CFA L3 Behavioral Finance Cram Guide - Cognitive and Emotional Biases
Cognitive & Emotional Biases
For a complete review on how the CFA Level 3 exam tests your understanding of behavioral finance see our overview post.
On the Exam: Be prepared for reading a passage, identifying a couple of emotional and cognitive errors, and writing what factors caused you to pick it out.
CON CON CON REP HIND
Cognitive Errors on the L3 Exam
Belief Perseverance Errors (CON CON CON REP HIND)
Conservatism : Emphasize old info/original more than new (common w/ analysts)
Confirmation bias : Seek confirming evidence and discount contradictory evidence
Illusion of control : Thinking you have more influence over an outcome than you do
Hindsight Bias : Selective memory. Tend to remember r correct views and forget mistakes.
Representativeness : Using overly simple if-then or rule-of-thumb decisions. Individuals use heuristics (experience) to classify information: “IF it looks a certain way THEN it must be in a certain category.” There are two forms representativeness bias can take: Base-rate neglect is where new info is given too much weight and sample-size neglect is assuming small samples represent the entire population.
Information Processing Errors (FAMA)
Framing & Anchoring: View info differently depending on the context/way it was received
Anchoring & Adjustment: Remain anchored to an initial value (expected price, forecast). It’s similar to conservatism bias, so remember on the exam that Anchoring & Adjustment is ALWAYS related to a SPECIFIC NUMBER
Mental Accounting: Individuals place wealth into different buckets to meet different goals/treat different sources of money differently depending on which bucket they are in. Ignores the fungible nature of wealth
Availability Bias: Focus on info that is easy to find, or focus on easily remembered past experiences
Emotional Errors (LOSERS)
See our full post on the emotional biases
Loss Aversion: Feeling greater pain for a loss than pleasure for a gain of equal value
Overconfidence : Think you know more than you do (illusion of knowledge/control). Also related to Self-attribution bias where you take credit for the good and pass blame when bad.
Self-control bias Insufficient saving due to tendency for overconsumption (short-run gratification) and over-emphasis on income versus total return.
Endowment bias : See assets you own as worth more than you’d actually be willing to pay to acquire them
Regret Aversion: Tendency to do nothing due to a fear of making the wrong decision. Basically making errors of omission instead of errors of commission
Status quo bias: A tendency to stay with current investments due to apathy (emotional desire to do nothing 401(ks), laziness
Analyst, or “Pro” Errors
Analysts/pros are subject to:
- Groupthink (Social proof bias)
- Illusion of knowledge
- Ego-defense mechanisms like hindsight and self-attribution.
The way the management of a company presents material on earnings calls can also influence analysts. Gamblers fallacy is thinking there will be a long-term reversal back to average more often there actually is. You seen see our full post on biases by investory type here.