Cognitive biases are unconscious errors in thinking that arise from problems related to memory, attention, and other mental mistakes. They increase our mental efficiency by enabling us to make quick decisions without any conscious deliberation. However, cognitive biases can alsi distort our thinking, leading to poor decision-making and false judgments.
There are many types of cognitive biases that have been identified by researchers in psychology, sociology, behavioral economics and finance. Cognitive biases in investing are mental errors that can affect how investors perceive and process information, leading to irrational or suboptimal decisions. Some of the cognitive biases that can influence investing behavior are:
- Hindsight bias: The tendency to overestimate one’s ability to have predicted an outcome after it has occurred. This can lead to overconfidence and faulty reasoning.
- Apophenia: The tendency to perceive meaningful connections between unrelated things. This can result from biological, psychological or social factors.
- Fundamental attribution error: The tendency to attribute other people’s behavior to their personality or disposition, while ignoring or minimizing the role of situational factors. This can lead to biased judgements or stereotypes.
- Overconfidence bias: The tendency to overestimate one’s own abilities, knowledge, or skills, resulting in excessive trading, underestimating risks, or ignoring contrary evidence.
- Self-serving bias: The tendency to attribute positive outcomes to one’s own skill and negative outcomes to external factors, such as luck or market conditions. This can lead to confirmation bias, hindsight bias, or an inability to learn from mistakes.
- Herd mentality: The tendency to follow the actions or opinions of others, especially in uncertain or ambiguous situations. This can lead to buying or selling based on market trends, fads, or rumors, rather than on fundamental analysis or personal goals.
- Loss aversion: The tendency to prefer avoiding losses over acquiring equivalent gains. This can lead to holding on to losing positions too long, selling winning positions too soon, or avoiding risky but potentially profitable opportunities.
- Framing bias: The tendency to be influenced by the way information is presented, rather than by the information itself. This can lead to making different choices based on how options are worded, ordered, or highlighted, or based on emotions, rather than facts, logic and fundamentals.
- Narrative fallacy: The tendency to create a coherent and causal story out of a series of facts or events, even when there is no evidence of such a connection. This can lead to overconfidence in one’s own explanations, overlooking alternative scenarios, or ignoring randomness or uncertainty.
- Anchoring bias: The tendency to rely too heavily on the first piece of information received when making decisions. This can lead to being influenced by irrelevant or outdated information, such as initial price, historical average, or personal experience.
- Confirmation bias: The tendency to seek out, interpret, or remember information that confirms one’s existing beliefs or hypotheses. This can lead to ignoring or dismissing contradictory evidence, being overconfident in one’s own opinions, or being biased in one’s research or analysis.
- Gambler’s fallacy: The tendency to believe that past events affect the probability of future events, especially in random or independent situations. This can lead to expecting a reversal after a streak of good or bad outcomes, or believing that one is “due” for a win or a loss.
- Representativeness heuristic: The tendency to judge the likelihood of an event by how well it matches a typical example or stereotype. This can lead to overestimating the frequency or probability of rare events, neglecting base rates or prior probabilities, or making false analogies.
- Availability heuristic: The tendency to judge the frequency or probability of an event by how easily examples come to mind. This can lead to being influenced by recency, salience, or vividness of information, rather than by its actual relevance or accuracy.
- Regret aversion bias: The tendency to avoid making decisions that might result in regret or disappointment. This can lead to following the heard, favoring the status quo or missing out on a good opportunity.
- Mood-congruent bias: The tendency to recall or process information that is consistent with one’s current mood. This can lead to investment decisions based on how we feel at the moment.