Lesson 1 of 8 · All lessons in this module
- Cognitive errors versus emotional biasesVideo lesson
- Belief perseverance I: conservatism and confirmation
- Belief perseverance II: representativeness, illusion of control and hindsight
- Information-processing biases: anchoring, mental accounting, framing and availabilityVideo lesson
- Emotional biases I: loss aversion and overconfidenceVideo lesson
- Emotional biases II: self-control, status quo, endowment and regret aversion
- Integrated case: a multi-bias file with 'least likely' and 'not shown' items
- Behavioural finance and market anomalies
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Lesson 1 of 8 · 13 min
Cognitive errors versus emotional biases
Behavioural biases come in two families: cognitive errors grow out of faulty reasoning and can usually be fixed with better information, while emotional biases grow out of feelings and usually have to be recognised and worked around.
In short
- Traditional finance assumes people use all available information and decide rationally; behavioural finance studies how people actually decide, often through mental shortcuts that lead to suboptimal results.
- Cognitive errors come from faulty reasoning: statistical, information-processing or memory mistakes. They are easier to correct through information, education and advice, so the usual response is to moderate them.
- Emotional biases come from impulse, intuition and feelings. They arise spontaneously and are hard to change, so the usual response is to adapt to them.
- Cognitive errors split into belief perseverance biases (conservatism, confirmation, representativeness, illusion of control, hindsight) and information-processing biases (anchoring and adjustment, mental accounting, framing, availability).
- The six emotional biases: loss aversion, overconfidence, self-control, status quo, endowment and regret aversion.
- One bias can have both cognitive and emotional features; it is classified by the side that dominates.
Rational in theory, human in practice
Traditional economic and financial theory assumes that decision makers gather all relevant information, weigh it correctly and pick the best option. That assumption underpins the idea that markets are efficient.
Behavioural finance challenges the assumption by looking at how people really behave. Faced with complex choices, people simplify: they lean on rules of thumb, first impressions and preferences. These shortcuts are fast and feel right, but they can produce systematically poor decisions. Such systematic departures from rational behaviour are behavioural biases.
The people of interest are financial market participants (FMPs): individual investors and finance professionals alike. Professionals are not immune; analysts, portfolio managers and advisers show the same biases as their clients.
The reading asks only whether a bias is present, not how strong it is. Detection relies on spotting typical statements or thought patterns (for example, 'I'll sell once it gets back to what I paid'). Formal diagnostic questionnaires exist but are outside the scope.
Two families of bias
Cognitive errors are mistakes of thinking. A person misjudges a probability, processes data illogically or misremembers what they predicted. Because the root is faulty reasoning, the cure is usually better reasoning: more or clearer information, education, a structured process or a second opinion.
Emotional biases are driven by feelings such as fear of loss, pride or the wish for comfort. They appear without conscious effort, and the person may not even want them. Telling someone that holding a losing stock is irrational rarely removes the pain of selling it, so the practical answer is often to accept the bias and build a plan around it.
This distinction matters because it tells an adviser how to respond. With a cognitive error, try to moderate the bias: recognise it and reduce or eliminate it. With an emotional bias, it is often only possible to adapt: recognise and accept it, then adjust decisions (for example, the asset allocation) to allow for it.
| Cognitive errors | Emotional biases | |
|---|---|---|
| Source | Faulty reasoning: statistical, information-processing or memory errors | Impulse, intuition and feelings |
| How they arise | Through flawed conscious thinking | Spontaneously, sometimes against the person's wishes |
| Ease of correction | Easier: better information, education, advice | Harder: feelings are difficult to change |
| Typical response | Moderate: reduce or eliminate the bias | Adapt: accept the bias and adjust for it |
| Members | Belief perseverance (5) and information-processing (4) biases | Loss aversion, overconfidence, self-control, status quo, endowment, regret aversion |
Memory hook: a cognitive error is like a calculation mistake (show the person the right working and they will usually fix it); an emotional bias is like a fear of flying (facts help a little, but you mostly plan around it).
The map of the fifteen biases
Cognitive errors divide into two groups. Belief perseverance biases describe the tendency to hold on to beliefs you already have, even at the cost of statistical, information-processing or memory errors. They are rooted in cognitive dissonance: the mental discomfort felt when new information clashes with existing beliefs. To ease the discomfort, people ignore or reshape the conflicting facts.
Information-processing biases (also called processing errors) are less about memory or updating probabilities and more about how information itself is handled: it is used illogically or irrationally.
A single bias can show both cognitive and emotional traits. Overconfidence is the standard case: it involves faulty reasoning, but it is classified as emotional because feelings drive it most of the time.
| Family | Group | Biases |
|---|---|---|
| Cognitive | Belief perseverance | Conservatism, confirmation, representativeness, illusion of control, hindsight |
| Cognitive | Information-processing | Anchoring and adjustment, mental accounting, framing, availability |
| Emotional | (no subgroups) | Loss aversion, overconfidence, self-control, status quo, endowment, regret aversion |
Worked examples
Example 1 Cognitive or emotional?
An adviser hears four remarks from clients. (1) 'I just can't bring myself to sell; it would hurt too much to lock in the loss.' (2) 'I estimated the drug's chance of approval from this one company's press releases.' (3) 'My retirement plan can wait; I'd rather enjoy the money now.' (4) 'I stuck with last year's revenue figure and nudged it down a little.' Classify each as a cognitive error or an emotional bias.
Example 2 Moderate or adapt?
Two clients of an Oslo wealth manager both hold portfolios that are too risky for their goals. Client P overweights a sector because she misread a statistical report. Client Q is deeply anxious about any visible loss and refuses to sell anything below cost. How should the adviser respond to each?
On the exam
Expect items asking which family a named bias belongs to, which family is easier to correct, whether to moderate or adapt, and which biases fall under belief perseverance versus information processing.
- Classifying overconfidence as cognitive. It has cognitive aspects but is classified as emotional.
- Swapping moderate and adapt. You moderate (reduce) cognitive errors and adapt to emotional biases.
- Putting anchoring or framing under belief perseverance. Both are information-processing biases.
- Assuming only retail investors are biased. Professionals are FMPs too.
Check yourself
Q1Compared with emotional biases, cognitive errors are most likely:
Q2Which of the following is classified as an information-processing bias?
Q3Belief perseverance biases are most closely linked to:
Q4An adviser recognises a client's bias, accepts it and adjusts the client's asset allocation to allow for it. The adviser is most likely:
Q5Overconfidence is classified as an emotional bias mainly because it:
Answer the 5 questions: +10 XP for each one you get right first time.
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