List of the top 10 most important biases in behavioral finance
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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 $2,000 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.
Additional Resources
Thank you for reading CFI’s guide on Cognitive Bias. To learn more, check out these additional resources below:
FAQs
Problem 2: Not enough meaning.
The world is very confusing, and we end up only seeing a tiny sliver of it, but we need to make some sense of it. Once the reduced stream of information comes in, we connect the dots, fill in the gaps with stuff we already think we know, and update our mental models of the world.
What is cognitive bias in your own words? ›
Cognitive bias is the tendency to act in an irrational way due to our limited ability to process information objectively. It is not always negative, but it can cloud our judgment and affect how clearly we perceive situations, people, or potential risks.
What is a quote about cognitive bias? ›
“When dealing with people, remember you are not dealing with creatures of logic, but with creatures bristling with prejudice and motivated by pride and vanity.”
Can you beat cognitive bias? ›
However, we can make an effort to be less biased. Here's the one trick you need to know to become less biased: awareness. Being aware of a cognitive bias and having it in the front of your mind when you make a decision will help you recognize it and ultimately avoid it.
Why should we avoid cognitive bias? ›
It can result in illogical and irrational decisions, and it can cause you to misjudge risks and threats. The researchers explained that cognitive bias is the tendency to make decisions or take action in an illogical way, caused by our values, memory, socialization, and other personal attributes.
What is the most common cognitive bias? ›
The hindsight bias is a common cognitive bias that involves the tendency to see events, even random ones, as more predictable than they are. It's also commonly referred to as the "I knew it all along" phenomenon.
What best describes cognitive bias? ›
Cognitive bias is a systematic thought process caused by the tendency of the human brain to simplify information processing through a filter of personal experience and preferences. The filtering process is a coping mechanism that enables the brain to prioritize and process large amounts of information quickly.
Are cognitive biases good or bad? ›
Overall, cognitive biases affect how you make decisions and can lead to difficulties in your career and personal life. But with practice, you can get better at recognizing when you may have a cognitive bias and how to change your perception of a situation.
What is a powerful quote about bias? ›
Bias and prejudice are attitudes to be kept in hand, not attitudes to be avoided. Hindsight bias makes surprises vanish. I think unconscious bias is one of the hardest things to get at.
What is the cognitive bias everyone thinks like me? ›
We often tend to overestimate how much other people agree with us and think that most people share our same values. This is called “the False Consensus effect”. This happens for several different reasons, including: The time spent with our family and friends, with whom we share similar opinions and values.
The distinction between a logical fallacy and a cognitive bias is that cognitive biases are rooted in the way the brain actually works whereas logical fallacies are errors in argument. Learners can be trained to avoid logical fallacies, but cognitive biases are trickier.
What is cognitive bias in simple words? ›
A cognitive bias is a systematic error in thinking that occurs when people process and interpret information in their surroundings, influencing their decisions and judgments. 1. The human brain is powerful but subject to limitations.
How do you break cognitive bias? ›
How to avoid cognitive biases
- Be aware of common biases. ...
- Reflect on past mistakes. ...
- Seek multiple perspectives. ...
- Embrace the opposite. ...
- Consider that you might have been wrong (and that's okay).
They did not tend to integrate arguments across different perspectives, which would indicate critical thinking. The researchers also assessed intelligence. They found that people who scored more highly on the intelligence test showed just as much of the cognitive bias as the rest.
What is the problem with cognitive bias? ›
Cognitive bias in all its forms prevents the exchange of accurate information, as we tend to avoid information we do not like or agree with. While we believe that we receive information objectively, our brains unconsciously filter data, distorting our perception of reality.
What are the problems with cognitive biases? ›
Cognitive biases can affect your decision-making skills, limit your problem-solving abilities, hamper your career success, damage the reliability of your memories, challenge your ability to respond in crisis situations, increase anxiety and depression, and impair your relationships.
What are the limitations of cognitive bias? ›
Other cognitive biases are a "by-product" of human processing limitations, resulting from a lack of appropriate mental mechanisms (bounded rationality), the impact of an individual's constitution and biological state (see embodied cognition), or simply from a limited capacity for information processing.
What is a lack of cognitive capacity? ›
What is cognitive impairment? Cognitive impairment is when a person has trouble remembering, learning new things, concentrating, or making decisions that affect their everyday life. Cognitive impairment ranges from mild to severe.
