20 Behavioral Biases
Some financial advisors are needlessly struggling with behavioral finance because they lack a systematic way to apply it to their client relationships. In my 2006 book, Behavioral Finance and Wealth Management, I outline a method of applying behavioral finance to private clients in a way that I now refer to as "bottom-up." This means that for financial advisors to diagnose and treat behavioral biases, he or she must first test for all behavioral biases in a client, and then determine which ones a client has before being able to use bias information to create a customized investment plan. In my book I describe the most common behavioral biases an advisor is likely to encounter, explain how to diagnose these biases, show how to identify behavioral
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For readers to understand behavioral investor types, they need to get a fundamental understanding of the 20 behavioral biases I outline in my book. In this article, we will review these biases that are encountered with actual clients, with a description of the bias and a classification of whether the bias is cognitive or emotional. Behavioral biases fall into two broad categories, cognitive and emotional, with both varieties yielding irrational judgments. A cognitive bias can be technically defined as a basic statistical, information processing, or memory error common to all human beings. They also can be thought of as "blind spots" or distortions in the human mind. Cognitive biases do not result from emotional or intellectual predisposition toward a certain judgments, but rather from subconscious mental procedures for processing …show more content…
For example, recency bias occurs when investors wrongly presume that market gains will continue forever and then will enter an asset class when prices are peaking, which can end badly with sharp price declines.
Continued from page 2.
Hindsight Bias
Bias Type: Cognitive
Some investors lack independent thought on investments and are susceptible to hindsight bias which occurs when an investor perceives investment outcomes as if they were predictable--even if they weren't. The result of hindsight bias is that it gives investors a false sense of security when making investment decisions, and thus excessive risk is taken.
Framing Bias
Bias Type: Cognitive
Framing bias is the tendency of investors to respond to various situations differently based on the context in which a choice is presented (framed). Often, investors focus too restrictively on one or two aspects of an investment situation, excluding critical considerations. The use of risk tolerance questionnaires provides a good example. Depending upon how questions are asked, framing bias can cause investors to respond to risk-tolerance questions in an either unduly conservative or risk-taking
For readers to understand behavioral investor types, they need to get a fundamental understanding of the 20 behavioral biases I outline in my book. In this article, we will review these biases that are encountered with actual clients, with a description of the bias and a classification of whether the bias is cognitive or emotional. Behavioral biases fall into two broad categories, cognitive and emotional, with both varieties yielding irrational judgments. A cognitive bias can be technically defined as a basic statistical, information processing, or memory error common to all human beings. They also can be thought of as "blind spots" or distortions in the human mind. Cognitive biases do not result from emotional or intellectual predisposition toward a certain judgments, but rather from subconscious mental procedures for processing …show more content…
For example, recency bias occurs when investors wrongly presume that market gains will continue forever and then will enter an asset class when prices are peaking, which can end badly with sharp price declines.
Continued from page 2.
Hindsight Bias
Bias Type: Cognitive
Some investors lack independent thought on investments and are susceptible to hindsight bias which occurs when an investor perceives investment outcomes as if they were predictable--even if they weren't. The result of hindsight bias is that it gives investors a false sense of security when making investment decisions, and thus excessive risk is taken.
Framing Bias
Bias Type: Cognitive
Framing bias is the tendency of investors to respond to various situations differently based on the context in which a choice is presented (framed). Often, investors focus too restrictively on one or two aspects of an investment situation, excluding critical considerations. The use of risk tolerance questionnaires provides a good example. Depending upon how questions are asked, framing bias can cause investors to respond to risk-tolerance questions in an either unduly conservative or risk-taking