1. Heuristics and Judgement
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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 suboptimal 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
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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
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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
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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
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The field of decision making can be loosely divided
into two parts:
 the study of prescriptive models and
 the study of descriptive models
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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
Question
GPA Prediction Task
Predict the college GPA of three
graduating students who entered SCU
with high school GPAs of
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2.2
3.0
3.8
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Typical Predictions
High School Prediction Actual
2.20
2.22
2.70
3.00
2.79
2.93
3.80
3.43
3.30
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Overreaction?
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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
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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
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There are 2 directions attached to
investors' reaction to stock price
events:
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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
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Underreaction is the opposite.
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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
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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:
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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:
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A= a guaranteed gain of $750
B =75% chance to gain $1,000
25% chance to gain $0
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Show NDX100
How Did You Decide?
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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.
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The Sony TV Story
Illustrative Example*
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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?
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Were there behavioral elements at
work in the Chromatron story?
Yes, at least three:
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excessive optimism
overconfidence and
aversion to a sure loss.
commitment escalation
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Excessive optimism and overconfidence
figure prominently.
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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.
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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?
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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
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Forceful Predictions Trigger Poor Policies
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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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Forceful Predictions Trigger Poor Policies
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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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Forceful Predictions Trigger Poor Policies
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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.”
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