A New Approach to Financial Policies and Regulations
Edited by Riccardo Viale, Shabnam Mousavi, Barbara Alemanni and Umberto Filotto
Chapter 10: The heuristics revolution: rethinking the role of uncertainty in finance
Modern finance has been shaped by the probabilistic revolution in physics. Following the portfolio-allocation framework of Markowitz and Merton, the assumption has been that all risks can be measured, priced and hedged, as in roulette. Yet banks do not play in a casino, but in the real, mostly uncertain world of finance. Under conditions of uncertainty (as opposed to risk), fine-tuned risk modeling is likely to fail, while robust heuristics are likely to succeed. This chapter uses insights from the study of heuristics to sketch the heuristics revolution in finance and behavioral finance: (1) to improve financial literacy of the general public by teaching useful heuristics, not just financial concepts; (2) to study systematically the heuristics that successful investors rely on; and (3) to investigate robust heuristics for banking regulation that make the financial world safer, as pioneered by the Bank of England.
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