Chapter 3 Flashcards
- Why people use heuristics? What is the advantage and disadvantage to use heuristics?
People use heuristics because they have limited time, information and cognitive ability and attention. These are like rules of thumb as decision making shortcut.
Advantage- simplify decision making, save time and resources
Disadvantage- sometimes falter when used outside of their natural domain
- What is the difference of risk and ambiguity? What is ambiguity aversion? What is Ellsberg Paradox? Why is it a paradox?
Risk- we know the probabilities of the risky outcomes
Ambiguity- we don’t know the probabilities associated with the risky outcomes
Ambiguity aversion-
Avoiding ambiguous situations with unknown probabilities as we know probability associatd with only one outcome so we choose that.
Ellsberg paradox
One urn paradox: 90 balls; 30 red , 60 black/yellow
- What is endowment effect and what is status quo bias? What is the possible heuristics for both biases?
Status Quo Bias-
Preference for keeping things the way they are.
It has familiarity heuristic and they assign any change as risk or loss.
People don’t change some things they have already because its too much effort to do otherwise and even if it is more profitable or better.
Endowment bias
They overvalue own items to items they don’t own. People choose to keep what they were endowed with more. Again familiarity heuristic can explain this.
- Give examples of home bias in investment. Give potential rational and behavioral explanations. What is the potential heuristics underlying the behavioral explanations?
Eg 1 Home bias puzzle where investors invest mostly in their home country.
Eg 2 Domestic investors feel their stock or market is less riskier than abroad.
Eg 3 investors feel what they know is less riskier than what they dk
Eg 4 Home Bias and Ambiguity Aversion- since countries like India, Thaliand, Romania have more ambiguity aversion they also have more home bias as they would only invest in things that are familiar to them.
Eg 5 Countries/Portfolio Managers also feel their market will give more returns than the actual return hence have familiarity driven over optimism.
Eg 6 when At&T was split, 7 baby bells were created to serve 7 different regions and people in that region eg southeast were holding disproportionate shares of southeast baby bell.
Behavioural Explanation:
- Investing in what you know
- Excessive optimism about domestic market
- Familiarity- what is familiar is good, the less you know the more you are afraid of or the less you try
Rational
- Institutional Restrictions
i. Capital movement restrictions
ii. Different trading costs
iii. Restrictions tax rates
Familairity heuristic is at play here as individuals perceive things that they know as less riskier than things they don’t know about. They would be more willing to bet on things they are familiar with.
- What is conjunction fallacy? Using Linda example to explain the underlying heuristics of conjunction fallacy.
It is a part of representativeness heuristic. Making judgement on an event based on a prototype or stereotype. Making judgement on a statement on how representative it is of the description.
Linda was described as someone who is active in social issues, single and outspoke. People were asked to rate the statements about her career and profession based on this description.
People voted for Linda being a bank teller from 1-9 (9 likely most). 3.5
Linda being bank teller and feminist. 5.6
But in a venn diagram of conjunction of Bank Teller and Feminist is done then the A (And) B will be less than A as it is a part of the whole. But this time bank teller population is more representative and present in the population but the second choice was more likely.
This was because the description was more representative of a feminist than a bank teller and people wouldn’t take these numbers into consideration for a simple survey.
Being a bank teller was being compensated by being a feminist.
- Give an example of investment behavior of structured products that violates probability rules and commits conjunction fallacy.
Barrier products are investment products that have a payoff depending on the return of certain underlying indices.
If at least one of the indices falls below a threshold/barrier, the value of the product falls.
Subjects were asked to estimate the probability that the indices of these countries fall below the threshold/Baskets:
Worst of baskets
The final payoff is the payoff of the worst performing index at maturity
■ Germany, Swiss, USA
■ USA
■ Probability of three indices falling below threshold =20%
■ Probability of US falling below threshold=32.5%
■ P(D)+P(CH)+P(US)> P(US) but this should be the case
■ But they didn’t say that in the survey so it is a violation of the conjunction fallacy.
■ They felt in the first choice the Swiss n German Indices protected the US index from falling below the threshold and hence they are being compensated by that.
- Using Bayesian framework to explain why representative heuristics can lead to neglect of base rate and conservatism bias.
- Explain how representative heuristics can lead to gambler’s fallacy and hot-hand fallacy?
Gambler’s fallacy- Fallacy that if an event has occurred more frequently recently then now it is unlikely to happen again in the future and vice versa.
How representative?- After streak of good returns we assume a correction like stock market strategists. Which means we are relying heavily on gambler’s fallacy
Hot Hand- after a nice streak we would expect the same player to do the shot. The possibility for him to make the next shot is also 50-50 and we forget about this and compare recent perfroamnce as our population sample and expect him to definitely make the shot.
Individual investors display hot hands impute recent performance.
Professional Investors- Strategits display gambler’s fallacy feel they know the process
Professional investors believe they know the process (fair coin).
Individual investors continuously impute the process based on
recent observations (as do basketball fans).
Financial behavior stemming from representativeness
!Good companies are good investments
! Chasing and attention grabbing
- Most people believes that if a company has high-quality management, a strong image and has enjoyed consistent growth in earnings, it must be a good investment. Is the view consistent with efficient market hypothesis? Which heuristics may drive such belief? Explain how such belief may lead to small-firm effect and value premium.
According to EMH all the information about the company should be reflected in the price. So good companies should have high prices and vice versa. So investors shouldn’t expect to get excess returns by investing in companies with good mgt qualities.
Representative heuristic may drive such belief. As they take these characteristics as representative of being a good investment with low risk and high return.
Small firm effect basically says that since the firm is small, they are mostly undervalued because investors don’t think that they have better management quality and earnings growth. They can then outperform big firms.
Value premium says that stocks that are undervalued with low p/e outperform growth stocks with high earnings growth over long term. So investors will get opportunity to take advantage of this undrvaluation and invest and earn more through these value stocks.
- Explain anchoring and adjustment heuristics. Give an example from surveys or experiments.
Anchoring heuristic is basically that our answer depends on the anchor point we were given to compare with.
Eg in real estate, one group was given low listing price and another high. So the high one appraised more and lower one appraised less because their anchoring point was different and they were influenced by it. So they adjusted the price according to the anchor.
- What is probability calibration? Give overconfidence vs. underconfidence can be reflected in probability judgment and confidence interval estimation?
Probability calibration is calculating how accurate is the probability judgement. Basically we see how correct we are given that we think we are correct.
Proportion of correct answers for 0.5= how many 0.5 correct/ total 0.5 answers we gave
So we plot proportion of correct answers for each confidence level on y axis and our confidence level on x axis. If we are overconfident then our self stated confidence level will be more than our proportion of answers that were correct and if we are under confident then our proportion of correct responses will be more than our confidence level.
We see in confidence interval estimation for the annual return compared with historical returns that laymen were narrower in their estimate as compared to professional investors. This shows that professional investors are less miscalibrated as compared to laymen. So they have a narrower range for return prediction.
If however, we are underconfident then we have a broader range for forecasted returns.
So younger people with uni education and workex in finance are less over confrident than old people without such an education or experience
- What is the difference between excessive optimism and overconfidence-driven probability miscalibration? Give an example.
Overconfidence driven probability miscalibration will lead to narrower range for annual return forecast and also they will be far off from the correct/true range.
Eg: laymen investors vs young
Excessive optimism will lead to assigning higher probabilities to favourable outcomes and lower to unfavourable.
Eg: get many job offers or get better grades than actual
- What are better-than-average effect and illusion of control?
Better than average we feel that we are better or more skilled than others. But only 50& of us can be better than average.
Eg: 82% thought they were in top 30% of driving safety group
Eg: many newlyweds thought their marriage would last but not
Illusion of control we think we have more control of the situation than necessarily true.
Eg: traders who thought they had high illusion of control performed worse and earned significantly less.
- What are self-attribution bias, hindsight bias and confirmation bias?
Self attribution bias- success because of themselves and failure because of others or bad luck
Hindsight bias- we know what was going to happen after it happened when we really dk
Confirmation bias- trying to search for evidence consistence with our prior beliefs to ignore conflicting data. Hypochondria
- What is excessive trading? What are the potential reasons that are related to overconfidence?
Excessive trading is trading a lot more than necessary in order to get better returns. it was seen in field study that the net risk adjusted return for all investors was below market level by 3%. But top 20% investors who traded the most underperformed the market by about 10%.
Overconfident traders traded the most and performed the worst. The reasons can be better than average based, excessive optimism, illusion of control, the most significant one- miscalibration based overconfidence. If they were really overconfident on how correct they are and then they took missteps more and were far off the market returns by trading more.
Higher education meant less trading and more experienced investors traded more.
