Beliefs, preferences, and biases investment advisors should know about.
Decision theorist Howard Raiffa [1968] introduces useful distinctions among three approaches to the analysis of decisions. Normative analysis is concerned with the rational solution to the decision problem. It defines the ideal that actual decisions should strive to approximate. Descriptive analysis is concerned with the manner in which real people actually make decisions. Prescriptive analysis is concerned with practical advice and help that people could use to make more rational decisions.
Financial advising is a prescriptive activity whose main objective should be to guide investors to make decisions that best serve their interests. To advise effectively, advisors must be guided by an accurate picture of the cognitive and emotional weaknesses of investors that relate to making investment decisions: their occasionally faulty assessment of their own interests and true wishes, the relevant facts that they tend to ignore, and the limits of their ability to accept advice and to live with the decisions they make. Our article sketches some parts of that picture, as they have emerged from research on judgment, decisionmaking and regret over the last three decades. The biases of judgment and decision making have sometimes been called cognitive illusions. Like visual illusions, the mistakes of intuitive reasoning are not easily eliminated. Consider the example of Exhibit 1. Although you can use a ruler to convince yourself that the two horizontal lines are of equal length, you will continue to see the second line as much longer than the other. Merely learning about illusions does not eliminate them.
The goal of learning about cognitive illusions and decision-making is to develop the skill of recognizing situations in which a particular error is likely. In such situations, as in the case of Exhibit 1, intuition cannot be trusted and it must be supplemented or replaced by more critical or analytical thinking – the equivalent of using a ruler to avoid a visual illusion.
Providing timely warnings about the pitfalls of intuition should be one of the responsibilities of financial advisors. More generally, an ability to recognize situations in which one is likely to make large errors is a useful skill for any decision-maker.
We follow a long tradition in discussions of decision-making, which distinguishes two elements: beliefs and preferences. Decisions theorists argue that any significant decision can be described as a choice between gambles, because the outcomes of possible options are not fully known in advance. A gamble is characterized by the range of its possible outcomes and by the probabilities of these outcomes. People make judgments about the probabilities; they assign values (sometimes called utilities) to outcomes; and they combine these beliefs and values in forming preferences about risky options.
Judgments can be systematically wrong in various ways. Systematic errors of judgment are called biases. We start by dealing with a selection of judgment biases. Then we discuss errors of preference, which arise either from mistakes that people make in assigning values to future outcomes or from improper combinations of probabilities and values. In both cases, we introduce each bias with a question that illustrates the bias and conclude with recommendations for financial advisors to help mitigate the harmful effects of these biases.
We conclude the article with a checklist that advisors can use to measure their effectiveness at dealing with these biases.
No comments:
Post a Comment