Behavioral Finance Primer

Definitions

  • Behavioral Finance proposes psychology-based theories to explain stock market anomalies and investor behavior that cannot be explained by classical economic theories.
  • Bias is a systematic deviation from rationality in judgment, where particular inclinations, feelings, or approaches influence a person’s ability to make objective decisions. In other words, a bias is a non-random pattern of error in judgment or decision-making.
  • Cognitive Biases are patterns of deviation in judgment that occur in particular situations, causing people to perceive reality or interpret information in an illogical or irrational way. These biases are related to memory, attention, and other mental mistakes that can affect decision-making and reasoning.
  • Emotional Biases are distortions in cognition and decision-making due to emotional factors. These biases are influenced by feelings that can cause individuals to overweight or underweight certain information or potential outcomes based on their emotional impact rather than objective data.
  • Social Biases are prejudices or decisions that are influenced by social factors, such as conformity to societal norms or the influence of group dynamics. These biases can result from the direct or indirect influence of others and can impact behavior and perceptions in a group context.
  • Debiasing exercises are strategies or practices designed to reduce or eliminate the influence of cognitive, emotional, and social biases in decision-making

Notable Names in Behavioral Finance

  • Daniel Kahneman and Amos Tversky: Psychologists whose work on the psychology of judgment and decision-making laid the groundwork for behavioral economics.
  • Richard Thaler: Economist known for his contributions to behavioral economics, particularly his work on nudges and the concept of ‘mental accounting’.
  • Robert J. Shiller: Economist who has written extensively on market volatility and has argued that market prices often deviate from fundamental values due to investor psychology.

33 Biases; Cognitive, Emotional and Social

  • Cognitive Biases (11):
  • Anchoring: The common human tendency to rely too heavily on the first piece of information offered.
  • Availability Heuristic: Overestimating the importance of information that is available to us.
  • Bandwagon Effect: Doing something primarily because many others are doing it.
  • Disposition Effect: The tendency to sell assets that have increased in value and hold assets that have decreased in value.
  • Dunning-Kruger Effect: When people with low ability at a task overestimate their ability.
  • Framing Effect: Drawing different conclusions from the same information, depending on how that information is presented.
  • Hindsight Bias: The inclination to see events that have already occurred as being more predictable than they were before they took place.
  • Overconfidence Bias: Overestimating one’s own ability to perform tasks or to make accurate predictions.
  • Recency Bias: The tendency to weigh recent events more heavily than earlier events.
  • Representativeness Heuristic: Assessing similarity of objects and organizing them based around the category prototype.
  • Confirmation Bias: The tendency to search for, interpret, favor, and recall information in a way that confirms one’s preexisting beliefs or hypotheses.
  • Emotional Biases (11):
  • Endowment Effect: Valuing an owned item more highly simply because you own it.
  • Loss Aversion: The strong preference to avoid losses over acquiring gains.
  • Overoptimism: Being overly optimistic about the outcome of planned actions.
  • Regret Aversion: The emotional reaction to making a decision that turns out to be poor.
  • Self-Control Bias: The tendency to consume today at the expense of saving for tomorrow.
  • Self-Attribution Bias: Attributing success to internal factors while attributing failures to external factors.
  • Status Quo Bias: The preference for the current state of affairs, resisting change.
  • Negativity Bias: The tendency to pay more attention and give more weight to negative than positive experiences or other kinds of information.
  • Affinity Bias: Preferring people who are like oneself or have similar interests.
  • Fear: Allowing fear to influence decision-making, often leading to avoidance of perceived risky situations.
  • Envy: Resenting others’ success or status, which can influence investment decisions or risk tolerance.
  • Social Biases (11):
  • Herd Behavior: Mirroring the actions of a larger group.
  • Groupthink: The practice of thinking or making decisions as a group in a way that discourages creativity or individual responsibility.
  • Network Effect: The effect that one user of a good or service has on the value of that product to other people.
  • Social Proof: The reliance on the feedback and actions of others to determine what is right and what is wrong in a given situation.
  • Authority Bias: The tendency to attribute greater accuracy to the opinion of an authority figure and be more influenced by that opinion.
  • Cultural Bias: The phenomenon of interpreting and judging phenomena by standards inherent to one’s own culture.
  • In-group Bias: The tendency for people to give preferential treatment to others they perceive to be members of their own groups.
  • Ostrich Effect: The decision to ignore dangerous or negative information by “burying” one’s head in the sand, like an ostrich.
  • Bystander Effect: The presence of others discourages an individual from intervening in an emergency situation.
  • False Consensus Effect: The tendency to overestimate how much other people agree with us.
  • Impact Bias: The tendency to overestimate the length or the intensity of the impact of future feeling states.

Any of the 33 abive of hundreds of biases classified can affect decision-making processes and behavior in financial contexts, leading to less than optimal financial outcomes. Recognizing these biases is the first step toward mitigating their effects.

Predictive Analytics

Predictive analytics harnesses vast stores of data and sophisticated algorithms to mitigate the influence of behavioral biases in decision-making. By analyzing historical trends, market patterns, and a multitude of variables, predictive models can provide objective assessments that stand apart from the emotional and cognitive distortions that often sway human judgment. Research in behavioral finance suggests that certain decisions, particularly those involving repetitive and data-intensive tasks, are more accurately made by algorithms. These algorithms may minimize the overconfidence, confirmation, and various other biases that humans are prone to, though in some systems compound inherently bias data or that of the algorithms author.

Debiasing

An exampole of a debiasing exercise is the “pre-mortem” analysis. In this exercise, before a decision is made, a team imagines that a project or investment has failed spectacularly and then works backward to determine what potentially could lead to that failure. This approach encourages individuals to identify potential problems and biases early, which can be overlooked due to overconfidence or groupthink. By anticipating challenges and examining them from the perspective of future failure, decision-makers can mitigate the impact of their biases and improve their planning and decision-making processes.

Pythia

With Pythia, we aim to leverage the power of predictive analytics to deliver clear, data-driven insights for financial planning and investment management. The field of behavioral finance offers invaluable insights into the ‘why’ behind investor actions and market movements. By understanding these biases, investors can make more informed decisions, potentially improving their investment strategies and avoiding common pitfalls driven by irrational behavior. It’s an ongoing journey of self-discovery, market watchfulness, and disciplined strategy adjustment to navigate the complex financial landscapes of our minds and markets.

A Note on Performance

After establishing Coroebus Wealth Management June 3, 2013, we began managing our bond portfolio in April of 2014. I have been advised not to offer my services based on market performance as capturing alpha is rare and past performance does not guarantee future results. That being said, we had a great year.

As the Federal Reserve Board remarks pivoted to a dovish tone, the commonly held benchmark Bloomberg Global Aggregate Bond Index returned 5.5% in 2023, following the bond markets worst year ever. As a passively managed strategy our portfolio returned 7.58% in 2023.

Although minimizing downside capture is key to long term performance, we believe volatility is a matter of tolerance rather than a pure measure of risk. Research supports portfolio managers capture enough alpha to pay themselves, and those who outperform their benchmark over a five to ten year period tend not to over the following period.

We won’t dive in to all of the risk metrics here as I would like to take a more behavioral perspective. As I reviewed monthly returns preparing for this post I noticed the strangest correlation between negative periods and having a generally poor state of being or mood. The anxiety of anticipating a decrease in cash flow may be a factor, we also accept anxiety is a cause of poor decision making.

As a solo entrepreneur balancing the daily operations and compliance issues that come with running an investment advisor can occupy mental bandwidth that may have been devoted to portfolio management tasks. We have met several existentially threatening challenges and have managed to persevere.

As I continue to make progress on Pythia, a certain joy has come with finally making progress on what may be my magna carta. As my mood improves so does my vision. Though balancing operations with immersing myself in computer science/IT, and my other endeavors is a challenge, I am absolutely excited to deliver a unique service to the industry.

Stay tuned.

23 In Review

Happy New Year! I’d just like to share what a positive year 2023 was for me personally, offering some chaos, growth, fresh starts and new beginnings. Being committed to lifelong learning we made a great investment of time in education last year and are on good footing in a very fast paced and exciting environment.

In 2023 we:

Earned NJ real estate agent license
Started great deeds fitness
Earned CompTIA Security+
Earned ISC2 Certified in Cybersecurity
Retained Pythia® service mark
Revamped coroebuswm.com
Accelerated progress on Pythia®

We believe GenerativeAI has fundamentally changed the landscape for business professionals and entrepreneurs. Learning how to use it to increase efficiency and effectiveness may be the greatest challenge for most.

See Coursera Prompt Enginneering

The Planning Fallacy and Resolutions

As we step into 2024, let’s talk about a common bias we fall into when setting our resolutions – the “Planning Fallacy.” 📉

The Planning Fallacy is our tendency to underestimate the time, costs, and risks of future actions while overestimating the benefits. 🙇🏽‍♂️It’s why we often set ambitious goals for the year ahead, only to struggle with follow-through. 😼 So, what can we do differently this year?

  1. Don’t abandon your dreams! Things take longer than we expect and can therefore sometimes feel impossible. Instead of setting overly optimistic resolutions, take a moment to assess your past experiences and set achievable, incremental goals.
  2. Break it Down; Divide your resolutions into smaller, manageable steps. This way, you’re less likely to get overwhelmed and more likely to stay on track.
  3. Monitor your progress; Use a journal or app to track your progress regularly. Celebrate small wins to stay motivated.
  4. You may be the kind of person who likes to keep your goals private. Consider sharing your resolutions with a friend or family member who can keep you accountable.
  5. Adapt; If you stumble, don’t give up! Learn from setbacks and adjust your plan as needed. Remember, it’s not about making resolutions and forgetting them by February. It’s about creating sustainable, long-lasting change.

Black History Month

In our next post we will share our portfolio performance for last year and offer an interest rate outlook. Health and prosperity to all in 2024.

I am having a great year. The kind that will be remembered for great years. Plato said I wasn’t welcomed here. Before I go, imma need three cheers.