Heuristics and Their Impact on Personal Finance

Today I want to talk to you about heuristics and what they mean for your finances. Heuristics are a major concept of psychology and play out heavily in the biases that cause our financial decisions.

So What are Heuristics?

A heuristic is basically the concept of the mind using short cuts to make judgements and decisions. In general the mind does not interpret every stimulus completely as it comes in. Most of the time it interprets based on prior experience and basic imperfect models to make judgements quickly.

For example when your mind sees a pricing discount most people are hardwired to judge the discount based on the reported percent off. Never mind that the retailer may have increased the original price before deriving the discount to come up with that percent. This example leads us to an important point, while these heuristics can help us to make judgements quickly, which is an important skill set, they can also sometimes lead us to the wrong conclusion. More serious examples might lead to things like Racial Profiling or Sexism.

This article though is not focused on the extreme cases, but more how these heuristics effect your every day financial decision making. Pricing may be a relatively benign case, but the ramifications go far beyond whether you get a good deal. They play heavily in the biases we see often mentioned with respect to personal finance. Just what are these biases?

Availability Bias

Basic the idea of availability bias is people make decisions based on the existence and ease of memory of prior examples or events. So the more readily you remember a good or bad result from a scenario, the more likely you will apply that result in any analysis of a situation.

Recency Bias

Going along with the availability bias is the recency bias. In effect the most recent behavior is the most easily available. Thus, we tend to act based on the events that have happened most recent. This bias especially scares me based on the current state of the stock market. It has been so long since we’ve had a truly bad year barely anyone remembers. As such individuals are more likely to think they are invincible, that they can never pick a bad stock. Needless to say when the next stock market crash occurs these people will be in for a rude awakening.  We have already seen this a bit with the latest stock market dips and the calls of the sky is falling, but in reality this correction has nothing on a recession.

Anchoring Bias

The famous experiment involving anchoring bias in psychology involves telling people a low or high number before asking them to estimate something that is uncountable. In the experiment the people are even told this base number has no bearing on the count. And yet, those who hear the low number tend to guess lower than those who heard the high. They in effect anchor on the number.

We see this in the stock market. People anchor on a prior valuation or metric. Say the P/E of a stock or the price. Then when it drops or raises associated to that metric they still make decisions based on that prior value. Really what they should be doing is making a decision based on the current situation of the company.

Confirmation Bias

The above biases are made all the more worse by a tendency of the brain to want to interpret data in a way as to confirm these biases.   If you believe it then your brain wants to provide you further evidence that it is true.  This is called a confirmation bias. Unfortunately this leads to issues like loss aversion and the sunk cost fallacy. Loss Aversion is when individuals attach a larger weight to a loss than an equal size upside. As such we tend to hold a stock while it is declining for fear of admitting we are wrong, seeing signs everywhere that things are about to reverse. This fear of selling ultimately leads to even bigger losses. When combined with todays recency bias this could get particularly nasty for some during the next contraction.

Clustering Illusion

Which brings us to one of the core ways the current market behavior is probably manifesting itself for your heuristic. It probably is showing as a clustering illusion. Basically most people by now have begun to see patterns in the otherwise random data of the market. As such the trading strategies get more common this late in a bull market. Sadly, if they ever are real they disappear quickly after they become public. Most of them are just illusions based on the other biases we mentioned earlier.  The common one I hear around our recent minor correction is to buy the dip as it’s a short term blip like others we’ve seen over the last few years.  This time may be different.

Survivorship bias

Which brings us to one more that goes along with clustering illusions, that is survivorship bias. You see this a lot with back testing data. This type of investor or investment is great and represents a replica table pattern of success because it has done so well. The problem of course is you only see the one that made it out of the hundreds of other potential choices in the same vein. This leads you to see a pattern by ignoring all the possible failures to instead view only the success and apply it to the entire population.

IPOs and venture capital appear to be falling heavy pray to this these days. Billion dollar unicorns (new companies raising a billing dollars in funding) are everywhere, but everyone seems to be forgetting how many new companies ultimately fail. Facebook is a survivor, but what happened to Myspace again?

Biases and Heuristics, What To Do About Them

It’s scary to think of all these biases and how they may impact your investment approach, your purchasing, or any other thing you do. But there is something you can do to avoid falling to them. If you go back and read my first sentences about heuristics you will find I noted they come about from short cuts of the mind. These short cuts are used to make snap judgements, especially in situations where you are in the heat of the moment. As such the real key is to bring yourself out of the heat of the moment and do a real analysis rather than a snap judgement.

The key in other worlds is to make an investment plan up front. Spend some real time figuring out what your plan is now before things start to down turn. Then put it in writing. Add to that some barriers that limit your ability to change your plan on the fly except in well thought out situations. While this won’t free all situations from bias and heuristic influence, it should help you to generally limit their negative influences.

Do you recognize any of these biases in yourself? If so are you actively controlling for them in any way?