The Behavioral Biases of Individuals

Refers to the preference of avoiding losses over acquiring equivalent gains. It leads to behaviors like holding losing investments too long (disposition effect) and selling winning investments too quickly.

Characterized by unwarranted faith in one's own abilities, leading to underestimation of risks and overestimation of expected returns. It includes two forms: prediction overconfidence and certainty overconfidence.

Occurs when individuals fail to act in pursuit of their long-term goals due to short-term gratification, often leading to insufficient savings for the future and excessive borrowing.

An emotional bias where individuals prefer to maintain their current situation rather than making a change, even when change is warranted, often due to inertia.

This bias causes individuals to value assets more highly simply because they own them, leading to reluctance in selling these assets even when it is financially advisable to do so.

Leads individuals to avoid making decisions due to the fear of regret, often resulting in overly conservative investment choices or following the crowd (herding behavior).

Cognitive errors are faulty reasoning processes that can often be corrected through better information, education, and advice. They include belief perseverance biases and processing errors.

Emotional biases stem from feelings or emotions and are harder to correct because they arise from impulses rather than conscious effort. These biases require recognition and adaptation rather than direct correction.

These biases involve clinging to previously held beliefs despite contrary evidence and include conservatism, confirmation bias, representativeness, illusion of control, and hindsight bias.

Processing errors occur when information is used illogically or irrationally in financial decision-making. Examples include anchoring and adjustment, mental accounting, framing, and availability.

Market anomalies are deviations from the efficient market hypothesis, characterized by predictable and persistent abnormal returns. These can stem from issues like the choice of asset pricing model, statistical biases, or temporary market disequilibria.

Momentum refers to the tendency of asset prices to continue in their current trajectory for periods, typically up to two years, before reversing. This phenomenon can be partially explained by behavioral biases such as availability bias, hindsight bias, and loss aversion.

Bubbles and crashes challenge the notion of market efficiency and are often characterized by rapid escalation and collapse of asset prices. Behavioral biases such as overconfidence, confirmation bias, and self-attribution bias play significant roles in these phenomena.

Value investing focuses on stocks that are undervalued relative to their fundamental worth, often indicated by metrics like low price-to-earnings ratios. Behavioral explanations for the outperformance of value stocks include biases like the halo effect and representativeness.

These biases occur when individuals cling to their initial beliefs despite new conflicting information, often leading to cognitive dissonance. Examples include conservatism bias, confirmation bias, representativeness bias, illusion of control, and hindsight bias.

Processing errors involve the illogical or irrational processing and use of information in decision-making. Key types include anchoring and adjustment, mental accounting, framing, and availability bias.

This bias involves maintaining prior views or forecasts and inadequately incorporating new, conflicting information, often leading to underreaction to new data.

Confirmation bias is the tendency to search for, interpret, favor, and recall information in a way that confirms one's preexisting beliefs or hypotheses.

This bias occurs when individuals classify new information based on past experiences and classifications, potentially leading to incorrect assessments due to base-rate neglect or sample-size neglect.

This bias leads individuals to believe they can control or influence outcomes when they cannot, often resulting in overconfidence in their ability to affect events.

Hindsight bias involves seeing past events as having been predictable and reasonable to expect, often leading to overestimations of one's ability to have predicted events.

This bias occurs when individuals rely too heavily on an initial piece of information (anchor) to make subsequent judgments, leading to insufficient adjustments based on new information.

Mental accounting involves dividing money into separate accounts in one's mind, affecting how decisions are made about spending and investing.

Framing bias occurs when individuals make decisions based on the way information is presented rather than just the information itself.

This bias involves overestimating the likelihood of events based on their availability in memory, which can be influenced by recent events or personally memorable occurrences.