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Key Concepts

The key concepts/ideas in Behavioural Finance that go some way to explaining how and why we make poor decisions are the use of heuristic techniques, biases and context.

Heuristics

On a daily basis we use heuristics techniques in decision making, it is a way we process information. What this means is, we take a simple approach to problem solving, that may not take into account all variables, but will produce a quick and satisfactory result, but may not be 100% accurate. Examples of this are: rules of thumb, making educated guesses, intuitive judgment, stereotyping, trial and error, or simply applying common sense.

Heuristics help simplify our lives on a daily basis. They are ingrained and have evolved over thousands of years.

However, heuristics don’t work in all situations and can lead to systematic deviations from logic, probability or rational choice. These systematic errors are called cognitive biases.

Biases

We are all biased. Whether we are looking at the markets, meeting someone for the first time or just having a coffee with a friend, we are all biased in our thinking in some way.

Our entire life is seen through filters, or biases, that we were either born with (via human evolution) or have developed ourselves through our own experiences.

There are two main types of bias: cognitive and emotional.

Cognitive biases are the result of an error in the way we process information. This can be because we don’t have all the information or we just aren’t analysing it correctly or we make assumptions that just aren’t correct.

Emotional biases are the result of social influences and life experiences. We make decisions and take action based on feelings instead of facts. Herd bias/behaviour for example is a common tendency to adopt the opinions and follow the behaviours of the majority to feel safer and to avoid conflict.

Not all biases are considered to be bad or cause irrational decisions. Psychologists believe that many biases serve an adaptive purpose – they allow us to reach decisions quickly and with a sufficiently suitable outcome.

Biases need to be understood, avoided or beneficially exploited.

PROSPECT THEORY - LOSS AVERSION - CONFIRMATION BIAS - OVERREACTION - MENTAL ACCOUNTING - HERD BEHAVIOUR - GAMBLER’S FALLACY - ANCHORING - FRAMING

Context

Context is very useful when it comes to problems. We evaluate almost everything by comparing it with something else. A lot of the time this is useful, however sometimes it can lead to illusions. These illusions lead us to make irrational or illogical decisions.

Look at this, which side of the bar is darker?

It is in fact the same colour throughout.

Optical illusions occur because perception depends on context.

  • Colour (and size) problems are all perceived relative to context, in other words to surrounding information, be it light, size or other factors
  • It is useful because context often has relevant information, though sometimes leads to wrong judgments (illusions)

Looking back at the image again, even though you now know the bar is the same colour; you physically still can’t see it with the context of the varying grey background.

As with visual perception, in choice problems we evaluate options by comparing them with alternatives, but as with visual problems, context can lead us to irrational or illogical decisions.

Here is an example:
These two scenarios would allow you to walk away with at least $1,500. But depending on the context of the option you may not end up with $1,500.

Most people choose Option 2 for Scenario 1 and Option 1 for Scenario 2.

The context for Scenario 1 was about gaining money.

When it comes to gains, we are willing to settle for sure gains, rather than take a risk for even more. Not an unsurprising result.

The context for Scenario 2 was about losing money.

Humans don’t like to lose, which is not fundamentally illogical, but it is the decisions we make when faced with loss that we depart from logical reasoning. Rather than settle for a sure loss, people gambled not to lose anything even if it could lead to greater loss – the risk is worth it.

We willingly engage in risk-seeking behaviours when we can limit our losses.

So the context of the choice again has led to illogical behaviour.

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