Behavioral finance definitions

Plan of the whole chapter

See also

Introduction

Main concepts: BF vs. EMH [see
also
abstract (slides)]

Behavioral-Finance Gallery

500+ keywords BF glossary and
and 1700+ members
BF forum

Part A (below)

Individual and social behavioral
biases

Part B

Economic and financial incidences

separ

Part A: Individual and social behavioral biases

Several behavioral biases can be involved at the individual level or the
social level.

They can have counterproductive effect in decision making, among
others in money management

Some are linked to cognition (memory and reasoning) and others to
emotions
.

=> Here we have the four main categories shown in the "main investors
     biases / errors"
matrix of the introduction article, and which are now
     detailed below

You can find the definitions of those various biases in the BF glossary,
via the Behavioral-Finance Gallery

   1. Individual cognitive biases / errors
      (financial psychology)

Pure defaults of attention / cognition: 

Human perceptions can be flawed, at the sensory level to start
with.

Even in simple things, human beings are not so good at observing
and finding facts

Also mental representations derived from those facts cannot fully
fit realities.

This gets worse when reality is complex and changing.

Humans are not too good either and at measuring the famous
"Sharpe rewards / risk ratio".

Here are examples of such bounded rationality:

People have in mind (memory) some "reference points"

  ( anchors / anchoring).

This reference is often a number, for example a previous stock price,
or estimate, or price trend.

This focusing might block their mind to situations changes that
makes those references obsolete.

It might lead them to cognitive dissonance / denial / status quo
bias and resistance to change
,the rejection of new facts that are
contrary to their beliefs, habits (*) and preconceived ideas.

When they get new information, they adjust their references
insufficiently (inertia, procrastination, conservatism, status quo
bias / under-reaction).

They also limit their interest to information that confirm their beliefs
(selective attention).

On the other hand, in some cases, later, when those information get
gradually confirmed, they might start adjusting too much, get carried
away, and turn the wheel too far.(over-reaction).

(*) Habits cannot be categorized fully as cognitive or emotional
     biases as many habits
are physical automatic responses.

Even if cognition (neuronal paths) and emotion (pain and pleasure)
are involved in habits, they might be seen nearly pure behavioral
biases
.

Other oversimplification sources / mental shortcuts are habits / heuristic
  biases /
limited heuristic / tunnel vision

They lead to decisions made on shallow / lazy thinking and mental
automatic pilot
(well, they help to gain time and minimize research
costs and efforts), based on a too small number of keywords,
anchors, stereotypes, paradigms or decision methods / models).

Heuristics are multiples. They are simplifications,
approaches, generalizations, stereotypes, rules of thumbs, or even
common paradigms.

Let us quote:

* the representativeness heuristic (we see a phenomenon and consider
   it as representative of a category of things or of a general notion or law)

* the availability heuristic (we start from the first thing we observe or
   imagine).

Framing also, as a selective representation of an issue, is related.

Most people are "frame dependent" and limit their approach to one angle,
selecting one immediately apparent way of defining the question they ask
themselves so that it influences their answer to it.

Also the wording / frame used to present an issue to them will influence
their decision:something offered for 3 dollars a day may seem less costly

than 1095 dollars a year.

Cognitive overload / information overload.
  It is
feeling to be drowned in
too many information. It is difficult
  to cope with complex / over-
abundant, ever
changing information
 
(investors cannot walk and chew gum at the same time).

  This is of course a consequence of the World evolutions and we have to
  adapt to it,
but also it can come from collective bureaucratic biases such
  as an hyperrregulation
which gives an illusion of protection.

It also may explain the tendency to stay anchored to old facts and beliefs,
follow the most apparent "red herrings" (see "rationalization" below) and
discard weak signals..

Logical fallacies: binary logic, sophisms, halo effect, causes / effects
   confusions, reductionism (focusing on a single element to explain a
   complex situation) and generalizations...)

And also numeracy bias (abusive belief in statistics and mathematical
trading models, distant from the economic context and not well adapted
to rare events or new situations).

Focusing also on a single numerical prevision (range estimate aversion)

Conversely an ignorance or a false idea of

the real probabilities of  risk and gain.

And of course attention biases as seen above.

Short memory: memory in markets is subject to a decay process.

The salience and duration of the original event is of course a factor that
can slow that decay.

Also human beings have some time myopia (time horizon bias), being
usually anchored on the immediate future without examining long term
consequences of their decision.

Overconfidence means that individuals overestimate their
  
information (knowledge illusion) and abilities.

Every investor thinks (s)he can beat the market. People even think,
in the extreme, but widespread, case of magical thinking / wishful
thinking
, that they influence outside events.

All this, coupled with anchoring::

Explain differences, and also clusters of opinions, that may put in
  
check the EMH,

On the bright side, help to find counterparts in the market even
  
when mimicry is strong, so that there is still some liquidity.

Lead to high trade volume (overtrading) from investors, and
   excess volatility
.

Another cause of overactivity is boredom, which can lead to game /
gambling behavior
.

It has been found that for fund managers (and even more for
individual traders) overtrading and underperformance are
correlated.

Are at the origin of a specific kind of winner's curse: the idea
   that a recent run
of rises or falls will be followed by a reaction
   (reversion to the mean).

 This idea forgets that statistics works with long series: in the long
  term things might average out, but in the short term extended
  clusters of similar outcomes may occur.

Rationalizing (getting stuck on immediate apparent explanations)
    leads to
explain by an apparently rational story, some analogy (halo
    effect),
or
another rhetoric / good story) :

Whatever action, even irrational, (finding a good reason for
    an urge
to buy or sell)

Whatever event, even of unclear origin (finding a reason for a
    market 
rise or fall, finding a pattern when there is none:
    representativeness heuristic
.

Whatever possible source of responsibility: we have here

* Attribution, which is to find an immediate culprit (demonization)
   for a bad event or hero (deification) for a good one

    * And self-attribution, a form of overconfidence or narcissism,
       which is the belief
that lucky events result from one's own skill.

The hindsight bias concerns people having forgotten their

    original estimates.

When seeing the outcome, they are likely to use it as an anchor and
assume their estimates must have been close to it.

 

Some flaws in the perception of the personal financial situation:
    mental accounts, house money, wealth effect.

   2. Social / collective / group cognitive biases

      ( financial psychosociology)

(affecting all players or at least some dominant types of investors)

Simplified common denominator:

Social behavior is usually based on on common conventions / beliefs /
paradigms / norms / social rules / memes.

We can add cultural biases, which males for narrow and bounded knowledge.

Those mind conditioners implanted via the imitation process of "social
learning
"
strike  either the whole population, or some sections of it (peer
influence, neighborhood effect, home bias, groupthink
).

They have their good and bad incidences, and even their necessity in various
cases, but they often also limit people's independence of mind and can bring
common mistakes when followed blindly.

To give only a trite example, individuals, as they get focused on these
aspects, tend to overlook, as seen above, most weak signals.

 

Rational mimetic expectations.

This kind of   feedback,

* Either negative (when the reaction / anticipation is self-corrective and
   compensate the event)

* Or positive (when it reinforces the initial event as a "vicious circle" or a
   "virtuous circle")
is a bias, and at the same time not a bias.

It could be rewarding to follow the trend although this reaction reinforces
it (percolation, informational cascades).
But this entails for investors to take the risk that one day that trend breaks.

This "rational" (or over-rational) bias can be measured not only by observing
the market, but also through street observation.

Or better, via consensus polls. Behavioral analysis considers that when
80 % or more of the investors are optimistic or pessimistic, the end of
that trend is near, as it becomes hard to convince new ones, and any
defection may trigger a trend reversal.

 

Manipulations, based on logical fallacies, disinformation and
    emotions (either the will to believe or paranoia),

Already possible from person to person, they get a new dimension in markets,
as groups and crowds are even more prone to get influenced.

However trust is needed in social activities, there are also few limits to human
gullibility
, all the more within groups and societies.

People accept easily obedience to authority, even to apparent
    authority.

Also, a mild form, personality cult / star system, is all over the place:

Mediatization of companies, and of company bosses, is growing.

It is estimated that 40 % of the time of a CEO is devoted to
communication.

This a good thing in itself, but propaganda and star system are not
far of each other sometimes.

Depositaries of economic power (i.e. Central Bank Presidents) are
   relentlessly
observed and their words get exaggerated interpretations.

Some analysts, journalists and specialists acquire a guru status.

Who (except lukewarm believers, like us cynical B-F people :-), or
some dye-hard asocial heretics, apostates, rebels, dissenters and
contrarians) will check the info or advices they give?

Who will say the king has no clothes / the Earth is not flat, and go
sometimes to the extreme (although it is not so easy to find the right
timing) of defecting and operating against the trend when it seems
necessary to save one's skin?

  3-4. Individual and social affect / emotions / passions

Emotions and feelings play a large part in decision making.
Emotion does not mean systematically irrationality.

Emotions are even useful to motivate people to act, to avoid passivity.

But they might be poorly controlled by reason.

It is known thanks to neuroscience research that decision activates brain
zones of pleasure and suffering which leads to attractions and
aversions
.

Here are some specific examples interfering in financial decisions:

  Greed, hope (optimistic bias), fear, , love,
      admiration, enthusiasm, disdain, hate and many others, which effects
     
on the market have still not been studied extensively...

  Even greed / fear, and simple risk aversion can be biased (prospect theory).

The "paradoxes" seen in the page probabilities, utility and decisions show
asymmetries in risk aversion.


A well known one is that, not only when fear reigns in the market, but also in
normal times, the loss aversion is stronger than the urge to seize
gain opportunities.

That may explain why:

In their portfolio, people prefer to sell winners than losers.

Their aversion to (an already real) loss is stronger than their aversion
to risk (the one they take by keeping downgraded stock in their
portfolios).

Often, it is often only after the losers fell for a long time that fear
takes over and that they sell them at the bottom.

Other reasons are commitment (see below), pride, regret
minimization
, etc.

Mental accounts: in many cases they dissociate their financial reasoning
   on new operations from their existing
financial situation  

This goes against the classical expected utility theory that states that
people take more risks if they are wealthier.

Panic contagions can spread faster (crashes...) than euphoria outbreaks.

That makes for fast and massive price falls, vanishing liquidity (liquidity
trap
)
and higher volatility (price agitation) on the descending path than during
the climb.

Commitment / foot in the door.

Once people start to accept to do a little thing, or just to listen to somebody,
they feel committed towards themselves (or to others).

Thus, they accept more easily to go one step (and then several steps)
further.

This habit building bias can lead to stubbornness (repeating the same
behavior whatever happens), and even to addiction.

Also, they value most the things that had cost them big efforts than
those obtained easily.

All that contributes to the reluctance to sell or to the cost averaging
practice.

The endowment effect is rather related: once somebody owns an
asset he overrates its value and would not accept to sell it at the
market price.


Social emotions / collective hysterias (crowd / mass behavior).

As seen above about mimetic expectations, people have a tendency for
conformity
of thinking with

People who are close to them (peer pressure),

The groups to which they belong ( groupthink)

The mass of other players ( epidemics, bandwagon effect,
    market consensus).

This goes against independence of mind, and full rationality and can lead to
extreme behaviors and, in financial markets, to strong anomalies

In a group or a crowd, individuals tend to lose their own reference and
inhibitions.

They share crowd emotions and behave like the crowd, sometimes going
to extreme actions that they would never have done by themselves.

That herd instinct / herding, exalted mimicry (something less "rational"
than the "cascades" seen above in chapter 2) leads, in stockmarkets, to:

Fashions and fads (mild form),

Bubbles and crashes (strong form).

  Off categories: autopilot biases

Some behavioral biases cannot be fully categorized as cognitive or
emotional, as they belong to quasi-physical - or clearly institutional -
automatisms

images/pi-arrig.gif For individuals: reflexes, habits, addictions...

images/pi-arrig.gif For human societies: rules and rites.

   5. In practice: precautions for investors

To make it short, here are some examples of attitudes 

which investors should be wary of.

Between you and me, all this applies also to decision-making

in many other decision fields than finance.

 

1 - Activity

Avoiding inertia and indecision as well as
hyperactivity

2 - Reaction

Being sure to adjust to new situations and
information

3 - Anchoring /
     focusing

Trying not to be anchored on past references
/ values

4 - Framing,
     heuristic, habit

Avoiding narrow interpretations and over-
simplifications

5 - Fallacy,
     attention

Revising erroneous knowledge and beliefs

6 - Attitude -
     Aversion

Avoiding biased expectations of pleasure /
pain that follow decisions

7 - Emotion

Avoiding the primacy of emotions over
reason

8 - Mimicry,
     manipulation

Being wary of biased social influences on
decisions

9 - Magic

Being wary of illusive expectations

10 - Pride

Trying not to be blinded by one's ego

11 - Preferences

Trying to have clear and consistent priorities

12 - Tilting

Trying to detect and to use - or to protect
from - market mispricing

More details in bfpractice pi.arlef.gif

 

Other sections of the chapter

See also

Introduction

BF vs. EMH

Behavioral-Finance Gallery

500+ keywords BF glossary

and 700+ members
BF forum

Part B

Economic and financial
incidences

separ

 This page last update: 24/04/15    
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