Representativeness Bias

BIAS DESCRIPTION

Bias Name: Representativeness

Bias Type: Cognitive

 When people are asked to judge the probability that

an object or event A belongs to class or process B, probabilities are evaluated by the degree to which A is representative of B, that is, by the degree to which A resembles B.

 classifying objects and thoughts

processing

new information by simultaneously incorporating insights gained from (usually) relevant past experiences Resultsdeception, producing an incorrect understanding of the new element

Technical Description.
Overreaction

gambler's fallacy: subjective psychological dynamics,

not mathematical realities, inspire this perception Base-rate Neglect: investors tend to rely on stereotypes when making investment decisions (value stocks). Sample-Size Neglect: law of small numbers.

EXAMPLES OF THE HARMFUL EFFECTS OF BASE-RATE NEGLECT FOR INVESTORS

What is the probability that AAA-rated Municipal

Bond A (issued by an inner city and racially divided county) belongs to Group n B (risky municipal bonds) rather than to Group C (safe municipal bonds)?

EXAMPLES OF THE HARMFUL EFFECTS OF SAMPLE-SIZE NEGLECT FOR INVESTORS

Investors can make significant financial errors when

they examine a money managers track record

Inadequate statistical data

investigating track records of stock analysts-success

of an analysts past few recommendations

 game of squash-theorem from probability theory: the

larger the sample of rounds, the greater likelihood of achieving the expected outcome (to go longer) time diversification-investors should spread their assets across ventures operating according to a variety of market cycles, giving their allocations plenty of time to work properly

Which Sequence of Coin Toss Results Appears Likelier?

Gamblers Fallacy, or the Law of Small Numbers

If six tosses of a fair coin all turn out to be heads, the

probability that the next toss will turn up heads is still one-half. investors ignore the statistically dominant result in order to satisfy their need for patterns

Advice
1. How does the fund that you are considering perform relative to similarly sized and similarly styled funds? 2. What is the tenure of the managers and advisors at the fund? 3. Are the managers well known and/or highly regarded? 4. Do the funds three-, five-, and ten-year returns all exceed market averages?

 Conservatism bias is a mental process in

which people cling to their prior views or forecasts at the expense of acknowledging new information. investor receives bad news-companys earnings contradicts another earnings estimate issued the previous month. Under-reaction

 Conservatisms vs. representativeness (under-

reaction and overreaction) If new data appears to fit, or appears representative of, an underlying model, then people may overweight that data in accordance with representativeness bias. if no representative relationship is evident, conservatism can dominate, which subsequently underemphasizes new data.

Over-weight base rate

Conservatism causes individuals to overweight base

rates and to under-react to sample evidence. As a result, they fail to react as a rational person would in the face of new evidence

 processing new information and updating beliefs is

cognitively costly and people may overreact to information that can be easily processed (Prof. Shleifer of Ohio State University).

PRACTICAL APPLICATION (James Montier: Behavioral Finance: Insightsn into Irrational Minds and Markets
stock market tends to under-react to fundamental

informationbe it dividend omissions or an earnings report. In the US, in the 60 days following an earnings announcement, stocks with the biggest positive earnings surprise tend to outperform the market by 2 percent, even after a 45 percent outperformance in the 60 days prior to the announcement.

PRACTICAL APPLICATION (James Montier: Behavioral Finance: Insights into Irrational Minds and Markets
People tend to cling to a view or a forecast. Once a

position has been stated, most people find it very hard to move away from that view. When movement does occur, it does so only very slowly.

Implications for Investors

Conservatism bias can cause investors to cling to a view

or a new forecast, behaving too inflexibly when presented with new information. When conservatism-biased investors do react to new information, they often do so too slowly. For example, if an earnings announcement depresses a stock that an investor holds, the conservative investor may be too slow to sell. Conservatism can relate to an underlying difficulty in processing new information. Because people experience mental stress when presented with complex data, an easy option is to simply stick to a prior belief.

Investor Overreaction
De Bondt and Thaler found that stocks with extremely poor

returns over the previous five years subsequently dramatically outperformed stocks with extremely high previous returns, even after making the standard risk adjustments. Barberis, if an investor ranks thousands of stocks based on how well they did over the past three to five years, he or she can then make a category for the biggest losers, the stocks that performed badly, and another for the biggest winners. What you will find is that the group of the biggest losers will actually do very well on average over the next few years. So it is a good strategy to buy these previous losers or undervalued stocks. loser stocks may simply be stocks that investors have become excessively pessimistic about. As the misperception is corrected, these stocks earn high returns.

Investor Underreaction
Barberis, Vishny, and Shleifer- investors sometimes

also make the mistake of under-reacting to certain types of financial news. Good news and bad news- signals an inefficient market Over reaction theory-long run performance Under reaction theory-short run performance.