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Judgement Biases - Overconfidence

Most people cannot correctly calibrate their probabilistic beliefs. Suppose you are asked:

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

Tuesday 18 April 2023 08:59 PM

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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 it could have been easily predicted.

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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 “knew it would happen all along.”

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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 a stalemate without reaching a peace settlement).

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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 FutureWhen 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 FutureThe 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 FutureJickling (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

RegularitiesPeople 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

RegularitiesOdean (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 - 27/5/2014Bulls run for the exit - FT - 15/10/2014

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Judgement Biases - Spurious

RegularitiesDe 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 runRuth 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 Annual Convention

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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?

(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?

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 Reassessment of the Relationship between GDP and Life Satisfaction Proto E. and Rustichini A. (2013)

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.

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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 short-term this relationship weakens. Indeed, in the short run, changes in social capital predict a much smaller portion of the changes in subjective well-being 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 and Social Capital. OECD, Paris, pp. 39–63.)

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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 pre-ordered 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; andd. 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 decision-making 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).

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Next Week

Distortions In Deriving Preferences