Lecture 8

Question 1

Heuristics

Answer 1

Mental shortcuts used to simplify complex judgements or decisions

Question 2

Availability Heuristic

Answer 2

Likelihood of an event happening depends on how easily it can be brought to mind, remembered or imagined

Question 3

Representativeness Heuristic

Answer 3

• Judgements based on stereotypes
• Unreasonably associating particular features or actions with specific outcomes or conclusions. Discrimination

Question 4

Anchoring and Adjustment Heuristic

Answer 4

Decisions are based on past/historical data rather than new/future information.
- Overly narrow confidence intervals
- Insufficient adjustment: People typically underreact to new information

Question 5

Affect Heuristic

Answer 5

Decisions based primarily on intuition, instinct and gut feeling

Question 6

The Framing Bias

Answer 6

Tradition Finance: Decision makers can see through the frame
Behavioural Finance: Perceptions are highly influenced by how decision problems are framed

Question 7

Loss Aversion (Prospect theory)

Answer 7

• Ability to tolerate loss
• Losses felt harder than gains (2.5 times)

Question 8

Disposition effect (Prospect theory)

Answer 8

Investors generally predisposed to sell winner too soon but hold on to losing stocks too long

Question 9

Sunk costs

Answer 9

Standard Finance: Prior lessons are sunk costs and should be ignored
But, Associated problems of guilt, regret and shame. We use many different unconscious strategies against mourning and bearing loss

Question 10

Aversion to Sure Loss

Answer 10

• People accept unfair risk to avoid sure loss, hoping to break even or win
• Odds are against them

Question 11

Hindsight Bias

Answer 11

• Once something has happened, we believe it was inevitable in hindsight
• Past decisions look wrong, although appropriate given the information available at the time

Question 12

Self-attribution bias

Answer 12

Credit taken for favourable outcomes, poor performance is blamed on the external environment, the market of the economy or bad luck

Question 13

Overconfidence

Answer 13

• We systematically overestimate our decision making abilities
• The greater the level of skill required and the more complex the task, the more confident we are
• Actual performance often has little or no relationship with level of confidence

Question 14

Illusion of knowledge

Answer 14

The more information we have the more confident we are

Question 15

Illusion of control

Answer 15

The more time spent analysing the situation and the more successful we have been, the more control we feel we have

Question 16

Overoptimism

Answer 16

People overestimate the likelihood of desired outcomes and underestimate the frequency of unfavourable events
Example: BoE forecasts

Question 17

Confirmation bias

Answer 17

• We see what we want to see and interpret evidence in terms of preconceived ideas
• Search for evidence consistent with previously held views and neglect potentially disconfirming information