Heuristics and Biases

Made by: Deepshikha Yadav (51) Saima Arshad (19)

Heuristics and Biases

When making decisions or judgments, we often use mental shortcuts or "rules of thumb" known as heuristics. Behavioural finance identifies a number of heuristics (Greek word for "discover") which describe different ways in which we make decisions quickly and with limited information, but which don't necessarily give the "correct" answer. These heuristics are useful tools in solving these problems but they can lead to systematic and harsh errors and cognitive biases. The problem is that these heuristics are not necessarily well suited for modern tasks, such as optimising an investment portfolio or making market timing decisions.

Types of heuristics
The most well known heuristics are :
Representative Availability Adjustment

Heuristics

Heuristics and Anchoring

Heuristics

Representative heuristics

When people make judgements on whether an object or event belongs to a certain class of objects or events, they generally rely on the representativeness heuristic to make that decision. The person is more likely to believe that an object belongs to a class if that object is highly representative of the class. If an object does not really represent the class the person will deem it less likely to actually belong to that class. For example, in a series of 10 coin tosses, most people judge the series HHTTHTHTTH to be more likely that the series HHHHHHHHHH (where H is heads and T is tails), even though both series are equality likely. The reason is that the first series looks more random than the second series. It "represents" our idea of what a random series should look like."

Availability Heuristics

This is where a person judges the probability of an event or frequency of an object based on the ease at which information about the event or object comes to mind A classic example of this is asking a person if there are more words in the English language beginning with the letter k than have k as their third letter. Since people tend to remember words by the letter they begin with rather than their third letter, they find it much easier to retrieve more examples of words beginning with k than words with k as their third letter.

Adjustment and Anchoring Heuristics

This is the heuristic used by people when they are trying to estimate a numerical answer to a question given either a figure to start from or by partially calculating the correct answer. According to this heuristic, people's estimate of the value of a quantity is disproportionately influenced by their knowledge of the value of a related (or sometimes unrelated) quantity. This other related quantity is termed the anchor and the process of adjusting from the anchor value to the value estimated is called adjustment.

Anchoring for comparable quantities

One form of anchoring is where the anchor is in fact logically related to the value that needs to be estimated. For instance, when trying to estimate the time taken for a particular journey, the person may use estimates for the time taken by a related journey but fail to accurately account for differences. Anchoring for incomparable quantities

Another form of anchoring is where the anchor is totally unrelated to the value that needs to be estimated, and hence, using it to influence the value being estimated is irrational. For instance, it has been found that people who were asked down to write a two/three-digit number based on the digits of their phone number, and were then asked to estimate some totally unrelated quantity, were influenced by the number they wrote down based on their phone number.

Heuristics driven biases

Gambler's fallacy Gambler's fallacy occurs when investors inappropriately predict that a trend will reverse, for example, a gambler playing a fair roulette table who has seen seven black outcomes in a row may think that the next spin 'must' produce a red outcome. This illusion may encourage the purchase or sale of a share on the grounds that the recent bad/good luck of the firm must be about to change.

Mental Accounting Mental accounting is a term given to the propensity of individuals to organize their world into separate 'mental accounts'. People separate their money into various mental accounts and treat a rupee in one account differently from a rupee in another because each account has a different significance for them. This can lead to inefficient decisionmaking, for example, an individual may borrow at a high interest rate to purchase a consumer item, while simultaneously saving at lower interest rates for a child's college fund.

Overconfidence People are overconfident about their abilities. One example is too little diversification, because of a tendency to invest too much in what one is familiar with. Illusions caused by over-confidence lead investors to overestimate their predictive ability (under EMH they have none) and to attempt to 'time' the market by buying or selling shares in advance of an anticipated share movement. One side effect of this can be to cause excessive trading, leading to increased trading costs. Anchoring Anchoring arises when a value scale is fixed or anchored by recent observations. An example would include a case where a share has recently suffered a substantial fall in price. An investor may be tempted to evaluate the 'worth' of the share by reference to the old trading range. As an example, take a company whose stock is trading at $10 a share. The company then announces a 300% earnings increase, but its stock price increases only to, say, $12 a share. The small rise occurs because investors are "anchored" to the $10 price. They believe that the earnings increase is temporary when, in fact, the company will probably maintain its new earnings level.

Loss Aversion or Escalation bias Loss aversion is based on the idea that the mental penalty associated with a given loss is greater than the mental reward from a gain of the same size. If investors are loss averse, they may be reluctant to realize losses and may even take increasing risks to escape from a losing position. This provides a viable explanation for 'averaging down' investment tactics, whereby investors increase their exposure to a falling stock, in an attempt to recoup prior losses. Disposition effect The disposition effect refers to the pattern that people avoid realizing paper losses and seek to realize paper gains. For example, if someone buys a stock at $30 that then drops to $22 before rising to $28, most people do not want to sell until the stock gets to above $30. The disposition effect manifests itself in lots of small gains being realized, and few small losses.

Representativeness It refers to the tendency to form judgments based on stereotypes. While representativeness may be a good rule of thumb, it can lead people astray. For example:

1. Investors may be too quick to detect patterns in data that are in fact random 2.Investors may become overly optimistic about past winners and overly pessimistic about past losers 3.Investors generally assume that good companies are good stocks

 Framing

Framing in behavioral finance is the choosing of particular words to present a given set of facts; it can influence the choices investors make. They found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. For example, restaurants may advertise early-bird specials or after-theatre discounts, but they never use peak-period surcharges. They get more business if people feel they are getting a discount at off-peak times rather than paying a surcharge at peak periods, even if the prices are identical. Also some investors typically consider the loss of $1 twice as painful as the pleasure received from a $1 gain.