Bachelor thesis. Cognitive limitations of Individuals during the financial crisis

Transcription

1 Bachelor thesis Cognitive limitations of Individuals during the financial crisis Tutor: Prof. Dr Matthias Dressler Student: Sigala Thomas (919579) Kiel University of applied sciences Business and administration 20/08/2012

2 2 Acknowledgements This Bachelor thesis has been an adventure which could not have reasonably been successful without the help of many persons. First of all, I am thankful toward Professor Dr. Matthias Dressler for the time he took to answer to my various questions but also his support along this work. Secondly, I would like to give all my gratitude to my family and friends who supported me and sometimes bore my bad mood. Finally, i would like to thank the business department of the Fachhoschule Kiel, and the ZBW (Leibniz information centre for economics) of Kiel, without which this work wouldn t have been possible. Sigala thomas

3 3 Contents First Chapter: Problem formulation 1.1. Introduction to the problem 1.2. Relevance in practice 1.3. Objective of the study 1.4. Procedure 1.5. Definition of the subject Second chapter: cognitive background 2.1. Hayek s cognitive theory I. Stimuli and categorization II. Dispositions III. Dispersed knowledge 2.2. Birth of behavioral economic and the bounded rationality 2.3. Prospect theory and heuristics I. The prospect theory II. Heuristics and biases Third chapter: Application to the financial crisis 3.1. The financial crisis I. Crises II. The subprime mortgage crisis 3.2. Cognitive biases of investors I. Adjustment and anchoring II. Availability heuristic and imaginability bias III. Representativeness heuristic IV. Perceived diversity heuristic and prospect theory V. Pricing the products Conclusion Implication and discussion References p4 p10 p31 p41 p42 p43

4 4 First chapter: problem formulation 1.1 Introduction to the problem The theory of the rational agents claims, as many of academicians, that economic agents are rational and the market is efficient. In such a theory, the market regulates itself and it does not need an external regulation. The full rationality of the agents leads to a sustainable market. This theory is the mainstream one and was widely accepted by economists before the financial crisis. This theory is incorporated in what we call today the neoclassical economic which is the mainstream economic today. The fully rationality of the agents is a theory involving any psychological aspects. Indeed, this full rationality means that economic agent, as all human being, has a total control over its brain. A certain amount of economists and psychologists tried to demonstrate that the brain has uncontrolled process which lead to irrational behaviors. The financial crisis of revealed the weakness of the classical theory. The mortgage crisis and as a result, the need of state intervention is the proof of the market s inefficiency. This crisis triggered a new attention towards past research and theories, especially concerning the behavior of economic agents.

5 5 1.2 Relevance in practice The several crisis occurred to the capitalism this last century prove that the market is not totally sustainable. Keynes was one of the first to think that the 1929 s crisis was made of irrational agents and establish the concept of animal spirit in his book: General theory of employment rate and Money. Keynes idea of animal spirit was that aggregate economy is driven by human sentiments, as a kind of waves of pessimist or optimism. According to Keynes, economics agents as human beings are irrationals. In 1739, David Hume used the term of animal spirit to trace the origins of human decision making as major field of human nature. 1 The human behavior has always been a source of discussion and research since the ancient Greek. It is true that even Platon in the Republic wrote upon the differences between desires and with the reason which Rule with wisdom and forethought on behalf of the entire soul. 2 Several economists wrote about the economic behavior and linked psychology to economic. Although these researches triggered attention of economists, they were rejected by most of them. The classic book the theory of moral sentiments by Adam Smith is one example of psychological insights of the economic behavior. Smith explored the role of emotion and instinct in our behavior. He viewed the human behavior as a struggle between the passions and an impartial spectator. F.A. Hayek in his book the sensory order published in 1952 developed a cognitive theory. In this book, Hayek s central argument is that human perception and human action is purely subjective. According to him, the mind 1. Hume, 1739, A Treatise of Human Nature, pp , 2. Economic Crises and the Complexity of Animal Spirits Modeling, PIROŞCĂ G., Theoretical and Applied Economics, vol. 2, pp. 555, 2011

6 6 does not represent physical or external events but is an interpretation of these events that we call reality. Hayek s cognitive theory is a very important study because it was one of the first study trying to connect the psychological field with the economic. He developed the foundations of what we will call later the cognitive science. Herbert A. Simon was one of the first to discuss the concept of organizational decision-making with uncertainty. He also developed the concept of bounded rationality. Simon and Katona are involved in the creation of behavioral economic. Their theories are used in behavioral economic which try to implement psychology input within the neo-classical economic theory. Simon defines behavioral economics as a commitment to empirical testing of the neoclassical assumptions of human behavior and to modify economic theory on the basis of what is found in the testing process. 3 They did not reject the assumption of the rationality of agents but rather claimed that perfect rationality does not represent reality. They developed concepts such as bounded rationality and contributed to the expansion of the cognitive science. Economists tried to build their economics on more psychological foundations even if the post-war neo classic economic theory was widely predominant. But these researches had little impact on economic field during the last century. 3. Models of bounded rationality, vol. 3: empirically grounded economic reason, MIT Press, 1997, Herbert A. Simon

7 7 Then, during the 70 s, Kahneman, Tversky and others researchers established common human errors using heuristics and biases. They also developed the prospect theory which differs from the neo-classic theories. In this theory, they tried to model economic decision of real life and try to be more accurate than the expected utility theory. With the work of Simon, Katona, Kahneman, Tversky and others researchers, the behavioral economic has earn a constant attention from economists over years. 1.3 Objective of the study Many economists as Adam Smith, F.A. Hayek, Herbert A. Simon, Kahneman and Tversky tried to link psychology and neuroscience with economic sciences. This is the proof of the attraction of psychology by economists, this will to link psychology and economic. Unfortunately, behavioral economics were rejected by the bulk of economists and is still not incorporated into the neo-classical economic. However, behavioral economic recently triggered attention with the financial crisis of With the work of Hayek, Smith, Kahneman and Simon, several academicians began to use cognitive theories to explain some aspects of the financial crisis. The fully rationality of economic agents as stated in the rational choice theory seems to do not represent the reality. We will study the fundamental works in cognitive science and specially authors such as F.A. Hayek, Herbert A. Simon, Kahneman and Tversky. With this cognitive background, we will apply some

8 8 heuristics and cognitive biases that may have occurred during the financial crisis. Our Paper will be structured as it follows. The first chapter is an introduction to the thesis. The second chapter will focus on the wide cognitive background developed along the last century. We will study the cognitive theory of Hayek, the concept of bounded rationality developed by Simon, but also the heuristics and cognitive biases developed by kahneman and Tversky. Then the third chapter will be the application of the precedent theories and concepts applied to the financial crisis. Finally, we will conclude this paper with new insights and possible implications that our study involves. This study is made of two main objectives. First of all, we will try to clearly explain the evolution of cognitive theories developed through the past century. Then, we will try, in a third chapter, to apply the cognitive knowledge developed before to the financial crisis. The huge amount of cognitive information that we will use in the second chapter took more time than I initially thought. This lack of time leads me to be unable to reach empirical result through an experiment. Nevertheless, we will try to demonstrate two hypotheses with the help of other researches. These two hypothesis concern the cognitive biases involved during the financial crisis. H1: structure of financial products led to heuristic H2: Heuristics triggered cognitive biases

9 9 These hypotheses are based on the primary and secondary sources we will study in the second chapter. 1.4 Procedure We will begin to explain the cognitive theory of Hayek who tried to link psychology to economic. Indeed, the cognitive theory of F.A. Hayek will be our fundamental source for the study. Then, we will describe concepts and theories used in behavioral economic. These concepts are the bounded rationality developed by Herbert A. Simon; the prospect theory, cognitive biases and heuristic mainly established by Kahneman and tversky. After studied the theoretical concepts of cognitive science and behavioral economics, we will briefly explain the financial crisis. Then, we will apply all this cognitive background to the special case of the financial crisis. Mainly, it will focus on traders and bankers who dealt with Collateralized Debt Obligations (CDOs) 1.5 Definition of the subject The subject of this research is cognitive limitations of individuals during the financial crisis. The term cognitive is defined by the Cambridge online dictionary as connected with thinking or conscious mental processes. Cognitive science

10 10 encompasses various research disciplines as psychology, artificial intelligence, philosophy, neuroscience, linguistics, anthropology, sociology and education 4. Cognitive limitations mean here cognitive biases or errors. In our study, we will focus on cognitive biases which have as origin heuristics. The cognitive psychology applied to economic leads to a more precise definition of behavioral economic. In fact as cognitive is linked to mental processes, we can affirm that behavioral economic is a branch of cognitive science. It is what claim Russel sage foundation president Eric Wanner who describes behavioral economics as an application of cognitive science to the realm of economic decision-making. 5 The individuals are, in our study, the investors. The period of study will be the years 2004 to 2010 and the financial crisis here is the subprime mortgage crisis of Second chapter: cognitive Background 2.1 Hayek s cognitive theory I. Stimuli and categorization 4. Thagard Paul, Cognitive Science, The Stanford Encyclopedia of Philosophy, Edward N. Zalta (ed.), Behavioral economics. Erik Angner, George Loewenstein.2006

11 11 Hayek was a classical liberal thinker and is known as an ardent fighter for a free society and market order in which government is restricted in the use of its coercive powers by a legal framework 6.Hayek developed his cognitive theory in his book the sensory order: An inquiry into the foundations of theoretical psychology (1952) and used the work of David Hume and Adam smith. According to Gick E., the works of these moral philosophers have significantly influenced Hayek s own view that individuals are driven by moral sentiments that can never be explained following a fully rational concept 7. This work was widely rejected and only recent work as Rizzelo (1999) or Butos and Koppl (2007) for instance interpret Hayek s work and lead to a better understanding of it. Moreover, recent works as Rizeollo (1999) concerning neuroscience seem to confirm Hayek s approach. The concept of human dispositions of Hayek is, as we will see, emphasis on individualism. His aim is to explain perception as well as human action as a purely subjective phenomenon. Hayek worked on the brain process and specifically on the simple stimulusresponse mechanism with a personal philosophical reasoning. Essentially, in Hayek s view, neuronal connections will only take place when a stimulus can be brought into relation to another similar stimulus. 8 One stimulus or several stimuli are then, classified in the so-called categories. These categories act like a filter and have, according to Hayek, 6/ 7. Cognitive theory and moral behavior: The contribution of FA Hayek to business ethics, Gick E., Journal of Business Ethics, Vol. 45, pp The Social Science of Hayek's The Sensory Order, Advances in Austrian Economics, Volume 13,pp.p , Gick E., 2010

12 12 two origins. They are actually genetically transmitted but also highly influenced by individual experience which can influence in return, the categories. We call these categories semi-permanent. As these categories have an individual insight, every individual has his own framework to perceive and understand the external environment. This means that experience plays a crucial role in allocating certain kinds of stimulus to certain categories. Experience here gathers individual experience but also the species evolution. This is by experience, that our mind would be able to connect a stimulus to another similar stimulus occurred in the past. Our neural system is in constant evolution as species and new connections are formed during the life. According to Hayek, a stimulus can be gathering as belonging to a certain class of stimuli. If not similarity between stimuli appears, no new stimulus can be perceived. 9 As point out by Evelyn Gick, this view corresponds with the finding of recent cognitive theories as Ledoux (2002, p52): an activity of a receiving neuron is triggered when a stimulus, the excitatory input arrives in conjunction with another stimulus. 10 These past experiences of our stimuli are needed in order to trigger new stimuli and therefore, classify them into categories. The result is that our framework has an individual insight which leads to interpret the physical world in a subjective manner. Indeed, our brain does not take a picture of the physical world but rather, try to explain it. 9/10. The Social Science of Hayek's The Sensory Order, Advances in Austrian Economics, Volume 13, pp , Gick E., 2010

13 13 What the apparatus of classification provides is more a sort of inventory of the kind of things of which the world is built up, a theory of how the world works rather than a picture of it. 11 The classification uses by the central nervous system has a dual nature. The map shows all the possible neural connections and the model refers to neuronal connections explained before. The maps are located, according to Hayek, in different levels of the neuronal order. Hayek (1952, the sensory order, p 92) wrote: while it is on the whole more likely that responses via the lowest centres will be innate for the individual, that is, acquired by the race in the course of evolution, while the responses effected by the higher centres will be largely based on individual experience, this cannot be regarded as a universal rule. Probably some inherited responses are effected on fairly high levels, while some learned responses may, after sufficient repetition, become almost completely automatic and be affected at low levels. Gick interprets it as follow: Very quick and predictable action refers to a category that operates on a lower level such as the message fire is dangerous. An action that follows a stimulus that is more complex such as the teacher doesn t look at me. Should I cheat or should I refrain from cheating because cheating is bad? will be the result of a multiple categorization. 12 The process of classification has an interesting feature. In fact, the original stimulus can never be perceived by the individual in its pure form. 11. Hayek, The sensory order, pp. 131, The Social Science of Hayek's The Sensory Order, Advances in Austrian Economics, Volume 13, pp , Gick E., 2010

14 14 This individual insight of past experiences used for stimulus lead to an abstract perception. 13 Modern cognitive sciences call this phenomenon object constancy. 14 II. Dispositions An important concept to understand Hayek s cognitive theory is the concept of dispositions. These dispositions were used by Hayek to explain why different people act differently when responding to the same stimulus and even why the same person act differently with the same stimulus. According to Hayek, the dispositions are the most convenient starting point [ ] which makes an organism inclined to respond to stimuli of a certain class, not by a particular response, but by a response of a certain kind 15 These dispositions can be found at two levels: on the level of perception and on the level of action. An important feature is that categories follow dispositions. 16 But the dispositions have not only a purpose to react in a certain way when exposed to a stimulus but also it expects to perceive a stimulus that relates to stimuli perceived earlier. 17 The perception and action levels of disposition lead to an exchange from the environment to the mind and from the mind to the environment. Indeed, our neuronal system perceives the rules of action of other people but also 13. Hayek, The sensory order, pp. 143, The Social Science of Hayek's The Sensory Order, Advances in Austrian Economics, Volume 13, pp , Gick E., UCLA Oral History 1978 Interviews with Friedrich Hayek, pp Archive.org. 16. Cognitive theory and moral behavior: The contribution of FA Hayek to business ethics, Gick E., Journal of Business Ethics, Vol. 45, , Hayek, the sensory order, 1952, p98

15 15 Respond to it through an action. There is a feedback from society to mind as well as the interaction from the society to our mind. Another important aspect of dispositions is that there are primary dispositions and overlapping dispositions. According to Hayek, the primary dispositions are the dispositions that an individual uses first. They are also called abstract rules and are the general rules passed through generations. They constitute the frame of the society, of a specific culture and it is why these primary dispositions can be predict. The primary dispositions give a rough direction that other dispositions will overlap. 18 Overlapping dispositions are adaptations to typical features of the environment 19 Primary dispositions as well as overlapping ones can be inmates, acquired by personal experience and based on human species evolution. These characteristics have as result, the impossibility to forecast an action. More than that, it leads to the impossibility to know which stimulus is activated, in which category it will go, what will be the dispositions use and which action it will trigger. This subjective feature of the cognitive process leads to a bias perception. Moreover, the feedback uses for stimuli lead to a colored perception by personal experience. The action, which is the final step of the cognitive process, will trigger a feedback which will modify the dispositions. 18. The Social Science of Hayek's The Sensory Order, Advances in Austrian Economics, Volume 13, pp , Gick E., Cognitive theory and moral behavior: The contribution of FA Hayek to business ethics, Gick E., Journal of Business Ethics, Vol. 45, , 2003

16 16 In a short paragraph, we will try to simplify and resume the cognitive process developed by Hayek. The physical world (external world) triggers a stimulus in our nervous system. This stimulus or these stimuli will be put in relation with another similar stimulus. Then, they will be filter in a category with the help of dispositions. It leads our brain to perceive the world in a subjective manner. Then, the primary and overlapping dispositions will be used to react depending on our past experiences and our traditional rules. It leads to an action which will trigger a feedback to our nervous system. So, there is a double interaction between the physical world and the so-called sensory order or phenomenal world. This cognitive theory leads to the concept of dispersed knowledge also developed by Hayek. III. Dispersed knowledge The concrete knowledge which guides the action of any group of people never exists as a consistent and coherent body. It only exists in the dispersed, incomplete, and inconsistent form in which it appears in many individual minds 20 Actually, as explained in the cognitive theory, the process of our neuronal system involves subjectivity. This subjectivity leads to a dispersed knowledge for the simple reason that this knowledge is based on a subjective perception and interpretation of it The sensory order, Hayek, 1952, pp Cognitive theory and moral behavior: The contribution of FA Hayek to business ethics, Gick E., Journal of Business Ethics, Vol. 45, , 2003

17 17 But this dispersed knowledge is not only the result of a limited understanding of the environment by our brain. It relies also on the fact that social system, market place in economics systems as the nervous systems are complex phenomena. 22 As a matter of fact, it appears unrealistic to state that an individual can understand the whole pattern of the world and even one single complex phenomenon as the whole economic system for instance. Moreover, the knowledge in the society is dispersed among individuals. Indeed, we only take in account a certain amount of knowledge to have its own representation of the world in order to respond to it. As seen before, F.A. Hayek has developed a real interesting cognitive theory in which the individual is not fully rational. This not fully-rationality is explained through neuronal process which involves individualism and subjectivity in collecting, interpreting, and responding to the environment s information. Now, we will study the development of behavioral economic and specially the concept of bounded rationality The birth of behavioral economic and the Bounded rationality Much of behavioral economic has been influenced by only one branch of psychology: cognitive psychology. 23 It seems fundamental to study the evolution of cognitive psychology. 22. Cognitive theory and moral behavior: The contribution of FA Hayek to business ethics, Gick E., Journal of Business Ethics, Vol. 45, , The credit crunch: Ideological, psychological and epistemological perspectives, Lewis Alan, Journal of Socio-Economics, Vol. 39, pp , 4/2010

18 18 "Cognitive psychology is dedicated to the study of thinking, reasoning and decision-making. 24 Basically, behavioral economists implement cognitive concepts into the neoclassical theory in order to better represent the reality. The main subject concerns the rationality of agents. Behavioral economic argues that the full rationality of individuals does not represent the real world. Powerful results have been obtained using the simple assumption of the full rationality of agents such as the theory of the firm, the consumer behavior and so on. But a full rationality requires unlimited cognitive capabilities. 25 There is experimental evidence of deviations from the utility maximization notably by Kahneman and al. (1982). The lack of empirical founded theories constitutes the main weakness of the classical theory. This lack of empirical founded theories led Herbert A. Simon to work on another models of rationality to describe economic behavior under uncertainty and risk. 26 In sum, we need to augment and amend the existing body of classical and neoclassical economic theory to achieve a more realistic picture of economic processes as well as a more accurate understanding of the equilibrium toward which these processes move The credit crunch: Ideological, psychological and epistemological perspectives, Lewis Alan, Journal of Socio-Economics, Vol. 39, pp , 4/ Bounded Rationality: The Adaptive Toolbox, Gigerenzer Gerd and Selten Reinhard, MIT Press, / 27. Models of Bounded Rationality, Vol. 3: Empirically Grounded Economic Reason, Herbert A. Simon, ; pp 275

19 19 The main contrasts between the neo-classical theory and behavioral economic are the two assumptions stated in the classical one. First, the given utility function claims that individuals are able to make consistent choices among a range of goods and services. The second theory is the utility maximization in which individuals chose the greatest utility alternative between a set of choices. 28 This latter represents the full rationality of agents. Moreover, the bounded rationality is clearly an alternative basis for the mathematical modeling of decision making, Three features characterized Simon s view of bound rationality: search for alternatives, satisficing, and aspiration levels. 29 Simon describes decision making as a search process guided by aspirational levels. An inspirational level is a value of goal variable that must be reached or surpassed by a satisfactory decision alternative. Aspirational levels are dynamic and they are adjusted to the situation. If the satisfactory alternatives are easy to find, these aspirations levels are raised. In contrast, if satisfactory alternatives are hard to find, these levels are lowered. 30 Bounded rational decision making necessary involves no optimizing procedures Models of Bounded Rationality, Vol. 3: Empirically Grounded Economic Reason, Herbert A. Simon, ; pp / 30/ 31. Bounded Rationality: The Adaptive Toolbox, Gigerenzer Gerd and Selten Reinhard, MIT Press,

20 20 The procedure of thinking is unconscious; it is the reason why these hidden processes are important for the theory of bounded rationality. In aspiration adaptive theory, the aspiration scheme takes the place of the preference order in the usual decision theory. 32 The decision maker does not research the optimum alternative but rather the alternative which will satisfy it enough. The reason is that they face uncertainty concerning the future in acquiring the present information. 33 It means that it is impossible to use probabilities when making decision because people face uncertainty about the future. It is close to the concept of benthamic calculation of Keynes. He claimed that when there is a lack of knowledge or it is uncertain, we are not able to make probabilities, we cannot have a good benthamic calculation of expected value. 34 Undoubtedly, biological and cultural evolutions as well as the acquisition of motivations dispositions in ontogenetic development are important influences on the structure and content of decision behavior. 35 Here it seems to refer to Hayek s cognitive theory. As explained in Hayek s cognitive theory, the process of analyzing the external environment is influenced by several factors such as traditional rules. That leads to a subjective decision behavior. The impossibility to objectively analyze present information leads to have uncertainty about the future. This uncertainty is translated in making decisions by satisficing. 32/ 33/ 35. Bounded Rationality: The Adaptive Toolbox, Gigerenzer Gerd and Selten Reinhard, MIT Press, The anti-benthamism of J.M. Keynes, implication to the general theory by Peter V mini ; retrospectives, animal spirits, roger Koppl, journal of economic perspective volume 5, number 3, summer 1991, page

21 21 "boundedly rational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information" 36 It clearly appears that Hayek s cognitive theory was widely used by Simon. Moreover, Simon s idea was that the economic agents use heuristics to make decisions rather than optimized decisions. Indeed, in making decisions by satisficing, they use simple rules. It is closed to the concept of dispersed knowledge used by Hayek in his cognitive theory. To summary, according to Simon, individuals have a limited understanding of the environment because they do not have the cognitive capabilities to understand complex phenomena such as the whole economic system. They use heuristics to readily make decisions. These decisions are not based on optimization but rather on the will of satisfaction. Finally, the limits in the process of present information s analyze lead to uncertainty concerning the future The Prospect theory and Heuristics I. The prospect theory Kahneman is widely recognized for his prospect theory that he developed with Tversky Williamson, Oliver E "The Economics of Organization: The Transaction Cost Approach." American Journal of Sociology, pp Choices, Values, and Frames, Kahneman Daniel, Tversky Amos, Cambridge University Press,

22 22 Expected utility theory reigned for decades as the dominant normative and descriptive theory of decision making under uncertainty. Nevertheless, this theory has been recently questioned by economists and there is a general agreement on the fact that it does not provide an adequate description of individual choice. It certainly appears that the decision makers systematically violate its basic tenets. 38 It is in this context, that Kahneman and Tversky developed the prospect theory. Their aim was to provide explanations to the major violations of expected utility theory in choices between risky prospects with a small number of outcomes. 39 This theory was used to model real-life choices rather than optimal decisions. This theory is a descriptive one and we will only resume it. There are two keys elements in this theory. First, a value function that is concave for gains, convex for losses and steeper for losses than for gains. 40 This tendency called the certainty effect, contributes to risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses. 41 Secondly, a nonlinear transformation of the probability scale, which overweight small probabilities and underweights moderate and high probabilities / 39/ 40/ 42. Choices, Values, and Frames, Kahneman Daniel, Tversky Amos, Cambridge University Press, Prospect theory, an analysis of decision under risk, Daniel Kahneman, Amos Tversky, Econometrica, 1979, pg. 263

23 23 II. Heuristics and biases Heuristics are cognitive devices that reduce the amount of data needed, and use short-cut rules of thumb to form judgments. 43 These Heuristics are widely unconscious mental process. These heuristics use beliefs concerning uncertain events. These judgments are all based on data of limited validity which are processed according to heuristic rules. 44 We will study three heuristics which one lead to different biases. These heuristics are: Representativeness, availability, and adjustment and anchoring. Representativeness First of all, according to Kahneman, representativeness can be illustrated by these questions: what is the probability that object A belongs to class B? What is the probability that event A generates from process B? And so on. In answering these questions, people rely on the representativeness heuristic, in which probabilities are evaluated by the degree to which A resembles B. 45 According to Kahneman, this approach to the judgment of probability leads to serious errors, because similarity, or representativeness, is not influenced by several factors that should affect judgments of probability Moral imagination or heuristic toolbox? Events and the risk assessment of structured financial products in the financial bubble, Fisher Colin and Malde Shishir, Vol. 20, pp , 04/ / 45/ 46. Judgment under Uncertainty: Heuristics and Biases, Kahneman, Slovic and Tversky, Cambridge University Press,

24 24 First error initialized by representativeness is the insensitivity to prior probability of outcomes. It appears that an individual uses prior probability when there is not description on the subject given. But when there is a description given, even a general and irrelevant one, the so-called representativeness leads to ignore prior probabilities. When no-specific evidence is given, prior probabilities are properly utilized; when worthless evidence is given, prior probabilities are ignored The second error triggered by representativeness is the insensitivity to sample size. When asking for a result in a sample drawn from a specific population, people use representativeness. 48 Truly, in this situation, people assesses to the likelihood of a sample result. They produce identical distribution in assessing the same probabilities of various samples. For example, a person will respond that there are 6 men in a group of 10 individuals for the reason that the whole population has a probability of 6 males on 10 individuals. This fundamental notion of statistics is evidently not part of people s repertoire of intuitions. 49 The third error using representativeness is the misconceptions of chance. According to the authors, chance is commonly viewed as a self-correcting process in which a deviation in one direction induces a deviation in the opposite direction to restore the equilibrium. 50 But this is a misconception of chance. 47/ 48/ 49. Judgment under Uncertainty: Heuristics and Biases, Kahneman, Slovic and Tversky, Cambridge University Press, , pp. 5

25 25 For instance, when a long run of red on the roulette wheel, most people believe that black is now due. The occurrence of black will result in a more representative sequence than the occurrence of an additional red. 50 The fourth and last cognitive bias is called regression to the mean. People assume that future outcomes will be directly predicable from past outcomes. They base predictions on the assumption of a perfect correlation with past data. The cognitive biases triggered by representativeness seem to be biases due to an imperfect representation of the reality by the mind. Availability Availability is the second heuristic we will study. It is defined as situations in which people assess the frequency of a class or the probability of an event by the ease with which instances or occurrences can be brought to mind. 51 It is similar to the personal experience used to perceive and respond to the environment in the Hayek s cognitive theory. Indeed it seems again that the individual experience plays a crucial role in the cognitive process. Even if availability is in main cases useful to assess frequency or probability, it leads to biases because it does not rely only on probability. First cognitive error associated to this heuristic is biases due to irretrievability of instances. 52 Depending of the ease to retrieve past instance of a class of event, the probability assess will differ. It means that there is a subjective factor which influences this probability. 50/ 51/ 52. Judgment under Uncertainty: Heuristics and Biases, Kahneman, Slovic and Tversky, Cambridge University Press, , pp. 7

26 26 When a size of a class is judged by the availability of its instances, a class whose sentences are easily retrieved will appear more numerous than a class of equal frequency whose instances are less retrievable 53 Instances that you personally experienced will be more influent than one you watch through media. The second type of biases is biases due to effectiveness of a search set 54 These biases are associated to the research process. The ease or not of this research process will influence the availability heuristic. Indeed, people were asking if it is more likely that a word begin with a r or that the word have a r at the third letter. The search process used by people will make appear easier to find word beginning with the r than words with a r at the third letter. 55 The third type of biases is the ones of imaginability. It appears when an individual has to assess a likelihood of a class whose instances are not stored in memory. He has to generate an imagined instance in order to evaluate probabilities in real life. Imaginability plays an important role to assess risk in an uncertain situation. The problem remains that this probability imagined have to be close to the real one in order to correctly represent the reality. It is why likelihoods can be under or overestimated. Another kind of biases is illusory correlation. Availability provides a natural account for the illusory-correlation effect. The judgment of how frequently two events co-occur could be based on the strength of the associative bond between them / 54/ 55/ 56. Judgment under Uncertainty: Heuristics and Biases, Kahneman, Slovic and Tversky, Cambridge University Press, , pp11-13

27 27 Then people judge the association between two events strength, they are likely to conclude that these events frequently co-occurred. We studied the availability heuristic which triggers various systematic biases. They are biases during the cognitive process of researching the information. They concern specially the search of instances in order to assess a probability. It appears that instances or personal experience play a crucial role in assessing probability about uncertainty and can lead to cognitive biases. We will study our third and last heuristic: adjustment and anchoring Adjustment and anchoring In many situations, people make estimates by starting from an initial value that is adjusted to yield the final answer. 57 In every case, the starting value has to be adjusted and it is these adjustments which are often insufficient. Different starting points yield different estimates, which are biased towards the initial values. We call this phenomenon anchoring 58 Individuals make estimates for values based upon an initial value and typically make insufficient adjustments from that anchor when establishing a final value. 59 Because these adjustments are insufficient, the final answer is biased. 60 Two classes of explanations have been developed to know the origin of these insufficient adjustments. They focus on the uncertainty for the true value or a 57/ 58. Judgment under Uncertainty: Heuristics and Biases, Kahneman, Slovic and Tversky, Cambridge University Press, , pp Heuristic Reasoning in Management Accounting: A Mixed Methods Analysis, Basel and Jörn Sebastian, ISBN: , , pp Heuristics and Biases: The Psychology of Intuitive Judgment, Gilovich Thomas and Griffin Dale and Kahneman Daniel, Cambridge University Press, , pp. 127

28 28 lack of cognitive effort. 61 People are more likely to stay close to the anchor because they had no previous knowledge to aid them in adjusting. We studied three main heuristics widely developed by Kahneman and tversky. First of all, the representativeness heuristic leads to several biases. This heuristic involves bias of perception which leads to assess biased likelihoods of uncertain events. The second heuristic, availability, leads to biases in the search process of similar events. The individual experience has a subjective effect on the cognitive process and leads to an incorrect assessment of probabilities. Finally, the third heuristic is called adjustment and anchoring. When judging under uncertainty, people often rely on an initial value which is called the anchor. In order to reach the final result, people adjust this anchor but this adjustment is biased because it is often insufficient. We have examined three heuristics use in the process of assessing probability in the case of uncertain events. Judgment is used to make decisions when there is not possibility of benthamic calculations. The use of heuristics involves a simplification of the real in order to respond to the environment. These heuristics are closed to the bounded rationality developed by Simon and the cognitive theory of Hayek. Actually in all of these theories, several features appear similar. The individual experience which lead to a subjective perception of the real world. The limited information processed by the brain in order to simplify the environment. 61. Heuristics and Biases: The Psychology of Intuitive Judgment, Gilovich Thomas and Griffin Dale and Kahneman Daniel, Cambridge University Press, , pp. 127

29 29 We will finally study the critiques of these concepts of heuristics and cognitive biases. Critiques Several authors as Gigerenzer criticized these theories. One of the main points is that heuristics have not yet been clearly explained in term of mental processes. We do not know yet how it precisely works and specially the whole cognitive process. Moreover, some authors as Kahneman claim that heuristics biases are exceptions to rationality. In contrast, authors as Gigerenzer and Selten, have claimed that heuristics biases constitute an adaptive toolbox which allows people to make fast and frugal decisions, which in our animal past may have increased survival ratios. 62 Indeed, these heuristics can have benefits in the fact that they able persons to readily make decisions and solve problems. But it leads to systematic cognitive biases which during specific cases as the subprime mortgage crisis could have played a negative role. It is why we will apply the cognitive theories and concepts explained before to the special case of the subprime mortgage crisis. 62. The credit crunch: Ideological, psychological and epistemological perspectives, Lewis Alan, Journal of Socio-Economics, vol 39, pp

30 30 Third chapter: Application to the financial crisis 3.1 The financial crisis I. The crises Crises are ruled by bursting bubbles. These bubbles appear when the gap between the real price of an asset and its market value gets an unsustainable level. 63 Market participants are generally eager to take part of the boom and the credit activity rise as the bubble. Speculative bubbles need to be filled with money. 64 This money comes mainly by the credit expansion. It leads to sustain the growth of the speculative bubble. The consequences can be a rise of prices and eventually of the inflation. But as PIROŞCĂ G. wrote, the rise of price can also be a consequence of the rising anticipation of market participants and not as origin the credit expansion. It was the case of the dotcom crisis. II. The subprime mortgage crisis The financial crisis started during the summer of the year As a result, many huge banks as Lehman brothers, Freddie mac and Citi group were rescued by governments or just disappeared. Several causes provoked the mortgage subprime crisis and we will only evoke the main ones. The low interest rates, the increasing lax lending standards and perhaps the belief that housing price will continue to increase led a huge amount of borrowers to take mortgages and to purchase houses between 2000 and These borrowers were living behind their means but were encouraged 63/ 64. Economic Crises and the Complexity of Animal Spirits Modelling, PIROŞCĂ G., Theoretical and Applied Economics Vol. 2, 2011

31 31 by attractive lending contracts. These lends were a result of a willing of investment by banks and hedge funds. At first, the business of investment banks was to originate and hold. This means that they generated business from ground zero and hold them for future returns. 65 But it has evolved in an originate and distribute to avoid the risky part of holding the business. These lends were gathering in CDO: Collateral Debt Obligation. CDOs are a type of structured asset-backed security (ABS). The constant deregulation by public actors led private agents to create complexes structure products misunderstood by the bulk of economic agents. People borrowed money making mortgage on their houses. Investment banks bought these mortgages from the lending banks and put them into a single financial product: the CDO. These CDOs were misunderstood financial products in the way that risky lends were gathering in a so-called CDO and these CDOs were good rated by credit agencies. Moreover, CDOs of second grade were created with hundreds or more of CDOs. And CDOs of third grade were also created with CDOs of second grade. Now, the highly risky feature of these financial products appears obvious. But it was not the case during the financial crisis because of the misunderstanding of the underlying elements of the CDOs. As they were rated AAA by credit agencies, they were a very profitable product for investors and these financial products dangerously increased until / 66. Economic Crises and the Complexity of Animal Spirits Modelling, PIROŞCĂ G., Theoretical and Applied Economics Vol. 2, 2011

32 32 It was almost impossible to track the origin of these CDOs and it was the reason why it was impossible to assess the real risk of it. These CDOs were part of the financial innovations and were not enough regulated. Others financial innovations such as credit default swap (CDS) insurance were poorly regulated and promoted as a non-risky product. As wrote before, these CDOs were rated AAA by rating agencies. Indeed as explained, the origins of these CDOs were impossible to trace and as a result, it was almost impossible to assess the real risk of these financial products. Moreover, the CDOs of second grade and third grade were also rated AAA. Another problem concerning rating agencies is the interest conflict of who need the rating and who is paying for it. 67 It would normally be the investors paying but it is not actually the case. It is the issuers of the mortgage related securities which pay rating agencies and this problem remains in our days. The low interest rate between 2001 and 2003 with these insufficient tested new financial products led investors from all over the world to invest in it. It fed the house and credit bubble until With the increasingly number of mortgage subprime delinquency, housing prices declined and the loss for investment banks and hedge funds dramatically rose. It led major banking institutions and hedge funds to run into bankruptcy which was the beginning of a worldwide financial crisis. This crisis can be attributed to a number of different factors. The public actors did not regulate these financial innovations enough and proposed an inadequate house policy. Then, the borrowers lived behind their means and took loans without understanding the risk involved. The banks and specially the investment funds created dangerous securitizations as the CDOs where the underlying risks were hidden. 67. The Financial Crisis: Moral Failure or Cognitive Failure?, Kling A., Harv. JL & Pub. Pol'y, Vol. 33, 2010

33 33 They transformed multiple risky loans in a single financial product. Moreover they originate them and distribute instead of hold them. The rating agencies finally wrongly rated these CDOs in according a rate of AAA and AA to them. They did not understand the origins of these CDOs and the underlying risks involved Cognitive biases of investors We will study specifically the aspects in relation with potential cognitive biases. To do so, we will study which characteristics of the financial crisis may have triggered heuristics. We will particularly aim the CDOs which are a main feature of the subprime crisis. I. Adjustment and anchoring Since the years 1980s, the financial products constantly evolved and this evolution was characterized by the complexity in the range and the form of structured financial products. 68 This complexity means that there was an inadequate and asymmetric distribution of the information about the price and the quantity of these products. This complexity may have triggered adjustment and anchoring heuristic. Indeed, as explained before, the CDOs were rated AAA by credit agencies. The rate given played the role of anchor. From this rate, institutions and individuals paid for these CD0s and insufficiently adjusted the value of them in their buying positions 69 68/ 69. The Financial Crisis: Moral Failure or Cognitive Failure?, Kling A., Harv. JL & Pub. Pol'y, Vol. 33, 2010

34 34 But why did the rating agencies wrongly rated the CDOs? Is it because they did not understand the underlying elements of the CDOs and the risk involved? In this case, it would be a cognitive error; they had bounded rationality and did not understand such a complex structure. It may be some truths in this explanation but the assumption that any economic agents understood the underlying risk of these financial products seem unrealistic. Moreover, the Financial Crisis Inquiry Commission seems to confirm this view in its tremendous report of January 2011: We conclude the failures of credit agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. 70 It proves that credit rating agencies were guilty to know the underlying risks of these financial products and to have a conflict of interest with investment banks. But it seems also to confirm that individual investors used adjustment and anchoring heuristic which led to cognitive biases. II. Availability heuristic and imaginability bias The particular complexity of financial products may have triggered availability heuristic. Indeed, availability heuristic is used for an easier search process. In the case of financial products, such as CDO or CDS, they were financial innovations. It results that anyone had already experienced them. There were no previous experiences to base a judgement or assess a probability. 70. The financial crisis inquiry report pp 26, FCIC.pdf