As mentioned in previous blog posts, people utilize heuristics in everyday decision making without even realizing it. Heuristics allow us to make decisions or come to conclusions more efficiently, sometimes leading to faulty choices and irrational thinking. In the following, we are going to dive a little deeper into understanding these heuristics. Representativeness is a key heuristic that commonly impacts beliefs and decision making. It is the tendency to link the probability of one event based on how much it resembles another event.
Strains of representativeness
Base rate neglect
People tend to pay more attention to the event specific information and ignore the base rate. For example, think about the performance of the stock market in the 1H of 2022. Strong emotions have resulted from the events over the past 6 months as well as the recency of it in our minds. In general, when it comes to the markets, people tend to overreact to news. This year there has been news about global tensions, high inflation, interest rates, etc. It is easy to let these different press releases increase emotions and in turn cause you to believe that certain events/outcomes have more likelihood than they statistically do.
Gambler’s Fallacy
The tendency for people to believe that the probability of an outcome decreases after a series of the same outcomes. A simple example of this is flipping a coin. After flipping tails 5 times in a row, this person would believe there is a higher likelihood of tails being flipped the next time. When you look at market performance an individual would believe after a certain company has done well for an extended period that it is due for a correction even when things say otherwise.
Hot Hand Fallacy
The tendency for people to believe that after continued outcomes there is more likelihood of that same outcome. A well-known example of this is a shooter in basketball. It is the tendency to believe that if the shooter, let’s say Anthony Edwards, has made 5 shots in a row that he will continue to be hot. There is some statistical evidence that supports this phenomenon in sports but not necessarily in investing. When it comes to your financial plan it is important to understand that something that was once a good investment does not mean it always will be.
Especially after the first 6 months of the year that we’ve had, it is more important than ever to understand these fallacies. When emotions are high, they become even more prevalent. Take a moment to reflect! Have any of your beliefs or choices over that past 6 months stemmed from these strains of representativeness?
For those of you who answered yes to this question, you are most definitely not alone. The first step to minimizing the impact of heuristics is awareness. When high emotions result from news reports, publications, ect. take a step back and reflect and evaluate the catalysts of your conclusions. Heuristics like, representativeness, are likely to be playing a key role. Another step to avoid heuristics is to apply logical thinking giving more weight to statistical evidence. And lastly, ask for feedback. It is often easier for others to notice when representativeness is in play. Seeking feedback from those who are experienced in that specific area, can be most helpful.