Heuristics and biases in decision making

Heuristics and biases in decision making

This is the first post in a series where I’ll be sharing some behavioural economics research with you. Specifically, the series will focus on the heuristics and biases that influence our relationship with money. Using market research and case studies in behavioural finance, relevant findings will be broken down into easy-to-understand examples. This first instalment uses System 1 and System 2 thinking examples to help us be more conscious of the workings of our brain. This will then aid the understanding of how heuristics and biases in decision making impact our behaviour with money. As we work through the series we’ll (hopefully) collectively become better at how we make our money decisions and how we interact with others in the same regard.

To begin, indulge me by doing this quick quiz. There are three questions. Grab a pencil, read the question and write down the first answer that comes to mind. Don’t think about it too much, just go with your first response.

  1. A bat and a ball together cost $110 in total. The bat costs $100 more than the ball. How much does the ball cost?
  2. If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?
  3. In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take the patch to cover half the lake?
Heuristics and biases in decision making
Heuristics and biases in decision making
Heuristics and biases in decision making

System 1 and System 2

Before we discuss the answers to the quiz, I need to introduce some of the breakthrough research that Daniel Kahneman, Nobel prize winner, has done on human decision making. His book, Thinking Fast and Slow, was a New York Times bestseller and is compulsory reading for any scholar in behavioural science. His work highlights that our brain has two operating systems, which we call System 1 and System 2 (think fast think slow).

System 1 makes up 95% of all our thinking. It is commonly referred to as fast thinking as it is unconscious, effortless and automatic thinking. It assesses a situation and quickly delivers an update on it.

Differently, System 2 is slow thinking. It is our controlled rational thinking. It is conscious and deliberate. It seeks out new or missing information when making decisions. As it requires effort to engage System 2, it’s understandable that it makes up less than 5% of all our thinking.

Let's look at this question as an example:

How many animals did Moses take on the ark?

Few people detect what is wrong with this question. So much so that it’s been dubbed the ‘Moses Illusion’. The fact is that Moses took NO animals onto the ark, Noah did!

Fast System 1 invests as little resources as necessary, so that things run quickly and smoothly. Thus, because Moses is not abnormal in a biblical context, System 1 unconsciously detects an association between Moses and the ark and quickly accepts the question. System 1 thinking generates context without you even realising it. And that context is often generated based on previous experience.

System 2 likes to think that it’s in charge and that it knows what’s going on, but that’s not the case. It’s actually in System 1 where things start and our fast brain which sends suggestions to our slow brain to evaluate. It’s not so much about System 1 vs System 2 thinking. Rather, problem solving happens in a dual process across both systems.

“

…think of the two systems as agents with their individual abilities, limitations, and functions.

Daniel Kahneman

Thinking slow and fast

Popular media suggests that we make about 35,000 decisions each day. This may sound like a large number, but if we consider that we daily make 221 decisions about food alone, it put’s it into context. If we had to consciously process each one of these decisions, our brains would crash. Imagine the effort to deliberately decide to put your right foot forward, then your left foot forward, when walking? This is why we need our quick thinking System 1. It helps prevent cognitive overload when performing mental activities. But in order for our System 1 to work so quickly and subconsciously, it uses a lot of shortcuts (also known as heuristics) to do so. This is where mistakes creep in, and this is where the behavioural biases which we’ll be discussing thrive!

System 1 is extremely beneficial in everyday life. If every mental activity we did, like brushing our teeth, required full mental effort, it would be exhausting. Click To Tweet

What are heuristics

System 1 and System 2 thinking examples

The heuristic psychology definition is derived from the Greek word meaning “to discover”. We should be thinking about it as a sort of problem-solving method which uses shortcuts in the decision making process to produce solutions within a limited timeframe or deadline. Given the limitations, the results from using different types of heuristics and biases in decision making are often not optimal. But they’re good-enough.

These shortcuts which our Fast System 1 brain uses save us the mental energy that is required when we use our Slow System 2 brain. Some people refer to System 1 as their intuition, gut feeling, or best-estimate. We review the information available, connect that to our experience, and then make a decision. But as previously alluded to, these decisions are often wrong. (And you’ll shortly see how wrong when we go through some System 1 and System 2 thinking examples.)

What are heuristics

The heuristic psychology definition is derived from the Greek word meaning “to discover”. We should be thinking about it as a sort of problem-solving method which uses shortcuts in the decision making process to produce solutions within a limited timeframe or deadline. Given the limitations, the results from using different types of heuristics and biases in decision making are often not optimal. But they’re good-enough.

These shortcuts which our Fast System 1 brain uses save us the mental energy that is required when we use our Slow System 2 brain. Some people refer to System 1 as their intuition, gut feeling, or best-estimate. We review the information available, connect that to our experience, and then make a decision. But as previously alluded to, these decisions are often wrong. (And you’ll shortly see how wrong when we go through some System 1 and System 2 thinking examples.)

System 1 and System 2 thinking examples

Cognitive biases

Now that you’re familiar with heuristics in psychology, the next step is to understand that a side-effect of using these shortcuts, is that it causes us to suffer from cognitive biases. Before we get too stuck on the psychology jargon, cognition is a term which refers to the mental process or action that is used to acquire knowledge and comprehension. These cognitive processes include remembering, thinking, knowing, judging and problem-solving.

We use heuristics (or mental shortcuts) to derive a solution to a problem. When a systematic error results from the use of heuristics in decision making, it’s called a cognitive bias. This most often happens when the heuristic doesn’t match the environment (either because the environment has changed or your ability to appropriately assess the environment is impaired).

Heuristics and biases in decision making

In South Africa, we call traffic lights ‘robots’ (don’t ask)! If I had to give directions to someone and say ‘turn right at the robots’, they would understand perfectly. If I had to do the same in the US, I’d likely be looked at very strangely. That naming convention works in my home environment, but it doesn’t work when I go out of it.

Heuristics and biases in decision making

In South Africa, we call traffic lights ‘robots’ (don’t ask)! If I had to give directions to someone and say ‘turn right at the robots’, they would understand perfectly. If I had to do the same in the US, I’d likely be looked at very strangely. That naming convention works in my home environment, but it doesn’t work when I go out of it.

Likewise, our parents did things a certain way and it might have worked for them back then, but it might not necessarily work for us now. As many of our heuristics come from past experience, we need to pay attention to constantly re-calibrate our beliefs and habits and check that they still fit the environment. When we don’t do this, and we repeatedly make the same mistakes because of these ‘misfit’ heuristics, they become biases.

Just because something worked in the past, doesn’t mean it will work again. Relying on an existing heuristic can result in incorrect decisions and the inability to improve processes. Click To Tweet

Fast and slow examples

Let me give you an example of how it all works together, System 1 and System 2 thinking, fast and slow thinking, heuristics and biases….

Let’s say you’re interviewing someone for a job position. The person steps into the room and you start using System 1 to make a fast judgement based on heuristics. These happen mostly unconsciously by your System 1 brain. If the person has tattoos you automatically think they’re perhaps too ‘out-there’ (affect heuristic), or if you have tattoos yourself you might like the person because they’re similar to you (similarity attraction bias). If the person is wearing glasses, your System 1 brain thinks he or she is smart (stereotyping bias). We are thinking fast!

Heuristics and biases in decision making
Heuristics and biases in decision making

Let’s say you’re interviewing someone for a job position. The person steps into the room and you start using System 1 to make a fast judgement based on heuristics. These happen mostly unconsciously by your System 1 brain. If the person has tattoos you automatically think they’re perhaps too ‘out-there’ (affect heuristic), or if you have tattoos yourself you might like the person because they’re similar to you (similarity attraction bias). If the person is wearing glasses, your System 1 brain thinks he or she is smart (stereotyping bias). We are thinking fast!

Your System 1 sends these suggestions to your System 2 without you even knowing the better. Your System 2 then spends the rest of the interview looking for anything to confirm the suggestions made by System 1 (confirmation bias). Thus, you make your final decision based on both operating systems, which use heuristics and are influenced by cognitive biases. We think fast and slow.

Knowing this allows us to understand that not all our first impressions are correct.

When it comes to making decisions, our rationality is limited by the information we have, the cognitive limitations of our minds, and the finite amount of time we have to make our decision. Click To Tweet

System 1 and System 2 thinking examples

Now that you hopefully have a surface level understanding of the two modes of thinking, let’s see how you did in the System 1 vs System 2 test I gave you at the start of this post:

  1. A bat and a ball together cost $110 in total. The bat costs $100 more than the ball. How much does the ball cost?
  2. If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?
  3. In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take the patch to cover half the lake?

Each of these three questions has an obvious but incorrect answer and a less obvious but correct response. In the first bat and ball question, the answer that comes to mind is $10 (when you’re thinking quickly). However, if you reflect on it for a little longer, you’ll notice that the correct answer is actually $5.

System 1 and System 2 thinking examples

Bat + Ball = $110

Bat – Ball = $100

2 x Bats = $210

Bat = $105, therefore Ball = $5.

This calculation requires mental effort. That’s why our System 1, which tries to work out an answer as quickly and seamlessly as possible, doesn’t get it right.

The answer to the 2nd widget question is 5 minutes, but 100 minutes is the incorrect answer often cited. And the correct answer for the 3rd lily pad question is 47 days, not 24 days.

These System 1 and System 2 thinking examples show you how your System 1 made quick work of the available information. If you didn’t get the correct answers your Slow System 2 is now compensating for that and challenging your original intuition or instinct.

We need to be thankful for System 1. Despite it’s bad reputation, it’s valuable and comes with many benefits. It’s the reason we have survived as a species. It we had to rationally think about what a loud explosion is and analyse it carefully instead of being scared and running away from it immediately, we wouldn’t be here.

The problems arise when we use System 1 rather than System 2, when System 2 would have been the appropriate system to use. These lead to all the biases we’re going to discuss in this blog series, which are not optimal.

Heuristics and biases in decision making

The most important take-away is that we are irrational human beings. It helps to accept this reality. But, my challenge to you is to work through this series and learn about your behavioural biases and how to improve system 2 thinking. And then – once you understand them better, try to be more aware of what system you’re using to avoid repeating mistakes, particularly those that can get you into financial trouble.

Likewise – in our relationships with others, it’s important to remember that they too are irrational. It is often superfluous to try and convince someone of something using logic and rational arguments or facts. People use System 1 shortcuts and most struggle with statistics. Thus, they cannot reason the probable outcomes of their decisions (and most rational outcomes are ultimately based on the effect of probable outcomes). Rather, people use heuristics and biases in decision making, and we’ll work through several of these in the upcoming posts.

We need to find a compromise. We need to recognise situations in which we are more likely to make mistakes, learn how to engage System 2 thinking, and try our best to avoid making mistakes when a lot is on the line.

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More in this series on behavioural biases

If you want to jump ahead... see our other posts in this series:
  • Mirror, mirror, on the wall, stop telling me I’m wonderful – This post focuses on the impact of overconfidence bias in decision making. It introduces the illusion of knowledge bias and the illusion of control bias to illustrate the difference between confidence and carelessness. It also discusses the better than average effect, the self-serving bias and fundamental attribution error. You’ll learn how to confront some unpalatable truths and get out of any false sense of comfort (if you’re up for the challenge?).
  • Why you can’t argue with a vegan – Ballsy title, we know. But if you read the post you’ll (hopefully) understand why. We’ll be discussing confirmation bias. It’s one of those psychological biases that you can see everywhere. We’ll also touch on cognitive dissonance theory. We all struggle with these biases. They’re both humorous and serious. But because of that, it’s useful to know how to avoid confirmation bias when you need to.
  • Size does matter… when it comes to framing – This post uses framing effect examples to show how framing bias influences the way we interpret information and make decisions. We discuss glossing, the compromise effect, and how the size of the frame can influence the volatility of your investment portfolio.
  • Loss aversion vs risk aversion – Once you understand framing, you’re ready for this post. It introduces an incredibly powerful bias known as loss aversion. It also touches on prospect theory, the disposition effect and impression management.
  • Anchors pulling you down? – Anchoring bias is a straightforward behavioural bias that causes us to focus on a certain initial value and then make decisions with reference to it. This post looks at some examples of this anchoring effect.
  • The danger of the default – Default options nudge us to make better decisions. The option of opting out also respects freedom of choice. This post unpacks this notion of libertarian paternalism and the perils of status quo bias.
  • Regret, it’s not a nice feeling – Regret influences the decisions we make and pushes us to conform to social norms. Examples of regret avoidance show us how this makes complete sense yet no sense at all.
  • When the past influences the future – The Concorde effect is a famous example of sunk cost investment. Too often we invest time, money and energy into something we should’ve just abandoned. This post looks at some examples of how sunk cost fallacy affects our human decision processes.
  • What’s mine is more valuable – In this post, you’ll learn why you place extra value on things you own. The endowment effect has implications for our investment portfolio, bonuses and consumer behaviour.
  • How to improve self-control – Self-control is an essential life skill. It’s what separates humans from the rest of the animal kingdom. Learn how to improve self-control to achieve your long-term goals.
  • Procrastination is the enemy of success: We know procrastination is the enemy of success. But while it looks like laziness, it’s often just mental exhaustion at play. Learn how to overcome procrastination.
  • The problem with wanting it now – When you delay instant gratification, you will experience long-term satisfaction. It’s the hyperbolic vs exponential discounting debate. Don’t let present bias win!
  • The power of first impressions – The order of information influences your decisions. First impressions matter! It’s all got to do with primacy and recency effects.
  • Learn to deal with uncertainty – Risk and uncertainty will always surround us. Gambler’s Fallacy, the hot-hand effect, the law of small numbers & ambiguity aversion are just some of the biases that arise because of it.
  • Stop stereotyping – Representativeness heuristic refers to the fact that we stereotype. It’s a mental shortcut. But beware of making unfounded comparisons.
  • Mental Accounting – Money is money! Or is it? Mental accounting says we place different values on different money which leads to irrational decision making.
  • Money Illusion– Money illusion is a sneaky bias. It causes us to focus on the amount of money in our hands, rather than it’s purchasing power.
  • Home bias – We invest close to home and in what we know. But this lack of diversification results in missed opportunities. Say hello to ‘home bias’.

Do you often make quick decisions that end up being wrong?

Do you have a story to share about how you tried doing the same thing in a different environment and it did not work?

Let us know in the comments below.

Making systematic errors with your money?

Interested in understanding your behaviour better?
Let us help

Do you often make quick decisions that end up being wrong?

Do you have a story to share about how you tried doing the same thing in a different environment and it did not work?

Let us know in the comments below.

Making systematic errors with your money?

Interested in understanding your behaviour better?
Let us help
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About the Author

I am passionate about helping people understand their behaviour with money and gently nudging them to spend less and save more. I have several academic journal publications on investor behaviour, financial literacy and personal finance, and perfectly understand the biases that influence how we manage our money. This blog is where I break down those ideas and share my thinking. I’ll try to cover relevant topics that my readers bring to my attention. Please read, share, and comment. That’s how we spread knowledge and help both ourselves and others to become in control of our financial situations.

Dr Gizelle Willows


Dr Gizelle Willows

 

PhD and NRF-rating in Behavioural Finance