Well, ‘Behavioral Investing’ may sound like a fancy term but it is as old as the existence of behavioral aspects influencing investment decision making.Talking about behavioral influences on us, few of my favorites quotes catches the essence like no other;
"If you don't know who you are the stock market is an expensive place to find out."
-George Goodman
"The markets are moved by animal spirits, and not by reason."
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“Markets can stay irrational longer than you can stay solvent.”
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Heuristics – A mental shortcut / Rule of
Thumb:
Origin: from Greek ‘heuriskein’ for ‘to find’.
“When we do not have the ability or willingness to process complex
questions or have to choose out of multiple choices many times, we resort to a
quick way of decision making based on what we already know”- that is
'heuristics’. It is a quick way or approach that the brain adopts to reach to
the solution/conclusion. Many times heuristics are gained by trial and error
method. Heuristics give us fast answers in order to make a decision pertaining
to complex questions without involving yourself in exhaustive research and
analysis. Though in a day to day life routine decisions taken based on
heuristics are mostly prudent but It is important to note that not all such
decisions taken based on the heuristics may turn out to be the optimal/best
choice. Hence, these decisions are prone to error.
We daily apply heuristics, period. But why?
Well, we have increasingly come to know that our brain cannot process way to
complex things and also our system 2 (as described
in the book: ‘Thinking fast and slow’) is lazy processing complex set-ups as
processing complex set-ups consumes a significant amount of energy. Hence,
naturally and sometimes after training our brain starts developing a mental
short cut to process or perform tasks.
Example from daily life:
1. How
many times you have bought the product just because it was ‘limited edition’
product or having only a few units left? When our decision to buy a product is
majorly driven by scarcity of the product rather than
requirement/utility/feature of the product – we are affected by ‘scarcity heuristic’.
Example from investment world:
1. The rule of 72 is heuristic. All it
provides is the quick but not precise answer to the question of how many years
it will take to double my money at a given interest rate.
2. Asset managers, investors and financial
professionals apply heuristics to speed up the investment decisions based on
limited data set. ‘Copycat investing’ can
be termed as heuristics, where an investor is trying to follow blinding other
famous investors’ strategies.
One of the very famous heuristics which
distort investment decision making is ‘representativeness’.
Representativeness Heuristic:
Investors can be under a heavy dose of
representative bias when they make long-term investment decisions based on
recent (last few quarters or last few years) performance of the mutual
funds/stocks etc.This bias also hit us hard when we choose a particular broker
or a stock analyst because of his stellar performance in the last few quarters.
In this context, when a very small sample time frame is taken for the analysis
purpose and labeling (hot or not so hot!) of a particular mutual fund/
stock/broker/ analyst is done based on performance during that time frame -we
are likely to make faulty long-term investment decisions.
Applying heuristics have advantages as well
as disadvantages.The art is to know
where not to apply heuristics!
Cognitive errors (Biases) and emotional
biases will be up for a brief discussion in the next blog.
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