Mistakes Investors Make: Heuristics (part 3)

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Caption: The crash of 1929 leading to the great depression (credit: The Simpsons)

Heuristics are mental shortcuts our brain takes to make things easier for us. Some shortcuts are learned, while others are passed down through evolutionary traits. Using heuristics we may not get an exact answer but may obtain a close approximation of the answer, which may or may not be factually correct. Taking a look at some of the leading heuristics, we can understand the common mistakes investors make, and what can be done to avoid making such mistakes.

Some of the most common shortcuts (or heuristics) investors make include:

1. Trial and error

Trial and error requires a stock picker to pick stocks until they pick the right stocks or until they stop picking stocks altogether. While a trial and error method may work for some experiments, it doesn’t indicate anything when investing in stocks. Over different periods, different stocks may perform differently.

2. Rule of thumb

Rule of thumb places emphasis on experience rather than theory to approximate a result. For example, an investor may feel as a rule of thumb to always invest in the stock market when its PE ratio falls below historic levels. However, each investor must consider their personal position and for how long they’re capable of tying money to an investment until it gives a return.

3. Educated guess

An educated guess is a best estimation of a result. In some cases, an educated guess may be enough to make an investment, however, in most cases it may not be enough.

4. Availability heuristic

Availability bias is an investor’s bias towards information made available to them. For example, an investor may see property prices rising in their neighbourhood and make the assumption that the housing market is growing or the purchase of a house will be profitable. However, the real market may be in a downturn, with selected areas increasing in value.

5. Representativeness heuristic

A representative heuristic is an investor’s perception that past performance can represent future events under the same or similar circumstances. An example of a representative heuristic is an investment in a stock because the sector outperformed the market, however, the stock or sector may underperform the market in the future.

6. Scarcity heuristic

Things that are scarce are perceived to be more valuable. However, in the stock market, scarcity may mean not enough buyers or sellers for a particular asset, which makes the asset difficult to buy or sell without incurring losses. Observing trading volumes, total shares in the market, and the number of new shares issued can help investors understand scarcity better.

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