Representativeness Heuristic: Understanding Cognitive Bias in Investing

Representativeness heuristic bias occurs when the similarity of objects or events confuses people’s thinking regarding the probability of an outcome. People frequently make the mistake of believing that two similar things or events are more closely correlated than they actually are. This representativeness heuristic is a common information processing error in behavioral finance theoryBehavioral FinanceBehavioral finance is the study of the influence of psychology on the behavior of investors or financial practitioners. It also includes the subsequent effects on the markets. It focuses on the fact that investors are not always rational.

Representativeness Heuristic Example

Let’s look at an example of information processing errors, commonly referred to as heuristic simplification. Let’s imagine the following scenario:

Consider Laura Smith. She is 31, single, outspoken and very bright. She majored in economics at university and, as a student, she was passionate about the issues of equality and discrimination.

Is it more likely that Laura works at a bank? Or, is it more likely that she works at a bank AND is active in the feminist movement?

Many people when asked this question go for option 2, that Laura works in a bank but is also active in the feminist movement. But that is incorrect. In fact, in giving that answer, they’ve actually been influenced by representativeness heuristic bias.

One of the things you want to think about is that you want to judge things strictly as they are statistically or logically, rather than as they merely appear.

The second option, “Laura works in a bank and is active in the feminist movement” is a subset of the first option, “Laura works in a bank.” Because of that fact, the second option can’t be more probable than the first. (The odds of Laura’s behavior(s) falling into a narrower subset must be statistically lower than the odds of her falling into the larger group of “bank employees”.)

This example is an excerpt from CFI’s Behavioral Finance Course.

Protecting against the Representativeness Heuristic

Let’s look at strategies to protect against this heuristic as an investor. You may want to consider keeping an investment diary. Write down your reasoning and then match it to the outcomes, whether good or bad.

In financial markets, one example of this representative bias is when investors automatically assume that good companies make good investments. However, that is not necessarily the case. A company may be excellent at their own business, but a poor judge of other businesses.

Another example is that of analysts forecasting future results based on historical performance. Just because a company has seen high growth for the past five years doesn’t necessarily mean that trend will continue indefinitely into the future.

Additional Resources

Thank you for reading this CFI guide to the representativeness heuristic and its place in financial decision making. To learn more, check out CFI’s Behavioral Finance Course.

Additional helpful resources include:

• Behavioral Interview QuestionsBehavioral Interview QuestionsBehavioral interview questions and answers. This list includes the most common interview questions and answers for finance jobs and behavioral soft skills. Behavioral interview questions are very common for finance jobs, and yet applicants are often under-prepared for them.
• Hindsight BiasHindsight BiasHindsight bias is the misconception, after the fact, that one "always knew" that they were right. Someone may also mistakenly assume that they possessed special insight or talent in predicting an outcome. This bias is an important concept in behavioral finance theory.
• Anchoring BiasAnchoring BiasAnchoring bias occurs when people rely too much on pre-existing information or the first information they find when making decisions. Anchors are an important concept in behavioral finance.
• Loss Aversion BiasLoss AversionLoss aversion is a tendency in behavioral finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains. The more one experiences losses, the more likely they are to become prone to loss aversion.