Heuristics, Overconfidence, and the Law of Small Number Bias

Essay Questions #7
Name
Professor Morey Spring 2022
Institution
Date
Directions: Answer all the below questions using slides 1-109 of Lecture 2
Turn in your essay questions on the blackboard (for essay 7) by 9 am on Monday, March 28.
1 What are heuristics? Explain. How are these different from the Utopian Economics described by Cassidy?
In behavioral finance, heuristics are shortcut methods used to solve problems quickly, hence delivering a more accurate result that is useful within the time constraints. The approach is often helpful in speeding up analysis and investment decisions among financial professionals. Unlike the heuristic approach that is helpful and realistic, Utopian economics is whereby economists engage themselves in constructing elegant theories of how markets work, wealth creation, and how to improve innovation. Without examining critically whether those theories will work out or not and the solutions in case they don't work. Cassidy calls this unrealistic because of the blind way of thinking contrary to how real people act.
2. Explain your results of doing the test on Slide 20? Were you overconfident?
My results were very poor compared to what is correct on the 21st-22nd slide. Yes. I was overconfident with the test because the questions provided a 90%confidence interval which, in my opinion, was easy to give the correct estimate according to my knowledge.
3. Shiller surveyed people in 1989, 1996, and 1999. He asked the question: "If the Dow dropped three percent tomorrow…." Explain why his results show overconfidence among investors.
The results show overconfidence among the investors because of their ability and knowledge in the stock market that comes from the repeated occurrence of the expected. Following the market pattern, it was easier for people to predict the future. For instance, in 1989, 35% predicted an increase, while 34% predicted a decrease. The results reveal that in 1989, people had no idea whether it would increase or decrease, in 1996, slight levels of confidence due to what occurred according to the expectation of many in 1989, In the year 1999, we see that people are overconfident about the increase, in that 56% of them predicted an increase while only 19% predicted a decrease.
4. Explain the Tom and Jerry slides. That is, show how overconfidence explains excessive trading.
According to the slides, overconfidence in business is characterized by investors' belief that they are smarter or know better than others, similar to the case of Tom and Jerry. From the explanations given in the slides, overconfidence often leads to excessive trading that can result in a negative performance of a business without an individual's knowledge. For instance, excessive trading, as mentioned in the slides, can lead to loss-making, which may negatively affect the business like the Enron Company that collapsed in 2001.
5. Why are we guilty of overconfidence?
Because overconfidence often comes with bad decision-making. In most cases, it makes people overestimate their abilities and, as a result, act aggressively. For instance, a moderately conservative investor in the stock market can initially turn to a more aggressive investor due to overconfidence in himself.
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