Question

Paul is a police detective in Glasgow. He solves 70% of his murder cases. This is not a bad achievement considering that he only actively researches 30% of the cases. If he actively researches a case, he has a 90% chance of solving it.

2.1. Assuming that he solves a case, how likely is it that he actively researched it?
2.2. If somebody answers 80% to question 2.1, what type of error is he or she committing? Explain your answer.

Ten years later, Paul has set up his own private detective agency. You are curious as to how much salary Paul is earning. You discuss the case with your 12-year old son, who knows absolutely nothing about salaries of private detectives, and he says: “I would not be surprised if Paul earns a million dollars per year”. Ten minutes later, when you are asked by a colleague how much you think that Paul earns, you reply: “Probably a million dollars.'

2.3. Which bias is described in the story above?

Given his large success as a private detective, Paul wants to start investing in the stock market. However, he is worried about the occurrence of a new stock market bubble. Therefore, he actively reads up on the Tech/Internet bubble burst that occurred in the year 2000. This bubble was predicted by Alan Greenspan and Robert Shiller well before the year 2000 when they argued that the market could be described by the term “irrational exuberance”.

2.4. What does the term “irrational exuberance” mean?

In his job, Paul makes a lot of money from arbitrage. However, one of the problems he has encountered is “noise-trader risk”.
2.5. Explain the term noise-trader risk.
2.6. Mention and briefly describe two other factors that hamper arbitrage.

Answer 1

2.3) This is a case of Belief Perseverance Bias which comes under the category of Cognitive biases as it arises when someone without gathering enough information on a question tends to seek results based on his previously held beliefs that he thinks to be true. As is evident from the above story that the answer to the question is merely based on what you think to be true as was said by your son without actually gathering the required information.

2.4) Irrational exuberance as the name suggests means over enthusiastic nature of investors which leads them investing in assets which they think are a good bet rather than judging them on the basis of the fundamentals like intrinsic value, etc. This means that the economic fundamentals are ignored by the investor and they keep buying the stock even when the fundamentals say otherwise. This creates a bubble which when bursts results in fire sales thereby causing the market to crash. This term infact was coined by Alan Greenspan during the dotcom bubble. For e.g.: Suppose A is a vegetable seller who believes that demand for green peas will increase and hence stocks up a lot of green peas, seeing him other vegetable sellers also follow him. This causes an increase in the price of green peas but in reality, the demand by customers hasn't increased as such. So when they realize this they end up selling their stock in fire sales at low prices than the cost.