Portfolio Construction · Reading 91
The Behavioral Biases of Individuals
CFA Level I · Portfolio Construction · Reading 91 · about 38 min
What you'll learn
- LOS 91.a Compare cognitive errors (faulty reasoning, can be mitigated) with emotional biases (feelings-based, often accommodated).
- LOS 91.b Describe the six emotional biases and their implications for financial decision making.
- LOS 91.c Explain how behavioral biases may contribute to bubbles, the value/growth anomaly and home bias.
Module 91.1
Cognitive Errors vs. Emotional Biases
This reading separates cognitive errors from emotional biases and explains why the first are usually mitigated and the second accommodated. It describes the belief perseverance and information-processing biases, the six emotional biases, and how behavioral biases may help explain bubbles and crashes, the value premium and home bias.
LOS 91.a — Cognitive errors versus emotional biases
Traditional finance assumes investors are fully rational and process all relevant information objectively. Behavioral finance, pioneered by Kahneman and Tversky, shows that people depart from rationality in systematic ways. Because these departures are widespread rather than random, they are predictable. Kahneman, Tversky and others suggest that if clients and their advisers understood these biases better, prices and returns would move closer to the efficient-market outcome of traditional theory.
Biases fall into two families:
Key concept
| Cognitive errors | Emotional biases | |
|---|---|---|
| Source | Faulty reasoning: misunderstanding statistics, information-processing mistakes, illogical reasoning, memory errors | Feelings, impulses or intuition; not the product of conscious thought |
| Nature | An attempt to reason that goes wrong | A spontaneous reaction |
| Fix | Can often be mitigated (reduced) through awareness, education, training or better information | Difficult to overcome; may have to be accommodated (the portfolio is adjusted to live with the bias) |
| Sub-groups | Belief perseverance biases and information-processing biases | Six biases (see Module 91.2) |
Many biases have both cognitive and emotional elements. When they do, the adviser is more likely to succeed by working on the cognitive part. A useful test: if a simple change in thinking or better information would make the investor drop the bias, treat it as cognitive. If the view rests on emotion the investor is unwilling or unable to change, treat it as emotional.
Example. A client keeps too much money in low-yield deposits because he misreads a volatility chart. Once the adviser shows him the long-run return data, he rebalances. Better information changed his decision, so the problem was a cognitive error. Another client refuses to sell a family-business stake despite a clear case for diversifying, saying that selling "just feels wrong". Her view rests on feelings she will not change, so it is an emotional bias to be accommodated.
LOS 91.b — Cognitive errors: belief perseverance biases
Belief perseverance is the tendency to cling to prior beliefs. It is rooted in cognitive dissonance: holding conflicting beliefs, or receiving information that challenges a current belief, causes stress. A person can relieve it by dropping the old belief or by discounting the new information (questioning its truth, source, relevance or importance). When the second route is easier, the result is a bias toward existing beliefs.
| Bias | Description | Typical consequence |
|---|---|---|
| Conservatism bias | Forms a reasonable initial view but fails to update it (or updates too slowly) when new information arrives; overweights prior probabilities | Holding positions too long; ignoring complex new data |
| Confirmation bias | Seeks and notices information that supports existing beliefs; avoids or discounts conflicting evidence, or distorts it to fit the prior view | Screens set up to confirm a view; overconfidence in a held belief. Remedy: deliberately seek contrary views |
| Representativeness bias | Classifies something by a few features and assumes it will behave like the category; treats two things that are alike in some respects as more alike in other respects than they are | Two forms: base-rate neglect (ignoring how common a trait is in the population) and sample-size neglect (generalizing from a small sample, e.g. three good years of a fund manager). Leads to overweighting a few characteristics and relying on simple rules and classifications instead of thorough analysis |
| Illusion of control bias | Believes one can control or influence outcomes that one cannot. Often linked with emotional biases: illusion of knowledge, self-attribution and overconfidence | Overweighting the employer's stock or other "controllable" holdings; poor diversification |
| Hindsight bias | Selective memory: sees past outcomes as predictable or even inevitable ("I knew it all along"), remembers correct forecasts and forgets wrong ones, overestimates what could have been known | Overconfidence; discarding sound methods that happened not to work |
Example (representativeness). An analyst meets the founder of a young biotech company. The firm has a charismatic leader, a strong patent and fast hiring, the traits she associates with the best-known biotech successes, so she projects rapid growth. She ignores the base rate: only a small fraction of early-stage biotech firms ever bring a product to market. Judging the firm by how closely it resembles a few famous winners, rather than by how often firms like it succeed, is base-rate neglect.
LOS 91.b — Cognitive errors: information-processing biases
These biases concern how information is processed rather than the decision itself.
| Bias | Description | Typical consequence |
|---|---|---|
| Anchoring and adjustment bias | Starts from an initial number (current price, last EPS, prior estimate) and adjusts too little as new data arrive | Underreacting to new information. Remedy: judge new data on its own merits rather than as an adjustment to the starting number |
| Mental accounting bias | Treats money differently depending on its source or the "account" it is in, instead of viewing the portfolio as a whole | Speculating with "found money" (bonuses, refunds), keeping an inheritance in low-risk bonds, treating income and capital gains differently, holding offsetting positions instead of considering correlations. New York taxi drivers who treat each day as a separate account and stop once a daily income target is met are a well-known case |
| Framing bias | Makes different choices depending on how the same facts are presented (as a gain or as a loss; over a short or a long horizon) | Overreacting to short-term volatility; mis-measured risk tolerance if questionnaire wording is biased |
| Availability bias | Judges probability by how easily examples come to mind; overweights recent, vivid, familiar or heavily publicized events | Choosing managers by advertising; limiting the universe to familiar firms; overreacting to recent news and ignoring long-run history |
Example (framing). An investor is offered a choice for a $30,000 position. Framed as gains, the choice is "keep $20,000 for certain" or "a one-third chance of keeping all $30,000 and a two-thirds chance of keeping $15,000". Both have an expected value of $20,000: one-third of 30,000 is 10,000, and two-thirds of 15,000 is 10,000. Most people take the sure amount. Framed as losses ("lose $10,000 for certain" versus the equivalent gamble), many switch to the gamble, even though the outcomes are identical.
Classification summary
Key concept
| Belief perseverance (cognitive) | Information processing (cognitive) | Emotional |
|---|---|---|
| Conservatism | Anchoring and adjustment | Loss-aversion bias |
| Confirmation | Mental accounting | Overconfidence bias |
| Representativeness | Framing | Self-control bias |
| Illusion of control | Availability | Status quo bias |
| Hindsight | Endowment bias | |
| Regret-aversion bias |
Common exam traps
- Conservatism and confirmation differ. Conservatism is failing to update a view; confirmation is selectively gathering or interpreting evidence to fit it.
- Conservatism and anchoring also differ, although both lead to underreaction. Anchoring starts from a specific number, such as a price or a prior EPS figure, and adjusts too little; conservatism is a belief perseverance bias in which a prior view or forecast is kept, or revised too slowly, as new information arrives.
- Availability is about ease of recall (recent, vivid, publicized events). Confirmation is about agreement with a prior view, and framing is about presentation.
- Mental accounting and framing are cognitive (information-processing) biases, even though they feel intuitive.
Exam shortcuts
- To classify a bias, ask whether better information or a simple change in thinking would make the investor drop it: if so, treat it as cognitive; if the view rests on emotion the investor will not or cannot change, treat it as emotional.
Bottom line
- Cognitive errors come from faulty reasoning and can often be mitigated through awareness, education, training or better information, while emotional biases arise from feelings or impulses and are hard to overcome, so the portfolio may have to accommodate them.
- Belief perseverance biases, rooted in cognitive dissonance, are conservatism, confirmation, representativeness, illusion of control and hindsight bias.
- Information-processing biases are anchoring and adjustment, mental accounting, framing and availability.
- Conservatism is failing to update a reasonable view, or updating it too slowly, confirmation bias is seeking and interpreting evidence to fit an existing view, and anchoring is adjusting too little from a specific starting number.
- Representativeness takes two forms, base-rate neglect (ignoring how common a trait is in the population) and sample-size neglect (generalizing from a small sample).
- Availability bias judges probability by how easily examples come to mind, and framing bias produces different choices from the same facts depending on how they are presented.
Quick check
An adviser notes several tendencies in a client's behavior. Which one is most likely a cognitive error rather than an emotional bias? The client:
Show answer and explanation
Correct answer: C
Classifying something by a few features and assuming it will share the characteristics of that category is representativeness bias, a belief perseverance bias and therefore a cognitive error.
Why the other options are wrong
- A. Taking extra risk to avoid realizing a loss is loss-aversion bias, an emotional bias.
- B. Inaction driven by fear of regretting a wrong decision is regret-aversion bias, an emotional bias.
Key takeaway Representativeness (categorizing) is cognitive; loss aversion and regret aversion are emotional.
Module 91.2
Emotional Biases
LOS 91.b — Emotional biases
Six biases are generally classified as emotional biases. LOS 91.a compares them with cognitive errors and explains why they are usually accommodated rather than corrected.
Key concept
| Bias | Description | Typical consequence |
|---|---|---|
| Loss-aversion bias | Losses hurt more than equal gains please; decisions are judged against a reference point | Trading too much by selling winners for small gains (higher costs, lower returns); holding deteriorating losers and taking excess risk after a decline in the hope of getting back to breakeven; a position may be seen as a gain or a loss depending on how the reference point is framed |
| Overconfidence bias | Overestimating one's own knowledge, reasoning or forecasting ability; includes illusion of knowledge; self-attribution bias, which is self-enhancing when it takes credit for successes and self-protecting when it blames others or circumstances for failures; prediction overconfidence (ranges too narrow); and certainty overconfidence (probability of being right overstated) | Underestimating risk, overestimating return, overtrading, too little diversification |
| Self-control bias | Lack of discipline: short-term satisfaction wins over long-term goals; hyperbolic discounting (preferring small payoffs now to larger ones later) | Undersaving for retirement, then taking excessive risk to catch up; overemphasis on income assets. Remedy: a formal plan and budget, reviewed regularly |
| Status quo bias | Comfort with the current situation; doing nothing is the default | Keeping an inappropriate allocation for years; ignoring better alternatives. Default options (e.g. automatic enrollment with opt-out) exploit it |
| Endowment bias | An asset feels more valuable simply because one owns it; owners tend to ask a higher price to sell it than they would pay to buy it | Holding inherited or familiar assets that no longer fit. Test: "Would you buy this today with new money?" |
| Regret-aversion bias | Fear that an action will turn out wrong leads to inaction; errors of commission weigh more than errors of omission. Herding is a form of regret aversion | Excess conservatism; following the crowd |
Loss aversion and risk aversion. A risk-averse investor, faced with two choices with the same expected return, picks the less risky one. A loss-averse investor measures outcomes against a reference point and may take on more risk to avoid realizing a loss than to secure an equal gain.
Example (loss aversion). An investor holds a stock bought at €80 that now trades at €56, a 30% loss. His research no longer supports the stock, but he says he will sell "once it gets back to €80". He is using the purchase price as the reference point and refusing to realize the loss, which is typical loss-aversion behavior. The only relevant question is whether the stock is worth holding at €56.
Common exam traps
- Status quo bias, regret aversion and endowment bias can all produce inaction. Status quo bias is comfort with the default; regret aversion is fear that acting will be a mistake; endowment bias makes an asset seem worth more because it is owned.
- Self-control bias concerns saving and spending discipline rather than trading decisions.
- Overconfidence has cognitive elements but is classified as an emotional bias, because it is hard to correct and rooted in the wish to feel good.
LOS 91.c — Behavioral biases and market characteristics
A market anomaly is a result that does not fit the prevailing model of risk and return. A market inefficiency is an anomaly that offers positive risk-adjusted returns. Many apparent anomalies disappear once small samples, time-period bias or a misspecified risk model are accounted for.
Key concept
Bubbles and crashes. Behavioral finance does not offer an overall explanation of bubbles, but several biases may contribute:
- Overconfidence causes investors to trade too much, underestimate risk and diversify too little.
- Self-attribution and hindsight bias (taking credit for gains in a bull market) reinforce overconfidence.
- Confirmation bias leads investors to dismiss evidence that prices cannot keep rising and to treat early declines as buying opportunities.
- Anchoring leads investors to treat recent highs as rational prices even as prices fall.
- Fear of regret keeps even skeptical investors in the market.
Exploiting a bubble is hard. Leaving too early and staying too long are both costly, and short selling a rising market is risky and restricted.
Value vs growth. Value stocks (low market-to-book, low P/E, high dividend yield) have outperformed growth stocks over long periods. In Fama and French's (1992) tests, the apparent value premium disappeared once size and book-to-market factors were included in the return model, which suggests the extra return compensates for risk. A behavioral explanation is the halo effect, a form of representativeness in which a firm's good features (fast growth, a rising share price) are extended to the conclusion that it is a good stock. The result is overvaluation of growth stocks.
Home bias. Investors overweight domestic or local companies despite the benefits of global diversification, perhaps believing they have better information or simply feeling more comfortable. Investors also tend to overrate firms whose products they use or whose marketing they see often.
Common exam traps
- Under-diversification is linked to overconfidence, illusion of control and availability (a preference for familiar firms), not to anchoring.
- Anchoring and regret aversion tend to keep investors in a bubble; they do not deflate it.
- The halo effect overvalues growth stocks, not local or familiar ones. Overweighting companies close to home is home bias.
Bottom line
- The six emotional biases are loss aversion, overconfidence, self-control, status quo, endowment and regret aversion.
- A loss-averse investor feels losses more than equal gains and judges outcomes against a reference point, so may sell winners too early, hold losers and take on more risk to avoid realizing a loss, unlike a risk-averse investor, who picks the less risky of two choices with the same expected return.
- Overconfidence, which includes illusion of knowledge, self-attribution, prediction overconfidence and certainty overconfidence, leads investors to underestimate risk, overtrade and diversify too little, and it is classified as emotional although it has cognitive elements.
- Self-control bias puts short-term satisfaction ahead of long-term goals, status quo bias makes doing nothing the default, endowment bias values an asset more because it is owned, and regret aversion makes errors of commission weigh more than errors of omission.
- A market anomaly does not fit the prevailing risk-return model, and it is a market inefficiency only if it offers positive risk-adjusted returns; many apparent anomalies disappear once small samples, time-period bias or a misspecified risk model are accounted for.
- Biases such as overconfidence, confirmation, anchoring and fear of regret may contribute to bubbles, the halo effect may explain overvaluation of growth stocks, and home bias leads investors to overweight domestic or local companies.
Quick check
Studies find that many investors hold far fewer securities than traditional portfolio theory would recommend. Which behavioral bias best explains this under-diversification?
Show answer and explanation
Correct answer: A
Overconfidence leads investors to overestimate their knowledge and underestimate risk, which results in overtrading and insufficient diversification.
Why the other options are wrong
- B. Anchoring may cause investors to treat recent highs as rational prices even as prices fall; it is not the usual explanation for under-diversification.
- C. Fear of regret (of missing gains) may keep skeptical investors in an overvalued market; it does not explain holding too few securities.
Key takeaway Under-diversification, overtrading and underestimating risk are hallmarks of overconfidence.
Practice Questions
Which of the following is classified as an information-processing bias?
Show answer and explanation
Correct answer: B
Anchoring and adjustment is a cognitive error in the information-processing group: an initial number is used as an anchor and adjusted too little as new information arrives.
Why the other options are wrong
- A. Regret aversion is an emotional bias.
- C. Status quo bias is an emotional bias.
Key takeaway Information-processing biases: anchoring and adjustment, mental accounting, framing, availability. By contrast, loss aversion, status quo and regret aversion are emotional biases.
Which of the following groups consists only of cognitive errors?
Show answer and explanation
Correct answer: B
Confirmation bias is a belief perseverance bias, and anchoring and adjustment and availability are information-processing biases. All three are therefore cognitive errors.
Why the other options are wrong
- A. Representativeness and framing are cognitive errors, but overconfidence is classified as an emotional bias.
- C. Endowment, regret-aversion and self-control biases are all emotional biases.
Key takeaway Cognitive = belief perseverance (conservatism, confirmation, representativeness, illusion of control, hindsight) + information processing (anchoring and adjustment, mental accounting, framing, availability). The six emotional biases are loss aversion, overconfidence, self-control, status quo, endowment and regret aversion.
This reading has 24 questions in the full bank. Practice all of them.
Key Takeaways
- Representativeness (categorizing) is cognitive; loss aversion and regret aversion are emotional.
- Information-processing biases: anchoring and adjustment, mental accounting, framing, availability. By contrast, loss aversion, status quo and regret aversion are emotional biases.
- Cognitive = belief perseverance (conservatism, confirmation, representativeness, illusion of control, hindsight) + information processing (anchoring and adjustment, mental accounting, framing, availability). The six emotional biases are loss aversion, overconfidence, self-control, status quo, endowment and regret aversion.
- Under-diversification, overtrading and underestimating risk are hallmarks of overconfidence.