Investor psychology: watch out for biases!

Updated on 30 July 2026

A cognitive bias is a systematic distortion in an investor's judgment that leads to irrational financial decisions, such as buying right before a crash or selling at a heavy loss. Behavioural finance studies these mechanisms. Here are the main biases to know before investing in the stock market, and how to neutralise them.

Key takeaways

• Confirmation bias leads investors to ignore negative signals about an asset once they feel emotionally attached to it.
• Herd behaviour and FOMO amplify market moves when a majority of investors follow the same trend without their own analysis.
• The gambler's fallacy leads investors to believe that a losing streak must eventually be followed by a compensating gain, instead of cutting a losing position.
• Irrational exuberance, a term coined by Alan Greenspan in 1996, describes the formation of speculative bubbles driven by excess collective confidence.
• Keeping a journal of every trade, wins and losses alike, limits the effect of selective memory on future decisions.

Most of these biases were formalised by psychologists Daniel Kahneman and Amos Tversky in their prospect theory (1979), which earned Kahneman the 2002 Nobel Memorial Prize in Economic Sciences.

What is confirmation bias in investing?

Confirmation bias is the tendency to notice only the information that confirms an opinion already formed about an investment, while dismissing signals that contradict it. It is a classic of investor psychology: processing only the information that suits us.

As an illustrative example (not a recommendation), an investor excited about a stock like Tesla will tend to look only at the good aspects: the enticing chart, positive sales figures, a promising future, while forgetting or ignoring the risks: an enormous valuation relative to revenue, growing competition, build-quality issues, or a visionary and charismatic but singular leader, representing a major key-person risk (SPOF, for Single Point Of Failure).

How to avoid it: stay pragmatic and do not get carried away by your emotions. The simplest fix is to use an analysis model that supports decision-making. If your assumptions are reasonable, the model will not lie to you.

What is herd behaviour in the stock market?

Herd behaviour pushes an investor to follow the dominant view of a large number of people, even when those people have no expertise on the subject, which amplifies market moves both upward and downward.

It is tempting to be swayed by the view shared by a large number of people, even when those people have no expertise at all on the subject. The mass movements that follow can create market over-reactions, both upward and downward. Just look at the number of Robinhood (a US trading app) customers who bought shares in Hertz, mostly beginner investors sharing their "buy the dip" conviction on Twitter. According to CNBC, Hertz stock then jumped more than 50% after the company selected, in May 2021, a $6 billion turnaround bid led by Knighthead Capital and Certares: the pre-bankruptcy shareholders ultimately received nearly $8 per share, an unusual outcome for a corporate bankruptcy. This phenomenon is the enemy of sound wealth management.

How to avoid it: always ask yourself whether your decision was made with a clear head, after a rigorous analysis of the investment, or whether you feel swept up in FOMO (Fear Of Missing Out) driven by a sudden wave of enthusiasm from many people, often on social media. A diversified approach, for example through ETFs, can be considered based on your profile and goals to limit concentration in individual stocks.

Overreaction and underreaction

A disproportionate reaction to an event occurs when an investor responds to a piece of news more strongly than its real impact warrants.  When the market is bullish, an investor can stay optimistic for a long time. Conversely, when it is bearish, pessimism can last longer than it should. When a majority of investors are biased this way, the market can experience a surge or a brutal drop that is completely disconnected from reality. These moves are especially pronounced on digital assets (DeFi, Bitcoin), which carry high volatility and a high risk of loss.

How to avoid it: do not fall into the trap of a wild guess when an event happens: "hey, this company just announced a COVID vaccine, I don't know much about vaccine approval processes, but it's surely a great stock to buy!" In general, investing in a subject you do not understand strongly increases the risk of loss.

Selective memory

We all have a more or less selective memory. When investing, an overly selective memory can cost us dearly. We tend to remember only our best investments and forget our mistakes, for reasons of ego or social recognition. This behaviour prevents us from learning from our mistakes and can lead us to repeat them endlessly.
How to avoid it: developing humility and a rigorous tracking process is key. For every transaction, note the details in a tracking file and add a comment explaining why you bought or sold, and what you could do better next time. Tools like Finary make it possible to centralise the history of your transactions and portfolio performance across all brokers, which makes this tracking work easier.

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The trap of sunk losses and the gambler's fallacy

Having the humility to accept mistakes or failure is an essential quality.
Failing to realise a loss is very dangerous, because it can lead to denial. Not selling a stock when you are deep in the red, and putting off the decision, will only amplify the losses. This can be made worse by the gambler's fallacy: the investor believes that if an event occurs many times in a row (here, the decline of their investment), the opposite event will eventually happen to compensate. This reasoning is flawed, since each market move remains independent of the previous ones. It is wiser to accept having made a mistake, or simply not having had the odds in your favour, to cut the loss and move on.

How to avoid it: a common practice is to set, in advance, a profit target and a maximum acceptable loss threshold. This approach should be tailored to your risk profile.

What is irrational exuberance in the stock market?

Irrational exuberance refers to the formation of a speculative bubble when enough over-confident investors buy at the same time, driving an artificial rise in the market followed by a correction. The phrase was first used by Alan Greenspan, chairman of the US Federal Reserve, in a speech on 5 December 1996, before being popularised by economist Robert Shiller in his book "Irrational Exuberance" (2000). It is a reminder that history cannot be used to predict the future with certainty: speculators rely on chart analysis and historical trends, but every economic event unfolds in a different context. Who could have predicted that the COVID crisis would trigger a months-long bull market in the short term, fuelled by central banks?

Irrational exuberance occurs when enough over-confident investors invest at the same time, driving an artificial rise in the market that will inevitably end in a correction. They all lead to bubbles: tulip mania (17th century), the Great Depression (1929), the dot-com bubble (2000), the US housing crash (2008). When is the next one?

How to avoid it: forecasts based solely on historical chart analysis should be treated with caution. An investment decision benefits from being grounded in an understanding of the economic context and your personal goals.

In brief

Keeping these main pitfalls in mind helps you stay more pragmatic in the face of your emotions and biases. To invest with discipline, a checklist can be a good solution, listing the critical points to check before every position. This way, you make sure you invested with a clear head, in an asset that matches your goals and values.

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Frequently asked questions

How can you recognise a cognitive bias in investing?

A cognitive bias often shows up as a decision made in the heat of emotion rather than through cold analysis: buying after a sharp rise, refusing to sell at a loss, or overconfidence in a forecast. A written, tracked investment process helps spot it.

Who formalised the theory of cognitive biases in finance?

Psychologists Daniel Kahneman and Amos Tversky laid the foundations of behavioural finance with prospect theory, published in 1979 in the journal Econometrica. This work earned Kahneman the 2002 Nobel Memorial Prize in Economic Sciences.

How can you protect yourself from herd behaviour in financial markets?

It comes down to checking whether an investment decision rests on personal analysis or on simple collective enthusiasm, often amplified by social media. Diversifying through ETFs rather than individual stocks also limits exposure to a single crowd bet.

Can irrational exuberance be anticipated?

Not with certainty: history never repeats itself identically, and speculative bubbles (tulips, dot-com, subprime) form in different economic contexts each time. Prudence means not basing a decision solely on extrapolating past trends.

Sources

The Sveriges Riksbank Prize in Economic Sciences 2002, Daniel Kahneman

Federal Reserve, speech by Alan Greenspan, 5 December 1996, "The Challenge of Central Banking in a Democratic Society"

Irrational exuberance, background on Robert Shiller's book (2000)

CNBC, Hertz shares surge by more than 50% after selecting $6 billion turnaround bid, 12 May 2021

Tulip mania, history of the tulip speculative bubble (1636-1637)