DISJUNCTION EFFECT

The disjunction effect is a tendency for people to want to wait to make decisions until
information is revealed, even if the information is not really important for the decision, and even
if they would make the same decision regardless of the information. The disjunction effect is a
contradiction to the "sure-thing principle" of rational behavior.
Experiments showing the disjunction effect were performed by Tversky and Shafir (1992). They
asked their subjects whether they would take one of the bets that Samuelson's lunch colleague,
discussed above, had refused, a coin toss in which one has equal chances to win $200 or lose
$100. Those who took the one bet were then asked whether they then wanted to take another
such bet. If they were asked after the outcome of the first bet was known, then it was found that a
majority of respondents took the second bet whether or not they had won the first. However, a
majority would not take the bet if they had to make the decision before the outcome of the bet
was known. If the outcome of the first bet is known and is good, then subjects think that they
have nothing to lose in taking the second, and if the outcome is bad they want to try to recoup
their losses. But if the outcome is not known, then they have no clear reason to accept the second
bet.

SELF DECEPTION
Self-deception is a process of denying or rationalizing away the relevance, significance, or
importance of opposing evidence and logical argument. Self-deception involves convincing
oneself of a truth (or lack of truth) so that one does not reveal any self-knowledge of the
deception. The concept of self-deception is a limit to the way we learn. When we mistakenly
think we know more than we actually do, we tend to miss information that we need to make an
informed decision.
3 sources of self-deception behaviour

● lack of knowledge
● the ability for self-deception
● allowing others to deceive

NEURO-FINANCE
Behavioral finance describe market price anomalies and individual decision biases.
Unfortunately, such descriptions of behavior have not proven amenable to generalization or
predictive modeling. Neurofinance research illuminates the fundamental mechanisms that
underlie how individual biases, irrational behavior, and collective buying and selling decisions
emerge. Using research tools and techniques borrowed from the field of neuroscience, scientists
are gaining the necessary insights to build comprehensive economic models of human economic
behavior and decision-making.

Just as the field of economics provides a foundation for traditional finance, neuroeconomics
research is informative of neurofinance. Neurofinance is not a separate field so much as a set of
experimental techniques and tools that practitioners in many other fields adopt to investigate
questions of central interest. Neurofinance experimentation is defined by the use of the
scientific method to identify drivers and modifiers of choice behavior.. The use of
neuroscientific research tools allows economists to look at biological drivers of decision-making.
In particular, many economists are interested in investigating the origins of nonoptimal
decision-making.

MENTAL ACCOUNTING
● Mental accounting is a behavioral economics concept that states that
humans place different values on money, which leads to irrational
decision making.
● The concept of mental accounting was developed by Richard Thaler in
1999.
● Thaler recommended that people should treat money as a fungible
commodity and treat all money the same, regardless of its origin or
use.

SELF CONTROL
Self-control bias which is a human behavioral tendency that causes people to fail to act
in pursuit of their long-term, overarching goals because of a lack of self-discipline. Many
people are notorious for displaying a lack of self-control when it comes to money.
Self-control bias can cause investors to spend more today at the expense of saving for
tomorrow. It may cause investors to fail to plan for retirement. Self-control bias can
cause asset-allocation imbalance problems and can also cause investors to lose sight
of basic financial principles, such as compounding of interest, dollar cost averaging, and
similar discipline behaviors that, if adhered to, can help create significant long-term
wealth. The benefits of self-discipline in investing are difficult to obtain. The results,
however, are well worth it.

REGRET AVOIDANCE
Regret avoidance (also known as regret aversion) is a theory used to explain
the tendency of investors to refuse to admit that a poor investment decision
was made. Risk avoidance can lead investors to hang on to poor investments
too long or to continue adding money in hopes that the situation will turn
around and losses can be recovered, thus avoiding feelings of regret. The
resulting behavior is sometimes called escalation of commitment.Regret
avoidance is when a person wastes time, energy, or money in order to avoid
feeling regret over an initial decision. The resources spent to ensure that the
initial investment was not wasted can exceed the value of that investment.
One example is buying a bad car, then spending more money on repairs than
the original cost of the car, rather than admit that a mistake was made and
that you should have just bought a different car.
"We are likely to make irrational or inappropriate decisions when we make
decisions under duress, when we make decisions without the proper context,

COGNITIVE DISSONANCE It refers to the mental conflict that occurs when a

person's behaviors and beliefs do not align. ... Cognitive dissonance causes
feelings of unease and tension, and people attempt to relieve this discomfort in
different ways.

Cognitive dissonance is the unpleasant emotion that results from holding two
contradictory beliefs, attitudes, or behaviors at the same time. The study of
cognitive dissonance is one of the most widely followed fields in social
psychology. The failure to resolve cognitive dissonance can lead to irrational
decision-making as a person contradicts their own self in their beliefs or
actions. The concept of cognitive dissonance has applications to investing.
One study suggests that the observation that people do not always treat sunk
costs as irrelevant to marginal decisions is at least in part due to cognitive
dissonance. Economists argue that it is irrational to continue throwing money
into an investment, or any project, that is failing and call doing so the "sunk
cost fallacy". Yet some investors can be observed to make this kind of
irrational decision. The study argued based on survey evidence that an
individual trader's future decision-making may be influenced by his previous
investment decisions. As such, his future decisions, which may be contrary to
his investing beliefs, are taken to reaffirm the amount of time and money he
has invested in his previous ones.

REPRESENTATIVENESS
Representativeness heuristic bias occurs when the similarity of objects or
events confuses people’s thinking regarding the probability of an outcome.
People frequently make the mistake of believing that two similar things or
events are more closely correlated than they actually are. This
representativeness heuristic is a common information processing error in
behavioral finance theory. In financial markets, one example of this
representative bias is when investors automatically assume that good
companies make good investments. However, that is not necessarily the case.
A company may be excellent at their own business, but a poor judge of other
businesses.
Another example is that of analysts forecasting future results based on
historical performance. Just because a company has seen high growth for the
past five years doesn’t necessarily mean that trend will continue indefinitely
into the future.

The representativeness heuristic is best illustrated through an example.

Consider the following:
“Mary is quiet, studious, and concerned with social issues. While an
undergraduate at Berkeley,
She majored in English literature and environmental studies.” Given this
information, indicate
which of the following two cases is most probable:

A. Mary is a librarian.
B. Mary is a librarian and an environmental organization member.

In this study conducted by Kahneman and Tversky,14 subjects assigned

greater probability to B, which is statistically nearly impossible since only a
subset of librarians can also be environmental organization members. People
put too much emphasis on the high probability that someone who matches the
description B is Mary, thereby neglecting the fact that A is the more general
case.15 Subsequently, this situation illustrates how investors should not
confuse what may appear to be a “good company” with a “good investment.”
Strictly speaking, investors should consider company products and services
separately from the firm’s financial fundamentals and current stock valuation.

AVAILABILITY

Availability bias refers to the tendency of investors to extrapolate their personal trends and
consider them to be the market reality. For instance, the business of a certain person may be profitable
even during a recession. Hence, they are likely to assume that even if the recession continues, the
market will continue to rise further. On the other hand, if a person has suffered a job loss in a growing
economy, he/she is likely to believe that the entire economy is headed downwards.

Availability bias is called the availability bias because it depends upon the user being able to recall their
experiences. The experiences which are most vivid or deeply experienced are the ones most readily
available for decision making. This is the reason that this bias is called the “availability bias.”

Availability bias is the reason that an investor who may have lost money in the share markets starts to
believe that the markets are excessively risky and hence avoids investing in them. Availability bias
basically explains how the beliefs of an investor can become excessively influenced by their experiences
and hence can go completely out of sync with reality.

Availability bias negatively affects the interests of investors. Some of these negative effects have
been listed below:

● As a result of availability bias, investors are often caught mitigating the wrong risk. This is
because the perception of the investor depends upon their own life experiences, which are
unpredictable. Also, investing with availability bias is like looking in the rearview mirror. People
with availability bias are looking at the most recent risks. For instance, investors with availability
bias in 2010 were trying to avoid mortgage-backed securities. The reality was that the fiasco in
mortgage-backed securities was already over. The next market bubble would most likely come
from a different type of security. Investors with availability bias would be too concerned about
mortgages since they would have lost money due to mortgages the last time. They would not be
paying attention to equity, debt, or other kinds of derivatives, which could become the reason for
the next downfall.
● Investors with availability bias are more likely to invest more in companies that they regularly hear
about. They are unlikely to select the best stocks because of investment rationale. Instead, they
are likely to have an inclination towards making investments in companies that are present in the
news. This creates the wrong incentive for companies. There are several companies that pay
media outlets to cover their stories more extensively. This helps them create a recall with the
investors. Hence, when investors are pitched with an investment for such a company, they are
more likely to make this investment decision.
● Investors with availability bias are more likely to overreact to market news. For instance, these
are the investors who create volatility in the market after an unexpected earnings announcement.
These are also the investors that trade excessively when there is news of a product recall by the
company. A small product recall might not have a large financial impact on the financials of the
company. However, investors with availability bias get carried away with all the negative publicity
in the news. This is the reason that they tend to overreact. More often than not, this has a
detrimental impact on their portfolio.

Availability bias generally impacts people who track their investments too much. While it is good to keep
an eye on the behavior of your investments, it is wrong to obsessively track their every moment. The
more a person pays attention to their investments, the more likely they are to make a premature and
wrong decision. The best defense against availability bias is to filter the news that we hear about our
investments and act on them in a rational manner

ANCHORING
Anchoring bias occurs when people rely too much on pre-existing information
or the first information they find when making decisions. For example, if you
first see a T-shirt that costs $1,200 – then see a second one that costs $100 –
you’re prone to see the second shirt as cheap. Whereas, if you’d merely seen
the second shirt, priced at $100, you’d probably not view it as cheap. The
anchor – the first price that you saw – unduly influenced your opinion.
Anchoring bias is an important concept in behavioral finance. If I were to ask
you where you think Apple’s stock will be in three months, how would you
approach it? Many people would first say, “Okay, where’s the stock today?” Then,
based on where the stock is today, they will make an assumption about where it’s
going to be in three months. That’s a form of anchoring bias. We’re starting with a
price today, and we’re building our sense of value based on that anchor.

BEHAVIOURAL PERSEVERANCE
Belief perseverance, also known as belief persistence, is the inability of people to
change their own belief even upon receiving new information or facts that
contradict or refute that belief. In other words, belief perseverance is the
tendency of individuals to hold on to their beliefs even when they should not. It is
an example of bias in behavioral finance.

Mike, a 32-year-old financial analyst, is heavily invested in Company A. Over

the past few weeks, sentiment regarding Company A has been severely
bearish due to major internal accounting fraud. The company’s share price
has plummeted to reflect this new information. In addition, other financial
analysts are negative about the shares of Company A and assign a low target
price. Mike, despite the accounting scandal and significant negative sentiment
regarding Company A, refuses to change his belief regarding the company and
continues to hold onto his shares in spite of the declining share price. As Mike
is sticking to a flawed investment strategy, this is an example of belief
perseverance.

Belief Perseverance Biases in Behavioral Finance

There are several major belief perseverance errors. Outlined in CFI’s
Behavioral Finance Glossary, they are:

● Conservatism bias: placing more emphasis on old information used to

form beliefs rather than on new information.
● Confirmation bias: only noticing information that agrees with old beliefs
or perceptions.
● The illusion of control: thinking that you can influence outcomes.
● Representativeness bias: classifying new information based on historic
information.
● Hindsight bias: seeing events or actions as predictable despite little or
no supporting evidence for predicting them.

Each belief perseverance error will be discussed in detail below.

Belief Perseverance Error: Conservatism Bias

Conservatism bias is a belief perseverance bias in which people fail to
incorporate new information and end up maintaining their old views or beliefs.

For example, an investor purchases a security of a pharmaceutical company

based on the fact that the company is about to finish stage 3 drug testing and
receive regulatory approval. Weeks later, the company announces that the
drug failed stage 3 testing and that the approval would be delayed by months,
if not years. If the investor clings onto his or her initial valuation of the
company and fails to change their evaluation according to the new
information disclosed, he would be guilty of conservatism bias.

Belief Perseverance Error: Confirmation Bias

Confirmation bias is a belief perseverance bias in which people look for
information that confirms their beliefs and exclude information that
contradicts those beliefs. Examples of confirmation bias include:

● Only considering positive information about an opportunity or

investment and ignoring negative information about the investment.
● Under-diversification in portfolios, as fund managers are convinced that
the stock value of a certain company will yield significant returns.

For example, a client of a wealth advisor may insist on adding new securities
to his portfolio without considering how the new securities will complement
the portfolio and its fundamental value. The client is only doing research that
confirms his belief that the securities are of good value without considering
the implications on the overall portfolio.

Belief Perseverance Error: Illusion of Control

The illusion of control bias is a belief perseverance bias in which individuals
think that they can control or influence outcomes when, in fact, they cannot.
Ellen Langer, a social psychologist and professor of psychology at Harvard
University, defines the illusion of control bias as the “expectancy of a personal
success probability inappropriately higher than the objective probability would
warrant.”

For example, a customer service representative who works at his local bank
and receives stock options may prefer to only invest in shares of that bank.
Since he works at this bank, he may feel that he has some control over the
share price. In reality, the customer service representative has virtually no
control over the share price of the bank.

Belief Perseverance Error: Representativeness Bias

Representativeness bias is a belief perseverance bias in which individuals use
past experiences or information to classify new information.
Representativeness bias involves basing decisions on historical trends
without determining whether historical information has predictive value.

For example, a company may evaluate its fund managers by placing heavy
emphasis on the high returns made over a short period without understanding
the probability of those returns happening. The company may hire a fund
manager based on his previous performance without considering whether
such returns are going to occur in the future.

Belief Perseverance Error: Hindsight Bias

Hindsight bias is a belief in perseverance bias in which individuals believe that
past events are predictable and inevitable. Hindsight bias is also known as the
“knew-it-all-along” effect or creeping determinism.

For example, an investor may claim that the technology bubble in the late
1990s was predictable and obvious. This is an example of the hindsight bias –
if it had been obvious at that time, it would not have escalated the way it did
and taken so many investors and analysts by surprise.

OVERCONFIDENCE

● Overconfidence bias is the tendency for a person to overestimate

their abilities.
● It may lead a person to think they’re a better-than-average driver or
an expert investor.
● Overconfidence bias may lead clients to make risky investments.
● Advisors might be able to counter overconfidence bias by
encouraging clients to make room for other perspectives.
Overconfidence can potentially be a pathway to poor portfolio
performance. Beyond that, clients’ overconfidence may also lead them to
overestimate their tolerance for risk, resulting in investment strategies
that don't truly align with their needs. Add to these dangers the high
costs of buying and selling assets, and the potential damage of
overconfidence on clients’ pocketbooks—and psyches—cannot be
underestimated.

Overconfidence bias can be countered in a number of ways. One

starting point is to encourage clients to make room for the perspective of
other people, from family members and friends to your financial team.
While we often overestimate our own abilities, we tend to be more
objective when considering the decisions of others.Another strategy is to
walk clients through past investment decisions and discuss how they
worked out. Demonstrate, if applicable, how overconfidence led to poor
outcomes over time, and compare these outcomes with the results the
client might have achieved with a more realistic approach.

OVERREACTION AND UNDERREACTION

An overreaction is an extreme emotional response to new information. In

finance and investing, it is an emotional response to a security such as a
stock or other investment, which is led either by greed or fear. Investors
overreacting to news cause the security to become either overbought or
oversold until it returns to its intrinsic value.

Investors are not always rational. Instead of pricing all publicly known
information perfectly and instantly, as the efficient market hypothesis
assumes, they are often affected by cognitive and emotional biases.

Some of the most influential work in behavioral finance concerns the initial
underreaction and subsequent overreaction of prices to new information.
Many funds now use behavioral finance strategies to exploit these biases in
their portfolios, especially in less efficient markets such as small-cap stocks.

Funds that seek to take advantage of overreactions look for companies whose
shares have been depressed by bad earnings news, but where the news is
likely to be temporary. Low price-to-book stocks, otherwise known as value
stocks, are an example of such stocks.

In contrast to overreaction, underreaction to new information is more likely to

be permanent. An underreaction is often caused by anchoring, a term that
describes people's attachment to old information, which is especially strong
when that information is critical to a coherent way of explaining the world (also
known as a hermeneutic) held by the investor. Anchoring ideas such as "brick
and mortar retail stores are dead" can cause investors to overlook
undervalued stocks and miss opportunities to make a profit.

conservatism bias, conservatism means that if two values of an asset are present,
the accountant recognizes the lower value. Hence, the principle of conservatism is
based on how an investor is supposed to react when they receive multiple and often
contradictory reports about the same asset.

This is the case in behavioral finance as well. However, it has been observed that
investors often form a deeply emotional view about an investment. This view may be
positive or negative. However, it was developed earlier. Then, when the same investor
is presented with information that is contradictory to their view formed earlier, they
simply discount the new information and hang on to their original opinion. Sometimes,
investors may not react to new information, and other times, they may react very slowly.

For example, investors may have a belief that a company like Enron is a good
investment. Hence, when early information about the possibility of a scam in Enron
came to light, a lot of these investors stuck to their previous views and were slow to
react. In the process, the details of the scam became public, and some investors lost a
huge portion of their investment.

The Root Cause of Conservatism Bias

As investors, we are aware that conservatism bias does actually exist in the marketplace. We have
experienced it ourselves, or we may have come across others who have experienced it over time.
However, we don’t much about the root causes because of which conservatism bias continues to exist.

● Failure to Revaluate Complex Data: The first and foremost reason is that formulating an opinion
on the financial position of a company is a complex task. The investor has to go through a wide
range of financial information and critically analyze the same before they can make any
decisions. This process is both arduous as well as time-consuming. The problem is that
whenever new information about the company comes out, the investor is supposed to perform the
entire analysis again. This can be physically as well as emotionally stressful for the investor.
Hence, instead of forming new opinions, the buyers simply hold on to pre-existing beliefs about
the firm.
● Cling to Forecasts: Investors have an innate need to feel validated. When investors go through
results, very few of them are objectively viewing the results. Instead, they are validating their own
beliefs. Hence, if an earlier forecast provided by the company or critics matches with their beliefs,
they tend to hang on to that belief instead of reformulating their beliefs. If an investor reads a
hundred-page report, they are more likely to remember the four or five pages that validate their
belief.
● Slow to React: The initial belief of the investor is firmly entrenched in their mind. Hence, they do
not change that belief unless there is overwhelming evidence that their initial belief is wrong. They
often take a long time processing the information in their heads. As a result, they are often slow to
react. This may cause them to hold on to stocks longer than they should cause erosion in their
wealth.

SELF ATTRIBUTION

Attribute bias describes the fact that securities that are chosen using one
predictive model or technique tend to have similar fundamental characteristics.

Attribute bias is simply a characteristic that is likely to happen unless models and
techniques are specifically designed not to include it.

Because of this bias, a model or statistical technique may lead to concentrated

market positions.

While attribute bias refers to a bias in the methodology of picking financial

instruments for a portfolio, self-attribution bias refers to a bias a person can
have that causes them to think that the success they have in business,
choosing investments, or other financial situations is because of their own
personal characteristics. Self-attribution bias is a phenomenon in which a
person disregards the role of luck or external forces in their own success and
attributes success solely to their own strengths and work.
RECENCY BIASES

Recency bias is the tendency to place too much emphasis on

experiences that are freshest in your memory—even if they are not the
most relevant or reliable. Would you want to go for a long ocean swim
after watching Jaws? Probably not, even though the actual risk of being
attacked by a shark is infinitesimally small.

In the investing world, recency bias can be hard to avoid. Clients display
recency bias when they make decisions based on recent events,
expecting that those events will continue into the future. It can lead them
to make irrational decisions, such as following a hot investment trend or

To combat recency bias, advisors can help their clients take a broader
view of how markets tend to move over time and the larger trends that
may have the biggest impact on their investment returns. During the
rebalancing process, consider illustrating to clients which investments
have fared well or poorly, and use that information to initiate a larger
discussion about how markets tend to move over time.elling securities
during a market downturn.