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A Holistic Approach to Representativeness Bias

Representativeness bias--or the tendency to use a prior frame of reference for current decisions--can be associated with hindsight, recency, and status quo bias.

Michael M. Pompian, 08/16/2012

This month's article is the 11th in a series called "Managing Behavior in a Volatile Market" and Part II of a discussion on a very important bias, representativeness. This series provides data and insight into the identification of key behavioral biases and also shows how to manage client behavior and emotion in this highly volatile market environment.

A substantial part of this series will be a review and analysis of answers to behavioral questions that were completed by a diverse set of 178 individual investors in 2011. The investors polled were not subscribers to Morningstar.com and/or Morningstar investor newsletter publications like the last survey, but they fit a similar profile in terms of investment objective and investor description.

By way of background, the survey questions were written to identify 20 key behavioral biases that I outline in my book, Behavioral Finance and Wealth Management. The second edition of the book, with updated biases and new case studies, is now available.

As noted in earlier articles, the intent of the survey was twofold. First, I wanted to identify the most prevalent biases ("Primary Biases"), so advisors would know what to look for when working with their clients. Second, I wanted to identify what secondary behaviors ("Secondary Biases") might also be lurking behind these primary biases. In other words, if client Smith has easily recognizable bias X, what other of the 19 biases might client Smith also be subject to?

The purpose in doing this is that advisors can hopefully recognize not only primary biases, but secondary biases as well. Often it is the unrecognizable biases that can cause substantial harm when attempting to keep clients on track to attaining financial goals. Advisors can hopefully gain significant insight into a range of a client's behavioral tendencies simply by being aware of a single common bias.

In order to rank as a primary bias, 50% or more of respondents need to answer at least "Agree" or "Strongly Agree" to a question designed to identify a certain bias.

There were seven biases that garnered at least 50% positive responses:

Loss Aversion Bias: The pain of losses is greater than the pleasure of gains

Anchoring Bias: Getting "anchored" to a price point when making an investment decision

Hindsight Bias: Believing that investment outcomes should have been able to be predicted

Recency Bias: Taking investment action based on the most recent data or trend rather than putting current situations into historical perspective

Representativeness Bias: Making current investment decisions using the results of past similar investments as a frame of reference

Status Quo Bias: Not taking action to change one's investment portfolio (i.e., doing nothing when prompted to do so)

Regret: Past (poor) decisions affect future investment decisions

When you are providing advice to clients, at a minimum you should be looking out for these seven biases, as they are likely to be the most commonly encountered. For example, let's say you identify that a client is loss averse. What are the other irrational biases they might be subject to? This series is intended to help answer this question for the seven biases listed above and provide tips on overcoming them.

In this article we will review the biases associated with representativeness bias. Fifty-three percent of 178 people responded that they agreed or strongly agreed to a question asking them if they were subject to representativeness bias (i.e., the idea that some investors tend to use prior experience as a frame of reference for current decisions). Of that group, at least half of those people were also subject to the following six biases:

1. Anchoring (71%)
2. Regret (62%)
3. Loss Aversion (61%)
4. Hindsight (54%)
5. Recency (52%)
6. Status Quo (52%)

For example, of the respondents who said they were subject to representativeness bias, 71% of them were also subject to a question designed to identify anchoring bias, and so on for the other five biases.

Below, I will provide commentary on the second three of these biases: hindsight, recency, and status quo. I will discuss why these biases are likely linked with representativeness and what you can do to counsel a client who has these biases.

Representativeness and Hindsight
Representativeness and hindsight certainly go together. Clients subject to representativeness use prior experience as a frame of reference for current decisions. Clients influenced by hindsight see past events as having been predictable and reasonable to expect.

People tend to remember their own predictions of the future as more accurate than they actually were because they are biased by the knowledge of what has actually happened. In other words, to alleviate discomfort associated with an unexpected occurrence, people tend to view things that have already happened as being relatively inevitable and predictable.

This view is often caused by the reconstructive nature of memory. When people look back, they do not have perfect memory; they tend to "fill in the gaps" with what they prefer to believe. In doing so, they may prevent themselves from learning from past mistakes.

When connecting this bias to representativeness, we can have a situation in which an investor may see an investment opportunity through the lens of a prior experience that included a false belief that they were able to predict the outcome. This behavior may cause them to have too much confidence in their investment acumen and consequently make costly mistakes.

Advice: As noted, hindsight bias often causes investors to overestimate the degree to which they predicted an investment outcome, thus giving them a false sense of confidence for future investments. In a situation in which an investment appreciates for reasons other than expected, it is important to make note of this fact because it is easy to fall into the trap of thinking, "I'm smart because this investment did well," but it may have done so for the wrong reason(s). Similarly, you may have had an investment thesis that was exactly right but some other event(s) may have caused the investment to perform poorly. This is the random nature of investing. Always try to be introspective and challenge your assumptions. This will make you and your clients better investors in the long run.

Representativeness and Recency
Representativeness and recency are naturally tied. Representativeness, as we know, occurs when investors use prior experience as a frame of reference for current decisions. Investors subject to recency bias put extra weight on events that occurred more recently rather than events that occurred in prior time periods.

Putting these two ideas together, clients often have their own reference points or lenses through which they judge current investment decisions--and these views can be tainted by looking at recent information. When this happens, they may attempt to put decisions in context based on current trends in the marketplace. This can be "hazardous to your wealth," because often investors who dive into asset classes that have had strong recent performance end up disappointed because they pay too high a price upon entry. One example is real estate in the last market cycle. Many who bought speculative real estate in 2006-2007 may still not be back to even.

Advice: As I have noted in past articles, advisors need to encourage their clients to judge every investment idea on its current merits, not based on past experiences. It's not always easy! Investment ideas and asset classes go through cycles of attractiveness and unattractiveness. Be flexible in your thinking! And, most importantly, pay attention to valuation.

Representativeness and Status Quo
Representativeness and status quo bias are connected. This may need some explanation, however. When people are subject to status quo bias, they don't embrace change easily. As noted, investors with representativeness bias use prior experience as a frame of reference for current decisions. Putting the two ideas together, some investors may be more comfortable seeing an investment opportunity in their own preferred historical context, which may involve not making changes. In this case, clients may be more comfortable keeping things the same than dealing with change, and thus they do not necessarily look for opportunities where change is beneficial. For example, a client may think about a past investment in which they lost money--if only they had done nothing!

Advice: Getting investors who do not wish to take action to "get off the dime" and make some decisions is not easy. And demonstrating through quantitative analysis is not always effective. Similar to regret, what I often recommend is to take action in smaller increments. For example, if the task is to get invested, then clients can "average in" to the markets--taking three months or six months to get invested. This often puts the fear of losses aside; if an investment goes down you can buy more at lower prices.

Hopefully you have learned something about representativeness and the biases connected with it. When you encounter a client with representativeness bias, think about the examples you have read about in this article. It might help to build a better client relationship!

In next month's article, we will review the second three biases associated with recency.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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