Availability Heuristic Will Affect Decision-making and Result in Bias

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1 2017 3rd International Conference on Management Science and Innovative Education (MSIE 2017) ISBN: Availability Heuristic Will Affect Decision-making and Result in Bias SIJIA MENG ABSTRACT Heuristic is a strategy that allows us to make decision without complicate information gathering and analyzing. Availability heuristic is a type of heuristic that concentrates on retrieving information from memory. However, there are four factors that may induce bias from the use of availability heuristic. A model will be established in this paper to assess the possibility of bias occurring in decision under availability heuristic. The existence of availability heuristic is also against the traditional financial market assumption. KEYWORDS Availability Heuristic; bias; financial market. INTRODUCTION Making decisions without complex information gathering and systematic analysis is a strategy called heuristic which is unknowingly utilized by many people. Even though it may not be optimal or perfect, it is usually sufficient for the immediate goals. It could be described as mental shortcut when people assess the likelihood for an uncertain event. Tversky and Kahneman indicated that these heuristics will lead to bias and errors when people make decisions even though they are helpful in some general cases [1]. They categorized these biases into three main types, namely representative heuristic, anchoring and adjustment, and availability heuristic. Representative heuristic means that people have a tendency to make decision of an uncertain event by considering the representative of it in similar cases. Two primary bias in representative heuristic are base rate neglect and sample size neglect [1]. Base rate neglect is that people mistakenly conclude the likelihood of this event without taking account of all relevant information as they rely on the similar and salient case or process which had happened in the past. Besides, the wrong choice of sample size compared to parent population will also lead to errors in analysis and assessment of this uncertain event. Therefore, even though representative heuristic will help people to make easy computation in certain events, it will lead to unwanted biases as people are too confident with their ability to predict the possibility of an event accurately [2]. Anchoring and adjustment implies that people will anchor an information as reference and make adjustments until they reach the final estimation. The piece of information used may be obtained from certain value or past event. Therefore, the initial value of this estimation is a historical data which may not be accurate for Sijia Meng, Department of Business and Economics, Monash University, Caulfield East VIC 3145, Australia, @qq.com. 267

2 estimation. Besides, this anchor prevents people to adjust their estimation with new information and therefore causing the forecast closely related to the original data. In addition to this, insufficient adjustments will cause errors in estimations as people will stop to make continuous adjustments since they have reached a plausible result [3]. Therefore, when people make decisions based on an anchor, they should be aware of the existence of bias in this kind of analysis and understand the possible effects. Availability heuristic describes that people tend to use instances or examples they can recall easily in a short time to evaluate the likelihood of an event. Even though availability is useful to assess the frequency of an event, it s still affect by four main factors which are irretrievability, imaginability, illusory correlation and the effectiveness of search set [1]. As a consequence, people relying on availability heuristic will result in estimation bias. This paper will focus on analyzing of availability heuristic. Section two will show some evidence on how availability heuristic influence people s decision making and four factors that will affect it. A simple model will be constructed in section 3 to describe the relationship between availability heuristic and possibility of errors or bias occurred under this method. Section 4 will discuss how availability heuristic challenges the tradition method of competitive market and how this model established in section three could be used in assessing decision-making in financial market. EVIDENCE AND LITERATURE REVIEW As mentioned in section 1, availability heuristic is a common type of cognitive style to assess the relative probability or frequency of an event rely on past experience and memory. Availability heuristic shows how these easily recalled examples will affect the judgement on frequency of that event. There are several evidences that supports the existence of availability heuristic. Khan, Qureshi and Ghafoor states that availability heuristic will significantly influence investor s buying decisions as people tend to choose companies with heavy advertisements [4]. Franklin Templetion Investment indicated most investors expected market index S&P 500 will either be down or flat in the years 2009, 2010 and 2011 as financial market just suffered from Global Financial Crisis (GFC) [5]. However, S&P actually had good performance during that time period. The reason of this expectation error is that investors had deep memories of GFC and estimated the market will have relative performance in next few years. Besides, Folkes showed availability heuristic will affect consumers judgement of a product performance [6]. For example, if consumers cannot taste some certain food products, they will be more likely to choose a product with awards for their first time. Therefore, these evidences proved the availability heuristic s existence and that it will lead to assessment bias by relying on this mental shortcut. There are four main reasons which would result in predictable errors. The first factor that leads to the bias is the retrievability of instances [1]. People usually think that the frequency of a certain event or instance is much higher when the similar or related past events is easily retrievable. This bias is shown in a study done by Lichtenstein where, on average, participants estimated that deaths caused by vehicle accidents are 350 times more frequent than deaths caused by diabetes while the actual statistic shows only 1.5 times more frequent [7]. This is due to the fact that vehicular accidents are far more easily retrievable comparing to deaths by diabetes because media coverage is far greater in accidents. The media bombardment of 268

3 accidents causes people to recall these incidents easily thus made a wrong prediction fortifies the existence of retrievability of instances bias. The biases of imaginability is a heuristic when someone needs to assess a situation based on a given rules or certain tasks instead of their memory. Tversky and Kahneman asked a number of test subjects that given 10 people to form a committee consisting k people, how many possible combinations of different groups can be formed when k=2,3,4,,8 [1]. Without complicated calculations, the subjects can only imagine the different combinations of the committee for when k equals each numbers. This makes the number of combinations seems to be much larger when k=2 than k=8 because it is much easier to imagine different combinations of committee members when k=2. The average estimation taken from the test subjects are 70 combinations for k=2 and 20 combinations for k=8 while the actual answer is 45 in both cases. This experiment successfully shown how imaginability causes unwanted biases in heuristics. The third factor is illusory correlation which refers to the phenomenon that people could perceive a relationship between two events or variables even though there are unrelated to each other. This idea was raised by Chapman and Chapman who found people tend to overestimate the relationship if there is unusual information exist [8]. For example, according to tylervigen.com, the US spending on science, space, and technology have 99.79% correlation with the number of suicides by hanging, strangulation, and suffocation from the year 1999 to the year 2009 [9]. This information can create an illusion for some people that the two are actually related to each other. However, there are absolutely no relationship between the two events even though they maintain such a high correlation for 10 years. The final factor is called the effectiveness of search set. When asked to filter out a massive set of data or information based on a certain rule, the amount of occurrence of a certain objects or instances are linked to the effectiveness of the search. Something easy to search for makes people felt like it is much more abundance. For example, which of the following have more words, a word starting with the letter r or a word with an r in the third letter? According to Tversky and Hahnemann, people approach this question by recalling words in both categories to compare [1]. However, most of them judges the frequency by the ease of recalling the words instead of the actual frequencies. Because they can search for the words starting with r much more easily, they think that words starting with r is much more abundant when the truth is the opposite. This proves that the effectiveness of searching can cause bias in heuristic judgments. Everyone has a tendency to maximize their own benefits during decision making instances. However, due to the possibility of biases occurred under availability heuristics thinking method, their decisions usually will not be the most optimized or perfect ones. MODEL Availability heuristic is some sort of mental shortcut in certain decision making situation. Even though this may be useful in some situation, there is still a possibility that it could lead to biases. This section will be focusing on constructing a model that can determine the probability of the existence of availability heuristic bias in a particular situation. However, in order to effectively utilize the model, an assumption 269

4 must be made that no factors other than availability heuristic will be able to cause bias in said situation. Overall, the process of making decisions can be divided into two major categories information retrieving and information processing. The two processes can be affected directly by the four bias-causing factors mentioned in section 2. Retrievability of instances can affect a person during information retrieving while illusory correlation and imaginability will cause bias during the processing of information. Effectiveness of search set can affect both processes. Suppose the general equation for the probability of bias occurrence can be written as below, P = p(a, b, α, β) (1) Where P is the probability of bias occurrence that is affected by, information retrieving, and, information processing. The probability of bias occurred during both retrieval of information and processing of it can be assigned as P α and P β. Due to the characteristics of tasks that people need to analysis, a and b is used to the equation as a scalable coefficient to act as an adjustable factor for the possibility of bias existence. The final product of the equation will have a value in the range of 0 P 1 with P = 0 represents the lack of bias in the decision while P = 1 means the existence of bias is guaranteed, though the consequence may not always be bad. Therefore, the equation above can be further modified as below. p(a, b, α, β) = ap α + bp β (2) Because a and b are added as a weight, the two value must satisfy a + b = 1. This simple rule keeps a and b inversely proportion to each other. The value of a and b will vary according to different situations. If the choice being made is heavily dependent on information retrieval compared to the processing of it, the value of a will have to be increased to increase the weight of P α in the equation. In other words, it quantifies the level of a person s information retrieving ability. A rating of 0 means that it is extremely difficult to retrieve the information they need while a rating of 1 indicates that they could recall the information required easily. P β requires the decision maker to rate the quality of technical analysis done for the decision making. The rating of 1 represents extreme detailed analysis is applied while 0 means not much analysis is applied. With all the values found, the equation should be able to estimate the probability of bias occurring in the decision made based on characteristic of problem itself and people s ability in information retrieving and processing. Besides, this equation will also provide an insight of the overall risk of that decision. INFLUENCES ON FINANCIAL MARKET Investors are considered to be rational and risk aversion in traditional financial market assumption. This means that they will only make decisions to maximize their utility instead of making transactions that will not contribute to their total wealth. However, this competitive market assumption has been challenged as investors 270

5 decision are mostly biased by heuristic. Therefore, availability heuristic is an important factor that leads to irrational decisions being made by investors. There are a plenty of occasions that availability heuristic will affect investors decision-making. For example, as mentioned in section 2, Khan, Qureshi and Ghafoor indicates that investors prefer to buy shares of companies with heavy advertisements as these companies will have a deeper impression in the investors memory [4]. Therefore, it is much easier for them to recall these memories thus generating intentions to make the purchase. However, not all heavily advertised companies will perform well. This incident shows that availability heuristic may lead to bias in decision making in an individual investor s perspective. In another case, Thakor said that Global Financial Crisis is an interesting case that shows the existence of the avalibility heuristic bias [10]. Before saving and loan crisis, there are several pre-conditions that led to this crisis, such as high inflation, high interest rate, and reversed yield curve. As this case is extremely famous in the financial market, it is highly possible that investors will easily take these conditions as a signal of a possible appearance of another financial crisis. Therefore, between the year 2007 and 2008, low interest rate encouraged investors to purchase houses with high level of leverage and eventually led to the property bubble. In the end, the decreasing property price and the fallacious use of credit derivatives resulted in GFC. This event showed that each financial crisis has its unique crisis-specific circumstances. Investors could retrieve the details of these two cases easily as they are both significant events in the history of financial market. Thus, with the different level of information process ability, it could lead to different possibility of bias occurred in decision making when they analysis another financial event. The model proposed in this article can have two separate functions. The first one is to enhance traditional financial models. For example, one of the most famous conventional model is the CAPM which assumes that investors are rational and market is perfect. With the existence of availability heuristic, not all investors will gather and process information professionally. Therefore, the model can add variables to adjust to the irrational of these investor s decisions to make forecasting more accurate. The other usage is to conduct research to better understand the degree of influence availability heuristic can cause to people s decision and the average probability that errors occurring in their decisions during extraordinary financial event, such as how people react or make decision before and after the China Share Market Crash. The result of these research could one day help regulators or governments to develop better regulations and establish better emergency plans in these extreme financial events. To sum up, availability heuristic is a psychological phenomenon that exists in almost every industry, especially in the field of finance. People should be aware of the weaknesses of this heuristic during the process of decision making. The possibility of bias in decision-making with availability heuristic will depend on the problem s characteristics and the person s ability to retrieve information and process information. The correct understanding and using of availability heuristic will lead to more accurate estimation. 271

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