Heuristics are “rules-of-thumb” that produce efficient judgments and decisions. Daniel Kahneman and Amos Tversky popularized these rules in their research and Kahneman’s book, Thinking Fast and Slow. In his book, Kahneman explains our System 1 and System 2 brains.
System 1 controls fast, intuitive thinking, while System 2 is slow and deliberate. Heuristics are a process of System 1.
There are three main mental heuristics.
The availability heuristic produces judgments based on easily accessible information. The System 1 brain follows the most efficient path, relying on easily accessible memories.
For example, suppose a member of your family recently experienced tornado damage. The experience may cause you to overestimate the probability of another tornado. This heuristic is often the culprit behind errors like recency bias.
When evaluating a security, many investors overweight high-visibility information, like a recent earnings report or a friend’s recommendation. The rapid judgment offered by the availability heuristic can lead to damaging biases.
The affect heuristic is a mental shortcut that relies on emotional reactions to make a quick judgment. For example, a restaurant will likely not offer an obscure dish if similar meals produced negative emotions in the past.
An investor may refuse to trade a specific security because of previous trading failures. The negative emotions experienced after a loss may influence their judgment. In the extreme, fear may prevent investors from re-entering the market after a significant downturn, also known as the “snake-bite effect.”
The representativeness heuristic is a shortcut that compares a difficult situation to a previously formed mental picture, simplifying the required judgment. The representativeness heuristic produces a decision based on what a person or object “should” resemble, similar to stereotyping. These mental representations are often accurate and save valuable time, but they can also be incomplete and discriminatory.
Investors often compare the current market to their previous memories, ignoring the present unique variables. The representativeness heuristic may judge the current environment similar to a previously successful trade, but that judgment is likely biased. Just as we often ignore someone’s individuality in favor of matching them to a group, investors ignore the individual attributes of a trade and overweight its similarity to previous experiences.