BEHAVIORAL FINANCE — CFA LEVEL III CHEAT SHEET

BIAS TAXONOMY & IDENTIFICATION

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COGNITIVE vs. EMOTIONAL: CORRECTION STRATEGY

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LOSS AVERSION & PROSPECT THEORY (KEY FORMULA)

Loss Aversion Coefficient: $$\text{λ (lambda)} ≈ 2.0 \text{ to } 2.5$$

Meaning: A loss of $X feels ≈ 2× worse than a gain of $X feels good.

Portfolio Behavior:

• Sell winners too early (lock in gains before they disappear)

• Hold losers too long (avoid realizing painful losses)

• Result: Suboptimal tax & realization outcomes

Mitigation: ✓ Frame in terms of goals achieved, not dollar losses ✓ Use automatic rebalancing (removes emotion from decisions) ✓ Broader evaluation periods (quarterly/annual vs. daily) ✓ Separate aspiration/essential goals to accept volatility in lower-priority buckets

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MYOPIC LOSS AVERSION (MLA)

Definition: Loss aversion amplified by narrow evaluation windows.

Mechanics:

• Daily reporting → see losses more often → feel pain more often → reduce risk tolerance

• Quarterly/annual reporting → see fewer losses → higher (appropriate) risk tolerance

Intervention: Shift to goal-based (not mark-to-market) reporting

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OVERCONFIDENCE RED FLAGS

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MENTAL ACCOUNTING: GOALS-BASED ALLOCATION

The Problem: Client has "safe" bucket (bonds) and "risky" bucket (stocks) treated independently. → Excessive caution in safe bucket + excessive risk in risky bucket = suboptimal overall.

The Solution: Goals-Based Framework

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Bias Type	Category	Definition	Portfolio Impact	Mitigation
Anchoring	Cognitive	Overweight initial information	Hold losers (anchor to buy price); miss new opportunities	Educate: ignore sunk costs
Framing	Cognitive	Different conclusion from same data presented differently	Risk aversion if loss-framed; risk-seeking if gain-framed	Reframe goals; use multi-perspective presentation
Availability Bias	Cognitive	Overweight easily recalled events	Overestimate crash probability after crash; chase recent winners	Education + diverse information sources
Representativeness	Cognitive	Judge by similarity to prototype	Buy "good company" assuming it's good investment	Educate: past ≠ future
Conservatism	Cognitive	Underreact to new information	Lag portfolio updates to changing conditions	Provide evidence; systematic rules
Confirmation Bias	Cognitive	Seek confirming info; ignore disconfirming	Echo chamber investing; miss red flags	Devil's advocate; forced analysis of opposing view
Loss Aversion	Emotional	Pain of loss ≈ 2× pleasure of equal gain	Hold losers too long; sell winners too early	Frame goals not losses; use rebalancing rules
Overconfidence	Emotional	Excessive faith in own ability	Insufficient diversification; excess trading; underestimate risk	Diversify; constraint rules; peer comparison
Self-Control Bias	Emotional	Fail to act in own long-term interest	Insufficient savings; overspending	Auto-withdrawal; auto-rebalancing; forced commitment
Status Quo Bias	Emotional	Prefer doing nothing over change	Portfolio inertia; miss rebalancing triggers	Auto-rebalancing rules in IPS
Regret Aversion	Emotional	Avoid decisions that might be regretted	Herd with consensus; hold excessive losers	Educate on opportunity cost of inaction
Mental Accounting	Cognitive	Treat money in separate "buckets" differently	Inconsistent risk-taking across accounts; excessive risk in "fun" bucket	Goals-based allocation; total wealth perspective
Cognitive Bias	Emotional Bias
Root: Faulty reasoning/info processing	Root: Feelings, not logic
Correctable by: Education, better data	Correctable by: Accommodation (work with bias, not against)
Advisor approach: EDUCATE	Advisor approach: ADAPT
Example: "You anchored to $80; that's a sunk cost"	Example: "I'll frame your portfolio as progress toward your goals, not daily losses"
Signal	Risk	Mitigation
"I can pick outperformers"	Insufficient diversification; underestimation of cost/difficulty	Force diversification constraints
Excess trading	Whipsaw losses; higher costs/taxes	Rebalancing rules; trading restrictions
Concentrated positions	Idiosyncratic risk uncompensated	Mandate diversification; position limits
"I beat the market" (recent run)	Regress-to-mean blindness	Peer benchmarking; longer performance windows
Goal Tier	Time Horizon	Success Probability Target	Asset Mix
Essential	Near-term (0–5 yr)	90%+	Bonds, annuities, cash
Important	Mid-term (5–15 yr)	70–80%	Balanced (stocks 40–60%)
Aspirational	Long-term (15+ yr)	50%	Growth (stocks 80%+)

Benefits: ✓ Anchors investor to purpose, not market swings ✓ Reduces panic selling (essential goals protected; aspirational goals accept volatility) ✓ Legitimizes differentiated risk across buckets (not mental accounting sin) ✓ Addresses loss aversion by framing goals, not losses

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ADVISOR DECISION TREE: WHEN TO EDUCATE vs. ADAPT

``` BIAS IDENTIFIED?