Behavioral Finance

Section: Behavioral Finance Estimated study time: 60 minutes Content: Behavioral finance challenges the neoclassical assumption of rational, self-interested investors with unlimited information-processing ability. Instead, it documents systematic cognitive errors (biases) and emotional influences that cause investors to deviate from rational decision-making. At CFA Level 2, behavioral finance is applied to understand anomalies in financial markets, explain deviations from intrinsic value, and improve investment decision-making by recognizing and mitigating biases. The Level 2 curriculum distinguishes cognitive biases (errors in information processing, which can be corrected with better information or techniques) from emotional biases (stemming from feelings and impulses, harder to correct and requiring accommodation in the investment process). Key cognitive biases tested at Level 2 include: (1) Framing bias — the way information is presented affects decisions even when the underlying facts are identical; an asset described as having a "70% survival rate" is treated differently than one with a "30% failure rate." (2) Anchoring and adjustment — investors place too much weight on an initial reference point (anchor) and adjust insufficiently from it, leading to underreaction to new information. (3) Confirmation bias — investors seek and preferentially weight information that confirms their existing beliefs, while ignoring contradictory evidence. (4) Representativeness — investors judge probability based on how closely an event resembles a prototype (e.g., assuming a company with a good past track record will continue to perform), leading to extrapolation of trends. (5) Availability bias — investors overweight information that is easily recalled (recent, dramatic, or frequently discussed), biasing decisions toward recent performance and ignoring base rates. Emotional biases include: (1) Loss aversion — investors feel losses approximately twice as intensely as equivalent gains (Kahneman-Tversky prospect theory); this leads…