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There is no way around the fact that our behavioural bias affects our investment decisions when we are presented with uncertainty. The study of Behavioral Finance explores how we as humans make investment decisions based on our irrational bias.  Heuristic Behaviors play a significant role when making investment-based decisions. Here is what you need to know about these psychological factors and what you can do to avoid the pitfalls of them.

Heuristic Behaviors

Heuristics are mental shortcuts that help us make decisions and judgements more efficiently. Heuristics play an important role in both Problem-solving and decision-making. To cope with the tremendous amount of information that we are bombarded with daily, our brains rely on these mental strategies to simplify the decision-making process, so we don’t spend endless amounts of time analyzing every detail of a given situation.  While they can help us figure out a solution to a problem faster, they can also lead us to inaccurate judgements(Bias)  about how commonly things occur or how representative certain things can be.

Hence, relying on heuristics is like using a GPS to drive to your local grocery store - it's straightforward, reliable, and gets you to your destination efficiently. But for more complex matters like investment decisions, using these same heuristics can be as risky as using a simple street map to navigate a cross-country road trip through unfamiliar territories. The unpredictable variables, such as traffic, weather, or road conditions, require not only a map but also real-time updates, careful planning, and a readiness to adapt to changing circumstances.

Types of Heuristics

There are many types of heuristics, each plays a role in decision-making. But they occur in different contexts, and understanding the different types can help you better understand which one you are using and when, hopefully, in turn, helping you make better investment decisions.  

Representativeness

This heuristic involves estimating the likelihood of an event based on what we think the most relevant or typical example of that event or product would be. For example, an investor might access the quality of a company by its past performance, assuming that since the company has fared well in the past, it will continue to do so in the future.

The representativeness heuristic acts as a handy tool for simplifying decision-making but on the other hand it can lead us to neglect crucial statistical realities. In the context of investing, this means that an investor might disregard broader market trends or the dynamics of the sector in which the company operates. For example, while a tech company might have a commendable past performance, if the whole tech industry is experiencing a downturn, investment in this company could be risky.

Affect

A type of mental shortcut where people make decisions based on the current state of their emotions. Essentially your affect plays a critical role in the choices and decisions that you make, both big and small. Your judgment of the relative merits or drawbacks of a particular individual, activity, or entity significantly influences the decisions you ultimately make. Take for example researchers who have found that when you are in a positive emotional state, you are more likely to perceive an activity as having high benefits and low risk . On the other hand, if you are in a negative emotional state, you are more likely to see the same activity as being low in benefits and high in risk.

Essentially it refers to our natural human tendency to make decisions based on our emotions or 'gut feelings', instead of based on a thorough analysis or objective evidence. While emotions are a crucial part of the human experience, they can lead to oversights in investment contexts. This can happen, for example, when a negative sentiment towards a certain industry or company overshadows its strong performance metrics, or when an unwarranted optimism about a ‘next big thing’ leads to overlooking essential risk factors. Such decisions driven by the affect heuristic can ultimately culminate in poor investment outcomes.

The last word

In conclusion, our inherent human biases and heuristics shape how we perceive and act upon financial decisions. They simplify our complex world, making it manageable and efficient to navigate. However, when it comes to investing, these mental shortcuts can lead us down misleading paths, causing us to ignore vital data and overestimate/underestimate potential risks. Whether it's the Representativeness heuristic leading us to extrapolate the past into the future without considering broader market trends, or the Affect heuristic causing our emotions to cloud objective judgments, it's essential to be aware of these biases. It's important to take a step back, evaluate the bigger picture, and, above all else, seek professional advice. Working with a financial advisor provides the objective insight and expertise you need to navigate around these biases, ensuring your investment decisions are rooted in sound financial analysis, not cognitive shortcuts.

As we journey through the unpredictable landscape of investment decisions, let's not forget that our mental GPS - our heuristics and biases - needs occasional recalibration.  Here's to making more informed, rational, and ultimately rewarding financial choices in our uncertain world.

Ready to make smarter bias-free investment decisions? Click here to book a free consultation.

References

https://www.verywellmind.com/what-is-the-affect-heuristic-2795028#citation-3

https://www.verywellmind.com/representativeness-heuristic-2795805

https://doi.org/10.1002/(SICI)1099-0771(200001/03)13:1%3C1::AID-BDM333%3E3.0.CO;2-S

   

- Mitchell Cathcart, Marketing Assistant, Kondwelani Kalinda, Licensed Assistant & Financial Planning Associate and Grant White, Portfolio Manager at Endeavour Wealth Management with iA Private Wealth, an award-winning office as recognized by the Carson Group. Together, Endeavour Wealth Management provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Mitchell Cathcart Marketing Assistant, Kondwelani Kalinda, Licensed Assistant& Financial Planning Associate and Grant White, Portfolio Manager for iA Private Wealth and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.  

iA Private Wealth Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. iA Private Wealth is a trademark and business name under which iA Private Wealth Inc. operates.

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