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
Not enough meaning. Biases that we use when we have too little information and need to fill in the gaps. Need to act fast. Biases that affect how we make decisions.
What is a good example of cognitive bias? ›
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. Assuming that everyone else shares your opinions or beliefs.
What are 5 cognitive biases that influence our decision-making? ›
5 Biases That Impact Decision-Making
- Similarity Bias. Similarity bias means that we often prefer things that are like us over things that are different than us. ...
- Expedience Bias. ...
- Experience Bias. ...
- Distance Bias. ...
- Safety Bias.
Cognitive bias allows us to quickly process and prioritize large amounts of data and fill in missing details, but it also distorts our understanding and creates errors in thought that can result in bad decisions and mistakes.
Is cognitive bias always bad? ›
Cognitive biases are not all bad.
Cognitive biases are mental shortcuts (known as heuristics) and they actually make a lot of sense: they're designed to help us survive in the hunter-gatherer sense.
Is a cognitive bias a thinking error? ›
Cognitive biases often stem from problems related to memory, attention and other mental mistakes. They're often unconscious decision-making processes that make it easy for individuals to be affected without intentionally realizing it.
What is cognitive bias for dummies? ›
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.
How to avoid cognitive bias? ›
How to Avoid Cognitive Bias. So, do your best to watch out for biases in your own thinking and decision making: take your time; question your own thoughts, intentions and motivation; consult with others; and guard scrupulously against these common thinking traps.
What best describes cognitive bias? ›
“If we have a cognitive bias, we may interpret information based off of our own beliefs and experiences,” explains Dr. Prewitt. “And sometimes, the ways that we interpret that information may or may not be accurate.” These biases can exist because of how you remember certain events or periods of your life.
What are the 8 cognitive biases you may encounter in your professional life? ›
Cognitive biases in the workplace
- Confirmation bias. Confirmation bias refers to the tendency to search for, favor, and focus on information that confirms one's preconceptions. ...
- Dunning-Kruger effect. ...
- Sunk cost fallacy. ...
- Optimism bias. ...
- Bandwagon effect. ...
- Planning fallacy. ...
- Anchoring bias. ...
- Self-serving bias.
Self-reflection helps you identify cognitive biases and evaluate how your beliefs, experiences, and preconceived notions influence your judgment and decision-making.
What are the 10 behavioral biases? ›
Second, we list the top 10 behavioral biases in project management: (1) strategic misrepresentation, (2) optimism bias, (3) uniqueness bias, (4) the planning fallacy, (5) overconfidence bias, (6) hindsight bias, (7) availability bias, (8) the base rate fallacy, (9) anchoring, and (10) escalation of commitment.
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.
What is one strategy to overcome cognitive bias? ›
One of the best ways to challenge our biases is to expose ourselves to different perspectives. Doing so allows us to compare and contrast other options for how things can be done. It can also reveal our own errors in thinking, providing the opportunity to correct ourselves before mistakes are made.
What are negative cognitive biases? ›
The negativity bias is a cognitive bias that results in adverse events having a more significant impact on our psychological state than positive events. Negativity bias occurs even when adverse events and positive events are of the same magnitude, meaning we feel negative events more intensely.
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 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.
