Cognitive bias
The term refers to consistent and systematic patterns of deviation from rational thinking that have a notable impact on individuals' judgments and decisions. In the financial context, these biases play a significant role in influencing how people handle their investments, evaluate risks, and make crucial financial decisions.
Many individuals find it challenging to make investment decisions without biases. However, investors can reduce these biases by recognising and understanding them. Establishing trading and investing rules can help mitigate biases when needed. Generally, biases in investing can be categorised into two main types: cognitive and emotional, both stemming from a tendency to favour one option over another.
Cognitive biases typically involve making decisions based on established concepts, which may or may not be accurate. Consider cognitive biases as rules of thumb that may or may not reflect reality.
Popular forms of cognitive bias in financial markets
- Confirmation bias – Do you tend to give more importance to the views of people who agree with you? Investors also exhibit this behaviour. How often do you evaluate a stock and then look for reports that support your viewpoint, rather than seeking information that might challenge your opinion?
- Gambler’s fallacy – Imagine the S&P has gone up for five consecutive trading sessions. If you decide to bet against the market, thinking it’s likely to drop on the sixth day, that’s a gambler’s fallacy. While it might happen statistically, past events don’t guarantee future ones. The market going up for five days doesn’t necessarily mean it will go down on the sixth day. Other factors could influence it.
Risk-aversion bias – Despite a thriving bull market, some investors have missed out on the rally due to a fear that it might change direction. Risk-averse bias often leads investors to give more importance to negative news than positive news. These investors tend to prioritise safe and conservative investments, especially during market uncertainties. This bias can result in placing greater emphasis on the potential downsides of risk rather than considering the potential rewards.
