Behavioural Economics Dictionary

Cognitive Bias

A cognitive bias is a systematic deviation from norm and rational thinking that often leads to misinterpret information or jump to inaccurate conclusions. Individuals create their own "subjective reality" from their perception of the object. An individual's construction of reality may dictate their behavior in the world.

An example of this is the systematic overestimation of “spectacular” causes of death, such as shark attacks, over less salient, more frequent causes (stroke). If the former was reported on the news, it’ll make these events stick in the audience’s mind. This results in a disproportionate weight perceived if compared to the reality of things.

Action Bias

The Action Bias or “Do Something Syndrome” is the outcome of our tendency to always do something by intervening when in fact things should be left as they are. This bias is a mix of a lack of patience and a strong desire to intervene without thinking and without considering the possibility of a downside.

Example: Suppose you’re a soccer goalkeeper, preparing to block a penalty kick in the midst of an important game. If you’re like most goalies, when attempting to stop a penalty kick, you’ll jump to either the left or right almost every time. Yet your chances of successfully blocking the kick are statistically greater if you simply stay still.

Confirmation Bias

The confirmation bias is the tendency to notice, focus on, interpret a situation, and give greater confidence to evidence that fits with our existing beliefs or values. Confirmation Bias is particularly problematic because it does not allow a person’s perspective to change based on evidence. Evaluating evidence takes time and energy, therefore our brain looks for such shortcuts to make the process more efficient.

Example: Imagine that you read an article about a political scandal, confirming everything you thought about a politician you dislike. You text a friend, who supports that politician, and she thinks the article completely vindicates the politician. Both friends read the same article and come up with different conclusions according to their own pre-existing beliefs.

Hindsight Bias

The hindsight bias is our tendency to look back at an unpredictable event and think it could have been predicted. Another name for this bias is the ‘knew-it-all-along’ effect.

This bias can have a negative influence on decision-making since it can lead to overconfidence in consequence assessment which can make an individual take unnecessary risk.

Example: A stockbroker was unsure whether he should buy a stock and decided not to buy it. However, a few months later the stock value increased by 50% and the stockbroker claims he was certain the value would rise.

IKEA Effect

The IKEA effect is a cognitive bias in which we value products we create more favorably than those are brought pre-assembled. The more involved people are in creating something the more they value the end product.

Example: The “do-it-yourself” strategy is widely used by companies. An example includes the Build-a-Bear which allows children to assemble their own stuffed animals.

Gambler’s Fallacy

The Gambler’s Fallacy is the irrational belief that prior outcomes in a series of events affect the probability of a future outcome, even though the events in question are independent and identically distributed.

This fallacy can lead to suboptimal decision-making. Part of making an informed decision surrounding a future event is considering the causal relationship it has with past events. In other words, we connect events that have happened in the past to events that will happen in the future but that are not causally related even though we think they are. What follows is a probabilistic outlook that is off the mark, and ignorance of the true causes of the event.

Example: When someone flips a coin, if the headlands face up, say, four or five times, most people will believe that the coin will land on the tails side next time, occasionally even arguing that the repeated “heads” coin increases the likelihood of a future “tails” coin.

Spotlight Effect

The Spotlight Effect is the tendency we have in overestimating how much other people are paying attention to us. In other words, we tend to think there is a “spotlight” on us at all times. This bias shows up frequently in our day-to-day lives both in positive situations and in negative ones.

The Spotlight Effect causes us to have an exaggerated view of our own significance to the people around us, leading us to misjudge situations and make decisions based on our overly inflated feelings of visibility.

Example: Before a team meeting at work, you overhear your co-workers talking and you join the conversation. After a long moment of silence, someone says, “Actually, we were talking about something else.” You apologize for interrupting and back away as you look around nervously, convinced the entire room overheard.

Bottom-Dollar Effect

The Bottom-Dollar effect describes our tendency to dislike products and services that exhaust our remaining budget. We are less satisfied with our purchases if they cause a strain on our finances.

The Bottom-Dollar effect suggests that we feel greater pain at spending money when we are near the end of our budget and therefore derive less pleasure from the purchase. That means we are spending money without even getting to feel good about what we spent it on, which doesn’t seem very logical. Our dissatisfaction has nothing to do with the actual product, but with the timing at which we bought it.

Example: Imagine two people paying the same ticket price for the same movie except they experience big differences in satisfaction. This happens if one of them exhausted all their funds in their pocket while the other did not.