HEURISTICS AND BIASES

HOW PEOPLE THINK

• We have shown that traditional models of decision-making under uncertainty like
EUT do not survive empirical testing.
• Systematic violations suggest a different decision making process is at place.
• Prospect theory as an empirically-founded alternative to EUT.
• We also showed that PT has evolutionary roots and holds across very different domains

• If we do not decide according to EUT it must mean that we collect, interpret and
process information in a way that is not rational in the neoclassical sense of the term.
• Can we see patterns/systematic violations?
COLLECTING AND INTERPRETING INFORMATION
• Homo oeconomicus has potentially infinite ability to collect and process all the
available information.
• Even if we assumed that real individuals could collect that much information (which is
not the case) what matters most is how information is read an understood.
• For instance, we tend to see what we expect or desire to see
• In some cases we unconsciously distort information to avoid psychological
inconsistencies.
• A starting point for our analysis is key element in decision-making under uncertainty:
probability
THINKING AN INTERPRETING IN AN UNCERTAIN WORLD
In decision making uncertainty is addressed through the analysis of the impact of
probabilities.
In EUT: probabilities are the weights associated to each outcome in the computation
of the expected value of a prospect
In PT: probabilities affect the slope of the value function and indirectly further affect
decision-making through the associated probability weights.

Do real people have a healthy relationship with probabilistic thinking?

WHICH ONE IS MORE LIKELY?

Linda is 31 years old, single, outspoken and very bright. She majored in philosophy.
As a student, she was deeply concerned with issues of discrimination and social justice
and also participated in anti-nuclear demonstration.
Which of the following statements is more likely?
A. Linda is a bank teller
B. Linda is a bank teller and a feminist
THE TAXI CAB PROBLEM
A cab was involved in a hit and run accident at night. Two cab companies, the Green
Taxi and the Blue Taxi, operate in the city. You are given the following data.

• 85% of the cabs of the city are Green and 15% are Blue
• a witness identified the cab as Blue.

The court tested reliability of the witness under the same circumstances that existed on
the night of the accident and concluded that the witness correctly identified each one
of the colors 80% of the time and failed 20% of the time.

What is the probability that the cab involved in the accident was Blue rather than
Green?
Modal answer to the Taxi cab problem is 80%
CONDITIONAL PROBABILITY AND BAYES THEOREM
The conditional probability of A given B is:

If A1,... An are incompatible propositions, one of which must be true, then the
Bayes theorem says that:
CONDITIONAL PROBABILITY AND BAYES THEOREM
Thus, the correct answer to the Taxi cab problem is

P (blue | idBlue ) 
P(idBlue ) * P(blue)
 
P(idBlue | Blue ) * P(blue)  P (idBlue | Green) * P( green)
80% *15%
  41%
80% *15%  20% * 85%

Subjects focus on the probability that the witness judgment is representative of the
color of the taxi
P(idBlue | Blue) =.8

instead that looking for what is really asked: P(Blue | idBlue)

 THE “MAMMOGRAPHY” PROBLEM
“Standard probability format”

The probability of breast cancer is 1% for a woman at age forty who participates in
routine screening. If a woman has breast cancer, the probability is 80% that she will
have a positive mammography. If a woman does not have breast cancer, the
probability is 9.6% that she will also have a positive mammography.

A woman in this age group had a positive mammography in a routine screening.

What is the probability that she actually has breast cancer?

THE “MAMMOGRAPHY” PROBLEM REVISITED
“Frequency format”

10 out of every 1000 women who participate in routine screening have breast
cancer.
8 out of 10 women with breast cancer will get a positive mammography. 95 out of
every 990 women without breast cancer will also get a positive mammography.
Here is a new representative sample of 100 women at age forty who got a positive
mammography in routine screening.

How many of the women do you expect to actually have breast cancer?

____out of 100
BAYESIAN INFERENCE
Framework for evaluating conditional probabilities
P(B|A)= P(A|B)*P(B)/P(A)
In our example B=having cancer A=having a positive mammography

For the homo oeconomicus it should not matter whether the above data are presented
in frequency or probability format but…
 BAYES RULE AND FREQUENCY
A “bayesian algorithm” is computationally much simpler if information is codified in a
frequency format instead of a probabilistic one:
𝑃 𝑐𝑎𝑛𝑐𝑒𝑟 ∗ 𝑃(𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒|𝑐𝑎𝑛𝑐𝑒𝑟)
=
𝑃 𝑐𝑎𝑛𝑐𝑒𝑟 ∗ 𝑃 𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑐𝑎𝑛𝑐𝑒𝑟 ∗ 𝑃 ℎ𝑒𝑎𝑙𝑡ℎ𝑦 ∗ 𝑃(𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒|ℎ𝑒𝑎𝑙𝑡ℎ𝑦)
P(cancer|positive) 0,01∗0,80
= = 0,078
0,01∗0,80+0,99∗0,096

freq( Positive | cancer )

 
freq( Positive | cancer ) * freq( Positive | noCancer )
8
  0.078
8  95
EMPIRICAL EVIDENCE
Gigerenzer e Hoffrage (1995)
12 diagnostic problems implying the
use of Bayes’ theorem

Results
probability format: 16% “bayesian”
answers
frequency format: 46% “bayesian”
answers
PROBABILITY AND THE “LAW OF SMALL NUMBERS”
• People have strong intuitions about random sampling.

• These intuitions are usually wrong:

• people view a sample randomly drawn form a population as highly representative,
that is, similar to the population in all essential characteristics (law of small
numbers)
• “hot hand” phenomenon

• Thus, they expect two small samples drawn from a same population to be more similar to
one another and to the population than sample population predicts.

• When judging the likelihood that a data set was generated by a particular model,
people will tend to infer it too quickly on the basis of too few data points.
THIS COIN IS RIGGED!!!
• When tossing a fair coin the proportion of heads in any
segment should stays closer to 50%
• each segment of the response sequence is “representative” of
the fairness of the coin

• Sequences like TTTTTTH are considered less likely than

sequences in which the number of tails and heads are more
similar!

• Gambler’s fallacy: when a number has not come out for a while, the gambler feels it is
“due” to come out!
• Trends everywhere: people underestimate noise and extract trends even when they are
not there
HOT HAND PHENOMENON
• Belief that a basketball player is more likely to hit a shot after hitting another one
than after a miss
• Empirical evidence shows the exact opposite!

• Translates into overinference of probability of good outcome after a strike of good

outcomes
• Empirical example: degree to which employees invest in their own firm’s stock
depends strongly on past performance
GAMBLER’S FALLACY VS HOT HAND
• GF: belief in negative autocorrelation of a non-autocorrelated random sequence of
outcomes
• HH: belief in positive autocorrelation of a non-autocorrelated random sequence of
outcomes
• Gambler’s fallacy and hot hand seemingly in contrast!
•But outcomes involved are different!

•This suggest that these seemingly constrasting effect may coexist.

• Can you think of an example where both apply?
SEMINAL HEURISTICS
BASE RATE FALLACY AND HEURISTICS
• Mistakes like the modal answer to the Taxi cab problem or the mammography
problem represent instances of the base rate fallacy
• Failure to take into account the base rate, or prior probabilites when
computing conditional probabilities
• Kahneman and Tversky (1974) explained the base rate fallacy introducing the
idea of heuristics
• simple rules that people use to solve problems, not necessarily coherent with
rational choice theory

• In particular, the taxi problem is an instance of the representativeness heuristic

• People categorize on the bases of prototypes and use these categories to
make judgements. How frequent these categories really are does not matter!
THE HEURISTICS AND BIASES PROGRAM
• Developed formally at the end of the 1970s by cognitive psychologists with the
objective ‘to categorize the deviations from what is indicated by rational choice
models, and, where possible, to improve heuristics so as to reduce those biases’
(Schwartz 2011).
• Heuristics are an irrational response to some form of information overload
• They may turn out to be ill suited to make optimal decisions, giving rise to different
biases.
• Key authors in this program are Kahneman and Tversky
• Seminal bias: representativeness, availability, adjustment and anchoring
AVAILABILITY AND RELATED BIASES
• Representativeness suggests that sample data are given too much importance
compared to population parameters
• Availability further shows that this effect may be amplified by the easiness with
which some sample data are called to mind:
• individuals assess the probability of an event depending on the easiness with which
similar occurrences come to mind.
• When easiness in recollection depends by recency of the event – recency bias
• When easiness in recollection depends by salience of the event – salience bias
ANCHORING
• It refers to the tendency of sticking to an arbitrary reference point when making
inferences, even when the reference point is not relevant to the decision task.
• Reference points can be suggested in the description of the problem or may be
determined in a completely random way
• in both cases, the anchor provided significantly affects estimates.

• Anchoring can lead to paying too little attention to sample data

• Possibly explained by
• uncertainty about the true value: individuals tend to move away from the anchor until they reach a
plausible range
• economizing on cognitive effort: anchor acts a further trigger for recollection of information that
supports the anchor as estimation
ANCHORING VS REPRESENTATIVENESS?
Anchoring: paying too little attention to sample data
Representativeness: giving too much weight to sample data
Are the two really in conflict?
People are coarsely calibrated and switch from giving too much to giving too little
attention depending on contextual cues
FAMILIARITY HEURISTICS
RISK OR AMBIGUITY?
• Recall that what we called an uncertain situation was one that might entail different
outcomes according to which state realized.
• In conditions of risk the probability distribution of the different outcomes is known
• In conditions of ambiguity the probability distribution of the different outcomes is
NOT known

• Clearly EUT-like models cannot be used without some adjustments in the case
in which the probabilities are not known.
• idea of subjective utility theory

•Ambiguity further fuels the preference for the familiar

DECISION 1 DECISION 2
You win if you draw You win if you draw
a white ball a black ball

Urn A Urn B
20 white balls and 20 40 white or black
black balls balls

Which urn do you want to draw from?

THE ELLSBERG PARADOX
Most subjects prefer to bet on Urn A (20 white and 20 black balls) both in Decision 1
and in Decision 2

This is not consistent with preferences which are function of outcomes and probabilities
alone.

Why?
THEORETICAL BACKGROUND
 Theory of choice under uncertainty (Savage, 1954)
 Two uncertain options are equivalent if both yield the identical probability
distribution over payoffs (consequences, outcomes).
 A rational decision maker will make no distinction between the case when the
probability is ambiguous and when it is precise, if the mean probability is identical in
both cases

 Subjective probability when p unknown

 Need to be consistent!
STATUS QUO BIAS
• Preference for sticking with what one already has as opposed to change
• Basically the same as the endowment effect but
• EE: riskless setting
• SQB: framed in risky context

Asset allocation experiment shows that no matter the initial preferences over four
classes of assets, subjects preffered the status quo investment choice when told that
they had inherited it.

Can you think of an explanation for this?

AN ALTERNATIVE VIEW OF Heuristics are NOT biases
HEURISTICS
ARE HEURISTICS IRRATIONAL?
• The original program on biases and heuristics inaugurated by Kahneman and
Tversky was built on a series of assumptions:
• There is an efficiency-accuracy trade off
• Shortcuts economize on effort but may lead to suboptimal behaviour
• Logic and statistical inference should be considered the proper tool for effective decision-
making.

• An alternative view has been developed by Gerd Gigerenzer and the ABC Group
starting in the 1990s
• Fierce competition between the two views that still lingers today
WHAT ARE HEURISTICS ACCORDING TO
GIGERENZER
• A heuristic is "a strategy that ignores part of the information, with the goal of
making decisions more quickly, frugally and/or more accurately than more complex
methods" (Gigerenzer and Gaissmaier 2011).
• Heuristics are adaptive responses that comply with requirements of psychological
plausibility, domain specificity, and ecological rationality.
• Heuristics incorporate a principle of ‘less is more’
• Often referred to as ‘fast and frugal’
THE HEURISTIC TOOLBOX
• (Gigerenzer, Todd, and ABC Group 1999) propose a set of tools that represent
building blocks to construct domain-specific heuristics.
• The Adaptive toolbox includes tools that allow addressing
• cognitive tasks that require to calculate, evaluate and choose
• adaptive tasks, more complex problems that involve mutual or multiple decisions
of different individuals, such as participating in the stock market or finding a
suitable partner.
THE HEURISTIC TOOLBOX CONTINUED
The tools included in the Adaptive toolbox can be summarized into three different
groups: search rules, stopping rules and decision rules.
Search rules for cues include random or ordered search and imitation, but also
emotions may play a significant role in reducing the choice alternatives.
Stopping rules can be cognitive or emotional and allow addressing alternatives that
need not be fully commensurable. Moreover, such rules do not have the goal to select
the best alternative in cost-benefit terms.
Decision rules are a form of one-reason decision-making, often relying only on one
cue, ignoring all other sources of information. This allows taking decisions even when
alternatives do not share a common measuring unit (i.e. cannot be translated into
values), as there is no need to compose or combine different cues.
HEURISTICS AT WORK
Gigerenzer and his team suggest that heuristics should not be studied just
descriptively, but with the overarching goal of assessing their effectiveness
measure the amount of error they generate and not give for granted that they are
the outcome of a faulty decision process.
Compare performance of simple decision heuristics with more complex models
Several applications in finance
DE MIGUEL ET AL. (2009)
DeMiguel uses the 1/N heuristic as a benchmark to assess the how different
rules for portfolio allocation suggested by traditional finance fare.
The 1/N heuristic implies that investors simply divide equally the money they
wish to invest in the available assets, without looking at any other information
regarding performance.
Use empirical datasets from the US equity market to test the effectiveness of
14 different portfolio models, measured looking at Sharpe ratio, certainty-
equivalent return and turnover
Results show that none of the 14 models are better than the naïve 1/N
heuristic across the three performance indicators.
FAST-AND-FRUGAL DECISION TREES
• Neth (2014) shows that heuristics can be useful especially when
• situations feature high levels of uncertainty,
• there is a large number of alternative options.

• Example: how can the regulators decide when a bank is at risk of failing?
• Very complex models may be devised to deal with this problem, but a simple
alternative exists: fast and frugal trees.
• FF-trees are decision trees where each node has only two child nodes, one of
which must be an exit node
REFERENCES
Chapter 5 A&D
DeMiguel, Victor and Garlappi, Lorenzo and Uppal, Raman, Optimal Versus Naive
Diversification: How Inefficient is the 1/N Portfolio Strategy? (May 2009). The Review
of Financial Studies, Vol. 22, Issue 5, pp. 1915-1953, 2009. Available at
SSRN: https://ssrn.com/abstract=1376199 or http://dx.doi.org/hhm075
Gigerenzer (2008) Why Heuristics work, Perspectives on Psychological Science
Gigerenzer and the ABC group (1999) Simple Heuristics that make us smart