Introduction

The traditional finance theory suggested that investors are generally assumed to be rational. They are believed to be based solely on their interests, omniscient about market information and risk-averse. However, it ignores the presence of behavioural biases as financial decisions are made by people, and people in all instances are shaped by their behavioural traits Behavioural finance challenges these assumptions by incorporating research on how individuals and markets behave. In this article, we explore a foundational concept of behavioural finance: behavioural biases. Investment professionals can potentially enhance economic outcomes by comprehending these biases, spotting them in both themselves and others and learning techniques to lessen their impact.

What is Behavioural Bias

Behavioural bias is defined as a cognitive bias that manifests itself in the form of a human behavioural tendency. This bias can lead to judgments and decision-making that deviate from what is considered to be rational or normal. Behavioural bias can be shaped by genetic, experiential, and emotional factors. experiential, and emotional factors.

There are many different types of behavioural biases, and they can be broadly classified into two main categories: cognitive biases and emotional biases. To be brief, cognitive biases are mental shortcuts that lead to inaccurate decisions while emotional biases are based on our feelings, rather than logic. It’s important to be aware of these biases to make better decisions. In this article, we will further explore these types of biases.

What are Cognitive Errors

Cognitive errors are biases that distort our perception of reality. They can lead us to make judgments and decisions that are not based on facts or logic, but on emotion or personal beliefs. Due to the limited time and ability of human cognitive information processing, it is necessary to use shortcuts or rules of thumb to solve problems quickly. This is why cognitive biases are often explained as a necessary by-product of cognitive information processing limitations. This ability to make decisions, judgments, or problem-solving in a fast and convenient process is academically called heuristic decision-making. Although heuristic decision-making can reduce the load on the brain, it comes at the cost of a lack of comprehensiveness and integrity in our thinking and decisions.

Psychologists attribute this type of bias to the manipulation of mental shortcuts. When one relies on limited heuristic principles, the complex task of evaluating probabilities and predicted values ​​is reduced to simpler judgmental operations.

Here are some examples that can derail investors' long-term objectives:

• Representativeness: Focus on detailed information
• Illusion of Control: Mistakenly believing that everything is under their control where they overestimate their influence
• Confirmation Bias: Only focus on information that is consistent with your point of view, and ignore information that is inconsistent with your point of view. Look for Positive information and ignore negative information
• Conservatism Bias: Overweight the past information
• Hindsight Bias: See events as having been predicted

What is Emotional Bias

Emotional bias is a type of cognitive bias that refers to the way our emotions can distort our perceptions and judgment. We all have emotions, and they can sometimes cloud our judgment or cause us to make decisions that we wouldn’t otherwise make.

When we humans experience negative emotions like fear, anger, or sadness, we are more likely to make decisions that are not in our best interest. This is because our emotions can cloud our judgment and lead us astray. We may make decisions based on what will feed our emotions in the short-term, rather than what is best for us in the long term. The effects of emotional bias can be similar to those of cognitive bias. The differentiator, however, is that it lies in fear/desire while cognitive bias lies in reasoning.

Here are a few examples:

• Loss aversion: A series of irrational actions to avoid losses Sell winner too soon and Hold loser too long
• Self-Control Bias: Inability to stick to long-term goals to satisfy short-term temptations
• Status Quo: too lazy to do anything to keep things the same
• Endowment Bias: Overestimating the value of something connected to oneself
• Regret Aversion: Avoid making decisions to avoid regret

Bottom Line

Investing is fraught with danger, and one of the biggest dangers is behavioural bias. This is when our habits and thought patterns lead us to make decisions that are not in our best interests. There is no foolproof method of getting rid of these biases as they are inherent in human nature. Investors can, however, be aware that they exist and slow down their thinking when making crucial financial decisions.

Author

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This article is written by Dyce Lim, Research Analyst

Dyce is a research analyst in TED Optimus, tasked with researching and performing analysis on companies. She holds a Bachelor of Science in Financial Analysis Degree from Sunway University. During her time at Sunway University, She has participated in the CFA Research Challenge 2019/2020 and won second runner-up in the event. She is also a CFA Level 2 candidate. She is an in-house author of TED Optimus.