https://www.newtraderu.com/2023/04/19/heuristics-and-biases-in-decision-making-explained/#content
Recognizing
the flawed nature of your thinking is a bold first step to challenging
it. “Heuristics” are straightforward rules of thumb that we develop
based on past experiences. They are cognitive tools that help make quick
decisions or judgments. Much like intuition, heuristics is a shortcut
to making a decision. Essentially, it’s a more logical way of going from
point A to point G, H, I, J, and sometimes even Z.
Our
brains are incredible machines that process vast amounts of
information. However, we often rely on mental shortcuts to cope with
this complexity. These shortcuts, known as heuristics, help us make
decisions more quickly. Unfortunately, they can also lead to cognitive
biases, which are systematic errors in our thinking. This blog post will
delve into common heuristics and biases and discuss how they impact our
decision-making processes.
What are good heuristics?
Heuristics can also be helpful in
decision-making by simplifying complex information and allowing us to
make quicker judgments. The best heuristics encapsulate helpful
information in a way that is intuitive to remember and act upon but also
specific to their context. Their power lies in their ability to induce
people to take better actions. Here are some valuable heuristics for
various decision-making situations:
- The recognition heuristic: When faced with a
choice between two alternatives, if one is recognized and the other is
not, people often assume that the recognized option is better or more
reliable. This heuristic can be helpful when limited information is
available and recognition is a proxy for quality or relevance.
- Take-the-best heuristic:
In this decision-making approach, people compare alternatives based on a
single most important attribute or criterion instead of considering all
available information. This heuristic can be helpful when a quick
decision is required, and the essential attribute strongly predicts the
desired outcome.
- Satisficing heuristic: Instead
of searching for the optimal solution, people choose the first option
that meets a minimum threshold or set of criteria (i.e., “good enough”).
This heuristic can help in situations with time constraints or when the
cost of searching for a better option outweighs the potential benefits.
- Rule of thumb:
General principles or guidelines that have proven effective in various
situations can serve as heuristics. For example, “measure twice, cut
once” is a rule of thumb in carpentry to avoid mistakes and waste.
- The 80/20 rule (Pareto Principle):
This heuristic suggests that 80% of outcomes or effects often result
from 20% of causes or inputs. By focusing on the most impactful 20%,
decision-makers can prioritize their efforts and resources more
effectively.
- Ockham’s razor: This heuristic
states that the simplest one is often the best choice when faced with
multiple competing explanations or hypotheses. By preferring more
straightforward explanations, decision-makers can avoid getting lost in
the complexity and make more efficient judgments.
- The 2-minute rule:
If a task can be completed in two minutes or less, do it immediately
instead of postponing it. This heuristic can help with time management
and productivity.
Remember that heuristics are not foolproof
and can lead to biases or errors. However, in many situations, they can
provide a practical approach to decision-making, especially when time
and resources are limited or perfect solutions are unattainable.
Cognitive Biases
List of cognitive biases:
- Availability heuristic
- Representativeness heuristic
- Anchoring and adjustment heuristic
- Confirmation bias
- Overconfidence bias
- Hindsight bias
- Loss aversion
- Sunk cost fallacy
- Fundamental attribution error
- Self-serving bias
Availability heuristic
Imagine
you are asked to estimate the likelihood of a specific event. Your mind
might immediately recall-related examples or experiences that stand
out. This is the availability heuristic at work. While helpful in some
cases, it can also be misleading. Highly memorable events or recent
occurrences may seem more likely than they are, leading to incorrect
judgments.
Representativeness heuristic
When
determining the probability of an event or whether something belongs to a
specific category, we often rely on the representativeness heuristic.
This mental shortcut involves comparing the subject in question to a
typical example. The more similar they are, the more likely we judge
them to belong together. Regrettably, this can result in base-rate
neglect, where we overlook the actual frequency of occurrences in the
population.
Anchoring and adjustment heuristic
We
all make estimates and decisions. One standard method is starting from
an initial value, or anchor, and making adjustments from there. This is
the anchoring and adjustment heuristic. In many cases, though, we fail
to adjust sufficiently. Consequently, the initial anchor can have an
outsized impact on our final judgment or decision.
Confirmation bias
We naturally favor
evidence that supports our pre-existing beliefs when presented with new
information. Confirmation bias is the name for this tendency. We seek
out, interpret, and remember information that aligns with our views
while ignoring or downplaying contradictory evidence. This can result in
a distorted understanding of reality.
Overconfidence bias
Feeling
confident in our abilities is generally a good thing. Nonetheless,
sometimes we go too far. The overconfidence bias refers to our tendency
to overestimate our knowledge, skills, or the accuracy of our
predictions. This can lead to poor decisions based on unrealistic
expectations. This happens when ignorance creates confidence when
competence, knowledge, and experience are absent.
Hindsight bias
After an event occurs, it’s
not uncommon to believe we “knew it all along.” This is known as
hindsight bias. Unfortunately, this can cause us to overestimate our
predictive abilities and may even result in poor decision-making in the
future.
Several factors contribute to the development of hindsight bias:
- Cognitive factors:
Our brain reconstructs memories and simplifies complex information to
create coherent narratives. When we look back at past events, we tend to
focus on the information supporting the outcome while dismissing or
downplaying information contradicting it. This selective recall and
memory distortion can make past events seem more predictable than they
were.
- Motivational factors: People generally
want to believe they are knowledgeable and can predict or understand the
world around them. Hindsight bias serves this desire by creating an
illusion of predictability and control. By convincing ourselves that we
“knew it all along,” we maintain a positive self-image and protect our
self-esteem.
- Social factors: Sometimes,
hindsight bias may arise from social influences. People tend to conform
to the opinions or expectations of others, especially if they perceive
those individuals as more knowledgeable or authoritative. If a group
agrees that a particular outcome is predictable, individuals within the
group may adopt this belief as well, even if they did not initially
think so.
Overall, hindsight bias stems from cognitive, motivational, and
social factors. Recognizing this bias can help improve decision-making,
reduce overconfidence in our predictive abilities, and promote more
objective evaluations of past events.
Loss aversion
We
often exhibit an asymmetric response to potential gains and losses.
Loss aversion is the term for our tendency to be more sensitive to
potential losses than equivalent gains. Consequently, we may act
risk-averse when evaluating potential gains while engaging in
risk-seeking behavior to avoid losses. In the markets, this causes
traders and investors to hold losing positions and hope the price
reverses back to even because they hate to lock in a loss.
Sunk cost fallacy
Humans
tend to stick with decisions or projects in which we’ve already
invested resources. The sunk cost fallacy describes our inclination to
continue these investments, even when it’s no longer rational. This can
waste valuable time, money, or effort on unproductive pursuits. People
don’t want to lose the previous time or money they have invested in
something, so they will keep wasting more time and money to try to get
their original investment back.
Fundamental attribution error
When observing
others’ behavior, we often place too much emphasis on their personality
traits and not enough on situational factors. This is called the
fundamental attribution error. Such an error can lead to
misunderstandings and incorrect assumptions about the motivations behind
people’s actions.
Self-serving bias
We
like to think highly of ourselves. The self-serving bias is our tendency
to attribute successes to our skills and efforts while blaming external
factors for our failures. This helps maintain a positive self-image but
can hinder personal growth and learning.
Key Takeaways
- Heuristics are mental shortcuts that can simplify decision-making but may also lead to cognitive biases.
- The availability heuristic can cause us to overestimate the likelihood of memorable or recent events.
- The representativeness heuristic can result in base-rate neglect and incorrect judgments about probabilities.
- The anchoring and adjustment are heuristics that may lead to disproportionate influence from initial values.
- Confirmation bias can distort our understanding of reality by favoring information that supports our pre-existing beliefs.
- Overconfidence bias can cause poor decisions based on unrealistic expectations.
- Hindsight bias may lead to an overestimation of our predictive abilities.
- Loss aversion can result in risk-averse behavior for gains and risk-seeking behavior for losses.
- The sunk cost fallacy can lead to wasting resources on unproductive pursuits.
- The fundamental attribution error may cause misunderstandings about others’ motivations.
- Self-serving
bias can hinder personal growth and learn by maintaining a positive
self-image at the expense of acknowledging mistakes.
Conclusion
In
summary, heuristics and biases are essential parts of our
decision-making processes. While these mental shortcuts can help us
navigate the complexities of daily life, they can also lead to
systematic errors in our thinking. Understanding and recognizing these
heuristics and biases can improve our decision-making skills, develop a
more accurate perception of reality, and ultimately make better choices
for ourselves and those around us. Remember these concepts as you
navigate your personal and professional life, and strive to make more
informed and unbiased decisions.
