Cognitive Biases and Market Reactions

In the central part of this chapter, readers will find an exploration of cognitive biases in the context of market overreactions, with the central thrust of cognitive biases being behavioural heuristics. In the foreground, the text associates three main biases with investors’ decision-making: the overconfidence bias, the anchoring bias, and the availability heuristic. The first of these, the overconfidence bias, is the one that prompts traders to believe they are more than 100% certain about the market trend, which leads to excessive risk-taking mistakes and overpricing. Second, anchoring bias causes traders to narrow their focus to a specific point in history, which distorts their valuation assessment and the resulting choices in a deal. On the one hand, the availability heuristic drives the markets to miss the original point by promoting an unequal reliance on the latest announcements of events, which in turn leads to groundless predictions and collective investor action. This chapter presents, for the first time, psychological biases through a case study of the 2010 Flash Crash, demonstrating that the prevalence of trading robots, combined with cognitive distortions, contributed to extreme volatility and rapid price fluctuations. Thanks to the discussion of these brain-related aspects, the chapter effectively conveys to people how cognitive biases influence the market and, in turn, impact financial stability within the sector.