Representativeness is another cognitive error that can impair your decision making. Simply stated, it is when you classify new information based on past categories and you misestimate probabilities. Does it sound complicated? Let me better explain with an example, the so-called “Linda Problem”.
Suppose there is Linda, 31 years old, single, outspoken, and very bright girl. She has got a major in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice. She also participated in an antinuclear demonstration. Among the following two scenarios, which one do you think is more probable (just note the first answer that comes to your mind):
- Linda is a bank teller
- Linda is a bank teller and she is also active in the feminist movement.
What was your answer? The majority of people would say that the second one is more likely. After all, the description of Linda fits perfectly as a member of a feminist movement. However, that’s the wrong answer.
The explanation is that to be a bank teller and active in the feminist movement, Linda needs to be a bank teller. Hence, the second group is a subset of the first one. As a matter of fact, every person who is a bank teller and active in a feminist movement is a bank teller, but there may be bank tellers that are not part of a feminist movement. As a consequence, in terms of probability, it is more likely that Linda belongs to the first group.
So this is an example of misestimating probabilities. What about the wrong classification? Look at the person in this picture. Her name is Sonia Dara, a sport illustrated swimsuit model. What is the first thing that comes to your mind when looking at her? Ok, I need to be more precise here to avoid misunderstanding from the male audience. Let me rephrase to “what do you think about her in terms of intelligence and interests?” Again, just notice the first thing that comes to your mind.
Sonia Dara. Picture taken from https://www.listal.com
Everyone may have different views on that, but I bet that not many thought at first something like: “Oh yes, she is definitely an Economics major at Harvard University”. Yet, she is.
This is a clear example of classifying someone according to previous categories we have in mind. And it happens all the time when we judge people from the car they drive or the clothes they wear.
Coming back to trading, why is representativeness so dangerous? If you are not aware of it, you may decide that a stock is a good investment just because recently it is going up. Maybe, you would fail to notice that the whole market is going up during that period, so the stock is not better than others.
How to address the representativeness? One way is to always ask yourself before you take any decision, what is the probability that something (e.g., an investment) belongs to one category rather than another one. In addition, remember to always follow your rules, and do not modify them according to what you feel is the right choice. Often times, it is not.
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