Behavioural finance applies human psychology to finance and in so doing deviates from the artificial version of reality on which modern portfolio theory and the arbitrage and option pricing theories of standard finance are based. In standard finance, investors are assumed to be rational at all times, and markets are assumed to be efficient, i.e. to reflect all known information at all times; to follow a random walk, showing no correlation between prices in one period and in another; and to show returns that form a normal distribution or a bell curve around a mean. Building on the intuitive implausibility of such a simplified and stylized model of the complexities of the stock market, the field of behavioural finance demonstrates the numerous ways in which biases, inconsistencies, and flawed judgements permeate investment decision making.

Understanding stock market investors’ cognitive psychology and behavioural tendencies is as important as analyzing the business interests that publicly traded shares represent. Hence, we are providing a pre-investing checklist of behavioural finance issues to be addressed in order to avoid these potentially costly traps and/or to take advantage of market price effects that reflect other investors’ cognitive errors. Following, in alphabetical order, is a list and a brief explanation of 29 of the most prevalent behavioural and cognitive biases.

Anchoring is a cognitive bias that describes the common human tendency to rely too heavily, or “anchor,” on one trait or piece of information when making decisions. For example, when a person considers buying a stock, he or she may focus excessively on the next two years’ earnings growth and use that criterion as a basis for evaluating the value of the stock, rather than considering how sustainable the current P/E ratio may be or considering all the risks faced by the company. It is also manifested in the tendency to be unduly influenced by inappropriate information when making estimates or forecasts of future performance, e.g., relying too much on past growth/performance as an indicator of future growth or glibly accepting other investors’ valuations/opinions without scrutinizing their bases.

Availability is a phenomenon whereby people predict the frequency of an event based on how easily an example can be brought to mind. It works on the principal that “if you can think of it, it must be important.” The perceived likelihood of an event is confused with perceptions of the magnitude of the consequences of that event. Media coverage can help fuel a person’s bias with widespread and extensive coverage of unusual events, such as spectacular new discoveries and less coverage of more routine, less sensational experiences. When an anecdote such as: “I invested in Apple shares when they were at $5 …” is used to support a proposition, the availability heuristic is at work. In these instances, the ease of imagining an example, or the vividness and emotional impact of that example, becomes more mind-absorbing than the actual statistical probability. Because an example is easily brought to mind—is mentally “available”—the single unrepresentative example is considered to be representative of the whole rather than a single outlying example in a range of data. An availability cascade occurs when repetition in public reinforces the phenomenon.

Ambiguity aversion or uncertainty aversion is the psychological preference for known risks over unknown risks. People would rather choose an option with fewer unknown elements than one with many unknown elements. Investors who are averse to ambiguity increase the probability and significance of the uncertain events in their minds. For example, investors may view companies in their own countries or regions or the companies that they work for as having fewer significant uncertainties and less risk associated with them than those in other countries, even though there is no evidence to support this view.

Attentional bias is the tendency to be influenced in decision making by emotionally charged stimuli (e.g., a compelling salesperson, a clever aphorism, or catch phrase) at the expense of other equally or potentially more relevant inputs and information presented in a more mundane manner.

Bandwagon effect or groupthink is the tendency to do or think certain things because many other people do. Every bull or bear market and every markedly in-favour and out-of-favour stock is likely to have been influenced by bandwagon/groupthink effects.

Bias blindness is the tendency to see cognitive biases in others more than in oneself.

Conservatism bias occurs when investors are too slow (i.e., too conservative) in updating their assessments and views in response to new evidence. This means that they initially under-react to news about a company, so that prices fully reflect new information only gradually. This bias tends to give rise to the opportunity to trade on the “momentum” of stock market gains or losses.

Cognitive dissonance occurs when newly acquired information conflicts with existing conclusions. This discomfort or imbalance must then be resolved. If it is resolved by going to undue lengths to discredit the relevance of the new information instead of objectively analyzing it and modifying previous conclusions accordingly, investors are likely to make matters worse by prolonging or increasing their exposure to dangerous risks.

Confirmation bias is the selective perception involved in emphasizing information and ideas that confirm our beliefs while discounting or devaluing whatever contradicts them. It is common among investors and requires a conscious effort to be open-minded and willing to objectively evaluate alternative views in order to overcome it.

Dunning-Kruger effect occurs when sub-competent managers of companies or investments fail to recognize their inadequacies because they lack the basic skills to distinguish between competence and incompetence.

Endowment bias occurs when people value an asset more highly if they own it than if they do not. The minimum selling price at which an owner of a security would sell it is usually well above the maximum price he or she would pay for the same security, according to psychologists tests, indicating that ownership of a security somehow endows it with an imagined value in the mind of the purchaser. Under economic theory, these two prices should be similar.

Essentialism is the mental categorization of things according to perceived features of their nature while giving short-shrift to other potentially more significant features, e.g., categorizing stocks as growth stocks based on past earnings growth performance and on the implicit assumption that they possess a common internal growth dynamic when in fact there may be large differences in the reasons for their past growth, in the nature of their respective businesses, and in their competitive positions within them.

Framing bias is the tendency to make different decisions depending on the context in which a choice is presented. Investors need to be adept at resisting this bias when consulting investment materials from companies and brokers that they use to make investment decisions and eliminating this bias from their minds when judging how much risk to take on and when to do so. For example, beware of the choices of benchmarks and peer groups used in presenting comparative performance and pricing information in research and sales material. Also, as an investor, be mindful of the trap of taking on too much risk in an attempt to “make it all back” after a market loss.

Hindsight bias is the tendency after an event has occurred to believe that the outcome was, or could easily have been, predicted in advance. A person subject to hindsight bias assumes that the outcome was the only one that was ever likely to occur and unduly discounts other possible outcomes. This bias gives investors a false sense of security and confidence when making investment decisions and makes it difficult for them to assess errors and learn from them.

Illusion of control is the tendency for people to overestimate their ability to control events and outcomes that they demonstrably have no influence over. The illusion is most common in familiar situations where the person knows the desired outcome. The illusion is strengthened by stressful and competitive situations, including securities trading. People are likely to overestimate their control in situations that are heavily dependent on chance. This illusion can lead to excessive trading, excessive risk-taking, and general overconfidence.

Illusory correlation occurs when two unrelated events are inaccurately perceived to be related. A common example of such an illusory correlation is the attribution by the media and many stock market traders of overall stock market movements to specific news items of the day.

Loss aversion bias occurs when people are more averse to taking a loss than they are eager to make a gain. It causes investors to hang on to losing stocks too long and to sell winning ones too soon. It interferes with objectivity and can distort risk– reward analysis and lead to bad investment decisions.

Mental accounting bias is the process by which people mentally frame financial assets artificially as belonging to certain non-interchangeable mental accounts, e.g., current income, current wealth, inheritance, bonus, gambling money, etc., with implications for their behaviour in administering these accounts. As the accounts are kept entirely separate mentally and there are different attitudes with respect to how the monies should be handled, the result can be irrational thinking and suboptimal overall portfolio performance.

Normalcy bias is the reluctance to consider or plan for an event that has never happened before even if available information suggests that it will (e.g., the U.S. sub-prime mortgage meltdown).

Optimism bias is the systematic tendency to be overly optimistic about the outcome of planned actions. This includes overestimating the probability of positive events and underestimating that of negative events. Optimism bias can result in excessive risk taking and in overpaying for investments, based on ascribing too-high probabilities to very favourable investment outcomes. It is a major reason for the development of stock market price bubbles.

Ostrich (or elephant-in-the-room) effect is the tendency to ignore an obvious negative situation.

Pessimism bias is the tendency of people who are depressed, possibly as a result of recent traumatic market experiences, to overestimate the likelihood of negative future events.

Pro-innovation bias is the tendency to be biased in favour of invention and innovation while often neglecting to objectively assess the limitations or weaknesses of new inventions or methods or the implementation risks in adopting them.

Overconfidence bias is the unjustified faith in one’s own cognitive abilities, reasoning, and judgment. It results in bad decisions founded on inadequate information and/or subjective, flawed reasoning. It has been called the most pervasive and potentially costly of all human cognitive biases and has been blamed for wars, stock market bubbles and crashes, lawsuits, strikes, vehicular accidents, and countless other mishaps.

Recency bias causes people to recall and base their judgements more on recent events that are vivid in their memories and less on older events. It is manifested in investors’ extensive use of fund managers’ performance results in recent years as justification for selecting funds in which to invest and in the prevalent belief that markets will continue to perform as they have performed in the recent past. It is called chronological snobbery when it takes the form of thinking that the art or science of an earlier time is inherently inferior to that of the present, e.g., “They didn’t know how to value such high-growth stocks in those days,” or, most famously, “This time it’s different.”

Regret aversion is the tendency to avoid taking any decisive action on the grounds that it may turn out badly. It is an obstacle to rational decision making, and, of course, not deciding is in itself a course of action that is unlikely to be optimal most of the time.

Representativeness bias causes people to overgeneralize from small or single samples and to mis-categorize events or situations according to irrelevant characteristics that they may share with other events or situations. For example, a low P/E stock might be mis-categorized as a value stock when it is in fact a cyclical company facing a rapid decline in EPS; or a technology company with one spectacular new product might be viewed erroneously as a company with the capability of continuously producing highly successful products.

Self-attribution bias causes people to ascribe their successes to their superior qualities (insight, judgement, etc.) while blaming their failures on others or on bad luck. It tends to inhibit learning from experience and the improvement of one’s performance over time.

Self-control bias is the difficulty of making sacrifices in the present or short term in pursuit of longer-term objectives.

Status quo bias is a tendency to prefer choice options that extend existing conditions or maintain the status quo.

To a degree, most of these psychological processes have had positive influences in human evolution, enabling the human species to make cognitive guesses, to draw conclusions based on limited information, and to function in a world that has always been full of dangerous unknowns. These innate mechanisms still serve a purpose, as they have for tens of thousands of years. But in the stock market, as in daily life, they can also mislead us if we are not aware of how they drive our behaviour and if we have not taken the time to analyze their appropriateness and relevance to the task at hand. It is telling that Malcolm Gladwell’s popular book on the value of intuitive behaviour, Blink, the Power of Thinking Without Thinking (Little, Brown and Company, 2005), does not discuss the investment world at any length. The value of snap, unthinking judgment evaporates very quickly when making investment decisions in the stock market, which constitutes an ever-changing, unstable, and highly complicated environment. For investors, Michael Mauboussin appropriately recommends an opposite approach to decision making in his book Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009). His thesis is that by spotting dangerous decision traps we can make significantly better investment decisions. It makes for illuminating further reading on a topic that serious investors cannot afford to ignore.