Transcript Document

Judgement Biases Overconfidence
Most people cannot correctly calibrate
probabilistic beliefs. Suppose you are asked:
their
State your 98% confidence interval for the S&P500
(see the definition) one month from today.
And then your prediction is compared against the
actual outcome.
Definitions
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Tuesday, 21 July 2015
9:58 PM
Judgement Biases Overconfidence
Repeat this exercise many times. If you are good at
probabilistic judgements, you should expect to
encounter about 98% of outcomes inside the
confidence interval and thus be “surprised” only 2%
of the times.
Most people, instead, experience surprise rates
between 15% and 20%. Thus, beware the investor who
is 99% sure.
See a recent review by Mannes and Moore (2013) and
section 9 of this course.
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Judgement Biases –
Overconfidence Whoops
“I believe it is peace for our time” (UK Prime Minister
Neville Chamberlain, after Munich Conference with
Hitler, September 30th, 1938).
“Anyone who expects a source of power from the
transformation of the atom is talking moonshine” (Ernest
Rutherford 1871 – 1937, leader of the team that first
split the atom).
“The Americans have need of the telephone, but we do
not. We have plenty of messenger boys” (Sir William
Preece, chief engineer of the British Post Office, 1876).
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Judgement Biases –
Overconfidence Whoops
“Radio has no future. Heavier-than-air flying machines
are impossible. X-rays will prove to be a hoax” (William
Thomson, Lord Kelvin, British scientist, 1899).
“Space flight is utter bilge. I don’t think anybody will
ever put up enough money to do such a thing … What
good would it do us?” (Richard Woolley, Astronomer
Royal, 1956. Sputnik was launched in 1957.)
“I think there is a world market for maybe five
computers” (Thomas Watson, chairman of IBM, 1943).
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Judgement Biases –
Overconfidence Whoops
“640 kilobytes [of computer memory] is enough for
anyone” (attributed to Bill Gates, though he denies the
attribution 1955-).
“We don’t like their sound, and guitar music is on the way
out” (Dick Rowe, of Decca Recording Co., rejecting the
Beatles, 1962).
“It will be years – not in my time – before a woman will
become Prime Minister” (Margaret Thatcher, 1974).
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Judgement Biases –
Overconfidence Whoops
“Earlier on today a woman rang and said she heard there
was a hurricane on the way. Well, if you’re watching,
don’t worry, there isn’t!” (Michael Fish, BBC weather
forecaster, hours before the Great Storm of 1987.
Technically the storm was not in fact a hurricane.)
“They couldn’t hit an elephant at this dist—” (Last words
of Union Army General John Sedgewick at the battle of
Spotsylvania Court House, 1864).
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Judgement Biases Hindsight
After an event has occurred, people cannot properly
reconstruct their state of uncertainty before the
event. Suppose you are asked:
On the day before the event, what was your
probability of a 5% drop in the S&P500?
After the facts, financial pundits and common
investors believe that they have an exact explanation
for what happened.
It almost seems that the event was so inevitable that
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it could have been easily predicted.
Judgement Biases Hindsight
Hindsight has two important consequences.
First, it tends to promote overconfidence, by
fostering the illusion that the world is more
predictable than it is.
Second, it often turns (in investors’ eyes) reasonable
gambles into foolish mistakes.
Hindsight bias is one of the most widely studied
biases in the judgment literature.
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Judgement Biases Hindsight
Fischhoff (1975, p. 288) first proposed this bias by
observing that
“(a) Reporting an outcome’s occurrence increases its
perceived probability of occurrence; and
(b) people who have received outcome knowledge are
largely unaware of its having changed their
perceptions [along the lines of (a)].”
Combining these, the literature on the hindsight bias
shows that people exaggerate the degree to which
their beliefs before an informative event would be
similar to their current beliefs. We tend to think we
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“knew it would happen all along.”
Judgement Biases Hindsight
After a politician wins election, people label it as
inevitable - and believe that they always thought it
was inevitable.
One example of Fischhoff’s (1975) original
demonstration of this effect was to give subjects a
historical passage regarding British intrusion into
India and military interaction with the Gurkhas of
Nepal.
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Judgement Biases Hindsight
Without being told the outcome of this interaction,
some subjects were asked to predict the likelihood of
each of four possible outcomes:
1) British victory
2) Gurkha victory
3) military stalemate with a peace settlement
4) military stalemate without a peace settlement
Four other sets of subjects were each told a
different one of the four outcomes was the true one
(the real true outcome is that the two sides fought to
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a stalemate without reaching a peace settlement).
Judgement Biases Hindsight
For all four outcomes, subjects on average guessed
that they would have estimated the probability of the
given event as about 15% more likely than those
subjects not told an outcome actually estimated it.
The bias is that perceived beliefs clearly reflect to
some degree the additional information they have;
people don’t sufficiently “subtract” information they
currently have about an outcome in imagining what
they would have thought without that information.
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Judgement Biases – Hindsight
Believing the Past Equals the Future
When investors start believing that the past equals the
future, they are acting as if there is no uncertainty in
the market. Unfortunately, uncertainty never vanishes.
There will always be ups and downs, overheated stocks,
bubbles, mini-bubbles, industry wide losses, panic selling
in Asia and other unexpected events in the market.
Believing that the past predicts the future is a sign of
overconfidence. When enough investors are
overconfident, we have the conditions of Greenspan's
famous, “irrational exuberance,” where investor
overconfidence pumps the market up to the point where a
huge correction is inevitable.
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Judgement Biases – Hindsight
Believing the Past Equals the Future
The investors who get hit the hardest, the ones who are
still all in just before the correction, are the
overconfident ones who are sure that the bull run will
last forever. Trusting that a bull won't turn on you is a
sure way to get yourself gored.
Definition - Bull market also reviewed later in this lecture
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Judgement Biases – Hindsight
Believing the Past Equals the Future
Jickling (2006), reflecting on the Enron scandal,
pondered whether the uncovering of significant
financial frauds is more the product of unique
circumstances or whether the discovery of frauds “is a
cyclical phenomenon” (Jickling 2006, p.2). As a cyclical
phenomenon the identification of fraud is somewhat
expected when the frenzy of a long-running bull market
ends. Of particular relevance to Madoff’s nearly twenty
year Ponzi scheme, is the proposition made by Jickling
(2006), that the ‘good times’ see a lowering of investor
and regulator vigilance, and such vigilance only returns
when the ‘party’ is over.
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Judgement Biases Optimism
Most people entertain beliefs biased in the direction
of optimism. Suppose you are asked:
Is your ability as a driver above or below the median?
And that the same question is posed to the members
of a group.
Usually, about 80% of the people believe that they
are above the median.
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Judgement Biases Optimism
The combination of optimism and overconfidence
leads investors to overestimate their knowledge and
underestimate risks, leaving them vulnerable to
statistical surprises.
It also fosters the illusion of control, which makes
people believe that risk can be managed by
knowledge and trading skill (Langer 1975).
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Judgement Biases Optimism
In a survey administered to 45 investors, De Bondt
(1998) reports that 89% agree with the statement
“I would rather have in my stock portfolio just a few
companies that I know well than many companies that
I know little about”
Whereas only 7% agree with the statement
“Because most investors do not like risk, risky stocks
sell at lower market prices”
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Mood Regulation
Other effects of current mood on judgment and
decision making may be viewed as mood regulation
(Rusting, 1998) - that is, maintaining a positive mood
or repairing a negative mood - which is an important
purpose of some of people’s actions.
Substantial evidence from research by Isen and
collaborators (summarized in Isen, 2000) shows that
people in a positive mood are risk averse because they
do not want a negative decision outcome (e.g., loss of
money on a risky stock investment) to destroy their
positive mood.
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Mood Regulation
Sometimes counteracting this, a positive mood also
increases optimism (e.g., Johnson and Tversky, 1983).
Conversely, people in a negative mood tend to take
more risks (Mano, 1992), possibly because they want a
positive outcome to repair their negative mood.
The disposition effect observed in stock markets
(Shefrin and Statman, 1985) implies that prior losses
result in risk seeking (keeping losers) while prior gains
result in risk aversion (selling winners).
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Mood Regulation
If prior losses induce a negative mood and prior gains
a positive mood, the disposition effect is consistent
with the previous research on mood effects (Isen,
2000).
Some studies have found that choices become more
risk averse after gains and more risk seeking after
losses, although other studies have found the
opposite (Franken et al. 2006).
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Judgement Biases Optimism
And just 18% agree with the statement that
“The risk of a stock depends on whether its price
typically moves with or against the market.”
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Judgement Biases Spurious Regularities
People tend to spot regularities even where there is
none. Suppose you are asked:
Which sequence is more likely to occur if a coin is
tossed - HHHTTT or HTHTTH?
Although the two sequences are equally likely, most
people wrongly believe that the second one is more
likely.
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Judgement Biases Spurious Regularities
Odean (1998) reports that, when individual investors sold
a stock and quickly bought another, the stock they sold on
average outperformed the stock they bought by 3.4% in
the first year (excluding transactions costs).
This costly over trading may be explained in terms of
spurious regularities and overconfidence.
A very frequent error is the extrapolation bias that
makes people optimistic in bullish markets and pessimistic
in bear markets (see the definition).
Definitions
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Judgement Biases Spurious Regularities
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Judgement Biases Spurious Regularities
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Judgement Biases Spurious Regularities
London and New York look to extend bull run - FT - 27/5/2014
Bulls run for the exit - FT - 15/10/2014
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Judgement Biases Spurious Regularities
De Bondt (1993) reports that the average gap
between the percentage of investors who are bullish
and the percentage that are bearish increases by
1.3% for every percentage point that the Dow Jones
(see the definition) raises in the previous week.
Definitions
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Bull Markets Can Be
Real Events
Bonds have enjoyed a spectacular 30-year bull run, but
since the start of the year investors have poured money
into global equity funds, prompting speculation that the
bond party may be over.
Conjecture over end of bond bull run
Ruth Sullivan, Financial Times, January 16, 2013
Clearly, the U.S. economy is gaining steam, though slowly.
Typically, that causes interest rates to rise, which drives
bond prices down - turning a bull market into a bear.
The End of the 30-year Bond Bull Market?
Wharton School of the University of Pennsylvania March 2012
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Judgement Biases - Do We
Know What Makes Us Happy?
The research on heuristics and biases indicates that
people misjudge the probabilistic consequences of
their decisions.
Research suggests that, even when they correctly
perceive the physical consequences of their decisions,
people systematically misperceive the well being they
derive from such outcomes.
How do people misperceive their utilities?
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Judgement Biases - Do We
Know What Makes Us Happy?
One pattern is that people underestimate how quickly
and how much they will adjust to changes, not
foreseeing that their reference points will change.
In a classic study, Brickman, Coates and Janoff-Bulman
(1978) interviewed both lottery winners and a control
group; the researchers found virtually no difference in
rated happiness of lottery non-winners and winners
(average winnings of $479,545).
They also found that lottery winners reported
significantly less pleasure from each of six mundane
daily activities.
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Judgement Biases - Do We
Know What Makes Us Happy?
While such interview evidence is inconclusive, the
researchers tried to control for alternative
explanations (such as selection bias or biased
presentation by interviewers).
Their evidence supported two reasons why lottery
winners would be less happy than the winners had
expected.
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Judgement Biases - Do We
Know What Makes Us Happy?
An alternate view is given by Gardner and Oswald
(2006) who report that winners of a medium-sized
prize of between £1,000 and £120,000 on Britain’s
National Lottery subsequently enjoyed a significant
improvement in their psychological well-being compared
with others who had only a small win, or no win at all.
However, the benefit wasn’t instantaneous, rather it
took approximately two years to kick in – probably, the
researchers surmised, because it was the act of
spending the winnings, rather than the winning itself,
that had a positive effect.
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Judgement Biases - Do We
Know What Makes Us Happy?
First, mundane experiences become less satisfying by
contrast with the “peak” experience of winning the
lottery.
Second, we become habituated to our circumstances:
Along the lines of Helson’s (1964) adaptation-level
theory and the previous material, eventually the main
carriers of utility become not the absolute levels of
consumption, but departures from our (new)
reference level.
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Judgement Biases - Do We
Know What Makes Us Happy?
Previous research showing that luxury consumption can be beneficial
for one’s well-being equate consumption with ownership. The paper
(Hudders and Pandelaere 2014) experimentally investigates whether
the impact of luxury consumption on one’s satisfaction with life
differs when this consumption implies ownership versus mere use of
luxury products. They found that ownership of luxury products is
associated with a higher satisfaction with life compared to
ownership of non-luxury products, the mere use of luxuries
decreases an individual’s satisfaction with life. This finding is
obtained for both a durable (a pen) and a non-durable (a chocolate).
In summary it means more to people to own a luxury product or
brand than to have the privilege of simply using one. Just using an
affordable luxury item you don't own can, in fact, dampen the feel
good factor that normally surrounds such products.
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Judgement Biases - Do We
Know What Makes Us Happy?
Money can buy you happiness...but only up to £45,000 - Telegraph - 15 Aug 2014
Money cannot buy you happiness, the old saying tells us. But having
enough money to live comfortably will help, according to new research. It
is the pursuit of great riches which can lead to misery as it distracts
people from more fulfilling aspects of life such as their relationships and
personal development, the study found. Feelings of wellbeing rose up to
an income of £45,000 a year ($75,000) but then stalled beyond this
point, according to the research presented to the American
Psychological Association. Frugality and a move away from materialism
lead to greater contentment, the authors claimed (Tatzel, M. 2014
(a,b,c) and Mishra et al. 2014).
Happier Consumers Can Lead to Healthier Environment, Research Reveals Tatzel - presented at the American Psychological Association’s 122nd 2.36
Annual
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Convention
Judgement Biases – Two
Examples
A lottery winner who has separated from his wife 15 months after
they took home £148 million has denied claims that an affair was
behind their divorce.
Adrian and Gillian Bayford won the EuroMillions prize in August last
year.
A Camelot spokeswoman said two per cent of winners had separated
from them partners after winning a major prize.
“99% of winners claimed to be as happy or happier than before their
win,” she added.
'We're all happy now' says £148 million lottery winner after
separating from wife Telegraph 20 Nov 2013
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Judgement Biases – Two
Examples
Dave and Angela Dawes won a £101 million fortune
just two years ago and swapped their flat for a
£9 million mansion.
But now relatives say the pair's six-year
relationship has ended after arguments over how
to spend their winnings.
Second EuroMillions couple split after rows over
money Telegraph 25 Nov 2013
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Judgement Biases - Do We
Know What Makes Us Happy?
In principle, of course, the remembered “loss” may
carry over time, or in any event be substantial
relative to the long-term utility consequences.
But for other more extreme examples of loss
aversion it is hard to believe that the “transition
utility” ranks high relative to long-term utility.
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Judgement Biases - Do We
Know What Makes Us Happy?
For instance, Thaler (1980, pp. 43-4) asked subjects
each of the following two survey questions:
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Judgement Biases - Do We
Know What Makes Us Happy?
(a) Assume you have been exposed to a disease which if
contracted leads to a quick and painless death within a
week. The probability you have the disease is 0.001.
What is the maximum you would be willing to pay for a
cure? How much would you want?
(b) Suppose volunteers were needed for research on
the above disease. All that would be required is that
you expose yourself to a 0.001 chance of contracting
the disease. What is the minimum payment you would
require to volunteer for this program? (You would not
be allowed to purchase the cure.) How much would you want?
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Judgement Biases - Do We
Know What Makes Us Happy?
The results.
Many people respond to questions (a) and (b) with
answers, which differ by an order of magnitude
or more! (A typical response is $200 and
$10,000.)
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What Makes Us Happy?
As reported by Proto and Rustichini (2013) the debate on
whether higher income in a country is associated with
higher life satisfaction is considered of crucial
importance for scientific and for policy reasons. The
debate is still open.
In a well-known finding, (Easterlin 1974) reported no
significant relationship between happiness and aggregate
income in time-series analysis. For example, Easterlin
shows that the income per capita in the USA in the
period 1974–2004 almost doubled, but the average level
of happiness showed no appreciable trend upwards.
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What Makes Us Happy?
This puzzling finding, appropriately called the Easterlin
Paradox, has been confirmed in similar studies by
psychologists (Diener et al. 1995) and political scientists
(Inglehart 1990), and has been confirmed for European
countries (Easterlin 1995) (although there is some
disagreement on the conclusion when an analysis based on
timeseries is used, see in particular (Oswald 1997) and
(Stevenson and Wolfers 2008). On the other hand, life
satisfaction appears to be strictly monotonically
increasing with income when one studies this relation at a
point in time across nations (Inglehart 1990; Deaton
2008; Stevenson and Wolfers 2008).
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What Makes Us Happy?
To reconcile the cross-sectional evidence with the
Easterlin Paradox, some have suggested that the positive
relation in happiness vanishes beyond some value of
income (Layard 2005; Inglehart 1990; Di Tella and
MacCulloch 2010). This last interpretation has been
questioned by Deaton (2008) and Stevenson and Wolfers
(2008), who claim that there is a positive relation
between GDP and life satisfaction in developed countries.
From the opposite perspective, it is being questioned by
Easterlin et al. (2010), who provide some evidence of no
long-run effect even for developing countries.
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What Makes Us Happy?
National happiness rises as a country’s gross domestic
product (GDP) per capita climbs, but tails off when the
rising wealth creates higher aspirations – which often
lead to a sense of disappointment.
In wealthy countries this “sweet spot” is found at around
£22,100, after which, happiness decreases as our
aspirations for better-quality housing, a higher standard
of education and consumer goods lead to increased levels
of anxiety and stress.
Experts confirm that money does buy happiness – but only up to
£22,100 Independent 28-11-2013
L
A Reassessment of the Relationship between GDP and Life
Satisfaction Proto E. and Rustichini A. (2013)
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What Makes Us Happy?
A circle in the
scatter plot
represents the
regional average
life satisfaction
and average
regional GDP.
The weights are
the sample sizes
for each region.
A Reassessment of the Relationship between GDP and Life
Satisfaction Proto E. and Rustichini A. (2013)
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What Makes Us Happy?
Of course the GDP is not the only index!
The Big Mac index.
The Economist January 23rd 2014, by D.H. & R.L.W.
For those interested, try the tool,
Big Mac index map and chart.
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What Makes Us Happy?
What predicts the evolution over time of subjective well-being? They
correlate the trends of subjective well-being with the trends of social
capital and/or GDP. They find that in the long and the medium run social
capital largely predicts the trends of subjective well-being. In the shortterm this relationship weakens. Indeed, in the short run, changes in social
capital predict a much smaller portion of the changes in subjective wellbeing than over longer periods. GDP follows a reverse path, thus
confirming the Easterlin paradox: in the short run GDP is more positively
correlated to well-being than in the medium-term, while in the long run
this correlation vanishes (Bartolini and Sarracino 2014). The authors
employ a massive data set.
Social capital is the expected collective or economic benefits derived
from the preferential treatment and cooperation between individuals and
groups. The OECD (2001, p. 41) gives a definition of social capital, as
“networks together with shared norms, values and understandings that
facilitate co-operation within or among groups”. (OECD, 2001. The
evidence on social capital. The Well-being of Nations: The Role of Human
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and Social Capital. OECD, Paris, pp. 39–63.)
What Makes Us Happy?
The study probes the reasons why increased income
does not enhance happiness based on the effects of
relative income and expected income. The study
analysis is based on results from the Taiwan Social
Change Survey from 1999 to 2002, using an ordered
probit model. The findings demonstrate that the
Taiwanese people are happier with an increase in
absolute income. However, the marginal effect is
reducing. In addition, relative income and expected
income meet the expectation, indicating that people’s
happiness is not only related to absolute income, but
also closely associated with the average income found
in society and expected income (Tsui 2014).
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Happiness, Experiences
versus Possessions
Over the past decade, an abundance of psychology
research has shown that experiences bring people
more happiness than do possessions. The idea that
experiential purchases are more satisfying than
material purchases, expanded on the current
understanding that spending money on experiences
“provide[s] more enduring happiness” (Kumar et al.
2014 KKG). They looked specifically at anticipation as a
driver of that happiness; whether the benefit of
spending money on an experience accrues before the
purchase has been made, in addition to after. And, yes,
it does.
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Happiness, Experiences
versus Possessions
Essentially, when you can't live in a moment, they say,
it's best to live in anticipation of an experience.
Experiential purchases like trips, concerts, movies, et
cetera, tend to trump material purchases because the
utility of buying anything really starts accruing before
you buy it (KKG).
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Happiness, Experiences
versus Possessions
Waiting for an experience apparently elicits more
happiness and excitement than waiting for a material
good (and more “pleasantness” too — an eerie metric).
By contrast, waiting for a possession is more likely
fraught with impatience than anticipation. “You can
think about waiting for a delicious meal at a nice
restaurant or looking forward to a vacation”, “and how
different that feels from waiting for, say, your preordered iPhone to arrive. Or when the two-day shipping
on Amazon Prime doesn’t seem fast enough” (KKG).
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Happiness, Experiences
versus Possessions
Prior work has shown that experiences tend to make
people happier because they are less likely to measure
the value of their experiences by comparing them to
those of others. For example, many people are unsure
if they would rather have a high salary that is lower
than that of their peers, or a lower salary that is
higher than that of their peers. With an experiential
good like vacation, that dilemma doesn't hold. Would
you rather have two weeks of vacation when your peers
only get one? Or four weeks when your peers get
eight? People choose four weeks with little hesitation
(KKG).
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Strategies As Solutions For
Biased Decision Making?
Fischhoff (1982) reviewed the results of four
strategies that had been proposed as solutions for
biased decision making:
a.
offering warnings about the possibility of bias;
b.
describing the direction of a bias;
c.
providing a dose of feedback; and
d.
offering an extended program of training with
feedback, coaching, and other interventions
designed to improve judgment.
Which do you think would be effective?
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Strategies As Solutions For
Biased Decision Making? No!
According to Fischhoff’s findings, which have
withstood 25 years of scrutiny, the first three
strategies yielded minimal success, and even intensive,
personalized feedback produced only moderate
improvements in decision making (Bazerman and Moore,
2008). This was not encouraging for researchers
hoping to improve people’s judgment and decisionmaking abilities.
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How Can Decision Making Be
Improved?
Milkman et al. (2014) suggest that the optimal moment
to address the question of how to improve human
decision making has arrived. After 50 years of
research by judgment and decision-making scholars,
psychologists have developed a detailed picture of the
ways in which human judgment is bounded. Milkman et
al. (2014) argue that the time has come to focus
attention on the search for strategies that will
improve judgments because decision-making errors are
costly and are growing more costly.
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How Can Decision Making Be
Improved?
Decision makers are receptive, and academic insights
are sure to follow from research on improvement. In
addition to calling for research on improvement
strategies, the existing literature pertaining to
improvement is reviewed and strategies and highlights
for promising directions of future research suggested.
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Or Is Bias Genetic?
For a long list of investment “biases,” including lack of
diversification, excessive trading, and the disposition
effect, we find that genetic differences explain up to
45% of the remaining variation across individual investors,
after controlling for observable individual characteristics.
The evidence is consistent with a view that investment
biases are manifestations of innate and evolutionary
ancient features of human behaviour. We find that work
experience with finance reduces genetic predispositions
to investment biases. Finally, we find that even genetically
identical investors, who grew up in the same family
environment, often differ substantially in their
investment
behaviours
due
to
individual-specific
experiences or events (Cronqvist and Siegel 2014). 2.59
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Next Week
Distortions In Deriving Preferences
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