Psychology Chapter on Decision Making

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Questions and Answers

What effect does hindsight bias have on individuals' perception of past events?

It reduces their confidence in making future decisions.

It makes individuals overly skeptical of past decisions.

It leads individuals to believe they could have predicted outcomes with certainty. (correct)

It enhances the ability to predict future outcomes accurately.

Which of the following best describes procrastination bias?

Overestimating the benefits of immediate gratification over long-term planning.

The inclination to diversify investments to avoid potential losses.

Deciding to delay immediate costs for potential higher future gains. (correct)

The tendency to make impulsive decisions without considering future consequences.

What is a common misconception associated with overconfidence bias in decision-making?

People are generally overly cautious in evaluating risks.

Individuals often underestimate their abilities to influence events.

Decision-makers believe they possess more knowledge than they actually do. (correct)

Confidence levels are unrelated to actual performance outcomes.

In the context of financial decisions, how may past performance affect investors' behavior?

They may overestimate the likelihood of similar returns due to hindsight bias. Signup and view all the answers

What is a suggested method to mitigate hindsight bias according to the content?

Informing individuals about the existence of hindsight bias. Signup and view all the answers

Which of the following best explains the defense mechanism against procrastination bias?

Encouraging a focus on long-term planning without distractions. Signup and view all the answers

What is one potential remedy for the underestimation of risks due to overconfidence bias?

Encourage collective decision-making processes. Signup and view all the answers

How does information overload relate to decision-making biases?

It complicates the evaluation of alternatives, potentially increasing bias. Signup and view all the answers

What is a primary criticism of regret theory in decision-making?

Regret effects are primarily due to framing effects. Signup and view all the answers

Which of the following concepts describes the tendency to avoid decisions due to the fear of making the wrong choice?

Procrastination Bias Signup and view all the answers

How does excessive use of past performance information affect decision-making in financial services?

It leads to overconfidence and poor choices. Signup and view all the answers

Which theory explains the inconsistency in choices when individuals value different lotteries differently based on monetary evaluations?

Preference Reversal Theory Signup and view all the answers

In the context of bounded rationality, which concept refers to the impact decision-making suffers due to the overwhelming amount of information available?

Information Overload Signup and view all the answers

Which of the following best illustrates the concept of overconfidence bias in financial decision-making?

Investors believing they can consistently outperform the market. Signup and view all the answers

What is the primary outcome of applying regret theory to decision frameworks in finance?

Systematic violation of traditional rationality principles. Signup and view all the answers

What behavioral tendency might someone exhibit when evaluating a risky investment compared to a guaranteed payoff?

Loss Aversion Signup and view all the answers

What is likely to occur as a consequence of information overload during decision-making?

Difficulty in identifying the best option. Signup and view all the answers

Procrastination bias is best characterized by which of the following behaviors?

Delaying or avoiding decisions despite knowing they need to be made. Signup and view all the answers

Overconfidence bias can manifest in decision-making as which of the following?

Both A and C. Signup and view all the answers

Which strategy might mitigate the effects of overconfidence bias in financial decision-making?

Seeking feedback from multiple stakeholders on decisions. Signup and view all the answers

How does past performance impact future decision-making according to biases?

It can create a false sense of security or overconfidence. Signup and view all the answers

Which of the following best describes the impact of loss aversion on decision-making?

Losses are perceived as more significant than equivalent gains. Signup and view all the answers

Immediacy or hyperdiscounting bias primarily influences decisions by causing individuals to:

Favor immediate rewards over larger, delayed rewards. Signup and view all the answers

In the context of decision-making, the endowment effect suggests that individuals:

Overvalue items simply because they possess them. Signup and view all the answers

What is a notable drawback of Friedman’s argument regarding adjustments to equilibrium?

Adjustment through private law may be hindered by negotiation frictions. Signup and view all the answers

Which of the following reflections could be considered a drawback of Stiglitz’s argument?

Regulators and supervisors can frequently fail in their duties. Signup and view all the answers

What implication does the need for food and safety regulations have in the context of Friedman’s argument?

Regulations should remain to protect vulnerable populations. Signup and view all the answers

Which concept is critiqued in Andrew Lo's discussions about market efficiency?

Efficient Market Hypothesis (EMH) Signup and view all the answers

In what way do negotiation frictions affect Friedman’s model of market adjustments?

They create barriers that prolong the adjustment period. Signup and view all the answers

What is a negative consequence of individuals mistakenly believing they are financially literate?

They often choose high-fee investments. Signup and view all the answers

What is one approach to help individuals recognize anchoring when making financial decisions?

Obliging the disclosure of underlying characteristics. Signup and view all the answers

Which statement exemplifies the concept of anchoring in financial decision-making?

Selecting a mortgage with interest rates based on past rates. Signup and view all the answers

What effect does acknowledging one’s lack of financial literacy have on investment behavior?

Encourages the use of cheaper default products. Signup and view all the answers

How can presenting average market returns help retail investors?

It assists them in distinguishing good investment deals. Signup and view all the answers

What is a key characteristic of hindsight bias in evaluating past events?

It encourages individuals to overlook alternative scenarios that could have occurred. Signup and view all the answers

Which of the following is a demonstration of procrastination bias?

Delaying payment for an immediate expense to avoid current financial strain. Signup and view all the answers

What might happen if individuals fail to adjust their assessments due to anchoring?

They might overestimate potential financial losses. Signup and view all the answers

What is a suggested remedy for individuals experiencing difficulties in recognizing their cognitive anchors?

Learning about anchoring prior to evaluating options. Signup and view all the answers

How does hindsight bias potentially impact retail investors?

It can result in overestimating the success of similar past investments. Signup and view all the answers

What characteristic of default financial products is highlighted as beneficial?

They are more transparent and less likely to exploit biases. Signup and view all the answers

What remedy has been suggested to counteract the effects of hindsight bias?

Provide transparency about the limitations of relying solely on past outcomes. Signup and view all the answers

Which of the following best captures the essence of creeping determinism associated with hindsight bias?

The tendency to reinterpret past events to fit known outcomes. Signup and view all the answers

In the context of decision-making, what is a likely consequence of procrastination bias?

People frequently delay necessary costs, reducing their future financial gains. Signup and view all the answers

What misconception might people hold about hindsight bias?

It is often perceived as a beneficial reflection tool. Signup and view all the answers

What might be a situational outcome when individuals experience procrastination bias?

Higher immediate costs incurred leading to diminished satisfaction. Signup and view all the answers

What phenomenon explains the preference for certain outcomes over probable ones in risk-averse scenarios?

Certainty effect Signup and view all the answers

Which concept describes the tendency to prefer a probable loss over a sure loss when confronted with negative outcomes?

Isolation effect Signup and view all the answers

In the context of Prospect Theory, what does the reflection effect primarily illustrate?

Greater sensitivity to losses than gains under certain conditions Signup and view all the answers

What is a consequence of the overestimation of certainty in decision-making?

Increased risk aversion in positive outcomes Signup and view all the answers

How does Prospect Theory interact with traditional expected utility theory (EUT)?

It enhances understanding of value assignment beyond EUT. Signup and view all the answers

Which of the following describes the phenomenon where diminishing marginal sensitivity occurs when evaluating losses?

Sensitivity decreases as losses increase Signup and view all the answers

In the context of decision-making under uncertainty, which aspect does the Prospect Theory address?

The violations of transitivity and invariance Signup and view all the answers

What typically influences people's choice between Gamble A and Gamble B?

The color of the ball being drawn Signup and view all the answers

What differentiates the Adaptive Market Hypothesis (AMH) from the Efficient Market Hypothesis (EMH)?

AMH recognizes arbitrage opportunities based on market cycles, while EMH suggests that such opportunities are always competed away. Signup and view all the answers

Which of the following is a common source of market failures?

Information asymmetry Signup and view all the answers

What type of market failure occurs due to individuals being unable to accurately assess the quality of information?

Adverse selection Signup and view all the answers

Which remedy could effectively address the issue of moral hazard in financial markets?

Creating contractual incentives or special clauses Signup and view all the answers

In the context of regulatory intervention theories, what is the primary goal of Public Interest Theories (PubIT)?

To ensure that markets serve the economic welfare and allocative efficiency Signup and view all the answers

Which of the following concepts is associated with underinvestment resulting from lack of clear risk signals in the market?

Knightian uncertainty Signup and view all the answers

What does bounded rationality suggest about decision-makers in economic scenarios?

They have cognitive limitations that affect their decision-making capability. Signup and view all the answers

When considering market externalities, what would be a typical characteristic of negative externalities?

They result in social marginal costs exceeding private marginal costs. Signup and view all the answers

Which concept best describes the phenomenon where market participants react to unpredictable forces affecting their decisions and resource allocation?

Illiquidity and contagion Signup and view all the answers

What type of market failure is primarily caused by the presence of high monitoring costs associated with information quality assessment?

Adverse selection Signup and view all the answers

Study Notes

Hindsight Bias

In hindsight, people overestimate how much they could have anticipated in foresight, this is known as creeping determinism.
People create a coherent story from known outcomes and events, downplaying other factors. This makes past events seem more predictable.
The known outcome acts as a reference point.

Preference Reversal

Choices between lotteries can contradict preferences based on monetary values.
The probability of winning influences preferences between lotteries.
People respond differently to choices and evaluations.
Preference reversal violates the assumptions of invariance and transitivity.

Regret Theory

Decision makers choose between outcomes based not only on the result but also on the alternative outcome they would have received (anticipated regret).
Regret theory explains preference reversal, Allais's paradox, common ratio, and isolation effects.
Regret effects are framing effects, occurring when comparisons are made.
Knowing the outcome of the forgone choice reduces anticipated regret.
There is a systematic issue in financial services with excessive use of past performance and overconfidence in stock markets.

Self-Serving Bias

Individuals tend to make judgements reflecting self-serving bias, like believing they are in the top 50% of drivers, ethics, etc.
Implications:
- Negotiating parties assess value in self-serving ways, reducing agreement space.
- Parties believe their notion of fairness is impartial and shared with the other party.
- Parties are willing to sacrifice to avoid unfair settlements, leading to no negotiation space.
The bias comes from neglecting contradictory evidence.

Prospect Theory

Attempts to explain how people assign value to different options, even when they don't strictly follow rational decision-making principles.
Addresses violations of transitivity, dominance, and invariance.
Examines three main effects that violate Expected Utility Theory:
- Certainty Effect: People overemphasize certainty, leading to risk aversion for gains and risk-seeking for losses.
- Reflection Effect: People are more sensitive to the first large negative deviation from a reference point.
  - Example: People are more likely to choose a probable loss over a certain loss.
- Isolation Effect: People focus on the differences between options rather than the overall context.

Bounded Rationality

Individuals make decisions differently than a perfectly rational economic agent, leading to predictable biases and distortions in decision-making.

Framing Effects

Decisions are influenced by how information is presented, leading to a divergence from rational choices.
People are more likely to choose options framed positively (e.g., “90% chance of survival”) rather than negatively (e.g., “10% chance of death”), even if the underlying possibilities are identical.

Anchoring and Adjustment

People tend to hold on to initial estimates (anchors) even when presented with contradictory information.
This can lead to under or overestimation of probabilities.
Example: A borrower may overestimate the likelihood of low interest rates based on past experiences.

Hindsight Bias

People overestimate their ability to have predicted past events.
They tend to create a comprehensive narrative after the fact, minimizing the impact of other possibilities.
Example: People who learn about an event tend to exaggerate its likelihood, overlooking other potential scenarios.

Procrastination Bias

The tendency to avoid immediate costs, even when doing so might yield future benefits.
Example: Focusing on immediate consumption (perceived as a gain) over saving (perceived as a loss).

Market Failures

Situations where market forces fail to allocate resources efficiently.
Often driven by information asymmetry, moral hazard, adverse selection, externalities, bounded rationality and market power.

Remedies for Market Failure

Focus on transparency, contractual incentives, and regulatory action.
Example: Increased disclosure of returns, regulations regarding fair market practices, and measures to reduce information asymmetry.

Theories of Regulatory Intervention

Public Interest Theories: Regulation seeks to promote the collective good, addressing market imperfections and protecting society from harm.
Private Interest Theories: Regulation is driven by private interests, with groups lobbying for regulations that benefit them, often through capturing regulatory agencies.
Public Choice Theory: Regulation is shaped by political forces, including the influence of interest groups and voter preferences.

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Description

Explore key concepts in decision-making psychology, including hindsight bias, preference reversal, and regret theory. Analyze how these theories explain the complexities of human choices and judgments. Enhance your understanding of how past experiences and potential regrets influence decisions.

Psychology Chapter on Decision Making

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Questions and Answers

What effect does hindsight bias have on individuals' perception of past events?

Which of the following best describes procrastination bias?

What is a common misconception associated with overconfidence bias in decision-making?

In the context of financial decisions, how may past performance affect investors' behavior?

What is a suggested method to mitigate hindsight bias according to the content?

Which of the following best explains the defense mechanism against procrastination bias?

What is one potential remedy for the underestimation of risks due to overconfidence bias?

How does information overload relate to decision-making biases?

What is a primary criticism of regret theory in decision-making?

Which of the following concepts describes the tendency to avoid decisions due to the fear of making the wrong choice?

How does excessive use of past performance information affect decision-making in financial services?

Which theory explains the inconsistency in choices when individuals value different lotteries differently based on monetary evaluations?

In the context of bounded rationality, which concept refers to the impact decision-making suffers due to the overwhelming amount of information available?

Which of the following best illustrates the concept of overconfidence bias in financial decision-making?

What is the primary outcome of applying regret theory to decision frameworks in finance?

What behavioral tendency might someone exhibit when evaluating a risky investment compared to a guaranteed payoff?

What is likely to occur as a consequence of information overload during decision-making?

Procrastination bias is best characterized by which of the following behaviors?

Overconfidence bias can manifest in decision-making as which of the following?

Which strategy might mitigate the effects of overconfidence bias in financial decision-making?

How does past performance impact future decision-making according to biases?

Which of the following best describes the impact of loss aversion on decision-making?

Immediacy or hyperdiscounting bias primarily influences decisions by causing individuals to:

In the context of decision-making, the endowment effect suggests that individuals:

What is a notable drawback of Friedman’s argument regarding adjustments to equilibrium?

Which of the following reflections could be considered a drawback of Stiglitz’s argument?

What implication does the need for food and safety regulations have in the context of Friedman’s argument?

Which concept is critiqued in Andrew Lo's discussions about market efficiency?

In what way do negotiation frictions affect Friedman’s model of market adjustments?

What is a negative consequence of individuals mistakenly believing they are financially literate?

What is one approach to help individuals recognize anchoring when making financial decisions?

Which statement exemplifies the concept of anchoring in financial decision-making?

What effect does acknowledging one’s lack of financial literacy have on investment behavior?

How can presenting average market returns help retail investors?

What is a key characteristic of hindsight bias in evaluating past events?

Which of the following is a demonstration of procrastination bias?

What might happen if individuals fail to adjust their assessments due to anchoring?

What is a suggested remedy for individuals experiencing difficulties in recognizing their cognitive anchors?

How does hindsight bias potentially impact retail investors?

What characteristic of default financial products is highlighted as beneficial?

What remedy has been suggested to counteract the effects of hindsight bias?

Which of the following best captures the essence of creeping determinism associated with hindsight bias?

In the context of decision-making, what is a likely consequence of procrastination bias?

What misconception might people hold about hindsight bias?

What might be a situational outcome when individuals experience procrastination bias?

What phenomenon explains the preference for certain outcomes over probable ones in risk-averse scenarios?

Which concept describes the tendency to prefer a probable loss over a sure loss when confronted with negative outcomes?

In the context of Prospect Theory, what does the reflection effect primarily illustrate?

What is a consequence of the overestimation of certainty in decision-making?

How does Prospect Theory interact with traditional expected utility theory (EUT)?

Which of the following describes the phenomenon where diminishing marginal sensitivity occurs when evaluating losses?

In the context of decision-making under uncertainty, which aspect does the Prospect Theory address?

What typically influences people's choice between Gamble A and Gamble B?

What differentiates the Adaptive Market Hypothesis (AMH) from the Efficient Market Hypothesis (EMH)?

Which of the following is a common source of market failures?

What type of market failure occurs due to individuals being unable to accurately assess the quality of information?

Which remedy could effectively address the issue of moral hazard in financial markets?

In the context of regulatory intervention theories, what is the primary goal of Public Interest Theories (PubIT)?

Which of the following concepts is associated with underinvestment resulting from lack of clear risk signals in the market?

What does bounded rationality suggest about decision-makers in economic scenarios?

When considering market externalities, what would be a typical characteristic of negative externalities?

Which concept best describes the phenomenon where market participants react to unpredictable forces affecting their decisions and resource allocation?

What type of market failure is primarily caused by the presence of high monitoring costs associated with information quality assessment?

Study Notes

Hindsight Bias

Preference Reversal

Regret Theory

Self-Serving Bias

Prospect Theory

Bounded Rationality

Framing Effects

Anchoring and Adjustment

Hindsight Bias

Procrastination Bias

Market Failures

Remedies for Market Failure