A review is presented of the book “Heuristics and Biases: The Psychology of Intuitive Judgment,” edited by Thomas Gilovich, Dale Griffin, and Daniel Kahneman.

Heuristics and Biases: The Psychology of Intuitive Judgment

Much research in the last two decades has demon- strated that human responses deviate from the performance deemed normative according to various models of decision mak- ing and rational judgment (e.g., the basic axioms of utility theory). This gap between the normative and the descriptive can be inter- preted as indicating systematic irrationalities in human cognition. However, four alternative interpretations preserve the assumption that human behavior and cognition is largely rational. These posit that the gap is due to (1) performance errors, (2) computational limitations, (3) the wrong norm being applied by the experi- menter, and (4) a different construal of the task by the subject. In the debates about the viability of these alternative explanations, attention has been focused too narrowly on the modal response. In a series of experiments involving most of the classic tasks in the heuristics and biases literature, we have examined the implica- tions of individual differences in performance for each of the four explanations of the normative/descriptive gap. Performance er- rors are a minor factor in the gap; computational limitations un- derlie non-normative responding on several tasks, particularly those that involve some type of cognitive decontextualization. Un- expected patterns of covariance can suggest when the wrong norm is being applied to a task or when an alternative construal of the task should be considered appropriate.

https://www.cambridge.org/core/services/aop-cambridge-core/content/view/S0140525X00003435

Individual differences in reasoning: Implications for the rationality debate?

The program of research now known as the heuristics and biases approach began with a survey of 84 participants at the 1969 meetings of the Mathematical Psychology Society and the American Psychological Association (Tversky & Kahneman, 1971). The respondents, including several authors of statistics texts, were asked realistic questions about the robustness of statistical estimates and the replicability of research results. The article commented tongue-in-heek on the prevalence of a belief that the law of large numbers applies to small numbers as well: Respondents placed too much confidence in the results of small samples, and their statistical judgments showed little sensitivity to sample size. The mathematical psychologists who participated in the survey not only should have known better – they did know better. Although their intuitive guesses were off the mark, most of them could have computed the correct answers on the back of an envelope. These sophisticated individuals apparently had access to two distinct approaches for answering statistical questions: one that is spontaneous, intuitive, effortless, and fast; and another that is deliberate, rule-governed, effortful, and slow. The persistence of large biases in the guesses of experts raised doubts about the educability of statistical intuitions. Moreover, it was known that the same biases affect choices in the real world, where researchers commonly select sample sizes that are too small to provide a fair test of their hypotheses (Cohen, 1969, 1992).

Representativeness revisited: Attribute substitution in intuitive judgment.

The affect heuristic

A number of theories have been proposed to explain the medium-term momentum in stock returns identified by Jegadeesh and Titman (1993). We test one such theory--based on the gradual-information-diffusion model of Hong and Stein (1997)--and establish three key results. First, once one moves past the very smallest stocks (where thin market-making capacity appears to be an issue) the profitability of momentum strategies declines sharply with firm size. Second, holding size fixed, momentum strategies work particularly well among stocks which have low analyst coverage. Finally, there is a strong asymmetry: the effect of analyst coverage is much more pronounced for stocks that are past losers than for stocks that are past winners. These findings are consistent with the hypothesis that firm-specific information only gradually across the investing public.

Bad News Travels Slowly: Size, Analyst Coverage and the Profitability of Momentum Strategies

A rational analysis of analyst behavior predicts that analysts immediately and without bias incorporate information into their forecasts. Several studies document analysts' tendency to systematically underreact to information. Underreaction is inconsistent with rationality. Other studies indicate that analysts systematically overreact to new information or that they are systematically optimistic. This study discriminates between these three hypotheses by examining the interaction between the nature of information and the type of reaction by analysts. The evidence indicates that analysts underreact to negative information, but overreact to positive information. These results are consistent with systematic optimism in response to information. THE LITERATURE ON FINANCIAL ANALYSTS defines the phrase "forecast inefficiency" to mean forecasts that fail to accurately incorporate new information on a timely basis and/or that are biased. These forecasts have also been described as irrational or suboptimal. Prior studies report inefficiency in analysts' forecasts, finding that they are upwardly biased and inaccurately reflect available information. Some studies conclude from this that analysts underreact to information; other studies conclude that analysts overreact. If markets treat analysts' forecasts as both rational and statistically optimal, then inefficient forecasts could have important implications for the efficiency of pricing in securities markets. In this paper, we reexamine the apparent tendency of analysts to misinterpret earnings information. The intent of this study is to discriminate between three hypotheses: (1) that analysts systematically underreact to new earnings information; (2) that analysts systematically overreact to new earnings information; and (3) that analysts are systematically optimistic in their reactions. For hypotheses (1) and (2), the direction of the misinterpretation (i.e., underor overreaction) is independent of the nature of the information received. In contrast, hypothesis (3) predicts that analysts are optimistic in interpreting

Inefficiency in Analysts' Earnings Forecasts: Systematic Misreaction or Systematic Optimism?

Securities analysts react optimistically to new information, underreacting to bad news and overreacting to good news. This evidence suggests that securities analysts might produce optimistic earnings forecasts in response to their economic incentives.

New Evidence on Serial Correlation in Analyst Forecast Errors

This article examines the effect of issuing debt with and without "poison put" covenants on outstanding debt and equity claims for the period 1988 to 1989. The analysis shows that "poison put" covenants affect stockholders negatively and outstanding bondholders positively, while debt issued without such covenants has no effect. The study also finds a negative relationship between stock and bond returns for firms issuing poison put debt. These results are consistent with a "mutual interest hypothesis," which suggests that the issuance of poison put debt protects managers and, coincidentally, bondholders, at the expense of stockholders. A CONTRACTUAL INNOVATION, KNOWN generically as "poison puts" or "super poison puts," has been introduced in the corporate bond market in recent years. The two principal covenants devised are put options and coupon adjustments triggered by the occurrence of "risk events" like hostile takeovers, acquisition of large stakes in firms (e.g., 30 percent), leveraged buyouts, and leveraged recapitalizations. One alleged purpose is to insulate managers from the market for corporate control. Alternatively, these covenants could be introduced to shelter bondholders from reductions in bond value that sometimes occur concurrently with corporate control activity. This article examines the effect on bondholder and stockholder wealth of issuing debt with these provisions and draws inferences about the true economic roles that they perform. Section I of the article describes the possible economic roles of event risk covenants and the implications of the issuance of these bonds for the value of the firm's stock and outstanding debt. Section II describes the sample and data used in this study. Section III outlines the methodology for assessing stockholder and bondholder wealth effects. Finally, Section IV presents the results of the empirical tests, and Section V concludes.

Poison Put Bonds: An Analysis of Their Economic Role

A rational analysis of analyst behavior predicts that analysts immediately and without bias incorporate information into their forecasts. Several studies document analysts' tendency to systematically underreact to information and are inconsistent with rationality. Other studies indicate that analysts systematically overreact to new information or that they are systematically optimistic. This study discriminates between these three hypotheses by examining the interaction between the nature of information and the type of reaction by analysts. The evidence indicates that analysts underreact to negative information, but overreact to positive information. These results are consistent with systematic optimism in response to information.

This study examines the nature of post-transaction restructuring activities for 32 large U.S. corporations that underwent management buyouts between 1983–89. This study (i) provides evidence on the extent and type of divestment and acquisition activities under private ownership; (ii) documents the outcomes associated with MBOs and the longevity of the buyout organization; and (iii) investigates the claim that buyouts are primarily mechanisms for breaking up public corporations and selling the pieces to related acquirers. The balance of the evidence indicates that restoring strategic focus is an essential function of the buyout for these large firms. However, the evidence also indicates that the buyout organization does continue to operate significant parts of the prebuyout firm. By far the majority of firms continue to meet their debt obligations satisfactorily during the buyout phase. Finally, the evidence indicates that asset sales to related acquirers derive more from efficiency considerations than market power.

https://www.jstor.org/stable/pdfplus/2486794.pdf

John C. Easterwood

Papers

Inefficiency in Analysts' Earnings Forecasts: Systematic Misreaction or Systematic Optimism?

New Evidence on Serial Correlation in Analyst Forecast Errors

Poison Put Bonds: An Analysis of Their Economic Role

Inefficiency in Analysts' Earnings Forecasts: Systematic Misreaction or Systematic Optimism?

Strategic redirection in large management buyouts: The evidence from post‐buyout restructuring activity