Subjective Probabilities: Psychological Evidence and Economic Applications

Abstract

Real-life decision makers are often forced to estimate the likelihood of uncertain future events. Usually, economists assume that agents behave as though they are fully rational, employing statistical rules to assess probabilities, and that they maximize expected utility. Psychological studies, however, have shown that people tend not to adhere to these rationality postulates. We review three rules of thumb taken from the psychology literature that people have been shown to rely on when assessing the likelihood of uncertain events. We construct a simple model of belief formation that incorporates these rules and present one formal and two illustrative applications in which these psychological phenomena cause deviations from anticipated economic outcomes.

The Availability Heuristic and Investors' Reaction to Company-Specific Events

“…Frieder [2003] finds that stock traders seek to buy after large positive earnings surprises and sell after large negative earnings surprises and explains this tendency by the availability heuristic, assuming that the salience of an earnings surprise increases in its magnitude. Chiodo et al [2003] construct a simple model of belief formation based on the assumption that it is easier for people to recall information that has recently arrived, and, respectively, investors overreact to new information. They analyze some economic phenomena, for example, that stocks with very high levels of press coverage underperform in the subsequent two years and provide heuristics-based explanations.…”