Camille Van Vyve

14 Mar 2024

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Representativeness bias: beware of misleading associations

I invested in ArgenX, a biotech which tripled its value in one year. As Celyad is also a listed European biotech, I guess it could give me a return of around + 200% quickly. This is an example of the representativeness bias: the tendency to generalize from a few elements or particular cases.

Representativeness bias: definition

Representativeness bias occurs when the similarity between objects or circumstances impairs the ability to assess the probability of an event. So, many make the mistake of believing that two similar things or events are more correlated than they actually are.

Judgment heuristics or simplification

The representativeness bias is, like the anchoring bias described in a previous blog, part of what are called "judgment heuristics". To explain them, Tversky and Kahneman highlighted two systems of thought and decision:

• the first, which could be described as quick and intuitive, relies on mental shortcuts and often leads to errors in judgment
• the second, more thoughtful and rational, is based on structured analytical reasoning, but is slower and consumes energy

Judgment heuristics are simplification mechanisms that arise to avoid the second system: a complicated question is replaced by a simpler question, which can be answered more easily.

A story of stereotypes

In cognitive science, the representativeness bias can appear when one has to estimate the probability that an object A belongs to a class B. These probabilities are estimated as a function of the degree to which A is representative of B, i.e. say according to the degree to which A looks like B. In our introductory example, ArgenX (A) is a good representation or a stereotype of “European efficient biotech” (B). As Celyad (C) looks like A, I automatically classify it in this same category.

Past performance is no guarantee of future returns

In terms of investment, the representativeness bias also manifests itself when we base our forecasts for a company on its past performance. Under uncertainty, investors tend to believe that a history of good performance is representative of an overall performance that the company will continue to show in the future. While the future value of a business can only be estimated in terms of its future cash flows! But making cash flow projections is a tedious exercise that many prefer to substitute for a simpler, although unfounded, analysis.

Absolute value VS relative

Likewise, an investor might judge that if a company is a leader in its field, it will also be a good investment. This is another “representation” of performance, without any rational basis, because this company could very well be a leader in a declining sector or in an unfavorable economic context, which obviously risks weighing on its stock market value.

Passive investing to avoid choosing

In passive investing, you are exposed to the global market, regardless of the amount invested. There is therefore no question of choosing the securities that make up your portfolio based on their past performance or X, Y or Z criteria: diversification is the one and only criterion. As a result, you avoid choosing between intuition and reasoning, and benefit from a high-performance investment formula that is simple and quick to set up (Best of the Test, says Test Achats magazine) without straining your brain.

Start my simulation

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