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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.

 

Cognitive

Emotional

 

Belief Perseverance

CON CON CON REP HIND

  • Con servatism
  • Con firmation bias
  • Illusiion of control
  • Hind sight Bias
  • Rep resentativeness

Info Processing

FAMA

  • Framing and Anchoring
  • Anchoring & Adjustment
  • Mental Accounting
  • Availability Bias

LOSERS

  • Loss aversion
  • Overconfidence
  • Self-control bias
  • Endowment bias
  • Regret Aversion
  • Status Quo bias

       

Cognitive Errors on the L3 Exam

Belief Perseverance Errors (CON CON CON REP HIND)

See our full post on these errors

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)

See our full post on information processing errors

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)
  • Overconfidence
  • Representativeness
  • 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.