Our brain works in mysterious ways with all the unfathomable information it stores and processes. It all seems a little incomprehensible to an ordinary man. However, scientific beliefs indicate how specific mechanisms lead to the final outcome of a problem, and that explains why we do what we do.
While doing math in classrooms, we have all heard our teachers talk about one definite solution, and it is quite understandable why most people have a similar belief about finance. But that’s entirely not true. There are probabilities of specific outcomes when it concerns finance, and that’s why heuristics’ rule of thumb is the safest bet for financial analysts or decision makers.
In our day-to-day life, we have to make choices ranging from minor ones to some major ones. We decide based on our set routine or, under certain circumstances, choose to take the most appropriate path. That sounds like something close to heuretics. Let’s dive deep into the basics and know its influence over decision-making in general or related to financial situations.
What are heuristics?
Every problem has a precise or close enough solution, and heuristics help find the most appropriate shortcut. It is a method of solving a problem through a practical approach that has been utilized once in a similar situation. The technique is a good choice for problem-solving when there is an extreme time constraint, or insufficient data or information availability.
It would be safe to say that the primary heuristic technique is finding a simple and close to efficient solution to an utterly complex problem. However, people with experience in managing circumstances and making decisions are likely to apply the heuristics technique. Financial experts often have hoards of complex data to analyze and conclude. Hence, a shortcut path seems the most viable solution.
The best example to understand the heuristics technique is the trial and error method. Several solutions are implemented, and the most efficient one is selected. Meanwhile, methods like intelligent guesswork or the elimination process can contribute well too.
Types of Heuristics
Humans often seek out the most accessible possible outcome to a very tricky situation. That’s because we have wired our brains to process precise information rather than fiddle with highly challenging processes. The heuristics technique has a sufficient number of limitations, but since it helps in saving time, it outweighs the consequences that might occur if a decision has not been made at the correct hour. There is a very limited possibility of an error in judgment taking place and affecting the final result. But financial advisors take these risks eventually based on their deep understanding, knowledge, and experience. In matters like the financial market, there isn’t a fixed method to rely on to estimate profit making. Nevertheless, a method or plan is devised to come close to a near-perfect decision..
So there are mainly three sorts of heuristic approaches:
- Representative refers to a technique wherein mental shortcuts are made based on behavior. That’s why it is a majorly identified technique in behavioral economics. Using this approach would mean finding a possible solution to a problem similar to a previous condition or traits of a past event.For instance, a potential investor might be drawn to fund a particular company in a related sector where he or she may have experienced success in the past. However, this approach could significantly go wrong as several factors and variables are at play.
- Availability refers to a mental shortcut approach where a solution is found based on something readily available or recallable. It is a method of relying on your memory with recently witnessed information or a frequently occurring circumstance because it would have a higher probability of offering an immediate enough solution to a complex problem.The most prominent example would be that investors who experienced losses in the 2000 or 2008 market crashes would likely have stayed away from investing in risky assets like equity. The most notable example is that investors who suffered losses in the market crashes of 2000 or 2008 would probably have refrained from investing in risky securities like equities.
- Affect, as the name suggests, has everything to do with our emotional responses, and the decisions might turn out to be emotional biases. The decision-making process has much to do with people’s present states of mind or emotions.Because of your mental state at the time, you might have decided against a fantastic investment opportunity. Therefore, the decision outcome would be predictable if they were happy, and it might not be positive if they were depressed. In either case, there may be a serious lack of judgment because of the emotional impact.
How does any of the Heuristics Approach impact our Decision Making Ability?
Big investors and financial analysts have a lot of data to make a concrete decision, but they need to reach a conclusion quickly in case of a time crunch. Moreover, the human brain has its limitations in dealing with, and processing, too much information; having too little could cause significant discrepancies. So, in both cases, the heuristics technique impacts the decisions, and here is how:
- The technique helps reach a quick conclusion and connects the dots with the most perceived outcome of a situation or a problem. The shortcuts are mental calculations, especially in personal finance, to create a near-concrete by-product or gain.
- Heuristics is a mind’s reaction to a situation demanding a quick solution. So, when making financial decisions, experts do not want to cause significant losses due to late decision-making. Loss aversion can occasionally affect choices, and vice versa.
- If decisions are made thoughtfully with enough experience, they could lead to expectant or desired outcomes. However, under emotional biases, the judgment could go significantly wrong, and the results wouldn’t be as expected.
While heuristics may be an excellent technique for quick decision-making, there are other factors too that can lead to poor decisions. Because you might perceive a situation as being similar to one from the past, there is a chance that you will make a poor decision, but the odds are constantly shifting, particularly in finance. The technique might not always work, and not every issue would be a standard. The best results can always be obtained through data and information analysis; mental shortcuts are occasionally the only appropriate method.