Thousands of ambitious financial analysts around the world will sit for one of the three the Chartered Financial Analyst (CFA) exams this weekend.
The very few candidates who are taking the level III exam will be tested on a fun topic: behavioral finance.
"Investors are 'normal,' not rational," says Meir Statman, one of the leading thinkers in behavioral finance.
Behavioral finance reconciles the discrepancy between rational valuation and irrational market pricing. It's a booming field of study. Top behavioral finance gurus include Yale's Robert Shiller and GMO's James Montier.
We compiled a list of the seven common behavioral biases that drive investor decisions. Read through them, and you'll quickly realize why you make such terrible financial decisions.
NOTE: These definitions are derived from Hersh Shefrin's Beyond Greed And Fear, which was required reading in the CFA Institute's Level III curriculum in 2009.
Investors believe they are awesome at investing.
Overconfidence may be the most obvious behavioral finance concept. This is when you place too much confidence in your ability to predict the outcomes of your investment decisions.
Overconfident investors are often underdiversified and thus more susceptible to volatility.
Investors are bad at processing new information.
Anchoring is related to overconfidence. For example, you make your initial investment decision based on the information available to you at the time. Later, you get news that materially affects any forecasts you initially made. But rather than conduct new analysis, you just revise your old analysis.
Because you are anchored, your revised analysis won't fully reflect the new information.
Investors connect the wrong things to each other.
A company might announce a string of great quarterly earnings. As a result, you assume the next earnings announcement will probably be great too. This error falls under a broad behavioral finance concept called representativeness: you incorrectly think one thing means something else.
Another example of representativeness is assuming a good company is a good stock.
See the rest of the story at Business Insider
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