The human side of investing: how cognitive errors distort financial decisions
The Sandbox Daily (10.22.2025)
Welcome, Sandbox friends.
Today’s Daily discusses:
how cognitive errors distort financial decisions
Let’s dig in.
Blake
Markets in review
EQUITIES: S&P 500 -0.53% | Dow -0.71% | Nasdaq 100 -0.99% | Russell 2000 -1.45%
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BITCOIN: -2.73% to $107,123
US DOLLAR INDEX: -0.05% to 98.881
CBOE TOTAL PUT/CALL RATIO: 0.88
VIX: +4.09% to 18.60
Quote of the day
“All too often, people concentrate on finding the right spouse, little realizing that half of any marriage is being the right spouse.”
- Unknown
The human side of investing: how cognitive errors distort financial decisions
The assumptions of traditional finance that individuals act as rational beings who objectively consider all relevant information to make cogent decisions, and more importantly that this process results in efficient markets, is viewing the world through rose-colored glasses.
Behavioral finance (BF) adapts to the observed behavior of market participants and inherent flaws we all exhibit. A better understanding of how we act in reality, rather than in theory, should allow for the construction of portfolios that better approximate the efficiency and optimization observed in traditional finance (TF) – thus leading to better outcomes.
Yesterday we reviewed some of the most common emotional biases that investors exhibit in their decision-making processes.
Today we will discuss cognitive errors that plague investors as well.
Cognitive errors are due primarily to faulty reasoning and logic. They often arise from a lack of understanding proper statistical analysis techniques, reasoning deficiencies, informational processing mistakes, or memory errors.
Simply put, cognitive errors are the mechanical blunders we all make. An unforced error, if you will.
We discuss the three most common cognitive errors below:
Recency bias: This behavior is the tendency to overweight the importance of recent events relative to the full set of observations and information.
We constantly observe this bias in everyday practice: it shows up as chasing recent returns or the latest and hottest investment fads. This occurs because we put undue emphasis on future probabilities and information by overweighting the present. In other words, our frame of reference is too narrow and base our decisions on small, recent sample sizes.
For example, if you began 2022 by increasing exposure to the growthiest and most speculative corners of the market like Cathie Wood’s Ark Innovation ETF (ARKK) in response to their glowing 2021 returns, you may suffer from recency bias and learned the hard way when your head got chopped off in the bear market. If new information is quickly priced in by a highly competitive and mostly efficient market – like the Fed raising interest rates at the fastest pace in history – prior returns will likely differ from future returns.
Mental accounting bias: This behavior is the tendency to treat money differently depending on how it’s categorized. Individuals ignore that money is fungible.
Investors may view their total investment portfolio as a pyramid comprised of layers with each sub-portfolio (layer) making up a different set of assets used to accomplish separate goals. Mental accounts can include goals like retirement, education, and bequests – and the sub-portfolios of assets that fund them.
The investor structures their portfolios in sub-accounts to meet different goals, but ignores total return, diversification, and correlation between each layer. The results are suboptimal from a TF perspective.
Confirmation bias: This is the behavior in which investors look for new information to support an existing view or distort contradictory facts that oppose their viewpoint. It is a kind of selection prejudice.
New evidence is used to support the original view, perception, or belief. Investors look for confirming evidence while discounting or flat-out ignoring information that contradicts their base rate.
The consequences of such behavior include investors who are slow to move off their initial anchor point, thereby holding investments too long. Under-diversification becomes problematic because the investor is overly convinced their ideas are correct.
Such cognitive errors can often be corrected or mitigated with better training or information, or even seeking qualified advice.
In contrast, emotional biases are not related to conscious thought and stem from feelings or impulses or intuition. As such, they are more difficult to overcome and often must be accommodated.
Ultimately, those who better understand their own biases and errors have a better chance of constructing and managing portfolios that benefit their future prosperity.
But, this often starts with asking the right questions, such as how do these shortcoming effect portfolio asset allocation, should they be moderated, and what are the quantifiable differences in potential outcomes?
We pick up tomorrow to discuss practical application of these BF concepts.
Source: CFA Institute
That’s all for today.
Blake
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Welcome to The Sandbox Daily, a daily curation of relevant research at the intersection of markets, economics, and lifestyle. We are committed to delivering high-quality and timely content to help investors make sense of capital markets.
Blake Millard is the Director of Investments at Sandbox Financial Partners, a Registered Investment Advisor. All opinions expressed here are solely his opinion and do not express or reflect the opinion of Sandbox Financial Partners. This Substack channel is for informational purposes only and should not be construed as investment advice. The information and opinions provided within should not be taken as specific advice on the merits of any investment decision by the reader. Investors should conduct their own due diligence regarding the prospects of any security discussed herein based on such investors’ own review of publicly available information. Clients of Sandbox Financial Partners may maintain positions in the markets, indexes, corporations, and/or securities discussed within The Sandbox Daily. Any projections, market outlooks, or estimates stated here are forward looking statements and are inherently unreliable; they are based upon certain assumptions and should not be construed to be indicative of the actual events that will occur.
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