Representativeness bias. Your mind classifies new information using familiar analogies. However, it increases your portfolio’s investment risks.
Representativeness bias occurs when new concepts are classified based on existing analogies, leading to incorrect understanding and investment risks. To optimise portfolios, investors should rely on comprehensive statistical analysis, diversify across asset classes, and avoid making decisions based on stereotypes. Discover whether you are prone to a representativeness bias and the extent to which it affects your investment decisions with PRAAMS BehaviouRisk.
Behavioural science. What is representativeness bias?
It is a behavioural tendency to classify new and unknown concepts in a way that resembles familiar constructs. Our perception tries to find the closest analogy from our experience to describe new knowledge. However, sometimes new and old concepts are incredibly different, resulting in an incorrect understanding of new ideas. Worse, mistaken perception tends to stay with us for a long time.
Representativeness bias is a cognitive bias, i.e., a mistake in decision-making. These biases can be effectively corrected with education.
What are the consequences and portfolio risks?
Such stereotypes impair investors’ ability to make the right investment decisions. Consider an investor who, without diligent risk analysis, classifies a stock as a ‘growth stock’ because it resembles other stocks he used to classify as ‘growth stocks’, i.e. it fits his stereotype of a ‘growth stock’. The incorrect ‘growth stock’ label might result in poor decisions. Another aspect of the bias is making decisions based on small samples, incorrectly assuming these are representative of the entire population. One might want to jump to a conclusion after seeing just a few examples, while the broader picture may be more complex and different.
What can I do to make my portfolio optimal?
Choosing a portfolio manager based on its most recent performance or relying on a trending research analyst with several good top trade ideas is unwise. Studies show that the previous year’s top-ranked funds tend to become the current year’s low-rankers. The same is valid for analysts: great advice tends to be followed by poor. Unsurprisingly, the situation is the same for asset classes — a good performance yesterday does not guarantee a good performance tomorrow. The better asset allocation strategy is to hold a diversified combination of assets and asset classes to level out temporary spikes. Also, it is risk-intelligent to avoid attempts to pick the best performers for the next year by basing your decision solely on recent performance. Portfolio selection must always be based on comprehensive long-term statistical analysis.
Another piece of advice is cycle diversification. Different industries react differently to economic cycles. Some sectors decline before the cycle and rise before it reaches its lowest point; the decline of others coincides with the cycle, while the rest are laggards. A diversified portfolio should include examples of all three types to level out the price fluctuations caused by an economic cycle. Similarly, higher-risk profile asset classes such as stocks and long-term bonds tend to exhibit a sharper reaction to economic cycles, displaying more significant swings during expansions and contractions. A smart investor must remember these nuances and diversify the portfolio with less volatile instruments to level out the cyclical effect.
Finally, basing decisions on stereotypes rather than statistics may lead to poor investment results and undermine investment objectives. If an investor is asked whether the AA-rated bond of a company with declining revenue, shrinking net profit, and problems with suppliers should be considered a safe or unsafe investment. Some would focus on the worsening financials and supplier chain risks as these are risk definitions for a risky investment and answer that such an investment is unsafe. However, we already know that this is an AA-rated bond. Thus, the probability of default is very close to zero, so it is likely to be a safe investment when all factors are considered.
