Behavioural finance refers to the study of psychological influences and biases that affect the behaviour or decisions of investors. It also studies how these influences affect the market. One of the primary areas in behavioural finance is the study of biases. A behavioural bias is an irrational belief that can affect an investor’s decision making, mostly unconsciously. One such bias comes from the representativeness heuristic.
What is Representativeness Heuristic?
Representativeness heuristic refers to the process individuals go through when estimating the likelihood of an event. When faced with such decisions, individuals usually use mental shortcuts or preexisting beliefs to make comparisons. This preexisting belief or mental shortcut is known as representativeness heuristic. This process consists of making decisions based on how they compare to beliefs that individuals have in their minds.
Representativeness heuristic can be significantly helpful in any decision-making process. It is because it helps make the process faster and, thus, shorter. However, it can also lead to individuals making wrong decisions. Heuristics, or these mental shortcuts, can help in many fields. However, in deliberate decision-making, they can cause biased decisions.
How does Representativeness Heuristic cause bias?
Representativeness heuristic involves finding similarities between decisions and acting accordingly. However, it can cause biased opinions, especially when individuals establish resemblance even where none exists. There are many reasons why individuals may make such comparisons. However, the primary cause is having preexisting beliefs or opinions about a specific object or event.
Another reason why representativeness heuristic bias may occur is due to time or resource constraints. When individuals don’t make decisions by comparing all the available information, it causes them to establish biased opinions. These opinions usually come from existing beliefs or mental shortcuts. Although there may be no or minor similarities between their existing beliefs and the specific decision, they still make comparisons.
How can individuals avoid Representativeness Heuristic Bias?
Like most other biases, one of the most efficient protection against representativeness heuristics is knowing it exists. When individuals are aware of the tendency to make comparisons even when none exist, they will make better decisions. Similarly, reflecting on their judgments for every decision can be helpful in establishing whether they have a biased opinion.
Another counteraction against this bias is being open to information. Often, individuals ignore information that can change their decisions. The primary cause of this comes from their tendency to compare new events with preexisting beliefs. Once they consider new opinions or feedback, they can make better decisions. Lastly, through critical thinking and applying logic to decisions, individuals can avoid representativeness heuristic bias.
Why is Representativeness Heuristic Bias crucial?
The representativeness heuristic is crucial for individuals from all fields for several reasons. One of the primary reasons is that it gives rise to various other biases. For example, the representativeness heuristic can lead to conjunction fallacy or gambler’s fallacy. Furthermore, it can also be used to influence or manipulate individual’s opinions.
For investors, the representativeness heuristic can also be crucial. During the investing process, investors come across various options that may have some resemblances. Usually, however, these similarities are not prominent. Despite that, investors end up making decisions based on them. Consequently, it leads to substantial losses for them.
The representativeness heuristic is a process in which individuals use mental shortcuts when estimating the possibilities of events. It can cause them to make comparisons and seek out similarities where there are none. The representativeness heuristic is avoidable in several ways. Despite that, individuals let it influence their decisions.