Equity markets were going through buoyant times. A steel company was planning a massive capital raising exercise through a rights issue. Suresh was very keen to participate in the same. However, Ramesh told him that he may avoid the same as the steel sector is a cyclical industry and studies have shown that investing in the sector over the long term has yielded average results. But Suresh just smirked and said, ‘Don’t be such a pessimist, the promoters are wonderful and I have a high regard for them’!
This is a crude illustration of the Affect Heuristic. Let us understand more about the same in this edition of Money Wisdom.
Affect heuristic broadly means a decision making bias where the current emotional state weighs on decision making. An affect is a momentary judgement; one takes a binary judgement (positive or negative basis factors like perceptions, likes and dislikes, experiences etc.). Also, in terms of the risks and benefits of a particular decision, we believe the risks are higher than the reward or vice-versa basis our ‘feelings’. Thus, objective thinking is compromised in favour of emotional impulses!
From the perspective of Investing and Financial markets:
1). Many-a-times, we regard or disregard investment ideas basis our experience and mindset about them. We don’t analyze investments through cold logic and mathematics, but basis our likes and dislikes.
2). We over-estimate the return potential and under-estimate the risk of investments basis our ‘emotional assessment’.
In fact, a quote by the legendary Benjamin Graham below ideally captures the essence of the Affect Heuristic.
‘Buy not on optimism, but on arithmetic’
So how can we avoid being a victim of this Bias, in financial markets or in life :
1). Beware and be-aware about our emotional states and its influence on decision making. Have a dispassionate approach towards decision making basis sound logic and principles.
2). Substitute the question, ‘How do I feel about this?’ with ‘What do I think about this?’
Thus don’t let the ‘Affect’ heuristic cause a wrong ‘Effect’ on your decision making process!
Let’s watch this video where Rolf Dobelli explains us about the Affect Heuristic and how not to be a victim of the same.
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