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. (For more, see: An Introduction to Behavioral Finance.) often times, this involves spotting the flaws in various strategies.
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 which contradicts their existing beliefs. 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. (For more, see: Behavioral Bias - Cognitive Vs. Emotional Bias In Investing.)
Some common example of cognitive errors include:
- Conservatism bias, 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 looked at carefully to determine its value.
- Base rate neglect is the opposite effect, whereby people put too little emphasis on the original information.
- Confirmation bias, 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 is an error made when people infer too much from a too-small sample size. In order to make meaningful statistical inference from a data set, it must be large enough to be significant.
- 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 and 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 happens 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.
- 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.
The Bottom Line
Cognitive errors in the way people process and analyze information can lead them to make irrational decisions which can negatively impact 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. 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 education of decision-makers or investors can help steer them to make better, more rational judgments. (For related reading, see "Cognitive vs. Emotional Investing Bias")