Level 1 CFA® Exam:
Emotional Biases
Emotional biases are biases that can arise due to emotional factors, such as fear, happiness, or anger. These biases can lead investors to make suboptimal decisions, such as selling after a stock market crash or buying after a stock market rally.
Loss-Aversion Bias
Loss-aversion bias is a tendency for investors to prefer avoiding losses to acquiring equivalent gains.
Loss-aversion bias can lead investors to make decisions that are not in their best interests, such as holding on to losing investments in the hope of a rebound or selling winning investments too early out of fear that the gains will disappear (the so-called disposition effect).
Loss-aversion bias can have a significant impact on the investment decision-making process. Investors who have loss-aversion bias miss out on investment opportunities, make suboptimal investment decisions, and end up with portfolios that have a misaligned risk-return tradeoff.
Overconfidence bias is the tendency to be too confident in one's own judgments and abilities. This can lead to bad investment decisions, as investors may take on too much risk or make trades based on overly optimistic predictions.
A related phenomenon is the so-called self-attribution bias, where people tend to attribute their successes to their own abilities and their failures to external factors.
Overconfidence bias can have serious implications for the investment decision-making process. Investors may take on too much risk (underestimating risk), as they may believe that they are more likely to achieve success. It can also lead to bad trades, as investors may act on overly optimistic predictions (overestimating expected returns). Also, it can make investors hold portfolios that are not well-diversified.
Self-attribution bias can enhance these problems, as investors may attribute their successes to their own abilities and their failures to external factors.
There are a few suggestions for managing the effects of overconfidence bias. One is to analyze past trades and identify both winners and losers. Another, which is equally important, is to be aware of the bias and to try to avoid letting it influence your decisions.
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Status quo bias is the tendency to stick with what is familiar, even if it is not the best option and better alternatives are available. As a result, an investor e.g. may be reluctant to sell losing positions or to buy new assets that may be outside of their comfort zone.
However, in the case of status quo bias maintaining a given position by an investor is not his/her conscious choice. To overcome status quo bias, it is important to be aware of the bias and to make conscious choices about investments. This may require education about the returns and risks of different investment assets.
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Regret-aversion bias is the tendency of investors to avoid making decisions that could lead to regret in the future. This often leads to a more conservative approach to investing, as investors are afraid of making mistakes that could cost them money.
The consequences of regret-aversion bias also include missing out on opportunities, as well as herding behavior, where investors follow the crowd just to feel safe instead of making their own decisions. This could lead to misaligned asset allocation or security selection and risk levels that are not in line with investors’ expectations and abilities to take the risk.
- Emotional biases are biases that can arise due to emotional factors, such as fear, happiness, or anger.
- Loss-aversion bias is a tendency for investors to prefer avoiding losses to acquiring equivalent gains.
- Overconfidence bias is the tendency to be too confident in one's own judgments and abilities.
- Self-control bias is the tendency to give in to short-term satisfaction, even if it means sacrificing long-term goals.
- Status quo bias is the tendency to stick with what is familiar, even if it is not the best option and better alternatives are available.
- Endowment bias refers to people's tendency to value something more highly simply because they own it.
- Regret-aversion bias is the tendency of investors to avoid making decisions that could lead to regret in the future.