Cognitive Biases in Trading


In This Chapter

  • Cognitive Biases
  • Cognitive Biases in Trading

Cognitive Bias
Cognitive bias is a systematic thought process that is caused by the capacity of the human brain to ease information processing through a filter of personal experience with their preferences.

Cognitive Biases in Trading

Overconfidence Bias
Overconfidence bias is the tendency of people to overestimate their abilities. It is a well-established bias in which a person’s subjective confidence in his/her own judgments is greater than the objective accuracy of those judgments. Overconfidence in investors can be dangerous as it significantly influences their reasoning even when facts and figures are present.

Confirmation Bias
Confirmation bias is an individual’s tendency to actively search for, interpret, and retain information linked to his/her preconceived thoughts and beliefs. For instance, if an investor has a belief that the prices of a particular stock he is holding will go up, then he will only look for such news and articles that support his belief and ignore all other information that suggests the prices may go down.

Information Bias
Information bias refers to seeking information when it doesn’t influence action. It can be believed that more information can be found to make the ultimate decision, even if the extra-acquired information is irrelevant. Investors are required to filter the information they receive from various sources. Not all news relating to the market is necessary, especially when you are in the market for long-run investment purposes, so ignoring the temporary daily news is necessary. Not filtering the information according to the investment objective may lead to selling the right investment due to short-term price fluctuations and buying a bad investment due to short-term rises in price.

Loss aversion
Loss aversion involves tendency of people to prefer avoiding losses rather than acquiring equivalent gains. Such individuals (investors) tend more to avoid any loss rather than to pursue gain by moving to the next available investment option and taking advantage of opportunity cost. For example, an investor holding stock A whose price is currently falling in the market but is unwilling to cut his loss and take advantage of available opportunity cost by investing in stock B.

Endowment effect
According to Behavioral Economics, the endowment effect is all about finding that people are more likely to retain an object owned rather than acquire the same object when they didn’t own it. This bias is strongly related to ownership. Being an investor, you will be willing to invest more or pay more for shares you already own from the same company rather than paying for shares of a new or unknown company.

Incentive-caused bias
Incentive-caused bias involves the impact of incentives on changing human behaviour and cognition. These incentives work as conscious and subconscious drivers of the thoughts and actions of people. They do what they perceive is in their best interest and are biased by incentives. The reward is the ultimate result an investor wants and is thus biased by it.

Oversimplification tendency
Humans usually want clear and straightforward explanations, even for understanding complex matters. This tendency is called the Oversimplification tendency. At times such a situation arises in the market, which is difficult to understand and leads to uncertainty in the market. In such a situation, it becomes difficult to find any clarity regarding investment.

Hindsight bias
Hindsight bias involves the common tendency for people to look backwards in time and perceive events as more predictable than they actually were. It is also known as the ‘knew-it-all-along’ phenomenon or creeping determinism. It is a kind of belief where an investor believes that he is able to understand and predict the market very well, and there are some events in the market that cannot be controlled, due to which the bad performance of investment arises. This kind of belief or bias leads to over-confidence in investors who consider investing an easy activity.

Bandwagon effect
The bandwagon effect says that people adopt certain behaviours, styles, or attitudes simply because others are doing so. This particular tendency of people is also called a herd mentality. For example, A invest in stocks of XYZ Company following a similar investment pattern as B just because B’s investment decisions are always right and earn him a good return.

Restraint bias
The restraint bias refers to the tendency of people to overestimate the level of control they have over their impulsive behaviours. Some investors are greedy; money is their ultimate goal. Hence, their investment decisions are influenced by this bias, and they cannot control their temptation for more and more capital appreciation.

Anchoring bias
Anchoring bias is the tendency of people to rely upon and make decisions based on the first piece of information they encounter. High weightage is given to past references or one piece of information. Sometimes, investors take decisions based on the current market price. Rather the decision should consider more factors like company management, industry trend, market trend, etc. Not only one but rather all factors must be given the same weightage.

Gambler Fallacy Bias
In the Gambler’s fallacy (also known as the Monte Carlo fallacy), an individual mistakenly believes that a particular random event is more likely or less likely to happen based on the outcome of a similar previous event. It is like gambling on an investment where the investor believes his decision is right and will turn out in his favour because similar previous trade was successful.

Ambiguity Effect Bias
Ambiguity effect describes how people avoid options that they consider ambiguous or lacking information. In such instances, people tend to select options for which the probability of a favourable outcome is known. They ignore the option for which the likelihood of a favourable outcome is unknown. For example, an investor will prefer to invest in government bonds where there is less risk, and a fixed rate of interest is known rather than investing in stocks of any company where the return is unknown.

Narrative Fallacy
Narrative fallacy is the tendency of people to create a story with cause-and-effect explanations out of random details and events. This cognitive bias leads people to see incidents and events as stories with logical chains of cause and effect. They might be attracted to risky stocks of new companies having a good story of high growth rather than also giving equal importance to alternate investment options of a well-established company whose stories may not be as good as the new ones.

Dunning–Kruger effect
It is a cognitive bias wherein people with less ability, expertise, or experience regarding a certain task or area of knowledge tend to overestimate their knowledge. From an investment perspective, this could be dangerous as any investment decision taken with this bias will surely not bear fruitful returns. Rather than over-estimating, the guidance of experts in the field is crucial.

Clustering Illusion
The clustering illusion is the ability to erroneously know the inevitable “streaks” or “clusters” that comes in small samples from random distributions to non-random. This illusion causes us to under-predict the amount of variability appearing in a small sample of random or pseudo random data.

Hot Hand Fallacy
It is the psychological condition in which people believe an individual is “hot” or “cold” depending on earlier performance when that performance has no bearing on future outcomes. This bias goes that consecutive winning or losing considers an investor’s hand “hot” or “cold”. Understanding it from an investment perspective, then, an investor may have an irrational view because he has won several times in a row, so now he becomes an expert, and naturally, this time, too, he will win.

Pseudo certainty Effect
The Pseudo certainty effect is considered to be people’s tendency, to make risk-averse alternatives if the expected outcome is positive rather than make risk-seeking choices to ignore negative outcomes.

Recency Bias
It is a cognitive bias that gives greater importance to the most recent event. It is the tendency to emphasize experiences that are freshest in your memory regardless of their relevance. For example, an investor holding ten shares of a company gives more importance to the recent good reports of the company that it will lead to an increase in share prices. But he might also want to consider the older news of the same company regarding being unable to pay off its dues on time. Whether new or old, an investor must be wise to consider all information before investing.

Self-Attribution Bias
In Self-attribution bias, a person disregards the role of luck or external forces in their success and attributes success solely to their own strengths and work. There are some events in the market that an investor cannot control and is hence obliged to follow. For example, any policy or norms change by the ruling government or regulatory authority will leave no option for an investor but to adhere to new norms and form an investment decision accordingly.

Status Quo Bias
Status quo bias shows the rigidity of the mind of an investor for change. It shows a lack of flexibility in the investor for change to happen. This bias is linked to lose aversion bias because an investor is reluctant to move on, change or even accept the change. Investors with status quo bias do not accept the facts even when presented with facts and factors; they show rigidity.

Investor’s Tip