Lecture 6-representativeness

Question 1

What is a heuristic simplification?

Answer 1

-The brain uses mental shortcuts to reduce the complexity of analysing information.

allow the brain to organise and quickly process large amounts of information.

Question 2

Why is heuristic simplification necessary?

Answer 2

They are necessary because the world, being a complicated place, must be simplified in order to allow decisions to be made.

These shortcuts allow the brain to generate an estimate of the answer before fully digesting all the available information.

Question 3

What are type 1 & 2 heuristics?

Answer 3

Autonomic and non-cognitive, conserving on effort.
Used when very quick choice is called for
Or when it’s “no big deal

-Cognitive and requiring effort, used when have time to ponder

Question 4

What is representativeness bias?

Answer 4

A representativeness heuristic is a cognitive bias in which an individual categorizes a situation based on a pattern of previous experiences or beliefs about the scenario.

-People Belief that even small samples should be representative of the population.

Question 5

Example of representativness

Answer 5

Investors chase the hot mutual funds, the high stock price gainers, and a rising stock market, as recent past is indicative of the future

Question 6

3 behaviours associated with representativeness

Answer 6

Gambler’s fallacy

Base rate neglect/underweighting

Conjunction fallacy

Question 7

What is base rate neglect?

Answer 7

• Neglecting information that reflects the actual rate of occurrence in the population
• Bayes rule requires that base rate of information and the individual information to be combined

Question 8

Kahneman and Tversky on base rate neglect

Answer 8

found that most people focused on individual information

People tend to rely on individuating information that is vivid or accessible when making probability estimates more than on base rate

e.g.Overweighting the extent to which the description of Jack is representative of their stereotype of an engineer or lawyer
Underweighting the information about the proportions of engineers and lawyers in the population.

Question 9

What is gamblers fallacy?

Answer 9

is the mistaken belief that if something happens more frequently than normal during a given period, it will happen less frequently in the future

Question 10

What is conjunction fallacy?

Answer 10

he conjunction fallacy occurs when it is assumed that multiple specific conditions are more probable than a single general one.

e.g bank teller or bank teller, feminist and works in a library

Question 11

Representatives heuristic in relation to investing

Answer 11

Representativeness is judgment based on stereotypes - things that share similar qualities are quite alike.

• Prestigious companies strong earnings, high sales high quality management.
• Although stocks of companies are not always good investments i.e. high P/E ratio
• Past performance relates to future performance which aint true

Question 12

Extrapolation bias in relation to representativeness

Answer 12

Investors believe that past returns represent what they should expect in the future.

Unfortunately, this bias leads investors to buying high and selling low, not a wining investment strategy !

Investors extrapolate past returns for individual stocks and mutual funds

Question 13

Extrapolation bias and momentum

Answer 13

Link it all into momentum and contrarian

However, loser tend to outperform winners over the next three years by 30% (Bondt and Thaler, 1985).

Question 14

Momentum and stock prices decreasing

Answer 14

Fast growing firms find that competition increases and slows their rate of growth.

Question 15

What is familiarity?

Answer 15

People prefer things that are familiar to them.

-In many cases, people believe the things they are familiar with are better then those things of which they are not familiar.

Question 16

Familiarity and investing

Answer 16

Investors have a “home bias” because companies from their own country are more familiar to them than foreign companies

-Rather than diversify on international markets

Question 17

What is foreign bias?

Answer 17

Some investors buy foreign firms that are familiar which means large firms with recognisable products.

For example, non-Japanese investors tend to own the large Japanese companies.

Question 18

What is local bias?

Answer 18

• Being more visible due to geographic proximity increases that familiarity – this known as “local bias”
• A typical money manager’s portfolio consists of firms that are located 100 miles closer to the manager’s office than the average US firm.
• The familiarity bias causes investors to be too confident in stocks that are familiar, judging them too optimistically on expected return and risk.

Question 19

Bodnaruk (2009) familiarity and local bias

Answer 19

30% of investors’ stock portfolio is invested in firms located within 250 miles of their homes.

-When an investor moves to a different city, they re-balance their portfolio

Question 20

Familiarity breeds investment problems Hong et al

Answer 20

Price pressures from investors drives prices up and make them more volatile