Hello, welcome back. In the last lecture we talked about how representativeness leads to an under waiting of the base rates or our prior information. There are also situations where the base rate is over emphasized which means that sometimes, we do the opposite, we tend to over rely on our prior information. Okay, so again, let's start with a couple of examples. Well, so the most frequent answer to the first question is 45%, right? The probability that you would assign to the event that the selected bag contains predominantly black chips, right. Most people answer 45%. Now the second question, is clearly much more difficult than the first, right? And the two most common answers that we get to these questions, is either 45% or 67%, why? Because these are the most salient numbers in the problem, right. 45% is the number of bags containing predominantly black chips. And 67% is the fractional black chips drawn with replacement, right? So those who respond 45%, do not really know how to incorporate the new information, so they stick with their initial beliefs. And people who say 67%, focus on the fact that two-thirds of the chips drawn with replacement are black, right. And so they ignore all the prior information just like we saw with their representative heuristic, right. Now of course the correct answer to the second question is in fact 96.04% right. Now typically in experiments, right? 55% of those responding, right? Choose either 45 or 67%, right? Now the remaining are all over the place but most are well below 96%, and in fact, most of the people are below 75%. Now what does this mean? Think about it. Well, what this means is, all right, people respond to conservatively to the new information, right? They are anchored on that 45%, number and they do not adjust sufficiently to the new information, right? Now this question is actually very analogous to the problem faced by financial analysts, right? So think of the bag, a company that in the future may operate in the black or in the red, right? Think of black chips standing for good future earnings. And red chips for poor future earnings, right. So you start out with some prior, just like the analyst starts out with some information. That leads them to form some initial beliefs, right. Now, how does the analyst react after the earnings announcement, well just like we've seen in this example, often analysts do not revise their earnings estimates enough to reflect the new information, right. So consequently, what happens is positive earnings surprise tend to be followed by more positive earnings surprises, right. Because the analysts don't update enough and conversely negative surprises are followed by more negative earnings surprises again, the analysts doesn't adjust enough, right. Remember the post earnings announcement drift that we talked about, right? It looks very much, it might be conservatism bias that is at work, right? Now, let me close with a final example. So, in the early 1970s, two psychologists it was Tversky, and then Kahneman, right. Who by the way, showed in several experiments that people are not always as rational as we make them in our models. And led the way in behavioral economics. They were in a very interesting experiment, right? So, they first asked people to spin a wheel of fortune, right? That was numbered from 0 to 100, and then afterwards they ask them to guess or estimate whether the percentage of total United Nations membership made up of African countries was higher or lower than the number that they had just spot, right. So here's the experiment. Spin the wheel of fortune, right. You get a number between 0 and 100. Then you estimate whether the percentage of African countries in the UN membership is higher or lower than your number. Well, turned out that the spins made a big difference, even though of course, right, these random numbers should have had no influence on people. On average, people who spun a low number, let's say number ten, guess only 25% of UN members were African nations. Whereas people who spun a higher number, let's say 65 guess that 45% were African. It's pretty amazing stuff. Well in this lecture, you learned about conservatism or anchor, right. The idea that is as soon as your intuition laches on a number, any number it just gets stuck there, all right. So for example, that's why real estate agents will usually show you the most expensive house on the market first, so that the others will seem relatively cheap by comparison. And in the financial world anchoring is everywhere.
