Human Decision Making - Statman Chapters

Question 1

What are the three kinds of knowledge?

Answer 1

1. Financial facts knowledge (financial markets, benefits of diversification, …)
2. Human-behavior knowledge (wants, cognitive shortcuts, emotional shortcuts and errors)
3. Information knowledge (Exclusively vs narrowly vs widely available knowledge)

Question 2

What are examples of wants, cognitive shortcuts and emotional shortcuts and errors?

Answer 2

Wants: riches, social status, adherence to values
Cognitive shortcuts: framing, hindsight, confirmation
Emotional shortcuts: hope, fear, pride, regret

Question 3

What is meant by “sunk costs” in the transition from ignorant to knowledgeable investor?

Answer 3

Costs that have already incurred and cannot be salvaged even when probed otherwise by cognitive and emotional errors

Question 4

What is meant by the transition from ignorant to knowledgeable investor?

Answer 4

A transformation from System 1 (intituitive) to System 2 (reflective “think”) can be worthwile when the benefits exceed the costs of transition. A transition from System 1 to System 2 costs money, time and physical and mental exertion.

A transition needs be done when System 1 leads to errors.

Question 5

What is meant by trade-offs between wants?

Answer 5

E.g. between utilitarian benefits of great wealth and expressive and emotional benefits of adherence to values.

Question 6

What is an example of a conflict between people’s wants and wants of others?

Answer 6

E.g. conflicts between benefits received by corporate managers and shareholders or financial advisors and clients

Question 7

There are 9 main wants of people. What are they?

Answer 7

1. Riches and protection from poverty
2. Nurture of children and families
3. Demonstrate competence
4. Playing games
5. Staying true to our values
6. Enjoy the comfort of familiarity and passion of patriotism
7. Gain high social status
8. Promote fairness
9. Paying no taxes

Question 8

What is the problem between wants for riches and protection from poverty and how can it be solved?

Answer 8

1. Hope for riches encourage to invest entire portfolio in stocks or lottery.
2. Fear of poverty encourages to divest portfolio in government bonds & social security.
   -> Solution: Balance two wants by dividing money into layers of portfolio pyramids (bottom: bonds, top: stocks)

Question 9

What is meant by “ambiguity aversion” and to what want is it related?

Answer 9

=The preference from known risks over unknown risks (its part of the want to demonstrate competence)
The investor rather chooses alternative where he knows the probability distribution of the outcome.

Question 10

What are examples where investors want to demonstrate competence?

Answer 10

1. Ambiguity aversion (prefer known risks)
2. People prefer to guess before the event -> that is more satisfactory when they are right and less uncomfortable when they are wrong -> influences trading frequency
3. males and investors with larger portfolios or more education perceive themselves as competent
4. People who trade more frequently perceive themselves as more competent

Question 11

What are examples for wants to stay true to our values?

Answer 11

E.g. mutual funds can follow precepts of religions
E.g. financial crisis and housing markets -> changes in circumstances affect trade-offs between utilitarian, expressive and emotional benefits

Question 12

What are wants for fairness?

Answer 12

1. Freedom from coercion is violated when one party possesses inside information and therefore refrains from trading.
2. Freedom to equal power is violated when income inequality is high; one trader possesses inside information.

Question 13

How can taxes be perceived as wants?

Answer 13

Low taxes deliver utilitarian benefits (tax-savings strategies also deliver expressive + emotional benefits)

Tax avoidance increases utilitarian benefits (keep more earnings), BUT can also reduce utilitarian benefits (engaging in tax avoidance results in paying higher interest in bank loans)

Question 14

Whats the difference between investors and consumers?

Answer 14

Rational investors only care about wealth production whereas consumers care about all benefits of wealth (utilitarian, expressive, emotional). Rational investors separate roles as investors from roles as consumers compared to normal investors.

Question 15

Whats the difference between a “sensation seeker” and a “knowledgeable sensation seeker”?

Answer 15

The “sensation seeker is blind to errors by overconfidence and keeps on buying lottery tickets due to the want for thrills and sensations, while he is ignorant of the price.
The “knowledgeable sensation seeker” acknowledges his overconfidence and is willing to pay the price to have thrills and sensations.

Question 16

What is meant by “Our Wants and Shoulds”? How do they differ?

Answer 16

Rational people are free of conflicts between wants and shoulds, normal investors are not.

Wants: Visceral, Benefits in present, Focus attention on expressive and emotional benefits, prompted by System 1

Shoulds: Reasoned, Benefits usually in future, Focus attention on utilitarian benefits, prompted by reflective system 2

An investment advice is filled with shoulds: save more, spend less, diversify, buy and hold

Question 17

What is an example of an conflict / trade-off between utilitarian, expressive and emotional benefits WITHIN a person?

Answer 17

Utilitarian benefits are dominated by expressive and emotional benefits.

E.g. workers value purpose and meaning of work, and are willing to trade utilitarian benefits of higher wage for benefits for socially responsible employer.

Question 18

What is an example of an conflict / trade-off between utilitarian, expressive and emotional benefits AMONG people?

Answer 18

Wants of agent (managers) can conflict with wants of principal (investor).

E.g. Agents may attempt to satisfy own wants rather than wants of clients -> principal-agent-conflict
E.g. CEO forced to retire during takeover

Question 19

What are the seven cognitive shortcuts?

Answer 19

1. Framing
2. Hindsight
3. Confirmation
4. Anchoring & Adjustment
5. Representativeness
6. Availability
7. Confidence

Question 20

What is the problem about cognitive shortcuts?

Answer 20

They are part of the intuitive “blink” System 1 and can lead to good choices BUT can also become errors when misleading into poor choices. Then the System 2 leads to better choices.

Knowledgeable people employ cognitive shortcuts correctly, ignorant people not.

Question 21

What is “framing”? When do investors commit framing errors?

Answer 21

=people make a decision based on the way the information is presented, not on the facts themselves (Example of quarterly results).

Example - Overreacting to short-term fluctuations: Investors may focus too much on short-term movements in stock prices, rather than the long-term fundamentals of the company.

Question 22

What is framing in mental accounting? When can it have positive, when negative consequences?

Answer 22

Mental accounting = a person places different values on the same amount of money, based on subjective criteria -> lead to irrational investment decisions

Positive: people frame money into distinctly labeled mental accounts and treat them acccordingly -> helps tacking the money

Negative: people keep money on specific account, unable to transfer money from one to another; people distinguish income earned with much effort and unearned income with little effort -> spend unearned more easily

Question 23

What is framing in money illusion?

Answer 23

Usage of nominal units of money in place of “real” (inflation-adjusted) units of money
e.g. 1. 2% nominal pay raise when inflation is at 3% = 1% real pay cut; 2. 1% nominal pay raise when inflation is at 0% = 1% real pay raise

-> people observe first situation as better due to framing pay cuts and raises in nominal units

Question 24

What is hindsight? What is good hindsight and what is bad hindsight?

Answer 24

=one becomes convinced they accurately predicted an event before it occurred

-> causes overconfidence and may lead to wrong decisions in the future

Good hindsight shortcuts lead people to repeat actions that brought good outcomes and avoid actions that brought bad outcomes.

Bad hindsight: errors when randomness and luck are prominent -> can mislead lucky trader; f.e. hindsight error in underestimating the volatility of stock prices

Question 25

What is meant by the "confirmation" error?

Answer 25

=people tend to seek out information that confirms their pre-existing beliefs and ignore information that contradicts them. -> mislead investors to choices that degrade returns while expecting choices to bolster return Investors believe they can pick winning stocks, thereby recording wins as confirming evidence and neglecting to record losses as disconfirming evidence.

Question 26

What is meant by "Anchoring & Adjustement" erros?

Answer 26

=occurs relying to heavily on an initial piece of information in the decision-making process Can result in substantial errors, e.g.: Stock traders use 52-week high as anchor and reference point against which they evaluate the potential impact of news ->predictions of long-term returns anchored by recent returns

Question 27

What is meant by "Representativeness"?

Answer 27

=individuals make judgements about the likelihood of an event based on how closely it matches their mental image or stereotype of that event, rather than on statistical or factual data. -> in short: individuals tend to rely on mental shortcuts or heuristics, rather than objective analysis F.e. investor may assume that a particular stock is a good investment because it fits their mental image of a succesful company, even if the company's financials are bad.

Question 28

What is meant by "Availability" bias / error?

Answer 28

=individuals make judgement based on the information that is most easily available to them, rather than on statistical or factual data. F.e. investor may be more likely to invest in a particular stock if they have recently read positive news stories about the company. Availability bias can lead to overlooking important information and making decisions that are not in the individual's best interest.

Question 29

Whats the difference between representativeness and availability?

Answer 29

Availability is about the information you can remember (shark attack). Representativeness is about the overestimation of the likelihood of an event based on that information.

Question 30

What is the difference between over(under-)estimation, over(under)placement and over(under)precision errors? All of them are confidence errors.

Answer 30

1.1 Overestimation occurs when expecting 12% return although objective assessment indicates it should be 8% 1.2 Underestimation occurs when expecting 6% return 2.1 Overplacement occurs when expecting our portfolio to place us in top 10%, when objective assessment places us among bottom 40% 2.2 Underplacement occurs when expecting to be among bottom 30% 3.1 Overprecision someone who believes they are correct 90% of the time but is only correct 50% of the time 3.2 Underprecision someone who believes they are correct 20% of the time but is correct 50% of the time

Question 31

For easy and difficult tasks, when are over(under)estimating and over(under)placement errors more likely?

Answer 31

Overestimating -> difficult tasks Underestimating -> easy tasks Errors occur because any estimate includes an error component (e.g. cannot overestimate A grade on easy test but can overestimate C grade on difficult test, estimating it as a B) Overplacement -> easy tasks Underplacement -> difficult tasks Investors perceiving investing as difficult task tend to underplace themselves relative to other investors

Question 32

What are three main emotional shortcuts and errors?

Answer 32

1. Emotion: very intense, short duration, clear focus 2. Mood: muted emotion, less intense than emotion, but longer duration 3. Affect: faint whisper of emotion or mood, stripped down to valence, feeling positive or negative towards sth

Question 33

What are the eight emotional shortcuts?

Answer 33

1. Hope & Fear 2. Greed, Ambition and Status Seeking 3. Happiness, sadness and disgust 4. Anger 5. Regret and Pride 6. Self-control 7. Mood 8. Affect

Question 34

What is the influence on / of fear & hope?

Answer 34

1. Stock market declines induce fear. 2. High stock market returns are associated with better mental health; high volatility is associated with poorer mental health 3. Fear increases risk aversion 4. Fearful investors switch to safe investments

Question 35

How is fear & hope associated with risks & returns?

Answer 35

1. Fearful investors expect low returns with high risk; hopeful investors high returns with low risk 2. Fear leads to early sell-off and is contagious

Question 36

How can anger have positive and negative effects? What is meant by anger?

Answer 36

=arises in response to threat or danger, but sign of internal control Anger can stimulate acting as optimist: -> people exposed to anger are more willing to invest in stocks, prefer medium and long-term investments, believe they can forecast stock-market trends -> HOWEVER, people disposed to anxiety prefer interest-bearing accounts, do not believe they can forecast stock-market trends Anger can counter cognitive errors -> can mislead into poor choices (underestimate likelihood of losses or bad outcomes) -> HOWever, can be beneficial in negotiations, expressing anger conveys thoughtness, can evoke fear in counterparts (BUT can also backfire)

Question 37

What could be an advantage of walking away from negotations?

Answer 37

It first imposes costs but yields possible benefits later in the form of fairness. Turning down unfair offers teaches others to be fair! -> part of Anger (emotional bias)

Question 38

How could regret aversion and pride seeking affect financial choices?

Answer 38

e.g. choice of buying or selling stocks 1. Investors prefer to repurchase stocks previously sold at a gain rather than stocks previously sold at a loss. 2. Investors prefer to repurchase stocks whose prices declined subsequent to an ealier sale rather than stocks whose prices increased.

Question 39

How is regret associated with responsibility for choices?

Answer 39

Responsibility can escalate commitment to choices in effort to minimize regret. Certain people shift blame when choices turn out badly, take responsibility when choice turns out positive -> underlies broker’s lament

Question 40

When is self-control insufficient, when excessive?

Answer 40

1. Insufficient when hot emotion urging immediate gratification overcomes cool cognition delaying gratification. 2. Excessive when hot emotion urging delayed gratification overcomes cool cognition urging immediate gratification. -> in other words: Too much self-control evident in tendency to spend less today than ideal level of spending

Question 41

What are the big five personality traits (in self-control)? Which is the most relevant and why?

Answer 41

Conscientiousness, extraversion, openness, agreeableness, neuroticism Most relevant: Conscientiousness -> most closely related to academic achievement, job performance, marital stability and longevity

Question 42

Mood can result in optimism (hope and happiness) and pessimism (fear and sadness). How can optimism be good and bad in a corporate context?

Answer 42

Good: motivation of project champions and teams to work hard on completing at promised low cost and high profit Bad: selection of losing projects Good consequences can be obtained without bad consequences: -> project committee selects projects promised to be profitable on basis of own estimates of costs and profits (properly adjusting upward cost estimates provided by project champions and adjusting downward profit estimates)

Question 43

What is affect? What are the affects of investments and emotional benefits?

Answer 43

=whisper of emotion/mood, in valence (refers to intrinsic attractiveness (positive valence) or aversiveness (negative valence) of an event, object or situation) Investments exclude affect: -> can distort information and influence beliefs -> positive affect of risky investments increases people's confidence in ability to evaluate them -> people update beliefs in a way that is consistent with self-preservation motive of maintain a positive emotional state and avoiding cognitive dissonance Emotional benefits affect: -> illustrates blurry line between wants and errors -> emotional error when paying more and having no additional benefits, no emotional error because of emotional benefits or costs of conforming or deviating to and from culture

Question 44

What is meant by the "wisdom of crowd" in overprecision errors?

Answer 44

The average of two guesses is generally more accurate than either guess. Wisdom of crowds is more accurate than wisdom of crowds within. An average of the guesses of two people is generally more accurate than an average of two guesses of one person

Question 45

What is meant by the endownment effect?

Answer 45

People tend to place a higher value on items they own compared to the value they would place on those same items if they were not the owners. This can lead to a reluctance to sell the item, even if it would be in their best interest to do so.

Question 46

How can the endownment effect be corrected?

Answer 46

1. Use of System 2 to counter emotional errors, specifically error of regret. 2. Diversification of portfolio 3. Seek advice from professionals

Question 47

What is the small-victories strategy?

Answer 47

Task is completed faster by breaking it down in smaller pieces -> can provide expressive and emotional benefits, and can result in utilitarian benefits when task is completed faster by breaking it down in smaller pieces