The Chartered Financial Analyst Institute (CFAI) defines 15 biases that might affect investors, analysts, retail traders, or basically anyone involved in the stock markets or finance in general. The 15 biases are broken up into nine cognitive errors and six emotional biases. The cognitive errors are further divided into five problems with belief perseverance and four information-processing errors.
We have looked at the emotional biases. These are the result of attitudes or feelings affecting how we make decisions. In this article it’s the cognitive errors turn. They arise from from errors in how we process information, remember facts and events, and from faulty application of probability and statistics. That suggests they should be easier to correct than emotional biases, as education, structure and process, and access to more accurate information should help deal with them.
Do stop believing
It can be uncomfortable abandoning things that were previously held to be true, and cognitive errors of the belief perseverance form seem to stem from a desire to stop that pain occurring:
- Confirmation bias
- Conservatism bias
- Representativeness bias
- Illusion of control bias
- Hindsight bias
These might be evident in how we select what type of information we are exposed to, or what we ignore. Perhaps information is perceived or interpreted differently depending on whether it would be harmful to our beliefs or not, or remembered in a more or less favourable light depending on what we want to be true. In short, when we hold onto a particular belief or idea, even in the face of contradictory evidence, we are exhibiting these biases.
Confirmation
Confirmation bias is a cognitive bias that refers to the tendency to search for, interpret, and recall information in a way that confirms our preexisting beliefs or hypotheses. Supportive information is given a high weight. Evidence that contradicts our beliefs on the other hand is discounted heavily or ignored entirely. This bias can affect our decision-making process, as it can lead us to make biased judgments or interpretations that are not based on objective or accurate information.
In the stock markets this could manifest as reading analyst reports that rate a stock someone likes as a buy, but ignoring those that say sell. Perhaps news articles reporting positive news for a company are digested thoroughly, but that one warning about problems down the road are quickly scrolled past. It is important to recognise this bias and to actively seek out information that challenges our beliefs, in order to make more informed and rational decisions.
Conservatism
Conservatism bias is a cognitive bias that refers to the tendency to favor prior beliefs and information over new or contradictory information. This bias can lead people to stick with familiar ideas and strategies, and are slow to update their opinions, even when new information suggests that they may be ineffective or incorrect.
This can lead to missed opportunities and prevent people from adapting to new information or changing circumstances. It is important to be aware of this bias and to actively seek out and evaluate new information in order to make informed and effective decisions.
Representativeness
Representativeness bias refers to the tendency to make judgments or decisions based on how well an individual or situation matches a particular prototype or stereotype. This bias can lead to over-reliance on stereotypes and can result in inaccurate judgments or decisions.
For example, when on hearing hoofbeats looking for horses, and not zebras might make sense for someone living in the English countryside. But, taking that rule of thumb on safari would be foolish.
Now, heuristics, like rules of thumb, are decision making shortcuts that can be deployed successfully. But, it is important to ask if the new thing being analysed truly does belong in the stereotypical category. It might have some superficial characteristics that suggest it should, but the true underlying base rate probability that it does indeed belong should be considered.
Sure, horses have hooves, so hearing hooves suggests could mean a horse. But, the base rate of any animal being a horse is different depending on if you are in the Serengeti or rural Buckinghamshire.
Another problem with representativeness bias occurs when conclusions about larger populations are drawn from a few samples, and overall, its easy to see how this bias can lead to errors in judgement and decision-making.
Illusion of control
Illusion of control is pretty self explanatory. As applied to investing in the stock market it might be seen as a person rating the chances of the price of a stock they own going up as much higher than that of an almost identical stock that they do not. People have been observed to be willing to pay a little more for a lottery ticket for which they pick the numbers compared to one where the numbers are chosen at random.
Hindsight is 20/20
Have often have we all said “I knew it all along!”? Events are often thought to have been more predictable than it actually was after the fact with hindsight bias. People tend to fill in cracks in their memory with the most comforting granite, and that might prevent them learning from mistakes.
This is representativeness bias and it can lead to overconfidence that similar situations can be identified and responded to with aplomb. It might also lead people to judge others who actually had to deal with a situation harshly, as in hindsight, they believe they would have been much more on the ball, when in fact, it real time this was a confusing, difficult and rapidly changing scenario.
Does not compute
Where as belief perseverance problems are to do with faulty memory and recall, and the application of probabilities being less than optimal, information-processing errors are about, well, how we process information inadequately:
- Framing bias
- Anchoring and adjustment bias
- Mental accounting bias
- Availability bias
Framing
Framing bias is a cognitive bias that occurs when people react differently to information depending on how it is presented or “framed”. In other words, people tend to make decisions based on how information is presented to them, rather than the actual information itself.
For example, if a product is advertised as “90% fat-free,” people are more likely to purchase it than if it is advertised as “10% fat.” This is because the first description frames the product in a positive light, while the second frames it in a negative light.
In the context of investing in the stock market, framing bias can influence an investor’s decision-making by affecting how information is presented to them. For instance, if a stock is presented as having “strong earnings potential,” investors may be more likely to buy the stock, rather than if it was presented as having “high risk.” Framing bias can lead investors to focus on certain aspects of a company or investment, while overlooking other important information that could impact their decision-making. It can also cause investors to react more strongly to positive or negative news, leading to an overreaction to market changes.
Anchoring and adjustment
Imagine two people haggling. One says £20, the other halves it to £10. The £20 was the anchor. It might have been chosen completely on a whim. The second haggler adjusts his bid based on the anchor, by halving it. This is an example of the anchoring and adjustment bias in action. We see this in big round number levels in stock market prices.
Market levels are another example of the bias in action. The FTSE 100 breaking 7,000, 8,000 (perhaps one day 9,000) is significant and tends to attract attention and later commentary on market moves are made in reference to the big round anchor number.
Mental accounting
People treat equal sums of money differently depending on the source and intended use. A $2,500 bonus might find its way into a savings account, but $2,500 of wages paid into a current account are spent without a second thought. A £25,000 self-invested pension plan is all tied up in bond funds, but a £25,000 ISA is invested in domestic stocks that are though to be growth ones.
Money, is money. Investment portfolios should be considered as a whole according to investment theory. Mental accounting biases run counter to this. In fact, goal-orientated investing is designed to allow for this bias. High-, low- and medium-risk buckets are established for long-, short-, and medium-term goals.
And finally….Availability
The availability bias is a cognitive bias that refers to the tendency to rely on easily available or salient information when making judgments or decisions, rather than seeking out and considering more comprehensive or accurate information. This bias can lead people to overestimate the likelihood or importance of events or phenomena that are more easily remembered or recalled, and to underestimate the likelihood or importance of events or phenomena that are less easily remembered or recalled.
This one can be summarised as: things that come easier to mind are often considered as more likely to happen. A fan of baseball is likely to come up with a longer list of baseball players than football ones. That does not mean that there are more baseball players than footballers. A list of names equally split between male and female ones, will typically be recalled as having more men on it, if the names of famous men are included. if someone hears about a plane crash on the news, they may become more fearful of flying, even though flying is statistically very safe. someone who lives in an area that is prone to tornadoes may perceive the risk of a tornado to be higher than it actually is, simply because they are more easily remembered and salient in their mind
Overall, the availability bias can lead to inaccurate judgments and decisions, as it can cause us to focus too much on easily available information and overlook important but less salient information. It is important to be aware of this bias and to actively seek out and consider all relevant information when making judgments or decisions.
So, I am probably not properly thinking about investing in the stock market. But recognising that biases exist is the first step to dealing with this issue. Once I know the major ones I can build mechanisms to detect if I am falling prey to them and hopefully do something about it.
The Storied Investor 
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