Behavioral finance FAQ / Glossary (Heuristic)

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Dates of related message(s) in the
Behavioral-Finance group (*):

Year/month, d: developed / discussed,
i: incidental

Affect Heuristic

See affect

Availability Heuristic, availability bias

01/2i,3i - 04/4i + see heuristic
(below), also :
rationalization,
cognitive trap, tunnel vision,
glamour stock, mindshare,
salient, reductionism

Heuristic (bias / shortcut / limited h.)

 

 


00/6i,8i,10i - 01/6i - 02/8i,10i
- 03/9i - 05/1i,9i - 06/1i
- 07/12i
- 08/5i +see availability heuristics,
anchoring, schema, framing,
representativeness,
rationalization,
automaticity bias...) + bfdef2

Still using Aunt Rose's cooking recipes?

Definition:

Heuristics are mental shortcuts / simplification we use routinely, more or
less consciously,

* to analyze situations,

* to predict their outcomes

* and take decisions.

Said more academically, they are preset models / schemas used as easy
and quick tools to bring solutions.

In money management, an activity in which there are times
when it is urgent to react,
heuristics, either well adapted or dangerously
biased, play an important part.

Useful or not?

Deciding lazily, by staying in a rut?

An heuristic, as an oversimplification and recurrent recipe can
be useful in decision making (see that phrase)...

...but only when dealing with recurrent
cases
(*).

(*) albeit even in that case it can freeze research for better
     solutions


Such a practice / rule of thumb
can easily fall into a damaging cognitive bias

when it:

in relation with:

1)

Becomes an
automaticity

/ habit (see those words)...

...if applied blindly even in
situations in which it
is irrelevant
, such as =


 

Rare events (see that phrase),

Cases when past solutions,

knowledge get obsolete and
maladapted
,

New issues or undetected 

evolutions that make usual
heuristics / paradigms obsolete,

Hidden details that change how
    to categorize the issue /
event,
    thus how to deal with it.

2)

Oversimplifies the
decision process...

...by using =

Limited information or

imagination (availability
heuristic), see below,

Or routine interpretation

models (representativeness
heuristic)
, see below also.

3)
Leads to
reductionism /
generalization
...

It tends to consider as general

explanations / rules =



Too salient but partial information,

Or pure and unverified first 

perception  / interpretation / fancy.

Or too primitive rules and criteria.

Then it overlooks factors and

data that are crucial to 
understand new situations.

A neglect that distorts individual 
and collective decisions.

4)
Freezes innovation,

through =


Neglect or hostility, out of laziness or  

because it is seen as heretical.

to use other methods (see
   
resistance to change)

to do research and questioning

(see cognitive dissonance

 

Is it sometimes related to too many
      or too few information?

Drowned in info?
Or thirsty for it?

An heuristic might compensate, as a first approach, too scarce
information
or, why not admit it, insufficient research for information).

Of course, it might help to make some initial opinion and use
temporary precautionary rule of actions.

In that case it will be compared later to the next events or to more
extensive information (see Bayesian probabilities, adjustment...).


An opposite peril lies in the "information bias" (see that phrase), to try
to accumulate too much information up to the last drop.

To gather all data, whatever their relevance and reliability, drowns us and
does not allow us to find the leading thread to understand the issue.

Also, as human beings, we must admit that it is impossible, or at least
that it consumes too much time, effort and means
, to gather and
integrate all facts and phenomena (see "cognitive overload" and
"attention biases"
), so we need some simple, even automatic practice
to face many situations.

Can "big data" save us (see numeracy)? Or make the issue worse?

More about the consequences, in general
      and also when markets are involved

Easy, speedy but dirty?

The pros

Heuristics as practical
and useful in many
cases
.

Such simplified
processes




Bring a gain of time and efforts, instead 

of having to "reinvent the wheel all the time,

Allow to act fast when needed,

Give a path to look for further exploration,
   like picking 
a fiber on the crime scene (but
   with the risk
that the mind get anchored on
   that first interpretaion).

Fit the "Occam's razor" principle, which  

states that, when in doubt, better use the 
simplest theory.

The cons

Heuristics can bring
cognitive biases
in
decision making.

They on their turn
cause activity and
price distortions in
markets.






 

 

  




 

For ex., investors often reduce
complex judgments by:

At the cognitive level, using simple rules 

thumbs (heuristics) to take decisions.

They might be affected by narrow
assumption,
limited
data or flimsy
routines
.

It can occur even when they think they
apply financial analysis, whether
fundamental, technical, quantitative or
even ...behavioral.

On the emotional level, deciding under
  
greed, fear, liking, dislike

Or even, at the operational level, acting

on pure autopilot / habits (see those words).

  Altogether, if we don't wonder how
     relevant are our
conclusions, a superficial
     and lazy
thinking.  

=> When those biases become collective;
     
they bring sizeable anomalies in
      financial
prices, return and volatility.

Some typical heuristics

Dubious recipe book

Description: relying on...

Type of heuristic

(see below + related articles)

...Immediate perception / impression /
   remembrance?

Availability
   heuristic / bias

...General belief / stereotype / repetitive
   pattern / category / relation ?

   (existing or illusory, relevant or not
   to the situation)

Representativeness
   heuristic / bias

Halo , reductionism,
   generalization

...Feelings seen as "instinct" or "intuition"?

...Often linked to love / hate, like / dislike

Affect heuristic

...Obsolete experience or solution,

...Or other simplified reference,
   description, or relation?

Anchoring

Framing

Selection bias

Not to forget Collective heuristics

  Take them with a lot
  of precautions!

"Conventional wisdom"

"Mainstream paradigms"

1) Availability heuristics, availability bias

Superintendent, I saw the cook with a knife in the kitchen,
why bother to look for other possible culprits?

Definition:

The availability heuristics is a cognitive bias / superficial
thinking /
oversimplification that narrows the
reasoning and
decision-making on :

How quickly and easily people recall or find a first

information,even if it refers to an anecdotal or event or to a
superficial / salient aspect of the situation, which acts as the
main reference / anchor
(priming effect).

Or how instantly they imagine the cause (the most likely
explanation
)
or evolution (prediction) for a situation.

Or how often people see an event, which makes them

think routinely that other events are just a repetition of it.

(here, we are close to a representativeness heuristic:
see that phrase below)

 

That biased mental process that "does not dig under the surface"
focuses on:

The most apparent, quasi magnetic traits / immediate
   perception
of a situation

The explanations, interpretations or consequences that come
    the
most easily to mind. For example relying on immediately

perceived probabilities without checking the real odds.

The most immediately available, or easy to imagine, information.

For example, glamour stocks keep on rising as information about
them become more and more widely accessible. Their fame rises
in parallel (see mind share), which attracts more and more buyers.


Sometimes copycat analogies with past situations

without analyzing if the similarities are real.

There is a neglect to enrich one's information on new evolutions,
and one's thinking in anticipating possible changes.

The tunnel vision allegory (see that phrase) illustrates that bias.

Also analogies inspired by what happens in unrelated other 
   
areas (see halo effect).

If this similarity game is not occasional, but becomes an ingrained
mental model / pattern, it reaches the state of representativeness
heuristic
(see below).

2) Representativeness heuristic, representativeness bias

Come on, supervisor, It seems to fit the chart,
so why bother to look further whether it will work?

Definition:

Representativeness is "to see patterns" in a more
formal
way than in availability heuristic, as the analogies
between
situations are assigned here to general preset
categories (stereotypes)

This type of heuristic bias / oversimplification is a form of mind
representation (see that word).

Here, some events are quickly, instinctively, without digging further,
assigned to concepts, images, rules or patterns that
seem to have strong
similarities.


Those general categories (stereotypes)
are either individual
or common to a whole group or a population).

This can lead for example to perceive a series of
coincidence
s as a pattern, or to see apparently similar
cases and events as obeying the same general process,
concept or rule.
See for example "cluster illusion".

In it extreme form, when coincidences or clusters are
taken as signs from the sky,representativeness heuristic
becomes superstition.

Thus, that heuristic, that might be useful to find a first explanation
path before looking further, can become a cognitive bias
when it narrows the reasoning and decision-making
on
how quickly and easily:


A belief that is usually widespread (*), and that deciders did not
  
make any effort to check, became a common decision criterion.

(*) For example among investors who did not do their homework
    
before buying or selling.

The decider becomes easily victim of a stereotype,
often drawn from past cases.

(like subscribing blindly to any IPOs because the last ones
were profitable for investors, not realizing that IPO
launchers will take advantage of that craze
with higher
prices).

The fastest, most clear cut and less complicated criteria and
    rule
of choices (routines) are taken as useful tools instead of
    trying to assess
the real situation by finding the real position
    of the cursor / thermometer.

Financial examples: As Martin Sewell says,
Technical Analysis is representativeness
.

Here are examples:

Finding a pattern (for example a price trend) in a too
   short / too
recent series of data which in fact are random 

There is a temptation to extrapolate it into the future.

Or expecting a reversion to the mean even in series of
  events too short
for that "law" to apply (see kurtosis, fat tails, 

small numbers, gambler's fallacy).

3) Affect   heuristic:

See that phrase.

4) Related phenomena:

See anchoring (single past reference),

See framing (reductive description / presentation)

See selection bias (focusing only on information that fit our
   interpretation)

Representativeness Heuristic

 

 


00/5d, 6i,10i,12i - 01/2i -
02/9i - 03/6i,11i - 04/7i
  -
05/1i,5i + see heuristic
(above), also image, perception,
cognitive, attention, neuro-
linguistic, framing, cluster
illusion, technical analysis

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

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