List of Behavioral Biases / Heuristics (Decision-making rules of

thumb) that affects financial decision making.

Jimmy Martínez-Correa

This document is divided in four parts explained below. The purpose of

the document is to make a list of biases, heuristics, decision-making
processes and behavioral concepts with their respective succinct
definition many times followed with an example that explains the
relevance for financial investing. I recommend reading the document
without jumping parts as I incrementally explain concepts that are used
later in the document.
Part 1 – “Beliefs / Expectations Dimension” explores various cognitive
biases and heuristics, such as the availability heuristic,
representativeness heuristic, confirmation bias, anchoring,
overconfidence, optimism, and self-attribution bias. These biases and
heuristics influence how individuals perceive and act on information,
potentially leading to suboptimal investment choices. The part provides
clear definitions and examples of each of these biases.
Part 2 – “Preferences/Aversion for Risk and Uncertainty Dimension”
addresses psychological phenomena like loss aversion, regret aversion,
pride seeking, mental accounting, the disposition effect, long-shot bias,
certainty effect, ambiguity aversion, and myopic loss aversion. These
biases relate to how individuals evaluate gains, losses, and uncertainty in
the context of investing and that can explain several biases in financial
investing.
Part 3 – “Social Dimension of Investing” delves into the impact of social
networks and herding behavior on investment decisions. It discusses how
information and opinions from peers and social circles can influence
individual choices, sometimes leading to irrational market behavior.
Part 4 – “Notions of Rationality” introduces concepts of ecological
rationality and constructivist rationality, highlighting the interplay
between subconscious, evolution-driven decision-making processes and
consciously designed, rational strategies. It also emphasizes the
importance of evaluating decisions based on the information available at
the time of making the decision, rather than solely on the outcome. I
believe that a course on behavioral biases for investing should allocate
some time to have a discussion about what it means to make rational
decisions.

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1 TABLE OF CONTENTS
Part 1 - Beliefs / Expectations Dimension: How people look for information to
make predictions and choices and how information can affect our decision-
making................................................................................................................... 2
Part 2 - Preferences/Aversion for Risk and Uncertainty Dimension: How people
look for information to make predictions and choices and how information can
affect our decision-making.................................................................................... 7
Part 3 – Social Dimension of Investing: How Social Contexts Affect Individuals’
Decisions............................................................................................................. 10
Part 4 – Notions of Rationality............................................................................ 11

PART 1 - BELIEFS / EXPECTATIONS DIMENSION: HOW PEOPLE LOOK FOR

INFORMATION TO MAKE PREDICTIONS AND CHOICES AND HOW
INFORMATION CAN AFFECT OUR DECISION-MAKING.

1. Availability Heurisitic: It is a mental shortcut or cognitive bias

that occurs when people make judgments about the likelihood of
events based on how easy it is for them to recall. If something is
more readily available in your memory, you are more likely to think
of it as being more common or likely to occur. This mental shortcut
can lead to biased judgments and decisions because it relies on the
accessibility of information in memory rather than a rational or
statistical assessment of probabilities.
a. Example: People buying stocks based on pieces of
information that appear in the news or hear from someone
that they consider good for stock picking. Availability
heuristic make people focus disproportionally on these very
available (in people’s head) pieces of information
disregarding other relevant information about stocks that
might also be relevant which can lead to mistakes in value
assessment.

2. Representativeness Heuristic: A mental shortcut that leads

individuals to make judgments about the likelihood of an event or
the category of an object based on how closely it resembles a
familiar or typical example, often neglecting important statistical
information. It can lead to errors and biased judgments because it
often disregard the base rate information and statistical
probabilities that should be considered for more accurate decision-
making.
a. Example: Hearing from a trader buddy about the new IPO of
a company that is great and falling for the narrative that is a

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 great investment disregarding the base rate probability that
many IPOs are not successful. Here the bias is thinking that
the IPO of that company has a good chance of being
successful just because of all the good things you heard about
but fail to recognize that many IPO are not successful (this is
a violation of Bayesian updating).
b. Representativeness can induce optimism (pessimism) about
the state of an economy if the stock market goes up (down)
for some time and is interpreted as a signal representative of
the economy being in good (bad) shape.
c. Representativeness makes it hard for the individual to tease
out what is a true or a false signal in the market, much like
false positives or false negatives in medical tests. Here the
false positives can be ups in the stock market when the
economy is not doing great and false negatives can be downs
in the stock market when the economy is doing just fine.

3. Confirmation Bias: The tendency to seek, interpret, and

remember information in a way that confirms one's preexisting
beliefs, while disregarding or discounting evidence that contradicts
those beliefs.
a. Example: An individual who strongly believes a particular
stock or a position is a good investment. This person might
actively seek out news and information that supports their
belief in the stock’s potential, such as positive earnings
reports, while ignoring negative news or critical analyses that
suggest otherwise. This biased approach to information can
lead to risky investment decisions or missed investment
opportunities if the prior beliefs is that one should not invest.

4. Anchoring: It is a cognitive bias that describes the human

tendency to rely heavily on the first piece of information
encountered when making decisions. This initial piece of
information, known as the “anchor,” influences subsequent
judgments or choices, often leading to decisions that are not
entirely rational or objective. People use anchors as reference
points to make judgments and estimates. The anchor can be a
specific number, value, price or piece of information, and
individuals typically make adjustments from that anchor to reach
their final decision. However, these adjustments are often
insufficient, leading to a systematic bias in judgment.
a. Example: A group of traders considers buying shares of XYZ
Inc., a tech company trading at $50 per share. Upon hearing
speculative news of a potential partnership, one trader
anchors their decision to a target price of $100 per share,
influencing the group. As unfavorable developments unfold

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 and the partnership fails, traders remain fixated on the $100
anchor, hesitating to adapt to changing market conditions,
leading to suboptimal decision-making. This illustrates how
anchoring can cause traders to cling to specific price points,
even when they become irrelevant, highlighting the need for
flexible decision-making in trading.

5. Overconfidence: It is a cognitive bias in which individuals tend to

have excessive confidence in their own judgments, abilities, or
knowledge, often overestimating their performance or the accuracy
of their beliefs, and underestimating the risks or potential errors in
their decision-making. This bias can lead to suboptimal choices
and, in the context of financial investing and trading, may result in
unwarranted risk-taking and poor investment decisions. In
probabilistic terms this translates into unwarranted confidence of
one’s best guess about an outcome and the corresponding
disregard of tail events.
a. Example: An example of overconfidence in stock trading is
when an investor, due to their belief in their own ability to
predict the market accurately, trades excessively or takes
large positions in a particular stock or asset, often without
conducting thorough research or analysis. This overconfident
trader might ignore warning signs or contrarian views from
the market and place significant bets on a stock, assuming it
will perform exceptionally well.

6. Optimism (Pessimism): Optimism (pessimism) is a psychological

and emotional disposition characterized by a positive (negative)
outlook, hopeful (negative) expectations, and the belief that
favorable (unfavorable) outcomes are more likely to occur.
Optimistic (pessimistic) individuals tend to see challenges and
situations in a positive (negative) light, anticipating good (bad)
results even in the face of uncertainty or adversity. Optimism can
be a useful psychological trait to keep going even in the face of
uncertainty, but when it comes to financial decisions unwarranted
optimism about the stock market can make traders blow up.
Optimism might be a good trait to train for a marathon but not
necessarily for financial investing. Pessimism instead could be a
useful trait to pay more attention to hidden risks or highly unlikely
events that can blow up traders.
a. There is a tendency to equate overconfidence with optimism
but these are two different psychological process.
Overconfidence is how confident I am about my best guess of
an outcome (of a stock for example) and optimism is when my
best guess of an outcome tend to be favorable. We tend to

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 equate overconfidence to optimism because in reality people
that tend to be overconfident can also be optimistic.

7. Self-attribution bias: Self-attribution bias, also known as self-

serving bias, is a cognitive bias where individuals tend to attribute
their successes to internal factors, such as their own abilities or
efforts, while attributing their failures to external factors, like bad
luck or external circumstances. This bias allows people to protect
their self-esteem and maintain a positive self-image. This bias is
one of the channels through which people can become
overconfident or optimistic (or both), as self-attribution bias can
contribute to overestimating one’s skills and abilities while
disregarding bad outcomes as something that is due to one’s
ability. This can explain why some people tend to be overconfident
and optimistic.
a. Example: Traders attributing good trades to their own ability
and disregarding bad trades as something that happened
because of luck or because of situations that could not be
“foreseen” or “predicted”.

8. Affect-as-information Hypothesis: The affect-as-information

hypothesis is a psychological theory that suggests people use their
current emotional states as a source of information when making
judgments or decisions. In other words, individuals rely on their
feelings or emotions to assess situations, people, or choices. These
feelings and emotions are not necessarily related to choices but yet
people use it as information relevant for the choice. This
psychological mechanism can explain why people become
overconfident or optimistic, for instance.
a. Example: An investor that has faced several successful trades
can feeling confident and upbeat and perceive the market as
less risky (even though conditions might have changed) and
be more inclined to interpret information optimistically,
leading to potentially riskier investment choices. Conversely,
an investor reeling from recent losses and gripped by anxiety
might adopt a more cautious approach, viewing the same
market conditions and opportunities through a pessimistic
lens.
b. There is a line of research that shows that affects/emotions
induced by factors unrelated to risks affect the perceived
likelihood of those risks. Negative (positive) emotions make
people belief that risks are more (less) likely than they
actually are.

9. The Effect of Experiences on Financial Decision-Making:

There is a line of research that explores the role of experiences

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 (good or bad) in financial and risk decision-making. For example,
the study by Malmendier and Nagel on "depression babies"
revealed that individuals who grew up during financial crises, such
as the Great Depression, tend to exhibit more risk-averse behaviors
in financial decision-making. This is a compelling illustration of how
historical experiences can leave a lasting imprint on one's approach
to risk and investment, underscoring the influence of behavioral
factors in economic choices.
a. There are different psychological channels through which
experiences can affect decision making. For example,
recency bias occurs when individuals give more weight to
recent events and observations when making judgments or
decisions. If people suffer from this, recent experiences have
more weight in people’s mind when making choices.
Experiences can also affect risk-taking by how traumatic they
were which taps into the availability heuristic making such
traumatic experience very important when making decisions
that can end up in the same traumatic experience.
b. Example: traders can make trades that end up in big losses
(gains) and this can constitute a traumatic (joyful) experience
that can make the trader very conservative (aggressive / risk
taking) when trading in the future.

10. The Gambler’s Fallacy: It is a cognitive bias that occurs

when an individual believes that past random events influence the
outcome of future random events, especially in games of chance.
This fallacy is based on the mistaken belief that, if a certain
outcome has occurred more frequently in the past, it becomes less
likely to happen in the future, or vice versa (the bias of believing
that “I am due a win” in a gambling situation). In reality, each
random event is independent, and past outcomes do not affect the
probabilities of future outcomes. People can also suffer from this in
the financial trading in the form of “mean reversion” of “negative
autocorrelation” of returns.
a. Example: Traders wrongly believing that the market is due a
“correction” now. It can go both ways. If the market has been
bearish, this bias means that people would tend to think that
the market should bounce back to the “mean” normal
returns. Or if the market has been bullish, this bias implies
that people believe that there should be a correction and
prices should go down.

11. Hot Hand Fallacy: It is a cognitive bias where individuals

believe that a recent streak of successes or good luck in a random
process (like investing in stocks) makes them more likely to
experience additional successes in the near future. This implies a

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 belief in positive autocorrelation, if things have been going great in
the past then things are going to be great in the future. It’s the
opposite of the gambler’s fallacy, which assumes that random
events will revert to the mean.
a. Example: In stock investing, the hot hand fallacy might occur
when an investor experiences a series of profitable trades,
leading them to believe that they possess a “hot hand” like in
basketball and can consistently make winning investments.
This overconfidence in their recent success may lead them to
take more risks or make aggressive investments, assuming
that their good fortune will continue. For example, imagine
an investor who has recently made several profitable trades
in
12. Information Overload: It occurs when individuals are
inundated with excessive information or data, making it
challenging to sift through and process the relevant information. In
financial trading, this can happen when traders have access to an
overwhelming amount of market data, news, reports, and analysis.
The sheer volume of information can lead to difficulties in
identifying critical signals, trends, or actionable insights,
potentially leading to confusion and poor trading decisions.
a. Example: A day trader who continuously monitors multiple
financial news sources, stock charts, and technical indicators
may experience information overload. This overwhelming
influx of data can make it challenging for them to filter out
noise from important market developments, potentially
impacting their trading decisions and overall performance.
13. Hindsight Bias: Hindsight bias, also known as the “I-knew-it-
all-along” or “Monday Quarterbacking” effect, is a cognitive bias
where individuals tend to perceive events as having been
predictable or foreseeable after they have already occurred, even if
there was little or no basis for predicting those events beforehand.
People afflicted by hindsight bias tend to overestimate their own
foresight or knowledge, leading to an inaccurate belief that they
knew the outcome all along. This bias can distort one’s assessment
of past decisions, making them appear more reasonable or obvious
in hindsight than they were at the time the decisions were made.
a. Example: Traders being lucky in a position and considering
that they knew the reasons why they made money in the
position, even though the real reasons could not be easily
foreseen.

14. Left digit bias: The cognitive bias of focusing on the leftmost
digits of numerical values, is a phenomenon in which people place
excessive importance on the leftmost digits of numbers while
underestimating the significance of the digits that follow. In the

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 context of trading, left-digit bias may manifest when traders fixate
on the leftmost digits in stock prices or other financial metrics,
such as the dollar value or price level. For example, if a stock’s
price is $49.95, traders may perceive it as significantly cheaper or
more attractive than a stock priced at $50.05, even though the
difference between the two prices is just a few cents.
a. Example: There is a study that shows a left digit biases which
is almost 2 times stronger when looking at profit than at price
when deciding to close a trade.

15. Thinking about Prices versus Thinking about Returns

are not Equivalent: Investors do not make sense of prices and
returns in the same way. Research have found that when people
are asked to make forecasts and they are shown information of
stocks in the form of prices (a line chart) this induces extrapolation
of recent past (e.g., stocks will keep going up if they have done so
in the recent past). If the same information is presented in the form
of bar charts of returns this draws attention to the entire available
history of information and forecasts are different than if they were
shown price information. Asking subjects to forecast returns as
opposed to prices results in higher expectations, whereas showing
them return charts as opposed to price charts results in lower
expectations.

16. Turkey Illusion: It refers to the phenomenon where, based on

past experiences and observations, an individual or entity may
believe that they have a comprehensive understanding of a system
or environment, only to be blindsided by unexpected and rare
events (referred to as "black swans" by Taleb). The term is derived
from the example of a turkey’s life experience: every day, the
turkey is fed, sheltered, and protected by the farmer, leading the
turkey to believe that life is predictable and secure. However, this
illusion is shattered when, shortly before Thanksgiving, the turkey
is unexpectedly slaughtered.
a. Example: In the context of financial markets, the turkey
illusion can apply to investors or traders who base their
decisions on historical data and patterns. They may become
overly confident that the future will resemble the past and
underestimate or disregard the potential for unforeseen
market shocks or rare events that can have a significant
impact on their investments. This concept highlights the
importance of being aware of the limitations of historical data
and the need for risk management strategies to account for
unpredictable events or risks with fat tails.

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 17. Rational inattention: It highlights the inherent cognitive
limitations people face when processing information and making
decisions. It underscores the importance of focusing on essential,
high-priority information while being aware of the potential biases
and missed opportunities that can result from the selective
allocation of attention. In financial decision making, recognizing
the concept of rational inattention can help investors and traders
develop strategies that account for these limitations and lead to
more effective choices.
a. Rational inattention is a framework that can help us
understand the reasons why many biases and heuristics
exists. This framework can help us understand why people
suffer from information overload, confirmation bias, paying
attention only to highly volatile variables in the market
disregarding less volatile variables that might hold important
pieces of information to understand the market. However, but
people only have the bandwidth to pay attention to high
volatility variables (as they might be perceived as more
informative for the individual).

PART 2 - PREFERENCES/AVERSION FOR RISK AND UNCERTAINTY

DIMENSION: HOW PEOPLE LOOK FOR INFORMATION TO MAKE
PREDICTIONS AND CHOICES AND HOW INFORMATION CAN AFFECT OUR
DECISION-MAKING.

18. Loss Aversion and Preferences for Gains vs. Losses: Loss
aversion refers to the psychological phenomenon where people
tend to strongly prefer avoiding losses over acquiring equivalent
gains. In other words, the pain of losing something is typically felt
more intensely than the pleasure of gaining the same thing.
Additionally, people evaluate outcomes in terms of gains or losses
with respect to a reference point that can be arbitrary, self-
imposed, externally imposed or manipulated. People have the
tendency to be risk averse when they feel that they are gaining
something and more risk seeking when they feel that they are
losing something (just like a gambler double down at the end of the
night to see if he can break even but running the risk or losing even
more). This dichotomy is also known as the reflection effect.
a. These are important components of the Prospect Theory
model that can explain the Disposition Effect, myopic loss
aversion, equity premium puzzle, and others.

19. Regret aversion: Describes the tendency of individuals to

avoid taking action or making decisions that might later lead to

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 regret. It is a cognitive bias in which people are more concerned
about the potential regret they might feel after a decision, even if
the decision is rational and reasonable, than the actual
consequences of the decision itself. People are trying to minimize
the regret they might feel if their choices turn out worse that
taking the alternative decision, even if the decision taken is in itself
good.

20. Pride seeking: Refers to the human tendency to seek actions

or behaviors that enhance one's self-esteem, reputation, or social
standing. It involves making choices or decisions that are motivated
by the desire to gain pride, recognition, or admiration from others
or even from oneself.

21. Mental Accounting: It is a concept that describes how

individuals mentally compartmentalize and categorize their
financial resources, assets, and expenses into separate “accounts”
or categories based on various criteria, such as the source of funds,
purpose, or time frame. This mental bookkeeping can lead to
distinct perceptions of money and influence decision-making in
financial matters. From a classical perspective, money is money
and it should all go into the same pot. Mental accounting put
psychological labels to different sources of money / wealth /
investments which makes people treat each account in a different
way.

22. Disposition effect: Refers to the tendency of investors to hold

on to losing investments for too long and to sell winning
investments too quickly. In other words, individuals have a
disposition to realize gains (sell winning investments) and avoid
realizing losses (hold onto losing investments).
a. This bias in investing can be explained by loss aversion in
combination with the reflection effect, by the combination of
regret aversion and pride seeking and mental accounts in the
sense that people find it more difficult to close mental
accounts at a loss (losing stocks) than accounts that are in
the positive (winning stocks). It can also be explained by
biases in expectations formation is people suffer from
reversion to the mean bias (discussed above).

23. Long-Shot Bias: Tendency for individuals to overvalue and

overinvest in unlikely or high-risk outcomes, particularly when the
potential rewards are disproportionately high compared to the
actual probability of success. In other words, the bias to like a lot
gambles or investments that with a small chance one can get very
rich. A potential explanation for this bias is the probability

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 weighting concept that explains why people have particular
preferences for probabilities.
a. Example: This bias can help explain a well-documented
anomaly called the low beta anomaly which implies that very
risky stocks are outperformed by safer stocks, even though in
theory very risky stocks should outperform safer stocks on
average so people are compensated for the extra risk they
take.

24. Certainty effect: The tendency to overvalue outcomes that

are certain or highly probable, even when the expected value or
rational assessment suggests otherwise. In other words an
increment of probabilities are more valuable the closer one gets to
full certainty. This can be also explained by the psychological
mechanism called probability weighting.
a. Example: Suppose two positions a trader is considering. In
option 1 the trader can make 1 mio with a 60% chance and in
option 2 can make 0.9 mio with 67% chance. Here option 1
can be the more appealing as the extra 0.1 mio of this option
are more valuable than the extra 7 percentage points in
probability of option 2. Now suppose the two options instead
yielded 1 mio with 90% chance and 0.9 mio with 97% chance.
Now option two might be more appealing even though it has
lower expected value. The reason is that the extra 7
percentage points in probability of option 2 are more valuable
than before because it takes the person closer to certainty.

25. Ambiguity Aversion: It refers to the individuals’ tendency to

prefer known risks with probabilities over unknown risks with
uncertain probabilities (or in other words, when probabilities are
not well-defined), even when the expected values of both options
are the same. This phenomenon is rooted in people’s discomfort
with ambiguity and their desire for clarity and certainty in decision-
making. The intuitive idea is that not all risks feel the same (a 50%
chance of winning 1000 DKK in the roulette wheel might not feel
the same as a 50% chance of winning 1000 DKK in the stock
market). This bias might make sense to follow as it can be a sort of
precautionary principle if one faces true uncertainty. However,
people react in a ambiguity averse manner if people feel ignorant
about something or distrust a situation or a person. In cases, where
ambiguity aversion is due to lack of knowledge that can potentially
be attained by the subject, ambiguity aversion might lead to
investment mistakes.
a. Example: Investment mistakes that can be explained by
ambiguity aversion. People tend to have underdiversified

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 portfolios heavily invested in home stocks (home bias), non-
participation in the stock market, among others.

26. Myopic Loss Aversion: It is the combination of loss aversion

and the tendency to evaluate portfolios very often to see how they
are doing over the investment horizon. When people are deciding
to invest, they consider a time horizon (say that is 1 year position)
that they want to commit to. Suppose people look at their portfolios
every months. People that suffer from Myopic Loss Aversion
evaluate investment options by the expectation of how they would
feel over the course of 12 months and not according to the
expectation of returns at the end of the time horizon. The more
often people expect that they will look at their portfolios over the
time horizon the bigger the chances of experiencing the up and
down swings of the stock market over the course of the year. Loss
aversion adds psychological pain to the swings in the stock market.
People suffering from Myopic Loss Aversion would tend to pick
positions that minimize the swings within the investment horizon to
minimize the psychological pain of market swings. This would
result in high conservatism and risk avoidance when choosing
positions, which are a mistake since the objective is to maximize
returns at the end of investment horizon for the investment
company (not minimize the psychological pain to the trader).

27. Defensive Decision-Making: Evaluating choices (for

instance trade positions) according to how easy or difficult it is to
defend the chosen option if things go wrong with that option. It is a
decision-making mechanism to avoid blame in environments that
punish people for bad outcomes or that people think (even if it is
not the case) that the environment will punish them for a bad
outcome.

28. The Sunk Cost Fallacy: It is a cognitive bias that occurs

when individuals consider the resources they have already invested
in a particular endeavor (money, time, effort) and allow those past
costs to influence their decision-making, even when those costs are
irrelevant to the current situation. In other words, people often
make decisions based on the desire to “get their money’s worth”
from past investments, rather than objectively evaluating the
prospective value and costs of the current choice.
a. Example: The sunk cost fallacy in investing occurs when
individuals hold onto declining assets because they've already
invested substantial amounts, hoping to recover their losses.
For instance, if an investor initially put $10,000 into a stock,
which later dropped to $2,000, they may resist selling due to
the belief that they should wait to recoup the initial

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 investment. It is the tendency to avoid cutting losses short
and opening the door to get even bigger losses due to the
fallacy that that is a sunk cost that should be recovered.

29. (Quasi)-Hyperbolic Discounting: Models that explain how

people have present-bias preferences and lack of self-control
represented in the form of time inconsistent preferences. Quasi-
hyperbolic discounting is very similar to exponential discounting in
the sense that people are assumed to have constant discount rate
(behaviorally this means that people are equally patient whether
they are deciding over choices 10 years or 20 years from now. The
time inconsistency appears when there are decisions that involves
giving up consumption today to consume more in the future. But if
people are asked to pre-commit to save more in the future, for
instance, and the choice is implemented automatically, then people
can achieve greater savings. Hyperbolic discounting generates
more time inconsistency in the sense that it is assumed that
individuals have decreasing discount rates over the time horizon.
Behaviorally, this means that people become more patient as the
decisions are placed further away in the future horizon.
a. Example: The Save-More-Tomorrow program by Thaler and
Benartzi assumes that people are quasi-hyperbolic
discounters, so they might make rational choices of saving
more if those choices are to be implemented in the future.
But the implementation of the saving choices has to be
automatic to avoid the temptation of changing plans.

PART 3 – SOCIAL DIMENSION OF INVESTING: HOW SOCIAL CONTEXTS

AFFECT INDIVIDUALS’ DECISIONS

30. Effect of Social Networks on Beliefs and Expectations:

Social networks (social media, networks of colleagues) determine
how to information / beliefs / expectations propagate to people. For
instance, people with extreme and stubborn views can have
disproportionate impact on the views of individuals that suffer from
confirmation bias, imperfect recall, availability heuristic and
representativeness; echo-chambers in networks can reinforce views
in the market that are not rational. Such framework can help us
understand events like the GameStop saga and how peers can
affect trading behavior of other peers.
31. Herding effect: The herding effect, in the context of financial
markets, refers to the tendency of investors to follow the behavior
and decisions of the crowd, often leading to the imitation of
prevailing market trends or sentiments. This behavior can result in
the collective overbuying or overselling of assets, creating market

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 bubbles and crashes. Herding is driven by the belief that the
crowd’s actions are indicative of valuable information or safety,
even when it may not be rational. It can amplify market volatility
and lead to suboptimal investment decisions, as individuals
prioritize conformity over independent analysis and assessment of
asset value.

PART 4 – NOTIONS OF RATIONALITY

32. Ecological Rationality: Practices, norms, rules-of-thumb or

institutional rules that dictates behavior and are part of our
biological or cultural heritage that “maximizes” survival.
Individuals tend to be less conscious of the reasons for the
rationality of such rules.
a. Example: Wisdom in the form of rules-of-thumb
(Tommelfingerregler) or simple heuristics past down from
seasoned traders to younger apprentices.

33. Constructivist rationality: Rules, course of action or designs

consciously and deliberatly created to make “optimal” choices. This
is a more conscious decision-making process where people are
more aware of the reasons for why choices made under this notion
of rationality are considered “optimal” or “rational”.
a. Example: Explicit trading strategies consciously defined after
careful consideration of the details of the strategy.
Investment strategies mechanically taught in universities.

34. Ex-ante vs. Ex-post Evaluation of Decisions: When making

decisions we try to do our best with the information we have at the
moment of the decision. When the decision yield fruits (say a trade
position) one can suffer from outcome bias, which is the tendency
to evaluate the choice as good or bad depending if the outcome is
good or bad. One should not evaluate choices ex-post in this way.
One should evaluate choices according to the information one had
at the moment of the choice (to avoid hindsight bias) and according
to the logic one had, not the outcome of the choice. The example
here is being drunk in a party and deciding to drive drunk home
and arriving home safely. This is definitely a bad choice because
the logic was to drive home drunk and one should not consider it a
good choice just because one arrived safely at home.

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