Correcting Cognitive and Emotional Errors (Chapter 5)

Question 1

In which environments should we use which System?

Answer 1

In predictable environments (f.e. chess) -> expertise allows to rely on System 1

In less predictable environments -> EXPLICIT use of System 2 because quick and precise feedback is scarce

Question 2

How can financial advisors improve financial behavior and well-being of both wirking and retired people?

Answer 2

1. more diversified portfolios
2. reduced trading activity
3. increased risk-adjusted stock returns
4. avoiding of taxable distributions
5. guide investors to realize losses
6. point out availability and hindsight errors caused by advertisements
7. convince investors to not sell all stocks after crash (out of fear)

Question 3

What is meant by correcting errors by prompting use of System 2?

Answer 3

1. Framing & mental accounting
2. Prospective hindsight
3. Correct overconfidence by wisdom of crowd
4. “Law of big numbers”
5. Correction of “endownment effect”

Question 4

Financial experts should have certain skills and characteristics to be good professionals. What are these?

Answer 4

1. Human-behavior knowledge
2. Financial knowledge
3. Confidence
4. Portfolio Analysis

Question 5

How to correct errors in general? How should an investor approach that?

Answer 5

1. Use human-behavior and financial-facts knowledge.
   and combine these with…
   …2. Advice of financial advisors
   …3. use of System 2
   …4. use of Incentives

Question 6

What is the role of financial advisors?

Answer 6

Guide investors
Provide information
Correct cognitive and emotional errors

e.g. can point out cognitive errors of availability and hindsight related to mututal funds advertisements

Question 7

How can the prompting use of system 2 correct errors?

Answer 7

1. Anchoring errors -> solution: proper framing
2. Hindsight errors -> solution: prospective hindsight
3. Overconfidence -> solution: Wisdom of crowd
4. Representativeness -> solution: “Law of big numbers”
5. Emotional errors -> solution: Correction of the “Endownment effect”

Question 8

How can anchoring be corrected?

Answer 8

1. …by proper framing: Reframe the information presented to the individual.
   -> framing highlights differences between features of anchor and target. This can make us consider many anchors rather than one. People evaluate plausibility of each anchor relative to others.
2. presenting alternative information:
   Presenting multiple pieces of information to an individual can help to shift their focus away from the initial anchor. By providing alternative information, the individual can be encouraged to consider a range of options and make a more informed decision.

Question 9

How can self-control errors be corrected?

Answer 9

…by framing and mental accounting, self-control can be increased.
-> positive Framing: shift their focus away from the immediate gratification of an impulsive decision and towards the long-term benefits of exercising self-control
-> mental accounting: By creating mental accounts for different types of spending, individuals can prioritize their spending and exercise self-control.

Question 10

How can hindsight errors be corrected?

Answer 10

…by prospective hindsight:
-> avoid hindsight bias in future

1. reflect on past decisions
2. consider alternative outcomes
3. seek out feedback
4. keep a record

e.g. considering why certain industry will perform worse than other industry 10 years from now -> elicits potential causes for failure not generated by using System 1

Question 11

How can overpresicion be corrected?

Answer 11

1. Split question of confidence interval in parts (10%, 50%)
2. Estimate for 1 month in future, 2 months, 3 months
   ->thereby, it becomes time explicit, highlighting uncertainty of estimates -> better calibrated confidence intervals
3. Wisdom of crowd -> average of two guesses by two people is more accurate than two guesses by one person

Question 12

How can representativeness errors be corrected?

Answer 12

…by considering 1. base-rate information AND 2. representativeness information

By using base rate information, individuals can make more informed decisions that are based on actual probabilities rather than stereotypes or previous experiences.

By providing individuals with a broader range of information, they can be encouraged to think beyond their initial stereotypes or previous experiences and make more informed decisions. -> “law of numbers”

Question 13

How can confirmation errors be corrected?

Answer 13

…by proper framing

Proper framing refers to presenting information in a way that is balanced and neutral, and presents both the potential benefits and potential drawbacks of a particular decision or investment. By presenting balanced information, individuals can make more informed decisions that are based on a full understanding of the potential outcomes.

…by Double-Blind Experiment (dont know what treatment and control group is)

Question 14

What is meant by the endowment effect?

Answer 14

=tendency of individuals to overvalue items that they already own, simply because they own them. The emotional attachment to the item makes it difficult for the owner to part with the item, and this attachment can lead to an overvaluation of the item.

Question 15

How can the endownment effect be corrected?

Answer 15

…by encouraging “thinking like a trader”
-> be ready to bear the emotional cost of regret
-> use System 2 to counter emotional errors

Question 16

How can quantitative models and algorithms be used to correct cognitive errors? What are the limitations?

Answer 16

They outperform human judgement, e.g. availability and representativeness errors
They improve investment selection process -> help avoid cognitive errors

Limitations:
People prefer human judgement -> lose confidence in models faster than in human forecasting making same mistake

Question 17

How can cognitive errors be corrected by incentives?

Answer 17

=Incentives reduce cost of good choices, while increase cost of poor choices

key to using incentives to correct cognitive errors in behavioral finance is to design incentives that are
1. aligned with long-term financial goals,
2. provide regular feedback on performance, and
3. encourage individuals to think critically and objectively about their financial decisions

Question 18

How can insufficient self-control errors be corrected by incentives?

Answer 18

1. Emotions, e.g. love of children can increase self-control
2. Mental accounts, e.g. people save more when receiving savings-labeled wages in two envelopes
3. Commitment devices, e.g. preventing premature withdrawals
4. Temptation building, e.g. bundles wants with shoulds (wants to win lottery, should save)

Question 19

How can excessive self-control errors be corrected by incentives?

Answer 19

Reluctant to indulge -> provide rewards or benefits for individuals who make decisions that are aligned with their long-term financial goals, but that also allow for some degree of flexibility or spontaneity

Question 20

Why are incentives not always effective in correcting errors?

Answer 20

They can backfire in sports or test taking -> reduces performance by increasing anxiety

Accountability improves performance where effort improves performance, not effective alone in correcting errors

Question 21

What is meant by “Readiness for Correction”?

Answer 21

=correction requires readiness for correction

Readiness for correction refers to an individual’s willingness and openness to acknowledge and correct cognitive errors that may be impacting their financial decision-making -> System 2 activation

BUT, activation of System 2 often hampered by:
-fatique + distraction
-poverty
-hunger, anger, arousal

Question 22

Firms can take advantage (exploiting) of making errors. When is that the case?

Answer 22

e.g. by hiding / shrouding information

Mostly done in markets where not all people are knowledgeable
Conflicts of interest induces advisors to misguide investors
Managers of credit card companies exploit unrealistic optimism, insufficient self-control

Question 23

What is meant by Correcting, Nudging and Mandating?

Answer 23

1. Correcting (debias) cognitive and emotional errors when pointing people to their wants
2. Nudge when pressing people towards shoulds
3. Mandate when pushing (shoving) people towards shoulds

Question 24

How does base rate information refer to representativeness bias? What does it mean?

Answer 24

Base rate information refers to the overall frequency or prevalence of an event or behavior in a population.

In representativeness bias, base rate information is often overlooked or ignored in favor of more vivid information. For example, if an investor is considering investing in a new startup company and is presented with information about the charismatic founder, cutting-edge technology, and impressive marketing materials, they may overestimate the potential success of the company based on this prototype information. But in truth, the company has bad financials (base rate information).

Question 25

Which errors can be better diminished by intelligence, which rather not?

Answer 25

overconfidence + hindsight error -> can be diminished by intelligence

anchoring errors / overcome resistance to realizing losses -> can not be diminished by intelligence