Behavioral finance FAQ / Glossary (Bias)

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Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

Behavior / behavioral

see behavioral

Behavioral biases in finance / economics / management


 


Many messages about "bias" in the
BF group + see anomalies,
rational,
cognitive, emotional, behavioral
finance, social psychology
+ bfdef site link + behavioral
economics / finance
definition in
this glossary.

Choose your proverb:

Hard and cruel:
"You always win if you bet on human stupidity"
Soft and lenient:

"Perfection does not belong to this world"

Definition: behavioral biases are:

Maladapted actions,
reactions or ... inactions

caused by erroneous decisions (this
excludes of course harms due to pure uncertainty).

Those blunders, a more explicit word, happen because of irrational, or at
least not fully rational mental processes.

Irrationality or bounded rationality (see rational / irrational) is
a rather common human trait
that cannot be totally avoided.

It would even be inhuman and irrational to expect full
rationality
!

Like in many aspects of nature or society, in which nothing is 0% or
100% true, sorry Aristotle and your binary logic, let us talk about 

"degrees" of rationality / irrationality.

The limited rationality phenomenon can be detailed as a series of
various cognitive / emotional biases as well as unchecked reflexes,
habits and heuristics
(see those various phrases).

They bring errors in judgment and behavior distortions.

Also, individual and social psychology shows that the human mind is also

influenced by groups ans society.

Nothing wrong of course for the individual to take into account common
issues.

But often it is takes the form of a contamination that makes us
skip rational analyses and lose our free will
.

Examples of behavioral biases
    (and related market anomalies)
:

(see also the "main investors biases" table in bfdef, and also the
general glossary list
)

Cognitive biases

Individual biases: anchoring, representativeness or

availability heuristic, unfounded beliefs, logical
fallacies,
memory flaws...

Collective biases: systemetic dependence on social
    learning, on external behaviors...

Emotional biases

Individual biases: loss aversion, affect heuristic,
   
overconfidence, hope and fear...

Collective biases: mimicry, herding...

Autopilot / reflexive biases
    (that go beyond cognition and emotion)

Individual biases: inertia, addictions, compulsions,
    bad reflexes or habits...

Collective biases: rules, rites, taboos...

Market anomalies: mispricing, price / return clusters,
     momentum,
fat tails / rare events...

The case of economics and finance:
     biases or anomalies?

When the wrong foot steps on the market's paw
and the biases' footprints lead to the cave of anomalies.


In finance / economics
, among other fields of activities, behavioral biases
are teeming
and they bring a majority of contra-productive outcomes,
even if luck in some cases saves the day.

Even when they deal with money, people are not
fully
"rational".  Money is even a human / social
field particularly prone to goofs, unless luck saves the day.

Economic players' decisions, and among them investors' decisions, are often

shallow-based (heuristic, anchoring)

and/or "under influence" (habits, groupthink, conformity and mimicry).

Decisions rarely match exactly what economists

call the decider's "utility" (see that word).

The gap might be small, but in some cases it is an abyss.

The results can even be the opposite of what could be seen as the person's
interest.

Also, biased investment behaviors, when shared by many
     investors,
can make asset prices and returns

  diverge  from standard economic

 paradigms, focused on rationality and utility.

To be fair, markets have (very) long term (progressive or violent) self-
correction mechanisms. In them an illusion or habit might survive
less time
than in other social systems, such as administration or
politics.

Following the distinctions made in the "social psychology" article, we can
consider separately
investor psychology, consumer psychology and the
behavior of markets.

This leads to analyze the differences and relations between:

Human behavioral biases or flaws that damage their money-

related  activities,as individual psychological deficiencies.


Market anomalies (see that word), as quantitative

consequences on prices or returns when those biases
become collective.

Some dogmatism can interfere in considering as anomalous
a price
or return that just does not fit the standard
valuation rules and criteria.

A typical criteria in those standard models is economic
"utility" (see that word) (*)

(*) OK, such a set of references to judge what is normal and
     rational might be itself biased,
but references and benchmarks
     are practical tools to help study some phenomena, don't they?

The case of asset markets

Micro / macro blunders

To take more specifically the example of asset markets (a key research
area of behavioral economic and finance), irrationalities leads to:

1) Individual / micro investment mistakes, as sources

of insufficient returns or excessive risk-taking for an investor,


2) Collective / macro behavioral biases, when

investors get influenced by one another and act as an emotional
crowd
(herding...).

Individual biases do not always average out, as some are
common to many investors
either "naturally" or because mimicry
contaminates them.


3) Market anomalies / inefficiencies,

such as mispricing or return anomalies between various assets,
periods, etc.

 

This micro / macro semantics is not stabilized.
Some reclassify the above as:

1-2) Investor biases,

3) Market anomalies,

aka

"Behavioral Finance
      Micro / BFMI,

"Psycho(socio)logical
     behavioral finance",

"Investor psychology",
      if said more simply.

aka

"Behavioral Finance Macro
    / BFMA",

"Quantitative behavioral
     finance".


Are all biases really biases?

Tentative adaptation, with a few finger burnt,
more than immediate perfection.


It is not certain that all behavioral biases are ...biased, and all market
anomalies...anomalous.

Here are two aspects that can make think otherwise:

1) As seen above, the criterion to define market rationality

usually addresses only "economic utility". There is a
puzzle here: it seems rather reductive to consider always
irrational a decision that just strays
from this narrow criterion.


2) Also, a school of thoughts, called evolutionary economics,

considers that what is labeled anomalies, biases or irrationalities 
are elements of an adaptation process.

Within such a process, things find their way gradually .

In parallel this improves the knowledge of economic players
(learning process) such as producers, workers, investors,
consumers.

       This evolution is done via heuristics (simple rules),
           approximations, trials and errors, more than by reaching
           immediately an optimum solution.

It does not means that the same biases will not reappear
later, when memory fades (see memory).

Are some investors less biased than others?

Darwinian process,
from Galapagos tortoises to market players.

Some researches have found behavioral biases
relatively less present in seasoned investors

(although some get narcissist after a streak of
good luck).

This immunity to market bugs might be:

Because they learnt by experience, by burning their fingers, improving

their market culture, creating an asymmetry of knowledge in their
favor (see asymmetry),

Or because of natural selection (see adaptable market) which makes

that investors who are still in the game are those who where smart
enough to survive ;-),

Or just by chance: beware of the "survivor bias" (see that word).

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

Members of the Behavioral Finance Group,
please vote on the glossary quality at
BF polls

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This page last update: 21/07/15           

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