Heuristics
In the end of 1960s, the series of academic papers on judgment and decision making by psychologists Amos Tversky and Daniel Kahneman[1] revolutionized academic research on human judgment. The main idea was that by making decisions under uncertainty people often relies on a limited number of simplifying heuristics rather than follow the laws of probability of the principles of statistics. The dictionary definition for the word “heuristic” refers to the experience-based techniques that help in problem solving and are used by experimenting, evaluating possible answers or solutions, or by trial and error.[2] Heuristics are in general useful and highly effective to assume decision in uncertain conditions but they are not perfectly accurate and also lead to systematic errors that are committed also by the people that operate in the financial markets. These heuristics surface in many different contexts, such as analysts' earnings forecasts, investors' evaluation of mutual fund performance, corporate takeover decisions, and the types of portfolios selected by both individual and institutional investors. Kahneman and Tversky originally identified three general heuristics: anchoring and adjustment, representativeness and availability heuristic that underlie many intuitive judgments under uncertainty. This chapter will describe the three main judgemental heuristics upon which financial participants rely and introduce some of the main heuristic-driven bias.
Anchoring and adjustment heuristic
Anchoring and adjustment heuristic refers to the decision-making process where quantitative assessments are required and these assessments can be influenced by suggestions.[3] When people are faced with uncertainty and have to estimate value or size of quantity, their decisions are usually based on an initial “anchor”. This means that people by forming estimated often use some reference points and start with some initial value that influence them at the moment, and...