Title LM05 The Behavioral Biases of Individuals IFT Notes.pdf ✅

LM05 The Behavioral Biases of Individuals 2025 Level I Notes © IFT. All rights reserved 1 LM05 The Behavioral Biases of Individuals 1. Introduction ....................................................................................................................................................... 3 2. Behavioral Bias Categories ........................................................................................................................... 3 3. Cognitive Errors ................................................................................................................................................ 3 3.1 Belief Perseverance Biases ................................................................................................................... 4 3.2 Processing Errors ..................................................................................................................................... 7 4. Emotional Biases ........................................................................................................................................... 11 4.1 Loss-Aversion Bias ............................................................................................................................... 11 4.2 Overconfidence Bias ............................................................................................................................ 13 4.3 Self-Control Bias .................................................................................................................................... 14 4.4 Status Quo Bias ...................................................................................................................................... 14 4.5 Endowment Bias .................................................................................................................................... 15 4.6 Regret-Aversion Bias ........................................................................................................................... 15 5. Behavioral Finance and Market Behavior ........................................................................................... 16 5.1 Defining Market Anomalies ............................................................................................................... 16 5.2 Momentum .............................................................................................................................................. 17 5.3 Bubbles and Crashes ............................................................................................................................ 17 5.4 Value ........................................................................................................................................................... 18 Summary ............................................................................................................................................................... 20 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM05 The Behavioral Biases of Individuals 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction Traditional finance assumes that individuals act rationally by considering all available information in their decision-making process. This leads to optimal outcomes and efficient markets. Behavioral finance challenges these assumptions by incorporating research on how individuals and markets actually behave. It assumes that people act “normal” rather than rational. It recognizes that people have behavioral biases that impact financial decision making. Behavioral biases can cause decisions to differ from the “rational” decisions of traditional finance. This reading is organized as follows:  Section 2 broadly characterizes behavioral biases into cognitive errors and emotional biases.  Section 3 explains cognitive errors, the consequences of each bias, detection of the bias, and guidance for overcoming these biases.  Section 4 describes emotional biases, the consequences of each bias, detection of the bias, and guidance for overcoming these biases.  Section 5 discusess how behavioral finance influences market behaviour and the occurance of market anomalies 2. Behavioral Bias Categories Behavioral biases can be either cognitive errors or emotional biases. Cognitive errors:  Stem from statistical, information-processing, or memory errors.  Can occur as a result of faulty reasoning.  Are more easily corrected than emotional biases.  Can be corrected through better information, education, and advice. Emotional biases:  Stem from impulse or intuition.  Are influenced by feelings and emotion.  Are spontaneous.  Are less easy to correct as compared to cognitive errors.  Can be recognized and “adapted” to. 3. Cognitive Errors There are two categories of cognitive biases: 1) belief perseverance biases and 2) information-processing biases.
LM05 The Behavioral Biases of Individuals 2025 Level I Notes © IFT. All rights reserved 3 Instructor’s Note: A summary of the nine cognitive errors is provided below. They are covered in detail in the subsequent sections. Memorize this summary. Belief perseverance biases  Conservatism bias: Maintain prior views by inadequately incorporating new information.  Confirmation bias: Look for and notice what confirms their beliefs.  Representativeness bias: Classify new information based on past experiences.  Illusion of control bias: False belief that we can influence or control outcomes.  Hindsight bias: See past events as having been predictable. Information-processing biases  Anchoring & adjustment bias: Incorrect use of psychological heuristics.  Mental accounting bias: Treat one sum of money different from other.  Framing bias: Answer question differently based on how it is asked.  Availability bias: Heuristic approach influenced by how easily outcome comes to mind. 3.1 Belief Perseverance Biases Belief perseverance is the tendency to cling to one’s previously held beliefs irrationally or illogically. Belief perseverance biases are closely related to cognitive dissonance. Cognitive dissonance is the mental discomfort that occurs when new information conflicts with old beliefs or cognitions. The belief perseverance biases discussed in this reading are: conservatism, confirmation, representativeness, illusion of control, and hindsight. Conservatism Bias Individuals maintain prior views by inadequately incorporating new information. From the traditional finance perspective, this can be described as the failure to update probabilities using Bayes’ formula. This bias has aspects of both statistical and information-processing errors. It causes individuals to overweight initial beliefs about probabilities and outcomes; and under-react to new information. Consequences of conservatism bias:  Maintain or be slow to update a view or a forecast, even when new information is available.  Opt to maintain a prior belief rather than deal with the mental stress of updating beliefs given complex data. This relates to an underlying difficulty in processing new information.
LM05 The Behavioral Biases of Individuals 2025 Level I Notes © IFT. All rights reserved 4  As a consequence of conservatism, an investor may hold a security longer than a rational decision maker. Detecting and overcoming conservatism bias:  Recognize that bias exists.  Ask questions when presented with new information: “How does this information change my forecast?” “What is the impact of this information?”  Updating of beliefs is inversely correlated with the effort involved. The more effort it takes to change a prior view, or the more effort it takes to process new information, the more likely the individual will ignore it.  Should conduct careful analysis incorporating the new information.  When it is difficult to interpret new information, seek advice from experts. Confirmation Bias Confirmation bias occurs when individuals look for and notice what confirms their beliefs and ignore what contradicts their beliefs. Embedded Example A client insists on continuing to hold stock, even when the adviser recommends otherwise because the client’s follow-up research seeks only information that confirms his belief that the investment is still a good value. Consequences of confirmation bias:  Consider only positive information about an existing investment and ignore negative information.  Develop screening criteria and ignore information that refutes the screening criteria’ validity or supports other screening criteria.  Under-diversify portfolios, leading to excessive exposure to risk.  Hold a disproportionate amount of their investment assets in their employing company’s stock. Because of the confirmation bias, the FMP(Financial market participant) is convinced of the company’s favorable prospects and ignores unfavorable information. Detecting and overcoming confirmation bias:  Seek information that challenges your (FMPs) beliefs.  Get corroborating support on an investment decision. If you are a technical analyst and you believe that the stock will go up. Before giving investment advice, it is advisable to get supporting information from (say) your colleague, a fundamental analyst. Because your colleague may have a completely different valuation of the stock. It is essential to make the extra effort to gather complete information, positive and negative, for better