What is Cognitive Bias?
A cognitive bias is an error in cognition that arises in a person’s line of reasoning when making a decision is flawed by personal beliefs. Cognitive errors play a major role in behavioral finance theory and are studied by investors and academics alike. This guide will cover the top 10 most important types of biases.
List of Top 10 Types of Cognitive Bias
Below is a list of the top 10 types of cognitive bias that exist in behavioral finance.
#1 Overconfidence Bias
Overconfidence results from someone’s false sense of their skill, talent, or self-belief. It can be a dangerous bias and is very prolific in behavioral finance and capital markets. The most common manifestations of overconfidence include the illusion of control, timing optimism, and the desirability effect. (The desirability effect is the belief that something will happen because you want it to.)
#2 Self Serving Bias
Self-serving cognitive bias is the propensity to attribute positive outcomes to skill and negative outcomes to luck. In other words, we attribute the cause of something to whatever is in our own best interest. Many of us can recall times that we’ve done something and decided that if everything is going to plan, it’s due to skill, and if things go the other way, then it’s just bad luck.
#3 Herd Mentality
Herd mentality is when investors blindly copy and follow what other famous investors are doing. When they do this, they are being influenced by emotion, rather than by independent analysis. There are four main types: self-deception, heuristic simplification, emotion, and social bias.
#4 Loss Aversion
Loss aversion is a tendency for investors to fear losses and avoid them more than they focus on trying to make profits. Many investors would rather not lose $2,00 than earn $3,000. The more losses one experiences, the more loss averse they likely become.
#5 Framing Cognitive Bias
Framing is when someone makes a decision because of the way information is presented to them, rather than based just on the facts. In other words, if someone sees the same facts presented in a different way, they are likely to come to a different conclusion about the information. Investors may pick investments differently, depending on how the opportunity is presented to them.
#6 Narrative Fallacy
The narrative fallacy occurs because we naturally like stories and find them easier to make sense of and relate to. It means we can be prone to choose less desirable outcomes due to the fact they have a better story behind them. This cognitive bias is similar to the framing bias.
#7 Anchoring Bias
Anchoring is the idea that we use pre-existing data as a reference point for all subsequent data, which can skew our decision-making processes. If you see a car that costs $85,000 and then another car that costs $30,000, you could be influenced to think the second car is very cheap. Whereas, if you saw a $5,000 car first and the $30,000 one second, you might think it’s very expensive.
#8 Confirmation Bias
Confirmation bias is the idea that people seek out information and data that confirms their pre-existing ideas. They tend to ignore contrary information. This can be a very dangerous cognitive bias in business and investing.
#9 Hindsight Bias
Hindsight bias is the theory that when people predict a correct outcome, they wrongly believe that they “knew it all along”.
#10 Representativeness Heuristic
Representativeness heuristic is a cognitive bias that happens when people falsely believe that if two objects are similar, then they are also correlated with each other. That is not always the case.
Cognitive Bias in Behavioral Finance
To learn more about the important role cognitive biases play in behavioral finance and business, check out CFI’s Behavioral Finance Course. The video-based tutorials will teach you all about errors in cognition and the types of traps investors can fall into.
Thank you for reading this CFI guide about the impact a cognitive bias can have. CFI is the official provider of the FMVA financial analyst certification program, designed to help anyone become a world-class analyst. To learn more, check out these additional resources below: