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Practice paper

Homo heuristicus in the financial world: From risk management to managing uncertainty

Hansjörg Neth, Björn Meder, Amit Kothiyal and Gerd Gigerenzer
Journal of Risk Management in Financial Institutions, 7 (2), 134-144 (2014)
https://doi.org/10.69554/BLMQ2227

Abstract

What — if anything — can psychology and decision science contribute to risk management in financial institutions? The turmoils of recent economic crises undermine the assumptions of classical economic models and threaten to dethrone Homo oeconomicus, who aims to make decisions by weighing and integrating all available information. But rather than proposing to replace the rational actor model with some notion of biased, fundamentally flawed and irrational agents, we advocate the alternative notion of Homo heuristicus, who uses simple, but ecologically rational strategies to make sound and robust decisions. Based on the conceptual distinction between risky and uncertain environments this paper presents theoretical and empirical evidence that boundedly rational agents prefer simple heuristics over more flexible models. We provide examples of successful heuristics, explain when and why heuristics work well, and illustrate these insights with a fast and frugal decision tree that helps to identify fragile banks. We conclude that all members of the financial community will benefit from simpler and more transparent products and regulations.

Keywords: simple heuristics; risk vs uncertainty; ecological rationality; bias-variance dilemma; fast and frugal decision tree

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Author's Biography

Hansjörg Neth is an adjunct researcher at the Center for Adaptive Behavior and Cognition (ABC) at the Max Planck Institute for Human Development, Berlin. Prior to his current appointment as acting chair of Cognition, Emotion, and Communication at the University of Freiburg he taught Cognitive and Decision Sciences at the University of Göttingen, was research assistant professor in Cognitive Science at Rensselaer Polytechnic Institute, USA, and holds a PhD in psychology from Cardiff University, UK.

Björn Meder is a research scientist at the Center for Adaptive Behavior and Cognition (ABC) at the Max Planck Institute for Human Development in Berlin. His research interests include judgment and decision making, causal inference, information search and cognitive modelling. Björn holds a PhD in psychology from the University of Göttingen, Germany.

Amit Kothiyal is a post-doctoral fellow at the Center for Adaptive Behavior and Cognition (ABC) at the Max Planck Institute for Human Development in Berlin. His research interests lie in decision making under risk and uncertainty. Amit received a PhD in economics from the Tinbergen Institute, Netherlands.

Gerd Gigerenzer is director of the Center for Adaptive Behavior and Cognition (ABC) and the Harding Center for Risk Literacy, both at the Max Planck Institute for Human Development, Berlin. His most recent books are Risk Savvy (2014), Ecological Rationality (2012, with Peter Todd), Heuristics (2011, with R. Hertwig and T. Pachur), and Better Doctors, Better Patients, Better Decisions (2011, with Sir Muir Gray).

Citation

Neth, Hansjörg, Meder, Björn, Kothiyal, Amit and Gigerenzer, Gerd (2014, March 1). `Homo heuristicus` in the financial world: From risk management to managing uncertainty. In the Journal of Risk Management in Financial Institutions, Volume 7, Issue 2. https://doi.org/10.69554/BLMQ2227.

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cover image, Journal of Risk Management in Financial Institutions
Journal of Risk Management in Financial Institutions
Volume 7 / Issue 2
© Henry Stewart
Publications LLP

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