Monday, 8 September 2008

Heuristic-driven biases: 1. Representativeness

1. Representativeness

Representativeness refers to the tendency to form judgements based on stereotypes.

For example, you may form an opinion about how a student would perform academically in college on the basis of how he has performed academically in school. While representativeness may be a good rule of thumb, it can also lead people astray.

For example: Investors may be too quick to detect patterns in data that are in fact random.

Investors may believe that a healthy growth of earnings in the past may be representative of high growth rate in future. They may not realise that there is a lot of randomness in earnings growth rates.

Investors may be drawn to mutual funds with a good track record because such funds are believed to be representative of well-performing funds. They may forget that even unskilled managers can earn high returns by chance.

Investors may become overly optimistic about past winners and overly pessimistic about past losers.

Investors generally assume that good companies are good stocks, although the opposite holds true most of the time.

No comments: