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 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.