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Chapter 6: Common Biases & Errors in Decision Making
Transcript of Chapter 6: Common Biases & Errors in Decision Making
This represents a specific case of selective perception: we seek out information that reaffirms our past choices, and we discount information that contradicts them.
We are most prone to the confirmation bias when we believe we have good information and strongly believe in our opinions.
This is our tendency to believe we can predict the outcome of random events.
Decision making suffers when we try to create meaning in random events, particularly when we turn imaginary patterns into superstitions.
To minimize effort and avoid difficult trade-offs, people tend to rely too heavily on experience, impulses, gut feelings, and convenient rules of thumb.
These shortcuts are helpful, however they also tend to distort our rationality.
There are 8 common biases in decision making:
escalation of commitment
This is when we're given factual questions and asked to judge the probability that our answers are correct, we tend to be far too optimistic.
"A 1977 study showed that 94% of college teachers think of themselves as above-average, and two-thirds say they are in the top quarter. And as for their students, other research shows both male and female college students over-estimate their intelligence, while males also over-estimate their attractiveness." (Essig)
This is our tendency to base judgements on information that is readily available.
The easier something is to recall, the more important it seems.
More people fear flying than fear driving in a car because the media gives much more attention to air accidents, we tend to overstate the risk of flying and understate the risk of driving.
"Child theft is a rare occurrence, but availability bias suggests a high probability of abduction."(WiseGEEK)
Escalation of Commitment
This refers to staying with a decision even when there is clear evidence it's wrong.
Individuals feel that they have invested so much time and energy in making their decisions that they have convinced themselves they're taking the right course of action and don't update their knowledge in the face of new information.
This is the tendency to fixate on initial information and fail to adequately adjust for subsequent information.
Anytime a negotiation takes place, so does anchoring. For example, when a prospective employer asks how much you made in your prior job, your answer typically anchors the employer's offer.
This is the tendency to prefer a sure thing over a risky outcome.
When a risky investment isn't paying off, most people would rather play it safe and cut their losses, but if they think the outcome is a sure thing they'll keep escalating.
This is the tendency to believe falsely, after the outcome is known, that we'd have accurately predicted it.
The hindsight bias reduces our ability to learn from the past. It lets us think we're better predictors than we are and can make us falsely confident.
Application: Finance Decision Making
How are financial decisions affected by errors and biases?
J.C. Penny has had a difficult time recovering from the recent financial crisis.
"Hedge fund billionaire William Ackman has acknowledged that his big investment in J.C. Penney was a mistake, but his decision to get out of the struggling retailer’s stock in late August increasingly looks like a brilliant move." (Vardi)
So in summary, we have talked about 8 common types of biases which are: overconfidence, anchoring, confirmation, availability, escalation of commitment, randomness error, risk aversion, and hindsight bias.
We have also discussed how these different biases can come in to play when making critical financial decisions.
Biases are always going to be a part of our everyday lives, but if we know how to reduce them, it can lead to lucid contemplation and also much better decision making.
Reducing Biases & Errors
Robbins, Stephen P., and Tim Judge.
. 15th ed. Boston: Pearson, 2013. Print.
"What Is Availability Bias?"
. N.p., n.d. Web. 07 Feb. 2014.
Essig, Todd. "The Benefits and Danger of Over-Confidence."
. Forbes Magazine, 19 Sept. 2011. Web. 09 Feb. 2014.
Vardi, Nathan. "Bill Ackman Was Right About J.C. Penney." Forbes. Forbes Magazine, 26 Sept. 2013. Web. 10 Feb. 2014.
. 2011. Photograph.
Cognitive Bias Parade
. May 2011. Web. 10 Feb. 2014.
The Great Gatsby.
. Telegraph Media Group, 11 May 2013. Web. 10 Feb. 2014.
Category Archives: Availability Bias
. N.d. Photograph.
The Behavioural Architects Global Insight Research and Consultancy
. Web. 10 Feb. 2014.
. N.d. Photograph.
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Bud Light - Labels Out. YouTube
. YouTube, 18 Apr. 2013. Web. 10 Feb. 2014.
Focus on goals
Look for information that dis-confirms your beliefs
Don't try to create meaning out of random events
Increase your options