The most significant foundational theories of modern finance, Modern Portfolio Theory and the Efficient Market Hypothesis, have an important assumption in common. In fact, academic research in finance and economics, as well as in many other social sciences, is based on the rational actor theory, which posits that people evaluate all information and options available to choose the one that maximizes benefits and minimizes costs……Continue reading….
By: Motley Fool Asset Management
Source: Motley Fool
.
Critics:
Many social institutions rely on individuals to make rational judgments. Across management, finance, medicine, and law, the most recurrent bias is overconfidence, though anchoring and framing also play substantial roles. While research in finance often uses large-scale data, studies in medicine and law frequently rely on vignette-based designs. Berthet highlights the lack of ecological validity in many studies and the need for deeper exploration of individual differences in susceptibility to bias.
The securities regulation regime largely assumes that all investors act as perfectly rational persons. In truth, actual investors face cognitive limitations from biases, heuristics, and framing effects. In some academic disciplines, the study of bias is very popular. For instance, bias is a wide spread and well studied phenomenon because most decisions that concern the minds and hearts of entrepreneurs are computationally intractable.
In law enforcement and legal decision-making, confirmation bias and related errors frequently influence investigative decisions and evidence evaluation. Structured intervention strategies, such as accountability measures and checklists, show some promise in reducing bias during case evaluations. A fair jury trial, for example, requires that the jury ignore irrelevant features of the case, weigh the relevant features appropriately, consider different possibilities open-mindedly and resist fallacies such as appeal to emotion.
The various biases demonstrated in these psychological experiments suggest that people will frequently fail to do all these things. However, they fail to do so in systematic, directional ways that are predictable. Cognitive biases can create other issues that arise in everyday life. Study participants who ate more unhealthy snack food tended to have less inhibitory control and more reliance on approach bias.
Cognitive biases could be linked to various eating disorders and how people view their bodies and their body image. Cognitive biases can be used in destructive ways. Some believe that there are people in authority who use cognitive biases and heuristics in order to manipulate others so that they can reach their end goals. Some medications and other health care treatments rely on cognitive biases in order to persuade others who are susceptible to cognitive biases to use their products.
Many see this as taking advantage of one’s natural struggle of judgement and decision-making. They also believe that it is the government’s responsibility to regulate these misleading ads. Cognitive biases also seem to play a role in property sale price and value. Participants in the experiment were shown a residential property. Afterwards, they were shown another property that was completely unrelated to the first property. They were asked to say what they believed the value and the sale price of the second property would be.
They found that showing the participants an unrelated property did have an effect on how they valued the second property. Cognitive biases can be used in non-destructive ways. In team science and collective problem-solving, the superiority bias can be beneficial. It leads to a diversity of solutions within a group, especially in complex problems, by preventing premature consensus on suboptimal solutions.
This example demonstrates how a cognitive bias, typically seen as a hindrance, can enhance collective decision-making by encouraging a wider exploration of possibilities. Cognitive biases are interlinked with collective illusions, a phenomenon where a group of people mistakenly believe that their views and preferences are shared by the majority, when in reality, they are not. These illusions often arise from various cognitive biases that misrepresent our perception of social norms and influence how we assess the beliefs of others.
Cognitive biases also influence the spread of misinformation, particularly in digital environments. Lazer, Baum, and Grinberg (2018) analyzed over 16,000 false news stories shared by millions of Twitter users during the 2016 U.S. election and found that false information spread significantly faster than accurate news. This occurs partly because misinformation aligns with existing beliefs and triggers emotional reactions, both of which are linked to confirmation and availability biases.
These findings illustrate how cognitive biases can distort public understanding and contribute to the rapid dissemination of false narratives. The content and direction of cognitive biases are not “arbitrary”. Debiasing is the reduction of biases in judgment and decision-making through incentives, nudges, and training. Cognitive bias mitigation and cognitive bias modification are forms of debiasing specifically applicable to cognitive biases and their effects.
One debiasing technique aims to decrease biases by encouraging individuals to use controlled processing compared to automatic processing. Because they cause systematic errors, cognitive biases cannot be compensated for using a wisdom of the crowd technique of averaging answers from several people. Reference class forecasting is a method for systematically debiasing estimates and decisions, based on what Daniel Kahneman has dubbed the outside view.
Cognitive bias modification (CBM) refers to the process of modifying cognitive biases in healthy people and also refers to a growing area of psychological (non-pharmaceutical) therapies for anxiety, depression and addiction called cognitive bias modification therapy (CBMT). CBMT is sub-group of therapies within a growing area of psychological therapies based on modifying cognitive processes with or without accompanying medication and talk therapy, sometimes referred to as applied cognitive processing therapies (ACPT).
Although cognitive bias modification can refer to modifying cognitive processes in healthy individuals, CBMT is a growing area of evidence-based psychological therapy, in which cognitive processes are modified to relieve suffering from serious depression, anxiety, and addiction. CBMT techniques are technology-assisted therapies that are delivered via a computer with or without clinician support.
CBM combines evidence and theory from the cognitive model of anxiety, cognitive neuroscience, and attentional models. Even one-shot training interventions, such as educational videos and debiasing games that taught mitigating strategies, significantly reduced the commission of several cognitive biases. Cognitive bias modification has also been used to help those with obsessive-compulsive beliefs and obsessive-compulsive disorder. This therapy has shown that it decreases the obsessive-compulsive beliefs and behaviors.
In relation to reducing the fundamental attribution error, monetary incentives and informing participants they will be held accountable for their attributions have been linked to the increase of accurate attributions. Individual differences in cognitive bias have also been linked to varying levels of cognitive abilities and functions. The Cognitive Reflection Test (CRT) has been used to help understand the connection between cognitive biases and cognitive ability.
There have been inconclusive results when using the Cognitive Reflection Test to understand ability. However, there does seem to be a correlation; those who gain a higher score on the Cognitive Reflection Test, have higher cognitive ability and rational-thinking skills. This in turn helps predict the performance on cognitive bias and heuristic tests. Those with higher CRT scores tend to be able to answer more correctly on different heuristic and cognitive bias tests and tasks.
Age is another individual difference that has an effect on one’s ability to be susceptible to cognitive bias. Older individuals tend to be more susceptible to cognitive biases and have less cognitive flexibility. However, older individuals were able to decrease their susceptibility to cognitive biases throughout ongoing trials. These experiments had both young and older adults complete a framing task. Younger adults had more cognitive flexibility than older adults. Cognitive flexibility is linked to helping overcome pre-existing biases.
Leave a Reply