Belief Irrationality
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OUTLINE
 Perception
of Information
 Framing effect, Anchoring bias, Availability
bias
 Optimism and Overconfidence
 Representativeness
 Belief Updating
 Cognitive conservatism and Confirmation bias
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PERCEPTION OF INFORMATION
Psychologists believe that the human mind is limited
in its ability to focus and process all the incoming
information.
 Framing effect. This consists in analyzing problems
without paying attention to their wider context or
even in an extremely isolated way.
 Tversky and Kahneman (1981, 1986) showed that
decision makers may display changing preferences
and make radically different choices depending on the
way in which the same, logically identical problem
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was presented to them.

PERCEPTION OF INFORMATION
One version of the framing bias is the so-called
money illusion.
 Another instance of framing is mental accounting in
which individual aspects of financial decisions are
perceived in isolation (Thaler, 1985, 1990, 1999).
 What may be especially important is separate
accounting for profit and loss because decision
makers usually have different preferences depending
on whether they relate to gains or losses.

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PERCEPTION OF INFORMATION
Diagnostic Question. p.A1-12
Psychologists have found that when faced with the
preceding question, the majority of people choose the
risk-free A over risky B, but choose the risky D over the
risk-free C.
• Aversion to a sure loss: Instead of accepting sure
losses, people are prone to accepting risky, actuarially
unfair prospects. (Psychological studies have
demonstrated that many people would choose D over C
even if the expected loss in D were more than $7,500.)

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PERCEPTION OF INFORMATION
•
•
•
Let compare the choice (A,D) with (B, C), it results
that (B, C) dominates (A,D). (B,C) provides more
gains and smaller losses than (A,D).
This is called the “Narrowing framing bias”. People
who engage in narrow framing ignore their overall
return-risk profile.
Decision problems are often framed opaquely rather
than transparently, and opaque framing often induce
people to make the wrong decision.
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PERCEPTION OF INFORMATION

•
•
Framing effects pertain to the manner people describe
the information involved in decision tasks. It means
that how the tasks are framed can affect decisions.
Think another question: would you be willing to take
a 25 percent chance of winning $7,500, but a 75
percent chance of losing $2,500?
Note this question is an alternative frame of the
second decision in p. A1-12: The alternative frame is
between C (a risk-free $0) and D (25% of a $7,500
gain, and 75% of $2,500 loss).
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PERCEPTION OF INFORMATION
•
When framed in this alternative form, most people
answer no, judging the potential gain of $7,500 does
not justify the 75% chance of losing $2,500. The
point is most people accept the risk when the problem
is framed to highlight the sure loss and refuse to
accept the risk when the problem is framed to ignore
the sure loss.
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PERCEPTION OF INFORMATION
Anchoring bias. When people try to estimate a
parameter or quantity, they start their thought process
by adopting a value that is sometimes completely
arbitrary (Kahneman and Tversky (1974)). There is
overwhelming empirical evidence to suggest that
people become very strongly attached to the initial
value (the “anchor”) and are not able to adjust their
final estimates correctly.
 Diagnostic Question (p. A1-10).The first question is
intended to provide a context for the way people
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think about the second question.

PERCEPTION OF INFORMATION
The issue here is whether people arrive at their
prediction of the year of Attila’s European defeat by
beginning with X (anchored number) and adjusting
up or down.
 Discussion. A regression of prediction year on the last
three digits of telephone number has a slope
coefficient that is about 0.75, which is significant at
the 5 percent level.
 Another experiment. In the experiment, subjects were
asked to estimate the percentage of African countries
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in the United Nations.

PERCEPTION OF INFORMATION
First, respondents were requested to spin a “wheel of
fortune” to generate a number between 0 and 100.
• Next, they had to say whether they believe the
percentage of African countries in the UN is lower or
higher than the randomly selected number. Then they
were asked to estimate the actual percentage of
Africa’s representatives among all UN members as
precisely as possible.
 It turned out that the initial, totally arbitrary anchor
value significantly influenced participants’ responses.
•
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PERCEPTION OF INFORMATION
Availability bias. The tendency to overestimate
probabilities or frequency of events we can remember
easily (Tversky and Kahneman, 1973; Taylor, 1982).
 Trying to estimate the probability of an event, people
often rely on their memory and search for relevant
information from the past. But memory might be
selective and our consciousness is most responsive to
signals that can be remembered most easily. We
usually attach too much importance to information
that is readily available, extreme, and often repeated,
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for example, in the media.

EXCESSIVE OPTIMISM
Excessive optimism. People overestimate how
frequently they will experience favorable outcome
and underestimate how frequently they will
experience unfavorable outcome.
 Diagnostic Question. p. A1-1
This diagnostic question was designed to provide
insight into the judgments that people form about
risks they confront. People rate how likely they are to
experience particular events relative to other people
who are similar to them. Are they prone to particular
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biases?

EXCESSIVE OPTIMISM

Discussion. A rating of 7 means that a person feels
that an event is as likely to happen to them as to
anyone else in similar circumstances.

It was found that typically the average rating for the
unfavorable events is below 7, while the average
rating for the favorable event is above 7.

While this kind of belief may be true for some
people, it can not be true for everyone.
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OVERCONFIDENCE
A lot of evidence suggests that decision makers are
generally overconfident. This can be manifested in
three basic ways: above-average effect, calibration
effect, and illusion of control.
1. Above-average effect: When making assessments
and constructing beliefs about reality, people consider
their knowledge and skills to be above the average.
They rate themselves better than the average man.
2. Calibration bias

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OVERCONFIDENCE
Diagnostic Question. p. A1-4
These are 10 difficult questions. The point of the
question is to establish low and high guesses that
bracket the true answer 90 percent of the time (a
range that you feel 90 percent confident that the right
answer will lie between your low and high guess).
 Discussion. A person scores a “hit” on a question
when the true answer lies between the low and high
guess. It was found that typically the most frequent
number of hits, and the average number of hits, is
about 4.

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OVERCONFIDENCE
When asked to provide information or make a
forecast without being precise but estimating within a
certain confidence range, people usually give answers
which indicate that they are overconfident as to the
precision of their knowledge.
 When people set their intervals too narrowly, their hit
rates would be small. When they set their intervals
too widely, their hit rates would be large. People who
are well-calibrated should expect to score nine hits
for the 10 questions (since the confidence level is 90
percent).

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OVERCONFIDENCE
Overconfidence grows with the degree of difficulty of
the tasks and if there are no prompt signals from the
environment that confirm or negate previous
information or previously made decisions.
 Barber and Odean (2001) document overconfidence
among investors and March and Shapira (1987), and
Ben-David, Graham, and Harvey (2007) provide
evidence on overconfidence among corporate
managers.

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OVERCONFIDENCE
3. Overconfidence also manifests itself in the illusion of
control. People are frequently convinced that their
actions may positively affect totally random outcomes.
Langer (1975) documents that lottery players place a
higher value on the tickets for which they themselves
picked the numbers than on the tickets filled in by the
quick-pick lottery machine.
 Diagnostic question (p. A1-6)
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OVERCONFIDENCE
Overconfidence is supported by the selectiveattribution bias, which consists in people attributing
successes (even random ones) to themselves and their
capabilities while explaining failures by independent
factors, such as bad luck, mistakes made by others,
and so on (Langer and Roth, 1975; Miller and Ross,
1975; Fischhoff, 1982; Taylor and Brown, 1988).
 Overconfidence is a bias pertains to how well people
understand the limits of their knowledge, their own
abilities, or both.

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REPRESENTATIVENESS
Representativeness heuristic. This is a mental shortcut
where the probability of an event or a state is
estimated through assessing the degree to which
incoming information is similar to a specific
remembered pattern (Kahneman and Tversky, 1973;
Tversky and Kahneman, 1974; Grether, 1980).
 Diagnostic Question. p. A1-5
Based on your friend’s descriptions about Linda, you
rank the eight possibilities about Linda’s current
interests and career.

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REPRESENTATIVENESS
Discussion. Typically people put activity in the
women’s movement and psychiatric social worker as
the most likely possibilities. The two situations that
people judge to be least likely are insurance
salesperson and bank teller.
 Psychologists suggest that people consider each
situation as a category and ask how representative
Linda is of the category. This kind of judgments
(heuristics) may result in systematic errors. For
example, most people assign a higher likelihood to
item 8 than they do to item 6.

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COGNITIVE CONSERVATISM
There is a lot to suggest that we cannot properly
update our forecasts in the light of new facts and that
we often treat such facts in a selective manner.
 Cognitive conservatism. Edwards (1968) proved that
even though new information usually triggers a
change in opinion in the direction predicted by the
Bayes’s rule, the value of the change is far from
satisfactory. People usually display excessive
cognitive conservatism and are slow to react to new
information.

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COGNITIVE CONSERVATISM

Although representativeness bias may stem from such
factors as overreaction to clear, descriptive signals
conforming to a stereotype, cognitive conservatism
occurs when such signals cannot be assigned to any
specific pattern familiar to the decision maker. In
such cases, the new information is likely to be
underestimated, and the decision maker will focus on
his initial assessments (Barberis and Thaler, 2003).
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CONFIRMATION BIAS
Confirmation Bias. This consists in a tendency to
look for information confirming a previously adopted
hypothesis while avoiding confrontation with facts
that could contradict one’s current opinions or disturb
a previously developed attitude toward a problem.
 Diagnostic Question. p. A1-4

Select the minimum number of cards that will enable
you to determine whether or not the hypothesis “Any
card having a vowel on one side has an even number
on the other side” is true.
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CONFIRMATION BIAS

Discussion. In this card test, most people turn over
the card with the a, and some turn over the card with
the 2 as well. Typically less than a third choose to
turn over just the a and the 3.

The correct answer is to turn over only the a and 3.
The efficient way of testing the validity of the
hypothesis is to turn over only the cards that might
falsify the hypothesis.
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CONFIRMATION BIAS

“a” card offers for both confirmation and falsification.
“b” card offers no evidence. “2” allows for
confirmation only. “3” allows for falsification only.
Thus, the only two cards that offer the potential for
falsification are the a and the 3.
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