Decision Heuristics

Question 1

Heuristics Definition

Answer 1

Process by which humans use mental shortcuts to quickly form judgements, make decisions and find solutions to complex problems

Question 2

Representativeness

Answer 2

Probabilities are evaluated to a degree that A is representative of B

If A is highly representative of B, probability that A originates from B is judged to be too high

If A is not representative of B, probability that A originates from B is judged to be low

1. Conjunction fallacy
2. Gambler’s Fallacy
3. Base Rate Neglect

Question 3

Conjunction Fallacy

Answer 3

Representativeness

Inference that a conjoint set or 2 or more specific conclusions is likelier than any single member of the same set

Violates the law of probability which states that the probability of 2 events occurring together is always less than or equal to the probability of the event occurring itself

Question 4

Base Rate Neglect

Answer 4

Representativeness

Subjects neglect the base rate which should have a major effect on the estimation of probability

Description appears representative of a 50%-50% event, subjects believe that this indeed neutral, ignoring what they know about prior probabilities

Question 5

Gambler’s Fallacy

Answer 5

Representativeness

Incorrect belief that if a particular event occurs more frequently than normal during the past, it is less likely to happen in the future although the probability of this event does not depend on what has happened in the past.

People view chance as a self correcting process in a deviation in one direction induces a deviation in the opposite direction to restore the equilibrium

Expect a sequence of events generated by a random process will represent the essential characteristics of that process even when the sequence is short

E.g. Coin toss. People know that in the LR, a coin will get as many tails as heads according to law of large numbers and this is mistakenly applied to a small sample

Question 6

Conservatism

Answer 6

People make estimates by starting from initial value that is adjusted o yield the final answer

Adjustments are insufficient and estimates are biased towards initial values

The initial value may be suggested by the formulation of the problem, may be the result of partial computation.

Different starting points yield different estimates which are biased towards initial values

e.g. Anchoring
Starting points are given to subjects, when subjects base their estimates on the result of some incomplete computations

Question 7

Conservatism vs Representativeness

Answer 7

Representativeness - overreaction to information, investors are too influenced by latest information

Conservatism - underreaction to information, investors fail to take in the latest information fully into consideration