Behavioural finance, ethics and professional judgement in investment practice
This domain tests whether you can recognise behavioural bias and apply ethical judgement in realistic investment decisions. The exam rewards specific diagnosis and a defensible process, not generic statements about acting professionally.
Biases
Anchoring attaches weight to an initial price or forecast. Confirmation bias seeks supporting evidence. Loss aversion makes losses feel worse than equivalent gains, encouraging loss realisation avoidance. Herding follows the crowd; recency overweights recent performance; home bias overweights familiar markets.
Ethics and judgement
Conflicts of interest must be identified, disclosed and managed. Suitability requires understanding the client's objectives, constraints and risk tolerance. Professional judgement means documenting the decision, the evidence and the alternative considered.
Worked example
A manager refuses to sell a stock trading below its purchase price, arguing it is 'bound to recover'. The purchase price is an anchor and the refusal is loss aversion; neither is evidence about future cashflows. The correct process is to re-underwrite the holding on current fundamentals, compare it with the opportunity set and document the sell or hold decision independently of the original cost.
Traps
- Labelling every mistake as a bias without evidence.
- Confusing disclosure with elimination of a conflict.
- Letting a client's past behaviour override a suitability assessment.
- Treating an ethical rule as optional when it reduces short-term return.