knowledge topics
Heuristics and Biases
KNOWLEDGE EXPECTED OF: Both CFP® Professionals and QAFPTM Professionals
- Define a heuristic.
- Explain the reasons why the brain uses heuristics in decision making.
- Explain the potential impact that a heuristic may have on decision making.
- Time spent making decision
- Effort expended making decision
- Appropriateness of decision
- Define types of heuristics that the brain may use when making decisions, such as:
- Affect heuristic
- Availability heuristic
- Representativeness heuristic
- Anchoring and adjustment heuristic
- Define a bias.
- Explain the potential impact that a bias may have on decision making.
- Identify factors that may impact biases, such as:
- Culture
- Religious and spiritual beliefs
- Gender
- Biology
- Learned behaviour
- Identify categories of biases, such as:
- Belief perseverance biases
- Information processing biases
- Emotional biases
- Define types of belief perseverance biases that an individual may possess, such as:
- Conservatism bias: the tendency to revise one’s belief insufficiently when presented with new evidence
- Confirmation bias: the tendency to focus on and interpret information in a way that confirms one preconceptions
- Cognitive dissonance: tendency to experience mental stress or discomfort when holding two or more contradictory ideas, beliefs or values at the same time, or when performing an action contradictory to one’s ideas, beliefs or values, or when confronted by new information that contradicts existing ideas, beliefs or values
- Hindsight bias: the belief that past events were predictable at the time they occurred
- Illusion of control: the overestimation of one’s control over external events
- Representativeness bias: the tendency to classify things based on a few characteristics without accounting for the base rates of those characteristics
- Define types of information processing biases that an individual may possess, such as:
- Anchoring and adjustment: the tendency to rely heavily on one piece of information when making a decision
- Availability / familiarity / frequency / saliency / recency bias: the tendency to overestimate the likelihood of events that are more easily recalled given the recency with which they occurred or the emotional charge they hold
- Framing bias: the tendency to draw different conclusions from different presentations of the same information
- Self-attribution bias: the tendency to claim more responsibility for successes than failures
- Sunk-cost bias: the decision to invest or spend money, time, effort, etc. despite new evidence that shows that the expected cost of doing so exceeds the expected benefits
- Outcome bias: the tendency to judge a decision by its eventual outcome instead of based on the quality of the decision at the time it was made
- Define types of emotional biases that an individual may possess, such as:
- Affinity bias: the tendency to be drawn to those people, things or decisions that one views as being similar to themselves
- Disposition bias: the tendency to sell an asset that has accumulated in value and resist selling an asset that has declined in value
- Endowment bias: the tendency to overvalue an object because they possess it
- Loss aversion bias: the tendency to view losses as more painful than similar amounts of gains
- Overconfidence bias: the tendency to be overly sure of oneself and their ideas
- Regret aversion bias: the tendency to avoid making decisions for fear of experiencing regret
- Self-control bias: the tendency to choose those actions that provide gratification in the short-term over the long-term
- Status quo bias: the tendency to choose to maintain the current situation rather than
- Define additional biases for which financial planners may be susceptible, such as:
- Curse of knowledge
- Empathy gap
- Framing effect
- Reactance
- Projection bias
- Illusion of transparency
- Naive realism
- Fundamental attribution error
- Modality effect
- Define mental accounting.
- Explain the general types of mental accounts.
- Current income account
- Asset account
- Future income account
- Explain the relative propensity to consume from each type of mental account.†
- Explain how mental accounting may impact decision making.
- Explain how decision making may be impacted based on variables such as:
- Individual’s initial point of reference
- Individual’s aversion to loss
- Individual’s view of guaranteed gains (losses) in comparison to expected gains (losses)
- Probability of events occurring
- Absolute and relative sizes of gain / loss
- Identify potential points of reference that may be used in the decision making process, such as:
- Starting point (i.e. $0, no goal, no plan)
- Initial point (i.e. amount invested)
- Current point (i.e. fair market value of investment)
- Peak or trough point (i.e. highest investment value)
- Future point (i.e. expected outcome or achievement of goal)
- Status quo
- Explain the impact of loss aversion on decision making.
† Russell, James. This is your brain on finances: Advising imperfect humans. (2011). Retrieved from: http://www.slideshare.net/rnja8c/behavioral-finance-for-financial-planners
Glossary of Verbs (mouse over to see definition)
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Define
To state exactly the meaning of
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Identify
To be aware of / to recognize and correctly name / to locate an appropriate resource
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Explain
To make clear the meaning of / to describe something in more detail or reveal relevant facts or ideas related to it
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Compare
To note the similarities and differences between two or more things
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Estimate
To determine an approximate value for
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Calculate
To find the value using mathematics
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Convert
To change from one form or purpose to another
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Evaluate
To reach a conclusion or make a judgement through careful study
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Interpret
To give the meaning of / to construe or understand / to translate orally
Read more about the Taxonomy used in the FP-BoK
