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Behavioural Finance - The influence the Affect Heuristic

Author: Adam Sideserf
15 February, 2016

What is the Affect Heuristic?

The affect heuristic is a mental shortcut that helps individuals make decisions quickly based on the way they feel (their “affect”) about a particular situation.

According to the latest research, if you have positive feelings about a certain activity then you are more likely to see the benefits of it as high and the risk as low. Conversely, if you are in a negative state of mind then you are more inclined to see the activity as being low in benefits and high in risk. Unfortunately, basing financial decisions on our emotional state rather than on a fuller understanding and appreciation of the likely outcomes could potentially lead to unfavourable results when it comes to our long term financial security.

Exaggerated fears

Our emotions not only dictate how we feel in our everyday lives, but they also exact a huge influence over how we feel, in general, about certain risks and how much we might dread certain outcomes.

Negative emotions, particularly fear, unduly influence our perception of risk. All of us have emotional attachments and associations with certain outcomes in different contexts, which, when it comes to making investment choices, can lead to illogical choices being made and opportunities being missed.

Loss aversion

Naturally enough, anyone who is considering how best to invest their money for the future will be keen to avoid any sort of financial loss. An aversion to such losses and a determination to avoid them can, however, come to cloud our judgment and leave us unwilling to take even the most sensible risks in the interest of seeing improved returns over time.

The affect heuristic essentially tells us that many of us are more likely to worry about what losses we might incur, or what hazards may lie ahead, rather that embrace the opportunities that are available to us and how much we might stand to gain.

Status quo bias

Most decisions that we make as individuals have a status quo alternative, which is to do nothing or maintain our current or previous decision. When it comes to financial planning, however, a preference for the current state of affairs can often lead to consumers simply backing themselves into a position of complete inertia with regard to their investments. This inactive and unengaged position is often described by the term “status quo bias”, which is common amongst investors of all ages and circumstances.

Of course, this bias is perfectly understandable and natural if you consider that an individual might be terrified of risking their money to any extent, in case they lose the lot. It is, however, generally an unfavourable position for an investor to take and makes it virtually impossible for them to maximise the potential of any money they may have at their disposal.

Overcoming complexity

Financial decision making is often complex. Anxieties about losing money and tendencies towards inertia are all too familiar for many investors. Clearly, the affect heuristic can have a powerful influence on investment decisions both large and small and not acknowledging its existence carries its own risk and potential for future financial losses.

Only by being aware of our tendency to be influenced by our emotions will we, as individual investors, be capable of making better informed, more objective and clear-headed financial decisions in the future.