Behavioural finance: what are heuristics?

When you make decisions, do you research all the relevant information, do you consider the possible outcomes, do you weigh up the pros and cons, and do you feel you make a fully-informed, rational decision? Or do you make a guess? Do you use a tried and trusted shortcut? Do you use a heuristic?

What are heuristics?

Heuristics are a subfield of cognitive psychology and behavioural science. They are shortcuts to simplify the assessment of probabilities in a decision making process. Initially, they dealt with cognitive biases in decision making, and then encompassed emotional factors.

The primary concern of the research was to understand and reduce the deviations from rational choice models. However, the research found that those biases were often systematic, or not random, and therefore they could be predicted.

What is important about heuristics?

Why focus on heuristics? The sociologist Herbert Simon introduced the concept of bounded rationality: if the decision making process is subject to constraints in terms of time and capacity to search for and process information, then the process will be satisfactory rather than properly rational.

And if decisions are not properly rational, how exactly are decisions made?

Why would a decision-maker use heuristics?

There are many reasons.

• Decision-makers might be unfamiliar with the technicalities and methods to solve a problem, or they might not have the necessary information to do it.
• Rules of thumb might be an effective (if not efficient) way to cope with sorting an overflow of information or searching for the proper piece of information.
• Finally, heuristics might be more efficient and effective when there is great uncertainty, or when the results of following the rules of thumb are close enough to the ‘proper’ solution.

We can justify the use of heuristics by bounded rationality and information overflow, but sometimes heuristics are misused. Decision-makers sometimes choose incorrectly when and what to use as rules of thumb, leading to unwanted consequences.

What are typical rules of thumb?

Anchoring and adjustment are typical rules of thumb. Decision makers anchor their reasoning to familiar states of the world.

When asked to guess whether or not the population in Greece is greater than 30 million, decision makers may give an answer (not necessarily correct). If asked, right after, how much the actual population of Greece is, they are extremely likely to reply with a number not far from 30 million, the anchor of the previous question.

Availability is another good example. When assessing the probability of losing their jobs, people usually put more weight on information that is more ‘accessible’, ie, readily available or easy to recall (because of its importance or it was recently gathered).

Understanding heuristics for financial regulation

There is not a systematic theory of heuristics yet, but understanding their use and formulation is overwhelmingly important for regulators, and for the decision-makers themselves.

Sometimes, those making decisions are unaware of the heuristics they use, and in some cases, they are even unaware they use heuristics. Sometimes decision-makers use heuristics in an intuitive and naïve way, sometimes there is a contrast between different heuristics, and in some cases they use these mental shortcuts impulsively, obtaining unwanted results.

A proper theory of heuristics would help decision-makers to use this powerful tool effectively, hopefully, accompanied by an increase in statistical and numerical accuracy.

Finally, understanding how people make their choices would help regulators to design effective policy measures.