Cognitive Biases

Overconfidence

Most people tend to overestimate their abilities in many areas. For instance, 65% of
Americans think their intelligence is above average and 73% think they’re better than average
drivers. When you overestimate how much you know about the market or a specific stock,
you’ll be tempted to make risky decisions like trying to time the market, which is trying to
predict the best time to buy or sell stocks, or overinvesting in high-risk stocks, which are
more likely to lose money. Overconfidence bias is the tendency for a person to overestimate
their abilities. A wealth of easily accessible online information, anecdotal evidence, or simple
luck in random investments may encourage investors to place excessive faith in their own
expertise. Overconfidence may lead investors to make risky investments. Most people tend to
overestimate their skills, whether it’s changing an electrical outlet or managing their own
finances.

Herd Mentality

The term herd instinct refers to the phenomenon where people join groups and follow the
actions of others under the assumption that other individuals have already done their research.
In financial markets, herd mentality can lead to asset bubbles, which is when the price of an
asset like a stock rises rapidly but will eventually fall, and market crashes, which occurs
when a lot of investors sell-off their stocks. Herd instincts are common in all aspects of
society, even within the financial sector, where investors follow what they perceive other
investors are doing, rather than relying on their own analysis. In other words, an investor who
exhibits herd instinct generally gravitates towards the same or similar investments as others.
Herd instinct at scale can create asset bubbles or market crashes via panic buying and panic
selling. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-
offs.

Emotional Gap

The emotional gap refers to decision making based on extreme emotions or emotional strains
such as anxiety, anger, fear, or excitement. Oftentimes, emotions are a key reason why people
do not make rational choices. For example, an investor’s desire to “get rich quick” can cause
them to make risky investments for a promise of quick returns. On the other hand, fear can
prevent investors from making sound investment decisions or entice them to prematurely sell
off assets at the first sign of trouble. Emotional gap can cause investors to make irrational
decisions based on their emotions rather than focus on hard facts and professional advice.

Anchoring

Anchoring is a heuristic in behavioural finance that describes subconscious use of irrelevant

information, such as the purchase price of a security or the estimated budget of the investor,
as a fixed reference point (or anchor) for making subsequent decisions about that security. An
anchoring bias can cause a financial market participant, such as a financial