Cognitive bias in the finance world

Quick question: Do you know what “cognitive bias” is?

Chances are, you probably do – you just haven’t heard this term before. By definition, cognitive bias is “the reliance on limited information of preconceived notions when making decisions.” In other words, it’s your state of mind (and more importantly, emotions) during any given decision-making process.

Cognitive bias has become a hot media topic over the past several years, but little research has been done on how it influences investment behavior. What’s more, the fields of behavioral science and behavioral finance are still fairly nascent; it was only a few years ago, in 2017, when behavioral economist Richard Thaler won the Nobel Prize in Economics.

How cognitive bias manifests in the finance world

While behavioral economics and behavioral finance overlap heavily, each has a few key characteristics that distinguishes it from the other. The former is concerned with the psychology that influences people’s economic and/or moneymaking decisions, while the latter focuses more specifically on the psychology that influences investor and market behavior. In other words, think of behavioral finance as a sub-category of behavioral economics. This is a significant departure from the classical approach, which asserts that people typically have well-defined preferences, and make informed and rational decisions.

Unsurprisingly, cognitive biases and unchecked emotions can massively impact our financial lives – for better or worse. However, the first step to safeguarding oneself against these influences is to know what they are and to have a process to reduce their impact.

Let’s take a closer look at some common cognitive biases which can impact one’s investment decision-making:

But there are also several key emotions that factor into people’s decision-making mindset:

As you may have guessed, these biases and emotions can wreak havoc on investment decisions if not managed properly, potentially affecting how money is spent, your choice of investments and even how much debt you’re comfortable with taking on. Fortunately, you can mitigate the risks by understanding the impact these biases and emotions can have on the financial decisions.

Reducing cognitive and emotional bias risk the right way

While there are several different approaches to mitigating these risks, self-awareness is perhaps the most critical first stepping stone. Below are some methods you can implement that may help reduce your own risk of cognitive and emotional bias, including the following:

The broader impact

Cognitive and emotional biases can also impact management-level decisions at an organization, especially since these decisions can impact company performance. In a white paper by Dr. Kathleen Locklear, Assistant Professor of Risk Management & Insurance at the State University of New York (SUNY), Oswego, cognitive biases were shown to produce psychological distortions that could prevent management from recognizing the early warning signs of emerging risk(s).

To illustrate this, only 49 companies on the original Fortune 500 list in 1955 remained in the exclusive annual rankings every year through 2024. This is simply mind-blowing given that these once highly-respected organizations were very clearly some of the country’s top performers at one point.

So what happened?

In short, these companies did not react adeptly enough in the face of mounting risks and disruptors. Instead, it may be because they let their cognitive and emotional biases cloud their decision-making to the point that they couldn’t form an effective counter-strategy in time.

The silver lining is we can learn from these organizations’ mistakes. To be successful, firms must implement strategies that nip cognitive and emotional biases in the bud whenever they arise. A positive corporate culture can also contribute to this larger goal, making it one of the most practical ways a firm can build and sustain its competitive advantage. Culture influences conduct, conduct informs behavior, behavior impacts decision-making, decision-making determines outcomes and outcomes shape organizational success or failure.

Implications for investors

Investors need to be aware of how cognitive and emotional biases can influence organization-level decisions, as the effects of both bad and good decisions can ripple throughout an entire firm. Following this, investors may also need to assess how quickly their firms deploy mechanisms that mitigate these biases. While this is admittedly no small feat, investors can start by looking at the structure of their boards and senior management. By analyzing these two teams, organization decision-makers can see if either or both are dominated by insiders, or if a firm is attracting new talent that fosters a healthy company culture. Once crystallized, these disclosures can be reviewed to get a sense of the firm’s commitment to diversity and inclusion, and what its corporate values are.

To tackle this from a more quantitative standpoint, investors can use third-party corporate governance scales to calculate their Corporate Governance Quotient from eight factors, including the following:

Studies show that the better an organization’s corporate governance is, the higher their shareholders’ returns will likely be. A successful team is made up of people whose skills and backgrounds balance each other out, strengthened by firms that attract, retain, develop and empower them to enhance culture, sustain competitive advantage and ultimately help generate favorable returns.

The bottom line

There’s no denying that your cognitive and emotional biases can work against you when you least need it. Because of this, it’s important to stay aware of how they influence you to mitigate any hazards. Similarly, investors must stay alert on a broader scale so that they can develop mechanisms that stop these biases from inflicting organizational damage. When an entire firm can successfully work in concert against organizational harm, everyone wins.

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