M01 - Probablity Biases

Probability Biases
Dr Yamini S.
Faculty of Operations and Analytics
Department of Management Studies, NIT
Trichy
Yamini | Behavioural Dynamics in Decision Making 1

Mental Shortcuts: Cognitive Heuristics
The Representativeness Heuristic
• Detailed association / Expected association - The
tendency to judge membership in a group by how
well a particular instance matches a prototype of
the group. Sometimes, when an event / object is a
representative of other, likelihood of occurrence /
outcome (any form of decision) is judged by its
similarity to the representative condition. The
probability of one given the other will be
overestimated
• Base rate neglect / Base rate fallacy: The tendency
to base judgements on specifics, ignoring general
statistical information
Halo Effect:
• It is the tendency for positive impressions of a
person, company, brand or product in one area
to positively influence one's opinion or feelings
in other areas
• It is also known as physical attractiveness
stereotype, where the overall impression about
a person influences how we feel or think about
their character

Horn Effect:
• It is the tendency of one perception of another
to be unduly influenced by single negative trait
• An opinion of a friend, a piece of music,
emotional state also have an influence on our
powers of observations, our thoughts, our
opinion and our behaviour. Putting some in
halo/ horn corner also influences how you react
in a situation involving this person

Conjunction Fallacy
• People have a false assumption that more
specific conditions are more probable than
more general ones
• This can be proven mathematically. The
probability of a conjunction is never greater
than the probability of its conjuncts
P (A) ≥ P(AՈB) ≤ P(B)
• Most people exhibit this bias because they use
the representativeness heuristic to make this
kind of judgment
Gambler’s fallacy
• It is the mistaken belief that if something happens more
frequently than normal during a given period, it will
happen less frequently in the future (or vice versa)
• In situations where the outcome being observed is truly
random and consists of independent trials of a random
process, this belief is false. The fallacy can arise in many
situations, but is most strongly associated with gambling,
where it is common among players
• The false assumption that the past independent events
have an effect on future outcomes
Gambler’s fallacy
• There is a bias against consecutive decisions (recent ones) in the same
direction
• When people make “yes-no” decisions, they're more likely to say yes if
their previous decision was no, and vice-versa
• Judgements of lawsuit, referees of sports, processing pattern of job and
loan application, interpreting the performance of a mutual fund
• Misconception of chance: Misperceptions of what constitutes a fair
process (assuming that the pattern regresses toward the mean) can
contrarily lead to unfair decisions

Hot Hand Fallacy
• Misconception that short random sequence resembles a long one by believing in
law of small numbers
• The 'hot hand' is the notion where people believe that after a string of successes (or
failures), an individual or entity is more likely to have continued success (or failure)
• Unfortunately, both the predictions (gamblers and hot hand phenomenon) are not
true and many gamblers commit both the fallacies on the same day
• Psychologists believe that the hot hand is a fallacy that stems from the
representative heuristic
• Still, some research shows that for certain sporting events, the hot hand may be
real

Hot Hand Fallacy
• Some research show that for certain sporting events,
the hot hand may be real
• Decision of an investor to buy or sell a mutual fund
depends largely on the track record of the fund
manager, they will be more likely to buy a winning
stock and sell a stock with negative earnings as the
trend length increases
• Once an investor, and likely a gambler, begins to think
they have a hot hand, many biases such as
overconfidence, illusion of control, recency bias and
hindsight bias can arise
Conservatism (belief revision)
• While processing information, it is the human tendency to revise one's
belief insufficiently when presented with new evidence
• It describes human belief revision in which persons over-weigh the prior
distribution (base rate) and under-weigh new sample evidence when
compared to Bayesian belief-revision
• People fail to adjust sufficiently far away from the initial "anchor“. There
is a noisy conversion of objective evidence (observation) into subjective
estimates (judgment)
• Less reliable evidence leads to conservative updating

Conservative Accounting
• All probable losses (expenses and liabilities) are recorded when they are discovered even
when there is uncertainty about the outcome
• However gains (revenues or assets) can only be registered when they are fully realized, even
when there is some uncertainty of receiving it
• It is also called as the prudence concept, where anticipate no profit, provide for all losses.
Inventory recorded should also be at the low of either its acquisition cost or current market
value
• One should always error on the most conservative side of any financial transaction, as it helps
the business entity to stay safe
• While going through the company’s financial statements, potential investors / tax preparation
pro / partners must get an assurance that the profit of the business is not overestimated,
otherwise it will mislead the company stakeholders

Ambiguity Aversion
• We are suspicious in situations when we are not sure of the
probability
• It is also known as uncertainty aversion, which is a preference for
known risks over unknown risks.
• Being specific in the offer and interaction and explaining how big
is the chance , instead of giving a vague information can interest
people and helps in reducing the aversion of being fooled
• Giving guaranteed offers and fixed discounts increases the sales
than probabilistic deals do
• Focus on the ambiguities present in your competitor’s offer and
emphasize on the certainty of your offer

Insensitivity to sample size
• It is a cognitive bias that occurs when people judge
the probability of obtaining a sample statistic without
respect to the sample size
• According to statistical theory, a small sample size
allows the statistical parameter to deviate
considerably compared to a large sample
• The results of larger samples deserve more trust than
smaller samples, as per law of large numbers
• Representativeness heuristic is also employed when
subjects estimate the probability of a specific
parameter of a sample
Illusion of Validity
• Overconfidence means that people exaggerate the accuracy of their
prediction of an outcome although there are other important factors that
affect the accuracy of prediction
• Overestimation: It occurs when people think they are better than they
truly are
• Over placement: It occurs when people believe they are better than
others
• Over precision: When people have exaggerated faith that they know the
truth

How probabilistic judgements are made?
• People are insensitive to prior probability of outcomes
Ignore base rate frequencies
• People are insensitive to sample size
Follow law of small numbers
• People have a misconception of chance
Follow gambler’s fallacy also hot hand fallacy
• People have illusion of validity and insensitiveness to predict events
• People exhibit conjunction fallacy
• People may use a biased sample, may ignoring a common cause or
confuse with cause and effect

Common mistakes in Data Interpretation
• Ignoring the prior probabilities when making decisions
• Associating higher weightage to the representations that we have in our
mind
• Not realising that conjunction (more specific ones) of two events is less
probable than the probability of one event happening (more general
ones)
• P(A) > P(AnB) < P(B)
• Smaller samples tend to deviate from standard statistics
• Being more conservative / generous in updating beliefs or predicting
probabilities
Common mistakes in Data Interpretation
• Thinking that future probabilities are altered by past ones, relying on the
sequence for independent events
• Completely disregard the probabilities when making decisions under
uncertainty
• Mistakenly believe that we can completely control chance events
• Extrapolating large scale patterns to samples of smaller size (law of large
numbers)
• Look at the sample size

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Probability Biases

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