Cognitive bias in finance and investment decisions explain why investors do not always behave rationally. By examining specific cognitive biases and how they impact financial decisions, investors can make better investment decisions, maximise investment skill and minimise any negative impact of irrational decision making.
Daniel Kahneman and Amos Tversky, psychologists known for their pioneering work in behavioural economics and the psychology of decision-making, propose that human beings are not accurately represented by economic theories of expected utility, risk aversion, rational decision-making and possessing rational expectations. Instead, the more accurate investment decision-making theories use behavioural concepts.
Investments are made under uncertainty because all potential future events and investment outcomes are unknown. In addition, individuals often use shortcuts in their decision-making processes and rely on cognitive biases to estimate and simplify, pursuing sense-making, instead of logic.
In other words, humans are susceptible to making poor decisions based on questionable rationale.
Cognitive Bias in Behavioural Finance
According to Kahneman and Tversky, cognitive bias refers to the “tendency of individuals to make systematic judgement errors when making decisions.”
Cognitive biases specific to investment decisions can be categorised as:
- Predicting the Future
- Believing Things That Aren’t Necessarily True
- Fearing Loss
- Being Led by the Ego
- Getting Attached
- Emotional bias
1. Predicting the Future
- Projection Bias – Overestimating how preferences remain stable over time.
- Recency Bias – Valuing more recent information.
- Representativeness Bias – Assuming choices or opportunities with similar qualities are the same.
- Law of Small Numbers – Incorrectly assuming that a small number of observations are representative of the general population.
- Gamblers Fallacy – Incorrectly predicting that if something happens more frequently than expected, it will happen less frequently in the future. Alternatively, if something happens less frequently than expected, it will happen more frequently in the future.
2. Beliefs that aren’t Necessarily True
- Hindsight Bias – After an event, the individual views the event as predictable, despite little or no objective basis for predicting it.
- Confirmation Bias – Filtering out information subconsciously supporting currently held opinions to tell us what we want to hear.
- Halo Effect – An impression of positive traits or characteristics influences judgment about an asset’s value or an individual’s character.
- Mental Accounting – Decision making sensitive to how the decision is articulated or how the alternatives are framed.
- House Money Effect – A tendency to take on more risk when investing profits.
3. Fearing Loss
- Loss Aversion treats loss and gains differently. The tendency is to avoid risk when gains are at stake and seek risk when losses are at stake because the perceived values of losses are greater than gains.
- The Disposition Effect is a tendency to close investments that have gained value or “winners” and maintain investments that have lost value or “losers.”
4. Being Led by the Ego
- Overconfidence – Overestimates the accuracy of knowledge, views, opinions, abilities and ability to make rational decisions.
- The illusion of Control – Overestimates the ability to control events or the environment.
- Blind-spot Bias – The inability to recognise their own cognitive biases.
5. Getting Attached
- Anchoring Bias – A tendency to favour familiar or comfortable people, places, things or investments.
- Endowment Effect – Valuing something more just because they own it.
- Justification Bias – Valuing things more highly that took more effort to acquire.
- Sunk Cost Effect or Retrospective Cost Bias – Continuing with a decision, not on its merits but the unrecoverable cost already incurred.
- Status Quo Bias – Not deciding at all, even if deciding to act is in the investor’s best interest.
6. Emotional Bias
Often as the result of current trends, fashions or fads, an emotional bias influences the individual through the social environment and interactions with others. This can often lead to pressure to conform to views, decisions, or actions.
Cognitive biases limit our ability to make rational investment decisions, even though they are not entirely negative — they can often help us simplify routine decisions by using our intuition and experience.
However, we should ensure we are fully aware of them so that we can make prudent investment decisions using robust, data-driven and rational processes.