Cognitive Errors Vs. Emotional Biases

Distinguishing between cognitive and emotional bias is not always a binary process. Some biases manifest elements of both cognitive and emotional aspects. Categorizing biases as cognitive or emotional is useful to analysts and advisors in answering the question of whether they should mitigate or adapt to a bias.

Emotional biases are harder to rectify than cognitive ones because they are based on impulse or intuition, including personal and, sometimes, irrational judgments. Most people agree that emotions are feelings that arise spontaneously rather than through conscious effort.

Cognitive errors tend to be much easier to ameliorate through coaching and education, while emotional biases are often deeply rooted and more difficult to correct.

1. Cognitive: Biases that arise due to a lack of information or information processing ability. Cognitive errors tend to belie a lack of investor sophistication.
2. Emotional: Biases that arise due to an investor’s strong emotions, sentiments, desires, or inability to self-regulate.

Question

A particular client has difficulty regulating their spending and often accumulates credit card debt, particularly by giving lavish gifts to family and friends. As a result, this client pays high-interest charges and has had their retirement plan derailed by at least a few years, according to their financial advisor. The type of behavior this investor most likely displays arises from:

1. Cognitive errors.
2. Emotional biases.
3. Modern portfolio theory.

Solution

The correct answer is B.

Inability to regulate consumption and spending often arises from emotional biases that ‘guide’ the investor off course and away from their stated long-term goals and plans.

A is incorrect: Cognitive errors involve a lack of understanding, which is not the case in the above question. The above client has impulse control problems but may well understand that the behaviors are less than optimal.

C is incorrect: Modern Portfolio Theory is a systematic process of using diversification to achieve investor benefits. It has nothing to do with behavioral finance in the above context.

Reading 1: The Behavioral Biases of Individuals

LOS 1 (a) Compare and contrast cognitive errors and emotional biases