If I stopped you on the road and asked you the one thing that was characteristic of managing money, what would say? If you’re like many people, chances are you probably said “the math” or “the complexity” of tasks and decisions involved in managing your money. In fact, entire industries have come into being, and making very good profits, thank you very much, premised on this fundamental construct that effective finance means complex finance.
Yet new research is showing increasingly that the old-fashioned “Keep it simple, stupid”, or KISS principle for short, surprisingly trumps much more sophisticated and complex rules of decision making and choice, even in fields as advanced as medicine and finance.
Underlying this entire phenomenon is a quirky aspect of human behavior, called a “heuristic”: a heuristic is a fast and frugal rule that is applied when a situation meets some high-level criteria, without going into the depths of the details. You may know these as rules of thumb.
Heuristics: a deeper look
Heuristics had developed a bit of a bad reputation because of their association with poor decisions: many of the behavioral biases in psychology are heuristics. For example the availability heuristic states that we tend to make judgements of something based on whether an instance of it is easily available to our minds – we may rate a stock as a better investment if we can easily recall having seen favorable news of it on the TV lately.
However, heuristics have always been used fairly effectively in many different fields: for example, in emergency rooms to triage patients based on just a few vital signs and diagnostic questions, without taking a very long time for a detailed patient history, or in cases of firefighting or military action where there is little time and even less information to make deep and thoughtful decisions in life-or-death situations.
In fact, even in the field of finance, heuristics have remained stubbornly resilient even in the most quantitatively sophisticated fields of work such as stock investing (“Invest in May and go away”) or personal financial planning (“The more risk-averse you are, the greater the share of your money in bonds”).
Why is this the case? And more importantly, is there any benefit to using these simple heuristics in managing your finances?
The case for heuristics
Imagine you’re a small business owner trying to manage a tough business. The business is the only source of income for you and your family, and you were raised in the trade, not having had the time or luxury to go to college. You don’t have the means to even hire an accountant. What is the best way to help you improve the finances of your business?
The traditional approach is to load such individuals or even those looking to improve personal finances with enormous amounts of “financial literacy” training programs: those that talk about cash flow, interest burden, debits, credits , debt and the like. What if instead of the usual approach, these individuals were just given a few simple rules on which to base the financial management of their business, with virtually no grounding in double-entry bookkeeping or working capital management principles? Surely they’d fare a lot worse,wouldn’t they?
However, a research study conducted on such entrepreneurs in the Dominican republic found exactly the opposite results. In a controlled experiment, small business owners who were given simple rules of thumb to manage working capital (for example, to pay themselves a weekly salary but to take no more cash out of the business for personal purposes), ended up with significantly better objective business outcomes than those that had been given more formal “financial literacy” training. Not only that, they even managed negative shocks such as a slump in sales better than the financial literacy group, and maintained better business records.
These kinds of outcomes are immensely encouraging because they hold out the hope that “everyday” people can also manage their finances better with a few thoughtful rules-of-thumb for a large majority of their financial dealings, and likely end up vastly better off as well.
Why are heuristics so prevalent and so resilient in the face of more “scientific” and “thorough” approaches?
Ideas42 is an organization dedicated to deploying behavior science for social good. The organization grew out of an initiative at Harvard University in 2008. In a research paper, Ideas 42 suggests that there are three main reasons why heuristics seem to work so well:
- First, humans have limited cognitive horsepower to absorb new information, so they do better when presented with less information. They just end up retaining more of it, with the increased likelihood that they’ll be able to recall it when the situation dictates. Heuristics are very brainpower-efficient, and are thus easily stored and recalled.
- Second, heuristics are typically easier to implement. For example, in the working capital example above, it’s a lot easier for a harried business owner to simply restrict herself to drawing a fixed weekly salary, making it a lot more likely she’ll not compromise the firm’s working capital, than it is that she’ll sit down and draw up the accounts every week. End result: greater shot of being actually implemented.
- Third, heuristics tend to be learned and shared in certain specific situations or contexts where they are most relevant, which means they are more likely to be remembered and applied correctly in similar situations in the future. In contrast, more formal training tends to occur in artificial situations, with lower likelihood of recall.
The bottom line
What does all of this mean? The guidance is plain: if we want to help people get on the road to both greater financial well-being as well as greater financial self-reliance, using thoughtful and well-designed heuristics and disseminating them widely is definitely the way to go.
For every financial lesson we try to impart, especially to adults, the first fall back must be to design an effective heuristic (with a suitable disclaimer when not to use it). On a side note, the liberal use of heuristics is probably the single biggest explanation for the ever-increasing of popular personal finance books and approaches -they’re nothing if not simple and memorable. (Example: “the 50-30-20 approach to a secure retirement”).
I had stunning first-hand experience with the power of heuristics in finance recently: I was working with a first-class craftsman who was woefully undercharging for his work. It was evident that he was not covering fixed and administrative costs, and barely scraping by as a result.
After frustrating hours spent explaining “dead time”, “cost of supplies” and the like, and the need for “margin”, I gave up out of exasperation and simply told him to divide his estimated cost by 0.7 before pricing his work. Bingo! Mission accomplished! He is a much happier camper, clients recognize that he is still undercharging for his work, so they don’t complain, and best of all, the constant scrape of financial want has eased considerably without added hours of “paper work” that he truly hates!
Imagine the power of that multiplied by millions!
The Power of Heuristics: Ideas 42
Keeping it Simple: Financial Literacy and Rules of Thumb – Alejandro Drexler, Greg Fischer, and Anoinette Schoar