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 1800+ members informative BF forum
Part A (below)	Individual and social behavioral biases
Part B	Economic and financial incidences

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

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, 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 progressively 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 bases as many habits are

physical automatic responses.

Even if cognition (neuronal paths) and emotion (pain and pleasure) are involved in habits, they might be said

to be nearly pure behavioral biases.

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

They lead to decisions made on shallow 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, selective approaches, generalizations, stereotypes,

rules of thumbs, or even common paradigms. Let us quote:

* the representativeness heuristic (we see a phenomenon and consider it to be representative of a general 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 dependant" and limit their approach to one angle, and select only 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 at 3 dollars a day may seem less costly than 1095 dollars a year.

Logical fallacies (binary logic, sophisms, confusions causes / effects, reductionism and generalizations...),

And also numeracy bias (abusive belief in statistics and mathematical trading models, distant from

he economic context and not well adapted to rare events or new situations).

Conversely an ignorance ou 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 the long term consequences of their decision.

Cognitive overload, feeling to be drowned in too many information

(investors cannot walk and chew gum at the same time).

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..

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, fur 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

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.

Simplified common denominator:

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

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

Those mind conditioners implanted via the imitation process of "social learning" concerns either the whole population,

or some sections of it (peer influence, neighborhood effect, home bias, groupthink).

They have their good and bad incidence, 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 influenceable.

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?

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 stocks).

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 utilitytheory 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 happen), 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 (bandwagon effect, market consensus, epidemics).

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).

Some behavioral biases cannot be fully categorized as cognitive or emotional,

as they belong to quasi-physical - or clearly institutional - automatisms

For individuals: addictions and habits,

For human societies : rules and rites.

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 following 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