Question

Identify and briefly describe any 4 behavioral biases identified in the behavioral finance literature and describe which types of investment decisions are influenced by those specific biases.

Answer 1

Biases in behavioral Finance

Behavioral biases are unreasonable beliefs or behaviors that can unconsciously impact our decision-making process.

There are two major categories of biases:

1. Cognitive Errors: They result from statistical, information processing or memory errors.

2. Emotional biases: Decisions which result from intuitions, feelings ,emotions rather than rational facts.

Four behavioral Biases in behavioral Finance Literature are as follows:

1. Anchoring Bias

Anchoring bias is when people rely too much on pre-existing information or the first information they find or see while making decisions. Example: If we were to invest in a stock and project its value in 3 months, then people might create a strong anchor towards its current value and project it to go up. They only revolve around the anchor which they have set in their mind.

2. Loss Aversion Bias

It is a type of cognitive bias, which states that pain of losing is psychologically twice as as the pleasure of gaining. This bias prevents the investors from taking risks in investment decisions even where their risk profile permits them to undertake the due risk. Example: A young investor is only investing in bonds and has no exposure to equity because he is afraid of losses related to equity.

3. Recency Bias

Recency Bias is another cognitive bias where people account for recent actions and give the highest importance to recent actions. Investors might continue to remain invested in a bull market because of the recent hike in stock prices even when they should be cautious. Investors with recency bias often fail to account for changes in economic cycle which adversely impact their investment decisions.

4. Overconfidence Bias

Overconfidence bias is an emotional bias where there is a high tendency of investors to hold a misleading assessment of their skills , intellect and talent. Its an egoistic belief where investors or analysts confuse themselves to be better than the market and have overconfidence to outperform it. An analyst might take excessive exposure to a stock and underdiversify their portfolio leading to higher risk and probability of higher losses.