Understanding Cognitive and Emotional Biases: Our daily lives are filled with decisions we make, some habits may be significant, while others may be quite casual. Unfortunately, these decisions are influenced by our observations, experiences, and how we reach certain conditions.

Even when shopping at a grocery store, we tend to favor certain products over others because we like the celebrities who endorse them. Investors are not immune to these biases. It may not come as a surprise that investors often experience emotional roller coasters when investing or trading.

Today, let's look at common investment biases that exist. Here, we will introduce cognitive biases and emotional biases when it comes to investing. The purpose of doing this is to study the causes of erroneous decisions, as this will help us avoid significant future losses.

An investor's main problem, or even his biggest enemy, might be himself.

Cognitive and Emotional Biases

Economic and financial theories are based on the assumption that individuals will act rationally, consider all available information in the decision-making process, and that the market is efficient. However, this is rarely the case. Studies show that 80% of individual investors and 30% of institutional investors do not always act logically.

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This brings us to behavioral finance. Behavioral finance is a branch of economics that explains investors' irrational decisions. These unreasonable decisions are the result of deeply ingrained biases. These biases are categorized as cognitive and emotional.

What are cognitive biases?

Cognitive biases are usually related to the way a person thinks. It is said that these biases are caused by errors in statistics, information processing, or storage, which lead to decisions that deviate from rational decision-making. Therefore, they can also be easily corrected through better information, education, and advice.

Take, for example, the security of a hotel hosting a celebrity event; if one of the celebrities owns a Lamborghini, then allowing the Lamborghini to enter might be considered. This is a flawed approach because it is not necessarily the right one.Types of Cognitive Biases

Here are some common types of cognitive biases in behavioral finance when making investments:

1. Confirmation Bias

Have you ever tried to gather facts to support your argument when encountering a dispute? Confirmation bias takes this step further because individuals with confirmation bias will only seek evidence that confirms their beliefs, while ignoring evidence that contradicts them.

For example, after conducting research, you have concluded that Old Zhang is suitable for investment. To support this point, you only need to seek confirmation from the research to bolster your argument, without considering any opposing arguments. Due to confirmation bias, your decision-making now becomes clouded. The simplest way to address this issue is to consciously collect information that contradicts your opinions.

2. Gambler's Fallacy

Humans strive to ensure that everything makes sense to them. This often leads them to search for patterns in areas where they do not exist. Nobel laureate Daniel Kahneman conducted a study in which his participants were asked, "When flipping a coin, which of the following sequences is more likely to occur - HHHTTT or HTHTTH?" Most people answered that the second sequence was more likely. Even though people already know that there is a 50-50 chance of flipping a coin in this situation, this is still flawed.

This situation also occurs in investments, where people tend to invest in funds simply because of their performance over the past five years. Investors might think this is a trend that will continue into the future. If a study is conducted from a statistical perspective, this might make sense, but past events have no relation to future events. If the market has been consistently rising for the past month, there is no necessity for it to fall tomorrow. Shorting the market based solely on this information is flawed.

3. Status Quo Bias

People feel more comfortable when things remain the same and are generally unwilling to change. In investments, this can be seen as only investing in industries that you seem to understand. Although it is necessary to have a deeper understanding of investments, this becomes an obstacle when people are unwilling to further pursue the desire for self-education. This will only limit their potential profits to certain opportunities.4. Negative Bias

This occurs when investors pay more attention to bad news than to good news. When CV-19 broke out in the country from February to March, the market began to show a bearish trend. However, a few months later, the market recovered to a bullish trend. Due to the negative news, many investors missed out on this rebound. This bias can reduce the likelihood of rewards.

5. Overconfidence Bias

Individuals with this bias believe that their cognitive abilities and skills in the investment field are superior to others. They also do not necessarily have to invest as a whole. Someone in the steel industry might think that because they come from the same background, they have better trading capabilities for steel companies. These investors overestimate their abilities and control over the market. They also reduce the time needed to assess risks.

When investors are overconfident about the market, it usually leads to excessive trading. This results in bubbles in the financial markets. Securities are bought at high prices here and then sold at low prices. These traders/investors perform poorly in the market because they overlook various factors affecting their performance.

6. Bandwagon Effect

Warren Buffett is one of the greatest investors in the world, and much of his success is attributed to resisting the influence of the bandwagon. Here, investors feel better when they invest along with the crowd, which also increases their confirmation bias.

What is Emotional Bias?

Emotional biases stem from feelings, perceptions, and beliefs about elements. Unfortunately, mixing emotions and investments often leads to wrong decisions. Here, essentially, the investor's mind is distracted by their emotions. Compared to cognitive biases, these biases are usually much harder to address.

Common Emotional BiasesHere are several common emotional biases in behavioral finance when making investments:

1. Loss Aversion Preference

One of the purposes of our investment is to avoid losses. However, this has become an important part of our nature, and even when we know that doing so can cause greater harm, we try our best to avoid losses. This is emphasized in the disposition effect. The term was coined by economists Hersh Shefrin and Meir Statman. The disposition effect is the tendency of investors to sell winning positions and hold losing positions.

For example, your portfolio includes securities that have recently started to lose money and will soon hit rock bottom. But you still hold onto it, hoping it will rebound. Here, the investor is averse to loss; they cannot sell the securities to avoid further losses. The rational thing to do here would be to sell the securities and redirect the investment into quality stocks.

2. Self-attribution Bias

Investors with this bias attribute the success of outcomes to their own actions and the poor outcomes to external factors. When the value of their investments increases, investors claim it as their own assets, ignoring other factors that may be at play. However, when the stock value declines, it is due to external factors.

3. Endowment Bias

Investors with this bias believe that assets they own are more valuable than those they do not own. This may cause them to continue holding onto securities even when there are more opportunities elsewhere.

In summary, today we discussed the differences between cognitive biases and emotional biases and how they affect your investment decisions. Every investor is likely to exhibit some biases, sometimes even both cognitive and emotional. As humans, we cannot eliminate these biases. However, understanding their existence and acknowledging that we have them is the first step in combating them. Then, we can incorporate some rules into our strategies to counteract these biases.For example:

A rule is that, regardless of any arguments, if there is a 15% loss, sell the security. Reaching the 15% threshold will require overcoming our emotions. However, successful investors have realized the importance of controlling biases. Happy investing!