Two areas of research heuristics and biases and prospect theory merged

Two areas of research heuristics and biases and

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Two areas of research, heuristics and biases and prospect theory, merged economics and psychology in the last half century. While many of the ideas had been around for a long time, Daniel Kahneman and Amos Tversky did a great deal to formalize the thinking. The heuristics and biases literature notes that we tend to operate with rules of thumb (heuristics), which are generally correct and save us lots of time. But these heuristics have associated biases that can lead to departures from logic or probability. Examples of heuristics include availability (rely on information that is available rather than relevant), representativeness (placing people or objects in categories that are inaccurate), and anchoring (placing too much weight on an anchor figure). There is now a long list of heuristics and biases, and great investors are those who not only understand these concepts but take steps to manage or mitigate behavioral biases in their investment process. Prospect theory shows how the decisions by individuals depart from normative economic approaches in risky situations. Loss aversion, which says that individuals tend to suffer more from losses than comparable gains, is a good example. While there may be a persuasive evolutionary explanation for loss aversion, it is not good for money management. 27 Epistemic rationality, or the degree to which your beliefs map accurately to the world, is an essential ingredient to RQ. People who score well on RQ are well calibrated, which means that the probabilities they assign to particular outcomes tend to be accurate over a large sample of judgments. One way to improve calibration is to keep score. You can track your forecasts and grade them based on outcomes. The ability to sidestep behavioral biases is likely part disposition, part training, and part environment. Great investors are those who are generally less affected by cognitive bias than the general population, learn about biases and how to cope with them, and put themselves in a work environment that allows them to think well. 8. Know the difference between information and influence. In classic markets for goods or services, prices are a highly informative mechanism. In microeconomics, the equilibrium price is one that balances supply and demand. A higher price creates more supply than demand, and hence excess supply. A lower price creates more demand than supply, and hence excess demand. The equilibrium price is also known as the market clearing price because it clears away excess supply or demand. Supply and demand curves may shift, but price is a very useful source of information about the market. Prices also provide useful information in capital markets. The main value is as an indication about expectations for future financial performance. (This is less true for derivatives, which may be efficiently priced even if the asset from which its price is derived is inefficiently priced.) As we saw in a prior point, great investors are adept at translating between expectations and fundamentals, and keep them separate in decision making. Further, arbitrageurs serve to close aberrant price gaps. Arbitrage is negative

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