Cognitive errors are more easily corrected because individuals are able to adapt their behavior if the source of the bias is logically identifiable.
Just to give you an example, think of the Enron case where investors kept buying the company stock although red flags were signalled by some analysts.
Why did it happen? Investors focused on positive information that was confirming their beliefs and disregarded negative information such as the red flags.
Confirmation bias is a cognitive error.
Individuals sometime overweight information that resonates with their forecast or belief and dismiss information that conflicts with their thought process.
When one understands that contradictory information could help him better assess the situation, one will be more inclined to adapt his behavior.
In other words, cognitive biases can be 'moderated' up to the point where they are reduced or eliminated.
It takes better information, education and advice to correct for them.
Emotional biases are the product of psychological predispositions and are more difficult to correct for.
They arise spontaneously and are related to feelings one might have, his perceptions or his life time experiences.
The most common example is loss aversion.
Individuals look at an investment and see it as a loss in wealth vs risk whereas a rational economic man will think of it as return vs risk.
This will cause an investor to make suboptimal decisions and even though he may wish to control his behavior, often he cannot.
In the end the investor could recognise the bias, accept it and 'adapt' to it.
It is much more difficult to eliminate emotional biases than it is with cognitive biases.
Now, let's dive into the subject and start with cognitive errors, what are the errors and how we can 'moderate' them.
As mentioned before, cognitive errors are divided into two categories, belief perseverance biases and information processing biases.
Let me start by giving you an example.
We all have an opinion about ourselves, looking in the mirror and seeing us as being smart, intelligent, tall, funny etc.
When we are faced with a challenge it will create mental stress which we will try to avoid it as much as possible by ignoring it or selectively remembering only bits and pieces that we like.
One thing for example that causes mental stress is when someone comes to you, for instance your boss, and says "you are not that good as you think you are".
Our self-defence mechanism is trying to avoid these situations as much as possible because we disagree or we fill embarrassed.
From a behavioral bias perspective it means we are avoiding cognitive dissonance.
In the financial realm this is much easier to explain, e.
g.
an analyst created a forecast but in the end it turns out his predicted outcome was out of range.
To avoid cognitive dissonance the analyst will think it through and do whatever he can to explain why his forecast was different.
In the end he will try to fit his forecast with the outcome to avoid mental discomfort.
Now let's take a closer look at the cognitive errors that stem from belief perseverance: conservatism bias, confirmation bias, representativeness bias, control bias and hindsight bias.
We will dive into the first bias, Conservatism.
Conservatism bias is a decision taken unconsciously by an individual.
When new information is released to the market the individual will try to place a greater weight on the previous information and not fully incorporate the new information.
Take as example a real-estate developer in the process of developing a residential community.
One year after he started the project the economic environment starts deteriorating and the unemployment claims rise, manufacturers' new orders for consumer goods and materials decrease, building permits drop and the overall economic sentiment falls.
At this point instead of reconsidering his strategy towards the whole project, the investor strongly believes the same variables apply and decides it is best to move forward with the development.
The risks he is facing are: the possibility of losing the credit facility from the banks because they see the economic environment more risky, or they can ask for more equity, or he could end up with the project not sold.
During the financial crisis many real-estate developers ended bankrupt because of the bad timing and decisions they've made.
From a financial perspective, asset managers or analysts working on a forecast or an investment will tend not to incorporate the new information into their forecast believing that their previous estimate is a better match of what the future holds.
It happens during many financial crises not only the last one and guess what - money were lost because they under react to, or fail to react at all on new information while continuing to maintain their beliefs.
A second bias I would like to discuss with you today is the confirmation bias.
As the name implies, it reflects individuals' tendency to look for confirmatory information.
Let's go back to our previous example with the real-estate developer.
Instead of incorporating new information, individuals will look for confirming evidence that their thought process was good while ignoring contradictory evidence.
People will notice only information that agrees with their beliefs.
They do it because they want to avoid cognitive dissonance, they don't want to be told "You know what? You were wrong!" As a result they will consider only positive information and ignore everything negative.
So, to avoid these two biases you should ask yourself the questions: "How is this information going to change my project?" and "What impact does this information have on my project?".
Also keep looking for information that contradicts your beliefs.
Positive and negative information will provide a complete clear picture about your decision.