Question

• How behaviors such as overconfidence, overoptimism, and confirmation bias can affect decision making.
• How framing effects can result in inconsistent and/or incorrect decisions.
• How the use of heuristics can lead to suboptimal financial decisions.

Answer 1

Overconfidence Overconfidence is the tendency that people overestimate their ability. Shefrin (2007) mentions overconfidence “pertains to how well people understand their own abilities and limits of their knowledge” (p.6). In general, people always place too much weight on their efforts, knowledge and skills, especially when the confidence level is very high.

Optimism bias is a cognitive bias that causes someone to believe that they themselves are less likely to experience a negative event. It is also known as unrealistic optimism or comparative optimism. Four factors exist that cause a person to be optimistically biased: their desired end state, their cognitive mechanisms, the information they have about themselves versus others, and overall mood.

Confirmation bias Confirmation bias is the tendency that investor prefer to interpret the information in the way that confirms their preconceptions and try to avoid the interpretation that contradict their beliefs (Shefrin, 2007). As a result, investor recalls the information selectively from their memory and use information to interpret evidences in a biased way.

Framing effect is an understanding and assessment that individual implements different behaviors when facing to the multiple choice that expressing the same meaning

Heuristics Heuristic, as known as a rule of thumb, is a way refers to problem solving, learning and discovery. Heuristics used by most managers because they speed up the process to find a solution when situation is extremely complicated. Schwartz mentions that “heuristics are shortcuts that simplify the complex methods of assessing the probabilities and values ordinarily required to make judgments, and eliminate the need for extensive calculation” (2010, p.57) Heuristics can make the decision-making much easier. There are many situations that investors would like using heuristic to solve problems. For example: firstly, when an investor is unaware of the optional method for the problem, even though the ideal solution does exist. Moreover, the investor does not have a resource to get help from others or it is too costly to get help from others. Secondly, it is hard for investors to obtain sufficient information for solving the problem, or maybe the time is limited for investors to make a decision. Thirdly, an investor may be not familiarity with programs to process the data. Moreover, the emotional features of the decision might be overwhelming. Heuristic sometimes can be a powerful tool to find the solution. However, when it was used in the wrong situation, it may cause investors to make systematic metal mistakes.