Home › CFA® Level I › Portfolio Construction
CFA® Level I · Portfolio Construction · free lesson
The Behavioral Biases of Individuals
Traditional finance assumes investors process information rationally; real investors, and their advisers, do not. This module classifies behavioral biases into cognitive errors and emotional biases, explains the most common biases in each group and how they distort decisions, shows how advisers should respond to each type, and links individual biases to market patterns such as momentum, bubbles and the value effect that traditional theory struggles to explain.
What you will learn
1. Compare and contrast cognitive errors and emotional biases and explain how an adviser should respond to each.
- Cognitive errors come from faulty reasoning; emotional biases from feelings and impulses.
- Cognitive errors divide into belief perseverance biases and information-processing biases.
- Cognitive errors can often be moderated with information and education.
- Emotional biases are harder to correct, so advisers often adapt to them.
- How far to adapt also depends on whether the bias threatens the client's essential goals.
2. Describe belief perseverance biases and their implications for financial decisions.
- Conservatism: underreacting to new information, updating views too slowly.
- Confirmation: favouring evidence that supports existing beliefs.
- Representativeness: judging by similarity; base-rate and sample-size neglect.
- Illusion of control: believing one can influence uncontrollable outcomes.
- Hindsight: seeing past events as predictable; fosters overconfidence.
3. Describe information-processing biases and their implications for financial decisions.
- Anchoring and adjustment: estimates stay too close to an initial value.
- Mental accounting: money treated differently by 'account', ignoring the whole portfolio.
- Framing: choices change with the presentation of identical information.
- Availability: likelihood judged by how easily examples come to mind.
- Remedies: fundamental anchors, whole-portfolio view, multiple frames, systematic research.
4. Describe the main emotional biases, including loss aversion and overconfidence, and their implications for financial decisions.
- Loss aversion: losses hurt more than equal gains; leads to the disposition effect.
- Overconfidence (illusion of knowledge, self-attribution): excessive trading, under-diversification.
- Self-control: undersaving for long-term goals.
- Status quo and endowment: inertia and overvaluing what one already owns.
- Regret aversion: avoiding action, or following the herd to share the blame.
5. Describe how behavioral biases can produce market characteristics that traditional finance struggles to explain, such as momentum, bubbles and crashes, and the value effect.
- Shared biases do not cancel out, so they can move market prices.
- Momentum: herding, availability, representativeness, regret aversion; underreaction from conservatism.
- Bubbles and crashes: overconfidence, confirmation, herding, then hindsight and the disposition effect.
- Value outperformance: halo effect leads investors to overpay for attractive growth companies.
- Behavioral explanations compete with risk-based explanations of the same patterns.
Module at a glance
- Cognitive errors come from faulty reasoning and can often be moderated; emotional biases come from feelings and are usually adapted to.
- Belief perseverance: conservatism, confirmation, representativeness, illusion of control, hindsight.
- Information processing: anchoring and adjustment, mental accounting, framing, availability.
- Emotional: loss aversion, overconfidence, self-control, status quo, endowment, regret aversion.
- Loss aversion produces the disposition effect: PGR above PLR.
- Shared biases can create momentum, bubbles and crashes, and value outperformance.
This free module has 5 lessons, 18 practice questions with full explanations.