Heuristics

In broad terms, a heuristic is a cognitive activity of creating something. However, in the article we narrow this definition down to a group of techniques that people use in order to generate fast and easy solutions to a problem within a limited time period. This definition of heuristic is used in behavioral economics. Investors might use this approach to facilitate investment decision making, sometimes even subconsciously. 

On the one hand, heuristic techniques frequently lead people to mistakes, on the other hand, they can be of great assistance in situations when achieving a perfect solution is either unfeasible, unreasonable, or just hard. Especially, when there is a shortage of time.

Heuristics include such techniques as availability, anchoring, familiarity, affect, and many others. Most of the time these hasty conclusions happen subconsciously. Also, these rules of thumb (e.g., trial and error, past formulas, historical analyses) are derived mostly from experience rather than from precise calculation and investigation. 

Origins of Heuristics 

Heuristics trace its roots back to ancient times. It has been developed at the intersection of sciences and humanities – philosophy, psychology, computer science, and other fields.

In terms of behavioral economics, heuristics gain relevance along with technological development. A lot of activities that were typical a few years ago, now become useless due to technological progress. For example, we don’t have to go out to order food. We can easily make it without leaving the house via delivery software.

All of these programs and services gain an enormous amount of information, which has to be upheld, reviewed, and modernized. When a specialist confronts such big and complex data it might be more reasonable for him or her to simplify the one's work rather than put maximum effort into analyzing it. This is where heuristics come into play.

In this context, we should pay attention to the scientific works of Herbert Simon who studied the reasons for managers and investors' irrational decisions on the market. He detected that the market participants tended to use heuristic techniques instead of spending maximum time and effort on finding an optimal decision. Their solutions can be characterized as satisficing (the term is derived from “satisfactory” and “sufficient”), or searching for a sufficient enough option. Simon explained this tendency by a biological limitation of the human mind.

Simon’s work formed the basis of Prospect theory created by Amos Tversky and Daniel Kahneman between the 1970s and 1980s. This theory, in turn, formed the basis of behavioral economics and defined some of the most common heuristic techniques that people tend to use while making financial decisions.

One of the most important theory’s outputs is that people’s suffering from losses is way stronger than excitement for their profits. Therefore, they are prone to ignore the risks of possible losses or, in contrast, avoid them at any cost. Either of these tendencies might lead them to irrational financial actions.

Pros and cons of Heuristic techniques

We’ve already mentioned the most important benefits of heuristic approach – it’s time and effort saved while solving difficult tasks. It’s hard to underestimate the price of time these days. Also, heuristics help you to make decisions with minimal data presented. But let’s draw attention to some of the disadvantages of these techniques.

Despite the fact that heuristics and rules of thumb are generally accessible for everyone, they might not be suitable for a specific time, person, situation, or other circumstances. Therefore, heuristics frequently lead people to mistakes. The question is whether these mistakes will be significant enough to cause people serious damages, or they will be outperformed by the advantage of saved time. For instance, if you copy someone else's investment strategy without conducting quantitative and qualitative analyses, then you might risk suffering losses, because the copied strategies can be useless or even harmful under certain circumstances. Investors who copy successful strategies of other traders are otherwise known as copycat investors.

Another less obvious disadvantage of heuristics is that you feed your unproven assumptions by constantly using these techniques. Every successful experience based on the heuristic conclusions will ensure you in their rightness, although they still remain unproven.

Types of Heuristic techniques

There are different types of heuristic techniques for solving problems:

• Availability – is a tendency of jumping to conclusions. Some events or facts evoke strong emotions that lead people to fast conclusions towards the frequency or severity of these events. For example, a person sees a movie about sharks attacking people, gets scared, and subconsciously starts to worry about getting attacked by sharks, thereby avoiding swimming in the sea. Another example might be about fear of investing in some sort of securities because of the previous unsuccessful experience of doing that.
• Representativeness – is also a mental bias of knowing the results based on the previous experience or some similar information. Basically, if you see that something has happened under certain circumstances, you assume that this would happen under the same circumstances again. For example, company A sells toys in the US and recently has entered the Chinese market. This decision leads to the successful results and its stock prices rise up significantly. Company B, also selling toys, intends to make the same move. A financial analyst might compare these situations and suggest that company B will repeat the success of company A. Due to the heuristic representativeness the analyst has saved his time by passing precise research on the previous performance, costs of production, quality of products of company B. However, the suggestion about the success of company B might be wrong. There is the main pitfall of every heuristic technique.
• Anchoring and adjustment – is another heuristic assumption that people often made. It refers to the tendency of sticking to an anchor, or a certain number/level/value in estimating something. This technique can be extremely helpful when you need to find an orienting point, but as any other bias might lead you to a serious mistake. For example, you might overpay for some securities or commodities by using the wrong anchor for making investment decisions.
• Satisficing – is the heuristic technique of choosing something sufficient or affordable enough instead of a perfect one. For example, you want to buy a certain pair of jeans, but eventually, buy a similar one that you find first.