Heuristics and their role in Finance

Traditional financial theories assume that finance is a scientific field. This means that just like in a scientific problem, a perfect solution exists even for financial problems as well. According to them, investors have the necessary resources and are capable of finding a solution to every problem in the financial domain. In reality, this is not the case. Firstly, the existence of a perfect solution is questionable, to begin with. Secondly, even if such a solution does exist, investors do not have the mental and financial resources to find out the most optimal solution. In simpler words, the cost of finding an optimal solution outweighs the benefits of doing so. This is the reason why investors often use heuristics or mental shortcuts in order to make their investment decisions.

In this article, we will understand what heuristics are and how they impact decision making in finance.

What are Mental Heuristics?

Heuristics are often defined as mental shortcuts or rules of thumb, which are used by investors while making decisions. For instance, we often hear that if the price earning ratio of a share comes below 15, then it is a good buy. The reality is that the valuation of stocks is a complex endeavor. It cannot just be reduced to a single number, such as the price-earnings ratio. Hence, the actual use of such a number is a shortcut. In psychological terms, such a shortcut is called a heuristic. The bottom line is that by using heuristics, investors consciously omit some of the information in order to make faster decisions.

The Need for Heuristics

Investors use heuristics even though there are other ways to enable decision making. This is because there are certain distinct advantages related to heuristics. Some of them have been written below:

The first problem is that all the information required for a scientific solution may not even exist in the open market. Even if such information exists, the investors may not be able to collate all the information within a given time frame.

Even if they somehow get their hands on all the information, the optimization problem may be quite difficult. This is because each investor has their own objectives depending upon the time frame of the investment, risk tolerance, etc. Hence, it would not be possible to find a single optimum solution that would be palatable to everyone. Deciding on the objective of each investor as well as finding the optimal solution for these objectives would be a complex and cumbersome process. The likelihood is that there will be several parameters involved in the process, which will optimization particularly challenging.

In some cases, even if all the information is available in the market, the ability of the decision-makers to correctly perceive such information and make reasonable choices based on them would be questionable. This is like it is likely that decision-makers are prone to bias and would not be able to make the correct decision since they would find it overwhelming.

This is the reason that over time investors begin to realize that the cost of making calculations is far greater than the benefit, which is likely to be derived out of it. So they simply skip the decision-making process and start following the trend based on one or two parameters. This is how shortcuts and heuristics are born. It may seem like only the uneducated and uninformed users use heuristics. However, this is not the case, and even the most sophisticated investors may find decision making to be unnerving and may finally give in to the use of heuristics.

The bottom line is that there is a possibility that using heuristics may lead to poor decision making. However, these decisions will be made very quickly. In many cases, the speed of this decision making makes up for the loss of quality in decision making. This is because the stock market is a place where decisions need to be made at a fast speed. If investors spend too much time thinking and analyzing their decisions, they are likely to miss some of the best buying opportunities on offer.

Using Heuristics for Decision Making

The bottom line is that avoiding heuristics 100% of the time is not possible when it comes to financial decision making. Investors have to learn to live with heuristics. This means that they have to get comfortable with making decisions where they do not have complete information. This also means that all decisions being made are probabilistic in nature. Investors should be aware that there are inherent risks that these decisions might turn out to be wrong. Hence, it is important to recognize these risks and also to manage them.

This is where the field of behavioral finance comes into play. Behavioral economists have conducted several studies in this regard. They have identified the various types of biases that exist. They have even categorized them so that the investors are more aware of the types of possible biases that they are likely to be dealing with and what actions needed to be taken in order to avoid them.

The bottom line is that heuristics are a necessity in the investment world. Investors cannot completely avoid them. Hence, they are better off studying them and using them to their own advantage.