Topic 5 - Balancing Wants, Acquiring Knowledge, and Correcting Cognitive and Emotional Errors

Question 1

What are examples of quick and precise feedback on short-term outcomes?

Answer 1

a trader gets an instant alert showing profit or loss from a recent stock sale

an analyst reviewing the market’s instant reaction to a company’s morning earnings release

Question 2

What are examples of delayed, sparse, and ambiguous long-term outcomes?

Answer 2

a portfolio manager reviewing the annual performance report of a diversified fund against its benchmark

an investment banker assesses the long term impact of a merger deal closed two years prior on the companies market share

Question 3

What can get in the way of facts when evaluating whether financial advisors, money managers, or physicians are experts?

Answer 3

Self-interest gets in the way

surgeons might want to try a new technique so they will urge patients to opt for the surgery

Question 4

How can financial advisors guide investors?

Answer 4

they can provide information on human behavior, financial facts, and correct cognitive and emotional errors

Question 5

What would an example be of a financial advisor guiding investors’ actions?

Answer 5

point out emotional errors of exaggerated fear when clients are thinking of selling all of their stocks after a market crash

Question 6

Is it true that from individual to individual we vary in vulnerability to cognitive and emotional errors?

Answer 6

This is true

Question 7

Genetic factors do have some say in how vulnerable we are to cognitive and emotional errors (true or false)

Answer 7

true

Question 8

What percent does research attribute to genetic factors with susceptibility to investment errors?

Answer 8

50%

Question 9

What do people do when faced with multiple anchors?

Answer 9

They compare the anchors and evaluate which one is more plausible, then use that as their anchor for their answer

Question 10

What is the “wisdom-of-crowds” method for correcting overprecision errors?

Answer 10

the average of two guesses is generally more accurate than either individual guess

Question 11

What is “wisdom of crowds within”?

Answer 11

you ask someone for their best guess at something, then say assuming you are wrong… what is your next guess.

Question 12

What is better, “wisdom of crowds within” or “wisdom of crowds”

Answer 12

wisdom of crowds is more accurate than wisdom of crowds within

The average guess of two people is generally more accurate than the average two guesses from one person

Question 13

What is the rephrasing the question to make time more explicit method when correcting overprecision errors?

Answer 13

If someone asks you to estimate a confidence interval 12 months into the future…

Start by estimating the confidence interval one month into the future, then 6 months in the future, then 12 months into the future. This slow buildup helps people be more accurate as they will widen their confidence as they estimate further dates.

Question 14

What is the splitting of the question into two parts method for correcting overprecision errors?

Answer 14

If someone is asking for a 20%, 50% and 80% confidence intervals, split the 20% and 50% into one group and the 80% into another.

Do the 20% and 50% confidence interval, then do the 80%, this will promote you to use system 2 and you should realize that you need to make the interval wider as you increase your confidence.

Question 15

People with insufficient self-control are what?

Answer 15

overly eager to indulge

Question 16

People with excessive self-control are what?

Answer 16

excessively reluctant to indulge

Question 17

What is the daily settlement rule and what does it provide for investors?

Answer 17

It ensures that all traders close their positions at the end of each day.

This acts as a rule and self-control devices

Question 18

What does the law of small numbers say when a firm has 6 years of beating the market?

Answer 18

we cannot predict nearly as accurately the future performance of a mutual fund by performance in 6 past years

we can predict quite accurately the quality of future meals at a restaurant by the quality of 6 past meals

Question 19

What error are we making if we conclude that a manager who beat the benchmark 6 years in a row is evidence of skill?

Answer 19

Representativeness error

Question 20

What is a correct evaluation of a manager who beats the benchmark for 6 years in a row?

Answer 20

We know that few mutal fund managrs beat their benchmarks consistently over the years
we know that flipping heads 6 times in 6 flips is only one in 64
we know that there are thousands of fund managers
it is likely that there would be a lucky fund manager who beats their benchmark 6 times in a row (just like the lucky 6 heads in a row from coin flips)

Question 21

what is base rate information from the representativeness error?

Answer 21

The proportion of times that a similar situation happened to you, but it was worthwhile

How many telemarketers who have interrupted dinner have been worthwhile listening to?

Question 22

What does wasons card selection show?

Answer 22

It shows that we should look for confirming evidence and disconfirming evidence

In reality, we often seek to flip cards that confirm the statement and are less likely to seek to flip cards that debunk the statement

Question 23

What bias is being shown in wasons card selection?

Answer 23

confirmation bias
the tendency to seek information that confirms a belief

Question 24

Which cards would you turn over to find it satisfies the rule “if a person drinks beer, then that person is 18 or older”

Drinking beer
drinking coke
22 years old
16 years old

Answer 24

Flip over drinking beer (confirming the statement), and 16 years old (disconfirming the statement)

Question 25

Which cards would you turn over to find it satisfies the rule “if a card has a D on one side, then it has a 7 on the other side”

Answer 25

Flip over the card with a D on one side (confirming the statement), and flip over the card with a 5 on one side (disconfirming the statement)

Question 26

One group of people was told that they were the employer, and the other group was told that they were the employee

What did both groups do with this statement:

“If an employee gets a pension then that employee must have worked for the firm for at least 10 years”

Here were the cards: (Pension, no pension, worked 12 years, worked 8 years)

Answer 26

Both groups looked for disconfirming evidence

Those who were told that they were the employer were better at detecting cases where the employee cheated (receiving a pension while only working 8 years)

those who were told that they were the employee were better at detecting cases where the employer cheated (providing no pension to an employee who worked for 12 years)

Question 27

What happens when a human forecaster makes a mistake vs an algorithmic forecaster?

Answer 27

We lose confidence in the algorithmic forecaster faster than we lose confidence in human forecasters after seeing them both make the same mistake

Question 28

What do commitment devices do?

Answer 28

they offer incentives that bolster self control

Question 29

What would some examples of commitment devices be?

Answer 29

A savings account that prevents premature withdrawals
Using automatic paycheck deductions for consistent retirement or investment savings

Question 30

What is the endowment effect?

Answer 30

people tend to assign a higher value to something just because they own it

Question 31

What is an example of the endowment effect?

Answer 31

If you receive a mug as a gift you would probably say its worth $6, if you own it and try to sell it, it is likely that you will ask a higher amount ($10)

You assign a higher value to something just because you own it

Question 32

How do you correct the endowment effect?

Answer 32

It requires the use of system 2 to counter emotional errors

Question 33

What emotional error is most prevalent in the endowment effect?

Answer 33

Regret

Question 34

How do you correct insufficient self-control?

Answer 34

Bundle wants (things you like doing) with shoulds (things you have trouble holding yourself to)

Ex: watching your favorite Netflix show only if you are running on the treadmill

Question 35

What do prize-linked savings help correct?

Answer 35

Insufficient self-control

Question 36

What is prize-linked savings?

Answer 36

Accounts that bundle the want of winning a lottery with the should of saving

A savings account that doesn’t accumulate much interest, but instead, they are entered into lotteries

Question 37

What are people with insufficient self-control most likely to do?

Answer 37

overly eager to indulge

Question 38

What are people with excessive self-control most likely to do?

Answer 38

excessively reluctant to do so

Question 39

If a woman is offered a $80 spa coupon or $85 in cash, what should someone with excessive self-control choose?

Answer 39

They should choose the spa gift card as they deserve to relax. if they chose the money their excessive self control would not allow them to use that money to relax, they would most likely spend it on groceries.

Question 40

What can help correct cognitive and emotional errors when investing?

Answer 40

An investment model (computer) that bases its decisions on inputs (profitability, susceptibility to bankruptcy, margin of safety, financial stability)

Question 41

When people saw a picture of what they will look like when they are old, what did that do to their decisions?

Answer 41

They choose future monetary rewards over immediate ones

Question 42

Are incentives always effective in correcting cognitive and emotional errors?

Answer 42

No

Question 43

Can incentives backfire?

Answer 43

Yea, they can reduce performance because of anxiety (test taking for example)

Question 44

Do financial advisors always have the best interest of their clients at heart?

Answer 44

No

Question 45

If there is an incentive for investing in an inferior investment (a financial advisor investing their client’s money)… what percent would take the incentive

Answer 45

50% of all financial advisors would recommend an inferior investment to clients if there was a bonus for recommending it

Question 46

If financial advisors were given a bonus for recommending an inferior investment to their clients, what would happen if the bonus was taken away a month later?

Answer 46

After the bonus was removed, it was found that advisors were 6 times more likely to recommend a subpar investment (as opposed to there being no bonus before)

Question 47

People who are ____ find it difficult to perform tasks that require self-control

Answer 47

fatigued

Question 48

____ people were more likely to succumb to temptation

Answer 48

distracted

Question 49

When is it good to postpone choices?

Answer 49

When depleted, fatigued, angry, aroused, hungry, or distracted

Question 50

When auditors met financial advisors what did they find in their portfolios?

Answer 50

Investment errors in the interest of the advisors: choosing high-cost active mutual funds
- Good investment strategies, yet they counter the interests of advisors by choosing low-cost index funds
- Advisors fail to correct the errors of investors, often reinforcing errors that conform to their interests

Question 51

Corrections are ____ when people ask for them

Answer 51

Libertarian

Question 52

Corrections are ___ or _____ when people do not ask for them.

Answer 52

Libertarian-paternalistic
or paternalistic

Question 53

Nudges are _____ as they allow people to resist by opting out

Answer 53

Libertarian-paternalistic

Question 54

Mandates are ____ as they do not allow people to resist by opting out

Answer 54

paternalistic