Behavioural Finance in Practice: formula sheet

Key formulas

Traditional finance core assumptions

Rational investors + efficient markets + consistent risk-return judgement

Behavioural finance questions these. It does not claim they are never true.

Behavioural finance core idea

Psychology (biases, emotions, heuristics) → investor decisions → possible price and portfolio effects

The errors are systematic and predictable, not purely random.

Two broad bias groups

Cognitive biases (thinking and information errors) and emotional biases (feeling-driven errors)

Cognitive biases are usually easier to reduce with information and education. Emotional biases come from feelings and are harder to change, so advisers often adapt the advice.

Cognitive vs emotional bias

Cognitive = faulty reasoning or information processing; Emotional = feeling or impulse

Cognitive biases are more correctable through information and education. Emotional biases are usually accommodated in the plan.

Belief perseverance group

Conservatism, confirmation, representativeness, illusion of control, hindsight

The common thread is holding on to a belief despite new evidence.

Information processing group

Anchoring and adjustment, mental accounting, framing, availability

The common thread is processing data in a flawed way. Overconfidence is sometimes listed with cognitive errors; follow the workbook grouping.

Bias to behaviour link

Overconfidence → excess trading; Anchoring → fixation on cost price; Confirmation → one-sided research; Availability → recent events overweighted

Use this to match a client's behaviour to the right bias.

Loss aversion

Pain of a loss > Pleasure of an equal gain

Linked to prospect theory. It explains holding losers and selling winners early (the disposition effect).

Regret aversion

Fear of regret → avoid or delay action, or follow the crowd

The investor wants to avoid the pain of a wrong decision, so may not act at all.

Endowment effect

Value placed on owned asset > Value placed on same asset if not owned

Ownership alone raises perceived value. It is not about the asset's merits.

Status quo bias

Default option preferred → no change

Inertia. The client sticks with the existing portfolio even if it no longer suits.

Cognitive vs emotional bias

Cognitive: flawed reasoning → correct it. Emotional: feeling-driven → adapt to it

A common exam distinction on how the adviser should respond.

Prospect theory core rule

Value = f(gain or loss from reference point), not f(final wealth)

The reference point decides whether an outcome feels like a gain or a loss.

Loss aversion

Pain of a loss > pleasure of an equal gain

Losses loom larger than equal gains. Do not say they are exactly twice as large; the exam only needs the direction.

Shape of the value function

Gains: concave (risk averse) | Losses: convex (risk seeking)

Explains booking small gains early and gambling to recover losses.

Disposition effect

Sell winners too early + hold losers too long

A result of loss aversion and the purchase price as reference point.

Mental accounting

Money is treated as non-fungible by source, purpose or label

Rational view: all money is fungible and the whole portfolio matters.

BB&K axes

Confidence (confident ↔ anxious) × Method of action (careful ↔ impetuous)

These two axes generate the five investor types.

Adventurer

Confident + impetuous

High risk-taking, strong views, difficult to advise, often concentrated portfolios.

Celebrity

Anxious + impetuous

Follows trends and others; needs guidance and a disciplined plan.

Individualist

Confident + careful

Independent and analytical; responds to facts.

Guardian

Anxious + careful

Capital preservation focus; low risk appetite.

Straight arrow

Balanced on both axes

Average risk tolerance; sensible and diversified.

Advice limit

Recommended risk ≤ lower of (risk tolerance, risk capacity)

Where the two differ, the lower one governs the portfolio.

Cognitive bias treatment

Cognitive bias → corrective approach (information, education, evidence)

Cognitive biases come from faulty reasoning, so better information can reduce them.

Emotional bias treatment

Emotional bias → adaptive approach (adjust the plan to the bias)

Emotional biases come from feelings, so they are hard to correct. Accommodate them.

Exception to the default

Large wealth cushion → adapt; goals at risk → correct more

A rule of thumb, not an absolute. Read the case facts.

Core advisory sequence

Identify bias → classify → choose corrective or adaptive → document

Use this order to reason through any case.

EMH versus behavioural view

EMH: price = fair value (rational investors) | Behavioural: price ≠ fair value can persist (biased investors)

The core contrast. Most questions test this.

Bubble cycle

Displacement → boom → euphoria → profit-taking → panic

Typical stages. Prices rise far above fundamentals, then fall fast. Exact stage names may vary by source, so focus on the sequence.

Momentum versus reversal

Momentum: short to medium term continuation | Reversal: long term turnaround

Momentum is explained by underreaction and herding. Reversal by overreaction.

Forms of EMH

Weak: past prices | Semi-strong: all public information | Strong: public and private information

Technical analysis fails under weak form. Fundamental analysis fails under semi-strong.

Quick revision

• Classical finance assumes rational investors; behavioural finance studies systematic departures from that.
• Cognitive biases come from faulty reasoning or information processing, and education or better information can often reduce them.
• Emotional biases come from feelings and impulses, and are harder to correct, so advisers often adapt the plan to them.
• Overconfidence means overestimating your own knowledge or ability.
• Loss aversion means losses hurt more than equal gains please.
• Prospect theory says people judge outcomes as gains or losses against a reference point, not by final wealth.
• Mental accounting means treating money differently depending on its source or purpose.
• Anchoring means relying too heavily on an initial reference value.
• Herding means following the crowd instead of your own analysis.
• Profiling should look at both ability and willingness to take risk.
• A good adviser names the behaviour, explains it simply, and ties the decision back to the client's goals.
• Market anomalies are patterns that are hard to explain by classical models, and behavioural explanations are offered for them.

Common mistakes

• Saying behavioural finance proves markets are never efficient. Fix: Remember that behavioural finance questions the assumptions and shows departures from them. It does not claim that every price is wrong.
• Treating behavioural errors as random mistakes. Fix: The key point is that biases are systematic and predictable, which is why advisers can anticipate and manage them.
• Treating confirmation bias and overconfidence as the same thing. Fix: Confirmation is about selecting evidence. Overconfidence is about overrating your own ability or knowledge.
• Mixing up representativeness and availability. Fix: Representativeness uses resemblance to a type or pattern. Availability uses how easily or recently an example is recalled.
• Confusing endowment effect with status quo bias. Fix: Endowment is about higher value because of ownership. Status quo is about preferring no change or effort. Look for 'values more' versus 'prefers to leave as is'.
• Treating loss aversion as plain risk aversion. Fix: Risk aversion is a general dislike of uncertainty. Loss aversion is the asymmetry that losses weigh more than equal gains, and it can cause holding losers.
• Saying prospect theory says people are always risk averse. Fix: Remember the split: risk averse in gains, risk seeking in losses.
• Treating framing and mental accounting as the same thing. Fix: Framing is about how a choice is presented. Mental accounting is about how money is sorted into buckets.
• Confusing adventurer with celebrity. Fix: Check confidence next. Adventurer is confident and acts on own views. Celebrity follows others and trends.
• Treating the personality type as the risk tolerance score. Fix: Remember type describes behaviour and decision style. Risk capacity still needs separate assessment.

Exam tips

• Expect direct questions contrasting traditional and behavioural finance. Learn the one-line difference: how investors should behave versus how they actually behave.
• Be careful with absolute words. Options saying behavioural finance always proves markets irrational are usually traps.
• For application questions, choose the option that adapts advice to the client's actual behaviour while staying within suitability.
• Know that biases are systematic and affect all investors, not only beginners.
• Group biases first as cognitive or emotional. Detailed bias names are covered in later topics.
• Expect scenario questions. Name the bias from the behaviour, and watch for close pairs such as anchoring and conservatism.
• Know the cognitive versus emotional split, including which can be corrected and which is accommodated.
• Learn the belief perseverance and information processing grouping from your workbook and answer by its wording.