If you are in finance, chances are you have heard of the CFA charter and its three levels of exams. CFA is considered one of the most prestigious designation you can have in the field of finance in general and asset management in particular. I have started studying for my Level 3 exam schedule for June 2014, and Behavioral Finance, a section only present in this level, has proven fascinating so far.
Frankly, behavioral finance is not a new concept in the field and in comparison to other subjects in the Level 3 exam, it is an easier bone to chew. It is interesting nonetheless how emotional biases and cognitive errors could drive even the most brilliant of minds in the field to miscalculations and in some cases, downright bad decision-making. In this article, I will present three main behavioral biases and discuss not only its relevance in a financial sense but also how it affects decision-making in ordinary businesses.
Anchoring: I find this to be the most fascinating behavior in the group. When confronted with an unknown quantity, a financial analyst is said to be anchoring if he chooses an arbitrary value and is reluctant to deviate significantly from this value. How is this present in business? Imagine a procurement manager who needs to purchase a new type of materials and he is not able to assess either the market value of the item or the production cost from the seller’s point of view. The seller is then able to propose a value that anchors in the buyer’s mind, and subsequent negotiations revolve around a discount from this original value.
Sample-size neglect: This bias happens when an analyst overweighs a certain information and does not take into account that this data point does not fully reflect of what he is trying to value. How might this behavior manifest itself in business? Imagine a marketing manager who suddenly sees a drop in sales volume for a few months. He panics and quickly initiates a discount program without analyzing the current month’s performance in relation to the overall trend of the market.
Naïve diversification: This is a simple yet gross error that portfolio managers could commit. When give some capital to invest in several categories of assets (for example stocks, bonds, private equity, etc.), a naïve diversifier would tend to allocate his funds equally among the options available, instead of looking for the best allocation scheme. In business, this behavior could be replicated in a team where the leader assigns the workload equally among the team members without regards to each individual’s strengths and weaknesses, which often leads to inefficient work performance.
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