Behavioral errors and biases

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Types of errors
Cognitive errors are basic statistical, information-
processing, or memory errors

Emotional biases arise as a result of attitudes and feelings

that cause the decision to deviate from rational utility
maximization

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Cognitive errors
Blind spots in human mind

Not due to predisposition towards some judgements

Investors can adapt their behavior if the source of bias is

logically identifiable

Better information, education, and advice is useful for

moderating the biases

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Emotional biases
Stem from impulse, sometimes unreasoned judgements

Individuals may be unable to control these emotions even if

they want to

Only possible to adapt to these biases

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Cognitive errors
1. Belief perseverance biases
i. Conservatism
ii. Confirmation
iii. Representativeness
▪ Base-rate neglect
▪ Sample-size neglect
iv. Illusion of control
v. Hindsight
2. Information processing biases
i. Anchoring
ii. Mental accounting
iii. Framing
iv. Availability
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Emotional biases
1. Loss aversion
• Disposition effect
2. Overconfidence
3. Self-control
4. Status quo
5. Endowment
6. Regret-aversion

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Cognitive errors (1)
Belief perseverance biases
i. Conservatism
ii. Confirmation
iii. Representativeness
▪ Base-rate neglect
▪ Sample-size neglect
iv. Illusion of control
v. Hindsight

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Conservatism
Maintaining your prior views (or forecasts) by failing to
properly incorporate new information as it becomes available

Me continuing to believe in EMH even after compelling evidence to the contrary 

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Conservatism …
Diagnosis
 Say that after you have made an investment based on your
own research, an advisor gives you information that
contradicts your opinion. What do you do?
 How frequently do you take in new information about the
market?

Mitigation
 React decisively and fully to any new information and seek
unbiased counsel

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Confirmation
Seeking out evidence that confirms your beliefs and ignoring
evidence that contradicts them
• Researchers frame their data in ways that tend to confirm their
hypotheses
• During an election season, people tend to seek positive information
that paints their favored candidates in a good light. They will also
look for information that casts the opposing candidate in a negative
light

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Confirmation …

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Confirmation …
Classic example: Capital punishment studies
• In one experiment (Lord, Lepper, and Ross, 1979), 24 pro-death
penalty students and 24 anti-death penalty students critically
evaluated “studies” on capital punishment
• These students found that studies which supported their pre-
existing view were superior to those which contradicted it, in a
number of detailed and specific ways
• In fact, the studies all described the same experimental procedure
but with only the purported result changed

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Confirmation …
Consequences for investments
 Only reaffirming evidence is considered
 Information is ignored that refutes the validity of the screen
 Under-diversified portfolios if you fall in love with a
particular stock or sector
 Holding too much of your own-company’s stock because
you are convinced of its growth prospects

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Confirmation …
Mitigation
 Actively look for information that challenges beliefs
 Obtain corroborating support for investment decision
• If a stock breaks through 52-week high, obtain supporting
information to assure good value
• Confirming an investment idea through purchase is not a good
strategy

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Representativeness
Classifying new information based on past experiences or the
way things have happened in the past

Rely on “best-fit” approximation

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Representativeness …
Linda is 31, single, outspoken, and very bright. She majored
in philosophy. As a student she was deeply concerned with
issues surrounding equality and discrimination. Is it more
likely that Linda is:

 A bank clerk, or

 A bank clerk and active in feminist movement?

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Representativeness …
Steve, a 30-year old American, has been described by a
former neighbor as follows: “Steve is a very shy and
withdrawn, invariably helpful, but with very little interest in
people or the social world. A meek and tidy soul, he has a
need for order and structure and a passion for detail.” Which
occupation is Steve currently more likely to have:

 Salesman, or

 Librarian?

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Representativeness …
What is the probability that Company A (ABC, a 75-year old
steel manufacturer that is having some business difficulties)
belongs to group X (value stocks that will likely recover)
rather than group Y (companies that will go out of business)?

What is the probability that a AAA-rated municipal bond

(issued by an “inner city” and a racially-divided county)
belongs to group X (risky municipal bonds) rather than to
group Y (safe municipal bonds)?

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Representativeness …
May explain long-term reversal: Stocks that have been
extreme losers in the preceding three years do much better
than extreme past winners over the subsequent three years
• Investors become unduly pessimistic about the prospects of the
past losers, driving down their prices. Prices revert back giving
exceptional returns

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Representativeness: Sample size neglect
Hot hands: Imagine that you’re the coach of a basketball
team. There’s 10 sec left, and your team is down by a
basket. Your star player (5-year career average of 55% shots
made) is only 2 for 10 today. Another veteran player (5-year
career average of 45% shots made) is 10 for 10 today.
Whom do you give the ball to?

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Representativeness: Hot hands

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Representativeness: Sample size neglect …
Law of small numbers!

Which of the following two sequence of coin tosses from an

unbiased coin is more likely?
HTHTHTHT
HHHHTTTT

Gambler’s fallacy: If a fair coin generates four heads in a

row, people will say that “tails are due.” Since they believe
that even a short sample should be representative of the fair
coin, there have to be more tails to balance out the large
number of heads
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Representativeness: Regression to mean
Flight training example (Kahneman)

Instructors of pilots found that bad landings improved after

verbal punishment, while good landings did not after praise

Concluded that verbal reward was detrimental to learning,

while punishment was beneficial

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Representativeness: Regression to mean
It’s been better to have been a novice than a professional the
past few years, because people with the most experience
have been the most cautious. But markets do regress back to
the mean, and I agree that we are late in the ball game. This
is the longest period we’ve ever had with such high returns
from equities, and I can’t believe it’s a new era that will just
keep going forever. I don’t know if returns going forward will
be 7% or 8%, but I’m pretty sure that they will be below
average.
Excerpt from an interview that appeared in the August 18, 1997 issue of Fortune magazine, with global
strategist Barton Biggs of Morgan Stanley and senior investment advisor Robert Farrell of Merrill Lynch

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Representativeness: Regression to mean
Regression to mean implies that future returns will be closer
to their historical average. But is does not mean that they
will be below their historical average

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Representativeness …
 Lack of performance persistence but performance-fund flow
relationship in mutual funds
 Difficulty in market timing

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Illusion of control
When people believe that they can control or influence
outcomes
• A mid-level manager may believe that he can personally influence
his employer's stock price
• People permitted to select their own numbers in lottery are willing
to pay a higher price than those using randomly assigned numbers

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Illusion of control …
Consequences
 Excessive trading
 Inadequate diversification (often due to over-investing in
own-company stock)

Mitigation
 Keep detailed records of your predictions and refer back to
these in order to get an honest assessment of your
predictive powers

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Hindsight bias
Seeing past events as having been inevitable and predictable
• People tend to remember their own predictions of the future as
more accurate than they actually were

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Hindsight bias …
Consequences
 Overestimating how well they predicted various events
 Unfairly assessing money manager or security performance

Mitigation
 Keep detailed records and refer back to them
 Seek out contrary and independent views

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Cognitive errors (2)
Information processing biases
i. Anchoring
ii. Mental accounting
iii. Framing
iv. Availability

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Anchoring
When required to estimate a value with unknown magnitude,
people generally begin by envisioning some initial default
number—an “anchor”—which they then adjust up or down to
reflect subsequent information and analysis
• Regardless of how the initial anchor was chosen, people tend to
adjust their anchors insufficiently and produce end approximations
that are, consequently, biased
• Related to conservatism bias

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Anchoring …
Real estate appraisal: Two groups of professional real-estate
agents were shown the same house. One group was given a
list price of $65,900, the other $83,900. Their average
appraisals were $67,811 and $75,190, respectively.
• When asked to explain their decisions, less than 25% mentioned
listing price as one of the factors

Do you anchor on market price while doing a DCF?

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Anchoring …
Consequences
 Holding onto a stock to attain a price that you are anchored
to, such as the purchase price or a high-water mark
(instead of rational analysis)
 Making a market or security forecast anchored to last year’s
market levels or ending securities prices

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Mental accounting
A process to code, categorize, and evaluate economic
outcomes by grouping their assets into any number of non-
fungible (non-interchangeable) mental accounts
• Segregating investments by source of funds
▪ Bonuses, salaries, etc. being invested in different accounts or managed
separately

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Mental accounting …
Imagine that you bought a ticket to a hit Broadway play. At
the theater you realize that you have lost your ticket which
cost $250. Do you spend another $250 to see the
performance?

Now imagine the same scenario, but you are planning to buy
the $250 ticket when you arrive. At the box office, you
realize that you have lost $250 somewhere in the parking lot.
Still, you have more than enough to buy the ticket. Do you?

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Mental accounting …
Imagine that you go a store to buy a lamp which sells for
$100. At the store, you discover that the same lamp is on
sale for $75 at a branch of the store five blocks away. Do you
go to the other branch to get the lower price?

Now imagine that you go the same store to buy a dining

room set which sells for $1,775. At the store you discover
that you can buy the same table and chairs for $1,750 at a
branch of the store five blocks away. Do you go to the other
branch to get the lower price?

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Mental accounting …
Mentally account for money as too sacred or special to
become too conservative with it
• Retirement money: 401(k), 403(b), 457 plans.
• $10K saved will grow to only $43K in bonds @5% but $174K in
stocks @10% over a period of 30 years
• Mentally accounting for retirement money as too special could
mean that you haven’t saved enough for your retirement

Retirement portfolio treated as MC Hammer portfolio!

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Mental accounting …
Mental accounting can cause investors to irrationally
distinguish between returns derived from income and those
derived from capital appreciation
• Can cause some investors to chase income streams and unwittingly
erode principal in the process

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Framing
Making skewed decisions based on how a question is framed

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Framing …
Imagine that you are the commander of an army, threatened with a
superior enemy force. Your staff say that your soldiers will be caught in
an ambush in which 600 soldiers will die unless you lead them to safety
by one of two available routes. If you take route A, 200 soldiers will be
saved. If you take route B, there is a one-third chance that 600 soldiers
will be saved and a two-thirds chance that none will be saved? Which
route do you take?

Imagine that once again you are the commander of an army,

threatened with a superior enemy force. Once again, your staff tells
you that if you take route A, 400 soldiers will die. If you take route B,
there is a one-third chance that no soldier will die and a two-thirds
chance that 600 soldiers will perish. Which route do you choose?

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Framing …
Choose a portfolio

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Framing …
Consequences
 Misidentifying risk tolerance
 Choosing sub-optimal investments
 Focus on short-term price fluctuations

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Availability
Estimating the probability of an outcome based on how easily
it comes to mind

Consequences
 Making choices based on advertising or reputation
 Limited range of investments are considered, which leads to
an insufficiently diversified portfolio and inappropriate asset
allocation

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Availability …
“All accidents”
and “all disease”
the same; in
reality 1:16.

Most overstated:
 Rare but
spectacular

Most
understated: “Rare” “Common”

 Common,
mostly non-fatal Slovic, Fischhoff, Lichtenstein (1982)
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Availability …
A. Estimate the percentage of words in the English language
that begin with the letter “a”
B. Estimate the percentage of words in the English language
that have the letter “a” as their third letter

Most people believe A (true 6%) is more likely than B (true

9%)
• Easier to retrieve first letter words from memory

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Availability …

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Availability …
Buying decision: Almost 5,000 stocks to choose from (U.S.).
Seek among those which easily come to mind. E.g., large
price changes

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Percent Order Imbalance

20
Large Discount Brokerage

15 Small Discount Brokerage

10 Large Retail Brokerage

0
1a 1b 2 3 4 5 6 7 8 9 10a 10b
-5

Partitions of Stocks Sorted on Previous Day's Return

Barber and Odean (2001) 48

Emotional biases
1. Loss aversion
• Disposition effect
2. Overconfidence
3. Self-control
4. Status quo
5. Endowment
6. Regret-aversion

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Loss aversion
Making increasingly risky bets in order to avoid suffering or
recognizing losses

When comparing absolute values, utility derived from a gain

is much lower than the utility given up with an equivalent
loss

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Loss aversion …
Imagine that you have just been given $1,000 and have
been asked to choose between two options. Option A:
Guaranteed additional $500. Option B: heads you get
additional $1000, tails gain nothing?

Now imagine that you have been given $2000 and have to
choose between two options. Option A: Guaranteed losing
$500. Option B: heads you lose $1000, tails lose nothing?

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Loss aversion …
Reference point: Investor A owns a block of share which she
originally bought at $100 per share. Investor B owns a block
of share of the same stock for which she paid $200 per
share. The value of stock was $160 yesterday and today it
dropped to $150 per share. Who do you think is more upset?

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Loss aversion …

Disposition effect: Holding (not selling) of losers too long and

selling (not holding) of winners too quickly

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Loss aversion …
People are pre-disposed to “get-even-itis”
• Have difficulty in making peace with their losses
• Disposition effect is the propensity to lock in sure gains than to lock
in sure loss

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Loss aversion: Disposition effect

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Loss aversion …
Individuals are more likely to sell stocks that have risen in
price rather than those that have fallen in price (Odean,
2001)
• Stock that is up in value is 70% more likely to be sold than a stock
that is down
• A losing stock is held for a median of 124 days while a winning
stock is held for a median of 102 days
• Stocks that investors sold outperform the stocks that they held by
3.4% over the next 12 months

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Loss aversion …
Coval and Shumway (2005) investigate morning and
afternoon trades of 426 traders of CBOT
• Assume significantly more risk in the afternoon trading following
morning losses than gains

Locke and Mann (1999) find that CME traders also display
disposition effect/loss aversion
• Best traders are the ones who are least loss-averse (sold their
losers and rode their winners)

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Overconfidence
Believing that you have superior knowledge, abilities, and
access to information (illusion of knowledge)

Intensified when combined with self-attribution bias

• Taking credit for successes and assigning responsibility for failures

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Overconfidence …
Prediction overconfidence
 Give high and low estimates for the weight in pounds of an
empty Boeing 747 aircraft. Choose numbers far apart to be
90% certain that the true answer lies in between.

Certainty overconfidence
 How good a driver are you? Compared to the drivers you
encounter on the road, are you above-average, average, or
below-average?

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Overconfidence …
May have biological evolutionary roots

May be part of human condition

• Five to six times as many optimistic adjectives as pessimistic
adjectives in virtually all languages

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Overconfidence …
Individuals who trade the most frequently post exceptionally
poor investment results

Source: Brad Barber and Terrance Odean, 2000, “Trading Is Hazardous to Your Wealth: The Common Stock
Investment Performance of Individual Investors,” Journal of Finance 55, 773–806.
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Overconfidence …
Barber and Odean (2001)
 Performance of stocks picked by men and women was
about the same

 Men traded 45% more than women

• And chose stocks in smaller companies, higher price-to-book, and
higher betas
• Earned 1.4% less on risk adjusted basis

 Single men traded 67% more and earned 3.5% less on a

risk-adjusted basis

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Overconfidence …
Day traders abandoned regular jobs to trade full time from
their personal computers

Most online traders were between 25 and 43 years old

75% of online traders were men; most active cohort was in

30-34 age group

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Overconfidence …
Mitigation

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Self-control
Inability to delay gratification

Failing to act in pursuit of your long-term financial objectives

due to a lack of self-discipline

Failing to save for retirement

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Self-control …
Hyperbolic discounting: Tendency to prefer small payoffs now
than large payoffs in the future, where the tendency
increases closer to the present both payoffs are

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Self-control …
Consequences
 Failing to save for retirement
 Taking on too much risk in an attempt to catch up
 Undiversified portfolio (e.g., too many equities, etc.)

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Status quo
Doing nothing rather than making optimal investment
decisions

Consequences
 Failing to explore new opportunities, specifically when a
change might the best decision for the portfolio
 Maintaining a portfolio that has drifted away from its
optimal allocation

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Endowment
Valuing assets more when you own them than when you
don’t

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Endowment …
Imagine that you recently found a ticket to the Final Four.
You very much want to go. Now a stranger offers to buy your
precious ticket. What is the smallest amount for which you
would sell?

Now imagine that you don’t have a ticket to the event, but
you really want one. How much would you be willing to pay?

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Endowment …
Investors hold onto securities that they have inherited,
regardless of whether retaining these securities makes sense

Investors hold onto securities that they have purchased

because they are familiar with these, even though this may
not make rational sense

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Endowment …
Fail to contribute to your pension plan
• Typically employers match 50¢ to each dollar of your contribution
up to 6% of your salary
• 12 million people choose not to accept this free money
▪ Costs employees $6 billion a year in missed employer matches
• Overvalue what they have today (today’s salary) and fail to value
what they could have

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Regret aversion
When past investment decisions - notably the regret
associated with them - have irrational influence over future
investment decisions

Being afraid to make a mistake because of regret associated

with past decisions

Markowitz had a 50-50 stock-bond portfolio “I visualized my

grief if the stock market went way up and I wasn’t in it—or it
went way down and I was completely in it. My intention was
to minimize my future regret.”

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Regret aversion …
Consequences
 Overly-conservative investing
 Investing in the familiar
 Herding behavior
 Hanging on to a losing investment in order to avoid
realizing a loss

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Skepticism
Don’t people make fewer mistakes when given proper
incentives?

Don’t people learn quickly and stop making mistakes?

Don’t people with expertise in some areas make fewer

mistakes?

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Skepticism …
Behavioral biases cost you money but reflect psychological
tendencies that bring benefits in other areas
• Tendency to weigh losses more than gains is doubtless useful from
evolutionary standpoint
• Tendency to set up mental accounts can serve you well, for
instance in saving for future

Many behavioral biases appear to conflict with each other

• People routinely overestimate their own abilities
• People blindly follow the actions of others

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

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