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
Some signs that you might be influenced by some type of cognitive bias include: Only paying attention to news stories that confirm your opinions. Blaming outside factors when things don't go your way. Attributing other people's success to luck, but taking personal credit for your own accomplishments.
What 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.
What is the most common cognitive bias? ›
Cognitive Bias #1: Confirmation Bias
It is strongly displayed for deeply rooted values or on issues that are emotionally charged. Confirmation bias cannot be eliminated entirely but Critical Thinking skills can help mitigate and manage it. An example of Confirmation bias is found during elections.
Why is cognitive bias bad? ›
For health care professionals, cognitive bias, left unchecked and unchallenged, can lead to erroneous diagnoses, poor treatment decisions, and bad outcomes.
Which of the following are examples of cognitive biases? ›
13 Types of Common Cognitive Biases That Might Be Impairing Your Judgment
- The Confirmation Bias.
- The Hindsight Bias.
- The Anchoring Bias.
- The Misinformation Effect.
- The Actor-Observer Bias.
- The False Consensus Effect.
- The Halo Effect.
- The Self-Serving Bias.
Definition. Positivity bias may denote three phenomena: a tendency for people to report positive views of reality; a tendency to hold positive expectations, views, and memories; and a tendency to favor positive information in reasoning.
What is the opposite of cognitive bias? ›
When making a decision by the fast system (heuristics), a bias is a deviation from the norm, wrong decision or cognitive bias. The opposite would be no deviation from the norm or wright answer.
What is cognitive bias in psychology today? ›
Cognitive biases are systematic patterns of thinking that can affect how we interact with others. Anchoring bias happens when we make judgments based on the first information we find. Negativity bias happens when we give more importance to negative experiences than positive ones.
What is the cognitive bias everyone thinks like you? ›
According to an article written by Kendra Cherry, this kind of cognitive bias leads people to believe that their own values and ideas are “normal” and that the majority of people share these same opinions. In psychology, the false consensus effect, also known as consensus bias.
Do all people have cognitive bias? ›
But we all have cognitive biases, which happen as an attempt by our brains to simplify all the information it receives every second. It's a systematic error in our thinking that influences and affects how we make decisions and how we think about the world around us.
According to research published in the Journal of Personality and Social Psychology, high-IQ individuals are just as susceptible to biases as anyone else, sometimes more so.
Are we born with cognitive bias? ›
We are born with a tendency for some cognitive biases, but we can also learn specific aspects of these biases.
What is a cognitive bias in everyday life? ›
In everyday life, we are often tricked by cognitive bias and over- or underestimate how risky our choices might be. Example: Cognitive bias in real life Many people think that traveling by plane is more dangerous than traveling by car. This, in part, is due to the availability heuristic (availability bias).
What is cognitive bias too much choice? ›
Choice overload can cause us to delay decision-making, considering the many options available is taxing on our cognitive systems. Having more options also leads to decreased satisfaction, lower confidence in our choices, and a higher chance that we will regret our decisions.
What is an example of cognitive bias in the classroom? ›
For example, if each group researches and learns about a different part of a topic, when it comes to listening to other groups present their findings to the class, students may be averse to learning or using knowledge from other groups. This would cause them to miss out on valuable material.
What is an example of cognitive thinking? ›
Examples of cognition include paying attention to something in the environment, learning something new, making decisions, processing language, sensing and perceiving environmental stimuli, solving problems, and using memory.
What is an example of availability cognitive bias? ›
Examples of Availability Bias
Excessive coverage on the news or social media about plane crashes uses vivid images and stories to elicit an emotional response. That's why many people develop a fear of flying - they remember those images the next time they fly.
What is an example of a cognitive bias in healthcare? ›
Within events reported to The Joint Commission, cognitive biases have been identified contributors to a number of sentinel events, from unintended retention of foreign objects (e.g., search satisficing), wrong site surgeries (e.g., confirmation bias), and patient falls (e.g., availability heuristic and ascertainment ...
