Cognitive Bias Theory: How It Impacts Your Investment Decisions?

“Humans are not machines. They analyze information through the lenses of their experience, knowledge, and cognitive biases. All of it makes their perception, their unique viewpoint.”- Naved Abdali

The quote you just read goes against a fundamental assumption in Traditional finance theories- “Investors are rational”. We have been studying human behavior in social psychology, economics, finance discipline, etc. If you are someone from a commerce background, then I am sure you have come across this assumption. Precisely this assumption stems from something called “The Efficient Market Hypothesis”. This hypothesis states that the stock prices reflect all the information in the market and when all the investors have access to this information equally, there’s no way anyone can beat the market. Superficially, this statement may not seem so off the mark, but when you dig deeper, the problems with it, become more evident.

First of all, investors in the market do not have equal access to all the information. But, that’s not the elephant in the room here. The greater issue is even if the information is equally accessible by everyone, the way everyone interprets each little piece of information is different. This is because our unique background, learning, experience, and motive cause us to act differently in similar situations. According to Nobel Prize winner Daniel Kahneman, we have two types of minds, not physically, but according to the way we take our decisions- The Intuitive mind and The analytical mind which he referred to as System 1 and System 2. System 1 is the brain's quick, automatic, intuitive method, whereas System 2 is the slower, more analytical mode of the mind.  Most of the problems relevant here lie with System 1 which is prone to various biases and errors. This system 1 which developed as a survival mechanism of our mind to take quick decisions in the wild has stayed with us, making us prone to various cognitive biases.

Cognitive biases are nothing but the mental shortcuts that people use to speed up the process of finding a satisfactory solution rather than an optimal one. An investor needs to be aware of these biases and learn how to deal with them before making important investment decisions. Today, we are going to learn about three of the common cognitive biases that affect investors.

1. Confirmation Bias: Confirmation bias is a bias that makes us prone to seek information that supports or reinforces our self-beliefs and values while rejecting evidence that contradicts our own. A common example of confirmation bias can be seen in people with vaccine hesitancy. When a vaccine-hesitant person hears or reads about any instance of adverse reaction to a vaccine, it confirms his existing belief. He will ignore what the research has to say! He will also go on Google and search for articles with the title “The negative effects of vaccine”. Ok! Enough with the vaccines! How are investors affected by cognitive bias?

Investors have selective memory, which causes them to select the information that will best serve to fuel their set narrative. For example, an investor may purchase a stock on the advice of a friend. Later, various stories concerning the company come in the news media, indicating that its stock is not a good investment, but the investor disregards them. This unintentional behavior severely impacts the investor's perception of the stock, leading to overconfidence and overweighting an investment in his portfolio.

2. Anchoring Bias: Anchoring bias is a tendency to rely on the first piece of information while making investment decisions. Investors are susceptible to making an erroneous judgment based on a specific reference point that may not be accurate or relevant. A common day-to-day example of this bias is seen when you are negotiating with a shopkeeper about the price of (for instance) a pair of jeans that you want to purchase. The first price of the seller acts as an anchor for your further bargaining, no matter how unreasonable that price is. If you went to another shop where the price offered is slightly below what was offered in the previous shop, you are likely to make the purchase. Because of this bias, investors will judge a stock to be expensive if it has reached its 52-week high. The 52-week high acts as an anchor. The investor may also be unwilling to trade in a stock that is more expensive than last year.

3. Loss Aversion Bias: People, in a situation where they can choose to take the guaranteed loss or a chance, opt for the latter because they hate to lose. On the contrary, if they have to choose between a guaranteed profit or a chance to earn a much higher return, they opt for the former. This phenomenon is called loss aversion. Loss aversion is associated with ‘regret aversion’, where individuals take chances to avoid feeling the pain of regret resulting from a poor investment decision. These investors are reluctant to invest in a bear market. They are more concerned about incurring a large loss than missing a substantial gain. All of this also depends upon the risk tolerance level of the investor but at times, many investors miss out on attractive investment opportunities due to this bias.

The list of cognitive biases goes on and on. It is perhaps not a good idea to read about all of them at once. But your journey to being a rational investor should begin with understanding your inherent behavioral or psychological bias. Warren Buffett famously said, "If you cannot control your emotions, you cannot control your money." That quote is still relevant even if you replace the word "emotions" with "cognitive biases."

Article by: Sumit Dhakal

MBS-Finance student at Lumbini Banijya Campus, Butwal

Email- sumeetdhakal@gmail.com