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Investing

Representativeness

11 Jan 2021
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Remember, heuristics are essentially inbuilt short-cuts designed to make human decision making both easier and more expedient. Representativeness is one such heuristic by which, to cope with the myriad information sources we are bombarded with every day, we tend to create stereotypes and patterns to categorise and make sense of information, often falsely.

For example, we tend to think of things as either ‘good’ or ‘bad’ based on a shortlist of qualities; however, while we may gain speed and simplicity, it is often at the expense of the more complex and nuanced reality of the situation.

Let’s put it another way. Humans assume, often incorrectly, that similarity in one aspect leads to similarities in other aspects. Accordingly, if something doesn’t seem to fit into a known category, we approximate to the nearest category available. In this way, we often tend to adopt false generalisations without being aware that we are doing so.

This can be seen prominently in the world of gambling. If we toss a coin and get heads five times in a row, we incorrectly assume or feel that the next toss is more likely to be tails than heads. However, logic dictates that tails’ chance on any toss is the same as heads — 50 per cent. This is known as the gambler’s fallacy. We assume incorrectly precisely because the pattern of alternating coin tosses sits more comfortably with us … it is more representative of the process. In other words, we expect a random process, such as tossing a coin, to yield random-looking results – we expect the results to be representative of the process that generated such results. In the same way, people assume the lottery numbers will be nicely spread out when the likelihood of the winning numbers being 1, 2, 3, 4, 5, and 6 is just the same as the likelihood of any particular set of nicely spread out numbers such as 4, 9, 17, 23, 35 and 41.

In the world of investing, false generalisations are commonplace. We often put stocks in a similar category as others based on one similarity, and in doing so have (by way of a shortcut) incorrectly assumed multiple similarities when there might, in fact, be very few. We also tend to form opinions on stocks based on limited information. We may view a stock as ‘good’ because the company’s chairperson is the chair of another successful company, when the chairperson may be the only similarity. Therefore, categorising these two companies together may be a big mistake.

So how do we go about combatting this rather sneaky heuristic? Well, keeping a simple investment diary can assist by compelling you to write down the rationale for investing in any given stock. Check your reasoning thoroughly, ensure it is not compromised by any of the cognitive biases we have looked at, and then ultimately compare your reasoning to the investment outcome, be it good or bad. Remember, good companies do not automatically make good investments, even though that particular narrative sits comfortably in our minds. It is representative of how things should be according to our interpretation of the world around us, but remember that things are seldom as they should be.

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