Behavioral Finance and Investor Types: Managing Behavior to Make Better Investment Decisions

Chapter 3

The Building Blocks: Behavioral Biases

The dictionary defines the word “bias” in a number of ways, including: a statistical sampling or testing error caused by systematically favoring some outcomes over others; a preference or an inclination, especially one that inhibits impartial judgment; an inclination or prejudice in favor of a particular viewpoint; an inclination of temperament or outlook, especially a personal and sometimes unreasoned judgment. In the context of this chapter, we are considering biases that result in irrational financial decisions caused by faulty cognitive reasoning or reasoning influenced by emotions. This classification—distinguishing between biases based on faulty cognitive reasoning (cognitive errors) and those based on reasoning influenced by feelings or emotions (emotional biases) is an important one and one that we will return to repeatedly throughout the book. Although researchers in the field of psychology have developed many different classifications and identifying factors to categorize and better understand biases, it is reasonable to place biases within these two categories.

Although there is a complex methodology to identifying and classifying biases, in short, cognitive errors stem from basic statistical, information processing, or memory errors; cognitive errors may be considered the result of faulty reasoning. Emotional biases stem from impulse or intuition and may be considered to result from reasoning influenced by feelings. ...