Bias is a disproportionate weight in favour of or against an idea or thing, usually in a way that is closed-minded, prejudicial, or unfair. We typically hear about the biases in a social context, however the investing decisions as well as in any life decisions can also be compromised by the biases we have.

Despite being based on the quantitative data, the investment models and decisions are frequently affected by the individuals’ psychology in form of fears and past decisions. At the high level, the biases are typically divided in two distinct categories: cognitive and emotional.

The cognitive biases are typically linked to the way we process information. As individuals we are prone to act irrationally and are likely to act illogically due to limitations in the way we process information.

The emotional biases are linked to the emotions and the way we control them. They are are distortions in cognition and decision-making due to emotional factors. These biases can arise from both positive and negative emotions and can impact various areas of life, including personal relationships, work, and financial decision.

Cognitive Biases

Cognitive biases are systematic patterns of deviation from rationality in judgment and decision-making. They are mental shortcuts that influence our thinking and perception of reality, often resulting in inaccurate or irrational judgments. Biases can be caused by many things, such as heuristics (mental shortcuts), social pressures, and emotions.

The main examples that relate to financial decisions are the following:

• Anchoring and Adjustment Bias: Anchoring and adjustment bias is a cognitive bias related to information processing. It occurs when individuals use a mental shortcut, known as a psychological heuristic, to influence how they estimate probabilities. When tasked with estimating an unknown value, people typically start by envisioning an initial reference point, referred to as an “anchor.” Subsequently, they make adjustments either upwards or downwards based on additional information and analysis.
• Mental Accounting Bias: Mental accounting bias is an information-processing bias in which individuals treat two equal-sized sums of money differently based on the mental account to which the money is assigned. These mental accounts are created based on arbitrary classifications such as the source of the money (e.g., salary, bonus, inheritance, gambling) or the intended use of the funds (e.g., leisure, necessities).
• Framing Bias: Framing bias is an information-processing bias that influences how a person responds to a question, depending on how that question is presented or “framed.”
• Availability Bias: Availability bias is an information-processing bias in which individuals rely on a heuristic approach to estimate the likelihood of an outcome based on how easily that outcome comes to mind. Outcomes that can be recalled readily are often perceived as more probable than those that are more challenging to recall or understand. People tend to unconsciously assume that thoughts, ideas, or images that readily come to mind represent unbiased estimates of statistical probabilities. This leads them to assess the probability of an event based on how easily they can recall a memory of that event, with recent events being more easily remembered and therefore more available for consideration.

Emotional Biases

While there is no universally accepted definition of emotion, it can generally be conceptualised as a mental state that emerges spontaneously, rather than being a product of deliberate conscious effort. Emotions can be unwelcome to those experiencing them; individuals may desire to exert control over their emotions and their reactions to them, yet find themselves unable to do so. Emotional biases pose a greater challenge for correction in investments context compared to cognitive errors, as they stem from impulses or intuition rather than deliberate calculations.

• Loss-Aversion Bias: Loss-aversion bias manifests as a psychological inclination wherein individuals exhibit a pronounced preference for evading losses over achieving gains. A body of empirical research on loss aversion indicates that, from a psychological perspective, losses wield significantly greater impact than equivalent gains. When assessing the comparative values, the utility derived from a gain is markedly lower than the utility forfeited in the context of an equivalent loss.
• Overconfidence Bias: Overconfidence bias represents a cognitive predisposition whereby individuals manifest unwarranted confidence in their intuitive reasoning, judgments, and cognitive capabilities. This heightened sense of self-assuredness may arise from an overestimation of one’s knowledge levels, competencies, and access to information. Overconfidence bias is recognized as predominantly emotional in nature due to its primary origins in emotional responses.
• Self-Control Bias: Self-control bias characterizes a cognitive inclination in which individuals falter in their pursuit of overarching, long-term objectives due to a deficiency in self-discipline. This bias inherently involves a conflict between the allure of immediate gratification and the achievement of enduring, long-range goals.
• Status Quo Bias: Status quo bias is an emotional predisposition where individuals exhibit a preference for inaction or the preservation of existing conditions, as opposed to initiating change. Generally, people tend to find comfort in maintaining the current state of affairs, displaying an inclination against actively seeking change, even when it may yield benefits. Furthermore, when presented with a situation in which a particular option is established as the default choice, individuals frequently adhere to that default without considering alternative choices.
• Endowment Bias: Endowment bias is an emotional predisposition in which individuals attribute a higher value to a particular asset when they possess ownership rights compared to when they do not. This phenomenon contradicts the principles of conventional economic theory, which says that the price an individual is willing to pay for a commodity should equate to the price at which they would be willing to sell the same commodity. One common instigator of endowment bias pertains to inherited securities.
• Regret-Aversion Bias: Regret-aversion bias is an emotional inclination observed in individuals who tend to eschew decision-making processes that might result in taking action, primarily due to apprehension that such decisions could lead to unfavourable outcomes. In simpler terms, people endeavour to sidestep the emotional distress associated with regret stemming from unwise choices. This cognitive tendency is notably pronounced in the context of investment decision-making. Regret aversion can compel individuals to retain their positions for extended periods, as they exhibit reluctance to divest for fear that the asset’s value might appreciate, subsequently causing them to regret their divestment decision.

Final remarks

In the context of financial markets, emotional and cognitive biases can have a significant impact on investment decisions by making them suboptimal investment. It is important for investors to be aware of these biases and to take steps to mitigate their effects. This can include developing a disciplined investment strategy, avoiding impulsive decisions, and seeking out diverse sources of information. By doing so, investors can make more informed decisions and improve their chances of achieving their financial goals.

Please note, none of the information on this blog represents the opinion of my employer and all information does not represent a financial advice.