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When Things Aren't What They Seem: The Dangers of Representative Bias

Mistakes can happen when investors project investing outcomes based solely on their own pre-existing ideas.

Michael M. Pompian, 04/28/2016

This month's article is the 15th in a series called "Behavioral Finance and Retirement," which is intended to provide insight to advisors on the unique needs and financial behaviors of clients who are entering that period of transition called "retirement."

I put retirement in quotation marks because people today are not retiring the way they used to. The days of the retirement party, the gold watch, and sitting out one's years doing crossword puzzles and watching "Wheel of Fortune" are over for most people.

We've all heard the analogy that the baby boomers are like a baseball going through a garden hose. Well, the baseball is getting to the end of the hose, and it's not leaving without a bang! And before it leaves, it will be a financial force to be reckoned with.

To serve retired clients properly, there are some key themes that advisors need to be aware of:

1. People are living longer than ever thanks in part to medical technology and better living habits such as diet and exercise. This is extending the length of time people are in a nonworking phase of life.

2. People's definition of retirement is changing, which is having a major impact on how individuals manage their finances.

3. In some cases, a certain segment of the population will have no choice but to produce some type of income after they leave the traditional workforce.

4. The responsibility of planning and investing for retirement has shifted in large part to the employee/retiree and away from corporations. As a result, behavioral biases significantly affect individuals who are entering or already in this phase of life.

In this article we are exploring another bias that affects investments in the retirement planning process: representativeness bias. This bias occurs as a result of a flawed perceptual framework when processing new information.

To make new information easier to process, some investors project outcomes that resonate with their own pre-existing ideas. An investor might view a particular stock, for example, as a value stock because it resembles an earlier value stock that was a successful investment--but the new investment is actually not a value stock. Imagine a high-flying biotech stock with scant earnings or assets dropping 25% after a negative drug-trial announcement. Some biased investors may take this situation to be representative of a "value" stock because it is cheap, but biotech stocks don't typically have earnings while traditional value stocks have had earnings in the past but are temporarily underperforming.

A jar of marbles provides another common example. Suppose you know that a jar has 100 marbles, but you don't know the colors of the marbles. You pull out five marbles, and three of them are red. You may, therefore, conclude that the majority of the marbles in the jar are red. Even though this is not a statistically significant sample, it is how many people make estimates.

Investment Implications for Retirement Planning
Let's consider a specific investment example of representativeness bias in the retirement context. Suppose a 65-year-old retiree investor is terrified by a recent movement in the markets, such as what occurred in 2008-09; I had personal experience with some clients who believed that we were going to experience a second "Great Depression," including a decade or more of depressed stock prices. In other words, some investors felt the market movements of 2009 were "representative" of the Great Depression. Just take a look at the following chart.

It's not hard to see how some investors got caught up in the idea we were heading for another Depression-like period and felt compelled to sell out of the markets. Of course, the right thing to do was to remain unbiased and actually buy during this period. Of course, that's very hard to do, but with your help, clients can be guided to a successful outcome.

In my own experience, I've seen many investors make incorrect conclusions about a current situation because they believe it is representative of a past episode. You should counsel your clients to "maintain the course" and stay invested during rocky times. Over time this has proven to be a sound strategy.

 

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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