SOLUTION: Harvard University Solving Problems Using Shortcuts & Heuristics Discussion

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Essay 6
Essay 6
1. What are heuristics? Explain. How are these different from the Utopian Economics
described by Cassidy?
Heuristics refer to methods of solving problems using shortcuts. Due to the excessive
amount of information available, it is difficult for people to deal with. Therefore, they create
shortcuts to come up with reasonable decisions. The downside of these heuristics is that they lead
to bias, systemic mistakes made due to the heuristics/shortcuts. As humans, we make systematic
mistakes all the time due to these shortcuts. These are different from the Utopian Economics
described by Cassidy because, in a utopian society, everything is always based on information.
Everything has an analytical approach that helps us understand market trends, decisions, and
outcomes. In a utopian society, people would think through all these steps and ultimately
determine what is right and what is wrong by careful processes. However, heuristics eliminate
the calculated planning and formulas and theories and allow people to use their intuition to make
decisions instead.
1. Explain your results of doing the test on Slide 20? Were you overconfident?
I got 5/10 correct.
Self-Test of Overconfidence
Martin Luther King’s age of death

My Answers
30-40

Correct Answers
39 years

Length of the Nile River (miles)

4000-4200

4187 Miles

Number of countries in OPEC

12-13

13 Countries

Number of books in the Old Testament

30-35

39 Books

Diameter of the moon (miles)

900-1000

2160 Miles

Weight of an empty Boeing 747 (pounds)

250,000-260,000

390,000 pounds

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Year in which Wolfgang Amadeus Mozart
was born
Gestation Period of an Asian Elephant (in
days)
Air distance from London to Tokyo (miles)

1750-1760

1756

500-550

645 days

5900-6000

5959 miles

Deepest known point in the ocean (feet)

10000-11000

36,198 feet

The questions I got right were the ones I knew the answers to, and the ones I got wrong, I
knew I had off. As the theory of overconfidence says, people place too much faith in their gut
feeling. People listen to their intuition because they are overconfident about their knowledge. In
this test, I was only overconfident in the questions I knew the answers to, and the remaining five
were all random guesses, and I knew I would not get them right.
1. Shiller surveyed people in 1989, 1996, and 1999. He asked the question: “If the Dow
dropped three percent tomorrow…”. Explain why his results show overconfidence among
investors.

Shiller surveyed people in 1989, 1996, and 1999 and asked the question, “If the Dow
dropped 3 percent tomorrow, I would guess that the day after tomorrow, the Dow would” each
year showing different results, with more and more overconfidence. The fact is, if people believe
in the efficient market hypothesis, they should say they don’t know the outcome of the day after
tomorrow. They would say they don’t know because the future should not be predictable. The
three percent crash should not help us predict at all in the future. However, if people are
overconfident, they believe markets will come right back up and state that they will increase on
the day after tomorrow. In 1989, people were not sure of the market. 35% said it would increase,
and 34% said it would decrease. In 1996 Shiller sees a slight change with people saying 46%
said it would increase, and 24% said it would decrease. But by 1999, the overconfidence in the

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market was at an extreme, saying 56% said it would increase, and 19% said it would decrease.
These results show overconfidence among investors because they believe that the market has to
go back up. They stopped being unsure of themselves and started to follow their intuition of what
they wanted to happen.
1. Explain the Tom and Jerry slides. That is, show how overconfidence explains excessive
trading.
In one example of Tom and Jerry’s scenario, you would need to believe we live in a
utopian economy and that efficient markets hold. Tom and Jerry are two financial analysts, not a
cat and mouse, and Tom mentions that he plans on buying 100 shares of Apple. Jerry claims that
it is convenient because he was planning on selling his 100 shares of Apple and offering to sell
his shares to Tom to save on commission fees. If the two believe in inefficient markets, they
should not trade. Tom believes Jerry is smart and thinks maybe he shouldn’t invest if Jerry wants
to pull out. Vice versa, Jerry thinks Tom is smart, and he wants to buy stocks because he thinks
the company is doing better than the figures. These assumptions that both think they are smart
are why they end up calling off the trade. However, in the reality of finance and economics, we
see the opposite holds. In reality, Tom and Jerry are overconfident like most people. They
believe they can outsmart each other. Jerry has no apprehension in doing the trade with Tom
because he believes he is smarter than Tom, while Tom believes he is smarter than Jerry. They
both believe that the other is the greater fool, which shows how too much confidence leads to
excessive trading. People are very confident, and they believe they know more than they do; that
is why we see so much trade volume today.
1. Why are we guilty of overconfidence?

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We are guilty of overconfidence because we have evolved to being overconfident to
alleviate disappointment. As humans, we have defense mechanisms to ease the disappointment.
Our defense mechanisms allow ourselves to move forward with a little damage to our selfesteem as possible and allow us to be optimistic for next time. For example, when a student does
not perform as they have expected, they make up excuses for themselves, such as they did better
than the class average considering that they had a headache or that their expectations were too
high. We have these self-defense mechanisms to cope with the fact that we were overconfident.
1. A longer answer is needed. Why don’t we learn from our mistakes? In your answer,
explain each of the four ideas. The four ideas are Self-attribution bias, Hindsight Bias,
Confirmation Bias, Cognitive Dissonance.
We don’t learn to be less confident due to the four ideas of self-attribution bias, hindsight
bias, confirmation bias, and cognitive dissonance. The idea of self-attribution bias is individuals
who attribute their success to innate aspects and blame failure on outside influences. An example
of this is when students do well on an exam, they credit it to their hard work and studying, but
they blame the teacher if they do poorly. When they do well, they take all the credit, leading to
overconfidence. Per contra, when they do poorly, they take none of the blame and push it to an
outside party. This shows that we do not learn from our mistakes.
Additionally, this type of bias asserts that we judge others more harshly than when we
judge ourselves. We aren’t honest with ourselves and don’t, and we continue to believe that we
are better than we are. We don’t learn from our mistakes because we can not be overconfident
when we are not honest with ourselves. The second bias is hindsight bias, which in short denotes
that the person knew it all along. People say that an event that has already passed was
predictable, even though it wasn’t. The hindsight bias makes people state that they knew the

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result all along when they did not. It also prevents people from learning from their mistakes
because they think that they understood the event that took place, and as a result, it hinders their
ability to predict the future. Giving in to the hindsight bias in finance is extremely dangerous
because it promotes investors to believe they have better predictive powers than they do truly.
Relying on these powers to predict the market can lead to poor decision making. This results in

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