Categorizing Behavioral Biases

The field of behavioral finance has become fairly developed over the years. There have been many psychologists as well as economists who have been spending a lot of time trying to obtain more information about how behavioral finance impacts decision making. This is the reason that in the past few articles, we have come across more than twenty different types of behavioral biases.

Some of these biases overlap with one another. However, for the most part, these biases are completely distinct. However, since there are so many of these biases, investors have a difficult time in keeping a check on these biases during decision making? It is a known fact that the human brain finds it difficult to memorize and keep track of more number of items.

Hence, as the number of biases increased, the drive to categorize them has also increased. The benefit of categorization is that similar biases that are caused by similar types of thinking are grouped together. Let’s have a look at the different categories of behavioral biases in this article.

Perception Based Biases

Perception-based biases are ones in which the investor is likely to face an adverse reaction because of their inability to correctly perceive information from different sources. The same information is available to different investors. However, the human mind is not meant to decipher all the information.

Instead, the attention of the human mind is diverted towards certain key facts. Perception-based biases get people focusing on the wrong facts.

Framing, anchoring, and sunk cost bias are some of the main examples of perception based biases. It needs to be noticed that a decision is being made in this case. Also, the investor is making an attempt to decide logically. However, their subconscious unknowingly changes the way the situation is perceived.

Biases Which Induce Inertia

There is another set of biases that have a lot in common with each other but are different as compared to other sets of biases. This is about biases that induce inertia. The defining feature of these biases is that it causes investors to abandon decision making. Investors who suffer from this bias become emotionally overwhelmed by the decision-making process and decide to abandon it midway. The endowment bias, status quo bias, etc., are all biases that induce inertia. When investors have this bias, their decision-making ability is impaired.

Biases Caused by Delusional Thinking

There are certain biases that are caused by delusional thinking. These biases happen to people who think of themselves as better or superior as compared to their peers in some way. The self-attribution bias and overconfidence bias fall into this category.

In order to avoid these biases, investors need to realize that some of their decisions may have gone right because of chance as well. Certain types of investors are more prone to delusional thinking than others. For instance, most investors who have this bias are from the young demographic.

Social Pressure Bias

There are some types of biases that are caused because investors just want to keep up with the Joneses. This means that they buy certain investments just because they want to fit in with their peers.

The most common example of this bias is the need for young people to buy real estate and become a homeowner. There are cultural influences that encourage them to do so. Their parents may have done it at a different age. However, the situation might be different, and it is quite possible that over the years, real estate has changed from a value based asset to an overheated asset class.

Biases Caused by Oversimplification

Lastly, there is a certain class of biases that are simply caused by the use of heuristics and oversimplification. The investors here have the correct intention and also read the information correctly. However, their decision-making process often goes wrong since they use shortcuts to make decisions.

For instance, they decide the future of a sector based on the performance of one individual stock. The representativeness bias, sunk-cost bias, etc., are some biases that fall in this category.

The reason behind the categorization of biases is simple. A large number of biases are difficult to manage and keep track of. However, a smaller number of categories can be more easily managed. Also, the prevalence of similar biases is more common in certain personality types. Hence, identifying categories that correspond to certain personality types is important.