Chapter 1. Decision Making

1.1 Introduction

This experiment is based on work by Kahneman & Tversky, two cognitive psychologists who have done a great number of experiments dealing with decision-making phenomena. They were able to identify several common decision making errors, and much of their work had great relevance for investment behavior. Eventually Kahneman would win the Nobel Prize in economics (unfortunately, Tversky had passed away before their work was credited by the Nobel committee).

1.2 Experiment Setup

1.3 Instructions

Press the space bar to start the experiment. A word problem will appear on the screen. Read the problem and provide an answer in the blank provided. After you’ve answered the problem, the next problem will appear.

1.4 Experiment

1.5 Results

1.6 Debriefing

Kahneman & Tversky conducted research on the strategies (heuristics) of decision-making. They identified three common heuristics: representativeness, availability, and anchoring and adjustment. The representativeness heuristic is the assumption that similarity is related to probability. When events share essential features or a common mechanism, they are thought to be more representative of the larger set of events. This representativeness is taken to mean that those events with common features occur with greater probability. The availability heuristic operates on the idea that events that are easy to recall are treated as more important than events that are difficult to recall. When using the availability heuristic, people will assume that the ease with which they can generate examples for an event is reflective of a high probability of occurrence and is therefore important. The anchoring and adjustment heuristic describes how people use intuition to assess probability. The anchor is the starting estimate of event probability; adjustments are made based on new information. However, this heuristic often leads to errors because individuals often have a cognitive bias towards early information, specifically information that helped them arrive at their anchor probability.

The three heuristics for decision-making examined by Kahneman and Tversky demonstrate that humans try to impose order on randomness. Further, Kahneman and Tversky’s work demonstrated that estimates about the probability of events or the structure of events are unduly influenced by preconceived ideas about the nature of the information being presented. The work of Kahneman and Tversky demonstrates that when faced with problems that require action, humans will “go with their gut” or rely on instinct rather than the laws of logic.

References:

Tversky, A. & Kahneman, D. (1973). Availability: a heuristic for judging frequency and probability. Cognitive Psychology, 5, 207-232.

Kilger, D. & Kudryavtsev, A. (2010). The availability heuristic and investors’ reaction to company-specific events. Journal of Behavioral Finance, 11(1), 50-65.

Kahneman, D. (2003). A perspective on judgment and choice: mapping bounded rationality. American Psychologist, 58(9), 697-720.

1.7 Quiz