Human beings often act in irrational and unexpected ways when it comes to business decisions, money, and finance. Behavioral finance tries to explain the difference between what economic theory predicts people will do and what they actually do in the heat of the moment. Oftentimes, this comes down to the specific biases people tend to have.
- Cognitive bias is an unconscious error in thinking that arises from the way people perceive the world and the information around them that determines how they make decisions.
- Emotional biases are different from cognitive biases; the latter primarily focuses on how the brain functions as opposed to feelings.
- Common types of cognitive biases include confirmation bias, hindsight bias, confidence bias, and framing bias.
- Overcoming cognitive biases is a critical step in individuals improving personal growth and other areas of their lives, such as running a business or investing.
- Ways to overcome cognitive bias include first being aware of a bias, understanding past patterns, diversifying the individuals around you, seeking change, and making different decisions.
There are two main types of biases that people commit causing them to deviate from rational decision-making: cognitive and emotional. Cognitive errors result from incomplete information or the inability to analyze the information that is available.
These cognitive errors can be classified as either belief perseverance or processing errors. Belief perseverance can be described as an individual's attempt to avoid cognitive dissonance; the mental conflict arising from information that contradicts their existing beliefs. This, for example, could take the form of reading information or following news that supports what you already believe.
Processing errors occur when an individual fails to manage and organize information properly, which can be due in part to the mental effort required to compute and analyze data.
These biases have a profound effect on how individuals view the world and how they make decisions within the world they perceive, even if some of these decisions are not in their best interest. Here are some common types of cognitive biases.
Types of Cognitive Bias
Conservatism bias is where people emphasize original, pre-existing information over new data. This can make decision-makers slow to react to new, critical information and place too much weight on base rates. When it comes to business decisions, new information should be looked at carefully to determine its value.
Base Rate Neglect
Base rate neglect is the opposite of conservatism bias, whereby people put too little emphasis on the original information. This can be detrimental as previous information has most often been vetted, tested, and proved. It also brings familiarity and understanding in a variety of processes that may allow for efficiency. This is not to say that new or improved methods should be ignored for traditional methods that work but may be outdated.
Confirmation bias is where people seek information that affirms existing beliefs while discounting or discarding information that might contradict them. This is a tough bias to overcome, but actively seeking out contradictory information or contrarian opinions can help to eliminate it.
Sample Size Neglect
Sample size neglect is an error made when people infer too much from too-small a sample size. In order to make meaningful statistical inference from a data set, it must be large enough to be significant. The basic idea to sample size neglect is that in a small sample size, there is a larger amount of variance than there is in a larger sample size. This, therefore, distorts information or conclusions.
Hindsight bias occurs when people perceive actual outcomes as reasonable and expected, but only after the fact. As the saying goes, hindsight is 20/20. People, therefore, tend to overestimate the accuracy of their forecasts which can lead them to take on too much risk. Keeping a detailed record of all forecasts and their outcomes can bring this bias to the attention of decision-makers.
Anchoring and Adjustment
Anchoring and adjustment happen when somebody fixates on a target number, such as the result of a calculation or valuation. People will tend to remain focused and stay close to those original targets even if the outcomes begin to deviate meaningfully from those forecasts.
This also applies if someone views the value of one item in comparison to another item. Both values may be incorrect, but an individual may perceive the second item's value differently due to the value of the first item than if they had only viewed the second item in isolation.
Mental accounting is when people earmark certain funds for certain goals and keep them separate. When this happens, the risk and reward of projects undertaken to achieve these goals are not considered as an overall portfolio and the effect of one on another is ignored.
For example, people often keep retirement money separate from spending money, which is distinct from emergency savings, which is apart from investments in a brokerage account.
Availability bias or recency bias skews perceived future probabilities based on memorable past events. For example, while shark attacks are exceedingly rare, if there have been headlines of a shark attack recently people will grossly overestimate the probability that another will occur and will irrationally stay out of the water.
Framing bias is when a person will process the same information differently depending on how it is presented and received. A patient may shudder when the doctor informs them that there is a 20% chance they will die from a certain disease but feel optimistic if instead they are told that there is an 80% chance they will survive.
Impact of Cognitive Bias
Cognitive errors in the way people process and analyze information can lead them to make irrational decisions that can negatively impact their business or investing decisions. Unlike emotional biases, cognitive errors have little to do with emotion and more to do with how the human brain has evolved.
The impact of cognitive bias on a business can be large as it hinders decision-making. Managers may hire the wrong candidates, may implement the wrong growth strategies, or fail to understand new technology and information that may further enhance a business.
The term "cognitive bias" was first introduced in the 1970s by Amos Tversky and Daniel Kahneman, two Israeli psychologists.
These information-processing errors could have arisen to help primitive humans survive in a time before money or finance came into existence. Understanding and being able to mitigate cognitive errors through the education of decision-makers or investors can help steer them to make better, more rational judgments.
The ability to think objectively and to see the entire picture outside of one's biases is a difficult process. Some ways to overcome this include delegating to other individuals so as to remove your cognitive bias, consulting other trusted people within your organization that have different backgrounds before making decisions, and forcing yourself to approach decisions in a different manner than you have typically done in the past.
How to Prevent Cognitive Bias
The first step in preventing cognitive bias is to realize that a bias exists. Knowing that you have a bias will allow you to overcome that bias through training or practice. Identifying a bias can be done by analyzing past decisions or taking specific tests that demonstrate how and why you think a certain way. Being able to self-critique is an important step in preventing cognitive bias.
Seeking out information from other sources or individuals than you normally would is one step in preventing cognitive bias that can open up how you see the world. As mentioned, having a diverse group of people around you will help you approach decision-making differently.
Taking time to make a decision also helps prevent cognitive bias. If someone is forced to make a decision on the spot, they will usually default to their bias. Allowing yourself enough time to analyze the situation, evaluate your own decision-making, and seek other perspectives will help minimize any bias.
What Are the Main Types of Cognitive Biases?
The main types of cognitive bias are confirmation bias, anchoring, framing bias, confidence bias, and hindsight bias.
How Does Cognitive Bias Affect Your Decision-Making Skills?
Cognitive bias distorts your decision-making skills. Rather than objectively viewing a situation and making an impartial decision, cognitive bias can lead to suboptimal decisions being made due to some inherent bias that has been ingrained in an individual for a long time. This can ruin personal growth, the success of a business, and relationships with others.
How Do I Stop Cognitive Bias?
To stop cognitive bias, one must be aware of the bias. Analyzing your decision-making history, why you chose one decision over another, and how that might relate to a bias. From there, try making different but smart decisions, reflect on yourself as an individual, strive for growth and understanding, and take notes of previous patterns and how those patterns can be broken.
The Bottom Line
All humans have cognitive biases that are ingrained in our heads since the day we are born. They are a result of our upbringing, experiences, and relationships. Cognitive biases may have helped us navigate our way through the world but they can be a hindrance to our own growth. Taking steps to notice and minimize your cognitive biases is a healthy step in personal growth that will positively impact a variety of areas of your life.