Overcoming Cognitive Biases: A Heuristic for Making Value Investing Decisions

Abstract

Investment decisions are subject to error due to cognitive biases of the decision makers. One method for preventing cognitive biases from influencing decisions is to specify the algorithm for the decision in advance and to apply it dispassionately. Heuristics are useful practical tools for simplifying decision making in a complex environment due to uncertainty, limited information and bounded rationality. We develop a simple heuristic for making value investing decisions based on profitability, financial stability, susceptibility to bankruptcy, and margin of safety. This achieves two goals. First, it simplifies the decision making process without compromising quality and secondly it enables the decision maker to avoid potential cognitive bias problems.

Keywords: value investing, cognitive biases, heuristics, margin of safety