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Subject 2. Cognitive Errors PDF Download

There are two categories of cognitive biases: 1) belief perseverance biases and information-processing biases.

Belief Perseverance Biases

Belief perseverance biases arise when individuals are selective in how they deal with new information that challenges their existing beliefs.

There are five sub-types of perseverance biases.

1. Individuals demonstrate conservatism bias by maintaining their previous beliefs and inadequately incorporating (or "under-reacting to") new information, even when this new information is significant. Those affected by conservatism bias will hold on to investments longer than a rational investor would.

2. Confirmation bias occurs when individuals place too much emphasis on information that confirms their existing beliefs and underweight (or ignore) information that challenges these beliefs. It is a particular concern for analysts conducting research and for all investors during periods of extreme prices (bubbles and crashes). Investors who are affected by confirmation bias may hold an un-diversified portfolio (possibly due to a concentrated position in own-company stock).

3. Representativeness bias occurs when an individual classifies new information based on past experiences and categories.

  1. Base rate neglect is the overweighting of new information and underweighting of base rates.
  2. Sample size neglect is the incorrect assumption that data from small sample sizes is representative of the overall population.

One way to identify representativeness bias is to determine whether the person is deriving information from the past and using that information in current investment strategy. For example, a mutual fund manager chooses an investment just because the current CEO did a good job in some other company in the past.

4. Illusion of control bias occurs when individuals incorrectly believe that they can control or influence outcomes, or for individuals to think that he have more control over the situation than he actually do. Hence, they have a false impression that future event are due to their skill rather than due to luck. Concentrated positions in own-company stock are common among those who are affected by illusion of control bias. Employees may believe that, because they can control their performance at work, they can influence their company's results. In reality, market prices are driven by a multitude of factors that are far beyond the control of any individual - even top managers.

5. Hindsight bias is the belief that past events were predictable and foreseeable. It is demonstrated by those who remember their forecasts that turned out to be accurate and forget those that were inaccurate. This can lead to excessive risk-taking due to an irrationally high assessment of one's ability to correctly predict outcomes.

Processing Errors

Information-processing biases occur when information is processed in an irrational manner. There are four sub-types of processing errors.

1. Anchoring and adjustment bias occurs when investors "anchor" themselves to the first information they receive and incorporate new information by adjusting this reference point - even if this new information suggests that a greater change is necessary.

While under-reacting to new information is similar to conservatism bias, anchoring and adjustment bias is associated with a specific reference point. It is this 'anchor' that they either adjust upwards or downwards. Conservatism bias is to maintain or slowly update views despite the presence of new information. In Example 5, Smythe is said to exhibit anchoring and adjustment bias because he maintains his forecast of EPS of 1 GBP.

2. Mental accounting bias occurs when an individual arbitrarily classifies money based on its source (e.g., salary, bonus, etc.) or intended use (e.g., retirement, current spending). These classifications/accounts manipulate investment decisions, despite money are fungible (interchangeable). The bias disregards the relationships between investments, leading to accidental risk-taking.

3. Framing bias occurs when an individual answers a question with the same basic facts differently depending on how it is asked. For example, an individual may choose to buy a lottery ticket if the possibility of winning a large prize is emphasized, but decline to do so if the extremely remote possibility of winning that prize is emphasized. Investors who are affected by framing bias may misidentify their risk tolerance based on how information is presented. Investors may concentrate on short-term price fluctuations and, therefore, disregard long-run considerations in the decision-making process.

4. People tend to base decisions on information that is readily available or easily recallable. This results in an availability bias in that probability estimates are skewed by how easily certain potential outcomes come to mind. Four sources of availability biases which are applicable to FMPs are: retrievability, categorization, narrow range of experience, and resonance.

Availability bias is similar to biases such as representativeness and overconfidence. The clearest demonstration of availability bias is when investors make decisions based on word-of-mouth or name recognition.

Cognitive errors can typically be corrected through education and recognizing the flaws in one's decision-making process. Measures such as actively seeking out information that challenges one's existing beliefs, keeping detailed records, and updating probabilities in an unbiased manner are generally applicable to all cognitive errors.

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