The Cost of Cognitive Bias in Investor Decision-Making

Investor decision-making can often be heavily biased from reality, resulting in undesirable trading results and worsened market efficiency. To quantify the overall impact in today's market, the present study aims at assessing how relevant these behaviour biases are in influencing cognitive biases such as overconfidence, loss aversion, and the disposition effect, therefore giving investors a way to combat this issue. Through brokerage transaction data along with the literature of other economists, this research paper identifies how biases affect trading frequency, asset allocation, and portfolio return. It shows how overconfident traders trade too much, incurring high transaction costs, while loss-averse investors keep depreciating stocks longer than warranted. Moreover, the disposition effect causes investors to sell winning stocks early, forgoing the subsequent price appreciation and reducing long-run portfolio returns. However, this paper also recognises that these biases serve important systemic functions, namely providing market liquidity and dampening panic selling during downturns, and therefore argues that the appropriate objective is not their elimination but the reduction of their private costs. The challenge, therefore, is not to make investors rational, but to make their irrationality less frequent and costly.