Cognitive Biases in Decision Making

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Questions and Answers

What does the term 'myopic loss aversion' refer to?

The tendency to overlook long-term gains due to frequent evaluations. (correct)

The belief that short-term observations will always provide a clearer understanding of risks.

The preference for earning small, certain gains rather than risking for larger uncertain gains.

The strong feeling of pain after experiencing a loss in an investment. (correct)

What is the probability of a positive return over a month according to the given probabilities?

50%

54%

67% (correct)

93%

How does the frequency of evaluations affect the experience of losses?

Losses are always less impactful when evaluated frequently.

Evaluating outcomes at longer intervals reduces the experience of loss.

Frequent evaluations decrease the perception of loss.

Frequent evaluations lead to a higher incidence of painful loss experiences. (correct)

Comparing daily, monthly, and annual observations, which scenario results in the highest ratio of pleasurable to unpleasurable experiences?

Annual observation. Signup and view all the answers

Which time scale has the lowest probability of a positive return?

Any second. Signup and view all the answers

What is the Disposition Effect?

The tendency to be risk averse over gains and risk seeking over losses. Signup and view all the answers

What is a framing effect in the context of decision making?

The dependence of preferences on how decision problems are formulated. Signup and view all the answers

In the context of Prospect Theory, what is the significance of the outcomes in games A and C?

They are identical in terms of total wealth after the game. Signup and view all the answers

In the Asian Disease Example, what change in framing leads to a reversal of preferences?

Describing outcomes by the number of lives saved versus lost. Signup and view all the answers

Which of the following behaviors is commonly associated with the Disposition Effect?

Investors hold onto winning stocks too long and sell losing stocks too early. Signup and view all the answers

How does Prospect Theory explain human behavior in financial decision-making?

People demonstrate inconsistent preferences when faced with risk. Signup and view all the answers

Which behavior is illustrated by the Asian Disease Example?

Risk seeking for losses and risk aversion for gains. Signup and view all the answers

How does the frequency of evaluations influence decision-making?

Frequency of evaluations can alter perception and choice. Signup and view all the answers

What do Games B and D demonstrate in terms of risk preferences?

Preference for risk when facing potential losses. Signup and view all the answers

What are potential real-life applications of framing effects?

Framing options in healthcare and investment decisions. Signup and view all the answers

Which of the following biases does the Disposition Effect contradict?

Risk seeking over gains. Signup and view all the answers

What was demonstrated in the experiment by Thaler, Tversky, Kahneman, and Schwartz (1997)?

Evaluating returns frequently affects portfolio allocation decisions. Signup and view all the answers

Why do individuals prefer to lock in gains according to the Disposition Effect?

To avoid the pain associated with realizing losses. Signup and view all the answers

What pattern of risk preferences does Prospect Theory identify?

Risk aversion for gains and risk seeking for losses. Signup and view all the answers

What does framing of investment options imply for investor behavior?

Minor changes in framing can yield different investment choices. Signup and view all the answers

What is one key principle regarding how people perceive outcomes in decision making?

Gains prompt a disregard for risk, while losses heighten it. Signup and view all the answers

What is the main reason that investors tend to avoid stocks according to myopic loss aversion?

Investors are loss averse and evaluate portfolios frequently. Signup and view all the answers

How does the endowment effect influence an individual's perception of value?

Individuals irrationally inflate the value of owned items. Signup and view all the answers

In behavioral economics, how are willingness to pay (WTP) and willingness to accept (WTA) expected to relate to each other?

WTP is approximately equal to WTA. Signup and view all the answers

If a neighbor is moving in and wants to install a chicken coop, what does this scenario imply about the risk of avian bird flu?

You would require a high payment to offset the risk. Signup and view all the answers

According to Benartzi and Thaler, what factor leads to investors behaving as if they have a one-year time horizon?

Frequent evaluations of portfolios due to loss aversion. Signup and view all the answers

What is the definition of willingness to pay (WTP)?

The amount a person is willing to pay to purchase a good. Signup and view all the answers

What psychological phenomenon can impact an investor's behavior towards safer assets like t-bills?

Myopic loss aversion. Signup and view all the answers

What experimental setup was used to demonstrate the endowment effect?

Half of the students were given an inexpensive desirable object. Signup and view all the answers

What is the Endowment Effect?

The tendency for individuals to prefer items they have owned over items they have not. Signup and view all the answers

Which scenario illustrates how the Endowment Effect manifests between buyers and sellers?

Sellers demand higher prices to part with their items than buyers are willing to offer. Signup and view all the answers

What role does loss aversion play in the Endowment Effect?

It makes individuals feel a loss when parting with owned items. Signup and view all the answers

According to reference dependence, what happens when an object becomes part of an individual's endowment?

Decisions regarding the object are framed as gains or losses. Signup and view all the answers

What does WTP stand for in the context of the experiment?

Willingness to Pay Signup and view all the answers

In the experiments conducted, which group exhibited behavior more like buyers rather than sellers?

Choosers Signup and view all the answers

What outcome would be expected from the trades if the goods were randomly assigned?

Only half of the items should change hands. Signup and view all the answers

What was a significant finding regarding the trading behavior of students during the experiment?

Very few students chose to trade, highlighting the Endowment Effect. Signup and view all the answers

What is narrow framing in decision-making?

Assessing each decision in isolation from others Signup and view all the answers

How does risk aversion affect decision-making for gains?

It results in a higher willingness to pay for sure gains Signup and view all the answers

What does the disjunction effect in decision-making imply?

Preferences may vary depending on the state of the world Signup and view all the answers

What does the Sure-thing Principle state about preferences?

Preferences should remain constant regardless of uncertainty Signup and view all the answers

What is the implication of the violation of the Sure-thing Principle as observed in Tversky & Shaffer's study?

Preferences can be inconsistent despite rational assessment Signup and view all the answers

In the scenario of passing the exam, what decision are individuals least likely to make?

Wait until the offer expires to decide Signup and view all the answers

What can be inferred about human decision-making behavior based on narrow framing?

Humans often miss the broader implications of individual choices Signup and view all the answers

How does risk-seeking behavior manifest during losses?

It encourages individuals to gamble for potential losses Signup and view all the answers

Study Notes

Prospect Theory predicts violations of EU utility and the 4-fold pattern of risk aversion.
The Disposition Effect is the tendency for individuals to be risk averse over gains, but risk-seeking over losses. Investors tend to sell assets that have gained value too early, while holding on to assets that have lost value for too long. This behavior is rooted in prospect theory and loss aversion.
Framing effects demonstrate that the way information is presented affects how people make decisions. Seemingly minor changes in framing can alter behavior. An example is the Asian Disease Example, where different framing of the same outcome leads to different choices.
Myopic Loss Aversion describes the combination of loss aversion and frequent evaluations of risky returns. Pleasure from a gain is less than the pain of an equivalent loss and losses occur more frequently at narrow time scales. This relates to why employees might forgo investing in equities for safer bonds.
Equity Risk Premium Puzzle describes why riskier assets (like stocks) return more than risk-free assets (like bonds), when risk-averse investors would theoretically prefer the guaranteed lower return of a risk-free asset. The average of real return on Stocks and Treasury bills, as well as the Equity Risk Premium in 2020, are relevant data. Further, the return principle can be explained through Mehra & Prescott.
The Endowment Effect demonstrates that people tend to assign more value to things they own, even if that value is objectively lower than the market value. This effect is often observed in willingness to pay versus willingness to accept, where selling price is significantly higher than buying price.
Limits to Prospect Theory include that some framing effects are not predicted by prospect theory. Also, the reference point is not adjusted dynamically in a sequence of gambles. The house money effect describes the tendency for people to take on greater risks when they perceive they are playing with money that isn't theirs (such as recent gains or windfalls). This is observed in real life examples like stock market gains, casino gambling, bonuses, or lottery wins.
The Disjunction Effect occurs when people prefer one option over another when the outcome of an event is known, but prefer the opposite when the outcome is unknown. This is demonstrated in examples regarding exam results and vacation packages. A lack of knowledge about the outcome from a gamble can create confusion in terms of choice/rationality.

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Description

This quiz explores various cognitive biases that influence decision-making processes, including Prospect Theory, the Disposition Effect, Framing Effects, and Myopic Loss Aversion. Delve into how these biases affect individual behavior, particularly in the context of investments and risk assessment.