Representativeness involves making judgments based on stereotypes.
Representativeness is a method that your brain uses to classify things rapidly and thereby creates shortcuts. You can see a classic example of this in politics. If you have two individuals, one from the right and another from the left, and have them watch the same political program, they will have different opinions of the objectivity and fairness of the program.
As applied to investments, representativeness appears when investors become overly negative about investments that have done poorly, and overly positive about ones that have done well in the past.
From this, stocks, in particular, can become undervalued and overvalued respectively. With mutual funds, the SEC tries to help mutual fund investors avoid representativeness with its prospectus-statement that “past performance is no guarantee of future results.” Yet the tracking of new cash flow into mutual funds almost always shows investor money chasing those funds with high rates of return during the last one, three, or five years. This tendency often results in investors buying after the funds have had their best performance. Investors form a bias and believe that a fund manager who performed well in a prior period of time has a good chance of continuing to perform well in the future.
Representativeness, can be a misleading guide to future investment performance.
In addition, individuals place too much value on what they know based on their experiences—this familiarity can be confused with knowledge.
This is related to Anchoring, the tendency to hold to certain beliefs even when faced with new information. For instance, it explains why investors who have not invested in international securities are reluctant to do so. Another example is employees allocating too much of their company’s retirement plan to company stock. Obviously, they are familiar with the company so they are comfortable investing in it. While the idea of “investing in what you know” makes sense, the danger is in the difference between your actual knowledge versus what you think you know. Many employees, unfortunately, found out this difference when so many Internet and telecommunication companies went bankrupt between 2000 and 2003. This also became apparent again in 2008 when many financial institutions went into bankruptcy or were forced to merge, resulting in large losses for shareholders. Many investors were comfortable owning these
While the idea of “investing in what you know” makes sense, the danger is in the difference between your actual knowledge versus what you think you know.
There Are Two Primary Types of Representativeness: Base-Rate Neglect and Sample-Size Neglect:
Base-rate neglect refers to investors attempting to determine the potential success of a new investment by comparing it to an already understood category or previously held investment. Essentially, the investor relies on stereotypes.
Sample-size neglect refers to an investor failing to accurately consider the sample size of the data used to make a judgment. The investor makes an assumption that
a smallsample size is representative of the larger body of data.
Next. Read about Money Mistake #6. Mental Accounting.