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Behavioural Finance: Heuristic methodologies

Sara from VF

Author: Sara Diamante

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Date of Publication: 13/06/2023

Errors or practices?

Often using the word decision error or behavioural bias assumes a negative meaning. Errors are such when the theoretical model is examined. Such an operator does not exist, so the word error should be scaled down since it describes the normality of behaviour. Even if they are normal, however, such behaviours lead to deviation from the financial optimum.

behavioral finance

What drives the investor to encounter such behaviours?

Certain client decisions are often labelled as irrational, but such demands originate from a lack of financial knowledge. If an investor doesn’t recognize the concept of risk-return trade-offs, the demand for risk-free gains is a rational demand, given his information set.[

Financial education is measured by knowledge of four different parameters:

Interest rate

Compound interest rate

Inflation rate

Risk diversification

According to some recent studies, one in three adults in the world is financially literate.In addition, besides there being high financial illiteracy, the index of mismatch between social classes and genders is also quite substantial. Most of the entities that carry out financial education are banking institutions, banking foundations, trade bodies and associations, and consortia of various kinds.

Financial Education

Moreover, there have been many initiatives over the years to address this situation, but it is still confusing and uncoordinated. One attempt to focus public efforts in a unified direction was made by the United Kingdom, through the CFEB(Consumer Financial Education Body). This had the task of raising the nation's financial capability. The centrality of counselling in this process is very important; it is necessary to offer generic financial counselling to improve financial capability.

Other causes influencing investor choices

The lack of financial knowledge is one factor, but not the only one that can explain why in making decisions, we deviate from best practices. In fact, there are other emotional and psychological factors that have been interpreted and summarised in behavioural finance.

Behavioural finance assumes that investors make their choices based on the expected utility theory. The latter involves a rather stringent assumption, that is, it invents homo economicus, a subject:

● Rational in perceptions

All information is acquired and processed according to probability theory.

● Rational in preferences

The preferences everyone has are pre-existing, stable, and consistent.

● Rational in the selection process

It is aimed at maximising preferences given market constraints.

Furthermore, countless studies demonstrate various inconsistencies between homo economicus and the individual forced to reason under conditions of uncertainty. The latter makes the use of a limited number of intuitive rules called heuristics that constitute the rules of behavioural finance. Traders use reality to determine cognitive rules, the result of approximations. So, such rules work well, but in some cases, they may be incorrect and can lead to systematic errors.

Heuristic rules

We can identify four major macro areas:

1. The heuristics of representativeness

2. The heuristics of availability

3. The heuristics of anchoring

4. The heuristics of affection

1. Representativeness

It refers to the tendency to resort to stereotypes when we are called upon to make decisions. Actually, it is the likelihood we ascribe to an event depends on how representative it is of a certain class.

2. Availability

Individuals tend to attribute probability to an event based on the numerosity and ease with which they remember the occurrence of an event. Thus, probability is estimated through the intensity with which such facts are available in our memory.

3. Anchoring

The habit of anchoring ourselves to a piece of information deemed important or to an initial hypothesis. The anchor may derive from the value previously assumed by a certain phenomenon, from the way the problem is posed, or from random information.

4. Effect

Predict that both positive and negative emotions or feelings characterising the investor at a given time may influence his or her choice.

Ex-post errors

In addition to cognitive errors (committed ex-ante) there are also limits to learning (committed ex-post).

Confirmation error is an error that our mind makes whenever data comes in that either confirms or disproves our beliefs. Our mind takes into account the information that supports our view and underestimates the information that contradicts it.

● Strongly related to the confirmation error is conservatism. The error of conservatism generates the tendency to underestimate the received information and anchor ourselves in previous beliefs.

● The retrospective judgement error is how the memory of our evaluations changes when we learn of the outcome of the evaluation. Once we learn of the result the memory of what we thought is altered.

● Another error is the attribution error, which is the search for an external cause to blame for poor choices.

Cognitive dissonance is the tendency to reject an event when it conflicts with our preconceived ideas.

Reference List

Heuristics Meaning

An Introduction to Behavioral Finance

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