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Behavioral Finance

Behavioral Finance: A Sneak Peak into OVTLYR’s Approach (Part 3)

By Mahesh Kashyap

(Ir)rationality

Generally, people are not rational. They are efficient. The vast majority of our day-to-day choices are decided heuristically, where we rely on the outcomes of previous decisions and their similarity to the one currently being made. For example, you may check traffic reports before your first day of work in a large, unfamiliar city, but soon you will develop a reliable pattern that – outside of a major catalyst, say, a blizzard – eventually becomes “your” route. When approaching a red traffic light, you don’t stop to consider the low probability of receiving a citation for blowing through it. You don’t even think about the high price to pay for potentially causing a major accident, because you’ve already solved that problem in your head long ago. And so, you stop. When reading the word “blink,” over 75% of readers will physically blink (were you one?), but they probably didn’t do so after a thoughtful consideration of the rational merits of blinking at that time.

Blink again. Building on over 200,000 years of human survival, heuristic thought is estimated to be exponentially faster, more efficient, than rational thought, and without it we would be able to complete only a fraction of our daily tasks. These mental shortcuts also allow us to build upon prior information, saving us from repeating elementary decisions as we process more complex problems. However, we become error prone when heuristics and various forms of cognitive biases permeate areas requiring deeper analytical thought.

Psychologist and Nobel Memorial Prize in Economic Sciences winner Daniel Kahneman explores the depths of fast, heuristic logic and slower, methodical reasoning in his 2011 book Thinking, Fast and slow.

Cognitive Biases

As of today, there are over 200 identified, categorized forms of cognitive bias, roughly half of which can have a direct impact on the actions of a market participant. A fraction of those not only can have a powerful affect in terms of outcomes, but are also highly prevalent amongst most everyone you meet (including those you may find yourself trading against).