Cognitive Biases

Welcome to our second article on behavioral biases where we will try to understand how investors make financial decisions. Our focus for the next few articles will be on cognitive biases. Much of what we know about cognitive biases in finance comes from the study of cognitive psychology. According to Psychologist World, “The cognitive approach in psychology is a relatively modern approach to human behavior that focuses on how we think.

It assumes that our thought processes affect the way in which we behave.

Key Assumptions

• Human behavior can be explained as a set of scientific processes.
• Our behavior can be explained as a series of responses to external stimuli.
• Behavior is controlled by our own thought processes, as opposed to genetic factors.

Research in cognitive psychology investigates a variety of topics, including memory, attention, perception, knowledge representation, reasoning, creativity, and problem solving.

As we discussed last week according to Michael M. Pompian, author of Behavioral Finance and Wealth Management, “Cognitive errors, which stem from basic statistical, information processing, or memory errors, are more easily corrected for than are emotional biases. Why? Investors are better able to adapt their behaviors or modify their processes if the source of the bias is illogical reasoning, even if the investor does not fully understand the investment issues under consideration. For example, an individual may not understand the complex mathematical process used to create a correlation table of asset classes, but he can understand that the process he is using to create a portfolio of uncorrelated investments is best. In other situations, cognitive biases can be thought of as “blind spots” or distortions in the human mind. Cognitive biases do not result from emotional or intellectual predispositions toward certain judgments, but rather from subconscious mental procedures for processing information. In general, because cognitive errors stem from faulty reasoning, better information, education, and advice can often correct for them.”

Pompian has identified two categories of cognitive biases. The first category contains “belief perseverance” biases. In general, belief perseverance may be thought of as the tendency to cling to one’s previously held beliefs irrationally or illogically. The belief continues to be held and justified by committing statistical, information processing, or memory errors.

The second category of cognitive biases has to do with “processing errors,” and describes how information may be processed and used illogically or irrationally in financial decision making. As opposed to belief perseverance biases, these are less related to errors of memory or in assigning and updating probabilities and instead have more to do with how information is processed.

Next week we will look at the belief perseverance category of cognitive biases, specifically cognitive dissonance.

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