1 1. heuristics and judgement what are heuristics? heuristics are cognitive tools we use to reduce...

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1. Heuristics and Judgement

What are heuristics? Heuristics are cognitive tools we use to reduce the information-processing demands of decision making. These provide time-pressured managers and other professionals with a simple way of dealing with a complex world, producing correct or partially correct judgments more often than not.

Does the use of heuristics predispose people to make sub-optimal decisions and formulate biased policies?

Systematically biased outcomes occur as a result of cognitive biases. These happen when a heuristic is inappropriately applied by a decision maker.

The key to improved judgment lies in learning to distinguish between appropriate and inappropriate uses of heuristics.

*This section developed off the works of Bazerman and Shefrin.

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1. Bounded Rationality and Cognitive Biases

Behavioral cognitive science focuses upon how seemingly rational agents interpret and act on information to make informed decisions. Contrary to assumption, agents do not always behave in a rational, predictable and an unbiased manner as would be indicated by definite models.

The rational model is based on a set of assumptions that prescribe how a decision should be made rather than describing how a decision is made. In his Nobel Prize-winning work, Simon (1957; March and Simon, 1958) suggested that individual judgment is bounded in its rationality and that we can better understand decision making by explaining actual, rather than normative (“what should be done”), decision processes. Resource limitations and behavioral biases keep decision makers from making the optimal decisions assumed in the rational model.

Knowledge of these biases can be used to make more rational decisions. Part of the material in this class will addresses the need to improve managerial judgment by identifying cognitive biases and discussing strategies for overcoming them.

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1. Managerial Behavior

Judgment is a major component of managerial work at all levels of the corporate world and constitutes a critical human resource in any organization. Many managers accept judgment as innate: “some people have it and others do not.” This attitude can waste a lot of potential human resources in organizations.

Since managers make hundreds of decisions daily, the systematic and time-consuming demands of rational decision making are simply not viable. Most significant decisions are made by judgment, rather than by a defined prescriptive model. This is evident in Mintzberg’s (1975) study of managerial behavior. Mintzberg found that the average manager engages in a different activity every nine minutes.

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1. Heuristics and Decision/Policy-making

Kahneman and Tversky (1979) – Nobel Prize (2002) suggest that people rely on a number of simplifying strategies, or rules of thumb, in making decisions. These simplifying strategies are called heuristics. They are the standard rules that implicitly direct our judgment. They serve as a mechanism for coping with the complex environment surrounding our decisions. In general, heuristics are helpful, but their use can sometimes lead to severe errors.

We will identify some hard-to-break heuristics, that impose constraints on our decision/policy-making effectiveness.

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1. Prescriptive and Descriptive

Models The field of decision making can be loosely divided into

two parts: the study of prescriptive models and the study of descriptive models

Prescriptive decision scientists are concerned with prescribing methods for making optimal decisions. For example, they might suggest a mathematical model to help a decision maker act more rationally. Descriptive decision researchers are concerned with the bounded way in which decisions are actually made, we explore both approaches.

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2. Behavioral Question

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3. Discussion of Behavioral QuestionGPA Prediction TaskPredict the college GPA of three graduating students who entered SCU with high school GPAs of 2.2 3.0 3.8

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Typical Predictions

High School Prediction Actual

2.20 2.22 2.703.00 2.79 2.933.80 3.43 3.30

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Overreaction? Predictions are too extreme. People overreact to high school

GPA. They fail to take proper account of

regression to the mean. Therefore, the further away GPA is

from its mean, the larger the error!

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The Moral

What is the basis for predictions that are too extreme?

Are students with low high school GPAs representative of poor students?

Representativeness? Is this psychological? Too much reliance on stereotypic thinking? Yes, it reflects heuristic-based thinking and

results in bias.

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4. Application to Stock Returns

There are 2 directions attached to investors' reaction to stock price events: Overreaction Underreaction

When investors overreact to bad news, they push the price of a stock down by more than is warranted by the information.

A similar statement holds when they overreact to good news.

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Underreaction

Underreaction is the opposite. The reaction is muted relative to the

information in question When investors underreact to bad

news, they don't push the price of a stock down enough to reflect the new information.

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De Bondt-Thaler

Sort stock by past 36 month performance.

Focus on the best and worst performers.

Follow performance over subsequent 60 months.

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Winner-Loser Effect:Over- or underreaction?

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Sample Table from Chapter 1 -Shefrin

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Decision Task & Loss Aversion

Choose between:

A= a guaranteed loss of $750

B =75% chance to lose $1,000 25% chance to lose $0

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Framing

Choose between:

A= a guaranteed gain of $750

B =75% chance to gain $1,000 25% chance to gain $0

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How Did You Decide?

Accept your loss? Secure your gain? Majority are averse to a sure loss and choose the risky

alternative and try to get even**. The manner in which a problem is stated or represented is

called its frame. Frame independence means that the manner in which a decision theoretic problem is framed is irrelevant; traditional finance assumes framing is transparent. Or, practitioners can see through all different ways cash flows might be described. In reality some frames may be opaque.

KT-Prospect Theory 1979-Individuals tend to be risk averse to positively framed choices and risk seeking to negatively framed choices.

Show NDX100Show NDX100

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The Sony TV StoryIllustrative Example*

Sony was founded in 1946 by Masaru Ibuka and Akio Morita.

In 1957, Sony introduced the first pocket-sized transistor radio.

*The Sony case is also described in Shefrin’s Journal of Applied Corporate Finance article that appeared in 2000.

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A few years later, Ibuka and Morita were working to develop a color television set.

In March 1961, Ibuka and Morita attended a trade show in New York, sponsored by the Institute of Electronics and Electrical Engineers.

While there, they viewed a television screen that featured the sharpest and brightest image they had ever seen.

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The Chromatron color tube was developed for the U.S. military by the Nobel Prize-winning physicist E. O. Lawrence (1901-1958). http://www.earlytelevision.org/chromatron.html

It was owned by Autometric Laboratory, a small subsidiary of Paramount Pictures.

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Morita negotiated a technical license from Paramount to produce a color television receiver designed around the Chromatron tube.

Ibuka led a two-year effort to develop a commercial prototype and process technology.

By September 1964, Ibuka’s team had succeeded in developing a prototype. However, they had not developed a commercially viable manufacturing process.

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Chronicler of events reports that Ibuka was both optimistic and confident.

He had the product announced and displayed in Sony’s showroom.

Consumer reaction was enthusiastic! Sony even invested in a new facility to

house the Chromatron assembly.

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Ibuka announced that the Chromatron would be Sony’s top priority.

He placed 150 people on its assembly line.

Can you guess the rest of the story?

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At this point, the production process yielded only two or three usable picture tubes per thousand produced.

The retail price of a Chromatron color television set was $550, but the cost of production was more than double that amount.

There was a sharp difference of opinion within the Sony leadership about the appropriate course of action.

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Morita wanted to terminate the Chromatron project.

However, Ibuka refused. Sony continued to produce and

sell Chromatron sets, eventually selling 13,000 sets, each one with a negative unit gross margin.

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In November 1966, Sony’s financial managers announced that Sony was “close to ruin.”

Only then did Ibuka agree to terminate the Chromatron project.

This commercial product was Sony's fifth after the tape recorder, transistor radio, transistor television and VTR. Production was assigned to the Osaki plant.http://www.sony.net/Fun/SH/1-11/h4.html

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Behavioral Elements?

Were there behavioral elements at work in the Chromatron story?

Yes, at least three: excessive optimism overconfidence and aversion to a sure loss. commitment escalation

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Excessive optimism and overconfidence figure prominently. Ibuka committed Sony to mass-produce

Chromatron sets before his engineers had developed a cost-effective mass production process.

Aversion to a sure loss figures prominently. Once losses began to mount, Ibuka continued

to invest in the project and would not accept a sure loss, preferring to gamble that a solution could be worked out.

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Most of Sony’s initial losses from the Chromatron stemmed from its investment in a new dedicated production facility—a sunk cost.

Of course, sunk costs are exactly that, sunk, and most textbooks in corporate finance warn readers to ignore them.

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For example, in their well-known corporate finance text, Richard Brealey and Stewart Myers state:

“Forget sunk costs. Sunk costs are like spilled milk: They are past and irreversible outflows. Because sunk costs are bygones, they cannot be affected by the decision to accept or reject the project, and so they should be ignored.”

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Agency Cost and Incentives?

Ibuka was a Sony founder and major shareholder.

But even being rewarded as a major shareholder did not prevent him from succumbing to overconfidence or loss aversion in his actions as a manager.

The Sony case illustrates that incentive effects by themselves will not necessarily overcome the impact of behavioral elements.

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Forceful Predictions Trigger Poor Policies

A parliamentary commission in Great Britain set up to investigate the value of the incandescent lightbulb concluded in 1878 that “(Edison’s idea are) good enough for our transatlantic friends … but unworthy of the attention of practical or scientific men.”

Alexander Graham Bell patented the telephone in 1876 and tried to sell it to Western Union, but the company was not interested. Lord Kelvin, on eof the preeminent British scientists of the nineteenth century said that “Radio has no future.”

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A potential initial investor in the Ford Motor Company was told by his banker, “The horse is here to stay, but the automobile is only a novelty – a fad.” The investor bought $5,000 worth of Ford stock anyway and sold his shares several years later for $12.5 million.

The editor of the London Daily Express, when told in 1922 that the inventor of television wanted to see him, said, “For God’s sake go down to reception and get rid of the lunatic who’s down there. He says he’s got a machine for seeing by wireless! Watch him – he may have a razor on him.”

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Newer technology seems to have been greeted no better. Thomas J. Watson, the founder of IBM, said in 1943, “I think there is a world market for about five computers.” Ken Olson, the founder of Digital Equipment, stated in 1977 just before the PC revolution began, “There is no reason for any individual to have a computer in their home.”