WK7 Cognitive Biases in Perception and Learning

Cognitive Biases Related to Perception and Learning

• 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.

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.