the solution to the simpler
problem solves the original problem, we call this reduction a transformation. When we transform
a large instance to a smaller instance of the same problem, the natural recursive algorithm is tail
recursive, meaning that the last step is a recursive call.
One of the major factors influencing the performance of an algorithm is the way the data items it
manipulates are organized. For this reason, it is essential that we include data structures in our
study of algorithms. The themes that we have discussed up to this point all apply to data
structures, but in a somewhat different way. For example, a specification of a data structure must
certainly include preconditions and postconditions for the operations on the structure. In
addition, the specification must in some way describe the information represented by the
structure, and how operations on the structure affect that information. As a result, proofs of
correctness must take into account this additional detail. While the analysis techniques apply
directly to operations on data structures, it will be necessary to introduce a new technique that
analyses sequences of operations on a data structure. Furthermore, even the language we are
using to express algorithms will need to be enriched in order to allow design and analysis of data
structures

6.8 BEHAVIOURAL INVESTOR TYPES

This is the second article in a series focusing on behavioural investor types and intended to help
advisors strengthen their relationships with their clients by helping them better understanding
clients' financial personalities. Once advisors understand the various investor types at play, they
can adjust their advisory approach for each type.

There are four behavioural investor types. We'll publish case studies over the next several
months.

6.8.1 Preserver

A preserver is an investor who places a great deal of emphasis on financial security and
preserving wealth, rather than taking risks to grow wealth. Such investors are guardians of their
assets, and they take losses very seriously. Preservers are often deliberate in their decisions and
sometimes have difficulty taking action with their investments, out of concern that they may
make the wrong decision or take on too much risk. They instead prefer to avoid making
decisions and sticking to the status quo. Preservers often obsess over short-term performance in
both up and down markets (but mostly down markets), and they also tend to worry about losing
what they had previously gained. This behaviour is consistent with how preservers have
approached their work and their personal lives--in a deliberate and cautious way.
Older investors often behave in a way that's aligned with the preserver behavioural investor type.
This is natural. As we age, certainty of cash flow becomes paramount. As such, it is common to
find preservers focusing their wealth on taking care of their family members and future
generations, especially funding life-enhancing experiences such as education and home buying.
Because the focus is on financial security, Preserver biases tend to be dominated by emotion
(relating to how they feel) rather than focusing on cognitive aspects (relating to how they think).

Wealth level may also influence preserver behaviour. Although not always the case, many
preservers that have gained wealth want to preserve it, and they therefore change their attitude
toward risk after gaining wealth. This is especially true when an investor has been through a
crisis that threatened his or her wealth (like in 2008, when the S&P 500 dropped 37% for the
year). The emotional biases that can affect preservers‘ ability to attain their financial goals are
loss aversion, status quo, and endowment biases. Preservers can also display certain cognitive
biases that relate to the same orientation, namely anchoring and mental accounting.

6.8.2 Follower

A follower investor is passive and often lacks interest in and/or has little aptitude for money or
investing. Furthermore, Follower investors typically do not have their own ideas about investing.
Rather, they may follow the lead of their friends and colleagues--or whatever general investing
fad is popular--to make their investment decisions. Often their decision-making process is
without regard to a long-term plan. They sometimes trick themselves into thinking they are adept
or talented in the investment realm when an investment decision works out, which can lead to
unwarranted risk seeking behaviour. Since they don't have their own ideas about investing,
Followers also may react differently when presented more than once with the same investment
proposal; that is, the way something is presented (framed) can make them think and act
differently. They also may regret not taking part in the latest investment fad, and may end up
investing at exactly the wrong time, when valuations are the highest.

One of the key challenges of working with followers is teaching them how to refrain from
overestimating their risk tolerance. An investment may appear so compelling that they jump in
without considering the risks. Advisors need to be careful not to suggest too many "hot"
investment ideas; followers will likely want to pursue all of them. Some followers don't like, or
even fear, the task of investing, and many put off making investment decisions without
professional advice; the result is that they maintain, often by default, high cash balances.
Followers generally comply with professional advice when they get it, and they try to educate
themselves financially.

Followers' biases tend to be cognitive, relating well to how they think, rather than emotional,
relating to how they feel. Biases of followers are recency, hindsight, regret aversion, framing,
and cognitive dissonance.

6.8.3 Independent

An independent investor has original ideas about investing and likes to get involved in the
investment process. Unlike followers, independents are quite engaged in the financial markets,
and they may have unconventional views on investing. This "contrarian" mindset, however, may
cause independents not to believe in following a long-term investment plan. With that said, many
independents can and do stick to an investment plan to accomplish their financial goals. At their
essence, independents are analytical, critical thinkers who make many of their decisions based on
logic and their own gut instinct. They are willing to take risks and act decisively when called
upon to do so. Independents can accomplish tasks when they put their minds to it; they tend to be
thinkers and doers as opposed to followers and dreamers.

Unfortunately, some are prone to biases that can torpedo their ability to reach goals. For
example, they may act too quickly, without learning as much as they can about their investments
before making them. For example, they may mistake reading an article in a business news
publication for doing original research. In their half-ready, full-on pursuit of profits, they may
leave some important stones unturned that could trip them up down the road. Independents' risk
tolerance is relatively high, and so is their ability to understand risk. Independents are realistic in
understanding that risky assets can, and do, go down. However, when their investments go down
they don't like to admit that they were wrong, or that they made a mistake (sound familiar?).
Independents often do their own research and don't feel comfortable with an investment until
they have confirmed their decision with research or some form of corroboration. They are
comfortable collaborating with advisors, though typically using advisors as sounding boards for
their own ideas. Independents are often comfortable speaking the language of finance and
understand financial terms. They aren't afraid to delve into the details of investments, including
the costs and fees of making investments. The behavioural biases of Independents are cognitive
conservatism, availability, confirmation, representativeness, and self-attribution.

6.8.4 Accumulator

The accumulator is an investor who is interested in accumulating wealth and is confident that he
or she can do so. These clients have typically been successful in some business pursuit and
believe in themselves enough that they will be successful investors. As such, they often like to
adjust their portfolio allocations and holdings to market conditions and may not wish to follow a
structured plan. Moreover, they want to influence decision-making or even control the decision-
making process, which potentially can diminish an advisor's role. At their core, accumulators are
risk takers and are firm believers that whatever path they choose is the correct one. Unlike
preservers, they are in the race to win--and win big. And unlike the followers, they rely on
themselves and want to be the ones steering the ship. And unlike individualists, they usually dig
down to the details rather than forge a course with half the information that they need.

Unfortunately, some accumulators are susceptible to biases that can limit their investment
success. For example, they may be too confident in their abilities. Since they are successful in
business or other pursuits, why shouldn't they be successful investors? And overconfidence
sometimes leads them to think they can control the outcome of the investment even though it
may be full of unknown risks. Accumulators can also let their spending get out of control at
times due to the "wealth effect" of having created assets that can lead to lifestyles that are more
extravagant than prudent. Accumulators also may make investments based on how the
opportunities they come across resonate with their personal affiliations or values.

Accumulators' risk tolerance is quite high, but when things go the wrong way (they lose money),
discomfort can be very high. This discomfort may arise not only from financial loss but also
from the blow to their confidence and the realization that they cannot control the outcomes of
investments. Some accumulators can be quite difficult for advisors to build close relationships
with, because these clients are making their own decisions rather than relying on the advice and
counsel of their advisor. These clients are entrepreneurial and often the first generation to create
wealth, and they are even more strong-willed and confident than Individualists. Left unadvised,
accumulators often trade too much, which can be a drag on investment performance.
Furthermore, they are quick decision makers but may chase higher risk investments than their
friends. If successful, they enjoy the thrill of making a good investment. Some accumulators can
be difficult to advise because they do not believe in basic investment principles such as
diversification and asset allocation. They are often hands-on and wish to be heavily involved in
the investment decision-making process. The behavioural biases of accumulators
are overconfidence, self-control, affinity, outcome, and illusion of control.

Michael M. Pompian, CFA, CAIA, CFP, is the founder and chief investment officer of Sun pointe
Investments, an investment advisor to family offices based in St. Louis, Missouri. His
book, Behavioural Finance and Wealth Management, is helping thousands of financial advisors
globally build better relationships with their clients. Contact Michael at
michael@[Link].

Independent Individualist

An Independent Individualist is an active investor with medium-to-high risk tolerance investor

with medium-to-high risk tolerance who is strong-willed and an independent thinker.
Independent Individualists are self-assured and ―trust their gut‖ when making decisions;
however, when they do research on their own, they may be susceptible to acting on the initial
information rather than getting corroboration from other sources. Sometimes advisors find that
an Independent Individualist client made an investment without consulting anyone. This can be
problematic because, due to their independent mindset, these clients maintain the view they had
when they made the investment, even when market conditions change. They often enjoy
investing and are comfortable taking risks, yet often resist following a financial plan.

Some Independent Individualists view investing as a way to make money to give investing as a
way to make money to give themselves freedom. They can be good clients because they are
usually busy people, although some will not accept financial advice. Others are obsessed with
trying to beat the market and may hold concentrated portfolios. Of all behavioural investor types,
Independent Individualists are the most likely to be contrarian, which can benefit them—and
lead them to continue their contrarian practices. Independent Individualist biases are cognitive:
conservatism, availability, confirmation, representativeness, and self-attribution. Conservatism
bias. This occurs when people cling to a prior view or forecast without acknowledging new
information. Independent Individualists often do this, behaving inflexibly when presented with
new information. For example, assume an investor buys a security based on an anticipated new
product announcement. The company then announces that it is experiencing problems bringing
the product to market. The investor may cling to the stock with the optimistic opinion that the
problems will soon be resolved, and fail to sell on the negative announcement. Availability bias.
People often estimate the probability of an outcome based on how prevalent that outcome is in
their lives. People exhibiting this bias perceive easily recalled possibilities as more likely than
those that are less prevalent. Ask your client to identify the ―best‖ mutual funds. Most
Independent Individualists would perform an Internet search and, most likely, find funds from
firms that engage in heavy advertising. Investors subject to availability bias are influenced to
pick funds from such companies, despite the fact that some of the best-performing funds
advertise very little if at all. Representativeness bias. This occurs as a result of a flawed
perceptual framework when processing new information. To make new information easier to
process, Independent Individualists project outcomes that resonate with their own pre-existing
ideas. An Independent Individualist might view a particular stock, for example, as a value stock
because it resembles an earlier value stock that was a successful investment—but the new
investment is actually not a value stock. For example, a high-flying biotech stock with scant
earnings or assets drops 25 percent after a negative product announcement. Some Independent
Individualists may take this to be representative of a value stock because it is cheap; but biotech
stocks don‘t typically have earnings, while traditional value stocks have had earnings in the past
but are temporarily underperforming. Self-attribution bias. This refers to the tendency to ascribe
successes to innate talents while blaming failures on outside influences. For example, suppose an
Independent Individualist makes an investment that goes up. The reason it went up is not due to
random factors such as economic conditions or competitor failures, but rather to the investor‘s
investment savvy. This is classic self-attribution bias. Confirmation bias. This occurs when
people observe, overvalue, or actively seek out information that confirms their claims, while
ignoring or devaluing evidence that might discount their claims. Confirmation bias can cause
investors to only seek information that confirms their beliefs about an investment and not seek
out information that may contradict their beliefs. This behaviour can leave investors in the dark
regarding the imminent decline of a stock. Advising Independent Individualists. Independent
Individualists can be difficult clients to advise, but they are usually grounded enough to listen to
sound advice when it is presented in a way that respects their independent mindset. As we have
learned, Independent Individualists are firm in their belief in themselves and their decisions, but
can be blind to contrary thinking. As with Friendly Followers, education is essential to changing
behaviour of Independent Individualists; their biases are predominantly cognitive. A good
approach is to have regular educational discussions during client meetings. This way, the advisor
does not point out unique or recent failures, but rather educates regularly and can incorporate
concepts that he or she feels are appropriate for the client.

The Active Accumulator is the most aggressive behavioural investor type. These aggressive
behavioural investor type. These clients are entrepreneurial and often the first generation to
create wealth, and they are even more strong-willed and confident than Independent
Individualists. At high wealth levels, Active Accumulators often have controlled the outcomes of
noninvestment activities and believe they can do the same with investing. This behaviour can
lead to overconfidence in investing activities. Left unadvised, Active Accumulators often have
high portfolio turnover rates, putting a drag on investment performance. Active Accumulators
seek risk in the hope of high return and are comfortable with volatility, although they don‘t like
it. Active Accumulators are quick decisionmakers but may chase higher risk investments than
their friends. If successful, they enjoy the thrill of making a good investment. Some Active
Accumulators can be Some Active Accumulators can be difficult to advise because they don‘t
usually believe in basic investment principles such as diversification and asset allocation. They
are often hands-on, wanting to be heavily involved in the investment decision- making process,
although some readily admit they lack investment knowledge. Biases of Active Accumulators
are overconfidence, self-control, optimism, and illusion of control. Overconfidence bias. This is
best described as unwarranted faith in one‘s own thoughts and abilities and contains both
cognitive and emotional elements. Overconfidence manifests itself in investors‘ overestimation
of the quality of their judgment. Many Active Accumulators claim an above-average aptitude for
selecting stocks; however, numerous studies have shown this to be a fallacy. For example, a
study done by researchers Odean and Barber4 showed that after trading costs (but before taxes),
the average investor underperformed the market by approximately 2 percent a year due to
unwarranted belief in their ability to assess the correct value of investment securities. Illusion of
control bias. This cognitive bias occurs when people believe they can control, or at least
influence, investment outcomes when, in fact, they cannot. Active Accumulators who are subject
to illusion of control bias believe that the best way to manage an investment portfolio is to
constantly adjust it. For example, trading- oriented investors who accept high levels of risk
believe themselves to possess more control over the outcome of their investments than they
actually do because they are pulling the trigger on each decision. To determine whether your
client has control bias, ask if they have a tendency to want to pick their own numbers on a lottery
ticket or want to be in control of the dice while playing a game of chance. Self-control bias. This
emotional bias is the tendency to consume today without saving for tomorrow. The primary
concern for advisors with this bias is a client with a high risk tolerance coupled with high
spending. For example, suppose you have an Active Accumulator client who prefers aggressive
investments and has high current spending needs and suddenly the financial markets hit some
severe turbulence. Just to meet expenses, this client may be forced to sell solid long-term
investments that have declined in value due to current market conditions. Optimism bias. Many
overly optimistic investors believe that bad investments will not happen to them—they will only
afflict others. Such an illusion can damage portfolios as people fail to acknowledge the potential
for adverse consequences in the investment decisions they make. An example of this emotional
bias occurs when employees allocate a high proportion of their 401(k) plan to their company‘s
stock. Undue optimism leads these employees to perceive their own firm as being unlikely to
suffer from economic misfortune. Advice for active accumulators. Active Accumulators are the
most difficult clients to advise. They like to control, or at least get deeply involved in, the details
of investment decision-making. They are emotionally charged and optimistic that their
investments will do well, even if that optimism is irrational. Some Active Accumulators need to
be monitored for excess spending which, when out of control, can inhibit performance of a long-
term portfolio. The best approach to dealing with these clients is to take control of the situation.
If advisors let the Active Accumulator If advisors let the Active Accumulator client dictate the
terms of the advisory engagement, they will always be at the mercy of the client‘s irrational
decision-making and the result will likely be an unhappy client and an unhappy advisor.
Advisors need to prove to the client that they have the ability to make wise, objective, long-term
decisions and can communicate these results in an effective way. Advisors who can demonstrate
the ability to take control of a situation will see their Active Accumulator clients fall into step
and be easier to advise.

 Behavioural finance, a study of the markets that draws on psychology, is throwing more
light on why people buy or sell the stocks they do - and even why they do not buy stocks
at all. This research on investor behaviour helps to explain the various 'market anomalies'
 that challenge standard theory. We conclude Most investors find that buying public
shares and rationalizing it for coming down is easy because others have that share and
think of it. Buying share with a bad imagination is more difficult than rationalizing it. It is
emerging from the academic world and beginning to be used in money management.

 The field merges concepts from financial economics, psychology and sociology in an
attempt to construct a more detailed model of human behaviour in financial markets.
Currently, no unified theory of behavioural finance exists. Shefrin and Statman began
work in this direction, but so far, most emphasis in the literature has been on identifying
behavioural decision-making attributes that are likely to have systematic effects on
financial market behaviour. Even as behavioural factors undoubtedly play a role in the
decision-making processes of investors, they do not quash all the predictions of efficient
market theory; they offer plausible explanations of financial markets which would
otherwise be categorized as anomalous.

6.9 SUMMARY

 Behavioural finance offers many useful insights for investment professionals. From the
plan sponsor‘s viewpoint, behavioural finance provides a framework for evaluating the
plan sponsor‘s viewpoint, behavioural finance provides a framework for evaluating active
investment managers, as illustrated by the ―questions to ask‖ in the previous section.

 Another insight that was not discussed, but is potentially useful to plan sponsors, is the
issue of diversification across active investment managers. If the source of alpha for most
managers is derived either by generating private (or superior) information or by
processing information better, then managers whose alpha is derived by capitalizing on
behavioural biases will be better ―diversifiers.‖

 This follows from the idea that if the source of alpha for behavioural managers is
different from the source of alpha for the vast majority of managers, then the returns
generated by behavioural managers will tend to have a low correlation with the returns
generated by more traditional managers. There are many other potentially useful
applications of behavioural finance that were not discussed in this article due to space
constraints. For example, principles of behavioural finance, and psychology in general,
 might be quite useful in dealings between the plan sponsor staff and the plan‘s board of
directors or trustees.

 We have learned a top-down method of identifying a client‘s behavioural investor

identifying a client‘s behavioural investor type. By learning this process and applying it
before creating an investment plan for a client, the client is more likely to be able to
adhere to a plan that is custom designed for them and, when this happens, financial
advisors build stronger relationships with their clients.

 The ultimate objective for this process is for advisors to get comfortable enough with the
BIT process such that it becomes natural, almost second nature, and can be incorporated
easily and efficiently into the advisory process. As a final note, advisors should realize
that clients will have stronger or weaker forms of the behavioural investor types
presented here based on the number and severity of the biases that are associated with
each behavioural investor type.

 Some clients will have a reasonably rational approach to investing, displaying few biases
and which have little impact on the investment process. Other clients will be highly
biased and their irrational behaviour will affect the investment process substantially.
Advisors need to use their best judgment when assessing the potency of a client‘s
irrational behaviour and adjust their advice accordingly.

 Once the advisor has classified the investor as active or passive, the investor as active or
passive, the next step is to administer a traditional risk tolerance questionnaire to begin
the process of identifying whether a client falls into one of the four behavioural investor
types. In the interest of keeping this article to a reasonable length, I have not included a
risk tolerance questionnaire.

 The advisor‘s task at this point is to determine where the client falls on the risk scale. The
next step is to confirm the expectation that certain behavioural traits will result in certain
behavioural investor types. If an investor is passive, and the risk tolerance questionnaire
reveals a very low risk tolerance, the investor is likely to be a Passive Preserver. If the
investor is passive and the questionnaire reveals a low to medium risk tolerance, the
 investor is likely to be a Friendly Follower. If an investor is active and has a medium to
high risk tolerance, the investor is likely to be an Independent Individualist.

 Finally, if an investor is active and has a high risk tolerance, the investor is likely to be an
Active Accumulator. This process is illustrated in the decision tree. If, after going
through this process, the advisor has narrowed the client down to one behavioural
investor type, the next task is to confirm this BIT expectation by determining if the client
has the biases associated with the expected BIT (as we learned earlier in the paper). This
will confirm the BIT diagnosis. It provides an overview of the characteristics of each
behavioural investor type.

6.10 KEYWORDS

 Implicit Bias: Occurs when someone consciously rejects stereotypes and supports anti-
discrimination efforts but also holds negative associations in their mind unconsciously.

 In group Bias: The tendency for groups to ―favour‖ themselves by rewarding group
members economically, socially, psychologically and emotionally in order to uplift one
group over another.

 Oppression: Results from the use of institutional power and privilege where one person
or group benefits at the expense of another; oppression is the use of power and the effects
of domination.

 Prejudice: A preconceived judgment about a person or group of people, usually

indicating negative bias.

 Stereotype: Blanket beliefs, unconscious associations and expectations about members

of certain groups that present an oversimplified opinion, prejudiced attitude or uncritical
judgment.

6.11 LEARNING ACTIVITY

1. Create a session on psychographic models of investor behaviour.

_____________________________________________________________________________________
_________________________________________________________________
 2. Create a survey on background of the development of behavioural investor types.

_____________________________________________________________________________________
_________________________________________________________________

6.12 UNIT END QUESTIONS

A. Descriptive Questions

Short Questions

1. What is top-down approach?

2. Who is investor?

3. Who is accumulator?

4. Who is preserver?

5. What is diagnostic process?

Long Questions

1. Explain the background of the development of behavioural investor types.

2. Illustrate the psychographic models of investor behaviour.

3. Illustrate the behavioural alpha process.

4. Examine the behavioural investor types.

5. Examine the behavioural investor type diagnostic process.

B. Multiple Choice Questions

1. Which among the following is good for stabilization in voltage divider bias, the current
I1 flowing through R1 and R2?

a. 10 IB
b. 3 IB
c. 2 IB
d. 4 IB
 2. What is the leakage current in a silicon transistor is about?

a. One hundredth
b. One tenth
c. One thousandth
d. One millionth

3. What is the operating point is also called as?

a. Cut off point

b. Quiescent point
c. Saturation point
d. None of these

4. Identify the location at which the operating point should be located for proper
amplification by a transistor circuit?

a. The end point

b. Middle
c. The maximum current point
d. None of these

5. Identify the point at which the operating point on the a.c. load line.

a. Also line
b. Does not line
c. May or may not line
d. Data insufficient

Answers

1-a, 2-c, 3-b, 4-b, 5-a

6.13 REFERENCES

Reference

 Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work*.
The journal of Finance.

 Fama, E. F. & French, K. R. (1992). The cross section of expected stock returns. the
Journal of Finance.

 Fischoff, B. (1982). For those condemned to study the past: Heuristics and biases in
hindsight. Judgement under uncertainty: Heuristics and biases.

Textbook

 Daniel, K. Hirshleifer, D. & Subrahmanyam, A. (1998). Investor psychology and security

market under and overreactions. the Journal of Finance.

 DeBondt, W, & Thaler, R. (1995). Financial decision-making in markets and firms: a

behavioural perspective. Handbooks in OR and MS, Elsevier, Amsterdam.

 De Long, J. B. Shleifer, A. Summers. L. H. & Waldmann, R. J. (1990). Noise trader risk

in financial markets. Journal of political Economy.

Website

 [Link]
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 [Link]
EcG9zAzEEdnRpZANEMTA0NV8xBHNlYwNzcg

 [Link]