Cognitive Biases

in Financial
Decision-
making
Chapter 2
 Learning
Outcomes
▪ Identify the cognitive
biases that affect financial
decision-making.
▪ Recommend solutions to
mitigate the effect of
cognitive biases.

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 Cognitive Bias Definition
• A cognitive bias is a systematic error in
thinking that occurs when people are
processing and interpreting information
in the world around them and affects the
decisions and judgments that they make.
• Cognitive biases are often a result of your
brain's attempt to simplify information
processing. Biases often work as rules of
thumb that help you make sense of the
world and reach decisions with relative
speed.
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https://www.verywellmind.com/what-is-a-cognitive-bias-2794963
O R G A N I C S C O M P A N Y
» The concept of cognitive bias was first
introduced by researchers Amos
Tversky and Daniel Kahneman in 1972.
Since then, researchers have described
a number of different types of biases
that affect decision-making in a wide
range of areas including social
behavior, cognition, behavioral
economics, education, management,
healthcare, business, and finance.

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 Signs 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
▪ Learning a little about a topic and then
assuming you know all there is to know
about it
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O R G A N I C S C O M P A N Y
My slide title
My subtitle
 Types of Cognitive Biases

1.Anchoring and Adjustment

2.Overconfidence Bias
3.Loss Aversion
4.Confirmation Bias
5.Availability Heuristic

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 1. Anchoring and Adjustment
How it Works
Definition
» Anchoring is a cognitive bias found in
» Anchoring and adjustment refers to a people, where they rely on facts provided
cognitive heuristic that influences how before a decision or an estimation is made.
people assess probabilities in an intuitive The facts may be completely unrelated or
manner. even absurd, but research shows that they
» According to the anchoring and significantly impact the outcome.
adjustment heuristic, people employ a » Anchoring is understood to be a
certain starting point (“the anchor”) and subconscious or semiconscious
make adjustments until they reach an phenomenon, while adjustment around the
acceptable value over time. The heuristic anchor is very much a conscious decision.
was first hypothesized by psychologist The mechanism that drives the anchoring
and economist Daniel Kahneman and effect is related to a similar concept called
cognitive psychologist Amos Tversky. suggestion.
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markets/anchoring-and-adjustment/
 Anchoring and Adjustment Effect in Finance

» For example, how much we are willing to pay for a product can be
influenced by this bias.
» If the first time we encounter an item’s price, it is significantly
lower than the next time(s) we encounter it; we would likely not
be willing to pay more for it.
» The opposite is true as well, as if the first time we encounter an
item’s price, it is significantly higher than the next time(s) we
encounter it, we would likely be very willing to pay for it.

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markets/anchoring-and-adjustment/
2. Overconfidence Bias
▪ A tendency to hold a false and
misleading assessment of our skills,
intellect, or talent
▪ An egotistical belief that we’re better
than we actually are
▪ A dangerous bias and is very prolific in
behavioral finance and capital markets
▪ Prone to making mistakes in investing
▪ Tends to make us less appropriately
cautious in our investment decisions
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 Types of Overconfidence

Over Illusion of Timing Desirability

Ranking Control Optimism Effect

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 3. Loss Aversion
» Loss aversion is a tendency in behavioral finance where investors are so
fearful of losses that they focus on trying to avoid a loss more so than on
making gains.
» The more one experiences losses, the more likely they are to become prone
to loss aversion.
» Research on loss aversion shows that investors feel the pain of a loss more
than twice as strongly as they feel the enjoyment of making a profit.

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 Loss Aversion in Practice
» Many investors don’t acknowledge a loss as being such until it is realized.
Therefore, to avoid experiencing the pain of a “real” loss, they will continue
to hold onto an investment even as their losses from it increase.
» This is because they can avoid psychologically or emotionally facing the fact
of their loss as long as they haven’t yet closed out the trade.
» In their subconscious, if not their conscious, thinking, the loss doesn’t
“count” until the investment is closed.
» The negative effect of this, of course, is that investors often continue to
hold onto losing investments much longer than they should and end up
suffering much bigger losses than necessary.

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O R G A N I C S C O M P A N Y
 Examples of Loss Aversion
» Investing in low-return, guaranteed investments over more promising
investments that carry higher risk
» Not selling a stock that you hold when your current rational analysis of the
stock clearly indicates that it should be abandoned as an investment
» Selling a stock that has gone up slightly in price just to realize a gain of any
amount, when your analysis indicates that the stock should be held longer
for a much larger profit
» Telling oneself that an investment is not a loss until it’s realized (i.e., when
the investment is sold)

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 4. Confirmation Bias
» Confirmation bias is the tendency of people to pay close attention
to information that confirms their belief and ignore information
that contradicts it.

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 Types of Confirmation Bias
TITLE Description
When forming conclusions or making decisions, people rely on available information. Bias in
research refers to an individual being one-sided when searching for information that supports
what the person already believes.
Bias in Research
This can manifest in the way the person phrases questions. Instead of looking for all relevant
data, the person asks questions in a way that reflects their preferences. Subsequently, yielding
answers that support their hypotheses.
Confirmation bias can also occur in the interpretation of information. When this happens, the
individual interprets the data with bias.
Bias in For instance, if a piece of information proves or supports their existing beliefs, they tend to
Interpretation favor this evidence. On the other hand, information that challenges or opposes their
preconceived notions causes discomfort. In response, they may disregard or criticize the
information.
Memory can be affected by confirmation bias. Two individuals may remember an incident
differently because people recall the past in a way that’s colored by their perception and what
Bias in Memory
they currently believe.
Recall
Bias in memory recall can also affect what things a person remembers. People tend to forget
evidence contradicting their beliefs and recall the details that support their biases.
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 Example of Confirmation Bias
» Let’s look at an example of confirmation bias:
» I have four cards for you (each has a number on one side and a
letter on the other side). One of the cards shows an E, one shows a
4 on one face, one has a K on one face, and one has a 7.
» I say that a card with a vowel on one side (such as “E”) must show
an even number on the other side.
» My question to you is: Which card(s) do you need to turn over to
see if I am telling the truth? And what’s the minimum number of
cards you need to turn over in order to see if I am telling the truth?

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Example of Confirmation Bias

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 Example of Confirmation Bias
» What did you choose? Most people will choose the E and
the 4. Unfortunately, that’s not the correct answer. The
correct answers are actually E and 7.
» If you turn over the E, and you find that there is an odd
number, you’ve proven that I was lying.
» If you turn over the 7 and you find that there is a vowel,
then again, I was lying.
» By turning over the 4, if there is a vowel on the other side,
you only prove that you don’t prove anything. All you do is
confirm my statement.
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O R G A N I C S C O M P A N Y
 Confirmation Bias
» We are all prone to confirmation bias. We tend to look for
confirming, rather than disconfirming, evidence. Most of
us have a really bad habit of only paying attention to
information that agrees with our existing beliefs. We also
have a tendency to form our views first, and then spend
the rest of the day looking for information that makes us
look right. Our natural tendency is to listen to people who
agree with us. Because it feels good, it feels all warm and
fuzzy, to hear our opinions reflected back to us.

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 5. Availability Heuristic
» The availability heuristic occurs when we judge the likelihood of
an event based on how easily we can recall similar events. If we
can vividly remember instances of that event, we deem it to be
more common than it actually is.

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 Example of Availability Heuristic
» When asked if falling airplane parts or shark attacks are a more
likely cause of death in the United States, most people would say
shark attacks. In reality, the chances of dying from falling airplane
parts are 30 times greater than the chances of being killed by a
shark.
» People overestimate the risk of shark attacks because there are
far more news stories and movies about them. As a result, images
of shark attacks are easier to bring to mind. If you can quickly
think of multiple examples of something happening, then you are
tricked into thinking it must happen often.
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 Assignment (Group Work)
»Recommend solutions to mitigate the effects of cognitive
biases to be presented next meeting.

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