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Representativeness Bias: I’ve seen this before so it must mean this!!

November 23, 2017

 

 

As traders, we rely on our experience and knowledge to make sense of market information. But
what if even this is not enough?

 

People classify new information based on past experience and classification. However if we
place undue weight on them and not recognize when they are not appropriate, we engage in
Representative bias.

 

So how can this bias negatively affect your investment decisions? The first case is wrong initial
classification. If I assume the stock of ABC company is a value stock, every new piece of
information I will interpret based on how it fits with this initial classification, when in fact it
might have been a growth stock. Not only was initial classification wrong, but it caused my
subsequent analysis to be flawed.

 

Investors can deal with this issue by thinking in probabilities. If I assign a probability that ABC is 80% likely to be a value stock, and new information keeps coming that contradicts this
classification, I just keep updating that probability until I feel its warranted to change it. Instead
of accepting it as correct and basing all analysis thereafter on it. Possibly interpreting it wrongly.

 

The second case is when we use representative bias as a heuristic (mental shortcuts) , simple
efficient rules we use to form judgment and make decisions. However, is the issue is complex,
we shouldn’t base decisions on simple rule of thumb. In a way it’s a type of stereotyping,
quickly categorizing things based on little information Such as assuming a person is smart
because they wear glasses.

 

So, what do to do?

 

- Recognize you are limited, your experience and knowledge won’t be able to make sense
of everything

 

- Due diligence, don’t quickly jump to conclusions because it resembles something in the
past, take the time to undertake a thorough and more difficult analysis


- Be careful about attaching too much weight on initial classification, or neglecting it and
placing too much weight on new information. Always try to assess their proper
probabilities


So remember, just because it looks like a duck, quacks like a duck, then it doesn’t have to be a
duck!

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