Cognitive and Emotional Biases

Hello all,

This week’s reading was Nudge: Improving Decisions about Health, Wealth, and Happiness. I love learning about nudges. What was particularly exciting for me was Thaler & Sunstein’s (2009) “Save More Tomorrow” nudge they discussed in chapter 6.

Like Thaler & Sunstein, I believe individuals tend to be gravely unprepared for retirement. The Save More Tomorrow nudge has been successful in getting folks to participate in the act of saving and retirement planning, but it stops short of helping them actually choose the optimal investments to maximize performance, although they touch on diversification and asset allocation briefly. It is this area that I would like to focus on throughout my schooling at the Chicago School of Professional Psychology. There are so many behavioral biases that individuals display when it comes to investing, and they tend to hurt overall portfolio performance.

I am a Chartered Financial Analyst and abide by the code of ethics put forth by the CFA Institute. When developing an investment strategy, they point out the fiduciary duties of understanding the individuals return objectives, risk profile, time horizon, liquidity needs, tax circumstances and other unique issues. They sum it up to providing the greatest risk adjusted return based on the individual’s suitability.

Where it falls short, in my opinion is addressing the innate behavioral biases that investors will exhibit. While embracing the current code regarding suitability, I would like to take it a step further and take into account an investors tendency towards poor decision-making. By addressing and explaining these biases (and how they are detrimental to one's retirement plan), I am hopeful to promote my theory of "anxiety adjusted returns". It is hard enough to choose from the various investment vehicles that we are presented with, why do we need the added worry about a potentially faulty decision-making process.

Pompian (2011) touches on 20 behavioral “flaws” that are routinely implemented that ultimately hurts the investor. These behavioral biases can be cognitive or emotional.

Examples of cognitive behavioral biases that affect our belief system include:

• Cognitive Dissonance Bias

• Conservatism Bias

• Confirmation Bias

• Representativeness Bias

• Illusion of Control Bias

• Hindsight Bias

Examples of cognitive behavioral biases that affect our information processing system include:

• Mental Accounting Bias

• Anchoring Bias

• Framing Bias

• Availability Bias

• Self-Attribution Bias

• Outcome Bias

• Recency Bias

Examples of emotional behavioral biases include:

• Loss Aversion Bias

• Overconfidence Bias

• Self-Control Bias

• Status Quo Bias

• Endowment Bias

• Regret Aversion Bias

• Affinity Bias

The key different between cognitive and emotion biases is that with cognitive biases we can be trained to overcome them and hopefully eliminate the bias. Emotional biases are part of our DNA and can never be eliminated, so we must learn to adapt to them and through conscience reasoning and an ability to recognize their existence (Pompian, 2011).

Over the course of my career I have developed certain nudges to help investors overcome the pitfalls of many of these biases and many of my essays throughout my time in this program are written to further enhance my learning of the topic.

I hope to utilize my life and career experience along with what I learn in this program to further develop ways to nudge people into making proper investment decisions. I would imagine that would be the central focus for the Capstone Project.

Joseph S. Kalinowski, CFA

Pompian, M. M. (2011). Behavioral finance and wealth management: how to build optimal portfolios that account for investor biases. Hoboken, NJ: Wiley.

Thaler, R., & Sunstein, C. (2009). Nudge: Improving Decisions about Health, Wealth, and Happiness. New York NY: Penguin Group USA