Behavioral Finance

Cognitive Biases
Belief Perseverance

Gonçalo Sommer Ribeiro

Behavioral Finance Belief Perseverance

Behavioral Finance
Trading Contest

• Register at https://app.howthemarketworks.com/register/309809
• Name of the contest: Behavioral Finance 2024
• Password: No pasword
• Trading period start 4th April, ends 16th May
• Initial cash balance $100k
• Try to check the account at least once per week, so you can keep track and
execute trades. There are some insightful user guides to help you explore
• Before the Exam date, on the 25th of May, deliver a 1-page report where you
self-analyze your performance from a Behavioral Finance perspective

The questions to be answered in the report are (at least):

• What biases have you fallen to?
• How did those biases affected you?
• What impact did it had on your returns? Try to quantify.
• What could you have done differently to avoid such outcomes?

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Behavioral Finance
Decision Making

• Facing uncertainty and an abundance of information to process, individuals

may not systematically describe problems, record necessary data, or synthesize
information to create rules for making decisions

• Instead, individuals may follow a more subjective, suboptimal path of

reasoning to determine a course of action consistent with their basic judgments
and preferences

• A decision maker may have neither the time nor the ability to arrive at a
perfectly optimal decision. Individuals strive to make good decisions by
simplifying the choices available, using a subset of the information available,
and discarding some possible alternatives to choose among a smaller number

• They are content to accept a solution that is “good enough” rather than
attempting to find the optimal answer. In doing so, they may unintentionally
bias the decision-making process. These biases may lead to irrational behaviors
and decisions

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Behavioral Finance
Biases
Definition

• Definition:
▪ a statistical sampling or testing error caused by systematically favoring
some outcomes over others
▪ a preference or an inclination, especially one that inhibits impartial
judgment
▪ an inclination or prejudice in favor of a particular viewpoint
▪ an inclination of temperament or outlook, especially a personal and
sometimes unreasoned judgment

• In this course we will consider biases that result in irrational financial

decisions caused by faulty cognitive reasoning or reasoning influenced by
feelings

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Behavioral Finance
Behavioral Finance MIcro

• Firstly, we focus on BFMI and the behavioral biases that individuals may
exhibit when making financial decisions

• BFMI attempts to observe and explain how individuals make financial

decisions

• This approach is in contrast to traditional theories of financial decision making

that describe how people should make decisions under uncertainty

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Behavioral Finance
Motivation too study BFMI

• “To invest successfully over a lifetime does not require a stratospheric IQ, unusual
business insight, or inside information. What’s needed is a sound intellectual framework
for decisions and the ability to keep emotions from corroding that framework”

• “The greatest enemies of equity investor are expenses and emotions”

• “Be fearful when others are greedy

Be greedy when others are fearful”

Quotes by Warren Buffett

Impact:

▪ Investment in Goldman Sachs in 2008

▪ Not buying into high equity valuations in 2021-2022

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Behavioral Finance
Types of Biases
Cognitive vs Emotional

• Cognitive errors stem from basic statistical, information-processing, or

memory errors; cognitive errors may be considered to result from reasoning
based on faulty thinking

• Emotional biases stem from impulse or intuition; emotional biases may be

considered to result from reasoning influenced by feelings

• Behavioral biases, cognitive or emotional, may cause decisions to deviate from

the rational decisions of traditional finance

• By understanding behavioral biases, investment professionals may be able to

improve economic outcomes. This may entail identifying behavioral biases
they themselves exhibit or behavioral biases of others

• Once a behavioral bias has been identified, it may be possible to either moderate
the bias or adapt to the bias so that the resulting financial decisions more closely
match the rational financial decisions assumed by traditional finance

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Behavioral Finance
Cognitive Biases

• Cognitive errors are basic statistical, information-processing, or memory

errors that cause the decision to deviate from the rational decisions of traditional
finance

• Cognitive errors can also be thought of as “blind spots” or distortions in the

human mind

• Cognitive errors are more easily corrected than emotional biases. Because
cognitive errors stem from faulty reasoning, better information, education, and
advice can often correct for them

• Individuals are better able to adapt their behaviors or modify their processes if
the source of the bias is logically identifiable, even if not completely
understood

• Cognitive biases can be “moderated”—to moderate the impact of a bias is to

recognize it and attempt to reduce or even eliminate it within the individual

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Behavioral Finance
Emotional Biases

• Because emotional biases stem from impulse or intuition, especially personal

and sometimes unreasoned judgments

• It is generally agreed that an emotion is a mental state that arises spontaneously

rather than through conscious effort. Emotions are related to feelings,
perceptions, or beliefs about elements, objects, or relations between them and
can be a function of reality or the imagination

• Emotions may be undesired to the individual feeling them and difficult to

control

• Thus, it may only be possible to recognize an emotional bias and

“adapt”/accommodate to it

• When a bias is adapted to, it is accepted and decisions are made that recognize
and adjust for it (rather than making an attempt to reduce or eliminate it)

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Behavioral Finance
Cognitive Biases
Belief Perseverance Biases

• Belief perseverance biases are closely related to the psychological concept of

cognitive dissonance

• Cognitive dissonance is the mental discomfort that occurs when new

information conflicts with previously held beliefs or cognitions

• To resolve this dissonance, people try to protect themselves by:

▪ notice only information of interest (selective exposure)

▪ ignore or modify information that conflicts with existing cognitions
(selective perception)
▪ or remember and consider only information that confirms existing
cognitions (selective retention)

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Behavioral Finance
Belief Perseverance Biases
Conservatism
Definition
• Conservatism bias is a mental process in which people keep their prior views
or forecasts at the expense of acknowledging new information

• This derives from humans' way of testing a hypothesis. While doing

experiments, people tend to confirm their own initial hypothesis instead of
rejecting other hypothesis that would make their solution right

• Emphasizing information used in original forecast over new data. There is an

underreaction to new information

• Conservatism causes individuals to overweight base rates and to underreact to

sample evidence

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Behavioral Finance
Belief Perseverance Biases
Conservatism
Explanations
• Processing new information and updating beliefs is cognitively costly

• Conservatism might be due to an underlying difficulty in processing new

information

• The costly-processing argument can be extended to explain base rate

overweighting

• Conservatism causes individuals to overweight base rates and to underreact to

sample evidence

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Behavioral Finance
Belief Perseverance Biases
Conservatism
Consequences
• “The stock market has tendency to underreact to fundamental information—be it
dividend omissions, initiations, or an earnings report. For instance in the US, in the 60
days following an earnings announcement, stocks with the biggest positive earnings
surprise tend to outperform the market by 2 percent, even after a 4–5 percent
outperformance in the 60 days prior to the announcement”

James Montier

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Behavioral Finance
Belief Perseverance Biases
Conservatism
Consequences
• “A cursory glance at the chart reveals that analysts are exceptionally good at telling you
what has just happened. They have invested too heavily in their view and hence will
only change it when presented with indisputable evidence of its falsehood”
James Montier

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Behavioral Finance
Belief Perseverance Biases
Conservatism
Implications for investors

1. Conservatism bias can cause investors to cling to a view or a forecast, behaving

too inflexibly when presented with new information
▪ Example: knowledge company about to release a new product but is facing delays

2. When conservatism-biased investors do react to new information, they often do

so too slowly
▪ Example: earnings announcement depresses a stock and investor take time to sell

3. Conservatism can relate to an underlying difficulty in processing new

information, so it is easier to keep with previous beliefs
▪ Example: growth stocks facing difficulty to deliver due to any given issue

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Behavioral Finance
Belief Perseverance Biases
Conservatism
Mitigation

• Investors must first avoid clinging to forecasts

• Investors should react, decisively, to new information

• Investors should seek new information to determine its value

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Behavioral Finance
Belief Perseverance Biases
Conservatism
Proxys
Examples of possible bias proxy’s:

• Analysts lag in their earnings estimates

• Compare analysts predictions with real market prices

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Behavioral Finance
Belief Perseverance Biases
Conservatism
Literature
• Belsky, Gary and Thomas Gilovich. Why Smart People Make Big Money
Mistakes-And How to Correct Them: Lessons from the New Science of
Behavioral Economics (Fireside, 2000)

• Evans, B. Bias in Human Reasoning: Causes and Consequences (Psychology

Press, 1990)

• Gilovich, Thomas. How We Know What Isn't' So: The Fallibility of Human
Reason in Everyday Life (New York: The Free Press, 1993)

• Reason, James. Human Error (Cambridge University Press 1990)

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Behavioral Finance
Belief Perseverance Biases
Conservatism
Markets Example
• New EV technology developed by Tesla and adopted by the market

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Behavioral Finance
Belief Perseverance Biases
Conservatism
Markets Example
• Release of iPhone 3 and App store, two revolutionary technologies

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Behavioral Finance
Belief Perseverance Biases
Confirmation
Definition
• Confirmation bias refers to a type of selective perception that emphasizes
ideas that confirm our beliefs, while devaluing whatever contradicts our beliefs

• Confirmation bias refers to our all-too-natural ability to convince ourselves of

whatever it is that we want to believe

• Attach undue emphasis to events that corroborate the outcomes we desire and
downplay whatever contrary evidence arises

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Behavioral Finance
Belief Perseverance Biases
Confirmation
Explanations
• We try to seek for information that proofs our previous beliefs so we can
confirm we were right, releasing a positive feeling about us

• Beliefs don’t need to be logically entrenched in order to kindle confirmation bias

• Studies have demonstrated that people excessively value confirmatory

information, that is, positive or supportive data

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Behavioral Finance
Belief Perseverance Biases
Confirmation
Consequences

• Employees’ penchant for overconcentrating in company stock

• Investors often fail to acknowledge anything negative about investments

they’ve just made

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Behavioral Finance
Belief Perseverance Biases
Confirmation
Implications for investors

1. Once we have a previous conception on how a stock should move, when new
information that contradicts our view comes to the market, we are slow to react
to that new information. So this make investors underreact to new information.
▪ Example: stock faces a decline due to new competition but investors keep prior beliefs

2. Investors believe strongly in predetermined “empirical evidence” such as

stocks breaking through a 52-week price high and have breakout
▪ Example: investors might believe the stock will outperform because it had a breakout,
confirming what they had previously conceived

3. Can cause employees to overconcentrate in company stock

▪ Example: investors like the company they work for so they buy more stock on top of
employee stock option plan

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Behavioral Finance
Belief Perseverance Biases
Confirmation
Mitigation

• Making sure to seek out information that could contradict—not just confirm—
their investment decisions

• When an investment decision is based on some preexisting criterion it is

advisable to cross verify the decision from additional perspectives: backtesting

• Employees should monitor any negative press regarding their own companies
and conduct research on any competing firms

• People who demonstrate a disproportionate degree of commitment to any stock

whatsoever should remember to seek out unfavorable data regarding that
stock

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Behavioral Finance
Belief Perseverance Biases
Confirmation
Literature

• Hart, W., Albarracín, D., Eagly, A. H., Brechan, I., Lindberg, M. J., and Merill, L.
2009. “Feeling Validated Versus Being Correct: A Meta-Analysis of Selective
Exposure to Information.”

• Nickerson, R. 1998. “Confirmation Bias: A Ubiquitous Phenomenon in Many

Guises.”

• Park, J., Konana, P., Gu, B., Kumar, A., and Raghunathan, R. 2013. “Information
Valuation and Confirmation Bias in Virtual Communities: Evidence from Stock
Message Boards.”

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Behavioral Finance
Belief Perseverance Biases
Confirmation
Proxys
Examples of possible bias proxy’s:

• Analysts recommendations (few) revisions

• Analysts recommendations dispersion

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Behavioral Finance
Belief Perseverance Biases
Confirmation
Markets Example
• ESG premium is calculated using best at class in ESG: outperforming tech
companies. Biased observations?

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Behavioral Finance
Belief Perseverance Biases
Representativeness
Definition
• Representativeness bias refers to the innate propensity for classifying objects
and thoughts

• When people are confronted with a new phenomenon that is inconsistent with
any of their preconstructed classifications, they subject it to those classifications
anyway, relying on a rough best-fit approximation

• This perceptual framework provides an expedient tool for processing new

information by simultaneously incorporating insights gained from (usually)
relevant/analogous past experiences

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Behavioral Finance
Belief Perseverance Biases
Representativeness
Explanations

1. Base-Rate Neglect
Investors attempt to determine the potential success of, say, an investment by
contextualizing the venture in a familiar, easy-to-understand classification scheme
▪ Example: “Value stock”, it is just a stereotype

2. Sample-Size Neglect
Investors when judging the likelihood of a particular investment outcome often fail
to accurately consider the sample size of the data on which they base their
judgments
▪ Example: assume that small sample sizes are representative of populations (or “real” data)

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Behavioral Finance
Belief Perseverance Biases
Representativeness
Consequences

• Investors create mental shortcut which simplify reality, but that might not be
accurate, leading them to make oversimplified decisions

• Readily available ideas are used to catalogue an analogous situation without

proper analysis of each situation individually

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Behavioral Finance
Belief Perseverance Biases
Representativeness
Implications for investors

1. Investors can make significant financial errors when they examine a money
manager’s track record (sample-size neglect)
▪ Example: looking at recent past performance of a fund manager

2. Investors also make similar mistakes when investigating track records of stock
analysts (sample-size neglect)

3. Investors can read negative news about a particular player in an industry and
try to sell their stocks in that industry (base-rate neglect)
▪ Example: unload oil stocks just because one oil company went bankrupt

4. Analysts can make precipitated judgements about a particular investment

using some easy to track indicator, such as ratios in stocks (P/E, P/B, Earnings
Yield..)

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Behavioral Finance
Belief Perseverance Biases
Representativeness
Mitigation

• Remember the first example, where you have group A, group B and their
intersection. How probable is it that you are get it right?

• Check numerous return time series in order to avoid evaluating managers by

their recent returns

• Avoid over reliance on a particular indicator which is just a part of a full

picture

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Behavioral Finance
Belief Perseverance Biases
Representativeness
Literature

• Kahneman, D. and Tversky, A. 1974. “Judgement under Uncertainty: Heuristics

and Biases.

• Khan, H. H., Naz, I., Qureshi, F., and Ghafoor, A. 2017. “Heuristics and stock
buying decision: Evidence from Malaysian and Pakistani stock markets.”

• Ganzach, Y. 2001. “Judging Risk and Return of Financial Assets.”

Organizational Behavior and Human Decision Processes 83 (2): 353-370.

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Behavioral Finance
Belief Perseverance Biases
Representativeness
Proxys
Examples of possible bias proxy’s:

• Test if the ratios commonly used to make financial decisions are indeed good
predictors of investments success

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Behavioral Finance
Belief Perseverance Biases
Representativeness
Markets Example
• TIPS are bonds which have their CFs linked to inflation, so many investors jump
into it without understanding the mechanics (dropping despite rising inflation)

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Behavioral Finance
Belief Perseverance Biases
Illusion of Control
Definition

• The illusion of control bias describes the tendency of human beings to believe
that they can control or at least influence outcomes when, in fact, they cannot

• “Expectancy of a personal success probability inappropriately higher than the

objective probability would warrant”

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Behavioral Finance
Belief Perseverance Biases
Illusion of Control
Explanations

• People have a belief they are in control of situations if the outcomes of those
situations have an influence on them

• That is probably because it gives them a sense of comfort that they can control
the outcomes of events that impact their life's

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Behavioral Finance
Belief Perseverance Biases
Illusion of Control
Consequences

• In the casino game, various research has demonstrated that people actually cast
the dice more vigorously when they are trying to attain a higher number

• Observed that people who were permitted to select their own numbers in a
hypothetical lottery game were also willing to pay a higher price per ticket than
subjects gambling on randomly assigned numbers

• People think that if they are in the driving seat, the probabilities of having a car
accident is lower, which might not be entirely true

• Investors think that by having more information about a company they will be
able to better control their investments, while management and the market will
be the ones deciding the future of a company

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Behavioral Finance
Belief Perseverance Biases
Illusion of Control
Implications for investors

1. Illusion of control bias can lead investors to trade more than is prudent
▪ Example: online traders believe themselves to possess more control over the outcomes of
their investments than they actually do. Excessive trading decreases returns

2. Illusions of control can lead investors to maintain under diversified portfolios

▪ Example: concentration is due to illusion they have some control over a few companies that
they know well

3. Illusion of control bias can cause investors to use limit orders and other such
techniques in order to experience a false sense of control over their investments
▪ Example: because an investor has a buying limit order below market price might give them
the illusion they will catch a good price, but things might have changed for that particular
stock

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Behavioral Finance
Belief Perseverance Biases
Illusion of Control
Mitigation

• Recognize that successful investing is a probabilistic activity

• Recognize and avoid circumstances that trigger susceptibility illusions of control

• Seek contrary viewpoints

• Investors should maintain records from transactions, including reminders

spelling out the rationale that underlie each trade. Basically, try to see if the
reasons why a trade was successful or not were the true reasons behind the
returns

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Behavioral Finance
Belief Perseverance Biases
Illusion of Control
Literature

• Presson, P.K. and V.A. Benassi, 1996. Illusion of Control: A Meta-Analytic

Review. Journal of Social Behavior and Personaliy

• Thompson, S.C., W. Armstrong and C. Thomas, 1998. Illusions of Control,

Underestimations, and Accuracy: A Control Heuristic Explanation.

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Behavioral Finance
Belief Perseverance Biases
Illusion of Control
Proxys
Examples of possible bias proxy’s:

• Performance of biggest market share in industry vs other players, where biggest

player controls the market and sets the innovation pace

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Behavioral Finance
Belief Perseverance Biases
Illusion of Control
Markets Example
• Wirecard was a big German company with great future prospects…

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Behavioral Finance
Belief Perseverance Biases
Hindsight
Definition

• Perceiving past outcomes as reasonable and expected at the time investment

decisions were made

“I knew it all along”. Once an event has elapsed, people afflicted with hindsight bias tend
to perceive that the event was predictable—even if it wasn’t. This behavior is precipitated
by the fact that actual outcomes are more readily grasped by people’s minds than the
infinite array of outcomes that could have but didn’t materialize

• Selective memory of past events, actions, or what was knowable in the past.
Tendency to remember correct views and forget mistakes

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Behavioral Finance
Belief Perseverance Biases
Hindsight
Explanations

• Unpredictable developments bother people, since it’s always embarrassment to

be taken by surprise. Hindsight bias alleviates embarrassment under these
circumstances, blunting the ugliest of surprises and populating our horizon,
instead, with inevitabilities

• Psychologically it is difficult to assume we were wrong because that creates a

bad feeling about us

• On the opposite side, people feel good when they are right, it is awarding for
our ego

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Behavioral Finance
Belief Perseverance Biases
Hindsight
Consequences

• People tend to overestimate the accuracy of their own predictions

▪ Example: from 1998 to 2001 every investor was fully on in the market, without
acknowledging it was a bubble, because “this time is different”. Only afterwards was
it clear that it was in fact a bubble.
▪ Are we going to experience the same for equity market now – in the US?

• Hindsight bias affects future forecasting, by underestimating the uncertainty

preceding the event in question and underrating the outcomes that could have
materialized but did not

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Behavioral Finance
Belief Perseverance Biases
Hindsight
Implications for investors
1. Hindsight bias gives investors a false sense of security when making
investment decisions

2. When an investment appreciates, hindsight-biased investors tend to rewrite

their own memories to portray the positive developments as if they were
predictable. This can instigate investors into more risk taking
▪ Example: The tech bubble, “this time is different”

3. Hindsight-biased investors also change the story when they fare poorly and
block out recollections of prior, incorrect forecasts in order to alleviate
embarrassment

4. Hindsight-biased investors can unduly fault their money managers when funds
perform poorly

5. Conversely, hindsight bias can cause investors to unduly praise their money
managers when funds perform well

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Behavioral Finance
Belief Perseverance Biases
Hindsight
Mitigation
• Predicting Gains: investors should review the history of the trade, check what
they were predicting and compare it with what happened in reality

• Predicting Losses: self-examination so an investor can understand what he did

wrong. To ensure evolution of one's ability to better invest, it is essential to
acknowledge where we made mistakes so we can avoid them in the future

• Investors should not unduly criticize money managers for poor performance,
by understanding the economic and returns cycle and check current market
conditions

• Nor should investors unduly praise money managers for good performance,
again the cycle and the recent market returns are probably the cause that
justifies such performances

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Behavioral Finance
Belief Perseverance Biases
Hindsight
Literature

• Christensen-Szalanski, J.J.J. and C.F. Willham, 1991. The hindsight bias: A meta-
analysis. Organizational Behavior and Human Decision Processes

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Behavioral Finance
Belief Perseverance Biases
Hindsight
Proxys
Examples of possible bias proxy’s:

• Compare predictions with real returns

▪ Analysts stock prices targets

▪ Analysts year end stock indices targets

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Behavioral Finance
Belief Perseverance Biases
Hindsight
Markets Example
• Is Nvidia in a bubble or this is just the start of a major AI trend?

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Behavioral Finance
Cognitive Biases
Belief Perseverance Biases
List of Biases
• Conservatism

• Confirmation

• Representativeness

• Illusion of control

• Hindsight

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