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

Psychological studies show that most people are overconfident about their own relative abilities, and unreasonably optimistic about their futures (e.g. Shelly E. Taylor and J.D. Brown, 1988; Neil D. Weinstein, 1980). When assessing their position in a distribution of peers on almost any positive trait-- like driving ability (Ola Svenson, 1981 ), income prospects, or longevity-- a vast majority of people say they are above the average, although of course, only half can be (if the trait is symmetrically distributed).
This paper explores whether optimistic biases could plausibly and predictably influence economic behavior in one particular setting-- entry into competitive games or markets. Many empirical studies show that most new businesses fail within a few years. For example, using plant level data from the U.S. Census of Manufacturers spanning 1963-1982, Timothy Dunne et al. (1988) estimated that 61.5 percent of all entrants exited within five years and 79.6 percent exited within 10 years. Most of these exits are failures (see also Dunne et al., 1989a, 1989b; D. Shapiro and R.S. Khemani, 1987).

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Overconfidence and Excess Entry: An Experimental Approach

Existing empirical evidence indicates that analyst forecasts of corporate earnings do not meet the strict rationality standards prescribed by econometric tests of the rational expectations hypothesis.1 In this paper, we address the question of whether the expectation formation process underlying analyst forecasts is adaptive, or whether these forecasts are influenced by noninformational factors, such as incentives arising from the market for their forecasts (O'Brien [1988], Lin and McNichols [1993], Francis and Philbrick [1993], and Dugar and Nathan [1992]), and interaction between judgmental and/or statistical forecasting methods (Bunn and Wright [1991], Fan [1990], and Hoerl and Kennard [1970]). The rejection of rational expectations gives rise to two views of the forecasting process of analysts. The first, based on an informational argument, is that the forecasting process is adaptive (Marcet and Sargent

Analysts' Interim Earnings Forecasts: Evidence on the Forecasting Process

In an experimental setting when outcomes are stochastically related to actions, predictions of equilibrium behavior depend not only on the participants' preference orderings of outcomes, but also on their orderings of lotteries on outcomes as well. We introduce and test a reward structure that can be utilized in any experimental setting to allow the experimenter to decree beforehand the subjects' preferences for lotteries on experimental outcomes. We show analytically that the proposed reward structure can induce subjects to behave as if they have the decreed preference function defined on experimental outcomes. Empirical tests using two different choice settings provide evidence to support this ability to control preferences.

Controlling Preferences for Lotteries on Units of Experimental Exchange

We study the performance of the rational expectations hypothesis in multiperiod experimental markets with multiple assets. We find that the markets are generally inefficient from the point of view of full information aggregation. However, arbitrage relationships hold, and it is not possible to detect the informational inefficiency by using some standard tests of market efficiency. These findings suggest that the lack of arbitrage opportunities and the failure of common tests to reject inefficiency are not sufficient to conclude that a market is informationally efficient. A GROWING BODY OF research has investigated whether the rational expectations hypothesis provides a reasonable description of behavior observed in laboratory markets. In this paper, we continue this investigation by examining information aggregation in fairly complex multiperiod markets with multiple stocks and experienced traders. We find strong evidence against information aggregation. However, we also find that conventional econometric tests are unable to reject the hypothesis of an informationally efficient market. Our study consists of two markets, one with three stocks and one with four. In each market, each stock has a two-period life. A stock pays a dividend at the end of each period, and the underlying distribution of endowments is common knowledge. Traders are given private information about the dividends. Important features of our laboratory markets are: (a) trading takes place in continuous time in a computerized market; (b) multiple units of the same asset can be traded in a single transaction; (c) the same dividends are paid to all owners of a stock; (d) the distribution of private information is not common knowledge; and, (e) borrowing and short sales are allowed. We analyze the data obtained from the experimental sessions in several ways. First, we study how efficiently our markets aggregate information by measuring the extent to which market prices reflect all available information. Since a stock pays dividends in both periods, the aggregation problem in the first period is more difficult than in the second (since the rational expectations price must correctly forecast the sequence of dividends). We find

Dynamic Stock Markets with Multiple Assets: An Experimental Analysis

A large body of literature has rejected rational expectations in relation to analyst forecasts. In this paper we start with a boundedly rational premise that analysts and managers adopt are influenced by the availability heuristic (Tversky and Kahneman [1973]). In the presence of business cycles, a rational growth forecast presupposes precise knowledge of the factors that cause a business cycle. In contrast, under the availability heuristic the current state is overweighted in the growth forecast and so whatever part of the business cycle the economy is currently in will be preserved by the investment decision. As a result, under the hypothesis of the availability heuristic we will observe ex-post, a systematic association between the drivers of this behavior (e.g., current state of the economy, industry, current performance) and subsequent forecast errors and (realized) growth when related to specific properties of the business cycle. We test for this condition and find evidence in support of it. The bou...

An Analysis of Financial Analysts' Optimism in Long-term Growth Forecasts

. This paper provides a dynamic analysis of ex post public disclosure in a privately informed stock market economy. Investors cannot observe the underlying laws of motion of the economy, and this precludes them from immediately forming rational expectations. Instead, expectations are formed adaptively, and two positive roles are identified for public disclosure. First, it enables investors to recursively modify their forecast rules each period using their most recent forecast errors. Second, public disclosure via its recursive modification role imposes a common influence over the time path of each investor's expectations, and this can drive the economy as a whole towards attaining a noisy rational expectations equilibrium.



Resume. L'auteur propose une analyse dynamique de la publication ex post dans un marche boursier disposant d'informations privilegiees. Les investisseurs ne peuvent observer les lois sous-jacentes aux mouvements de l'economie, et il leur est done impossible de formuler immediatement leurs previsions rationnelles. Les previsions s'elaborent plutoCt de facon adaptative, et deux roles positifs sont attribues a la publication. Premierement, elle permet aux investisseurs de proceder a l'ajustement recursif de leurs regles previsionnelles pour chaque periode, a partir de leur erreur previsionnelle la plus recente. Deuxiemement, la publication, grâce a son role d'ajustement recursif, exerce une influence uniforme sur l'evolution temporelle des previsions de chaque investisseur, ce qui peut mener l'economie dans son ensemble vers un equilibre instable de previsions rationnelles.

John O'Brien

Papers

Analysts' Interim Earnings Forecasts: Evidence on the Forecasting Process

Controlling Preferences for Lotteries on Units of Experimental Exchange

Dynamic Stock Markets with Multiple Assets: An Experimental Analysis

An Analysis of Financial Analysts' Optimism in Long-term Growth Forecasts

Ex post disclosure and the coordination of investors' adaptive expectations*