WK7 Cognitive Biases in Perception and Learning

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Questions and Answers

What is the initial probability that a randomly chosen bag contains predominantly red chips?

55%

30%

75%

45% (correct)

What happens to the estimate of the probability that the bag has predominantly red chips after drawing 8 red chips and 4 black chips?

Decreases to 30%

Increases to 60%

Increases to 96% (correct)

Remains at 45%

Which heuristic can lead individuals to incorrectly assess the probability of an event based on recent examples or instances that come to mind easily?

Representativeness Heuristic

Availability Heuristic (correct)

Base Rate Fallacy

Anchoring Heuristic

What is a consequence of conservatism in decision making?

Under-reacting to new information Signup and view all the answers

What characterizes the 'boom-bust cycle' mentioned?

It varies in length. Signup and view all the answers

Which of the following best describes the gambler’s fallacy?

Expecting future probabilities to be influenced by past events. Signup and view all the answers

How do people typically respond to new information according to the conservatism principle?

They somewhat adjust their beliefs but remain anchored to prior information. Signup and view all the answers

How does one define the representativeness heuristic?

Assuming similarities in events will yield similar outcomes. Signup and view all the answers

What phenomenon causes individuals to overestimate the probability of conjunctive events?

Anchoring effect Signup and view all the answers

What was the most common order of preference regarding likelihood in Tversky and Kahneman's study on drawing marbles?

B-A-C Signup and view all the answers

Which type of event is described as one that must occur in conjunction with others?

Conjunctive event Signup and view all the answers

What finding did Wilson et al. (1996) conclude regarding the anchoring effects?

Forewarnings do not eliminate anchoring effects. Signup and view all the answers

According to the information, what is a major characteristic of overconfidence bias?

Providing too narrow ranges for uncertain values. Signup and view all the answers

What is the correct probability of drawing at least one red marble in seven attempts from a bag containing 10% red marbles?

$52\%$ Signup and view all the answers

What common misconception is highlighted in surveys about driving abilities?

Most people believe they are above-average drivers. Signup and view all the answers

What does the term 'disjunctive event' refer to in the context of probability?

Events that occur independently. Signup and view all the answers

What can cause individuals to overweight the probability of a rare event?

There has been a recent, highly publicized occurrence Signup and view all the answers

Which of the following factors influences the availability heuristic by making recent events more likely to be recalled?

Recency bias Signup and view all the answers

How do vivid events affect an individual's perception of risk?

They make the events seem more frequent and prominent Signup and view all the answers

Which behavior represents an example of the availability heuristic in investment decisions?

Flocking to funds with recent high returns Signup and view all the answers

What effect does personal experience have on the availability heuristic?

It increases the likelihood of recalling one’s own experiences more easily Signup and view all the answers

After witnessing an alarming event, what is a possible change in people's perceptions regarding related risks?

They overlook statistical evidence Signup and view all the answers

Which scenario best exemplifies the impact of vividness in selling low probability outcomes, such as insurance?

Emphasizing recent natural disasters or accidents Signup and view all the answers

How does the recency effect influence performance reviews by managers?

Managers give more weight to the last three months of performance Signup and view all the answers

What effect does heavy media coverage have on public perception of rare events like shark attacks?

It leads people to overestimate the likelihood of those events occurring. Signup and view all the answers

How does the availability heuristic affect investor behavior after a significant market crash?

Investors may overestimate the likelihood of a future crash. Signup and view all the answers

What was a significant factor that fueled speculative bubbles in the cryptocurrency market?

Success stories of early investors becoming widely publicized. Signup and view all the answers

According to studies by Barber and Odean and Fang and Peress, how do investors tend to behave regarding attention-grabbing stocks?

They buy stocks in the news but do not outperform the market. Signup and view all the answers

What misconception may arise from consuming excessive news about crime rates?

The perception that crime rates have drastically increased. Signup and view all the answers

What is the primary drawback of making investment decisions based on the availability heuristic?

It leads to misjudgments about market trends and risks. Signup and view all the answers

How might news coverage of violent crimes influence public perception?

It can create an illusion of increased crime prevalence. Signup and view all the answers

What psychological bias can lead investors to focus more on media-covered stocks rather than other opportunities?

Availability heuristic Signup and view all the answers

What is one consequence of self-attribution bias on investor behavior?

Investors over-react to confirming news and under-react to disconfirming news. Signup and view all the answers

Which of the following is a result of overconfidence in corporate finance?

Executives underestimate time and uncertainty in new projects. Signup and view all the answers

How does overconfidence influence the behavior of executives when making acquisitions?

It increases their likelihood of making risky acquisitions. Signup and view all the answers

What is commitment escalation in the context of overconfidence?

Persisting with a project because stopping would admit a mistake. Signup and view all the answers

What effect does self-fulfilling prophecy have on market behavior?

If investors expect a rise, it can contribute to an actual rise. Signup and view all the answers

Why might overconfident CFOs use lower discount rates for cash flows?

They assess the projects as less risky than they are. Signup and view all the answers

What characteristic difference is observed in male executives compared to female executives regarding stock purchases?

Men's purchased stocks typically underperform those they sold by a greater margin. Signup and view all the answers

How does overconfidence affect investment success over time?

It generally leads to increased overconfidence due to past successes. Signup and view all the answers

What is the primary consequence of herding behavior in financial markets?

Formation of stock price bubbles and crashes Signup and view all the answers

Which cognitive bias influences investors to believe that a popular investment is more likely to be a good decision?

Representativeness heuristic Signup and view all the answers

What feature is characteristic of the disposition effect in investment behavior?

Holding onto losing investments for too long Signup and view all the answers

During which market scenario is herding behavior particularly pronounced in real estate?

Housing booms Signup and view all the answers

Which of the following best describes an outcome of the disposition effect?

Suboptimal trading by locking in gains too early Signup and view all the answers

What psychological factor often causes investors to refuse to sell assets below their original purchase price?

Anchoring Signup and view all the answers

In the context of cryptocurrencies, herding behavior was evident as investors rushed to buy based on what factor?

Media hype and social media trends Signup and view all the answers

Which of the following scenarios illustrates herding behavior during the dot-com bubble?

A surge in investments in technology stocks following market trends Signup and view all the answers

Study Notes

Cognitive biases significantly impact how individuals form beliefs about uncertain financial outcomes.
Different economic agents may perceive the same risk level quite differently.
Stock markets involve a vast amount of diverse information necessitating extensive information processing for future return forecasts.
Process 1, related to beliefs, and Process 2, related to making choices, are both crucial stages in forming financial beliefs.

Key Learning Objectives

Understanding behavioral biases in how individuals construct beliefs about uncertain payoffs is critical.
Recognizing and understanding why economic actors perceive identical risk levels differently is important.

Information Acquisition and Information Processing

Stock markets experience a wide variety of information sources.
Forecasting future returns often necessitates analyzing vast amounts of data.
Information processing is a crucial part of this forecasting process.

Information Processing

This section focuses on the complexities of processing information, likely to have been discussed in further detail.

Information: The More, the Better?

This is a question concerning whether more information always positively impacts decision quality.

Experts Judgment

Tetlock (2005) found that expert political predictions are not significantly better than those made by non-experts.
Expert financial predictions are often less reliable than popularly perceived.
Slovic et al. (1972) found that experienced brokers often have a poor understanding of their own internal decision-making processes.
Oskamp (1965) and Slovic (1973) research revealed that increasing the amount of available information does not always improve decision quality, but significantly improves confidence.

Limited Capability to Process Information

Individuals have limited cognitive capabilities in dealing with vast quantities of data.
Dijksterhuis et al. (2007) found that individuals struggle to make choices that are efficient when presented with an overload of information.
Information overload may cause individuals to make worse decisions, leading to information fatigue in financial matters.
In financial contexts, overload may result in investors overlooking crucial details, making emotional decisions, or depending on oversimplified heuristics.

Belief Perseverance

People tend to maintain their initial beliefs even if confronted with contradictory evidence ("belief perseverance").
The initial interpretation proves exceedingly difficult to remove or change.
The "Guess the Rule" experiment illustrates how initial interpretations persist even when exposed to negative feedback. (Wason, 1960)

Belief Perseverance - Confirmation Bias

Individuals tend to seek out and focus on information that confirms pre-existing views, while avoiding contradictory data ("confirmation bias").
This can lead to biased or inaccurate conclusions, particularly in financial decisions/expert judgments.

The Selective Attention Task

The experiment highlights the fact that attention is a finite resource.
Participants' focus is limited by the task at hand, often overlooking unexpected or irrelevant information.
What individuals perceive depends strongly on their pre-existing expectations and questions.

Inattentional Blindness in the Field

Investors may overlook relevant asset categories or information sources they do not intently concentrate on.
Understanding the link between customer-supplier relationships and the impact on financial market information is crucial.
When presented with many stocks, investors tend to rely on heuristic-based methods for decision-making.
Unusual news or trades will attract the most attention, and investors may be disproportionately inclined to focus on these attributes.

Bayes' Rule

A mathematical formula used for updating probabilities based on new evidence.
This illustrates an important part of understanding how new evidence should be incorporated in forming financial beliefs.
In practice, the Bayes' rule is rarely used in financial decision-making.

Heuristics

Mental shortcuts used to manage the vast quantities of information encountered daily.
Heuristics can be useful in everyday contexts.
Kahneman and Tversky identified three important heuristics: anchoring, availability, and representativeness.

The Representativeness Heuristic

Decision-makers often rely on similarity to make probabilistic judgments.
This can lead to significant errors, such as failing to account for base rates.
The experiment demonstrates how easily people are misled by apparent similarity in scenarios rather than the true underlying probabilities.

Sample Size Neglect

The representativeness heuristic can lead to misperceptions about the influence of sample size on probabilistic judgments.
People tend to focus on small sample representations, often disregarding larger sample data ("law of small numbers").

The Portfolio Manager's Performance

This experiment is used to illustrate how easily investors are misled into believing that previous patterns continue over the long-term.

Law of Small Numbers

People struggle with generating truly random sequences and tend to interpret short sequences as representative of long-run patterns.

Gambler's Fallacy

This bias describes the mistaken belief that the probability of an event changes after a series of events.
The belief that a roulette wheel must "balance out" or that repeated losses increase the probability of gain is an example of this bias.
This bias is often observed in financial markets, influencing investor decision-making.

Conservatism - Stock Picker Game

Demonstrates how slow individuals are to adapt beliefs when faced with new information.
Individuals tend to underreact to new information, retaining previous beliefs ("conservatism").
Incorporating newly acquired information often leads to slower, more cautious revision of financial beliefs.

The Availability Heuristic

People assess the likelihood of events based on how easily comparable instances come to mind.
Recency, vividness, personal experiences, and media coverage all affect judgment and estimates of likelihood.

Overconfidence

An overestimation of one's own ability to accurately assess risk.

Overconfidence in Stock Markets

In financial matters, overconfidence often leads investors to overestimate the accuracy and effectiveness of both their own portfolio judgment and the market forecast in general.

Overconfidence and Self-Attribution Bias

Overconfidence may be enhanced by success and reduced by failure.
Successes are often attributed to skill; failures are often attributed to circumstances.

Overconfidence and Corporate Finance

Overconfident executives may contribute to significant corporate mistakes, delayed recognition of problems, and potentially costly ventures.

Overconfidence in Stock Market and Household Finance

Overconfidence can affect financial decision-making in both individual and corporate contexts.

Confirmation Bias

A bias that predisposes investors to favor information that supports their pre-existing beliefs, while disregarding contradictory information.

Herding Behavior

The tendency to make judgments and investments based on the actions of others, often in the absence of comprehensive analysis.
Investors may mimic market trends based on the actions of others, leading to herding and suboptimal results.

The Disposition Effect

A behavioral bias that influences investment decisions, causing investors to sell winning investments prematurely and hold losing investments longer.
The desire to lock in gains or avoid further losses often leads to suboptimal investment decisions.

Theoretical Models in Overconfidence

Fischhoff, Slovic, and Lichtenstein (1977) developed models that predicted excessive trading by overconfident investors.
Studies by psychologists and economists have illustrated that overconfidence can have significant but negative impacts on financial results.

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Description

Explore how cognitive biases influence the formation of beliefs regarding uncertain financial outcomes. This quiz examines the differences in risk perception among economic agents and the importance of information processing in stock market predictions.