Heuristics & Biases

Chapter 5
Introduction
Human Computers
• Collect all relevant information
• Unlimited processing power
• Select the best choice under given circumstances

However, individuals are

• Imperfect in deciding about relevant information
• Inefficient in to collect all available information

For example, CAPM (requires studying universe of securities; Markowitz model)

The focus of this lesson is how people make decisions with limited time and information in
a world of uncertainty.
PERCEPTION, MEMORY, AND HEURISTICS
Perception
• Perception plays a critical role in the selection of information.
• Expectations shape perception.
• We often “see” what “we expect to see”.
• We often “see” what “we desire to see”.
• Sometimes perception can be distorted in a self-serving fashion.
• Cognitive dissonance creates a situation where people are motivated
to reduce or avoid psychological inconsistencies, often in order to
promote a positive self-image.
Memory
• The standard view that past experiences have somehow been written
to the brain’s hard drive and are then retrieved, even if at
considerable effort, is not the way our brain works.
• Memory is reconstructive.
• Memory is not only reconstructive, but also variable, in intensity.
• Affective labeling (positive and negative) but also variable
Ding, Y., Hellmann, A., & De Mello, L. (2017). Factors driving memory fallibility: A conceptual framework for accounting and finance
studies. Journal of Behavioral and Experimental Finance, 14, 14-22.
Ding, Y., Hellmann, A., & De Mello, L. (2017). Factors driving memory fallibility: A conceptual framework for accounting and finance
studies. Journal of Behavioral and Experimental Finance, 14, 14-22.
Ding, Y., Hellmann, A., & De Mello, L. (2017). Factors driving memory fallibility: A conceptual framework for accounting and finance
studies. Journal of Behavioral and Experimental Finance, 14, 14-22.
Ahmad, F. (2019). A systematic review of the role of Big Data Analytics in reducing the influence of cognitive errors on the audit judgement. Revista de Contabilidad-
Spanish Accounting Review, 22(2), 187-202.
Framing Effects
• Perception and memory are influenced by context, or the frame.
• For example, a sports announcer of average height looks short when
interviewing a basketball player, but tall when interviewing a jockey.
This is known as the “contrast effect.”
• For example:
• Person A is “intelligent, industrious, impulsive, critical, stubborn, envious”
• Person B is “envious, stubborn, critical, impulsive, industrious, intelligent.”
• Primacy effect & Recency Effect
• Halo effect: Interviewee example
Ease of Processing & Information Overload
• Information that is easier to understand is often viewed as more likely
to be true.
• Information overload is a state of confusion and decision avoidance.
Heuristics
• A heuristic is a decision rule that utilizes a subset of the information
set. (e.g., gunshot, smell in fridge)
• Types of Decision making
• Type I – Heuristic: reflexive, autonomic, and noncognitive, and economize on
effort
• Type II – Normative (Rational): Cognitive in nature
FAMILIARITY AND RELATED HEURISTICS
• Familiarity: People have a preference for the familiar.
• Ambiguity aversion is driven by the fact that people prefer risk to
uncertainty. (e.g., probability of drawing balls)
• Diversification Heuristic: People like to try a little bit of everything
when choices are not mutually exclusive.
• Status Quo & Endowment Effect (e.g., inheritance in the form of
shares & amount)
REPRESENTATIVENESS AND RELATED BIASES
• Conjunction Fallacy
• Base-rate Neglect
• Gambler Fallacy & Hot Hand Fallacy
• Availability, Recency & Salience
• Anchoring
IRRATIONALITY AND ADAPTATION
• Fast & Frugal Heuristics: the purpose of heuristics is to employ a
minimum of time, knowledge, and computation in order to make
adaptive choices in real-world environments.
• This approach is in the spirit of so-called bounded rationality.
• It is unreasonable to believe that man is capable of the kind of
complicated optimization problems that conventional economic
models assume. Instead, man “satisfices,” which amounts to doing
the best that he can under the circumstances.