Week 8 Flashcards
Humans often make poor financial decisions despite “” the benefits of “”, “”, and risk management.
understanding, saving, investing
There are 3 different ways researchers study decision-making
○ Normative = Ideal decisions
- It asks: “What’s the best possible choice?”
Based on logic, goals, and values.
○ Descriptive: Real decisions
- “What do people actually do?”
- Studies how people really behave, even if it’s irrational or biased.
○ Prescriptive: Better decisions
- It asks: “How can we help people improve their decisions?”
- Focuses on creating tools, advice, or nudges to help.
The brain operates on two different systems..and what are they also called?
Brain operates on two different systems:
1. Intuition —automatic, effortless, and efficient [System 1]
2. Rational — slow, effortful, and rational [System 2]
What is System 1 and System 2? How do we use them?
System 1 is useful for things like choosing which food staples to buy, what to wear, or the best route to
take to work. T
- These are decisions that we do not actively contemplate
For System 2, in our daily lives, we face many complex financial decisions.
- For example, whether or not to attend university, buy a house, how much to save for retirement, or what kind of investments to make.
What are Heuristics?
Heuristics: are mental shortcuts or rules of thumb that people use to make decisions or solve problems quickly and easily.
Instead of analyzing every detail, your brain uses a simple strategy that usually works well — but not always.
- For example, the advice to save 10% of your income toward retirement or that an emergency fund should be about 3 to 6 months of your income.
- If you’re shopping and see two similar products, you might pick the more expensive one because you assume “you get what you pay for.” — That’s a heuristic — it’s fast, but not guaranteed to be right.
- These shortcuts were developed because financial decisions are difficult
List the 3 main types of Heuristics?
- Representativeness
- Availability
- Anchoring and adjustment
Heuristics: What is Representativeness ?
Representativeness
Is the tendency to overgeneralize from a few characteristics or observations. The most obvious example of this is stereotypes
- Ex. Mason is tall so he must be a basketball player
- Ex. That person is wearing a suit so they must be a successful business person
Heuristics,Representativeness: Define the Base rate, Regression to the mean, and Gambler’s fallacy
Base rate: the actual statistical likelihood of something happening (also called prior probability)
Example:
- A person seems shy, calm, and detail-oriented — we might guess they’re a librarian.
- But: Statistically, there are way more salespeople than librarians.
- So, it’s actually more likely they’re a salesperson, based on base rates.
- Key point: We often ignore base rates and instead rely on how someone seems based on traits — this is a common thinking error.
Regression to the mean: When an outcome is unusually high or low, future outcomes are likely to be closer to average. It’s a reminder that extreme results don’t last — things tend to even out over time.
Example:
- After very high stock market returns, it’s likely that future returns will be lower and return to the average.
- Note: People often overlook this because of the representativeness heuristic (we expect patterns to continue).
Gambler’s/Conjunction Fallacy (Gambling Effect): The false belief that past random events affect future ones.
Example:
- After flipping 9 heads in a row, you might wrongly believe the next flip is “due” to be tails.
- Reality: Each flip is independent — still a 50/50 chance.
- Common confusion: People mix this up with regression to the mean, which is about long-term averages—not immediate outcomes.
“you lost to the slot lot machine, but next time you’ll win big”
Heuristics: What is Availability ?
Availability heuristic: is the tendency for our brain to use a select and limited criteria of information when making a decision.
- Recency
- Frequency
- Extremeness
- Vividness
- Skewed towards negatively
^ The information we use tends to be based on this
It’s a helpful shortcut because the universe of information we could use is overwhelming
- For example, lotteries sell more tickets after a big payout. Why? Because people just heard about someone winning so they think it happens often and they don’t want to lose out. The probability of winning the lottery does not change, it is always infinitesimally small.
The availability heuristic leads us to systematically “” certain things, like our risk of dying in plane crash, a car accident or by homicide.
- We perceive the risk as “” “” than actual probabilities predict.
And at the same time, we tend to systematically “” other risks, such as dying from less dramatic causes such as diabetes, heart disease, or cancer.
- these risks are “” “” (probable) to happen
overestimate, much higher
…………………….
underestimate, more likely
Heuristics, Availability: Define the False consensus effect and The validity effect
False consensus effect: This leads us to believe other people think like we do because our opinion dominates our considerations.
- For example, we might think other people share the same political ideologies or religious beliefs we do. This can cause confusion and sometimes discomfort and is something to be aware of when talking with clients.
The validity effect: It is the tendency for something to become more valid simply because it is repeated often.
- Look no further than the “fake news” phenomenon for an example of this effect in action. It’s easy for something to start trending on social media and before you know it, people have decided that it must be true because they keep seeing it.
Heuristics: What is Anchoring and adjustment ?
Anchoring and adjustment: We tend to rely too heavily on the first piece of information (the “anchor”) when making decisions.
- The initial anchor tends to influence final estimates, leading to biases in decision-making.
Example:
- If you guess L.A.’s population, you might start with Toronto’s (2.5–3M) and adjust from there — even if it’s not a great reference.
In investing:
- People often anchor to a stock’s current price, even before checking fundamentals like earnings.
- A low price anchor can lead to undervaluing; a high price anchor can lead to overvaluing.
Heuristics, Anchoring and adjustment: Define Status quo bias, Loss Aversion, Disposition Effect, Myopic Loss Aversion, Sunk Cost (do need to define)
Status quo bias: It’s our tendency to prefer things to stay the same — the path of least resistance.
We treat our current situation as the reference point, even if change could be beneficial.
Key idea:
- Any change feels risky because it might lead to losses, even if it could also bring gains.
- This bias can hold people back from making better financial, career, or life decisions.
Loss Aversion: People feel the pain of losses more strongly than the pleasure of equivalent gains.
Key idea: Losing $100 feels worse than gaining $100 feels good.
Example:
* In a car study, customers starting with a fully-loaded model were reluctant to remove features (felt like a loss).
* They spent $1,000 more on average than those who started with a basic model and added features.
Disposition Effect: A bias caused by loss aversion, where people avoid realizing a loss.
Main behavior:
- Investors hold onto losing stocks because selling would mean admitting the loss.
Other side:
- Investors might panic and sell quickly during market drops to avoid further losses.
Key idea:
- Both reactions come from the same place: fear of losing.
Myopic Loss Aversion: People focus too much on short-term losses, even when the long-term outlook is good.
This fear can stop them from making smart, long-term investments.
Example:
- An investor avoids putting money into the stock market because they’re worried about short-term drops, even though the market tends to grow over time.
