heuristics and biases

Question 1

what is common ratio effect?

Answer 1

the overweighting of low-prob events and certainty effect

Question 2

does prospect theory cover emotions?

Answer 2

No!

Question 3

in the prospect theory negative domain value function, what is -lambda and what does the size mean?

Answer 3

coefficient of loss aversion - the kink at the origin that accounts for loss aversion.

if lamda > 1, reflects loss aversion

Question 4

what is the equation for the PT value function in the positive domain?

Answer 4

in positive domain usually v(z) = Z^a where Z positive and a is between 0 and 1, creating the risk averse curve. increasing a is decreasing risk aversion.

Question 5

what is the equation of the PT value function in the negative domain?

Answer 5

in negative v(z) = -lambda(-z)^Beta where Z negative, lambda bigger than 1 and beta is between 0 and 1. increasing beta decreases risk seeking attitude to losses

Question 6

who is responsible for bounded raitonality?

Answer 6

simon

Question 7

what are the main arguments for and against heuristics in the modern, complex world?

Answer 7

can be inefficient in increasingly complex world, leading to errors and mistakes in decision making.

not analysing things properly because taking shortcuts with heuristics. counterargument that there’s such an increase in information offered that mental shortcuts are the only viable solution to dealing with it all.

Question 8

what is the 1/n heuristic?

Answer 8

n things to invest in, put 1/n in each. technically leads to inefficient portfolios, with lower utilities because higher risk/reward. results in you being on a completely different (and worse) utility function to if you’ve gone through all MPT steps. arguably, the new utility function could be equal to or even better than the orginal utility function once cost of computing everything taken out.

Question 9

what is home bias?

Answer 9

?? find out

Question 10

what are the two types of heuristic?

Answer 10

1 - autonomic. useful when a quick, uncomplicated decision required.

2 - cognitive. more complex, slower.

Question 11

how does perception and memory link with heurisitics?

Answer 11

often see what we expect to see. brain has subconscious part that recieves and processes info, then sends it to conscious part of brain.

research chows we only share 20% of perception with our neighbours, gender effects.

perception really important in behavioural finance as opposed to traditional finance. can be linked to framing in prospect theory.

Question 12

what is cognitive dissonance?

Answer 12

cognitive dissonance - motivation to reduce or avoid psychological inconsistencies, often to promote positive self-image.

memory imprecise and reconstructive - e.g. studies of people misremembering predictions of returns to match what actually happened to avoid cognitive dissonance of things being inconsistent.

Question 13

what are primary and recency effects?

Answer 13

primary effect - if given loads of info on something at same time, get overloaded and get paralysed by it. primary effect says first bit of info recieved is the bit that sticks and is what we base our decisions on.

recency effect - when information given over time, recent news sticks with you. if you’ve been getting good news consistently but bad news comes it makes you forget it’s been going good up until now.

Question 14

what three heuristics/biases fall under the familiarity umbrella?

Answer 14

ambiguity aversion, diversification heuristic, status quo bias/endowment effect.

Question 15

what is ambiguity averrsion?

Answer 15

people usually ambiguity averse — see experiment above. ellsberg (?) paradox; red and black ball experiment. 50/50 split more popular than an unknown split despite having the same EVs.

Question 16

what type of heuristic relates to people failing to understand probabilities?

Answer 16

representativeness

Question 17

what is the conjunction fallacy? what hype of bias is it?

Answer 17

manifestation of representativeness — linda effect. people don’t understand that you can’t combine subsets of probabilities. i.e. people have no notion of joint probabilities.

representativeness bias

Question 18

what are two examples of base rate neglect?

Answer 18

hot hand phenomenon - thinking the conditional distribution should look like the sample. assume good performance will continue.

gambler’s fallacy - sample should look like population. assume good performance will reverse to bad. mistake is applying law of large numbers to a small sample.

Question 19

what is anchoring?

Answer 19

insufficient adjustment from initial value estimate

intial estimate often relates to frame of problem. people often anchor on totally irrelevant numbers that appear in the problem frame.

analysts’ forecasts (earnings, share prices)

Question 20

what is hindsight bias?

Answer 20

wanting to believe you knew it all along

Question 21

what is the halo effect?

Answer 21

halo effect - statements and views taken more seriously if physical attributes are appealing.

Question 22

what has been found in terms of ease of processing and information overload?

Answer 22

people seem to prefer situations characterised by ease of processing. information viewed as more understandable viewed as more likely to be true.

information overload leads to procrastination and the indefinite action.

Question 23

how does familiarity affect people’s likelihood to accept a gamble?

Answer 23

people more likely to accept a gamble if they feel they have better understanding of the relevant context. Tversky and Heath experiment found when people felt when they had some competence on questions they were more likely to gamble based on the competence rather than a random lottery. whatever the self-perceived level of knowledge, the probability of success was viewed as identical between two alternatives - e.g. if ppt was 50% comfortable in answers being correct then gamble would have been successful with 50% probability; and if someone was 75% comfortable random lottery would be 75% chance of success. logical conclusion is that people have preference for familiar.

Question 24

what is the diversification heuristic?

Answer 24

people like to try a little bit of everything when choices are not mutually exclusive.

variety-seeking makes choice simpler, saving time and reducing decision conflict

Question 25

what is status quo bias/endowment effect?

Answer 25

preference for current state also follows from comfort seeking. people are resistant to change, fearing regret.

tend to hold on to what is current possessed (your endowments).

status quo bias or endowment effect is manifestation of loss in riskless context.

people feel most comfortable with current state of affairs even though it wasn’t something they had no part in choosing.

Question 26

what is base rate neglect?

Answer 26

ignoring the genuine probabilties in some way - e.g. if given neutral description of man and asked if he is lawyer or engineer (having been told there’s a 70% chance he’s a lawyer), ppts said its a 50/50 chance despite knowing it’s not.

Question 27

what is bayesian updating?

Answer 27

bayes’ rule, useful relationship that allows us to evaluate conditional probs: prob of event B given event A = prob of A given B * ratio of simple probs of B to A.

allows one to optimally update probs based on arrival of new info.

Question 28

what is the availability heuristic?

Answer 28

availability heuristic - events called to mind easily are believed to have greater likelihood of occurring. people tend to own behaviours better since easier to recall.

Question 29

what explains anchoring?

Answer 29

one view is uncertainty about true value, meaning decision makers move answer away from anchoring value until they enter plausible range. greater uncertainty = greater plausible range, and more insufficient adjustment occurs.

other view is lack of cognitive effort to move away from anchor.

Question 30

do heuristic induced errors cancel out?

Answer 30

who knows…

do they cancel or do they map into market outcomes? are prices wrong because of systematic investor error? if many investors use same heuristic at same time, could be source of systematic error.