25. Behavioral Finance in Algorithmic Hypothesis Formation

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Behavioral finance studies how people make decisions and examines the psychological factors that influence and skew their decision-making process.

The traditional economic and financial theory generally assumes that market participants always act rationally by considering all available information in the decision-making process. In reality, financial decision-making is a complex situation. When faced with so much information to constantly process and update, people often don’t have the time or ability to come up with a completely optimal decision. Instead, they often take an easier and more subjective approach. They often use only parts of the available information and determine a course of action that best suits their judgment and priorities. They are content with making a “sufficiently good” choice rather than making an “optimal” choice. In this way, they may inadvertently bias the investment decision-making process. 

Behavioral finance does not assume people are always rational. It believes that people are limited in controlling themselves and are influenced by their own biases. These biases are in two main groups: cognitive errors and emotional biases.

Cognitive Errors

These types of errors are basic statistical errors, information processing errors, or memory capacities. They cause decisions to deviate from rationality. In general, cognitive errors stem from faulty reasoning. It can often be, however, mitigated or eliminated through better information, education, and advice. Cognitive errors can be grouped into 2 types:

  • Belief perseverance biases: come from the result of mental discomfort. It occurs when new information conflicts with pre existing beliefs or perceptions. To resolve this dissonance, people are likely to ignore conflicting information. They only consider information that confirms their existing beliefs and thoughts.

  • Information processing biases: refer to information being processed and used in illogical and irrational manners.

Below are some common belief perseverance biases and their corresponding behaviors in financial investment.


Below are some common processing errors and their corresponding behaviors in financial investment.

Emotional Bias

Emotional bias arises spontaneously from feelings and attitudes. It can cause decisions to deviate from rationality. It is typically harder to correct compared to cognitive errors because they originate from impulses and intuition rather than logical calculations. A person usually can only recognize and learn to adapt to it rather than correct itself.

Below are some common emotional biases and their corresponding behaviors in financial investment.