4 & 5- Heuristics & Biases (Deck 3) Flashcards
What is base rate neglect?
The tendency to ignore the general prevalence (base rate information) of an event in favour of case-specific details. For example, if a person is told that 70% of a group are engineers and 30% are lawyers, when given a neutral description (not in favour of either) about an individual from this group, they are likely to assume that the chance of the person being an engineer or lawyer is 50% despite being made aware of the previous statistic.
What are some implications of representativeness and related biases on financial decision making?
- Misjudging good companies as good investments even if the stock is overvalued.
- Misjudging risk and return. Assuming highly volatile stocks have higher returns, even when the risk-adjusted return is poor (e.g., assuming penny stocks will be the next big thing even though most penny stocks crash).
- Trend chasing and momentum investing. Investors assume stocks with strong past performance will continue performing well, ignoring the fact that past success does not predict future returns (e.g., GameStop).
- Story investing: Choosing investments based on narratives instead of data. E.g., investing in a new startup led by a former Amazon executive despite the fact that 90% of startups fail.
How to overcome representativeness bias in investing?
Look at long-term fundamentals, not just recent trends. Always check base rates – what percentage of similar companies succeed?
What is the availability heuristic?
People estimate the probability of an event based on how easily they can recall an example. The more vivid or recent an event is, the more we overestimate its likelihood.
Events that stand out - due to media coverage, social media attention or vividness - feel more likely than they actually are.
What are implications of the availability heuristic in finance?
- Overestimating unlikely risks (market panic)
- Chasing trends (FOMO investing)
- Misjudging long-term vs. short-term probabilities
- Biased risk perception in investing
What is confirmation bias?
The tendency to seek, interpret, and recall information that confirms our pre-existing beliefs while ignoring contradictory evidence.
- Selecting sources of data which are likely to correspond with our prior beliefs (a form of selection bias).
- Selective treatment of new information
- Seeking confirmation instead of falsification. We prefer proving our ideas right rather than testing if they might be wrong.
What are some implications of confirmation bias in finance?
- Holding on to losing investments for too long
- Under-diversifying a portfolio
- Poor decision-making in trading
- Overconfidence in stock picks
- Creating market bubbles
What is overconfidence?
The tendency for people to overestimate their knowledge, abilities, and the precision of their information, or to be overly optimistic of the future and their ability to control it.
What are some forms of overconfidence?
- Better-than-average effect: the tendency to overestimate abilities and accomplishments compared to others. Most people believe they are better than average in skills like driving, intelligence, or leadership. For example, investors overestimate their ability to pick winning stocks.
- Miscalibration: the tendency to overestimate the precision of their predictions, estimates or knowledge. For example, “I am 99% sure this is correct” when the actual accuracy is much lower.
- Illusion of control: the tendency to believe we have control over outcomes that are actually random or out of our control. This bias leads to risky behaviours in gambling, investing, and business.
- Excessive optimism is the tendency to overestimate the probability of positive outcomes while downplaying risks. This can lead to overestimating stock market returns and overconfidence in startup success.
What is the Dunning-Kruger effect?
People with low ability overestimate their competence, while experts tend to underestimate themselves.
What are some impacts of overconfidence on financial decisions?
- Excessively frequent trading
- Under-diversification & risk-taking, over-weighting single stocks.
- Overconfidence in financial advisors & fund managers
