Level 1 CFA® Exam:
Cognitive Errors – Intro for Level 1 CFA Candidatesstar content check off when done
Cognitive errors stem from faulty cognitive reasoning.
We can classify cognitive errors into 2 main categories:
- belief perseverance biases, and
- processing errors.
Belief perseverance biases:
- illusion of control,
- anchoring and adjustment,
- mental accounting,
Level 1 CFA Exam: Belief Perseverance Biasesstar content check off when done
Belief perseverance biases occur when an investor feels mental discomfort when new information conflicts with his or her beliefs or cognitions. To adjust to this cognitive dissonance, the investor mentally modifies and adjusts the conflicting information and takes into account only the part of the information that is in line with his previously held beliefs and cognitions.
Conservatism is a slow reaction to new information and sticking to previous opinions.
Confirmation bias is the cognitive error of seeking out only the kind of information that confirms one's preexisting beliefs and ignoring the information that contradicts those beliefs. For example, if you believe that stock X will go up, you might only look for new stories that confirm that belief and ignore stories that suggest that the stock might go down.
The consequences of confirmation bias can be significant, as it can lead to bad decisions being made. For example, if you only look for information that confirms your beliefs, you might miss important information that contradicts those beliefs. This can lead to a situation when you make bad investment decisions or miss out on good investment opportunities.
Representativeness is when investors assess new information based on their experience with similar information.
2 types of representativeness are:
- base-rate neglect, and
- sample-size neglect.
Base-rate neglect is the cognitive error of completely ignoring base rates (prior probabilities) when making judgments about the likelihood of something happening.
Sample-size neglect is the cognitive error of completely ignoring sample sizes when making judgments about the likelihood of something happening.
Level 1 CFA Exam: Processing Errorsstar content check off when done
Processing errors refer to errors that occur during the process of gathering and interpreting information.
Anchoring & Adjustment
Anchoring and adjustment bias is the cognitive error of relying too heavily on the first piece of information that you receive (the "anchor") when making decisions. For example, if you want to predict the future price of the stock, you might anchor on the stock's price at a given moment and adjust your prediction upward or downward when the stock's price changes.
Mental accounting is the cognitive error of assigning different values to money depending on its source or intended use. For example, you might think of money from your savings account as "safe" money, and money from your investment account as "risky" money.
Mental accounting can also lead to the cognitive error of thinking of different investment assets as being completely separate from one another. For example, you might think of your investment in stocks, bonds, and real estate as being not related to each other. Then, you may fail to realize that they are all subject to the same underlying economic forces. This can lead to bad investment decisions, as you might not diversify your portfolio properly.
Level 1 CFA Exam Takeaways: Cognitive Errorsstar content check off when done
- We can classify cognitive errors into 2 main categories: belief perseverance biases and processing errors.
- Belief perseverance biases include: conservatism, confirmation, representativeness, illusion of control, and hindsight.
- Processing errors include: anchoring and adjustment, mental accounting, framing, and availability.