Tag: Psychology

Mental Model: Anchoring

We often pay attention to irrelevant information when making decisions.

One way this can play out is in the form of ‘anchoring.’ When we make an estimate, we can end up using irrelevant information as our ‘anchor.’ We then adjust from there, often failing to make sufficient updates.

Once we establish an anchor, we tend to focus on information which is consistent with it, ignoring information which is not. For example, when people buy houses, they tend to negotiate with the listed price as their starting point. Sellers tend to use the price they paid for the house as their starting point.

Anchoring is a fascinating psychological phenomenon. Experts and non-experts in a given area are affected by it alike. It can occur any time you need to give a numerical estimate. This can even affect those whose jobs are based on computing numerical figures, such as accountants.

* * *

Psychologists Amos Tversky and Daniel Kahneman first identified the concept of anchoring.

In one experiment, they asked participants to estimate the percentage of African nations which are members of the United Nations (UN.) One group was asked if the figure were greater or lower than 35%. Another group was asked if it were greater or lower than 65%. Participants in the first group gave much lower estimates. They used the number in their question as their anchor. Other studies have reproduced similar results.

The power of anchoring can be explained by the confirmation heuristic and by the limitations of our own mind. We selectively access hypothesis-consistent information without realizing it. Availability may also play a role in anchoring.

There are numerous examples of anchoring in everyday life:

  • Children are tracked by schools that categorize them by ability at an early age and based on this initial “anchor” teachers derive expectations. Teachers tend to expect children assigned to the lower group to achieve little and have much higher expectations of children in the top group (for more info see Darley and Gross, 1983). Malcolm Gladwell talks more about anchoring in his book outliers.
  • First impressions are a form of anchoring.
  • Minimum payments on credit card bills.
  • Posted interest rates at banks.
  • Prices on a menu in restaurants.

* * *

Heuristic and Biases: The Psychology of Intuitive Judgment offers:

“To examine this heuristic, Tversky and Kahneman (1974) developed a paradigm in which participants are given an irrelevant number and asked if the answer to the question is greater or less than that value. After this comparative assessment, participants provide an absolute answer. Countless experiments have shown that people’s absolute answers are influenced by initial comparison with the irrelevant anchor. People estimate that Gandhi lived to be roughly 67 years old, for example, if they first decided whether he died before or after the age of 140, but only 50years old if they first decided whether he died before or after the age of 9.

Anchoring effects have traditionally been interpreted as a result of insufficient adjustment from an irrelevant value, but recent evidence casts doubt on this account. Instead, anchoring effects observed in the standard paradigm appear to be produced by the increased accessibility of anchor consistent information.

* * *

In Judgment and Decision Making, David Hardman says:

Anchoring effects have been observed in a variety of domains including pricing, negotiation, legal judgment, lotteries and gambles, probability estimates, and general knowledge. In one of these studies, Northcraft and Neale (1987) demonstrated anchoring effects in the pricing estimates of estate agents…

Despite the robustness of the anchoring effect, there has been little agreement as to the true nature of the underlying processes. One theory that has been proposed is that of selective anchoring (Mussweilier and Strack, 1997). According to this account, the comparative question task activates information into memory that is subsequently more accessible when making an absolute judgment….

Epley (2004) listed four findings that are consistent with the selective memory account: (1) People attend to shared features between the anchor and target more than to unique features; (2) Completion of a standard anchoring task speeds identification of words consistent with implications of an anchor value rather than words inconsistent with it; (3) The size of anchoring effects can be influenced by altering the hypothesis tested in the comparative assessment (for example, asking whether the anchor is less than a target value has a different effect to asking whether it is more than a target value); (4) People with greater domain knowledge are less susceptible to the effects of irrelevant anchors.

* * *

In Fooled by Randomness, Nicholas Taleb writes:

Anchoring to a number is the reason people do not react to their total wealth, but rather to differences of wealth from whatever number they are currently anchored to. This is in major conflict with economic theory, as according to economists, someone with $1 million in the bank would be more satisfied than if he had $500 thousand but this is not necessarily the case.

* * *

Tversky and Kahneman (1974)

In many situations, people make estimates by starting from an initial value that is adjusted to yield the final answer. The initial value, or starting point, may be suggested by the formulation of the problem, or it may be the result of a partial computation. In either case, adjustments are typically insufficient (Slovic & Lichtenstein, 1971). That is, different starting points yield different estimates, which are biased toward the initial values. We call this phenomenon anchoring.

* * *

Russell Fuller writes:

Psychologists have documented that when people make quantitative estimates, their estimates may be heavily influenced by previous values of the item. For example, it is not an accident that a used car salesman always starts negotiating with a high price and then works down. The salesman is trying to get the consumer anchored on the high price so that when he offers a lower price, the consumer will estimate that the lower price represents a good value. Anchoring can cause investors to under-react to new information.

Anchoring is part of the Farnam Street Latticework of mental models.

The Psychology of Pirates: How to Choose a Ransom

Reading The Invisible Hook really got me hooked on learning more about pirates.

How do pirates decide what ransom to ask for?

The answer, from an interview with an actual pirate, might surprise you. Despite what many think, they are very smart and intuitively grasp governance, incentives, and other aspects of human nature. This interview touches on incentives, reinforcement, moral hazard, and anchoring.

How do you pirates decide on what ransom to ask for?

Once you have a ship, it’s a win-win situation. We attack many ships everyday, but only a few are ever profitable. No one will come to the rescue of a third-world ship with an Indian or African crew, so we release them immediately. But if the ship is from Western country or with valuable cargo like oil, weapons or then its like winning a lottery jackpot. We begin asking a high price and then go down until we agree on a price.

How do you know a ship in far away coast in the first place and its flagship?

Often we know about a ship’s cargo, owners and port of origin before we even board it. That way we can price our demands based on its load. For those with very valuable cargo on board then we contact the media and publicize the capture and put pressure on the companies to negotiate for its release.

From what I’ve seen, initial demands tend to be about 10 times the previous publicized ransom, is this a rule of thumb?

We know that we won’t get our initial demands, but we use it as a starting point and negotiate downwards to our eventual target.  But as a rule, yes, that’s about right.

Does the length of a hijacking change the ransom that pirates are willing to accept?

Yes. Armed men are expensive as are the laborers, accountants, cooks and khat suppliers on land. During long negotiations our men get tired and we need to rotate them out three times a week. Add to that the risk from navies attacking us and we can be convinced to lower our demands.

 

What are the key factors to making a successful attack on a ship?

The key to our success is that we are willing to die, and the crews are not. Beyond that, in my case deploy a boat with six men to get close to the ship and leave another in reserve near the coast just in case we need backup. We use sophisticated equipment that allows us to spot our targets from a distance. We always have to be close to the main sea lane and keep in touch with each other using talkie phones.

 

How much does it cost to outfit a pirate mission?

A single mission with 12 armed men and boats costs a little over $30,000. But a successful investor has to dispatch at least three or four missions to get lucky once.

How are the pirates organized? (Are there pirate leaders, financiers, and specialists?)

The financiers are the most important since they organize and plan the big shot operations and are able to pay running cost[s]. Financiers always need to forge deals with traders, land cruiser owners, translators, business people to keep the supplies flowing during operations and manage the logistics.  There is a long supply chain involved in every hijacking.

 

Are there internal conflicts within the pirate gangs?

No. In piracy, everyones’ life depends on everyone else’s. There is some professional competition between groups, but we cooperate with information and logistics when it’s required. We won’t fight amongst ourselves as long as the money is paid as promised.  We have never had any conflicts within my group.

 

***

Still curious? The Invisible Hook looks at legendary pirate captains like Blackbeard, Black Bart Roberts, and Calico Jack Rackam, and shows how pirates’ search for plunder led them to pioneer remarkable and forward-thinking practices.

The Anatomy of a Decision: An Introduction to Decision Making

“The only proven way to raise your odds of making a good decision is
to learn to use a good decision-making process—one that can
get you the best solution with a minimal
loss of time, energy, money, and composure.”
— John Hammond

***

This is an introduction to decision making.

A good decision-making process can literally change the world.

Consider the following example from Predictable Surprises: In 1962, when spy planes spotted Soviet missiles in Cuba, U.S. military leaders urged President Kennedy to authorize an immediate attack. Fresh from the bruising failure of the Bay of Pigs, Kennedy instead set up a structured decision-making process to evaluate his options. In a precursor of the Devil’s Advocacy method, Kennedy established two groups each including government officials and outside experts, to develop and evaluate the two main options–attack Cuba or set up a blockade to prevent more missiles from reaching its shores. Based on the groups’ analysis and debate, Kennedy decided to establish a blockade. The Soviets backed down, and nuclear war was averted. Recently available documents suggest that if the United States had invaded Cuba, the consequences would have been catastrophic: Soviet missiles that had not been located by U.S. Intelligence could still have struck several U.S. cities.

The concept of a decision-making process can be found in the early history of thinking. Decisions should be the result of rational and deliberate reasoning.

Plato argues that human knowledge can be derived based on reason alone using deduction and self-evident propositions. Aristotle formalized logic with logical proofs where someone could reasonably determine if a conclusion was true or false.

However, as we will discover, not all decisions are perfectly rational. Often, we let our system one thinking–intuition–make decisions for us. Our intuition is based on long-term memory that has been primarily acquired over the years through learning and allows our mind to process and judge without conscious awareness. System one thinking, however, does not always lead to optimal solutions and often tricks our mind to thinking that consequences and second-order effects are either non-existent or less probable than reality would indicate.

In Predictable Surprises Max Bazerman writes:

Rigorous decision analysis combines a systematic assessment of the probabilities of future events with a hard-headed evaluation of the costs and benefits of particular outcomes. As such, it can be an invaluable tool in helping organizations overcome the biases that hinder them in estimating the likelihood of unpleasant events. Decision analysis begins with a clear definition of the decision to be made, followed by an explicit statement of objectives and explicit criteria for assessing the “goodness” of alternative courses of action, by which we mean the net cost or benefit as perceived by the decision-maker. The next steps involve identifying potential courses of action and their consequences. Because these elements often are laid out visually in a decision tree, this technique is known as “decision tree analysis.” Finally, the technique instructs decision-makers to explicitly assess and make trade-offs based on the potential costs and benefits of different courses of action.

To conduct a proper decision analysis, leaders must carefully quantify costs and benefits, their tolerance for accepting risk, and the extent of uncertainty associated with different potential outcomes. These assumptions are inherently subjective, but the process of quantification is nonetheless extremely valuable’ it forces participants to express their assumptions and beliefs, thereby making them transparent and subject to challenge and improvement.

From Judgment in Management Decision Making by Max Bazerman:

The term judgment refers to the cognitive aspects of the decision-making process. To fully understand judgment, we must first identify the components of the decision-making process that require it.

Let’s look at six steps you should take, either implicitly or explicitly, when applying a “rational” decision-making process to each scenario.

1. Define the problem. (M)anagers often act without a thorough understanding of the problem to be solved, leading them to solve the wrong problem. Accurate judgment is required to identify and define the problem. Managers often err by (a) defining the problem in terms of a proposed solution, (b) missing a bigger problem, or (c) diagnosing the problem in terms of its symptoms. Your goal should be to solve the problem not just eliminate its temporary symptoms.

2. Identify the criteria. Most decisions require you to accomplish more than one objective. When buying a car, you may want to maximize fuel economy, minimize cost, maximize comfort, and so on. The rational decision maker will identify all relevant criteria in the decision-making process.

3. Weight the criteria. Different criteria will vary in importance to a decision maker. Rational decision makers will know the relative value they place on each of the criteria identified. The value may be specified in dollars, points, or whatever scoring system makes sense.

4. Generate alternatives. The fourth step in the decision-making process requires identification of possible courses of action. Decision makers often spend an inappropriate amount of search time seeking alternatives, thus creating a barrier to effective decision making. An optimal search continues only until the cost of the search outweighs the value of added information.

5. Rate each alternative on each criterion. How well will each of the alternative solutions achieve each of the defined criteria? This is often the most difficult stage of the decision-making process, as it typically requires us to forecast future events. The rational decision maker carefully assesses the potential consequences on each of the identified criteria of selecting each of the alternative solutions.

6. Compute the optimal decision. Ideally, after all of the first five steps have been completed, the process of computing the optimal decision consists of (a) multiplying the ratings in step 5 by the weight of each criterion, (b) adding up the weighted ratings across all of the criteria for each alternative, and (c) choosing the solution with the highest sum of weighted ratings.

Hammond, Keeney, and Raiffa suggest 8 steps in their book Smart Choices:

1. Work on the right problem.
2. Identify all criteria.
3. Create imaginative alternatives.
4. Understand the consequences.
5. Grapple with your tradeoffs.
6. Clarify your uncertainties.
7. Think hard about your risk tolerance.
8. Consider linked decisions.

* * *

People, however, are not always entirely logical machines. In Judgment in Managerial Decision Making, the distinction between System One and System Two thinking becomes clear:

System 1 thinking refers to our intuitive system, which is typically fast, automatic, effortless, implicit, and emotional. We make most decisions in life using System 1 thinking. For instance, we usually decide how to interpret verbal language or visual information automatically and unconsciously. By contrast, System 2 refers to reasoning that is slower, conscious, effortful, explicit, and logical. System 2 thinking can be broken down into (1) define the problem; (2) identify the criteria; (3) weigh the criteria; (4) generate alternatives; (5) rate each alternative on each criterion; (6) compute the optimal decision.

In most situations, our system 1 thinking is quite sufficient; it would be impractical, for example, to logically reason through every choice we make while shopping for groceries. But System 2 logic should preferably influence our most important decisions.

* * *

When making a decision, we are psychologically influenced either consciously or unconsciously. By exploring these biases and other elementary, worldly wisdom, we hope to make you a better decision-maker.

Following a rational decision process can help us focus on outcomes that are low in probability but high in potential costs. Without easily quantifiable costs, we often dismiss low probability events or fall prey to biases. We don’t want to be the fragilista.

Even rational decision-making processes like the one presented above make several assumptions. The first assumption is that a rational decision-maker is completely informed which means they know about all the possible options and outcomes. The second major assumption is that the decision-maker does not fall prey to any biases that might impact the rational decision.

In researching decision-making processes, it struck us as odd that few people question the information upon which criteria are measured. For instance, if you are purchasing a car and use fuel efficiency as the sole criterion for decision making, you would need to make sure that the cars under consideration were all tested and measured fuel consumption in the same way. This second order of thinking can help you make better decisions.

If you want to make better decisions, you should read Judgment in Managerial Decision Making. That is the best book I’ve come across on decision making. If you know of a better one, please send me an email.

Stanovich’s book, What Intelligence Tests Miss: The Psychology of Rational Thought, proposes a whole range of cognitive abilities and dispositions independent of intelligence that have at least as much to do with whether we think and behave rationally.

 

Follow your curiosity to The best books on the psychology behind human decision making and Problem Solving 101.