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Heuristics: Decision-making trap?

Jun 24, 2008

‘Heuristics’ pertains to the process of gaining knowledge or some desired result by intelligent guesswork rather than by following some organised hypothesis. In other words, heuristics is the process of doing mental shortcuts for complex decision-making. As human psychology plays a vital role while making investment decisions, heuristic is very pertinent to investment decision-making. While making their investments in stocks, many investors use heuristics. Although it appears that they are taking more rational decisions, but most of the times, the decisions are fast and frugal. In fact, it is easy to fall into trap of bad decision-making habits without realising it.

How heuristics affect decision-making
Let us see how we use heuristics while making decisions of investing in stocks.

In general, people are insensitive to sample size and they draw strong inferences from small number of cases. In the stock market, investors can apply the same logic. They base their buying or selling decision on a very small set of information. For example - buying stocks only on the basis of price movement.

In other cases, people tend to get biased by information that is easier to recall and information that is recent. In the stock market, some investors generally end up buying stocks that they have at their top of the minds or those that have recently been in news. Another example that can be cited regarding this decision short-cut is investments in ‘famous’ stocks rather than ‘good’ stocks.

Bubble and crash in stock markets can be traced back to heuristic and biases market participants have. A positive run could inflate prices beyond rational levels while a negative run could depress them to unjustified levels.

How to avoid heuristic biases?
It is very important that investors do not get trapped into this kind of decision-making short cut while making investing decisions. To avoid this, investors should clearly understand their investing habits. It is pertinent to analyse how an investment decision is made - whether the same is based on some bias or is it based on proper research and analysis.

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