Ok, apologies for the long post. But given the lack of practice questions in CFAI readings on behavioral finance, I made some outline notes of the main points based on LOS. Have pasted below in case anyone may find them useful 1. Heuristic-driven bias 1.1. Representativeness Reliance on stereotypes Tendency to base predictions on how representative something seems to be 1.2. Overconfidence Setting confidence intervals too narrowly Overconfident people tend to get surprised more frequently than anticipated 1.3. Anchoring and adjustment Failure to fully incorporate new information into expectations Earnings estimates not revised enough in response to new information Results in analysts getting surprised repeatedly 1.4. Aversion to ambiguity The unwillingness to go into the abyss Rather take the sure bet than the uncertain bet with a potentially better outcome 2. Frame dependence 2.1. Loss aversion People would rather take a gamble between a big loss and no loss rather than a certain small loss Leads to investors holding onto loss-making investments in a gamble that they will regain value and they will not need to realize loss 2.2. Self-control Source of the “don’t dip into capital rule” Investors with this frame dependence prefer dividend-paying stocks because they believe it will control the urge to dip into capital. Such investors fear outliving their savings 2.3. Regret Minimization Can lead investors to prefer dividend paying stocks. Allows them to finance consumption out of dividends rather than selling stock. If stock subsequently rises, they feel regret. Selecting sub-optimal allocations for fear of future regret. Example: Markowitz 2.4. Money illusion Tendency not to adjust for inflation Someone who receives 5% pay rise with 4% inflation is regarded as better off than someone who receives 2% pay rise with 0% inflation 3. Inefficient markets 3.1. Effects stemming from representativeness Investors become too optimistic about past winners and too pessimistic about past losers Results in better future returns for past losers as these become undervalued 3.2. Effects stemming from conservatism (anchoring and adjustment) Conservatism results in earnings estimates not being revised enough in response to new information 3.3. Effects stemming from frame dependence Myopic loss aversion caused investors to shy away from stocks in the past, creating conditions for them to be able to outperform bonds by 7% in real terms 3.4. Effects stemming from overconfidence Overconfident Investors take bad bets because they fail to recognize when they are at an informational disadvantage Overconfident investors trade too frequently 4. Portfolios, pyramids, emotions and biases 4.1. Influence of hope and fear Fear causes investors to look at things from the bottom up and ask how bad things can get Hope causes people to look at things from the top down and emphasizes the need for potential on the upside 4.2. Pyramid systems to address security, potential and aspiration Bottom layer of pyramid addresses security. Includes money market funds and CDS Middle layer addresses potential and includes bonds. Includes use of zero-coupon bonds to fund things like college education Top layer addresses aspirations and includes stocks needed for appreciation Five-year rule: Don’t put money into stocks if you are less than five years from your goal 4.3. Effects of regret and self-attribution bias on financial advisor relationships Financial advisor gives investor a psychological call option. Can blame advisor and avoid regret if things go well, but can claim the credit and attribute success to personal skills when things go right 4.4. Effect of overconfidence on portfolio construction Overconfident investors fail to diversify because they are convinced that they can pick winners Widespread naïve diversification using the 1/n rule 5. Investment decision making in defined contribution pension plans 5.1. Why DC plan participants create inefficient portfolios 5.1.1. Little or no investment knowledge Only 20% of DC investors consider themselves knowledgeable 5.1.2. Bounds to rationality, self-control and self-interest 5.1.2.1. Bounded rationality Limits on intelligence and time mean that individuals cannot solve problems optimally Instead they use rules of thumbs (“heuristics”) to drive investment decisions 5.1.2.2. Bounded self-control Even when the right thing to do is apparent, people may not do it (analogy with not exercising) 5.1.2.3. Bounded self-interest People do not pursue their own self interest to the extent assumed 5.1.3. Impacts of status quo bias, loss aversion, 1/n diversification and the endorsement effect 5.1.3.1. Status quo bias Empirical research suggests most plan participants never make any changes 5.1.3.2. Myopic loss aversion Plan participants shown 1-year returns make much lower allocation to stocks than those shown 30-yr compound returns since the latter are much less likely to show loss 5.1.3.3. 1/n diversification Strong tendency to allocate equally between funds on offer 5.1.3.4. Endorsement effect Plan participants assume that the funds on offer are implicit guidance on what allocation to adopt. May lead to 1/n diversification 5.1.4. Why do DC plan participants invest heavily in own company stock? Employees tend not to view their companies as risky as they prefer to “invest in the familiar” Similar to “home country bias” in many portfolios 6. Folly of forecasting 6.1. Illusions of knowledge and control Illusion of knowledge: economist and analysts think they know more than everyone else Empirical evidence suggests investment professionals are more confident in their forecasting than the general public Analysts cite “detailed knowledge”, “experience” and “hard work” as factors behind their forecasts. Points to an illusion of control The worst forecasters tend to be the most overconfident ones 6.2. Ego defense mechanisms Forecasters exhibit strong evidence of conservatism bias – tendency to hang onto views for too long Five common defenses: The “if” only defense: They would have been correct if original advice had been followed The “ceteris parebus” defense: Something else out of the ordinary occurred The “I was almost right” defense The “It just hasn’t happened yet” defense “Single prediction defense”: Framework was right even though forecast was wrong. The “forecasting is pointless defense” 6.3. Why are forecasts still used Investors feel that in order to outperform, they need insight that others don’t have Anchoring: tendency to latch unto irrelevant information 7. Survey of behavioral finance 7.1. Critique of classic observation that rational agents will undo mispricing Strategies to exploit mispricing can be risky and costly, allowing the mispricing to remain unchallenged 7.2. “There is no free lunch” and “prices are right” “There is no free lunch” can be true in efficient and inefficient markets “Prices are right” is only true in an efficient market “Prices are right” implies “No free lunch” but not vice versa 7.3. Risks and costs associated with arbitrage 7.3.1. Fundamental risk Risk that bad news about fundamental value causes further adverse price movements. Can try to hedge with offsetting position in similar security, but substitute securities are never perfect If the R-squared on a regression of stock returns on substitute securities is greater than 25%, then the hedge is almost perfect 7.3.2. Noise trade risk Risk that noise traders (e.g. pessimistic investors in a perceived undervalued stock) continue to push the stock down and make the mispricing worse If mispricing that the arbitrageur is trying to exploit worsens, short-term oriented investors may conclude he is incompetent or lenders could require higher margin and lead to forced selling. Makes arbitrageur more cautious from the start 7.3.3. Implementation costs Transaction costs can make it unattractive to exploit mispricing Cost of finding a mispricing can be substantial 7.3.4. Sufficient conditions for arbitrage to be limited 7.3.4.1. If no perfect substitute: Arbitrageurs are risk averse. Ensures no single arbitrageur can wipe out mispricing Fundamental risk is systematic in that it can’t be eliminated by taking many substitute positions. Ensures that large number of smaller investors cannot wipe out mispricing. 7.3.4.2. If a perfect substitute exists: Arbitrageurs are risk averse and have a short-term horizon. Ensures that mispricing cannot be wiped out by a single arbitrageur Noise trader risk is systematic. Ensures that even a large number of small investors cannot eliminate the mispricing. 7.3.5. Evidence 7.3.5.1. Royal Dutch and Shell Ratio of Royal Dutch and Shell should have been 1.5 throughout, but this has not always the case historically. 8. Alpha hunters and Beta grazers 8.1. Chronic versus acute inefficiencies Acute inefficiencies can be arbitraged away Chronic inefficiencies are less discernable and more resistant to resolution 8.1.1. Convoy behavior Herding or clustering behavior of institutional funds Critical mass of investors can form a pricing consensus that becomes a de facto reality even if it is erroneous 8.1.2. Bayesian rigidity Extreme case of anchoring and conservatism 8.1.3. Price target revisionism Tendency to revise price targets higher when they have been achieved rather than close out the position 8.1.4. Ebullience cycle Tendency to leave envelope unopened when things are going bad Tendency to open envelopes in up market, creating ebullient atmosphere and even more aggressive investment 8.2. Rebalancing behavior 8.2.1. Holders: Effectively reduce equity allocation in falling markets. Little market impact 8.2.2. Rebalancers: Have a smoothing effect 8.2.3. Valuators: Includes both contrarians and momentum strategists. Contrarians have moderating impact on market trends while momentum strategists magnify them 8.2.4. Shifters: Shift in allocations due to fundamental change in circumstances.
add to favourites… 
great post
thanks man…great post
thanks very much. i wish you had taken out those reference numbers out. you must have spent a lot of time in making sure that you type the correct ones…
By far one of the more helpful posts out there. I owe you a beer.
thank you mcg - a real gem
Very good, I will save this as a cheat sheet.
thanks dude
Great stuff. Can I have your original word file? Indentation and numbering are terrible after copy and paste. al_bin@iname.com Thanks very much! - sticky
here is a cleaner version…thanks mcg 1. Heuristic-driven bias 1.1. Representativeness Reliance on stereotypes Tendency to base predictions on how representative something seems to be 1.2. Overconfidence Setting confidence intervals too narrowly Overconfident people tend to get surprised more frequently than anticipated 1.3. Anchoring and adjustment Failure to fully incorporate new information into expectations Earnings estimates not revised enough in response to new information Results in analysts getting surprised repeatedly 1.4. Aversion to ambiguity The unwillingness to go into the abyss Rather take the sure bet than the uncertain bet with a potentially better outcome 2. Frame dependence 2.1. Loss aversion People would rather take a gamble between a big loss and no loss rather than a certain small loss Leads to investors holding onto loss-making investments in a gamble that they will regain value and they will not need to realize loss 2.2. Self-control Source of the “don’t dip into capital rule” Investors with this frame dependence prefer dividend-paying stocks because they believe it will control the urge to dip into capital. Such investors fear outliving their savings 2.3. Regret Minimization Can lead investors to prefer dividend paying stocks. Allows them to finance consumption out of dividends rather than selling stock. If stock subsequently rises, they feel regret. Selecting sub-optimal allocations for fear of future regret. Example: Markowitz 2.4. Money illusion Tendency not to adjust for inflation Someone who receives 5% pay rise with 4% inflation is regarded as better off than someone who receives 2% pay rise with 0% inflation 3. Inefficient markets 3.1. Effects stemming from representativeness Investors become too optimistic about past winners and too pessimistic about past losers Results in better future returns for past losers as these become undervalued 3.2. Effects stemming from conservatism (anchoring and adjustment) Conservatism results in earnings estimates not being revised enough in response to new information 3.3. Effects stemming from frame dependence Myopic loss aversion caused investors to shy away from stocks in the past, creating conditions for them to be able to outperform bonds by 7% in real terms 3.4. Effects stemming from overconfidence Overconfident Investors take bad bets because they fail to recognize when they are at an informational disadvantage Overconfident investors trade too frequently 4. Portfolios, pyramids, emotions and biases 4.1. Influence of hope and fear Fear causes investors to look at things from the bottom up and ask how bad things can get Hope causes people to look at things from the top down and emphasizes the need for potential on the upside 4.2. Pyramid systems to address security, potential and aspiration Bottom layer of pyramid addresses security. Includes money market funds and CDS Middle layer addresses potential and includes bonds. Includes use of zero-coupon bonds to fund things like college education Top layer addresses aspirations and includes stocks needed for appreciation Five-year rule: Don’t put money into stocks if you are less than five years from your goal 4.3. Effects of regret and self-attribution bias on financial advisor relationships Financial advisor gives investor a psychological call option. Can blame advisor and avoid regret if things go well, but can claim the credit and attribute success to personal skills when things go right 4.4. Effect of overconfidence on portfolio construction Overconfident investors fail to diversify because they are convinced that they can pick winners Widespread naïve diversification using the 1/n rule 5. Investment decision making in defined contribution pension plans 5.1. Why DC plan participants create inefficient portfolios 5.1.1. Little or no investment knowledge Only 20% of DC investors consider themselves knowledgeable 5.1.2. Bounds to rationality, self-control and self-interest 5.1.2.1. Bounded rationality Limits on intelligence and time mean that individuals cannot solve problems optimally Instead they use rules of thumbs (“heuristics”) to drive investment decisions 5.1.2.2. Bounded self-control Even when the right thing to do is apparent, people may not do it (analogy with not exercising) 5.1.2.3. Bounded self-interest People do not pursue their own self interest to the extent assumed 5.1.3. Impacts of status quo bias, loss aversion, 1/n diversification and the endorsement effect 5.1.3.1. Status quo bias Empirical research suggests most plan participants never make any changes 5.1.3.2. Myopic loss aversion Plan participants shown 1-year returns make much lower allocation to stocks than those shown 30-yr compound returns since the latter are much less likely to show loss 5.1.3.3. 1/n diversification Strong tendency to allocate equally between funds on offer 5.1.3.4. Endorsement effect Plan participants assume that the funds on offer are implicit guidance on what allocation to adopt. May lead to 1/n diversification 5.1.4. Why do DC plan participants invest heavily in own company stock? Employees tend not to view their companies as risky as they prefer to “invest in the familiar” Similar to “home country bias” in many portfolios 6. Folly of forecasting 6.1. Illusions of knowledge and control Illusion of knowledge: economist and analysts think they know more than everyone else Empirical evidence suggests investment professionals are more confident in their forecasting than the general public Analysts cite “detailed knowledge”, “experience” and “hard work” as factors behind their forecasts. Points to an illusion of control The worst forecasters tend to be the most overconfident ones 6.2. Ego defense mechanisms Forecasters exhibit strong evidence of conservatism bias – tendency to hang onto views for too long Five common defenses: The “if” only defense: They would have been correct if original advice had been followed The “ceteris parebus” defense: Something else out of the ordinary occurred The “I was almost right” defense The “It just hasn’t happened yet” defense “Single prediction defense”: Framework was right even though forecast was wrong. The “forecasting is pointless defense” 6.3. Why are forecasts still used Investors feel that in order to outperform, they need insight that others don’t have Anchoring: tendency to latch unto irrelevant information 7. Survey of behavioral finance 7.1. Critique of classic observation that rational agents will undo mispricing Strategies to exploit mispricing can be risky and costly, allowing the mispricing to remain unchallenged 7.2. “There is no free lunch” and “prices are right” “There is no free lunch” can be true in efficient and inefficient markets “Prices are right” is only true in an efficient market “Prices are right” implies “No free lunch” but not vice versa 7.3. Risks and costs associated with arbitrage 7.3.1. Fundamental risk Risk that bad news about fundamental value causes further adverse price movements. Can try to hedge with offsetting position in similar security, but substitute securities are never perfect If the R-squared on a regression of stock returns on substitute securities is greater than 25%, then the hedge is almost perfect 7.3.2. Noise trade risk Risk that noise traders (e.g. pessimistic investors in a perceived undervalued stock) continue to push the stock down and make the mispricing worse If mispricing that the arbitrageur is trying to exploit worsens, short-term oriented investors may conclude he is incompetent or lenders could require higher margin and lead to forced selling. Makes arbitrageur more cautious from the start 7.3.3. Implementation costs Transaction costs can make it unattractive to exploit mispricing Cost of finding a mispricing can be substantial 7.3.4. Sufficient conditions for arbitrage to be limited 7.3.4.1. If no perfect substitute: Arbitrageurs are risk averse. Ensures no single arbitrageur can wipe out mispricing Fundamental risk is systematic in that it can’t be eliminated by taking many substitute positions. Ensures that large number of smaller investors cannot wipe out mispricing. 7.3.4.2. If a perfect substitute exists: Arbitrageurs are risk averse and have a short-term horizon. Ensures that mispricing cannot be wiped out by a single arbitrageur Noise trader risk is systematic. Ensures that even a large number of small investors cannot eliminate the mispricing. 7.3.5. Evidence 7.3.5.1. Royal Dutch and Shell Ratio of Royal Dutch and Shell should have been 1.5 throughout, but this has not always the case historically. 8. Alpha hunters and Beta grazers 8.1. Chronic versus acute inefficiencies Acute inefficiencies can be arbitraged away Chronic inefficiencies are less discernable and more resistant to resolution 8.1.1. Convoy behavior Herding or clustering behavior of institutional funds Critical mass of investors can form a pricing consensus that becomes a de facto reality even if it is erroneous 8.1.2. Bayesian rigidity Extreme case of anchoring and conservatism 8.1.3. Price target revisionism Tendency to revise price targets higher when they have been achieved rather than close out the position 8.1.4. Ebullience cycle Tendency to leave envelope unopened when things are going bad Tendency to open envelopes in up market, creating ebullient atmosphere and even more aggressive investment 8.2. Rebalancing behavior 8.2.1. Holders: Effectively reduce equity allocation in falling markets. Little market impact 8.2.2. Rebalancers: Have a smoothing effect 8.2.3. Valuators: Includes both contrarians and momentum strategists. Contrarians have moderating impact on market trends while momentum strategists magnify them 8.2.4. Shifters: Shift in allocations due to fundamental change in circumstances.
thanks very much 10X useful than Schweser’s coverage
Glad to hear you guys find it useful. ( :
The Royal Dutch and Shell thing, thats the first time I’ve read anything about that. I was under the impression that empircal evidence or specific test cases are NOT tested, but rather for our understanding in the readings…?
Thanks, this is just great!!!
double post.
i think you left out “process versus outcome” under chronic inefficiencies (should be 8.1.1). It is the behavioral bias where investors allow their recent performance to dictate future decisions. The example is that investors tend to analyze poof performers but automatically attribute good performers to skill (rather than analyzing and possibly finding out that it was all luck.) other than that, the summary was great. thanks.
Did anyone notice on the 2007 exam the behavioral question that had other biases on it not listed above? Schweser did not mention anything about confirming evidence bias? This is frustrating. I agree that this was aa great post.
Would you feel more regret because of a missed investment opportunity or an investment decision that went wrong?
Missed.
Thanks.