Lecture 1: Ch. 1 & 2 Flashcards
Measuring overconfidence
Malmendier &Tate [2005 & 2008] - 2 measure
Malmendier &Tate [2005 & 2008]:
• Option based measure (longholder measured - held vested options until the year of expiration);
• Business press portrayal based [text analysis]: “confident” & “optimistic” vs “cautious” &“conservative”
Measuring overconfidence
Otto [2014]
• Firms earnings forecast that exceeded realized earnings;
Measuring overconfidence
Ben-David, et al. [2013]
• Survey measure based on confidence intervals
Biases: self- deceptive and feeling based predisposition towards error
- Overconfidence about abilities and knowledge (better than average effect)
- Excessive optimism (overestimation of favorable outcomes and underestimation of bad outcome)
- Confirmation bias (tendency to ignore information that disconfirms your view and ideas - closely related to Selective Perception)
- Ilussion of control (Over-estimation of how much control you have over outcomes of your own actions)
Confirmation bias
A tendency to ignore information that disconfirms your view and ideas - closely related to Selective Perception: individuals perceive what they want to in media messages while ignoring opposing viewpoints
Illusion of control
• Over-estimation of how much control you have over outcomes of your own actions.
• In general, outcomes depend on combination of Skill and Luck.
Illusion of control over-estimates the skill component
[→ Illusion of control may lead to over-optimism and may reinforce overconfidence]
Define what heuristic is.
Name 4 examples and briefly explain them.
‘the brain uses shortcuts to reduce the complexity of analyzing information’: mental rules-of-thumb of appropriate behavior.
Cognitive heuristics:
1) Representativeness (Likelihood of X being related to Y is judged by the degree to which Y is representative of X (stereotyping effect))
2) Availability (Impact of the ease with which it can be brought to mind (salience effect))
→ People rely on information that is readily available and intuitive relative to information that is less salient and more abstract thereby biasing judgments
3) Anchoring and Adjustment (Different starting points tend to yield different conclusions)
→ Anchoring effect, with Adjustments being slow and insufficient
Feeling and emotion based:
4) Affect (Leads to placing heavy reliance on intuition and ‘gut feeling’, being guided by what feels comfortable & familiar)
What is framing? What two behavioral theories can explain that?
Framing refers to the presentation and/or the mental
representation of decision problems
Framing effect: When decisions are easily influenced by the manner in which the setting for the decision task is framed
-> Typical form of Mental Accounting:
Make little boxes (e.g. many bank-accounts for different purposes), don’t see the overall picture, too narrow-made decisions
-> In Prospect Theory, framing plays a crucial role
Shows different predictions than in the Expected Utility theory
Crucial element of framing: outcome relative to reference level (when we talk about either gains or losses)
Prospect theory vs Expected Utility theory
Expected utility theory:
- People are always risk averse
- Presentation (framing) does not matter
- Stochastic dominance (people optimize)
- Rational decision making
Prospect theory:
- If gains, people are usually risk-averse; If losses, people are usually risk-seeking
- Decisions are frame dependent
- Dominance is violated
- Realistic decision making
Main characteristics of Prospect Theory
› Reference Point (e.g. zero or current wealth rather than absolute outcomes)
• Usually the status quo
› Focus on changes: Gains and Losses
• Risk Aversion in the domain of gains
• Risk Seeking in the domain of losses
› Loss Aversion
• “losses loom larger than gains”
——-Embedded in the so-called value function—————-
__________________________________________
› Additional issue: Decision Weights
• Small probabilities are typically overweighted
Define Bounded Rationality and provide 2 mental mechanisms for it
› “The core notion … is that individuals are intendedly
rational. Although decision-makers try to be rational,
they are constrained by limited cognitive capabilities
and incomplete information, and thus their actions
may be less than completely rational in spite of their
best intentions and efforts” (March, 1994).
› People are satisfiers rather than optimizers
› Memory, perception, and information people have, is not perfect
Bounded rationality is the idea that in decision-making, rationality of individuals is limited by the information they have, the cognitive limitations of their minds, and the finite amount of time they have to make a decision.
2 mechanisms: Heuristics and Framing effect
