HeuristicDriven Bias: The First Theme

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Heuristic-Driven BiasThe First Theme

• Taken from
• Beyond Greed Fear Understanding Behavioral
  Finance and the Psychology of Investing
• by Hersh Shefrin

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What is the heuristic-driven bias?

• The heuristic-driven bias is the improper
  influence of flawed assumptions and imperfect
  decision strategies that can lead investors to
  make errors in judgment.
• Heuristic-driven bias includes behavioral
  concepts like availability, representativeness,
  anchoring-and-adjustment, overconfidence, and
  aversion to ambiguity.

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Heuristics

• A heuristic is an informal, speculative, shortcut
  strategy that we use in decision making.
• They indirectly influence our judgment by
  affecting how we selectively process information
  from a complex environment.
• Heuristics can be helpful at times, but are not
  always accurate. They can lead to other
  cognitive biases.

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Availability Heuristic

• Occurs when we make judgments on the basis of how
  easily we can call to mind what we perceive as
  relative instances of a given phenomenon
• The ease of imagining an example, or the
  vividness and emotional impact of that example
  becomes more credible than actual statistical
  probability of the event occuring.

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Biases caused by the availability heuristic

• Ease of recall (based on vividness)
• Example Which is the more frequent cause of
  death in the U.S., homicide or stroke?
• Retrievability (based on memory structures)
• Example Are there more words in the English
  language that begin with R or have R as the third
  letter?
• Presumed associations
• Example Are couples who get married under the
  age of 25 more likely to have larger families?

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Representativeness Heuristic

• People look for traits that an individual,
  object, or event may have that correspond with
  previously formed stereotypes.

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Biases caused by the representativeness heuristic

• Insensitivity to sample size
• Example (from Tversky and Kahneman)
• A town is served by two hospitals. In the
  large one, 45 babies are born each day and in the
  smaller hospital about 15 babies are born each
  day. For a period of one year, each hospital
  recorded days in which more than 60 of the
  babies born were boys. Which hospital do you
  think recorded more such days?
• a. The larger hospital
• b. The smaller hospital
• c. About the same

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Biases caused by the representativeness heuristic

• Misconceptions of chance
• People expect a sequence of random events to
  look random, and believe that outcomes of
  previous random events affect future random
  events.
• Example (gamblers fallacy)
• After holding bad cards on 10 hands of
  poker, the player believes he is due a good
  hand.

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Biases caused by the representativeness heuristic

• Regression to the mean
• People assume that future outcomes will be
  directly predictable from past outcomes. They
  base predictions on the assumption of a perfect
  correlation with past data.
• Example Using high school GPA as a
  predictor of college GPA.

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Overconfidence

• People are imperfect at gauging their own level
  of accuracy.
• People fail to appreciate the difficulty of
  questions. They do not decrease their confidence
  as their knowledge about the subject of a
  question decreases.
• People tend to be more overconfident when asked
  to respond to questions of moderate to extreme
  difficulty than when responding to simple
  questions.

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Anchoring Adjustment

• A psychological heuristic which influences the
  way people intuitively assess probabilities.
• People start with an implicitly suggested
  reference point (the "anchor") and make
  adjustments to it to reach their estimate.
• People respond conservatively to new information,
  especially if the new information increases the
  level of uncertainty.

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Aversion to Ambiguity

• Describes an attitude of preference for known
  risks over unknown risks, or the familiar to the
  unfamiliar.
• Example Willingness to gamble when the
  odds are even vs the
• unwillingness to gamble
  when the odds are unknown.

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Emotion Cognition

• Many of the cognitive biases discussed have
  emotional components.
• Emotion is an important context effect for the
  encoding and retrieval of memory. This suggests
  that phenomena involving the availability
  heuristic, which relies on our ability to recall
  events, could have both cognitive and emotional
  components.

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Summary

• Heuristic-driven bias is influenced by
• 1. Availability
• a. Ease of recall
• b. Retrievability
• c. Presumed associations

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Summary

• Heuristic-driven bias is influenced by
• 2. Representativeness
• a. Insensitivity to sample size
• b. Misconceptions of chance
• c. Regression to the mean

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Summary

• Heuristic-driven bias is influenced by
• 3. Overconfidence
• 4. Anchoring and Adjustment
• 5. Aversion to Ambiguity
• 6. Emotion and Cognition