In our previous newsletter, we scratched the surface on behavioral finance and its implications on the investor’s decision making process. We uncovered two types of behavioral biases that market participants face: cognitive biases and emotional biases. We further look to explore what cognitive biases are, the causes and implications they can have on the decisions made by investors, and how their impact can be reduced.
Biases that result from poor quality information or misinterpretation of information are known as cognitive biases. These attributes result in the market participant acting on information in a manner that does not reflect its true nature and thus results in poor decisions. There are two types of cognitive biases: belief perseverance biases and information processing biases.
We often see founders in the startups space struggling with strategic decision making and fundraising. A lot of the struggles can be attributed to not being able to identify their own behavioral biases and the inability to act on objective reality. Before we dive into how founders can overcome these biases, let’s first understand them in-depth.
Belief perseverance biases
Belief perseverance refers to an inclination to maintain existing beliefs. This is achieved by committing statistical errors, not processing information correctly or not recalling information in an appropriate manner. Belief perseverance biases are closely related to the psychological concept of “cognitive dissonance”. Highlighted below are examples of perseverance bias:
Conservatism bias: When the participant is too slow to incorporate new information into their decision making framework and sticks to a base of older beliefs.
Confirmation bias: When the participant tends to ignore conflicting information and only account for information that supports existing beliefs.
Representative bias: The tendency to classify new information on the basis of past information or experiences.
Illusion of control: The belief that people can influence the outcome of actions when they cannot.
Information processing biases
Information processing biases are a product of information not being assessed logically or rationally. When decisions are made under the influence of these biases, the decisions made are based on faulty heuristics that result in outcomes, opposite of what it was set out to achieve. Mindfulness about information processing biases can help better manage and correct them while making decisions. Examples of information processing biases are highlighted below:
Anchoring and adjustment bias: When required to estimate a value of unknown magnitude, people generally envision a number and adjust their analysis up or down to reflect the initial numbers.
Framing bias: A person tends to respond differently to the same problem, if framed differently.
Availability bias: The tendency to estimate probability on the basis of how easily something comes to mind.
The silver lining to cognitive biases is that they can be overcome with the right set of behaviors. The key to overcoming cognitive biases is to acknowledge their presence, and engage in behaviors that enable the practitioner to act against the biases. In order to do so, one should actively seek out conflicting information and opinions. Doing so will result in the decision maker being more aware of the variables that may affect the outcome of the decision. The benefits of overcoming cognitive biases are not limited to strategic decisions, but can also help founders overcome day-to-day operational challenges.