Heuristics Flashcards
Type 2 Heuristic
Cognitive and requiring effort.
Used when you have more time to ponder.
Type 2 can overrule type 1.
Familiarity heuristic
When the familiar is favored over novel places, people, and things.
Home bias (Familiarity practical implications) - financial examples
- over-investing in home country’s equities
- over investing in geographically close equities
- potential cost: Forego gains from international diversification.
- Bias to invest in own firm’s equity.
- Home bias seems to be driven by a comfort level with the familiar.
- Goes against diversification theory.
Representativeness Heuristic:
people judge probabilities “by the degree to which A is representative of B, that is by the degree to which A resembles B.
Conjunction fallacy (representativeness)
A probability mistake that occurs when one believes that a joint probability is higher than one of the simple probabilities.
ex. People feel that the probability that they will win the lottery and be overjoyed the next day is higher than the probability that they will just win the lottery.
Biases related to representativeness:
- availability: Freely available, easily processed information is more compelling.
- recency: Recent evidence is more compelling
- Salience: dramatic evidence is more compelling
Representativeness bias in Finance
- Good companies are good investments:
because it seems obvious that if a company has high quality management, a strong image and has enjoyed consistent growth in earnings, it must be a good investment. - Investors tend to believe past performance leads to future performance. - Trend following, momentum in choosing stocks, performance chasing in choosing mutual funds.
- Individual investors are more likely to buy high attention stocks (news, high trading volume, extreme returns)
Anchoring:
The tendency to adhere to prior beliefs longer than one should. ex. when asking for how much a wine is, if you’re asked about your social security number before it, and it is high, then you will guess a high wine price.
Endowment effect
The fact that people often demand much more to give up an object than they would be willing to pay to acquire it.
Status quo bias:
a preference for the current state that biases the economist against both buying and selling his wine is an illustration of status quo bias.
Status quo bias definition:
individuals have a strong tendency to remain at the status quo, because the disadvantages of leaving it loom larger than advantages.
Decision frame:
a decision maker’s view of a problem and the possible outcomes. They can be affected by:
Presentation, perception of questions, personal characteristics
Mental accounting
The set of cognitive operations used by individuals to organize, evaluate and keep track of financial activities.
This is a description of way people intuitively do these things, and how it impacts financial decision making.
Consistent with PT?
People feel losses more severely than gains, so when there is discretion as to when to close an account, they may choose to avoid doing so if losses will result.
Opening and closing accounts (mental acc)
Once an account is closed, you go back to zero. This is evidence that people avoid closing accounts at a loss.
In prospect theory however, the problem is that it was set up to deal with one-shot gambles.
If we go back to zero, it is segregation, or move along the curve is integration.
Issues and weaknesses of Prospect theory:
- biggest limitation is the inability to provide insight into general asset pricing theory
- PT is the somewhat arbitrariness of reference point adjustment (when we open and close accounts)
- PT cannot account for regret or disappointment.
