When it comes to our money, we like to think we’re making rational decisions. Yet, research in behavioural finance suggests that our emotions and personal beliefs play a far more significant role in our decision-making than we might think. Previously, we briefly examined how our emotions can influence our spending habits. Now, we will take a step back and discuss how personal beliefs and systematic errors in judgment can impact financial decisions. It may help you understand why trying to time the market is so challenging by examining the effects of these from the perspective of an active trader.

Cognitive Bias

• Distortions in perception and judgement that are shaped by personal beliefs about oneself and the world

You can think of a cognitive bias as wearing rose-coloured glasses. Although you can see through them, they tint your view of the world. By drawing on your past experiences and aligning the current situation you are facing with your personal beliefs and experiences, your perceptions of yourself and the world around you are distorted. While these biases can assist in interpreting information, they can also lead to systematic errors in judgment. Much like emotions, cognitive biases can influence our behaviour unconsciously, making it essential to reflect on how they may impact our decisions.

Self-Serving Bias

• The tendency to take credit for positive events or outcomes and deny responsibility for negative events or outcomes

Consider a time when you heard someone brag about a stock they bought that shot up in value. Did they give themselves a pat on the back and act like it was all because of their genius? Likely, a profitable investment was not entirely the result of their expert ability to analyze market trends but instead demonstrates the self-serving bias in action. The self-serving bias highlights the tendency for us to take credit for our successes but also blame our failures on others or circumstances beyond our control. For instance, consider a time when you heard someone talk about the stocks that did not perform well. Did they toss it up as a matter of bad luck?

The self-serving bias influences how we respond to gains and losses. When our investments yield high returns, we consider this evidence that we are intelligent investors, which increases our confidence in our investing skills and leads to more aggressive trading [1]. These tendencies are driven by the belief that we are intelligent and competent individuals who make good decisions—something we all want to believe is true. The self-serving bias supports our self-esteem by aligning our perception with a positive self-image. Whether we are conscious of it or not, this bias is something we all experience daily, and it produces clear and predictable patterns of human behaviour.

Overconfidence

• Overestimating one’s abilities or knowledge

How funny do you think you are? Odds are, not as funny as you think. In one study, 80% of people claimed to have an above-average sense of humour, but this doesn’t make statistical sense [2]. After all, how could 80% of people be above average? The phenomenon is called overplacement, or the tendency to rate ourselves higher (or better) on some ability or characteristic than we are.

Overplacement has been observed in the general population across various traits, including intelligence, creativity, and driving ability, as well as among professionals in the financial sector. In 2013, one study found that CFOs consistently overestimated their ability to predict their firm’s financial performance [3]. Now, if they don’t even know what is going to happen, how would anyone else? Surprisingly, this confidence tends to increase in situations with greater levels of uncertainty. Investors often feel more confident, or even overconfident, when making judgments about stocks that are difficult to value [4].

Overconfidence, the tendency to overestimate our abilities, is another cognitive bias that has several known effects on investing behaviour. For one, overconfident investors are overly optimistic about their prospects, tend to invest more aggressively, and take on greater risks in more volatile markets, hoping to reap larger returns [5]. Overaggressive strategies, however, tend to result in financial losses. Investors also tend to be overconfident about information they receive concerning a stock’s price, interpreting their tips as more informative and reliable than they actually are [6]. These overreactions produce predictable patterns in stock prices, where further gains follow sudden price jumps in the short term, until the overreaction is corrected by losses in the long term [7]. Remember, there is no proven way to time the market.

The hard truth is that we see the world and ourselves the way we want to. We tend to seek out evidence that supports our positive self-image and disregard information that challenges it. These biases may not always lead to the most rational decisions, but they aren’t entirely harmful; they can help regulate emotions, boost confidence, fuel motivation, and shape the overall sense of self. Understanding how these biases can alter your thinking is a valuable skill —it gives you the clarity to make better choices, which you and your wallet will appreciate.