In the last post we discussed two biases that often occur in the information processing stage of the decision making process: representativeness bias and conservatism and herding Bias (see: here). This week we will discuss the anchoring bias and framing bias that may occur in this stage:

Anchoring:

The anchoring bias describes a human tendency to rely on an initial piece of information offered to us (the “anchor”) when making decisions. After the anchor has been set, a decision an individual makes becomes relative to the anchor (which might be an irrelevant point of reference to the decision in hand). Often, when people realize that an anchor is irrelevant to the decision in hand, they still find it hard to adjust away from the anchor. The anchor leads people to create reasons and access information that is consistent with that anchor and avoid information that is inconsistent with it.

To demonstrate the anchoring bias Tversky and Kahneman held an experiment where participants were assigned a random anchor and were later asked to answer a question. To set an anchor, participants were given a random number (in some experiments the anchor was set by asking participants to write down the last two digits of their phone number or social security number). After the anchor was set, participants were asked to state whether the percentage of African nations among the UN is higher or lower than the anchor. Later they were asked to give their best estimation to the percentage of UN countries that are African. The random anchor that was given to the participants had substantial impact on their estimates. For example, people who started with the number 10 had an average estimate of 25% whereas people who started with the number 65 had an average estimate of 45%. Despite the fact that participants were aware of the anchor being random and unrelated to their judgment task, it still had a significant effect on their judgment.

Dan Ariely took this experiment a step further. His findings suggest that initial anchors do not only affect our judgment regarding the current decision we face but effect all the related decisions we make in the future as well. For example, an anchor set for purchasing a car does not only effect the purchase of the current car but our future purchase of a new car as well.

In investment decisions, anchors can vary from current stock prices to peer investment quotes and evaluations. Managers who are anchored to these figures are likely to underestimate or overestimate an investment’s actual worth and therefore exhibit bad judgment behavior.

Framing:

The decisions we make tend to be affected by how our choices are framed. The term framing is used to refer to alternative wording of the same objective information that significantly changes the decisions people make. We would not expect different wording (framing) of the decision to affect our ability to make rational choices, when in fact it does.

To demonstrate the framing bias Tversky and Kahneman asked people the following question regarding medical treatment in the case of lung cancer:

If you were diagnosed with lung cancer and had been given the following statistics, which treatment would you prefer?

• Surgery: Of 100 people having surgery 90 live through the postoperative period, 68 are alive at the end of the first year and 34 are alive at the end of five years.
• Radiation therapy: Of 100 people having radiation therapy all live through the treatment, 77 are alive at the end of the first year and 22 are alive at the end of five years.

In this case 82% chose surgery and 18% chose radiation therapy.

A second group of different people were given the same instructions only this time they had to choose from the following options:

• Surgery: Of 100 people having surgery 10 die during surgery or the post-operative period, 32 die by the end of the first year and 66 die by the end of five years.
• Radiation therapy: Of 100 people having radiation therapy none die during treatment, 23 die by the end of the first year and 78 die by the end of five years.

In this case 56% chose surgery and 44% chose radiation therapy.

The difference in the framing of the statistics produced a change in the preference towards the radiation treatment (from 18% in the survival frame to 44% in the mortality frame). The advantage of radiation therapy over surgery grows larger when it is stated as a reduction of the risk of immediate death from 10% to 0% rather than as an increase from 90% to 100% in the rate of survival.

The way information is framed may have an effect on a manager’s decision whether to engage in an investment or not. Managers might find themselves dismissing an investment opportunity just because the information was presented in a certain way (for example, analysis of predicted losses rather than possible gains). A certain investment opportunity may be framed in negative terms and therefore be rejected whereas the same investment may be framed in positive terms and therefore be accepted.

Next we will wrap up the biases in the information processing stage and later start to discuss biases in the decision making stage.

For suggested readings related to this post please contact me at: etbiran@gmail.com