Behavioral Finance 101: Heuristics

DanielCrosbyDr. Daniel Crosby, Ph.D., IncBlot Behavioral Finance

While the field of behavioral finance has been around for 40 or so years (depending on who you ask), it truly came into its own in 2002 when Daniel Kahneman received the Nobel Memorial Prize in Economics for his work around uncertainty and decision-making. Although he claims never to have taken an economics class, Kahneman’s work shed new light on the ways in which actual people behave under real-life circumstances, as opposed to the idealized assumptions of efficient market hypothesis, the theretofore ascendant paradigm for understanding investment outcomes.

While one of the nagging critiques of behavioral finance is that it has no mutually-agreed-upon philosophical framework, most psychologists divide it into three pillars: heuristics, irrational behavior and framing. Over the next few weeks, we’ll take each of those three pillars and try and understand them a little more deeply. In so doing, we’ll also tackle the “so what” of behavioral finance for the average investor. Without any further adieu I give you Part One of our survey course on behavioral finance – Heuristics.

I’m not sure what time of day you’re reading this, but whenever it is I can be sure of one thing: you’ve already made a lot of decisions today. First of all, there was whether or not to hit the snooze button. Then, what to have for breakfast? Luffa with body wash or bar soap in the shower? Grey suit or navy suit? And so on and so forth. The point is, given the myriad decisions we all face every day, it’s no wonder that we end up relying on heuristics or experiential rules of thumb, when making even important decisions. To give you a little firsthand experience with heuristics, I’d like to ask you to do the following:

5.9.13_Crosby_BeFiBlog_1Quick! Name all the words you can that begin with the letter “K.” Go on, I’m not listening. (Insert Jeopardy theme song here). How many were you able to come up with? Now, name all of the words you can in which K is the third letter. How many could you name this time?

If you are like most people, you found it easier to generate a list of words that begin with K; the words probably came to you more quickly and were more plentiful in number. But, did you know that there are three times as many words in which K is the third letter than there are that start with K? If that’s the case, why is it so much easier to create a list of words that start with K?

5.9.13_Crosby_BeFiBlog_1_pic3It turns out that our mind’s retrieval process is far from perfect, and a number of biases play into our ability to retrieve data with which we’ll make a decision. Psychologists call this fallibility in your memory retrieval mechanism the “availability heuristic,” which simply means that we predict the likelihood of an event based on things we can easily call to mind. Unfortunately for us, the imperfections of the availability heuristic are hard at work as we attempt to gauge the riskiness of different decisions, including how to allocate our assets.

In addition to having a memory better suited to recall things at the beginning and the end of a list, we are also better able to envision things that are scary. I know this first hand. Roughly six years ago, I moved to the North Shore of Hawaii along with my wife for a six-month internship. Although our lodging was humble, we were thrilled to be together in paradise and eager to immerse ourselves in the local culture and all the natural beauty it had to offer. That is, until I watched “Shark Week.”

5.9.13_Crosby_BeFiBlog_1_pic5For the uninitiated, “Shark Week” is the Discovery Channel’s seven-day documentary programming binge featuring all things finned and scary. A typical program begins by detailing sharks’ predatory powers, refined over eons of evolution, as they are brought to bear on the lives of some unlucky surfers. As the show nears its end, the narrator typically makes the requisite plea for appreciating these noble beasts, a message that has inevitably been over-ridden by the previous 60 minutes of fear mongering.

For one week straight, I sat transfixed by the accounts of one-legged surfers undeterred by their ill fortune (“Gotta get back on the board, dude”) and waders who had narrowly escaped with their lives. Heretofore an excellent swimmer and ocean lover, I resolved at the end of that week that I would not set foot in Hawaiian waters. And indeed I did not. So traumatized was I by the availability of bad news that I found myself unable to muster the courage to snorkel, dive or do any of the other activities I had so looked forward to just a week ago.

In reality, the chance of a shark attacking me was virtually nonexistent. The odds of me getting away with murder (about 1 in 2), being made a Saint (about 1 in 20 million) and having my pajamas catch fire (about 1 in 30 million), were all exponentially greater than me being bitten by a shark (about 1 in 300 million). My perception of risk was warped wildly by my choice to watch a program that played on human fear for ratings and my actions played out accordingly. This, my friends, is heuristic decision making hard at work.

Hopefully by now the application to investment decision-making is becoming apparent. For so long, we have been sold an economic model that posited that we had perfect, uniform access to information and made decisions that weighed that information objectively. In reality, our storage and retrieval processes are imperfect, with recent and emotionally charged pieces of data looming larger than the rest.

5.9.13_Crosby_BeFiBlog_1_pic4Investors and financial services professionals that understand these imperfections are better positioned to understand the limitations of their knowledge and try to intervene accordingly. At times this may mean taking a more tentative position to circumvent undue risk. Other times this may mean digging a little deeper on what may initially appear to be a foolproof trade. Whatever the case, it is only after we free ourselves from the myth of homo-economicus, that we are able truly become our best investing selves. Making decisions based on subjective logic needn’t be your undoing as an investor, but assuming that you’re a perfectly logical decision maker just might.