The Psychology of Decisions

People are prone to mistakes in judgements and predictions, deviating from the rational standards asserted by economic decision theory.  However, these mistakes are not random because we err in predictable ways.  Often, we don't use deliberate and careful reasoning in our decision making.  Instead, we resort to decision making shortcuts. 

These shortcuts have been referred to as judgmental heuristics.  Sometimes they cause us to have biases and misjudgments and they lead to faulty decision making.  This is due to attribute substitution, which is when the information needed to make a judgement isn't readily available and we base our decisions instead on information which quickly comes into our minds.


Representative Heuristic - This is when we use a mental model of a typical group or category to make judgments on individual objects or events.  For example, one may think it would be a great thing to join a startup technology firm because in their mind they may think of enormously successful startups such as Apple or Microsoft.  This causes us to ignore base rates, which are the number of individuals in each category...successes and failures.  If fact, the  vast majority of startups end up in failure.  Based on this, one should avoid working for a startup technology company because the odds are that it will fail.  

Availability Heuristic - This is when we estimate the likelihood of based on the ease of which examples come into mind.  People tend to overestimate the likelihood of an event if they can easily imagine it or have recently experienced it.  For example, research shows that doctors are more likely to diagnose a patient with a particular condition if they have recently diagnosed another patient with the same condition.  

Affect Heuristic - This is when information that increases the perceived benefits of an activity tends to decrease the perceived risks and information that increases the perceived risks of an activity tends to decrease the perceived benefits.  

Anchoring - This is when we fixate unconsciously on the initial value or estimate ending in a final judgment that is biased based on the initial value.  This can affect our judgements if the starting estimate is poorly chosen or even arbitrary.

Loss Aversion - This occurs when we the displeasure of losing something outweighs the pleasure  Most people of gaining something of equal value.  Most people will reject a fair gamble unless the payoff is about three times the amount of the loss.

Unrealistic Optimism - This is when decision makers tend to anticipate predominately good news.  At high levels, optimism can cause counter productive and even reckless behavior.  extreme optimists save less, have a shorter time horizons for financial planning, and are less cautious with their investments.   

Conclusion - Due to the constraints of limited time, information, attention, and memory, humans do not always make rational decisions.  In many cases our decisions are the result of automatic mental shortcuts.  With this knowledge and awareness of how our intuitions can be wrong, we can be more careful and thoughtful and this will allow us to make better and more profitable decisions.