Behavioral Finance and Your Portfolio. Michael M. Pompian
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information that conflicts with existing beliefs (called selective perception), and/or remember and consider only information that confirms existing beliefs (called selective retention). Aspects of these behaviors are contained in the biases categorized as belief perseverance. The six belief perseverance biases covered in this book are: cognitive dissonance, conservatism, confirmation, representativeness, illusion of control, and hindsight.
Information-Processing Biases
The second category of cognitive biases has to do with “processing errors,” and describes how information may be processed and used illogically or irrationally in financial decision making. As opposed to belief perseverance biases, these are less related to errors of memory or in assigning and updating probabilities and instead have more to do with how information is processed. The seven processing errors discussed are: anchoring and adjustment, mental accounting, framing, availability, self-attribution bias, outcome bias, and recency bias.
Individuals are less likely to make cognitive errors if they remain vigilant to the possibility that they may occur. A systematic process to describe problems and objectives; to gather, record, and synthesize information; to document decisions and the reasoning behind them; and to compare the actual outcomes with expected results will help reduce cognitive errors.
Emotional Biases
Although emotion has no single universally accepted definition, it is generally agreed upon that an emotion is a mental state that arises spontaneously rather than through conscious effort. Emotions are related to feelings, perceptions, or beliefs about elements, objects, or relations between them; these can be a function of reality or the imagination. Emotions may result in physical manifestations, often involuntary. Emotions can cause investors to make suboptimal decisions. Emotions may be unwanted by the individuals feeling them, and while they may wish to control the emotion and their response to it, they often cannot.
Emotional biases are harder to correct for than cognitive errors because they originate from impulse or intuition rather than conscious calculations. In other words, a bias that is an inclination of temperament or outlook, especially a personal and sometimes unreasonable judgment, is harder to correct. When investors adapt to a bias, they accept it and make decisions that recognize and adjust for it rather than making an attempt to reduce it. To moderate the impact of a bias is to recognize it and to attempt to reduce or even eliminate it within the individual rather than to accept the bias. In the case of emotional biases, it may be possible to only recognize the bias and adapt to it rather than correct for it.
Emotional biases stem from impulse, intuition, and feelings and may result in personal and unreasoned decisions. When possible, focusing on cognitive aspects of the biases may be more effective than trying to alter an emotional response. Also, educating the investors about the investment decision-making process and portfolio theory can be helpful in moving the decision making from an emotional basis to a cognitive basis. When biases are emotional in nature, drawing them to the attention of the individual making the decision is unlikely to lead to positive outcomes. The individual is likely to become defensive rather than receptive to considering alternatives. Thinking of the appropriate questions to ask and to focus on as well as potentially altering the decision-making process are likely to be the most effective options.
Emotional biases can cause investors to make suboptimal decisions. The emotional biases are rarely identified and recorded in the decision-making process because they have to do with how people feel rather than what and how they think. The six emotional biases discussed are: loss aversion, overconfidence, self-control, status quo, endowment, and regret aversion. In the discussion of each of these biases, some related biases may be discussed.
Figure 2.2 Categorization of Twenty Behavioral Biases
Figure 2.2 below is a roadmap for the 20 biases that you will be seeing in the upcoming chapters.
A Final Word on Biases
The cognitive-emotional distinction will help us determine when and how to adjust for behavioral biases in financial decision making. However, it should be noted that specific biases may have some common aspects and that a specific bias may seem to have both cognitive and emotional aspects. Researchers in financial decision making have identified numerous and specific behavioral biases. This book will not attempt to discuss all identified biases but rather will discuss what I consider to be the most important biases within the cognitive-emotional framework for considering potential biases. This framework will be useful in developing an awareness of biases, their implications, and ways of moderating their impact or adapting to them. The intent is to help investors and their advisors to have a heightened awareness of biases so that financial decisions and resulting economic outcomes are potentially improved.
PART II BELIEF PERSEVERANCE BIASES DEFINED AND ILLUSTRATED
In Chapters 3 through 22, 20 behavioral biases, both cognitive and emotional, will be discussed. There are two types of cognitive bias reviewed in Chapters 3 through 15. The first type, belief perseverance biases, the focus of Part Two of the book, are covered now in Chapters 3 through 8. The second type, information processing cognitive biases, will be covered in Chapters 9 through 15. Emotional biases are then covered in Chapters 16 through 22.
In these chapters, the same basic format is used to discuss each bias, in order to promote greater accessibility. First, each bias is named, categorized as emotional or cognitive, including subtype (belief perseverance or information processing), and then generally described. This is followed by the all-important concrete practical application, in which it is demonstrated how each bias has been used, or can be used, in a practical situation. The practical application portion varies in content, consisting of either an intensive review of applied research or a case study. Implications for investors are then delineated. A diagnostic test and test-result analysis follow, providing a tool to indicate potential susceptibility to certain biases. Finally, advice on managing the effects of each bias, in order to minimize its effects, is offered.
3 Belief Perseverance Bias #1: Cognitive Dissonance Bias
This above all: to thine own self be true, And it must follow, as the night the day, Thou canst not then be false to any man.
—Polonius to Laertes, in Shakespeare's Hamlet
Bias Description
Bias Name: Cognitive dissonance
Bias Type: Cognitive
Subtype: Belief perseverance
General Description
When newly acquired information conflicts with preexisting understandings, people often experience mental discomfort—a psychological phenomenon known as cognitive dissonance. Cognitions,