ACC10007 Financial Information for Decision Making Final Assessment Questions – Semester 2 2020
Judgment and Decision making - UvA Master A&C - Extensive Summary + Short Summary - Grade 8.6
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Vrije Universiteit Amsterdam (VU)
Msc Financial Management
Behavioral finance (E_FIN_BF)
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Summary financial behavior
Judgment in managerial decision making
Bazerman & Moore
Chapter 1
Introduction to managerial decision making
Anatomy of decisions
The term judgement refers to the cognitive aspects of our decision making process. To fully
understand judgement we have to identify the components of the decision making process. There
are six steps when applying a ‘rational’ decision making process.
1. Define the problem: accurate judgement is required to identify and define the problems.
Mangers often err by (a) defining the problem in terms of a proposed solution, (b) missing a
bigger problem, or (c) diagnosing the problem in terms of its symptoms.
2. Identify the criteria: The rational decision maker will identify all relevant criteria in the
decision-making process.
3. Weigh the criteria: Rational decision makers will know the relative value they place on
each of the criteria identified.
4. Generate alternatives: Identify possible courses of action. An optimal search continues
only until the cost of the search outweighs the value of the added information.
5. Rate each alternative on each criterion: The rational decision maker carefully assesses
the potential consequences of selecting each of the alternative solution on each of the
identified criteria.
6. Compute the optimal decision: Optimal decision consists of (1) multiplying the rating in
step five by the weight of each criterion, (2) adding up the weighted ratings across all of
the criteria for each alternative, and (3) choosing the solution with the highest sum of the
weighted ratings.
System 1 & 2 thinking
System 1 thinking refers to our intuitive system, which is typically fast automatic, effortless,
implicit, and emotional.
System 2 thinking refers to reasoning that is slower, conscious, effortful, explicit and logical.
System 1 thinking is quite sufficient, but system 2 logic should preferably influence our most
important decisions. System 1 thinking is used when people are busier, more rushed and have
more on their minds. Biases are more likely to occur in system 1 as in system 2.
Bounds of human attention and rationality
Rationality refers to the decision-making process that is logically expected to lead to the optimal
result, given an accurate assessment of the decision maker’s values and risk preferences.
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.
Two schools of thought: prescriptive models and descriptive models
Prescriptive decision analysts develop methods for making optimal decisions
Descriptive decision considers how decisions are actually made.
People rely on a number of simplifying strategies, or rules of thumb, when making decisions.
These are called heuristics. Heuristics and biases explain how people deviate from a fully rational
decision making process in individual and competitive situations.
Decision making is bounded in two ways:
• Our will power is bounded, we give grater weight to present concerns then to future concerns
• Our self-interest is bounded, we care about the outcomes of others
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,Bounded awareness: common tendency to overlook obvious, important, and readily available
information.
Bounded ethically: ethics are limited in ways of which we are unaware.
Judgemental heuristics
Availability Heuristic: People assess the frequency, probability, or likely causes of an event by
the degree to which instances or occurrences of that even are readily available in memory. An
event that evokes emotions and is vivid, easily imagined and specific will be more available than
an event that is unemotional in nature, bland and difficult to imagine or vague.
Representativeness Heuristic: When making a judgement about an individual, people tend to
look for traits the individual may have that correspond with previously formed stereotypes.
Managers may predict a person’s performance based on an established category of people that
the individual represent for them. (Salespeople are extrovert, ex-athletes and white men)
Conformation Heuristic: There are always at least four separate situations to consider when
assessing the association between two events, assuming each one just has two possible
outcomes. However, our everyday decision making commonly neglects this fact. Instead we
intuitively use selective date when testing hypothesis.
Conformation bias: We search for and interpret evidence in a way that supports the conclusion we
favored oat the outset.
Anchoring: Some irrelevant initial hypothesis or starting point holds undue sway over our
judgements.
Hindsight bias: Too quickly dismiss in retrospect, the possibility that things could have turned out
differently then they did.
The Affect Heuristic: Most of our judgements follow an affective or emotional, evaluation that
occurs even before any higher-level reasoning takes place. Affective heuristic is all the more likely
to be used when people are busy or under time constraints.
Chapter 2
Overconfidence
Overconfidence is one of the most potent and pervasive biases to which human judgement is
vulnerable. Second, it facilitates may of the other biases. Without overconfidence we would be
better able to acknowledge our own shortcomings and correct other biases.
The mother of all biases
Overconfidence has been blamed for wars, stock market bubbles, strikes, unnecessary lawsuits,
high rates of entrepreneurial bankruptcy etc.
No probleem in judgement and decision making is more prevalent and more potentially
catastrophic than overconfidence.
Overconfidence has been studied in three basic ways:
• Over precision describes the tendency to be too sure our judgements and decisions are
accurate, uninterested in testing our assumptions, and dismissive of evidence suggesting we
might be wrong. It leads us to draw overly narrow confidence intervals and to be too certain
that we know the truth.
• Overestimation is the common tendency to think we’re better, smarter, faster, more capable,
more attractive, or more popular than we actually are. As a consequence, we overestimate
how much we will accomplish in a limited amount of time or believe we have more control
than we actually do.
• Overplacement is the tendency to falsely think we rank higher than others on certain
dimensions, particularly in competitive contexts. Overplacement can lead people to be too
interested in competing with others in negotiations, in markets, in the costs, or on the
battlefield.
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, Over precision
In a test on over precision most people bound only between three (30 percent) and seven (70
percent) of the quantities despite being 98 percent confident that each of their ranges will
surround the true value. This due to that we are more confident than we deserve to be regarding
the accuracy of our knowledge. Most of us are overconfident in the precision of our beliefs.
In domains where we are experts, our knowledge is more precisie, more narrower specification of
confidence intervals. However we are still overconfident. Our confidence intervals narrowed to
such a degree that we often failed to capture the correct answer, and the hit rates did not
increase. (So still as overconfident in domains where they are experts as where they are no
experts)
People act is if they are sure they know the truth. They draws their bull’s eyes too small, make
their confidence intervals too narrow and don’t shift their actions as much as they should in the
face of uncertainty.
Our greatest power is that we know that we don’t know and we are open to being wrong and
learning (Cassidy, 2011).
It is unwise to be too sure of one’s own wisdom (Ghandi)
Causes of over precision
Over precision springs from the desire to relieve internal dissonance, or a state of tension
regarding the right decision or cause of action. People in a stressful state of tension feel
motivated to relieve this dissonance, even if this requires them to change what they believe.
In essence, asking people to think of a second estimate produced a crowd in the individuals
mind, and the average of this small crowds opinion was more accurate than the individuals first
estimate.
We prefer to hear perspectives that are similar to our won, despite the fact that hearing different
perspectives is more helpful and informative. Because the human mind is better at searching
memory for evidence that confirms rather than disconfirms our beliefs, when we assess our
confidence in a belief, it is easier for us to generate supportive rather than contradictory evidence.
Our outward expression of confidence help others feel sure about us. We see them as more
capable and therefore tend to elevate them to positions of status and influence. But when they are
later discovered to have been in error, their credibility is undermined and their reputation suffers.
Thinking about why you are wrong might help correct for the influence of the confirmation bias on
your confidence judgements. We move in an instant from the old belief to a new belief. Therefor
we almost never have the experience of believing something we know to be false. Instead we blief
we are right about everything all of the time and this becomes the usual state of affairs.
Consequence of over precision
Over precision makes us too sure of our judgements, such that we are often in error yet rarely in
doubt. This makes us too reluctant to take advice from others, suspicious of those whose views
differ from our own. Reluctant to revise our opinions, we tend to ignore feedback from others on
the problems we face. We give substantially less weight to others advice including very useful
advice, than our own options and our accuracy suffers as a result.
Considering others perspectives takes energy and attention because it requires us to move from
the comfortable familiarity of how we are used to seeing things to the unfamiliar vantage point of
an outside view. If only we were better at acknowledging the imperfections in our knowledge and
insights, we could better calibrate our choices to account for our uncertainty.
Overestimation
Overestimation describes the common tendency to think you’re better across a number of
domains than you actually are.
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