The average adult makes 33,000 to 35,000 decisions each day. Thankfully, most are inconsequential and automatic, but a few may be more important and require a calculated approach in assessing the probability of uncertain future events. Many decisions are based on acquired beliefs or ‘heuristic principles’.
Have You Ever Heard of Heuristics?
In his book ‘Thinking, Fast and Slow,’ Professor Daniel Kahneman, one of the architects of Behavioural Economics, defines heuristics as “a simple procedure that helps find adequate, though often imperfect, answers to difficult questions.” We can think of these as mental short-cuts or rule of thumb strategies which allow people to solve problems and make judgements quickly and efficiently. In general, these heuristics are quite useful, but sometimes they lead to significant and predictable mistakes in decision making.
Some examples of heuristics are ‘availability’ which involves making decisions based upon how easy it is to bring something to mind and ‘anchoring’ which involves the tendency to be overly influenced by the first bit of information we learn.
Heuristics can lead to biases such as:
- ‘overconfidence’ which is the tendency for people to overestimate their abilities in many areas and,
- ‘loss aversion’ which is the notion that people feel the pain of a loss more acutely than the euphoria of a gain. Loss aversion is especially apparent in financial decision making. Investors tend to hold onto losing stocks too long or sell winning stocks too fast out of fear of realising losses.
The Gambler’s Fallacy – Probability Has No Memory!
Another interesting bias is the tendency to disregard probability when deciding under uncertainty. In general, people are not good at assessing probabilities. One well known example of this is ‘Gambler’s Fallacy.’ After observing a long run of red on the roulette wheel, most people wrongly believe that black is now due. Essentially, it is when one believes that an outcome is more or less likely to happen based on the outcomes they have previously experienced. Gambler’s Fallacy is often also called the ‘Monte Carlo Fallacy’ which got its name from an unfortunate event which occurred in August 1913 in a Monte Carlo Casino. During a game of roulette, the ball landed on black 26 times in a row. That represents a probability of 1 in 66.6 million! Gamblers in the casino began placing huge bets on red thinking that a long streak of red would now follow. They lost millions. The moral of the story is that probability has no memory and so one outcome does not impact the likelihood of the next independent event.
The Monty Hall Problem – Which Door Would You Open?
Another interesting example of how our intuitions and heuristics lead us to make poor decisions is the ‘Monty Hall Problem’. Monty Hall was the host of an exceedingly popular television game show from the 1950s to the 1980s called ‘Let’s Make a Deal’. In this show, a contestant is presented with three doors. Behind one of them is a new car. Behind the other two are goats. The contestant picks a door, say door one. Before opening it, the host, who knows where the new car lies, proceeds to open one of the other doors which contains a goat, say door three. The host then asks the contestant whether they want to switch or whether they will stick with their original pick. What would you do?
Most contestants would stick with their original pick, thinking that there is now a 50/50 chance of the car being behind the door they originally picked. This is a wrong assumption and the correct strategy would be to switch where you would have 2/3rds probably of picking the new car. The new information that the host presented, cannot be ignored and changes the probabilities in the contestant’s favour. Some may be familiar with this problem as it featured in a scene in the film ‘21’, starring Kevin Spacey, but the dilemma first became famous in 1990 when columnist for ‘Parade’ Magazine, Marilyn vos Savant, wrote that the contestant should switch. Vos Savant was known, at the time, as the world’s smartest woman because of her entry in the Guinness Book of World Records for having the highest IQ. She received thousands of angry letters many from PhDs in mathematics and statistics claiming that she was wrong. Even experts are susceptible to biases and cognitive errors.
Behavioural Finance: a Bridge between Theory and Reality to Help us Make Financial Decisions
The above examples illustrate that many decisions are not purely rational and that emotion and intuition play a role in practise. This has significant implications on people’s financial decisions. Traditional economic and finance theory is predicated on the assumption that everyone is rational and makes optimal decisions, when in real life, this assumption does not always hold. This idea is the foundation of Behavioural Finance, which attempts to combine elements of economics and psychology to understand how and why people, both as individuals and collectively as a market, behave the way they do. It provides a bridge between theory and reality which provides helpful insights in understanding investment decision making and market behaviour. Furthermore, Behavioural Finance can guide us to make better financial decisions.
Whilst they are difficult to control, being aware of our own heuristics and the biases to which they lead could improve judgements and decisions in situations of uncertainty. In a world full of algorithm driven social media advertising, artificial intelligence generated deep fakes, and political parties and Governments taking advantage of voter biases to influence election results, it is all the more important to develop decision-making awareness to make thoughtful and objective choices.
Written by
Michael Tabone, CFA
Senior Portfolio Manager, ReAPS Asset Management Ltd
Approved and issued by ReAPS Asset Management Limited. ReAPS Asset Management Limited (C77747) with registered address at APS Centre, Tower Street, Birkirkara BKR 4012 is regulated by the Malta Financial Services Authority as a UCITS Management Company and to carry out Investment Services activities under the Investment Services Act 1994 and is registered as an Investment Manager under the Retirement Pensions Act.
ReAPS Asset Management Limited is a fully owned subsidiary of APS Bank plc. APS Bank plc is regulated by the Malta Financial Services Authority as a Credit Institution under the Banking Act 1994 and to carry out Investment Services activities under the Investment Services Act 1994.
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